Bill Gross on the New Normal

Bill Gross, the “Bond King” is going to great lengths to get us to understand that the world is in a state of reversion to what he and El-Erian, his co-chief at PIMCO coined as the “New Normal” 3 months ago, in his latest missive - “Bon” or “Non” Appétit?.

Our economy which once feasted, no, binged, unable to stop itself, on debt and leverage, and on the basis that home and other asset prices would rise to the sky, is now fasting, cleansing itself of the fat that accumulated, and it is a long-term process that will take many years to complete.

Here are some of the highlights from the letter, which you may download here:
Gross re-iterates the “New Normal” - Its starting to sound a lot like “The Emperor’s New Clothes“:

Our economy’s lights, if not switched off in a rehash of the 1930s Depression, have certainly been dimmed in a 21st century version likely to be labeled the Great Recession. Much like John McSherry, U.S. and many global consumers gorged themselves on Big Macs of all varieties: burgers to be sure, but also McHouses, McHummers, and McFlatscreens, all financed with excessive amounts of McCredit created under the mistaken assumption that the asset prices securitizing them could never go down. What a colossal McStake that turned out to be. Now, however, with financial markets seemingly calmed and an inventory-based recovery in store for the balance of 2009, there is a developing optimism that we can go back to the lifestyle of yesteryear. PIMCO’s driving thesis however, if not a juxtaposition, is succinctly described as a “new normal” where growth is slower, profit margins are narrower, and asset returns are smaller than in decades past based upon the delevering and reregulating of the global economy, which in turn should substantially inhibit the “gorging” of goods and services that we grew used to in decades past.

Forecasts based on econometric models inevitably miss these secular/structural breaks in historical patterns because it is impossible to quantify human behavior, and long-term trends involving risk-taking and in turn derisking are decidedly human in their origin. Bell-shaped curves with Gaussian/random distributions fail to anticipate that human beings do not make decisions by chance or independently of each other, but in many cases in reaction to one another. Humanity’s personal and social computers appear to be programmed that way. And so, instead of “normal” distributions, economists and investors must learn to be on the lookout for “black swans,” and if not, then certainly “fat tails,” which differ from the measurement of natural phenomena accepted in science. “New normals,” flatter-shaped bell curves, and structural shifts in previously accepted standards become not only possible, but probable as human nature reacts to itself and its prior behavior. The efficient market hypothesis was always dead from the get-go, but academic tenure and Nobel prizes were food for the unwilling or perhaps unthinking.

Others are starting to wonder about the emperors new clothes, the “green shoots”:
I was impressed this weekend by an article in the Op-Ed section of The New York Times by staff writer Bob Herbert. “No Recovery in Sight” was the heading and his opening sentence asked, “How do you put together a consumer economy that works when the consumers are out of work?” That is really all one needs to ask when divining our economy’s future fortune. Unless an optimist can prescribe how to put Humpty Dumpty back together again and shuffle him/her back to work then there can be no return to an “old normal.” As unemployment approaches 10%, what is less well publicized is that the number of “underutilized” workers in the U.S. has increased dramatically from 15 to 30 million. Those without jobs, as well as those individuals who only work part-time and have become discouraged and stopped looking, total 30 MILLION people. The number is staggering. Commonsensically, one has to know that many or most of these are untrained for the demands of a green-oriented, goods-producing future economy. Imagine a welding rod in the hands of an investment banker or mortgage broker and you’ll understand the implications quicker than any economist using an econometric model.

Fifteen Words to describe the era that led us to our current economic crisis:
The supersizing of financial leverage and consumer spending in concert with the politicizing of deregulation describes in fifteen words our most recent brush with irrational behavior and inefficient markets. Greed will come again. But for now, the trend is the other way and it promises to persist for a generation at a minimum. The fact is that American consumers have suffered a collapse in wealth of at least $15 trillion since early 2007. Global estimates are less reliable, but certainly in multiples of that figure. And when potential spenders feel less rich by that much, the only model one can use to forecast the future is a commonsensical one that predicts higher savings, lower consumption, and an economic growth rate that staggers forward at a new normal closer to 2 as opposed to 3½%. There’s no magic in that number, and no model to back it up, just a lot of commonsense that says this is how people and economic societies behave when stressed and stretched to a near breaking point.

Where do we go from here:
Investors who stuffed themselves on a constant diet of asset appreciation for the past quarter-century will now be enclosed in a cage featuring government-mandated, consumer-oriented fasting. “Non Appétit,” not Bon Appétit, will become the apt description for the American consumer, and significant parts of the global economy, including the U.S. Because this is so, short-term policy rates will be kept low for longer than cyclical norms, and the outlook for risk assets - stocks, high yield bonds, and commercial and residential real estate will involve just that - risk. Investors should stress secure income offered by bonds and stable dividend-paying equities. Consumer Cuisinart consumption is a relic of the past.

Canadians not Saving Enough for Retirement

From the Globe and Mail:

"When the stock market was soaring and the economy was stronger, one hardly heard of any worries about private pensions. Many baby boomers were confidently facing retirement since they were thought to be healthier, better educated and wealthier than their parents' generation.

But now, with the collapse of the stock market as well as the economy, the boomers' easy coast into retirement has changed.Not surprisingly, a number of prominent organizations, including the C.D. Howe Institute, have recently concluded that Canadians are not saving enough for their retirement.

This basic conclusion is correct and seems even more relevant today because the economy is in recession and Canadians are losing their jobs.Simple economic theory, such as the life-cycle savings hypothesis (that individuals should put aside savings in their productive working years to maintain their standard of living in retirement), is useful in framing the policy choice for individuals, but it is not very practical with respect to telling them what they should do when everything goes wrong.

But how much should a Canadian actually save for retirement? The answer is: Who knows? We have no idea how long we'll live. Should we save enough to last until 75 or 95? If we save for a 95-year lifetime, the amount needed is obviously much greater.

One could save enough to buy an annuity at the time of retirement, an annuity that would provide an adequate income for life. But how much should we put aside to buy this annuity?

The amount of income an annuity will provide at retirement depends on the interest rates at the time the annuity is purchased and the income stream begins. Will one save enough to buy an annuity assuming the current level of interest rates? Canadian government bonds now yield from 2 per cent to just over 3 per cent. Or should one presume at the time of retirement that interest rates will be at the level they were in the early 1980s, when Canadian bonds yielded more than 16 per cent? If one assumes the high rate of interest, then the amount of saving needed for retirement would be a fraction of the amount needed with today's much lower rates.

All of these reasons demonstrate the inability of any person to know how much to save for retirement. So what's the public policy response? Do we need more registered retirement savings plan room? Do we need more defined-contribution pension plans? (A defined plan is one in which both the individual and employer contribute a set amount, with the individual investing those funds in some form until retirement.)

The problem with RRSPs and defined-contribution pension plans is that the amount needed for a set retirement income is always unknown. The additional problem is that the whole investment risk is carried by the individual saver. If the investment is successful, more funds are available at retirement; if it isn't, there's less to count on.For the baffled individual trying to plan for retirement income, private defined-benefit pension plans are very attractive, assuming the company that sponsors the plan remains solvent and the plan is adequately funded. (A defined-benefit plan is one that provides a set pension amount at the time of retirement usually based on both years of service and level of income. The costs to the individual and employer are based on those factors as well.)

There is also enormous cost savings and economic efficiency in very large defined-benefit pension plans such as the Canada Pension Plan when they are adequately funded.

The large pension plan knows how long we'll live because it deals in large numbers of people and uses averages for life expectancy. Thus, large defined-benefit plans can estimate fairly precisely the amount of savings one needs for the lifespan of the average pensioner in their plan. The large defined-benefit plan can also take a long-term view of interest rates and market returns, a perspective not often available to the individual investor. This again increases the economic efficiency of such plans as the CPP.

Three obvious public policy conclusions flow from this analysis:

Substantially increase the size of the CPP so it provides for a much larger proportion of income replacement on the retirement of Canadians. Many studies have recommended this idea. An increase in CPP contributions and coverage could be done over several years in a way that ensures the CPP remains fully funded.

Develop a system whereby companies and their employees can buy additional defined-benefit pension coverage from the CPP. These supplementary pensions would need to be fully funded and would be fully portable (as they are held in the CPP). An add-on plan to the CPP would provide companies and individuals with the economic efficiencies and the substantial cost savings that only a large plan can generate.Develop a strategy to get companies that have lost the incentive to provide defined-benefit plans back into the business of offering them. This will not be easy. Companies have moved away from such plans because of complex pension laws designed to protect workers, and their experience that such plans are costly and difficult to manage. In addition, employees are wary of such plans when they see large companies fail to fully fund their plans or go bankrupt with their pension plans underfunded.

A policy of both increasing the CPP and allowing companies and individuals to buy supplementary pensions from the CPP is one acceptable policy move. Another is a much closer monitoring of pension plans by regulators. A positive move in this direction would be the establishment of the proposed national pension guarantee system.Another feature of such a system would be to require underfunded pension plans to pay higher premiums for coverage. In other words, any company that requests relief from its required funding - that is, additional time to make up a pension deficiency - should pay an additional premium for such forbearance."

Doug Peters is former chief economist of the Toronto-Dominion Bank. Arthur Donner is a Toronto-based economic consultant.

CGA Study Finds Canadians Foolish With Money

Where Has the Money Gone: The State of Canadian Household Debt in a Stumbling Economy

Related Information
Media Release
Download Report
CGA-Canada shares its views on indebtedness of Canadian households (March 2009)[PDF — 98KB]

Backgrounder
In the winter of 2008, the Certified General Accountants Association of Canada (CGA-Canada) embarked on a second consumer survey on the topic of household debt and consumption in Canada. A similar survey was commissioned by CGA-Canada in the spring of 2007. The purpose of this particular survey seeks to understand the extent to which the economic and financial crisis worsened financial positions of Canadians having already experienced some financial strains. As we have seen, the topic of household debt and consumption is timely, relevant and critical for Canadians to consider. We anticipate that this new report entitled Where Has the Money Gone: The State of Canadian Household Debt in a Stumbling Economy, will be of significant value to the Canadian public.

Key Report Highlights
Increasing debt load
Household debt is at an all-time high reaching $1.3 trillion in 2008 and the escalation of debt is primarily caused by consumption motives rather than asset accumulation.
The three main indicators of household indebtedness (debt-to-income, debt-to-assets and debt-to-net worth ratios) deteriorated significantly in the past two years and particularly during 2008.
Canadian households are financing consumption activity and fuelling gross domestic product growth with unearned money as families increasingly reach for credit to finance day-to-day living expenses.
The majority (58%) of survey respondents with rising debt said that day-to-day living expenses are the main cause for the increasing debt. This was higher than the 52% reported in 2007.
Lines of credit and credit cards account for the largest proportion of consumer debt, with 85% of indebted Canadians reporting that they have outstanding debt on a credit card.
A large proportion of Canadians acknowledged their debt as increasing. The proportion of respondents with rising debt went up from 35% in 2007 to 42% in 2008.
84% (vs. 81% in 2007) of Canadians are concerned that household debt is rising. 21% of Canadians who are in debt say they are in over their heads and can no longer manage their debt load.
Interestingly enough though, 79% of indebted Canadians are still confident that they can either manage their debt well or take on more debt load.
The majority of respondents (65%) felt that debt limits their ability to reach financial goals in at least one of the critical areas of retirement, education, leisure and travel, or financial security in unexpected circumstances.

Lack of savings
One third of Canadians do not commit any resources to savings and deteriorating economic conditions have not yet had the usual effect of encouraging increased savings.
Even with the temporary relief of a credit card or line of credit, one quarter of Canadians would not be able to handle an unforeseen expenditure of $5,000 and 1 in 10 would face difficulty in dealing with $500 unforeseen expense.
The majority (78%) of surveyed said they would not change their saving patterns in order to build or rebuild the financial cushion.
Economic factors
The Canadian economy has been recession free for 17 years before the events of 2008. The most recent recession took place over a 12 month period between April 1990 and March 1991.
Recent data on the job losses and bankruptcies leaves little doubt that the situation of the household sector has worsened.
Canadians, though, perceive their financial condition to be better than it is and many are not aware of how the economic downturn has impacted their financial situation.
Nearly one quarter (24%) of those surveyed did not think that a moderate decrease in housing or stock market, an increase in interest rates, cuts in salary, or reduced access to credit would noticeably affect their financial situation.

Vulnerable Canadian households
Certain socio-economic groups are particularly susceptible to increasing debt. The most vulnerable are the hardest hit – low income, households with children, young adults, the retired.
Canadian families in particular are struggling with increasing debt. Households with one or more children under the age of 18 reported debt as rising more often than those with no children, with 49% reporting their debt had substantially increased.
Respondents with lower income were much more likely to report increasing debt compared to the respondents in other income groups. And, those with low wealth continue to sink into debt and to experience further deteriorating in their net worth positions.
Debt-free households do exist of course and 88% of debt-free respondents lived in one or two-person households and were significantly less likely to have children under the age of 18.

Regional differences
There are regional differences for those carrying household debt.
As many as 56% of British Columbians told us their debt increased compared to the Canadian average of 42%.
Some 30% of residents in the Atlantic Provinces maintained an unchanged debt level compared to 23% of the total respondents who said their debt remained the same.
Debt-free respondents were more likely to be Ontario residents.

Recommendations

Balanced approach
The current level of indebtedness of Canadian households is a highly disturbing matter, particularly given the extent of the recent economic shocks (income shock, assets price shock and interest rate shock) and prospects for improving household financial security are low.
Although CGA-Canada recognizes the importance of consumer spending for business development and for economic growth, a balanced approach to spending, saving and paying down debt may be more of a desirable option than trying to promote consumer spending as a solution for the current economic downturn.
Canadians long-term financial goals should include accumulation of appreciable financial assets, building of a larger more diversified financial cushion and retirement investment. CGA-Canada urges Canadians to consider such savings vehicles as RRSPs and TSFAs.
CGA-Canada believes debt is rightfully a personal decision, however, it is crucial that Canadians be aware of potential risks of increasing individual household debt.
It is important to remember that risk tolerances of financial institutions should not be exercised as a substitute for the judgment of individuals who must discern between the good and bad of being in debt.

Financial literacy
Financial literacy remains an issue – Canadians frequently don’t understand the effect of carrying debt and the costs associated with servicing debt.
Households’ knowledge and skill to understand their own financial circumstances and the motivation to borrow, to spend and to save become crucial to marshalling households’ financial security and wellbeing.
Canadians need to take very seriously the issue of developing their financial capability, that is, improving their knowledge, skills and discipline when making financial decisions.
There is also an opportunity for government and the educational community to help Canadians improve their financial capability.
More needs to be done in educating the public on money management, spending, shopping habits, warning signs of financial difficulties and obtaining and using credit.

Uncommon Sense from Charles Munger

Here is an article (hat tip to Calculated Risk) that I think is worth a good read.

Here is a couple of highlights:

As we look at the current situation, how much of theresponsibility would you lay at the feet of the accounting profession?
I would argue that a majority of the horrors we face would not have happened if the accounting profession developed and enforced better accounting. They are way too liberal in providing the kind of accounting the financial promoters want. They’ve sold out, and they do not even realize that they’ve sold out.

Would you give an example of a particular accounting practice you find problematic?
Take derivative trading with mark-to-market accounting, which degenerates into mark-to-model. Two firms make a big derivative trade and the accountants on both sides show a large
profit from the same trade.

And they can’t both be right. But both of them are following the rules.
Yes, and nobody is even bothered by the folly. It violates the most elemental principles of common sense. And the reasons they do it are: (1) there’s a demand for it from the financial
promoters, (2) fixing the system is hard work, and (3) they are afraid that a sensible fix might create new responsibilities that cause new litigation risks for accountants.

Link to Stanford Law.

Swine Flu

The Swine Flu:

From the Washington Post.

The Debt Snowball Method

I have seen this work very effectively in several instances where I have done credit counselling for people.

From Wikipedia, the free encyclopedia

The debt-snowball method is a debt reduction strategy, whereby one who owes on more than one account pays off the accounts with the smaller balances first, proceeding to the larger ones later.

Overview
The debt-snowball method of debt repayment is a form of debt management that is most often applied to repaying revolving credit — such as credit cards. Under the method, extra cash is dedicated to paying debts with the smallest amount owed.

This method has gained more recognition recently due to the fact that it is the primary debt-reduction method taught by many financial and wealth experts. However, it has always existed, as people have a tendency to want to take care of smaller, easier-to-take-care-of things first.

Methodology
The basic steps in the debt snowball method are as follows:

List all debts in ascending order from smallest balance to largest.

This is the method's most distinctive feature, in that the order is determined by amount owed, not the rate of interest charged. However, if two debts are very close in amount owed, then the debt with the higher interest rate would be moved above in the list.

Commit to pay the minimum payment on every debt.

Determine how much extra can be applied towards the smallest debt.

Pay the minimum payment plus the extra amount towards that smallest debt until it is paid off.
Note that some lenders will apply extra amounts towards the next payment; in order for the method to work the lenders need to be contacted and told that extra payments are to go directly toward principal reduction.

Once a debt is paid in full, add the old minimum payment (plus any extra amount available) from the first debt to the minimum payment on the second smallest debt, and apply the new sum to repaying the second smallest debt.

Repeat until all debts are paid in full.

In theory, by the time the final debts are reached, the extra amount paid toward the larger debts will grow quickly, similar to a snowball rolling downhill gathering more snow (thus the name).

The theory works as much on human psychology as it does on financial principles; by paying the smaller debts first, the individual, couple, or family sees fewer bills as more individual debts are paid off, thus giving ongoing positive feedback on their progress towards eliminating their debt.

A first home mortgage is not generally included in the debt snowball, but is instead paid off as part of one's larger financial plan. As an example, many financial plans pay off home mortgages in a later step, along with any other debt which is equal to or greater than half of one's annual take-home pay.

The issue of whether one should make retirement contributions during the debt reduction process is a matter of dispute among proponents of this method:

Some argue that all contributions are to be halted during the debt snowball, thus freeing up more money to pay down the debt snowball.

Others dispute this practice, citing the cost of compounding interest to be greater than the gains of paying off debt.

Some compromise by arguing that retirement contributions should be reduced to only the minimum amount that the employer will match with an employee, but not eliminated completely.

Many financial and wealth experts teach that this halting of retirement contributions should last no more than two years.

Simple Example
An example of the debt-snowball method in action is shown below.
A person has the following amounts of debt and additional funds available to pay debt (the debt is listed with the smallest balance first, as recommended by the method):
Credit Card A - $250 balance - $25/month minimum
Credit Card B - $500 balance - $26/month minimum
Car Payment - $2500 balance - $150/month minimum
Loan - $5000 balance - $200/month minimum

The person has an additional $100/month which can be devoted to repayment of debt.
Under the debt-snowball method, payments for the first two months would be made to debtors as follows:
Credit Card A - $125 ($25/month minimum + $100 additional available)
Credit Card B - $26/month minimum
Car Payment - $150/month minimum
Loan - $200/month minimum

After two months (presuming the person has not added to the balances, which would defeat the purpose of debt reduction), Credit Card A would be paid in full, and the remaining balances as follows:
Credit Card B - $448
Car Payment - $2200
Loan - $4600

The person would then take the $125 previously used to pay off Credit Card A and apply it as additional payment to the Credit Card B balance, which would make payments for the next three months as follows:
Credit Card B - $151 ($26/month minimum + $125 additional available)
Car Payment - $150/month minimum
Loan - $200/month minimum

After three months Credit Card B would be paid in full (the final payment would be $146), and the remaining balances would be as follows:
Car Payment - $1750
Loan - $4000

The person would then take the $151 previously used to pay off Credit Card B and apply it as additional payment to the car loan balance, which would make payments as follows:
Car Payment - $301 ($150/month minimum + $151 additional available)
Loan - $200/month minimum

It would take six months to pay the car loan (the final payment being $245), whereupon the person would then make payments of $501/month toward the loan (which would have a $2800 balance) for six months (with the last payment at $295).

Thus in 15 months the person has repaid four loans, with two of them being paid in a mere five months and three within one year.

Benefits
The primary benefit of the smallest-balance plan is the psychological benefit of seeing results sooner. A secondary benefit of the smallest-balance plan is the reduction of total amount owed to lenders in a single month. This is a risk reduction in the event of a lost job or emergency.

Criticism
People with more financial discipline can get ahead quicker by paying off the credit cards and loans with the higher interest rates first. This will minimize costs to become debt-free faster than the smallest-balance approach. Dave Ramsey, a proponent of the debt-snowball method, concedes that "the math" leans toward paying the highest interest debt first; however, based on his experience, Ramsey states that personal finance is "20 percent head knowledge and 80 percent behavior" and that people trying to reduce debt need "quick wins" in order to remain motivated toward debt reduction.

The Debt-Snowball method is only for those on high enough incomes to be able to meet all the minimum repayment requirements on their debts. This method could instead lead to problems for those who are struggling to meet these minimum payments demands. In this circumstance, an individual should not be advised to pay creditors differing amounts as this could count as non-equitable repayment, leading to problems (e.g. with going bankrupt, or with maintaining non-equitable repayments over longer periods).

Levity?

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