The Foreclosure Fiasco

Shaun Donovan, Obama’s HUD Secretary, has said that there is no “structural issue” with the mortgage foreclosure process. From Market Watch:

He said there’s no evidence yet of “structural” issues with the Mortgage Electronic Registration System, an electronic registry of home loans that critics have charged with violating property record-keeping laws. Banks that package loans into bonds called mortgage-backed securities often rely on MERS to track owners of mortgages as the securities change hands.

There are plenty of interesting takes on this issue (see below), which we have been following since late 2009.  It seems apparent from Donovan’s comments that the Obama administration doesn’t see the foreclosure issue as something to campaign on.  It’s an interesting political gamble either way.  Standing up to lenders’ foreclosure agents might rally parts of the Dems’ base.  While the “let the market work” counter argument wouldn’t normally sway voters from either side, the fact that We the Taxpayer still own stakes in some of the banks at the center of the crisis might be causing Dems to fear that a foreclosure freeze would hand the GOP another club to beat them over the head with as the campaign season wraps up (though one can also argue that siding with “put back plaintiffs” could recover taxpayer funds too). 

For those who haven’t been following recent developments, here are some key aspects:

The one that has been apparent for the longest is whether or not MERS, which is essentially just a database for securitized mortgages, has standing to foreclose, and whether a clear chain of title can be established to a property where the lender used MERS to track the securitized mortgage on it.  Industry proponents tend to argue that chain of title has conventionally been documented after the fact as necessary to foreclose.  But that’s been put to the test with all of the litigation arising out of the foreclosure mess, and a slew of recent court decisions have put the lending industry on the defensive.

Recent discoveries have documented the existence of “robo-signers”, employees who sign many thousands of affidavits saying they are familiar with the details of each mortgage foreclosure when obviously they couldn’t be.  There have also been clearer (though far fewer) occurrences of outright fraud by foreclosure agents (some of which industry proponents still defend as business as usual practices), as well as instances of baseless foreclosures (people who are not delinquent on their mortgage losing their home).  When you consider the fact that most foreclosed properties are sold to someone, the utter FUBARness of the situation becomes apparent.

A more recent aspect is the potential “put backs” of certain mortgage securities to the investment banks and/or originators, which we wrote about last week.  The recent suit filed by several large money managers, which is mentioned in the HUD article, is based on this aspect of the mortgage fiasco.  It’s interesting to note that investment banks are now reserving for “put back” losses, while most of them felt it was an immaterial risk just six months or so ago.

—

More mortgage related reading…hat tips are due, but unfortunately, I forgot to note them. Most are via Warren Mosler’s blog post linked below.

Tax Credit + Tax Credit Expiration + Record Foreclosures + Documentation Issues + Probes + Renewed Foreclosure Spike (?) = Home Price Uncertainty and Volatility

http://www.ibtimes.com/articles/71820/20101014/u-s-foreclosure-repossessions-record-september-housing-bubble-foreclosure-filings.htm

Plaintiffs, including fifty state attorney generals, have been pushing back on foreclosures, while judges are seeking to tighten up the legal proceedings:

http://www.bizjournals.com/jacksonville/stories/2010/10/11/daily38.html?ana=yfcpc

http://www.nypost.com/p/news/business/hear_ye_hear_ye_EVyzIEMklFWu9GSwn3oaSN

An interesting debate between contributors to Calculated Risk and Naked Capitalism: 

http://www.calculatedriskblog.com/2010/10/why-did-mortgage-servicers-use-robo.html

http://www.nakedcapitalism.com/2010/10/guest-post-so-why-did-the-mortgage-servicers-use-robo-signers.html

Warren Mosler’s take — this wave of the crisis lends support to his belief that “The financial sector is a lot more trouble than it’s worth”:

http://www.nakedcapitalism.com/2010/10/guest-post-so-why-did-the-mortgage-servicers-use-robo-signers.html

The world of private equity is involved, via investments in some of the ‘foreclosure mill’ firms. I can understand why this might have looked like an attractive investment idea. But as one of the subjects of the article notes, private equity investors will tend to push hard for lower cost, higher margin (and/or turnover) production, which has obvious social costs and consequences as a foreclosure tsunami unfolds. And what happens if the investments were levered up, and the mill operations are shut down as a result of current probes and litigation? It’s not just the executives and clients of that private equity shop that suffer then — all of us get to share the pain. And that’s the main problem with innovation in the financial sector. Leverage means that the costs are absorbed by society, i.e., people who had nothing to do with the risk taking. Definitely a call for private equity clients to stay on top of what their managers are doing:  http://www.nytimes.com/2010/10/21/business/21equity.html?_r=1

The MMT folks weigh in — Randy Wray, Bill Black, Marshall Auerback:

http://www.benzinga.com/comment/reply/524394

http://www.benzinga.com/life/politics/10/10/517948/if-not-now-when

http://www.newdeal20.org/2010/10/15/foreclosure-fraud-we-need-to-fix-the-banks-again-23421/

“Positively Evil”

Felix Salmon has written a good piece on the behavior of the investment banks that bought, securitized, and sold mortgages in the years leading up to the crisis (emphasis added, bold only):

…[Investment banks] tested only a small portion of the loans in [a] pool [of mortgages]. So [they] knew that if there were a bunch of bad loans [discovered by testing], there were bound to be even more bad loans among the loans that…had not [been] tested. And those loans it couldn’t put back to the originator, because [they] didn’t know exactly which loans they were.

If there had been any common sense in the investment banks, that would have been the end of the deal. But there wasn’t. Rather than simply telling the originator that its loan pool wasn’t good enough, the investment banks would instead renegotiate the amount of money they were paying for the pool.

This is where things get positively evil. The investment banks didn’t mind buying up loans they knew were bad, because they considered themselves to be in the moving business rather than the storage business. They weren’t going to hold on to the loans: they were just going to package them up and sell them on to some buy-side sucker.

In fact, the banks had an incentive to buy loans they knew were bad. Because when the loans proved to be bad, the banks could go back to the originator and get a discount on the amount of money they were paying for the pool. And the less money they paid for the pool, the more profit they could make when they turned it into mortgage bonds and sold it off to investors.

Now here’s the scandal: the investors were never informed of the results of [the] test[s]. The investment banks were perfectly happy to ask for a discount on the loans when they found out how badly-underwritten the loan pool was. But they didn’t pass that discount on to investors, who were kept in the dark about that fact.

Disconcerting stuff, though judging by a recent Bloomberg poll, it wouldn’t surprise most Americans:

Wall Street financial firms and the mortgage industry get the most blame for the country’s economic weakness. More than three-quarters of the 1,000 Americans polled say the former has hurt the economy, while more than 80 percent fault the latter.

On a related note, Warren Mosler made the following observations in a recent presentation (pdf):

There is no public purpose served by allowing:

• Banks to sell their loans
• Sales of credit default risk when loans are based on credit analysis
• Banks to engage in any secondary market activity
• Proprietary trading

Mosler also observed that ”Banking should be a lot more limited than even restoring Glass-Steagall implies,” and that “The number of regulators needed increases geometrically with expanded bank activities.” He also ably dissected TARP and the shortcomings in federal stimulus measures. As he cleverly puts it on his website, “The financial sector is more trouble than it’s worth.”

And indeed, some empirical studies support the argument that the financial sector has been a mammoth rent sucking machine for decades. But good luck doing anything about it. Its immense profitability and resulting political clout have made it a powerful lobby, which is reflected in many parts of the recent Dodd-Frank legislation, as well as the deregulatory push of recent decades. And the fact is, the activities that Mosler listed have made some people incredibly wealthy, and there are simply too many more who want their shot at the million or billion dollar carrot, social consequences be damned. In fact, few if any of them even have a clue that their activities are socially harmful or neutral at best. Nothing quiets one’s conscience like visions of philanthropy, I suppose.

But despite the opaque complexities of the industry, people are on to it, as the Bloomberg poll shows. And the threat of pitch forks, however distant, might be at work in some recent industry actions, like the shutting down of proprietary trading desks and (tangentially) FINRA’s proposal to allow investors to select an all-public panel of arbitrators. Time will tell.

“Money we don’t have”

Good NYT article on deficit hysteria, with an especially illustrative quote from Rep. Cooper (D, TN):

“We have to stop spending money we don’t have,” said Representative Jim Cooper, a Tennessee Democrat who voted against the bill. “I hope deficit reduction fever is catching.”

The U.S. is in the midst of a balance sheet recession, with demographic ratios shifting an an unfavorable economic direction for several more years.  Under those conditions, deficit reduction fever will lead directly to the dreaded Japanese Disease —  another decade of stagnation, underemployment, and opportunity costs, all of which will impose greater burdens on future generations than expanded federal deficits would.

And policymakers — not to mention most members of the electorate, including analysts and the media — continue to commit two fundamental errors regarding fiscal policy:

1. They believe that all deficit spending must be financed with interest bearing debt, thus competing with the private sector for scarce financial resources.  However, judging by current Treasury rates, there’s still plenty of room for expanded federal borrowing.  And there’s a symbiosis between federal deficits and repair of balance sheets in the financial sector, as evidenced by the perfect quarters turned in by several major investment banks recently.  Politically, that relationship is almost nauseating, as it’s doing very little to relieve distressed households — but it nevertheless makes apparent the  dynamic between public sector fiscal deficits and private sector balance sheet relief.
2. They also believe implicitly that the U.S. is on a gold or similar standard, where fiscal and monetary policies are constrained by the supply of some exogenous factor, and governments can thus literally “run out of money.”  Governments can’t run out of money, as it is ’created’ by nothing more than digital ledger entries.  In other words, government (today, via operations of the quasi-private Fed) is the sole creator and supplier of high powered money.  Thus, the only constraint on money creation is inflation and a loss of confidence in the currency, and at the moment, those forces are emphatically not in play.  This too is symptomatic of Japanese Disease.

The fears of incumbent politicians like Cooper are certainly understandable.  But they’re borne of either ignorance about how these things work, or self-preservation.  Either way, it smacks of lousy political leadership. 

And given that Republicans are likely to benefit in November, we’d expect the trend towards fiscal conservatism to intensify.  Even President Obama, in a speech yesterday, promised the following:

• A three year freeze on all non-discretionary federal spending beginning in 2011
• Expiration of tax cuts via sunset provisions
• Elimination of 120 federal programs
• Reinstatement of PAYGO
• Higher fees on banks that are expected to lower federal deficits by $90B over ten years

He promised all of this as a way to force the public sector to budget in the same way that families and businesses do.  Again, this is wrong, and is borne of either ignorance or pandering.  And as with Congress, it smacks of crummy political leadership either way. 

The administration’s jawboning is also reminiscent of budget austerity measures touted by the Carter administration in the 1970s in reaction to the “tax revolt” — austerity measures that contributed to its eventual demise, even though they may have been more appropriate to the conditions prevailing at the time (e.g., baby boomers entering adulthood, global trade and financial integration, etc).   Today, austerity is far less appropriate, but even more vigorously pursued.  That almost certainly spells trouble for Obama in 2012 – assuming the GOP can field a worthy candidate and avoid blowing all of its political capital in the intervening years. 

You also have to wonder, were he to experience a change of heart, whether there’s any credible way for him to backtrack from his neo-liberal rhetoric.  The DLC, Brookings, Peterson, and all the other usual suspects have painted the guy into one hell of a corner.

In the meantime, assuming that reality will align with rhetoric, the political climate continues to be favorable to the USD and Treasuries, and rather risky to gold.  A contrarian call? You bet.  But it’s based on what we think is a well-grounded and – just as importantly – non-ideological assessment of the facts. 

IMPORTANT DISCLOSURES: Symmetry Capital Management, LLC (“SCM”) is a state registered investment adviser in the Commonwealth of Pennsylvania. The views expressed by the author are as of the publication date, and are subject to change based on market and other conditions. The foregoing information is for informational, educational, or entertainment purposes only. It does not constitute an offer to buy or a solicitation to sell any security, or to engage in any investment strategy. Investors should not use this information as a basis for any investment decisions without first consulting their own financial adviser. SCM is an Amazon.com associate, and earns a commission on sales generated through links from our website. Some clients of the firm are long GLL and/or long TLT.  At the time of writing, neither the firm nor its principals owned any securities mentioned. PAST PERFORMANCE IS NO GUARANTEE OF FUTURE RESULTS.

URLs:

http://www.nytimes.com/2010/05/29/us/politics/29deficit.html

http://www.japanreview.net/review_bsr.htm

http://www.miraeasset.com/ourmarket/outlookView.do?board_id=1125&group_id=1&pageNo=2

http://www.investmentnews.com/article/20100602/FREE/100609973

http://seekingalpha.com/article/208174-how-deficit-hawks-will-keep-cutting-spending-until-we-re-all-on-food-stamps

Geanakoplos on the Leverage Cycle

We came across this gem today — video of a presentation that [future Nobel Prize recipient] John Geanakoplos gave on leverage cycles at a Legg Mason conference, with accompanying slides.

URLs:

http://www.leggmason.com/thoughtleaderforum/2008/conference/webcasts/Geanakoplos-webcast.asp

http://www.leggmason.com/thoughtleaderforum/2008/conference/John_Geanakoplos_slides.pdf

http://cowles.econ.yale.edu/~gean/publications.htm

Fool: God & banks are perfect

Great piece by Morgan Housel for Motley Fool – when it comes to stimulus, masters of the universe stand at the front of the line. Ridiculous…

…what trading results used to look like. Take this chart, made with data from Goldman’s annual report, which shows how many days Goldman’s trading division made specific amounts of money in 2003:

Source: Goldman Sachs annual report.

…it looks like a bell curve. Some big losses. Some big gains. Lots of in between. That’s what you’d expect. Now compare that with 2009’s breakdown of daily trading results:

Source: Goldman Sachs annual report.

No more bell curve. In 2009, Goldman’s trading division made boatloads of money on most days, lots of money on many days, and … that’s about it. Raging success became the norm. In six years flat, the concept of “risk” was seemingly vaporized.

Why? What changed? It’s hard to tell because Goldman is unwavering in its quest to keep trading information secret…

Goldman has developed a cute habit of beating around the bush when investors and reporters ask about these details. Asked whether the recent trading success was from client-driven or proprietary trading, COO Gary Cohn replied, “Over the last 12 months we have only recorded 11 loss days. It is implausible that a proprietary-driven business model could be right 96 percent of the time.”

Well, no it’s not, and I’ll tell you why. What has changed recently, and what has been a tailwind to banks’ proprietary trading operations, are 1) the concept of “too big to fail,” and 2) investment banks becoming bank holding companies (as Goldman did in the Fall of 2008), which provides access to the Federal Reserve’s safety net…

The absurdity of banks using the Federal Reserve to borrow money on the cheap for trading purposes, rather than lending to the broader economy, is the foundation of the so-called Volcker Rule proposed earlier this year, named after former Fed chairman Paul Volcker. Under the Volcker Rule, banks tied to the Fed would be banned from proprietary trading. Period.

Congress votes sometime over the next few days on whether to include a version of the Volcker Rule in forthcoming financial regulation bills. If you want to let your Senator know how you feel on this issue, click here for their contact information.

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. At the time of writing, neither the firm nor its clients owns securities issued by Goldman Sachs; a principal of the firm owns Goldman Sachs common shares in a personal account. 

URLs:

http://www.fool.com/investing/general/2010/05/14/only-god-and-the-banks-are-perfect.aspx

Astounding assertion from Hassett

Kevin Hassett must have been asleep for the past two decades.

First, in a column yesterday on sovereign debt, he argued (correctly we think) that the current rescue package for Greece is doomed:

The fatal flaw in the plan is that the European nations bailing out Greece — even Germany, where government debt has risen to about 80 percent of gross domestic product — have similar budget problems and even less political will to take similar medicine. Their plan appears to rest on the hope that lenders won’t notice. Eventually they will, and when that happens, a worldwide loss of faith in government debt markets is a virtual certainty.

But he starts heading for the deep end (emphasis added):

In other words, it is hardly good news for a creditor if a hopelessly bankrupt borrower offers to take on the debts of a hopelessly bankrupt borrower.

During the financial crisis, faith was restored in large financial institutions because toxic assets were essentially exchanged for government bonds. If government bonds become toxic, there will be no effective treatment options remaining. The collapse will have no bottom.

There are three problems here.

First, to call European governments “hopelessly bankrupt” is to simply recognize that the EMU was designed in such a way as to prevent the ECB from monetizing the debts of member nations. Some relatively simple changes to the EMU framework would prevent EMU member governments (or a supranational fiscal body) from ever becoming ”hopelessly bankrupt.” Such changes might not be high probability, but they are clearly on the minds of European leaders and policymakers.

Second, to say that there are “no effective options remaining” if all of Europe were to face default is bizarre. In a sovereign debt deflation spiral, some level of monetization, either via direct open market purchases of government debt, or unsterilized fiscal expansion, or both, is the patently obvious answer. And his convenient use of ”essentially” in describing the prior chapter in the global financial crisis allows him to leave out a critical step – money creation. And no, Cassandra, in a debt deflation spiral, monetization and fiscal expansion are unlikely to prove inflationary.

Third, to claim that a “collapse will have no bottom” is rhetorical fear mongering, devoid of any conception of natural cycles, including human ones. Every collapse has an end, by definition. In the worst case, the world’s monetary and financial systems collapse, and we end up bartering with our neighbors, friends, and families; in other words, a two century step backwards. Not pretty, but not exactly “bottomless” either. And to believe that the world’s institutions would stand by and let such a thing happen is ridiculously far fetched, better suited to a backyard-bunker novel than a business column.

He then goes off the deep end completely (emphasis added, black only):

While the U.S. has been above the fray so far, an International Monetary Fund working paper published in 2003 suggests it is hardly in safe territory…

The paper, written by economists Paolo Manasse of the University of Bologna along with Nouriel Roubini of New York University and the IMF’s Axel Schimmelpfennig, studied historical sovereign-debt crises, exactly the situations that Western nations are hoping to avoid. They found that external debt levels — money owed to foreigners — exceeding 50 percent was a key indicator that debt default may occur.

Here is the chilling fact: the average external debt as a percent of GDP among countries in their sample the year before a sovereign debt crisis was 54.7 percent, and 71.4 percent in the crisis year. The U.S. external debt on Dec. 31, 2009, was $13.77 trillion, or almost 100 percent of GDP. For much of Europe, the story is worse.

A key force driving external debt higher has been the increase in government borrowing. In its first year, the Obama administration managed to add more than $8 trillion to the expected 2019 debt, now projected to reach $17.5 trillion.

Even the optimistic scenario only delays the inevitable. Along this path, lenders continue to happily purchase government debt in the near term. But even then, the relatively healthy U.S. will look like Greece within a decade.

Our advice? Read the paper before letting Kevin get too far under your skin. The Manasse-Roubini study’s sample was composed of 54 “market access countries”, which means emerging economies with significant access to international capital markets.  Examples include Algeria, Argentina, Bolivia, Brazil, Chile, Costa Rica, Egypt, Indonesia, Jamaica, Jordan, Korea, Mexico, Morocco, Pakistan, Panama, Peru, Philippines, South Africa, Thailand, Turkey, Uruguay, and Venezuela. It was not a study of mature economies with deep and fully developed capital markets and an internationally recognized currency, e.g., the U.S., the U.K., Japan, and western Europe. Chilling??? Come on, Kev…

For Hassett to extend the study’s findings to the U.S. and other developed economies without serious qualification betrays a certain degree of historical ignorance (including Japan, whose recent history he must have slept through), or financial ignorance, which seems unlikely given his credentials, or just good old intellectual dishonesty in the service of political ends. Whichever one is at work, it reflects poorly on him.

He continues:

The only path forward is one in which the major developed nations collectively make long-run budget adjustments designed to soothe market fears before a crisis ensues. Given that the only nation serious about deficit reduction right now is Greece, it seems almost impossible for this story to reach a happy end.

Which markets is he watching, exactly? Credit spreads have been coming under increasing strain as countries have been rolling out their austerity plans. And if being “serious about deficit reduction” is a magic pill, why is Greece’s sovereign debt still the most loathed in the EMU? 

And which nations is he listening to? Spain, Portugal, and Ireland are clearly serious about deficit reduction, and Italy is signalling that it might be; and yet their credit obligations are also relatively unloved by the market. Hassett is clearly missing some part of this dynamic.

And recent flights to safety notwithstanding, the USD and Treasuries have been strengthening as deficit reduction moves towards center stage in U.S. politics. This is eerily similar to how Japanese Government Bonds and the Yen behaved from 1989 — incessantly grinding higher despite repeated warnings like the one Hassett is now making to ”the major developed nations.”

What’s happening in Europe, and to the debt of Greece and the other ‘PIIG’ nations in particular, is being driven by the combination of an undeveloped fiscal structure for the EMU and strict constraints on the ECB’s open market activities. Yes, Greece’s prior government screwed up royally (apparently with some help from our sacred financial sector) and needs to make adjustments and amends to its fellow EMU members. But certain aspects of the crisis are also related to national policies and the EMU’s institutional framework that are depressing total output in much of the EU — in other words, there are amends aplenty to go around. And most importantly, hairshirt economics are not likely to improve the situation.

Hassett concludes:

Our choice is panic now, or panic later.

Clearly, Hassett is choosing panic now. And the last people you want by your side in a crisis — much less making decisions — are the panicky types.

URLs:

http://preview.bloomberg.com/news/2010-05-17/greece-s-bailout-heroes-arrive-in-leaky-boats-commentary-by-kevin-hassett.html

http://www.businessweek.com/news/2010-05-17/eu-faces-trichet-s-quantum-leap-call-as-euro-falls-update2-.html

http://www1.voanews.com/english/news/europe/Greek-PM-Considers-Legal-Action-Against-US-Banks-93885419.html

http://www.timesonline.co.uk/tol/news/world/us_and_americas/article6907681.ece

SEC’s Goldman bombshell

The SEC has filed a civil complaint against Goldman Sachs alleging fraud (yes, the f-word) for synthesizing an asset backed security related to residential mortgage loans in 2007. It was done for one of Goldman’s prize clients — John Paulson’s hedge fund, which returned billions of dollars to partners as the wave of mortgages security downgrades and defaults broke (and according to some authors, alerted Goldman to looming problems in mortgage markets) – so that he could take a large short position in (i.e., sell) U.S. mortgage securities.

The rub is that every short seller requires a buyer. And the SEC complaint alleges that Goldman’s and others’ disclosures to buyers were not above board.

There are many, many angles to this story — reputational risk, the firm’s culture and political capital, effects on pending financial regulation, implications for other investment banks and certain hedge funds — the list goes on. We think there are two quick takeaways worth thinking about:

First, the episode illuminates the dark side of financial innovation. There are actually grounds in financial theory for defending creation of this type of product. But it’s apparent that such innovations create serious agency risks for the parties involved. And the SEC is alleging that Goldman did not manage those risks effectively.

Second, we can use the event to cast a different light on the idea of “too big to fail.” At least in this case, the problem appears to have been that Goldman was too big to conduct itself ethically. We’ll leave it to readers to debate whether  “greedy” should be substituted for “big”. In the meantime, the market has been vomiting Goldman shares since the news broke.

URLs:

http://sec.gov/news/press/2010/2010-59.htm

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. At the time of this writing, neither the firm nor its clients own shares of stock or any securities issued by Goldman Sachs. One of the firm’s principals owns shares of Goldman Sachs common stock. 

Good column by Ron Rhoades

 Good column by Ron Rhoades on RIABiz.com, in which he predicts what types of financial reforms might come out of Congress in the current session. He echoes some concerns we’ve raised (emphasis added):

There are many parts of the overall financial services reform legislation that are incremental improvements over what we have today, and which should be supported. I hope the upcoming amendments will address “too big to fail” and reduce the perverse compensation incentives which tend to drive improper risk-taking activities.

I am deeply troubled, however, by the lack of oversight of all credit default swaps and other forms of derivatives. There are likely to remain many gaps in regulation which can continue to be exploited.

Additionally, much of the bill appears to fragment, rather than to consolidate, banking regulation. Regulation needs to be robust – to paraphrase James Madison, if securities industry participants were all angels, regulation would not be needed. But regulation also needs to be efficient. Our country cannot afford inefficient regulation of the same functional areas through duplicative, often over-lapping agencies.

This point, on disclosure as panacea, was particularly interesting, and lends some support to our call (and others’) for bringing basic financial education (legal might be a good idea too) into primary education:

The fundamental problem is that the SEC continues to emphasize disclosure above all else. While I support better disclosures of compensation practices and conflicts of interest, we must be realistic in what disclosure can accomplish. Disclosures are usually ineffective, as research into behavioral biases has demonstrated.

Today the financial world is far more complex for consumers than it was in 1940. Hence, disclosures utterly fail to overcome the huge “knowledge gap” between financial advisors and their clients.

The full column is available here: http://www.riabiz.com/a/748005?subscribed=true

Days of reckoning for state pensions?

Northwestern professor Joshua Rauh has published a paper in which he estimates that (1) state pension funds will run out of money in an average of 10 to 20 years and (2) the current gap between state pension assets and liabilities is equivalent to 25% of outstanding federal debt.

Rauh points out that actuarial practices understate the gap, and that with 8% annual return on pension assets [optimistic in our view], annual contributions to pension funds would have to double over the next ten years to close the gap. That’s a heck of a tax increase and/or shift in social spending at the state level. And given the contractual nature of defined retirement benefits, the fact that they are not indexed to nominal asset values in any way, and the importance they are afforded in most state constitutions, it seems unlikely that any ground can be made up on the benefits side of the equation.

States potentially have the option of scrip’ting away part of the problem by issuing their own currency (a more permanent version of California’s IOUs). The problem there is that many pension beneficiaries may live outside of the state they worked for, and that such measures might run afoul of pension guarantees.

Thus, it seems inevitable that the federal government will become more deeply involved in this issue in coming years. And while a great deal has been made of a ‘Keynesian revival’ in economic policy over the past few years, the pension crisis, like demographic cycles, actually seems to call for a revival of Abba Lerner’s ‘functional finance’, and the neo-chartalist school in general.

Essentially, if tax related or other burdens associated with pension fund solvency would impose deflation and/or penalties on real output, then the sanest way to resolve the crisis would be to employ the federal government’s capacity to issue interest and non-interest bearing debt (Treasury bills/notes/bonds and U.S. dollars, respectively), as we did with the financial system.

While straightforward in theory and operation, functional finance could prove a bit messier in its outcomes, given that U.S. dollars are still the global reserve currency. As we’ve pointed our previously, goods subject to the Law of One Price, primarily commodities, could very well ”inflate” in price, even if core U.S. price indices are relatively tame. That combination can have a regressive impact on households, and asymmetric impacts by industry.

If mishandled, it would mean that we’re shifting some of the adjustment costs in state pension assets to people outside and inside our borders who had nothing to do with the problem, while others would benefit unduly. Messy stuff.

URLs:

http://kelloggfinance.wordpress.com/2010/03/22/the-day-of-reckoning-for-state-pension-plans/

http://www.kellogg.northwestern.edu/faculty/rauh/research/RauhASPSSUSC2010.pdf

http://www.sscommonsense.org/page04.html

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

http://www.ucm.es/info/ec/ecocri/cas/Febrero.pdf

Banking regulation: Volcker vs. Basel

There’s additional chatter about financial regulatory reform today due to a luncheon speech that Paul Volcker’s giving on the subject. The debate continues to center around whether more stringent restrictions under the so-called Volcker Rule make sense, or whether capital requirements are a better way to go. The latter approach has some eloquent defenders, and seems to be favored by Asian and European regulators, but they should take heed of this new IMF study:

Using data for over 3,000 banks in 86 countries, we find that neither the overall index of BCP [Basel Core Principles on capital requirements] compliance nor its individual components are robustly associated with bank risk measured by Z-scores. We also fail to find a relationship between BCP compliance and systemic risk measured by a system-wide Z score.

And the band plays on…with each passing day it becomes more doubtful that something constructive will be done before the next financial crisis unfolds.

URLs:

http://www.imf.org/external/pubs/ft/wp/2010/wp1081.pdf

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