Thursday, November 18, 2004

PBGC Bleeding Red Ink

The PBGC confirmed earlier this week that its deficit, already at the highest in its history, had doubled in its last fiscal year from $11.2 billion to $23.3 billion. Much of the loss for fiscal year 2004 was a result of pension fund failures in the airline industry. The agency has now lost an average of $10 billion a year for the last three years.

Furthermore, the agency now faces $96 billion worth of risk from companies that are "reasonably possible" to default on their pension promises compared to $82 billion just one year ago.

Tuesday, November 16, 2004

Social Security

As I suggested in an earlier post, the dominant issue of GWB’s second term is very likely to be Social Security reform. The following is an extensive and incredibly insightful discussion of this issue by Michael Davlin. The article is lengthy (and in a few places makes non-trivial demands on the reader’s understanding of finance), but believe me when I say that this article will well repay careful reading. I have not yet had to time to analyze these comments sufficiently to decide if I agree with all of his recommendations, but I definitely agree with most of them. Most important of all, his words of warning regarding the perils of guaranteed minimum income proposals (Free Puts For All) must be heeded. Beyond the conclusions, the overall analysis of the issue is flawless from beginning to end and will provide an excellent introduction to Social Security to anyone who is interested. This article stands in stark contrast to the grossly inaccurate crap we hear about SS from our politicians.

Please allow me to cut through all the SSBS so we can have an intelligent discussion. Repeat three times after me: my government has no wealth; my government has no wealth; my government has no wealth. Wait a second for that to sink in ... there! Now we can proceed on firm grounds.

With the exception of tax futures (aka Treasury notes and bonds), the only marketable assets owned by your federal government are a whole lot of super valuable real estate they refuse to sell, a bunch of buildings that would make for nice commercial office space and some nifty weapons systems. When a ninny like Rep. Bob Matsui of California, top Democrat on the House Ways and Means Social Security subcommittee, says something really stupid and dishonest like "we're talking about an infusion of $2 trillion in revenues to maintain current benefits, and we don't have that money now," he's dissembling because even he is smart enough to realize that the federal government doesn't have any money for any of the currently promised benefits.

In no meaningful or honest sense is any aspect of SS funded. Every dime paid to beneficiaries will come from future taxes. SS owns no stocks; it owns no commercial bonds; it owns no income producing properties. The only real question remaining is who is going to pay those future taxes; will they be payroll or general taxes? Some of you may be thinking but, but ... SS owns a bunch Treasury script which is just like a Treasury bond, and those can be sold to raise cash. True enough. But where do you think those future coupons and maturity payments are going to come from? That's right, future general taxes! It's all going to come from taxes; either payroll or general. That's unavoidable. Come to grips with it.

Let's be honest about this program. We should just toss into the crock box enough Treasury tax futures to allow an actuary to call SS fully funded, kill the payroll tax for both employees and employers, set up the entire liability on the federal government's books, and require SS to maintain this state of being fully funded. This is no less a scam than the current system, so why not do it now and be done with it? In fact, this is no different than the way the current system functions. This move has several benefits: it's an honest accounting of the federal government's debt; any expansion of the program will trigger an immediate and full hit to the budget; and it's consistent with the Roosevelt administration's contention that SS payroll taxes are general, and not dedicated, taxes. Let the federal government fund the entire program from general taxes, not regressive payroll taxes.

The only way to lower those future taxes is to treat the benefits as what the Roosevelt administration claimed them to be when they strong armed the SCOTUS and hoodwinked the public: legally, they are gratuities from your government, and none of us has any property right to them. [This was confirmed by a 1960 SCOTUS decision. – ALD] So let's means test the benefits, and make SS strictly a welfare program instead of an intergenerational income redistribution program. Somebody's going to get screwed - that's inevitable - but we can at least ensure it will be the people who will still manage to get by afterwards with only some slight financial stiffness and soreness. Social Security has been a fraud since its inception, as was pointed out from the start by a few actuaries who were derided as Jeremiahs. It's high time people recognize its true nature, and deal with it.

The equity premium argument is a bunch of BS too, which I'll be happy to dispense with in a second post if anyone's curious.

Useful sidekick: I'm all ears. Or is it eyes?

Thank God there's at least one curious cat in the audience. For a while I was afraid I was going to have to ask me to explain this to me. I will attack the equity premium claim from four angles:
• The claim on its face.
• How an extra $2,000,000,000,000 chasing equity premia might affect them.
• How corporate capital structures and projects might change.
• How an income guarantee from SS under these proposals might affect the premia.

The Claim On Its Face

The advantage of buying debt is that you get paid before people who buy equity. Once you account for the cost of bearing the risks in owning equity that arise from having to stand at the back of the dinner line, you are ex ante no better off with equities than you are with debt. If you were, why would anyone ever be willing to sell equity or buy debt?

A lot of you younger actuaries have studied some quantitative finance (if not, get cracking). In pricing, what is the expected return on equities, and what is the expected return on debt? That's right; they both have the same expected return, the risk free rate (or, more accurately, the perceived least risky rate). That's why pension plans should discount their liabilities at the risk free rate, whether they hold asset portfolios of equities or debt.

But, but, but ... look at the historical time series. Equities beat debt over most long investment horizons. Is quantitative finance wrong then? Well, reason. QF says that, under the realistic probability distribution, equity will have an excess expected return vis a vis debt. Note that this is an expectation, not a prediction. This excess return may be realized, it may not be.

The Italian actuary and subjective probability theorist Bruno de Finetti refused to call this probabilistic measure expectation, because he felt, correctly I believe, that the everyday meaning of the word always crept into people's thoughts and created a feeling of prediction, when it is truly no such thing. He suggested the alternative of prevision, which sounds like a bad translation from Italian, but I like because it causes me to picture myself peering into a cloudy crystal ball with a bandanna on my head ... and that's probably very appropriate when it comes to discussing the things actuaries discuss. We don't predict; we can't; we're not Gods, or even gods.

There are other reasons to question the inevitability of the equity premium argument. Were observed returns carefully adjusted for taxes? Even if they were, one size fits none in that department; depending upon your tax bracket, you might be better off, risk adjusted and after tax, holding debt. And what about risk? Were after tax returns higher for equity after risk bearing is treated like the cost that it is? If not, then what's the point to the strategy?

Also, are there reasons that equity returns might have been abnormally high in the United States post World War II? America was a safe haven for the world's capital until very recently. To whom did the benefits of that flow? And the recent trend in globalization, did the benefits of that redound to domestic labor, debt, or equity? The question answers itself, doesn't it? And what about tax laws which double tax equity, pushing corporations towards leverage and, consequently, equity with higher ex ante risk premia (less equity means whatever equity there is derives its value from claims to cash much farther out in the probabilistic revenue tails)? And what about the great inflation of the 1970s, when many companies were able to increase the real value of their assets while reducing the real value of their debt, all to the benefit of equity? I believe many historically contingent and transient factors acted to produce what appear to be clockwork equity premia.

But all that is prolog; what's going to happen going forward? I could give you another list of reasons why things could go the other way. Just ask the Japanese. Finance is not quantum theory. We have no stationary, ergodic, stochastic event generators for our world, from which we can appraise the future by looking backwards, or with a faith in ergodicity by merely looking at the state of the world today. No, things are more complicated than that.

$2,000,000,000,000 Chasing Equity Premia

If people are told they should invest their now privatized 2% of income in equities because their long term returns will be higher, then that alone will have the same effect as a change in investor preferences for equities vs. debt. The price of equities will have reason to rise, the price of debt reason to fall, and conversely for their expected returns. The net effect could very well be a narrowing of ex ante equity premia. Is this not obvious, especially when we're talking about an aggregate investment in equities with twelve trailing zeroes?

Corporate Capital Structures And Projects

As I mentioned, double taxation of corporate dividends produced more highly leveraged companies with higher ex ante equity premia. With this "privatization" proposal, one of those double taxes is going to be greatly deferred, reducing its economic bite. Logically, we can expect corporations to want to shift back to more equity and less debt. Happily, this is exactly what our newly flush SS investors want them to do. The debt shifted to equity will reallocate less risky claims to revenue from existing but terminating debt to new equity. This means that both equity risk returns and debt returns should begin to decline (think about it). This means projects which were either too risky, or not sufficiently profitable, or too long term, will begin to look more feasible at the margin. Corporations will begin to invest in these previously foregone projects because their costs of capital have dropped. This is may be a good thing (longer term projects may be just dandy) or a bad thing (riskier projects haven't become less risky). It is quite possible that embarking on sufficiently risky projects could increase ex ante equity premia, if SS investors correctly perceive the new risks. But I don't view that as very likely. So, on balance, in light of the discussion in the previous section, I would expect equity premia to narrow.

Free Puts For All

Most of the privatization proposals I have reviewed involve an umbrella guarantee of income, regardless of the performance of the accumulated 2% of income in equities or other instruments. This is financially equivalent to the taxpayers, aka the Social Security System, issuing free puts on those portfolios at a strike price equal to the market value of the umbrella guarantee. You don't have to be Warren Buffett or, more appropriately, Charles Keating, to anticipate what's going to happen next. That's right, anyone who's both rational and paying attention will shift their portfolio into riskier stocks, maximizing their expected wealth and the value of the free put, as well as increasing the likelihood that the equity premium strategy will fail. The potential for abuse here dwarfs that of the piddling S&L / FSLIC / FDIC meltdown in the 1980s. When it predictably occurs, it will be labeled another instance of market failure by government intellectuals (aka economists) and everyone will promise to never again try anything risky with our sound and time-tested system of social security.

The Bottom Line

The equity premium is an ex ante mathematical tautology, not an ex post inevitable truth. Neither equity nor debt stochastically dominates the other in a choice theoretic sense. Whether equity or debt is better for you (in the sense of preferable) depends upon your appetite for downside risk. Both good timing and favorable outcomes are prerequisites for the realization of at least the expected premia. The magnitude of the investments involved will perturb the equity premia. Politically unavoidable secondary guarantees on these "privatized" portfolios will induce risk taking and fraud, undermining the odds of capturing equity premia. Many other factors - demographics, technology breakthroughs, foreign capital, exports, energy - must be as favorable as they were over the last 100 years for observed time series to remain relevant. This is unlikely. The likelihood of failure is high enough, for which blame will be shifted to the only thing that really works, markets, that these schemes pose political risks that should give proponents of markets serious cause for concern.

I'd much rather see the payroll tax obliterated, convert more of the low end earners into FIT taxpayers in order to realign their appetites for "free" government stuff, needs test the benefits, and then leave us free to invest or not invest whatever little it is we have left of our incomes as we care to, not as we're told to.

Useful sidekick: If holding a large amount of an organizations' debt is similar to a veto, I'm not sure I'd want the government release that much debt in bonds.

The feds have already issued that debt in bonds. They're owned by SS and pretty much hidden from view. But they're there, awaiting coupon and principal payments from the income taxes paid by your children and grandchildren. That's what all the excess SS revenue over benefit payments has been buying during this period where SS is supposedly "healthy." Essentially, all of us little schmoes have been forced to buy these Treasury instruments with our working incomes, and we've had to pay income taxes on those purchases to boot! This gives the federal government a reliable and captive sink for the enormous debt they float to fund all the experiments in empire that you find objectionable. With honest accounting, explicit debt, and no payroll tax, the federal government will have to make some tough choices for a change: sell even more debt to willing rather than forced domestic and foreign buyers, raise non-payroll taxes, or cut some spending. No matter which they choose, this will impede their ability to [spend]. The feds are already beginning to have problems moving the volume of bonds they're selling now, before having to also take those "sold" to SS to market as well. To dump this extra volume on voluntary rather than captive purchasers, Treasury rates will have to rise, making federal debt issuance once again less attractive relative to tax increases and spending cuts. I like it!

As for the veto worry, the worst that I think would happen is that foreign central banks would want to dump their dollar denominated securities, and the result of that would a pretty big drop in the dollar in relation to other currencies. You can view that as sort of a declaration of national bankruptcy, only less messy. We'd end up paying more for imports, but our foreign lenders would get less than they had hoped from us, our exports would become more competitive, and some of the pressure to off-shore production would abate, and even reverse in some instances. We'd clear the air, get rid of the payroll tax, stick it to foreign central banks instead of your kids, shore up domestic jobs, and, most importantly, put a tighter leash on our [spending]. What's not for you to like in that?

Monday, November 15, 2004

Did Enron Teach Us Nothing?

Among 401(k) participants invested in company stock, the average is 40.5% of holdings.

More than one out of four employees have 50% or more of their holdings in company stock.


Friday, November 12, 2004

Please Explain...

Michael Cherkasky, president and chief executive officer, told a conference call with analysts that more staff cuts may be necessary as the company seeks to "right size our business depending on our revenue."

Wait a second now. Revenue is up...
  • Revenues totaled $2.97 billion in the third quarter, up from $2.84 billion a year earlier. That's an increase of 4.6%.
  • For the first nine months of the year, revenues were $9.22 billion, up from $8.55 billion in 2003. That's an increase of 7.8%.

So, why is "rightsizing" necessary again?

Tuesday, November 09, 2004

Marsh & McLennan to Layoff 3,000 Employees

The story:

Marsh & McLennan Cos. (MMC), the financial-services titan facing accusations of bid-rigging, announced plans to cut 3,000 jobs, or about 5% of its work force. About 75% of the job cuts announced Tuesday will come from Marsh's risk and insurance services unit. The cutbacks will result in pretax charges of $325 million over the next six months and lead to annual cost savings of $400 million, the company said.

The numbers behind the story:
  • For the third quarter, Marsh reported net income of $21 million, or four cents a share, down sharply from $357 million, or 65 cents a share, a year earlier. Revenue increased 4.7% to $2.97 billion from $2.84 billion.
  • Putnam had $209 billion in assets under management at the end of last month, down from about $280 billion before the mutual fund trading scandal enveloped Putnam and several rivals last fall.