Tuesday, December 29, 2009

The Revival of the Bank of the United States

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

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

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

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

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

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

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

Saturday, December 26, 2009

Japan: 20 Years of Lessons for America

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

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

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

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

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

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

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

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

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

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

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

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

Tuesday, December 22, 2009

Has America Lost Its Optimism?

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

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

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

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

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

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

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

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

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

Sunday, December 20, 2009

Lumps of Coal

Christmas lumps of coal came early for some this year:

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

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

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

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

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

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

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

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

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

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

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

Wednesday, December 16, 2009

Fannie and Freddie: Don't Privatize Them Again

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

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

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

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

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

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

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

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

Sunday, December 13, 2009

How the Tea Parties Are Helping the Democrats

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

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

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

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

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

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

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

Wednesday, December 9, 2009

Is America Ready for Britain's Banker Bonus Tax?

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

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

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

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

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

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

Sunday, December 6, 2009

Is the Federal Reserve's Free Ride Ending?

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

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

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

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

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

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

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

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

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

Thursday, December 3, 2009

Warning from the Price-Earnings Ratio

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

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

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

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

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

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

Tuesday, December 1, 2009

Will the Fed's Reverse Repos Reverse Anything?

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

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

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

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

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

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

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

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