America, the great bastion of free enterprise, now confronts the spectacle of its government trying to fight the markets. When the real estate, mortgage and stock markets began tumbling last year, the Federal Reserve sharply reduced interest rates in an effort to stem losses. It may have softened the blow, but the losses nevertheless remain gargantuan. When banks stopped lending to each other, the Fed stepped in with billions of dollars of loans, taking mortgage-based derivatives and other kitchen sinks as collateral. When Bear Stearns tottered at the brink, the Fed guaranteed a bunch of its hinky assets in order to induce J.P. Morgan to make an acquisition it might well not have otherwise made. When Fannie Mae and Freddie Mac's stock lost most of their value, the Fed stepped in with yet more promises of credit, and the Treasury Department announced a plan for the government to invest in Fannie and Freddie. Brilliant. Treasury wants authority to invest taxpayer money in companies that no private investor in its right mind would invest in.
The SEC made a cameo appearance and issued an order limiting the ability to sell short the stock of Fannie, Freddie and certain large financial institutions that are primary dealers of the Federal Reserve. Shareholders of these firms can momentarily wipe the perspiration from their brows. But shareholders of GM, Ford and all of the other thousands of public companies in America might wonder why firms so badly mismanaged as Fannie, Freddie and some of the primary dealers are insulated from market realities.
The U.S. government is trying to fight the markets--the real estate market, the stock market and the derivatives market. This isn't likely to be a winning proposition. The losses that have been or will be sustained in these markets are in the trillions, too great for any government to absorb or control. Governments that try to take on massive market forces eventually lose. The Communist governments of the Soviet Union and China couldn't beat market forces and wound up joining them. The U.K. government's attempt to defend an overvalued pound in 1992 against short sellers ended in failure and devaluation. The U.S. government's decades long efforts to fight market forces in the agricultural commodities markets has resulted in unjustified and irrational farm subsidies. The Japanese government's efforts to avoid recognizing the Japanese banking system's losses from the collapse of real estate and stock prices in that country in 1990 resulted in failure and stagnation that still bedevils Japan.
In its waning days, the second Bush administration appears to be placing on the federal government responsibility for all liabilities and even share values of the core players of our financial system. This is a really bad idea, not only because of the moral hazard it creates--incentivizing the financially powerful to take exorbitant risks--but also because it ultimately puts the government in the position of trying to combat market realities.
What can be done? Organize a new mortgage agency to replace Fannie and Freddie, this time with a very clear statutory articulation of the extent, if any, of the government's responsibilities for its liabilities. Then, wind down and liquidate Fannie and Freddie. This is what the government did with the bad savings and loan associations in the early 1990s. They weren't bailed out and their shareholders were wiped out. Their poorly performing managements lost their jobs. The government thrashed around through most of the 1980s, trying to avoid the reality of the S&Ls' losses in the real estate markets. During that time, the S&Ls continued on their merry way, incurring more and more losses. The price to taxpayers of all this governmental squirming was about $3,000 apiece. If the federal government thrashes around more with Fannie, Freddie and the major financial firms in an effort to avoid confronting their losses, the outcome won't be particularly different. All of this administration's principal actors will be out of office before the full implications of the current policy emerge. But we schlemiels (read taxpayers) will have a firm grip on the bag for a long time.
Thursday, July 17, 2008
Tuesday, July 15, 2008
How to Protect Your Money
Jimmy Stewart is no longer with us, so a run on a bank is likely to lead to its collapse. That's the lesson of Bear Stearns, and the lesson was repeated again with the recent federal seizure of IndyMac, just last year the 9th largest mortgage bank in the country. IndyMac's collapse was precipitated by the flight of hot money--brokered deposits that are paid high interest rates but which can evaporate in nanoseconds. In this case, they did evaporate in nanoseconds after publicity about IndyMac's problems. Oddly, following the Federal Deposit Insurance Corp.'s seizure of IndyMac, large numbers of depositors lined up outside its branches to withdraw their money. After the FDIC seizes a bank, making a withdrawal doesn't change things. If your account(s) are fully insured, they will be entirely protected after the federal takeover. If your account(s) are only partially insured, you took your loss at the moment of federal seizure and withdrawal thereafter won't make you any better off.
In order to protect your money, you have three options:
FDIC Insurance. The FDIC insures your deposits at any particular bank up to $100,000 per customer. The FDIC totals up all your accounts to calculate your coverage, so if you have $10,000 in your checking account and $98,000 in a CD, you are uninsured to the tune of $8,000. If you have an interest in one or more joint accounts, your interests in all joint accounts will be totalled up and you will have an additional $100,000 of coverage. For example, if you have a joint account with your spouse which has $120,000 in it and a joint account with a parent with $90,000 in it, your personal interests total $105,000 and you are $5,000 uninsured. IRAs are separately insured for an additional $250,000. There are nuances to the FDIC's rules and you should go to www.fdic.gov for more information. You can count on the federal government to stand by its deposit insurance commitment, because anything less would lead to the collapse of the financial system. If a portion of your bank accounts is uninsured, pull it out of that bank and put it in another bank. You get a clean slate with each bank. The rules for credit unions are the same, and you may get a slightly higher interest rate from a credit union.
U.S. Treasury securities. You can invest in U.S. Treasury bills, notes and bonds, and get unlimited protection for your money. These are direct obligations of the United States, and will be paid, period. U.S. savings bonds are also entirely safe, but there is a $5,000 per year limit on your purchases of savings bonds, so they aren't of much use when you have a large sum of money you prefer not to lose. You can buy these investments directly from the Treasury Department (at www.treasurydirect.gov). Treasury bills, notes and bonds can also be purchased through brokerage firms. Savings bonds can be purchased through banks and credit unions. Among other things, you can get inflation protection from Treasury securities called TIPS and savings bonds called I-bonds.
Money market funds that invest only in U.S. Treasury securities. If you want to keep your money liquid, but still get the protection of U.S. Treasury securities, invest in a money market fund that holds only U.S. Treasury securities. There are a number of such funds offered by mutual fund companies--use your favorite search engine to find them.
None of these options pays very high interest rates. But, given that almost all asset classes are dropping in value, low interest rates are better than a poke in the eye with a sharp stick. While you can always keep your cash in a safe deposit box or in your mattress, you have the problems of physical security and inflation. Cash earns zero interest, so its value is sure to diminish as the inflation monster roars.
In order to protect your money, you have three options:
FDIC Insurance. The FDIC insures your deposits at any particular bank up to $100,000 per customer. The FDIC totals up all your accounts to calculate your coverage, so if you have $10,000 in your checking account and $98,000 in a CD, you are uninsured to the tune of $8,000. If you have an interest in one or more joint accounts, your interests in all joint accounts will be totalled up and you will have an additional $100,000 of coverage. For example, if you have a joint account with your spouse which has $120,000 in it and a joint account with a parent with $90,000 in it, your personal interests total $105,000 and you are $5,000 uninsured. IRAs are separately insured for an additional $250,000. There are nuances to the FDIC's rules and you should go to www.fdic.gov for more information. You can count on the federal government to stand by its deposit insurance commitment, because anything less would lead to the collapse of the financial system. If a portion of your bank accounts is uninsured, pull it out of that bank and put it in another bank. You get a clean slate with each bank. The rules for credit unions are the same, and you may get a slightly higher interest rate from a credit union.
U.S. Treasury securities. You can invest in U.S. Treasury bills, notes and bonds, and get unlimited protection for your money. These are direct obligations of the United States, and will be paid, period. U.S. savings bonds are also entirely safe, but there is a $5,000 per year limit on your purchases of savings bonds, so they aren't of much use when you have a large sum of money you prefer not to lose. You can buy these investments directly from the Treasury Department (at www.treasurydirect.gov). Treasury bills, notes and bonds can also be purchased through brokerage firms. Savings bonds can be purchased through banks and credit unions. Among other things, you can get inflation protection from Treasury securities called TIPS and savings bonds called I-bonds.
Money market funds that invest only in U.S. Treasury securities. If you want to keep your money liquid, but still get the protection of U.S. Treasury securities, invest in a money market fund that holds only U.S. Treasury securities. There are a number of such funds offered by mutual fund companies--use your favorite search engine to find them.
None of these options pays very high interest rates. But, given that almost all asset classes are dropping in value, low interest rates are better than a poke in the eye with a sharp stick. While you can always keep your cash in a safe deposit box or in your mattress, you have the problems of physical security and inflation. Cash earns zero interest, so its value is sure to diminish as the inflation monster roars.
Sunday, July 13, 2008
A Fair Bailout for Fannie and Freddie: Create a New Mortgage Agency
The Bush administration is once again winging its way through a financial crisis, this time trying to keep Fannie Mae and Freddie Mac on their feet. The Fed has announced that it's given the Federal Reserve Bank of New York the authority to make loans to Fannie and Freddie. The Treasury Department has announced a plan to seek authorization from Congress to increase the credit line Fannie and Freddie have with the Treasury Department (currently at $2.25 billion, lunch money in today's mortgage markets), give Treasury the authority to make equity investments in Fannie and Freddie, and give the Fed greater regulatory authority over Fannie and Freddie.
These proposals look like more rubber bands and chewing gum. The Treasury Department plan is just a proposal. Treasury currently has no authority to do anything except lend Fannie and Freddie $2.25 billion, which may be enough to keep them going for a day or two. The Fed's loan authorization is a tad misleading. It says that the loans will be collateralized by "U.S. government and federal agency securities." How much in the way of U.S. Treasury bills and notes do we think Fannie and Freddie hold? Not much, we'd guess. But if Fannie and Freddie submit agency securities as collateral to the Fed, those securities could be obligations of Fannie and Freddie (which are among the biggest issuers of agency securities). In other words, such collateral would be impaired in value, just like Fannie and Freddie. That's a great deal for Fannie and Freddie, but the taxpayers may be getting yet another stick in the eye from the bailout boys of the Bush administration.
The Fed's loan authority may be enough to keep Fannie and Freddie afloat for the near term. But that would likely be at the expense of more socializing risk while privatizing rewards for wealthy people.
The Treasury Department's plan is aimed at working with Fannie and Freddie as they now exist. That seems more expedient than sensible. Fannie and Freddie's financial conditions remain unclear years after accounting scandals left them unable for a number of quarters to report their financial condition. They've also sent hundreds of billions of dollars worth (or more) of mortgages into special purpose entities, investment vehicles that for accounting purposes are supposed to be separate from Fannie and Freddie. But these vehicles are cousins of the SIVs and conduits that bedeviled banks, and which some banks eventually had to bring onto their balance sheets at great cost. Will Fannie and Freddie have to take on some undisclosed liabilities from these special purpose entities? If so, how many billions are we talking about?
The truth is that Fannie and Freddie are pigs in a poke. The taxpayers shouldn't have to bail them out or prop them up any more than absolutely necessary to prevent a collapse of the financial system. But Fannie's and Freddie's shareholders should have to take their lumps (taxpayers shouldn't protect the value of private equity investments). And Fannie's and Freddie's creditors should have to assume the credit risk that can fairly be laid on them for lending to such severely undercapitalized and mismanaged institutions. In other words, they should take their fair share of losses.
The people who really deserve a bailout here are America's future homeowners, the ones that Fannie and Freddie are supposed to be helping. If they have to borrow through mortgages bought by Fannie or Freddie, the interest rate they'd pay would be elevated because creditors would demand greater returns on account of Fannie's and Freddie's past miscalculations, shenanigans and mismanagement. Why should a young family, starting out, in Indiana, Mississippi or Oregon, have to pay higher interest rates because Fannie or Freddie messed up?
The best thing for the future would be a new mortgage agency, one that starts with a clean slate: new management, prudential lending standards, clean accounting process, no undisclosed liabilities from special purpose entities overhanging the picture, and no loss of credibility with investors. Fannie and Freddie have botched things up badly, and in a free enterprise system, those who botch things up should pay the price. Of course, this proposal is just a pipe dream. If anyone in Congress or the administration actually seriously pushed this idea, Fannie and Freddie would roll out their lobbying juggernauts and quash any attempt to give taxpayers and new homeowners a square deal. After all, in Washington, insiders always win.
These proposals look like more rubber bands and chewing gum. The Treasury Department plan is just a proposal. Treasury currently has no authority to do anything except lend Fannie and Freddie $2.25 billion, which may be enough to keep them going for a day or two. The Fed's loan authorization is a tad misleading. It says that the loans will be collateralized by "U.S. government and federal agency securities." How much in the way of U.S. Treasury bills and notes do we think Fannie and Freddie hold? Not much, we'd guess. But if Fannie and Freddie submit agency securities as collateral to the Fed, those securities could be obligations of Fannie and Freddie (which are among the biggest issuers of agency securities). In other words, such collateral would be impaired in value, just like Fannie and Freddie. That's a great deal for Fannie and Freddie, but the taxpayers may be getting yet another stick in the eye from the bailout boys of the Bush administration.
The Fed's loan authority may be enough to keep Fannie and Freddie afloat for the near term. But that would likely be at the expense of more socializing risk while privatizing rewards for wealthy people.
The Treasury Department's plan is aimed at working with Fannie and Freddie as they now exist. That seems more expedient than sensible. Fannie and Freddie's financial conditions remain unclear years after accounting scandals left them unable for a number of quarters to report their financial condition. They've also sent hundreds of billions of dollars worth (or more) of mortgages into special purpose entities, investment vehicles that for accounting purposes are supposed to be separate from Fannie and Freddie. But these vehicles are cousins of the SIVs and conduits that bedeviled banks, and which some banks eventually had to bring onto their balance sheets at great cost. Will Fannie and Freddie have to take on some undisclosed liabilities from these special purpose entities? If so, how many billions are we talking about?
The truth is that Fannie and Freddie are pigs in a poke. The taxpayers shouldn't have to bail them out or prop them up any more than absolutely necessary to prevent a collapse of the financial system. But Fannie's and Freddie's shareholders should have to take their lumps (taxpayers shouldn't protect the value of private equity investments). And Fannie's and Freddie's creditors should have to assume the credit risk that can fairly be laid on them for lending to such severely undercapitalized and mismanaged institutions. In other words, they should take their fair share of losses.
The people who really deserve a bailout here are America's future homeowners, the ones that Fannie and Freddie are supposed to be helping. If they have to borrow through mortgages bought by Fannie or Freddie, the interest rate they'd pay would be elevated because creditors would demand greater returns on account of Fannie's and Freddie's past miscalculations, shenanigans and mismanagement. Why should a young family, starting out, in Indiana, Mississippi or Oregon, have to pay higher interest rates because Fannie or Freddie messed up?
The best thing for the future would be a new mortgage agency, one that starts with a clean slate: new management, prudential lending standards, clean accounting process, no undisclosed liabilities from special purpose entities overhanging the picture, and no loss of credibility with investors. Fannie and Freddie have botched things up badly, and in a free enterprise system, those who botch things up should pay the price. Of course, this proposal is just a pipe dream. If anyone in Congress or the administration actually seriously pushed this idea, Fannie and Freddie would roll out their lobbying juggernauts and quash any attempt to give taxpayers and new homeowners a square deal. After all, in Washington, insiders always win.
Thursday, July 10, 2008
Financial Mistakes That Are Okay in Down Times
Almost all asset classes are stagnant or falling in value. Even oil is treading water. There don't seem to be any good investments. It's easy to step back from saving and investing when you think you'll lose money tomorrow, next week, next month and even next year. Add growing inflation to the equation and the mentality of the 1970s could set in, when it seemed smarter to spend immediately on consumer durables like cars, TVs, washing machines, air conditioners and so on because the price would only be higher in the future. Conventional investment wisdom teaches that you should continue to invest on a disciplined basis, dollar cost averaging as markets sink and thereby lowering your overall investment costs. But when investing in stocks feels like choking down fried liver and stewed beets, this is more easily said than done.
The worst financial planning mistake of all is to stop saving. If you don't save, you won't have much of a financial future. Life on only Social Security is dreary at best, especially after you run out of ketchup to put on the dog food you bought on sale. Unless you're laid off, the one thing you should always do is keep saving. If you're having trouble stepping up to the plate and buying more assets likely to sink in value, feel free to make a few investing "mistakes." These are things that you shouldn't normally do. But every rule has exceptions.
Keep it in cash. Put your savings in a money market fund, money market account or other short term investment. (See http://blogger.uncleleosden.com/2007/05/investing-for-short-term.html for short term investing ideas.) This insulates you from losses. You also won't get much in the way of returns, and could miss out on market gains. Don't keep the money in cash indefinitely. But if this is what it takes to let you save and sleep at the same time, do it for at least the time being.
Time the market. Ordinarily, investment gurus frown on market timing. It's impossible for almost all people to identify market trends accurately. If you feel better about saving with the idea that you'll keep your money in cash until the market appears to hit a bottom or turning point, give it a try. Your chances of success at market timing aren't high, but at least you're still saving.
Build up cash instead of paying down high interest rate debt. If your cash reserves are low or nonexistent, it makes sense to build them up in these times of recession. You don't know when you might be laid off, or your bonus cut. Cash is king when times are tough, because these are the times you won't be able to get a loan when you need it the most. Even if you have to maintain some high interest rate debt, building up a cash reserve of three to six months living expenses (including minimum payments on your debt) is a good idea.
Borrow, if you must, from your 401(k) account. Normally, borrowing from a retirement account is a big no-no. But if your back is to the wall, and you're permitted by your 401(k) plan to borrow from your account, it's a better loan than borrowing from a credit card at a very high interest rate and very possibly easier than wrangling with a bank over your rapidly evaporating home equity line of credit (which nowadays banks are yanking left and right with little notice). You'll lose investment gains on the borrowed amount while the loan is outstanding. But at least those funds will eventually return to the role of funding your retirement. If you withdraw them from your 401(k) account, you'll pay taxes, and a 10% penalty if you're less than 59 and 1/2 years old, and lose the potential investment gains on the money forever.
If you make these "mistakes," return to a habit of steady saving and investing as soon as possible. That's how to build wealth over the long term. Don't chase returns by investing in the latest "hot" investment. You'll end up being a sucker for every asset bubble just before it bursts. And don't give up on building wealth. This is one aspect of life where it's abundantly true that quitters aren't winners.
The worst financial planning mistake of all is to stop saving. If you don't save, you won't have much of a financial future. Life on only Social Security is dreary at best, especially after you run out of ketchup to put on the dog food you bought on sale. Unless you're laid off, the one thing you should always do is keep saving. If you're having trouble stepping up to the plate and buying more assets likely to sink in value, feel free to make a few investing "mistakes." These are things that you shouldn't normally do. But every rule has exceptions.
Keep it in cash. Put your savings in a money market fund, money market account or other short term investment. (See http://blogger.uncleleosden.com/2007/05/investing-for-short-term.html for short term investing ideas.) This insulates you from losses. You also won't get much in the way of returns, and could miss out on market gains. Don't keep the money in cash indefinitely. But if this is what it takes to let you save and sleep at the same time, do it for at least the time being.
Time the market. Ordinarily, investment gurus frown on market timing. It's impossible for almost all people to identify market trends accurately. If you feel better about saving with the idea that you'll keep your money in cash until the market appears to hit a bottom or turning point, give it a try. Your chances of success at market timing aren't high, but at least you're still saving.
Build up cash instead of paying down high interest rate debt. If your cash reserves are low or nonexistent, it makes sense to build them up in these times of recession. You don't know when you might be laid off, or your bonus cut. Cash is king when times are tough, because these are the times you won't be able to get a loan when you need it the most. Even if you have to maintain some high interest rate debt, building up a cash reserve of three to six months living expenses (including minimum payments on your debt) is a good idea.
Borrow, if you must, from your 401(k) account. Normally, borrowing from a retirement account is a big no-no. But if your back is to the wall, and you're permitted by your 401(k) plan to borrow from your account, it's a better loan than borrowing from a credit card at a very high interest rate and very possibly easier than wrangling with a bank over your rapidly evaporating home equity line of credit (which nowadays banks are yanking left and right with little notice). You'll lose investment gains on the borrowed amount while the loan is outstanding. But at least those funds will eventually return to the role of funding your retirement. If you withdraw them from your 401(k) account, you'll pay taxes, and a 10% penalty if you're less than 59 and 1/2 years old, and lose the potential investment gains on the money forever.
If you make these "mistakes," return to a habit of steady saving and investing as soon as possible. That's how to build wealth over the long term. Don't chase returns by investing in the latest "hot" investment. You'll end up being a sucker for every asset bubble just before it bursts. And don't give up on building wealth. This is one aspect of life where it's abundantly true that quitters aren't winners.
Tuesday, July 1, 2008
Mortgage Payment Resets Peak
Old MacDonald had an ARM.
The payments started low.
Then the payments took a jump,
And caused a lot of woe.
With a jump, jump here.
And a jump, jump there.
Here a jump, there a jump,
Everywhere a jump, jump.
Old MacDonald lost his farm.
Now he is quite po’.
Monthly payments on hundreds of thousands of subprime loans are resetting to higher levels now. We're close to the peak level of resets. Over the next six months, we'll see the impact of the resets on foreclosure rates. With the economy slowing, real estate prices dropping, gas and food prices absorbing more and more of household budgets, and interest rates trending upwards, the prognosis is for more defaults and foreclosures. If that happens, real estate values will drop even more, making even more foreclosures probable. And to make things worse, large numbers of option ARMs will begin to require amortization of the principal of the loans, which will mean more payment increases.
All this, because lenders made two fundamental errors. First, they forgot that loans should be made on the basis of the borrower's ability to repay, not on the value of the collateral. Back in the bad old days when lenders were prudent, this was a serious no-no. Second, many subprime and option ARM loans were made on the assumption that the collateral--real estate--would always increase in value, allowing a troubled borrower to refinance or sell in the case of default. That they were wrong is now obvious. The downturn in real estate values illustrates why a lender should never make a loan based on the value of the collateral.
Lenders now face increased regulation. And rightly so. If they lend or invest customers' money in such a disastrous way, a few stern regulatory frowns are in order.
Perhaps more disturbing is all the talk of propping up and reviving the real estate market with public money. In particular, talk inside and outside the Fed about the economy not recovering unless taxpayer funds are provided only makes the government an enabler of all the bad things that mortgage lenders did. You can't build an economy by pumping up asset values. The wealth of nations is derived from production, not asset speculation. Japan, Korea, China and India became players in the world economy through manufacturing, not by pumping up their real estate values. Indeed, when Japan did do that, it got burned in the crash that began in 1989 and didn't end until recently.
There's a fin de siecle feeling in the air. A few people are getting astoundingly wealthy, often through asset speculation. Disparities between the wealthy and everyone else grow. The government resorts to expediency at every turn to maintain social equanimity--we don't just mean subsidies for real estate, but also agricultural price supports, federally subsidized flood plain insurance, and the like. The United States deploys a volunteer military to fight an unpopular war in a distant place (a hundred years ago, it was the Phillipines; today it's Southwest Asia). An unexpected fire from the prairies has produced a presumptive Democratic presidential nominee who is the first African-American to receive such an honor.
A century ago, America lived through unrest of the Gilded Age and the Progressive Era, and emerged the strongest nation in the world, one that put an end to the enormously destructive European war called World War I and World War II (which really were one war). But America then was a manufacturing nation, which furnished the resources to quell the fighting in Europe. Today, with its asset-based economy and gargantuan foreign debt, America is in a much more precarious position. So as mortgage resets further batter our economy, we should consider that we didn't get here simply because some lenders allowed their standards to slip. We got here because we want to have things without working for them. And that's not a prescription for prosperity.
The payments started low.
Then the payments took a jump,
And caused a lot of woe.
With a jump, jump here.
And a jump, jump there.
Here a jump, there a jump,
Everywhere a jump, jump.
Old MacDonald lost his farm.
Now he is quite po’.
Monthly payments on hundreds of thousands of subprime loans are resetting to higher levels now. We're close to the peak level of resets. Over the next six months, we'll see the impact of the resets on foreclosure rates. With the economy slowing, real estate prices dropping, gas and food prices absorbing more and more of household budgets, and interest rates trending upwards, the prognosis is for more defaults and foreclosures. If that happens, real estate values will drop even more, making even more foreclosures probable. And to make things worse, large numbers of option ARMs will begin to require amortization of the principal of the loans, which will mean more payment increases.
All this, because lenders made two fundamental errors. First, they forgot that loans should be made on the basis of the borrower's ability to repay, not on the value of the collateral. Back in the bad old days when lenders were prudent, this was a serious no-no. Second, many subprime and option ARM loans were made on the assumption that the collateral--real estate--would always increase in value, allowing a troubled borrower to refinance or sell in the case of default. That they were wrong is now obvious. The downturn in real estate values illustrates why a lender should never make a loan based on the value of the collateral.
Lenders now face increased regulation. And rightly so. If they lend or invest customers' money in such a disastrous way, a few stern regulatory frowns are in order.
Perhaps more disturbing is all the talk of propping up and reviving the real estate market with public money. In particular, talk inside and outside the Fed about the economy not recovering unless taxpayer funds are provided only makes the government an enabler of all the bad things that mortgage lenders did. You can't build an economy by pumping up asset values. The wealth of nations is derived from production, not asset speculation. Japan, Korea, China and India became players in the world economy through manufacturing, not by pumping up their real estate values. Indeed, when Japan did do that, it got burned in the crash that began in 1989 and didn't end until recently.
There's a fin de siecle feeling in the air. A few people are getting astoundingly wealthy, often through asset speculation. Disparities between the wealthy and everyone else grow. The government resorts to expediency at every turn to maintain social equanimity--we don't just mean subsidies for real estate, but also agricultural price supports, federally subsidized flood plain insurance, and the like. The United States deploys a volunteer military to fight an unpopular war in a distant place (a hundred years ago, it was the Phillipines; today it's Southwest Asia). An unexpected fire from the prairies has produced a presumptive Democratic presidential nominee who is the first African-American to receive such an honor.
A century ago, America lived through unrest of the Gilded Age and the Progressive Era, and emerged the strongest nation in the world, one that put an end to the enormously destructive European war called World War I and World War II (which really were one war). But America then was a manufacturing nation, which furnished the resources to quell the fighting in Europe. Today, with its asset-based economy and gargantuan foreign debt, America is in a much more precarious position. So as mortgage resets further batter our economy, we should consider that we didn't get here simply because some lenders allowed their standards to slip. We got here because we want to have things without working for them. And that's not a prescription for prosperity.
Sunday, June 29, 2008
Tax Rebates Pump Up the Gross National Debt
Late last week, the Department of Commerce reported that personal income before taxes had grown 1.9% in May 2008, compared to April 2008. After taxes, personal income grew 5.7%. By contrast, in the preceding month, April 2008, personal income grew 0.3% before taxes and 0.4% after taxes. May looks good, no?
No. Most of the May increase was attributable to tax rebate payments from the IRS. Without these stimulus payments, personal income after taxes would have grown only 0.4% in May. That is to say, 5.3% of the May increase in after tax income was due to the government's stimulus payments.
Let's consider where the money for the rebates came from. The federal government is running a budget deficit to the tune of hundreds of billions. It didn't have any excess cash lying around in its vaults. If the government was already running a deficit and then sent out some $50 billion in rebates in April and May 2008, the only way it could have gotten the money was to borrow more.
But is there any public accounting for the borrowings? They'll show up eventually in government statistics about the federal debt and budget deficit. However, the personal income "increase" they created isn't really a net increase in income or wealth. It is simply a transfer of wealth from the future to the present.
This is no different than an individual who takes out a loan to get money for current use. The loan proceeds aren't really income. They are simply a frontloading of wealth from the future to the present. The borrower's future well-being will be diminished by the burdens of debt service and repayment. The future well-being of the United States will be similarly diminished.
The stimulus payments will only modestly increase the trillions of dollars of debt now carried by the federal government, and the additional interest expense might also seem relatively minor. But as the demographic composition of America changes, with fewer workers and more retirees, the impact of additional federal debt on taxpayers will be magnified. And if there are more stimulus payments, as some politicians are calling for, the impact on the federal debt will grow.
We're getting a misleading picture of the stimulus payments. They don't really increase personal incomes except in an immediate and misleading sense. Taxpayers, including the taxpayers receiving the payments, and/or their children, will bear the burden of repaying the debt taken on to fund the payments.
Government stimulus programs generally don't work. They were attempted in the 1930s, the 1970s, and the early 2000s, and had little lasting impact. The only stimulus program that truly revived the economy was World War II, when the federal government's budget--funded with war bonds and other borrowings--amounted to 50% of the economy. But war isn't an option today for economic policy. And the current stimulus program will have trivial impact, at best.
The stimulus payments reflect a belief that more debt will solve our problems. But that's how we got into trouble in the first place. People came to believe that credit was the way to attain a nice lifestyle. The fussy, old-fashioned notion of earning and saving went the way of the Model T. Income was simply a metric used to measure how much credit you could get. Credit became wealth. Buying a house with no money down was the smart play because you wouldn't have to save a penny and could spend your money on other things. Look how well we're doing now.
It would be nice if the government would set an example and stop treating credit as wealth. Policies designed to bolster manufacturing--the true foundation of national wealth--should be favored. Today, bread and circuses are the policies of choice in Washington. However, we should bear in mind how much good they did for the Roman Empire.
No. Most of the May increase was attributable to tax rebate payments from the IRS. Without these stimulus payments, personal income after taxes would have grown only 0.4% in May. That is to say, 5.3% of the May increase in after tax income was due to the government's stimulus payments.
Let's consider where the money for the rebates came from. The federal government is running a budget deficit to the tune of hundreds of billions. It didn't have any excess cash lying around in its vaults. If the government was already running a deficit and then sent out some $50 billion in rebates in April and May 2008, the only way it could have gotten the money was to borrow more.
But is there any public accounting for the borrowings? They'll show up eventually in government statistics about the federal debt and budget deficit. However, the personal income "increase" they created isn't really a net increase in income or wealth. It is simply a transfer of wealth from the future to the present.
This is no different than an individual who takes out a loan to get money for current use. The loan proceeds aren't really income. They are simply a frontloading of wealth from the future to the present. The borrower's future well-being will be diminished by the burdens of debt service and repayment. The future well-being of the United States will be similarly diminished.
The stimulus payments will only modestly increase the trillions of dollars of debt now carried by the federal government, and the additional interest expense might also seem relatively minor. But as the demographic composition of America changes, with fewer workers and more retirees, the impact of additional federal debt on taxpayers will be magnified. And if there are more stimulus payments, as some politicians are calling for, the impact on the federal debt will grow.
We're getting a misleading picture of the stimulus payments. They don't really increase personal incomes except in an immediate and misleading sense. Taxpayers, including the taxpayers receiving the payments, and/or their children, will bear the burden of repaying the debt taken on to fund the payments.
Government stimulus programs generally don't work. They were attempted in the 1930s, the 1970s, and the early 2000s, and had little lasting impact. The only stimulus program that truly revived the economy was World War II, when the federal government's budget--funded with war bonds and other borrowings--amounted to 50% of the economy. But war isn't an option today for economic policy. And the current stimulus program will have trivial impact, at best.
The stimulus payments reflect a belief that more debt will solve our problems. But that's how we got into trouble in the first place. People came to believe that credit was the way to attain a nice lifestyle. The fussy, old-fashioned notion of earning and saving went the way of the Model T. Income was simply a metric used to measure how much credit you could get. Credit became wealth. Buying a house with no money down was the smart play because you wouldn't have to save a penny and could spend your money on other things. Look how well we're doing now.
It would be nice if the government would set an example and stop treating credit as wealth. Policies designed to bolster manufacturing--the true foundation of national wealth--should be favored. Today, bread and circuses are the policies of choice in Washington. However, we should bear in mind how much good they did for the Roman Empire.
Thursday, June 26, 2008
Greed Kills Financial Plans
Today, the Dow Jones Industrial Average fell 358 points, and, at 18.5% below its all time high, is close to bear market territory (defined as a 20% drop). Bonds haven't done well, either, as rising inflation and credit concerns (in the case of corporate bonds) have taken their toll. Foreign stock markets have been dropping, most notably the Indian and Chinese markets that popped so aggressively last year. It seems like almost all standard investments are dogs. What's an investor to do?
Commodities like gold and silver beckon, while oil sings its siren song. But commodities have been on a long boom, and we now know from lessons administered by the real estate market that no boom goes on forever. Over the next 30 years, oil prices will surely rise. But over the next 2 or 3 years, they could fall. Gold and silver are default investments, where people go when nothing else seems attractive. They have limited underlying value, and, as long term investments, haven't kept pace with inflation over the decades. Beware the glitter of precious metals.
Now is the season for snake oil salesmen. They emerge from dark places to tell you what you want to hear. You'll be offered disarmingly simple investments in prime bank notes. Or you'll have the opportunity to invest in technology that turns coal into natural gas, or perhaps sure-fire leases in Latin American real estate.
Maybe you're knowledgeable enough to avoid ostrich farm-type investment opportunties. But can you resist money market-like investments that pay more than money market funds but are said to be as safe? (Many thousands bought into auction rate securities, and have found their money frozen.) How about investments that are guaranteed not to lose money, and may rise if the stock market rises? (Some variable annuities offer these features, only with very steep fees and nasty early redemption charges that may well push the upside below stock market averages.) Did you invest in the stock of banks, brokerage firms and other financial services companies, which did quite well as long as the real estate market kept rising?
What we now see in the financial markets is the risk part of risk and reward. The two go hand in hand. You can't turn a profit all the time, except by accepting the low returns of bank CDs, money market funds and U.S. Treasury securities. Avoid stretching for yield when the investment stretches credulity. Ride out the current downturn. Invest for the long term and you're likely to be rewarded. Be shortsighted, and suffer the consequences. Greed kills financial plans. See http://www.uncleleosden.com/Step6aGreed.html.
Commodities like gold and silver beckon, while oil sings its siren song. But commodities have been on a long boom, and we now know from lessons administered by the real estate market that no boom goes on forever. Over the next 30 years, oil prices will surely rise. But over the next 2 or 3 years, they could fall. Gold and silver are default investments, where people go when nothing else seems attractive. They have limited underlying value, and, as long term investments, haven't kept pace with inflation over the decades. Beware the glitter of precious metals.
Now is the season for snake oil salesmen. They emerge from dark places to tell you what you want to hear. You'll be offered disarmingly simple investments in prime bank notes. Or you'll have the opportunity to invest in technology that turns coal into natural gas, or perhaps sure-fire leases in Latin American real estate.
Maybe you're knowledgeable enough to avoid ostrich farm-type investment opportunties. But can you resist money market-like investments that pay more than money market funds but are said to be as safe? (Many thousands bought into auction rate securities, and have found their money frozen.) How about investments that are guaranteed not to lose money, and may rise if the stock market rises? (Some variable annuities offer these features, only with very steep fees and nasty early redemption charges that may well push the upside below stock market averages.) Did you invest in the stock of banks, brokerage firms and other financial services companies, which did quite well as long as the real estate market kept rising?
What we now see in the financial markets is the risk part of risk and reward. The two go hand in hand. You can't turn a profit all the time, except by accepting the low returns of bank CDs, money market funds and U.S. Treasury securities. Avoid stretching for yield when the investment stretches credulity. Ride out the current downturn. Invest for the long term and you're likely to be rewarded. Be shortsighted, and suffer the consequences. Greed kills financial plans. See http://www.uncleleosden.com/Step6aGreed.html.
Tuesday, June 24, 2008
Profiting from Stagflation
In these stagflationary times, it’s hard to know how to invest. Almost all asset classes seem to be falling in value. The assets that aren’t—like oil—are volatile and probably caught up in a bubble. You know how things go--invest in a bubble and it will burst two days later. There are ways, however, to profit from stagflation.
First, develop good financial habits. Save more. This will help your portfolio grow even if its returns are tepid. Instead of saving 2% or 3% of your income, make it 5%, or 10%. Better yet, make it 15% or 20% and pretty much guarantee that your standard of living won't fall in retirement. (For an explanation of why this is so, see http://blogger.uncleleosden.com/2007/04/goals-for-retirement-saving-and-why.html.) Invest in a diversified way. Form the right financial habits and you’ll profit for the rest of your life.
Take up a cause close to your heart. There's more to life than fretting over your retirement portfolio as it meanders. Volunteer. Advocate. Help the disadvantaged. Work on something larger than yourself and you'll have good memories for the rest of your life.
If you’re laid off and have a lot of time on your hands, use your wealth of time. Read books you always intended to read. There’s the public library if you don’t want to buy them. Rent DVDs of classic movies you’ve always wanted to see. Start playing the piano again. The instrument you inherited from your parents could sing once again. Spend more time with your loved ones. Use the time fruitfully and you'll profit even if you're not being paid.
When confronted with adversity, look for opportunity. By all accounts, the economy will be dreary for a while, and inflation will probably get nastier. Opportunities to profit financially will diminish. But other profit opportunities will come up; keep them in mind.
First, develop good financial habits. Save more. This will help your portfolio grow even if its returns are tepid. Instead of saving 2% or 3% of your income, make it 5%, or 10%. Better yet, make it 15% or 20% and pretty much guarantee that your standard of living won't fall in retirement. (For an explanation of why this is so, see http://blogger.uncleleosden.com/2007/04/goals-for-retirement-saving-and-why.html.) Invest in a diversified way. Form the right financial habits and you’ll profit for the rest of your life.
Take up a cause close to your heart. There's more to life than fretting over your retirement portfolio as it meanders. Volunteer. Advocate. Help the disadvantaged. Work on something larger than yourself and you'll have good memories for the rest of your life.
If you’re laid off and have a lot of time on your hands, use your wealth of time. Read books you always intended to read. There’s the public library if you don’t want to buy them. Rent DVDs of classic movies you’ve always wanted to see. Start playing the piano again. The instrument you inherited from your parents could sing once again. Spend more time with your loved ones. Use the time fruitfully and you'll profit even if you're not being paid.
When confronted with adversity, look for opportunity. By all accounts, the economy will be dreary for a while, and inflation will probably get nastier. Opportunities to profit financially will diminish. But other profit opportunities will come up; keep them in mind.
Sunday, June 22, 2008
If You're Concerned About the Price of Oil, Watch Israel and the U.S. Fifth Fleet
Israel, it's just been reported, recently conducted a military exercise that appeared to simulate an aerial attack on Iranian nuclear facilities. Two years ago, Israel fought a war in Lebanon against Iran's proxies, Hezbollah. Things didn't go well for Israel, to a large degree because Israeli intelligence severely underestimated Hezbollah's military capabilities. No doubt Israel now takes Iran very seriously, just as Iran takes Israel very seriously. The exercise could be the prelude to the real thing. This is all the more likely because the hawkish, but soon to be concluded George W. Bush presidency may offer the Israelis a degree of support that future presidents, chastened by the failure of the Iraq War, would not provide.
The Iranians will probably have trouble stopping an Israeli air raid. Israel's capability for long distance air attacks is legendary. Iran's air force is a mulligan stew of miscellaneous aircraft, some pretty modern but most out of date and lacking in spare parts. Many of them are not in operational condition. Iran's air defense system is of uncertain quality, with an apparently disappointing performance in the Iran-Iraq War during the early 1980s.
But the Iranians appear to subscribe to the notion that the best defense is a good offense, and have a good understanding of asymmetric warfare. Iran has built up its ballistic missile force, and is modernizing its navy with submarines, frigates and other ships that can deliver missiles. Missiles are hard to stop. Israel found this out in its 2006 war with Hezbollah, during which Hezbollah missiles bombarded Israeli cities that no enemy airplanes could possibly approach.
Iran likely hopes to prevent an Israeli attack through a policy of modified mutual assured destruction. If Israel bombs Iranian nuclear facilities, Iran likely will do everything it can to stop the flow of oil to the industrialized world. With its arsenal of missiles, Iran would surely bombard Saudi Arabia, Kuwait and other Persian Gulf oil producers. Since the most productive oil fields in the world are in eastern Saudi Arabia, an easy ballistic missile shot from Iran, Iran's ability to disrupt the world's oil markets is plain to see.
While the Saudis, Kuwaitis and other Persian Gulf nations have modern military aircraft, courtesy of the United States, F-15s aren't designed to stop barrages of hundreds or thousands of missiles. Indeed, they might need reinforced concrete bunkers as protection against such attacks. And even if the Saudis and Kuwaitis have Patriot missile defense systems, those systems won't defend oil tankers trying to pass through the Persian Gulf from Exocet or other cruise missiles.
All of which is a long way of saying that if Israel attacks Iran, the U.S. will have to get involved, like it or not. The best way to stop Iranian retaliation against oil producing nations would be air attacks by U.S. forces against Iran's missile forces. The Israelis don't have the capability to launch the massive attacks needed against Iran's missiles. Only the United States, with its vast surveillance and reconnaissance capabilities, and its enormous array of cruise missiles, piloted aircraft, drone aircraft and smart weapons, could have any hope of containing Iran's missiles.
The U.S. Fifth Fleet, which is assigned to the Persian Gulf region, would play a crucial role. While the U.S. already has air forces involved in the Iraq War, those forces likely aren't enough to fight on the Iranian front as well as the Iraqi front. The Fifth Fleet, beefed up with more than its usual complement of carriers, would have to be brought to bear.
Thus, the movements of the Fifth Fleet and Israel's pronouncements about Iran bear watching. If there's a scenario for $200 a barrel oil in the next six months, this is it. After that, a new President will reside in the White House, no doubt putting a restraining hand on Israel's air force. It's possible that the Bush administration's turn in the last couple of years toward diplomacy in the Middle East will bear fruit. By all accounts, few Iranians want war with America, and even fewer Americans want war with Iran. But if we had control over events, oil wouldn't now be trading at $135 a barrel.
The Iranians will probably have trouble stopping an Israeli air raid. Israel's capability for long distance air attacks is legendary. Iran's air force is a mulligan stew of miscellaneous aircraft, some pretty modern but most out of date and lacking in spare parts. Many of them are not in operational condition. Iran's air defense system is of uncertain quality, with an apparently disappointing performance in the Iran-Iraq War during the early 1980s.
But the Iranians appear to subscribe to the notion that the best defense is a good offense, and have a good understanding of asymmetric warfare. Iran has built up its ballistic missile force, and is modernizing its navy with submarines, frigates and other ships that can deliver missiles. Missiles are hard to stop. Israel found this out in its 2006 war with Hezbollah, during which Hezbollah missiles bombarded Israeli cities that no enemy airplanes could possibly approach.
Iran likely hopes to prevent an Israeli attack through a policy of modified mutual assured destruction. If Israel bombs Iranian nuclear facilities, Iran likely will do everything it can to stop the flow of oil to the industrialized world. With its arsenal of missiles, Iran would surely bombard Saudi Arabia, Kuwait and other Persian Gulf oil producers. Since the most productive oil fields in the world are in eastern Saudi Arabia, an easy ballistic missile shot from Iran, Iran's ability to disrupt the world's oil markets is plain to see.
While the Saudis, Kuwaitis and other Persian Gulf nations have modern military aircraft, courtesy of the United States, F-15s aren't designed to stop barrages of hundreds or thousands of missiles. Indeed, they might need reinforced concrete bunkers as protection against such attacks. And even if the Saudis and Kuwaitis have Patriot missile defense systems, those systems won't defend oil tankers trying to pass through the Persian Gulf from Exocet or other cruise missiles.
All of which is a long way of saying that if Israel attacks Iran, the U.S. will have to get involved, like it or not. The best way to stop Iranian retaliation against oil producing nations would be air attacks by U.S. forces against Iran's missile forces. The Israelis don't have the capability to launch the massive attacks needed against Iran's missiles. Only the United States, with its vast surveillance and reconnaissance capabilities, and its enormous array of cruise missiles, piloted aircraft, drone aircraft and smart weapons, could have any hope of containing Iran's missiles.
The U.S. Fifth Fleet, which is assigned to the Persian Gulf region, would play a crucial role. While the U.S. already has air forces involved in the Iraq War, those forces likely aren't enough to fight on the Iranian front as well as the Iraqi front. The Fifth Fleet, beefed up with more than its usual complement of carriers, would have to be brought to bear.
Thus, the movements of the Fifth Fleet and Israel's pronouncements about Iran bear watching. If there's a scenario for $200 a barrel oil in the next six months, this is it. After that, a new President will reside in the White House, no doubt putting a restraining hand on Israel's air force. It's possible that the Bush administration's turn in the last couple of years toward diplomacy in the Middle East will bear fruit. By all accounts, few Iranians want war with America, and even fewer Americans want war with Iran. But if we had control over events, oil wouldn't now be trading at $135 a barrel.
Thursday, June 19, 2008
Is Credit Default Indigestion Coming?
Even as the summer solstice approaches, shadows are lengthening in the credit derivatives market. Credit derivatives are contracts that are akin to default insurance for bonds and other indebtedness. Holders of debt buy credit derivatives (usually in the form of credit default swaps) from counterparties willing to take the risk of a default. If the debtor defaults, the holder of the debt then turns to the counterparty to cover losses. The notional amount of credit derivatives more than doubled from $17.1 trillion as of Dec. 31, 2005 to $34.4 trillion as of Dec. 31, 2006, and then almost doubled again to $62.2 trillion as of Dec. 31, 2007. With the economy slowing and the credit crunch persisting, it would be fair to think that this trend has continued in 2008.
Notional amount is similar to the face amount of the debt, and is not necessarily or even likely to be a measure of the potential loss. But, with the economic downturn, continued housing market problems, persistent credit crunch, escalating energy prices and general economic malaise, it's easy to contemplate the possibility of hundreds of billions of dollars of losses and maybe more. The rapid growth of this market--at a rate of 100% a year--tells us that holders of debt certainly perceive the potential for lots of defaults, or they wouldn't have paid for credit derivative protection.
Regulators and the financial services industry are moving to make the credit derivatives market more transparent and to strengthen its clearing processes by creating a central clearing facility that would ensure contracts are paid. These are steps in the right direction. But what about the large and rapidly increasing quantity of credit derivatives that today are still traded in the old-fashioned over-the-counter manner? These contracts are often done over the phone, and then are followed up with written confirmation. The paperwork has sometimes lagged behind the trades, and the only significant assurance that a counterparty would fulfill the contract in the event of default is the counterparty's word. If the counterparty stiffs you, you'd have to go to court and ask a judge to give the matter some thought.
Only the larger financial services companies and firms can play in the credit derivatives sandbox. The amounts of debt involved are so great that only well-capitalized companies can credibly serve as counterparties. One must wonder whether these firms have enough wherewithal to cover the liabilities that will arise, because there surely will be liabilities. If there are widespread defaults on credit derivatives, the financial storm that would follow would make last summer's mortgage crisis and credit crunch will feel like a gentle summer breeze.
The regulators hopefully are looking into the risks of the credit default market. They should be finding out who's got how much exposure to whom, and when it might materialize. Then, they should take steps to shore up weak points and have a game plan for dealing with the fallout of a flurry of defaults. Last spring, there were warning signals that the mortgage crisis was coming. Nevertheless, the regulators were, to be generous, caught absolutely flatfooted. A year later, they've managed to arrest a couple of former mid-level Bear Stearns executives. But wouldn't it have been much better if they had acted to prevent some of the bad things from happening? Would it do much good if, a year from now, a couple of mid-level credit derivatives executives are arrested?
Notional amount is similar to the face amount of the debt, and is not necessarily or even likely to be a measure of the potential loss. But, with the economic downturn, continued housing market problems, persistent credit crunch, escalating energy prices and general economic malaise, it's easy to contemplate the possibility of hundreds of billions of dollars of losses and maybe more. The rapid growth of this market--at a rate of 100% a year--tells us that holders of debt certainly perceive the potential for lots of defaults, or they wouldn't have paid for credit derivative protection.
Regulators and the financial services industry are moving to make the credit derivatives market more transparent and to strengthen its clearing processes by creating a central clearing facility that would ensure contracts are paid. These are steps in the right direction. But what about the large and rapidly increasing quantity of credit derivatives that today are still traded in the old-fashioned over-the-counter manner? These contracts are often done over the phone, and then are followed up with written confirmation. The paperwork has sometimes lagged behind the trades, and the only significant assurance that a counterparty would fulfill the contract in the event of default is the counterparty's word. If the counterparty stiffs you, you'd have to go to court and ask a judge to give the matter some thought.
Only the larger financial services companies and firms can play in the credit derivatives sandbox. The amounts of debt involved are so great that only well-capitalized companies can credibly serve as counterparties. One must wonder whether these firms have enough wherewithal to cover the liabilities that will arise, because there surely will be liabilities. If there are widespread defaults on credit derivatives, the financial storm that would follow would make last summer's mortgage crisis and credit crunch will feel like a gentle summer breeze.
The regulators hopefully are looking into the risks of the credit default market. They should be finding out who's got how much exposure to whom, and when it might materialize. Then, they should take steps to shore up weak points and have a game plan for dealing with the fallout of a flurry of defaults. Last spring, there were warning signals that the mortgage crisis was coming. Nevertheless, the regulators were, to be generous, caught absolutely flatfooted. A year later, they've managed to arrest a couple of former mid-level Bear Stearns executives. But wouldn't it have been much better if they had acted to prevent some of the bad things from happening? Would it do much good if, a year from now, a couple of mid-level credit derivatives executives are arrested?
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