19 May 2013

A Cellars Market

Traditionally, finance quants bleat that government bonds "drive out" private (physical?) investment, and are therefore, ipso facto, bad. Bad for everyone, not just the coupon clipping class. The traditionalists miss the point, of course. As one of my econ professors pointed out: you get lucky, make a lot of money, and spend the rest of your life (as will your spawn) living off the market rate of interest. And that means, generally, Treasuries. In a time of Quantitative Easing, what are the finance quants up to?

The traditionalists have put themselves between a rock and a hard place. They want two opposites to be true at one and the same time; just adjusted to your particular circumstance. The rock: high risk-free Treasury rates drive out productive private investment in innovation, but increase un-earned income for the 1%. The hard place: cratered risk-free Treasury rates drive down the opportunity cost of productive private investment in innovation, but reduce un-earned income for the 1% (who are presumed to avoid the "risk" of equities). The reality: due to the enormous slack in the US (and global, it turns out) economy, QEx is having no obvious effect in driving out private investment. Most of that QEx moolah is going into fiduciary maneuvers, not plant and equipment. Refinancing of corporate debt is doing a Casey Jones. Even The Wall Street Journal admits it.
Private equity, in particular, has been eager to refinance the massive amounts of debt it accumulated during the leveraged-buyout boom, in addition to raising funds to pay special dividends to private equity sponsors this year. So far this year, $120 billion in leveraged loans have been issued, 62% of which have been used for refinancing. That compares with $158 billion in all of 2010, when 32% were used for refinancing.

And Citi agrees (who'd a thunk it?)
So far, so good; this part of the transmission mechanism seems to be working well enough. But this burst of issuance does not seem to reflect a confident corporate sector borrowing heavily to fund expansionary capex. Rather, CEOs seem to have used this money to refinance old debts.

So, we have corporate (risk taking?) CEOs on a sugar high, shuffling off expensive debt from years ago. What a way to re-pay the economy. But, as written here before, when physical investment is hampered by payback periods extending beyond product life cycles, what else is a CEO supposed to do? Give money away to lie-abouts? (Not that the CEOs do all that much heavy lifting; they could be visionary, seeking out productive and profitable physical investment. But Noooooo!!) This is just the circumstance where Keynes, et al, call for governments to proactively invest in physical assets; when the chicken shit corner office types run for cover. And from the collapse they created.

(If you want a full autopsy, then this paper will help. Lots of data and some algebra, and a good deal of historical argument; what the authors call "event-study methodology".)

But there is an effect. Let's say you're a pension fund, and by law/regulation/preference, you've mostly held bonds. You've gotten 7%, say, on average. Now, bond prices have risen, and returns have fallen. What to do? Well, you dive into equities. Pension funds have been in equities for some time, it's nothing new. But with the cratering of Treasuries, and the knock-on effect to corporates, coupon clipping isn't as easy and profitable as it used to be. You could sell off those bonds, at a profit, but that's a one-time gain. You're now chock-a-block in moolah.

Well, now you know why the stock market has risen. Here's the unintended (one hopes, anyway) consequence: an annual 10% capital gain means that only a Ponzi stock market can do that. Oops. Once again: returns to physical investment drive all other interest rates, whether measurable in a conventional data sense or not. Financial engineering for profit is a zero-sum game. Real productivity increase comes from technological progress, and can be sustained only if generally distributed. Hoarding by the few leads to failure of the mass of population. In due time, even the few can't afford progress, since the number of buyers is insufficient to amortize the necessary capital. In time, even the 1% need Obamacare.

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