Grant's Interest Rate Observer X-Mas Issue
Grant's Interest Rate Observer X-Mas Issue
Grant's Interest Rate Observer X-Mas Issue
EDITOR
M
erry and H
appy
To the readers, and potential readers, of Grants:
This compilation of recent articles, our Holiday e-issue, is for you.
Please pass it along, with my compliments, to any and all prospective
members of the greater Grants family.
Not yet a subscriber? Make yourself the gift of a years worth of
Grants at the special New Years rate of $965, thats $60 off the regular
subscription price.
We resume regular publication with the issue dated Jan. 10, 2014.
Sincerely yours,
James Grant
Vol. 31 Winter Break DECEMBER 26, 2013 Two Wall Street, New York, New York 10005 www.grantspub.com
(January 11, 2013) Like a well-fed
teenager, the national debt keeps
growing and growing. On Dec. 31, it
bumped its head against the statutory
ceiling that never seems to contain
it. That would be $16.394 trillion, or
the cash equivalent of 360.7 million
pounds of $100 bills. We write in sup-
port of the ceiling.
Reciprocally, we write against the
debt. At prevailing pygmy interest rates,
we are bearish on the bonds of which it
consists. We oppose, too, the sneaky no-
menclature of American public finance,
including the title affixed to the De-
partment of the Debt. Inasmuch as the
Treasury holds no net treasure, Timothy
Geithners agency should be properly
and frankly rebranded. And we oppose
the monetary legerdemain by which so
much of the debt is financed, notably
the nonstop bond buying of the Depart-
ment of Money Printing. This is the bu-
reau known officiallyanother misno-
meras Americas central bank.
The operating procedures of the de-
partments of Debt and Money Print-
ing didnt come from nowhere. They
sprang from the heads of learned
economists. As imbibed by somewhat
less learned politicians and journalists,
the economists ideas were reduced
to bite-size, destructive, policy-ready
form, e.g., We owe it to ourselves,
and America issues the worlds re-
serve currency, so whats the harm?
and A family has to balance its bud-
get but a nation is different.
The first debt ceiling was enacted
in 1917 after the United States entered
World War I. It authorized the sale of
long-dated 4% bonds in the sum of
apprehensions of an 18
th
-century wor-
rywart. Just how correct was the author
of The Wealth of Nations may be
seen in the fact that the United States
has been able to continue to fund itself
despite not one but two defaults over
the past 80 years: in 1933, when the
dollar was devalued to one-thirty-fifth
of an ounce of gold from a little more
than one-twentieth of an ounce, and in
1971 when the government stopped
exchanging dollars for gold at any rate.
J.P. Morgan, too, had a point when he
admonished that a bear on America
would certainly go broke.
But neither Smith nor Morgan lived
to see the pure paper dollar or todays
routine immense peacetime budget
deficits. Nor did they live to see the
triumph of the ideas of the economists
who neglected to consider the tempta-
tions inherent in the reserve-currency
gimmick. Borrow what you like,
America, in effect, the architects of
the post-1971 monetary arrangements
proposed, you can pay your bills,
foreign and domestic, in the currency
that only you may lawfully print. Now,
just dont go printing too much. A na-
tion of saints might resist the urge to
overdo it. As for us mortals, the debt
ceiling speaks for itself. Perhaps, ob-
serving affairs from the economic and
financial wing of the kingdom of heav-
en, Smith and Morgan are just as wor-
ried as Grants is.
In fiscal and monetary thought,
there is the modern era and the pre-
modern era. The modern era is the
age of heavy public indebtedness
and paper money; were in it. The
ancient era, the age of minimum in-
$7.5 billion; the 1917 gross national
product amounted to $60 billion. (For
perspective, todays $16 trillion-plus
debt ceiling stacks up against a $15.7
trillion GDP.) It was no good omen
that the Senate passed the 1917 act
without a dissenting vote in record
time, according to The New York Times.
The next year Congress enacted an in-
terest-rate ceiling that prohibited the
sale of any U.S. Treasury bond with
any coupon greater than 4
1
/4%.
Since 1917, observes colleague
Charley Grant, the ceiling has been
raised 107 times. Expressed as a com-
pound annual rate of growth, the debt
ceiling has risen by 8.4%, the nomi-
nal GDP by 6%. Twenty-nine more
years on this track and the debt ceiling
would be double the size of GDP.
There is a great deal of ruin in a
nation, said Adam Smith to calm the
Lower the debt ceiling
Id advise you to stop shorting Amazon.
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debtedness and a convertible cur-
rency, is the one that your professor
dismissed with a smile in Economics
101. Grants stands for a modern adap-
tation of ancient thinking.
The creation in time of peace of a
debt likely to become permanent is an
evil for which there is no equivalent,
said President Martin Van Buren,
speaking for the ancients, in his third
annual message to Congress in 1839.
As the sole manufacturer of dollars,
whose debt is denominated in dol-
lars, the U.S. government can never
become insolvent, i.e., unable to pay
its bills, write Brett W. Fawley and
Luciana Juvenal, economists at the
Federal Reserve Bank of St. Louis, on
behalf of the moderns. In this sense,
the government is not dependent on
credit markets to remain operational.
Moreover, there will always be a mar-
ket for U.S. government debt at home
because the U.S. government has the
only means of creating risk-free dollar-
denominated assets. . . .
The Van Buren approach has the
longer pedigree, the better grounding
in history and the surer claim to horse
sense. The St. Louis approach, al-
though ahistorical and actually a little
bit crazy, is the doctrine of the Ph.D.s.
The prejudice against peacetime
borrowing persisted through the
1920s. It lingered into the 1930s
Franklin D. Roosevelt himself aspired
to balance the budgetand made a
brief return appearance after the close
of World War II. On June 3, 1946, the
Senate passed by unanimous consent a
bill to reduce the federal debt limit to
$275 billion from $300 billion. Wide-
ly viewed in Congress as a definite
step toward the end of deficit financ-
ing by the Government, said The New
York Times of the measure in which the
House concurred and which the presi-
dent, Harry S. Truman, signed.
The Iraq and Afghan wars have, of
course, been fought on the cuff. Not
so the Korean War; in the early 1950s,
the debt ceiling went unraised. Be-
cause the [war] was mostly financed
by higher taxes rather than by in-
creased debt, says the Congress-
ional Research Services new history of
the debt ceiling, the limit remained
at $275 billion until 1954. Not until
March 1962 did the debt limit again
reach $300 billion, where it had origi-
nally been set in 1945.
Meanwhile, the rate of inflation was
creeping higher, pressuring bond pric-
es. The Eisenhower administration
was stymied by the aforementioned
1918 law that capped long-dated Trea-
sury coupons at 4
1
/4%. The administra-
tion of John F. Kennedy, however, was
not so inhibited. Shortly after the 1961
inauguration, the presidents brother,
Attorney General Robert F. Kennedy,
ruled that the interest-rate cap did not
bar the issuance of a 4
1
/4% bond priced
at a discount to par, and, therefore, at a
yield higher than 4
1
/4%.
The New York Times report of this
legal innovation is more than a little
timely amid urgings (including that by
former House Speaker Nancy Pelosi)
that President Obama do an end run
around Congress and raise the debt
ceiling by executive order.
That was not a new finding, said
the Times account of the attorney gen-
erals ruling. The Eisenhower admin-
istration found the same thingthat it
was legally possible to get around the
ceiling. The Eisenhower administra-
tion did not try this, however, because
it didnt think it could get away with
it. Interest rates were already high
in 1959. They were a hot political is-
sue. The Democrats were in control
of Congress. In short, the climate for
0
2
4
6
8
10
12
14
16
18%
0
2
4
6
8
10
12
14
16
$18
12/12 9/06 9/01 9/96 9/91 9/86 9/81
Debt trap
30-year Treasury yield (left scale)
and federal debt limit in trillions of dollars (right scale)
sources: The Bloomberg, Office of Management and Budget
T
r
e
a
s
u
r
y
y
i
e
l
d
f
e
d
e
r
a
l
d
e
b
t
i
n
t
r
i
l
l
i
o
n
s
debt
Treasury
yield
0
10
20
30
40
50
60
70
80
0
10
20
30
40
50
60
70
80
16 15 14 13 12 11 10 9 8 7 6 5 4 3 2 1
Faster and furiouser
time required for Congress to raise debt limit by each trillion dollars
source: Office of Management and Budget
n
u
m
b
e
r
o
f
y
e
a
r
s
n
u
m
b
e
r
o
f
y
e
a
r
s
trillions of dollars
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cutting legal corners was most unfavor-
able, so President Eisenhower asked
Congress for specific permission. Con-
gress refused.
The law hadnt changed, in short,
the Times noted. What has changed
is the occupancy of the White House.
It cant be pure coincidence that
growth in the public debt accelerated
following the 1971 default. The Unit-
ed States had, since the first Roos-
evelt administration, borrowed dollars
convertible into one-thirty-fifth of an
ounce of gold. When Nixon redefined
the currency as an uncollateralized
piece of paper instead of a convertible
onethereby defaulting on debts de-
nominated in gold dollarsthe debt
ceiling stood at around $400 billion.
Over the next 10 years, Congress ratch-
eted up the limit to $1 trillionthat is,
as Andrew H. Tisch pointed out in a
June 26 op-ed essay in The Wall Street
Journal, a sum that, paid out in $100
bills, would weigh 22 million pounds.
(The anodyne word trillion is a kind
of verbal narcotic that lulls the people
into a false sense of comprehension,
Tisch suggested.)
And as the par value of the out-
standing debt approached $1 trillion,
long-dated Treasury yields pushed
through 15%. As a matter of fact, the
first trillion-dollar debt ceiling autho-
rization and the all-time record high
in government bond rates occurred
within 24 hours of each other.
Bond Prices Continue Weak, as
Treasury Pays Record 15.78% on 20-
Year Offering, said the headline over
the Oct. 1, 1981, Wall Street Journal
bond dispatch. A Debt of $1 Tril-
lion: Its Effect on Economy, said
the headline over the Oct. 1, 1981,
New York Times report on the loom-
ing American fiscal milestone. The
bond market still is very uneasy about
the economic policies of the Reagan
administration and the large planned
budget deficits, said John O. Wil-
son, a senior vice president of Bank
of America, to the Journals Tom Her-
man. It was possible to infer that soar-
ing debt caused flyaway bond yields.
It was an erroneous inference, but
one that briefly troubled the national
conscience. Blaming 15% interest
rates on the deficit (a mere 2.6% of
GDP in fiscal 1981, in fact), politi-
cians resolved to do better. Weve
only balanced the budget once in
the last 20 years, declared President
Ronald Reagan in a televised address
to the nation. One trillion dollars
of debtif we as a nation needed a
warning, let that be it.
Whether or not America needed
a warning, it declined to heed one.
Many governments have come to
power upon a platform of economy
but never twice, observes Freeman
Tilden in his quirky and wonderful
book, A World in Debt (1935). We
often hear that a politician is equipped
with a mandate from his constituents
toward economy in government. What
this really means is that he is directed
by his electors to urge other politi-
cianssimilarly instructedto spend
less, so that his district can spend more.
As this leads to an impasse, the way
out is clear. Each votes as much as pos-
sible. In politics, the word economy
refers to something somebody else has
done, or has not done, or is to be re-
quired to do or not to do.
Especially do Tildens words apply
to a country equipped with a magic
credit card. What credit card might this
be? Why, the one economists know as
the reserve-currency privilege. We
rather call it a bane, as the ability to
pay ones foreign debts in ones own
currency constitutes an irresistible
temptation to overspend and overbor-
row. Especially is this so when ones
creditorse.g., the Peoples Repub-
lic of Chinafacilitate the buildup
of American debts in their own mer-
cantilist interest. When gold was the
worlds money, there were no privi-
leges; one nations currency was as
Well-marked book
(December 14, 2012) iStar Finan-
cial (SFI on the New York Stock
Exchange) lives and breathes. This
seemingly minor claim to fame is
no small accolade for a real estate
finance business that borrowed to
buy at the top of the market in 2007.
But, like Marleys ghost, iStar really
does exist, and Grants is bullish on
it.
Let us only say that there are
warts. The income statement is a
fright, the directors vote no divi-
dend and management wont come
to the phone (at least, not to talk to
us). The $6 billion balance sheet,
though less encumbered than it
used to be, is still leveraged, and
nonperforming loans are still a drag
on earnings. The CEO, Jay Sugar-
man, 50, earned $25.9 million in
2011, a figure that puts him in the
running for a new title that the
staff of Grants has teased from the
Bloomberg data base. This is the
title: recipient of the highest total
compensation as a percentage of the
market cap of the company that the
CEO leads.
iStar, which is organized as a real
estate investment trust, opened for
business in 1993, went public in
1998 andskipping ahead a full
decadepurchased the commercial
and construction loan portfolio of
the Fremont, Calif., General Bank
in July 2007 at the opening gun of
the great debt contraction. Over
the next 16 months, the SFI share
price, too, did some contracting, to
$1 from $45. Then, on March 16,
2009, iStar negotiated a $1 billion
secured term loan from its bankers.
The clouds parted, the sun shone
and Sugarman exhaled.
Its funding base secured, re-
lates colleague David Peligal, iS-
tar showed its mettle by buying
back boatloads of stock at huge
discounts to book and hundreds of
millions of dollars of debt at mean-
ingful discounts to par. Before the
crisis broke, there were 131 mil-
lion iStar shares outstanding. To-
day, there are 83.6 million, at $7.88
each. After shooting itself in the
guesswork put the figure in the teens.
And do you know how the administra-
tions of Woodrow Wilson and Warren
G. Harding met this calamity? They
balanced the budget and, through the
Federal Reserve, raisednot low-
eredinterest rates. They made no
attempt to prop up wages or prices but
let them find their own level (the Fed
was, in fact, promoting deflation). After
which, a vibrant and job-filled recov-
ery began and the 1920s proverbially
roared. Say, I happen to have written
a short book on the 1920-21 depres-
sion that Simon & Schuster is going to
publish next year. The working title is,
Triumph of the Invisible Hand. May
I count on you for a blurb?
We can all agree that the American
economy is in a kind of trance. You pin
the blamethe immediate blameon
the government, saying, or again imply-
ing, that it hasnt done nearly enough.
Imagine, you said at the IMF, a sit-
uation where natural and equilibrium
interest rates have fallen significantly
below zero. In such a situation, you
broadly hint, QE forever would be just
what the doctor ordered.
Maybe youve seen John B. Taylors
critique of your speech. In rebuttal,
that eminent Stanford economist says
theres no need to imagine the cause
of our long-lingering non-recovery.
The Affordable Care Act, Dodd-Frank
and the 2013 payroll-tax hike are star-
ing us right in the face. I happen to
agree with Taylor. But Im beginning
to wonder if the supposed science of
macroeconomics isnt just politics
dressed up in algebra.
One more thing: On camera with
Bloomberg TV on Nov. 21, you
seemed awfully sure of yourself that
history would vindicate todays radical
monetary measures. On the question
of whether the Fed stepping up and
providing liquidity when no one else
would was the right thing to do, I think
historians are going to judge that about
98 to 2, were your exact words.
Concerning what future historians
might or might not say, you should re-
ally treat yourself to the YouTube clip
of former President George W. Bush
bantering with Jay Leno. Bush is say-
ing that hes been reading some re-
cently published books about George
Washington. If theyre still writing
biographies of the first guy, drawls W.
in his funny-humble way, the 43
rd
guy
doesnt have to worry about it.
Restaurants (DRI on the New York
Stock Exchange), which owns those
outlets and derives 88% of its revenue
from them, earned 11.4% on assets in
fiscal 2006 but only 6.4% on assets in
fiscal 2013, ended May.
And heres the kicker: The stock
market loves Darden. It loves it for
its financial engineering. It wasnt the
food that generated growth in earnings
per share of 5.4% a year between 2006
and 2013. The secret to this feat was
growth in debt; net borrowings were
up by 22.2% a year over the same span.
Now the shares change hands at 18.7
times earnings and 9.6 times enter-
prise value (market cap plus net debt)
to EBITDA (earnings before interest,
taxes, depreciation and amortization).
Its almost as rich a valuation as the
ones that made the peak of the 2007
private-equity boom.
My friend John Hamburger, presi-
dent of Restaurant Finance Monitor,
sponsored his annual restaurant finance
conference in Las Vegas this month.
And do you know what he reported to
his subscribers about that event? He
told them that among the attendees
were the largest number of restaurant
lenders, investors and restaurant op-
erators on hand in our 24-year history.
And he added, While were more than
happy to take credit for superior orga-
nizing skills, a big shout-out goes to
the Bernanke-Yellen credit palooza. .
. . It cant be a good sign that work-
ing Americans can hardly afford to eat
at the restaurants on which the bankers
and promoters continue to extract fees
and to heap leverage.
I think I can guess what youre go-
ing to say, because you said it at the
IMF meeting. Youre going to say that
Ben Bernankes Stakhanovite feats of
money conjuring very likely saved the
world from having to reprise the years
1929-33. You cant prove it, and I cant
disprove it. But why this harking to the
Great Depression and only the Great
Depression? Youd think it was the
only cyclical event in American history.
I myself have been thinking about
the depression of 1920-21. Measured
from peak to trough, this bump in the
road featured drops of 31.6% in indus-
trial production, 46.6% in stock prices
and 40.8% in wholesale prices. The col-
lapse in wholesale prices was reckoned
the most violent in American annals up
until that time. No reliable data exist
on unemployment, but contemporary
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foot with the Fremont purchase,
iStar smartly managed its liabilities
during the crisis. There arent too
many financials, especially credit-
focused ones, that had both the
will and the way to shrink their
share counts. Except for manage-
ments coolness under fireto be
sure, fire it had partly trained on it-
selfthe iStar book value per share
would certainly be lower than the
$10.23 one can simplistically cal-
culate today: $1.4 billion of book
equity minus $545 million for the
preferreds divided by 83.6 million
of outstanding common shares.
Lending is iStars main operating
business. Real estate developers are
its principal customers, and they bor-
row from $20 million to $150 million
for periods of three to 10 years. Whole
loans, loan participations and debt se-
curities stock the iStar portfolio.
Sometimes the borrowers bite off
more than they can service or repay,
which opens the door to a second
business line. iStar acquires prop-
erties, or shells of half-completed
properties, through foreclosure,
deed in lieu of foreclosure, or in
satisfaction of nonperforming loans.
These buildings, and this land, are
mainly what make us bullish.
A third line of business is the
net-lease assets divisionleasing a
finished property to a single credit-
worthy corporate tenant. There are
miscellaneous investments besides,
including a 24.2% stake in LNR
Property, a mortgage special servicer.
Chief sources of revenue for iS-
tar are interest income and lease
income, but neither is adequate to
deliver a net profit. Losses before
earnings from equity-method in-
vestments and other items totaled
$288.4 million in the first nine
months of 2012, better than the
$1.34 billion recognized in 2009, but
a loss nonetheless. Apple, Peligal
remarks, the company is not.
It is not a beat-and-raise
story, Peligal continues, nor a
my- est i mat es- ar e- hi gher - t han-
the-Streets story. Its not even a
I-think-theyre-going-to-make-a-
lot-of-money-on-a-GAAP-income-
basis kind of story. Theyre going
to lose money over the next few
quarters, and it wouldnt be sur-
prising if book value fell a little bit
during that time.
iStar is rather the story of asset
values still hidden butperhaps
with an assist from Chairman Ben
Bernankeultimately to be realized
on a $900 million land portfolio that
is going to be sold to home build-
ers over the next 12 to 36 months,
and on a $400 million condominium
portfolio that is in the process of
being sold, unit by deluxe unit, to
wealthy home buyers. The value
proposition we judge to be compel-
ling, but instant gratification plays
no part in it.
Landthe companys high-quali-
ty acres destined for master-planned
communities or for waterfront de-
velopmentwas a topic on the
third-quarter conference call. The
managed land portfolio, Sugarman
told dialers-in, . . .can be broken
down a few different ways, but one
simple way is to group them accord-
ing to when they will begin produc-
tion. Our current portfolio has 10%
of assets by book value already in
production, and we anticipate hav-
ing approximately 60% by book val-
ue to be in production by the end of
2014. The remainder are expected
0
200
400
600
800
1,000
1,200
0
200
400
600
800
1,000
1,200
501+ 201-500 101-200 20-100
Sugarmans a finalist
dollars of market cap to dollars of CEO pay of
companies with market cap above $500 million
dollars of market cap to dollars of CEO pay
iStar CEO
fits in here
source: The Bloomberg
n
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o
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s
0
20
40
60
80
100
$120
0
20
40
60
80
100
$120
12/11/12 3/12 3/11 3/10 3/09 3/08 3/07
Solvent for sure
iStar 5.85% senior notes of 2017
source: The Bloomberg
p
r
i
c
e
p
r
i
c
e
Winter Break-GRANTS/DECEMBER 26, 2013 9 SUBSCRIBE! - go to www.grantspub.com or call 212-809-7994
to begin production between 2015
and 2017. This portfolio should be
a strong contributor to future earn-
ings, though not until a majority of
the projects are in full selling mode
and will remain both cash flow and
earnings negative until then.
The companys condominium
exposure consists of $264 million
in performing loans, $65 million
in nonperforming loans andthe
stuff with the upside potential, we
judge$389 million in other real
estate owned. The iStar OREO
portfolio features such sanctuaries
for the one-tenth of 1% of American
earners as 10 Rittenhouse Square
in Philadelphia (an unfinished,
6,900-square-foot space will cost
you $7 million, not that you should
even blink) and Ocean House in
South Beach in Miami, Fla. Both
projects are said to be more than
70% sold. Two years ago, relates
Peligal, there was a lot of doubt
about iStars condo portfolio. To-
day, there is not.
The process by which a lender
by trade becomes an owner and de-
veloper begins with someones mis-
calculation. Lets say, says Peli-
gal, iStar lent to a condominium
developer, the developer couldnt
pay and iStar repossessed the collat-
eral. The project is stalled, so iStar
must complete it. The lobby needs
work, the fixtures are uninstalled,
whatever. Money goes out of iStars
door to salvageand to improve and
enhancethe value of the project.
The expenses go on and onfor
security guards, maintenance, utili-
ties. As long as these outlays con-
tinue, the condo will remain an eye-
sore on iStars income statement.
But its not a terrible assumption to
make that the dollars theyre invest-
ing today are going to allow them to
sell the building for a 30% gain com-
pared to where it is marked on the
balance sheet.
But this assumption is one that an
investor will have to make him- or
herself. Goldman Sachs may mark
its assets to market, but iStar does
something else. It estimates what an
asset might be worth in the future,
but discounts that value by what the
asset might fetch today. Fair value
accountingthe kind that iStar, a
finance company, employsdefers
the recognition of any accretion in
value of repossessed collateral un-
til the moment of sale or leasing.
The bottom line, notes Peligal,
is that it takes a very long time for
these assets to generate what looks
like GAAP earnings. But we could
potentially see $100 million to $150
million in gains thrown off from the
stable of repossessed condos in the
next 18 months.
Ori Uziel, a big iStar owner
andanda paid-up subscriber to
Grants, tells Peligal that what the
iStar doubters miss is the quality of
the iStar assets. Most people dont
know the tracts of land were talk-
ing about, Uziel says. If you do
know what tracts of land were talk-
ing about, you should be encour-
aged, but its a long-tailed process.
. . . For an investor to invest here,
you have to realize that book value
is worth more than what is stated in
the 10-Q. This is because the credit
tenant lease assets are worth more
than book, the condos are worth
more than book, their stake in LNR
is worth more than book, etc. There
is probably not much loss content
on the loans, although some people
point to mezzanine loans in Europe
as potentially a problem. But its not
very much. What youre left with is
a big bet on residential land and the
potential to restart the lending busi-
ness. Almost all the land is single-
family residential and its marked at
about, according to my calculations,
40 to 45 cents on the dollar vs. peak
prices. Some of it is less than that,
some of it is more than that. They
just sold a piece of property in Hol-
lywood, Calif., to Kilroy Realty for
basically the peak market price. iS-
tar actually had it on its books for
that price and it was the piece of
land I was most worried about. This
is because it was sold for $15 mil-
lion in 2003 and then $66 million
in 2006. iStar had it on its books for
$64.5 million, and they just sold it
for $65 million. Those are the num-
bers. The market is marking down a
well-marked book.
10 Rittenhouse Square, Philadelphiaan iStar trophy
Winter Break-GRANTS/DECEMBER 26, 2013 10 SUBSCRIBE! - go to www.grantspub.com or call 212-809-7994
With the Oct. 15 closing on a
new $1.82 billion credit facility, iS-
tar secured a lower cost of capital
and a more forgiving debt-maturi-
ty schedule. Next year, $1 billion
of debt falls due, then essentially
nothing until 2017. Moodys be-
stowed its approval on the autumn
financing by raising its iStar debt
rating to B2 from B3. On the third-
quarter call, Sugarman said that
some additional reduction in cor-
porate leveragenow running at
the top of the companys expressed
2.0:1 to 2.5:1 preferred rangeis
probably prudent.
Incidentally, in fairness to Sugar-
man, the stockholders themselves
voted to bestow the $23.4 million of
multiyear stock awards that formed
the principal source of his $25.9
million jackpot in 2011. But in fair-
ness to us, his sympathetic analysts,
theres nothing to do but guess
about the reason, or reasons, behind
his sale of 188,175 shares of iStar at
the end of November. We are going
to guess that the use of proceeds
was to fund his professional soc-
cer team, the Philadelphia Union,
which, at 10-18-6, failed to make the
Major League Soccer playoffs this
year. Even contending teams cost
money. Sometimes non-contending
teams cost more.
One of the interesting things
about iStar is how hard it is to get
information from the company,
Peligal winds up. Maybe theres a
reason. Maybe silence better serves
the interest of a buyer of discounted
shares (its own) or the developer
of discounted land. Banks typically
sell their foreclosed land. Not iStar,
which has to spend money to devel-
op its land. If thats the strategy, you
wouldnt want your IR team putting
out press releases telling the world
how valuable the portfolio will be in
2015. Could this land be worth 50%
more than where its listed on the
books now? Its possible. Could it
be worth 100% more? Also possible.
Those devilish Cartoons.
Everyone has a favoriteorder yours!
Own a print of a Hank Blaustein masterpiece.
Find your favorite in the Grants cartoon treasury: www.grantspub.com/cartoon
5x5 cartoon size, signed by Hank, matted for $150, framed for $250
0
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$60
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$60
1/12 1/10 1/08 1/06 1/04 1/02
Back from the Abyss
SFI stock price
source: The Bloomberg
p
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Dec. 11,
$7.88
Winter Break-GRANTS/DECEMBER 26, 2013 11 SUBSCRIBE! - go to www.grantspub.com or call 212-809-7994
If you think about the numbers,
theres potentially $5 a share to $10
a share of upside for the land port-
folio, and probably only a few bucks
of downside.
Break ball in billiards
(April 19, 2013) In the game of eight
ball, the first shot is the break shot, in
which the lady or gent with the cue
stick scatters 15 balls all over the felted
table. In order to do this, advises an
online authority on the physics of bil-
liards, you must hit the cue ball with
a certain force a certain distance away
from the rack and at a certain angle.
Two weeks ago, Haruhiko Kuro-
da, newly installed governor of the
Bank of Japan, set markets in motion
with a powerfully struck break shot.
Where the caroming monetary, inter-
est-rate and volatility balls will come
to rest is the subject at hand. The
answer in preview: They will come
to rest in places the central bankers
havent thought of.
Markets were prepared to hear about
a ramping up of Japanese QE, but the
new governor astounded them. He
promised to double the size of the Japa-
nese monetary base by the end of 2014,
and to buy not only JGBs but also eq-
uity ETFs and real estate investment
truststo buy what, on the scale of
Americas GDP, would amount to $190
billions worth of assets each month,
compared to the mere $85 billion per
month that the Fed is putting away.
With all of this, Kuroda redefined the
term radical ease. Compared to the
Bank of Japan, the Federal Reserve
now seems just moderately wild-haired.
The BoJ has succeeded in out-Bernan-
ke-ing even the chairman of the Fed.
Since Kuroda hefted his cue stick,
bond yields have declined in the West,
though they have risen in Japan. The
yen has weakened and the Nikkei has
lifted. These, perhaps with the ex-
ception of the action in JGBs (the 10-
year rate has vaulted to 0.581% from
0.441%), are the consequences that
Kuroda intended. Still to come are the
consequences he didnt intend.
Many are the possibilities un-
der the always interesting heading
of Things the Authorities Didnt
Think of Before They Ran the Press-
es and Overrode the Price Mecha-
nism. Already, the Bank of Japan has
made its mark on bond yields. Pres-
ently, it may leave its calling card in
China, where credit formation was
already fast and furious before the
yen exchange rate dipped, and in the
volatility markets. But the nature of
clacking and clicking billiard balls is
that they go where they will. Kuroda-
san has launched the world on a new
financial adventure.
On one consequence, we can
bank, however. By instigating an-
other lurch higher in bond prices,
Kuroda will, by that increment, de-
value credit analysis. And by devalu-
ing credit analysis, he will speed the
day of the next crisis of lending and
borrowing. By legitimizing a new,
even more radical strain of QE, he
will embolden othersthe incoming
governor of the Bank of England,
Mark Carney, seems a likely candi-
dateto experiment with greater
feats of money printing. Revolu-
tions devour their children, even
revolutions undertaken by the mild-
mannered scholars of the global cen-
tral-banking community.
Surmising that yield-starved Japa-
nese will snap up fixed-income secu-
rities denominated in non-yen curren-
cies, speculators have taken anticipatory
action. They have pushed zloty-de-
nominated 10-year Polish government
bonds down to 3.52%, peso-denominat-
ed Mexican government 10-year yields
down to 4.72%, lei-denominated Ro-
manian government seven-year yields
down to 5.05%, and high-grade Euro-
pean corporate yields down to 2.31%.
They have created such an alignment
of the fixed-income stars that Ba2/BB-
rated CNH Global N.V., the product of
a 1999 merger between Case Corp. and
New Holland N.V., was able last week
to raise $600 million for five years at a
yield of just 3
5
/8%.
On April 12, European Union finance
ministers gave Portugal and Ireland
seven-year extensions in which to repay
their bailout loans. Preceding this act of
purposeful charity, the split-rated Euro-
pean Financial Stability Facility paid a
yield of just 0.956% to borrow 8 billion
for five years. So great was the unslaked
demand that the supra-national bail-
out fund could have raised 14 billion.
What once looked rich is no longer rich
any more, the weekend Financial Times
quoted Steven Major, head of fixed-in-
come research at HSBC, as saying. Say
goodbye to the yield floor.
And goodbye, tooat least in a tem-
porary, cyclical wayto old-fashioned
credit work. Uniformly tiny interest
rates dull the effort to distinguish good
investments from bad. At next-to-noth-
ing percent, one credit looks much like
another. The blurring of gradations
in credit quality, owing to the undif-
ferentiated flight into fixed-income
securities, will do nothing to enhance
the reasoned allocation of capital. On
a positive notewe speak now as jour-
nalistsunreasoned capital allocation
never fails to make for good copy.
According to Money Fund Intelligence,
4/12/13 1/12 1/11 1/10 1/09 1/08
Example of an intended outcome
Nikkei (left scale) vs. yen (right scale)
source: The Bloomberg
N
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7,000
8,000
9,000
10,000
11,000
12,000
13,000
14,000
15,000
16,000
yen
Nikkei 225
Winter Break-GRANTS/DECEMBER 26, 2013 12 SUBSCRIBE! - go to www.grantspub.com or call 212-809-7994
U.S. prime money-market mutual funds
raised their exposure to euro zone issu-
ers to 20% of assets in February from
14% of assets in August. Assume that
the relevant funds know their credits.
But with yields on euro zone money-
market instruments pinned at only a
few basis points above zero, the differ-
ence between money-good and money-
not-so-good is of little or no practical
consequence. For a return of virtually
nothing, what avails due diligence?
In the sovereign debt market, too,
fund flows quash analysis. Last week,
the European Commission issued a
lengthy indictment of French public
finance and French industrial competi-
tiveness. Government debt is too high,
the labor market is too rigid and taxes
are too high, said the bill of particulars.
French public-sector indebtedness rep-
resents a vulnerability, not only for the
country itself, but also for the euro area
as a whole, the commissioners added.
Yet, in the face of these risks, the yield
on 10-year French sovereign debt has
dwindled to 1.82%, about as low as it
has ever been. A double-A-plus credit,
France is under surveillance for down-
grade by Moodys, Standard & Poors
and Fitch. It is not, however, as yet un-
der surveillance by Mr. Market.
The clustering of sovereign bond
yields in the neighborhood of nothing
after tax and after inflation figured in
some weekend brainstorming about the
mobilization of European gold. Would
it not be better to issue bonds against
this national treasure rather than to sell
it outright? You may recall that France
issued bonds in 1973 secured by the na-
tional gold stock. Dubbed Giscards,
after the then-French president Valery
Giscard dEstaing, they featured in
Tom Wolfes novel, Bonfire of the
Vanities. Yet, as the Lex column of
the Financial Times noted the other day,
with interest rates pressed to the floor,
the yields on gold-backed bonds might
not be meaningfully lower than those
attached to plain-vanilla securities de-
nominated in paper currencies.
Even fewer basis points would remain
for private consumption if the European
Commissions mooted financial transac-
tions tax were enacted, as it might very
well be, effective Sept. 1. The taxthe
FTTwould be levied at each stage of
a financial transaction, according to FT
columnist John Dizard: So if a U.S.
bank sells a French company bond to a
U.K. insurer, and each, as is customary,
uses a bond broker, the tax on the one
transaction adds up to 60 basis points.
At current rates of decline in Continen-
tal yields, there will hardly be 60 basis
points left for the EU to seize.
Kuroda-sans break ball may ricochet
around the monetary billiards table for
many a moon. Chinese lending and bor-
rowing were on a tear before the Japanese
demarche. In the first quarter, the broad-
est measure of Chinese lending climbed
by 6.16 trillion renminbi, or $1 trillion, the
equivalent of 12% of 2012 GDP. How
will Chinese finance officials answer
the competitive threat presented by the
suddenly cheaper yen and by the pro-
spectively reflating Japanese economy?
We will venture that China will respond
by keeping up the torrid gait of credit
growth. If the first-quarter rate persisted
for the rest of the year, growth in cred-
ittotal social financingin China in
2013 would amount to 47% of output,
the most on record since at least 2002 and
six percentage points ahead even of the
emergency rate of infusion in 2009.
Prolonged periods of extreme mon-
etary ease are good for journalists,
governments and speculators, but not
for savers and producers. We take this
truth to be self-evident (although the
IMF has lent its authority to the propo-
sition in a new Global Financial Stabil-
ity Report), and we accept as given that
the central banks have no informed
idea of what the money they conjure
will finally do or to whom it will ulti-
mately do it.
It isnt only the central bankers who
cant predict the consequences of un-
precedented actions. Most mortals
cant. But we will take a guess. The
Japanese initiative of April 4 will pro-
voke other central banks to act, per-
haps to cheapen their own currencies
or to nip a nascent panicMondays,
The history of modern finance
in Grants cartoons
See The World According to Grants,
a pictorial and musical journey. Just log on to
grantspub.com for this special holiday treat.
All this and more!
Go to www.grantspub.com
And as long as youre visiting, check 30 years of archived
Grants articles, searchable by date or keyword.
BOUT ARCHIVES OUR IDEAS VIDEOS RESOURCES CONFE
John Ihii Sousu Iunk Buustein
This
A GRANTS retrospective
is the
year
that was
Winter Break-GRANTS/DECEMBER 26, 2013 13 SUBSCRIBE! - go to www.grantspub.com or call 212-809-7994
for examplein the bud. In so acting,
the mandarins will scatter another rack
of monetary billiard balls. Ultimately,
the central banks themselves will drive
thinking investors out of bonds and
into assets the value of which does not
depend on the stable value of money.
Uncommonly preferred
(September 21, 2012) If markets
were efficient, inquires colleague Da-
vid Peligal, why would Hyundai Mo-
tors second preferred securities (005387
KS on Bloomberg) trade at 32% of
the price of Hyundais common stock
(005380 KS on Bloomberg) when, for
all intents and purposes, the two securi-
ties are economically identical? There
happens to be no good reason. Now un-
folding is a bullish expos on a distant
market inefficiency.
Mind you, South Korea does not ex-
actly roll out the welcome mat for foreign
value seekers. Professionals will find no
insuperable barrier to buying Korean
preferreds that trade at anomalous dis-
counts to the corresponding common.
And neither, for that matter, will the
persistent retail investor. But to com-
plete the required documentation will
require some intercontinental e-mailing.
You cant just call Charles Schwab.
The analysis now unfolding deals
mainly, though not exclusively, with
the eccentric market in Korean pre-
ferreds. Other topics include the na-
ture of value, corporate governance,
cultural differences in this supposed
age of financial globalization and the
importance (or non-importance) of
catalysts, market liquidity and vot-
ing rights in the delivery of superior
investment returns. Buy the persis-
tently discounted, evidently catalyst-
free Korean preferreds, even without
hedging through a sale of the underly-
ing common, is our conclusion.
To begin at the beginning, 148 issues
of Korean preferred are listed with a col-
lective market cap of some $10 billion.
While a portion of these issues are tiny
and illiquid, others trade $10 million or
more a day. None is listed in the MSCI
Index, which means that, for the index-
hugging, Korean-focused mutual funds,
they might as well not exist.
In Korea, Peligal explains, the
term preferred share will appear as
something of a misnomer to an investor
in U.S. equities. While giving the holder
full economic participation rights in the
earnings stream of a business and a pri-
ority dividend, Korean preferred shares
lack voting rights. One may therefore
think of them as non-voting common
shares. Theres no question that voting
rights have value, but how much of it?
In Korea, the value of a vote is quite low.
Investors willing to pay three times the
price for a vote are paying a hefty price
for a quiet vote in a country with chae-
bols, concentrated family ownership and
a distinct lack of corporate activism.
Then, too, you cant buy and sell the
preferreds as easily as you can the com-
mon. Besides, Korean common shares
have delivered better returns than the
corresponding preferreds over the past
five to seven years. Furthermore, Kore-
an managements (in general) seem in no
hurry to help in closing a valuation gap
that, according to a six-foot pile of CFA
manuals, shouldnt even exist. Maybe
the valuation anomaly wouldnt persist
if more foreigners could read prospec-
tuses written in Korean, but few can.
But maybe, Peligal proceeds, the
sheer size of the discounts is reason
enough to take the plunge. Lets go back
to the Hyundai Motor example. That
9/12/12 9/10 9/08 9/06 9/04 9/02
Not so preferred
price of Hyundai second preferred shares as percent of common
source: The Bloomberg
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70%
25
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65
70%
9/12/12 9/10 9/08 9/06 9/04 9/02
Sale days in preferred
historical median discount of Korean preferred shares vs. common
source: The Bloomberg
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25%
75
65
55
45
35
25%
Winter Break-GRANTS/DECEMBER 26, 2013 14 SUBSCRIBE! - go to www.grantspub.com or call 212-809-7994
second preferred issue (the automaker
has three) is trading at 79,700 won and
yields 2.3%. Hyundai common is trading
at 248,500 won and yields 0.7%. Ergo, a
68% discount, about as steep a discount
as any in the past 10 years. Historically,
Korean preferreds have traded at an av-
erage discount of 54%; its 69% today.
In fact, the preferreds, on average, are as
deeply discounted as they were during
the 1997 Asian financial crisis. Remem-
ber, if a discount narrows to 60% from
70%, you dont make a 10% return. You
make a 33% return.
Arbitrageurs might choose to go
long the preferreds and short the un-
derlying common. Sticking with
Hyundai, Peligal notes, such a strat-
egy would deliver an after-tax carry
of 1.4%, although there are good rea-
sons to buy the preferreds outright. So
doing, one would not necessarily be
trusting in the market to close an un-
reasonably (say we) wide discount, but
rather in the tendency for good things
to happen to cheap stocks.
Korean preferreds, an anonymi-
ty-seeking, buy-side analyst informs
Peligal, are a bizarre exception to
the phenomena we see with investors
overpaying for yield without regard for
NAV. It would seem prudent that Ko-
rean investors arent reaching for yield.
However, in this instance, its actu-
ally incredibly imprudent, because an
investor could basically buy the same
economic claim at a much cheaper
price. This behavior is so inconsistent
with what we, as a fund, are seeing else-
where in the world.
Unusual, too, are Korean preferred
valuations in comparison with those
of similar securities in other countries.
Whether set against Indian differen-
tial voting-rights shares, Italian savings
shares, Swiss participation certificates
or German preferred shares, Korean dis-
counts vis--vis the relevant common
shares are in a league of their own.
Theres no guarantee, of course, that
cheap securities cant become cheap-
er (it happens all the time in Value
Land). But, as discounts widen, other
things being the same, yields increase.
Thus, Peligal observes, if the Hyun-
dai second preferred securities were
to trade at a 90% discount, their yield
would jump to roughly 8%. By com-
parison, short-dated Hyundai corporate
debtthe 4s of 2017, for instanceare
priced to yield less than 3%. The Kore-
an governments two-year note fetches
2.87%, its 10-year note 3.08%.
At a 60% discount, Peligals afore-
quoted informant says, you might have
said that it would never go to a 70%
discount. But when we buy something
cheap enough, our experience has been
that we are more likely to be positively
surprised than negatively surprised.
Armor Capital, a New York-head-
quartered hedge fund with $382 mil-
lion under management, has had its
share of pleasant preferred-induced
surprises. Boris Zhilin, principal (and,
let the record show, a paid-up subscrib-
er to Grants), says that two such issues
have been in the funds portfolio since
the mid-2000s. They are Amorepacific
Corp. (090435 KS on Bloomberg) and
LG Household and Healthcare (051905
KS on Bloomberg), the former trading
at six times, the latter nine times, Ar-
mors estimate of 2013 earnings, and at
discounts to the underlying common of
72% and 69%, respectively.
One has to be happy with a return
that comes from dividends and rein-
vestment decisions by management
and not from people waking up and
realizing, My God, these discounts
are crazy, Zhilin says. If people
do come to this realization, great. But
one shouldnt invest expecting that
to happen. The other big takeaway
is that high-quality businesses, the
ones that tend to become intrinsically
more valuable over time, are the best
investments when it comes to deeply
discounted preferred shares. These
businesses turn time, as an investment
parameter, from a potential detractor
to a very helpful friend and ally. This
allows one to earn attractive absolute
returns, even in periods like the past
five to seven years, when the mul-
tiples of many preferred shares con-
tracted and the discount to the com-
mon shares widened.
Kyung Suk Choi is the man at Dae-
woo Securities who sets up brokerage
accounts for foreign nationals. To fill
out the necessary forms and secure an
investment ID from the Korean finan-
cial authorities, e-mail him at kyungsuk.
choi@dwsec.com. Or, if you can come to
terms with the name, Boom Securities,
affiliated with Monex Group, executes
orders for American investors in Asian
markets: https://baby.boom.com.hk/en/
is the Web address.
Yellen on deck
(November 16, 2012) By reelecting
President Barack Obama, the Ameri-
can people have very likely secured
the reappointment of Federal Re-
serve Chairman Ben S. Bernanke.
Or, if not Bernanke himself, then an
intellectual doppelgnger. The Ph.D.
standard won in a walk two Tuesdays
ago, though it wasnt even on the bal-
lot.
This back-door affirmation of pro-
fessorial monetary management will
eventually go down as the elections
most important outcome. We say
eventually. Come the next col-
lapsed asset bubble or the next roar-
ing inflation, many will recall that
they actually never did understand
what the various distinguished former
Ivy League economics department
heads were talking about. Then,
again, as will come to light, neither
did the supposed experts.
Either the lessons of monetary his-
tory are moot or our mandarins are
wrong. We write, in the first place,
to support the latter hypothesis, and,
second, to speculate anew on the
consequences of QE, ZIRP, Opera-
tion Twist and modern central bank
communications policy. Look-
ing back at todays ultra-low interest
rates, investors will think of the fable
of the boiled frog and belatedly real-
ize that they were the duped amphib-
ians.
The lessons of monetary history
is an admittedly vague and conten-
tious term. But its easy enough to
show that paper currencies tend to
lose their value, and that govern-
ments that borrow in paper currencies
tend to overborrow. It is writ.
Unwritten is the timing of the de-
nouement of the printing of boodles
of money, though the sequence of
sin and suffering makes a comeup-
pance of some kind inevitable. Sin
comes first, always. If we suffered
before we sinned, we wouldnt sin.
If the pleasure and pain of monetary
overstimulation were coterminous,
there would be no inflation, no fast-
climbing public debt and no explod-
ing asset bubbles. The cost of over-
cranking the presses would be just
as obvious, and just as immediate, as
the thrill induced by the monetary
pick-me-up. As it is, the pleasure
Winter Break-GRANTS/DECEMBER 26, 2013 15 SUBSCRIBE! - go to www.grantspub.com or call 212-809-7994
is immediate, the pain prospective.
And ifas in the case of Chairman
Bernankes central bankthe ma-
terialization of new money perks up
the prices of stocks, bonds and real
estate, there is a general submission
to the wisdom of the professors.
Dont worry, they say. There is
plenty of slack in the product and
labor markets. There is the need
for continued de-leveraging. There
is a shortfall in aggregate demand.
There has been a collapse in the rate
of monetary turnover, or velocity,
as well as a breakdown in the link-
age between central bank credit and
commercial bank credit. There is, in
consequence, no realistic chance that
todays unconventional policy will be
the source of tomorrows inflation.
Anyway, inflationary expectations
are most satisfactorily anchored. And
who anchored them? Why, the deep
thinkers at the Fed assert, they them-
selves did.
If Chairman Ben S. Bernanke is the
deep thinker-in-chief, the Feds vice
chairman, Janet Yellen, is his princi-
pal doppelgnger. She is as depend-
able a voice as there is on the Fed for
radical experimentationon Tues-
day, she urged that the FOMC hold
the funds rate at zero until the unem-
ployment rate and the inflation rate
meet with the mandarins approval.
Gold bulls should light a candle on
her birthday, August 13, and pray that
she rises to lead the Fed when its
time for the chairman to go. If Ber-
nanke is good for, let us say, $3,000
an ounce in the bullion price, Yellen
is a force for $4,000. If, at the close
of Bernankes term in January 2014,
he chooses to step down, or is chosen
to step down, she would be a strong
contender to succeed him.
The holder of a Ph.D. in econom-
ics from Yale University, Yellen has
every necessary credential to man-
age the pure paper monetary system.
Chairman of the Council of Economic
Advisers under Bill Clinton, a one-
time Fed governor, a one-time presi-
dent of the Federal Reserve Bank of
San Francisco and a former professor
at the Haas School of Business at the
University of California at Berkeley,
Yellen has taught, as well, at Harvard
University and the London School of
Economics. And while it is true that
she was presented with the Adam
Smith Award by the National Associa-
tion for Business Economics, that hon-
or should not be counted against her in
the running to manage the institution
that strives to manage the economy by
manipulating the value of the curren-
cy. She has no slavish attachment to
the price mechanism. On the contrary,
shes foursquare for mandarin rule.
Neither will it hurt Yellens chan-
ces when the time comes to pick a
new chairman that the vice chairman
is a company woman. I will be the
first to say that it is always difficult
to get monetary policy just right,
she acknowledged at the Common-
wealth Club of California in June
2009, two years after the start of the
financial panic that our central bank
so signally failed to anticipate. But
the Feds analytical prowess is top-
notch and our forecasting record is
second to none.
Which is not to say, however, that
this possible nominee to lead the
FOMC has no mind of her own. In
a 2003 talk at the Federal Reserve
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3/11 3/01 3/91 3/81 3/71 3/61
1.2
1.4
1.6
1.8
2.0
2.2
2.4x
Pushing on a string
U.S. monetary base in billions of dollars (left scale)
vs. velocity of M-2 (right scale)
sources: Federal Reserve, Federal Reserve Bank of St. Louis
m
o
n
e
t
a
r
y
b
a
s
e
v
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l
o
c
i
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y
o
f
M
-
2
monetary
base
velocity
0
500
1,000
1,500
2,000
2,500
$3,000
Winter Break-GRANTS/DECEMBER 26, 2013 16 SUBSCRIBE! - go to www.grantspub.com or call 212-809-7994
Bank of St. Louis, former Fed gover-
nor Laurence H. Meyer described a
telltale exchange on how to define the
fraught phrase, price stability. The
scene was Meyers first FOMC meet-
ing, in July 1996, and then-governor
Janet Yellen was making the case for
inflation targeting; she said she would
aim for 2%. Chairman Greenspan re-
plied that the Federal Reserve had a
mandate to foster stable prices, not
rising ones. Whereupon Yellen re-
plied that the Fed also had a mandate
to promote full employment. To hear
her tell it, some increment of curren-
cy depreciation was a necessary lubri-
cant for economic growth.
Janet then seized the initiative,
Meyer related, asking the chairman
to indicate how he would define price
stability. Greenspan tried to get away
with his vague definition. Price sta-
bility is the state in which expected
changes in the general price level
do not effectively alter business or
household decisions. But Yellen
pressed him and asked if he could
put a number on that. Remarkably,
the chairman agreed, and said he pre-
ferred zero inflation, correctly mea-
sured. Janet asked him if he could
settle for 2% incorrectly measured.
It was a rare flash of recorded wit
for the vice chairman, but Greenspan
had the better point. Measurement
of inflation is inherently subjective.
But even Greenspans definition was
too narrow. Changes in the measured
price level these days are admittedly
minor. They do not effectively al-
ter business or household decisions.
But zero-percent interest rates are
another matter. They have scram-
bled investment decision-making.
They have changed the way firms
and households think about risk, and
they have warped the structure of
the economy itself.
Open before us is an essay in the
July-September issue of the English
journal, World Economics, entitled,
Too Loose for Comfort. Compare
real interest rates with real income
growth in the G-7 countries from 1950
and 2009, and you make an interest-
ing discovery, write the authors, John
C. Michaelson and Sbastien E.J.
Walker. You find that falling interest
rates are only so effective in nurturing
growth; beyond a certain point, they
seem to hinder it. Not that this obser-
vation proves anything, they hasten to
add: maybe low growth causes low
real interest rates, and not the other
way around. However, they go on,
we believe that there is a reasonable
argument to be made to support the
hypothesis that low (indeed, nega-
tive) real interest rates are impeding
economic growth at present, at least
in the U.S. and in the U.K. (euro-area
countries currently face problems of a
rather different nature).
ZIRP and QE amount to central
bank-led attacks on saving and sav-
ers, Michaelson and Walker contin-
ue. The famine in interest income
has ground down households and
the beneficiaries of trusts, who have
less income to spend; retirement ac-
counts, which need replenishing to
compensate for lower investment in-
come; pension plans, which have to
seek additional funding from their
sponsors or from taxpayers; endow-
ments, which have fewer resources
available to support their missions;
foundations, which have less funds to
give; and companies with cash. These
stresses also undermine the resto-
ration of confidence, which is a key
ingredient for recovery. Moreover,
high earners in the financial sector,
which benefits from an implicit sub-
-6
-4
-2
0
2
4
6
8
10%
-6
-4
-2
0
2
4
6
8
10%
2012E 2007 2002 1997 1992 1987
Low rates, slow growth
Japan economic growth vs. 10-year bond yield
sources: The Bloomberg, IMF
1
0
-
y
e
a
r
y
i
e
l
d
r
e
a
l
g
r
o
w
t
h
10-year Japanese government bond yield
real GDP growth
900
1,000
1,100
1,200
1,300
1,400
$1,500
900
1,000
1,100
1,200
1,300
1,400
$1,500
9/12 1/12 1/11 1/10 1/09 1/08
A Fed-induced famine
personal interest income
source: The Bloomberg
i
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s
o
f
d
o
l
l
a
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s
i
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b
i
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l
i
o
n
s
o
f
d
o
l
l
a
r
s
Winter Break-GRANTS/DECEMBER 26, 2013 17 SUBSCRIBE! - go to www.grantspub.com or call 212-809-7994
sidy (in the form of virtually interest-
free loans), have a lower propensity
to consume, as a proportion of their
income, than less well-off households
that have foregone income; this trans-
fer is a drag on the economy, while
increasing socially divisive wealth
disparities.
Yes, the stewards of the Ph.D. stan-
dard will reply, but look at Japan. Yes,
rejoin Michaelson and Walker, lets
do look at Japan. Herewith is their
reading of the sorry Japanese story, in
bullet points:
Jle economy uoes not resonu
to ultra-low rates.
Policymakers view tle rollem
as inadequate demand (as house-
holds, companies and public-sector
bodies tighten their belts).
n resonse, tle central government
borrows more at ultra-low rates, with the
aim of stimulating the economy.
Borroweu finus go towarus oliti-
cally directed activities with little eco-
nomic benefit, and funds withdrawn
from the economy in both taxes and
borrowing further destroy demand.
Jlis leaus to even more govern-
ment borrowing to fund stimulus
spending.
Jle government cannot afforu
to pay a higher rate of interest on the
debt it has accumulated, leaving the
central bank reluctant to raise rates for
fear of bankrupting the government.
An artificially low cost of capital
exacts another cost, observes Jesper
Koll, head of equity research at J.P.
Morgan in Tokyo. This cost is the
extra lease on life that E-Z financing
accords to failing older businesses.
They should leave this world, but
they cant, or wont, because their
creditors keep infusing them with
subsidized credit. Imagine a forest
in which the big trees never die. It
would be nice for the old timber, but
fatal for the seedlings that cant find
sunlight. That forest is Japan, Koll
says. Could it become America?
No, Yellen et al. would likely reply.
The monetary mandarins dont give
much thought to the unintended con-
sequences of their own mathematical-
ly calibrated policies. They deny that
ZIRP accelerates the downward spiral
of our federal finances. They refuse
to accept that the reserve-currency
privilege constitutes an ever-present
temptation for America to overbor-
row. They seem deaf to objections
that ultra-low interest rates may be
perpetuating the national economic
half-sleep, rather than cutting it short.
Lacking the once-burned speculators
respect for Mr. Market, they seem
to believe that the old gentleman is
theirs to command.
If you listen to them talk to each
other, you would likely not com-
prehend. But you could hardly fail
to pick up on their supreme profes-
sional self-confidence. Addressing
her fellow economists in Boston in
June, Yellen lapsed into shoptalk.
Concerning the optimal control
path of the federal funds rate, she
said, the Fed employs an economet-
ric modelthe FRB/US model.
Such a path is chosen to minimize
the value of a specific loss func-
tion conditional on a baseline fore-
cast of economic conditions, she
said. The loss function attempts
to quantify the social costs result-
ing from deviations of inflation from
the Committees longer-run goal and
from deviations of unemployment
from its longer-run normal rate. A
footnote was appended to the end of
this sentence, and here is what the
footnote said:
Under this approach, the central
banks plans are assumed to be com-
pletely transparent and credible to
the public. In particular, both the poli-
cymaker and private agents are assumed
to act as if they have perfect foresight about
the evolution of the economy, including the
future path of monetary policy, in that
they ignore the possibility of unanticipated
future shocks to the economy. This as-
sumption of certainty equivalence is
commonly used but is not an intrinsic
feature of optimal control techniques.
Indeed, the fully optimal policy under
uncertainty involves the specification
of a complete set of state-contingent
policy paths.
What can one conclude from these
non-English sentences, especially the
one that we have printed in italics?
We conclude that a Chairman Yellen
would be unprepared for the possibil-
ity of unscripted outcomes. Like the
incumbent chairman, she has spent
her entire career with fiat money. And
like the chairman, she seems to have
given no serious thought to the thou-
sands of years of monetary history that
preceded the post-1971 worldwide
experiment in nonconvertible curren-
cies. If, for Yellen, monetary history
isnt bunk, it is evidently extraneous.
She would hardly flinchwe would
bet a Krugerrand on itif the gold
price tripled.
In the aforementioned speech in
Boston, Yellen discounted concerns
that the Fed would bungle its exit
from its posture of extreme, radi-
cal, unprecedented and heretofore
unimagined accommodation. The
FOMC, she said, has tested a vari-
ety of tools to ensure that we will be
able to raise short-term interest rates
when needed while gradually return-
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5
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25%
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-5
0
5
10
15
20
25%
1/12 1/10 1/08 1/06 1/04 1/02 1/00
What the Fed targets and what it doesnt
year-over-year change in PCE index vs. home prices
source: The Bloomberg
y
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o
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y
c
h
a
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g
e
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P
C
E
i
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d
e
x
y
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o
-
y
c
h
a
n
g
e
i
n
h
o
m
e
p
r
i
c
e
s
PCE:
1.7%
home price:
1.35%
Winter Break-GRANTS/DECEMBER 26, 2013 18 SUBSCRIBE! - go to www.grantspub.com or call 212-809-7994
ing the portfolio to a more normal size
and composition.
She addressed the cost of living in
the same soothing vein. Really, there
is nothing to worry about: [I]nfla-
tion, she said, abstracting from the
transitory effects of movements in oil
prices, has been running near 2% over
the past two years, and I expect it to
remain at or below the Federal Open
Market Committees 2% objective
for the foreseeable future. The vice
chairman did hasten to add that noth-
ing is certain and that she could be
mistaken. But surprises, if surprises
there be, will likely be on the down-
side, she said, necessitating very easy
money for a very long time to come.
Perhaps no one now living (cer-
tainly, no one now working on Wall
Street) recalls the furious debates over
Federal Reserve operating methods
as the central bank began operations
during World War I. The Ben Bernan-
ke of that time, a man named W.P.G.
Harding, resisted demands that the
Fed target the price levelfor there
was pressure from the start to do just
thatand he explained his reasoning
in his 1925 memoir, The Formative
Period of the Federal Reserve System
(During the World Crisis). It wasnt
at all clear, said Harding, that such a
feat was technically possibleprices
responded to changes in the discount
rate, then the Feds principal mon-
etary lever, with long and variable
lags. Then, too, the very act of trying
to control the price level through in-
terest-rate manipulation would put
the [Federal Reserve] Board in the
attitude of assuming to be the arbiter
of prices, and that then an advance or
reduction in rates would reflect the
Boards opinion that prices were too
high or too low, as the case may be,
and proclaim its intention to attempt
to rectify them. The question then
arises, would the country be willing
to commit so important a question
as the fixing of a proper price level
to any board or commission? Any an-
nouncement by the Federal Reserve
Board of a purpose to control prices
by means of discount rates would, in
my opinion, lead to the destruction of
the Federal Reserve System.
Harding was wrong on both points,
a 21
st
-century central banker would
likely contend. The econometrically
empowered Federal Reserve can
plainly hold the inflation rate at the
desired 2% marker, he or she would
reply (just look at the recent record).
And as to the political advisability of
an unelected committee of civil ser-
vants overriding the price level, why
whos complaining?
The presidential election was more
than a triumph for Barack Obama. It
was likewise a victory for an approach
to monetary management that puts
the economics professoriat at the con-
trols of a fiat-currency regime. Heres
a bubble that the Feds macropru-
dential sleuths will never warn you
againstthe bubble in modern-day
central banking.
Tropical storm
(April 5, 2013) In the municipal
bond market, eyes today are locked
on the city of Stockton, Calif., which
is in bankruptcy proceedings, or on
the state of Illinois, which perhaps
deserves to be. We write to urge a re-
focusing. A timelier object of inves-
tor concern is the Commonwealth of
Puerto Rico. Here is a disaster long
ago made butsomehowforever
new and worse.
For the aspiring short seller, theres
a catch, however. The market in
which Puerto Ricos debt is quoted
does not respond to stimuli. Unlike
the markets in corporate debt or equi-
ties, it does not react to news. It hard-
ly trades at all, observes Joe Mysak,
editor at Bloomberg Daily Brief, Munici-
pal Market, and perhaps the greatest
living authority on tax-exempt securi-
ties. Munis trade for the first 30 days
of their existence and then vanish
into lockboxes and portfolios. From
heaven, as the adepts refer to these
resting places, the bonds re-emerge
upon maturity. Its in many ways an
inert asset class, Mysak says.
Puerto Rico, rated one notch above
investment grade, may yet give that
proposition a proper test. Moodys
last May disclosed that the island has
gross, tax-supported debt on the order
of $58 billion, more than any state ex-
cept California ($102 billion) and New
York ($63 billion). In another claim
to fame, the commonwealth boasts
net tax-supported debt equivalent to
88.6% of 2011 personal income, almost
10 times that of runner-up Hawaii
(9.6%) and almost 15 times that of pe-
rennial whipping boys Illinois and Cal-
ifornia (6% each). You wonder where
Puerto Rico would be if Washington,
D.C., did not contribute a third of its
annual budget.
In fairness, the commonwealth
ran a smaller budget deficit last year
than it did the year before. But that
fact, plus the weather and the poli-
ticians access to the federal money
hose, largely exhausts the islands
defenses. Unemployment stands at
14.5% (better than the 2010 peak of
16.9% but worse than the 2006 trough
of 10.2%), while the special entity
created after a 2006 financial crisis to
125
150
175
200
225
3/13 1/12 1/11 1/10 1/09 1/08 1/07 1/06
10
12
14
16
18%
Bond prices firm, labor market not
S&P Municipal Bond Puerto Rico Index (left scale)
and Puerto Ricos unemployment rate (right scale)
source: The Bloomberg
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d
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v
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j
o
b
l
e
s
s
r
a
t
e
municipal bond
index
unemployment rate
municipal bond
index
unemployment rate
Winter Break-GRANTS/DECEMBER 26, 2013 19 SUBSCRIBE! - go to www.grantspub.com or call 212-809-7994
restore the governments finances has
almost exhausted its own $15 billion
borrowing authority. If there were a
tournament to decide the most mis-
erably managed government in the
country, Puerto Rico would enter as
the top seed.
And what makes the Puerto Rican
financial hole so much deeper and
darker, say, than the ones the Land of
Lincoln or the Empire State have
dug for themselves? Pension malprac-
tice could alone explain the disparity.
Puerto Ricos main pension plan,
the Employees Retirement Service
(ERS), which serves about 250,000
past and present workers, showed
a funding ratio of just 6% as of June
30, 2011, relates colleague Charley
Grant. What is a funding ratio? Di-
vide the value of a plans assets by the
present value of its obligations. To put
a 6% ratio in context, the five Illinois
pension plans, deservedly the subjects
of scorn and handwringing, show a
funded ratio of about 40%.
Its true that the Illinois pension
plans assume a quite generous 8% dis-
count rate, Grant continues, and the
funded ratio would be significantly
lower if the Springfield actuaries used
the 3.75% rate assumed by all but one
of the regional Federal Reserve banks.
Puerto Rico assumes 6.4%. Regardless
of discount-rate assumptions, though,
Illinois is not projected to exhaust its
pension assets for at least seven years,
according to Sean McShea, president
of Ryan Labs Asset Management. Cali-
fornias projected depletion of pension
assets is decades away. As for Puerto
Rico, relates the commonwealths Gov-
ernment Development Bank, the ERS
will exhaust its plan assets by June 30,
2014. On the same authority, the un-
funded liability of the ERS represents
more than half the commonwealths
$64 billion GDP. Whereas membership
of CalPERS and CalSTRS comprises
about 6.6% of Californias population,
Puerto Ricos two plans (the teachers
plan included) cover 9% of the Puerto
Rican population.
Only by the skin of its teeth is the com-
monwealth an investment-grade credit.
In reducing its rating to Baa3 from Baa1
in December, Moodys had a few things
to say about the quality of the islands
pension management. In addition to
low asset levels, the agency noted,
ERS commingles the assets of both its
defined benefit [after the closing of the
defined benefit plan in 1999, new en-
trants into the workforce were enrolled in
a defined contribution plan] and defined
contribution members, meaning future
D.C. payouts must be paid by ERS. No
corresponding liabilities for these even-
tual payouts have been disclosed.
No argument, then, that Puerto Rico
is a weak credit. But there is a market
for tax shelters, Uncle Sam is gener-
ous to a fault, and the newly installed
governor (in a disputed election), Ale-
jandro Garca Padilla, pledges to enact
a springtime pension reform (no details
just yet). So the Puerto Rico 5
1
/4s of
July 2023 (callable at par in July 2022)
change hands at 101.72 to yield 5.03%,
161 basis points higher than a com-
parable 10-year Illinois G.O., which
Moodys rates A2.
Taste as much as science deter-
mines what is adequate compensation
for risk-taking. We judge that Puerto
Rican debtholders are inadequately
compensated (though they seem not
to mind). If the market is indeed com-
placent, why does it not speak up for
itself? Economists at the Federal Re-
serve Bank of Cleveland took a crack at
the answer in a February essay entitled,
Do Public Pension Obligations Affect
State Funding Costs? No, they con-
clude. Just perhaps, the authors ven-
ture, investors might conclude that . . .
while the risk-adjusted returns offered
by municipal bonds may be negative,
these returns might still exceed the re-
turns on other investments in the low
interest-rate environment. In other
words, in an environment of depressed
yields, municipal bonds are the least
bad investment.
Which would make Puerto Rican
G.O.s the most bad of the least bad. The
tax-exempt market should be careful
when it finally does wake up. It might
fall out of bed.
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