Jeffrey Gundlach, Bond Savant

Can you spot the $34 billion fund manager? Jeffrey Gundlach (third from left), who runs DoubleLine Capital, the fastest-growing mutual fund startup in history. His mid-'80s haircut is only slightly less weird than his rise to the top

DoubleLine Capital’s new office is high up in a downtown Los Angeles skyscraper, with unobstructed views of the famous Hollywood sign. As you walk out of the elevator, a huge canvas with the firm’s logo greets you; DoubleLine founder Jeffrey Gundlach painted it himself. Pass a six-foot-tall faux terra-cotta Chinese warrior and you’ll find a conference office called the Van Gogh Room. The Van Gogh Room has no Van Goghs, though it does display a pair of landscape paintings and looks out to a reception area adorned with other paintings Gundlach won at auction. It also, on this visit, contains Gundlach, sitting at the end of the conference table in a crisp button-down shirt, with a goatee and rust-colored hair, cut short.
The idea was to interview Gundlach, whose company is the fastest-growing mutual fund startup in history, but the conversation quickly turns into a kind of test. Gundlach wants you to know he is a connoisseur of fine art. He also wants you to know you don’t know squat.
Photograph by Todd Weaver for Bloomberg BusinessweekGundlach in his new L.A. offices
“Do you know the total U.S. debt?” he asks.
Around $15 trillion?
“Right,” he says. “Do you know what percentage of national revenue comes from the income tax?”
No idea.
“You’re forgiven for not knowing that,” he says. “It’s not what you do. But if you’re managing bond money, it’s the least you should know. Was it Socrates who said, ‘It’s that I know that I don’t know everything’?” Gundlach is fond of quoting the great and ancient in the service of macro bets: A recent PowerPoint presentation on the future of bond yields started nearly every slide with a quotation from Shakespeare.
He dives into why he alone can trounce the competition in bond funds. “I can still do about 7 percent in a world of 2 percent,” he says. “You stress-test your portfolio constantly. You think about it and analyze it to death. Other people don’t know how. I wish I could teach it to somebody.”
Since DoubleLine first took investor money in April 2010, it has amassed $34 billion in assets. Even as it quadrupled in size last year, DoubleLine’s $22 billion Total Return Bond Fund (DBLTX) outperformed 99 percent of its rivals. The firm takes in $80 million to $100 million in new client dollars every day.
Unlike the reigning bond king, Bill Gross, manager of Pimco’s $259 billion Total Return Fund, DoubleLine Total Return invests primarily in mortgage-backed securities, which Gundlach says he can combine into a portfolio that posts higher returns even during economic downturns. In January, Barry Ritholtz, the New York finance blogger who helps manage $500 million in high-net-worth assets, moved all of his Pimco assets to DoubleLine. Ritholtz says that with the Federal Reserve maintaining its zero-interest rate policy and Treasury bonds yielding so little, Gundlach’s less understood mortgage market expertise was needed to get his clients higher yields without having to make a firmwide bet on interest rates. “It was a straight-up trade for me,” Ritholtz says. “Bill Gross for Jeffrey Gundlach—no player to be named later.”
DoubleLine is not only the fastest-growing mutual fund startup ever, it may also be the fund with the strangest genesis. Two and a half years ago, Gundlach was fired by his old employer, Trust Company of the West, where he and his team managed 70 percent of that firm’s $110 billion in assets. It was a messy departure that involved mass defections, a stash of porn and drug paraphernalia, and an acrimonious trial. The rival firm Gundlach founded may outgrow its ancestor.


Gundlach grew up in Buffalo. His father was a chemist at a company that made wax for bowling alleys, and his mother was a housewife. Although his uncle Robert Gundlach invented the photocopier and his grandfather Emanuel Gundlach formulated a hair tonic popular in the 1950s called Wildroot Cream-Oil, he says his family scraped to get by. “When our drying machine broke, it didn’t get fixed,” he says. “My mother would just run clotheslines all across the backyard.”
What he lacked in privilege, Gundlach says, he made up for with hard work and intelligence. “Look, I’ve never needed to network,” he says. “I was always at the top of my class, always got straight As. I got a near-perfect math SAT.” He went to Dartmouth on financial aid, graduated summa cum laude in math and philosophy in 1981, and entered Yale’s applied mathematics Ph.D. program. Two years later he dropped out and drove to California to become the drummer for a rock band called Radical Flats. He had a Flock of Seagulls pompadour and a day job at insurer Transamerica. A year later, broke and watching Lifestyles of the Rich and Famous on a little black-and-white TV, he resolved to become an investment banker.
He opened a phone book, flipped to “Investment Managers,” and talked his way into a meeting at TCW. He knew nothing about bonds, but the firm was impressed enough by his math skills to offer him a job. By the time he showed up for his first day of work as an analyst on the bond desk, he’d already mastered the math in Sidney Homer and Martin Leibowitz’s Inside the Yield Book, which lays out the field of bond analysis. “Very few people can do that,” he boasts. “Like, very few. I quickly realized I knew more than most people who worked at TCW for years.”
As he immersed himself in the bond market—duration analysis, the yield curve, prepayment risk—Gundlach quickly rose up the firm’s ranks. By 1987, as the savings and loan crisis took hold, the 28-year-old had a reputation as TCW’s mortgage wunderkind. The firm gave him $500 million to manage, and he finally quit his band, which by then was called Thinking Out Loud.


The bond market is a grinder’s playground. A big winner, like Gundlach in 2011, might deliver 9.5 percent. Gross’s Total Return Fund last year, with its more diversified strategy, earned 4.2 percent. A long-term winner might deliver annual returns of 6 percent or 7 percent. Managers can invest in Treasuries, among the safest securities on the planet, but with yields near record lows—a 10-year government bond earns 1.9 percent—it takes other vehicles to deliver a competitive return, especially after fees, taxes, and inflation. (Bond funds are chiefly measured against the Barclays Capital Aggregate Bond Index, just as equity funds aim to beat the Standard & Poor’s 500-stock index.) To increase returns, a manager can buy riskier foreign sovereign and corporate debt, but such an approach can go very wrong. That happened at Pimco last year when it avoided Treasuries just as they staged one of their best rallies in history.
Photograph by Cheryl HimmelsteinAt TCW, his former employer, in 2005
Gundlach favors mortgage-backed securities, which are themselves portfolios of home loans. There are two types: guaranteed and non-guaranteed. Guaranteed mortgages are backed by Ginnie Mae, Freddie Mac (FMCC), and Fannie Mae (FNMA), which are sponsored by the government. They’re more secure and thus have lower yields than their non-guaranteed counterparts. These bonds must still yield more than Treasuries to compensate investors for the risk of homeowners prepaying their mortgages. Like Treasuries, they increase in value when the bond market gets anxious about risk. That’s what transpired last year, amid fears of a European meltdown.
Non-guaranteed mortgage securities are directly issued by financial companies and banks not associated with the government, and come with no credit guarantee. The higher risk is reflected in higher yields. If the economy and housing do well, and investors prefer riskier assets to government bonds, non-guaranteed mortgage securities will both pay a nice yield and appreciate in value. The Gundlach theorem: A portfolio with a blend of both kinds of mortgage securities will combine credit risk and interest rate risk in a way that throws off higher returns.
Gundlach has been playing the mortgage market for decades. In 1990 he took home his first million-dollar paycheck. Over the following decade, his pay swelled into the tens of millions. At TCW Total Return, Gundlach rode through the worst of the financial crisis, from 2007 to 2009, to return 9.1 percent a year. By 2009 he was making $40 million a year, and his team was managing most of TCW’s assets.


Just after lunch on Friday, Dec. 4, 2009, Gundlach, then 50 and TCW’s chief investment officer, watched as the bond market closed on the East Coast. It had been a great year: His TCW Total Return Fund had posted more than double the average return of its peers. Morningstar (MORN) had nominated him Fixed Income Manager of the Decade, and he was on track, he says, to collect hundreds of millions in salary and bonuses over the next couple of years.
Gundlach headed upstairs for what he believed was an executive meeting. Instead, in the boardroom, he was met by TCW’s chief counsel and an attorney from Quinn Emanuel Urquhart & Sullivan. They presented him with a document alleging gross misconduct, including an attempt to steal staff and confidential client and trade information to launch his own rival firm. His 24 years with TCW were over, effective immediately. His BlackBerry was already disabled.
Gundlach kept an office on the west side of L.A., where he would work some mornings to avoid rush-hour traffic. Figuring he’d go collect his belongings, he pulled out of TCW’s garage in his Porsche and headed to Santa Monica. At that office, he recalls, he found the door broken and the desk drawers ransacked. TCW would later claim Gundlach kept in his office a stash of porn, sexual devices, and pot-smoking accessories. In a letter to DoubleLine clients, Gundlach called those items “vestiges of closed chapters” of his life. TCW spokesman Peter Viles says the office was company property that security personnel entered with a key.
Back at TCW’s trading floor, Chief Executive Officer Marc Stern informed Gundlach’s team that their boss was gone, and that TCW was acquiring rival Metropolitan West to plug the hole. The following morning, 15 senior members of Gundlach’s team repaired to his house. Gundlach’s then-wife, Nancy, made coffee. (That’s her, second from left, in the band photo at the beginning of this article.) Louis Lucido, a deputy at TCW, brought donuts.
By noon, 14 of the gang of 15 had resigned from TCW. The holdout was Philip Barach, co-manager of the TCW Total Return Fund. Surrounded by a circle of mutineers, Gundlach, who says he got misty-eyed, persuaded Barach to join them. The two men shook hands and hugged, and the reunited team applauded Barach as he thumbed out his own resignation on his BlackBerry. “It was a total leap of faith,” recalls Barach, now DoubleLine’s president. “I wasn’t poor. But this was all or nothing.” That night, he says, TCW CEO Stern drove to his house and offered him a minimum of $10 million a year over six years to stay, with an understanding that the 57-year-old could retire and collect his entire package in just three years. Barach turned down the offer.
“TCW made a multitude of miscalculations,” says Gundlach. “Even if they’d kept most of the team, the clients would have fled. They knew that I ran it.” TCW’s spokesman, Viles, responds that the acquisition of $30 billion MetWest more than made up for the loss of Gundlach.
By the following Wednesday, Gundlach had his 15 colleagues, plus 17 more who had also bolted from TCW, running around town to get the new operation running. Lucido bought 30 laptops with a personal credit card at Best Buy (BBY). Others Googled client names; TCW had seized their computers and Rolodexes. Barach and Gundlach prevailed upon Oaktree Capital, a $67 billion investment firm run by former TCW Chief Investment Officer Howard Marks, to kick in an undisclosed amount. On Dec. 14, five days after Gundlach was fired, DoubleLine put out its first press release.
On Jan. 7, 2010, TCW filed a lawsuit against Gundlach alleging conspiracy, breach of fiduciary duty, and theft of proprietary information. The suit claimed Gundlach had been planning for months to leave TCW and start a rival firm, and that his behavior was “erratic” and “increasingly and openly confrontational.” Forty-five out of 65 of Gundlach’s old TCW team had since decamped for DoubleLine.
“The day we were sued, the phones stopped ringing,” says Bonnie Baha, one of Gundlach’s crew of defectors. “Each of us had families to support. Not one of us was drawing a salary.” On Feb. 10, a month after TCW filed its suit, Gundlach put out a press release announcing a countersuit to recoup $1.25 billion in fees he says TCW owed him and his team. “I believe the facts stack up overwhelmingly on our side,” he said in the statement. “I would be delighted to see this case go to trial tomorrow, if that were feasible.”
DoubleLine in its early days, says Gundlach, faced the chicken-or-egg problem of not yet having nearly enough client assets to prove itself—which, of course, it could hope to do only with enough client assets. He says he realized his last best hope was opening DoubleLine to the masses. “If we were going to make it,” he says, “it would have to come down to mutual funds. It was like putting my record up to a popular vote.”
On April 6, 2010, with staff in and out of depositions related to the trial, DoubleLine launched its own Total Return Fund. A Merrill Lynch brokerage office immediately wired $65 million. By December 2010, the fund had crossed $7 billion in assets under management. One early adopter was broker Kurt Brouwer of the $700 million investment adviser Brouwer & Janachowski in Tiburon, Calif. “We used TCW Total Return, so we were comfortable with him,” he says. “The transition wasn’t traumatic. We just left TCW and moved over to DoubleLine. People are motivated when they start new funds. The messy, sordid details weren’t important to us.”


In September 2011, after six weeks of trial, an L.A. jury awarded Gundlach and three associates $67 million in unpaid wages. While the jury also found them liable for breaching their fiduciary duty to TCW and misusing company secrets, it didn’t deem the breach important enough to award TCW any damages. In December, before that decision was finalized, Gundlach and TCW agreed to settle their dispute; terms of the deal are confidential. As for that pleasure stash in Gundlach’s office, the presiding judge ruled in July that it was immaterial to the case. The jury never learned about it.
Gundlach says he will consider closing DoubleLine’s mortgage-backed investments to new money when they hit $50 billion in assets. “Do you realize that the week after TCW got rid of me, $30 billion in assets left the firm? That’s $150 million in annual fees,” says Gundlach. (TCW’s Viles calls those numbers “wildly inaccurate.”) Gundlach continues: “They figured that changing fund managers was no different than changing branch managers at the local bank.” He stops to tick off his achievements—a decade at the top of his category, taking DoubleLine’s assets from zero to $34 billion in three years. “Find me anyone else in this industry that did that.”

Invest in stocks? FORGET ABOUT IT

Main street hates stocks.
That is according to today’s front page of USA Today: The print edition had a center column, above the fold, screaming green headline “Invest in stocks? FORGET ABOUT IT.” That Cap and Bold headline is as it was in original. (The online version was the tamer Invest in stocks? Small players still smarting ^[1]).
It may surprise some people to learn this is both an expected and positive development. It implies eventual lower prices (over the intermediate term), but will also help to create that elusive lasting market bottom, as I will explain in a moment.
First, an excerpt:

“On Main Street these days, investing in the stock market is about as popular as watching a scary movie on a 12-inch black-and-white TV.
Wall Street’s long-running story about how stocks are the best way to build wealth seems tired, dated and less believable to many individual investors. Playing the market isn’t as sexy as it used to be. Since the 2008-09 financial crisis, the buy-now mentality has been replaced by a get-me-out, wait-and-see, bonds-are-safer line of thinking.
Stocks remain out of fashion even though the stock market has risen more than 100% since the bear market ended three years ago. It’s up 25% since October and 9% this year.”

This is no surprise — between the run of scandals in the 1990s and 2000s, the dot com implosion, analyst scandal, the 2007-09 crash, housing collapse, the flash crash, and HFT, mom and pop have taken their ball and gone home.
This is how bear markets eventually end.
Most people misunderstand what drives secular bull and bear markets, focusing on prices alone as the defining characteristics. I believe this is in error, or at very least paints an incomplete picture.
Whenever I give a market presentation at a conference, I always use the chart below. It explains in great deal how Main Street investor psychology impacts the long secular cycles of bull (green) and bear (red) markets. Note the metric at bottom, which is P/E ratio.
My definition of a Secular Bull Market: An extended period of time, typically lasting 10-20 years, driven by broad economic shifts that create an environment conducive to increasing corporate revenue and earnings. Its most dominant feature is the increasing willingness of investors to pay more and more for a dollar of earnings.
You can see this in the 1982-2000 secular bull market. Total returns were driven partly by earnings improvements, but far more by multiple expansion. This is essentially a psychological component.
A Secular Bear Market reflects the opposite: Following an extended secular bull, it is a period of time marked by increased volatility, frequent cyclical rallies and corrections, in an economically challenging environment. The dominant feature is that Investors are willing to pay less and less for that same dollar of earnings.
We see that today. Profits going up as volumes go down; investor interest ebbs and fades. Its how markets can go sideways or even rally and still see P/E ratios fall.
Ultimately, when the process generates enough investor disgust, we can form a lasting market low, typically, in the Single digit P/E ratios.
(The caveat is we don’t know how unprecedented Fed printing affects this psychological process).
>
click for ginormous chart
^[2]
Original chart, Crestmont Research (annotations added)
>
Source:
Invest in stocks? Small players still smarting ^[1]
Adam Shell
USAToday, May 8, 2012
http://www.usatoday.com/money/perfi/stocks/story/2013-01-07/fears-of-investing-in-stocks/54815608/1

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Article printed from The Big Picture: http://www.ritholtz.com/blog
URL to article: http://www.ritholtz.com/blog/2012/05/invest-in-stocks-forget-about-it/

Benchmark obsession undermines investor returns

Sir John Templeton, the pioneering global investor, argued that the aim of investing was quite simply “maximum real returns”. Over time this simple but powerful objective has been lost. This is all the more surprising because, clearly, real returns matter to the end investor, particularly in current markets. Pensions are paid from real returns not relative ones.

So where did the concept of relative performance originate? It probably stemmed from good intentions (as do most bad ideas). Why pay active fees if the managers don’t deliver returns above a passive benchmark? However, this idea has morphed into an unhealthy obsession with pigeon-holing managers into niche buckets.

The late great value investor Bob Kirby opined: “Performance measurement is one of those basically good ideas that somehow got totally out of control. In many cases, the intense application of performance measurement techniques has actually served to impede the purpose it is supposed to serve”.
Investment committees spend an inordinate amount of time discussing decisions such as which small-cap growth manager to hire.
Yet often they fail to devote the same energy to discussing the asset classes to choose. They should spend more time selecting the asset classes. After all, the extra performance from a good manager over an asset class is unlikely to be much more than the icing on the cake.
Perhaps this neglect of the importance of asset class decisions stems from the fact that such discussions are inevitably harder than discussing the relative merits of a beauty parade of managers. Often discussions on asset classes degenerate into debates over the economic outlook.
Sadly this is largely an investment dead end. There is no evidence that anyone can read the economic tea leaves consistently well. As if that wasn’t difficult enough, even if you got the economics right, you still have to work out how the markets will react, and which assets will benefit.
Many institutional investors have their asset allocation dictated to them from asset liability studies, or simply implement a fixed ‘strategic’ asset allocation, thus abdicating responsibility for any discussion on asset classes. There is also a tendency to view ‘strategic’ as meaning static. This assumption needs challenging.
When a pensions plan appoints a manager with an investable benchmark they inadvertently create incentives to alter the manager’s behaviour.
Suddenly everything becomes relative, so the manager starts to think about relative valuation (ie is the asset I’m buying cheap relative to the benchmark?), relative risk (ie. I mustn’t deviate too far from my benchmark as I will be taking on ‘tracking error’), and, worst of all, relative return (ie. I did a good job because I only lost 30 per cent of your investment, and the benchmark was down 50 per cent). So while an investable benchmark makes measuring performance an easy task, it isn’t necessarily good for focusing the manager’s mind on generating real returns. Relative benchmarks are often employed to the detriment of real returns and the preservation of capital.
Thankfully, there is a simple, although not easy (to borrow Warren Buffett’s phrase), alternative – to use a value approach across a wide range of assets. Buy when an asset is cheap, and sell when an asset gets expensive – buy low and sell high, a sensible approach to both the preservation and growth of capital.
Valuation is the primary determinant of long-term returns, and the closest thing we have to a law of gravity in finance. For instance, buying assets when they are expensive (high price/earnings ratios in the equity space and low yields in the bond space) tends to result in low returns. In contrast, buying cheap assets generally leads to high long-term returns. So moving your assets in response to valuation signals makes sense.
Of course, there is a downside to this style of investing. In order to pursue a value-driven approach you need two key traits – patience and a willingness to be contrarian. Unfortunately these traits are in rare supply, and become almost extinct when people act in groups (such as committees).
Let’s end as we began with a quotation from Sir John Templeton: “If you buy the same securities as other people, you will have the same results as other people. It is impossible to produce a superior performance unless you do something different from the majority. To buy when others are despondently selling and to sell when others are greedily buying requires the greatest fortitude and pays the greatest reward”.
James Montier is a member of GMO’s asset allocation team and the author of several books including Behavioural Investing: A Practitioner’s Guide to Applying Behavioural Finance

Statistics on Hedge Fund Performance versus Markets

Forget about correlations. Here are the conditional probabilities between equity market monthly returns and hedge fund returns as represented by the MSCI World Equity Index and the HFRI Hedge Fund Index respectively.

 

Since Jan 1997, over 183 months,

• Hedge funds were positive when equities were positive 98 months or 54% of the time.
• Hedge funds were negative when equities were negative 54 months or 30% of the time.
• Hedge funds were positive when equities were negative 24 months or 13% of the time... And
• Hedge funds were negative when equities were positive 7 months or 4% of the time.

Thus, when equities are down, the chances of your hedge fund losing money are: 54 out of 78 or 69%.

And, when equities are up, the chances of your hedge fund losing money are 7 out of 105 or 7%.

  

However:

Since Jan 2008, over 51 months,

• Hedge funds were positive when equities were positive 24 months or 47% of the time.
• Hedge funds were negative when equities were negative 21 months or 41% of the time.
• Hedge funds were positive when equities were negative 5  months or 10% of the time. And...
• Hedge funds were negative when equities were positive 1 month or 2% of the time.

Thus, when equities are down, the chances of your hedge fund losing money are: 21 out of 26 or 81%.

And, when equities are up, the chances of your hedge fund losing money are 1 out of 25 or 4%.  

Post 2008, the markets have begun to behave in a very volatile and erratic fashion that has confounded many hedge fund managers who had previously navigated market crises such as 1998 and 2001 successfully.

Speech Notes: Howard Marks at NYSSA

On April 5, Howard Marks, legendary investor and Chairman of Oaktree Capital Management, spoke at New York Society of Securities Analysts.  He is also the author of the book, “The Most Important Thing: Uncommon Sense for the Thoughtful Investor.” Distressed Debt Investing was in attendance as he presented his views on the topic of “Human Side of Investing.”

According to Howard Marks, the discipline that is most important is not accounting or economics, but psychology.  He started off with a quote from Yogi Berra, “In theory, there is no difference between theory and practice; but in practice, there is.”  And this difference is what is at the essence of the human side of investing.  Even though the business schools teach that the markets are objective and efficient, and generally follow the “Capital Market Line (CML) curve (“riskier assets always provide higher returns”), it was handily disproved in both contrasting time periods of Q2 2007 and Q4 2008. Essentially, the upward sloping CML does not work in practice.  In practice, riskier assets must appear to provide higher returns, else they won’t attract capital.  But that does not mean that those promised returns arrive in reality.  If the risky assets provided higher returns, then they can’t be deemed risky after all.  In Q2 2007 the risk premium was very inadequate, whereas in Q4 2008 it was overly excessive.  The truth is that market is made up of people with emotions, insecurities, and foibles, and they often make mistakes.  They tend to swing to erroneous extremes.

One has to be very careful about the value and price relationship.  If you buy without discernment to the price, the returns would be all over the place – sometimes good, and sometimes bad.  In theory, people want more of something at lower prices and less of something at higher prices.  However, in practice, people tend to warm to investments as they rise and shun them when they fall.  In markets, the demand curve looks the opposite of how it looks in microeconomics theory based on supply and demand.

The normal investor behaves like a pendulum with constant swings between optimism and pessimism, between risk tolerance and risk aversion.  Although, the statistical “mean” location for the pendulum swing is in the middle, that happy medium is rarely seen in the markets, just as the pendulum spends almost no time at its “mean” during the swing.

Next, he talked about the 3 stages of bull market.  The first stage occurs when few smart people begin to believe that there will be improvement.  The second stage occurs when most people recognize that improvement is actually taking place.  The third stage occurs when everybody and their brother believe that things will continue getting better forever.  And that’s how bubbles come into existence.  The belief becomes that the price of a particular asset will only rise forever, that it can’t go down.  But when the pendulum swings like it did in 2008-09, bear market happens.  The 3 stages of bear market, conversely, are: first, when few people realize that things are overpriced and will prices likely will fold; second, when most people see that he decline is taking place; and third, when everybody believes that things will only get worse forever.  That last stage was the apt description of the credit markets in fourth quarter of 2008 and equities in first quarter 2009.  Any asset can be attractive or unattractive depending on the stage in which it is bought, i.e. depending on how much optimism or pessimism is embodied in the price.  The adage we should remember is: “What a wise man does in the beginning, the fool does in the end.”  What we should be is a contrarian.  We should be a seller in the third stage of the bull market, and buyer in the third stage of the bear market.  He quoted Mark Twain: “When you find you are on the same side as the majority, it is time to reform.”

Contrarianism is very important but very difficult.  To make his point, he quoted David Swenson who runs investments for Yale’s endowment fund: “Establishing and maintaining an unconventional investment profile requires acceptance of uncomfortably idiosyncratic portfolio which frequently appear to be downright imprudent in the eyes of the conventional wisdom.”  However, if one wants to be a successful contrarian, one has to believe that conventional wisdom by itself is a bit of an oxymoron because what is conventional is often not wise because most people start believing in something only when it is the third stage of either market extreme.

What is it that permits bubbles and crashes to happen frequently?  Howard Marks pointed the reason to be failure of investor memory especially since when the investor’s memory is faced with greed/fear, memory loses.  When people forget the past, they tend to repeat the same mistakes done previously.  He recommended reading his latest memo, “Déjà vu all over again” in which he discusses contrarian signals. He went on to say that behaving pro-cyclically is one of the greatest, most frequent mistakes.  We should strive to be anti-cyclical, but it requires strong memory and contrarian bent.

Another important thing is understanding and knowing what you don’t know.  A lot of people do not know what they don’t know, and essentially overestimate what they know.  Investing is a business full of testosterone and they think that you are not a man if you don’t know what’s exactly going to happen in say, five years.  In fact, some people think they know everything, some people think they are supposed to know everything, and a lot more act as if they know even when they don’t.  Mark Twain put it the best: “It ain’t what you don’t know that gets you in trouble.  It’s what you know for sure that ain’t so.” 

He then referred to the memo he wrote 8-10 years back, “Us Versus Them,” describing two schools – the “I Know” school, and the “I Don’t know” school.  He is a proud, card carrying-member of the latter.  It is very important to understand the difference between the two schools.  “I Know” school is confident about its forecast of the future, and “I Don’t Know” school is skeptical about that forecast.  The former can only prepare for one outcome, whereas the latter hedges against uncertainty and prioritizes avoidance of losses over the maximization of gains.  The latter approach is more likely to result in a successful investment career.  Therefore, the motto at Oaktree is to “Avoid the losers; the winners will take care of themselves.”  As long as the portfolios are built to avoid losers, they will do okay.

Most of the times, investors think that only the most likely thing is going to happen and they really only  prepare for just one outcome.  Howard Marks doesn’t seem to think highly of economists as they do not draw ranges or probabilities of the forecasts they give out, and are more often than not proven wrong.  He implored that while investing one should never forget the story of the 6 feet tall man who drowned in a stream which, on average, was five feet deep.  It is not enough to know what the average outcome will be; instead one has to have an idea of the likely shape of the outcome distribution curve.  One of the things investors should always be ready for is the unlikely disaster and should not ignore the “tails.”  Unlikely things happen all the time, and the likely things do not happen all the time; we need to build our portfolios to account for that.  This is not easy as Charlie Munger says, “None of this is easy, and if anyone thinks it is easy, he is stupid.”  It is not easy in investing to make above average returns as most of the people do single scenario investing which ignores that more things can happen than will happen.  The most likely outcome does not happen that often.  And that is what Howard Marks thinks risk actually is.  It is not standard deviation or volatility of returns; for him it is losing money. 

There are 3 ingredients for success in investing: aggressiveness, timing, and skill.  If you have the first two, you don’t need the third.  But that’s unlikely to remain the case in the long run as it is very hard to do the right thing, at the right time consistently in the investing business.  He then went on to talk about the two twin imposters in investing: Short term outperformance, and Short term underperformance.  They really don’t tell anything about an investor’s ability to outperform in the long run.  He referred to the memo he wrote in 2006 after the melt down of the hedge fund, Amaranth, in which he dissects the events from his vantage point.  He thinks that Amaranth’s problems didn’t start in 2006 when it went down a 100%; the problems started in 2005 when it went up a 100%.  Going up or down 100% can be two sides of the same coin, and can be result of combination of sheer aggressiveness and luck/timing.  If a person goes up a 100% one year, it does not guarantee that he will go up significantly again next year. 

He recommended reading the book “Fooled by Randomness” by Nassim Taleb, and understanding not only black swan phenomenon but also the concept of “alternative histories,” especially as it pertains to judging investors for the long term given that there is a lot of randomness in the world.  Just because something should happen does not mean that it would happen.  One of the things Howard Marks believes is that the correctness or the quality of a single decision can’t be judged by one outcome alone because of that randomness.  One has to assess the decision-makers outcomes over a somewhat longer period of time to assess that person’s skill.

Lastly he concluded by saying that forces that influence investors also push them towards mistakes.  Investing in obvious things, things that are easily understood, things that are doing well, etc. – these are all easy to do.  These things become names everybody wants to invest in.  But just by that virtue, most of the times these assets become overpriced and unlikely to be bargains.  Bargains that investors find in their lifetimes are likely to have hidden appeal, not be easily understood, and be unpopular.  Things that appear hard to invest in are where bargains are found.  Bargains do not appeal to herds.  Any given asset can be a good buy or a bad buy depending on the price.  There is no such thing as a “good idea” until you know the price. 

In the Q&A session, he shared his view that he did not believe that equities currently have excessive optimism built into the prices. He also thought that the high yield is relatively more attractive now than it was in 2007 despite the similarly low yields as the spreads are generous right now versus the treasuries.  It is hard for investors to get away from the business of relative selection.  Next, he suggested that as a professional investor you should not let the clients put you up on a pedestal, but rather should set reasonable expectations with them.  On the question of why CEOs of companies consistently overestimate performance, he felt that a lot of CEOs are good salesmen who might belong to the “I Know” school.   (By the way, unsurprisingly, he thought CNBC is big on that school as well.)  On how to protect against black swans, he suggested using portfolio diversification, basically buying those assets that would behave differently in a certain environment.  However, this can be hard to do especially if one is mandated to only be in a particular asset class, but one has to nevertheless try to reduce the correlation.  Finally, currently he is reading Sebastian Mallaby’s book, “More Money than God.”

When the tail-event becomes the standard risk

If anyone can bring metaphor and illustration to the market in volatility,  it’s Chris Cole at Artemis Captial Management, a volatility-focused investment firm.
Take the intro of his latest note as an example:

Imagine the world economy as an armada of ships passing through a narrow and dangerous strait leading to the sea of prosperity. Navigating the channel is treacherous for to err too far to one side and your ship plunges off the waterfall of deflation but too close to the other and it burns in the hellfire of inflation.
—-

Today the existential fear of world’s end deflation is so powerful investors are willing to pay the highest prices for portfolio insurance in nearly two decades. The market for forward volatility has become unhinged as the SPX variance and VIX futures curves sustain historically high premiums over low spot vol.
My argument is not that this extreme fear is misplaced but that it is mispriced.
Like Odysseus in the epic poem the global economy is trapped between the monsters of Scylla and Charybdis. We risk one to avoid the other. From one world’s end to the next sometimes I wonder if decades from now we will look back with the hindsight that we were all hedging the wrong tail.

Cole has been arguing for a while that the injection of huge amounts of QE-money into the system — the equivalent of a giant put option –  has undoubtedly had an impact on volatility markets, and most likely in ways we don’t really understand. Yet.
For one thing, Cole observes that since early 2009 volatility spikes have consistently occurred shortly after the end of central bank balance sheet expansion.  “The greater the level of monetary expansion the calmer the Vix and the higher the gains in the S&P 500 index (and vice versa). Volatility markets know this and that game theory expectation has contributed to the steepest SPX volatility curves in over two decades.”
Note the following chart to observe the shift in the volatility curves:

What’s more, there’s even been a correlation between central bank balance sheet expansion and short interest build-up in the VXX, one of the most popular Vix-linked exchange traded notes, observes Cole:

Short interest levels on VXX typically climb during Fed balance sheet expansion and continue to do so well after the printing ends until the inevitable VIX spike causes rapid short covering. The dynamic was most evident during the 2011 summer correction when VXX short interest tracked with Fed balance sheet expansion through April and continued to climb all the way until the VIX hit 43 in August. During VIX spikes in both May 2010 and August 2011 traders shorting the VXX overstayed their welcome at the stimulus punchbowl failing to recognize the Fed had left the party and the reality police were knocking on the door.

So where does this leave us?

According to Cole the world is now in the midst of a new volatility regime,  a regime that’s defined by investors’ willingness to pay almost anything to shield themselves and their portfolios from the next deflationary apocalypse. All of which is translating to abnormally steep volatility curves, overpriced tail risk, high implied volatility of volatility, and underperformance of portfolio insurance.

Investors are consequently losing sight of what might really be considered a black swan event.

As he notes:

Tail risk insurance is at the most expensive relative levels in over two decades of data reflecting a profound emotional fear of deflationary collapse.

Tail risk bets protecting against extreme declines in equity markets are now priced at multiple times the eight decade historical probability of those declines being realized (we can never know for certain true future probability). The evolution of portfolio insurance premium is observable via the implied probability distributions for returns backed-out from S&P 500 index options.

Tail-events are effecively being priced as if they were standard risks. That means you get much better pricing today hedging smaller declines of higher probablity rather than very rare but extreme crashes, says Cole.

Which means one of two things.  The chances of another deflationary crash are really much more probable than before, or deflationary fear is hugely mispriced in the market. Inflationary fear, on the other hand, is massively underpriced.

And none of that changes the fact, says Cole, that when a crash does happen and all these buyers look to cash in on their expensive tail risk insurance, the jackpot will have become a lot smaller.

“All that expensive protection will likely underperform expectations and in the end you would have done better hedging closer to the odds. It is hard to make money knowing what everyone else already knows.”

Maybe the market is correct in buying tail risk insurance … but everyone is just hedging the wrong tail.

That’s to say: Don’t be fearful of a crash. Rather, be fearful of not participating in a mega rally.

But don’t label Cole a paranoid inflationista. He isn’t coming to that conclusion because he’s obsessed with money debasement and the hoarding of gold bullion. His conclusion is based on the market’s own pricing of inflation risk.

Hyperinflation is now the outlier — and as a result it’s very cheap to protect against it in volatility markets.

His conclusion:

I can’t tell you if hyperinflation will ever occur but what I do know is that the single most undervalued asset class to hedge against this rare event is volatility itself. As institutional and retail investors herd into commodities, farmland, and gold they ignore the powerful leverage afforded to them using extremely long-dated call options and model-free variance.

Something for the goldbugs to chew on, at the very least.

For more of his thinking check out the full note in the Long Room.

Whither the Yale model?

David Swensen has been called “Yale’s $8 billion man ^[1]” for outperforming the average university endowment by that amount during the first 20 years of his tenure as Yale’s Chief Investment Officer. Chalk that outperformance up to the success of what’s become known as the “Yale model,” or the insight that institutional investors like endowments or pension funds can achieve outsize returns by allocating a large chunk of their assets to hedge funds, private equity, real estate, and other alternative investments.
As Swensen explained in a lecture ^[2] he gave to Yale MBAs in 2008 , the Yale model rests on two core tenets: 1) “an equity bias for portfolios with a long time horizon,” because equities and equity-like alternative investments tend to rise in value in the long run; and 2) diversification, because by spreading investments among several asset classes with varying degrees of liquidity, ”for any given level of risk, you can increase the return.”
These days, though, it seems both of Swensen’s credos have become passé in the community of corporate pension fund managers, as Reuters’ Sam Forgione reported ^[3] late last week:

For the first time in over a decade, more of the $1.246 trillion assets represented by the 100 largest U.S. corporate pension funds is now in bonds instead of equities, according to pension consulting firm Milliman…
“There will definitely be less demand for equities from corporate pensions if you look out the next several years,” said Aaron Meder, head of U.S. pension solutions for Legal and General Investment Management America. Corporations are “tired of the volatility in the stock market, so they want to de-risk their pensions,” he added.

What’s striking here isn’t that pension funds no longer share Swensen’s fondness for allocating money to hedge funds or private equity — after all, Swensen himself believes ^[4] that the majority of institutional investors who can’t match the resources or qualifications of Yale’s Investment Office “should be 100 percent passive.” Rather, it’s that Swensen’s golden rules of asset management — stocks for the long run and diversification — seem to be out of fashion. Pension-fund managers that have years to ride out losses on their stock portfolios until they turn into gains are increasingly throwing in the towel in favor of less volatile, lower-returning bonds. The advantage of endowments and pension funds that Swensen has touted for years — a near-infinite time horizon — is being ignored.
This risk aversion among institutional investors is trickling down to the retail level, too. Mom-and-pop investors withdrew $4.43 billion from equity funds last week, the largest amount since the start of the year, data from the Investment Company Institute showed ^[5] today. These investors are also showing a preference for fixed income: bond funds saw with $6.12 billion in inflows that same week, for a total of over $26 billion in the previous three weeks.
The question institutional investors are now asking is whether the events of the past few years require a re-appraisal of principles underpinning the Yale model. Hedge funds, one of Swensen’s darling asset classes, had a particularly bad 2011 ^[6], with the average fund down nearly 5 percent and some stock-picking funds down 19 percent. The New York Times published a story ^[7] earlier this week that claimed that over the past five years, a set of public workers’ pension funds that had more of their assets in hedge funds, private equity, and real estate posted lower returns and paid higher fees than those with stodgier portfolios.
For what it’s worth, Yale’s target allocation ^[8] for fiscal year 2012 includes having over 70 percent of its portfolio in private equity, real estate, and hedge funds and only around 10 percent in U.S. stocks, bonds, and cash; for fiscal year 2011, Yale’s endowment returned 21.9%.

Jim Chanos: "Long Corruption and Short Property in China" s

Hedge fund manager and renowned short seller Jim Chanos of Kynikos Associates was interviewed on CNBC today from the Delivering Alpha conference. Chanos is known for his short of Enron before it collapsed.

Recent Portfolio Activity

Chanos says that "we're long corruption and short property in China." As such, he's long the Macau casinos. He didn't name names but obviously Wynn (WYNN) has a large presence there via Wynn Macau (1128.HK), as does MGM (MGM) and SJM Holdings (0880.HK), controlled by the family of Stanley Ho.

Conversely, we originally detailed how he was also shorting the property developers in the country.

In the past month, Chanos has pressed his shorts in the renewables sector (green energy) and in particular, solar. We covered Chanos' presentation at the Ira Sohn Conference where he said he was short First Solar (FSLR) as well as wind power play Vestas (CPH: VWS).

Chanos also noted that his fund is not short US banks.

To watch Chanos' interview <<- click.

Passport Capital Sees "Major Retrenchment in Risk Assets"

Passport Capital founder John Burbank recently sent out a letter to investors updating their macro views.

Despite being net short, their Passport Global fund is up 4.1% for the year. Their neutrally-exposed Long/Short fund has returned 7.5% and their net long Special Opportunities fund is up 12.9% for the year.

Burbank writes, "I have strong conviction about our current positioning - perhaps as strong as I have ever felt in the 11+ years that I have been running Passport Capital. Simply put, I believe that the current market environment is setting up for a major retrenchment in risk assets and we are well positioned to benefit from this."

Just a month ago, Burbank made an appearance and said that 2012 is a stockpicker's market.


Passport Capital's Main Views

They feel that Central Bank liquidity has merely boosted prices but has done nothing else constructive. Burbank believes that deflation is the real risk (see the best investments during deflation). The hedge fund also takes the stance that equity markets are misconstruing economic growth in the developed world.

Passport feels a recession is coming in 2012 or early 2013 in the US. They note that average equity declines during recessions is 40%, though even a 20% decline would take the market back to the October 2011 lows.


Burbank's Portfolio Changes

In late 2011, they reduced portfolio illiquidity and have been selling into strength in the equity markets as of late. They've also boosted hedges and shorts "less to reduce net exposure and more to add idiosyncratic risk aligned with our negative economic view."

Burbank's firm also bought more physical gold and also started a position in Brent Crude Oil. These are both plays on increasing Central Bank liquidity. You'll recall that John Paulson originally started his gold fund as a bet against the US dollar as well.

Passport has also started a position in mortgage backed securities which they believe to "have the potential to deliver high risk-adjusted yield irrespective of equity market valuations." Additionally, they initiated a positive-carry position in deflationary rates trade (3yr1yr) which they feel will benefit from either the Fed holding short-term rates low or a risk-off period.


Saudi Equities Most Compelling

Passport has their single largest equity allocation to Saudi equities. Even though that market is up 23% year-to-date, they feel that "Saudi equities constitute the best single asymmetric equity market we can find."

Read more: http://www.marketfolly.com/2012/04/passport-capital-sees-major.html#ixzz1rGiUb5sY

What Dan Loeb Has Learned As An Investor

1. His style of investing has evolved and adapted to the investment environment, his process has evolved significantly. Importance of process itself on running an investment management firm. Leadership is very important. Most firms fail from dysfunctional process, or leadership of the firm.

2. Areas of focus and interest: if spending all your time reading research reports and only looking at screen, you will fail. Be well-rounded, travel, study things outside of the narrow topics of finance. If investing was just about numbers, any young accountant could do this. More than industry analysis, need to understand why you make decision, when it’s right to be contrary, when its not. Santa Fe institute has good ideas.

3. Importance in today’s world of political analysis. You can be right about financials, but if you don’t understand what the next move is by our politicians, you can get it wrong.

4. Looking at portfolios, think deeply about process over outcome. If you do something the right way enough times, you’ll win. Look at risk in an intelligent way, look at Alpha generation, not just how much money you make.


On Value Investing: Let's not delude ourselves; some of us are just buying really crappy companies at low prices. Don't make excuses for making bad investments at apparently cheap valuations. He'd rather pay up for a better business that has some growth.


On Managing Risk: He was down 30% in 2008, went from 6B in assets to 1.4B in assets, so he knows that everyone says they’re long term investors, but they still don’t want to lose money in any given year. He’s back up to 9B in assets now. He doesn’t want to lose money in any given year. Tries to have things in different sectors, and asset classes. Has 1.8B mortgage portfolio now for example. Uses tail-risk hedges, and shorts to hedge risk. To have a sustainable, growing business, managing volatility is important.


On “Stinky Feet Stocks”: When your first reaction to a pitch is that’s a terrible stock or industry, those have often been some of their best investments. He considers that a positive when it’s something in an out of favor industry. Auto parts in 2009, European banks in beginning of this year.

They use private investigators on shorts, to know the situation better than the rest of the world. Be sure to also check out Dan Loeb's recommended reading list.

Investors hunt strategies in era of ‘repression’

“Financial repression” is here. And it is causing a headache for investors.
It may be little more than a buzz phrase in the markets but a growing number of strategists believe it accurately encapsulates how sovereign debt markets are being distorted by central bank and government policies that keep interest rates at historic lows.

Real bond yields, those adjusted for inflation, are at their lowest since the 1970s in the US and UK. And if the effect of central bank action is to prevent market mechanisms from responding to inflation, an element of the repression, then this poses big questions for investors’ asset allocation strategies.
Andreas Utermann, chief investment officer at Allianz Global Investors, is unequivocal: “We are clearly in a phase of financial repression. The central banks are clear about it: they are manipulating the capital markets,” he says. “It will mean continual uncertainty.”
For banks, the big worry is that they become the captive buyers of sovereign debt. Indeed, the evidence from Spain and Italy after the European Central Bank’s provision of cheap loans in December and February suggests that is already the case. Much of the billions of euros in cheap ECB money was used to buy eurozone government debt, leading to a fall in bond yields.
At the same time, the search for haven assets, combined with “quantitative easing” in the US and UK, means that yields are well below inflation rates in the government bond markets of America and Britain, as well as Germany. Allianz, the German insurer, holds, largely for regulatory reasons, 90 per cent of its assets in debt instruments, with only 6 per cent in equities.
But, rather than keep pouring money into low-yielding debt, as encouraged by central banks and governments, investors can escape the repression, say strategists. One way out is to opt for equities or corporate credit, so-called risky assets.
“There is a strong argument that when real yields are negative, people look for assets where they can at least get a real return. You want to get closer to real assets rather than IOUs,” says Hans Lorenzen, credit analyst at Citi.
The problem for such a strategy is whether it makes sense over the mid to long term. Mr Lorenzen argues that looking at the last big period of financial repression from the post-war era when there were strong equity returns and low credit spreads in the 1950s and 1960s could be misleading. “For me it is the difference in growth. It was a very different world. Repression wasn’t a problem for returns in risk assets like credit and equities as growth was strong and default rates were low,” he says of that era.
The world today is different. Growth in all developed countries, but especially in Europe, is expected to be mediocre at best while deleveraging or debt reduction is far more widespread through the economy than it was after the war. That may not bode well for risky assets.
Didier Duret, chief investment officer of ABN Amro Private Banking, says an unconsidered move into risky assets is dangerous. “You need to move away from the crowded trades,” he argues. He has been trimming exposure to US equities, investment grade corporate debt – where yields are close to all-time lows – as well as government bonds.
Rather, he suggests assets such as Asian corporate bonds. “You get the same credit rating but you have an additional spread of 30-50 basis points,” he says. In equities he suggests a “barbell” strategy, with cylicals such as Taiwanese companies balanced by defensives such as Malaysian stocks.
Mr Utermann proposes a “simple” two-pronged strategy. The first part is to focus on equities that have strong cash flows and dividends. While critics of this trade point to the large number of strategists recommending it, Mr Utermann says most equity portfolios are constructed at the moment with an anti-dividend bias.
Companies that have maintained dividends have performed poorly – banks and utilities for example – while the best performers such as technology groups have a bad track record on payouts, Apple’s recent announcement notwithstanding. So he recommends ensuring investors have real exposure to dividend companies.
His second piece of advice is to invest in emerging markets equities and bonds without hedging to participate in what he anticipates will be an appreciation of their currencies. “If you believe capital markets will normalise, it will require a fundamental realignment in currencies,” he says, arguing developed countries will see theirs weaken.
The uncomfortable truth for many investors, however, is that financial repression is likely to be a long-winded process with many ups and downs. Mr Lorenzen argues that the two most likely outcomes are a prolonged bout of inflation such as came in the 1970s after the last period of financial repression, or a Japan-style scenario of low growth and choppy markets.
“You can be in a long-term bearish trend but in the periods when monetary policy is being loosened very aggressively you can have these very strong rallies,” he says.
“The difficulty for investors is understanding the relationship between the poor fundamentals and strong liquidity injections. In the long run fundamentals will dominate but at times the liquidity will take over.”

Financial Repression Has Come Back to Stay: Carmen M. Reinhart

By Carmen M. Reinhart - Mar 11, 2012

As they have before in the aftermath of financial crises or wars, governments and central banks are increasingly resorting to a form of “taxation” that helps liquidate the huge overhang of public and private debt and eases the burden of servicing that debt.

Such policies, known as financial repression, usually involve a strong connection between the government, the central bank and the financial sector. In the U.S., as in Europe, at present, this means consistent negative real interest rates (yielding less than the rate of inflation) that are equivalent to a tax on bondholders and, more generally, savers.

In the past, other measures also included directed lending to the government by captive domestic entities (such as pension funds or banks), explicit or implicit caps on interest rates, regulation of cross-border capital movements, and (generally) a tighter coordination between governments and banks, either explicitly through public ownership of some institutions or through heavy “moral suasion” by officials.

Central banks in both developed and developing countries are being subjected to complementary pressures. Emerging markets may increasingly look to financial regulatory measures to keep international capital “out” (especially given the expansive monetary policy stance pursued by the U.S. and Europe). Meanwhile, advanced economies have incentives to keep capital “in” and create a domestic captive audience to absorb the financing for the high existing levels of public debt.

Common Cause

Concerned about potential overheating, rising inflationary pressures and the related competitiveness issues, emerging- market economies may continue to welcome changes in the regulatory landscape that keep financial flows at home. Indeed, this trend is already well under way. This concern means advanced and emerging-market economies are finding common cause in increased regulation and/or restrictions on international financial flows and, more broadly, the return to more tightly regulated domestic financial environments.

This scenario entails both a process of financial deglobalization (the reappearance of home bias in finance) and the re-emergence of more heavily regulated domestic financial markets.

-- Public and Private Debt Overhang: Elevated levels of public debt in the U.S. and elsewhere will probably be the most enduring legacy of the post-2007 financial crises. For the advanced economies, public debts had not approached these levels since the end of World War II.

Figure 1 (attached), which traces the evolution of average gross public debt for the 22 advanced economies from 1900 to 2011 demonstrates the magnitude of the policy challenges now facing many (if not most) of these countries. However, these numbers significantly understate the magnitude of the debt surge in recent years by excluding record private borrowing -- particularly by banks -- which remains a major possible contingent liability of governments.

Throughout history, debt-to-GDP ratios have been reduced in five ways: economic growth, substantive fiscal adjustment or austerity plans, explicit default or restructuring of private and/or public debt, a surprise burst in inflation, and a steady dose of financial repression that is accompanied by an equally steady dose of inflation. It is critical to note that the last two options -- inflation and financial repression -- are only viable for domestic-currency debts (the euro area is a special hybrid case).

Closed Channels

Some of these channels have been used in combination during historical episodes of debt reduction. Fiscal adjustment, however, is usually painful in the short run and politically difficult to deliver. Debt restructuring leaves a troublesome stigma and is also often associated with deep recessions. Pretending that no restructuring will be necessary doesn’t make the debt overhang disappear. For many, if not most, advanced countries, concerns about those debt burdens will shape policy choices for many years to come.

In this setting, monetary policy in the advanced economies is likely to remain “overburdened” for some time.

Complicating the situation is the fact that the debt overhang isn’t limited to the public sector, as it was immediately after World War II. There is now a high degree of leverage in the private sector, especially in the financial industry and households. In addition, the recent buildup in external leverage was greater than in past crises. This debt overhang and the financial fragility it creates are a common feature of most advanced economies, along with stubbornly high unemployment. Concerns that higher real interest rates and deflation will worsen an already precarious situation will probably impose added constraints on monetary policy.

-- Negative Real Interest Rates, 1945-1980 and Post-2008: One of the main goals of financial repression is to keep nominal interest rates lower than would otherwise prevail. This effect, other things being equal, reduces governments’ interest expenses for a given stock of debt and contributes to deficit reduction. However, when financial repression produces negative real interest rates and reduces or liquidates existing debts, it is a transfer from creditors (savers) to borrowers and, in some cases, governments.

This amounts to a tax that has interesting political- economy properties. Unlike income, consumption or sales taxes, the “repression” tax rate is determined by factors such as financial regulations and inflation performance, which are opaque -- if not invisible -- to the highly politicized realm of fiscal policy. Given that deficit reduction usually involves highly unpopular spending cuts and/or tax increases, the “stealthier” financial-repression tax may be a more politically palatable alternative.

Bretton Woods

Liberal capital-market regulations and international capital mobility had their heyday before World War I, when the gold standard was in force. However, the Great Depression, followed by World War II, put an end to laissez-faire banking. It was in this environment that the Bretton Woods arrangement of fixed exchange rates and tightly controlled domestic and international capital markets was conceived.

The result was a combination of very low nominal interest rates and inflationary spurts of varying intensities across the advanced economies. The obvious results were real interest rates -- whether for Treasury bills (see attached Figure 2), central bank discount rates, deposits or loans -- that were markedly negative from 1945 to 1946.

For the next 35 years or so, real interest rates in both advanced and emerging economies were, on average, negative. Binding interest-rate ceilings on deposits (which kept real ex- post deposit rates even more negative than real ex-post rates on Treasury bills) “induced” domestic savers to hold government bonds. In addition to the effect of capital controls, leakages by investors in search of higher yields elsewhere were limited because the incidence of negative returns on government bonds and on deposits was, more or less, a universal phenomenon at this time.

The frequency distributions of real rates for the period of financial repression (1945 to 1980) and the years following financial liberalization, shown in Figure 2, highlight the universality of lower real interest rates prior to the 1980s and the high incidence of negative real interest rates.

A striking feature of Figure 2, however, is that real ex- post interest rates (shown for Treasury bills) for the advanced economies have, once again, turned increasingly negative since the outbreak of the crisis, and this trend has been intensifying.

Real rates have been negative for about half of the observations and below 1 percent for about 82 percent of the observations. This turn to lower real interest rates has occurred even though several sovereign borrowers have been teetering on the verge of default or restructuring (with the attendant higher risk premiums). Real ex-post central bank discount rates and bank deposit rates have also become markedly lower since 2007.

Negative Rates

Critical factors explaining the high incidence of negative real interest rates after the crisis are the aggressively expansive stance of monetary policy and heavy central bank intervention in many advanced and emerging economies.

This raises the broad question of whether current interest rates are more likely to reflect market conditions or whether they are determined by the actions of official large players in financial markets. A large role for non-market forces in interest-rate determination is a central feature of financial repression.

In the U.S. Treasury market, the increasing role of official players (or conversely the shrinking role of “outside market players”) is made plain in Figure 3, which shows the evolution from 1945 through 2010 of the share of “outside” marketable U.S. Treasury securities plus those of so-called government-sponsored enterprises, such as the mortgage companies Fannie Mae and Freddie Mac.

The combination of the Federal Reserve’s two rounds of quantitative easing and, more importantly, record purchases of U.S. Treasuries (and quasi-Treasuries, the government-sponsored enterprises, or GSEs) by foreign central banks (notably China) has left the share of outside marketable Treasury securities at almost 50 percent, and when GSEs are included, below 65 percent.

These are the lowest shares since the expansive monetary policy stance of the U.S. regularly associated with the breakdown of Bretton Woods in the early 1970s. That, too, was a period of rising oil, gold and commodity prices, negative real interest rates, currency turmoil and, eventually, higher inflation.

A similar situation prevails in the U.K., where the Bank of England’s quantitative-easing policies since the crisis -- coupled with the requirement (since October 2009) that banks hold a higher share of gilts in their portfolios to satisfy tougher liquidity standards -- have reduced the share of “outside” gilts to about 70 percent. If foreign official holdings (by central banks) were included in this calculus, the share of outside gilts would be considerably lower.

ECB Purchases

The European Central Bank’s purchases of the bonds of Greece, Ireland and Portugal amounted to about 76 billion euros ($100.9 billion) from May 2010 to March 2011 and account for about 12 percent of the combined general government debts of those three countries.

To summarize, central banks on both sides of the Atlantic (and the Pacific, for that matter) have become even bigger players in purchases of government debt, possibly for the indefinite future. Meanwhile, fear of currency appreciation continues to drive central banks in manyemerging markets to purchase U.S. (and, increasingly, European) government bonds on a large scale. That means markets for government bonds are increasingly populated by nonmarket players, calling into question the information content of bond prices relative to their underlying risk profile -- a common feature of financially repressed systems.

-- Modern Financial Repression, 2008-2012: Advanced economies face the common policy challenge of finding prospective buyers for their abundance of government debt. Huge purchases of such debt by central banks around the world have played a clear role in keeping nominal and real interest rates low. In addition, the Basel III rules provide for the preferential treatment of government debt in bank balance sheets.

Other approaches to creating or expanding demand for government debt may be more direct. For example, at the height of the financial crisis, U.K. banks were required to hold a larger share of gilts in their portfolio. Figure 4 documents how Greek, Irish and Portuguese banks among others have already increased their exposures to domestic public debt.

Thus, the process where debts are being “placed” at below market interest rates in pension funds and other more captive domestic financial institutions is under way in several countries in Europe. Spain recently reintroduced a de facto form of interest-rate ceilings on bank deposits.

It is difficult to sort out the exact motivations, but as bank deposits have migrated from the periphery countries in Europe to Germany and Scandinavia, among others, the amount of disclosure, red tape and other requirements that are necessary to make such transfers has been on the rise. Although some of these requirements may be motivated by a government’s desire to curb money laundering and tax evasion, the measures also amount, in some cases, to administrative capital controls.

Similar trends are emerging in Eastern Europe. The pension reform adopted by the Polish parliament in March 2011 has been criticized by the Polish Confederation of Private Employers, which said the proposal is intended to hide part of the state’s debt by grabbing the money of the insured and passing the buck to future governments. Hungary has nationalized its prefunded pension plans and excluded the cost of the reforms from public debt figures. Bulgaria has taken similar measures.

Faced with a private and public domestic debt overhang of historic proportions, policy makers will be preoccupied with debt reduction, debt management, and, in general, efforts to keep debt-servicing costs manageable.

In this setting, financial repression in its many guises (with its dual aims of keeping interest rates low and creating or maintaining captive domestic audiences) will probably find renewed favor and will likely be with us for a long time.