Sunday, November 30, 2008

The Economic Crisis: Trading on Expectations

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

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

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

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

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

Tuesday, November 25, 2008

Are We Headed for a Depression?

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

Reasons to Expect a Depression.

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

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

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

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

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

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

Reasons Not to Expect a Depression.

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

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

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

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

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

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

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

Sunday, November 23, 2008

Searching for a Market Bottom

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

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

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

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

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

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

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

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

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

Wednesday, November 19, 2008

A New Crisis for the Financial Crisis: The Presidential Transition

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

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

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

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

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

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

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

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

Friday, November 14, 2008

What Might a GM Bankruptcy Look Like?

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

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

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

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

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

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

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

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

Thursday, November 13, 2008

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

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

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

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

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

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

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

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

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

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

Sunday, November 9, 2008

Enlist Private Capital to Combat the Economic Crisis

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

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

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

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

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

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

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

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

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

Thursday, November 6, 2008

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

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

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

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

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

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

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

Wednesday, November 5, 2008

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

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

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

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

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

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

Monday, November 3, 2008

Can the Federal Reserve Handle the Volatility?

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

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

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

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

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