Tuesday, March 31, 2009

How the G-20 Could (Unwittingly) Help America

This week's G-20 meeting will resemble a game of musical chairs. Everyone will think of themselves and scramble for a limited number of seats. Germany and other Western European nations want greater contributions to the International Monetary Fund, to help out Eastern European nations and former Soviet satellite states which today are major export markets for them. China, Japan, India and South Korea want to protect their export markets, the largest of which is America, and their dollar denominated investments. Canada and Mexico would want to maintain the stability of their biggest trading partner, the United States. Saudi Arabia and Turkey, the Middle Eastern members, are close U.S. allies and do not benefit from seeing America weakened. Even Russia, which wants to bluff America away from former Soviet republics, would lose out if America weakened so much that the world's economy nosedived, depriving Russia of desperately needed oil revenues and damaging its substantial holdings of dollar denominated assets.

A meaningful program of increased IMF funding requires American participation, since America would be the largest potential source of funds. The Asian export nations have little choice but to prop up America, or they lose export markets and suffer investment losses. Other G-20 members need a strong America much more than they need lectures from Western European nations about prudence and cowboys. Whether or not any of the G-20 will admit it, they all have an interest in American success at the meeting. Being the world's only superpower places singular burdens on the United States (most recently exemplified by President Obama's decision to ramp up U.S. military strength in Afghanistan while Western European nations look for quiet ways to slip their forces out of the country). But it also provides an occasional situational advantage.

The world's current economic problems are so severe that a meeting like the G-20's cannot accomplish much. It will take years of hard work and sacrifice to work through our problems. President Obama cannot hit a home run at this meeting. Indeed, he will have endure scoldings from a number of other participants, because much of the world feels the need to blame America. (So what's new?) But he may be able to bunt his way onto first, since just about everyone will, at least quietly, have an interest in seeing him succeed. A few small successes and no major blowups would be a good result--for other nations as well as America.

America's current advantage isn't necessarily permanent. When the President returns, he should focus on strengthening the nation's industrial base and increasing its worker productivity. We need to produce more wealth; we cannot continue to derive wealth by taking out second and third home equity loans or peddling incomprehensible derivatives contracts to investors. America's prowess in manufacturing, agriculture and other production were crucial to its rise in the 20th Century, and are the key to future prosperity. The U.S. produces a number of high value goods and services--such as aircraft, entertainment, computer software, and medical technology--as well as massive quantities of food, all of which serve domestic and foreign markets. In addition, America has the best university system in the world and can provide higher educational services to numerous foreign students. Ultimately, we can't borrow or use printed money to work our way out of our economic problems. The wealth of nations derives from creating things that other people want to buy. We're really good borrowers right now. We need to become better producers and sellers.

Sunday, March 29, 2009

The G-20 Meeting: Are All Economics Local?

All politics is local, the late Tip O'Neill said. This dynamic will underlie the proceedings of the G-20 meeting this week. As the worldwide economic downturn has progressed, governments are playing an increasingly important role, bailing out banks, catching the unemployed in safety nets, and sometimes stimulating economic activity. The politicization of the economic crisis means that political concerns will increasingly drive the statements and actions of the national leaders attending the G-20 summit. Even at the lofty level of the G-20, politics remain local; and that will make for a messy meeting.

Each nation's leader will focus on how he or she is covered by the press at home. "It's the economy, stupid," is a universal political principle, and the standing of numerous leaders rests on how well they deal with the current crisis. The Euro bloc nations will scold the U.S. for allowing its banking system to act so recklessly as to trigger a worldwide recession (not an unfair criticism). But the Europeans will reject American calls for increased stimulus spending, and argue in favor of heightened regulation that dampens financial sector risk taking. These views will play well in cafes and bier gartens on the continent.

The Chinese and Japanese will urge the U.S. to keep the dollar strong and trade barriers low. They want to protect the value of their vast holdings of U.S. dollar denominated investments (in the trillions when you add it all up), and they also want to export their way out of their recessions. Other Asian members of the G-20 will concur.

Russia will play the role of spoiler, taking every opportunity to yank America's chain. The Russians no doubt perceive America to have weakened itself with self-inflicted wounds from its financial sector, and will seek to regain influence lost with the fall of the Soviet Union.

The U.K. and most other British Commonwealth members of the G-20 will awkwardly look down at their hands and whenever possible clear their throats in lieu of speaking. They cannot publicly defend America, yet they are aware--as are most other G-20 nations--that America is the world's last, best hope. No other country can organize and implement a comprehensive response to the economic crisis. No other country has America's resources--the largest national economy and the issuer of the world's reserve currency and most favored sovereign debt. Most importantly, no other nation has the inherent generosity and open heart that America has. In the last century, America lost over 500,000 lives and spent untold billions fighting two world wars in order to bring peace around the globe. In spite of these enormous sacrifices, America obtained no new territory and extracted no reparations from its vanquished foes. America is the only major nation in the world trusted well enough to lead the process of recovery.

Barack Obama is reported widely to be a student of Lincoln and perhaps Roosevelt. He should spend some time studying Dwight Eisenhower--not the Eisenhower presidency, but the war years. In 1939, Eisenhower was a colonel who had long held staff positions and had scant prospects for becoming a general. With the instigation of the Second World War in Europe, the need for the United States greatly to expand its peacetime Army made Eisenhower, with his organizational and administrative skills, and diplomatic demeanor, a valuable officer. By mid-1940, he became a general, and by late 1942, he was given command of the U.S. Army's first major operation in the Atlantic theater, the invasion of North Africa. Eisenhower was promoted to this position ahead of over 100 more senior generals, enjoying a meteoric rise not unlike that of the Illinois state legislator who now occupies the White House. Eisenhower's diplomatic skills proved crucial in binding together the British and American Armies. The British superiority in combat experience and, initially, combat effectivess, had to be acknowledged and given due credit. The American role as the supplier of the resources that would provide the margin of victory, however, meant that America had to gradually and subtly assert itself as the senior member of the partnership. Eisenhower deferred repeatedly to the British, greatly annoying his fellow American generals. But in so often deferring while sometimes declining, he solidified America's standing as the dominant member of the alliance. British desires to use American military strength to preserve their empire were set aside. American desires to invade continental Europe promptly and get the war over with prevailed. Yet all this was done so diplomatically (by FDR and others as well as Eisenhower) that even today, America and the United Kingdom retain a special relationship.

Barack Obama will return from Europe with little in the way of immediate results except perhaps for a feel-good statement or two. But he is said to be a good listener. As such, and with some subtle pushing and prodding, he may be able to lay the foundation for a coordinated process of recovery. Let's hope he succeeds. Otherwise, it may turn out that, in this crisis, all economics are local, and that would not auger well for anyone.

Thursday, March 26, 2009

Beware the Herd Behavior of Bulls

Bulls, and other cattle, run around in herds. Participating in herd behavior is risky, because herd animals don't think for themselves. They just follow everyone else. In the stock markets, that meant riding the Dow up to 14,000 and then down to 6,500. The conventional wisdom (read, herd mentality) is that you shouldn't try to time markets. Yet, every contrarian who sold while the Dow was high, or simply stayed out of the market since 1996, outsmarted the herd.

Of course, no one wants to miss out on the market's recovery. That's why the market had such a sharp snapback after the Dow dipped to 6500 a couple of weeks ago. But sharp snapbacks reflect herdlike investing--a lot of people jump in because other people are jumping in. The short sellers add to the buy pressure by covering their shorts whenever they smell a snapback. But if there's one thing that's repeatedly ambushed the herd during the current recession, it's that sharp snapbacks have proven illusory, serving as preludes to new market lows.

That hasn't been for technical reasons. It's that things are bad in the nation's and world's economies. The stock market ultimately reflects the underlying economy. Recently, the government has been putting out positive news about relieving banks of toxic assets, pumping cash into the consumer loan markets, and spending yet more, this time through the federal budget bill. And some recent statistics about durable goods orders and recent home sales haven't been quite as appallingly bad as expected. But you can't have a healthy stock market based on government spending and a couple of very bad, but not horrendous, statistics. If the stock market is to truly recover, the free enterprise part of the free enterprise system has to be doing well. There, however, the news is less glowing.

Commercial real estate is sliding fast, following in the footsteps of residential real estate. This complicates the federal banking regulators' tasks, because commercial real estate loans are a staple of hundreds of medium sized banks. The derivatives-based problems of the major banks could be dealt with through contacts with a handful of formerly very well-paid CEOs. It will take an army of regulatory staff and probably many billions more from taxpayers to cope if the commercial real estate downturn causes banks to collapse.

Trade protectionism is on the rise. Trade barriers of various subtle or not so subtle designs are springing up like dandelions on a well-watered lawn. Things are happening so fast that they may have already slipped out of control. It's unlikely the upcoming G-20 meeting will produce any breakthroughs. In anticipation of the meeting, fingerpointing and recriminations are already in the air. The G-20 meeting is more likely to illuminate differences among the 20 than any unity of policy.

International trade is wilting. Among other things, the Japanese economy's exports have fallen by almost half, compared to a year ago. The Chinese are struggling with millions of newly unemployed, without the unemployment compensation programs that, in the U.S., keep the jobless from becoming immediately desperate. If the major exporters make fewer sales in America and elsewhere, they'll have less money to buy U.S. Treasury debt. Unlike the Federal Reserve, they can't print dollars to fund the Treasury Department's borrowings. If international trade continues to stagnate, we could easily all become poorer.

U.K. Bond Auction Fails. A recent auction of 40-year U.K. government bonds received bids for 93% of the bonds being offered. By contrast, the U.S. Treasury's auctions are routinely oversubscribed. While, by itself, the failure of one U.K. bond auction of a really long term maturity doesn't signal the need to boost one's supplies of freeze-dried food, water and camping equipment, it's rather troubling at a time when government action is the only game in town for reviving the world's major economies. If the U.K. continues to have funding problems, guess who might have to bail it out? (Hint: look in a mirror if you're unsure.) This isn't a theoretical point. The U.S. "loaned" the U.K. an enormous sum of money via the Lend Lease Program during World War II and didn't get repaid. We've bailed out the U.K. in a previous crisis, and it's not inconceivable we might have to do it again.

Cognoscenti skeptical of Geithner's plan. Many, and perhaps most, of the more discerning commentators have expressed concerns about the effectiveness of Secretary Geithner's toxic asset purchase plan. While it's clear that he'll give the ranch away to hedge funds and other institutional investors for participating--which is why they're now signing up--the plan doesn't resolve the devil that's been hidden in the details all along: how do you set the purchase price of the toxic assets? The banks will want the highest price possible, while the private investors will want the lowest price. If the buyers offer too little, the banks may keep the dodgy stuff on their balance sheets, thereby undermining the plan. Banks may resist regulatory pressure to sell at significant losses, since that would require them to recapitalize with current shareholders being diluted. And if the recapitalization is funded by the taxpayers (which is likely to be the case), then executive compensation and a lot of other aspects of banking will be dictated by the government. That's fair from the standpoint of the electorate, but not much to the liking of bankers aspiring to a mansion in the Hamptons.

Put some cash in the market now, if you like. But remember that it could easily become a long term investment if the economic picture follows current trends. Herds can stampede over cliffs if they don't watch where they're going, and there's no certainty that the current rally isn't headed toward thin air. Corporate earnings reports for the first quarter will start coming out next week and the G-20 meeting begins the following weekend. We'll soon know more.

Tuesday, March 24, 2009

The Economic Crisis: Can Geithner Hit A Moving Target?

Treasury Secretary Geithner's toxic asset purchase plan certainly buoyed the stock market when it was announced on Monday, March 23, 2009. The market rose almost 7%. Since the Geithner plan continues the Bush 43 administration's policy of socializing losses while privatizing gains, it's no surprise that the stock market--which reflects the value of the private sector--would have jumped. But the stock market is notoriously unreliable as a predictor of the future. After all, when the market reached its all time peak in October 2007, were we getting any signals that 18 months later, it would be down over 50%, to levels first reached in the mid-1990s? Today's drop of 1.5% (DJIA) to 2.5% (Nasdaq) may have indicated some second thoughts about the Geithner plan.

One thought that may not have gotten a lot of attention is that Geithner focused on a historical problem: the large hornet's nest of toxic assets left over from the collapse of the housing market and the credit bubble. These assets have been a herd of elephants in the living room, and understandably catch everyone's attention. But as the seas in the worldwide economy have gotten rougher, a lot of stuff has started slipping and sliding around on the deck. Much of it is overseas and may not command much coverage by the American press. Lack of press coverage, though, doesn't mean it's unimportant. Think back to how much attention credit default swaps got in June 2008, three months before the U.S. bailout of AIG. It wasn't much, although you could have read about them in our blog (see http://blogger.uncleleosden.com/2008/06/is-credit-default-indigestion-coming.html).

In addition to the toxic asset problem, we have European unwillingness to provide sizeable fiscal stimuli. European nations accept higher levels of unemployment and lower levels of economic growth than does America. The European toleration for stagnation will be a drag on U.S. efforts to re-ignite the economy. When President Obama goes to the G-20 meeting in early April, he'll find out that there won't be a reverse Marshall Plan.

In addition, the economies of Eastern Europe and the former Soviet Union are weakening. Recently, a Russian state owned aircraft leasing company (Finance Leasing Co.) defaulted on $250 million of bonds. That's not a large default, but the Russian government could have prevented it and chose not to. The default brings back very bad memories of Russia's 1998 currency crisis and bond defaults. Those events led to the near collapse of Long Term Capital Management, which could have brought down the world's banking system had the Federal Reserve not strong-armed the major banks into a bailout. The economic woes of Eastern Europe and the former Soviet Union could potentially take down large banks in Germany and Austria. Recall that the collapse of a major Austrian bank, Creditanstalt, precipitated a financial crisis in the early 1930s leading to the Great Depression.

In addition, China's government has proposed establishing a new international reserve currency to replace the dollar. While the Chinese government has also said it would continue to buy U.S. Treasury securities, ambiguity like this isn't accidental. A Chinese loss of confidence in the dollar will reverberate worldwide, and make it harder for the Treasury Dept. to borrow. That, in turn, would make it costlier for the government to provide cheap financing to purchasers of toxic assets. With China, Japan and other foreign nations now serving as America's bankers, let's remember that we need at least their implicit approval of any major deficit spending program. And they're mostly frowning these days.

It's easier to hit a stationary target than a moving one. Geithner may, or may not, have scored a hit with his toxic asset plan. We'll know soon enough. But economic conditions around the world continue to deteriorate, and other assets are becoming toxic. The overall target--restoration of economic health--is moving rapidly, and merely removing the current batch of toxic assets from bank balance sheets won't necessarily revive the credit markets if other factors continue to drive the economy down. The Bush 43 administration was repeatedly behind the curve, and arguably didn't hit targets much better than Dick Cheney with his shotgun. Geithner, President Obama and other world leaders need to swing their points of aim ahead of the moving targets and pull the trigger in time to score direct hits.

Monday, March 23, 2009

Mortgage Relief

July 25, 2009 Update: The Obama administration has improved the Making Home Affordable program to give homeowners who are not yet in foreclosure an expanded opportunity to refinance. If you've been current on your monthly payments for the past year, you may now be able to refinance even if you are as much as 125% underwater on your mortgage (the earlier standard was not more than 105% underwater). This is a significant improvement over the original program. For more details, see http://blogger.uncleleosden.com/2009/07/more-mortgage-relief.html.

Original Blog: The Obama administration has launched a housing affordability initiative called "Making Home Affordable" (www.makinghomeaffordable.gov). It provides two alternatives for homeowners having problems paying their mortgages. Both alternatives are sponsored by the government, so you may get a better deal going through this program than you would if you tried to negotiate on your own. This program is aimed at forestalling foreclosures by helping homeowners who haven't yet defaulted but anticipate problems making their payments. (People who are way deep in default would probably have to pursue other options.)

The first alternative is to refinance. You should try for a mortgage offering a low, fixed rate, to make your housing costs predictable. You may qualify for a refinancing if the amount of the mortgage (plus any refinancing costs) does not exceed 105% of the value of the house. If there is a home equity loan or second mortgage on the house, the second lender will have to agree to the refinancing. (If refinancing would lower the payments on the first mortgage, you could point out to the second lender that these lower payments would increase your ability to pay the second loan.) You also need to be current on your mortgage, and not have been more than 30 days late in making a payment during the last 12 months. Your loan must be owned or guaranteed by Fannie Mae or Freddie Mac (which means larger loans might not qualify). Refinancing will not reduce the amount of the mortgage. But if you can lock in a low, fixed rate mortgage, having predictable monthly payments will reduce your sleep deficit.

The second alternative is to modify the mortgage to lower your payments for a five-year period to not more than 31% of your gross (i.e., pretax) monthly income. People who have been re-assigned from full-time to part-time work, or who no longer get overtime may benefit from this alternative. So may two-income couples when one member is laid off and the combined household income drops. The loan must not exceed $729,750 and the home must be your primary residence. The government offers incentives to loan processors to reduce your interest rate to as low as 2% in order to get your monthly payment to the 31% level. If you stay current on the reduced payments for 5 years, the government will pay down a small part of the principal balance of your mortgage. After 5 years, the government will have reduced your principal balance by $5,000, so it's important to stay current. Also after 5 years, the payments on your mortgage can increase one percentage point a year until they reach the market rate for mortgages on the day when your loan is modified.

The second alternative could involve extending your mortgage to 40 years, or deferring repayment of part of the principal balance of the loan. The latter step might result in a balloon payment at the end of your mortgage, something that you should thoroughly understand before agreeing to the deal. Either you'll have to save up enough cash for the balloon payment, get more financing, or sell the house. The lender also has the option of forgiving part of the principal balance. But that's voluntary on the part of the lender and you shouldn't hold your breath hoping for it. (Our guess is that lottery tickets would be an easier way of reducing your principal balance than expecting voluntary principal reductions from lenders.)

To explore options under the Making Home Affordable program, contact your loan servicer or lender. You may also get free counseling by calling the Hope Now Alliance at 1-888-995-HOPE (4673) and speaking to counsellors approved by the Department of Housing and Urban Development. Beware of people claiming to offer mortgage relief for a fee. There are a lot of mortgage scams, now that numerous borrowers are in trouble.

If you don't qualify for assistance under the Making Home Affordable program, consider seeking help from nonprofit housing organizations. See http://blogger.uncleleosden.com/2007/12/how-to-handle-mortgage-default.html for more information. Good luck.

Sunday, March 22, 2009

Instead of Taxing Bonuses, Why Not Tax Assets?

The outrage over the AIG bonuses is understandable. Taxpayers fork over $170 billion plus in bailout bucks because of AIG's mistakes, and AIG gives already well-paid executives hundreds of millions in bonuses. These bonuses were possible only because the taxpayers kept AIG on life support, not because AIG's management and employees did a great job running the company.

But bonuses aren't the heart of the problem. The core problem is the humungous size of AIG's balance sheet. The company took advantage of its erstwhile AAA credit rating, based on years of building a traditional insurance business, and leveraged it in the derivatives market. One subsidiary in particular, AIG Financial Products, sold so many credit default swaps they became almost ubiquitous in the world of finance, to the point where they threatened the viability of a disturbing large number of major banks in the U.S. and Europe.

Size is the critical problem. If AIG's credit default swap business had been much smaller, no taxpayer bailout would have been necessary. If Bear Stearns, Fannie Mae, Freddie Mac, Citigroup and various other crippled financial institutions hadn't been so large, their problems would not have required taxpayer funded blank check bailouts.

Taxing bonuses may be emotionally satisfying; but it's more complex than it may first appear. At least on a going forward basis, some people at large banks may actually deserve big bonuses if they serve the banks well. A bonus tax also doesn't focus on the huge balance sheets that led to the bailouts.

A better idea would be to tax assets at the too-big-to-fail financial institutions, which might include the top 50 to 100 firms. The tax should be progressive, with rates getting higher as the institution becomes larger, because larger institutions tend to present ever greater risks. Not only should banks be taxed, but brokerage firms, insurance companies and other institutions that might be deemed too big to fail should be included. Such a tax wouldn't be a form of insurance--we're not talking about establishing an insurance fund for all major financial institutions. That already exists: it's called the U.S. Treasury. An asset tax would give taxpayers some compensation for the enormous risks that the financial system poses to them. It would also create a reason for financial institutions to pause and think before ballooning up their balance sheets.

It is axiomatic within the world of money management that there are only a limited number of good investment opportunities. That's why mutual funds sometimes close the doors to new investors. When they get to the size where they can't identify enough good investments for new investor money, they decline to take the money rather than make bad investments. If only the big banks had taken such an approach, we wouldn't now be stuck funding multi-trillion dollar bailouts. But they chose the path of short term profits from rapid and highly leverage expansion of their balance sheets. Taxing such a business strategy would discourage socially undesirable behavior, just as tobacco taxes discourage smoking.

The asset tax would have to apply not only to balance sheets, but also to assets in off-balance sheet vehicles when banks are exposed (as a matter of law or of practical realities) to such off-balance sheet assets. Much of today's problems stem from off-balance sheet exposures (recall Bear Stearns, Merrill Lynch and Citigroup, among others). The asset tax would also apply to other assets that the banks may be required (by law or commercial practicalities) to buy back or support in the event of default or other impairments to value. It's important to include assets for which taxed institutions have commercial responsibility, even without clear legal liability, because some major banks have bought back bad investments they underwrote even when they weren't on the hook legally speaking, in order to protect their reputations. These repurchased assets likely have contributed to the need for taxpayer funded bailouts. A broad scope to the asset tax would discourage the use of smoke and mirror devices such as off-balance sheet financing and improve the clarity and accuracy of bank financial statements. We certainly need that.

How much should the asset tax be? First, let's guess what quantity of assets would be encompassed by such a tax. The FDIC website (www.fdic.gov) indicates that the total assets of federally insured banks approaches $14 trillion. Of course, the vast majority of insured banks would be too small for an asset tax, since it would be imposed only on the largest, too-big-to-fail institutions. But the big banks are very large. For example, Citigroup, although shrinking, may still have close to $2 trillion in assets. Let's assume the too-big-to-fail banks have a combined total of $10 trillion in assets. We'd have to count other large financial institutions as well, since the AIGs of the world also fall into the category of too big to fail. AIG has perhaps $800 billion in assets. We'll assume that $5 trillion in assets from these non-bank institutions is taxed. That would make a total tax base of $15 trillion.

As noted above, a progressive rate structure would be ideal. But, for the sake of simplicity, we'll use an average rate of 0.25% of total assets per year. That would raise $37.5 billion per year. By contrast, the financial sector bailouts have exceeded $1 trillion and are probably headed for $2 trillion. Individual taxpayers pay about $1.1 trillion a year in federal income taxes. $37.5 billion would surely be more than the amount a bonus tax on bailed out bankers would raise, and an asset tax in this amount would certainly be fair considering that taxpayers are now funding the largest federal corporate welfare program in history.

Inflicting punishment on those that deserve it can be cathartic. But addressing the core problem is likely to be more fruitful in the long run. Let's try an asset tax.

Thursday, March 19, 2009

Is the Federal Reserve Trying to Get a Free Lunch?

Yesterday, the Fed announced that it would buy up to $300 billion of long term U.S. Treasury securities and $750 billions of mortgage-backed securities to push down mortgage and other interest rates. The backdrop to these measures is the U.S. Treasury's plan to borrow around $1.8 trillion to support the stimulus package and other federal spending, which will place upward pressure on interest rates. But, yesterday, the stock market rose, as did the bond market. Things looked rosy.

At least for the moment. The financial markets, however, operate at lightening speed, and doubts about the Treasury's program have already appeared. The problem is that the Fed will, in a nutshell, simply print the money it uses to buy these securities. It's using $1.05 trillion worth of--well, what? Printed money--actually, electronic entries on the banking system's computers; but most "money" today consists of electronic entries. There is no real economic value underlying this printed money. By contrast, if the Fed used tax money collected by the Treasury and loaned to the Fed, it would be using real money. That, however, would likely require tax increases that no one would consider politically acceptable.

The dollar has dropped several percentage points in the last two days against the Euro, Yen and British pound. The currency markets see the dangers of the Fed dropping a bunch of printed money into the financial system. Longer term interest rates, which dropped over 40 basis points yesterday (an astonishing one-day move), are rising today. The stock market is losing a little ground.

The reaction in the currency markets is highly problematic. The largest lenders to the U.S. Treasury today are China and Japan. A drop in the dollar, coupled with a sharp drop interest rates, discourages them from further lending. Printed money presents the danger of inflation that could impose loses on them. Inflation generally is bad to lenders, because they're repaid with less valuable dollars. The relative tranquility in U.S. consumer and producer prices isn't terribly important to China, Japan and other foreign lenders. They aren't trying to buy milk, bread, or gasoline here. What matters to them are the value of the dollar and the interest rates on dollar-denominated investments. The Fed's printing of money may or may not inflate the price of potatoes in Moline. But it is diminishing the value of the dollar in the currency markets while simultaneously pushing interest rates lower. From the standpoint of a foreign lender, that's a double whammy.

What the Fed persists in refusing to understand, notwithstanding mountain ranges of evidence to the contrary, is that easy money policies cause inflation. Since the late 1990s, the inflation has been in the price of assets. First, we had the tech stock bubble. Then, there were the real estate and credit bubbles. Then, there were the bubbles in oil and other commodities. All of these asset inflations ended badly. What reason is there to think that another bubble, this time in U.S. dollar-denominated debt, is a good idea?

The Fed is standing boldly at the roulette wheel, betting that people will treat its printed money as having value. On a micro level, as the average American worker gets another $13 a paycheck, or whatever the amount is, that may happen. But in the financial markets, the big players face big risks and have a broader view of things. They've been burned badly by the recent asset bubbles, and are likely to pause before again playing with fire. If the Fed thinks that they'll believe its printed money has value, then the Fed is looking for a free lunch.

Easy money can fool all of the people some of the time, and some of the people all of the time. But it can't fool all of the people around the globe all of the time. The road to economic recovery will be built by cleaning up the financial system and strengthening the economy's ability to produce valuable goods and services. Easy money has produced false hope and then painful losses, time and time and time again. It's a sign of intelligence to learn from one's mistakes. Perhaps some learning is in order.

Tuesday, March 17, 2009

Time to Reorganize AIG

The continuing outrage over AIG's dumber than dumb payment of executive bonuses and retention payments after receiving federal bailout money threatens to undermine the government's efforts to prop up the financial system. Not only were many of the executives involved at the scene of the crime when shiploads of losses were incurred, some that received "retention payments" have already left AIG. This suggests that AIG isn't just spectacularly stupid. One wonders whether AIG is no longer functional as an organization. Perhaps the decision making process within the company has lost touch with the larger world and become so tone deaf to political sensibilities that it cannot effectively run the company any longer. The fact that AIG continues to book losses and soak up a never ending stream of taxpayer money only heightens these concerns.

Worst of all, the AIG situation has so outraged the public that the federal government no longer has the political capital to stage another major bailout should one be necessary. While we won't name any names, anyone who has even casually followed recent financial news knows that there are at least one or two very large banks that may be teetering at the brink, and which may require comprehensive federal action sooner or later. But with AIG's insufferable insensitivity to political sensibilities fresh in mind, the taxpayers won't stomach another big bailout. What would happen, then, isn't likely to be pretty.

It's time to end the bailout of AIG. No more federal assistance. It's too late, baby.

However, we shouldn't simply let AIG fail. The taxpayers have already sunk $170 to $180 billion into AIG, and own almost 80% of the company. A liquidation might result in substantial losses for the taxpayers. Instead, the company should be reorganized in a way that would maximize the value of the company for its various constituencies without any more checks from the United States.

One subsidiary, AIG Financial Products, caused the bulk of AIG's problems. For the most part, its other subsidiaries are real insurance companies that offer traditional products like property and casualty coverage, auto policies, life insurance and so on. These latter operations have real value. AIG should be split into two entities: AIG Financial Products by itself ("Bad AIG"), and the rest of AIG ("Good AIG"). Such a split accomplishes two things. First, a traditional liquidation could precipitate a "run" on the good AIG subsidiaries by customers seeking to cash out policies. That might lead to the unwarranted collapse of those subsidiaries. Splitting up AIG separates the problem child from the healthier parts of the company. That should help prevent a run. Second, a split up allows taxpayers to make profits that might be lost in a traditional liquidation. Here's how.

Good AIG would be given the capital its constituent subsidiaries now maintain to meet state law requirements. That would protect the customers. The customers of Good AIG have the highest priority to AIG's assets in the event of a liquidation and need to be protected to dissuade them from staging a run. Appropriately capitalized, Good AIG could continue doing business as usual.

AIG-FP's customers, however, don't have the same level of protection as, say, AIG's life insurance customers, since FP didn't sell traditional insurance products. Instead, it was basically a really large hedge fund. Its customers (i.e., its counterparties) are actually creditors, and have substantially less negotiating strength than traditional insurance customers. The counterparties could be given stock in both Good AIG and Bad AIG. The United States, along with other current stockholders, would also receive stock in Good AIG and Bad AIG. The relative amounts of stock each would receive would depend on the value of FP's counterparties' claims assuming there are no more federal bailouts (as well there may not be), relative to the amount of the United States' contribution of $170 to $180 billion as a secured lender (see below), with a proportionate allocation for other current shareholders. Figuring out what these proportions would be might not be easy, but it can be done.

Why would FP's counterparties go along with this idea? First, the prospects of further U.S. bailouts for AIG is growing dim and the counterparties have few choices in the absence of a bailout. The United States' interest in AIG actually consists mostly of loans collateralized by AIG's assets, along with a warrant and senior preferred stock. The warrant and preferred stock give the United States an equity interest, but the U.S. is first and foremost a secured lender. As such, the U.S. has first dibs on the assets over creditors like the counterparties. The latter would likely be up the creek sans paddle if they tried to slug it out in court with the U.S. Besides, vulture investors swoop into liquidations with bids so low catfish couldn't find them. There wouldn't be that much to fight over in a liquidation, and the counterparties would very possibly come out quite badly.

Second, forcing AIG into a traditional liquidation would likely cause a "run" not only on AIG but also on insurance companies worldwide. FP's counterparties are major banks (see our preceding blog) that either own insurance operations or have intricate connections with the insurance industry. If they precipitate a general run on insurance companies, they would make their own problems much worse. The U.S. government now serves as Sugar Daddy to the world's largest financial institutions (see our preceding blog). FP's counterparties would have to go along with a reorganization of AIG if that's what their Sugar Daddy wanted.

The taxpayers and other shareholders of Good AIG could profit by holding their stock for 5 to 10 years, until the financial sector recovers, and then selling. Since Good AIG consists of basically sound businesses that sell products people need, there is a strong likelihood of long term profits. Maybe these would be large profits.

The taxpayers and other shareholders of Bad AIG have a more complex problem. They would have to evaluate how to make the most out of the complex contracts into which FP entered. If, however, Bad AIG understands that it would receive no federal bailouts, then its shareholders and management would have to reach for their bootstraps and do their best. Perhaps they'd find a way to make a little money; perhaps not. Either way, because there would be no more federal assistance, Bad AIG could pay whatever salaries and bonuses it wanted in order to hire and retain whoever it thought to have the abilities it needs. While AIG richly deserves the criticism it has received for its mistakes, it is not wrong in contending that it needs highly specialized and relatively expensive help to unwind FP's holdings. The way for it to hire and retain those people without further criticism is to stop taking federal money.

Of course, cutting AIG off from the federal trough means that many of AIG's counterparties may have to book losses. It's unclear how large those losses would be. Some of the counterparties may require further government assistance to stay afloat. American banks in such straits can resort to the TARP and other alphabet soup bailout measures federal authorities now offer. Foreign banks can turn to their home governments. U.S. taxpayers have already forked over $57 billion to foreign counterparties of AIG (see our preceding blog). It's time for their home governments to pitch in and help. Those governments have regulatory authority over their banks and didn't stop them from dealing with AIG-FP. Since those governments share some of the blame, they ought to bear some of the costs.

It's unclear that taxpayers would necessarily secure an overall net profit from a reorganization of AIG, because of the potential need of counterparties for more governmental assistance. However, AIG has become a black hole, and taxpayer losses from the status quo could, for all we know, be gargantuan (if they aren't already). Most importantly, AIG's bad behavior is undermining the legitimacy of the entire federal program to stabilize the financial system. As things stand now, the public won't put up with another big bailout. But reality is that another one may be needed.

Fed Chairman Ben Bernanke has predicted that the recession might be over by the end of this year if the financial system is stabilized. That's a really big "if" and it got bigger as a result of AIG's recent insensitive and supercilious arrogance (redundancy intended). It's time to say enough already of AIG. Break it up, take it off the dole, and hope for the best, because we certainly aren't getting the best now.

Sunday, March 15, 2009

The Economic Crisis: So Who's Zooming Who Now?

We're working past the initial shock and surprise of the financial crisis, and are onto the second stage--outrage. The cost of the bailouts and stimuli is running into multiple trillions. Taxpayers, especially those in the middle class who see little apparent benefit from all these bailouts, are baffled and indignant that they should have to pay for the mistakes or recklessness of others. They feel that political and governmental processes have been used to take advantage of them. And they have a point. When you look at what's going on with the bailouts and stimulus measures, there are undeserving winners and undeserving losers. Who's zoomin' who?

AIG takes today's top prize for zooming taxpayers. It's received more than $170 billion of bailout money, and just revealed that it paid $165 million in bonuses and retention payments to executives at AIG Financial Products, the subsidiary that created the bulk of the AIG losses covered by taxpayers. Why pay bonuses to a bunch of executives who created losses? Why pay money to retain them? AIG insisted that these bonuses were required by contract, and they had to pay them. Didn't the contracts also require good performance? Or did AIG agree to pay these people millions simply to show up at the office? If AIG hadn't been bailed out, it would have gone into bankruptcy, and these employees probably would have gotten, at best, pennies on the dollar for their bonus and retention payment claims. However, because the taxpayer stepped in due to AIG Financial Products' horrible performance, these executives got full compensation while many taxpayers' marginal rates are slated for increases. That's zoomin'.

Perhaps shamed by the public outrage over its bonuses, AIG today released the names of the financial institutions and other counterparties that benefited from its $170 billion plus bailout. AIG has been resisting disclosure; but it appears to have belatedly learned that chutzpah isn't always a winning strategy. Billion dollar members of the AIG Wing of the Bailout Hall of Shame (i.e., those that received a billion dollars or more) include Goldman Sachs (recipient of $12.9 billion), Societe Generale (recipient of $11.9 billion), Deutsche Bank (recipient of $11.8 billion), Bank of America (recipient of $12 billion, of which $6.8 billion went to Merrill Lynch and $5.2 billion went to Bank of America exclusive of Merrill), Barclays (recipient of $8.5 billion), UBS (recipient of $5 billion), BNP Paribas (recipient of $4.9 billion), HSBC, a British bank holding company (recipient of $3.5 billion), Dresdner Bank (recipient of $2.6 billion), Citigroup (recipient of $2.3 billion), Calyon, a French bank (recipient of $2.3 billion), DZ Bank, a German bank (recipient of $1.7 billion), Wachovia (recipient of $1.5 billion), ING (recipient of $1.5 billion), Morgan Stanley (recipient of $1.2 billion), and Bank of Montreal (recipient of $1.1 billion). Among these banks alone, foreign institutions received a total of $54.8 billion, with $53.7 billion going over to Europe. Add other less shameful bailout recipients and the totals for foreign bailees reaches over $57 billion (with over $56 billion going to Europe).

Many financially struggling banks are zooming taxpayers—why face reality and write off toxic assets when you can foist your losses on the taxpayers--who will end up buying or financing the purchase of a lot of your toxic assets--and then get a capital infusion from them after you book your losses? Simply hang on long enough (while pressuring Congress and regulators for a break on the mark-to-market accounting rules that would otherwise force you to own up to your losses), until the government comes around and takes the hot tamales off your lap.

The wealthy nations of western European, who have the resources to join with the U.S. in a massive stimulus effort but won't go along, are big time zoomers of the American taxpayer. They may figure the U.S. will provide more stimulus anyway if they stall and delay. They’ll get part of the benefit of U.S. stimulus through exports to America, without having to pay the cost. With the AIG bailout having already funnelled $56 billion plus over the Europe, they probably think the Americans will blink if there's a showdown. Twice in the 20th Century, America fought wars to bring peace to Europe, spending many billions of dollars and losing some 400,000 American lives. America has already demonstrated that it will pay an enormous price to solve Europe's problems. Why wouldn't the Europeans again wait for America to come to the rescue?

Zoomers include some borrowers using HUD insured mortgages, too many of whom are defaulting after only one or maybe no payments. A quick default indicates that fraud was likely involved in the mortgage. So the taxpayers may have not only been zoomed but defrauded as well.

Banks and other mortgage lenders are zooming in their efforts to fight legislation giving bankruptcy judges the power to modify the terms of mortgages. If judges can’t do this, more struggling homeowners will have to seek direct assistance from government programs. Why allow judges to have the power to impose losses on bank shareholders and on investors who bought the mortgages, when the taxpayer can be made to take the loss?

Perhaps many struggling mortgage borrowers will also be zoomers. With the recently announced mortgage assistance program, they now have an incentive to seek taxpayer assistance instead of dealing with the consequences of their own poor judgments.

GM and Chrysler, and their various constituencies--management, employees, creditors, and shareholders--are zooming. Ford, to its credit, is not.

Before you, as a taxpayer, become totally outraged, remember that we're doing a little zooming, too. The U.S. is zooming China. The federal government has borrowed so much from China (over $720 billion) that the Chinese are concerned that more fiscal adventurism by the U.S. government will drive down the value of outstanding U.S. Treasury debt. One ironic aspect of China's situation is that the U.S. nationalized Fannie and Freddie in order to bail out their creditors, which included China. But the U.S. will have to borrow to finance the Fan/Fred bailout, and to whom will the U.S. turn in order to sell the U.S. Treasury debt needed? China, of course. So the Chinese are in the position of having to fund their own bailout. The result is they are at risk again, only as holders of Treasury securities now instead of Fannie Maes and Freddie Macs.

While China would benefit from more U.S. government stimulus and bailout spending (since China exports so much in the way of consumer goods to the U.S.), it oddly is counselling restraint. The Chinese have maintained a continuing civilization for some 4,000 years, and perhaps they're worth listening to, if only because they've demonstrated an ability to survive that no other country begins to approach. China has used paper money for over 1,000 years and has experience going back to the Ming Dynasty (A.D. 1368 to 1644) with government currency manipulations that resulted in hyperinflation. They're not comparing the teachings of John Maynard Keynes to those of Milton Friedman; 20th Century theories from the West have limited influence on their thinking. They're a practical people who are looking back at their own hard experiences. They know that a government that borrows and/or prints enough money will destroy its currency, and that economic distress will quickly ensue. Indeed, monetary profligacy by the Nationalist Chinese government in the 1920s and 1930s made it easier for the Communist Party to establish a foothold; so the Chinese Communists are well aware of the dangers of printing money.

The dollar is the world's reserve currency, and its fall from grace may be slowed by that status. But reserve currencies are not immune from the laws of economics (ask the British about how the pound once was, and then wasn't, the world's reserve currency). If the Chinese think fiscal restraint would be the better part of valor, Americans would be well advised to consider caution before charging down the valley, with cannons on the right, cannons on the left and cannons in front.

The Chinese expression of concern may have been in part to assuage domestic concerns about China's dependency on America. China has a long history of isolation from other nations (which not coincidentally began in the 1400s during an earlier period of financial instability). Its strategy during the last 35 years of opening up to the West was a calculated risk taken by China's erstwhile Communist leaders to produce wealth while breaking its dependency on the Soviet Union. If that gamble doesn't pay off, there's a serious possibility that China will turn inward again. This would not be a good thing for America.

China's huge holdings of dollar denominated assets align its interests with America's. If America goes under, China takes gargantuan financial losses. So they're afraid of being zoomed. And we, too, should be afraid of zooming China, because China is probably the only country left in the world that could take the lead in financing America. If China is zoomed, it will hold back on lending more to America. The rest of the world would take notice, and international finance and trade would be endangered. The U.S. government would have produced the result that it most desperately wants to avoid. Very few Americans contend the government shouldn't act, and we would contend that the government should act vigorously. But, just as there are limits to a government's military power (as demonstrated in Vietnam and Iraq), there are limits to a government's economic power and its political legitimacy. Go beyond those limits, and the Big D could loom. The current taxpayer outrage, and the Chinese nervousness, should be taken as signs from canaries in a coal mine.

Thursday, March 12, 2009

What Bernie Madoff Told Us Today

Bernie Madoff pled guilty to 11 felony charges today in the federal court in Manhattan. In his plea statement, he said, "[A]s the years went by I realized that my arrest and this day would inevitably come."

He knew he'd face the music because his Ponzi scheme was ultimately untenable. He couldn't continue to pay steady, above average returns forever. Wall Street is in New York, not on the shores of Lake Wobegon. Bernie was a little man in a booth, and he knew that when someone drew back the curtain, he would be revealed as a humbug.

Unfortunately for his victims, they can't just click their heels three times, repeating "there's no place like home" and miraculously get their money back. The principle of caveat emptor hasn't legally applied in the stock markets since the federal securities laws were adopted in 1933 and 1934. But it remains a sound practical guidepost. When the money has evaporated, as is the case with Bernie's little scam, all the legal liability in the world can't make the investors whole. Be cautious about investment opportunities. If it sounds too good to be true, it probably isn't true.

One wonders whether Bernie has leveled with the court and with his victims. He didn't agree to cooperate with the government. That suggests that he has secrets he'd prefer to take to the grave. His plea statement (which lawyers call an "allocution") was carefully crafted to point the finger at himself, and only himself. It would make Bernie appear to be a super-con, who perpetrated a $64 billion fraud all by himself. Yet, one would have to suspend credulity to accept that he could have pulled this off alone. Too much work was required, too many documents were necessary, too many communications were made, and too much money was involved. There are plenty of American banks that don't have $64 billion in deposits. Are we to believe that ole Bernie, all by his little lonesome self on the 17th floor of the Lipstick Building, was able to skim off more money than the GDP of some nations?

Bernie's scam takes us from the world of stocks and bonds to the world of crime. In the criminal world, a guy doesn't plead guilty to almost a dozen felony counts, putting himself in federal prison probably for the rest of his life, unless he's got a powerful reason or two. What's his game? Who's he shielding? Is he protecting his former colleagues? If so, why? What do they have on him? Is he protecting his wife? Or other family members? Why not try to cut a deal with the prosecutors to shield his family and perhaps others from criminal prosection in return for his guilty plea and cooperation? Such deals are not unknown.

Let's recall that a $64 billion Ponzi scheme implies a cash flow of $64 billion. That's really quite a lot of cash. Neither Bill Gates nor Warren Buffett have anywhere near that much cash. Their wealth is embodied in stocks and other assets. Much of the $64 billion probably was paid to withdrawing investors to maintain the appearance that all was well. But you have to consider the possibility that Bernie was up to something more than stealing from his family, friends, colleagues, charities and others. Was he laundering money? That would probably have been easy, given the cash flow he controlled. If so, whose money was he laundering? U.S. citizens evading taxes? Mobsters and other drug dealers trying legitimize their ill-gotten gains? U.S. intelligence activities that couldn't be funded through conventional government appropriations processes? Russian oligarchs trying to stash a nest egg in a safe Western country? Leaders of foreign governments stealing from their citizens? Other dark forces? If such persons were among Bernie's victims, they might not consider civil remedies available in American courts to be adequate recompense.

Bernie could be better off than some of his victims. He'll always get three squares a day, and a warm place to sleep. He'll have access to indoor plumbing; no peeing in an alley. He'll get free medical care and free clothing--not exactly stylish stuff but he won't look out of place for his environs. He won't have to skulk into a supermarket and buy dog food for a fictitious dog. And there's the fact that security in federal prisons isn't bad. Not all that many inmates are murdered. Bernie, in effect, might have today talked his way to free security service for the rest of his life.

An intelligent guy like Bernie Madoff doesn't ensure that he'll quietly stay in the pen for life without having a really strong reason or two. The government is continuing its investigation, as it should, because it's doubtful we have the full story. And we don't want the government to be scammed by Bernie, not this time.

Tuesday, March 10, 2009

Did Citigroup Just Bet the Ranch?

Today, March 10, 2009, the Dow Jones Industrial Average rose 379 points, about 5.8%. A crucial reason for the upward burst was a Citigroup memo, from CEO Vikram Pandit to employees, which wound up in the hands of the press. The memo stated that Citigroup was profitable for the first two months of the year.

This memo was filed with the SEC, possibly because its leakage into the public realm may have made filing advisable under the SEC's Regulation FD. One wonders whether Pandit considered the possibility of a leak before issuing the memo. A corporation's financial results after the first two months of a quarter can often be quite preliminary. A lot of hard decisions about asset writedowns, loan loss reserves, and other crucial accounting items are made in the last month of the quarter. Many are made in the last few days of the quarter. The fact that a corporation is profitable before these tough calls are made may be of little significance by the time quarterly results are reported.

By all indications, all of the stressors on Citigroup's financial performance over the last year and a half persist. The real estate market continues to fall, credit is freezing up again, bids on hinky assets are lower than a snake's belly, the U.S. and world economies are sinking at increasing velocities, loans of every stripe and variety are experiencing increasing rates of default, and the federal government continues its slow, torpid fan dance about nationalizing, or not, the major banks. Is there a significant risk of more big writedowns by Citigroup at the end of this quarter? Does a bear sit in the woods?

If Citigroup does report bad numbers at the end of the current quarter, today's memo from Pandit will acquire a haunting quality. Clearly the market took it positively. An adverse report of full quarterly results will not only have a negative impact on the stock market, but the negativity will be exacerbated by the contrast with today's upbeat message. In such circumstances, Citigroup would likely buy itself shareholder lawsuits and regulatory investigations. But those would be minor concerns compared to its loss of credibility in the market. The worst thing a large, troubled bank could do today is to raise hopes, only to dash them a few weeks later. At that juncture, any potential for private infusions of capital would, however evanescent they may be today, totally evaporate. Nationalization would be the bank's only future.

So Citigroup may have bet the ranch today. We'll soon find out if that's so.

Sunday, March 8, 2009

The Economic Crisis: Build, Don't Just Bail

The American public is suffering from bailout fatigue. Last week's announcement of a mortgage bailout prompted more criticism than praise, as the fiscally responsible denounced having to prop up the irresponsible and reckless. The Federal Reserve's soon to be implemented TALF (Term Asset-Backed Securities Loan Facility) will provide hedge funds and other wealthy money managers the opportunity to greatly increase their net worth by investing in consumer, student and small business loans while taxpayers largely bear the risk of loss. It's hard for the smart money to turn away from a heads we win, tails the taxpayers lose bet. And that's what the Fed is offering them.

Then, there's AIG. Last week, Federal Reserve Vice Chairman Donald Kohn declined, in Congressional testimony, to identify the financial institutions that, as AIG counterparties, received billions of U.S. taxpayer monies through the bailout of AIG. This was like waving a red cape in front of Congress and the press. Congress made noise about withholding further bailout money. The press began running articles listing names of counterparties. The Wall Street weekend print edition ran a story, as did CNNMoney.com (http://money.cnn.com/2009/03/07/news/companies/aig.fortune/index.htm?postversion=2009030713). While the two lists aren't identical, you get the general picture that many of the world's largest banks transferred their AIG-related losses to the taxpayers, including a few that haven't previously been publicly identified as being in serious trouble.

Central bankers like to operate in secrecy, since they are afraid that the very fact of their doing their jobs--helping banks--can lead to runs that then push the banks under. That's not a trivial concern. But neither is the democratic nature of our government. The public is entitled to know what the government is up to, especially when it's spending hundreds of billions. In the absence of sunlight, government officials can make seriously bad decisions. Take a look at the Pentagon Papers case and what those documents say about the government's slide down the slippery slope in the Vietnam War. One important lesson from that case is that making important public policy in secret usually turns out badly.

The AIG bailout is turning out badly. With the Fed vigorously withholding information, Congress and the press now confidently assert that AIG has become a black hole. There is no public evidence to the contrary. Repeated assertions by government officials that all the bailout spending is, in the final analysis, of benefit to the public sound too much like "trust us." Perhaps more than is appreciated, the Bush 43 administration eviscerated public trust in the government. The M.I.A. WMDs used to justify the Iraq War, the disastrous response to Hurricane Katrina, the politicization of the Department of Justice, and, of course, the hear no evil, see no evil regulatory oversight of the financial markets combined to create a degree of voter mistrust that harks back to the post-Nixon 1970s. "Trust us" doesn't work any more.

It goes without saying that the smart move for the Fed would be to issue, at 8:30 a.m. on Monday, March 9, 2009, a press release publicly identifying the counterparties that benefited from the AIG bailout. We'll soon find out whether the Fed does the smart thing.

Perhaps equally, if not more, important is the need to spend more federal stimulus money to build the economy rather than bail out the undeserving. Just about all the bailout spending is devoted to short term measures designed to revive the flow of credit. Aside from the fact that they don't seem to be working, except to benefit wealthy and reckless bankers or reckless and irresponsible borrowers, these measures are boosting the federal deficit by quantum leaps. When the numbers get big enough (and they have), taxpayers worry about how they and their children will repay all this debt.

At the end of World War II, the U.S. had a much larger debt load, relative to GDP, than what it is currently expected to borrow for the economic crisis. The World War II public debt was more than 100% of GDP, while the current and likely federal stimulus and bailout programs may run the federal debt up to about 60% of GDP. The burden of World War II debt was reduced because the U.S. economy--and especially the productivity of U.S. workers--grew rapidly for the 25 years following the war. In other words, prosperity came from growth of the real economy and improvement of worker productivity. More efficiently building better cars, washing machines, computers, televisions and other goods created real wealth, so much so that the post-war American standard of living rose dramatically in spite of all the war debt.

To give the American taxpayer more of a stake in the government's current fiscal policy, the Obama administration should direct more money toward building and less toward bailing. The bailees are already in line for several trillion. Funding for building--measures that are explicitly aimed at fostering growth or improving worker productivity--may total around $212 billion. This includes $111 billion for infrastructure and scientific research, $53 billion for education and training, $43 billion for energy, and $5 billion for accelerated depreciation of new purchases of equipment. In other words, less than 10% of the spending now devoted to dealing with the financial and economic crises is aimed at boosting economic growth and improving worker productivity, the things that can make the future look bright to taxpayers. The remaining 90% plus is devoted to short term aid for the reckless, irresponsible and often wealthy that supposedly will provide trickle-down treats to taxpayers.

Trickle down doesn't sell in today's markets. Direct action is necessary. More fiscal spending should be devoted to strengthening the economy and improving worker productivity. Tax policy should encourage research and development, and new investment. Perhaps special attention could be given to fostering nationwide availability of high-speed wireless Internet access--a powerful information highway system could complement the concrete and pavement Interstate highway system begun in the 1950s. Given that the U.S. has an increasingly ideas-based economy, a robust communications system is essential.

Federal policy should enhance long term growth, and not just engage in short term pump priming. Without clear, concrete benefits for all, the government's fiscal and monetary policies may well lose legitimacy in the eyes of the electorate. If that happens, the groundhog will see a big, dark shadow and you should prepare for a long, cold winter.

Wednesday, March 4, 2009

Banking on Social Security

It sounds like an oxymoron, but a lot of people will probably end up banking on Social Security. With the U.S. and world economies deleveraging from a massive credit bubble, the values of all sorts of assets continue to fall. Asset values will bottom out eventually. But no one knows when that will happen, and recovery is likely to be slow. Stock and real estate prices will probably need a decade or more before they approach their previous peaks on an inflation adjusted basis. People who expected their homes and 401(k) accounts to cover retirement expenses are now lowering their expectations. Social Security is likely to be a crucial financial foundation for many millions of retirees. With that in mind, here are a couple of things to remember.

Working longer builds benefits. You knew that, but have you ever tried to quantify the impact of working longer? Look at your annual statement from Social Security for an idea of how much more you get if you keep working. There's a potentially big difference if you work until 70 instead of starting to draw benefits at 62 (about a 50% increase). If you start to collect benefits at 62, your benefits will be permanently reduced (although you'll get increases for inflation). Working longer also provides earned income from which you can save more. Now that the stock market is back to 1996-97 levels (meaning that 13 years of investment gains have simply evaporated), we now understand that Ben Franklin had it right: a penny saved indeed is a penny earned. Granted, working, in general, stinks. But so does poverty. If you have to depend mostly on Social Security in your retirement, the extra $100 or $200 a month you'd get from working longer will make a noticeable difference. For more information on when to start collecting benefits, see http://blogger.uncleleosden.com/2007/05/mysteries-of-social-security-retirement_02.html.

Dependents can collect benefits, too. One of the less well known features of Social Security retirement benefits is that dependents of retirees can also collect benefits. There are limits on how much a family, in total, can receive (up to 150% to 180% of the retiree's benefits). This feature is a great way to save for college expenses of your late in life children or your grandchildren if they are your dependents. However, you aren't required to use the money for college expenses. Family structures keep changing and evolving, and many older folks are raising children or grandchildren. Keep in mind the possibility of benefits for dependents. You may want to start collecting benefits sooner rather than later, if doing so is in the overall best interests of the family.

There's plenty of yacking in the press and on political blogs about the insolvency, bankruptcy, infeasibility or whatever of Social Security. Don't worry. Social Security is here to stay. Your Representatives and Senators won't keep their jobs if the system becomes truly endangered. The amounts of benefits may have to be trimmed a little, and retirement ages may be pushed back a bit. But the fundamental system will remain sound, especially since people no longer can count on the stock and real estate markets. Younger voters may grumble. But they'll realize soon enough that if Social Security doesn't support their parents, they'll have to. That will clarify their thinking.

Monday, March 2, 2009

The Costs of the AIG Bailout

With today's announcement that AIG will get another $30 billion in federal credit, the total cost of its federal bailout has reached approximately $180 billion. The total TARP funding is $700 billion and total Federal Reserve emergency facilities for the financial markets run into the trillions. So $180 billion might not seem like much. However, consider what could be done if it were spent otherwise.

Health Insurance. Let's assume the cost of insuring a family of 4 is $15,000 a year (perhaps a high estimate, but we're being conservative). With $180 billion, the federal government could insure some 12 million families. Many of the uninsured are single. Still, with $180 billion, we could cover most of the 40 to 50 million Americans without health insurance.

Unemployment Compensation. Let's assume the average cost of unemployment compensation benefits are $1,000 a month and that a person receives a year of benefits. That would be $12,000 a year. If we applied $180 billion unemployment comp, we could cover 15 million unemployed people for a year. That might be close all the unemployed we have now.

Mortgage Relief. The cost of helping struggling homeowners is very difficult to estimate since the government still hasn't released the details of how the program will work. But let's make a very rough estimate that assistance would cost taxpayers $30,000 per mortgage. This would include interest rate and principal reductions and other relief. With $180 billion, we could provide relief to the owners of 6 million homes. No one knows for sure how much mortgage relief is needed, but easing the pain for the owners of 6 million homes would surely sooth the housing markets.

Social Security. The Social Security Administration says that the average retirement benefit in 2009 is $1153 per month (equivalent to $13,836 a year). With $180 billion, benefits for some 13 million Social Security recipients could be funded for a year at current average levels. Approximately 41 million people receive Social Security retirements or are dependents of Social Security retirement recipients. So $180 billion would cover a large part of their needs.

National Security. The Air Force's F-22 Raptor, an aerial interceptor that would give the U.S. Air Force command of the skies for decades to come, is the most expensive fighter ever. Current plans call for 183 to be produced, at a total program cost of $62 billion (or $339 million per plane). With 183 F-22s, the Air Force would have to continue to use the 1970s vintage F-15. The Air Force would like many more F-22's, because potential adversaries have aircraft that can match the F-15. President Obama would like to contain defense spending and direct more federal monies toward civilian programs. Let's take $180 billion, and allocate half of it--$90 billion--to cover the entire cost of the F-22 program and also build more planes. The incremental cost of additional planes is very difficult to estimate, given the vagaries of the military procurement process. But publicly available information indicates that $150 million per plane may be a reasonable approximation. At that price, the Air Force could get another 186 F-22s, doubling the its air superiority capability, and we'd still have $90 billion left for whatever else seemed like a good idea.

Auto Makers. GM and Chrysler have asked for an additional $21 billion in loans from the federal government. These requests seem to be on the low side. Many believe that the ultimate cost of bailing out the auto companies, and their suppliers and dealers, may be much greater, possibly up to $130 billion. With $180 billion, we could bail out the auto companies and their suppliers and dealers, and still have $50 billion left. The auto makers directly or indirectly supporting 2 million jobs, and unemployment is closing in on 8 percent. Favoring an insurance company over the heart of America's manufacturing sector is gradually becoming open to question.

The AIG bailout, for the most part, protect's AIG's creditors, especially its credit default swap counterparties. The latter are said to include a number of large European banks. The AIG bailout has been justified on the ground that its collapse would create havoc in the world's financial system. But would the home nations of these European banks simply allow them to collapse? That's extremely doubtful, given the financial sector bailouts that have already been implemented by European governments. Just as the U.S. government isn't going to let the U.S. banking system go under, neither will the Europeans allow their banks to collapse. The U.S. bailout of AIG is, in part, a wealth transfer from U.S. taxpayers to European banks (and perhaps, indirectly, to European taxpayers). Europe is a nice place, with good food and drink, quaint castles, and an abundance of interesting museums. But the European banks and other institutional investors that bought credit default swaps from AIG were consenting adults, and should be held responsible for the credit risks they voluntarily undertook. When you look at what else the U.S. could get for $180 billion, you have to wonder if we are truly getting our money's worth from the AIG bailout. And if so, shouldn't the Europeans have to spare a dime or two for the bailout?

The CEO of AIG has said he wants to ensure the company repays the bailout funds. However, today AIG reported a $62 billion loss for the fourth quarter of 2008, the largest quarterly loss by any corporation in American history. The company also reported a $99 billion loss for all of 2008. With results like these, the prospects of AIG repaying the bailout grow dimmer. And the potential for additional bailout funding for AIG grows. If you've wondered what it would be like to be on a slippery slope, now you know.