Thursday, January 28, 2010

Obama and Leadership

Where do I stand on the Obama Presidency?

I stand at about the same place I did last year at this time.

President Obama has put too many projects into his “top priority” list. After a year in office with not a whole lot to point to, he still insists that he will stay the course and continue to pursue the things he has been pursuing.

My experience in leadership cautions me that a leader cannot have too many top priorities. This is true if things are running pretty smoothly and it is especially true if one is in a turnaround situation.

To me, Obama’s job was to execute the turnaround of a pretty sick patient!

Leadership is to bring focus to a situation, identifying what is immediately important and what can be put off for awhile. Leadership is about communicating this focus to others so that they know what they are to concentrate on and they can get on board with the leader. Then the leader needs to bring sufficient resources to bear on the problem so that the goals and objectives of the organization can be met.

There will be diversions along the way. That is just the way the world is. Because the leader knows that she or he will face these other, unknown bumps along the road, having a disciplined agenda will allow the leader to take care of these “diversions” while still pursuing the major goals and objectives.

President Obama put too many projects on his “top priority” list. He did not focus. He had the “Audacity of Hope” driving him on. And, while that may be very appealing and good speech material, everything would have had to go “just right” for the president to achieve all the goals he set for himself.

Someone once was elected to office by focusing on the claim, “It’s the economy, stupid!”

But, this tunnel vision never seemed to be a part of the Obama persona.

Looking back one year, however, it is easy for us to now say, “It was the economy, stupid!”

Last year at this time we were tottering on the brink of another “Great Depression.” There was a lot of fear in the country. America’s biggest banks were on the edge, the economy was in the tank, and unemployment was growing. Foreclosures were rising as were bankruptcies. And, most of the rest of the world was in at least as bad shape as was the United States.

The Obama administration, along with Congress, produced a stimulus plan. There was the interjection of the government into the auto industry and one or two other efforts to head off problems. The Federal Reserve pursued “quantitative easing” keeping its target interest rate around zero.

Things did get better. Analysts are claiming that the “Great Recession” ended somewhere in the second half of 2009. But, unemployment still remains high. Foreclosures and bankruptcies are still taking place at near record rates. There remain over 550 banks on the problem bank list of the FDIC. And, the economy seems lethargic. Our consumer advocate, Elizabeth Warren, is raising concerns over the demise of the middle class. There is the criticism that the focus of the recovery was on Wall Street and not Main Street. Some prominent economists, Stiglitz, Krugman, and Roubini, are worried about a double-dip in the economy.

News about the President’s efforts on the economy were quickly displaced by trips around the world, about health care reform, about global warming, about energy policy and a myriad of other initiatives.

Of particular concern here was the Obama health care effort. I will just make three points here. First, President Obama turned the development of the legislation over to the Reid/Pelosi leadership in the Congress to craft the bill. Obama disappeared. Questions about where the president stood or what he was for received vague, disconnected answers because he was not leading the charge.

The story I heard for this tactic was that the health care bill presented by President Clinton failed because it was crafted in the White House and did not include sufficient Congressional participation in the process. Obama was not going to make this mistake. President Clinton, of course, denies this reason for the failure of the 1993 effort at health care reform.

Second, the emphasis that was placed on obtaining 60 votes in the Senate to pass the legislation put several self-seeking Senators in the driver’s seat. (Who says ‘moral bankruptcy’ is just centered in the Wall Street banks?) Rather than focusing on the health care bill itself, the nation was appalled by the behavior of a few of America’s elite holding everyone else hostage in order to get their special interests taken care of.

Third, the size of the effort was overwhelming. All people heard was universal coverage, coverage of pre-existing conditions, public option, and so forth and so on. The picture that came through to ordinary people was “huge plan” must be connected with “huge cost.” This was the way the government worked. All the efforts and machinations of the politicians to build a plan that would not cost the American people “one dime” just did not resonate with the public. Universal efforts were expensive and always cost more than expected. And, this would just add to the huge deficits predicted for the next ten years or so.

And, this was going on while the president spoke, always eloquently, about his other concerns.

Then, there was Iran, and Iraq, and Afghanistan, and the Christmas terrorist bomber, and Massachusetts (and Virginia and New Jersey) and other detours.

The consequence? Confusion, uncertainty, frustration, anger, you name it, on the part of the people. What are the priorities? Where does the president stand? What does the president want us to do? What are the rules? Who is in charge, Congress or the President? What is important?

And, the economy? I don’t know when I have seen a situation in which such uncertainty exists. First, the big banks are helped. (Yesterday we heard that the crucial thing was that the economy did not collapse, not how much money Goldman or the French or whoever got.) Then the big banks became the big bad guys. Now we need to re-regulate them. But, how are they going to be regulated? What about foreclosures? Can anything be done about them? And, then the small- and medium-sized banks aren’t lending. How can we get credit flowing again? And, so on and so on.

People and businesses can’t follow if they don’t know where their leaders are heading, what their main priorities are. People and businesses can’t plan if they don’t know what the rules and regulations are going to be. People and businesses can’t commit if they are plagued with uncertainty.

The State of the Union address last evening did not resolve any of these issues for me or lessen my concerns. To me the issue is leadership and the respect for a leader is earned. This is a question of the rubber hitting the road and no speech, no matter how eloquent it might be is going to change this fact. I am still waiting for the focus of intention and the focus of effort.

Tuesday, January 26, 2010

Regulation and Information--Part C

The final point I would like to make in this series is that you cannot build and maintain a rigid financial regulatory system based on the achievement of specific outcomes if you insist on inflating the economy that includes this regulatory system and expect the regulated institutions to remain idle. This is the story of the last 50 years when the dollar lost 85% of its purchasing power. If the government creates an inflationary environment, financial institutions will not stand still, especially in this Age of Information.

Also, in my view, the United States government has injected large amounts of moral hazard into the economy and the financial markets over the past fifty years or so. And, the presence of this moral hazard has had a lot to do with the recent collapse of the financial markets and the economy.

Before going into this let me just say that I believe that almost everyone is greedy. I use the word greedy with all the bad things it conveys, because that is the word being tossed around so loosely these days. I do not believe, as the economist Joseph Stiglitz seems to, that the bankers of Wall Street are any more “morally bankrupt” than he is or any of the rest of us. We all are greedy and respond to the incentives that are placed before us. With that said, let’s now move on.

I want to concentrate on two specific areas in which the government has created moral hazard and helped to form the incentives that led to the bust of 2008. The first has to do with monetary policy and the second has to do with housing finance. Both have contributed to what I have called the credit inflation of the last 50 years.

A credit inflation occurs when the credit in an economy grows more rapidly than the economy itself or more rapidly than specific sectors in the economy. In the early part of the period under review, focus was primarily on consumer and wholesale price inflation. At this time, analysts were mainly concerned with money stock growth and the consumer price index or the GDP Deflator. Asset bubbles were not on the radar yet.

However, inflation creates the incentive to increase debt and as the amount of debt in the economy increases there is pressure on both financial and non-financial institutions to increase their financial leverage, to create a greater mismatch between the maturities of their assets and liabilities, and to take on riskier assets, to goose up returns. Credit creation thrives in an inflationary environment!

Inflation is good for credit and so the cumulative effect of a period of inflation is the creation of more debt! In the Age of Information, the incentive to create more debt is a license for financial innovation.

The dance began in the 1960s and, as former Citigroup CEO “Chuck” Prince so eloquently expressed it in the 2000s, if the music continues to play, you must continue to dance!

And, the enormous creation of credit spilled over into sectors other than consumer purchases creating a bubble here and a bubble there. The beauty about financial innovation in the Age of Information is that specific assets and specific asset markets don’t really matter because all that is being traded is information. The result: as “Chuck” Prince implied, the dance continued in the areas where the music was still playing. Credit flowed into the markets that had the most action so that you got one market “popping” at this time and another market “popping” at another time. And, innovations in new financial instruments and markets were created to help the music flow to all markets.

How does this scenario relate to monetary policy? Well, the monetary authorities acted in a very asymmetrical way. If markets seemed to be dropping, the Federal Reserve would come in and stop the fall. This was especially important if unemployment seemed to be impacted by the drop. The behavior became so predictable that it was given a name: the “Greenspan put.”

On the upside, the central bank attempted to maintain control of consumer price inflation, especially after the pain of the late 1970s and early 1980s, but believed that it could do nothing with respect to asset bubbles that inflated prices in various sub-markets, like housing.

The moral hazard that was created allowed prices to constantly rise for the Fed would always reflate the economy before there was any chance for prices to fall. And, consumers could only buy about 15 cents worth of goods and services in 2010 with what $1.00 could buy in January 1961. Also in asset markets like housing, prices rose and rose and rose during this period to the point where people were absolutely confident that housing prices could never fall. So, where are you going to place your bets after all this time which created the fundamental assumption that policymakers would continue the credit inflation indefinitely.

The other area where the government created moral hazard was in the housing market. To own your home is a big part of the “American Dream.” Owning your own home creates self-respect and stability. It is a great place to raise kids and it generates community. It produces good citizens.

So, anything that can be done to support home ownership in America is good!

The savings and loan industry was dedicated to financing homes. The Federal Housing Administration (FHA) was there to help people get mortgages for homes and played a huge role in home ownership for GIs returning home from World War II. But, Fannie Mae and Freddie Mac were created to help mortgage finance and to make sure money flowed into the industry. Then the Department of Housing and Urban Development was created and help flowed through a myriad of programs to assist low-income families to own their own homes. And, then the mortgage-backed security was created and so on and so forth.

Ultimately, we got a great information age idea, the sub-prime loan. This program combines the drive to get home ownership to more and more individuals and families, often without the needed financial wherewithal, and credit inflation, because if housing prices never go down they must be going up. And, this allows people who cannot afford the down-payment on a house to earn that down-payment through the inflation of the price of their home. Oh, by-the-way, you can originate the loans and then get them packaged and securitized to sell to financial institutions in China or Sweden.

Isn’t the Age of Information great! If the government has anything to say about it, “No downside risk!”

Well, Fannie Mae and Freddie Mac own most of the American mortgage market now and both are ‘bankrupt.’ The FHA is in deep, deep financial trouble. And, so are many banks and other financial institutions in the United States. And, the Treasury is going crazy trying to develop a program or programs that will help individuals and families stay out of foreclosure and lose their homes.

Bottom line: in the Age of Information, information spreads and spreads rapidly. Financial innovation will accelerate as we go forward for financial innovation will be applied to any area, regulated or not, that promises financial gain. Unfortunately, my guess is that the federal government and Congress will not have the discipline it needs to stop creating credit inflations and to keep from creating more and more moral hazard in the future. Consequently, the financial regulation that will be forthcoming will be backwards looking and, hence, will not prevent the next crisis.

Monday, January 25, 2010

Regulation and Information--Part B

In my previous post, “Regulation and Information—Part A” I argued that banking and finance has become nothing more than information, and in this Age of Information, money and finance have just become the movement of 0s and 1s. As a consequence, finance has gotten away from people and physical assets and paper money and other forms of wealth, like gold, and just become bits of information that can be “diced and sliced” every which way and that can be bought and sold worldwide.

This post, as promised, has to do with my ideas about the possibilities for the regulation of banking and financial institutions. I will post a Part C tomorrow.

First, I need to explain a little bit about where I am coming from. I call myself an “Information Libertarian”. I believe that history shows that information spreads and cannot be contained. Its spread can be slowed down for a while, by governments or religious bodies for example, but eventually the spread of information wins out. As an Information Libertarian, I believe that it is my responsibility to help speed along the spread of information and, where this spread is being contested or resisted, help to unlock the doors that is keeping information bottled up.

To me, information must see the light of day so that it can be tested, used, and lead to the discovery of more information. In this way false information, information not allowed to change, and other constraints on the problem solving and decision making capabilities of humans can be seen for what they are and transcended.

Rules and regulations in the past have tended to rely too much on what I would call “the achievement of outcomes” and not enough on the “process of how things are being done.”

Reliance on “outcomes” focuses upon the wrong things and is very expensive for those being regulated as well as for those that are doing the regulating. The reason: if there is sufficient incentive for the regulated to do the thing being regulated, it will get done in one way or another, in spite of the regulation. This was the essence of the quote by John Bogle, the founder and former chief executive officer of the Vanguard Group, in my post of January 19 (see Bogle stated that “There are few regulations that smart, motivated, targets cannot evade.” This was a part of what I was attempting to say in Part A of my discussion of regulation and information: the means of evading regulations has become sophisticated and easier in this Age of Information.

Also the cost of regulating in such an environment has increased substantially. The talent and skill required, along with the necessary patience and persistence of the regulator has gone up exponentially. In my experience, the regulator is ALWAYS behind the industry in knowing and understanding what is going on. How far behind they are varies from situation to situation and is a constant concern. But, you can rest assured that the regulators are behind the regulated.

As I have written in previous posts, the big banks have once more jumped ahead of the regulators in the past year as these banking giants have gained strength. Nothing has helped them more than the subsidy the Federal Reserve has given them by maintaining short term interest rates at such low levels: the Fed has given them “the gift that keeps on giving.” Not only have these banks regained health, they have moved way ahead of the regulators who have been dealing with all the problem small- and medium-sized banks and the squabbles takikng place in Washington, D. C. over how the banks and other financial institutions should be regulated.

This is the problem of focusing on “outcomes.”

I have argued over and over in earlier posts that banks and other financial institutions need to be subject to greater openness and transparency. This is consistent with my views on the need for information to spread and is consistent with my views on what kind of regulation can achieve some degree of success. It is also consistent with the idea that laws and regulations should focus on “process” and not “outcomes.”

Making banks and other financial institutions open up their books and causing their operations to be more transparent is the only way that I can see, in this Age of Information, to effectively have some impact on the behavior of these organizations. Having to report accurately and often to not only the regulators but also to shareholders as well as the public in general is the only way to be able to have some impact on them over time. The idea is that if they can’t hide what they are doing they will be a little more careful about what actions they take.

I cannot buy the argument that financial institutions need to keep their information on customers or what they are doing proprietary for if they don’t their spreads will go away. We saw what a disaster this was in terms of Long Term Capital Management. To me, the running of a financial institution is like coaching a football team: everyone knows the plays; the winning team is usually the one that executes the best or is the luckiest. Everyone knew what Long Term Capital Management was doing and others mimicked them. When things went the wrong way everyone tried to exit at the same time. Sounds like the subprime mortgage market doesn’t it?

I have also been a constant proponent of “mark-to-market” accounting. Let me describe to you how I see this tool. Banks, and other financial institutions, take risks. In order to achieve a few more basis points return over competitors, executives have either taken on assets that are a little riskier than they did before, or, mismatch the maturities of assets and liabilities a little more than they did. Shouldn’t we the regulators, the investors, the depositors, the analysts know this?

They, the bankers, have taken the interest rate risk and the credit risk and should be held accountable. To me it is childish for the bankers to “cry foul” when the market goes against them saying that it is unfair to force them to recognize the mismatched position they have taken. They are the ones that took the risk, they should be held accountable for doing so. They get the credit when things go well. Shouldn’t they be called on the carpet when things go the other way? If you know you might get caught, should you go ahead and do something?

In this case, maybe the bankers need to present two sets of books. One set to show what the value of the assets are if they (the assets) are held to maturity. Another set of books to reflect actual market values. The crucial thing is that the current real position of the bank needs to be “owned” by those running the bank.

The point is that if a management doesn’t want the public and the regulators to know that they have taken excessive risks, then they shouldn’t take the excessive risks.

In the Age of Information, the probability that people will find out what you are doing, particularly if you have some prominence, is higher than before and is increasing every day. We have just seen what can happen when some prominent person lives a life all out of character with who people thought he was. And, the fall has been pretty substantial.

Again, if this person didn’t want us to find out about his extra-curricular activities, he shouldn’t have pursued them. Simple as that!

The objective in requiring openness and transparency in reporting financial data is to say to people “before the fact”: if you take on too much risk or run your business in a careless manner, we will call you out on it. The “we” stands for investors, depositors, or regulators. The financial position of a bank or a financial institution should be “out-in-the-open” in great detail and the analysis of investors and regulators should be shared. If the bankers know they may be exposed then maybe the banks will attack their problems sooner rather than later.

Sunday, January 24, 2010

Regulation and Information--Part A

One of the things that bothers me about all the talk concerning the re-regulation of banks and other financial institutions is that it is “framed” within the context of the Great Depression and the Glass-Steagall Act, the Banking Act of 1933.

Get real people, times have changed!

We are not back in the age of the manufacturing, we are in the information age. We are not early in the 20th century, we are at the beginning of the 21st century. And, while no person commands my respect in the same way that Paul Volcker does, we do not need regulation that is in the mold of Glass-Steagall.

Finance is information. This dollar bill can be exchanged for that dollar bill. These dollars can be exchanged for so many Euros. Even more so, my set of 0s and 1s can be traded for your set of 0s and 1s: your checking account, my debit card, and her credit card.

Even individuals don’t trade in anything more than 0s and 1s these days. Finance, even at the most elemental level is just about information. And the more sophisticated that one gets, the more esoteric the information flow can become. And, that is the issue.

But, the post-World War II transformation in the financial industry began in earnest in the 1960s. The commercial banks were constrained by the Glass-Steagall Act and by geographic constraints. Yet, the world was growing. And, the banks, in order to be competitive in the world needed to become bigger and more geographically dispersed.

Three financial innovations were in place by the end of the 1960s that began to change of everything: the creation of the Bank Holding Company; the invention of the large denomination negotiable Certificate of Deposit; and the Eurodollar account.

The Bank Holding Company gave banks a freedom that they did not have when their charters limited their activity to just being a deposit taking bank. The large denomination negotiable Certificate of Deposit was an innovation that indicated that just about any financial instrument could become marketable. The development of the Eurodollar market showed that banks could raise funds worldwide and in different forms.

These three changes, when combined, turned large banks into liability managers and not asset managers. In essence, the invention of the large CD and the Eurodollar put an end to any constraints on the size of a financial institution. These instruments allowed banks to buy or sell all the funds they wanted at the going market interest rate. For all intents and purposes, by the start of the 1970s all interstate constraints on bank operations were history. And, except for capital requirements, all constraints on the size of financial institutions were history. The ability to manage liabilities ended these boundaries.

Other developments took place during this time. I will just discuss two of them. The first is the mortgage-backed security. In the 1960s politicians decided that if more housing got into the hands of the middle income classes that there would be a greater chance that they could get re-elected. They considered the mortgage, a long term asset. Then they looked at pension funds and insurance companies and saw that these institutions held long term assets. Mortgages were not quite what the pension funds or insurance companies wanted: mortgages came in sizes less than $100,000 in value when they wanted assets in the millions of dollars; also mortgages paid principal and interest whereas these funds and companies just wanted interest payments. So there were some hurdles to overcome.

As people worked with the idea, they saw that the mortgages generated and held by depository institutions could be bundled up into another form of security in order to get the size of asset needed. They also worked with the idea that the cash flow streams from the initial mortgages could be cut up in different ways so as to make individual streams of cash flows that were more desirable to the pension funds and insurance companies. Eventually they saw that securities could even be created that paid just interest (Interest Only securities or IOs) or that just made principal payments (Principal Only or P0s).

Bottom line, cash flows could be cut up (or in current terms ‘sliced and diced’) in any way that could sell! And, what is the abstract view of this? Cash flows are just 0s and 1s and 0s and 1s can be put in any form that anyone wants. These cash flow 0s and 1s could have assets behind them like houses, autos, or credit cards, or they could just be cash flows. What difference did it really make?

Of course, it could make a lot of difference. (I can’t be too ironic in what I write!)

If cash flows could just be created, why not asset values? Hence the idea of “notional” values.

Take an interest rate swap, for example. No money changes hands, the whole transaction is based on ‘notional’ values. Thus, a swap of a fixed interest payment arrangement for a variable interest payment arrangement could be achieved. Both parties are ‘better off’ and there is no real exchange of liabilities.

I could go on, but I don’t think I need to. By now you can see where I am going. Finance, today, is just 0s and 1s and people, individuals as well as institutions, don’t need real assets on which to base cash flows and cash flows can be ‘sliced and diced’ in any way imaginable so as to meet the needs and desires of those that want to acquire them. In essence, everything, all information, can be computerized and treated as interchangeable.

At least in the machines: at least ‘on paper’. But, this is the modern world of finance. That is why mathematicians, statisticians, physicists, and other “Quants” can play with this stuff. The modern world of finance is just information and information is just 0s and 1s. At the highest level, it is not people and assets and things. It is just 0s and 1s.

And, if you are concerned with this then you need to be aware of what is coming. This is the world of the future. There is a vibrant area of study that deals with information markets. The idea is that everything, and I mean everything, can be transformed into information and a market can be created for it. Robert Shiller, the behavioral economist of “Irrational Exuberance” is one of the leaders of this field.

Modern day finance is the model with the idea that this model can be extended to anything and everything. So get ready!

The fundamental point I want to make today is that the world of finance in the Age of Information is entirely different than the world of finance in the Age of Manufacturing. The 1930s are not directly transferrable into the 2010s! The rules and regulation of the modern world are not the same as the rules and regulations that needed to be applied to the world of the thirties. And the way to regulate the world of the 2010s is the subject of my next post.

Let me just close by saying that even Paul Volcker missed the point when he said that the only banking innovation of the last 50 years that was significant was the ATM machine, that all the other financial innovation contributed nothing to the age. The ATM is an ‘information age’ machine and is a part of the innovation that took place in the Age of Information. If one really understands this age then one cannot make the distinction between the ATM and all the other financial innovations that took place during this time period. Volcker has missed the point!

Saturday, January 23, 2010

Politics and Regulation

I would like to recommend two more articles on the growing move to greater regulation. Both appeared this Saturday morning. The first by John Authers, “Politicians look to enter another Faustian pact,” appeared in the Financial Times ( The second by Jason Zweig, “Will New Rules Tame the Wall Street Tiger?” appeared in the Wall Street Journal (
Both articles discuss the unfolding drama in Washington, D. C. concerning the direction events are taking and both authors make some suggestion as to the direction regulation should take.

The important take-away from each article, however, is that politicians often enact laws, rules, and regulations that either miss the point or provide impediments to competition that banks and other financial institutions spend millions of dollars to get around, eventually succeeding.

Zweig argues in his piece that “the bad behavior on Wall Street in the 1920s wasn’t really caused by the blurring of commercial and investment banking”. The bad behavior he lists include “collusion among firms to jack up prices, sweetheart deals for favored clients, shoddy due diligence, too little disclosure of risk, too much trading on borrowed money, betting that securities would go down while telling the public they would go up.”

However, Zweig presents the argument that “there is a strain in the American psyche that has always worried about concentration of financial power.” Drawing upon this populist concern, Senator Carter Glass and Representative Henry Steagall were able to pass legislation fondly remembered as the Banking Act of 1933.

[Disclosure: I was born in the state of Missouri, formally a Unit Banking state, and my grandfather was a Missouri banker. My hand was photographed in the check copying machine in the latter part of the 1940s. Missouri bankers were paranoid about the “concentration of financial power!"]

Zweig’s conclusion is that “the Obama proposals are politically shrewd, because they tap into the same populist anger that motivated the Glass-Steagall legislation in 1933.”

Authers also compares the present time with that of the 1930s. He prefaces his discussion of the 1930s by stating that “Tighter regulation involves a Faustian bargain, of accepting greater stability in return for limiting ‘upside’, or potential growth.” The Glass-Steagall Act, the Faustian bargain, “worked” as “Bank runs, endemic for decades before the 1930s, disappeared in the US after this package of reforms. Growth in both markets and the economy was relatively stable.”

“Over the years, financial ingenuity and regulatory changes found a way around most of the repressive 1930s rules.” By 1998, there was basically nothing left and the rules were finally buried.

“The White House’s proposal on Thursday can loosely be called an attempt to apply the spirit of Glass-Steagall for the new era.”

The end result of the process will be up to Congress.

And what hope do we have?

Authers’ conclusion: “It is not clear that as a deliberative body it (the Congress) is capable of making a coherent decision.”

“It looks as though US and European political institutions are about to go through much the same test that they failed in the autumn of 2008. It is the risk that they fail again that worries the market.”

‘Nuff said!

See my position on this point: “Bracing for the New Banking Regulations” (

Thursday, January 21, 2010

Obama's Push for Bank Reform

“President Obama on Thursday will publicly propose giving bank regulators the power to limit the size of the nation’s largest banks and the scope of their risk-taking activities.” This from the New York Times ( and from the Wall Street Journal (

After the Tuesday victory of Scott Brown in the Massachusetts Senate race, the Obama administration seems to be going “populist” and taking on Wall Street and the bankers seems to be the way to go!

Simon Johnson, a professor at MIT, published this advice on the New Republic website this morning: “Run hard now, against the big banks. If they oppose the administration, this will make their power more blatant--and just strengthen the case for breaking them up. And if the biggest banks stay quiet, so much the better--go for even more sensible reform to constrain reckless risk-taking in the financial sector.” (See

This, I believe, is the wrong direction for the Obama administration to take. First of all, I believe it is incorrect. See for example my post from yesterday, “Blame the Central Bankers” ( Also see my post from Wednesday “Bracing for New Banking Regulations” (

Secondly, there is strong evidence that you cannot win on a “populist” platform. Arguing from the “populist” approach can vote someone out of office, but it doesn’t seem to be able to elect anyone to office.

I still believe that Al Gore had the 2000 election wrapped up until he took on the “populist” mantel during the election campaign. I can still see him overlooking the Mississippi River in Mark Twain’s childhood home town of Hannibal, Missouri. Then I heard him starting to expound on the world as a “populist” politician would. My comment to others at that time: if Gore keeps heading in this direction he has lost the election!

The same advice also comes from one of the most astute political families in America: the Clinton family. In Robert Rubin’s book “In an Uncertain World: Tough Choices from Wall Street to Washington,” Rubin presents a discussion he had with Hillary Clinton. He wanted to take a public approach to an issue that was couched in “populist” language. Rubin states that Hillary responded strongly to his ideas with the comment that one could not win elections relying on a “populist” message. Rubin, consequently, backed off this approach to presenting the matter.
And, he succeeded in getting what he was after, politically.

I believe that the approach the President is taking toward banking reform should be strongly rejected. Not only do I believe that it will not help him to get re-elected, I believe that it would be a disaster for the American financial system!

Wednesday, January 20, 2010

Blame the Central Bankers more than the Private Bankers

“I cannot help thinking that the central bankers are escaping very lightly in the post-crisis dust-up. For while incentive structures in banking exacerbated the credit bubble, they were a much less potent cause of trouble than central bank behavior across the world.”

So writes John Plender in the Financial Times this morning (See “Blame the Central Bankers more than the Private Bankers”:

This article should be read!

One point that Plender makes is that maybe we need fewer academic central bankers and “more private sector bankers with a practical understanding of markets.” You mean heading up the Economics Department at Princeton is not enough to be the head of a central bank?

“The academics who dominate modern central banking were ideologically committed to the notion of efficient markets and to exclusive reliance on inflation targeting regardless of imbalances arising from easy credit and soaring asset prices.”

The consequence? An asymmetrical approach to monetary policy: “Interest rates were reduced when asset prices fell, but were not raised in response to wildly overheating markets.”

This focus gave us the ridiculously low interest rates in the United States from 2002 through to 2004 and the subsequent asset (housing) bubble which accompanied them. This conclusion comes even after and “In spite of the bizarre recent assertion by Ben Bernanke…that the Fed was largely innocent in the matter of bubble creation.”

This mindset, Plender argues, is still around and is present in some of the approaches to fight systemic risk and to provide “macro-prudential” regulation and supervision. The mix of policy that these “academic” officials are proposing “suffers from the single disadvantage that it will not work.”

What Mr. Plender really asks for is central bankers that have less experience with the academic study of banking and financial markets and that have more practical experience in these markets.

The particular approach followed by central bankers, Plender continues, led to the rise in bank leverage which was “a far more important factor” in the crisis than was financial innovation.

How could this be?

Well, the incentive structures in banking placed emphasis on current bank earnings. And, the surest way to increase performance during the 1990s and 2000s was to leverage up the portfolio so as to earn a few more basis points. This behavior had to continue because competitors kept doing it. As “Chuck” Prince, the Chairman and CEO of Citigroup, so eloquently put it, if the music is still playing you must continue to dance. Competition demanded more basis points to keep in the dance for investor’s money.

And, the continued increases in leverage were underwritten by the monetary authorities who followed the philosophy of central banking described above. When the bubble burst, the leverage, of course, worked in the opposite direction.

I would highly recommend reading Plender’s article.

Tuesday, January 19, 2010

The Move Toward More Regulation

The air is heating up when it comes to the subject of banking regulation. The only advice I can offer those considering changes in the regulatory environment is “be careful.”

The main reason for this caution?

John Bogle, the founder and former chief executive of the Vanguard Group, wrote it very succinctly in the Wall Street Journal this morning: “There are few regulations that smart, motivated, targets cannot evade.” (See “Restoring Faith in Financial Markets:
Another reason for this caution comes from Mervyn King, governor of the Bank of England: “The belief that appropriate regulation can ensure that speculative activities do not result in failures is a delusion.” Andrew Ross Sorkin provided this quote in the New York Times this morning. (See “Big, in Banks, is in the Eye of the Beholder”:

According to these two individuals, banks cannot be prevented from engaging in the types of activities that they really want to be engaged in and there is little that supervision can do to keep them from failing due to speculative activities.

In other words, bankers cannot be protected from themselves.

Why is this?

There are two very good reasons. First, in this Information Age, almost anything can be done with cash flows and risk, and regulators will always be behind the curve in trying to catch up with what is going on in the financial sector. After the financial crisis of 2008, this type of behavior has began again in the bigger banking organizations and I would argue that the regulators are already at least three- to six-months behind what these institutions are now doing.

Second, the financial community is truly global now and the flow of money (information) is very fluid. If something cannot be done somewhere it can always move elsewhere. Discussions about what the BRICs are doing (see the week long series of articles on Brazil, Russia, India, and China in the Financial Times this week) present one picture of how the world is continuing to shrink, financially. Another picture of the flow of funds throughout the world is captured in a recent research paper by MIT’s Ricardo Caballero which is quoted in the recent article in Time magazine: “Did Foreigners Cause America’s Financial Crisis?” by Stephen Gandel. (See,8599,1954240,00.html.)

I would like to make one other point: many people continue to assume that behind active governmental policy and regulation are government officials and bureaucrats that are either more perceptive and talented than their private sector counterparts, or, are less self-serving than their private sector counterparts, or, are better placed to observe how the world works than are their private sector counterparts.

In my estimation, government officials and bureaucrats are not more capable or talented than their private sector counterparts and they are certainly not less self-interested. Furthermore, in my experience in government, they are not better placed or better informed about what is going on in the world. This latter point is one that the economist Friedrich Hayek made over and over again.

There is no research that I have seen that indicates that those that work for government perform any better than those that work in the private sector. If anything, the argument goes the other way: government cannot hire or attract people of the same quality that work in the private sector. Furthermore, there is no evidence to prove, in my mind, that people that work in government service are any less greedy for advancement or personal gain than are people that work in the private sector.

Finally, in their attempt to protect the society from “bad outcomes” the government has tended to err on the side of creating an environment for greater and greater private sector risk-taking. This has come in several forms. The obvious case currently is the “Greenspan put” or the bank bailouts that have created moral hazard and greater and greater amounts of risk taking. (See the article by Peter Boone and Simon Johnson in today’s Financial Times, “A Bank Levy will not stop the Doomsday Cycle”:

Another case relates to the underlying emphasis on trying to maintain low levels of unemployment. This has created an environment that encourages risk taking in terms of increased financial leverage, maturity mismatching, and financial innovation. I have referred to the whole period from 1960 to the present as one in which the government underwrote an environment of credit inflation.

Furthermore, this continual effort to stimulate the economy has tended to put people back to work in jobs that were outdated or in industries that needed change. In order to protect the worker, the easiest and best approach was to put workers back into their old jobs. We see the consequence of this policy in the problems experienced in the auto industry, the steel industry, and many other areas that formerly represented the industrial base of America.

Last, special interest programs, such as housing, although designed with good intent, have ended up with several government agencies serving as the residual lender and insurer of mortgages. Over the past several years we have focused on Fannie Mae and Freddie Mac, but it is now obvious that we cannot ignore the FHA. (See the article by Nick Timiraos in today’s Wall Street Journal, “Souring Mortgages, Weak Market Put Loan Agency on a Tightrope”: This effort has resulted in the federal government becoming biggest player in the housing market, by a long shot!

To me, regulation of the banking sector should focus on two things. The first relates to capital requirements. They should be raised.

Second, there needs to be greater transparency and openness in transactions, deals, and balance sheets.

Almost every other kind of regulation that can be put on the books, in the words of John Bogle, can be evaded. We cannot protect the bankers from themselves. But, we can attempt to protect investors and other wealth holders by giving them more information about those institutions they want to invest in. But, like the bankers, ultimately we cannot protect these investors and other wealth holders from themselves.

Monday, January 18, 2010

A Look At The Monetary Aggregates

The growth of the monetary aggregates has slowed significantly in recent months. This, of course, does not mean that the significant concerns over the $1.0 trillion in excess reserves in the banking system have evaporated. By no means!

Looking at the monetary aggregates does provide us with vital information about what economic units are doing with their assets. We took a look at this in an earlier post last November: At that earlier time, it was obvious that people were moving their assets into transaction accounts and shorter maturity deposits. Also, people were moving money from thrift institutions into commercial banks.

This general movement of wealth can be called “bearish”. That is, when people lack confidence in the economy and in the future, they move into cash and other very liquid assets.

The December year-over-year rate of increase of the currency held outside the banking system stands at 5.7%. This is right in line with the growth rate of M1, the narrow measure of the money stock, which was 5.9% in December.

These growth rates are the lowest to be achieved in 2009. As I shall argue, this is not a sign that “bearishness” is over, just that it lessened throughout the year.

The August year-over-year growth rate for currency was 10.5% and for October 8.3%. The similar measures for the M1 measure of the money stock were 18.5% and 13.4%, respectively. Thus, the move into these assets have slowed, measurably.

There is still strong information that economic units are moving funds from time and savings accounts into transaction accounts. The December year-over-year growth rate of non-M1 accounts, primarily time and savings deposits, was 2.4%, substantially below the growth rate of Demand Deposits and other Checkable Deposits which stood at 6.3%.

The movement here also indicates that the movement from thrift institutions to commercial banks remained strong. For example, the year-over-year rate of growth of Thrift Deposits was 1.7% and this included an increase of Checkable Deposits at thrift institutions of 13.1%. The thrift industry is still really suffering.

Add to this the fact that the 1.7% figure includes deposits at Credit Unions, which are rising significantly, strengthens the argument that the traditional thrift industry continues to suffer badly!

Additional evidence of the move into very liquid assets is the fact that the amount of money placed in Retail Money Funds dropped almost 26%, year-over-year, and the money placed in Institutional Money Funds fell by 8.0%, year-over-year.

People continue to be afraid of the future, and, as a consequence they remain very bearish in terms of how they are managing their assets.

This leads to the conclusion that the basic positive movements in financial markets, in the stock market and in the bond market, almost all come from institutional trading. And, this “good” performance is coming from the interest rate subsidy that the Federal Reserve is providing to the banking system and the financial markets.

The increase in transaction accounts in the banking system has meant that the required reserves of the banking system have increased. The December year-over-year rate of increase of required reserves in the banking system was 18.5%.

To cover this, the Federal Reserve, continuing to err on the side of providing too many reserves, increased the monetary base by 22.0% over the same period of time. As a result, excess reserves rose by 40%.

The banking system still tells us a lot about what is happening within the economy. It tells us what the banks, themselves, are doing. It tells us how people are allocating their assets. It provides us with a gauge about the bullishness or bearishness of economic units. It also gives us some information on how the different sectors of the banking industry, big banks, small- and medium-sized banks, and thrift institutions are doing.

The scorecard:

  • People are still moving their money from savings accounts to transaction accounts;
  • Commercial banks, in general, are not lending;
  • Economic units are, by-and-large, still very bearish;
  • Big banks are doing very, very well;
  • Small- and medium-sized banks are still on the edge;
  • And, thrift institutions are really suffering.

One doesn’t see much of a recovery captured in these results.

Sunday, January 17, 2010

Federal Reserve Exit Watch: Part 6

Debate seems to be picking up about the Federal Reserve exiting its current policy stance. Last week Thomas Hoenig, President of the Federal Reserve Bank of Kansas City, and Charles Plosser, President of the Federal Reserve Bank of Philadelphia, spoke last week of the forthcoming need to wind down the Fed’s position. Hoenig said that the Fed should end its purchase program of mortgage-backed securities and Plosser talked about the recovery being sustainable even as existing fiscal and monetary stimulus programs recede.

Still, economists are pessimistic about when the Fed will begin to raise its target for the Federal Funds rate. The effective Federal Funds rate in recent months has averaged about 12 basis points. Bloomberg News conducted a survey of economists’ expectations and the median forecast was for the target rate to remain unchanged through September 2010 and then rise by a half of a point in December 2010.

Since the Federal Reserve finally realized in 2008 that there was a financial crisis and began to combat the unfolding chaos, the basic policy of the Fed has been to throw whatever it can at the wall so that a sufficient amount of what is thrown will stick so that a financial collapse can be avoided.

Can people who devised such a policy really be expected to move its target rate up until it is far past the time that a rise is needed? And, the Fed will then face a situation in which rising interest rates will put many holders of Treasury securities and mortgage-backed bonds underwater and the question will then be, “Can the Fed afford to raise interest rates too swiftly because of all the losses it will create?”

Right now, the Fed is subsidizing the profits of the large banks (and not the small- and medium-sized banks) by its interest rate policy (of course, the Obama administration has threatened to tax away a good deal of the profits). It is just amazing the contradictions in monetary and fiscal policy that are coming out of Washington, D. C. these days. Confusion reigns!

It is no wonder that businesses and banks don’t want to do much of anything these days. They don’t know what the economic policy and regulatory environment will be in three years, let alone three months.

Anyway, the Federal Reserve continues to add reserve balances to the banking system. In the past 13-week period ending Wednesday, January 13, 2010, the Fed has added about $84 billion in reserves to the banking system.

Remember in August 2008 when the total reserves of the whole banking system were only about $44 billion!

Of this $84 billion, $62 billion was put into the banking system in the latest 4-week period.

The major contributor to this increase was security purchases by the Federal Reserve in the open market. In the latest 4-week period, the Fed added almost $71 billion to its securities portfolio bringing the total new purchases for the last 13 weeks up to $233 billion.

A large portion of this increase went to offset the decline in several of the special facilities set up to handle the financial crisis. For example, the amount of funds supplied the banking system through the Term Auction Credit facility fell by about $80 billion over the 13-week period, by $10 billion over the last 4 weeks.

The swap facility with foreign central banks also continued to decline dramatically, falling by almost $38 billion in the latest 13-week period and by about $9 billion in the last four weeks.

In total, it appears as if the funds supplied the banking system through special financial crisis facilities fell by $42 billion over the past 13 weeks and by only $2 billion over the last two.

Thus, the Federal Reserve continues to let these special facilities wind down, replacing them in the banking system through open market purchases.

In terms of preparing for the Fed’s exit, there has recently been trading in reverse repurchase agreements with dealers, but there was no “practice” activity in the past four weeks presumably because of the seasonal Thanksgiving/Christmas churning in the banking system.

As of Wednesday, January 13, 2010, the Federal Reserve held $969 billion in mortgage-backed securities in its portfolio. The central bank has authorized purchases of up to $1.25 trillion going into March of this year. As mentioned earlier, there seems to be substantial debate within the Fed as to whether or not this program should reach the maximum total. We shall see.

The Fed now holds $777 billion in Treasury securities and $161 in the securities of Federal Agencies.

So, the Fed Exit watch continues. So far, the Federal Reserve has honored the path that it started out on: purchasing securities to add to its portfolio thereby replacing the funds draining away from the special facilities created to combat the financial crisis.

Obviously, the real test has not begun. Within the next month or two, if the recovery continues, the Fed is going to come under more and more pressure to start raising its target rate of interest. Until then, big banks will continue to arbitrage the Treasury market and the carry trade will continue to prosper. This behavior is based on the assumption that the Fed is not going to let short term rates rise for a while.

When this assumption is broken, expectations will have to be reset and there will be a re-adjustment in the financial markets as investors exit their arbitrage positions.

What the Fed does then remains to be seen.

However, by maintaining its current policy stance, if the economy doesn’t recover or goes into a double dip recession, the Federal Reserve cannot be accused of aborting the upswing by raising its target interest rate too soon.

Friday, January 15, 2010

Tax Evasion?

In the last few days we have seen a ton of headlines and articles talking about how President Obama is going to tax the major banks of the country (including US branches of foreign banks) in order to recoup the bailout funds paid to the banks that went to save them.

The President pledged to “recover every single dime the American people are owed.”

Remember that Mr. Obama is the protector of the dime since he vowed that the health care plan would not cost the American public “one dime”!

The estimated bottom-line cost to the banking system is about $100 billion over a ten-year period.

The banking system is, of course, lobbying as hard as it can to prevent such a tax from being levied. And, lobbyists are earning a lot of money off of this.

But, the President has heard the voice of the little people who are angry at the bankers.

Oh, and then there is the need for new bank regulation.

The estimated cost of this new regulation is in the billions of dollars.

The banking system is, of course, lobbying as hard as it can to prevent such regulation from being inacted. And, lobbyists are earning a lot of money off of this.

But, the President has heard the voice of the little people who are angry at the bankers.

What can we bet on?

My experience in running banks and in studying banks and the banking industry is that the big banks will not, ultimately, pay much of the bill at all.

The reason for this is that the banks will find many, many ways to get around any new laws, regulations, and taxes or will pass the cost of the new laws, regulations, and taxes on to others.

Let me just say here that I don’t mean to single out just the banks in this area. In this Age of Information and with a global network of business and finance almost everyone that has wealth or financial clout or is big can find ways to avoid laws, regulations, and taxes. And, if you don’t believe this it just shows how good these people and organizations are at evading them.

And, the people and organizations that can evade or avoid these new laws, regulations, and taxes the best are the ones that the President and the “populists” are after. The people and businesses that are the least able to avoid the new laws, regulations, and taxes are those that can least afford the consequences of the new laws, regulations, and taxes. This will include the small- and medium-sized banks and people from Main Street. This has happened over and over again throughout history.

Just an example: in the 1960s it was almost the mantra of a certain brand of economist that a little inflation (an inflation tax, if you will) would help the “little people” because it would result in more employment. This was captured in something called “the Phillips Curve.”

The result? In the short run employment was a little higher but people found that inflationary expectations adjusted and over a longer period of time it took more and more inflation to sustain the small rise in employment associated with the higher inflation. By the end of the 1970s we had a real crisis!

Furthermore, those with more wealth or who were better connected could protect themselves from inflation. They could purchase assets, like homes, and art, and securities that appreciated in value with increases in prices. The less well-to-do or the less well-connected could not do this and so the wealth distribution in the country became more skewed.

Thirdly, higher and higher inflation affects productivity and this impacted the use of existing capital and the hiring of the less educated and less trained worker. Unused capacity in manufacturing and under-employment rose over time again hurting those that were the least able to protect themselves.

The purchasing power of the dollar declined from 1961 to the present: where one dollar could buy one dollar’s worth of goods at the former time, it could only buy 17 cents worth of goods now. And, who has suffered the most? Main Street and not Wall Street!

There are two forces dominating the banking scene right now and neither one of them can lead to the construction of sound banking regulations and banking practices. The first is the emotion of the present. People may be upset about what has happened and are particularly incensed at the profits that the large banks are posting. However, an emotional response to current events cannot lead to a rational result. Basing laws, regulations, and taxes on a populist outburst will only produce consequences that are regretted in the future.

Second, it has been my observation that politicians only fight the last war. This is popular because the “last war” is discussed in the press and it is what the constituents of the politicians are responding to. Furthermore, the issues are so complex that the politicians don’t even understand what happened in the “last war”. If you don’t believe this take a look at the initial work the Financial Crisis Inquiry Commission.

Finally, the big banks that the politicians are going after have already moved on “light years” ahead of what happened in the “last war”. I have written several posts on this very fact. Thus, the politicians are firing at the wake of a rapidly moving boat and will miss their target by a lot!

Oh, well, politicians have to get their 15 minutes of fame and try and get re-elected: Seems like we could spend our time concentrating of more productive efforts.


If anyone should be congratulated for the massive profits that have been posted by the “big banks” over the past nine months it should be Ben Bernanke and the Federal Reserve System. Since the real strength of the earnings, especially in banks like JPMorgan Chase, have been in investment banking and trading, one can argue that the Federal Reserve policy of keeping short-term interest rates near zero has subsidized the pockets of the big bankers. Thus one could ask if any of the huge bonuses being paid out by the “big banks” are going to the Chairman and his officers in the Federal Reserve System. They certainly deserve them!

Tuesday, January 12, 2010

The Problem with Debt

The economy is recovering. The areas that seem to show the most life are those sectors that have had sufficient debt relief so as to be able to move forward. The big banks are moving out in a very robust fashion, just how robust we will begin to hear this week. The auto industry seems to be moving ahead, albeit a little more slowly than the big banks. And, there are other areas that show signs of moving forward, the health industry and firms in the information technology industry.

The big cloud hanging over all of this is the debt that still is outstanding in many sectors of the economy. The problem with debt is that it just won’t go away. Regardless of any adjustments made to who owes what to whom, if there is debt outstanding, someone has to pay for it in some fashion.

The big banks were saved, but who picked up the tab for the bailout? The taxpayer did, or, at least the taxpayer has footed the bill pending a potential Obama tax on the banks to “recover” some of the bailout monies.

Who saved the auto industry and subsequently holds the IOU for the rescue? A large part of the financial restructuring came at the expense of those that had provided credit or equity funds to the car companies. And, the federal government also paid a share.

If homeowners got relief from their mortgage and consumer debt, who would pay the bill? Shareholders of the bank, holders of mortgage-backed securities, and the federal government. (You might check out this little piece by Peter Eavis in today’s Wall Street Journal:

And, what about the debt that is related to commercial real estate lending? Shareholders of banks, holders of commercial mortgage vehicles, and the federal government.

Then we move to the financial problems of the states. Recent information points to the fact that 36 states in the United States are having financial problems and these could lead to deficits in the state budgets of around $350 billion this year and next. Where is the money going to come to pay for these shortfalls? States have already attempted to sell off properties, outsource functions to the private sector, and even turn some things over to the federal government.

Part of the problem here is that the tax base in most states has collapsed as unemployment and under-employment have risen, as property values have fallen, and as business earnings have collapsed. Rating agencies have begun to lower credit ratings on some states. The best guess is that ratings will drop on many other states before the year is over.

And, what about local and municipal governments? Same problems.

And, then, what about the federal government? Without totaling up the bill for the problems mentioned above, let alone the escalation of wars here and there all over the world, health care reform, and some kind of energy bill, many expect federal deficits over the next ten years to total $15 to $18 trillion!

Who is going to purchase all or almost all of this debt? China?

What I find scary is that our “friends” are voicing concern in different ways. For example, the Financial Times this morning carries the opinion piece of Gideon Rachman titled “Bankruptcy Could Be Good for America”: The point Rachman makes is that the Brics, Brazil, Russia, India, and China all went through economic reform before they “broke out” into their current ascendency. Brazil’s reform came in the 1990s, Russia defaulted in the late 1990s, India embraced economic reform in 1991, and China moved to a new mindset in the early 1990s. “Those much discussed emerging powers, the Brics, all needed a fiscal crisis to set them on the road to economic reform and national resurgence. America may one day be lucky enough to experience its very own national fiscal crisis.”

Even if we print money to pay for the federal debt, as the Federal Reserve has done over the last year or so, (the monetary base rose 23% from December 2008 to December 2009, and rose by 101% over the previous 12 months) someone, somewhere will pay this debt in terms of a reduction in purchasing power.

Need I mention that since January 1961 the purchasing power of one dollar has dropped to roughly $0.15. Inflating the United States government out of its debts has a long, post-World War II history.

Might this process of “printing money” continue?

Seems like a lot of people believe that it will. For one there is the problem of rising long term interest rates. More and more worry is being expressed about the expected increases. Why? Well most analysts believe that the Federal Reserve has helped to keep long term interest rates lower than they would have been in order to provide liquidity to the financial markets and to support the mortgage market. On January 6, 2010, the Fed held on their balance sheet $777 billion in U. S. Treasury securities, $160 billion in Federal Agency debt securities, and $909 billion in Mortgage-backed securities.

This totals $1.846 trillion in securities held by the central bank! The concern is that in the last week of August, 2008, the Fed had provided only $741 billion in funds to the banking system through some kind of market or auction based transaction.

How much affect these purchases have had on keeping long term interest rates lower than they would have been is currently being debated. What is not in question is that, sooner or later, interest rates are going to begin to rise, first because the Fed’s artificial support will be removed, but rates will rise as the economy begins to improve, further pressure will be put on rates as issuers of bonds race to place debt before the rise takes place (See “Rate Rise Fears Spark Rush to Issue Bonds:, and as inflationary expectations are incorporated into bond yields.

How fast will the Fed allow interest rates to rise because rising interest rates will slow down economic recovery. Also, the Fed has created another problem by keeping short term interest rates so low. Not only have these low rates created arbitrage possibilities for domestic investment, borrow short term money in the 35 to 65 basis point range and invest in 10-year government bonds at 3.50% to 3.80% but also for the international carry trade. It is argued that the Fed cannot allow rates to go up too fast or big financial institutions and other investors will get trapped in losses that will not help the economic recovery.

The point of all this discussion is that any “exit” strategy that the Fed is planning to reduce the securities held on its balance sheet from current levels to even a level of $1.0 trillion, let alone the $741 billion mentioned above, is already in jeopardy. And, many are arguing that in the face of such overwhelming future deficits, the Fed will be forced to print even more money than it has over the last 17 months.

The problem with debt is that debt, once issued, really does not go away. Someone has to pay for it!

Sunday, January 10, 2010

Smaller Banks Continue to Struggle

Smaller banks continued to struggle, balance sheet-wise, in the fourth quarter of 2009. Data have just been released bringing us through the last banking week of the year, December 30, 2009.

These data come from the H.8 release of the Federal Reserve System and are seasonally adjusted. Although there are some inconsistencies in the data series over time, this is the best comprehensive view we have of the banking system and can give us some idea of what is happening to banks if examined on a regular basis.

Large domestically chartered banks are the largest 25 domestically chartered banks in the United States and possessed about $6.7 trillion in assets on December 30, 2009. Small banks are the banks not included in the largest 25 and possessed about $3.6 trillion in assets on the same date. This difference in size gives you some indication of the relative importance, based on asset-size, of the two categories of banks. And, there are over 8 thousand FDIC insured banks in the United States.

Large banks, as we have heard, are going to report record or near record-level results for the calendar year 2009 and bonuses are expected to approach the levels reached in the peak year of 2007.

There is some indication that the interest-earning assets of large banks are starting to grow again. Over the past 13-week period securities held by these banks increased by about $87 billion and Loans and Leases rose by around $106 billion. Surprisingly, most of the increases in loans came in residential home loans and commercial real estates mortgages, $83 billion and $20 billion, respectively. Commercial and Industrial loans continued to decline over this period, dropping by about $27 billion.

We see similar behavior over the past 4-week period as the securities portfolio rose by about $21 billion and Residential and Commercial loans increased by a combined $12 billion. Business loans dropped this time period by about $7 billion.

Very little money, if any, is going into the business sector.

The improvement in the position of the larger banks has allowed them to reduce their holdings of cash assets by $172 billion over the past 13 weeks, by $26 billion in the last 4 weeks.

On the other hand, small banks really seem to be struggling. Profit-wise, the news is not good for this sector.

Their balance sheet performance is not all that good, either. Over the past 4-week period, the smaller banks have lost $36 billion in assets and have lost a total of $108 billion in assets over the past 13-weelk period.

All of this reduction has come in earning assets other than securities. Over the whole 13 week period the smaller banks have kept their securities portfolio roughly constant. Hence, the reduction in assets has been centered on their loan portfolios.

The biggest drop: commercial real estate mortgages. The smaller banks have seen their holdings of commercial mortgages drop by around $50 billion over the past 13 weeks; the drop has been slightly less than $20 billion for the last 4 weeks.

We have heard over and over again about the problems in commercial real estate and what a serious problem this is for the small- and medium-sized banks in this country. We have seen a decline of more than 10% in portfolio assets in this category over the past 12 months. The forecasts are for an additional decline by at least this amount over the next 12 to 18 months.

This is not a good picture.

The residential mortgage portfolio also continues to decline. We see another $8 billion reduction in this number over the last 13 weeks, the majority of the fall coming in the last four weeks.

The thing to watch here is that as unemployment stays high, as people continue to leave the workforce, and as businesses go more and more to hiring temporary help, the residential mortgage sector is expected to remain on the weak side. Almost everyone seems to predicting more foreclosures and more bankruptcies and the brunt of these difficulties is expected to fall on the small- to medium-sized banks.

Remember that at the end of the third quarter the FDIC had 552 banks, mostly smaller ones, on its list of problem banks. This number is expected to grow this year, even accounting for the number of banks that will actually fail. People are saying that about one-third of this total will fail which will be that 3 to 3.5 banks will fail every week for the next 12 to 18 months.

Are there any good signs or is everything bad?

Well, the big banks seem to be in great shape and are off to the races!

The small- and medium-sized banks seem to be in for some very rough times.

The gap widens further and further between Wall Street and Main Street!

And, as we have said before, thrift institutions seem to be in the same boat as the small- and medium-sized banks.

Today, it seems as if, if you want to be small, you should be a credit union!

Just one comment on regulatory reform: it seems to me that a part of regulatory reform needs to be a total restructuring of the financial services industry. The mumbo-jumbo we have right now is just a residual from the past and bears no rational relationship to anything that makes sense.

Thrift institutions were, at one time, the only financial institutions dedicated to the housing industry. At one time they were useful. They seem totally superfluous at the present time.

Others, particularly in Great Britain, seem intent upon a restructuring that would separate the deposit banking function of financial institutions from the deal making/trading function of financial institutions.

Perhaps before we spend a lot of time developing a regulatory structure of new bandages and splints for the old system, people should put in some serious time thinking about what financial institutions are needed and how functions should be allocated across institutions.

Friday, January 8, 2010

Something is Wrong!

A headline in the New York Times, “Walk Away From Your Mortgage!”

Why not?

The best remedy for the current economic malaise?

Since there is too much debt, let’s all just walk away from our debt.

And, if the New York Times is printing such material, then it must be OK! Right?

As we “recover” from the Great Recession we see pockets of problems all over the place. Things just don’t fit together the way they used to. And, what we are doing to combat these problems doesn’t seem to be relieving the suffering. The whole world seems to be dislocated.

There is too much debt outstanding. No one disagrees with that, but how do you get people and businesses and governments to start spending again when they are desperate to reduce their outstanding debt?

Other headlines this morning point to the problems in commercial real estate. In “Delinquency Rate Rises for Mortgages” we read that “More than 6% of commercial-mortgage borrowers in the U. S. have fallen behind in their payments, a sign of potential troubles ahead as nearly $40 billion of commercial-mortgage-backed bonds come due this year.” (See Also, “Further Slide Seen in N. Y. Commercial Real Estate” points to the fact that 180 buildings totaling $12.5 billion in value, are in trouble in Manhattan. (See

But, the problems don’t seem to be just in commercial real estate. The New York Times article cited above states that at least one quarter of all residential mortgages in the United States are underwater and that 10% of the mortgages outstanding are delinquent. Another round of foreclosures and bankruptcies seem to be on the way.

Which brings us to the banking system: here the difficulties bifurcate depending upon size. If you are really big you seem to be doing very, very well these days. In fact, it seems as if the “good ole daze” have returned for these bankers. Risk-taking and speculation in the carry trade abound. Simon Johnson, an economist at MIT issued a warning on CNBC yesterday morning that the next phase of the financial crisis could be just beginning and this gets back to the risk-taking of the six major banks in the US whose combined balance sheets exceed 60% of United States GDP.

If you are smaller, however, your problems are immense. The smaller banks are carrying the burden of the commercial real estate problems and consumer debt and mortgages still present these banks with problems because these loans represented “Main Street” and were not all packaged and sold to investors in Finland. Remember there are 552 banks, all small- and medium-sized banks that are on the FDICs list of problem banks and this is expected to grow this year before declining, generally do to actual failures.

There are more dislocations throughout the economy that point to persisting problems. For example, in manufacturing, since the 1960s the unused capacity of United States industry has continually declined from peak usage to peak usage of that capacity The latest peak utilization of capacity still saw that about 20% of the industrial capacity of the United States remained unused. Unused capacity for the past thirty years seems to average around 23% to 24%.

We see unused capacity in the labor force as well. Since the 1970s under-employment of labor has grown quite consistently. Attention is focused upon the unemployment rate, but this measure does not include those individuals that have left the labor force because they are discouraged and those that are only working part time but would like to work more. We have seen estimates that 17% to 20% of the employable people in the United States are under-employed. Another dislocation that is not comforting.

Then we hear about the problems in state and local governments. Reports indicate that there are more than 30 states that are currently experiencing fiscal difficulties. We hear most about California and New York, but there are many other states particularly in the west and southwest that are having real problems. One estimate is that the states will have a combined budget shortfall of at least $350 billion in the fiscal years of 2010 and 2011. And, this doesn’t even get to the difficulties that are being faced by local governmental bodies.

And, there are the dislocations being created by the federal government. Budget deficits for the next ten years have been placed in the range of $15 trillion. The United States is fighting in three wars throughout the world. The government is passing health care legislation that has been justified fiscally by postponing start dates of programs from three to five years. There is climate control efforts being considered along with regulations, like anti-pollution controls, that will just exacerbate the economic and fiscal problems of the country. Then there are other changes in the rules and regulations that apply to industry that will further change the playing field and create greater uncertainty about what management’s should do.

There is the problem of unemployment, the number one issue among the American voter. (And, you thought the number one issue was health care or pollution or terrorism or the war in Afghanistan.) But, there is a dislocation problem relating to federal government stimulus programs.

For fifty years or so, the federal government has attempted to stimulate the economy to put people back to work in the same jobs that they were released from. The government has sought to put unemployed people back to work in the steel industry, in the auto industry, and in other jobs that are the backbone of American industry (according to the labor unions and others). As a consequence, the steel industry lost competitiveness, the auto industry lost competitiveness, and so do many other industries.

This effort to stimulate the economy and put people back into the jobs that they had lost has contributed greatly to the increase in the unused industrial capacity and to the increase in the under-employed in this country. The effort to constantly maintain a low unemployment rate by putting people back into the jobs they have lost has resulted in a massive slide in the competitive position of the United States.

The point of this discussion is my concern with the huge dislocations that now exist within the country. Things are out-of-whack and it is going to take us quite a while for us to get things back together again. Yes, we can try and “force” the economy back into a position of higher employment and greater capacity utilization, of lower debt burdens and greater solvency. But, this would just postpone, once again, the need to realign the country to deal with the pressures of the 21st century.

Something has changed, however. The United States is now facing a more competitive and hostile world economy. The government may not be able to “force” the economy back into its old mold.

Wednesday, January 6, 2010

Housing and Banking

One of the most disturbing statistics around these days is the status of home owners. The New York Times reported yesterday that it is estimated that one-third of homeowners with a mortgage, or 16 million people, owe more than their homes are worth. Any further drop in home prices, of course, would just enlarge that figure and exacerbate the problem.

This, to me, raises additional concern about the banking industry. My guess is that banks, and other financial institutions, haven’t taken this potential write down onto their balance sheets. For one, they don’t know which individuals in the 16 million are going to default on their mortgage and they don’t know when that is going to happen.

This is, of course, a very important reason for banks not to lend at this time. They are uncertain as to the real condition of their own balance sheets.

The forecast is for a new flood of foreclosed homes to hit the market later this winter and spring.
It has been argued that the best way to assist troubled borrowers is not through reducing the interest rate that has to be paid on the mortgage but by reducing the balance of the mortgage. But, this would mean that in reducing the balance on the mortgages of troubled borrowers, the banks would have to take the loss immediately, something they may not have reserved for, given the fact that they don’t know exactly who is going to need assistance. Many of the plans require the borrower to come in for assistance.

This, however, would reduce the capital that the bank has and threaten the existence of the bank.

And, how many banks are already on the problem bank list of the FDIC? At the end of the third quarter of 2009 the number was 552.

What might be the strategy of the banks?

Well, if banks amend the mortgage agreement to include a lower interest rate they do not have to recognize any loss on the loan at the present time.

But, analysts have said, this just postpones the problem and, in all likelihood, the borrowers will still not be able to pay back their mortgage and so this just slows down the recognition of the failure of the loan.

Right! That is the point!

Banks gain something by adjusting loan rates. They lose by granting principal reductions. By adjusting loan rates, they don’t have to take a charge-off right now. If they grant principal reductions they do have to take the charge-off right now.

Bankers are always more willing to postpone taking charge-offs in the hopes of the environment improving. At least that was my experience in doing bank turnarounds.

Furthermore, the location of the problem we are discussing is in the small- and medium-sized banks in this country.

The big banks, they are running away with huge profits gained from the excessively low interest rates (thank you Fed!) and the large trading profits made in bond and foreign exchange markets. This is not their problem, now.

Also, these small- and medium-sized banks face additional problems down the road in commercial real estate, car loans, and other extensions of credit made during the credit inflation of the 2000s.

It seems to me that Main Street is still not “out-of-the-woods” and that 2010 may be the time when the Main Street “shake-out” really occurs. I hope not, but we need to be aware of this possibility.

The total of 552 troubled banks is really disconcerting. It only seems to me that this number will rise in 2010 before it begins to fall. Best guess is, however, that there will be a lot of bank failures this year.


I would like to recommend the article in the New York Times this morning by David Leonhardt with the title “If Fed Missed This Bubble, Will It See a New One?” (

I would also suggest reading this article along with reading my post from Monday, January 4, “The Bernanke Fed in 2010.” (

Leonhardt quotes the recent Bernanke speech with regards to “lax regulation”: “The solution, he (Bernanke) said, was ‘better and smarter’ regulation. He never acknowledge that the Fed simply missed the bubble.”

Going further Mr. Leonhardt argues that “This lack of self-criticism is feeding Congressional hostility toward the Fed.” It is also fueling the criticism of other interested parties.

“He (Bernanke) and his colleagues fell victim to the same weakness that bedeviled the engineers of the Challenger space shuttle, the planners of the Vietnam and Iraq Wars, and the airline pilots who have made tragic cockpit errors. They didn’t adequately question their own assumptions.
It’s an entirely human mistake.”

From which Leonhardt concludes: “Which is why it is likely to happen again.”

Need I say more?

Tuesday, January 5, 2010

The Chinese Dilemma

China seems to be determined to continue to peg the value of its currency against the dollar. Then it points its finger at the United States anytime someone representing the United States raises a question about its practice.

As long as China continues to follow this policy, the United States is locked into a corner with no really good options.

The problem of the United States is the problem of a country that has lost its discipline: a person, an organization, a nation, that loses its discipline is only left with painful decisions. And, given an adversary like China that knows when it has a favorable advantage over another, the bad situation only becomes worse.

The assumption of United States supremacy which most presidential administrations worked with since the 1960s created an aura of invincibility, a feeling that the government could conduct its monetary and fiscal policies without regard for the rest of the world. The Bush administration “strutted” into power in its cowboy boots and its Colt 45s ready to enforce this attitude on other nations.

Unfortunately, for the United States this assumption no longer holds. Although the United States is still the most powerful nation on this planet, both in terms of its economic machine and its military presence, it is not in the same place it once was relative to other nations. As a consequence, the country pays a price if it tries to disregard the rest of the world in the conduct of its monetary and fiscal policies.

The prodigal nature of Bush 43 resulted in the value of the dollar, using almost any measure, declining by about 40% between early 2002 and the summer of 2008. Obviously, the monetary and fiscal policies of Bush 43 were not well received by the international financial community.

After the flight to quality into the dollar during the financial crisis of 2008, the value of the dollar has dropped about 14% from its near-term peak in March 2009 to the present time. World financial markets are not approving the economic policies of the United States government!

Meanwhile the Chinese sell goods to the rest of the world and live off of an export driven economy.

And, what happens if the United States does nothing about this?

The value of the dollar will continue to decline and the prestige of the United States in the world will continue to fall. And, the carry trade will continue to prosper and big financial institutions and financial players will continue to rake in billions of dollars in profits by borrowing dollars at ridiculously low United States interest rates, selling the dollar, and investing in higher interest rates throughout the world.

The big banks will continue to get stronger…and bigger. The rest: well that is their problem!

The two major alternatives being suggested are either to raise interest rates and try to moderate the rise in government debt or to raise protective barriers against international trade.

The first of these alternatives does not seem realistic to expect at this time. With unemployment at current levels and with foreclosures and bankruptcies remaining high, the political interests in the United States are not going to condone higher interest rates and a less expansionary fiscal policy. Using monetary and fiscal policy to stem the decline in the dollar is, it seems to me, just not going to happen.

The other major alternative now being floated: greater protection for United States manufacturing and industry. Paul Krugman, the Nobel prize-winning economist, writes about “Chinese New Year” in last Thursday’s New York Times (see He concludes as follows:

“there’s the claim that protectionism is always a bad thing, in any circumstances. If that’s what you believe, however, you learned Econ 101 from the wrong people — because when unemployment is high and the government can’t restore full employment, the usual rules don’t apply.

Let me quote from a classic paper by the late Paul Samuelson, who more or less created modern economics: “With employment less than full ... all the debunked mercantilistic arguments” — that is, claims that nations who subsidize their exports effectively steal jobs from other countries — “turn out to be valid.” He then went on to argue that persistently misaligned exchange rates create “genuine problems for free-trade apologetics.” The best answer to these problems is getting exchange rates back to where they ought to be. But that’s exactly what China is refusing to let happen.

The bottom line is that Chinese mercantilism is a growing problem, and the victims of that mercantilism have little to lose from a trade confrontation. So I’d urge China’s government to reconsider its stubbornness. Otherwise, the very mild protectionism it’s currently complaining about will be the start of something much bigger.”

If unemployment remains high and economic growth continues to stagnate, and the value of the United States dollar continues to decline, the argument that Krugman presents will become more and more convincing, especially as we move to an election. Krugman is now saying that a double-dip economy is more probable than it was a month or two ago and the current stimulus will disappear after the middle of the year. Thus, tighter monetary and fiscal policies, toeing this line, are not appropriate.

This alternative can, therefore, become a real threat and we could experience a rising tide of interest in greater amounts of protectionism as 2010 proceeds. Once the ball gets rolling in this direction it becomes hard to stop and other nations must respond in kind to protect themselves. This would just be a replay of the 1930s, when an earlier death spiral of globalization took place. Even a person who was generally in favor of free trade like John Maynard Keynes became, for a while, a supporter of protectionism because the British government was doing nothing else.

The United States is in a corner and there are no real good choices available to it. As said earlier, when one loses their discipline nothing becomes easier. Bush 43 was totally undisciplined and we are currently paying the price for it. No one seems to have a good idea how to get out of the current malaise and so alternatives like protectionism are bound to gain ascendency.

Monday, January 4, 2010

Following Mr. Bernanke and the Fed into the New Year!

Have you ever noticed that when someone doesn’t have the skills to do a job well that they ask for more control so that they can do the job better next time?

Enter Ben Bernanke into the New Year!

Speaking in Atlanta yesterday, Mr. Bernanke made the following statements about monetary policy in the first decade of this century.

“Stronger regulation and supervision aimed at problems with underwriting practices and lenders’ risk management would have been a more effective and surgical approach to constraining the housing bubble than a general increase in interest rates.”

“When historical relationships are taken into account, it is difficult to ascribe the house price bubble either to monetary policy or to the broader macroeconomic environments.”

So much for that!

At the annual meeting of the American Economic Association we heard that the excessively low interest rates set by the central bank during the 2002 through 2006 period, when Bernanke was a member of the Board of Governors of the Federal Reserve System and the arch-defender of Chairman Alan Greenspan and the low interest rate policy, that the level at which interest rates were set were “appropriately low.”

Imagine that, Mr. Bernanke (now), defending Mr. Bernanke (then). I am truly surprised!

I’m not buying.

Remember, too, that this was a time that large budget deficits were accruing due to the Bush tax cuts and the build up for the Bush war-plan.

Monetary policy and fiscal policy marched hand-in-hand during this period. So much for the independence of the American central bank!

And, how does Mr. Bernanke explain the reaction of the international investment community to this policy stance?

Evidence can be found in the foreign exchange market: the value of the dollar, given most measures of its value, declined by about 40% into the spring of 2008. It seems as if investors did not think that interest rates were set “appropriately low.”

And, this gets me back to my original point: my experience, both in running organizations and in studying those that run organizations, leads me to the conclusion that when people fail to perform their job they ask for more hands-on-control in the areas their job covers. They believe that with greater hands-on-control that they will be able to perform better than they have in the past.

Never, in my experience, have I seen the move to greater control work! Consequently, I don’t expect that giving the Federal Reserve more regulatory control will work at this time either.

And, Mr. Bernanke and the Federal Reserve have an altogether different problem if they “muck up” their exit strategy from the Fed’s inflated balance sheet.

Are they going to save themselves in this area by having greater regulatory control?

I think not!

It is obvious that Mr. Bernanke is going to be re-confirmed as the Chairman of the Board of Governors of the Federal Reserve System, an integral part of the Obama administration.

Investors must remember this going forward. We have huge government deficits in our future. We have a banking system where, at least in the smaller banks, there are still large balances of underwater loans. The wave of home foreclosures does not seem to be over. We have bankruptcies that are still occurring. Unemployment, and under-employment, will continue to remain low for some time into the future. And so on, and so forth.

As a consequence, given past behavior, it is a good bet that Mr. Bernanke is going to err on the side of the politicians that need to get re-elected in 2010 and in 2012.

Investors need to keep this in mind. As we have gone through a period of time when everything the Fed had was thrown against the financial crisis, it seems that the future will include a Fed that errs on the side of keeping things excessively easy. In effect, monetary policy is being conducted with little or no discipline.

Nothing new here for the Bernanke Fed!

The remedy for that, Mr. Bernanke told us yesterday, is to give the Fed greater regulatory control. The assumption is that regulatory control will make up for the lack of discipline elsewhere.

And, you know what can happen when we assume.