ApacheCadillac

Strike Three!

2011-08-03T14:29:00.000-07:00

The naturally optomistic bias of the human mind is such that when someone speaks of convergence, the assumption is always that the process will involve bringing the inferior to the level of the superior, improve the condition of the less fortunate so that it more closely approaches that of their betters. Why should that be?

Consider, for a moment, the issue of political risk in investing. In orgies of reflexive self-congratulation, rich investors residing in rich countries have for decades assured themselves that investments in poorer, more primitive places carried with them a political risk and required a discount that was unnecessary in countries that were more economically advanced, more politically stable and (generally) whiter. Proponents of investment in economically poorer, politically more tumultuous and (frequently) off-color countries enthusiastically argued that progress towards elected governments, free markets and rule of law reduced these risks (and the required discount), as those lesser breeds made steady progress towards the Olympian heights of the developed world's commercial splendor.

But perhaps the convergence is trending in the other direction. Without regard for whether conditionas are improving in the emerging market countries or other parts of the world, perhaps the developed world is experiencing a deteriorating set of political conditions such that there is now political risk associated with investments in the United States or the Eurozone similar to that traditionally associated with Brazil or India.

Consider this summer and last summer.

Strike One! The treatment of BP during the oil spill in the Gulf of Mexico over the summer of 2010. Four companies were deeply involved in that situation. BP owned a 60% interest inthe lease and was the lease operator. An American company owned the other 40% of the lease and at one point started baying with the hounds. Another American company was the drilling contractor. A third American company manufacturer the blowout preventer that failed to prevent the blowout.

Of those four companies, which one bore the brunt of the assault? The foreign one, of course. A classic exercise in Banana Republic allocation of political blame. Although that wasn't the limit of the political risk. Anyone with an economic interest in oil and gas drilling and production in the Gulf of Mexico found that interest buffeted for months.

Strike Two! The PIGS in Euroland. Who would have thought that the arrest on sexual assault charges of the front-runner in next year's French presidential race would almost disrupt the elaborate quadrille under way to hold the Euro together, save the Franco-German banking system and make the indolent South pay for its sins? Fortunately Christine LaGarde can pronounce 'exorbitant seigneurage' (in English).

Strike Three! The circus just ended in Washington D.C. over raising the federal debt ceiling. Wilful sovereign default (which may not even be possible in the United States) is all about political risk. There is not a financial metric on the planet that can address it.

No more need be said.

The End of the Risk Free Asset

2011-07-27T07:35:00.000-07:00

However the debate of over the extension of the U.S. government's debt ceiling plays out, this episode marks the beginning of the end of the risk-free asset. What that will mean for financial models, economic policy, asset-liability management, investment strategy and so on is anybody's guess. But the mere circumstance that the federal government is entertaining the possibility of default as a result of political exigencies challenges forever the assumption that U.S. dollar denominated short-term U.S. Treasury obligations can serve as a risk-free benchmark.

Observers as a group have been so fixed on the recent commonplace circumstance of sovereign default--the inabilility of the borrower to service debt denominated in foreign currencies--that the rather more difficult context of a borrower electing to default despite its ability to meet its obligations or defaulting for other (overwhelming) reasons has been overlooked. In other words, everyone has been endlessly focused on the example of Argentina within the last decade rather than Ecuador. Or on Russia 1998 rather than Russia 1917.

The apparatus is in place for handicapping, assessing and evaluating sovereign defaults of the first type. One can argue that inflation is a form of default for sovereign credits capable of borrowing in their own currencies, and inflation is a topic that has been beaten to death. The machinery for dealing with those credits that have borrowed in dollars may be controversial, but the drill is commonly understood. It even translates into Euroland.

The second type of sovereign default, though, is a horse of a different color. In the paradigm Stephen Roach used to employ (pre-2008), the sources are exogenous rather than endogenous. More colorfully, if the politicians are unwilling to pay a government's debts, it matters little whether they came to power through a Tea Party, rolled in with an invader's tanks, or led a revolution that involved standing the ministers of the prior government against a wall and shooting them.

Obviously, no one knows what the result of this astonishing display of financial irresponsibility will be. I am not going to hazard a detailed guess. In the short term, probably not the end of the world. Probably not a non-event. Probably a recession, that may have been coming anyway. A Washington Recession of 2011 to go with the Wall Street Recession of 2008. Probably a great deal of short term confusion, disruption and hardship. If culpability for causing this situation clearly lies with the Republicans in the House, the responsibility for how the disruption is handled with clearly lie with the Democrats in the Administration.

Longer term, it is hard to say what it will do to interest rates. No one can predict the term structure, level, or credit spreads of interest rates in a world without a risk-free benchmark. I suppose the value of financial assets across the board should diminish dramatically, but whether that happens quickly or slowly is anyone's guess.

It will be bad for the dollar. It opens a window for the Germans to lead the Euro into a new role. But it's astonishing how little interest a country that started two world wars using its military machine to conquer Europe has so little interest in doing so using the economic and financial muscle. That calculus may be recomputed. Unless all the Germans are on vacation for August, in which case that can wait until autumn.

All the smart money has been betting on a collapse of the Euro because of its conceptual flaw--a common currency without a common political system. But given the performance of the American political system this summer, perhaps that's not the defect it seemed to be. A unitary political system without a common agreement to honor its full faith and credit financial obligations doesn't assure very much. Certainly not enough for U.S. Treasuries to serve as the 'risk-free' asset of the global financial system.

So, get ready for a brave new world . . .

The Time o'the Jarmins--The Irish Should Default Spectacularly

2010-11-12T20:17:00.000-08:00

In 1916 the Easter Rising Failed.

Men were hanged.

Casemate came home to face the music and he was hanged. Ah, those Black Diaries.

He was in Jarmany tryin' to arrange for the u-boats to deliver a load of weapons to support the Patriots. The Jarmins, the u-boat, the weapons, never arrived.

Same thing happened in the Year of the French. 1798, I think it was.

I dunna know how stupid the Irish are, but if they can't, once every hunnert years, stand up and die, they're stupider than the good Lord himself can save.

Mind you, I'm not talking about knee capping and the religious stuff.

Foreclosure, Fiasco and Frolic with MERS

2010-11-06T07:09:00.000-07:00

A week blessedly silent on the 'fraudclosure' front came to an end yesterday when the decline in pending sales for existing homes was attributed by the National Association of Realtors spokesperson to the bottleneck in the foreclosure pipeline. To hit the refresh button, here is a Q and A, supplemented with some judgment calls:

1. Will MERS work? MERS is the electronic recording system used by the 'industry' in lieu of compliance with recording requirements that vary by the jurisdiction in which the secured property is located. First, for some purposes MERS was such a success that it was extended from residential to commercial properties, so in some sense MERS works. But the question that has everyone excited is:will MERS work when the rubber hits the road in a foreclosure?

The answer to that is--MERS should work some of the time for some purposes, but it almost certainly won't work all of the time, and there is an unacceptable degree of uncertainty surrounding how it will play out. When it doesn't work, it should be fairly easy to fix, assuming the backup documentation is in order.

2. What's wrong with MERS? There is an effort being made to portray the problem as simply one of paperwork lapses and antiquated local filing requirements. It actually runs deeper than that. There is a conceptual (and constitutional) limitation on judicial power--courts only decide cases and controversies in disputes brought to them by litigants. Courts do not go shopping for opportunities to flex judicial muscle (unlike, say, a police force, that should chase criminals rather than simply waiting for them). To bring a lawsuit, the prospective litigant must be a 'real party in interest.' A real party in interest is someone with a injury or other legally recognisable stake in the outcome of the controversy. In a nutshell, MERS more closely resembles a custodian or a registrar, who wouldn't be a real party in interest, than a trustee or a beneficial owner, who could be. To put it in lay terms, if you have a warranty issue with your car, the owner of the garage where you park it can't sue the car maker for you, you have to do something about it yourself.

The good news is that it's not generally that hard to figure out who should be bringing the lawsuit, again, assuming the backup documentation is in order.

3. That's the second time you've qualified an answer with that comment about backup documentation. What gives? Over the last several decades a complex and standardized process has developed in which home loans were made, mortgages originated, warehoused, deposited in trusts and used as backing for the issuance by the trusts of 'mortgage backed' securities. Then, until the loan was refinanced or otherwise paid off, a 'mortgage servicer' collected monthly payments, distributed the proceeds to the securities owners and handled any administrative or similar issues that came up (for instance, usually made sure that property insurance and taxes were paid). That was how the system was supposed to work.

It has recently come to light that in many instances chunks of this work, mostly in the middle of the chain, simply weren't done. In other words, at the front end the house closing came off without a hitch. At the back end, the MBS were issued and sold without a hitch. But, the transfers in the middle--the movement of the note and the mortgage through the conduit of bankruptcy remote vehicles--didn't happen, for whatever reason.

There are also allegations that in some jurisdictions the loan documentation was routinely destroyed. (Gretchen Morgenstern recently made this claim in a New York Times article about the situation in Florida). If true, this is mindboggling, since the legal genome is deeply imprinted with the bedrock belief that certain kinds of promises, to be legally enforceable, have to be in writing. There is something called the Statute of Frauds, dating back to the English common law, not only before the American Revolution, but before the colonization of North America. We inherited it, it runs through our legal system the same way trial by jury does. It's common sense, really. There are two kinds of promises. One, is, for example, "I'll never forget our anniversary." The other is, for example, "from even date herewith, borrower promises to pay lender $857.62 on the fifth day of each month until August 5, 2035." The latter you can sue on in court, good luck with the former.

If there are widespread documentation problems of this sort, regulators of the financial institutions responsible for those back office failures will face a challenge to their supervisory authority concerning, not the liquidity and solvency of the responsible institutions, but the adequacy and soundness of their managements, systems and controls. It may be enough to sink a couple of boats.

4. But assuming the backup documentation is there, the MERS issue can be fixed easily?

Easily may be an overstatement. Let's qualify it with three considerations: (1) economies of scale, (2) the example of bankrupt originators, and (3) the question of who owned what, when?

Economies of scale. This is a high volume process. We are talking assembly line justice, not a handcrafted approach tailored to each borrower's unique circumstances. A lawyer's rule of thumb is that it costs three times as much to fix a problem as it costs to do it right the first time. And keep in mind, it is totally appropriate for the borrower (or her lawyer) to object to any shortcut or impropriety. If the shoe was on the other foot, you can be sure the bank and its lawyer would be.

Unfortunately for the servicers and the MBS holders, I don't think these fixes are going to lend themselves to economies of scale. It will cost as much to correct the documentation on a $100,000 mortgage as on a $300,000 one. There may be more walkaways at the low end and more contested proceedings at the high end, but that is not so much an opportunity for economies of scale as a recognition of additional unpredictable cost in certain circumstances.

One area worth paying particular attention to is commercial real estate. In the bankruptcies and workouts of various failed commercial development projects, it's reasonable to expect all the MERS issues to be litigated completely and expensively. That will litigation among creditors--there won't be any homeowner victim/deadbeats in that arena. Those stakes are worth litigations. And that's an arena in which technical deficiencies in documentation (such as failure to timely perfect a security interest) tend to be penalized severely, to the benefit of the competing creditor/vultures.

Bankrupt originators. The outfits that originators mortgages weren't the most stable financial institutions. A number of them have gone belly up and are in their own bankruptcy proceedings. If, because of 'paperwork deficiencies' there are pools of assets potentially available to the creditors in those proceedings, those claims will be made. The problem has nothing to do with homeowners and mortgage servicing outfits. But you can bet it will gum up the works.

And it offers a good example of the simple fact that in this situation everyone is not going to pull together. The situation is rife with conflicting interests (and internal conflicts of interest). There is not much point to ascribing evil motives to litigants (or their lawyers) in civil proceedings, though it is certainly common.

Who owns what, when? The big issues in a foreclosure are getting the property back, of course. But there are also issues of past due amounts and servicer fees. Taking care of the MERS problem does not address the question of who is owed what, how the proceeds from the sale of the foreclosed property are distributed, what is the fate of any second lien holders, whether there will be a deficiency judgment, etc., etc. On one level, these issues are technical. But they are also disputable. It's a safe guess that they will be disputed.

5. Does resolving the procedural questions involving MERS solve the whole problem?

No, it doesn't even begin to. It's a good first step, but no, no, no . . .

Earthquake?

2010-11-03T09:05:00.000-07:00

We've shifted from Change You Can Believe in to change you can't believe in. And that's the transition from Obamanos to the Tea Partiers. Party like it's 1773, I guess.

This is the third consecutive election in which the American electorate has collectively asserted a more or less coherent opinion. In each case, it boiled down to 'throw the bums out.' So far, nothing of the sort has happened. In 2006 with the Republican losses, in a parliamentary system a new government would have been formed. In 2008, with the sweeping Democratic victory, a new government with an ability to implement new policies would have been installed.

Does anyone seriously think that control of the House will give the Republicans the ability to do anything more than formally, finally and completely stalemate the Democrats in control of the Senate and the Presidency? That, and perhaps shut down the government. That, and utterly preclude effect action at the national level on any of the issues concerning the economy.

This country is starting to look like a richer version of China (or maybe Mexico back in the days of the PRI). With a better human rights record, in either case.

Postscript.

Mrs. Sarah Palin, the former governor of Alaska, announced the results of the midterm elections with a video of a roaring grizzly bear, forepaws waving in the air, alluding to her 'mama grizzly' theme. Elsewhere, in the People's Republic of China, the Party announced the results of the 2012 presidential succession with the appointment of Mr. Xi Jinping to the Central Military Commission. While Sarah Palin has expressed a taste for grizzly bears, Xi Jingping has expressed a distaste for overfed foreigners with nothing better to do than criticize China.

Home and Away

2010-10-29T15:00:00.000-07:00

Consider a country in another time and space. It is big and sprawling. It is too big and and too sprawling to be governed by a cadre, ruling class or oligarchy. It is a veritable nation-state of quasi-continental dimensions. In form it is a representative government, somewhere between a people's republic and a constitutional monarchy. But its political processes are as captured and as ossified as one might expect of an ancient, honored and imperial republic. Not a single party state by any means, but two parties jointly rule in a comfortable though occasionally unruly duopoly. This country still imagines itself as a Beacon on a Hill.

As might be expected, it has a political class and a financial elite. They are not exactly open, and not exactly closed. Porous is perhaps the best way to think of them. And much of the rest of the place is not particularly interested in joining either. There is also a cultural elite (several, in fact), various underclasses of varying hue and diverse origins, and all the complications and ramifications of several centuries of development as a civilization (all the while trying to imagine itself as a source of innovation and progress). For whatever reason, that bit is critical to its identity.

A few years ago, an economic crisis developed, mostly as a result of internal contradictions in organization, but in the aftermath of a some fairly miserable foreign adventures. And the situation had enough external aspects that it is possible, as most peoples are want to do, to blame the rest of the world for the current difficulties. As a result these people find themselves is a slow and tedious recovery without the instant return to happy prosperity that they believe is their due as the world's Beacon on a Hill and source of innovation and progress. That has soured the politics and the economy, and made them a bit more unruly, but so far had no greater ramifications.

In the throes of the economic crisis, that financial elite successfully held the political class hostage with a threat that boiled down, according to a domestic humorist, to 'save our banks or we'll kill your economy.' A reasonable number of the banks were saved, and since then the government has papered over (literally, printing gobs of the stuff) the inability of the banking systems to meet broad swaths of the mandate its social contract implies. In the process, interestingly, various agencies of the government have developed a set of procedures, capacities and competencies that significantly reduce the necessity for a financial services sector as presently constructed. But that has occurred almost by stealth, with virtually no public comment.

In the aftermath of the crisis, the political class was collectively enraged by the failure of the financial elite that it had just saved to 'stay bought.' This is entirely understandable. As a group the political class is premised on relationships rather than transactions. Relationships come in all varieties and strengths, but they are generally characterized by concepts of power, obligation, and nuanced flexibility through time. As a group, the financial elite is oriented towards transactions. Transactions come in equal variety, but they are generally one-off, creating no long term obligations, and the terms are set at the outset, lived up to, then renegotiated (or confirmed) before the next piece of business is done.

From the point of view of the financial elite, the political class were suckers. They didn't extract enough advantage at the outset of the transaction and so they sold their assistance too cheaply. To come back afterwards and expect to recut the deal is naive beyond words. Once past the crisis, the sensible thing to do, for the financial elite, was address the urgent rebuilding of their wealth--both at the institutional and the personal level. The public optics of that exercise would be manageable.

Fairness compels a distant observer to note that the first match of this series was fought in the home court of the financial elite. The political class was operating on the turf of the financial elite, for high stakes. The early innings moved at a fast moving pace, without time or space for reflection, compromise or error. When in its latter stages the political class attempted to collect for its assistance, it got stiffed (so did the public interest, but only a fool would expect optimal policy outcomes in a game played by these rules).

And there will be a rematch. It may come fairly soon. But it will not play out quickly. It will not play out on the home turf of the financial barons. It may not play out in public. And the result is not foreordained.

I have the sense that the opening volleys are being fired in this whole mortgage fiasco. The early efforts to quantify the impact are fairly amusing. We haven't even figured out how to characterize what's been going on. Is it a paperwork snafu caused by antiquated real estate filing requirements under state law? Is it the commission on an almost heroic scale of routine criminal acts of forgery and perjury for which bank charters should be surrendered and senior executives imprisoned. Is it a systems breakdown that with the commitment of organizational resources on a massive scale can be remediated. Is it the sort of back office failure of epic proportions that delivered the final blow to so many Wall Street brokerages of the Go-Go Years and required a regulatory reshaping of that landscape?

So damage assessment is way premature. How this plays not only will depend on what needs to happen to fix the problem that first brought it to light. It will depend on a variety of other agendas: internal agendas, public agendas, regulatory agendas, private agendas. And the battle lines aren't drawn yet, the roles haven't been defined. Look at the New York Fed--it is a regulator, customer, agent, plaintiff, etc., etc.

And just because the financiers won their home game, that doesn't give them any advantage when they play away. If the way they've run their operations in the past is any sign, Big D has never been a strong point on their side. And that's what will be needed. Nor have cohesion, class solidarity or anything else along the lines of cooperative, collective, united front activities been strong points. Their leadership are the alpha fish of a shark tank--cold, slimy, powerful, dangerous and stupid.

Furthermore, on the basis of their behavior since the crash, I think it is more likely that they will be hooked, netted and filleted. But time--lots of it--will tell.

Throwing in the Towel

2010-10-26T06:32:00.000-07:00

Is this the beginning of the end,
for our old friend,
extend and pretend?

At least as far as the commercial and residential real estate markets and the continued viability of the financial services sector as presently constituted are concerned?

Consider the following seven data points/factoids/developments:

1. Over the summer the first time home buyer incentive program came to an end. There is no political appetite for resuming it.

2. All of the housing indexes are indicating a resumption in house price declines. Good news for home buyers, bad news for home owners and lenders.

3. Residential and commercial construction is dead. Still dead. Not yet undead. Making no contribution to the 'recovery,' such as the recovery is.

4. HAMP was a failure. And servicer footdragging/non-cooperation that contributed to that preceded the inevitable homeowner redefaults to come.

5. There is the nasty little problem of a huge slug of not-yet-written down second mortgage loans on the books of various TBTF financial institutions (arguably a reason for the footdragging mentioned in point 4?).

6. The commercial real estate market, which hasn't been supported with the kind of governmental effort that has distorted the residential market, has resumed its decline and continues to set new lows. A contributor to continuing weakness of bank balance sheets and a harbinger of the residential real estate market?

7. The foreclosure gate scandal is leading all kinds of revelations about how the originate-to-distribute business model has actually been functioning (perhaps since inception?).

And a bonus, freebie, consideration--18 months ago the feds required the major banks to prepare stress tests predicated on a pair of assumptions concerning the path of residential real estate prices and unemployment levels. House prices could drop slightly more than 15% from where they are today without dropping to the the price levels projected in that exercise for the base case. House prices would have to drop almost 25% before reaching the levels projected in the more adverse case for the stress tests.

All of this suggests that a strategy of 'let's just hold things together 'til things get better' may have exhausted its utility and that the the time may have come to actually address the problems.

G20 Meeting and the Lessons of Japan

2010-10-25T06:40:00.000-07:00

The truth that was illuminated at the G20 meeting.

If you assess currency manipulation by the impact of policy on exchange rates rather than the announced intentions of policymakers, we are all manipulating our exchange rates.

Er, so let's change the paradigm?

The Lesson of Japanese Lost Decade.

In a world of globalized trade and free international capital flows, the effects of a Keynesian approach to economic stimulus at the nation state level will dissipate across the globe and cannot be effectively targeted within the geographical boundaries of a national economy actively participating in the international trade (probably either as an exporter or an importer). You simply turn your currency into a funding vehicle for the carry trade.

Anyone care to speculate in the emerging markets using the dollar as a funding currency?

Blood on the Knife

2010-10-24T15:42:00.001-07:00

We need some blood on the knife.

That's my takeaway on the progress of the financial crisis so far. There is a public appetite for blood on the knife, and it hasn't been satiated. To put a finer point on it, the retributive aspect of justice has been sacrificed to the pragmatic interest in keeping the wheels on the system. It's time to shift gears.

There is an inchoate sense of rage that the people who made this mess, and profited handsomely from it, are getting off scot-free, leaving the rest of us to clean it up and pay for it. I think that's a big part of the Tea Party rage and will be the explanation for the midterm success of the Republicans (one of whom in Texas, my God, is calling for armed insurrection, claiming it is constitutionally permissible. Not since Edmund Ruffin of South Carolina in 1861 has such nonsense, oh, wait a minute, I forget Rick Perry of Texas about 18 months ago . . . )

I wish I could say that those in authority above us are too principled and committed to the rule of law to indulge such a taste. But I don't think so. The perp walks following Enron and the other scandals of a decade back suggest not. I think they are simply gutless, spineless and clueless.

It's time to throw some resources into criminal task forces. Now, there's a shovel ready project everybody can agree on.

Appalling Wall Street Journal Attack on Lawyers

2010-10-21T12:40:00.000-07:00

The Wall Street Journal published one of those stupid 'shoot the messenger' articles about the consumer lawyers who by doing their jobs brought to light the robosigning and document fabrication that has become endemic in the foreclosure process. The article reeked of implicit class bigotry, which will play well with the WSJ's intended demographic. And properly reflects the complete capture by paradigm of the formerly ink-stained wretches who currently inhabit the gilded cage of the higher reaches of salaried journalism.

The denizens of Wall Street whom the WSJ serves elected to jettison the safeguards, procedures and formalities of the credit culture they had inherited. That credit culture had developed over generations. Remember the three C's? Probably not. For the last decade, those pillars of financial innovation shoved money out the door with utter abandon and cut a lot of corners doing that. They lent a lot of money to customers they shouldn't have.

Now, surprise, they're taking the same cavalier approach to getting the money back.

The great public was willing to take the money pushed its way. But when it comes to cowboy recklessness in getting the money back, not so fast, hombre. The legal and judicial safeguards and procedures developed over generations in real property matters exist to protect legal rights. They evolved and reflect a prudent and painfully developed set of accomodations and balances. Just because the financial services sector lost its collective sanity and jettisoned the credit culture is no reason for the judicial system to follow its example.

And the news of the last couple of months suggest that those legal safeguards and procedures need to be strengthened, not diminished. Which, of course, is what the New York courts took a step towards yesterday by rule imposing additional duties on counsel for foreclosing financial institutions.

Wells Fargo and the New York Fed: Three Fronts and A Big Issue

2010-10-20T10:55:00.000-07:00

Yesterday was big for the New York Fed on the MBS problem. Bill Dudley implicitly questioned the adequacy of the current back office operations in a speech and in a demand letter the New York Fed joined a group of other potential plaintiffs in starting the clock ticking on BofA in a situation involving bad loan putbacks.

Meanwhile, out on the left coast Wells Fargo today vigorously defended its own mortgage servicing operation. Admittedly, the defense could be interpreted, depending on one's perspective, as either 'our operations meet and exceed industry standards' or 'we're not as lame as the rest of the business.' But it was vigorous.

All of this has been freighted with much meaning. But I'm not so sure that the people either dismissing or heralding these developments have enough to go on to be very persuasive. The old joke about litigators--frequently wrong but never in doubt--comes to mind.

So I'm not going to say anything about the viability of the litigation implicitly threatened by a demand letter. I'm not going to speculate on the course of regulatory response to the possibility that material operations of some too big to fail financial institutions suffer from inadequate systems, procedures and controls, or management failures that have resulted in a pattern of routine violations of law. And I don't know how to sort out what Wells Fargo senior management says on the quarterly earnings call versus what Wells Fargo operating managers say under oath in deposition (beyond observing that maybe neither bank officers nor sworn testimony enjoy the confidence they'd once earned).

Instead, I'll offer something organizational--three fronts and a big issue. There are three fronts on which the mortgage backed securities business is being challenged.

Front No. 1. The originate to distribute part of the model. This where the put back issue comes from. There appear to be some problems with the disclosures made in offering documents. This will all be the grist of expensive and lengthy litigation. Both the plaintiffs and the defendants will be drawn from the financial services sector. There may be tax issues, though I'd be stunned if the IRS challenged the conduit status of the REMICs. The separation of record and beneficial ownership of the notes and security interests occurred at this point, but the problems it is now presenting lead directly to Front No. 2.

Front No. 2. The ongoing mortgage servicing operations of trustees and servicing organizations. In a kinder and gentler time (the boom of five years ago), these operations were seen as essentially custodial (the trustee holding the property for the benefit of the trust that issued the MBS) and ministerial--the accounting, recording keeping, reporting, disbursing of cash flows, etc.--of the mortgage servicer. These systems are now being stressed past the breaking point. In the first instance, that stress showed up in the foreclosure scandal, but it's rapidly spreading to other issues (viz., the demand letter). That first stress takes us to Front No. 3.

Front. No. 3. The legal issues coming out of the foreclosure disclosures. This is rough stuff. Without prejudging the question of whether the actual conduct was an endemic and indefensible as it appears to have been, the policy question of what to do about it is just beginning to surface. Do you settle for a patch and a local fix? Or do you conclude that the too big to fail financial institutions require rethinking? One relevant observation--those institutions seems to have many, many problems in a wide variety of different arenas. Foreclosure gate is part of a pattern, not a one-off. Consider the pay to play scandals in state and municipal finance. Consider the pay practices. And, don't forget the meltdown in the financial markets two years ago (a situation salvaged by bureaucrats and the taxpayer, though the leadership of those institutions and their publicists have conveniently forgotten that).

And, finally, the big issue. It's less global than pondering what to do about too big to fail financial institutions, but it's an aspect of their size. Conflicts of interest are a huge problem in the mortgage servicing business. The extent to which the different roles are intertwined in different operations of the same ultimate parent organization are going to be an enormous obstacle to resolving this mess. (It also may be a fatal weakness in legal attempts to contain it). One of the institutions joining in the demand on Bank of America is 34% owned by BofA. Wells Fargo is famous for making both first and second mortgages on the same property. One reason HAMP is believed to have had such dismal results is that the servicers were in a blatant conflict of interest situation.

All in all, interesting times. A lovely mess of policy issues, legal complications, operational challenges, all in a stew of tangled jurisdictional questions, potential criminal liabilities, and so on. A recipe for . . .

Back Office Collapses in History

2010-10-19T07:38:00.000-07:00

Of course it's still way too early to tell just how systemically important the back office failings of the mortgage servicers will turn out to be. But NY Fed President Dudley referenced the importance of robust back office operations underpinning a functioning mortgage securities markets in his speech this morning. And that is important.

Indeed, the financial markets were wrecked by a back office meltdown the living of memory man, indeed in the memory (just barely) of non-retirement age living man--and woman, for that matter, though back then the women weren't the, ah, players they've since become. Actually, the back office meltdown just finished the job. It came after a market boom followed by a meltdown had stressed the whole system, against the backdrop of prolonged and unsatisfying military entanglements on the Asian landmass and a rickety economy.

Maybe that all sounds familiar. And in the last three years we've had a debate about whether we were headed for a reprise of the 1930s or the 1970s. What I'm talking about here happened early in the 1970s, and was really the final inning of a game started in the 1960s.

The 1960s were the Go-Go years. You had mutual funds instead of program trading and conglomerates rather than hedge funds, but you had the same psychology of boom. Which was followed by bust. And throughout it all, elevated levels of transactional activities.

All of which settled on paper. And all that paper swamped the back offices. Now these were the back offices of the member firms of New York Stock Exchange firms. Those firms were partnerships and the partners were frequently more interested in playing golf at Winged Foot, racing sailboats on Long Island City or drinking at the Brook Club.

By the time anybody started paying any attention, the systems had broken down. As in, knee deep in trade slips, lost stock certificates, daily ledgers weeks behind in recording transactions, blown settlements, broken trades, etc. A number of firms failed.

Unlike the current situation, all of these failures were internal, pretty much confined to Manhattan, maybe bleeding over to Jersey City. An effort today is being made to portray the problem as one of antiquated state property laws and filing requirements. As far as I can tell, those antiquated state systems and procedures work just fine, and 'time-tested' might be a more polite adjective.

The problem is a systemic back office failure to comply with state legal requirements, leaving the beneficial owners of the notes in a position where they are unable to efficiently and quickly assert their rights under state law. At worst, they lose the benefit of their security interest and become general creditors in a bankruptcy. At best, at considerable expense to the trusts, servicers and perhaps even the deal sponsors, the remedial work necessary to comply with well-established state law requirements.

But it's difficult to challenge the notion that, if a litigant wants to assert rights in a state court under the laws of that state, it should be compelled to comply with the procedural requirements of that forum. And it that litigant is a federally regulated financial institution, it's about time that federal regulators look into the situation. If those institutions have by their own strategic decisions, operating procedures, and resource allocation, put themselves in a position where they can't obtain state legal remedies, then there need to be some changes--in the financial institutions, not in the state laws.

Political Fallout from the Foreclosure Mess

2010-10-18T08:10:00.000-07:00

As far as I can tell, so far there hasn't been any.

On a personal level, our political classes don't have a dog in the fight. They may be collectively regretting the purchase of that vacation condo back in 2005, but they are current on the mortgage of their principal residence (except for that California representative).

On an professional level, the foreclosure mess is as much a problem as it is an opportunity. It lies awkwardly on top of a construct created by various spin meisters at a great expenditure of time, effort and treasure, to paint in the darkest colors a collection of deadbeat borrowers who took out liar loans to speculate in homes they never should have been allowed to buy, then, to top it off, ruthlessly defaulted. Now, to use Ron Zeigler's words from his time as Nixon's press secretary, those facts are no longer operative.

Now, in Congressional district by Congressional district, media outlet after media outlet develop endless heart rending stories of incredible abuses. Well, in the context of millions of foreclosures, if you have thousands of horror stories, that's a rate of one in a thousand. As long as those stories sell newspapers, atttract eyeballs or goose the ratings, that vein will be mined. So it's reasonable to expect the stories to continue, at least through the midterms.

Inside the Beltway, the political leadership is doing what comes natural to it. Congress will grandstand with hearings. Those may not help homeowners or shed much light on the situation, but they'll put the heat on the mortgage servicers and provide some entertainment. If they have anyeffect, it will be to jell public opinion and (more importantly) the political calculus against any legislative accommodation of the financial services sector on this one.

And within the agencies and executive branch, those politicians are doing what comes naturally to them when tossed a hot potato. They're handing the hot potato off to the professionals. Of course, in this case the professionals will be teams from enforcement, compliance, regulatory oversight, and perhaps the criminal division of DOJ (in a liaison capacity, at first). That's already happening. Those mills grind slowly and implacably and are pretty hard to turn off, once fired up.

So there, the process is at work. But as far as political fallout in the run up to the midterm elections, nothing has developed so far. Maybe, given the timing of all this, the problem has to be a post-election issue.

Which brings us back to the bigger question of what kind of construct to put on foreclosure-gate. Is it a story of modern innovative and creative financial institutions who've developed new and better ways of making the American Dream possible being tripped up by a few ancient legal technicalities in a few backwards state jurisdictions? Is it a crisis threatening the integrity of our largest securities market and most important financial institutions that requires a federal fix to a patchwork of outmoded state real property laws? Or it is an arrogant, out-of-control Wall Street, not satisfied with destroying the retirement savings of millions, not satiated by shipping the jobs of more millions off to China, launching a criminal attack on the American Dream of home ownership?

My gut tells me that the first choice is so ludicrous at this juncture that even the toadies and lackies still mouthing it will be told by their masters to shush. So the alternatives likely come down to some blend of the second and the third. The problem with the second choice is that the card has already been played once in the last couple of years, and I sense that the political classes feel betrayed in the aftermath by the financial elite. The problem with the third choice is that it sounds like so much tea party dementia and drivel.

I suppose an ideal outcome would be to cloth the policies implicit in the third in the phraseology of the second. That'll happen when pigs fly.

The State of Play or . . .

2010-10-17T07:57:00.000-07:00

moving slowly and implacably.

Two very important things to remember as the robo-signing scandal morphs into something more interesting and systemically threatening.

First, we are only in the earliest stages of the unfolding of this situation. It's too early to tell what we are dealing with. The problem may have been brewing for some time (and with benefit of hindsight it may come to be regarded as having been inevitable). But until the large servicers started voluntarily suspending foreclosures the situation didn't occupy that much bandwidth. It was possible to assume that lenders had simply adapted to the subprime market and underwater houses the aggressive repo techniques they'd always used to grab cars securing bad car loans and the furniture involved in various tawdry lease to buy schemes.

The shock of the public announcements that the country's largest mortgage servicers were suspending foreclosures grabbed public attention. It made the Daily Show. Unfortunately, as a culture we've become addicted to the idea that everything should be resolved in a 30 or 60 minute media window, or over the course of a week (the length of a made-for-TV mini-series), or (at the longest) a viewing season.

So far, not one aspect of the financial crisis has conformed to those dramatic dictates. Don't expect this one to, either.

The second is like unto it. This situation does not lend itself to quantification. We've developed a taste in this country for measuring, quantifying, modelling the impact of a development or a decision on (you chose) a divisional P&L statement, an investment portfolio, a tranche is a securitization, etc. The important decisions in that process were always veiled in the model's assumptions or the financial statements footnotes. But not worry. Those things didn't lend themselves to sound-bite treatment, anyway.

What's happening--foreclosure gate--presents a legal, regulatory, management and operational set of issues, and their interplay that defy prediction, much less forecasting, modelling or quantifying for purposes of throwing a number up on a trading screen, modelling impacts on tranches of differeing seniorities of changes in cash flow projections or determining the adequacy of a litigation reserve. Unfortunately, there's a reason they call them talking heads, not thinking heads.

That idea that a non-trivial part of the operations of too big to fail financial institutions have involved recurring violations of law, and that those operations cannot as currently configured by conducted without those legal violations is something to think about. It requires more than a knee jerk reaction.

If spending that time gives industry apologists, shills and lobbyists time to regroup, that is a cost of how things work. It also gives time to determine whether some of these institutions should be indicted, and at what organizational levels.

So Why Did They Stop?

2010-10-16T08:06:00.000-07:00

Why have most of the major banks stopped foreclosing on residential property? Let's discard a bunch of possibilities:

1. They are torn by conscience stricken concerns over possible errors ejecting innocent homeowners from their residences? There is utterly no factual support for this answer, and it's inconsistent with all the past talk of liar loans, ruthless defaulters and so on.

2. They were cowed into it by the aggressive law enforcement efforts of a posse of 50 state attorneys general. Nah, the posse formed up after the announcements of the suspensions. Classic reactive government, not proactive at all.

3. They were responding to public outrage in a crisis management mode. The problem with this theory is that so far the public is more perplexed than outraged. Neither Wall Street nor Main Street has quite figured out what to think. The same goes for the political class inside the Beltway and the Main Stream Media.

I have a theory, and it is only a theory. The only way that the mortgage servicers have of filing foreclosures in the volumes current circumstances dictate requires the filing of sworn affadavits that contain misstatements of facts and documents that have been fabricated ('recreated'). Since knowingly swearing to false testimony (which is what an affadivit is) and since fabricating documents to be filed in judicial proceedings are criminal activities, the servicers had to stop. To continue would be to knowingly continue in criminal activities. Stopping may not be sufficient, but it is certainly necessary.

This is completely independent of the issue of whether there 'should' as a policy matter be a moratorium on mortgage foreclosures. This is completely independent of any 'harmful impact of the housing recovery.' This has nothing to do with the state of the MBS market, or put backs. Very simply, if the robo-signing foreclosure mill activities may involve routine forgery and perjury, the legal risk to responsible corporate officers and the institutional risk to regulated financial institutions is too great to permit it to continue.

Foreclosures will resume on a routine basis when the servicers can develop a new routine.

The Kid Who Grew Up To Be President

2010-10-15T08:06:00.000-07:00

There was this kid, real smart, a hard worker. He went to law school. He became president of the Harvard Law Review. Must have done well in those first year law courses. Like Paper Chase. He had to really, really grok the property law and the civil procedure and all that stuff. Drunk the koolaid big time. You don't get to be an editor of the law review unless you really, really buy into it. It forms the way you think for the rest of your life.

So this kid grows up to be president. Of the United States. And he has a lot on his plate. He wanted the job, of course, but he never thought fate would heap a financial crisis on his plate. I mean, he turned his back on those high Wall Street salaries when he left Harvard and instead took the path that led to the White House. And now, once there, what's he staring at, but a steaming heap of Wall Street.

Now, how does the kid inside the man react to learning that those big Wall Street banks have been hiring people to routinely perjure themselves (so routinely that the job title is 'Limited Signing Officer') and have outsourced their forgery needs to a third party which actually published a price list for 'file reconstruction.'? Not once, not twice, but tens of thousands of times.

I don't know how the kid inside the man reacts. But one last tidbit, the kid was raised by his grandma. And she had a low level functionary job in a bank. She was in charge of the loan files, and promissory notes, or something like that. At the bank she did women's work in an era when the men were the executives, and took home the big paychecks. Then she came home and raised the kid and his sister.

Will the kid let the system put the modern day equivalent of his grandma in jail, or maybe he'll go after bigger fish. Depends on what kind of man he is, I guess.

Technically Accurate Comment on Mortgage-Gate

2010-10-14T15:56:00.000-07:00

The amount of confusion, posturing and excitement over recent developments on the foreclosure front, and the implications, plausible and impausible of it, is something else. One good thing about it--the rise of the robo-signers has purged the idea of ruthless defaulters from the public vocabulary--although I'm a bit perplexed at the attempted canonization of deadbeat borrowers.

Here is a stab at what all this means and doesn't mean.

Overstatement No. 1. This does not impact the title of every piece of residential real estate that was purchased or refinanced since the turn of the century. Real property is conveyed by deed, and the deed is recorded in the the jurisdiction where the property is located. If the transfer involved borrowing money (a note and a mortgage), a sensible noteholder will also record the mortgage in the same jurisdiction to create a perfected security. Once the security interest is perfected (or filed) it is a matter of public record and anyone who proposes to acquire the property (or lend money against it) does so with knowledge of the pre-existing loan.

But, unless the borrower defaults and we have a--bingo--foreclosure, the mere existence of the perfected security interest doesn't transfer the property to anybody (there is a slight qualification of this in jurisdictions like Texas where deeds in lieu are closing documents, but this is the general rule). The deed, from current owner to the acquiring owner, is the document that transfers title.

There is a mess here, all right. But it doesn't impact every property that has been financed or refinanced since mortgage backed securities came into existence.

Overstatement No. 2. Everybody who has bought a mortgage backed security that went from triple A to junk can put their bad paper back to the deal sponsors because the trust wasn't funded, the conduit tax status has been broken, and the prospectus was full of lies and omissions.

By and large these trusts are instruments of and governed by New York law, not the law of the jurisdictions in which the properties securing the notes are found. The one trust document that I've read clearly contemplated a bulk assignment in blank of all MERS eligible mortgages. Without ever reaching the question of whether a bulk assignment in blank of promissory notes and mortgages is any good in most jurisdictions (it probably is not), it most certainly satisfied the requirements of the trust instrument. Why New York law would disregard the language of the trust instrument isn't clear to me. And if the trust was funded as contemplated by the trust certificate, the likelihood of the IRS coming in to challenge the conduit tax treatment of the vehicle is slim to none. If, as I'm sure happened, the IRS issued revenue rulings blessing standard industry practice, the chances of that goes to zero.

With the two overstatements out of the way, four things are pretty clear:

Problem No. 1. Systematic perjury and forgery seems to have become industry practice in dealing with documentation deficiencies. The judicial system very properly polices itself pretty strictly on this stuff. A price list for 'file recreation' and related services is making the rounds. Finding a euphemism for forgery doesn't make it any less objectionable. I've never met a judge who was in the least bit impressed with the 'we do this all the time' explanation (that excuse being considered an aggravating rather than an ameliorating circumstance). In view of how widespread the activity was, current efforts by industry apologists to minimize the involvement of more senior management in these practices merely makes out a prima facie case for their failure to supervise or take reasonable steps to insure compliance with applicable law.

Problem No. 2. Servicers and trustees are under a fiduciary duty to the owners of the MBS issued by the trusts to rectify the consequences of past sloppy practices and negligence. Without spending some time under the hood it is a little difficult to say just how that plays out. But it is quite likely that a too big too fail bank is on too many sides of the problem to be in a position to deal with the conflicts of interest and fiduciary duties of a trustee and servicer. This is a structural problem with the way the originate to distribute system of financing residential real estate has developed.

Problem No. 3. From what has surfaced so far, there are quite likely some serious issues with the way in which the results third party due diligence on the loan portfolios was disclosed in the offering materials. This is currently being posed an an information asymmetry between deal sponsors and investors, and maybe in an era so tolerant of proprietary trading that's a way of explaining it. But, on a more basic level, if the fail rates on portfolio samples are anything like what has been reported, there is some question why the pools were ever securitized in the first place. If one assumes that the samples accurately reflected the composition of the loan portfolios, any claim that the mortgages in the pools had been underwritten in compliance with anyone's standards seems a stretch. This is the stuff of years and years of securities litigation.

Problem No. 4. The process of foreclosure just got a lot more expensive, in terms of time, money, management attention, etc. The fact that the notes weren't properly transferred in accordance with the law of the jurisdiction in which the foreclosure is occuring (even if New York law was satisfied), doesn't mean the debt goes away, or that there is not a valid security interest in the mortgage. It just means an added step of determining the record owner and bringing it (or its successor in interest, if it is defunct) into the proceeding.

And the interplay between this and the prior pattern of perjury and forgery will exacerbate the whole situation.

And that's the state of play today. We'll see about tomorrow.

Politics and Economics

2009-11-04T10:05:00.000-08:00

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

2009-11-03T13:14:00.000-08:00

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

2009-09-28T10:36:00.000-07:00

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?

2009-09-26T11:59:00.000-07:00

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

2009-07-28T12:14:00.001-07:00

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

2009-07-27T11:08:00.000-07:00

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

2009-07-26T11:30:00.000-07:00

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.

Lehman, Redux

2009-07-13T10:39:00.000-07:00

The looming failure of CIT offers the real possibility of a repeat of the Lehman Brothers shock.

The reasons that Lehman Brothers was permitted to fail in a disorderly fashion aren't worth visiting in any detail, mostly because of the storm of post-hoc CYA bullshit that cascades forth from otherwise decent people at the first inquiry into those reasons. Suffice to say that no one adequately appreciated the consequences of the Lehman bankruptcy, and everyone immediately (okay, it took the House two tries) sprang into action when those consequences were understood.

Does the CIT failure have the same potential for systemic risk that Lehman did.

The answer is simple. No, if you are concerned only with the stability of the financial services sector. Within the financial services sector, Lehman was more systemically important.

Unfortunately, if you are concerned with the general economy and not the casino, the answer is also simple. The answer is, Yes. CIT is systemically more important to the flow of credit in the general economy than was Lehman, which was, after all, merely a capital markets player.

CIT provides financing to businesses that operate in the general economy. You can call that financing liquidity, working capital, floor planning, receivables factoring, whatever. It makes no difference how you describe it, the financing provided by CIT and its competitors is critical to the continued operation of a huge swath of the economy.

It is easy from a certain perspective to dismiss this swath as a bunch of Dunkin' Donut franchises. After all, we could all do with a few less donuts, right?

It is more accurate to describe this swath as the Main Street mom-and-pop merchants who have survived the onslaught on the Walmarts and Targets and Costcos. The businesses who are CIT's customers are hardware stores, furniture outlets, franchised tire dealerships, music stores, boat dealerships, etc. Anybody who has to finance inventory or receivables.

And times are tough for these businesses. The consumer has retrenched. Not so many big ticket consumer durables are being bought (the auto industry may be the poster child for this observation, but it extends to clarinets and baby furniture, too). Many, many of these businesses are operating on the forebearance of their lenders, they aren't making the inventory turns the floor planning arrangements contemplate, the receivables are a little hairy. Some of them have waiver letters, others are simply letting it ride. And lenders, like landlords, are working with their good tenant/borrowers.

Only a mandarin safely entrenched from the realities of the marketplace and the credit markets would blithely assume that following the failure of CIT, companies like GE Credit, Litton and Wells Fargo will step into the void and meet the credit needs of former CIT borrowers. Two reasons they won't. First, they are too busy rebuilding their own balance sheets to do much more than give lip service to meeting the broader social needs that provide the only conceivable justification for the special privileges the government has accorded them. Second, the reason CIT is teetering is that its customers are teetering. Those customers aren't very attractive credits. As new business, they are non-starters.

So, this is likely to be a learning experience. While Vikram Pandit wanders across the landscape proclaiming that the future of Citi lies in global adventures, the credit needs of Main Street will be unmet. Small and medium size businesses will fail at an accelerated rate. Unemployment will rise, the economic 'recovery' will stall. In some ways it will be like last Fall's commercial paper adventure, except that the administrative challenge of providing credit to thousands of small to medium sized business will probably prove insurmountable.

Clearly, the economy will not tank on the failure of CIT. From a cool and dispassionate perspective, it almost seems like an experiment worth running. But that perspective may be hard to maintain if bankrupt small businessmen start dousing themselves in gasoline and setting themselves on fire on the Washington Mall.

Get Ready for the Kooky Ideas

2009-07-11T12:48:00.000-07:00

Because here they come. A veritable flood. Certain to be dismissed initially. But some, like Sarah Palin, will gain traction.

Right now we (the collective 'we') have framed up our economic, political and social issues with a shared set of assumptions that are themselves becoming a casualty of the current unpleasantness. A mainstream articulation of that framework can be found in the Larry Summers interview in today's Financial Times. From one flank a more offbeat expression is offered by Nouriel Roubini on a very regular basis. On Summer's other flank, (if any still survive) can be found the pollyannish house economists of various organs and organizations promoting real estate purchases and equity investment (current faves, 'this is a stock picker's market', and 'buy and hold is a dead strategy'). Up above, from the academic highground, Krugman lobs his contributions down on us (to his credit, asking rhetorically last week who defines this framework and why there are 'unpersons').

But, the framework exists. And it exists for good reason. Nobody wants to have to listen to the kooks who think there is a pill that can turn water into gasoline, or who believe they've invented a perpetual motion machine (the call for economic salvation through a War on Global Warming comes close to these, IMHO, but it enjoys bizarre credibility that I personally chalk to the need even in a secular society for public demonstrations of faith).

I think the framework may be about to shred, in part because it's losing its objective utility, and in part because the participants are losing their faith in it. On the one hand, it may be possible to salvage the intellectual fabric and construct a workable, if makeshift set of policy responses using the salvage. On the other, it may be time to put the 'political' back into 'political economics'. And if that's the case, the current lineup and the current teams need to be recast.

"Paging Dr. Reich? This is central casting. Governor Palin would like to meet with you. We know you've heard of her, and are probably skeptical, but she's an empty headed vessel just waiting to be filled. You be da guy."

Personally, I've immunized myself (more or less) to all this by spending the last few months reading the Cantos of Ezra Pound. Pound was a guy who gave kooky economic theories the full monty. (Other kooky theories, as well--notably, anti-semiticism). He fell for a guy named Clifford Douglas, who was sort of an unhousebroken Hyman Minsky. Yes, folks, when it's broke it gets a great deal more baroque that H.M.

And EP ended up under indictment for the capital crime of treason, finally going over the edge sitting in a prison cell near that of a fellow named Till (who was one day led from his cell and hanged for 'murder with all the trimmings'). That Till was the father of the Emmet Till who was murdered in a racist incident in the mid-50s that contributed mightily to the emergence of the Civil Rights movement (and whose coffin is currently playing a bit part in a rather lurid bit of graveyard crime in Chicago).

You can immunize yourself however you want to. Just don't go deaf to reason listening to the siren songs of Bristol Bay.

Financial Reform A.D. 600

2009-06-28T08:28:00.000-07:00

"Bankers shall not file coins,
nor make false ones
Nor put a slave . . . in charge of their business
. . . .
if they do not notify counterfeits that come in
and from whom
shall be flogged, shaved and exiled
And in this there can have been few innovations"

Pound, The Cantos of Ezra Pound, Canto XCVII (p. 687, New Directions Edition)

That being a rough translation (per Pound) of the Code of Justinian, coming after the rules for the notaries, goldsmiths and bakers and such.

It does tend to put the current rather modest proposals for financial reform in perspective. And the suggestion that there need be few innovations resonates of the observation that the only indisputably beneficial financial innovation of the last generation has been the ATM. But do not despair, ye serfs of finance, at least Justinian's Code did not proscribe branding, blinding or cropping (as in amputating the offending hand) for your transgressions.

The Forty Percent Problem

2009-06-20T11:00:00.000-07:00

In 2007, approximately 40% of the earnings of the S&P 500 were attributable to the financial services sector. It is difficult at this point to estimate with any assurance the extent to which those financial services sector earnings were inflated by fraud, aggressive accounting practices, overleverage and a cyclical spike in levels of transactional activity, but all of those factors contributed. And it's difficult to say the extent to which appropriate regulatory reform and consumer protections initiatives will undermine the core earnings power of the predatory franchises on which so much hope for sector recovery in pinned.

If you remove that 40% of the earnings from the price earnings ratio of the S&P 500, and you look at the 40% decline in the price level of the S&P 500 since 2007, one nicely offsets the other. That is food for thought.

There are other factors at work, of course. Earnings in 2007 outside the financial services sector were at a cylical high, and can be expected to deteriorate sharply in a recession (just as recovery from recession-depressed levels to some idealized norm can be expected). No one really knows what the price/earnings ratio of a stock, much less of a market index 'should' be--though much ink has been spilled on the subject.

It's sufficient to say that the market has discounted the collapse of the financial services sector, though the sequence of events through which that occurs has yet to unfold. And the ramifications of that haven't yet been fully felt--nor, perhaps, fully discounted by Mr. Market.

My own guess is that unemployment will continue to rise, the magnitude of commercial real estate problems will be revealed with ghastly consequences for any number of traditional bank lenders, house prices will, in the aggregate, continue to decline until residential real estate has roughly half the value prevailing at the peak in 2006 or so, credit card delinquencies will rise, and so on. And an already crippled financial services sector will founder. Someone along the way, it will lose its place at the table.

It will be interesting to see what the new world looks like. I suspect that the transition issues and difficult adjustments of the formerly middle class, the elderly, upside down homeowners, the structurally unemployed, etc., will dominate the discussion, and strategies for restoring the global edge of the American financial services sector, if any, will have a distinctly archaic ring. My gut feeling is that the developed world is in for a prolonged period of painful adjustment, and deteriorating public sentiment will be fueled by reports of relatively progress in those parts of the developing world that have sufficiently large domestic demand that their economic growth in not dependent on the American consumer. I'm not predicting blood in the streets, or even bread riots. Just an opaque and heavy economically glum environment that sours the social mood, and contrasts with the innocent happiness of the furriner on holiday, using the cheap dollar to rub it in.

Not Quite Ready for Prime Time

2009-06-15T12:11:00.000-07:00

Let's get real. There seems to be a great deal of dissatisfaction with and disappointment in the Obama Administration's approach to the reforming the financial services sector and and outlawing the current (admittedly toxic) executive compensation practices. I think the disappointed are confusing cognitive recognition of a problem and identification of potential solutions with the actual process of change.

So why isn't meaningful reform in the cards for the next year or two?

Team Obama did not exactly enter the 2008 presidential race focused on the economy or the financial services sector in particular. As I recall, the global hot button was the Middle East (a/k/a Islamic terrorism, the wars in Iraq and Afghanistan) and the domestic hot button was reforming the health care delivery arrangements. Not much bandwidth was devoted, until around Labor Day, to the general economy, much less Wall Street (except when it came to fundraising).

So, if the first reason expectations should be low at this point in time is simply that financial reform wasn't on the agenda, the second has to do with that second little fact--the fund raising business. The financial services sector has bought and paid for the government and its regulators for at least a generation. It is easy to get angry about this, but it is also pointless to do so. Big campaign contributions and the machinery of retained lobbyists buy access and mindspace, and influence policy and regulation. But there is a limit to their impact. The Marc Rich pardon notwithstanding, it is very difficult to actually buy an outcome. When the result is controversial and the groups opposing it have made their campaign contributions and hired their own lobbyists, the impact of it all is, if not neutralized, at least offset (and can lead to truly bizarre outcomes and terrible policies with unbelievable real world outcomes--viz., the attempted privatization of military services by the like of Blackwater).

Right now, sitting here today, the financial services sector retains its seat at the table and is still regarded as a participant in the process, a patient whose informed consent is required for the procedure. Soon, enough, unless there are magic reversals in the unemployment rate and the direction of commercial and residential real estate prices, the financial services sector will come to be regarded as a corpse to be harvested for useful organs and dissected for the enlightenment of future generations of medical students. Not yet.

Then there is the issue of executive compensation. Given the extent to which Summers, Emmanuel and Geithner's wife have all suckled at the Wall Street teat over the last decade, I think it is impossible for those guys to approach the issue without trepidation. What made Larry Summers worth over five million dollars to Wall Street or Rahm Emmanuel worth over fifteen million? Politicians are not notoriously introspective, but it would be hard not to question yourself under the circumstances, and that is disregarding entirely the public embarassment and political advantage to one's adversaries of the situation, and without even reaching the ethical implications of either betraying a constituency you have allowed to buy you or failing to act in the public interest while in public service.

There are three reasons not to have high expectations. They are all grounded in the realpolitik of expediency. In the short term they are insurmountable. In the intermediate to longer term, they fall away, depending on the course of future developments. But for the time being, expect experimenting with the cosmetics and some serious rearranging of the deck chairs. And don't get mad or excited about it. Just wait patiently.

Flavors of Players

2009-06-05T21:47:00.000-07:00

To understand the state of play, you need to know the players. Right now, as the economic crisis unfolds in the United States (and, for that matter, globally), there are three flavors of players (Stateside). They are:

1. The Financial Elite.
2. The Political Class.
3. The Technocrats.

The financial elite, formerly known as the Masters of the Universe, are the varied and assorted hedge fund managers, traders, merchant bankers, etc., etc.--the whole of the seven-figure income and eight-figure net worth (formerly) herd bulls/alpha males of the financial services sector, their direct reports, and those who report to those direct reports. They are convinced they've done nothing wrong, that they've been overwhelmed by unforeseeable circumstances that have similarly impacted everyone else within the ambit of their world view, and they are collectively responsible, directly, proximately for the global economic crisis. They are clueless, and the incomprehensible ineptness of their responses to their current situation is slowly sinking in.

2. The Political Class, happy in the good times to take money from the financial elite and rein in the technocrats in exchange for the lucre, which much rather be prattling on about gay marriage, narco terrorism, green energy and any other available hot button that doing the heavy lifting of making decisions about the government's role in the economy. Unfortunately for them, the screw ups of the financial elite compel official notice. The earliest inclination of this group was to punt the problem to the technocrats, but we may well have reached the limits of that strategy. Past that point, these guys will engage, and the results of their engagement will be stunning. Time will tell whether that means good stunning or bad stunning.

3. The Technocrats are suddenly in the uncomfortable situation of getting what they've been wishing for--an opportunity to perform front and center, on stage, with power (or influence, depending on their niche). There are limits to this opportunity, and it's rather opaque at this point, since they pretend to serve their masters in the political class and the public sensibilities (not to mention to the innate conservative stupidity of the political class) require adherence to the convention that the private sector (read, financial elite) is capable of managing its own affairs. That is a convention which the political class is finding daily more laughable. Unfortunately, at the very moment these have been given to shine, they're finding that most of the tools in their kit are, er, inoperative. Though whiny, they are collectively quite bright, and if appropriately engaged with the political class they have the potential to make a positive contribution to the situation.

Odd Resonances

2009-06-01T10:39:00.000-07:00

A current question in economic circles is why the massive expansion of the money supply as aresult of the Federal Reserve’s strenuous efforts to deal with the financial crisis and ensuing general recession has led to utterly no discernible inflationary pressures, at least in the short term. After all, it’s a generally accepted fundamental precept of modern macroeconomic theory that, ceterus paribus (ah, such as old fashion phrase, a whiff of napalm in the morning), an expansion of the monetary supply will generate inflationary pressures, and we have witnessed over the last year a veritable explosion in the money supply.

The succinct and apparently indisputable answer is that the expansion of the money supply has occurred in tandem with a slowing in its velocity, dressed up with the occasional pontification about appreciating the difference between statistics that are expressions of first derivatives and those which express second order derivatives. Without honoring the mathematical window dressing, let’s accept that observation as simple, gospel truth.

What is stunning to me is that the idea resonates with the long-discarded ideas of an English engineer-civil servant-social theorist named Clifford Douglas who in the early 20s developed an idea of Social Capital. I am currently reading a magisterial exegesis of the poetry of Ezra Pound, and, before falling in with Mussolini’s fascism, Pound was temporarily captivated by the ideas of Douglas.

Douglas was not talking about the money supply. Douglas was not a Marxist (he felt the attribution of all value ultimately to labor and toil of the contemporary working classes and peasantry was fallacious). He was not an economist (not even by the more flexible standards of his day). He may have been a crackpot. But his diatribes on cost accounting and contempt for the reliance on markets to both price and value goods and services are seductive.

In a nutshell, he argued, with respect to capital, not the money supply, that the velocity of capital, not the quantity of it, explained the vicious grip of banks and the financial interest on the general economy. His argument echoed that of the American populists and progressives of a generation earlier that Wall Street held the country in its talons, crucifying Man on a Cross of Gold as surely as our Savior suffered on a Roman cross of timber. In a wonderful analogy, he made the argument that to ignore velocity would lead one, in the context of demographics, to claim that, because everyone who is born eventually dies, the birth rates and the death rates must be identical, and so the population must be stable, which it patently is not. These statistics are matters of rates, not absolute quantities (and it hardly required the invocation of Calculus to understand it).

I’m not sure if Douglas is worth exploring, or not. He was a whacko, and, like Pound, more than a whiff of anti-semeticism pervades his writing. But clearly, all of the post World War II macro orthodoxies are being found wanting. Hence, you have Paul Krugman reading Hyman Minsky. Thus, the endless invocations of the same few phrases of John Mayard Keynes (efforts to restore ‘animal spirits’ by fiat seem to me about as likely to succeed as efforts to repulse the Mongols by sending the patriarch and his bishops beyond the city walls to parade the icons before the approaching horsemen).

It’s enough to make me wonder if these issues are, at bottom, really issues of the economy, at all.

Non Quant Indicators

2009-05-28T21:20:00.000-07:00

that the credit markets are close to deconstructing again. Not sure if they mean anything. But two salient factoids are being systemically forced down the throats of those who trade:

1. The U.S. housing market is continuing to deteriorate, and the deterioration, so far, has no end point.
2. The financial services sector, and the debt instruments generated over the last decade, cannot survive point 1, and so it, its equity and its contractual obligations are valueless.

Given enough time, which it has had, the federal government can step in to sponsor a utility-like financial services sector that will meet the needs of the general economy (point 1), but the consequences of point 2, over the intermediate to long term, are quite opaque.

Vive l'opaquace!

Confirmation Bias

2009-05-28T10:55:00.000-07:00

'Confirmation bias' is a term to describe the tendency of the human mind, once a conclusion has been drawn, to emphasize subsequently received information that supports the decision or conclusion and to diminish, distinguish or otherwise minimize the significance of information which contradicts, undermines or otherwise calls it into question.

The current reporting of the trends on residential housing prices offers countless examples of confirmation bias in action. The operative conclusion/decision is the conviction which has prevailed for the last several generations in the United States that house prices always go up, that your home is your best investment, etc. The date coming in recently, to put it mildly, calls that conventional wisdom into question.

All of that data is bad for homeowners, homebuilders, anyone in the real estate business. Some of it is less bad that others. But none of it is exactly positive. However, it is possible to draw some second-order inferences that are non-negative. If the rate of new home construction has falled below the absorption rate for new home inventory and below the rate of household formation, that implies that eventually the situation should turn around. If interest rates are being held at artificially low levels to make mortgages less expensive, that results in an affordability index that would support increased levels of home ownership (if only the sidelined new home owners weren't scared to death of losing their shirts of 'the biggest purchase you'll ever make").

But, even though all the data is bad, the talking heads find someone willing to say something neutral, and the headline writers twist those words into something positive. I really don't think this is the machinations of the National Association of Realtors or the Homebuilders at work. I think it's confirmation bias in action.

Which would suggest that we have a ways to go before it's purged.

The Bush Legacy, Memorial Day 2009

2009-05-24T09:35:00.000-07:00

Ever notice how in the last year of the second term of a presidency voices are raised in speculation about the hallowed legacy that the incumbent soon to be departed will leave behind? The fund raising machine is cranked up one last time for the benefit of an ever more grandiosie presidential library and respectful columns written about His concern for His legacy dominating His remaining waking hours of Power.

Well, it's Memorial Day Weekend, time to consider legacies and such, even if we haven't heard too much about the Bush legacy recently. Dick Cheny is out there defending torture, the invasion of Iraq and various other crimes and mistakes, to what purpose I know not. But as to the legacy, all is quiet on that front (apologies to Erich Maria Remarque, another good Memorial Day read, in any country, though he wrote as a German after the Great War).

Perhaps there won't be one. Perhaps we will simply roll it all back to 2000. I think that right now if you gave people that choice, without much thought, they'd grab it. In retrospect, most of the 'productivity' gains of the last eight years resulted from 'innovations' in the financial services sector, and just about everyone would like to pretend like that never happened. So, take her back to 2000, skipper.

Well, there is a little problem with that. If you take house prices back to 2000 (not that far really), house prices have to fall roughly another 30% (nation-wide, based on the Case Shiller index, peak to trough), or as far again as they've already fallen (a bit worse that the more adverse scenario of the recently completed stress test exercise). Awful, but in the ballpark of people's tolerable reality dosage. The real horror would be in taking levels of economic activity back to that level. If you reverse 8 years of 2.2% annual economic growth, you drop the standard of living by some 15-16%. That is not quite a Depression Era level of readjustment, but it's far worse than anything since World War II in the United States.

That prospect exceeds the dosage of any tolerable reality check. But, it's a distinct possiblity, if not already baked in. Kinda leaves a guy wondering where the recent stock market rally came from (not that I'm betting against it continuing).

Of course, the Clinton Legacy was Bush, so maybe the Dems better keep quiet. To borrow the title, itself borrowed, of course, of Dean Acheson's memoirs, Messrs. Geithner and Summers, at least, were Present at the Creation of the current economic mess, even if Phil Gramm played the role of Gilgamesh.

Minsky, Path Dependency and the Hegelian Dialectic

2009-05-22T22:15:00.000-07:00

It's been all downhill since the Hegelian dialectic was hijacked by the Marxists and became dialetical materialism. Start with a mode of argument--thesis, anthesis and synthesis-and deploy it to analyze problems in 19th century political economics. And you have a concept that takes into consideration the prosaic and indisputable observation that the seeds of the next problem are generally found in the solutions to the current problem. An economic and political context in crisis yields an outcome, dependent on the prevailing correlation of forces, and, lo and behold, the new stasis has in it an internal tension that results in eventual crisis, which in turn yields a resolution that creates yet another new set of circumstances, that in turn . . .

And so you have dialectical materialism for idiots. I mean, there is a great deal more to it than that, if you are interested.

In its most recent iteration there is the lovely thought that future outcomes are path dependent, which is even easier. I believe path dependency can be summed up in the observation that what happens eventually depends on what happens between now and then. And that differing intermediate outcomes either foreclose or increase the probability of different ultimate outcomes.

Path dependency is a useful corrective to what Hyman Minsky referred to as the Olympian fallacy. The Olympian fallacy, which also has theological overtones and resonate with chaos theory, holds that a prime mover can set a process or policy or strategy in motion and it will inevitably lead to the desired outcome. Nice as it is to think that the butterflies wings half a world away cause the typhoon, the thought has little practical application in human affairs. Rather, in application, the ideal is transformed into the real, or becomes something alien to those who originally imagined it.

So, it's not entirely clear how all this will come out. But it's pretty clear that future choices and options will be determined by choices made today and the outcomes of those choices. And perhaps by choices made in the past, which are only working out as real world outcomes today.

Death of the Sinecures?

2009-05-19T08:57:00.000-07:00

Our economy is littered with sinecures.

Technically, I suppose a sinecure in a position, generally a government or academic appointment, in which very little in the way of work, effort or responsibility in required of the incumbent, who nonetheless enjoys a handsome income from the position. In 18th century England, the politics of the day depended heavily on a patronage system involving sinecures, livings and rotten boroughs, which in turn were political appoints, clerical positions and parliament seats filled through appointment by a senior member of the local nobility. In 19th century America, political patronage filled precisely the same role--I had a great grandfather who was the Republican postmaster of Omaha, Nebraska for decades, as a party stalwart and veteran of the Grand Army of the Republic (not something my Georgia kin deemed appropriate to notice officially).

So much for the history lesson. The modern American economy is littered with positions that amount to sinecures. Today's Republicans love to take pot shots at public sector sinecures--as though a horse breeder named Michael Brown had been appointed head of FEMA at the time of Katrina through some merit driven process. And the academic bureaucracy that has developed over the last century probably has more than its fair share of positions in which time serving well positioned bureaucrats have found themselves a safe haven, pending retirement in a decade or perhaps a generation.

But we have private sector sinecures, as well, if you take a somewhat expansive definition of sinecure, and consider any job offering a heavy paycheck for light lifting a form of sinecure. Consider all those divorcees peddling real estate to their still married sororiety sisters. That gig rolled to a close about a year ago. Consider all those credit managers and service managers at sleepy auto dealerships where business has been slow for years, but where the axe finally fell last week. The pay was good, the work was easy, you just had to be a good fit with the family that owned the place. Now, gone. Poof.

On another level, think about all the businesses that serviced the needs of booming sectors of the recent credit-bubble inflated economy. A read an internal memo circulated at J.P. Morgan trying to control car hire, tipping and deal toy expenses. These are probably not good times to be an event planner on Manhattan or in Southern California. Not too sure how the personal trainers and life coaches are doing, either.

Finally, how about good old print journalism? Every decent sized community in the country has a daily newspaper that fewer and fewer people read. Every daily newspaper has local news coverage--business, sports, community affairs. All that requires staffing. To hear the publishers lament, their communities will be culturally impoverished with the loss of that coverage. Perhaps, but if readership is collapsing, and craigslist has ended the want ad gravy train, something is going to give. I don't think the replacement of want ads by craigslist will diminish the vitality of community culture, any more than a shrinking real estate section or using the email instead of the Sunday supplements to flog department store sales will.

But what will change are the job prospects of those reporters. Journalism is apparently one of the favorite majors at the University of Oregon. Mock if you will, call it an English major without the rigor of taking a course in Shakespeare, but it was a major of choice for kids looking for sinecures.

And it appears that the sinecures are being squeezed out of the economy. Oh well, back to work.

A Better Class of Victim

2009-05-14T16:46:00.000-07:00

For the last half century in the United States the victims of any economic downturn were invariably the same, at least in the sense that they generally came from the bottom half of the income distribution. Oh, occasionally there'd be some regional variety--petroleum geologists in the Oil Patch back in the 80s, a bunch of white shoe paperhangers in the 60s (i.e., go-go year stock brokers), the occasional wave of aeronautical engineer layoffs in Southern California as the defense cycle turned, the almost comical dot.com geek zillionaires turned burger flippers. But, on the whole, the burden generally and relentlessly fell on the unionized worker, the craftsman, Joe Sixpack, AS the people for whom he voted dismissively labelled him.

Now, the for the first time, we may actually be in a situation where the pain and the burden falls disporportionately on the well employed, well-educated and well off. The 32% of the population that doesn't own a home are spectators to the popping of the housing bubble. The majority of Americans will less than $50,000 in financial assets (or is it $15,000) are not taking the paper losses on their 401ks that their supervisors, and their supervisors' managers, are letting pile up unopened. You've got to have some wealth to feel its destruction. And the elements in the service sector which are for the first time bearing the brunt of the downturn include lawyers and architects as well as retail clerks and minimum wage waitstaff. When an auto dealership closes, the credit manager, sales manager and service manager are all out of a job, not just the floor sales reps and the cleaning staff.

I don't want to overstate this. But the political implications of economic distress that really touches the midle class and the upper middle class in this country is unexplored territory. Conventional wisdom is that the reaction will be conservative--politically and socially. I don't doubt for a minute that in this instance there will be a conservative social reaction. But the political one is harder to call. The political right is so thoroughly tainted with responsibility that it is difficult, for a couple of election cycles, at least, to see it benefiting, even if Team Obama flubs completely. If Team Obama muddles through, I could see a shift to the right as the slog gets longer and longer and memories fade about how the mess came about in the first place. But, in the short term, it's hard to see it.

In terms of historical precedent, I'd offer two conflicting possibilities. One is the rise of fascist tendencies in '30s Europe. The other is the Populist/Progressive movements in the United States of a century ago. I'd guess we're more likely to see a reprise of the latter than the former (in the United States, at least), but I'm far from certain.

Criminalizing Financial Mismanagement

2009-05-12T21:19:00.000-07:00

A nuance that has generally been missed about the recent episode allowing the banks to negotiate the outcome of the stress tests is the practical consequence to those responsible for running those institutions. In their discussions with their regulators, they cannot possibly have appropriately qualified their representations and negotiating positions to take into consideration all of the internally available information tending to question or undermine the assertions confidently made to, and taken at face value by, the federal civil servants who, if events do not play out as projected, will ultimately testify in criminal proceedings that they were not apprised on the information available to the defendants that contradicted or undermined their criminal misrepresentations. Let a lay jury determine, in light of subsequent events, whether criminal liability should attach to those conscious decisions to present without qualification unfounded hopes as though they were grounded in fact, rather than result-oriented self delusion.

Give the dialectic time to work out. The stakes are getting higher, and, like gamblers three sheets to the wind, the players aren't cognizant of it.

Weapons of Class Destruction

2009-05-11T10:19:00.000-07:00

As we lurch towards a new global financial architecture, each country has something to learn from the other, and each has something to offer. In the spirit of international brotherhood, I'd like to offer some suggestions--about what the United States has to offer China, what China has to offer Russia, and what Russia has to offer the United States.

From the United States, the Chinese can draw valuable and specific lessons as to how various technocratic policies and initiatives can effectively work to refine and fine tune a powerful, globally competitive economy. While the example of the last 24 months isn't particularly edifying, U.S. policies drawn from the second half of the last century can be mined for extremely valuable precedent.

From China, the Russians need to take away a more impressionist sense of how better to accomplish the transition from a command and control economy to one that unleashes the productive potential of a large population occupying a continental space. Over reliance on natural resources and preferential dismantling of state enterprises transforming former managers into oligarchs did not work so well as continuous agnostic meddling. The first step is for the apparachiks to acknowledge they have something to learn from the Mandarins.

From the Russians, the Americans need to learn how to deal with their oligarchs. The first step, of course, is to stop thinking of the financial oligarchy as a meritorious elite in any sense, and admit the cognitive capture of the regulators by Wall Street. Then, redefine the Masters of the Universe as Enemies of the People. The Masters of the Universe were, after all, the ones who orchestrated the evisceration of the American economy and the conversion of a productive citizenry with savings into a mewling horde of consumers indebted up to their eyeballs. While showtrials and bullets in the stairwell aren't in the American tradition, tarring and feathering certainly is.

What we need are weapons of class destruction that maximize wealth impairment while minimizing the loss of human life.

Happy Mo-Fo Day!

2009-05-10T21:27:00.000-07:00

On behalf of hedge fund managers, financial services CEOs and other Masters of the Universe, I wish to publicly protest the injustice of this Hallmark Greeting card holiday called 'mother's day'.

Why doesn't the public celebrate Mother Fucker's Day?

Yes, the financial elite has captured the commanding heights inside the Beltway. Yes, we have secured the better part of a trillion dollars to support our equity, and God knows how much more for the preferred, the debtholders, the counter-parties, and the control group. But how much respect, how much affection, has accompanied that niggardly acknowledgement of just how necessary financial oxygen is for the morons to keep on breathing.

We want the morons to worship us as infants worship their mothers. Suck on this!

A Mexican Standoff

2009-05-05T15:54:00.000-07:00

Or, more appropriately, a Chinese American standoff. Here, in a nutshell is the situation:

1. The Chinese are nervous about holding large dollar denominated foreign reserves, but are also nervous about allowing their currency to appreciate. The only way to keep the currency to appreciate is to buy dollar denominated assets in sufficient amounts to keep that from happening.

2. The Americans want the Chinese to allow the Chinese currency to appreciate, but need the Chinese to continue buying U.S. government securities to finance the American deficits (fiscal and trade). If the Chinese were to stop increasing, much less begin liquidating, their dollar holdings there would be a serious problem.

So, the Chinese cannot achieve their currency objective without continuing to finance the American deficit. The Americans may lecture on currency manipulation (lecturers fallen silent recently) but urgently need the Chinese purchasing presence.

What makes this situation unusual, from an American perspective, is that the outcome is dependent more on how the Chinese assess the situation than on any American initiative.

The United States is in the unfamiliar position of responding to the policies of others, rather than framing an initiating its own. This is Un-American, and a situation ripe for miscalculation.

Neo-Marxist Caveats, Part 2

2009-05-03T09:53:00.000-07:00

The first step towards assessing the current American situation employing a neo-Marxist analysis is to assess the Marxist approach itself in little of current circumstances. In particular, the continuing conceptual viability of several of the key building blocks of the approach is questionable.

The first of these is the notion of defining class in terms of relationship with the means of production. Forest of trees have died, and oceans of ink have been spilled in an effort to define class, which is a slippery concept indeed. A bit less attention has been devoted to defining the idea of 'means of production', mostly, because doing so actually requires some understanding of how things work, how work is done and all sorts of grubby details about all sorts of odd little backwaters in which the vast majority of humankind labors.

Suffice it to say that a mid-19th century focus on the industrial wastelands and imperial steamship routes of the dominant European nationstates of the era are about as relevant to the beginning of the third millenium as exegesis of Sharepeare's bare ruined choirs of 16th century Catholicism would have been to understanding the 18th century Enlightenment on England.

I would be inclined to acknowledge from the get go that class is defined in political and social as well as economic terms, and that the 'means of production' has to be understood to mean something radically different in a service dominated economy with an significant public sector than it did a century and a half ago. That said, focusing on what makes fmembers of the population productive (or economically autonomous) rather than blathering on about the "American consumer" or the "consumer society" or looking to renewed credit flows to stimulate consumer spending as a way out of the economic malaise is probably a step in the right direction.

A second major caveat to a neo-Marxist analysis is what I'll call the Freudian problem. Like Freudian analysis, Marxism was a product of a time and place, and it's not at all clear how well either travels through time and space so as to be usefully applied elsewhere (even assuming that they served explicatory purposes where they originated). There can be perfectly valid, local belief systems that organize human activity and regulate human conduct that do not serve the came purpose once exported. Voodoo and witchcraft may have local power in Haiti, but in New Orleans, they are merely camp. Clearly, the Freudian approach to understanding the human mind was premised on a set of bourgeoisie family relationships that were simply not to be found in, say, the Japanese imperial court or an Amerindian tribe.

A fair amount of the Marxist tradition falls prey to the same tendencies. There is a progressively more complex self-referential conceptual trend of increasing refinement that is progressively less-intelligible to outsiders and, indeed, less and less concerned with the external world and more and more focused on the internal balance of philosophical construct.

This criticism is not, however, confined to Marxist philosophical developments. No fair minded legally trained American can help but look on the development of First Amendment jurisprudence and not marvel at how we have tied ourselves in knots in a similar fashion. The ancient criticism of the Scholastics debating how many angels can dance on the head of a pin shows similar theological tendencies. So, while the Freudian analogy is cautionary, it is not a grounds for discarding the approach.

Basically, this is boiling down to a question of whether one can identify groups of actors sufficiently well defined by their roles to be deemed classes, and whether those actors have a reified class consciousness that determines (in some sense) their actions.

Neo-Marxist Approach, Part 1

2009-04-30T21:07:00.000-07:00

It's time to put the politics back into political economics.

The Financial Times is taking a first tiny step by introducing ideas of behavioral economics into the discourse. But that is a timid, trivial and bourgeois approach to a bigger problem.

Let's begin by accepting that the current analytical framework is roughly as bankrupt as the financial services sector that crucified the general economy on its own contradictions. So, folks are casting about for something a bit more, er, operative.

There are some serious problems with attempting a neo-Marxist construct to explain the current mess. And that's leaving aside the delicate American queasiness at being labelled a socialist, a commie, a pinko, or anything of that sort. Forget, for the moment, that queasiness, or at least enjoy the outre opportunity to leave respectability behind.

First serious problem is that state directed economic production schemes utterly failed in the 20th century. Call it communism. Call it socialism. Call it state planning. Call it Marxist-Leninist. As a way of organizing complex economic activity, the approach which had its genesis in the writings of Karl Marx and Frederich Engels in the mid-19th century failed the test of history. Their thoughts, as developed and implemented by their followers and adherents, were relatively inferior to alternative approaches to organizing collective economic activities. This approach failed in multiple cultures and different societies. So, let's not even suggest that Marxist-Leninist state planning provides a viable approach to organizing and regulating the economy of a developed or developing country. But that doesn't mean it doesn't offer a tool with which to critique the current situation.

Second serious problem is that no one, and I mean no one, has been pursuing seriously an attempt to apply this analytical framework to the current economic situation for at least a generation. Following the collapse of the Soviet Empire in Eastern Europe, I believe all the departments of Marxist-Leninist studies were shut down. In the West, the few adherents of the approach focused themselves of issues of social justice, income distribution, and the like--not so much attempting to understand the prevailing economic system as critique certain of its outcomes. And most of those guys are either dead or pensioned off. There is no expertise, and there are no experts.

Third serious problem is that there is no coherent and agreed theoretical framework that can be applied to the current crisis. There are (or were) as many flavors of Marxism as there have been flavors of ice cream in the last century or so. And they've all melted into a big puddle. On the other hand, this may be an advantage, since it would allow picking and chosing, adapting and applying what's useful, while leaving the rest of it in the intellectual recycling bin.

With those caveats, we proceed.

Stale News Remains Important

2009-04-29T13:45:00.000-07:00

Some things to remember if you want to anticipate the future:

1. In the United States, the financial services sector is and will remain until recapitalized, insolvent. This is a solvency problem, not just a liquidity problem. 6 of 19 per the leaked stress test results, need additional capital. And that's the official story. We need to learn how to get along without those guys.

2. U.S. house prices are and will continue to decline, making it impossible to value a huge chunk of assets critical to financial services sector liquidity. The sociological consequences of unemployed company store peons trapped in real estate they don't own are interesting. And, commercial real estate is in the early stages of joining the residential stuff in a revaluation. While the trajectory is the same, the commercial stuff will be, ah, lumpy, and less suceptible to smoothing.

3. The regulatory apparatus has been captured by the financial services sector. Whatever squabbling is under way within the political classes (viz., the competitive outing of Raul Emmanuel and Larry Summers this month, and the Thain/Lewis catfight, with Paulson calling the count), has yet to metastize into a purge of the financial elite. While bullets in the head aren't called for in America, a rather less drastic purge in, ahem, called for. This is, incidentally, a global issue.

4. The epicenter of this particular crisis was in at the heart of the developed world, and that is where the pain is most likely to be felt most intently. Countries like China, India and Brazil have an opportunity to, if not displace their betters, at least join them at the high table. If that happens, look for some changes in the menu.

And that is the way it looks from here, today.

Why I Mock John Maynard Keynes

2009-04-21T10:57:00.000-07:00

In case anyone has missed it, we are in a bit of a fix financially, on a global basis. The policy works and mandarins of assorted stripes generally responsible for keeping this sort of thing from happening are perplexed, and more than aggravated that a number of the formerly reliable levers that worked when employed now produce--when tugged--nothing. New techniques from the bottom of the toolbox are being taken out--quantitative easing--and much dark muttering of 'pushing on a string' can be heard in the distance, in the darkness.

So, if the macroeconomic tools of a lifetime and the institutional expertise of the worlds central banks and international monetary authorities has most its magic, it's time for something else. Because most of these guys were trained in the second half of the 20th century, and because John Maynard Keynes was the fellow whose approach had been most recently superceded, there is a group grope of the Keynesian canon, for something that, if not functional, at least sounds profound.

That's why I mock all the invocations of J.M. Keynes. If you actually go back and read the guy, he has some interesting observations that shed light on the current mess. For that matter, so does Ezra Pound. But the solution is no more to be found in Keynes' writings than in Pound's Cantos. And the aspects of Keynes that are being invoked are among the least interesting of his observations (to me, at least, I find his policy prescriptions pretty pedestrian, while his conjectures on how his world got in its fix quite intriguing in the application to the current fiasco).

So, my first alternative is Marxist economic analysis. Unfortunately, while the Marxists have some great one-liners, as I've tried to deploy what I remember of Marxist economics to the current situation, I find that it really doesn't work very well. It is destructively inspirational, rather than immediately applicable.

But more of that another time.

Bank Earnings

2009-04-20T13:42:00.000-07:00

Okay, confession time.

I personally have been involve--not within any applicable statute of limitations, I hasten to add--in the preparation of quarterly and annual earnings reports for publicly held financial institutions. As a matter of fact, one of those institutions is, today, buried deep inside the AIG mess, and for my services to that predecessor entity I am entitled to a small pension which, a recent communication from AIG assures me, is safe. I happen to believe that communication because the pension is so small that it's guaranteed by the PGBIC so, while the dollars in which it is paid may be worth far less when I receive them than anyone would have anticipated, I would assume that when the times comes, I will receive my pittance in what script is then legal tender.

Based on personal experience, I can say that, with the most honorable of motives and the best of intentions, accurately reflecting the financial results of any financial institution in a quarterly or even annual time frame is an exercise in subjective judgement, and, to put it mildly, reasonable people can differ. Based on what I'm seeing as a member of the great unwashed, I cannot tell whether the motives are honorable and the intentions above reproach with the financial institutions currently reporting their earnings, but these are stressful times, and such times test the mettle of all involved, a certain number of whom always fall short.

So I can understand how some of the the banks are actually reporting earnings. What I can't understand is why.

Citicorp reports earnings. But those earnings are dwarfed by an item that reflects the impairment of the value of its own debt (which is only impaired because of doubts about the enterprise itself). In other words, they are making money by going broke. Or so they claim. Wells Fargo is reporting record earnings at the same time that it is adding to its loan loss reserves in amounts that are virtually certain, in hindsight, to seem laughable. Goldmans Sachs is reporting earning, but its CFO is essentially lying to the public about the benefits Goldman received from payments on AIG CDS and the firm orphaned the month of December.

Why? These guys are setting themselves up for serious trouble down the road. The phrase 'buying time' comes to mind, but buying time only makes sense if you expectd something to change. And the way the political classes and their technocrats are going to remember this will be truly ugly sometime between the World Series and Thanksgiving. The first quarter will be remembered as when the banks reported the government bailout of AIG as their own profits.

That may be simplistic. But there is enough truth to it that it will stick. Fooled me once, shame on you. Fooled me twice, shame on me.

Fiasco 2.0 The Pension Funds are Broken, too.

2009-04-19T17:13:00.000-07:00

Just who are the victims of the current mess?

It's easy enough to say that we all are, but that really isn't true.

Are homeowners who used their houses like ATMs to finance everything from their children's college educations to trips to Disneyworld? Are we really going to try to differentiate between those who borrowed for praiseworthy ends (presumably the former) and those who didn't (presumably the latter). Are the first time home buyers who bought into the American dream at absolutely the wrong time? Are the amateur real estate speculators who loaded up on liar loans because they'd attended one of those make a million dollars in real estate using other people's money seminars that used to advertised so profusely?

I suppose the first time home buyers are more sympathetic victims than the high school principals trying to get rich after taking the early retirement package. But, so what?

It's fun to bash the perps--but to what purpose?

I mean, I see the importance of enforcing fraud laws at the local and community levels, and pursuing exemplary justice not merely in the cases of appraisers, mortgage brokers and title companies, but straw borrowers and those who took out the liar loans, as well. I see even more importance and purpose in systematically destroying the financial elite that has grown up with a parasitic financial services sector that no longer serves the needs of the general economy but rather milks the general economy insatiably for its own gaming and profit.

Here is my concern for today--pension funds, endowments and other investment pools that exist to meet non-economic social needs. These things truly are victims of the current mess. Whether a foundation is going to have to curtail its funding of the programs it was created to pursue, a university is forced to reduce its research and educational activities to conform to its resources in a new environment, or a pension fund has become unable to meet its actuarially defined future obligations, a social problem has been created that may have a financial genesis, but doesn't have an economic solution.

Focus on the pension funds. A pension fund is a pool of assets that should be matched to a pool of liabilities. Historically, pension funds have made unrealistic projections of their managers' abilities to generate financial returns from those assets and when the managers actually had good couple of innings, the sponsors used the excuse of overfunding to reduce contributions or even capture the excess. Now, hit the present. The liabilities of pension funds are relatively unaffected by the current financial crisis. But the valuation of their assets most certain is.

Even if the general economy stumbles to some kind of recovery, there will be another round of crisis. Globally, financial assets are taking a hair cut. Globally, liabilities to current and future pensioners have not. That is going to create the mother of all asset-liability mismatches.

On one level, this is the problem of the so-called Social Security Trust Fund, and it is no big deal in terms of economic policy, because it is a demographic problem (a hairy demographic problem, but a demographic problem, nonetheless). But, unlike Social Security, a program of the federal government, private pension funds are, well, private. They have sponsors with limited legal obligations to make them whole, and they have the ability to become insolvent. There is a modest federal underpinning to the whole thing, of course, the Pension Benefit Guaranty Corporation, but it will be looking to its Treasury backstop long after the FDIC has pumped that well dry.

Perhaps, once again, poverty will be the companion of age.

Is Team Obama Clueless?

2009-04-18T10:09:00.000-07:00

It is difficult not to be sympathetic to the observation that making policy (or managing an institution) is more difficult that usual when the consequences of decisions play out in so many unpredictable ways. In uncertain times, outcomes are harder to predict, so caution is the order of the day, and any undertaking must begin with an acknowledgement that success or failure will depend or more than just the ingenuity of the strategy or the efficacy of its execution.

That said, we are witnessing some decisions that appear to have been made with no consideration whatsover of their consequences. Not the second order effects, or the knock on consequences, but the basic cause and effect issues. I'm not sure if the Obama administration's stress testing of the major TARP recipients had its genesis in a speechwriter's desire for a good soundbite, a business as usual misunderstanding several layers down in the regulatory bureaucracy or a profound misread of just how interested a number of vocal constituencies would be in the outcome. But it appears to have been set in motion with no clear sense of what the outcome would be, almost as though the government is simply curious about the financial condition of the financial services sector.

These guys now appear to be floundering like students who haven't done any of the work and the mid-term is looming. Getting sick and rescheduling has already pushed back the deadline. But sooner or later, the results of setting the process in motion are going to come out. One way or the other.

And these guys have put themselves in the worst of all possible worlds. To the extent that institutions show healthy, the test itself will be damned as insufficiently rigorous. To the extent that weaker institutions are highlighted, the grounds are laid for an immediate culling of the herd. Perhaps that is a good thing, since it will facilitate the piecemeal dismantling of the financial services sector, which is necessary, but would be hard in a single pass. However, is difficult to believe that the stress tests are a blow in an ongoing campaign to dismantle the financial services sector, given the time, effort and treasure that is going into propping it up.

It's one thing to take a calculated risk and fail. It's quite another to make a move with no appreciation, not even of the risks involved, but of the dynamic you're set in motion. The ongoing saga of the stress tests appear to be a good example of the latter.

Republican Treason

2009-04-17T08:22:00.000-07:00

This is slightly off topic for this blog.

What gives with the Grand Old Party? Yesterday, at some kind of staged right wing political event (a 'tea party') the Governor of Texas floated the idea that Texas just might secede from the Union. His trial balloon went over like a lead balloon and today he is busily backtracking. But he is on tape, just like the governor of Illinois trying to sell Barrack Obama's senate seat.

This isn't the first incident along these lines. Several years ago Sarah Palin was a speaker at the annual convention of the Alaskans for Independence movement. She got a free pass during the presidential campaign I suspect because she played the 'my husband made me do it' card (Todd Palin is the seccessionist family member, apparently he doesn't do the dishes, can't see Russia from his kitchen window, or fails to appreciate the concept of strength in numbers).

Palin and Perry are not trivial politicians. Two of the three most populous states in the country have Republican governors, and Perry is governor of one of them. Of course, Palin was the Republican vice presidential nominee in the last presidential campaign, as well as being the sitting governor of Alaska. What gives?

Now, treason has a highly technical definition in this country (unlike some places). For Perry and Palin, the two or more witnesses requirement is satisfied. I'd leave it others to decide whether travelling to and participating in an event promoting the dismemberment of the Union constituting an action aiding the enemies of the United States. FWIW, on the law, Perry might have the better defense, since Palin's Alaskan whackos are presumably serious and presumably plan their events to promote their purposes, while Perry just got carried away at a made-for-media right wing shennanigan.

Why is this getting any attention? I suspect it's an early warning sign of some fairly significant stresses the body politic is about to suffer. The issue of whether the United States are a single country was decided almost a century and a half ago (indeed, Texas was part of that failed succession). But what holds the country together today?

Since World War II, external pressures have played an important role--but now that the old Soviet Union has dismembered, despite the putative threat of militant Islam, those pressures are dialed way, way back. It is a common culture, set of values, and world view? While there continues to be general acceptance of the importance of the institutions of civil society, the rule of law, and a bland non-challenging secular mindset, the praise of diversity, exaltation of tolerance and confinement of religious issues to a private spiritual sphere of the individual citizen have privatised those previous commons.

These aren't easy questions. Almost makes me wish for the good old days of 2006. Back then, leading Republicans refrained from treasonous sentiments, and satisfied themselves with insider trading (Senate Majority Leader Bill Frist), playing political bagman (House Majority Leader Tom Delay) and molesting teenage boys ((House Whip Thomas Foley).

Six Factoids: Oregon v. China

2009-04-16T08:36:00.001-07:00

I live in Oregon, but I pay attention to what's going on in China because, well, because it seems like a good idea.

Here are three little Oregon tidbits in the last week or so.

1. Citing inability to obtain construction financing, the developer of a 32 story downtown Portland office building abruptly halted construction on the project last Friday. Right now the building-to-be is a hole in the ground with the foundation poured behind Nordstrom's and next to the Fox Tower (primo location). I'm sure there is more to the story than has been made public, and the blather about redesign and resumption of construction in 2010 is just that.

2. The Oregon unemployment rate shot up to over 12% in March, probably the highest in the nation, according to the state official making the announcement. The increase in unemployment was attributed to previously non-working people entering the job market, rather than job losses. In other words, there is some movement between U-6 and U-3. That movement is probably the most important aspect of the factoid.

3. When it adjourned several months ago the State Legislature announced with great fanfare a program to create 3000 new jobs immediately. Last week the state agency responsible for tracking such things reported that 16 new jobs had been created. Congrats to the 16 lucky winners!

Meanwhile, across the Pacific pond--

1. China has become the world's largest domestic auto market, selling more than a million cars a month. This is probably temporary because the U.S. auto market runs a good deal higher than that before it crashed, and should again assuming we get back to something resuming 'normal', but China's new status is a comment on the effectiveness of their stimulus efforts.

2. Chinese banks are attaining the lending objectives established by the central authorities--in other words, credit creation has resumed in China. They are probably making a lot of bad loans, but the stimulative purpose of the credit creation is being achieved with a speed that the developed world is having trouble matching. This is a bit of a head scratcher, because it calls into question some of the premises of how our own financial sector is organized and why it is coddled.

3. The Chinese central government is busily telling its public that their economic fate is dependent on what happens in China, not elsewhere in the world. They appear to be making a concerted effort to get that message out as broadly and persuasively as possible. This is important for a couple of reasons--it suggests they expecting further export deterioration, they want to prepare their public for massive forex losses and for the time being they are eschewing the strategy of blaming their country's problems on the foreign demons. The first is a no-brainer, the second is simply prudent, and we should all be grateful for the last.

Okay, annetdotal evidence is a lousy substitute for reasoning and analysis. But, sometimes it's worth paying attention to what's going on around you. Otherwise you get blindsided, drift off into irrelevance, and miss out on a great deal of life's daily entertainment.

Fear Greed and all that follows

2009-04-15T07:47:00.000-07:00

Right now we are watching a conflict blossom between the financial elite in this country and the political class. This is kind of fun because for the last generation the political class has turned itself into the handmaiden of the political elite (a handmaiden being a euphemism for an Emperor's Club escort), and the financial elite has come to regard the political class with all the trust and respect an Emperor's Club escort gets from her john.

Now, the financial elite collectively has a world view that would have fear and greed serving as the emotional yin and yang driving human behavior. And God knows there is room for the intrusion of behavioral sciences into economic analysis, and it is finally beginning as an offset to the quantative approach so mainstream today. (Fear and greed is just a simplified and bastardized summation of the consideration of behaviorial aspects of market performance and those who worship at the altar of Keynes may prefer the term animal spirits.)

But there is more to the world that fear and greed. Enter the political classes, an intrinsically messier group of people than the financial elite. Traditionally these guys have had their own simplistic yin and yang of the levers of power--the carrot and the stick. The donkey carries his load--feed him a carrot, the mule balks--smack him with the stick. It's roughly as sophisticated as the fear and greed analysis of market movements, and every bit as useful.

The Emperor's Club escorts are still operating on their johns' terms. They are thinking in terms of fear and greed. They need a dose of the old paradigm shift. As the freed slave told ole' Massah, 'de bottom rail on top now.'

It will take a couple of months, and a few more cards will have to turn, but eventually, the political class, or at least some of the less bent over elements within it, will realize that carrots and sticks, not fear and greed are what are operative in the current environment. It would premature, at this point, to start publicly brandishing the stick. It would not be premature to discontinue the endless appeals to greed to get the financial elite to do what it needs to do to salvage its sorry situation. It would not be premature to stop denying the realities of which the public is properly fearful. It would be premature to begin privately reminding people of influence within the financial elite that the stick does exist and has been dusted off. (The best targets for such reminders might be board members, legal counsel, asset managers, anybody but the managements of the institutions themselves, who would find being cut out of the loop even more terrifying than hearing the news directly.) The pretense that this is a liquidity crisis and that we are all doomed if the banks fail is growing thin.

The banks have failed, we are not all doomed, or at least we are not dead yet. But we need to start preparing for the world to come, rather than trying to prop up what's already dead and resuscitate the zoombies.

Patience, Process and Pianos

2009-04-14T07:42:00.000-07:00

"See it, solve it, fix it," is the modern day technocrat's translations of "veni, vidi, vici." There is a tendency to look at the mess in the financial services sector, take a look at the state of the general economy, do a down and dirty on just what that means for real estate values, credit card receivables and corporate credits, and reach the inarguable conclusion that the banks are currently insolvent, individually and collectively, that the passage of time is only going to make things worse, and that the only question is whether a few of the strongest ones will tumble into the abyss without government life support from their own stupidity or because of systemic issues of counterparty risk. But that question isn't very important from a systemic perspective--it amounts to debating the seamanship of the Somali pirates.

Having sized the situation up, then it is a simple matter of solving for 'x'--in this case a healthy prosperous private sector banking system meeting the needs of the general economy and providing plenty of post-public service enrichment opportunities to the political classes. Having seen it and solved it, fixing it comes next. This is the part most people aren't very good at. At least not the people who become consultants, venture capitalists, lawyers, professors, investment bankers, analysts, technocrats.

It should not be particularly difficult, assuming everyone involved understands on which side their bread is buttered, that the public is cut out of the process (I'm afraid that 'populist' and 'public' have the same Latin roots), and this inconvenient internet technology invented by the venture capitalist vice president Al Gore doesn't blow the lid off the sausage maker. Still, even without the internet, the sausage maker is perpetually gummed up. I guess everybody's too good and too smart to learn how to take it apart or get their hands dirty cleaning it.

I am as guilty of this as the next technocrat or policy wonk. To paraphrase T.S. Eliot, between the thought and the deed, between the word and the action, falls the shadow.

We are in the shadows now.

There is a dynamic at work that no one is commenting upon. Everyone is growing impatient. Those noted Republican populists Richard Shelby and John McCain are calling on the president to allow Citigroup and Bank of America to fail. Because he won't take decisive action, Obama's supporters to the left are muttering about regulatory capture and threatening to wash their hands of him on the grounds that he's sold out to Wall Street. As for the vaunted stress tests, some are contemptuous of them, some are confused by them, and many are bored with them.

I tend to think of the stress tests as a political fig leaf. Fig leaves can serve a purpose. Travelling through Italy last year, I saw a fair number of fig leaves. It was easy to think of them as rather silly, but they served their purpose. At least, when the choice was being made, instead of getting rid of a significant piece of sculpture and replacing it with something vapid and chaste, there was a minor debasement of a major work of art, which survived as a consequence.

Step back, and regard the current situation as an unfolding dynamic. At the end of the day, all of the major financial institutions in the country will have failed. The survivors will have been chosen by the government, capitalized by the government, and initially managed by the government. While they may continue the wear the colors of the gangs that destroyed them (the Stage Coach may well roll on, the house of Morgan may remain in the lexicon), they will be defined by and dictated to by regulatory authorities more focused on their meeting the needs of the general economy than their maximizing value for their shareholders (assuming they have any).

However, this is a result that is going to take time. Bluntly, the banks must first fail, and the financially elite utterly discredited, before the political will to reform the financial services sector will develop. Even then it will not develop unless the failure of the financial services sector has a sufficiently vicious impact on the public. No one in there right mind would wish for that latter. Unfortunately, if the current regime of technocrats (Bernacke, Paulson, Geithner, Summers, etc.) are correct, that vicious impact is inevitable if there is a systemic failure. So, they are in denial of the possibility of a systemic failure.

It is liberating to say that there is a possibility, verging on inevitability, of a systemic failure, and to start thinking about what comes next. It then becomes possible to start considering steps to ameliorate that vicious impact (recognising its inevitability), and reform the financial services sector, rather than revolutionizing our current forms of economic organization.

I am currently, in my dotage, learning to play the piano. Playing the piano, for an adult, is an interesting discipline. A piece of music has a tempo, it proceeds on a beat. A sure way to muck it up is to hurry it up. It must be allowed to unfold at its own pace. You can't go fast through the easy parts and slow down when it gets hard. And, as you master the piece, you discover that it has a dynamic. To interpret the music, you have to be able to express the dynamic.

That's where we are in the reformation of the financial services sector.

Larry Summers?

2009-04-13T11:00:00.000-07:00

Is Larry Summers going to be the Andrei Schliefer of the Obama Administration, or is he merely Henry Kissinger without the refined moral compass?

In any event, I doubt we'll ever hear about Larry Summer praying on his knees with a scotch-sodden Obama. Ultimately, Obama will go looking for siloviki.

A wonderful thing about the internet is that it makes footnotes and explanations less needed. Simply google or use wikipedia for 'Schliefer', 'siloviki' or, for that matter, 'Kissinger' or 'moral compass', depending on your age.

Of Arabs and Arbs

2009-04-12T08:08:00.000-07:00

The two words sound about the same in English spoken with a West Texas twang. Just ask the guys who ran El Paso Natural Gas into the ground back in the '80s.

The good news is that if you are still alive, your way of life will probably survive the current financial crisis. The bad news is that you may not survive the next one, which is coming, and if you do survive that one, there is another one coming after that.

I tend to look at the current situation as though it had two components--a severe recession in the general economy and a solvency crisis in the financial services sector. I'm in good company taking that view, but it's important to remember that the one affects the other--so that the recession was triggered by the financial services sector liquidity crisis, and the future solvency of the financial services sector is virtually certain to be impacted by deteriorating conditions in the general economy.

That said, let's statically assume that the stimulus package will 'work', bolstering the level of economic activity and buffering the worst of the recession's impact (without regard to the failure of the social safety net in the current environment). And let's assume that eventually one of the bailouts does the trick and we have a financial services sector in which, even if lending activity is non-existent, the comp committee is meeting again. In other words, the recent bear market rally correctly discounting an imminent mild improvement in short term economic conditions (I leave for you to decide whether that is merely a slowing or end of the deterioration or an actual improvement off the new base--nobody is realistically projecting a return to the glory days).

What does that success buy us? I think it buys us two things. First, it will give the feedback loop time to run from the general economy back into the financial services sector. Already weakened financial institutions will have to absorb the consequences of the recession (remember that the current capital crisis came out of the clear blue sky in a healthy general economy, this new event is much more typical). Of course, whether, even with government injections, the institutions can find the capital buffer to absorb that is a problem for another day (i.e., the next crisis).

The second thing that it buys us is time to deal with the issues the People's Bank of China has begun ventilating in articles and speeches by its personnel and on its website. In the most thought provoking thing I have read this month was Martin Wolfe's conjecture that these concerns will lie at the root of the next global financial crisis. Well, the premise there is that there will be another global financial crisis, and that it will come sooner rather than later. I think that's a sound premise. How it will be manifest--a currency crisis, a refunding crisis, inflationary pressures from monetizing the costs of the bailout--is a topic for the future.

The human mind is wired so that it vividly remembers major events, but memory tends to screen and obscure the details of the circumstances of those events and the mechanics by which they unfolded. There is a great deal of talk about the Great Depression and the 70s, but most of it omits the gritty fact that those Big Events were actually a series of smaller, cumulative crises that unfolded through time, frequently with the policies intended to address on crisis triggering the subsequent one. In neither of those situations did the internal dynamic of a market economy, as tweaked by the inputs of technocrats in positions of regulatory power, determine the more important outcomes.

As much as the economists are clutching to John Maynard Keynes and The General Theory, it might be time to recall The Dialectic of History, too.

Financial Innovation

2009-04-11T09:42:00.000-07:00

Financial innovation is to innovation as theft is to wages. For both the thief and the worker, there is certainly economic gain from their industry. It is a bit harder to see the broader social benefit from the activities of the average thief than it is find benefit from the productive efforts of the average working person.

The use of terms like 'financial engineering' to dignify gaming schemes and regulatory arbitrage with some quantitative aspects should offend both linguists and engineers. Most derivatives and swap products are simply insurance contracts for which no adequate reserving was undertaken. The fact that the regulatory regime was so weak that it was possible to do this offers no excuse for the organizations that took on the risks without appropriately underwriting and pricing them. Those organizations were, after all, private enterprises with a profit making goal. Some--AIG, in particular--even had the internal expertise to do it right. Instead, for whatever reason, they chose as their business model the casino rather than the insurance syndicate. And, even as a casino, they didn't get it right. They confused their gross with their net, and compensated the coupiers and the dealers out the gross, forgetting the need to payoff the winning customers.

Financial Markets Closed Today

2009-04-10T10:03:00.000-07:00

in the United States, but here is the question--are they working, even when they are open?

I guess that leads to two more questions--how do you judge, and which markets? For instance, the market for residential real estate isn't really a financial market, but I'd argue that the market for commercial real estate is. Clearly the equity markets are financial markets, as are the commodities markets, and as are the various markets (formal and informal) in which debt securities, credit swaps and the like a created, placed, layered and, sometimes, traded. That final collection of markets, with so many tailored instruments and so little liquidity is the one about which the biggest questions have to be asked.

Self-professed proponents of the free markets who know argue that we are facing a liquidity, not a solvency crisis don't generally distinguish between the equity markets valuing a financial institution's publicly traded securities, and the swaps markets in which that same institution surveys the landscape in vain for a credible pricing benchmark. But there is a real distinction.

Most commodities, real estate, equities, forex markets, etc., appear to be working just fine. You may not like the action, but they are functional if you judge them by three factors--does the market in question provide adequate liquidity for most purposes, is the price signalling generated by trading activity generally accurate for most purposes, and are the transaction costs reasonable (not optimal, and not frictionless, mind you, just reasonable).

The markets for debt instruments and their derivatives are another kettle of fish. Those markets are the sources of the anomolous price signalling that The Financial Times reports every few weeks--interest rates going negative, corporate default projections in excess of 100% of principle, and so on. In a functioning market, arbitrage would eliminate those before Lex could highlight them in a mocking squib.

Perhaps the best argument for unwinding the casino, and banning further financial innovation for a generation or so, is that it would allow time through custom, practice, trial and error and a generation of practical experience, to develop the norms, procedures and institutions necessary to a sophisticated financial market. That may not be the conclusion a true believer in the free market would promote, but I'm not a true believer in the free markets anymore.

The Politics of All This

2009-04-09T06:42:00.000-07:00

First off, who knows if the bank bailout, whether in its current or in some future form, can work? Personally, I have my doubts, but they are grounded more general economic, cultural and political concerns than the specific financial mechanics of any particular program. Leaving those doubts aside, a bailout will work, or it won't work, one or the other. What are the consequences?

The economic consequences of a failed bailout are very bad indeed. But, I'll argue that, for the financial services sector, the political consequences of a successful bailout may be even worse. It is a matter of timing.

The current recession is still gathering steam. More likely than not, it will bottom out, perhaps on the schedule predicted by the all-powerful Fed Chairman, sometime next year, maybe a bit before. But bottoming just means things stop getting worse, more or less. So there we sit, with double digit unemployement, most of the country upside down on its mortgage, our cars are getting older, and so are all the other baubles imported in the glory days. The cult of the CEO is a dim memory. Paris Hilton and the celebutantes an embarassing one. Thin may still be in, but rich won't be.

Meanwhile, TARP has turned out to be a huge success. Banks are again profitable. All the losses from the housing bubble's collapse have been nationalized, but the customer gouging profitability of an oligarchy of regulatorily privileged financial institutions has been re-established.

Something tells me the public perception of all this will not be that Ken Lewis and his ilk were far sighted visionaries deserving of all the wealth bestowed on them by their grateful boards of directors. Something tells me you'll get a nice slow burn that will just grow until it finds an outlet.

Four Good Three Bad

2009-04-07T16:38:00.000-07:00

Looking at the Case Shiller numbers for January, here's a down and dirty reaction:

The three worst metropolitan areas in the country to own a house are Charlotte, NC, Portland, OR and Seattle, WA. The four best are Atlanta, GA, Cleveland, OH, Dallas, TX and Denver, CO.

On the eventual level of housing prices, everyone else is free to predict how low they will go.

But the basis for my prediction for those seven markets is as follows:

Those seven cities have experienced relatively mild housing declines to date (all less than 20% at a time when the national average is 30%), so the question is, of the cities that have suffered least so far, which are most likely to get a pass on the national nightmare, and which are most likely to have their worst ahead of them (in other words, which will have relatively less severe house price declines and which will have declines that are delayed, but every bit as severe as those elsewhere in the country?).

When you look at how far back the declines to date have taken price levels in various cities, an interesting bifurcation opens up. In Atlanta, Cleveland, Denver and Dallas, even though price declines have been relatively moderate, housing prices are back to 2000-2001 levels (nationally, price levels have not retreated quite that far). In other words, the bubble has been deflated in those cities as much or more than it has in places like Phoenix, Las Vegas and Tampa (where housing prices have only backed down to 2003-2004 levels). The bubble never developed to the same extent in Atlanta and its peers that it did in Phoenix and such.

By contrast, house prices have also declined 20% or less in Charlotte, Portland and Seattle, but house prices have only backed down to 2005 levels. Assuming those places are as vulnerable as anywhere else to the nationwide correction currently underway, it would appear that it merely late reaching those areas, and that they have a considerable way to fall, if house prices in those cities are to return to levels comparable to those of roughly around the turn of the century. That is, unless there is something that reduces their vulnerability. That doesn't seem particularly likely. Even at the height of the bubble, Portland had a reputation for poor affordability, and, in today's economic circumstances, the dependence of the Charlotte regional economy on the financial services sector has to be worrisome.

Other people can provide a more sophisticated analysis of the national metric. For that, I'm sticking with an unwind, a regression to the norm, an overshoot and then a recovery. Time is the only independent variable and it's going to take time. My little contribution is in noting four good and three bad local markets.

When Do the Wheels Come Off?

2009-04-05T09:45:00.001-07:00

Or have they already?

It all depends on what you mean.

With last year's carnage in various financial markets, we've already bought and paid for a grim recession, which we're experiencing this year. No more carnage is necessary in the debt and equity markets to discount a great deal more future discomfort. As a matter of fact, the implied rates of default at which credit swaps are currently trading would suffice to discount a depression, not a recession.

So, higher unemployment, lower real estate prices (residential and commercial), and outright contraction in global levels of economic activity are already priced into the market. But their full impact hasn't yet been felt in the general economy.

That's all well and good at the macro level. At the more personal, individual level, though, the questions are more in the nature of, will my spouse keep his/her job? How far underwater are we on our house? Why is there only half as much in my 401K as this time last year?

Those are the questions of the merely worried. For the roughly 15% of the workforce captured by the U-6 unemployment number, the questions are a bit rougher, on the whole. (Incidentally, if you want to compare current employment to the headline 25% number tossed around for the Great Depression, use U-6, not the lower, headline U-3 figure).

That 15% is the group of people who are in the process of learning just how frayed the social safety net has been left about a quarter of a century of Reagan revolution, new Democrat reform and the Bush family ascendancy. I don't know what a laid off third year law firm associate does, with a six-figure educational debt, and utterly no prospect of replacing his or her $150,000 salary. But it's no wonder rents in Manhattan are plunging.

I think that most of the 282,000 people laid off so far from financial services sector jobs had the resources to keep going for a few months, maybe a year. By and large, they aren't the segment of the population living literally paycheck to paycheck. But, by and large, they are a population segment with very high living expenses, and backing down from the life style, particularly for families, is going to be a very tricky proposition indeed. More than a few DINK marriages will shatter, and when there are kids involved, I dunno. . .

This is going to be the first post war recession in which the impact falls as heavily on the service sector as that of past recessions has fallen on the manufacturing sector. And given wage rates prevailing in the services sector, that means that the impact will be felt higher up the ladder, well into the middle class.

And that is likely to have political ramifications. You can't eat family values or right to life rhetoric. Don't hedge fund managers and Wall Street traders make hate crime targets every bit as attractive as gays?

Between them and the pitchforks

2009-04-04T13:18:00.000-07:00

Reportedly, the president of the United States told a group of assembled financial services sector CEOs gathered at the White House a week ago last Friday that his administration was the only thing standing between them and the pitchforks. I don't doubt the accuracy of the report, though it may capture the substance of his message rather than the words he actually used.

I don't know how I feel about that. I would hope that there was a continuum on which to build policy, and not merely a stark choice between simplistic and retributive populist anger bringing down the house and a corrupt and entrenched financial elite a bit overdue for its day of judgment. I do suspect that the political classes in Washington has lost confidence in the financial elite to mend its own affairs, and is struggling with that. If Obama delivered a message like that reported, doing so would tend to confirm my suspicion.

Unfortunately, given the limited political acuity of the bubble boys who are financial services CEOS, I also suspect that the message is lost of them. What they heard was that Obama was like a Chicago cop on horseback doing crowd control in Grant Park. He's wearing the city's livery, taking his orders, and doing his best to keep order in the mob.

But if this continues on its present course, Obama will presently realize that this isn't a matter of crowd control and that the fire department and its high pressure hoses aren't backing him up--they've stood down to see who comes out on top. At that point, he'll understand that his People want to see the back of his head and the asshole of his horse as he leads their charge, not a handsome cop on a handsome horse sidling along the flanks of their protest, keeping them on the approved march route.

If it comes to that, we will have reached an interesting moment.

Bad News for (Financial) Pain Suffers

2009-04-03T09:31:00.000-07:00

I just read my first CNN article on the silver lining to the the recent financial cloudburst--relating the good fortune of a family that purchased, for $200,000 a house that had previously sold for a half million dollars. The gist of the story was that one man's misfortune is another's opportunity. Happy overweight dad and two his two daughters smiling at the camera. The losing former homeowner was nowhere to be seen.

I am afraid that the bad news of home price declines, with the theme of American dream turned into nightmare, has been mined for about all its worth. It is so 2008. A bit like the fall in the stock market. The new media event will be focused on life ever after, after the housing bubble popped, after the stock market meltdown, after debt fueled consumer spending shuttered into lower gear, in the new economy with its ongoing elimination of legacy sinecures being sequentially rooted out wherever they may be found in the old economy.

Don't get me wrong There will continue to be bad news. That last story--the death of the sinecure gig--will meane rising unemployment, and the next year may feature a dollar crisis of some sort. The auto companies have just begun their turn in the barrel, and don't count the financial services sector out--they'll be back this summer with some major institutional failures and outright government takeovers, then later, again, with a wave of indictments. I'm telling ya, that Wall Street story has legs. If there are any newspapers left to print it.

But the bandwidth devoted to innocent victimhood, of decent folks just minding their own business when, bam, they got blindsided, is about to contract. Look for uplifting tales of hardworking retirees returning to the workforce, making a new contribution and finding the good life in a new venue. With a little luck, maybe we'll have a morality play about universal health care coverage, and develop an approach to paying for universal medical coverage as good as the health care generally delivered to employed people in this country. That wouldn't just be a story, that would be social progress.

Remember, when we hit bottom, we start to look up, even if the recovery is the most gradual of hells.

Changing Perspective on the Bailout

2009-03-30T13:35:00.000-07:00

A shift in perspective is underway, and the public perception of the AIG bailout illustrates it.

Until very recently, the mantra weirdly reflected the 'good bank/bad bank' idea. There were good banks--like Goldman Sachs or JP Morgan, and there were bad banks--like Citi or WAMU. Also, of course, there were lousy banks will agility--Merrill or Wachovia. The government was busily bailing out the bad and the lousy so that the competently managed institutions would not be swamped by the splatter from the failing ones. This was the dread 'systemic risk.'

However, in the last week or so, I've begun reading descriptions of the AIG bailout that conceptually are dismissing AIG as a mere conduit for federal assistance that is, in substance, being received by the AIG counterparties. In other words, the ultimate bailout recipient is perceived as Goldman, not AIG, because Goldman was the counterparty receiving large sums initally channelled through AIG. This perception is being fanned by some lying done by Goldman and its spokesmen when The New Yorks Times attempted reporting the story last fall.

The minute you stop treating counterparties as innocent victims who, in the interest of addressing systemic risk, should be made whole, and start thinking of them as bailout recipients, you have taken a gigantic step towards a paradigm shift. We seem to be realizing that the so-called competently managed institutions were merely more adept at gaming a fundamentally flawed system. They were gamblers in the casino like the others, just a bit luckier or better at the odds.

Meanwhile, the Banks are . . .

2009-03-30T13:27:00.001-07:00

still insolvent.

Kid glove treatment they may get, while the auto manufacturers are slapped around. But the financial services sector remains insolvent, floating along in a sea of liquidity courtesy of the Fed and Treasury.

Personally, I'd like to see the TARP recipients treated like Chrysler and General Motors. But that's at least six months off. Of course, the more public money gets poured into them, and the more blatently imprudent their accounting becomes, the greater the baying for blood at the end of the day.

I also think that at least, with respect to Chrysler and General Motors, the federal government has a point of view, that is developing into a program, that will probably work. It will work because the resources are available to make it work. It will work because with a new capital structure the enterprises are viable because at a new price point their products are attractive.

The mechanics of a out-of-court cramdown are elusive. But a prepackaged federally backed reorganization with judicial blessing, out of which something that looks a great deal more like a German car company is the most likely result, at this point. That's assuming that the equity is wiped out, the debt takes a huge haircut, and all the pension liabilities are somewhow assumed by the federal government.

Meanwhile, the damage continues to grow on Wall Street.

Cognitive Capture

2009-03-27T09:19:00.000-07:00

Last August at the Federal Reserve's Jackson Hole Conference a European economist named Wilhem Buiter told his audience the federal regulators of the financial services sector had become the victims of cognitive capture and were no longer capable of regulating the institutions subject to their purview in the public interest. In this May's Atlantic Monthly, Simon Johnson, a former head economist of the International Monetary Fund will make, in essence, the same argument, in a more provocative form. He argues that the current American financial crisis resembles those that have struck emerging markets economies in the last generation not only in the unexpected suddeness of its onslaught (a liquidity event), but, more importantly, in the extent to which the local financial institutions have succeeded in establishing autonomy from local government, and, indeed, compelling government support for their own failing strategies.

Events since last August have tended to confirm Buiter's argument, and Johnson's article is a reasonable explanation for the ad hoc and disjointed efforts to date of the federal government to address the collapse of the money center financial institutions. In defense of the Paulson-Geithner approach, it's not clear that any better alternative was available, or, for that matter, is available yet.

The obvious takeaway is that the interests of the financial institutions, their executives and the providers of their capital must be subordinated to the public interest. A further takeaway is that the economic power and political influence of the financial elite must be clipped. The human part of this latter is oddly difficult, since it requires summarily dispatching a leadership that, as recently as a year ago, was popularly lionized in the cult of the billionaire CEO. Finally, and perhaps most difficult, some alternative to the ideology of the perfect deregulated free market has to be developed to underpin a different approach to the provision of financial services, and that is very hard to do on the fly.

The other, huge problem with the Buiter/Johnson argument is that it amounts to a restaurant review when what is called for is a new recipe. Still, it's a start . . .

But Will They Work?

2009-03-26T13:02:00.000-07:00

Or maybe a better question would be, what about the side effects or unintended consequences?

Right now the U.S. government is attempting to address the financial crisis with two unprecedented programs, each of which explores new ground. The Treasury is unrolling the much criticised Troubled Asset Relief Program, to great and sensible criticism that it will enrich a few speculators by guaranteeing the downside of their investment to encourage them to overpay for toxic assets and free up bank balance sheets. Over course, even if the assets change hands at prices above what they would clear in a market transaction, that price is likely to be below their carrying value on the books of the institution owning them, which will necessitate further writedowns and result in additional capital impairment.

Variation on TARP have been kicking around for six months. My sense is that six months ago there was far more confidence than there is today about the capacity of financial institutions to raise additional capital. I will predict that TARP will unfold as follows:

1. A few deals will be done.

2. The writedowns will be horrific, and the impairments will occur not only at the institutions selling their exposures at an agreed price but at all institutions holding similar instruments (the accounting rules are being changed even as I write this so that won't automatic, but it will nonetheless be very difficult to avoid).

3. The insolvency of the capital markets institutions will be again demonstrated, and piecemeal nationalization will proceed apace.

4. If the housing markets continue to deteriorate (in the sense of declining house prices, not levels of real estate activity), the deals that are done will end up underwater.

The other big new initiative is, of course, quantitative easing. I think this boils down to one arm of the government (the Fed) buying the debt securities of a second arm of the government (Treasury), and, when the dust settles, proceeds from the short term obligations of the Fed being 'invested' in the long-term obligations of the Treasury. It vaguely resembles the operation of the Social Security Trust Fund. I believe the idea is to gain some control over the yield curve, and it may succeed in doing that. But it is premised on the ability of the Fed to fund its operations at the short end of the curve, which has never been in doublt, but then, an operation like this has never been tried.

My sense is that in the intermediate term, there will be either, a currency crisis, a surge of domestic inflation, or both. Just because deflation is currently a bigger threat than inflation doesn't mean inflationary possibilities in the longer term can be dismissed out of hand (though the argument is made from time to time). And my sense of the currency issue is that the effects of quantitative easing will be subsumed in a greater set of issues.

But, 15 years ago James Carville, then working in the Clinton White House, memorably said that when he died he wanted to come back as the bond market, because everybody was scared of the bond market. I get the feeling the government has lost its fear of the bond market and, if that's the case, that would be a bad thing.

Chinese Salvo

2009-03-24T07:57:00.000-07:00

In the 1970s Nixon's Secretary of the Treasury, John Connolly, famously told the Europeans that the dollar was 'our currency, but your problem.' DeGaulle's Minister of Finance had earlier complained that the Americans enjoyed, in global financial affairs, the 'exorbitant privilege' of seigneurage. In other words, the Americans controlled the mint, or the printing presses, given the closing of the gold window.

Right here before the G20 meeting, China has officially taken notice.

The head of the Chinese central bank has published an article suggesting that the dollar be replaced as the world's reserve currency with a ramped up set of special drawing rights at the International Monetary Fund.

Now, effectively replacing the dollar as the leading reserve currency would effectively clip the wings of the U.S. government. Of course, it is not likely to happen in the short run, but the Chinese are, in effect, drawing a line in the sand and sooner or later, people may start to cross over. In the meantime, to forestall the development of a trend, the Americans will be compelled to consult, or at least informally consider, the perspectives, instincts and concerns of its largest creditor.

It's also worth remembering that the dollar is the de facto global reserve currency because of the magnitude of the American economy, and the practical decisions taken by central banks and in financial markets around the world. Any shift away from it is liable to be organic, rather than by fiat. That said, organic shifts can be sudden, rather than incremental, and occur as phase changes, rather than trends.

(Un)employment

2009-03-23T07:51:00.000-07:00

Given last week's blowup over Wall Street bonuses, and today's ruckus over the asset relief proposal, it's worth remembering for a moment what Karl Marx once called the reserve army of labor--the unemployed.

Prediction--we are headed for a double digit national unemployment rate by the middle of the year.

The West Coast is already there. California, Nevada and Oregon all have unemployment rates of over 10%. I'm not sure about Washington State, but between Nordstrom's, Starbucks, Boeing and Washington Mutual headcount reductions, it is coming. The reason Obama was talking so much about job creation last winter was that his advisors could see it coming in the numbers they had then. I suspect the equity markets are already pricing in these kinds of numbers, although I don't think the current stress testing for financial institutions anticipates it.

In addition, though harder to measure, annecdotal reports of a reduction in hours worked by full time and part time hourly workers are making the rounds. In my own extended family, I'm aware of a truck driver, hospital employee and retail clerk who've all had their hours cut. Making sense of this will be difficult, because you've got seasonality in lots of the businesses that hire part time hourly help. Admittedly, those jobs are generally at the lower end of the payscale, which means that their impact in diminished in the aggregate. On the other hand, all of those paychecks get spent, so in terms of economic stimulus, they are more important than the tax cut for a relatively better off recipient who uses it to rebuild his household balance sheet (the currently popular 25 cent phrase for saving, rather than spending, the government's stimulus package).

Rising unemployment will have as big a political impact as it does economic consequences.

Hedgistan Quiz

2009-03-22T21:07:00.000-07:00

The Lords of Hedgistan are, by and large, graduates of Ivy League Colleges and the sorts of places where, to be admitted, one must have scored very well indeed on the SAT. The SAT is a multiple choice test that supposedly measures preparation and aptitude for the purpose of college admission.

In the current economic climate, it's important to get back to the basics, and to give the Lords an opportunity to shine again in the multiple choice context in which they made their first tentative steps towards wealth beyond imagining. So, here's the test, fellas, just two questions, but, just like the real SATs (or the valuation of a Tier 3 asset), the grading is a bit opaque.

1. You have made yourself tens of millions of dollars, your investors have lost hundreds of millions of dollars, and the general public has suffered billions of dollars in damages from your activity. An aroused public has responded. The appropriate response is:

a. You should be taxed of every last penny of the money you made and held up as an example of greed, corruption and short sighted selfishness.

b. You should be taken to midfield of the nearest sports stadium, and, in front of an audience consisting of every business school student within a hundred miles, have a placard describing your offenses hung around your neck, and shot in the back of the head.

c. Like a Chinese prostitute caught dealing drugs, you should be quietly hauled off in a white van and harvested for your internal organs.

2. You live in:

a. New York City

b. Kabul

c. Shanghai.

The Day Wall Street Dies

2009-03-21T13:06:00.000-07:00

Wow.

In less than a week, Congress reacted to the AIG bonus 'scandal' with competing House and Senate proposals that are draconian in concept. If anything remotely resembling either of them becomes part of the Tax Code, Wall Street in its current configuration will die.

That may not be such a bad thing. The compensation system was a leading (perhaps the leading) contributing cause to the current crisis, and rather than being tweaked or overhauled, perhaps it should be savagely dispatched.

As I understand the proposals, the House would impose a 90% tax on any bonus paid by any financial institution which has received funds greater than $5-billion from the Treasury under the Troubled Asset Relief Plan. The Senate proposal would impose a 70% tax on any bonus from any financial institution which has received more than $100-million. Either approach would severely limit the compensation to the highest paid employees of essentially all of the major capital markets banks.

That would certainly suck the oxygen out of the room at BofA, Citi, Goldman, JPMorgan, Morgan Stanley, etc.

Rather than accepting at face value the shrill protests of the leaders of those institutions about losing the best and the brightest, it's worth giving some balanced consideration to the likely consequences of enacting punative bonus taxation (particularly as some form of punative taxation certainly appears in the cards). First, the best and the brightest made the mess, but they may not be mission critical to cleaning it up. The honest and the competent, not the best and the brightest, may be what's called for. Second, in the short term, exactly where are the incumbents going to go if they lose their chance at great wealth? No one is talking about cutting these heroes back to the minimum wage. I think it's still possible to live well on a million dollars a year, even in New York.

Think back to Enron. After it collapsed, any number of high flying traders found themselves stuck, ruined financially, and occupied cleaning up the mess they had made for their base salaries, with no incentive comp to speak of. Yeah, most of them eventually moved on, but the entire industry sector melted down, so that process took awhile, and the cleanup wasn't in the least bit complicated by any lack of people to get the work done. So, it's safe to ignore the shrill bullshit of Ken Lewis, et al.

In the longer term, though, the result of effective limits on compensation paid by the TARP recipients may have a positive consequence for Wall Street. Right now, the TARP recipients are institutions comprised of three very different kinds of activities: a utility function (traditional banking intermediation), a casino activity (their capital markets operations, what sunk them) and a cruise line (providing various kinds of asset management, mergers and acquisitions advisory and similar services that are not particularly capital intensive).

The utility function can function effectively under salary caps. It may not be very exciting, but the work will get done. The casino gets shut down under salary caps. Actually, the hedge funds can continue to operate, but they'll have to produce alpha without leverage as the utility bankers will be incented to ration credit away from speculative and towards more socially productive activities. And the non-capital intensive advisory services will simply move out from under the umbrella of the financial supermarket model, and resume the independent existence they led prior to the great consolidation of financial services in the last fifteen years.

That last is probably where the money will be in the future.

Isn't life interesting after a sea change? So much for deregulation, and thank you, Phil Gramm, for your contribution to putting the politics back into political economics.

Housing Dux and Redux

2009-03-20T08:11:00.000-07:00

I had lunch earlier in the week with a guy who works for a very large (more than 400 agents) real estate brokerage. He is in administration, he is not an agent. Here are the relevant factoids: his firm's commission volumes are down 40% from the peak (from $1.9-billion to $1.1-billion), there not too much agent attrition yet but its coming, the worst home to own in this market is 5-6 years old in an outlying suburb that wasn't completely built out when the boom ended, the only warm spot in the market is in the $250-350,000 range, and the higher end of the market is DOA. So, the Portland, OR market is not that dissimilar to the Santa Fe, NM market. Not that surprising. Both of them are in the West, neither of them overheated spectacularly, but each did enjoy some abnormal price appreciation before the bust.

There will be two bottoms in the housing market. One bottom will occur when new home construction, home sales volumes, real estate commissions, levels of mortgage financing activity, and so on hit bottom. For the general economy (and to my friend), that's the bottom that matters.

The other bottom is the one that matters for individual home owners. That's the point at which existing home prices stop declining. That's the one that matters to most aging boomers.

The two bottoms will not occur at the same time. The first one very well may be occurring even as I write. If not, it is very close. And when it occurs, and when there is a very mild pickup, that will be very good news indeed for the general economy. Hint, though, think L, not V.

The second one is a ways off. The rent to buy comparison still favors renting. The media is full of comments like (earlier this week) 'There is no rational reason to buy a house in today's economic environment.' The animal spirits that operated to exacerbate upward price trends a few years back are now operating to futher deflate prices. Experience in the sand states suggests that when prices drop by 40-50% new buyers come into the market, but the rest of the country is only half way to price declines of those magnitudes. The upper end of the market (anything requiring a jumbo to finance) has frozen up, and the only way it will thaw is with a price blowout (which, in my humble opinion, is ultimately inevitable, though it can be delayed).

So, basically, residential housing investment losses will continue to be a drag on the economy. But the adverse impact of declining levels of housing related activity (construction, sales, financing, major appliance and furniture purchases, etc.) has already been absorbed. Time to pay less attention to housing and let the homeowners suffer quietly, trapped wherever they may have been when the music stopped, until a day of reckoning when growing paper losses are ultimately realized.

AIG Theatre and the Political Dialectic

2009-03-19T10:26:00.000-07:00

A hoary dramatic device is to use a small incident as a vehicle to explore all the facets and ramifications of a much larger issue. The AIG bonuses are currently serving that purpose. In themselves, they represent small sums, as compared to the rather larger amounts of financial support the federal government has provided AIG and all the TARP participants. However, compared to the compensation most taxpayers know personally, they are obscenely large 'payments for failure' at best, and theft, at worst.

So, the matter will be addressed. All the ventilating underway merely shadows deeply felt views that will be expressed in the resolution of larger issues. I do think that the political classes in the country have collectively lost confidence in the financial elite. And I think the public wants its pound of flesh.

And, attacking the compensation structure is actually a reasonable way of taking a first step towards re-regulating the financial services sector and confining it within the parameters appropriate to a utility function. By removing the motive for speculation and risk taking, you will surely diminish it considerably.

I doubt very few employees impacted to a vastly curtailed compensation structure will be able to jump ship to hedge funds where they can resume their shennanigans. And I suspect fewer and fewer hedge funds will find sources of funding for the leverage that substituted for alpha in their heyday.

Of Sea Changes and the Dialectic of Politics

2009-03-18T11:47:00.000-07:00

The tone out of Washington, D.C. is changing. Somewhere, somehow, some conclusions have been drawn about how to handle the financial and economic crises. They aren't being publicized yet, most likely they haven't completely jelled. In a nutshell, there has been a complete loss of confidence among the political classes of the ability of the financial elite to manage its own affairs and a corresponding shift in the balance of political power.

This is not a partisan matter. The Senator who called on the responsible AIG executives to do the honorable thing and commit suicide was a Republican. The suggestions that the AIG bonuses be confiscated through punative taxation are bipartisan. Vikram Pandit and Ken Lewis are increasingly coming across as shrill, defensive and utterly out of touch.

I suspect that to some extent this shift is a product of public mood, and to some extent its the product of reasonably accurate short term economic forecasting. The public is beginning to bay for blood. That blood lust is only going to intensify as the strength of the recession is increasingly felt by more and more people. Totally unrelated, a further declining in housing prices is almost inevitable, and any economic modeling of that will predict the demise of much of what's left of the financial services sector. Basically, the big banks are on their collective deathbed. I'm sure there will be survivors, but they will be the survivors that the government has selected.

In a nutshell, it's time to start thinking in terms of the political dynamic, rather than in terms of the existing structure of the financial services sector and the ordinary functioning of capital markets. Not that anybody is ready of a such an adult conversation in public.

Kremlinologists--FDIC--what is the meaning of this?

2009-03-14T10:36:00.000-07:00

Three tidbits--

1. Bernancke is scheduled for the entire hour of 60 minutes this Sunday.
2. Over 200 FDIC personnel have been sent to Puerto Rico for undisclosed reasons.
3. No banks were closed this Friday.

Speculation--point one has nothing to do with points two and three, but points two and three are related.

There are any number of messages the Fed Chairman could plan to deliver Sunday evening. One might be reassurances over the seizure of Citicorp or BofA, but that is only one, and coming on the heels of the G20 Finance Ministers meeting, not the most likely. It is possible, but not likely.

OTOH, the last week has seen positively bizarre announcements about Citicorp. An admission of hardly surprising contingency planning was immediately followed by a claim that the operating results of the bank were the best in several years (which did the stock so much good that Lewis of BofA made the same announcement about his bank later in the week). Somebody needs to tell those guys that their problems are in the operating results of the commercial banking operations, they lie in the areas of asset quality and capital markets trading activities.

As far as points 2 and 3 are concerned, the point towards the FDIC gearing up for an operation of a new order of magnitude. So far, the bank closures have been small--WAMU excepted, and that was orchestrated as a handoff to Chase. IndyMac is the biggest institution to date where the FDIC has actually taken control. My guess is that the feds are trying to get their ducks in a row for a larger resolution, though probably not the Citicorp size. There are a number of problem regionals--Ohio has a nice collection--and stepping up to one of those situations may very well be the next move.

Ah, for the days of decoding the meaning of who stood by whom on Lenin's Tomb reviewing the May Day Parades of days gone past.

Be Careful What you Wish For

2009-03-13T08:29:00.000-07:00

Declining Chinese trade surpluses mean a reduced demand for U.S. Treasuries as a place to park the proceeds. That will make refunding operations more difficult and expensive, at precisely the time that they are ramping up to cover the costs of repeated bailouts of the financial services sector, the fiscal stimulus package required by the general economy, and the expansion of the federal balance sheet to substitute for contract private leverage.

For the last few years, loud complaints about currency manipulation, foreign purchases of U.S. Treasuries and a flood of cheap imports have been endless. The facts offered enough support for the arguments so that, even though the analysis and policy prescriptions were ludicrously flawed, the braying never ceased.

It would now appear that we may have to live in a world where the Chinese appetite for our debt is not endless, the flood of cheap imports turns to a trickle, and the currency manipulation argument is a dim memory. Of course, to entice purchases of U.S. debt, the coupons will have to rise, life without the cheap imports will be poorer and more frugal, and a stronger yuan will buffer Chinese consumers from higher energy prices just when they are biting Americans all the harder. Oh, and we get to live through all this with house values down in nominal and real terms. In the U.S., the next ten years may feel a lot like Buffalo, Cleveland and Pittsburg, 1970-80.

Be careful what you wish for.

Class Warfare

2009-03-12T12:29:00.000-07:00

America has never seen much of it.

And America's unlikely to see much of it. But the conservative commentators seem very concerned that the lower classes are losing their respect for and deference to the wealthy, and raising the specter of class warfare. If this economic situation deteriorates sufficiently that serious scapegoating is required, and if it bites hard enough that the 'family values/religious right' agenda loses its appeal the the lower middle class, you could see an interesting repolarization of American politics.

Right now, the suggestion seems to be that increasing the progressivity of the federal income tax structure is tantamount to class warfare on the wealthy. I disagree. All that is on the table right now is modestly undoing the diminuition of rate progressivity that has been the pattern for the last quarter of a century.

Class warfare would be using the tax code to destroy certain ways of life. For example, the tax code currently imposes a confiscatory excise tax on the proceeds from the sale of machine guns. If you amended the tax code to impose a confiscatory excise tax on any income derived from investment of the proceeds of a bonus paid in the last X years by an institution that subsequently received TARP funding, that might be construed as class warfare. Particularly if you did it in such a way, with presumptions of attribution, etc., that essentially confiscated the future income of any bonus recipient.

Warnings against class warfare will probably cease when it dawns on those making them that right now the idea has a certain amount of political appeal. Politically, that appeal appears to be growing. Candidly, it's about time that the pendulum swing on the income distribution front.

Gloom in the Blogosphere

2009-03-10T09:25:00.000-07:00

'Bleak, negative and forboding' pretty much sums up the economic outlook of the blogosphere as I've reviewed it over the last two days. Obama has been captured by his experts and is flat wrong when he publicly claims that the blogosphere is a realm of simple-minded one-issue commentators. It is a good deal more nuanced than that. But, there does seem to be a certain unanimity about just how grim the future will be. And, after spending a week driving across the American West, which, amber fields of winter wheat lightly dusted with snow and purple mountains majesty (also snow glistening), is still there, still hiring and still dealing, I'm a little curious about the disconnect. Normality, in a minor key, on the one hand, and a crescendo of doom, on the other.

Three possible explanations--

1. The Jungian collective gesalt of the blogosphere is correctly anticipating a political, cultural, economic and military phase change that will end the world as we know it. In other words, this is the winter of 1915 or 1931.

2. This is the psychological capitulation that accompanies a market bottom. That doesn't mean a recovery is imminent. Nor does it mean that further declines will be avoided, since there are multiple markets. But it does mean that animal spirits are dead, that in some markets, at least, we've bottomed, even if the general economy will continue to deteriorate, housing prices will continue to drop, the consumer will stay on the sidelines, and the financial services sector continue to unwind.

3. People active in the blogosphere tend, as a group, to be close to the financial services sector and so they feel proximity to the victims of the direct impact of the current events. I suspect the first wave of Wall Street layoffs, through last summer, weeded out the marginal performers, an enhanced version of regular performance reviews. Starting last summer, good people started losing their jobs. This winter's bonus season was a pale imitation of last year's rewards. The bonus culture is dead. It will be many years before it comes back. Ask a dot.com option holders, ca. 2002.

None of the people (a few special situations excepted) laid off are finding new positions. Further cutbacks are on the way. The savings/assets people had to tide them through are losing value at an astonishing rate. There is a practical limit to how much a person can reduce his living expenses by without leaving town. If you leave town, there is no where to go. There guys are in worse shape than the Enron employees trapped in that wreckage after it collapsed.

I suspect the gloom is the product of a combination of 2 and 3. I've never been a Jungian. Capitulation is the classic explanation. But I've felt for some time that, because in the current crisis high income professionals in the services sector will feel the pain as much as hourly blue collar workers, the cries and lamentations will be louder.

Confusion

2009-03-08T18:00:00.000-07:00

I'm not sure anyone has a good handle on what is, and what is not, important economic data right now.

There may be a tendency to emphasize the familiar and close by over the important and the alien. one of two things can happen when the situation gets confusing--either you open up to new stimuli, or you default back to the familiar..

My sense is that the media and the political establishment is desperately trying to regain their comfort zones. That may not lead to either good policy or accurate reporting. It will lead to an obsession with the mechanics of readjustment and preclude any kind of coherent response to the need for reform to keep this from happening again.

Driving across the Western United States last week, I couldn't help noticing a number of things. One, there seems to be a fair amount of hiring going on, at least at the bottom of the pyramid. Two, the collapse is itself creating economic opportunities, if you believe the touting on the billboards on the interstate through Salt Lake City. Three, there is a huge swath of country that, having missed out on the bubble, is not being splattered too badly by its bursting. Four, life goes on.

For instance, if residential real estate prices fall far enough, transaction volumes pick up. If transaction volumes pick up, commissions (and related transaction fees) start flowing again. All that happens at lower levels, of course, and doesn't do any good for the non-survivors. The glory days are over, but life goes on . . .

And perhaps a bleak and sodden economic climate is exactly what' needed to nurture the requisite reforms.

An Odd Thought, and a Prediction . . .

2009-03-05T16:22:00.000-08:00

Odd Thought--
How has U.S. government policy gotten to the point where the objective is to stabilize house prices and thereby protect the equity of homeowners and the value of securities collateralized by mortgages? I understand the political pressure to do this, but isn't it ass backwards?
Government policy should be promoting affordable housing and low housing prices. Appreciation in home values should be recognized as an undesirable drag on the general economy. Perhaps gains on the sale of residences should be taxed at a higher rate, rather than exempted from taxation, to control unwanted appreciation? Rather than relying on the escalator of building equity through leveraged appreciation, people wanting to grow their net worth should refrain from consumption to generate savings, then invest those savings productively.
The transition may be awful, but the thought is intriguing.

Prediction--
The way in which the limits of federal borrowing power will be manifest is in increasing funding costs. Qualitative easing will enhance the ability of central banks to control the yield curve further out, but in the end, the substitution of sovereign credit for the discredited AAA collateralized structures will have a boundary. An inflation tax will be the way out of the box. Combined with a devaluation of the dollar against some, but not all, currencies. Not sure when the refunding crisis will hit. I'd guess in about a year or so.

Santa Fe Report

2009-03-05T09:59:00.000-08:00

Miscellaneous factoids--
1. This is the slow season. There is a feeling that it's unusually slow, even for the slow season, but that is less a concern than the anticipatory fear that this summer the tourists won't show up. That is, they won't show up at the high end--opera goers and art purchasers, or at the low end, the souvenir shoppers spending the weekend in town on their way to a week at a church camp somewhere in northern New Mexico.
2. The real estate market is dead. Many, many agents have left the business and some have left town. On our first night here, we ran into an older woman we knew from when we lived here a couple of years ago. She's retiring, not showing housing, and considering moving to Mexico to lower her living expenses. A friend whose brother runs a real estate agency says his brother's headcount is down. Supposedly, residential real estate is down 20% or so, and commercial is following. No one is predicting an upturn or even an end to the decline.
3. The community is surprisingly healthy. Santa Fe depends on seasonal tourism, public sector employment (it's the state capital) and regional commerce (it serves northern New Mexico for just about anything that doesn't require a trip down to Albuquerque). State employment is reasonably resilient. Last summer was okay on the tourism front. And the region, never very prosperous, is creaking along as usual (once out of Santa Fe and Taos, northern New Mexico is very slow, always).

Short View?

2009-03-04T08:16:00.000-08:00

John Authers in the Short View feature at The Financial Times Reports reports that, with the recent U.S. stock market declines, we are now in the second most severe market downturn in the last century. He reaches that conclusion by taking the beginning of the current market decline all the way back to 2001, making the fair point that, taking into consideration fluctuations in the value of the dollar and such, the October 2007 market peak approximated the turn of the century dot.com peak, so that three three big market declines of the last hundred years were 1929-1937, 1966-1974 and now 2000-2009. The current episode is roughly as severe as the 1966-74 episode, more moderate than the 1929-37 episode, and slightly longer than either of the other two.

I'm not sure this is the short view of things, but interesting nonetheless. And it underlines the point that we've bought ourselves one hell of a recession with the declines in asset values that have already occurred and that further declines in the stock market will be discounting, in effect, a recession.

My instincts lead me to forecast a great deal more misery, but more in the general economy than the one financial markets. One more catharsis in the financial markets as later in the year the U.S. government reaches a political resolution to the problems of the four money center banks controlling 64% of U.S. commercial deposits, then a long, slow slog as the economy continues to sag, residential real estate values continue to decline, and we all adjust to an economy less focused on the financial services sector, the U.S. consumer, and real estate appreciation (residential and commercial). Not just long and slow, but sour, wretched and bitter, as well.

There you have it. A prediction, like a sonnet, has a certain form. The key rule is, never include a date and a number in the same sentence. Mark this prediction 'complied.'

Tax Farming (and Harvest)

2009-02-24T13:06:00.000-08:00

John Thain has been ordered to provide the attorney general of New York State with information relating to bonus payments by Merrill Lynch prior to its acquisition by Bank of America.

I hope that the attorney general insures that the information is made available to that part of his staff responsible prosecuting tax evasion as well as those responsible for investigating securities fraud.

I suspect that if New York State were devote substantial resources to a comprehensive compliance audit of every recipient of such a bonus, the recoveries from taxpayers who had not fully paid their taxes would more than cover the cost of the exercise.

If New York State were to pursue criminal sanctions for mischaracterization of income, misrepresentation of domicile, and so on, some small part of the public's blood lust might be satisfied (or perhaps merely whetted).

This would be a good thing.

It worked on Al Capone. It's time to treat the banksters like gangsters.

The cart and the horse

2009-02-23T09:27:00.000-08:00

I'm not sure whether the statements out of Washington are still operative, but one psuedo-sophisticated justification advanced in various backgrounders to explain the failure of government policy, to date, to turn the clock back, to say, mid-2006, is that we can't fix the banks until we work through the housing crisis.

I'm coming to the conclusion this is wrong on two counts.

First, conceptually, it confuses the triggering event with the underlying causes of the current situation. If the trigger had been subprime mortgages, it was going to be hung bridge loans. If it hadn't been hung bridge loans, it would have been leverage in Hedgistan (remember Hedgistan?).

Second, I'm beginning to think that there is a link, but the policymakers have it backwards. In other words, until the financial sector's crisis is worked through, the downward pressure on housing prices pretty much insures that the housing issues will continue to vex and plague us all. Right now, the lower end of the housing market has repriced, and there is adequate liquidity so that transactional volumes are recovering (at the new, lower price levels). Time will tell whether those prices hold, of if the knife catchers were early. But at least it's a functioning market. However, when you reach the part of the housing market that relies on jumbo financing, it is dead. Yes, there were always a few uber rich cash buyers, but they never made the market. Right now, you can't borrow in the amounts required to finance a house costing more than a million dollars, the owners are generally in a position to 'wait it out' and the prospective buyers are sidelined by a lack of financing (also by a nervous apprehension that the market is liable to crack at those price levels, just like it did at the entry level). The conflux--buyers strike, no financing and obstinate sellers--will likely be resolved just as it was lower down the food chain.

But that resolution will have a await the return of the lenders, and the lenders are not coming back until the mess in the financial services sector is straightened out.

Stiffing the Professional Classes

2009-02-20T10:54:00.000-08:00

Listening to a Bloomberg reporter interview Yale professor and housing guru Robert Shiller, I couldn't help detecting a certain anguish in her voice as she described the plight of jumbo mortgage borrowers, left out of the current version of the Obama administration's housing rescue package. Reading a Bloomberg article on soaring default rates among jumbo borrowers reinforced my sense that the interviewer actually knew, from personal exposure, something about the issue (not that she's personally in the situation, but her socio-economic cohort sure is). Sort of like the difference between living through a hurricane and watching the event on national televison.

There are going to be a lot of upside down homeowners with six figure incomes, seven figure real estate exposure, sufficient assets outside their homes and retirement accounts, etc. who are about to be awfully surprised the first time a major life event compelling recognition of a real estate loss occurs. I'm talking job loss, divorce, corporate relocation, retirement, etc.

Plowing through Obama's version of a bildingsroman (novel of a young man coming of age), I don't think he's going to personally have much sympathy for that group. Of course, others in his adminstration will, since it is the class to which they belong.

This promises cultural and social consequences as well as having economic implications. It may have political repercussions, as well, though it's going to take a while for the innate conservatism of those who believe themselves winners on the basis of merit to be punctured.

Consumer Spending Collapse

2009-02-19T10:55:00.000-08:00

This is annectdotal to the point of personal.

Since the first of the year, my personal consumer spending has completely collapsed. Ignoring services for the moment, in the last six weeks I have personally spent more on maintenance and repair of existing possessions than I have spent acquiring new stuff. By maintenance and repair I mean tuning a piano, clothing alterations, replacing the broken glass in a picture frame. Most of the money I have spent on clothing represented cashing in a gift card received at Christmas.

This is neither me going broke in a cash since nor the traditional post holiday lull in consumption reflected satiation after the consumption excess of the holidays. We had a very light Christmas, and, though we're suffering with everyone else, we're not in a cash bind. No, as far as I can tell, I'm buying nothing because I'm simply not in the mood to spend. If I go shopping, its to buy groceries. If I go to Home Depot, it's for light bulbs. I am not tempted by the late winter pre-Season discounts on the propane grills. I have enough clothes and other crap to last me for the rest of the year, and then some.

Two slight qualifications. Obviously, we're still buying groceries, paying the utility bills, etc. And, the rest of my family is not quite as retrenched as I am. I think their psychological outlook is not quite so bleak, dark and forboding. I hope they are correct and I'm just over-reacting.

But the reaction is undeniable, and startling.

The casino, the cruise line and the utility company

2009-02-18T10:23:00.000-08:00

Going into this financial crisis, the financial services sector has become one part casino, one part cruise line and one part utility, all unfortunately jumbled up and intertwined. The situation was dressed up and described in complimentary terms as the 'financial supermarket' model of the future. Citicorp was the exemplar.

Well into the mess, using summer 2007 and the time when innocence ended, we can now see that rolling those three kinds of activities into single entities, and, in effect, cross collateralizing the liabilities associated with each was, not to put too fine a point on it, insane.

The crying need de jour is to somewho unsort the jumble. Shut down the casino, leaving the players to bear (and bare) their losses. Let the cruise line sail away, to thrive or sink on the skills of its crew and the public's demand for asset management and investment advisory services. And nationalize the utility, so that deposits can be gathered, credit extended, transactions cleared, and so on, for the smooth functioning of the general economy.

Easier said than done.

Night of the Long Knives

2009-02-15T20:19:00.000-08:00

for major law firms.

I suppose it is fair enough. The Wall Street and Beltway lawyers were the shock troops of financial deregulation, and to this day in the pay and under the thumb of their clients who prospered in the recent economic episode now ending in tears and terror for all involved.

But, if you're enough of a street fightin' man, when the times change, your ability to belt out the leider inevitably ends in the gurgle of a slit throat.

Law firms are interesting animals. Full of sophisticated people, they are themselves quite primitive. They tend to have one big long term liability--their real estate leases--and one big short term asset--their accounts receivable. They don't have any capital to speak of--in a partnership the capital accounts are kept minimal and in an LLC the shareholders equity is de minimus for a combination of tax and practical business reasons.

On top of that, the quarter to half of the attorneys who are the proprietors--the partners--tend to view their incomes, not as the firm's profits, but rather as their salaries/draws for their own law practices. So, in effect, the firms have Godawful operating leverage, even if they don't have much financial leverage (and even less of an equity cushion).

In a truly bad year, not an off year, a bad year, the firm's profits disappear. That means the partners have no incomes. In a horrible year, with losses, not only do the partners have no incomes, the firm has no equity cushion to absorb the losses.

Major law firms are a post WWII phenomena. The major firms of earlier eras were fundamentally different creatures. Most of the partners of those versions of today's power houses could go a year or so without income from the firm. I'm not sure that is still the case.

My guess is that you'll be seeing some chaos in the legal profession.

Tough times at the Barber Shop

2009-02-13T21:01:00.001-08:00

Terry the barber reports people are spacing their haircuts further apart.

Terry cuts hair in downtown Portland, Oregon, in the basement of the local Wells Fargo headquarters. He's been around for a while and has a good client base. He isn't losing many customers (a few, but not many), but his business is down 20-25% and he attributes it to people letting their hair go a little longer between cuts.

He's philosophical. But he left my hair a little longer than last time. Maybe two weeks longer. No fool there.

Progress?

2009-02-11T11:46:00.000-08:00

We may be seeing a few signs of progress.

New Realism. Only the politicians are still talking about getting things back to the way they were. Even with them, it is beginning to sink in that the People are Really Mad. You can get away with a lot when nobody's paying attention, not so much when they are. People are on the cusp of paying attention, and they don't like what they see so far.

Nationalization of the Banks. Even POTUS is publicly discussing the Swedish alternative for dealing with the financial crisis. He's giving the American people the choice of a Japanese or a Swedish outcome. He notes we have a different political culture and society than Sweden, but the last time I checked, the U.S. didn't look much like Japan, either. So, we'll be finding our own way, but with a due regard for the experience of others.

Socialism. Right now the social agenda of the new administration is completely on hold. Be interesting to see if health care reform gets lost in the shuffle. But if the public mood continues to shift, there will be a new focus of the strands in American culture that emphasizes collective effort, community action, fairness and equality, rather than those celebrating the free market efficiency, meritocratic individualism and personal freedom for anyone who is not a free-thinking pervert of color.

Remember the hung bridge loans of the LBO Boom?

2009-02-08T21:28:00.000-08:00

They don't get much attention these days. This time last year, there was a school of thought that held that cov lite LBO financing posed a greater risk than structured finance product to the balance sheets of global capital markets institutions. Of course, this time last year, the SIVs and other off balance sheet arrangements hadn't been brought back onto those balance sheets.

Still, those loans were made, and they are sitting somewhere (in the case of Lyondell, on a bankruptcy schedule). But they aren't getting much attention, at least not publicly. I have to wonder if that's because they were quietly and successfully written down and placed while the media frenzy was focused on other issues, or if like landmines left over from some long ended conflict, they aren't still a lurking danger.

Tonight's prediction--this is going to be a long, variegated and unpleasant ordeal. The impact will fall unevenly, the sequencing of events will be uncertain (but interelated), and the closer you were to the point of impact the worse it will be for you.

In other words, for a change the American homeowner and the London investment banker are going to feel the impact more than the Japanese apartment dweller or the Brazilian shopkeeper.

The Piano Tuner's Report

2009-02-07T17:52:00.000-08:00

According to our piano tuner, these are hard times to be in the business of selling pianos. They are expensive, not exactly necessities, so no surprise there.

What is a surprise, is that he says these are good times for piano teachers and piano tuners. Compared to conventional retail therapy, a weekly piano lesson are apparently a mere pittance. And, in a tough economic climate, people turn inward and try to find a space that doesn't cost much to occupy. If you already own your piano, playing it fits the bill--it's much cheaper than a round of golf or a massage.

So, on his tuning appointment before mine, he tuned the piano of a guy who'd been told he was to be laid off and the end of the month. The guy said he wanted to get the piano tuned while he still had a paycheck, and, soon to be out of work, he figured he'd have plenty of time to play it.

At least it hasn't gotten to the point where people are trying to raise cash by selling their pianos. If that starts happening, the D word may be the right one to describe the economic climate.

Let's Do the Two Step

2009-02-05T09:05:00.000-08:00

Face, a bad bank, ring fence, troubled asset relief purchase approach to resolving the insolvency of the financial services sector makes no sense, if it's a one step approach. But if there is a hidden agenda (or a multiphase strategy, to put it more politely), it may be a good first step.

Step one. Buy troubled assets at a fair price. A fair price is above the market clearing fire sale price, on the one hand, but it's below the mark to model carrying value of the 'asset' on the financial institution's balance sheet. In the presence of a willing buyer in volume at a fair price, the accounting justification for mark to model disappears, and all holders of like assets must mark them them to the 'fair price.'

Step two. Marking these assets to this price will blow enormous holes in the balance sheets of any number of financial institutions. It will result in portfolio losses for any number of pension funds, endowments, hedge funds, etc. These will be the inevitable consequences of the 'price discovery' process.

Step three. Manage the resulting insolvency of the regulated financial institutions. In a nutshell, de facto nationalization, but perhaps graded in to dismantle the side bets without bringing the edifice down. In other words, shut down the casino for good, or for a generation, at least, but preserve the utility like functions of the banking system that justify special relief for it in the first place.

Step four. Keep a weather eye out for systemic risk resulting from the stress on other institutional investors--CalPers, the Texas Teachers Retirement Fund and similar entities will have to be monitored, but it's not clear what, if any, assistance they will require.

Halo Slipping?

2009-02-04T21:20:00.000-08:00

The tax problems of the Obama nominees may be a precursor of business as usual. Withdrawing the Richardson and the Daschle nominations raises two questions. One, was the issue one of bad vetting or bad judgment? Two, has the Democratic establishment under the Bush Administration been as tainted with venal habits as their Republican counterparts.

Probably, answers--to question one, both, to question two, yes.

Number Games

2009-02-03T13:13:00.001-08:00

When is ten percent not ten percent?

There is a game that gets played when people start talking about peak-to-trough declines. It goes like this: Let's say that the nearest historical parallel to the performance of an asset class is a 50 percent decline, peak to trough, and that the asset class in question has declined 40 percent to date. To reach the 50% mark, what further decline is required?

If you said, 10%, you are right, but only if you are measuring off the peak price. The percentage decline from the current price required to get from 60% to 50% is closer to 16.7%. That's because to drop from 60 to 50 requires a drop of 10/60, or 1/6. A 10% decline from 60% would be a reduction of 6% to 54%. A 16.7% decline from 60% gets you to 50%.

So, it's a common mistake. But not one you'd expect the former chief economist of the IMF to make writing in The Wall Street Journal.

Another common mistake is to take a factoid and mangle it. Assume that it is true that 10% of the residential real estate mortgages in the United States is in default, delinquent or otherwise troubled. That does not mean that 10% of American households are in default, or even that 10% of American homeowners are in default (the home ownership statistic in America is around 2/3rds, and about a third of the homes that are owned are not mortgaged.

Enough of this.

How will America react

2009-02-02T10:35:00.000-08:00

culturally and politically to relative decline in its economic strength and global political pre-eminence?

The world doesn't love us. Some of it fears us, some of it respects us, some of it has some lingering appreciation for past services rendered. A relatively small but growing sliver hates the United States and holds its people, its culture and its values in contempt. The last couple of years have, unfortunately, been kind to that sliver. But the vast majority of the global population is in a watching mode, waiting to see how all this unfolds for the good ole USA.

We do seem to be headed for a diminution. The last time this happened was in the 1970s, but that turned out to be a false dawn for the old Soviet Union. Despite the initiatives in Africa, and in part because of those in Afghanistan, efforts to exploit American weakness in a variety of global theatres failed more or less completely--less because of the skillfulness with which the U.S. government countered and more because the 'correlation of forces' about which Soviet strategists of the time blathered turned out to be illusory and the internal contradictions, not of capitalism, but of the Soviet Empire turned out to be mortal.

This time around, I don't see the Chinese reacting with the same eagerness and embarking on a self-destructive exercise in global over-reach. But I also don't see the United States in quite the distress, in terms of a military quagmire or economic morass, that we found ourselves in by the early 70s. The Iraq adventure has not come at the internal social cost incurred in Southeast Asia, and so far the economic is not as indescribably screwed up as it was by 1973--with price controls, inflation and alternate day gasoline rationing. Give our politicians time, and we may achieve a similar level of economic misery, and make no mistake, even if the internal political costs of Iraq are lower than those of Vietnam, there were be a price to be paid, in terms of international power, for mistakes in the Middle East.

It will be interesting to watch the take of the American public on all this as it unfolds. So far, we're not quite to the level of scapegoating--although public outrage at Wall Street compensation could easily evolve into that. And some scapegoating might be healthy, cathartic and cautionary.

New York--Detroit Redux?

2009-02-01T10:42:00.000-08:00

Rudy Guiliani has pointed out an inconvenient truth.

The regional economy of the New York metropolitan area is driven by the bonus structure and bonus dollars of the financial services sector. Take away the excessive financial services sector compensation, and the place will start looking like it did back in the 1970s.

Stop and think about it. What drives an average Manhattan apartment price to around a million dollars? What makes five thousand dollars a month seem like a reasonable rent for a one bedroom apartment? Where does the money come from to pay all that private school tuition?

The antics of the new Guilded Age may have seemed pretty repugnant to those of us on the outside looking in, but there is no denying the trickle down effect. All those nannies, car service drivers, executive coaches, real estate agents and so one were indirectly feeding from the trough that was nourishing the managing directors and their kin. Take away the bonus, take away the personal trainer. This year, send the kids to camp to pass on renting in the Hamptons. Let's do something more adventurous (and cheaper). It's pretty safe to predict that there will be many fewer new kitchens, much more jewelry discretely on consignment, and an reduction in the size of expense account tabs.

Generally, the regions that have been ground zero for the economic impact of bad news have been peripheral, perhaps even remote. Detroit is a long way from either Coast. Back in the 80s, the Oil Patch was flyover territory. Today, in Southern California, the misery is centered in the Inland Empire, and a few delusional homeowners are still hoping that the Westside of LA will get a free pass in this mess (it won't).

Well, it looks like the residents of Manhattan, the tonier parts of the outer boroughs and the better suburbs are going to get to eat their own cooking for a change. I hope they like Spam.

Jolting Factoid de Jour

2009-01-31T12:56:00.000-08:00

Driving up to the Whole Food Store in Tigard, Oregon, what did I see but an large placard advertising 'great prices'. Now, I've never thought of the Whole Food Store as competitive on price. Not for nothing is it called the Whole Paycheck Store. But no one goes there to save money. Of course, you save money but eating at home instead of eating out, but there are cheaper ways of buying groceries to feed yourself at home.

Then, I read in the David Rosenberg (Merrill Lynch) piece claiming that the economy is already in a depression. He buttresses his argument by claiming that there is evidence of a substitution effect in grocery price trends (affluent households substituting an inferior good like chicken for veal, less affluent ones substituting Spam for canned tuna).

Now, anyone who took economics in the middle of the last century will recall that argument. But it has been since sometime in the last century that, in affluent America, any substitution effect was discussed in response to rising food costs. The substitution that has been occuring for the last generation has consisted of eating at home instead of the higher cost, more convenient alternative of eating out. Rise of the two income family, both spouses working, who wants to come home and cook and all that.

If people have started playing with the menu at home, we're in a new environment. If the Whole Paycheck Store has decided to compete on price, we're in a new environment. Anybody know a fancy name for mac and cheese?

It's Different This Time

2009-01-30T17:04:00.001-08:00

Perhaps the most dangerous words in the English language when used in economic forecasting.

Nonetheless, let me argue for a moment, that the current financial crisis is, in one interesting way, different from any other since the Great Depression.

Here's the difference--in all other post-War recessions, the brunt of the loss was borne by those on the margins of society, those who were over-leveraged, the less educated, blue collar workers, unskilled labor, the non-geographically mobile, etc. The affluent, the professional classes, the corporate, political and media elite could pontificate and observe the costs of globalization and the wonders of creative destruction, without feeling any particular impact.

This time it's different. The difference is in who is going to bear the brunt of this episode.

The economically marginal who've tumbled into the hell of part time hourly work without benefits had already hit bottom before this mess started. Those people weren't buying new cars, sending kids to college off the home equity ATM, and socking away six figure balances in 401k's. And we do have a frayed and tattered social safety net in this country that to some extent ameliorated and ameliorates their distress. That safety net isn't going to disappear, and is likely to improve substantially over the next couple of years, to the benefit of the economically marginal. They will suffer, but they actually face the possibility of improved circumstances.

This puppy has put those with something left to lose squarely in its cross hairs. The affluent, the professional classes, the economic elite, are the ones most at risk.Say you are an opinion leader with a major media organization, or a partner in a national law firm, or a corporate vice president with a publicly listed company. You have a six figure income, a house once worth seven figures, sizeable retirement savings, and various other financial assets.

Hopefully, you've still got the job. But everything else has taken a major hit in the last 18 months and God forbid you lose the job, because the pickings are slim, and more likely than not, whatever you can find will pay significantly less (and you'll be worth less, since part of your value at the old place was tied up in your organization specific knowledge, skills and contribution.

And if you have leverage that previously seemed modest, it will be looming major larger in the new order of things.

Here comes the Prussian Officer Corps

2009-01-09T14:03:00.000-08:00

Following World War I, among other challenges Weimar Germany faced was a large cohort of disciplined, well-trained aristocrats mired in a military tradition, left defeated, disillusioned and unemployed following the war. They were, to put it mildly, a source of social instability, and the Junkers famously thought they could use an Austrian corporal to manage the country, with catastrophic consequences not just for Germany.

We are about to see a similar deluge of talent coming off Wall Street. Ivy League graduates with inflated expectations, impossible salary requirements, and utterly no skills useful in the brave new world following the collapse of the financial services sector. These people are, not to put too fine a point on it, a potential cadre of explosive discontent.

In the United States, structural unemployment has generally afflicted those without voice, less well educated workforces dispersed far from media centers and major metropolitan areas. The Good and the Great could smugly counsel retooling and retraining, oblivious to what is involved for a 45-year-old head of a household trying to reorient his job skill set to an entry level position for which he or she is likely to be a less preferred candidate. This time, the crowd getting the sack will be more vociferous, more visible, and (incidentally) more hated. Nobody hated a laid off autoworker the way people are going to hate former Masters of the Universe held responsible for destroying the American Way of Life.

Temperate Question

2008-12-30T10:37:00.000-08:00

A spot of temperance in the holiday conviviality may be appropriate.

So what?

So, we have the following American phenomena that are indisputable.

1. Housing prices are in freefall. Disputes center on whether the decline will abate in late 2009 or sometime in 2010.

2. Through mismanagement, our money center banks have decapitalized themselves and are insolvent. Okay, this is slightly arguable, apologists would prefer to talk about perfect storms, risk management failures, bailouts, restructurings, etc. Fact of the matter, the banking system is not currently functional.

3. The general economy is, and has been for a year, in a recession. Thank you, NBER.

4. The pattern this recession will take is, at present, unknowable. Pretty clearly, the following are in serious trouble: anyone dependent on consumer spending, the real estate sector, the auto sector, any heavily leveraged organization. It's probably safe to assume that trouble in on its way for anyone whose principle customers fall into any of those catagories, and also for any public sector entity dependent on property or sales tax revenues.

How this will play out is anybody's guess. Typically, a stable banking sector would buffer the healthier parts of the economy from the troubled part. But, basically, the financial services sector is where the whole mess started (yes, subprime lending and a residential real estate bubble were the triggers, but a healthy financial services sector would have buffered the general economy from, rather than amplified and transmitted those problems to, the general economy.

We got a Christmas Card a few days ago wishing us a healthy and a happy 2009, and noting that a prosperous 2009 did not appear to be in the cards. I wish you the same.

Zombie Banks

2008-12-29T18:56:00.001-08:00

Death to financial institutions!

The only justification for the extraordinary privileges enjoyed by lightly regulated banks, the extraordinary leverage available to essentially unregulated hedge funds and the mere existence of the so-called shadow banking system was that they served a greater social purpose than the personal enrichment of the participants.

It turns out that they do not.

So they should, collectively, exit the scene. Their corporate existence should be terminated. Whether the institutions are regulated out of existence, their activities are taxed to destruction or their leaders taken out and summarily shot is a matter of national taste, cultural and legal tradition.

Let's face it. Collectively, the major banks are zombies, as in, walking dead. Their problems simply overwhelm their capitalization, currently--and with any conceivable level of government support. One can argue specific cases, but there are also a couple of inarguable cases, starting with Citi.

You can't bring a zombie back to life. You can bury it.

And once buried, before the stench of the corpse has fouled the entire community, you can approach the next step of the dialectic. The resources currently being put at risk to salvage of the current system should be allocated with a strategy that will assure that, rather than being frittered away in a futile exercise, their placement will facilitate that next stage in the dialectic.