Monday, March 30, 2009

Is mark to market's repeal the missing link?

It is still is not clear that mark to market will be repealed. But it appears to be on that track.

Mark-to-market as a fun house mirror, not a window to value
Some are blaming evil bank lobbies for all the pressure that finally produced capitulation on the issue. AND there may be some truth to that. But the case for repeal has its own special, intrinsic merit. It's the same reason we are not necessarily better off shaving in the reflection of a 'fun house' mirror than in no mirror at all...

No redeeming social value...
The point is that mark-to-market has produced bad results. It has led to no price discovery and yields no transparency. There is nothing really to recommend its retention. Granted that taking it away does not mean that you would get better results; valuations could stray further for reality and in the opposite direction. But it does look like alleviating the market of the mark to market rule could help to revitalize the valuation of securities pricing. That might make the risk worthwhile

Is this the missing link - the missing carrot - to get banks involved in the New Treasury plan?

As an adjunct to the Treasury/FDIC auction plan
When Treasury launched its auction plan one repeated criticism-admitted just this weekend in Tim Geithner's press appearance- is that there is nothing in it to motivate banks to participate in the securities purchase plan by selling 'toxic' assets. The Treasury/FDIC plans offer leverage for investors, low interest loans, plus some substantial protection against risk. To assist and attract asset sellers it offered nothing. Is mark-to-market the missing element to motivate sellers? It could be.

Impact of mark-to-market on bank willingness to sell assets
If you believe as I do that mark-to-market has depressed securities prices, then taking it away could actually cause prices to rise. Once banks were no longer burdened by such a low prices on their books (due to mark-to-market), losses no longer loom and sales become possible. If banks can sell securities above the level where they are now valued, asset sales will produce profits at banks not losses. Ironically it might take the elimination of mark-to-market to make the markets work and to generate transactions on these securities that could help bank examiners ascertain the value of the securities that banks now will have discretion to price.

Finders, keepers
Of course, another possibility is that banks simply markup their prices and put them into earnings. But if banks really need to unburden themselves of the 'assets' that the market views with such suspicion, then actually selling them- getting rid of them- is a superior strategy as long as the price difference is not too great between the price where they can be sold and where a bank would try to 'mark' them. This discussion assumes that the Fed's Bernanke and FDIC's Bair are right when they say things like 'long term value lies above market value' (Bernanke) or that 'banks hold a lot of securities on the balance sheet at distressed prices' (Bair).

Safeguards and Synergy
The key will be to keep bank examiners active when the rule change goes into effect. For banks since there is so little trust about the value of these securities, selling at something less than long run value if it does not require too big of a give away could make real sense. If they take advantage of the rule change simply to hold securities and mark them up, that would have less credibility. So the BEST all worlds right now, is the accounting rule change combined with the treasury auction plan.

Goodhart's law revisited?
I have suggested in the past that mark-to-market was sort of like Goodhart's Law in action. Forcing securities to be marked to market eventually made the markets themselves dysfunctional and unsuited to the task at hand. Similarly taking off the burden of mark to market may allow securities markets to flourish again and to provide a reasonable benchmark of value - but only if that is not required.

Loan modification: an ancillary beneficiary?
There is also an issue here (either real or bogus) pertaining to banks doing mortgage loan modification. Some have claimed that they are 'afraid' to modify loans since 'accounting rules' could cause them to have to mark down all other loans in the same vicinity if they mark down or modify one. This, it is argued, is under the idea that the whole region is impacted. That seems foggy since mortgage modification is such a loan by loan and borrower by borrower unique event. I think that the banker's assertion is a foolish application of mark-to-market. But it would be good to take that sort of argument away from the banks.

Modify or die? The lemon law
Banks could learn from auto companies. The 'lemon law' caused auto companies to have to stand behind their products. They did not like it, but it was the law that was critical in establishing liability and getting product quality back up. Banks have no sense of pride in their achievements- apart from their P&L, asset size, ROA, and bonus payouts. They sell you a mortgage and if it goes bad, they have no responsibility to you- only to their shareholders to foreclose. But foreclosure is expensive and banks need to consider that cost Vs the potential benefit of a modification- a real modification. When banks lend, they do not warrant the house price or the mortgage rate if it is adjustable. But they have mislead borrowers about the ease of refiing and that has not been deemed an issue under fairness in lending laws. Banks need to get some motivation to modify mortgages in a way to benefit the borrower, just as the lemon law once motivated automakers. To date, most bank loan modifications do not do that. In one study, nearly half of the loan-mods wound up saddling the borrower with higher payments. So if removing mark-to-market helps to get a real loan-mod process going, that would be another positive contribution.

Rule change is not just a sop to big banks FUGGETTABBOUDDIT
I am not a banker. I have been arguing for a very long time about the evils of mark-to-market. It has taken a long time to get this issue moving along. This is not about helping big banks. This is about trying to get loans to reflect TRUE VALUE instead of distorted point-in-time-value. There is merit in the idea and the rule change should not be looked at a sop to big banks.

Don't judge a rule by its title
We know that economics sees time and place as important considerations in the valuation process. But when accounting rules disrupt that process, the rules no longer are good or fair or helpful in determining true value, even currently. Just because you call it 'fair value' accounting does not mean that it is.

A change for the better
I like this rule change and I think it could be just what the upcoming auctions need to get banks into the game as motivated sellers. Ironically if you eliminate mark to market rules, the markets might come to value securities in a much better, fairer and more objective way than they do now.

The Stick and the Carrot

I've been hearing some things said about the Obama team's auto plan I feel I must weigh in on. For those saying 'O' doesn't get it, I think they are the ones who don't get it.

High Stakes Poker With a Twist
The problem the O-man has at this point is trying to communicate to the public and protect his 'hand' at the same time. If you are in a poker game it is hard to play that game (where bluffing is a critical skill) and talk about your hand at the same time.

Perception Vs Reality
For those of you who want to dump on the automakers for not getting a deal on time, understand that everyone knows the score: suppliers, the UAW, stock holders, bond holders- everyone, knows that the government has deep pockets and has dug in deeply for banks, so why not for autos? These players do not want to give in if they can have it all. One group does not want to give a concession if another won't. And so on. Its a game. It's a strategy. It's better than reality TV. It's very hard for GM and Chrysler to get good deals when its counterparties think the government will bankroll just about anything. The Obama team is trying to change that perception.

The stick is out and he is whacking GM...
Obama's plan puts several forces in play, competing forces. He offers some money, but holds back the big bucks. He addresses GM in public. He has fired its head but does not besmirch the Wagoner's reputation- he says its time for a new approach. This suggests to me that O understands that the auto dealers, while naturally, were caught in a circumstance that was partly of their own making, are also riddled by events beyond their control. Moreover the auto industry had been making progress when this crisis hit. He wants the bond holders and stock holders and others to see that he is willing wreak some havoc on them. Firing GM's Wagoner did that.

The carrot is a stick too
By saying the government would stand behind auto warranties he covered on of the biggest fears of bankruptcy, arguably making it less painful and more likely as an alternative. He then said we would use all the tools and mentioned bankruptcy as one, saying that such an approach could allow the company to jettison bad contracts and debts. Here he was also speaking to dealers that have contractual arrangements they do not wish to give up. Anyone that has looked at it knows that one reason GM's progress has been slow is because of all the competing interests with real leverage. So bondholders think they can hold out for 1oo cents on the dollar? Maybe they will get a lot less under bankruptcy. The government is trying to make sure its money is not simply downstreamed to players who should take losses. This IS harder ball than it or the Fed played with the banks, however. Don't want to be converted to an equity stake from bond stake? Ok I'll match your gambit and raise you one warranty guarantee... What now?

Why tougher on Gratiot that on Wall street?
For those out of the know, 'Gratiot' is a uniquely named major artery in Detroit. I think the Administration is paying harder here because it thinks it knows the agenda and the risk better. Undoubtedly the Fed and the administration regret all the monies dispersed with such little good effect in the financial sector. But there, things were just too complicated and entangled and no one really knew how much would unravel if they pulled one loose thread. Autos are different. The risk seems more tractable and better known.

Don't short sell the admin effort
This does not mean that O does not understand how painful and drawn out bankruptcy can be. He does not want to OWN and RUN GM or Chrysler. But he wants more concessions. Those with skin in the game have to lose a little. This is no bail out... Well it's not a complete bail out... He needs to get them back to the table to bargain more, to offer more. To do that they must understand that they have a lot more to lose.

Far better to be banker than an automaker
The automakers are in a different stew than the bankers. In autoland executives stew in their own juices. In banking, the customer does the stewing. True, automakers have been under-performing and losing market share for a longer time. Bankers pretended to be masters of the universe and paid out huge bonuses even after it became clear they were abject failures. Automakers also have been upgrading their product, while the banker's product is still undergoing one of the most painful and drawn-out 'recalls' on record. What's interesting in banking is that when you have a dysfunctional product, the buyer has to pay, not the seller. In autoland if you sell a lemon you must stand behind it and fix it or replace it. Are bankers 'replacing' bad mortgage products sold under illusion and false promises? Why are the 'property rights' for mortgages so different than for autos? In both cases a buyer made the decision to buy it. Only the purchasers of financial products are considered to be idiots when they are hornswaggled. I guess physical engineering is harder to understand than financial engineering... Really? All of these are important auto-banker differences.

The bail out that did not occur
Since union agreements and legacy health care costs are a big part of the automaker problem it is hard to look at the industry and the execs as the same sort of corporate bad guys as bankers. Automakers gave pay and benefits to the rank and file. Bankers paid lavishly those at the top (themselves). Nationwide medical reform could have bailed GM out. But we never got there.

Finally good tactics from Team-O
As a tactical plan I think I like what O and his crew are doing. They were dealt a bad hand but they are playing it with gusto and grit, stretching the game out and bluffing in a very credible way. Maybe they even are serious. about the bankruptcy 'threat.' Not knowing is what makes it credible.

So, yes, there have been a lot of mis-steps, in this crisis but autoland is one place where the effort seems to be going much better.

Go O!

Sunday, March 29, 2009

Easy as ABC

I just saw Tim Geithner on ABC interviewed by George Stephanopolis. George's staff was well prepared. George, himself, had no idea how to ask a follow-up question.

Tim skated free.

Let it be: Geithner's tact is one we all could learn from, but then we would never have meaningful discourse. Tim repeatedly ignored the brunt of George's questions and went on to make his assertions about policy. On the subject of the AIG bailout monies paid to foreign banks, Tim dodged saying 'we had no authority'. George did not ask what would you do now? Or, was money given to AIG initially with too few strings attached? Or, is there any way to go after those funds now, after the fact? George just let it go.

There won't be an answer, let it be: So if you watched ABC you got very little in the way of cross examination. Timmy-G laid out his plan said it was the best of series of bad choices and said he would never bailout a banker to help him- it's all for the economy.


Different strokes for different folks: As I look at the economy I have a flip-flop of the government's forecast. It has slow growth with momentum building to as much at 4% growth. I see strong growth early in the expansion then fading and becoming challenged.

'U' 'V' rays: The economy is in recession. It is a mature downturn. The recession has been virulent. We are looking to recovery. The early recovery period is usually characterized by STRONG growth. GDP is always strong early on in the expansion; in any recession with large job losses, job creation EARLY in the recovery period tends to strong. There is NO example in the Post-War period of a recession with 'V'-shaped job losses and a 'U'--shaped recovery. Yet that is the administration forecasts. I think they have their forecast profile backwards.

Cyclical push meets structural sag: To me the issue is this: as we lose fear and the economy rebounds some jobs will come back quickly. Some of the depressed areas will revive quickly. And once we have shot back part way, how soon do the long term or structural issues begin to bite? After a rapid recovery of some of the easiest demand, the problems of a less vibrant auto sector, lower pay for their remaining workers, recovery in housing but still huge set backs to wealth there- same for stocks - will take a toll on how fast the economy will grow. The intermediate term growth potential of the economy has been knocked for a loop but the potential for strong growth early in THIS recovery is still excellent.

Ponder those trade offs. And let's hope that someone with the ability to ask a better follow up question interviews Timmy sometime soon.

Thursday, March 26, 2009

The old dog wouldn't hunt- will this one bark?

Tim Geithner has a plan to reform and re-regulate the financial system

One for all
It's for one super-regulator. Once again Geithner provided some overview of the issues but no details. This was no cookbook recipe. It was more like a photo spread that showed how good the food could look and described the aroma. Recipe in next month's journal...

The question is whether one super regulator could have done any better. Ask yourself, "what difference would it have made?" It might have caught the credit default swaps. The Geithner plan calls for more capital but is that enough? Could banks in this last episode possibly have had enough capital to cover for what they did? I doubt it. This crisis was not about the lack of capital at banks rather it was about the lack of judgment by bankers, the lack of critical oversight- not of oversight... and the willingness to go where no man has gone before. It sounded bold- Star Trek-like. But it wasn't.

Star Drek
Yes, the crisis was a series of mistakes. They lead to bad results. Bad work by rocket scientists or at least by the ones that plied their trade on Wall Street. We still can't agree on what caused it all so the idea of preventing a repeat is not very promising. Was it the Wall Street compensation system? Was it lax oversight? Was it undue leaning on untested mathematics and statistics? We have nothing in the new Geithner system to protect against these things. He has not bought into a reimposition of Glass Steagall of any sort.

Geithner is looking to use exchanges for plain vanilla derivatives and to make sure that transactors have skin in the game on all transactions. He would regulate private equity and hedge funds for the first time. People did lose money in such ventures; those were not the cause of systemic instability, however. The unregulated part of the market carried its own water and took its own lumps in this crisis. It was the 'regulated' banks and securities firms whose losses threatened the system.

Still at risk
On balance the Geithner plan closes some trouble-causing loop holes and perhaps it closes some potential loopholes. It would make sure that credit default swaps were paid attention to by some regulator. But so much of what whet wrong was about failed judgment at banks. Banks do not appear to be denied access to any of these activities under the new plan. Also what could have been done about lawmakers bending age-old rules to get their constituents in on a hot market traditional credit requirements had closed them out of? No super regulator will be that super.

Monday, March 23, 2009

MARKETS LOVE IT - So are crtiics wrong?

NEC head Larry Summers defends THE PLAN saying how can anyone be opposed to a plan that re-starts markets.

or earth to Larry, earth to Larry...

Beam me down Scottie...
NOTHING in this plan restarts markets. It is like a Sci-Fi movie creating a parallel universe only Treasury is just creating a paralell market. All the bells and whistles (as Paul Krugman puts it) attached to participating and privileged investors, those are what MIGHT make it go. There is nothing in this to restart the unaided market. There is no boost in transaction values that anyone outside of the governments select group of investors will benefit from.

Still waiting...
Only when the economy improves will private sector unaided investors change thieir tune or raise their bids.

Bad rules, Still rule!
The government is dealing with a market distorted by bad rules (mark-to-market accounting) by creating a new set of distortions. This does not re-start free markets as Summers claims.

Still markets like it.

Markets like it! That does not mean it's good. Kids like to eat sugar, too
It could be that markets are happy that there is a plan at long last. It is a supportive plan. It could get these special selected investors to buy some troubled assets. it might help some banks. But I think what is being misread by markets is that this plan has no legs, spawns no synergies, creates no externalities. It gets its juice from special breaks (guarantees, risk limitations, low interest rates and synthetic leverage) not available to general market players so it will not lift market prices even if these special players are willing to buy toxicity at a higher price. No one else will...

The real bottom line
This plan simply creates a second special market where troubled assets will have more value because of special treatment.

Taking from the poor to give to the rich?
One other problem is that it makes the troubled banks take some losses and will transfer the eventual gain on these toxic assets to this other special investor group. Is that what you want to do when banks need the capital more desperately?

Why markets are UP!
As these points sink in, markets may no longer be as enamored with THE PLAN. On the other hand, my view is that markets are so over sold they hardly need a reason to rally. So this rally may be less about this plan than about 'a plan' and another day closer to a real recovery. Remember, rallies after huge bear markets are often funny things that people don't believe in. There are many reasons to distrust rallies in bear markets. The big reason is it's hard to tell when its really transformed into a bull. By the time you know, much of the rally is water under the bridge.

A beard rally?
Is this treasury plan just a 'beard' for the market to rise sharply as it looks head to eventual recovery not to the fruits of this limited plan? Is this rally not about THE PLAN at all?

Inquiring minds want to know. After seeing the powerful rally in stocks I remain unconvinced about the Treasury's plan. After hearing Larry Summers talk and register disappointment with Paul Krugman's view I am still not convinced either. I do not necessarily agree with Krugman (who wants nationalization) but I agree that the government is phonying up the market to get results and Summers is pretending like it is just giving it an honest boost. Well hamburger helper is not real hamburger, Larry.

Steroids as the example?
When you inject steriods into some players and they start hititng home runs you should not expect those players who did not get the injections to perform better too. It doesn't work like that. Someone ought to tell Summers that.

Ask not how you can manipulate markets... but how your country can manipulate markets for you.

Ask not how you can manipulate markets...
but how your country can manipulate markets for you.

The Treasury 'boys' are at it again. There is a lot to this plan from Timmy G (not to be confused with the smooth jazz sounds and elevator music from Kenny-G) and the structures are complicated but in the end, like in the Band's song, "The Weight," says, it puts the load right on me, the tax payer. And on you, of course...

How else could it work? As Billy Withers said, Nothing from nothin' leaves nothin'.

Nothing up my sleeve!
Like any magician there is a lot of misdirection here. One of the misdirective points is to tell us that investors could loose all their money! Tell that to home 'owners' who put 20% down and have seen a 20% price drop wipe them out. As Kris Kristofferson wrote, when you got nothin' you got nothin' to lose. So now, these 'hand picked' investors are coming into a plan with more government support than the troops get in Iraq. Meanwhile, home 'owners' are left dangling. Where's the risk?

Presto change-o: more misdirection
The plan, on closer inspection, looks a lot like the failed Fannie-Freddie model. Interest costs lowered by low interest loans (for F&F it was low rates via government guarantees), losses limited by making loans non-recourse (more guarantees), leverage provided to enhance returns. I thought leverage was going to be bad in this brave new world? Taking 'government' as an explicit investor, along-side the private folk is to aid confidence and also providing funding and to do it without question. So, in the end, private sector investors gets the benefits of leverage without the downside. If the fund goes bust the investor can walk away with only a capital loss the rest of the asset losses (the remaining 92%!) goes to the government. This reminds us that the government provides 92% percent of the funding and gets 50% of the upside. Why, you ask? Since it only 'matches' private sector 'capital' with its own 'capital' it looks like the government is splitting the profits 50/50. That's even more magician's misdirection. Remember that means that the government has 92% of the risk and gets 8% of the profit. That is the reality. Still like the sound of that plan?

There are other 'modules' to this program as well. But you get the idea how this works...

On balance the program will not restart markets. No one else outside of the sweet dealers (the Real Sweet sixteen?) could afford to pay those prices. The Fed/Treasury/FDIC otherwise known as 'government' is creating a special side market. Don't expect its prices to catch on until the economy does better. That is, until it is no longer needed.

If you thought AIG was a bad deal, it only resulted in less that $150mln in bonus payouts, for non performers. This plan will generate BILLIONS for private sector participants who are taking less risk that it seems.

OH, Timmy, you put the weight right on me...


So critics say what would YOU do Bob?
...You cynical critic.

Here it is, and it's so simple.

Get rid of mark to market rules. Do that and the stress on current market value evaporates. Banks no longer need to mark to a price everyone thinks is wrong. Does this have risk? Yes. Every plan has a cost, the question is, "what cost do you wish to pay?" You could relax M-to-M with more rules and oversight creating a process for taking securities off M-to-M. In the end it would be a lot cheaper and would not require the Treasury to pick special investors to make special huge profits. And, on that subject I have another question, are these investors different than the sellers? Will some folk be selling to themselves? My plan is far, far superior to this one.

I want to take the distortion off the market. The Timmy G plan wants to create another new synthetic distorted market. How could any economist like that? Some respect for markets this government is showing. Jimmy the markets open with guarantees and subsidized rates and when things go wrong break the tax code and tax all the 'undeserved' bonus getters (AIG). These are not steps in the right direction for an ostensible market-based economy.

Ask not how you can manipulate markets but how your country can manipulate markets for you.

Sunday, March 22, 2009

What Toxic Assets and Pawn Shops Have In Common

I always have loved oxymorons. If 'Toxic Asset' isn't one, I'll eat my hat.

Now there is plan to deal with these bank busting beasts of the balance sheet nether world. It seems to be to try and get auctions for these market outcasts by sweetening their intrinsic cyanide with low interest loans, government partnerships and limited liability. Hey, how do I get in on that? Oh, as the tax-payer I fund it? Thanks guys!

The give-away seems substantial. Will it work?

GREAT EXPECTATIONS...good expectations?
There are several aspects of this question. Will it get transactions going? Will it help to solve the TA problem in a meaningful way? As to the former I'm guessing it will get some transactions; as to the latter I don't think this is a systemic barn-burner of a solution.

Reality GAP
The REAL problem with these toxic assets is the gap between a FORM OF REALITY and the PERCEPTION of reality. Since no one is really closing this gap the plan is swimming up stream against a strong current. The one form of reality is the mark to market price. The perception is the long term value where all good bankers expect their loan values one day to one climb.

We have seen the enemy...
Let me return to a familiar theme: mark-to-market is the ENEMY. Economists glorify markets but we know there are malfunctions and distortions from time to time. There are even markets to bridge the gap when those things happen. Consider this: the Pawn Shop as a model for what toxic assets really are and how they are treated.

Government plan as a GIANT PAWN SHOP
Pawn shops have existed for many, many years and business cycles. I note this to make the point that THEY are part of a system and not a 'malfunction' per se. But these shops cater to a particular clientèle. They lend a fraction of the value against assets of various sorts. Why? Why do people put up so much collateral than what a loan is really worth? The answer is because they need quick money (liquidity). Also because they do not want to really sell the item for good and they have hopes of buying it back. Moreover, it's because if they did not put up the asset for collateral they would get money by borrowing at a very high rate.

Banks as pawn shop customers...
Compare this to banks and their toxic assets. Banks do not sell them because in time they think they will be worth more. They do not sell their assets for pennies on the dollar also because they do not need the liquidity- the Fed has provided plenty of that. So banks are not being forced into liquidation (no forced liquidity/solvency) crisis. They mistrust one another on the value of the other guy's assets but remain steadfast that their own TAs are going to prove to be worth more in time. So how does the Treasury plan poke through this double-dealing facade of value?

The Treasury plan: drum roll please...
Basically it doesn't. If it provides enough VIG to the investors they might step up to the plate and get aggressive enough for banks to part with a few of their TAs and take the loss. But the banks get nothing from this. The do get to unload their TAs, but at close to mark-to-market prices, something they have tried to avoid. I see the banks- the asset sellers- as the problem here. Buyers are getting some good incentives to buy and to sweeten prices (their bids) but they need the lure of a gain and that means they need to NOT PAY long term value. So what breaks that log jam? Listen on Monday. As of yet I have not heard it.

Mark to mythology with St Mark
Mark to market accounting is still the villain here. It forces banks to mark to a market that is depressed and that requirement further depresses prices and those acts, in turn, make the market illiquid. It is this wedge between long term value and mark-to-market that is the issue/problem. Get rid of mark-to-market and the Treasury plan could work. Keep it and I don't see a solution.

Still, stay tuned for new news on the plan on Monday from Timmy G.

Friday, March 20, 2009

Corporal punishment leads to general disarray

What if you gave someone a helping hand then sued them for taking it?

Is that any different from what the government is doing regarding AIG? Financial support has been given now AFTER THE FACT the 'government' is going after some AIG employees that have benefited from the government's aid because they have contracts that pre-dated the support. That's right 'predated.' They are not even benefitting so much from what the government is doing as their pre-arranged compensation is making it look bad for the Feds. It is a nightmare 'PR' event for the government. And the elected officials are handling it well -- as well as any other group of elementary school children might.

Facts Vs fallout
Read my previous posting for more on this topic of AIG and the government's trampling of the rule of law. I am not here concerned with those facts rather with the fallout. The fallout is that with the government playing HG Wells and the time machine with the rules many will choose not to play. What a pity.

Revision does not work here.

TALF rhymes with Ralph - what's Up-Chuck?
The Fed has now launched the TALF a program that could help restart lending to consumers in the economy. But NO ONE wants to use it. Why? Well I have no scientific survey but you can bet that it has a lot to do with the treatment of banks and of AIG under TARP. Private firms are chocking on the potential consequences. No sooner do they get the money than the not-so-golden handcuffs start to come out and the rules get changed. And if the current rules can't be changed legally Congress passes new ones to achieve the same impact. Don't mess with us! That's what this says. but what it really says is don't DEAL with us and markets have gotten that message

Got a deal with the Fed's? ...want to rethink that?
Suddenly the 'deal' is something different than when it was discussed. And while you can't do that retroactively remember you have to be careful when you play against the guys who write and can rewrite the rules. You would not play Monopoly with someone that had that power so why play 'real life?'

Yet another inconvenient truth
No one wants to have their terms of employment and compensation controlled by a government with politicians more concerned with throwing red meat to an outraged public than in standing up to the firestorm of concerned voters and explaining what happened. It's easier to point a finger and get red-faced than to deal with the issue at hand.

Talk about being overpaid... at any price...

Now they have killed the Fed's goose that was going to lay some golden eggs. Instead, that foul is nearly sterile.

The Fed's first TALF offering was woefully undersubscribed. Underwriting 2 percent of its capacity is not going to help the economy much.

Pelosi puts her best foot forward...
Meanwhile, Nancy Pelosi set us straight. House Democrats are not at fault. Senator Dodd (rhymes with God) and the White House set those details...not House democrats. Pelosi is crowing that when the chips were down, she was irrelevant. Just to be sure, though, she blamed the Fed for riding in on short notice to the rescue. Nancy, baby, you know what public service is all about. It's all about YOU. Just like the politicians that have tried to set up residency in Maryland for tax purposes to avoid taxes in the state they represent! (Democratic Rep. Pete Stark, for one). This stuff is priceless. Public service. Now you understand it. It's why farmers say they are getting their Cattle 'serviced'. We are getting 'serviced' by our elected representatives as well? Try to enjoy it. And although it's bad for your health, have a cigarette, when they're done - if they ever finish.


When a 'bonus' is not a bonus

Misplaced anger at AIG

Or... why put the onus on the bonus?

Does AIG really stand for 'Almost In Government?'

Do not view this as a weaselly article in support over overpaid and undeserving AIG 'bonus-getters'. It may seem like that but it is not.

Define a bonus...
A bonus is a payment for a job well done or a payment to workers of a firm who did their jobs 'well' as the firm had a very prosperous year. Most of us think a bonus should not be paid if a firm has a very bad year and loses money- especially not if it is on the brink of bankruptcy and gets a federal bail-out to survive. Still, there is a question for a firm that is well diversified and for employees in some business units who do very well. But their contribution is swamped by losses elsewhere at the firm. That 'bonus' decision is more complicated.

Decision-making when it gets 'complicated'
A private or publicly traded firm without a cloud of a federal bailout over its head, might still pay bonuses in that situation to retain key players for the period ahead. A money-maker whose efforts are swamped by other business units and denied a bonus is sure to go elsewhere and might even command a 'signing bonus' like some baseball prospect out of college. This might even be true of a skilled pro who himself lost a lot money in the current year. But when public monies are bailing out the firm, such payments look much more inappropriate since doing this for the sake of 'the firm' and viewing the firm as a 'going concern' to be protected is a suspect action in and of itself. Moreover at time when so many on Wall Streeters are being let go it's hard to argue such workers could easily catch-on elsewhere. So why pay to retain them?

Rescinding 'undeserved' payouts
Passing a bill to claw back the bonus paid in this environment seems defensible, in this light. You take the step to remove the bonus that never should have been paid in the first place. But should it? Who has the real facts and who is the judge and jury here? Oh Congress? Does that make you feel better???

Bonuses? Were these bonuses?
I began this discussion talking about 'bonuses' and describing what they are. But what AIG 'seems' to have is a set of 'guaranteed payments'. They are not bonuses; they are NOT 'performance related'. Contracts agreed into should not be violated or abrogated in any way without proper due process involving the parties that entered into the agreement. If a firm can be shown to have entered into such a contract illegally that is one thing. But in the case of AIG what it did is more or less standard operating procedure on Wall Street (and I don't mean that in a bad or smarmy way- read on).

Standard operating procedure...
The complication is that on Wall Street, while firms seem to make money, a lot of it actually made by people and NOT by the structure of the firm. Change the people at a firm and you might find that huge blocks of business (and profits) go away. When stock salesmen leave one firm for another they often 'take their book,' their list of clients, and with that goes the business that those clients generate. Think of it as taking your cell phone number with you when you leave Verizon and go to AT&T or vice versa. When you do that, the business you do goes over to the new company. Sometimes they pay you (incentives for joining) for making that switch because they know you are bringing them business, revenue for the future.

So there is a question of where the value added comes from. Wall Street is not an auto assembly plant where you can take out any assembler and stick in another and expect the same result.

Keeping employees 'happy' and 'well paid' is part of the business model for good reason. You can envy them for that or not. But this is common in the world of sales even beyond Wall Street, where sales commissions are earned.

The downside of the downside
By now we know the downside of this 'model.' Employees share the profits, but when things go wrong the firm -and its shareholders- eat all the risk (loss). Granted, this is a 'minor bug' (!) that has to be worked out of the system. But this was the business model. Shareholders have put up with it. So have CEOs but then they profited greatly from it, too.

Another inconvenient truth
Still, the point is this: when a firm like AIG goes bad, its best earners (or "rainmakers") simply leave. Others on the street understand that good people have bad years. Okay really bad years...Okay 'Six-sigma' bad years... Still, when you are out leading a kayaking tour around the shore and a tsunami swamps all the boats and all those in your tour DIE does that make you a bad guide? Now we can debate the applicability of this example and the role of the Wall Street trader in the demise of AIG, but the only issue here is did these AIG employees get retention guarantees (not bonuses!!) or not? If so the idea was to keep them working on the Titanic as it sank to mitigate losses- not to refloat the boat- what is wrong with that? They were not retained under false hope. And hard to believe, the guys probably had other options- the top guys.

Hey, how many baseball players get a juicy contract after having a 'bad year' because someone thinks they still 'got it?' And how much do they make??

Blame the guilty!!
If there is an issue it is with the Treasury providing its funding without finding out if such contracts existed. There should be no sense of dishonor to employees at AIG that received such guarantees. Unless or until we know the particulars of their agreement, there is nothing out of sorts or even inappropriate about those payouts. The SIZE seems a bit excessive in these days. And that is a knock against the management that offered such large retention payments. Ironically, had these employees worked at the best of the best of the best firms on the Street, they would not have made such money this year. So who was it that signed off on such largess? Why didn't Treasury (or the Fed??) know about these contracts? As I said, the existence of these sorts of contracts is well known on the street in bad times. Shame on the regulators!

Bring a new guy who is a producer into a troubled firm at troubled times? You have to give that guy a guarantee. I worked at a large Japanese securities firm at one time as its Chief economist in NY. I never got a guarantee. But as that firm expanded into the equities business amid boom years, it had to pay huge guarantees to employees to get them to leave prosperous established Wall Street firms to go to a start up that had unproved abilities to generate earnings, profits and commissions.

What is wrong and WHO is outraged??
I do not defend Wall Street for what it has done or accept its ways of operating because they are there. There is in fact good logic behind what AIG did but here we have another example of how Size Matters. It's more the scale of the guarantees that seems so wrong for the times than their existence. It's also that Senator Dodd has been a prime recipient of campaign contributions from at least one of those slated to get a huge AIG 'payment'. Are you surprised? So WHO is really outraged here?

Don't sweat the 'small stuff'
This concern about bonuses is a concern about peanuts. There has been no outcry over the billions paid out to Goldman Sachs when the AIG bailout funds were dispersed and money were paid in full when mark-to-market prices would have strongly indicated otherwise... Goldman was paid in full! It had a very special relationship with both the US treasury and the NY Fed at the time. That seems far more smarmy than picking on guys who had guaranteed payments to spend extra time on the deck of the Titanic. Doesn't it?

It's the scale that is out of proportion
It is the scale of the payout at AIG that is at issue much more than the payout itself. So will Congress tax all the guarantees away and open the door of intervention into commerce in all sorts of unseemly ways? A bonus is not a bonus when it gets taxed away. It is not a bonus if it is a guaranteed payment. When you tax away a guaranteed payment that was bargained in good faith by both sides, you are asking for trouble. That is especially true if you were privy to the facts long ago as I suspect many (of the 'outraged') members of Congress really were. Some of these recipients were guys contributing to Senate and House campaign funds. That's what is really smarmy here. No air-freshener in the world will remove the stink that hangs over Washington from this affair.

Get outraged about that and about the BILLIONS AIG paid out to undeserving counterparties. Claw back some that. Okay, be envious of people getting guaranteed pay outs when you don't. Or of baseball players making millions to hit this spinning sphere better than you can or of basketball players with big biceps and strong leaping legs. Some people have a special physical skill, for others it is mental. We need to decide if we are going to be a nation that abides by the rule of law or not. It is up to Congress and the Fed to supervise the deal they entered into when they choose to bail out AIG. Save the sinking ship and you save the rats too.

When someone 'blows it', be sure to blame the right party.

Tuesday, March 17, 2009

The luck of the Irish for the Fed?

Yes, I know the expression 'luck of the Irish' is supposed to be upbeat. But what was lucky about the potato famine?

The Fed is pondering doing a few of the last things it had 'threatened' it might do to stimulate the economy. It is a good time to wonder if the Fed will follow through. Will it really buy long-dated treasuries in an attempt to drive yields down? Is that a good idea? Will it work?

Academic studies suggest that the Fed will have a hard time imposing any meaningful impact on long term treasury yields by simply purchasing long term treasury paper. Financial assets are simply too good at being substitutes for one another for that to work. When something alters the yield on a bond or a note to the market's dislike the market finds it is easy to shift into something else. That sort of asset ambivalence will make it hard for the Fed to have market impact by buying Treasuries in some preferred habitat.

Second it's not a good idea. If cutting short term rates to zero has not brought longer rates down, there is a reason for that. Going out there and grabbing the yield curve by the neck and stomping on it (so to speak) is not likely to enhance market confidence in the Fed for 'doing the right thing.'

If the Fed has some evidence that there is some market imperfection at work there may be room and grounds to act. But the Fed should be careful. There are any number of market participants that are worried that the Fed's balance sheet expansion ultimately will prove inflationary. That is a factor that could elevate longer treasury yields and it is why the Fed should be careful about fiddling with the curve.

In fiddling with the yield curve the Fed is playing with fire. There is little reason to think that such interventions could be powerfully effective and many more reason to think that the Fed could get itself in trouble with such an operation. Given the importance of long term rates to international investors, I would worry about some impact on US capital flows, too.

On balance if what the 'government' really wants, is to get mortgage rates lower for new borrowers and current mortgage holders, it should just start a subsidy program for them. That is the most efficient thing to do. All this messing around in an already messed up marketplace is unlikely to do much good and could do harm.

Monday, March 16, 2009

New bank regs-Right; Systemic risk manager-Sure

As if requiring banks to have more capital on hand will solve the problem...

The losses banks suffered in this episode should make it clear that no amount of capital would have been enough. This idea of getting tough by gritting you teeth and stomping your feet and making banks do something unpleasant just is not going to get the job done.

Banks simply did stuff they never should have done. Banks took on a load of securities they had no grasp on at all. Banks lost their way and got involved in a business that was totally inappropriate for banks - institutions with insured deposits.

Banks need to be excluded from such transactions in the future. Watch the regulators closely as to how they approach this issue because the most important politicians on the most important regulatory committees get the most MONEY from the financial and real estate lobbies. So watch that closely when these guys say things like,' Oh I think banks have something to offer in that area"... Right.

In the G-20 as well as in the US there is starting to be some interest in something called systemic risk. What is this? Systemic risk is when everything goes wrong and you are the regulator and didn't have a clue.

More specifically (and less sarcastically), it refers to a condition of a broad-based breakdown in which elements that markets usually depend upon no longer function. In short it could be anything. How a regulator will 'look out for it' I don't know.

Look back at our recent little episode when 'everything' went wrong. What would a systemic risk manger have highlighted? Too many sub-prime loans? Or would it be to note that sub-prime loans themselves are too dangerous? Would he have tried to talk the rocket scientists back to earth and out of orbit? Was it the banks that stopped getting 20% down on most houses or testing for income? Would he have seen the leverage? What the system experienced, was the breakdown in prudence. As far as I can see there was nothing systemic that went wrong apart from bad judgment fueled by greed-systemic bad judgment and systemic greed.

At the time of the Latin American debt crisis in the late 1970s had you looked at the domestic factors that correlated with debt problems across Latin American countries you would have been satisfied that your Latin American lending was well diversified, At the same time those domestic factors that correlate with national debt problems were not highly correlated across those countries. But then they were; of course, and that shift was unexpected. Something happened that had not been present before and that could not have been been identified/predicted. Excessive lending to them: all of them? each of them? Okay, we might have picked up on that. But when the shift came, it put all the Latin American borrowers in the same boat then proceeded to sink it. In the event you would have found that all your Latin American lending was in trouble. Would a systemic risk manager have seen any of that?

In 1998 the same sort of thing triggered across developing economies. Once the darling of international lenders suddenly, they became the goats of the markets and totally undesired.

The S&L crisis in 1980 was easier to predict. You had banks with fixed rate long term assets acquired in an era of interest rate ceilings for depository institutions. That ceiling protected them and the values of their securities. But then regulators removed the rate ceilings. Uh, Oh... Then the central bank let inflation creep, Uh oh, then climb, Uh oh, and then soar. A systemic risk manager could have seen that one coming. But I don't know what could have been done about it other than to have run monetary policy better from the outset.

On balance I guess I don't believe much in systemic risk as a factor that can be managed. It stands to reason if a new and untested asset class is being piled up it is a risk. It is untested. I have never believed that statistical 'stress testing; could take the place of actual tried and true market behavior. So if anyone thinks that a systemic risk manager could have stopped all the securitization and derivitivization in the markets then that person would believe that a systemic risk manger could do some good. I'm not that person.

I think that the very idea is a joke. The markets, the regulators and the politicians all drank the same Kool Aid and passed it along to their friends. It served a purpose for each of them. Who that might have blown a systemic whistle would have stood a chance to be heard? I think no one.

Systemic risk manager is the guy you hire to lock the barn door after the horses are gone to reassure people that next time things will be different. But they won't.

The secret here is to have better regulators and tougher ones and not mince words or thoughts about what better regulation will mean. It will mean denying banks certain activities. and I wonder if we are up to it? Dodd was against reforming Fannie Mae. Frank wanted to let poor people into the booming housing market; he wanted to break down barriers to entry like down payments and income tests for home-buyers. We did that, it didn't work the way he thought. How were these Poobahs of oversight going to back a systemic risk manager who would have told them NO?

If there is one common theme of some sort, however, for a systemic agency to glom-onto it is that in the late 1970s and in the 2007-09 period huge shifts in he BOP positions emerged internationally due to oil dollars that had to be recycled. They put financial intermediaries to a test that they failed. One 'trigger' for a systemic risk manager to watch is what happens when oil revenues surge and must quickly be recycled? Follow the money. A related problem is the structural US current account deficit and the capital that the US sucks in. Chronic deficit and surplus countries must find ways to shed those labels. Do that and the money flows are less likely to become a problem.

Wednesday, March 11, 2009

Mark-to-market: Buffett's take and more

Warren Buffett in Margaritaville...and revisiting the evil spawn of Goodhart's law

Yes, I know that Warren isn't Jimmy. But his suggestion on mark-to-market puts him on the OUTS with regulators, hence in Margaritaville, La LA land or some other location of banishment.

The issue here I think is much broader than should we use mark-to-market. No one I know thinks that the markets for these derivative Securities are being priced 'right.'

So if markets can't get the prices right WHY EVER MARK THINGS TO MARKET for ANY purpose?

This is the question no one wants to touch. Marking to market is a Holy Grail with a curse attached and so is Free Trade. Touch either with ill-intent and you turn to stone.

As a guy with a PhD in economics writing about how Free Trade is not all its cracked up to be could get my degree revoked- well not really but it could pull your reputation out from under your feet and brand you as a quack. The Fed's are doing the same thing with mark-to-market. It is being canonized by the establishment and it is time to STOP IT before that happens.


If markets do get distorted and dysfunctional why would you want to mark to THAT?

We know that market do these things. The IMF has rules that apply to when countries are allowed to intervene in dysfunctional currency markets and it cites things like volatility and wide bid/offer spreads and the like. So it's not like MAINSTREAM economics says this can't happen. Quite the opposite. How wide are bid/offer spreads of mortgage derivatives-could they be any wider? Do they they even exist?

Warren has an idea to free bank balance sheets from this M-2-M constraint for regulatory capital. But that misses the point: if is bad for the goose it's bad for the gander, to turn an old expression, just a bit.

In economics there is something called Goodhart's law that is a counterpart to the Heisenberg Principle in physics. In economics the application has been to targeting money supply. Charles Goodhart (former B of E Governor) declared that any measure of money the authorities chose to target for policy purposes instantly became irrelevant.

What I suggest is that we have another example of Goodharts law (GL) applied to financial assets and their markets.

To 'get' this you need to understand the idea behind GL. The notion is that you have a an economic relationship that 'works' to start with. You identify a variable that is related to a policy objective in stable way. But once you elevate your target variable to the status of a 'target' or 'market benchmark' - that is, once you begin acting like the relationship is immutable, it changes. So the indicator you have elevated in status, stops working. You are back to square-one.

After this experience , we can understand why central bankers are unflappable by the failure of mark-to-market since they have used flawed, patched and redefined money measures again and again and again in their most recent history. Some central banks still rely on these flawed indicators.

So why not have regulators ignore the flaws in market to market too? That is exactly what they are doing. And that is the problem. They are worshiping the golden calf and breaking the stone tablets.

What I am suggesting is controversial. I am not simply arguing that central bankers have another flawed policy crutch but that a certain circular reasoning has been introduced by relying on a market valuation system that puts values on securities that even its owners cannot price. Market value may not be 'the sum' of all the individual values but when only the market can assess value that's a BIG RED FLAG. How does that happen? At the end of the day its a critique that is a bit like the Lucas critique but of a different sort.

I do not argue perfect information, quite the contrary. If people believe that 'markets know' even when people don't, you set up an infallibility loop that is very dangerous. The question is whether Adam Smith did not realize that the invisible hand could also give you the invisible finger - the fickle finger of fate.

To wind this up let me say that this may not so much be a property of markets but of how they are used. Putting market judgment ahead of your own I think is subversive and wrong. The drift in economics to use ARIMA models for anything gives us an understanding of nothing about the underlying economic structures. Derivatives pricing is one example of interposing 'statistical regularity and probability statements' in the place of knowledge. George Stigler once sneered at Ricardo's 93% labor theory of value as being nothing to base a whole theory upon- theory is not 93% but 100%.

So if we have incomplete knowledge how can we build on that as a base and expect anything other than bad to occur? Marking to market is one of those traps. One problem may be that we used heuristic devices to make this market work (just as we used some measures of 'money' to stand for theoretical money when we tired to do money supply targeting in the real world). I have no problem with monetarism based on a theoretical money, but once we try to give that concept of money life and use it in the real world we run flat into Goodhart's law. Now we see it happen again.

The same goblins come to haunt us when we make markets for hybrid securities. Where do these markets come from? Do they spring full-formed out of the head of Zeus? No. We begin by making assumptions. Apparently in setting up worst case scenarios for derivatives 'it was decided' that the lower bound for national house prices would be to assume that they might not rise Yr/Yr. In fact nationwide they have fallen quite sharply, by over 20% in all depending on the measure you choose. No wonder mortgage related securities fell so much more than their theoretical 'theoretical' limits.

In valuing options it is standard to use a set period to measure volatility. But why? Volatility shifts around.

In short it may not be markets 'per se' that get things wrong but the way in which they are used and constructed. The 'rules' that are adopted to 'get pricing results' may simply be wrong, in which case the market will fail to function since its participants will reject prices (fail to transact on them) when they find them to be not credible. The upshot may even be that the actual market prices are really not so wrong, but that users simply can't get themselves to believe that they have invested under what have proved to be such Pollyanna assumptions.

It is also true - and this is Goodhart's law in action - that when the authorities adopt a method for valuation it can take on life of its own and affect valuation itself. Suppose some stabilizing bank speculator thinks mark-to-market prices are a joke and wants to buy distressed securities at a higher price? Once he deposits them on his balance sheet he will have to take an immediate loss and write down of capital. He can't hold them for long term gain. Rules that did allow for that were in effect in 1982 when we emerged from a bad recession and banks were also woefully under capitalized (or they would have been had mark-to-market been imposed). The point is that mark-to-market actually affects reality it is not a passive observer.

In any event I think there is ample reason to distrust market pricing. Warren Buffett always used say that everyday you can pretend there is little guy called Mr Market and he is wiling to buy and sell at set prices. Warren never bought into the idea that markets get it right. That notion is the purview of economists who have a lot at stake for that be true. If it is not true, then most of the the conclusions economics comes to are simply irrelevant. There is a lot at stake when you get critical of markets and their ability to get it right.

But when regulators put so much strain on markets it is not surprising that markets crumble under the load. What if bankers had forced Best Buy to value all its inventory at the prices Circuit City was selling its inventory, as it had its going out of business sale? Hey that's mark to market! Suppose that caused Best Buy to violate lending covenants related to capitalization requirements for its own loans? Then it too may have been forced into bankruptcy, then PC Richards then J&R Stereo then, then, then... Let's don't pretend mark-to-market has no real world consequences. Mark-to-market is most vicious in finance where you buy and sell at the same market price (bid/offer spreads). Not as damaging in electronics and retailing where you have healthy markups to sell at retail over wholesale costs.

There are real world consequence you set in motion when you create a regulatory feed back loop as we have done with mark to market. It changes the world.

The rule is STUPID.


It is pro-cyclical

It is damaging

It ought to be rescinded for all purposes and accountants and auditors should have to find a better way to do their job than to rely on Mr Market all the time.

Monday, March 9, 2009

Or ahead of the fastball?

Behind the curve or ahead of the fast ball either way you strike out
Paul Krugman's NYT Op-Ed piece is critical of the original Obama stimulus plan for not doing enough- not being big enough. In his Op Ed he gives us his 'I-told-you-so' and shares his worst fears with us. See link below to Behind the curve: (cut and paste it into your browser).

Obama's Agenda-plan
Well, thanks for that Paul. But let's remember that the knock by some of us to the original was not that it was not big enough but that about 30% of the spending came after one year. To begin with it was 30% smaller than it seemed. And then there is the further critique that the plan had too much agenda and not enough stimulus in it. That was my critique and I stick by it. Too small? I'm still not convinced.

Bipartisan bickering
We continue to have bipartisan bickering as Democrats push for their pet-rock projects still identified with earmarks despite the fact that the O-man said we'd have no more of that. And, for their part, Republicans stone-wall them on cooperation. The latest twist is the declaration this weekend by the patriotic supporter of Japanese and other foreign-related auto makers in his state as Senator Shelby now wants a BIG BANK to go bust. Hey where was this sage advice Mr Shelby (R-Alabama) when Republicans were in the White House? McCain joined in on this ideological excursion into the realm of financial policy madness. McCain remember ran as the guy who was not an expert on the economy, but now from the back benches HE KNOWS... How many times do we have to to observe the fallout from a large financial company like Lehman Brothers before we appreciate how destructive it is? Are Republicans so anxious to get back to office and so jaded about their chances that they are willing to push polices that could destroy the counrry itself, and try to blame Democrats for it?

Bipartisanship is like bisexuality- it's no stand but a one-nighter
I really don't know who to blame but this is not what I think of when someone pledges bi-partisanship. Apart from the usual culprits: Democrats and Republicans I don't know who to hold responsible. These two parties partition the country and take turns running the place. One year one party fools us into trusting it and the next the other fools us into dumping them and trusting the other guy. It never works or changes. Shelby himself is a senior member of the Senate banking committee. He is a guy with blood on his hands and spilled all over his shoes from the handling for Fannie and Freddie Mac. Yet, he is out there exhorting us to let banks fail. How crazy is that? NO wonder the country is in trouble HE is supposed to be the Senate's financial oversight. God help us.

So who gave us PMS?

We have PMS: Pessimistic Mania Syndrome.

Where did we get it?

Suddenly we have another definition of depression and it is two years of unemployment at 10% or more. Where did that come from? 10% unemployment a depression? I don't think so.

..."Bradford DeLong, a former Treasury official who is now a professor at Berkeley, says a depression is a two-year period with unemployment at 10 percent or above"... See Bloomberg, 'Depression Dynamic Takes Hold as Markets, Banks Revisit 1930s'

In 1982-83 we averaged 10% unemployment for 17 months and there was not a whisper of depression - very bad and ugly recession yes, but no depression. Now with unemployment ratcheted up to 8.1% everyone is in the depression camp. What has happened?

Stoking fear of depression
For one thing fear of depression should be limited by the government's actions to stabilize banks. Although some- also in government - seem determined to undermine that act of stability and support. Over the weekend Senator's Shelby and McCain urged the Obama administration to let some big banks fail. Huh? Yep. Fail. Shelby said...'If they're dead, they ought to be buried." Clearly Shelby is brain-dead, maybe he ought to be buried first... He wants to let Detroit automakers go down, let banks down, of what country is this man a citizen, let alone a senator? Does he represent the best interests of Japan in America? Japan is propping up the Japanese automakers that have plants in his state (where they are getting huge subsidies to operate) why not extend the same helping hand to Detroit? After all it's more a credit problem than an intrinsic auto problem. Cut sales by one third in one fell swoop and what industry could survive?

There they go again... but it's not what you think
But Republicans have a history of misunderstanding the government's role. When Newt Gingrich was a leader in Congress he led a failed attempt to shut down government by trying to restrict its ability to issue debt. Failing to pass debt ceiling legislation in a timely fashion as they did could have forced the US to default on its debt as well, a horrific prospect that Gingrich-led Republicans once were gleeful about. It is something about which Mr Gingrich is now remorseful. Let's hope that this swipe at the banks by key Republican leaders will go away, too without becoming part of some future expose on 'what not to do in a financial crisis'. This is one time that you can take Ronald Reagan's words and turn them back on Republicans, " There they go again."

Brain first, mouth second
In the fragile economic environment we are now in, it is more important for economists and policymakers to watch their words and their language. The WSJ already has published results that qualifies as depression-inflammatory research by Robert Barro. He argues that a depression (defined in a much more draconian way than above) is a 20% probability. See the side links to my comment on this feeble effort by one of Harvard's best and most manipulative economists.

More PMS
Pessimistic market selling (PMS) has been another hallmark of this downturn. There can be no justification for current market values except in a framework that sees the economy going down the toilet and into the septic tank. In that scenario, government prop-up efforts fail. The only bets in favor of that outcome come from a few Republicans longing to make headlines for themselves and to impede progress of the Obama administration. They seem to have abandoned their quest for family values and proper stock market values as well. Yet there is no reason to bet against either Uncle Sam or Ben-at-the-Fed Bernanke. The Administration has stumbled persistently in its attempt to deal with the financial crisis but it has made clear its objective-to save it and to keep any financial malaise from spreading. The Fed has been both nimble and innovative.

There is no sensible reason to vote or bet on failure in this endeavor.

Forget the lawyers: Kill the Democrats and the Republicans
When the Republicans were in charge of this mess under 'W' they hardly did any better. It's not about partisanship. It's about the economy, the difficulty of dealing with the problem and admitting that this a bi-partisan problem with finger prints from Both Republicans and Democrats all over it. The sooner the TWO parties stop trying to play this for ideological gain and focus on helping American's and the US economy the better off we all will be.

My advice:
But don't hold your breath waiting for that to happen...

Moreover be wary...
Be very skeptical of all these bad things that are supposed to happen based on FORECASTS. The World Bank has a real doosey of a pessimistic forecast out today. Many economists are now jumping on the 'my forecast is more depressing than your forecast' bandwagon. No one predicted this terrible downturn there is no credibility among those saying how much worse it will get or must get. We are out of economic-land into opinion-land now. So beware whose fairy tale you buy into- be especially wary of tales told by ideological economists.

Sunday, March 8, 2009

Don't give up, Don't ever give up

The stock market has had a really rotten recession. It never has a good one, of course. But the drop in the DJIA from the cycle peak in this recession is the worst in at least 48 years.

As ‘March madness’ is upon us, it is a good time to remember the words of New Yorker and former NC State basketball coach Jim Valvano. At a gathering for the Espy awards while fighting a losing battle against a virulent and advanced form of cancer Valvano declared his intention to fight it to the end and urged every to ‘Don’t give up - don’t ever give up’. These words from the feisty, inspirational and combative Valvano are essential for stock market investors to remember. Let them ring in your ears.

Crime, Punishment and Restitution
While stocks fall in recessions they also bounce back sharply when recessions end. And while a lot of financial advisors are telling people that if they can’t afford to lose any more money they should pull out, investors must weigh that advice against the prospect for a sharp market recovery after what are in February nearly 16 months of recession. In the Post- War period it’s about as long as any recession has lasted. That does not mean this one has to end next month but it reminds you that a great toll has been taken on the economy and that by this time the economy is usually in recovery. And we should be reminded that… as much has been done by the Fed and the administration to turn this around as in any previous recession in the last 50 years. Sure there are some special problems, too.

You should be reminded that some indicators are stirring. Job losses are bad but are not worsening- the low point for the pace of job losses was in December. Jobless claims may have peaked. There is a lot of stimulus money being spent and the government is crudely (yes) poorly (yes) but also pretty clearly, backstopping financial institutions removing the threat of a recession turning to depression from some domino effect on failing financial institutions. Ya got a lot o’potential So look at the opportunity. In the worst recession’s recovery in about the last half-century, stocks rose from the cycle low to their first month of recovery by 14.1% - over a period of four months. That was the worst performance for stocks as recovery took hold. Stocks made their biggest drop from the cycle peak (using monthly DJIA data) and fell 38.3% in 1973. Then, in that same cycle, rose 33% from their low in the final three months of recession and one month of recovery (yes 33% in four months). The longest recessions 1973-75 and 1981-82 produced the largest end-of-recession gains in the stock market. So bear that in mind as this recession looks set to surpass them in length and has already surpassed them in terms of the market plunge.

No risk, no reward - We cannot be sure that we have seen the bottom in this market yet although the DJIA and other indices are off from their respective peaks by over 50%. Yet, because certain economic series are slowing their pace of decline and hinting at a recovery it is probably as good a time as ever to turn in the bear suit. ‘Trees do not grow to the sky’, the saying goes, and neither do stock markets fall to China (or from China to the US either, for that matter).

Things are only as grim as you make them.

Thursday, March 5, 2009

Probability of depression is 20% Really?

Robert Barro Harvard professor and frequent story teller in the Journal Op-Ed section is at it again. To refresh your memory we have seen Mr Barro offer opinions before. He 'discovered' that the US economy works 'best' when the office of the CEA is vacant. He did this when trying to demonstrate that office of the Council of Economic Aadvisors is unimportant because the economist of his choice would not be occupying it that year. We have somewhat hilariously heard him tell us us that the multiplier for government spending is small and perhaps below unity using data from the war years when policy was trying to squeeze everything it could out of the (private) economy to aid the war effort as it expanded its own spending. Barro used that as evidence that Keynesian stimulus does not work. He bridged war-time policy results into a more general conclusion despite the obvious bias. Now he has discovered the market for pessimism.

'See what are the odds of a depression' (link below) in teh WSJ
Barro's answer 20%!

Depression: want some? Read his article
Depressions are unusual events- thankfully. Of course the idea here is that this is conditional probability and his calculation turns on that. The associative event is the sharp drop in the stock market. Since we already know that the stock market has fallen so much, Barro has arrayed data with other periods of sharp declines in peacetime stock markets. He has calculated probabilities of 'depression' using an international data set. The data surely support Barro's probablitiy number but that is not the issue: The issue is this: do you believe their relevance? Mr Barro has a way of getting data to say things he wants them to say whether or not its true.

Peer review?
In this case Barro has lumped the US, a huge economy, in with a group of much smaller countries and more vulerable economies, right off that seems inappropriate. Barro seems to have taken no account of the activist role government has played in this epidsode. He places a zero weight on the unprecedented actions of the Fed and the Treasury and their multi-trillion dollar support effort. That harldy seems appropriate either, does it?

Odds of depression
Frankly the idea that there is a one in five chance of depression right now in the US seems one of the more irresponsible things for an economist to write. Bridging the conclusion to the US from an international data set where other economies would not have had the resources of the US and in circumstances in which their economies would have been starved of capital fleeing from a stock market collapse, hardly seem to place the US in a data set of peers (The US continues to get huge capital inflows). What relevance is there to the US in 2009? I do not doubt that Mr Barro has a supporting set of criteria for his statistical statement. I just wonder if the data have any relevance to the use he has made of them. Often in empirical research it is what you do not control for that gets you in trouble. This would not be the first time that statistics were used improperly. You can go back to most of the pricing of mortgage-backed securities in this cycle for other examples.

Ignore it!
I'd recommend not following the link to Barro's article. It will only frustrate you, worry you, and in the end confuse you, because I would bet dollars to donuts that the odds of the results of this study applying to the US right now are miniscule.

Time to kick the pessimism, if not the pessimists.

Monday, March 2, 2009

Is that the FAT LADY singing?? Already?

You know the story. It's not over 'til the Fat Lady sings. Where ever that is.

The expression made famous by baseball linguist Yogi Berra may apply now to our economy and to its recession. It would be fitting that a recession that fooled everyone, seemed like it was not one at all, then seemed mild, then seemed severe and is now being called 'a depression' by many would end just as the greatest investor or our time, Warren Buffett, has said the year will be toast and there could be a multi-year hangover. This recession has made fools of just about everyone in one way or another. Why stop now?

But why the optimism? Fair question.

Answer: My cyclical index from the ISM data, of course.

The chart above shows the plot of the index from the inception of the ISM data. The chart plots the cyclical index against the bands of historic recessions. The cyclical index is a ratio involving three ISM components. I average the orders index and the production index then take that average as a ratio to the employment index. Since orders is a leading series, production is coincident and employment lags I get a a ratio that identifies the manufacturing sector in transition.

The chart shows clearly that this plain vanilla index reaches lows in or just before recessions then jumps though hoops late in recessions or early in recoveries- just as it has done in this cycle -and as it is doing right now. The signal is as authentically strong just as it was authentically weak previously in this recession. The signal has been very reliable. See the chart above and how the indicator has oscillated around the economy's recession bands. .

I am encouraged that the manufacturing sector is saying that the turning point lies ahead and not too far ahead at that. The history of this simple well grounded indicator is there in chart for all to see.

The future bears some watching with a closer, more optimistic, eye because of it.