Tuesday, December 23, 2008

Social Security: a Sacrifice That Shouldn't Be Made

President-elect Barack Obama, upon taking office, will focus on reviving the economy. A massive $850 billion plus stimulus package appears likely. While the nation’s immediate problems are undeniably important, he must bear in mind the long term: specifically, Social Security.

America’s retirement systems are largely evaporating. The defined benefit pension plan will soon be less well known than the Brontosaurus. Many employers are putting a halt to employer matches to 401(k) plans; and many employees can’t get those matches anyway because they can no longer afford to contribute to their 401(k) accounts. Many are borrowing from their accounts or making early (and heavily taxed) withdrawals in order to make ends meet. The IRA account has become largely irrelevant, since it has so many limitations that only moderate or low income earners can obtain its full tax benefits—and they haven’t got the extra income to contribute. Besides, with stocks and corporate bonds both down, there isn’t much for 401(k) plans or IRAs to invest in.

Meanwhile, the Federal Reserve and the Internal Revenue Code both pummel savers. The Fed keeps interest rates low and the tax laws treat interest and interest-like dividends paid by money market funds as ordinary income, making sure that the thrifty and prudent are duly punished for their lack of recklessness. What incentive do you have to save for retirement?

Of course, you could always invest. But, in what? Real estate could have recently lost over 50% of your investment in some markets. Stocks could have recently lost you over 40% in virtually all markets. Your fate as an investor is in the hands of rich and powerful people on Wall Street, who seem to prefer boosting their already enormous current incomes at the expense of your long term welfare. And that’s where you stand even if you weren’t investing with Bernie Madoff.

Social Security is the last retirement system standing. It’s saved millions of elderly from poverty, and serves as the foundation of retirement for most Americans. Whatever else the federal government does, it must preserve Social Security. Social Security has never provided more than a modest income, and it won’t be able to do more in the future. But significantly cutting benefits will only rearrange how we pay for the costs of retirement. Younger people will end up supporting parents, aunts, uncles and maybe grandparents. And even if they don’t, they’ll be taxed to pay for the municipal shelters and soup kitchens that will give Grams and Uncle Horace a warm place to sleep and a little something to eat. And, perhaps most importantly, a Social Security system that will keep its promises to today's 25-year olds gives them hope for the future. One of the great illusions of the free enterprise system is the idea that we can stand alone as individuals. Maybe Daniel Boone could look at the world that way. But even by Kit Carson’s time, the fate of solitary mountain men trapping and hunting in the Rockies was tied to Eastern clothing fashions.

FDR’s attempts to stimulate the economy out of the Great Depression had limited success at best. In 1938, the U.S. was still gripped by stagnation and high unemployment. But he hit a home run by enacting Social Security. It, like federal deposit insurance, is one of the economic cornerstones of the nation. If the system truly must be changed (a conclusion that depends heavily on the assumptions one makes), better that the early and full retirement ages be pushed back than benefits be cut. It would be harsh and heartless to reduce benefits for folks in their 70s, 80s and beyond, when they would be much less able to work, if they could work at all. The United States will be in for some tough times in the next few years. Ensuring the vitality of Social Security will do much to build confidence in our futures.

Saturday, December 20, 2008

Have We Reached a Market Bottom?

The Dow Jones Industrial Average has been trading between 8,000 and 9,000 for the last few weeks. Some financial professionals have been proclaiming a bottom to the stock market. They point to the 40% drop in the Dow, which is almost the worst it has performed since World War II, and contend that the bad news about the economy has been factored into stock prices. Things should improve from hereon forward, they proclaim.

But look at what's happened in the last week. The Federal Reserve lowered short term interest rates to an effective rate of zero. Barack Obama announced his choices for chair of the SEC and CFTC, and a Fed governor. His transition team has been leaking proposals for a stimulus package that could exceed the $700 billion TARP program. GM and Chrysler got critically needed bridge loans that will carry them through the next three months, until the Obama administration can make longer term decisions about auto maker aid. The Bush administration has announced that it will seek authority to spend the second $350 billion tranche of the TARP program (which means more money will probably flow into the economy even before Barack Obama is inaugurated). But what happened in the stock market? There were ups and downs, but by the end of the week, the market was little changed.

One could argue that the good news about the economy--which consists almost entirely of actual or proposed government actions--has also been subsumed into stock prices. From this perspective, the implementation by the Obama administration of its announced programs could have limited impact on stock prices. The government may have expended its ammunition. If so, we would then be at the mercy of economic, as opposed to political, forces.

The news from the economic front is ugly. Unemployment is rising while economic activity is slowing. Real estate prices show no sign of bottoming out. Europe's economy is sliding faster than expected. China and Japan are busy trying to prop up their own economies. The dollar has reversed its gains and is sliding again (a consequence of the Fed's interest rate cut), setting the stage for potential capital flight. Stores are offering enomous discounts before Christmas in order to lure in suddenly thrifty consumers. Employee pay raises for next year will be modest at best; many will see shrinking pay checks. Yes, oil prices are dropping like a rock, but that's only because the economy is swooning. Is all this subsumed in stock prices? Or is it possible that the worsening recession will push stock prices down from current levels?

Only by looking backwards can we call the actual bottom of a market. The rest of the time, we can only make our best guesses based on the limited information we have about the future. But remember that if the bad news about the future can be incorporated into stock prices, so can the good news. Indeed, one would expect that this always happens, since investors would rationally incorporate all information into stock prices. If that's the case, unexpected news will dictate where stock prices go. Be cautious. It's been unexpected news that has driven the market and the economy down since 2007. If you're going to invest in the market, do it a little bit at a time. We've seen all too clearly the dangers of embracing too much risk.

Tuesday, December 16, 2008

The Bernard Madoff Scandal: How Many More Ponzi Schemes Are There?

An important question arising from the Bernard Madoff scandal is what wider impact will it have? The proportions of the reported fraud--$50 billion over the course of years--probably set some sort of record. The victims included a number of people who could be featured in Lifestyles of the Rich and Famous. The fact that some charities--and, consequently, the beneficiaries of their charitable activities--were also victims darkens the tragedy of the events.

This is the sort of event that shakes investor confidence--in this case, the investors who have enough to turn it over to money managers. These aren't the people with $50,000 or $100,000 in a mutual fund; or $200,000 in a stock trading account. These are people with millions, who hand their hard-earned assets over to investment professionals that supposedly can provide them with selective access to especially good investments. Many of these investors have tony addresses in West Palm Beach, the Hamptons, La Jolla and Marin County. But others live relatively modestly in suburbs better known for the quality of their schools than the opulence of their neighborhoods. These folks tend to be highly skilled in their chosen fields or professions, but not terribly sophisticated about money. That's why they rely on money managers.

When it's reported that a man of Bernard Madoff's prominence (well known financial executive and former Chairman of the Nasdaq Stock Market) is a crook, investors naturally begin wondering if their own money manager is a crook. They'll make inquiries, and perhaps check with other sources. Many of them will submit withdrawal requests, preferring to live with the low returns that accompany federal deposit insurance than the possibility that they could lose everything. Those withdrawal requests will be like a hound flushing a rabbit, forcing whatever other frauds there might be out into the open when the fraudster can't honor the withdrawal requests.

Are there other Madoff-like scams? We don't know, but probably yes. Money managers, as Madoff purported to be, need to do better, somehow, than the market. There's no need to hire a money manager if all the performance you'll get is the market average. An inexpensive index fund is a much easier and more profitable way to go.

According to news reports, Bernie Madoff claimed to have an investment strategy that would produce unusually stable earnings. If you can take the volatility out of the stock market, but produce stock market-like 8% to 12% per year returns on average, your product will be an easy sell with the monied classes. Think back, say, to the stock market volatility of the last few months and you'll see the appeal of stable, stock market-like returns. Of course, as reported, Madoff didn't really have a magic investment formula that did away with volatility, and the recent volatility of the stock market did him in when he couldn't honor investor withdrawal requests.

Other money managers make their own claims as to how they'll improve on the market. But what if the law of averages catches up with them and they can't meet their claims? The honest ones will admit their failings and take their lumps. The sleazy ones will perpetrate a fraud.

Rising financial markets cover up a multitude of frauds. Good times draw investment dollars into the market and make investors inclined to believe that anything is possible. But the law of averages hasn't been repealed and markets also fall. Falling financial markets reveal frauds, when investors try to pull out and discover they can't get their money back. Unless you've been hanging with Rip van Winkle for the last year, you've probably noticed that our financial markets have been bungee jumping without a rope. As the financial tide ebbs low, all kinds of scum will be exposed.

Investor withdrawal requests were a major reason for the sharp drop in the stock market in September, October and November of this year. The market has, momentarily, appeared to level off. The Madoff case, and any others of its ilk that emerge, will probably trigger more investor withdrawal requests. If the money managers are legit, they'll have to sell securities in order to meet those requests. If the money managers are crooks, the ensuing scandal will further erode investor confidence. Either way, the existence of, or even potential for, more large Ponzi schemes a la Bernie Madoff will dampen already battered investor spirits and add to the sell pressure in the market.

Will the impact of the Madoff scandal and any others like it drive the stock market down? That's hard to say. The Federal Reserve has printed a trillion dollars plus in the last three months in order to prop up the financial system, and there's no limit on how much more it can print. It's also evident that the Fed and other federal authorities are intent on supporting stock market values, regardless of what they might have said to the contrary. But no amount of government bookkeeping--in actuality, the Fed creates money by making computer entries on its records of the accounts of member banks--can serve as a long term substitute for investor confidence. We now have a continuing mortgage crisis, a widening credit crunch, worldwide recession and a mega scam, and it's not at all clear that the federal cavalry riding over the crest of the hill can slay all these dragons.

Sunday, December 14, 2008

Con Artists

The recent charges of fraud against Bernard Madoff, once a prominent Nasdaq market maker, remind us that, amidst a financial crisis involving complex financial instruments and obscure investment vehicles with names like SIV, conduit and SPEs, there still remains room for plain old con artistry. If true, the charges against Madoff would demonstrate that people who want something too much are easy victims, and that there are plenty of smooth talkers ready to take advantage of them.

Think back to times you were out on the town. It was 15 minutes to closing time, and you still hadn't hooked up with anyone. You didn't want to go home alone, and people who hadn't looked so good an hour ago were starting to look better now. What did you do, and did it turn out to be a mistake?

With the stock market down 40% plus, real estate still dropping, and even commodities falling in value, investors may become desperate for yield. Beware. This is the hour of the con artist, those crooks that prowl the country club circuit, cocktail parties and even church socials for victims. The more you want something, the more likely you might believe someone who promises it to you. Your emotions can work against you. Be dispassionate and skeptical. Think about how hard it was to accumulate the money you have, and how painful it would be to lose it. Don't swing for the fences because would-be home run hitters strike out a lot. The same basic principles that governed investing before the Civil War still apply today.

If it's too good to be true, it probably isn't true. One of the allegations against Madoff is that he delivered remarkably steady earnings, in both good times and bad. Many people want certainty in an uncertain world, and a clever crook can take advantage of that desire by promising and appearing to deliver six impossible things before breakfast. The sad thing is that some people might buy into the scheme. Don't believe that certainty is possible, except with the very low returns offered by U.S. Treasury securities and FDIC insured bank accounts. Otherwise, be cautious and skeptical. The financial markets are volatile and even the best sometimes lose money (Goldman Sachs and Morgan Stanley, two of the Street's most prominent firms, are expected to report losses this week). Someone who claims to be able to consistently outperform the market is promising something that's too good to be true.

Diversify. News stories about the Madoff case report that some individuals and nonprofits may have lost most or all of their money. If so, then they violated one of the cardinal principles of investing. Never put all your money in one investment or one place. Diversify. In the final analysis, investors can't know for sure if a person is a crook. (See our blog at http://blogger.uncleleosden.com/2007/05/how-to-spot-crook.html.) That's why you should never put all your eggs in one basket.

Greed Kills. Greed kills financial plans. If you're desperate for yield and willing to believe that you can beat the odds, you'll become careless and miss warning signals. As in many other walks of life, if your goals are reasonable, you have a pretty good chance of attaining them. Investing for reasonable yields so that you'll have a comfortable retirement is more conducive to long term financial security than betting the ranch in the hope of getting yourself into the Forbes 400. If you look for something that's almost impossible, you probably won't get it.

Wednesday, December 10, 2008

Financial Planning in a Time of Uncertainty

If there's one overriding problem with federal policies to deal with the ongoing financial and economic crises, it's that they've failed to reduce uncertainty. Banks are seeing a thaw in the credit crunch, but primarily because interbank loans are guaranteed by governments now. Why not make a loan if the government will ensure repayment? Consumers and nonfinancial corporations don't enjoy government backing. They are being squeezed ever more tightly by a vortex of credit cutbacks, reduced consumer spending, layoffs, flagging consumer confidence, business closings and failures, more layoffs, even less consumer spending, so on and so forth, etc., etc.

Federal economic policy to date has been aimed at stabilizing the banking system, not the real estate market. Falling real estate values, which show no signs of bottoming out, only exacerbate the problem. There won't be a significant rebound in real estate for years. That means no free flowing home equity loans, no easy refis, no quick exits from loan defaults by selling the property, and all the other tricks that worked so wonderfully when real estate values were rising at abnormally high rates. There won't be any magic elixir for the economy coming from real estate.

Where and when will it all end? Nobody knows. Even with Bush administration backing, a potential bridge loan for the American auto companies seems to be in trouble in the Senate, where the Republican old guard will make one final stand before the Obama administration takes office. The Republicans might, one last time, have their way momentarily. If they do, however, that means GM and Chrysler bankruptcies, and possibly Ford as well. (See the preceding blog for why.) What could ensue from those bankruptcies is unclear, but sure to be ugly. The only question is how ugly.

What's a person to do? In a time of national uncertainty, create some personal certainty. Don't wait for the government to stabilize things. Stabilize your personal finances. When financial storms are blowing, the most stable have the best chance of survival. Here are some things to think about.

Save more. During hard times, nothing provides financial stability and high quality sleep as well as a nice pile of cash. See http://blogger.uncleleosden.com/2008/12/how-to-build-wealth-in-recession.html.

Maintain health insurance coverage. Nothing can wreck your personal finances like a major health problem. Health problems are perhaps the most common reason for individuals to declare bankruptcy. If you're laid off, exercise your COBRA rights to stay with your employer's group policy. If you think COBRA is too expensive, exercise your rights anyway, to be sure you've coverage for at least the next 18 months. Then, shop around for a cheaper policy. But first make sure you're protected. If your employer goes out of business and terminates its health insurance coverage, look for alternative coverage (for more information, see http://blogger.uncleleosden.com/2007/06/how-to-find-health-insurance.html and http://blogger.uncleleosden.com/2007/09/health-insurance-update.html). But don't go uninsured.

Consider a job with a pension. Pensions still exist. Some large corporations offer them, and many government and educational jobs offer pensions. The same is true for military service and many law enforcement jobs. Not everyone is cut out for these jobs. But if you are, your golden years will be a lot rosier with a pension. See our discussion of hope for the financially lost at http://blogger.uncleleosden.com/2007/05/how-to-retire-without-saving.html.

Increase your Social Security payments by working longer. Social Security is actually a government sponsored pension program for almost all workers in America. Your payments increase if you work more years, and are adjusted for inflation. While Social Security itself provides only a modest income, it's a darn sight better than poverty. The longer you work the more Social Security you get, and the more stable your finances will be. See http://blogger.uncleleosden.com/2007/05/mysteries-of-social-security-retirement.html.

Pay off your mortgage. With today's real estate crisis, this one's a no brainer. Don't think about how you might leverage your house to make money in other investments. What other investments are there today that could make you a higher return than the interest rate on your mortgage? And even if there might appear to be some, how would you cover the risk of the investment failing? (As we now know, it remains possible, even in the 21st century, for investments to fail.) Paying off a mortgage clears the roof over your head of a really big lien, which significantly reduces your risks. Reducing risk increases stability. And that's the name of the game today.

Marshal your assets. Get your finances organized and make sure you've got everything you're entitled to. Cash all checks you receive--believe it or not, large numbers of checks (including some IRS refunds) are not cashed or deposited. Close out small bank accounts you're not using. If you have a jar of change you're not using, take it to a bank and deposit it. Sell property you have no use for and no sentimental reason to keep. Find out if you have unclaimed property. If you do, claim it. See http://blogger.uncleleosden.com/2007/05/unclaimed-money.html and http://blogger.uncleleosden.com/2008/08/how-to-avoid-having-unclaimed-property.html.

Reduce and avoid debt. This one shouldn't need explanation these days.

Friday, December 5, 2008

GM Bankruptcy or Bailout? We'll Know Soon. Very Soon.

Over the next few days, Congress and the White House will try to put together a bailout for GM, Ford and Chrysler. If they don't succeed, there will be a number of shopping days left before Christmas when GM institutes bankruptcy proceedings.

With all the publicity about its cash flow crunch, GM's suppliers are getting antsy about shipping parts without getting paid up front. Demands on GM's cash will increase at exactly the time when it is running out of cash. Some creditors may jump into court in an effort to collect on their debts quickly, before things completely fall apart. Without a bailout, the only way to stem the chaos would be a bankruptcy filing. And the filing would have to be made immediately in order to conserve as much of GM's dwindling cash reserves as possible. The company wouldn't want to burn down its funds and then file for bankruptcy, since that would leave it with no cash for a reorganization.

If there is no bailout, Christmas in bankruptcy could also be in store for Chrysler and major auto parts suppliers. Chrysler, too, has predicted that, without a bailout, it will run out of cash by the end of December. So its situtation is similar to GM's, and, without federal funds, it would have the same incentive to duck into bankruptcy court sooner rather than later.

The parts suppliers' problems could play out like this: if GM (and Chrysler) institute bankruptcy proceedings, they'll immediately stop paying trade debt in order to conserve their cash. Tens of millions and perhaps hundreds of millions of dollars of accounts receivable owed by GM and Chrysler to the parts suppliers would immediately be uncollectible in the ordinary course of business. (The parts suppliers would, in turn, stop shipping to GM and Chrysler until they got concrete assurances of payment for new parts, but that wouldn't get their old accounts receivable paid.) The nonpayment of accounts receivable would put the suppliers into a cash flow crunch, and could violate the terms (covenants) of bank loans they might have and bonds they might have issued. The cash flow crunch and covenant violations could put the parts suppliers in operational and legal jeopardy, giving them the incentive to file for bankruptcy as soon as possible in order to conserve their cash resources and avoid creditor lawsuits.

Once in bankruptcy, the future of these companies would be highly incertain. Consumers might well avoid buying a long term product like a car from a bankrupt company. Car buyers want warranties to be honored and replacement parts to be available. Without plenty of customers, the bankrupt companies' chances of successfully reorganizing would be somewhere between none and zero. The worldwide automotive industry has lots of excess capacity, because it was geared up for the boom times of 2006 and 2007, when auto sales were 40% or more higher than they are today. Toyota, Honda, Nissan and others would fire up their idle capacity and move with alacrity to supply more cars while GM's and Chrysler's creditors, suppliers, shareholders, management, and labor unions enriched lawyers sparring around in court. Lost market share would be difficult or impossible for the American companies to regain, because the trust between manufacturers and consumers would have eroded.

Ford, too, might have to follow GM and Chrysler into bankruptcy. It shares many suppliers with the other auto companies. If the suppliers are bogged down in bankruptcy, they may be unable to supply Ford adequately. Consumers may shy away from Ford, too, in the belief that it's near the brink. Of course, that belief could make a Ford bankruptcy a reality. Maybe a regulatory agency can prohibit short sellers from acting on the belief that a bank is about to go under. But the government can't force consumers to buy cars from an auto manufacturer they believe is about to go under.

Congress is expected to vote on the bailout next week. If there is no bailout, expect a GM (and very possibly a Chrysler) bankruptcy filing probably by late Friday afternoon or some time next weekend. They wouldn't need to file a bankruptcy petition at a clerk of court's office during regular business hours. All they'd need to do is find a bankruptcy judge with jurisdiction over the case and give him or her the filing, at home or somewhere else. Bankruptcy judges are cooperative about accepting petitions from publicly traded companies at odd hours. Filing during stock market hours could lead to messy trading--that is, messier than the mess that you'd have anyway.

News reports at the time we write this blog indicate that the Bush Administration and Congressional leaders are trying to put together a $15 billion bridge loan to tide the auto companies over until Barack Obama is inaugurated. Clearly, George W. Bush figures auto company bankruptcies could be really bad, and doesn't want that mess as part of his already very messy legacy. The Democrats hold the better hand. If there is a bailout, they can claim most of the credit for it. If there isn't a bailout, the GM and Chrysler bankruptcies will have begun on George W. Bush's watch, and the Dems can blame the Republicans. Then, with their increased control over the legislature in the next Congressional session, the Dems will be able to ride to the rescue with a massive stimulus package and secure the loyalty of large swaths of the electorate for potentially a long time. The leaders in both parties understand this dynamic. While many Republican (and some Democratic) lawmakers would rather drink horseradish straight up than vote for an auto company bailout, there seems to be a good chance that enough of them will go along with a bailout so that they can pass the hot tamale to President Obama when he takes office. If that happens, he'll truly learn what it means to have the buck stop with him.

Wednesday, December 3, 2008

How to Build Wealth in a Recession

Okay, it's now been officially announced that we're in a recession. Which you probably had noticed since the recession actually began in December 2007. Now that we're experiencing the volatile side of stock market volatility and 401(k) accounts are becoming 201(k)s, building wealth seems ever more difficult. It is, but there's a time honored way to increase your net worth that has almost been forgotten in America.

It's called saving. And it's the key to building wealth, in good times and bad. Here's why. Take the long term historical average gains in stocks, beginning around the early 1900s, and you'll get a figure like 6% to 7% per year. Let's work with 7%. Take out 3% for inflation, which is another rough long term average. That leaves 4%. Then, take out 1.5% for investment costs (read your mutual fund prospectuses; many of you will find this is no exaggeration). Then take out another 1.5% for taxes (remember that for 401(k)s and other retirement accounts, you'll pay ordinary income tax rates on your withdrawals, not the lower capital gains rates). We're down to 1% per year. If your investment costs and/or tax bracket are on the high side, you may be close to 0%. The numbers shown in your account statements may not seem so bad, but they aren't adjusted for inflation or reduced by the taxes you'll pay.

The picture gets grimmer when one factors in stock market volatility. The 7% per year average gain is just an average. As we so painfully know from this year, not all years are average and we're not in Lake Wobegon. The stock market first reached current levels (8419 for the Dow Jones Industrial Average) in February 1998. In other words, if you invested $1,000 in the stock market in early 1998 and held it until now, over ten years, your investment would have gone exactly, precisely nowhere. Passbook savings would have been more rewarding (plus you'd have a toaster and FDIC insurance). If your retirement strategy was to bank on stock market returns, you'd be looking at golden years eating dog food while working part-time at a discount store where you might be trampled by irrationally exuberant shoppers.

Simply stated, the key to building wealth is to save a lot. You won't net much from the stock market (and bonds and money markets are even less promising on a long term basis). Don't expect to be able to invest your way to millionaire status. We've seen what happens to those that buy into Wall Street's innovative financial engineering. And, unless you're a tremendously energetic self-starter with a very understanding family, you won't be able to become a millionaire by establishing a business.

In a sense, this is very reassuring. Saving is something anyone can do. You don't need a college degree, or even a high school diploma. You don't need a sophisticated understanding of investments or finance. Putting 10% of your earnings into passbook savings would probably do you more good than putting 1% of your earnings into stocks. While stocks, based on long term historical data, have been better performers than safer investments like passbook savings accounts, you should save in whatever way that gives you peace of mind. If you can't stomach stock market volatility, try the neighborhood bank. The worst thing you can do is give up and not save.

One advantage of saving a lot is you learn to live on less, because more of your current income is going into savings. As a result, you'll need less money in retirement to maintain your current lifestyle, while you'll put away more money. This saving-spending dynamic provides a powerful retirement planning tool. A little math reveals that saving 15% to 20% of your earnings for 30 years will, together with Social Security, pretty much allow you in your golden years to maintain your pre-retirement lifestyle. (See http://blogger.uncleleosden.com/2009/07/simplest-financial-plan-of-all.html). While saving that much is a challenge, it's not impossible. Try to rationalize living without Carzilla or a gargantuan flatscreen TV today so that you can avoid eating dog food in old age. Some of us don't find that a hard choice.

Those that are unemployed, retired, or face large medical expenses can't follow this strategy. But with unemployment around 7% (the currently announced rate is 6.5% but it's headed upward), that means 93% of the work force is employed and most of them can save. You may have a lot of excuses for not saving, but you can't buy a steak in retirement with an excuse. You'll need money for that. In the marathon that is life, slow, plodding, frugal savers win in the long run.

Sunday, November 30, 2008

The Economic Crisis: Trading on Expectations

Barack Obama's political skills were on full display over the last 10 days. Around 3:00 p.m.in the afternoon of Friday, Nov. 21, 2008, someone (presumably from the Obama camp) leaked the nomination of Timothy Geitner, president of the NY Fed, as Treasury Secretary. In the last hour of trading, the stock market rose about 6%, a big jump even for these volatile days. The next week, the Obama team dropped names for economic appointments faster than Kobe drives to the hoop: along with Geitner, Lawrence Summers and Paul Volcker are the best known. Together with a Citigroup bailout that gave taxpayers plenty of risk and an unclear amount of reward, Obama's talk therapy boosted the market for five trading days in a row, by a total of 17%.

But talk therapy has its limitations. As applied to the economic crisis, it suffers from the basic problem as the Bush Administration's approach. The Bush Administration has viewed the economic crisis as fundamentally a problem with "confidence." In keeping with this outlook, it has acted primarily to keep the financial system on life support, even to the extent of putting $7 trillion plus of taxpayer money on the line. This blunderbuss approach, which included infusing capital into banks that didn't particularly want it, undermines a basic dynamic of markets: separating the winners from the losers. All financial institutions of any real size are to be saved; they have been federally transported to Lake Wobegon, U.S.A. It avoids confronting the biggest bogeyman in the financial regulators' closets: the still unbooked mortgage and other credit losses that America's financial institutions are carrying. These losses evidently will be carried until when? When the real estate market recovers? (Stop playing the laugh track.) When the banks raise enough private capital--from whom(?)--to write them off without becoming insolvent? (I said, stop playing the laugh track.) When investors--especially foreign investors like the central banks of China and Japan--that bought mortgage-backed investments from American financial institutions agree to take losses instead of trying to foist them back onto the firms that sold them the investments? (Well, all right, we really have only two options: laugh or cry; might as well laugh.) You can't really have confidence in American financial institutions because no one knows how much unbooked loss they're carrying, and the federal regulators aren't about to make them face the music, ahem, we mean provide greater transparency. Without transparency, investors are starved for information and capital markets cannot clear. Only the dole remains. That's why even once mighty Citigroup had to go to the feds, hat in hand, and ask for more porridge.

The gargantuan price tag of these bailouts might be worth it if they were working. But, there's the rub. Confidence is still lagging, and the economy is nosediving. President-elect Obama can't turn things around with just publicity and name dropping. The confidence-building game so vigorously played by the Bush administration has been a failure. While hope springs eternal, economic reality always wins over hope. And that reality is cracking mirrors.

The 17% rise in the stock market since Geitner's expected appointment was leaked on Friday, Nov. 21, reflects very high expectations of Barack Obama, expectations that he himself fueled. He must be cautious about fueling these expectations further. It would be easy for him to talk his way into hero status. But then, come January, the electorate would expect him to deliver, and that would be more easily said than done. At this point, a convoy of aircraft carriers would be easier to turn around than the economy.

We want Barack Obama to be a successful President. America badly needs a successful President. But he won't be successful if he builds up expectations beyond his ability to deliver, and last week's market jump indicates he might have done just that. Franklin Delano Roosevelt never promised a chicken in every pot. Indeed, he stay largely out of sight during the transition period, letting the Hoover Administration take its lumps. With today's hyperactive and hyperfast financial markets, President-elect Obama can't just passively wait things out until his inauguration. But he should avoid making things appear more rosy than they are, because the financial markets are merciless in punishing those that are thought to be less rosy than they appeared, say, two minutes ago. Consult with former Bear Stearns and Lehman Brothers personnel on this point, if it's unclear.

Tuesday, November 25, 2008

Are We Headed for a Depression?

The economy, virtually all major asset classes, consumer spending, and manufacturing are all shrinking. The question of the day is whether we will have another Depression. Things are already worse than the average recession in the post-World War II era. Only the deep recession of 1981-82 was more severe; and the current downturn may eventually exceed that one. Is the economy about to take a bungee jump without a rope?

Reasons to Expect a Depression.

Bank Failures. The Great Depression was heralded by thousands of bank failures. We have had only a handful thus far. Losses to depositors have been minor, since the big banks that got into trouble have been acquired by stronger banks, with all depositors protected. Although the number of troubled banks is growing, it doesn’t look right now like we’ll have a failure rate anywhere close to the levels of the 1930s.

But there’s more to the story. The banking system circa 2005-06 was far different from the banking system circa 1929. Banking, in its most elementary form, involves intermediaries (i.e., bankers) taking money from savers and lending it to borrowers. This intermediation was done by bricks and mortar institutions in every small town and city in America in the 1920s and 1930s. However, by 2005, the process of banking had bifurcated. Loans were initially extended by the bricks and mortar places. But the loans were then bundled into packages and sold to investors. This is known as securitization, and involved trillions of dollars. Most mortgage loans were securitized, and large quantities of car loans and credit card balances were securitized. In essence, savers provided the money used by mutual funds, pension funds, hedge funds and other investment vehicles to invest in securitized debt. These investment vehicles played an intermediation role in funding the loans. The savers’ “deposits,” if you will, consisted of their interests in securitized debt, which were not federally insured.

Since the mortgage debacle began in 2007, many investors in securitized debt have taken mega losses. With the economy receding, the prospects are for more losses as borrowers of all sorts become increasingly likely to default. The securitization market has come to a screeching halt. Virtually the only mortgage loans being made are those underwritten or bought by government controlled entities, like Fannie Mae, Freddie Mac and the FHA. Consumer credit is shrinking rapidly as banks cut back on credit lines of all sorts (home equity, credit card, etc.); car loans are hard to get except for the most creditworthy. The result is that a major part of the de facto banking industry circa 2007 has collapsed. Jimmy Stewart wasn’t a debt securitizer and there’s no one comparable who can restore confidence. In reality, the collapse of the securitization market constituted a multi-trillion dollar banking failure.

Bursting of Asset Bubbles. Really bad economic downturns, like the Long Depression of the 1870s and the Great Depression of the 1930s, have been preceded by the bursting of big asset bubbles. Speculative excess in railroads and other investments played a major role in triggering the downturn in the 1870s. Investor over-exuberance in the 1920s real estate and stock markets did much to instigate the Great Depression. Today, we’ve had bubbles in real estate, stocks and, most recently, commodities like oil, fueled by easy credit. Indeed, the securitization market was a big credit bubble that burst painfully. Trillions of dollars have been lost in the last two years as these asset classes have sunk in value. These losses continue, and more will be sustained in the foreseeable future.

No Exit. The most recent economic trauma that may be comparable to ours today is the Japanese economic crisis that followed the collapse of its real estate and stock markets in 1989-90. The Japanese stock market fell around 80%, and the banking system was saddled with bad real estate and commercial loans for years. The Japanese economy has stagnated since then, even to this day. But Japan did not experience anything approaching a depression. Perhaps one of the most important reasons for this was that Japan was able to maintain large export markets, and thereby sustain many major industries. Most importantly, this included its automobile manufacturers, which have worldwide markets. The United States doesn't have supersized export markets that can compensate for its economic failures at home. Such was also the case in the 1930s, when any attempt by the U.S. or other nations to export their way out of their problems was met by stiff national trade barriers imposed in an excess of protectionism. The U.S. economy was like a closed loop, left with only its internal resources, and those had been too badly damaged to support a recovery.

Thus, the current situation in some ways bears an eerie resemblance to the early 1930s.

Reasons Not to Expect a Depression.

Kinder, Gentler Government. Over the course of the 20th Century, governments in the United States and other capitalist nations learned that sustaining democracy along with free enterprise requires the government to soften the harshness of capitalism. The free enterprise system is a great motivator, and rewards winners handsomely. But losers are given short or no shrift. There was little social safety net in the 1930s, and, as the Depression descended, discontent grew. Socialism and even Communism gain traction in America. In Europe, even darker clouds rolled in as fascism attained dictatorships in Germany and Italy, and provoked a devastating world war that killed tens of millions.

Franklin Delano Roosevelt may, as his critics charged, have had a mediocre intellect and been a traitor to his class. But he made capitalism safe for democracy. With public works programs, public employment programs, Social Security and other measures, he took people off the soup kitchen lines and put them to work or pulled them out of poverty. Unemployment and workers compensation, Medicare, Medicaid and other such programs were instituted to further buffer the unfortunate from the hard laws of the markets. Today, unemployment compensation has become increasingly generous, and COBRA rights extend the health insurance benefits of those that are laid off. Various government programs provide for worker retraining and health insurance for underage children and those who can't find private coverage. Although job loss remains a very difficult experience, it doesn't today usually have the devastating impact that it had in the 1930s.

Proactive Central Banks. The Federal Reserve and other central banks around the globe have been on the job since the early stages of the crisis. Although they seemed to be initially in denial about the size of the problems, they now fully appreciate that a lot of stinky stuff is hitting the fan fast. They've been working together to keep the financial system on life support, and prevent bank failures from cascading. They couldn't prevent the biggest bank failure of all--the collapse of the securitization market--because it is largely unregulated. But they've helped regulated institutions absorb the body blows from that collapse.

Bailout Binge. Along with liquidity transfusions provided by central banks, the U.S. Treasury Department and equivalent bodies of foreign governments have been recapitalizing, nationalizing or otherwise bailing out ailing financial institutions. There are principled reasons for concern about the extraordinary extent of the bailouts--we're talking trillions--but principles sometimes become a tad hazy when your stomach is growling. Rightly or wrongly, there's no end in sight to the bailouts, and they will soften the impact of the economic downturn.

Fiscal Stimulus. The government has, to date, focused almost entirely on preventing a collapse of the financial system. That's important, but the financial system can't be sound unless the real economy is healthy. Some in government seem to have finally realized this. President-elect Obama is proposing a massive government employment program. The Federal Reserve and Treasury Department have announced a program to use government funds to bring relief to the ice cold consumer credit market. Broadly focused government spending will provide more widespread relief and restore a measure of confidence in the government that has been lost by its almost obsessive focus on the well-being of Wall Street.

There may be an exit. All of the government's spending will require more federal borrowing. Since Americans have largely forsworn saving, the funds will have to be borrowed overseas. Nations with capital surpluses, such as China and Japan, have been notably understanding about funding the U.S. government's deficits. Although they have obvious self-interest--a healthy U.S. provides much of their export markets--they are taking some significant risks by continuing to buy U.S. government debt. Since the U.S. can obtain funding from outside its weakened internal economy, it has a chance to work its way out of its problems. Imagine a family burdened with education debt, a mortgage, car debt and credit card debt. A well-off relative lends them, say, $25,000 to help sort things out. This money, which comes from outside their world of never-ending debt payments, lets them get back on their feet and stabilize their finances. Loans from China, Japan and other creditor nations are an external factor that may have a similar benefit for the U.S.

All in all, it's unlikely the U.S. will go into a downturn like the Great Depression. The cost of avoiding such an outcome, however, will be a massive increase in federal debt. Taxpayers for a long time will bear the costs of such borrowing. These borrowings are also likely to push up longer term interest rates, thus depressing commercial activity and long term economic growth. Higher interest rates also dampen housing and stock prices. And if the Fed manages to keep long term interest rates down, all the liquidity it's now pumping into the economy could either produce price inflation or stimulate another asset bubble and burst that will once again push the economy down. We may end up with a long period of stagnation or slow growth like Japan post-1990. There still is no free lunch. That's one lesson that the credit-driven boom of the early 2000s and the subsequent collapse teach us. This time, though, we should take the lesson to heart and try moderation instead of irrational exuberance.

Sunday, November 23, 2008

Searching for a Market Bottom

The question of the day--every day, it seems--is whether the market has reached a bottom. Let's look at the evidence.

Bottom. The market has dropped over 40% from its all time record high, almost as much as it dropped during the OPEC oil embargo era in the 1970s. That was a time of stagflation, when the economy was bedeviled by high inflation and stagnation. We have the stagnation today, but not the inflation.

The government is taking a variety of actions to combat the credit crunch and economic slowdown. One can find a number of problems with the government's approach. But inaction isn't one of them. In total, the argument goes, the government's monetary and fiscal measures should prop things up well enough that the economy can reboot and get going again.

After a brief pause, during which the market fell 20% after Election Day, President-elect Obama is selecting the key officials needed for his economic policies and programs. Following the Friday (11/21) news report of the expected selection of Timothy Geithner, president of the Federal Reserve Bank of New York, as Treasury Secretary, the market jumped 6% in an hour. Moreover, with Citigroup having spent the last week fighting off speculation about its potential collapse, the government is expected to announce tomorrow, Nov. 24, 2008, that it will backstop some of Citigroup's losses (i.e., assume the losses if they occur) and invest in Citigroup. From a certain perspective, there's never been a better time to be a major bank.

It's clear that the government will continue to fight against economic decline. President-elect Obama has proposed a massive jobs program that would employ 2.5 million people. You'd have to go back to the 1930s to find anything comparable.

Not a Bottom. There's no good economic news. The economy is, by all indications, shrinking, perhaps by as much as an annual rate of 5%. (If so, that would be a shocker; the U.S. economy doesn't often shrink so fast.) Unemployment is rising rapidly, up to 6.5% now and likely to reach 8% or 9% next year. That's nasty. We're in the middle of the fourth quarter, and information about corporate earnings is scarce. Much more will be available 4 to 8 weeks from now. But there's not much reason to expect good overall earnings news. While some companies do well in bad times (e.g., Wal-Mart), the economy as a whole doesn't benefit when consumers are cutting back and bargain hunting. And the export market is looking sorrier and sorrier, with the dollar strengthening and the world economy weakening. Without good economic news, there won't be a true market bottom. After all, stock values ultimately depend on the performance of the real economy, and that isn't good these days.

The quantity of federal action shouldn't be confused with the quality of federal action. There are reasons to be concerned that the government has quality control problems. When Treasury Secretary Paulson proposed the Troubled Asset Relief Program in late September, he said it would be used to buy hinky assets from banks. This induced banks to hold onto these bad boys, instead of selling them, in the hope that the Treasury would give them a better price than those greedy bottom fishers who, investing private capital, would only offer small beer. But then, a couple of weeks ago, Secretary Paulson said "never mind" to the idea of spending taxpayer money on asset purchases, preferring to use the funds for capital infusions into financial institutions. That left the banks that held this dodgy paper dangling. They were whipsawed by the government's on again, off again idea for TARP. Citigroup held a large bundle of dodgy assets, and it's no surprise that it began circling the drain when the only potential high-paying buyer for the stuff headed off to play in a different sand box.

Federal regulators have, perhaps too much, focused on the fact that the economy won't be healthy without a sound financial system. That's true, but there won't be a sound financial system without a healthy economy. Right now, the economy is getting mushier and mushier. Almost all the federal money spent on economic measures has been devoted to the financial markets' problems. But things there aren't getting much better. Although the credit crunch for banks seems to be easing, that's not doing the rest of the world much good because the banks are deleveraging and cutting back on lending. A bunch of healthy banks who lend to each other because they're all backstopped by the government aren't, from a societal standpoint, terribly useful. They should get taxpayer money only if they do the taxpayers some good. And the damndest thing is that many bank stocks fell last week along with Citigroup's stock. So, for all we know, more banks will soon be looking for another bailout. Meanwhile, the federal government is doing little for the rest of the economy.

So, do we have a market bottom? It's hard to say yes. Right now, the stock market is all government, all the time. It goes up when there's positive news from the government (e.g., the expected appointment of Timothy Geithner as Treasury Secretary). Otherwise, it goes down as more bad economic news rolls out. This is troubling, since the government cannot ultimately prop up the stock market. Only a healthy economy can do that. The 6% jump in the last hour of trading on Friday is symptomatic of a market that still harbors false hopes, that the appointment of any particular individual will save the day. There is no messiah for the economic crisis. And as long as investors look for an easy way out--a single individual or a single government proposal to make all the boo boos go away--stock valuations will probably be unrealistically high and further market drops will be likely. Be cautious about putting money into the market now. You aren't necessarily making a mistake, but be sure that you invest only money you won't need for a long time.

Wednesday, November 19, 2008

A New Crisis for the Financial Crisis: The Presidential Transition

On November 6, 1860, Abraham Lincoln was elected the 16th President of the United States. The country was in a political crisis, with some Southern states threatening to secede. At that time, Presidents-elect were not sworn into office until early March of the year following their elections. During the four months between Lincoln's election and his inauguration on March 4, 1861, seven Southern states seceded, establishing the Confederacy. Lincoln's predecessor, James Buchanan, who may possibly have been the worst President ever, was entirely ineffectual in dealing with the dissolution of the Union. In the ensuing civil war, 600,000 Americans died.

Things are nowhere nearly as bad today. The Civil War turned the country from these United States of America to the United States of America, and so unified it has grown to be the most powerful nation on Earth. But we have a nasty financial crisis on our hands that shows every indication of getting worse. Today, the Dow Jones Industrial Average fell 5% and the more comprehensive S&P 500 index fell 6%, mostly on more bad economic news and lowered prospects of immediate assistance for the American auto companies. The Bush Administration has taken down its tents and packed up for its departure. The Treasury Department has suspended further application of its bailout powers under the $700 billion TARP (the now troubled Troubled Assets Relief Program), leaving some $60 billion uncommitted and another $350 billion untapped that can be spent only if Treasury requests it from Congress (and no request has been made). The Federal Reserve will continue to prop up the financial services industry, but its ability to support and stimulate the larger economy is virtually gone. While it may lower interest rates again, there's little reason to believe that such a step would do much good. The level of interest rates has little to do with the amount of lending these days.

Banks aren't lending because their continuing losses from mortgages, real estate, consumer credit and myriad other sources compel them to deleverage and hoard funds. The $250 billion from TARP that Treasury is investing in a number of banks will help to keep them afloat. But it won't have much impact on ordinary folks whose home equity lines of credit, credit card limits and other sources of credit are being cut back by the banks. Securitization of loans, the primary way banks have offloaded loans in recent years so that they could lend more, has virtually stopped. Vast numbers of investors were burned badly by the securitization of bad, dumb and fraudulent mortgage loans, and that way of doing business will never come back. Perhaps a new form of securitization will some day rise from the ashes. But, at least for now, the phoenix remains a mythological figure in the world of finance.

The stock market had risen yesterday, partly because of a perception that the market might be bottoming out and partly due to signs of potential progress on an auto company bailout. These hopes were dashed today; and there's nothing on the horizon to indicate near term improvement. The G-20 conference last weekend in Washington turned out to be a marshmellow roast where prominent leaders from around the globe sang "Kumbaya" in their native languages. It was a short seller's dream.

Two months--the time until Barack Obama is inaugurated--is an eternity in the financial markets. Two months ago, the stock market was mostly trading over 11,000. Since then, we've lost 3,000 points, or around 27%. Another 27% drop from today's price levels would produce a Dow of around 5840. That would make a lot of people unhappy. Could it happen? That's anyone's guess at this point. A couple of months ago, some market professionals were calling a market bottom around the mid-11,000s. They probably now have a heightened appreciation of the undesirability of egg on one's face.

If the Treasury Department had begun purchasing mortgage-related assets immediately after TARP was enacted on October 3, 2008, some of the banks selling those assets might have gotten higher prices than they could get today. Secretary Paulson's plan to buy such assets, and his recent decision to drop that idea, left the banks holding the bag. Mortgage-related assets have fallen in value since October 3, 2008 (as foreclosures have increased and real estate prices fallen). Selling banks will have to book larger losses now than they would have had they sold in early October. This illustrates the price of delay in today's hyperfast financial markets.

The unpleasant but unvarnished truth is that only swift and substantial government action can have any significant impact on the economic downturn. Two months delay means another two months during which layoffs increase, consumers pull back further, credit disappears, stock, real estate and other asset prices drop, bank losses build and confidence evaporates. Government policy and action for the economic crisis can't wait two months while George W. Bush ruefully packs boxes and entertains pardon petitions.

President-elect Obama should make the selection of his Treasury Secretary the top priority for the transition. Selection of the rest of the Cabinet can come later. Planning the Inaugural celebrations can come later. He must name a Treasury nominee now; every day could be costly in the stock markets. He and his nominee should immediately begin coordinating with Treasury Secretary Paulson, Fed Chairman Ben Bernanke and their staffs about what to do now (i.e., as in not in January). The Obama camp will have to call the shots. They'll have to make decisions with only incomplete information and not enough time to think things through. They'll have everyone in the world screaming at them for every mistake they make; and they'd better expect some of those along the way. The outgoing administration may have to swallow hard, avert their eyes and do some things they dislike for the sake of Old Glory. They may have to abandon their own policies and let the incoming administration have its way, because it will anyway. If there ever was a time to rise above partisan politics, now is that time.

Friday, November 14, 2008

What Might a GM Bankruptcy Look Like?

The Bush Administration has made clear that it will not sign off on a bailout of GM. GM's management has said that the company might have to file for bankruptcy by the end of this year. If so, the company will be in the tank before President Obama has a chance to put together a bailout bill. Let's take a look at what might happen in a GM bankruptcy.

Sales would probably fall off. A new car is a five or more year proposition for many buyers. They wouldn't want to buy a car from a bankrupt company that might not be around in a year or two to support the warranty and ensure a steady supply of replacement parts. GM would have to institute large, and perhaps massive, layoffs. Its suppliers would, in turn, have to make large, or even massive, layoffs. If the suppliers go into bankruptcy, their ability to supply not only GM, but also Ford and Chrysler, could be adversely affected. Ford and Chrysler, already seriously weakened, could begin circling the drain.

In order to reorganize and emerge from bankruptcy, GM would need "debtor-in-possession" financing, a special form of financing provided to bankrupt companies. But how many lenders are there, in these days of the credit crunch, who would fork over the billions needed by badly crippled GM for a reorganization? Maybe only a few. Very possibly none.

So GM might be unable to reorganize. In that case, its bankruptcy would be converted to a Chapter 7 liquidation. Some argue that this would be a good thing, that competitors would buy pieces of GM and get those pieces up and running again. But what competitors have the money to buy parts of GM? The financially strong ones, like Toyota and Honda. What might Toyota and Honda do if they bought some of GM's plants and facilities. Hint: it wouldn't be to operate them. The auto industry is plagued by serious overcapacity. Toyota and Honda could expand their share of the U.S. auto market by permanently closing any GM plants and facilities they bought in a Chapter 7 liquidation.

Would any leveraged buyout firms buy parts of GM? Not after Cerberus got clobbered for its investment in Chrysler. There don't appear to be any American investors who could come up with the money to establish a new company to take on Toyota and Honda. Any such transaction would require billions of dollars in bank credit lines, and what banks in the credit crunch era would finance such a business plan against such capable competitors? Today, banks only want to invest in U.S. Treasury securities. There wouldn't be a lot of them volunteering to finance a startup to compete against the likes of Toyota and Honda.

So GM's bankruptcy could end up with the U.S. auto industry seriously diminished. No nation remains great without a strong industrial base (compare the U.K. before and after World War II for proof of this proposition). Bailing out GM would be distasteful, since government bailouts are, as a matter of principle, not to be encouraged. But after the hundreds of billions of federal dollars that have flowed to Wall Street, it's hard to stand on principle because one ends up standing on hypocrisy.

One good thing about a Chapter 7 liquidation is that GM's current management would lose their jobs. That needs to happen anyway. After 8 years as GM's CEO, Rick Wagoner hasn't got the job done. He bet the company on a commodities play: that the price of oil would stay low and that the company could keep building high profit, low fuel economy trucks. He was wrong, and even though he is CEO, he like everyone else should pay for his mistakes. Is Rick Wagoner a bad man? No. Is he stupid? No. Did he try his best? No doubt he did. But he gets paid millions and should deliver performance commensurate with his pay. He hasn't. Besides, GM needs a new face in order to credibly promise better future performance. If GM goes into bankruptcy, its one real chance may be federal assistance in lieu of debtor-in-possession financing. A new face has a better chance of winning over skeptics with a believable promise of improved future performance.

Let's recall that the 1979 Chrysler bailout, along with management changes at that company, worked and provided U.S. taxpayers with a profit. GM can produce quality vehicles (check out the new Buicks). It has innovative engineers and perhaps the best styling among the U.S. auto companies (most of the time; the Cavalier was sad looking on its good days and the Lumina was hardly luminous). If we deviate from dour, rigid application of free market principles and provide some taxpayer support, we might end up a lot better off than we would without GM.

Thursday, November 13, 2008

The Next Two Months: A Most Dangerous Time for the Financial Markets

We're now in the interregnum, with a Democratic President-elect to replace the Republican lame duck two months from now. The Republicans, grumpy about being clobbered in last week's elections, aren't eager to take up Democratic initiatives, like a bailout of GM. Treasury Secretary Hank Paulson has put the $700 billion bailout plan on hold. About $290 billion of it has been committed to supporting banks and other financial institutions, primarily through capital infusions. Another $60 billion is authorized to be spent by Treasury, but remains uncommitted. The rest of the funds, $350 billion, cannot be spent without further approval by Congress, and Paulson doesn't plan to ask for it. While the Federal Reserve and Treasury can use existing authority to lend to and invest in financial institutions, there won't be any significant new initiatives by the government until Barack Obama is sworn in.

In today's hyper volatile stock market, two months is a lifetime. The market dropped 17% in October. What will November be like? Within the past two and a half weeks, the market rose almost 20%, dropped 14% and then rebounded 7%. If there's one thing we've learned in the last six months, it's that we have no idea what will happen tomorrow, let alone next week or next month. This year, entire nations--like Iceland, of all places--have become insolvent. All the major investment banks in America have disappeared or been converted into commercial banks. Almost all major commercial banks in America have received capital infusions from the federal government. AIG, the nation's largest insurance company, has been virtually nationalized. The U.S. government, by taking control of Fannie Mae and Freddie Mac, effectively runs the mortgage business in America. Europe is on the ropes, with the Euro dropping like a rock against the dollar. Oil prices have been manic depressive. The recession, in America and overseas, promises to be worse than we expected yesterday.

Today's 552 point jump in the Dow may appear positive at first glance. But it seems to be mostly speculative frenzy. Not only did stock prices rise, but so did oil and wholesale gasoline prices. That doesn't make sense, since an increase in energy costs would only depress an already weakened economy. However, this kind of price activity could be explained as bottom fishers buying up any asset that has recently dropped a lot--in other words, speculation. Some market mavens claim there is a floor to stock prices at the 8,000 level of the Dow, because the market has twice hit that level this fall and rebounded. But it's risky to believe in talismanic stock index levels. Looking at the underlying economics makes more sense.

Good things could happen during the next two months. The sharp drop in oil prices may stimulate consumer spending, which is now lagging badly. Perhaps--just perhaps--truck sales might increase a bit, giving GM, Ford and Chrysler badly needed profits. The stronger dollar may bring in foreign investment, supporting U.S. stock and other asset prices. Japan and China may infuse capital into the IMF, which could lend it out to smaller nations with faltering economies and soften the worldwide recession.

Bad things could happen during the next two months. Consumer credit is tight and could easily get tighter. Consumers have started to realize that they haven't necessarily never met a debt they didn't like. They're deleveraging. That means lower consumption, which will lead to higher unemployment.

GM could go into bankruptcy. The outcome of such a bankruptcy is extremely difficult to game out. It's possible GM could successfully reorganize. But it's also possible that, with the auto industry severely burdened by overcapacity, GM wouldn't be able to attract enough new capital to effectively reorganize. The uncertainty of the situation would probably depress stock values, since the market hates uncertainty.

Housing prices could continue to drop. There is no reason to think that they've bottomed out. The Bush administration's latest mortgage relief proposal might help 10% of the homeowners who are underwater on their mortgages. And it wouldn't help those that are already in the foreclosure process, which includes a lot of homeowners. Mortgage rates are, if anything, rising.

Corporate earnings could fall more than expected. That's certainly been commonplace in the third quarter of 2008, as the nation and the world have slipped into recession more quickly than initially thought. Beginning in early December, we'll start getting indications as to how the winter earnings season will go. Much more information will come out in the two weeks before the Inauguration. The picture might be grim.

Thus, the next two months will be a most dangerous time for investors. There will be plenty of risks and no hope of any new major government initiatives to offset the risks. Don't think today's 7% market jump means much. Buy stocks, if you're feeling bold or your investment horizon is way off in the distance. Don't invest anything you can't afford to lose. At the same time, don't lose heart. There's nothing about the current economic crisis that tells us the U.S. can't recover. Recovery may be a ways away. But things were a whole lot worse in the 1930s. This, too, will pass.

Sunday, November 9, 2008

Enlist Private Capital to Combat the Economic Crisis

Barack Obama has a lot on his plate: a financial sector in crisis, an economy in recession, unresolved wars in Southwest Asia, a health insurance system badly in need of reform, a national infrastructure that is sometimes, as in Minneapolis, literally collapsing, a needlessly complex tax system, and a national zeitgeist that is dispirited and has very high expectations of him. At the same time, the resources for addressing these problems look thinner by the day. If one tries to total up the cost of covering the financial sector's losses in mortgages, CDOs, credit default swaps, credit card debt, car loans and other bad loans and investments, the number reaches several trillions. Then, there's the potential cost of assisting defaulting homeowners avoid foreclosure. That's hundreds of billions more, and maybe another trillion.

What are the resources that could be tapped to alleviate the problems? America's gross domestic product is something on the order of $14 trillion. The federal government's budget for fiscal 2008 (the year ended Sept. 30, 2008) was something around $3 trillion, with a deficit of about $450 billion. The total federal debt outstanding is $10 trillion. The government simply can't wrestle trillions more from the domestic economy in order to deal with the financial crisis. Presumably, some of the needed money can be borrowed overseas, since the whole world is sliding into recession and the dollar retains its image as a safe haven. Indeed, about a quarter of the outstanding public debt (or $2.5 trillion) is held by foreign lenders. But borrow another $4 or $5 trillion overseas? Not likely. Even the hundreds of billions needed over the next few months to fund the Treasury Department's continued financial sector bailouts (pursuant to the $700 billion bailout bill enacted this fall) and a proposed $60 to $100 billion stimulus package now being touted by Congressional leaders will seriously test the world's appetite for U.S. government debt.

Plainly stated, the U.S. government doesn't have and cannot get enough resources to fully deal with today's economic crisis. Given the near complete disarray on Wall Street (evidenced by the continued credit crunch), and shrinking options for Main Street companies (does GM have a corporate strategy aside from getting federal bailout money?), the government has to tap new veins of capital or see the economy slide further.

Fortunately, there is a substantial amount of cash sitting in private hands. It's unclear how large this hoard is. But you know it's there from the large amounts of mutual fund and hedge fund redemptions, and withdrawals from money market funds. Trading volume in the stock markets has been very light in recent weeks, which is part of the reason for the extraordinary volatility in stock prices. A lot of investors have yanked their savings from anything that presents risk and parked it in ultrasafe places. And they're not putting it into stocks, real estate or anything else that appears to be a sinking asset. This money represents a pool of funds that, if put back to work in the stock and real estate markets, and through the banking system, could do much to revive the economy.

How can private capital be enticed to assist in the economic recovery?

Home buyers tax credit. All the talk of assistance for defaulting homeowners raises questions of fairness and exploitation of government aid. The large majority of homeowners with mortgages pay on time, even though many are under water. If defaulting homeowners receive government sponsored reductions of principal and interest rates, other under water homeowners have an incentive to cash in on the government program by defaulting as well (even if they can continue to make payments) and angling for a better deal for themselves at the taxpayers' expense. Another way to support real estate prices would be to give home buyers a tax credit--not just for first time buyers, but for all buyers. The point of this credit is to increase demand for real estate and not redistribute income. Maybe some sort of limit could be established to avoid subsidizing rich and famous lifestyles. But a tax credit such as 5% of the purchase price up to a limit of $50,000 would do much to encourage buyers to step in. Mortgage relief will be messy and expensive. A tax credit may be expensive, but it would be simply and direct, and therefore likely to have a faster impact.

Interest and Dividend Income Deduction. It's essential to encourage Americans to save more. That would increase the amount of domestic capital (a good thing regardless of what it is used for, because the U.S. is overly dependent on foreign capital). Since savings would often be placed in bank accounts, the banking system would get a low cost and stable source of funding, something it desperately needs. Other such savings would go into money market funds, and could flow from there into the badly frazzled commercial paper market. Such a deduction should be provided for interest income and dividend income now taxed as ordinary income (like dividends from money market funds). Allowing individuals to shelter from income taxes up to $20,000 per year of interest and dividends would do much to encourage saving, and increase funding for banks and money market funds.

Double the Deductions for Retirement Account Contributions. Increasing the deduction for retirement account contributions (i.e., for accounts like 401(k)'s, 403(b)'s, IRAs, Roth IRAs, SEP-IRAs, etc.) would stimulate savings, because many people use the amount of the deduction as a retirement guideline and save the maximum amount allowed. Even though this isn't necessarily good retirement planning (you should estimate your retirement needs and save enough to meet those needs, not save the amount the tax code allows you to deduct), it's a behavioral pattern that would bring more capital into the financial system and the stock markets. That capital is badly needed. Doubling the deduction would also assist older workers (especially those close to retirement). Many of them have suffered recent losses in the stock market, and would benefit from a larger deduction to beef up their depleted retirement funds.

These measures would negatively impact taxes collected. And most of the tax benefits would go to upper middle class people. But one must offset those considerations against the advantages of bringing private capital back into the real estate and stock markets, and into the financial system. The government can't do it alone; President-elect Obama's remarks last Friday (Nov. 7, 2008) acknowledged as much. We can either let this private capital sit on the sidelines, while the government tries to tackle an impossible task, or we can work toward a combined effort that may help to stave off a really deep recession.

Thursday, November 6, 2008

Time for a New Approach to the Economic Crisis: End the Government Confidence Game

The stock market has dropped 10% over the last two trading days since Barack Obama was elected President. President-elect Obama shouldn't take it too hard. The market's drop has little to do with him. It's the result of the George W. Bush Administration's failed confidence game in dealing with the financial crisis.

All financial markets are based on confidence. This is true whether we're talking about stock, bonds, options, currencies, mortgage-backed securities, synthetic CDOs, or derivatives of derivatives. The Bush Administration's focus in responding to the mortgage crisis and credit crunch has focused on trying to restore confidence in order to get credit flowing. The Federal Reserve's ever-expanding programs of loans to an ever-widening circle of business enterprises, the bailouts of Bear Stearns and AIG, the nationalizations of Fannie Mae and Freddie Mac, and the still somewhat amorphous $700 billion bailout bill which will be used in some fashion that will eventually be defined are all meant to prop up the financial system by instilling confidence.

In the ten days preceding the recent election, the stock market gained about 18%, after central banks around the world announced a plan to make coordinated interest rate cuts in order to stimulate flagging economies. The surge in stock prices may also have been driven in part by the relief that the uncertainty of the presidential campaign was about to end (the financial markets hate uncertainty, because it's very hard to price).

However, after the election, the markets had to face the fact that the recession hadn't gone away, notwithstanding all the government bailouts, programs and policies. The Bush Administration's policies have lagged behind the economic tailspin, which is no longer driven only by falling real estate values and rising mortgage default rates, but also by a widespread slowdown in consumer spending driven by a number of disparate factors. Among other things, job losses are worse than expected, European banks turn out to have nastier problems than we thought, larger nations are quickly nationalizing their banking systems and smaller nations effectively admitted their insolvency by seeking IMF assistance. Retailers are almost all reporting bad financial results, with only Wal-Mart having something positive to say because it's focusing on serving the down market portion of the down market segment. Manufacturing is hurting and the U.S. export market will weaken as a result of the recent strengthening of the dollar.

It may be tempting to President-elect Obama to say something about our having nothing to fear except fear itself. That wouldn't set the right tone now. The Bush Administration's confidence game has failed, because confidence games don't work when assets are falling in value. Almost all asset classes, from stocks to bonds to commodities to real estate to the economy as a whole, are now falling in value. Everyone knows it, and everyone who has money to lend also has good reason to be cautious about lending. And a lot of people who have money invested in the stock markets are trying to get out.

Instead, President-elect Obama should use words that invoke Winston Churchill's promise of blood, toil, tears and sweat. Candor from the White House is essential. We're at the early stages of battling a difficult economic crisis. Few of us will escape wholly unscathed, and all of us will have to make sacrifices. While America's problems today do not begin to approach the depths of Britain's problems in the spring of 1940, we need to unify and find a sense of national purpose, step back from the partisan rancor of recent years, and work together to find lasting solutions. Further, we can't expect government to fix all problems. Those Americans who now reach for their bootstraps will end up much better off than those that wait with hands held out. The new President should be candid about what the government can't do and the importance of self-reliance and self-help. We Americans have always wanted a government of limited powers, and we'll have to work for it if we still want one.

Wednesday, November 5, 2008

Barack Obama, and the Revival of the Rust Belt and Hope

The election of Barack Obama as President includes a lot of firsts. One that has received little media attention is that for the first time in more than a generation, the Rust Belt has played a crucial role in electing a President who would serve its economic interests. Since the late 1960s, the Rust Belt has drifted away from the Democratic Party (or perhaps one could say that the increasingly liberal Democratic Party drifted away from the Rust Belt). The Republicans, normally the shrewder political operators as compared to the Democrats, took full advantage of Rust Belt disillusionment to repeatedly swing crucial swing states in their direction. Yet, all this support for the Republican Party resulted in little federal economic assistance for the Rust Belt while jobs and industries shifted to the Sun Belt or other nations.

This time, Wall Street greed and mismanagement, coupled with benign neglect by financial regulators, created the recession into which the nation is now descending. Republican sloganeering couldn't shift voters' focus away from stagnating middle class incomes, increased inflation, greater unemployment and falling real estate and retirement account values. Rust Belt voters from Pennsylvania to Wisconsin and Minnesota went for the guy who most clearly promised to do something for them. In one of the rustiest of states, Ohio voters told Joe Wurzelbacher to pipe down and go back to plumbing.

None to late, either, because the United States needs to revive its manufacturing capacity. The wealth of a nation ultimately comes from its ability to produce. Wall Street's financial engineering, dabbling with derivatives and corporate takeovers all too often create little more than paper wealth that isn't worth the paper it's printed on. The Bush administration's policies make sense to the Wall Streeters who now hold senior positions in the Department of the Treasury. They wouldn't question why the banking system must be preserved. But ask a laid-off auto worker why it makes sense for the government to subsidize J.P. Morgan Chase's merger with Bear Stearns, but not GM's merger with Chrysler. Considerations of government interference with market mechanisms and moral hazard ring hollow when the government subsidizes the banking system while allowing dividends still to be paid to private bank shareholders.

America needs to strengthen its productive capability if it's going to achieve a lasting recovery from the recession. We can't afford to revive the economy again with a methadone-like dose of easy money (although that seems to be the Bush administration's principal policy). That would only set the stage for more asset bubbles and bursts. Barack Obama's election provides an opportunity to rebuild a crucial economic sector.

It will also help to restore America's standing among nations. The George W. Bush administration's record of unilateral militarism has done much to mar American's image. But John McCain's honorable conduct of his campaign--hard fought, but without Willy Horton moments or Swift Boat ambushes--avoided the rancor that delegitimized other recent presidential elections, and strengthened the nation's integrity. And Barack Obama's election vividly demonstrates to the world that America is, as it was in 1776, a nation of principles and dreams, where voters are fair-minded and are willing to look beyond the bigotry and prejudices of the past, where society and life can get better, and where anyone--anyone--with talent and the willingness to work hard can become President.

Monday, November 3, 2008

Can the Federal Reserve Handle the Volatility?

As we discussed in our preceding blog, volatility in the stock market discourages investors. Buy and your investment suddenly drops in value. Place an order to purchase, and the market jumps before your order can be executed, causing you to pay more. With investment opportunities like these, you might prefer to sit in front of the TV, drink beer and eat potato chips. Better to pork out than take trading losses.

Volatility is also a macro-level problem. Two months ago, the Fed had to be cautious about lowering interest rates because of the high price of oil. The dollar was in the doldrums, adding to the inflationary pressure. Today, oil is regressing back to 2005 levels, and some low tax states may soon see gas under $2 a gallon. At the same time, the dollar has rebounded briskly against the Euro (although it's slumping against the yen). The Fed is now concerned with deflation--that rarely seen phenomenon where overall price levels fall. Deflation discourages consumption, because consumers wait for prices to drop before buying. Inventories pile up, manufacturing slows down and layoffs increase. Debt becomes more burdensome to repay, since borrowers must use more expensive dollars to pay their obligations.

In order to forestall deflation, the Fed lowered interest rates recently, a measure that is also meant to stimulate the recessionary economy. Monetary policy tends to take effect at a glacial pace. Interest rate changes often require 12 to 18 months to have a significant impact. Do we really think that oil prices will stay low for the next 12 to 18 months for the convenience of central banks around the world? Or is it possible that they may pop unexpectedly, as they did this past spring? Could the dollar slide again when investors get a fix on the size of future U.S. government deficits after the costs of all the bailouts and lending facilities becomes clear? The recent federal bailouts and interventions have, if anything, only increased America's status as the biggest spendthrift of all. This isn't good for the dollar.

Will the Fed be able to handle the unexpected volatility that we now know to expect? Will it be willing to change policies if a few months from now inflation, not deflation, turns out to be the problem? Events in the current financial crisis have moved very fast, and the government has been forced to improvise extemporaneously. At this point, its response consists essentially of just one measure: pumping as much liquidity into the financial system as fast as it possibly can. Methadone does work, in a manner of speaking. But it substitutes one addiction for another and the financial system is now addicted to government interventions and bailouts. The stock markets surged last week amidst a sequence of coordinated worldwide interest rate cuts. But you can't have a financial system that's all government all the time. The Soviets and Communist Chinese tried that idea and it didn't work out so well. One scary scenario is that the stock markets might soon bubble up on a cushion of government interventions and become disconnected from economic reality. The disconnect with reality has happened in the recent past--in the real estate, mortgage, and derivatives markets. Re-connecting was painful. Let's hope that the stock markets' current frothiness isn't irrationally exuberant.

All of the economic news from last week went from bad to worse. The nation's slide into recession may be sharper than the stock market expects. Layoffs are increasing quickly. Consumption is falling as people are actually saving. This is really weird. When Americans start saving, you know times are tough. The full picture may not have shown up in current official statistics, but it would basically take the appearance of the Yeti on people's front lawns to get red-blooded Americans to save. But they are, and that means, aside from confirmation of the existence of the Yeti, that we're probably in for a full-bore recession, the kind where parking enforcement officers find deep in their hearts the compassion to overlook illegally parked cars with people sleeping in them, close to where the soup kitchens are located.

Thursday, October 30, 2008

Why Stock Market Jumps Discourage Investing

On Tuesday, Oct. 28, 2008, the stock market jumped about 11% in a single trading session. Good news, yes?

Well, not necessarily. Let's say you had been watching the market fall for most of the preceding week, and decided after the 300 point drop in the Dow Jones Industrial Average on Monday (Oct. 27) to start buying stocks. Your buy orders would have been executed in a rising market on Tuesday. If you have tried to buy mutual fund shares, you would have paid the closing prices for Tuesday (which could have been around 11% higher than the prices you saw Monday evening). The big jump on Tuesday might have been very costly. Most years don't provide investors with an 11% return. Anyone buying stocks or stock-based mutual funds on Tuesday could have "lost" more than a year's gain.

Everyone understands how downward volatility in the stock markets discourages investors. Upward volatility also contains traps. To some degree, you might be able to lessen this risk by buying ETFs, which can be purchased at intraday prices. But in a highly volatile market, getting an ETF order executed at the price you see one moment may be difficult if the market moves abruptly the next moment (which, these days, can easily happen). Consumers would be discouraged if the price of lettuce could rise between the time you took it down from the display case to the time you brought to the cash register. Stock investors can similarly be discouraged by a divergence between the prices they see and the prices they pay.

Much of the volatility may be attributable to big players trading the entire market, using program trading or comparable derivatives contracts. This kind of trading can run right over individual investors (see our blog at http://blogger.uncleleosden.com/2007/07/why-stock-market-bounces-around.html). There's actually quite a bit of liquidity sitting on the sidelines right now. But the volatility of the market will encourage it to stay on the sidelines. That isn't good. Without a significant inflow of liquidity, the market cannot truly recover.

No federal intervention or bailout can directly reduce stock market volatility. The volatility is a product of the uncertainties about the financial system and the economy, and these uncertainties abound. Perhaps the various federal measures aimed at helping an ever-increasing array of institutions, companies and individuals will eventually lead to calmer markets. Then, again, perhaps the large amounts of still unrecognized losses from the mortgage crisis and the slowing of the world economy will keep the markets jumpy. Until things calm down, though, don't expect a true market recovery.

Monday, October 27, 2008

Financial Projections for This Year and Next

Here are our predictions for the near and not so near term in the world of finance.

The Federal Reserve Board will lower interest rates this week. A half-point cut to a fed funds rate of 1% seems likely, and will very possibly be coordinated with interest rate cuts by the central banks of other major nations.

It won't make much difference. The financial markets will probably rally briefly on the interest rate cut(s). Then, the now familiar credit crisis malaise will settle back in, because interest rate cuts do little to restore confidence on the part of lenders. Banks are starting to lend to other banks again, only because banks have more or less been nationalized and the government will ensure that their debts are repaid. But banks are reluctant to lend to operating businesses in the real economy, because that involves actual risk. With the large amounts of mortgage-related losses that they probably still have to write off, banks would want to hold onto whatever capital they have to offset those write-offs. Making new loans is probably a lower priority than funding the company Christmas party.

Cash will be your new best friend for the next year or two or three. They that holdeth cash sleepeth well these days. That, by itself, makes saving worthwhile. In addition, cash can be used to buy stocks and real estate when they're cheap. Cash provides a buffer in case of job loss, illness or disability. The value of cash can be eroded by inflation, and the government isn't doing anything to combat inflation. The Fed's current anti-inflation policy is to hope that the economic slowdown will constrain price increases. That might work. But economic slowdowns and inflation aren't mutually exclusive. There was a time within living memory when seemingly normal men wore leisure suits and economic stagnation co-existed with nasty inflation. There have been some signs of leisure suits making a comeback. Let's hope that stagflation doesn't come along, too. Whether or not it does, cash has replaced the home equity loan as the latest measure of prosperity. Indeed, much of the purpose of the recent bailouts of banks, brokerage firms, and money market funds is to ensure that there are safe places to keep cash besides your mattress. The government will protect your cash even if it won't prop up your stock holdings or the value of your house.

Taxes will increase. Barack Obama has been pretty straightforward on this point. John McCain won't have much choice, with all the demands of the various federal bailouts along with the wars overseas. Fortunately for both candidates, the Bush 43 tax cuts expire soon, and whoever is the next President can monkey around with "extending" those cuts in ways that effectively raise taxes from current levels. Alternative minimum tax relief, which is needed every year, provides further opportunities for increasing the flow of dollars into the Treasury under the guise of giving taxpayers a break.

The recession will get worse before it gets better. At this point, only the most Panglossian of optimists (e.g., the members of the Board of Governors of the Federal Reserve System) don't see a stomach churner of a recession coming. The economic crisis has gone global. Nations from Iceland to the Ukraine to Pakistan to Hong Kong (which is part of China) are struggling. Even Kuwait, which by numerous measures is a wealthy place, has instituted bank deposit guarantees and bailed out a bank. There won't be any great safe haven overseas for your investment dollars. Even Switzerland, long time bastion of stability, recently infused capital into one of its major banks, UBS. Sovereign wealth funds won't be a source of succor, not with the price of oil falling by more than half in a couple of months. There are storm clouds in every direction and they all seem to be blowing toward us.

Eventually, things will get better. They always have, and that's a reason to think that they will again. Both the stock market and real estate market will find their way out of the abyss. But it's hard to see a quick recovery. Meanwhile, keep in mind the possibility of buying stocks and real estate when they are cheap. It's not clear that you should be buying now. Take your own counsel on that question. But buying low and selling high is probably a strategy you can implement beginning some time in the next year or two.

Friday, October 24, 2008

Reforming the Credit Rating Process

Recent news accounts report that employees at certain credit rating agencies sometimes knew that some of the deals they were evaluating were pigs without lipstick, and questioned the wisdom of rating them. The fact that the credit rating agencies are typically compensated by the issuers of the debt they are rating, instead of by investors, fuels concerns over potential conflicts of interest. Since many mortgage-backed securities that initially received AAA-quality ratings have since been downgraded for reasons that may have been foreseeable, the integrity of the credit rating process has become intensely important. This is particularly so since many institutional investors are required by law to rely on credit ratings with respect to some of the investments they can make.

Probably the greatest concern is the way the credit rating agencies are compensated. When you're paid by the person you're evaluating, how objective can you be? No matter how many rules and procedures are in place, will the credit rating agencies ever be willing to bite the hand that feeds them?

It would be much cleaner to have the rating agency funded by investors. There is a large community of institutional investors--mutual fund management companies, pension funds, university endowments, and so on--that has a powerful interest in disinterested and objective ratings. They also have the money to fund a nonprofit rating organization, and the market power to demand that issuers of debt agree to ratings by nonprofit rating agency.

An investor funded credit rating agency isn't as far fetched as it may sound. The credit rating process began with investors paying the fees, and it can return to that. In the consumer products arena, an independent nonprofit, Consumer Reports, stands as the most credible evaluator. Consumer Reports does not accept advertising from the companies whose products its evaluates, and it buys those products rather take free samples. By maintaining independence from manufacturers, its credibility is enhanced. If you want to find out how much pizazz a car has, you can read an ordinary car magazine. But if you want to find out the hard facts about how reliable a car is, you're better off reading Consumer Reports.

The established credit rating agencies are for profit organizations. Don't look for them to convert into nonprofit do-gooders. The buyside community (i.e., investors) will have to take the initiative to establish a new rating agency. Doing so may seem to involve a lot of work and expense. But, perhaps institutional investors could tally up their losses in the past couple of years from rated securities, and then they might see what's been truly expensive.