How the Crisis Catapulted Us Into the Future

“How the Crisis Catapulted Us Into the Future,” is the title of Martin Wolf’s opinion piece in the Financial Times this morning. Wolf, in the article, ruminates on what he experienced last week at the World Economic Forum held at Davos and how this all fits into the world we are now living in.

Wolf concludes: “The crisis has not proved a great turning point, so far. But we cannot conclude that it is of small significance. It has brought some transformation, much acceleration of previous trends and, above all, great uncertainty. That uncertainty was present all along. But now we know.” (http://www.ft.com/cms/s/0/5fc7e840-2e45-11e0-8733-00144feabdc0.html#axzz1Chh2pOYC)

The usual items are mentioned. First, the “turnarounds” such as the tightening of financial regulation, the de-leveraging that still continues, the lessening of “global’ imbalances”, and the vulnerability of the Eurozone’s “excessive accumulations of private and public sector leverage.” Then there are the “accelerations” such as the new focus on sovereign fiscal affairs, the “accelerated shift in the global balance of economic power,” the changes in relative attitudes in the west and in the east, and the uncertainties related to how the future is going to work out.

There is another change that has taken place over the past three and one-half years that Wolf doesn’t allude to but is one that has also accelerated during the crisis and will play an even more important role in the future. A consequence of the financial crisis has been the rapid advancement in the use of information technology in the world and the effect this advancement has had in changing the way we all do business and how we govern and how we all live.

First, the headlines in newspapers all over the world tell us of the events taking place in Tunisia and Egypt, and in Jordan and Syria, and elsewhere. Could these events, would these events have taken place if information had not spread about conditions in different parts of the world and if communications had not been as complete as they are. In Egypt the Internet was closed down, but that didn’t stop information from traveling.

Analysts have argued that two factors seemed to be catalysts for the uprisings that have taken place: food prices and unemployment. In terms of the former, information spread that food prices were an international concern and impacting countries with autocratic governments the worst. Unrest was experienced in other countries as more and more people reacted to governments that were a part of the problem and not a part of the solution.

In addition, people had more and more information that countries other than the developed countries were experiencing economic expansion. China and India and Brazil, among others were creating a future and putting people, educated people, to work. This was not happening in Tunisia or Egypt, Jordan or Syria or in some of the other countries experiencing unrest.

Information and the spread of information is something governments are going to have to take more and more into consideration in the future. But, this does not just extend to social issues.

Governments are finding it harder and harder to hide things. One of the fallouts of the crisis in the Eurozone is that governments like Greece were hiding things so that its financial condition was not really apparent to its people and to people in the investment community. Spain is now experiencing some of this within its regional governments. This is causing Spain real headaches in attempting to stem the impending financial crisis it faces.

But, people in the United States cannot be too smug in this area. More and more we are finding out how state and local governments “hide things” in managing their finances especially in the accounting for pension fund liabilities.

On top of these revelations, there was the release of large amounts of inside information connected with the organization called WikiLeaks. This, apparently, has had some impact on middle eastern events as well as disclosures relating to military and diplomatic relationships. We were reminded once again of this release of this “secret” information in the article in the New York Times Magazine, “The Boy Who Kicked The Hornet’s Nest” which appeared over the weekend. (http://www.nytimes.com/2011/01/30/magazine/30Wikileaks-t.html?adxnnl=1&ref=magazine&adxnnlx=1296651604-/6As33QJtY/sr5n+tM0J5w)

Information spreads and, although it may be contained in the short run, over the longer run its spread cannot be stopped. This is a major problem for governments.

The WikiLeaks adventure also spilled over into the business sector as several firms or banks were threatened with disclosures. But, the information “leakage” problem extends far beyond just WikiLeaks. Today, in Mr. Wolf’s paper, the Financial Times, there was a detailed piece on “industrial espionage” titled “Data Out of the Door.”( http://www.ft.com/cms/s/0/ba6c82c0-2e44-11e0-8733-00144feabdc0.html#axzz1Chh2pOYC)

“Cyber-spying has fast become a specific threat for many companies. ‘Industrial cyber-espionage is one of the biggest problems that all nations are facing,’ says Melissa Hathaway, a former US intelligence official and the leader of a digital security review set up by President Barack Obama.

The scale of hacking to gain corporate information has gone so far, she says, that the Securities and Exchange Commission…might soon need to require companies to assess routinely for the benefit of shareholders how well they are protecting themselves from electronic attacks.”

On the other side of the ledger, this fact also says a lot about what companies can and should
reveal to the investment community. People can get more and more company information these days and it is very important for a business to accept this fact and address the issue of how open and transparent it must be to earn the trust and confidence of the investing community.

Nothing can be worse for a company to be ‘”caught out” and have to admit it was hiding information from the public that should have been released.

Modern information technology is impacting business in another way raising all sorts of different questions. How closely can finance be regulated when finance, which is nothing more than information, can be transmitted around the world in seconds…or less? How can financial transactions be understood when financial information can be “sliced and diced” in any way it can conceivably be re-constructed? How fast can transactions take place? How fast should transactions be able to take place? How secure are all these transactions? How have “the Quants” changed their business practices since the melt down of August 2007? What other ways can the “physical” be transformed into just information?

Rahm Emanuel, formerly President Obama’s Chief of Staff, once stated that one should “never waste a crisis.” I believe that many people and organizations, especially people and organizations within the financial industry, acted this way during the crisis. As a consequence, the world is a very different place now than it was three and a half years ago.

The problem going forward is that many people and businesses are looking forward to what they can do in the future while many governments and other institutions, like religious groups, are only looking to regain the past. This divergence only adds to the uncertainty that Mr. Wolf observes in the world today.

Basel III (Chuckle)

I guess I should say something about the new Basel III regulations.

I will present three “facts” that, I believe, says it all.

These three facts are as follows: 2019; financial markets rose when the news of the agreement was announced; and the agreement was more liberal than feared because a more restrictive agreement was opposed by the German government and the German banks.

First, the new capital requirements do not have to be fully met until 2019. There are some liquidity requirements that must be met by 2015, but this is still five years out.

By 2019, let alone 2015, the world banking structure will be entirely different than it is currently. The world of financial institutions is changing so rapidly due to the advancement of technology and the globalization of finance that over the next five years or so the way finance is conducted will be hardly knowable in today’s terms. I have written many times in the past year about how the United States banks have “gone beyond” the thinking of government legislators and regulators in terms of the creation of the Dodd-Frank financial reform act.

There is no way you can write successful banking regulations that attempt to prevent the recurrence of a past financial crisis. To require something to be done but then give these institutions nine years to conform…is a joke.

Second, financial markets responded positively to the news of the Basel agreements. To me, investors are saying, “Whew! The people writing the Basel rules didn’t do anything really stupid!”

Third, Germany rules the roost. How important is it for a nation to have a strong economy and its finances more under control than the other countries it is dealing with?

Very important! (Are you listening America?)

Especially in a time of economic and financial uncertainty, the player with the strong economy and the stronger financial position holds most of the cards. In order for a community to reach an agreement and have any hopes that the agreement will be implemented, the stronger nation must continue to participate in the community. Thus, concessions must be made.

One can interpret the announcement of the Basel III agreement in this way: the European community is still together but in reaching agreement it is apparent that Germany has the veto power. Germany will continue to have this power going forward until other nations get their economies and their finances in order.

Banks in Europe and in the United States were concerned about what would come out of the recent regulation writing sessions. They, of course, lobbied for less restriction and greater flexibility. The banks did want to have some influence on the outcome. The rules and regulations coming out of the negotiations could have been a lot more inconvenient for the banks.
Still, the large banks will continue on their way. Rules and regulations will always lag behind what the modern commercial bank and commercial banking industry can do, and does. I believe, that banking and finance will change more in the next five years or so than it has in the last thirty. Try and regulate that!

Liqudity Traps are For Real

When I was studying economics, the idea that an economy might face a “liquidity trap” seemed absurd. Basically, the concept of the liquidity trap was that the monetary authorities could not “push on a string”. In other words, the liquidity trap represented a time when the central bank could inject a large amount of reserves into the banking system and people (and businesses) would prefer to hold more money than to hold debt. Thus, funds could not get into the bond market which would mean that businesses would not invest in inventories, plant, or, equipment, and the economy would stay mired at a low rate of activity.

This was why deficit spending on the part of the government was necessary, at least for those following the Keynesian dogma, because it was the only way to increase aggregate demand and re-charge economic activity.

Well, we are in a liquidity trap. The Federal Reserve has injected more than $1.0 trillion of excess reserves into the banking system and has kept short-term interest rates close to zero. And, commercial banks have not lent these excess reserves so they continue to rest on the balance sheets of the banking system. The question is, what needs to be done next?

Furthermore, the government has tried deficit spending to spur on the economy, but this effort seems to have had a less-than-dramatic impact on the economic recovery now seemingly underway. Keynesian dogmatists argue vociferously that the problem is that the government has not spent enough…that the Obama administration has been too timid.

But, this approach to the concept of liquidity traps hinges upon the assumption that the crucial economic relationship is found on the asset side of the balance sheet, on the division of assets between holding money or holding bonds. The analysis completely ignores the liability side of the balance sheet. Nothing is said about the amount of leverage the economic unit has built into its balance sheet. Hence, the issue of whether or not an economic unit has “too much” debt doesn’t even enter the picture. And, this is the problem.

There is an article in the Financial Times this morning that I believe does a good job in addressing this issue. The article is “Leverage Crises are Nature’s Way of Telling Us to Slow Down” by Jamil Baz, Chief Investment Strategist for GLG Partners (http://www.ft.com/cms/s/0/580fa460-8e8d-11df-964e-00144feab49a.html).

Baz argues that the near-collapse of the world financial system followed by a deep recession was “a crisis of leverage.” The ratio of total debt to gross domestic product in the United States reached 350 percent in 2007. Whereas nations could perhaps maintain a level of 200 percent and still achieve healthy economic growth, the 350 percent figure that remains in the United States (and that also exists at higher levels in many of the leading developed countries) cannot be sustained.

The consequence is that at some time in the future the United States and other developed countries are going to have to deleverage. But, deleveraging is going to be costly in terms of future economic growth. We, in essence, have to pay for the past sins we have committed in building up such an enormous debt structure.

Baz presents “three hard realities we need to bear in mind” that result from having too much leverage. These hard realities are:

• When you are bankrupt, you either have to default on your debts or you save so you can repay your debts;
• Policy choices under such circumstances are not appetizing with one school of thought advising taking morphine now followed by cold turkey later and the other school proposing cold turkey now;
• If you are a politician, you may be under the illusion that you are in charge whereas the real decision-maker is the bond market.

He concludes: “maybe leverage crises are nature’s way of telling us to slow down. Policymakers can ignore this message at their own peril. In their anxiousness to avoid past mistakes, they run the risk of an even bigger mistake: fighting leverage with still more leverage, a strategy that might suitably be dubbed “gambling for resurrection”.

The liquidity trap now being faced by policy makers comes from the liability side of the balance sheet. People and businesses are faced with the choice of either going bankrupt or increasing their savings so as to repay their debts. As Baz says, “This is neither ideology nor economics, simply arithmetics.”

But, it does mean that commercial banks may not want to lend and people and businesses, in aggregate, may not want to borrow. Pushing on a string in this case has little or nothing to do with the asset side of balance sheets and everything to do with the liability side of balance sheets. The Federal Reserve cannot force the commercial banks to lend or people to borrow.

The liquidity trap looked at in this way is real and has been operating for more than a year.

The problem is that if you consider the liquidity trap in this way you can clearly see the dilemma presented by Baz in terms of the policy choices that are currently available. This is why one could argue that it took so long for the Great Depression to end. People and businesses had to work off their debts…they had to go “cold turkey” for a while. In this sense, the economists Irving Fisher and Joseph Schumpeter were closer to understanding the economic situation that existed in the 1930s than was Keynes!

If Baz is correct then the choices are pain now versus more pain in the future. The problems associated with the increased leveraging of the economy cannot be put off forever. Debt must eventually be paid down!

Mr. Volcker Speaks

Former Fed Chairman, Paul Volcker spoke yesterday at the Peterson Institute for International Economics. All week I had been hearing comments about this speech and how people seemed to be waiting for Volker’s remarks. Yet, this morning, there was only one report on the speech which appeared in the New York Times (http://www.nytimes.com/2010/03/31/business/31regulate.html?ref=business) and then it was buried at the bottom of page B6 of the business section.

It seems as if Volcker didn’t really say very much. In fact, the discussion of his remarks was combined with a discussion of the words of Robert Gibbs, the White House Press Secretary. The bottom line: it is highly likely that the United States will get a re-regulation package for its financial system this year. Gibbs even said that “the Senate might move on the legislation by the end of May”.

Just a couple of comments on the issues that were mentioned in this article.

First, the article states that the legislation to “overhaul the nation’s financial system…is intended to prevent a recurrence of the conditions that led to the 2008 financial crisis and the government bailouts that followed.”

If this is what the legislation is intended to do, we have already lost the battle. As I have stated over and over again, the problem with regulatory legislation is that it is always fighting the last war.

Let me state this as bluntly as possible: We will never have “a recurrence of the conditions that led to the 2008 financial crisis!”

Financial crises do not repeat themselves.

I do agree with Carmen Reinhart and Ken Rogoff in their book “This Time is Different” that the buildup to a financial crisis is always accompanied by the cry of those riding the crest of the economic expansion that “This time is different!” This claim, however, refers to the belief of the perpetrators of the claim that no collapse will follow the buildup that they are going through.

When I say that financial crises do not repeat themselves I mean that the specific conditions preceding a financial collapse, the specific behavior of the financial institutions and the financial leaders, are always different from past collapses. There is new technology, new instruments, new institutional arrangements, and so forth. Things change significantly enough so that the new regulations put into effect at the end of the last financial collapse don’t quite apply to the conditions that exist before the next financial collapse.

This gets into my second point which addresses Volcker’s concern about the growth of the financial services industry relative to the growth in other sectors in the rest of the economy.

We are told that “Mr. Volcker was critical of the broad growth in the financial services industry in recent decades. Finance came to represent an ever-greater share of corporate profits, even as average earnings for most American workers did not rise.”

Volker is quoted as saying “The question that really jumps out for me is, given all that data, whether the enormous gains in the financial sector—in compensation and profits—reflect the relative contributions that sector has made to the growth of human welfare.”

The article continues, “He also asked whether the financial sector contributed to underlying imbalances in the economy, as Americans raided their savings and relied on a housing bubble to maintain excessively high consumptions levels.”

My response to this is that from 1961 through 2008, the purchasing power of the dollar declined by almost 85%. In this inflationary environment, many American families came to believe that the best way to “save” was to buy a house and watch the value of the house rise. In addition, they could further leverage the constantly rising value of their house to “maintain excessively high consumptions levels.”

Mr. Volcker, more than anyone else in the United States, recognized the problem created by the inflationary environment of the late 1970s and early 1980s and, during his tenure as the Chairman of the Board of Governors of the Federal Reserve System, fought inflation with all that the Fed could bring against this destructive dragon. He deserves major praise for what he accomplished at this time.

Still, over this 1961-2008 period, inflation was the major economic incentive in existence in the economy. By the end of the 1960s, commercial banks had innovated to the point that they became “liability managers” and created the ability to expand to any size that they wanted. This happened because the start of this inflationary period made it necessary for banks to have the flexibility to expand beyond the geographic and asset constraints that restricted their ability to compete.

In the early 1970s the mortgage-backed security was invented (by the government by-the-way) and in the middle 1980s the mortgage market became the largest component of the capital markets. As inflationary expectations rose and resulted in higher interest rates during this time, interest rate risk became more of an issue and the interest rate futures market was created.

Need I say more? Financial innovation thrived in the inflationary environment and, as a consequence, the financial industry grew! And, grew! And grew!

Did the “enormous gains in the financial sector reflect the relative contributions that sector has made to the growth in human welfare”? Did “the financial sector contribute to underlying imbalances in the economy”?

I think you know how I would answer both of these questions.

Another piece of the news this morning struck me. Citigroup is spinning off Primerica (http://www.ft.com/cms/s/0/cef26d7c-3c41-11df-b316-00144feabdc0.html). Primerica was one of the first companies purchased by Sandy Weill in the late 1980s that became part of the financial conglomerate Citigroup. Everything about financial innovation and the relative growth of the financial services sector of the economy during this inflationary period is captured in Weill’s wild ride to the top as he constructed Citigroup piece by piece.

And, now we have the dismantling of Citigroup. Is this picture the icon of the new age of finance?

Higher capital requirements can contribute to sounder financial behavior. More disclosure and increased audit standards can also contribute to sounder financial behavior. Still, we cannot build a regulatory structure that will prevent a recurrence of financial crises whether based on the 2008 experience or the experience of some other time period. Furthermore, we cannot prevent greedy politicians from supporting policies that create an inflationary bias to the economy in order to get re-elected.

Regulation of the “bad guys” on Wall Street is popular now. However, it won’t prevent a volatile future.

Credit Market Debt: Why Is So Much Going to Bank Holding Companies?

Credit market debt increased by only 3% from the end of the second quarter of 2008 to the end of the quarter of 2009, a total of roughly $1.5 trillion. Of course, the primary story concerns the shifts in borrowing that took place during this time. The data used in this analysis is from the Flow of Funds accounts from the Federal Reserve.

One should note that the only two really substantial increases in credit market debt during this time period were the Federal Government and bank holding companies. Bank holding companies?

The Federal Government is easily identified as one of the primary borrowers during this time period as the debt of the government rose 36% or a total of $1.9 trillion. This is the largest year-over-year increase, dollar-wise, in history! But, this is not a surprise for we knew this was coming.

Note, that this increase does not include other sources of government debt extension in what are called “Funding Corporations” that include the creations of the Federal Reserve System to fund AIG and so on. This source of government funding reached a maximum of $445 billion in the fourth quarter of 2008 and dropped off to only $224 billion by the end of the second quarter of 2009.

One thing that has interested me is the performance of the commercial banking industry. The commercial banking industry, as a whole, has increased its use of credit market debt by a little more than 23%, although U. S. chartered commercial banks have actually reduced its reliance on this source of funds by about 6%. Note, too, that the credit market debt of the whole financial sector declined by about 1%.

The difference has come in the dramatic increase in the use of credit market debt by bank holding companies. Bank holding companies increased their use of this source of funds by 50%, an increase of $365 billion. In the process, the bank holding companies reduced their reliance on commercial paper by $78 billion and raised a net of $443 billion in corporate bonds. Thus there was not only a substantial increase in the funds bank holding companies raised during this time period, there was also a lengthening of the liabilities of these institutions.

One should call attention to the fact that Goldman, Sachs and Morgan Stanley became bank holding companies during this time period. How much of an impact this fact had on these aggregate numbers is hard to tell, but one should be aware of this movement. These two organizations became bank holding companies on September 22, 2008 and the bank holding numbers did not really increase appreciably during the third or fourth quarters of the year. Although total financial assets in bank holding companies rose modestly from the end of the second quarter to the end of the fourth quarter, actual credit market liabilities decreased. The numbers really began to jump upwards at the end of the first quarter of 2009.

Another factor influencing bank holding company debt during this time is the guarantee on bank bonds provided by the federal government. This gave bank holding companies the ability to raise funds relatively more cheaply than they could have raised them otherwise: a good reason to raise funds.

The interesting thing is that the raising of these funds did little or nothing to spur on bank lending or commercial bank growth. Investment in bank subsidiaries by bank holding companies went up by about $112 billion but this certainly doesn’t seem to have gone into bank loans since most of the increase in U. S. chartered commercial bank assets has been in the form of a rise in cash assets and government securities.

Total financial assets at banks rose by about $950 billion from the end of the second quarter of 2008 until the end of the second quarter of 2009. However, cash assets and reserves at the Federal Reserve rose by $430 and Government, Agency and GSE-backed securities rose by $185 billion. The only lending category to show much of a rise was the mortgage category, $233 billion, and this was primarily in commercial real estate. Commercial loans actually declined by about $100 billion. Something called Miscellaneous Assets rose by about $160 billion. Not a lot of lending going on in the banking sector.

However, investment by bank holding companies in nonbank subsidiaries actually rose by about $630 billion and investment in Other Miscellaneous assets rose by about $150 billion!

Thus, bank holding companies invested almost $800 billion in funding nonbank assets.

It seems as if big financial institutions are continuing to behave in the same way that they did before the financial markets started to unravel toward the end of 2007. That is, they put their money into non-bank operations, areas that the regulators did not have a lot of insight into or control over. That is, the banking system is still not relying on the fundamentals of banking to make money these days! They are returning to the areas that proved to be so profitable to them before the crash. And, once again, we seem to be in the dark as to what exactly they are doing.

Even through the credit crisis of 2008 and 2009, the credit markets provided some issuers of debt a substantial amount of funds. However, it seems as if these funds are going into hands that were very similar to the ones that were obtaining funds right before the crisis took place.

Too much power to too few people: the Lehman debacle.

It is so easy to blame the private sector. And, the government can hide behind “good intentions” and “the public interest.”

For a different view, read the article by John Cochrane and Luigi Zingales who write on “Lehman and the Financial Crisis” in the Wall Street Journal, http://online.wsj.com/article/SB10001424052970203440104574403144004792338.html#mod=todays_us_opinion. The argument is presented here that it was not the failure of Lehman Brothers that set off the financial crisis. It was the panic move by Ben Bernanke and Hank Paulson that resulted in the financial crisis. This mirrors something I wrote last fall on November 16 titled “The Bailout Plan: Did Bernanke Panic?”: http://seekingalpha.com/article/106186-the-bailout-plan-did-bernanke-panic.

As Cochrane and Zingales write, Fannie Mae and Freddie Mac were taken over on September 7, 2008. Lehman Brothers filed for bankruptcy on September 15. AIG was bailed out on September 16. I believe, as I say in the post above, that everything changed that Tuesday evening when the bailout of AIG was announced.

Bernanke called Paulson on Wednesday September 17. As reported later in the Wall Street Journal, and I quote from my post: The Wall Street Journal article reports that by Wednesday afternoon “Bernanke reached the end of his rope.” He called Paulson and “with an occasional quaver in his voice” he spoke “unusually bluntly” to the Treasury Secretary. Paulson did not move immediately. He had to sleep on it, and on Thursday morning, he committed.

Friday evening Bernanke and Paulson met with Congressional leaders and again I quote from the earlier post: Paulson called the leadership in Congress and asked them to have a meeting with himself and Bernanke on Friday evening. The few members of Congress that talked with the press after that meeting said that Bernanke did most of the talking and “scared the daylights out of everyone.” Bernanke knew his history of the Great Depression and he knew currents events. He was very logical and very articulate. The leaders were told that they had to act and they had to act fast. The plan was to have a bill before Congress on Monday seeking Congressional approval (of both houses) by the following Friday. The Treasury Department had a bill ready (three pages long) by midnight Saturday evening. The price tag - $700 billion. Why $700 billion? Because it was a big number!

But, Cochrane and Zingales state that on Monday September 22, “bank credit-default swap (CDS) spreads were at the same level as on September 12…The Libor-OIS spread—which captures the perceived riskiness of short-term interbank lending—rose only 18 points the day of Lehman’s collapse, while it shot up more than 60 points from September 23 to September 25, after the TARP testimony.” That is Bernanke and Paulson appeared in front of Congress on September 23 and 24 and gave speeches on the need for the TARP funding.

The reason for the subsequent market activity? Cochrane and Zingales claim that “In effect, these speeches amounted to ‘The financial system is about to collapse. We can’t tell you why. We need $700 billion. We can’t tell you what we’re going to do with it.” The authors conclude with “That’s a pretty good way to start a financial crisis.”

The conclusion: putting all the blame on the Lehman failure takes the focus off the main story. The main story is not that there was just one policy failure at this time. The main story is that the government continued to screw up after creating the financial environment and credit inflation that resulted in the asset bubble of earlier in the decade. It continued to screw up in the series of band aids that the Fed and the Treasury imposed on the economy and financial system beginning in December 2007. And, in doing so, the government continued to build up the moral hazard in existence in the system and continued to expand the federal debt outstanding to met ever larger needs for financial bailouts.

By not focusing on the main story, we risk an even larger series of policy failures in the future. That is, the federal government now is doing pretty much what the federal government did last year and the year before and is creating even more massive amounts of debt in the process.

Bail Out or Wimp Out?

The Obama administration is going to have to make a decision soon…is it going to try and commit to a program that will actually do something for banking and other financial institutions or is it going to extend the waffling on this issue that began last fall?

People in the administration say that something has to be done…and it has to be done fast…but, there is this problem about buying assets from these troubled institutions…we don’t know what price we should pay for them.

All I can advise them in terms of setting prices is…do the very best you can…at this moment in time! Yes, there is great uncertainty as to the prices of many or most of these assets…but, that is not the issue at this stage of the game.

Beginning in December 2007, things changed in Washington, D. C. The Federal Reserve System did something that had never been done before. It innovated! It created the Term Auction Facility; it introduced a dollar swap facility with other central banks around the world; as well as the Primary Dealer credit facility. Since that time the Fed has developed several other new ways to put dollars into the banking system.

In March 2008, the Fed and the Treasury engineered the Bear Stearns takeover and in September 2008 the world changed even more as Lehman Brothers was allowed to fail and AIG was essentially nationalized. The American model of financial markets and institutions would never be the same again.

And, things continued on from there with the $700 billion bailout bill passed by Congress and the efforts of Treasury Secretary Paulson and Fed Chairman Bernanke to sooth markets and get credit flowing once again.

The Obama administration has taken over from Bush43 and argued that with the crisis at hand…something must be done to avoid a “catastrophe”…in the words of President Obama himself.

My point is…it is not time to waffle on trying to save the banking and financial system from the bad assets they have on the books.

The government IS involved…up to its neck and beyond! The Obama stimulus package is an attempt to stimulate the economy. But, in my estimation, it will not do a lot. If the current size of the package is, being generous, around $850 billion and the multiplier of this spending is between 0.4 and 0.6 (see my post of January 26, 2009, http://seekingalpha.com/article/116414-what-will-be-the-impact-of-obama-s-stimulus-plan) then the effect on the economy will be between $340 billion and $510 billion of additional output. Not a great “bang-for-the-buck”, but, we are told, it is the effort that is so important at this particular moment.

There will be more to come…promises the Obama administration. Additional programs need to follow this package. More dollars need to be thrown at the problem.

Still, there is the problem of bad assets. What is going to be done with all the toxic waste that is now held by our financial institutions?

Well, since there is way too much debt in the financial system, there could be a massive write down of assets…the banks and other financial institutions absorbing the hair cut. (See my post of February 4, 2009, http://seekingalpha.com/article/118475-two-painful-proposals-to-reduce-our-excess-debt.) At this stage of the effort there does not seem to be a lot of interest in this approach so we probably should put this idea on the back burner for another time.

Thus, if something has to be done…along with the $850 billion stimulus plan…let the Federal Government buy these toxic assets from the banks and other financial institutions. Many estimates place the difference between what these institutions value the assets on their books and the price that the Federal Government would buy them at is a minimum of $2.0 trillion. If the banks and other financial institutions took this kind of a hit to their balance sheets…many of the organizations would be bankrupt…kaput…out-of-business.

My question to this is…aren’t they bankrupt…kaput…out-of-business…already?

The issue is that many of these institutions are large…would require a lot of management talent to run them…and what about the shareholders? Well, the shareholders have no rights…because there is no equity left in these institutions. Let us recognize this and get on with it. Many of these institutions are large…which means there is a major need for management talent. But…why should the managements that got these institutions into the positions they now are in be expected to get them straightened out and healthy again?

This reminds me of many of the “dog-and-pony shows” that I observed during the S & L crisis twenty-some years ago. In these “shows” the existing management would get up in front of potential investors and say…”Yes, we have run this bank for the past 20-some years…and, yes, we basically bankrupted the band…but…WE HAVE LEARNED our lessons! Give us $100.0 million so that we can turn this bank around and make it into something you will be proud of!”

In most cases, the potential investors dug into their pockets and forked over the $100.0 million. Few, if any, of the “born again” managements were successful in turning their institutions around. Oh, well…live and learn!

Unfortunately, the same thing seems to be in play here. The managements that got us here claim that they can be the managements that get us back to health again. What did P. T. Barnum say?

A number of these banks and other financial institutions appear to be insolvent…their managements are hanging on by their finger nails…the credit system is not functioning as it might…and the government is dawdling.

Buy the assets. Remove the shareholders…they had their turn to oversee these institutions. Take over these banks…and see that the banks get new top managements. If you are going to do it…then, do it! Cut out the half-fast programs. Postponing government action only creates more uncertainty, and, as we know too well, the market hates uncertainty.

The Obama campaign called for change in Washington, D. C. It said an Obama administration would change things…action would be taken. Well, action needs to be taken. Obama was right the other evening when he said that his administration will be remembered for stopping the economic downturn and getting things moving upwards again…or not. Not much else is going to matter. And, whether or not you agree with the policies and programs that are being presented…and to a large extent I don’t…I do agree with the general feeling that if you are going to fail…or succeed…you will have to do it in a very committed way. Half-measures are bound to fail…if for no other reason than they won’t raise the confidence of the nation.

So, Mr. Obama, come out with a strong plan for taking care of these toxic assets and come out with a strong plan for removing the chaff from the banking system. Half-way measures are not going to resolve the issue because there will still need to be further adjustments sometime down the road. Be strong! All you can do is what you think is best for the country!

This Issue Is Debt! Too Much of It!

Going forward…the primary issue the world is going to have to face is debt…lots and lots of debt. Debt is clogging the blood vessels of the world financial system!

And the proposal to get us out of this dilemma?

Create even more debt!

If the problem is too much debt then the economy has to go through the pain of working this debt off…and this is called a debt/deflation. As people and companies and government reduce the amount of debt on their balance sheets they withdraw from the spending stream…and save…exactly what people and companies and governments are doing at the present time. But, removing spending from the spending stream reduces the demand for goods and services, causes firms to cut people from their employee rolls…and creates a downward spiral in economic activity. The economy engages in cumulative behavior and gets deeper and deeper into a hole.

This is what the people and the government want to avoid…if possible.

The Obama stimulus proposal is a way to get us out of the current economic crisis.
(There is another way that I will discuss below.) Basically, it is an attempt to inflate our way out of all the debt that exists. The Federal Reserve is doing its part in trying to pump up the amount of cash that exists within the system. But, creating money in this way takes time for the inflation to work its way through the system because it must go through banks and other financial organizations. And, this system, right now, seems to be functioning at a very low level.

Keynes saw this problem in the 1930s and proposed a way of getting around the banking and financial systems…create massive amounts of government expenditures and put this spending directly in the economic system…financing the deficits with government debt. Then, as the economic system starts to turnaround and pick up steam…the banking and financial system will pick up some steam and provide the “kicker” to create the inflationary environment needed to reduce the real value of the debt that had been built up…including the debt the government deficit spending just added to the pile.

Therefore, the first way to reduce the amount of debt that is outstanding in the economy is to create more debt so as to un-clog the banking and financial system…create an inflationary environment…and watch the “real value” of the debt decline.

This is a long term process and has several problems to face along the way. One of these is the question of how much spending should the government undertake? The issue here is about what the “multiplier” of government spending really is. I treated this in a post on January 26, 2009, titled “What will be the impact of Obama’s stimulus plan, http://seekingalpha.com/article/116414-what-will-be-the-impact-of-obama-s-stimulus-plan. Another question has to do with the process of enacting the stimulus plan into law. This I treated in a post on February 2, 2009, titled “the Obama Stimulus plan: Why I’m Concerned”, http://seekingalpha.com/article/117878-the-obama-stimulus-plan-why-i-m-concerned.

However, the ultimate issue relates to the amount of debt that is outstanding…in the United States…and in the world. If the amount of debt HAS to be reduced…and it must be reduced in order to get the economy functioning again…then, following this approach, inflation must take place to reduce the real value of the debt. The danger with this plan is that if inflation is not cut off at some time in the future, the incentives in the economy will be to return to a “go-right-on” and “business-as-usual” approach to living. That is…we will be right back where we were around the middle of this decade, where leverage was good and more leverage was even better, especially within an inflationary environment where things need to be kept “pumped up”! If this happens, we will still be addicted and still have the “monkey on our backs.”

Another way to reduce the amount of debt outstanding in the economy is to basically “write down” or “re-write” the debt and not create any more through an enormous fiscal stimulus plan like that proposed by the Obama administration. This would involve a massive restructuring of existing business balance sheets…both financial institutions as well as non-financial institutions. Insolvent institutions…including the auto companies…need to be recognized as such. In effect, existing shareholders in these companies have lost their investment…so much for good governance and oversight. Bondholders will have to accept an exchange…taking “new” debt at, say, 75% or 50% of the current face value…or preferred shares for the debt they hold…or taking an equity position in the company…maybe even warrants.

These exchanges would have to be negotiated…but the bondholders would have to understand that, as things now stand, the companies are insolvent and they could get nothing if the restructuring does not take place. Plus, the companies or the bondholders…or the public…really does not want the government to take over these institutions. We do not want state-run companies…financial or non-financial…because the fate of the nation would be much worse with a nationalization of industry than it would with an imposed “re-structuring” of the balance sheets of these businesses…financial and non-financial.

In terms of the consumer…a similar thing would have to take place. The major concern has been related to the housing sector and mortgages. But, we are now seeing a massive wave approaching of defaults on credit cards, car loans, and other types of debt that the consumer has taken on. Similar to the re-structuring of the business sector, the balance sheets of consumers must be re-structured. How we do this cannot really be discussed in this short post, but the idea would be that organizations that have extended credit to the consumer sector will have to take a haircut on the amount of debt that is owed by each consumer and the terms of repayment will have to be restructured in order to make the probability of repayment of the debt realistic. Again, this re-structuring would have to be negotiated…but we are talking here about much lower costs than would accumulate if there were more foreclosures and bankruptcies…more lawyers’ fees…and more costs all the way around. And, this could be done in a much shorter period of time than if all these bad assets had to be “worked out”.

I have given two extreme solutions to the problem of the debt overhang. The fundamental crisis is connected with the fact that there is too much debt in the system. For the system to work this dislocation out we would have to go through a period of debt-deflation. The two extremes presented here are, first, the Keynesian approach which is to inflate the economy and reduce the real value of the debt, or, second, to impose a debt-restructuring on the economy which would allow for a negotiated reduction in the debt loads of all economic units in the system.

People will really not be happy with either of these extreme solutions…or, for that matter…any combination of the efforts. But, once one loses their discipline, as the United States and the world did in the 2000s…there are no good solutions available to get out of the hole that has been dug. All people can do is to “take their medicine” and vow not to let such a situation ever occur again. However, looking back at history, one cannot be very confident that we will maintain our discipline once we get over the crisis.

I would like to make just one more suggestion. There is only one real change I would like to see to the regulatory structure…for both financial and non-financial firms…and that is the imposition of almost complete openness and transparency of the business and financial records of companies. Whatever a company does…it should be open to its owners…and to anyone else that might be interested.

Concerns about the Obama Stimulus Plan

As the Obama Stimulus Plan becomes more and more of a reality, many different people are asking many different questions about it. To me, there are four basic issues that need to be debated very seriously before any such plan is passed by Congress. The first question is…how fast do we really need to move in passing such a plan? Second…how big does the stimulus package really need to be? Third…how is all the debt created by such a plan going to be financed? And fourth, can the stimulus really be withdrawn once the crisis is over?

In terms of speed of enactment we hear over and over again that speed is of the essence. Things are really bad…and things are going to get a lot worse. We need to get into the game and do something as quickly as possible!

We heard this argument before, not too long ago. It was reported in the Wall Street Journal, that “Federal Reserve Chairman Ben Bernanke reached the end of his rope on Wednesday afternoon, September 17.” Bernanke was reacting to things falling apart in the financial industry. He called Treasury Secretary Hank Paulson and said that the administration had to move. Thursday September 18. Paulson responded that he was “on board”. Bernanke insisted that Congressional leaders had to be assembled…which Paulson set up for that Friday evening. Bernanke read them the riot act at that meeting and insisted that a bill…what became TARP…be enacted no later than Monday or everything would fall apart. (For more on this see my post on Seeking Alpha of November 16, 2008, “The Bailout Plan: Did Bernanke Panic?”) The bill was not enacted that Monday and the last half of the TARP money was not released until just recently.

Now we are hearing the call again. We must hurry. The Obama Stimulus Plan has been put on the fast track…and the pressure is on to get the plan enacted by Congress by President’s Day, February 16. But, does this plan really need to be enacted that quickly? Is it better to have any plan by President’s Day or is it better to have a plan that works?

It seems to me that the pressure to get something done quickly has important implications for the second question asked above. Since so little is known about how effective the plan will be…the issue becomes…MORE IS BETTER! Given the uncertainty of how the plan will work, it is important to throw as much as possible against the wall in the hopes that some of it will stick.

Wow! What a way to run a government! But that is what Bernanke/Paulson did.

And, this approach gives rise to the new justification for the program…confidence. The argument goes that “If the government shows that it is serious in ending the recession and this seriousness is reflected in the size of the stimulus package…this will spur on an increase in confidence…which is just what the economy needs right now!”

Let me get this straight. It doesn’t really matter whether or not the stimulus plan works…what is important is that the stimulus plan be very large…so that people will regain confidence.

And, if this is the underlying theory behind the stimulus plan…how is this going to raise the confidence of the world wide investment community…which relates to the third question presented above…to invest in the debt of the United States government?

Oh, well…the United States dollar is the world’s reserve currency and the United States debt is the place for world investors to go when there is a “flight to quality” in world financial markets. Given this fact, people will continue to flock to United States Treasury issues. No doubt about it!

As Alice Rivlin, economist of the Brookings Institution, former member of the Board of Governors of the Federal Reserve System, First Director of the Congressional Budget Office, and Director of the Office of Management and Budget (a cabinet position and appointed by President Bill Clinton a Democrat) recently testified before Congress…”We seem to be counting on the Chinese to keep investing to pay for this (the U. S. deficits) and we’re assuming that the rest of the world isn’t going to lose confidence once we use this moment to spend on a whole range of programs. And, I’m not sure that’s the right assumption.”

Rivlin also has something to say about the fourth question…the question about what happens in the long run. She states that “Because we’re doing this outside the budget process, it means that no one has to talk about what the long-term effects of any of this might be.” That is, what is going to happen beyond the short run if much of this expenditure is still going into the economy as the economy begins to grow again. No one is anticipating how this situation might be dealt with.

As Niall Ferguson, who shares his time between Harvard University and Oxford University, stated recently at Davos…and I am paraphrasing…the new administration seems to believe that by creating an impressive amount of new leverage that it can resolve a financial crisis created by an excessive amount of leverage.

So, I go back to the first question…do we really need to rush so quickly? Yes, I agree with President Obama…he won…he gets to set the table. But, does he want to do it right…or does he just want to do it?

The Congress is supposed to be a deliberative body…it is supposed to mull things over…kick them around…debate and dialogue with one another. Isn’t it better to get something right…than to not do something well…or to do something that may not work?

Projects should not just be put into a stimulus plan…just because they are a “good idea” or because “they are something we want to do and they are available.” Projects, to be included, need to have some real justification for their inclusion in such a plan…the benefit of the project (the whole flow of benefits accruing from the project) should exceed the social cost of the project. Questions should be asked about the timing of the project and when the expected benefits are expected to be received. The Congress should be very intentional about what it is going to do…how much it is going to spend. Success of execution should be the key criteria as to whether a project gets included in the plan…not just the speed of passing the bill.

If Congress were to judge the plan…the whole plan as well as the components of the plan…in this fashion, then something more specific could be said about the size of the plan. Given that every element of the plan could stand up to some form of cost-benefit analysis then the size of the plan would be less of an issue. We would have some rationale for the size of the plan…it would not be a question of hoping some of the material thrown against the wall would stick! The parts of the plan would be chosen because they work…not because they make the plan “large”.

There still will remain questions about financing a stimulus plan. A plan constructed as suggested above would still result in the creation of a lot of new debt the United States government would have to issue. But, the investment community would have more justification to “trust” the plan because the Congress has done its homework…and, if the Congress had done its homework there would be something to say about how the debt will be financed and paid down in the future. That is, the United States government would be acting like a responsible steward of its fiscal responsibilities, something world financial markets have not seen for eight years or so.

To me, this is a crucial issue the Obama administration and the United States government has to deal with…restoring confidence in the fiscal credibility of the United States…something that Bush43 fell far short of doing. Rushing into the fray with a hastily constructed, ill-conceived stimulus plan, one that relies on the Chinese and the rest-of-the-world to finance with no thought for the future is not going to resolve the financial and economic mess we are now experiencing.

Are Derivatives the Problem?

Bob Shiller, the Yale economist, has gotten a lot of press in recent days supporting the use of derivatives and arguing against the use of the efficient markets model in understanding financial (and non-financial) markets. I am supportive of what he is trying to say. In this post I present my reasoning for this support…you can go to Bob’s articles in the Wall Street Journal and elsewhere and his upcoming book (along with his many other books) to get his view.

First, human beings are innovators. They are problem solvers and are constantly pushing the edge trying to come up with something new that makes things better.

The problem we are dealing with here is risk. People, investors, don’t like risk. They are constantly trying to reduce risk in their lives…and they are willing to pay to reduce risk.

And, this is the essence of derivatives. Derivatives are risk reducing tools that can be used to hedge cash flows and thereby protect individuals from assuming more risk than they would like. People will pay for this…derivatives will get invented.

Answer me this…will a large number of people pay someone to invent a tool for increasing risk? The answer to this is no! People don’t pay people to build speculative instruments. The expected return to speculation is zero or less. Now how much will you pay for someone to create a tool that can provide you with an expected return of zero or less? Right…nothing!

People will pay innovators to build instruments that help to reduce risk because they are receiving value by being able to reduce the risk. Now this does not mean that people will not use these risk reducing instruments to speculate with. Hedging is providing a cash flow to offset the movements of all or part of another uncertain cash flow. Speculation means that you are taking an uncovered position…that is, you are working with only one of the cash flows.

So, like other innovations, derivatives have been created for a positive reason…but can be used in ways that increase risk. Like cars…or drugs…or nuclear energy plants. All these can be used in positive ways…but they can also be used in other ways as well.

Conclusion: derivatives will continue to be used, created, and, at times, misused. Financial innovation is with us and will continue with us. My experience supports the view that only a minimal amount of regulation will be effective to control the use of derivatives because part of innovation…is to get around the rules. That’s life!

My second point has to do with the efficient market hypothesis. People who support the efficient market hypothesis argue that market prices reflect all the information that is available to the market at a particular time. That is, market prices are correct. In essence, everyone in the market knows what information is available, what that information means, and how that information is translated into market prices…for all time. At least, there is a well informed group of arbitragers that know these things so that “on the margin” market prices can be made “right”.

In the world I live in, individuals have to deal with incomplete information…especially about the future. That is why uncertainty exists and why people have created probability theory as a way to deal with incomplete information and the resulting uncertainty. For prices to be “correct” and for markets to be “efficient” we need complete information which means no probability distributions for we will have certainty. I can’t believe that everyone in the market, given what information is available, knows what the price of every stock will be at every period of time in the future.

When we have incomplete information markets cannot be efficient because we don’t know the exact models to forecast the future with and we don’t know the appropriate probability distributions that surround our forecasts. As a consequence, our risk management models, as well as our risk management controls, have been inadequate. As such, our hedges have contained more risk in them than we had anticipated and our speculative positions have provided way more risk that we had assumed. Thus, our financial structure has been out-of-line with where we thought we were and our financial system has been more fragile than we thought.

My third point concerns the incentives present in an economy. People will use the instruments that are available to them in ways that are consistent with the incentives that exist within the economy at a given time. For example, in the past, the price of a house may have appreciated over time but this was not the real value of the house. The real value of the house was the flow of services that people received over time…it was this which made the house a home. What people acquired was the flow of housing services…not the stock…not the house itself. This was because the house was not going to be sold…at least not for a long time into the future. In this sense the price of the house was only important at the time of purchase.

What changed? In recent years in too many cases the price of the house became more important than the flow of services. Why? Because in many cases, houses were “sold” every two or three years. People with teaser interest rates, or whatever, that reset every three years, “sold” their house to themselves because the game was to refinance the house using the inflated house price to get a better mortgage rate. Living in the home was not the essence of the deal…speculation on the house price was the focus…and this was seen explicitly in the many “speculative” deals that arose at this time. And this was the essence of the asset-based securities used to support these transactions.

Also, remind me sometime to tell you about my friend that ran a mutual fund who avoided moving into dot.com stocks until the year before the stock market bubble burst. He did not move into these securities until he saw that too much money was leaving his fund…going into funds showing better results because they had invested in dot.com stocks. And he made the front page of the Wall Street Journal when the bubble burst and his “late-in-the-day” bets…collapsed.

Finally, my last issue has to do with the government. Unfortunately, in many cases, government policies can dominate the economy; government policies can create the incentives that people respond to. And, although the government may not mean to, it can create incentives that are detrimental, at least over the longer run, to the health of the economy.

If you have read many of my posts, you know that I believe that the Bush43 tax cuts, the war on terror along with other events that inflated the spending of the government, and the Greenspan “low interest rate” policy set the scene for the bubble in the housing market, the exponential increase in credit over the past eight years, and the overwhelming increase in leverage. The incentives that were created during this time put more and more pressure on business executives to take speculative positions and finance these positions with more and more leverage.

Who was responsible for the behavior of these business executives? Like my friend that ran the mutual fund…even those that were relatively conservative in their business decisions…ultimately found themselves forced into positions where they had to take on more risk than they would like. Competitive pressures “forced” decision makers to respond to the current environment that existed in the market place. After-the-fact they seem to have been overly greedy. After-the-fact they appear to have been insensitive to the risk they were taking…careless even. And now, people and politicians have dumped on them for their mis-guided behavior. The politicians that created the environment many years ago…although they might have lost the election…walk away defending their legacy in other areas. This is one of the difficult things about economics…results often trail, by many, many years, those policies and programs that were their cause.

Yes, I agree with Shiller that derivatives are here to stay. And, I agree with Shiller that many new kinds of derivative securities will be invented in the future. I just wish that we could invent a derivative that would allow us to hedge against bad policy making in Washington, D. C.

The Collapse of Citi

Banking is a commodity business. Banking deals with information…I am holding $100.00of yours in something called a transaction account…I am holding your IOU for $1,000,000.00. Whereas, historically, these sums had to do with a physical quantity…something like gold…now all banking is basically conducted in 0’s and 1’s.

Banking is just information and the movement of information. Banking is a commodity business.

Yes, there are some other products and services connected with the banking business. There is safe keeping…you can get coin and currency back from you transaction account. We will clear payments for you though the banking system so that you can pay people from your account without the use of coin and currency and you can receive payments from other which will be put into your account. That is, we clear transactions through the banking system. We will do your accounting for you and send you a monthly statement. We will make loans to you and provide many different kinds of services for you connected with your loan. And there are many other products and services that banks provide their customers…individuals, businesses, and governments.

Banks used to get paid for these services primarily in interest payments or in deposit balances that were kept at the bank. In the 1980s, however, we got another idea. We can isolate these products and services, account for them, and then charge the customer fees for these particular products and services they use and then we, the banks, won’t have to build in payment for them in the interest rates charged on the loans or by means of the deposit balances that the customer had been required to keep at the bank.

Fees are good because they don’t depend upon loan or deposit balances, but depend upon other products or services rendered.

In the 1980s depository institutions found another way to generate fee income. In the 1970s the government had invented a new financial instrument called a mortgage-backed security that could help financial institutions make more money available to people who wanted to own homes and the depository institution could make these mortgage loans, securitize them so they could sell them and not hold them on their balance sheets, and collect fees for originating and, possibly servicing them. Furthermore, the banks would not have to worry about the interest rate risk that came from holding assets with long term maturities like mortgages and support them with deposits that were available on demand or had short-term maturities.

Banks liked fees and started to build businesses based on fee income. They looked farther and farther in an effort to find more sources of fee income. They built or acquired subsidiaries that generated fee income. And banking companies grew and became diversified…even conglomerate in nature.

But, the banks saw that more than just mortgages could be securitized and they saw that these securitized loans could be traded and in so doing more and more fees could be generated, but they also found that they could make trading profits from dealing in these securitized loans. And so banks began trading in securitized loans…otherwise called derivatives…and developing arbitrage strategies to take advantage of market discrepancies. But, to take advantage of market discrepancies they had to increase the amount of leverage they used so as to earn competitive returns.

Yet, the nature of banking did not change. Banking is a commodity business.

Not only is the business of borrowing money in the form of deposits and lending that money out to businesses and consumers in different kinds of loans a commodity business, the banks found that competition made all the products and services they offered into commodities as well. And, trading…well no one makes money over the longer haul on trading…because it, too, is composed of transactions in commodities.

Banks can earn a return on capital that is equal to what the capital can earn elsewhere given the normal risk a bank assumes. But, banks cannot mold themselves into institutions that can produce and sustain competitive advantages over other firms and industries. The business model they tried did not work. Yet, like other firms and other industries that come to believe in a business model that doesn’t work, their continued efforts to make the business model work only exacerbated the problem. Generally, this extra effort meant taking more and more risks and then even using extra-legal means to produce the results wanted.

I am not saying that banks committed fraud, but I have very serious concerns about the off-balance sheet practices along with other accounting efforts that the banks used in an attempt to generate the higher returns they felt they had to earn. However, the competitive pressure to perform does push people and organizations to walk the edge of ethical practices.

Citi…whatever…had a business model that did not work. And, this model was tested over about a decade…and it never worked. The investment community realized this and was only luke-warm about the company’s stock. Yet, management stuck with the model and tried all the tricks to make its business model work. They were true believers.

No one stood up, however, and mentioned that the emperor didn’t have on any clothes.

Banking is a commodity business. Citi…whatever…is said to be cutting back its organization by a third…and this is from the reduction in size that had already been achieved. They are supposedly getting back to fundamentals…into areas in which they have a core competency. Supposedly, its management has a better appreciation of the markets it will be working in. Let’s hope so.

And so the debt deflation goes on. The example of the banks…and of Citi-whatever…shows why it is so difficult to achieve a turnaround in the financial system and the economy during a time such as this. In the previous forty years or so, many companies, like Citi-whatever, took advantage of the almost continuous expansion of the economy and the government support of that expansion. Now the re-construction of these companies must take place.

The big question on the table right now concerns the stimulus plan being put together by President-elect Obama and his team. With companies…like Citi-whatever…drawing back and restructuring, how much effect can the stimulus plan have on the economy? The stimulus plan must not only attempt to reverse the economic down-term but must overcome the impact of the companies that are deleveraging their financial structure or are withdrawing from markets. The administration is shooting at a target that is moving away from it.

Trillions and Trillions

Carl Sagan only talked about “Billions and Billions” of heavenly bodies out there in the universe.

Barack Obama, President-elect, talks about “Trillions and Trillions.”

That’s Federal budget deficits, of course.

The Federal Government, according to the President-elect, is going to have to spend and spend and create these kinds of deficits if it is to side-track the economic downturn and put people back to work.

Paul Krugman, a supporter of this kind of spending, in his New York Times column on Monday, “Fighting Off Depression” (http://www.nytimes.com/2009/01/05/opinion/05krugman.html?em), makes the following statement: “This looks an awful lot like the beginning of a second Great Depression. So will we “act swiftly and boldly” enough to stop that from happening?”

Bush 43, during his reign, created more debt than all the administrations before him. So what is new in the Obama approach? Just size?

One of the things that is new is that the people coming into the Obama government believe in an active government and the ‘planned’ use of the budget to stimulate the economy. The Bush 43 team did not.

As I have said before, the Bush 43 team reminded me of the Nixon team that administered wage and price controls in the 1971-72 period. I remember very distinctly sitting in the room in the White House with George Schultz, Arthur Burns, Maury Stans, and others, watching these people administer wage and price controls with their noses turned up in disgust, doing the last thing in the world they believed in or wanted to do…control wages and prices.

This is the same feeling I got from Hank Paulson and Ben Bernanke…they really did not philosophically believe in what they were doing and really did not want to be doing what they were doing. And, as a consequence, they were not very good at it.

The general approach taken by Paulson and Bernanke in the financial crises was…throw “stuff” against the wall and see how much of it sticks. The important thing was to throw enough “stuff” at the problem so that enough will stick so as to defuse the crises. In performing in this way they did not look like they knew what they were doing…try this…no, try that…no, let’s do it this way…they were not disciplined…more is better…and they did not inspire much confidence.

Now we have a team coming into power that believes in the use of the fiscal tools they are going to inherit and they have confidence that they can use them in a productive way. This is the difference between the Obama team and the Bush 43 team. How the Obama team executes their plans is very important because both international and domestic financial markets need to have confidence in the United States administration, something they have not had for at least seven years.

The lack of confidence in the Bush 43 administration was exhibited in the relatively steady, six year decline in the value of the United States dollar, a decline in value of more than 40%. This lack of confidence grew out of the undisciplined way Bush 43 conducted the monetary and fiscal policies of the country. This lack of discipline in the Federal government set the tone for a growing lack of discipline in financial practices. International markets proved to be correct in that the whole financial structure built upon government, as well as private, debt and inflationary bubbles ultimately crashed.

To recover…confidence must be rebuilt!

This is why the appearance (and reality) of discipline is vital! Yes, the Obama team is proposing deficits that will be measured in the trillions. But, the spending and tax cuts that produce these large deficits must not be just throwing ‘stuff’ against the wall. There must be well thought out reasons for the expenditures and tax relief…there must be oversight and controls to accompany the programs…and there must be thought given to what is going to happen to all this spending and deficits once the corner is turned and the economy and the financial markets stabilize.

I know that this is asking a lot…yet, it was the lack of discipline that got us into the current situation…and, the only long term way to get us out of the current situation is to re-establish discipline over what is being done. If there is little or no discipline in what the Obama administration proposes…confidence will erode…and relatively quickly…and markets will continue to tank. Market support will only come from a belief in the commitment and execution of a believable plan.

The major parts of the Obama spending programs seem reasonable…build infrastructure, health care reform, education, and investment in new energy programs. Major emphasis on these things, however, is not “quick fix” solutions. They represent a commitment not only to government spending, but also to investments in the future that can build intellectual and social capital.

Economists have contended that government spending during the Great Depression never reached a level to really stimulate the economy until the spending connected with World War II came along. But, one of the benefits of the government spending during that war period was all of the innovations and new applications that resulted from the spending and ended up in new industries and further innovation in the post-war period that spurred on economic growth in the future. That is, the government spending did not just support the existing, out-of-date industrial structure of the 1930s (like our current car industry), but created the basis for a new structure, new jobs, and a new life.

There is still concern that the fiscal programs being proposed will have the desired effect on the economy and the financial markets. It has still not been proven that government spending can be substituted for private spending in order to create sustainable growth and permanent jobs. In has still not been proven that the world can absorb all of the government debt that is being created. It has still not been proven that the government can generate all of these deficits and not end up monetizing a large portion of them.

There is still a lot of uncertainty.

Financial markets want to believe in the Obama administration. Financial markets want to believe that the Obama team is competent. Financial markets want to believe that the economic package that is being constructed will work. Financial markets want to see discipline re-established.

However, the numbers are so large…

The Declining Dollar

The decline in the value of the dollar has gotten increasing headlines since the Federal Reserve Board of Governors released its new monetary policy efforts on Tuesday. Many short run reasons are being given for the recent decline in the value of the dollar, especially against the Euro and the Yen.

The most intriguing explanation for the decline, however, is a longer term reason. In this explanation, analysts argue that the decline in the value of the dollar is just a continuation of the trend which began in early 2002 and continued through until early August 2008.

The story that accompanies this explanation is that a series of events in 2001 and 2002 convinced international markets that the United States government had forfeited any discipline it had established over its fiscal and monetary policies. First, there was the huge Bush (43) tax cut that moved the government’s budget from one of surplus to one of deficit. This was followed by the war on terror and the Iraq invasion which exacerbated the amount of the budget deficit.

In addition to this the Greenspan Federal Reserve cut the target Federal Funds rate to very low levels, around 1% or so, for a period of about two years. Mr. Greenspan’s concern, apparently, was fear of an extended recession following the burst of the dot.com bubble in the stock market. The result was the creation of the housing bubble as well as smaller bubbles in other areas of the economy, including commodity prices.

As a consequence of these actions, massive amounts of debt were created. Fortunately for the United States…at the time…was that over 50% of this debt…both private and public debt…was financed outside of the United States…large amounts being placed in China, India, and the middle east…although as we found out…banks all over the world acquired huge quantities of mortgage-backed debt.

The interesting thing that was learned from this period is that consumer inflation (as measured by the Consumer Price Index) could be kept in check while inflation ran rapid in asset prices (particularly in housing prices and commodity prices at this time). The monetary authorities concentrated on consumer prices and did nothing with respect to asset prices.

The thing is that “self-reinforcing expectations” can get built into asset prices leading to a massive increase of financial leverage. Consumer credit can be expanded for purchases of the items individuals purchase, but this credit expansion cannot match the possibilities for increase that exist as asset prices go up substantially, year-after-year.

Foreign exchange rates capture the relative expectations of people that operate in these markets. The specific ‘relative expectations’ that are relevant here pertain to how market participants judge how the economies of different countries are expected to perform. Performance in this instance relates to the state of the economy, performance of government’s in terms of their conduct of their economic policies, and expected inflation.

In this respect, Paul Volcker, former Chairman of the Board of Governors of the Federal Reserve System, has stated that the price of a country’s currency is the most important price in its economy. The value of a country’s currency is, in a real sense, the “grade card” of the country’s economic and monetary policy, relative to the rest of the world.

Thus, as the value of the United States dollar fell more than 40% from early 2002 to August 2008, participants in international financial markets were indicating a belief that the government of the United States was showing little or no discipline over its budget and this was connected with an extremely “loose” monetary policy. To these market participants, the United States would have to “pay the piper”, sooner or later.

As the story continues, when the financial markets fell apart in September, the United States dollar became the “quality” asset in the world and investors flocked to the dollar as they repatriated assets from all over the globe in order to invest in U. S. Treasury securities. As a consequence of this rush to quality the value of the United States dollar rose.

This latter movement has apparently come to an end. There seems to be a number of short-run reasons for the recent decline in the value of the United States dollar…one of them being a move on the part of foreign investors to get back into their own currencies to dress up their year-end balance sheets.

But, there is another reason given for the drop in the value of the dollar and this is connected with the decisions of the Federal Reserve that were announced on Tuesday and the projected rise in the deficit of the federal government. For all intents and purposes, the target Federal Funds rate is now approximately zero. In addition, the Fed said that it would buy financial assets, long term U. S. Treasury issues and mortgage backed bonds and so forth in order to flood the financial markets with liquidity. And, they warned, they will continue to do this for as long as necessary…whatever “necessary” means. On top of this, the Obama team seems to be talking about adding roughly $1.0 trillion in expenditures to the federal budget to get the United States economy going again.

One can easily draw from this the assumption that the world will be flooded with dollars…millions and millions of dollars. How should one react to this in terms of the value of the dollar?

One could argue that this is exactly what world financial markets have been predicting would happen since early in 2002. (They did not, and could not, predict precisely the path of the collapse.) This is exactly the reason why the United States dollar has declined by about 40% since then!

The problem is that there are no “good” decisions left for the United States. This is the dilemma that must be faced when discipline in lost. When one sees the consequences of a lack of discipline, one does what one needs to do in order to get one’s life back in order. Getting discipline back into one’s life is a matter of one step at a time.

In terms of priorities…getting the economy going and avoiding a cumulative collapse is number one. Until this is accomplished, we may just have to see the value of the dollar continue to decline.

On Daming "Free" Markets!

Currently, there is a rush to jump on the bandwagon to damn the concept of free markets…or, at least “freer” markets. I say “freer” markets because the American economy has never had totally “free” markets. But, the current meltdown has coincided with the claim that “freer” markets don’t work!

We even see the sorry spectacle of Alan Greenspan appearing before Congress and admitting that he was “shocked” that the system didn’t work as he had imagined it would. The problem with this, in my mind, is that Alan Greenspan, in his responses, had to take one of two positions. The first one was to admit that his conceptual thinking about how financial markets and the economy worked was wrong. The second one was that he…and the Fed…and the Bush administration…screwed up royally.

Perhaps there was really only one response that Greenspan considered.

It is important to consider the second possible response, however, because it is important for our consideration of how we interpret the financial meltdown and the causes of this meltdown. How we interpret these events will influence our efforts to regulate or re-regulate the financial system.

Returning to the concept of “freer” markets one must argue that we can never achieve completely free markets, that there will always be laws, regulations, and regulators that impact financial and economic markets. The issue is where the balance is struck between more oversight and control and less oversight and control.

The danger is that if we totally focus on the idea that markets don’t work very well without a lot of regulation and oversight we will set the balance further to the side of constraining and controlling the economic and financial system. In my opinion, this would not be helpful, in the longer run, to the financial system and the health of the economy and economic growth.

Certainly, industry leaders cannot be absolved of all responsibility. It can be strongly argued that the past eight years or so did not produce a stellar performance by the leaders of finance and commerce in the United States. Risk management and executive oversight fell fall short of what should have been desired. But, this is not the entire story.

For economic and financial markets to function in an effective way they must be associated with “appropriate” monetary and fiscal policies. I have argued for a long time that the monetary and fiscal policies of the Bush administration have been abysmal and these policies created an environment that encouraged the behavior that was exhibited by our leaders of finance and commerce. (See my post of October 28, 2008, “The Threat of Too Much Regulation,” http://maseportfolio.blogspot.com/.)

My big fear is that, in a rush to judgment, all the blame will be placed upon the greed of the bankers and the fact that financial markets don’t work well if they don’t have a lot of regulation. If we re-regulate American finance and industry assuming this to be the only story, I fear that we will only be dampening our future and our children’s future.

Also, if we make this assumption about our bankers and the financial markets we will let Mr. Bush and Mr. Greenspan “off the hook”. Our governmental leaders are at least as guilty of the current financial morass as are our industry leaders…IF NOT MORE! If we are to re-regulate financial institutions and financial markets in a sensible and realistic way we cannot ignore the role that our government leaders played in the current crisis. WE MUST BE VERY CAREFUL NOT TO OVER-REGULATE!

The Threat Of Too Much Regulation

Once again, Tom Friedman of the New York Times has some very worthwhile things to say. Whereas one may not totally agree with all of his arguments, I believe that one can always gain something by reading him.

This past Sunday, Friedman commented upon the government bailout and the coming effort to re-regulate the financial markets: http://www.nytimes.com/2008/10/26/opinion/26friedman.html. He quotes the consultant David Smick: “Government bailouts and guarantees, while at times needed, always come with unintended consequences.” Then he goes on to say that he, Friedman, “is not criticizing the decision to shore up the banks…We need better regulation. But, most of all, we need better management.”

Friedman concludes, however, that “We must not overshoot in regulating the markets because they (the bankers) overshot in their risk-taking.”

This is all the further the argument is carried these days: they (the bankers) “overshot in their risk-taking.” There is very little discussion about how the environment was created in which this excessive risk-taking arose. Since almost all of the blame is falling on the bankers, it is to be expected that almost all the re-regulation will also fall on the bankers.

But, Friedman argues, “We must not overshoot in regulating the markets…” and rightfully so. We must not overshoot in regulating the markets because maybe…just maybe…the environment for excessive risk-taking was created by the government and not by the bankers. This is not a new argument, but it is one that tends to be forgotten while people focus primarily on the current turmoil that is swirling around them. It also tends to be forgotten because economic consequences tend to occur with a substantial lag behind the causative events that started everything off.

In looking for such a cause, I once again return to the failure of the current administration to combat the decline in the value of the United States dollar. The performance of a currency relative to other currencies depends upon market perceptions about future rates of inflation. If the inflation rate in the home country is expected to be more rapid than the inflation rates in other countries, the value of the home country’s currency will tend to decline. The value of the home country’s currency will tend to appreciate when the opposite is the case.

The value of the United States dollar began to decline in 2002 and continued to decline through August 2008. This decline followed about seven years in which the value of the United States dollar rose. So, it can be assumed that participants in foreign exchange markets came to believe that future inflation in the United States would exceed that in other countries, a reversal of the belief that had existed over the previous decade.

What seemed to be the cause of this change in expectations? The change seems to be very closely related to the Bush tax cuts, the consequent anticipation of substantial deficits in the Federal budget, and the acceleration in the costs associated with the war on terror and in Iraq. The deficits themselves are not considered to be inflationary, but in the western world, every major increase in government budget deficits were connected with a monetization of the debt at some time in the future. Given the size of the projected deficits it was expected that the United States government could not avoid monetizing a large portion of these anticipated deficits.

In the case of the United States, however, an unexpected path was taken. The large deficits of the United States government were underwritten by China, Middle-Eastern oil producing nations, and others. In effect, foreign governments monetized the Bush deficits taking the pressure off the Federal Reserve, even allowing the Fed to keep short term interest rates at extremely low levels for three-to-four years. This was something unheard of in terms of global economics.

And, where did a great deal of the funds connected with the monetized debt go? It went into the United States housing market. The history of financial innovation in the late twentieth century is a fascinating one. Of especial interest is the growth of the market for securitized mortgages. The first package of securitized mortgages came to market in the first half of the 1970s. By the middle of the 1980s, mortgage-related securities became the largest component of the capital markets. Playing in this end of the market became ‘sexier’ than any other. And, the attraction grew and grew and drew in more and more new players from around the world. The market for securitized mortgages became the playground for the world and attracted a large portion of the United States dollars now circulating around the globe.

Thus, through the market for securitized mortgages, the United States housing market became one of the bubbles that resulted from the ‘monetizing’ of the large deficits that were created by the United States government. The expected United States inflation came about through unusual channels, but the participants in the foreign exchange markets were correct in calling for the decline in the value of the United States dollar.

In my view, the speculative atmosphere that evolved in financial markets and financial institutions which resulted in excessive risk-taking was the result of the failure of policy makers to defend the value of the United States dollar. Most other countries in the world that created government deficits that were monetized had to back off from such policies as the value of their currencies declined on foreign exchange markets. This response was due to the resulting inflation in those countries. (France in the 1980s is a prime example.) These countries did not have others within the world like China and the countries of the Middle East, to absorb their debt the way that China and the Middle East purchased the United States debt.

The massive United States government deficits went global and in going global helped flood world financial markets with funds that narrowed interest rate spreads and created an environment where more and more risk had to be taken to keep institutional returns up. Financial leverage and other techniques of financial engineering became commonplace. The structure of the marketplace became more and more fragile.

The rest is history. But, now we have to deal with the aftermath. In my mind, the fault for the financial collapse does not lie solely with the bankers…a large share of blame should fall to the Government officials that created the environment in which the bankers had to operate. Yes, one can argue that the bankers took on excessive risk. But, one cannot let the Government officials off the hook. We cannot afford to over-regulate the financial markets because the government was irresponsible.

Yes, the financial markets need to be regulated but…who is going to regulate the regulators and the policymakers? Congress does not seem capable of it.

It seems to me that the regulators and the policy makers need some oversight but the only ones
that can ultimately provide that oversight are you and me…the voters. How can we, therefore, react in a timely manner against “bad policy” and bring about a change in direction? That, as always, remains the main question.

Forthcoming Regulatory Changes?

Reading the Wall Street Journal Saturday morning, I saw the headlines, “Bush Administration Rushes Regulatory Changes Before Time Is Up.” See http://online.wsj.com/article/SB122489005913868559.html?mod=todays_us_page_one.

My heartbeat accelerated. I started reading the first paragraph…”The Bush administration is hurrying to push through regulatory changes in politically sensitive areas such as endangered-species protection…WHAT!...health-care policy…Huh?...and other areas.”

The article stated that this is the rush to “cement new regulations” by pushing through “last-minute changes” intended to cement the legacy of the out-going President. These regulations are consistent with the philosophy of the current administration and are aimed toward stamping the imprint of the administration on Washington, D. C. before its turns out the lights on January 19, 2009.

Whoa! I thought we had a financial crisis…one brought on by insufficient regulation…a crisis that is now spreading deeper and deeper into the bowels of Main Street…and the world. What about the progress of the bailout of all the financial institutions of the country, the rescue of homeowners that are facing foreclosure, the plans being announced daily to lay off thousands of more workers, and the deepening recession? What about the financial world that is going to exist after the collapse of 2008 and the institutions and regulation that are going to define the “game” and its players in the future?

The problem is that when it comes to dealing with the financial crisis, this administration…the gang that couldn’t shoot straight…doesn’t have a consistent vision or philosophy to deal with the economic and financial situation. We saw this in the “breakdown” of former Fed Chairman Alan Greenspan in his appearance before Congress this past week. Greenspan commented that he was in “a state of shocked dis-belief”. Helicopter Ben…the current Fed Chairman…is tossing billions and billions of dollars out into the world! And, Treasury Secretary Paulson is running around trying this plan…and then changing the plan…and then changing the plan again…and then changing the plan again…

The problem is…no one is in charge…and no one has any idea what to do.

Need I say it again…the ‘decider’ has decided to take it on the lamb…the leader of the free world is no where to be seen.

Perhaps we should take some sage advice from Anna Schwartz who was the co-author with Nobel prize-winner Milton Freidman of “A Monetary History of the United States”. An interview with Ms. Schwartz appeared in the most recent issue of Barron’s, “Tearing Into the Fed and Treasury Plans” (October 27, 2008). I don’t agree with all Ms. Schwartz has to say, but here is some wisdom I think is very important for all of us to consider.

“The way you clear up problems in the credit market is through coming up with a clear, understandable plan and then executing it precisely.

My hope is that they will solve the problem by doing a bang-up job. But there’s already been talk about having to come back for more money. The risk of being unclear and doing things ad hoc is that you gradually destroy faith in the financial system…

…if we keep making things more uncertain, and feeding the fear without minimizing the problems, we could eventually make it so that Americans lose faith in their financial system.”

I just don’t see where the “clear, reasonable plan” is going to come from. Also, at the present time, I don’t see where the people are that are going to “execute the plan precisely.” And, with the economy falling deeper and deeper into a recession, a leader has not yet arisen that is providing us with the “philosophy and vision” we need to guide us through the recovery.

The scary thing coming out of the interview with Ms. Schwartz is the concern about a “loss of faith” and the “feeding of fear”. Where is the leader we need?