One of the truest thing ever said is that there are lies, damn lies, and then statistics. One shouldn't confuse statistics with underlying truths. It is easy to become obsessed by statistics, and lose sight of underlying truths.
The Gross Domestic Product (GDP) is a measure of economic activity. In essence it consists of adding up all expenditures for consumption, investment (without accounting for depreciation), government, and exports, and then subtracting imports. GDP, therefore, can be said to measure total national spending. If the government focuses on boosting GDP, then increasing any of these types of spending serves the policy. And when times are good, it may not seem to matter if $1,000,000 is spent investing in a chain of franchised hair salons, a small software company, or a machine tool shop.
However, not all economic activity is the same. That becomes clearer when times are tough. As the unemployment rate rises and the nation looks for ways to create jobs, the need for more hairstylists to give $100 haircuts is a lot lower than the need for skilled computer programmers to create ingenious new software or for skilled workers to operate the precision machine tools used to produce high quality equipment. Economic strength comes from having strong core industries that produce essential or important products. One can't build lasting wealth by processing documents for refinancing mortgages or underwriting asset securitizations. There have been many economically healthy times without refi transactions or a securitization market. But true economic strength is difficult to attain without robust industries that make tangible and valuable products.
That's why the government's bailouts of GM and Chrysler from bankruptcy make sense. Manufacturing motor vehicles not only employs a lot of people, it also uses a lot of technology. Modern cars and trucks require advanced materials; sheet steel isn't enough. They also contain a lot of computing power--dozens of tiny computers are built into today's cars and trucks to do everything from regulating the mixture of fuel and air going into the engine's cylinders to triggering the air bags to operating the GPS system. The days when a 17-year old kid could work on a car with a couple of screwdrivers and a set of socket wrenches are long gone. Thus, the auto industry supports a variety of sectors of the economy.
It also helps to preserve critical manufacturing skill sets. Only a small number of nations have skilled workers who can operate precision machine tools, the foundation of any advanced manufacturing industry. The machine tool industry makes the machines that make the cars, airplanes, and goods that we consume. If you've ever wondered how the HVAC system in your house was made, it was made by machines that were built by the machine tool industry. Without machine tools, we'd be back in the 18th century, relying on fireplaces and open windows. Machine tools also built the machines that built the tractors, harvesters and other equipment used by farmers. Food would be much more expensive and less abundant without machine tools.
The government will no doubt do some dumb and silly things with GM and Chrysler. There are fears that bureaucrats may end up deciding how many cars will be blue and how many will be red. Or how many models and options will be available. Surely, on a day-to-day, granular level, some of the taxpayers' money will be wasted. When that happens, the press will have a field day playing gotcha journalism, which will curb any bureaucratic inclinations toward micromanagement.
Government subsidies have been crucial in the nation's development. The settlement of the vast farmlands of the Midwest and West was facilitated by the Homestead Act and the government's subsidies to the railroads, which could cheaply ship goods to farmers and bring their harvests to the populous East. The Postal System's mail delivery contracts were crucial to the infant commercial airline industry in the 1920s and 1930s. The Interstate Highway system speeded up all economic activity. The Internet began as a Defense Department experiment, and has evolved into the biggest information revolution in history.
The auto industry historically led the way out of recessions. This time, things will be different. GM and Chrysler have shut down a number of plants and largely halted production for the next few months. They and their suppliers have laid of hundreds of thousands, and many more layoffs are likely by the end of the summer. Production, we hope, will then resume. But without the tens of billions dollars in government bailouts, GM and Chrysler would very likely be headed toward liquidation. In that case, which American industry would lead the way out of recession? There aren't many good candidates.
The government bailouts of GM and Chrysler aren't a sure bet. The taxpayers could be taken to the cleaners. But what's the alternative? A trip to the cleaners anyway for heightened recession, increased unemployment compensation and Medicaid costs, and ripple effect bankruptcies of suppliers and the unemployed. In some communities, the tertiary impact might even lead to municipal bankruptcies and unheated classrooms. Trillions of dollars of federal bailout money has been expended to stabilize the banks. Bank stocks are doing better, and refi activity is up. But you can't build a strong economy just by refinancing mortgages, even if the increased spending from refi increases GDP on a statistical level. We took that approach recently, in the early 2000s, and things didn't turn out so well.
The financial system cannot become truly healthy, and the economy cannot truly recover, until the real economy revives. That's why the GM and Chrysler bailouts, as distasteful and risky as they may be, are sound government policy.
Sunday, May 31, 2009
Monday, May 25, 2009
Central Banking's Last Hurrah?
The current system of central banking, which has been in place for approximately the last century, is on the cusp of establishing its worth, or spectacularly failing. Central banks, in the U.S. and elsewhere, usually succeed in stabilizing the financial system during moderate downturns. But they have never successfully rescued an economy from a severe downturn. The Great Depression ended only because of the enormous boost in government spending required by World War II. Severe downturns in the Third World, which have been common in the postwar era, have usually been resolved with the assistance of external sources of funding such as the IMF and aid from First World nations. The one severe downturn in the U.S. in the postwar era before our current times was the stagnation of the 1970s. The weight of opinion today is that the Federal Reserve did a poor job in the 1970s, allowing inflation to skyrocket while the economy stagnated. Only after a new Chairman, Paul Volcker, was installed did the Fed bite the bullet and do the right thing, quelling inflation even though the cost was a severe recession in 1981-82. It helped that the price of oil fell to $10 a barrel by the mid-1980s, with gasoline sometimes available for less than $1 a gallon.
Because the U.S. was by far the largest economy in the world in the 1970s, there was no external source of funding or aid to help pull it out of the 1970s downturn. The nation had to work its way out of the mess, slowly and painfully. Even though Chairman Volcker, in the end, saved the day, U.S. central banking deserves a C- for its performance that decade. Of course, that's better than the F it deserves for its performance in the 1930s.
As in the 1970s, today there is no external source of funding or aid that can help the U.S. Indeed, the IMF is seeking more capital from the United States and other industrialized nations to help stabilize Eastern Europe and other small nations experiencing major downturns. So America, and the Federal Reserve, will have to go it alone.
The Fed's principal tactic has been to print money. There are an ever increasing number of alphabet soup programs through which the Fed has operated its printing press: TALF, TAF, TSLF, AMLF, PDCF, loans to the FDIC, purchases of U.S. Treasury securities, etc., etc. But when you get past the technical details, these programs consist of dispensing "money" that the Fed creates simply by making appropriate computer entries in the banking system's records. The Fed's printing press has increasingly become the source of credit in the U.S. for individuals, businesses, and the federal government.
All this liquidity is having an impact. The economy seems to be declining less quickly, oil (and gasoline) prices are rising briskly, stock values have bounced up, and the dollar is shrinking. As was the case for the last decade, Fed easy money policies are triggering asset inflation. It happened in the 1990s, when Alan Greenspan's mistaken belief in a paradigm shift rationalized low interest rates that bubbled up tech stock prices, followed by a collapse from which the stock market has yet to recover. It happened in the 2001-2005 era, when easy money created the now notorious real estate boom and bust, with which we still struggle. It happened again in 2007-08, when Fed easy money intended to prop up the banking industry and real estate market instead caused a bubble in oil prices that broke the back of America's auto companies. (Think about it: if oil prices in 2008 had stayed around $60 a barrel and gas around $2.50 a gallon, American car companies would be having a tough time today but wouldn't be in or on the verge of bankruptcy.) Now, with the economy headed for 10% unemployment and the worst drop in GDP since the 1930s, the Fed is running the printing press day and night, and some asset values are starting to bubble again. One doesn't like to think of the central bank as a one trick dog, but . . .
If all this works, Ben Bernanke and his colleagues will be heroes. But no government program that consists primarily of printing money has ever before salvaged a sinking economy. In World War II, the massive military budget was funded by borrowing (recall the war bond drives) and tax hikes. To prevent inflation, there were price controls and strict rationing of civilian access to food, fuel and various other essentials. No new cars were made for the civilian market from the beginning of 1942 until the end of the war. The nation paid its way to victory and economic recovery; it didn't debase its currency. While it's true that massive government spending did pull the U.S. out of the Great Depression, the nation did so with real money.
Right wingers who stockpile food, water and ammo foam at the mouth about fiat money (i.e., paper money issued by a government) and the temptation of debasement it poses to governments. Most of the time, their concerns are misplaced because central banks learned from the experiences of 1920s Germany, 20th Century Latin America, and various other economic disasters that printing money provides only false, short lived hope. The Fed hopes that its flood of liquidity will stimulate the economy, and intends to withdraw the liquidity soon thereafter to prevent inflation and panic. But withdrawal of the liquidity could cause the economy to turn downward again, a la 1937-38, when FDR's administration did something comparable.
The Fed is on a road no central bank has successfully driven down, and the way is foggy. Congress is no help because its sound bite-driven histrionics preclude further government stimulus programs (which would have to be funded mostly by borrowing because Americans no longer believe in paying their way). There is a chance that the Fed could pull this off. The hard part will be withdrawing the liquidity as the economy rebounds. Some pain would be inevitable and the ensuing political outcry might sway the central bank to give the wino a few more bucks.
If the Fed fails, central banking as we know it will have to change. The Fed's poor oversight of the risk levels taken by the banking industry allowed the current crisis to develop. If the Fed can allow a disaster to arise and then not fix it, the Fed has to change. Its ability to print money would have to be substantially limited. We'll need much stricter risk management for the banking system, similar to the Canadian system. Perhaps the derivatives market will have to be separated from the core banking system and made the province of parties having an underlying economic need for the contracts, trading with counterparties that aren't affiliated with banks. These measures will probably reduce America's potential for growth. But they would also reduce America's potential for losses. With the stock market having attained no net gains for the last ten or eleven years (longer if one takes account of inflation), and numerous 401(k) accounts now devastated, reducing the potential for loss would be no small achievement.
Because the U.S. was by far the largest economy in the world in the 1970s, there was no external source of funding or aid to help pull it out of the 1970s downturn. The nation had to work its way out of the mess, slowly and painfully. Even though Chairman Volcker, in the end, saved the day, U.S. central banking deserves a C- for its performance that decade. Of course, that's better than the F it deserves for its performance in the 1930s.
As in the 1970s, today there is no external source of funding or aid that can help the U.S. Indeed, the IMF is seeking more capital from the United States and other industrialized nations to help stabilize Eastern Europe and other small nations experiencing major downturns. So America, and the Federal Reserve, will have to go it alone.
The Fed's principal tactic has been to print money. There are an ever increasing number of alphabet soup programs through which the Fed has operated its printing press: TALF, TAF, TSLF, AMLF, PDCF, loans to the FDIC, purchases of U.S. Treasury securities, etc., etc. But when you get past the technical details, these programs consist of dispensing "money" that the Fed creates simply by making appropriate computer entries in the banking system's records. The Fed's printing press has increasingly become the source of credit in the U.S. for individuals, businesses, and the federal government.
All this liquidity is having an impact. The economy seems to be declining less quickly, oil (and gasoline) prices are rising briskly, stock values have bounced up, and the dollar is shrinking. As was the case for the last decade, Fed easy money policies are triggering asset inflation. It happened in the 1990s, when Alan Greenspan's mistaken belief in a paradigm shift rationalized low interest rates that bubbled up tech stock prices, followed by a collapse from which the stock market has yet to recover. It happened in the 2001-2005 era, when easy money created the now notorious real estate boom and bust, with which we still struggle. It happened again in 2007-08, when Fed easy money intended to prop up the banking industry and real estate market instead caused a bubble in oil prices that broke the back of America's auto companies. (Think about it: if oil prices in 2008 had stayed around $60 a barrel and gas around $2.50 a gallon, American car companies would be having a tough time today but wouldn't be in or on the verge of bankruptcy.) Now, with the economy headed for 10% unemployment and the worst drop in GDP since the 1930s, the Fed is running the printing press day and night, and some asset values are starting to bubble again. One doesn't like to think of the central bank as a one trick dog, but . . .
If all this works, Ben Bernanke and his colleagues will be heroes. But no government program that consists primarily of printing money has ever before salvaged a sinking economy. In World War II, the massive military budget was funded by borrowing (recall the war bond drives) and tax hikes. To prevent inflation, there were price controls and strict rationing of civilian access to food, fuel and various other essentials. No new cars were made for the civilian market from the beginning of 1942 until the end of the war. The nation paid its way to victory and economic recovery; it didn't debase its currency. While it's true that massive government spending did pull the U.S. out of the Great Depression, the nation did so with real money.
Right wingers who stockpile food, water and ammo foam at the mouth about fiat money (i.e., paper money issued by a government) and the temptation of debasement it poses to governments. Most of the time, their concerns are misplaced because central banks learned from the experiences of 1920s Germany, 20th Century Latin America, and various other economic disasters that printing money provides only false, short lived hope. The Fed hopes that its flood of liquidity will stimulate the economy, and intends to withdraw the liquidity soon thereafter to prevent inflation and panic. But withdrawal of the liquidity could cause the economy to turn downward again, a la 1937-38, when FDR's administration did something comparable.
The Fed is on a road no central bank has successfully driven down, and the way is foggy. Congress is no help because its sound bite-driven histrionics preclude further government stimulus programs (which would have to be funded mostly by borrowing because Americans no longer believe in paying their way). There is a chance that the Fed could pull this off. The hard part will be withdrawing the liquidity as the economy rebounds. Some pain would be inevitable and the ensuing political outcry might sway the central bank to give the wino a few more bucks.
If the Fed fails, central banking as we know it will have to change. The Fed's poor oversight of the risk levels taken by the banking industry allowed the current crisis to develop. If the Fed can allow a disaster to arise and then not fix it, the Fed has to change. Its ability to print money would have to be substantially limited. We'll need much stricter risk management for the banking system, similar to the Canadian system. Perhaps the derivatives market will have to be separated from the core banking system and made the province of parties having an underlying economic need for the contracts, trading with counterparties that aren't affiliated with banks. These measures will probably reduce America's potential for growth. But they would also reduce America's potential for losses. With the stock market having attained no net gains for the last ten or eleven years (longer if one takes account of inflation), and numerous 401(k) accounts now devastated, reducing the potential for loss would be no small achievement.
Wednesday, May 20, 2009
The Stock Market: Sell in May and Go Away?
Now they tell us. While a couple of Federal Reserve governors have recently talked about green shoots in the economy and the like, the Fed staff predicted in April that the economy would get worse than expected earlier this year. It's not as bad as W and the WMDs in Iraq, but you'd think that by now senior federal officials would realize it's not a good idea to say one thing when their staff are saying something contrary. After the release of this information, the Dow Jones Industrial Average abruptly dropped about 100 points, from around up 50 to close down 52.
Now that all of us with market exposure have lost some money, the question is what to do. Those with rose tinted glasses would say we just got a buying opportunity. However, there's an old adage in the stock markets: sell in May and go away. It refers to the fact that the market often is flat to negative during the summer months. September can be volatile (either upwards or downwards). October has the deserved reputation as the worst month--not every or even most years. But almost all the big drops since 1929 have occurred in October. No one knows why (and anyone who claims to know is a liar, a fool or both).
Having said all that, there's no way to predict the current market. Stock values right now pretty much depend on governmental policy--the more government intervention, the higher the market goes. That's why the market rose from March 6 through a couple of weeks ago: the federal government fired up a bunch of programs and the Treasury Dept. and the Fed did so-called "stress tests" of the 19 largest banks. There's no major governmental action in the offing, although some of the federal government's programs will probably intensify in the next six months. The underlying economy is in bad shape and getting worse. Some people think it's getting worse at a slower rate than three months ago, and take heart from that. But getting worse is still getting worse. The credit markets are thawing slightly, but only because the federal government has de facto guaranteed the liabilities of the major banks (which comes very close to nationalizing them, although no one in government wants to admit to that). In short, the U.S. economy and the world economy are in bad shape, with no clear sign of recovery any time soon.
The federal government, for all its programs, still hasn't solved the two baseline problems in the financial system--an extremely ill housing market and trillions of dollars of unbooked losses lingering on the books of the banking system. There is no real cure for these problems that's politically feasible (California's voters just rebelled over a state deficit of some tens of billions of dollars, so there's no way America's taxpayers will pony up the trillions needed to cure these baseline problems).
If you invest now, you might be ahead six or twelve months from now. But no responsible adviser would give you assurances about that. You might also be sitting on top of serious losses (especially if the world economy keeps sliding the way it has so far this year). You should be prepared to wait at least ten years for meaningful returns (net of inflation). One way of looking at things is that you could invest today in U.S. Treasury ten-year notes and get about 3.2% (after commissions) per annum for 10 years. Will the stock market return more than 3.2% per annum for the next ten years? Unclear. It's lost close to that much per year during the preceding ten years. Perhaps after ten years, the market will have had a decent chance to show meaningful gains above 3.2% per annum (although we wouldn't predict that). But if you might need the money some time sooner than ten years, you should think about keeping it out of the market and putting it in something safe like U.S. Treasuries. It could take 20-25 years for the stock market to recover, net of inflation, from the current mess. The last time something like this happened, in the early 1970s, the market didn't recover, net of inflation, until about 1991. And the market didn't recover from the 1929-1932 crash until the mid-1950s.
Some people are predicting the Dow could drop to 4,000. While that may seem far fetched, can it be ruled it out? What's already happened is no more far fetched. If you can't stomach the possibility of serious losses on money you invest today, stay out of the market. It's easy to regret the gains you could have had if you had a little more nerve, but it's really hard to recover from the losses you didn't expect. The best financial planning today is to spend less and save more. That generates an immediate increase in your wealth.
Now that all of us with market exposure have lost some money, the question is what to do. Those with rose tinted glasses would say we just got a buying opportunity. However, there's an old adage in the stock markets: sell in May and go away. It refers to the fact that the market often is flat to negative during the summer months. September can be volatile (either upwards or downwards). October has the deserved reputation as the worst month--not every or even most years. But almost all the big drops since 1929 have occurred in October. No one knows why (and anyone who claims to know is a liar, a fool or both).
Having said all that, there's no way to predict the current market. Stock values right now pretty much depend on governmental policy--the more government intervention, the higher the market goes. That's why the market rose from March 6 through a couple of weeks ago: the federal government fired up a bunch of programs and the Treasury Dept. and the Fed did so-called "stress tests" of the 19 largest banks. There's no major governmental action in the offing, although some of the federal government's programs will probably intensify in the next six months. The underlying economy is in bad shape and getting worse. Some people think it's getting worse at a slower rate than three months ago, and take heart from that. But getting worse is still getting worse. The credit markets are thawing slightly, but only because the federal government has de facto guaranteed the liabilities of the major banks (which comes very close to nationalizing them, although no one in government wants to admit to that). In short, the U.S. economy and the world economy are in bad shape, with no clear sign of recovery any time soon.
The federal government, for all its programs, still hasn't solved the two baseline problems in the financial system--an extremely ill housing market and trillions of dollars of unbooked losses lingering on the books of the banking system. There is no real cure for these problems that's politically feasible (California's voters just rebelled over a state deficit of some tens of billions of dollars, so there's no way America's taxpayers will pony up the trillions needed to cure these baseline problems).
If you invest now, you might be ahead six or twelve months from now. But no responsible adviser would give you assurances about that. You might also be sitting on top of serious losses (especially if the world economy keeps sliding the way it has so far this year). You should be prepared to wait at least ten years for meaningful returns (net of inflation). One way of looking at things is that you could invest today in U.S. Treasury ten-year notes and get about 3.2% (after commissions) per annum for 10 years. Will the stock market return more than 3.2% per annum for the next ten years? Unclear. It's lost close to that much per year during the preceding ten years. Perhaps after ten years, the market will have had a decent chance to show meaningful gains above 3.2% per annum (although we wouldn't predict that). But if you might need the money some time sooner than ten years, you should think about keeping it out of the market and putting it in something safe like U.S. Treasuries. It could take 20-25 years for the stock market to recover, net of inflation, from the current mess. The last time something like this happened, in the early 1970s, the market didn't recover, net of inflation, until about 1991. And the market didn't recover from the 1929-1932 crash until the mid-1950s.
Some people are predicting the Dow could drop to 4,000. While that may seem far fetched, can it be ruled it out? What's already happened is no more far fetched. If you can't stomach the possibility of serious losses on money you invest today, stay out of the market. It's easy to regret the gains you could have had if you had a little more nerve, but it's really hard to recover from the losses you didn't expect. The best financial planning today is to spend less and save more. That generates an immediate increase in your wealth.
Sunday, May 17, 2009
How About a Tax on Derivatives Transactions?
Last week, the administration made its proposal for reforming the derivatives market. A lot of it was old news. For standardized derivatives, the settlement and clearance process would be improved, and regulatory oversight of derivatives dealers would be increased. The latter measure would mostly affect hedge funds, since broker-dealers that transact in derivatives are already heavily regulated.
Largely left out of regulatory purview are so-called customized derivatives contracts. These, by definition, are not standardized. Establishing regulatory regimes for them would be harder because they come in a variety of sizes and shapes. However, they may prove to be extremely important. After all, the derivatives contracts that have been so problematic in the last two years—collateralized debt obligations and credit default swaps—were customized (although there has been a recent trend toward standardization). The fact is that customized contracts may cause no end of problems. Regulators have said they intend to impose tough margin requirements and strong risk management measures to deal with the problems presented by customized derivatives. Okay, we’ll stipulate to that. But should more be done?
A flaw in the derivatives market, especially the customized derivatives market, is that the cost of excess and recklessness has largely been borne by the U.S. taxpayer. When Bear Stearns, AIG and other Wall Street firms were on the verge of the abyss because of their derivatives losses, the taxpayers stepped forward (or rather were pushed forward by the Bush administration) into the line of fire and absorbed the losses that would otherwise have fallen on the creditors of these firms. Of course, we’re all grateful to be able to take a bullet for Wall Street. But economists would say that a large part of the cost of undesirable behavior in the derivatives market has been externalized by the willingness of the government to foist the cost on taxpayers. When costs are externalized like this, private interests will leap to take advantage of the favorable asymmetry and the economy’s resources will be misallocated in ever-increasing proportion until yet another bubble bursts. Too much capital will flow into the derivatives market, and too little into, say, investments in manufacturing, environmental protection, repair of our highways and bridges, and educational opportunity.
What happens in the absence of a bailout? Look at the high tech bubble of the late 1990s, which burst in 2000-2002. That bubble created the all-time high valuation for the stock market, which has never fully recovered. There were no taxpayer bailouts of investors in high tech companies, and the tech sector has been much more rational since then. Tech companies no longer go public simply on the promise that some day they might have revenues and perhaps even earnings. Tech investors have learned, of all things, that they need to be sensible about what they put their money into.
Because of the central role of the financial system in our economy, there’s no way to get the taxpayer off the hook for banking bailouts. More manic depressive behavior from the financial services sector, at taxpayers’ expense, is surely in our future. So, why not impose a tax on derivatives transactions? It would, in an approximate way, compensate taxpayers for at least some of the burdens they bear. It would moderate the imbalance between risk and reward that taxpayer guarantee of derivatives transactions has created. It might indeed slow down the activity in this market, but consider whether taxpayer subsidized financial mania shouldn’t be discouraged. A tax on, say, the market price of derivatives transactions, would, in plain English, be abundantly fair considering what an incredible pain in the arse the derivatives industry has been.
Of course, many on Wall Street would be horrified at the notion of such a tax. They would argue that it would impede innovation and burden a market that’s important to reviving the economy. But these arguments are like saying that a sales tax shouldn’t be imposed on purchases of the iPhone or flat screen TVs. There's plenty of innovation in crucial industries subject to sales taxes.
The government already imposes a tax on stock trades. In addition, companies offering stock and other securities to the public pay registration fees to the SEC (which forwards them to the U.S. Treasury; the agency doesn't keep them). There’s, in effect, a tax on deposits you make in your bank account (federal deposit insurance premiums effectively reduce the interest rates that a bank could otherwise pay customers). With the federal deficit ballooning by the day and Wall Street's losses the biggest single reason for the bloat, some revenue from a derivatives tax would be just thing to make the world a little better for the taxpaying public.
Largely left out of regulatory purview are so-called customized derivatives contracts. These, by definition, are not standardized. Establishing regulatory regimes for them would be harder because they come in a variety of sizes and shapes. However, they may prove to be extremely important. After all, the derivatives contracts that have been so problematic in the last two years—collateralized debt obligations and credit default swaps—were customized (although there has been a recent trend toward standardization). The fact is that customized contracts may cause no end of problems. Regulators have said they intend to impose tough margin requirements and strong risk management measures to deal with the problems presented by customized derivatives. Okay, we’ll stipulate to that. But should more be done?
A flaw in the derivatives market, especially the customized derivatives market, is that the cost of excess and recklessness has largely been borne by the U.S. taxpayer. When Bear Stearns, AIG and other Wall Street firms were on the verge of the abyss because of their derivatives losses, the taxpayers stepped forward (or rather were pushed forward by the Bush administration) into the line of fire and absorbed the losses that would otherwise have fallen on the creditors of these firms. Of course, we’re all grateful to be able to take a bullet for Wall Street. But economists would say that a large part of the cost of undesirable behavior in the derivatives market has been externalized by the willingness of the government to foist the cost on taxpayers. When costs are externalized like this, private interests will leap to take advantage of the favorable asymmetry and the economy’s resources will be misallocated in ever-increasing proportion until yet another bubble bursts. Too much capital will flow into the derivatives market, and too little into, say, investments in manufacturing, environmental protection, repair of our highways and bridges, and educational opportunity.
What happens in the absence of a bailout? Look at the high tech bubble of the late 1990s, which burst in 2000-2002. That bubble created the all-time high valuation for the stock market, which has never fully recovered. There were no taxpayer bailouts of investors in high tech companies, and the tech sector has been much more rational since then. Tech companies no longer go public simply on the promise that some day they might have revenues and perhaps even earnings. Tech investors have learned, of all things, that they need to be sensible about what they put their money into.
Because of the central role of the financial system in our economy, there’s no way to get the taxpayer off the hook for banking bailouts. More manic depressive behavior from the financial services sector, at taxpayers’ expense, is surely in our future. So, why not impose a tax on derivatives transactions? It would, in an approximate way, compensate taxpayers for at least some of the burdens they bear. It would moderate the imbalance between risk and reward that taxpayer guarantee of derivatives transactions has created. It might indeed slow down the activity in this market, but consider whether taxpayer subsidized financial mania shouldn’t be discouraged. A tax on, say, the market price of derivatives transactions, would, in plain English, be abundantly fair considering what an incredible pain in the arse the derivatives industry has been.
Of course, many on Wall Street would be horrified at the notion of such a tax. They would argue that it would impede innovation and burden a market that’s important to reviving the economy. But these arguments are like saying that a sales tax shouldn’t be imposed on purchases of the iPhone or flat screen TVs. There's plenty of innovation in crucial industries subject to sales taxes.
The government already imposes a tax on stock trades. In addition, companies offering stock and other securities to the public pay registration fees to the SEC (which forwards them to the U.S. Treasury; the agency doesn't keep them). There’s, in effect, a tax on deposits you make in your bank account (federal deposit insurance premiums effectively reduce the interest rates that a bank could otherwise pay customers). With the federal deficit ballooning by the day and Wall Street's losses the biggest single reason for the bloat, some revenue from a derivatives tax would be just thing to make the world a little better for the taxpaying public.
Sunday, May 10, 2009
The Hard Part of the Stress Tests Now Begins
Like so many other staged events in Washington, the bank stress tests results looked good when first announced. The numbers were less alarming than some of the worst case thinking. Bank stocks, which have led the two-month rally, helped to lift the market to yet another positive week.
Then, the press hounds began sniffing around. Ever since Richard Nixon declared he wasn’t a crook, the Washington press corps has made hay by taking the shine off government pronouncements. Now we learn from the Wall Street Journal (on Saturday 5/9/09) that the Federal Reserve’s initial conclusions from the stress tests were considerably more negative than the announced results. At least several banks were asked to raise more capital than their final quotas. Citigroup reportedly was told it needed an additional $35 billion, a number that shrank to $5.5 billion by the time it was made public. Bank of America’s number was supposedly more than $50 billion at first, although jawboning reduced it to $33.9 billion. All told, it would seem that the banks talked the Fed down more than a total of $50 billion in additional capital.
Those banks asked to raise more capital need to come up with a total of $74.6 billion. That figure would have been over $125 billion if the Fed hadn’t improved its grading. But what the hell. This is America, the land of grade inflation where students’ basic math and grammar skills are declining even as everyone is placed on the honor roll.
The stress test are just talk--talk therapy, at best. So far, not a penny of additional capital has been infused. Not a dollar's worth of toxic assets has been transferred. Not a single penny of additional loans has been made. We're supposed to feel better because the government told us that we should feel better. If this really worked, Bernanke and Paulson could have simply appeared on a few Sunday morning talk shows and by their mere words lifted the economy from the doldrums.
As things stand, the less healthy banks will have to raise almost $75 billion in the next six months. That’s a lot of capital, considering how crippled the financial services industry is. Recently, the U.S. government had a little trouble with a $14 billion 30-year bond auction, with rates going higher than expected. If the best borrower in the world is hitting potholes in the money markets, think about the problems banks on the dole might face. They’d have to price their stock very cheaply in order to attract investors. That would dilute existing shares and push secondary market prices down. And if they sold preferred stock to raise capital, the downward pressure on common shares would be comparable. The preferred stock would have to pay an appealing dividend to attract investors; and that would take earnings away from common shareholders. Just as bank stocks have led the market’s two-month rally, dilution of their shares could cap and even reverse the rally.
Another problem is that interest rates are at historic lows. If, as Fed Chairman Ben Bernanke predicted this past week, the economy begins to recover late this year, the Fed will have to start raising interest rates and withdraw some of the trillions of dollars of liquidity it has flung at the credit markets in the last year or so, lest it run the risk of serious inflation. Banks would find their profit margins shrinking. The stress tests made certain assumptions about banks' future earnings (which, if in fact attained, could be added to the capital buffer needed by the banks). Rising interest rates would probably decrease those future earnings, thus undermining the assumptions.
With the real economy still in decline, banks will want to horde their capital in order to stay within stress test projections. That would mean they won’t err in favor of increased lending. The stagnation in the larger economy, with its rising unemployment, increased mortgage and credit card defaults, and rising numbers of bankruptcies, would likely continue. Although there are signs that the rate of the economy's decline is slowing, banks continue to tighten credit standards in an effort to save themselves ahead of anyone else. It's one thing to stop an economic decline and another thing to instigate a recovery. The recovery doesn't necessarily follow from the end of the decline (see Japan).
The stress testing process may have encouraged banks to take advantage of recently relaxed accounting standards for the toxic assets that have so badly bedeviled them. They may have booked high values for these assets and chosen to keep them on their books instead selling them to the government’s PPIP program. As long as banks’ balance sheets remain toxic, the banking industry cannot truly recover, and neither can the economy. Thus, the stress testing process may delay or even preclude a true cleanup and recovery for the banks and the nation. One wonders whether the FASB’s relaxation of accounting rules made it easy for the Fed to justify lower capital requirements. If so, the Fed may be papering over the problems.
Then, the press hounds began sniffing around. Ever since Richard Nixon declared he wasn’t a crook, the Washington press corps has made hay by taking the shine off government pronouncements. Now we learn from the Wall Street Journal (on Saturday 5/9/09) that the Federal Reserve’s initial conclusions from the stress tests were considerably more negative than the announced results. At least several banks were asked to raise more capital than their final quotas. Citigroup reportedly was told it needed an additional $35 billion, a number that shrank to $5.5 billion by the time it was made public. Bank of America’s number was supposedly more than $50 billion at first, although jawboning reduced it to $33.9 billion. All told, it would seem that the banks talked the Fed down more than a total of $50 billion in additional capital.
Those banks asked to raise more capital need to come up with a total of $74.6 billion. That figure would have been over $125 billion if the Fed hadn’t improved its grading. But what the hell. This is America, the land of grade inflation where students’ basic math and grammar skills are declining even as everyone is placed on the honor roll.
The stress test are just talk--talk therapy, at best. So far, not a penny of additional capital has been infused. Not a dollar's worth of toxic assets has been transferred. Not a single penny of additional loans has been made. We're supposed to feel better because the government told us that we should feel better. If this really worked, Bernanke and Paulson could have simply appeared on a few Sunday morning talk shows and by their mere words lifted the economy from the doldrums.
As things stand, the less healthy banks will have to raise almost $75 billion in the next six months. That’s a lot of capital, considering how crippled the financial services industry is. Recently, the U.S. government had a little trouble with a $14 billion 30-year bond auction, with rates going higher than expected. If the best borrower in the world is hitting potholes in the money markets, think about the problems banks on the dole might face. They’d have to price their stock very cheaply in order to attract investors. That would dilute existing shares and push secondary market prices down. And if they sold preferred stock to raise capital, the downward pressure on common shares would be comparable. The preferred stock would have to pay an appealing dividend to attract investors; and that would take earnings away from common shareholders. Just as bank stocks have led the market’s two-month rally, dilution of their shares could cap and even reverse the rally.
Another problem is that interest rates are at historic lows. If, as Fed Chairman Ben Bernanke predicted this past week, the economy begins to recover late this year, the Fed will have to start raising interest rates and withdraw some of the trillions of dollars of liquidity it has flung at the credit markets in the last year or so, lest it run the risk of serious inflation. Banks would find their profit margins shrinking. The stress tests made certain assumptions about banks' future earnings (which, if in fact attained, could be added to the capital buffer needed by the banks). Rising interest rates would probably decrease those future earnings, thus undermining the assumptions.
With the real economy still in decline, banks will want to horde their capital in order to stay within stress test projections. That would mean they won’t err in favor of increased lending. The stagnation in the larger economy, with its rising unemployment, increased mortgage and credit card defaults, and rising numbers of bankruptcies, would likely continue. Although there are signs that the rate of the economy's decline is slowing, banks continue to tighten credit standards in an effort to save themselves ahead of anyone else. It's one thing to stop an economic decline and another thing to instigate a recovery. The recovery doesn't necessarily follow from the end of the decline (see Japan).
The stress testing process may have encouraged banks to take advantage of recently relaxed accounting standards for the toxic assets that have so badly bedeviled them. They may have booked high values for these assets and chosen to keep them on their books instead selling them to the government’s PPIP program. As long as banks’ balance sheets remain toxic, the banking industry cannot truly recover, and neither can the economy. Thus, the stress testing process may delay or even preclude a true cleanup and recovery for the banks and the nation. One wonders whether the FASB’s relaxation of accounting rules made it easy for the Fed to justify lower capital requirements. If so, the Fed may be papering over the problems.
Sunday, May 3, 2009
The Chrysler Bankruptcy: Creditors Hit the Wall
Secured creditors, the most favored class in finance, were probably glad to have this weekend to catch their breath after the Chrysler bankruptcy filing. They went eyeball to eyeball with the Obama administration in the Chrysler bailout negotiations, and didn't get what they wanted. Apparently, a large portion of Chrysler's secured debt was held by hedge funds and speculators of similar ilk that bought their holdings for pennies on the dollar and were hoping to extract more pennies from the government as part of a non-bankruptcy bailout. Faced again with the specter of Wall Street profiteering at the expense of middle class taxpayers, the Obama administration bargained hard for concessions. The secured debt holders played a classic game of Wall Street brinksmanship, and the company went over the brink into bankruptcy court.
The secured debt holders probably guessed that after the Lehman bankruptcy, where the Bush administration tried to impose discipline on creditors and wound up bailing out AIG's creditors dollar for dollar, the government would flinch whenever debt holders stood firm. But they may have failed to look objectively at political reality. The American taxpayer is fed up with bailouts for the wealthy, and the Obama administration may recognize that there is a limit to the government's borrowing and printing of money. Even though the U.S. government can run a marathon of a deficit, sooner or later it will hit the wall. And it did with the Chrysler situation.
The creditors are now stuck slugging it out in bankruptcy court, where they would have been if the government hadn't been around for them to try to game. Faced with having to rest on their legal rights, they may succeed to asserting their liens on Chrysler's assets. But so what? Who will buy those assets? There is only one ready buyer who will pay anything approaching a semi-passable price, and that's Fiat supported by the U.S. government. Those are the same players that the creditors just failed to game. With the auto market shrinking dramatically, Chrysler's factories and manufacturing equipment are basically surplus capacity. Few investors will buy production equipment that makes products with no market. The secured creditors won't realize much more than scrap value if they try to auction off Chrysler's hard assets piecemeal. The only significant value in this bankrupt's estate lies in selling some portion of Chrysler as a going concern, with the tradenames that for decades have meant something to Americans. So the secured creditors will probably find themselves again staring at the U.S. government and Fiat as the only buyers willing to pay anything substantial for Chrysler's assets. Do they think they'll see much improvement in the price offered?
By taking creditors off the pedestal that the Bush administration put them on with the AIG bailout, the Obama administration has done well for taxpayers. The GM bailout remains on the negotiating table, and the lines in the sand are now clearer. A resolution with GM's creditors may now be easier. Even more importantly, creditors of large financial institutions must now be furrowing their brows over the possibility that the U.S. government might not pay them out dollar for dollar. Perhaps they're even beginning to perspire. That's not a bad thing. It took a lot of creditor participation to make the big banks too big to fail. If creditors realize that too big to fail doesn't mean too big for creditors to take a loss, then some degree of rationality might return to the money markets. Markets where certain players cannot lose are destined for dysfunction, and that's where we are with today's credit markets. Perhaps creditors will in the future be less eager to participate in the over-leveraging of already large banks.
"Irony" is used way too much in today's public discussion. But one irony of the Chrysler situation is that a foreign auto company may end up being the biggest winner. That shouldn't provoke too much concern. All auto companies today with any chance of success are multi-national. Toyota is famously global, sometimes shipping a few thousand vehicles a year to dusty third world countries that most sales executives in Detroit never heard of. One reason why Toyota compact pickup trucks perform so well is that they have been tested in every imaginable environment. Ford and GM have a chance of survival in part because they have worldwide operations. Chrysler was too heavily concentrated in North America, and was highly vulnerable when the North American credit bubble popped. Linking the surviving parts of Chrysler with Fiat strengthens both companies. Many people employed at Chrysler and its parts suppliers won't be returning to the plants, because their jobs are gone forever. However, some will if the Chrysler bankruptcy reorganization is successful, and many dealerships could survive as Chrysler/Fiat dealerships. Perhaps 100,000 or more jobs could be saved.
Government assistance in the economy has a long history in America. The Erie Canal, the homesteading of the West, the national railroad system, the air transportation system, the interstate highway system, and the enormous tax and finance subsidies for residential real estate are just some of the most obvious examples. Government safety nets like unemployment compensation, health insurance for many of the needy, and worker retraining programs play important roles in softening the harshness of capitalism. Manufacturing is part of the core of any strong economy, and some government assistance to preserve manufacturing jobs is likely to be money well-spent. We can't build an economy processing paper for home loan refinancings and mortgage securitizations. We need to make things--things people want to buy. Let's hope for a successful reorganization of Chrysler in bankruptcy court.
The secured debt holders probably guessed that after the Lehman bankruptcy, where the Bush administration tried to impose discipline on creditors and wound up bailing out AIG's creditors dollar for dollar, the government would flinch whenever debt holders stood firm. But they may have failed to look objectively at political reality. The American taxpayer is fed up with bailouts for the wealthy, and the Obama administration may recognize that there is a limit to the government's borrowing and printing of money. Even though the U.S. government can run a marathon of a deficit, sooner or later it will hit the wall. And it did with the Chrysler situation.
The creditors are now stuck slugging it out in bankruptcy court, where they would have been if the government hadn't been around for them to try to game. Faced with having to rest on their legal rights, they may succeed to asserting their liens on Chrysler's assets. But so what? Who will buy those assets? There is only one ready buyer who will pay anything approaching a semi-passable price, and that's Fiat supported by the U.S. government. Those are the same players that the creditors just failed to game. With the auto market shrinking dramatically, Chrysler's factories and manufacturing equipment are basically surplus capacity. Few investors will buy production equipment that makes products with no market. The secured creditors won't realize much more than scrap value if they try to auction off Chrysler's hard assets piecemeal. The only significant value in this bankrupt's estate lies in selling some portion of Chrysler as a going concern, with the tradenames that for decades have meant something to Americans. So the secured creditors will probably find themselves again staring at the U.S. government and Fiat as the only buyers willing to pay anything substantial for Chrysler's assets. Do they think they'll see much improvement in the price offered?
By taking creditors off the pedestal that the Bush administration put them on with the AIG bailout, the Obama administration has done well for taxpayers. The GM bailout remains on the negotiating table, and the lines in the sand are now clearer. A resolution with GM's creditors may now be easier. Even more importantly, creditors of large financial institutions must now be furrowing their brows over the possibility that the U.S. government might not pay them out dollar for dollar. Perhaps they're even beginning to perspire. That's not a bad thing. It took a lot of creditor participation to make the big banks too big to fail. If creditors realize that too big to fail doesn't mean too big for creditors to take a loss, then some degree of rationality might return to the money markets. Markets where certain players cannot lose are destined for dysfunction, and that's where we are with today's credit markets. Perhaps creditors will in the future be less eager to participate in the over-leveraging of already large banks.
"Irony" is used way too much in today's public discussion. But one irony of the Chrysler situation is that a foreign auto company may end up being the biggest winner. That shouldn't provoke too much concern. All auto companies today with any chance of success are multi-national. Toyota is famously global, sometimes shipping a few thousand vehicles a year to dusty third world countries that most sales executives in Detroit never heard of. One reason why Toyota compact pickup trucks perform so well is that they have been tested in every imaginable environment. Ford and GM have a chance of survival in part because they have worldwide operations. Chrysler was too heavily concentrated in North America, and was highly vulnerable when the North American credit bubble popped. Linking the surviving parts of Chrysler with Fiat strengthens both companies. Many people employed at Chrysler and its parts suppliers won't be returning to the plants, because their jobs are gone forever. However, some will if the Chrysler bankruptcy reorganization is successful, and many dealerships could survive as Chrysler/Fiat dealerships. Perhaps 100,000 or more jobs could be saved.
Government assistance in the economy has a long history in America. The Erie Canal, the homesteading of the West, the national railroad system, the air transportation system, the interstate highway system, and the enormous tax and finance subsidies for residential real estate are just some of the most obvious examples. Government safety nets like unemployment compensation, health insurance for many of the needy, and worker retraining programs play important roles in softening the harshness of capitalism. Manufacturing is part of the core of any strong economy, and some government assistance to preserve manufacturing jobs is likely to be money well-spent. We can't build an economy processing paper for home loan refinancings and mortgage securitizations. We need to make things--things people want to buy. Let's hope for a successful reorganization of Chrysler in bankruptcy court.
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