Hundred Year Bonds? Are You Kidding?

SoThe Wall Street Journal reports 100 year bonds are back.  As you can probably guess, I am not a fan...unless I'm an issuer!

Very simply, corporate bonds have two components to their value: time and credit risk.  Lending money for a long time should pay higher interest than lending money for a shorter period--there's fundamentally more risk involved.  (This is why the yield curve slopes upward.)  Then there's risk of default by the issuer.  This often means the greater risk of lending to a company than the US government.

By extension, bond holders are short a put on the equity of the company.  Why?  Straight bonds do not share in the upside of company performance.  Bonds will only perform as promised or worse.  Never better.  No CEO ever said, "Gee, we did really well, let's send some extra coupon payments to our debt holders as a reward." 

On the other hand, if the equity of the company goes to zero, that means you start eating into what the bond holders own.  That's downside.

So, back to 100 year bonds.  Chances are, one hundred year bonds will default.  There's no reason to believe any economy, on average, has a chance of surviving 100 years.  Look at history.  War, revolution, runaway inflation.  Something gets them.  Then, layer on idiosyncratic risk of individual companies? 

So wait a second, if this is so obvious, why aren't 100 year bonds priced so that they have equity like returns, since they own all the equity downside, and they own that risk, more or less, forever?

As the WSJ says, 100 year bonds in the past have been purchased by insurance companies with very long tail liabilities, (like life insurance.)  These guys should know they're short a put, forever.  Some may, some may not.  In either case their regulators, investors and rating agencies tell them to hold bonds; holding stocks has higher costs, both direct and indirect.  Therefore, even for a worse deal, they're better off holding "inferior" equity that they can legally call a bond rather than holding equity they have to disclose. 

Get it?  Okay, so will someone please give me a 100 year mortgage??  Hmmm...wait...way back in 2007 couldn't we call get our negative amortization option ARMs?  I guess I missed my chance.

Earthquakes and Credit Rating Agencies

Credit rating agencies have been under intense heat for a long time.  Recently, Congress has joined the action.  For those unaware, the issue surrounds (mostly) AAA ratings.  Triple A bonds, investors believed, had "very little" risk.  The problem, however, results because no one knew what that meant.  But, it's worse than that: Even if investors knew what that meant, we won't live long enough to know if the agencies were right.

The business of underwriting catastrophic risk, like earthquakes and hurricanes, faces the same problem.  How can you tell if someone is good or bad at pricing risk?  The events they price happen (thankfully) truly infrequently.  So, when they lose money, are they wrong or unlucky? 

Suppose you know for certain that an event has a one in 500 year chance of occurring.  The event happens next year.  That's unfortunate luck.  You could be great a pricing such risk.  In fact, you could have been paid superbly to take the risk.  However, you lost.

Now, complicate matters ever so slightly, but reasonably.  You think the event happens once in 500 years.  But, maybe it's one in 400, maybe it's one in 600.  You can't be sure.  (Ask someone who didn't get a D in his first undergrad statistics class to tell you how many years it will take to know whether it's one in 400, 500 or 600. ) Now, if the event happens next year, you don't know if you were unlucky and right or unlucky and wrong, no matter how much premium you collected to take the risk.

What does this have to do with AAA rated bonds?  All we can say for sure in 2010 is that an incredibly rare economic catastrophe happened in 2008 and 2009.  We can't really say how rare with any degree of precision.  Worse, the rating agencies never even declared default probabilities for different bonds.

Where does that leave investors?  It's actually pretty difficult to say the rating agencies did anything wrong based on outcomes.  Bonds defaulted.  An incredibly rare event happened, but we don't know how rare.  And, bonds defaulted.

Do I defend the rating agencies?  No, I dare not.  Fault the rating agencies for their processes.  Do not fault them for defaulted bonds and observable outcomes.

Money Market Fraud? No, Fund!

Suppose you had a risky investment that fluctuated in value all day, every day. Also, suppose you wanted to use this investment like a checking account, but you really didn't like all that "bouncing around" of the investment's value.  Wouldn't it be cool if you could just pretend it didn't bounce around?  I mean, who ever got hurt by hiding a little risk, ignoring a little volatility, or putting fake prices on illiquid securities, right?

In a nutshell, I just described your money market fund.  The SEC announced their reform plan today. Among other things, they allegedly "considered" moving to a floating net asset value.  Surprise!  All the comments from investment companies opposed this change.  Imagine that! The companies who's business depends on convincing the public that their risky portfolios have no risk because every day they're allowed to manufacture a share price of $1.00, (unless a disaster strikes, of course!) opposed changes that would have required them to let you see the risk!!  I know, crazy, right?

Why I hate gift cards

Every economist on the planet loves to remind us that gift giving is inefficient, here's a good one from The Economist.) Yes, cash is king. Gift givers think it's too impersonal, so they roll out the gift cards.

They're telling themselves they aren't so boorish as to give cash. Giving cash pre-allocated to the store or enterprise of the giver's choice is so much more expressive. Right.

But it's worse than that. Cash gifts can go directly to the bank. Given FDIC, they're safe. Or, you spend them, however, wherever you want. If you are so inclined, you can buy something in particular that will remind you of the gift giver.

Gift cards are a monitoring disaster waiting to happen, not just simply because you lose them. Imagine someone gave you a gift and said "Here's a hundred bucks. But, it might not be worth $100 because this is actually a claim on $100 from a counterparty that really isn't particularly credit worthy."

From the store's perspective, these things are incredible. They borrow money very cheaply because the buyers don't account for the risk, or this risk is viewed as less "important" than the "thoughtfulness" of the gift. Why do you think Target will sell you a gift card for iTunes? Because Target takes a cut to distribute non-interest bearing, unsecured bonds for Apple Inc.! Target