Friday, March 23, 2007

Let's talk about risk

Let's talk about risk, baby
Let's talk about you and me
Let's talk about all the good things
And the bad things that may be
Let's talk about risk
Let's talk about risk
Let's talk about risk
Let's talk about risk
paraphrased from Salt 'n' Pepa

We can guarantee cash benefits as far out and at whatever size you like, but we cannot guarantee their purchasing power. Alan Greenspan

One of the more perplexing developments, at least to old school thinking fellows like myself, in financial market participants' perception of risk is the view that bonds,
at current rates of interest, particularly those issued by the US government, are less risky than Gold. I find the view perplexing in that it has very little basis in fact. As the Greenspan quote above alludes, there are no guarantees of purchasing power for the currency in which US bonds are currently (but not originally) denominated, US$. There is also no guarantee of the purchasing power of Gold, but unlike paper money, recalling Jefferson's adage about truth, this does not need the support of government.

Risk is defined as:

1. The possibility of suffering harm or loss; danger.
2. A factor, thing, element, or course involving uncertain danger; a hazard: "the usual risks of the desert: rattlesnakes, the heat, and lack of water" (Frank Clancy).
a. The danger or probability of loss to an insurer.
b. The amount that an insurance company stands to lose.
a. The variability of returns from an investment.
b. The chance of nonpayment of a debt.
5. One considered with respect to the possibility of loss: a poor risk.

The only variation of the definition that might lead one to the conclusion evidently held by the financial markets is 4-a, the variability of returns, and even then only when one restricts one's data set. It is true that Gold was a poor investment, unless you were a very nimble trader, in the late
70s and early 80s compared to US bonds. Double digit interest rates and new found stability for the purchasing power of the US$ from the mid 80s through the late 90s, but since lost, made US bonds a much better investment. But that was then.

In this century Gold has been a far less risky investment than US bonds according to variation 4-a not only because Gold has more than doubled, thus erasing the interest rate gain of bonds, but also because of the loss of purchasing power of the US$.

Moving beyond that one variation in the definition of risk, however, in the current context, it doesn't even seem to me to be a contest. Over the long term, and especially in extremis, Gold is, at least according to history, by far and away less risky than US bonds. Gold does not default, nor change the terms of repayment on the fly (Nixon closing the Gold window). It is what it is- a metal almost always acceptable in trade whose value, based on the thing itself, not the fiat of governments, throughout the past few millennia has always been relatively high.

Corporate, and by that term I mean to include governmental, religious and commercial variants, bonds have, throughout history, from time to time, defaulted. Bonds have their days in the sun, but as they draw their value from the power of the issuing institution, and not the intrinsic value of the thing itself, their value can go to zero, or as was the case with US bonds after Nixon closed the Gold window, can have their value eroded to mere cents on the dollar.

This is not to argue that there are never, or will never again be, periods of time when bonds prove to be better investments than Gold. I'm eagerly awaiting the time when governments need to compete for savings again. Rather, it is to argue that all bonds carry an inherent risk of non-performance that Gold does not. Gold transcends institutions of men. Faith in insitutions is always fleeting, albeit sometimes for quite long periods of time. It is this risk of non-performance, or minimally of failure to repay in kind that I feel to be missing from current calculations of risk.

US government bond advocates hang their hat, if you will, on the period from 1980 through 1999, but expanding their data set to include the preceding decade exposes their view as far less certain. For bonds to become an attractive investment for me interest rates would need to be much higher, like double digits. But even with the current yield curve at 5% the US mortgage market is near disintermediation. The US economy will, I fear, go through some difficult periods to get interest rates high enough to make US government Bonds worth the risk.

Of course, to agree with the view put forward here you have to be able to imagine that the US government will be unable to maintain the value of the US$. Despite the history of bonds in general, disclaimers from Fed Chairmen like Greenspan, and the dismal record of the Fed in maintaining the purchasing power of the US$, the US government is apparently considered, or at least inspires sufficient fear in prominent speakers to evoke statements to that effect, to be different than all other institutions in history.

US Bonds will be less risky than Gold as an investment in the current context if and only if the US government is truly different than all other institutions and retains the ability to do what Greenspan said it couldn't, maintain the purchasing power of the US$. Although I don't usually use Greenspan's views to support my own, in this case, I agree with him.

Some might question the wisdom of fighting conventional views in this matter. To those I would argue that history is filled with the downfall of previously considered indestructible institutions. The scheme of Carlo Ponzi, which immortalized, so far at least, his name in financial infamy, comes to mind.

It is worth noting that depositors at Ponzi's Security Exchange Company had always received on withdrawal, their promised 50% return in ninety days up until his public relations man reported that
Security Exchange Company had never invested one cent in the depreciated European currencies from which he claimed his returns came. So long as investors kept depositing their cash with his company he was able to keep up with withdrawal demands.

People, even the well heeled, it seems, are susceptible to believing things that are too good to be true. Ponzi's scheme could, it seems to me, have gone on for many more years until it ran out of additional depositors. That is, the theoretical absurdity inherent in his scheme would only be exposed in fact when he reached the limit of everyone already being in the pool, so to write. Fortunately, the scheme was stopped before it reached that point.

Given that Greenspan's admission didn't lead people to question their faith in the US government's ability to produce returns for US bond investors, nor has the evidence over the first 6 years of this century, I wonder what it will take to shake their faith?

Barring the discovery of US Bond loving Central Banks on another planet, the US government will eventually run out of additional depositors and then we will see what is risky and what is not.

I met a traveller from an antique land,
who said--"Two vast and trunkless legs of stone
Stand in the desart....Near them, on the sand,
Half sunk a shattered visage lies, whose frown,
And wrinkled lip, and sneer of cold command,
Tell that its sculptor well those passions read
Which yet survive, stamped on these lifeless things,
The hand that mocked them, and the heart that fed;
And on the pedestal, these words appear:
My name is Ozymandias, King of Kings,
Look on my Works, ye Mighty, and despair!
Nothing beside remains. Round the decay
Of that colossal Wreck, boundless and bare
The lone and level sands stretch far away."
Ozymandius - Percy Bysshe Shelley


Bev & Mike said...

By "at 5% the US mortgage market is near disintermediation" do you mean that mortgage investors would sell and with the proceeds buy govies?

Dude said...

Disintermediation in general refers to the middle man being cut out of the process. In finance, it usually refers to a problem with the middle man, in this case, the mortgage financiers who distribute savings to housing investors. Because of poor lending standards, the recent rise in interest rates has exposed their miscalculations and the mortgage "middle man" is becoming incapable of performing his function.

More generally, the finacial intermediaries haven't been pricing the time value of currency correctly, or so I believe, thus as rates normalize, they have problems.

Bev & Mike said...

Dude, In the past, when S&Ls had ceilings on the amount of interest they could pay found "disintermediation" meant savers were taking out their money and investing it where they could get higher rates. The S&Ls couldn't attract the money needed for their operations.

Are you saying the "middle men" are no longer able to distribute money from banks to home buyers? Also can you explain "he time value of currency correctly". Sorry to appear so dense. This is a new way for me of looking at the problem.

Dude said...

You hit the nail on the head. The Fed is doing the same job the ceilings used to do, keeping rates too low to attract to cover risks.

Lenders are unprepared for the higher rates necessary to attract savers because their portfolios are geared for lower rates.