Thursday, November 29, 2007

Alternative Minimum Tax Mess Delays IRS Refunds

You can expect your income tax refund next year to be delayed. Despite fervent promises, Congress didn’t deal with the alternative minimum tax before Thanksgiving. Although Congress can be expected to fix the AMT (at least for this year) after it gets back from the Thanksgiving break, the IRS will need about ten weeks to program its computers to incorporate the fix. Consequently, refunds will be delayed.

The alternative minimum tax is the shadow tax system that affects more and more people. It was originally enacted in 1969 because of outcries over a few wealthy persons who paid little or no any income tax under the regular tax code. The AMT was meant to prevent the wealthy from using a variety of deductions and other provisions to avoid paying taxes.

However, the AMT is seriously flawed. It does not adjust for inflation. Thus, it reaches farther down the economic ladder as nominal incomes rise with inflation. The regular income tax brackets are raised to account for inflation, so the federal government doesn’t get an automatic revenue boost simply from the cheapening of the currency. But the AMT is the ace up the government’s sleeve. Depending on how much additional income it wants each year, the government enacts the “patch” on the AMT annually to bring in extra revenues the regular tax code wouldn’t have provided. It's true that the patch prevents full application of the AMT (which would reach into the middle middle class), but the patch nevertheless results in taxation of a lot of people who will never own a yacht.

The lurking presence of the AMT means that taxpayers have to do two calculations of their tax liability each year: once for the regular tax code and a second time for the AMT. Both calculations are required even if you don’t owe any AMT, because you can’t determine that you owe no AMT until you do both calculations. Thus, the AMT means more work for you at tax time even if you don’t owe more tax.

The AMT is schizophrenic, as taxes go. Some of the benefits it penalizes are long term capital gains, accelerated depreciation, percentage depletion allowances, and income from specified private activity municipal bonds (i.e., revenue bonds). This sounds like the AMT as it was originally intended. Most people who work in cubicles and drive Dodge Neons or Honda Civics don’t report many of these items on their tax returns.

But other deductions that are penalized by the AMT include state and local taxes, and personal exemptions (read, exemptions for dependent children). What are they smoking on Capitol Hill? Do people sneak around and pay state and local taxes with sly smiles in order to slip one by the IRS? Do people have children in order to flip off the tax man? Given America’s demographic problems, with increasing numbers of older people expecting smaller numbers of younger people to cover their Social Security payments, why does it make sense to tax parents more for having children?

The flaws of the AMT notwithstanding, there is little hope for serious change. The AMT provides tens of billions of dollars of extra tax revenues each year. It reaches into the upper middle class and extracts extra payments from millions of people who are not tax-dodging filthy rich, but rather those with large families who live in states with high state income taxes. The federal government is now mainlining revenues from the AMT and, with the mammoth budget deficits it runs, it won’t kick the AMT habit any time soon.

So the most you can expect is another ad hoc patch in the next few weeks, whose tardiness will delay your refund. Hopefully, Congress and the IRS will also give us extra time to get our tax returns filed, since we probably won’t be able to get instructions and forms on how to comply with the “patched” AMT at the crack of dawn on Jan. 2, 2008. But heaven forbid that we should hope for dispensation from the tax system.

Legal News: the judge that didn't like cell phones.

Tuesday, November 27, 2007

Did Mortgage Bankers Puff Up Appraisals?

The attorney general of New York, Andrew Cuomo, has sued a mortgage appraisal firm for allegedly inflating its appraisals under pressure from a major mortgage bank, Washington Mutual. At the same time, the New York A.G.’s office is reportedly conducting an investigation of other participants in the mortgage markets, including Fannie Mae and Freddie Mac.

If it turns out that appraisals have been puffed up due to pressure from mortgage bankers, the impact on the mortgage mess could be enormous. Appraisals are supposed to verify for lenders the value of the property being bought. If its value is less than the mortgage loan, the lenders, rationally speaking, wouldn’t want to make the loan. The borrower would have little or no stake in the house. If the borrower has trouble making payments, refinancing would be impossible and the borrower might just walk away. The loan wouldn’t be well-supported by its collateral, and the lender would be likely to take losses.

The NY AG alleges that at least one mortgage lender pressured an appraisal firm to inflate its valuations. In other words, the lender supposedly did something that would be economically irrational—lean on an appraisal firm to phony up documentation so the lender could make a risky loan that had an increased risk of nonpayment. Why would a banker do that?

The defendant in the NY AG’s case has denied liability. But if the facts are as alleged, a possible motive might be that the lender would make a lot of money from fees while selling the loan in the mortgage markets and thereby dodging the risk of default and foreclosure. In other words, the availability of the securities market as a dumping ground for phonied up loans may have made it all too tempting to play this game. And the more you play the game, the more money you make. As we know, huge quantities of dumb mortgage loans have been made. Did mortgage lenders lean on appraisal firms to phony up the numbers so the mortgage lenders could make and sell more loans in order to get more fees?

A rising market covers up a multitude of frauds. And a rising real estate market would have covered up appraisal fraud, if it occurred. Indeed, phonying up appraisals would have boosted the market higher. Thus the fraud could have assisted in covering up the fraud with more fraud.

However, we know from the Dutch experiment with tulip bulbs that no market can rise continuously forever. And so it was with the real estate markets. This, like all balloons, deflated; and we are left to sort things out.

If appraisals were phonied up, the consequences would have rippled out in many directions. Homes will be worth less than expected. That will hinder refinancings and resales, which will heighten the risks of defaults and foreclosures. Investors in mortgage-backed securities and CDOs will have paid too much for their investments, and might become new best friends with plaintiffs lawyers. Banks that pressured appraisers to pretty things up and then sold the mortgages into the secondary mortgage market might face increased capital requirements, and mega civil and even criminal liability. Investors will be hurt when losses from mortgage-backed securities and CDOs prove to be even greater than already expected as recoveries from foreclosures disappoint. Insurers of mortgage-backed securities and CDOs may face even greater liabilities on their guarantees. Consequently, other investments they’ve guaranteed, such as municipal bonds, could suffer as the insurers’ creditworthiness declines. In short, a lot of people might end up in a deep, dark vat.

The NY AG deserves credit for acting. Appraisal fraud, if it occurred, would present a fundamental threat to the integrity of the real estate market; and, derivatively, to the secondary mortgage market, the CDO market, and any other markets they might affect. We need to do more than provide liquidity to distressed banks and accommodations for victimized borrowers. We need to deal with wrongdoers, and ensure that there are consequences for engaging in fraud.

Legal Footnote: standing on a New York sidewalk is not a crime.

Sunday, November 25, 2007

A Lesson From the Subprime Mortgage Mess: Risk Never Dies

If you own municipal bonds, you might think you’re far removed from the subprime mortgage mess. After all, muni bond holders are probably the last vestige of the coupon clippers of yore, cautious, conservative, parsimonious with their tax liabilities, and about the last people who’d have an interest in illiquid, opaque, alphabet soup derivatives.

But the muni bond market has been shuddering lately, because insurers of muni bonds, such as MBIA, Ambac, CIFG, and FGIC, have subprime mortgage exposure. These companies insured billions of dollars of CDOs, derivatives contracts based on pools of mortgages. They have evidently been taking writedowns on account of their CDO exposure. That, in turn, has raised questions about their ability to stand behind their guarantees of municipal bonds. Guaranteed muni bonds are suddenly less valuable than they were a little while ago. Coupon clippers living in Beacon Hill are seeing dips in the value of some of their muni holdings because an investment bank in midtown Manhattan underwrote opaque and illiquid CDOs that purported to turn low-grade, high risk mortgage loans into AAA-rated investments that were bought with extreme levels of margin debt by a 34-year old hedge fund manager in Darien who has a very good resume but not much common sense.

This was made possible courtesy of the derivatives markets, the famed bazaar where risk could be bought, sold, swapped, insured, sliced, diced, stripped, mixed together and synthesized, all served with your choice of ketchup, mustard, mayonnaise, relish, pickles, onions, sauerkraut and horseradish. Holders of risk could, for a price, offload just about any can of worms they found too slimey to keep. From their perspective, risk could miraculously be eliminated.

But muni bond investors are spilling their tea on account of fly-by-night mortgage brokers selling impossible-to-repay option ARM mortgages to poorly educated home buyers in places like Detroit, Cleveland and Fresno. This illustrates a simple, but frequently overlooked, truth in the financial markets: risk never dies. All financial transactions involve risk of one sort or another. These risks can be and often are transferred. That’s what insurance is for, and that’s what the derivatives markets do. Transference of risk, though, doesn’t mean the risk ceases to exist. It’s still around, supposedly in someone else’s hands, but nevertheless maintaining a pulse and brain wave activity. If the risk blows up, somebody will take a loss. The only question is who.

When an insurance company insures a CDO, it will initially take the loss from a mortgage default. In the ordinary course of business, insurers maintain reserves to cover anticipated losses and can take mortgage defaults in stride. But, as we discussed before, the risks created by the subprime mortgage industry were enormous (see The insurers evidently didn’t have large enough reserves for the amount of risk that was out there. Perhaps they weren't aware of the enormous amount of dumb mortgage loans that were made, or how intertwined liabilities in the derivatives markets have become. Whatever the case, there was more risk than they were expecting.

If the Department of Motor Vehicles were to lower its standards and license a large number of poorly trained and unskilled drivers, the public (as well as auto insurers) would be outraged. Maybe there’s an argument that society is better off if more people can drive. Then, they could drive to where jobs are, and unemployment levels would drop. Auto manufacturers and dealers would probably enjoy increased sales. But this shouldn’t happen if it comes at great cost to the rest of us in the form of accidents and injuries.

Vast numbers of mortgage loans have been made that won’t ever be repaid. There is an argument that society may be better off if more people are homeowners. But that’s true only if it doesn’t involve great cost to the rest of us. The surfeit of subprime loans made in the last few years resulted from the illusion that the risks of these things could somehow be made managed or diffused. From the standpoint of mortgage loan originators, lending risk seemed to disappear. Since financial engineering made the risks seem to disappear, too many mortgage brokers and bankers apparently thought it would be okay to make enormous amounts of risky and downright lousy loans, especially if they got a lot of fee income in the process. Now, with losses from the subprime mess popping up in unexpected places, we are painfully reminded that risk never dies.

The dollar is declining, and foreign and American capital is gradually shifting into investments denominated in other currencies. This trend can only have been exacerbated by the subprime mess. After all, sudden investment losses, not currency fluctuations or balance of trade deficits, are the root cause of capital flight. The subprime mess has led to losses in the stock market, real estate market, bond market, derivatives market and now the municipal finance market. What’s next? All of these losses make the dollar seem like a lousy bet. The rating agencies are reportedly reviewing a number of bond insurers, and if they downgrade them, zillions of dollars of insured bonds will drop in value. Is there a good dollar-denominated investment still standing? Is it a wonder that capital is buying a ticket on the next plane to anywhere, as long as it’s out of the country?

Risk places stress on the financial system. The more risk that’s created, the greater the levels of stress. The challenge for the banking system and its regulators is to keep risk levels under control. That means constraining the amount of risk that’s created. With blowback from SIVs, guarantees on CDOs, proprietary mortgage-backed investments, LBO commitments, and the like, banks are learning the hard way that you can’t truly shift risk away, not when you create shiploads of it. There are too many interconnections in the financial system. This leads to the horrifying conclusion that, of all things, prudential lending standards will have to be imposed. But we’re living in a horror movie already, as risks that were thought to be long dead pop up out of every closet, attic and basement.

Art News: Million dollar painting found in trash.

Sunday, November 18, 2007

Thankfulness Amidst Subprime Mortgages, SIVs, Conduits and Credit Crunches

Let us note, in passing, that Thanksgiving will be this Thursday. Christmas decorations already festoon many stores. A few homeowners have put up their holiday lights. Retailers have shamelessly leaked to the media word of special sales beginning as early as midnight of the day after Thanksgiving. But, before we move on to the year end spenderama, perhaps we should reflect on a few things we should be thankful for.

Less financial lunacy. Before this summer, large numbers of highly educated and extremely well-compensated people on Wall Street acted as if they believed that the real estate markets would rise continuously forever, and that people with poor credit histories and no demonstrated ability to pay were good risks for adjustable rate mortgages, no matter how onerous the terms. Many fewer people today subscribe to these notions. A reduction of lunacy is always good.

Unregulated banking activities revealed. Many major banks have quietly financed a lot of activity through unregulated vehicles called SIVs, conduits and other odd names. Until recently, not much about these entities was known to bank investors, depositors or regulators. But we now know that they played a significant role in fostering the still ongoing credit crunch. Even though many problems remain to be addressed with respect to these off-balance sheet vehicles, more information in the market is better than less information. Had they remained buried in the footnotes of Forms 10-K, the problems they present might have remained unknown, and the risks they present to the financial system could have grown even greater than they are.

Derivatives defenestrated. Contrary to the mantras tediously chanted by their acolytes, derivatives have proven not to reduce volatility and make markets more efficient. Instead, they have turned out to increase risk levels and ensnare market participants worldwide in intertwined liabilities that can't be easily unwound without seriously wounding the financial system. Derivatives have been used, not as the hedging mechanisms they were advertised to be, but rather for speculation. And, because they are unregulated and information about them is either scant or nonexistent, the thicket of entangled exposures they created among major financial institutions went virtually undetected by regulators until both the worms and the can had become very large. The asset-backed securities market has already shrunk. Other derivatives markets, such as for default insurance and other credit derivatives, may be shrinking as underwriters demand increased premiums for the fact that risk never dies. Derivatives, to be sure, are no more magical or bulletproof than common stock or convertible subordinated debentures. They are just another type of financial instrument, with advantages and disadvantages. And that's good for people to know.

Hedge funds humbled. The new masters of the universe for the 2000s have proven, as they did in Tom Wolfe's superb novel, to have feet of clay. For the sake of getting a few basis points over Treasuries, they dove into an impenetrable mass of opaque asset-backed investments that proved illiquid when one would have given a kingdom for liquidity. Holders of capital who invested in the hedge funds that took losses are now finding out that when you invest in an unregulated vehicle, you're on your own when things go badly. There are no regulators to help you out. Good luck, because you'll need it.

Regulators required to rethink. The financial regulators have largely been caught flat-footed by the subprime mess and the credit crunch. They evidently didn't know how bad things were in the subprime mortgage market until it was too late. They apparently didn't realize how much stress had built up in the financial system with the creation of so many poorly conceived loans. They seem to have been unaware of the risks and problems presented by the bank-sponsored SIVs and conduits that are now desperately seeking a bailout. The regulators have muddled through thus far without a serious breakdown in the financial system. But the smarter ones among them know that muddling through isn't good enough for the future. It appears that basic regulatory issues are being reviewed and reconsidered in Europe. U.S. regulators, on the other hand, seem to be doing a pretty good imitation of Calvin Coolidge on a slow day. But with more losses to come from the subprime mess, and a presidential election coming in less than a year, that may change.

Executives exit. Two high profile CEOs and various other senior executives at a variety of financial institutions are now pursuing other interests as a result of losses at their firms. This is good. Nothing promotes accountability as much as holding people accountable. Given the magnitude of the losses, most of which fall on innocent investors, accountability is badly needed.

Markets like mattresses. Like a well-made mattress, the stock market has absorbed blow after blow from the subprime mess and credit crunch, and dropped only about 7% from their all-time highs. The Dow, S&P and Nasdaq remain up for the year. Unemployment is around 4.7%, virtually full employment level. Inflation remains moderate, albeit with hints of less moderation to come. A visitor from another planet might wonder why the enormous uproar. Of course, there's a point where the markets will turn south in a big way. But we're not there now, and perhaps won't get there.

Terrific fall colors. Perhaps it's because of the drought, which may be due to global warming, but the fall colors of leaves, at least in the mid-Atlantic area, are gorgeous. If you remember that some things in life are timeless, your time in life will be improved.

Babies smile at parents. Regardless of the fact that the ABX index, which tracks credit default swaps, continues to decline, babies still smile at their parents. Thirty years from now, that's what you'll remember best about these times.

Happy Thanksgiving.

Collector's News. If you want something very few other people will have, buy a piece of the Eiffel Tower.

Friday, November 16, 2007

The Mortgage Crisis at the Intersection of Main and Wall

On Thursday, November 15, 2007, the House passed a bill that would provide for licensing of mortgage brokers, require that mortgage loans be within the capability of borrowers to repay, and place liability for loan violations on banks that package mortgages into mortgage-backed securities. Bankers were quick to complain, and are reportedly seeking aid and comfort in the Senate. They may get a friendlier reception there, but the outcome remains unclear.

This legislation was predictable. The history of government regulation in America follows a well-established pattern. An industry grows and becomes economically powerful. It overreaches. A lot of people are injured. Public outcries for government action lead to regulatory initiatives. Thus it was for the railroads, whose monopolistic pricing led to the creation of the Interstate Commerce Commission. Thus it was for insurance companies, whose legendary use of impenetrable legalistically worded exceptions, exclusions and limitations gave the term "fine print" its popular meaning. Their reward was regulation by every state of the Union. And, so, too, for the banks, whose inability in the late 1800s and early 1900s to deal with a series of credit crunches left numerous depositors ruined, not through any fault of their own but because of faulty lending by the banks. The result was the creation of the Federal Reserve System.

In the manner of greased pigs at the county fair, businesses try to slip out of the grasp of regulators. For the financial services industry, the tactic was to convince the government not to regulate derivatives. And for the better part of the last 30 years, as derivatives were developed, the government largely refrained from regulating them. Realizing that they had the government where they wanted it, the financial services industry then slipped the business of banking into the unregulated derivatives market. Loans, the traditional province of banking, were packaged into asset-backed securities and sold to investors. The vehicles that connected investors to loans became, functionally speaking, the real banks. These vehicles, like Detroit's products, came in various shapes, sizes, models and colors. They have names like ABS, MBS, CDO, CLO, CMO, CBO, SIV, SPE, and so on and so forth. They were the actual source of funding for loans, using money from investors who effectively were depositors.

Given the absence of regulation in the derivatives sector of the banking industry, it's not surprising that this sector grew phenomenally. Without the limitations imposed by regulation (such as fair treatment of customers or adequate capitalization) and the costs of complying with regulation, revenues could flow faster toward the bottom line and gratifyingly large bonuses. Thus, bankers had every incentive to slip quietly out of the purview of the regulators.

Unfortunately, a lot of mortgage borrowers were trampled on the bankers' way to the Bentley dealer. Granted, many of those borrowers are in places like Cleveland and Detroit, cities that Wall Streeters might hardly deign to fly over. To a Leona Helmsley, these borrowers might have been little people. But in a democracy, they're the people, and they have votes.

Markets and market-based economies are harsh. They make some people winners, and some people losers. They have no code of chivalry. All too often, a small number of people become extremely wealthy by exploiting and victimizing many other people. This creates enormous imbalances of power and wealth that foster envy and social instability.

Government regulation enacted through democratic processes is how society regains its balance. Americans believe in the free enterprise system, and have no problems with a person accumulating dollars honestly earned, even a lot of dollars. But our economy is national and even international in scale. Only governments and their regulatory power can restrain the worst excesses of unregulated businesses. And we have certainly seen excesses in the subprime mortgage mess.

The legislation that passed the House will begin the process of bringing the unregulated portion of the banking industry under government oversight. It may not get through the Senate. And if it does, it will probably get a really big frown at the White House. (The big guy at 1600 PA Ave will probably forget that it was FDR, not Herbert Hoover, who was mourned by thousands of weeping people lining the streets of Washington when his horse-drawn caisson passed by; but W seems to have a problem with the vision thing.)

This is a win, win situation for the Democrats. If legislation is adopted, they can claim credit. If the Republicans block it in the Senate or the White House, the Democrats gain ammunition for the 2008 elections. All indications are that mortgage defaults for 2008 will be worse than they've been for 2007. More pain will be inflicted on Main Street, and the people will respond through the political process.

Could the bankers have avoided this outcome? Yes, if they had refrained from excess. But that would have required long term thinking and strategic planning. With the year-end bonus beckoning, why think about some schlemiel in a rundown Midwestern city who has a mortgage reset in a couple of years?

A few banking executives will perhaps realize that there may be other areas of banking with the potential for blowups like this. After all, mortgages aren't the only thing you can ease off the balance sheet through structured finance legerdemain. Perhaps they will quietly consult with their Audit Committees, auditors and attorneys about whether or not prudence might be the better part of valor. And perhaps this time, they will act before the government does.

Food News: world's record for downing hot sauce. What follows? The world's record for downing antacids?

Tuesday, November 13, 2007

How to Heal the U.S. Economy

Today, November 13, 2007, the business news was dominated by the mortgage mess. Recently announced bank losses make clear that the Federal Reserve's interest rate cuts in September and October haven't made the boo boos go away. Instead, they've returned with a vengeance, bigger than ever, and are knocking chief executives out of corner suites. All predictions are for further losses this current quarter and next year. While the Federal Reserve expects an economic slowdown, but no recession, many private sector prognosticators are more pessimistic.

Clearly, the financial services sector is wagging the entire U.S. economy. The New York Times reported on Sunday, November 11, 2007, that the financial sector accounts for 31 percent of all corporate profits in America. That's too much. You can't build a thriving economy on financial services. Banks don't produce anything tangible--you can't eat a financial service, wear one or seek shelter under one. Financial services are simply an adjunct to the true heart of any economy--the production of goods. People survive by extracting resources from the environment around them. That's why the production of goods remains the foundation of true economic strength. (If you don't believe this, think about China.)

Financial services firms are unquestionably necessary in a modern economy. They facilitate the process of economic exchange on a large scale, across long distances and even over international borders. They pool excess savings and make it available to businesses that hope to make productive use of it. They provide investment services to those who hope to save for the future.

But, as any good economist will tell you, there is a limit to the value of anything. Too much of anything and it loses value. The first bite of Belgian chocolate is much better than the 20th bite. And so, too, with financial services. Financial services firms used to make their money by providing savings and investment vehicles for the thrifty, underwriting offerings of securities for companies that needed capital, and making loans to businesses and other borrowers that were creditworthy. Today, financial services firms are obsessed with booking fee income, even if it means creating and selling opaque, complex, risky and illiquid investments that ultimately are causing a lot of pain and doing little or no good. The recklessness of the bankers involved in this stuff has resulted in hundreds of billions of dollars of accrued or likely losses. That's still a lot of money, even today.

Financial losses such as these cannot be eliminated. The only question is where they will land. They've been landing on hedge fund investors, banks, mortgage lenders, mortgage brokers, and last, but certainly not least, homeowners. And if there is a government bailout, as some on Wall Street and in Washington are crying for, losses will land on the taxpayers.

The subprime mess is the product of taking financial services too far. We don't need this much financial engineering. We don't need this much investment in real estate. Trying to turn people with poor creditworthiness or no creditworthiness into homeowners is like trying to build a house in a rain forest with mud bricks. And the worst part of it is that this was national policy. Homeownership was encouraged, not only for its supposed civic benefits, but because a rising real estate market would provide home equity that consumers could tap into in order to continue their merry escapades at the mall.

But you can't build wealth by creating asset bubbles. Home prices and equity can't rise continuously forever. Why all the brilliant and highly educated people on Wall Street couldn't figure this out is a very good reason not to rely on financial services to be a future engine for the U.S. economy. These are not people who should receive government subsidies or bailouts. The financial services firms should be forced to take responsibility for their actions, and book their losses.

The wealth of the U.S. is shrinking, with the dollar dropping in value and foreign capital quietly exiting with scarcely a tip for the hat check girl. Given our zero percent savings rate, America's limited capital base shouldn't be funneled toward more financial engineering or further attempts to make home loans to the non-creditworthy. Instead, it should be guided toward production.

America is a creative nation. Its creativity has made it the science and technology center of the world. More Nobel Prize winners in the sciences live and work in the U.S. than anywhere else. The Silicon Valley is a magnet for geeks from all corners of the globe. Formal and informal venture capital is available for almost every manner of tinkerer and garage-based technology startup. With its advantages in science and technology, America is a natural for the production of high tech products. Biotech is another area of great potential. Entertainment, including movies and television programming, is a major export. Okay, 98% of it is dreck, but it's better dreck than the movies and TV programming other nations produce. With global warming and industrial pollution in the third world rising, pollution control and environmental protection technologies are another area where America could do well. America is perhaps the world's largest producer of commercial aircraft.

International trade agreements make direct government subsidies of particular industries problematic. But let's stop diverting undue amounts of capital into real estate. It's only encouraged a degree of financial engineering that was too clever by half--and then half again. And we should require adult behavior from Wall Street. The Fed should keep the overall financial system liquid enough to function. But it should require losses to be booked, and managements to be held accountable. We have a crisis today in the financial markets because of a severe misallocation of capital caused in part by government policy and in part by monumental misjudgments by financial services firms. Extending or perpetuating that misallocation will prevent the U.S. economy from healing. The pimply-faced kid in a garage attic working on a pocket-sized device that makes phone calls, brews coffee, browses the Internet, picks up the dry cleaning, takes photographs, writes a novel, cooks a meal, displays TV programs, and drives your car automatically using GPS, is the future of America. He shouldn't have to compete for capital with a bunch of real estate speculators who have access to government subsidies.

Animal News: cows flee McDonalds. Who can blame them?

Monday, November 12, 2007

Is There Something About the Subprime Mortgage Mess the Federal Reserve Hasn't Told Us?

On Friday, November 9, 2007, the Wall Street Journal (page A2) reported that Federal Reserve Board Chairman Ben Bernanke proposed at a Congressional hearing that the federal government guarantee jumbo mortgages up to $1 million so that they can be resold into the secondary mortgage market. If you’re experiencing cognitive dissonance, you’re not alone.

Jumbo mortgages are mortgages greater than $417,000. Fannie Mae and Freddie Mac cannot, by law, purchase mortgages greater than this amount. Smaller mortgages (“conforming loans”) can be bought by Fannie and Freddie, and are readily resold because they benefit from the implicit federal government guarantee of Fannie and Freddie. Since the subprime mess and the ensuing credit crunch, jumbo mortgages have generally been shunned by investors and are now available only at significantly higher interest rates than conforming mortgages.

A federal guarantee of jumbo mortgages up to $1 million would be a subsidy for the upper middle class and the wealthy. Once enacted, it, like all government benefits for the well-off, would never be repealed. Although Chairman Bernanke said the government should impose a fee for the guarantee, do we really believe that it would be a fair amount? With the political influence of the well-to-do, might not the fee be set at a level that would warm the hearts of Lexus drivers everywhere?

This proposal includes moral hazard of the first degree. If a federal guarantee of jumbos becomes available, you can bet that lenders will require borrowers to pay for it, so that they, the lenders, can continue their business as usual of making loans and selling them to dodge responsibility if a loan goes sour. With federally guaranteed loans easily sold in the secondary mortgage market, lenders will have no incentive to enforce meaningful credit standards. Perhaps some federal agency somewhere will try to impose credit standards through the process of issuing guarantees. But what federal agency has the staff and resources to process trillions of dollars of loans to hundreds of thousands of people? The political pressure to process large quantities of loans very fast would be enormous. Eventually, ordinary taxpaying citizens could end up subsidizing the McMansion fantasies of the more fortunate in America.

Market based economies work well only if their markets are allowed to function properly. People who qualify for a jumbo mortgage can take care of themselves, even if they have to pay higher interest rates. Their creditworthiness, if properly packaged in transparent mortgage-backed securities, should be marketable in the secondary mortgage markets. There is private insurance for these securities, and for jumbo mortgages, if investors really want it. Why not let all these well-to-do people pay their own way for a product that they have the means to pay for? The federal government has enough burdens with Social Security, Medicare and Medicaid. Why should it now take on the housing needs of the upper middle class?

More important than this being bad policy, though, is the suspicion that something really scary must be going on. This idea is right out of the European Social Democratic play book. A really big bogeyman must be out there in the subprime world to make a free market Republican like Chairman Bernanke even think of federal guarantees of jumbos, let alone say it out loud at a Congressional hearing. Is the subprime mortgage mess and credit crunch worse than anyone is admitting publicly? Is the banking system so bedeviled with real estate losses that the entire U.S. housing market--conforming loans and jumbos--has to be federally guaranteed? Are there an enormous number of jumbo loans out there that are likely to default, and can only be refinanced with federal guarantees? Is the U.S. banking system insolvent, or likely to become insolvent shortly?

The lack of transparency about the subprime mess is one of the reasons why the financial markets are so unsteady. Yes, if the picture is really bad and everyone finds out, there is a risk of a run on U.S. banks and the dollar. But runs can, and have been, precipitated by uncertainty. Chairman Bernanke’s proposal only adds to the uncertainty. Before U.S. taxpayers become liable for every upper middle class mortgage issued in America, perhaps they should be given the full picture of what’s going on.

Crime News: a Robin Hood banker. Was he helping subprime borrowers?

Thursday, November 8, 2007

Passbook Savings: a Cure for the Banking and Real Estate Crisis

Just like hemlines, banking practices change with the times. Downpayments have come back into fashion, much to the consternation of credit lovers everywhere, who thought themselves the vanguard of the cashless society. Would-be home buyers find themselves scrambling for something to put on the barrelhead. Personal finance writers have suggested that they borrow from retirement accounts or life insurance policies, or through margin loans collateralized by their stocks and bonds. Other suggestions include finding out if your employer has a program to assist employees to buy homes, or making a withdrawal from the First National Bank of Parental Munificence. The one thing that gets little or no attention is the simplest way of all to put together a downpayment: clamp down on spending and build up savings.

Reading this advice, one senses little movement up the learning up. The subprime mess, and the credit crunch and banking crisis that ensued, are the product of a 60-year expansion in the availability of consumer credit. Almost unheard of before World War II, 30-year mortgages became readily available for returning GIs. The 20% downpayment typically required until the 1980s was a sharp departure from the 50% downpayment usually needed in the 1930s and before. Credit cards , an innovation that came to fruition in the 1950s, allowed just about anyone to sign chits, formerly the reserve of the wealthy at their exclusive clubs. Levels of household debt grew ever larger, and downpayments required for home mortgages and car loans grew ever smaller. Government policy encouraged and facilitated borrowing, with deductions for mortgage interest (and, for a while, even interest on personal debts like credit cards), and sponsorship of entities like Fannie Mae and Freddie Mac to create a secondary mortgage market.

The growth of the credit monster reached its high water mark in the last few years, with the emergence of the no doc, no downpayment, option to defer repayment mortgage. What a wonderful innovation! Your aspirations, your dreams didn't need to be limited by your educational attainments, career choices, income or net worth. You simply sat down with a mortgage broker, shuffled some papers around, and ended up with much to boast about at cocktail parties.

We're now in the processing of learning how the story ends. Like all no free lunch stories, the denouement is that there is no such thing as a free lunch. Lenders have a bad habit of expecting repayment. You don't enhance your lifestyle by borrowing. All you do is frontload it. You're able to consume more sooner. But your consumption later in life is constrained by the fact that you have loan repayments to make. (Think about your student loans if you don't believe this point.)

The subprime mess stems in part from the fact that the borrowers simply didn't have adequate financial resources for traditional (i.e., prudent) loans, and therefore resorted to teaser rate, no downpayment, option ARM loans. Whether they had moderate incomes and couldn't easily save, or made good incomes but wouldn't save, they weren't prepared for the risks of using easy money to finance their homes. Squirrels that store a lot of acorns survive the winter. But we're now seeing what happens to squirrels that aren't so thrifty.

Policymakers seeking to address the subprime and associated messes are calling, variously, for lenders to give borrowers breaks, taxpayer funded assistance for low and moderate income defaulting homeowners, Federal Reserve interest rate cuts, and the imposition of new duties on mortgage brokers and lenders. But are we dealing with the illness or just treating symptoms? How about encouraging people to help themselves?

A baseline problem is that personal and household balance sheets have been deteriorating for many years. Savings rates are now effectively zero, and sometimes negative. On average, Americans are borrowing to finance their current lifestyles. The myriad ways of providing consumer credit --and delaying its repayment--seem innovative and even wondrous. But so did the Titantic.

As our credit-besotted nation piles up on icebergs of unmanageable debt, perhaps we should consider treating the illness. Personal and household balance sheets need to be strengthened. The medication needed is well-known: savings. But like other medications, it's easy to forget to take, especially when yet another sale at the mall beckons with siren song. The government has contributed to the problem by making it easy to borrow. The government should now contribute to the solution by making it easy to save.

Here's our proposal. The first $10,000 of interest income (and equivalents like dividends paid by money market funds) should be exempt from taxation (with $20,000 exempt for couples filing jointly). By exempt, we mean exempt: no regular tax, no alternative minimum tax. All interest income and equivalents above $10,000 (or 20K for married couples filing jointly) should be taxed the same as qualified dividends (which, for those of you who aren't lucky enough to receive qualified dividends, are taxed at lower rates than the salary or wage you earned working from 9 to 5). This proposal will provide an incentive to those with moderate or middle class incomes to save in the pedestrian, low interest accounts available to them. Passbook savings, money market accounts and CDs might enjoy renewed popularity. People who badly need savings might start to put a few nickels away. With some time and effort, they might accumulate a decent downpayment, qualify for a loan that won't wreck their finances in a couple of years, and attain true home ownership. Perhaps, just this once, the middle class could get a break.

Yes, this proposal would also benefit the well-to-do. Those with a lot of savings would pay lower taxes on interest income. But the banking system would benefit from larger amounts of retail deposits. As we are in the process of learning, the big banks were (and perhaps still are) heavily funded by short term, easily spooked money. Old-fashioned savings accounts and CDs are much more stable sources of funding. And if there's one thing banks need now, it's stability.

The many years of central bank sponsored easy credit have fueled asset bubbles. Banks, being at the heart of the credit extension process, have in effect become speculators in asset values. That hasn't worked out real well. Let's ease them back toward their traditional roles as lenders to borrowers who are well-prepared to repay the loans.

Environmental (?) News:
banana spill in the North Sea.

Wednesday, November 7, 2007

How Banks Took Derivatives Too Far

We’ve recently learned that major banks guaranteed the value of some of the derivatives they sold. Hedge funds were promised that if CDO interests that they bought fell below a certain value, the bank selling the interests would buy them back at a guaranteed price. Asset-backed commercial paper issued by bank-affiliated SIVs was 10% to 50% guaranteed by the banks sponsoring the SIVs.

More recently, it was reported in the Wall Street Journal (11/1/07, P. C3), that some money market funds that invest primarily in tax-exempt securities (i.e., municipal securities) bought short term, tax-exempt investments through so-called “tender-option bond programs.” These investments were derivatives synthesized from long term municipal bonds into short term investments that money market funds could purchase. Some of these synthetic instruments, however, were given low investment ratings, and Merrill Lynch, which underwrote these puppies, guaranteed to pay them if the underlying municipal bonds didn’t pay in full. Some money market funds, nervous about Merrill’s recently announced losses, have sold their holdings back to Merrill, not wanting to find out later whether its ability to honor its guarantee will hold up.

CDO interests; asset-backed commercial paper; now synthetic tax-exempt investments. All of a sudden, this isn’t very much fun any more. How much of the derivatives market have the banks guaranteed? Have they guaranteed other types of derivatives? Are their balance sheets and income statements accurate? Have they fully disclosed the risks from these guarantees? With all these contingent liabilities, are there questions about the safety and soundness of some major banks?

This adds to the cognitive dissonance already abundant in the financial markets. The Norman Rockwell version of the derivatives market is that it consists of a bunch of freckle-faced kids sipping frappes and trading contracts that repackage and shift risk to parties that choose to bear it. Volatility is supposedly damped. Market efficiency is supposedly enhanced. Smiles spread across many faces.

But these guarantees don’t shift risk. They retain it. The banks offering the guarantees were, in essence, giving the investors a put option, the ability to offload the derivative in case it turned out to be a turkey. Risk wasn’t shifted. Volatility, as we now know, has been exacerbated. Market efficiency, as we now know in spades, has been undermined by the credit crunch. Smiles are few and far between.

If these deals were so bad for the banks, then why did the banks do them? In a word: fees.

The banks got underwriting, advisory, servicing and perhaps other fees for doing derivatives offerings. Fee income came into vogue for commercial banks over the last 15 years, as risk-based capital requirements were gradually implemented. Banks were encouraged to offload the risks of commercial lending and make their money as intermediaries in the credit process. Fees were supposed to be a low risk way of making profits. That’s one of the reasons why you’re clobbered with charges for being one hour late in paying your monthly credit card statement, going $1 over your credit limit, and bouncing a check even one time after 10 years as a loyal customer. Banks love fee income, much more than they love having you as a customer. Investment banks love fee income, too, especially if they aren’t proprietary trading powerhouses.

Smackdowns of retail banking customers generate fees at a clip of $20 or $30 at a time. If you trample a large enough number of customers, it becomes real money. But derivatives deals provide millions of dollars of fees and other compensation per deal, a seemingly more efficient way to make money. Like moths drawn toward a flame, the banks moved into the derivatives market in their usual herd-like fashion, and did deals in abundance.

Evidently, they found the going tougher than expected. Some money managers, it would appear, realized that there were worms in them thar cans they were buying, and negotiated guarantees. The guarantor-banks, instead of selling derivatives, wound up selling put contracts for derivatives. This was a good deal for the money managers, who wound up with heads I win, tails you lose investments. But the guarantor-banks got lost on the way to Lake Wobegon.

Derivatives contracts can serve bona fide and valuable purposes when used in ways for which they were intended. But altering them so that they don’t really pass a lot of risk—transferring the upside, but not the downside isn’t much of a risk transfer—undermines the purpose of having a derivatives market. Suspicions arise that risk management got lost in the rush to record entries in that nice fee income category that would please stock market analysts and regulators. But risk, if unmanaged, remains coiled up, perhaps hard to see against the leaf cover on the forest floor, but ready to strike if the opportunity arises.

Derivatives have been taken too far. They’re not a magical instrument that will solve all problems in the financial markets. Like a socket wrench or a pair of pliers, they are tools, and nothing more. Like all tools, they must be used properly and wisely. Some shrinkage of the derivatives market, along with standardization of products and much greater transparency, would be a good thing.

Crime News: pet sitter that overfed potbellied pig charged with animal cruelty (no, we're not kidding).

Sunday, November 4, 2007

How Long Term Interest Rates Limit the Federal Reserve's Options

You get the impression that, all public protestations aside, the Fed would like to bail out the CDO and mortgage-backed securities markets. Its surprise half-point fed funds rate cut on September 18, and the more recent quarter-point cut on Oct. 31, won't have much impact on overall economic growth for months, perhaps many months, since interest rate changes need time to work their way through the system. (Check to see if the interest rates on your credit cards have dropped--you'll see what we mean about things taking time.) The justification in the economic data for these cuts was skimpy, especially the quarter-point drop on Oct. 31. But the financial markets wailed loudly and threatened to throw a monumental fit, so the Fed indulged them. The best of all worlds for the Fed would be to take monetary action that can be explained as beneficial for the economy as a whole, but which quietly alleviates the pain that so many market participants are feeling.

Yet, in spite of the Fed's interest rate cuts, the major banks reported some mega losses for the third quarter, topped by Merrill's $8.4 billion. This illustrates a limitation on the Fed's ability to deal with the subprime mess.

The Fed's power to affect interest rates is focused on the short term debt market. Fed funds are overnight loans that banks make to each other. Overnight is about as short a term for a loan as you can get.

But CDOs and other mortgage-backed securities are usually medium to long term investments. Most mortgages are paid approximately 2 to 10 years after they are taken out. That's roughly how long people wait to either refinance or sell their homes. Consequently, mortgage-backed securities tend to have longer terms than fed fund loans. Of course, it's possible to create short-term derivatives from mortgages. But at the end of the day, someone has to hold the right to the long term payments. So, there will always be longer term interests in any securitization of mortgages. And given the trillions of dollars of mortgages that have been securitized, the long term interests exist in large quantity. Perhaps one might think that lowering long term interest rates would increase the value of mortgage-backed securities (in the way it would increase the value of a traditional bond). If that could be done, we'd have a bailout, presto quick. But let's look at interest rate movements.

Since June 2004, the Fed has raised the fed funds rate from 1% to 5.25%, and then moved it back down to 4.5%. Short term interest rates, such as banks' prime lending rates and interest rates on money market funds, followed the upswings and downswings in the fed funds rate closely. What about longer term rates?

The most important long term security in the financial markets is the 10-year U.S. Treasury Note. It serves as the benchmark for all other debt of comparable maturity, because it is effectively free of credit risk. Credit risk, as we know so well from the credit crunch, is the murkiest of all risks that debt instruments bear. Eliminate credit risk, and you can get a much clearer picture of the time value of money. The 10-year Treasury Note is issued in abundance, since it is the Treasury Department's principal long term borrowing instrument. (Thirty-year Treasury bonds were not issued between 2001 and 2006.) Investment banks and other market players use the 10-year note as a hedging tool (because of its creditworthiness and easy availability), and institutional investors worldwide seek out the 10-year note as a safe haven.

During the time that the fed funds rate was moving within a range of 4.25 percentage points, the 10-year Treasury Note, starting in June 2004, varied between roughly 3.9% and 5.3%, a range of 1.4 percentage points. Moreover, the 10-year note was often the most inverted part of an inverted yield curve, dropping even as the fed funds rate was rising.

In other words, changes in the fed funds rate don't have much impact on longer term interest rates. In June 2004, the 10-year Treasury Note was yielding at around 4.7% when the fed funds rate was 1%. Today, it yields around 4.3%, even though fed funds rates today are 3.5 percentage points higher. The Fed can cut short term interest rates as much as it wants, and it won't have much impact on mid to long term interest rates.

It's also important to remember is that a drop in longer term interest rates may not increase the value of CDOs and other mortgage-backed securities. A drop in longer term interest rates can increase the frequency of refinancings, as borrowers seek to lower their monthly payments by getting a new and cheaper mortgage, and using it off the old one. Thus, in an environment of falling interest rates, the pool of mortgages supporting an existing mortgage-backed security may pay off faster than investors had hoped. They receive their principal back sooner, and must now re-invest at the lower prevailing rates. This represents a loss of long term income to them. Thus, a drop in longer term interest rates, which would ordinarily increase the value of existing longer term debt, may actually decrease the value of a mortgage-backed security. (However, the opposite isn't likely to be true--an increase in longer term interest rates probably won't do much to increase the revenue stream from the mortgage pool, but would depress the value of that stream.)

So, even if the Fed could lower long term interest rates, such a move might backfire by hurting the value of mortgage-backed securities. This is probably an important reason why three major banks and the Treasury Department have proposed a Super Conduit (or Super SIV, as some commentators call it) to bail out SIV-bedeviled banks. This is one respect in which the Fed can't ride to the rescue. Holders of mortgage-backed securities will likely have to work their way through their problems themselves. The fact that an ad hoc solution like the Super Conduit was even proposed tells you that there are no obvious solutions to the problem (see our blog at

The financial markets have been pouty ever since the Fed signaled that their Halloween candy might have to last for a while. Inflation risks are rising (as we predicted in, and the Fed may be constrained from more interest rate cuts. That may be just as well, since it is doubtful that interest rate cuts could do much to alleviate the subprime mess. But they could fuel inflation. Let's not forget that the foundation of today's prosperity (yes, the economic data continues to show that the U.S. is prosperous, housing downturn notwithstanding) emanates from Fed Chairman Paul Volcker's unwavering stand against inflation at the end of the 1970s and in the early 1980s, which threw the U.S. into a painful recession that saw unemployment rise to more than 10%. Inflation is the biggest asset bubble of all, one that pumps up the price of all assets, and working our way out of an inflationary bubble would be far more painful than dealing with the current mortgage mess.

Legal Update: coin-flipping judge gets the boot. (That's right; a judge flipped a coin to make a decision.)

Thursday, November 1, 2007

Risk Management: Should the Investment Banks Have Remained Partnerships?

To state the obvious, investment banks have a risk management problem. Merrill just wrote of $8 billion and its CEO abruptly retired. Bear Stearns' president left under a cloud this past summer, and questions now swirl around its CEO. Questions also swirl around the CEO of Citigroup. Senior executives at a number of banks have hit white water in their careers. An analyst downgrade of Citigroup today contributed to a 362 point drop in the Dow Jones Industrial Average.

These are supposed to be smart people. And they're supposed to have smart people working for them. How could it be that they'd record losses in the hundreds of millions or billions--and just for one quarter? You'd think they'd have effective risk management systems, not only because that's part of their jobs, but also because the consequences can be so great.

But are the consequences so great? Stanley O'Neal, the now retired CEO of Merrill, reportedly left with $161 million. You could buy a jet and a yacht with that much money and still have plenty left over for caviar and champagne. Chances are many other departed executives didn't end up homeless and selling apples on the sidewalk. Of course, they suffered embarrassment and probably some loss of income. Their careers may have been sidetracked for a while. They may have to hold onto the leased Mercedes instead of upgrading to a Bentley. But peanut butter and crackers remain scarce in their diets.

Once upon a time, investment banks were partnerships (specifically, what lawyers would call general partnerships). Legally speaking, this meant each partner was liable to the full extent of his personal wealth for the firm's debts. If the firm had catastrophic financial results, a partner's coop apartment on Park Avenue was at risk. As were his Cadillac, art work, watches, china, savings, and investments. In other words, he could lose everything he had.

All of the partners were bound to pay the debts and liabilities that every other partner incurred on behalf of the firm. If a partner on the trading desk made some bad bets on bonds using margin and lost money, the partners in the mergers and acquisition department were at risk for payment of the margin debt. And if the partners in M&A gave some ill-conceived advice about the value of a deal, and wound up having to settle a class action lawsuit, the partners on the trading desk were at risk for paying the judgment in the class action lawsuit. All of the partners were bound by and bound to each other.

Consequently, the partnerships took risk management very seriously. When the fellow in the office next door can deprive you of your home, and you can deprive him of his, both of you will carefully evaluate the risks of your activities against the rewards. Downside risks concentrate the mind wonderfully, and partnerships concentrated on risk management.

Fast forward to 2007. All of the investments banks have become corporations. The ownership of corporations is embodied primarily in their common stock, which provides limited liability to shareholders. You can lose the amount of money you invest in the stock, but you can't lose more than that. The limited liability feature of corporations has allowed them to accumulate vast amounts of capital. It's the characteristic that, first and foremost, encourages investors to commit their capital to the corporation.

But investors hate to lose the money they've invested in the stock. Even if they won't lose their homes, cars and big-screen TVs, they still feel the pain of downside risk.

The top executives that run the major investment banks, however, are heavily insulated from the risks of doing a poor job. Compensation agreements provide golden and even platinum parachutes. Failure is punished by dumping shiploads of money on the poor performer. Executives are given the incentive to take excessive risk. How else will they make more money than by failing?

There is no possibility that the major investment banks can be reconstituted as partnerships. They're too big and far flung. Furthermore, they've lost the special culture of mutual trust blended with mutual scrutiny that successful partnerships have. Instead, their massive risk management failures present corporate governance problems of the first degree.

Management is the first line of defense in risk management. Management has failed. The Board of Directors are the next line of defense. By all appearances, they have failed, having placed too much reliance on management. Granted, CDOs and other asset-backed securities are complex. But it's the responsibility of the Board to supervise management, and, in particular, to prevent management from damaging the corporation. Directors should change executive incentives, so that management suffers real and painful financial losses if the company suffers losses. Heads I win, tails you lose executive compensation agreements reward taking excessive risk. If so-called top tier executive talent won't sign up without such protection, don't hire them. These executive compensation arrangements haven't been producing top tier financial results; try something different. Pass real risk of loss onto the CEO and concentrate his or her mind wonderfully.

Animal News: abusive feeding by a petsitter?