Sunday, June 29, 2008

Tax Rebates Pump Up the Gross National Debt

Late last week, the Department of Commerce reported that personal income before taxes had grown 1.9% in May 2008, compared to April 2008. After taxes, personal income grew 5.7%. By contrast, in the preceding month, April 2008, personal income grew 0.3% before taxes and 0.4% after taxes. May looks good, no?

No. Most of the May increase was attributable to tax rebate payments from the IRS. Without these stimulus payments, personal income after taxes would have grown only 0.4% in May. That is to say, 5.3% of the May increase in after tax income was due to the government's stimulus payments.

Let's consider where the money for the rebates came from. The federal government is running a budget deficit to the tune of hundreds of billions. It didn't have any excess cash lying around in its vaults. If the government was already running a deficit and then sent out some $50 billion in rebates in April and May 2008, the only way it could have gotten the money was to borrow more.

But is there any public accounting for the borrowings? They'll show up eventually in government statistics about the federal debt and budget deficit. However, the personal income "increase" they created isn't really a net increase in income or wealth. It is simply a transfer of wealth from the future to the present.

This is no different than an individual who takes out a loan to get money for current use. The loan proceeds aren't really income. They are simply a frontloading of wealth from the future to the present. The borrower's future well-being will be diminished by the burdens of debt service and repayment. The future well-being of the United States will be similarly diminished.

The stimulus payments will only modestly increase the trillions of dollars of debt now carried by the federal government, and the additional interest expense might also seem relatively minor. But as the demographic composition of America changes, with fewer workers and more retirees, the impact of additional federal debt on taxpayers will be magnified. And if there are more stimulus payments, as some politicians are calling for, the impact on the federal debt will grow.

We're getting a misleading picture of the stimulus payments. They don't really increase personal incomes except in an immediate and misleading sense. Taxpayers, including the taxpayers receiving the payments, and/or their children, will bear the burden of repaying the debt taken on to fund the payments.

Government stimulus programs generally don't work. They were attempted in the 1930s, the 1970s, and the early 2000s, and had little lasting impact. The only stimulus program that truly revived the economy was World War II, when the federal government's budget--funded with war bonds and other borrowings--amounted to 50% of the economy. But war isn't an option today for economic policy. And the current stimulus program will have trivial impact, at best.

The stimulus payments reflect a belief that more debt will solve our problems. But that's how we got into trouble in the first place. People came to believe that credit was the way to attain a nice lifestyle. The fussy, old-fashioned notion of earning and saving went the way of the Model T. Income was simply a metric used to measure how much credit you could get. Credit became wealth. Buying a house with no money down was the smart play because you wouldn't have to save a penny and could spend your money on other things. Look how well we're doing now.

It would be nice if the government would set an example and stop treating credit as wealth. Policies designed to bolster manufacturing--the true foundation of national wealth--should be favored. Today, bread and circuses are the policies of choice in Washington. However, we should bear in mind how much good they did for the Roman Empire.

Thursday, June 26, 2008

Greed Kills Financial Plans

Today, the Dow Jones Industrial Average fell 358 points, and, at 18.5% below its all time high, is close to bear market territory (defined as a 20% drop). Bonds haven't done well, either, as rising inflation and credit concerns (in the case of corporate bonds) have taken their toll. Foreign stock markets have been dropping, most notably the Indian and Chinese markets that popped so aggressively last year. It seems like almost all standard investments are dogs. What's an investor to do?

Commodities like gold and silver beckon, while oil sings its siren song. But commodities have been on a long boom, and we now know from lessons administered by the real estate market that no boom goes on forever. Over the next 30 years, oil prices will surely rise. But over the next 2 or 3 years, they could fall. Gold and silver are default investments, where people go when nothing else seems attractive. They have limited underlying value, and, as long term investments, haven't kept pace with inflation over the decades. Beware the glitter of precious metals.

Now is the season for snake oil salesmen. They emerge from dark places to tell you what you want to hear. You'll be offered disarmingly simple investments in prime bank notes. Or you'll have the opportunity to invest in technology that turns coal into natural gas, or perhaps sure-fire leases in Latin American real estate.

Maybe you're knowledgeable enough to avoid ostrich farm-type investment opportunties. But can you resist money market-like investments that pay more than money market funds but are said to be as safe? (Many thousands bought into auction rate securities, and have found their money frozen.) How about investments that are guaranteed not to lose money, and may rise if the stock market rises? (Some variable annuities offer these features, only with very steep fees and nasty early redemption charges that may well push the upside below stock market averages.) Did you invest in the stock of banks, brokerage firms and other financial services companies, which did quite well as long as the real estate market kept rising?

What we now see in the financial markets is the risk part of risk and reward. The two go hand in hand. You can't turn a profit all the time, except by accepting the low returns of bank CDs, money market funds and U.S. Treasury securities. Avoid stretching for yield when the investment stretches credulity. Ride out the current downturn. Invest for the long term and you're likely to be rewarded. Be shortsighted, and suffer the consequences. Greed kills financial plans.

Tuesday, June 24, 2008

Profiting from Stagflation

In these stagflationary times, it’s hard to know how to invest. Almost all asset classes seem to be falling in value. The assets that aren’t—like oil—are volatile and probably caught up in a bubble. You know how things go--invest in a bubble and it will burst two days later. There are ways, however, to profit from stagflation.

First, develop good financial habits. Save more. This will help your portfolio grow even if its returns are tepid. Instead of saving 2% or 3% of your income, make it 5%, or 10%. Better yet, make it 15% or 20% and pretty much guarantee that your standard of living won't fall in retirement. (For an explanation of why this is so, see Invest in a diversified way. Form the right financial habits and you’ll profit for the rest of your life.

Take up a cause close to your heart. There's more to life than fretting over your retirement portfolio as it meanders. Volunteer. Advocate. Help the disadvantaged. Work on something larger than yourself and you'll have good memories for the rest of your life.

If you’re laid off and have a lot of time on your hands, use your wealth of time. Read books you always intended to read. There’s the public library if you don’t want to buy them. Rent DVDs of classic movies you’ve always wanted to see. Start playing the piano again. The instrument you inherited from your parents could sing once again. Spend more time with your loved ones. Use the time fruitfully and you'll profit even if you're not being paid.

When confronted with adversity, look for opportunity. By all accounts, the economy will be dreary for a while, and inflation will probably get nastier. Opportunities to profit financially will diminish. But other profit opportunities will come up; keep them in mind.

Sunday, June 22, 2008

If You're Concerned About the Price of Oil, Watch Israel and the U.S. Fifth Fleet

Israel, it's just been reported, recently conducted a military exercise that appeared to simulate an aerial attack on Iranian nuclear facilities. Two years ago, Israel fought a war in Lebanon against Iran's proxies, Hezbollah. Things didn't go well for Israel, to a large degree because Israeli intelligence severely underestimated Hezbollah's military capabilities. No doubt Israel now takes Iran very seriously, just as Iran takes Israel very seriously. The exercise could be the prelude to the real thing. This is all the more likely because the hawkish, but soon to be concluded George W. Bush presidency may offer the Israelis a degree of support that future presidents, chastened by the failure of the Iraq War, would not provide.

The Iranians will probably have trouble stopping an Israeli air raid. Israel's capability for long distance air attacks is legendary. Iran's air force is a mulligan stew of miscellaneous aircraft, some pretty modern but most out of date and lacking in spare parts. Many of them are not in operational condition. Iran's air defense system is of uncertain quality, with an apparently disappointing performance in the Iran-Iraq War during the early 1980s.

But the Iranians appear to subscribe to the notion that the best defense is a good offense, and have a good understanding of asymmetric warfare. Iran has built up its ballistic missile force, and is modernizing its navy with submarines, frigates and other ships that can deliver missiles. Missiles are hard to stop. Israel found this out in its 2006 war with Hezbollah, during which Hezbollah missiles bombarded Israeli cities that no enemy airplanes could possibly approach.

Iran likely hopes to prevent an Israeli attack through a policy of modified mutual assured destruction. If Israel bombs Iranian nuclear facilities, Iran likely will do everything it can to stop the flow of oil to the industrialized world. With its arsenal of missiles, Iran would surely bombard Saudi Arabia, Kuwait and other Persian Gulf oil producers. Since the most productive oil fields in the world are in eastern Saudi Arabia, an easy ballistic missile shot from Iran, Iran's ability to disrupt the world's oil markets is plain to see.

While the Saudis, Kuwaitis and other Persian Gulf nations have modern military aircraft, courtesy of the United States, F-15s aren't designed to stop barrages of hundreds or thousands of missiles. Indeed, they might need reinforced concrete bunkers as protection against such attacks. And even if the Saudis and Kuwaitis have Patriot missile defense systems, those systems won't defend oil tankers trying to pass through the Persian Gulf from Exocet or other cruise missiles.

All of which is a long way of saying that if Israel attacks Iran, the U.S. will have to get involved, like it or not. The best way to stop Iranian retaliation against oil producing nations would be air attacks by U.S. forces against Iran's missile forces. The Israelis don't have the capability to launch the massive attacks needed against Iran's missiles. Only the United States, with its vast surveillance and reconnaissance capabilities, and its enormous array of cruise missiles, piloted aircraft, drone aircraft and smart weapons, could have any hope of containing Iran's missiles.

The U.S. Fifth Fleet, which is assigned to the Persian Gulf region, would play a crucial role. While the U.S. already has air forces involved in the Iraq War, those forces likely aren't enough to fight on the Iranian front as well as the Iraqi front. The Fifth Fleet, beefed up with more than its usual complement of carriers, would have to be brought to bear.

Thus, the movements of the Fifth Fleet and Israel's pronouncements about Iran bear watching. If there's a scenario for $200 a barrel oil in the next six months, this is it. After that, a new President will reside in the White House, no doubt putting a restraining hand on Israel's air force. It's possible that the Bush administration's turn in the last couple of years toward diplomacy in the Middle East will bear fruit. By all accounts, few Iranians want war with America, and even fewer Americans want war with Iran. But if we had control over events, oil wouldn't now be trading at $135 a barrel.

Thursday, June 19, 2008

Is Credit Default Indigestion Coming?

Even as the summer solstice approaches, shadows are lengthening in the credit derivatives market. Credit derivatives are contracts that are akin to default insurance for bonds and other indebtedness. Holders of debt buy credit derivatives (usually in the form of credit default swaps) from counterparties willing to take the risk of a default. If the debtor defaults, the holder of the debt then turns to the counterparty to cover losses. The notional amount of credit derivatives more than doubled from $17.1 trillion as of Dec. 31, 2005 to $34.4 trillion as of Dec. 31, 2006, and then almost doubled again to $62.2 trillion as of Dec. 31, 2007. With the economy slowing and the credit crunch persisting, it would be fair to think that this trend has continued in 2008.

Notional amount is similar to the face amount of the debt, and is not necessarily or even likely to be a measure of the potential loss. But, with the economic downturn, continued housing market problems, persistent credit crunch, escalating energy prices and general economic malaise, it's easy to contemplate the possibility of hundreds of billions of dollars of losses and maybe more. The rapid growth of this market--at a rate of 100% a year--tells us that holders of debt certainly perceive the potential for lots of defaults, or they wouldn't have paid for credit derivative protection.

Regulators and the financial services industry are moving to make the credit derivatives market more transparent and to strengthen its clearing processes by creating a central clearing facility that would ensure contracts are paid. These are steps in the right direction. But what about the large and rapidly increasing quantity of credit derivatives that today are still traded in the old-fashioned over-the-counter manner? These contracts are often done over the phone, and then are followed up with written confirmation. The paperwork has sometimes lagged behind the trades, and the only significant assurance that a counterparty would fulfill the contract in the event of default is the counterparty's word. If the counterparty stiffs you, you'd have to go to court and ask a judge to give the matter some thought.

Only the larger financial services companies and firms can play in the credit derivatives sandbox. The amounts of debt involved are so great that only well-capitalized companies can credibly serve as counterparties. One must wonder whether these firms have enough wherewithal to cover the liabilities that will arise, because there surely will be liabilities. If there are widespread defaults on credit derivatives, the financial storm that would follow would make last summer's mortgage crisis and credit crunch will feel like a gentle summer breeze.

The regulators hopefully are looking into the risks of the credit default market. They should be finding out who's got how much exposure to whom, and when it might materialize. Then, they should take steps to shore up weak points and have a game plan for dealing with the fallout of a flurry of defaults. Last spring, there were warning signals that the mortgage crisis was coming. Nevertheless, the regulators were, to be generous, caught absolutely flatfooted. A year later, they've managed to arrest a couple of former mid-level Bear Stearns executives. But wouldn't it have been much better if they had acted to prevent some of the bad things from happening? Would it do much good if, a year from now, a couple of mid-level credit derivatives executives are arrested?

Wednesday, June 18, 2008

A Rhyme for Recessionary Times

Jack and Jill

Faced rising bills.

And could afford

Only bread and water.

Jill asked, why not

Sell our house and lot?

Said Jack,

‘Cause they’re under water.

The American economy is based on credit and growth in asset values. When credit contracts and asset prices fall, the entire economy contracts, and there are no easy ways to recover. Everyone, from powerful investment banks to laid off wage earners, is suffering. Old fashioned fussbudgets mumble about living within one's means, saving nickels, and prudent investing. But politicians, knowing that the way to the electorate's heart is through their pocketbooks, promise bread and circuses while conveniently omitting to mention that the bread and circuses come at the dispensation of foreign creditors. Rome fell. Britain, too, after fighting World War II on borrowed money (loaned courtesy of the United States, which was considerate enough to press the issue of repayment only gently). The United States cannot prosper by indulging in more borrowing and consuming. Nor can it benefit from more cheap government-funded credit provided courtesy of the Federal Reserve. We've had enough of bubbles and we don't need stagflation. Presidential candidates speak of change. Real change would involve offering greater incentives to engage in productive activity--creating goods and services that can be sold worldwide--and wealth building activity, like saving.

Monday, June 16, 2008

Defend the Dollar: Make the Federal Reserve's Job Simpler

The declining dollar has hit Main Street in a big way. Commodity prices are rising faster in dollar denominated terms than Euro denominated terms because the dollar is falling against the Euro. In particular, oil prices denominated in dollars have risen much faster than oil prices denominated in Euros. If oil prices in America had risen in relative terms only as much as they have in Europe, oil would be about $80 a barrel instead of $135. Stabilizing the dollar would help to keep inflation under control.

How to stabilize the dollar? Let’s begin by understanding that inflation primarily results from governments increasing the amount of currency they issue. If they did not increase the amount of currency, price increases in some things (like gasoline and food) would leave comparatively less money for other things, and the prices of the latter would face downward pressure. Inflation would be constrained because a transfer of wealth to energy and food producers would mean a loss of wealth for others.

Ideologues on the right advocate a return to the gold standard as a means of controlling inflation. The dollar would be redeemable for a fixed amount of gold. You’d just take your cash to a Federal Reserve bank and exchange it for gleaming bullion. This idea has superficial appeal; if the paper currency becomes inflated, protect your wealth by converting it to gold. But there isn’t enough gold in the government’s hands to begin to cover the quantity of dollars outstanding at current market prices for gold. (It would be important to set the redemption rate at current market prices; a higher benchmark would automatically inflate the dollar.) The gold standard prevailed in the U.S. until 1971, a fact that didn’t prevent significant inflation in the years immediately following World War II or in the 1960s. The gold standard became symbolic, because everyone knew that they couldn’t realistically redeem their dollars for gold.

A better way would be to simplify the Fed’s responsibilities. The Fed is expected not only to keep prices stable, but also to maintain maximum employment and keep long term interest rates moderate. This is a complex set of responsibilities that can’t always be fulfilled simultaneously. Keeping employment up requires low interest rates to stimulate consumer spending and business investment. But low interest rates diminish the value of the dollar and facilitate inflation. The Fed can’t have it both ways, and must dance over slippery rocks in the rapids in order to keep the economy going and the dollar steady. It can’t always keep a firm footing.

By contrast, the European Central Bank, which issues the Euro, is principally responsible for maintaining price stability (i.e., combating inflation). The ECB is independent of any particular nation, and is expected to give preference to price stability over economic growth or unemployment levels. The Euro isn’t hurting right now.

The differences between the Fed’s responsibilities and the ECB’s responsibilities do much to explain why the ECB sometimes zigs when the Fed zags. For example, the ECB has held interest rates in the Euro-zone steady during the last ten months, while the Fed has been lowering them. The ECB even recently hinted at raising rates, which flummoxed the dollar when it was just barely stabilizing.

Reducing the Fed’s responsibilities so that its primary job is protecting the stability of the dollar and the safety and soundness of the financial system still leaves it with a full plate. Then, however, it could concentrate on something it probably could do effectively, especially since it could more easily coordinate policies with the ECB. If the Fed has to prop up the economy with cheap credit, and then clean up the mess left by credit-induced bubbles, it always be caught between a conflicting web of priorities that it cannot fully serve.

Much of the problem is that neither Congress nor the White House has stepped up to the plate to adequately deal with the economy’s problems. One could argue that the Fed can react to economic ills much more quickly—and there’s no doubt that the legislative process closely resembles an aircraft carrier turning. But the Fed’s interest rate policies are blunt and easily misdirected tools that can have only short term impact on the direction of the economy with serious risk of asset bubbles and other unpleasant side effects. The Fed’s discount rate and fed fund rate target are government-prescribed prices for credit; and government price controls always distort markets. If government prescribed interest rates are used primarily to protect the value of the one government asset that is central to the economy—the currency—then the government serves the vital economic function of providing a reliable medium of exchange.

Thursday, June 12, 2008

Carl Icahn's Non-Auction of Yahoo

Carl Icahn's gambit with Yahoo is falling apart. Today, Yahoo announced that its talks with Microsoft have ended. Apparently, the two companies discussed the possibility of a merger and less comprehensive transactions as well. Yahoo reportedly asked Microsoft if it was still willing to pay the $33 a share Microsoft had offered earlier this year, and Microsoft said no. Microsoft evidently wanted to buy Yahoo's online advertising business and Yahoo, unwilling to sell its crown jewel, said no. Both Yahoo and Microsoft have strategic problems. But they apparently won't be working together to solve them.

Icahn's mistake was buying an interest in a company that had only one realistic suitor. No one other than Microsoft could feasibly have acquired Yahoo. By stepping in and turning up the heat on Yahoo's management, Icahn weakened management's negotiating position and may have made Microsoft think it could extract Yahoo's best asset without having to buy all of Yahoo's problems. If Yahoo had sold its online advertising business to Microsoft, it probably wouldn't have been left with enough of a company to do anything except liquidate. That, to be sure, would have delighted Microsoft. And it might not have meant much profit for Icahn and other dissident shareholders.

Icahn seems to be off his game. A company that has only one realistic suitor cannot be auctioned. A meaningful auction requires at least two bidders. Who did Icahn think Yahoo could have played Microsoft against in order to trigger a bidding contest? Perhaps he thought Microsoft needed Yahoo so badly it would increase its offer, even if there were no other bidder. But Microsoft has a shipload of cash in its treasury, and can keep cruising along for a long time while mulling its strategic alternatives.

Icahn threatens a proxy contest at Yahoo's August shareholders meeting. While it's unclear he would win, let's assume he does. Then what? He's said he'd hire a brilliant outside executive to replace Yahoo's current management. Okay. But is he likely to install a manager who would look to revive Yahoo? Or is Icahn more likely to resort to his past strategy of breaking up companies he controls and selling the individual pieces? Icahn has a somewhat thin history of patiently operating companies until they succeed. And that may be what Microsoft is thinking. If Icahn wins the proxy contest, Microsoft might swoop in and buy Yahoo's crown jewel online advertising business at a price that a sole bidder could command--and then leave Icahn to clean up the remaining mess.

Tuesday, June 10, 2008

How About Risk Management Without Steroids?

In recent years, risk managers have often relied on hedging as a way to mitigate risk. When a firm hedges its asset positions, it presumably can hold more assets, expanding its balance sheet and earning greater returns on its capital.

There is, however, a basic problem with this approach. A perfect hedge (i.e., one that offsets a loss on the primary asset dollar for dollar) would eliminate any potential profit on the primary asset. For example, assume a firm holds $1 billion of 30-year U.S. Treasury bonds. A perfect hedge would be a short position of $1 billion of 30-year U.S. Treasury bonds, taken at the same time that the firm buys the long position. Any such transaction would offer essentially no profit potential, since all gains on the long position would be completely offset by losses on the short position, and vice versa. No firm will bother with trades like this. An imperfect hedge is necessary to have the potential for profit.

Thus, hedged transactions in the real world will be imperfectly hedged. Finding the right hedge can become a matter of guesswork and judgment. You have to pick something that doesn't take all the pizzazz out of the trade, but saves you from the rising waters when Katrina blows in. The history of hedging is replete with spectacular failures. In the 1987 stock market crash, the portfolio insurance on which numerous institutional investors counted not only failed, but may have aggravated the market's downturn. In 1998, Long Term Capital Management's collapse was attributable in part to hedged positions moving the wrong way at the wrong time. Most recently, Lehman's $2.8 billion second quarter 2008 writedown, the first quarterly loss in its history, resulted in part from hedges doing the Funky Chicken when they were expected to do the Twist.

The fact that credit has been so inexpensive in recent years may well have encouraged the use of hedges. When a bank can borrow cheaply, its incentive to increase its balance sheet is magnified. Lower-yielding (or higher risk) assets can become attractive, and the availability of hedges helps it rationalize bulking up the balance sheet. The imperfections of the hedges may be less glaring against a backdrop of inexpensive money.

However, in the financial markets, as elsewhere, there is a season for all things. The risky side of taking risks sometimes manifests itself. Then, losses are sustained. Hedges, necessarily imperfect to begin with, may reveal unexpectedly unpleasant characteristics. The safety net breaks and write-offs follow.

Using hedges to manage risk is like taking steroids. Steroids have legitimate medicinal uses, and when used properly can help to save lives. Even then, they may have side effects. But you shouldn't use steroids to become something that you're not.

Hedges are analogous. They can play a legitimate role in trading strategies. But a firm can't use hedges to rationalize greatly increasing its asset levels without commensurately increasing its capital. You're taking naked risk when you hedge your bets. It's one thing if a run-of-the-mill hedge fund does this. However, major banks, and other financial institutions that are de jure or de facto protected by the U.S. taxpayer, shouldn't use hedges as a substitute for careful evaluation and limitation of risk. They should prudently analyze risks, including the exposure that hedges involve, and maintain an extra dollop of capital for the moment when their hedges let them down.

Sunday, June 8, 2008

There Isn't a Bubble in the Oil Markets?

Let’s look at oil prices for the last week. On Monday, June 2, 2008, the price of light sweet crude closed around $128 a barrel. On Tuesday, June 3, 2008, it closed around $124 a barrel, down about 3%. On Wednesday, June 4, 2008, it closed around $122 a barrel, down another 1.6%. On Thursday, June 5, 2008, it changed direction and closed at nearly $128 a barrel, up about 4.6%. Finally, on Friday, June 6, 2008, it closed at $138.54 a barrel, up about 8.4%. Oil price increases like these could slow the economy and aggravate inflation (i.e., produce stagflation). On Friday, the Dow Jones Industrial Average fell almost 400 points, into territory approaching its low point since the beginning of the mortgage crisis and the credit crunch.

If you were to believe the oil industry and government explanations for these price movements, what happened was: (a) on Tuesday, June 3, 2008, fundamental demand for oil, especially in China and India, dropped about 3%; (b) on Wednesday, June 4, 2008, fundamental demand for oil, especially in China and India, dropped another 1.6%; (c) on Thursday, June 5, 2008, fundamental demand for oil, especially in China and India, rose about 4.6%; and (d) on Friday, June 6, 2008, fundamental demand for oil, especially in China and India (where everyone was filling their tanks for weekend excursions), rose 8.4%.

That explanation seems absurd because it is absurd. Fundamental demand doesn’t explain current short term price movements in the oil markets, because it doesn’t change that fast.

News events may have influenced the direction of the price movements. Early last week, a gasoline inventory report indicated unexpectedly large inventories in the U.S. That, together with comments by Federal Reserve Chairman Ben Bernanke about supporting the dollar, pushed oil prices down. Then, counter-comments later in the week by the president of the European Central Bank to the effect that the European bank might raise interest rates (and thereby support the Euro and weaken the dollar), led to a price jump amidst a buying frenzy. It didn’t help that an Israeli newspaper reported the possibility of an Israeli attack on Iranian nuclear facilities some time soon.

Even though these news events may have affected the direction of prices, they don’t explain the frenzied trading and the large amount of the price changes. The possibility of interest rate increases by the European Central Bank has been mentioned in the financial news for months. The possibility of military action against Iran—by Israel or the United States—has been bandied about for years.

So what accounts for the pricing histrionics? Most likely, speculation and maybe a touch of manipulation. Let’s start with speculation. News reports indicate that hedge funds and other institutional investors are jumping into the oil market. That's not surprising. Professional money managers are measured against market averages. If you’re running a hedge fund and your performance only matches the S&P 500, your client base, and your continued employment, will have a very short half-life. In order to stay in business, you have to beat the market. So you look for whatever is hot. If it’s high tech stocks, you buy high tech stocks. If it’s mortgage-backed derivatives, you buy derivatives. If it’s oil, you buy oil futures. The hotter something gets, the more you want it. And since you can buy oil futures using a lot of leverage, you could boost your profits by borrowing aggressively. With the Fed generously cutting interest rates and taking all kinds of hinky assets as collateral, banks can obtain the funds to lend to commodities speculators.

It isn’t hard to discern a speculative bubble in the oil markets. Maybe some professional economists would assert that they can’t spot a bubble in the making. However, whether or not linear and/or nonlinear regression analyses would indicate a bubble in the oil markets, we shouldn’t let the professional orthodoxy of economists interfere with common sense. A bubble occurs when investors buy an asset because they believe they can sell it in the near future to someone else at a higher price. Their investment decisions are unburdened by any consideration of the fundamental value of the asset. They just hope to find a greater fool than they. We have a speculative bubble in the oil markets today.

Manipulation is darker possibility. Proof is harder to find, because much of the evidence may be overseas, in markets where regulation is even more diffident than the light touch of the U.S. Commodities Futures Trading Commission. But here’s how it could be done. OPEC is resolutely refusing to increase production. Other oil producers, who don’t belong to OPEC, appear to be producing pretty much at full capacity. Thus, there is a limited supply of oil that won’t be significantly increased in the next year or two. The inflexibility of supply allows for gamesmanship. The nasties could go to the less transparent markets overseas and, using leverage, buy up a shipload of near term futures contracts. A large part of the world’s oil production is delivered under long term contracts, so you don’t need to buy close to the entire world’s supply. You just need to buy enough contracts to influence the spot market. If you work in concert with a few of your like-minded money managers, you could put together a formidable consortium. Since your overseas buying might be rather opaque, other players wouldn’t easily pick up on what was going on and could unknowingly agree to deliver oil to you at prices they think are high. As your influence over the oil market increases, prices will rise unexpectedly higher. Your counterparties will rush to cover their exposure by buying contracts for delivery of oil themselves. That will only increase the buying pressure and push up the price further.

You wouldn’t need to corner the market in the classic sense. All you’d need to do is induce a little panic among the shorts. Because the near term supply of oil is static, if you create a bit of frenzy, your beloved counterparties will have to scramble.

Is there any way to get some control over the speculation and possible manipulation in the oil markets? Regulators of banks and broker-dealers could check up on how much credit is being extended to finance oil trading. Given the spike in oil prices, these loans are getting riskier and regulatory oversight would be appropriate. If commodities market regulators wish to investigate the possibility of manipulation, they could do so. However, commodities regulators aren’t renowned for being hard charging, and we shouldn’t get our hopes up that a whole lot of law enforcement will happen. The CFTC recently announced that it was investigating trading in the oil markets. But as we just noted, commodities regulators aren't renowned for being hard charging, and we shouldn't get our hopes up that a whole lot of law enforcement will happen. In the meantime, skip the meat and fish counters at the supermarket and start putting generic peanut butter on generic crackers in order to have enough money to cover your gas bills.

Thursday, June 5, 2008

The Failed Promise of Derivatives

Bond insurers MBIA and Ambac were downgraded today. Bank regulators again warned that banks should raise more capital since they will be facing more losses. Even though the stock market jumped today (over 200 points for the Dow), the financial sector remains weaken and may be weakening.

It wasn't supposed to be this way. Derivatives contracts were supposed to take risk and disperse it across a broad spectrum of investors, thus dampening the ups and downs of the financial markets. But they didn't. They created an illusion of risk management, which led Wall Street to discount the potential for losses. Normally, risk and reward walk hand-in-hand down Wall Street. The riskier the investment, the greater the chance of a big payoff. But if you can somehow offload the risk, then you can make big money with little chance of losses.

At least, that was the way it was supposed to work with derivatives. As things turned out, however, just about the entire Street wound up making a great, big, unhedged bet that real estate values would keep rising indefinitely. This was an easy bet to make if you don't think you can lose, and an enormous volume of very bad loans were made. Wall Streeters thought they had their risks covered--or dispersed, rather. But it turned out that the risks just slipped back to them in the complex network of exposures that the big financial players have with each other. Thus, the Street in actuality faces the really large amount of losses that are inevitable when one makes an enormous volume of very bad loans.

One crucial lesson to learn from this is that derivatives are nothing special. They have no magical qualities. They cannot lift the financial world out of the dust from whence it came. They are simply another financial product, as pedestrian as common stock and insurance. Common stock is an important element of corporate finance today. But its advantages and disadvantages are well-understood, and companies will borrow from banks or issue bonds if the cost of capital from borrowing is lower. Insurance is also an important financial product, one that transfers risk from a single insured to a pool of premium funds paid by all customers of an insurance company. But no one sees insurance as a panacea for the financial world's ills. Since premiums paid and risk transferred are normally closely connected, insurance usually can't be used as a means to make big money.

Derivatives will continue to have a market. Appropriately constructed, marketed, and priced, they can serve bona fide needs to transfer risk among informed and consenting market participants. But they can't effectuate an overall net reduction of risk and do not protect the financial system as a whole. The costs of risk have to land somewhere; derivatives, at best, only change the identity of the bearer of those costs. When derivatives are used to justify increasing the aggregate risks in the financial system, the financial system as a whole will pay the price. That is what has happened during the last year, and what is continuing now.

So the next time someone offers you an opportunity to buy a derivative, see it as nothing more exciting than another insurance product, or another potential stock investment. And, as far as regulation goes, regulating derivatives isn't any more controversial than regulating the stock market or insurance companies. Derivatives are just another financial product that aren't deserving of any special treatment or insulation from rules. If we stop viewing derivatives as some sort of magical elixir and use them only within the limits of their logic, they can continue to be valuable financial tools.

Tuesday, June 3, 2008

How to Raise Cash in Hard Times

With the economy slowing, layoffs rising, mortgage payments re-setting upwards, bonuses evaporating, and prices rising, we’re re-learning an old lesson. Cash is king when times are hard. People go into bankruptcy, not because they’re insolvent in an accounting sense, but because they’ve run out of cash. Many who have fallen on hard times are searching for ways to raise cash. Here are some ideas.

Best option: increase household income.

Find a higher paying job.

Work more paid overtime, if available, or get a second job.

Make a job of your hobby. Start selling the wooden duck decoys you’ve carved for fun, or seeds for the gigantic tomatoes you grow in your garden.

Second best option: reduce spending. This option really goes hand-in-hand with increasing household income. But all too many of us find it psychologically harder to cut back than to try to scare up some extra cash. Nevertheless, reducing spending is an excellent way to stay afloat financially, especially if you can establish good lifelong financial habits in the process.

Cut back on eating out, entertainment, and home furnishings. You need that 186” flat screen TV a whole lot less than you may think.

Reduce the number of cars in your household (and maybe increase the number of bicycles). If you’re a city dweller, consider car sharing services instead of ownership. Buses and subways aren't so when you consider how much less expensive they are than car ownership.

Keep your car longer. The fewer cars you buy during your life, the lower your auto costs will be. The only exception would be that if you’re willing to downsize your choice of autos in the following way. This involves changing cars with little or no net cash layout, and ending up with a much more gas efficient, but smaller vehicle. For example, if you own a three-year old GMC Yukon and are willing to trade it in or sell it in order to buy a new Honda Fit or Toyota Yaris, you might be able do this with little or no cash out of your pocket. But you’d have to be willing to drive a much smaller (albeit much greener) car.

Shop at sales and in second hand stores.

Cut out unnecessary trips to the mall, and reduce spending and gas costs.

Third best option: tap your accumulated resources. You built wealth for a reason. Now you know what that reason was.

Reach into your emergency cash fund. These are the times for the emergency fund. If you don’t have one, remember this moment when you do get back on your feet and make sure that you don't make that mistake again.

Sell unwanted stuff through garage sales or online auctions. But beware of selling family heirlooms and other valued property in a moment of desperation. Your grandmother's diamond ring and your grandfather's Purple Heart from World War II have special meaning for your family. Hold onto them.

Fourth best option: borrowing. This isn’t a good idea when your ability to repay is diminishing. Borrowing when times are hard increases your financial risk even if it reduces immediate pressures. You’ll have to pay back the loans, or be in a worse situation. But if the first three options aren't available, borrowing may be necessary.

Use credit cards, but only as much as is essential. Borrowing from a credit card is expensive, especially if you take cash advances.

Borrow home equity. But banks are rolling back home equity lines of credit, especially for people living in areas of declining real estate prices (which means most of the populated areas of the United States). If you can borrow under a home equity loan or line of credit, it will be cheaper than credit card debt. But be darned sure you can repay the loan. Otherwise, you’ll lose your home.

Borrow against your 401(k) account. This isn’t good for your long term retirement finances, because it slows down the compounding of the assets in the account. Interest rates on these loans usually aren't high. But the interest rate isn’t the only price you pay. Reduced retirement savings is also part of the equation.

Fifth best option: cashing out your future. These options are the most costly and the least desirable. Take them only if you’re desperate. You’ll be tapping into resources meant for the future, so you’re cannibalizing your future well-being for present needs.

Early withdrawal of retirement savings. You can do this from an IRA or a 401(k) at a former employer (the 401(k) at your current employment can't be withdrawn while you still work there). But you'll have to pay income taxes and a 10% penalty on the amounts withdrawn. It’s a very costly way to get cash, and you’re making your retirement less golden.

Take out a reverse mortgage. This option is available only if you’re 62 or older and own a home. These mortgages don’t have to be repaid until you’ve permanently moved away from the home or sell it, or have passed away. That’s an advantage. However, they come with high fees, and may well eliminate any inheritance from the home that you hoped to leave for your heirs. And once you take out a reverse mortgage, you will have difficulty ever again borrowing against your home. So think things through carefully before taking out a reverse mortgage. (And never take out a reverse mortgage in order to invest in something else; use it only to get money for living or medical expenses.)

Sell your life insurance policy, structured settlement, and other future stream of income. There are companies that buy rights you may have to future income. The type of assets they buy include life insurance policies, structured settlements (i.e., legal settlements from claims for injuries, which are paid out over time) and even lawsuits that haven’t been resolved yet. The buyers in these situations pay sharply discounted prices, and you should hire a fee-only financial planner to review the proposed terms and any other options you might have. A financial planner costs money at a time when you don’t have much money. But it would be money well spent, because the buyers of these assets are financial pros who are out to profit at your expense. Protect yourself and get professional advice.

Sell future appreciation in your home. This is a type of deal where a company pays you cash in exchange for, say, half the future appreciation in the value of your home. These deals are also expensive for you, and you should get advice from a fee-only financial planner before signing up for one of them.

Payday loans. These are short term loans, made a week or two before your paycheck arrives, and are repaid from your paycheck. You get the amount remaining after the payday lender takes its share. Its share will often include a very high interest charge (sometimes equivalent to over 100% per year). Avoid payday loans like the plague. Borrowing from a credit card is a bargain by comparison.

Sunday, June 1, 2008

The Next Wave of Mortgage Losses

A deceptively simple rule of accounting is that a bank or other company doesn't have to record a loss unless the loss belongs to it. This seems obvious enough. Why should one have to record a loss that belongs to someone else?

But as with so many other things in the mortgage crisis, there's more to this notion than meets the eye. There were many players involved in the process of creating mortgages, mortgage-backed securities, and CDOs and other alphabet soup derivatives backed by mortgages. These included borrowers, mortgage brokers, mortgage bankers, investment banks, investors, credit rating agencies and government sponsored enterprises like Fannie and Freddie. The process was complex at all levels. Borrowers were of uncertain creditworthiness and appraisals may have been inflated. Mortgage payments were unpredictable in amount after an initial teaser rate. A plethora of fees designed to enrich middlemen without necessarily providing borrowers with anything of value increased burdens on homeowners. Bankers didn't do enough to verify the limited borrower information that came their way, apparently figuring that since they didn't plan on bearing the risk of default, there was no point to being fussbudgets about prudence. Investment banks underwriting mortgage-backed securities and derivatives were too busy booking fee income to think through the risks they were taking. Investors were promised that AAA-rated investments could be created from subprime debt, an alchemy that credit rating agencies too readily believed in.

Complexity such as this creates fertile ground for efforts to pass the buck. Lenders try to impose losses on borrowers by foreclosing and then pursuing borrowers for any remaining unpaid debt. Borrowers refuse to pay and make claims against mortgage brokers and lenders for deception and other alleged unfairness. Investors make claims against investment banks for overstating the qualities and understating the problems of derivatives and/or the mortgages underlying them. Investment banks, mortgage banks, mortgage brokers, and credit rating agencies, faced with claims from many directions, become well-practiced finger pointers. With all the complexity, confusion and finger pointing, a bank or other company may be able to avoid owning up to losses for quite a while.

However, the unbooked losses here may run into the hundreds of billions--too big for people to just swallow and move on. They will be pursued until they're settled or resolved by a court. That process is ongoing, with some results emerging. A bankruptcy judge in Oakland, CA recently ruled that when borrowers inflated their incomes in an all too obvious way and the bank did not follow its own guidelines for evaluating the borrowers' stated income, the bank would not be allowed to collect the unpaid mortgage debt remaining after foreclosure. The bank, it would appear, was deemed to have been irresponsible in the way it made the loan and would not be allowed to collect anything beyond the collateral. This case could have gone either way, since both the borrowers and the bank could be said to be at fault. The judge chose to put the loss on the bank. Given the large number of no doc, liar and similar loans made by mortgage brokers and bankers in recent years, widespread judicial application of the principle underlying this decision could result in significant additional losses for banks.

Investors in mortgages and mortgage-backed investments have been trying hard to make lenders repurchase loans that go into default. Repurchasing in effect places the losses of default and foreclosure on the lenders, not the investors. While the lenders may not be required to repurchase all defaulting mortgages, they could easily get stuck with the ones where fraud or deceptions on the borrowers occurred, or where mistakes in the loan underwriting process were made. That could amount to a lot of mortgages. Investors like Fannie and Freddie are facing potentially big hits, and are pushing back vigorously. Bond insurers, who might also be on the hook for mortgage defaults in mortgage-backed investments they've insured, are also passing the hot tamale as much as possible.

Millions of adjustable rate mortgages are re-setting this year, producing even more defaults. The credit rating agencies now review mortgage-backed investments on a continuing basis. As the underlying mortgages get hinkier and hinkier, the ratings on these investments could be lowered. Every time they are lowered, more losses are suffered.

Some high ranking government officials and pundits have recently made soothing noises about the mortgage crisis. Be cautious about believing them. As legal processes proceed and claims are resolved, unbooked losses from the mortgage crisis will be allocated and recorded. That won't be a pretty process.