Thursday, March 24, 2011

Derivatives Dealers Grumpy Over Deutsche Bank Ruling

Derivatives dealers worldwide are grumpy because of a ruling by the highest civil court in Germany finding that Deutsche Bank AG was responsible for disclosing the risks of a derivatives transaction to a company that bought an interest rate swap. The German court was concerned by the bank's conflict of interest from the risks in the transaction being stacked in its favor, at the customer's expense. The court especially didn't like the bank's failure to disclose that the customer's starting value in the transaction was an unrealized loss of -80,000 Euros, or over -$100,000. The court noted that although Deutsche Bank had warned the client that the risk of loss was theoretically infinite, it also predicted that the transaction would be profitable for the customer. The court thought the bank should have made loud and clear that the customer's losses could really be costly, and not just theoretically so. (See Wall Street Journal, Dec. 23, 2011, P. C3).

From a derivatives dealer's standpoint, disclosure obligations like those required by the German court seriously erode the dealer's informational advantage. In the financial markets, an informational advantage is more valuable than gold. That's why, as illustrated by the U.S. government's investigation into trading by hedge fund manager Galleon Group and others, there is so much apparent insider trading. Having the informational advantage really pays. If derivatives dealers now have to make disclosures as contemplated by the German ruling, bank profits might suffer. And nothing, as we all know, could be more horrifying than that.

The U.S. SEC's 2010 case against Goldman Sachs for its role in a mortgage-related derivatives transaction called Abacus 2007-AC1 crimped the style of banks acting as underwriters. The German court's ruling may have a bigger day-to-day impact, since it concerns a bank acting as a dealer in the interest rate swaps market. Trillions of dollars of transactions per month take place in this market. Banks are dealers--i.e., they act as principal on one side or the other of the swap--because customers don't want the credit risk of any counterparty other than a very large (and de facto government guaranteed bank). Too-large-to-fail banks of commercially powerful nations like Germany and the U.S. have an advantage in this market, since their governments' implicit guarantees are worth much more than, say, the Greek or Dubai government's guarantee. If the laws of commercially powerful nations like Germany and the U.S. begin to tilt the derivatives playing field toward anything approaching level, the banks may seek more accommodating nations in which to ply their derivatives trade. But, as financial markets globalize, there will be fewer and fewer places for big banks to go. And increasingly savvy corporate clients may abjure from doing transactions routed through a Caribbean island or Equatorial African nation.

Progress on the regulatory reforms in the Dodd-Frank financial legislation enacted last year has, on the best of days, been confined to the slow lane. Big banks have lobbied combatively to limit and water down the changes. The SEC has long known of the informational disparity in the derivatives market, having brought an enforcement case in 1994 that illustrated the problem. See Perhaps the German court's decision will help to encourage U.S. regulators to push through the headwinds of the big bank lobbying juggernaut. Some of the big banks' corporate customers have been convinced to lobby against change. But the German case, and the SEC's 2010 and 1994 cases, reveal that corporate customers sometimes don't even know what they don't know. It's one thing to let people knowingly take risks. It's another thing to leave them unknowing and saddled with risk.

Tuesday, March 22, 2011

Health Insurance for Pre-existing Conditions

[Updated Feb. 19, 2013]

If you're healthy, health insurance is an expensive annoyance. You know you should have it, but it seems like a waste of money. And millions of Americans go without health insurance, because they don't want to be expensively annoyed. But if they get sick or are injured while uninsured, they learn the hard way that, even more than a loan, health insurance is hard to get when you really need it. That's why you should always have health insurance, especially if you're in good health (when it's much easier to get).

Once you become sick or are injured, you have a pre-existing condition. From the perspective of a health insurer, that very possibly makes you a losing proposition. No one likes losing propositions, and certainly not insurance companies, whose business is, in essence, to bet on the health of their customers. Very few people today contract leprosy, but a lot of people who have a pre-existing condition and are uninsured learn what it feels like to be a leper.

So how can you protect yourself?

Get health insurance while you're healthy. The best way to cover pre-existing conditions is to be insured at the time they first occur. It's now illegal for insurance companies to drop coverage for customers who get sick or are injured. Axing customers who might actually make claims is prohibited by the federal health insurance reform enacted last year (derisively called Obamacare, but it really does help those who are sick or injured).

Keep your current health insurance. If you are covered by health insurance, keep it. That would mean exercising your COBRA rights if your employment is terminated. As your COBRA coverage expires (usually after 18 months), buy an individual policy to continue coverage. Avoid time gaps in coverage--continuous coverage one way or another makes it essentially impossible for insurers to stiff you on pre-existing conditions.

Be young. Last year's health insurance reform law now makes it illegal for insurers to decline coverage for children under the age of 19 due to pre-existing conditions. In addition, young adults up to age 26 may be covered under their parents' health insurance (if their parents have family coverage).

Be old. If you're 65 or older, make sure you're enrolled in Medicare (at least Parts A and B, and also Part D if you don't otherwise have prescription medication insurance). Pre-existing conditions are covered by Medicare.

State pools. Many states have insurance pools that offer coverage for their residents with pre-existing conditions. These pools can be expensive. But being uninsured with a pre-existing condition can be more expensive.

Federal High Risk Pool. A federal program created by last year's health insurance reform provides coverage to those who are uninsured with pre-existing conditions. This program isn't cheap, but is less expensive than many state pools. (A problem for those in state pools who want to switch to the lower cost federal program is that you have to be uninsured for something like six months before you can get into the federal program; that's because the federal program is meant to help the uninsured, not the expensively insured.) The federal high risk pool expires in 2014, when a permanent program for comprehensive nationwide health insurance coverage is supposed to begin. The website for the federal high risk program is at www.pcip.govFeb. 19, 2013 update:  the federal high risk pool is  closing on Feb. 22, 2013 because of funding problems.  If you want to participate, get your application in by Feb. 22, 2013.  If you miss this deadline, look for any available state insurance pool, find out if you're eligible for Medicaid (see below), try a community health center, and wait until 2014, when comprehensive insurance coverage under the Affordable Care Act will become available.

2014. If you live until 2014, a comprehensive nationwide program for health insurance coverage will begin, which will prohibit health insurers from excluding pre-existing conditions.  Insurance for those who otherwise aren't covered can be purchased through so-called health insurance exchanges.  Your home state may offer an exchange (possibly in conjunction with other states), and a federal exchange will be available if your state does not offer one.

And if you're broke? If your financial condition is sufficient modest, you may qualify for Medicaid (it's primarily for people with dependent children or a disability). You might also be able to get care at a community health center (which generally serve the low income). And there's always the hospital emergency room, which provides care to the indigent (although it may not be as comprehensive as the care provided to the insured).

For more information, see, and The U.S. Department of Health & Human Services provides a website where you can research health insurance options:

Tuesday, March 15, 2011

Losers and Winners on the Ides of March

They weren't kidding about the Ides of March.

LOSERS. This is a day for losers.

Japan. With the 9.0 earthquake (about as big as they come) and the 30-foot tsunami that followed, Japan got walloped. Now, the rising risk of reactor fuel meltdown has the Japanese nation turning to its nuclear industry and asking, "Et tu?"

Industrialized World. Japan is deeply integrated into the world economy, as an exporter and importer. The ramifications of the soon-to-come earthquake-driven recession there affect crucial industries around the globe, including electronics, automotive, insurance (obviously), petroleum, and banking. With China slowing its economy to rein in inflation, Europe turning to austerity as it struggles with its currency crisis, and America getting by on the methadone of Federal Reserve easy, easy money, there's not a whole lot of horsepower in the international economy to pick up the slack left by Japan. The stock markets are starting to figure this out.

Nuclear Power Industry. While some Japanese nuclear power plant workers may, in effect, be committing hara kiri trying to contain meltdown risk, nuclear power projects worldwide are being curtailed and cut. When you play around with stuff that has real potential for destruction, no amount of engineering can guarantee safety. That's true of nuclear energy, and it's also true of financial derivatives.

Libyan Rebels. With the world's attention diverted to East Asia, the Libyan rebels' chances for resupply and a no-fly zone from other nations are fading rapidly. The U.S. buys little or no Libyan oil, and has no vital national interest there. Britain and France were quick to advocate a no-fly zone, but they know that only the U.S. Navy has the resources and power to actually impose one. That means America would have to bear the burdens and take the casualties. The U.S. government is clearly stalling for time--its demand for UN authorization is a transparent pretext for delay. Maybe the Obama administration knows something it can't really share with the rest of us, yet. Things in the Persian Gulf may be worse than the news services have reported. Saudi Arabian troops have rolled (in unmarked vehicles) into Bahrain, in order to help the Bahraini government stay in control. Things in the Persian Gulf could be deteriorating, and the U.S. military may have to keep its powder dry in order to retain the option to play a role there, where the U.S. has a large vested interest.

Barack Obama. The President hesitated to join up with the Libyan rebels, and they now think he has a secret pact with Gaddafi. Obama has called on Gaddafi to cede power and leave Libya, so Gaddafi knows that Obama isn't on his side. No matter who wins in Libya, America and Obama lose. The Japanese nuclear crisis has blown up Obama's nuclear power policies, and a recession in Japan could put pressure on the administration to apply more fiscal stimulus (i.e., engage in more deficit spending, which isn't exactly politically trendy these days). The perhaps not well publicized unrest in Bahrain and Saudi Arabia, along with a deteriorating situation in Yemen, put the Obama administration in the position of wanting to side with oppressive monarchs in order to protect U.S. interests. Even if these monarchs survive, America's already compromised image in the Arab world will suffer.

Republicans. International events are taking front page news coverage away from Republicans and their domestically-focused agenda. They can't easily criticize President Obama's foreign policy, which is strikingly similar to George W. Bush's. They may have to settle for appearances on Dancing With the Stars.

WINNERS. Even in ugly situations, there are winners. That's why you find the most cynical of stock market speculators swarming into select parts of the market when a crisis hits.

Natural Gas and Shale Oil. The NIMBY style controversies over fracking may seem manageable in light of massive radiation releases from Japanese nuclear power plants. Natural gas and shale oil might have to be repriced to cover the costs of reimbursing people damaged by fracking. But the stuff is found in plenitude in these United States, and will surely be a growing source of energy in the future.

Coal. It's not beloved by environmentalists and mining it leaves ugly scars on the land. But America has massive coal reserves and will surely turn more and more to them in the future. Long term, alternative/renewable energy sources may begin to play a major role in America, but for the short and medium term, coal will be definitely be a part of our lives.

Oil Producers. Oil producers, like Venezuela, Russia, Nigeria and Canada, see their fortunes rise. Too bad not all of them are friendly to America.

Iran. Iran gets a win-win here: increased revenues from rising oil prices and more opportunity from the Arab uprising to stir up Shiite co-religionists on the Arabian peninsula.

China and Taiwan. As Japan's economy struggles, Chinese and Taiwanese companies will get a chance to get into high value-added product lines the Japanese have dominated. Semiconductors and high tech automotive components are obvious targets. Look for Chinese automobile companies to try to move up their deadlines for introducing their products to America.

Tuesday, March 8, 2011

Will the Arab Revolution Topple the Dollar?

As unrest in the Arab world has grown over the past few weeks, the dollar has fallen in value. That would seem anomalous, since the dollar has served for decades as a safe haven in times of crisis. But investors apparently have noticed that the U.S. is unbalanced: too much in the way of imports, not enough in the way of exports, and a growing federal deficit that is likely to punish holders of U.S. Treasury securities if it isn't brought under control.

Exacerbating things is the rising price of oil. Since oil is traded in dollars, the lower the value of the dollar, the cheaper oil becomes to holders of other currencies. One player to watch in particular is China, a large consumer of oil with a growing appetite. The Chinese have already been gradually diversifying their foreign currency investments away from the dollar. Rising oil prices may, more than all the political pressure that can be exerted by the U.S. and other Western governments, convince the Chinese government to truly de-link the yuan from the dollar. As the yuan rises, oil becomes cheaper for the Chinese. If China can turn its economy toward domestic consumption--a goal the Chinese government acknowledges--look for the yuan to rise markedly against the dollar.

Some in the U.S. government would contend all this is good. A cheaper dollar enhances America's exporting competitiveness. But the price of a cheaper dollar is likely to be higher inflation--in gasoline prices and also the price of our numerous imports. The Fed's ultra-easy money policies would have to end and interest rates would rise. That would throw a wrench into the economy in many ways, from slowing the still feeble real estate market to discouraging business expansion to wrecking Wall Street profitability (which rests on a zero cost of funds) to knocking down stock prices.

The Arab revolution is almost entirely out of the control of Western governments, especially the mess in Libya. And even if things in the Arab world settle down in a few months, growing demand from Asia will continue to support and maybe push up oil prices. It's in the interest of the rest of the world to weaken the dollar in order to make oil cheaper. Even serial exporters like China and Japan have to weigh the increased cost of oil against their export revenues in deciding whether or not to keep their currencies weak against the dollar. Also, it seems to be a goal of the Federal Reserve's relentless easy credit policy to weaken the dollar. As the dollar drops, OPEC and other sellers of oil may begin to demand payment in other currencies. The dollar would drop further in such a scenario. Even though America would get an exporting boost from a falling dollar, rising interest rates here would slow the economy at the same time. How this mix of countervailing forces would play out is anyone's guess.

In the financial markets, something unexpected usually causes market breaks, crashes and other singularities. After all, expected events are quickly incorporated into asset prices. The dollar market is too big for an abrupt crash. But the Arab revolution has unexpectedly highlighted the dollar's weaknesses. That won't be good for the greenback.

Sunday, March 6, 2011

Stop Worrying About Deflation

The Federal Reserve is running its monetary printing press day and night, desperately seeking to inflate the U.S. dollar. It may have accomplished its goal, at least outside the U.S. Oil, which is traded in dollars, has risen sharply in the past few months (starting well before the Arab unrest). Food prices worldwide have also risen. Global supply of food hasn't fallen. But increased demand for meat, poultry and other higher status foods, especially in China and the rest of the developing world, has strained supplies of grain, and pushed up the price of bread. It's probably no accident that the unrest in the Arab world was preceded by rising bread prices. It's tough to be complacent if you and your family are having trouble getting enough to eat.

In America, there seems to be little inflation. The Fed worries that deflation, even though it's not actually occurring, would lead consumers, hoping for lower prices later, to hold back on spending and retard the economic recovery. It asserts that Japan's meandering price levels are a cause for its economic stagnation. So the Fed keeps shoving bales of dollars off its loading dock. But this is a misadventure in misjudgment.

First, deflation today would help consumers. Household incomes have hardly risen for decades, and consumers react to higher prices by cutting back, not spending more. Rising gasoline and food prices discourage discretionary expenditures. Some people may swap a fuel hog for a gas sipper. But most can't afford to do that, so they just spend less on other things. Price deflation would increase their spending power and lift demand.

The last period of sustained deflation was in the 1930s. But that deflation was the result of the economic downturn, not the cause. Speculative financial and real estate bubbles, aggravated by misguided monetary policies, caused the Great Depression. Did deflation retard recovery from the Great Depression? There's not a lot of evidence of that. Joblessness, by all indications, was the primary factor holding the economy back. When employment rose as America geared up for World War II, consumer spending rose. (It was partially delayed by rationing during World War II, but there was a surge of consumer spending as the war ended which led to the postwar prosperity.)

Sustained deflation also took place during the Gilded Age (1865-1900), when prices dropped by roughly one third. This was a period of great economic growth. Although punctuated by financial bubbles and sharp recessions, the Gilded Age saw dazzling technological innovation (construction of municipal electrical energy systems, the telephone, improved steel manufacturing and oil refining, etc.), legal innovation (evolution of the general business corporation), and financial innovation (nationwide capital markets that featured vibrant secondary markets in common stock and corporate bonds). All this innovation spurred enormous growth. Income distribution was problematic, as business elites accumulated vast fortunes, often by forming cartels and monopolies, while workers struggled to get living wages and farmers combated monopolistic railroad freight rates. Price deflation was a gift to ordinary Americans trying to survive. The growth of mass market mail order retailers, like Sears Roebuck and Montgomery Wards, signaled that Americans of this era had little aversion to consumption in spite of falling prices.

The way the Fed measures inflation tints the lenses through which it sees a threat of deflation. The Fed's preferred benchmark is the Personal Consumption Expenditures Price Index (PCE). The better known Consumer Price Index measures changes in price of certain selected consumer items. For example, the CPI measures inflation or deflation in the price of name brand coffee by comparing the current price of that coffee against its past price. By contrast, the PCE incorporates substitution of products by consumers. If the price of name brand coffee rises, and consumers switch to less expensive supermarket house brand coffee, the PCE records lower inflation than the CPI because consumers avoided paying the price increase in name brand coffee by switching to lower cost house brand. The fact that drinking house brand coffee can sometimes be a near death experience isn't counted as inflation.

The PCE typically records about one-third less inflation than the CPI. So by focusing on the PCE, the Fed sees a greater potential for deflation. But the Fed's use of the PCE means that a reduction in living standards in response to rising prices doesn't count in the measurement of inflation. That notion would be a hard sell to shoppers facing the daily realities revealed on grocery store shelves. It also means that the harder the Fed tries to instill inflation, the lower it might push living standards as consumers substitute cheaper and cheaper goods when their preferred choices become costlier as a result of Fed inflating. Perhaps the Fed should consider that forcing people to substitute sawdust for bread might snatch defeat from the jaws of victory.

The primary reason why people consume or don't is confidence in the future. Moribund consumption in Japan is due to Japan's uncertain future. Younger Japanese adults face dismal employment prospects, often limited to temporary jobs instead of the lifetime employment contracts given their parents. Since younger adults tend to consume with vigor, their lousy employment picture dampens economic growth. (Older Japanese are actually spending more as they tap into their savings for retirement, but this hasn't made up for the reticence of the young.)

No matter how much the Fed inflates prices in America, people won't consume deliriously if they fear layoffs. Using your old washer and dryer for a while longer makes sense of you're trying to reduce debt and build up an emergency cash fund. Spending like the maniacal days of 2005 doesn't make sense if your house looks like it's headed for a double dip in value. The Fed thinks that rising prices will scare people into spending. Rising prices do scare people. But, in these uncertain times, they scare people into pulling back. A little deflation would come as a relief.

Thursday, March 3, 2011

How to Avoid Running Out of Money in Retirement

The fear of running out of money may be the biggest financial dilemma for most retirees. There's no perfect solution to the problem. But plenty of people have long, enjoyable retirements and leave something behind for their heirs. So the problem isn't insurmountable. Here are some ideas.

Build up your Social Security and pension credits. Whatever Congress and the President do to reform Social Security, they won't abolish it. It will be there in one form or another when you retire. Working as long as possible to maximize your benefits ensures a lifelong stream of inflation-adjusted payments. While Social Security won't cover more than the basics, life is easier when you have the basics covered. If you're fortunate enough to have a pension, work as long as you can to boost your pension payments. Working longer, although not as much fun as shuffleboard, is one of the best ways to make sure you're as well prepared as possible for retirement.

Save. The more you save, in retirement accounts or otherwise, the better off you will be in retirement. Non-savers, by definition, have already run out of money, and poor savers will quickly fall into the abyss. It's important to have a pool of cash available for big expenses like assisted living and other medical bills. If all you have are comparatively small streams of payments like Social Security and perhaps a pension, and you need to go into assisted living, you'll have effectively run out of money even though you're still getting a monthly income.

Pay down debts. Ideally, you should have no mortgage and little or no other debt by the time you retire. Debt, and its accompanying interest expenses, are negative savings. Some financial advisers will conjure up scenarios where you supposedly might be better off with a mortgage or some other debt. But debt involves risk, and the recent financial crisis and Great Recession amply demonstrate that risk can easily lead to losses. Financial stability is very important for a comfortable retirement, and debt destabilizes.

Invest conservatively. The older you get, the less time you have to recover from investment losses. Keeping some money in assets with potential for appreciation, like stocks, is a good idea because of long term risks of inflation. But be cautious about investing in stocks and other volatile assets. Perhaps a third of your portfolio might prudently be kept in stocks. As you get older, that proportion should shrink so that you don't get walloped by the stock market when you're 83.

Consider an annuity. It's easier to establish a budget if you have a predictable monthly income. An immediate annuity can provide either a fixed monthly payment or one that rises with inflation. (The latter is costlier, but you get additional peace of mind.) Annuities are issued by insurance companies, and they can go bankrupt. If you want the benefits of an annuity, consider buying two, each for half the amount you want to invest, from different insurance companies. Both should have solid credit ratings. With two different insurers, you diversify your risks.

Be cautious with variable annuities. They tend to have high expenses and varying (as the name indicates) payments. That uncertainty of payments may, for some, defeat the purpose of an annuity.

Note that annuities lock up the capital you invest in them, meaning you can't get access to it. All you can get are the payments. You'll almost surely need some liquid assets during retirement, for medical expenses and large items like cars. Never spend more than half your savings on annuities. Indeed, given the limitations of annuities, spend only the minimum amount needed to give you the peace of mind you're trying to secure.

Think about long term care insurance. Although increasingly expensive, long term care insurance gives you hundreds of thousands of dollars of buying power if you have to go into assisted living or have other major similar needs. Long term care insurance helps to preserve your savings (which may be important if you have a spouse or partner whose financial security you wish to protect). In addition, if you want to avoid a nursing home that accepts Medicaid patients--some feel that such nursing homes provide lower quality services--long term care insurance could be essential to affording a more exclusive facility.

Work part-time. Okay, working isn't exactly what you had in mind for retirement. But it allows you to spend less of your savings while you're able to work. If and when you reach the point where you can't work, you'll be glad you worked as long as you did.

Wednesday, March 2, 2011

The SEC's Inconvenient Case Against a Corporate Director

Yesterday, the SEC leveled charges of leaking inside information against Rajat Gupta, a former director of Goldman Sachs & Co. and Proctor & Gamble Co. He stands accused of passing inside information he obtained as a director of these two companies to Raj Rajaratnam, the founder of Galleon Group, an investment firm, who allegedly took advantage of that information to make millions in trading profits. Among other things, Gupta supposedly gave Rajaratnam advance notice of Berkshire Hathaway's 2008 $5 billion investment in Goldman. This investment was a crucial vote of confidence in GS, made at a time when the financial crisis cast doubt on the prospects of all major Wall Street firms. That this moment of salvation was allegedly corrupted by insider trading resulting from a Goldman director's leak only reinforces popular perceptions of Wall Street as a den of thieves.

Gupta has categorically denied the SEC's allegations, and pledged to fight the charges. Nevertheless, the case is rather inconvenient for Congressional Republicans hellbent on slashing the SEC's budget. Insider trading cases often involve high level corporate employees and executives. But they almost never reach the board of directors. Goldman was the premier investment bank in America during the financial crisis, and Proctor & Gamble is an iconic American business corporation. That these two companies would have a director allegedly leaking inside information to an investment firm illustrates why vigorous federal financial regulation is needed.

Insider trading isn't the focus of the Dodd-Frank bill. But uncovering alleged leaking by a director of elite American corporations casts a shadow over the complaints of the Chamber of Commerce and others that the Dodd-Frank legislation unfairly burdens honest and misunderstood businesses. If the allegations against Gupta prove true, they will remind us that private sector management and governance processes are not foolproof, and that federal oversight remains essential.