Marshall the Moody’s Mauler

Marshall Auerback offered up a brutal dismantling of rating agencies’ negative outlooks on sovereign debt issuers like Japan, the U.K., and the U.S.

America’s Triple AAA credit rating could be at risk should its nascent economic revival not develop into a full-blown recovery, Moody’s Investor Service warned yesterday…

Sound familiar? The so-called “Big Three” ratings agencies have been making claims like this for years: in Japan, the UK and, now, the United States. It is worth recalling that these are the same organizations which, as recently as 2007, were conferring Triple AAA ratings on subprime mortgage paper…

Unlike Moody’s, we think it is absurd to say that the government is going to ‘run out of money’ as our President has repeated. It is not dependent on China or anyone else. There is no operational limit to how much government can spend, when it wants to spend. This includes making interest payments and Social Security and Medicare and Medicaid payments. It includes all government payments made in dollars to anyone.

And if Moody’s (or any other ratings agency) genuinely thinks that government debt is intrinsically evil and that surpluses should be the stated goal of US government policy (in order to safeguard America’s Triple AAA rating) then it must spell out the full consequences of this policy choice. The ratings agencies appear incapable or (at the very least) unwilling to explain the essential sectoral relationships that link the government, private and external sectors. They seem to think that you can have everything – a budget surplus and high private saving and debt reduction. You cannot as a matter of plain accounting logic unless you suddenly start net exporting in great volumes, (which has not happened to the US in its post W.W. II history), or if the domestic private sector is either choosing to deleverage or use leverage less than in the past, that means it will take large and increasing fiscal deficits, or small and decreasing trade deficits, or some combination of the two, in order to achieve trend real GDP growth paths. Otherwise, the result is stagnation or in the extreme, debt deflation. That will not do much to enhance America’s credit rating.

If there’s one thing that Auerback and his fellow neo-chartalists stand out on, it’s this: rating agencies, policymakers, economists, pundits, and many, many others think and speak about debt, deficits, and money as if the world still operated on some type of commodity standard. It does not. Smaller economies may be forced by circumstance to be on hard currency standards, at least operationally, and that is somewhat analogous to a commodity standard. But there is no compelling reason why any issuer of the world’s major currencies (ex-ECB ) should ever miss a debt payment. It’s preposterous.

And yet people actually buy protection against default on U.S. treasury debt via credit default swaps (CDS)! That’s a financial snake oil that comes with potentially significant economic costs. Here’s why:

• Holders of Treasury debt are giving away money to the counter parties selling CDS protection.*
• If it were possible for the U.S. government to default, what counter party could possibly cover its obligations? Diligence schmiligence?
• Leverage, insufficient regulation, and herding behavior have actually made the long CDS trade a winner at times over the past several years.
• That means a greater amount of capital becomes (mis)allocated to people who have done nothing to improve overall economic well-being.
• Those winners will suffer delusions of genius, which almost guarantees they’ll make bad decisions in the future.
• If those bad decisions are levered highly enough, their errors will have systemic implications.
• Add opportunity costs to the risk of systemic damage and the net long term social costs of such behavior are almost certainly negative.

* It might not seem like much — at 50 basis points it costs $50,000 to “insure” $10MM of Treasury debt — but if we assume, for example, that a pension fund is on the long side of the swap, it’s giving away the equivalent of one or two pensioners’ incomes. And while it might look like a good move as long as speculation in Treasury CDS continues to run, the real economic value is ZERO, for the reasons outlined by Auerback.

URLs:

http://www.newdeal20.org/?p=8162

http://www.reuters.com/article/idUSN0524400220100205?loomia_ow=t0:s0:a49:g43:r1:c1.000000:b30347234:z0

Mosler blowing minds (sort of)

Warren Mosler was given a brief spot on CNBC this morning to discuss his version of modern monetary theory, an idea that deserve a wider audience. The cognitive dissonance he induced among the host, a co-hosting economics reporter, and a successful hedge fund manager was pretty apparent. Warren lacks the charisma to make a quick sale, but as the co-host pointed out in the wrap up, it was a start.

Krugman vs CNBC

A couple of CNBC commentators ripped Paul Krugman for today’s op-ed on budget deficits, with Rick Santelli saying something about lining a bird cage. We aren’t defending Krugman against charges of self-contradiction or factual inaccuracies, but we are definitely siding with him on the economic substance of his argument (the lonely wingnut’s sojourn continues).

Prevailing rhetoric holds that the U.S. government is over extended, and that there’s precious little room for additional economic stimulus. That would be true if US dollars could only be obtained by taking them from people who have them, or by digging new ones out of the ground. In that case, servicing our debts — both private and public — would be quite burdensome. But the reality is that in a modern monetary system, monetary units are simply ledger entries. Whether carried in hand as a Treasury obligation, or held digitally in a bank account, all dollars are created out of thin air by the Federal Reserve in response to demands of the banking system.

The federal government does not have direct control of the Federal Reserve, so its control of money creation is only indirect (if Congress wished, it could wrest control of USD creation from the quasi-private Fed, a measure that a small number of radical but diverse members might like to see). But existing arrangements do not change the basic fact that the U.S. has the capacity to print the money (the non-interest bearing debt) used to service its public debt. That means that the only meaningful constraint on the level of our pubic debt is people’s willingness to accept the USD. And despite the sophomoric rhetoric on that point, people are still overwhelmingly willing to accept USDs.

The claim that Congress is “spending money that we don’t have” is even more egregious. To reiterate: if USDs could only be dug out of the ground, or pulled out of taxpayers’ pockets, then the argument might make some sense. But as long as we have the ability to create USDs out of thin air, then Congress has the ability to spend new USDs instead of existing ones.

The conservative argument against this type of Keynesian activism rests on a couple of key pillars, and under certain conditions, they’re valid: (1) as long as government constraints on the private sector are moderate, an economy will grow at or near full capacity; (2) public demand for capital will always tend to ‘crowd out’ private sector borrowing; and (3) public sector allocation of capital is inevitably distorted, which imposes long run economic costs. 

As long as those assumptions are valid, then Congressional thrift, beyond a basic level of social insurance and national defense spending, is a desirable objective. However:

(1) History doesn’t lend strong support to the idea that an unbridled private sector will always and everywhere produce positive growth; and if monetary policy is constrained by a zero bound (i.e., interest rates can’t go below zero), then whenever growth is below potential, fiscal stimulus is appropriate (and can be enacted in myriad ways that appeal to lefties or righties). This is especially true for long economic cycles, such as the Great Depression, Japan from 1989 until 2008 or so, and several developed western economies since roughly 1999. Judging by the available empirical research, demographic composition could be the main driver of these cycles (and if the effect is strong enough, it might deemphasize the importance of rationality vs behavioralism in theory and policy making).

(2) When private sector demand for capital is contracting, as can happen in a long down cycle, then public sector demand for capital (i.e., deficits and debt issuance) is beneficial, and should foster rather than crowd out private sector credit demand. However, under certain conditions, this will only work if money creation is supportive of public sector credit demand, i.e, if new money is created to finance the public sector debt (the conservative point of view tends to see this as banana republic monetary policy, but that isn’t always the case). Today, banks are taking advantage of a steep yield curve to borrow funds from the Federal Reserve (which creates new USDs) to purchase higher yielding Treasury debt, i.e., a significant amount of our public debt is being ‘monetized’. While that would be a bad thing in an inflationary environment, it’s a good thing when it offsets deflationary forces. Almost everyone who parrots the prevailing rhetoric is overlooking this dynamic.

(3) Public sector capital allocation is certainly prone to distortion in as much as it is not subjected to competition and the judgement of diverse agents. But asymmetries in the private sector can have powerfully negative effects too (financial crisis, anyone?). And while there’s room in our political system for new institutions designed to allocate public resources more optimally, the existing ones, such as voting, negotiation, and oversight, should do a good enough job in the meantime.

Krugman wrote that “there’s no reason to panic about budget prospects for the next few years, or even for the next decade,” and apparently this has some pundits and analysts pulling their hair out. But if prevailing demographic ratios are going to drive another decade of subpar economic outcomes…then he’s absolutely right!  

When the real economy is humming along, we can leave the creation and allocation of new USDs to the private sector, and rein in public deficits without doing too much harm. But when the state of the real economy is uncertain, as it certainly is now (pun intended), the refusal to finance public spending, investment, and intermediation via the creation of new dollars (within the constraints dictated by inflation objectives and expectations) is inherently deflationary and destructive. And that is what undermines the sophomoric notion that we are “leaving a mountain of debt to our grandchildren.” If the public sector is not active enough to offset destructive forces acting in the economy today, then our grandchildren will be worse off. Like most economic variables, public debt levels mean nothing in isolation. And we shouldn’t just look at it relative to current GDP. We must also look at it relative to opportunity cost, or looked at another way, to future GDP. There are actions that the public sector can take today to favorably impact GDP in the future, but they all require financing, including deficit spending. We should only be frightened of deficits when they are scarier than the opportunity costs imposed by government saving. Today, that is simply not the case.

So Krugman is right to be concerned about the policy outlook, which he has a rather pessimistic view of:

Washington now has its priorities all wrong: all the talk is about how to shave a few billion dollars off government spending, while there’s hardly any willingness to tackle mass unemployment. Policy is headed in the wrong direction — and millions of Americans will pay the price.

We’ve expressed similar concerns since 2H09, but it now looks to us as though the Obama administration is “triangulating” on deficits and the federal debt, with no intention to substantially withdraw fiscal stimulus in the government’s 2011 fiscal year (though again, we’re still trying to figure out how the president’s emphasis on PAYGO fits into this). If we’re right, then the readjustments underway in exchange rates, specifically the Euro and USD, are being driven by the Euro and sovereign debt concerns, rather than from the USD side. That means we should settle into a new exchange rate equilibrium in the coming weeks, at which point risky assets should start to recover. It’s going to be a bumpy ride, but we’ll get there.

URLs:

http://www.nytimes.com/2010/02/05/opinion/05krugman.html

IMPORTANT DISCLOSURES: Symmetry Capital Management, LLC is a state registered investment advisor. The foregoing information is for informational, educational, or entertainment purposes only. It does not constitute an offer to buy nor a solicitation to sell any security, or to engage in any investment strategy. Symmetry Capital Management, LLC is an Amazon.com associate, and earns a commission on sales generated through links from our website. At the time of writing, the firm, its principals, and its clients did not own any securities mentioned, or any securities issued by entities mentioned.

I’ll see your PAYGO and raise you a double dip

A key objective raised by President Obama in his state of the union address was to address the ‘fiscal hole’ of the federal government. His rationale was that “like any cash strapped family, we will work within a budget to invest in what we need and sacrifice what we don’t.” he asked Congress to reinstate PAYGO, which reportedly helped the federal government “record surpluses in the 1990s,” and advocated investing in people “without leaving them a mountain of debt.” He closed on this point by saying that it’s just common sense.

Culturally, these ideas resonate with Americans. And for a business or household, budget constraints are a matter of common sense (even though we don’t always adhere to them). But there is no budget constraint on a government that can create money, i.e., non-interest bearing debt, out of thin air. The only meaningful constraint to the level of non-interest bearing debt is inflation, which occurs when a government creates more money than the economy requires, causing its non-interest bearing debt to lose value against most goods and services. Thus, while it may score some political points (thanks to our primary educational system’s lack of a financial and economic curriculum?), it’s absurd for the president to embrace the common sense that households and businesses use in setting budgets. The federal government faces an entirely different kind of budget constraint.

Instead, given the government’s power to create money, common sense would hold that the amount of money supplied to the economy should be equal to the amount of money required by the economy (please note, this simplification is not an attempt to resurrect the policy prescriptions of old school monetarism). Thus, the proper approach to budgets at the federal level is to ask whether there is currently a surfeit or deficit of USDs in our economy. Given the number of private financial commitments that were entered into in the past decade, and dramatic declines in economic activity, it’s difficult to argue that there’s currently a surfeit of dollars. And if recent political rhetoric is any indication, dollars are likely to become scarcer in the years ahead (it would be ironic if, instead of inflation, deflation became the motivating force behind a move away from the USD as global reserve currency).

The president did set forth some positive ideas, such as a zero capital gains tax on small business investment, capital investment incentives for companies of all sizes, and infrastructure investment. Assuming these are financed at least in part by new money creation, they would help to prevent a renewed liquidity crunch. But to the extent that they are “offset” by cuts or freezes elsewhere in the name of closing fiscal gaps and filling in budget holes, or by higher taxes on other activities, the net short term effect on the economy will be nil or worse. And like Japan, we’ll be in for our second lost decade out of two. As we’ve pointed out, leaving future generations without a “mountain of debt” sometimes means leaving them with equivalent (or greater) opportunity costs. We should strive to avoid both of those outcomes. To do so, we have to rethink the cultural common sense that debt is always and everywhere to be avoided.

From an investing standpoint, if vigorous policy actions follow the path being laid out by the rhetoric and “common sense” emanating from so many quarters, then the USD will continue to strengthen, the real economy will stagnate or weaken further, and nominal asset values will fall for all but the highest grade government paper. In that scenario, we would be lucky to tread water and leave only 16% of the country underemployed.

Mr. President, I’ll see your PAYGO and raise you a double dip recession.

RELATED READING (file under confirmation bias): 

We’re well aware that our current view of things puts us shoulder to shoulder with some members of the “loony left”, but the macroeconomics of this stuff are fairly straightforward. Our lonely wing nut sojourn continues, placing us in lockstep with one Mr. Paul Krugman: http://krugman.blogs.nytimes.com/2010/01/26/obama-liquidates-himself/.

The Fed is seeking an exit strategy from its liquidity programs and low interest rate policy. The impact of that exit can be either muted or amplified by Congressional actions. If Congress becomes hawkish, there is no reason for the Fed to do so. If they both begin tightening, it’s hello 1937: http://www.bloomberg.com/apps/news?pid=20601015&sid=aXeUAV7_bz_o

An excellent idea from Warren Mosler — a full payroll tax holiday — that has yet to fall on the radar of federal policymakers: http://moslereconomics.com/2010/01/28/tea-party-plan-for-dems-cut-to-the-front-with-tax-cuts/. Here’s how Mosler describes the cause of poor economic policymaking: “…so-called economic experts have confused themselves and their political masters with contrived explanations for the way the economy works, and their limited vision has limited the range of policy choice. The result has been a monumental economic and social disaster caused by an obvious shortage of aggregate demand. The spending power needed to make mortgage payments, car payments, and do a bit of shopping- all of which would fix the economy and end the financial crisis- just isn’t there.”

Marshall Auerback writes that “Any kind of spending cuts in the middle of the worst recession since the Great Depression is insane.  What we are beginning to see is the return of Herbert Hoover and the ‘liquidationists.’” http://www.newdeal20.org/?p=7731

Ed Harrison posts an email exchange with Auerback, in which the latter wrote: “What the US government is now in danger of repeating is taking its economy down the fast track to a double-dip recession.  With investment still flat, consumers trying to increase their saving ratio and net exports making a negative contribution to growth – the President and his advisors evidently believe the persistently high unemployment is something the private sector has to deal with.”  http://www.creditwritedowns.com/2010/01/what-president-obama-can-do-to-improve-the-economy.html. As we’ve noted elsewhere, the demographic research of folks like John Geanakoplos, Diane Macunovich, and Ajay Kapur implies that for the next decade, the U.S. private sector is not going to behave as the baby boomer decades have conditioned us to expect. Hence the case for a more activist — and just as importantly, ’self-financing’ – public sector. ‘Self financing’ today means the Federal Reserve creating the dollars that enable primary dealer banks to absorb Treasury offerings at auction via direct bids.  For that process to continue, the federal government must continue to issue debt, rather than shoveling dirt on the people and institutions that are still near the bottom of our deep ’fiscal hole’.

Jonathan Zasloff writes (TOH Krugman) that “At some point someone must make an argument for government.” http://www.samefacts.com/2010/01/politics-and-leadership/obamas-self-inflicted-lobotomy-proceeds-apace/  Why are Democrats today so afraid to make that argument? Like the health care debacle, could the lessons learned in the Clinton years be ill suited to today? As for the GOP, our take is that by harping on government in all its forms (besides those forms that help favored firms and industries collect their share of rents from the rest of us, of course), Republicans leave the door open to the development of increasingly socialist policies. In fact, if our take on the state of the private sector in the coming decade is accurate, they will practically mandate it.

State unemployment insurance tracker at Pro Publica (TOH Credit Writedowns) shows how critical federal government support currently is for many states: http://projects.propublica.org/unemployment/

George Soros thinks that premature budget tightening could be bearish for gold prices: http://www.telegraph.co.uk/finance/financetopics/davos/7085504/Davos-2010-George-Soros-warns-gold-is-now-the-ultimate-bubble.html. Reminiscent of Jon Nadler’s argument last fall against gold: http://symmetrycapital.net/index.php/blog/2009/11/a-gold-bears-comments/

Finally, in what might be a mirror image of our loney wing nut position, Bill Gross seems to be exhibiting a profound case of anti-Keynesianism: http://www.pimco.com/LeftNav/Featured+Market+Commentary/IO/2010/February+2010+Gross+Ring+of+Fire.htm

Dollar Strength & Foreign Credit

We came across an interesting piece on the relationship between the USD and commercial credit activity outside the U.S., as shown in the chart below. The implication, based on a quick and dirty visual analysis, is that if USD strengthening continues (the red line, which is plotted inversely), then foreign commercial paper (the blue line) is likely to contract. In other words, a dearer dollar could spell trouble for foreign economies, and that would have negative implications for economic activity, commodities, and risky assets abroad, all else equal.

This piece of evidence, combined with our strong dollar call yesterday, raises some fascinating possibilities. A rush to the USD was not on many strategists’ radar in 2009, or even to this point in 2010. Judging by markets’ performance today and yesterday, we could be seeing a significant break from those views. Then again, we might just be seeing the first notable stock market correction since last year; a USD squeeze might also be a short lived phenomenon.

We see too many moving parts to make a firm call either way. The markets continue to face the spectre of tightening federal purse strings and a ‘less easy’ Federal Reserve in 2010, and as of this week, they are now sitting in the middle of the open conflict that has broken out between the administration and the financial industry.  

We also see complexities in that battle that make it hard to come down on either side. We offered criticism of Obama’s initial remarks on the financial assets tax, though we later qualified it, and some of his remarks today were spot on. And while government policies and institutions certainly set up incentives to greed and stupidity, the actions embodying greed and stupidity (and the massive trading of rents that did little or nothing — arguably less – for economic welfare) were taken by individuals and organizations in the financial industry. And yet the overall tone of hawkishness from policymakers has negative implications for everyone, regardless of what street they make a living on.

There’s also a little noted irony in the apparent desire of some Democrats to constrain the size and activities of the financial sector. If Ajay Kapur’s research is on the mark, the sector is going to be shrinking in the years ahead regardless of regulatory changes, due to the shrinking ratio of middle aged adults.  A more interesting thing to speculate on, given the continuing centrality of the USD in the global economy, is how well those faster growing regions of the world will cope with tigher global liquidity. 

[UPDATE 1/21/2010 - In a CNBC interview moments ago, House Financial Services Commitee chairman Barney Frank put a far kinder and gentler spin on the recent presidential bluster, saying that a regulatory regime shift would have to be drawn out over several years and do a minimal amount of harm. This appears to have calmed frayed nerves in the market, and is a nifty scoop for Burnett and Cramer. Cramer's inferring that Paul Volcker (a man with a history of bull-in-a-china-shop approaches to policy) has the President's ear, while Frank comes down with the more nuanced regulatory views of Fed and Treasury, which could make for some political drama in the year ahead. It could even be a high stakes game of good cop, bad cop -- time will tell.]

http://shadowcapitalism.com/2010/01/20/the-implications-of-a-dollar-squeeze-on-foreign-banks-credit-access/

http://www.miraeasset.com/data/download.jsp?file_path=upload&file_name=MiraeAsset_TheGlobalInvestigator_20090812.pdf

http://www.cnbc.com/id/15840232?video=1340630859

http://www.cnbc.com/id/34979114/site/14081545

A Strong Dollar Call

President Obama, continuing his recent streak of verbal fiscal hawkishness (our view is admittedly contrarian) signed a memorandum today regarding tax delinquencies among government contractors. To the extent that federal contracts are awared to tax evaders and tax cheats due to poor information sharing or availability, this is a good initiative, and it’s based on analyses from the GAO like this one.

It was the President’s remarks that were most telling, especially his argument that the federal government needs to align itself with the values and norms that tax paying households live by (of course, this completely ignores the fact that only the federal government can create the money required to fulfill tax, debt, and other financial obligations, not just of the public sector, but of the private sector as well). The underlying message of recent remarks by the President is that tightening via “fiscal discipline” is very likely in the months and years ahead; Obama is clearly signalling that he has staked out a very center-right position among Democrats, similar to the Blue Dogs and Democratic Leadership Council, as summed up in this recent piece by Harold Ford, Jr:

The ability of the private sector to produce new jobs — our economic future — depends on how quickly we can get back on the path to fiscal responsibility. This means that any health-care reform plan should be paid for — a promise that President Obama has made, and one that his predecessor should have made.

Ford’s assertions are based on the rather shaky assumption that they hold under all economic conditions. But as we’ve noted recently, there are only some environments where this holds true, while there are other environments where it does not. In the former, fiscal conservatism may be appropriate due to “crowding out” and other concerns. In the latter, the private sector’s capacity to produce jobs actually depends on public sector demand, investment, and intermediation, i.e., deficits. 

Most people, Ford included, accept this idea in the short run, e.g., during a financial crisis or a sharp economic downturn. But what we’re arguing, essentially, is that pessimistic expectations are sometimes rational, and that the factors driving them can theoretically remain in force over fairly long cycles of ten, twenty, or thirty years, even longer.  In the situation at hand, when we look at demographic shifts in the U.S. and residual damage from the financial crisis, we think the decade ahead will be of the latter variety in both the U.S. and mature European economies.  So the message of Ford, his fellow Blue Dogs, the DLC, and President Obama (especially of late) might be a suboptimal direction for policy, however well it might have worked in the 1980s and 1990s. [1/20/2010 UPDATE - well written piece here on how public thinking about policy is heavily informed by experiences since the 1980s, which might be akin to driving by the rear view mirror]

As a result, we now see several forces at work that lead us to expect a strengthening USD, all else equal. First, the prevailing view among Democrats appears to be that voters will favor fiscal hawks in midterm elections, and they will respond accordingly. Second, we expect upside volatility in the real economy in 2010 (due in no small part to public sector demand), which will relax pressures for additional fiscal stimulus. Third, invoking the ideas of the neo-Chartalists, we’d argue that when the federal government places a high value on “fiscal responsibility” or “fiscal conservatism”, it implies that monetary units are going to become more scarce, and thus more valuable. In other words, if the President’s recent signalling is sincere, the USD is likely to appreciate (as will Treasuries, despite their compressed yields), and commodities and other carry trade and risky assets are likely to suffer (today’s market movements seem to support this argument).

While most pundits are attributing today’s market developments to the Republican capture of Kennedy’s senate seat yesterday, and/or to policy tightening in China, which are almost certainly factors, we would argue that far too many are overlooking the impact that President Obama’s current policy tenor is having on the USD. He’s essentially promising that the “tokens” required to settle economic transactions and engage in productive activity are going to become scarcer.

This implies some important changes in who the marginal actors are in the political economy. After the 2008 election, we asserted that the Blue Dogs would be the marginal player in setting the course of economic policy. The President’s upcoming budget will give us a clearer idea of whether their fiscal conservatism, as Obama’s current rhetoric implies, has indeed become dominant. If it has, then we think the Fed becomes the marginal factor in policy direction and economic outcomes. How soon and how sharply they tighten will determine the risk of a 1937 or Japan style recession, and it will also have critical implications for the performance of emerging market equities and other risky assets in the short to intermediate term.

URLs:

http://www.whitehouse.gov/the-press-office/memorandum-heads-executive-departments-and-agencies-1

http://www.gao.gov/new.items/d07742t.pdf

http://www.dlc.org/ndol_ci.cfm?contentid=255070&kaid=85&subid=65

http://en.wikipedia.org/wiki/Chartalism

http://www.cfeps.org/pubs/wp-pdf/WP10-Wray.pdf

2004 CSE Not to Blame for Crisis?

We’ve argued in several places that changes to the SEC’s Consolidated Supervised Entity’s program in 2004 contributed to the dramatic rise in systemic leverage that precipitated the financial crisis. The SEC’s Director of Trading and Markets offered a rebuttal to this argument back in April 2009: http://www.sec.gov/news/speech/2009/spch040909ers.htm

Today, I want to discuss a Commission action that I believe has been unfairly characterized as being a major contributor to the current crisis. I am referring to the Commission’s 2004 rule amendments to the broker-dealer net capital rule that established the consolidated supervised entity (CSE) program. Since August 2008, commenters in the press and elsewhere have suggested that the 2004 amendments removed a leverage restriction that had prevented the firms from taking on debt that exceeded more than twelve times their capital and, as a consequence, the Commission allowed these firms to increase their debt-to-capital ratios to unsafe levels well-above 12-to-1, indeed to 33-to-1 as some have suggested. These commenters point to the 2004 amendments as a significant factor leading to the demise of Bear Stearns. While this theme has been repeated often in the press and elsewhere, it lacks foundation in fact.

It’s an interesting speech, but several facts still argue against letting the SEC and other regulators off the hook. First, leverage at the largest investment banks, including Bear Stearns, Lehman Brothers, and Merrill Lynch — and in the financial system as a whole — was far beyond anything that could be considered prudent. So whether due to CSE changes or something else entirely, this is still a clear sign of regulatory failure. Second, Christopher Cox, towards the end of his tenure as SEC chief, took actions and made statements that were damning of the CSE:

Washington, D.C., Sept. 26, 2008 — Securities and Exchange Commission Chairman Christopher Cox today announced a decision by the Division of Trading and Markets to end the Consolidated Supervised Entities (CSE) program, created in 2004 as a way for global investment bank conglomerates that lack a supervisor under law to voluntarily submit to regulation. Chairman Cox also described the agency’s plans for enhancing SEC oversight of the broker-dealer subsidiaries of bank holding companies regulated by the Federal Reserve, based on the recent Memorandum of Understanding (MOU) between the SEC and the Fed.

…Because of the lack of explicit statutory authority for the Commission to require these investment bank holding companies to report their capital, maintain liquidity, or submit to leverage requirements, the Commission in 2004 created a voluntary program, the Consolidated Supervised Entities program, in an effort to fill this regulatory gap.

As I have reported to the Congress multiple times in recent months, the CSE program was fundamentally flawed from the beginning, because investment banks could opt in or out of supervision voluntarily. The fact that investment bank holding companies could withdraw from this voluntary supervision at their discretion diminished the perceived mandate of the CSE program, and weakened its effectiveness.

It sounds like Director Sirri’s argument, that the CSE did not explicitly allow higher leverage ratios, might very well hold water. But his speech does not address the issues that Chairman Cox’s statement raised — namely, that the CSE left gaping holes in financial regulation that were ruthlessly exploited by the largest investment banks.

URLs:

http://www.sec.gov/news/speech/2009/spch040909ers.htm

http://www.sec.gov/news/press/2008/2008-230.htm

Between a ‘Derm and a Donkey

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2010.01.14  MEA CULPA – The following entry was based on a news report that mislabeled bank assets (loans, credit) as liabilities (deposits, capital). That’s a common mistake — most people would tend to think of money that someone else put into their care as an “asset”. After reading the FT’s front page story on the proposed bank levy, we note that it’s designed to be applied to exactly the kinds of assets that helped to precipitate the financial crisis. We therefore apologize for calling it a joke, and for the other aspersions we cast in its direction (see below). Our initial assessment was obviously wrong. It might not be a bad idea, and perhaps the Obama administration has taken the position that it will be easier to administer than tighter capital requirements; or perhaps the threat of the tax is being used as leverage in tightening long term capital requirements.  However…

(1) A fifteen basis point haircut on typical investment bank returns, especially if nothing is done about the leverage that can be employed, is awfully skimpy;  

(2) There are still risks in who will actually bear the cost;

(3) the activities of investment banks actually do some social good, believe it or not;

(4) The President and Congress are still more like Herbert Hoover than FDR/JFK/RR; and

(5) We’re still stuck between ‘Derms and Dems for the foreseeable future.

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In our latest Idle Speculator, we asserted that in the years ahead, the U.S. economy was likely to remain stuck between a pachyderm and a donkey. If today’s events are any indication, it’s a good call. President Obama called for a punitive tax on large banks, and the only Republican response we’ve heard so far is from a Congresswoman who mostly railed against public spending. In our view, both sides continue to make little if any sense. 

President Obama’s bank tax would apply only to institutions with $50B or more in assets, and the rate would be 15 basis points (0.15%). However, the levy would not be on bank income, but rather on banks’ liabilities, i.e., deposits. What does this mean? We’d need to take a closer look once legislation is drafted, but based on what’s been said, here’s our initial impression:

First, the large banks aren’t going to pay a damn thing. Depositors (savers) are simply going to take a 0.15% haircut on the interest rate they receive, all else equal. Essentially, this will just act as an additional tax on people who deposit funds with large banks, and/or as a marginal incentive to deposit funds with other institutions.

Second, it won’t do anything to prevent the systemic leverage and boneheaded risk taking that got us into this mess. Systemic fragility arises when banks create too many assets (by extending credit) relative to their liabilities and capital. If the government wanted to prevent this through taxation rather than regulation (probably a bad idea to begin with), then it should be taxing bank assets. Of course, even then, it would simply mean that debtors’ interest rates would go up by the amount of the tax…which means the banks still wouldn’t pay a damn thing (refer back to point one).

In his remarks, the President said:

“My determination to achieve this goal is only heightened when I see reports of massive profits and obscene bonuses at the very firms who owe their continued existence to the American people who have not been made whole, and who continue to face real hardship in this recession…”

As in his recent comments on the jobs situation, the President shot well wide of the mark. While it’s reportedly an attempt to marshall populist support by attacking a particulary unpopular industry, the approach is a joke (as supporting evidence, we’d point out that Financials are the third best performing sector in the S&P 500 today, and that Money Center and Regional Banks are among the best performing industries within it). 

We can only infer that of late, the President has been listening to the very worst strategists in his Cabinet, folks who would recommend Herbert Hoover’s approach to economic crisis and recovery over FDR’s (or JFK’s or Reagan’s if you prefer) at a time when the latter’s is far more appropriate. Obama’s current hawkishness is evident in the AP article:

Obama said he was determined that every dollar spent from the $700 billion Troubled Asset Relief Program to rescue Wall Street firms, auto companies and mortgage holders is either repaid or paid for in some fashion.

His party’s hawkishness is also evident in the continuing failure to extend the COBRA subsidy under ARRA (a cynic might infer that this is intended to garner more support for heath care reform, but it’s a hawkish action either way). Thus, despite all the talk on the right and among tea party goers about “tax and spend liberals”, the reality looks quite different to us. The American electorate continues to be presented with only two choices — revenue hawks and budget hawks, i.e., higher taxes or lower spending – and those are essentially flip sides of the same coin.

In any case, forcing depositors to take a haircut, forcing debtors to pay marginally higher interest rates, or recovering every single dollar issued under TARP will do nothing to remedy the real hardships being faced by the American people in this recession. It also does nothing to prevent another financial crisis. If the President really wants to accomplish something on those counts, here are a few suggestions:

• Push hard for focused, meaningful financial regulatory reforms that will prevent excessive systemic fragility.
• Use the federal government’s creditworthiness and risk taking capacity to provide more direct assistance (i.e., employment) to the underemployed. 
• Stop being so terrified of budget deficits. Thinking about structural deficits is OK, but acting now to solve them could actually make the problem worse (ask Japan).
• Let private sector intermediaries (banks) use a historically steep yield curve to continue repairing their balance sheets by financing public deficits.
• If you insist on attacking TARP recipients, target the agents who control them (e.g., executive compensation or bonuses above a certain level), not owners, depositors, and borrowers.
• Enact policy measures that lower uncertainty, raise optimism, and thus increase the private demand for credit and investment.

You might also demand some accountability from whichever advisors had the most influence over today’s statement and last Friday’s…

URLs:

http://symmetrycapital.net/idlespeculation/20100112.pdf

http://news.yahoo.com/s/ap/20100114/ap_on_bi_ge/us_obama_bank_fees

http://biz.yahoo.com/p/

http://biz.yahoo.com/p/4conameu.html

http://www.dol.gov/ebsa/faqs/faq-cobra-arra.html

http://www.ft.com/cms/s/0/a025fd26-00ad-11df-ae8d-00144feabdc0.html

http://ftalphaville.ft.com/blog/2010/01/14/126481/the-back-of-the-envelope-bank-levy/

Rubin to the Rescue?

In Newsweek, former Goldman Sachs CEO, Clinton Treasury Secretary, and Citigroup bigwig Robert Rubin offers his analysis of the Great Recession and proposed nostrums for preventing another:

Given my views as to the causes of the crisis, I would recommend the following:

• There should be greatly increased capital and margin requirements for derivatives and other instruments of financial engineering to create a greater cushion when trouble develops and to reduce risk exposure. I developed this view during my many years of working with derivatives before entering government, as described in my 2003 book, In an Uncertain World.
• Standard derivative contracts should trade on an exchange to increase transparency. Transactions that are custom designed would not be exchange traded but would be subject to the same capital and margin requirements as listed transactions. Disclosure requirements could be considered for customized transactions, to provide private counterparties and regulators with the transparency to understand the risks.
• There should be two sets of more stringent leverage limitations for systemically significant institutions, one defined by risk-based models and the second by much simpler measures, since mathematical models can’t capture the full range of real-world possibilities.
• There should be significant constraints on off-balance-sheet financing; for example, institutions must retain ownership of a portion of off-balance-sheet assets.
• We need a change in accounting systems to avoid the artificial effects of mark-to-market accounting for illiquid assets on balance sheets and on markets. There are other accounting approaches that would better reflect long-run values for these assets.
• We should also provide effective mechanisms for dealing with systemically important nonbank financial institutions—including bank holding companies—that get into trouble, to mitigate “too big to fail” concerns, but practical ways to do this need to be developed.
• There should be greatly increased protections, both to safeguard consumers and to reduce systemic risk. The elements should include readily understandable disclosure, suitability requirements, prohibition of practices or instruments inherently susceptible to abuse, and, if some practical way can be found, personalized advice for the most vulnerable consumers.

Fair enough, mostly no brainers, but is Rubin being disingenuous? As we’ve previously written, there seem to be growing threats to to the man’s political capital, particularly within the Democratic party. And judging by this piece from Marshall Auerback, those threats still exist, and have intensified since 2006:

As one of the people whose policies threw the global economy off the rails, Rubin may be uniquely qualified to provide solutions as to how to get the economy back on track. But that would presuppose that the man actually acknowledged mistakes (as some of his other Goldman Sachs/Clinton Administration colleagues, such as Gary Gensler, have done) and displayed at least a marginal understanding of where he went wrong.

No such luck. We get the usual self-serving “nobody could have possibly predicted a crisis of this magnitude” right at the start…

Auerback cites a damning interview with the former head of the CFTC, Brooksley Born (a position now held by the aforementioned Gary Gensler):

…as analysts sort out the origins of what has become the worst financial crisis since the Great Depression, Born has emerged as a sort of modern-day Cassandra. Some people believe the debacle could have been averted or muted had Greenspan and others followed her advice.As chairperson of the CFTC, Born advocated reining in the huge and growing market for financial derivatives.

According to Auerback:

Rubin now suggests that Born’s problem was one of style, rather than substance: she, being “too confrontational”, risked aborting any politically feasible reform of OTC derivatives. That’s certainly an interesting reinterpretation of Rubin’s actual role as Treasury Secretary, during which he laid the groundwork for today’s crisis through an aggressive championing of financial deregulation. It’s hard to think of one instance where the former Goldman Sachs CEO actually came down hard on his former Wall Street colleagues. Had he at least acknowledged some remorse or recognition of error, he would be more appropriately suited for an advisory role on how to fix the global economy, much as a reformed criminal often has useful insights on penal reform.No such luck here. If being one of the worst Treasury Secretaries ever wasn’t enough, Rubin left another unfortunate legacy at Citigroup, where he was a senior advisor after he quit the Treasury. He left Citi just before its near collapse amidst criticism of his performance. A distinguishing moment of his tenure was when Rubin got hold of Peter Fisher in the US Treasury Department to try to put pressure on the bond-rating agencies to avoid downgrading Enron’ debt which was a debtor of Citigroup…

Letting him publicly expound on getting the global economy back on track is akin to providing Kim Il Jong-il a public platform on human rights. Unlike Greenspan, who at least admitted mistakes, Rubin expects to be taken seriously as a policy maker despite acknowledging zero responsibility for the debacle that threw millions of Americans into unemployment. People around the world have lost their jobs, savings, and more largely thanks to the policies championed by this misguided deficit warrior.

Ouch.

We’ll pile on by reminding people that as Treasury Secretary, Rubin presided over implementation of the “strong dollar” policy designed by his predecessor, Lloyd Bentsen, which had damaging effects on many developing nations’ economies. He’s also featured prominently in a recent list at Motley Fool of “The 10 Dumbest Banker Quotes of All Time”. And we agree with Auerback that a sincere mea culpa for past errors, whether at Treasury or Citigroup, would buy the man some badly needed goodwill. We think he should also expand his bullet points to include the following: 

• Let’s not repeat the mistake of believing that experts always know best.
• Let’s agree that optimal outcomes often require more than just unbridled private actors.
• Let’s resolve not to get caught up in any more cults of personality, whether adorer or adoree.

Update 01/07/2010 (via Mark Thoma) – Larry Summers, who is currently President Obama’s National Economic Council chief, and was Robert Rubin’s protege and eventual successor at the Clinton Treasury, also finds his political capital under attack from both the left and the right.   

IMPORTANT DISCLOSURE: Symmetry Capital Management, LLC is a member of the Amazon Associates program, and earns a revenue sharing fee of approximately 4% on qualified purchases made by clicking through from our website.

URLs:

http://www.newsweek.com/id/225623/page/2

http://www.amazon.com/gp/product/0375757309?ie=UTF8&tag=symmetrycapit-20&linkCode=as2&camp=1789&creative=390957&creativeASIN=0375757309

http://www.newdeal20.org/?p=7270

http://www.stanfordalumni.org/news/magazine/2009/marapr/features/born.html

http://www.fool.com/investing/general/2009/11/25/the-10-dumbest-banker-quotes-of-all-time.aspx

http://www.economicprincipals.com/issues/2010.01.03/880.html

http://capitalgainsandgames.com/blog/bruce-bartlett/1373/summers-out

CFO.com: NACM’s Credit Managers Index

Interesting story on CFO.com about the latest Credit Managers Index reading from NACM:

As of December 1, the index, based on a survey of about 1,000 trade-credit managers during the last 10 days of the month, had risen to an annual high of 52.3. (A score of 50 means creditors think they’ve entered a growth mode. The index is based on credit managers’ perceptions of growth, decline, or status quo conditions in various aspects of trade credit.)

…the index hit 39.7 during December 2008, the all-time bottom in the index’s seven-year history. Since then, it’s risen steadily to its current annual high. That surge has been cause for an enthusiasm among creditors that’s “not really champagne-cork-opening excitement, it’s wine-box-opening excitement. We’re getting there,” says the NACM’s economist, Chris Kuehl.

That’s a mildly bullish sign, although as the article points out, “a true strengthening…depends on an upsurge in consumer demand.”

[Kuehl's analogy resonates in my house -- it's been a box wine recession for us. In fact, we've been bottle free for so long that we now have a nook carved out among the cookbooks in which a five liter box of cabernet (Almaden or Carlo Rossi, whoever's cheaper) fits like a glove. We're still trying to come up with a clever idea for all those plastic bags though -- suggestions are welcomed!]

URLs:

http://www.cfo.com/article.cfm/14462467

http://www.sfgate.com/cgi-bin/article.cgi?f=/c/a/2003/12/04/WIGV13EPSU1.DTL