Monthly Archives: April 2014

Liberal Education

Scott Samuelson at The Atlantic has posted on teaching philosophy at a community college.  I have urged my own kids to pursue a liberal education, for their own benefit.  Money quote:

Henry David Thoreau is as relevant as ever when he writes, “We seem to have forgotten that the expression ‘a liberal education’ originally meant among the Romans one worthy of free men; while the learning of trades and professions by which to get your livelihood merely, was considered worthy of slaves only.”

One minor sticking point:  I’m pretty sure STEM stands for Science, Technology, Engineering, and Math.  Not economics (although they use math, it’s not a science).

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I haven’t done this in a while.  You really need to read this whole thing.  It’s about how, now instead of providing an implicit guarantee to big banks, along with that, Congress is working to add an explicit guarantee to the mortgage backed securities.  Yes, those things that went bad to start the last financial crisis.  Here’s the link to David Stockman’s blog, where this is published..

The Johnson-Crapo Scam: More Reasons To Kill Fannie/Freddie Dead

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The leaders of the U.S. Senate Banking Committee, Sen. Tim Johnson (D., S.D.) and Sen. Mike Crapo (R., Idaho), released a draft bill on Sunday that would provide explicit government guarantees on mortgage-backed securities (MBS) generated by privately-owned banks and financial institutions. The gigantic giveaway to Wall Street would put US taxpayers on the hook for 90 percent of the losses on toxic MBS the likes of which crashed the financial system in 2008 plunging the economy into the deepest slump since the Great Depression. Proponents of the bill say that new rules by the Consumer Financial Protection Bureau (CFPB) –which set standards for a “qualified mortgage” (QM)– assure that borrowers will be able to repay their loans thus reducing the chances of a similar meltdown in the future. However, those QE rules were largely shaped by lobbyists and attorneys from the banking industry who eviscerated strict underwriting requirements– like high FICO scores and 20 percent down payments– in order to lend freely to borrowers who may be less able to repay their loans. Additionally, a particularly lethal clause has been inserted into the bill that would provide blanket coverage for all MBS (whether they met the CFPB’s QE standard or not) in the event of another financial crisis. Here’s the paragraph:

“Sec.305. Authority to protect taxpayers in unusual and exigent market conditions….

If the Corporation, the Chairman of the Federal Reserve Board of Governors and the Secretary of the Treasury, in consultation with the Secretary of Housing and Urban Development, determine that unusual and exigent circumstances threaten mortgage credit availability within the U.S. housing market, FMIC may provide insurance on covered securities that do not meet the requirements under section 302 including those for first loss position of private market holders.” (“Freddie And Fannie Reform – The Monster Has Arrived”, Zero Hedge)

In other words, if the bill passes, US taxpayers will be responsible for any and all bailouts deemed necessary by the regulators mentioned above. And, since all of those regulators are in Wall Street’s hip-pocket, there’s no question what they’ll do when the time comes. They’ll bailout they’re fatcat buddies and dump the losses on John Q. Public.

If you can’t believe what you are reading or if you think that the system is so thoroughly corrupt it can’t be fixed; you’re not alone. This latest outrage just confirms that the Congress, the executive and all the chief regulators are mere marionettes performing whatever task is asked of them by their Wall Street paymasters.

The stated goal of the Johnson-Crapo bill is to “overhaul” mortgage giants Fannie Mae and Freddie Mac so that “private capital can play the central role in home finance.” (That’s how Barack Obama summed it up.) Of course, that’s not really the purpose at all. The real objective is to hand over the profit-generating mechanism to the private banks (Fannie and Freddie have been raking in the dough for the last three years) while the red ink is passed on to the public. That’s what’s really going on.

According to the Wall Street Journal, the bill will

“construct an elaborate new platform by which a number of private-sector entities, together with a privately held but federally regulated utility, would replace key roles long played by Fannie and Freddie….”

“The legislation replaces the mortgage-finance giants with a new system in which the government would continue to play a potentially significant role insuring U.S. home loans.” (“Plan for Mortgage Giants Takes Shape”, Wall Street Journal)

“Significant role”? What significant role? (Here’s where it gets interesting.)

The WSJ:

“The Senate bill would repurpose the firms’ existing regulator as a new “Federal Mortgage Insurance Corp.” and charge the agency with approving new firms to pool loans into securities. Those firms could then purchase federal insurance to guarantee payments to investors in those bonds. The FMIC would insure mortgage bonds much the way the Federal Deposit Insurance Corp. provides bank-deposit insurance.”

Unbelievable. So they want to turn F and F into an insurance company that backs up the garbage mortgages created by the same banks that just ripped us all off for trillions of dollars on the same freaking swindle?

You can’t be serious?

More from the WSJ: “Mortgage guarantors would be required to maintain a 10% capital buffer against losses and to have that capital extinguished before the federal insurance would be triggered.”

10 percent? What the hell difference does 10 percent make; that’s a drop in the bucket. If the banks are going to issue mortgages to people who can’t repay the debt, then they need to cover the damn losses themselves, otherwise they shouldn’t be in the banking biz to begin with, right?

This is such an outrageous, in-your-face ripoff, it shouldn’t even require a response. These jokers should be laughed out of the senate. All the same, the bill is moving forward, and President Twoface has thrown his weigh behind it. Is there sort of illicit, under-the-table, villainous activity this man won’t support?

Not when it comes to his big bank buddies, there isn’t. Now check out this clip from an article by economist Dean Baker. Baker refers to the Corker-Warner bill, but the Crapo-Johnson fiasco is roughly the same deal. Here’s Baker:

“The Corker-Warner bill does much more than just eliminate Fannie and Freddie. In their place, it would establish a system whereby private financial institutions could issue mortgage-backed securities (MBS) that carry a government guarantee. In the event that a large number of mortgages in the MBS went bad, the investors would be on the hook for losses up to 10 percent of its value, after that point the government gets the tab.

If you think that sounds like a reasonable system, then you must not have been around during the housing crash and ensuing financial crisis. At the peak of the crisis in 2008-2009 the worst subprime MBS were selling at 30-40 cents on the dollar. This means the government would have been picking up a large tab under the Corker-Warner system, even if investors had been forced to eat a loss equal to 10 percent of the MBS price.

The pre-crisis financial structure gave banks an enormous incentive to package low quality and even fraudulent mortgages into MBS. The system laid out in the Corker-Warner bill would make these incentives even larger. The biggest difference is that now the banks can tell investors that their MBS come with a government guarantee, so that they most they stand to lose is 10 percent of the purchase price.” (“The disastrous idea for privatizing Fannie and Freddie”, Dean Baker, Al Jazeera)

Just ponder that last part for a minute: “The bill would make these incentives even larger.”

Do you really think we should create bigger incentives for these dirtbags to rip us off? Does that make sense to you? Here’s more from Baker:

“The changes in financial regulation are also unlikely to provide much protection. In the immediate wake of the crisis there were demands securitizers keep a substantial stake in the mortgages they put into their pools, to ensure that they had an incentive to only securitize good mortgages. Some reformers were demanding as much as a 20 percent stake in every mortgage.

Over the course of the debate on the Dodd-Frank bill and subsequent rules writing this stake got ever smaller. Instead of being 20 percent, it was decided that securitizers only had to keep a 5 percent stake. And for mortgages meeting certain standards they wouldn’t have to keep any stake at all.

Originally only mortgages in which the homeowner had a down payment of 20 percent or more passed this good mortgage standard. That cutoff got lowered to 10 percent and then was lowered further to 5 percent. Even though mortgages with just 5 percent down are four times as likely to default as mortgages with 20 percent or more down, securitizers will not be required to keep any stake in them when they put them into a MBS.”

Hold on there, Dean. You mean Dodd Frank didn’t ”put things right”? What the heck? I thought that “tough new regulations” assured us that the banks wouldn’t blow up the system again in five years or so. Was that all baloney?

Yep, sure was. 100% baloney. Once the banks unleashed their army of attorneys and lobbyists on Capital Hill, new regulations didn’t stand a chance. They turned Dodd Frank into mincemeat and now we’re back to square one.

And don’t expect the ratings agencies to help out either because they’re in the same shape they were before the crash. No changes at all. They still get paid by the guys who issue the mortgage-backed securities (MBS) which is about the same as if you paid the salary of the guy who grades your midterm exam. Do you think that might cloud his judgment a bit? You’re damn right, it would; just like paying the ratings agencies guarantees you’ll get the rating you want. The whole system sucks.

And as far as the new Consumer Financial Protection Bureau, well, you guessed it. The banks played a role in drafting the new “Qualified Mortgage” standard too, which is really no standard at all, since no self-respecting lender would ever use the same criteria for issuing a loan or mortgage. For example, no banker is going to say, “Heck, Josh, we don’t need your credit scores. We don’t need a down-payment. We’re all friends here, right? So, how much do you need for that mortgage old buddy, $300,000, $400,000, $500,000. You name it. The sky’s the limit.”

No down payment? No credit scores? And they have the audacity to call this a qualified mortgage?

Qualified for what? Qualified for sticking it to the taxpayers? The real purpose of the qualified mortgage is to protect the banks from their own shifty deals. That’s what it’s all about. It provides them with “safe harbor” in the event that the borrower defaults. What does that mean?

It means that the government can’t get its money back if the loan blows up. The qualified mortgage actually protects the banks, not the consumer. That’s why it’s such a farce, just like Dodd Frank is a farce. Nothing has changed. Nothing. In fact, it’s gotten worse. Now we’re on the hook for whatever losses the banks run up peddling mortgage credit to anyone who can fog a mirror.

We’ll leave the last word for Dean Baker, since he seems like the only guy in America who has figured out what the hell is going on:

“In short, the Corker-Warner plan to privatize Fannie and Freddie is essentially a proposal to reinstitute the structure of incentives that gave us the housing bubble and the financial crisis, but this time with the added fuel of an explicit government guarantee on the subprime MBS. If that doesn’t sound like a great idea to you then you haven’t spent enough time around powerful people in Washington.”

The Johnson-Crapo bill doesn’t have anything to do with “winding down” Fannie and Freddie or “overhauling” the mortgage finance industry. It’s a bald-face ripoff engineered by two chiseling senators who are putting the country at risk to beef up Wall Street’s bottom line.

It’s the scam of the century.

MIKE WHITNEY lives in Washington state. He is a contributor to Hopeless: Barack Obama and the Politics of Illusion (AK Press). Hopeless is also available in a Kindle edition. He can be reached at

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Piketty and Social Security

Interesting post by Kevin Williamson.  I did not check the math.

The basis of Piketty’s book is that r>g, and this historical fact is the cause of income and wealth inequality, and is self perpetuating (where r is the return on capital, meaning investment in productive assets, and g is the growth rate of the overall economy).  If you can buy into his logic here, which I think is pretty good, it follows kind of obviously that it makes more sense for the government to require everyone to invest in productive assets rather than handing social security payments over to the government (which can be expected to grow no faster than the overall economy, right?).  So Williamson does the math, and comes up with this:

Professor Piketty estimates that the return on capital over the coming decades will be between 4 percent and 5 percent; historical returns to equity investments run about 7 percent, but let’s be conservative and split Professor Piketty’s estimate, assuming a 4.5 percent return. And in keeping with the first theorem of English-major math, let’s replace that 12.4 percent Social Security tax with a poet-friendly 10 percent. Investing 10 percent of your income at a 4.5 percent return over the course of a 45-year working life produces a higher income in retirement than you enjoyed in your working life, regardless of your income level.

Of course, the problem with this is the sheer impracticality of how this would work in practice.  Williamson notes these issues:

There are all sorts of caveats to be issued here, of course: The transition to an asset-based system rather than a cash-flow-based system would be hairy indeed, and such a system would create some opportunities for cupidity, stupidity, fecklessness, recklessness, and more, although it should be borne in mind that — the three most important words in political economy being “Compared with what?” — those opportunities for trouble would constitute a substantial improvement on our current Social Security program, the failure of which is an inevitability.

And I would add, the biggest problem of all is that Congress would be the ones setting up the program.  Which means they would build a system at the direction of those with the most influence, which right now appears to be big banks and large corporations.  So the system might be set up with individual accounts that allow trading (ideal, you say? think of the churning opportunity).  Or maybe you would be forced to buy a certain percentage US Treasuries.   Or even a specified or limited portfolio, which would cause massive distortion in the markets.  Or some kind of pay-to-play advisor scheme, where you can have an advisor, but that person or firm must meet some federal requirement or acquire a license.  So many awful possibilities.

Although I agree that the actual investment of forced savings would be hugely preferable to today’s system, and not just due to returns to the savers, I have very little faith that Congress would set it up in a way that would leave those returns unmolested.

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Self-driving car; now available with city street capabilities

This is so cool.  I can hardly wait for the snow capable car.  And deer-dodging.  Oh, and the heaved-up dirt road navigation.  I’m sure there are lots more variables for driving conditions.  Which makes me a little skeptical on the effective dates.  But really, it will just be like internet availability, or cell phone towers, or anything else.  First usable by the masses in California and big cities, and maybe someday out here in the sticks.  Still waiting on those internet tubes to get here.  But on the bright side, cell phone service areas are still steadily improving.

Google’s self-driving car project began in 2009. The vehicle’s early life was confined almost entirely to California highways. Hundreds of thousands of test miles later, the car more or less has mastered the art — rather, the computer science — of staying in its lane and keeping its speed. So about a year and a half ago, Google’s team shifted focus from the predictable sweep of freeways to the unpredictable maze of city streets. I was invited along as the first journalist to witness how the car is handling its new urban lifestyle.

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Measles in Brazil

The Guardian has posted a report on how the reduction in vaccination rates in Europe and the US is causing measles outbreaks not just in those areas, but also in countries where vaccination has been largely adhered to, namely Brazil.

One theme I noticed in the article is that countries tend to make announcements that communicable diseases have been “eradicated” in their country or state.  The renewed infections documented in the article show that really, no disease can be considered eradicated unless it is eradicated from the whole world.  Which is why our kids still get polio vaccines, even though it was eradicated in the US in 1979.

Despite it being only three months into 2014, this is the first year that the number of measles cases in California has surpassed 40 since 2000, when the highly contagious disease was declared eradicated in the U.S., KQED reports.

Sometimes there are ideas contrary to popular belief that are, in fact, correct.  Those ideas get ridiculed and “disproven” right up until they get accepted.  The problem is that “vaccines are ineffective and harmful” is not one of those unpopular but correct ideas.  It is now being proven WRONG, in fact, and in a sad and ugly way.

I don’t know how you convince the hard-core vaccine opposition to comply.  There’s too much human nature tied up in it.  Contrarianism, pride, group-think.  The science really doesn’t matter to those who refuse to vaccinate their kids.

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One crony at a time…

That’s how to pick them off, I guess.  Split off one small group at a time from the powerful rich, because after all, even the richest of the rich can’t go it alone.

This positive article from normally gloomy David Stockman details how we may be close to eliminating ONE giveaway to the large corporations, the Export-Import Bank.

Some conservatives, led by Ryan and Hensarling, … want to make 2014 the year that they end President Obama’s “crony” bank once and for all.

“This is our opportunity to advance our welfare-reform agenda, which starts by getting rid of corporate welfare,” Ryan said in a statement on Friday.

Ryan has not proposed ending Ex-Im in his budgets because the issue splits the party. A number of Republicans, supported by business groups like the Chamber of Commerce, support reauthorizing the bank.

“There is no doubt that Chairman Ryan’s voice will be important in this debate and his vocal stance this early in the debate has certainly garnered a lot of attention. The fight over Ex-Im has the potential to help redefine the Republican Party, which is something Ryan knows how to do, most notably on entitlement reform,” said Dan Holler of Heritage Action, which opposes Ex-Im.

It’s hilarious that they refer to it as “Obama’s crony bank.”  It was founded in 1934 by FDR, and I”m guessing it was reauthorized prior to the most recent changes in 2012.  Don’t get me wrong, I’m no fan of Obama or Ex-Im, but the finger pointing in DC gets so old.  My 15 year old son, who really does not pay much attention to politics, has for years now been blaming Obama for everything.  And I mean everything.  Running late for school? Obama’s fault.  Spilled milk?  Obama’s fault.  Dogs ran off?  Obama’s fault.  Maybe he’s going to be a politician.  Or a political reporter.

At any rate, it’s nice to see that maybe we can get ONE of these things eliminated.  It seems to me that back in 1934, everything involving exports and imports must have been much, much more difficult and time consuming.  All the communications, the legal stuff, and the banking.  We have a lot better access to foreign markets, banks, legal information, etc. today, and certainly lots of creative financing is available, so why do we need Ex-Im?

Also it provides a model for those of us interested in eliminating these built in advantages for the rich and large corporations.  Divide and conquer.  Yes, it’s discouraging, because they are likely to invent new tax breaks and programs and advantages at twice the rate that existing ones can be eliminated, but the elimination of even ONE would be a welcome change.

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The Problem(s) with Banking

Paul Krugman’s latest is titled “Is a Banking Ban the Answer?”  and once again I am resisting the urge to name-call.

It’s funny, I don’t really have an educated opinion on the actual discussion here, which is around fractional reserve banking and how to best minimize risk going forward as it relates to required minimum reserves.  I would love to know what John Hussman thinks about this article, and the topic in general.

My issue with this post is the part about the financial crisis of 2008, and how it relates to the banking industry.  Krugman writes:

Are we really sure that banking problems are the whole story about what went wrong? I’ve made this point before, but look at any measure of financial stress: what you see is a huge peak in 2008 that quickly went down:

Yet the quick return to normality in financial markets (achieved, to be sure, through bailouts and guarantees) did not produce a quick recovery in the real economy; on the contrary, we’re still depressed and many advanced countries are now on the edge of deflation, more than five years later. This strongly suggests that while bank runs may have brought things to a head, the problems ran deeper; in particular, I’m strongly of the view (based in part on Mian and Sufi’s work) that broader issues of excess leverage, and the resulting balance-sheet problems of many households, are key.

What’s wrong with this picture (literally)?  It appears as if, and Krugman writes as if, all things being equal, there was financial stress, and it went away (or at least back to “normal”).  But all things are not equal.

  1. FASB changes allowing mark-to-unicorn happened at exactly the time financial stress went down.  What a coincidence.  And are still in place today.  FAS-157 was introduced in 2007 to require mark-to-market using some sort of fair value justification.  Prior to that, hard to value assets were carried at no more than cost.  Now, who knows?  They can value assets at whatever value they choose.  This means that whatever stress existed due to assets losing value may or may not have gone away, but it definitely appeared to go away.
  2. Once the bailouts occurred, TBTF was established as the baseline for the big banks.  The Fed has calculated the excess profits that the banks get for this now codified policy.  This insurance has eliminated a lot of financial stress, because now we know that the stress won’t actually result in TBTF bank failures.
  3. It seems that Krugman is implying that household balance sheet issues have been eliminated, or at least reduced.  This is simply not true.  Many household balance sheets were improved through foreclosure.  Enough households suffered foreclosure that it reduced the country’s household mortgage debt:fredgraph1

But what about the rest of the household debt load?  It had a brief period of reduction, but we are back at it:fredgraph2

Maybe the real economy has not recovered so quickly because measures of it are more accurate, or harder to manipulate.  Maybe the fixes that allowed the financial stress measures to bounce back so quickly actually are holding back the real economy.

It’s as if Krugman is looking for a way to excuse the banking industry as victims of the crisis, rather than as its principal actors and architects.  Another way to look at is that banks caused the crisis, took the public money and guarantees, have completely failed to fix any of the underlying issues, continue the same practices today, and want to know why the rest of us can’t just get over it and get with the(ir) program.  And the real economy is failing to respond accordingly.


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Executive Compensation

Saw this post from Karl Denninger, and WOW!  I agree those statements are shocking!

First, what happened at the Coke shareholders meeting 4/23/14 (from Rob Cox at Reuters):

On Wednesday, just a small minority of shareholders voted against a compensation plan that would potentially have handed up to $16.6 billion worth of stock to 6,400 executives.

And the surprise is this (again from Rob Cox):

…Wintergreen Advisers’ David Winters objected to a plan that would have effectively handed assets created by previous generations of Coke entrepreneurs to today’s shop stewards. Coke’s defense – that dilution from the option scheme could be offset by stock buybacks – only compounded the notion that the principals’ wealth is being used to overpay their agents.

But the real disappointment is that Buffett, known as a bold straight-shooter, came off as a coward in the Coke affair. He didn’t agree with the company’s compensation plan but abstained from voting for fear of suggesting he lacked confidence in Chairman and Chief Executive Muhtar Kent.

As Winters summed it up, Buffett “had the opportunity to take a stand against excessive management compensation and failed to seize it.”

Karl Denninger has the direct quotes from Warren Buffett:

He was asked about the CocaCola resolution put before the shareholders (Berkshire has a big position) and how he was voting on it.  He said he “abstained.”

But it was the next statement that left me speechless.

He said that “It’s kind of un-American to vote ‘No’ at a Coke meeting”; adding that “taking them on is a bit like belching at the dinner table.”


Worse, in a follow-up he asked if he silently sat for — or worse, voted for — other compensation plans he didn’t like and he said not only had he but he had never seen anyone in his 55 years speak out against them at a boardroom table!

Really disappointing…


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Immigration (Bryan Caplan)

Excellent post in favor of immigration.  To be more specific, totally open borders.

Bryan Caplan argues that there are two reasons to argue in favor of immigration, basic fairness (how is it fair to punish someone for being born to the wrong parents?), and the net greater good (immigrants in total provide much more positive economic impact than anything they take).  More than that, I would also argue that the USA needs immigrants, not just for economic growth, but to continue the uniquely American tradition of a melting-pot society.  We are a country of immigrants, and it has made us dynamic and innovative and strong.  I wonder if without the continuing influx of changing culture, new ideas, and the enthusiasm and optimism required to immigrate, our country may stagnate both economically and culturally.

On the topic of economic growth and immigration, Mr. Caplan says:

When driverless cars arrive, you can count on people to complain that they’re putting truck-drivers out of work. But by this logic, we’d be richer if law-makers in the 19th-century banned the tractor. The fundamental truth of economic growth: While innovation often hurts immediate competitors, it is the fountainhead of rising prosperity.Doesn’t immigration hurt workers by increasing the supply of labor? It’s complicated, because immigration also increases labor demand. After all, workers buy stuff. To grasp immigration’s full effect, keep both eyes on production. Trapping Mexican farm workers on primitive Mexican farms starves them and us. It’s far better if they move here and enrich themselves by putting better and cheaper food on our tables.

Like driverless cars, immigration can impoverish some Americans while enriching the rest.

The experience of USA with immigration speaks for itself.  Why are we putting so much of our resources into keeping out exactly the people who have the most to contribute to all of us?

Edit 4/28/14:  Here’s a great post from Motley Fool explaining exactly why we NEED immigration.  One graph, keeping in mind the net gain for US is entirely due to immigration:

motley chart



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More from Edesess on Rebalancing

So, one of my complaints about the Edesess article has been answered.  Nothing about risk, you say?  Here’s a whole article on risk and rebalancing, once again concluding that rebalancing is not of any value, and in fact may be harmful.

I think this one is even more misleading, with the same glaring omission of any reference to an intended financial plan, or desirable asset allocation.  There is some analysis of portfolios holding equities and cash, or equities and treasuries, and how they fare over extended time periods.  Which is all well and good except that not many advisors would agree that #1, it’s a responsible idea to increase equity percentage as time progresses, which is the inevitable result over a long enough time period here, and #2,  it’s a good idea to just let whatever happens, happen, as far as asset allocation goes, over the short term or the long term.  It’s generally agreed upon that an individual will be better suited for different asset allocations at different stages of their life, and that asset allocation should be determined and managed throughout the investment timeline, not just once at the beginning.

Then he ends with this really egregious example:

The danger of a worst-case scenario with a rebalancing strategy

Although rebalancing is held forth as a way to control risk, it can – in a worst-case scenario – lead to genuinely dire results in a way that a buy-and-hold strategy cannot. The following is from William Bernstein’s recent short book, “Deep Risk: How History Informs Portfolio Design (Investing for Adults)” (p. 49):

Consider the following exercise; imagine, for a moment, it is June 30, 1929, and you plan to retire in five years and have a $100,000 portfolio that is 75/25 stocks/ bonds; $75,000 of stocks, represented by the CRSP 1-10 index, and $ 25,000 in 5-year Treasury notes, your LMP [Liability Matching Portfolio]. The $25,000 of bonds, you figure, is adequate to pay for 10 years of living expenses, which you estimate at $2,500 per year, a more than adequate outlay in 1929. You are not too concerned by the fact that your LMP will last you only 10 years; you figure you will be able raise additional living expenses by selling your stocks, and you resolve to rebalance your portfolio back to its 75/25 composition every year on June 30.

Here’s how this scenario plays out: By June 30, 1930, stocks have fallen by 26%, so you have to sell $6,528 of your Treasuries to buy more stocks to bring the portfolio back to 75/25. Over the next year, stocks fall another 26%, and on June 30, 1931, you’ve got to sell $4,616 more of those precious Treasuries.

The next 12 months are even more of a disaster, with stocks losing more than 64%. On June 30, 1932, your Treasury stash is worth $16,959, and you calculate that to get back to 75/25, you’ll have to sell $8,357 of them – nearly half of the notes – to toss into what now clearly looks like a deep-risk rat hole. This will leave you just $9,324 in liquid Treasuries – less than four years of living expenses.

Bernstein’s purpose in developing this scenario is, in part, to illustrate the difficulty of determining in real-time whether a stock market incident like that of 1929-32 is an example of “shallow risk” or “deep risk.” Bernstein defines shallow risk as “a loss of real capital that recovers relatively quickly” while deep risk is “a permanent loss of real capital.” If an investor is concerned about deep risk, he or she may be better off with a buy-and-hold strategy than with a rebalancing strategy.

And that’s the end of the example.  But it’s not the end of the scenario, is it?  There are still 2 years left before retirement.  As of June 30, 1933, stocks had more than doubled.  The stock portfolio would have risen to $66,573 by that time.  With rebalancing, you would buy back about $10,000 of the treasuries, and be down overall about 25% from the original $100,000.  Stocks were down about 4% in the fifth and final year before retirement, but if you take out $2,500 per year starting in year 6, and rebalance every year, this portfolio NEVER RUNS OUT OF MONEY.  By 1953 the balance is over $250,000.  Where’s the “deep risk”?  Not only that, but starting in June 1936, the strategy with rebalancing is always worth more in total than the strategy of buy and hold, with spending down the bonds first.  That’s only 4 years after the strategy has been dismissed as a failure by the author.  What “clearly looks like a deep-risk rat hole,” is in fact a great buying opportunity.  Which is where the discipline of rebalancing steps in to override that lizard brain.

He ends with his only mention of considering the investor’s needs:

Neither buy-and-hold nor rebalancing is necessarily the best strategy in all cases. In fact, any strategy will need to be adjusted periodically based on the investor’s circumstances and the investment prospects.

And with that second sentence, pretty much undoes his entire article.


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