Arnold Kling  

Some Bailout Commentary

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James DeLong wonders what the business model is for Wall Street.


Or, "We borrow from the government at low rates and lend back to the government at a premium, and for that we get paid a lot." (From the investment analyst GaveKal, on the Greek bailout: "European banks should now make enormous profits by acting as a permanent conduit for ECB [European Central Bank] lending to various weak EMU [Economic and Monetary Union] governments. After all, borrowing money from the ECB at 1% to lend it back to EMU governments at 5% plus, while enjoying a permanent liquidity guarantee from the ECB, is not a bad business to be in!")

Like me, he is puzzled that folks who do not seem to have produced the social benefit that would correspond to their incomes are viewed as necessary to bail out.

Also, via Tyler Cowen, we have this article, in which Steve Barrow of Standard Bank gets to make a simple but obvious point.


He that says if they had wanted to "save" the euro, they would have tightened monetary conditions, but these have in fact been loosened .

I hope so. The talk of "sterilization" suggests instead that the European Central Bank is undertaking Piggy Bank operations rather than monetary expansion. But the decline in the euro is consistent with monetary expansion. As Scott Sumner says, competitive devaluation would be a good thing.

Meanwhile, I have rejiggered my portfolio, just so you know. I decided that TBT may be a good way to play short-term movements in interest rates, but I find it unsatisfying as a long-term bet on high inflation and high interest rates. As rates move up and down, they seem to lose more when bond prices rise than they gain when bond prices fall. At least, that's how it looks to me. Maybe they are net long options, so they are paying an insurance premium. In any case, I shifted more into PCRIX instead. My thinking is to use commodities as my reserve currency. But I refuse to be a gold bug. I am pretty far off the deep end as it is, and that would be just about the last step.



COMMENTS (8 to date)
Doc Merlin writes:

'As Scott Sumner says, competitive devaluation would be a good thing'

Maybe in early 1998 when we had adverse NGDP shocks. Now it would just cause more bubbles in non-nominal goods that have very low productivity growth. If they did this, gold and silver will increase in price and land will start increasing in price again.

Doc Merlin writes:

Bah, I meant 2008!

Tracy W writes:

This has been puzzling me about financial markets for a while - where has the money been coming from?

It's sad that James DeLong wandered off into a US-focused rant about Republicans at the end of his article, when the financial markets in London have also been making large profits, implying to me at least that this isn't entirely about US politics.

Steve Waldman writes:

Arnold — Your suspicions re TBT are right on. Leveraged ETFs that seek to reproduce 2x or 3x returns (short or long) are very questionable vehicles for long-term speculation even when they are performing exactly as advertised.

TBT promises twice the inverse daily performance of 20+ year Treasuries. Suppose that the value of the fund's reference portfolio is $100 at time 0. On day one, the value of the portfolio falls by 10% to $90. On day two, the value rises by 11% back to $100.

What would have happened to TBT? Suppose that end the end of Day 0, TBT trades at $100. On Day 1, an investor would have achieved a gain of twice 10% of $100, or $20. So TBT trades at $120. On Day 2, the investor would have received a loss of twice 11% on $120, or $26.

The reference portfolio would have made a quick round trip, from $100 on Day 0 back to $100 at the end of Day 2. But holders of TBT would have experienced a $6 loss on the fluctuation. This is not due to tracking error or poor management. It is an arithmetic implication of daily-return-based, leveraged ETFs.

If you can short efficiently, you are better off shorting "ultra" long ETFs than buying "ultra" short ETFs. But you may not be able to short efficiently. The cost of borrowing the shares and financing your short position might or might not overwhelm attempts to make the arithmetic drag work for you by taking the other side of the trade. (FD: I have played with this. I hold short positions in leveraged ETFs, with very mixed results.)

There's a very nice paper on all this by Cheng & Madhavan http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1393995

See also http://direxionshares.com/pdfs/Compounding_Article_ETFs.pdf

p.s. my views on the likely evolution of interest rates are similar to yours. i express those views via futures markets.

JPIrving writes:

You can make some easy cash if you time TBT right though. I made something like 10 or 15% over 5 weeks back when the reference ETF (TLT 30 year gov bonds) was trading over 100 in the aftermath of the financial crisis. It really depends how the compounding hits you, I have run some monte carlos using the TBT rule and as long as it is a fairly straight shot to your target 30 year bond price you can stay in for weeks or even months and still get a return over a non leveraged short.

TLT is around 94 right now, if it moves quickly to 90 or 88, while the euro remains weak that will suggest investors have downgraded U.S. paper's safe haven status. Right?

Personally I think Canadian debt looks far more attractive as a safe haven. Is U.S. debt's safety credentials stuck in some sort of causality loop? Everyone expects everyone else to go there for safety?

Steve writes:

Steve Waldman:

How do you get past the abstract to read that paper?

Hal (GT) writes:

Read a novel idea the other day. We should just print some money and go buy Greece. What is it? Like 400Billion? Pocket change for the US. Just get the presses rolling and buy the country. Save the world.

Plamus writes:

Steve, here's an ungated copy of the paper: http://www.docstoc.com/docs/5577389/The-Dynamics-of-Leveraged-and-InverseExchange-Traded-Funds

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