Tuesday, December 29, 2009

The Revival of the Bank of the United States

The U.S. government is, for all practical purposes, becoming the most important bank in America. Two recent measures demonstrate the point. First, the Treasury Department announced yesterday that it was lifting the $200 billion limit it had previously placed on the funding it would provide to each of Fannie Mae and Freddie Mac. It will now back those two firms without limit. Admittedly, $200 billion is pocket change these days, with our multi-trillion dollar federal debt and all that. But the absence of any limit now means that for all practical purposes, the federal government, through its cheery sales staff (Fannie, Freddie, Ginnie Mae and the FHA) is responsible for virtually all the mortgage loans in America. Okay, the government is technically guaranteeing the loans, not funding them. But without the government (and taxpayers) being on the hook for defaults, there would be hardly any mortgages. The government makes today's real estate market (however weak it may be) possible.

Second, the Federal Reserve announced yesterday a new measure to "withdraw" some of the accommodative flood of liquidity it spewed into the financial system over the past year. It will offer interest bearing term deposits (equivalent to certificates of deposit) to member banks. These deposits will take cash out of the financial system for the length of the term, so there is a temporary reduction of liquidity. But what happens when the term ends? The deposit goes back to the member bank, where as part of the money supply it could have inflationary impact.

Why doesn't the Fed simply take back some of the cash it printed and sent out into the financial system? It hasn't said. Remember that much of that money was used to buy asset-backed securities and U.S. Treasury securities. One suspects that the reason is that it can't find buyers for those assets, not without pushing interest rates higher than it wants them to go. Thus, the Fed won't reduce its balance sheet (just as it wouldn't with its previously announced reverse repo idea; see http://blogger.uncleleosden.com/2009/12/will-feds-reverse-repos-reverse.html). The Fed will continue as a major financier of asset-backed securities and U.S. Treasury securities (the latter being really weird because it means the government is printing the money it "borrows" and spends; that would be a pure money print in any place except a rabbit hole).

One also suspects that another reason for the member bank term deposit idea is that these accounts would be treated as part of the bank's capital for regulatory purposes. The banks all know that higher capital requirements are in the picture. If they had to buy, say, U.S. Treasury securities in the bond markets to meet those requirements, they might push interest rates up. By offering special CDs to member banks only, the Fed allows them to meet capital requirements without having to roil the Treasury securities markets. In other words, the federal government would appear to be providing special funding to capitalize banks while keeping interest rates lower.

We've already proposed that Fannie and Freddie be reconstituted as nonprofit organizations whose public purpose would not be entwined with private, profit-seeking shareholder interests that distort incentives. See http://blogger.uncleleosden.com/2009/12/fannie-and-freddie-dont-privatize-them.html. Yesterday's announcement by the Treasury Department that it was lifting its ceiling on federal assistance boosted Fannie's and Freddie's stock prices by about 20% over the last two days. This was a nice belated Christmas present to the speculators who probably comprise most of Fannie's and Freddie's shareholders. But what about the taxpayers, who so generously now guarantee assistance without limit to Fannie and Freddie? They get lumps of coal, as far as we can tell.

There are good reasons for government intervention in times of crisis and panic. But growing mission creep is turning the government into another Bank of the United States. There were two Banks of the United States in the late 18th and early 19th centuries. The federal government twice created a national bank in order to provide financial services on a larger scale than it thought private banks of the day could handle. But the charter of the Second Bank of the United States was allowed to expire by President Andrew Jackson, out of concern that the Bank favored commercial interests of the East Coast, to the detriment of rural interests and the Western states (those now called the Midwest). This may ring bells in light of present day concerns that the federal government is too attentive to Wall Street while ignoring Main Street.

When the government supersedes private industry, market principles become diluted by politics. This isn't wrong by itself. Taxes, police and fire protection, national defense, social safety nets like unemployment compensation, workers compensation, Social Security, Medicare, Medicaid and so on all represent political solutions to problems that market principles were thought to handle poorly. But if the federal government is going to become the most important bank in the country, then we should have a serious, explicit discussion about how it will allocate credit--instead of today's quiet, step-by-step mission creep--and why so much federal support should be given to humongous private banks that compensate their executives munificently but lend so little the government needs to step in and lend in their place at the expense of the soon-to-be-more-heavily-taxed citizenry.

Saturday, December 26, 2009

Japan: 20 Years of Lessons for America

On Dec. 29, 1989, the Nikkei 225, Japan's stock market benchmark, closed at an all time high of 38,915.87. On Friday, Dec. 25, 2009 (a trading day in Tokyo), the Nikkei 225 closed at 10,494.71. It's been lower, with a post-1989 low of 7,603.76 in April 2003. That's about an 80% drop, not quite as bad as the Dow Jones Industrial Average's 89% drop during the Great Depression but still pretty awful. An investor who bought the Nikkei 225 at its peak would have a 73% loss today.

Japan's economy was the world's most impressive from 1960 to 1989. In the 1960s, it grew at a rate of about 10% a year, comparable to China today. In the 1970s, it grew at an annual rate of 5%, and in the 1980s, 4% a year. The slowing growth rate reflected the maturation of the Japanese economy, but not decline. In the late 1980s, Japanese investors bought American icons like Rockefeller Center and Columbia Pictures. Many viewed Japan as an unstoppable economic juggernaut.

The 1980s Japanese stock market bubble, and a concurrent real estate bubble, were attributable to the ready availability of cheap capital stemming from Japanese government policies that encouraged saving and low interest rates. The combination of the two led many Japanese to speculate in stocks and real estate. If this sounds familiar, then look at the late 1990s and the 2000s in the United States. There is an eerie resemblance, with the Federal Reserve using monetary policy to ensure a steady supply of cheap capital.

Like all assets bubbles, the Japanese stock and real estate markets popped eventually. The Japanese response also resembled America's response to the 2007-08 financial crisis: all government all the time. Banks were propped up as their accounting standards were relaxed. Losses were swept under the carpet while banks stopped lending. Fiscal discipline evaporated and government deficits ballooned. Government cash handouts to consumers provided temporary stimulus.

But none of it did much lasting good. Japanese economic growth slowed dramatically after 1989, down to the range of 1% to 2% on average. Japanese unemployment levels rose, and remain high. The Japanese social safety net, much of it based on the lifetime employment policies of large companies, frayed. The Japanese consumer, already cautious, became yet more thrifty. Once a mecca for the world's fashion brands, Japan today is singlehandedly causing a depression among European fashion companies. The Japanese economy shrank by 0.7% in 2008 as a result of the world financial crisis and likely has shrunk by more in 2009.

A natural question is whether the U.S. is headed for anything like Japan's 20 years of stagnation. It has suffered a painful stock and real estate market crash, not as proportionately large as Japan's, but nevertheless the worst since the Great Depression. The U.S. government has responded faster than Japan's, but in much the same way--bailouts and grade inflation (in the form of relaxed accounting requirements) for banks, a surfeit of deficit spending, a trillion dollar plus money print by the Fed, and cash given one way or another to consumers. The private sector response has also been similar. Japanese banks didn't make new loans, because of all the bad loans they didn't have to write down. The Japanese government liquidity that was dumped into the economy found its way to investments in Japanese government debt (i.e., the Japanese trusted only their government and wouldn't make private sector investments), and the carry trade, where yen were swapped for higher yielding currencies (like the U.S. dollar) and invested overseas. Today, U.S. banks don't make new loans because they still hold a lot of bad loans and cranky assets. Vast shiploads of the U.S. government's stimulus money is flowing into the carry trade and going overseas, or is being used for commodities and stock speculation. Some of the money loaned by the Fed to U.S. banks is being invested in U.S. Treasuries or is left on deposit at the Federal Reserve Banks. The net effect of these circular transactions is the outright transfer of money by the U.S. government to banks (in the form of interest payments less the minimal costs of banks borrowing from the Fed) for no reason other than that they are member banks.

In short, sloshing a lot of money around is a poor substitute for dealing with economic fundamentals. One begins to suspect that the Fed's and Treasury's secret intention is to stall for time in the hope that the economy somehow recovers. But evidence of recovery is limited, and such that exists indicates a slow recovery. The U.S. stock markets have risen some 60% since March 2009. But the Nikkei 225 also had sharp spikes during its secular decline of the last 20 years. Today's bulls seem to assume that because the market has been on a tear recently, it will always and forever rise. There evidently is no bull market on the learning curve.

The Japanese experience of the last 20 years contains a couple of noteworthy lessons. First, monetary policy doesn't have much impact when the financial system is dysfunctional. Pumping vast amounts of cash into banks and other financial firms has little benefit for the real economy if the cash is siphoned off into commodities and stock speculation, the carry trade, U.S. Treasury securities, or is held in anticipation of having to write off losses banks have been allowed to defer. The velocity of money--or rate at which it turns over--is effectively zero when the cash simply is sent back to the government, as is the case when American banks take federal assistance and invest it in Treasury securities or deposit it with a Federal Reserve Bank. For the velocity of money to be positive (a predicate to effective monetary policy), new loans need to be made. That's been mighty slow to happen.

Second, zero or ultra low interest rate policies won't necessarily spark an economic revival. Indeed, they may be unproductive. When the cost of borrowing is virtually zero, a lot of basically stupid activities begin to make mathematical sense in an ROI (return on investment) analysis. Thus, a lot of the federal stimulus has gone into commodities and currency speculation. Or else it has been used to gamble in stocks when the price-earnings ratio is signalling with a big, bright yellow light (see http://blogger.uncleleosden.com/2009/12/warning-from-price-earnings-ratio.html). Asset speculation won't revive the real economy. At the same time, savers--especially retirees who live on interest from their assiduously accumulated CD's--embrace thrift more than ever, reducing consumption when consumption is most needed by the economy. It's one thing to reduce the fed funds rate to lower banks' costs of borrowing in order to motivate them to lend. But when they won't lend because their books are full of rotten-to-the-core assets, reducing interest rates only cuts consumption without increasing lending. The Fed may be pushing things backwards.

Huge government deficits and big money prints can stave off a plunge into depression. They did in Japan, and they have in America. But they won't produce prosperity. That's the lesson that Japan of the last 20 years teaches, and the one that America hopefully learns before suffering 20 years of stagnation itself. Raising interest rates would impose at least the beginnings of investment discipline resulting from an actual cost of capital, which in turn would lead investors to question the wackiness of some of the stuff that's now au courant. Perhaps some funds would even be put to use in the real economy. Even if GDP growth were muted in the short term by increasing interest rates, money invested more intelligently could lay the foundation for long term growth. If Wall Street won't serve the socially valuable purpose of intermediation between savers and economic investment (as opposed to financial speculation), it should be bypassed. Stimulus money could be used for job creation and funding Main Street, as the Obama administration has lately proposed. From massive subsidies for the Erie canal and transcontinental railroad, to mail delivery contracts for nascent airlines, to investment tax credits and job creation measures of every stripe and variety, governments have intervened in the economy for the public welfare. Why stop now? Conservative purists and theorists would object, but their guys, Alan and W, really screwed things up. Why listen to a bunch of failures?

Additionally, immigration standards should be relaxed for highly educated workers from other countries that could bolster America's high tech and other industries. Taking other nations' intellectual capital provides a competitive boost of the first order. Those seeking to come here are ambitious and hardworking. They're exactly the people needed to revive the economy.

There are good reasons for the Fed to pull back from its unprecedented liquidity dump of the last year. But that's not enough. The Fed should impose much more stringent bank capital requirements. It should also make banks book the losses that remain swept under the carpet and greatly improve their risk management controls. Capitalism works only if responsibility and accountability are part of the picture. The government, by intervening, prevented market forces from imposing full responsibility and accountability on Wall Street. The government's subsequent kind and gentle treatment of the reckless few, who caused so much harm to so many, leaves open the possibility of future morasses. Such morasses have been Japan's experience for the last two decades, and they portend America's future unless risk, as well as reward, falls on the high and mighty along with everyone else.

Tuesday, December 22, 2009

Has America Lost Its Optimism?

Commentators, often on the op ed pages of more conservative publications (think the Wall Street Journal) are wont to say that America is losing its optimism. People no longer have hope for the future. They don't see how the country can recover from its current problems. Predictions are made for a permanent increase in unemployment levels and economic weakness.

This moodiness seems to spring from a sense of loss of control. As America grew and prospered, its citizens became powerless and dependent. The Industrial Revolution of the 19th Century fractured the extended family by pulling children to distant cities in search of jobs, often hundreds or even thousands of miles away from their parents and siblings. People became employees, usually paid enough to support themselves and perhaps their nuclear families. But they lost the means to self-sufficiency (i.e., ownership of farm land). Their continued prosperity depended on the success of the businesses for which they worked.

The financial system made people even more dependent by increasing access to credit. As wage and salary paying jobs created the appearance of a stable income, the extension of credit seemed less risky. If the borrower got a steady paycheck, the means to gradually repay loans seemed assured. Unlike farmers, whose ability to repay debt depended on the uncertain success of their crops, an employee with stable employment could pay according to a schedule. Put some numbers on paper, apply some middle school math, and debt looked like just another expense. Banks made it easier and easier to borrow more and more. Everything would have worked out fine if everyone stayed employed and paid their debts.

We now know it was all an illusion. Just like farming, modern economic enterprises have good times and bad times. Weather, locusts and other pests, diseases and a host of other unpredictable and uncontrollable factors can wreck a crop. Similarly, today's average citizen can lose a job for a host of reasons beyond his or her control, or even comprehension. A couple of years ago, who would have thought that the recklessness of a small group of mortgage lenders and derivatives dealers, together with an utter failure of risk management at a few large banks and other financial institutions, could throw most of the industrialized world into a major recession and send millions of workers in numerous industries into the ranks of the unemployed?

Today, almost no one has a family farm to go back to when times are tough. Modern income levels aren't high enough for siblings or parents to step forward and help much if one loses one's job. A government safety net keeps many off the streets for a while. (See http://blogger.uncleleosden.com/2009/07/survival-kit-for-layoffs-and.html.) But America doesn't provide an iron rice bowl--and neither does China any longer. Ultimately, we're each on our own. And given the unpredictability and, indeed, flat out incomprehensibility of matters economic, it's not surprising that some are losing faith in the future.

Hope, though, springs eternal, and not without reason in America. This is the nation of second chances, where innovation and risktaking are admired and encouraged. Failure here doesn't have to be permanent, not in a society where everyone can recreate themselves and try again. America was founded on dreams, and declared independence so that its citizens could pursue happiness. America today continues to embrace dreams and dreamers, and nothing drives economic growth as much as unvarnished aspiration.

Of course, we can't depend solely on cheerful talk. Reality must be dealt with, in government and business. The financial system, source of so many of today's economic problems, needs a substantial fix and soon. Much more effort must be put into getting people on Main Street back to work. That large and longstanding open wound on the body politic--access to health insurance coverage--must be healed. Wars should be limited and avoided. Many major empires--Roman, Byzantine, Spanish, and British--fell in large part because of the costs of warfare.

In the near term, the future may be uncertain. The economy seems to be recovering, and the stock market has rebounded to 1999 levels (we still have a decade of no gains). But these gains are built on the thin and potential weak foundation of lots of government spending and a whopping huge money print by the Federal Reserve. The 1999-2000 tech stock crash and the 2007-08 mortgage and credit crises teach us that when the economy and stock market rest on weak foundations, they will decline.

But over the longer term, the forces that propelled America out of the many recessions and depressions in its economic history remain intact. Most importantly, other nations just don't accommodate dreamers and innovators like America. This nation has market dominance in those respects. And like any company with market dominance, its chances of future success remain very good. Don't lose hope. Happy Holidays.

Sunday, December 20, 2009

Lumps of Coal

Christmas lumps of coal came early for some this year:

Bernie Madoff, who will spend the rest of his life in prison.

GM’s former management. Rick Wagoner, Fritz Henderson, and other old timers in the executive ranks lost their jobs after many years at GM. It’s hard to say they didn’t deserve it, especially Wagoner for betting GM and its employees’ prosperity on the price of oil. It’s one thing if you take all of your personal savings and put it on a single roll of the dice. But if you’re responsible to millions of shareholders and employees, a touch of prudence and at least the first draft of Plan B are good management strategies. Let's hope the telephone guy now in charge at GM has some good ideas.

Sovereign debt holders. It began with Dubai and its grandiose ambitions, which ultimately rested on wishful hoping. Now the illness has spread to Greece, Lithuania, Iceland, Latvia and other small European nations. Some of these troubled countries are members of the Euro Zone, and the wealthier members of the European Union are imitating Alphonse and Gaston as they try to figure out how to pass the hot tamale. They talk about IMF assistance to the beleaguered. Look for quiet increases in support for the IMF from the bigger Euro bloc nations. They know some sort of bailout is likely, but would want a circumspect way of funding it.

The Republican Party, which finds itself riven by tea parties and inquisitional undercurrents. Its struggle to redefine itself is understandable in light of the drubbing it took in the 2008 presidential election. The internecine nature of the feuding could cripple the party for years to come.

Tiger Woods. By all indications, he’s an intelligent guy whose story seems more like Eliot Spitzer’s than the typical celebrity-cheating-on-his-wife tabloid fodder. As with Spitzer, you have to wonder how Tiger could have figured he wouldn’t be caught. Tiger’s evidently taken a page from Spitzer’s playbook, disappearing until things cool off. Then, like Spitzer, Tiger will try to rehabilitate himself. Given his tremendous athletic ability and pro golf’s need for television revenues, chances are he’ll succeed. But Tiger’s done us all a favor by re-affirming, however unintentionally and indirectly, that integrity matters. With American culture having morphed from its pioneer, yeoman farmer roots to a social networking frenzy of marketing, image and popularity, it’s reassuring that integrity, along with thrift and prudence, still mean something. In spite of all the economic wreckage, there’s hope for America.

Tarek and Michaele Salahi, the White House party-crashing self-promoters whose notoriety seems to have hurt them more than it helped. If so, that would be a rare instance of 15 minutes of fame turning out badly in a celebrity-obsessed nation.

Let’s hope Santa has some extra lumps, because just deserts remain to be given to:

Bernie Madoff, because what he did deserves much worse than life in prison. At a minimum, his only prison jobs should be cleaning bathrooms with a toothbrush and collecting trash with a 1-quart plastic bag.

Senator Chris Dodd, for his lousy financial regulatory reform proposal. It would put way too much power in one place—a new super regulator for banks—while seriously weakening the FDIC, the one federal regulator that spotted the iceberg before the economy smacked into it. We are again reminded that Washington’s guiding principle is no good deed will go unpunished. Senator Dodd may be rethinking his proposal, and we hope he does.

Big taxpayer-subsidized mega-bonus-paying banks that don’t make new loans. The highest living welfare queens in American history, the big banks pay stupendous bonuses while pulling credit lines from consumers and small businesses. They prosper at public expense as unemployment reaches the highest levels in over 25 years. Yet they need serious parenting to learn the concept of gratitude. Most 2-year olds can be taught to say “thank you," but not, it seems, the best paid bankers.

Obstructionist Republicans in Congress. The Republicans’ only “strategy,” if you will, is to obstruct whatever the Democrats are trying to do. This may be in keeping with their special talent for going negative in political campaigns. But the American people won’t ultimately be won over by the Calvin Coolidge take-a-nap-every-afternoon style of governance, not in a time of privation and crisis. There’s a reason why FDR was elected to the White House four times in a row: he was a doer, not a naysayer.

Wednesday, December 16, 2009

Fannie and Freddie: Don't Privatize Them Again

For all practical purposes, Fannie Mae and Freddie Mac now belong to the federal government. They were taken over by the government in the late summer of 2008 and remain under federal control. There has been discussion of re-creating them as private entities with some federal participation (in the form of guarantees of mortgage-backed securities they issue) and a lot of regulation, including profit limitations.

This is weird. The problems at Fannie and Freddie stem to a large degree from their mixed private-public nature. They ostensibly were privatized, but investors assumed that they were implicitly backed by the government. Fannie and Freddie took undue advantage of that assumption and seized a very large part of the mortgage market. They had a competitive advantage from their presumed implicit government protection, and could outcompete truly private mortgage lenders. They used some of their copious profits to hire the biggest lobbying guns in Washington to stave off meaningful regulation and effective private sector competition. By becoming so large with the benefit of a presumed government safety net, they made it unavoidable that the government provide them with a safety net. Yet the profits from their salad days went to their private shareholders and high level executives. Taxpayers only got to hold a bag with some really stinky stuff in it, while their homes sank in value.

Since the 1930s, promotion of home ownership has been a federal policy. Fannie Mae was created in 1938 as a federal mortgage financier, and was publicly owned for 30 years. In 1968, Fannie Mae was privatized, to remove it from the federal balance sheet (and thereby lower the apparent amount of debt carried by the federal government). In 1970, Freddie Mac was created as a private entity whose mission was essentially the same as Fannie Mae's, in order to compete against Fannie Mae. (This was an early sub silentio admission that private mortgage lenders couldn't effectively compete against Fannie.) While these two behemoths were not explicitly included in the federal government's balance sheet, it had to continue backing them up, if only because the market believed it would. Thus, Fannie and Freddie always existed to serve governmental policies and have always been liabilities of the government, regardless of what did or did not appear on the federal balance sheet. The 2008 bailouts and takeovers of Fannie and Freddie only reinforce this reality.

We can't take the federal out of Fannie and Freddie. So we should take the private for profit interests out of them. Doing so would rationalize the way they operate. They'd no longer have the incentive to dominate the mortgage markets in order to pump up their revenues and balance sheets to satisfy the demands of shareholders for ever increasing share prices. Their executives would no longer obtain pecuniary benefits from using aggressive accounting to boost bonuses and stock prices, as was the case in the late 1990s and early 2000s. Nor would they hire droves of expensive and influential lobbyists to protect their franchises from both private sector competition and prudent federal regulation. Shareholders would not profit while taxpayers bore losses.

Fannie and Freddie should be reorganized as nonprofit entities, similar to the Federal Reserve Banks. Mortgage lenders that want to do business with Fannie and Freddie would become members and would capitalize them, like the member banks of the Federal Reserve system. Their boards should have a majority of public members. Current shareholders should be bought out at prices reflecting the ocean of losses the Fannie and Freddie have inflicted on taxpayers.

Such a structure would not impede the flow of capital into the housing markets. Indeed, by making federal backing for Fannie/Freddie underwritten mortgage-backed securities all the more clear, capital would flow more readily. For a point of comparison, look how easily capital flows into U.S. Treasury securities, notwithstanding their very low interest rates.

By removing private profit-seeking interests from Fannie and Freddie, we restore to public control entities that exist primarily to serve public interests. The 30-year mortgage is a creature of government policy--before Fannie, mortgages tended to be in the range of five years, with a 50% downpayment. Fannie was created specifically to make the 30-year mortgage available, and the arguments for continuing federal participation in Fannie and Freddie revolve around the need to ensure the availability of inexpensive 30-year mortgages. While public ownership and control aren't panaceas--it's easy to think of public programs that have been screwed up--the opportunities for private profit made the problems at Fannie and Freddie much larger than they would have otherwise been.

The federal government, through Fannie and Freddie, the FHA, Ginnie Mae, tax deductions and credits, Federal Reserve purchases of mortgage-backed securities, and other measures, has staged a enormous, gigantic, gargantuan intervention in the housing markets. America's capital has been steered toward housing and away from other investments. This intervention won't end; indeed, with the current housing slump, it's becoming even more extreme as buyer tax credits extend and expand. The wisdom of public subsidies for housing can and will be debated until the end of the republic, because that's how long they'll exist. But we can at least eliminate the potential for private profit at taxpayer risk--and the increased distortion of the mortgage markets it can create--and restore what has always been a public policy to public status.

Sunday, December 13, 2009

How the Tea Parties Are Helping the Democrats

With the Tea Parties surging as the loudest manifestation of populist outrage, many Republicans are crowing and a few have already proclaimed victory in the fall 2010 Congressional elections. Tea Partiers are trying to organize on a national level, although the very attempt to organize is exposing schisms among them. Republican power brokers, struggling with demands for ideological purity, blanch at the thought of the partying hordes. The worst case scenario for them is the possibility of a takeover by a heresy-hunting rabble that marginalizes the party. In the smoothly disciplined corporate world of mainstream Republicanism, the rank and file are supposed to provide votes and funding, not ideas and commentary.

Unnoticed amidst the shouting and spouting is how the Democrats have moved quickly to strengthen their positions. President Obama is ramping up troop levels in Afghanistan, seeking to justify war even as he receives the Nobel Peace Prize. He's much more cautious than a year ago about what to do with the inmates at Guantanamo. By all indications, he's got nary a peep about the rapidly disappearing public health insurance option. His Wall Street centric economics policy team has suddenly discovered the joys of helping small business and creating jobs.

Congress, too, is trying to get right with the electorate. A turbocharged push on health care reform has resulted in serious action; a bill will probably reach the President well before the 2010 elections. As popular anger at Wall Street has mounted, financial regulatory reform was approved this past week by the House. The big banks are p.o.'d, something that will play well on Main Street.

A crucial factor in today's political mosh pit is that the Democrats control the White House and both chambers of the legislature. Unusually, they can muster 60 votes in the Senate and overcome Republican attempts to filibuster. Thus, the rarest of all circumstances exists in Washington: a government that can actually get things done. And it is.

President Obama and Congress are shifting back toward the middle, accommodating the independents who put them in power. The President's Afghanistan strategy is particularly revealing. By authorizing more troops, he undermines the charge of being soft on terrorism. He has persuaded America's allies to furnish about 20% of the additional troops, thus avoiding the international irritation of W's go-it-alone policies. The 18-month time frame for beginning withdrawals conveniently falls after the fall 2010 elections, so voters won't feel as if they are voting for or against the war. Hopefully, the President's Afghanistan policy will produce something approaching a victory in the war. It is clearly designed to help win the 2010 elections.

Dismayed liberals in the Democratic Party have a lot to say, but not that much they can do. Indeed, their complaints complete the portrait of a President and Congress for the broad electorate.

Some Democrat losses in the Congressional elections of 2010 wouldn't be surprising. The dominant party always loses something in mid-term elections. But Republican proclamations of triumph are premature. If the President and Congress retake the political middle, the Democrats will be able to sit back and watch as the Savonarolas of the right burn their fires hotter and hotter.

Wednesday, December 9, 2009

Is America Ready for Britain's Banker Bonus Tax?

The British government has just announced a one-time 50% tax on banker bonuses. This affects all banks in the U.K., including subsidiaries of foreign banks. Only bonuses larger than 25,000 pounds (about $41,000) are subject to the special tax. This and other British government limitations on bonuses send a pretty clear signal that the Labour government of Prime Minister Gordon Brown will keep a heavy regulatory hand on banking while recovering through taxes some of the $1 trillion or so in assistance the British government provided to banks.

In the U.S., Bank of America announced that it will repay all of the $45 billion in financial aid it received from the TARP program. Among other things, this will free up B of A from the executive compensation limitations imposed by TARP and from paying the U.S. Treasury dividends on B of A preferred stock it owns through TARP. Much of B of A's ability to make this repayment is because of the extensive federal support given to banks, courtesy of the taxpayers. The Fed has funded the banks at a cost of virtually zero, and banks in many instances used that ultra cheap money to invest in U.S. Treasury securities or mortgage-backed securities effectively guaranteed by taxpayers. In other words, B of A is in part repaying TARP money with funds that it directly or indirectly received from taxpayers. The Treasury Department will probably put this down on its TARP scorecard as repayment in full, but how that could be when taxpayers provided some of the money that they received in "repayment"?

It would hardly be unprecedented for taxpayers to receive the short end of the stick. But they may also be receiving the short end of Britain's stick. The British tax on banker bonuses is a not very well-disguised way of inviting banks in London to reduce their riskier activities or move them out of the U.K. Risky activities generate enormous profits, and consequently gratifying bonuses. Since profits are the source of outsized compensation, bankers would move the risky stuff somewhere else and earn their mega bonuses there, before reducing their gaggle of golden egg laying geese.

The U.S. may be a logical place to shift the risky stuff. Financial regulatory reform is gradually slipping down the administration's list of priorities. Virtually all the changes that have been or are being made are the result of administrative and regulatory measures taken by the existing body of agencies (i.e., the Fed, FDIC, Treasury Dept., SEC, CFTC, etc.). Reform of the derivatives markets is taking place to a large degree through industry measures to improve the settlement and clearance process (with stern encouragement from regulators). The bigger issues of monitoring systemic risk and greater transparency in the derivatives markets are stalled in rush hour traffic, as health care reform and federal budgetary matters take front row seats, with a Congressional debate over the wisdom of President Obama's Afghanistan policy close behind. Riskier financial activity could quietly slip across the Atlantic and settle in, with little immediate oversight by the federal government. The American taxpayer might soon again be on the hook for another AIG-type monster bailout, and not even know it until too late.

The problem rests with the too-big-to fail-doctrine, where large financial institutions have the incentive is to conduct risky activities--somewhere--instead of be prudent. The individuals involved in high-octane financial activities rarely lose even if the crazy stuff they do is so systemically bad the federal deficit has to be almost doubled to salvage the economy. Bankers are incentivized to shift risky activity to new venues if they get the boot. Prudence doesn't finance yachts. And if the government--and taxpayers--will absorb the cost of bankers' failures, then all the better (from the bankers' standpoint).

Governments in continental Europe, Canada, and Asia won't welcome derivatives traders gone wild. America is the one remaining major economic power with the infrastructure to support fancy finance. Britain could, in effect, be exporting some of its most difficult financial regulatory problems. And the American taxpayer may be left holding the bag.

Sunday, December 6, 2009

Is the Federal Reserve's Free Ride Ending?

The announcement on Friday, Dec.4, that the unemployment rate had fallen slightly from 10.2 % to 10 % surprised many, and perhaps dismayed some at the Fed. At its Nov. 3-4, 2009 meeting, the Fed announced that it expected to keep the fed funds rate at "exceptionally low" levels for an "extended period" of time. That announcement helped to fuel stock and commodities prices for the month of November. But after Friday's announced unemployment drop, stocks closed with only a modest gain, gold fell 4%, oil fell a little over 1% and the 10-year Treasury note fell about 0.75% in value (with an increase in yield of about 10 basis points). The dollar rallied.

These market reactions were spurred by the implication that the Fed will have to raise interest rates sooner than it expected. An interest rate hike would strengthen the dollar, reduce the value of gold, and push bond yields higher (and bond prices lower). The price drop in oil--seemingly odd because a recovering economy would be expected to consume more oil--is a reflection of the asset bubbling spurred by the Fed's cheap money policies. The huge amounts of cash pumped by the Fed into the financial system pushed down the dollar, thereby making oil more valuable in dollar terms. If the Fed begins to pull back on its accommodation, thereby strengthening the dollar, oil prices in dollar terms would naturally abate.

The Fed's predictive powers have been demonstrably lacking. It failed to see the implications of the growth in the mid-2000s of looney mortgages (the kind given to people who couldn't repay), the misplaced risks and rewards of the securitization process (where Wall Street made monstrous amounts of money from doing deals--including excessively risky deals, recklessly stupid deals and irredeemably bad deals), the increasing opacity of the financial system's true condition caused by derivatives and then derivatives of derivatives, and finally the monumental blockheadedness of concentrating at AIG credit default swaps insuring hundreds of billions of dollars worth of mostly mortgage-related investments. One wonders whether the Fed has underestimated the pace of the economy's recovery.

On one level, we hope it has. Continuation of the Great Recession much longer could inflict lasting damage to consumers, workers, businesses and investors that might lead to the stagnation that has bedeviled Japan since its massive asset bubble burst in 1989-90. There, people seem to have lost faith in just about everything except the government. This was most recently demonstrated by the Japanese government's cancellation of plans to privatize its postal system (which is not only a mail carrier, but an enormous bank and insurance company). The U.S. government's greatly expanded role in the economy could easily become permanent if the private sector doesn't revive soon.

But a Christmas present in the form of improved economic performance could lead to volatility in the financial markets. A lot of players (they used to be called investors, but today long term investing is about as trendy as a large SUV) have borrowed dollars at cheap, short term rates, converted them into other currencies and invested in longer term plays denominated in other currencies. Or else they invested in oil or oil futures, betting that continued bottom of the barrel interest rates would push oil prices ever higher in dollar terms. Or they took heart from the Treasury securities market's improbable rally this year and the Fed's ongoing trillion dollar program to buy Treasuries and mortgage-backed securities, and used cheap borrowed money to purchase higher yielding long term securities they thought would be propped up by the Fed's massive money print. Or they jumped into the stock market with the hope that the Fed's gusher of liquidity would continue to push stocks higher, even after a 60% rally this year.

All this activity was premised on the Fed correctly foreseeing economic stagnation and keeping short term interest rates virtually at zero, as it publicly proclaimed. If the Fed again turns out to be wrong, and has to hike rates sooner than expected, a lot of free rides will end. The players who have borrowed short and invested long may well have to unwind their positions, learning the hard way that not matching the duration of your borrowings with the duration of your investments entails risk. That could lead to volatility in the financial markets. If the volatility begins to create systemic problems, the credit crunch could again rear its hideous head and banks may again become catatonic. Then we'd probably have the much feared double-dip recession.

The Fed meets again on Dec. 15 and 16, 2009. Don't expect any rate hikes then. But the Fed may be compelled by continuing good news to modify its promise (that's how financial markets players have been viewing it) of ultra low interest rates. If it does, the speculators in the financial markets might have to make painful adjustments (as they probably already are).

Even as the Fed for the past year has given banks and other financial market participants a virtually free ride on borrowed money, it's gotten a free ride in terms of monetary easing. With banks making almost no new loans and pulling back existing credit, no amount of Fed accommodation seemed to have any impact on consumer prices. The Fed could keeping shoving printed money off its loading dock and not pay the price of monetary policy gone wild.

But the law of unintended consequences always lies in wait to ambush federal economic policy. The Fed didn't intend for its monetary easing to stimulate asset speculation here and abroad, even though it should have been sensitized to that risk by its role in the pumping up the real estate bubble. Chairman Bernanke's pledge of greater transparency of the Fed's thinking is a good idea. But when the Fed starts to play that most dangerous game--publicly predicting the future course of the economy and interest rates--it had damn well better be right. Or the rest of us will pay the price.

Thursday, December 3, 2009

Warning from the Price-Earnings Ratio

The price-earnings ratio is one of the most widely used investing metrics. Simply put, it's the ratio of the price of a share of stock compared to its earnings per share. One can use past earnings (typically, the past 12 months), or predicted future earnings (typically, the next 12 months). Past earnings tend to be a more solid number, although they didn't work out real well in the case of Enron, or some other companies that turned out to have fabricated earnings. Predicted future earnings is theoretically a more significant number, since stock values tend first and foremost to be based on anticipated future performance of the company. But one investor's prediction is another investor's fantasy. The accuracy of the prediction makes all the difference in the world.

Low p/e ratios are viewed as indicating stocks are cheap. High p/e ratios are usually taken to mean stocks are expensive and perhaps headed for a fall, or else speculative (i.e., based on the hope of a rise, and perhaps a big rise, in future profits).

By and large, the S&P 500 has a historical average p/e ratio of around 15 (based on past earnings). In the stock market boom of the late 1990s, the S&P 500's p/e ratio spiked up into the 40s. In the late 1990s, the U.S. economy was riding a wave. A huge peace dividend from the end of the Cold War pumped up the private sector as defense spending fell. The United States avoided major military conflicts, and enjoyed large gains in productivity. The economy benefited from cheap money provided by the Federal Reserve (probably too much and too cheap). The Silicon Valley and other tech centers blossomed. The economic outlook was rosy, and avid investors pushed the p/e ratio to 40+. We now know it meant stocks were quite speculative and volatile.

After the 2000-01 tech stock crash, the S&P 500 settled into the mid-20s during the early to mid-2000s. Last year, when the stock market crashed, the ratio dropped to the 15-20 range. Considering how gloomy things looked, a p/e ratio of 15 may have seemed pretty optimistic.

One might argue that this year's stock market rally vindicated last fall's relatively congenial p/e ratio. But the economic picture creates cognitive dissonance. We have a feeble real estate market, rising unemployment, spasmodic job creation, likely federal tax increases, limited ability of the government to authorize more stimulus spending, and an American public scared shirtless into saving. Just about the only thing that explains the 60% rally this year is the relentlessly accommodative Fed, which pumped out printed money like it was beer at a frat party. That money wasn't loaned to Main Street, but had to go somewhere. The stock market was one popular destination.

Today's S&P 500 p/e ratio based on the past 12 months of earnings is 72.83 (see http://online.wsj.com/mdc/public/page/2_3021-peyield.html). That's well above the speculative peak of the tech stock boom. When almost all prognostications for economic recovery are guardedly cautious, or else cautiously guarded, such a high p/e ratio seems to indicate that corporate profits will grow at a dazzling rate next year, or that the market is on very thin ice. Few predict the former. At the same time, the Fed can't keep pumping out printed money. It may even take the radical step of withdrawing a bit of it. Think of what happens to a frat party if the beer runs low. Today's p/e ratio tells you that if you buy the market now, view your investment as a long term bet.

Tuesday, December 1, 2009

Will the Fed's Reverse Repos Reverse Anything?

To settle the tummies of inflation hawks, the Federal Reserve Board has announced that it will use reverse repurchases to withdraw some of the oceans of dollars it has pumped into the financial system in the last year or so. If one sniffs this proposal carefully, one might detect an odd odor. We won't go so far as to suggest that it might be a rat, or fishy. Nor will we make commentaries about the state of Denmark. But a brief pause to think might be in order.

As part of its actions earlier this year to stimulate the economy, the Fed purchased vast quantities of U.S. Treasury securities and mortgage-backed securities. In so doing, it shoved enormous amounts of cash out its loading dock. That cash could be an inflationary time bomb if left long enough in the financial system. Now the Fed has been testing the reverse repo as a means of draining away some of the oceans of cash. The question is how well this would work.

A reverse repo consists of the Fed selling some of its Treasury or mortgage backed securities temporarily, with an agreement that it will buy the securities back on a predetermined date. The price it will pay when the securities return is fixed at the time the transaction is initiated, and includes an interest factor that in effect makes the transaction a loan of cash to the Fed by the temporary buyer of the securities. Lending cash to the Fed takes money out of the financial system. But the return trip of the securities back to the Fed releases the cash back into the financial system along with interest. Thus, the cash is withdrawn, but only temporarily.

Reverse repos are short term transactions, lasting a day, two days, a week or perhaps a month. But they do not permanently remove funds from the financial system, nor do they permanently reduce the Fed's balance sheet. At the end of the transaction, the cash goes back out into the financial system and the securities return to the Fed's $2 trillion balance sheet. The Fed could reduce its stimulus over a longer term by doing a continuing sequence of reverse repos, rolling over each transaction as it comes due with a replacement reverse repo. But there are limits to the reverse repo market, as there are to any market. Moving hundreds of billions of dollars of stimulus out of the financial system via reverse repo would surely require raising interest rates and perhaps sharply. That doesn't seem to be in the Fed's game plan, given its stated intention to keep short term rates at zero for an extended period of time.

A reverse repo is a very tentative and temporary way of withdrawing liquidity, and gives the Fed great flexibility to stop withdrawing liquidity on a moment's notice (especially if it uses reverse repos having maturities of not more than a few days). It's not a way to withdraw stimulus on a large-scale permanent basis. One begins to suspect that the Fed doesn't really want to withdraw much liquidity, and is using the reverse repo as a way of doing something to appease inflation hawks without committing to do much. In short, if you're worried about inflation, keep worrying.

The Fed's reverse repo plan also signals more storm clouds for the economy. There is hardly a crowd of "natural buyers" clamoring to buy the hundreds of billions of dollars of mortgage backed securities held by the Fed. "Natural buyers" is a Wall Street term referring to persons who buy for the purposes of investing. Five years ago, mutual funds, pension funds, money managers, municipalities and all variety of investors were natural buyers of mortgage backed securities. We know what happened next. Now, with the real estate market way down and still shaky, borrowers are defaulting and walking away as their homes go underwater. Mortgage backed securities tend to be dodgy investments because it's difficult, at best, to predict default rates (except that we know they can be ugly). In other words, the Fed can't sell its mortgage backed securities, not without driving long term interest rates way, way up (which is something it won't do). And if it tried, it would drain away whatever limited investor money exists for mortgage financing for current and future home purchases. That would only further batter the real estate market. So the Fed's balance sheet is likely to remain very large for quite a while.

The Fed, in truth, is no longer just a bank regulator but has become one of the largest banks in America. It's bought up a large part of the mortgage backed securities market, and funded a lot of sales of Treasury securities (which is really weird because it means, in reality, that the Fed is printing money and handing it over to the Treasury Dept.). The Fed has also provided significant funding for other asset backed securities and assisted money market funds and the commercial paper market. All the while, it's served as the banker of last (and now first) resort of its member banks. The Fed has intervened in a major way with market forces that ordinarily determine who is creditworthy and who is not, and its intervention doesn't appear likely to recede any time soon. Long term suspension of market forces will have deleterious effects. The only question is which deleterious effects will emerge to erode our prosperity. Inflation? Asset bubbles and busts? Inefficient allocation of society's resources in politically favored asset classes? Growth of irrational and irascible populism that will trigger capital flight? More than any other branch or agency, the Fed is substituting governmental judgment for the market's judgment, and for an increasingly extended period of time. Many nations on the Eurasian continent and elsewhere tried this, and it didn't end well. There's no reason to think that things will be different here.

As Congress considers what to do about financial regulatory reform, it is appropriately scrutinizing the growing power of the Fed. We don't think the Fed is acting in bad faith or in collusion with gnomes in Zurich. The gold standard, rifle-cleaning, nonperishables-stocking crowd needs professional treatment for paranoia. But recent history amply demonstrates that the Fed doesn't have all the answers. It reasonably argues it needs independence from political pressure in the formulation of monetary policy. But it doesn't need the authority to be the largest bank and most powerful financial regulator at the same time. There's too much potential for conflict between the roles of central bank, bank regulator, systemic risk regulator and large scale extender of credit to borrowers high and low. The Fed's overall authority should be limited, just as its independence in formulating monetary policy should be safeguarded.

Sunday, November 29, 2009

Dubai Debt Derivatives Doubts

One mystery of the Dubai debt crisis is the extremely limited information about derivatives contracts for Dubai debt. Credit default swaps protecting debt holders were rising rapidly in price last week as the crisis reached a head. That's hardly surprising, nor is it terribly significant from a systemic question.

The key question is whether we have another AIG--i.e., a financial institution that wrote a large portion of the credit default swaps, or insurance, for Dubai debt protecting debt holders in the event of a default. AIG made a concentrated bet on the value of the real estate market, without any government agencies knowing until it was too late. U.S. taxpayers paid the price. Although the AIG situation should serve as the impetus for meaningful reform of the derivatives market, Wall Street banks have been lobbying vigorously to limit change. Efforts at reform in Europe haven't made much progress, either.

Thus, there is no easy way for regulators anywhere in the world to figure out whether the derivatives risks stemming from the Dubai debt crisis are under control or not. It appears that the banking system of the United Arab Emirates, of which Dubai is a member, is at significant risk. The UAE central bank has already announced a new credit facility to support its banking system. This is what central banks typically do--protect the banking system but not the debtors. Investors holding Dubai debt, especially those in Europe and the U.S., might not benefit much from stabilization of the UAE banking system.

Abu Dhabi, Dubai's oil-rich neighbor, has announced that it will support select Dubai companies, but will not provide blanket protection for Dubai debt holders. In addition, Abu Dhabi may not pay out debt holders 100 cents on the dollar. One suspects that Abu Dhabi will select those companies whose defaults would seriously injure Abu Dhabi's banks and citizens. Holders of other Dubai debt will likely be left looking for any port in the storm.

The problems aren't necessarily limited to Dubai. These crises always have secondary and tertiary effects. Some market participants are getting nervous about debt of other UAE members, and also the debt of certain nations in Eastern Europe and elsewhere. What if credit default swaps for the debt of these other nations were written by a major financial institution that also wrote a lot of Dubai credit default swaps? A major Western financial company could be in serious trouble, but there's no straightforward way to find out if this is the case.

The Dubai crisis is a reminder that the financial crisis of 2007-08 has continued into 2009, as the global economic slowdown takes its toll wherever leverage was used in abundance. And that would include lots of places. Banks worldwide continue to sit on substantial potential losses from residential and commercial real estate. And consumer loan losses have grown along with rising unemployment levels. We're still in the woods, even if some green shoots are visible.

European and U.S. banks have said little or nothing about their Dubai/UAE exposure. Their regulators have said even less. Very possibly, everyone's still scrambling trying to figure out where the problems are. The possibility of another AIG cannot be ignored. After all, the number of financial institutions that are large and well-capitalized enough to be credible issuers of credit default swaps would be quite limited, especially after the AIG mess. If there is a financial institution with concentrated Dubai/UAE/whatever risk, it will probably be a large and well-known one in Europe or the U.S.

Since Abu Dhabi and the UAE won't fully protect holders of Dubai debt, it goes without saying that they won't protect any Western financial institution that's hurting from writing too many Dubai credit default swaps. Perhaps large financial institutions have learned from the AIG experience not to concentrate too much risk in credit default swaps. Then again, movement up the learning curve cannot be assumed. Would it not be possible that Dubai debtholders were willing to buy credit default swaps from a single large dealer because they would anticipate another AIG-style 100 cents on the dollar bailout if bad things happened? Would the Fed hold the line and make them take losses? Or do we think that its still vivid memories of Lehman's collapse would lead it, once again, to speed up the printing presses and churn out more dollars?

As we write this blog, Asian shares are up 2% or more in the belief that the Dubai crisis has been overblown. Maybe so. But remember that it took 15 months or more for the impact on AIG of the real estate and credit crises to become publicly known. And even if there is no AIG, Part Deux looming in the future, the sudden shakiness of a lot of developing world debt will probably lead major banks to pull back even further on lending, contracting the money supply all the more so, and creating more drag on economic activity.

The Dubai crisis illustrates how the government interventions of the last year have slowed, but not prevented, the deleveraging process. Market forces will have their way sooner or later, one way or another. A lot of potential bad debt remains extant, which means that deleveraging will persist for years and demand for credit default swaps will continue to be strong. The risk of another AIG is real, and substantial reform of the derivatives market should be undertaken now, before the Fed and Treasury Department fail in their quest to prevent a second Great Depression.

Tuesday, November 24, 2009

Let's Be Thankful


Congress is looking closely at the Fed. In the last few years, the Fed has done a terrible job, and then a good (but risky) job dealing with the consequences of its terrible job. Some close scrutiny and double guessing would be healthy for the Fed. Congress may moderate the Fed's responsibilities and power, which could turn out for the better. Making the Fed into an uber-regulator, as proposed by the administration, would be a very risky move. Virtually all of the government's power to deal with a financial crisis would be vested in a single agency that too vigorously resists oversight. The potential for narrow focus, an oversupply of certitude in its own wisdom, and increased traffic through the revolving door make such a concentration of regulatory power a bad idea. Even though Congress is proceeding with a maximum of soundbite histrionics that obscure the substantive importance of the issues, it's making the Fed take a hard and careful look at itself. That's Congress' role in the Constitutional structure of the government, and the Fed will be a better agency after enduring the cacophony of democracy.

Retail investors have sat out the stock market rally. An objective look at the evidence strongly suggests that, for the next year or so, the market has quite a bit more downside risk than upside. Maybe stocks will drift a bit higher. But only those that believe assets only rise in value and never fall would think that 2010 will be a banner year for stocks. The good thing about retail investors sidelining themselves is that if and when the market falls, the impact on consumption will probably be less than 2008's nosedive. If your portfolio hasn't been hammered, you'll have less gut level fear of $4 lattes.

Health insurance reform is progressing. It seems like just about every alternative is criticized for involving increased costs. But the question is compared to what? Health care costs have risen faster than inflation for decades. Health care now absorbs about 16% of GDP and is expected to rise to about 20% in ten years. If a reformed health insurance system provides more comprehensive and fairer coverage, isn't that a worthwhile result? Costs are going to rise anyway if we leave our current incomplete and unfair system in place. Costs are a very important issue, but not reforming health insurance coverage isn't going to keep costs under control. We should work to achieve comprehensive and fair coverage now. Costs will be debated and dealt with as far as one can see into the future, because they'll always be an issue.

U.S. troop levels in Iraq are falling. Iraq wasn't and isn't of strategic consequence to the United States. That's why W and Dick, with their juvenile, tunnel-vision machismo, recklessly weakened the U.S. military by fighting an unnecessary war at a time of rising worldwide commitments for America. The real problems--the growing quagmire in Afghanistan, a soon-to-be nuclear armed Iran, the security of Pakistan's nuclear arsenal, safe havens for terrorists in Pakistan, Yemen and elsewhere, and the twilight zone quality of North Korea's bipolar Kabuki theatrics over missiles and nuclear weapons--will absorb all the resources the U.S. can muster.

Jon and Kate are going off the air. We like the 8. But, toward the end, Jon and Kate were mostly enriching TLC and the tabloids while sounding, shall we say, a bit tiresome.

We're reading less about Lindsay, Paris and Britney. After you've read 100 train wreck stories, the 101st really isn't all that interesting. But fear not for the tabloids. They've always got Brad, Angie and Jennifer.

Monday, November 23, 2009

Congress, the Administration, and the Fed: Ships Passing in the NIght

The soundbite du jour on Capitol Hill is outrage over the Federal Reserve Board. The Fed, according to outspoken members of Congress, encouraged profligacy with low interest rates, missed the boat on the financial crisis, failed to protect retail borrowers, coddled and protected Wall Street firms, and now wants even more power, as proposed by the Obama administration. The Fed, particularly Chairman Ben Bernanke, is trying to reach out to the legislature and make nice. However, there is scant indication that it admits a whole lot of error, or that it would settle for less than the administration's proposal to increase its jurisdiction and power.

Meanwhile, in the next ring of this circus, Congressional criticism of Treasury Secretary Timothy Geithner is increasing in volume and stridency. Some have called for his resignation. Geithner, who doesn't have the professorial detachment that may be Bernanke's best PR weapon, forgot to smile.

In the third ring of the federal circus, swing votes in Congress dig in their heels in opposition to a public health plan for the uninsured, even as a majority of the public supports one. The administration seems to be ducking for cover behind both sides of this fence.

The level of federal dysfunction has risen along with the Dow. When the markets were plunging a year ago, there was near unanimity in Washington. The one time Congress got fussy, initially voting down TARP, stocks nosedived. An overnight plunge in 401(k) accounts concentrated legislators' minds wonderfully, forcing Congress to get right with its constituents. TARP lived.

Now that investors are feeling a little better about their portfolios, Congress is feeling its oats again and becoming, well, democratic. Cacophony is in the nature of democracies, and Washington is very natural these days. Wall Street compensation is leaping and bounding again, as is unemployment on Main Street. So there's lots of grist for the condemnation mill.

One hundred schools of populism have bloomed and now contend. We have tea parties, Sarah Palin book parties, increasingly unpredictable independent voters, Lou Dobbs resigning from CNN with an indication that he might enter politics (Sarah, watch your right flank--this guy is your real competition), and more. Militia movements awaken from hibernation. Guns and ammo sales boom amidst rising prices (the firearms industry loves Democratic presidents). The bi-coastal elites that control the Democratic Party misunderstand just about all of this. The guns and ammo sales, and reawakened militias, aren't an indication of increasingly violent tendencies so much as an expression of uncertainty and fear, a way to feel like you're protecting yourself because you don't think you can count on the government. Tea parties, Palin, Dobbs, Glenn Beck and the like find support because citizens feel that no one in Washington speaks for them.

The federal government's ability to function could be critical to economic recovery. The economy last year stepped back from the abyss because of massive governmental intervention. Even today, the economy and stock market are all government, all the time. As long as the Fed promises to keep interest rates at zero, the dollar remains weak and the stock market moves up (a somewhat dysfunctional correlation since a weak dollar will ultimately undermine America's way to borrow its way out of recession). But if the Fed's policy were to change, the market and perhaps the economy would do a 180 muy pronto.

The next 11 months, leading up to the fall 2010 elections, will be a crucial test for the federal government. Health care reform is essential. Federal financial regulation must be altered to prevent, well, a helluva lot of things. No more too big to fail banks. No more runaway, unregulated derivatives markets. No more stupid mortgage loans to people who have no demonstrated ability to pay. No more easing back on bank capital requirements as assets are bubbling and leverage is booming.

People in Washington are talking past each other; indeed, sailing past in the dead of night. And that's just the Democrats. The Republicans don't even look at the Democrats when they speak, but instead the TV cameras and their potential campaign donors. We know at this point that there won't be any bipartisan marshmellow roasts where Kumbaya tops the charts. But we have an economy and financial system that are all government, all the time. If the government doesn't function, at least minimally, the economic recovery, ever so fragile, will become evanescent.

Thursday, November 19, 2009

The Strange Pricing of Money

Strangely enough, the economies of the United States and all other major countries rest on prices set by the government. Market forces establish most prices. Governments--specifically, central banks--set the price of money.

The price of money is usually seen as the interest rate paid for loans. In general, central banks set short term interest rates for loans they make to banks, and for interbank loans (i.e., loans between banks). The Federal Reserve in the United States does this primarily through its discount rate, and the fed funds target rate. In addition, the Federal Reserve has gone farther than usual during the current economic crisis by purchasing large quantities of Treasury securities and mortgage-backed securities in order to hold down long term interest rates.

Federally prescribed interest rates are tools for combating economic problems. As the economy nosedives, the Fed lowers interest rates in order to soften the impact of the plunge and foster recovery. When inflation flares, the Fed raises interest rates in order to dampen pricing pressures.

It goes without saying that political considerations affect the government's pricing of money. In order to stave off a depression, the Fed last year reduced its fed funds target to a range of 0 to 0.25%, about as low as you can go. The European Central Bank, created against the backdrop of the German hyperinflation of the 1920s and the political extremism it fueled, focuses primarily on keeping prices stable, and was less aggressive on cutting rates.

Market forces seem to have little to do with government pricing of money. Commercial and consumer loan markets set the price of individual and corporate creditworthiness, with recognition (most of the time) that not everyone will repay a loan. But the price of money itself is set by governments to advance governmental goals.

How does the government know what price for money is right? Without the interaction of supply and demand to settle upon an equilibrium, can the government establish a price level that allocates resources efficiently? Or will it set a price that is politically expedient but not economically sound?

The pure time value of money, without considering credit risk, inflation or other factors, is believed to be somewhere around 3%. At the beginning of 2001, the fed funds rate was targeted by the Federal Reserve at 6%. Inflation in 2000 was 3.4% (as measured by the CPI-U), so a 6% fed funds target rate pretty much squared with the natural time value of money. But as the tech stock bubble collapsed, and then the 9/11/01 bombings took place, the Fed went whole hog for stimulus, lowering the fed funds target to 1.75% by the end of 2001. It didn't stop there, reducing the fed funds rate to 1.25% late in 2002 and to 1% in June 2003. Inflation averaged just under 2% per year from 2001 to 2003. When inflation is added to the 3% pure time value of money, one would have expected a free market to offer interest rates of around 5%. So the government's pricing of money was, in effect, negative. It shouldn't be surprising that everyone in the country with a pulse and a signature wanted a mortgage loan, regardless of their ability to pay. Giveaways attract interest. And this giveaway pumped up a big bubble in the housing and credit markets. We know the rest of the story.

Today, inflation in the last year is just barely negative, and the fed funds target rate is just barely positive. So another government sponsored giveaway is in progress. The Fed's purpose--revival of the economy--is salutory. But market forces, even when ignored or disrupted, have a way of coming back at you. A shipload of stimulus/accommodation/bailout money is funneling overseas via the carry trade to revive commodities prices and the economies of other nations. Fed governors seem to believe asset bubbles to be theoretical and not to be found in the wild. Foreign officials have already expressed concern over ongoing dollar-driven asset bubbles. Add to this continuing questions about how mere green shoots could support a 60% stock market rally in the last eight months, and the specter of asset bubbles grows.

Other cheap federal money sits on bank balance sheets, waiting to offset likely writedowns for yet more real estate lending losses. Scant portions of federal money have reached the real economy.

With so little federal money reaching the real economy, the question arises whether today the Fed's pricing of money allocates resources efficiently and spurs productive economic activity. GDP is growing again. But that's to a large degree because the federal government portion of GDP is growing. Take away this statistical effect, and the picture is less rosy. The government can always pump up GDP statistics by borrowing or printing more money. But with unemployment rising, there is a serious question how much good it's actually doing.

It would seem that for the second time this decade, the Fed has mispriced money. The first time, it produced gross distortions in the real estate and credit markets. There are signs it's producing more distortions now. Realistically, no modern industrialized economy can exist without fiat money (i.e., government issued currency). Complex economies require enormous amounts of exchange to circulate, and there isn't enough gold, silver and copper in the world to accommodate the need. But when the government misprices its currency, bad things will happen. Market forces, one way or another, will clear. It took them a while during the recent real estate and credit boom to bust, but bust they did and how. The Fed's stated intention of keeping short term interest rates at zero for the foreseeable, extended future is coming dangerously close to violating the law of unintended consequences.

Tuesday, November 17, 2009

Bernie Madoff's Ponzi Scheme is Cleaned Up While the Federal Scheme Keeps on Rolling

How much would you pay for Jesse James' revolver? He was highly felonious, robbing numerous banks and taking a role in many murders. But his revolver, if it ever were auctioned, would probably sell in the millions. Crime, as long as it's notorious, confers value. We saw this last weekend.

The federal marshalls' auction of Bernie and Ruth's paraphernalia produced some surprisingly large bids. A pair of diamond earrings thought to be worth $21,400 went for $70,000. Bernie's Mets jacket went for $14,500. A wooden duck decoy thought to be worth $60 went for $4,750. A pair of boogie boards estimated at $90 went for $1,000. Someone even paid $500 for a table made from a tree trunk, saying he hoped Bernie had stashed some money inside it. (This is a long shot; Bernie didn't have to salt away money since he could always rip off another investor if he needed more cash.) All told, the auction yielded over $900,000, well over the $500,000 or so that was expected.

Some of the aggressive bidding could come from the eBay effect--put "Madoff" into the Search function on eBay and you'll see a few of the auctioned items already for sale. Since you can't flip houses today, try Bernie's and Ruth's belongings. Other buyers may be biding their time, as the continuing Madoff saga leads to more prosecutions, further revelations and enhanced value for his erstwhile possessions. Still other buyers may hold onto their acquisitions, feeling good about owning something that once belonged to someone who was seriously bad.

Meanwhile, back at the ranch, the U.S. government continues to operate the biggest Ponzi scheme of all. The official federal debt will probably end the year over $12 trillion, around 90% of the U.S. Gross Domestic Product. Ten years ago, it was under 60% of GDP. By 2011, it will probably exceed 100% of GDP. And we're not counting unbooked liabilities from Social Security, Medicare, Medicaid, Fannie Mae, Freddie Mac, FHA and continued bank bailouts. Let's not even go there because the RAM in most personal computers can't handle numbers that large.

America's government debt will never be repaid. It's gotten too big. The government pays debt coming due by finding new lenders or convincing holders of old debt to roll their investments over. The government is lucky that the dollar is the world's reserve currency, or it would be up a poorly lit creek. (For more on this point, see http://blogger.uncleleosden.com/2009/11/is-federal-government-tempted-by-moral.html.)

Using new loans to pay off old loans isn't by itself illegal. Many corporations do that with their bonds and commercial paper. All banks fund daily operations that way. A Ponzi scheme differs from legitimate enterprise because the bad guys don't use the money they take in to operate bona fide businesses. They pocket it and use it to buy cars, jewelry, houses, clothing, vacations, expensive meals and so on. In short, it's used for consumption.

What does the U.S. government do with all its borrowed money? Stuff that looks suspiciously like consumption. Most government operations aren't meant to generate profits. Law enforcement and regulation protect lives and property. The courts are there to resolve disputes. The President is supposed to manage the Executive branch departments and provide leadership. The legislative process is supposed to do something useful, although what that might be seems to have been lost in the mists of time. These operations are not intended to yield dividends or create wealth. They are forms of consumption. So, too, is most of the federal stimulus spending. And the federal bailouts and accommodations that are never repaid (which could total to a large amount) will end up as consumption.

Granted, not personal consumption. But that simply means that the federal government isn't operating an illegal Ponzi scheme. Since the government survives mainly by wheedling money out of Peter to pay Paul, its finances sure look like some kind of Ponzi scheme. To make things worse, nowadays when Peter doesn't have enough cash to cover all the government's spending, the Federal Reserve simply prints money. Indeed, trillions of dollars worth. Paul gets . . . paper spun out of thin air.

Recent comments by Chairman Bernanke and other governors indicate that the Fed isn't about to pull back those printed dollars. The Fed's balance sheet will apparently stay its Brobdingnagian size as far into the future as one can foresee. The latest thinking at the Fed about "withdrawing" liquidity seems to be that it would pay higher interest rates on member bank deposits at Federal Reserve banks. That would put a floor under fed fund rates, and arguably reduce interbank lending (and thereby constrain overall lending). But the target for fed fund rates these days is zero to 0.25%, so even if the Fed pays 0.2% and effectively prevents fed fund rates from going below 0.2%, how much will lending be constrained? The hot, new thing in the financial markets is the carry trade, where speculators borrow dollars, convert them into foreign currencies, and invest overseas for returns expected to be a shipload larger than 0.25%. A 0.2% interest rate on member bank deposits won't constrain an unemployed novice day trader let alone a multi-billion dollar hedge fund. We hesitate to delve into anathema, but the Fed needs to raise its fed funds target rate before it will constrain much of anything.

So we have a government ponzi scheme, which gives itself a boost by printing money whenever it can't find new lenders. What a racket. No wonder the Chinese and other foreign creditors of America are nervous.

There is a way out of the federal Ponzi scheme--a marked increase in federal tax revenues, which is devoted to debt repayment. That could come from a brisk resumption of economic growth or by increasing taxes. The former seems as likely as Godot's arrival. The latter may happen, although the additional tax dollars don't seem destined for debt reduction.

Nevertheless, let's accentuate the positive. With all these freshly minted dollars floating around, it's understandable why the bids at the Madoff auction were higher than expected. Bernie's victims, at least, can be grateful for federal profligacy.

Sunday, November 15, 2009

Currency Exchange Rates: Playing Musical Chairs with Fire

Currency exchange rates have been much in the news as President Obama makes his first visit to China. The dollar is sinking, and China has ensured that its yuan falls in tandem with the dollar. Other nations, disadvantaged by the drop in two of the most important currencies in the world, complain vociferously. The U.S. government proclaims a strong dollar policy, and then looks away as the dollar continues to fall. The Chinese government scolds the U.S. government, which lectures back.

The currency markets are different from other markets. They don't just consist of private buyers and sellers. Governments also get involved, and generally do so for political and macro-economic reasons. Since nothing is as unpredictable as politics, currency exchange rates can move in ways that seem seriously out of whack.

To make things worse, currency exchange fluctuations are, at best, a zero-sum game. One currency's gain comes at the expense of other currencies, and resulting trade imbalances have a similar effect on the nations issuing the currencies. Only today, it's worse than that. Two powerful nations--America and China--rely on policies that may produce near term gains for them but potential longer term losses for everyone. The currency markets may now be a negative sum game.

For decades, China has linked the yuan to the dollar. Thirty years ago, the rate was about 8 yuan to the dollar. Today, it's around 6.8 yuan to the dollar. By contrast, the Japanese yen has tripled in value against the dollar during the same time period. The yuan has never been fully convertible into other currencies, as China has sought to prevent the rapid inflows and outflows of foreign capital that have bedeviled the development of other Third World nations. Considering the devastation wreaked in Asia by the 1997-98 financial crisis, one would have to concede that the Chinese have a point. They aren't unvarnished capitalists, and won't allow markets to operate freely simply as a matter of principle. They utilize market forces pragmatically, mixing in government dictat whenever they believe Adam Smith's invisible hand may be a little shaky. By holding the the yuan relatively steady against the dollar, they ensure pricing stability for their exports to dollar bloc nations (i.e., nations that use the dollar or maintain currency stability against the dollar, including the U.S. and, at times, various nations in Latin America). Chinese manufacturers could largely ignore the complexities and costs of currency fluctuations and commit to low, fixed prices to buyers abroad.

China's fixed exchange rate did much to make China a dominant exporter. But it had to take a lot of dollars in exchange--ultimately trillions of dollars. These were mostly invested in U.S. Treasury securities and American mortgage-backed securities (on which the Chinese have already taken nasty losses resulting from the mortgage crisis). Now, as the dollar falls in value, China loses more money on these assets. Hence, China's scoldings to the U.S. government to get its house in order and prop up the greenback.

The U.S. government in turn has countered that China is itself responsible for this dilemma, having created the trade imbalance that resulted in its enormous dollar holdings. The U.S. government would have China restructure its economy to focus on domestic consumption, and reduce exports to take pressure off the dollar.

However, neither government is doing much to change the status quo. China's government has launched a major stimulus program to forestall economic slowdown, with much of its spending directed at building infrastructure. These are wise expenditures for a developing nation, but they do little to promote domestic consumption. The Chinese are among the world's most frugal people, because they have no other choice. China has no Social Security system. Most Chinese have no pensions; the pensions that exist are meager. The health insurance that was part of Communist China's iron rice bowl has disappeared along with sales of Chairman Mao's little red book. The Chinese save because it's the only way they can have health care and a half-way decent retirement. The Chinese government has done nothing to alter this dynamic. Since China needs about 8% economic growth every year simply to keep up with population growth, it has no choice except to keep exporting. And to do that, it has to keep its currency stable against the dollar.

The U.S. government has responded to America's economic crisis primarily by borrowing and printing dollars--shiploads of dollars. Pushed by the forces of a lot of supply and not so much demand, the dollar has not surprisingly fallen in value. Euro bloc nations have grumbled about the rise of the Euro, especially export-dependent Germany. Several smaller Asian exporting nations have recently been buying dollars in order to defend their currencies. Oil exporters, like Russia and the OPEC nations, have complained of losses in their holdings of dollar-denominated assets and hinted at pricing oil in a basket of currencies to free themselves of dollar risk. In short, the U.S. government's primary response to the economic crisis has imposed losses on the rest of the world.

The flood of the cheap money being pumped out by the Fed has fueled the "carry trade," in which speculators borrow dollars at extremely low interest rates, convert them into currencies where interest rates are higher (such as in much of Asia) and invest overseas for those higher returns. This outflow of dollars is stimulating economic activity in other nations, and appears to be creating asset bubbles in Asia. While other nations don't mind a touch of stimulus courtesy of the Fed, many in Asia have vivid and disturbing memories of the Asian financial crisis of 1997-98, when asset bubbles fueled by inflows of foreign capital burst painfully and caused severe recessions.

There is little sign that the U.S. government intends to pull its stimulus back. The Fed has made clear its intention to maintain zero interest rates as far into the future as one can foresee. The carry trade will expand and perhaps even explode--in a time of slow economic recovery, it's one of the very few ways to make fast money. China will complain and lecture, but won't change the exchange rate of the yuan by much, because it needs continued access to American markets. Other exporting nations will grumble and defend their currencies with little likelihood of long term success. Oil exporters and other holders of dollars (including China and Japan) will take more losses on their dollar reserves, as there is no other currency or asset into which they can easily transfer their wealth.

American and Chinese expediency have created dangerous dynamics in the world economy. America can win only if other nations continue to fund its gigantic deficits and tolerate its uncontrolled printing of dollars by taking losses as the dollar falls. China can win only if it continues to export to America and hope that other nations will help it fund America's deficits while they become more vulnerable to Chinese exports themselves. The rest of the world is scrambling to figure out how to limit its losses and avoid being blown up by carry trade asset bubbles. Everyone, one way or another, is trying to shift their economic problems to other nations, a process that won't have a happy ending. This is starting to look like a game of musical chairs where the limited number of chairs is diminishing and all could end up net losers. If, somehow, the people running these nations would stop playing a children's game.

Wednesday, November 11, 2009

Techniques for Retirement Saving

Technique matters a lot in tennis, golf, basketball and a host of other sports and activities. It also matters to investors. If a middle income American approaches investing--especially long term retirement saving--the right way, he or she can be hundreds of thousands of dollars better off when receiving the retirement watch, than someone's whose technique is poor. Here are a few basic pointers that can take you a long way.

Calculate your net worth regularly. Keeping score is essential. You have to know if you're making progress. You'll need to know when you're not making progress or losing ground, so you can take action to turn the tide. Knowledge can be painful in times of market downturns, but avoiding reality won't improve your retirement finances. You may or may not have a fixed saving goal. Having a goal is good, but not essential. See http://blogger.uncleleosden.com/2007/04/goals-for-retirement-saving-and-why.html. But it's essential to know where you stand. That knowledge alone will keep you focused on building wealth for the future. Calculate your net worth at least every three months. See http://blogger.uncleleosden.com/2007/04/secret-to-building-wealth.html.

Automate the saving process and use retirement accounts. Participate in any 401(k) or equivalent retirement plan your employer may offer. Maximize the amount you contribute. Some people think you might want to contribute only enough to get an employer match and then contribute to a Roth IRA; this isn't a bad idea but you have to be conscientious about the Roth contributions because they aren't necessarily automatic (read on for the solution to this problem). If you don't have access to an employer sponsored plan, open an IRA--or a Roth IRA if you think your future tax rates will be higher than today's--and arrange with your bank to have funds transferred every month (or every two weeks if you are paid on a biweekly basis) to the IRA. It's a good idea to use retirement accounts like 401(k)s and IRAs because they are separate from your regular bank and securities accounts, and the money in them is harder to spend before retirement. For more information, see http://blogger.uncleleosden.com/2007/04/automate-to-accumulate.html.

Average returns take you to Lake Wobegon. Money managers (such as those at actively managed mutual funds) usually don't perform as well as market averages like the S&P 500. There are a number of reasons for this, including their higher trading costs and their compensation. But the bottom line is you are likely to end up with less. Focus on long term gains. Stick with index funds and other low cost investments. If you aim to get the market average for a return, you'll probably end up doing better than average. For more, see http://blogger.uncleleosden.com/2007/06/why-average-investor-does-well.html.

Keep it simple. Investing is, among other things, a sales transaction. A financial firm is the seller and you're the buyer. Complexity favors sellers and places you at a disadvantage. The seller will naturally know more about the product than you will. The law requires that sellers of financial products make a variety of disclosures to buyers. But even if those disclosures are made, the seller will probably still have a better understanding of the product than you will. So you may have trouble figuring out if the product is truly to your advantage. The complexity of some annuities and other insurance products, and some leveraged ETFs, is so great as to make them virtually opaque. Investing in opacity isn't a good idea. Complex products also tend to have higher costs, which negatively impact investor returns. Stick to index funds, and maybe some individual stocks and bonds. Plain old bank CDs aren't bad when the markets seem turbulent. If you don't understand a financial product, avoid it.

The easiest budget of all--save a good percentage of your income (especially if you're self-employed). Budgeting sucks and it seems like every month something comes up that you didn't anticipate. Then, there are the "discussions" with your significant other about how much should be allocated to what expenses, and also last week's rampage off the budget. If you want a simple way to budget, don't focus on how much you spend, but instead on how much you save. Target a good-sized percentage of your monthly income (10% is good, 15% is much better, and 20% is a home run), and make sure that come hell or high water you save at least that much. If replacing your car's exhaust system one month prevents you from hitting your goal, then add enough more the next month or two so that you backfill the deficit. The percentage-of-income-saved method allows you to avoid a lot of handwringing over lattes or not, and inter-spousal sniping, while meeting retirement goals. If you can consistently save 15% to 20% of your earnings over the course of a 30 to 40 year career, you could end up with enough to pretty much maintain your pre-retirement lifestyle during your golden years. If you're self-employed and have an uneven income, it's particularly important to save a good-sized percentage of your income because you can't easily automate the saving process. For more, see http://blogger.uncleleosden.com/2009/07/simplest-financial-plan-of-all.html.

Build your benefits. Even though private sector employers are abandoning pensions faster than New York high society abandoned Bernie and Ruth Madoff, just about everyone has the equivalent of a pension through the Social Security system. Although much maligned and stereotyped, Social Security is the port in the storm for tens of millions of Americans. The longer you work, the greater your benefits will be. Even though the level of Social Security benefits is subject to the whim and caprice of Congress, the tenure of members of Congress is subject to the whim and caprice of voters (including most of the tens of millions of Social Securities recipients). Whatever Congress may do in the future about Social Security benefits, it won't destroy the system and you'll be better off by working longer. If you're fortunate enough to have access to a pension, work as long as you can to boost your benefits. You'll sleep better, without having to buy a new mattress, if you can count on the automatic deposit of a monthly check. For more, see http://blogger.uncleleosden.com/2007/05/how-to-retire-without-saving.html.

Attitude. Perhaps the most important factor, but the hardest one to control, is how you view money and saving. If you look at them the right way, you'll do fine. Understand that you have a finite stream of income during your life. If you spend your money, you can't save it. It's gone forever, and you're left with the now diminished remainder of your finite stream of lifetime income. Saving is a choice, not a sacrifice. Money saved now builds security for the future. Because your lifetime income is finite, you can economize now or economize later. Consider that eating dog food in your old age probably won't be a high point of your life. Remember that savings generate returns that can be compounded, so they may increase your finite lifetime income. Save enough, and you'll hit a financial home run by compounding. (See http://blogger.uncleleosden.com/2009/09/if-you-love-compounding-compounding.html.) This isn't about being greedy in an unseemly way or living like a pauper during your working years. It's about common sense and living within your means. If you adopt the right attitude, you'll establish control over your finances, and that will give you a very good feeling.