Financial

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10
Mar 10

Are We a Socialist Country?

Europeans and Russians are socialists.  Americans are staunch capitalists.  Maybe all it took was a financial crisis to reveal the slide toward socialism in America.  During the Cold War, faced with a military threat from the Soviet Union, Americans would rather have died than become socialists:  better dead than red.  Unwittingly, we now invite socialism into our lives.  Ironically Wall Street firms and large industrial corporations, the purported bastions of capitalism, have paved the way to socialism.  A left-leaning Administration has been only too happy to oblige.

The Slippery Slope

The road to hell is paved with good intentions.  I do not think any of the pillars of our economy intended that the country become socialistic.   Each entity was merely maximizing its own position, seeking to enhance shareholder value.   When financial crisis hit, our formerly capitalistic businesses could not rush to Washington fast enough to seek support, bailouts and guarantees from the government.   The government was only too happy to oblige with the passage of TARP and then an alphabet soup of government support and guarantee programs.  In one short crisis period from summer 2008 to spring 2009, the government ignored 200 years of American economic and constitutional history to save a group of greedy and profligate bankers and industrial corporations.   The end result: we privatized profit and socialized losses.

A Factual Progression

Here are the events that have taken us on the path to socialism:

  • The Federal Reserve’s active role in the forced sale of Bear Stearns to JP Morgan
  • The Government seizure of Fannie Mae and Freddie Mac
  • TARP:  Government purchase of troubled assets from private financial institutions
  • Goldman Sachs and Morgan Stanley become banks by expedited process  to obtain government guarantees
  • Government seizure of AIG and complete payback to private institutions for credit derivative losses
  • Federal Reserve intervention in broker mergers, with guarantees against losses (Washington Mutual with JP Morgan, Wachovia with Wells Fargo)
  • Federal Reserve intervention with $1.3 trillion in loans to companies outside the financial sector (GE).
  • Government removal of management at GM and Chrysler
  • Restrictions on executive pay for banks receiving bailout funds
  • Government restrictions on foreclosures unless there has been a Home Affordable Modification Program review.
  • Administration desperation to pass comprehensive health insurance program.   See Timeline:Global  Economy in Crisis

How Did We Get Here?

We invited the devil in the door.  Banks claimed that they could not withstand loan and derivative losses.  Unemployed Americans wanted extensions in unemployment benefits and stimulus programs.  Nobody wanted to see the stock market crash and their portfolios and retirement plans decimated.  Big business wanted the profit opportunity in universal health care coverage.  Insurance companies did not want to hurt their policy holders.  Auto workers wanted to maintain their rich union contracts.  The litany goes on.

Once we were a brave, independent and self-reliant nation.  Now when adversity strikes our first inclination is to blame others and call Washington for a bailout or a handout.  I do believe in the concept of welfare.  Welfare was meant for the truly dire circumstance, the impoverished citizen. Welfare was not meant for auto workers to maintain above market wages and job guarantees, banks to get paid in full for risky derivative bets, GE or GM, homeowners who falsified their income disclosures to remain in McMansions or every insurance policy to be paid in full.

Capitalism is about freedom, risk and failure.  Without failure there can be no progress.  The slide toward socialism is an escape from freedom and ultimately an end to progress.

My European immigrant grandfather lived through the Depression, World War Two, and into the 1980’s.  He once told me he was most proud that he never went on relief (welfare).  We should return to the ways of our forbearers, regain our mettle and become too proud to ask for a handout or bailout.   Our freedom and that of our children depend on it.

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2
Mar 10

Goldman and the Winner Take All Society

Finally, Goldman Sachs has gone too far.  In A Reputation as Good as Goldman?  Part I, we discussed Goldman’s selling of mortgage backed securities, and its role in the current Greek budget crisis.  These activities clearly contributed to its self-inflicted reputational damage.

Perhaps the hubris went further.   Does Goldman believe that its status as a favored Federal Reserve “too big to fail” firm will insulate it from government investigation? Last week Ben Bernanke put a dent in Goldman’s Teflon shield:

Ben S. Bernanke, the Federal Reserve chairman, told Congress Thursday that the Fed was ‘looking into a number of questions relating to Goldman Sachs and other companies and their derivatives arrangements with Greece.’

Mr. Bernanke said the Securities and Exchange Commission was also concerned about how derivatives — financial instruments that are largely unregulated and do not trade on public exchanges — have contributed to Greece’s problems. ‘Obviously, using these instruments in a way that intentionally destabilizes a company or a country is counterproductive,’ he said. See In Greece’s Crisis, Fed Studies Wall St.’s Activities.

In Is Goldman Finally About to Be Leashed and Collared? Yves Smith observes and analyzes Goldman’s corporate culture.  As a former employee, she reports on colleagues’ piggish and overly aggressive behavior. But in an otherwise excellent post, I believe she overlooks the role of current compensation systems.

Pay Practices and Reputation

In previously discussing the banking crisis, we pointed out a fundamental principal: you get what you incent.

Banks were interested in generating upfront fees. Incentives were predicated on “making the deal.”  The best way to make a deal was to ignore the creditworthiness of the borrower.  The banker who made the bad loan suffered no personal financial penalty.  There was no “skin in the game.” Why not write as many loans to poor credits as possible? See Hard Truths from the Banking Crisis.

The Goldman culture incents a “winner take all” mentality.  Since it is a public corporation rather than a partnership everyone is an employee.    A highly mobile employee rather than an owner is far less concerned about the firm’s long term reputation.  That employee wants to maximize current compensation; worrying about future consequences is for suckers.  Drawing on this paradigm, we are not shocked by headlines excoriating the firm for trading against its clients’ interests, shorting the municipal bonds it helped underwrite, skirting EU rules, or tanking the housing market.

Goldman operates in a larger Wall Street and indeed general culture that encourages greed at the expense of overall civic good:

  • Successful hedge funds report individual earnings in the hundreds of million dollars per employee.
  • Loyalty is dead.  Employees change firms. Highly paid athletes change teams without a second thought.
  • The media treats great wealth as reason for great celebrity.
  • Compensation validates individual worth.
  • Government backstops losses and allows gains to remain private.
  • The zeitgeist promotes: “I better grab as much as I can now before the economy implodes.”

Does It Have To Be This Way?

Any alert Board of Directors should be asking some difficult questions.  Why aren’t we concerned about the long-term firm reputation?  What do we want the corporate culture to be? Just because we can legally do a transaction should we be doing it?  How do we blend partnership-based personal accountability with a public corporation structure?   How do we get employees to care about the long-term view?  How do we meet the competitive threat of hedge funds and private equity without damaging corporate reputation? How does our compensation system comport with these concerns?

Yves Smith noted that it was as dangerous for anyone to get in the way of a Goldman employee and a profit making opportunity as it was to get between a predatory animal and its kill.  Goldman has managed to get itself between a very worried Obama Administration and a very angry public.  How ironic if the Goldman predatory lion becomes the Administration sacrificial lamb.

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24
Feb 10

The Mirage of a Financialized Economy

We have spent the last 30 years preoccupied by financial things.  Finance was once the handmaiden of productive enterprise.  That is, Wall Street served productive enterprise, raising and allocating capital for worthy endeavors.  Finance existed for helping railroads, utilities, builders and manufacturers to issue stocks and bonds.  Further, finance helped maintain orderly exchanges where stocks and bonds could be traded.

Building a successful business is difficult. Once an entrepreneur raises capital, he must deploy it properly.  He must hire employees, build factories, develop products, plan marketing strategies, manage production, packaging and shipping, and a myriad of other activities.

A recent concept, financialization is defined as:

…a term sometimes used in discussions of financial capitalism which developed over several decades leading up to the 2007-2010 financial crisis, and in which financial leverage tended to override capital (equity) and financial markets tended to dominate over the traditional industrial economy.

[It] describes an economic system or process that attempts to reduce all value that is exchanged (whether tangible, intangible, future or present promises, etc.) either into a financial instrument or a derivative of a financial instrument.  Source Wikipedia.

Financializing the economy promised a short cut to making money.  We are now paying for that false promise.

Living through Financial Engineering

I started my corporate career in 1977.  I worked for a telecommunications and manufacturing conglomerate that served 27 million telephone customers, employed 250,000 people worldwide, manufactured products ranging from the humble incandescent light bulb to sophisticated microchips.  Leaders in the company were operating executives.  Executive compensation was moderate.

In the 1980’s and 1990’s the winds of financializing change swept through corporate America.  The underlying producing businesses were viewed as stodgy and unimaginative.  Paper mills, lighting plants, railroads and telecommunication companies were boring “cash cows.”   “White shoe” business schools preached financial innovation, or to give it a more professional sounding name, financial engineering. The CFO function dominated.  Executive compensation increased exponentially.

The number of engineering opportunities was boundless:

  • Terminate pension plans and pocket the surplus assets
  • Create leveraged employee stock ownership plans to make 401k contributions
  • Take out gigantic company owned life insurance plans on large swaths of the workforce
  • Issue huge amounts of debt and buy back the company’s equity
  • Create voluntary employee benefit trusts to pre-fund retiree health benefits for unionized employees.
  • Create leasing and realty divisions within the company for both internal and external needs
  • Take the firm private through a management organized leveraged buyout

These are but a few of the financial techniques employed to inflate company earnings or turn a quick profit. Most of these strategies involved taking on large amounts of debt and exploiting loop holes in the tax code. None of this enhanced the productive capabilities of the underlying business. The “cow” was slowly starving and the bricks and mortar of the enterprise were crumbling.

Enron and WorldCom

The beginning of the new millennium saw two major American corporations, Enron and WorldCom, disintegrate.  Accounting fraud was at the heart of these collapses.  Enron created off shore entities to hide losses and posted yet unrealized revenue as profit.  WorldCom underreported line costs by capitalizing items which should have been expenses.  They also inflated revenues through bogus accounting.  Not only did these entities hurt their shareholders, but also their competitors who had to compete again these fraudulent entities for scarce capital.

Sarbanes-Oxley was passed in 2004 to stop these accounting maneuvers and restore integrity.  The subsequent collapse of Bear Stearns and Lehman tells us that Sarbanes-Oxley failed, and that financial transparency still does not exist.

The Evils of Financialization

Financialization of the economy has become an evil unto itself.  Culprits in the 2008 financial crisis: sub-prime lending, mortgage-backed securities, collateralized debt obligations, off balance sheet structured investment vehicles, hedge funds, private equity,  excessive leverage are all the progeny of the 1980’s schemes and strategies to enhance corporate financial performance.

I have two observations.  First, many of these maneuvers are nothing more than alchemy applied to finance.  Old saws such as “there is no free lunch” and “you can’t get something for nothing” remain true.  Slapping a Nobel Prize or a prestigious business school imprimatur on a strategy does not change these universal truths.

Second, an early rule of investing I learned is: when one sector becomes more than 30% of the value of the S&P 500 index, sell that sector. This was true in the 1980’s when the oil sector passed that benchmark and in 2008 when the financial sector did the same. Too much of society’s resources and human capital are now tied up in one area of the economy. At least in the case of oil there was a real societal good.

The financial industry in 2008 and now has become a financial casino without the glitz or charm of the Mirage. In fact, it has become a mirage and that says a lot.

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19
Feb 10

A Reputation as Good as Goldman Part II

In A Reputation as Good as Goldman Part I, we examined Goldman’s role in exacerbating the housing market collapse, AIG’s demise, and the Greek government debt crisis.  These major stories were the subject of separate front page articles in the New York Times. Mentors had always warned me no to be too clever by half, a lesson Goldman perhaps missed.   Are the Goldman stories symptomatic of behavior for the last ten years on Wall Street?  Was this always the way Wall Street firms and Goldman behaved?

Sydney Weinberg

In 1930, Sydney Weinberg became the head of Goldman Sachs. He ran the firm for the next 39 years.  By 2010 standards, he was an unlikely person for the job. He had left school at 15 (1907) and started at the struggling brokerage firm as a janitor’s assistant.  He then served in the Navy during World War I, returned to the firm and ultimately became co-head of the securities trading group. He is credited with saving Goldman Sachs from bankruptcy during the Depression. See Annals of Business: The Uses of Adversity by Malcolm Gladwell

In 1956, Weinberg managed his greatest corporate coup. Goldman Sachs was selected to handle for the Ford Motor Company the enormously difficult, largest ever until that time, initial public offering.  The effort took two years. The most fascinating part of the transaction was Weinberg’s fee:

When Henry Ford had asked Weinberg at the outset what his fee would be, Weinberg had declined to get specific; he offered to work for a dollar a year until everything was over and then let the family decide what his efforts were really worth.  Far more than the actual fee, Weinberg always said he appreciated an affectionate, handwritten letter he received from Ford which says, along with other flattering things, “Without you, it could not have been accomplished.” Weinberg had the letter framed and hung in his office, where he would proudly direct visitors’ attention to it, saying: “That’s the big payoff as far as I am concerned…” The fee finally paid was estimated at the time to be as high as a million dollars. The actual fee was nowhere near that amount: For two years’ work and a dazzling success, the indispensable man was paid only $250,000. Deeply disappointed, Sidney Weinberg never mentioned the amount.  See The Partnership: The Making of Goldman Sachs by Charles D. Ellis.

Weinberg understood the value of a continuing relationship with Ford Motor Company and was soon appointed to their board.  Moreover, for nearly a half century, Goldman became the chief investment bank for Ford which vaulted the firm into the top tier of Wall Street firms.  To Sydney Weinberg reputation was everything.

Tradition and the Making of a Culture

John Weinberg followed his father Sidney as head of the firm.  The younger Weinberg preserved his father’s ethic and corporate culture.

Once upon a time, Goldman Sachs shunned publicity.  During the period from 1930 to 1969, Sydney Weinberg ran Goldman Sachs where he developed a staunch corporate cultural aversion to publicity.  During the 1970s, a tandem of John Weinberg and John Whitehead assumed the reigns of leadership at Goldman Sachs.  Whitehead left the company in 1984 to enter public life.  John Weinberg carried on in the same vein as his father Sydney – shunning publicity – to the point where he hired a man to keep his name and his firm’s out of the press.  He kept him off the full-time payroll (though he sat full-time at a desk in head office) so that if, improbably, a comment did slip out, it could be honestly dismissed as not coming from a Goldman Sachs employee.  John Weinberg served as sole senior partner and chairman until 1990.  His mantra was to put the client’s interests first and he wouldn’t allow Goldman to be involved in (sic) hostile takeovers. See All Roads Lead to Goldman Sachs.

As a young law student, Ben Stein interviewed with John Weinberg.  He was impressed with Weinberg as a “smart guy,” but also surmised that he inherited the position from his father, Sydney Weinberg:

But what I did not know about John Weinberg was that even though he was rich and well connected, as a young man he joined the Marines to fight the Japanese in the Pacific, then fought again in Korea. That was America’s ruling class then. The scions of the rich went off to fight. See Looking for the Will Beyond the Battlefield

Clearly, John Weinberg believed that honor and service to one’s country mattered.  But in the current Goldman and Wall Street culture, going off to serve one’s country is for the common folk: why do that and miss out on so many deals and great bonuses?

What Changed?

The end of the Weinbergs’ era can be traced to several factors.  First, Goldman Sachs, Morgan Stanley and other large investment firms were partnerships.  This means the partners were investing their personal fortunes.  Moreover, retained capital was extremely important to the future success of the business.  Thus, there was a limit on executive compensation based on capital and personal preservation.  Second, as firms went public, it was easier to convince a less involved board of directors (rather than partners) to pay large bonuses to executives. Third, those same executives became increasingly greedy, and probed and trampled ethical boundaries. Short-term thinking reigned on Wall Street.  Fourth, compliant government officials endorsed and enabled these behaviors instead of regulating them.

Finally, we need to look at the important intersection of law and ethics.  Just because something is legal does not mean one should do it.  A legal thing is not always an ethical thing.  Would the Weinbergs’ have permitted Goldman to take positions against their own clients?   Would they have forced AIG into insolvency? Would they have designed scams to fool the EU? I doubt it.

It will be a long time before Goldman restores its reputation.  And President Obama is not catalyzing any restoration of ethics or reputation by calling the current Goldman CEO a savvy businessman.   By its actions, I doubt if Goldman Sachs cares.

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18
Feb 10

A Reputation as Good as Goldman? Part I

Part I of II in a series. Part II here.

“It takes 20 years to build a reputation and five minutes to ruin it. If you think about that, you’ll do things differently.”

Warren Buffett

Arguably the greatest living investor, Warren Buffet, clearly valued a person’s or an organization’s reputation.   In 2008 Buffet was the “white knight” investor for a struggling Goldman Sachs, investing $5b in the firm.  A mentor of mine had wise complementary counsel to Buffet’s:  when providing legal advice, be sure that you would be comfortable if that advice were to appear in a New York Times, Washington Post or Wall Street Journal front page article.

We live in  an age of greed, and indeed supreme irony.   Perhaps Mr. Buffet never shared his wise advice with the senior management of Goldman Sachs.  Worse, maybe he did and they ignored him.  In any event, how has Goldman’s reputation fared?  Let’s examine three separate front page New York Times articles.

Banks Bundled Bad Debt, Bet Against It And Won (NY Times, December 24, 2009)

Goldman Sachs sold mortgage-backed debt securities to pension funds and insurance companies. To hedge their position and to profit from a decline in the housing market, Goldman created a synthetic derivative security called Abacus. This second security was a direct bet against the position of their institutional clients. The mortgage-backed debt securities sold to the institutional clients performed poorly, with losses in the billions. Some of the original securities were of such poor quality that losses occurred within months of issue. Goldman created these synthetic securities well in excess of any hedging needs, permitting it to profit handsomely at the expense of its institutional clients.  The obvious ethical problem was succinctly stated:

“The simultaneous selling of securities to customers and shorting them because they believed they were going to default is the most cynical use of credit information that I have ever seen,” said Sylvain R. Raynes, an expert in structured finance at R & R Consulting in New York. “When you buy protection against an event that you have a hand in causing, you are buying fire insurance on someone else’s house and then committing arson.”

The SEC and other governmental agencies are investigating Goldman and other firms to determine whether or not they violated “fair dealing” rules.

Testy Conflict with Goldman Helped Push A.I.G. to Edge (NY Times, February 7, 2010)

AIG insured some of Goldman’s complex mortgage securities.  When the housing crisis deepened, AIG paid Goldman $2b to cover potential losses. AIG later asserted that Goldman had inflated the potential losses and sought monies back. Goldman countered that it was due even more money.  The SEC is now looking into whether or not Goldman’s demands for loss coverage depressed the mortgage market and hastened AIG’s demise.

In another supreme irony, after the government took over AIG, Goldman received an additional $12.9b from taxpayers, one hundred percent of expected losses.

Wall St. Helped to Mask Debt Fueling Europe’s Crisis (NY Times, February 14, 2010)

Goldman’s questionable financial maneuvers were not confined to the United States.

As worries over Greece rattle world markets, records and interviews show that with Wall Street’s help, the nation engaged in a decade-long effort to skirt European debt limits. One deal created by Goldman Sachs helped obscure billions in debt from the budget overseers in Brussels.

Even as the crisis was nearing the flashpoint, banks were searching for ways to help Greece forestall the day of reckoning. In early November — three months before Athens became the epicenter of global financial anxiety — a team from Goldman Sachs arrived in the ancient city with a very modern proposition for a government struggling to pay its bills, according to two people who were briefed on the meeting.

The bankers, led by Goldman’s president, Gary D. Cohn, held out a financing instrument that would have pushed debt from Greece’s health care system far into the future, much as when strapped homeowners take out second mortgages to pay off their credit cards.

European authorities are looking into the role of Goldman and others in skirting EU rules.

Is There Another Way?

Has the American public been lulled into believing that this is an acceptable way of doing business, or do we require the people involved to be publicly excoriated, tried, convicted and jailed before we acknowledge their tactics were shabby?  Is Goldman Sachs an institution now synonymous with crafty machinations and greedy outcomes? Are its tactics symptomatic of a Wall Street “disease?”  Is there an alternative way of doing things?  Does reputation matter?  Part II will examine these issues and possibilities.

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16
Feb 10

Where Are We Now?

“Where Are We Now?” is my fiftieth blog post.  The purpose of a political and economic blog is to “connect the dots” looking for coherent patterns.  This post will attempt to do just that, warning you that the emerging pattern is disturbing.

Slow Motion Depressions

Policy makers in Washington and other western capitals are recently smug. They proclaim that, through coordinated monetary and fiscal response, we have averted the Second Great Depression.  More bluntly, all we have done is throw a lot of money at the problem through unprecedented monetary easing and a fiscal policy of bailouts and stimulus bills.  The core financial issue remains:  western countries and the US in particular have too much debt and insufficient income to service that debt.  Depressions have their own timetable. In my opinion, government intervention has only slowed the timetable, but definitely has not averted the event.

The Magic Act

Politicians and central bankers are a bit like magicians.  While an observer is firmly focused on the right hand we miss the left hand’s activities, which are hiding in plain sight.   Just look at current economic and financial trends:

  • Increasing Risk of Sovereign Debt Default – In late 2009 a problem arose with the financial solvency of Dubai.  Much like the subprime crisis in the US, financial pundits assured the public that the Dubai default was minor and self contained.  Yesterday, credit protection for Dubai rose to a record high exceeding the November peak. See Dubai CDS Hits 652, Ploughs Through November Highs As Gold Jumps.   Greece too is on the verge of sovereign debt default and is seeking a European Union bailout.  Portugal, Ireland, Italy and Spain are reportedly in dire financial trouble as well.  The United States, Japan and United Kingdom are not immune from talk of default.
  • Crisis at the State Level – The Center for Budget and Politics has projected 48 of 50 states will have budget deficits.  Cumulatively, the Center estimates an $180b shortfall for this fiscal year.  All states with the exception of Vermont have a balanced budget requirement.  Some assistance to the states has been proffered through the American Recovery and Reinvestment Act, but it is questionable whether this aid can continue. See Recession Continues to Batter State Budgets; State Responses Could Slow Recovery. It is more likely that states will follow the lead of newly elected Republican Governor Chris Christie.  Recognizing that the state is on the edge of bankruptcy, Christie has declared a fiscal “state of emergency” and intends to slash $2.2b from the budget. See Chris Christie Declares Fiscal ‘State of Emergency,’ Paving Way for NJ Spending Cuts. The crisis in municipal finance portends trouble in the municipal bond markets.  The unsuspecting public has purchased municipals in search of yield and instead may receive an unpleasant surprise.
  • National Fiscal Irresponsibility – President Obama signed into law a $1.9t increase in the debt ceiling, raising it to $14.2t. As the administration has predicted deficits out to 2020, this ceiling will rise each and every year. Also, it does not include the Christmas Eve bailout of Fannie Mae and Freddie Mac which provided “unlimited financial assistance” to these two entities. We will likely exceed our previous limit of $400b on financial assistance under emergency bailout provisions.  See US Promises Unlimited Financial Assistance to Fannie Mae and Freddie Mac.  Moreover, how can we continue to finance these deficits without an increase in interest rates?  However, such an increase in interest rates could put the US in a “doom loop,” as interest payments become the dominant budget line item crowding out other federal spending programs.
  • China – Recently China has made a number of financial moves that do not bode well for the US and world economy. First, China has ordered its currency managers to withdraw from any US dollar denominated risk assets, such as corporate bonds, equities and only invest in US guaranteed assets.  Second, it has raised its reserve requirements on its own banks to dampen an over-inflated domestic real estate market.   Speculation in Chinese real estate has reached the point that Jim Chanos, a respected investor, predicts an economic collapse.  See Jim Chanos: China Bubble Ready to Burst. Given the size of our deficits, the US desperately needs China to continue purchasing US government securities. The world needs China as a growth engine to continue world trade and prevent a second leg of the recession.

Harbingers of the Economic Unraveling

Before the next phase of an economic crisis there are often clues to impending problems. Some harbingers to consider:

  • Junk Bonds – The Greek crisis has spurred investors to sell junk bonds, highly risky assets, at the fastest rate since 2005.  As a result credit spreads are widening between treasury and higher risk corporate bonds. See Junk Bond Spreads Widening: A Canary in the Coal Mine.
  • Problems in a Treasury Auction – Last week’s US 30-year Treasury bond auction was considered a failure.  Indirect bids, that is, foreign buyers, dried up and the government had to offer a yield of 4.72% compared to an expected yield of 4.687%.  See Dismal $16b 30 Year Auction
  • Credit Card Problems – Capital One, a major credit card issuer, reports that in January delinquencies rose and that expected unrecoverable loans have risen to 10.41% from 10.14% in December. See Capital One: Credit -Card Delinquencies Rose in January.
  • State and Municipal Finance –In its upcoming July 1 fiscal year budget, California expects a $20b shortfall.  Illinois has a $61b pension shortfall, and is borrowing to make contributions.   Harrisburg, Pennsylvania, is contemplating a March 1 bankruptcy filing.  These stories are the proverbial tip of the municipal finance debt iceberg. See Illinois Pension Fund $61b Underwater; State Borrows Money for 2010 Contribution; California $20b in the Hole Again.

Reality

Till now the policy direction of the Obama administration and other western leaders has been to “extend and pretend:”  we will ignore economic realities by permitting banks to suspend “mark to market accounting” and we will send various administration spokesmen to spread the fairy dust of “green shoots” to pacify an anxious public.  Essentially, we have an economic policy of faith and hope that willfully ignores reality.  Economics does respond to the laws of mathematics.  Like a termite that silently eats away the wooden supports of a house, excessive debt has eaten away the structure of the world economy.  There will be more troubled countries like Dubai and states like California before this Depression has run its course.

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2
Feb 10

Timothy Geithner and Plausible Deniability

Congressional hearings often make wonderful theater.  Last week at the House Oversight and Government Reform Committee, the American public heard testimony from Timothy Geithner, former head of the Federal Reserve Bank of New York and now US Treasury Secretary and Henry Paulson, former US Treasury Secretary.  Both men’s testimony relied on one premise: if we did not bail out AIG and pay its counterparties 100 cents on the dollar, the financial world as we know it would have ended,  i.e., the US would have plunged into a second Great Depression.  By written statement, Fed Reserve chair Ben Bernanke informed the Committee of his full support for this decision.  In person, Henry Paulson agreed.  However, both men said they had nothing to do with the decision.  Further, Mr. Geithner testified that he had relied on his staff or details of the bailout.  And even further than that, he later distanced himself from the decision whether nor not to disclose the details of the bailout. America was treated to the concept of “plausible deniability.”

Plausible Deniability

Working in a corporation one gets a firsthand look at the concept of “plausible deniability.”  Plausible deniability works something like this: a crisis starts; an important decision must be made; a senior executive is charged with making a decision; the senior executive delegates much of the preparatory work to  staff or a trusted lieutenant; the staff or trusted lieutenant ultimately makes a recommendation which later becomes “The Decision. “  If or when something goes wrong in the future, the senior executive denies involvement and places the blame on the staff or the trusted lieutenant.  Almost every time, the superiors of the senior executive accept this scenario.  The senior executive survives.

Let’s Get Real

Harry Truman said “the buck stops here,” meaning that the most senior executive has ultimate responsibility for a decision.  Perhaps with President Clinton or at some time it became fashionable for the senior person to distance himself from the decision so that he would have plausible deniability.  Further, it was expected that subordinates would “throw themselves on their swords” to preserve their boss.

It stretches credulity that the three most senior financial executives in government, The Chairman of the Federal Reserve, the President of the New York Federal Reserve and the Treasury Secretary did not know the intimate details of the AIG bailout.  At stake at the time was $62b of taxpayer money to effect this phase of the bailout.  All three men agree that if the bailout did not take place financial Armageddon would have ensued.

More is expected of our public servants. We appointed these individuals because of their unique skills, judgment and character. Apparently, these individuals were unavailable in the AIG crisis to make critical decisions.  Based on these stated actions, I deplore the confirmation of Ben Bernanke.  Moreover, I would ask for the resignation of Timothy Geithner.

It is time that high level government officials took responsibility and become the watchdog of the public purse. Trying to blame subordinates should elicit the response from the public: “that dog won’t hunt!”

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21
Jan 10

The Barbell Economy

Political statements come in all shapes and form.  Tuesday it arrived with the election of Republican Scott Brown of Massachusetts to the United States Senate. Pundits conjured instantaneous rationales for this upset: the proposed health care bill, bailout of the banks, high unemployment rate, rise in the price of gasoline, declining home prices among others.

We can attribute Brown’s victory to any or all of these rationales; however, we are describing the symptom and not the disease.  The disease is the “barbell economy.”  On one side of the barbell we have the rich who have been rewarded with bailouts, large bonuses, hedge fund profits, at the expense of taxpayers.  These people appear to be insulated from the recession. On the other side of the barbell are the growing numbers of poor people who utilize our many social safety nets: welfare, food stamps, loan modification programs, Medicaid and others.  The dwindling middle class, the fulcrum of American society and the bar that holds up the barbell, is being disenfranchised and economically destroyed.

The Destruction of the Middle Class

We have witnessed the slow destruction of the middle class over the last 30 years.  Two wage earners were needed to maintain a middle class life style.  Then middle class wealth was destroyed in the stock market crashes of 2000 and 2008.  Easy credit and low interest rates mired the middle class in a cycle of debt.  Good paying jobs were outsourced to low wage foreign countries.  Unemployment soared and wage growth was eliminated.  Inflation in necessary commodities such as gasoline siphoned off more income.  The coup de grace was the implosion in house prices.

Albert Edwards, Global Strategist for Societe Generale, opines that the Federal Reserve has destroyed the middle class:

Some recent reading has got me thinking as to whether the US and UK central banks were actively complicit in an aggressive re-distributive policy benefiting the very rich. Indeed, it has been amazing how little political backlash there has been against the stagnation of ordinary people’s earnings in the US and UK. Did central banks, in creating housing bubbles, help distract middle class attention from this re-distributive policy by allowing them to keep consuming via equity extraction?  The emergence of extreme inequality might never otherwise have been tolerated by the electorate (see chart below).  And now the bubbles have burst, along with central banks? credibility, what now?

He cites the Census Bureau analysis that median income failed to rise in real terms for the entire decade, the first time that median income did not rise in all US history. See Scandal Edwards Alleges Central Banks were Complicit in Robbing the Middle Classes.

The middle class is now left with 10% percent unemployment (effectively 17% or more), decimated retirement income, skyrocketing health insurance premiums,  rising state and local taxes, a high debt load and a house with zero or negative equity.  Further, middle class tax payers are not stupid.  They know that taxes will soar to pay for these deficits and expansion of entitlement programs.  Promised a new political regime of hope, change and transparency, the middle class has endured a year of betrayal.

The Politics of Anger

Both Democrats and Republicans misread the current situation.  Middle class voters feel abandoned by both parties.  Backroom deals on health care legislation are only symptomatic of a deeply flawed and corrupt political system where the rich and connected obtain special favors and ignore the middle class.

The middle class is the bedrock of America.  Paraphrasing George Bailey’s defense of his father’s character in It’s a Wonderful Life, the middle class “does most of the working and paying and living and dying” in America.   The middle class needs real hope, not false promises of hope.  The two parties need to pay immediate attention to the middle of this economic barbell.  If they do not, more of this current group of elected officials might just be added to the unemployment rolls.

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18
Jan 10

Government Intervention and Bowmar Brains

In 1971, Indiana-based Bowmar Instruments introduced the first hand-held LED (Light Emitting Diode) calculator.  The “Bowmar Brain” was a huge success.  Other manufacturers developed cheaper calculators, and when the company could no longer compete, it went bankrupt in 1976.

What if the Government Intervened?

Starting with Chrysler in the 1970’s to GM and Chrysler in 2009 government has intervened to either prevent bankruptcy (Chrysler) or to distort the bankruptcy process (GM and Chrysler).  It has justified its intervention by touting the vital importance of these businesses to economic recovery, the need for jobs in severely depressed Midwestern states or national security.

What if the government had intervened in the Bowmar bankruptcy? After all, the first hand-held LED calculator was economically important to both Texas and Indiana.  Texas Instruments supplied Bowmar’s calculator chips.  Further, the hand-held calculator and LED technologies had important scientific and military importance.

In 2010, it seems absurd to even raise the possibility that government should have “saved” Bowmar.  However, we know from our current circumstance that government is whimsical and has indeed prevented private entities from going bankrupt.  This prompts us to consider “what if?”

In the 1970’s calculators were expensive: more than $100 for a Bowmar and $500 or more for HP business and scientific models.  Government intervention would have kept prices artificially high.  Today calculators are included at no extra cost in the basic Windows computer package and banks give away inexpensive calculators as promotional items.

Government intervention would have stunted development of LED technology. Today LED technology is ubiquitous; it is used in signage, energy efficient illumination and in photo optical applications such as remote controls.  See Wikipedia LED. Would the government have been able to innovate?  I would suggest not.

The Heavy Hand of Government

Today we witness the spectacle of the government intervening in numerous traditionally private activities:

  • Banks
  • Money Market Funds
  • Auto Manufacturers
  • Health Care
  • Mortgage Lending

Even conceding that the current Administration never intended to socialize broad swaths of private industry, the speed and scope of current federal involvement has put us on exactly that road. Financial media and the White House credit these measures with saving the economy and condition us to accept government solutions to private economic problems. This role is more than that of a regulator.  Government has become a major operator in direct competition with other domestic and foreign private enterprises.

What is the Real Cost?

One cost is the recent proposed special tax on large banks who accepted TARP funds. Government largesse is an inappropriate “free lunch,” but even this mistake is not the greatest harm.  Government intervention encourages investment based on political rather than economic considerations.  Did we really solve the problem of costly union collective bargaining agreements when the government took control of Chrysler and GM?  That would have jeopardized union support for Administration policies. See The Greediest Generation – Where Has Shared Sacrifice Gone?

Will these companies produce cars that consumers want to buy, or cars that meet the government’s environmental agenda?  The heavy hand of government will ultimately stifle all industries that it touches.   In the health care industry, this is of more than academic interest. We may pay with our lives.

If current governmental policy was in force in 1976, we all might be using very expensive and very large hand-held Bowmar Brains.  It is a worrisome trend that we should all be concerned about.

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11
Jan 10

The Organic Economy

Paul Samuelson, Nobel Prize winning economist, MIT professor and innovator of the mathematical approach to economics passed away last month.  See NY Times obituary.  Economics: An Introductory Analysis is still the leading textbook for introductory college economic courses.  Samuelson’s mathematical approach was the antecedent of econometric modeling wherein economic theory is combined with statistical methods to analyze and test economic relationships. Many of Obama’s advisors are proponents of mathematical modeling. Unfortunately, the real word is messier than Dr. Samuelson and his protégés would have you believe.

Economics and Hubris

An ivory tower economist who mixes math, economics and high powered computers as likely as not cooks up a stew full of hubris.  I have a friend who studied with Lawrence Klein, another Nobel Prize winner.  Econometricians believe that if one has enough statistical inputs and a big enough computer we can predict and control the economy.  From the public pronouncements of Obama’s economic team and endless reassurances of recovery, this hubris is alive and well in Washington.

The Human Equation

Mathematics overlooks the human element, with all its unpredictability:  fear, greed and yes – hubris.  We over borrow and take excessive risks in good times and over save avoid risk and hoard in bad times.

We have just had the financial equivalent of a heart attack.  What would an economic doctor prescribe to a post-heart attack patient?

  • Rest – save, don’t spend
  • Go on a diet and lose weight – get out of debt, don’t take on new debt
  • Exercise – engage in economically productive activities; don’t speculate, merely trading in financial claims
  • Quit smoking and drink in moderation – banks should avoid toxic lending and regulators should prosecute predatory lending practices

You Can’t Fool Mother Nature

Administration policy makers believe that their technocratic skills can immediately revive the economy.  Since the economy is the sum of human actions, it is perhaps more organic, lifelike and anthropomorphic than policy makers would like.  Armed with mathematical models and Keynesian dogma, technocrats believe they can accelerate recovery without harm to the patient.  Their prescription is to add more debt at every level, inviting our “patient”, the consumer and the profligate financial institutions return to their errant ways. These habits caused the financial heart attack in the first place.

Instead the Administration could have encouraged the patient to do the hard work of economic rest, weight loss and exercise, creating a path to long term recovery and preventing a relapse. We came close to the second Great Depression.  The actions of the Administration in short cutting much needed lessons can only lead to a worse and this time possibly fatal financial heart attack.

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