We learned late last week that 18 of the largest banks (including, among others, Goldman Sachs, Morgan Stanley, J.P. Morgan Chase, Bank of America and Citigroup) displayed a pattern of temporarily lowering their debt levels at the end of each quarter, just in time for their quarterly reports, and then ratcheting their borrowings back up at the beginning of the next quarter. (See Wall Street Journal, April 9, 2010, p. C1). Their reported debt levels averaged 42% below the intraquarter peaks. Thus, their quarterly reports understated the risks they carried.
As we know from the Lehman bankruptcy examiner's report, Lehman used a transaction called "Repo 105" to understate its leverage. While it is unclear that other major banks engaged in Repo 105 trades, they evidently have other ways to achieve a similar result.
Let us ask: who's in the dark? Not management of the big banks. They should be and hopefully are monitoring leverage levels on a continuing basis throughout market hours (which are basically 24 hours a day, five days a week, because trading is global). Certainly, they'd have the data at their fingertips.
Federal banking regulators can easily find out any time how leveraged the big banks are. They have examiners stationed at each of the major money center banks, who can get information on the spot. So there can be a continuous flow of information to the feds--and we hope there is.
That leaves (you've probably guessed it): you, the public investor. You're the chump. It's understandable why management wouldn't want you to know how risky their operations are. You might lower the price you're willing to pay for the bank's stock. That's not conducive to a brontosaurus size executive bonus. By reporting lower quarter-end leverage than they hold most of the time, the big banks can maintain a higher stock price. It's likely the big banks' lawyers have cleverly included language in their public filings saying that bank leverage levels fluctuate. But there's a distinct possibility they didn't disclose that they typically ease leverage levels down at the end of each quarter and pump them back up at the beginning of the next.
All this reinforces the case to require banks, and other public companies, to make continuous disclosure. We've advocated the idea before. See http://blogger.uncleleosden.com/2009/10/allow-insider-trading-why-not-reduce.html. Our earlier essay argued that with continuous disclosure, there would be less inside information and therefore probably less insider trading. Now, we can see that continuous disclosure would result in fairer pricing of stocks. It may well be that bank stocks are over-valued because investors didn't realize how risky they are.
Continuous disclosure isn't difficult. It's already made to management as a matter of course, and to federal banking regulators on demand. We're not talking about highly tentative or immaterial information; we're talking about the info management relies on to run the banks and keep them solvent. There is no technological impediment to continuous disclosure, and the cost is small, since the data is already collected, crunched and disseminated (to some). Certain accounting decisions tend to be made on a quarterly or annual basis. Asset writedowns, adding to or drawing down reserves, writing off bad debts, depreciation and depletion are examples. But that's because the current reporting regime requires quarterly and annual reports. There's no intrinsic reason why these decisions can't be made more frequently. Even if they can't be made every day, assets depreciate and deplete, reserves can be set aside or used, and bad debts become uncollectible all the time, not just at the ends of quarters or years.
The quarterly and annual reporting requirements evolved in the 1930s and 1940s, when accountants collected data and prepared financial statements using pencils, paper and mechanical desk calculators. With the enormous capabilities of modern computers, there is no reason except inertia to stick with a quarterly and annual reporting regime. Indeed, there already are continuous reporting requirements for a limited number of items on SEC Form 8-K. The agency recognizes the need for continuous reporting; the only question is how much information should be continuously reported.
Of course, public companies will oppose the idea. Financial reporting is all too often treated as a game, in which management tries to present the company in the best possible light without violating any controlling legal precedents. And sometimes management presents the company in a better light than that and goes to jail. With only a tiny handful of exceptions, public companies don't seem to think that giving the public investor the full picture is a priority. That's too bad, because many public investors--i.e., individual investors--are MIA from the current stock market rally. Numerous commentators have observed that the past year's bull market progressed on rather thin volume, with individual investors licking their 2007-08 wounds from the sidelines. Even though the market has gone up for something like seven of the last eight weeks, the individual investor still hunkers down.
Of course, revealing the higher actual leverage of banks would tend to push their stock prices down. Indeed, continuous disclosure could in the near term be a short seller's banquet. But let us remember that a small group of mostly anonymous short sellers were among the first to realize that the real estate and mortgage markets amounted to a greatly over-valued bucket of mashed potatoes. Management and federal banking regulators, who had much better access to the relevant data, stood right at the front bumper but failed to see the tractor-trailer bearing down on them.
Continuous disclosure would enhance market fairness and efficiency. When stock prices reach a truly fair level, investor trust can begin. If investors continue to feel the stock market is a casino where they're always betting against the house, they'll embrace federally insured bank accounts and money market funds that invest only in U.S. Treasuries. This is exactly what happened in Japan after its 1989-90 stock market cataclysm, and the favorite savings vehicle for the Japanese today is an account with their postal system. (As odd as it sounds, the Japanese postal system runs the largest bank in the world measured by deposits; but then again, the U.S. postal system offered savings accounts until 1967.) Numerous individual investors in Japan never found their way back to equities. Very possibly, for many Americans that will also be the road not taken.
Sunday, April 11, 2010
Thursday, April 8, 2010
Demote GDP and Enhance Economic Well-Being
The most frequently used measure of economic well-being is Gross Domestic Product. Government and private sector leaders, economists, commentators and polemicists fixate over GDP. Its upward movements prompt celebrations and congratulations (usually, self-congratulations). Its downward movements provoke calls for resignation, electoral ouster, and tea parties, and fuel no end of tiresome cable TV commentary. Whether the country is in an economic downturn or upturn is defined by movements in GDP.
Whenever a numerical figure is used as an important benchmark, it can become a tail that wags the dog. A well-known example is corporate earnings per share. Public companies scheme and maneuver to make earnings per share large enough to cast management in a good light and boost the company's stock price. While there are legal ways to "manage" earnings per share, financial regulators' rap sheets are replete with public companies that lied and cheated in order to doll up their financial statements. Earnings per share as a benchmark drives behavior. It is a narrow, incomplete way of measuring a company's value, which diverts management's attention toward the next quarter and away from long term planning and investment.
The use of GDP to measure economic well-being may distort government behavior. GDP, as it's usually calculated, measures the amount of a nation's consumption and investment. It includes private consumption (ham, eggs, shoes, DVDs, cars, kiddie train sets, etc.), gross investment (basically, business investment plus new home sales), government spending (which doesn't include transfer payments like Social Security and unemployment compensation, but these tend to get picked up through private consumption), and net exports (gross exports minus gross imports, which can yield a negative number). Most of GDP consists of consumption (private consumption and most government spending, reduced by net exports (read, net imports)). Business investment, new home sales, and government investment account for a relatively small portion of GDP.
GDP does not differentiate between consumption financed with debt, as opposed to consumption paid for with earnings or savings. Thus, consumers indulging in home equity loans or cash out mortgage refinancings boost GDP by the full extent of the dollars they borrow and spend. The same is true when a government borrows money to pay for its spending. Thus, the government is incentivized to borrow and spend in order to boost GDP, as opposed to raising taxes to cover its budget (which would reduce private spending and perhaps business investment, thereby diminishing GDP). The government is similarly rewarded when it cuts taxes (providing more money for private consumption and business investment), and substitutes borrowed money to cover its budget. Either way, government borrowing can boost GDP and make the government look good.
Government subsidies of private borrowing, such as home mortgage and home equity loans, can also enhance GDP, because GDP is not adjusted for private consumption fueled by debt. If government policy inflates home prices, which in turn encourage more tax code subsidized borrowing to finance consumption, the larger GDP becomes and the better the government looks.
A major shortcoming of GDP is that it doesn't reflect the worst aspects of the current financially driven economic crisis. Instability and volatility in the stock and real estate markets have shaken the middle and upper middle classes. Increased unemployment levels don't show up in GDP. Wage and salary cuts, reductions in working hours, and other earnings losses aren't recorded in GDP. The hundreds of billions of dollars of interest income lost by savers, who can get barely a pittance for their hard earned savings, is not an input for GDP. Even the loss of home equity loans and generous credit card lines of credit, so important to fueling the boom of the early 2000s, doesn't enter into the calculation of GDP. All of these factors may be reflected indirectly in lower consumption and reduced business investment. But those statistical effects don't begin to reflect the insecurity gripping tens of millions of Americans. Government pronouncements and Wall Street boosterism that tout GDP growth clash with the daily experiences of typical Americans. A recovering GDP uplifts the stock market, disproportionately benefiting the wealthy and well-to-do. But this uneven impact fuels Tea Parties and other harbingers of discontent.
A number of readily available statistics can be used to create a more complete picture of economic well-being. Unemployment levels, median household income, per capita income, distribution of income, trends in asset values, volatility in asset values, savings rates, debt growth or reduction, business investment, and changes in worker productivity all help to round out the picture. There is no single measure of economic well-being that really works. We have to look at a basket of statistics to get the full picture. And getting the full picture would lead to more well-rounded government policies. GDP is a valid measure of an economy's size. But using it as the principal benchmark for the government's performance can distort government policy by encouraging borrowing, while reminding numerous Americans that they remain outside the Beltway.
Homeowners didn't become wealthier by embracing home equity loans and cash out mortgage refinancings. They simply frontloaded their consumption. Now, later in life, they are having to pay for their unwillingness to delay gratification. Borrowing to finance government spending is largely the same (with the exception of government investment in highways, bridges and other infrastructure, which may enhance future economic growth). A better balanced approach to measuring economic well-being would reduce the political reward to the government from borrowing to finance deficits.
The Euro zone sovereign debt crisis illustrates the dangers of outsized government borrowing. Greece's economy is about 0.6% of the world economy. But bailing it out has proven to be intractable. Imagine what could happen if a much larger economy overspent.
Whenever a numerical figure is used as an important benchmark, it can become a tail that wags the dog. A well-known example is corporate earnings per share. Public companies scheme and maneuver to make earnings per share large enough to cast management in a good light and boost the company's stock price. While there are legal ways to "manage" earnings per share, financial regulators' rap sheets are replete with public companies that lied and cheated in order to doll up their financial statements. Earnings per share as a benchmark drives behavior. It is a narrow, incomplete way of measuring a company's value, which diverts management's attention toward the next quarter and away from long term planning and investment.
The use of GDP to measure economic well-being may distort government behavior. GDP, as it's usually calculated, measures the amount of a nation's consumption and investment. It includes private consumption (ham, eggs, shoes, DVDs, cars, kiddie train sets, etc.), gross investment (basically, business investment plus new home sales), government spending (which doesn't include transfer payments like Social Security and unemployment compensation, but these tend to get picked up through private consumption), and net exports (gross exports minus gross imports, which can yield a negative number). Most of GDP consists of consumption (private consumption and most government spending, reduced by net exports (read, net imports)). Business investment, new home sales, and government investment account for a relatively small portion of GDP.
GDP does not differentiate between consumption financed with debt, as opposed to consumption paid for with earnings or savings. Thus, consumers indulging in home equity loans or cash out mortgage refinancings boost GDP by the full extent of the dollars they borrow and spend. The same is true when a government borrows money to pay for its spending. Thus, the government is incentivized to borrow and spend in order to boost GDP, as opposed to raising taxes to cover its budget (which would reduce private spending and perhaps business investment, thereby diminishing GDP). The government is similarly rewarded when it cuts taxes (providing more money for private consumption and business investment), and substitutes borrowed money to cover its budget. Either way, government borrowing can boost GDP and make the government look good.
Government subsidies of private borrowing, such as home mortgage and home equity loans, can also enhance GDP, because GDP is not adjusted for private consumption fueled by debt. If government policy inflates home prices, which in turn encourage more tax code subsidized borrowing to finance consumption, the larger GDP becomes and the better the government looks.
A major shortcoming of GDP is that it doesn't reflect the worst aspects of the current financially driven economic crisis. Instability and volatility in the stock and real estate markets have shaken the middle and upper middle classes. Increased unemployment levels don't show up in GDP. Wage and salary cuts, reductions in working hours, and other earnings losses aren't recorded in GDP. The hundreds of billions of dollars of interest income lost by savers, who can get barely a pittance for their hard earned savings, is not an input for GDP. Even the loss of home equity loans and generous credit card lines of credit, so important to fueling the boom of the early 2000s, doesn't enter into the calculation of GDP. All of these factors may be reflected indirectly in lower consumption and reduced business investment. But those statistical effects don't begin to reflect the insecurity gripping tens of millions of Americans. Government pronouncements and Wall Street boosterism that tout GDP growth clash with the daily experiences of typical Americans. A recovering GDP uplifts the stock market, disproportionately benefiting the wealthy and well-to-do. But this uneven impact fuels Tea Parties and other harbingers of discontent.
A number of readily available statistics can be used to create a more complete picture of economic well-being. Unemployment levels, median household income, per capita income, distribution of income, trends in asset values, volatility in asset values, savings rates, debt growth or reduction, business investment, and changes in worker productivity all help to round out the picture. There is no single measure of economic well-being that really works. We have to look at a basket of statistics to get the full picture. And getting the full picture would lead to more well-rounded government policies. GDP is a valid measure of an economy's size. But using it as the principal benchmark for the government's performance can distort government policy by encouraging borrowing, while reminding numerous Americans that they remain outside the Beltway.
Homeowners didn't become wealthier by embracing home equity loans and cash out mortgage refinancings. They simply frontloaded their consumption. Now, later in life, they are having to pay for their unwillingness to delay gratification. Borrowing to finance government spending is largely the same (with the exception of government investment in highways, bridges and other infrastructure, which may enhance future economic growth). A better balanced approach to measuring economic well-being would reduce the political reward to the government from borrowing to finance deficits.
The Euro zone sovereign debt crisis illustrates the dangers of outsized government borrowing. Greece's economy is about 0.6% of the world economy. But bailing it out has proven to be intractable. Imagine what could happen if a much larger economy overspent.
Sunday, April 4, 2010
The Devil's Casino: A Morality Tale of the Rise and Fall of Lehman Brothers
Apres le scandale, les livres. The latest on the collapse of Lehman Brothers is Vicky Ward's The Devil's Casino. The complimentary copy sent to me for review by the publisher, John Wiley & Sons Inc., comes in a dust jacket depicting a deck of cards with the joker face up. The imagery is a propos, and the book presents a gripping, page-turner of a tale. But there's much more to this book than a story about exceedingly wealthy bankers taking undue risks in the heedless pursuit of shameless self-aggrandizement. It presents a morality tale, not just about people, but also about organizations and their life cycles.
Here's an overview of the book. In the mid-1980s, Lehman, a proud and distinguished mid-sized investment bank, sold itself to Shearson American Express. The senior management of the old Lehman mostly left. Taking over as the management of the newly acquired subsidiary were Richard Fuld and his deputy, Christopher Pettit. In the middle of their careers, these two men were suddenly dislocated and had to adjust to new bosses and a new corporate culture. Pettit, a West Point graduate and decorated Vietnam War combat vet, had built up the highly successful commercial paper operation at Lehman, instilling in it the sense of solidarity found in elite military units. Apparently driven by loyalty to his people as well as the realization that his future success likely depended on keeping them together, Pettit risked his career by insisting to his new bosses that the commercial paper operation be kept together. Noting how profitable Pettit's operation had been, Shearson's management reluctantly acquiesced.
Fuld and Pettit joined together to maintain a de facto Lehman inside Shearson (with some personnel persisting in answering their phones "Lehman"). Fuld took on the difficult task of alternately staving off and then cultivating Shearson's management, a job for which the plainspoken Pettit had no appetite. Pettit, in turn, managed "Lehman's" day-to-day operations inside Shearson, with close friends from his early days at the firm reporting to him. The division of duties played to both Fuld's and Pettit's strengths, and "Lehman" prospered.
Even as "Lehman" prospered, Fuld and Pettit began to change. Fuld, successful as a hands-on trader, became isolated as a senior executive. One vignette recounted in the book has him ordering shirts from the L.L. Bean catalog during the work day. Fuld also sought to acquire the polish and poise of Wall Street's executive elite, taking self-improvement training and, most importantly, scrutinizing and learning from the most talented men around him. He let Pettit handle daily operations; Fuld's focus was upward, geared toward advancing his career.
It's less clear how and why Pettit changed. As the firm grew, he may have been frustrated by his inability to supervise thousands of employees with the close, personal style he had previously used in successfully overseeing hundreds. His marriage to his high school sweetheart deteriorated and he took up with another woman who worked at "Lehman." This affair grated with the family-oriented culture at the "firm," which Fuld in particular sought to instill. It also marred Pettit's image, as the man who had symbolized the best in the "firm" revealed his feet of clay.
"Lehman's" pugnacious independence not surprisingly led Shearson American Express to spin it off, after ten years. But independence seemed to bring out the unattractive side of Lehman's senior executives. Fuld evidently saw the firm as the ticket, not only to wealth, but also the recognition that would come from being the CEO of a top tier Wall Street firm. He made the firm's growth a priority. He also became increasingly insecure about Pettit, whose charisma and leadership abilities Fuld could not match. Pettit was the one person in the firm who could compete with Fuld for the top job.
At the same time, Pettit's relationship with his lieutenants apparently frayed, perhaps because of his affair, and in part because of the inevitable vicissitudes of the markets. One example recounted in The Devil's Casino is the Mexican peso crisis of 1995, for which Lehman had $5 billion of exposure, a significant amount for the recently spun off firm. Pettit held Joe Gregory, then the head of fixed income, responsible for the unexpectedly large size of this exposure (Pettit had known of $1 billion). Pettit took to dressing Gregory down on a weekly basis. Gregory had previously been one of Pettit's closest friends at the firm, but the now their friendship fractured. Exactly why Pettit was so angry isn't clear; perhaps it was Pettit's military background subconsciously influencing his perception of events. For a combat unit to survive and be effective, every member must do his job. Otherwise, the entire unit may be imperiled and wiped out. Excuses and explanations don't resurrect dead soldiers; performance of one's duties is essential. Friendship is subordinated this imperative, because failure on the battlefield can be so costly. Pettit may have overreacted, from the viewpoint of a civilian dealing with a firm's misguided investments. Gregory evidently bore scars from this castigation, and, as Ward tells the story, later served as the Judas Iscariot who engineered Pettit's downfall.
Whatever Pettit's motivation, he was losing support within the firm and there were plenty of people who thought they would benefit if he departed. Fuld, although nominally the CEO, seemingly did not have the gumption to force Pettit out. He acted only when pushed by a conspiracy, comprised of Gregory and others among Pettit's lieutenants. Pettit was demoted and soon departed, tragically dying shortly thereafter in a snowmobiling accident.
As described in The Devil's Casino, Pettit's departure marked the moment when Lehman became engulfed by the atavistic impulses of lesser men than Christopher Pettit. Fuld did not immediately replace Pettit, leaving the Chief Operating Officer position open for several years. Yet, he stayed aloof from daily operations, with the firm being managed through a committee composed of the heads of the major operational units. This structure may have been conducive to promoting profitability (Fuld's uppermost goal). But it left matters crucial to the organic health of the firm as a whole, such as risk management, at a disadvantage. When Fuld eventually selected a COO, it was Joe Gregory, whom Fuld did not regard as competition for the CEO position.
The rest of the story, told in substantial and engaging detail, is well-known in its overarching features. Lehman endeavored to be David among the Goliaths of Wall Street, scoring some successes that only fueled management's hunger for more favorable headlines. Risk management came to be viewed as tiresome, and risk managers received less of management's attention.
By the early 2000s, Lehman had fallen hard for the allure of real estate, betting more and more of its balance sheet on a seemingly golden goose of an asset that kept increasing in value. Fuld's sound instincts as a trader evidently abandoned him, and Lehman piled into real estate while the smarter firms were pulling back. As the mortgage crisis unfolded in 2007 and 2008, astute players, such as short seller David Einhorn, began questioning Lehman's strategy. The firm changed CFOs, installing the attractive but not well-qualified Erin Callan as the new CFO. Although she was remarkably poised and momentarily effective in presenting the firm as solvent, her short tenure ended after a few months when the firm had to report $2.8 billion in quarterly losses, its first publicly reported losses ever. What may have been the firm's last ditch effort to substitute image for substance failed, and the die was cast. Although Fuld belatedly realized that he needed to improve the quality of the firm's management, he could not undo the firm's gargantuan real estate exposure. Lehman's new management, which included alumni previously shoved aside by the prior management, couldn't save the firm when its short term funding fled, and it was forced to seek the protection of the bankruptcy courts.
The Devil's Casino covers familiar issues, such as the dependence of Lehman and other Wall Street on short term funding to make less than liquid investments, and the federal government's decision not deploy taxpayer money to bail out Lehman. However, the longer story it tells, of the late 20th Century Lehman's origins as subsidiary and then spin-off of Shearson American Express, illustrates issues that haven't received as much coverage.
Lehman's evolution, first as a unified upstart led by a charismatic leader, and then as an increasingly dysfunctional real estate investor, exemplifies how organizations become strong, grow, prosper, but then lose focus, weaken and fracture. This is a story seen many times in many organizations. But it's a singularly important problem when it happens to financial firms with wide-ranging exposures throughout the financial system. Ward's depiction of a distant CEO who drives out the most capable man in the organization belies Wall Street's claim to believe that its people are its real capital. Wall Street firms, like so many other organizations, are susceptible to the machinations of office politics, where the well-being of the organization is subordinated to the personal interests of a few at the top. When this happens at a money center bank with worldwide exposure, the potential consequences to society and taxpayers may be painful.
What does this imply? First, boards of directors of major financial institutions have to be more proactive about the quality and style of management. It is in fact true that people are a Wall Street firm's real capital. A CEO who can't maintain the quality of personnel, or even worse forces out the best, needs encouragement to pursue other interests. While most corporate boards wouldn't regard personnel management to be within their normal duties, directors of major banks should be more assiduous. Lehman's directors scarcely manage occasional cameo appearances in The Devil's Casino. Perhaps they played a larger role than depicted in the book. But as far as a reader of The Devil's Casino can tell, there was no meaningful check or balance on the way Fuld performed his job. Thus, Lehman's viability as a firm was exposed to Fuld's individual weaknesses.
Another consideration is that federal regulators need to be more attentive to the quality of management. This is not a new problem for the Federal Reserve. The Fed has the authority to remove officers of banks under its supervision for specified statutory reasons, and from time to time has exercised this authority. Typically, the Fed informally signals its displeasure with a particular banker, and the astute bank removes the offending individual before the Fed feels the need to take formal action. Under the systemic risk monitoring responsibility that may soon rest with the Fed, regulators must recognize that risk taking is often a matter of personality and ambition, not just employee incentives and trading strategies, and they should be prepared to remove any individual executive or group of executives who might, with the enormous resources of a major bank, put the financial system in jeopardy.
Ultimately, the responsibility for maintaining the vitality of an organization rests with management. In this respect, The Devil's Casino offers an in-depth study of a failed organization for executives elsewhere to ponder. Whatever Dick Fuld intended, he didn't intend for Lehman to fail so spectacularly. CEOs everywhere should view his fate as an object lesson. To make an organization succeed, the top executive must understand that the organization is greater than he or she, and its needs and welfare supersede his or hers. If you want to be a rock star, learn to play the guitar. If you think you can use an organization to reach the klieg lights, remember Dick Fuld.
The Devil's Casino is written in a readily accessible, fast-paced style that Vicky Ward likely honed as a contributing editor of Vanity Fair. While this is a serious book that tells a serious story, those inclined to indulge, perhaps just occasionally, in voyeuristic schadenfreude will not be disappointed by vignettes about a senior executive's wife having a walk-in shoe closet larger than a store, the sartorial conformity expected of senior executives, the ruthless pecking order among management's wives, and the Prussian discipline expected of Lehman wives when it came to the firm's interests. The book synthesizes an enormous amount of information in an impressively coherent way. We offer a minor suggestion that the three references to "Robert Rubin" be clarified to distinguish Robert S. Rubin, formerly a senior partner of Lehman who is mentioned twice (the first two times), from Robert E. Rubin, former Co-Chairman of Goldman Sachs, then Secretary of the Treasury and then a director of Citigroup, who is the third reference to Robert Rubin (and correctly identified as a former Secretary of the Treasury but not distinguished from the earlier references to "Robert Rubin").
Here's an overview of the book. In the mid-1980s, Lehman, a proud and distinguished mid-sized investment bank, sold itself to Shearson American Express. The senior management of the old Lehman mostly left. Taking over as the management of the newly acquired subsidiary were Richard Fuld and his deputy, Christopher Pettit. In the middle of their careers, these two men were suddenly dislocated and had to adjust to new bosses and a new corporate culture. Pettit, a West Point graduate and decorated Vietnam War combat vet, had built up the highly successful commercial paper operation at Lehman, instilling in it the sense of solidarity found in elite military units. Apparently driven by loyalty to his people as well as the realization that his future success likely depended on keeping them together, Pettit risked his career by insisting to his new bosses that the commercial paper operation be kept together. Noting how profitable Pettit's operation had been, Shearson's management reluctantly acquiesced.
Fuld and Pettit joined together to maintain a de facto Lehman inside Shearson (with some personnel persisting in answering their phones "Lehman"). Fuld took on the difficult task of alternately staving off and then cultivating Shearson's management, a job for which the plainspoken Pettit had no appetite. Pettit, in turn, managed "Lehman's" day-to-day operations inside Shearson, with close friends from his early days at the firm reporting to him. The division of duties played to both Fuld's and Pettit's strengths, and "Lehman" prospered.
Even as "Lehman" prospered, Fuld and Pettit began to change. Fuld, successful as a hands-on trader, became isolated as a senior executive. One vignette recounted in the book has him ordering shirts from the L.L. Bean catalog during the work day. Fuld also sought to acquire the polish and poise of Wall Street's executive elite, taking self-improvement training and, most importantly, scrutinizing and learning from the most talented men around him. He let Pettit handle daily operations; Fuld's focus was upward, geared toward advancing his career.
It's less clear how and why Pettit changed. As the firm grew, he may have been frustrated by his inability to supervise thousands of employees with the close, personal style he had previously used in successfully overseeing hundreds. His marriage to his high school sweetheart deteriorated and he took up with another woman who worked at "Lehman." This affair grated with the family-oriented culture at the "firm," which Fuld in particular sought to instill. It also marred Pettit's image, as the man who had symbolized the best in the "firm" revealed his feet of clay.
"Lehman's" pugnacious independence not surprisingly led Shearson American Express to spin it off, after ten years. But independence seemed to bring out the unattractive side of Lehman's senior executives. Fuld evidently saw the firm as the ticket, not only to wealth, but also the recognition that would come from being the CEO of a top tier Wall Street firm. He made the firm's growth a priority. He also became increasingly insecure about Pettit, whose charisma and leadership abilities Fuld could not match. Pettit was the one person in the firm who could compete with Fuld for the top job.
At the same time, Pettit's relationship with his lieutenants apparently frayed, perhaps because of his affair, and in part because of the inevitable vicissitudes of the markets. One example recounted in The Devil's Casino is the Mexican peso crisis of 1995, for which Lehman had $5 billion of exposure, a significant amount for the recently spun off firm. Pettit held Joe Gregory, then the head of fixed income, responsible for the unexpectedly large size of this exposure (Pettit had known of $1 billion). Pettit took to dressing Gregory down on a weekly basis. Gregory had previously been one of Pettit's closest friends at the firm, but the now their friendship fractured. Exactly why Pettit was so angry isn't clear; perhaps it was Pettit's military background subconsciously influencing his perception of events. For a combat unit to survive and be effective, every member must do his job. Otherwise, the entire unit may be imperiled and wiped out. Excuses and explanations don't resurrect dead soldiers; performance of one's duties is essential. Friendship is subordinated this imperative, because failure on the battlefield can be so costly. Pettit may have overreacted, from the viewpoint of a civilian dealing with a firm's misguided investments. Gregory evidently bore scars from this castigation, and, as Ward tells the story, later served as the Judas Iscariot who engineered Pettit's downfall.
Whatever Pettit's motivation, he was losing support within the firm and there were plenty of people who thought they would benefit if he departed. Fuld, although nominally the CEO, seemingly did not have the gumption to force Pettit out. He acted only when pushed by a conspiracy, comprised of Gregory and others among Pettit's lieutenants. Pettit was demoted and soon departed, tragically dying shortly thereafter in a snowmobiling accident.
As described in The Devil's Casino, Pettit's departure marked the moment when Lehman became engulfed by the atavistic impulses of lesser men than Christopher Pettit. Fuld did not immediately replace Pettit, leaving the Chief Operating Officer position open for several years. Yet, he stayed aloof from daily operations, with the firm being managed through a committee composed of the heads of the major operational units. This structure may have been conducive to promoting profitability (Fuld's uppermost goal). But it left matters crucial to the organic health of the firm as a whole, such as risk management, at a disadvantage. When Fuld eventually selected a COO, it was Joe Gregory, whom Fuld did not regard as competition for the CEO position.
The rest of the story, told in substantial and engaging detail, is well-known in its overarching features. Lehman endeavored to be David among the Goliaths of Wall Street, scoring some successes that only fueled management's hunger for more favorable headlines. Risk management came to be viewed as tiresome, and risk managers received less of management's attention.
By the early 2000s, Lehman had fallen hard for the allure of real estate, betting more and more of its balance sheet on a seemingly golden goose of an asset that kept increasing in value. Fuld's sound instincts as a trader evidently abandoned him, and Lehman piled into real estate while the smarter firms were pulling back. As the mortgage crisis unfolded in 2007 and 2008, astute players, such as short seller David Einhorn, began questioning Lehman's strategy. The firm changed CFOs, installing the attractive but not well-qualified Erin Callan as the new CFO. Although she was remarkably poised and momentarily effective in presenting the firm as solvent, her short tenure ended after a few months when the firm had to report $2.8 billion in quarterly losses, its first publicly reported losses ever. What may have been the firm's last ditch effort to substitute image for substance failed, and the die was cast. Although Fuld belatedly realized that he needed to improve the quality of the firm's management, he could not undo the firm's gargantuan real estate exposure. Lehman's new management, which included alumni previously shoved aside by the prior management, couldn't save the firm when its short term funding fled, and it was forced to seek the protection of the bankruptcy courts.
The Devil's Casino covers familiar issues, such as the dependence of Lehman and other Wall Street on short term funding to make less than liquid investments, and the federal government's decision not deploy taxpayer money to bail out Lehman. However, the longer story it tells, of the late 20th Century Lehman's origins as subsidiary and then spin-off of Shearson American Express, illustrates issues that haven't received as much coverage.
Lehman's evolution, first as a unified upstart led by a charismatic leader, and then as an increasingly dysfunctional real estate investor, exemplifies how organizations become strong, grow, prosper, but then lose focus, weaken and fracture. This is a story seen many times in many organizations. But it's a singularly important problem when it happens to financial firms with wide-ranging exposures throughout the financial system. Ward's depiction of a distant CEO who drives out the most capable man in the organization belies Wall Street's claim to believe that its people are its real capital. Wall Street firms, like so many other organizations, are susceptible to the machinations of office politics, where the well-being of the organization is subordinated to the personal interests of a few at the top. When this happens at a money center bank with worldwide exposure, the potential consequences to society and taxpayers may be painful.
What does this imply? First, boards of directors of major financial institutions have to be more proactive about the quality and style of management. It is in fact true that people are a Wall Street firm's real capital. A CEO who can't maintain the quality of personnel, or even worse forces out the best, needs encouragement to pursue other interests. While most corporate boards wouldn't regard personnel management to be within their normal duties, directors of major banks should be more assiduous. Lehman's directors scarcely manage occasional cameo appearances in The Devil's Casino. Perhaps they played a larger role than depicted in the book. But as far as a reader of The Devil's Casino can tell, there was no meaningful check or balance on the way Fuld performed his job. Thus, Lehman's viability as a firm was exposed to Fuld's individual weaknesses.
Another consideration is that federal regulators need to be more attentive to the quality of management. This is not a new problem for the Federal Reserve. The Fed has the authority to remove officers of banks under its supervision for specified statutory reasons, and from time to time has exercised this authority. Typically, the Fed informally signals its displeasure with a particular banker, and the astute bank removes the offending individual before the Fed feels the need to take formal action. Under the systemic risk monitoring responsibility that may soon rest with the Fed, regulators must recognize that risk taking is often a matter of personality and ambition, not just employee incentives and trading strategies, and they should be prepared to remove any individual executive or group of executives who might, with the enormous resources of a major bank, put the financial system in jeopardy.
Ultimately, the responsibility for maintaining the vitality of an organization rests with management. In this respect, The Devil's Casino offers an in-depth study of a failed organization for executives elsewhere to ponder. Whatever Dick Fuld intended, he didn't intend for Lehman to fail so spectacularly. CEOs everywhere should view his fate as an object lesson. To make an organization succeed, the top executive must understand that the organization is greater than he or she, and its needs and welfare supersede his or hers. If you want to be a rock star, learn to play the guitar. If you think you can use an organization to reach the klieg lights, remember Dick Fuld.
The Devil's Casino is written in a readily accessible, fast-paced style that Vicky Ward likely honed as a contributing editor of Vanity Fair. While this is a serious book that tells a serious story, those inclined to indulge, perhaps just occasionally, in voyeuristic schadenfreude will not be disappointed by vignettes about a senior executive's wife having a walk-in shoe closet larger than a store, the sartorial conformity expected of senior executives, the ruthless pecking order among management's wives, and the Prussian discipline expected of Lehman wives when it came to the firm's interests. The book synthesizes an enormous amount of information in an impressively coherent way. We offer a minor suggestion that the three references to "Robert Rubin" be clarified to distinguish Robert S. Rubin, formerly a senior partner of Lehman who is mentioned twice (the first two times), from Robert E. Rubin, former Co-Chairman of Goldman Sachs, then Secretary of the Treasury and then a director of Citigroup, who is the third reference to Robert Rubin (and correctly identified as a former Secretary of the Treasury but not distinguished from the earlier references to "Robert Rubin").
Thursday, April 1, 2010
Benefits of Federal Health Insurance Reform
2010's federal health insurance reform includes a wide-ranging panoply of programs, credits and other measures. Folks currently covered by employer sponsored health insurance plans won't experience much immediate change. But over the next year and later, they'll see improvements.
Those having trouble getting coverage will find the new law a big improvement. The recent legislation isn't Internet-friendly--it can't be summarized to two paragraphs or less. But there are a number of provisions that could soon change things for millions of Americans. Here they are, with those taking effect sooner listed first.
Small Business Tax Credit. Small businesses may get a tax credit of as much as 35% of their employee health insurance premiums, depending on how large they are, starting immediately and running through 2013. Small, in this case, means small (as in no more than the equivalent of 25 full-time employees). These companies, which may number as many as 4 million, are perhaps the most likely not to offer health insurance to employees, so the credit could bring more people under the umbrella of employer-sponsored coverage. The credit will increase to 50% of premiums beginning in 2014 and is available for any two consecutive years at the 50% level.
Closing the Medicare D Doughnut Hole. Those covered by Medicare D policies who in 2010 hit the gap in coverage called the "doughnut hole" will be eligible for a $250 rebate. Beginning in 2011, a 50% discount (instead of the rebate) will be available for prescriptions filled in the doughnut hole. The doughnut hole will be closed in 2020.
Federal High Risk Pool. By the end of June, 2010, a federal high risk insurance pool will become available for persons with pre-existing conditions who are having trouble getting coverage otherwise. This pool is temporary, and will operate until federally established health insurance exchanges provide a permanent source of coverage beginning in 2014. At that point, persons with pre-existing conditions can purchase health insurance through the exchanges or some other way, such as individually acquiring coverage. You can more information and application options at https://www.pcip.gov/.
Federal Assistance for Employers Covering Early Retirees. By the end of June 2010, a temporary federal program will begin offering reinsurance to employers providing early retirees (i.e., those between the ages of 55 and 64) with health insurance during retirement. Reinsurance is an indirect way of subsidizing retiree health insurance coverage, and should make it easier for employers to maintain coverage for early retirees. (Retirees 65 and older are eligible for Medicare coverage, so the reinsurance program doesn't extend to them.) The reinsurance program will be superseded in 2014 by the health insurance exchanges.
No More Punishing the Sick. Just as banks are notorious for denying credit to those who need it the most, sometimes insurance companies drop customers because they fall ill. Beginning at the end of September 2010, insurance companies will be prohibited from engaging in this practice. Some Tiny Tims will enjoy Christmas early this year when their Scrooge-like health insurers can no longer ax them.
Children Under 19 Cannot Be Turned Down for Pre-existing Conditions. By the end of September 2010, insurers won't be able to turn down children under 19 because of pre-existing conditions. (By 2014, insurers won't be allowed to turn anyone down for pre-existing conditions.) The high risk pool mentioned above could cover children who aren't protected by this provision.
Young Adult Dependents Up to Age 26 Can Be Covered by Parents. By the end of September 2010, young adults up to age 26 who are dependents of their parents will be eligible for coverage under their parents' policies (unless they live in a state that mandates coverage to an older age, such as 28 or 29).
No Lifetime Caps on Coverage. By the end of September 2010, insurers won't be allowed to impose lifetime limits on coverage.
Phaseout of Annual Limits on Coverage. By the end of September 2010, insurers will face greater restrictions on their ability to place annual limits on coverage. By 2014, annual limits will be eliminated.
Free Preventive Care. By the end of September 201o, new private insurance plans will have to cover preventive care without co-pays or deductibles. Beginning in 2011, Medicare will provide the same free preventive care coverage.
Increased Funding for Community Health Centers. Beginning in October 2010, community health centers--clinics that provide primary care to mostly low income patients--will receive increased federal funding in order to almost double over the next five years the number of patients they treat. This should help alleviate the shortage of primary care throughout much of America.
Independent Appeals Process. By the end of September 2010, new health plans will be required to have independent appeals processes for customers denied claims or coverage. This could be very important if you or a family member have a major health issue.
This year's health insurance reform affects many other aspects of the health care system, and will be implemented over the next decade or so. A more permanent system with health insurance exchanges should be in place by 2014. The number of primary care practitioners should increase. The patchwork health insurance system of the past will gradually be phased down, and near universal coverage should result from the federal programs. In the meantime, if you want information about current health insurance resources, take a look at http://blogger.uncleleosden.com/2007/06/how-to-find-health-insurance.html. Illegal immigrants cannot participate in the federally sponsored system, and may have to fall back on the remnants of the old health care system. This limitation is understandable from a political standpoint. However, if an illegal immigrant has, for example, tuberculosis, meningitis or some other transmissible illness, we all benefit if that person gets good health care.
Those having trouble getting coverage will find the new law a big improvement. The recent legislation isn't Internet-friendly--it can't be summarized to two paragraphs or less. But there are a number of provisions that could soon change things for millions of Americans. Here they are, with those taking effect sooner listed first.
Small Business Tax Credit. Small businesses may get a tax credit of as much as 35% of their employee health insurance premiums, depending on how large they are, starting immediately and running through 2013. Small, in this case, means small (as in no more than the equivalent of 25 full-time employees). These companies, which may number as many as 4 million, are perhaps the most likely not to offer health insurance to employees, so the credit could bring more people under the umbrella of employer-sponsored coverage. The credit will increase to 50% of premiums beginning in 2014 and is available for any two consecutive years at the 50% level.
Closing the Medicare D Doughnut Hole. Those covered by Medicare D policies who in 2010 hit the gap in coverage called the "doughnut hole" will be eligible for a $250 rebate. Beginning in 2011, a 50% discount (instead of the rebate) will be available for prescriptions filled in the doughnut hole. The doughnut hole will be closed in 2020.
Federal High Risk Pool. By the end of June, 2010, a federal high risk insurance pool will become available for persons with pre-existing conditions who are having trouble getting coverage otherwise. This pool is temporary, and will operate until federally established health insurance exchanges provide a permanent source of coverage beginning in 2014. At that point, persons with pre-existing conditions can purchase health insurance through the exchanges or some other way, such as individually acquiring coverage. You can more information and application options at https://www.pcip.gov/.
Federal Assistance for Employers Covering Early Retirees. By the end of June 2010, a temporary federal program will begin offering reinsurance to employers providing early retirees (i.e., those between the ages of 55 and 64) with health insurance during retirement. Reinsurance is an indirect way of subsidizing retiree health insurance coverage, and should make it easier for employers to maintain coverage for early retirees. (Retirees 65 and older are eligible for Medicare coverage, so the reinsurance program doesn't extend to them.) The reinsurance program will be superseded in 2014 by the health insurance exchanges.
No More Punishing the Sick. Just as banks are notorious for denying credit to those who need it the most, sometimes insurance companies drop customers because they fall ill. Beginning at the end of September 2010, insurance companies will be prohibited from engaging in this practice. Some Tiny Tims will enjoy Christmas early this year when their Scrooge-like health insurers can no longer ax them.
Children Under 19 Cannot Be Turned Down for Pre-existing Conditions. By the end of September 2010, insurers won't be able to turn down children under 19 because of pre-existing conditions. (By 2014, insurers won't be allowed to turn anyone down for pre-existing conditions.) The high risk pool mentioned above could cover children who aren't protected by this provision.
Young Adult Dependents Up to Age 26 Can Be Covered by Parents. By the end of September 2010, young adults up to age 26 who are dependents of their parents will be eligible for coverage under their parents' policies (unless they live in a state that mandates coverage to an older age, such as 28 or 29).
No Lifetime Caps on Coverage. By the end of September 2010, insurers won't be allowed to impose lifetime limits on coverage.
Phaseout of Annual Limits on Coverage. By the end of September 2010, insurers will face greater restrictions on their ability to place annual limits on coverage. By 2014, annual limits will be eliminated.
Free Preventive Care. By the end of September 201o, new private insurance plans will have to cover preventive care without co-pays or deductibles. Beginning in 2011, Medicare will provide the same free preventive care coverage.
Increased Funding for Community Health Centers. Beginning in October 2010, community health centers--clinics that provide primary care to mostly low income patients--will receive increased federal funding in order to almost double over the next five years the number of patients they treat. This should help alleviate the shortage of primary care throughout much of America.
Independent Appeals Process. By the end of September 2010, new health plans will be required to have independent appeals processes for customers denied claims or coverage. This could be very important if you or a family member have a major health issue.
This year's health insurance reform affects many other aspects of the health care system, and will be implemented over the next decade or so. A more permanent system with health insurance exchanges should be in place by 2014. The number of primary care practitioners should increase. The patchwork health insurance system of the past will gradually be phased down, and near universal coverage should result from the federal programs. In the meantime, if you want information about current health insurance resources, take a look at http://blogger.uncleleosden.com/2007/06/how-to-find-health-insurance.html. Illegal immigrants cannot participate in the federally sponsored system, and may have to fall back on the remnants of the old health care system. This limitation is understandable from a political standpoint. However, if an illegal immigrant has, for example, tuberculosis, meningitis or some other transmissible illness, we all benefit if that person gets good health care.
Wednesday, March 31, 2010
Does Too Big to Fail Mean Too Big to Change?
Now that we, the taxpaying electorate, have bailed out Wall Street, Wall Street is mightily resisting all efforts toward effective financial regulatory change. The proposed independent consumer protection agency seems likely to end up a division of the Fed. That would be the same Fed that famously insisted there was no housing bubble--right at the peak of the housing bubble. If they can't see the problem, they won't fix it. Consumers, emptor.
Investors, emptor, as well. It now seems that the concept of a fiduciary duty probably will not be imposed on stockbrokers. Too bad, since it would have required stockbrokers to put the customer first--admittedly a quaint notion but one that might restore some confidence in the financial markets. But given how the Treasury Department and the Fed have persistently put Wall Street first, with taxpayers and everyone else second, it's hardly surprising that Congress and the administration don't see why investors, who crucially furnish the capital that fuel the financial markets, should get a break.
The derivatives market--the shadow banking sector whose unregulated rambunctiousness made the mortgage and credit crises of 2007-08 possible--continues to dodge and weave away from serious efforts at reform. While the CFTC and SEC are pushing for change, one gets the sense that power brokers are quietly maneuvering at Congressional fundraisers to put concrete shoes on derivatives reform and take it for a nocturnal boat ride.
The "Volcker Rule," a proposal to separate taxpayer supported federally insured deposits from high risk bank proprietary activities, seems to have run afoul of a basic Wall Street principle: money talks and fairness walks. The financial sector, once the epitome of free markets, now seems never to see a federal subsidy it doesn't like. Moral hazard is good for profits, and profits are good for bonuses. Wall Street will pig out on as much federal largess as it can scoop out of the hands of taxpayers.
All this isn't surprising when one considers that the basic structure of Wall Street was saved in the bailouts of the last 18 months. The big banks now follow the imperative of all organizations and endeavor to preserve their status quo. Given their enormous financial power, restored by dumping a lot of risk and loss onto the backs of taxpayers, it's hardly surprising they can wheel in panzer divisions of lobbyists and roll back their opposition.
Too big to fail, therefore, may turn out to mean too big to change. The financial behemoths that played crucial roles in the recent financial crisis may escape largely unscathed and unchanged. What, then, would prevent a recurrence of the crisis? The tale of Fannie Mae and Freddie Mac may be instructive. For decades, Fannie and Freddie used their enormous financial resources to fund the most powerful lobby in Washington, bar none, while their officers and other personnel relentlessly made self-interested campaign contributions. Key members of Congress of both parties became running dogs for Fan and Fred, snapping up all the doggie treats tossed in their direction. All efforts to reform Fan and Fred, and reduce the systemic risk they presented, failed miserably. It was not until they, along with others, created a bad mortgage loan tsunami that overwhelmed every sea wall in the financial sector that the government, facing economic Armageddon, seized control of Fan and Fred, and put an end to their lobbying juggernaut. But the cost of nationalizing them has been hundreds of billions--a premium price for regulatory reform.
Not changing the landscape of financial regulation won't improve things, not in the short or long run. It would only set the stage for another crisis, one that very possibly will be worse than the recent one. The doctrine of too big to fail seems to have saved and consolidated powerful banks that now are using their restored financial and political muscle to hinder and delay desperately needed regulatory reform. Although the key players--Ben Bernanke, Henry Paulson and Timothy Geithner--surely wouldn't have intended such a result, their very strongly held belief that one must save the financial sector above all appears to have led to this dilemma. There is no shame or gratitude on Wall Street, where money--and only money--talks. If taxpayers bail them out, they'll proceed with business as usual, even when, and especially if, increased regulation to protect taxpayers would crimp their profits. Chumps are not meant to be repaid.
Investors, emptor, as well. It now seems that the concept of a fiduciary duty probably will not be imposed on stockbrokers. Too bad, since it would have required stockbrokers to put the customer first--admittedly a quaint notion but one that might restore some confidence in the financial markets. But given how the Treasury Department and the Fed have persistently put Wall Street first, with taxpayers and everyone else second, it's hardly surprising that Congress and the administration don't see why investors, who crucially furnish the capital that fuel the financial markets, should get a break.
The derivatives market--the shadow banking sector whose unregulated rambunctiousness made the mortgage and credit crises of 2007-08 possible--continues to dodge and weave away from serious efforts at reform. While the CFTC and SEC are pushing for change, one gets the sense that power brokers are quietly maneuvering at Congressional fundraisers to put concrete shoes on derivatives reform and take it for a nocturnal boat ride.
The "Volcker Rule," a proposal to separate taxpayer supported federally insured deposits from high risk bank proprietary activities, seems to have run afoul of a basic Wall Street principle: money talks and fairness walks. The financial sector, once the epitome of free markets, now seems never to see a federal subsidy it doesn't like. Moral hazard is good for profits, and profits are good for bonuses. Wall Street will pig out on as much federal largess as it can scoop out of the hands of taxpayers.
All this isn't surprising when one considers that the basic structure of Wall Street was saved in the bailouts of the last 18 months. The big banks now follow the imperative of all organizations and endeavor to preserve their status quo. Given their enormous financial power, restored by dumping a lot of risk and loss onto the backs of taxpayers, it's hardly surprising they can wheel in panzer divisions of lobbyists and roll back their opposition.
Too big to fail, therefore, may turn out to mean too big to change. The financial behemoths that played crucial roles in the recent financial crisis may escape largely unscathed and unchanged. What, then, would prevent a recurrence of the crisis? The tale of Fannie Mae and Freddie Mac may be instructive. For decades, Fannie and Freddie used their enormous financial resources to fund the most powerful lobby in Washington, bar none, while their officers and other personnel relentlessly made self-interested campaign contributions. Key members of Congress of both parties became running dogs for Fan and Fred, snapping up all the doggie treats tossed in their direction. All efforts to reform Fan and Fred, and reduce the systemic risk they presented, failed miserably. It was not until they, along with others, created a bad mortgage loan tsunami that overwhelmed every sea wall in the financial sector that the government, facing economic Armageddon, seized control of Fan and Fred, and put an end to their lobbying juggernaut. But the cost of nationalizing them has been hundreds of billions--a premium price for regulatory reform.
Not changing the landscape of financial regulation won't improve things, not in the short or long run. It would only set the stage for another crisis, one that very possibly will be worse than the recent one. The doctrine of too big to fail seems to have saved and consolidated powerful banks that now are using their restored financial and political muscle to hinder and delay desperately needed regulatory reform. Although the key players--Ben Bernanke, Henry Paulson and Timothy Geithner--surely wouldn't have intended such a result, their very strongly held belief that one must save the financial sector above all appears to have led to this dilemma. There is no shame or gratitude on Wall Street, where money--and only money--talks. If taxpayers bail them out, they'll proceed with business as usual, even when, and especially if, increased regulation to protect taxpayers would crimp their profits. Chumps are not meant to be repaid.
Monday, March 29, 2010
A 2010 Tax Strategy for the Democrats: Reform the Estate Tax
Barack Obama's political strategy for this year's mid-term elections seems pretty clear. He will take action, working with the Democrats in Congress to enact legislation, and acting as the chief executive where legislative action isn't possible. The recent health insurance reform, adopted with only Democratic support in Congress, is the most obvious example. Legislation for financial regulatory reform is on the move; some sort of bill will probably make it through Congress this year. Obama's recent recess appointments of 15 nominees is another example of his apparent decision to make 2010 a year of action.
The ballooning federal deficit will likely require a tax increase sooner or later. This being an election year, expect a lot of hemming and hawing, and no increase. There is one tax measure--not an increase--that probably could be enacted this year. And if the Democrats try it and are blocked by the Republicans, the Democrats would score political points for trying.
That would be federal estate tax reform. The Bush 43 tax cuts are bizarrely structured to provide for no estate tax in 2010 but a reversion next year to an old $1,000,000 threshold for the imposition of the tax. This anamoly is, like so many things in Washington, a political ploy, this one designed to make the cost of the tax cuts appear lower than they'd have been if the estate tax had been permanently eliminated. This sleight of hand made it easier for Congress to sign off, with the presumption that someone else would fix the problem when the tax reverted back to the $1,000,000 threshold.
Last year, there was general agreement among Democratic and Republican power brokers that reform of the estate tax should revolve around excluding the first $3.5 million of the estate from taxation and imposing the tax on amounts above that level, with the $3.5 million threshold to be adjusted for inflation. However, amidst last year's squabbling over bank bailouts and bonuses, the surge of Tea Parties, faux bipartisanship over health insurance reform, and pandemic adolescent finger pointing by high ranking federal officials and prominent members of Congress, nothing was done about estate tax reform.
For understandable reasons, estate tax reform this year has been shoved to the back part of the back burner that isn't even lit. But a Democratic initiative to enact the $3.5 million compromise that existed last year might work to their political advantage this fall.
Although this year's temporary repeal of the estate tax sounds like a boondoogle for the wealthy, it actually includes a potential unpleasant surprise for many. When the estate tax is in effect, heirs and other recipients of inheritances receive a "stepped up basis" (i.e., a base value of the higher of the original cost of the asset or its value at the time of the deceased person's death). For many assets, like stocks, real estate and collectibles, a stepped up basis means that when the recipient sells after inheriting the asset, income taxes (usually capital gains taxes) will be calculated by subtracting the stepped up basis from the proceeds of the sale to determine taxable gain.
However, when there is no estate tax, heirs and other recipients of inherited assets do not receive a stepped up basis. They get only a "carry over basis" (i.e., the deceased person's basis, which could be much lower than a stepped up basis for assets like stocks, real estate and collectibles). Thus, if they sell, their income tax is calculated by subtracted the carry over basis from the sales proceeds. This will often result in much greater taxes.
A $3.5 million exclusion from estate taxation would benefit the upper middle class, in particular those whose estates run in the range of $3.5 million to a bit above $5 million. These folks (or their heirs, really) might be worse off with no estate tax. Their heirs would get only a carryover basis, and be potentially subject to taxation on much larger gains than they'd face with a stepped up basis. The $3.5 million exclusion would largely shelter upper middle class estates from estate tax, while conferring a stepped basis that would significantly shelter the heirs if and when they sold the inherited assets.
The larger an estate, the more the benefit from a complete repeal of the estate tax. But that is a temporary circumstance, since the estate tax returns with a $1,000,000 threshold in 2011. Then, both the upper middle class and the wealthier are subject to higher levels of estate tax.
At first glance, it might make sense for the Democrats to simply let the estate tax lapse back down to a $1,000,000 threshold. With the growing federal deficit and a middle class core constituency, the Democrats would seem likely to lean toward soaking the rich (and upper middle class). But elections today are all about capturing the independents, the swing voters in between left and right who often outnumber party loyalists on either side. The estate tax matters to many small business owners and farmers, who can accumulate over $1,000,000 in net worth even if their annual incomes are modest. Many professional and managerial couples in the Northeast or the West Coast can exceed the $1 million threshold by owning a suburban home in a good school district and having a 401(k) account or two. These upper middle class folks are often opinion leaders and frequent contributors to political campaigns. Although their numbers aren't large, their influence can be significant.
Estate tax reform would demonstrate that the Democrats aren't focused solely on extracting more from taxpayers. It would be a step toward tax equity, and an acknowledgment that those who have worked hard, saved diligently and perhaps created some jobs are entitled to keep a reasonable amount of their hard-earned wealth. It would align Democrats with the American Dream, the notion that anyone who works hard and lives prudently should have a shot at the brass ring. The $1 million threshold hits anyone who reaches the iconic status of a millionaire. Although $1 million isn't what it used to be, it still conveys powerful symbolism and having the estate tax kick in right when the American Dream is attained is the kind of thing that heats the water at Tea Parties.
Republicans would have a hard time opposing estate tax reform. The $1 million threshold is something they rejected with the Bush 43 tax cuts, and they would be compelled to vote in favor of raising it. Certainly, some of them would favor a more dramatic rollback of the estate tax. But others would realize that their outcries over the burgeoning deficit would clash with demands for abolishing the estate tax. Charitable and educational institutions in all Congressional districts, needing endowments now more than ever, would lobby for retaining the tax, putting Republican legislators in the position of damaging local institutions if they favor outright repeal.
Thus, the Democrats would probably secure enough Republican votes that estate tax reform couldn't be filibustered or otherwise blocked. Lifting the threshold would probably cost the Treasury some tax revenues, although the impact is less clear than one might think. Resumption of the $1 million threshold might not benefit the Treasury the most; it could benefit estate planning attorneys the most, along with the finance professionals managing the tax shelters that would blossom if the $1 million threshold took effect. If the Republicans somehow prevented the Democrats from reforming the estate tax, the Democrats could score points in the mid-term elections for trying.
Estate tax reform would position Democrats closer to the political middle, and give them credit for fostering tax equity. It wouldn't directly benefit most voters; only around 2% of estates were subject to estate tax when it kicked in at the $1 million level. But reform would brighten their dreams for their children, whom they hope will face estate tax problems.
The ballooning federal deficit will likely require a tax increase sooner or later. This being an election year, expect a lot of hemming and hawing, and no increase. There is one tax measure--not an increase--that probably could be enacted this year. And if the Democrats try it and are blocked by the Republicans, the Democrats would score political points for trying.
That would be federal estate tax reform. The Bush 43 tax cuts are bizarrely structured to provide for no estate tax in 2010 but a reversion next year to an old $1,000,000 threshold for the imposition of the tax. This anamoly is, like so many things in Washington, a political ploy, this one designed to make the cost of the tax cuts appear lower than they'd have been if the estate tax had been permanently eliminated. This sleight of hand made it easier for Congress to sign off, with the presumption that someone else would fix the problem when the tax reverted back to the $1,000,000 threshold.
Last year, there was general agreement among Democratic and Republican power brokers that reform of the estate tax should revolve around excluding the first $3.5 million of the estate from taxation and imposing the tax on amounts above that level, with the $3.5 million threshold to be adjusted for inflation. However, amidst last year's squabbling over bank bailouts and bonuses, the surge of Tea Parties, faux bipartisanship over health insurance reform, and pandemic adolescent finger pointing by high ranking federal officials and prominent members of Congress, nothing was done about estate tax reform.
For understandable reasons, estate tax reform this year has been shoved to the back part of the back burner that isn't even lit. But a Democratic initiative to enact the $3.5 million compromise that existed last year might work to their political advantage this fall.
Although this year's temporary repeal of the estate tax sounds like a boondoogle for the wealthy, it actually includes a potential unpleasant surprise for many. When the estate tax is in effect, heirs and other recipients of inheritances receive a "stepped up basis" (i.e., a base value of the higher of the original cost of the asset or its value at the time of the deceased person's death). For many assets, like stocks, real estate and collectibles, a stepped up basis means that when the recipient sells after inheriting the asset, income taxes (usually capital gains taxes) will be calculated by subtracting the stepped up basis from the proceeds of the sale to determine taxable gain.
However, when there is no estate tax, heirs and other recipients of inherited assets do not receive a stepped up basis. They get only a "carry over basis" (i.e., the deceased person's basis, which could be much lower than a stepped up basis for assets like stocks, real estate and collectibles). Thus, if they sell, their income tax is calculated by subtracted the carry over basis from the sales proceeds. This will often result in much greater taxes.
A $3.5 million exclusion from estate taxation would benefit the upper middle class, in particular those whose estates run in the range of $3.5 million to a bit above $5 million. These folks (or their heirs, really) might be worse off with no estate tax. Their heirs would get only a carryover basis, and be potentially subject to taxation on much larger gains than they'd face with a stepped up basis. The $3.5 million exclusion would largely shelter upper middle class estates from estate tax, while conferring a stepped basis that would significantly shelter the heirs if and when they sold the inherited assets.
The larger an estate, the more the benefit from a complete repeal of the estate tax. But that is a temporary circumstance, since the estate tax returns with a $1,000,000 threshold in 2011. Then, both the upper middle class and the wealthier are subject to higher levels of estate tax.
At first glance, it might make sense for the Democrats to simply let the estate tax lapse back down to a $1,000,000 threshold. With the growing federal deficit and a middle class core constituency, the Democrats would seem likely to lean toward soaking the rich (and upper middle class). But elections today are all about capturing the independents, the swing voters in between left and right who often outnumber party loyalists on either side. The estate tax matters to many small business owners and farmers, who can accumulate over $1,000,000 in net worth even if their annual incomes are modest. Many professional and managerial couples in the Northeast or the West Coast can exceed the $1 million threshold by owning a suburban home in a good school district and having a 401(k) account or two. These upper middle class folks are often opinion leaders and frequent contributors to political campaigns. Although their numbers aren't large, their influence can be significant.
Estate tax reform would demonstrate that the Democrats aren't focused solely on extracting more from taxpayers. It would be a step toward tax equity, and an acknowledgment that those who have worked hard, saved diligently and perhaps created some jobs are entitled to keep a reasonable amount of their hard-earned wealth. It would align Democrats with the American Dream, the notion that anyone who works hard and lives prudently should have a shot at the brass ring. The $1 million threshold hits anyone who reaches the iconic status of a millionaire. Although $1 million isn't what it used to be, it still conveys powerful symbolism and having the estate tax kick in right when the American Dream is attained is the kind of thing that heats the water at Tea Parties.
Republicans would have a hard time opposing estate tax reform. The $1 million threshold is something they rejected with the Bush 43 tax cuts, and they would be compelled to vote in favor of raising it. Certainly, some of them would favor a more dramatic rollback of the estate tax. But others would realize that their outcries over the burgeoning deficit would clash with demands for abolishing the estate tax. Charitable and educational institutions in all Congressional districts, needing endowments now more than ever, would lobby for retaining the tax, putting Republican legislators in the position of damaging local institutions if they favor outright repeal.
Thus, the Democrats would probably secure enough Republican votes that estate tax reform couldn't be filibustered or otherwise blocked. Lifting the threshold would probably cost the Treasury some tax revenues, although the impact is less clear than one might think. Resumption of the $1 million threshold might not benefit the Treasury the most; it could benefit estate planning attorneys the most, along with the finance professionals managing the tax shelters that would blossom if the $1 million threshold took effect. If the Republicans somehow prevented the Democrats from reforming the estate tax, the Democrats could score points in the mid-term elections for trying.
Estate tax reform would position Democrats closer to the political middle, and give them credit for fostering tax equity. It wouldn't directly benefit most voters; only around 2% of estates were subject to estate tax when it kicked in at the $1 million level. But reform would brighten their dreams for their children, whom they hope will face estate tax problems.
Sunday, March 28, 2010
The EU's Lesson in Civics
Sometimes, we are reminded that the civics class we took in high school wasn't just an occasion for the boys in the back row to pull pigtails and have snicker fests making fun of the goody two-shoe student government types who earnestly raised their hands all the time. The crisis over Greece's sovereign debt illustrates why effective government is good for business and the economy.
Late last week, the EU announced a bailout plan, of sorts, to provide Greece with assistance in case it could not successfully borrow in the financial markets. The details of the plan remain vague. One feature that was prominently mentioned, though, was that the IMF would supposedly participate in the bailout. Why include the IMF? In part, to spread the costs of the bailout farther, as a palliative to the frugal German electorate. Less publicized but probably more important is that the IMF doesn't just hand over money to distressed nations. It imposes tough love requirements for fiscal responsibility (read, fiscal austerity) that steer the borrowing nation back to the straight and narrow. These conditions fill a gap left in the EU's governance--namely that there is no means for the EU to compel its members to adhere to its fiscal standard (i.e., that their government deficits not exceed 3% of GDP). The EU ostensibly monitors its members for compliance. But oversight has failed, with Greece successfully understating its deficit for years, until it 'fessed up last fall to violations. And even if the EU had uncovered violations, it has no enforcement process to mandate improved behavior. Imagine a police force with defective radar guns, no cruisers and no ticket books, and you have the EU.
The IMF can produce results. The Asian Tiger nations caught in the 1997 currency crisis spent time in IMF boot camp, down on the deck giving twenty. Today, they are prosperous. The IMF cure involves painful economic adjustments and more than a smidgen of increased unemployment. So the threat of IMF involvement may push Greece to get right with the EU. But one high ranking EU official, Vitor Constancio of Portugal (a nation with its own sovereign debt problems), reportedly rejected IMF involvement. So the waters were muddied just as they were clarified.
The generality and absence of details about this bailout package raises suspicions that the EU is gaming the financial markets, announcing the discovery of the Seven Cities of Cibola without explaining precisely how to get there. Talk therapy is a cheaper way to keep Greece's borrowing rates from skyrocketing than cash on the barrelhead. When you get down to it, talk may be all the EU has to offer, because it has no way to compel member nations to contribute to a bailout, even if they've agreed to participate. Add the fact that Germany still hasn't committed to help fund a bailout, and one wonders whether "bailing" here means helping Greece or avoiding any role in helping Greece.
The EU's charter (the Maastricht Treaty) is weaker than the Articles of Confederation that the thirteen original United States had to abandon in 1789 in favor of a Constitution that provided for a much stronger national government. As much as today's conservatives might dispute it, the power of the federal government is a crucial reason for America's prosperity. It promoted the development of national transportation systems (railroads, airlines and interstate highways) and communications systems (a national postal service, the telegraph, the telephone, radio, television, and now the Internet). It subsidized the settlement of farm land (with measures like the Homestead Act and the Oklahoma land rush), and helped agriculture recover from the Dust Bowl (with Department of Agriculture programs and price supports). It promoted investor confidence after the 1929 stock market crash, and stabilized the banking system with the Federal Reserve system and federal deposit insurance. Many of these programs have had disparate regional impact, where one part of the U.S. subsidizes another part. But the nation as a whole has benefited and grown. While federal policy sometimes goes too far, the United States would never have become the world's sole superpower without a powerful federal government.
The EU has almost no chance of evolving into a single nation, the way the United States unified from semi-autonomous states to a single nation. Its differences are greater than those of the American states, and there is no looming military threat (like Great Britain to the fledgling United States) to impel unity. Thus, effective government will elude the EU and its sovereign debt problems are likely to continue. As long as the EU can mollify the financial markets with talk therapy, the status quo may limp along. But if Germany's parsimonious electorate is called upon to actually plunk down real cash money, we might easily see the beginning of the end of the EU. Greece cannot be ejected from the EU (its charter has no mechanism for expelling non-compliant members). But Germany has no obligation to fund a bailout or remain in the EU. Today, the Germans expect the Greeks to behave like Germans, and the Greeks expect the Germans to behave like Greeks. Neither is going to happen. Sooner or later, everyone over there will look across the Atlantic for a bailout. With populism roiling the political waters here, there will be no second Marshall Plan.
So the sovereign debt crisis is likely to continue unless the financial markets decide against the weight of the evidence that Greece is a good credit after all. And when you get frustrated with the way things are going in Washington, just look across the Atlantic for a reminder that things could be worse, maybe a lot worse.
Late last week, the EU announced a bailout plan, of sorts, to provide Greece with assistance in case it could not successfully borrow in the financial markets. The details of the plan remain vague. One feature that was prominently mentioned, though, was that the IMF would supposedly participate in the bailout. Why include the IMF? In part, to spread the costs of the bailout farther, as a palliative to the frugal German electorate. Less publicized but probably more important is that the IMF doesn't just hand over money to distressed nations. It imposes tough love requirements for fiscal responsibility (read, fiscal austerity) that steer the borrowing nation back to the straight and narrow. These conditions fill a gap left in the EU's governance--namely that there is no means for the EU to compel its members to adhere to its fiscal standard (i.e., that their government deficits not exceed 3% of GDP). The EU ostensibly monitors its members for compliance. But oversight has failed, with Greece successfully understating its deficit for years, until it 'fessed up last fall to violations. And even if the EU had uncovered violations, it has no enforcement process to mandate improved behavior. Imagine a police force with defective radar guns, no cruisers and no ticket books, and you have the EU.
The IMF can produce results. The Asian Tiger nations caught in the 1997 currency crisis spent time in IMF boot camp, down on the deck giving twenty. Today, they are prosperous. The IMF cure involves painful economic adjustments and more than a smidgen of increased unemployment. So the threat of IMF involvement may push Greece to get right with the EU. But one high ranking EU official, Vitor Constancio of Portugal (a nation with its own sovereign debt problems), reportedly rejected IMF involvement. So the waters were muddied just as they were clarified.
The generality and absence of details about this bailout package raises suspicions that the EU is gaming the financial markets, announcing the discovery of the Seven Cities of Cibola without explaining precisely how to get there. Talk therapy is a cheaper way to keep Greece's borrowing rates from skyrocketing than cash on the barrelhead. When you get down to it, talk may be all the EU has to offer, because it has no way to compel member nations to contribute to a bailout, even if they've agreed to participate. Add the fact that Germany still hasn't committed to help fund a bailout, and one wonders whether "bailing" here means helping Greece or avoiding any role in helping Greece.
The EU's charter (the Maastricht Treaty) is weaker than the Articles of Confederation that the thirteen original United States had to abandon in 1789 in favor of a Constitution that provided for a much stronger national government. As much as today's conservatives might dispute it, the power of the federal government is a crucial reason for America's prosperity. It promoted the development of national transportation systems (railroads, airlines and interstate highways) and communications systems (a national postal service, the telegraph, the telephone, radio, television, and now the Internet). It subsidized the settlement of farm land (with measures like the Homestead Act and the Oklahoma land rush), and helped agriculture recover from the Dust Bowl (with Department of Agriculture programs and price supports). It promoted investor confidence after the 1929 stock market crash, and stabilized the banking system with the Federal Reserve system and federal deposit insurance. Many of these programs have had disparate regional impact, where one part of the U.S. subsidizes another part. But the nation as a whole has benefited and grown. While federal policy sometimes goes too far, the United States would never have become the world's sole superpower without a powerful federal government.
The EU has almost no chance of evolving into a single nation, the way the United States unified from semi-autonomous states to a single nation. Its differences are greater than those of the American states, and there is no looming military threat (like Great Britain to the fledgling United States) to impel unity. Thus, effective government will elude the EU and its sovereign debt problems are likely to continue. As long as the EU can mollify the financial markets with talk therapy, the status quo may limp along. But if Germany's parsimonious electorate is called upon to actually plunk down real cash money, we might easily see the beginning of the end of the EU. Greece cannot be ejected from the EU (its charter has no mechanism for expelling non-compliant members). But Germany has no obligation to fund a bailout or remain in the EU. Today, the Germans expect the Greeks to behave like Germans, and the Greeks expect the Germans to behave like Greeks. Neither is going to happen. Sooner or later, everyone over there will look across the Atlantic for a bailout. With populism roiling the political waters here, there will be no second Marshall Plan.
So the sovereign debt crisis is likely to continue unless the financial markets decide against the weight of the evidence that Greece is a good credit after all. And when you get frustrated with the way things are going in Washington, just look across the Atlantic for a reminder that things could be worse, maybe a lot worse.
Tuesday, March 23, 2010
Federalism in the Derivatives Market
Financial regulatory reform at the federal level is bogged down in a lobbying scrum. The Senate Finance Committee just voted along party lines to send Senator Christopher Dodd's bill to the Senate floor. But the outcome and timing there remains in unclear. All we know is that something might happen sometime. The subject with the least certainty of reform is the derivatives market.
The derivatives market was the scene of the crime for the 2007-08 financial crisis. Stupid, bad and fraudulent mortgage lending practices at the consumer level were greatly magnified by the profits and compensation that could be and were obtained from securitization and the creation of CDOs, CMOs, and so on. Derivatives seemed to magically transfer risk out of sight (and therefore out of mind), while generating Brobdingnagian earnings for Wall Street. Bad loans were transformed into "good" investments, and a lot of very smart financiers somehow concluded that if bad loans could thusly made good, then they should make many, many more bad loans in order to do more "good."
The sheer weight of all those bad loans--trillions of dollars worth--are a crucial reason why the economy remains stagnant. The housing market won't recover for years because of the overhang from foreclosures and homes with defaulted mortgages awaiting foreclosures. Much of today's long term unemployment is attributable to people, mostly men, who were formerly employed in homebuilding and now have nowhere to go. The derivatives markets have done great damage to the economy.
Moreover, it appears that many American municipalities bought derivatives products that turned out to be losers, costing them taxpayer money rather than saving it. The idea apparently was that certain derivatives, like interest rate swaps, could provide cities with a lower net cost of borrowing. But interest rates, pushed down by the Fed, have imposed costs on these cities rather than saving them money. Municipal services are being cut in order to make payments to big banks.
Some states may limit the ability of municipalities to purchase financial derivatives. The risks are seen as incomprehensible and therefore too large. (If you don't understand an investment risk, it's too large for you because you don't know how bad things can get.) Limiting municipal investments isn't new. Many municipalities can invest bond offerings only in extremely low risk investments; no junk bonds or penny stocks. There's nothing intrinsically wrong with taking derivatives off the table. It looks like some states won't wait for federal reforms. They'll change the derivatives markets their own way.
Meanwhile, across the pond, the EU is giving increasingly serious consideration to limiting trading in credit default swaps. Furthermore, the uproar over the use of derivatives to sweep sovereign debt under the carpet is likely to shrink the market for such maneuvers.
Wall Street's lobbying power is unsurpassed, and meaningful federal action to improve the regulation of derivatives cannot be predicted. But that doesn't mean everyone else will take their losses lying down. State governments may feel impelled to act. The EU clearly intends to act. The derivatives markets may be balkanized with a different set of rules every few hundred miles. The Street may get what it wished for--and then be sorry.
Of course, the big banks that are the principal dealers in the derivatives markets could revive an old, discarded Wall Street tradition and offer derivatives in ways that place the interests of customers first. But that would be so 20th Century.
The derivatives market was the scene of the crime for the 2007-08 financial crisis. Stupid, bad and fraudulent mortgage lending practices at the consumer level were greatly magnified by the profits and compensation that could be and were obtained from securitization and the creation of CDOs, CMOs, and so on. Derivatives seemed to magically transfer risk out of sight (and therefore out of mind), while generating Brobdingnagian earnings for Wall Street. Bad loans were transformed into "good" investments, and a lot of very smart financiers somehow concluded that if bad loans could thusly made good, then they should make many, many more bad loans in order to do more "good."
The sheer weight of all those bad loans--trillions of dollars worth--are a crucial reason why the economy remains stagnant. The housing market won't recover for years because of the overhang from foreclosures and homes with defaulted mortgages awaiting foreclosures. Much of today's long term unemployment is attributable to people, mostly men, who were formerly employed in homebuilding and now have nowhere to go. The derivatives markets have done great damage to the economy.
Moreover, it appears that many American municipalities bought derivatives products that turned out to be losers, costing them taxpayer money rather than saving it. The idea apparently was that certain derivatives, like interest rate swaps, could provide cities with a lower net cost of borrowing. But interest rates, pushed down by the Fed, have imposed costs on these cities rather than saving them money. Municipal services are being cut in order to make payments to big banks.
Some states may limit the ability of municipalities to purchase financial derivatives. The risks are seen as incomprehensible and therefore too large. (If you don't understand an investment risk, it's too large for you because you don't know how bad things can get.) Limiting municipal investments isn't new. Many municipalities can invest bond offerings only in extremely low risk investments; no junk bonds or penny stocks. There's nothing intrinsically wrong with taking derivatives off the table. It looks like some states won't wait for federal reforms. They'll change the derivatives markets their own way.
Meanwhile, across the pond, the EU is giving increasingly serious consideration to limiting trading in credit default swaps. Furthermore, the uproar over the use of derivatives to sweep sovereign debt under the carpet is likely to shrink the market for such maneuvers.
Wall Street's lobbying power is unsurpassed, and meaningful federal action to improve the regulation of derivatives cannot be predicted. But that doesn't mean everyone else will take their losses lying down. State governments may feel impelled to act. The EU clearly intends to act. The derivatives markets may be balkanized with a different set of rules every few hundred miles. The Street may get what it wished for--and then be sorry.
Of course, the big banks that are the principal dealers in the derivatives markets could revive an old, discarded Wall Street tradition and offer derivatives in ways that place the interests of customers first. But that would be so 20th Century.
Sunday, March 21, 2010
Political Stereotyping: Why Health Insurance Reform Was So Difficult
Just about everyone agrees that America's health insurance system is broken and needs to be fixed. Why, then, has change been so difficult to achieve? There are many reasons. One very important but rarely mentioned one is political stereotyping.
Political stereotyping, as we use the phrase, means attacking a politician for fitting the stereotype of his or her party and background. For example, President Obama has been typecast by the tea parties and the right as a big spending, big government politician. Being a Democrat who espouses mostly moderate and liberal ideas, he is vulnerable to such stereotyping.
It's very difficult for any politician to achieve change when the change is susceptible to political stereotyping. President George W. Bush's "ownership society" proposal to change the Social Security system by cutting back on guaranteed benefits and introducing government-funded investment accounts was easily be typecast as Republican parsimony toward moderate and low income Americans. It was DOA.
But Medicare Part D, an expensive prescription drug benefit that looked suspiciously Democratic, was enacted during the Bush 43 administration. This program, although weirdly structured with a "doughnut hole" in benefits, contravened the political stereotype of George W. Bush and was adopted with considerable Democratic support. (Postscript: the Obama health insurance reform will close the doughnut hole, good news for the many retirees having high prescription medication expenses.)
Presidents are often successful when contravening their political stereotypes. President Obama encountered relatively light opposition to escalating the war in Afghanistan. President Clinton famously failed to reform health insurance, but was singularly successful in closing the federal deficit and producing a surplus (putatively a Republican aspiration if there ever was one). Clinton deregulated the financial sector, another seemingly contra-stereotypical policy that would unfortunately contribute to the 2007-08 financial crisis. He also reformed welfare to reduce opportunities for recipients to stay on the dole for long periods of time.
Farther back in time, Richard Nixon attained rapprochement with China, a step that a Democratic President would have been vilified for taking. President Eisenhower's expensive program to build the interstate highway system was an easier sell coming from a Republican President.
Programs that fit political stereotypes are usually adopted when the party in the White House has a large majority in Congress and the urgency of a crisis to invoke. Franklin Delano Roosevelt's New Deal wouldn't have been possible except for the Great Depression and the large Democratic majority in Congress. Lyndon Johnson's civil rights program followed from his landslide victory in 1964 and the increasing stridency over civil rights. The last great political battle over health insurance--the Medicare program adopted in 1965--also followed from the Democratic landslide of 1964.
Barack Obama's health insurance reform, approved by the thinnest of margins, was achieved only because of the sweeping Democratic victory in 2008 and the virtual breakdown of the status quo in health insurance. Nevertheless, with the Democrats having demonstrated the ability to deliver on a major program, they have overcome the disadvantages of fitting the stereotype. The yin and yang of Washington have shifted again.
Political stereotyping, as we use the phrase, means attacking a politician for fitting the stereotype of his or her party and background. For example, President Obama has been typecast by the tea parties and the right as a big spending, big government politician. Being a Democrat who espouses mostly moderate and liberal ideas, he is vulnerable to such stereotyping.
It's very difficult for any politician to achieve change when the change is susceptible to political stereotyping. President George W. Bush's "ownership society" proposal to change the Social Security system by cutting back on guaranteed benefits and introducing government-funded investment accounts was easily be typecast as Republican parsimony toward moderate and low income Americans. It was DOA.
But Medicare Part D, an expensive prescription drug benefit that looked suspiciously Democratic, was enacted during the Bush 43 administration. This program, although weirdly structured with a "doughnut hole" in benefits, contravened the political stereotype of George W. Bush and was adopted with considerable Democratic support. (Postscript: the Obama health insurance reform will close the doughnut hole, good news for the many retirees having high prescription medication expenses.)
Presidents are often successful when contravening their political stereotypes. President Obama encountered relatively light opposition to escalating the war in Afghanistan. President Clinton famously failed to reform health insurance, but was singularly successful in closing the federal deficit and producing a surplus (putatively a Republican aspiration if there ever was one). Clinton deregulated the financial sector, another seemingly contra-stereotypical policy that would unfortunately contribute to the 2007-08 financial crisis. He also reformed welfare to reduce opportunities for recipients to stay on the dole for long periods of time.
Farther back in time, Richard Nixon attained rapprochement with China, a step that a Democratic President would have been vilified for taking. President Eisenhower's expensive program to build the interstate highway system was an easier sell coming from a Republican President.
Programs that fit political stereotypes are usually adopted when the party in the White House has a large majority in Congress and the urgency of a crisis to invoke. Franklin Delano Roosevelt's New Deal wouldn't have been possible except for the Great Depression and the large Democratic majority in Congress. Lyndon Johnson's civil rights program followed from his landslide victory in 1964 and the increasing stridency over civil rights. The last great political battle over health insurance--the Medicare program adopted in 1965--also followed from the Democratic landslide of 1964.
Barack Obama's health insurance reform, approved by the thinnest of margins, was achieved only because of the sweeping Democratic victory in 2008 and the virtual breakdown of the status quo in health insurance. Nevertheless, with the Democrats having demonstrated the ability to deliver on a major program, they have overcome the disadvantages of fitting the stereotype. The yin and yang of Washington have shifted again.
Thursday, March 18, 2010
China Bails as Germany Declines to Bail. Will America Bail?
The Chinese government is conducting stress tests on over 1,000 Chinese companies to ascertain how a rise in the value of China's currency, the yuan, would affect them. See http://www.bloomberg.com/apps/news?pid=newsarchive&sid=ahhhMkrA.A.I. This happens at a time when the U.S. and other countries have complained about the strength of the yuan. Members of Congress have threatened to take action against China (although given Congress' record of alacrity on legislative initiatives recently, the Chinese would hardly be quivering in their shoes).
Nevertheless, it is potentially significant that China's government is scoping out the impact of re-valuing the yuan upwards. Americans and other non-Chinese shouldn't delude themselves that their complaints have much to do with China's apparent inclination to re-value. China's economic policies are driven by internal concerns. While the Chinese government hardly is a paragon of transparency, there's probably an overriding reason why China might now re-value the yuan. It has no good investments outside of China for future trade surpluses. The dollar, overall, has dropped during the last decade and can be expected to keep sinking. The Euro is suddenly looking shaky, with the recent surge of EU sovereign debt problems, hinky national accounting systems and preposterous posturing substituting for a solution. The yen offers low-yields and doesn't have attractive long term prospects, not with Japan's massive government debt.
The yuan, by contrast, is likely to be a good investment. Although there is currently a bubbly froth in China's real estate and credit markets (sound familiar?), the People's Republic remains on an upward long term trajectory. By raising the value of the yuan, the Chinese government reduces China's trade imbalances and the cash surplus it needs to recirculate to other countries. U.S. imports to China may rise, although you can bet China's government intends to encourage Chinese companies to redirect their attentions to domestic markets. Throughout the last 30 years of modernization, the Chinese have quietly made a priority of economic self-reliance, encouraging Chinese companies to improve technological applications and productive efficiency, with the goal of competing against and ultimately supplanting foreign companies selling in China. If the yuan is re-valued upward, China's push for self-sufficiency will intensify, and probably enjoy considerable success. Then, the Chinese government will look smart for investing in the yuan and bailing on the currencies of stagnating foreign nations.
Meanwhile, back at the ranch, the EU is starting to look less unified. The French have stepped forward and argued for an explicit bailout of Greece. The Germans, no doubt irked by the fact that France's gallantry would be funded by Germany's wealth, have intimated that perhaps Greece should depart the EU in order to pursue other opportunities (or something to that effect). On a subliminal level, it's disquieting to see France and Germany disagreeing over a nation in the Balkans. At least this time, neither stormtroopers nor poilus are on the alert.
Nevertheless, the Europeans seem to be drifting back toward the dynamics of continental relations in the early part of the preceding century, when nations seemed simply to misunderstand where their neighbors were coming from. France's President, Nicholas Sarkozy, by proposing a concrete bailout plan for Greece, was inviting Germany's Chancellor, Angela Merkel, to commit political suicide. Seeing as how Merkel worked her way up the political ladder to become Germany's first female chancellor, self-immolation isn't likely to be in her playbook. While the French electorate is surely applauding Sarkozy's efforts to allocate some of Germany's wealth to Greece, Germany's electorate will only encourage Merkel to flip Sarkozy a pelican, or something like that. This isn't likely to end in a cozy circle with everyone roasting marshmellows and singing Kumbaya.
Greece has threatened to go to the IMF for assistance if the EU doesn't soon come up with a concrete bailout plan. The Germans shrugged. Without German participation, there will be no EU bailout plan because France and other pro-bailout nations have only the courage of Germany's convictions.
Thus, it may pass that Greece goes to the IMF. That's when Greek prime minister George Papandreou's quiet visit with President Obama last week may acquire greater significance. While next to nothing has been said publicly about the purpose and outcome of that meeting, it wouldn't be a surprise to see an American contribution to the IMF not long after Greece applies for help. After all, doughboys and GIs twice went over there to solve Europe's problems. Greenbacks may have to make the same trip soon.
Nevertheless, it is potentially significant that China's government is scoping out the impact of re-valuing the yuan upwards. Americans and other non-Chinese shouldn't delude themselves that their complaints have much to do with China's apparent inclination to re-value. China's economic policies are driven by internal concerns. While the Chinese government hardly is a paragon of transparency, there's probably an overriding reason why China might now re-value the yuan. It has no good investments outside of China for future trade surpluses. The dollar, overall, has dropped during the last decade and can be expected to keep sinking. The Euro is suddenly looking shaky, with the recent surge of EU sovereign debt problems, hinky national accounting systems and preposterous posturing substituting for a solution. The yen offers low-yields and doesn't have attractive long term prospects, not with Japan's massive government debt.
The yuan, by contrast, is likely to be a good investment. Although there is currently a bubbly froth in China's real estate and credit markets (sound familiar?), the People's Republic remains on an upward long term trajectory. By raising the value of the yuan, the Chinese government reduces China's trade imbalances and the cash surplus it needs to recirculate to other countries. U.S. imports to China may rise, although you can bet China's government intends to encourage Chinese companies to redirect their attentions to domestic markets. Throughout the last 30 years of modernization, the Chinese have quietly made a priority of economic self-reliance, encouraging Chinese companies to improve technological applications and productive efficiency, with the goal of competing against and ultimately supplanting foreign companies selling in China. If the yuan is re-valued upward, China's push for self-sufficiency will intensify, and probably enjoy considerable success. Then, the Chinese government will look smart for investing in the yuan and bailing on the currencies of stagnating foreign nations.
Meanwhile, back at the ranch, the EU is starting to look less unified. The French have stepped forward and argued for an explicit bailout of Greece. The Germans, no doubt irked by the fact that France's gallantry would be funded by Germany's wealth, have intimated that perhaps Greece should depart the EU in order to pursue other opportunities (or something to that effect). On a subliminal level, it's disquieting to see France and Germany disagreeing over a nation in the Balkans. At least this time, neither stormtroopers nor poilus are on the alert.
Nevertheless, the Europeans seem to be drifting back toward the dynamics of continental relations in the early part of the preceding century, when nations seemed simply to misunderstand where their neighbors were coming from. France's President, Nicholas Sarkozy, by proposing a concrete bailout plan for Greece, was inviting Germany's Chancellor, Angela Merkel, to commit political suicide. Seeing as how Merkel worked her way up the political ladder to become Germany's first female chancellor, self-immolation isn't likely to be in her playbook. While the French electorate is surely applauding Sarkozy's efforts to allocate some of Germany's wealth to Greece, Germany's electorate will only encourage Merkel to flip Sarkozy a pelican, or something like that. This isn't likely to end in a cozy circle with everyone roasting marshmellows and singing Kumbaya.
Greece has threatened to go to the IMF for assistance if the EU doesn't soon come up with a concrete bailout plan. The Germans shrugged. Without German participation, there will be no EU bailout plan because France and other pro-bailout nations have only the courage of Germany's convictions.
Thus, it may pass that Greece goes to the IMF. That's when Greek prime minister George Papandreou's quiet visit with President Obama last week may acquire greater significance. While next to nothing has been said publicly about the purpose and outcome of that meeting, it wouldn't be a surprise to see an American contribution to the IMF not long after Greece applies for help. After all, doughboys and GIs twice went over there to solve Europe's problems. Greenbacks may have to make the same trip soon.
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