Sunday, January 31, 2010

Corporate Political Money Is Harmless

A recent article in the Times — bless some reporter’s or editor’s contrarian heart – asks the question: so, what effect does corporate money actually have on democracy?” The answer seems to be: none at all. One of the economists cited is Peter’s Missouri colleague, and my former student, Jeff Milyo: "There is just no good evidence that campaign finance laws have any effect on actual corruption."
The above excerpt is from "Apocalypse Averted" by Dick Langlois on Organization and Markets.

From the New York Times article mentioned in the above quote:
Justice Anthony M. Kennedy noted in his opinion that no evidence was marshaled in 100,000 pages of legal briefs to show that unrestricted campaign money ever bought a lawmaker’s vote. And even after Congress further tightened the rules with the landmark McCain-Feingold law in 2002, banning hundreds of millions of dollars in unlimited contributions to the political parties, public trust in government fell to new lows, according to polls.

And what about the corporations that contributed so much of that money? A review of the biggest corporate donors found that their stock prices were unaffected after they stopped giving to the parties. The results suggest that those companies did not lose their influence and may have been giving "because they were shaken down by politicians," said Nathaniel Persily, a professor at Columbia Law School who has studied the law’s impact.

"There is no evidence that stricter campaign finance rules reduce corruption or raise positive assessments of government," said Kenneth Mayer, a professor of political science at the University of Wisconsin-Madison. "It seems like such an obvious relationship but it has proven impossible to prove."

Saturday, January 30, 2010

Markets Predict A US Bond Default More Likely Than Coca-Cola Default

Trading in the credit-default swap market this week shows that investors now view a default by the U.S. Treasury as more likely than a default by the Coca-Cola Company....Now the United States has taken its place next to Italy and Spain in a special club that no major country wants to join -- countries whose debt is considered less safe than that of Blue Chip businesses.
from the Wall Street Journal article, "In Coke We Trust" by James Freeman.

Have Presidential Economic Advisers And The CEA Outlived Their Usefulness?

In 1946, after WWII, with fresh memories of the Great Depression, faith in Keynesian economics and a belief in successful government intervention in the economy, Congress passed the Employment Act of 1946 and established the Council of Economic Advisers (CEA) to advise the President.

As stated on Whitehouse.gov:
The Council of Economic Advisers assists the President with the development and implementation of our nation’s economic policy. Led by a Chair and two members, the Council consists of a team of highly-trained professional economists, forecasters and statistical experts who draw upon evidence-based research to provide the President with thorough and timely economic analysis. Christina Romer was appointed by President Obama and confirmed by the Senate to serve as Chair of the Council. Austan Goolsbee and Cecilia Rouse have been confirmed to serve as the Council’s two members.
In 1978, Congress passed the Humphrey-Hawkins law. It required the President to seek the inconsistent economic goals of full employment without inflation. The CEA's annual economic report on the economy, employment and jobs became a political document as it presented the President's goals for employment and economic growth in a favorable future scenario in accordance with electoral party economic platforms.

These days the political parties have opposing opinions of the effects of government intervention and taxes on economic growth and employment based on their different ideologies. The CEA's report and advice to the President is often just a restatement of his/hers party's prior philosophical and economic beliefs of the power of government intervention and the economic effects of taxes, supplemented with charts, graphs and numerical projections.

Past CEA chairs have said in substance that when they were advising the President, an economic policy's ability to get public acceptance and Congressional votes for passage was the paramount practicality and it overrode economic theory and research results.

Since Presidential political parties' economic policies reflect their ideologies, there is very little need to advise a President regularly on economics. Additionally, Congress can and often does hold hearings for new legislation where experts testify. The best minds and experts in economics can present their views and research in person or in writing at those times. Similarly, as the President does on other matters, there is nothing to stop him from hearing the views of economists and other economic advisers, which is what Presidents did before the CEA.

Other than producing documents and charts for other economists to accept, reject, criticize or defend, there is little purpose these days for the CEA. Regulatory issues, such as restructuring the financial system fall under the Treasury Secretary and not the CEA.

There is little reason these days to package ideologies in an economic paper of charts and numbers signed and presented by CEA members. It is time to stop the political charade and just abolish the CEA.

Friday, January 29, 2010

In Honor Of Mars Rover Spirit: Great Job!

Spirit from XKCD:






















Thanks to all the people who conceived, designed, built, programmed and managed the Mars rover Spirit over the years.

Is it too much anthropomorphism to send Eve?

Thursday, January 28, 2010

US Unemployment Reduction Worse Than Other Countries

Rebecca Wilder on News N Economics blog posted charts showing that relative to each country's previous levels of unemployment, current US unemployment levels are worse than Asia, Emerging Europe and other G7 countries with the exception of Latvia.

See Rebecca's wonderful charts in her blog post, "Unemployment rates: U.S. versus the rest of the world."

The economic policy question of the day is why is the US experiencing worse unemployment and slower job growth than most developed countries and what can be done to create faster job growth?

Do Not Burst Bubbles: The Alternative Universe To Compare Economic Results Does Not Exist

EMH [Efficient Market Hypothesis]does not say anything about fundamental values because fundamental values are an undefined term. Fundamental values seem relevant after the fact because we focus on the particular meaning that makes the price appear over valued.

For example, for stocks, there are many 'fundamental value' criteria. Is it price to earnings, price to dividends, price to sales, price to cash flow, price to free cash flow, Gordon dividend growth model (with what growth rate), discounted cash flow (what growth rate, what discount rate), price to EBIT, price to competitor ratios, breakup value, etc.

For options, you write, "Event studies such as these are not quite enough to address Hanson's concern, since they do not consider false alarms: situations in which the prices of options signaled an increase in volatility that did not eventually materialize."

You are saying if I call the fire department everyday, and if one of those days my house is on fire, I have a good strategy. [I should have said people who call for the Fed to burst bubbles instead of 'you'.] Using implied option volatility that does not lead to a bubble collapse means, the Fed will do the wrong thing many times in order to make sure it does the right thing in a bubble. That is like telling a surgeon to cut into everyone to remove his or her appendix to prevent appendicitis. How many unnecessary recessions and periods of high unemployment are you willing to endure to prevent one bubble?

EMH says several things, but two important ones are:

It says past prices and past gains are irrelevant for determining the future gains and prices tomorrow, next week, next year, etc.

It says public information, including past public information, in addition to price information does not give you any ability to generate a better return than anyone else can or to tell what the price will be in any future time period.

Hindsight is wonderful. It tells the quarterback (The Fed) what play (money supply, interest rate policy) he should not have done. It does not guarantee that a different action would succeed. Many say Fed's loose money policies caused the housing bubble. Do we know that a tight money policy at that time would stop the housing bubble?

Even if we can call a bubble as it is happening and the Fed acts and the bubble crashes, is the economy worse or better off than if the bubble crashes without Fed action? Without a bubble, could we put ourselves in a worse economy than we currently are? We do not know. No models or predictors of the bubble crash predicted the severity of this recession. Without the ability to predict this recession from a bubble burst, how do we know it would not have been worse without the bubble?

How do we know that any Fed action to reduce asset prices in a bubble (housing), will only affect that asset (housing) and not other assets not in a bubble. Could the remedy cause a deflationary spiral across many assets and be worse than the bubble?

What do we gain and lose by interfering with bubbles? If we had stopped the dotcom bubble, would we have never had companies such as Amazon and EBay, to name two, or Google years later?

The alternative universe for us to compare economic results does not exist. We will never know if the proposed cure works or does not, or if the economy is better or worse for bursting a bubble.

I posted the above as a comment on Rajiv Sethi:thoughts on economics, finance, crime and identity... Blog, "Identifying Bubbles."

Bacteria Modifed To Produce Oil

Researchers have engineered a common type of bacteria to produce biodiesel and other goodies from plain old plants. The microbial trickery, detailed today in the journal Nature, promises to add "nature's petroleum" to America's energy supply within the next few years.
From "Bacteria rebuilt to make oil" by Alan Boyle.

After Foreclosure, Lenders Go After Former Homeowners For Unpaid Balances

Amid a crisis that stripped $6.4 trillion, or 28 percent, from the value of U.S. residential real estate since the 2006 peak, lenders are exercising their rights to pursue unpaid mortgage balances. To get their money, they can seize wages, tap bank accounts and put liens on other assets held by debtors.
From Bloomberg, "Lenders Pursue Mortgage Payoffs Long After Homeowners Default" By Kathleen M. Howley.

Wednesday, January 27, 2010

Is The Future Safety Net Multiple Jobs At Multiple Employers?














The above chart is from the New York Times article, "Job-Juggling and Job Loss" by Catherine Rampell.

States that have the highest percentage rate of workers with multiple jobs have the lowest unemployment. How will current and future workers respond to this severe economic downturn and high unemployment? Will they modify their behavior and hold multiple jobs from multiple employers as a way to diversify away the risk of a long-term loss of wages?

Certainly, at the non-professional level where job pay is hourly, it makes sense to diversify employers and hold two or more jobs from different companies. Does it make sense for managerial and professional workers who get a set weekly or yearly salary independent of the hours worked?

In the current recession where many white collar managers, lawyers, and other professionals are losing their jobs, facing long term unemployment and extended periods of lost wages, it would also make sense for them to have jobs at multiple employers and maybe also in multiple fields and sectors. Of course, there are logistical and structural issues to overcome, but nothing that is insurmountable.

Is the future of US employment, full workweeks through multiple part-time jobs at multiple employers? It is a possibility.

If employers benefit from full time employees over part-timers, employers will pay a premium wage for full time workers to offset the value of diversification to employees. Of course, there is a chance employers will find the lower wages of part-timers more valuable than having full time employees. It will come down to how risk adverse future employees become after this economic downturn and how important salary reduction is to employers across a wider range of job categories.

Will employees value a safety net of multiple employers in multiple sectors and fields over the higher wage premium of single employers?

Will employers value the lower wages of part timers more than the additional company value of a full time employee?

The next decade will tell. Either is a possible outcome.

Auotmatic Federal Tax Increases Next Year

...next year there will also be substantial tax increases for a great many Americans. The first reason will be the expiration of the Bush tax cuts. The top personal income tax rate will rise next Jan. 1 to 39.6% from 35%, a hike of nearly one-eighth. The dividend tax rate will rise to 39.6%, more than 2½ times the current 15%. And the capital gains tax rate will rise by a third, to 20% from 15%. If the House health care bill had passed, all three of these rates would have risen to 45%.

The estate tax, which fell to zero this year under the Bush tax cuts, will return in 2011--or sooner, if Congress acts to restore it. Another likely tax increase will be on the income of private equity and hedge-fund managers, from the capital gains rate of 15% to the new higher income tax rates. It has already been passed by the House and is supported by the Obama administration, as is an additional 10-year, $90 billion tax on banks aimed at "rolling back bonuses for top earners." It would affect some 50 banks, insurance companies, and large broker-dealers.

Meanwhile a number of last year's tax deductions have disappeared due to the failure of Congress to extend them into this year. The tax deduction for state and local sales taxes is one; the deduction for college tuition and fees is another; and the 50% write-off for small businesses for capital purchases--equipment, machinery or building a new plant--has disappeared as well, which will have a negative effect upon the construction of new business operation facilities.
From The Wall Street Journal opinion piece, "An Economic Time Bomb" by Pete Du Pont.

Tuesday, January 26, 2010

Obama-Volcker Rule Will Not Prevent A Future Financial Crisis

If an institution has a high risk tolerance, then limiting leverage, a firm's size, and its activities will not reduce the riskiness of the firm.

As a simple example, suppose a financial institution has one asset category, residential real estate loans (mortgages) totaling $100. Suppose the bank is a prudent lender and requires a 50 percent downpayment for every mortgage (a 2 to 1 leverage ratio for the borrower). The bank's $100 of mortgages is backing $200 of homes. If the bank has $3 of equity, its leverage ratio is 33.3 to 1, $100 of loans to $3 of equity. The house price risk the bank undertook is leveraged 66.7 to 1. $200 of real estate collateral is backed by $3 of equity.

Suppose we require the bank to hold twice as much capital, $6 of equity instead of $3 for each $1 of loans. Does the bank keep it 50 percent downpayment requirement or does it reduce the downpayment?

If the bank wants the same risk, it will reduce the downpayment requirement for its mortgages to 25 percent. Now, its $100 of mortgages will back $400 of home value, and the bank's leverage ratio will look better, 100 to 6, 16.7 ratio, instead of 100 to 3, a 33.3 ratio. The risk though will be the same because $400 of real estate value is backed by $6 of equity for a ratio of 66.7. The bank has the same home value risk as before.


The value of a collateralized loan is dependent on both the expected default rate and the value of the collateral. If default rates increase, the value of the loan portfolio decreases. If the collateral value decreases, the loan portfolio value decreases. If both happen simultaneously, there is a greater loan value decrease than from either alone. If default rates correlate with collateral value, there will be further declines in portfolio value over and beyond those that occur if default rates are not correlated with asset values. During the crisis, some of the CDOs held by Bear Stearns and others lost 70 percent or more of their value, while still being current in principal and interest payments.

In real financial institutions with many categories of loans and investments, some collateralized and some not, it will be impossible for regulators to monitor or prevent the shift in to higher asset risk with a lower leverage ratio.

Accounting values will never capture all loan or bank asset risk. There is, as in the example above, hidden leverage. Additionally, there are embedded options in assets and loans that increase their riskiness over their dollar amounts. Also, there are co-movements, correlation, effects that are not easily recognizable by regulators.

The regulators will never see full interconnectedness. In one part of the country, a bank could be lending to a homebuilder while another bank is lending to the buyers of those homes. The two banks could be in different parts of the country, lending to different groups (buyers and builders), and yet the banks are interconnected in their fates. A third bank could be lending to a business that likes to open near new home developments. The third bank's fate is bound to the first two.

There is also asymmetric information risk between the regulator and the bank. Can a regulator distinguish the riskiness of different small businesses, related businesses, new ventures, similar loans to different geographical areas, different economy sectors?

Banks can always increase or decrease the risk of their assets to keep the institutions' riskiness constant as regulators change leverage ratios.

There is an unresolved aspect of the recent financial crisis that might help to determine how governing bodies should proceed.

Did the banks think their risk was lower than it actually was? In other words, did they, the markets, the regulators and others honestly believe that the real estate investments (mortgages, CDOs, MBSs, etc.) were safe investments that could be highly leveraged to realize more risk, but one that remained after increased leverage, a modest and a safe risk for the bank? Alternatively, did they have a high risk appetite, recognize the amount of risk they were taking and gamble and lose?

If the bankers, the markets, individuals and the regulators did not see the risk, then we had an unexpected earthquake in an area that never has earthquakes. Whatever we do to prevent future earthquakes will not prevent future unexpected events from happening, such as a lightning strike or a tsunami. Future financial market crises become an unpleasant fact like a rare lightning strike. Even those who say they saw a real estate bubble never expected the severity of the financial crisis, the failure of firms, and the extent of the economic downturn.

If bankers, individuals (remember they were the ones with the insatiable demand for homes and home loans) businesses, and possibly government saw the risk, gambled and lost, we have to focus on why the economy's risk tolerance rose. Without an understanding of what created higher risk tolerance, government and regulator attempts to reduce institutional risk will fail. Controlling size or allowing failures will not be enough. The institutions will find ways through regulatory arbitrage, asymmetric information, embedded, and non-observable risks to keep their riskiness at a high level. The regulator will be a cat who can never catch the mouse. Future financial crises from high risk will continue to occur despite regulatory efforts.

Part of the regulatory solution begins by recognizing that future catastrophic financial events will occur unexpectedly, despite best analysis and modifications to regulatory and institutional structure, creating huge losses to financial institutions and harming the real economy.

Governments and regulators need better plans for after the fact damage control to the economy and financial institutions whether or not it is unpreventable. We need to develop solutions to keep business and consumer lending available, and to minimize and undo all the other foreseeable negative financial and real economy effects that occur during and after a financial crisis.

While attempts to prevent financial crises is admirable, we may achieve more economic success by assuming they will occasionally occur and developing the equivalent of fire departments and the Red Cross to deal with situations after a crisis occurs.

Originally, governments and economists thought institutions like the Federal Reserve, Bank of England, etc. were enough of a fire department and aid organization. We need to rethink that philosophy and see if we need additional organizations or tools for future crises.

The above is a comment I posted on VOX blog, "Too interconnected to fail = too big to fail: What is in a leverage ratio?" by Danile Gros.

[Also see my other post: "Obama's New Bank Restrictions Increase Systemic Risk"]

Monday, January 25, 2010

Why Good Schools And Poorly Performing Schools Stay That Way: Survivorship, Selection, Retention And Filtering Bias

I am in favor of more information about schools, teachers and student educational performance because I believe there is not enough accountability by school systems for the educational performance of students and because I believe desirable outcomes should be measured to allow for corrective feedback at all levels of the organization, including school, teacher and student.

I would think that parents and educators would want information that measured performance and also allowed for corrective actions. Too much information or the wrong set of information is not helpful.

It is individual teacher and individual student level longitudinal (over time) information, which is almost never forthcoming in any disclosure by school systems, that best measures a student's and a teacher's performance. Has the teacher been able to improve the student's performance over the year? Yes, good school for that student: No, bad school for that student.

A large data set of information maybe interesting for conversational topics but is costly both to the parents and the schools, in the sense that both must expend effort in learning which data is useful information for improving student performance and which data is extraneous information.

The problem with aggregated non-specific student and non-specific teacher information is that over any time period the students and the teachers change and comparisons of increasing or decreasing test scores are made against two different groups. This year's graduating students with teacher group A are compared to last year's graduates with teacher group B, for example, without knowing if comparison of the two groups is valid.

There are indications in educational performance data that there is selection and filtering bias, which interferes with the usefulness of the information for parent decision-making. For example, schools with high scores tend to demand a commitment to more schoolwork than lower performing schools and also over other student interests. Do parents and children who want more schoolwork move into these school areas and produce higher test scores or do the schools and teachers. Whether better performing schools, in the sense of higher student scores, attract better achieving students or produce better achieving students is often ambiguous from most studies of performance. Do good students make schools look better on tests or do good schools make students look better on tests?

There are also indications that schools signal which students they want to enroll, which students they want to keep, and which students' families they want to move to another school area. In the US, it is sometimes as simple as whether the school highlights the winning science fair participants or the football team, but often the signals are much more subtle and less obvious. There is a survivability bias. Good schools may look better than other schools because they are better at enrolling, separating and retaining the higher performing students, and the poorer performing students move away from the school. Educational studies almost never control for survivorship bias.

Any educational information to be useful to parents has to allow them to choose a school that would benefit THEIR child. The current state of educational information about schools does not offer information to anyone that allows changes to be made to a school to improve its performance for any fixed student body. Yes, school scores can be improved but it is often by selecting a better performing group of students for testing and not by actually improving student performance. If it were easy to make improvement changes or if people really knew, what changes to make to improve schools, student outcomes at all schools, even poor performing schools, would be improved a long time ago.

The data is unreliable for recommending changes to schools to improve student outcomes and that is why student performance is deteriorating in many schools. It is also why every recommendation that has come out of previous data studies has failed to produce the desired results of significantly improving student test score outcomes.

I posted an almost identical comment on Core economics blog, "What has transparency ever done for us?" by Joshua Gans.

Sunday, January 24, 2010

Midwest Cooling From Crop Irrigation

From 1970 through 2009, average high temperatures at the sites in Iowa and Illinois during July and August were between 0.5 and 1.0 degrees F (0.28 and 0.56 degrees C) cooler than they were for the years 1930 through 1969, the researchers found. The amount of precipitation received in the region has changed substantially as well: Average rainfall for July and August from the 1970s through 2009 was about 0.33 inches (0.8 centimeters) higher each month than it was from the 1930s through the 1960s.

[David] Changnon suggested that fewer hot days and more precipitation are linked, because humid air warms more slowly than dry air does. One likely source of the extra moisture is the region’s agriculture. Plants pump vast amounts of water from surface soil into the atmosphere as they grow, and thirsty row crops such as corn and soybeans are much more prevalent in the region these days — about 97 percent of farmland is planted in those crops now, versus about 57 percent in the 1930s, Changnon notes. Also, the plants are spaced more closely now (about 30 inches apart, versus the 40-inch spacing typical in the 1930s), a trend that has boosted the numbers of water-pumping plants per acre by about 60 percent.
From "Crop irrigation could be cooling Midwest" by Sid Perkins in Science News.

States Need To Rethink How They Allocate Their Scarce Resources

When state universities run out of money to fund classes to meet the needs and interests of all their students, they need to change the way they choose who benefits and gets into the classes they want and who does not. Other state agencies that provide non-life saving programs also need to change allocation methods of their programs to their constituencies.

For example, in The New York Times article, "Students Face a Class Struggle at State Colleges" by Katherine Mieszkowski on January 23, 2010, California University students are assigned a time to register for the remaining open classes. No preference is given to a student who values an open course more highly than another student with an earlier registration time. The later registering student may out of interest or requirement place a greater value on a particular course that an earlier registering student who would be equally satisfied and happy to take a different course.

One way to have a fairer course registration would be to use an auction (or trading) process for student registrations instead of the typical time slot method. Students could be given a fixed amount of play money that they could use to bid (or buy) for an open seat in a course. At the end of the bidding (or trading) process, open seats that are left over and available could be assigned on a first come first serve basis (or some other standardized method, such as randomized alphabet of first letter, and if needed second, then third, etc of last name, or other equally fair method), to students who still need more course credit that term. After all students register, a day of trading could be allowed for students, who desire, to improve their valuation of their semester courses.

The point is that there are many auction and market experts available who could help universities and government agencies designed fairer methods to allocate course and non-life essential programs. At universities, it would be fairer in the sense that those students who place a higher value on a course than other students will get a greater chance of successfully registering for that course than the students who care less about that course. Time slot registration does not consider the educational worth of the course to the student.

Allocation methods based on a program's recipient's self-valuation of that benefit versus another benefit from the same program would be fairer to constituencies in these times of severe state budgetary constraints. Recipients given a play money amount to buy or bid for their choices of the benefits of a program would feel like they got their monies worth because they will have outbid other potential recipients and spent all their budget.

See my previous post on this topic, "What If Colleges Auctioned Classes?"

Saturday, January 23, 2010

Middle-Class Frustration

"The Context Of Middle-Class Frustration" by Doctor Zero.
The frustration of the middle class is the angry confusion of people who can appreciate the opportunities Big Government denies them. It is the anxiety of those who hear the businesses who employ them relentlessly demonized, while the ruling class is never held responsible for its foolishness, waste, and theft. It is the resentment of people who suffer through disasters that President Obama and his allies regard as opportunities. It’s the hearty distrust of a State, and its media apparatus, that declares every frigid blast of bad economic news to be “unexpected” – but expects us to believe it can predict market fluctuations, technological advances, and even the global climate.
The author, Doctor Zero, is John Hayward and he lives in Florida.

Is It Time To Allow Large Banks To Issue Private Bank Notes?

Below is a comment I posted on Econlog blog, "Too Small to Succeed?" by David Henderson.
Actually, the failure of rural banks [during the Great Depression] was ironic. In addition to Federal law, most State banking laws also prohibited intra-state and interstate banking. The common belief was that the rural banks would just send the deposits to the cities and there would be insufficient funds for farmers, etc. Laws intended to help rural areas actually hurt them during the Depression.

The decline of the agricultural workforce allowed banks to expand nationally without negative political ramifications.

Eliminating deposit insurance now is politically very difficult and the insurance is often cited as the sole cause of the moral hazard problem. Unfortunately, when federal deposit insurance was passed, private bank notes were also banned.

These private bank notes traded as currency at par or discounts based on the healthiness of the bank issuing them. Their exchange values were probably the foremost indicators of a bank's safety and soundness. The bank notes also stopped moral hazard.

As far as I know, the reintroduction of private bank notes as currency has not be studied or promoted (but my knowledge of this area of research is limited).

Could allowing banks to issue private bank notes remove moral hazard issues? Are private bank notes viable in today's economy? Could the Fed still control the money supply? SEC issuance problems?

Gift and prepaid merchant cards are like private money in many ways since insolvency and bankruptcy leave the cardholder as a general creditor of the firm. I do not know of markets that trade these cards and reflect the viability of the issuing merchant. It may be one reason bank prepaid cards, such as Visa, MasterCard and American Express have gained in popularity over private merchant cards.

Volcker Was Very Unpopular As A Fed Chairman

People forget that there was also a populist revolt against Paul Volcker when he was Fed Chairman. His tight monetary policies made interest rates were very high (21 percent prime rate). Many economists and the public at the time believed that Volcker's failure to expand the money supply delayed the economic recovery from the 1980-81 recession and caused unemployment and interest rates to remain excessively high. The public often expressed its resentment and disagreement with the Fed's policies.

People protested against the Fed's refusal to grow the money supply, "FED OFFICIALS BOOED IN CHICAGO ON RATES" by Winston Williams, New York Times, June 22, 1981

Fortunately, Reagan did not bow to populist sentiment, supported Volcker and later reappointed him. Volcker is now held in high esteem as an excellent Fed Chairman and Reagan is viewed positively for the way he backed Volcker and allowed him to continue his monetary policies to control inflation and break the stagflation cycle of the 1970s.

7 To 10 Percent Cost Increases For Large Employers Under Unmodified Senate Health Care

Should that Senate bill pass unmodified and become law, the cost of employer-provided health care for large companies would shoot up an additional 7% to 10% per year (beyond current increases) over the next decade, for a grand total of between $62.7 billion and $89.2 billion, estimates the HR Policy Assn., a group of human-resource executives at the country's largest 300 or so firms.
****
If a health-care reform bill similar to the ones in Congress is eventually passed, how will companies react? According to the HR Policy Assn., many members are already considering such actions as reducing benefits for both retirees and employees, passing on the cost of any excise tax to workers, and even delaying hiring for open positions.
From "The Bill for the Senate's Bill" by Alix Stuart on CFO.com.

10 Percent Membership Loss For Private Sector Unions In 2009

Organized labor lost 10% of its members in the private sector last year, the largest decline in more than 25 years. The drop is on par with the fall in total employment but threatens to significantly limit labor's ability to influence elections and legislation.

On Friday, the Labor Department reported private-sector unions lost 834,000 members, bringing membership down to 7.2% of the private-sector work force, from 7.6% the year before.
From The Wall Street Journal article, "Union Membership Drops 10%" by By Kris Maher.

Friday, January 22, 2010

More Union Workers In Government Than Private Sector

There are now more government union workers than private sector union workers.

Read "In Unions, Government Workers Surpass Private-Sector Workers" By Catherine Rampell in the New York Times.

Chance Of Double Dip Recession Now Greater: Stocks And Economic Growth Are 55 Percent Riskier Over Last 3 Days

Over the last three days, as President Obama unveiled his plan to restrict bank activities, the S&P500 volatility index (CBOE VIX) rose 55 percent. On Tuesday, January 19, the VIX closed at 17.58. On Friday, January 22, the VIX closed at 27.31.

The stock market and the economy are now 55 percent riskier than they were a few days ago. As the stock market is a signal of US economic growth, the chances for a double dip recession are now greater than they were a few days ago.

The populist backlash, led by President Obama, against banks is the main reason for the increase risk. The President is angry for the Democratic Senate loss in Massachusetts and the now unlikely passage of health care reform. Governmental policy originating from anger and retribution, especially to appease a populist backlash, rarely leads to good policies and often has many negative, unwanted and unintended economic consequences.

Part of the uncertainties facing future US economic growth are the doubts about the confirmation of Fed Chairman Ben Bernanke, the loss of Presidential influence of Larry Summers and Tim Geithner, the new proposed Volcker banking restrictions and the uncertainty of what other populist economic proposals will come out of the current Administration and Congress.

The loss of over 5 percent of the S&P500 and Dow Jones Industrial Indices value in the last three days, coupled with a 55 percent increase in risk, is directly attributable to President Obama's leadership, policies and Congressional influence.

World Poverty Is Falling

Between 1970 and 2006, the global poverty rate has been cut by nearly three quarters. The percentage of the world population living on less than $1 a day (in PPP-adjusted 2000 dollars) went from 26.8% in 1970 to 5.4% in 2006.
From "Parametric estimations of the world distribution of income" by Maxim Pinkovskiy and Xavier Sala-i-Martin on VOX.

Volcker Created The Foundation For The Current Crisis And Had His Own Financial Crisis As Fed Chairman

Paul Volcker's policies to cure 1970s stagflation, as Fed Chairman during the 1980s, were responsible for the savings and loan crisis of the 1980s and for setting into motion many of the economic forces that led to the current financial crisis. He also created the worst post WWII recession up to that time, 1980-1 recession.

During the early 1980s, Volcker's tight monetary policy and his shift to targeting the money supply instead of interest rates forced the prime rate up to 21 percent. The increase in short-term interest rates precipitated the S&L crisis. S&Ls at that time primarily made fixed rate mortgages funded by low rate deposits and other short maturity low interest rate instruments.

Volcker's high interest rates caused S&Ls to fund existing long-term, low rate mortgages with high interest rate, high cost money. The S&Ls suffered huge financial losses as a result and caused the S&L crisis, which cost the taxpayer, billion of dollars.

High interest rates also caused disintermediation in consumer banking as depositors shifted their funds to higher paying money market mutual funds. The high rates and lost deposits forced banks to finance their lending with higher cost funding.

Bankers' experiences under Volcker led banks to push variable, adjustable rate mortgages. Volcker's policies also led banks to expand across state lines to increase their consumer deposit sources, to seek merger partners and to consolidate into bigger financial institutions. It also made banks want to sell the loans off their books instead of holding them and taking the interest rate risk, which led to increased securitization of consumer loans and mortgages.

Banks also looked for ways to earn money from sources other than lending to consumers, such as consumer banking fees, investment banking and proprietary trading.

So in summary, while Volcker successfully stopped stagflation of the 1970s, his policies led to the S&L crisis, bank consolidation into TBTF, securitization of mortgages, increased fees on consumer banking products and pushed banks into non-lending revenue streams such as investment banking and proprietary trading.

What reason do we have to believe that any of the policies he has persuaded President Obama to adopt about bank risk will not cause as much future harm to the banking system as the previous Volcker policies as Fed Chairman.

The stock market understands the potential economic harm from Volcker's policy suggestions to Obama and the VIX (CBOE S&P Volatility Index) increased on Thursday by 19 percent.

Obama's New Bank Restrictions Increase Systemic Risk: The VIX Rose 19 Percent

Congressional and Executive Branch changes to laws, regulations and policies to reduce the systemic risk of the financial system, such as Obama's new banking restrictions, often have an opposite effect and increase the systemic risk.

As an example, Franklin Edwards and Edward Morrison explained in an article "Derivatives and the Bankruptcy Code: Why the Special Treatment?" (Winter 2005, Yale Journal of Regulation) that simple, logical changes to laws and regulations to prevent systemic risk in a bankruptcy proceeding created the need for the Federal Reserve to step into the collapse of LTCM (Long Term Capital Management) to prevent a systemic risk crisis. The very Congressional changes to the US Bankruptcy laws for derivative settlements intended to prevent a systemic risk crisis exacerbated the LTCM crisis and forced the Federal Reserve to intervene to prevent the failure of other financial institutions.

Edwards and Morrison state:
Thus, one view of the potential for LTCM to have caused a systemic crisis is that this crisis was precipitated by the very provisions of the Bankruptcy Code that were designed to assure stability in derivatives markets.

Had these provisions not been adopted, it is very likely that there would not have been either an “abrupt and disorderly close-out of LTCM’s positions” or an “unwinding [of] LTCM’s portfolio in a forced liquidation.” There probably would have been no need for the Federal Reserve to intervene to prevent a “seizing up of markets . . . [that] could have potentially impaired the economies of many nations, including our own.”
Earlier in the article, they write:
The collapse of Long Term Capital Management (“LTCM”) in Fall 1998 and the Federal Reserve Bank’s subsequent efforts to orchestrate a bailout raise important questions about the structure of the Bankruptcy Code. The Code contains numerous provisions affording special treatment to financial derivatives contracts, the most important of which exempts these contracts from the “automatic stay” and permits counterparties to terminate derivatives contracts with a debtor in bankruptcy and seize underlying collateral. No other counterparty or creditor of the debtor has such freedom; to the contrary, the automatic stay prohibits them from undertaking any act that threatens the debtor’s assets. It is commonly believed that the exemption for derivatives contracts helps reduce “systemic risk” in financial markets, that is, the risk that multiple major financial market participants will fail at the same time and, as a result, drastically reduce market liquidity…. Risk of a systemic meltdown arose there and prompted intervention by the Federal Reserve precisely because derivatives contracts were exempt from the automatic stay. Derivatives contracts may merit special treatment, but fear of systemic risk is a red herring.
Yesterday (Thursday), the S&P Volatility Index (CBOE VIX) rose 19.2 percent for a gain of $3.59. Market participants expect stocks to be almost 20 percent riskier than they were before President Obama announced his banking risk proposal. The market does not believe his proposal reduces systemic risk.

Franklin R. Edwards is the Arthur F. Burns Professor of Economics and Finance, Columbia Business School.

Edward R. Morrison is an Associate Professor of Law, Columbia Law School.

[Also see my other post: "Obama-Volcker Rule Will Not Prevent A Future Financial Crisis"]

Wednesday, January 20, 2010

Separating The Specifics From The Goal Of Health Care Reform

It is surprising that Democratic pundits do not separate the specific bills in Congress from the goal of health care reform.

Most of the public in Massachusetts and in the US support reform. They do not support the Senate or House bills before Congress.

For many reasons, the electorate does not see the two proposed laws as positive reform. The public sees special favors, unrealistic cost savings estimates, uncertain cost savings promises without assurances and few if any benefits to their own health care.

Passage of a health care law derived from a compromise of the two bills will not change that perception.

The two biggest benefits cited was the prohibition against using a pre-existing condition to deny health insurance coverage and coverage for the uninsured. The public understood that to make that happen all Congress needed to pass was a simple law making it illegal to use pre-existing conditions and an increase in the coverage of either Medicare or Medicaid for the uninsured. There was no need for deals, pork, promises about uncertain future outcomes, etc.

The bills are icebergs. Most of their provisions and future effects were not above water and visible to the public. The public was suspicious and angry about the special favors for select groups.

The Democrats do not seem to be able to separate their need to pass health care reform law from the quality of the law they want to pass. They are willing to pass a bad law because it is called health care reform. The public is not so enamored of the title and instead wants substantive, useful, helpful, positive change passed. Unfortunately, the President assured a Democratic loss of Senate control and that the bill as is would not pass when he sent signals (deal with the unions, etc) that he was willing to agree to almost anything to get a law called health care reform passed.
The above is my comment to Ezra Klein's post "Political courage" on The Washington Post.

A Simple Health Care Proposal

Raise the Medicare tax by half a percentage point, and eliminate the tax-deductibiity of health insurance benefits for people making more than $150K a year in household income, $100K for singles. Then make the federal government the insurer of last resort. Any medical expenses more than 15% or 20% of household income, get picked up by Uncle Sam.
A simple health care reform proposal, post Scott Brown's Senate election win, "Killing Off the Insurers the Conservative Way" by Megan McArdle. One of many new health care proposals that will surface after the Democratic loss in Massachusetts.

Intrade Now Trading An Obamacare Security

Intrade added a security to track the progress and chance of passage of health care reform before July 1, 2010. At expiry at midnight, June 30, 2010, the security pays either 100 or 0 depending on the passage of health care reform or not.

The last trading price can be viewed as the percentage chance of passage of a health care law that satisfies the requirements of the contract. The last price as of this writing is 38, which indicates a 38 percent chance health care reform will pass by midnight, June 30, 2010.

The contract specifics are:
The "contract will settle (expire) at 100 ($10.00) if a healthcare reform bill is passed into law before midnight ET on the date specified in the contract.

The contract will settle (expire) at 0 ($0.00) if if a healthcare reform bill is not passed into law before midnight ET on the date specified in the contract.

Expiry will be based on the official passage of a healthcare reform bill into law, as reported by three independent and reliable media sources.

For purposes of this contract a healthcare reform bill is considered one of the following:

- The Affordable Health Care for America Act (H.R. 3962)
- The Patient Protection and Affordable Care Act (H.R. 3590)
- A bill reconciling the differences between the two bills named above

If any of these bills are passed into law the contract will expire at 100. If none of these three are passed into law the contract will expire at 0."
Obamacare health care security price chart:
Price for Will Obamacare health care reform become law in the United States? at intrade.com

Tuesday, January 19, 2010

Insurance Commissioners Looking To Drop NRSRO Ratings For Commercial Mortgage-Backed Securities (CMBS) Capital

The US National Association of Insurance Commissioners (NAIC) is considering removing nationally recognised statistical rating agencies (NRSROs) from the determination of its commercial mortgage-backed security (CMBS) capital requirements.
From "NAIC chair considering CMBS ratings snub" by Aaron Woolner in Life & Pensions, 18 Jan 2010 via Risk.net.

Bank Too Big To Fail Subsidy Less Than Reports

...more conservative estimate of the TBTF [too big to fail] subsidy...come up with a dollar value of $6.3 billion. This estimate is ignored by most commenters, who tend instead to focus on the more shocking $34.1 billion estimate.
***
...the spread between large bank and small bank borrowing costs was actually higher during the fourth quarter of 2001 than it ever reached during the current financial crisis. Is it reasonable to assume that the gap in 2001 was attributable to large banks being too big to fail? I don’t think so, and I doubt if anyone can point to serious speculation that any of the countries largest banks might fail and that they would bailed out by the government during the fourth quarter of 2001. This suggests that a rate spread resulting from people flocking to larger banks during times of economic uncertainty, like the period immediately preceding 9/11, can be as big as or bigger than the rate spread we are currently observing.
From "Debunking The $34.1 Billion Too Big To Fail Subsidy" by Adam Ozimek.

See my previous post on Adam's analysis of TBTF, "Too Big Too Fail Does Not Exist And Is Just Rhetoric" and read Adam's comment to that post.

Monday, January 18, 2010

Poverty Makes Natural Disasters Worse: Wealth Mitigates Natural Disasters.

The earthquake in Haiti was a magnitude of 7.0. According to Wikipedia, the 1989 Loma Prieta quake in San Francisco was either 7.0 or 6.9 depending on which scale is used. In other words, the intensities were fairly similar. Haiti is devastated. If the New York Times is correct, the death toll could be in the tens of thousands. The death toll in the 1989 quake was 63, if you include indirect deaths due the quake.

The difference is wealth. San Francisco is one of the wealthiest areas in our part of the world, while Haiti is the poorest. Poverty makes natural disasters worse. Wealth mitigates natural disasters.
From "Wealth, Poverty, and Natural Disasters: Prosperity saves lives" by James Peron in January/February 2010 issue of The Freeman.

Sunday, January 17, 2010

Markets Predict Republican Win In Massachusetts US Senate Race

Intrade financial markets, which trade various event securities including election outcome securities, is predicting a Republican party win in the election to fill the Massachusetts US Senate seat.

The security price for the Democratic candidate, Martha Coakley, as of 9:45 AM EST, Sunday, Jan 17, 2010 is 45.1. (Click on chart for latest price.)

Price for Winner of Massachusetts Special Election (to replace Ted Kennedy) at intrade.com


The security price for the Republican candidate, Scott Brown, as of 9:45 AM EST, Sunday, Jan 17, 2010 is 56.8.(Click on chart for latest price.)

Price for Winner of Massachusetts Special Election (to replace Ted Kennedy) at intrade.com

Saturday, January 16, 2010

Did The Fed Really Pop The Dotcom Bubble?

If you look at real and nominal home prices and price to rent ratios, you see that housing started to move above trend about 1997-98. When the Fed burst the dotcom bubble in 2000, housing was already in the early part of a bubble, yet not one of these three home price indicators shows a decline when the dotcom bubble burst.

What tool does the Fed have that allows it to target the dotcom price bubble, but not the house price bubble? Could the two assets have such different price elasticities to some Fed action?

Comparing the two asset prices would seem to support that the Fed's actions did not directly burst the dotcom bubble.

Dotcom cooled because either the Fed affected a part of the economy that hurt the dotcom businesses more, or the dotcom collapse was just a coincidental occurrence and not a cause and effect.

Friday, January 15, 2010

Too Big Too Fail Does Not Exist And Is Just Rhetoric

it’s well established that larger firms in all sorts of industries have a lower risk premium than smaller but otherwise similar firms. According to Ibbotsons Valuation Yearbook from 2008, the risk premium for the largest 10% of firms is 34 bps below the CAPM rate, and for second largest 10%of firms is 68 bps above it*. So using a standard valuation handbook, firms in the largest decile should borrow at 102 bps below the rate charged for the second largest group of firms. You hardly need to appeal to a too big to fail premium to explain a 78 bps gap between the rates charged to large banks and small banks.
Read Adam Ozimek's interesting blog post on Modeled Behavior, "Who Knew Banks Were Too Big To Fail, And Does It Matter?"

Deleveraging Lasts 6 to 7 Years: Early Drag On GDP: McKinsey & Co.

New McKinsey research shows that the challenge of reducing total debt levels relative to GDP is a global problem that is only just getting started. Leverage is still very high in some sectors of several countries, including the United States. History also shows that deleveraging episodes are painful—on average lasting six to seven years—and exert a significant drag on GDP growth in the early stages.
From "Deleveraging: Now the hard part: The challenge of managing the enormous debt burden weighing on global recovery is only just beginning" by Susan Lund, Charles Roxburgh, and Tony Wimmer in the January 2010, McKinsey Quarterly. Weblinks to the executive summary and the full report are available in the McKinsey Quarterly article.

15 Percent Donate To Haiti Relief Via Cellphone Text: Bye Bye Telethons

The American Red Cross received about 15 percent of its Haitian earthquake relief donations via cellphone texts.

From The New York Times article, "Burst of Mobile Giving Adds Millions in Relief Funds" by Jenna Wortham:
In the aftermath of the earthquake in Haiti, many Americans are reaching for their cellphones to make a donation via text message.
***
The American Red Cross, which is working with a mobile donations firm called mGive, said Thursday that it had raised more than $5 million this way.
***
The mobile donations are part of a larger surge of money flowing to the relief effort. The Red Cross said it had collected nearly $35 million as of Thursday night, surpassing the amounts it received in the same time period after Hurricane Katrina and the Indian Ocean tsunami.

Suppose Bankers Had Modeled A Severe Home Price Collapse During The Bubble

Suppose bankers did model a 40 percent home price decline. The banks would realize that repackaging and securitizing mortgages was too risky to do. They would also realize that a regular mortgage was also too risky because the collateral, the house, could lose 40 percent of its value. As a cushion, they would want another 10 percent on top and require every house buyer in the US to put 50 percent down to buy a house. Plus, if they did not package and sell the loans, the banks would quickly run out of funds to lend. Not only would subprime and Alt-A loans stop, all mortgage lending would just about come to a halt.

What happens then? No homebuyers. No construction industry. Almost no one can sell a home. Home prices collapse to levels below or the same as current levels. People panic, become afraid and angry at the banks for their irresponsible lack of lending and high down payment requirement. People save a lot of money (to buy a home, out of fear about the economy) instead of spending it. Recession and maybe a depression happen.

Extreme risk aversion is bad for the economy. Banks make loans and take risks. If banks do not take risk, they do not make loans. If you want banks to avoid risk, that means borrowers have to reduce their riskiness by putting up more cash and collateral or not taking out loans and increasing their indebtedness.

If banks do not sell the loans, they quickly run out of cash to lend.

I think we were in a damn if I do, damn if I do not situation with housing.

What we needed was (1) a way for the banks to slightly increase their risk avoidance (no very high loan to value mortgages, no teaser rates, no bad credit or inability to repay mortgages) and (2) for the government to simultaneous lower house price appreciation, lower demand for mortgages and lower demand for new or different homes. Lowering housing demand would have to be done without creating fear and anxiety in the consumer about the future and without creating high unemployment and a recession. I think if the government or the Fed tried to do (2), they ran a real risk of creating a slow economy and a recession similar to our current plight.

I do not think there was an easy way. There were no gentle ways. Once the housing ball started rolling and home prices appreciated dramatically, stopping housing would hurt the consumer and the economy and send it into a recession.

I posted an almost identical comment as the above to Megan McCardle's piece on The Atlantic website, "Jamie Dimon Says They Didn't Model Massive House Price Collapse."

Thursday, January 14, 2010

Bigger Banks From The Liability Tax

After the bank liability tax goes into effect and in contemplation of it happening, expect banks to grow in size.

Big banks will merge with smaller banks with FDIC insured deposits. Smaller banks are almost exclusively funded by capital and deposits. Merging with a bigger bank that is taxed will allow the bigger bank to use the deposits in place of its non-insured funding debt. Especially in this low lending environment where banks are heavily invested in US Treasury securities and cash like instruments, a merger with a deposit based institution will allow banks to reduce their potential tax burden and also have room for new loans when the economy recovers and lending demand increases.

See my previous post on this topic, "White House Bank Liability Tax Will Increase Financial System Risk."

Comment To John Carney's Article On Financial Crisis Inquiry Commisssion

Below is the comment I posted to John Carney's article I discuss in the immediately preceding blog post, "The Financial Crisis Inquiry Commission Doesn’t Get It."
Great article John.

Investing is not rocket science. There are two simple rules. There is no free lunch and do not put all your eggs in one basket.

Sophisticated Investors always had the choice to place funds into US Treasury Securities, which are highly liquid and which have a low risk of default. You do not need to hire an investment manager and pay a high salary to put all your funds into Treasuries.

Pension funds, mutual funds and other sophisticated investors hire investment mangers to take risks to attempt to achieve returns higher than the returns from US Treasuries. The only way to get a higher return is to take risks. Those additional debt risks include extra defaults and more concentration in a single sector (residential mortgages), i.e. less diversification. (Mortgages also have prepayment risk, but that is a different kind of risk and does not result in a loss of principal.)

Sophisticated investors knew they were taking risk because they knew the expected return was higher than a US Treasury or a GNMA of the same maturity. If the return were not higher, they would not have bothered buying the mortgage related securities from Goldman. These investors also know the risk of placing too much money into a single sector (housing), and a single product (non-government insured mortgages). Only the most inexperienced and stupid fund manager thought there was a free lunch. They did not have to read the documentation to know that there was risk.

The credit rating is irrelevant to most sophisticated investors except to the extent some are restricted by law from investing in categories below a certain rating. If the sophisticated investor relied on the credit rating to determine his investments, then the problem was with that organization for not going out and hiring experienced investment managers who understood risk and who knew what questions to ask. The credit rating in the aftermath of this financial crisis is being used as a memo to file to CYA since there has been a lot of Monday morning quarterbacking, but the managers knew what they were doing despite their claims of denial now. The investors are just trying to deflect blame from themselves for their stupidity.

Despite what those who are unfamiliar with the process think, institutional sales people, from Goldman and other firms, are used to tough questions about their products. Buyers know these products are complex. Sophisticated investors usually have to get approvals from a committee or a least a head person to buy. Salespeople and analysts from Goldman and other firms are willing and often do talk to clients to answer any questions. Sensitivity charts are prepared to show what happens under different scenarios, such as if interest rates go up, down, defaults are below, above x, etc. If a selling firm cannot answer a reasonable question, such as how will your product perform if defaults go up by x percent or house prices decline by x percent, there is always a competitor who will be glad to get the business, especially to take it away from Goldman, do the analysis and sell the product to you. Otherwise,, the buyer should and can just walk away from the product and invest in something else. Many products fail to sell because sophisticated investment buyers are not convinced it met their needs, is sufficiently analyzed or understood by the selling firm.

The Financial Crisis Inquiry Commission Doesn’t Get It

The Financial Crisis Inquiry Commission thinks its role is the same as the Consumer Products Safety Commission. If it succeeds in convincing Congress that that is its proper role, the only allowable investments will be US Treasuries.
Philip Angelides, chairman of the Financial Crisis Inquiry Commission, doesn’t get it.

...Angelides has a world view that is overly constricted by the ideology of regulators. His intellectual world cannot contain “good products” that result in huge losses for their buyers. Blankfein [CEO and Chairman, Goldman Sachs] tried many times to get the chairman to open his mind. It remained decidedly closed.
***
A structured credit product—whether its as simple as a mortgage backed security or a complex CDO—is not necessary flawed if it produces losses. Even enormous losses. Indeed, it might be perfectly well-designed but still deliver the buyers losses.

The point of creating structured financial products is to create exposures to certain risks and opportunities. A mortgage backed security, for instance, might be designed to expose buyers to subprime mortgages. If it is well-structured it will expose its owners to the upside and downside of the mortgages pooled within it.
***
When Goldman was selling the financial products, it wasn’t necessary telling the buyers that these were great investments. It was telling them that they were investments that would give them the exposures they were looking for. If you were bullish on the mortgage market and a skeptic of the Bubble Thesis—a thesis that Goldman had very publicly embraced—then buying mortgage backed securities from Goldman was a way to put that bullishness into action.

Angelides, the former California state treasurer, just has too much of paternalistic world view to understand that it is possible to sell a financial product without believing the buyer’s rationale for buying it.

This really is the heart of the matter. Angelides thinks it is wrong for Goldman to underwrite financial products that create exposures it does not want for itself. As long as Goldman wasn’t lying to clients or over-hyping the financial products—and so far, no one has shown any evidence of this—there’s nothing really wrong with what Goldman was doing. If sophisticated investors want to take on risk, they should be permitted to.
From "How Lloyd Blankfein’s Brilliant Answers Befuddled The Financial Crisis Commissioners" by John Carney.

White House Bank Liability Tax Will Increase Financial System Risk

This is written before the announcement of the actual tax proposal!

A proposal to tax liabilities [defined as assets minus insured deposits and minus equity] is a lot more complicated than the White House appears to realize and has the potential to increase the risk to the financial system. Each decision point will affect a bank's behavior to minimize its tax payment. The most obvious change in bank behavior will be to derive more income from fees, since it will not require an increase in taxable liabilities. Insured deposits will also increase, which will increase the FDIC's liability and further weaken it. More insured deposits increases the moral hazard and risk to the banking system since the ultimate risk is borne by the FDIC and the government.

Are assets at booked value, market value, or some other value? For example, a bank loan has many values: To name a few; It has its original amount value; a net value less a loan loss reserve; a market value if sold; a fair value determined by management or accountants; a value plus capitalization of expenses associated with the loan; a value plus accruals of interest and other income. Do banks follow regulators, IRS, FASB or IFRS rules for assets and deposits? Which regulators do the banks follow? The SEC, FDIC, and OCC do not agree exactly on accounting treatments. Will the tax be on the international portion of the banks or just the domestic portion?

Additionally, at what level of an entity do you make the measurements? Items can have a duality. A consolidated entity level is different than at a subsidiary level and an item can have different characteristics at different legal entity levels. For example, if the parent holding company issues debt, it is liability. If it takes the cash from the debt and puts in into a subsidiary for ownership equity, it becomes equity at the subsidiary level and not a liability.

There are numerous problems for measuring equity. Equity is not the same as capital. Capital is a regulatory concept and defined by regulator as to what is or is not included. Equity is an accounting concept, reflecting the initial equity invested in the firm plus additions and subtractions over the subsequent accounting periods. Equity reflects write-downs, which for accounting purposes may not match regulatory write-downs. Equity is also a residual of assets minus liabilities.

The White House decisions about the workings of the tax will cause banks to modify their balance sheets to minimize the tax. Fees will increase where they can be raised. Uninsured deposits will become insured, sometimes just by manipulation of the book entries. Where achievable, the uninsured deposits of several institutions will be totaled and split into smaller insured chunks. The smaller deposits will be redeposited among the several banks as insured deposits for the same total amount at each bank. Regulators are pushing banks to increase their insured deposits and increase the FDIC's liability.

There will also be numerous other changes in bank behavior that will be unexpected and unintended consequences will occur. The regulators will set into motion changes in the financial system that will have many unforeseen consequences. The regulators will be putting out fires from this tax for years.

The above is a comment that I posted on The Conglomerate Blog, "President Obama Will Unveil Financial Firm Tax on Thursday" by Christine Hurt and on The Wall St. Journal's article, "White House's Tax Proposal Targets Big Banks' Risks"

Wednesday, January 13, 2010

Real Per Capita Personal Income On A Tear: No Stagnation

For example, over the entire period from 1967 to 2005, median real household income — that is, money income adjusted for inflation — rose by 31%. For selected periods within that long span, real household incomes rose even less, and those selected periods have often been cited by the intelligentsia to claim that income and living standards have "stagnated." Meanwhile, real per capita income rose by 122% over that same span, from 1967 to 2005. When a more than doubling of income is called "stagnation," that is one of the many feats of verbal virtuosity.
From "How Media Misuse Income Data" by Mark Perry on Carpe Diem.

Tuesday, January 12, 2010

FDIC Wants Insurance Fund Paid For Banks' Compensation Risks

The FDIC wants to adjust the premiums that banks pay into the deposit insurance fund based on the structure of a bank's employee compensation system. The FDIC in an advanced notice of rule making is seeking comments on ways that the FDIC could modify the risk-based deposit insurance assessment system to account for the risks posed by employee compensation programs.

Sheila Bair will not propose a cap on bank employee compensation. Whether her decision is based on politics, ideology or the belief that the structure of the employee pay system is more relevant to the institution's risk than the amount an employee is paid is an open question.

The FDIC press release follows:
FDIC Board Seeks Comment on Incorporating Employee Compensation Structures Into the Risk Assessment System:
Board Approves Advance Notice of Proposed Rulemaking

FOR IMMEDIATE RELEASE
January 11, 2010
Media Contact:
Andrew Gray (202-898-7192)

Board Approves Advance Notice of Proposed Rulemaking

The Board of Directors of the Federal Deposit Insurance Corporation (FDIC) today approved an Advance Notice of Proposed Rulemaking (ANPR) seeking input on whether certain employee compensation structures pose risks that should be captured in the deposit insurance assessment program.

"A broad consensus of academic studies agrees that poorly designed compensation structures can misalign incentives and induce risk taking. I share those concerns. The recent crisis has shown that compensation practices that encourage excessive risk can create significant losses in the financial system and the deposit insurance fund," FDIC Chairman Sheila Bair said.

The ANPR includes a broad set of questions designed to solicit information on the types of structures that should be encouraged and on whether and how employee compensation should be factored into the risk-based pricing system. The ANPR will go out for public comment for 30 days after publication in the Federal Register.

"I believe this ANPR suggests a good approach by targeting compensation structures, rather than levels of compensation. It contains no features which would limit the amount of compensation paid to employees. And I feel that the supervisory efforts underway can be strengthened by the FDIC's effort to provide incentives for banks to achieve higher standards," Chairman Sheila Bair said.

###

Sunday, January 10, 2010

Are Obama's Policies Delaying Economic Recovery?

Is the uncertainty created by Obama's legislative and policy agenda, including health care, slowing the US recovery, delaying capital investment and extending unemployment. A University of Houston Finance Professor says it does?
the massive rise in uncertainty associated with this policy ferment [health care legislation] is sufficient to impede measured economic performance because it is rational for businesses and individuals to delay investment and hiring decisions until the uncertainty is resolved.
From Deja Vu? by Craig Pirrong on Organizations and Markets blog.

Also read, "Regime Uncertainty: Why the Great Depression Lasted So Long and Why Prosperity Resumed after the War" by Robert Higgs on the Independent Institute blog. Higgs' thesis is that the uncertainty created by FDR's Depression era policies delayed economic recovery and extended the length of the Great Depression.

Would Feynman Disprove Global Warming Science As A 'Cargo Cult Science'?

Richard Feynman gave a famous speech, "Cargo Cult Science," as Caltech's 1974 commencement address about the improper application of the scientific method. If you read the entire four page speech, or just the Wikipedia article on the topic of Cargo Cult Science, you will come away with the conclusion that Global Warming Science is Cargo Cult Science and a bunch of bunk.

Although the science of man-made Global Warming meets all the criteria set forth by Feynman for poor science, that does not mean that man-made Global Warming is not occurring. It means we do not have the science to back up the claim that man or man-made CO2 emissions are responsible.

It is important to make a distinction that I am sure Feynman would make. There is Global Warming Science and there is the actual existence or lack there of the earth's Global Warming.

Global Warming Science that blames man-made CO2 emissions is under attack for following poor scientific methods. Man-made global warming is a hypothesis. It is a guess that we have neither proved nor disproved. We just do not know because those most responsible, those who we trusted to do the science behind man-made effects on the global climate, have violated our trust by not presenting to us honest, reproducible results of the effect.

Additionally, there is no assurance from the number of scientists that agree with the Global Warming conclusions. One only has to read Feynman's description, in his Caltech speech, of how it took scientists years to achieve the correct number for the charge of an electron originally incorrectly computed experimentally by Millikan in his famous floating oil drop experiment. According to Feynman:
When they got a number that was too high above Millikan’s, they thought something must be wrong—and they would look for and find a reason why something might be wrong. When they got a number closer to Millikan’s value they didn’t look so hard. And so they eliminated the numbers that were too far off, and did other things like that.
We have seen clear evidence in the released emails that there was scientific intimidation of the scientists who produced results different than the accepted results of global warming due to man-made CO2 emissions.

Those that say, it is better to be more cautious and decrease man-made emissions of CO2, do not understand the risk in reducing CO2 emissions. The US and other nation's can only reduce man-made CO2 emissions by reducing output, that is by reducing GDP and GDP growth.

The decline in the growth of future GDP will occur no matter which method the government chooses to reduce greenhouse gas emissions. Cap And Trade, Carbon Tax, government investment into green technology or some other government-imposed method will all reduce future GDP output growth.

All the methods will either increase the costs of production inputs or divert investment money, capital and labor away from market-based criteria of resource allocation. Government directed investment diverts money from where it will produce the best-expected return to a lower return investment because it does not use market prices and expected returns as its criteria. All the methods of government mandated emission reduction will reduce future GDP growth.

Imagine a US with higher prices, lower salaries and high unemployment, such as we currently have in the US for many more years. Lower GDP also means lower tax receipts, less government and private money to help the poor, less money for education, less money to fund research into cures for diseases, less R&D money for new technologies and fewer opportunities for advancement for the poor into the middle and upper income brackets.

The alternative is to do nothing until there is greater certainty that CO2 and man-made CO2 emissions are causing the warming that will result in a temperature increase, according to the Cargo Cult Scientists, of 2-5 degrees Centigrade.

The global temperature increase, assuming Global Warming scientists are correct, will not lead to the destruction of the world or the US. It will cause some cultural and political problems. Some coastal communities might become inhabitable due to rising water levels, but there will still be more than enough space that is habitable in the US. There will be a physical shift in land used for agricultural production, but there will be no shortage of food or other agricultural products.

Feynman, if he were alive, would have taken the Global Warming scientist straight on and showed them to be the scientific charlatans that they are. He would not deny that Global Warming might be occurring. He would say show me the reproducible scientific evidence to prove it. Without the evidence of reproducible results, he would remain a skeptic.

Saturday, January 9, 2010

Excellent Video Of Thomas Sowell Views On Intellectuals And Society

Mark Perry on Carpe Diem has very kindly provided in his blog post, "Thomas Sowell on 'Intellectuals and Society'," the weblinks to an excellent five part video interview with Thomas Sowell about his new book, "Intellectuals and Society". Each segment is approximately seven minutes in length.

I highly recommend the full 35 minute interview, but especially the second segment on income inequality for those interested in the topic.

Since these are the days of portable listening and viewing devices, I am providing two additional weblinks to the interview, to supplement those available on Mark Perry's blog.

One link is to a single audio MP3 of the entire interview. The other link is a single Quicktime video of the whole interview, as opposed to the five segment files available on Carpe Diem.

The audio link for listening or download is here.(click to listen or right click and save link or target as to save to computer for transfer to a listening device). The audio file is 42MB.

The Quicktime video link for viewing or download is here.(click to view or right click and save link or target as to save to computer for transfer to a viewing device). The video file is 178MB.

Thomas Sowell is the Rose and Milton Friedman Senior Fellow at The Hoover Institution at Stanford University.

Enjoy. It is an excellent interview.

Friday, January 8, 2010

Are Commercial And Residential Real Estate Collapses Related?

There are more boom and bust cycles in commercial real estate (certainly on a regional level) than residential. Bank CRE lending went bust in the mid to late 1970s (money center banks had severe commercial real estate loan problems then), the late 1980s (Bank of New England among others had tremendous problems) through early 1990s (purported reason for Chase-Chemical Bank merger) and now.

Residential housing did not go through the same severe post WWII boom/bust cycle until now. The S&L collapse of the 1980s was due mostly to a mismatch in funding. Using short-term rates to fund long term fixed mortgages and when short-term rates rose, legacy fixed rate mortgages on the S&L books produced losses instead of profits. There was not a similar housing price collapse or excessive residential mortgage defaults that caused the S&L problems.

It would be astounding in this economic downturn if CRE did not show a severe downturn. Commercial real estate developers seem to always overbuild in good times, suffer huge losses in bad economic times and take the banks with them. Their philosophy is if you build it they will come and I will build it if you give me the loan until banks stop lending to them, call in the debt, and they file for bankruptcy or restructure their debt.

CRE difficulties are on a distinct cycle that follows the ups and downs of the economy. The cycle is separate from residential and just happens to overlap this residential housing crisis.

I think the fundamental question is if the economy had not gone into a recession would the housing market have collapsed any way? If it were in a bubble then it did not need a recession to burst and housing would have crashed anyway. Maybe it would collapse later than it did, but it was inevitable.

If the early effects of the recession started and caused the housing collapse (lower productivity, increased unemployment, lower HH income, lower than expected growth in HH income, higher oil prices) then the recession is the prime mover. There may have been feedback and amplification from the concurrent housing collapse, which made the recession worse. In this scenario, the housing bubble is a side issue to the recession causes and is only an issue for why it was not contained and limited in its effect.

We could just be in the unfortunate situation of having two bad economic things occurring at the same time. A housing bubble burst and a recession. In which case, more work needs to be done on the cause of the recession, why it became so severe and on what the Fed missed that allowed the recession to happen. That is a different focus that preventing future bubbles.

There has not been a coherent and clear understanding of why the housing collapse caused such a severe recession (certainly in employment and consumer demand). A homeowner that defaults or walks away from a mortgage, frees up the excess amount of the monthly payment over renting, a lower priced home, or moving in with someone else and consumer demand should not decrease. Even those that foresaw the bubble collapse never expected the economy to collapse as much as it did.

I think we are dealing with two different issues that just happened at the same time. Something akin to a flood and a war, both horrible if they happen at the same time, but neither causes the other. The housing bubble burst and something else caused severe unemployment, a consumer demand collapse and a recession.
The above is a comment I posted to Arnold Kling's post, "Commercial Real Estate Prices: What Inference to Draw?" on EconLog.

Winning And Losing States Under Health Care Reform


















The above chart (click on chart to enlarge) and the text below are from "Health Care Reform: State Winners And Losers" by Claudia Schur and Marc Berkon on the Health Affairs blog.

Schur and Berkon write:
Determining Winners and Losers

Here’s how our categorization of states works—we classified states as “High Benefit” if the percentage of uninsured is above the national average and as “Low Benefit” if the rate is less than the national average. We then classified states by whether they would be “High Cost”—the top half of the distribution—for each of the financing approaches.

As Exhibit 1 shows, the states most likely to “win” as a result of health care reform are Arkansas, Idaho, Kentucky, North Carolina, Oklahoma, Tennessee, and Utah. All of these states have a relatively high number of uninsured and all are in the bottom half of states in terms of cost under both financing mechanisms. States with a high proportion of uninsured residents also included Arizona, Florida, Nevada, Texas, and Wyoming, but those states are above average in terms of the costs they would bear under each financing option.

Among the states most likely to “lose” are Delaware, Nebraska, and New Hampshire as well as the District of Columbia. Each of these states has a relatively lower-than-average proportion of uninsured residents, and each would fall in the “High Cost” category under either of the financing options. There are four states—Alabama, Indiana, Michigan, and Rhode Island—that while also “Low Benefit” are “Low Cost” as well.

The winner-loser status of the remaining states depends on the financing mechanism used. Under scenarios of taxing higher-income residents, six states (Alaska, California, Colorado, Georgia, New Jersey, and Virginia) would “lose” in terms of cost but would benefit in terms of expanded coverage. Another nine states would be high-cost and low-benefit under either of the financing options. With a tax on high-premium insurance policies, nine states would fare the worst; these states would be both “Low Benefit” and “High Cost” under this scenario.
Read the complete post here.

Wednesday, January 6, 2010

Obama Wants 'Cadillac Tax' In Final Healthcare Law

President Obama told top Democratic House members on Wednesday that he favored a tax on insurance companies offering more-expensive healthcare plans as a means of extending insurance to millions of people who are not covered, according to a person familiar with the meeting.
Read "Obama favors 'Cadillac tax' for healthcare" in the Los Angeles Times by Peter Nicholas.

Trade Wars Between States?

Free trade exists between all the states and it is one of the infrequently discussed benefits of the United States. The individual states do not impose special tariffs on goods from the other states and we all use the same currency in the US.

Minnesota wants to impose a carbon tax on goods made in North Dakota that use coal produced electricity. The goal of reducing coal plant emissions is admirable. It benefits the health of its citizens and reduces carbon dioxide emissions. If the Minnesota precedent catches on, free trade will cease to exist in the US to the detriment of the entire country's residents. Read "Minnesota levies world's first carbon tariff...against North Dakota"

Fortunately, the US constitution protects interstate commerce among the states. The constitution also prevents states from imposing tariffs on imports or exports.

Unfortunately, once a state imposes some form of tariff on another state's exported goods or services, such as Minnesota's carbon tariff on imported goods, it will be left to the US Supreme Court to decide the legality of the action. Any written decision of the court, even one that overturns the state import tariff, risks defining the legal boundaries of acceptable restrictions on goods imported from the other states.

An interstate carbon tax is a bad model that will result in other states attempting to enforce their own economic, scientific, moral and ethical philosophies on the other states. States could tax non-union labor goods, or goods from states that have right to work laws. States with high unemployment will attempt to find ways to prevent imported goods from lower unemployment states that produce competitive products.

The possibilities of finding and using distinctions between one state and another to set import duties and restrictions are boundless.

Hopefully, the US Supreme Court will eventually stop this type of action without sending any signals of legal ways to do it.

Regulators, Congress Limit Bank Competition; Cause High Fees, Poor Service

Left out of Andrew Martin's story ["How Visa, Using Card Fees, Dominates a Market"] is the role the FDIC and the House Financial Service Committee played in maintaining the high interchange fees and decreasing competition.

In 2005, Wal-Mart filed an application with the FDIC to buy a Utah based Industrial Bank. Wal-Mart stated in its application and press releases that it wanted to own the bank to save on transaction fees from debit cards, credit cards, etc.

Knowing the competitiveness of Wal-Mart, it would use its transaction fee savings to lower prices, which would have put tremendous pressure from competing merchants on banks, Visa and MasterCharge to lower their transaction fees.

Unfortunately, for the consumer, the FDIC, the Democratic controlled House Financial Services Committee and the Independent Community Bankers Association opposed Wal-Mart's application. The FDIC did not approve the application.

The reason fees are high in banking products and services is that our banking regulators and Congress do not want low cost competitors in the banking industry and stop the competition that would lower consumer costs. When voters complain, they pass price fixing legislation, but do nothing to solve the underlying problems.

The tight regulation of the consumer banking industry leaves little opportunity for real price lowering competition. If Congress and the banking regulators allowed the consumer banking market to be competitive, prices would go down and services would improve.
Above is the comment I posted on Felix Salmon's Reuters Blog, "The interchange-fee rip-off" about Andrew Martin's New York Times article, "How Visa, Using Card Fees, Dominates a Market" on debit card interchange fees.