Month: September 2008

Something for Nothing

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As I have been thinking and reading about the credit crisis my mind has been chewing on the idea that there are two very different kinds of investing. One is the kind of investing where you put in an initial outlay of resources and follow that with efforts to improve the investment (whether that is a company, an idea, or a building) so that the final product is greater than the sum invested and thus turns a profit. Some examples are finding a company in need of cash with a good idea, a business plan, and the support of other qualified investors and giving them cash to help realize their plans and turn a profit. Another example is buying a distressed property and fixing it up. Perhaps you are purchasing a house for $150,000 in an area where most houses are going for $225,000. You put in an extra $70,000 in materials and time to get the house in prime shape and then sell it for $240,000 – realizing $20,000 profit for your efforts.

The second kind of investing is the shortcut based on the mentality of seeking something for nothing – it’s called speculating. Although it may look similar to traditional investing it is really just a serious form of gambling. An example of this would be buying into a company that is cutting corners to turn a profit and operating with a loose regard for the rules of their business. They put on a good show with richly rewarded executives and a lot of talk, but there is no substance to their ideas if you do a little digging. Another example would be "flipping" a house. You go in and buy a house with an interest-only mortgage where the owner is in a hurry to sell and then you turn around and sell the house at a $100,000 profit within weeks without putting in any work. It also applies to those who purchase a large, showy home (compared to what their income should support) with an adjustable rate mortgage on the assumption that the value of the home will rise in time to refinance the home later using the "equity" gained by sitting in the home for a year – worse is when they intend not only to refinance, but to refinance and get cash out to support a lifestyle that they cannot support on their regular income.

A financial crisis, at least for individual cases, may result from either approach to investing – but it is much more likely (and I believe it is generally more damaging) when the crisis results from speculating. I am convinced that every time we experience a bubble in the economy – whether it’s a tech bubble, a housing bubble, or any thing else – the bubble is a result of speculation, even though there is legitimate investing taking place as well. In our current credit crunch we will not be able completely sort out those who were burned by speculating and those who were legitimately investing (the same is true anytime a bubble bursts) so we must either rescue some or all of those who were speculating, or else we will have to accept in advance that many people who did nothing wrong will be paying the price for the fallout from the rampant speculation that caused the crisis.

Tags bailout, economics, money

National

Amateur vs Professional

The financial amateurs in Congress have given us the 110 page text of their bailout plan which they will probably vote on today. It’s pretty much like the 102 page draft I wrote about on Saturday. They added the option to insure troubled assets in addition to the option to buy such assets. They also settled on the Graduated Authority to Purchase version rather than a straight-up $700B gift. I’m not sure if this is new, but there is also an option to remove the mark-to-market rules in the latest version.

The financial professionals such as Ross Perot have outlined a much better plan at perotcharts.com. Their plan in the immediate term calls for:

Modification or removal of mark-to-market
A 120 moratorium on foreclosures and dividend payments by banks
Higher national standards for capital bases at banks with the Treasury able to buy equity in those banks who cannot raise equity to meet the standard
Raising the FDIC guarantee from $100,000 to $250,000
Using any profits from equity that the government does buy to strengthen Social Security
An independent oversight board for the plan
Criminal investigations into the causes of the crisis

Later they would fix the Glass-Stegall Act, amend bankruptcy regulations, and give HUD/Fannie Mae/Freddie Mac the authority to work with individual homeowners facing foreclosure.

It’s too bad our amateur decision makers are so busy listening to the vested-interests rather than the independent professionals.

Tags bailout, economics, fiscal restraint, money

National

A First Glance at the Bailout Bill

Post author By David
Post date September 27, 2008
4 Comments on A First Glance at the Bailout Bill

I don’t claim to have read the full 102 page text of the bailout draft proposal yet, but I wanted to share my first reactions after jumping around to some of the sections that caught my interest.

Section 110 – Executive compensation (p. 29)

I like the idea of controls on executive compensation for participating companies, but the regulations here are vague and toothless. For example, the bill prohibits "inappropriate or excessive severance compensation." (110 3b) Considering how much the executives of large companies make, it should specify that there be zero compensation for severance.

Section 114 – Graduated Authorization to Purchase (P. 38)

This section was a pleasant surprise. It appears that it is not settled, but I like the idea of having a tiered approach to how much the Treasury is authorized to spend. The levels here are $250B initially, $350B upon notice from the treasury, and $700B if Congress does not oppose within 15 days the proposal of the treasury for that level of authority. Personally I think there should be an intermediate level of $500B where the treasury must write a proposal and the Congress has 8 days to decline before it takes effect.

Does anyone want to make bets on how long it takes the Treasury to bump its authority from $250B to $350B?

Section 119 – Termination of Authority (p. 55)

This might be my favorite section. I was pleasantly surprised that the authority was only granted until December 31, 2009 – with the option to petition for an extension by describing how extended authority will benefit the taxpayers. Even with a petition the authority is specified to end only two years from the day the bill is originally signed. Of course I won’t hold my breath that it will die in two years or less. I will believe it when it happens.

Section 123 – Minimizing Foreclosures (p. 65)

What I saw of this section suggested an approach that would not cost taxpayers anything – that’s the right aproach. The efforts to minimize foreclosures are directed at restructuring loans by extending their terms where appropriate.

One More Wish

I would like to see a provision, on the outside chance that this program actually generates a profit, that any profit realized by the treasury through this program will be used 100% to pay down the national debt – this should not be used as a windfall by Congress to fund some pet projects.

Tags bailout, money, reactions

culture

Put in the Effort

Maybe I’m just reacting to the tone of the article suggesting that Twitter is taking the place of blogging among elected officials in Utah (and elsewhere) but this quote by Ric Cantrell says it all:

”Maybe this is a sign of the times, but blogging got to be too tedious,” said Ric Cantrell, chief deputy of the Utah Senate, who blogs and uses Twitter on behalf of the Republican majority.

I’m sure that Ric’s view is much more nuanced than those 15 words, but it’s easy for people to get enamored wtih twitter and forget how limited 140 characters can be. Twitter has little if any effectiveness in substantive discussion – that’s where blogs can be a useful means of communication between people. For simple updates I have no problem with the use of Twitter.

Tags discourse, twitter, Utah

life National

Write In “No Confidence”

Somewhere in the news yesterday I heard that voters are beginning to like Sarah Palin less as they get to know more about her. I thought that was interesting since I heard basically the same thing said about Barack Obama back in June or July. My own experience is that I am liking both Obama and McCain less and less the more I hear or see from them. On the other hand, if I had the option to mix-and-match from the two tickets I would be most supportive of (read "least opposed to") a Biden-Palin ticket (not quote sure who I’d put at the top).

Perhaps Hillary Clinton was onto something since she had maxed out her negatives before she even started campaigning. I had long ago concluded that I was not voting for one of the major tickets this year, but this morning I decided that unless I am able to get behind one of the third party tickets (which I have not been able to do so far) I will be writing in "No Confidence" on November 4th.

Tags 2008, elections, McCain, Obama, parties

National

Economics 101 (Bush Edition)

Post author By David
Post date September 25, 2008
6 Comments on Economics 101 (Bush Edition)

Wasn’t it so nice for our president to give the country a lesson in economics. He worked hard to reinforce the image of Washington knows best. Unfortunately his lesson left out a few details that are less than flattering for Washington. Let’s review the text of his speech. I’ll skip all the real fluff and focus on those parts of the speech that need correction.

This large influx of money to U.S. banks and financial institutions, along with low interest rates, made it easier for Americans to get credit. These developments allowed more families to borrow money for cars, and homes, and college tuition, some for the first time.

It’s nice to cite the "large influx of money" but the real problem was "{artificially} low interest rates" that were being managed by the Federal Reserve Board. These are what allowed for people to get credit too easily to buy cars and houses that they often had no business buying – certainly not at the inflated prices that tend to follow easy credit. And lets not kid ourselves, loans for college tuition are an inconsequential fraction of this problem but citing them makes it harder to argue against all that easy credit in the first place.

Easy credit, combined with the faulty brainless assumption that home values would continue to rise, led to excesses and bad decisions. (corrections in italics)

The following statement is almost entirely true and when we insert the one final bit of truth it is very damning to the idea of government intervention.

Two of the leading purchasers of mortgage-backed securities were Fannie Mae and Freddie Mac.

Because these companies were chartered by Congress, many believed they were guaranteed by the federal government. This allowed them to borrow enormous sums of money, fuel the market for questionable investments, and put our financial system at risk. (emphasis added)

The one bit of untruth there was the implication that people were wrong to believe that Fannie and Freddie were guaranteed by the government. When push came to shove, the government stepped in and guaranteed both entities. Even if it had not, it was the perception of such a guarantee that allowed those companies to "put our financial system at risk."

The market is not functioning properly. There has been a widespread loss of confidence, and major sectors of America’s financial system are at risk of shutting down.

If the market is allowed to correct itself those sectors would shut down and restart, like a computer reboot. Though the process would be painful in the short term, the problems would be corrected much faster than if we insist on picking our way down the face of the cliff.

Perhaps we should take note of the fact that our government has been actively assisting the market for 7 years allowing the housing market to artificially expand our economy during a time when we should have allowed for a market correction following the Tech bubble and the shock of 9/11. Now the problem is worse than it was which gives us more excuse to pursue the same course with more drastic measures.

Without $700 Billion worth of intervention, Bush predicts:

Even if you have good credit history, it would be more difficult for you to get the loans you need to buy a car or send your children to college. And, ultimately, our country could experience a long and painful recession.

In a free market individuals and businesses would be learning to deal with the difficulties of tighter credit by living within their means, but "We must not let that happen." Because our market has been manipulated with artificially low interest rates and other such "minor" interventions the true value of a new car or a college education has become distorted. I note that Bush did not list buying a house as something that would be more difficult, I’m sure that’s because reckless home buying on easy credit is a visible part of the problem.

Lest we forget our recent history, while we have not had a serious recession (which would generally last less than 12 months) our last 84 months (at least) have been filled with news of job losses and anemic economic growth. We credited the rise of home prices with what little growth we saw and blamed the war, outsourcing, and illegal immigrants in turn for the lack of real growth.

Now we are seeing the one positive thing we saw as the primary cause of our current predicament – and yet we fail to realize that the reason for our unnatural 84 month see-saw is government intervention in the markets. Ultimately we have experienced a long and painful open wound which is now infected which was caused by our attempts to avoid the surgery of a natural market correction.

The president paints a rosy picture of how the proposed intervention would function, but the fact is that the proposal so far lacks any structure to guarantee anything like the picture we are being sold.

I liked the reference to the FDIC:

And through the FDIC, every savings account, checking account, and certificate of deposit is insured by the federal government for up to $100,000.

The FDIC has been in existence for 75 years, and no one has ever lost a penny on an insured deposit, and this will not change.

In order to avoid some panic, let’s remind ourselves that the above statement is true, those accounts which are based on actual cash value are safe so far, and safely insured by the government already. With that safety net, we should take our chances with Wall Street and let the government bail out the savings of those who lose money if their local banks ever fail.

Despite corrections in the marketplace and instances of abuse, democratic capitalism is the best system ever devised.

It has unleashed the talents and the productivity and entrepreneurial spirit of our citizens. It has once made this country the best place in the world to invest and do business. And it gives gave our economy the flexibility and resilience to absorb shocks, adjust, and bounce back. (corrections in italics)

Since then we have decided that we want to unleash the entrepreneurial spirit without having to absorb shocks and adjust. Good luck with that plan.

Tags bailout, Bush, economics, fiscal restraint, money

culture

Curbing Innovation

When talking about a $700 Billion intervention it only makes sense that taxpayers and members of Congress would want that money to go where it’s needed rather than to propping up salaries of $50 Million/year to executives of failing companies.

But Wall Street, its lobbyists and trade groups are waging a feverish lobbying campaign to try to fight compensation curbs. Pay restrictions, they say, would sap incentives to hard work and innovation, and hurt the financial sector and the American economy. (emphasis mine)

It seems to me that incentives to work hard and be innovative got us into this mess – I think we would want to sap those incentives for the time being.

Tags bailout, government, money, New York Times

Local National

Everyone Should Read This

I’m not one to link and run, but sometimes there is really nothing to add. I think that everyone should read what Obi wan has to say about the bailout situation.

Tags bailout, connections, economics, money

National

We Must Do Better

There has been no shortage of opposition to the hastily proposed $700 Billion Gift Card (Chris Suellentrop provides a nice rundown) – unfortunately little of the real opposition comes from members of Congress. Our own Senator Bennett has flipped from being wary to being supportive because, as every elected official knows, foolish action is better than rational inaction where re-election is concerned.

We are lucky right now to have a divided government – at least there is an initial reaction of shock from the Democrats at the lack of thought that has gone into the initial proposal. Democrats want to add in a few more dubious provisions, but at least they also want to provide some oversight in the process as well. The Republican leadership does not want any delay:

"When there’s a fire in your kitchen threatening to burn down your home, you don’t want someone stopping the firefighters on the way and demanding they hand out smoke detectors first or lecturing you about the hazards of keeping paint in the basement," Senator Mitch McConnell of Kentucky, the Republican leader, said in a speech on the Senate floor. "You want them to put out the fire before it burns down your home and everything you’ve saved for your whole life."

That analogy fits the goals of the administrations and their MO but it misses the actual situation. The truth is that a few houses have already burned down and others are smoldering in the neighborhood. In response, this fire department is proposing to break the dam above the town to quickly douse the neighborhood without considering the extra flood damage that may result and the fact that their action could weaken or destroy properties that are not currently in danger. They are so busy trying to look heroic by taking drastic action that they have failed to consider any minimal rational restraint in their proposal.

For those who are not afflicted by D.C. Myopia, the holes in the plan are gaping (Jay Evensen and Jason Linkins) and there are many better options being presented in short order. Paul Krugman astutely asks:

The premise of the Paulson plan– though never stated bluntly — is that these assets are hugely underpriced, so that Uncle Sam can buy them at prices that help the financial industry a lot, without big losses for taxpayers. Are you prepared to bet $700 billion on that premise?

I’m not – I wouldn’t bet $10 on that.

Sebastian Mallaby is generous enough to illustrate two alternative proposals by academics that carry lower risks and higher potential returns for taxpayers.

Within hours of the Treasury announcement Friday, economists had proposed preferable alternatives. Their core insight is that it is better to boost the banking system by increasing its capital than by reducing its loans. Given a fatter capital cushion, banks would have time to dispose of the bad loans in an orderly fashion. Taxpayers would be spared the experience of wandering into a bad-loan bazaar and being ripped off by every merchant.

Raghuram Rajan and Luigi Zingales of the University of Chicago suggest ways to force the banks to raise capital without tapping the taxpayers. First, the government should tell banks to cancel all dividend payments. . . Second, the government should tell all healthy banks to issue new equity. Again, banks resist doing this because they don’t want to signal weakness. . . A government order could cut through these obstacles.

Meanwhile, Charles Calomiris of Columbia University and Douglas Elmendorf of the Brookings Institution have offered versions of another idea. The government should help not by buying banks’ bad loans but by buying equity stakes in the banks themselves. Whereas it’s horribly complicated to value bad loans, banks have share prices you can look up in seconds . . . The share prices of banks that recovered would rise, compensating taxpayers for losses on their stakes in the banks that eventually went under.

Mallaby also points out the difference between the Paulson Proposal and the Resolution Trust Corporation that it might be compared to:

The RTC collected and eventually sold off loans made by thrifts that had gone bust. The administration proposes to buy up bad loans before the lenders go bust. This difference raises several questions.

The first is whether the bailout is necessary. In 1989, there was no choice. The federal government insured the thrifts, so when they failed, the feds were left holding their loans; the RTC’s job was simply to get rid of them. But in buying bad loans before banks fail, the Bush administration would be signing up for a financial war of choice.

Despite the widespread opposition to this knee-jerk reaction in Washington (I’ve only linked to 5 examples) I fear that the bill that gets passed all too quickly will look almost exactly like the one Secetary Paulson proposed. I think government is the only institution that can consistently be efficient where they should be deliberative and inefficient in all other things.

Please take the time to contact your Congressional representatives to encourage them to slow down on this and avoid a few of the gaping potholes before them.

Tags bailout, change congress, Deseret News, economics, fiscal restraint, government, New York Times, Salt Lake Tribune

National

A Managed Economy

I try not to focus on political or economic issues on Sunday, but I had a hard time when I noticed the figure "$700 Billion" yesterday. I was particularly worried by this statement:

. . . it would allow Treasury to act unilaterally: Its decisions could not be reviewed by any court or administrative body and, once the emergency legislation was approved, the administration could raise the $700 billion through government borrowing and would not be subject to Congress’ traditional power of the purse. . .

”It essentially creates an economic czar with no administrative oversight, no legal review, no legislative review. And it gives one man $700 billion to disperse as he needs fit,” said Sen. Dianne Feinstein, D-Calif., referring to Treasury Secretary Henry M. Paulson Jr.

”He will have complete, unbridled authority subject to no law,” she said.

In an administration that is already known for stretching its authority I have long had some fear of the consequences of the War on Terror. After this I am equally worried about the consequences of the War on Economic Uncertainty if this measure passes as submitted.

Thankfully the Democratic congress is pushing back on some aspects of the plan such as the lack of oversight.

Democrats want the measure to include independent oversight, homeowner protections and limits on executive compensation, House Speaker Nancy Pelosi, D-Calif., said in a statement early Sunday evening.

"We will not simply hand over a $700 billion blank check to Wall Street and hope for a better outcome," she said.

While I historically agree with the Republican party more often than the Democratic party on economic issues, I very much side with the Democrats on this one (if I’m forced to choose one of those two positions). We must have a healthy system of checks and balances between branches of the government. Regardless of the checks that may be imposed by Congress, anyone who still argues that we have a free market is either lying or ignorant.

I saw much more encouraging news this morning:

Goldman Sachs and Morgan Stanley, the last two independent investment banks on Wall Street, will transform themselves into bank holding companies subject to far greater regulation, the Federal Reserve said Sunday night.

The firms requested the change themselves . . .

(emphasis added)

This is how a free market is supposed to work. The individual companies recognize their precarious position and make changes themselves. Only the threat of failure will cause them to do this. Having the safety-net of a bailout available only encourages more risky practices. What is really interesting to me about this move is that it essentially reverses a "protective measure" that was passed in the Great Depression. Apparently that intervention in the market helped to facilitate our latest economic shock.

By the way, the plan includes a provision to raise the debt limit from $10.6 Trillion to $11.3 Trillion. What good is it to have a limit if those who are "limited" are allowed to move the goalposts at will?

Tags bailout, checks and balances, economics, fiscal restraint, government, national debt, Salt Lake Tribune