Politics and Economics

It's time to recognize an inconvenient truth--circumstances beyond our control have put the politics back into political economics. Yep, that's right. The playground has been invaded. And the invaders won't necessarily be all that impressed or swayed by technocratic arguments. The systemic risk will go up, and the breakage will be, well, non-trivial. Blame for the breakage, incidentally, will fall erratically on those who caused it, those who suffered, those who tried to prevent it and the completely uninvolved.

Timely indicator #1--This morning Bloomberg's website (of the organization, not the mayor)carried the following headline, "Profit Not Satanic, Barclays Says, after Goldman invokes Jesus". Now, there is a mindset. I suppose next we'll have evangelical pastors of megachurchs trumpeting the profitability of their organizations?

Timely indicator #2--McKinsey distributed a piece to its readership entitled, "Sociopolitical Issues in Hard Time . . . ", which is elegant corporate speak for 'the usual payoffs to politicians aren't working and we need to try something else'. The usual operating assumption of successful private sector executives is that regulatory/legal/public policy issues can be resolved through litigation, negotiation, lobbying, political contributions, and, if all else fails, compliance. That version of reality is, er, no longer operative.

It has taken over a year, but the political class in the United States is awakening slowly to a couple of facts:
1. A year ago the financial system failed. It has been on government support ever since.
2. The public is slowly, lost job by lost job, home appraisal by home appraisal, realizing that something is seriously wrong in its collective pocketbook.
3. The people running the financial institutions cannot be trusted to play the new game--they have used the respite to default back to their old reality.
4. A previously oblivious and indifferent swath of the public is in the process of a volatile and potentially disruptive political awakening.
5. Something's up.

Note that one rhymes with three and two rhymes with four, and five is the conclusion.

It's not clear whether the Republicans or the Democrats will grab onto this issue. The Republicans do the politics of bitterness and resentment better than the Democrats (regardless of who is in power). But the issue plays better into the Democratic world view (the Republicans are such toadying wealth worshippers on economic issues). And, while the Republicans enjoy the advantages of indiscipline and experimentation, they currently are squandering it by putting their kooky right on display (it will take a while for the new governors of Virginia and New Jersey to offset the antics of Sarah "the Maverick" Palin and Rick "Tea Party" Perry). Play to the faithful, play on, but remember, the rest of the world is looking on. The Democrats are busily rolling in the hay with the Wall Street Tar Baby, but tar can be washed off, and all the White House to do to shift gears is accept a couple of resignations (Geithner and Summers), install Volker in a postion of authority, and use the presidential pulpit to light into Wall Street (malefactors of great wealth, and so on, I believe there are some scripts in the vault).

Obama is a careerist, but he turned his back on Wall Street once before (after being president of The Harvard Law Review and clerking on the Supreme Court), and he could do so again.

Puzzles, Mysteries and the Rise of the Blogosphere

Some old fart who retired from the CIA years ago used to claim that there were two kinds of intelligence problems--the puzzles, which could be solved with additional pieces of information, and the mysteries, which required analysis, and, in the end, a judgement call. Puzzles tended to be quantifiable (both as formulated and as answered) while mysteries tended to be more subjective and dependent on analytical work (again, both as posed and in terms of response). The late-20th century mandarins of Pax Americana were, on the whole, happier with puzzles than with mysteries (at least as they surveyed the external world).

Certainly, today, the pride of the mainstream media lies in its ability to provide coverage and hard information. Some of this coverage may verge on the ridiculous (Anderson Cooper on the tip of the spear facing the Taliban, Anderson Cooper on the seawall facing the storm surge). Some of the coverage is historically heroic (printing the Pentagon Papers). But when the defenders of the existing media, with its far flung network of bureaus and stringers, its travel budgets and longstanding sources, make the argue that navel-gazing bloggers can't hope to meet the need for reporting, for hard information, they are focusing on the puzzles, not the mysteries.

What the bloggers do well--frequently better than the traditional media--is address the mysteries. And right now, and for the foreseeable future, the ability to decipher the mysteries is more useful than the capacity to unearth more pieces of the puzzle. The isn't always the case. But right now, particularly in the financial sphere, it is. Given that most financial news consists of rewritten press releases, conference calls posted on the internet, and statistical series with highly choreographed release rituals (admittedly designed more to insure the integrity of the financial markets and level the playing field than to insure maximum publicity), the opportunity for SCOOP are pretty small.

So, floreat Blogonia!

Just charge down Majuba Hill and don't worry to much about the point of the spear.

Repricing Risk vs. Reappraising Risk

Eighteen months ago no one would have argued that a triple A rated CMO was a riskier investment than Brazilian or Indonesian corporate debt. Eighteen months ago, no one would have claimed that the equity securities of Lehman, Citibank or AIG were riskier than those of Banco Itau or China Life. It was established to the point of truism, well grounded in any review of recent financial history, that, independent of the returns required to compensate for risk premia, that the relative riskiness of various kinds of investment were well quantified and the relationships presented opportunities for arbitrage and relative return strategy that could be safely based on the immutable and unchanging relationships between the various investment alternatives.

At the same time--eighteen months ago--a great deal of ongoing handwringing was in progress about the extremely low levels, on a historical basis, of risk premia generally. Spreads to risk free returns were at historically compressed levels. Barrels on ink were spilled on paper, and electrons beyond count sent zipping through the blogosphere, on the subject. Since then, a similar amount of descriptive time and effort has been spent on the mispricing of risk, in light of the untoward subsequent developments.

Risk can be priced, or mispriced. Risk can be mispriced in insurance markets, even assuming competent underwriting. Risk can be mispriced in financial markets, when for regulatory or other reasons the attractiveness or ugliness of an asset distorts the buy side or the sell side. But in all circumstances, the pricing of risk needs to be distinguished for the appraising of risk, even though realistically misappraised risk will almost always also be mispriced.

I suspect emerging markets debt and equity have been misappraised (at least on a relative basis) as well as mispriced for the last decade or so--since the Russian and Asian debt crises late in the last century. Even assuming that all financial assets have been overvalued during most of that timeframe (i.e., until late 2008 risk premia had declined only to reprice violently at that time), as an asset class, the riskiness of emerging markets securities was also mis-appraised. And, I suspect, as far as emerging markets securities were concerned, the errors were offsetting rather than reinforcing. Because of losses in the relatively recent past, the riskiness of emerging markets assets was overestimated. Because the tendency of market participants to drink the current koolaid, the riskiness of highly-rated structured products created by the rocket scientists was significantly underestimated. The end result--seriously skewed relative valuations.

What does this mean for the future? It suggests that near term, the prospects for structured product are bleak indeed, since history suggests markets are none too kind the detrius found in the vicinity of ground zero of the latest serious embarassment. It'll be a long time before the yield hogs can be slopped with structured product.

I don't think, near term, that the prospects are high for a blissful trip on the rocket ship are in order for the emerging markets. Short term, there will be a great deal of pitching and yawing as the reappraisal of the riskiness of those securities proceeds. But, in the longer term, if those economies perform as anticipated, and those issuers generate the growth to be expected in tandem with that performance, there is likely to be a postive outcome to that reappraisal. And that, in term, will result in a repricing of those securities.

And that repricing will occur without regard to the prevailing levels of risk premia. If risk premia remain elevated and the price levels of financial assets are generally impaired, the securities of emerging markets issues will record subdued performance (though perhaps relatively less weak as compared to alternative investments). If risk premia stablize, the performance of the emerging markets may be less subdued, and the potential for a bubble may be realized.

Coordinated Policies or Vigilante Justice?

The former present of Sinopec is sitting in a Chinese prison under a suspended sentence of death for having taken $30-million in improper payments. The founders of Satayam Computer Services, their accountants and various others are stewing in an Indian jail, while their individual responsibilities for the fraud dubbed 'India's Enron' earlier this year are sorted out. Both Sinopec and Satayam (now Mahindra Satayam) survived the malfeasance, continue to employ thousands of staff, and remain participants in their respective national economies. Even their stockholders survived.

Meanwhile, if you look at the aftermath of the carnage caused on Wall Street or the City of London by the practitioners of global finance, you find utterly no parallel success in holding the most senior executives of the institutions that failed personally accountable. A couple of hedge fund managers at Bear Stearns are on the scorecard, and that's about it. When you consider the arguments being made several years ago that superior corporate governance and a more sophisticated regulatory regime were competitive advantages of U.S. and Western finance, and a 'public good' to be exported to less advanced countries, you can reasonably ask yourself why anybody would want to import a system so demonstrably ineffective? All it yielded was behaviors sufficiently marginal and arguably non-criminal that they could not be effectively condemned and punished.

There is one American practice that has been pioneered for the last generation that the rest of the world might want to consider adopting. The United States government has aggressively pursued extraterritorial activities with conseqences within the United States which violated U.S. law. Leaving aside the issue of pursuing terrorists abroad (more a matter of national defense than enforcement of domestic laws), the least controversial of these initiatives has been in combatting drug trafficking. The United States government has, with considerable success, pursued various Columbian drug lords for their activities outside the United States that had inevitable consequences inside the United States.

Various agencies of the United States government have been willing to pursue overseas activities that led to domestic consequences in connection with other, less clearly criminal activities. The trials and tribulations of UBS in connection with facilitating tax fraud and evasion are currently in the media. A few years ago, there was some controversy over rendition of several British bankers who had defrauded their (British) employer, in connection with the Enron affair. From time to time, the Department of Justice has pursued foreign cartels fixing prices who met (outside the U.S.) to set prices within the country. In each situation, there must be a jurisdictional nexus with the United States, but it can be pretty attenuated.

What does all this imply?

Well, there is a choice. The G-20 can announce its intention of pursing lowest common denominator coordinated action to regulate financial institutions and cap banker pay. Or individual countries can leave Pittsburgh and take advantage of the announced common intention and each pursue its own more or less aggressive approach dealing with the issues. The opportunity to follow the American lead and assert extraterrorial jurisdiction is there.

Then the prudent banker would be well advised to comply with the most restrictive regulation arguably applicable to his activities. Might throw a bit of cold water on the animal spirits.

Rx Healthcare

I'm not sure what the argument is about.

The United States already has an effective, working system of universal healthcare. It's called Medicare.

It covers substantially all the population, without regard to ability to pay, pre-existing conditions, or anything of the sort. All a person has to do is meet the age-based enrollment requirement. I'm not sure what the policy justification is for the extremely high minimum age requirement, but we have age requirements related to voting, the consumption of alcohol and tobacco, driving an automobile, and so on, so I don't have any problem in the abstract with an age requirement.

If the opponents of universal medical coverage had any political courage or intellectual integrity, they would be working hard to repeal Medicare and get the government the hell out of the health insurance business. If the supporters of universal medical care were clever, they would be working hard to repeal (or at least lower) that minimum age requirement.

But, no, we are all knotted up in our underwear not quite sure what to do with an incoherent health care delivery system that perversely expects private for-profit entities operating in a free market to ration medical care in an efficient, fair and politically acceptable way. Wrong tools for the job, fellas.

Ruthless Default

Now let us praise Ruthless Defaults.

In the lexicon of financial institutions that extend consumer credit, a 'ruthless default' is a decision of a consumer borrower to discontinue servicing his or her debt obligations even though current cash flow (or unused borrowing capacity) would allow that borrower to do so. Rather than being recognized as a prudent financial decision in some circumstances, it is subject to mockery and denigration on a blanket basis. The mockery tends to focus on the past bad financial decisions the borrower made to get into the current financial bind (such as overpaying for a house or incurring uninsured medical expenses). The denigration tends to focus on the sanctity of contract, which is an escalation in to the moral sphere of earlier warnings about damaging one's credit rating.

Leaving the mockery and denigration aside, as I understand the concept, a ruthless default occurs when a person assesses their current financial situation and makes a 'zero based' decision on how to go forward. The priority given to staying current on the mortgage, the credit card debt and car payment, versus buying groceries, continuing the 401(k) contribution and keeping the utilities turned on, is matter of personal decision. The borrower disregards how he or she came to be in the present situation, and prioritizes and makes decisions on the basis of what makes the most sense going forward.

To the chagrin of commercial lenders, consumers stupid enough to have succumb to all sorts of insane credit blandishments in a prior incarnation, are turning out to be intelligent enough to realize that it's more important to keep the lights turned on than to protect the vanished equity in a house that they will eventually lose to a short sale or a foreclosure. And retirement plan balances frequently have greater protection in a personal bankruptcy than the personal goods bought on credit.

So, call it ruthless, call it self-interested, default is apparently beginning to occur with sufficient frequency that it's gotten the attention of industry and of the main stream media. It's not clear whether it will become so widespread as to impact general public attitudes towards indebtedness, but is becoming clear that earlier industry and rating agncy assumptions about the behavior of consumers in financial distress are no longer operative.

There should be no surprise in this. People are going to put protecting themselves before protecting the people who have lent them money. What is a little surprising is the reasonable conclusions people are reaching about how best to protect themselves. At a minimum, people have lost faith in the proposition that house prices only go up, and that your house is the best investment you'll ever make. Beyond that, I'm getting the sense that the weird belief that a good credit rating, or credit score, was some kind of financial 'asset' is beginning to fray, though I'm not ready to announce a return to a 'pay as you go' mentality.

One interesting thing about ruthless default is that it is an alternative to entering the chute of credit counselling, debt repayment plans or personal bankruptcy. In each of those officially sanctioned alternatives, the debtor relinquishes autonomy over his or her personal finances in exchange for some form of forbearance and accomodation. By contrast, ruthless default is a zen move. The debtor simply does nothing (more precisely, stops making paymens) and leaves the response up to the creditor.

The mortgage servicer can initiate foreclosure, foreclose and pursue any deficiency. The credit cards can be cancelled. The car can be repossessed. Foreclosure takes months. The cancelled credit card issuer is still stuck as a general unsecured debtor for a bad loan. Only the repo man gets his collateral back promptly and in immediately saleable condition. But in everyone of these situations, the transaction costs and the administrative effort associated with pursing the remedy was simply not factored into the original extension of credit. And the machinery to accomplish the remedy is not in place, at least systemically at the levels of activity required to respond to widespread ruthless default.

Or perhaps I should say 'rational default'?

Animal Spirits

Not yet dead. And that carries with it an immediate and an intermediate implication.

Short term--we'll have a period of incomprehensible but irritating giddiness in the financial markets which will significantly grate on both the general public and the political classes. Ballooning bank profits will highlight the different fates of Main Street and Wall Street while rising unemployment and credit card defaults plague the middle and working classes. But, bankers will get highly publicized base salary increases, equity markets will remain bouyant (despite anemic corporate profits), and the public's suffering and misery will remain oddly invisible.

Intermediate--the adjustment to the 'new normal' will be sour and seriously constrain the ability of policymakers and the regulatory apparatus to respond to the next systemic crisis. The refusal of animal spirits to die will undermine any meaningful reform initiatives, which in turn will absolve the political classes of any meaningful commitment to defend or sustain the institutions that survive the current financial crisis. Efforts by those institutions at some point down the line to call of public resources to save their private bacon will not exactly be rebuffed, but will result in an outcome currently unforeseen by anyone and that will be the product of a gesalt that has yet to develop a recognisable identity.

A year ago, under the leadership of President Bush and Secretary Paulson, the financial services sector was politicized. The implicit government guarantee of the leverage of the 19 TARP institutions forever changed the character of those institutions and made them quasi public entities. They continue to be run for private purposes, but that situation cannot last forever.

And won't.