Matt Levine writes,

principally, you can divide the thing into more than two tranches of claim. (Very safe super-senior claims get paid first, quite safe senior claims get paid next, then somewhat risky mezzanine claims, then quite risky equity claims.)

. . .Much of what happens in finance is some form of this move. And the reason for that is basically that some people want to own safe things, because they have money that they don’t want to lose, and other people want to own risky things, because they have money that they want to turn into more money. If you have something that is moderately risky, someone will buy it, but if you slice it into things that are super-safe and things that are super-risky, more people might buy them. Financial theory suggests that this is impossible but virtually all of financial practice disagrees.

The link goes to the Modigliani-Miller theorem. That theorem says that moves like this do not eliminate risk–they just redistribute it.

I like to say that the nonfinancial sector wants to hold short-term riskless assets and issue risky long-term liabilities; the financial sector accommodates this by doing the opposite. But the debt and equity claims issued by the financial sector have to be owned by someone. Ultimately, households hold those claims, but with government regularly stepping in, particularly to redistribute losses.

Every day, Levine seems to come across a new scheme by which financial intermediaries are getting away with issuing liabilities that are riskier than they are represented as being. These are schemes that will not end well.

Andy Kessler writes,

Joby Aviation, which plans to begin an electric air taxi service in 2024, is worth more than Lufthansa, EasyJet or JetBlue. Does that seem right? In this market, why not? Heck, earlier this year, Tesla was worth more than the next nine car manufacturers combined, though now only the next six. Beyond Meat, made with pea protein, is worth more than the entire market for peas eaten globally—like the bumper sticker says: Imagine whirled peas. Do fundamentals even matter?

He takes the old-fashioned view, which I share, that fundamentals do matter. But we are in an era in which many people are happy to own assets with no fundamental value, based on confidence that someone else will pay at least as much for those assets. Call it The Bitcoin Era.

I don’t think that anyone can say which is less likely to hold its value: a $30,000 Bitcoin or a $100,000 ten-year Treasury bond.

Kessler blames the Fed for the distortions in asset markets. But I think that this credits the Fed with too much power. I think that in recent decades we have seen intangible assets increase in importance relative to tangible goods. So people have become conditioned to seeing value in things like reputation or corporate culture or regulatory advantage.

But I do think there is such a thing as going overboard in valuing intangible assets. Just as in the public intellectual space the angry partisan hacks have driven real thinkers to the margins, in financial markets the fools have driven the more sober investors to the sidelines.

Larry Summers writes,

when the Fed substitutes short-term bank reserves for longer-term debt, the government is unaccountably “terming in” the debt and shortening the maturity of its liabilities. This approach makes little sense — no homeowner in the present circumstances would opt for a variable-rate mortgage with rates so low. It is unwise at a time of unprecedented growth in federal debt and prospective deficits, along with record-low real long-term borrowing costs. If ever there were a moment to increase longer-term borrowing, it is now.

Let’s say that the Treasury issues a 10-year bond. Good news! It locks in low rates. But then let’s say the Fed buys the bond by crediting a bank with reserves and paying interest on those reserves. It holds a fixed-rate asset funded by variable-rate liabilities. If it were a private bank, it would be dinged for taking too much duration risk.

DeFi is cool. I am not. I write,

I bet that in order for DeFi to work, you need an understanding of financial institutions in addition to an understanding of blockchain and the layers that have been added to it. I don’t think that young techies understand financial institutions as well as I do. And I think I have a better chance of explaining my knowledge of financial institutions to young techies than they have of explaining DeFi technology to me. So I hereby offer to teach a course in financial institutions.

In all the discussion of proposed increases in the capital gains tax, I have not seen any mention of the fact that capital gains are not adjusted for inflation for tax purposes. This is important, because by definition long-term capital gains come from assets that are held long enough for inflation to erode their value.

For example suppose I buy stock today for $100, and five years from now I can sell it for $120. Suppose that in the meantime the cost of living has gone up at total of 15 percent, and that the capital gains tax rate is 40 percent. That means that I can keep 60 percent of my $20 gain, or $12. So I will have $112 in five years, even though I would need $115 just to keep up with inflation.

So even if the Democrats do not increase the tax rate on capital gains at all, they can still end up taxing the heck out of capital gains by causing a lot of inflation. Which I believe they will do.

Investors, have a nice day.

House prices have been soaring lately. Stock prices reached new highs as this was written (earlier in April). Are these bubbles?

If you go by the ratio of property prices to rents or stock prices to dividends, one would say “yes.” But there is the possibility of inflation to take into account.

If a condo rents that rents for $2000 a month sells for $1 million, that is a ridiculously high sale price. But suppose that after a decade of inflation, the rent is $20,000 a month. Then even if the price/rent ratio drops by 80 percent, the nominal sales price will still be $2 million. So the price will have doubled. If you are looking for an inflation hedge, real estate is a legitimate candidate.* In the long run, so are stocks.

*In this example, the price does not keep up with inflation. But it’s hard to find assets that will exactly keep up with inflation. Inflation-indexed bonds do so in theory–but not if official measures of inflation are slow to capture actual inflation and/or the issuer ends up defaulting on them.

So I would not advise you to short stocks or real estate today (you can short real estate by being a renter and putting your savings into ordinary bonds). You might come out ahead, but not if inflation really takes off.

I do not subscribe to strong market efficiency. I believe that there are times when can call “bubble” and be correct. But not now. Because of inflation risk, when it comes to stocks and real estate, This Time is Different.