Thursday, January 31, 2008

Survival Gear for a Recession

In perhaps its most extraordinary monetary action ever, the Federal Reserve lowered interest rates 125 basis points over the last two weeks. Either there really is a serious chance of a recession, or Wall Street has flimflammed the Fed big time. We'll assume, for the purposes of discussion, that it's the former.

To prepare for a recession, you should think about the following.

Love cash. Everyone likes cash, but usually because they can use it buy something. To prepare for a recession, you should love cash. Save up as much as you can and keep a tight grip on it. Feel really bad about parting ways with your greenbacks. An emergency fund of 3 to 6 months of living expenses is a good idea, and the idea gets better the bigger the emergency fund is. Emergency money should be kept in a safe place like a federally insured bank or credit union account, or a money market fund that invests only in U.S. Treasury securities. (For ideas about where to invest short term money, see As you face the cold winds of recession, grace under pressure is a lot easier when you have a pocket full of cash.

Hate debt. While you're still employed, don't take on any new or increased debt, and start paying down everything except the big ticket items that you can't pay down (like the mortgage). Begin with high interest rate debt like credit cards. Not only does this eliminate excessive interest charges, but it also increases a line of credit you could tap into if you're laid off. Just as Demon Rum has ruined many lives and relationships, Devil Debt can do and has done the same.

Deal with important medical issues. If you have important medical problems, deal with them while you're still employed and have health insurance coverage. While many people who are laid off can continue their health insurance coverage under COBRA, they have to pay the full cost of the premiums. And some employees don't have COBRA rights. The worst case scenario would be the employer going into bankruptcy and terminating its health insurance plan altogether. In that case, COBRA rights disappear because there is no health insurance plan they fall under. This maneuver is very nasty. But it has been done, so don't take anything for granted, especially if your employer is teetering on the brink. If you lose health insurance coverage or don't have it, there are resources you can use to look for coverage. See

Keep saving for retirement. Unless you lose your job, keep saving for retirement. If you do lose your job, your retirement savings program will necessarily stop. You should boost your own personal safety net while you can. You don't want your retirement to be one long recession.

Mortgage Default. If you run into trouble with paying your mortgage, either because the monthly payments increase or you lose your job, there may be ways to get help. Nonprofit organizations sometimes provide assistance, as do various state and local governments. There is a federally sponsored ARM rate freeze that will help some, but probably not all that many, borrowers. Of course, you should try to negotiate with the lender as best as you can. For more information, see

Job loss. If you lose your job, the recession becomes a depression for you. You should still make the most out of the situation. Negotiate for the best termination benefits you can get. Your employer may have a formula such as a week's salary for each year of employment. In addition to that, ask for any commissions, awards and bonuses you've earned or been given. Also ask for payment for unused vacation and sick days. Get what you can from any stock options or restricted stock you hold. Continue your health insurance coverage under COBRA if you can. Apply for unemployment compensation if you qualify. For more details, see

Evidently, most of us will be getting rebate checks from the federal government some time in 2008. This makes for passable political theater. But it has little to do with economic security. If you want to survive a recession, rely on yourself.

Hope springs eternal: 92-year old legally blind golfer gets hole-in-one.

Tuesday, January 29, 2008

Interest Rate Cuts: Whose Lead is the Federal Reserve Following?

At this point, it is widely perceived that the Federal Reserve is cutting interest rates because the stock markets want rate cuts. The Fed's surprise 75 basis point cut last week came upon the heels of sharply falling stock markets in Asia and Europe. The U.S. and other stock markets have more or less stabilized since then, but only because there is an expectation of more rate cuts this week.

Since it seems pretty clear that market expectations are driving Fed rate cuts, it's worth asking what's driving the market. The Norman Rockwell version of the stock market consists of numerous freckle-faced investors, sitting at soda fountains sipping frappes and placing buy and sell orders. Their collective judgment arguably provides a measure of insight about the state of the economy. The prices these investors are willing to pay for stocks are based on their predictions of the future value of those stocks, which will be affected by their expectations of good or bad economic conditions. Dropping stock prices may reflect an expectation that the economy is in for a bad time. Is the Fed mistaken to consider the views of all these folks?

Now, let's look at the markets of the 21st Century. We have a derivative contract called a stock index future, which allows an investor to speculate in the future value of a stock index like the S&P 500 or the Nasdaq 100. Like any futures contract, stock index futures can be traded on margin (and quite a lot of it). The stock index futures markets and the stock market are inextricably tied together. Any firm that writes stock index futures contracts will likely be trading baskets of the underlying stocks to hedge its positions. Activity in the futures market can result in large bundles of buy and sell orders hitting the stock markets. Thus, the futures market can drive the stock markets. Witness the stock index futures liquidations done by Societe Generale a week and a half ago, after it discovered that a junior trader had made the wrong bets. These sales may have contributed to the down trend in the European stock markets that alarmed the Fed into making its 75 basis point cut.

The cart, therefore, can end up pulling the horse. Over the last two decades, trading in the financial markets has become increasingly a game for big institutional investors, and the futures markets have increasingly taken the lead from the stock markets. But the stock index futures market doesn't look anything like a Norman Rockwell painting. It's dominated by high tech trading firms that use computers to trade in ways that even many Wall Streeters find esoteric. These people are financial market pros. Mom and Pop, who would struggle to tell you what a 10-K is, don't mess around in the stock index futures market.

If the stock index futures market is driving the stock market, and the stock market is driving the Fed's interest rate cuts, then doesn't it begin to look like a small group of financial market pros is making the central bank do its bidding? The short term trading interests of these market insiders are not the same as the long term investment interests of the general public. When the Fed allows itself to react to short term market movements, which seems to have been the case recently, there's a chance it's serving the interests of a small group of well-capitalized traders who are tough and market-savvy enough to think that they can push around a central bank. (Type "Black Wednesday and British pound" into your favorite search engine for an example of how financial speculators can take on a central bank.)

The economic data as to the likelihood of recession is mixed and does not alone present a compelling case for dramatic interest rate cuts, especially after last week's 75 basis point theatrics. Perhaps the Fed could cobble together a case for further cuts this week. Whether or not it can, however, it is now saddled with the impression that its monetary policy is at the beck and call of the stock markets--and perhaps the short term trading interests of futures market speculators. This impression will prove costly to the central bank.

Animal News: here's an opportunity to adopt a donkey.

Sunday, January 27, 2008

Societe Generale's $7.2 Billion Loss: Were the Trades Based on Inside Information?

You probably already know that Societe Generale, the second largest bank in France, announced this past week that it lost $7.2 billion as a result of bad trades in European stock index futures. SocGen ascribed the losses to the "pure fraud" of a lone wolf trader who supposedly worked many extra hours to circumvent the bank's internal controls and undertake unauthorized trades in amounts of tens of billions. Oddly, he didn't personally gain anything from these trades, which initially were profitable, nor did SocGen attribute any motive to him.

Huh? $7.2 billion down the drain with no personal profit or motive? Was the trader involved, identified as Jerome Kerviel, an odd duck who went to great lengths to monkey around with SocGen's computer systems for the sheer thrill of it? He is a single male making an income of $145,000 a year in Paris, the city of lights that draws attractive women from all over France and elsewhere, and all he wanted to do was engage in computer subterfuges so he could trade in esoteric financial instruments for no personal gain?

Okay. And we're the king of England, with a bridge in Brooklyn we'd love to sell you for a very fair price.

Maybe there's another explanation for all this. Maybe someone--or maybe some more than one--at SocGen was trading on inside information.

We all know, especially after 2007, that the stock market is volatile. Anyone who trades stocks would like to have ways to reduce that volatility and increase their chances of profiting. Getting inside information is one of the best ways of boosting your trading returns. It's rather illegal in many circumstances. But that doesn't stop a lot of people. The desire for doubloons trumps fussiness over legalities.

What inside information could SocGen have had? After all, the trading was in futures contracts for European stock indices, such as the CAC 40 and the DAX. It's hard to imagine getting inside information about 40 French or 30 German companies.

But there is one possibility--the European banking authorities and their regulatory intentions. SocGen, like any major bank, would be in constant contact with regulators. The world's banking regulators have worked closely with each other and with the major banks to deal with the subprime mess and the ensuing credit mess. Such a cooperative approach is appropriate and desirable. But the banks would have learned a lot about the regulators' intentions. In the heat of the credit crunch this past year, the regulators may well have wanted to let the banks know that government suppport and assistance would be available 24/7 in generous amounts. While the regulators have also sent the same message to the world, the people working for the major banks would see the facial expressions and hear the vocal intonations of the regulators. They would have had a chance to ask questions and get clarifications, perhaps with winks and nods that neither financial press or any ordinary 401(k) investor in Cubicleville would know about. Maybe SocGen personnel believed they got a better understanding of regulatory intentions than the public markets.

If SocGen personnel came to believe they knew more than the rest of the market, they might have thought that otherwise risky bets in European stock market futures looked like smart plays. Government protection sets a floor on your potential losses. Bigger bets make more sense. Such a scenario could explain why someone at SocGen would choose to trade heavily in large-cap index futures at a time when market volatility was growing. Having inside information emboldens.

If something like this transpired, many questions remain. Did Jerome Kerviel, a junior trader, really perpetrate all this on his own? Who else knew what and when? And was it legal or illegal?

One could also ask whether SocGen's sales last week, undertaken to close out its positions, were unlawful insider trading. The bank, but not the rest of the world, knew about the losses. Ordinarily, under U.S. law, a company having material inside information about itself can't trade in its own stock. The CAC 40, which was apparently one of the stock indices involved in the trading, includes SocGen stock. SocGen constitutes over 4% of the weight of the index, and a significant move in SocGen stock's price might affect the entire index. And if SocGen had disclosed its losses before unwinding any CAC 40 futures positions it held, the index might have lost value for additional reasons (such as the risk of a weakened SocGen to the world's financial system). Maybe there's an insider trading issue here.

More information will probably emerge about SocGen's losses and how they occurred. One thing is clear, though. The losses in the recent financial crisis have mostly occurred in largely unregulated derivatives markets. The stock market, which is heavily regulated, has seen much smaller losses. While Wall Street interests have repeatedly resisted any effort to extend the regulatory umbrella to the derivatives markets, each multi-billion dollar scandal further undermines the argument for leaving the markets alone to work their magic.

Hospitality News: there's a chaplain in the bar. But who would go to a bar where you'd feel like you had to behave yourself?

Thursday, January 24, 2008

Retirement Planning 2008

As banks book losses and high ranking financial services executives pursue other interests, people still need to prepare for retirement. Here are a few things to think about.

Market Volatility. The downswings of the market are what the long term part of long term investing is all about. Unlike an elementary school soccer game, where everyone gets an award, the stock markets are not meant to build self-esteem. You will lose as well as win. Maximize your chances to win by focusing on the long term. Avoid panic selling, and consider judicious purchases during market swoons.

Diversify. The future direction of the stock, bond and other financial markets gets murkier by the day. The smart play is to diversify your investments. That way, you place a number of different bets to multiply your chances of success while reducing the risk of a big loss. Concentrating one’s bets was the strategy a lot of investment and commercial banks pursued with mortgages and leveraged buyout financings. When you swing for a home run, you have a good chance of striking out. There were many strike outs this past year. Most likely, 2008 will be a year in which many investors hit singles, at best. Diversify your investments.

Step up your savings. With the short term direction of the stock markets uncertain, one way to boost your retirement portfolio is to increase the amounts that you save. Maybe that, in your mind, calls for sacrifice. Well, retirement with only limited resources also calls for sacrifice, maybe a lot of it. When you’re old, perhaps ill, and unable or unwilling to work, sacrifice will be painful. Save more now and buy some peace of mind. You’ll have only a finite amount of income during your working years, and if you don’t save some of it, you won’t have much of a retirement.

401(k) Changes. Employers are now starting to automatically enroll new employees in 401(k) plans unless the employees opt out. It used to be that employees had to opt in, and large numbers of them didn’t. So they missed important opportunities to build wealth for retirement. 401(k) investment choices are now often being simplified, which should make things easier for participants. If you haven’t enrolled in your employer’s 401(k) plan, enroll. If you’re automatically enrolled, don’t opt out. Most employers are withholding only 3% of automatic enrollees earnings, and perhaps making a matching contribution in the same amount. That’s not enough for a solid retirement. You should try to save at least 15% to 20% of your earnings, either inside or outside a retirement account. See

Many 401(k) plans offer lifecycle or target date retirement funds as investment options. These funds allocate your savings to age-appropriate mixes of assets. Your money is invested aggressively if you’re young and have decades to go before retirement. As you grow older, the mix of investments is gradually made more conservative to solidify your gains. This is what you should be doing anyway if you manage your money yourself. The lifecycle or target date fund does the work for you, so your life is simplified.

IRA Contribution Limits. In 2008, you’ll be able to contribute up to a combined total of $5,000 to your traditional and Roth IRAs, or $6,000 if you are 50 or older (including those who turn 50 during 2008). You can still make contributions for 2007 up through April 15, 2008 (but the limits are $4,000, or $5,000 if you were 50 or older in 2007). If you participate in any employer-sponsored retirement plan, such as a 401(k), 403(b), SIMPLE IRA or SEP-IRA, contact your plan administrator for information about the plan’s contribution limits and any matching contributions.

Proprietary reverse mortgages. These mortgages are large reverse mortgages, ones that exceed the $363,000 loan limit for FHA-backed reverse mortgages. Most reverse mortgages issued today are guaranteed by the FHA, which is a great comfort to the lender. But the FHA won’t back reverse mortgages above $363,000. So banks are starting to offer proprietary reverse mortgages in higher amounts (perhaps as much as $10 million, if you have a mansion that would support such a loan). Like any reverse mortgage, these jumbo loans let you pay off existing loans, take out additional equity as a lump sum of cash, and/or establish a line of credit. The loan and interest are repaid when you die, move out permanently or sell the house (or mansion). You don’t need to make monthly payments. In this way, a reverse mortgage can simplify your life.

The downside is that perhaps all of the value of your house will go to repaying the reverse mortgage. Your heirs may get nothing from the house. You also need to safeguard the cash or credit line that the proprietary reverse mortgage gives you, because you probably won’t be able to borrow against the house again. The reverse mortgage will have a first lien on your house and will probably preclude another home equity loan. These are serious considerations, and you should think carefully before taking out a reverse mortgage.

Animal News: is the Mayor a dognapper?

Tuesday, January 22, 2008

The Losses From the Surprise Federal Reserve Rate Cuts

Today, January 22, 2008, the Fed announced a surprise 0.75% cut in the fed funds rate and the discount rate. This announcement was made in between regularly scheduled Open Market Committee meetings, and was the result of a special teleconference meeting. The Fed's statement explaining the surprise cut ( says that the Fed took this action because of a "weakening of the economic outlook and increasing downside risks to growth." However, there is little doubt that the real reason for the rate cut was the sharp drops in Asian and European stock markets the last couple of days (almost 10% in Japan and around 4-6% in Europe).

The U.S. markets gyrated widely today, dropping over 4% and then recovering to close with the Dow down 1% and the Nasdaq down 2%. Did the Fed rate cut help? It probably gave some comfort to stock investors. But the reality of today's financial markets, with derivatives contracts that allow you to bet on any price movement of just about anything that is traded, is that nothing happens without creating losers as well as winners.

Among today's losers would be anyone on the short side of the Treasury securities market or the AAA rated corporate bond market. An interest rate cut would reduce the value of any short position in these securities. Since the Fed's action was a surprise, the risk of such a cut would not have been priced into the original trade in which the short position was taken.

Similarly, anyone holding the fixed rate side of an interest rate swap would have lost money. Interest rate swaps, in essence, involve an exchange of the risk of a fixed rate loan (which would lose value if rates go down) for the risk of a variable rate loan (which would lose value if rates go up). A surprise action by the Fed would probably not have been factored into a decision to participate in an interest rate swap. So the holder of the fixed rate would have taken a loss.

Other losers would have included those silly people who save money in bank accounts and money market funds, in the belief that prudence and restraint will somehow be rewarded. Will these savers help stimulate the economy with greater spending when their interest and dividend income is dropping? That's doubtful. It's another example of how, in today's wonderland financial markets, no good deed will go unpunished.

It is hardly a secret that many market players factor their expectations of the Fed's actions into their trading decisions. Chairman Bernanke has, if anything, fueled this tendency by promising greater transparency of the Fed's intentions. Today's surprise cut, though, may have damaged the Fed's program for greater transparency. The derivatives markets could become more illiquid when there is an increased risk of Fed surprises. With asset-backed derivatives, other structured finance instruments, and credit default swaps already under severe pressure, it wouldn't help to make the market in interest rate risk more illiquid.

The losers could include banks, hedge funds, insurance companies and other institutional investors. Because the derivatives market is largely unregulated and quite opaque, the impact of the losses from today's cuts may not be known until first quarter 2008 financial results are reported in March for many investment banks, and in April for many commercial banks. Hedge fund losses probably wouldn't ever become public, although their impact could be felt in reduced liquidity. The financial markets will see the benefits of the rate cuts immediately; but the losses will be revealed only months later. If those losses are significant, the Fed may have set the stage for more instability.

The dual-sided, anything can be traded derivatives markets make it harder for the Fed and other central banks to take monetary action that would produce a net benefit. The more ambiguous monetary policy becomes, the more illusory it will be. Time will tell soon enough what we are dealing with.

Animal News: are cows a global warming threat?

Thursday, January 17, 2008

Does the Federal Reserve See Stagflation in Our Future?

Just about everyone on Wall Street expects the Fed to lower interest rates by a half point at its January 29-30,2008 meeting. Many on the Street are clamoring for a larger cut. What’s interesting is that today, Chairman Ben Bernanke announced, in testimony before Congress, his support for fiscal measures to stimulate the economy. Basically, that means taking a bunch of money from the U.S. Treasury (in the range of $75 to $100 billion, perhaps) and throwing it at taxpayers.

We like a check from the Treasury as much as anyone, especially if it comes with no strings attached and encouragement to spend. But it’s peculiar that the Fed Chairman, who is the czar of monetary policy, would propose a fiscal measure. Fiscal measures can only be taken by Congress and the President.

Ben Bernanke has the misfortune not to be what Alan Greenspan was: lucky. Greenspan benefited from the defeat of Communism, which greatly reduced the federal government’s defense spending and freed up a lot of resources for private investment. Worker productivity rose sharply during the 1990s, which allowed the Fed to get away with interest rate cuts without triggering high levels of inflation. Further, the derivatives market worked reasonably well during most of Greenspan’s tenure, transferring risk to parties willing to bear it without fostering undue levels of risk.

Bernanke has not done as well with his rolls of the dice. Defense spending has risen again with the wars in Iraq and Afghanistan. Income taxes were cut, so the federal deficit has ballooned. Productivity growth is no longer bounding upwards by leaps and bounds. The derivatives market, especially the mortgage-related portion, has created vast amounts of undue risk and losses. These risks and losses are buried in opaque, unregulated over-the-counter markets that are little understood; and they pop up unexpectedly to ambush banks and regulators.

Worst of all for Chairman Bernanke, inflation is on the rise. The CPI was 4.1% in 2007, and the core CPI (which excludes food and energy) was 2.4%. Both figures are too high for Fed comfort. What makes things worse is that real wages fell about 1% after inflation in 2007. By contrast, in 2006, real wages rose about 2% after inflation. Last year’s loss of worker buying power means lower consumer spending (which depressed the most recent Christmas shopping season). Expectations for continued higher levels of inflation mean that real wages may fall further. (With the economy slowing, employees aren’t in a position to demand higher wages, so their spending power will probably keep falling.)

If the Fed lowers interest rates, it may increase inflation. That, in turn, could further erode real wages. The economic downturn may grow worse as consumer demand falls, putting pressure on the Fed to further lower interest rates. However, more rate cuts would only exacerbate inflation, reduce real wages some more, and again depress economic growth.

Inflation by itself undermines economic confidence. But when inflation erodes real wages, causing economic weakness, we have stagflation, the economic malaise last seen in the 1970s. This is a particularly toxic predicament, because fixing stagflation requires sharp interest rate increases that foster a genuinely nasty recession (far worse than the current slowdown). That was the case in the early 1980s, when then Fed Chairman Paul Volcker wrung 13% annual inflation out of the U.S. economy at the cost of a recession that produced 10% unemployment. Volcker did the right thing. And in the finest Washington tradition of never allowing a good deed to go unpunished, his reputation has suffered ever since.

Bernanke now faces an incipient stagflation. He may be encouraging fiscal measures because he can’t lower interest rates as sharply as Wall Street would like, without setting off incendiary inflation. It seems possible that the market is starting figure that out, seeing as how the Dow dropped 306 points today.

When financial losses are as large as those of the subprime mortgage mess, there’s no easy, painless way out of it. If you’re hit by a car and suffer serious injuries, pain and a long recovery are inevitable. No amount of painkillers will change that; and too much painkiller will probably make things worse.

Retirement News: gaining weight doesn’t increase a pension.

Tuesday, January 15, 2008

Have the Central Banks Fueled Asset Speculation Again?

Remember the emergency year-end credit provided by central banks in Europe and the U.S. last December? The $500 billion in Europe and the $40 billion in America? The borrowing banks did something with that money. They couldn’t make a profit (or just break even) by putting the money in their vaults. They’d have to re-lend it somewhere.

Banks haven’t been exactly rushing to make mortgage loans; we all know that. And consumer spending has been slowing. So it doesn’t look that the banks are throwing loans at consumers. Where did the money go?

Since the new year began, petroleum has reached as high as $100 a barrel and gold has jumped over $900 an ounce. Why these sudden price rises? It’s not like everyone made a New Year’s resolution to drive more or flash more bling. Did the flood of credit at the end of last year fueled more asset speculation?

Something like that happened in 1999-2000. Fear that Y2K computer malfunctions would result in a credit freeze led the major central banks, including the Fed, to pump a boatload of money into the banking system in the fall of 1999. The sky didn’t fall on Jan. 1, 2000. But the stock market jumped. In particular, the dotcom heavy Nasdaq market rose more than 50% between the fall of 1999 and April 2000. Then, stocks cratered.

As the Fed and other central banks now talk about lowering interest rates, we should be mindful of the potential for unintended consequences. With the dotcom and real estate bubbles and busts fresh in our memories, we should realize that, if credit conditions are now eased further, more asset bubbles may result. Are we prepared for that consequence? After all, asset bubbles are what got us into the current mess.

Let's also consider what asset classes might become bubbly. Real estate is spiraling downwards and will for a while. U.S. stocks aren't a good candidate, with losses from the mortgage mess overhanging the stock market and the declining dollar driving capital overseas. Commodities and foreign stocks are more likely to bubble up. That wouldn't help America. The dotcom and real estate bubbles, although ultimately damaging, at least temporarily increased 401(k) balances and home equity. This, in turn, boosted consumer spending, the engine of the U.S. economy. But few Americans benefit from increases in the price of oil or gold. And only wealthy Americans with plenty of capital to send overseas would profit from a bubble in foreign stocks.

So the next bubble would probably hurt, but not help. What game plan do the Fed and other central banks have if things get bubbly again?

Crime News: why you shouldn't walk along a highway with a snake around your body.

Sunday, January 13, 2008

Should We Fear Our Fear of Recession?

Predictions of a recession for the U.S. grow. Some say we're already in a recession. Calls for action are growing louder. The financial markets clamor for interest rate cuts, and Fed governors wink and nod accommodatingly. Proposals for fiscal stimuli are made--and then taken seriously. The Treasury Secretary calls for more interest rate relief on adjustable rate mortgages--this time on mortgages for prime borrowers who have the means to pay. It's hard to predict exactly what will happen in 2008. But it's easy to predict that a messy situation will be made messier.

Let's take interest rate cuts. Will they help? The history of the last 15 years of monetary policy teaches that interest rate cuts tend to fuel asset bubbles. Interest rate easing in the late 1990s inspired the stock market boom of that era, which eventuated in the stock market bust of 2001-02. To combat the fallout from the stock market bust (and the 9/11/01 bombings), the Fed dramatically lowered interest rates again, only to fuel the real estate boom and bust of the 2000s.

Interest rate cuts now may provide momentary relief for bank balance sheets. But will they really boost lending and spending, and save the U.S. from a recession? Mortgages are much harder to come by, because credit standards are actually being applied to borrowers. Lowering mortgage rates by a quarter or half point won't make someone who has no documented income or assets any more creditworthy than before. And if your credit card's interest rate was lowered by a percentage point, how much more will you buy now that rate is 18% instead of 19%?

Let's look at how extra credit generated by interest rate cuts might to be used to speculate in assets. U.S. assets, like stocks and real estate, aren't likely candidates for the next round of speculation. Been there, done that. What's more probable? Think about commodities like oil and gold. Or foreign stocks, which have been on a tear the last few years. Speculation in commodities and foreign stocks, however, wouldn't do that much for Americans. Will much of the benefit of the Fed's interest rate cuts flow overseas?

Fiscal stimuli are another hot topic. One proposal is to give all taxpayers an additional $500 (or $1,000 for those who are married, filing jointly), along with their refunds. The flow of this additional cash is meant to goose the economy. But it may not come soon enough, or be large enough, to have a major impact. And it could divert funds away from real needs that the government should address--say, health care for children or vets.

Treasury Secretary Paulson proposed last week that prime adjustable rate mortgages be frozen at their initial rates, like his proposal for certain subprime mortgages. Let's remember that prime mortgages are for people who can afford to pay them, including the increased monthly payments. Why should people who have the ability to pay get a break? Many of these borrowers have upper middle class or higher incomes. Should the government invade the sanctity of contracts to make the well-off even more well-off?

Recessions are part of life in market based economies. They serve as a mechanism to counter bad economic decisions. If people are held to the consequences of their bad decisions, they'll learn not to make them. Political considerations, of course, impel governments to try to insulate people from the consequences of their bad economic decisions. Capitalism is harsh, and there's a case to be made for government softening its harshness. But there's a point where the great and all powerful government turns out to be a little man behind a curtain; and we'd be better off not believing in him.

Animal News: another German celebrity polar bear cub.

Thursday, January 10, 2008

Countrywide Financial and Central Banking's End Game

Financial news websites today report that Bank of America is in negotiations to acquire Countrywide Financial, the nation's largest mortgage bank. Countrywide has been plagued in recent days by rumors of its impending bankruptcy, which it has denied. Nevertheless, the reports of an acquisition by Bank of America only fuel suspicions that Countrywide is circling the drain.

How might Countrywide, the largest mortgage bank in the country, be reaching the end of the line? The answer may well be that Countrywide is running out of creditors. Since the subprime mortgage crisis this past summer, Countrywide has encountered difficulties borrowing in corporate debt markets, and has turned to its thrift subsidiary and to the Federal Home Bank System for funding. The thrift has about $60 billion in deposits. It also is the conduit for loans from the Federal Home Loan Bank System, a federally sponsored central banking system for thrift institutions. However, Countrywide does not have a giant retail thrift operation, and cannot easily gather massive amounts of deposits. It has reportedly borrowed about $51 billion from the Federal Home Loan Bank System, but apparently is running of collateral for further loans.

The FHLBS has about $45 billion in capital, so its loans to Countrywide exceed its capital. These loans are secured by mortgages and mortgage-backed collateral. Collateral is only worth what someone will pay for it. If Countrywide went into bankruptcy, the FHLBS would have to sell that collateral. Given today's mortgage markets, do we think there's a chance they might not collect 100 cents on the dollar? Does a bear sit in the woods?

The size of the FHLBS's exposure to Countrywide has created controversy in Congress. It's likely the FHLBS isn't throwing many loans at Countrywide any more. With Countrywide's portfolio of mortgages and home equity loans apparently still deteriorating, who else will step forward and take the place of the FHLBS? And if Countrywide went into bankruptcy, wouldn't the solvency of the FHLBS come into question? If the thrifts lost their central bank, how could they cope with the credit crunch? The hot tamale, dear taxpayer, would circle back to you, just as it did in the thrift crisis of the 1980s.

If Bank of America acquires Countrywide, it will, in effect, bail out the Federal Home Loan Bank System with respect to its exposure to Countrywide. That's nice. But what on earth did the FHLBS think it was doing lending $51 billion to Countrywide? Yes, there's a tenet of central banking that in times of crisis, the central bank should provide liquidity. But there are limits to how much a central bank can lend, since borrowers may run out of permissible collateral and even a central bank's capital is limited. (The alternative, lending an unlimited amount of money, is tantamount to producing an inflationary whirlwind.) Since there are limits to how much the central bank can lend, the central bank needs an end game if its member banks sustain really large losses.

What was the FHLBS's end game for Countrywide? What was the plan for dealing with Countrywide if it couldn't stay in operation? As far as we can discern, there was no end game. And that's the scariest thing of all; because the same analysis applies to what the Federal Reserve is doing with the larger commercial banking system. It has been providing liquidity. A lot of it. But what if the banks' losses turn out to be really, really big? There are rumors that late January could see announcements of very large bank losses. Then what will the Fed do?

Today's Wall Street Journal (1/10/08, P. A1) reports that Citigroup and Merrill Lynch are seeking capital infusions in the billions from foreign sources. It makes sense to look overseas, because there isn't enough available capital in the U.S. to prop up our troubled banking system. Narrow-minded economic nationalists notwithstanding, these foreign infusions of capital are good for us. They give influential foreign financiers investments in the heart of the U.S. financial system and the U.S. economy. The new investors will have an incentive to protect the U.S. dollar, instead of dumping it. Most likely, the Fed is quietly supportive of these foreign capital infusions. After all, what other alternatives does it have?

The risk management deficiencies of the Federal Reserve, Federal Home Loan Bank System and other bank regulators have become glaringly obvious. We now have Bank of America very possibly bailing out the FHLBS. What's next? The central banks of China and Japan, maybe with the help of the Saudis and the Persian Gulf states, bailing out the Fed? If they can't or won't, what's Plan B? And, furthermore, what will the federal banking regulators do to prevent a crisis like this from happening again?

Animal News: pigs that glow.

Wednesday, January 9, 2008

A Wish for Financial Literacy

There are many causes and reasons for the subprime mortgage mess and the ensuing real estate downturn. Many people in high ranking and powerful positions bear a great deal of responsibility and not a small amount of blame. But we should recognize that the best protection we have against financial problems is our own financial literacy. How many adjustable rate mortgage borrowers today wish they had better understood their mortgages before they signed on the dotted line? How many home equity borrowers wish they had realized how a downturn in the real estate market could lock them into their current homes when the home's value plunged below the amounts of their mortgages and home equity lines of credit? As the new year begins, let's try to improve financial literacy.

Understand loans before taking them out. Many people obsess over the nuances of investment strategies and the consequences of investing 22.56% of one's portfolio in foreign stocks, as opposed to 23.14%. But they casually sign adjustable rate mortgage loans with little or no understanding of how the monthly payments can balloon. Remember: a killer loan wrecks your finances far worse than a poor choice of investments. Study the terms of loans carefully before signing anything. If you don't understand, ask questions. If you're not sure you understand, don't take out the loan. Consider seeking help from a financial planner (preferably one that's fee only) or other financially literate person.

Recognize the need to save, because risk never dies. With Social Security, Medicare and the coverage of most people by health insurance, many of the historic reasons for saving have been reduced. Additional government programs, like disaster relief and flood insurance, further lessen the apparent need to save. And the government subsidies for the housing market (in the form of interest expense deductions, the implicit guarantee of Fannie Mae and Freddie Mac, the Federal Home Loan Bank System, the FHA, etc.) have boosted housing values, creating home equity that served as piggy banks in lieu of savings accounts and certificates of deposit. But the recent mortgage crisis and housing downturn teach that risk never dies, and that asset speculation is an inadequate substitute for saving. Having a pool of cash saved for emergencies and unexpected expenses covers a multitude of financial sins. The first and foremost element of financial literacy is to understand the need to save.

Teach your children how to handle money. The need for financial literacy begins as soon as kids grasp the essential concept of money. If they learn the habit of saving at an early age, they will be in your debt for the rest of their lives. For suggestions, see

Urge your local schools to teach personal finance. Since many parents don't know how to handle their finances, they can't teach their children very well. Personal finance could easily be taught in high school, or even middle school. Just covering the basics would go a long way to promoting badly needed financial literacy. If more people had said "no" to the really nasty and burdensome adjustable rate mortgages that are today wrecking the mortgage markets and driving real estate values down, we'd all be better off.

That's our wish for financial literacy. The rest is up to you. It's entirely fair and right to blame Wall Street and the government for the mistakes they've made. But protecting yourself starts at home.

Strange News: reefer madness leads to animal thefts.

Monday, January 7, 2008

Warren Buffett's New Bond Insurer: a Commentary on Financial Reporting

The recent announcement that Berkshire Hathaway, the public company headed by Warren Buffett, is establishing a bond insurer is, unintentionally, one of the sternest criticisms yet of the financial reporting and disclosures by the firms involved in the mortgage crisis and associated problems.

Buffett is best known for his skill at identifying promising established businesses. He invests in them, leaves management in place to do its job, and counts up the money as it rolls in. What he hasn’t done much of is rent space in a sagging strip mall, put fliers on parked cars, advertise on the local UHF stations, sponsor the greased pig contest at the county fair, and do all the other things that business startups have to do.

But now, he has a newly minted license from New York State to insure bonds. The business strategy is obvious. The major bond insurers, like Ambac, MBIA and others, have incurred painful losses from their poorly timed entry into the business of guaranteeing mortgage-backed obligations. These insurers, whose credit ratings are imperiled, would not exactly be the first choice today of municipalities seeking to beef up the creditworthiness of their bonds. A fresh face in the industry, with a pristine balance sheet and a glamorous name (for the financial world) like Warren Buffett attached to it, will probably attract customers from far and wide.

That Buffett would start his own bond insurance operation reflects poorly on the financial reporting and disclosures of the firms involved in the subprime mess. Their losses seemingly came out of nowhere. How many investors can say they were aware of the potential for such losses? What disclosure was made? And if it was made, was it buried in footnotes or boilerplate listings of possible risks? Were financial statements misleading because they did not include affiliated structured finance vehicles like SIVs and conduits? The established bond insurers apparently didn't see this train wreck coming. And they're in the business of identifying and evaluating risks like these.

The established bond insurers are obvious candidates for takeovers, given that their weakened financial condition leaves them with few options. The unusual emergence of Warren Buffett as entrepreneur suggests that he couldn’t follow his usual strategy of buying an established business because he couldn’t figure out how much risk it entailed and what it would be worth. His decision to start a new business takes exquisite advantage of the question marks over the financial statements of the established bond insurers and the opacity of the financial reporting and disclosures by firms involved in mortgage-backed investments. Whether or not they complied with the rules, the uncertainty surrounding their financial condition is enough to provide an opening for a new kid on the block.

Animal News: don't saddle up and ride a buffalo. Did you know that already?