International Finance

Bailout Nation Lives

Where is the coordination of economic policy among the Federal Reserve, the Treasury and Congress? In testimony before Congress, Ben Bernanke, Chairman of the Federal Reserve warned against large budget deficits:

The Fed chief repeated his call for lawmakers to come up with a long-term plan to reduce the federal budget deficit, which is projected to widen to a record $1.55 trillion this fiscal year. “Unless we as a nation make a strong commitment to fiscal responsibility, in the longer run, we will have neither financial stability nor healthy economic growth,” he said. See Bernanke Says Fed Prepared to Counter Effects of Europe Crisis

It is clear that bailouts are not consistent with fiscal responsibility. But it seems the Administration and Congress are tone deaf to these no more bailout pleas.

No Constituency Left Behind

We have analyzed the bailout actions of the Bush and Obama administrations. See Are We a Socialist Country? It has been a long and undistinguished progression from Bear Stearns, AIG, American Express, GM, Chrysler, GE and others. We have collectively decided that banks, insurance, automotive, industrial, credit card and other companies are too systemically important to fail, and are therefore bailout worthy.

Despite all protestation the Obama Administration appears to be on a constant search for new bailout candidates:

- A $23B Bailout for Teachers – Education Secretary Arne Duncan urged Congress to support a $23b jobs bill to prevent teacher layoffs.

- Why Leave Out Pension Funds? – Senator Casey, D-PA proposes affording two large multi-employer Teamster pension plans federal protection. The estimated cost would be $8-10b.

- US Largesse Goes Global – Through IMF membership, the US taxpayer will be funding the bailout of Greece and other European nations. IMF Chairman Boutros-Ghali pointed out the perilous financial position of the IMF and the need for more member capital contributions. Rep. McMorris Rodgers, R-CA highlights the hidden cost to us:

“This should give pause to Treasury Secretary Geithner and others who boasted that the IMF’s bailout bonanza wouldn’t cost U.S. taxpayers a dime,” said Rep. McMorris Rodgers. “In truth, the cost to U.S. taxpayers goes up every few weeks. After the Greek bailout, it stood at about $7 billion; after the EU bailout, it stood at about $60 billion. Now – based on Mr. Boutros-Ghali’s comments – we’re talking at possibly $100 billion or more. This has got to stop.” See Congresswoman McMorris Rodgers Responds to IMF Statement Europe Bailout will Cost US Taxpayers 100 billion+

- As we have pointed out, Fannie Mae and Freddie Mac are uncapped, growing, perpetual bailouts. See Shredding the Social Fabric.

The Hidden Costs of Bailouts

Politicians are constantly on the prowl for a free lunch. Bailouts and promises of “little cost to the taxpayer” provide that seemingly free repast. A closer look at the bailout phenomenon shows us its high and hidden price tag. A look at some unintended consequences:

Bailouts only add to the burgeoning federal deficit.
Ultimately, they will be paid for either through higher taxes, higher inflation or both.
We are eroding financial discipline. GM was roundly criticized for giving away a new Corvette to a Detroit Tiger, who pitched a near perfect game.
Likewise, we are eroding fiscal discipline in states and municipalities, which should be cutting budgets and raising taxes rather than seeking bailouts.
We are compromising our most basic federal system of separation of powers, as a state and local function, education, becomes a federal ward.
We are encouraging moral hazard with reckless and profligate behavior (and prudent behavior is punished).
Bailouts beget other bailouts, as it become impossible to draw the line when future constituencies come to Washington for their bailout.
Today’s funding of bailouts limits the flexibility of the Administration to respond to future, more serious crises.

Fundamentally, bailouts are unfair, as one group is leveraging its political clout to earn a bailout at the expense of innocent taxpayers. Rewarding the profligate and the irresponsible makes little sense as public policy. It is time to end the bailouts.

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26
May 10

The Failure of the Technocrats

The Bible has some great story lines. The inhabitants of Babel built a huge tower to the heavens to challenge the Master of the Universe. Of course they failed; the tower first burned and then was swallowed up by the earth. And the Master punished them with a fitting and eternal dilemma: the world’s people no longer were able to understand each other. They would forever after have seventy different languages, live in different locations, and most importantly have different mindsets and worldviews. My own additional take on the moral of the story: when man believes he can control the entire universe and challenge the Deity, he is asking for trouble and retribution from the Master.

It is not unreasonable to postulate that we have made technology and its enhancements into a deity of sorts. Without question, in several ways, man is pushing the ethical boundaries of its use of technology This is not anti-technology rant, as there is much good in technological innovation, but rather a comment on hubris and limits. Perhaps it is worth thinking about whether or not we are courting some divine retribution of our own.

The Financial Crisis

At the core of the financial crisis is the naïve belief that we can control risk with numbers and computers. The inherently risky subprime crisis and debacle is the most spectacular example. Look at the components: first, mathematical modeling of historical default rates. Next, customer “choice” in risk level, when really the product carried risk level for everyone. Then, bogus “protections” in the form of derivative “insurance” and “AAA ratings” that offered no protection at all. Mathematicians used their own models to demonstrate the safety of their products. Their marketing departments brilliantly sold us on core assumptions that were not true: US house prices would always increase in price; subprime mortgages would default at the same historical rates; homeowners would do everything possible to hang onto their homes; and counterparties underwriting the risk would be fine to pay creditors in the event of massive default.

As we now know, these assumptions were horribly wrong. Mathematicians and Wall Street learned little from the 1998 failure of Long Term Capital Management where interest rate, equity and currency modeling diverged from historical patterns. The result was near destruction of the financial system.

Deepwater Horizon

It is now more than five weeks after the Deepwater Horizon oil spill, and we appear no closer to staunching the spill at the source. Americans have given little thought to the complexity of drilling in 5000 feet of water into 13000 feet of rock. Oil and gas pressures are enormous and literally destroyed the blow out preventers. The US Coast Guard has characterized the process to cap the well as challenging as the Apollo 13 rescue. We do not even have a good estimate how much oil is spilling each day. The original 5000 barrel per day estimates have been supplanted by scientific estimations of 40,000 to 100,000 barrels per day; a disaster the magnitude of the Exxon Valdez occurring every couple of days.

Our thirst for oil has led us to the outer boundaries of man’s capability to control the consequences.

Enter the Technocrats

Perhaps it is time to re-think the role of technocrats in society. We have believed the mainstream media’s propaganda that with the right science, math or technology we can control the universe. This attitude is no more in evidence than in the hubris of Bernanke, Geithner, Summers and Obama that they have conquered natural economic cycles and protected us from another depression.

In fact, we do not know if we have entered a second downturn. However, we should be highly skeptical if not outright disdainful of any all-knowing group of technocrats. Man is having trouble controlling “smaller events” like one oil well or one country’s subprime market. Our own economy is complex and exists within a more complex backdrop of global events like a crashing Euro, Chinese inflation, diminishing energy resources, conflict in the Middle East and other interlocking problems.

Adjusting a couple of economic dials through deficit spending, bailouts and artifice will probably end in tears. The European Commission and the Obama Administration would be better served re-reading the Tower of Babel story and holding off self-congratulations in any language.

We have heard “mission accomplished” one too many times.

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11
May 10

Extend, Pretend and Crash?

After Monday’s European Union’s (“EU”) trillion dollar bailout, Zero Hedge’s headline encapsulated what had transpired: “Even Keynes Is Spinning in His Grave.” “Extend and pretend” is now official worldwide economic dogma, as embodied in this unprecedented bailout. Why extend and pretend? Has anything really changed?

Pretending as Public Policy

We live in an age of irresponsibility. We seem to be responding to all types of crises with sluggish denial and finger pointing. From Katrina to the Financial Crisis to the Deepwater Horizon oil rig disaster, government massages the news, assigns culprits and acts only when pushed by market events or an outraged public. Instead of thoughtful, real and comprehensive solutions the policy is “extend or pretend.” More plainly, the goal is to conjure a stop gap solution and pray that time and luck will save the day.

A History of Extend and Pretend

At the end of the Bush Administration, the financial crisis lent itself to “extend and pretend” policymaking. The fractious, polarized political culture made it ever easier to opt for this policy choice. Obama, if anything a master politician, has adhered to these same choices. Let’s look at how “extend and pretend” continues even now:

- Mark to Market Accounting – Facing pressure from the banks and Congress, in April 2009, the SEC suspended the mark to market accounting rules for bank assets. Given mounting foreclosures in the housing market, it is highly likely that the banks are not properly valuing these assets. Pundits believe that many major banks are insolvent.

- The Federal Reserve – Through the TARP and other bail out programs, as of March 31, 2010, the Federal Reserve balance sheet has expanded to over $2 trillion, mainly in dubious mortgage backed securities. Once again, analysts are questioning the worth of these securities and the Fed’s solvency.

- Government Sponsored Enterprises (“GSEs”) –We are ignoring the hapless Fannie Mae and Freddie Mac agencies in the midst of our stock market and banking dramas. Despite the vaunted financial reform efforts, we haven’t even considered crafting a solution to the GSE mess. Instead of reform, on Christmas Eve 2009, the Administration extended unlimited financial assistance to these businesses. Buried in our naïve enthusiasm for the ECB bailout is a painful reminder of taxpayer obligations. Fannie Mae posted a quarterly loss of $11.5b and needs at least $8.4b from the government to continue.

- General Motors – After proudly proclaiming in a national ad campaign that they had re-paid loans to the government, Senator Grassley found that the company merely tapped a US Treasury escrow account to repay its TARP loan.

Extend and Pretend Goes Global

Today’s EU trillion dollar bailout is more of the same. The three part program is to create a 750 billion Euro fiscal support program, buy bonds in dysfunctional markets (quantitative easing) and enter into swap lines with the Federal Reserve to obtain dollars. This is “extend and pretend” taken to an entirely new level. It is not even clear or sure whether the EU can obtain IMF approval to move forward. Problem countries will require austerity measures. In sum, this is exponential “extend and pretend,” as troubled governments pretend to have a program to calm their markets and citizens. And even if they enact these programs they do not deal with underlying structural issues in the EU, where too little income supports too much debt.

It All Comes Down to Honesty

The political elites in the US and Europe do not want to face the economic realities. Honesty and candor with electorates are in short supply. Instead of leaders we have a class of venal and calculating politicians. Happy to solve the problems of today with band aids, they invite greater calamities, where the patient may be lucky to make it out of intensive care and may yet succumb to massive infection.

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4
May 10

Goldilocks and Scary Headlines

In the previous bull market cycle, Larry Kudlow of CNBC touted the perfect “goldilocks economy.” While not using the terms goldilocks economy, Michael Hanson, economist for Bank of America, is again touting a benign investment environment. He predicts that over the next several years the economy will grow at 2.5-3.5 percent, interest rates will remain low and inflation will be subdued. He also maintains that the growing federal deficit is the only “minor” concern. B of A’s wealth management approach appears to be the fairly standard mantra: emphasize tax efficiency, and diversify among various asset classes.

This blog does not provide advice as might your investment adviser, guru or astrologist. However, I find something deeply disturbing about the aforementioned advice and forecasts. The core of this philosophy is that past is prologue, and the next fifty years will look just like the past twenty-five. But asset diversification strategy did not take into account that in 2007 and 2008, with the exception of US treasury securities, all markets declined simultaneously. Robert Prechter of Elliott Wave called this phenomenon “It’s All One Market.” And indeed diversification assured portfolio losses of 40% or more.

The Real World Intrudes

Counter to the “goldilocks” world view espoused by CNBC and wealth management firms, messy facts keep cropping up daily. Recent cautions for any investor or policy maker:

More than a Million in the U.S. May Lose Job Benefits – Congress is concerned with federal deficits and extended unemployment benefits. They believe that these benefits are a disincentive to finding work, and they are disinclined to extend the 99 week ceiling. Thus, 1 million people face an immediate loss of benefits with an estimated loss of 400,000 per month thereafter.

Morgan Stanley: Strategic Defaults Reach 12% – These are the mortgage holders with the capacity to pay, and yet choose to default. Twelve per cent of all mortgage defaults in February 2010 were of the strategic variety. As I predicted, “bailout nation” has given license to strategic defaulters to just walk away from their underwater home values. See Flirting with Economic and Political Breakdown.

Is the UK Preparing to follow the PIIGS into the Abyss

With $2 Trillion in 3 Year Funding Needs by the PIIGS, the IMF is Helpless to Do Anything but Sit Back and Watch

Spanish Unemployment Rate Tops 20%

Containment Fails: European CDS Explode as Market Looks to Future Bail Outs, Bank Runs

Mainstream media keeps reassuring the public that the crisis in Greece is well contained. But just remember how Ben Bernanke assured the financial markets that our subprime crisis was also well contained. Government financial profligacy is having major repercussions in the European financial markets. Bailouts of private banks, out of control public sector salaries and pensions, overregulation, and (with the assistance of American investment banks) financial chicanery to hide public indebtedness debt have come home to roost. Credit spreads, the difference between the gold standard German bonds and other European government debt, especially the “PIIGS” (Portugal, Ireland, Italy, Greece, Spain), have widened to alarming numbers. Even the UK has experienced widening of credit spreads against German bonds. Eurozone unemployment is soaring. Despite EU and IMF efforts to bail out Greece, credit spreads again widened today and the Euro plunged.

Justice Department Opens Goldman Sachs Criminal Investigation Sources Say – The significance here is not whether or not the government can prove that Goldman committed crimes. Rather, the importance of the investigation is that the tide has turned. Financial firms will be on the defensive and unfortunately their most profitable products operate on the edge of the law. Inevitably, more government oversight will cut profitability and remove one more support from the already fragile economic recovery. See also Watershed Event in the Financial Crisis – SEC v. Goldman.

Uncertainty Abounds

Risk and reward need to correlate. Perhaps diversification and the rosy scenarios of years past will win out. But this small selection of troubling headlines suggests otherwise. I would view the diversification thesis very skeptically. As they used to say on television’s Hill Street Blues: “Hey, let’s be careful out there.”

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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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27
Dec 09

Seven Black Swans a-Swimming

The holiday spirit lingers. With all due respect to the Twelve Days of Christmas, let’s see if we can predict seven potential black swan events for 2010. But we have a conundrum. According to Nassim Taleb (author: The Black Swan: The Impact of the Highly Improbable), “black swan events” are high-impact, hard-to-predict and rare events that are beyond the realm of normal expectations, that is, statistical outliers. Thus, if we are able to predict them, they may not be true “black swan events.”

I will leave that issue for philosophers. Let’s focus on possible “disturbances in the Force” which can render useless the carefully orchestrated Obama, Geithner, Bernanke engineered recovery.

Black Swan Event Gestation

The government and mainstream media have been extremely helpful in identifying “black swan events.” These even have usually been hidden in plain sight and then reported by main stream media. Then we have a noted academician or high government official contextualizing the event to make the public believe that the occurrence of the event is improbable or lunacy. Examples: Ben Bernanke reassures the public that sub-prime losses were well contained and no threat to the economy. Tim Geithner proclaims that the largest banks were well capitalized.

In the former Soviet Union the joke was that nothing was true until it was officially denied.

2010 Candidates for Black Swan Event of the Year

And now for an Academy Award moment, the nominees please:

The Dubai World default – We are again receiving governmental reassurance that the Dubai World is well contained. Hearing this has eerie echoes of the sub-prime crisis being well contained. Why? We live in a highly interdependent worldwide financial system: if a butterfly flaps its wings in Beijing… you know the rest.
The US defaults on its sovereign debt – The Obama administration provided financial guarantees to everyone from American Express to GE to money market funds to Citicorp. More than 2 trillion dollars of new US Treasury debt will need to be financed in 2010. Is there enough money in the world to fund these deficits? What if a Treasury auction fails; that is, there are not enough bids to cover the amount offered? That is like having a garage sale and nobody coming by.
The FDIC runs out of money – One commentator believes that the FDIC ran out of money in October 2009. The FDIC is trying to muddle through by not aggressively closing problem banks. Yes, the Treasury could step in and loan the FDIC money, but review the second bullet above on the potential for sovereign debt default. Also, modern day bank runs occur via the internet rather than through heartwarming scenes a la It’s a Wonderful Life. There is no George Bailey and no honeymoon money to bail out the money center banks.
Commercial real estate implosion – Commercial real estate – office buildings, hotels, regional and strip malls and multi- family dwellings have had a price decline of 41% since 2007. Rents have declined in all categories. Commercial real estate heavily utilizes short-term financing which require frequent re-financing at three, five and seven year intervals. Re-financing needs will double from 2009 to 2010. Already stressed regional banks financed much of the growth in commercial real estate. Next year could be the perfect storm as both public and private sectors tap a limited pool of capital.
State, county or municipal insolvency – Multiple states are nearly insolvent. The same problems exist at the county and city levels. States cannot declare bankruptcy, but counties and municipalities can. A cascade of these bankruptcies would tax state treasuries. A series of state defaults would put pressure on the Federal government for another set of bailouts. Municipal defaults would send shockwaves through all financial markets.
Pension Fund Failure – Public and private pension funds are massively underfunded. See Underfunded Pension Plans: The Next Shoe to Drop. Next year could be the year of recognition. PBGC has limited resources to bailout the private sector funds and there is no PBGC coverage for public pension funds. Multiple pension fund failures loom on the horizon.
War in the Middle East – Iran has shown contempt for international efforts to stop its nuclear development program. Israel or the United States may be forced to take military action. Iran has threatened to retaliate by closing the Straits of Hormuz, the international oil shipment passage way for Gulf oil. Oil prices could soar crippling the world economy.

The Sky is Clouded with Black Swans

Given the nature of black swan events, I cannot predict that any will land. It is even more difficult to determine whether or not they are even black swan events at all. Other worthy candidates: dollar collapse, earthquakes and volcanoes, sovereign debt default in Portugal, Spain, Italy, Ireland, Greece, the United Kingdom (or all these countries), Euro collapse, depression in China, constitutional crisis in the United States. The list is long and fraught with possibility. Or the black swan event could be that nothing happens at all.

Still hope spring eternal, keep checking the skies and Happy New Year.

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