Great Walls of Cash

With stock markets still shaking our nerves and rattling our brains, it has become fashionable to look at the piles of cash still parked in savings and time deposits and money market funds and argue it can only be bullish for stocks.

The argument goes that, as fear continues to recede, investors will put their excessive cash holdings back into higher-yielding assets, which is clearly good for equities. Indeed, some go as far as to contend that this excess liquidity alone can provide support to equities in the near-term, even if economic data fail to (positively) surprise us in the coming months.

I’m about to take issue with this argument, but let me say it’s not exactly on theoretical grounds… From a macroeconomic perspective, an excessive increase in liquidity should affect asset prices by driving up the demand for less liquid assets—be it stocks, bonds, real estate or a Rodin sculpture.

In fact, this portfolio-rebalancing channel is partly the theoretical rationale behind the Fed’s quantitative easing: Flood banks with cash to the point that they are so overwhelmed by it that they decide to give some of it up in exchange of less liquid, riskier assets—like loans to the private sector.

Here is the problem, however: It’s not exactly clear when liquidity is “excessive”. Most measures of “excess liquidity” have flaws that are likely to be exaggerated in the current environment.

For instance, some compare the current stock of M2 (or the subcomponent of M2 that comprises savings deposits, time deposits and retail money funds) with what M2 would have been, had it grown at the potential nominal GDP growth rate. This latter is the combined rate of potential real GDP growth and the Fed’s “target” inflation rate (that is consistent with price stability).

[Incidentally, the rationale behind such a comparison is the so-called “quantity theory of money”—the idea that money supply should only expand to reflect the expansion in the demand for goods and services (aka GDP), assuming a constant financial “technology” and stable inflation expectations.]

The problems with such a comparison are clear: The first has to do with the inevitable “ad hocness” of having to pick a base year. Another has to do with the sensitivities of the results to different assumptions of what is a reasonable potential GDP growth.

One way to bypass these problems is to look at the ratio of M2 (or your favorite broad monetary aggregate) to GDP, and whether it deviates from “trend”—with a positive deviation pointing to “excess” liquidity. (In the same spirit, some look at deviations of credit/GDP from trend). In fact, the current M2/GDP ratio appears to exceed its trend levels, suggesting(?) that cash holdings are excessive.

But this is not good either… First, the resulting deviation from trend is sensitive to the way we choose to specify the trend itself (linear, etc), as well as the period over which it’s specified. Second (and most important in my view), this approach relies on fairly naïve assumptions about the demand for money—namely, that money demand is solely determined by the demand for goods and services, while everything else is constant (technology, expectations, etc).

The obvious (and my preferred) way to correct this is to compare current monetary aggregates with a theoretical estimate of money demand that is based on a more sophisticated specification of money demand than the one suggested by the quantity theory.

But good luck with that! Not only would the resulting estimates be dependent on your chosen specification; the main problem is that, in the present environment, any model estimated on historic data will likely produce misleading results, given the huge shock on investors’ liquidity preference brought by the financial crisis.

So is there a way around this?

One way is to tackle the portfolio-rebalancing argument head on: By looking at “imbalances” in the composition of investors’ portfolios. The idea is that, if such an analysis finds that investors are, on aggregate, heavy on cash and short of equities, they will have to rebalance by selling cash and buying more equities.

In fact, in this spirit (I guess), one often quoted ratio is that of M2 (or just the sum of savings & time deposits plus money funds) to the market capitalization of the stock market. This ratio is currently still very high by historic standards, suggesting an imbalance (excess cash) that, it is argued, is bullish for stocks.

I actually think that this is a bogus ratio to look at. Investors’ portfolios do not comprise just cash and equities, but also bonds and other forms of wealth including real estate.

Importantly, the whole idea of portfolio rebalancing hinges upon the idea that there is a “benchmark” (optimal) allocation that the rebalancing will try to achieve. But what determines that benchmark?

Many analysts just eyeball the data, take the long-term average and claim that current levels are excessive compared to that average… ergo, rebalancing (out of cash and into equities) will have to occur.

But looking at the long-run average (i.e. a constant) for a benchmark is naïve: The benchmark is not static, but time-varying, depending on the expected risk and return on each asset class: equities, fixed income, cash and so on.

So what do we get when we take this into account? One of the big investment banks on Wall Street conducted the analysis recently, looking at a global portfolio of stocks, bonds and cash and taking into account the time-variation in the benchmarks.

Evidently, the results depend on one’s assumptions about the expected returns for each asset class, and notably for equities: Per their assumptions, a great deal of expected future stock returns is influenced by past stock returns over a given (long) period of time... which, these days, translates into relatively low expected returns for equities, in light of the two stock market busts that we’ve had in the course of 10 years.

Accordingly, despite their recent increase, global cash holdings actually come out to be in line with the “benchmark” allocation. The “overweight” asset class turns out to be bonds, with equities on the underweight side.

Obviously, changing the assumptions (e.g. positing higher equity returns based on, say, forward-looking assumptions) would change the outcome.

But if there is a conclusion here is that simply looking at those great walls of cash says very little about whether stocks are about to be set on fire!

We are all Keynesians now

I don’t know when it was exactly that Pimco’s Bill Gross took his SAT exam but it must have been a long time ago. And that’s not a judgment on his looks, which brim with So Cal youthfulness. Rather, it’s a judgment based on his latest call for the US Treasury to step in to buy (on behalf of taxpayers) the numerous acronym-of-securities that are being dumped into the market by troubled financial institutions.

Cynics of course could rush to read this as a frantic plea to the government to… “for god’s sake…! Save our as*&*&s,..! We were wrong… Got in too early… failed to see how massive a deleveraging would be needed to correct the excesses of recent years.. (excesses we invariably disparaged, by the way, and take credit for avoiding).. So we used our pile of cash to buy, you know, those “bargains” that emerged from the ashes early on.. the Citigroups of this world, Fannie & Freddie MBS.. and so on.. but prices keep on falling.. it hurts!”

I won’t go there. And that’s because, apart from billions of assets “hurting,” Gross and his Pimco buddies have (high-quality) brains. And they seem to have used them in this case to offer an economic rationale for their call. So let’s see if that one works.

The paradox of deleveraging: The idea of Treasury intervention goes back to an earlier article by Pimco’s “spokesman” par excellence, Paul McCulley. McCulley argues that it is one thing for a single bank to shed assets in order to reduce its leverage to more acceptable levels; but it’s another thing if every bank does so at the same time.

The reason is that collective asset-shedding drives asset prices down, creating losses for all those who own them (including the banks), which in turn reduces banks’ equity. Lower equity means leverage goes back up—which makes the whole deleveraging effort counterproductive. That’s what McCulley calls “the paradox of deleveraging.”

The solution? Bring in the Treasury! Have them buy enough dumped assets to stop their prices from falling… so that all those who need to deleverage can do so in peace (and those with cash can buy some of the dumped stuff without worrying about further price declines).

Makes sense? Well, it makes as much sense as another paradox that McCulley uses as an analogy, Keynes’ paradox of thrift: That’s the thesis that if everyone, collectively, save more, aggregate consumption will fall, and so will incomes. And, since people save less when they earn less, aggregate savings will fall—once again, beating the purpose of saving in the first place. So savings is bad for growth??! Sounds like it, and the way to stop this is to have the government step in and spend more!...

...Right, only that economic thought has advanced since then (a little bit). Indeed, I hear that even big Keynes fans like Nobel-prize winner Paul Samuelson dropped references to the thrift paradox in more recent versions of their economic textbooks (evidently after McCulley and Gross’ time!)

The reason is that the “paradox” ignores a few basic points: First, lower consumption should drive prices down—eventually by enough to spur new consumption. Moreover, the “paradox” confuses “savings” with cash hoarding: When people save, they don’t actually keep their cash in their drawers. They put it in stocks, a new home or other investments or, alternatively, in banks, which go on to lend to the productive sector. That’s good for growth! Finally, when the supply of savings increases, interest rates should fall, spurring higher investment—again, good for growth.

Back to deleveraging: Never mind the paradox of thrift. But what about the paradox of deleveraging? Hmmm… The argument rests on the assumption that current asset prices don't make sense.. that they are falling way below what is justified by fundamentals—say, historic default and recovery rates on mortgages.

But hey, if that’s so obvious, why isn’t the “buy-side” stepping in? Why is Gross warning (/threatening?) that “We, as well as our Sovereign Wealth Fund (SWF) and central bank counterparts, are reluctant to make additional commitments”? If anything, some of the “bargains” they bought in January are even better bargains now! Gross of course can defend himself: Ongoing deleveraging will keep on lowering prices. So why buy now instead of waiting until prices are cheaper?.. and cheaper?.. even cheaper?

A role for the government then? Perhaps. But not the one Gross and McCulley call for. IF prices are "fair" (or way below fair), the problem seems to be one of (failure of) coordination: Pimco doesn’t get in because, alone, it will get hurt. But suppose Paulson organized a luxury weekend retreat for the Pimcos and Blackrocks and Wellingtons of this world… and brought in the Chinese too, and a few SWFs from the Gulf states. I mean, some of these guys are flush with cash. Together, they should be able to garner an impressive demand for all the acronymed "bargains" floating out there—and entice smaller players in the process. Not a penny of taxpayer money—the government is just the coordinator.

Problem is, the “fairness” of current prices remains a trillion-dollar question. Especially as the economy weakens further and unemployment keeps climbing. And even more so since the prices of many of these securities were extremely dubious to begin with—to the point that Gross himself labeled some of them as “garbage” only a few months back.

So that's it, the government is called to buy the garbage... Or could I be reading this wrongly? Maybe it’s just called to buy the “good”, truly undervalued, stuff? (You know, those bargains that that Pimco and others bought early on?) But if one were to stop the spiraling impact of deleveraging on prices one should not discriminate, right?

Internalizing the externality: But could a government intervention be justified by the existence of a market failure, like an externality? You know, when you have some agents (read “undercapitalized banks”) deleveraging and, in the process, cause collateral damage (read “falling asset prices”) on good guys (read “Pimco & co”)? Even here, the government’s role is not obvious. The market-based solution would have the “bad” guys “internalize” the cost of their actions.

Of course, it’s unrealistic to ask Merrill, Citi & co. to compensate investors for the losses they have inflicted on them. But maybe they should start paying a bigger price. There are more than one ways for banks to deleverage—shed assets, which hurts everyone, or raise capital, which hurts them, as new capital is becoming more and more expensive. What? Did I hear Lehmans was having trouble raising money from the Koreans because it didn’t like the price??! It’s about time banks swallow it. Needless to say, that would be good news for Pimco & co, who should be able to participate in the recapitalization process at much more attractive rates.

Ultimately, the excesses of the past few years are turning out to have been too gigantic for even the wildest of imaginations. But asking the government (taxpayer) to assume a liability of still-unknown proportions is clearly wrong—a massive wealth transfer from (greedy) borrowers to (prudent) savers. Yet, this is what we are seeing, with July’s housing bill and the latest government plan to bail out Fannie and Freddie.

We are all Keynesians now.


Glossary: deleveraging, paradox of thrift, externality, Keynesian economics

Bill Gross: Government must buy assets to prevent “tsunami”

Government takes control of Fannie and Freddie

Alpha Beta Sigma: Understanding the Greeks

No, I’m not referring to some new fraternity here, dedicated to the promotion of enlightenment, upliftment and/or collective drunkenness. Besides, I wouldn’t know. I got my college education on the other side of the Atlantic, at a place where the frat-boy equivalents preferred to vomit in their tailcoats and where, rather than Greek letters, social clubs often bore the names of the homosexual lovers of medieval kings.

It’s the other Greeks I’ll talk about. The ones used in finance, which are as much misunderstood as the idea that hummus is a Greek dish (it’s not!). The list is pretty long, thanks to the creative use of an alphabet of twenty-four letters. But here I’ll refrain from getting deep into the exotic maze of greek squiggles and contain myself to three of them—the sigma, the beta and the alpha. What are they?

The sigma, σ: Say you think of yourself as a pretty mellow and jovial guy on average, yet, with frequent bouts of Dalai-Lama bliss to “American Psycho” lunacy, or anything in between. Abstracting from the fact that you might want to see a shrink, an economist’s diagnosis of your condition would probably sound something like “a jolly fellow more or less, whose mood exhibits a high standard deviation.” That so-called “standard deviation” is the sigma. It is a measure of how erratic, how dispersed your moods can be, “above” and “below” your average jovial self.

Now say that in the course of your college life you came across a few other “high-sigma” soulmates and you decided to form a fraternity—call it Phi Tau Delta (ΦΤΔ), the Greek initials of the expression “Beware of the Greeks!”. Now, not only are your “brothers” as temperamental as yourself, but your moods tend to vary together; similar things excite you at similar times. We’ll call that a high covariance. No Greek letter here, although a variant concept—correlation—has been assigned by the pros the letter ρ (rho).

Both the standard deviation and the covariance are important for understanding risk, especially when it comes to investing in a portfolio of different securities. To understand this better, let’s go back to our frat-boy example.

Avoiding idiosyncrasies: Suppose I am a bar owner and one of my “regulars” is a ΦΤΔ member. A loyal client, an ardent g&t consumer, yet potentially a nasty business given his sporadic destructive splurges, especially manifested when his baseball team loses. However, I could still do just fine, if my clientele is fairly large and diverse and perhaps less passionate about sports or less keen on participating in havoc. In that case, at worst, I might get a couple of broken chairs, some spilled-over g&t’s and a few spells of foul language before our ΦΤΔ friend is kicked out of the door by those who want to keep on with their happy-hour cocktails in peace.

In other words, by having a large and diversified clientele with variable tastes for anarchy and/or baseball, I managed to minimize the “idiosyncratic risk” to my business from our friend’s eccentricity. In a similar way, if I own a stock that is volatile because of certain idiosyncratic features of the corresponding company—say it’s a mining company in Chile whose workers invariably go on strike—I can diversify away that risk by buying the stocks of many other companies which have neither labor issues nor an exposure to Chilean politics. This idiosyncratic risk is effectively what is encapsulated by the standard deviation.

Risky business: Imagine on the other hand a scenario where the entire ΦΤΔ membership are regulars at my bar, while the rest of my clientele are also pretty passionate sports fans, as well as supporting the same team as ΦΤΔ. Now that’s a risky business. Sure those ΦΤΔ guys drink a lot, which can’t be bad for revenue; and sure, there is something to be said about the entertainment value of a bunch of loud drunkards trying to quote Hamlet while throwing chairs at each other. But hey, these are my chairs that they are throwing, these are my glasses that are broken on the floor... and that is my autographed Yankees shirt they’re about to take down from the wall to wipe off their mess!! Worse, while they’re at it, everyone else is drawn in, though perhaps less “passionately” than the frat-boys, and the entire place gets smashed.

Put it plainly, the fact that my entire clientele tends to drink, get loud and destroy together in response to the same stimuli, makes my business very risky because I have no way to diversify away that risk. I can’t find different clients. That non-diversifiable risk is called the “systematic risk.”

The beta, β: This is where the beta comes in. Beta is a measure of the systematic risk of, say, a single stock or a portfolio of stocks. It measures the risk that stems from the portfolio’s covariance with the stock market as a whole—the risk that you cannot diversify away by adding more and more securities. The higher the covariance, the higher the beta, the higher the systematic risk. And the higher the risk you’re taking, the more you want to get paid.

So let’s go back to the frat-boy example. In our second scenario earlier, our ΦΤΔ boys are “high beta.” Their mood tends to swing in the same direction as the mood of my other patrons, but more: Under the “right” prodding, they will drink more, shout more and destroy more. This makes them a rather risky addition to my clientele—I mean, I’d much rather have a fraternity that promotes spiritual development by discussing yoga breathing exercises (over alcohol of course) while everyone else roars as the Yankees are getting smacked by the Indians.

But choice I have not. And given the risk I’m taking here, I expect to get paid for it. That is, I will tend to require higher compensation from the frat boys than the rest of my patrons in the form of, say, regularly higher tips for the potential physical and reputational damage that they may cause on my establishment. Similarly for stocks. If a stock has a high beta (that is a beta larger than 1, which is the beta of the market as a whole), I will expect proportionately higher returns from that stock than the returns of the market index (say the S&P 500).

The alpha, α: So what about that alpha? Alpha is a measure of how well a portfolio of stocks has performed after adjusting for the risks involved. Effectively, what you want to know is how well your portfolio did compared to other portfolios with similar risk characteristics. One way to adjust for these risks is to look at portfolios with similar beta as yours. While simplistic, this approach can be a first step in understanding whether your investment manager has given you great returns because of his/her superior acumen rather than because of riskier choices (which would lead to a higher beta).

Going back to that bar of mine, if I tell you that my profit for the year was 30 percent higher than the other bars in my neighborhood, you might want to congratulate me at first. But on second thought, just when you’re about to give me a check for that loan I asked you for, you may want to ask me a few questions. Am I really a genius or could I be relying for my revenues on those rowdy ΦΤΔ characters who, at any time, could ransack the place? What matters for judging an investment manager’s ability is not the higher returns stemming from higher systematic risk (higher beta) but those due to superior stock picking (that will yield a higher alpha).

So there you go. Your first step in understanding the Greeks (although, as I hinted earlier, what is referred to as “the Greeks” in finance are greek letters used in the context of pricing options—such as the γ (gamma), the δ (delta), the θ (theta) and the ν (called “vega” by the traders, even though the actual Greek letter is called “ni”). Still.. even with this limited knowledge, you will at least know how big a tip to give me when you come to watch the playoffs at my bar!

Glossary: standard deviation, idiosyncratic risk, systematic risk, covariance beta, alpha, tailcoats, hummus, Beware of the Greeks

Sorry, I missed your call...

Some market players are becoming a bit “antisocial” these days. The latest one to breach the market etiquette was Carlyle Capital, a multi-billion-dollar investment fund and offshoot of the powerful private equity group, Carlyle Group. Apparently, Carlyle’s bankers had been calling for days and, after days of silence, the company came out last week to simply say “Sorry… I missed your calls!”

Now these are not any calls. They’re margin calls, and missing them is a pretty serious matter! Indeed, the news added fuel to the fire that has been burning in credit markets for months, sending risk premia to scary new heights as investors began to wonder who else might join Carlyle’s in its antisocial behavior! And sure enough, later on Friday, another company, Thornbug, a provider of “jumbo” (large) mortgages said it couldn’t meet its margin calls, putting its survival in doubt.

So what are margin calls? I mean, who’s calling? And are Carlyle & co. being plain rude?

Telling the tale: Let’s say we’re back in July 2007. You take a look at the latest economic data releases—rising mortgage delinquencies, falling house prices and all—and somehow decide that, nonetheless, it’s still a fabulous time to invest in mortgage-related securities. So you go to your broker and say:

“Hey, I see some high quality stuff out there.. but I only have one thousand dollars to invest. Why don’t you lend me another couple of thousand? I can make more money this way! And if it makes you feel better, I can give you collateral for the loan. Some good, low-risk bonds I own, maybe some cash…Deal?”

Now that’s smart! So now you have two thousand dollars to invest, which means that you can make much more money. How?

Working out the multiples: Say you only had your own $1,000 and the price of your chosen investments went 20% up. You gain—20% (or $200). But now you have $3,000 invested so a 20% price increase translates into a $600 profit. So you take your $3,600, pay back the $2,000 you owe to your broker (with some interest) and you are left with $1,600—a hefty 60% gain on your initial investment!

Of course that’s all great if the market goes up. If it goes down, yes, you guessed it… You’re SCR#($@D! And if you bother to do the calculation, you will note that, the more money you borrow to invest (or the more “levered” you are), the more multiply scr#($@d you are in a downturn!

The collateral you deposited with your broker is the “margin.” Brokers ask for margins because they know the downside can get pretty ugly in Dow-Land. And they want to be comforted that, even if your market acumen were misplaced, and your investments went downhill, they can still get their money back.

Reasonable deals: But let’s go back to last July. So you borrowed $2,000, added it to your own $1,000 and invested all of it in securities that are linked to the performance of residential mortgages. But you didn’t pick any mortgages. You knew that something was fishy in the subprime sector, so you said “I’ll only go for the safe stuff, triple-A-rated securities linked to mortgages issued by Fannie (Mae) and Freddie (Mac).” “These can’t possibly go bad,” you thought. “Not only are they good quality, but Fannie and Freddie are government-sponsored agencies. And the government can’t possibly let them join the fallen.”

“Sounds reasonable,” said your broker. So he lent you the money, but under the following conditions: That at any point in time, you maintain collateral in your account that is at least 15 percent of the market value of your assets. This is the maintenance margin. And that, if your “equity (or the value of your investments minus your debt) fell below the maintenance margin, you would need to find extra collateral and deposit it in your margin account. Otherwise, he reserved the right to start selling part of your existing collateral and use the cash to repay part of your debt, so that your equity goes back up again to acceptable levels.

Now I made up the 15% but, generally, the level of the maintenance margin depends on a number of factors. These include government regulations, brokers’ discretion, the level of competition among brokers to get your business, your overall creditworthiness and how risky the investments you want to make with the borrowed money are.

So, for example, you would expect that when many brokers compete for your business, they might be a bit more lax in the restrictions they place on you, and be happy with a 10% maintenance margin (provided it still lies within the government’s regulatory limits). Similarly, if a certain type of investment is very volatile, your broker will want a bigger cushion since the value can go down very rapidly.

When margins hit the fan: Come August 2007. Markets are getting nervous, as a series of land-mines explode in the credit world—mortgage delinquencies, bankrupt hedge funds, defaulting “SIVs”, major banks under threat. Your investments begin to shake. Your equity is still in positive territory but it’s getting dangerously close to the maintenance margin level. Indeed, as the crisis continues through November, ooops, the equity drops below the margin. And… you receive a call!

“Hello?” (It’s your broker!) You panic… and don’t pick it up! He leaves you a, message, a kind reminder that you need to replenish your margin account, else…

Shoot! Markets are cash-strapped and there is little hope you will find any investor willing to fund you. What to do? You call your mother!

“Hey mom, how are ya, not sure you’ve been following the news… but my investments are in a bit of a strain these days. And I’m short of cash. So when I heard Carlyle Capital managed to get a $150 million credit line from its own mother, Calryle Group, I got inspired and thought you might be able to lend me a few hundred bucks.”

Your mom is upset. “I can’t believe you refused your broker’s calls! What the hell will he think of me??” “I spent years teaching you manners, helping you build your reputation, and now this!” So she sends you the cash, together with a sweet, motherly note saying that this is your last chance.

But the credit-market carnage continues and is spilling over even to “safer” securities, the Fannies and Freddies of this world. This time it’s very serious. Not only are your investments going down. Not only is there more volatility in the market. Not only are you short of cash. But so is your broker, which makes him more nervous about his clients potentially going bust. So as soon as your equity falls below the margin, he calls again… and again and again. And as you “miss” his calls, he leaves you a message notifying you that he just took over your collateral, sold it for cash and used it to reduce your debt. And that, in light of the abysmal market conditions, you’re likely to get more calls soon.

That’s the Carlyle story.. kind of. One important difference being that Carlyle was not two, but thirty times leveraged, so start doing the math to see by which multiple it’s getting scr#^$%d.

But there is a bigger issue.. bigger than Carlyle, Thornbug & co. The more companies are facing margin calls, the more “fire sales” you would expect either by themselves (to reduce their exposure to risky assets with plummeting value) or by their brokers (as they want to recoup at least part of the cash they lent). This is driving prices down to obscenely low levels, even for securities that (in "normal" circumstances) would be safe.

So fasten your seatbelts, because the next few weeks will be bumpy. And, unlike most circumstances, calling your mother won’t help.


Glossary: Maintenance margins, equity, leverage, margin calls, etiquette

Bearing bonds..

I thought I was done with Christmas presents and was looking forward to the next commercial occasion for gift exchanges: Valentine’s Day. Mother has made a custom of sending me a box of dark bitter chocolates, which every year I receive with a momentary guise of suspense, as if it’s from someone totally unexpected.

But no. I recently hosted an old friend from Oxford, a Renaissance man of sorts engaged in theater production, a revolution in the Middle East and daytime bond trading. So after the usual hugs, “it’s been aaages!!” and top-down scrutiny to confirm that we “haven’t changed at all,” he digs into his carry-on to find my Christmas gift.

With the aplomb of someone about to unveil a lost treasure, he presents me with a brown envelope, rumpled and torn, addressee’s name crossed out and hurried smudges with his to-do list. I salivate with excitement! I grab the envelope, tear whatever was left of it and reveal my present: A bearer bond! An original bearer bond, coupons and all, issued in 1928 by the State of Bahia in Brazil!

Hmm.. I sense something short of drooling enthusiasm in the audience! OK, let me defend myself. First of all, my bond is a fine-looking object. You have the name of the borrower (or issuer)—the State of Bahia—written on top in an imposing semi-circular header. The value of the principal (or face value) of 10 pounds sterling, is shown on each side, encased in a heart-shaped flowery frame. The bond’s 5% annual interest is prominently shown at the bottom, and it was collected biannually upon submission of small rectangular coupons attached to the document (see picture).

A dense calligraphy script spells out the terms and conditions in English and French—testimony of the dominance of British (and less so French) capital in financing infrastructure projects in Brazil, from railways to public utilities, during the 19th and early 20th centuries. Among the terms and conditions, you can find the maturity of the bond, an option for Bahia’s government to repay before the bond’s maturity date (a call option in modern finance jargon), and the government’s commitment to continue to meet its payment obligations “whether in time of peace or war and whether the bearers be subjects or Citizens of a friendly or hostile country.”

Still not convinced? Well, let me say my bond has an extra, special feature: It’s a bearer bond! Bearer bonds have been almost phased out in the United States for the following reason: Unlike other, “registered” bonds, which carry the name of the owner and which can only be transferred subject to their owner’s endorsement, anyone who finds and holds a bearer bond can go and collect the interest and principal. Without a specified owner, you could use these bonds in lieu of cash, and some saw this as an opportunity to hide some of their cash earnings for federal tax purposes. Moreover, bearer bonds were risky to hold, as they could be stolen or, let’s say, “found in some antique market in Oxford!” Yeah, I know what you’re thinking: Why don’t I take this bond, fly down to Bahia, cash it in and top it with a bit of bossa nova?

Truth is, as much as I want to deny it, my bond is pretty worthless. In 1943 it was annulled in the context of a debt restructuring plan between Brazil and its external creditors, a few years after the government went bust and declared default. Let us note it was not Brazil’s first time (nor the last!). My bond itself was issued in early 1928 as part of an earlier debt restructuring scheme, under which part of the money raised by the bond issue would be used to repay interest on Bahia’s foreign debt, which the state had stopped paying for some years.

It’s all kind of similar to you going on arrears on your mortgage and renegotiating the terms with your bank… only bigger and messier. And with the non-trivial difference that, whereas your bank can take back your home and say goodbye, in the case of foreign sovereigns it’s kind of difficult to take over their property short of declaring war on them (and winning).

Defaults are a fact of life and a look onto the subprime mortgage saga here in America reminds us that they are not just the plague of remote, exotic places with unpronounceable names. Indeed, Brazil’s economy is booming these days, with the country having more than enough foreign assets to repay its entire foreign debt, and with foreign investment at new highs.

Many of us wondering are of course whether Brazil might ever hit the wall again. But meanwhile, I prefer to relish the small artistic details of the State of Bahia’s badge, imprinted right in the middle of my bond’s header: It pictures a man, semi-nude, with a wheel and a sledgehammer (symbol of Bahia’s industry); a woman carrying the State flag (symbolizing the Republic); and a shield in the middle showing a boat sailing on. “Per ardua surgo”—I rise through difficulties.

Glossary: nominal value, coupon, maturity, debt restructuring, bossa nova, Bond, Bearer Bond.

Triple-A Rescue

No, this is not about emergency road rescues. This is about the American government’s future ability to repay its debt... you know, those US Treasuries you hold in your investment portfolio.

Moody’s, an agency that ranks countries according to their capacity (and willingness) to repay their debt, said yesterday the US government could lose first-class rating due to pressures on its finances from the rising costs of the Medicare and Medicaid programs.

Moody’s rankings (or “credit ratings," to throw in some indispensable party jargon) come in the form of letters: A, B, C and so on, and combinations thereof. Triple-A (Aaa) types are the top of the class, and the American government shares that front row with Germany, France, the UK and Canada among others.

At the other end of the spectrum you have the B’s and C’s—or “Basket Cases”. These are the likes of Argentina, Belize, Lebanon or Ecuador, who are either about to go bust, or have gone bust multiple times in the past, or who have “promised” to go bust because, in some parts of the world, screwing up investors scores political points.

So what’s the big deal with a teeny downgrade to “double A” (Aa)? We are still A-types, aren’t we? Well, pretty big actually. And not just because we would now go back a row to sit with the likes of Belgium, Kuwait and Macao!

US Treasuries, which are short-term debt obligations of the US government, are considered the world over to be “risk-free.” Rain or shine, you always get your money back, plus interest—the “risk-free rate.” Nobody expects the US government to default on its debt. As such, the interest rate paid by US Treasuries sets the benchmark for the interest rate paid by riskier borrowers, from Argentina, to Walmart, to you and your mortgage.

Now this is big. Aa doesn't sound as risk-free as Aaa, so you can imagine the chaos of trying to find another benchmark for pricing the millions of investment instruments out there.

And then there are your investments. When a borrower, be it the government of Argentina or mortgage issuer Countrywide, has its credit rating downgraded, this tends to lower the price of the bonds they issue. This makes sense. The more of a basket case you are, the cheaper it should be for me to buy your bonds. Put it in plainer terms, if you are a triple-A, I could lend you today $97 and require that you pay me $100 in a year from now. Making a respectable 3 percent interest. But if you suddenly get Aa, rest assured I’ll ask for more.. I’d lend you, say, $96 for the $100 that you’ll give me in a year from now!

Now, what would happen if all those who hold US government debt, from you and me, to Japanese housewives, to the likes of China or Saudi Arabia, dumped their trillions of US debt securities out of fear of price falls because of a future downgrade? Yes, that's right, a downward spiral in the value of your investments.

To be fair, one would realistically expect that Moody’s concerns over America’s public finances will be resolved, at least partially, way before a downgrade occurs. After all, it’s not the first time that the agency cries wolf!

But it wouldn’t really harm if you actually did something about it… Like, demand from your elected representatives a meaningful and sustainable solution to the healthcare situation. Try it… it’s risk-free!

Glossary: US Treasuries, credit-rating, triple-A, risk-free rate, basket case.