Friday, August 22, 2008

Lessons of Financial Crisis?

Today's Wall Street Journal's Money & Investing carried an article by Joellen Perry entitled, "Lessons of Financial Crisis."

Ms. Perry opens her piece with this passage,

"Some of the world's brightest economic minds agree the current financial crisis exposed major flaws in the system, but disagree about the role regulators should play in preventing a repeat.

At an annual gathering Thursday of economic Nobel laureates on a tiny, medieval island in southern Germany, three winners of the Nobel Price in economics and one Peace Prize winner lamented the excessive risk-taking, lax management and impenetrable complexity at the heart of the financial system's current turmoil."

So far, so good. But as Ms. Perry reports on the laureates' angst over bankers tossing their clients over the side in pursuit of profits, it becomes clear that this gang of ivory tower geniuses just doesn't understand the real world of finance.

The fact that Myron Scholes, co-architect and gargantuan money-loser, with John Meriwether and another Nobel prize winner, Robert Merton, of Long Term Capital Management, is one of the whiners should tell you something. These guys are not all rooted in the real world of modern day finance.

For example, Daniel McFadden, the 2000 Nobel Economic laureate, suggested,

"We may need a financial-instrument administration that tests the robustness of financial instruments and approves only the uses where they can do no harm."

Have you stopped laughing yet? I haven't.

At least Scholes noted,

"Sometimes, the cost of regulation might be far greater than its benefits."

Let's get a few things straight.

First, financial services is unique among sectors in that leverage allows a few individuals to profit, now, from transactions which might, in the future, prove to be money-losing. So the incentive of really smart people to quickly fleece less-smart people on a large scale is immense.

Second, regulators aren't paid very much. And operate in specific countries. Thus, the smart individuals who design and produce new, complex and 'innovative' financial instruments will always be a few steps ahead of the regulators.

McFadden's idea is so stupid you almost can't believe anyone would actually voice it. All someone has to do to evade his proposed regulatory scheme is locate their financial services business or exchange in Lower Slobbovia, after having contributed generously to that country's government, or promising to pay attractive tax rates for the privilege of nonexistent regulatory oversight.

There's always a domicile for the financial service concept seeking less regulation.

Third, how can anyone affect, in process, the harmful use of financial products? Sometimes the damage comes from a fallacy of composition, wherein what a few may profitably do becomes disastrous on a large scale.

Isn't this what occurred with CDOs? A few badly-designed instruments wouldn't have really affected but a few unwise investors. A huge volume of them has undermined valuations on a global scale.

Which brings me to my own salient point about this topic, and Ms. Perry's very good article.

The real lesson of financial crises, in my opinion, is that buyers always need to beware. Period.

As noted investor Wilbur Ross has stated,

" 'When someone mentions two words, financial engineering, you know it's really an attempt to underprice risk.' "

Why would you buy something so complex that you can't understand it? Why would a 'sophisticated' investor, including a Wall Street Journal investments columnist, buy something because,

"Like other victims I've heard from, I got a call urging me to take advantage of an offer that was being extended to valuable clients."

Financial services isn't like medicine, where the doctor treats a largely-unaffectable supply of diseased bodies.

In financial services, everyone with money is a target whom to separate from said money. The implied fiduciary principles and behaviors of financial services purveyors, consultants, et. al., are highly suspect when paired with the motive for these vendors of products and advice to make a profit from their clients.

Simply put, responsible adults do not:

-take out mortgages at rates and in amounts they feel they cannot actually pay.
-invest in financial instruments they can't understand simply because someone paid to get them to do so says it's 'a good idea,' or 'an offer to valuable clients.'
-hand over their financial assets and futures to people who will be paid in the event of non-performance.

Most of the so-called financial services 'crises' came about because investors- either in financial institutions or financial products- exercised too little, or no, due diligence and caution when investing in the aforesaid 'assets.'

It's not the suppliers of financial services we need to regulate. They will always exist, smarter and faster-moving than any regulator.

We need to make sure that investors realize they are on their own to analyze their asset and liability options and must live with the financial consequences of their choices.

That's how risk is best managed. When the investors and borrowers feel they must take responsibility for their financial actions.

That's the real lesson of financial crises. They are preventable if people don't expect something for nothing, or extra financial gain for no added risk.

Thursday, August 21, 2008

About Those GSEs: Fannie & Freddie

There's been quite a bit of ink spilled recently over Fannie Mae and Freddie Mac, the GSEs for mortgage finance. I haven't directly addressed their plight since I wrote this post a little over a month ago.

Now, with both of them near financial death, it's appropriate to revisit the topic. I wrote in that piece,

"My overall view of the situation is that it is a mistake to give more capital access to the same crew that got into this mess.

The implicit Federal Government guarantee clearly led to an imbalanced strategy over the last decade. Both institutions enriched employees, especially senior management, while failing to pay careful attention to the growing risks on their own balance sheets.

For this, we have Congress to thank, since it tends to view Fannie and Freddie as a large real estate finance cookie jar for their own pet agendas.

Of the choices which the Journal's article suggests, I think I would go with the Bush administration's desire to replace the current boards with members whose stated objective would be to clean up the balance sheets of the two firms and gradually shrink their role in the housing markets.

In this day and age, if a government-affiliated lender can't do a decent job securitizing housing loans, why allow it to exist?

We'll always get better performance from the private sector, assuming adequate regulation.

Now, we have the worst of both worlds- shareholders losing value due to entrenched, incompetent management, and the Federal Government picking up the tab.Shareholders chose to own the companies' stocks (I have owned equity in both firms in the past), so they deserve to lose their capital.

But to prevent a replay of this fiasco, I think it's time to remove the governmental connection to the two mortgage securitization firms as soon as it is possible."

Yesterday, over lunch, my partner and I discussed how the situation could best be resolved now. Everyone seems to fear a 'market collapse' in Fannie- and Freddie-issued mortgage-backed securities.

But as I see it, there are actually two distinct problems to be solved.

The first problem involves the treatment of outstanding GSE-issued mortgage-backed securities. These pretty much have to be backed by the US Treasury. To fail in this regard would be to, as my friend B, whose opinions I published in this post, cause large-scale losses in virtually every pension and retirement fund in the nation.

It's instructive to consider that what is involved here is only making up the losses from defaulted mortgages in these securities. If Fannie and Freddie were actually providing a value-adding service, including effective risk management, this wouldn't be a big problem. The expected value of losses from defaults would be low.

If, on the other hand, that expected value is high, then this alone argues for simply shutting the two GSEs down. Service their issued securities, but liquidate the companies.

The second problem is the role of the two GSEs in ongoing US housing finance. Here, articles discuss the new difficulties the two companies have in rolling over their longer-term debt.

To me, the solution here is simple, as I just stated two paragraphs above. Terminate the organizations.

Don't roll the debt over. Liquidate the companies' assets, and use remaining shareholder equity to satisfy any debts. Place what's left into receivership to work out any remaining unpaid creditors.

But, you ask, what about the mortgage finance industry? Won't this, as one Wall Street Journal op-ed cried, bring US housing finance markets to a standstill?

No. Of course not.

In our economy, absent unwise governmental interference or regulation, something worth doing will be done by someone, at a profit.

So, too, will that occur in this case. By killing the GSEs, room will be made for private mortgage conduit companies to do the work, if it's valuable and profitable, of mortgage securitization.

I suppose it's possible that investors might not currently trust any securities backed by mortgages, for fear of experiencing more of the same they have gotten from Fannie's and Freddie's poor underwriting standards and unwise programs requiring too little equity from borrowers.

In time, a well-run portfolio lender could easily begin to liquify their balance sheet via securitization. There's nothing magical about it. A few well-run mortgage banks and a few investment banks could fill investor demand for mortgage-backed securities left by the GSEs.

In time, the better home finance lenders with lower delinquency and default rates would command higher prices, and lower yields, for both their securitized mortgage notes and their debt. And equity.

Simply put, if there's a need for the functions which the GSEs performed, won't we see sufficient capacity, and better performance, from private-sector firms doing the same thing?

Well, we know one thing. We won't see worse underwriting practices in these securities. The very worst system you could possibly design is to pay government-backed entities private-sector-style compensation. Risk is transferred to the government, while rewards accrue, unfairly, to the equity holders and management.

With private-sector players doing this work, risk and reward would be appropriately put back together, where they belong. But, most importantly, Fannie and Freddie should be prevented from doing anymore ongoing mortgage finance securitization. With their track record, whether taken over by Treasury, or not, they simply have to be shut down, so room can be made for more effective firms with better risk management to replace their shoddy underwriting practices.

Wednesday, August 20, 2008

Economics, Growth & Inflation On My Mind

Brian Wesbury's excellent piece in yesterday's Wall Street Journal, "Inflation Is a Clear and Present Danger," moved me to write a piece on recent developments in the US economy.

But, to start this post, I'd like to refer to an economics editorial in the Journal on July 25th by David Ranson, head of research at H.C. Wainwright Economics. Among several excellent points he made, this one stood out in my mind,

"There's an old saying that if your neighbors are losing their jobs it's a recession; if yu are losing yours it's a depression. It's therefore unfortunate that such a large fraction of prominent forecasters hails from the financial community. Their views are colored by the turmoil suffered in their industry. In an earlier generation, many of the best-known forecasters ran economics departments in nonfinancial companies. Today these are a dying breed, thanks to the past decades of corporate cost-cutting.

We are not a nation of whiners, but we do have a lot of alarmists. It is becoming politically incorrect to suggest that the economy is basically sound.

We shouldn't expect forecasters to shrug off the depressing effects of what's happening in their own back yards. This is human nature. We just need to keep things in perspective when we listen to them. A more objective diagnosis is especially needed during an election year, in which many unfounded fears are broadcast and amplified by the media."

Ranson wrote quite a bit to chew over in those three paragraphs- all of it true. He hit the nail on the head when he noted that economists in the financial sector, being employed by managements that have screwed up their industry big time this past year, see the rest of the US economy in similarly dire straits.

And they do shout about their misperceptions to anyone who will listen.

Ranson made another interesting point in his editorial. He also wrote,

"A natural system has built-in redundancy. It manages and heals itself. The economic system is no exception. On this page about 10 years ago, Penny Russell and I argued against the idea that the economy is a "house of cards," susceptible to collapse as soon as a few cards are dislodged. We suggested that it's more like a beehive. The future of the hive does not depend on the full employment for all the worker bees. In fact, an accident can put many bees out of action without compromising the hive as a whole.....Yet despite the human tragedies at the local level, the system as a whole muddies through.

Failure to recognize this endangers the mental health of our society. We create a far bigger tragedy when we lose heart, change the rules of the game, or act recklessly with quick fixes."

I really love that analogy. It's so apt for a market economy such as that of the US. Yes, technically, we have a mixed economy, with such a large government sector. But the driving force of value creation is the private sector. And that sector does heal itself. Thanks to individual initiative, resources and creative energy flow naturally to the areas with the best opportunity for economic success.

The system prospers and thrives, although, at any one time, individual 'worker bees' may be displaced. It has always been this way in the American economy from the time the colonies of Jamestown and Plymouth were founded.

However, even if growth in the US economy has not vanished, and a recession is not necessarily underway, or even on the horizon, inflation does seem to now be a renewed threat to our prosperity, as Brian Wesbury warned in his editorial. He began by writing,

"The most painful and frustrating economic policy blunder of the past 50 years was the Great Inflation of the 1970s. Painful, because it was the catalyst for three damaging recessions (1973-75, 1980, 1981-82), all the while eroding living standards and seriously undermining confidence in America.

It was also deeply frustrating. Despite the teaching of Milton Friedman -- which clearly explained that inflation was caused by too much money chasing too few goods -- a combination of bad economic models, denial and political expediency allowed it to happen.

President Reagan meets with Paul Volcker, chairman of the Federal Reserve Board, 1981.
One would think that the odds of a repeat were low, and for 20 years, after Ronald Reagan and his Fed Chairman Paul Volcker had the courage to get inflation under control with tight money and tax cuts, this was true. Unfortunately, the lessons seem to be fading. Today, the U.S. (and through it the world) faces its greatest threat from inflation in 30 years. And as in the past, this threat is being met with denial and political expediency."

Strong words, but true. I respect Wesbury as being a very talented, blunt-speaking and insightful economist. One of those who, per Ranson's piece, probably would have worked in a large US corporation twenty years ago. Now, he's with a money management firm.

Wesbury continues,

"As is so often the case, after the Fed has acted, but before the typical lag in monetary policy has fully played out, conventional wisdom argues that the Fed has become impotent. Back in 2002 and 2003, the logic was that the Fed was powerless over globalization, and low-cost labor would continue to feed deflation. In addition, because long-term rates were rising as the Fed cut short-term rates, many thought that markets were undermining Fed intentions.

But, as always, when the Fed injects excess liquidity into the system, inflation begins to rise. As early as 2002, soaring commodity prices and a falling dollar became the canaries in the coal mine of excessively loose monetary policy.

But oil and food are absorbing a large part of excess Fed liquidity. When consumers spend more on energy, they have less to spend in other arenas. This reduces demand for other goods, keeping prices lower than they would be otherwise. This helps explain the divergence between overall and core measures of inflation.

This divergence is now coming to an end. If the recent decline in energy and food prices continues, that money will be released and other prices will start to rise more quickly. The July jump of 0.3% in "core" CPI inflation is likely one of the first signs.

Some argue that the recent drop in commodity prices indicates lessening inflationary pressures. But nothing could be further from the truth. Commodity prices had reached levels that were not justified by current monetary policy. As a result, their pullback is just a correction, not the beginning of a new trend. If this pullback had occurred as the Fed was lifting the federal-funds rate, like back in 1999, it would be a different story. Excluding food and energy from the CPI is sometimes justified because their price movements are often volatile and short-lived. But the five-year average annual growth rate of the CPI, which should smooth out any short run issues, is now 3.6% -- its highest level since 1994. Moreover, the Cleveland Fed's trimmed mean CPI, which excludes the 8% of prices growing the fastest and the 8% growing the slowest, is also up 3.6% in the past year -- its fastest growth since 1991."

Wesbury clearly identifies empirical measures which show inflation on the rise. To address the cause- an overly-rapid expansion of the US monetary base- he writes,

"With the real (or inflation-adjusted) federal-funds rate now negative, the signals are clear. The Fed is still adding more money to the system than is demanded, and this suggests that the general increase in inflationary pressures will continue. The only question is whether policy makers will get the courage to fight inflation before it gets out of control.

And this is the rub. Much like the 1970s, there is a widespread denial that inflation is a problem today. Some argue that Fed policy is not easy, either because the money supply is not growing, or that banks are deleveraging, which counteracts any attempt by the Fed to inject money.

The first argument hits at the root of Friedman's monetary theory. If money is not growing, then how can inflation be a problem? But money is growing. No measure of money is declining, despite bank deleveraging, and Reserve Bank Credit (the Fed's balance sheet) has expanded at a 14.4% annual rate in the past three months.

Another sign of easy money is that every country that pegs to the dollar, including China and the United Arab Emirates, is experiencing a rapid acceleration in its inflation rates as it imports inflationary U.S. monetary policy.

The second argument is belied by history. Between 1983 and 1994, exactly 2,747 U.S. banks and S&L's failed, representing total assets of $894 billion. During that period of deleveraging, real GDP in the U.S. expanded at an annual average of 3.5%. The Great Depression is the only period of sharp economic contraction in the U.S. correlated with bank failures. But that was clearly related to a deflationary mistake in Fed policy. Real interest rates were outrageously high in the late 1920s, and much of the '30s, which is not true today."

It's typical of Wesbury's genius that he finds and presents exactly the evidence that contradicts most of the hand-wringing worriers who despair at the self-induced casualties in the financial services sector. Failures or consolidations of large investment and commercial banks, due to their own bad risk management, needn't cripple the rest of the US economy, nor cause a recession.

Finally, Wesbury notes,

"One of the reasons that monetary policy is so loose today is that our economy is addicted once again to easy money and low interest rates. We hear over and over that the Fed cannot tighten because the housing market and the economy are vulnerable. This was the same argument made in the pre-Volcker 1970s, when the U.S. bounced from one economic crisis to the next.

But a look back at the past 40 years clearly shows that the economy was much healthier in the 1980s and '90s, when real interest rates were high, rather than low as they were in the 1960s and '70s."

He's right again. Reagan, together with Volcker, engineered lower taxes (fiscal policy) and higher interest rates (monetary policy) which laid the foundation for over 20 years of healthy US economic growth.

Wesbury closes by reminding us of the damage the late Senator (D-MN) Hubert Humphrey did with his idiotic "Humphrey-Hawkins" dual Fed mandate law. By forcing the Fed to take employment into account, rather than simply focus on a stable growth in the monetary base, Humphrey bequeathed a legacy of economic risk to his nation upon his death.

As Wesbury comically puts it,

"The Fed's "dual mandate" -- to keep the economy strong and prices stable -- serves to support this mistake. In contrast, the European Central Bank has a single mandate: price stability. No wonder the dollar has been so weak relative to the euro. Imagine two football teams. One with a single mandate: win. The other with a dual mandate: win and keep your uniforms clean. It's clear that the one with the single mandate will have more success in achieving its goals over time."

Wesbury ends his editorial with a call for a return to the courageous actions of Reagan and Volcker by today's government leaders.

Ranson demonstrates that our economy is neither fragile, nor in danger from lack of growth. Wesbury reminds us of the medicines which, taken over 20 years ago, led to our economy's remarkable performance since then.

Let's hope leaders in US government and industry listen to both of these economists. Soon.

Tuesday, August 19, 2008

Where'd It All Go?

Last week on CNBC's morning program, co-anchors Joe Kernen and Becky Quick were asking, regarding the mortgage/housing market troubles,

"Where'd all the money go that went into these houses that are now empty?"

Kernen was musing about where all that money went which was borrowed to build now-useless housing.

Who ended up with the money? Or did it just 'disappear?'

Pardon me for saying so, but, isn't that a stupid question? And Kernen and Quick are both smart enough to already know the answer.

The money was part of the assessed, imputed present-value of those homes, lent by financial service providers.

Essentially, based upon local demographics, overall economic outlook and the borrowers' financial outlook and current condition, someone lent them the money to build a house of some assumed value in that market at that time. No matter how long the chain of borrowers and lenders, eventually, at the end of it, some person or entity bought a financial instrument promising repayment, over time, at some interest rate, in exchange for the cash that trickled back to the home's purchaser, with which to pay the various people engaged in building the home.

So the money in those homes- the value lent against them- went to the contractors, tradesmen, and, yes, a little went to the financial intermediaries, as well.

As with the excessive lending and capitalization of web-based companies during the '' boom, capital flowed from people and entities to projects- homes or businesses- judged to have future value and an ability to repay the borrowed money.

Of course, to the extent that financial intermediaries used excessive leverage, the dollars lent by investors became, in some cases, 30 or more times that amount. Banks are allowed certain capital ratios by the Basel Accords, while the banks allow certain ratios for brokers to which they lend. With firms such as Merrill Lynch and Bear Stearns purchasing and operating mortgage banks, I'm sure the leverage for dollars flowing into the housing sector were greatly amplified versus prior housing bubbles.

As I reflected on this post earlier this morning, it occurred to me that one of the by-products of the excessive investment in the housing sector was an overall economic leverage which was much greater than if those investor dollars had flowed to a non-financial sector, such as energy, consumer goods, or almost any other sector.

The investments in housing and related sectors diverted funding from other sectors. But, since so much of the real estate boom was predicated on values which, especially in 'hotter' markets like Las Vegas, Florida and California, could not long be sustained, those investments were at risk nearly from the outset.

When the leveraged 'values' declined, the thinner-than-normal equity slices evaporated quickly, and investors took their hits next- almost immediately. For example, a low-down-payment mortgage requiring only 5% of the purchase price of the home from the buyer could only withstand a 5% drop in real estate values before investors began to lose their capital.

With so much borrowed money flowing into an overheating sector, the damage to our economy was magnified because so much forecasted future value was brought forward, monetized as housing prices, lent, and spent.

So the answer to Kernen's and Quick's question is that an abnormally large amount of economic 'value' was created on paper, in the financial markets, to lend to buyers of over-valued houses which quickly lost value and destroyed the imputed values which had been assessed, borrowed, lent, and spent on housing and related items.

The cash went to pay builders, furnishers, appliance makers, etc. The offsetting 'credits' for these 'assets' are, of course, assets on the lenders/investors balance sheets. But they have now had to be written down to current values.

The laborers, contractors, and publicly-held house-furnishing-related companies enjoyed a brief, accelerated boom in revenues. Perhaps some even expanded capacity and created downstream revenue growth themselves.

Now, however, as Paul Samuelson's accelerator-multiplier work informs us, the same breakneck growth in housing-related spending and lending which drove prices and 'values' up in the expansion, are at work in reverse, coursing through the sector and depressing values.

The values represented by the peak prices of homes bought and constructed were contextual, and have vanished. The real dollars exchanged for those prices did, for a moment in time, also exist.

But the reverse multiplier effect on all these vendors, assets, etc., have destroyed much of the capital created and borrowed to fund these houses.

Since valuation is a function of perceptions, those values are now gone. And so is much of the transitory wealth which existed at the time of peak values in the housing markets.

Monday, August 18, 2008

Jeff Immelt Lies On CNBC This Morning

Jeff Immelt, GE's inept CEO, gave a hilariously pompous interview to one of the co-anchors from his own network, CNBC, this morning.

One of the perks Immelt enjoys as CEO of the ailing diversified industrial conglomerate is a steady stream of public appearances on CNBC. He can count on lapdog-style softball questions from his 'interviewers,' who are, of course, his own employees.

Jeff sure wouldn't want any tough questions on the country's largest business cable network, now, would he?

And he never has to worry when he books an appearance on his own network.

This morning, though, Immelt reached a new low.

He lied. Clearly and unambiguously, he lied.

What he said, in a sort of fumbling, embarrassed run-on answer to some inane question, was, referring to GE's recent performance,

"We've delivered for our advertisers and for our investors."

But if you look at the series of Yahoo-sourced price charts in this post depicting GE and the S&P500 Index for the past 6 months, 1, 2, 5 and 40 years, the falsity of Immelt's statement is instantly apparent.

In none of these charts does GE outperform the S&P under Immelt's reign. Not one.

The 40-year chart shows GE outperforming the Index, but that goes back to when Jones and Welch also ran GE. In entirely different eras than today's.

I suppose if Immelt has resorted to measuring performance over 2-3 month periods of his choosing, then, yes, GE has briefly, recently "outperformed" the S&P, as depicted in the latter part of the curves on the 6-month price chart.

But for a guy who has mismanaged and, my new favorite term, "misled" GE for 8 years, come September, this is surely reaching. Not to mention wildly distorting and contorting reality to make them fit his own definitions of GE's performance.

It's another measure of Immelt's desperation that he babbled about delivering for advertisers.

Jeff, those are customers. You have to give them what they paid for.

If you are now declaring success because you managed to fulfill your contracts with customers in GE's entertainment units, then your shareholders are probably much worse off than they realized.

Among the other idiocies Immelt babbled about in the interview were that GE's entertainment, infrastructure and other businesses still make sense being in a common corporate shell. And that GE's NBC network is a valuable asset, albeit only when it has 'high quality' content, i.e., has purchased Olympic coverage rights at astronomical rates.

At one point in his monologue, Immelt rattled off some revenue, income, and growth statistics for GE, attempting to justify his value destruction under the guise of logic amounting to,

'Hey, we're big and slowly getting bigger. We make some money. That's enough, isn't it?'

No, Jeff, it's not enough. It's not about net income growth or size. It's about the total return you can consistently deliver for your shareholders in excess of what they can earn for next to nothing by buying the S&P500 Index, which is far less risky than your outmoded conglomerate.

In fact, by no means can Jeff's investors, i.e., shareholders, feel they have been delivered for, or to. Look at the last chart. It's clear that GE's value peaked just about the time at which Immelt replaced Jack Welch as GE's CEO. It's been downhill from there for GE shareholders.

During the time in which Immelt has destroyed GE shareholder value, the S&P has remained flat.

Immelt has destroyed value by retaining GE's outdated and unwieldy conglomerate structure for far too long.

It's a testament to Jack Welch's following among the financial community, and investors, that GE's stock price performance handily outperformed the index's during his reign from the early 1980s to 2001.

Welch probably could have outperformed the S&P500 running a lemonade stand. The guy not only managed GE to exceed investor expectations, but somehow magically had what it took to sprinkle pixie dust into analysts' eyes and convince them that GE's archaic conglomerate structure still added value.

Immelt, on the other hand, has failed at this from the moment he took over the CEO's job.

It's one thing to acknowledge failure and try harder. Or even ask forgiveness for failing.

Immelt would even get points if he just admitted that GE isn't working with him at the helm, and either step down as CEO or break the company up.

But to simply lie about GE's total return performance 'for investors' is a new low. Even for Immelt.