Tuesday, October 30, 2007

Will Price Fixing Be Part of the Bank-SIV Bailout?

On Monday, Oct. 29, 2007, Allan Sloan, a Fortune magazine columnist, reported that the proposed bailout vehicle for SIV-bedeviled banks--which we call the Super Conduit--would "pool not only money but analytical information as well." Here's a link. http://money.cnn.com/2007/10/26/magazines/fortune/citishelter.fortune/index.htm?postversion=2007102914.

The mortgage-backed securities and derivatives that are held by the SIVs, and which would be bought by the Super Conduit, are creatures of mathematical models. Their structures and supposed values have been derived from mathematical modeling. "Analytical information" would be central to placing valuations on these things.

The pooling of pricing information is a feature of price fixing schemes. Airlines reservations systems and stock markets (which consolidate quotes from a number of dealers) are examples of potential venues for collusion. Indeed, the Antitrust Division of the Justice Department and the SEC have found collusive behavior in certain such venues.

The collection of analytical information by the Super Conduit could provide an opportunity for the banks participating in the Super Conduit to compare notes and reach agreement on prices. Such an amiable way of doing business would probably be, for those banks, a welcome change from the free market low-ball/no-ball bidding of independent third parties that might have been asked for quotes in recent months. Assemble at 3:00 p.m. and swap analytical information, establish prices at 4:00 p.m., and be at the gentleman's club by 5:00 p.m. for cocktails. No need to get their French cuffs soiled by short, nasty and brutish experiences in competitive markets.

Think of the benefits of such a process. Prices can be set high enough to soften the losses of SIV-burdened banks. The same high prices can be used as reference points for accounting valuations--what a relief to be able to use a monopolistic price instead of a competitive price. Vulture funds and other third party bidders offering bona fide free market prices can be smugly shooed away, or at least told to go around back to the kitchen door of the gentleman's club, where they might be sold a few table scraps that no one else wants. The Super Conduit doesn't need to trade with anyone except the banks that it's meant to bail out. So there can be a nice, closed derivatives market for banks only. Non-banks need not apply, thank you.

The banks sponsoring the Super Conduit might well try to use the involvement of the Treasury Department as protection from antitrust liability, under a legal doctrine called Noerr-Pennington. Whether or not that approach truly works is unclear, since Noerr-Pennington traditionally applies to the notion of members of an industry petitioning the government to act. In this case, the Treasury Department isn't taking any real action. It's just offering encouragement and moral suasion. It has no significant jurisdiction over the banks' mortgage and derivatives problems, and couldn't act in a formal way. So its presence may have no prophylactic legal effect.

So what if the Super Conduit rigs prices? Who loses?

For one, the investors in the Super Conduit will eventually lose out if it overpays for its assets. Mortgage-backed and other asset-backed securities are nothing more than streams of income that pay out whatever they pay out, and overpaying for them doesn't increase that stream of income. These investors will primarily consist of the purchasers of commercial paper issued by the Super Conduit. The commercial paper will probably be guaranteed by banks participating in the Super Conduit (otherwise, no one in their right minds would buy the stuff). So if there are losses, then those losses may well eventually rebound back at the guaranteeing banks. The Super Conduit may be nothing more than a vehicle for deferring recognition of losses. That's unlikely to foster safety and soundness in the banking system. A banking system won't be healthy if it's got a bunch of losses hanging like the Sword of Damocles over its head. Take a look at Japan in the 1990's, if you want an example.

On a larger scale, the biggest loser will be the U.S. financial markets. The subprime mess and credit crunch are a serious blot on the reputation of the derivatives markets. The path to redemption and recovery lie in standardizing derivatives products (to make pricing easier) and making the market more transparent--publicly displayed quotes and trade reporting would probably do much to rebuild investor confidence. Concocting a vehicle that could be used as a smoke-filled room to swap pricing information and come up with unusually high prices available only to Wall Street insiders would only confirm suspicions that model-based derivatives have little value to Main Street and are mostly used to benefit the big players on Wall Street.

Animal News: is Bigfoot in PA? http://www.wjactv.com/slideshow/news/14447006/detail.html.

Saturday, October 27, 2007

How the Brokerage Firms Dealt the Hedge Funds a Mortgage-Backed Ace in the Hole

The Associated Press reported on Friday, October 26, 2007, that broker-dealer subsidiaries of some of the largest bank holding companies gave price guarantees to hedge funds that bought mortgage-backed securities from them. See http://www.wtop.com/?nid=111&sid=581261. Reportedly, Bank of America, Citigroup and JPMorgan Chase are the bank holding companies involved. While not all the details of these guarantees are known, it seems that if the hedge fund tried to sell the mortgage-backed security and couldn't get a minimum guaranteed price, the broker would provide liquidity to the hedge fund in some manner. The broker might buy back the security, find another buyer for it, or pay a penalty to the hedge fund. One way or another, it would seem that if the mortgage-backed security's price fell below a specified level, the security pretty much belonged to the broker, not the hedge fund.

Could you get a brokerage firm to guarantee that if you bought a stock from them, they'd protect you if the price of the stock fell below a specified level? We didn't think so. They might try to sell you a product like a put option if you wanted protection, and that would allow them to earn another commission from you. But they wouldn't take the risk themselves that the stock price might fall below the level you wanted to protect. So this guarantee of mortgage-backed securities is unusual, to say the least.

The guarantee, which hasn't been exactly highly publicized amidst the subprime mess and credit market blowup, explains a lot. This is one reason why brokers were able to sell so many mortgage-backed securities to hedge funds. What they were really selling was Lake Wobegon, that wonderful place where, among other things, all investments do above average.

The guarantee is likely to be one reason by so many bank holding companies have recently been announcing so many losses. With hedge funds facing numerous withdrawal requests but unable to sell their mortgage-backed securities in the open market, they've no doubt turned to the brokers that guaranteed a minimum price for those hot tamales.

The guarantee is also likely to be one reason why the Federal Reserve has been so concerned about the subprime mess and credit crunch. It could cause major blowback on the bank holding companies that are the parent corporations of the brokerage firms that issued the guarantees. The Fed has relaxed regulatory requirements to allow the commercial bank subsidiaries of these bank holding companies to lend badly needed liquidity to their broker-dealer affiliates. This was part of a quiet bailout of the banks we discussed this past August. http://blogger.uncleleosden.com/2007/08/federal-reserves-quiet-bailout-of.html.

The existence of the guarantee raises a few questions. First, did the bank holding companies adequately account for the mortgage-backed securities that were protected? One might wonder whether the bank holding companies could truly treat these securities as sold to the hedge funds, when the bank holding companies bore the risk of loss on them below a certain price level. Ordinarily, a company can't account for an asset as sold if it still holds some aspects of ownership, and bearing risk of loss is a strong indication of ownership. Should the mortgage-backed securities that were guaranteed have been carried on the bank holding companies' balance sheets? And even if the bank holding companies could validly keep these guaranteed mortgage-backed securities off their balance sheets, did they maintain appropriate reserves for the possibility that they might have to honor the guarantees?

Another question is whether the bank holding companies adequately disclosed the risks associated with the guarantees. These guarantees meant that if the market for mortgage-backed securities fell far enough, big time blowback would happen. SEC regulations say that public companies should make disclosures about their market risks (that's in 17 C.F.R. 229.305, for those of the lawyerly persuasion). Should the bank holding companies have made market risk disclosure about the guaranteed mortgage-backed securities, and, if so, did they?

A third question is when did the Fed find out about these guarantees? It's obvious such guarantees have implications for the safety and soundness of the nation's banking system. It's also obvious that these guarantees would explain why so many mortgage-backed securities of questionable liquidity could be sold. And it's additionally obvious that selling a whopping shipload of these mortgage-backed securities could create a lot of stress for the financial system. It would be one thing if a brokerage firm that has no commercial bank affiliate and therefore isn't regulated by the Fed issued guarantees such as these. Such a firm would not put federally insured deposits at risk. But a bank holding company that has an investment banking subsidiary can do just that through risky investment banking activities (and aren't just about all of them pretty risky?). It's the Fed's job to know about things like these guarantees while they are being made, not after the fact when they've apparently caused large losses.

One final thought. The guarantees may be part of the reason why there are few sales of mortgage-backed securities. The hedge funds know that they don't have to sell if the bona fide third party bids get below a certain level. So sales don't occur if the market really nosedives. Why is that bad? Because normal market mechanisms are disrupted. There are vulture funds and other junkyard investors out there, looking for mortgage-backed bargains. But they can't do a trade if the hedge funds are putting the guaranteed securities back to the brokerage firms. Thus, no price floor is established and the market price is indeterminate, which is another way of saying zero. Many important accounting, lending and investment decisions can't be made without a positive market price. But the guarantees may be impeding the establishment of market prices. But the hedge funds aren't about to forgo their guarantees and trade in the open market, so there's no easy way out of this gridlock.

Food News: the source of chocolate cravings? http://www.wtop.com/?nid=106&sid=1266102.

Thursday, October 25, 2007

Choosing Financial Stocks in a Time of SIVs and Credit Crunches

Many large commercial and investment banks announced painful writedowns and large losses for the third quarter of 2007. Some other banks, though, have announced relatively moderate writedowns and continued earnings strength. Are the latter a good buy?

One lesson from the high tech boom of the 1990s is that when you have a distressed industry, think carefully before investing in the apparent winners. Recall the telecom industry circa 2000 and 2001. Company after company was announcing writedowns and losses from aggressive expansion and industry overcapacity. Some companies folded. But WorldCom kept announcing strong financial results. You might have thought WorldCom would be a good investment.

Fastforward to June 2002. WorldCom publicly admitted to having engaged in an accounting fraud involving billions of dollars. Those glowing earnings reports were bunk. Shareholders were hung out to dry. The biggest difference between WorldCom and the losing telecom companies was that WorldCom was willing to lie about its performance.

The financial services industry is currently living in a world of turmoil, with much of the turmoil stemming from CDOs and other mortgage-related derivatives that are traded only by appointment and often have no open market price (especially not after the credit crunch began). These “assets” are the source of a lot of the recently announced losses. Valuing them is often a matter of judgment. The bank can use a mathematical model for valuation, but there’s wiggle room in the models and they haven’t been exactly spot on when it came to predicting cash prices (see http://blogger.uncleleosden.com/2007/08/how-computers-did-in-financial-markets.html).

Only the banks and their auditors know what actually happened with this past quarter’s accounting. But here are a couple of thoughts. A bank that wanted to avoid a bad third quarter this year could have given itself the benefit of the doubt at every turn and come up with results that didn’t look bad. This would have been a dangerous tack. If the real estate sector continues to decline (as many predict), circumstances in the fourth quarter may compel more writedowns at year end. And if a bank’s writedown this past quarter was relatively small, the writedown at year end may have to be relatively gargantuan (because those benefits of the doubt tend to evaporate as asset values slide).

Of course, there’s also the possibility that a bank with a serious CDO-subprime problem may have taken the opposite approach and been highly aggressive in writing down hinky assets. Then, at year end, it might report relatively positive results for the fourth quarter. Concerns have been aired that the banks reporting large writedowns may be creating "cookie jar reserves” that they could tap into in the future to smooth out more turmoil in their earnings. If such is the case, they are likely to have a problem with the authorities, since maintaining cookie jar reserves is considered bad accounting form.

Nevertheless, if you’re going to take a flyer on a stock in a volatile sector like financial services, do you want the one that might report improvement in the future, or the one that might have spent too much time primping in front of a mirror? Is it possible that the banks reporting strong results now simply are better managed and avoided riskier plays? Yes, that’s possible, and maybe it’s true. But WorldCom was considered a well-managed company until it blew up. Think and research carefully before plunging into stocks of banks and other companies holding volatile assets.

Ironic News: a lock of Che's hair sells for $100,000. http://www.wtop.com/?nid=456&sid=1278591. The old revolutionary must be turning over in his grave at the thought that his hair might have been subjected to capitalism.

Wednesday, October 24, 2007

What if the Super Conduit for SIVs Fails?

The Super Conduit proposed by three major banks and the Treasury Dept. seems to be moving forward. It has reportedly received indications of interest to the tune of $60 billion, mostly from other commercial banks. The Super Conduit is searching for $80 billion to $100 billion of funding, so $60 billion sounds pretty good. But maybe we should be cautious. An indication of interest isn’t a commitment. And a commitment these days is kind of like a wave of the hand on the Street. All kinds of people are trying to walk away from commitments. Private equity guys don’t want to do deals that no longer offer yacht-buying profits. Banks don’t want to fund private equity deals with bonds that offer them, the lenders, little in the way of meaningful rights. Mortgage companies don’t want to buy back stupid mortgage loans they made which, not surprisingly, have now defaulted. So the indications of interest for the Super Conduit might not quite make it to the altar if things start to look kind of hinky.

And there’s much about the Super Conduit that could be hinky. It will supposedly buy “good” mortgage-backed securities from distressed bank-affiliated SIVs, and will make money by charging them fees and paying them discount prices. If it actually operates that way, it will be the largest pawnshop on Wall Street.

But trying to make the Super Conduit profitable seems to involve a square hole-round peg problem. The assets that it would buy consist primarily of mortgage-backed securities, and the value of those puppies depends on the fortunes of the real estate market. No one, not anyone, not even economists on the payroll of real estate trade associations, is predicting anything except further decline in the real estate markets for the next year or two. How can you make a profit from assets that are likely to deteriorate? Only by being a real vulture and paying super-low prices that leave the bank-affiliated SIVs by the roadside, barefoot and pregnant. In that case, though, the Super Conduit wouldn’t serve its primary purpose of bailing out the SIV-bedeviled banks.

So the Super Conduit may end up paying not-such-low prices. And that would increase its risk of losses. What if it ends up being a bust? In order to avoid total breakdown of the credit markets, the participating banks would have to ensure that the investors that buy the Super Conduit's commercial paper would be paid out in full. If the banks did that, though, they'd be looking at taking the losses themselves.

But that’s where we are now. Banks are looking at taking losses, and have proposed the Super Conduit in order to avoid doing so. If the Super Conduit fails, what’s the next step? What is Plan B? Surely, all those really smart people on Wall Street and in the Treasury Department realize that the Super Conduit may sustain losses, and therefore have a contingency plan in their hip pockets ready to go. Otherwise, they wouldn’t have proposed the Super Conduit in the first place. Right?

We’re dealing with a severely weakened administration that has a demonstrable problem with contingency planning. A certain foreign policy adventure whose name shall not be spoken is Exhibit A in this regard. The emergency plan for Katrina is Exhibit B. You get the picture. These people struggle futilely to shift the point of aim away from their own feet.

The Super Conduit is intended to operate for about a year. Maybe the plan is to keep the SIV-bedeviled banks on life support until a Democrat takes office in January 2009. That’s a cute way of saddling the opposition with a nasty mess. But what if a Republican wins the 2008 presidential election? Not the highest-odds bet in London right now, but a nontrivial possibility given the Democrats’ demonstrable history of aiming at their own feet. In that case, the Republicans will have done it again to their feet.

The Treasury Department’s involvement in the Super Conduit implies the potential for a taxpayer-funded bailout if all else fails. The Treasury Department has vehemently denied that any such measure is within contemplation. Let’s hope so. If it happened, we’d be Japan in the 1990’s. After their stock and real estate markets crashed in 1989-90, the Japanese banks, with encouragement from the Japanese government, kept funding bad loans instead of recording the losses they had sustained. Japan lost the opportunity to invest in new industries and technologies. Instead, the Chinese became the new Asian powerhouse. While Japan still has a much larger economy than China, China’s vitality is much larger than Japan’s. It is a foregone conclusion that China will surpass Japan, probably before many of us begin to collect Social Security.

Wall Street has made a bunch of bad investments in real estate and related derivatives. We shouldn’t keep funding doggy investments. The banks should write off their losses and move on. If that means that some banks may be hampered for a while, so be it, even if there is a near term economic slowdown. If the troubled banks develop liquidity problems, funding is available at the Fed discount window. That’s what it’s there for. But let’s not fund the stupid real estate investments they made and then hid from view in SIVs and conduits. You can’t build wealth by throwing good money after bad. If America is to remain competitive with the rising economic powers in Asia and a resurgent EU, we shouldn’t deplete our capital assets by continuing to fund reckless and poorly conceived investments created by fast money financiers.

The losses from the SIVs and conduits are perhaps so great that they’d cripple some banks. If so, sell the banks to new owners. If they’re too big for any one buyer, break them up into constituent parts—retail, investment banking, credit cards, etc. Then sell or spin off the constituent parts. And fire some people with the nicest of the corner offices. If the big banks learn that they aren’t too big to fail, and their high-ranking executives learn the meaning of accountability, they’ll start evaluating and managing their risks responsibly.

Animal News: the parrot--a fire alarm that doesn't need a battery. http://www.wtop.com/?nid=456&sid=1275565.

Monday, October 22, 2007

SIVs, Conduits and the Credit Crises in Our Future

Esoteric investment vehicles called SIVs and conduits have become cocktail party topics. The U.S. Treasury and the nation's largest commercial banks are sponsoring a bailout of banks affiliated with distressed SIVs and conduits, to the tune of $80 to $100 billion dollars. The G-7 and IMF issued statements at meetings held this weekend expressing concern about the credit crisis and encouraging central bank action to limit its impact. Financial journalists write about the losses sustained and the losses to be incurred in the future, and the financial engineering games that created the losses. Economists are quoted on cable television predicting recession, or not.

It's clear from both the Fed's surprise half-point interest rate cut in September and the Treasury's sponsorship of the super conduit that supposedly will stabilize the debt market that the government thinks the credit crunch is serious and an ongoing problem. There's plenty of speculation about whether or not the Fed will cut interest rates further, and even a little commentary on the possibility that the taxpayers will have to provide some money to bail out the big banks. In other words, there's plenty of talk about how those responsible for the mess can be insulated from risk. But there's little discussion about the need for increased government oversight to prevent the kind of reckless excess that characterized the CDO market until recently.

The government that simply reacts to the crisis of the moment, and doesn't plan for the next recurrence of problems, is doomed to be unprepared for the next mess. Generals and admirals are sometimes accused of preparing to fight the last war. But at least they are doing something about the future. While the financial regulators and Congress have issued some statements and even held a few hearings, no substantial steps have been taken to prevent a recurrence of the problem.

Market forces have worked poorly in this situation. We have to consider that markets aren't machines or automated processes. They consist of the interactions of people, and people can be irrational, oblivious, gullible, and, most importantly, greedy yet fearful. All of this means that people--and therefore markets--can screw up.

First, over-investment in mortgages resulted in the creation of vast quantities of risky derivatives (CDOs and others of their ilk) that few understood. The valuations ascribed to these investments were based on the assumption that the real estate market would continue rising indefinitely. That a perpetually rising real estate market had never before occurred in the history of the world was no impediment to the belief that it would happen now.

Then, when the ship hit the fan (well, you know what we mean), investors froze up and refused to invest in anything except gilt-edged investments like U.S. Treasury securities. Investors didn't conduct much of a reasoned analysis of anything, especially if it might have something to do with asset-backed securities. They simply wouldn't touch private sector debt. Perhaps this was an overreaction. But it was understandable in light of the absence of transparency in the derivatives markets. In the absence of reliable information, why risk your capital?

Contrast the credit markets with the stock markets. Even with Friday's drop, the Dow Jones Industrial Average is up about 8.5% for the year. The stock markets are vastly more transparent than the derivatives markets. Even though they are sometimes volatile, there hasn't been a freeze up in the stock markets since the Depression. Even after the 1987 crash, investors kept buying, because there is so much information available about stocks that many felt they could reasonably assess their chances.

Without an improved regulatory regime in the derivatives markets and for hedge funds, future crises like the current one are a given. The financial services sector of the U.S. economy has grown larger even as the manufacturing sector has shrunk. Whether or not this makes much sense from the standpoint of national policy can be questioned. There is nothing about America that gives it any special advantage in financial services. Unlike our pool of intellectual capital in the Silicon Valley, our pool of creative talent in the entertainment industry (entertainment is America's second largest export, after commercial aircraft), or our vast farmlands, Wall Street's talents and products are fairly easily replicated in other nations. And that's happening. London is a serious challenger to New York. And China is promoting the growth of its financial markets. Much and perhaps most of the growth in investment capital (i.e., savings) today is overseas. The Chinese, Japanese and other Asians are compulsive savers. The OPEC and other oil producing nations are piling up vast amounts of oil profits to reinvest. There is no particular reason why those savings must flow to Wall Street, and increasingly, they won't, especially with the dollar falling in value.

Nevertheless, the government seems intent on protecting the financial services industry. In that case, it should do so the right way, and build for the long term. Although not without its faults, America does two things really well compared to most of the rest of the world. Americans truly believe in integrity and honesty, and these values have been infused into the processes of American life. When Americans go to a government office, they expect to be able to conduct their affairs in accordance with law, and not have to pay petty bribes to petty functionaries just to get the day-to-day processes of the government to operate. There really aren't that many other places in the world where this is true.

Similarly, Americans expect to be treated fairly and honestly when buying or investing in something. They expect prices to be fair, and howl when they think they've been taken advantage of (witness the controversy over Apple's recent $200 price cut for the iPhone). In most other countries, bargaining is a way of life, and you have live with the bargain you made. Opacity in the market is an advantage for the seller that the seller will strive to maintain.

Thus, Americans do integrity and honesty really well. Let's infuse a serious dose of integrity, honesty, transparency and responsibility into the derivatives markets and the hedge fund industry. Sure, this means increased regulation. But it also means greater investor confidence and a competitive advantage over other nations that don't do integrity and honesty as well.

Animal News: pet cockroaches. http://www.wtop.com/?nid=456&sid=1273362. Some people are weird.

Thursday, October 18, 2007

The Government's Plan for Dealing with the Credit Crunch

It can be informative to ask simple questions. Amidst all the details, complexities and nuances of the subprime mess and the credit crunch, let's ask a simple question. Why is the Treasury Department involved in dealing with this situation?

As you surely know, several major banks, along with Treasury, have proposed the formation of a special investment vehicle (which we call the "Super Conduit") to purchase mortgage-backed assets from structured investment vehicles (SIVs) affiliated with banks that have run onto the shoals of the subprime mess. These purchases would help the SIVs repay commercial paper that the affiliated banks have guaranteed. If the banks were required to pay on their guarantees, they'd have to book a bunch of losses because the SIVs' assets may not be valuable enough to repay the banks for fulfilling the guarantees. It's not clear this proposal will work (see our preceding blog at http://blogger.uncleleosden.com/2007/10/super-conduit-new-clothes-for-banks.html). Whether or not it does, there remains the question why the Treasury Dept. is in the picture at all.

The Treasury Department doesn't have primary regulatory responsibility for banking. The Federal Reserve and other banking agencies have that hot tamale. The Treasury Department doesn't have primary responsibility for regulating the financial markets. The SEC and the CFTC perform those duties. While the Treasury Dept. has authority to regulate U.S. Treasury securities auctions, and require reports of cash transactions with banks (if they exceed $10,000), these areas are hardly affected by the subprime mess. So Treasury doesn't have a whole lot of legal jurisdiction here. Does that mean we have government employees doing work they don't have to do? Pigs would waltz on the Moon first.

There appear to be two basic reasons why Treasury stuck its nose into this particular latrine. First, the banks sponsoring the Super Conduit are acting a bit like a cartel. The Super Conduit, from a banker's perspective, could be viewed as "stabilizing" prices of CDOs. Others might characterize it as a group of powerful banks getting together and fixing prices (instead of letting them go way down where their competitors could buy them for a song). That could violate the antitrust laws. However, if the banks involve the government in their discussions, they might be able to rely on a legal doctrine called Noerr-Pennington to dodge antitrust liability.

Second, and probably more important, the Treasury Dept. appears to be lending its stature to the discussions. In the uncertainty and opacity of the subprime mess, leadership is sorely needed, and Treasury may have been one of the few parties that could provide it.

One might ask why the Federal Reserve, which was instrumental in organizing the 1998 bank bailout of Long Term Capital Management, isn't actively involved in the Super Conduit. There could be a simple reason. The Fed is the primary regulator of all major U.S. commercial banks. It can also ensure that the major investment banks have access to credit (by telling the commercial banks to lend to the investment banks, which is more or less what the Fed did after the 1987 stock market crash). If the Fed took the lead in these discussions and encouraged all the major banks to participate, it could be viewed as implicitly guaranteeing the financial viability of the Super Conduit. That is a can of worms the Fed wouldn't want to buy.

Treasury, on the other hand, doesn't have the legal authority to make or fulfill any such guarantee. So it's in a position to lend its stature and engage in moral suasion, without having to deal with claims of a guarantee.

It all sounds so cute and clever, no?


The fact that Treasury, a department of the federal government with no significant jurisdiction in the matter, involves itself with the subprime mess tells you that the government has no plan for dealing with the crisis. It never saw the credit crunch coming, and didn't prepare for it. It purposely turned away from regulating the derivatives market and hedge funds, to the point where it didn't have even basic information about the scope and extent of the problems. The government didn't realize how abusive to customers some mortgage brokers and mortgage companies could be. It didn't realize how esoteric and detached from financial reality CDOs had become. It was unaware of the tremendous amount of leverage hedge funds were using to invest in CDOs. The leverage created hair trigger conditions for a downturn if CDOs took even relatively small losses (since leverage would magnify the impact of the losses). It didn't understand how far the bank-affiliated SIVs and conduits had gone in pursuing a strategy of borrowing short term (with commercial paper) and investing in longer term CDOs. This strategy is particularly weird considering that the yield curve was inverted for much of the past few years (so the cost of borrowing would squeeze profit margins unless the SIVs and conduits took larger and larger risks in search of earnings).

Consider the government's response to the crisis. The Fed first turned up the liquidity spigot, then made the largely symbolic move of lowering the discount rate, and finally announced its surprise half-point fed funds rate cut. Now, we have Treasury, with no jurisdiction, stepping in as a sponsor of the Super Conduit. Do we get the impression that the government is winging it? Are these people making it up as they go along? Does this bring back memories of the halcyon days of youth, when the conversation in the huddle of a touch football game might sound something like, "okay, Tommy, you go to the left down the sideline, and Jimmy, you go out on the right and slant in, and Pete, you line up on the right end and come back to me so I can give you the ball for a reverse if I want to, but maybe I'll keep the ball and throw it, or maybe I'll run with it around the end, or . . . "

The primary responsibility for the subprime mess and the credit crunch doesn't rest with the government. It falls on the mortgage brokers, mortgage companies, investment bankers, hedge fund managers and other players who saw the real estate markets as the newest and best source of fast money, the easy way, get it while you can, and the devil take the hindmost. But the process of holding these parties accountable will take a while, in many cases proceeding with all deliberate speed in the courts.

The government was a facilitator par excellence of all this exuberance, what with the Fed's easy credit policies and the tax code favoring speculative investment over old fashioned working, earning, thrift and prudence. So the government should help with the cleanup. But it is going to need luck if it keeps throwing Hail Mary passes and tries to be the first player in 60 years to score with a drop kick.

The government has no choice except to muddle through the current situation. However, just to prove that bureaucrats can move up the learning curve, a more proactive regulatory regime for the problem children of the subprime mess and credit crunch would brighten the future of the financial markets.

Crime News: burglar cleans up mess he made. http://www.wtop.com/?nid=456&sid=1272472.

Tuesday, October 16, 2007

The Super Conduit--New Clothes for Banks?

The largest banks in America—Citigroup, Bank of America and J.P. Morgan Chase—have announced that they are sponsoring an investment vehicle (called the Master Liquidity-Enhancement Conduit), which will supposedly have $75 billion to $100 billion to bail out bank-related structured investment vehicles (SIVs) that hold mortgage-backed securities, by buying some of their assets. The new investment vehicle, which we will call the Super Conduit, is a creature of structured finance, like the conduits and SIVs that we’ve discussed previously in http://blogger.uncleleosden.com/2007/09/conduits-and-sivs-chill-from-shadow.html and http://blogger.uncleleosden.com/2007/08/were-subprime-mortgage-risks-hidden.html.

The conduits and SIVs were set up by major banks as investment funds for riskier assets, such as CDOs, that the banks may have underwritten but didn’t want to hold directly. The conduits and SIVs raised a lot of capital by issuing commercial paper, which was 10% to 50% guaranteed by the banks sponsoring them. Some of these SIVs have been hit upside the noggin by the decline of the real estate markets and the subprime mess. Many of their assets have lost value, sometimes sharply. When they’ve tried to sell assets in the open markets, they have frequently been offered discounted prices by skittish and skeptical buyers. And for some CDOs containing subprime mortgages, the SIVs been offered their choice between nada, zip or zero.

The SIVs face potential big-time losses if they keep liquidating assets. Thus, as the SIVs’ commercial paper falls due, the banks that sponsored the SIVs confront the prospect of having to honor their guarantees. Nothing could be less attractive to the banks, since some of the SIVs’ losses might become the banks’ losses if guarantees have to be fulfilled. Executive bonuses could suffer.

So the Super Conduit has been organized to ride to the rescue. Sponsoring parties, including the U.S. Treasury, which provided cheerleading although no money, have tried to sound like cavalry bugles signaling a charge. But let’s put our ears to the ground and think carefully about what we hear.

First, the Super Conduit has to find backers and investors. The backers would consist of banks that would guarantee the commercial paper the Super Conduit would issue to raise money to buy assets from the distressed SIVs. And investors would have to be found to buy the Super Conduit’s commercial paper. The banks backing the Super Conduit would apparently receive fees for services provided to the Super Conduit. Investors would presumably receive a premium in the interest rate on the commercial paper, especially if the bank guarantees aren’t 100%.

Most major banks on Wall Street reportedly haven’t committed to backing the Super Conduit yet. They may be wondering why they should bail out their competitors. After all, this is Wall Street, and if you want a friend, head for the Humane Society’s chapter in Manhattan. Wall Street logic dictates that when a competitor is in trouble, wait for it to really go downhill and then buy its assets at a massive discount. Participating in a bailout could mean losing an opportunity to buy at a cheaper price. Let's remember that Wall Street was built on the notion of buying low and selling high.

The sponsors of the Super Conduit attempt to address that issue by saying that the Super Conduit will only buy high quality mortgage-backed securities from the distressed SIVs. Moreover, they will charge the SIVs fees and pay discounted prices. This sounds more like banking: when the customer is desperate, smack him with fees and lend him the least you can for the most you can extract. So, maybe the Super Conduit's sponsoring banks apparently aren’t asking other banks join in a bailout. Perhaps they’re asking them to join in a feeding frenzy.

This is where the cross-currents of the Super Conduit proposal churn into a vortex. To induce the other sharks—pardon us—the other banks to participate in the Super Conduit, the sponsoring banks have to make the Super Conduit a good deal for them. But doing so comes at the expense of the distressed SIVs. They’re the entities that will be paying the fees and receiving the discounted prices—and all for the sake of selling their best assets. The SIVs will be left with their less desirable assets, which they won’t be able to sell to the Super Conduit. Having only those less desirable assets will make it even more difficult to pay off their remaining commercial paper. So what’s in it for the SIVs, or the holders of their remaining commercial paper?

Of course, the banks sponsoring the SIVs benefit, at least temporarily. If the SIVs’ maturing commercial paper is paid off with money from the Super Conduit, the SIV sponsors won’t have to honor their guarantees or record the losses that might well come with honoring their guarantees. But with the SIVs further weakened by paying fees to sell their best assets at discount prices, isn’t it all the more likely that the SIVs will collapse and the SIV-sponsoring banks will have to book losses?

With the real estate market still declining and further mortgage distress likely in the next few years as more ARMs reset to higher monthly payments, perhaps many of the CDOs currently held by the SIVs are headed ever closer to the septic tank. This might include some of the “good” assets that the SIVs could sell to the Super Conduit. Why would the banks not sponsoring the Super Conduit choose to join in a guarantee of the Super Conduit's commercial paper when it's supported by potentially declining assets?

The Super Conduit, if it is successfully organized, might buy the SIV-sponsoring banks a little time. Maybe, just maybe, the commercial paper market will regain some confidence and the SIVs will recover the ability to roll over their remaining commercial paper. But what are the chances of that? There’s nothing on the horizon that would signal improvement in the underlying problem, the distress in the real estate markets. So, the Super Conduit could simply turn out to be another bit of Wall Street financial engineering that doesn’t change the fact that we live in a world of risk and losses, and eventually will have to deal with it.

Tech News: there are times when it isn't worth it to send a text message. http://www.wtop.com/?nid=456&sid=1270021.

Monday, October 15, 2007

Personal Finance in a Recession

Will there be a recession? That’s the TV interview question for numerous economists, and their answers range from yes to no. If the question is changed to whether the economy will slow down, the answers range from yes to yes. Whatever your personal prediction, it seems that rougher waters are likely in the next year or two. How can you prepare?

I. While You Have a Job

First, let's look at what you do now, while you've still got a job.

Cash. Build up an emergency cash reserve of three to six months' living expenses. This means all your expenses, including the mortgage, car payment, student loan payments, credit card payments, gas, groceries, utilities, clothing, entertainment, and whatever else. Now more than ever, cash is important. Cash puts you in the driver’s seat during a recession.

Reduce credit card debt. Credit card debt is very expensive—some cards have interest rates as high as 30%. Interest expenses are an extravagance if money is tight. Also, paying your balance down gives you some unused credit to fall back on in case you need it.

Avoid payday lenders. This means starting now. Their goal is to rope you into a continuing series of loans (with a continuing series of expensive fees). If you get hooked on their product now and then are laid off, you could get clobbered.

Switch to a fixed rate mortgage. If you face the possibility of an increase in monthly payments in the next couple of years, think about refinancing now, while you still have a good job. If you lose your job and your payment rises, you could be caught between a rock and a hard place and end up in bankruptcy. Even if a fixed rate mortgage increases your current payment, you’ll have your interest rate risks under control. A fixed rate mortgage is preferable anyway (see http://blogger.uncleleosden.com/2007/05/how-right-mortgage-loan-helps-you-build.html). Its payments don't increase with inflation. Most salaries do increase with inflation, which means that, over time, your mortgage gets a lot cheaper. Baby Boomers may remember that their parents had monthly mortgage payments of $125 to $200. Those payments were pretty big at first, when the parents made $6,000 a year (or $500 a month before taxes). But, by the 1970s and 80s, when the parents made $20,000 or more a year, those payments were lower than car payments.

Take care of important medical care. If you need significant medical care, do it now, while you’re still employed and insured. Do you need a knee or hip replacement? Have you been putting off that colonoscopy? Does the fibroid keep getting bigger? While many medical procedures can’t be timed, don’t put off to tomorrow what you should do anyway today, while you still have a job.

Think about any valid disability claim you have. If you would be entitled to disability, think carefully about delaying it. If you’re laid off, you may lose the disability coverage. Collecting disability is a major step away from future employment, and it could mean that you’d be unable to get your career back on track if you later recover from your disability. But it also means a steady flow of income (albeit lower than your salary).

II. If You Lose Your Job

If the worst happens, and you lose your job, keep your head up and eyes open. Job loss can be emotionally devastating, but a lot remains at stake, so focus on the future.

Check out your benefits. Look into severance benefits, health insurance coverage, payment of accrued vacation and sick days, payment of bonuses and commissions you’ve earned, retention of stock options and restricted stock (or your ESOP account, if you have one), and any other elements of your compensation or benefits. Get a statement of the balance of your 401(k) account (it should not be affected by your layoff, except that neither you nor the employer will make more contributions). Consult with your union, if you belong to one.

Continue health insurance coverage. If you can exercise COBRA rights to retain your current employer’s health insurance policy, do so. Even if you think you might be able to buy coverage at lower expense under an individual policy (that’s not a high probability unless you reduce coverage), protect yourself through COBRA. Then, take your time to do a price and benefits comparison. If you lose your COBRA rights up front, you could end up in a tight spot.

What if Your Employer Shuts Down? In extreme cases, your employer may go out of business. If so, it’s likely to go into bankruptcy, and you may get little or nothing in the way of severance benefits. However, there are some things to keep in mind.

First, your pension may be protected by the Pension Benefits Guaranty Corp., a federal agency that guarantees pension benefits up to certain limits. Check with your pension administrator.

Second, your 401(k) account should be intact, although any employer stock in it will probably be worthless. If you have an ESOP account, that will probably be worthless, unless you've diversified its investments away from just holding your employer's stock. Diversification is something only employees who are 55 or older and have been with the company for at least 10 years can do--and they should, for safety's sake.

Third, your health insurance plan may have been terminated just before the employer shut down. This is a nasty tactic that some companies use at the last minute. If it happens to you, you won’t have any COBRA rights because there won’t be any health insurance plan to provide you with continuing coverage. However, a federal law called HIPAA gives you guaranteed access to an individual policy for 63 days after the employer’s health insurance plan terminates. Buy an individual policy before the 63 days runs.

Apply for Unemployment Compensation. If you’re eligible, apply for unemployment compensation. It’s there for people in your situation. You’ll have to demonstrate that you’re making efforts to find a job. But you should look for another job, anyway. Staying employed is one of the best ways to maintain your financial well-being, health and self-esteem.

Sell unneeded stuff before borrowing. If you’re running short of cash and still have no immediate prospects for new employment, sell off stuff you don’t use or need any more. If you haven’t used the trailer with the popup tent in five years, you probably won’t use it in the next ten. If the golf clubs have decorated your basement for the better part of a decade, they’d probably be happier in the hands of someone who might actually take them onto the links. What about all that stuff in large plastic boxes in the crawl space just below the roof? Why will it benefit you if it stays there another five years? It’s best to avoid borrowing while unemployed, because you have no obvious way to repay the debts. While jobs may be impermanent, debts are a certainty. Avoid them.

Reduce spending for services. Now that you have a lot of free time, mow the lawn yourself. You did it when you were 14. You can do it now. And think about cutting back or terminating the housecleaning service. Pushing a vacuum cleaner or cleaning a bathroom isn’t the worst thing in the world, not when you compare it to going into bankruptcy and losing your home. Cut back to basic cable. Yes, you have more free time, but will it be fruitfully used by vegging out in front of the tube? If you’re not working, do you need an expensive cell phone plan? Who will you be talking to all the time, now that no one needs your signoff on the latest proposal? Unnecessary consumption isn’t the way to survive a layoff.

Avoid get rich quick schemes. Particularly nasty vultures posing as people hover around during bad times, looking for the weak and vulnerable. If you’re unemployed and desperate, count yourself among their potential prey. When you’re in dire need of money, it’s easy to believe what you want to hear. And lots of con artists will be there to say it in the hope that you will give them some of your now scarce cash. Get rich quick schemes are usually a surefire way to lose money. For more on fraudsters and crooks, go to http://blogger.uncleleosden.com/2007/05/how-to-spot-crook.html.

Fashion Update: handcuffs. http://www.wtop.com/?nid=456&sid=1267365.

Friday, October 12, 2007

Tax Planning

As the end of the year grows closer, thoughts turn to holidays, shopping, and . . . tax planning. Deductions are purchased. Income is deferred, or transformed into capital gains. Shelter is sought.

But how much tax-driven maneuvering is actually good for you? Sure, it gives you near instant gratification to look at your return and see that you’ve deducted away some of the tax liability. Have you also lost something else, though? Here are some things to keep in mind.

Investing comes first; taxes are secondary.

One typical 4th quarter tax maneuver is “harvesting” losses on stocks and other investments in order to offset gains on other investments. You sell some of your losers so you can reduce or avoid paying taxes on your winners. To make things even better, if you have losses remaining after offsetting capital gains (or if you have no capital gains), you can even use as much as $3,000 of losses to offset ordinary income (married, filing separately get $1,500 each). Excess undeducted losses can be carried over and deducted in future returns. Sounds like a good deal, no?

What if the stock you sold was actually a good investment that you should have held? There isn’t a stock that doesn’t go down in value some of the time, even the good stocks. Selling to generate a deduction may cost you a long term investment opportunity. Of course, you tell yourself, you would only sell the dogs. And that strategy works if you know which of your stocks are dogs. Sometimes, when a company has made an unequivocal turn toward bankruptcy court, you can fairly count it as a dog. But many of this year’s poor performers may be next year’s shining stars.

Don’t blindly sell a stock just because you want a deductible loss. Conversely, don’t hold a doggy stock simply because you have no gains against which to deduct it. Do what makes sense from an investment standpoint. Building wealth comes first and foremost from saving and intelligent investing. Remember that any deductible loss is a real loss that actually cost you money; it’s not something that occurred on a piece of paper. Wealth ultimately is not created from generating real losses.

There’s a strategy to avoid the lost opportunity problem: sell a loser before the end of the year and buy it back. That way, you’ll incur a loss and yet will own the stock for future gains. This strategy works, but only if you’re mindful of the rule against wash sales. If you buy the losing stock 30 days or less before or after you sell it, you may well violate the wash sale rule and be precluded from deducting the loss. The 30 day requirement is meant to put you “at risk” of market changes in the value of the stock, so that you can’t generate mere paper losses.

Tax Shelters

Another tax consideration is whether you should structure your investments to take advantage of tax shelters. The most readily available tax shelters for most Americans are retirement accounts like 401(k)s and IRAs. These general purpose retirement accounts have little or no investment bias. In other words, they don’t steer you toward any particular type of investment and can be used with a wide variety of investments. Thus, you can have a well-diversified portfolio within the retirement account. That makes these types of accounts highly desirable as tax shelters.

Most other tax shelters have a lot of investment bias. This is most easily seen in the thoroughbred stable/ostrich farm type of tax shelter, where your money must go into a particular type of investment in order to get deductible losses. Common tax shelters with investment bias are insurance products like whole life policies and annuities, where you shelter earnings on the money you invest (until it is distributed to you) only if you buy insurance products. Another very common tax shelter with investment bias is the municipal bond. If you want the benefit of this shelter, you have to allocate some of your hard earned savings to municipal debt.

Buying a tax shelter with investment bias is a good idea only if the investment bias makes sense within the context of your overall personal finances. Don’t invest in an ostrich farm unless it fits into an overall strategy of diversification. Remember that the first goal of investing is to generate gains, and an ostrich farm may not serve this goal as well as it provides deductible losses.

Don’t put 90% of your savings into muni bonds simply because you’re ticked off at the IRS, but haven’t quite reached the stage of buying a cabin on a ridge somewhere. The returns are low, even after you take account of the tax benefits. Defaults occur. And you can even be taxed for some municipal bond income under the alternative minimum tax, if the bonds are “private activity” municipal bonds. (Private activity bonds, sometimes called revenue bonds, are paid only from the revenues of a private enterprise that borrows the proceeds of the revenue bond offering from the issuing municipality).

Don’t buy an insurance product simply because you’ve maxed out your 401(k) and IRA. The insurance product may provide a tax shelter, but one that often comes with steep costs like commissions and fees (which you may have a hard time quantifying given the opaque nature of a lot of insurance contracts). Given the commissions and other expenses of many insurance products, opening a taxable account with a mutual fund company and investing in a low cost index fund may work out better for you in the end.

Most tax shelters resulted from lobbying by special interest groups and their tassled loafer-wearing lobbyists. They weren’t created with your personal finance needs as the uppermost priority. Don’t see these tax shelters as your uppermost priority.

Crime News: did the minister steal from the newlyweds? http://www.wtop.com/?nid=456&sid=1261008.

Tuesday, October 9, 2007

How the Government Fosters Market Instability

The U.S. government promotes instability in the financial markets. Not intentionally; but its policies have that effect. Here’s how.

Low Interest Rates. Interest rates once reflected the time value of money--that is, the value that a lender placed on a dollar in the future versus a dollar today. Today, interest rates are established to a large degree by central banks such as the Federal Reserve, as a way of controlling the rate of economic activity. The market dynamic of individual--atomistic, to use the economist’s term--lenders and borrowers interacting with each other to find interest rate equilibriums has been superseded by centralized decisions about the government’s preferred rates of inflation and economic growth. The Federal Reserve kept interest rates low. Recall Econ 101. When the price of something is low, people consume more of it. Since the government kept the price of credit low, people have borrowed more heavily. Large amounts of borrowed funds were used for speculative investment, which inflated asset prices, especially real estate values. That, as we have discussed before (http://blogger.uncleleosden.com/2007/08/uncle-alans-legacy-at-federal-reserve.html), ended with things spinning out of control in the now falling real estate markets.

Risk-based Capital Standards. The Federal Reserve and the central banks of other industrialized nations apply risk-based capital standards to the commercial banks they regulate. In other words, the higher the risks of the assets they hold, the more capital they must maintain. These standards, in effect, raise the costs for banks to hold relatively risky assets like many private sector loans. That would include mortgages, credit card balances, and corporate loans. To keep their capital requirements and expenses down, banks sold off much of their loan portfolios to investors. The problem is that these investors represent a flightier “deposit” base than traditional depositors. When confronted with uncertainty, they stopped making deposits (i.e., stop buying loans from the banks), and tried to extract the money they’d already invested in assets purchased from the banks by dumping those assets on the open market. That led to the buyer’s strike in the CDO market, the commercial paper market, the leveraged buyout market and the overall corporate debt market.

The risk-based capital standards didn't restrain banks from creating risk. The banks created vast amounts of risk and purportedly transferred it to investors because they dodged increased capital requirements and received nice inflows of fee income for doing so. But those risks rebounded back at the banks to the tune of $20 billion plus in recent write-offs, and perhaps more in the future. Bank regulators apparently didn't appreciate that it's extremely difficult for a bank to fully separate itself from a loan it's made. Investors won't buy every risk inherent in a loan; just a contractually defined set of risks whose meaning lawyers can squabble over for years. And bank regulators may not have fully understood the extent to which banks used off-balance sheet vehicles to "purchase" the risky loans the banks were creating. See http://blogger.uncleleosden.com/2007/09/conduits-and-sivs-chill-from-shadow.html. These investment vehicles were usually funded by the banks, and their losses sometimes became the banks' losses. The banks may not, in many cases, have transferred the risk of loss after all. Risk-based capital standards may have made regulators focus too much on the banks' accounting practices, instead on their lending activities. And those activities did much to destabilize the markets.

Tax Policy. The structure of the tax system discourages prudence and encourages risk-taking. Interest from bank deposits, money market funds, bonds and other conservative investments is taxed at high ordinary income rates. Long term capital gains and qualified dividends are taxed at lower rates. Buying a home is favored with mortgage interest and property tax deductions, and the exclusion of gains from income taxation (up to $250,000 for individuals and $500,000 for married couples). While investing in common stocks and real estate confers benefits to society up to a point, the 2000-01 stock market crash, the recent real estate bubble, and older events like the stock market crashes of the 1970s and 1930s demonstrate that over-investment in these particular asset classes can be a problem. But with income from savings taxed at ordinary rates, people have little incentive to invest conservatively and thereby provide a stable pool of capital for borrowers. (The overall negative savings rate of American households demonstrates the point.) Thus, too much capital—whether it be for mortgage, credit card, or corporate loans, or even the federal government’s borrowings--seems to come from flighty investors in the financial markets. Much, perhaps too much, of that capital is short term and ready to fly off to the European Union or Japan on a moment’s notice.

Federal Deficit. The enormous federal deficit is funded to a large degree from overseas. Ordinarily, one would expect the deficit to push interest rates up, since it competes for a large quantity of the world’s holdings of dollars. The Fed, however, has dealt with that problem by holding interest rates down. But the large quantity of Treasury securities held overseas adds to the pressure on the dollar. As the dollar declines, investors will sell off dollar-denominated assets, adding to their volatility.

Lack of Regulation of Derivatives and Hedge Funds. It has been government policy for 20 or more years to refrain from regulating over-the-counter financial derivatives and hedge funds. Hedge funds investing in over-the-counter financial derivatives are at the heart of the current credit crisis. The lack of regulation left the government unaware, until too late, of the reckless use of poorly conceived adjustable rate mortgages that were sometimes marketed through hucksterism and fraud in enormous amounts and packaged into carelessly constructed financial derivatives that presented exceedingly high levels of risk that may not have been fully disclosed to investors. The regulatory shortfall also left the government, at the moment of crisis, not having sufficient detailed information about the high degree of leverage used to finance the intertwined investments, liabilities and exposures of market participants. As a result, it made policy based in part on anecdote and guesswork. The rationalization for not regulating derivatives—that sophisticated market players would use them to spread risk and smooth market turbulence—sounds strained in light of the continuing credit crunch and the $20 billion or so that major financial institutions have written off in the last few weeks. Somehow, in spite of all the brilliant minds on Wall Street, a few tens of billions of dollars of risk wasn’t spread around. And the rationalization for not regulating hedge funds—that they’re market pros who know what they’re doing and regulation would only interfere with their rational allocation of capital—might still be useful as a gag line on late night television, but not much more.

The private sector had the perfect opportunity to get its act together after the Long Term Capital debacle. But it did not heed the warning, since annual bonuses beckoned and the losses that might emerge five years hence were problems for five years hence. The regulation of derivatives and hedge funds can be tailored to focus on the problem areas (http://blogger.uncleleosden.com/2007/08/financial-engineering-money-maker-and.html). But, after everything the hedge funds and their derivatives investments have done in recent months to disturb our tranquility and equanimity, the head-in-the-sand act by the regulators no longer washes.

The government doesn’t bear primary responsibility for the subprime mortgage mess. That falls on the mortgage brokers, banks, investment bankers and hedge fund money managers that created and invested in the dumb mortgages and derivatives that created the losses. These people naturally are the first to call for Federal Reserve interest rate cuts, since they need to foist responsibility on the government before the class action plaintiffs lawyers can get a foothold.

The government doesn’t intend to foster instability; indeed its policies are meant to have the opposite effect. But policies that might have originally served sound purposes now sometimes have unintended consequences. Financial institutions, investors and ordinary citizens are discouraged by the government from subscribing to old-fashioned virtues like prudence, thrift, and moderation.

In heat of crisis, we focus on whether or not we can hear the distant bugle calls of the cavalry riding to the rescue. Fortunately, the Federal Reserve can still, if necessary, fire a few more volleys with monetary policy. However, it will run out of ammunition sooner or later, especially if inflation flares up. Then what? The federal government no longer has a fiscal policy; it simply engages in deficit spending without the slightest hint of restraint. With the tax structure punishing savers, there isn’t much of a domestic pool of capital to finance new private sector investment. The decline in the dollar will motivate foreign sources of capital to demand exceedingly high premiums. So the question remains: then what? When one looks at the last 20 years in Japan, with speculative bubbles in the late 1980s in its stock and real estate markets, followed by stagnation that continues to this day, one can see how an economic juggernaut that lets speculative risk run riot can end up in limbo for a long time.

Travel News: If you're headed for New York for a good night's sleep, here's a hotel to think about. http://www.wtop.com/?nid=456&sid=1263424.

Monday, October 8, 2007

The Globalization of Finance and the New Ugly Americans

The United States won two global wars in the 20th Century. The first was World War II, a struggle against fascism. The economic might of the nation produced 100,000 military aircraft, more than 50,000 tanks, over 100 aircraft carriers, 2,750 cargo vessels called Liberty ships, and enough other resources to support 16 million personnel in uniform. While valor and constancy in the face of hardship are essential military qualities, a steady supply of ammunition and rations, combined with friendly skies above, greatly enhance the prospects of victory.

The second global war of the 20th Century was the struggle against Communism. Although this war involved localized fighting in Korea, Southeast Asia, Afghanistan and southern Africa, along with a bunch of cloak and dagger stuff in Latin America, it consisted primarily of an arms race between the Soviet Union and the United States. At the end of the day, it’s hard to say who might have prevailed in a military confrontation. America dominated the skies, but Soviet submarines were a serious threat. There is no doubt, however, that America’s enormous wealth and technological lead made continuation of the arms race infeasible for the Soviets. The U.S. economy won the Cold War.

After the Iron Curtain fell in 1990, the values of the victorious economy spread rapidly throughout the world. The Soviet command and control economy was largely privatized. The Communists calling the shots in Beijing, with characteristic Chinese pragmatism, became capitalist in all but name, and more convincingly so than the Soviets. Socialist regimes throughout the Third World abandoned attempts to centralize their economies and solicited capital from Western companies and banks.

Stock exchanges sprang up everywhere. Financial markets were globalized. Many foreign nations established independent financial regulators modeled after the U.S. bank and securities regulators. American notions of investment and risk management received acceptance. Just as Roman gods came to be worshiped where Carthaginian armies once held sway, freewheeling American-style finance gained ascendancy.

American financiers were quick to promote their products worldwide. It became possible to buy U.S. stocks and bonds around the globe 24 hours a day. The U.S. Treasury securities that fund the enormous federal deficit were sold heavily overseas. And the U.S. housing market also came to be funded from overseas, as mortgage-backed securities were peddled as ways to safely secure a higher return than U.S. Treasury securities.

Unfortunately, not all of the American financial products worked out well. Mortgage-related losses have caused banks in Germany and the U.K. to effectively go under. Hedge funds in several foreign nations have folded. Many foreign banks have recorded hundreds of millions or even billions of dollars of losses. As we have discussed before (see http://blogger.uncleleosden.com/2007/07/how-cdo-market-increased-subprime.html), mortgage-related investments were created with the sophomoric notion that prices in the real estate market would keep rising, while scant attention was paid to the excessive risk levels that the investments contained. How could the brilliant minds on Wall Street, educated at the finest universities and working for the haughtiest of investment banks, have created such a mess? Did they really believe that the exceptionally favorable conditions of the post-Communism era would last forever?

Any salesperson knows that it can be easier to sell a product to a less knowledgeable customer than one that knows the lay of the land. Could it be that CDOs and other now toxic financial instruments were easy sells overseas when the mantras of asset diversification and risk spreading resonated under the peeling bells celebrating capitalism’s victory? Was the evident superiority of the free enterprise system used too glibly to promote belief in the infallibility of American financial products? Did any of the American bankers selling these products overseas consider the potential for long-term damage to relationships when their customers realized that the American prince was a toad? Or did the pursuit of the biggest annual bonus render all of these considerations immaterial?

A nation’s products, when sold overseas, fairly or unfairly reflect on the nation. Defects in Chinese food products and toys cast China in a poor light, even though the nation as a whole was not responsible for their manufacture. One could reasonably say that the Chinese government should have regulated these products more carefully, and it now may be taking steps toward doing so.

Similarly, defective American financial products, fairly or unfairly, reflect badly on the United States. Foreigners may quietly be saying that Americans were short-sighted and too quick to make light of risk, while looking for a fast buck at the expense of investors from other nations. They might think that U.S. regulators should have been more vigilant in overseeing the highly overpaid financial engineers who created these disasters. Perhaps U.S. regulators are taking steps to do so, although evidence to this effect remains scant.

With the dollar sinking, foreigners have plenty of incentive to shift capital away from American financial products. The stock markets of other nations have grown in the process of post-Cold War globalization, and there are ample investment opportunities denominated in currencies other than dollars for Middle Eastern oil potentates, Asian central banks, Swiss dentists, Japanese housewives, and other holders of excess capital. And don’t be surprised if American hedge funds sneak a peak across the oceans. After all, they won’t be earning that 2% and 20% for long if they don’t generate profits. While the most sophisticated of investors, regardless of nationality, will understand that investments must be evaluated on their own merits, many of the investors injured by the mortgage mess aren't so worldly.

Things in the world of money and finance are often done quietly, behind closed doors. Because the United States remains the world’s financial superpower, foreign criticism of its monetary policies and investment products may remain muted, if for no reason than to keep the financial markets calm. But there would need to be little more than a raised eyebrow from a government official, or a frown from a senior corporate officer, to make money managers worldwide turn away from dollar-denominated investments.

Economic models go in and out of fashion. The more heavily regulated economies of nations like Japan, Korea and, to some degree, Germany, operate better when markets are volatile and economic well-being is unpredictable. In these nations, government regulation, along with cultural restraints, prevent the intrusion of high levels of risk, even though they suppress the potential for the outsized profitability that fuels innovation and investment. Less regulated and more free-wheeling environments, such as America and the financial markets of London, do better when markets are less volatile and times are flush. Under such circumstances, risk-reward ratios swing in favor of taking chances, and lack of restraint and regulation pays dividends. Whither the world economic cycle? Ask three economists, and you’ll get four answers. But the sale of shoddy American financial products will look thoughtless and arrogant to foreigners booking losses, at the same time that those losses and the market volatility they have caused will push the world economy away from the conditions favoring the victors of the 20th Century.

Automotive News: the vehicle for a family of 19. http://www.wtop.com/?nid=456&sid=1262548.

Friday, October 5, 2007

Financial and Personal Privacy

As the use of the Internet extends farther and farther, more information about you becomes available on the world’s largest communications medium. Consequently, the less privacy you have. Personal privacy was once defined by property lines: your home was your castle. Today, privacy is much more a matter of your personal information, and who knows it.

Technology won’t entirely solve the problem. The Internet was designed for communicating information, not protecting it. While legitimate and responsible organizations will constantly strive to improve privacy protections for their customers and constituents, there’s bound to be somebody somewhere who can hack through any technological solution. Identity theft has become rampant.

Don’t rely on the law. The legal system is behind the times in terms of defining and protecting personal and financial privacy in the Internet Age. A sales person cannot trespass on your property and bombard you with sales pitches. But businesses can buy your personal information and use it in a variety of annoying and unwanted ways, all the while increasing the risk that your identity will be stolen. Ten or twenty years from now, the legal system may have caught up with technology and business practices, and constructed strong protection for personal information. Until then, rely more on yourself than the law.

Here are some suggestions:

1. Leave Fewer Footprints. Internet banking and payment systems may be convenient for you. But the reason they’re so prevalent is that they are convenient for banks, utilities, credit card companies, and the other organizations providing them. A large part of the financial system involves bookkeeping, and it’s cheaper to keep books with a computer than with human beings. So the banks, credit card issuers, etc. want you online. The fact that it’s more convenient for you is just a marketing ploy to make you more convenient and profitable for them. But the more your financial life is online, the larger the number of your footprints for online predators to spot and track. Every fall, numerous deer fall prey to people wearing bright orange. It’s usually the incautious deer that end up decorating someone’s wall.

2. Read the Privacy Notices. Banks and credit card companies are required by law to disclose to you their privacy practices. These disclosures are usually made in slips of paper tucked into your monthly account statements, that have an annoying habit of falling out when you open the envelope. It’s almost as if someone wants you to be so annoyed you throw the slip of paper away without reading it. Don’t throw it away. Read it. The disclosures will tell you how much access the bank will provide to others about your account records. Especially important are the disclosures concerning access by third parties. That means the bank may provide your personal information to persons outside the bank. You may have the right to object to some of these third party disclosures, such as those made for marketing purposes. Make sure you object if you don’t like them. Limit the number of organizations that have personal information about you. Reduce the spam, junk mail and marketing telephone calls you get.

3. Don’t Go For 15 Minutes of Fame. Andy Warhol wasn’t talking about something good when he referred to everyone having 15 minutes of fame. Celebrity does more to entertain the audience than elevate the subject. Splattering your entire life on the Internet facilitates identity theft. It also can limit your options. Maybe once you were a beer-swilling gearhead, but today you’re pursuing an MBA with the hope of securing a job with an investment bank. There’s nothing wrong with your ambition. This is America, and it’s the inalienable right of all Americans to re-create themselves. But those photos posted online, showing you stumbling over empty quarter barrel kegs on your way to worship the porcelain goddess, may clash with the pinstriped image you now want to project.

4. Check Your Credit Reports. You’re entitled to a free copy of your credit report once a year from the three credit reporting agencies: Experian, TransUnion and Equifax. Checking your reports doesn’t directly protect your privacy. It just tells you who’s been poking around in your records. But finding that out is the first step toward dealing with improper or unwanted access to your records.

5. Freeze Your Credit History. If you’re a resident of most states, you can freeze your credit history, and make it inaccessible to third parties except with your express permission. We’ve discussed this before at http://blogger.uncleleosden.com/2007/06/protecting-your-credit-files-with-fraud.html. This is a very good idea, because you then control access to some of the most important of your personal information. It creates a little more work for you whenever you apply for credit (because you have to personally lift the freeze to let the potential creditor see your credit history). That can take a few days. But it’s a small price to pay for privacy.

6. Safeguard Your Paper Records. Have a locking mailbox. (A lot of identity theft today still begins with the theft from mailboxes.) Shred or at least tear up financial records you throw away. Have a home safe—you have people coming in to work on your house, clean it, repair the appliances and do a variety of other things; not all of them can necessarily be trusted. Keep the number of credit cards you have down to a minimum. Close out the credit cards you don’t use. This will reduce the quantity of paper records for someone else to steal.

Protecting your privacy takes work. But it's worth it. Repairing your credit history after your identity has been stolen is a veritable task of Sisyphus. Preventing an identity theft takes much less effort than repairing the damage from a theft.

Crime News: Using bugs as mules. http://www.wtop.com/?nid=456&sid=1261401.

Wednesday, October 3, 2007

Assisted Living: Financing, Choosing and Monitoring

One of the largest potential expenses an elderly person faces is assisted living. Assisted living is for those that have difficulty living independently, but are still capable to some degree of taking care of themselves. Assisted living facilities provide a resident with individual space—usually an apartment or a large room that is comparable to a studio apartment. They also provide meals and help with daily needs like bathing, dressing, taking medication, and getting around. The facility may be as small as a large house, or as large as an apartment complex.

I. Financing Assisted Living

The cost of assisted living is high and headed higher. It’s not unusual in large urban areas to pay $5,000 or more a month. That translates into $60,000+ a year. Medicare does not cover the cost of assisted living. Neither does Medicaid. There are several ways to pay for it.

Long Term Care Insurance. Long term care insurance is growing in popularity because it can cover a substantial amount of the cost of assisted living, as well as other expenses of caring for the elderly. It’s best to buy coverage when you’re under 50 or, better yet, under 40, if possible. The younger you buy, the more likely the premiums will fit within your budget. If you wait to buy long term care insurance until you are in your late 50s or early 60s, the cost will be very high (several thousand dollars a year per person).

Savings and other assets. The potential need for assisted living and other care is one of the strongest reasons for saving scrupulously when you’re younger. If you can’t afford long term care insurance or don’t want to buy it, having a pool of savings will give you peace of mind. Another alternative is to sell non-cash assets. If you won’t be driving your ’71 ‘Cuda convertible with the 426 hemi engine any longer, consider selling it to raise money for the costs of assisted living.

Sell the house. If you weren’t a good saver, but always paid the mortgage on time, you may have entered retirement with your house free and clear of debt. If so, good for you, because the house can be sold to pay for assisted living. Forget about a reverse mortgage—you can’t get a reverse mortgage if you’re not going to live in your house. If you already have a reverse mortgage on the house, you may not be able to raise much money by selling the house, because the reverse mortgage has to be paid first. That’s a reason to be cautious about taking out a reverse mortgage.

Family. Members of your family may be willing to help cover the cost of assisted living. This, of course, is a question each family must decide for itself. If you don’t want to turn to your children, buy insurance and/or save.

II. Choosing a Facility

By the time an elderly person needs assisted living, choosing a facility will likely be the responsibility of a younger member of the family. Almost by definition, the elderly person won’t be mentally or physically capable of driving around and inspecting a number of places. So, if you’re the person responsible for choosing a facility, here are a few things to keep in mind.

State licensing. Many states require assisted living facilities to be licensed. Check to see if that’s the case in your state, and ask the state government if the facilities you’re considering are properly licensed. Also find out if the facility (or its parent company) is the subject of any enforcement or disciplinary proceedings. Ask the state government if you can obtain the results of any inspections of the facilities (probably not, but it doesn’t hurt to ask).

Visit the Facilities. Personally visit every facility that’s under consideration. Take a tour. Ask every question that comes to mind. Don’t be shy or reticent. Your loved one may be living here soon, so be a tough customer. The facility will have its sales staff give you the tour, so you won't learn about the place's imperfections unless you're nosy.

Try to get a look at some of the current residents. If you’re relatively young, seeing elderly folks in a setting like assisted living can be somewhat of a shock. They are frail and move slowly. Many aren't very alert, and some barely seem coherent. Without doing anything you would consider rude or instrusive, though, try to evaluate how the residents are doing. Do they appear content? Do they seem comfortable? Do they look like they’re doped up? Do they appear unhappy? Do they seem frightened or intimidated by the staff? If possible, consider engaging one or more of them in a brief conversation and ask how they like the place.

Find out about staffing, especially at night. If a facility with a couple hundred residents has only a handful of staff on duty at night, be cautious. Ask how often they check on the residents at night. (Nightly checks are essential, since elderly residents can fall and hurt themselves in the darkness, and be unable to summon help.) Find out what qualifications the night staff have—is any one of them a nurse? The night staffing is especially important if your family member is mentally impaired.

Find out how many nurses they have on staff and what kind of nurses these are—the number of RNs is important, as are the times or shifts they work.

Make sure the facility has an emergency electrical generator, which can step in if the power goes down. (Elderly people should always have air conditioning and heat, especially if they’re paying $5,000 a month or more.)

Make sure that you, as a family member, are entitled to visit your resident family member at any time of night or day, any day of the year, with no exceptions for holidays or any other time. You and your elderly family member should never be cut off from each other.

Sample the food. You know it will taste like cafeteria food. But if they can’t even manage to serve fresh or frozen vegetables instead of canned, move onto the next facility on your list.

Get references. Ask people you know for references about facilities. A reference may be far more informative than the facility's sales brochure or a tour. A person with a family member who's lived at the facility will have months or years of experience with the place. Ask how diligent, caring and considerate the staff are. Ask how promptly the staff returns phone calls and how forthright they are in answering questions. Ask what complaints the reference or the reference's family member had. Ask about slip ups and foul ups.

Make sure you evaluate the person giving you the reference. A colleague who is a nice, easy-going person and who doesn’t make waves may tell you a facility is fantastic. Discount that opinion. If a demanding, pushy, and aggressive acquaintance tells you a facility is fantastic, consider that a valuable reference. Don't place much weight on a facility's reputation. Reputation and reality are sometimes far apart when it comes to assisted living facilities. No facility is perfect; you want to know about the imperfections.

III. After the Move

Once your family member takes up residence at a facility, be vigilant. Now is the time to be a really tough customer. Visit the facility often. Don’t go at the same time on the same days each week. Vary the days of the week you visit, and the times when you arrive and leave. Find out if the place is clean all the time, or only during daytime business hours, when outsiders are likely to be visiting? Are the scheduled activities for residents actually conducted? Are residents able to move around, and are they properly escorted outdoors (especially if mentally impaired)? If your family member mostly stays in his or her apartment, does the staff check up on him or her? Is your family member eating regularly? Is the correct medication dispensed and given at the correct times and in the correct doses? Is laundry done on time and is it clean? Has anything been stolen from your family member's apartment?

Be sure to visit at night and observe what’s going on. Do the night staff members have family or friends visiting them in the lobby? Are they playing with their children or chatting with their siblings? Is the staff distracted from monitoring the residents? Are the staff clustered at the front desk, around the nurses station, or in the smoking area outside, catching up on gossip? Are food trays left uncollected in the hallways for hours on end?

Don’t be reluctant to complain. In many cases, your elderly family member won’t be as capable of complaining and following through on a complaint as you. This isn’t like your workplace, where you may have colleagues to help you and supervisors to field the hard questions. You’re on the front line and you’re probably on your own. Take charge.

Caring for an elderly parent or other family member will be one of the most difficult things you’ll do, because it will demand a lot of you and everything you do will be tinged with sadness. But if you do it well, you’ll have the satisfaction of knowing that you did your best when it really meant something to someone very important to you.

Food News: a new grits eating champion. http://www.wtop.com/?nid=456&sid=1258645.