Sunday, September 30, 2007

A Lesson for Wall Street From GM and the UAW

The recent GM-UAW labor agreement, which remains to be ratified by the UAW membership, marks a potentially crucial transition in health insurance. The union will take over the responsibility for providing GM retirees with health insurance, while GM transfers as much as $35 billion to help cover the costs.

GM's motives are simple. It offloads a potentially enormous liability--said to be as much as $51 billion--and puts itself on a more competitive footing with foreign auto manufacturers, whose health care costs are much lower.

The UAW's situation somewhat more complex. GM, as we all know, has recently spent more time losing money than making it. Its continued viability isn't a certainty. If GM goes bankrupt, it might repudiate its union contracts and cut off health insurance for retirees, leaving them to fend for themselves. The assets transferred by GM will go into a type of trust called a voluntary employees' beneficiary association (VEBA). IF GM goes bankrupt after the VEBA is funded, the VEBA remains to provide retiree health insurance. Granted, retirees will probably face higher co-pays and deductibles than before. That's still better than paying for individual policies.

The Chinese have a saying that when enduring difficulties, one "eats bitterness." No doubt many UAW members feel as if they are eating bitterness now. However, the new labor pact also represents one of America's great strengths: its economic flexibility. Health care costs have been rising faster than incomes and inflation. American companies faced with foreign competition have complained loudly about having a disadvantageous cost structure. By shifting the cost of retiree insurance to the UAW-run VEBA, GM's unionized employees have helped to level the playing field. While more of the responsiblity for health care will fall on the union and retirees, more of the responsibility for making the company succeed will fall on GM's management. They've now negotiated away one of their loudest excuses for failure, and it becomes incumbent on them to produce successes instead of making excuses. Recent high ratings for some Buick products suggest that GM may yet be able to accomplish the one thing it must: put out high quality vehicles.

The pressures and risks of the marketplace have fallen heavily on GM and its employees. They have responded, and the company may return to prosperity.

On Wall Street, however, all the talk is about further government indulgence in the form of more Federal Reserve interest rate cuts. The S&P 500 closed higher at the end of the third quarter than where it started, notwithstanding the mortgage mess. The only reason for that level of performance was the Fed's Sept. 18, 2007 interest rate cuts. Perhaps, over the last couple of days, many hedge fundies have high-fived their way through a champagne-soaked weekend as they game out the chances of more Fed cuts. Even though it wasn't the stated purpose of the Fed to bail out financial speculators, you won't convince the speculators of that. They've learned that if they take a lot of risk, the Fed can't afford to let them fail. So all their incentives are to make more money by taking even more risk, knowing that they've got the Fed boxed in. The fact that they might ultimately create an untenable amount of risk and stress in the financial system gets scant attention because, presumably, it can always be deferred another quarter by another Fed rate cut.

With no government bailout in sight, GM and the UAW took private sector action to resolve the health insurance problem that governments in America simply haven't been able to solve. Although the skies over Michigan are dark right now, this could be a beginning of better times. On Wall Street, the weather appears to be clear and sunny. Believing that they've got the Fed to cover their bets, the financial types have no reason to leave the casino. Government subsidies have never brought true prosperity on any industry. But, while the bonuses are good, you'll never get anyone to believe that.

You've been waiting for this: a new stone skipping champion.

Friday, September 28, 2007

Losses From the Federal Reserve Interest Rate Cuts

As the stock market continues to shine in the light of the Federal Reserve’s recent interest rate cuts, let’s consider the losers. There were losers. Today’s financial markets allow you to profit from virtually any change in direction of any financial instrument. Some profited from the pain of the subprime mortgage mess. Most prominently, this included investment bank Goldman Sachs, which recently reported a sizeable gain from betting that the mortgage markets were going to belly flop. Who were losers?

Those that held dollar denominated assets. The dollar was sinking before the rate cuts, and sank even more afterwards. Anyone who held dollar denominated assets lost money. Americans, whose native currency is the dollar, are relatively unaffected by the loss, unless they travel overseas or need to buy imported goods from Europe. In order to protect export industries, China largely links its currency to the dollar, and Japan tries to keep its currency from dropping much against the dollar. So the prices of goods from China are not likely to be affected much by the drop in the dollar, and the prices of goods from Japan will probably be affected only to a limited extent.

Foreigners and foreign nations took significant losses. Many apparently are shifting their investments out of the dollar and into other currencies. The oil producing Middle Eastern emirates, who have to invest large pools of cash from their oil profits, are said to be doing this.

Another big loser was China. Because it keeps its currency in rough parity with the dollar, a drop in the dollar means a drop in China’s currency (the yuan). China imports a lot of oil, which is priced in dollars and becomes more expensive when the dollar drops. The Chinese central bank has already announced that it is investing some of its dollar denominated assets in other currencies. That trend can be expected to continue.

Those that bet against inflation. The aggressiveness of the Fed’s interest rate cuts heightened inflationary fears. Those fears are reflected in yields on the 10-year Treasury note and the 30-Treasury bond, which have risen since the Fed rate cuts. Everyone who was holding these longer term Treasury securities before the Fed cuts has taken losses. Losers would include many investment banks and hedge funds, which hold these securities as hedges, investments, and sales inventory, and for other purposes. Many other investors bought them as part of a flight to quality. Now that the Fed has made riskier investments more attractive, quality investments suffer by comparison.

Those that believed the Fed would act slowly. Many believed, during the past summer, that the Fed had signaled it would be reluctant to do anything that might smack of a bailout of investors who made reckless decisions. The derivatives market would have provided ways to place bets on a slow process of accommodation. The Sept. 18, 2007 half-point cuts were a surprise accommodation that was anything but slow. Hedge funds and everyone else who had bet on gradualism got a scrape on the knee.

Many of the losers were diversified or hedged, and would likely have profited from other holdings and positions. But the effects of the rate cut may be muted by the fact that it caused some loss. How bad were these losses? We might get some idea in early October, after the close of the third quarter for commercial banks, and again in early December, after the late November close of the fiscal year for investment banks.

The U.S. economy may be the biggest loser. The Sept. 18 rate cuts took the financial markets a step away from the notion of market risk. They may have provided too much comfort to speculators, and, most importantly, to the banks that financed speculators. These constituencies now expect a bailout whenever they stumble. If the government bails out investors and lenders who make bad decisions, then capital will remain misallocated in favor of those bad decisions. Economic rewards will be based on governmental and political considerations. Markets will play a secondary role. Economic pain will be allocated toward those that lack political power, such as hourly wage workers and small businesses. Holders of capital will choose to invest in businesses that have influence in Washington, while ideas with economic merit remain unfunded.

Even though the Fed’s rate cuts were meant to stimulate the economy, the result might turn out to be . . . Japan, where a central bank policy of accommodation after the 1989 stock and real estate market crashes led to stagnation. The accommodation was made, to a large degree, to protect Japan’s banks from having to write down a plethora of bad real estate loans (does this sound familiar?). The overhang from this debt lasted for about 15 years, while Japan’s banks did little to finance new commerce or industry. Even today, Japan has not recovered the economic vibrancy it had in the 1960s, 70s and 80s.

In Asia, during the years when Japan was crippled by bad loans it refused to confront, a newly capitalist and very hungry China became a manufacturing giant. Today, China, India and other low cost-manufacturing nations endeavor to become wealthy by producing inexpensive goods and services. In America, people try to become wealthy by speculating in asset values and financial derivatives. After the huge run-up in real estate values from 2001 to 2005, there isn’t likely to be much future wealth generation from real estate for a long time (see our previous blog at However, in spite of all of the Fed’s public commentary, there seems to be little doubt in the financial markets that the Fed will prop up stocks and financial instruments derived from real estate values.

The wealth of nations doesn’t come from government subsidies, nor does it come from making speculators and their financiers welfare queens. As hedge funds hire the cream of the business schools’ graduates, one wonders whether America’s intellectual capital is being misallocated. The tech sector didn’t get a government bail out after the 2000 crash. Many idiotically conceived dot com companies collapsed and lots of mostly young people lost their jobs. Today, America’s tech sector is vibrant and unemployment rates remain low notwithstanding one month’s disappointing data. We learn more from our losses than our successes. Will the Fed’s policies impede Wall Street’s move up the learning curve?

Crime News: Man admits stealing 1500 girls' shoes. Did you ever think that Imelda could be surpassed?

Tuesday, September 25, 2007

When Will Housing Prices Recover?

Today, September 25, 2007, the National Association of Realtors reported that sales of existing houses had fallen again, for the sixth straight month. Sales in July 2007 fell to a seasonally adjusted annualized rate of 5.5 million, down more than 12% from last summer. The NAR reported that prices of homes sold had actually risen 0.2% from a year ago. But another source, the S&P/Case & Shiller Index, reported that home prices were down 4.5% from July 2006 to July 2007. Most other data indicate falling home prices.

A question on the minds of all homeowners, home sellers and home buyers is when will prices stabilize and recover? Of course, no one knows for sure. Predicting the weather is much more certain in economic prognostication. There is, however, an investment technique that may provide insight.

Many money managers subscribe to the notion that assets have predictable values that can be discerned from historical information. For example, bond traders posit that interest rates will generally be higher the longer the maturity of a financial instrument. Thus, a 30-year Treasury bond should usually have a higher interest rate than a 2-year Treasury note. This phenomenon is called an upwards sloping yield curve. The yield curve can also invert, with rates on longer term debt becoming lower than rates on shorter term debt. That was the case for much of the last few years. Treasury markets traders sometimes employ trading strategies based on the idea that the anomalies in the yield curve will disappear eventually and the yield curve will revert to its normal upwards sloping shape. This strategy is called a reversion to mean, because it posits that the yield curve will eventually revert to its mean (or average) relative values.

The concept of reversion to mean can be employed with other assets. Let's look at housing. Housing prices, over the last century, have increased at a rate of about 1% per year, net of inflation. For most of this time period, the rise in housing prices was gradual. In some periods, like the Depression of the 1930s, prices fell.

However, from 2001 to the end of 2005, housing prices rose about 30% net of inflation, a rate vastly in excess of the historical mean. This eye-popping rate of increase is why housing prices were in a bubble, and why the bubble eventually had to burst. Growth in household incomes, which has been virtually negligible, couldn't begin to finance prices increases like these. The creativity and recklessness of the financial markets was strained to the limit to devise new and increasingly implausible mortgage loans. But even the stupidest of teaser rate option ARM mortgage loans eventually became untenable when used to finance prices increases wildly beyond the growth in buyers' true ability to pay.

Housing prices have fallen about 7%, net of inflation, since the 2005 peak. Thus, they are about 23% above 2001 levels, net of inflation. If we assume that housing prices had risen at their historical average rate of 1% since 2001, we'd have a total increase of 6% (after inflation). Current housing prices, however, are about 17% above that level.

The implication of this analysis is that if you buy a house at today's prices, you may not see any increase in value, net of inflation, for about 17 years. This conclusion is dependent on a number of variables, such as the rate of growth of the U.S. economy, growth in individual and household incomes, the availability of credit for home mortgages, government policies toward housing, so on and so forth. And it is based on national average figures, which may not entirely apply to many individual housing markets. But if we assume that housing, like other assets, adheres to a predictable pattern, returns from owning a home, after adjusting for inflation, will probably be modest for over a decade, and perhaps for much longer.

During the first 40 years of the 20th century, housing values meandered. From 1989 to 2000, housing values, net of inflation, showed losses rather than gains. There's no reason to think that another 15 or 17 years of no net gains after inflation aren't possible. Stocks, by comparison, have risen around 2% t0 3% a year after inflation. That's why putting your retirement money in a diversified portfolio containing a significant stock component is likely to work out better than betting the ranch on, well, the ranch.

Tech News: Is someone listening in on your Internet phone calls?

Sunday, September 23, 2007

Financial Market Speculators Jump Back on the Merry-Go-Round

Scarcely a moment had passed after the Fed announced its interest rate cuts before speculators jumped back into the financial markets. As reported in the Wall Street Journal (9/20/07, p. C1) and the Washington Post (9/22/07, p. D1), the Fed's interest rate cuts prompted increased speculative interest in emerging markets and the petroleum markets. These markets are expected to benefit from the rate cuts, but aren't tainted by the subprime mortgage and other other asset-backed securities messes. Thus, investors haven't lost confidence in them and they are ripe for bubbles. As reported by the Journal, one gambit is to jump in now, at an early stage, and pray for irrational exuberance. Speculators aren't gun shy about bubbles; they hope for them.

It goes without saying that the Fed would not have wanted to encourage more speculation,. Speculative excess has already brought us the 2007 credit crunch. The emerging markets were the bubbly source of the 1997-98 financial crisis. That, as you may recall, culminated in the near-collapse of Long Term Capital Management, hailed by some as an unsinkable battleship among hedge funds. And it was in the energy markets last year that Amaranth Advisers, another large hedge fund, foundered on the shoals of high leverage and high risk.

Profiting from government subsidies, however, is a time honored way of making easy money. Is it a surprise that agriculture has shifted away from the family farm to big-time enterprise? The availability of the government subsidies attracts capital and makes large-scale, subsidized operations the sensible thing to do.

There is a lot of speculation in agriculture. Farmers are gamblers by the nature of their occupation. But the amount of cropland available, and a variety of other factors, limit the extent to which farmers can speculate. Yields can increase by 10%, 20% or even somewhat more for any given crop from year to year. But they can't increase by several hundred fold.

Financial derivatives, on the other hand, allow investors to transact in equivalents of the underlying assets, and can multiply the amount of money invested with respect to those assets many times over. There is only so much crude oil being recovered at any given moment in time. But there are few effective limits on the amounts of derivative contracts based on crude oil that can be traded or held. And derivative contracts based on emerging markets are similarly without effective limits. Thus, the amounts of speculative risk derived from these markets can balloon upwards quickly, constrained only by the instincts of market participants for caution. The latter, as we now know from the subprime mess, may be scant.

Also scant is the Fed's ability to monitor ongoing and future speculation. The near complete absence of regulation of hedge funds and other entities of their ilk leaves the Fed with no comprehensive information about the extent of the risks building up in the financial system. Instead, it must rely on anedoctal information, making monetary policy perhaps in response to hearsay.

Could speculation in the emerging markets and the petroleum markets create levels of risk comparable to the problems of the mortgage markets? There's no way to know. There's no way to prevent it. And there's no reason to believe that it won't eventually endanger the stability of the financial system.

Past opposition to the regulation of hedge funds and the derivatives markets has been ideological in its fervor. But what ideological purpose is served by the government indemnifying the financial system from unmonitored, unregulated and unlimited risk? We have what is government insurance of financial assets on the one hand, without any controls over the risks to which those assets are placed. No commercial property insurer would provide coverage without assessing the risks involved and insisting on some controls over them. Moreover, it would charge premiums.

The Fed's interest rate cuts may bolster the economy. Or they may not, depending on how things go. With a falling dollar, rising oil prices, rising food prices and continued Brobdingnagian federal deficits, the prospects for inflation are hardly rosy. Now that the asset speculators have resumed their merry romp, perhaps we should ask the question that should have been asked with respect to another government policy: how does all this end?

Animal News: Cat returns from Oz.

Friday, September 21, 2007

Personal Investment Vignettes: XBRL, Pink Sheet Labels, and Art Loans

Here are some personal finance pointers, geared for those of you who like to research and select your own investments.

1. XBRL Interactive Capability for Investors. XBRL is a computer language providing an interactive capability that could help investors compare particular types of data for companies. For example, if you wanted to compare earnings per share and revenue growth for the same or different companies, XBRL is meant to make it easier to retrieve and use the necessary information. This application of XBRL is currently a pilot project of the SEC, and you can test it yourself by going to the SEC website (, look for the link on the left hand side of the home page that says “interactive data,” and click on it. Then, look at the bottom of the “News” section for “Interactive Financial Report Viewer” and click on that. You’ll go to a different website that has the pilot program. Pick a company’s filings, and start playing around. You can create charts, print out the information you see, and get the data in an Excel speadsheet. This is still a pilot program, and the few dozen companies participating are volunteers. The SEC just announced, on Sept. 20, 2007, that the market cap for XBRL companies has reached $2 trillion.

Although the Commission’s enthusiasm for XBRL sometimes has the spontaneity of a May Day celebration in Beijing, the use of XBRL is likely to grow. There are a couple of things to remember. First, XBRL may tend to standardize analyses, by encouraging users to compare companies using types of data that readily apply to all or many companies (such as earnings per share). This type of analysis could overlook the unique qualities that a company may have. The special features of the company may separate it from its competitors, and could be crucial to a wise decision to invest, or not invest. Too much reliance on XBRL analysis may lead you to more easily overlook a company’s individual strengths (and weaknesses). Stated otherwise, all the number crunching in the world doesn't replace sound judgment.

Second, another potential issue is that if XBRL analysis tends to become standardized (with everyone focusing on a limited number of types of data), the temptation for fraudsters to manipulate those types of data will increase. Thus, the data that everyone concentrates on may actually become less reliable. It will be important for auditors and the SEC to keep a close eye on this potential problem.

2. Pink Sheets Labels for Stocks. The Pink Sheets have historically been a trading venue for low-priced stocks about which little was often known. Not infrequently, these stocks were the subjects of manipulations and other scams. The Pink Sheets are now an electronic quotation system. In an apparent effort to upgrade its image, the Pink Sheets now attach a label to each listed stock. There are four labels: (a) a “PS” that indicates current information is available about the company; (b) an inverted triangular “Yield” sign indicating that only limited information about the company is available; (c) an octagonal “Stop” sign that indicates no information is available about the company; and (d) a skull and cross-bones, indicating that the company has been promoted by spam or other questionable means. If you’re thinking about investing in Pink Sheet stocks, pay attention to the label.

One more thing: if you see a “Q” at the end of a Pink Sheet company’s stock symbol, that means the company is in bankruptcy proceedings. If you’re at the Pink Sheets website ( and click on a bankrupt company’s symbol, you’ll be taken to the Pink Sheet page about the company. It will prominently display a warning that the company is in bankruptcy. Think carefully before investing. Bankruptcy proceedings are meant to help the debtor and provide some protection to creditors. Shareholders are last in line at the trough. Often, the shareholders of a bankrupt company lose all the value in their stock after the company is reorganized or liquidated.

3. Art Loans. Be careful taking out loans against your art. The Wall Street Journal (Sept. 1-2, 2007, p. B1) reports that, as the financial markets have recently become unsettled, banks and other lenders are becoming skittish about making loans collateralized by art. They are demanding better collateralization, and stiffer terms. That’s just as well, since you should think very carefully before using art work as collateral. You lose big if the work is ever repossessed. Your neighbor can buy a Maserati to match yours. But there’s only one of the van Gogh on your wall, and that’s your van Gogh, unless you allow it to become the bank’s property.

Animal News: here's why you shouldn't put a rattlesnake in your mouth.

Wednesday, September 19, 2007

Did the Fed Lower Interest Rates Because of the Threat of Inflation?

The Federal Reserve lowered the fed funds rate and the discount rate by 0.5% each on Tuesday, September 18, 2007. The stock markets celebrated, with the Dow Jones Industrial Average jumping almost 336 points. Many commentators attributed the Fed action to the need to combat a slowing economy and the credit crunch in the financial markets.

However, the Fed's statement accompanying the interest rate cuts noted that the Fed "judges that some inflation risks remain" and that it would "continue to monitor inflation developments carefully." The Fed promised that it would "act as needed to foster price stability and sustainable economic growth."

A commitment to "foster price stability and sustainable economic growth" hardly reflects a pyromaniacal desire to light a fire under the economy. Indeed, the Fed stated that "[t]oday's action is intended to help forestall some of the adverse effects on the broader economy that might otherwise arise from the disruptions in financial markets and to promote moderate growth over time." Moderate growth over time? That's worth a 336 point one-day jump in the Dow?

Let's consider the nonobvious. Perhaps inflation really did have something to do with the Fed's interest rate cuts. We'll put ourselves in the shoes of the Fed. Most of the Fed governors and the Fed's professional staff are economists, and economists love data. So we'll dive into some data.

Inflation is measured by assuming that an index of prices from a base time period starts with a value of 100. The Bureau of Labor Statistics (, which compiles the Consumer Price Index, uses 1982-1984 as the base time period. Price increases are incorporated into the base from time to time, and elevate its value. Price decreases are also incorporated into the base and push its value down. The Consumer Price Index for all Urban Consumers (CPI-U) is a commonly employed measure of inflation.

By August 2006, the value of the CPI-U had risen to a value of 203.9. This means that consumer prices, on the whole, had slightly more than doubled compared to the base period of 1982-1984. Then, a funny happened on the way to the Forum. The CPI-U fell. In September 2006, its value dropped to 202.9. In October 2006, its value fell further to 201.8. In November 2006, its value drooped even lower to 201.5. Only in December 2006 did consumer prices resume their upward march, moving up slightly to a value of 201.8. That, however, was still more than 1% lower than prices in August 2006. It was not until March 2007 that the CPI-U exceeded its value in August 2006.

The reason for this dip in the CPI-U was primarily due to the drop in oil and gasoline prices that began last August and continued into the fall. Gas was as high as $3.00 a gallon in the summer of 2006. By the late fall, it had fallen into the lower end of the $2 a gallon range. Such a dramatic price drop produced temporary deflation, a welcome but rare event.

Inflation is popularly measured from year to year. Most people don't care that, technically speaking, the value of the CPI-U was 208.299 in July 2007. What they care about is how fast consumer prices are rising annually. And that's the problem facing the Fed.

If consumer prices now simply stay level, the rate of inflation will increase this fall. That's because of last fall's price decreases. They will cause the difference between this year's price level and last year's level to increase, resulting in a higher inflation rate. This isn't just a statistical phenomenon. It is a reflection of the differences between real prices real people paid last fall and real prices real people face now. It depicts a true economic burden because people are no longer getting last fall's lower prices.

The cognoscenti among readers might note that the Fed prefers price indexes exclusive of food and energy costs (often called the "core" rate of inflation). Food and energy prices are sometimes volatile and create short-term upswings and downswings that wash out over time. Okay. If you look at the CPI-U excluding food and energy costs, you'll find a smaller, but similar trend. In August 2006, the CPI-U excluding food and energy costs was at 206.7. In September 2006, it rose to 207.2, and in October it rose again to 207.8. However, in November 2006, it dropped to 207.6 and in December 2006, it dropped again to 207.3. It would be in January 2007 that the CPI-U rose above its October 2006 peak. Thus, if the CPI-U excluding food and energy costs stays level this fall, the year-to-year change will increase. Again, we would see inflation rising.

It is doubtful that consumer prices, whether measured by the CPI-U or the CPI-U excluding food and energy prices, will stay flat this fall. Petroleum prices have recently reached an all time peak over $80 a barrel, and food prices keep rising relentlessly (up over 4% compared to last year). The core rate of inflation for producer prices revealed on Tuesday morning was 0.2% for August 2007, a disquieting figure. An increase in the rate of inflation this fall is virtually inevitable.

The Fed knows this. If they had waited to lower interest rates, or lowered them only a quarter point on Tuesday, the increase in inflation later this year could easily stymie an effort to lower interest rates later, even if the evidence began to show more clearly that the economy was headed for a recession. The Fed's reputation as an inflation fighter, which is crucial to its ability to stimulate the economy while keeping prices stable, would be mud if it cut rates in the face of rising inflation. Thus, it had to cut interest rates now, before the likely inflation statistics tied its hands.

It's unclear whether the economy will tip over into a recession. What's clear is that inflation will likely increase. By lower interest rates now, the Fed may have been trying to get ahead of the curve with respect to the economy. It almost surely was trying to get ahead of the curve of rising inflation.

Crime News: turmoil on Wall Street reaches the gym.

Monday, September 17, 2007

If the Fed Lowers Interest Rates, It's Not About You

Much of the debate over how to deal with the ongoing credit crunch is whether or not the Fed should assist investors holding real estate-related investments with a cut in the fed funds rate. Free market purists believe that any hint of a bailout would be anathema. Investors, they contend, should be required to act like adults and suffer the consequences of their decisions. If they made a poor investment decision, they should incur the loss. This allows the market to function properly and allocate resources efficiently.

If the Fed bails out investors, moral hazard infiltrates the market and resources are misallocated by government subsidy. The purists note that government subsidies, once created, are never repealed. The misallocation of resources becomes a permanent distortion of the economy. Agricultural interests and homeowners in flood plains are prime examples of this phenomenon. While very little farm subsidy money is paid today to American Gothic-type family farmers, agricultural subsidies have become as permanent a part of America as the freedom of speech and religion. Houses that should never have been built have been constructed and reconstructed dangerously close to threatening waters.

The Fed is clearly intent on protecting the banking system, as is its legal mandate. Banks are at the heart of the financial markets. If the banking system doesn’t function properly, money—which today consists largely of credit, not green pieces of paper—stops flowing. In colonial America, if you had no money, you could swap a few beaver pelts and buckskins for bacon, flour, powder and lead. Today, however, money is the currency of the land. The Fed has been providing liquidity to the banking system in order to keep things steady. However, it has resisted lowering the fed funds rate, to avoid the specter of a government bailout of wealthy, but reckless, investors.

Recently, however, the government has reported a bad job growth number. Even though this datum is one bit of information in a sea of ambiguous information, numerous market participants, observers, and pontificators have seized upon it and cried out for a reduction of the fed funds rate. If monetary policy were dictated by majority vote of the punditocracy, a rate cut would be beyond doubt.

The Fed’s members, by all indications, have no appetite to bail out the Bentley-buying hedge fundies who, in spite of their name brand Bachelor degrees and MBAs, thought that real estate values would rise forever. But one must ask whether circumstances will force the Fed’s hand. What if the banks are among the investors who made foolish real-estate related investments and are now facing serious losses?

As we discussed in our earlier blog (, many large banks have set up affiliated entities not included on the banks’ financial statements, called conduits and SIVs (structured investment vehicles). They use these affiliates to borrow money in the commercial paper market and invest in mortgage backed securities and derivatives. This strategy of borrowing short term to invest long term carries significant risks, as the savings and loan associations found out in the 1980s. It seems especially reckless when one considers the inverted yield curve we’ve had during much of the past few years. To make this risky strategy work, a bank, through its conduit or SIV, would have to find medium or long term investments that provide returns exceeding its elevated short term cost of borrowing. It appears that some institutions climbed up the risk ladder to get higher yields from asset-backed investments. That would be a brilliant strategy as long as real estate values never stopped rising.

The conduits and SIVs were backed by standby lines of credit offered by banks, usually the ones that sponsored them. These lines of credit gave the conduits and SIVs the credibility to borrow in the commercial paper markets. But when commercial paper buyers got the asset-backed heebie jeebies, conduits and SIVs had to draw on their standby lines of credit to repay maturing commercial paper. As a consequence, the mortgages and other assets that the conduits and SIVs held were effectively added to the banks’ balance sheets. In other words, the banks held the risk of loss on these tamales after all. And, as the tamales got hotter, the banks’ losses grew.

There’s the rub for the Fed. The banks, as well as $1,000 a bottle champagne-drinking hedge fund managers, were making reckless investment decisions. They were doing so in conduits and SIVs that they kept off their financial statements, so the risks weren’t immediately obvious. But chickens, even though they strut and peck wherever they might, eventually come home to roost. And the losses for the conduits and SIVs are strutting towards the banking system. While the federal banking regulators might do well to investigate whether or not banks were inappropriately reckless, they also have to worry about the stability of the banking system.

The major banks appear to be well-capitalized. But no one knows the full extent of the credit crunch losses. Banks have direct exposure to conduits and SIVs to which they've loaned money. Enumerating the losses remains a challenge, as many of these assets have been accounted for by mathematical models, and the reliability of those models has been Yugo-like when confronted with the realities of a falling real estate market. (See our blog at And what about the banks' indirect exposure? The credit crunch has pushed down all kinds of asset values. Financial institutions all over the world are sustaining losses in disparate markets. Every week, another bank somewhere needs a bailout. Last week, a U.K. bank called Northern Rock was bailed out by the Bank of England. The American banks surely want a fed funds rate cut, because it would likely improve the third quarter financial results they report in early October. And the Fed, which lives in fear of a run on the banking system, would be sorely tempted to help them in order to maintain confidence in the banking system.

The Fed meets on Tuesday, September 18, 2007. If it lowers interest rates, many will applaud. The applauders will be unable to resist the temptation to think that they had something to do with it. Hedge fund operators will believe that their lobbyists in Washington came through for them. Real estate interests will think that they were astute in manipulating financial journalists to take their point of view. Politicians will take credit in publications mailed to their constituents at taxpayer expense. Editorial page editors across the nation will think that the Fed heeded the outcry from the citizenry.

That the Fed might have been simply discharging its lawful mandate to protect the safety and soundness of the banking system may be lost amidst the surge of acclamation and credit-taking. All of the beneficiaries of a rate cut will think it was done for them, and will conclude that the Fed should always be there for them. Thus it is how government subsidies become a permanent part of our national landscape. The iron rice bowl proved untenable in Communist China. The laws of economics do not make it any more tenable in America. When, however, the iron rice bowl is provided to the wealthy and powerful, learning that lesson will be time-consuming and costly.

Crime News: a bathroom gets its 15 minutes of fame.

Friday, September 14, 2007

Health Insurance Update

We’ve previously listed a number of ways to look for health insurance coverage. See It’s a difficult problem, because there are no easy or inexpensive alternatives (unless your income is quite low, but that isn’t fun either). Here a few more thoughts.

1. Eligibility website. A website at can help you determine whether or not you are eligible for various types of health insurance coverage, and what your options might be. Click on the “Eligibility Tool” at the top of the home page. You’ll have to answer a few questions about prior coverage, income, age, health, and any special status you might have, and then you’ll be given advice. The website may help you locate coverage about which you might not have known. You can also call 1-800-234-1317 for assistancfe.

2. Individual Policies. Some health insurance companies are now making greater effort to offer plans for individuals. The ranks of the uninsured are growing every year, which means the insurers’ customer base in employer group policies is shrinking. So the insurers are reaching out to new customers. Also, they no doubt realize that the more people are uninsured, the greater the potential for government intervention that might take their business away. That could happen anyway, since many of the individual policies offered tend to target young people. These policies may also have high deductibles and significant limitations on coverage (maternity care may not be covered, and if you or your spouse is pregnant, that’s a whopping huge limitation). But if you have no other good choices, this is something to consider. The big health insurers like Blue Cross, Aetna, Humana and Kaiser Permanente may be worth contacting.

3. HIPAA. The Health Insurance Portability and Accountability Act requires, among other things, that individuals who have at least 18 months of coverage under a group plan must be accepted for coverage in individual plans without limitations for pre-existing conditions. The individual must have been covered by the group plan within the last 63 days. A person covered under COBRA rights by a prior employer also has the right under HIPAA to individual coverage without limitation for pre-existing conditions. If you’re going to lose group coverage, remember your HIPAA rights and make sure you continue your health insurance coverage.

Animal News: when it comes to police work, nice dogs finish last.

Wednesday, September 12, 2007

Investing in Volatile Times

With the markets turning bipolar, and a bank or two being bailed out every week, investors are understandably nervous. Different asset classes take turns losing value. Investments thought to be safe, like money market funds, turn out to hold asset-backed commercial paper, a security some now deem toxic. Information about the extent of the subprime mortgage and related messes is inadequate. In these times of confusion and incomplete information, many market participants may be buying and selling for the wrong reasons. That only increases the seeming irrationality of the markets.

What’s an investor to do? Here are a few ideas.

1. Diversify. If you can’t reasonably predict which assets will rise and which will fall, diversification allows you to use gains from rising assets to offset losses from falling assets. Your portfolio’s volatility will be muted, and your antacid budget reduced. Diversification is also the sensible way to invest for the long term, so you’re doing your retirement planning a good turn.

2. Dollar-cost averaging. A standard investment technique is to invest a fixed amount of money at regular intervals. The bi-weekly or monthly contribution you make to your 401(k) or equivalent retirement account is a good example of this approach. By investing a fixed amount at regular intervals, you average out the costs of your investments and avoid the risks of trying to time the market. Most investors (and many professional money managers) are not very good at timing the market. Given the long term historical rise of the stock markets, it makes sense to stay in the game. Dollar-cost averaging ensures that you do so without having to guess which fork in the road the market will take tomorrow.

3. Ease back from 80 mph. Another way to reduce the volatility of your portfolio is to make it more conservative. Stick to well-established investments built around benchmarks you understand—index funds, short or medium term bond funds, and money markets. Or go with a lifecycle or target date retirement fund. These funds are long term investment vehicles where the fund managers do the diversification for you. Because they are retirement-oriented, they generally aren’t loaded with risk. Instead, they tend to stick to meat-and-potatoes funds for their equity exposure. See our discussion of lifecycle funds at Conservative investments may, in fact, do well in the next few years. Risk is being re-priced, and low risk investments may be relatively valuable for a while.

4. Save whichever way you can. If you really can’t stomach the ups and downs and uncertainties of the financial markets, put your money into safe, short term investments like money market funds, credit union and bank CDs, and high interest rate online bank accounts. See our earlier blog for suggestions about short term investments. If you’re concerned about interest rates dropping, buy a CD with a term of several years, or U.S. Treasury notes with similar maturities. That way, you’ll lock in current rates. This strategy could turn against you if interest rates rise (which isn’t forecast by most seers, but the one thing that’s certain is you never know for sure). With the uncertainties of the times, ensuring that you save, however conservatively, remains a smart move. If the only way you can bring yourself to save is to put your money into today’s equivalent of the mattress, then go for it. Maybe, when things calm down a bit, you can diversify. But the worst thing to do is to stop saving.

Entertainment News: read about the air guitar champ.

Monday, September 10, 2007

Conduits and SIVs: a Chill from the Shadow Banking System

A rising market covers up a multitude of risks. But when the market falls, things that seemed clever may turn out to something else. Many major banks have used off-balance sheet vehicles to secure funding. We discussed this phenomenon in It would seem that some of them may have misjudged how things would turn out.

In general, a bank might use an off-balance vehicle called a conduit or a SIV (or structured investment vehicle) to purchase its loans and securitize them. The bank frequently provides the conduit or SIV a standby line of credit or other credit facility, that allows the conduit or SIV to issue commercial paper. The funds from the commercial paper are used to buy loans from the bank, which are then pooled into asset-backed securities (such as mortgage-backed securities). The conduit or SIV, in essence, becomes a source of funding for the bank. These vehicles are typically not consolidated on the bank's financial statements and are not regulated as if they were part of the bank. They are, in essence, a shadow banking system, that operates in tandem with the regulated banking system. However, the standby credit facilities that the bank provides, if drawn down by the conduit or SIV, can make the conduit's or SIV's problems part of the bank's problems. So the conduit or SIV can have an impact on the regulated banking system.

The business model for these off-balance sheet entities contains the potential for a serious bank management mistake. The commercial paper that funds the conduit or SIV is short term money. The mortgage-backed securities and other asset-backed investments that the conduit or SIV invest in are longer term. Problems arise if the conduit or SIV can't roll over its commercial paper. It would lose the continuing funding for its longer term investments, and would have to liquidate them, if possible, in order to pay the maturing commercial paper.

Today, mortgage-backed securities have largely become toxic, as have many other asset-backed securities. A lot of money market investors don't want to buy the commercial paper offered by conduits and SIVs because of their heavy exposure to these toxic assets. And the conduits and SIVs would have difficulty selling their toxic assets. So they might have to default on their commercial paper--but for the standby credit facilities provided by the banks that set them up.

If the conduit or SIV draws on the credit facility, the toxic assets effectively belong to the bank. The risks the bank sought to avoid by using off-balance sheet vehicles end up on the bank's balance sheet anyway, and losses from those risks may reduce earnings. Banks that presented themselves to the world as well-capitalized and as prudent allocators of their assets may turn out to have been more reckless and less solid than one might have thought. The soundness of their management's strategies could be called into question. Borrowing short to invest long is a time-honored mistake by bankers. They did it in the 1980s, and got burned. Okay, conduits and SIVs are essentially unregulated, but why would the absence of federal banking examiners make a risky strategy any less risky?

To make things more interesting, recall the yield curve inversion of recent years. One wonders how the banks could have effectively used conduits and SIVs with the yield curve inverted for so long. As bond market aficionados know, a yield curve inversion means that intermediate term interest rates have often been lower than short term interest rates. This is anomalous because one would expect to pay a higher rate to borrow for ten years than two years. But such was often not the case.

With the conduits and SIVs borrowing at short term rates, and investing in longer term maturities, they could have found themselves running a negative cash flow if they invested in the more conservative debt instruments. Did they climb up the risk ladder in order to make their borrow short, invest long strategy appear to be profitable? Did they remember that the higher up the risk ladder you climb, the harder the fall if the market fails to continue rising indefinitely? Do the banks' managements have any good explanation for allowing the conduits and SIVs to pursue a borrow short term, invest longer term strategy while the yield curve was inverted?

A couple of Australian banks and a Singaporean bank have apparently been forced to provide assistance to conduits they sponsored. Rumors of conduit problems have swirled around Citigroup.

The efficacy of the regulators' oversight could also be called into question. Were the conduits and SIVs just accounting sleights-of-hand that allowed banks to take off-book risks that were effectively on their books? How was the apparent enthusiastic use of conduits and SIVs, backed by standby credit facilities provided by their sponsoring banks, compatible with the maintenance of the safety and soundness of the banking system? The regulators should be familiar with risks of borrowing short term and lending long term. Did they question the use of conduits and SIVs? Did they consider the wisdom of the basic business model of these entities in light of the inversion of the yield curve? As the debt markets proceed with their decline, a multitude of risks taken in the shadow banking system may see the light of day.

Strange News: an airline dress code?

Thursday, September 6, 2007

Be Wary of the Allure of Short Term Trading

The financial markets eagerly await the federal government's August jobs report, due to be released on Friday, September 7, 2007. If the number for job growth is low--less than 100,000, for example--the markets will probably rally. If job growth is high--200,000 or more--the markets will probably tank. The thinking is that a low number indicates a flagging economy, one in need of the fed funds rate cut that the market badly wants from the Federal Reserve. A high number, on the other hand, indicates a strong economy with the potential for inflation. That would very possibly lead the Fed to stay the course on interest rates.

Rate cut proponents point toward the subprime mortgage mess and the stagnant real estate market as reasons to expect lagging job growth. Mortgage bankers are being laid off with abandon, and real estate brokers are checking out new lines of work. Suppliers to the construction business are seeing revenues fall, and will cut employment. Manufacturers of home appliances are in the same fix. Even some investment banker and hedge fund types are getting pink slips, as deal flow and securities trading recede.

There are also reasons why job growth might be strong. Exports, helped by the falling dollar, have done well. The service sector has remained healthy. Wage pressure has eased and worker productivity has risen, making it more cost effective to hire workers. Not all of the predicted fallout from the real estate bust might happen. Some construction workers, like the skilled trades, can simply shift over to other building projects, such as hospitals and nursing homes. Unskilled construction workers can work on road projects. Many people that hold real estate broker's licenses have day jobs, and were brokers only on weekends and in the evenings. They can give up real estate without affecting job statistics. Or they can resume other careers they had set aside.

So how will the job growth number come out? We don't know. But we do know that the number really won't matter. Even if it pushes the market up or down 150 points on Friday, it won't matter. Within a few days, new statistics and news will have pushed the market to another level (maybe up; maybe down). At best, job growth in August 2007 will be one small datum in a sea of information that, in the aggregate, will determine what the Fed and other central banks do.

So why the fascination with the jobs growth number?

Because it will induce short term trading. People who hope to make money quickly will attempt to ride the volatility created by the job growth number. That sounds like day trading, a practice discouraged for individual investors because of its comparatively high expenses and low returns. But hedge funds, managed mutual funds, and institutional investors are often enthusiastic day traders. Professional money managers handle the investments for these entities, and must beat market averages if they are to keep their jobs. They can't beat the market by buying and holding. They could try to find investments that perform better than average. But, for every Warren Buffett or Peter Lynch, there are 10,000 Toms, Dicks and Harrys managing money who won't get to Lake Wobegon. Or, they can try to trade short term and generate some quick profits that boost their returns above their most dire competitors, the index funds.

Most of the trading in the financial markets today is done by institutional investors. The Norman Rockwell-ish image of the frugal individual, hunching over thick volumes of Moody's or Standard & Poor's in the public library reference room to uncover an investment diamond in the rough, is about as timely as the Edsel. An individual attempting to day trade can easily be overrun by the institutional tractor trailers barreling through the markets. (See our blog about stock market volatility at While some institutional investors may beat market averages, many and probably most don't. It's well known that most portfolio managers for managed mutual funds don't beat market averages. Statistics about hedge funds are harder to get, and perhaps less definitive. Certainly, after the subprime mess, hedge fund returns probably will not glow quite as brightly as they might have a year or two ago.

So what, then, is the appeal of short term trading?

It benefits Wall Street stock brokerage firms. Short term trading generates income for them. They get commissions from the buyers, as well as commissions from the sellers. They get commissions when a short term trader buys. They then get commissions when the short term trader sells. For some stocks, where the brokerage firm (or an affiliate) makes a market, they may also get trading profits (which you might see disclosed on a trade confirmation as a "markup" or "markdown"). If a customer buys on margin, they also get interest income from the margin loan. Excess cash balances in the customer's account are often invested in money market funds operated by an affiliate of the brokerage firm.

The brokerage firms have a lot of incentive to make the jobs growth, inflation, trade deficit, manufacturing sector, non-manufacturing sector, jobless claims and GDP data, and a host of other statistics, appear significant for a day. If they can get investors ginned up, they will make a bunch of money from transactional charges. It doesn't matter whether the market goes up or down, as long as investors trade.

Friday's Data Queen for the Day will be the jobs growth report. But the investor planning for a 25-year retirement that will start 20 years from now, or for a child's college education that will start 12 years from today, shouldn't give a rat's left ear what the report says or how the market reacts. An investment strategy of diversified long term investment remains the best move--see our blog about why the average investor does well, at That probably doesn't involve any trading tomorrow.

Strange News: fake palm trees, the latest in landscaping.

Wednesday, September 5, 2007

Financial Derivatives and the Business Cycle Redux

The Dow Jones Industrial Average ended up 91 today. But if you were a banker, you didn't have such a good day.

Today, the Federal Reserve and other government agencies issued a "Statement on Loss Mitigation Strategies for Servicers of Residential Mortgages." Written in the understated parlance of financial regulation, the statement urges banks and other institutions that "service" mortgages (i.e., collect the monthly payments, transfer debt payments to the holders of the mortgages, pay out money escrowed for taxes, etc.) to try to work things out so that distressed mortgage borrowers don't lose their homes. The regulators mention various "loss mitigation" strategies, such as deferring some loan payments, rolling delinquent payments into principal (which is another way of deferring them), conversion of adjustable rate loans into fixed rate loans, and even a reduction of the principal of the loan.

Defaulting homeowners who may have been lured into adjustable rate or interest only loans they didn't fully understand may see a little light in the darkness coming from this statement. However, let's not overlook the fact that the statement focuses on "loss mitigation," meaning the reduction of loss. It's not talking about loss to the homeowner. It means loss to the bank. The statement notes that "prudent workout arrangements that are consistent with safe and sound lending practices are generally in the long-term best interest of both the financial institution and the borrower." In other words, any workout has to benefit the lender as well as the borrower, and those borrowers who are in really big trouble may not get a workout.

Why would the Fed and other regulators encourage loan workouts? Stated otherwise, what would happen if there weren't workouts? More homeowners would default, and losses on their mortgages would have to be recorded. Initially, the loss might appear to fall on the hedge funds and other investors that bought the CDO tranches that have an interest in the income stream from these mortgages. However, in many circumstances, the banks that provided the mortgages for the CDOs might have to buy back defaulting mortgages. That would mean much of the loss would fall on the banks. The banks, in turn, could try to make the mortgage brokers who initially originated the loans buy back the defaulting mortgages. But many of those mortgage brokers are now in bankruptcy proceedings, and their buyback obligations aren't worth the price of a pack of chewing gum.

So the loss on many defaulting mortgages will fall on the only remaining deep pockets--the banks. This is the loss the regulators want to mitigate, because if it gets too large, the financial system takes on the consistency of jello. And given the apparently vast amount of losses that may bubble up from the subprime morass, the threat of jello must be taken seriously.

There's more. September is also the month when banks have to begin trying to refinance several hundred billions (yes, billions, not millions) of dollars of loans for leveraged buyouts. Many of these deals have been temporarily financed by bridge loans extended by the major banks (see our blog at However, the banks don't want to be long term financiers of these deals, and would like to sell bonds and other loans to hedge funds and other institutional buyers to replace the bridge loans. That way, if the leverage buyouts fail, yogurt would fall on the investors and not the bridge-lending banks.

But it remains to be seen if the banks will be able to find long term investors for the deals. Many of those deals were priced at a time when risk was seen as a hobgoblin of little minds. Today, with the true size of the risk goblin emerging, great thinkers are paying attention. The we'll-pay-you-back-when-we-feel-like-it bonds that financed leveraged buyouts six or twelve months ago will today be about as well-received by institutional investors as carriers of hemorrhagic fever. If the banks can't find outside investors, they themselves will have to become long term financiers of the leverage buyouts, often at disadvantageous terms. That means further potential for loss.

Unfortunately for the banks, the regulators can't issue statements encouraging the private equity firms to renegotiate their financing arrangements with the banks. Those arrangements greatly favor the private equity firms, and, the LBO boys didn't get yacht-buying rich by giving money away.

So the regulators are left to use whatever moral suasion they have to urge banks to be nice, but not overly nice, to distressed mortgage borrowers. What does that tell us?

On the level of the network news, it means that the regulators sound kind of warm and fuzzy. That's nice. And it's not exactly bad p.r.

But on a systemic level, we have an admission, implicitly, by the regulators that the derivatives markets have failed in their essential promise. Going back through the last 20 years, one sees the derivatives industry promoting its products with the claim that they would disperse risk and subdue volatility. Risk would be purchased by those that wanted to bear it, and those that didn't want it would be liberated from its onerous yoke. In particular, the major banks at the heart of the financial system would transfer away the risks that could cause a systemic failure, and safety and soundness would spread far and wide in the banking system. The financial markets would bask in the copacetic glow of a new and better world.

The problem was that the alchemy of derivatives didn't alter human nature. Presented with a path that apparently led to the Seven Cities of Cibola, investment bankers, hedge fund operators, and kindred souls worldwide plunged into the derivatives market, demanding vast quantities of risky financial instruments that they could purchase for their journeys to the kingdom of Croesus. These folks were too smart to believe that the business cycle had been repealed. But they managed to outsmart themselves into believing that the risk of the business cycle, as to them, could be traded away. Thus, they boldly bought risky investments that none had dared to invest in before, and in the process caused the creation much greater aggregate risk than otherwise would have existed. Stated otherwise, they engaged in speculative excess.

Speculative excess in the financial markets has a long and venerated history. Tulip bulbs in Holland, swamp land in Florida, silver futures, and earnings-free dotcom stocks are just a few of the better known examples. The darndest thing is that even though you'd think people would move up the learning curve after each pop of the bubble, progress remains painfully slow. We now have the derivatives bubble, where people thought that the magical qualities of derivatives contracts would make the business cycle go away, at least as to them. And they invested like anyone who thought they'd never face a downturn would invest. If the markets will always be friendly, at least as to oneself, there is logically no risk that isn't worth taking.

Unfortunately, the business cycle is the product of speculative excess, and human nature assures that speculative excess--and therefore the business cycle--will always be with us. There is no vaccine, no magic bullet. Any contract or investment that can be used to hedge or transfer risk can also be used for speculative purposes. Just flip it around and a prudent hedge becomes a wild gamble.

The regulators have assiduously avoided regulating derivatives, and now their only options are treating the symptoms with monetary policy, and moral suasion. The efficacy of both is uncertain. Preventative measures haven't appeared publicly on regulatory agendas. No individual player in the derivatives market has an incentive to seriously urge reform. From the perspective of any one market participant, it's easier to just trade away one's risk and the Devil take the hindmost. Of course, as we now know, the banks at the center of the financial system can't really trade away risk. But the private sector doesn't have the ability or incentives to assess and address systemic risk. The question at hand is whether anyone else will take up the mantle.

Health News: warning, popcorn fumes may be hazardous to your health.

Monday, September 3, 2007

The Federal Reserve's Other Consumer Debt Problem?

About three-quarters of the consumer debt in America is mortgage debt. If you have a pulse, you know that there has been a crisis in the mortgage markets, as subprime mortgage defaults have proven much worse than many expected and caused investors to pull back from buying mortgages. That, in turn, has made the mortgage market less liquid. Credit standards have tightened and it's harder for a lot of borrowers to get home loans. Low interest rate mortgages are available only for those that have sterling credit ratings and a 20% downpayment.

The other 25% of consumer debt includes credit cards, department store cards, auto loans and the like. Much of this debt has also been sold by the banks and other creditors that originated it, and packaged by investment banks into CDOs, commercial paper and other asset-backed securities. As the credit crunch in the financial markets has spread, investors have backed away from these securities as well.

One reason why many CDOs have not received cash bids when put up for auction is that they consist of a mixed bag of indebtedness. Mortgages, credit card balances, car loans, and corporate loans have sometimes been thrown together into a Mulligan stew of indebtedness. A trader asked for a cash bid on these instruments has to separately analyze each type of debt in order to come up with a valuation. In today's markets, where 20 seconds is an eternity, potential buyers can't feasibly separate all these disparate strands of debt and then figure out what they are worth. Maybe there was a diversification angle to mix and matching all these different obligations. But, in a credit crunch, they become a witch's brew of toads, frogs, snakes, newts, worms and nightshade that all fear to touch.

As investors step back from non-mortgage debt, banks and other debt originators will find themselves holding the bag . . . uh, we mean risk. That will reduce their enthusiasm for lending to the least creditworthy, and perhaps raise costs for the more creditworthy. While the pullback in non-mortgage debt is likely to be less extreme than, say, the Republican flight from Senator Larry Craig, cutbacks in non-mortgage credit are inevitable when the flow of investors dollars slows.

The ongoing financial crunch is often described in market jargon: it's a repricing of risk, a flight to quality, a loss of liquidity. The use of technocratic terminology sometimes hints at a reluctance to state the obvious. Perhaps we should take a look at the underlying dynamics.

The speech Chairman Bernanke gave on Friday (August 31, 2007) was widely interpreted to mean that the Fed will cut its target for the fed funds rate on September 18, 20o7, and probably at least one more time this fall. Perhaps so. Perhaps not. The amount of pain from the subprime mess is still largely unquantified (at least publicly), but is loudly proclaimed with liberal use of adjectives. It could be pretty bad. On the other hand, the losses, however large, may be mostly confined to wealthy hedge fund investors and financial institutions that will be bailed out by central banks. The economy evidently grew briskly in the 2nd quarter of this year, and inflation continues to be an itch the Fed seems to want to scratch. One strong hurricane that turns north, instead of going west into central Mexico, and inflation could look ugly again. But, as they say, we'll see.

Chairman Bernanke's speech also contained a discussion of the history of credit for home purchases that's worth a look. (Here's a link to the speech. Some 80 or 90 years ago, mortgages were short term (ten years or less) and required 50% downpayments. If those standards were applied today, the qualified borrowers couldn't field a basketball team. Then, with coming of the Depression in the 1930s, mortgage terms were made more liberal. After the Allied victory in WWII, a grateful nation made, among other things, the 30-year mortgage readily available to the returning GIs, and Father-Knows-Best communities sprang up throughout suburbia.

Non-mortgage consumer debt also became more easily obtainable. While store credit was a longstanding feature of agrarian society where farmers could only pay when they harvested their crops and brought livestock into feed stations, the proliferation of credit cards came of age with the television. Minimum payment requirements for the cards have been dropping for decades. Some are now so low that you almost don't have to repay the debt.

Car loans evolved similarly. Thirty years ago, the standard term of a car loan was three years. Today, it's more like six years. As we have discussed before, (, easy credit terms aren't necessarily good credit terms. In fact, they're often bad credit terms, because you ultimately pay more interest for the loan than you would with a shorter term loan. You have a finite amount of income (everyone does, no matter how much you make). The more of your finite lifetime income you spend on interest, the less money you'll have for personal consumption.

Consumer debt appears to enhance our lifestyles, because we don't have to save in order to buy things. We buy them now and pay later. That enhancement, however, is an illusion. Consumer credit frontloads consumption. You can consume now. But credit doesn't increase your lifetime income. If you consume now, you have to devote some of your future income to interest payments. That reduces your future consumption. The more you consume today on credit, the less you'll consume later in life. It's a zero-sum game because you will make only so much money during your life and no more. Credit simply changes the timing of your consumption, and it reduces the amount you have to spend, because some of your money will go to enriching banks. People who pay cash end up with more wealth and can afford more lifestyle. (Paying cash also makes you a smarter consumer because you weigh your nickels and dimes more carefully.) The timing of a cash-payer's consumption is different, but it beats eating dog food in your old age.

However, lest we sound like we've read too much Cotton Mather, let's return to macroeconomics. The securitization of debt--including mortgage and non-mortgage debt--brought a lot of investor money into the credit markets, and made easy credit much easier. As credit terms eased, more consumption was frontloaded. And the more that consumption was frontloaded, the more easy--and easier--credit was needed to continue the trend of rosy economic growth. For a while, the credit markets responded with adjustable rate mortgages, interest only mortgages, teaser rates, home equity loans, and credit cards with low introductory rates, low balance transfer rates, rebates, points and Lilliputian minimum monthly payments. In turn, the economy kept growing, all the while robbing the future of more consumption.

This is the other consumer debt problem confronting the Fed. Consumption is 70% of the U.S. economy. With the subprime goblin scaring investors away from all asset-backed securities, consumer credit will be less able to play its historic role of frontloading consumption and boosting economic growth. There is no ready replacement. People can't easily turn from credit-based consumption to cash-based consumption. Such a transition, although possible, takes a major adjustment (called "saving") and a lot of time. But household savings have been going more negative than campaigning politicians. And household income and wages have risen like a failed souffle.

A fed funds rate cut will probably have little impact on credit card interest rates. Credit cards are cash cows for banks, and people who carry a balance from month-to-month are more dependent on their credit cards than the United States is dependent on gasoline-driven automobiles. These people would have great difficulty walking away from credit cards no matter how high rates become. Credit card rates were high and higher during the early 2000s, when the fed funds rates was 1%. There's no reason to think that the Fed lowering fed funds from 5.25% to 5% or 4.75% will reduce credit card rates one whit.

There's nothing the Fed can feasibly do to maintain the frontloading of consumption, and it would probably do more damage than good if it tried. Perhaps a change of the nation's economic focus would be in order. Maybe the Fed should try to stimulate growth by promoting conditions that favor investment. An environment where inflation is kept under control, the financial markets function reasonably well, the dollar maintains relatively predictable value and a pool of savings is built to provide home-based capital (i.e., less susceptible to capital flight) would encourage greater business investment. America is not made wealthier by corporate spending devoted to share buybacks. America is made wealthier by the manufacture of superb commercial aircraft (our largest export), entertainment (yes, Hollywood is our second largest export, even though one might not have suspected that foreigners would have tastes as lowbrow as ours), and sophisticated computer hardware and software.

The credit-based consumption-frontloading model for our economy exists only at the sufferance of our creditors--and they're suffering so much now they've been rethinking things. The fastest-growing economies in the world today are those that favor investment and production. We may be forced by the pullback from the securitization of assets to reduce our dependency on credit-based consumption. That's a market trend that the Fed shouldn't fight. Ultimately, no one--not even the Fed--can successfully fight the market. (Whenever it's tried, it's caused price or asset inflation and misallocated resources.) We can't borrow and spend our way to economic health. Without the narcotic effects of easy credit, we'll be in for some pain. But that's preferable to more narcotics. Britain borrowed a lot to win World War II. The United States manufactured a lot to win World War II. Who was better off in the end?

Animal News: Chupacabra sighting.