Thursday, March 26, 2009
Working On It
While you're waiting, Galen has returned to the blogging business. He is a very serious medical blogger, but he can also be exceptionally funny. His new home is here, and he diverts himself today with a look at the containment that's breaking out in the Federal Reserve Laboratory.
Galen also pointed me to this Coyote post about a doctor who is trying to provide medical care to the uninsured. Cost - $79 monthly, plus $10 copay each visit. His problem - the state wants to shut his clinic down because it claims he is running an unregulated insurance plan. Words fail me - read the post.
As Joy commented earlier, it is more important to get people health care than insurance, and if you want to be brutally honest about it, primary care is where most real problems get averted. That's what people need the most - and good primary care is where you get the cost savings.
Honestly, this is how most people GOT primary health care when I was a kid. In PA (when I was a teenager) we went to the old doctor my Mom's grandfather had used since the 30's. In the 50s, you paid $25 a month and that would cover your family, plus a bit for visits. That was a lot of money back then. For hospitalization, people had major medical if anything. But you could get most things done at that doctor's, and they almost always handed you any prescription medicine right then. You could get minor surgery, etc. X-rays.
Galen has the best succinct discussion of the Medicare pressures on his blog I have seen. Also see this.
If you are feeling too intimidated, stop and look at this brief video. It has a happy ending. Expertise plus paying attention can produce seeming miracles. We need to move from this sort of politics to that sort of execution.
Wednesday, March 25, 2009
Everyone Gets Cockleburr Rations For Dinner
The numbers that came in for January and February did show what P-Nat projected, which was a gradual bottoming pattern overall and the beginning of some upticks. Bloomberg today:
Orders for U.S. durable goods unexpectedly rose in February on a rebound in demand for machinery, computers and defense equipment.Last night Obama took credit for these events, but the stimulus package had nothing to do with it - the effects of that haven't even hit the economy yet. Very little of that package will be felt in the first half of 2009, in fact, and less than 25% of the effect will be felt in 2009. I would also like to point out that at the time the stimulus bill was being debated, the administration was claiming that the economic emergency was so dire that the representatives and senators shouldn't even be allowed to read the thing before they voted on it. Instead, this was what was really going on in the economy.
Combined with reports showing improvements in retail sales, residential construction and home resales, the figures indicate the economy is stabilizing after shrinking last quarter at the fastest pace in a quarter century. Stepped-up efforts by the Obama administration and Federal Reserve to ease the credit crunch may help revive growth later this year.
According to P-Nat, the major drivers of these statistics were price drops and need. Price drops in housing and price drops in energy, which led to a defusing of inflation, and led to control of food prices, which resulted in a pretty signficant boost to effective incomes for the bottom third of the households in the US. And need, which is just a matter of appliances, autos, shoes and clothing, for example, wearing out, babies being born, people buying things they really need, because they have to have them whether they want to spend money or not.
It is now my tragic duty to explain that all of that positive effect of price drops has been nullified by the recent policy actions. The UK's rising inflation is now our own, and this summer the effect will completely disrupt forces which were generating a slow turn for the better in the US economy.
Last week I was so sick at heart that I didn't think I could continue writing this blog. But many factors, including the intelligent commenters over here, the conversation at the convenience store, Shrinkwrapped's stunningly good explanation of the new bank bailout plan, some timely email therapy from my main economic thinking buddy (who seems almost as shaken as I am), and the fact that two commenters on this blog (Joy and Boots) have made policy suggestions that in fact would greatly help the situation, have strengthened my spine a little.
I will have to deal with my own emotions as best I can, but I am convinced that the American people have the ability to understand what must be done, the courage to accept it, and the grace to forge a way forward that is realistic and can generate slow, consistent and reasonably fair improvements in our basic circumstances. We are, as an aggregate, far better than our current leadership shows.
I am, however, terrified and struggling to control it. The way I model and envision the economy (domestic and foreign) is largely through modeling the chances and options of people, households and nations, so there is no comfortable distance here for me.
I suppose I need to address Ken's questions about why Treasury just can't print more money and buy more Treasury bonds. He doesn't see a problem with the perpetual money motion machine. In the meantime, I would like to suggest a quick review of the UK Bubble's domestic coverage, which notes that gilt (their government bond) auctions are in trouble, the money supply is ballooning, and surprise, inflation, not deflation, is the result. Who'd a thunk?
I would like to hope that I am wrong, but P-Nat is pretty much an independent entity - an AI system of sorts that is not determined by inputs but by possible interactions between economic vectors, with probabilistic functions. In essence, it tests current conditions, forms theories, tests those with randomization, and then often starts demanding a bunch of information. I have developed an enraged, wary respect for P-Nat.
Currently it's demanding a bunch of information about ag prices, plantings etc, that I just don't have. I sure hope it's not going to tell me that a bunch of people are about to starve to death.
Tuesday, March 24, 2009
It's Not Going Over Well
Transcript at NY Times.
Calculated Risk posted a link to the feed with a notice about the press conference, and the comments on that post are extremely funny. Jas Jain is ranting on again about corruption, and everyone's agreeing with him. In response to the question by one commenter as to who is listening to this, another commenter replies "The Dopes of Hope". Another commenter "When was the last time the US was this far in the tank? Watching this made me ask that question."
Yet another commenter:
I liked this:
"So yes, the government can create demand temporarily, but that can't fill the export gap forever."
If no one is buying then none of this is going to work!!!!!!
What do we produce?
Where is the average citizen going to get the money to buy it? None of this addresses that." Then he or she posts a link to the latest news about Japan's exports - down almost 50% YoY.
Another commenter posts a link to a Reuters article detailing Moody's projections about the cost of US energy under Obama's cap and trade proposal, and ends with a succinct "Bend over, Bubba":
U.S. electricity prices are likely to rise 15 to 30 percent if a national cap on carbon dioxide emissions is instituted, according to a report by Moody's Investors Service.But on a brighter note, apparently Obama did succeed in changing some people's minds. One commenter writes:
And "the vast majority" of the burden of those higher costs will be borne by residents as large industrial users are likely to be successful in lobbying U.S. lawmakers for special rates and tariffs, the report dated March showed.
If carbon dioxide (CO2) emissions are priced at $20 per metric ton, it would add about $48 billion in costs for the electric utility sector, Moody's said.
Just got DH to agree, we start moving our money out of the U.S. tomorrow.I'm not sure that is what Obama hoped to accomplish.
I'm wondering what Geithner thought was going to happen? People were willing to accept very low returns on Treasuries in order to preserve capital during a time of global economic disruption, but once you make it clear you are going to deflate your currency, no. This will end in dollar flight and an inability to sell our debt internationally. REALLY.
An actual debate broke out on DU yesterday over Geithner. Obama is losing his base over this.
The Devil Is In The Definitions
If you think the problem is low house prices and a poor economy, then of course the Geithner plan is doomed to make the problem worse.
Obviously the Geithner plan constitutes a massive taxpayer subsidy given to a few large institutions (less than 30) about which there are genuine fears of failure. No one can honestly dispute that. But look at what one of the defenders of the plan has to say about it:
The basic plan, as has been well-rehearsed by now, is for the government to provide generous loans to private investors for buying the banks' depressed, mortgage-related assets.So this subsidy (which is hidden) will be succeeded by a yet larger subsidy? That doesn't sound like much of a confidence-builder to me.
The banks will want to unload their bad, mortgage-related assets even if they have to sell them at a discount relative to where they currently value them. The banks will do this, assuming the discount isn't too great, because hanging onto the assets is creating uncertainty about the amount of capital they have, and the uncertainty is discouraging them from making loans. (Better to take a small, certain loss and be done with it than to keep facing the prospect of a very large loss later on.) Of course, this will still leave the banks undercapitalized. But, without the prospect of large future losses hanging over them (which the Treasury program will have eliminated), private investors might be more willing to provide banks with capital. More plausibly, having demonstrated to American taxpayers that it can manage something tricky like getting the bad assets off the banks' books, Treasury will find it easier to get more money from Congress to recapitalize them.
The link between the fate of this large institutions and the economy is asserted to be a decline in lending, which causes lower spending and lower monetary velocity throughout the economy. But will buying bad assets at inflated prices restore lending to previous levels? The answer is that of course it won't, and if you pin any halfway sane economist down, they concede that it won't. The reason why banks pulled back on lending is that there had been too much lending, and poorly underwritten loans were defaulting, which led to the bad debt securitizations.
The only way to keep from writing new bad debt is to tighten lending standards. Further, the public at a whole has a much higher level of absolute debt in comparison to incomes and assets than it did in 2000, so new creditworthy borrowers are harder to come by. This means that lending can't even return to the norms of the late 1990s or early 2000s, because of this:
Note that household absolute debt levels about doubled from early 2000 to the middle of 2008. That is an impressive accomplishment of sorts that we cannot repeat. This debt was accumulated on cars, RVs, boats, credit cards, and homes (and a lot of auto, boat and CC debt was moved into home debt). In more detail:
The problem of expanded household debt is somewhat exacerbated by the declining employment/population ratios. First, for perspective, the long series:
Note that the movement of the baby boomers into prime working years, plus the movement of women into the workforce jacked workforce participation rates up to remarkable highs in the 1990s. This cannot be repeated even if the economy were booming, because the boomers are aging rapidly. Demographics alone ensure that workforce participation rates will continue to drop for a time. Detail:
And there's one more little piece to this puzzle - the development of the US current account deficit (trade deficit) over the last 15 years:
This means that we are earning less and borrowing more not just as individuals, or households, but as a nation.
One potential strategy proposed to deal with high debt loads is to deliberately induce inflation, which reduces debt in relationship to incomes. That was the goal of the first part of the Geithner plan, which involved having the Treasury create money and buy US Treasuries and other debt. And it succeeded instantly. The price of oil has risen over 10%, for example.
However, this strategy cannot work for the US for two reasons. First, it is inflationary, and although existing debt will be deflated in relationship to incomes, existing incomes will be deflated by the higher cost of imports. Thus, the US will experience lower incomes from demographics even as the real debt burden deflates. Declining incomes don't help in conjunction with declining debt - it is the ratio that's important.
Second, demographics have produced a situation in which we owe a big debt to our own citizens in the form of retirement benefits. If we cut those benefits, we cut their incomes. If we maintain those benefits, we rapidly ratchet up our debt to our citizens even as our household debt declines. An inflated currency buys less of external goods, and we are importing massive amounts of consumer goods and energy. Therefore the US does not have the option to inflate our currency to escape our debt. You can do that to escape internal debt, but not to escape external debt when you are a substantial net importer.
Third, most of US economic activity at this point stems from the consumer service economy, which is a derivative of private real incomes. Since private real incomes will be deflated by higher import costs of clothing, shoes, medicine, chemicals and petroleum, to name a few, the consumer segment of the economy will continue to decline.
There is only one economic way out for the US, and that is to boost production on a broad scale. We need to produce more energy (but it must be at a price to keep our manufacturers competitive in the global economy), but we also need to produce more of many goods for export or domestic sale. And this will happen regardless of what we plan to do, because inflating our dollar will literally prevent the US population from being able to buy as much goods from the world at large.
If the current administration inflates energy prices by taxes (carbon cap and trade) or by restricting production, the US population will just end up being able to buy less goods overall due to diversion of their incomes to the basics of living.
In short, the jig is up. All this BS about education is nonsense. Spending more on education won't help the economy at all - it will hurt it. We need to produce goods. To the extent we don't jack up production, consumption will continue to fall over time.
There are two interviews with Galbraith available at these links. Essentially he says the same thing I have been writing - that the problem is not that the banks can't lend, but that borrowers have borrowed too much.
In effect, Joy's question about using stimulus money simply to pay off consumer debt comes a lot closer to redressing the immediate economic problem than any of the Obama administration's moves so far. It would tend to shunt money back to banks, it would jack up real incomes, and it would boost consumer spending somewhat.
As a result of the recent Treasury moves, US structural inflation is now at about 7% for the next year. That is the minimum figure I could come up with. It may well be more. So that cuts US real incomes, which is hardly the recipe for escaping a recession. Recessions end when real incomes rebound, because even though 5 percent of the people may have lost jobs, the percentage of those still working is much higher overall. As the working majority cuts debt and increases savings, plus sees easing in price pressures, their incomes rebound.
If you deliberately inflate, you can induce temporary asset price increases, but real incomes deflate, so after a few years you are left with a net negative. That's pretty much how the series of three recessions in the 70s and early 80s was produced, and Volcker ended the bleeding by stopping the inflation.
The immediate effect of Treasury's deliberate devaluation of the dollar was to raise the cost of oil-based energy about 15%, and it will go higher. The increase in home sales and retail sales in January and February was entirely produced by declines in energy and energy-produced costs for the consumer, and Treasury just reversed that trend.
Monday, March 23, 2009
The Reality-Based Party
Shrinkwrapped writes about despair and concern over this administration's performance spreading on the right and left. In part, he notes:
If Obama has his way, he will manage to worsen (continue to worsen) our recession and increase international instability at the same time. In Scott Johnson's phrasing, Barack Obama may well combine "infantile leftism and adolescent grandiosity" in a perfectly dysfunctional whole. Only someone steeped in the academic culture can continue to believe in infantile leftism after they have begun to actually pay their own bills. But that is no reason for despair; in fact I would suggest that despite all the damage that Barack Obama and the infantile leftists can do in the next 4 years, he is also offering a marvelous opportunity that, if squandered, will be our loss, not his.He is correct about the lack of reality found in both parties currently. But will this change or will the system oscillate between two unrealistic poles, with each pole blaming the other for the inevitable failure?
The American center and right have slowly been drawn into the orbit of the "nanny state." George W. Bush perfectly captured this ethos with his "Compassionate Conservatism." The Republicans, prior to the capture of the Congress by the Democrats, became indistinguishable form Democrats in their propensity to spend without any particular concerns about actually paying for their wish list. Our entire country has been living beyond our means with the unstated infantile fantasy that "someone" will rescue us for our profligacy. Reality is painful, yet we see signs that the sleeping giant of America may be waking up. The "Tea Parties" have evoked an interesting response.
We have reached a pass in which the CBO's explication of the economic lunacy of Obama's agenda barely upsets Washington politicians. The only hope is that the country itself rebels.
My Name Is Bond - James "Bad" Bond
With that playing in the background, the credits give way to the opening scene. Setting, a Wall Street financial's headquarters. Ms BarelyAPenny is ushering in James "Bad" Bond to speak to a figure sitting in front of an untinted window. The light from the window streams dazzlingly past this figure, and neither the viewer nor our hero sees more than a shadowed figure nearly drowned by scintillating light. This shadowed figure speaks. Slowly, gravely, paternally.
"James, I've called you here because I've heard through the grapevine that you aren't pleased by our new "Bonuses if Congress doesn't want the Money" compensation plan, and that you are seeking another opportunity."
James "Bad" Bond, stirred but not shaken, replies with his best Clint Eastwood imitation. His acting talents are few, so he merely narrows his eyes and breathes a bit heavily. "I offloaded nearly 80% of that SIV with only 70% of the cost covered by a non-recourse loan. Your eventual losses will probably be cut by 40%. I was promised 2 percent, and a lousy million just doesn't cut it."
The shadowed figure swivels in his chair, causing his outline to shimmer in the light. James "Bad" Bond is not impressed. "Oh, don't be misled," the Shadowed One says gently. "We understand your position. Indeed, we sympathize. Our problem is with the auditors. They found the corporation that wound up with most of the bonds sitting in our Level 3 assets. It should have been enough to have the first fund pay back its no recourse loan from us, but no, now they are raising difficulties on the valuation of the company you formed to buy them. And after that little Bernie problem, it appears that no other auditing firm is prepared to work with us either to accept our current valuation of that firm. But none of that is your fault, James, and we have a high regard for you.
"In fact, we have a proposition and an opportunity for you."
James "Bad" Bond narrows his eyes, wondering if it is too late for acting school.
"London is calling, James. London. You have heard of the Treasury plan, haven't you?"
James nods, attempting to exude strong, silent displeasure.
"Think of the opportunities, man! They are willing to lend up to 100% of the capital, with no recourse loans, and they don't care who buys the stuff. Your mission, James (and if you don't accept it this interview will not end well) is to take 1 billion money in seed money from us, go to London, establish a fund there, and participate in the Treasury program. Success is guaranteed as long as you remember to pay yourself a high salary!"
James smiles. This is a mission he can handle. "The jet?" he asks.
"Buy yourself one, James! And make sure to get some nice offices over there. Word has it that financial space is opening up at very good prices. We look forward to doing business with you. Ms. BarelyAPenny has a list of realtors, London lawyers and other resources for you."
The Treasury plan's official terms can be found here (PPIP). The definition of "private sector financing" is hilarious. For the first segment:
If a bank has a pool of residential mortgages with $100 face value that they are seeking to divest,It's a great way to privatize profits and nationalize losses!!! The loans are non-recourse because they are secured only by the assets purchased. Needless to say this constitutes a raid on FDIC resources. I suspect the healthy banks will end up paying for this guarantee.
the bank would approach the FDIC. The FDIC would determine, according to the above process, that they would be willing to leverage the pool at a 6-to-1 debt-to-equity ratio. The pool would then be auctioned by the FDIC, with several private buyers submitting bids. The highest bid from the private sector – in this example, $84 – would define the total price paid by the private investors and the Treasury for the mortgages. Of this $84 purchase price, the Treasury and the private investors would split the $12 equity portion. The new PPIF would issue debt for the remaining $72 of the price and the debt would be guaranteed by the FDIC. This guarantee would be secured by the purchased assets. The private investor would then manage the servicing of the asset pool and the timing of its disposition on an ongoing basis – using asset managers approved and subject to oversight by the FDIC. Through transactions like this, the Legacy Loans Program is designed to use private sector pricing to cleanse banks’ balance sheets of troubled assets and create a more healthy banking system.
The second part of the program uses the TALF to fund purchases:
However, any private investor, even those who do not partner with Treasury under the Public-Private Investment Program, will also be able to access the TALF to purchase legacy securities.When I read that, I was thinking "This isn't serious. This is cover for something else." And here is the something else:
Through this expansion of the TALF, non-recourse loans will be made available to investors to fund purchases of legacy securitization assets. Eligible assets are expected to include certain non-agency residential mortgage-backed securities (“RMBS”) that were originally rated AAA, and outstanding and commercial mortgage-back securities (“CMBS”) and ABS that are rated AAA. Borrowers will need to meet certain eligibility criteria. Haircuts will be determined at a later date and will reflect the riskiness of the assets provided as collateral.
In conjunction with these efforts, the Treasury is also announcing a program to partner with private fund managers to support the market for legacy securities.
Under this program, private investment managers will have the opportunity to apply for qualification as a Fund Manager (“FM”). Applicants will be pre-qualified based upon criteria that are expected to include a demonstrable historical track record in the targeted asset classes, a minimum amount of assets under management in the targeted asset classes, and detailed structural proposals for the proposed Legacy Securities PPIF. Treasury expects to approve approximately 5 FMs and may consider adding more depending on the quality of applications received. Approved FMs will have a period of time to raise private capital to target the designated asset classes and will receive matching equity capital from Treasury. FMs will be required to submit a fundraising plan to include retail investors, if possible. Treasury equity capital will be invested on a fully side-by-side basis with these private investors in each PPIF.So this is a call to restart the SIVs.
Furthermore, FMs will have the ability, to the extent their fund structures meet certain guidelines, to subscribe to Treasury for senior debt for the PPIFs in the amount of up to 50% of a fund’s total equity capital, and Treasury will consider requests for senior debt for the PPIFs in the amount of up to 100% of a fund’s total equity capital subject to further restrictions on asset level leverage, redemption rights, disposition priorities, and other factors Treasury deems relevant. This senior debt will have the same duration as the underlying fund and will be repaid on a pro-rata basis as principal repayments or disposition proceeds are realized by the PPIF. These senior loans will be structurally subordinated to any financing extended by the Federal Reserve to these PPIFs via the TALF.
Remember the SIVs? Those off-balance-sheet funds that held long term assets, guaranteed by the institutions or funded by no-recourse loans, which used these pools as security for money-market funds? Now they are back, but they are truly funded by Treasury, so they are actually off the balance sheets of the major financials.
The sky's the limit. Krugman is having a fit over this:
This is more than disappointing. In fact, it fills me with a sense of despair.He's wrong. This plan will work, especially for James "Bad" Bond and the Shadowed One. It will put the taxpayer on the hook for all that bad debt, but it will bail the institutions out of their situation. Last year, the big financials were giving their own no-recourse loans to anybody who would take the stuff off their hands. This year, Treasury does it.
But the Geithner scheme would offer a one-way bet: if asset values go up, the investors profit, but if they go down, the investors can walk away from their debt. So this isn’t really about letting markets work. It’s just an indirect, disguised way to subsidize purchases of bad assets.
But the real problem with this plan is that it won’t work. Yes, troubled assets may be somewhat undervalued. But the fact is that financial executives literally bet their banks on the belief that there was no housing bubble, and the related belief that unprecedented levels of household debt were no problem. They lost that bet. And no amount of financial hocus-pocus — for that is what the Geithner plan amounts to — will change that fact.
The auditors won't have a problem with this (for FDIC-insured institutions):
Consideration paid to Participant Banks in exchange for purchased Eligible Asset Pools will be in the form of cash or cash and debt issued by the PPIFs. PPIF debt will be guaranteed by the FDIC. Terms of the debt and debt guarantee will be as stipulated in the FDIC Guaranteed Secured Debt for PPIF Term Sheet.So, the bank hands over the loans, doesn't have to pay any more into reserves, and gets guaranteed debt back. Some of them will show an immediate addition to capital because they had already set aside substantial ALLL on the loans, and now that gets recovered.
Because losses on loans come slowly, there will be short-term profit, and who the heck cares about long-term losses as soon as you recover your initial investment, which is very little. Given the first example, the private investor's capital at-risk is 6 billion out of the 84 billion theoretically valued pool which had an original value of 100 billion. You can make that off almost any loan pool; you only need to get back 12 cents on the original dollar to break even long term, and in the mean time you get a nice run of profits. It would be a pretty dumb bunny who couldn't make this pay even if you have to way overbid on the pools. But of course the deal has to be sweet. The entire point of it is to unload the stuff at a much higher price than the market will offer.
It's a great time to be in London, out of the reach of Congress Critters, but with US government-guaranteed profits. And this has been in the pipeline ever since, to my astonished guffaws, CIT Group was allowed to become a bank. The big financials dumped a lot of money into CIT so they could dump debt on it, and then the lousy FDIC wouldn't cooperate.
Let the Special Financial Olympics begin. Hope, change, cash for troubled bankers. It's paarrrty time on the Street.
Friday, March 20, 2009
And Circumciiiiised The Skiiiiiipper!
I am recovering, but the shock of reading about the Treasury's plans to spend over 1.4 trillion dollars buying securitized debt by printing money is durable. It will be another day or two before I can stop reeling and write coherently. It is a cheat, and it is going to be a very costly one for the average American.
Here's a question for you: Why are UK bigwigs talking about reality, whereas our leading lights seem bent on boldly trekking further into economic Fantasia?
Thursday, March 19, 2009
VA Funding Issue Update
Thank you all for the intelligent commentary while I have been shivering, sweating, bitching and whimpering.
A couple of notes as to why this is a bad idea:
- Tricare eligibility is restricted primarily to retirees, active duty and dependents thereof. So a lot of reservists, etc, won't have it once they come off active duty, and a lot of vets who served a few years aren't eligible.
- No one knows what the actual cost would be, but the proposal projected a savings of 530-540 million annually. This seems pretty hefty and indicates that quite a few persons would be affected.
- Most jobs in this country are actually in small companies that have small group insurance. Rates are boosted to reflect the claims. People who work for larger companies or state/gov/local/agencies have no clue. One person going to the hospital for something like a heart problem or a head injury can produce a $200-$400 monthly increase in premiums within a couple of months.
- Therefore this proposal has the potential to produce some very difficult problems for smaller companies and veterans.
That legisliation would, for example, allow the ICBA to contract for several different group policies. Then any of their members could offer those group-rated plans to their own employees. The same for mechanics, engineers, etc. That way, if a company with 11 employees sends one of them to the hospital with a heart attack, their premiums won't jack up 40% a few months later.
Since no bad idea ever seems to go to the political graveyard, I would urge readers to contact their representatives and senators about this proposal if you haven't already. Only instilling fear in legislators will prevent this from sifted back into some legislation that there is no time to read.
Apparently there are DC discussions about dumping the filibuster to run some more legislation through the pipeline, so I'd be wary.
Tuesday, March 17, 2009
Some Banking Points
But I would like to point you all to a couple of banking/risk related posts:
At Ace: Sweet Fancy Moses: Bank Rapped for Keeping Balance Sheets, um, Balanced; Feds Censure It for Not Aggressively Enough Pouring Money Down CRA Rathole. The bank was slapped with a "Needs to Improve" CRA rating due to low loan volume. And ordinarily that makes sense, but when you find yourself operating in a poisoned environment in which people have written bad loans for low rates all around you, you may reasonably get "paranoid about credit quality", and you almost certainly will have to pull back on your lending to avoid being sucked into the black hole created by loose lending. It's not a net negative, because once the bust happens, you'll have the money to lend to worthwhile borrowers who are getting cut off from the larger institutions.
The Anchoress. Here's a topic you might have thought you'd never see at The Anchoress, but when she does it, she does it well. First she links to a paper on Ponzi schemes in political economies which advances the theory that there is some rationality to how this happens:
This paper argues that if agents correctly believe in the possibility of a partial bailout when a gigantic Ponzi scheme collapses, and they recognize that a bailout is tantamount to a redistribution of wealth from non-participants to participants, it may be rational for agents to participate, even if they know that it is the last round. We model a political economy where an unscrupulous profit-maximizing promoter can design gigantic Ponzi schemes to cynically exploit this “too big to fail” doctrine.Then she throws in a bit of history relating to the GSEs. It's an excellent post.
In the Clinton administration, there was a very close partnership between the large financials and the government. For example, there was the Mexican bond bailout and intervention in hedge fund problems a la LTCM. It is no accident that when Enron realized it was about to blow, they had a govie contact the government and expected the government to intervene.
Here, from March 2006, is a somewhat long post from Econotech addressing the basic problem: that governments (not just the US) had kept bailing out financials out of fear, which created a financial culture that was unafraid of risk and that therefore felt free to create bubbles in the belief that whatever was destroyed in the popping of the bubble, it would not be them:
The deliberate opacity of the credit and derivative markets (which is being addressed behind the scenes in places such as the Counterparty Risk Management Policy Group) makes the current credit excesses potentially dangerous, especially given the unfathomable size of the markets (derivatives are $300-400 trillion in notional value).Yes, it does.
The big speculators in these markets ultimately expect to get bailed out, yet once again, should their overly leveraged trades ever blow up in their faces, e.g. as they have been going all the way back to the Latin American debt crises of the 1980s, through the S&L crsis, the Mexican bond crisis, Asian financial crisis, Russian default crisis, Brazil and Argentive crises, and ultimately the TMT equity crash, in the last case through Greenspan's negative real interest rates for three years igniting a global real estate boom and Japan's zero rates funding speculative global "carry trades." Yes, it'a long list, and these bailouts have been a bipartisan political policy.
This combination of enormous gains on opaque private trades with the public providing implicit insurance against economically-destabilizing losses (the "too big to be allowed to fail syndrome," a la the LTCM precedent in October 1998) is blatantly NOT fair and honest and creates immense "moral hazard" which greatly distorts global capital flows into speculative activity and away from real productive uses.
I'd like to close with a slice of MoM's Mom theory, which beats Greenspan's theory all hollow. Greenspan's theory, as explicated in his Jackson Hole remarks in 2005:
The structure of our economy will doubtless change in the years ahead. In particular, our analysis of economic developments almost surely will need to deal in greater detail with balance sheet considerations than was the case in the earlier decades of the postwar period. The determination of global economic activity in recent years has been influenced importantly by capital gains on various types of assets, and the liabilities that finance them. Our forecasts and hence policy are becoming increasingly driven by asset price changes.Greenspan blew enough bubbles to make it obvious that he believed bubbles could be managed, and earlier in this speech he blew a little bubble about the Fed's risk management:
The steep rise in the ratio of household net worth to disposable income in the mid-1990s, after a half-century of stability, is a case in point. Although the ratio fell with the collapse of equity prices in 2000, it has rebounded noticeably over the past couple of years, reflecting the rise in the prices of equities and houses.
Whether the currently elevated level of the wealth-to-income ratio will be sustained in the longer run remains to be seen. But arguably, the growing stability of the world economy over the past decade may have encouraged investors to accept increasingly lower levels of compensation for risk. They are exhibiting a seeming willingness to project stability and commit over an ever more extended time horizon.
The lowered risk premiums--the apparent consequence of a long period of economic stability--coupled with greater productivity growth have propelled asset prices higher.5 The rising prices of stocks, bonds and, more recently, of homes, have engendered a large increase in the market value of claims which, when converted o cash, are a source of purchasing power. Financial intermediaries, of course, routinely convert capital gains in stocks, bonds, and homes into cash for businesses and households to facilitate purchase transactions.6 The conversions have been markedly facilitated by the financial innovation that has greatly reduced the cost of such transactions.
Thus, this vast increase in the market value of asset claims is in part the indirect result of investors accepting lower compensation for risk. Such an increase in market value is too often viewed by market participants as structural and permanent. To some extent, those higher values may be reflecting the increased flexibility and resilience of our economy. But what they perceive as newly abundant liquidity can readily disappear. Any onset of increased investor caution elevates risk premiums and, as a consequence, lowers asset values and promotes the liquidation of the debt that supported higher asset prices. This is the reason that history has not dealt kindly with the aftermath of protracted periods of low risk premiums.
6. Capital gains do not add to GDP. The higher prices of plant and equipment and homes are reflected in an economy's cost structure, which directly or indirectly increases prices of goods and services, leaving real output largely unaffected. Capital gains, of course, cannot supply any of the saving required to finance gross domestic investment.
Given our inevitably incomplete knowledge about key structural aspects of an ever-changing economy and the sometimes asymmetric costs or benefits of particular outcomes, the paradigm on which we have settled has come to involve, at its core, crucial elements of risk management. In this approach, a central bank needs to consider not only the most likely future path for the economy but also the distribution of possible outcomes about that path. The decisionmakers then need to reach a judgment about the probabilities, costs, and benefits of various possible outcomes under alternative choices for policy.Mom's Mom theory:
The risk-management approach has gained greater traction as a consequence of the step-up in globalization and the technological changes of the 1990s, which found us adjusting to events without the comfort of relevant history to guide us. Forecasts of change in the global economic structure--for that is what we are now required to construct--can usefully be described only in probabalistic terms. In other words, point forecasts need to be supplemented by a clear understanding of the nature and magnitude of the risks that surround them.
My mother's theory of risk management was that as soon as any company started reporting mostly income from capital gains, she sold the dang stock. She'd give them a period of time to restructure and actually make some money, but if they couldn't show any actual, significant business income derived from sources other than buying, selling and arbitraging other businesses and assets, out the door it went. For example, she sold Tyco in the first half of 2001 because she couldn't figure out how the company was really making real money. Her idea was that if it wasn't making money from anything but arbitrage, a bust was coming. My mother was an excellent investor.
I believe that my mother was correct, and that periods of wealth and trade generated mostly from non-income-producing capital gains always produce a serious subsequent bust. I believe that such risks cannot be managed because of a very simple set of economic facts:
- To monetize capital gains (spend them), one must either borrow against the assets or sell the assets,
- Selling assets limits the growth of capital gains,
- If borrowings rise consistently and disproportionately more than incomes, real spendable income is being diverted to loan servicing, thus creating the need to borrow more to get spendable income,
- Eventually, either lenders will become unwilling to lend or borrowers will be unable to service their debt,
- After which, large numbers of people will have to sell assets to monetize capital gains,
- Which destroys the capital gains,
- Which abruptly lands the lenders in a game of strip poker, which they are doomed to lose.
Greenspan believed that the role of central banks wasn't to diagnose and correct bubbles.
I believe that is one of the main functions of a central bank, and that it is not difficult to tell when a bubble is emerging.
Monday, March 16, 2009
Congress Alert - VA
- Some veterans will be priced out of medical insurance,
- Some veterans won't get jobs (small businesses can't afford high health premiums, so they won't hire vets),
- Some small group and perhaps family policies may reach caps over the veteran's treatment costs and then the rest of the group won't have coverage.
We just extended SCHIP coverage to families with median incomes, and in many cases, adults who were covered under SCHIP as children will be able to continue to get subsidized health care as adults. If it comes down to budget, the veteran gets first claim.
It looks like Congress was not too receptive to the idea, but there is a lot of activity at the moment, and this issue should be kept extremely visible to senators and representatives. If costs must be cut, the Priority B group can be cut down. The one thing we must not do is toss injured vets to the vagaries of the private health insurance system. The proposal is odd - on the one hand, they want to grant more benefits to more vets. On the other hand, they expect private insurance companies to cover a significant chunk of the cost.
This link will allow to find and contact your representatives and senators. It's not a partisan issue - it's one of basic fairness. Any person with a significant medical problem who has ever tried to get individual or small group insurance coverage will realize what a nightmare this could be.
Friday, March 13, 2009
For Your Reading Pleasure, The Times Online Goes Postal On MBAs
If Robespierre were to ascend from hell and seek out today’s guillotine fodder, he might start with a list of those with three incriminating initials beside their names: MBA. The Masters of Business Administration, that swollen class of jargon-spewing, value-destroying financiers and consultants have done more than any other group of people to create the economic misery we find ourselves in.I don't disagree with some of the sentiments:
From Royal Bank of Scotland to Merrill Lynch, from HBOS to Leh-man Brothers, the Masters of Disaster have their fingerprints on every recent financial fiasco.
I write as the holder of an MBA from Harvard Business School – once regarded as a golden ticket to riches, but these days more like scarlet letters of shame.
If doctors or lawyers wreaked such havoc in their own professions, we would certainly reconsider what is being taught at medical and law schools.
Also, the dog decided that maybe he didn't really want to be diabetic, and his insulin needs are fluctuating on the very low side, so for a few days I have to step up his testing regime.
The Zen of Dog is an interesting story, but what it really means I do not know.
Thursday, March 12, 2009
First, The Economics
Michigan (7.7 percent), Oregon (7.4), Idaho (7.2), Wisconsin (6.7), Rhode Island (6.5), Pennsylvania (6.3), Nevada (6.2), Montana (5.9), Alaska (5.7), Indiana (5.7), Massachusetts (5.7), New Jersey (5.7), and Vermont (5.7)However this is no surprise; unemployment is a lagging indicator.
February retail sales show continued improvement overall. Looking at table 2A (percentage change, seasonally adjusted):
- Overall change was -0.1% from January, but January was revised up to be +1.8% from December.
- The weakness in February compared to January was in automobile dealers (-4.9%).
- Most of the discretionary leading indicators in February were quite positive: furniture (+0.7%), electronics & appliances (+1.2%), clothing (+2.8%), sport & hobby (+0.2%), miscellaneous store (+2.2%).
- Note that the improvements in furniture and electronics & appliances are probably somewhat associated with the YoY boom in home sales in the West. As prices drop, those properties become cash-flowing for investors, and this generates a wave of refurbishing and refitting which helps retailers as the homes are prepped for rental.
- Grocery stores dropped 1%. This is a sign that bottom-level inflation is coming through to the consumers, given how tight grocery spending has been. (When food costs were rising at 9% annually, no way could you see this.)
Consumer credit (G.19),which came out a few days ago, showed a strongly positive trend. The SA numbers are highly misleading in times of major change. The relevant number is that in Q3, total consumer credit outstanding was 2592.3 billion, and in January, outstanding consumer credit was 2588.5 billion. Normally consumer credit rises through the end of the year, and then consumers spend the first quarter slowly paying that off. Revolving credit showed the same pattern. At the end of Q3 it was 975.8 billion, and at the end of January it was estimated to be 973.6 billion. Because consumers have to shed debt before they can begin to spend, this is a healthy development.
WalMart reported a 5.1% gain in same store sales for February. One of the reasons why recessions are self-limiting is that consumer spending is constrained in part through caution during the first part of the recession. Consumers tend to build cash, pay down debt, and halt discretionary purchases, fearing unemployment and wage cuts, etc. Although unemployment generally keeps rising after the trough (the minimum level of economic activity), consumer needs also accumulate. Eventually, the cautious but employed and financially stable consumers have to buy that new refrigerator, car, etc.
There are several more shocks coming. One (the increase in fuel costs) is already moving along. This is in part due to OPEC, but more probably due to some of that extra trillion in cash being used to hold oil to profit off the futures market, and also due to changed expectations due to Obama's moves in terminating the oil shale leases and reinstituting the ban in off-shore drilling. Because fuel costs are so intimately woven into food prices, this will limit the the recovery in real incomes.
The second shock is inflation expectations, which influence the price at which investors are willing to lend money. Personally, I reviewed the budget and spending plans, and decided that I am going to hold on to my inflation stuff longer than I had previously expected. There is so much that is ill-founded in these plans, and more that is overtly inflationary. Therefore my 5-year returns need to be higher than I had previously thought; if I cannot get them on the market right now (and I can't), I will just sit on my money. Others will do likewise.
The third shock are the well-intentioned but basically crazy plan to stuff Fannie and Freddie with bad, high-risk, cheap mortgages. That means investors aren't going to buy the stuff, and so Treasury is going to have to guarantee it or buy it, which is a pretty severe economic disruption in and of itself.
The fourth shock comes in the muni market, as the ugly truth of muni defaults sinks in. Around the nation, many local governments are going to have to cut back.
These are just domestic shocks and meantime, the European banking crisis is going to inflict further international damage.
Wednesday, March 11, 2009
From A Slightly Different Angle
Yes, free the president from his flacks, fixers and goons -- his posse of smirky smart alecks and provincial rubes, who were shrewd enough to beat the slow, pompous Clintons in the mano-a-mano primaries but who seem like dazed lost lambs in the brave new world of federal legislation and global statesmanship.She still supports Obama:
Heads should be rolling at the White House for the embarrassing series of flubs that have overshadowed President Obama's first seven weeks in office and given the scattered, demoralized Republicans a huge boost toward regrouping and resurrection. (Michelle, please use those fabulous toned arms to butt some heads!)
President Obama -- in whom I still have great hope and confidence -- has been ill-served by his advisors and staff. Yes, they have all been blindsided and overwhelmed by the crushing demands of the presidency.This is a remarkably odd take.
- How does Camille think the president got his staff? Didn't he pick these smirky smart alecks?
- Is Michelle, the person whose only substantive experience was the $300,000 hospital job that was so important it isn't being filled, really the person who would know how to pick the right advisors?
- Can any president-elect truly be "blindsided" by "the crushing demands of the presidency?" If his advisors are, doesn't that indicate that he picked a slate of advisors who exemplify the Dunning effect?
- Isn't Camille calling Hillary a provincial rube as well as a slow, pompous Clinton? We know that Hillary's Russian-language skills aren't that hot, but isn't this a low blow?
There is no more appropriate metaphor for the way the Obama administration has mishandled affairs than the fact that our Secretary of State went over to Russia, a state in crisis, with a cute little gesture like a reset button that said "Overcharge". Not only is this kid stuff, it's just plain wrong.
For something that is emphatically not kid stuff, see James Galbraith's testimony before the House Financial Services Committee on February 26, 2009. I heartily agree with many of the points he makes here.
I have cited and discussed economic analysis from the Levy Institute before, and Galbraith also did so in his testimony. The bottom line is that the US economic difficulties are rooted in fundamentals rather than ephemerals, as explained in the Levy Institute's December 08 Strategic Analysis:
As early as 2004, in a Strategic Analysis subtitled Why Net Exports Must Now Be the Motor for U.S. Growth,2 we argued that continued growth in net lending to the private sector was an impossibility, and that at some stage there would have to be a collapse both in lending and in private expenditure relative to income. We also argued that it would not be possible to save the situation by applying another fiscal stimulus (as in 2001) because that would increase the budget deficit to about 8 percent of GDP, implying that the public debt would then be hurtling toward 100 percent of GDP, with more to come. These processes were allowed to continue nonetheless, and we perforce had to bring the short-term prospect into sharper focus. As the turnaround in net lending eventually became manifest, we predicted in our November 2007 analysis3—without being too precise about the timing— that there would be a recession in 2008.That is the depression-like event I have been writing about. For what it's worth, I use a drastically different methodology than these economists, yet I come up with very similar results.
As illustrated in the extreme right-hand section of Figure 1, the implication of these assumptions, taken together, is that GDP will fall about 12 percent below trend between now and 2010, while unemployment will rise to about 10 percent.
The only ways out are dollar devaluation (which will happen automatically soon enough), a sharp rise in domestic output for baseline consumption (food, energy), destruction of the private debt overload, and recovery of domestic incomes, because what has changed in the international economic outlook is the ability of the world to hike consumption of US-produced goods. Thus, we cannot hope to adjust our output gap as elucidated by LI through significant growth in US exports. We can only adjust that gap through enhanced production for our own consumption.
The problem with the Obama administration's plans as they now stand is that the energy tax will not reduce petroleum imports significantly. Instead, it will continue to move production offshore, thus making the output gap worse. This in turn will lower US incomes and raise baseline inflation, which will also lower US incomes. That will give unemployment another kick up.
The only way out is to open up domestic and near offshore drilling, build nuclear power plants, and develop the shale oils, which are economically competitive at current price levels with some very small guarantees.
Next up, insurance, which will bring me back to address Carl's arguments about the need for Glass-Steagall.
A New World Of Hurt
Zero growth forecast for Chinese terminals:
China's biggest terminal operator has predicted zero growth in container throughput in 2009 for the first time ever as demand peters out in the mainland's key export markets.Later on in the article the head of the LA Board of Harbor Commissioners is quoted as stating "We are in a new world of hurt," and it is hard to disagree when one takes a sober look at the numbers.
China Merchants (Holdings) Inter-national has a 34 percent share of the mainland container market, which company chairman Fu Yuning said would remain at 129 million TEUs this year.
"This is the first time in history it will remain unchanged over the previous year," Fu told delegates at the Transpacific Maritime conference in downtown Los Angeles.
China seems to be having some success with its internal spending program, but export orders are continuing to fall:
China's customs agency said Wednesday that merchandise exports in February plunged 25.7% from a year earlier. That is one of the biggest drops on record, and extends the 17.5% fall in January for a fourth straight monthly decline.So the internal spending isn't likely to help the region much overall.
Imports declined by a slightly less dramatic 24.1%, thanks in part to government spending, which other data also issued Wednesday showed picking up in February.
Japan is in even worse shape:
Exports in January dropped a record 46.3% from a year earlier to 3.28 trillion yen, the fourth consecutive month of year-on-year declines, with exports to the US hardest hit, registering a 52.9% drop.Germany, another manufacturing powerhouse, is seeing truly epic drops in orders (January):
Car exports alone dropped 66.1%, with semiconductor and electronic parts exports down 52.8%.
Orders plunged 38 percent from a year earlier, the biggest drop since data for a reunified Germany started in 1991, the Economy Ministry in Berlin said today. From December they fell 8 percent, four times as much as economists expected and extending their worst decline on record. “The annual slump is absolutely catastrophic,” said Alexander Koch, an economist at UniCredit MIB in Munich. “The extent of declines is terrifying.”Ex-European orders dropped 18.2%, and domestic demand is dropping heftily now. I included that last quote in case you all were thinking that I am a gloom-and-doomer.
Judging by January US wholesale inventories, we aren't going to be helping!!
Until that line declines, it's a safe bet that new orders will be declining. There's nothing worse than sitting on warehouses of stuff you aren't selling as your credit lines get stretched thin.
Global air freight for January:
The alarming 22.6 percent collapse in cargo markets in December worsened in January 2009 with a 23.2 percent year-on-year drop in freight demand, according to the International Air Traffic Association (IATA).IATA is begging Obama to put money into airports and traffic control improvements. Instead they are going to get fuel price hikes and taxes on GHG engine outputs.
Asia Pacific carriers, representing 43 percent of the market, led the cargo decline with a 28.1 percent year-on-year drop. This was followed closely by the other major market players: European carriers (-23 percent) and North American carriers (-19.3 percent).
Russian railroads are improving their forecast for 2009. The new projection is for revenue to be down only 20% YoY. Maersk is increasing shipping rates in April, followed by a July increase, calling current rates unsustainable. We'll see.
India is doing relatively better, but IT profits will probably come down sharply this year. (Services have been carrying Indian GDP recently.) Tomorrow we get Indian industrial production. However the rupee's collapse is helping some sectors; apparel exports are now rising.
I think China will have to devalue.
And what of Japan? Japan has staggering public debt levels, a current account deficit, and collapsing exports as well as shrinking domestic demand. Japan has slowly moved a lot of new production overseas to countries like Indonesia, and Japan's current account surplus has been created by increasing levels of repatriated profits. But those profits are due to weaken for a while to come, as countries like the Phillippines, Malaysia, Singapore, and Indonesia start to really feel the impact of the global downturn. This worries me terribly, because Japan is the world's number 2 economy, and changes in Japan's economic relationship to other economies holds the potential to cause severe global disruption.
Brazil contracted 3.6% in Q4 08, although the signs of resurging commodity prices have helped boost their currency. However, the boom was coming to a natural subsidence last year already, January industrial output was down over 17%, and weakening trade with countries like Argentina is going to hit the ag sector. Venezuela is just a shambling disaster bent on a glorious suicide under Chavez, and Argentina is lurching along in a world of hurt.
Mexico is helped by the peso's decline, but that same decline is boosting inflation rapidly and cuts into real incomes, which is producing a fall in internal auto sales that exacerbates declining auto exports. Overall manufacturing isn't doing much better, with exports dropping 30% in January. The Mexican economy will not grow in 2009. It may shrink as much as 2.5% by my calculations, though I seem to be more pessimistic than most. Perhaps there is something I'm not seeing.
In light of all this, I nearly passed out when I read some of the spending increases folded into the Barbie Doll Congress' latest spending bill. It is nice to know that tattoo removal and Hawaiian welfare are still on Congress' horizon, but it does seem that overall economic reality hasn't managed to enter the chambers. Yet. An 8% increase in overall funding for most of the government seems a bit excessive under the circumstances, doesn't it? Especially since this comes on top of that 787 billion stimulus thingie of a month ago. If spending money like water could lift the US economy out of a recession, our economy would be booming.
Update: Congress just has to wake up, and it had better do so soon. Here is the trend in federal tax receipts:
This isn't going to change for the better very soon either, and it exposes the fantasy of the Obama budget proposal.
Monday, March 09, 2009
Poker And The Need For Glass-Steagall
See the "Reality Bites" issue of John Mauldin's newsletter, which includes a discussion of risk:
The biggest challenge facing policymakers is not short-term recovery, however. Eventually, stimulus is likely to arrest the forces of economic collapse and stabilize matters – at least temporarily. But the real problem is sowing the seeds of long-term, sustainable, organic economic growth. This is really the crux of the policy challenge. The United States in the midst of the worst economic downturn in 80 years as the result of a panoply of extremely poor economic policy choices. Economist Roger W. Garrison draws an important distinction between "healthy economic growth, which is saving-induced (and hence sustainable), and artificial booms, which are policy-induced (and hence unsustainable)."2 In other words, monetary policy that kept interest rates low for an extended period of time, tax policy that favored debt over equity, regulatory policy that allowed financial institutions to operate opaquely, and social policy that pushed home ownership regardless of affordability, all combined to create artificial economic demand that could only be financed with debt because the savings (i.e. equity) to purchase them did not exist.This issue (written by the author of the HCM Market Letter) goes on to discuss the problem of creating sustainable economic growth conjoined with policies that are jacking up government debt:
Another bout of policy-induced growth will not only repeat the mistakes of the past, but leave the economy even weaker, teetering on an unstable foundation of government support that cannot be sustained indefinitely without impairing America's balance sheet, credit rating, and ultimately its geopolitical might. Whether America's short-term political orientation can ever address this conundrum is the greatest question facing policymakers today. HCM has no hesitation in saying that much of what the government has proposed thus far to deal with the crisis won't come close to dealing with the long-term issue of creating savings-induced or organic growth. This means that any near-term relief (i.e. relief that occurs within the next five years) is most likely to give way to years of below trend growth because the economy will be lacking the organic foundation of growth it needs.End update.
In order to try to compress this a little, I am going to refer back to several prior posts.
The first is How Did We Get Here, written in September of 08. This covers some of the basics about the difference between banks and SEC regulated financial institutions, the role of REITs, and the repeal of Glass-Steagall (which essentially occurred piecemeal through the 90s, but was finalized in 1999). Please also see the Wikipedia entry, which is very informative.
(Btw, for those who persist in believing either party is the sole culprit, the Clinton administration was a major driver of GLB reform, and the final vote in the Senate was 38 Aye, 7 Nay Dems and 52 Aye, 1 Nay GOP. Our current situation is as strongly bipartisan as it gets. McCain did not vote. Fitzgerald (R) voted present, as did seven Dem senators. In the house, the GOP voted it in 207-5, and the Dems voted it in 155-51. Thus each party now has a very strong incentive to obfuscate the issues here. Pelosi voted for it. Reid voted for it. House vote. Senate vote.)
The next part of the puzzle is basically covered by this 2007 post Long-Short Financial Gearing - as long as there was a crying need for the ABCP securities used as the fodder for the gearing system (money markets), nobody in investment banking gave a flip about the underlying risks. The reason why shoddy securities looked so appetizing was that the return on the securities was leveraged up by the spread between long and short rates.
Carl over at No Oil For Pacifists does not see my argument about why conglomerating financial businesses produces far more systemic risk. That is because Carl is a very logical thinker, and he operates by trying sort things into discrete sets (i.e. does this always have to mean this?). But that is not the type of thinking that is involved in banking and investment decisions, which always contain a degree of risk, i.e., the sets are always intermingled, and not only that, the degree of intersection is unknowable in any working system. Thus banking compensates for unknowability by requiring more profits to set up a reserve.
I tried to figure out many ways to get it across to him, and I finally concluded that I could do no better than by using Ben England's (he's a doctor) poker analogy:
I used to play a fair amount of Texas Hold'em a while back. Particularly bad players like to bet a lot on marginal hands, and refuse to fold despite worsening odds on the upcoming cards. I've seen plenty of them get lucky and amass a pile of chips early in the game, but usually their sloppy play will catch up with them and they'll start losing hands.This is probably a better analogy than he even knows, although the moment I read it I was struck by the hilarious appropriateness of his thinking.
Once their stack is down, their play will get even more desperate, making larger bets on poor hands in hopes of hitting a big pot and restoring their bankroll. Soon their stack is completely gone, and they're rebuying back in the game, still playing aggressively in hopes of getting back.
Usually they'll leave the table down 80 bucks in a 20 dollar buy in game after being up 60-70 dollars.
In poker, the decent player stays or folds based on a relatively strict calculation involving the money at stake and the chance of winning the pot. In other words, if a relatively small bet gives you a small chance at winning a very big pot, you should stay in, or If:
Chance of Winning * Amount in Pot > $ amount to stay in, stay, but if
Chance of Winning * Amount in Pot < $ amount to stay in, fold. So a 30% chance of winning a $10 pot = $3.00 winnings. If I have to come up with $5 for the chance to win $3.00, I fold, because this is obviously a losing strategy over time. But if I have a 70% chance of winning a $10 pot ($7.00), that $5 bet may well be the best course. A 30% chance of winning a $30 dollar pot = $9 (not $12!) winnings, and it is generally rational to spend $5 for that chance. Beyond that one simply goes on knowledge of the other players' likely strategies to modify your calculations. So what I am trying to explain is that the recent breed of the best-and-brightest investment bankers are decent poker players, although terrible bankers. The difference between traditional bankers (commercial bankers) and investment bankers is that commercial bankers must pay attention to systemic risk. Investment bankers don't.
Allowing financial businesses to conglomerate and verticalize lines of business which have traditionally been handled by counterparties creates a situation in which the pot (potential return) gets much larger for each decision point. In other words, whereas in commercial banking the decision to say yes or no to a car loan or a home loan provides profit X, in a verticalized, conglomerated transaction the total profit from saying yes to a car loan or home loan may be more like 2X or 3X. Therefore, a straight line analysis will tell the poker-playing financial conglomerate to take on more risk.
Furthermore, allowing financial companies to be in the insurance business, the securitization and investment selling business, plus own the banking side (taking deposits and writing loans), plus verticalize (the holding company owns investment houses, banks, mortgage origination, servicing, and even insurance) destroys the independence of decision making.
Reprinting from the first post linked above, I reiterate that parties under the non-conglomerated financial system have a much lower incentive to take on risk in any single transaction, whereas when you allow the conglomeration of business lines, the profit from writing any particular appears much higher. This is because when you have a bunch of counterparties, each of whom is liable for all of the risk in their part of the transaction, but each of whom receives only a portion of the overall profit, the pot for each party is smaller. A lot more loans will be refused under this system:
The primary reason for the enhanced risks to a financial system that involves vertical lines of production and conglomerated functions is that it destroys counterparty checks and balances. Here is a somewhat simple example using mortgages.
Bank writes mortgages. It lays off portions of its larger commercial loans to other banks (participations), keeps some shorter-term and variable mortgages, plus home equities, and sells the other consumer mortgage loans either to GSEs or to larger institutions which then batch them and securitize them. When selling mortgages the bank often retains servicing rights on the mortgages.
In writing its mortgages, the bank employs:
- An independent appraisal staff. These appraisers are reviewed annually by the board to see if their loans have produced losses on default, and the approved appraiser list is checked against the lists provided by the mortgage buying entities. The appraisers know that, and know that their profitable relationship with the bank will be jeopardized if they overestimate valuations. Thus their incentive is to be conservative and protect the bank from loss. By doing so they are maintaining their business lines.
- Independent title companies. The title companies used are bonded, licensed and and insured. If there is a problem, they will end up covering it.
- Property insurance companies. The approved ones are state-licensed and examined. The incentive to the bank is just to make sure that they are covered and their risk of loss is controlled. Property insurance companies are also rated and approved by the entities buying the mortgages.
- Mortgage insurance, if required by the bank's loan risk assessment and/or the mortgage buyer. Again, these companies are reviewed by the major players, such as GSEs.
When the bank sells mortgages, it does so under a system of covenants and representations, which basically require the bank to take back loans that are not properly documented and evaluated. So, for example, if a loan defaults almost immediately after initiation, the bank is going to be stuck with it or get it back. Likewise, if the loan later defaults and loss review at the buyer turns up an erroneous original verifications of income, or bad DTIs, or misrepresentations of income, or a funky appraisal, the bank gets its bouncing baby back. If the buyer doesn't review on default but MI is involved, the mortgage insurance company does review.
Further, the fundamental structure of Fannie-type mortgage securities was the pass-through, in which Fannie bought back defaulted loans from the investment pool. The way this system evolved tended to maximize longevity of players and accountability of players. To preserve access to Fannie, one generally anted up when asked to do so. And the same was true for the title insurance company, etc. In general, it was a trust-based system with a lot of accountability for the end results. The aggregator (the GSE) took nearly full responsibility for the outcome and passed that responsibility back down the line.
In this system, the profit of each counterparty largely depends on meeting mutual commitments (sustaining line of business) plus controlling one's own risks. Management of risks is independent. If one of the companies becomes financially unstable, it will lose business rapidly and pose potential losses to the other parties, so company "certification", whether formal or informal, tends to take place at several levels. Adequate capitalization is one of the prerequisites for maintaining your business relationships. The system as a whole is much bigger than any one bank or company, so participants can fail or be shuffled off to pasture without rocking the entire system.
As it ended up in the GLB era of bright and shining financial innovation:
Investment bank buys holding company. Holding company owns a bank and a bunch of mortgage companies that are non-banks, an insurance company, a title firm, and an outfit that contracts for appraisals. In addition, IB wants to maximize profits, so it sets up a subprime servicing company of its own. IB will generate mortgages through this origination arm, plus securitize them, plus write interest rate swaps on the resulting securities. In order to get large enough pools of mortgages, the IB also buys from other such non-bank companies and banks. In order for the banks to get enough mortgages to sell, many of the banks do wholesale mortgages, buying loans from mortgage brokers to sell through to the aggregators.
Note that the IB gets profit from virtually every step in this process. When one leg of it fails, it can plausibly argue that it is merely moving money from one arm to another. Further, the eventual investment product does not truly protect the investors. Unlike the old-fashioned, non-innovative, Fannie pass-through mortgage bond, buyers of the resulting tranched bonds do accept the risk of default in most circumstances.