Sunday, December 30, 2012

Over the Fiscal Cliff and Through the Woods

Over the cliff and through the woods,
To a grand recession we go.
Congress knows the way to waste its last day,
raising taxes and adding woe.

Over the cliff and through the woods,
To a grand recession we go.
The Fed is on deck, printing money like heck,
Investors are losing dough.

Over the cliff and through the woods,
To a grand recession we go.
The Dems go their way to make the rich pay,
Republicans say no no.

Over the cliff and through the woods,
To a grand recession we go.
Where the deficit shrinks, while the jobless drink,
Eating cake is for the po'.

Happy New Year.

Wednesday, December 19, 2012

The Fiscal Cliff Negotiations: Just Who Is Barack Obama?

Recent negotiations over the fiscal cliff, which seem to be faltering after initial signs of progress, raise a persistent question about Barack Obama:  has he any political principles?  After campaigning this fall to protect the poor and middle class, he agreed in fiscal cliff negotiations to changes to the income tax structure and Social Security that are more damaging to the poor and middle class than the prosperous segments of American society.  By accepting Republican demands for the Social Security inflation adjustment to be the Chained Consumer Price Index, Obama has effectively reduced inflation protection for Social Security recipients, military retirees and federal civilian retirees, the vast majority of whom are low or middle income.  At the same time, because the same inflation adjustment would be made to income tax brackets, the brackets would rise more slowly during inflationary times.  That would effectively result in heavier taxation across the board, a seemingly regressive result.  Additionally, Obama agreed to raise the threshold for higher tax brackets from his original position of $250,000 to $400,000.  To be cynical, this might be viewed as a gift to the upper middle class professionals who often are his supporters and contributors.  And to be more cynical, it can be observed that many lower income folks, especially older whites heavily reliant on Social Security and/or military pensions, tend to be Republican more often than Democrat.  Perhaps the President sees little to lose in imposing austerity on them.

One wonders if Obama, after four years of dealing with the Great Recession, understands even the basic structure of the U.S. economy.  Our economy is 70% consumption.  Money in the hands of the poor and middle class gets spent.  They don't have enough to save hardly a penny.  This spending stimulates the economy.  Money in the hands of the upper middle and upper classes is frequently saved, allowing the rich to get richer relative to other income categories.  By raising taxes on the poor and middle class while cutting benefits to Social Security recipients, and military and federal civilian retirees, the President is reducing consumption and its stimulative impact on the economy, while exacerbating the inequality in wealth distribution.  What policy sense does this make?

During his first term, Obama demonstrated time and time again at critical junctures that he is a clever politician and dealmaker much more than a leader.  He craftily co-opted his most serious Democratic rival, Hillary Clinton, by making her secretary of state.  And he kept the liberal wing of the Democratic Party at bay by putting one of their number, Joe Biden, in the Vice President's residence.  But he has few loyal constituencies.  His one signal achievement, the Affordable Care Act, may transform life in America.  But transformational legislation doesn't necessarily bestow greatness on a President.  Lyndon Johnson's Great Society programs transformed America far more than anything Barack Obama has done or will do.  Indeed, the Voting Rights Act of 1965 enfranchised black and other disadvantaged Americans, paving the way for Obama to win the White House.  But Johnson has been denied the mantel of greatness.  While this is due in large part to his foreign policy catastrophe in Vietnam, it's also because Johnson, like Obama, was a consummate politician without any large loyal constituencies.  There's no one running around singing Johnson's praises.  Obama will always be remembered as the first nonwhite President, and there's a measure of greatness in that.  But John Kennedy was America's first non-Protestant President, and in 1960 that was an achievement not far from Obama's achievement in 2008.  Kennedy is remembered today for his charisma and charm.  But he doesn't rank among the great Presidents.  And, because Obama seems to value a deal more than principles or loyalty to constituents, neither will he. 

Wednesday, December 12, 2012

How Will the Fed Deal With Speculation on the Fed?

The Federal Reserve's historic announcement today of specific benchmarks for changes in monetary policy--no positive short term interest rates permitted until unemployment is 6.5% or lower, or inflation exceeds 2.5%--got a resounding shrug from the stock market, which closed flat.  Or maybe it wasn't a shrug, but puzzlement.  This policy takes the Fed into uncharted territory, and the truth is no one really knows what will happen next. 

One thing that's certain, though, is financial speculators just got another trading opportunity. With the Fed specifying benchmarks, speculators can concentrate bets on which way economic statistics will go.  For example, if you think unemployment will drop quickly, short sell the long end of the Treasury securities market.  Or buy a derivatives contract over the counter to quietly do the same thing without the regulators having much idea of what you're up to. 

Because of the Fed's unquestioned ability to move the financial markets, these benchmark bets may be very large.  Indeed, as the Fed's balance sheet balloons even more above its current $3 trillion level in its relentless prosecution of QE ad infinitum, its potential impact on the financial markets will billow proportionately.  Speculators may pile on the risk in the hope of getting even more bang for the leveraged buck. 

With prospects for "real" investments like stocks and bonds murky and guarded, hedge funds and other money managers may be tempted to make benchmark bets instead of living with the disappointing returns available from the real world.  After all, they need to beat the averages in order to attract investors, and benchmark betting could offer a lucrative way to do that (if you guess right).  The financial contracts for making such a bet are manifold, so the quantity of betting may be unlimited.  Since much of this betting could take place in the over-the-counter derivatives markets, central banks and other regulators might not have a good idea how much gambling is going on.  The specter of systemic risk could lurk. 

If benchmark betting becomes a popular play, the Fed might be confronted with the problem of collateral damage to the financial system and economy if economic statistics move in unexpected ways.  If important players in the financial markets suffer a lot of collateral damage from speculative wounds, the Fed might have to deviate from its expected course of action (such as by not raising interest rates or working down its balance sheet even though unemployment drops below the 6.5% benchmark).  In such an instance, the very policy that the Fed is attempting to implement could be undermined. 

But there is no practical way for the Fed to prevent benchmark betting.  Even if it can control the risks taken by the largest money center banks (and that's no certainty by a long shot--witness J.P. Morgan's London Whale debacle), it can't control the risks that myriad hedge funds and other investment vehicles, many of which would be in other countries, might take.  If a lot of these speculators are leaning right when the economic statistics move left, the Fed and other central banks might have a highly problematic problem. 

The idea behind the Fed's announcement of benchmarks is to make monetary policy more transparent and understandable.  That's nice theory.  But the abundance of wise guy speculators in the financial markets can muck up (that's the polite phraseology) the works. 

Friday, December 7, 2012

Will Stocks Drop Over the Cliff?

The stock market has been eerily calm in spite of all the sturm und drang over the fiscal cliff.  After a brief sell-off following President Obama's re-election, the Dow Jones Industrial Average has treaded water right around the 13,000 mark.  Evidently, the market believes the anonymously leaked assurances from both the Republican and Democratic sides that a deal on the fiscal cliff will be reached.  And, rationally speaking, that should happen.  So maybe the market is justified in its equanimity.

But is it?  Looking back at the most recent comparable instance of fiscal dysfunction, the 2011 debt ceiling scrum, we find that "resolution" of the political problem was followed by a drop in the market.

The debt ceiling fight simmered until June and July 2011, when all hell broke loose and records were set for political dysfunction in Washington.  Only at the last minute, on August 2, 2011, was a deal to lift the debt ceiling finalized and approved by Congress.  The Dow, which floated around in the 12,000s during July, fell below 11,000 within a week.  One might have thought that resolution of the debt ceiling battle would produce a market rally.  But, no, just the reverse happened.

The debt ceiling fight revealed the depths of America's political dysfunction.  Standard & Poor's cut America's credit rating on August 5, 2011.  The future looked, if anything, more uncertain than before the debt ceiling crisis.  The resolution to the debt ceiling problem was to kick the can down the road, and defer confronting the government's tax and spending issues until after the November 2012 elections.  Stalling and delaying isn't the kind of thing to inspire investors.  The market's frothiness before the deal and its drop after the deal seemed like a classic case of buy on the rumor and sell on the news.

Well, that may be where we are headed today.  There are plenty of nice sounding rumors being floated by politicians who have plenty of incentive to shade the truth.  Reality is that whatever compromise the Republicans and Democrats reach on the fiscal cliff will surely be ugly.  The pie is too small to be apportioned in a way that will make many, if any, happy.  With the "resolution" to the fiscal cliff likely to make most of the nation grumpy, stocks aren't likely to be exuberant.  Whatever you do, don't bet on politics to produce investment gains.

Wednesday, November 28, 2012

Political Risks of the Fiscal Cliff

Who faces the greatest political risks from the fiscal cliff?  It ain't the Democrats.  They could do nothing, and watch the pre-Bush tax rates go back into effect in 2013.  While this would have a near term negative impact on consumer spending, it would lower the federal deficit.  That would promote long term economic growth.  The President would take some heat for the economic slowdown, but the Democrats would have four years to recover before facing the 2016 Presidential election.  By then, the economy might well be improving.

If there is a deal on the fiscal cliff, it would probably include some cuts to Medicare and Medicaid, and perhaps to Social Security (although the latter is less likely, since Social Security is actually much less of a fiscal problem and more visible to the voting public).  The Democrats would blame these cuts on Republican insistence (of which there is plenty).  Meanwhile, the Democrats would take credit for whatever tax increases or enhancements or whatever else would be part of the deal, which probably would fall more heavily on the rich than the 99%.

The Republican insistence on no tax rate increases allows President Obama to replay his winning electoral strategy of advocating tax increases for the rich.  Republicans believe too much in their own P.R., that all taxes increases are invariably bad and that spending cuts would somehow be made to prevent taxes from increasing.  A majority of the electorate thinks otherwise, and the Republicans conceded these voters (let's call them the 51%) to President Obama. 

 The baseline problem with the Bush tax cuts is that they reduce federal revenues to the point where Social Security and Medicare--the two most sacred bovines of American politics--are imperiled.  It's one thing to attack federal funding of bridges leading to nowhere.  It's another to take away bread and butter from the elderly.  Republicans have managed to put themselves in a corner where they seek to protect low taxes for the wealthy while trying to squeeze pensioners having modest incomes.  They ultimately can't protect the wealthy from a tax increase--the Democrats can do nothing and those increases will take effect at midnight, Jan. 1, 2013.  But the Republicans can manage to look like Scrooge during the Christmas season as they advocate cuts for moderate income retirees.  Politically, it won't be the Democrats who tumble over the fiscal cliff.

Sunday, November 18, 2012

Why Insurance Products Can Make Lousy Investments

If you're considering an insurance product that includes an investment feature, consider the following two examples of why you might want to say no.

Mass Mutual.  On Nov. 15, 2012, the SEC sued Massachusetts Mutual Life Insurance Company in an administrative proceeding (an agency process somewhat like a court case, although conducted within the SEC instead of in a court).  Mass Mutual settled without admitting or denying the SEC's charges.  The essential accusation the agency leveled against Mass Mutual was that it didn't adequately explain to customers how withdrawals from variable annuities under certain circumstances could drain their accounts of value.  (See the SEC's press release at

Variable annuities involve the customer making periodic payments for a number of years and directing how the money is invested in a tax sheltered annuity. Eventually, the invested amounts can be used to purchase an income stream from the insurance company. The investments may do well or poorly.  To ameliorate the potential for poor investment returns, Mass Mutual offered an optional rider that, for an additional premium, gave customers a GMIB, or Guaranteed Minimum Income Benefit.  The GMIB guaranteed a minimum value that customers could use eventually to purchase an income stream, regardless of how poorly their investments did.

The GMIB could increase by 5% or 6%, depending on the rider.  Mass Mutual capped the level of the GMIB (through a somewhat complex formula).  Once the cap was reached, the GMIB wouldn't increase.  Mass Mutual also allowed customers to make withdrawals from their annuities before they converted the investment value into an income stream.  If they made a withdrawal before the GMIB reached its cap, the withdrawal would reduce the GMIB value (and the value of the invested assets as well), but wouldn't prevent the GMIB from continuing to increase.  However, after the GMIB reached its cap, withdrawals would decrease the GMIB and it wouldn't increase the next year.  Thus, making withdrawals after the GMIB reached its cap could permanently shrink the GMIB--under some potential circumstances, to zero.  According to the SEC, Mass Mutual didn't clearly explain how the GMIB, which might be thought by customers to be a guaranteed minimum value, wasn't guaranteed if the customer made withdrawals after it reached its cap.

Got it?  Pretty simple, right?  To be sure, after it was nabbed by the SEC, Mass Mutual did the right thing and eliminated the cap on the GMIB.  But if you furrowed your brow over the details of this annuity (and we've just summarized them--read the SEC's press release and order cited above for a gorier rendition), you should think twice--and then three times--and then four times--and then five, six, seven and many more times before investing in a variable annuity.

Universal Life.  The other example is in today's Wall Street Journal (Nov. 17-18, 2012, P. B9), which reports that low interest rates may require universal life insurance policy holders to pay higher premiums or face the cancellation of their policies.  Universal life is a form of permanent life insurance that allows customers to have life insurance coverage for long periods of time (i.e., longer than the perhaps 20 years allowed in term life coverage), often with flexibility in the amounts of the premiums paid.  Universal life also has an investment feature, and customers can use money from the investment account to help cover the cost of their life insurance.  As customers age, the cost of life insurance coverage naturally increases.  But today's low interest rate environment has been detrimental to investment returns, including those of universal life policies.  Many universal life customers are facing the need to pay increased premiums, or see a reduction of their life insurance coverage or even the cancellation of their policies.  Large numbers of universal life policies were sold years ago, before the Federal Reserve declared war on positive interest rates.  So the current low rate environment and its consequences for universal life policies probably come as a surprise to many customers. 

Insurance products like variable annuities and permanent life insurance can sometimes put customers into the middle of the complexities of the financial markets.  You're subject to many of the same risks as professional investors and traders.  But you probably don't have the same level of knowledge, experience, and information as they do.  Sophisticated insurance products can be labyrinthine mazes of risk shifting, and it's possible to run into the Minotaur.  Traditional insurance, which consists of the pooling of risks, can offer sensible protections.  But stick to policies that are easy to understand, because then you'll know what you're getting into.  Term life and fixed annuities can be useful for many people. Super dooper, turbo-charged complex insurance products that also invest your savings, pick up your dry cleaning and get the oil changed in your car are to be viewed cautiously, and then skeptically.

Sunday, November 11, 2012

The Republican Redistricting Nightmare

The Republican Party is all tangled up in a pickle of its own making: redistricting. And this pickle doesn't taste very good.

Redistricting is the re-drawing of the borders of Congressional districts.  It often happens after a decennial census, when the results show significant population change.  In most states, redistricting is done by state legislatures, sometimes subject to the approval of the governor.  The potential for political shenanigans is obvious, and the federal courts have presided over many cases alleging gerrymandering.  But stacking the deck in your favor isn't always unconstitutional, depending on how you do it, and there are many districts resembling Rorschach tests for ghouls that are legally tilted in favor of one party or the other. 

The Republicans have been very successful at redistricting.  In recent decades, they have used political successes at the state level to string together districts that look like they were inspired by Jackson Pollock but vote reliably Republican.  They got what they wished for.

Then came the Tea Party.  A problem with democracy is the little people can't always be kept in line.  They can sometimes be unruly and demanding.  When riled up enough, they may even assert control.  The doyens of the Republican Party found this out the hard way in 2009 and 2010, when malcontents of many kinds coalesced into the Tea Party movement.  Although Tea Partiers counted some Independents and even a few lapsed Democrats within their ranks, the movement as a whole gravitated toward the Republican Party and pushed it ideologically rightward.  To make things worse, the erstwhile 2008 Republican Vice Presidential nominee, Sarah Palin, went rogue on the party's leadership and helped many radical right Tea Partiers win primary elections in 2010 over mainstream Republicans.  Thus, in 2010, a number of Tea Party and other seriously right wing candidates won elections in reliably Republican districts.

Now, the Republican leadership is stuck with these Tea Party legislators.  Perched in districts well-drawn to protect incumbency, these birds ain't going nowhere.  They'll keep the Republican agenda firmly anchored to starboard, even though the route to an electoral majority veers to port.  The Republican chieftains can't sponsor centrist candidates or advance a more moderate iteration of the vision thing without alienating their base, now ensconced in Republican cocoons.  

Political segregation prevents the Republican Party from evolving.  For those that are creationists, this is probably okay.  But others in the GOP may realize that they've been too clever by half, and that they helped to make the Democratic strategy of political integration a winner.

Wednesday, November 7, 2012

All That Noise, All Those Robocalls, and Nothing Changed

We had the elections, and nothing changed.  Barack Obama was re-elected President.  The Democrats kept control of the Senate.  The Republicans kept control of the House.  After all the accusations, attack ads, junk mail, robocalls, soaring campaign rhetoric, and lies, we can look forward to . . . more gridlock.

This election was the comeuppance of all the money bag men who nonymously or anonymously tried to buy their way into political power.  Hiding behind secretive nonprofits, monied interests barraged users of every type of media with relentless harangues and unending fear mongering.  While Democratic war chests were very large, Republican funding was Brobdingnagian.  But all that spending, and counter-spending, produced very little change.

That's a great result.  It shows that the American voter isn't a dumbo who can be cynically manipulated by unnamed puppet masters with zillions to spend behind the scenes to instill subliminal fears.  Politicians and political parties must, however difficult it may be, offer something that is in the public interest.  They need to demonstrate that they have something positive to say and do.  The political process remains a means for societal concerns to be debated and resolved.  The rich may not get richer.  The poor may not get poorer. 

Many problems lay ahead.  The fiscal cliff approaches anon.  The economy remains in first gear, and unemployment levels feel like the real bad hangover that comes from drinking the worm as well as the tequila.  The federal deficit must be dealt with.  As difficult as these problems may seem, the defeat of the monied interests is a sign of hope--hope that politicians may try doing something constructive for a change, rather than cater to those that offer to hand over the biggest checks.

Tuesday, October 30, 2012

The Great Anxiety

The Great Recession has morphed into the Great Anxiety.  Economic growth is tepid, enough so that it inspires little confidence.  Unemployment, still high, is falling, but so slowly that consumers' animal spirits remain tame.  Individual investors, confronted by three year highs in the stock market, celebrate by fleeing.  The members of Congress devote their energies to calling each other finks, rat finks, double rat finks, and triple rat finks, while the nation veers toward a fiscal vortex.  Both candidates for the Presidency, although individually quite intelligent and accomplished, swap lies about how the other is lying and inspire little more than resigned sighs from their supporters.  The Federal Reserve is operating the only show in town, and its program consists of printing money, printing money while riding a bicycle sitting backwards, printing money while juggling eight balls and printing money while doing double somersaults on a trapeze.  But the Fed can't do much to resolve the problems in Europe, which is now sliding into recession even as the sovereign debt crisis gets kicked farther down the road.

If the Federal Reserve Board is correct in believing that public confidence is crucial to economic growth, then we are a long way from healthy, sustainable growth.  By all current indications, whichever candidate for President wins won't inspire much confidence.  Congress appears likely to remain divided between a Republican House and a Democratic Senate.  Gridlock isn't that big a problem when the economy is strong.  But it is deadly when the economy is moribund.  For better or for worse, a somnolent economy needs a decisive government, and we probably won't have one. Can kicking isn't a sound federal economic policy.  Both Japan, and more recently, the European Union, have vigorously kicked the can numerous times.  The problem, though, is that business people and consumers all know that the can is still there, and can bite them in the butt big time.  So they don't make big commitments; they don't go exuberant.  Can kicking virtually guarantees stagnation.  Yet can kicking has been the order of the day in Washington.

In a time when lukewarm coffee is all that you can hope for, invest cautiously.  It's not a bad idea to hold some risk assets.  But limit your exposure, and avoid the riskiest.  Hold a good dollop of stable assets, and don't stretch for yield.  One important way to give your net worth a boost is to save more.  Remember that the thriftiest squirrels have the best chance of surviving winter--and the coming winter could be cold indeed.

Sunday, October 21, 2012

Manufacturing Matters

In the end, Steve Jobs got his revenge.  Once marginalized by Microsoft and its monopoly on PC operating systems, and then kicked out of Apple, the company he founded, Jobs was recalled to Apple as it was sliding into a death spiral.  He proceeded to rebuild his brain child into the most successful business corporation today.  Apple is the leader of its market segment--that segment being the mobile world.  It manufactures visually attractive and highly efficacious mobile devices.  Okay, they had a problem with maps.  But Apple has overcome its previous belly flops, and it will surely overcome this one.  Its high prices may keep it out of the reach of some consumers.  But those that can afford its products tend to be the well-off who are highly sought by advertisers.

By contrast, Google and Facebook are now looking at the abyss.  They haven't figured out mobile, at a time when mobile products are the fastest growing consumer high tech segment.  Both Google and Facebook rely heavily on advertising, but mobile screens are too small for the kinds of ads that have proven successful on PCs and traditional laptops.  There isn't yet a mobile-specific advertising strategy that really works.  As the world becomes more mobile, Google and Facebook face the potential for a Yahoo-style decline, unless they solve the advertising problem or find alternative revenue sources.  Solving the advertising problem requires gathering more and more detailed information about individuals using their products.  But that could bring them into greater conflict with governmental protections for privacy.  This is a particular issue in Europe, and a growing issue in America.  These privacy protections will ultimately limit the extent to which Google and Facebook can facilitate the targeting of ads.  One interesting notion is perhaps Yahoo, with its banner ad business (which doesn't rely on detailed personal information), will eventually prove the tortoise in its race against Google and Facebook.

In part, Google and Facebook confront the problem of all successful high tech companies.  No matter how well you're doing, the next big thing is coming and you'd better be prepared for it or others will out-innovate you and leave you in the dust.  IBM didn't anticipate the PC, and it lost its standing as the predominant computer company.  Microsoft didn't anticipate the ubiquity and importance of the Internet, and it's in a slow fade.  RIM didn't anticipate how consumers would flock to the smart phone, and it's barely staying alive on its corporate customer base.

But failure to anticipate the next big thing isn't the only dynamic.  Part of the dynamic is that Apple manufactured the next big thing.  By creating products that elevated the mobile experience by quantum leaps, Apple made consumers want mobile products.  By manufacturing and selling these products, Apple derives a very large part of its revenues from selling hardware and software packaged together.  It doesn't give consumers stuff for free and hope that it can slip in a few ads here and there.  It makes and sells stuff for cash money.

Making and selling stuff has, for millenia, been the heart of economic activity.  The evolution of the industrialized world revolved around elevating the manufacturing process to a grand scale, so that vast quantities of stuff could be made efficiently and sold at prices a lot of people could afford.  Steve Jobs' relentless commitment to manufacturing--and thus control over product design and quality--placed Apple at the core of the industrial process.  By manufacturing high quality and innovative stuff, Apple avoided the commoditization of PCs (which bedeviled Dell, Hewlett Packard and other companies) and elevated itself to the top of the high tech world. 

This isn't a sales pitch for you to run out and invest in Apple.  Its stock, on a tear earlier this year, has been falling back recently.  Its maps debacle hurt, and its future--always uncertain because it's in the most volatile of industries, high tech--has been made more unpredictable by the death of Steve Jobs.  The point here is that Apple's business strategy of manufacturing made it strong, and is a sound idea for American economic policy.  America increasingly doesn't manufacture.  But you can't build a strong national economy on management consulting, investment banking, hedge funds, law practice, health care, restaurants, and services like hair salons, pet walking, personal shopping, and the secondary and tertiary retailing in websites like eBay.  The foundation of a strong economy is manufacturing.  Look at Germany.  Look at China.  America was once the manufacturing giant of the industrialized world.  While it can't return to that status, it can look for ways to encourage manufacturing.  We all know Apple manufactures a lot of components in China.  But well under half of its revenue dollars are spent in China.  Much more is allocated to spending in America, for things like retailing, distribution, employee payroll and so on.  Successful manufacturing companies make their home countries strong. 

Most of the debate today over fiscal policy revolves around the amounts of federal spending and federal taxation.  But fiscal policy isn't just a matter of accounting.  The nation benefits by spending and taxing wisely.  Keeping Social Security, Medicare and Medicaid in the black will be easier if we have a robust manufacturing sector.  The pie is much easier to divide if it's bigger.

Sunday, October 14, 2012

Pan Europeanism's Gambit

It would appear that a group of key European leaders combating the EU financial crisis have coalesced around the banner of Pan Europeanism.  Mario Draghi, head of the European Central Bank, has positioned the ECB to start financing struggling EU governments.  This is a paradigm shift from past ECB policies, and moves the ECB toward the money printing mode of the Federal Reserve and the Bank of England.  Recently, Angela Merkel, Germany's Chancellor, has spoken of cutting Greece a break on its austerity obligations under the terms of the EU's bailout for that nation. Such magnanimity is at rather sharp odds with her tough stated positions not many months ago.  The recent election in France of Socialist Francois Hollande shifted the EU's political center of gravity toward more accommodative measures--Hollande's notion of austerity is to raise taxes on the wealthy and give them a taste of austerity. 

The award of the Nobel Peace Prize to the European Union may be the latest move in the gambit to persuade skeptical northern European taxpayers of the need to keep the EU together.  The point is that failure to stay together will raise the specter of another continental war.  Although actual war seems highly unlikely in today's non- and often anti-militaristic Europe, the subliminal message is clear. 

The Nobel award is like a mutual admiration society of Pan Europeanists high fiving each other. The political in-crowd on the continent has to be very pleased with itself at the moment.  But the baseline problem for saving the EU remains whether or not northern European taxpayers are prepared to foot the bill for keeping the whole shebang together.  If not, the $1.5 million or so that comes with a Nobel Prize won't matter.  An interesting question is who will the EU select as its representative to receive the award.  Here's betting it's Angela Merkel, who needs political cover.

Sunday, October 7, 2012

How Government Adds Risk to Risk Assets

The Federal Reserve has been on a tear, squashing interest rates in order to coerce investors into risk assets.  But investors, especially individual investors, have been zigging where the Fed wants them to zag.  They have succumbed to post traumatic stock disorder, and abandoned equities with abandon. 

Fear of stocks isn't just a product of the market busts of recent years.  It's also driven by too many known unknowns.  The role of government in pumping up asset prices has become so great that it receives more attention from financial news services than economic fundamentals.  But, as mandated by the law of unintended consequences, government actions have made risk assets less attractive.  Here's how.

The Fed has become less predictable.  In years past, the Federal Reserve was slow to reveal its thinking and the reasons for its policy actions.  Chairman Ben Bernanke has endeavored to be more transparent.  And he has been more transparent about the workings of the Open Market Committee and its thinking.  But what has been revealed only confounds.  The Fed is quite open about its intention to provide monetary stimulus in order to boost employment.  But no one knows what level of employment will cause the Fed to ease back, or what rate of inflation will lead it to move interest rates up.  No one knows what type or form of additional quantitative easing the Fed will employ if employment levels remain unsatisfactory (however unsatisfactory may be defined).  Will it buy car loans, credit card debt, bankers acceptances, commercial paper, corporate bonds, junk bonds, common stocks, or something else?  Whether or not, why, when, how, how fast, and how much are important, but unanswered, questions concerning the Fed's potential unwinding of its massive $3 trillion plus balance sheet. Any purchaser of risk assets would want answers to these questions.  But answers are unavailable.

The Fed is relentlessly driving its monetary wagon train under the motto "full employment or bust."  By acting so vigorously and creatively, however, it has created a lot of uncertainty even as it has stabilized the financial system.  There are so many uncertainties about the route the Fed is taking that individual investors don't want to hitch up their wagons and join the trek.  What the Fed will do next is anybody's guess, and because of its outsized impact on risk asset prices, this unpredictability makes risk assets riskier.

Fiscal funk.  Congress's dysfunction was on full display last year when those freakin' idiots--excuse me, the esteemed members of Congress--almost blew up America's creditworthiness in the debt ceiling debacle.  Things haven't changed.  Forecasting fiscal policy is like peering into a black hole.  It's impenetrable.  Whatever happens could make things worse.  Also, consider the permanently temporary nature of the Bush II tax cuts, which have fallen into the habit of being extended a year at a time.  The analysis of risk assets becomes labyrinthine when the tax system is established for only a year at a time. Another big, bad black hole is known as the fiscal cliff, which is huffing and puffing furiously.  Yet we don't know if we're in a house of straw, wood or brick.  All these fiscal foulups accentuate the risk in risk assets. 

Rational investors trying to reason their way to well-founded decisions haven't got a popsicle's chance in hell of figuring out the upsides and downsides of risk assets.  They just know that these known unknowns heighten the risks.  In such circumstances, digging the fox hole deeper and hunkering down all the more make sense.

Friday, October 5, 2012

Would You Invest in Government?

Investors have an unusual problem today:  should they invest in government?  No, that's not political rhetoric.  It's perhaps the biggest question facing anyone with cash to allocate.  Asset prices have been manipulated upward by central banks and other government policies.  Stocks and bonds would not be trading at today's prices had it not been for all of the merry money printing by the major central banks during the past few years.  Indeed, the Federal Reserve takes credit for over half the rise in stock prices since 1994.  See  If you buy stocks or bonds now, you're betting that central banks can continue this juggling act. Is that possible?  Let's look at real estate.

Real estate prices for decades received government support on a massive scale.  Beginning in the 1930s and 1940s, various government lending and finance programs (think Fannie Mae, Freddie Mac, Ginnie Mae, FHA, etc.), along with tax deductions for mortgage interest and property taxes, plus more specialized programs like federal flood insurance, have combined to create a vast support network for real estate, worth trillions of dollars.  Add Federal Reserve easy money policies starting in the 1990s going forward, and real estate prices were boosted leaps and bounds by government largess.  We know, however, how this story ends.  Humpty Dumpty had a great fall, and all the government's programs and bailouts since the financial crisis of 2007-08 haven't put Humpty together again.  To be sure, a great deal of private avarice and stupidity played central roles in the real estate catastrophe.  But the presence of the government, lending a helping hand at every turn, made it easy to believe that real estate prices would never drop. 

Stock and bond prices now seem similarly invincible.  Even though Europe is sliding into recession, China's growth is slowing, and America's economy sputters and coughs just above recession level, stocks keep bubbling up.  Any positive economic statistics add to the ecstasy.  Negative ones slip from short term memory.  Many investors skittish about stocks have no qualms about diving into bonds, even though bond values have been driven to extreme heights.  Central bankers worldwide issue virtual carbon copies of each other's press releases declaring their unswerving commitment to keep printing money until . . . well, until . . . well, it's not clear where the process will end because the printing presses are now set to run ad infinitum.

To invest today, you have to pay the government prescribed price. To assess the risks of financial assets, you have to give heavy weight to political considerations--and those ain't pretty.  Buying financial assets like stocks and bonds is essentially an act of faith--faith in governments, and especially in central banks.  But faithfulness in this respect may not get you through the Pearly Gates.

Sunday, September 23, 2012

Costs of Quantitative Easing

The law of unintended consequences haunts economic policy.  The Federal Reserve's quantitative easing program, now in its third phase, is meant to provide economic stimulus.  However, it also drags on the economy.  Let us count the ways.

Reduced Interest Income.  Hundreds of billions of dollars of interest income have been lost because of the Fed's longstanding campaign to drive down borrowing costs.  Losses of this magnitude undoubtedly have dampened consumer demand.  Even though QE likely sprung loose some personal income by providing lower mortgage rates for homeowners to refinance, tight standards applied by banks making mortgage loans have limited the refi impact of lower rates.

Reduced Retirement Savings.  As bond yields shrivel up like corn in today's drought-ridden Midwest, many retirements look bleaker.  Even though the stock market has boomed, large numbers of shell-shocked savers abandoned stocks after the 2008-09 market crash and haven't participated in the gains.  Instead, they ducked into bonds.  Although the improbable bond rally of the past few years generated capital gains for many bond holders, the basic return sought by bond investors comes from interest paid.  That has been paltry.  As retirements look bleaker, many workers cut back on current consumption in order to save more.

Pension Pain.  Despite appearances from some recent press coverage, pension funds cannot take large risks, overall, with their portfolios.  However much publicity pensions' alternative investments may generate, a large part of pension assets must be invested in high quality bonds.  As returns on these puppies shrink, employers corporate and municipal confront the necessity for greater contributions.  Workers may be laid off, citizens may receive fewer public services, state and local taxes may be raised, shareholders may endure lower returns, and those workers still employed may have to make greater pension contributions.  All of which would further discourage current consumption.

Insurers Backpedal.  Insurance companies' returns on their investments are falling.  This means policies that depend on long term returns, such as annuities and long term care policies, become more expensive or even impossible to buy.  Or else, they offer fewer benefits.  Policy holders suffer.  Those people who want to provide for themselves, through long term care policies, annuities, whole life and similar products, have a harder time.  More people end up having to rely on government programs like Social Security, Medicaid and so on.  That's not good in an age of serious federal deficits.

Yield Curve Flattens Bank Incentive to Lend.  Back in the days when they made loans, banks would borrow short term (usually through demand deposits, interbank loans via the fed funds market, and savings accounts) and lend longer term.  The difference between short term interest rates (historically lower) and longer term interest rates (historically higher) provided profits for the banks.  But the yield curve (the graph of interest rates from short to long) has been flattened by the Fed's monetary policies.  There isn't that much difference any more between short and long term rates.  Potential profitability for banks has been squeezed.  Banks have less incentive to lend, and fewer loans means less potential for economic growth.

The Fed has sworn on a stack of printed money to keep short term rates darn near invisible until at least mid-2015.  It may achieve some of its objectives.  But it will also create unintended consequences.  The impact of these opposite reactions to the Fed's actions may be greater than the central bank foresees.  There are few real life experiments in economics.  But if we look at the most obvious example of the impact of a central bank squashing interest rates for years at a time, we can see that Japan has remained moribund for two decades since its financial and real estate crashes in the early 1990s.  The Bank of Japan has ruthlessly stamped out any positive upswings of interest rates in that nation.  But that hasn't produced the spark needed to revive Japan's economy.

It now looks like the Fed will keep rates unnaturally low for the better part of a decade.  Given Japan's experience, one wonders what is in the Fed's playbook.  If it's a sensible fiscal program from Congress and the White House, the next question would be what is the Fed smoking?  But if the Fed is acting on the reasonable assumption that we will have fiscal dysfunction for the foreseeable future, only the arrival of Godot, it would seem, would offer reason for optimism.

Friday, September 14, 2012

The Fed's QE3: An Old Dog Pulling An Old Trick

Since the financial crisis of 2008, the Federal Reserve has striven to show that an old dog can learn new tricks. Its grab bag of novel programs have at various times propped a variety of financial markets, ranging from commercial paper to asset backed securities to U.S. Treasury securities, as well as banks and other financial institutions. Its aggressive use of quantitative easing has in particular stood out from Fed monetary policy of yore, in which discount and fed funds rate adjustments, along with changes in bank reserve requirements, were the only flavors of monetary policy served up.

The recently announced QE3 looks innovative: it's permanent until the labor market is doing 70 in a 35mph zone, will involve $40 billion of purchases per month, and is focused on mortgage backed securities. The Treasury securities market isn't targeted (although it's still being stage managed through Operation Twist to push down yields on long maturities). But QE3 is really just an old trick performed in a different way.

Going back to the new paradigm days of Chairman Alan Greenspan, the Fed has believed that the real estate market leads recoveries. One of the Fed's major frustrations with the Great Recession has been the moribund housing market. It remains badly hung over from over-indulgence in leverage, and battered consumer balance sheets make it difficult for many wannabe buyers to qualify for loans. QE3 is a direct shot of liquidity into the housing market, made with the hope of lowering mortgage rates, stimulating buyers and boosting the economy.

But we've heard this song before. After the 2000 tech stock crash and the 9/11/01 stock market swoon, Chairman Greenspan squashed interest rates with the intention of goosing real estate in order to keep the economy growing. It worked. Already in recovery mode from a downturn in the 1990s, real estate skyrocketed in the early and mid-2000s. The economy grew. Employment levels were good. Everything was peachy.

Until the bubble burst. Since 2007, we have paid the price for the Fed's campaign ten years ago to use the housing market as a way to foster economic growth. Too much of America's wealth was invested in real estate, and the resulting losses continue to choke the economy. One would think the Fed learned a lesson--that concentrating America's capital into a single market sector is risky and when that market sector turns down (as all markets do from time to time), the losses are exacerbated by the over-concentration.

But perhaps old dogs fall back on old tricks. There is serious concern that the Fed has run low on ammo. It can't push interest rates much lower. It can't keep distorting the U.S. Treasury market and give the federal government a very low cost way to run up the deficit. And banks don't want to lend no matter what the Fed signals, because loans are risky and the banks could take losses. So the Fed has decided to directly finance the mortgage markets by purchasing $40 billion per month in the MBS market. In other words, it's going to goose the housing market in the hope of stimulating the economy.

Some people like roller coasters. Others find them nauseating. The last time we got on this roller coaster, the ride ended badly. Nevertheless, the Fed is getting on again. Short term, it may enjoy success, just as the Greenspan Fed enjoyed success--for a while. But long term, the Fed faces a dilemma. In order to prevent another real estate bubble, the Fed has to maintain prudent lending standards. But prudence won't lead to the euphoric exuberance that could launch the economy into the dramatic rise that the Fed seems to be seeking. Will the Fed use its supervisory powers over the financial system to loosen up lending standards, with the concomitant risk of a housing bubble and bust, followed by a Greater Recession? Aroma of rat drifts into the ambient environment. QE3 may not really work unless it fosters really large risks. And we know what can happen when there's a lot of risk around.

Monday, September 10, 2012

Why Doesn't the Fed Fix Facebook?

By all indications, the Federal Reserve has taken up the job of keeping the stock market happy. It's high time the Fed fixed Facebook. There may be good reasons why Facebook has lost half or more of its IPO value. But there are also good reasons why the the economy is in the doldrums. Just as the Fed has fired off numerous weapons to stimulate the economy and make the financial markets feel better, the Fed should make Facebook investors happy. They'll increase their consumer spending if their stock goes up and that will boost the economy. Everyone will be happy because QE is the source of all happiness these days.

The Fed should announce QE-Facebook: it will buy up FB shares, not at the current market price but at the original IPO price. After all, the point is to boost confidence, and bailing FB investors out of their losses is a good way to boost confidence. Nothing better than a do-over when you made a boo boo. Better yet, the Fed should buy FB shares at double--no wait, triple--no wait, quadruple the IPO price, or $152 a share. That way, investors would get the benefit of the IPO pop they were all expecting. That would really give the economy a zing.

There's no logical reason to stop with FB. The Fed could also buy Zynga and other IPO stocks at pop prices. Indeed, the Fed could simply announce QE-stocks and stand as a ready buyer in the stock markets for all stocks at whatever price investors expect however unreasonably.

Throughout this summer, the stock market has moved up as the world economy has deteriorated and the U.S. economy has slowed. This rise was all because of central bank easing and the expectation of continued central bank easing. Unlimited central bank easing is the best kind, and the ECB just served it up (kind of, see the preceding blog The days when central banks would take away the punch bowl just as the party was warming up are long gone. Now, the central banks host the parties, which always have open bars. If the Fed wants a good party, it should open up the taps and let them flow freely. QE-Facebook. QE-Zynga. QE-all stocks.

Saturday, September 8, 2012

What's Behind the ECB's Unlimited Bond Buying Program?

It's kind of hard not to smell a rat in Mario Draghi's proposal for the European Central Bank to make "unlimited" purchases of sovereign bonds of troubled EU member nations. According to the proposal, the ECB will buy an EU member's bonds if the member requests assistance and submits to fiscal oversight by the EU. The latter, however, has been the problem with Greece. It doesn't want to submit to the EU's fiscal oversight. And when it did agree to terms demanded by the EU, it failed to comply with them. In return, Greece has been given break after break after break. It effectively defaulted months ago, but the EU papered the default over with a loan workout that forced creditors to sustain losses (which they may have recouped via credit default swaps, so the losses actually fell on the writers of the CDSs or their unfortunate direct, secondary or tertiary counterparties who held the ultimate risk of loss). Stated otherwise, the EU has supported Greece without Greece having to do the full austerity dance it was supposed to do.

The two countries that Draghi's proposal was aimed to help, Spain and Italy, insist that they will not submit to fiscal oversight by the EU (for domestic political reasons). If they really mean it, that means they won't get bond buying assistance from the ECB. Possibly, their hardline insistence that they won't ask for help (and thereby submit to central oversight) is a bluff, meant to get Draghi to drop the fiscal oversight condition. They could simply let market forces push their bond yields higher. That would shove the EU closer to the brink. Draghi might then drop the fiscal oversight condition when the markets threaten to go haywire. Of course, the bluff isn't really aimed at Draghi, who seems amenable enough to U.S. Fed-style money printing, but at the Germans and other northern Europeans of the frugal persuasion. The Greeks have proven themselves adept at brinksmanship with Germany and its economic allies. Spain and Italy have little incentive to be any more austere.

Germany may be wealthy enough to bail out Greece. But it can't bail out both Spain and Italy, which have much larger economies. So a move by Draghi to drop the fiscal oversight condition could lead to German withdrawal from the EU. That could be catastrophic. But writing blank checks to Greece, Spain and Italy could be catastrophic for Germany, and one can't expect Germany to knowingly sign up for a catastrophe. Mario Draghi may be playing a most dangerous game, and he'd better play it well or the abyss will beckon.

Monday, September 3, 2012

Ignore the Election. Try a Little Science.

As far as economic growth goes, forget about the Presidential election. Neither party is focused on what really matters: basic scientific research. All great surges in economic growth have resulted from scientific advancement. When humans acquired enough scientific knowledge to engage in agriculture, they were able to grow large surpluses of food. These surpluses were used to support the development of settled societies, with cities, specialized workers, the centralization of knowledge through educational institutions, and control over resources like rivers and their floods. Human populations increased exponentially, as did human wealth.

The leap from a largely agricultural world to an industrialized world began with the development of the steam engine at the end of the 18th Century. The steam engine allowed humans to harness very large quantities of power derived by burning wood, and later fossil fuels. The vast increase in power offered by the steam engine led the way to the railroad, steam ships, giant factories that provided economies of scale, and even a few early cars.

In the 19th Century, the harnessing of electricity led to the telegraph, telephone, small and large scale lights and lighting systems, and all manner of machinery and equipment. New technologies for extracting and utilizing fossil fuels like coal, oil and natural gas vastly increased the amount of power available to humans, especially through the use of the internal combustion engine that powers almost all motor vehicles today. With that great increase in power came an enormous improvement in living standards.

In the 20th Century, advances in knowledge of electromagnetic radiation gave rise to the radio, television, cell phones and the wireless computers used today (variously called smart phones, tablets, etc.). Advances in agriculture have eliminated a great deal of the hunger that plagued much of the world before World War II. Developments in material sciences led to the semiconductor revolution, which is the foundation of all modern computers. The Internet, invented by [fill in the name of your favorite politician], has revolutionized communication.

In short, the big score comes when humans make major scientific advances and find ways to exploit them. Money printing and interest rate manipulation by the Fed, supply side tax cutting, deficit spending, scorched earth treatment for Medicare and Medicaid, and just about all the other hooey that politicians can't stop talking about don't amount to jack compared to the effectiveness of scientific advance in fostering economic growth. Much and perhaps most of today's political debate revolves around how to split up a seemingly inadequate pie. But the supposed conflicts between the 1% vs. the 99%, older folks vs. younger ones, taxpayers vs. beneficiaries of the social safety net, and so on all become less consequential if the pie expands at a faster rate.

Don't expect private financing sources to support basic scientific research. Private capital wants to reap its profit within a few years, and concentrates on applied science. But applied science doesn't provide lasting prosperity (ask the Japanese, masters of applied science, about this point). Support for basic scientific research is essential to long term prosperity. If there's one item in the federal budget that should be boosted, this is it.

Monday, August 13, 2012

How the Federal Reserve Discourages Consumer Demand

The Fed has, for the past four years, waged a relentless war on interest rates, suppressing them to zero at the short end of the yield curve and to record lows at the long end. This was all done in the hope of encouraging lending and fostering consumer demand. With about 70% of the U.S. economy coming from consumption, there is good reason to try to encourage consumers. But the Fed's basic approach has been to tilt the playing field sharply toward borrowers and punish savers for having the temerity to be frugal, all with questionable impact on consumer demand.

The boost given to borrowers appears to be limited. Interest rates on credit cards have, if anything, been rising. This is in part due to changes in the law that have limited some of the fees with which banks previously whacked their customers. But the sharp drop in short term rates since 2008 has not been mirrored in the credit card market. With recent credit card rate increases, borrowers have the incentive to reduce balances, not boost spending.

In the mortgage markets, rates are reaching all time lows. But only a limited segment of mortgage borrowers are able to qualify for refinancing (and a lot that can refi have already done so). The people who need help the most (i.e., those underwater on their mortgages) find refinancing a tough slog, if possible at all.

In the business world, rates may or may not be dropping, depending on the creditworthiness of the borrower. Business people tend to be cautious right now, with all the headwinds from slowing economies in America and Asia, recession in Europe, the unsolvable Euro crisis, and near complete political dysfunction in Washington. Drops in interest rates aren't likely to greatly affect their view toward business borrowing, investment or hiring. That's evident from the fact that businesses are choosing to hold billions of dollars in cash for essentially no return rather than invest or hire. If you're not deploying your own cash to invest or hire, why would you borrow even at a low interest rate to invest or hire?

But the impact of low interest rates on savers is significant. Let's hypothetically take a relatively frugal American who is approaching or in retirement, and in 2006 had $750,000 in a diversified portfolio. During the financial crisis of 2007-08, this portfolio, we'll assume, was pummeled down to $500,000. Many investors victimized in this fashion have fled equities and put their reduced savings into fixed income investments. For the sake of simplicity, let's assume the Fed's war on interest rates kept the yield curve 1% below where it might have been with a somewhat more balanced approach by the Fed. (Thus, at the low end, the Fed would today be targeting a fed funds rate of 1 to 1.25% instead of today's 0 to 0.25%.) The interest lost by our hypothetical saver would be $5,000 a year. Compounded over 4 years, the saver would have lost about $20,302 before taxes. While this amount after taxes wouldn't buy a yacht, and only a modest car, consumption would probably be noticeably boosted if millions of Americans had enough additional money to buy a modest car.

Given that the Fed has promised to keep interest rates ultra low until late 2014, the lost income will reach approximately $30,760 per hypothetical saver in a couple of years. And this amount could increase if the Fed extends that promise into 2015 (a serious possibility).

It's important to keep in mind that these income losses are permanent. There is no way savers can recoup these losses. The Fed won't boost interest rates extra high later on in order to bail out the frugal. So savers' consumption will be permanently reduced.

The Fed claims to be greatly concerned with consumer expectations and their general state of mind, believing that public confidence is crucial to restoring demand and prosperity. The message sent by the Fed's long and continuing war on interest rates is that things are bad and will be bad for a long time. Any rational consumer, particularly those that are frugal to begin with, will hunker down, dig the fox hole even deeper, cover it with a sturdy layer of thick logs, camouflage it with an abundance of branches and brush, and never even dare to peek out.

The situation in Japan is illuminating. The Japanese central bank has, since its own financial crisis in 1989-90, banished positive interest rates from the land (encouraging the so-called carry trade, where Japanese citizens deploy their savings or borrowed yen into investments in foreign currencies that offer positive returns; thus Japan's capital is productively used in other nations). Japanese consumers have gone from being luxury hounds to penny pinchers and bargain hunters. Japan has been stagnant for more than two decades, and its most recent economic statistics show that the stagnation has become a seemingly permanent and undesired house guest. America appears to be headed down the same path. Although the headlines generated by politicians and candidates for political office promise solutions, hard evidence to be optimistic remains scarce. Even the tech sector, America's economic sweetheart, has offered a lot of disappointment lately, with Facebook's stock losing almost half its IPO valuation and other familiar tech companies serving up results akin to the financial equivalent of Spam quiche. Will America become Japan? This is no longer the question. The question now is how will America stop being like Japan.

Thursday, August 2, 2012

Knightmare in the Financial Markets

Knight Capital's announcement today that it lost $440 million yesterday (Wednesday, Aug. 1, 2012) when its trading system went haywire illustrates the potentially dramatic consequences of computerized trading. Details on exactly what happened remain scarce. But it appears that trading volume at Knight spiked for some 30 to 45 minutes at many strange prices. A large number of trades were cancelled. Broker-dealers that normally route orders to Knight have temporarily ceased to send it business until the air is cleared.

Knight opened for trading this morning, saying that it still complied with regulatory capital requirements. Nevertheless, its capital position is reportedly not pretty, and news stories indicate that it's seeking a capital infusion, plus an emergency loan from a major bank. Knight may not survive if it doesn't establish confidence among the broker-dealer community within a day or two.

And that's the really scary thing about the Knight debacle. It's conceivable that Knight could have been rendered immediately insolvent if its big trading glitch had lasted a bit longer, or had involved a somewhat larger number of transactions. Such an insolvency would have impacted Knight's counterparties, possibly imperiling them if their exposures to Knight were large enough. If these counterparties had become insolvent, the financial miasma could have spread and other firms knocked down like falling dominoes. All this, potentially, because of less than an hour's computerized trading gone haywire.

The risk of insolvency in such a situation could be heightened by the fact that other market participants might observe such a debacle in real time and pull their accounts before the trading day ended. This, were it to occur, would amount to a run on Knight. Now that the financial community knows that Knight (and perhaps its competitors) can become imperiled within an hour's time, they might be all the quicker to grab for their money first, and ask questions later. The quaint display of depositor anxiety so sentimentally portrayed in It's A Wonderful Life would be a mere box car compared to the Maserati of broker-dealer flight in our world of computerized trading.

Sadly, regulators would probably have little or no idea of what would be going on. The SEC recently adopted rules for a consolidated audit trail with a requirement to report trades to the agency. But the new rules call for next day reporting to the SEC. The agency wouldn't be able to track in real time what the cannoli was going on, and hence would be behind the curve as market participants cut and ran.

Of course, the Federal Reserve would jump in with bailout checks for one and all of the imperiled firms if a meltdown of the financial system loomed. But the availability of desperation-driven, last ditch bailouts offers little comfort. More than ever, market participants and regulators need to get a handle on computerized trading. The ability of computers to execute vast numbers of ridiculous trades without any constraint is really, truly, seriously dangerous. By all indications, the financial markets are now operating on a sudden death basis. That cannot end well.

Sunday, July 29, 2012

How the Financial Markets Enable the EU Sovereign Debt Crisis

Imagine Barack Obama or Mitt Romney saying, "If re-elected/elected President, I'm going to do everything I can to restore prosperity and full employment, and, believe me, it will be enough." The stock market's reaction would be neutral to negative, and a lot of people, perhaps most, would laugh and suggest the candidate try out as a joke writer for the Tonight Show.

Last week, the head of the European Central Bank, Mario Draghi, vowed to do everything he could to prevent the collapse of the Euro zone and added that "it will be enough." He offered no details on what he had in mind. The stock market rallied and Euro zone interest rates dipped. The next day, the leaders of Germany and France, Angela Merkel and Francois Hollande, rose from the chorus and shouted "Amen" (while also skimping on details). The stock market rose again, with the Dow Jones Industrial Average closing over 13,000, a threshold it hadn't crossed since May. In the last two trading days of the past week, the Dow rose almost 400 points (or 3.15%)--all because a few EU leaders swore on a stack of sovereign bonds that, by golly, they were going to something or other really good.

This follows a pattern that has persisted throughout the EU sovereign debt crisis. Storm clouds gather, interest rates rise, and stocks fall. European leaders, alarmed by the market action, issue rosy press releases, promising rose gardens while avoiding any detailed explanation of how salvation will be attained. Stocks rise while interest rates fall. Everyone is happy.

But, then, reality inserts itself. The baseline problem with the EU debt crisis is that the sovereign liabilities in questions are simply too great for the debtor nations to repay. The question is where the losses will fall--on creditors, citizens of debtor nations, taxpayers of wealthy EU nations, issuers of credit default swaps or other interested parties? The intractable tussling over this essential and, for some, existential, question forces examination of ugly details revealing that there are no easy answers. Bottom line: someone needs to give up a shipload of real wealth to pay off the debts. There are no volunteers. Stocks again fall and interest rates again rise.

But the EU's leadership has learned that the financial markets respond to talk therapy, and talk is cheap. If they talk interest rates down, even if only temporarily, they can stall on making the hard choices needed for true resolution. Politicians have never met a hard choice they wanted to make. So they yak their way to a brief respite, and fiddle until the markets waver again. Meanwhile, overall debt levels among EU nations keep rising while Europe slides into recession. There's something wrong with this picture. But, as long as the financial markets display an appetite for b.s., the EU's leaders will keep serving it up.

Saturday, July 21, 2012

Hedge Fund Money Managers

In Hedge Fund Market Wizards, author Jack D. Schwager explores the trading styles and techniques of 15 current or former hedge fund money managers. The book, provided without charge to this writer by publisher John Wiley & Sons, Inc., presents interviews with each trader featured, along with commentary by the author. The traders, whom the author believes to be highly successful compared to their peers, include some who are well-known in the financial community and others who are not. The interviewees are variously active in one or more of the major financial markets, including stocks, bonds, commodities, and derivatives. Some trade hundreds of times a day, holding positions for as a little as a few moments, while others are value investors, seeking in some cases to outsmart their peers by outlasting them.

The featured traders were asked to explain the keys to their success. Each has a different story. Some got their start as elementary school age kids. Others drifted into trading. Some manage billions of dollars of investor funds. Others deliberately limit themselves to tens of millions. Their ranks include academics, attorneys, accountants and college dropouts. While their paths to success varied greatly, all were persistent, patient, open-minded and willing to learn from mistakes, and loss averse. The last trait may be the one that the ordinary investors have the hardest time emulating. Each trader featured in the book has stringent ways of limiting losses, and learned to pull the plug on losers quickly, even if doing so meant admitting error and taking a few hits to one's ego. Most, perhaps counterintuitively, weren't terribly greedy. They would start taking profits without trying to score the maximum gain possible. Making some gains, and then looking for another good opportunity, is generally preferred over squeezing the last penny of profit from any given position (with its concomitant risk of overplaying one's hand).

Some of the traders employ rigorously defined parameters. Others apparently rely mostly on their intuition. But they weren't all numbers crunchers and screen watchers. One, perhaps not illegally, got some nonpublic information about a public company from a U.S. government agency. Another (mentioned but not interviewed), hoping to profit from the impending collapse of the real estate market in 2007-08, may have convinced an investment bank to create a derivatives based investment relating to real estate assets the trader suggested, believing those assets to be weak and to provide a good shorting opportunity.

Who would benefit from reading this book? Other traders, for one, just to get an idea of what their peers are thinking. Much of the material in the interviews is already well-known to money management professionals, but the ways that successful traders mix and match the kaleidoscopic inflow of information and ideas into the financial markets can be insightful. Of course, one cannot expect that the interviewees revealed everything they know and do. No good trader would do that. Not if he wanted to keep making money in the markets.

Potential hedge fund investors--in other words, accredited investors--would find the book helpful in revealing the enormous variety of money management styles and techniques. As author Jack Schwager emphasizes, you can't rely on past performance as a certain indicator of future performance. You have to look at investment approaches and risk management, and find a manager with whom you are comfortable.

Ordinary investors might find the book insightful, not because they could use most of the trading techniques discussed. Hedge fund managers do a lot of stuff that you shouldn't try at home. But reading the book can help crystallize an individual's thinking about his or her personal investment approach. As Mr. Schwager highlights, it's important to invest in ways that you find comfortable, to learn from your mistakes, to adjust to changes in the markets, to limit losses, and to find out how you personally can be successful.

The book presumes a considerable degree of financial literacy on the part of the readers. The author is an experienced money manager and tosses around many terms and concepts familiar to the cognoscenti that aren't defined in the book. Have a good Web browser handy if you don't know the lingo of the financial markets. In addition, very little math is presented in the book. But mathematical concepts underlie the financial markets. If you don't have a facility for arithmetic and a basic understanding of statistical analysis, you won't follow the discussion much of the time. Beginning investors should start their reading elsewhere.

One limitation of the book is that it casts little light on high speed computerized trading, which comprises the majority of today's stock trading volume. The impact of algorithmic trading by the millisecond, particularly on the perhaps decreasing number of live humans active in the markets, is a crucial question and problem as we look toward the future. Answers are difficult to discern, but badly needed. Humans can't possibly keep up with machines that trade faster than the blink of an eye, especially when the algorithms deployed are dynamic (i.e., they can change on the run). If Mr. Schwager can coax some high speed traders into talking for his next book, he might well do investors and the financial markets a considerable service.

Sunday, July 15, 2012

LIBOR: Good Enough For Government

The Libor price fixing scandal keeps growing. Following Barclay's payment of $450 million in a settlement with regulators, word now comes of a U.S. Department of Justice criminal investigation into the morass. Indictments may come soon. Private civil lawsuits galore have been filed. The potential liabilities of the banks caught up in the scandal could run tens of billions, and maybe hundreds of billions if the price fixing is shown to have taken place over a sufficiently long period of time. If the latter were proven to be the case, many of the world's major banks would possibly be insolvent. Which would mean that the world's financial system could be at risk of collapse. Taxpayers on both sides of the Atlantic should brace themselves for yet another bailout of the major banks.

A crucial reason for the enormous potential liabilities is derivatives. (Yes, derivatives have done us in again.) The big banks that participated in setting Libor were often major dealers in the derivatives markets, and many of their products were based on Libor. That meant that they were exposed whether Libor was rising or falling. If they manipulated Libor up, one set of customers and/or counterparties would be injured (and therefore have a right to sue). If they manipulated Libor down, another set of customers and/or counterparties would be injured (and therefore have a right to sue). Since the price fixing could violate U.S. antitrust laws, the defendant banks may face liabilities for the treble damages permitted under the antitrust laws. Trebling the effect of the bad behavior could mean big, big money.

Vast legions of lawyers are now licking their chops at the prospect of suing or defending big banks with respect to the Libor mess. Their retirement accounts will reap rich harvests. Many will finance their childrens' higher educations with the fruits of their Libor engagements. And the modestly paid attorneys working on the government side of the cases can burnish their resumes with high profile cases.

If we want to reduce the likelihood of such windfalls for the legal profession--and, incidentally, enhance the integrity of the financial markets--we must find a better way to determine Libor. The British Bankers Association, a private organization that doesn't appear to be subject to direct government oversight, currently presides over the process of determining Libor. It's done a lousy job. Time to do a Trump and relieve BBA of this responsibility.

What's the best candidate for the job? The U.S. government. Not exactly the most obvious choice, but better than the alternatives. The private sector methodology for determining Libor was too easily infected with agendas and ulterior motives driven by the profit imperative. Government statisticians don't face such pressures. Admittedly, government statistics aren't perfect. But their methodologies are publicly known. We can praise or criticize those methodologies, and work to improve them. But we don't have to worry about price fixing.

One U.S. government statistic, the Consumer Price Index, plays a role in the economy comparable to Libor. Social Security benefits are adjusted when the CPI increases. Many public compensation schemes and private contracts adjust pay and/or benefits when the CPI increases. While numerous economists, statisticians, pundits, bloggers and other riff raff decry this or that about the CPI, no one has said it's secretly rigged. The Bureau of Labor Statistics is trusted to calculate and announce CPI figures.

Perhaps a group in the U.S. Commerce Department could be given the responsibility for determining Libor. (We should disregard America's special relationship with Britain and exclude the Brits from Libor calculations; they had their chance and blew it, big time.) The Commerce Department does not regulate any banks, nor does it have responsibility for monetary policy, nor does it finance the operations of the U.S. government. It has no vested interests, and could credibly determine Libor (preferably using actual market transactions, rather than the opinions of banks of the interest rate at which they could fund themselves, which is the formulation of Libor that has proven to be so problematic).

Having the U.S. government determine Libor would accomplish two important things. First, it would enhance the integrity and credibility of the announced rate. Since public confidence is, ultimately, the only thing that really matters in the financial markets, integrity and credibility are worthwhile. Second, a government determined rate wouldn't give rise to private liabilities the way that Libor has with each manipulated tick up and each manipulated tick down. The massive potential liabilities that major banks face, and the possible collapse of the financial system they could produce, would simply not arise. The cost of a handful of government statisticians putting out Libor might run a few million a year. The cost to taxpayers of bailing out the dodos at the big banks who have screwed up yet again could run billions and billions more and then billions more. At the risk of voicing a political heresy, there are some jobs government does better than the alternatives, and calculating Libor is one of them.

Thursday, July 12, 2012

Stocks Are Not Cheap

Forget what the bulls have to say. The Federal Reserve Bank of New York just released a study showing that over 50% of the increase in the S&P 500 since 1994 is due to Federal Reserve actions. Without central bank intervention, the market as measured by the S&P 500 would be around 600 instead of today's close at 1334.76. In other words, based on economic fundamentals, stocks are overpriced by more than 100%. That's a sell if there ever was one. It looks like all the retail investors who are abandoning the market aren't so dumb after all.

One may quibble with the Fed's methodology. Its staff looked at market activity in the 24 hours before the Fed announced Open Market Committee decisions, totaled and netted the market movements, and came up with the more than 50% figure. It's certainly possible that some portion of the market movements in the 24 hours before announcements of Open Market Committee decisions could be attributed to other causes. In fact, it would be surprising if the only discernible reason for these movements over an 18-year time span was anticipation of the Fed. But even if only 25% of the S&P's rise since 1994 is due to the Fed, stocks still remain seriously overpriced. They're a buy only if you have faith in the efficacy of central banks. And history does not vindicate such confidence.

Of course, the Fed isn't recommending that investors sell. It's certainly not about to undo all the accommodation and easing it's instituted over the past 18 years, not for quite a while. So the central bank put for stocks will remain in place for now. But ultimately, the government, including the almighty Fed, cannot prescribe stock prices (even though it's acting like it desperately wants to). If you choose to invest in stocks, expect volatility (especially if things in Europe continue their slide into the septic system) and a long wait before any big payoff arrives.

Friday, July 6, 2012

Target2: The EU's Little Surprise

Well, it seems that if the financially weaker members of the Euro zone were to go belly up, their Target2 liabilities alone might be enough to soak up the entire EU bailout bazooka. Isn't that something?

What are Target2 liabilities, you ask? The Euro zone operates a settlement and clearance system called Target2. Settlement and clearance systems have existed for centuries, serving to provide centralized places where checks and other funds transfers between banks can be netted out and paid. For example, most major European banks have claims on each other for payment of checks, wire transfers and numerous other types of funds transfers. These transactions can be done directly with each bank (highly inefficient), or presented to a centralized clearinghouse, which adds up all claims of and on each bank, nets them, and asks the bank at the end of each business day to make a single payment to (or receive a single payment from) the clearinghouse. The Federal Reserve System operates a humungous settlement and clearance system for American and foreign banks dealing in dollar denominated transactions. Without settlement and clearance systems, modern finance couldn't exist.

The prototypical settlement and clearance system doesn't extend overnight credit. Its job is to make sure there are no unpaid liabilities on the part of member banks and expects each member to completely pay all its obligations at the end of the business day.

But the EU's Target2 system evidently is different. It seems to have a little spigot for overnight credit. And, indeed a fount for some EU member nations. Greece reportedly has a 100 billion EU indebtedness at Target2 (see The total unpaid Target2 liabilities of Greece, Spain, Italy and other troubled Euro zone member nations could be in the range of 700 billion plus Euros, equal to or greater than the 700 billion Euro bailout bazooka. And we haven't counted the formal sovereign debt of these nations, which totals in the trillions of Euros. Target2 requires collateral for intraday credit. But its collateral requirements, if any, for overnight credit are unclear. There may be none.

This is a funny way to run a settlement and clearance operation, with credit available on a continuing, overnight basis. It contravenes the basic purpose of settlement and clearance, which is to balance the books. By allowing member nations to participate on an unbalanced basis, Target2 seems to have bought itself a mission creep problem that it can't solve without blowing up the European Monetary Union. After all, how does Target2 collect from Greece or another nation with an unpaid overnight balance? If it boots that nation out of Target2, it effectively boots that nation out of the Euro zone. That, in turn, precipitates all the dire consequences that Europe's leaders profess to want to avoid.

If a Euro zone member nation--let's randomly pick Greece--is unable or refuses to pay its Target2 liabilities, the losses evidently would be allocated among the central banks in the Euro zone. Most likely, the central banks of the larger nations like Germany and France would bear more liability than, say, Finland's central bank. Hence, the incentive for the EU powerhouses to keep trying to muddle through the crisis even though Greece is trying mightily not to repay its debts and Germany is striving mightily not to pay Greece's debts, either.

How Target2 became a secret sugar daddy for the spendthrift Euro zone members remains unclear. Whatever the explanation, the sudden surfacing of these liabilities only darkens the clouds gathering over the European financial world. Target2 evidently has been quietly carrying these liabilities without forcing repayment. That doesn't promote confidence in its financial solidity. Wary member banks might be inclined to take defensive measures, and those, if extreme enough, could resemble a credit crunch. We just had a credit crunch in 2008 and it made for a lousy party. There's no easy way to reduce these Target2 liabilities since the debtor nations ain't got the moola to pay down the outstanding overnight balances. Which means they'll be barking up any nearby tree for yet another bailout.

But the EU's bailout bazooka appears overwhelmed once Target2 is added into the mix of indebtedness it's supposed to cover. High ranking EU officials will surely issue a comforting sounding press release or two to paper over the Target2 problem. But talk therapy, a favorite EU maneuver, hasn't done squat to resolve the crisis and it won't help much here, either.

Thursday, June 28, 2012

The Supreme Court's Big Surprise

The Supreme Court held a surprise affirmation party for Obamacare today. Most pundits and experts had predicted the health insurance law would be overturned, and aren't enjoying the party very much. But the biggest surprise was the key vote in upholding the law, which came from Chief Justice John Roberts. Most observers of the court had perceived Roberts to be reliably conservative in the political sense. The Citizens United case (Citizens United v. FEC, 558 U.S. 50 (2010)) was regarded as a classic example of how Roberts and the four other conservative justices on the Supreme Court banded together to rule favorably for conservative interests, and unleash a torrent of business funding into the campaign process, most of which is going to Republican candidates.

In today's healthcare ruling, however, Roberts appeared to take a judicially conservative approach, finding a narrow ground to uphold the mandate for uninsured individuals to buy coverage and deferring to the policy judgments of the legislative branch, while explicitly avoiding any endorsement of them. Such displays of judicial restraint have seemingly fallen out of fashion at the Court. No doubt Roberts knows that public estimation of the Court has been falling as it has increasingly been seen as a political body. The perceived politicization of the Supreme Court has turned the judicial confirmation process for both Supreme Court justices and lower court judges into a hyper-paranoid brawl of an inquisition over every possible nuance of every statement, whether written or oral and without regard to remoteness in time, made by the nominee under any circumstances whatsoever. It's no wonder the judicial confirmation process is clogged, backlogged and bogged down. Nominees are no longer viewed as potential judges, but as potential tools to secure political gains.

Restoring the Supreme Court and the lower courts to their intended role as judicial forums would force politicians in Congress and the White House to take their jobs more seriously. They could no longer count on the courts to clean up messes they make. Possibly one reason why conservatives in Congress were so uncompromising about Obamacare is that they gambled the Court would smack it down if they couldn't. If they had understood the Court would show deference to the outcome of the political process, they might have engaged more seriously with the Democrats to fashion a compromise. Perhaps this is one message the Chief Justice meant to send. Certainly, if Obamacare had been struck down, some alternative more acceptable to conservatives would have been enacted to replace it, but then very possibly litigated by liberals and dumped back into the Supreme Court's lap. The Court might then have been placed in the position of fashioning America's health insurance policies. Roberts, as a judicial conservative, would surely not have wanted this.

The Supreme Court is the duck billed platypus of the democratic process, an oddly structured decisional body composed of unelected people with lifetime appointments who can make crucially important decisions based on whatever they individually believe to be right. While all of them purport to base their decisions on the Constitution, the flexibility of that document is copiously evidenced by the abundance of concurrences and dissents that blossom with each difficult decision. To maintain its legitimacy and effectiveness, the Court has to find and fulfill what each generation of citizens perceives as its proper judicial role. It must treat the Constitution as an organic organic (not a typo) document, with its meaning capable of changing and evolving as the needs and welfare of the nation require. For example, the meaning of the Commerce Clause, as interpreted in early New Deal cases, would not be conducive to today's federal economic regulatory structure, designed as it is to foster nationwide confidence in the regulated matters. Had that interpretation not changed with the times, we would probably be a poorer nation today.

Yet, the Court cannot reach so far that it appears to be stretching beyond the meaning of the words of the Constitution. Americans have a very high regard for the rule of law. This is not surprising, considering that the United States was not founded based on tribal or ethnic loyalties, or religious beliefs, or the imposition of sheer military power. It was founded by the voluntary congregation of former British colonies that depended greatly on the effective functioning of the Constitution to maintain their union and thus ensure their survival. Without the rule of law, the nation could fail (and almost did fail, twice). The Supreme Court has the task of constraining the other branches of the government, the states, and, indeed, itself to stay within their respective constitutional roles. Just as the Court has to stop Congress, the Executive Branch and the states from overreaching, it has to stop itself from overreaching.

Finding the right balance between judicial activism and judicial restraint is one of the most crucial challenges for every generation of justices, and especially every chief justice. The loudest sound you hear in the political blogosphere tonight is conservative teeth gnashing. But behind that, there is a faint of hum of legal scholars saying "hmmmmmmmmmm, maybe John Roberts will attain stature among the chief justices."

Wednesday, June 20, 2012

The Fed: Let's Twist Again

The Federal Reserve's message today was: Let's Twist Again, Like We Did Last Summer.

The market wanted more of a QE3 Shotgun approach. When the Fed announced its modest extension of the Twist, the market gyrated, doing the Locomotion, and ending slightly down. Perhaps the Fed thought the market would say I Thank You. But no such luck, not from Wall Street. If you took losses today, you can Cry If You Want To. You might feel better if you go Downtown.

But don't worry. The Fed said that it Heard Through the Grapevine that the economy might be slowing, and that the market should Hold On, I'm Coming, because it's prepared to launch QE3 if necessary.

The market has blithely ignored negative economic data over the past week and has rallied in the hope of Fed accommodation. Just as When A Man Loves A Woman, the market can't keep its mind on nothing else. Market players hung on every word of current and former members of the Fed Open Market Committee, even asking Please, Mr. Postman for news of impending government intervention. The market Ain't Too Proud To Beg for more money printing. The Fed knows this, and if the economic clouds darken, it will roll out QE3, hoping to spur Dancing in the Street and push market averages Higher and Higher.

But QE3, compared to earlier QE's, has less potential for effectiveness and greater possibility of negative side effects like inflation. If the Fed's accommodation goes haywire, we could have a Heat Wave and meltdown in the financial markets. Of course, with the EU crisis far from over (and perhaps getting worse), and the U.S. economy slowing, the Fed may have little choice but to take that risk. Today's financial markets have no tolerance for any downturns exceeding 2%, expecting instead to Rock Around the Clock. The markets are all government, all the time. So, it might not be a bad idea to Say A Little Prayer.

Tuesday, June 19, 2012

A Social Security Hint For Stay At Home Parents and Other Part-timers

If you're a stay at home parent, or have been laid off, or are otherwise not working full time, you can still do something to prepare for retirement. That would be to work part-time, because even a small amount of earnings from part-time work builds your Social Security record.

To be eligible for Social Security retirement benefits, you first need to accumulate 40 credits. You get a credit by earning a minimum amount ($1130 in 2012 for each credit, with this amount to be adjusted over time as wages increase). You can earn up to 4 credits per year. Thus, it takes at least ten working years to earn 40 credits. If you don't have 40 credits, even a small amount of earned income from part-time work can help you earn more credits.

Once you have 40 credits, your Social Security benefits will be calculated based on your highest 35 years of earnings. People who work a full career until their 60s will have 35 or more years with earnings. But stay at home parents and many other people who, for whatever reasons, don't work a full career, may have many years with zero earnings. Those zero years bring down the level of benefits to which you would be entitled. By working even a little during some of those years, you'd reduce the number of zero years, thereby boosting your benefits.

If you're not allergic to math, here's a more detailed explanation of what happens (in 2012 dollars; the amounts discussed below will increase over time as wages increase). Social Security calculates your total earnings for your top 35 years (with the earnings from earlier years adjusted to their equivalents in today's dollars). Then it divides the total by 35 and divides the result by 12, to get an average monthly earnings for your top 35 years. It then takes the first $767 of that average monthly figure and multiplies by 90%. You'll get that 90% in your benefits. Then Social Security takes the next $3857 in your average monthly earnings and multiplies by 32%. You'll get the 32% in your benefits. Any amount in your average monthly above the $3857 tier is multiplied by 15%. That 15% is added to your monthly benefit.

In brief, Social Security replaces 90% of the first $767 of your average monthly earnings, 32% of the next $3857 of your average monthly earnings, and 15% of anything above that. When you have a lot of zero years in your Social Security record, your average monthly earnings may fall below the $767 level, and any increase in that average will improve your Social Security benefits by 90% of the increase (until you surpass the $767 level). This is worth working for.

Maybe you plan to collect under your spouse's Social Security record. That can often be advantageous, assuming your spouse has a substantial record and you remain married to that spouse long enough. But life is unpredictable, and your own Social Security record can't be taken away from you. Building it up makes sense.

These days, incomes are stagnant, investment returns are volatile and often lousy, and homes are still dropping in value (on a national basis). Upticking your Social Security benefits by working part-time, even if just a little, is a way to improve your retirement. Ignore the cocktail party wisdom that Social Security won't be around for you. It will. Maybe not in its current form. But some kind of national retirement benefits program will be in place. With half of all Americans not saving at all for retirement, and many others not saving enough, we can't afford not to have a Social Security program. Make the most of it.

For more on Social Security, see (how Social Security benefits are calculated), (when to start collecting), and (who is eligible to collect).