Thursday, December 31, 2009
Talking your book, Vince?
Here's another view of the data, with details on Rick Santelli's favorite, "emergency benefits." It's Mark Gongloff's Wall Street Journal piece in this morning's edition, entitled "5.6 Million Reasons to Doubt Jobless Rate."
"The way jobless claims have been receding should signal that U.S. unemployment has finally peaked. That probably isn't the case this time.
The Labor Department releases data on new claims for unemployment benefits on Thursday. Economists estimate claims rose to 455,000 in the Christmas week from 452,000 the prior week.
Holidays make it tricky to seasonally adjust claims. Many economists instead focus on the four-week moving average, which irons out weekly fluctuations.
Fortunately, that average has fallen steadily, from a high in April of 658,750 to 465,250, a 29% drop.
Since the Labor Department started tracking weekly jobless claims in 1967, such declines have signaled an unemployment peak. In fact, by the time this average has fallen by 29%, unemployment already has topped out, typically about six months earlier.
History suggests October's 10.2% unemployment rate was the worst of it, which would do wonders for the sustainability of the economic recovery. It also would mean the Federal Reserve raises rates sooner than investors expect.
So why do most economists still think unemployment has further to rise? Part of the blame goes to the unusually stubborn nature of joblessness in this recession.
The number of workers drawing regular benefits has fallen, from a record 6.9 million in June to just over five million. But instead of finding jobs, most of those people have exhausted regular benefits and joined the rolls of people drawing extended and emergency benefits.
That number has swelled from 2.8 million in late June, when regular continuing claims peaked, to 4.7 million in early December. That extra 1.9 million matches the number of people no longer drawing regular benefits.
Those people already are counted in unemployment. Another 5.6 million aren't: That is the number of people who have given up looking for work and no longer drawing benefits and thus aren't counted in the labor force or in unemployment, which is the jobless percentage of the labor force.
When they start looking again, as they typically do in recoveries, they will rejoin the labor force, competing with the roughly 9.9 million people drawing benefits. That alone will raise the unemployment rate again."
Pretty scary, isn't it? It harks back to my post on this nuance last October.
The 4.7 million additional workers who burned through conventional jobless benefits, and are now drawing "emergency benefits," is what Rick Santelli of CNBC has been noting with alarm recently. This has become a sort of hidden tax in the form of silently extended jobless benefits which you and I fund, with, of course, printed or borrowed, not value-created money.
Santelli's, and Gongloff's points are, this aging of unemployed on extra-long benefits adds some worrisome detail to the otherwise positive-sounding news that overall new claims are down.
Look, nobody in their right mind has ever said 2009 would be a year of extreme US economic decline. After the recession which officially began in December of 2007, eventually, the rate of decline would ease. We may even be at a point of cessation of growing unemployment.
But a healthy economy involves actually adding workers. Despite Vince Farrell's assertions, that's not what today's report indicated. Farrell grossly misinterpreted the data.
Then we come to Gongloff's last point, and mine in the older post. Thanks to carefully-defined terms, the government can avoid including 5.6 million formerly-employed Americans who are no longer "looking for work," and, therefore, able to be uncounted as unemployed.
Another statistical sleight-of-hand which makes things look much better than they really are.
We may have neared a point of maximal unemployment, in terms of newly-idled workers. But it's unlikely, thanks to a number of governmental missteps handling the recent financial crisis and recession, we have seen the last of rising unemployment. And we certainly are very far from actually seeing unemployment decline through new hires.
Gongloff- and Santelli- are correct. We should view these allegedly rosy jobless claim numbers suspiciously.
How the world has changed, as described in this article, sent to me by a friend, which appeared yesterday in McClatchy's online edition.
Entitled, "Investors could only lose in Goldman's Caymans deals," it would seem to mark a new low in the ease with which Goldman will saddle its clients with losses as it knowingly takes the other side of the deal, if only indirectly through side bets via swaps with third parties.
Perhaps not since the audio tapes of Bankers Trusts' derivatives salesmen detailed their wanton of customers whom they considered to be stupid, and said so, has such explicit evidence of an investment or commercial bank's callous attitude toward its customers come to light.
According to the article,
"McClatchy has obtained previously undisclosed documents that provide a closer look at the shadowy $1.3 trillion market since 2002 for complex offshore deals, which Chicago financial consultant and frequent Goldman critic Janet Tavakoli said at times met "every definition of a Ponzi scheme."
The documents include the offering circulars for 40 of Goldman's estimated 148 deals in the Cayman Islands over a seven-year period, including a dozen of its more exotic transactions tied to mortgages and consumer loans that it marketed in 2006 and 2007, at the crest of the booming market for subprime mortgages to marginally qualified borrowers.
In some of these transactions, investors not only bought shaky securities backed by residential mortgages, but also took on the role of insurers by agreeing to pay Goldman and others massive sums if risky home loans nose-dived in value — as Goldman was effectively betting they would."
That last part, alone, is pretty tough to understand. How could sophisticated institutional investors, including, evidently, many pension funds, buy a position in risky engineered securities, then be induced to also sell Goldman, the originator, insurance on the performance of those same bonds?
The article continues,
"While Goldman wasn't alone in the offshore deal making, it was the only big Wall Street investment bank to exit the subprime mortgage market safely, and it played a pivotal role, hedging its bets earlier and with more parties than any of its rivals did.
McClatchy reported on Nov. 1 that in 2006 and 2007, Goldman peddled more than $40 billion in U.S.-registered securities backed by at least 200,000 risky home mortgages, but never told the buyers it was secretly betting that a sharp drop in U.S. housing prices would send the value of those securities plummeting. Many of those bets were made in the Caymans deals.
At the time, Goldman's chief spokesman, Lucas van Praag, dismissed as "untrue" any suggestion that the firm had misled the pension funds, insurers, foreign banks and other investors that bought those bonds. Two weeks later, however, Chairman and Chief Executive Lloyd Blankfein publicly apologized — without elaborating — for Goldman's role in the subprime debacle.
Goldman's wagers against mortgage securities similar to those it was selling to its clients are now the subject of an inquiry by the Securities and Exchange Commission, according to two people familiar with the matter who declined to be identified because of its sensitivity. Spokesmen for Goldman and the SEC declined to comment on the inquiry.
Goldman's defenders argue that the legendary firm's relatively unscathed escape from the housing collapse is further evidence that it's smarter and quicker than its competitors. Its critics, however, say that the firm's behavior in recent years shows that it's slipped its ethical moorings; that Wall Street has degenerated into a casino in which the house constantly invents new games to ensure that its profits keep growing; and that it's high time for tougher federal regulations.
Tavakoli, an expert in these types of securities, said it's time to start discussing "massive fraud in the financial markets" that she said stemmed from these offshore deals.
"I'm talking about hundreds of billions of dollars in securitizations," she said, without singling out Goldman or any other dealer. " . . . We nearly destroyed the global financial markets.""
It looks like Goldman may finally have gone too far in actively selling clients on one market view, then investing the other way for itself. This piece is far more explicit and, in my opinion, damaging to Goldman than anything I've read in the Wall Street Journal.
As a detailed example of what the McClatchy piece contends, consider these next passages,
"However, one billion-dollar transaction that Goldman assembled in early 2006 is illustrative. It called for the firm to receive as much as $720 million from Merrill Lynch and other investors if defaults surged in a pool of dicey U.S. residential mortgages, according to documents in a court dispute among the parties.
Securities experts said that deal is headed for a crash that's likely to cause serious losses for Merrill Lynch, which Bank of America acquired a year ago in a $50 billion government-arranged rescue.
Taxpayers got hit for tens of billions of dollars in the Caymans deals because Goldman and others bought up to $80 billion in insurance from American International Group on the risky home mortgage securities underlying the deals.
AIG, rescued in September 2008 with $182 billion from U.S. taxpayers, later paid $62 billion to settle those credit-default swap contracts. The special inspector general who's tracking the use of federal bailout money has reported that beginning in 2004, Goldman itself bought $22 billion in insurance from AIG for dozens of pools of unregistered securities backed by dicey types of home loans.
When the federal government saved nearly bankrupt AIG, Goldman got $13.9 billion of the bailout money, and it still holds more than $8 billion in protection from AIG.
Tavakoli said that Goldman's subprime dealings burned taxpayers a second way. She said that three foreign banks — France's Calyon and Societe Generale and the Bank of Montreal — bought protection against securities they purchased in Goldman's Caymans deals, using AIG as a backstop.
Those banks got a total of $22.6 billion from AIG (Societe Generale $16.9 billion, Calyon $4.3 billion and Bank of Montreal $1.4 billion), though not all of the money was related to investments in deals underwritten by Goldman.
Each of the 12 Goldman deals in 2006 and 2007 traced by McClatchy included credit-default swaps that reserved a chance for the firm to lay down modest wagers that could bring thousand-fold returns if a bundle of securities, in several cases risky home mortgages, cratered.
The investors wouldn't buy the securities, but would agree that the insurance would hinge on their performance. Goldman said that it or an affiliate would hold those bets, at least initially.
"This might look stupid in hindsight, but at the time the investors thought they were lucky to get a piece of low-risk (AAA-rated) bonds created by Goldman Sachs with above-market returns," said Kopff, the securities expert."
This may, of course, all get swept under the proverbial rug again. But something tells me that the fact that Goldman made so much money on deals which US taxpayers ultimately paid for might cause this to be tossed to the Department of Justice as a possible fraud case. I'm no lawyer, so I don't know if there's actually a basis for that. But, sadly, when has that stopped Justice from attempting to coerce companies or citizens in the past?
On that note, the article states,
"The documents obtained by McClatchy also reveal that:
_ Goldman's Caymans deals were riddled with potential conflicts of interest, which Goldman disclosed deep in prospectuses that typically ran 200 pages or more. Goldman created the companies that oversaw the deals, selected many of the securities to be peddled, including mortgages it had securitized, and in several instances placed huge bets against similar loans.
_ Despite Goldman's assertion that its top executives didn't decide to exit the risky mortgage securities market until December 2006, the documents indicate that Goldman secretly bet on a sharp housing downturn much earlier than that.
_ Goldman pegged at least 11 of its Caymans deals in 2006 and 2007 on swaps tied in some cases to the performance of a bundle of securities that it neither owned nor sold, but used as markers to coax investors into covering its bets on a housing downturn.
_ If Goldman opted to buy the maximum swap protection cited in the 12 deals in which McClatchy found that it sold both swaps and mortgage-backed securities, and if the securities underlying the swaps defaulted, its clients would owe the firm $4.1 billion. If all 31 deals were similarly structured, investors could be on the hook to Goldman for as much as $10.6 billion, according to Kopff, who assisted McClatchy in analyzing the documents.
From 2005 to 2007, Goldman says it invited only sophisticated investors to act as its insurers. In those CDOs, Kopff said, Goldman appears to have created "mini-AIGs in the Caymans," arranging for investors to post the money that would cover the bets up front.
Kopff charged that Goldman inserted the credit-default swaps into CDO deals "like a Trojan Horse — secret bets that the same types of bonds that they were selling to their clients would in fact fail."
Goldman's chief financial officer, David Viniar, has said that the firm purchased the AIG swaps only as an "intermediary" on behalf of its clients, first writing protection on their securities, and then buying its own protection to eliminate those risks.
If that were true of all of the swaps contracts, however, Goldman would have earned only the lucrative investment fees on the deals and any gains from selling protection to its clients.
In a Dec. 24 letter to McClatchy, Goldman said it sold those products only to sophisticated investors and fully informed them of which securities would be the basis of any swap bets. The investors, it said, "could simply decide not to participate if they did not like some or all the securities.""
On the subject of why none of this has come to light, the article contends,
"Whether Goldman deceived investors with its secret bets depends partly on whether the courts or investigators conclude that disclosing the swaps would have dissuaded potential buyers from purchasing its registered mortgage securities, the experts said. Separate questions of disclosure could apply to clients who invested in the Caymans deals.
The Wall Street figure who insisted upon anonymity said that despite all the hoopla, there were few private investors in CDOs, and that banks have suffered most of the losses, one reason "why you haven't seen a lot of complaining."
However, other experts said that many of Wall Street's victims have chosen to remain silent. Douglas Elliott, a former investment banker at J.P. Morgan Chase who's a fellow at The Brookings Institution, a center-left policy organization in Washington, said that pension funds are loath to discuss investments that "blow up" because "it could potentially lead to lawsuits against them."
Christopher Whelan, a senior vice president and managing director of California-based Institutional Risk Analysis, said that foreign banks "got stuffed" in the Caymans deals, but that Wall Street dealers typically averted litigation by buying back failed securities at a discount to avoid court fights. Any investors who sued would face the threat of being "blackballed" — shunned by Wall Street firms, he said."
Which is why it's so important to get rid of any notion that any commercial or investment bank (the latter of which there are no longer any large ones) has any sort of implicit guarantees of rescue from the federal government.
Remember, Goldman did these things when it was completely on its own. Now, it's apparently viewed as one of the "too big to fail" institutions.
Any guess on how that new designation will affect their appetite for risk, and likelihood of repeating this sort of financial sleight of hand?
Wednesday, December 30, 2009
Prior to this, there was some sense of winding down the two failed GSEs. Not anymore.
Now, these badly-managed quasi-government financial utilities have new leases on life to blunder into even larger messes.
This is the very antithesis of Schumpeterian dynamics. Rather than let failure be punished with death, our government is now doubling down on financial stupidity and bad risk management.
Happy New Year!
Citing the implosion of politically-protected and government-guaranteed Fannie Mae and Freddie Mac, Koppell argues that, in exchange for governmental backing, these banks will slowly, inexorably be drawn into political capital allocation. For example, he contends.
"Financial institutions will inevitably be beset by requests from members of Congress to "take another look" at rejected loan applications from favored constituents."
Further in his editorial, Koppell observes,
"The question is whether the marginal benefit of maintaining large integrated financial groups justifies the hazards that they introduce. There is scant evidence that financial giants make working capital more affordable or allocate credit more efficiently than smaller institutions. In fact, they may siphon capital away from lending activities that more directly expand the economy."
Amen to that.
I was a senior planning executive at Chase Manhattan Bank when it employed about 45,000 people. Now, the bloated financial utility has over 220,000 people.
Do you think smarter people are running Chase now? Don't bet on it. It's just an amalgamation of four old-fashioned money center banks which once did the same things in four different organizations scattered across Manhattan and the world: Chemical Bank, Manufacturers Hanover, JP Morgan and Chase Manhattan.
What you see now is simply the compressed remains of the four money center banks which weren't Citi, and didn't fail, like Bankers Trust.
I can vouch for Koppell's suspicions. Even in its smaller days, Chase Manhattan's scope and scale resulted in inefficient capital allocations among its businesses, "play it safe" lending and operating decisions by business managers, and far too much political maneuvering for career advancement.
I'm quite sure it's only worse now.
Add government guarantees, and you are looking at even worse problems. Think of Merrill's runaway mortgage finance unit of a few years ago, on steroids.
This time, any mess that some fairly innocuous business buried in the bowels of Chase gets into will be paid for by- you and me. As taxpayers.
Think this will result in more effective risk management at Chase? Not on your life.
Koppell finishes his piece by noting,
"To the leaders of financial powerhouses, the siren song of government backing will be nearly irresistible, particularly when irritants like federal pay czar Kenneth Feinberg can be tuned out. Unlike Ulysses, however, these captains of finance will never bind themselves to the mast. If we don't do it for them, we'll all end up on the rocks."
There's only one silver lining which I can see in all of this.
That is, my friend B's prediction from 1996 will come true among the ashes of exploded, government-seized banks whose activities were guaranteed. After the next blowup, they will probably be restricted from risky activities like underwriting and proprietary trading, as Paul Volcker has suggested.
In their absence, dozens of private equity firms and boutique lenders, traders and underwriters will flourish.
Nature and markets abhor vacuums where services need to exist to service demand. When the inept, gigantic financial utilities have been "guaranteed" out of the riskier financial businesses, new, more skilled ones will replace them.
Tuesday, December 29, 2009
Recall, if you will, that government interventions were based, at the time, on the unknown size of risks to the financial markets and, presumably, the economy, from allowing derivatives contracts to fail.
Yet, here we are, on the brink of 2010, with no new derivatives exchange in place.
The article recounts the various actions of derivatives customers, brokers, and sellers. But buried in the piece is the one really simple fact that explains it all,
"For Wall Street, switching to exchanges would have cut their profits in a lucrative business. "Exchanges are anathema to the dealers," because the resulting price disclosure "would lower the profits on each trade they handle, and they would handle many fewer trades," said Darrell Duffie, a finance professor at Stanford business school."
That's it in a nutshell. After taking government handouts and the benefits of zero-rate fed funds, a number of financial service firms blocked Congressional attempts to replace the risky current practice of largely unsupervised, party-to-party credit derivatives trading with an exchange.
The direct benefits of exchange-based trading, of course, is that counterparty risks are assumed by the exchange, which monitors and demands adequate collateral, plus clears and settles each day's trades.
This allows risks to be more easily known, margins to be set and enforced, and the prospect of endless daisy chains of loss from one failed contract to be eliminated.
But the price of this systemic safety, of course, is always the profits of an inefficient market.
No financial product which has moved to exchanges has ever gotten more profitable. In fact, Wall Street firms dream up innovative products primarily to escape the low profit margins of widely-traded products. This is essentially what Paul Volcker was suggesting in his recent remarks about financial innovation at a Wall Street Journal conference.
As a recent Journal piece on which I wrote this post was correct, we were originally told that AIG had to be saved due to derivatives exposure for the entire financial sector.
If the administration has changed its mind, then an explicit accounting of just what was the risk would be in order.
If not, and we need a derivatives exchange, then one should have been in place by now. We certainly have enough existing models to quickly develop one for credit default swaps and related derivatives.
It is no longer a partisan issue. One of the functions of government is to handle issues like this. That a functioning derivatives exchange has not yet been made operational is shameful.
We pay taxes for a government to provide basic services. Instead, last year, we witnesses billions of taxpayer dollars paid to avoid, we were told, financial sector disaster due to failed derivatives contracts.
It's about a derivatives exchange was in place. The systemic costs of our federal government fumbling with the consequences of not having such an exchange are too great too allow remaining investment banks and brokers to retain high profit margins on derivatives.
Monday, December 28, 2009
Tedford has an enviable record over the past 20 years, as described by the Journal, as a fixed-income fund manager with Stephens. I found these passages describing part of his model to be extremely compelling,
"The key data point in Mr. Tedford's model: the monetary base, basically money circulating through the public or reserve banks on deposit with the Federal Reserve. Over long sweeps of time, he says, inflation closely tracks increases in the monetary base that exceed economic growth.
For instance, he notes, in the 40 years to 2007 the U.S. monetary base grew at 7.08% a year. Gross domestic product, meanwhile, grew at 3.04%. The resulting surplus monetary-base growth of 4.04% closely matches CPI and the personal-consumption-expenditures price index, another measure of overall inflation."
The piece goes on to note that the U.S. monetary ballooned from less than $850 billion (the Journal stated "million," but I'm fairly sure that is a typo) in August, 2008, to more than $2T at the end of last month. Tedford explained that, even if you subtract $1T still held as reserves, the resulting growth in monetary base is "one of the highest changes I've ever measured."
For evidence, Tedford observed that as of October, the year-over-year CPI had sunk .02%, while the year-to-date change is 2.3%.
This article struck me as one of those pieces that crystallizes common sense.
I've been following the thinking of several prominent economists in the Wall Street Journal this year. Two themes have made a lot of sense to me.
One is that whatever growth the US economy seems to exhibit will be the result of federal printing or borrowing money, not real, lasting, reliable private sector growth.
The other is the incredible growth in the monetary base. Alan Reynolds and Art Laffer have both mentioned this as a reason to worry about coming hyper-inflation. Now Tedford, with a proven track record in fixed income, is taking action along those lines.
You don't have to be really smart or have a PhD in economics to understand the following question.
If the US monetary base, valued to reflect the worth of the US economy, was under $1T at mid-2008, and it now is more than double that, does this represent a true increase in value in the US economy? Especially just after, or still during, an economic recession?
Of course it doesn't. It cannot.
What it represents can then only be one of, or a mixture of, two things- the present value of suddenly-monetized growth, or a simple depreciation of the currency, leading to subsequent inflation.
I can't see how the world's investors have magically granted the US double the prior present value of future economic growth. So it makes more sense that we have about double the amount of dollars in existence to value the same amount of economic worth in our economy.
Any way you slice it, that's depreciation of the dollar that will lead to inflation.
Only this morning, a guest on CNBC expressed doubt that the Fed will raise rates at any time before next November, thus leaving us open to an inflation-tinged bout of 'growth.' He doubted that any equity market gains would be "real," either in the deflated or reliably-sourced sense.
I think he was correct. It's not clear exactly when the effect of the huge monetary base increase will hit, but history strongly suggests it won't be correctly or effectively handled by a Fed reduction in the base in a timely fashion. Second, federal spending will hit the economy in such a manner as to exacerbate inflation and, then, when expended, lead to a fall in equity values as private sector growth fails to immediately pick up for borrowed-money growth.
For anyone else who, like me, remembers the rise of inflation in the 1970s, it is very discomforting to see these economic indicators coinciding- federal spending, higher deficits, much higher monetary base, amid a recession.
Thursday, December 24, 2009
"Since last September, the government's case for bailing out AIG has rested on the notion that the company was too big to fail.
Last week's news that this was not in fact the motive for AIG's rescue has implications that go well beyond the Obama administration's efforts to regulate CDSs and other derivatives."
According to the TARP's inspector general, Neil Barofsky, Geithner did not, in fact, believe AIG's credit default swap exposures were "a relevant factor" in the rescue.
Wallison's point is that, based upon the government's initial reasons for bailing out the insurer, Congress has rushed through some bad new regulatory legislation promulgated on the theory of unsupervised interconnectedness of large financial institutions.
If this weren't the reason for AIG's "rescue," then what was? And why are we so worried about something that Geithner contends wasn't the reason for taking over privately-owned AIG?
This sort of quasi-Constitutional, quasi-political question has somehow escaped notice in all the furor over private sector companies- insurers, commercial and investment banks- which were simply distributing the government's own flawed, low-quality mortgage-backed securities.
Perhaps that fact that the two major architects of Fannie Mae's and Freddie Mac's demise, Barney Frank and Chris Dodd, are in charge of all things financial in Congress, has a lot to do with why there has been no in-depth investigation of a Republican administration's concerns over interconnectedness that, upon closer inspection, was actually nowhere to be found.
Considering Congress' headlong rush to another piece of bad legislation, this time redrafting financial sector regulations, it would be a good time to pause and go through the AIG debacle slowly, with a fine-toothed comb, to learn exactly who was worried about the insurer, and why.
Wednesday, December 23, 2009
With so much was made of a piddling .2% unemployment drop the other month, what are we to deduce from this huge downward GDP restatement? After all, it's about nearly one-quarter of the prior 2.8% total, and slightly more than 20% of that amount.
That the equities indices rose yesterday, despite this news, is not necessarily remarkable. One day moves don't necessarily produce interpretive results.
But you have to wonder about what this restatement means for the near term US economic growth rate, ex federal spending. After all, this is a 2.2% rate with quite a bit of federal intervention in so many areas of the economy- autos, housing, $787B of fiscal appropriations, nearly-infinitely extended jobless benefits, etc.
Just this morning, before writing this, I happened to see Harvard economics professor Ken Rogoff on CNBC giving some rather gloomy outlooks on the economy going forward. He foresees continuing increases in unemployment, noting that we need to replace 11 million jobs now to regain pre-recession employment levels. He also expects rising foreclosures.
In the midst of such huge federal economic interventions, it's simply difficult to see how anyone can tease economic health out of a single quarter's positive growth rate, especially when it is revised downward so sharply.
Tuesday, December 22, 2009
Monday, December 21, 2009
There were, however, three aspects to his editorial which I found questionable.
First is his seemingly blithe dismissal of Fed and fiscal intervention as being so important for what growth we've seen in the past two quarters. For all that, Blinder calls himself "cautiously optimistic."
Second, he is betting on personal savings rates remaining anemic. He more or less blows off the recent rise in the rate, claims everyone is overstating it, and then effectively determines that the savings rate won't really factor into the economy's near term recovery.
If the deleveraging about which I've written, and others have observed, is real, Blinder is underestimating the effect that consumer savings will have on the economy. It will result in less growth than he expects.
But the point Blinder makes about inventory builds was what really caught my eye. He asserts that "firms will not want to deplete their stocks indefinitely."
A quick canvass of some business colleagues confirmed that Blinder has missed the transition from inventory cycles to more smoothly-linked supply chains. Of course, government data collection measures inventories. But that doesn't mean they exist as they did 10, 20, or 40 years ago.
In a similar fashion, SIC codes are laughably out of date. You can see how companies are classified, but the density of GDP among the codes is totally skewed from what it was at their inception.
Back to inventories.
One of my friends is the chief engineer for a lab equipment supply firm. They don't even order raw materials until they have orders in hand.
Four years ago, a friend of mine with a major consumer products company said, to paraphrase him,
'We've been studying warehousing, and we think in the future, it will look a lot like JB Hunt.'
That's the trucking firm. He meant they were transitioning to a steady, constant supply of goods from their factories onto trucks to major customers.
I personally don't believe the inventory rebuild that so many pundits believe will rescue the US economy is coming.
Economists who don't work in industry may not be realizing how much has changed in the US economy in the past few decades. Perhaps they are the same economists who still believe modern recoveries will bring job growth, despite that not being true for nearly 30 years.
Near-seamless, contemporaneous producer builds for end customers has been a holy grail for decades. With modern IT, intra-vendor links and the internet, it's come to the point of being essentially here for many firms and sectors.
In the ideal business world, inventories don't exist. In time, perhaps they'll only exist in the minds of economists and old, antiquated government economic data series.
Friday, December 18, 2009
Skimming through the section, I found nothing particularly interesting, other than Paul Volcker's remarks. Everyone else was either one of many unimpressive, unimaginative executives at a cookie-cutter made global financial institution, or hailed from a damaged one.
But Volcker was much different, as usual.
According to Alan Murray's written piece recounting Volcker's comments, he began,
"Well, you are not going to be very happy with my response. I heard an awful lot of particulars here that I agree with to some degree, but my overall impression is that you have not come anywhere near close enough to responding with necessary vigor or structural changes to the crisis that we have had.
I hear about these wonderful innovations in the financial markets, and they sure as hell need a lot of innovation. I can tell you of two—credit-default swaps and collateralized debt obligations—which took us right to the brink of disaster. Were they wonderful innovations that we want to create more of?
You want boards of directors to be informed about all of these innovative new products and to understand them, but I do not know what boards of directors you are talking about. I have been on boards of directors, and the chance that they are going to understand these products that you are dishing out, or that you are going to want to explain it to them, quite frankly, is nil.
I mean: Wake up, gentlemen. I can only say that your response is inadequate. I wish that somebody would give me some shred of neutral evidence about the relationship between financial innovation recently and the growth of the economy, just one shred of information. I am getting a bit wound up here."
Volcker waggishly announced that, in his opinion, the finest example of financial innovation in the past 20 years, more mechanical than financial, really, was the ATM.
But Volcker's correct. While extending the availability of consumer credit via cards and somewhat more flexible mortgages has been productive, the more esoteric financial engineering products have created more problems than they probably solved. And certainly not contributed to smooth, healthy economic growth.
To provide more conclusive evidence, Volcker reportedly then confided,
"A few years ago I happened to be at a conference of business people, not financial people, and I was making a presentation. The conference was being addressed by a very vigorous young investment banker from London who was explaining to all these older executives how their companies would be dust if they did not realize the joys of financial innovation and financial engineering, and that they had better get with it.
I was listening to this, and I found myself sitting next to one of the inventors of financial engineering. I didn't know him, but I knew who he was and that he had won a Nobel Prize, and I nudged him and asked what all the financial engineering does for the economy and what it does for productivity.
Much to my surprise, he leaned over and whispered in my ear that it does nothing—and this was from a leader in the world of financial engineering. I asked him what it did do, and he said that it moves around the rents in the financial system—and besides, it's a lot of intellectual fun."
The man to whom Volcker refers is almost certainly either Myron Scholes or Robert Merton, both of Long Term Capital Management infamy. It's a very telling tale, knowing this. The sort of comment which those who have always suspected financiers of being careless with the systemic impacts of their risk-related activities find confirming the worst of those suspicions.
" I am not sure that I said innovation in itself is a bad thing. I said that I have found very little evidence that vast amounts of innovation in financial markets in recent years have had a visible effect on the productivity of the economy. Maybe you can show me that I am wrong. All I know is that the economy was rising very nicely in the 1950s and 1960s without all of these innovations. Indeed, it was quite good in the 1980s without credit-default swaps and without securitization and without CDOs.
I do not know if something happened that suddenly made these innovations essential for growth. In fact, we had greater speed of growth and particularly did not put the whole economy at risk of collapse. That is the main concern that I think we all need to have.
If it is really true that the world economy was on the brink of a great depression that was greatly complicated by financial problems, then we have a rather basic problem that calls for our best thinking, and structural innovation if necessary. I do not want to stop you all from innovating, but do it within a structure that will not put the entire world economy at risk."
I like and agree with Volcker's point that productive, useful innovation is fine. But reckless innovation for the sheer sake of bolstering profit margins, which is actually the genesis of most of the more damaging so-called innovations, is not.
Consider, for example, if, instead of CDOs, financial service firms had created exchanges for trading whole mortgage loans. Instead of being forced to buy packages of loans of varying quality, an investor could diversify risk geographically, or otherwise, himself. Risks would be managed via collateral requirements for the exchange members, so the sort of daisy-chain defaults that so worry investors today would be non-existent.
Further, Volcker implies something I also believe, which is that credit derivatives add no value. Probably because he, too, realizes that they can't remove risk, only transfer it. At a cost.
Volcker then addressed what he feels would work,"First, let us agree that we have a problem with moral hazard. I do not think that there is any perfect answer in dealing with it, but I would suggest that we can approach an answer by recognizing that elements of finance have always been risky and that's certainly true of the commercial-banking system.
I think we need the commercial banking system for more than automatic teller machines. Commercial banks are still at the heart of the system.
In a crisis, everybody runs back to the commercial banks. They, after all, run the payment system. We cannot have this global economy without commercial banks operating an efficient payment system globally as well as nationally. They provide a depository outlet for individuals and businesses, and they are still big credit providers for small and medium-size businesses, but they backstop most of the big borrowers as well. The commercial-paper market is totally dependent on the commercial banking market. They are an essential financial institution that has historically been protected. It has been protected on one side and regulated on the other side.
I think that it is extraneous to that function that they do hedge funds, equity funds and that they trade in commodities and securities, and a lot of other stuff, which is secondary in terms of direct responsibilities for lenders, borrowers, depositors and all the rest.
There is nothing wrong with any of those activities, but let you nonbank people do it and you can provide fluidity in markets and flexibility. If you fail, you're going to fail, and I am not going to help you, and your stockholders are going to be gone, and your creditors will be at risk, and that is the way that it should be.
How can I be so blithe about making that statement? We need a new institutional arrangement which I believe has a lot of support. We need a resolution facility. What can that resolution facility do? If one of you fails and has systemic risk, then it steps in, takes you over and either liquidates or merges you, but it does not save you. That ought to be a kind of iron cross."
This squares with my own, and my friend B's views. B predicted the evolution to these sorts of Glass-Steagal banks, as a few national banks morphed into today's Chase, Citi and BofA. He noted, as has Volcker, but over ten years ago, that such large deposit gatherers and lenders would need to be restricted from risking that capital in trading, underwriting or other investment banking activities.
The solution we need isn't more complex regulation, so much as a reasoned return to a past regulation, and better, permanent severing of the riskier finance activities from the federally-insured, mainstays of deposit-taking and basic consumer and commercial lending.
Thursday, December 17, 2009
Recently, I've been reading about JP Morgan's role as the orchestrator of a resolution of the Panic of 1907.
This website discusses some of the details of that Panic. The author, Fred Foldvary, teaches economics at the University of Santa Clara. Written in May of 2007, well before the first shot of the 2008 financial crisis, which was the failure of two Bear Stearns funds which invested in CDOs.
Salient passages from his piece on the Panic of 1907 include,
"One hundred years ago, there was a financial panic in the United States. There were runs on the banks as depositors rushed to take out their money before they ran out of currency. The stock market dropped to half its peak 1906 average.
The financial crisis began in New York City, home of most of the financial “trust” companies. The panic induced Congress to create the Federal Reserve System (the “Fed”) in 1913 to prevent any more such financial crises. But the Fed failed to prevent the even worse bank failures of the Great Depression.
The fundamental causes of the Panic of 1907 were the flawed monetary and fiscal systems of the United States. The federal government’s control of the money during and after the Civil War created a rigid money supply that did not respond to the demand for money. During that era, agriculture dominated the economy, and the inflexible money supply created a crunch and a spike up in interest rates whenever farmers and others need to borrow funds.
Federal taxes fell mostly on the sale of goods, with high tariffs and excise taxes on goods. The great expansion of state-subsidized infrastructure such as canals, railroads, and highways, along with other government services, pumped up land values, subsidizing land ownership. Economic booms were accompanied with land speculation as land values rose, and the speculation was financed with borrowed money. Real estate was a major asset of companies such as the railroads, whose shares rose in value as real estate prices escalated, and speculators also borrowed to buy the shares of stock. The stock market bubble rested on the real estate bubble, and then high interest rates and high real estate prices dried up investment, causing a recession and fall in stock market shares, resulting in bank failures as loans turned bad. Depositors would then panic and rush to take out their money.
The same story happened again and again, but after 18 years, new speculators had no experience with the previous panic, and older investors kept hoping to recover past losses and make a killing before the crash. The establishment of the Fed did create a more flexible money supply, as the Fed can expand the money without limit. Federal deposit insurance, starting in 1933, ended bank panics, but this only shifted the financial risks to the government and thus to taxpayers and bond owners. The fundamental policy of federal control of the money remained, and the fiscal system of taxing production while subsidizing land value also has remained.
The Panic of 1907 shook confidence in the U.S. financial system, but the people and the government officials learned the wrong lessons. The problem with the banking system was the federal control of the money supply, and the effective remedy would have been free market banking, where the banks and other private firms would issue private currency backed by gold. With competitive banking, the private bank notes and deposited funds would expand flexibly in accord with the demand for money and borrowing, while the redemption into gold would prevent inflation. That is how the Scottish free banking system worked previously. But instead, Congress moved towards greater federal control of money and banking, a policy which failed to prevent the Great Depression and which led to the continuous inflation since World War II and also to more recessions.
The effective policy to end panics and depressions is free banking and land-value tappation, the tapping of land value and rent for public revenue, which would prevent speculative excess. The institutional details are different today than one hundred years ago, but the fundamental structural causes of depression have not changed. The current real estate boom has peaked out, and with much of financial collateral based on real estate loans, the economy is headed towards the same end, a crash. This time, rather than a panic focused on financial institutions, federal policies have spread the risk to the entire economy, so the next crash will be much worse than the brief panic of 1907, and this time, a clique of bankers will not save us."
Foldvary points out that the creation of the Fed didn't remove any risk from the US financial system. It simply allowed the federal government to occasionally shift risk from the private sector to all taxpayers.
Again, we see how risk is conserved, never eliminated, when assets are simply sold or insured.
Further, I think it's noteworthy that Morgan's role as the ramrod among fellow financiers resulted in both contribution of capital by all parties, as well as the elimination of some banking houses. Foldvary doesn't provide details, but other sources you can Google on the subject do.
Here are the points I wish to make.
In the Panic of 1907, informed participants in the financial markets moved to clean up the mess. Being involved in the business, they had intimate knowledge of who should fail, what should be shored up, and how much money it would take. Their realization that further delay or failure to resolve the crisis might cause all of them more losses motivated them to resolution in the most efficient manner they could devise.
Somehow, without a Fed, printing more money, quantitative easing, or the federal government buying mortgages, the US and its economy managed to survive and prosper.
In 2008, just over one hundred years later, with a functioning Fed, the crisis that actually began in mid-2007 still isn't over. The Fed still has enormous amounts of private financial instruments on its balance sheet. It has printed billions of dollars, though for exactly what, has yet to be explained.
Rather than guide weak financial institutions to failure, the Fed and Treasury intervened to prop up failed banking managements and models. As a result, many inept management teams continue to populate the financial sector.
Additionally, despite 100 years of government oversight of the financial sector, the creation of the Fed, hundreds of rules and many regulatory agencies, the very same causes of financial panic which humans created in 1907 reappeared in 2007-08.
Does this not point out the futility of regulation which claims to reassure and insure the public against their own, innate behaviors? And didn't this regulation basically fail to avoid the same sort of crisis which occurred a century ago?
Rather than heavy-up regulatory oversight and further complicate operations of the financial sector, maybe it's time we admitted that natural human behaviors in a free society will lead to occasional panics. Central banks can't eliminate them. And the financial risks created on the way to panics can't be magically eliminated by a federal government or central bank, either.
Perhaps the best we can do is to magnify the penalties of excessive risk taking by making institutional failure the clear outcome. After setting margin requirements for loans and leverage, I think the best government can do is to oversee those simple safeguards, then get out of the way, and let those who imprudently take risks suffer the consequences.
That includes those who unwisely choose counterparties which fail, e.g., Goldman Sachs. Or banks which overpay for mortgage finance companies, e.g., Wachovia and BofA. Or mismanaged behemoths, e.g., Citigroup.
Our financial system survived prior panics in which the weak and inept were not saved. Why would it be any different today?
The video of the exchange appears below. The verbal sparring begins at 4:20, with Santelli finally losing patience at 5:18.
Wednesday, December 16, 2009
Meyer uttered a dictum which I admit to believing. It was popular during the last eight years, during Bush's administration. The argumentative phrase is,
"Deficits don't matter."
Meyer conditioned it with the observation that there is no evidence that deficit levels are related to inflation rates.
As I noted, when it was uttered in the past decade, I concurred.
But I have begun to reflect more seriously recently on how models fail. Most economic and other behavioral models fail in times of extreme conditions and values.
My roots in quantitative work run to consumer choice modeling and statistical analysis of marketing data. Among a variety of quantitative models which were developed by the 1970s to explain or predict consumer choices between products were a class known technically as "disjunctive additive" models.
Rather than summing all terms to produce a score which was associated with some choice, these models contained thresholds which, when exceeded, caused different values to be returned.
These models weren't universally employed, in part due to the challenge of parameter estimation and, in part, due to the programming difficulties in software of the time.
But the salient point which I took away is the understanding that real human behavior is not linear over all values of relevant variables. At certain levels of environmental or model variables, behaviors change in non-linear fashion.
I'm now thinking that, throughout the past 80 years, Larry Meyer has been correct. The macro variables surrounding the US national debt and deficits- global conflict, existence of a powerful communist superpower, trading partners recovering from WWII devastation, lack of large pools of savings in other economic centers, a dynamically-growing, little-regulated US economy with sane social spending policies- were conducive to buyers of Treasuries calmly investing in said instruments.
However, it would seem that the US economy, monetary and social spending policies may now be causing the general assumptions and environments which existed in the past, which sustained Meyer's comment, to be violated. Regarding US deficits, the behavior of global investors with respect to US debt and dollars may even now be exceeding some threshold which will cause non-linear, changed behaviors with respect to their desire to hold US financial obligations, and the returns they will now demand for holding them.
Of course there is no direct, simple relationship between an annual US government budget deficit and the consumer price index, per se.
But, in extreme conditions, there probably will be. How?
Consider this transmission effect.
When total US spending grows to some very large level, necessitating either higher taxes, debt issuance, or, as I read yesterday in Von Mises' book, The Theory of Money and Credit, "the printing of notes," and there are no higher taxes, but increased debt issuance and printing of notes, then investors in Treasuries and holders of dollars will begin to observe the stealthy depreciation of their assets' values.
To Von Mises, this is inflation. It's the antecedent of Milton Friedman's historic statement,
"Inflation is always and everywhere a monetary phenomenon."
When investors in US Treasuries and/or dollars see more dollar obligations being created than value in dollars in the short term, they will demand higher rates, if they choose to hold Treasuries at all. They may even decline to bid on Treasuries at auctions and, then, when they do, demand higher rates to hold them.
Thus, government "crowding out" of private spending with government spending and/or borrowing, can create investor demands for higher rates on Treasuries, which will drive effective interest rates up for the US government.
As the effective value of dollars fall, with higher rates, prices of commodities and products bought with dollars, now having less value, will necessarily, in dollar terms, appear to rise.
I think the current period is actually different than those prior periods underpinning the research on which Meyer relies for the validity of his observation.
Eighty years of nearly-constant explicit US government deficits, not counting the hidden unfunded social obligations of Social Security, Medicare, Medicaid and various state and local government employee pensions, seem to have delivered the US to a point at which deficits may now finally matter for inflation prospects.
Tuesday, December 15, 2009
When asked about his take on the recession and recovery, Paulsen launched into a spectacularly sunny diatribe about how great the recovery has been. True, his math was a little vague.
For example, he noted the absolute difference between the -6.4% GDP growth in the worst recent quarter and the most recent +2.4% (these may be off by a few tenths of percents), proclaiming that a really great recovery.
Most economists with whom I'm familiar typically compare trough-peak measures to other peak-trough measures.
No, he just marvels at how the trough is negative, the new recent value is positive, so, wow, things are great!
I wondered how he could be getting away with this, because the program's supposed foil for Paulsen was, in fact, another shill.
He's a 'chief equities strategist' at an investment bank. And he agreed with everything Paulsen said.
Then it hit me.....
These guys are on the program to talk their firms' books. You know, talk up viewer interest in equities which, as it happens, both guys' institutions hold. And, in the foil's case, also broker.
You can't say enough about how generous CNBC is to its guests.
Have an equity you hold and want to pump? Why, get on CNBC and be interviewed by Maria Bartiromo. Like Lee Cooperman did for Home Depot almost exactly three years ago.
So what we saw this morning was Paulsen's rather unusual depiction of a hearty, healthy, robust US economy which he confidently predicted would grow normally and fast, just like it has in "every other" recovery. No details. No mention of jobless recoveries which have been the norm since 1982.
Rather, Paulsen wanted to give the clear and strong impression that it's now full speed ahead for equities. Get in there behind Wells' book and make Paulsen proud....and a lot of money, too, by the way.
One of the passages I wrote reflected my overall sense of the type of managerial skills and qualities bred by the old telephony companies,
"In all of this, however, there loomed large a business and financial fact. Old-style circuit-switched telephony depended upon regulatory tariffs. These were set, as with most utilities, like power companies, based upon assets.
In effect, those portions of your telephone service which were subject to regulation were priced to provide the telephone company a target rate of return on assets. That's why the old Western Electric built gold-plated, everlasting switchgear. That's why the telephone companies capitalized unbelievably large amounts of labor to install said switchgear as asset value.
In 1983, the average line management talent of ATT was basically involved in internal allocation fights, regulatory affairs management, and some small but ineffective amount of competitive activity. The truth was that what ATT and its units did was take a regulatory-provided pot of money and divide it up, using somewhat initially arbitrary, but thereafter consistent rules, among the various operating companies, Long Lines and Western Electric. From that pot of gold, funding for Bell Laboratories was also provided.
My point in relating this history is to provide some background for the world of then-middle and -senior ATT and operating company management. Folks like, well, Ed Whitacre. And some of my former colleagues who hung in at ATT and gradually moved up the ranks amidst the ongoing confusion as the newly-deregulated firm went through amazing changes."
Now comes word from ATT that they are seeking ways to incent iPhone customers to actually use their phones less for data and various other bandwidth-hogging applications.
This spoof, one of the "fake Steve Jobs" series, sent to me by a colleague, couldn't be more topical, nor accurate.
Of all the passages in the piece, perhaps these two best distills the point of "Jobs' " rant,
"So let’s talk traffic. We’ve got people who love this goddamn phone so much that they’re living on it. Yes, that’s crushing your network. Yes, 3% of your users are taking up 40% of your bandwidth. You see this as a bad thing. It’s not. It’s a good thing. It’s a blessing. It’s an indication that people love what we’re doing, which means you now have a reason to go out and double or triple or quadruple your damn network capacity. Jesus! I can’t believe I’m explaining this to you. You’re in the business of selling bandwidth. That pipe is what you sell. Right now what the market is telling you is that you can sell even more! Lots more! Good Lord. The world is changing, and you’re right in the sweet spot.
And now here we are. Right here in your own backyard, an American company creates a brilliant phone, and that company hands it to you, and gives you an exclusive deal to carry it — and all you guys can do is complain about how much people want to use it. You, Randall Stephenson, and your lazy stupid company — you are the problem. You are what’s wrong with this country."
But ATT can't really seem to shake that old regulatory mindset. Yes, they sell bandwidth. But it's not like they're going to actually raise capital to build a lot more cellular towers and figure out how to increase wireless network capacity.
No, they're happy with the old 'busy hour' mindset. The mindset that equates busy signals with a contentedly fully-used network. Why overbuild?
It is ludicrous to see a vendor mis-price a service, then, when stimulating demand, react by trying to cut usage, when the demand is habit-forming. If ATT were really intelligent, they'd address pricing with subsequent contracts, but, in the meantime, build out or lease capacity to satisfy demand and retain all those iPhone customers.
But I think that's like asking a leopard to change its spots. This is, after all, a unit of a telephone company.
Not some cutting-edge technology services firm.
No, it's only ATT.