The Federal Reserve's Failure to Supervise

Sometimes, the way to solve a problem is to question your assumptions. That's a lesson the Federal Reserve should take from the Financial Crisis Inquiry Commission's Final Report. There's an interesting tidbit on p. 54, which quotes a former senior Fed staff member as writing, "Supervisors understood that forceful and proactive supervision, especially early intervention before management weaknesses were reflected in poor financial performance, might be viewed as i) overly-intrusive, burdensome, and heavy-handed, ii) an undesirable constraint on credit availability, or iii) inconsistent with the Fed's public posture." In other words, when a bank was making profits, especially lots of profits, regulatory staff were supposed to hold back.

This is exactly wrong. Undergraduate level economics teaches that any high degree of profitability should be ironed out by competitive forces in the market. Thus, the existence of high profitability may be a sign that something less than entirely desirable may be happening. The bank might be taking a lot of risk (remember that risk comes with reward), such as by underwriting mortgage loans to people whose documented ability to repay is skimpy or nonexistent. Or the bank may be doing something illegal. Fraud, manipulation and other illegal conduct can be immensely profitable. That's why there are so many financial shenanigans. High profitability is a yellow flag, indicating that increased regulatory scrutiny is warranted.

Requiring staff members to hold back until a bank's financial performance has nosedived, as the Fed apparently did, is tantamount to fiddling until disasters burst forth and wreak a full measure of havoc and collateral damage. No glory is attained when the cavalry charges over the hill after the wagon train has been massacred.

The FCIC final report also notes, on p. xvii, that in 1980, the financial sector earned 15% of total corporate profits in America. This figure grew to 27% by 2006. This sustained rise in profitability is another yellow flag. It could indicate a sustained increase in risk levels (uh, duh). Or it could be a sign of illegal behavior. Either way, a sustained rise in profitability should have been seen as a reason for greater regulatory alertness.

Sustained elevated profitability might also indicate cartelization, with large, powerful banks extracting outsized profits by dominating markets. This is also undesirable, as greater oligopoly power would reduce the benefits of competition. Regulators should be vigilant against a shift toward concentration in market power.

The Fed appears to have viewed bank profitability as desirable. Better financial performers would presumably be more stable and less likely to collapse, which would reduce the Fed's worries. But we now know that the sustained increase in bank profitability resulted from high risk and sometimes illegal conduct that exacerbated the instability of the financial sector, ultimately leading to the crisis of 2007-08.

It may be counter-intuitive for regulators to scrutinize their regulatees more closely when the latter are reporting rosier financial performance. But greater profitability is a yellow flag, and perhaps a red flag, for serious problems. Regulators are not supposed to be cheerleaders for management, nor are they supposed to relax when the regulated industry is prosperous. They must apply unrelenting skepticism, 24/7. The history of financial crises preceding the creation of the Federal Reserve well-document that markets are not invariably self-correcting or self-regulating. That's why the Fed was created. One of the root causes of financial bubbles is too much credulity. The civil servants charged with preventing these disasters should never add to the credulity.

Champion Cellists on the Move

This past week, Davos chattered as Egypt burned. Stock markets shuddered, and high ranking government officials worldwide issued statements and proclamations that were promptly ignored in the streets of Cairo. Hedge funds shorting oil were clobbered when petroleum prices surged, and the dollar rose as it took on its customary role as a refuge in times of crisis. The Euro, too close to the restiveness, fell back. None of this was entertaining.

More entertaining are the live performances by some champion cellists. They don't merely play notes. They squiggle, squirm, grin, frown, look around, roll their eyes and hug the instrument. Here are four of the finest, each playing the rousing third movement of Haydn's Cello Concerto No. 1.

Yo Yo Ma seems to scan the balconies for good-looking women. He must have seen some, because he delivers an inspired performance. http://www.youtube.com/watch?v=-S8pW74t2QQ&feature=related.

Han Na Chang, a Korean prodigy who has blossomed into one of the world's best cellists, bounces, frowns, purses her lips, puffs up her cheeks, and grins from coast to coast. She is one happy cellist. http://www.youtube.com/watch?v=-aoUxKfHS9I&feature=related.

Julian Lloyd Webber, brother of impressario Andrew Lloyd Webber, is one of the doyennes of Britain's cellist community. Here he is, in vaguely Medieval costume, playing brilliantly while flicking some lint off his left hand and occasionally flashing the whites of his eyes. http://www.youtube.com/watch?v=13GHrPNJzNQ&feature=related.

Mstislav Rostropovich demonstrates, however, that one need not squiggle all over the stage to play masterfully. He simply hugs the instrument, juts his jaw, and delivers a performance worthy of a maestro. http://www.youtube.com/watch?v=Vo113j8sQRE&feature=related.

Artistry at the Piano

The Financial Crisis Inquiry Commission issued its solemn report today, excoriating some, castigating others, and ascribing blame from sea to shining sea. Four dissenters expounded on their frustrations with the majority, leaving their fellow commissioners well-scolded. If you've been paying attention to the recent financial crisis, you've pretty read everything the commission has to say. Its report is likely to leave the debates unresolved. Which is typically what commissions in Washington, D.C. accomplish.

Onto more important things. Today's classical pianists tend to be technically precise, overly expressive of their very strongly felt emotions, scared shirtless of even a minor deviation from stylistic norms, theatrical in a conformist way, and just about impossible to distinguish from one another. Conservatories produce performers, and rather predictable ones. However, within living memory, great concert halls were graced with the presence of artists. The well-known artists--think of names like Rubenstein and Horowitz--serve as the templates for today's conservatory graduates. There were others who were distinctive, singular, unique. To fully appreciate the breadth and depth of classical music, one must leave well-marked trails and explore. Here are a few starting points.

Claudio Arrau. One of the most underappreciated pianists of the 20th Century, Chilean-born Claudio Arrau played with a self-possessed, deliberate style, seeming to hesitate before striking a note as if to think through the sound he wanted to produce. Always keeping the tempo under control however passionate the piece, Arrau added elegance to even the most tempestuous passages. Sometimes described as a romantic, Arrau maintained fidelity to the score and was never more romantic than the composer (a fault common among today's performers). Listen to Arrau play a passage from Beethoven's Appassionata piano sonata, a technically difficult piece through which Arrau movingly explores the depths of Beethoven's greatness. http://www.youtube.com/watch?v=w7GftdLYSsI&feature=related.

Glenn Gould. Known for his percussive interpretations of Bach, Canadian-born Glenn Gould was less contrapuntal than faithful to the score. Bach didn't write for the piano, an instrument that didn't exist in his day. Pianists playing Bach today are usually performing his pieces for harpsichord, a contrapuntal instrument incapable of modulating its tone or changing its volume. Although Gould is famed for largely eschewing Romantic music, he played pieces written for the piano sweetly and passionately with an understated touch that gently highlighted the emotion infused by the composer. Allow him to lead you through a passage from Beethoven's Piano Sonata No. 31. http://www.youtube.com/watch?v=rTfNSMcH2TY&feature=related.

Alicia de Larrocha. Spanish-born Alicia de Larrocha was not even five feet tall, yet she managed to wrap her small hands around the masterpieces of the piano repertoire. With verve and a perfect sense of tempo, de Larrocha painted magical musical landscapes, staying within the confines of the score and eliciting the emotions embodied in the composition. Here she is, gliding through Bach's French Suite No. 6. http://www.youtube.com/watch?v=Fiokjl-_gtA&feature=related.

Friedrich Gulda. Austrian Friedrich Gulda was the bad boy of Europe's classical music scene, once faking his own death just for laughs. He was theatrical, in a deviant sort of way that poked convention in the eye. (In the video attached below, Gulda performs wearing a turtle neck shirt and a hat that seems vaguely Turkish.) Although unorthodox and unrestrained, Gulda was a rarity: he had fun on stage. And while doing so brought unvarnished joy to his performances. Here's Gulda playing the first movement of Mozart's Piano Concerto No. 20, while also conducting the orchestra that accompanies him. http://www.youtube.com/watch?v=VtTqpqGIIYU.

None of this is to detract from the greatness of the well-known masters. For the finest performance this writer has ever heard of Chopin's Polonaise N0. 53 (the "Heroic," which for many serves as Poland's de facto national anthem), see this video of Polish-born Artur Rubenstein performing in Moscow. He must have been inspired by the venue to stick it to Poland's oppressors by reaching the heights of lyricism and grandeur. http://www.youtube.com/watch?v=nsl7XDTBaJo.

Hope For the Financially Lost

Financial plans can be blown up because of job loss, illness, elderly parents who need support, or bad investments. Some people simply can't save. Whatever the situation, there remains hope for the financially lost to have at least a decent retirement.

Boost your benefits. Work as long as possible to build up Social Security and, if available, pension benefits. This is especially important for those that can't save. Even if you aren't working, delay taking Social Security benefits as long as you can (unless you're 70 or older). Delaying Social Security increases benefits. For more, see http://blogger.uncleleosden.com/2007/05/mysteries-of-social-security-retirement_02.html.

Stay together. Couples generally are better off than singles, because they can pool their resources. Even if their only resources are Social Security benefits, a couple are usually better off together than individually. Of course, togetherness isn't always possible. When it is, there are financial, as well as other, benefits. For more, see http://blogger.uncleleosden.com/2007/05/mysteries-of-social-security-retirement_03.html.

Get a job with a pension. Government, law enforcement, military and educational jobs usually offer a pension or other retirement plan. Although pension benefits in many state and municipal jobs are being adjusted to meet fiscal realities, they will still be better than nothing. Not everyone is cut out for these lines of work. If you find a private sector job with a pension, then try to stay there long enough to accrue meaningful benefits. For those who can't save, a pension is golden. You just have to work long enough to vest; saving isn't necessary. If you need assistance figuring out if the amount of pension benefits your employer promises is correct, contact the American Academy of Actuaries at http://www.actuary.org/palprogram.asp. They'll give you up to four hours of free help. If you think your benefits are too low, contact a regional pension counseling project for free assistance. http://www.pensionrights.org/counseling-projects.

Buy a house and pay off the mortgage. Buy a house, pay off the mortgage, and don't borrow against the house until you retire. This strategy will build equity in a piece of real estate that you can add to your Social Security benefits (and pension benefits, if any). Even though strategic defaults have become fashionable, the unfashionable may have an advantage in the long run.

None of these strategies will finance a yacht. Remember that it's never too late to save, even if you're living on just Social Security. Cash is sublime when times are tough.

Foreclosure Robo-Blob Grows

Like a blob in a low-budget horror film that grows larger and larger until it smothers everything, the foreclosure robo mess is ballooning. We now learn that there are robo signing problems with notices of foreclosure in at least some states having nonjudicial foreclosure procedures. (See http://www.cnbc.com/id/41250862). In nonjudicial foreclosure states, where a creditor doesn't need to go to court to foreclose, the trustee bank handling the foreclosure has to give notice to the homeowner of the impending foreclosure, and file the notice in a public office. One of the tiresome requirements of the law is that the person signing the notice should ascertain that there is a valid legal reason for foreclosure. However, it may be that employees of trustees or their agents were robo-signing notices of foreclosure--i.e., affixing their John Hancocks without first bestirring themselves to review the facts of the case and ensure that a valid basis for foreclosure existed.

Nag, nag, nag, nag, nag. The law is such a pain in the . . . assssssk a lawyer what the effect of a defective notice might be and you'd probably be told that it means questions come up whether the bank can obtain clear title from the foreclosure. The bank may be unable to resell the property. Bad debts would remain on its books. The real estate market would linger in its current morass, with the Sword of Robo-Damocles dangling over foreclosed properties the banks have resold or try to resell.

The robo-mess revealed last fall, with robo-signers gone wild in judicial foreclosures, mucked up the foreclosure process in close to two dozen states. The kicker about the latest revelations is that if robo-signing permeated the nonjudicial foreclosure states, then the robo-mess will have reached every state. We've previously suggested the foreclosure crisis needs a national solution. (See http://blogger.uncleleosden.com/2010/10/foreclosure-crisis-time-to-put-mortgage.html.) This would be all the more so, now that robo-signers seem to lurk the length and breadth of the nation.

When you think about it, the robo problem is the problem in the real estate markets. We got to where we are today with mortgage lenders robo-lending to every Tom, Dick and Harry who had a signature and a pulse, without regard to income, employment, assets, past credit history, or anything else that might be relevant to a borrower's ability to repay. Then, the big banks on Wall Street bought up vast quantities of hinky mortgages that the robo-lenders churned out and robo-stuffed them into asset pools underlying mortgage-backed securities and derivatives, making financial sausages containing a lot of things you really wouldn't want if you knew about them. (Investors are now trying to regurgitate the bad mortgages by making underwriters buy them back.) Then, when things fell apart, the big banks tried robo-signing their way through the foreclosure process, disregarding the dreary requirements of the law that might interfere with the bottom line. Somehow, all this robo-banking has to stop. If it doesn't, only a matter of time separates us from the next financial robo-wreck.

The Fed and Foreign Policy

The Fed's easy money policies have spurred inflation and rising real estate prices in China. China's informal link of the yuan to the dollar in effect imports U.S. monetary policy into China. Even though the slack in the U.S. economy from the Great Recession has held prices down here, the red hot Chinese economy reacted to excess liquidity by pushing up prices there.

The Chinese have a deep fear of inflation, having experienced far worse in their four millenia of existence as a civilization than anything Americans have seen. They're imposing monetary constraints, and even resorting to price controls. The Fed is meeting this Tuesday and Wednesday, and is expected to continue running its money printing press at full throttle. With its inflationary implications for the yuan, the Fed's current stance provides China a reason to de-link the yuan from the dollar. Once the yuan is de-linked, China can regain control of its own monetary policies.

The dissatisfaction of Chinese consumers with inflation has much more influence on Beijing's thinking than all the haranguing of the U.S. and European governments. Thus, the yuan is edging up in value, and is becoming more freely tradeable in international currency markets. Its continued rise against the dollar can be expected, albeit at a carefully managed rate. Among other things, a rising yuan makes it easier for China to buy oil and other commodities traded in dollars. Greater Chinese demand would push up the dollar-denominated price of those commodities.

This will be a mixed bag for America. As the yuan rises, U.S. exports to China may increase, creating jobs here. But a falling dollar also means a loss of buying power. America imports a lot from China, and as the yuan rises, those imports become more expensive. Cheaper substitutes may be available in some instances--Southeast and South Asia offer lower cost alternatives for manufacturing clothes. But the manufacture of high tech components that go into computers, cell phones, PDAs, tablet computers and what not can't easily be shifted to new suppliers. And rising oil and other commodities prices have obvious implications for American consumers. A rising yuan, bottom line, means falling wealth levels in America.

It may be that the Fed intends to engineer a drop in the dollar's value. That would be one way it can discharge its statutory mandate to foster full employment. America's wealth levels during the past decade were puffed up by the profligate borrowing that funded the nation's consumption. Debt-fueled "prosperity" can't go on indefinitely, and America's wealth was at risk for a fall.

As the dollar drops against the yuan, the Chinese government will take losses on its vast portfolio of dollar-denominated investments. It would likely be willing to take these losses in order to hold inflation in check and keep its citizens from becoming overly restive.

Many Americans would consider jobs for some of the unemployed at the expense of less buying power for all to be a fair trade. High unemployment has many social costs, ranging from increased government spending to discouraging consumption to familial distress and breakdowns. Fair or not, however, as the yuan rises, American living standards could be squeezed.

Uncle Leo's Den Steps Down

Uncle Leo's Den, the website formerly connected to this blog, is no longer operating due to technical difficulties beyond my rudimentary computer programming skills. I hope to offer its content in some other form in the future. This blog lives. Please keep reading. It's the unanimous view of all--political left, right and middle, business and financial communities, investors, consumers, wealthy, poor, middle class and off-the-grid dropouts--that the country and the world are going to hell. That means there's plenty to write about.

Good Thing Goldman's Earnings are Down

It's a good thing Goldman Sachs just reported that its 4th quarter 2010 earnings are down 52%. Not for its officers, employees, or shareholders, but for the economy and the nation. Too much capital has flowed into financial services. Too much of America's talent and energy has gone into financial engineering. If creating and trading cleverly concocted financial side bets becomes less lucrative, maybe some of the nation's best and brightest will devote their careers to something that has lasting value.

It's really not surprising that Goldman's earnings are down. The financial crisis of the past three years caused the derivatives market to contract sharply. Too of these contracts that were too clever by half proved to be pigs in pokes, and investors grew twice shy. Derivatives, enveloped in opacity, commanded high margins. Without this lucrative business, and in an uncertain economy where clients didn't want to take big risks, Goldman's financial performance was bound to lag.

One wonders if Goldman's personnel are taking the news a bit too hard. Almost surely they had an inkling of what was coming before it was announced. GS's stumble in the rather public Facebook private placement may smack of an investment bank trying too hard to buttress its reputation for prowess on the eve of a decidedly downcast earnings announcement. Sometimes, it's better to go with the flow. Capitalism is cyclical. Exceptions aren't made for even the best investment banks. And that's good, because America can't retain its standing as a world power through financial intermediation. China has become the second most powerful nation in the world with a financial system that is rudimentary compared to ours. America needs to return to its economic roots and concentrate on producing things of value.

A Key to Facebook's Valuation

Recent press reports indicate that Facebook may go public in a year or so. Its recently reported private placement deal with Goldman Sachs supposedly put a $50 billion valuation on Facebook. Many think this is an optimistic number. Conventional measures of value are hard to apply to Facebook because it doesn't publicly disclose its finances. Uncertainties about its business model add to the problem. One wild card is the continued evolution of online privacy policies.

In many respects, online privacy is an oxymoron. Every day brings news of yet more security breakdowns and thefts of personal information. There doesn't seem to be a website that can't be hacked into, one way or another.

But online crime isn't the most important factor affecting online privacy. The commercialization of the Internet is far more significant. Businesses that want to sell your personal information will do much more to reduce online privacy than pimply kids eating junk food in front of computer screens.

Banks are starting to place targeted ads in your online statements. If your bank account shows, say, several recent debit card charges for fast food breakfasts, you may be offered a discount on your next Egg McMuffin. Some bank customers may like the idea of getting a discount while they review their account activity. Others will be creeped out by the idea that the most confidential financial information they have is being mined for the further profitability of purveyors of salt, sugar and fat. Many customers would be outraged at the possibility that insurance companies might pay to know about their slovenly eating habits and charge them higher life, health or disability insurance premiums. Actual insurance company access to your bank account hasn't been reported in the news, but don't think insurers--and the websites that are collecting your personal information--aren't pondering the possibility.

Banks have a lot of ways to make money, yet they are trying to profit from selling your personal information. Think of the pressures on Facebook, which has far fewer potential revenue streams than a bank. The most valuable thing Facebook has is the personal information it gathers about its members. If it can't find a way to monetize that data, its future could be difficult.

The FTC is proposing guidelines about online privacy. Members of Congress are getting interested in the issue and may offer legislation. One way or another, the law in this area will evolve and soon. When it does, Facebook's stock market value could rise or fall, depending on what rules are imposed. Indeed, since the monetization of personal information is likely to be Facebook's biggest potential revenue stream, online privacy laws could be crucial to determining the company's valuation.

Unintended Consequences of Monetary Policy

Today's news reported that China's foreign exchange reserves have risen to $2.85 trillion (yes, trillion, not billion), an increase of 20% over the past year. This is almost triple the next highest amount of foreign reserves held by a central bank (Japan, at $1.04 trillion). At the same time, China's trade balance narrowed over the past year. In other words, China's increased holdings of foreign reserves don't come from a net increase in exports.

Many commentators blame China's low exchange rate for the yuan, which it depresses in order to protect its exporters. But if net exports aren't increasing, something else is going on. A prime suspect is the carry trade, in which speculators borrow dollars made cheap by the Fed's easy money policies and convert them into yuan in order to profit from China's rising interest rates. The dichotomy in interest rates between China (high) and America (low) gives capital the incentive to flee the U.S. for higher returns in China. The fact that China has recently loosened trading restrictions in the yuan, allowing it to be traded in Hong Kong and now the U.S., only makes such capital flight easier. The Chinese central bank will levitate rates further in order to combat accelerating inflation in China, so the disparity with America will only increase.

China's high interest rate/low yuan exchange rate strategy exacerbates economic imbalance. The high rates will predictably draw in foreign capital, and the low exchange rate for the yuan will only aggravate the phenomenon by making it cheap in forex terms to buy high interest rate yuan obligations. But the Federal Reserve's easy money policy heightens incentives for speculators to invest the dollars it's printing in China rather than America. Such a capital outflow would help explain why inflation has been so low in the U.S., notwithstanding the Fed's 'round the clock money printing operation. Capital outflow detracts from whatever stimulus effect the Fed's quantitative easing program might have. Although unintended, QE is boosting China's forex reserves. The Chinese want to eat their cake and have it, too. So does the Fed, hoping that printing money will spur growth without inflation. But it isn't spurring much growth, and is producing inflation in China. That does nobody much good.

Monetary policy is heightening the imbalance between China and America. The Fed doesn't intend this, and the Chinese surely recognize the dangers as well. But China can't turn on a dime away from an export driven economy, and the Fed clearly will persist in QE come hell or high water. So we shouldn't expect things to change much in the foreseeable future.