Robert Shiller, in his book The Subprime Solution offers a risk management tool for governments. It is a “Trill” and it pays a perpetual share of GDP.

As GDP increases, the instrument pays a higher coupon. During a recession, it pays less. Quite the floating instrument. Shiller assumes each share would pay roughly $15, believing perpetual GDP would average $15 trillion annually. (Hence the “Trill”). Each Trill would be worth roughly $300. This assumes the US Risk Free rate is 5%. The risk-less rate of the US economy is 5%.

The “Risk” that is managed is during hard times, the government obviously owes less in debt service costs. In times of plenty, the government can afford to pay more. But in bad times, governments would have more cash on hand to handle a crisis (such as today).

The Pros.

• This instrument allows the market to truly estimate GDP growth. In some ways, the instrument is worth issuing simply to have a market view (a great view) of GDP growth.
• One now has the ability- with TIPS, Treasuries, and Trills- to estimate real GDP growth given  market views.
• Instead of perpetual Instruments, it could be more beneficial to issue “Trills” expiring annually, similar to TIPS and Treasuries. This way, one could have the market truly predicting GDP growth.

The Reasons for Pause:

• Reviewing the LM curve, as output grows, interest rates rise. As the economy falters, interest rates fall. Even in today’s crisis, this relationship holds true. The Trill’s desired hedge already exists. Further, this means the government has the ability to re-finance higher yielding paper in tougher times.
• The Hedge: Shiller’s main reason for the GDP indexed Trill is to provide government “room to spare” should a contraction occur. As GDP declines, so would tax receipts, lowering government revenue. It then is hard to argue the Government would have spare cash to attack a crisis.
• Other Financings: GDP, remember, is defined as Consumption + Investment + Government Expenditure + Net Exports. GDP could remain stable year on year, but Imports could still rise. In this example, Investment (Foreign Direct Investment) remains unchanged meaning the Current Account Deficit is in the form of domestic bonds and stocks, essentially payments to foreigners from US income. Trill payments could remain unchanged, but the country as a whole would pay more to maintain the same standard of living (in the short run).

Robert Shiller is one of our smartest thinkers on real property. Let’s work on the Trill as it has definite promise as a positive instrument for US Debt.

Is the liquidity crunch over?

Here is my thinking:

Let’s review treasury rates (aka, the “riskless” rates) for the US and UK over the next six months. According to the Financial Times data on November 14^th, 2008:

• US treasuries set to expire in six months yield 87 basis points (Deflation).
• UK treasuries set to expire in six months yield 199 basis points (who knows)
• One British Pound today is worth 1.4827 US Dollars
• One British Pound’s worth in six months as of today’s spot forward is 1.4807 US Dollars

The rates for sovereign taxpayer debt and the interlinking value in currency should display the differences in risk of each country.

• $100 invested in US treasuries vs. $100 invested in UK treasuries and converted at the corresponding spot and forward rates should yield the same rate of return.
• Converting $100 to pound equivalents, investing in UK treasuries, and returning those pounds to US Dollars six months from now returns a dollar more (.98 US cents) in value.

In normal times, no way. Someone in any trading house would be looking for the “blips” to quote Michael Lewis from Liar’s Poker. Here are a two observations why this opportunity exists today:

• As discussed in previous posts, we’ve witnessed massive flight to quality recently, as capital has left emerging markets and safe harbored itself in US Treasuries
• The REPO market continues to be stressful. Again, as discussed in previous posts, the lack of shorting treasury opportunities has caused massive spreads differences in otherwise equally risky cash flows.

What is interesting though is that the link between currency and risk still exists for the most part. For the UK though, that means its current treasury yields are tied far more to the US and the Dollar than they are to their own interest rate policy (currently at 3.00%). While the Bank of England has been aggressive in rate reductions, its own government bonds in no way reflect this.

Reporter Saskia Scholtes of the Financial Times was wise to diagnose our current crisis correctly almost one year ago on Newshour with Jim Lehrer. We had a “financial markets problem” We still do.

Since Ms. Scholtes’ diagnosis, it is becoming clearer the “financial markets problem” is spreading to the overall economy. This is particularly worrisome over this past week with special attention the Fed’s policy decision.

As we correctly noted in our previous post (to be sure, this blog is large enough for our over sized ego),

Ben Bernanke and the Federal Reserve enacted a massive rate cut. But has it worked? Has it bolstered confidence in the overall markets? We present two frameworks to analyze the cut and the market’s reaction (assuming additional pricing was occurred).

First is oil. Oil’s trajectory in various days in October (below) has been remarkably unchanged.

Sure, oil rose from the cut. But the real story is how powerful dollar’s pricing is behind oil’s future prices. And here is the real concern:

The Fed’s cut has two objectives:

• Lower credit conditions to ease lending strain, bolstering the economy
• In anticipation of further economic contraction, ensure deflationary conditions do not persist.

The Fisher Equation derives the market’s inflation expectations. Below is the previous Monday and Friday (before and after the Rate Cut) TIPS and Treasury Yields, and the derived inflation expectations.

No doubt treasury yields are low in an investor. But suppose treasuries were priced 100 -200 basis points higher. Given TIPS yields, there is still a view we are headed into a deflationary period. Given the dollar’s increased pricing power tomorrow vs. today, it should give us pause about the following:

• What is Oil’s true future price?
• Given that holding cash under the mattress is now worth more tomorrow than it is today, is the treasury fix fixing anything?

Since last we spoke, the government invested $125 billion into the nine biggest banks and will invest $125 billion into an additional number of banks, potentially other financial companies. The investments, up to $25 billion or 3% of risk weighted assets into any specific company, are supposed to ease liquidity issues, and reduce cost of funds between banks.

For Taxpayers, the returns depend on your view.

• The terms of the treasury (on behalf of the tax-payer) investment are a dividend of 5% of invested capital.
• The preferred share investment is callable anytime after three years.
• Should the banks issue new equity prior to three years, they can buy out the tax-payer at par with that funding. In essence, any current equity owner is diluted regardless.

The taxpayer does not have any savings (found in lack in government surplus), so it must raise debt to fund the bank bailout.

Examining two and five year treasury yields, they are priced at 1.555% and 2.609%. respectively.  Assuming the Treasury Department does the right thing (See Note Four A), it will sell five year debt to finance the bailout.

Doing the math, paying 2.609% to receive 5% seems like a good deal. It does make a lot of arguments against it seem not as compelling.

Here’s another way to look at the deal though.

Assume the treasury invests up to $250 Billion, the returns over three years are $6 Billion a year. Enough to pay for approximately one year of pork projects John McCain rails against continuously.

Is this then a good investment? You decide.

The Treasury can choose how to finance this purchase.

First though, the plan gives us insight into when Treasury foresees the US Economy recovering. If all preferred shares are callable in three years, but only redeemable through equity (and not debt) prior to, then in essence, Treasury believes we will not fully calm the credit markets until three years from now.

At present, The Treasury issues 2 Years, 5 Years, and 10 Years. Yet Treasury must know most banks will call the preferred shares by year five when the dividend percentage increases from 5% to 9%.

Yet how many banks will take out the preferred shares prior to year three? Probably not many.

The safest debt instrument then is a five year treasury debt instrument. Here is why:

• The Yield on Five Year Treasuries is 2.609%, cheap money.

• No refinance risk. The preferred shares are retired back piece by piece through the next five years. While there is a chance of buying back treasuries at a premium when the debt is retired, the debt is so cheap; this problem is hard to imagine.

• Isolates the problem to the current administration. No doubt, models exist predicting when various banks will pay back the preferred shares, estimating duration and a possible combination of two year debt, five year debt and accept some refinance risk if funding is further needed.