America's Political Dichotomy

America's most salient political dichotomy isn't Democratic vs. Republican, liberal vs. conservative, or Tea Partier vs. Occupier. It's that most Americans talk conservative but act liberal. They don't like Big Government. But don't mess with their Social Security and Medicare benefits. They see themselves as sturdy, self-sufficient individuals. But, when things go badly, they turn to unemployment comp, food stamps, and COBRA and HIPAA rights to health insurance. They don't like regulations limiting their investment options. But they love federal deposit insurance. And when the stock market plummets, they expect the government to do something.

This dichotomy explains much of the results of the Republican primaries. Many Republicans love the conservative talk coming from Santorum, Gingrich and Paul. Americans are dreamers (other countries don't dedicate themselves to the pursuit of happiness). And the idealistic talk of Santorum, Gingrich and Paul is appealing to many. But larger numbers of Republicans understand that the pragmatic, nuanced approach taken by Romney paves the way to the political middle, where general elections are won. Major right wing government shrinkers won't beat Barack Obama, who angles for the political middle by diligently working the angles of the dichotomy: instigate major reform of health insurance, but take out Osama bin Laden; block the Keystone Pipeline, but talk tough to Iran; target the 1%, but keep open the prison for terrorists at Guantanamo Bay.

Forty-five years ago, the Republican Party understood this dichotomy very well. Richard Nixon, a candidate with a lot less charisma than Mitt Romney (imagine that), beat cheerful Hubert Humphrey by talking tough about crime, the North Vietnamese, the Soviets, and the Chinese, while treading lightly on the benefits government provided to the citizenry. Nixon's 1968 victory initiated a 24-year period of Republican domination of the White House. It wasn't until 1992, when Bill Clinton triangulated the traditional Democratic platform in a major shift toward the middle, that the Democrats again became competitive for the White House.

Now, Republicans have become more and more entangled in the conservative talk part of the dichotomy, and less observant of the need to make voters feel comfortable with them. The dichotomy could easily continue to bifurcate Republican primary results all the way to the Republican Convention. If so, Obama's chances for re-election will increase all the more.

Maybe the Retail Investor is Retiring

A persistent trend for the past three years is that retail investors have been bailing out of the stock market. Even now, with the market reaching new post-2008 highs, individual investors continue their exodus. Stock market pundits scold shrilly, pointing out that these wusses have missed out on the big rally of the past six months. The same wusses are deemed to be short-sighted for piling into bond funds at a time of historically low interest rates following a 30-year bond market rally. The pundits pronounce retail investors foolish, or worse.

But stock market pundits often get it wrong. Very few of them predicted the 2008 crash. Most don't have investment records that beat the S&P 500. Retail investors may in fact be acting very rationally. The oldest Baby Boomers are reaching retirement age--i.e., 65. It's accepted wisdom that investors should ease out of stocks as they get older, and shift into bonds to stabilize their portfolios. This portfolio shift was recommended long before the 2008 crash, and nothing that's happened since then has made it seem less than wise.

The volatility in the stock market, resulting from its domination by short term, big money, usually computerized traders, would like nothing better than plenty of retail participation. That would give the smart money more sheep to shear. But having been just recently shorn, Boomers and other investors may be less willing to buy into the hype. Prices of risk assets have painfully proven to be ephemeral. Real estate, on the whole, is still falling. Stocks are bipolar. Just because the Dow tops 13,000 doesn't mean its worth 13,000 or anything near that, not unless you plan to sell tomorrow. Retail investors--or at least the Boomers among them--may be gradually retiring. And this trend could continue for a generation.

The Greek Debt Crisis: Another Failure of Derivatives

Once again, derivatives have failed. This time, it's in the Greek sovereign debt crisis. Greece and many EU member nations are dead set on making private holders of Greek bonds take losses in the range of 70% of the face value of the bonds. Not only that, but the EU wants to structure the hit to private bondholders in such a way that it doesn't trigger the requirement for credit default swaps (which are insurance on the bonds) to pay injured bond holders. The legalities involved become rather labyrinthine at the margin. Suffice it to say that the entire bucket of yogurt may well end up in court, where attorneys charging very reasonable fees will secure the funds needed for their children's college tuition.

Court isn't where holders of credit default swaps want to be. Even if, after years of litigation, they receive substantial recompense, they are likely to view CDS's as a flop. A derivatives contract is meaningless if it doesn't transfer risk as advertised. And CDS's on Greek sovereign debt are starting to look pretty hinky.

An interesting question is why is the EU so intent on preventing payouts on the CDS's? Possibly, the EU is concerned that the counterparty risk is concentrated in one or a few institutions, where the losses from payouts might be destabilizing. We're also told that we are supposed to be comforted by the fact that the net exposure in the CDS market for Greek bonds is around 3 billion Euros and that CDS exposures are collateralized, so that counterparties shouldn't be caught in a "run" a la AIG 2008. Okay, 3 billion Euros isn't that much for the world financial system as a whole. But what if it's concentrated in one or two or three firms? As for collateral, what quality are we talking about? If the collateral is EU sovereign bonds (a likely possibility), then one would be forgiven for nervousness about undercollateralization.

In addition, the EU may wish to punish the speculators that bought up Greek sovereign debt at substantial discounts to face value and would profit handsomely if they received CDS payouts (which could be as much as 100 cents on the Euro, although technicalities of the calculation of payouts could result in smaller but potentially still profitable payouts). Ever since hedge funds walloped the British pound in 1992, Europeans have had a fear of financial speculators. Whether that's rightly or wrongly so, CDS holders may be suffering as a result.

Whatever the problem may be, the EU's fears of CDS payouts are evident. Surely, this sordid episode will shake up the market for EU sovereign bonds. Liquidity will fall as private investors realize they can't offload the risk of the political dysfunction that's at the heart of the crisis. EU members have criticized the Volcker rule, arguing that it will discourage big U.S. banks from making markets in EU sovereign bonds. These critics, however, should deal with their own botch-ups before foisting blame on American efforts to safeguard depositors' money. The heart of the EU sovereign debt crisis is that Europeans wanted the benefits of a currency union without having an effective mechanism for dealing with the risks. As bond investors come to realize it's difficult to offload political risk via the CDS market, liquidity in EU sovereign bonds will surely diminish. And the fault lies on the eastern side of the Pond.

Distribution of Income and Wealth is the Issue

As much as many politicians--mostly on the right--try to deny it, today's politics are all about the distribution of wealth and income. Democrats, with President Obama at the forefront, have made financial inequality a crucial element of their 2012 platform. Republicans argue against new taxes, and for the long term reduction of taxes and the shrinkage of the federal deficit. That, too, affects the distribution of financial resources, mostly in directions unfavorable to middle class and modest income households. Long term cuts, to be effective, would have to come to a large degree from Medicare and Medicaid, which verge on insolvency in the relatively near future. Social Security benefits may well shrink over time, although the cuts aren't likely to be apocalyptic. The 1% won't have to trim their sails much if the Republicans have their way. Most of the rest of us will notice the increased costs we would bear.

The Euro crisis is all about the distribution of economic resources. As a whole, Europe has more than enough money to resolve the sovereign debt crisis. But a lot of the money that would have to be paid out to bond vigilantes would come from the good burghers of northern Europe, and they have no appetite to cover chits signed by spendthrift members of the EU. Reality is the Europe isn't a whole, and its continental wealth isn't available to cover the debts of profligate nations. The thrifty don't want to distribute their wealth to the prodigal.

In China and India, even as substantial middle classes emerge with the turn toward capitalism, hundreds of millions remain mired in poverty. The governments of both nations, in different ways, grapple with difficult problems of distributing the fruits of growth. China also confronts a demographic problem far worse than America's; its principal solution to date has been to slash the safety net once provided by the iron rice bowl. Both nations equivocate when asked to commit large sums to bailing out Europe. How can they explain to their citizens why they should save much wealthier Europeans from themselves?

In times of brisk economic growth, the expanding size of the pie makes sharing easier. Stagnation, however, brings out harpies. Increasing growth is the obvious solution. But that, for sure, falls into the category of more easily said than done (for elaboration on this point, call Ben Bernanke, Fed Chairman and Tim Geithner, Treasury Secretary).

Since the times when humans clung together in small groups of hunter-gatherers, distributional questions have existed. Hunting is a hit or miss process (pun intended), and the lucky hunter bringing down a deer would expect to share it with the entire group, just as the next day, another lucky hunter would share.

In a modern free enterprise system, protection of private property rights is important to provide incentives to work, save and invest. But market forces, alone, do not always produce distributions of financial rewards that comport with societal needs and norms. The demands of market-based economies altered social structures. Extended families disappeared as children reaching adulthood move hundreds and even thousands of miles away to find suitable jobs. Family-based safety nets evaporated as families splintered. But market forces make no provision for those injured on the job, the sick, the disabled, the laid-off or other unfortunates; and most certainly not for the elderly who no longer wish to or can work. Government programs were necessary to fill the gap.

There are no easy answers to distributional questions. But it's important to debate and decide them, because they are among the most crucial issues of the day. Trying to silence President Obama by accusing him of class warfare is tantamount to avoiding the central point in today's political dialogue. Whichever side you take on the question of the size of federal deficits, or the allocation of tax burdens, you're talking about the distribution of financial resources. A nation that faces up to the responsibility of dealing with this problem has a chance to reach the accommodations that lead to social harmony. A nation that ducks the issue and indulges in political mudslinging will face a grim future.

Rising Oil Prices: Has the Fed Been Too Clever By Half?

In eviscerating interest rates and quantitatively tranquillizing (we're way past easing), the Fed has sought to push investors into risk assets. Investors have responded. Stocks have risen sharply over the past six months. More disturbingly, oil and gasoline prices have bounced up, too.

The standard explanation for rising oil prices--demand from emerging markets like China and India--seems less plausible now that these economies are slowing down. The threat of Iran going off the deep end points toward higher prices. But Saudi Arabia's expressed intention to keep prices stable can't be taken lightly either.

However, the flood of liquidity that has come out of the Fed surely is a factor in rising petroleum prices, as all this cash has to find a home somewhere in the financial system. Rising oil prices create jobs in some parts of the country, but discourage consumers in all parts. While oil consumption won't fall much in the short term (because demand for gasoline is relatively inelastic, as economists would put it), consumption of clothes, food, vacations, and other things will suffer as gas bills snarf up the monthly budget. Recently improving economic statistics may reverse their trend.

The distribution of income enters the picture. Owners and sellers of risk assets benefit handsomely from the Fed's easing, while consumers (most of whom are middle class and hold little or no risk assets) are shortchanged. This matters in America, where consumption is 70% of the economy. One can see why QE 1, 2 and perhaps soon to be announced 3 haven't and won't boost economic growth that much. With the QEs, the Fed giveth, and it taketh away. The net gain to the economy is unclear.

Is the Fed Banking on a Crisis?

Scary things can happen when a central bank prepares for a crisis and it doesn't occur. In the late 1990s, there was a great deal of handwringing over the so-called Y2K problem. Numerous computer programs written in the 1960s and 1970s didn't originally accommodate dates in the twenty-first century, evidently because no one thought they would be in use for that long. But they were, and vast armies of computer programmers were deployed to modify programs written in ancient, almost forgotten computer tongues like Fortran and Cobol.

The Fed, alarmed at the possibility that bank and other computer systems might abruptly fail at 12:00 am, January 1, 2000, flooded the financial system with liquidity during 1999, to combat the risk of a credit crunch at the outset of the new century. This liquidity had to go somewhere, and a lot went into stocks. In the last quarter of 1999 and the first quarter of 2000, the S&P 500 rose about 12-13% (or 24-26% on an annualized basis), and the Nasdaq rose by two-thirds (or about 135% on an annualized basis). We know what happened next--the tech bubble burst and stocks have never, on an inflation adjusted basis, returned to their March and April 2000 heights.

There was no Y2K crisis, as it turned out. The armies of programmers carried the day, and the world rolled right into the twenty-first century as if there had been nothing to worry about.

But the Fed's flood of liquidity set the stage for the crisis that actually occurred: the collapse of the tech stock bubble. Although tech stocks were bubbling anyway, the Fed made things worse by lowering the price of cash, thereby effectively escalating the price of stocks. The Fed's bargain basement sale on liquidity in 1999 was to the stock market bubble like gasoline poured on a prairie fire.

Since last fall, the Fed has been sending double and even triple trailer trucks filled with liquidity from its loading dock 24/7. It's ruthlessly stamped out any positive interest rates on the short end of the yield curve, and thoroughly cowed the long end. Its apparent rationales for such actions include preparation for crises such as the sovereign debt mess across the pond, Iran's nuclear ambitions, and so on. Not surprisingly, stocks have risen over the past six months. Liquidity has to go somewhere. In late 1999 and early 2000, it went into stocks. During the past six months, we seem to see something similar.

If there really is a crisis today--like a credit crunch in Europe from Greece's default (the Greek default has effectively occurred; all that's happening now is the negotiation of the exact amounts of the losses to be borne by taxpayers, bondholders, etc.), a war between Israel, Iran and who knows who else, or the real estate bubble in China pops--the Fed will probably look wise and prudent for having engineered the biggest liquidity dump in central banking history.

But if the Europeans somehow muddle through (the stock market's current assumption), Iranian nuclear ambitions are somehow constrained without use of force (the stock market's current assumption) and the Chinese government manages a soft landing (the stock market's current assumption), then what will happen with stocks? Since late last summer, the DJIA has risen about 18% (or 36% on an annualized basis). The economy has been improving, but hardly enough to account for this kind of upswing.

Price inflation has been comparatively low (although more of a problem for those with modest incomes than the top 20%). But asset inflation is alive, well and snarling. If we avoid a major crisis this year, stocks may well soar. And perhaps soar some more. But then what? We have an all too recent and vivid history of government engineered asset bubbles ending badly. Whether you think history repeats itself or only rhymes, things are starting to look disturbingly familiar.

Freddie Mac's Silly Boo Boo

We are told today that Freddie Mac has some $3.4 billions in derivatives called "inverse floaters" that profit if homeowners do not refinance out of high interest rate mortgages. At the same time that Freddie Mac was accumulating its holdings of inverse floaters, it was tightening requirements for refinancings, thus either wittingly or unwittingly increasing its chances of profiting from its inverse floaters.

The contradiction between Freddie's investment in inverse floaters and its mission of fostering affordable housing for Americans is obvious. Freddie's regulator, the Federal Housing Finance Agency, has been pushing Freddie and Fannie Mae to limit the extent to which they receive taxpayer subsidies. Seeking investment gains has been one way of pursuing that goal. That may be why Freddie took a flyer with the inverse floaters.

While details remain scarce, it appears from news reports that these inverse floaters are interest only strips--investments that paying the holder (Freddie, in this case) the interest payments from a large pool of mortgages. Refinancings of these mortgages mean that interest payments from the pooled mortgages would stop (while interest payments on the new, refinanced mortgages would go to whoever holds the right to those payments, not to the strip). So the more the old mortgages in the pool are refinanced, the greater the likelihood of Freddie losing money on the strip. Inverse floaters are likely to be volatile in value if interest rates change, and probably aren't very liquid because they're risky.

Refinancings increase as interest rates drop. By investing in the inverse floaters, Freddie was in effect speculating on the direction of interest rates. If rates dropped, the inverse floaters would lose money. If rates rose, the inverse floaters could rise in value (although higher mortgage rates would detract from the value of the stream of interest payments, which would be detrimental to the value of the inverse floaters). These inverse floaters may have been a bet on largely stable interest rates.

The silly thing about all this is that Freddie was speculating on the direction of interest rates in volatile investments that would be an embarrassment if the financial press found out about them. After being nationalized in 2008, Freddie should have become greatly sensitized to the need to look good while doing good. These inverse floaters could produce outsized losses if refinancings pick up. Taxpayers might then be called on to provide more subsidies to Freddie, not fewer. And not because Freddie took losses trying to make homes more affordable for America but because it was betting homes wouldn't become more affordable.

It's entirely possible that Freddie's traders have an explanation for the inverse portfolios that sounded pretty good when they talked among themselves. But from a public relations standpoint, the inverse floaters are silly, at best. The true problem is that Freddie and Fannie have too many conflicting goals, attempt to fulfill too many differing expectations, and are simply too big. There are some pretty good arguments that the biggest banks should be broken up into smaller, not too big to fail pieces. All of those arguments apply a fortiori to Freddie and Fannie.

Will Hedge Fund Returns Drop?

The last couple of years have seen aggressive enforcement of the insider trading laws by the U.S. Department of Justice and the SEC. The use of wiretap authority has given federal prosecutors a powerful tool not deployed in years past, and greatly amplified investigators' ability to uncover illegal tipping. It seems that, almost every month or two, another hedge fund or traders associated with hedge funds, plead guilty, settle civil charges or both. Entire networks of tipping and insider trading have been blown up.

Traders at surviving hedge funds have no doubt taken notice of the downfall of many of their peers. Those that were dancing at the edge of the curb, or beyond, may well be cooling their jets. Many phone lines on Wall Street are probably less busy these days.

Competitive pressures were doubtless a major reason for hedge funds to engage in insider trading. If a hedge fund that takes 2% of a customer's assets and 20% of gains wants to stay in business, it has to beat the S&P 500 by quite a lot. That's much more easily said than done in the secular bear market that has existed since the stock market downturn in 2000. Inside information offers an edge that can't be beat (as long as you're not caught), and many hedgies just couldn't resist the temptation have a soto voce telephone conversation or twenty-six.

However, explaining lame returns to dissatisfied investors is a lot better than sharing a cell with Bubba. Even if you lose your investors, you don't have to clean latrines used by a lot of other guys. With it likely that many fewer "just between you and me" conversations are taking place on the Street, one must wonder whether hedge fund returns will drop. If you're an accredited investor, or managing money for one, you naturally don't want your money involved in illegality. But you also might ask yourself what returns hedge funds might offer now that federal electronics are policing the markets. A guy who wants 2 and 20 needs to be pretty talented in order to legally make the returns that justify a hedge fund investment, especially with that industry crowded with firms competing for the special profits that economists call "rent" (meaning profits above the level that a competitive market would provide). Think carefully before locking up your money in a hedge fund.

The Greek Debt Crisis and the Failure of Credit Default Swaps

The Greek debt crisis, from which the entire European sovereign debt morass arises, comes down to a dispute between the Greek government and a group of private investors who hold large amounts of Greek bonds. These investors, many of whom appear to be hedge funds, are refusing to swallow as much loss as the Greek government demands. The Greek government is threatening default. The investors respond by, in essence, saying, "Go ahead. Make my day."

If the Greek government defaults, the investors will turn to credit default swaps they bought to protect against losses on Greek bonds. These CDS's are like insurance coverage against a Greek default. The government wants the investors to "voluntarily" agree to concessions, which wouldn't trigger CDS payouts. The investors have bargained hard, apparently emboldened by the knowledge that they can turn to their insurers if negotiations fail and Greece defaults.

Although usually described as insurance, the CDS's in this instance are being used for speculative purposes. The hedge funds may actually profit more by forcing the Greek government to default, than by working toward a consensual resolution. A default could have severe consequences, triggering a credit crisis in Europe that could circumnavigate the global financial system at the speed of a broadband Internet connection and plaster the world economy with a major credit crunch. Economic dislocation and recession would surely ensue.

When an "insurance" contract turns out to encourage recklessness, it has failed. Insurance is meant to protect against outsized loss, not to encourage insureds to foster or instigate losses. CDS's appear to be motivating speculators to disrupt a nation's finances. That's undesirable, no matter how you look at it.

Regulators and the financial services industry have done little to prevent derivatives, and credit default swaps in particular, from wrecking the financial system, as happened in 2008. Now, derivatives again pose a similar danger. People who don't learn from their mistakes are doomed to make them again. A sense of impending doom is growing.

The Great Government Risk Transfer

One of the most singular characteristics of government policy since the Great Depression has been to shift financial risks from private hands to the government. Early programs in this respect had broad support because they benefited most citizens. Federal deposit insurance, Social Security and Medicare are notable examples. Other such programs benefited those thought to deserve special protection, such as subsidies for farmers, Aid for Dependent Children, and Medicaid. Fannie Mae, Freddie Mac, Ginnie Mae and HUD were created to boost home ownership, which was believed to promote good citizenship. America, once riven by dissension and social conflict from the sufferings of the Great Depression, stabilized and prospered (helped in part by the fact that it was the one big industrialized nation left standing after WWII). The middle class, in particular, enjoyed the fruits of a life in which many of the vicissitudes of dependency in an industrialized world were lessened. Income inequality shrank and optimism swept away the despair of the Depression.

In the past thirty years or so, the nature of government risk transfers has changed. More recent federal policies have taken financial risks off the hands of the well-to-do and transferred them to taxpayers. Most prominent has been the Federal Reserve's relentless low interest rate program, which boosted the value of risk assets like stocks, bonds and commodities. The Greenspan/Bernanke put--a dramatic lowering of interest rates and expansion of the money supply every time the stock market throws a hissy fit--is now a permanent feature of federal monetary policy. The Fed could not step back from providing, at zero cost to investors, the Grand Put without triggering a horrendous stock market crash. It's no wonder that the rich--whose burgeoning wealth derives mostly from stocks and other risk assets--have gotten richer. With the almighty Fed running interference for them, it's hard for the owners of risk assets not to get wealthier.

Other aspects of federal risk transfer benefitting the wealthy include Fannie Mae, Freddie Mac and HUD, without which the mortgage-backed securities market could not exist. Wall Street banks and financiers are among the biggest beneficiaries of this market. Other familiar examples are the evolution of large-scale farming subsidized by large amounts of farm subsidies and physicians who speed-treat patients to maximize their Medicare billings. Developers and homeowners in flood zones benefit from federal flood insurance, at the expense of taxpayers living on higher ground. Bailout programs like TARP disproportionately benefited the wealthy, while federal mortgage refinance and principal writedown programs that would benefit the unfortunate, have been largely ineffectual.

It's no surprise the wealthy have gotten the most out of federal risk transfers. They control the political process and can steer government policy in their favor. Mitt Romney's narrow victory in the Iowa caucuses only reinforces this trend. Money talks. Those with money have staying power in the political process. The ABM movement in the Republican Party (read Anyone But Mitt) isn't over his wealth, but his moderate views. So if another candidate surpasses Romney in the end and wins the White House, expect the Republicans not to disturb the prosperity of the well-to-do, although those less well-off and retirees should be apprehensive.

The Obama administration, for all its rhetoric, has presented little true threat to the wealthy. It agreed to a moderate temporary version of the estate tax, and has grudgingly gone along with a temporary continuation of the Bush II income tax cuts. Its Treasury Secretary has, overall, been a solid supporter of Wall Street (in spite of occasional politically motivated rhetoric to the contrary). And, despite policy proposals floated to the contrary, Fannie Mae and Freddie Mac continue in their central role financing the U.S. real estate market.

The question is whether this risk transfer can continue. Taxpayers don't have endless resources. Already we have a fierce debate over federal deficits, and there is much talk of imposing more risk on those of moderate and low income (by reducing Social Security, Medicare and Medicaid benefits). In Europe, we see the makings of a taxpayer revolt, with those in southern Europe objecting to paying more to cover the profligacy of their governments while those in northern Europe object to paying more to cover the profligacy of their southern neighbors.

American taxpayers haven't really honed in on the Great Government Risk Transfer in the U.S., even though it underlies many of today's political controversies. If the costs of such risk transfers continue to mushroom, citizens will eventually figure out that their pockets are being picked. If we truly believe in a market-based economy, governed by the principles of free markets, we have to cut back on the government's risk transfers, especially the ones benefiting the wealthy. Those who have capital to invest can do the most for society if they invest in ways undistorted by government subsidies. As things stand now, the wealthy have the incentive to profit off of taxpayers. It's fine if someone works hard, saves, invests wisely and gets rich. It's not fine if someone pigs out at the public trough. Income inequality honesty earned is deserved. Income inequality fostered and supported by government policy is unacceptable.