Tuesday, December 30, 2008

Are We Going to Repeat the Bankrupt Policies of the 1930s?

As stated before on a number of occasions economists understand many of the mistakes made during the Great Depression, so countries should not be making those same mistakes again. Wrong! One of the mistakes made in the 1930s were the various protectionist polices of countries, thereby hampering international trade, exacerbating the economic problems of the time. Well it looks like we may be doing it again. Text in bold is my emphasis. From the UK Telegraph:

The riots have begun. Civil protest is breaking out in cities across Russia, China, and beyond.

Greece has been in turmoil for 11 days. The mood seems to have turned "pre-insurrectionary" in parts of Athens - to borrow from the Marxist handbook.


This is a foretaste of what the world may face as the "crisis of capitalism" - another Marxist phase making a comeback - starts to turn two hundred million lives upside down.

We are advancing to the political stage of this global train wreck. Regimes are being tested. Those relying on perma-boom to mask a lack of democratic or ancestral legitimacy may try to gain time by the usual methods: trade barriers, sabre-rattling, and barbed wire.

Dominique Strauss-Kahn, the head of the International Monetary Fund, is worried enough to ditch a half-century of IMF orthodoxy, calling for a fiscal boost worth 2pc of world GDP to "prevent global depression".

"If we are not able to do that, then social unrest may happen in many countries, including advanced economies. We are facing an unprecedented decline in output. All around the planet, the people have reacted with feelings going from surprise to anger, and from anger to fear," he said.

Russia has begun to shut down trade as it adjusts to the shock of Urals oil below $40 a barrel. It has imposed import tariffs of 30pc on cars, 15pc on farm kit, and 95pc on poultry (above quota levels). "It is possible during the financial crisis to support domestic producers by raising customs duties," said Premier Vladimir Putin.

Russia is not alone. India and Vietnam have imposed steel tariffs. Indonesia is resorting to special "licences" to choke off imports.

The Kremlin is alarmed by a 13pc fall in industrial output over the last five months. There have been street protests in Moscow, St Petersburg, Kaliningrad, Vladivostok and Barnaul. Police crushed "Dissent Marchers" holding copies of Russia's constitution above their heads in Moscow's Triumfalnaya Square.

"Russia has not seen anything like these nationwide protests before," said Boris Kagarlitsky from Moscow's Globalization Institute.

The Duma is widening the treason law to catch most forms of political dissent, and unwelcome forms of journalism. Jury trials for state crimes are to be abolished.

Yevgeny Kiseloyov at the Moscow Times said it feels eerily like December 1 1934 when Stalin unveiled his "Enemies of the People" law, kicking off the Great Terror.

The omens are not good in China either. Taxis are being bugged by state police. The great unknown is how Beijing will respond as its state-directed export strategy hits a brick wall, leaving exposed a vast eyesore of concrete and excess plant.

Exports fell 2.2pc in November. Toy, textile, footwear, and furniture plants are being closed across Guangdong, now the riot hub of South China. Some 40m Chinese workers are expected to lose their jobs. Party officials have warned of "mass-scale social turmoil".

The Politburo is giving mixed signals. We don't yet know how much of the country's plan to boost domestic demand through a $586bn stimulus package is real, and how much is a wish-list sent to party bosses in the hinterland without funding.

Shortly after President Hu Jintao said China is "losing competitive edge in the world market", we saw a move towards export subsidies for the steel industry and a dip in the yuan peg - even though China already has the world's biggest reserves ($2 trillion) and the biggest trade surplus ($40bn a month).

So is the Communist Party mulling a 1930s "beggar-thy-neighbour" strategy of devaluation to export its way out of trouble? Such raw mercantilism can only draw a sharp retort from Washington and Brussels in this climate.

"During a global slowdown, you can't have countries trying to take advantage of others by manipulating their currencies," said Frank Vargo from the US National Association of Manufacturers. (This is what happened during the Great Depression.)

It is a view shared entirely by President-elect Barack Obama. "China must change its currency practices. Because it pegs its currency at an artificially low rate, China is running massive current account surpluses. This is not good for American firms and workers, not good for the world," he said in October. The new intake of radical Democrats on Capitol Hill will hold him to it.

There has been much talk lately of America's Smoot-Hawley Tariff Act, which set off the protectionist dominoes in 1930. It is usually invoked by free traders to make the wrong point. The relevant message of Smoot-Hawley is that America was then the big exporter, playing the China role. By resorting to tariffs, it set off retaliation, and was the biggest victim of its own folly.

Britain and the Dominions retreated into Imperial Preference. Other countries joined. This became the "growth bloc" of the 1930s, free from the deflation constraints of the Gold Standard. High tariffs stopped the stimulus leaking out.


It was a successful strategy - given the awful alternatives - and was the key reason why Britain's economy contracted by just 5pc during the Depression, against 15pc for France, and 30pc for the US.

Could we see such a closed "growth bloc" emerging now, this time led by the US, entailing a massive rupture of world's trading system? Perhaps.

This crisis has already brought us a monetary revolution as interest rates approach zero across the G10. It may overturn the "New World Order" as well, unless we move with great care in grim months ahead. This is where events turn dangerous.

The last great era of globalisation peaked just before 1914. You know the rest of the story.

Sunday, December 28, 2008

This Weekend's Contemplation - Our Collective Success is not Guarantied

I ran across the following editorial in the WSJ and found it very interesting. Simply put our success in handling the current economic situation is not guarantied. This will be an important concept to keep in mind over the next few weeks, months, and probably years as the US and the rest of the world winds their way through the economic collapse. It is important to remember that although we know many of the things "we" did wrong during the Great Depression, "we" were still relatively unsuccessful to getting the economy up and running. Therefore, we know what we did wrong, but we don't know what to do right. Will this take a decade like the author believes? I don't know, but I am planning on relatively tough times until the 2013 - 2015 time period. Text in bold is my emphasis.

How many times have you heard that we've learned the lessons of the Great Depression and won't repeat the same mistakes?

That statement is a bit of a false promise, since there was only one Great Depression, and many, many steps were taken and not taken, with no chance to rerun the experiment over and over to figure out what worked, or would have worked, and what didn't.

Letting hundreds of banks collapse, destroying savings and confidence, is one mistake we won't make again. But many want to insist, without evidence, that more government spending would have ended the depression. That's the direction the Obama administration is taking. Others say government did not do enough to restore business confidence, or did too much to damage it, piling on taxes, regulation and labor unions. This at least is firmer ground. Plenty of evidence from history shows that actions hostile to business tend to be related to an absence of prosperity.

But more important than these talismanic assurances about what we've learned from the Great Depression is the mistake in assuming that, even if we had a coherent view of what should be done, coherent polices would therefore be implemented.

This has little relation to how policy is made in a democracy.

Policy is always bad to a degree, but long periods of prosperity tend to be self-reinforcing since powerful interests are born with the means and motive to preserve the status quo. That status quo may really be a contributor to prosperity, such as regulatory restraint and moderate tax rates. That status quo may in some respects be ill-advised, such as excessive subsidy to housing debt.

But once prosperity blows up, the quasi-virtuous policy circle becomes an unvirtuous one as new interest groups come to the fore to exploit an appetite, previously weak, to impose their costly or vindictive wish lists. And even well-meaning policy gets twisted and rendered incoherent.

It's already happening to our banking bailout. If injecting government capital to improve confidence in banks was a good idea, it did nothing to improve the banks' own confidence in their borrowers. Yet now that banks have government capital, they're being pressed to lend to politically favored constituents regardless of their own judgment about whether the borrower is good for the money.

Or take the gathering auto bailout: Taxpayer dollars are being thrown at Detroit auto makers to make them "viable," even as Congress imposes new fuel-mileage mandates requiring them to incur tens of billions in costs unlikely to be recouped from their customers -- the definition of "nonviable."

Mr. Obama's troops palpitate with excitement at the prospect of $1 trillion in "stimulus," though any net benefit to the economy likely will be incidental. Al Gore has thrown out the window any unpopular carbon taxes in favor of direct subsidies to his green energy investments. He sees the moment for what it is -- alarm about global warming has degenerated into a pretext. Billions will be diverted from useful purposes to create "green jobs" that deliver no meaningful impact on climate or the accumulation of atmospheric carbon.

Large "confidence" costs were always destined to flow from the extreme steps being taken, even if advisable, to prop up the economy. The federal government's alternating takeovers and bailouts of companies are inherently destabilizing and create massive uncertainty in investors and businesses. The Fed's shocking steps to print money and acquire every kind of private asset and, soon perhaps, washing machines and Chevy Tahoes, may in retrospect be seen as just the right medicine. At the moment, no rational investor or business manager looks upon such doings with confidence in our economic future.


On top of it all, the Madoff scandal is peculiarly demoralizing in ways that may make its impact greater than the sum of its parts.

Our point here is that the bad policy vicious circle probably has a long way to run. While it's still possible to entertain wild hopes about an Obama administration, such hopes are partly self-liquidating on closer inspection -- they exist in the first place only because Mr. Obama has given us so little to go on, except campaign boilerplate.

Bottom line: Politics is in charge -- in a way that makes a lost decade of subpar prosperity more likely than not.

Saturday, December 27, 2008

More on the Christmas Shopping Bust

I saw this in the WSJ yesterday and the picture says more than 1,000 words.











Friday, December 26, 2008

The 2008 Holiday Shopping Season is a Bust

Early analysis indicates that clothes and electronics had declines of about 20% this Holiday season. This analysis is also stated in nominal terms so one could subtract another 4 - 5% for inflation. Yowee! The after Christmas sales should be good. Text in bold is my emphasis. From Yahoo.com:

Retailers' sales fell as much as 4 percent during the holiday season, as the weak economy and bad weather created one of the worst holiday shopping climates in modern times, according to data released on Thursday by SpendingPulse.

The figures, from the retail data service of MasterCard Advisors, show the 2008 holiday shopping season was the weakest in decades, as U.S. consumers cut spending as they confront a yearlong recession, mounting job losses and tighter credit.

"It's probably one of the most challenging holiday seasons we've ever had in modern times," said Michael McNamara, vice president of Research and Analysis at MasterCard Advisors.

"We had a very difficult economic environment. Weather patterns were not favorable toward the end of season, and that resulted in one of the most challenging economic seasons we've seen in decades."

The figures exclude auto and gas sales but include grocery, restaurant and specialty food sales. Although SpendingPulse did not exempt the food prices, McNamara said the decline would have been steeper without them.

"There's a lot of food that provide a buffer for the total retail sales numbers," he said.

SpendingPulse tracks sales activity in the MasterCard Inc payments network and couples that with estimates for all other payment forms, including cash and checks. It has been tracking holiday spending figures since 2002. Exact comparisons beyond that year are difficult because of changes in measurements.

The holiday shopping season typically runs from the day after U.S. Thanksgiving, which occurs on the fourth Thursday of November, until Christmas Eve. But this year Thanksgiving was a week later than last year.

To benchmark a comparison, SpendingPulse measured the season from November 1 through December 24. Sales fell 2 percent in November and 4 percent from December 1 through December 24, according to SpendingPulse.

The holiday sales season can account for up to 40 percent of a retailer's annual revenue.

Sales at specialty apparel retailers like Gap Inc and Abercrombie & Fitch Co fell 19.7 percent this year, SpendingPulse said. When factoring in department store results, sales fell about 20 percent, McNamara said.

Women's apparel sales fell 22.7 percent; men's clothing sales were off 14.3 percent, and footwear sales fell 13.5 percent, SpendingPulse said.

This year, the higher the price, the more consumers did without, SpendingPulse said. Sales at specialty electronics and appliance chains such as Best Buy Co Inc fell 26.7 percent, it said.
(I assumed that clothes were hit hard, but it looks like electronics were hit as well.)

Luxury sales, which include sales at high-end department stores, leather goods boutiques, pricier jewelry stores and restaurants, fell 34.5 percent, SpendingPulse said. Excluding jewelry, sales fell 21.2 percent.

"There's a much different bonus environment, especially in New York and the financial services industry," McNamara said, of the traditional luxury good customer base.

"But also, the deteriorating employment figures across multiple industries across the country look like they're having a more significant impact at the higher end," he said.

Online sales benefited from the bad weather seen in the northern United States within the last two weeks of the season. E-commerce sales ended down 2.3 percent, but rose 1.8 percent in the final two weeks of the holiday season.

Nearly all retailers -- from department stores such as Macy's Inc and J.C. Penney Co Inc to specialty apparel chains like Aeropostale Inc and AnnTaylor Stores Corp -- offered aggressive discounts this holiday season to lure reticent shoppers.

SpendingPulse results do not include the post-Christmas spending activity, which has been growing with the popularity of gift cards that are typically redeemed after Christmas and post-holiday sales.

Thursday, December 18, 2008

Debt Deflation, Monetary Policy and Inflation

The title sounds a little daunting, but if you take the time to read the article below from the UK Telegraph it actually is not that difficult. Basically the potential deflation is enhanced by the high levels of debt, so the Fed floods the system with money, which in turn dramactically increases the chances of severe inflation. Text in bold is my emphasis.

We know what causes a recession to metastasize into a slump. Irving Fisher, the paramount US economist of the inter-war years, wrote the text in 1933: "Debt-Deflation Theory of Great Depressions".

"Such a disaster is somewhat like the capsizing of a ship which, under ordinary conditions is always near stable equilibrium but which, after being tipped beyond a certain angle, has no longer this tendency to return to equilibrium, but a tendency to depart further from it," he said.


Today we call this "Gladwell's tipping point". Once it goes, you can't get back up. This is why the Federal Reserve has resorted to emergency measures that seem mad at first sight.

It has not only cut rates to near zero for the first time in US history, it is also conjuring $2 trillion of stimulus out of thin air. This is Quantitative Easing, or just plain 'QE' in our brave new world.

The key is the toxic mix of high debt and deflation. An economy can handle one at a time, but not both.

The reason why it "departs further" from equilibrium is more or less understood. The burden of debt increases as prices fall, creating self-feeding spiral. This is what Fisher called the "swelling dollar" effect. Real debt costs rose by 40pc from 1929 to early 1933 by his count. Debtors suffocated to death.

Brian Reading from Lombard Street Research has revived this neglected thesis and come up with some disturbing figures. US household debt is now $13.9 trillion, down just 1pc from its peak last year. Meanwhile household wealth has fallen 14pc as property crashes, a loss of $6.67 trillion. The debt-to-wealth ratio is rocketing.

Clearly the US is already in the grip of debt-deflation. "The obvious conclusion is that the Fed should print money to purchase private sector assets so as to drive up their price," he said.

Fed chief Ben Bernanke does not need prompting. He made his name as a Princeton professor studying the "credit channel" causes of depressions. Now fate has put him in charge of the channel.

Under his guidance, the Fed has this week pledged to "employ all available tools" to stave off deflation - and damn the torpedoes. It will purchase "large quantities of agency debt and mortgage-backed securities." It will evaluate "the potential benefits of purchasing longer-term Treasury securities," i.e, printing money to pay the Pentagon.

Put bluntly, the Fed is deliberately stoking inflation. At some point it will succeed. Then the risk flips quickly to spiralling inflation as the elastic snaps back. There will be a second point of danger.

By late 2009, if not before, the bond vigilantes may start to fret about the liquidity lake. They will worry that the Fed may have to start feeding its holdings of debt back onto the market. The Fed's balance sheet has already risen from $800bn in September to $2.2 trillion this month. It will be $3 trillion by early next year.

"The bond markets could go into free fall," said Marc Ostwald from Monument Securities.
"The Fed went into this all guns blazing just as the Neo-cons went into Iraq thinking it was a great idea to get rid of Saddam, without planning an exit strategy. As soon as we get the first uptick in inflation, the markets are going to turn and say this is what we feared would happen all along. Then what?" he said.


New Star's Simon Ward said all three measures of the US broad money supply are flashing recovery. M2 has risen at annual rate of 17pc over three months.

"It has all changed since the Fed began buying commercial paper in October. If the money supply is booming at 20pc in six months, inflation will become a concern. Given that public debt ratios are already on an explosive path, we risk a debt trap," he said.

For now, the bond markets are quiet. Futures contracts are pricing five years of deflation in the US. Yields on 10-year US Treasuries have halved since early November to 2.09pc, the lowest since the Fed's data began. Three-month dollar LIBOR has plummeted to 1.53pc.

It is the same pattern across the world. 10-year yields have fallen to 1.27pc in Japan, 3pc in Germany, 3.2pc in Britain, and 3.49pc in France.

The bond markets seem to be betting that emergency action by central banks will take a very long time to work, if it works at all. By cutting to zero, the Fed has come close to shutting down the US 'repo' market that plays a crucial role in providing liquidity. It has caused havoc to the $3.5 trillion money markets - as the Bank of Japan, burned by experienced, had warned. It has become even harder for banks to raise money. Some argue that extreme monetary policy is already doing more harm than good.

Mr Bernanke is known for his "helicopter speech" in November 2002, when he nonchalantly talked of the Fed's "printing press" and said it was the easiest thing in the world to "reverse deflation."

Less known is his joint-paper in 2004 - "Monetary Policy Alternatives at the zero-bound". By then doubts were creeping in. He admitted to "considerable uncertainty" as to whether extreme tools will actually work. Liquidity could fail to gain traction.

Put another way, the Fed is flying by the seat of its pants. It should never have let debt grow to such grotesque levels in the first place.

Wednesday, December 17, 2008

Recent Poll Shows that the Consumer May Be Catching on to the Severity of the Situation

The article below gives the results of a monthly poll indicating that the consumer just might be catching on as to the severity of the economic situation. I contrast this with a poll taken in Q2 that indicated that 62% of respondents thought their homes had appreciated in the last year even though 77% of homes depreciated in value. Until the consumer catches on to the current economic situation the normal market clearing forces will not be able to take hold. By the way, I included the political portion of the article to give an indication of just how poorly the current Congress and President are viewed. I point this out to indicate that it is hard to lead if one is not well regarded. Text in bold is my emphasis. From Yahoo News (that should translate in your mind to Reuters):

A recession-mired economy and growing job insecurity have shaken American confidence in the future despite an upbeat view of President-elect Barack Obama's performance, according to a Reuters/Zogby poll released on Wednesday.

The Reuters/Zogby Index, which measures the mood of the country, dipped to 90.5 in December from 93.3 in November as seven of the 10 measures of public opinion used in the index declined.

Americans are feeling less secure in their jobs and more worried about the country's direction in the midst of a year-old recession and signs of widespread economic distress in nearly every sector, the poll found.

The sagging public mood returned after a burst of optimism last month, when Obama was elected to the White House on promises of changing the status quo and transforming the Washington political culture, pollster John Zogby said.

"The glow of the election has worn off a bit," Zogby said. "People are gearing up for what they know and what the president-elect has told them -- things are going to get worse."

Obama, who will take over from President George W. Bush on January 20, earned positive marks from 65 percent of the poll's respondents for his early performance in naming Cabinet members and gearing up to tackle the economic crisis.

In contrast, Bush earned positive job reviews from 24 percent in the poll, slightly higher than the record Zogby-poll low of 21 percent in October. Bush, architect of the unpopular Iraq war, has been dogged by some of the lowest approval ratings in U.S. presidential history.

Zogby said the worsening mood was a function in part of the lengthy transition, and Obama's inauguration next month would probably bolster public confidence again.

"We're sort of between things here," he said. "You've got one guy leaving who clearly is not in control, and the other guy coming in is not in control yet."

Most of the dips in mood were small and well within the poll's margin of error of 3.1 percentage points, but those who felt "very" or "fairly" secure in their jobs fell to just more than 59 percent from nearly 64 percent.

The number of people who were not very or not at all secure in their jobs doubled from 7 percent to 14 percent.

"What you're hearing people talking about for the first time in a long time is significant job insecurity," Zogby said.

The poll follows months of unrelenting economic turmoil, with a slumping housing market, gyrating stock markets and accelerating job losses creating uncertainty. Congress passed a $700 billion bailout for the U.S. financial services industry but rejected a much smaller package for ailing automakers.

About 54 percent of Americans oppose a bailout for the auto industry, compared to 41 percent who back one, the poll found. (Why are so many people against a auto company bail-out?)

The number of Americans who believe the country is on the right track dropped from 30 percent last month to 28 percent, still above June's all-time Zogby poll low of 16 percent.
"The bottom line is people are scared," Zogby said.


About 78 percent of Americans said they would be cutting back on spending for presents and entertainment during this holiday season because of the recession, although 71 percent said they expected the economy will be doing better in a year.

Positive ratings for the Bush administration's foreign policy dipped from 25 percent to 23 percent, while positive marks for the administration's economic policy remained mired at an abysmal 6 percent.

The number of people who gave their personal finances positive marks fell from 48 percent to 47 percent, and the number who are proud of their country fell slightly from 92 percent to 91 percent.

The only index question to rise was the approval rating for Congress, which inched up from a paltry 8 percent to 10 percent.

Obama's selection of Cabinet members like New York Sen. Hillary Clinton at state and Defense Secretary Robert Gates won approval from 60 percent.

The index combines responses to 10 questions on Americans' views about their leaders, the direction of the country and their future.

A score above 100 indicates the public mood has improved since the July 2007 benchmark. A score below 100, like the one this month, shows the mood has soured.

The RZI is released on the third Wednesday of each month. This month's telephone poll, taken Wednesday through Saturday, surveyed 1,039 likely voters.

Monday, December 15, 2008

The Credit Crisis and Monetary Policy

There have been a lot of complaints about the current monetary policy of the Fed and its apparent "lack-of" effect on the credit crisis. What many fail to realize is that without many of the recent monetary moves the credit crisis would be worse than it is now and worse than what it would be going forward. There are no rabbits to pull out of any hats. At this point it is all about making the patient more comfortable. The amrkets still have to go through all the pain. Text in bold is my emphasis. From the WSJ:

There is a common view that the Federal Reserve's monetary policy has been ineffective, akin to "pushing on a string." Aggressive monetary policy easing during the recent financial crisis has, after all, been unable to lower the cost of credit or increase its availability to households and businesses.

This view has been expressed in a number of op-eds, and also by some members of the Federal Open Market Committee. This perspective is dangerous because it leads to the conclusion that there is no reason to use monetary policy to cope with the current crisis; all that aggressive easing of monetary policy does is weaken the credibility of the central bank with regard to inflation without stimulating the economy.

Is this true? To see why the opposite is the case and why aggressive monetary policy easing is called for, ask yourself: What if the Fed had not cut rates during the current crisis?

Tighter monetary policy -- by restraining consumer spending and business investment -- would have made it more likely that the economic downturn would be even more severe, which would result in even greater uncertainty about asset values. Tighter monetary policy would then have made an adverse feedback loop more likely: The greater uncertainty about asset values would raise credit spreads, causing economic activity to contract further, thereby creating more uncertainty, making the financial crisis worse, causing the economic activity to contract further, and so on.

If the Fed had not aggressively cut rates, the result would have been both higher interest rates on Treasury securities and a substantial increase in credit risk on other assets. Interest rates relevant to household and business spending decisions would then have been much higher than what we see currently.

In short, not only has monetary policy been effective during the current financial crisis, it has been even more potent than during normal times. That's because it not only lowered interest rates on Treasury securities but also helped lower the spread between Treasury bonds and riskier assets.

This does not mean that monetary policy alone can offset the contractionary effect of the current massive disruption in the credit markets. The financial crisis has led to such a widening of credit spreads and tightening of credit standards that aggressive monetary policy easing has not been enough to contain the crisis. This is why the Fed and other central banks have provided liquidity support to particular sectors of the financial system.

Even though the Fed's liquidity injections, which have expanded the Fed balance sheet by well over a trillion dollars, have been extremely useful in limiting the negative impacts of the financial crisis, they have not been enough. A fiscal stimulus package is needed to keep the U.S. economy from entering into a deep recession. The $500 billion question is whether the fiscal package can be done right so it has the maximum impact in the short-run but does not lead to future tax burdens that are unsustainable.

The fact that monetary policy is more potent than during normal times argues for even more aggressive easing during financial crises. By easing aggressively to offset the negative effects of financial turmoil on economic activity -- this includes cutting interest rates preemptively, as well as using nonconventional monetary policy tools if interest rates fall to zero -- monetary policy can reduce the likelihood that a financial disruption might set off an adverse feedback loop. The resulting reduction in uncertainty can then make it easier for the markets to value assets, hastening the return of normal market functioning.

Aggressive easing of monetary policy poses the danger that it might destabilize inflation expectations, which could then lead to a significant rise in inflation in the future. How can the Fed keep inflation expectations solidly anchored so it can respond preemptively to financial disruptions? It needs to communicate that it will be flexible in the opposite direction by raising interest rates quickly if there is a rapid recovery in financial markets, or if there is an upward shift in projections for future inflation. In this way the Fed can show that it is prepared to take back some of the insurance it has provided by its earlier monetary-policy easing.

The most dangerous aspect of the belief that monetary policy is ineffective during financial crises is that it may promote policy inaction when action is most needed. If anything, monetary policy makers must respond rapidly during financial crises because aggressive monetary policy easing can make adverse feedback loops less likely.

Sunday, December 14, 2008

The Lack of Transparency for the Various Federal Bail-Outs Continues

This ties with the post below. As the bail-outs continue the lack of transparency continues. I understand that Fed does not want to disclose who is getting money, so there is not a run on the institution. But, how does the taxpayer know that all the bail-outs are worthwhile. How much of our money is at risk and how much risk is there? Text in bold is my emphasis. From Bloomberg:

The Federal Reserve refused a request by Bloomberg News to disclose the recipients of more than $2 trillion of emergency loans from U.S. taxpayers and the assets the central bank is accepting as collateral.

Bloomberg filed suit Nov. 7 under the U.S. Freedom of Information Act requesting details about the terms of 11 Fed lending programs, most created during the deepest financial crisis since the Great Depression.

The Fed responded Dec. 8, saying it’s allowed to withhold internal memos as well as information about trade secrets and commercial information. The institution confirmed that a records search found 231 pages of documents pertaining to some of the requests.

“If they told us what they held, we would know the potential losses that the government may take and that’s what they don’t want us to know,” said Carlos Mendez, a senior managing director at New York-based ICP Capital LLC, which oversees $22 billion in assets.

The Fed stepped into a rescue role that was the original purpose of the Treasury’s $700 billion Troubled Asset Relief Program. The central bank loans don’t have the oversight safeguards that Congress imposed upon the TARP.

Total Fed lending exceeded $2 trillion for the first time Nov. 6. It rose by 138 percent, or $1.23 trillion, in the 12 weeks since Sept. 14, when central bank governors relaxed collateral standards to accept securities that weren’t rated AAA.

Congress is demanding more transparency from the Fed and Treasury on bailout, most recently during Dec. 10 hearings by the House Financial Services committee when Representative David Scott, a Georgia Democrat, said Americans had “been bamboozled.”

Bloomberg News, a unit of New York-based Bloomberg LP, on May 21 asked the Fed to provide data on collateral posted from April 4 to May 20. The central bank said on June 19 that it needed until July 3 to search documents and determine whether it would make them public. Bloomberg didn’t receive a formal response that would let it file an appeal within the legal time limit.

On Oct. 25, Bloomberg filed another request, expanding the range of when the collateral was posted. It filed suit Nov. 7.

In response to Bloomberg’s request, the Fed said the U.S. is facing “an unprecedented crisis” in which “loss in confidence in and between financial institutions can occur with lightning speed and devastating effects.”

The Fed supplied copies of three e-mails in response to a request that it disclose the identities of those supplying data on collateral as well as their contracts.

While the senders and recipients of the messages were revealed, the contents were erased except for two phrases identifying a vendor as “IDC.” One of the e-mails’ subject lines refers to “Interactive Data -- Auction Rate Security Advisory May 1, 2008.”

Brian Willinsky, a spokesman for Bedford, Massachusetts- based Interactive Data Corp., a seller of fixed-income securities information, declined to comment.

“Notwithstanding calls for enhanced transparency, the Board must protect against the substantial, multiple harms that might result from disclosure,” Jennifer J. Johnson, the secretary for the Fed’s Board of Governors, said in a letter e-mailed to Bloomberg News.

“In its considered judgment and in view of current circumstances, it would be a dangerous step to release this otherwise confidential information,” she wrote.

New York-based Citigroup Inc., which is shrinking its global workforce of 352,000 through asset sales and job cuts, is among the nine biggest banks receiving $125 billion in capital from the TARP since it was signed into law Oct. 3. More than 170 regional lenders are seeking an additional $74 billion.

Fed Chairman Ben S. Bernanke and Treasury Secretary Henry Paulson said in September they would meet congressional demands for transparency in a $700 billion bailout of the banking system.

The Freedom of Information Act obliges federal agencies to make government documents available to the press and public. The Bloomberg lawsuit, filed in New York, doesn’t seek money damages.

“There has to be something they can tell the public because we have a right to know what they are doing,” said Lucy Dalglish, executive director of the Arlington, Virginia-based Reporters Committee for Freedom of the Press.

“It would really be a shame if we have to find this out 10 years from now after some really nasty class-action suit and our financial system has completely collapsed,” she said.

The Fed’s five-page response to Bloomberg may be “unprecedented” because the board usually doesn’t go into such detail about its position, said Lee Levine, a partner at Levine Sullivan Koch & Schulz LLP in Washington.

“This is uncharted territory,” said Levine during an interview from his New York office. “The Freedom of Information Act wasn’t built to anticipate this situation and that’s evident from the way the Fed tried to shoehorn their argument into the trade-secrets exemption.”

The Fed lent cash and government bonds to banks that handed over collateral including stocks and subprime and structured securities such as collateralized debt obligations, according to the Fed Web site.


Borrowers include the now-bankrupt Lehman Brothers Holdings Inc., Citigroup and New York-based JPMorgan Chase & Co., the country’s biggest bank by assets.

Banks oppose any release of information because that might signal weakness and spur short-selling or a run by depositors, Scott Talbott, senior vice president of government affairs for the Financial Services Roundtable, a Washington trade group, said in an interview last month.

“Americans don’t want to get blindsided anymore,” Mendez said in an interview. “They don’t want it sugarcoated or whitewashed. They want the complete truth. The truth is we can’t take all the pain right now.”


The Bloomberg lawsuit said the collateral lists “are central to understanding and assessing the government’s response to the most cataclysmic financial crisis in America since the Great Depression.”

In response, the Fed argued that the trade-secret exemption could be expanded to include potential harm to any of the central bank’s customers, said Bruce Johnson, a lawyer at Davis Wright Tremaine LLP in Seattle. That expansion is not contained in the freedom-of-information law, Johnson said.

“I understand where they are coming from bureaucratically, but that means it’s all the more necessary for taxpayers to know what exactly is going on because of all the money that is being hurled at the banking system,” Johnson said.

The Bloomberg lawsuit is Bloomberg LP v. Board of Governors of the Federal Reserve System, 08-CV-9595, U.S. District Court, Southern District of New York (Manhattan).

Uncle Sam is running Up Quite a Tab - $8.5T in Commitments

Below is a artcile from the SF Chronicle outlining the commitments made so far to bail-out the US financial system. As you can see the commitments are far ranging and cover numerous parts of the financial industry (double click on the table below to enlarge). Two things bother me: 1) This is a lot of money and 2) we are no where near done bailing out parts of the industry. The pension and insurance portions of the industry have taken large invesment losses in the last 12 months and we do not even hear about them. Also do you really think the banks are done asking for money. Text in bold is my emphasis.

The federal government committed an additional $800 billion to two new loan programs on Tuesday, bringing its cumulative commitment to financial rescue initiatives to a staggering $8.5 trillion, according to Bloomberg News.

That sum represents almost 60 percent of the nation's estimated gross domestic product.

Given the unprecedented size and complexity of these programs and the fact that many have never been tried before, it's impossible to predict how much they will cost taxpayers. The final cost won't be known for many years.

The money has been committed to a wide array of programs, including loans and loan guarantees, asset purchases, equity investments in financial companies, tax breaks for banks, help for struggling homeowners and a currency stabilization fund.

Most of the money, about $5.5 trillion, comes from the Federal Reserve, which as an independent entity does not need congressional approval to lend money to banks or, in "unusual and exigent circumstances," to other financial institutions.

To stimulate lending, the Fed said on Tuesday it will purchase up to $600 billion in mortgage debt issued or backed by Fannie Mae, Freddie Mac and government housing agencies. It also will lend up to $200 billion to holders of securities backed by consumer and small-business loans. All but $20 billion of that $800 billion represents new commitments, a Fed spokeswoman said.

About $1.1 trillion of the $8.5 trillion is coming from the Treasury Department, including $700 billion approved by Congress in dramatic fashion under the Troubled Asset Relief Program.

The rest of the commitments are coming from the Federal Deposit Insurance Corp. and the Federal Housing Administration.

Only about $3.2 trillion of the $8.5 trillion has been tapped so far, according to Bloomberg. Some of it might never be.

Relatively little of the money represents direct outlays of cash with no strings attached, such as the $168 billion in stimulus checks mailed last spring.

Most of the money is going into loans or loan guarantees, asset purchases or stock investments on which the government could see some return.

"If the economy were to miraculously recover, the taxpayer could make money. That's not my best guess or even a likely scenario," but it's not inconceivable, says Anil Kashyap, a professor at the University of Chicago's Booth School of Business.

The risk/reward ratio for taxpayers varies greatly from program to program.

For example, the first deal the government made when it bailed out insurance giant AIG had little risk and a lot of potential upside for taxpayers, Kashyap said. "Then it turned out the situation (at AIG) was worse than realized, and the terms were so brutal (to AIG) that we had to renegotiate. Now we have given them a lot more credit on more generous terms."

Kashyap says the worst deal for taxpayers could be the Citigroup deal announced late Sunday. The government agreed to buy an additional $20 billion in preferred stock and absorb up to $249 billion in losses on troubled assets owned by Citi.

Given that Citigroup's entire market value on Friday was $20.5 billion, "instead of taking that $20 billion in preferred shares we could have bought the company," he says.

It's hard to say how much the overall rescue attempt will add to the annual deficit or the national debt because the government accounts for each program differently.

If the Treasury borrows money to finance a program, that money adds to the federal debt and must eventually be paid off, with interest, says Diane Lim Rogers, chief economist with the Concord Coalition, a nonpartisan group that aims to eliminate federal deficits.

The federal debt held by the public has risen to $6.4 trillion from $5.5 trillion at the end of August. (Total debt, including that owed to Social Security and other government agencies, stands at more than $10 trillion.)

However, a $1 billion increase in the federal debt does not necessarily increase the annual budget deficit by $1 billion because it is expected to be repaid over time, Rogers said.

A deficit arises when the government's expenditures exceed its revenues in a particular year. Some estimate that the federal deficit will exceed $1 trillion this fiscal year as a result of the economic slowdown and efforts to revive it.

The Fed's activities to shore up the financial system do not show up directly on the federal budget, although they can have an impact. The Fed lends money from its own balance sheet or by essentially creating new money. It has been doing both this year.

The problem is, "if you print money all the time, the money becomes worth less," Rogers says. This usually leads to higher inflation and higher interest rates. The value of the dollar also falls because foreign investors become less willing to invest in the United States.

Today, interest rates are relatively low and the dollar has been mostly strengthening this year because U.S. Treasury securities "are still for the moment a very safe thing to be investing in because the financial market is so unstable," Rogers said. "Once we stabilize the stock market, people will not be so enamored of clutching onto Treasurys."

At that point, interest rates and inflation will rise. Increased borrowing by the Treasury will also put upward pressure on interest rates.

Today, however, the Fed is more worried about deflation than inflation and is willing to flood the market with money if necessary to prevent an economic collapse.

Federal Reserve Chairman Ben Bernanke "has ordered the helicopters to get ready," said Axel Merk, president of Merk Investments. "The helicopters are hovering and the first cash is making it through the seams. Soon, a door may be opened."

Rogers says her biggest fear is not hyperinflation and the social unrest it could unleash. "I'm more worried about a lot of federal dollars being committed and not having much to show for it. My worst fear is we are leaving our children with a huge debt burden and not much left to pay it back."

Key dates in the federal government's campaign to alleviate the economic crisis.

March 11: The Federal Reserve announces a rescue package to provide up to $200 billion in loans to banks and investment houses and let them put up risky mortgage-backed securities as collateral.

March 16: The Fed provides a $29 billion loan to JPMorgan Chase & Co. as part of its purchase of investment bank Bear Stearns.

July 30: President Bush signs a housing bill including $300 billion in new loan authority for the government to back cheaper mortgages for troubled homeowners.

Sept. 7: The Treasury takes over mortgage giants Fannie Mae and Freddie Mac, putting them into a conservatorship and pledging up to $200 billion to back their assets.

Sept. 16: The Fed injects $85 billion into the failing American International Group, one of the world's largest insurance companies.

Sept. 16: The Fed pumps $70 billion more into the nation's financial system to help ease credit stresses.

Sept. 19: The Treasury temporarily guarantees money market funds against losses up to $50 billion.

Oct. 3: President Bush signs the $700 billion economic bailout package. Treasury Secretary Henry Paulson says the money will be used to buy distressed mortgage-related securities from banks.

Oct. 6: The Fed increases a short-term loan program, saying it is boosting short-term lending to banks to $150 billion.

Oct. 7: The Fed says it will start buying unsecured short-term debt from companies, and says that up to $1.3 trillion of the debt may qualify for the program.

Oct. 8: The Fed agrees to lend AIG $37.8 billion more, bringing total to about $123 billion.

Oct. 14: The Treasury says it will use $250 billion of the $700 billion bailout to inject capital into the banks, with $125 billion provided to nine of the largest.

Oct. 14: The FDIC says it will temporarily guarantee up to a total of $1.4 trillion in loans between banks.

Oct. 21: The Fed says it will provide up to $540 billion in financing to provide liquidity for money market mutual funds.

Nov. 10: The Treasury and Fed replace the two loans provided to AIG with a $150 billion aid package that includes an infusion of $40 billion from the government's bailout fund.

Nov. 12: Paulson says the government will not buy distressed mortgage-related assets, but instead will concentrate on injecting capital into banks.

Nov. 17: Treasury says it has provided $33.6 billion in capital to another 21 banks. So far, the government has invested $158.6 billion in 30 banks.

Sunday: The Treasury says it will invest $20 billion in Citigroup Inc., on top of $25 billion provided Oct. 14. The Treasury, Fed and FDIC also pledge to backstop large losses Citigroup might absorb on $306 billion in real estate-related assets.

Tuesday: The Fed says it will purchase up to $600 billion more in mortgage-related assets and will lend up to $200 billion to the holders of securities backed by various types of consumer loans.

This article was published on November 26, 2008.




Friday, December 12, 2008

It Is All About the Preservation of Capital

The rush to gold and US Treasuries has been going on for since September. If you don't believe me check the yield on your money market account or try to buy some junk silver dollars (sold only for their silver content, not their numismatic value) and find that the price is basically twice the value of the silver content. The market (smart money, big money, sophisticated investors, whatever you want to call them) has finally figured out that it is all about the "preservation of capital" and forget return. (That is why I find all the "cheer leading" on TV, CNBC comes to mind, so amusing if it weren't for the for the fact that a lot of their content is downright misinformation.)

Actually, this causes some real problems. Because the interest rate on your Treasuries is so low, it is possible to have fees that exceed the yield, basically giving a negative yield on a money market account. In simple words, you pay the money market account to keep your money for you (Hmmmm!!!). What should a person due? Consider moving their money to high-rated bond funds (where all the bonds are AAA); some companies are going to exist at the end of this, so buy those companies; Bill Gross believes that you should buy debt instruments and not stock; move your money to savings accounts, what do you do with your money that exceeds FDIC limits; etc.

Anybody out there in blog-o-land have any ideas?

Text in bold is my emphasis. From the UK Telegraph:

The investor search for a safe places to store wealth as the financial crisis shakes faith in the system has caused extraordinary moves in global markets over recent days, driving the yield on 3-month US Treasuries below zero and causing a rush for physical holdings of gold.

"It is sheer unmitigated fear: even institutions are looking for mattresses to put their money until the end of the year," said Marc Ostwald, a bond expert at Insinger de Beaufort.


The rush for the safety of US Treasury debt is playing havoc with America's $7 trillion "repo" market used to manage liquidity. Fund managers are hoovering up any safe asset they can find because they do not know what the world will look like in January when normal business picks up again. Three-month bills fell to minus 0.01pc on Tuesday, implying that funds are paying the US government for protection.

"You know the US Treasury will give you your money back, but your bank might not be there," said Paul Ashworth, US economist for Capital Economics.

The gold markets have also been in turmoil. Traders say it has become extremely hard to buy the physical metal in the form of bars or coins. The market has moved into "backwardation" for the first time, meaning that futures contracts are now priced more cheaply than actual bullion prices.

It appears that hedge funds in distress are being forced to cash in profits on gold futures to cover losses elsewhere or to meet redemptions by clients. But smaller retail investors – and perhaps some big players – are buying bullion in record volumes to store in vaults.

The latest data from the World Gold Council shows that demand for coins, bars, and exchange traded funds (ETFs) doubled in the third quarter to 382 tonnes compared to a year earlier. This matches the entire set of gold auctions by the Bank of England between 1999 and 2002.
Peter Hambro, head Peter Hambro Gold, said the data reflects a "remarkable" shift in the structure of the market. The rush to safety reflects a mix of fears about the fragility of world finance and concerns that the move towards zero interest rates could set off an inflationary surge further down the road, and possibly call into question the worth of some paper currencies.
The near paralysis in the "repo" markets may prove to be no more than pre-Christmas jitters as banks square their books.

However, there are some signs that extreme monetary stimulus by the US Federal Reserve and other banks is starting to have unintended consequences.

The Bank of Japan is it is reluctant to cut its rates to zero again because of the damage this causes to the money markets, which serve as a key lubricant of the credit system. The US is now starting to face the same dilemma.

Thursday, December 11, 2008

Once Again Some Comments About the Future

The following from CCMoney.com (Forbes) are excerpts from two of the eight commentaries from business professionals. I have include Nouriel Roubini and Meredith Whitney, but the others from such notables as Bob Shiller (as in Case-Shiller), Jim Rogers (partnered with George Soros), Shiela Bair (head of the FDIC) are very interesting and give other points of view specific to their area of expertise. I encourage you to read the other commentators at CNNMoney.com.

Nouriel Roubini:

We are in the middle of a very severe recession that's going to continue through all of 2009 - the worst U.S. recession in the past 50 years. It's the bursting of a huge leveraged-up credit bubble. There's no going back, and there is no bottom to it. It was excessive in everything from subprime to prime, from credit cards to student loans, from corporate bonds to muni bonds. You name it. And it's all reversing right now in a very, very massive way. At this point it's not just a U.S. recession. All of the advanced economies are at the beginning of a hard landing. And emerging markets, beginning with China, are in a severe slowdown. So we're having a global recession and it's becoming worse.

Things are going to be awful for everyday people. U.S. GDP growth is going to be negative through the end of 2009. And the recovery in 2010 and 2011, if there is one, is going to be so weak - with a growth rate of 1% to 1.5% - that it's going to feel like a recession. I see the unemployment rate peaking at around 9% by 2010. The value of homes has already fallen 25%. In my view, home prices are going to fall by another 15% before bottoming out in 2010.

For the next 12 months I would stay away from risky assets. I would stay away from the stock market. I would stay away from commodities. I would stay away from credit, both high-yield and high-grade. I would stay in cash or cashlike instruments such as short-term or longer-term government bonds. It's better to stay in things with low returns rather than to lose 50% of your wealth. You should preserve capital. It'll be hard and challenging enough. I wish I could be more cheerful, but I was right a year ago, and I think I'll be right this year too.

Meredith Whitney:

What the federal government has done so far- with TARP, bailing out Citigroup, etc. - has stemmed the bleeding, but what it hasn't done is fundamentally alter the landscape. Yes, there's been a tremendous amount of capital thrown into the system, but my concern is that it's just going to plug the holes. It's not going to create new liquidity, which is what the system so desperately needs.

When the government announces these plans, investors get excited and hopeful. But details have been slim, and while I appreciate the government saying, "We've been wrong here. Let's try something different," the strategy changes have not solved anything. So far we've had TARP 1.0, TARP 2.0, and TARP 3.0, and I'm certain there will be a 4.0, a 5.0, and a 6.0. There has to be, because the companies cannot raise the capital they need, which means that the default provider of capital has to be the federal government.

What happens in 2009? Frankly, it's hard for me to predict what's going to happen next week, never mind next year. What I will say is that I expect all these banks to be back in the market looking for more capital. We'll also have a wholesale restructuring of our banking system, probably toward the end of 2009. There will be banks getting smaller, banks going away, and banks consolidating. At the same time, though, I think you'll see more new banks created. We've already seen more applications. And it's a great idea: You start with a clean balance sheet and make loans today with today's information. Plus, right now you've got a yield curve that's good for lending.

I think the overall economy will be worse than people expect. The biggest issue will be consumer spending. If 2008 was characterized by the market impacting the economy, then 2009 will be about the economy impacting the market. It's already started.

Wednesday, December 10, 2008

Another View of What the Future Could Hold

Per yesterday's post below concerning what the economy could look like when we emerge from current credit crisis, below is a view of what the stock market could look like. The essay (in its entirety) is from Michael Gross from PIMCO, who usually pens some pretty thought provoking material. Don't get hung up on the DJIA going to 5,000, the real issue is how stocks may be valued going forward. Text in bold is my emphasis. From PIMCO:

Here I go again! Gosh it was only six years ago that I cemented my place in stock market history by predicting that the Dow would fall from 8,500 to 5,000, instead of going up to 14,000 where it peaked in October of 2007. Well, I could use the standard set of excuses: 1) No one else saw it coming, 2) I was misinterpreted, and taken out of context, 3) I was tired, overworked, and had family problems, or 4) I had just come out of rehab. But these days what really works is a full confession. I mean, like, uh, it was totally my fault and I take full responsibility. The fact is I was only off by 9,000 points. That’s my story, and I’m stickin’ to it.

Well, fools rush in. This time though I’m definitely older and maybe a little bit wiser. No magic number, nor a specific target date from the Swami of the Dow. This one will be more conceptual, but still present a “take” that you can criticize or damn with faint praise. And no, despite the title, it doesn’t imply that the stock market is headed to 5,000 and that I was always right or just a little bit early. It only suggests that I’m readdressing the critical topic of equity valuation – that mysterious fragile flower where price is part perception, part valuation, and part hope or lack thereof. Press on, Swami.

Let me first announce a fundamental premise with which I think all rational investors would agree: I believe in stocks for the long run – but only if purchased at the right price. That statement packs a real punch. It says that capitalism is and will remain a going concern, that risk-taking – over the long run – will be rewarded, but only from a starting price that correctly anticipates the economy’s growth and its share of after-tax corporate profits within it. Acknowledging the above, let’s look at a few basic standards of valuation that historically have stood the test of time, to see if at least the price is right.

One of them is what is known as the “Q” ratio, or the value of the stock market relative to the replacement cost of net assets. The basic logic behind “Q” is that capitalism works. If the “Q” is above 1.0, then the market is valuing a company at more than it costs to reproduce it; stock prices should fall. If it is below 1.0, then stocks are undervalued because new businesses can’t be created at as cheap a price as they can be bought in the open market. In the short run, this ratio is volatile as shown below but it tends to be mean reverting, which is critical. As long as capitalism is a going concern, “Q” should mean revert to 1.0. If so, then oh, oh what a “Q”! Today’s Q ratio has almost never been lower and certainly not since WWII, implying extreme undervaluation, as seen in Chart 1.


Another long-term standard of valuation comes from the good ol‘ P/E ratio, where earnings per share, or E, is compared as a function of P, or price. Chart 2, going all the way back to 1871, shows the same relatively massive undervaluation, not only in the U.S. but elsewhere. This has been a global bear market. Yet here one should be careful. The sage of rationality, Yale’s Robert Shiller, cautions us to look at earnings on an historical 10-year moving average to remove adverse or fortuitous cyclicality. When measured on this basis, P/E’s are cheap but less so, slightly below their mean average for the past century.
Professor Shiller may be on to something, although even his 10-year approach may not be enough to adjust for our future economy and its functioning within the context of a delevering as opposed to a levering financial system. Recent Investment Outlooks and indeed, discussions in PIMCO’s Investment Committee and Secular Forums for the past several years have pointed to the necessity to view current changes as not only non-cyclical, but non-secular. They are, in fact, likely to be transgenerational. We will not go back to what we have known and gotten used to. It’s like comparing Newton and Einstein: both were right but their rules governed entirely different domains. We are now morphing towards a world where the government fist is being substituted for the invisible hand, where regulation trumps Wild West capitalism, and where corporate profits are no longer a function of leverage, cheap financing and the rather mindless ability to make a deal with other people’s money. Welcome to a new universe stock market investors! In this rather “sheepish” as opposed to “brave” new world, here are some considerations that may affect Q ratios, P/E’s, and ultimately stock prices for years to come:

Corporate profits have been positively affected for at least the past several decades by several trends that appear to be reversing. Leverage and gearing ratios – the ability of companies to make money by making paper – are coming down, not going up. In addition, the availability of cheap financing – absent government’s checkbook – will likely not return. Narrow yield spreads and low real corporate interest rates are gone. Last, but not least, the historical declines of corporate tax rates, shown graphically in Chart 3, will not likely continue downward in a Democratically-dominated Washington.

Globalization’s salutary growth rate of recent years may now be stunted. While public pronouncements from almost all major economies affirm the necessity for increased trade and policy coordination, and avoiding the destructive tendencies of one-off currency devaluations as a local remedy for global problems, investors should not bank on the free trade mentality of recent years to support historic growth rates. Already we are seeing separate ad hoc policy responses with very little cooperation. Not only does the EU’s approach differ from that of the U.S., but France is in many ways an odd man out within its own community. Asia is legitimately suspicious of any U.S. endorsed approach given the failure of America’s capitalistic model.


Animal spirits, and with them the entrepreneurial dynamism of risk-taking has likely experienced a body blow. Not only have dancers on the financed-based dance floor been shown the exit à la Chuck Prince, but those that remain have been publicly chastened and handcuffed. Golden parachutes, options, executive compensation and bonuses themselves are now at risk. Care to climb to the throne of this new world? Well, yes, egos will always dominate, but the rules will be changed and hormone levels lowered.

The benevolent fist of government is imperative and inevitable, but it will come at a cost. The champion of free enterprise, Ronald Reagan, knew that growth of the private sector was in no small way dependent on deregulation and the lowering of tax rates. Now that those trends have necessarily come to an end, no rational investors should expect innovation and productivity to be unaffected. Profit and earnings per share growth will suffer.

My transgenerational stock market outlook is this: stocks are cheap when valued within the context of a financed-based economy once dominated by leverage, cheap financing, and even lower corporate tax rates. That world, however, is in our past not our future. More regulation, lower leverage, higher taxes, and a lack of entrepreneurial testosterone are what we must get used to – that and a government checkbook that allows for healing, but crowds the private sector into an awkward and less productive corner. Dow 5,000? We don’t have to go there if current domestic and global policies are focused on asset price support and eventual recapitalization of lending institutions. But 14,000 is a stretch as well. One only has to recognize that roughly 20% of bank capital is now owned by the U.S. government and that a near proportionate share of profits will flow in that direction as well. Better to own corporate bonds than corporate stocks, but that’s a story for another Investment Outlook.


William H. Gross
Managing Director

Tuesday, December 9, 2008

Changes Resulting from the Credit Crisis

Let's face we are in the middle of the credit crisis, unemployment is going to get worse, we are in for a long severe recession (on a good day), the housing market is in the tank, the stock market is down 40% from its high point and will probably hit new lows in 2009, etc. We already know all that. The only real question now is how deep and how long the recession will last. This is difficult to answer because this is a dynamic process and so the answers will only emerge over time.

The question I have is what will the business environment look like in 3 or 5 or 10 years from now as we emerge on the other side of the current crisis. Below are excerpts from a editorial in the WSJ that I believe have some relevance. Text in bold is my emphasis.

There have been more than a dozen financial crises since the end of World War II. The aftermath of each was transitory, and markets rebounded rather quickly. The current crisis will be different; it will usher in profound and lasting structural, behavioral and regulatory changes. Here are some of the more important:

- International portfolio diversification has been undermined. This long-heralded investment strategy has failed to weather the test of the current credit crisis. Many non-U.S. stock indices have fallen more than U.S. equities markets, a trend especially pronounced in very popular developing countries, where there was a growing belief among investors that their economies would perform largely independently of the industrialized world.


But developing nations depend heavily on the developed world to consume their products and services and to finance their business activities. When liquidity is ample and credit readily available, developing economies thrive. When global credit comes under pressure, they suffer even more than their more developed counterparts. This is why the strategy of international portfolio diversification needs to be rethought and improved if it is to remain an abiding principle of asset allocation.


- Risk modeling will lose popularity. Elaborate modeling formulas for options and other complex financial derivatives that are useful for dynamic hedging under normal circumstances are of little use when transactions cannot be made without huge price concessions. Stated differently, most models rest on assumptions about normal, rational financial behavior, but lose their predictive power during times of financial euphoria or panic. Consequently, the magnitude of the current crisis calls into question whether, even after markets stabilize, sophisticated risk modeling can ever regain its former status.


- Financial concentration will gain even greater momentum and influence. This is the most profound long-term consequence of the current credit crisis. Leading independent investment banks already have been taken over by large financial conglomerates that are controlled by commercial banking entities, as have giant deposit institutions. Within the next year, many smaller and medium-sized financial institutions also will lose their independent identities.

Today, more than half of all nonfinancial debt (debt held by households, nonfinancial companies and government) is held by the top 15 institutions. These were the very firms that played a central role in creating an unprecedented amount of debt by securitization and complex new credit instruments. They also pushed for legal structures that made many aspects of the financial markets opaque.


In the years ahead, the influence of these financial conglomerates will be overwhelming -- and they will limit any moves toward greater economic democracy. These conglomerates are and will continue to be infused with conflicts of interest because of their multiple roles in securities underwriting, in lending and investing, in the making of secondary markets, and in the management of other people's money. And because there will be fewer market participants of importance, the price volatility of financial assets likely will remain high.


Through their global reach, these firms will transmit financial contagion even more quickly than it spread in the current credit crisis. When the current crisis abates, the pricing power of these huge financial conglomerates will grow significantly, at the expense of borrowers and investors.

(The comments about the financial conglomerates are interesting. I thought the purpose of the financial conglomerates is to make them easier to regulate, but the author sees these same issues in a different light. One thing that may happen is that the "normal" banking portion of the financial conglomerates may be split off and treated more like a public utility than a traditional corporation. When I say normal I mean checking, savings, credit cards, auto loans, mortgages, etc. The more common consumer products.)


- The end of an era of ballooning nonfinancial debt. The rapid growth of nonfinancial debt has been a key driver of U.S. economic growth in recent decades. Since 2000 alone, nonfinancial debt outpaced the growth of nominal GDP by nearly $8 trillion -- more than double the $3.5 trillion gap of the 1990s, which already was excessive. But the techniques and institutions that generated the tidal wave of debt creation now are in disarray. Already we are seeing a dramatic slowdown in rate of growth of household and business debt, a trend that will continue for some time. (The source of deflationary pressure.)


- U.S. government borrowing will continue to swell, at least for a few years. New net U.S. government debt issuance could exceed $1 trillion per year -- as federal revenues slow, spending increases, and funds are needed to rescue additional financial institutions.
There is a silver lining: The combination of shrinking private sector demands and expanding federal demands will on balance improve the credit quality of many portfolios. But the central question will be whether policy makers can define and implement a strategy that will slow government borrowing as private-sector credit demands reassert themselves in the medium term.

- Americans will begin to save again. The personal savings rate (as a percentage of disposable family income) has been tepid for years, and actually fell below zero in 2006. Since then, it has increased slightly into positive territory. Although this perplexes many economists and policy makers, I see no mystery. The erosion of personal savings is chiefly the result of massive debt creation.

A brief review of debt and savings rates since 1960 shows the correlation. From 1960 to 1990, according to the Federal Reserve, the growth of nonfinancial debt exceeded that of nominal GDP by 1.5 times on average, while the savings rate averaged 9% per year. From 1991 to 2000, debt exceeded the growth of GDP by 1.8 times, while the savings rate averaged 4.7%. Since 2001, debt has grown twice as fast as GDP, while the savings rate has averaged a mere 1.4%. The lesson is clear: If the savings rate is to return to healthy levels, we must put an end to the reckless creation of debt.

- Regulatory reform of financial markets will carry high stakes. While the need for reform is widely acknowledged, less well understood is the extraordinary balancing act that U.S. lawmakers must achieve. On the one hand, the new regulatory regime needs to be comprehensive enough to take into account major structural changes that have unfolded in recent decades. On the other hand, it must assure reasonable credit growth and competitive credit markets. Every new measure will impinge on embedded interests, making the whole enterprise -- essential as it is to our nation's economic health -- a major political contest.