Wednesday, September 23, 2009

Middle of the week links

The real travesty that has become abundantly clear: Hat tip to The Pragmatic Capitalist (TPC) for posting the link to this piece in The New Republic. In it the author argues that despite the events of last fall that were seemingly about to bring all of Wall Street to its knees, aside from a few notable casualties (Dick Fuld, Jimmy Cayne), there are a lot of bankers who are not much worse off one year later:

With the benefit of hindsight, we can argue about whether the actions taken to address the rolling crisis of confidence were wise. What is inarguable is the special treatment that bankers received. It wasn't just that jobs were preserved or that annual bonuses continued to be paid. It was that, unlike every employee of every company that goes bankrupt for reasons related to its own position or general industrial conditions, the bankers had their equity preserved by the government's rescue efforts--whereas, say, the bailouts of GM and Chrysler left nothing for their shareholders.

In practice, this meant that 1,000 or so senior employees in each of the institutions with major investment banking operations avoided the disappearance of their accumulated wealth, numbering in the millions of dollars per employee in the vast majority of cases--and in the tens of millions of dollars in many cases. In public corporations across most industries, only a handful of employees are compensated to this degree (the notable exception being the technology industry, where IPO stock can lead to riches but where companies do not get bailed out in the event of failure). But, in major banks, the extent of stock-based ownership awarded as a central component of bonuses and the run-up in equity values in the years preceding the crash led to hundreds upon hundreds of managing directors gaining expansive paper wealth.

Other than in the Lehman and Bear failures, the government stepped in to bail out the banks and thus preserved some equity value. Accordingly, those bankers who were holding millions of dollars of company stock and options were spared. Also, without any clawback provisions for bonuses achieved through dubious practices, many of the culprits of this crisis have been able to keep their wealth while the taxpayer is forced to assume the risk of a future blow up. Yes, this is what we call moral hazard and it has not gone anywhere. If anything, the risks are even more pronounced and the political will to make meaningful changes is waning. So, if you were hoping that the banking oligarchy would not survive the crisis, I have very bad news for you: looks like it is here to stay and may be even more powerful now.

The blind leading the blind: Another hat tip to TPC for posting the link to this article in The Sydney Morning Herald. Ever wonder why so few economists completely missed the debt bubble and subsequent collapse? According to this author, the answer is that their inability to see what was evolving was rooted in their belief that markets are self correcting and that the economy is usually in a balanced equilibrium. Some economists even held the view that unemployment is voluntary and completely ignored the behavioral and psychological factors that influence business cycles. If the market is always right and the participants are always rational, then how could asset prices get out of line with fundamentals? Well, at least in housing it looks like they did. Unfortunately, many of the economists who could have warned us about our excesses simply didn’t believe there could be such dislocations and explicitly weren’t looking for it.

Do you see what all this means? It means academic economists tend to focus their attention on what happens when everything is going right - when markets are in equilibrium - and give little thought to the circumstances in which things could go wrong.

Now do you see why so few economists could see the global financial crisis coming? They didn't see it because they weren't looking for it.

(Even those who now contrive to believe that the problems we've seen in the past year and more were caused by faulty government intervention in markets, rather than any fault on the part of markets themselves, weren't warning that these interventions could lead to disaster. No, markets were getting their way and the anti-government brigade was content that all would be well.)

Mauldin still arguing for deflation: In his weekly email, John Mauldin included some analysis from The Liscio report that highlights the continued contraction in credit. Somehow home equity lines are still supplementing the availability of consumer credit, but I have to believe this cannot last as more borrowers move towards being under water. What does this mean? According to Mauldin and the Liscio report, it means that consumer will be de-leveraging for years to come and the overall leverage ratio has to fall dramatically to get back to pre-crisis levels.In other words there is a risk of debt deflation irrespective of what the Fed is trying to do.

Speaking of consumer credit, July's decline, while not the worst ever, was about two standard deviations below the mean -- and the yearly decline is now the sharpest ever. (See graphs) The decline is being driven by revolving credit, meaning mainly credit cards. Partly offsetting that contraction, though, is continued strength in revolving home equity lines of credit (HELCs), whose yearly growth is surprisingly closer to its 2004 high than the 0 line.

And, as we keep pointing out, the longer-term picture suggests that deleveraging has only begun. Measured against after-tax income, consumer debt levels are drifting lower, but have a long way to go even to get back to late 1990s levels.

That's especially true if you add HELCs to the traditional forms of consumer credit. Recent declines in the consumer debt burden are considerably milder than we saw in previous recessions (and note that the declines typically continue for at least several months after the cyclical trough).

FDIC deposit fund is about to be seriously broke: Another hat tip to John Mauldin for posting this commentary from Institutional Risk Analytics. In the piece from IRA, the author attempts to estimate the amount of money the FDIC will have to borrow to replenish its dwindling fund based on specific loss rate projections and number of bank failures. IRA believes that significantly more banks are in serious trouble than what is indicated by the FDIC’s problem bank list. Currently, the group places the lowest F rating on over 2250 banks with more than $13.3 Trillion (yes, you read that right) in assets as compared to the 416 on the FDIC’s list. The implication? The FDIC may have to borrow hundreds of billions of dollars from the Treasury or from the banks it regulates to cope with the ensuing losses:

An important point in the analysis is that estimated losses for failed bank resolutions by the FDIC are running around a quarter of failed bank assets, a level much higher than between 1980 and 1995, when failures cost an average 11 percent. Our firm's long-held view of the likely loss rate peak for the US banks in this credit cycle is 2x 1990 loss rates or, as noted by the IMF, around 4 percent of total loans. Since total loans and leases held by all FDIC-insured banks was some $7.7 trillion as of Q2 2009, the IMF estimate implies a cumulative loss of over $300 billion.

If you start with the internal assumptions used by our firm that roughly half of the banks currently rated "F" or some 1,000 banks will fail and/or be merged with another institution and that the loss to the FDIC bank insurance fund will be approximately 20-25% of total assets, then the cost of these resolutions to the FDIC through the full credit downturn could be in excess of $400-500 billion. Keep in mind that in making this alarming estimate we ignore other banks currently in ratings strata above "F" and that some of these institutions may indeed fail as well. Also, our overall "worst case" or maximum probable loss ("MPL") for large US banks above $10 billion in assets is $800 billion through the current credit cycle."

How opposed would you be to a gas tax? I know nobody likes spending money on gas. Americans were spoiled by cheap gas for many years and we got used to visits to the pump not being traumatic experiences. But, shouldn’t we be conserving gas to reduce our dependence on foreign oil supplies and to minimize carbon emissions? Forget for one second the near term impact on your life of higher gas prices or a gas tax and remember that we are trying to make this world sustainable so that our children can enjoy a higher quality of life than we do. Given that basic goal, shouldn’t the price manipulations be used as they are the most effective mechanism for influencing demand? I say yes. I’m willing to pay more at the pump so that my children and grandchildren can have a future. Not buying it? Ok, if you don’t believe in global warming or peak oil, what about taxing gas to reduce the deficit and pay for health care?

According to the energy economist Phil Verleger, a $1 tax on gasoline and diesel fuel would raise about $140 billion a year. If I had that money, I’d devote 45 cents of each dollar to pay down the deficit and satisfy the debt hawks, 45 cents to pay for new health care and 10 cents to cushion the burden of such a tax on the poor and on those who need to drive long distances.

Such a tax would make our economy healthier by reducing the deficit, by stimulating the renewable energy industry, by strengthening the dollar through shrinking oil imports and by helping to shift the burden of health care away from business to government so our companies can compete better globally. Such a tax would make our population healthier by expanding health care and reducing emissions. Such a tax would make our national-security healthier by shrinking our dependence on oil from countries that have drawn a bull’s-eye on our backs and by increasing our leverage over petro-dictators, like those in Iran, Russia and Venezuela, through shrinking their oil incomes.

In sum, we would be physically healthier, economically healthier and strategically healthier. And yet, amazingly, even talking about such a tax is “off the table” in Washington. You can’t mention it. But sending your neighbor’s son or daughter to risk their lives in Afghanistan? No problem. Talk away. Pound your chest.

Some say a gas tax can never be implemented without provoking riots in the streets. My guess is that it would take something similar to the oil shock of the 1970s to break American’s sense of entitlement when it comes to cheap gas. It’s quite unfortunate that it will likely take some kind of catastrophe to force the government and public to take measures that are actually probably in their best interest anyway.

Simon Johnson continues to remind us that nothing has changed: In an op-ed piece this weekend in the NY Times, The Baseline Scenario’s Simon Johnson pleads with us to see that our regulators and decision makers when it comes to financial institutions have been compromised. As a result, the meaningful reforms that need to be implemented in order to protect against another financial sector crisis have not been put into place. Instead, we have financial cheerleaders who are thrilled that bank stocks have soared in price. When all people focus on is market confidence as evidenced by reduced credit spreads and higher stock prices and completely ignore leverage and systemic risk, they are prone to miss the long term implications of their actions or inaction. In this case, this myopic focus on quarterly GDP, quarterly bank earnings and the bounce the market has seen since the lows in March is reducing the impetus to change the structure of the financial system. It’s hard for me to imagine any market participant wanting to go through the tumultuous September 2008 to March 2009 period again. So, whether you are a super bull or hiding under the covers bear, shouldn’t you want some regulations in place to help mitigate the damage financial institutions cause when they go bust?

A high-level position at the Federal Reserve, the Treasury, the White House National Economic Council or at a Congressional committee overseeing banking can be a ticket to riches when public service is done. The result is that our main regulatory bodies, including the Fed, are deeply compromised. Rather than act as the tough overseers of the public purse that we need — and that we had before 1980 — they have become cheerleaders for the financial sector.

These cheerleaders, in turn, generate financial cycles by letting our financial system grow too fast, with far too little capital for the risks it takes. When the Federal Reserve inevitably bails banks out, it receives great applause (particularly from the financial sector). Yet with each cycle of failure and bailout, the financial system grows ever larger and more dangerous…

In today’s nascent global recovery, we are already seeing bubble-like rises in the prices of real estate and assets, from Hong Kong and Singapore to Brazil. And many more emerging markets will likewise soon boom. The details of who makes which crazy loans to whom will no doubt be different from what they were from 2002 to 2007, but the basic structure of incentives in the system is unchanged. The same people are running the American banks, and the same regulators are regulating them, so you can easily get the same outcome here as we have just seen.

(Picture of Dick Fuld courtesy of