Sunday, October 31, 2010

Will a Republican Congress Smack Down the Fed?

Expectations are high that the Republicans will take control of the House of Representatives in the mid-term elections two days from now, and perhaps the Senate as well. Victory celebrations, however, will last only one night. The next morning, the victors, whoever they may be, will face an ornery electorate clamoring for action.

Action will be hard to come by. With a Democratic White House, and the Democrats either controlling the Senate or holding almost half its seats, gridlock is inevitable. Further fiscal stimulus is off the table. Tax "policy" will consist of chaos and lunacy. Congress will regress from its recent productive (albeit controversial) mode to its norm of swapping trash talking soundbites and issuing self-congratulatory press releases, while incessantly searching for the next photo op and more campaign contributions.

The only active part of the government, in regard to economic policy, will be the Federal Reserve. The worst kept secret in Washington is that next week the Fed will renew its program of quantitative easing, possibly beginning with the purchase of $500 billion of Treasury securities. Although Chairman Bernanke and other Fed officials wrap this policy in elegant bureaucratese, it amounts to printing money, pure and simple. Roll the lettuce out of the printing press and move it off the loading dock. Grumpy old skeptics mutter under their breath about inflationary risk, and point to gold's escalating price. But senior Fed officials repeatedly offer solemn assurances that they've got things under control.

Newly elected and emboldened Republicans, especially the ideologues, may see the Fed as a convenient target. It failed to spot the mortgage crisis until things blew up, then bailed out Wall Street at the expense of Main Street, next successfully lobbied for increased power under the Dodd-Frank financial regulatory reform bill, and more recently missed the foreclosure mess. Some conservatives, economists and others, view the Fed's easy money policy as the primary reason for the past decade's asset bubbles, and the Fed's regulatory failings as crucial reasons why those bubbles were so damaging. A few far right wing purists would find the printing of money to stimulate the economy indistinguishable from sorcery.

Majority control of the House would give the Republicans control over committee hearings. Some of them might delight in holding Congressional hearings where they could berate Fed witnesses on C-Span and score points with their constituents. Since the Fed may be the only hope Democrats and President Obama, in particular, would have for a revival of the economy, some Republicans might see advantages to intimidating the central bank. The Fed, by law, is independent of Congress. But the law and political reality don't necessarily correspond closely. The Fed might be subdued by a barrage from Republican/Tea Party evening news headliner wannabes. If that happens, expect a lot of asset classes--stocks, bonds, gold and other commodities--to fall in value. The financial markets now depend heavily on government intervention to sustain prices. As a policy matter, that's not a good thing. But it's not easily undone. If political pressure smacks down the Fed, it could also smack down the markets.

Thursday, October 28, 2010

The Cash Balance Pension: a Retirement Plan for the Future?

It's hardly a secret that retirement plans and retirement planning are a mess. Traditional defined benefit pensions can be costly to fund properly and all too often have proven to be underfunded. Employers battered by the recession sometimes abandon their plans, leaving beneficiaries with only the payments guaranteed by the federal Pension Benefit Guaranty Corp. These plans are going the way of the dinosaurs.

Newer defined contribution plans like 401(k)s are much less risky for employers. But the risks are dumped on beneficiaries, who are at the mercy of high expenses, Wall Street induced economic crises, flash crashes and other financial market volatility, and limited numbers of often unattractive investment options. It's almost impossible to predict the benefits one will receive from a defined contribution plan, and funding an account is more an act of faith than planning for retirement. The average defined contribution plan account is worth somewhere near $70,000. When you think about it, that's a lot of money to put in a black hole.

Both employers and employees want something better. Oddly, a runt of the retirement planning litter called the cash balance pension may provide an answer. It's an amalgam of not entirely attractive features. But it may prove workable in an uncertain world.

The cash balance plan annually credits a dollar value to each employee's account. The amount credited is usually a percentage of the employee's compensation. The accumulated balance in each employee's account is paid interest (at a fixed or variable rate, as specified by the plan), which is compounded annually. Employee accounts gain value over time from annual credits and the compounding of interest. Upon retirement, the employee generally has a choice between receiving the account value as a lump sum, or using it to buy an annuity (which would provide monthly payments). If an employee leaves the employer before retiring, he or she retains the accrued value of his or her cash balance account and can remove the money from account.

The cash balance plan is a compromise. The employer guarantees the growth of account balances up to the point of retirement or termination of employment. Then, the employee is responsible for deciding what to do with the account after retirement: either withdraw a lump sum and personally invest it at market risk, or take an annuity that provides monthly payments. The employer can fund the annuity through a contract with an insurance company, largely relieving the employer of the burdens of guaranteeing years and perhaps decades of retirement benefits. (However, the employer remains legally liable for the annuity payments and bears the risk of the creditworthiness of the insurance company.) Cash balance pensions are guaranteed by the Pension Benefit Guaranty Corp., so there is federal backing for employees' benefits.

The advantage to employees is that the employer takes on the costs and risks of funding the cash balance plan until the employee retires. The formulaic nature of the cash balance plan makes it easier for employees to predict how much they'll have upon reaching retirement age, and thereby facilitates financial planning. Employers benefit from the same predictability, making it easier to fund and manage the plan. Small businesses also get large tax deductions from cash balance plans.

Are cash balance plans a win-win? Not necessarily. They have a poor reputation stemming from litigation over early iterations of these plans, when employers converted from traditional defined benefit pensions to cash balance plans in ways that left longtime employees feeling shafted. Some cash balance plans have been attacked in court for alleged unlawful discrimination against older workers. Because cash balance plans can be structured to give older employees lower benefits than traditional defined benefit plans, they are disfavored by many workers.

But pension plans are voluntary, and an employer doesn't need to offer any kind of pension. Many don't, substituting 401(k) plans and all the risks they present to workers. Other employers offer nothing, leaving employees to limited self-help measures such as IRAs. A cash balance plan has the somewhat dissatisfying quality of a compromise. But it offers a degree of certainty and predictability to both employers and employees. Many employers want to offer pensions plans as a means of recruiting and retaining employees, yet don't want the burdens of traditional defined benefit pensions. The cash balance plan may be a way for employers to have such a recruiting tool, and for employees to predictably accumulate retirement benefits in amounts they'd never save on their own.

Tuesday, October 26, 2010

The 21st Century Global Economics Experiment

Not since the days of the Cold War has there been such a clash of national economics policies. The UK has made an abrupt U-turn away from deficit spending, embracing the hair shirt of austerity. Elsewhere in Europe, big spending EU governments have followed suit, although not with the fervor of true believers. Keynesian economics may be disproved, or not.

America is caught in political crosscurrents, with fiscal policy stifled by a prairie fire of populism. The Federal Reserve is the only show in town, and the financial markets believe the Fed will put on a dazzling performance. Stock, commodities and bond valuations all presume that the Fed is going to walk into the joint and be a real big spender. Monetary policy is at the plate, and no one is on deck. The Austrian school of economics may be disproved, or not.

In China, an ad hoc amalgam of state controlled enterprise and fiercely capitalistic forces has propelled the Chinese economy into a meteoric rise. The Communist Party in China has craftily exploited market forces to raise living standards, thereby legitimizing its continued control while it gradually jettisons a failed ideology. The Chinese are wittingly or unwittingly recreating an updated version of dynastic China, where government played a large role in the economy but allowed private trade and commerce to spark growth. Imperial China was for over 1,000 years the wealthiest nation in the world, so this model has a history of success. If China continues its upward trajectory, free market ideologues may be discombobulated. Or not, if the heavy hand of state control of the economy and political freedoms smothers the individual initiative needed for lasting prosperity.

Since economists can't conduct controlled experiments, the world today is about as good as it gets for students of comparative economics. Ten or twenty years from now, tentative conclusions might be possible. Or not, since nothing in economics is ever truly resolved. Schools of thought mostly go in and out of fashion.

But what if they're all wrong? What if austerity in the Old World produces stagnation or even recession? What if the Fed's forthcoming liquidity dump fails? The financial system already has a trillion dollars of unused liquidity on deposit at Federal Reserve banks. More liquidity is likely to be just the proverbial push on a string, while stagnation continues. And what if China's real estate and credit bubbles burst, pushing China into the stagnation experienced by Japan and now America? With China's severe demographic problem of too many old and not enough young, any slowdown in China's growth could upset the entire apple cart the government is trying to push along.

If all models and all schools of thought are wrong, we have a problem. There wouldn't be any credible paradigm in which to find solutions. We might find ourselves mired in slumps and malaise, with struggling to muddle through the only strategy. But Americans are good at muddling. Every major crisis in American history, from the Revolution to the Civil War to World War II to the Cold War, was a painful muddle. Even if all the economists are confounded, Americans can still have faith in themselves, and that's always proven to be enough.

Monday, October 25, 2010

Principles the Democrats Should Learn From the Tea Partiers

The stridency of the Tea Partiers should remind Democrats of a crucial fact: America is a nation founded on principles, Constitutional and other principles. The perception that these principles have been violated drives the anger and energy of the Tea Partiers and others similarly disillusioned. People tend to get fired up when they believe matters of principle are at stake, and that's what you see today.

It may well be that big corporate money is being quietly funneled by cynical Republican operatives into key political races. But that money works only if voters can be motivated or swayed by it. The populist outrage over perceived transgression of foundational political principles provides the fuel that conservative corporate funding can inflame.

The lesson for Democrats scrambling in this last week of campaigning is that they cannot just talk about accomplishments--economic stimulus, financial regulatory reform and, yes, health insurance reform--or (accurately) point out that they inherited a grossly mismanaged economy and a horribly misconceived foreign policy from George W. Bush, the worst President since the 19th Century. They can't just make promises; voters no longer have faith in politicians' promises. The Democrats have to talk about how they stand for principles and how they have and will vindicate principles. They need to remind voters that they are the party that promotes opportunity for all, that supports education through action and not just talk, that advances fairness and tolerance, and that protects liberty (after all, it was during the G.W. Bush administration that federal law enforcement and intelligence agencies were discovered to have engaged in questionable electronic snooping on the American public). Many voters in this election will make their decisions based their principles. The Democrats haven't been part of that dialogue, and they will lose many currently undecided votes if they don't talk about principles and take principled stands.

Thursday, October 21, 2010

What If Federal Health Insurance Reform is Unconstitutional?

The constitutionality of the 2010 health insurance reform is now being actively litigated in several federal district courts. So far, the law has stood. The provision with the greatest chance of being struck down by the courts is the provision requiring most uninsured individuals to buy insurance coverage in 2014 or pay a tax.

This requirement makes sense from an insurance standpoint, since it helps spread the cost of coverage among a broader, rather than narrower, group of people. A similar requirement was included in recent health insurance reform in Massachusetts.

The basic claim of unconstitutionality of the federal requirement is that it is beyond the constitutional authority of the federal government. The federal government, as we all learned in high school, has only the powers conferred on it by the Constitution. Opponents of the health insurance reform argue that the new law amounts to an exercise of general governmental police powers, something that a state government could do but which is outside the limited grants of federal authority set forth in the Constitution.

First things first. It's highly unlikely that, if the courts find the 2014 mandatory insurance purchase requirement unconstitutional, they would strike down the entire health reform legislation. The Supreme Court has instructed that if one part of an act of Congress is unconstitutional, the offending part is to be severed and, normally, the rest of the act is to be upheld. This principal of limiting the impact of findings of unconstitutionality was recently applied in a case called Free Enterprise Fund v. PCAOB, handed down in June 2010. In that case, the Supreme Court found that one aspect of the law creating the PCAOB (an organization regulating accountants) was unconstitutional (in that the SEC could remove governing board members of the PCAOB only for good cause). But the court decided that, by tossing this one provision, the SEC would be able to remove governing board members at will and that such an interpretation of the law would make the PCAOB constitutional. So the Court excised the one bad provision of the law and upheld the rest.

Such an approach is likely to be applied to the health insurance reform. If the 2014 mandatory insurance purchase requirement is deemed unconstitutional, the rest of the law will probably stand.

Moreover, there is a pretty straightforward fix if the courts strike down the mandatory purchase requirement. That would be to make it voluntary for individuals to buy health insurance but charge them higher premiums the older they are when they buy in. This is the approach taken with Medicare Part B: it's voluntary but charges higher premiums the older a person is at the time he or she first enrolls.

The problem presented by voluntary enrollment is that people could wait until they are sick or injured before buying insurance. Because the new health insurance legislation requires insurance companies to accept all applicants and to cover pre-existing conditions (thus tremendously improving health insurance over today's morass), an individual could game the system and start paying premiums only when he or she needs expensive health care. By charging late enrollees higher premiums, Medicare Part B makes them pay for the risks and potential expenses they represent. The same could be done for younger folks.

Financial advisers generally advise older folks to sign up for Medicare Part B at the earliest opportunity (age 65) to avoid the higher premiums imposed for waiting. A comparable premium structure for younger folks could create the same incentive. The larger the pool of insured people, the more rational and fair health insurance in America will be. If the 2014 mandatory purchase requirement is struck down, a ready fix is available.

Tuesday, October 19, 2010

So What the Heck is China Up To?

The Chinese central bank raised interest rates today, signaling a slowdown in the growth of China's economy. Financial markets in the rest of the world took the news badly. The U.S. markets dropped 1.5 %.

China's government moved to cool down a blistering economy, driven by fear of inflation and a bubble in its real estate market. Must be tough to have such problems--economic growth that's too fast, rapidly rising asset values. Oddly perhaps, these problems stem from the U.S. Federal Reserve's easy money monetary policy. Because the Chinese yuan is tied to the dollar at a more or less fixed exchange rate, U.S. monetary policy flows through to China and becomes China's de facto monetary policy. The flood of liquidity from the Fed has had limited stimulative effect in America because of the slack in the U.S. economy. But China's economy is much more taut and easy money makes things happen in China.

Just as America's monetary policy becomes China's, so does China's monetary policy become America's. The dollar rose in the currency markets, and interest rates in the U.S. Treasuries market moved up, seemingly in sympathy with the Chinese move.

Logically, if the Chinese government wanted better control over the Chinese economy, it would de-link the yuan from the dollar and rid China of the Fed's easy money policies. Why hasn't it? With all the international outcry over the relatively weak yuan, the Chinese would garner brownie points with many other nations if they did so. And Chinese manufacturers could probably cover much or all of the cost increases resulting from a rising yuan by squeezing more productivity out of their facilities and employees. The Japanese faced the same challenge with a rising yen in the 1970s and 1980s. They quite successfully increased productivity and protected their export industries.

While the Chinese central bank, unlike the U.S. Fed, does not issue statements explaining its actions, a glance at the tea leaves suggests an explanation. China holds trillions of dollars of investments denominated in dollars--U.S. Treasuries, mortgage-backed investments and other paper. De-linking the yuan from the dollar, and the resulting fall in the dollar, could impose hundreds of billions of dollars of investment losses on the Chinese. Even though China is no longer expanding its dollar exposure, and instead buying Euro denominated investments, it remains stuck in a bear hug with the dollar and must protect the value of the dollar. By raising its own interest rates, it raises the value of the dollar, offsetting some of the dollar's recent weakness.

The underlying source of all this angst, sturm and drang is China's trade surplus. Whether denominated in dollars, Euros or whatever, China maintains a large and persistent trade surplus with the rest of the world. By all indications, it intends to maintain this trade surplus, even though Chinese leaders pay lip service to the notion of increasing domestic consumption. Much of the outside world perceives China's trade surplus as economic aggression, and reciprocates with disapproval, at a minimum. But China, the world's oldest continuous civilization, hasn't survived 4,000 years by poking everyone else in the eye with a sharp stick. So what the heck are they up to?

China has a severe demographic problem. It doesn't have enough young people to support all the older Chinese who will be retiring in the next few decades. With an already enormous population of 1.3 billion relying on its limited resources, China can't add enough young people, either through births or immigration, to satisfy its needs. By saving enormous amounts of money denominated in key foreign currencies like the dollar and Euro, China acquires the ability to purchase resources from other nations to support its old folks. It can draw on the productive capacity of younger people elsewhere in the world by purchasing the goods they produce. Without a large stash of foreign currency, however, China could have a difficult time supporting its retirees through imports. It would have to export Chinese goods in order to acquire the necessary foreign exchange, and its ability to do so ten, twenty, thirty or more years from now is unpredictable. By stashing away foreign currency now, while it has a trade advantage, it builds up a reservoir on which to draw later.

What does this mean for the future? That America will be closely connected to China for a long time, and very possibly on terms not highly favorable to America. But the good news is that eventually, when China needs to import goods to support its elderly, it will logically look to spend many of its dollars in the country that issues them.

Monday, October 18, 2010

To the Fed: Fill Our Stockings With Cash, and Checks

The worst kept secret in the financial markets is that the Fed in November will begin a program of purchasing debt in an effort to revive the faltering economy. This measure, called quantitative easing, is a renewal of an earlier bond purchase program that puffed up the Fed's balance sheet by more than a trillion dollars to a total of $2 trillion. But the Fed's easy money policies haven't resulted in a whole of lending. Member banks of the Federal Reserve system have something like a trillion dollars on deposit with the Fed, earning interest at a very modest rate but on a risk free basis. What good will drenching the system with more liquidity do? The trillion already deposited by banks at the Fed tells us that more liquidity will simply be parked in similarly low risk, non-stimulative places. Giving the economy a boost requires either lending the money to a productive economic activity, or having it spent on consumption. Money from the Fed redeposited with the Fed doesn't do squat.

Why not have the government issue checks to every American? Say $1,000 each. That would cost about $300 billion, which is well within the range of potential bond purchases of the renewed Fed program. Money sent in this way to citizens will mostly be spent, providing a direct stimulus to the economy. No need to borrow and add to the federal deficit. We could have the Fed print the money, as it would for a bond purchase program. Just create an account at the Fed in the name of the U.S. Treasury and credit it with $300 billion. Voila! Then mail checks to each American. If the Fed feels the need later on to withdraw this liquidity in order to discourage inflation, it can sell some of its current $2 trillion balance sheet. That would pull liquidity out of the financial system.

With the holiday season approaching, a check for each American would set the right tone. We could even put the Fed program to music, with the following lyrics sung to the tune of "Santa Baby," torch singer Eartha Kitt's signature song:

Mr. Chairman, just slip a check under the tree, for me
Been awfully good this year, Mr. Chairman.
So hurry down the chimney tonight.

Mr. Chairman, a bond that is convertible too, brand new
We look up to you, Mr. Chairman
So hurry down the chimney tonight.

Think of all the folks dismissed.
They could use a little lift.
Next year things could be just as bad,
Take a look at the unemployment lists.

Mr. Chairman, come fill our stockings with cash, and checks.
Sign your X on the line, Mr. Chairman.
So hurry down the chimney tonight.

Mr. Chairman we don't want a limo or a yacht.
Not a lot.
Just a thousand will do, Mr. Chairman.
So hurry down the chimney tonight.

Mr. Chairman, we forgot to mention one thing, a ring.
The one we pawned is gone, Mr. Chairman.
So hurry down the chimney tonight.

Come and light our Christmas tree
We're using decorations covered with rust.
We really do believe in you.
Let's see if you believe in us.

Mr. Chairman, one more thing we really do need, a deed
To a home of our own, Mr. Chairman.
So hurry down the chimney tonight.
Hurry down the chimney tonight.

Wednesday, October 13, 2010

Saturday Night at the Fed

All financial markets are rising: stocks, bonds and, especially, commodities. There isn't a bad bet to be seen. Financial advisers are saddling up their best horses and heading out onto the range to try to round up all the investors who've strayed away in recent times. Irascible old coots who lived through the financial crises of ancient times, like 2008, look at the economy's stagnation and mutter under their breaths about things being too good to be true.

The boom in asset values is no accident. For a couple of months, senior Federal Reserve officials have been talking up the idea of quantitative easing: i.e., buying up large amounts of debt in order to pump more cash into the economy. The purpose would be to combat the increasingly evident stagnation in growth and employment levels. Although the Fed hasn't actually made any debt purchases yet, and pretends it won't necessarily act, it has swished and swayed through a fan dance that makes tantalizing promises.

The markets have bought into the message and bounced up from August doldrums. As each day brings more evidence of economic slowdown, the markets rise to new heights in the expectation of yet another Fed rescue. At this point, the markets have the Fed cornered. If it doesn't put out, asset values will sink like stones.

Let's not kid ourselves. The Fed wants to be in this position. The markets have taken the lead and the Fed can claim it's only following. That's hogwash. The Fed is like someone who doesn't want to be bored on a Saturday evening and, all spiffed up and decked out, goes to a singles bar and doesn't return home that night. When you put yourself in certain situations, you want what's going to happen to happen. And the Fed wants the markets to bounce up and force it to go ahead with quantitative easing.

Whether QE does any good is a different question. The Fed may disappoint, by not announcing a big enough buyback. Asset values will then fall. And even if the Fed swings for the fences, there's reason to question whether our economy, already awash with unused liquidity, will grow faster if drenched with more. But, whatever its value, QE is coming.

Tuesday, October 12, 2010

The Foreclosure Crisis: Time to Put the Mortgage Industry in Federal Court

Another major bank, Wells Fargo, announced today that it's placing its foreclosures under review. Morgan Stanley estimated that as many as 9 million foreclosures might be open to legal challenge. (See Mortgages whose ownership is unclear create an additional, potentially massive problem. They may have to be written off bank balance sheets. Or, if they were supposedly sold but really not, the "purchasing" investors may be entitled to reimbursement for failure of the underwriting bank to deliver the mortgages. The number of mortgages where title is unclear hasn't been reported. But it could be very large.

Legal processes are erupting nationwide. Lawsuits by the truckload are being filed. Attorneys general in 40 or more states are investigating. Federal agencies and departments are huddling and inquiring. Subpoenas are flying. The legal profession is smiling. Its recession has just ended and prosperity is around the corner.

The foreclosure crisis has become a raging bull. There are, or will be, many, many thousands of lawsuits brought over one aspect or another of the morass. The courts will be clogged for years. Title to millions of homes could be clouded for a long time. Real estate sales could slump as buyers back off and title insurance becomes far more expensive than before.

There's no easy or quick way out of the mess. Indeed, we got into this mess because banks owning or servicing mortgages wanted a quick and easy way through the complexities of recording liens against real estate and foreclosing on those liens. Those banks apparently didn't want to bother with the due process of law. They will now get a shipload of due process, from the courts of just about every state in the nation, and many federal courts as well.

Not even Charles Dickens could write so byzantine a novel, nor Mary Shelley so horrifying a story. The prospect of 50 or more judicial systems reaching every variety of result in this ocean of litigation (and taking years to do so), with no established mechanism for consistency or predictability, is stupefying. Homeowners could experience widely varying outcomes, depending on where they live. Investors in mortgage-backed investments may have little or no idea what their now increasingly illiquid investments are worth. Banks would face unenviable choices for accounting for the situation. Mortgage investors and bank shareholders may well indulge in class action litigation.

A gargantuan problem such as this needs an organized and unified nationwide process for resolution. The current multi-jurisdictional mosh pit promises only legal pandemonium. The financial markets will stomach such bedlam for only so long, and that won't be very long.

But how to institute a national claims resolution process? Federal regulators can correctly say, as they did with the Lehman situation, that they have no statutory authority to take on the problem. State officials have no authority beyond the borders of their respective states.

A claims process in federal court may offer a solution. The process would involve reviewing records relating to mortgage ownership, resolving disputes and deciding who owns what. Attorneys with appropriate backgrounds could be recruited to serve as special masters to handle the enormous amount of work this would entail. The federal claims process could also look into foreclosures, past, present and prospective, and resolve uncertainties and competing claims. (The latter process could be handled through related proceedings in federal district courts in each state, where local lawyers having knowledge of their particular state's laws could serve as special masters to resolve mortgage recordation and foreclosure issues, but as part of a national process to keep the overall resolution of the problem coordinated.) By using attorneys as special masters, the resources of the courts would be magnified exponentially. As things now stand, the foreclosure process has clogged up numerous state courts, with no obvious way to clear up the traffic jams.

Other claims, such as class actions by investors or shareholders, could also be incorporated into the master claims process and resolved as part and parcel of the nationwide cleanup of the mortgage market and foreclosure process. Judges and federal magistrates might be the best adjudicators for these other claims, as they are the most likely to resemble the kind of litigation judges and magistrates routinely handle.

A unified national process could offer at least some degree of consistency in procedures and principles. It might also provide for coordination of various claims, and some notion of a timetable. And the appeals process would be greatly simplified. Information about the mortgage problems would be centralized and presented in a more organized way, offering greater transparency to the financial markets. The big banks, which may face the greatest liabilities here, would have a single process in which to resolve the myriad claims they now likely face, simplifying their management, accounting and regulatory problems.

The federal courts have experience administering cases with vast numbers of claims. Products liability litigation over asbestos related illness and injury provides an example, in which the claims of thousands of individuals have been resolved, in some cases with substantial payments. A nationwide mortgage and foreclosure cleanup process might well be the most complex proceeding ever undertaken by the federal courts. But if there were ever a time to take on such a challenge, this is it.

There isn't an obvious way to institute such a proceeding. Perhaps a number of interested parties, including major banks, the key mortgage guarantors such as Fannie Mae and Freddie Mac, their regulator (OFHEO, or Office of Federal Housing Enterprise Oversight), the FHA, as many state attorneys general as can be mustered, federal financial regulators (citing their need to promote the safety and soundness of banks, and monitor and control systemic risk), and whoever else has legal standing to join the party could band together and petition a federal district court in Washington or New York (where the federal district courts have substantial experience handling massive litigation, and where there are hordes of lawyers who could be lined up to serve as special masters). As a legal foundation for such a process, the petitioners might invoke the equity jurisdiction of the federal courts (a body of law that, more or less, says the courts can, within certain limits, create solutions to problems that the existing legal system can't handle or doesn't handle well). Even though it's unlikely any of these parties alone could convince a court to institute such a proceeding, the combined interests of a consortium of interested parties might present a strong enough foundation that a judge would find jurisdiction.

Equity jurisprudence may be insufficient. If so, an act of Congress would be required. That's a scary thought. The temptation for the politicians to politicize such a process is obvious. But the alternative is a legal quagmire stretching from sea to shining sea. A unified national claims process, even if polluted by the underhanded, craven and disgraceful manipulations of pompous, self-interested politicians, may offer a less imperfect solution. (The biggest problem could turn out to be that Congress won't act quickly enough, a distinct possibility given today's shifting political winds; and that would aggravate a seriously aggravated situation.)

The bonfire of the mortgages is burning hot and fiercely, spreading its flames like a prairie fire on a windy day. A unified nationwide claims resolution process may be the only feasible alternative to the inferno.

Saturday, October 9, 2010

How Big Is the Foreclosure Mess?

The size of the foreclosure morass is a crucial question. The moratoriums are hitting the real estate markets like a tractor trailer. Bank losses are inevitable. If the crisis is large enough, it could present systemic risk. Federal regulators and the rest of us need to know pronto if the banking system is going have a fainting spell just because some pennywise and pound foolish bankers thought it would be a good idea to disregard formal legal procedures for making mortgage loans, securitizing them and then foreclosing on them. Probably hundreds of thousands of foreclosures have now ground to a halt, and possibly hundreds of thousands more will be brought into question (including many foreclosures already done). Questions over ownership of mortgages and flaws in foreclosure procedures present the potential for another body blow to the banking system. Even though some of the foreclosure problems have been known for many months or even longer than a year, federal banking regulators have missed the boat again in not seeing this hot tamale right in their laps. Oh well, America will always have taxpayers, so there's a ready herd of sheep to be sacrificed if the bankers don't want to bear the losses themselves.

One potentially useful way to get a sense for the magnitude of the monster would be to read the 3rd quarter financial reports that the major banks will be filing soon. The foreclosure crisis couldn't have blown up at a worse time for them. The third quarter ended for most banks on September 30, 2010. The publicly traded ones have to file a public quarterly report by November 14, 2010. Those filings would include disclosure about the foreclosure mess, and the financial information reported would have to reflect costs and losses from the crisis (such as reserves to cover potential liabilities and writeoffs). Banks that understate the extent of the problems may find themselves sued by regulators and shareholders, so they have strong reasons to be forthright. At the same time, if the foreclosure problems are really big, being forthright might make their creditors a little weak at the knees. Memories of firms with names like Bear, Stearns and Lehman would stir. Bank creditors might be overheard muttering something about the devil taking the hindmost.

Five weeks remain until the banks must file their 3rd quarter reports. That's not much time to get a handle on the situation. They have to figure out the actual and potential losses from their own mortgage holdings, and also the extent of the blowback from mortgages they thought they sold, and securitizations they underwrote or are servicing. Because many banks issue quarterly financial results in press releases within two or three weeks after the end of the quarter, they actually have much less time than the formal filing deadline gives them. The numbers and information in those press releases must also accurately reflect the impact and ramifications of the mess. The heat is on. We may know more very soon.

Wednesday, October 6, 2010

The Monster Within the Foreclosure Crisis

The foreclosure crisis is going from bad to worse. More foreclosures are stopping. Buyers are stepping back from bank owned properties. The U.S. Department of Justice has started looking into the mess.

The crisis is a tabloid's dream: Robo-signers gone wild, lawyers and courts operating foreclosure mills, homeowners booted through fraud, politicians pontificating, and subpoenas flying. But there's a Frankenstein that lurks within this house of horrors: the question of who owns mortgages. This is the worst aspect of the crisis, and if the problem is widespread, it could have extremely damaging consequences.

News coverage has reported that, sometimes, banks attempting to foreclose couldn't prove they owned the mortgage in question (or that they represented the true owner, if the bank was servicing the mortgage). When proof of ownership was lacking, the bank evidently provided courts with documentation that may not entirely be on the up and up. This practice, which could amount to a fraud on the court and be subject to criminal punishment, is now under review as banks, judges, plaintiffs lawyers, prosecutors, and all kinds of other folks try to sort things out.

If the ownership problem is widespread--and it might be, since it seems to have arisen from the hyper-pace of creation and securitization of trillions of dollars of mortgages in past years--the implications could be enormously bad. Banks would have to write off mortgages they can't prove they own, and reverse any past recognition of revenue and earnings from those mortgages. After all, banks can't claim as an asset a mortgage they don't own, nor can they recognize revenue from a non-owned mortgage. The sheer scale of mortgage lending and securitization is such that even if only 1% of mortgages are affected by ownership problems, the amounts involved could reach $100 billion or more of mystery mortgages. (There are about $14 trillion of mortgages outstanding, $7.5 trillion of which are securitized.) The U.S. banking industry would have a tough time swallowing another $100 billion of losses, especially now that banks already need to bulk up their capital to meet heightened capital requirements. Taxpayers, put your hands on your wallets.

Another implication of the mortgage ownership problem is that the downturn in the real estate market could be dragged out for years longer than otherwise. Foreclosures aren't legit unless the true creditor is seeking to collect the loan. It will now take months and even years to plow through legal records to establish true ownership of the many, many thousands of mortgages that might be in question. Buyers will step back from bidding for foreclosed properties. No matter, since some title companies aren't insuring title to such properties, so the banks probably couldn't sell them anyway. The foreclosures now in suspension won't be held off forever. Eventually, some resolution of the current mess will be achieved, those foreclosures will proceed, and the recovered properties resold. So these properties overhang the market, and buyers will be cautious about bidding even for non-foreclosure listings.

Then, there are the foreclosures in states where court approval isn't required. About 23 or so states that require court approvals for foreclosures. The rest allow foreclosures to proceed without court orders. But that doesn't mean that inability to prove ownership of the mortgage is okay in those states. To the contrary, booting a homeowner without being the true creditor on the mortgage probably violates the law in more than one way. Doing so may well be a fraud on the owner. If a sheriff's deputies were used to evict the owner, the lender might be deemed to have lied to sheriff. Lying to a peace officer is never a good idea. A subsequent buyer would not obtain clear title, so the lender might well be deemed to have perpetrated a second fraud. If such clouds over title are widespread, real estate markets in nonjudicial foreclosure states could be crippled for years, as title insurance companies try to sort out their risks and buyers stay away.

Another aspect of the mortgage ownership problem emerges in the securitization market. Large quantities of foreclosure mortgages are or were securitized. The mortgage ownership question implies that investors in the securitizations of those mortgages might or might not have invested in actual mortgages. To the extent, they did not, the banks that underwrote the securitizations can look forward to receiving investors' fraud claims. To make things worse, in the case of past foreclosures, investors who received the proceeds of foreclosures on mortgages they didn't actually have an interest in might be liable to repay the money. Needless to say, they would look to the banks servicing the mortgages for recompense. Given the apparently lousy state of the recordkeeping, the morass on the securitization end of the things could take years to clear up. The revival of the securitization market might be pushed back for a similarly long period. If things turn out to be really bad, securitization as a large-scale method of financing may be gone forever.

The foreclosure mess bears watching. It seems to be about where the financial crisis was in 2007: a year before we see the worst of things. If the foreclosure mess turns out to be a real monster, expect Wall Street and the real estate industry to try to dump it where the financial crisis ended up--in the laps of taxpayers. Whether that will be politically feasible is open to question. We are now witnessing the largest taxpayers' revolt since the Whiskey Rebellion in the 1790s. Maybe this time the banks will have to bear the losses they created.

Sunday, October 3, 2010

What to Do About the Flash Crash?

The Oct. 1, 2010 joint SEC-CFTC report on the May 6, 2010 flash crash revealed that the market plunge was triggered by a single large sell order in a derivatives contract called the E-Mini, which is a futures contract that tracks the S&P 500 index. The story from the report, which is summarized here, is that the big sell order, placed by a mutual fund complex after the market had fallen about 4%, was for 75,000 contracts, having a value of around $4 billion. The mutual fund complex, unnamed in the report, wanted to hedge a large existing stock market position. It apparently hoped that selling the E-Mini contracts would protect its investors from further loss if the market continued to fall.

The mutual fund complex, which hasn't been officially identified although only those without Internet access can't figure out its probable identity, chose a automated computer execution process based on an algorithm that simply sent out the amount of orders it calculated to be 9% of the previous minute's trading volume. These orders were placed without regard price or time. That made the algorithm insensitive to the impact its orders might have on the market. It was an automaton that simply measured the preceding trading volume and pumped out 9% of that volume in new orders. If trading volume fell, the number of new sell orders the algorithm would send out would fall. If volume rose, so would quantity of new sell orders the algorithm issued.

The early sales from the 75,000 contract E-Mini sell order were purchased by other institutional investors, mostly high speed traders that don't hold their purchases for very long. As more sell orders came in from the algorithm, the early purchasers got nervous about the E-Mini contracts they'd already purchased and tried to sell them. Thus, they added to the trading volume generated by the algorithm's sales. The algorithm took this increased trading volume as a signal to place even more sell orders (since 9% of a larger number calls for more orders than 9% of a smaller number).

Buying interest, however, shrank as more and more E-Mini sell orders came on the market. Some high frequency traders began to buy and sell from each other, because there were fewer and fewer other buyers. But that only increased trading volume, which led the algorithm to dump yet more sell orders onto the market. This only made things worse.

Some of the traders buying E-Minis sold individual S&P 500 stocks to hedge themselves (i.e., to limit their risk from holding E-Minis). This put downward pressure on stocks, which led to the plunge that the investing public saw.

It was not until a computer system at the Chicago Mercantile Exchange, where the E-Mini contract is traded, implemented a temporary trading halt that the downward motion of the derviatives market was stopped. When trading resumed five seconds later (a long time in the world of computerized trading), E-Mini prices stabilized and then rose. The algorithm actually sold some contracts into this rising market.

Meanwhile, back at the ranch, stocks were still plunging. The early stock price drops had triggered more sell orders, as traders and their computers far and wide interpreted the market volatility as a signal to bail out. Buying interest exited stage right, exacerbating price plunges. Some stock sell orders were executed for a penny per share. Eventually, trades more than 60% above or below the 2:40 p.m. prices (which the exchanges and FINRA, a stock market regulator, deemed to be pre-lunacy prices), were cancelled. Why 60%? It's not very clear in the report.

Although the flash crash was over very quickly, it produced a intraday drop of 5-6% in stock prices (on top of a 4% drop that had already occurred that day). This scared the bejesus out of many investors, especially individuals, who subsequently moved more money out of stocks and into bonds even though bonds have absurdly low yields.

The report doesn't include any prescriptions for the future. No doubt, the SEC's and CFTC's enforcement divisions are sniffing around for violations of law. But there is scant indication in the report that anyone in either agency sees a likelihood of enforcement action. A crucial question is why did the selling mutual fund complex choose an algorithm that issued sell orders based on trading volume only, without any assessment of price impact and without regard to how quickly its orders were landing in the market. It had previously sold such a large quantity of E-Mini's, but much more slowly and without the sudden price drops. The report doesn't cast any light on the seller's thinking.

Based on the information available to date, there is a serious chance that neither the SEC nor CFTC will do anything on the enforcement front. On the regulatory front, the SEC has approved tighter triggers for trading halts. Sudden price moves in the most frequently traded stocks of 10% or more within a period of five minutes now result in a 5-minute trading halt. The SEC has also tried to make the process of canceling trades at seemingly off-market prices more transparent.

But the SEC and CFTC don't seem to think they can prevent another flash crash. At least, if they think they can, they surely didn't make that point in the report. Realistically, it would be quite difficult for them to "prevent" another flash crash, because they'd have to control the volume of orders reaching the market, trying in some way to balance buying interest with selling interest. Any such effort by the government would be destined to failure, as it would require the government to define supply and demand, fundamental market forces that governments can't effectively define. So it seems that the regulators can only soften the impact of future flash crashes.

So is there no legal consequence? A large institutional investor can just wallop the market and everyone who is clobbered learns the hard way that passbook savings are so bad?

There may be an answer in the history of American business. About 150 years ago, businesses began incorporating under newly enacted state laws that allowed anyone to create a corporation. Because the corporate form of business protected investors from unlimited personal legal liability for the business's liabilities, it became the dominant form of business enterprise. Incorporated businesses attracted large amounts of capital and grew quickly. Their reach became regional and then national. Companies in one state sold products to customers in other states 2,000 or even 3,000 miles away.

Some of these products were shoddy or defective. When customers tried to sue, they were hindered by a variety of legal doctrines, some of which dated back to medieval English law. Many state legislatures and some state courts took steps to modernize the law, resulting in the evolution of today's law of products liability. This body of law is based on principles that lawyers call "tort law," which hold that a person who is negligent can have civil monetary liability for the foreseeable consequences of his or her acts, even if the person didn't intend to cause injury. For example, early in the 20th century, courts began to hold auto manufacturers liable for defects in cars, even when they were thousands of miles away and didn't directly sell the car to the injured person. This was an outcome that the courts of the Civil War era would have considered unspeakable. But it quickly became the law of the land when commerce grew to be national in scope.

The financial markets have evolved way beyond the current legal structure. And the snail's pace of legislative reform, with the Dodd-Frank Act coming two years after the financial crisis of 2008, offers little hope that the top-down government regulation of the financial markets from Washington will keep pace. Maybe it's time to think about applying the principles of tort law to players in the financial markets. The mutual fund complex that evidently triggered the flash crash chose a forceful way of executing a massive quantity of sell orders in the E-Mini that it perhaps should have foreseen would cause disruption, chaos and losses to innocent investors. The threat of financial liability for losses and damage might well make market players pause and think before using potentially injurious trading tools.

A major advantage of applying tort law is that it doesn't try to regulate conduct. It creates liability that leads people to regulate their own conduct. Tort law applies to drivers on the roads. While many drivers don't seem to believe in scrupulous adherence to the rules of the road, almost all drivers try in their own way to be careful because an accident that injures others can lead to a jump in their insurance premiums. In other words, negligence costs them money so they exercise care.

Many on Wall Street would be aghast at the idea of tort law being applied to financial market players. The liabilities, they might proclaim, would destroy the financial system. But the same arguments could have been made about products liability law being applied to auto companies and all manner of other manufacturers. In general, that hasn't happened. And when it threatened, many companies ducked into bankruptcy court and worked out ways to compensate injured persons while continuing as businesses. The courts applied tort law in measured ways that allowed injured persons to obtain recompense without destroying American commerce.

The threat of tort liability to actors in the financial market could lead them to monitor and moderate their behavior. No government would tell them how to trade. They would decide for themselves how to trade. But they couldn't think only about themselves. They'd have to be concerned about smacking the corn flakes out of other market participants. Tort liability would motivate them to design and use trading algorithms and other trading tools in kinder and gentler ways, making the markets a better and safer experience for all.