After today's 268 point drop in the Dow Jones Industrial Average, it's clear that the sovereign debt crisis has investors rattled. What started late last year as a smallish, but high profile anticipatory default by Dubai last fall, quickly smoothed over with a partial bailout from Abu Dhabi, has morphed into a European problem. Greece seems to be in the worst shape among Euro bloc nations, with credit default swaps for its debt imitating a jack-in-a-box. Portugal, Ireland and Spain increasingly receive unflattering coverage in the financial press. The wealthier Euro bloc nations--Germany, France and the Netherlands--noticeably squirm when the news coverage turns to the question of bailouts. The European Union puts on the appearance of threatening to get a buzzcut and administer tough love. But it's hard to imagine that the EU would actually give Greece the boot. That would almost surely result in Greece defaulting on its sovereign debt, which would escalate the pressure on other weak European nations and turn the crisis into a panic. It would be like letting Lehman Brothers fail, only on an international level. We remember how the Lehman thing turned out.
So a European bailout, however distasteful to French, German and Dutch palates, is likely. The question is what conditions the bailors will impose. The problem is that the European Union prescribes fiscal conditions for membership (i.e., member nations are supposed to limit their governmental budget deficits to 3% of gross domestic product), but doesn't have much control over member nation finances. While the EU can kick out offending members, that's a nuclear remedy that can't feasibly be used in the real world because it would only make things worse. But handing over bailout Euros would reward the profligate nations at the expense of the prudent ones. (Does this sound familiar to American taxpayers?) The German, French and Dutch may refuse to simply write checks.
Europe is facing a dilemma not unlike the newly independent United States in the 1780s. The Revolution had been very expensive, and both the individual states and the Continental Congress incurred substantial debt to pay for the war. At the same time, their ties to each other were far weaker than today, while their differences led to no end of commercial disputes and debates about who should pay the Revolutionary War debt. The infant democracy was in danger of falling apart, and convened a constitutional convention to try to redraft the nation's legal framework. The result, so deeply flawed that it led to a bloody civil war 72 years later, was nevertheless workable enough that today we still limp along with it, in somewhat amended form, in spite of the legislative dysfunction it allows where Senators need to work only when 60 of them are so inclined. But one benefit of the Constitution adopted in 1789 was that the newly reconstituted United States government assumed responsibility for all Revolutionary War debt, whether incurred by the states or the earlier government under the Articles of Confederation. Thus, the price of a national bailout of the states was a far stronger federal government.
Just as the original thirteen American states couldn't afford to splinter apart, with covetous, imperialistic European nations waiting to snatch them up, the European Union cannot afford to splinter apart. This is not so much about the economic benefits of unification--lowering trade barriers and other costs of doing business and thereby spurring production and growth--as it is about the renewed financial crisis a failure of the European Union would create. But to hold the EU together and legitimize the bailout(s) for the electorates in the wealthier member nations, greater authority would probably have to be given to the central government in Brussels, especially over fiscal matters. Getting there would be difficult, just as the drafting and ratification of the U.S. Constitution was difficult. But survival may well depend its success, and necessity is the mother of invention.
If the EU achieves greater fiscal unity as a result of the sovereign debt crisis, its populace can take comfort from the world's recent rediscovery that prudence is a better long term strategy than profligacy. And other big spenders--such as Japan, the U.K., and, of course, the United States--should take notice that lunches aren't free, not even for sovereign nations, even if it takes a while to get the bill.
Thursday, February 4, 2010
Wednesday, February 3, 2010
Will Wall Street Get a Pass on Derivatives Reform?
Both Republicans and Democrats, in the rush to seize the momentum of today's neo-Populism, are buying up the entire denim overalls market and learning to chew straw. But they seem to have lost focus on the derivatives market, the place where the 2007-08 financial crisis began. Had it not been for the big Wall Street firms who created and underwrote vast quantities of mortgage-related derivatives, like CDOs, synthetic CDOs, CDOs squared, and other diverse and sundry bets and side bets on the values of all variety of assets, and their amen choir of money managers and investment advisers who drank avidly of some special lower Manhattan kool-aid before chanting that real estate values would never fall, we wouldn't be where we are today. The Great Recession was caused, first and foremost, by excess on Wall Street in the derivatives market. Profligate borrowing and overspending by consumers, and poor management by the U.S. auto companies and other corporations, were secondary problems that came into play only after the financial system froze up and required a multi-trillion dollar bailout from . . . well, you and me.
The most pressing problem in the derivatives markets is the lack of information. Investors don't know and can't easily learn what they've gotten themselves into. We can say that a thousand times, but let's recall the metaphor that a picture is worth a thousand words. There are very few pictures of the derivatives market, and they would only show a bunch of people in front of computer screens shouting into telephones. Tape recordings, however, fit the metaphor nicely. In financial dealings, what people say is much more important than how they look. As luck would have it, a few tapes of the goings on in the derivatives market have surfaced.
In December 1994, the SEC sued the securities broker-dealer subsidiary of a large bank called Bankers Trust. (In the Matter of BT Securities Corporation, SEC Rel. Nos. 33-7124, 34-35136 (Dec. 22, 1994)). As it happened, BT Securities taped recorded its derivatives sales people, a common practice on Wall Street as a protective measure against customers who try to avoid responsibility for their transactions. Of course, what's sauce for the goose can be sauce for the gander and for regulators, and the SEC got plenty of sauce from the BT Securities' tapes. As presented in the SEC's allegations (which BT Securities neither admitted nor denied), here are some of the tidbits found on the tapes.
BT Securities sold a company called Gibson Greetings (a greetings card company) customized derivatives called interest rate swaps that were meant to reduce Gibson Greetings' borrowing costs. These derivatives didn't trade in a market. Thus, there was no publicly quoted price for Gibson Greetings to compare BT's prices against. BT used computer modeling to determine the value of these derivatives. Gibson Greetings, which had to account for the derivatives on its financial statements, depended on information from BT to establish their values. Some of the derivatives were leveraged, with the result that small interest rate movements could produce large changes in value.
Gibson Greetings didn't fully understand the derivatives it bought--and BT knew it. A managing director at BT was taped saying, "from the very beginning, [Gibson] just, you know, really put themselves in our hands like 96% . . . And we have known that from day one." This managing director also said, "these guys [Gibson] have done some pretty wild stuff. And you know, they probably do not understand it quite as well as they should. I think that they have a pretty good understanding of it, but not perfect. And that's like perfect for us." Thus, Gibson Greetings was at an informational disadvantage, and BT understood that was good for BT.
Many of Gibson Greetings' derivatives positions were losers. Gibson Greetings looked to BT for information about how much it was losing. BT apparently wasn't eager to give its customer bad news and understated the losses by millions of dollars. This lack of candor created a "differential" between Gibson Greetings' actual losses and the rosier picture it received from BT. The informational "differential" only exacerbated the problem. If BT had to unwind the positions, Gibson Greetings would be in for an unpleasant surprise. As a BT managing director put it," . . . the problem is that we are too far away between what he [a Gibson Greetings executive] thinks it is and what reality is . . . You know, we gotta try to close that gap." The managing director suggested more lies to offset the effect of the earlier lies: " . . . when there's a big move, you know, if the market backs up like this, and he is down another 1.3 million, we can tell him he is down another 2. And vice versa. If the market really rallies like crazy, and he's made back a couple of million dollars, you can say you have only made back a half a million."
A number of the derivatives BT sold to Gibson Greetings were supposed to reduce or offset negative effects of earlier derivatives Gibson Greetings had bought from BT. But, according to the SEC, BT did not disclose to Gibson Greetings that the terms of the new derivatives sometimes included unrealized losses or fees, totaling millions in the aggregate, that would make the transactions less beneficial to BT.
The SEC wasn't alone in getting BT tapes. In litigation brought by another BT client, consumer products giant Proctor & Gamble, more taped recorded statements were made public. In one conversation, two BT employees discussing a derivatives transaction with P&G allegedly said, "They [P&G] would never know. They would never be able to know how much money was taken out of that [in reference to large expected BT profits from the transaction]." The other employee allegedly replied, "Never, no way, no way. That's the beauty of Bankers Trust." See http://www.businessweek.com/1995/42/b34461.htm. Another BT employee allegedly said about derivatives, "Funny business, you know? Lure people into that calm and then just totally f___ 'em."
The picture drawn by these tapes is that even large, successful business corporations have a hard time understanding complex financial instruments created by Wall Street and sold in an opaque environment. It's ironic that Wall Street apparently has recruited a number of its corporate clients to lobby against reform of the derivatives markets. If it's accurate that they don't fully understand what these financial products involve, there's a possibility they've been maneuvered by the potential predators into lobbying against regulatory reforms that could reduce the ability of the predators to victimize them. But if you don't know what you don't know, you might do yourself unknowing harm, especially if you lobby against rules to make you more knowledgeable.
There are no great or complex secrets about the basic problems in the derivatives markets. Information from these tapes showing the derivatives markets as it really operates, warts and all, has been publicly available for 15 or more years. We can see that the derivatives dealers are able to take advantage of even large, successful businesses because of the opacity of the market. Investors can't protect themselves because they don't have the necessary information; and in some cases may not even realize that they don't have the necessary information. A century after Louis Brandeis' famous observation, sunshine remains a superb disinfectant. Here are some of our suggestions for improvement, made over two years ago but still pertinent: http://blogger.uncleleosden.com/2007/12/weve-got-bailouts-how-about-fixing.html.
The most pressing problem in the derivatives markets is the lack of information. Investors don't know and can't easily learn what they've gotten themselves into. We can say that a thousand times, but let's recall the metaphor that a picture is worth a thousand words. There are very few pictures of the derivatives market, and they would only show a bunch of people in front of computer screens shouting into telephones. Tape recordings, however, fit the metaphor nicely. In financial dealings, what people say is much more important than how they look. As luck would have it, a few tapes of the goings on in the derivatives market have surfaced.
In December 1994, the SEC sued the securities broker-dealer subsidiary of a large bank called Bankers Trust. (In the Matter of BT Securities Corporation, SEC Rel. Nos. 33-7124, 34-35136 (Dec. 22, 1994)). As it happened, BT Securities taped recorded its derivatives sales people, a common practice on Wall Street as a protective measure against customers who try to avoid responsibility for their transactions. Of course, what's sauce for the goose can be sauce for the gander and for regulators, and the SEC got plenty of sauce from the BT Securities' tapes. As presented in the SEC's allegations (which BT Securities neither admitted nor denied), here are some of the tidbits found on the tapes.
BT Securities sold a company called Gibson Greetings (a greetings card company) customized derivatives called interest rate swaps that were meant to reduce Gibson Greetings' borrowing costs. These derivatives didn't trade in a market. Thus, there was no publicly quoted price for Gibson Greetings to compare BT's prices against. BT used computer modeling to determine the value of these derivatives. Gibson Greetings, which had to account for the derivatives on its financial statements, depended on information from BT to establish their values. Some of the derivatives were leveraged, with the result that small interest rate movements could produce large changes in value.
Gibson Greetings didn't fully understand the derivatives it bought--and BT knew it. A managing director at BT was taped saying, "from the very beginning, [Gibson] just, you know, really put themselves in our hands like 96% . . . And we have known that from day one." This managing director also said, "these guys [Gibson] have done some pretty wild stuff. And you know, they probably do not understand it quite as well as they should. I think that they have a pretty good understanding of it, but not perfect. And that's like perfect for us." Thus, Gibson Greetings was at an informational disadvantage, and BT understood that was good for BT.
Many of Gibson Greetings' derivatives positions were losers. Gibson Greetings looked to BT for information about how much it was losing. BT apparently wasn't eager to give its customer bad news and understated the losses by millions of dollars. This lack of candor created a "differential" between Gibson Greetings' actual losses and the rosier picture it received from BT. The informational "differential" only exacerbated the problem. If BT had to unwind the positions, Gibson Greetings would be in for an unpleasant surprise. As a BT managing director put it," . . . the problem is that we are too far away between what he [a Gibson Greetings executive] thinks it is and what reality is . . . You know, we gotta try to close that gap." The managing director suggested more lies to offset the effect of the earlier lies: " . . . when there's a big move, you know, if the market backs up like this, and he is down another 1.3 million, we can tell him he is down another 2. And vice versa. If the market really rallies like crazy, and he's made back a couple of million dollars, you can say you have only made back a half a million."
A number of the derivatives BT sold to Gibson Greetings were supposed to reduce or offset negative effects of earlier derivatives Gibson Greetings had bought from BT. But, according to the SEC, BT did not disclose to Gibson Greetings that the terms of the new derivatives sometimes included unrealized losses or fees, totaling millions in the aggregate, that would make the transactions less beneficial to BT.
The SEC wasn't alone in getting BT tapes. In litigation brought by another BT client, consumer products giant Proctor & Gamble, more taped recorded statements were made public. In one conversation, two BT employees discussing a derivatives transaction with P&G allegedly said, "They [P&G] would never know. They would never be able to know how much money was taken out of that [in reference to large expected BT profits from the transaction]." The other employee allegedly replied, "Never, no way, no way. That's the beauty of Bankers Trust." See http://www.businessweek.com/1995/42/b34461.htm. Another BT employee allegedly said about derivatives, "Funny business, you know? Lure people into that calm and then just totally f___ 'em."
The picture drawn by these tapes is that even large, successful business corporations have a hard time understanding complex financial instruments created by Wall Street and sold in an opaque environment. It's ironic that Wall Street apparently has recruited a number of its corporate clients to lobby against reform of the derivatives markets. If it's accurate that they don't fully understand what these financial products involve, there's a possibility they've been maneuvered by the potential predators into lobbying against regulatory reforms that could reduce the ability of the predators to victimize them. But if you don't know what you don't know, you might do yourself unknowing harm, especially if you lobby against rules to make you more knowledgeable.
There are no great or complex secrets about the basic problems in the derivatives markets. Information from these tapes showing the derivatives markets as it really operates, warts and all, has been publicly available for 15 or more years. We can see that the derivatives dealers are able to take advantage of even large, successful businesses because of the opacity of the market. Investors can't protect themselves because they don't have the necessary information; and in some cases may not even realize that they don't have the necessary information. A century after Louis Brandeis' famous observation, sunshine remains a superb disinfectant. Here are some of our suggestions for improvement, made over two years ago but still pertinent: http://blogger.uncleleosden.com/2007/12/weve-got-bailouts-how-about-fixing.html.
Sunday, January 31, 2010
A Chill Wind from Davos Blows onto Wall Street
The annual meeting of the World Economic Forum in Davos, Switzerland is a gathering of the world's business and political elites that inflames the paranoia of the gun-cleaning, nonperishable food stocking, cabin on a ridge dwelling crowd. High ranking people with easily recognized names schmooze, eat, drink--and talk about what? It's not entirely clear. Imaginations step in to fill the informational void. Conspiracies are avidly inferred. Entrenchment of the well-to-do is strongly suspected. Speculation abounds that ordinary people are mocked and their interests laughingly sold down the river.
But perhaps not this year. CNBC reports that the big banks were told by government figures that more regulation was on the way, whether or not they liked it. http://www.cnbc.com/id/35157632. Evidently, the bankers didn't even bother to protest, seemingly recognizing that they've overstepped by recovering so exuberantly from last year's crisis with the benefit of government bailouts, while everyone else continues to struggle with economic stagnation and high unemployment.
They probably thought they had things taken care of. Going back to the 2008 Presidential election, Wall Streeters, led by the folks at Goldman Sachs, contributed more to Barack Obama than John McCain. And the difference wasn't small. Of course, you didn't need a Wharton MBA quality intellect to figure out that Barack Obama would win. And Wall Street, an industry kept afloat by government bailouts, obviously had to side with the winner. Since Obama was sworn in, Wall Street lobbyists have quietly but furiously pushed back against the various proposals to reform financial regulation, with considerable success. A couple of months ago, only modest changes seemed likely. The big banks were surely breathing easier.
Then, the Republicans screwed everything up. They slipped into Massachusetts in the dead of night and ambushed a somnolent Democrat in the special election for Ted Kennedy's replacement. Having lost in a flash his best chance to reform the health insurance mess, President Obama went with the flow and joined in the populist outrage over big bank bailouts. He immediately rehabilitated Paul Volcker, the former Chairman of the Fed who was being confined to a re-education camp for liberals, and ordered column left march. The ghost of the Glass-Steagall Act was seen wandering the streets of lower Manhattan during market trading hours.
Things got worse in Davos. Reportedly, Rep. Barney Frank (D-Mass.), not exactly a minor recipient of campaign contributions from the financial services industry, was vocal among the eminent about the imminence of increased regulation. In step with him were several high ranking European governmental officials. The message was that regulators would work across international borders to prevent financial institutions from pulling . . . things . . . in one country that they couldn't do in other countries. There would be no exit from increased regulation.
With the Davos 2010 manifesto beginning with "regulators of the world, unite," all of Wall Street's careful political planning in 2008 seems to have been for naught. Stricter rules are coming down the pike. And the Street has nowhere to go, since the Republicans started the whole thing with their victory in Massachusetts. Maybe the moral of the story is hell hath no fury like a political party scorned. Today's populist anger is like flood waters overwhelming a dam, and some Republican members of Congress are trying to catch the insurgent wave. The erstwhile party of big business won't make a united stand to protect Wall Street.
There is a lesson here for the financial services community. The free market ethic of the 1980s and 1990s is dead and gone, crushed by hundreds of billions of dollars of undocumented, unsupported, unjustified and plain old stupid mortgage loans that impelled the largest government intervention ever in America's financial system. The polity no longer believes that what's good for corporate profits is good for America. An industry sometimes can, through a well-funded lobbying campaign, slip quietly through the weed-infested, brackish, swamp waters of political Washington and fix things so its interests appear protected. But not when its survival requires an enormous helping--and then seconds and thirds--of the nation's resources. You ultimately can't ask the middle class many in a democracy to serve the interests of a privileged few. When the electorate believes it's been ripped off, it has the means to take action. Even when the most powerful corporations are concerned. No business in a democracy is a profit center unto itself. To survive and thrive, it must find a way to fit into and serve the needs of the larger community, giving as well as taking.
We've been here before. The industrialization and cartelization of America in the 19th century led to populism at the turn of the 20th century. The ensuing fifty years of political struggle witnessed the creation of the federal regulatory structure we now have, along with unemployment compensation, Social Security and the other social welfare programs that form today's safety net. Although the business community slowed the process of change, the electorate eventually had its way. It will again. Free market theoreticians may sputter and fume as the perfection of their markets is muddied by politicians and bureaucrats. But free markets as they exist in the real world tend toward, and eventually wallow in, excess. Lacking the ability to restrain themselves, yet with their excess inflicting massive collateral risk and damage on society, they sooner or later invite government regulation. Thus it has been, and thus it is now.
We should also recall that the 20th Century was, on the whole, a time of great economic growth and rising prosperity. The increase in government regulation and participation in the economy eased political conflict, improved education, infrastructure, communications and transportation, and enhanced the legitimacy of the status quo. Calls for radical change lost their appeal. The social balance and stability achieved by the growth of government enhanced business opportunities and facilitated investment. Profits are less predictable when a lot of people wave pitchforks at corporate headquarters. The truth is, increased regulation is for Wall Street's own good.
But perhaps not this year. CNBC reports that the big banks were told by government figures that more regulation was on the way, whether or not they liked it. http://www.cnbc.com/id/35157632. Evidently, the bankers didn't even bother to protest, seemingly recognizing that they've overstepped by recovering so exuberantly from last year's crisis with the benefit of government bailouts, while everyone else continues to struggle with economic stagnation and high unemployment.
They probably thought they had things taken care of. Going back to the 2008 Presidential election, Wall Streeters, led by the folks at Goldman Sachs, contributed more to Barack Obama than John McCain. And the difference wasn't small. Of course, you didn't need a Wharton MBA quality intellect to figure out that Barack Obama would win. And Wall Street, an industry kept afloat by government bailouts, obviously had to side with the winner. Since Obama was sworn in, Wall Street lobbyists have quietly but furiously pushed back against the various proposals to reform financial regulation, with considerable success. A couple of months ago, only modest changes seemed likely. The big banks were surely breathing easier.
Then, the Republicans screwed everything up. They slipped into Massachusetts in the dead of night and ambushed a somnolent Democrat in the special election for Ted Kennedy's replacement. Having lost in a flash his best chance to reform the health insurance mess, President Obama went with the flow and joined in the populist outrage over big bank bailouts. He immediately rehabilitated Paul Volcker, the former Chairman of the Fed who was being confined to a re-education camp for liberals, and ordered column left march. The ghost of the Glass-Steagall Act was seen wandering the streets of lower Manhattan during market trading hours.
Things got worse in Davos. Reportedly, Rep. Barney Frank (D-Mass.), not exactly a minor recipient of campaign contributions from the financial services industry, was vocal among the eminent about the imminence of increased regulation. In step with him were several high ranking European governmental officials. The message was that regulators would work across international borders to prevent financial institutions from pulling . . . things . . . in one country that they couldn't do in other countries. There would be no exit from increased regulation.
With the Davos 2010 manifesto beginning with "regulators of the world, unite," all of Wall Street's careful political planning in 2008 seems to have been for naught. Stricter rules are coming down the pike. And the Street has nowhere to go, since the Republicans started the whole thing with their victory in Massachusetts. Maybe the moral of the story is hell hath no fury like a political party scorned. Today's populist anger is like flood waters overwhelming a dam, and some Republican members of Congress are trying to catch the insurgent wave. The erstwhile party of big business won't make a united stand to protect Wall Street.
There is a lesson here for the financial services community. The free market ethic of the 1980s and 1990s is dead and gone, crushed by hundreds of billions of dollars of undocumented, unsupported, unjustified and plain old stupid mortgage loans that impelled the largest government intervention ever in America's financial system. The polity no longer believes that what's good for corporate profits is good for America. An industry sometimes can, through a well-funded lobbying campaign, slip quietly through the weed-infested, brackish, swamp waters of political Washington and fix things so its interests appear protected. But not when its survival requires an enormous helping--and then seconds and thirds--of the nation's resources. You ultimately can't ask the middle class many in a democracy to serve the interests of a privileged few. When the electorate believes it's been ripped off, it has the means to take action. Even when the most powerful corporations are concerned. No business in a democracy is a profit center unto itself. To survive and thrive, it must find a way to fit into and serve the needs of the larger community, giving as well as taking.
We've been here before. The industrialization and cartelization of America in the 19th century led to populism at the turn of the 20th century. The ensuing fifty years of political struggle witnessed the creation of the federal regulatory structure we now have, along with unemployment compensation, Social Security and the other social welfare programs that form today's safety net. Although the business community slowed the process of change, the electorate eventually had its way. It will again. Free market theoreticians may sputter and fume as the perfection of their markets is muddied by politicians and bureaucrats. But free markets as they exist in the real world tend toward, and eventually wallow in, excess. Lacking the ability to restrain themselves, yet with their excess inflicting massive collateral risk and damage on society, they sooner or later invite government regulation. Thus it has been, and thus it is now.
We should also recall that the 20th Century was, on the whole, a time of great economic growth and rising prosperity. The increase in government regulation and participation in the economy eased political conflict, improved education, infrastructure, communications and transportation, and enhanced the legitimacy of the status quo. Calls for radical change lost their appeal. The social balance and stability achieved by the growth of government enhanced business opportunities and facilitated investment. Profits are less predictable when a lot of people wave pitchforks at corporate headquarters. The truth is, increased regulation is for Wall Street's own good.
Thursday, January 28, 2010
The Bubble Keeps on Bursting: Municipal Debt
The Big Asset Bubble of the early and mid-2000s continues to burst. The next big splatter may come from municipal debt, especially state government debt.
As we know, the Big Bubble puffed up real estate, stocks and other assets, and increased economic activity. That gave states more income and transactions to tax. State budgets bubbled up, and residents grew accustomed higher levels of service. When real estate and stocks nosedived, and the economy slid into recession, state revenues fell. But state debt holders continue to demand payment in full. California's problems have been well-publicized; its rating was cut a couple of weeks ago, although it's still somewhat above junk level. Other troubled states include Illinois, Arizona, Kentucky and Virginia.
All of these states are struggling to close their deficits. Unlike the federal government, states and municipalities are generally required by law not to have deficits. So cuts have to be made and/or taxes and fees have to be raised. At least that's what's prescribed by law. But state legislators and governors sometimes answer to a higher authority than the law--namely, their political futures. The governmental dysfunction in California is Rabelaisian in its grotesqueness and satire-worthiness. A default was narrowly avoided last fall, but could loom again this spring. Would the federal government bail out California? Given today's politics, with the Obama administration having today survived a second populist insurgent strike with the Senate's confirmation of Ben Bernanke for a second term as Fed Chairman, one would say no. But then again, that's what Gerald Ford said when New York City was on the verge of default in 1975, only to extend the city a loan that he adamantly refused against all the evidence to characterize as a bailout.
The problem with a major default in the muni bond markets, by California for example, is that it could chill the entire sector. That's what happened with money market funds right after the Lehman Brothers bankruptcy filing in September 2008. A well-known money market fund called Reserve Primary had to break the buck (i.e., reduce the valuation of its shares to below $1 each) because it held Lehman securities that had suddenly gotten very stinky. Investors across the entire multi trillion dollar money market fund sector freaked out. Only the announcement of an ad hoc temporary Treasury Department program insuring money market funds kept the entire sector from blowing up.
Sector-wide panic in the muni bond markets could shut down many state and local governments. They often borrow early in a year to pay employees and other operating expenses, and repay those borrowings later in the year after collecting enough taxes. A freeze-up in the muni bond markets might greatly reduce their liquidity, and leave them unable to cover operating expenses. Even if they could continue to operate, drastic cutbacks in employment levels and spending would exacerbate the slowness of the economic recovery--or even turn the economy back toward recession. If the administration and Congress have to choose between fiscal rectitude and facing a host of additional unemployed, angry voters in the fall, it isn't hard to foresee that expediency will be the better part of valor.
The federal government has already provided assistance to the municipal bond market. Last spring's stimulus package included a provision whereby the federal government would subsidize states' issuance of taxable bonds, so-called Build America Bonds. The federal government reimburses states for 35% of the interest expense of Build America Bonds, which effectively makes them about equally as expensive to states as regular nontaxable bonds. But the higher interest rate paid on Build America Bonds appeals to pension funds and other institutional investors that don't pay income taxes. So a potentially broader pool of investors than traditional high-income individual buyers of municipal bonds is available to invest in Build America Bonds.
These bonds have proven popular: close to $100 billion worth have been issued in less than a year. The federal government's potential interest costs are in the tens of billions. But the scarier thought is that bond holders may look to the federal government for a bailout if the states default on their Build America Bonds. After all, the federal subsidy drew many of them to these bonds in the first place. Of course, the federal government has no legal obligation to repay Build America Bonds. Then again, it had no legal obligation to pay the debts of Fannie Mae and Freddie Mac, or AIG, or . . . well, you see the point.
The U.S. Supreme Court just ruled that corporations and unions are no longer restricted in their campaign contributions. Unions, a bedrock Democratic constituency, are increasingly comprised of state and local government employees. After all, government employment levels have grown as industrial employment levels have fallen, and unions, like corporations, are driven by Darwinian imperative. In the acidic, 60/40, partisan atmosphere of today's national politics, expect unions to demand their due from the Democrats. With corporate America now ordering extra checks for all the additional campaign contributions it plans to make (and not to Democrats), a direct or indirect, one way or another federal bailout of state governments is all but inevitable.
As we know, the Big Bubble puffed up real estate, stocks and other assets, and increased economic activity. That gave states more income and transactions to tax. State budgets bubbled up, and residents grew accustomed higher levels of service. When real estate and stocks nosedived, and the economy slid into recession, state revenues fell. But state debt holders continue to demand payment in full. California's problems have been well-publicized; its rating was cut a couple of weeks ago, although it's still somewhat above junk level. Other troubled states include Illinois, Arizona, Kentucky and Virginia.
All of these states are struggling to close their deficits. Unlike the federal government, states and municipalities are generally required by law not to have deficits. So cuts have to be made and/or taxes and fees have to be raised. At least that's what's prescribed by law. But state legislators and governors sometimes answer to a higher authority than the law--namely, their political futures. The governmental dysfunction in California is Rabelaisian in its grotesqueness and satire-worthiness. A default was narrowly avoided last fall, but could loom again this spring. Would the federal government bail out California? Given today's politics, with the Obama administration having today survived a second populist insurgent strike with the Senate's confirmation of Ben Bernanke for a second term as Fed Chairman, one would say no. But then again, that's what Gerald Ford said when New York City was on the verge of default in 1975, only to extend the city a loan that he adamantly refused against all the evidence to characterize as a bailout.
The problem with a major default in the muni bond markets, by California for example, is that it could chill the entire sector. That's what happened with money market funds right after the Lehman Brothers bankruptcy filing in September 2008. A well-known money market fund called Reserve Primary had to break the buck (i.e., reduce the valuation of its shares to below $1 each) because it held Lehman securities that had suddenly gotten very stinky. Investors across the entire multi trillion dollar money market fund sector freaked out. Only the announcement of an ad hoc temporary Treasury Department program insuring money market funds kept the entire sector from blowing up.
Sector-wide panic in the muni bond markets could shut down many state and local governments. They often borrow early in a year to pay employees and other operating expenses, and repay those borrowings later in the year after collecting enough taxes. A freeze-up in the muni bond markets might greatly reduce their liquidity, and leave them unable to cover operating expenses. Even if they could continue to operate, drastic cutbacks in employment levels and spending would exacerbate the slowness of the economic recovery--or even turn the economy back toward recession. If the administration and Congress have to choose between fiscal rectitude and facing a host of additional unemployed, angry voters in the fall, it isn't hard to foresee that expediency will be the better part of valor.
The federal government has already provided assistance to the municipal bond market. Last spring's stimulus package included a provision whereby the federal government would subsidize states' issuance of taxable bonds, so-called Build America Bonds. The federal government reimburses states for 35% of the interest expense of Build America Bonds, which effectively makes them about equally as expensive to states as regular nontaxable bonds. But the higher interest rate paid on Build America Bonds appeals to pension funds and other institutional investors that don't pay income taxes. So a potentially broader pool of investors than traditional high-income individual buyers of municipal bonds is available to invest in Build America Bonds.
These bonds have proven popular: close to $100 billion worth have been issued in less than a year. The federal government's potential interest costs are in the tens of billions. But the scarier thought is that bond holders may look to the federal government for a bailout if the states default on their Build America Bonds. After all, the federal subsidy drew many of them to these bonds in the first place. Of course, the federal government has no legal obligation to repay Build America Bonds. Then again, it had no legal obligation to pay the debts of Fannie Mae and Freddie Mac, or AIG, or . . . well, you see the point.
The U.S. Supreme Court just ruled that corporations and unions are no longer restricted in their campaign contributions. Unions, a bedrock Democratic constituency, are increasingly comprised of state and local government employees. After all, government employment levels have grown as industrial employment levels have fallen, and unions, like corporations, are driven by Darwinian imperative. In the acidic, 60/40, partisan atmosphere of today's national politics, expect unions to demand their due from the Democrats. With corporate America now ordering extra checks for all the additional campaign contributions it plans to make (and not to Democrats), a direct or indirect, one way or another federal bailout of state governments is all but inevitable.
Tuesday, January 26, 2010
Ben Bernanke and Moral Hazard
At the end of last week, when it looked like Ben Bernanke might not be confirmed for re-appointment as Chairman of the Fed, the stock market was in a tizzy, with the Dow dropping over 200 points on Friday alone. Now, after repeated insistent pronouncements by high level administration and Congressional figures that Bernanke will be approved for a second term, the markets have stabilized and even moved slightly upwards. If you're invested in stocks, that's good. But only for now. In the long run, you, we and all have a problem.
It's no secret the stock markets are complex. With the Internet's informational horn of plenty and thousands of pages of SEC filings per year per company, the data flow is overwhelming. But the crucial information of what a company is truly about and where it's going is very difficult to discern. Add to this the fact that there are thousands of public companies, and anyone who tries to rationally analyze the totality of the markets is destined for discombobulation. Some investors seek out talismanic signs--those would be the now tarnished credit rating agencies' little letter and number grades. Others follow gurus--whichever analyst du jour has the best discernible track record from whatever point of view one considers meaningful. But, more than anything, today's markets rely on big medicine--the big medicine of big government.
Not long ago, the most esteemed medicine man was Alan Greenspan. In an age of asset volatility, beginning with the 1987 stock market crash, Greenspan seemed to have magical powers. He could calm roiling waters. While the Japanese stock and real estate markets boomed and busted, leaving Japan in seemingly perpetual stagnation, Greenspan wielded the monetary wand first to expunge any signs of inflation, and then transport American assets--equities and real estate--to Lake Wobegon, where they all performed above average. Nary a cloud was to be seen in ever brighter blue skies. Seldom was heard a discouraging word. The buffalo roamed. The deer and the antelope played. Chairman Greenspan was practically deified and the markets rose ever higher while he presided over the Fed.
But Chairman Greenspan's big medicine offended the gods of supply and demand. He, a professional economist, had the hubris to think that he could magically stop prices from falling, and the economy from contracting. The gods simmered, then fumed, and then raged. Finally, they cast fearsome bolts of lightning that set the financial world ablaze and burned down numerous houses of cards. The nation was tossed out of Lake Webegon. Justice, untempered by mercy, was administered by the laws of supply and demand.
Alan Greenspan's luck continued to hold. By the time the ship hit the iceberg, he had departed the Fed and taken up a new role as eminence grise to the financially powerful. In his place was a new Chairman, Ben Bernanke, whose medicine was untested.
It's conceivable that the stock market crash of 2007-08 was severe as it was because the Fed was then chaired by a rookie. Because Bernanke wasn't predictable at that time, asset prices couldn't be easily established, and demand fell away.
We know what happened next. The Fed opened up all of its doors, even the emergency exits in the cafeteria, and invited every imaginable financial institution to come in for loans. It organized the first ever money printers' SWAT team to work 'round the clock rescuing beleaguered financial firms. Short term interest rates magically disappeared, and they've been gone for so long many teenagers and children don't believe they ever really existed.
But the stock market revived, and the real estate market may soon be moved from the ICU. Ben Bernanke was complimented, then toasted, and most recently, deified as Man of the Year. The markets now believe in his magic. As long as Bernanke serves as their totem, they will know that no bullet can kill them. Appetite for risk has made a comeback. The bulls strut in the range.
The financial markets' reliance on Great Men is a bad sign. Trading and investing have become bets on the direction of government policy. It's easier to rely on the perceived avuncular omniscience of a senior federal official than deal with the markets in all their mindnumbing complexity. Enormous political pressure is placed on the Chairman of the Fed to pump out soothing liquidity forever. Enormous political pressure is placed on the administration and Congress to keep the seemingly gifted Medicine Man in the Fed Chairmanship forever.
As long as the Big Medicine Man stays in office, no risk will be deemed too great, no speculation foolish. All assets will be good buys, because if supply ever threatens to exceed demand, Uncle Ben will pump out more liquidity to absorb the evil excess.
It was this way with Uncle Alan that we got the Great Bursting Bubble of 2007-08. Now, with the financial markets clinging to Ben Bernanke like lint, the cycle appears poised to renew itself. The financial markets have become increasingly addicted to government policy--and in particular, government handouts. This isn't a story that will have a happy ending in the long run. Lasting prosperity won't come from Big Medicine Men. It will come from the individual efforts of people producing things that other people want to buy, and from the financial markets financing the efforts of these productive people. But the near term profits and bonuses of Wall Street are harder to harvest from the pedestrian activities of the production process. Massive cash flows provided by the Fed are much more lucrative. Plus ca change, plus c'est la meme chose. And that's too bad.
It's no secret the stock markets are complex. With the Internet's informational horn of plenty and thousands of pages of SEC filings per year per company, the data flow is overwhelming. But the crucial information of what a company is truly about and where it's going is very difficult to discern. Add to this the fact that there are thousands of public companies, and anyone who tries to rationally analyze the totality of the markets is destined for discombobulation. Some investors seek out talismanic signs--those would be the now tarnished credit rating agencies' little letter and number grades. Others follow gurus--whichever analyst du jour has the best discernible track record from whatever point of view one considers meaningful. But, more than anything, today's markets rely on big medicine--the big medicine of big government.
Not long ago, the most esteemed medicine man was Alan Greenspan. In an age of asset volatility, beginning with the 1987 stock market crash, Greenspan seemed to have magical powers. He could calm roiling waters. While the Japanese stock and real estate markets boomed and busted, leaving Japan in seemingly perpetual stagnation, Greenspan wielded the monetary wand first to expunge any signs of inflation, and then transport American assets--equities and real estate--to Lake Wobegon, where they all performed above average. Nary a cloud was to be seen in ever brighter blue skies. Seldom was heard a discouraging word. The buffalo roamed. The deer and the antelope played. Chairman Greenspan was practically deified and the markets rose ever higher while he presided over the Fed.
But Chairman Greenspan's big medicine offended the gods of supply and demand. He, a professional economist, had the hubris to think that he could magically stop prices from falling, and the economy from contracting. The gods simmered, then fumed, and then raged. Finally, they cast fearsome bolts of lightning that set the financial world ablaze and burned down numerous houses of cards. The nation was tossed out of Lake Webegon. Justice, untempered by mercy, was administered by the laws of supply and demand.
Alan Greenspan's luck continued to hold. By the time the ship hit the iceberg, he had departed the Fed and taken up a new role as eminence grise to the financially powerful. In his place was a new Chairman, Ben Bernanke, whose medicine was untested.
It's conceivable that the stock market crash of 2007-08 was severe as it was because the Fed was then chaired by a rookie. Because Bernanke wasn't predictable at that time, asset prices couldn't be easily established, and demand fell away.
We know what happened next. The Fed opened up all of its doors, even the emergency exits in the cafeteria, and invited every imaginable financial institution to come in for loans. It organized the first ever money printers' SWAT team to work 'round the clock rescuing beleaguered financial firms. Short term interest rates magically disappeared, and they've been gone for so long many teenagers and children don't believe they ever really existed.
But the stock market revived, and the real estate market may soon be moved from the ICU. Ben Bernanke was complimented, then toasted, and most recently, deified as Man of the Year. The markets now believe in his magic. As long as Bernanke serves as their totem, they will know that no bullet can kill them. Appetite for risk has made a comeback. The bulls strut in the range.
The financial markets' reliance on Great Men is a bad sign. Trading and investing have become bets on the direction of government policy. It's easier to rely on the perceived avuncular omniscience of a senior federal official than deal with the markets in all their mindnumbing complexity. Enormous political pressure is placed on the Chairman of the Fed to pump out soothing liquidity forever. Enormous political pressure is placed on the administration and Congress to keep the seemingly gifted Medicine Man in the Fed Chairmanship forever.
As long as the Big Medicine Man stays in office, no risk will be deemed too great, no speculation foolish. All assets will be good buys, because if supply ever threatens to exceed demand, Uncle Ben will pump out more liquidity to absorb the evil excess.
It was this way with Uncle Alan that we got the Great Bursting Bubble of 2007-08. Now, with the financial markets clinging to Ben Bernanke like lint, the cycle appears poised to renew itself. The financial markets have become increasingly addicted to government policy--and in particular, government handouts. This isn't a story that will have a happy ending in the long run. Lasting prosperity won't come from Big Medicine Men. It will come from the individual efforts of people producing things that other people want to buy, and from the financial markets financing the efforts of these productive people. But the near term profits and bonuses of Wall Street are harder to harvest from the pedestrian activities of the production process. Massive cash flows provided by the Fed are much more lucrative. Plus ca change, plus c'est la meme chose. And that's too bad.
Sunday, January 24, 2010
Uncertainty: Wall Street's Nightmare
Last week, the stock market fell 4%. Although somewhat disappointing earnings announcements were part of the reason, politics were the driving factor. Republican Scott Brown's surprise win as senator to replace Ted Kennedy was predicted by some to be positive for the stock market. Wrong. As soon as the Obama administration realized that it had been ambushed, it reversed course on financial regulatory reform, wheeled Paul Volcker out of the closet where it had been hiding him, and aimed the heavy political artillery at Wall Street. Stocks fell away at the end of the week, as renewed vigor for increased regulation and taxes implied moderation of future corporate earnings.
Political disarray is increasing. Democratic discipline, not exactly Prussian in the best of times, is evaporating fast. More and more senators are announcing their opposition to the renomination of Ben Bernanke as Fed Chairman. He must be reconfirmed by midnight, Jan. 31, 2010, or he ceases to be Chairman (and becomes an ordinary Fed governor). Frenzied headcounts indicate over 40 uncommitted senators. Considering that Scott Brown won in a last minute wave of populist insurgency, it's hard to predict what will happen. Republicans, smug over their guerrilla victory in Massachusetts, have put themselves in a bind. Bernanke is closely linked with Alan Greenspan and his Wall Street-centric outlook and policies. A vote for Bernanke is a vote to continue massive government subsidized profits and bonuses for Wall Street. A good case can be made for re-confirming Bernanke. But it's harder to make in the face of large numbers of angry people waving pitchforks.
If Bernanke, a George W. Bush appointee, isn't re-confirmed, President Obama can choose his own nominee. He isn't likely to choose the usual suspects--Larry Summers or Tim Geithner. They're too easily linked to policies favoring Wall Street. Christina Romer, Chair of the Council of Economic Advisers, is a possibility. She is less well-known in official Washington and therefore presents a smaller target for confirmation proceedings. Although she is seen as neo-Keynesian, anathema among the laissez-faire, a populist insurgency demanding job creation might endorse big government that helps ordinary people instead of Wall Street. And if Romer doesn't vet well, expect another nominee who won't cater to Republican preferences.
The Fed Chairmanship problem isn't exactly a win-win for Obama, since he re-nominated Bernanke and rejection would leave some splatter on him. But it's a lose-lose for the Republicans. It they support the Wall Street-subsidizing, money printing Bernanke, they offend the mob. If they vote against Bernanke, they'll face a Democratic nominee whose proclivities may match Bernanke on the monetary front and exceed his on the regulatory front.
The same dynamic operates with the President's call for more stringent bank regulation. If Republicans oppose it, they'll be painted as running dogs for the big banks that the mob detests. But supporting increased regulation only imperils a traditional Republican bulwark.
The President has just announced his support of a bipartisan deficit commission to develop ways to combat the federal deficit. This proposal, sponsored by Republican senator Judd Gregg (R-N.H.) and Democratic Senator Kent Conrad (D-N.D.), presents another dilemma for Republicans. The populist insurgency has demanded control over the deficit. With current and projected deficits as large as they are, the commission will have little choice but to recommend tax increases as well as spending cuts. More heresy looms in Republicans' futures.
All this leads to uncertainty on Wall Street and in corporate America. Uncertainty is bad for stock prices. It's harder to project corporate earnings when government policies are in flux. In many ways, businesses and especially Wall Street, can do well regardless of what the rules are, as long as the rules are clear and predictable. When federal marginal income tax brackets were 90% (as they were during and just after World War II), Wall Streeters made good money selling tax shelters. When the Glass-Steagall Act prevented commercial banks and investment banks from operating in the same corporate structure, investment bankers nevertheless got monster bonuses--it was commercial bankers, ulcerated with envy, who pushed for the repeal of Glass-Steagall. But when the rules are vague and likely to change, and members of both parties become internal dissidents, stock prices waver.
As stock prices fall, so do the values of 401(k) accounts across the nation. This portends more instability. The New Populism is really the Great Unalignment. There's no way to know where the outrage will flow. Neither Democrats nor Republicans can count on the nouveau insurgents. The anger Republicans surreptitiously fueled with their quiet funding of Scott Brown's campaign could easily boomerang against them. President Obama, who snidely sniped at Scott Brown's truck, again revealed an elitism--now toward truck owners in addition to gun owners--that he needs to get over fast. He may not realize it, but he simply isn't in touch with the American middle class. Maybe it's because he's spent too much time around elites and elite-wannabes. Maybe it's because he has a burning drive to escape the modesty of his own upbringing. But he has this problem--and it's him, not his advisers, not his party. Maybe he should change the oil and filter in a pickup truck a couple of times. Maybe, once every week, he should have a hot dog and baked beans for lunch. Maybe he should spend a half an hour at a firing range with a 9mm semiautomatic, and then another half an hour with a .38 special. However he does it, he needs to deal with this disconnect. His Democratic colleagues on the Hill are scrambling for cover and they'll abandon him in a heartbeat if that's necessary to saving their hides this fall.
It's always been true that political friendships exist only in fair weather. But storm clouds have rolled in and it's likely to keep raining until the mid-term elections. The Democrats are likely to lose some seats. But they may gain others if Republicans start to believe too much in their own publicity (as happened in upstate New York recently). However things turn out in November, the continued uncertainty portends a tough year for stocks.
Political disarray is increasing. Democratic discipline, not exactly Prussian in the best of times, is evaporating fast. More and more senators are announcing their opposition to the renomination of Ben Bernanke as Fed Chairman. He must be reconfirmed by midnight, Jan. 31, 2010, or he ceases to be Chairman (and becomes an ordinary Fed governor). Frenzied headcounts indicate over 40 uncommitted senators. Considering that Scott Brown won in a last minute wave of populist insurgency, it's hard to predict what will happen. Republicans, smug over their guerrilla victory in Massachusetts, have put themselves in a bind. Bernanke is closely linked with Alan Greenspan and his Wall Street-centric outlook and policies. A vote for Bernanke is a vote to continue massive government subsidized profits and bonuses for Wall Street. A good case can be made for re-confirming Bernanke. But it's harder to make in the face of large numbers of angry people waving pitchforks.
If Bernanke, a George W. Bush appointee, isn't re-confirmed, President Obama can choose his own nominee. He isn't likely to choose the usual suspects--Larry Summers or Tim Geithner. They're too easily linked to policies favoring Wall Street. Christina Romer, Chair of the Council of Economic Advisers, is a possibility. She is less well-known in official Washington and therefore presents a smaller target for confirmation proceedings. Although she is seen as neo-Keynesian, anathema among the laissez-faire, a populist insurgency demanding job creation might endorse big government that helps ordinary people instead of Wall Street. And if Romer doesn't vet well, expect another nominee who won't cater to Republican preferences.
The Fed Chairmanship problem isn't exactly a win-win for Obama, since he re-nominated Bernanke and rejection would leave some splatter on him. But it's a lose-lose for the Republicans. It they support the Wall Street-subsidizing, money printing Bernanke, they offend the mob. If they vote against Bernanke, they'll face a Democratic nominee whose proclivities may match Bernanke on the monetary front and exceed his on the regulatory front.
The same dynamic operates with the President's call for more stringent bank regulation. If Republicans oppose it, they'll be painted as running dogs for the big banks that the mob detests. But supporting increased regulation only imperils a traditional Republican bulwark.
The President has just announced his support of a bipartisan deficit commission to develop ways to combat the federal deficit. This proposal, sponsored by Republican senator Judd Gregg (R-N.H.) and Democratic Senator Kent Conrad (D-N.D.), presents another dilemma for Republicans. The populist insurgency has demanded control over the deficit. With current and projected deficits as large as they are, the commission will have little choice but to recommend tax increases as well as spending cuts. More heresy looms in Republicans' futures.
All this leads to uncertainty on Wall Street and in corporate America. Uncertainty is bad for stock prices. It's harder to project corporate earnings when government policies are in flux. In many ways, businesses and especially Wall Street, can do well regardless of what the rules are, as long as the rules are clear and predictable. When federal marginal income tax brackets were 90% (as they were during and just after World War II), Wall Streeters made good money selling tax shelters. When the Glass-Steagall Act prevented commercial banks and investment banks from operating in the same corporate structure, investment bankers nevertheless got monster bonuses--it was commercial bankers, ulcerated with envy, who pushed for the repeal of Glass-Steagall. But when the rules are vague and likely to change, and members of both parties become internal dissidents, stock prices waver.
As stock prices fall, so do the values of 401(k) accounts across the nation. This portends more instability. The New Populism is really the Great Unalignment. There's no way to know where the outrage will flow. Neither Democrats nor Republicans can count on the nouveau insurgents. The anger Republicans surreptitiously fueled with their quiet funding of Scott Brown's campaign could easily boomerang against them. President Obama, who snidely sniped at Scott Brown's truck, again revealed an elitism--now toward truck owners in addition to gun owners--that he needs to get over fast. He may not realize it, but he simply isn't in touch with the American middle class. Maybe it's because he's spent too much time around elites and elite-wannabes. Maybe it's because he has a burning drive to escape the modesty of his own upbringing. But he has this problem--and it's him, not his advisers, not his party. Maybe he should change the oil and filter in a pickup truck a couple of times. Maybe, once every week, he should have a hot dog and baked beans for lunch. Maybe he should spend a half an hour at a firing range with a 9mm semiautomatic, and then another half an hour with a .38 special. However he does it, he needs to deal with this disconnect. His Democratic colleagues on the Hill are scrambling for cover and they'll abandon him in a heartbeat if that's necessary to saving their hides this fall.
It's always been true that political friendships exist only in fair weather. But storm clouds have rolled in and it's likely to keep raining until the mid-term elections. The Democrats are likely to lose some seats. But they may gain others if Republicans start to believe too much in their own publicity (as happened in upstate New York recently). However things turn out in November, the continued uncertainty portends a tough year for stocks.
Friday, January 22, 2010
Blowback on Wall Street from Scott Brown's election in Massachusetts
A problem with blowback is you can't be sure what it will hit. Scott Brown's election as the senator from Massachusetts to replace Ted Kennedy was blowback from the Obama administration's inattentiveness to the independent voters who put it in office. But that election led the administration to cater to those same independents by shifting focus away from health insurance reform and back toward Wall Street.
The big money lobbyists almost pulled it off. A quiet, but determined lobbying effort in the second half of 2009 had persuaded the administration and Congress to slide financial regulatory reform toward the back burner. Most Democratic political capital was committed to reforming health insurance. The Republicans, realizing that the Dems were tied up with Washington problems, set an ambush in Massachusetts. Just as inattentive deer don't survive the time in the fall when a lot of people wearing blaze orange enter the woods, Martha Coakley and the Dems paid the price for not staying alert.
Then, Barack Obama demonstrated why he was elected President. Two days after the debacle, the President announced a proposal to place new restrictions on the activities of big banks designed to prevent them from using federally insured deposits or loans from the Federal Reserve to engage in risky and speculative activities. Remember that last week, the administration proposed a tax that would fall primarily on big banks' short term borrowings (excluding customer deposits), thus discouraging them from using fast money leverage. Taking these two initiatives together, big banks will have powerful incentives to formally split their depositary and investment banking operations. Add the extensive regulation of bank holding companies that exists and the increased holding company regulation that may well be on the way, and you have a regulatory mix that would encourage a complete corporate breakup between depositary banks offering federally insured deposits and the Masters of the Universe who do the wild and woolly stuff.
Yesterday, the political theater was vivid, with Paul Volcker standing next to the President as he announced the proposal to revive, sub silentio, the Glass-Steagel Act. Volcker, a former Chairman of the Federal Reserve and an unyielding proponent of increased prudential regulation for banking, is widely reported to have been in the Democrats' gulag for the past year. It seems that Scott Brown unintentionally got Volcker sprung, and along with him serious intent to crack down on Wall Street.
That wasn't quite what the Republican agents provocateurs assisting Brown intended, either. But they placed their chips on the outrage of independents. Those who live by populist ire die by populist ire. Wall Street stands shoulder to shoulder with the federal government as a target of independents. The President and his aides know this, and they have turned their agenda on a dime to steer the pitchforks toward the big banks. If the Republicans use their 41-vote minority in the Senate to block the new, improved financial regulatory reform proposal, they will find themselves on the wrong side of pickup truck-driving insurgents. It's very unpleasant to be hit by a pickup truck.
The big money lobbyists almost pulled it off. A quiet, but determined lobbying effort in the second half of 2009 had persuaded the administration and Congress to slide financial regulatory reform toward the back burner. Most Democratic political capital was committed to reforming health insurance. The Republicans, realizing that the Dems were tied up with Washington problems, set an ambush in Massachusetts. Just as inattentive deer don't survive the time in the fall when a lot of people wearing blaze orange enter the woods, Martha Coakley and the Dems paid the price for not staying alert.
Then, Barack Obama demonstrated why he was elected President. Two days after the debacle, the President announced a proposal to place new restrictions on the activities of big banks designed to prevent them from using federally insured deposits or loans from the Federal Reserve to engage in risky and speculative activities. Remember that last week, the administration proposed a tax that would fall primarily on big banks' short term borrowings (excluding customer deposits), thus discouraging them from using fast money leverage. Taking these two initiatives together, big banks will have powerful incentives to formally split their depositary and investment banking operations. Add the extensive regulation of bank holding companies that exists and the increased holding company regulation that may well be on the way, and you have a regulatory mix that would encourage a complete corporate breakup between depositary banks offering federally insured deposits and the Masters of the Universe who do the wild and woolly stuff.
Yesterday, the political theater was vivid, with Paul Volcker standing next to the President as he announced the proposal to revive, sub silentio, the Glass-Steagel Act. Volcker, a former Chairman of the Federal Reserve and an unyielding proponent of increased prudential regulation for banking, is widely reported to have been in the Democrats' gulag for the past year. It seems that Scott Brown unintentionally got Volcker sprung, and along with him serious intent to crack down on Wall Street.
That wasn't quite what the Republican agents provocateurs assisting Brown intended, either. But they placed their chips on the outrage of independents. Those who live by populist ire die by populist ire. Wall Street stands shoulder to shoulder with the federal government as a target of independents. The President and his aides know this, and they have turned their agenda on a dime to steer the pitchforks toward the big banks. If the Republicans use their 41-vote minority in the Senate to block the new, improved financial regulatory reform proposal, they will find themselves on the wrong side of pickup truck-driving insurgents. It's very unpleasant to be hit by a pickup truck.
Wednesday, January 20, 2010
The Ten Biggest Losers in the Massachusetts Special Senatorial Election
There was more than one loser when Scott Brown won yesterday's special election in Massachusetts to replace Ted Kennedy.
Barack Obama. His already complex job just became a lot more complicated.
Sarah Palin. She's been upstaged almost as badly as Barack Obama. The Republicans desperately need new, younger candidates. Scott Brown, although not entirely without baggage himself, doesn't need a battalion of bellhops the way Palin does, with McCain's former campaign staff carefully calibrating their telescopic sights to snipe at her, the issues from her family, the issues from her almost inlaws, those interesting reimbursements from the State of Alaska while she was governor, the photo of her with a dead, bloody caribou, and quitting the governorship promptly after attaining national stature and cashing in with a book contract, the Fox commentator deal, etc. Today, Brown didn't exactly deny harboring Presidential ambitions, so watch for Palin to sneak up on the rug he's standing on and give it a hard yank.
Mitt Romney, Mike Huckabee, Newt Gingrinch, et al. The old, white guys in the Republican Party are finished. The party's way back to the White House will be through a younger, fresher insurgent candidate who appeals to the ever fickle independents that are now the key to victory. Republican power brokers will be looking for ways to quietly offload those same old, same old guys.
White House staff. It is the way of Washington that someone take the fall for a disaster like Brown's successful guerilla campaign. The vicious flood of leaks over who's to blame and who was asleep at the switch indicate a fierce internecine battle among Team Obama. Sooner or later, someone will have to resign to spend more time with their family or pursue other interests.
Levi Johnston. Another guy who posed nude has suddenly gained the limelight. As Sarah Palin's public aura fades, so does Levi Johnston's. He's said he'd be content as an electrician. He'd better stay on track to get licensed.
The uninsured. Those without health insurance had better reach down for their bootstraps and pull hard, because they may be getting no other options.
The insured. Reality is that the insured and paying patients pay for the emergency room and pro bono care that the uninsured often rely on. Maybe your taxes won't be raised now, but your health care costs and insurance premiums will remain high and probably go higher.
Health care providers. With today's crazy quilt health care insurance/no insurance system likely to stay largely in place, and with taxpayers less likely to contribute to covering health care costs, the only remaining pool of cash to be tapped as health care costs inexorably rise is the dollar flow to health care providers. Reimbursement rates are likely to be squeezed. The plastic surgeons and neurosurgeons forced to trade down from Maseratis to Mercedeses won't get any sympathy. But pediatricians already sometimes vaccinate kids at cost, or even at a loss. And they and general practitioners scarcely make what executive assistants on Wall Street make. Cutting their reimbursements rates isn't likely to produce a good outcome.
Scott Brown's truck. Driving on the small town roads of Wrentham, Mass. doesn't put a lot of wear and tear on a motor vehicle, especially something as sturdy as a pickup truck. But D.C.'s potholes interspersed with short stretches of macadam are a very different story. When you idle a truck for eons in rush hour congestion and then drive it off a cliff every 50 feet, the tires, suspension, undercarriage, frame, and engine earn their keep. One D.C. mile is the same as 20 Wrentham miles. Senator Brown won't be able to add 200,000 D.C. miles to the truck.
And, oh yeah, Martha Coakley. It's hard to exclude the losing candidate from this list, but, all things considered, she's far from the biggest loser.
Barack Obama. His already complex job just became a lot more complicated.
Sarah Palin. She's been upstaged almost as badly as Barack Obama. The Republicans desperately need new, younger candidates. Scott Brown, although not entirely without baggage himself, doesn't need a battalion of bellhops the way Palin does, with McCain's former campaign staff carefully calibrating their telescopic sights to snipe at her, the issues from her family, the issues from her almost inlaws, those interesting reimbursements from the State of Alaska while she was governor, the photo of her with a dead, bloody caribou, and quitting the governorship promptly after attaining national stature and cashing in with a book contract, the Fox commentator deal, etc. Today, Brown didn't exactly deny harboring Presidential ambitions, so watch for Palin to sneak up on the rug he's standing on and give it a hard yank.
Mitt Romney, Mike Huckabee, Newt Gingrinch, et al. The old, white guys in the Republican Party are finished. The party's way back to the White House will be through a younger, fresher insurgent candidate who appeals to the ever fickle independents that are now the key to victory. Republican power brokers will be looking for ways to quietly offload those same old, same old guys.
White House staff. It is the way of Washington that someone take the fall for a disaster like Brown's successful guerilla campaign. The vicious flood of leaks over who's to blame and who was asleep at the switch indicate a fierce internecine battle among Team Obama. Sooner or later, someone will have to resign to spend more time with their family or pursue other interests.
Levi Johnston. Another guy who posed nude has suddenly gained the limelight. As Sarah Palin's public aura fades, so does Levi Johnston's. He's said he'd be content as an electrician. He'd better stay on track to get licensed.
The uninsured. Those without health insurance had better reach down for their bootstraps and pull hard, because they may be getting no other options.
The insured. Reality is that the insured and paying patients pay for the emergency room and pro bono care that the uninsured often rely on. Maybe your taxes won't be raised now, but your health care costs and insurance premiums will remain high and probably go higher.
Health care providers. With today's crazy quilt health care insurance/no insurance system likely to stay largely in place, and with taxpayers less likely to contribute to covering health care costs, the only remaining pool of cash to be tapped as health care costs inexorably rise is the dollar flow to health care providers. Reimbursement rates are likely to be squeezed. The plastic surgeons and neurosurgeons forced to trade down from Maseratis to Mercedeses won't get any sympathy. But pediatricians already sometimes vaccinate kids at cost, or even at a loss. And they and general practitioners scarcely make what executive assistants on Wall Street make. Cutting their reimbursements rates isn't likely to produce a good outcome.
Scott Brown's truck. Driving on the small town roads of Wrentham, Mass. doesn't put a lot of wear and tear on a motor vehicle, especially something as sturdy as a pickup truck. But D.C.'s potholes interspersed with short stretches of macadam are a very different story. When you idle a truck for eons in rush hour congestion and then drive it off a cliff every 50 feet, the tires, suspension, undercarriage, frame, and engine earn their keep. One D.C. mile is the same as 20 Wrentham miles. Senator Brown won't be able to add 200,000 D.C. miles to the truck.
And, oh yeah, Martha Coakley. It's hard to exclude the losing candidate from this list, but, all things considered, she's far from the biggest loser.
Tuesday, January 19, 2010
Team Obama: No Longer the Smartest Guys in the Room
With the election of Republican Scott Brown as Ted Kennedy's replacement from Massachusetts, it's clear that Team Obama needs to rethink things. Forget the close analysis of who's responsible for what remark or who made the wrong call with which policy position. This election was as much a referendum on the administration as it was about the merits of the candidates.
Brown won by adopting Obama's strategy of tapping into voter discontent. Martha Coakley, the Democrat, was a legacy candidate, trying to ride into office on Ted Kennedy's legacy. But legacy candidates don't do well these days. Both Hillary Clinton and John McCain invoked the past during their 2008 campaigns and it didn't serve them well. Creigh Deeds, a Democratic candidate for governor of Virginia last year, had a similarly bad experience running as a legacy candidate. Scott Brown is a heretofore minor politician, a Massachusetts state senator with nothing to lose. In a campaign involving such a candidate, the size of the fight in the dog is what counts the most. With the agility of a judo master, he characterized himself as the outraged underdog, and won over outraged voters.
It's unclear that there is much logic to his or their outrage. The Obama administration's health care reform effort seems to have drawn the most populist ire. That defies logic, as this is the one program in Obama's agenda that might offer the broadest benefit to the electorate. But as much as people were tired of George W. Bush's failures, they're also scared of changes in their insurance coverage (if they have any), and they're scared of higher premiums and higher taxes.
Voters are also angry with economic policies. The Bush II administration, in providing hundreds of billions of bailout dollars to banks and having the government assume myriad liabilities that would otherwise have pushed the banking system into bankruptcy, practically socialized the financial system and left taxpayers at risk for untold losses. The Obama administration bought into the Bush administration's bank-loving policies lock, stock and barrel, and added its own economic stimulus package. Bankers rejoiced as their earnings and bonuses rebounded, but taxpayers bemoaned the bonuses and shivered at the thought of their burdens. Even though President Obama has promised to recover the costs of the bailouts, Scott Brown caught him at a moment when he hadn't yet acted on the promise.
Team Obama needs to stop politicking and take a hard look in the mirror. In 2008, they were the smartest guys in the room, propelling a former state senator from Illinois into the White House in 6 years. Then, the Republicans, with footprints all over their butts, did the thing Americans do so well. They thought about what had just happened, how painful it had been, the ways in which they needed to change, and adapted. Some of their changes are weird--it remains possible that the party could melt down in an Inquisitional drive for ideological purity. But other Republicans realized that Barack Obama had won by working from the ground level up, and that they could do the same thing.
Team Obama, by contrast, seems to have become remote, elite. They've appointed a lot of very well-credentialed Washington insiders into high level positions, who've given them a lot of conventional advice that won't ruffle the feathers of too many powerful people. Their policies of bailout and stimulus have mostly helped those that are well-off and influential, but scare the hell out of the middle class. They try to influence bellwether Democratic campaigns, like the recent Virginia governor's election and Martha Coakley's campaign in Massachusetts, but are quick to dodge any hint of responsibility for failure, pre-emptively pointing fingers at the losing candidates. In short, they've taken on a distinct inside-the-Beltway aura, and within less than a year. That's exactly what pisses voters off.
They have to take stock of themselves. Whether or not they can see it, they aren't so smart any more. They didn't anticipate how quickly and completely the Republicans would learn from the 2008 Obama campaign. They don't seem to understand how fickle uncertainty and frustration have made the electorate. They seem more indwelling and hesitant. Why hasn't the President publicly taken the lead on health insurance reform? News stories report that he has been quietly negotiating potential compromises between the House and the Senate. But getting something as big and as controversial as health insurance reform done requires leadership from him more than it requires negotiation. The Democrats haven't wrapped up health insurance reform after a year, and now their lack of alacrity traps them in a situation they failed to anticipate from a special senatorial election.
The Obama team are consummate politicians. But running a campaign and running a Presidency are two different things. In the first, you have to make sure you say the right thing at the right time. The second requires executive ability--the skills needed to get things done. Bill Clinton, whose cup runneth over with charisma, was and still is a superb politician. But his lack of executive ability resulted in an eight-year Presidency that was one of the least productive in the 20th Century. His legacy as a President will be modest.
Barack Obama still has time for achievement. Health care reform can yet be passed by Congress. The result won't be as pretty as many would like, and the Senate's leadership would have to commit to work to change the objectionable features. But President Obama now needs to step out front and center and take the lead. He is no doubt stinging from the fact that he campaigned for the losing candidate in Massachusetts this past weekend, after first saying he wouldn't. That hesitant participation in the Coakley campaign is precisely the sort of stutter step that makes the President look weak. But Obama is now in for a dime; he might as well go in for a dollar. If he flinches, the Republicans will know they've got him, not just for health insurance reform, but for the rest of his Presidency. Lyndon Johnson kicked every reluctant Congressional butt necessary to get the great civil rights laws of the mid-1960s adopted, putting his standing at risk. His success made him a great domestic President, second in the 20th Century only to FDR.
By all indications, Barack Obama has an introspective side to his personality, and he's probably thinking things over furiously. No doubt he realizes that his honeymoon with voters is now over. But some of the people around him need to consider carefully that Barack Obama's election in 2008 wasn't as much about him as it was about voter discontent. That discontent is hydralike--it goes in many directions, is difficult to channel, and if seemingly suppressed can sprout back up with greater force than before. Team Obama doesn't have everything figured out, and they have less figured out now than they did three or six months ago. Once they understand this, and embrace it, they'll do better.
Brown won by adopting Obama's strategy of tapping into voter discontent. Martha Coakley, the Democrat, was a legacy candidate, trying to ride into office on Ted Kennedy's legacy. But legacy candidates don't do well these days. Both Hillary Clinton and John McCain invoked the past during their 2008 campaigns and it didn't serve them well. Creigh Deeds, a Democratic candidate for governor of Virginia last year, had a similarly bad experience running as a legacy candidate. Scott Brown is a heretofore minor politician, a Massachusetts state senator with nothing to lose. In a campaign involving such a candidate, the size of the fight in the dog is what counts the most. With the agility of a judo master, he characterized himself as the outraged underdog, and won over outraged voters.
It's unclear that there is much logic to his or their outrage. The Obama administration's health care reform effort seems to have drawn the most populist ire. That defies logic, as this is the one program in Obama's agenda that might offer the broadest benefit to the electorate. But as much as people were tired of George W. Bush's failures, they're also scared of changes in their insurance coverage (if they have any), and they're scared of higher premiums and higher taxes.
Voters are also angry with economic policies. The Bush II administration, in providing hundreds of billions of bailout dollars to banks and having the government assume myriad liabilities that would otherwise have pushed the banking system into bankruptcy, practically socialized the financial system and left taxpayers at risk for untold losses. The Obama administration bought into the Bush administration's bank-loving policies lock, stock and barrel, and added its own economic stimulus package. Bankers rejoiced as their earnings and bonuses rebounded, but taxpayers bemoaned the bonuses and shivered at the thought of their burdens. Even though President Obama has promised to recover the costs of the bailouts, Scott Brown caught him at a moment when he hadn't yet acted on the promise.
Team Obama needs to stop politicking and take a hard look in the mirror. In 2008, they were the smartest guys in the room, propelling a former state senator from Illinois into the White House in 6 years. Then, the Republicans, with footprints all over their butts, did the thing Americans do so well. They thought about what had just happened, how painful it had been, the ways in which they needed to change, and adapted. Some of their changes are weird--it remains possible that the party could melt down in an Inquisitional drive for ideological purity. But other Republicans realized that Barack Obama had won by working from the ground level up, and that they could do the same thing.
Team Obama, by contrast, seems to have become remote, elite. They've appointed a lot of very well-credentialed Washington insiders into high level positions, who've given them a lot of conventional advice that won't ruffle the feathers of too many powerful people. Their policies of bailout and stimulus have mostly helped those that are well-off and influential, but scare the hell out of the middle class. They try to influence bellwether Democratic campaigns, like the recent Virginia governor's election and Martha Coakley's campaign in Massachusetts, but are quick to dodge any hint of responsibility for failure, pre-emptively pointing fingers at the losing candidates. In short, they've taken on a distinct inside-the-Beltway aura, and within less than a year. That's exactly what pisses voters off.
They have to take stock of themselves. Whether or not they can see it, they aren't so smart any more. They didn't anticipate how quickly and completely the Republicans would learn from the 2008 Obama campaign. They don't seem to understand how fickle uncertainty and frustration have made the electorate. They seem more indwelling and hesitant. Why hasn't the President publicly taken the lead on health insurance reform? News stories report that he has been quietly negotiating potential compromises between the House and the Senate. But getting something as big and as controversial as health insurance reform done requires leadership from him more than it requires negotiation. The Democrats haven't wrapped up health insurance reform after a year, and now their lack of alacrity traps them in a situation they failed to anticipate from a special senatorial election.
The Obama team are consummate politicians. But running a campaign and running a Presidency are two different things. In the first, you have to make sure you say the right thing at the right time. The second requires executive ability--the skills needed to get things done. Bill Clinton, whose cup runneth over with charisma, was and still is a superb politician. But his lack of executive ability resulted in an eight-year Presidency that was one of the least productive in the 20th Century. His legacy as a President will be modest.
Barack Obama still has time for achievement. Health care reform can yet be passed by Congress. The result won't be as pretty as many would like, and the Senate's leadership would have to commit to work to change the objectionable features. But President Obama now needs to step out front and center and take the lead. He is no doubt stinging from the fact that he campaigned for the losing candidate in Massachusetts this past weekend, after first saying he wouldn't. That hesitant participation in the Coakley campaign is precisely the sort of stutter step that makes the President look weak. But Obama is now in for a dime; he might as well go in for a dollar. If he flinches, the Republicans will know they've got him, not just for health insurance reform, but for the rest of his Presidency. Lyndon Johnson kicked every reluctant Congressional butt necessary to get the great civil rights laws of the mid-1960s adopted, putting his standing at risk. His success made him a great domestic President, second in the 20th Century only to FDR.
By all indications, Barack Obama has an introspective side to his personality, and he's probably thinking things over furiously. No doubt he realizes that his honeymoon with voters is now over. But some of the people around him need to consider carefully that Barack Obama's election in 2008 wasn't as much about him as it was about voter discontent. That discontent is hydralike--it goes in many directions, is difficult to channel, and if seemingly suppressed can sprout back up with greater force than before. Team Obama doesn't have everything figured out, and they have less figured out now than they did three or six months ago. Once they understand this, and embrace it, they'll do better.
Sunday, January 17, 2010
The Stock Market: Priced, Again, for Perfection
Last week, both Intel and J.P. Morgan announced earnings that significantly beat Street estimates. The market promptly dropped. What gives?
Analysts questioned the loan losses at J.P. Morgan; revenues were also below expectations. Intel's results generally drew praise. The problem, it would seem, is that the improvements at both companies didn't surpass expectations enough. In other words, hitting a home run isn't good enough these days. To see your stock price rise, you have to hit a grand slam home run out of the park, beyond the parking lot and across the street. One doesn't have to delve into the world of whisper numbers and other market rumors to understand what's going on. Just look at the price-earnings ratio.
The price-earnings ratio for the S&P 500, based on trailing earnings, is 70.79 (see p. B4, The Wall Street Journal, Jan. 16-17, 2010). This is way, way, way higher than the historical average of 15. A p/e ratio this high means that investors expect tremendous improvement in earnings or that we have a deliriously bubbly market. Or both. (See http://blogger.uncleleosden.com/2009/12/warning-from-price-earnings-ratio.html.) Whatever the case, it's clear that the market is priced for perfection. Anything less than absolutely gorgeous, gem quality financial reports from bellwether stocks like Intel and J.P. Morgan, and the market will start getting butterflies in its tummy. If this seems familiar, think back to the market peak in 2007, when the Dow topped 14,000, or the tech stock peak in early 2000.
After rising 60% in six months, the market has risen only 4% or so in the last three months. The bull is tired after its long run. Most analysts predict high quality earnings reports this month. But will that be enough? A p/e ratio of 70.79 sets the bar at stratospheric levels.
Some gamblers think that if Scott Brown, the Republican candidate in the Massachusetts special election for senator (to replace the late Ted Kennedy) wins, the market will take off in the belief that a Republican victory will kill health insurance reform and constrain federal spending. If you want to bet on this play, make sure you have your stop loss orders in place. The Democrats can work their way around the loss of a 60-vote majority in the Senate by having the House approve the Senate version of the reform bill or by rushing a compromise bill through the Senate before Brown can be sworn in. Neither alternative would be easy, but both are more palatable to the Democratic leadership than a failure of health insurance reform. The Democrats misjudged the voter sentiment in Massachusetts. But their problems with control of the Senate and the threat it poses to health insurance reform now have their full attention. Be cautious about betting your money on the Democrats making more mistakes.
You might want to get stop loss orders in place anyway. Even if Martha Coakley, the Democratic candidate for senator in the Massachusetts special election, wins, the late Republican surge sends a loud and clear signal to the Obama administration to hold the line on deficit spending, something the administration cannot ignore with the fall mid-term elections approaching. Whether or not the economy needs more stimulus, it won't be getting much more, if any, from the federal budget.
Of course, there's always the monetary printing press at the Federal Reserve, which recently installed showers and bunkrooms for the employees working 'round the clock. But even the Fed, which in the last 15 years hasn't met an asset bubble or an inflationary threat it didn't like, will eventually realize it's pushing on a string. The banks the Fed has been subsidizing are sitting on top of their very cheap federal funds instead of lending them out, while maintaining myriad unbooked losses (with the help of a politically coerced relaxation of accounting standards last year), reporting the resulting "earnings" (it's amazing how well a bank will do if loan losses are unbooked instead of booked), and paying really big employee bonuses. The Fed has avoided triggering inflation because the banks have avoided lending out their federal assistance. They hoard it against the need to book more loan losses. Since the funds don't circulate, they don't trigger inflation, but they also don't stimulate economic activity. That doesn't bode well for a stock market priced for perfection. Caveat emptor.
Analysts questioned the loan losses at J.P. Morgan; revenues were also below expectations. Intel's results generally drew praise. The problem, it would seem, is that the improvements at both companies didn't surpass expectations enough. In other words, hitting a home run isn't good enough these days. To see your stock price rise, you have to hit a grand slam home run out of the park, beyond the parking lot and across the street. One doesn't have to delve into the world of whisper numbers and other market rumors to understand what's going on. Just look at the price-earnings ratio.
The price-earnings ratio for the S&P 500, based on trailing earnings, is 70.79 (see p. B4, The Wall Street Journal, Jan. 16-17, 2010). This is way, way, way higher than the historical average of 15. A p/e ratio this high means that investors expect tremendous improvement in earnings or that we have a deliriously bubbly market. Or both. (See http://blogger.uncleleosden.com/2009/12/warning-from-price-earnings-ratio.html.) Whatever the case, it's clear that the market is priced for perfection. Anything less than absolutely gorgeous, gem quality financial reports from bellwether stocks like Intel and J.P. Morgan, and the market will start getting butterflies in its tummy. If this seems familiar, think back to the market peak in 2007, when the Dow topped 14,000, or the tech stock peak in early 2000.
After rising 60% in six months, the market has risen only 4% or so in the last three months. The bull is tired after its long run. Most analysts predict high quality earnings reports this month. But will that be enough? A p/e ratio of 70.79 sets the bar at stratospheric levels.
Some gamblers think that if Scott Brown, the Republican candidate in the Massachusetts special election for senator (to replace the late Ted Kennedy) wins, the market will take off in the belief that a Republican victory will kill health insurance reform and constrain federal spending. If you want to bet on this play, make sure you have your stop loss orders in place. The Democrats can work their way around the loss of a 60-vote majority in the Senate by having the House approve the Senate version of the reform bill or by rushing a compromise bill through the Senate before Brown can be sworn in. Neither alternative would be easy, but both are more palatable to the Democratic leadership than a failure of health insurance reform. The Democrats misjudged the voter sentiment in Massachusetts. But their problems with control of the Senate and the threat it poses to health insurance reform now have their full attention. Be cautious about betting your money on the Democrats making more mistakes.
You might want to get stop loss orders in place anyway. Even if Martha Coakley, the Democratic candidate for senator in the Massachusetts special election, wins, the late Republican surge sends a loud and clear signal to the Obama administration to hold the line on deficit spending, something the administration cannot ignore with the fall mid-term elections approaching. Whether or not the economy needs more stimulus, it won't be getting much more, if any, from the federal budget.
Of course, there's always the monetary printing press at the Federal Reserve, which recently installed showers and bunkrooms for the employees working 'round the clock. But even the Fed, which in the last 15 years hasn't met an asset bubble or an inflationary threat it didn't like, will eventually realize it's pushing on a string. The banks the Fed has been subsidizing are sitting on top of their very cheap federal funds instead of lending them out, while maintaining myriad unbooked losses (with the help of a politically coerced relaxation of accounting standards last year), reporting the resulting "earnings" (it's amazing how well a bank will do if loan losses are unbooked instead of booked), and paying really big employee bonuses. The Fed has avoided triggering inflation because the banks have avoided lending out their federal assistance. They hoard it against the need to book more loan losses. Since the funds don't circulate, they don't trigger inflation, but they also don't stimulate economic activity. That doesn't bode well for a stock market priced for perfection. Caveat emptor.
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