Roubini: A Disgrace and a Rip-Off

Congressional Democrats (and others, to be fair) have frequently referred to Fed Chair Bernanke’s expertise on the Great Depression as an argument for the proposed bailout plan from Treasury and Congress. Bernanke is a smart guy and an accomplished academic, but in the crisis at hand (which we recently argued is not a repeat of the Great Depression), we place more credence in economist Nouriel Roubini, who has been calling the credit crisis for some time. According to Roubini, the rescue plan as currently conceived is a "disgrace" and a "rip-off":

…the claim by the Fed and Treasury that spending $700 billion of public money is the best way to recapitalize banks has absolutely no factual basis or justification. This way of recapitalizing financial institutions is a total rip-off that will mostly benefit – at a huge expense for the US taxpayer – the common and preferred shareholders and even unsecured creditors of the banks. Even the late addition of some warrants that the government will get in exchange of this massive injection of public money is only a cosmetic fig leaf of dubious value as the form and size of such warrants is totally vague and fuzzy.

So this rescue plan is a huge and massive bailout of the shareholders and the unsecured creditors of the financial firms (not just banks but also other non bank financial institutions); with $700 billion of taxpayer money the pockets of reckless bankers and investors have been made fatter under the fake argument that bailing out Wall Street was necessary to rescue Main Street from a severe recession. Instead, the restoration of the financial health of distressed financial firms could have been achieved with a cheaper and better use of public money.

This makes us more confident in our assessment that the electorate (and the House members who listened to them) are "smarter" than the group of people who drafted the plan. Something needs to be done, but doing it poorly could be worse than doing nothing, as painful as that might be. Michael Lewitt apparently agrees with that argument. He echoes the advice we offered in a client note this morning, which is to breathe deeply and relax–the best thing to do in a panic. He also garners our admiration by quoting Thomas Kuhn.

On a side note, we also agree with him that the income gap (more properly the compensation gap) is a legitimate social concern. But we disagree with the rather simple prescription of higher marginal tax rates as the best way to rein it in. Consider that the gap accelerated in the 1990s following legislation that capped the deductibility of executive salaries at $1,000,000. That led to the expanded use of derivative compensation, which made the leverage gimmicks that Lewitt describes almost inevitable. He sounds to me like a Bill Gates or Warren Buffet, someone who seems to believe that, because they are willing to endure a much higher marginal tax rate, everyone else in their income bracket would be too. When the total tax burden on income is accounted for, it becomes exceedingly unlikely. That said, we think the income tax is the least of our tax code concerns. Complete overhaul would be nice, but short of that, we need to focus on the anti-competitive and distorting nature of corporate taxes.

URLs: 

http://tinyurl.com/RGE08093001

http://www.investorsinsight.com/blogs/john_mauldins_outside_the_box/archive/2008/09/29/haste-makes-waste.aspx

A Few More Dominos Fall

Two more financial institutions across the Atlantic–U.K. mortgage lender Bradford & Bingley, and continental bank Fortis–tumbled over the weekend. And today, Wachovia is apparently the next casualty in the U.S., and is reportedly in talks with Citigroup, federal regulators, and the FDIC. On top of last week’s demise of mortgage-laden Washington Mutual, this is quite a string of dominos. However, the fact that a major money center back has now tumbled makes us think that we’re finally starting to see the beginning of the end.

The global economy still faces a long, drawn-out delevering, and it’s very likely that growth in the U.S. and Europe will be low or negative, and that unemployment will rise.

URLs:

http://biz.yahoo.com/ap/080929/eu_britain_bradford_bingley.html 

http://biz.yahoo.com/ap/080929/eu_netherlands_fortis.html 

IMPORTANT DISCLOSURES:  The foregoing blog post is informational and entertainment purposes only. It does not constitute in any way a recommendation or an offer to buy or sell any security, or to engage in any particular investment strategy. Clients and/or principals of Symmetry Capital Management, LLC may hold long or short interests in any of the securities mentioned.

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The Birk Economic Recovery Plan

There’s an interesting viral e-mail out there called ‘The Birk Economic Recovery Plan’, pasted below.

At first glance, it looks like a heck of an idea. This would reliquify the banking system and let people repair their balance sheets. Better yet, it would get rid of a lot of the agency risk involved, as all taxpayers would get a piece, not just those who contributed to the crisis. Basically, taxpayers would monetize future tax payments to cut themselves a big check today. Kudos to Birk for thinking outside the box.

There’s one not-so-small problem though–the math is off by three zeroes. If Treasury divvied up $85B (the AIG bail out) among 200MM taxpayers, everyone would get $425. Even if we divvied up the $700B ‘bazooka’, people would only receive $3500. That’s not enough to pay the typical credit card balance, much less a mortgage. As Milton Friedman said, there’s no such thing as a free lunch.

This illuminates the crux of the credit market problem–we’re talking about a financial system, which means we’re talking about leverage. The only way a financial economy can recover from a crisis without causing excessive inflation or asset contraction is through rising future income. Government stimulus checks, executive compensation restrictions, and public works spending will not raise the overall level of household income. Only lower taxes (including, especially, corporate taxes), trade and financial openness, and efficient and effective regulation can do that. If you’d like to learn more, please see our recent ‘Idle Speculator’ piece, available at http://www.654advisors.com/idlespeculation/20080925_policy_mix.pdf

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It’s the Policy Mix, Stupid!

Our latest ‘Idle Speculator’ piece outlines the causes and potential effects of the financial crisis, and more importantly, the optimal direction for public policy in coming years.

Be warned, it’s a long piece. However, I segregated much of the wonkish and tangential stuff in footnotes. If you skip those, it shouldn’t take too long to read.

We welcome your comments and feedback. Please feel free to share this with anyone that you think might be interested.

URLs:

http://www.654advisors.com/idlespeculation/20080925_policy_mix.pdf

http://www.654advisors.com/idle-speculator/

The Depression Will Not Be Televized…

…because there will be no depression!

Reference to the Great Depression are quite in vogue these days (Sen. Harry Reid just cited Fed chair Bernanke’s academic expertise on the subject during a press conference), but they are off the mark. The Great Depression was the sharpest and deepest economic contraction in modern history, and its damage was global and long lasting. We are in the midst of a global economic slowdown, a possible domestic recession, and a massive credit seizure. But we’re not headed for a depression–not yet anyways. 

The only thing that can cause a depression to occur in a financial (i.e., money and credit driven) economy is for the marginal cost of a new unit of money to rise well above the expected return on  marginal investment in the real economy.*** A high degree of leverage (i.e., debt) can amplify the effects of a depression, but it cannot directly cause a depression.

For a depression to occur, Congress would have to dramatically raise taxes, regulations, and trade barriers, and the Federal Reserve would have to significantly hike interest rates. While Congress is clearly trying to pull us in the direction of lower returns on economic activity, the Federal Reserve is absolutely not in deflationary territory, even though the value of domestic assets are falling. We may be in for a stubborn recession or contraction, but at this point, a depression is not going to happen.

*** There have been two major depressions in U.S. history, the Great Depression of (roughly) 1930-1942, and the Long Depression (previously known as the Great Depression) of 1873-1896. In both events, the cost of money rose well above the rate of return on profit seeking activity. In the Great Depression, it happened very abruptly, when high trade barriers and higher taxes lowered expected returns on economic activity at the same time that several major central banks tried to forcefully reimpose the pre-WWI parity value of gold, which raised the real cost of money and credit dramatically. They basically tried to force the global economy into a much smaller box overnight, and tax and trade burdens made the box that much smaller. In the lesser known Long Depression, the marginal cost of money rose when a large part of the world moved onto the global gold standard in 1873; this raised the demand for (and thus relative value of) gold, but monetary authorities did not raise the parity value of gold accordingly. The deflationary effects persisted as, in the ensuing 20 years, a dearth of global gold discoveries caused the real value of gold to move further and further above its nominal parity; that caused money, which had its value tied directly to gold’s, to also rise in value against all assets, goods, and services (William Jennings Bryan’s famous ‘Cross of Gold’ speech was given in 1896, the same year of massive gold discoveries in South Africa that eventually alleviated longstanding deflationary pressures). However, unlike the Great Depression, the Long Depression unfolded during a period marked by dramatic expansion of global trade, low barriers to investment and productive activity, and rising incomes and wealth. This helped make it a more drawn out but less destructive affair than the Great Depression.

Status of the Rescue Package

A good deal of news hay is being made over the "failure" of Congress to come to agreement with a rescue package for financial markets. A common mantra is to "blame House Republicans" (though we would note that senior GOP Senator Richard Shelby is also opposed to the plan as written). To the extent that the Democrats’ plan could be passed if not for Republican resistance, the "blame Republicans" chant might ring true. However…

1. As Rep. Paul Ryan pointed out to an interviewer (source: CNBC, no cite or link), the Democrats have enough votes to pass their plan. That they are hesitating to do so would seem to speak volumes about their confidence in the current plan.
2. The best thinking on economic policy has tended to come from House Republicans since at least 1994 (a claim that many academic economists would deride, which actually bolsters our confidence). They’re not perfect (no one is), but as a group they seem to best understand the importance of incentives and investment to the country’s future well-being. And since they’re the ones holding it up, I’m far more confident in the eventual outcome than I would otherwise be. A $700B investment account should not be created without clear agreement on objectives. A CNBC interviewee just reported that the House GOP has been working on an alternative plan with economist Alan Meltzer, who is no lightweight (again, no cite–we’re reporting this on the fly). 
3. The current plan is reported to be extremely unpopular with the American public, who views it (perhaps correctly) as a Wall Street bailout. First, and most obvious, the GOP could be seen as ‘pandering’ to voters on this issue. But an electorate of hundreds of millions is far smarter than a Congress of several hundred at almost any point in time. The House GOP appears to be the only group involved that accepts such an idea–proponents of this plan might, in their frustration, call this pandering–but whatever term you use, isn’t this basic point of representative politics?

A few other items–two policy analysts on CNBC moments ago (no cite, last names Anderson and Wucher) were just talking about the fundamental importance of economic policy, broadly, which is the only way to emerge from this crisis with the least long term damage–the key points, according to one, are low taxes, foreign investment, and trade. Amen. We will be releasing a paper on this  very subject in the next few days, because it’s a critical addition to the current policy debate (for a preview, see our recent entry ‘Competitiveness and the Policy Mix’).

Finally, the McCain campaign’s tactics this week have been fascinating. We believe his decision to "suspend" operations is a combination of crafty (and risky) opportunism for his campaign, and also an expression of his fundamental personality and character. How it plays out will depend entirely on how independent voters eventually view the outcome of his actions.

Credit Market News — Good, Bad, and Ugly

Good news? Equity markets were up today.

Bad? Credit markets still look horifically risk averse…which doesn’t bode well for equity markets.

Ugly? Rumor that Chinese bank regulators have instructed Chinese banks not to engage in interbank lending to U.S. banks. If confirmed, get ready for more "Blame China" sloganeering out of Congress.

URLs:  

http://www.reuters.com/article/newsOne/idUSPEK16693720080925 

Macke on Treasury’s Bazooka Requisition

Jeff Macke offers a good analysis of why the Treasury Secretary’s request for a $700,000,000,000 "bazooka" makes strategic sense, when you take psychology, behavior, politics, and incentives into account:

…$700 billion - a number that says "The government is going to take this entire problem down, all at once."

…[It] is intended to get guys like Warren Buffet to step in – guys who’ll be thinking, "No sense letting the government sop up the excess returns generated by holding these things to maturity; I’ll buy them myself, before the morons from Treasury get here."

…you give [Hank Paulson] a bazooka, rather than a BB gun, precisely because you don’t want him to have to shoot. A BB gun invites invasion. A bazooka makes a point.

…the difference between Congress going for the whole megillah or doing it in tranches is this: In tranches, every block that gets used up makes it less likely that another one is coming (because you gotta go back to Congress to beg some more). In effect, the government would eliminate a certain block of toxic assets but, in so doing, would make the rest of the group even more toxic (and therefore less likely to be backstopped by the government…).

…If the government does this in tranches, there will be literally no end to the outflow. If they do it in one, enormous, statement-making block, it’s possible the system will start running again.

Update 9/26/08: There’s another school of thought out there, which is that the promise of government assistance is actually contributing something to the credit market lockup. Markets are capable of resolving this crisis–the only reason a rescue plan is in the works is that many policymakers fear the acute economic fallout that would ensue. But private actors will not begin to move convincingly towards resolution as long as Congress (i.e., the U.S. taxpayer) is clearly in the picture.

URL:

http://www.minyanville.com/articles/Bernanke-Paulson-Fed-bailout-treasury-government/index/a/19151/from/msn

Competitiveness and the Policy Mix

Fred Smith, the CEO of FedEx, made some excellent comments on how best to raise workers’ incomes, which is to make the corporate tax code less punitive (he was explaining why he intends to vote for John McCain, when he feels that U.S. income disparity is a concern). The video clip is available on CNBC’s website, and the relevant comments start at the 8 minute, 30 seconds mark.

Less encouraging were Sen. Sam Brownback’s comments and questions to Fed Chairman Bernanke, who is currently giving testimony. Brownback, a Republican, essentially claimed that lower interest rates would ensure competitiveness of the U.S. economy, and expressed his desire that the Fed not focus on inflation. That’s just plain wrong, and it’s a recipe for a 1970s style stagflation. Competitiveness is best addressed through Congressional policies, not monetary policy, and the proper role of the Fed is to maintain a stable value for the US dollar. Brownback’s errors demonstrate that neither party is immune to economic and policy errors, or to repeating the mistakes of the past.

UDATE (Senate): Sen. Jim DeMint just laid out some good questions and arguments about regulation, capital investment, and competitiveness.

UPDATE #2 (House): Secretary Paulson and Chairman Bernanke deserve credit for the effort they’re putting into resolving this crisis, but…they’ve fielded several questions on competitiveness and economic growth, and they are completely overlooking the non-financial and non-monetary aspects, that we believe are the critical lever in resolving this process. Essentially, they claim that by unlocking credit markets, they will restore the means to consumption. That objective sits on a one legged stool. First, credit markets have problems, but are still assumed to be rational in the long run–aren’t they signalling (among other things) that the capacity to support consumer debt in the US has been maxed out? Second, credit markets can only expand to the extent that debtors are able to repay, something that tax, trade, and regulatory policies have an enormous and direct impact on! Paulson is missing a huge opportunity to demonstrate leadership on the policy directions that need to be taken to improve US competitiveness in the global economy. Perhaps he feels he would risk too much by doing so, given how much he is asking for. But this crisis will not be resolved expediently unless expectations of future income improve. Rep. Tom Feeney of Florida is hitting on those points as I type this, citing the trade and tax errors made by President Hoover that, in combination with severe monetary errors, brought on the Great Depression. He’s also laying blame on the Federal Reserve for easy money, and roping in government policy errors for its share of the blame. Good stuff.

URLs:

http://www.cnbc.com/id/15840232?video=866167097

http://www.cnbc.com/id/15840232?video=866240817 

AIG: Private Sector Revolt?

A really interesting e-mail from the WSJ:

NEWS ALERT
from The Wall Street Journal

Sept. 19, 2008

Major shareholders are pursuing an effort to try to help pay off the federal governmen’s loan to American International Group Inc. in time to avoid having Washington take an 80% stake in the company, according to a person familiar with the matter.

Hurdles to these shareholders’ efforts could be high, as they and other investors they may attract would have to put up significant sums. This week, the government agreed to lend AIG up to $85 billion to help it avoid possible bankruptcy, in exchange for a right to take a controlling stake in the giant insurance conglomerate.

This is FASCINATING stuff. There are some strange parallels to past events, like a familiar drama where the cast has been totally reshuffled. The conflict is a fuzzy analogy to the hostile takeover binge of the 1980s. This time around, the U.S. Government is playing the role of the barbarians at the gate, threatening to take over wide swaths of underperforming assets and equity, while private sector shareholders are playing the role of the besieged, just as executives and boards did when the barbarians were running amok. A really interesting wrinkle in this episode is that the Secretary of the Treasury is also one of those disgruntled private shareholders.

Is it even remotely possible that these folks could pony up $85B? Two to three years ago they probably could have pulled it off. But the credit well looks awfully dry these days…