Tuesday, June 30, 2009

Will Bernie Madoff Now Talk?

In sentencing Bernard Madoff to 150 years, Judge Denny Chin expressed the outrage and condemnation that so many feel. He also set in motion a subtle dynamic.

The 150 year sentence must be a record for white collar crime. With Madoff being 71, he's destined to die in prison. That is, unless the sentence is reduced.

An inmate whose record is so egregious as Madoff's won't have much chance for a reduction of sentence. But he might pull it off if he provides substantial and fruitful cooperation to the government's continuing investigation. In this case, cooperation would include, at a minimum, information, testimony, documents, and any assets he hasn't turned over. While Madoff may have provided the government with some information through his lawyer, cooperation of the sentencing-reducing sort would mean full, unreserved and comprehensive disclosure, with nothing held back (except possibly limited amounts of information subject to legal privileges like the attorney-client privilege).

Clearly, Madoff doesn't want to spend the rest of his life in jail. His lawyer proposed a 12 year sentence, which isn't any slap on the wrist because it would mean incarceration in a medium security prison. You'd be better off in a 50-year old motel near the freeway in downtown Detroit than in a medium security prison (although that would be a close call). But a 12 year sentence, with time off for good behavior, might have gotten him out before he went six feet under. He hasn't got a prayer of living to see an early release for good behavior now.

As we discussed before, it is very curious that Madoff pled guilty without agreeing to cooperate with the government (see http://blogger.uncleleosden.com/2009/03/what-bernie-madoff-told-us-today.html). For a guy who apparently doesn't want to spend the rest of his life in prison, cooperation would be the most obvious way to get a lighter sentence. Since Madoff didn't agree to cooperate, he may well have something to hide. Billions stashed away overseas? He was laundering money for narco traffickers? He was hiding assets for foreign dictators and Russian oligarchs? His unreserved cooperation would mean jail time for his wife and sons?

Judge Chin, a former federal prosecutor, would surely understand the pressure a 150 year sentence would place on Madoff to cooperate. And perhaps that was his intention. Madoff and his lawyer will probably be chatting about this question. Perhaps equally important, people that Madoff might implicate will likely be chatting with their lawyers about this question. If Madoff fingers them now, their sentences could be harsher than if they stepped forward first, admitted guilt and themselves cooperated with the government. If they step forward quickly before Bernie talks, they may get significantly better outcomes than Bernie.

Madoff and others may have been stonewalling the government so far. But the 150 year sentence places Bernie under greater pressure to cooperate. Others who may be involved in the scam know, as do we all, that Madoff has betrayed plenty of people before. Can they be sure he'll protect them now? Or should they step forward first and get the sweetest deal available under the circumstances from the government?

The Bernie Madoff story may not be over. Time will tell.

Sunday, June 28, 2009

Bernie Madoff's Legacy: Fraud Insurance?

Bernie Madoff is scheduled to be sentenced tomorrow, Monday, June 29, 2009, in the federal district court in Manhattan. Given the enormity of his frauds, he is more likely to get justice than mercy--and deservedly so. Shakespeare notwithstanding, there are times when the quality of mercy would be strained.

Madoff's legacy includes devastated victims, penniless retirees, ruined charities, embarrassed regulators and a lengthy process of recovering assets that will probably yield his victims only pennies on their invested dollars. Few will benefit from Madoff's scam--he had a good time while it lasted, and the authors and publishers of the 14 definitive accounts of the Madoff story to be released in the next 2 weeks may also benefit. Hollywood script writers surely are busy, even though 9 out of 10 of their products won't actually be made into films.

Madoff is making a contribution to popular culture, although not in a way he would have intended. Perhaps part of his legacy could be a contribution to the investment markets, although not in a way he would have intended.

The Madoff mess raises the question whether there should be fraud insurance; that is, insurance that would protect investors from losses caused by fraud. If, at first glance, this seems like a strange idea, consider the fact that it already exists in other settings.

Fraud is simply a form of theft. Standard property insurance policies like auto and homeowners coverage contain provisions covering losses from theft. Businesses can buy fidelity bonds, which protect them against loss resulting from employee theft and fraud. In a limited sense, FDIC and SIPC insurance protect against some fraud. If a bank or brokerage firm collapse because of fraudulent activities of the persons controlling the bank or firm, the FDIC and SIPC protect customers to the same extent that they would if the bank or firm collapsed because of poor economic conditions. If a brokerage firm takes a customer's money and sends the customer account statements showing stock, bond and other securities holdings, but the firm in fact does not buy anything for the customer and simply pockets his or her money, SIPC would protect that customer to the extent of its $500,000 limit (with a $100,000 limit for cash shown on the account statements).

Credit card companies generally absorb all unauthorized charges when a cardholder's card or account number is stolen. The cost of doing this is built into the fees and interest charges imposed on customers by the credit card companies. That is akin to an insurance policy for credit card theft and fraud where the premiums are included in the overall costs of credit card usage.

Thus, the cost of fraud is regularly quantified and insured in some settings. Greater coverage for investors is likely to be feasible. The FDIC was founded in 1933 and SIPC in 1970. Statistical resources in those days (including databases and computing power) were much less than what is available today. With today's much greater analytical ability, quantifying the potential for fraud should be easier than 40 or 75 years ago.

Fraud insurance could go farther than SIPC insurance, in that it could cover brokerage accounts above SIPC's $500,000 limit. It could also insure against fraud in particular investments. Recall Enron and WorldCom. These are companies whose stock values were largely blown up by management fraud. Of course, fraud insurance wouldn't cover market risk. If a company is honest, but poorly managed, investors will have to take their lumps. But if management loots the company, the insurer would pay. Although the amounts would be larger, this isn't terribly different from the insurer paying when a lower level finance department employee loots a company's checking account.

Of course, some of the details could be devilish. Stockholders lose market value when management engages in fraud, and they're primarily interested in having that market value protected. Insurance policies with carefully crafted and well-disclosed parameters to the scope of market losses covered may be the answer. Insurers could cover specified dollar amounts per share of market loss, or larger specified amounts if investors are willing to pay higher premiums. The reason why quantified exposures could work is that insurers would probably be able to turn around and hedge them with offsetting contracts, or find reinsurers to take some of the risk. Open-ended exposures would be much hotter tamales.

Fraud insurance should be a private sector product. While the private sector doesn't always get it right (look at the mess with credit default swaps creating systemic risk to the financial system), fraud insurance offered under government auspices would entail too much potential for politically driven, morally hazardous bailouts.

Of course, not all investments would be eligible for coverage. Take a congenial, Stetson-wearing fellow driving a nice new three-quarter ton pickup truck with a crew cab who offers sure-to-win shares in an ostrich farm. It's doubtful any fraud insurer would cover his glowing investment opportunities. And an insurer asked to put its butt on the line for a Madoff investment might find Bernie's eerily steady returns a bit too unnerving. However, the unavailability of coverage for some investments isn't necessarily bad: it would provide valuable information to investors. If an investment can't be insured, maybe it's not such a good idea.

Fraud coverage might be expensive, depending on the investment. But giving investors a choice to buy coverage could improve the investing climate, just as the availability of sometimes expensive flood and hurricane insurance in some areas has facilitated development. Today's securities markets are bigger and more complex than ever. Even extremely wealthy, well-educated and sophisticated people didn't figure out that Bernie Madoff was a fraud. Without greater availability of insurance, investors cowed by the bear market and the Madoff and other frauds may find it easier to rationalize stuffing a mattress full of cash. (Note that federal deposit insurance is perhaps the most important reason why customers have faith in the banking system, even though many of today's senior banking executives have provided a plethora of reasons for depositors to hit the mattresses.)

There's a lot of talk in Washington and New York about restoring faith in the financial system. But that talk isn't winning investors over. As they say on the Street, money talks and bullswaggle walks. Fraud insurance means money to an investor who's been ripped off. Its time may have come.

Wednesday, June 24, 2009

Keeping Your Loved Ones Away From Financial Predators

When it comes to financial predation, the Bernie Madoffs of the world get all the publicity (lucky them). The banality of ordinary financial ripoffs means they get much less press coverage. Most of the chiseling by the financial services industry is just that--snipping off a bit too much in fees here or generating too many commissions there, while putting the investor at undue risk. The losses are often measured in thousands or tens of thousands per client, instead of the millions or more lost by many of Madoff's victims. But this low level snitching, in the aggregate, is big business because numerous people are victimized. Not all financial predation is necessarily illegal. When it is, proof is often difficult to get because the predators target the weak--elderly folks with failing minds, children or impaired adults living on structured settlements or inheritances, or unsophisticated and trusting adults. These people are less able to take care of themselves or serve as witnesses in legal proceedings against the bad guys. So it's important for those who are helping the dependent and weak to be alert to signs of financial predation.

Here are certain typical problems to watch for.

Money shifting from known investment types to the unknown. If your aged parent has, all his or her life, invested conservatively and paid off the mortgage, a sudden change in asset mix to weird, strange, bizarre, incomprehensible or just plain silly investments is a danger signal. Most likely, a sweet-talking money manager has flimflamed your loved one into buying a bunch of high risk assets that pay the money manager large commissions or other income. It's important to understand that most con artists are difficult to spot. The stereotypical fast talker with shifty eyes, a quavering lower lip and too much aftershave rarely succeeds as a crook. Really good crooks are very hard to spot--read up about Bernie Madoff for more on this point. Also see http://blogger.uncleleosden.com/2007/05/how-to-spot-crook.html.

Money shifting from insured bank accounts to uninsured investments. Folks who are dependent or weak, like the elderly, minors or the mentally impaired, shouldn't have portfolios that resemble a hedge fund's. A goodly amount of federally insured cash is usually in their best interests. If you see an outflow of safe money into uninsured investments, look more closely and find out what's going on. While a young adult in good health might reasonably take some major risks, the weak and dependent need reliability and safety.

Money moving often from one investment to another. When you see your loved one first investing in one thing, and a few months later selling the first and buying another, and a few months later repeating the same pattern, be alert. A money manager may be "churning" your loved one's assets. Churning is a common problem with brokerage firms, where brokers get less sophisticated clients to do a lot of buying and selling of stocks, bonds and other investments, in order to generate commissions for the brokers. In extreme cases, these commissions and poor investment choices can reduce a client's account by half or more.

Unjustified real estate loans (reverse mortgages). While a lot of complex real estate lending (like adjustable rate loans with teaser rates and no money down) has ground to a halt with the collapse of the real estate market, reverse mortgages are still being offered. They offer a way for an older person (62 or older) to borrow against his or her home, and not have to repay the loan until the home is sold, or the borrower permanently moves out or dies. For older people with little liquidity and a desire to stay at home, reverse mortgages may be appropriate. But these loans also involve steep fees that may tempt mortgage brokers to fast talk an older person into taking an unneeded reverse mortgage. The worst scenario is a reverse mortgage where some or all of the loan proceeds are used to buy an investment that pays the mortgage broker a second fat commission. If an aged parent starts looking into a reverse mortgage, try to provide a little skepticism. It may be the right thing for some, but certainly not for everyone. See http://blogger.uncleleosden.com/2007/06/reverse-mortgages.html.

Deferred Annuities. An elderly person has little reason to buy a deferred annuity. An immediate annuity (one that begins payments right away) may be a suitable estate planning tool, if it involves half or less of a person's assets. See http://blogger.uncleleosden.com/2007/06/annuities.html. But a deferred annuity will generally be a terrible idea for someone who is 70, 80 or older. Anyone in that age group who buys a deferred annuity may well have been victimized by a sales person looking for a fat and fast commission. A younger retired person (like age 60 or 62) might reasonably buy a deferred annuity that begins payments at, say age 80, as a way of ensuring that he or she doesn't run out of money late in life. Even then, beware of the fees, withdrawal charges and other costs, especially if a variable deferred annuity is under consideration.

Tax Shelters with tax shelters.
Funds in a retirement account, like an IRA or 401(k), should never be used to buy a tax shelter--such as a deferred annuity. Retirement accounts are already tax shelters. Buying a tax shelter with already sheltered funds generally means the investor needlessly paid extra fees and costs.

Life insurance. Life insurance is usually for parents and other adults with dependents. A dependent or an elderly person isn't likely to have a need for life insurance. Even if there is one reason or another, the cost of life insurance for a 7o or 80-year old will probably be too high to be worth paying. Whole life, universal life or other life insurance that involves an investment feature is highly suspect. These policies are usually costly in terms of fees, surrender charges, etc., and are notorious for having surprise provisions buried in the fine print. If your elderly or dependent loved one all of a sudden develops an interest in life insurance, be skeptical.

It's tough to take care of an elderly person or other dependent. See http://blogger.uncleleosden.com/2007/10/assisted-living-financing-choosing-and.html. But it will probably be one of the best things you do in your life. It may end sadly, but you'll have the profound satisfaction of having done the right thing for someone who means a lot to you.

Sunday, June 21, 2009

Will the Financial Regulatory Reform Package Work?


Okay, now that we've taken care of the important stuff, let's turn to something boring. To evaluate the likely effectiveness of the new financial regulatory reform package, we should consider how the next financial markets boom, bust and morass will happen. The story begins with money (where everything on Wall Street begins).

High profit products sold by Wall Street tend to be those that are new, innovative and preferably (from the Street's point of view) complex. The newer and more unfamiliar the product, the less customers understand it and the larger the markup that can be charged. A new product is easily pitched as a better mousetrap--customers don't understand it well enough to know better. New products are readily used to create new fashions, and anything that's fashionable will be profitable.

Another key factor in profitability is regulation--or, rather, the avoidance of it. The less the regulators hover around, the more earnings reach the bottom line. It costs money to protect investors and consumers. Unregulated or lightly regulated financial products boost executive bonuses.

These are the most important reasons why we wound up having such big problems with CDOs, credit default swaps and all the rest of the derivatives market menagerie we now know and love so well. They were new, complex, not well understood and hardly touched by regulation. Wall Street took advantage of them to create a multi-trillion dollar unregulated banking industry, using SIVs and other holding tanks that the accounting rules allowed to be swept under the rug whenever anyone might be looking. The result was a vast, highly leveraged, unregulated, and virtually invisible banking industry that took so much risk it wrecked the economy and truck bombed the federal deficit.

The new financial regulatory reform package includes myriad provisions for dealing with derivatives, unpayable mortgage loans to the uncreditworthy, inadequate capital requirements for banks, oversight of firms whose viability can threaten the stability of the financial system, and various other issues that emerged during the past 18 months of financial crisis. The question remains, however, whether the government is building a mighty Maginot Line that clever financial engineers will outflank.

The next thing that is likely to blow up Wall Street won't be a financial product that now exists, since current products are or will soon be heavily regulated. The next thing will be developed when the contours of financial regulatory reform become clearer, and the product can be designed to steer around regulated territory. Since it doesn't exist yet, the new product has no name. For now, let's call it a chicken salad sandwich.

The chicken salad sandwich will be carefully crafted so that it doesn't fall within the legal definition of a security (to avoid SEC regulation), a commodities futures contract (to avoid CFTC regulation), a depository account (to avoid banking regulation), an insurance product (to avoid state regulation), or anything else that is heavily regulated. To the extent that it might slip into the crosshairs of a regulator, the financial firms and their legions of lobbyists will work every angle and fundraiser in Washington to ensure that it stays out of official purview. That's what happened with derivatives contracts in the 1980s and 1990s (and we're now paying the price). The financial services industry will try to repeat that "success" with the chicken salad sandwich. It will also work over the accounting standards setters to keep the chicken salad sandwich off any financial statements that anyone might have to disclose publicly. Information is power, and keeping information out of the hands of regulators and investors increases Wall Street's power (and profits).

Assuming the Street is successful in carving out an unregulated enclave for the chicken salad sandwich, it will drive truckloads upon truckloads of investor money into the promised land (or the land of promises, to be precise) and invest it all in chicken salad sandwiches. The price of chicken salad will rise, and then skyrocket. Fortunes will be made on Wall Street. Real estate values in the Hamptons and on the Vineyard will revive. Expensive, tasteless parties will again be reported in the society pages. Manufacturers of $6,000 umbrella stands will start hiring. Financiers will prosper, indulge and gloat. That is, until market forces we now know too well reach the point of excess and force the Street, once more, to say goodbye to all that.

The 88-page description of the proposed regulatory reforms issued last week includes a lot of talk about federal regulators working harder, better, more comprehensively and in greater coordination with each other. A lot of attention is paid to asset-backed securities, derivatives, hedge funds and other players in the recent financial drama. But there isn't much recognition of the likely source of future problems--innovative products designed to slip through the regulatory net. Yes, the proposal calls for the formation of a Financial Services Oversight Council that will, among other things, "identify gaps in regulation and prepare an annual report to Congress on market developments and potential emerging risks." That's nice: another government report.

But what we need is a strong mandate for lots of official curiosity about potential future economic time bombs. If everything done by all financial firms falls under future regulation (a possibility the current proposals do not seem to envision), the chicken salad sandwich could be produced by nonfinancial firms. That isn't hypothetical. Recall how Enron was a major player in the energy markets. You don't have to be a financial firm to speculate. The proposed regulatory reforms will require increased government funding, more civil servants and greater regulatory vigor. But it will be mostly wasted if chicken salad sandwiches are allowed to bloviate into another large, unregulated financial sector. The Panic of 1907, the stock market crash of 1929 and the recent debacle all involved significant leverage in largely unregulated financial markets which eventually collapsed and caused enormous collateral damage. By contrast, the 2000 tech stock collapse didn't bring down a large part of the financial sector and the economy continued to do reasonably well.

Curiously, the proposed reforms did not include a simple measure that might significantly reduce the potential for a future chicken salad debacle. The 1987 stock market crash, during which the Dow Jones Industrial Average dropped 22% in a single day, did not result in anything like the recession we are now experiencing. That, in all likelihood, is because the commercial banking sector, which in those days was separated from investment banking by virtue of the Glass-Steagall Act, was not seriously damaged by the stock market panic. Indeed, the Federal Reserve used commercial banks to prop up investment banks with a gush of credit. On the other hand, when Bear Stearns and Lehman teetered at the brink in 2008, there was no stable commercial banking sector for the Fed to use in similar fashion, and things got ugly.

Like the 2000 tech stock collapse, the 1987 stock market crash indicates that asset bubbles are less of a systemic threat when there exists a commercial banking sector that isn't heavily exposed to them. Congress, the administration, regulators and regulatees will be debating financial regulatory reform for many months to come. It is seriously heretical in today's Washington-New York orbit to suggest a revival of Glass-Steagall. But we don't need to call it Glass-Steagall. Let's call it a dill pickle. A dill pickle that insulates the commercial banking sector from the volatility of more speculative activities creates an anchor to the financial system and therefore the economy. Supported by federal deposit insurance, the dill pickle version of commercial banking would be boring, and not enormously profitable. But it would provide comparative stability. By contrast, the combined commercial-investment banks we have today create enormous risk and then spread it widely throughout the economy. When the risks are realized, pain isn't focused narrowly but instead spreads widely throughout the economy.

Moderation of risk encourages economic activity. That's why the corporate form of doing business, with limited liability to shareholders, was a crucial building block of the modern industrialized economy. Moderation of the risk of systemic financial failure is also critically important to economic health. That's why federal deposit insurance was enacted. But banks have become so large that the federal budget (or, rather, deficit) has become the financial system's true backstop. Breaking up the big banks into comparatively stable commercial banks and risk taking investment banks would reduce the size of some too-big-to-fail firms and lessen the economy-wide impact of financial volatility. There's no reason for people in Flint or Montgomery to bear the risks of financial speculation by Wall Streeters. They presently do so because the federal financial regulatory system allows that to happen. Things don't have to be that way.

Tuesday, June 16, 2009

A Bailout for the States?

Abraham Lincoln sat on an old tree that had fallen next to the stream, finding restful the mellifluous gurgle of its waters. Heaven was ever so peaceful. Although he was sometimes bored from having little more to do than read and think, the burdens of his former life, especially from the great Civil War, seemed a distant storm that had blown past in the prevailing winds never to return.

Lincoln was preparing to turn his attention to the book in his lap when he heard the rustling of grass and leaves. He turned to see a man in a tri-cornered hat approaching.

"Alexander," he said.

"Good morning, Abraham," said Alexander Hamilton. "I trust you are well."

"It's difficult to be anything else here," said Lincoln, grateful that his flaws and failings had not prevented his passage through the Pearly Gates. He had come to learn that many viewed him as a great President. But in his heart he still saw himself as an awkward young man struggling to find his way in the world, and was surprised and embarrassed when others saw goodness in him that he didn't see in himself.

"No doubt about that, my friend. This place is much better than our previous habitat," said Hamilton. "By the way, are you following what's going on back there?"

"I can't say I pay close attention," said Lincoln. "I prefer peace of mind."

"There is much to be said for peace of mind," acknowledged Hamilton. "I would never dream of disturbing your peace of mind; except for some important unfinished business."

Lincoln suppressed the urge to sigh. Hamilton could be prickly and there was no point marring the Heavenly bliss.

"I believe that, in light of where we are, all of our Earthly business is done," he said.

"Not necessarily," said Hamilton earnestly. "Let me explain. The nation is suffering from a bad economic slowdown, triggered by excess financial speculation. The federal government is taking measures to stimulate the economy. But the economy continues to deteriorate. The states are running short of money. Some will be insolvent in a matter of a few months. One state, California, has already petitioned the federal government for assistance, but has been turned down. California has grown dramatically since you were President. It now has the eighth largest economy in the world, by itself. If its government has a fiscal crisis, the California economy could be severely disrupted. That, in turn, would hinder the national economy's recovery and perhaps even cause it to decline further."

"How can I do anything about this?" asked Lincoln.

"The new President, Barack Obama, greatly admires you," said Hamilton. "You could appear in one of his dreams and urge him to use federal money to bail out California."

Lincoln thought about Hamilton's suggestion. His brow furrowed deeper and deeper.

"I suppose this suggestion comes from your old idea of having the federal government assume the states' debts from the Revolution," he finally said.

"That would have unified the nation at an earlier time, and perhaps enhanced its growth and development," said Hamilton defensively.

"I don't think a bailout of the states now would be prudent," he said.

"Why not? The national welfare is at stake," said Hamilton. "The economy is in decline and there scant signs of recovery."

"A federal government that dispenses budgetary funding to the states would quickly become a domineering national government," said Lincoln. "That would be very dangerous."

"I thought you believed in a strong national government," said Hamilton.

"I believe in the Union," said Lincoln. "And the Constitution. The Constitution provides for a federal government of limited powers. All other powers are reserved to the States."

"But states rights was the battle cry of the Confederates," said Hamilton.

"The states play a crucial role in the Union," said Lincoln. "As the respository of all governmental powers not specifically conferred on the federal government, they can take advantage of the blessings of liberty and undertake all manner of new endeavors. They can experiment with new ideas, and promote the improvement and advancement of ideals, all without interference from the federal government. If, however, the federal government were to control the states' purse strings, it could also control their policies and governance."

"A strong national government was America's only defense against the retrogressive obfuscations of the slave states to preserve an abomination on the North American continent," cried Hamilton.

"Recall, my friend, that certain of the Northern states abolished slavery before the national government did," said Lincoln. "The abolitionist stances of these states paved the way for the federal government to do so during the exigencies of war. The slave states, by contrast, invoked the authority of the federal government to adopt the Fugitive Slave Laws to overcome Northern state law efforts to protect runaway slaves. National power can be used for good or evil. The states should bear the consequences of their poor fiscal judgments. Only then will their policies improve."

"But, Abraham, only the federal government has the means to raise the money needed to save the day," said Hamilton. "Its tax authority reaches much farther than the states. Remember what Franklin said: United we stand, divided we fall."

"Franklin was talking about how to fight a war," said Lincoln. "When it comes to the budgetary difficulties of the states, the question is who should bear the burdens of each state's spending decisions? If the answer is the federal taxpayer, then all notions of thrift and responsibility will be lost."

"I forgot," said Hamilton with a sigh. "You're the fellow who, legend has it, walked 5 miles or something like that to repay a debt of a few pennies."

"The federal tax structure is full of needless complexities and unfairnesses. Placing the burden of state expenditures on the federal taxpayer only exacerbates the undesirable effects of the federal tax structure," said Lincoln.

For a moment, nothing but the mellifluous gurgling of the stream could be heard.

"Well, I thought I'd try, " said Hamilton.

"Alexander, you've always had the nation's best interests at heart, and for that I commend you," said Lincoln. "Now, let us rest and leave the difficulties to those that created them."

Sunday, June 14, 2009

The Fed's June Meeting: Swimming Against the Tide of Interest Rates?

In America did the Federal Reserve
A stately pleasure land decree,
Where Dollar, the sacred river, ran
Through markets measureless to man,
Down to a sunless sea.

In a week and a half, the Federal Reserve's Open Market Committee will hold its June meeting. As usual, the most important question will be what the Fed does and says about interest rates. Stepping away from the anxieties of the moment and looking back at the last 15 or 20 years, one can see that the Fed has tended to followed market signals. Fed interest rate cuts and increases were often anticipated by the movement of market interest rates. The market's anticipation of monetary policy made it easier for the Fed to change government controlled rates, since it was leading where the market was prepared to follow (and sometimes had already gone).

Short term interest rates haven't changed in recent months. They are effectively controlled by the Fed's target rate for federal funds, which is currently between 0% and 0.25%. The price of short term dollars is what the Federal Reserve says it is. In effect, the Fed uses monetary policy as a price control.

However, the longer maturities in the bond markets roam much more freely. They are largely creatures of the market, rambling high and low as they wish. The Federal Reserve tried to corral them late last year and earlier this year with its quantitative easing program of buying longer term debt. But the Fed needs to practice bunching up the herd and moving it in the desired direction. Long term rates sprang loose and have risen sharply. A month ago, two-year Treasury notes were yielding around 0.87 %. Today, it's more like 1.27%. Ten-year Treasuries were yielding about 3.11% a month ago. Now, it's closer to 3.79%. Thirty-year Treasuries were yielding approximately 4.1 %. Nowadays, their yield is in the range of 4.64%. Mortgage rates have followed, leaving many would be re-financers and buyers stranded. At the same time, oil and gasoline prices are rising sharply, a natural market response to the flood of dollars but a threat to economic recovery.

The Fed's low interest rate policy is meant to spur economic activity and hoist the American consumer back on a lofty pedestal. But it's pretty clear from market signals that bond investors are nervous about all the money the Fed is printing with its low interest rates (and its quantitative easing debt purchases). While lots of well-credentialed commentators pooh pooh the threat of inflation (they evidently don't buy gasoline), the people with serious money on the line (i.e., bond investors) see things differently. They are trying to signal the Fed to move interest rates up. With the current crisis mentality in our nation's financial center (Washington), that's not happening any time soon.

But then the question comes up, what will happen when the government tries to fight the market's desire for higher rates? Today's incipient combination of rising commodities prices, rising mortgage rates and lots of government cash still sloshing around in the markets could result in another cycle of asset bubbles that painfully burst while the real economy stagnates. One wouldn't characterize this scenario as stagflation, but so what? It's bad. And bad isn't good.

Usually, governments that fight markets win in the near term and lose in the long term (recall the Soviet Union, a nation that no longer exists). Governments that accommodate market forces tend to survive (as in "Communist" China). Politically speaking, the United States is hardly about to splinter; if anything, it's rallied around its new President. But the Fed is increasingly trying to swim against market currents, and that's increasingly disturbing.

Thursday, June 11, 2009

Smarter Investors: a Problem for the Fed

Against all odds, there’s a possibility investors are a little smarter than they were three or four years ago. That’s unlikely. Investors have rarely managed to climb up the learning curve. The recent stock market collapse is near-conclusive proof that they remain as gullible and reckless as their grandparents and great grandparents in the 1920s.

Yet the recent sharp rise in long term Treasury securities yields and drop in the dollar suggest that investors fear the Fed. Specifically, they may be concerned that the Fed is printing so much money (and the Treasury is borrowing so much money) that another asset bubble is in the making. Ten years ago, investors didn’t worry about bubbles because, by all indications, the Fed in those days didn’t worry about bubbles. The tech stock bubble, the real estate bubble, and the credit bubble have administered painful lessons. Investors now worry about bubbles.

It’s unclear that the Fed worries about bubbles. It’s printing money like there’s no tomorrow. If it continues to print money like this, there won’t be much of a tomorrow. Investors have learned not to trust governments, not even the U.S. government. They’ve tuned into the fact that governments tolerate and sometimes even facilitate bubbles. It takes gullible investors to create a bubble, but it takes governments to grease the process with easy money. Investors have seemingly made some progress up the learning curve. But the government remains a one-trick dog.

In the last year, the U.S. government has dumped shiploads of cash into the economy. This cash is supposed to spur economic activity. But a policy of printing money requires true believers. People, and investors in particular, have to believe in the value of the currency. Evidence of apostasy exists.

The Big Money Dump has had limited effect. Banks aren’t lending if they have any alternative whatsoever and investors are staying away from the asset-backed securities market, which in the past decade was the true banking sector. Consequently, much of the Fed’s money is going into asset markets—Treasury securities for a while, now petroleum, gold, silver and so on. The Treasury bubble is bursting fast. Petroleum is the trade du jour. But the oil price rise counteracts the basic purpose of all the Fed’s money printing. Rising energy prices are tantamount to a reduction of consumer income, the worst outcome for an economy that depends on consumer spending. Rising mortgage rates have the same effect.

Thus, the markets are undermining federal policies. Backwards looking economic data shows that the economy is no longer sinking as fast as it was six months ago. But sinking is still sinking. Going from panic to malaise won’t feel good for long. The key question is when will the economy turn around and begin growing. The answer depends on the forward looking data. With gas prices jumping sharply, mortgage rates following Treasury rates upwards, unemployment still growing, and worst of all investors getting smarter, the federal government’s prospects for forging an economic recovery remain fogged in, at best.

Sunday, June 7, 2009

Death of a Millionaire

(The following is an imaginary conversation that, to our knowledge, has never taken place at the Metropolitan Correctional Center in Manhattan.)

Fred sat down on the bench and watched the other prisoners exercising. At the age of 60, he only felt the need to stretch his arms and legs a bit. Beyond that, exercise was just another thing he had lost interest in. Especially now, when after three days in prison, the stark reality of confinement was sinking in.

The older man on the other end of the bench turned and gave Fred a half-smile.

“How are you?” he asked.

“I’ve been better,” said Fred.

The older man nodded and said, “I know what you mean.”

Both men fell silent. Since things at the Metropolitan Correctional Center didn’t change much from day to day, there wasn’t much to talk about. But Fred figured that maybe this older guy, who seemed rather congenial, might be helpful.

“Say, do you know how to get something to read?” asked Fred.

“If you can find a guard who likes you, you might be able to spend extra time at the library,” said the older man.

“I’ll have to work on being pals with the guards, I guess,” said Fred. “I don’t find looking at walls very entertaining.”

“They’re not good conversationalists,” agreed the older man. “I tried looking out the window. It’s small and the bars get in the way. But I gave bird watching a try.”

“How did that go?” asked Fred, desperate for any diversion.

“After you learn to spot the pigeons, sparrows and the occasional hawk, there wasn’t much to see. I saw a seagull once or twice, and maybe a crow. That was the high point of bird watching for me.”

“I try to follow the little bit of the news I can learn,” said Fred. “But it all seems kind of irrelevant. In this place, it doesn’t matter what I think or feel about anything.”

“Oh, now, don’t think that way, uh, . . . what’s your name?”


“Hi, Fred. I’m Bernie.”

Fred looked at the extended hand, and after a moment gave a brief squeeze. It was funny how in prison social customs like shaking hands were still followed. Never before in his life had it seemed like so little mattered. But decorum remained.

“Listen, Fred, you can’t be negative. You have to keep your chin up, even in a place like this.”

Fred gave Bernie a puzzled look. But the older man kept the half-smile on his face, and gestured upwards with his right hand, as if he were lifting something.

“You’re not kidding,” said Fred.

“No. I always try to look at the bright side of things,” said Bernie.

Fred turned away, and slowly said, “So did I, once.”

“What happened?”

“I’ve been spending a lot of time thinking about that,” said Fred. “I still don’t know exactly what happened. I thought I was doing everything right. I mean, not exactly everything. I started college, but then dropped out after a couple of years. That was in the late 60s, and I was kind of rebellious, a free thinker. I dabbled in the counterculture. Went to a commune, but that was too weird so I left within weeks. I got a bunch of dead end jobs, lived in cheap apartments, and had a bunch of girlfriends; didn’t keep any of them for long. I got by, until I got tired of just getting by. Then I went back to college and earned a bachelors degree.”

“Good for you,” said Bernie. “You see, finishing college is an investment for the future, and investing is an act of optimism. You were an optimist when you did that.”

“Except that the economy was going to hell. That was in the 70s, when we had stagflation and malaise and disco.”

“I’m glad to say I never got into disco,” said Bernie.

“I'm sorry to say I did. The 70s were the Me Decade, if you remember,” said Fred.

“I don’t remember that,” said Bernie. “I was busy trying to build a business and support a family.”

“I could see job opportunities for college grads weren’t good, so I went to law school,” said Fred.

“That’s great. You became a professional man,” said Bernie.

“Yeah. I became a lawyer. I did well in school, so a big law firm hired me. They paid a lot, but I had to work day and night and weekends. That and the office politics got old real fast. So I took a job in a small firm where the hours and people were sane. Then I got married and bought a house in the suburbs. Had two kids, two cars, one dog and one cat. My life became normal.”

“Sounds like everything was going well,” said Bernie.

“It was,” said Fred. “My marriage was happy, the kids were smart and well-behaved, I became a partner at the firm and we traded up to a larger house in a better school district. Everything was going well. But, as I look back, I realize I had stopped thinking.”

“How so?” asked Bernie.

“I just began doing what everyone else was doing,” said Fred. “Going after a fancier lifestyle, trying to get all the symbols of success—big house, big cars, private schools for the kids, vacations in Europe, all that stuff. I even began to collect art—primitive folk art because I didn’t want to compete against the hedge fund guys. I borrowed against my house--for cars, tuition, clothes, you name it. Everyone was doing it and with housing values going up every year, it seemed like a winning bet. I didn’t forget about my retirement. I had a retirement plan, and invested in stocks, just like all the advisers told us. “

“Then, it all fell apart,” Fred continued. “My retirement plan took a beating when tech stocks collapsed in 2000. I thought my house would save me, and for a while it did. But then Wall Street blew up the housing market with these derivatives, which I still don’t understand. After that, the rest of the stock market collapsed, taking my retirement plan with it. The economy went to hell, and law business with it. My partners and I couldn’t agree how to salvage the firm, and it just fell apart. At my age, you can’t get anyone else to hire you. So I was unemployed and likely to stay that way. I couldn’t pay the mortgage and the home equity loans, so the house went into foreclosure. I had to move into a cheap apartment. It was like my life had gone full circle and I was 22 again, using an orange crate for a coffee table.”

“Life is funny,” agreed Bernie. “You can be king of the world one day and here at MCC the next.”

“The damndest thing is I was only doing what everyone else was doing,” said Fred. “I got an education and built a career. I bought the house in the suburbs and funded the retirement plan. Everyone said you had to be in stocks, so I put my money, and faith, in stocks. Between the house and the stocks, I was a millionaire just a few years ago.”

“Congratulations. You had the American Dream,” said Bernie.

“And then lost it. For reasons I still can’t wrap my head around. I mean, the Wall Street banks and hedge funds didn’t want the markets to collapse. How could they have done all the crazy stuff they did? The regulators didn’t want the chaos and panic they now have to deal with. How could they have let things run amok? I’d like to blame somebody besides myself. I only did what all these smart experts said I should do.”

“You shouldn’t blame yourself,” said Bernie. “A lot of things are out of your control.”

“I kind of went out of control. I went to Washington and began screaming outside the White House.”

“Is that what you’re in here for? Threatening the President?” asked Bernie.

“No. When the guards found out I was just mad about losing my house, my job and my retirement savings, they took me to a shelter for the homeless, where I got a hot meal and a place to stay for the night. I couldn’t stay angry after that, so I came back to New York. But I got mad again in New York and went to the Federal Reserve Bank in Manhattan. I began screaming at the regulators and blockaded some of their limousines as they were trying to leave.”

“So you’re in here for interfering with the operations of the federal government?” asked Bernie.

“No. When a Fed staffer found out I was pissed off because I was broke and out of work, he took me to a deli for lunch and listened to me complain for two hours. After he was so nice, I couldn’t stay mad at the regulators.”

“So how come you’re here?” asked Bernie.

“I regressed. I went back to being 22. With no job, no house and no money, I was in the same place I had been when I was 22. The millionaire me was gone forever. I did a juvenile thing. I took a picture of my bare ass, loaded it onto my computer and e-mailed it to every bank, mortgage lender, brokerage firm, investment adviser and anyone else who had any connection to my now ruined finances. I must have sent it to 50 places. The FBI arrested me and charged me with 50 counts of Internet porn.”

Bernie’s half-smile grew ever so slightly wider. “You must have gotten some satisfaction from doing that.”

“It was a childish thing to do, but, yes, I did feel better,” said Fred. “I’m still a bit rebellious, a bit of a free thinker.”

“I think you’ll get out pretty soon because you’ll have the sympathies of the judge and jury,” said Bernie.

“Maybe so. Then, I’ll have to figure out what to do. One thing I know is I have to start thinking for myself and stop doing things just because everyone else is doing them. With my working life almost over, and the financial and real estate markets a mess, I’ll never be a millionaire again. I have to find a new focus to life, maybe do something for the homeless or disadvantaged.”

“Attaboy, Fred. That’s the way to think. Optimism makes the world go around,” said Bernie.

“Why are you so cheery?” asked Fred. “You’ll never get out of prison.”

Bernie’s half-smile disappeared abruptly.

“I’m sorry,” said Fred. “I realized who you are when you told me your name is Bernie. You’re the guy that operated a $64 billion Ponzi scheme. They’ll never let you out.”

“I’ve always been an optimist,” said Bernie. “I had to be one, to start a firm in a cutthroat place like Wall Street. Then, when I began stepping over the line, I had to believe that somehow things would get better, I would be able to straighten things out, and make everyone whole. Later, when I realized that I would never be able to unravel things, I had to hope that I would be able to keep juggling all the balls and somehow not get caught. Most of the time, I was right to be optimistic. The markets kept going up, and my investors were like you—they didn’t really think about things. They just did what everyone else was doing. It was a helluva time while it lasted.”

Wednesday, June 3, 2009

Financial Accounting Trainwrecks Coming

With the recession 18 months along and things still getting worse, it's as certain as the sun rising in the east that we'll see some corporate accounting and financial reporting failures. This would be in addition to the well-publicized mess on Wall Street. Even though the recession started because of Wall Street's recklessness and mismanagement, all of corporate America has been hit by falling sales, tightened (or turned off) credit, and difficulties raising capital. A lot of companies are in tight spots, and there surely is plenty of temptation to be overly optimistic in reporting financial results.

It was about at this point during the 2000-2002 stock market and economic downturn that WorldCom and Enron blew up. We'll probably soon see one or more similar trainwrecks. Accounting frauds have a life of their own. Once you cook the books, you usually have to keep cooking the books every subsequent quarter and year. That's because corporate books and records reflect a continuing process, where earlier profits or losses affect today's assets and liabilities. If the profits or losses were, say, freshened up the previous quarter, today's assets could be too large, today's liabilities could be too small, or both. Thus, the company has an ongoing problem that requires it to own up to fibbing (ha, ha, that would be funny if shareholders' money weren't involved), or bake today's financial reports so that there aren't segue problems with the preceding quarter. The longer the shenanigans continue, the greater the chances the fraud will fall apart and be exposed because it gets harder and harder to keep reheating the books. This far into the recession, some frauds could be nearing the breaking point.

Of course, there have been lots of public companies that have been reporting terrible results in the last year or so. Perhaps people are becoming more honest. Ha, ha, just another little joke. Moses lugged stone tablets down a mountain in part because people have long had a tendency to promise rose gardens.

Maybe the much criticized Sarbanes-Oxley Act is keeping more public companies in line. Ouch. A lot of corporate types and their lobbyists wouldn't like that thought. But Sarbox is probably an important reason why we haven't yet seen any large, brand name companies nabbed for accounting fraud.

However, with the economy doing so badly, it's surely just a matter of time before a big financial accounting scandal erupts. If we're lucky, it will involve high-maintenance mistresses, $5,000 umbrellas, $20,000 bidets, $5 million extreme executive office makeovers, senior executives sharing flights to posh destinations on the company jet with attractive younger subordinates for a corporate retreat (or something like that), and corporate coverage of all operating costs of the CEO's thoroughbred farm, along with enough additional cash to cover the CEO's income tax liabilities resulting from the company's purchases of hay, oats, and so forth. The real action in financial reporting frauds is in the manipulation of accounting reserves, overly generous interpretations of the definition of revenue, near mystical processes in the closing of the company's books where good numbers magically appear, so on and so forth. But that stuff is boring. And the thought of all the employees who lost their 401(k) accounts because their company stock proved worthless is depressing. The fun is finding out what all those hard charging, overbearing, disdainful executive types did with the moola after they picked the shareholders' pockets. After all, if you can't find a laugh in all this stuff, you might have to cry.

Monday, June 1, 2009

Buying a Car in the 21st Century

Now that we taxpayers own GM and Chrysler, car buying won't be the same. The next time you buy a car, should you favor your car companies, as opposed to Ford, Toyota, Honda, etc.? After all, if GM and Chrysler sell more cars rather than less, they will need fewer of your tax dollars in bailout money from the U.S. Treasury. And the Treasury's holdings of GM and Chrysler stock will increase in value, which could ultimately ease your tax burdens if the government sells these shareholdings at a profit. Why not make some money while you spend some?

Perhaps you'll see the Secretary of the Treasury or the Vice President on prime time TV, pitching GM or Chrysler products. (Biden's got the smile for the job.) The Social Security Administration could include brightly colored sales brochures along with your annual benefits statement.

The Fed might offer zero percent financing for GM and Chrysler vehicles, but only until the end of the month. The IRS could give rebates for purchases made during this weekend's bargain blowout.

If the GM or Chrysler product you buy turns out to be a lemon, you'll be able to write your Representative or Senator about warranty work that isn't satisfactory. And you can complain to the Treasury, or better yet the White House, if there aren't enough cupholders or the paint peals after a few years.

Bad boys who fear the FBI will learn to look for unmarked GM or Chyrsler sedans, instead of Ford Crown Vics. The EPA Adminstrator's official car will be a Chevy Volt.

If things turn out well enough for GM and Chrysler, maybe Ford will want to sell some stock to the U.S. government. Toyota and Honda, too. After all, business is business.