Saturday, August 20, 2011

Scarlett O'Hara's Risk-Free Rate

Frederick J. Sheehan is the author of Panderer to Power: The Untold Story of How Alan Greenspan Enriched Wall Street and Left a Legacy of Recession (McGraw-Hill, 2009) and "The Coming Collapse of the Municipal Bond Market" (, 2009)

The death of the long-established risk-to-reward asset categories was the subject of "It's Over." From lowest to highest: cash, bonds, and stocks, are the pecking order of institutional investment policies. Pension plans and endowments that have wandered into warehouses and gas-pipeline management often retain the outline as a mental diagram. The assets with the highest assumed risk (using statistical measurements) are expected to produce the highest return. The genesis for this construction is the Capital Asset Pricing Model (CAPM), a deeply flawed academic theory.

"It's Over" struck a nerve with readers who have suffered from its domination of asset management over the past three decades. Some gave speeches denouncing it, some forsook advancement, and many endured business-school indoctrination in bewilderment.

The CAPM is not worth further examination (other than the necessity to understand the structure of the institutional mind). However, there is one train of thought that should be considered by the average investor: the incapacity of the model to consider discontinuities. There is no room to "be prepared for the next time the world turns over." That happens every generation or three, and it is happening today.

Quoting from "It's Over":

"There is also the much larger problem of constructing an asset pecking order with rigged asset returns and yields. The market rate for Treasury bills is not zero. The coming dislocation that institutional and retail investors face is, to most if not all, incomprehensible. Consider the reconstruction of Scarlet O'Hara's Capital Asset Pricing Model after 1860. She discovered what can happen to chimerical fortunes built on the backs of government-fixed, zero-percent, risk-free rates."

Each morning the news in the U.S. and Europe veers closer to the closing scene of George Bernard Shaw's Heartbreak House. Recent market turbulence indicates recognition, but the disappearing euro and dollar are treated in the media as a distant political argument among economists, the most destructive group of cross-border planners imaginable. The Federal Reserve, U.S. Treasury Department, European Union, and European Central Bank are acting in unison - that is, in their own short-term interests. Doing so, the independence and viability of personal assets, pension plans, municipalities, colleges, and museums - you can add to this list - are at stake.

The debt-ceiling debate in the U.S. was the most pointless waste of air since Elizabeth Taylor divorced her twelfth husband. First, the debt-ceiling question is not the same as the question of whether the federal government will make good on bond payments, but the two became hopelessly intermingled.

Separating the two: A country that spends one dollar for every 59 cents in tax receipts cannot freeze its level of spending. As a practical matter, cash-matching of inflows to outflows was not possible with over 45 million Americans receiving food stamps, consumers having drawn down savings by $149 billion between September 2010, and April 2011 (during a period when inflation-adjusted spending fell), when 64% of the population is unable to put $1,000 together in an emergency (The National Foundation for Credit Counseling, August 12, 2011, Chicago Tribune), and with a military currently deployed in over 100 different countries. QED.

Second, the federal government did not waver from its commitment to meet bond payment obligations. This was not clear from listening to the media, or the U.S. Treasury Secretary, who bears the duty to defend the nation's credit, integrity of the dollar, and integrity of his office.

Standard & Poor's implicitly downgraded the U.S. Treasury Secretary along with the nation's credit. On July 10, 2011, Treasury Secretary Tim Geithner settled the bond-payment question on Meet the Press: "Let me make this clear: The U.S. is not going to default. We are a country that pays its bills. We're going to meet our obligations." He contradicted himself on July 27, 2011, as stated in The King Report: "[B]y August 2, [2011], Treasury Secretary Tim Geithner says the government will run out of money to pay all its bills, including obligations to bondholders. "On July 28, 2011, Bloomberg reported: "The U.S. Treasury will give priority to making interest payments to holders of government bonds when due if lawmakers fail to reach an agreement to raise the debt ceiling, according to an administration official." This was the case all along.

The double-talk was issued by a Treasury Secretary who did not pay his taxes until a Senate committee requested that he do so (the Internal Revenue Service reports to Geithner) and who acknowledges: "I never had a real job," (April 2010).

Europe is even more distraught. This is a real, current crisis. The Eurocrats will do anything to prevent a dismantling of the euro; yet, it is coming to an end, or, about to be reduced in scope. The unelected authorities may be able to delay the inevitable, but that will require an enormous amount of money printing. Estimates of €1 trillion to save the Italian and Spanish banking systems are common, but, no one knows the side effects beforehand. Estimates of write-offs and losses over the past few years (Citigroup, Fannie Mae) have generally come up short.

French President Nicholas Sarkozy's statement on August 16, 2011, that the size of the current bailout fund (EFSF) is large enough (€440 billion) is not credible. It is not clear if €440 billion is large enough to prevent Greece and Portugal from rupturing. It is possible that the August 16 meeting between Sarkozy and German Chancellor Angela Merkel ended with an agreement that it is time to cut bait. (They also dismissed "Eurobond" monetization, but euro-salvation initiatives never quite die.) They may have decided expansion of the money-printing adventure will drag France and Germany into the abyss.

Whether or not this is the case, European markets will be chaotic in the months ahead (as they will in the U.S.), with a good chance capital controls will be instituted to prevent Europeans from moving their money elsewhere: an example of a rare occurrence that has not been anticipated by the usual investment strategy. Swiss franc and gold movements show where the more alert European money is moving. Gold has risen from $1,500 on July 5, 2011, to over $1,800 on August 18, 2011. The consequences to U.S. banks, in such an intertwined financial world, are being discounted in the market.

Should an Iron Curtain of capital controls surround Europe, U.S. authorities may issue some gobbledygook nonsense of how Europe's unfortunate decision forced the United States' hand. Doing do, captive financial assets, with limited avenues of dispersal, will drift into 10-year Geithners and the common stocks of National Champions selected by the United Auto Workers and the chairman of the President's Council on Jobs and Competitiveness, General Electric Chairman Jeffrey Immelt.

Now, the star of the show:

To Scarlett O'Hara, her family's plantation in Georgia (Tara) was as risk-free as it comes. Probably to Mr. O'Hara, too, who did not contemplate hard times. When Scarlett wanted to chase other long-term assets (Ashley Wilkes), she told her father "plantations don't amount to anything." Mr. O'Hara fumed: "Land is the only thing in the world that amounts to anything, for 'tis the only thing in the world that lasts, and don't you be forgetting it!" This sounds like an old Fannie Mae ad, not to confuse the honor of Mr. O'Hara and Jim Johnston.

Scarlett's father favored the Capital Asset Pricing Model of the day (100% plantation weighting; risk-free, perpetual, cotton-backed dividends) as did the other, local, wealth-management offices. The plantation owners could not wait to beat those Yankees. (Lincoln and Hamlin, not Jeter and Rivera.) Defeat did not cross their minds. The book value of Tara and Twelve Oaks (Ashley Wilkes' family plantation) was chiseled in stone, just as the historical stock-market and bond-market returns stamped in indelible ink by Jeremy Siegel, Rex Sinquefield and Roger Ibbotson, are as immutable to asset allocation today as they will be gone with the wind tomorrow.

Rhett Butler was what might be considered a contrarian thinker. It is approaching a truism today that a contrarian thinker does not mean much more than common sense. That is, once every generation or two, the world blows up. So it was with Butler, who told the war-whooping plantation owners: "I have seen many things that you have not seen. The thousands of immigrants who would be glad to fight for the Yankees for food and a few dollars, the factories, the foundries, the shipyards, the iron and coal mines - all the things we have not got. Why all we have is cotton and slaves and arrogance. They'd lick us in a month." His comments were not appreciated, and why would they listen to this disreputable financier (which he was), lounging as they were at Twelve Oaks: "the beautiful white-columned house that crowned the hill like a Greek temple."

The South marched off to war and Rhett Butler bought cotton. Scarlett did not approve. She told Rhett he was "vile and a mercenary."

Butler disagreed: "Mercenary? No, I'm farsighted. Though perhaps that is merely a synonym for mercenary. At least, people who were not as farsighted as I will call it that. Any loyal Confederate who had a thousand dollars in cash in 1861 could have done what I did, but how few were mercenary enough to take advantage of the opportunities! [To deflect hostility after preventing money from leaving the European Union (and from the U.S, later), the euro authorities will blame the mercenary Europeans who are buying Swiss francs and gold. Such an accusation always goes down well with loyal, though not far-sighted, citizens when they suffer relative impoverishment at the hands of the authorities. - FJS] As, for instance, right after Fort Sumter fell and before the blockade was established [that prevented leakage from the Confederate financial system - FJS], I bought up several thousand bales of cotton at dirt-cheap prices and ran them to England. [Butler shipped his assets offshore - FJS] They are still there in warehouses in Liverpool. I've never sold them. I'm holding them until the English mills have to have cotton and will give any price. I wouldn't be surprised if I got a dollar a pound."

Scarlett's reply sounds typical, though far more original, than that of a Wall Street airhead on CNBC: "You'll get a dollar a pound when elephants roost in trees."

On the 220-year-chart of cotton prices in the 2010 CRB Yearbook it looks as though cotton rose from around 10 cents a bushel in 1860 to $1.05 a bushel a couple of years later.

Scarlett, clinging to her ERISA-sanctioned policy, which was therefore legally risk-free, retorted: "[I] don't need your advice. Do you think Pa is a pauper? He's got all the money I'll ever need..." This could be an occasion to discuss the topical question of what is money? (see:"Do you think Ben Bernanke is J.P. Morgan?", but Butler, (or Margaret Mitchell), is an expert in the field.

Rhett, with a better historical sense than Scarlett, (even while she, herself, unschooled, would have been shocked at the narrow-minded, ahistorical theories of modern economists), replied: "I imagine the French aristocrats thought practically the same thing until the very moment when they climbed into the tumbrels."

Meanwhile, back at Tara, Mr. O'Hara had stuck with the plantation owner's CAPM: "The South had always lived by selling cotton and buying the things it did not produce, but now it could neither sell nor buy [because of the union blockade of southern ports - FJS]. Gerald O'Hara had three years' crops of cotton stored under the shed near the gin house at Tara, but little good it did him. In Liverpool it would bring one hundred and fifty thousand dollars, but there was no hope of getting it to Liverpool. Gerald had changed from a wealthy man to a man who was wondering how he would feed his family and his negroes through the winter." When it rains it pours: "With the new fall of currency, prices soared again. Beef, pork, and butter cost thirty-five dollars a pound, flour fourteen hundred dollars a barrel....[W]arm clothing, when it was obtainable had risen to such prohibitive prices that Atlanta ladies were lining their old dresses with rags and reinforcing them with newspapers to keep out the wind."

Butler knew what he wanted in a girl and he made sure he got it - a woman who knew how to make money during bad times: "I'm going to be a rich man when this war is over, Scarlett....I told you once before that there were two times for making big money, one in the upbuilding of a country and the other in its destruction. Slow money on the upbuilding, fast money in the crack-up. Remember my words." There were probably similar reminders when investment banks paid credit-rating agencies for AAA ratings on CDOs.

Rhett's concept of money was so old that it's new: "I've made money enough, and it's in English banks and in gold. None of this worthless paper for me." The Confederacy had been reduced to paper money, not necessarily a road to ruin but given Rhett's belief: "the Confederacy is doomed....It had to go and it's going now," he took the only course of action a man with common sense would follow.

Rhett's far-sightedness was not well received: "It simply made everyone furious that an old speculator who always said nasty things about the Confederacy should have so much money when we were all so poor." If the Powers That Were had paid attention to the "nasty things" Rhett Butler willingly shared with anyone who would listen in 1860, he would have remained a shady, wealthy, but unimportant figure.

On the battlefield, writing to his wife (Melanie), Ashley Wilkes expressed contempt for the leaders whom he had trusted: "I see too clearly that we have been betrayed, betrayed by our arrogant Southern selves, believing that King Cotton could save the world. Betrayed too, by words and catch-phrases, prejudices and hatreds coming from the mouths of those highly placed, those men whom we respected and revered - 'King Cotton, Slavery, States' Rights, Damn Yankees.'" Ashley had trusted the Confederacy's Committee to Save the World (see February 15, 1999 cover of Time magazine )

Rhett's sermons were not in vein. Parlor discussions at Tara praised Southern advances but Scarlett listened in contempt. "They haven't any idea what is really happening to themselves or to the South. They still think, in spite of everything, that nothing really dreadful can happen to any of them because they are who they are - O'Hara's, Wilkeses, Hamiltons. [Or: Harvard, Princeton, the Fed. Or: pension plans, endowments, family offices. Or: stocks-for-the-long-run, Too-Big-to-Fail banks, Treasuries, money-market funds. - FJS] Oh, They're all fools! They'll never realize! They'll go right on thinking and living as they always have and nothing will change them....They don't change to meet changed conditions because they think it'll all be over soon."

Scarlett was witness to the fall: "The charred remains of [Twelve Oaks] had crowned the hill in white-columned dignity. The deep pit which had been the cellar, the blackened field-stone foundations and two mighty foundations marked the sight...Ashley had married his bride here but his son and son's son would never bring brides to this house....The House was dead."

This will be the lament of unfortunate trusts and endowments that mistakenly believed they have apportioned their assets for perpetuity.

Tara may have met the same fate but Scarlett had spirit - and was ruthless, inexhaustible, and refused defeat. Nevertheless, she needed aid and solicited her TARP: Rhett Butler. During her same train-of-thought quoted above ("Oh, they're all fools!"), Scarlett concluded: "They think God is going to work a miracle for their benefit. But He won't. The only miracle that's going to be worked around here is the one I'm going to work on Rhett Butler."

Rhett was not forthcoming: "I couldn't give [you money] if I wanted to. I haven't a cent on me. Not a dollar in Atlanta. I have some money, but not here. And I'm not saying where it is or how much. But if I tried to draw a draft on it, the Yankees would be on me like a duck on a June bug..."

From a zero-percent, risk-free rate, money could not be had at any price.

Much later in the book, Rhett explains in textbook fashion his refusal to participate in Scarlett's miracle. Only a sampling is included here. It springs to mind that the author wrote a long story while concealing a coded tract on how to preserve financial independence, legally or illegally, during a time when the government has exceeded its legal authority: "If I'd drawn a draft they could have traced it somehow and I doubt if you'd have gotten a cent. My only hope lay in doing nothing. I knew the money was pretty safe, for if worse came to worse...I could have named every Yankee patriot who sold me bullets and machinery during the war. Then there would have been a stink because some of them are high up in Washington now."

On that score, Rhett tells Scarlett how he secured his release from a post-War federal prison: "I employed a delicate system of blackmail on a friend in Washington who is quite high in the counsels of the Federal government. A splendid fellow - one of the staunch Union patriots from whom I used to buy muskets and hoop skirts for the confederacy.... [H]e hastened to use his influence, and so I was released. Influence is everything, Scarlett. Remember that when you get arrested. Influence is everything, and guilt and innocence merely an academic question."

And so it goes.

Margaret Mitchell, author of Gone with the Wind, was very much surprised that her book was even publishable. She wrote to a reviewer at the time [1936]: "I wrote the book nearly 10 years ago.... It seemed, to be quite frank, pretty lousy and I never submitted it to any agent or publisher.... I wrote the book when the Great American Boom was at its height and the high tide of the Jazz Age was with us. Everyone I knew had a car, a radio, an electric ice box and a baby that they were buying on time (everybody except me!). Heaven knows I didn't foresee the Depression.... I was writing about an upheaval I'd heard about when I was a small child. For I spent Sunday afternoons [hearing about men and women who survived the War and Reconstruction].... I heard them talk about friends who came through it all and friends who went under.... And all during my childhood, I'd been told to be prepared for the next time the world turned over.... So I suppose that explains why I wrote a book about hard times when the country was enjoying its biggest boom."