Tuesday, October 28, 2008

Hail to the King!

I don’t know if this is a function of the media coverage or a real phenomena, but it looks like a lot of the people at risk for losing their houses in the next wave of foreclosures will be the newly unemployed. Whenever I read an article about foreclosures, the stories feature people who just lost their job.

Now, as far as recessions go, this is not my first rodeo. We had spikes in the unemployment rate in 2001 and in 1991 when the economy contracted. But from my admittedly foggy recollection of news coverage from those days, I do not remember a lot of foreclosures being associated with the downturn.

To the extent that this is a real phenomena, I wonder if this is a function of increasing household leverage. During previous recessions, did folks have more savings that could tide them over a rough patch? Or is it that these days, the mortgages are so large that making the payments exhausts one’s savings more rapidly than in years past?

In an uncertain environment, you want to have more stored fat to carry you through the lean times. Whether because we’re leaner (financially, not physically) or because our burdens are heavier, it seems like people who lose their jobs in this recession are at much higher risk of a financial upset turning catastrophic.

I wonder if some people thought they were “storing fat” though their home equity. Either by making extra equity payments, or rising housing prices, maybe some thought they were storing up equity. The simultaneous drops in housing prices and credit availability have given the lie to that theory.

Cash is king right now, and cash is the only truly liquid investment. Times like these demonstrate the critical importance of keeping an emergency fund available.

Wednesday, October 22, 2008

Give the guy a break!

Sometimes the media coverage amazes me.

Take Joe the Plumber. The guy questions Barack Obama's tax plans at a campaign stop in Ohio. Based on Obama's answer to his question, the interaction gets posted to the internet, and is picked up by the McCain campaign, who used it in the last debate between McCain and Obama.

So apparently editors around the country start asking who is this Joe the Plumber, and what is his story. What seems like a hundred reporters sift through every public record on this guy, and report the following scoops:

His name isn't really Joe.
He doesn't hold a plumbing license.
At one point he was in arrears on his taxes.
The business he works for probably doesn't generate over $250,000 in earnings for the owner.

Who gives a crap.

What made the exchange newsworthy wasn't the question, or the questioner. It was the candidate's response. Barack Obama said "I think things go better when you share the wealth." What he meant was "I think things go better when I share your wealth." Barack Obama's tax plan proposes to use the government as the intermediary to transfer money from people who have it to people who don't.

Take from the rich and give to the poor.

As I have said before, Barack Obama will be the Robin Hood President.

And focusing on Joe, or Sam, or whatever his name is, distracts us from focusing on the candidate's proposals, and the implications of those proposals.

Monday, October 20, 2008

Tax Cut Semantics

When is a tax cut not a tax cut? Barack Obama claims that his economic proposals include tax cuts for 95% of Americans. But to do so would require redefining what it means to cut someone’s taxes. To understand what I mean, it’s necessary to illustrate the differences between tax deductions, nonrefundable tax credits, and refundable tax credits.

The basic concept behind income taxation is pretty simple. You take your income and subtract out deductions to come up with adjusted gross income (AGI). Then you multiply AGI by a percentage to figure how much tax you have to pay. The US tax is progressive. That is, the more money you make, the bigger the percentage you hand over to the Federal government.

Tax deductions are things like paying home mortgage interest, or saving for retirement by putting money into an IRA. You deduct the money you put into those things from your income. So if you are in a 15% tax bracket, for every dollar you put toward your IRA, your taxes are reduced by fifteen cents.

Your deductions can only drop your income down to zero. You can’t have negative income and get any kind of rebate from the IRS.

Then there are the tax credits, nonrefundable and refundable. After calculating how much tax you owe, based on your adjusted income, tax credits reduce the final sum of taxes paid. For every dollar of tax credit, your taxes are reduced by a dollar. For nonrefundable credits, you can reduce your tax liability down to zero, but then the game stops. With nonrefundable credits, you can’t have a negative liability and get any kind of a rebate from the IRS.

This brings us to refundable tax credits. With this type of tax credit, after your tax liability is reduced to zero, any credit left over is yours to keep. Which means the government sends you a check.

Tax deductions, nonrefundable tax credits, and refundable tax credits: guess which type the Barack Obama plan calls for when he says he’ll cut taxes for 95% of Americans? Now here’s the thing about this tax “cut.” After deductions from income, and existing tax credits, about 40% of American households don’t pay any income tax. But under the Obama plan, they would be getting money from the government.

So, getting back to our original question, when is a tax cut not a tax cut? When it’s welfare.

Tuesday, October 14, 2008

New Ideas for Spending Money

Where do they come up with this stuff?

In the face of a plunging stock market and moribund credit markets, both Presidential candidates are reaching deeper into their goodie bags to come up with new bribes, er, enticements to try and stimulate the economy. Sure, because $700 billion to buy up banks and mortgages wasn’t enough.

Last week John McCain fired off a salvo. He proposed rescinding the requirement that owners of IRA’s and 401K’s have to start taking withdrawals from retirement accounts starting at age 70 ½. Why force people to sell assets into a down market, when that just increases the downward pressure on stock values? Actually, I think this is a pretty good idea, but then again, I’ve never heard a good argument for why mandatory withdrawals from retirement accounts were necessary in the first place.

After meeting with his economic advisors over the weekend, McCain apparently felt that anything else they proposed was too gimmicky, so he hasn’t come out with anything new this week. Of course, there is one more presidential debate coming up, so maybe he’s saving up for that.

In the meantime, Barack Obama came out with multiple gimmicks, er, policy proposals this week. First, he wants to mail out a $1000 check to everyone whose household income was less than $150,000. He also wants to extend unemployment benefits for another 13 weeks. This looks like a straightforward increase in welfare to me, pure and simple.

Senator Obama wants to impose a three month moratorium on foreclosures for any bank that accepts the Federal bailout money. You have to wonder what the economic point of this is. Does he anticipate that people will start paying their mortgages again after a three month grace period? Wouldn’t an increase in the number of foreclosures in process (loans go delinquent, but none ever get resolved) put even more stress on the banks that taxpayer money is going to bail out? The political point is a little more self evident: “Vote for me, folks, and I’ll give you three months free rent!”

Then there is the idea of removing penalties for 401K withdrawals. This allows you to get the tax break for contributing to a retirement plan, without actually having to forego the immediate consumption. Americans don’t save enough for retirement now, so let’s make it easier to consume instead of invest. This is the triumph of short term gratification over long term planning. Times may be tough now, but they will be even tougher when you are too old to continue working.

My personal favorite among Senator Obama’s new proposals is the tax credit for adding employees to the payroll. He has proposed a $3000 tax credit be given to businesses for every person they hire. This is basically offering a bribe to go out and hire people, but it is not even an effective bribe. In my hiring and firing, if I need to hire people, I hire them, and $3000 from the government isn’t nearly enough to sway my opinion. A new employee costs at least $20,000 a year. Unless you have enough business to justify that expense, a $3000 dollar subsidy doesn’t begin to cover that cost.

As a conservative, I long for the days when every problem didn’t automatically become the concern of the US government. Both parties seem to be caught up in the game of seeing who can offer more tax revenue to the citizenry. I’ll be happy in three weeks when the Pander fest known as the general election campaign is over.

Wednesday, October 8, 2008

If at first you don't succeed...leave it alone.

The crisis in the nation’s, and the world’s, credit markets continues to persist. From reading news reports, I hear that credit is “frozen,” and that “banks are afraid to lend to one another.” The standard line being used is that without access to credit, businesses cannot buy inventory or payroll, consumers cannot buy cars or houses, and the entire economy is in danger of grinding to a halt.

In the face of the credit market freeze, the Federal Reserve and the Treasury are announcing new actions almost every day to try and get the buyers of securities off the sidelines (there is no shortage of people wanting to sell IOU’s, just not a lot of people buying them these days).

In the last week the Fed has taken the following actions:
-It has started buying unsecured commercial paper. These are basically short-term loans made to individual companies for funding operations. They are usually not backed by any collateral.
-Fed Chairman Ben Bernanke promised to cut interest rates in a speech on Tuesday. That’s usually good for cheering up the markets.
-This morning, the Fed did cut interest rates, along with six other central banks around the world, in a coordinated action. Okay, now we know all of the central bankers are serious about restarting the stalled credit markets.
-The latest proposal that has been floated is a plan for the Fed to buy ownership stakes in banks.

All of this of course, is on top of the $700 billion Treasury bailout that passed Congress last week, also known as the mother of all interventions.

The first thing that strikes me about all of this is the emphasis on making loans and borrowing money as the engine of the economy. Wasn’t it too much borrowing, and lending to people who couldn’t pay the money back that got us into this mess?

The other thing that strikes me is the frenetic nature of the government’s actions. They want an immediate reaction, and when the market doesn’t oblige, they cough up another plan to see if that will give them an immediate reaction.

In the manufacturing arena, one reaction to problems is called "overadjusting the process." You take a part coming off the machine, measure it, and then tweak the machine. Then you do it again, and again, and again. The problem with that is that you never let the process stabilize to normal capability. Sometimes you have to resist the temptation to keep pulling on the levers and knobs, and just let the machine run for a while to determine your true process capability.

It feels like governments are trying to do the same thing. Every day a new program or intervention is announced, without giving the markets time to settle down and get used to the last adjustment. It probably doesn't help that it is an election year. My favorite metaphor for this is “pulling the plant out of the soil to check on the growth of the roots.”

There are a lot of people who work in the credit markets. Leave 'em alone to do their jobs, and eventually they will figure out how to muddle through. Interest rates will spike higher for awhile, even for ultrasafe borrowers like the state of California and AT&T. But as investors figure out that California is not going to default, trading volume will go up, and rates will come back down.

I have a lot of faith in letting people muddle through. It is not always efficient, and it is almost never pretty, but in my experience, letting people do their jobs seems to work.

Tuesday, October 7, 2008

A Tale of Two Deals

A little less than two weeks ago, Citibank agreed to take over the banking operations of Wachovia Bank. This was a deal engineered by the Treasury Department to protect depositors of Wachovia. Although Wachovia did not technically fail, this was certainly a shotgun wedding arranged by the regulators. Citibank agreed to pay $2 billion for Wachovia.

Interestingly, Citibank agreed to pay for the first $41 billion of losses on Wachovia’s loan portfolio. After that, the Treasury (meaning we the people) agreed to indemnify the folks at Citibank for any additional losses. In other deals of this type, the government has taken the losses up front, as a sweetener to get the acquiring party to do the deal.

For example, when Bear Stearns was acquired by JP Morgan Chase earlier this year, the Federal Reserve took $30 billion of bad assets off Bear Stearns’ books before the sale went through. Since the Wachovia deal is structured the other way around, Citibank has powerful incentives to keep the losses as low as possible. This tells me that nobody, and I mean nobody, really knows which loans are going to default, and what the recovery on the collateral will be when all the foreclosures are done and the houses resold. But I digress.

So anyway, the Treasury pushes through a crash sale of Wachovia to Citibank. Three days later Wells Fargo offers $15 billion to buy Wachovia in a separate deal. The CEO of Wachovia, using the keen business acumen honed by decades of experience in high finance, quickly realizes the Wells Fargo offer is about 750% better than the Citibank offer. Wow, maybe the guy is worth the $19 million in signing bonus and severance pay he’s going to get for six months worth of work.

Wachovia’s Board of Directors quickly approves the sale to Wells Fargo. Citibank, spurned at the altar as Wachovia elopes with Wells Fargo, cries foul. All three banks hire $400 an hour lawyers and go searching for judges who will rule in their favor. The corporate equivalent of a barroom brawl erupts. Or maybe a mud wrestling match.

The latest news is that the banks have called off their attack dogs, and some kind of compromise deal is in the works. All very entertaining, but what does it have to do with us.

Just this: the guys at Treasury put together the Citigroup-Wachovia deal, and less than a week later somebody else offers 750% more for the same assets. And let’s not forget that there is no risk to the taxpayers in the Wells Fargo offer. Thirteen billion dollars is a lot of money to leave on the table in a negotiation. I mean, it’s not exactly a rounding error.

I can’t really fault the T-men either. Their priority was to protect the depositors, and get the deal done as smoothly as possible, with minimal disruption to the financial markets. Getting the best deal possible was never even on their radar screen. For the Citigroup team, getting the best deal possible is always their primary consideration, and those boys have sharp elbows. For that matter, the same could be said for Wells Fargo.

But here’s the thing. Didn’t Congress just pass legislation allocating $700 billion of the government’s money (meaning we the people) to buy up financial assets? Didn’t the money get allocated to the Treasury Department? And aren’t the T-men going to buy those financial assets from banks like Citigroup and Wells Fargo? Using our money? Forgive me if I’m wrong, but isn’t the Treasury’s primary goal to support the banks, and not to get the best deal possible?

We the people are going to get rolled like a drunk on New Year’s morning.

Sunday, October 5, 2008

It's been a wild ride so far!

The last month has been an amazing time to watch the financial markets. More and bigger changes have occurred among the major players in the US financial system than in the previous generation.

A quick recap:
The Federal government took over Fannie Mae and Freddie Mac, effectively nationalizing the US mortgage market.
Lehman Brothers goes bankrupt.
The US government buys 80% of one of the largest insurance companies, AIG, in exchange for an $85 billion loan.
Bank of America acquires Merrill Lynch.
After a run on deposits, Washington Mutual is taken over by Federal regulators and is sold to JP Morgan Chase. This is the largest bank failure in US history.
Just prior to failing, Federal regulators engineer a deal for Citibank to take over the banking operations of Wachovia bank.

While all that was happening, the last two major independent investment banks, Morgan Stanley and Goldman Sachs, decide to rewrite their charters to change to more ordinary commercial banks. This move will require them to continue the process of deleveraging that has been going on all year, and will also require them to accept a much higher level of regulation than they have previously had to deal with.

What else happened last week? Oh yeah, after the House rejected a $700 bailout of the financial markets, the Senate passed a sweetened bill, and the House accepted that. So now the Treasury is going to directly own $700 billion in mortgage packed securities. Since these will be distressed assets (otherwise why sell them to the bailout fund), it is likely the government will own mortgages with a face value of well over a trillion dollars.

So, while competition in the banking sector is being dramatically reduced, and the investment banking industry is essentially eliminated, the Federal government becomes the largest player in the mortgage market.

I thought we were supposed to be the guys who believed in free markets.

Thursday, October 2, 2008

Financial Market Bailout, Take II

If at first you don’t succeed…

The government’s bailout plan for the credit markets passed in the US Senate last night, after failing in the House of Representatives on Monday. The revised legislation will probably come up for another vote in the House on Friday.

In the first stampeded rush to judgement, the unpopular bill failed, in part because of the very size of the package, and the unprecedented leeway the Treasury secretary was given in handing out $700 billion of the taxpayer’s money. Also disturbing many lawmakers, of both parties, was how quickly the message of the administration changed from “the system is stressed, but still working,” over to “if you don’t give us this authority, your ATM will stop working.”

In order to get more votes for the proposal (note I did not say “make the proposal more popular”) the Senate followed the time honored tradition of packing more lard into the pork barrel. The revised plan now includes an increase in insurance on bank deposits, up from $100,000 to $250,000. It now also includes a grab bag of tax breaks estimated to cost another $100 billion.

Great! Spending $700 billion in one fell swoop isn’t enough. Let’s plug another $100 billion on top of that. I thought this plan was half baked before. The Senate version looks like they pulled the cake out of the oven, saw it was half baked, and decided the answer was to add a bunch more ingredients to the mix.

I’ve heard of smearing lipstick on a pig, but who knew they had invented lipstick body wash?

Adding to the hysteria has been the behavior of the stock market. The House fails the bill, and the market drops 700 points! The bailout is resurrected in the Senate, and the market leaps 500 points! The market opens quiet, waiting to see if the revised bailout passes the House!

I’m put in mind of the two year old who throws a tantrum in the aisle of the grocery store until the parent buys them the candy they want.

Try this on for size: leave the markets alone. If the credit market starts to seize up, let it. In the short run, interest rates will go up, and it will be harder to get loans. But after a while, the boys and girls on Wall Street will figure out that if they don’t play nice, their jobs will go away, and the markets will start functioning again.

At least, that’s my theory. I call it “Free Market Economics.” It’s too bad that we’re not going to see that theory tried out.