Thursday, May 29, 2008

Unconventional Gas Saving Tips

You already know that, to improve your gas mileage, you should drive gently, keep your tires inflated and drive at highway speeds closer to 60 than 80. Here are a few tips that you may not have heard before. They may not work for everyone. But based on my experience, they could help you reduce your gas expenses.

Hold onto your car longer. A Ford Explorer I once owned got its best mileage after 70,000 miles. The mileage at 70K was about 10-12% better than when the Explorer was new, and about 5% better than when it had 30,000 to 40,000 miles. In fact, I got 21 mpg on the highway after the 70K mark, which was higher than the EPA estimate of 20 mpg highway mileage. Why? I think it was because the engine, transmission, ball bearings and other parts were well broken-in after 70,000 miles. A broken-in car runs with less friction, and therefore should provide better mileage. If you’re the type to trade in a new car after two or three years, think again. You may be missing out on some of the best years of the car’s life.

Try mid-grade. Once I found a gas station with a marketing gimmick of selling regular and mid-grade gas for the same low price (the level at which neighboring stations sold regular). I couldn’t pass up a bargain and filled up with mid-grade, even though my car is designed to run on regular. My mileage was about 10% better with mid-grade. I don’t know exactly why this happened. But I’d guess that because mid-grade has higher octane, it delivers a little more energy per gallon and therefore moves the car a little more efficiently. If you can find mid-grade for a price only a few cents higher than regular, you might try filling with mid-grade just to see how things go. (For those budget-minded drivers who are wondering where they can find the station that sells mid-grade for the same price as regular, I don’t have its name or exact address, but it’s in Burnsville, MN on or near Nicollet Ave.)

Avoid ethanol. Although this notion is heretical in farm states, try using gas that doesn’t contain ethanol. Ethanol reduces mileage slightly. The times I’ve used regular without ethanol, I seem to get about a 5% improvement in mileage. If you can find plain old regular for more or less the same price as regular with ethanol, give it a try and see what happens.

Clean up your car. If you clean up your car, you’ll almost surely lighten it. Weight is a critical factor in mileage. There could easily be 50 or 100 pounds of excess weight in your car (you know, the golf clubs you haven't used in months, the old home furnishings you still haven't donated to charity, etc.). Lighten your car and see an uptick in mileage.

Don’t idle the engine. Modern cars have fuel injection systems that use very little fuel to start the engine after it’s warmed up (which would be after the first half-mile or mile following a cold start). That’s why hybrid engines save on gas. In a hybrid, the gas engine shuts down when the car is traveling at low speed or is stopped, and then starts up when more power is needed. Sometimes, European drivers turn off their engines at long stop lights. America’s go-go culture might make that inadvisable here. But, otherwise, if you’re likely to wait more than about 30 seconds, turn off the engine.

Tuesday, May 27, 2008

Assessing the Social Costs of Credit

As we now all know, a glut of lending over the last few years has resulted in a serious economic hangover. Perhaps a trillion dollars or more of losses overhang the U.S. financial system. We are, for all practical purposes, in a recession. Inflation is ticking upwards, the dollar is dropping and the rising cost of energy is making all of the foregoing even worse. A variety of government actions have been or will be taken. The cost to taxpayers is already many billions, and with many additional billions surely to be paid.

We should recognize that the recent credit orgy imposed significant social costs. Social cost is an economist's notion for costs of economic activity that aren't incorporated into market prices. For example, the infamous smog of the 1950s and 1960s in Los Angeles and other cities caused serious health problems that were not reflected in the cost of gasoline. In order to account for these costs and make market prices more realistic, pollution control requirements were imposed. Much of the computerization of today's automobiles is directed at minimizing pollution, not enhancing gas mileage. The cost of these computers is borne by car buyers, as it should be since their driving creates the pollution. But we have much cleaner air today, a direct result of government action to incorporate the social costs of automobiles into market prices.

The reckless over-extension of credit during the last few years has produced numerous foreclosures, declining neighborhoods, ruined credit histories, bankruptcies, Wall Street bailouts, massive layoffs, recession and decline in the dollar. These are social costs that were not reflected in the market price of credit. Indeed, the Federal Reserve's easy money policies of the 2000s took exactly the wrong approach.

Increased federal regulation of banks, and also securities firms, is under way. Congress and the new President will be considering ways to improve the regulation of the financial markets. One measure that has not been proposed, but which deserves consideration, is to impose financial assessments on banks and securities firms based on the riskiness of the loans they make or underwrite. In other words, the more risky the lending activity undertaken, the larger an assessment the bank or securities firm should pay.

These assessments should be paid to the U.S. Treasury. They should not go into the FDIC insurance fund because the U.S. taxpayer, not the FDIC, is the primary insurer of financial firms today. These assessments would, in effect, compensate the taxpayer for assuming the risks that the Federal Reserve unilaterally decided, in the Bear Stearns bailout, that taxpayers would bear; and for bearing the other costs the have been or will be imposed on taxpayers as a result of the current financial crisis.

Determining the amounts of such assessments could be based on insurance principles. Not all of the costs of the credit crisis are known yet (at least not publicly). But once a fair picture of the total costs emerges, amounts can be determined.

Such assessments would surely raise the cost of credit. That, of course, is the idea. Over-extension of credit has proven to have numerous costs not reflected in the current or past market prices of credit. This market dysfunction should be corrected, or we can be confident that future crises will arise.

Such a program of assessments wouldn't interfere with the functioning of a free market. The market for credit is government controlled to begin with. The Federal Reserve, as the central bank, sets the baseline price of credit with its discount rate and its fed funds target rate. Virtually all other interest rates, one way or another, key off the Fed's prescribed rates. A program of risk-based assessments would enhance the efficiency of the pricing of credit, such that all (or at least more) of the costs of extending credit would be reflected in the price.

It's Econ 101 that underpricing results in overconsumption. That's our credit crisis in a nutshell. If the credit markets are to function more efficiently in the future, they should reflect the true cost of credit.

Sunday, May 25, 2008

Watch the Winners: a Lesson from Societe Generale

Societe Generale, Societe Generale,

Dormez vous, dormez vous?

Sonnez les alarmes, sonnez les alarmes.

Din, dan, don. Din, dan, don.

A report from an internal investigation conducted by Societe Generale into its $7.7 billion loss from the activities of its trader, Jerome Kerviel, recently revealed that an assistant trader may have helped Kerviel. The level of this assistant's involvement remains unclear. And even though the bank maintains that no one knew what Kerviel was up to, executives in his chain of command have been leaving the bank, or are in the process of departing. Societe Generale's initial explanation that the entire loss was the result of Kerviel acting alone and without anyone's knowledge may or may not be accurate. But it is unquestionably pathetic.

SocGen's trading scandal illustrates a basic oversight failure: not watching its winners. Sound management goes beyond keeping an eye on the weak performers and other obvious potential sources of problems. You have to evaluate your success stories. How are they generating such great returns? How did they go from being average or below average performers to such stars? Was it brilliance that no one spotted, or unacceptable risk taking that no one detected?

Kerviel was engaged in proprietary trading for SocGen. Big profits from proprietary trading involve big risks. It's not a volume business. The Jerome Kerviels of the world don't make a billion dollars by selling 100 million Big Macs. They make a billion dollars by going way out on a limb. Apparently, Kerviel made some sizeable profits for SocGen in 2007. Surely management noticed his profits, and one suspects that the entire chain of command was eager to share in the credit (as well as the bonuses). But how could they explain outsized performance by a low level trader such as Kerviel, who supposedly was limited to hedged positions that should generate modest, if reliable, profits? There's no such thing as a gift horse when proprietary trading profits are concerned. Big profits mean that someone somewhere took some big risks. It's management's job to figure out where that happened and whether or not it was authorized and acceptable.

It may seem to cut against a business corporation's cultural grain to question success. Making money is what corporations are supposed to do. But corporations use other people's money, namely the shareholders' money. It's management's responsibility to ensure prudent and authorized use of that money. This responsibility is only magnified when a major international bank like SocGen is concerned. A failure of a bank such as this could have repercussions worldwide. Like or not, we all have a stake in SocGen and other financial institutions of its stature. Regulators should ensure that money center banks and other major financial institutions watch their winners.

Thursday, May 22, 2008

Oil Price Surprises

We’ve all been surprised by the jump in oil prices. Things were bad enough when oil went to $65 a barrel and gas rose over $2.50 a gallon. Now, with oil doubled to $130 a barrel, and gas inevitably headed over $4.00 a gallon, our lives are changing. No more double cheeseburgers; one patty will have to do. Carpooling, last popular when Leave It to Beaver was running in prime time, is making a comeback. Thrift shops are chic. Young urban men are rethinking their metrosexuality as manicures begin to look awfully expensive.

But some people have been really surprised by the oil price rise. If you think you have problems, what about:

Federal Reserve. The Fed’s interest rate cuts have weakened the dollar, which is an important reason why oil prices keep rising. The Fed was trying to bolster the economy. But it may have instead hampered it, putting inflationary pressure on consumers already burdened by stagnant wages and layoffs. This illustrates that not only is stagflation possible, it may actually be spurred by government policy. The Fed’s governors probably haven’t slept that well during the last nine months, but this problem has got to be a real sleep killer.

Bush Administration. W is in the legacy building part of his Presidency, and things don’t look good. Among other things, his erstwhile Arab allies have twice rebuffed him on requests to increase oil production. How many lives has America lost and how many hundreds of billions of dollars have we spent protecting certain OPEC members? W can’t even wheedle a little boost in oil production out of these guys and they were supposed to be his friends. Friends like these will make his legacy worse than he ever imagined.

Banks and Brokerage Firms. Even though an analyst here or there may have predicted maniacal highs for oil prices, most people on Wall Street probably didn’t expect the current stratospheric prices. Remember, though, that petroleum traders buy futures contracts on margin. Banks and brokerage firms extend that margin credit. This means that the lenders could be as exposed, or more so, than the speculators. Let’s not kid ourselves about the speculation. Notwithstanding solemn pronouncements by government officials and cable TV pundits about oil prices being attributable to increased fundamental demand, the 30% price rise in oil this year to date involves a lot of speculative fever. Fundamental demand hasn’t risen that much in the first few months of this year. We have a bubble in the oil markets, and like all financial bubbles it will burst sooner or later, with nasty losses. The recent oil price rise has probably surprised margin loan and risk management people at many major financial firms. The question for the Street and its regulators is whether this time, with yet another bubble ballooning upward, they are prepared for the pop. Or, as with the housing and credit bubbles, will their heads remain in the sand until it’s too late?

Tuesday, May 20, 2008

Is Microsoft Pursuing the Wrong Breakup?

Today's Wall Street Journal (5/20/08, p. B1) reports that Microsoft offered to buy Yahoo's online search ad business. The proposal also included a sale of Microsoft's Asian assets, and the acquisition of a minority interest by Microsoft in the residual Yahoo. The Journal also cites sources close to Yahoo as indicating Yahoo's board isn't likely to embrace this proposal.

That Yahoo's board wouldn't like this idea is no surprise. Microsoft, in essence, proposes that Yahoo sell Microsoft its crown jewel, then offload its Asian assets (does that make sense when Asia is the fastest growing part of the world's economy?) and then let Microsoft take a minority stake in the crumbs left on Yahoo's plate. Yahoo would presumably get enough cash to unburden itself of pesky shareholders like Carl Icahn and now Boone Pickens. But it would lose much of the heart of the company and have Microsoft, as a powerful minority shareholder, thereafter looking over its shoulder and potentially constraining it from ever again being a threat to Microsoft. In essence, Microsoft is proposing that Yahoo pretty much liquidate itself. Unless Yahoo can get a very good price for its search ad business and its Asian assets, this deal would not make much sense for Yahoo. And it's in Microsoft's interests to give Yahoo the lowest price possible.

Short term risk arb-type shareholders such as Icahn and Pickens shouldn't open the champagne bottles yet. If Yahoo's management feels too much under the gun, it may agree to terms that are unfavorable to Yahoo (and therefore to its shareholders). And if Yahoo's management did a deal with Microsoft, they could essentially eliminate Microsoft as a potential acquirer of Yahoo. That would reduce the profit potential of Yahoo for the Icahns and Pickenses of the world.

Microsoft's proposal would largely achieve the same result as an acquisition of Yahoo would have accomplished (i.e., get Yahoo's crown jewels and allow Microsoft to face only Google in the contest for online search business), at a lower dollar cost. But is it a good idea for Microsoft? One could say that Microsoft is fighting, not the past war, but the war preceding that one. Using search engines to draw Internet traffic was a hot idea at the end of the 1990's and at the beginning of the 2000's. Google has largely won that war. Since then, social networking sites like MySpace and Facebook took off as the hot new way to draw Internet traffic. That's another train that Microsoft missed (although Google and Yahoo also didn't cover themselves with glory when it came to social networking). By trying to buy Yahoo, or at least its search ad business, Microsoft is taking a large step backwards and trying to buy a rather old hot new thing.

Yahoo's search ad business is a mature business, not a sizzling start up. In the high tech world, buying mature businesses hasn't been a particularly rewarding strategy (recall Time-Warner/AOL, and Hewlett-Packard/Compaq). The big rewards come from getting in at the ground level. But Internet start ups present almost a conflict of interest with big, established businesses. The name of the game for an Internet business is to draw traffic. Over time, there have been a variety of ways to do this--AOL's subscription model, Yahoo's portal model, Google's search capabilities, and now the social networking phenomenon. Each of these innovations succeeds in part by drawing traffic away from older businesses. How can an established company truly be innovative when innovation could involve cannibalizing itself?

That seems to be Microsoft's problem--it saw the Internet as a threat and had trouble embracing the threat. Apparently, it never heard the adage that one should keep one's friends close and one's enemies closer (attributed variously to Sun Tzu, Machiavelli, Vito Corleone and perhaps others). So they protected their core PC operating system business while the rest of the world moved on.

Microsoft isn't solving its real problem by acquiring Yahoo or Yahoo's online search ad business. It still has the conflict of interest with its operating system business. While Microsoft wages war on itself, the real innovators in the high tech world are developing hardware and software that would make PCs and their operating systems irrelevant. One hundred new applications (mostly mobile) are blooming and contending with each other for the future of the Internet. But Microsoft isn't among them, nor has it shown any real talent for acquiring the up and coming ones.

Microsoft should break itself up. The Windows business should be split off from the rest of the company, and Microsoft's shareholders given stock in the spinoff. In this way, Microsoft's enormous resources could be redeployed, probably with greater latitude and ability to innovate. Of course, the two offspring could easily end up competing with each other. But the net benefit to shareholders is what really counts. Instead of devoting billions to purchasing mature businesses (which, in the high tech world means those whose future potential is unclear), Microsoft just might produce greater long term gains for its shareholders by splitting itself up. The current struggle among Microsoft, Yahoo and Yahoo's short term shareholders to generate gains from Yahoo's stagnant online search ad business may require a little too much wishful thinking to be successful for all. And if no win-win solution is possible, whatever outcome eventuates won't be pretty.

Sunday, May 18, 2008

Where Are the Rest of the Mortgage Losses?

Losses from the mortgage crisis have been estimated at $1 trillion or more. To date, banks and brokerage firms have written off around $330 billion in losses. So there seem to be about $700 billion or so in losses that could still be lurking around. Last week, the Fed's Chairman Bernanke urged banks to raise more capital. While banks and brokerage firms have raised about $244 billion in capital since last summer, they apparently haven't done enough for the Chairman's liking. The fact that some banks continue to pay dividends while needing more capital wouldn't endear them to the regulators. Nor should it endear them to taxpayers, who would foot the bill for further Bear Stearns-style bailouts.

Some of the $700 billion in remaining losses may have been incurred by hedge funds, which usually don't disclose their financial results. Perhaps other losses are being batted back and forth between mortgage holders, mortgage insurers, bond holders, bond insurers, CDO holders, and credit derivatives issuers. As long as each player in this game of musical chairs believes that it has a chair, it may be reluctant to book losses.

Perhaps yet more of the losses are caught up in discussions among firms, auditors and regulators concerning proper accounting treatment, and will be booked when people run out of arguments. Given how cheap talk is, people have every incentive to keep talking instead of facing up to bad news.

It's also possible that the recent easing of the credit crunch has enhanced some asset values. But the continued slowdown in the housing market and the economy as a whole would limit the potential for such enhancement, and may even reverse it. This is a time to be cautious about counting eggs; count chickens for a reality check.

As we know from the last nine months of financial markets uproar, losses cannot be made to go away. They often can't even be effectively shifted by derivatives contracts or other financial sorcery. Once they arise, they have to land somewhere, and someone has take the pain they cause. The remaining losses can't stay out of view forever. Chairman Bernanke didn't urge banks to raise more capital just for the heck of it. Chances are he knows something.

If you're an investor, don't get too aggressive. Stay diversified and cautious. If you're involved in politics, understand that the losses will give the Democrats more ammo. If you're a consumer, build up cash reserves and reduce debt. If you're in the workforce, keep your resume up-to-date and ready to go. And if you're a regulator, try to be prepared this time.

Thursday, May 15, 2008

What is Carl Icahn's Exit Strategy with Yahoo?

Today, Carl Icahn, corporate raider par excellence, announced that he would wage a proxy contest with Yahoo. At first glance, he may appear to have a strong hand to play, given that Yahoo just spurned a merger offer from Microsoft without announcing any detailed alternative for enhancing shareholder value. Many disappointed shareholders may be tempted to side with Icahn, who has a proven record of making short term profits from corporate changes of control.

But will those profits come easily by waging a proxy contest with Yahoo? There's only one obvious buyer for Yahoo, and that's the one that just walked away. Icahn reportedly contacted Microsoft and asked if it would be interested in renewing its offer. Microsoft supposedly was noncommittal. That's not surprising. Microsoft, if it is still a potential buyer, would want to get Yahoo for the lowest price possible. Making any kind of promise or commitment to Icahn would only limit Microsoft's options.

Microsoft would be wise to tread carefully now. It walked away from waging a proxy contest itself, probably because there are many shareholders who remain loyal to Yahoo's management and because of the fluid nature of the Silicon Valley. Given the highly competitive and entrepreneurial nature of the Silicon Valley, there's always someone out there who is looking to hire Yahoo's best employees. If the best and brightest at Yahoo got nervous about working for a New York corporate raider or a corporate behemoth headquartered hundreds of miles away in Redmond, Washington, they can have dinner with one or two other companies and be at a new job in a few weeks. Carl Icahn is a tough customer, and if the roughhousing he will surely give Yahoo scares away some of its most capable people, there may not be enough of Yahoo left to interest Microsoft. After all, an Internet company's only real asset consists of its people.

Microsoft evidently was interested in buying Yahoo, in order to keep its book of advertisers away from Google. However, a search engine's relationship with advertisers is often the shortest end of the short term. A lot of advertising space is auctioned on an ongoing basis, and advertisers can decide on the spur of the moment whether or not to run their ads, simply by adjusting the price they're willing to pay. While Yahoo does have a significant amount of "fixed" (i.e., banner) advertising, this largely undirected advertising isn't likely to see growing revenues in the future. Yahoo's advertisers can easily take their business elsewhere. Certainly, Icahn's presence wouldn't encourage them to spend more money on Yahoo. Frankly, neither would Microsoft's acquisition of Yahoo; witness how MSN's been notably unsuccessful in attracting Internet advertising.

So perhaps Steve Balmer's best decision in this whole scenario was to walk away from Yahoo. And maybe he won't change his mind if Icahn wins his proxy contest, because Yahoo could be seriously damaged goods by the time the proxy contest is over.

In that case, what does Icahn do? There aren't any other high tech companies that are obvious buyers for Yahoo (except Google, which would face insurmountable antitrust problems, either in Washington, D.C., Brussels or both). Main Street corporations probably wouldn't want to touch Yahoo, not after seeing how things went with Time-Warner's acquisition of AOL.

Moreover, Yahoo isn't like a lot of conglomerates found on Main Street. It doesn't consist of disparate subsidiaries and lines of business that can be sold off separately at a nice profit. Yahoo provides a bunch of services that draw customers from each other. These services are supposed to provide synergies that produce a whole greater than the parts. It wouldn't be easy to strip them off from the corporate parent and sell them piecemeal. With the economy slowing and advertisers becoming more selective about how they spend, Yahoo's constituent pieces may not command premium prices. The sell-off-the-valuable-assets strategy that Icahn pursued with TWA couldn't easily be applied here.

To make things worse, the credit crunch on Wall Street would probably preclude other exit strategies Icahn might have pursued in the past. Yahoo would likely have a hard time getting the financing for a recapitalization and share buyback program of a magnitude that would satisfy the Icahns among its shareholder base. Financing for corporate deals has been tightening up since last summer. With Yahoo's less than glowing performance in recent years, lenders might pause before taking this plunge.

So Icahn has only one good shot here: win the proxy contest and sell Yahoo to Microsoft. If Balmer can buy Yahoo cheaply enough, he'd probably still proceed. Of course, that's the last thing that Icahn would want. Carl Icahn doesn't wage proxy contests so other people can make a lot of money. He's in it for himself, and would seek a premium price from Microsoft. But Icahn holds a weaker hand than Microsoft. Microsoft has an enormous cash flow and a gigantic cash hoard, and can easily survive without Yahoo. It may be on a path of gradual long term decline, as newcomers like My Space and Facebook, and a resurgent Apple, grow. But Microsoft needs a Yahoo deal a whole lot less than Icahn (who may well have bought Yahoo stock with borrowed money and could therefore have interest charges building up with each passing day). Icahn's looking for a short term play. But if he actually wins the proxy contest, he'll probably be in a weaker position to negotiate a high price than Yahoo's management (and recall how successful they were).

So be cautious about buying Yahoo stock now, in the expectation of Icahn producing a profit for you. He's tough and resourceful, but so are his adversaries. He could lose this proxy contest. And even if he won, Yahoo may be so battered that he won't be able to sell it for a great price.

Tuesday, May 13, 2008

The Economy Now Enters the Political Dead Zone

The economy is wobbling, the credit crunch has abated but only slightly, housing prices continue to drop, and consumer spending is now caught in a chill north wind. However, there will be essentially no more meaningful governmental action between now and the Presidential election this November.

The Presidential contest is now in full swing. Congress has no incentive to do anything that might make the Republican administration look good, and the administration has no incentive to do anything that might make the Democratically controlled Congress look good. As a practical matter, there is scarcely enough time to engage in the usual sparring, negotiating and maneuvering that precedes any successful legislation. The tax rebates are an example of unusually quick legislation and it took a number of weeks to put together the tax rebate bill that made it through Congress and was signed by the President. Then, the IRS needed more weeks to do the computer programming and administrative work necessary to get the checks rolling out the door. That was a simple bill. Anything further the government might do (such as mortgage relief), would be far too complex to finish by November.

As we all know, when Presidential elections are concerned, it's the economy. Since we know that we're not stupid. The question remains, however, what could the meaning of "it" be?

Economic Stagnation. Whether or not we're in a recession is a semantic question that has little real significance any more. The economy is slowing down, people are losing jobs, middle class incomes are on a slippery slope, and expectations are low. The Fed's interest rate cuts over the last eight months may prevent the economy from shrinking. But they won't undo the malaise that is sinking into the electorate's psyche.

Housing Slump. Hundreds of thousands of adjustable rate mortgages are resetting this year, and that means many more defaults. Add in the job losses from the slowing economy, and the number of foreclosures this year will probably continue at a seriously elevated pace. Home prices are expected to fall. Nothing the federal government is now doing will significantly change the outlook for this year.

Credit Crunch. Chairman Bernanke and Secretary Paulson have recently said that the credit crunch shows signs of easing. But Bernanke also cautioned that things are far from normal. Add in the problems that consumers are now confronting, with home equity lines of credit being shut down and credit card terms tightening up, and you have what may be a growing problem. Even if the major financial institutions are a little farther from collapse than they were a couple of months ago, the paucity of credit will remain for at least the remainder of the year. If things start heading south again, expect the Fed to lower interest rates more. But it's getting very low on ammo. The fed funds rate is targeted at 2% now, and the Fed can't lower it much more. Besides, a rate cut now would be unlikely to have any effect on the overall economy before the election. If a major financial institution does a Bear Stearns, the Fed can take some billions of that institution's losses onto its balance sheet and save the day (at least for a few days). But the credit crunch will largely have to unwind on its own.

Inflation. Here's the real kicker. If the Fed's actions during the last eight months are successful, the economy will keep growing. But the Fed has been counting on an economic slowdown to combat inflation. It can't have it both ways--either there is a recession which restrains inflation, or there isn't a recession and inflation flares up. To make things worse, this isn't demand-pull inflation of the 1960's sort. We have heavy worldwide demand for commodities (like oil) and a great deal of speculative excess. Every time some teenage rebels in Nigeria fire a couple of RPGs, oil prices jump another dollar a barrel. You have to wonder if the Nigerian rebels hold the long side of petroleum futures contracts.

Inflation is the Democrats greatest economic talking point this election season. Unlike the housing crisis or job losses, inflation affects everyone every day and just about everywhere. You drive down the street and see gas prices higher than yesterday. You go to the grocery store and bread and milk have gone up again. You need a vacation, but the cost of commuting has eaten up your travel budget. Inflation gives every voter a reason to be discontent.

Congress is making a lot of noise about the Strategic Petroleum Reserve. Many members want the administration to stop buying oil to fill it up. Some members want oil released from the Strategic Petroleum Reserve, to knock down spot prices in the wholesale markets. The administration is adamant about filling the reserve, even though it's already 97% full, and is even more adamant about not releasing oil in order to knock down prices. Well, it's May and the Presidential election is still six months away. Here's our prediction. If, in October of this year, oil prices are still in the 120s or higher, and John McCain is in a tight battle, expect the administration to release some oil from the Strategic Petroleum Reserve. The Reserve is too small to have any lasting impact on oil prices. But it could have a short term impact on spot prices. A carefully timed strategy of releases could force highly leveraged speculators (and just about all commodities speculators are highly leveraged) to sell off their positions before they get margin calls. This will cause wholesale prices to crumble. Retail prices will follow soon thereafter (you can bet the major oil companies will lower prices at their stations because the last thing they want is some excess profits taxing Democrat in the White House). So, who knows? Maybe there will be some relief on the inflation front.

Sunday, May 11, 2008

How George W. Bush Helped Barack Obama

Barack Obama will be the Democratic nominee for President. Hillary Clinton may not believe it yet. But, this being a democracy, what most people believe is what counts, and Obama has more support than Clinton.

A funny thing about the Democratic primaries is how George W. Bush gave Obama a crucial advantage over Clinton. Probably no Republican President in the last 75 years has been as damaging to the political right as George W. Bush. His foreign policies have largely failed. He has seriously worn down America’s ground forces, leaving us with reduced military options in dealing with Iran, a nation that really may be building weapons of mass destruction. His domestic policies have largely been non-existent, or, if they exist, are controversial (like No Child Left Behind). His fiscal policies have turned a balanced federal budget into a deficit-riddled mess. By so completely botching the job of President, he revived the political left in America (which, on its own, was in the process of disintegrating from dated ideologies and self-destructive squabbling).

Most Democratic politicians in recent years have desperately tried to avoid being labeled as liberals or members of the left. The Sunbelt Presidents (Johnson, Nixon, Carter, Reagan, George H.W. Bush (sort of a Sunbelt guy), Bill Clinton and George W. Bush) all got to the White House by seizing the political middle. Most importantly for Hillary, Bill Clinton famously retrieved the White House for the Democrats by playing to the political middle.

In a democracy, political change comes from the ground up. Barack Obama, newly arrived in Washington from the streets of Chicago and the halls of the Illinois state capitol in Springfield, was closer to sidewalk level than Hillary Clinton and sensed the revival of the left. No doubt, he noticed Howard Dean’s 2004 grassroots, Internet-based fundraising success, an early sign that there was ground level discontent he could tap into. Although many of his positions are actually similar to Clinton’s, he sounds like he’s farther to the left, and that’s what people are hearing.

Hillary Clinton, buffered by position and wealth, had a harder time picking up the signals. Given how far she and Bill Clinton had gotten by aiming for the middle, her antennae probably weren’t well attuned to receiving a different message. Since her election as Senator from New York, Hillary Clinton has, until recently, carefully stayed in and around the political middle. She voted for the Iraq War, then supported it, then criticized it and now promises, if elected President, to end it. This sequence of position shifts closely mirrors changes in the sentiments of the American political middle. When the campaigning for the primaries began last fall, it’s no surprise that she did what had been so successful for Bill and her in the past. She thought her nomination was inevitable, and tried to position herself in the middle for the general election against whoever the Republican nominee would be.

All too late, she figured out where the action was. Just barely in time for some Rustbelt primaries, she became an old-fashioned working class liberal, reaching out to blue collar workers who might be put off by Obama’s message of change. Blue collar workers have been hurt by change. They’d prefer that things have stayed as they were. They don’t have an obvious place in Obama’s political paradigm, and were easily scooped up by Clinton--at least until her Pyrrhic victory in Indiana. Exit polls showed that many voters felt she wasn’t credible enough. She will win a few more small primaries. But the music’s over for her. And all because she didn’t figure out soon enough that George W. Bush had resuscitated the left.

The general election this fall will be, as always, a fight for the middle. But the middle this year has shifted. Both Obama and McCain are to the left of the centers of their respective parties. That’s no accident because the electorate has shifted leftward. George W. Bush, Karl Rove and Dick Cheney hoped, in 2000, that they would establish a permanent Republican majority. But they overreached, and paved the way for the revival of the Democratic Party.

Thursday, May 8, 2008

Will the Bank of America-Countrywide Deal Be Bailed Out?

(In the spirit of Eenie, Meenie, Minie, Moe)

If a big bank starts to go,

Bail it out, give it some dough.

If it hollers, give it moe,

Too big to fail,

If you have to know.

Bank of America seems to be hesitating before it steps up to the altar to merge with Countrywide. Last week, it said in a filing with the SEC that it might or might not stand behind some $39 billion of Countrywide's debt. After this disclosure, S&P promptly announced a downgrade of Countrywide to junk status. Bank of America says it still intends to acquire Countrywide. But skepticism about the deal is popping up and Bank of America's management took some heat at its recent shareholders meeting about acquiring Countrywide.

What's going on? It might be that Bank of America's management is feeling a wee bit embarrassed by J.P. Morgan's deal to purchase Bear Stearns, which was announced a couple of months after Bank of America agreed to buy Countrywide. More precisely, the Federal Reserve's agreement to effectively take $29 billion of toxic Bear Stearns assets off J.P. Morgan's hands made the deal attractive. Bank of America didn't get any such sweetener for the Countrywide deal, and the continuing cascade of bad news from the housing market could be making the Countrywide acquisition look less brilliant by the day.

By wavering on whether or not to back Countrywide's debt, Bank of America might be trying to put pressure on the Fed to take some of the hot tamales from Countrywide's balance sheet off Bank of America's hands. The government has only slightly thawed the deep freeze in the credit markets, and wouldn't want to see things ice up again. If Bank of America backed out of the Countrywide deal, the financial markets could turn frigid in nanoseconds.

That's the problem with bailouts. When the government bails out one bank, its competitors will want bailouts, too. Bank of America isn't in the best of shape as things stand, having already written off billions of dollars of mortgage-related losses. It's a really big bank, one that the Fed can't afford to allow to fail, or even get queasy. (Imagine the morass if the financial markets refused to lend to Bank of America, as happened with Bear Stearns.) So don't be surprised if we, the people, end up owning the bad part of Countrywide, just as we own the bad part of Bear Stearns. In the meantime, hope for oil and grain prices to fall.

Tuesday, May 6, 2008

Put Taxpayer-financed Mortgage Bailouts in Borrower Credit Histories

(In the spirit of “Humpty Dumpty”):

The mortgage market was having a ball,

When all of a sudden, it took a great fall.

All the Street’s bankers and a chairman named Ben

Couldn’t put the market together again.

Today, May 6, 2008, Chairman Ben Bernanke of the Federal Reserve again urged lenders and mortgage loan servicers to reduce the amounts owed on underwater mortgages to the reduced value of the property. In other words, if the value of the property has fallen below the amount of the mortgage debt, the lender or loan servicer should simply swallow the price drop as a loss. The Bush administration is trying to increase the role of the FHA, Fannie Mae and Freddie Mac in refinancing distressed homeowners. John McCain, the presumptive Republican nominee, makes proposals that are largely similar to Chairman Bernanke's and the Bush administration's ideas. The two Democrats vying for the presidential nomination, Barack Obama and Hillary Clinton, make more expansive proposals for federal assistance to distressed homeowners.

What will actually happen depends a lot on who wins the election this November. But we would make one suggestion that should apply regardless of who becomes the next President: all mortgage borrowers who receive taxpayer financed assistance should have an asterisk inserted in their credit histories.

One of the primary arguments against government bailouts of distressed homeowners is that those who were reckless and imprudent, or maybe even deceptive or fraudulent, benefit at the expense of those who were scrupulous and honest. Economists call this problem "moral hazard." It rewards people for taking undue risks and behaving in undesired ways, which only leads them to engage in more undesirable conduct in the future. The costs of their misbehavior, on the other hand, are borne by innocent bystanders.

What makes the current mortgage crisis so problematic is that the losses are astronomical--certainly hundreds of billions, and perhaps more than a trillion, dollars. Last time we checked, that's still a fairly large number. A game of musical chairs is now progress, with borrowers, bankers, investors, loan originators, loan servicers and, unfortunately, taxpayers all maneuvering to see who has to bear those losses. With the amounts involved so large, all the private sector players are doing the expedient thing and turning to the federal government with their hands held out. Given the political pressure, taxpayer-funded assistance of one sort or another is inevitable. We will surely end up with billions of dollars of moral hazard in the mortgage markets.

But to slightly reduce the free ride effect that a federal bailout would create, the government should insist that all federal refinancings be specifically noted in the borrower's credit history. Without federal assistance, the borrower would almost surely have defaulted and had black marks placed on his or her credit history (as well as probably lost his or her home). Recording the fact of a federal bailout will tell future lenders that this borrower may not be a sterling customer. In this way, those borrowers who were reckless, imprudent, or worse, may bear some future consequences. They might have a harder time getting loans (and rightly so). When the taxpayer is saving these borrowers their homes, it's only fair to create a disincentive for the borrowers ever again to be a public burden.

Some borrowers have sad stories to tell about how they were pressured and deceived by unscrupulous lenders into signing up for astoundingly one-sided and unfair loans. And we hope the mortgage originators and lenders in these cases are sued, found liable, and better yet, convicted and imprisoned for long periods of time where they can contemplate their crimes as they break up many rocks. But borrowers have moral responsibility, at a minimum, to know and understand the terms of their loans; and they have no right to a taxpayer-financed bailout. Banks have been booking billions of dollars of losses, mortgage firms have been going into bankruptcy, many financial services employees have lost their jobs (including a few CEOs) and more will probably lose theirs. Thus, many of the participants in this morass have suffered adverse consequences for the mistakes that were made. Borrowers who take a handout from the taxpayers should also have to live with at least some consequences of their behavior.

Sunday, May 4, 2008

How Someone Thinking Outside the Box Will Eat Wall Street's Mortgage-backed Lunch

The ongoing discussion of the credit rating agencies' failure to accurately rate mortgage-backed securities and derivatives based on them illustrates a problem that has received almost no attention: the financial instruments that the rating agencies are supposed to rate are simply too complex. That fact is abundantly evidenced by the fact that the investment banks that created those investments are booking enormous losses themselves because they didn't understand the risks. The need to bailout Bear Stearns, one of the doyens of the mortgage-backed market, only reinforces the point. Even the financial wizards who brewed up these instruments in their laptop cauldrons didn't understand them.

The credit agencies came into being in order to deal with complexity. Let's step back to the time when Model T's were an innovation and World War I remained in the future. Bonds were favored over common stocks in those days. An absence of inflation on an overall basis (and indeed a long period of deflation after the Civil War) made bonds an attractive investment, much more so than common stocks with their fluctuating values. With the advent of the telegraph, and rapid delivery of the mails through the railroad system, the financial markets had become national--and, indeed, international--in scope. The increased size of the financial markets presented an informational problem. How could investors in Boston know how sound a mining or timber company in Colorado might be? Accounting and other financial reporting in those days was less standardized than it is today, and by all accounts, dodgier. That may sound like something in light of Enron and all the surprise writeoffs these days by major banks. But many investors in those days paid more attention to the reliability of a company's dividends than to its earnings announcements because the dividend provided cash that you could use at the bakery and the haberdashery. Financial reports were often just pieces of paper that you could only use for . . . well, you know what we mean.

Part of the answer to these informational problems was the evolution of the credit rating agencies, which then as now focused primarily on the likelihood of bonds being repaid. By simplifying the investor's job of judging the creditworthiness of a company, the credit rating agencies made investing much easier. This, in turn, built up investor confidence and increased the liquidity of the markets.

The credit rating agencies' recent airball in the mortgage-backed and derivatives markets has spurred a debate about their manner of compensation (paid by the issuer, an obvious conflict of interest since no issuer wants to pay for an unfavorable opinion), their competence (their salaries aren't competitive with the best investment banks, so the presumption is that they can't hire the most capable people), the manner in which they are regulated, and the fact that they may have done more than rate CDOs and involved themselves in discussions about derivative structures (when it's not their job to design financial instruments). Change is in the air for the credit rating agencies. But that's the less important part of this story.

The real problem is that Wall Street makes big, big profits from innovations, especially complex innovations. New products can generally be sold for higher markups than established, well-known products. This is partly because people pay for novelty (ask clothing manufacturers about this). It's also partly due to lack of familiarity with the new products, especially if they are complex. A well-marketed new product that people don't fully understand might be sold at a high price because buyers are persuaded to over-value the product. This is the case with a lot of variable annuities, which are constantly being brought forth in new and ever more complicated structures.

The current crop of mortgage-backed securities, CDOs, and CDOs invested in CDOs also illustrate the point. This entire market was premised on the belief that residential real estate would never fall in value. But very few people seemed to have focused on the potential fallacy of this assumption, in part because mortgage-backed securities and derivatives were supposed to have magical qualities when it came to reducing risk. But when you tried to figure out if and how they actually reduced risk, you'd enter a labyrinth that contained a nasty Minotaur. We're now hoping for Theseus to make an appearance.

Reform with respect to the credit rating agencies could do some good. But Wall Street's profit incentives will lead it to create new and possibly even more complex financial instruments to replace the ones that are now discredited. Why? Because that's where the big bucks are, especially if you're focused on your year end bonus, and not the interests of investors in their retirements ten, twenty and thirty years in the future. The credit rating agencies, investors and other market participants will likely be challenged to understand and manage the risks of the next generation of high-falutin' things from the Street.

Because the profit incentives are for Wall Street to continue to pump out ever more complex products, there is an opportunity here for someone else to step in and seize some market share. Simplification and reducing costs for investors is something that Wall Street doesn't do. But others, unaffected by obsessions over who is seated where in which Midtown Manhattan restaurant, can do them, and make a lot of money at it. The discount brokerage business, which provides a comparatively simple and low cost product to investors, was created to a large degree outside of New York (especially by a guy in San Francisco named Charles Schwab). The mutual fund, although complex in its technical details, greatly simplifies the individual investor's job by providing packaged diversification, investment management, and accounting services, often at very economical prices. The mutual fund business is rooted in places like Pennsylvania and Massachusetts.

America's real estate markets have become heavily dependent on investor financing. The old-fashioned savings and loan, credit union funding of mortgages with customer deposit accounts won't provide enough loans to satisfy borrower demand. And we can't rely on Fannie and Freddie any more. Even with the government relaxing loan underwriting restrictions, market realities have forced Fannie and Freddie to effectively tighten, and not loosen, lending standards. It may be that Fannie and Freddie are becoming too big and complex to manage (especially from a risk management standpoint). Neither they, nor the FHA, are likely to burst out of a telephone booth and save the day here.

In order to attract investor money to the mortgage markets, new and simpler mortgage-based investments are necessary. There's nothing wrong with pooling mortgages and selling interests in those pools. But don't pretend that this reduces the risks of investment in mortgages, and don't try to turn lead into gold by purportedly shifting these risks through complex derivatives to counterparties that may stand you up at the worst imaginable time. If we go back to the 1987 stock market crash, portfolio insurance (a derivative) did little or nothing to protect equity investors from loss. Indeed, some believe portfolio insurance made the losses worse. Provide investors with full disclosure of the risks of investing in mortgages. In this case, full disclosure means full disclosure--people can accept risk if they know about it in advance. But don't create a complex instrument and then try to rely on disclosure. Even if you make legally adequate disclosure, investors will often be confounded by complexity and royally ticked off when they lose money. Design the instrument to be easy to understand, and investor confidence will rise.

Mortgage-backed investments should be standardized. This will make them more readily understood. It will also facilitate the creation and maintenance of liquid secondary markets, something that CDOs sorely lack.

The qualities of clarity, predictability and low costs that would characterize the next generation of mortgage-backed products aren't attractive to Wall Street's financial engineers. These aren't the kind of financial products that get an investment banker a mansion in the Hamptons quickly.

Someone in St. Paul, Kansas City, Boston, Philadelphia, Phoenix or Sacramento may well design and develop such a product. A great deal of the money invested in U.S. mortgages comes from overseas. Perhaps someone in London, Hong Kong, or who knows, maybe Helsinki, will design a competing product. Since there is so much demand for mortgage funding, it's likely that simpler, clearer and more easily tradeable mortgage-backed investments will be created. Just don't look for them to come from Wall Street.

Friday, May 2, 2008

Pay Disparity in a Nutshell

Hey, diddle diddle,

My pay raise was little.

The CEO’s jumped over the moon.

The little dog laughed,

To see such a gap,

Saying, you can cry or go to the saloon.