Public Policy – Page 73 – The Aleph Blog

Notes from Recent Travels

Posted on 21 November 200922 November 2009 by David Merkel

Before I begin this evening, I would like to comment on my absence for the last week.? I gave a talk on Friday to the Southeastern Actuaries Conference.? I found myself behind the eight-ball, because of my many other projects, and so I had to block out the time to write and prepare the talk.

I?m going to turn the talk into a post, or a series of posts.? If you want to view the presentation before then, you can download it here (PPT PDF).? I needed more time; I wanted to do more with it ? but you reach the end of your time, and you have to make your speech. ?I didn?t feel well on the day I presented it; my throat was sore.? So, my apologies to any at SEAC who felt my talk was marginal.

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One thing that came out of the SEAC meetings was an actuarial analysis of the health bill.? The presenter tried to be as neutral as possible, but the more he said, the more the actuaries I talked with said, ?This bill doesn?t make sense.?? Now, I?m not a health actuary; I am a life and investments actuary by training.? Roughly 1/3rd of the audience were health actuaries, and 2/3rds were life actuaries.? The response was not, ?This will hurt the industry.?? The response was more like, ?This won?t work.? The costs are underestimated, and the taxes are overestimated.? This has real potential to mess up the good parts of the system, and be a very costly fix to the less generous parts of the system.? Taxes are front-ended, and costs are back-ended.? The analyses that show savings over ten years will show significant losses in the long run.

Among my pet peeves is that the bills are likely to do away with HSAs, which more than most health plan designs, gives real incentives to keep health care costs down.? If anything, moving away from first dollar coverage to catastrophic coverage would be a real incentive to keep down health costs.

I genuinely hope this does not pass Congress, and that nothing is done.? Then again, perhaps the Democrats want to commit political suicide.? Not that I like the Republicans much, but cramming through an ill-thought-out plan not favored by most Americans, can?t do much for their chances in 2010.

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Secretary Geithner changed his view on why the AIG bailout was done.? He now says it was not over the derivatives counterparty, AIG Financial Products.? He probably says that because the government could have cut a better deal with creditors and did not, leaving the taxpayers on the hook.? Having thus bailed out Goldman, and other US and foreign investment banks that were due payments from AIG, the malodor of aiding investment banks in an opaque way is something the Treasury wants to lose.

So, now he claims it was to prevent systemic risk from failure of AIG?s operating insurance companies.? Now, I know that the life and mortgage insurance companies would have died, because of research I did in March and April of 2009.? But in September of 2008, no one was arguing about the insurance subsidiaries; it was all about AIG Financial Products.? No one was focusing on the weird losses from securities lending at the life subsidiaries of AIG.

Taking a step back, Insurance companies don?t produce systemic risk to the same degree that banks do.? First, the insurance industry is only one-third the size of the banking industry.? Second, insurance asset investment regulations are stricter for insurers than the bank regulations.? Third, the leverage isn?t as high, and the sources of profit are more diversified.? Finally, the liability structure is longer for most insurers, making ?runs? less likely.

So, what would have happened if the Fed hadn?t come in and rescued AIG?

I recommended at the time that the government wall off the derivatives counterparty, and then analyze what the risks would be to the system as a whole if AIG did not pay on its derivative agreements in full.
The life and mortgage companies would have failed.? The mortgage companies would have added to the losses of Fannie and Freddie.? No state guaranty funds there.? The life companies might have passed $1-3 billion of losses to the state guaranty funds, hitting the life insurance industry when it was weak, but it would have killed few companies.
There were support clauses in many of AIG?s main P&C companies for some of the Life companies.? The P&C companies could have made good on those, and perhaps the state guaranty funds would have been clear.
Perhaps International Lease Finance or American General Finance would have been weak, but they would not have died immediately? and there would have been little systematic risk from any failure.
Common and preferred shareholders would have been wiped out, and maybe junior bondholders.? Senior bondholders might have been forced to compromise.

This isn?t good, but it is also not systematic risk.? After walling off AIGFP, there was no systemic risk from letting AIG fail.

Holding companies should never be bailed out.? There is no case for protecting them.? Operating subsidiaries are another thing; they are regulated for the good of consumers, ostensibly.

Ergo, I find the logic of the Treasury and Secretary Geithner wanting if he is claiming he was trying to avoid systemic risk in bailing out AIG, outside of AIGFP.? These arguments were not made in 2008, and in general, it is really difficult for an insurance company to generate systemic risk.? Systemic risk stems from short-funded financials, and in general, insurance companies do not fit that description.

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This is just another reason why average Americans don?t trust the Fed.? But there are many reasons:

The Fed will not submit to full transparency of its actions.
They will not comply with legitimate FOIA requests.
They can?t be replaced by the people, but they have a big impact on the lives of the people.
Congress does a lousy job regulating them.
They acted high-handedly in bailing out entities like Bear Stearns and AIG that should have been put into bankruptcy.? Bailouts violate the sense of fairness that most Americans have.? Systemic risk could have been avoided without bailing them out in entire.

Is it any surprise then, the Congress, having done a lousy job of regulating the Fed and the Treasury, points the finger and blames those that they have been appointed to rule?? Alas, I see a lot of room for blame to go around, but few are willing to take it in DC.? There is no equivalent of Truman?s ?The Buck Stops Here.?

In a bad environment like this, many governmental entities worry for their survival.? Good.? They should worry.? There is the outside possibility that things could change dramatically after the next election.? Perhaps ending the Fed won’t be a pipe dream then.? After all, the US did quite well without a central bank for most of its existence.

Deeds, not Words on the US Dollar

Posted on 12 November 2009 by David Merkel

From Bloomberg, I quote our Treasury Secretary:

?I believe deeply that it?s very important to the United States, to the economic health of the United States, that we maintain a strong dollar,? Geithner told reporters in Tokyo today.

Before I write, I can hear my friend Caroline Baum of Bloomberg gearing up her mental energies to say something like, “Again?? How many times can they say that with a straight face?”

If I wanted to create a strong dollar, what would I do?

I would have the Fed raise short-term rates.
I would reduce the creation of dollar claims by bringing the Federal budget into balance.

Neither of these are realities.? Thus the weak dollar.

But perhaps there is another way, and if you are reading me at the Treasury, please listen.? The idea is to make the countries that have acquired a lot of Dollar obligations realize that they are likely better off acquiring goods and services from the US now, rather than at a lower exchange rate later.

There is brinksmanship here, but when I was a bond trader, I could make it happen.? In the present context, there is no value to piling up more dollar obligations in exchange for goods today, unless one has a domestic political agenda to fulfill.

Now, with Japan and China, (and OPEC) both should be encouraged in this way.? Buy today, your dollars will likely buy less tomorrow.? That one action would restore balance to the global economy, as less business would be done on a credit basis across nations.

After that, the harder problem of dealing with structural US budget deficits becomes paramount.? What do you do with a government that has promised more than it can deliver?? The French Revolution comes to mind, but maybe we can do something more gentle.? The President addresses the nation, and tells the Baby Boomers that benefits from Medicare will be reduced.? It becomes a small medical needs and hospice program.? The nation can’t afford anything more, and if you were paying attention, you knew that.? Oh, and the foolish Part D, created by Bush gets eliminated, with no replacement.

As for Social Security, it becomes means-tested, and becomes an old age welfare program, complete with stigma.? “If you are receiving Social Security, you couldn’t have done that well.”

If we take actions like that, the US can survive.? Short of that, we face significant inflation, and a greater diminution of our living standards.

Until then, whoever is our Treasury Secretary will go around the world and say, “The US is committed to a strong dollar.”? And this is a valuable service.? We all need fairy tales to help us fall asleep easily at night, both here and abroad.

How to Regulate the Banks, and other Financials

Posted on 11 November 2009 by David Merkel

At the Treasury meeting, I commented that the insurers were better regulated for solvency than the banks.? One of the reasons for that is that they do harder stress tests, and they look longer-term.

So, if one is trying to regulate banks for solvency, there are two things to do:

Set risk-based capital formulas so that few institutions fail.
Make it even less likely that larger institutions fail.

As a clever old boss of mine once said, “A banks liabilities are its assets, and its assets are its liabilities.”? The idea is this — banks that focus on their deposit franchises have something of real value — that is hard to replicate.? But any bank can invest their funds aggressively, which will lead to defaults with higher frequency.? It is true of insurers as well, most financials die from bad investing policies, and short-term liabilities that require complacent funding markets.

The essence of a good risk-based capital formula is that it forces intelligent diversification, and forces adequate liquidity.? No assets should be bought that the liability structure of the bank cannot hold until maturity.? There should be no concentration of assets by class, subclass, or credit, that would be adequate to lead to failure.

My view is that a proper risk-based capital regime would start with asset subclasses, and double the capital held on the largest subclass, and 1.5X the capital on the second largest subclass.? After that, within each subclass, the top 10 credits get twice the level of capital, the next 10 1.5x the level of capital.

Having managed assets in a framework like this, I can tell you that it creates diversification.? But the next part is even more important, because short-term funding structures are a recipe for default.

It is almost always initially profitable to borrow short and lend long.? That said, it is a noisy trade.? Who can be sure that short rates will remain below the rates at which one invested long?? The second component of a good risk-based capital formula is that there is no investing in assets that are longer than the liabilities that fund the financial institution.? (For wonks only: regulated financial institutions should be matching assets versus liabilities as their most aggressive posture.? Unregulated financials can do what they want.? And no investing in unregulated financials by regulated financials.)

But after all that, there must be a capital penalty on larger institutions.? Let financial institutions get as large as they like, but once they get to a certain level of assets, say $100 billion, start raising capital requirements so that it is uneconomic to manage more than $500 billion in assets.? If we had regulations like that, the too big to fail issue would not occur.? As they got close to the barrier banks would break themselves up, without any external intervention.

Beyond that, no modeling of asset correlations would be brought into the modeling because risky asset correlations go to one in a crisis. Any advantage derived from diversification should be accepted as earned, and not capitalized as planned for.

Dodd’s Proposals

There are good things in Senator Dodd’s proposals, but I want to focus on a few things.

Either eliminate the Fed, or let it manage systemic risk.? Why?? The Fed creates most systemic risk through its monetary policy.? What tools would a new regulator have to constrain the Fed?? None?? I thought so.? In a fiat currency economy, the central bank must constrain credit in order to constrain monetary policy and systemic risk.

I don’t think there has to be a single regulator, as much as the regulators should choose whom they regulate, rather than vice-versa.? Options are always bad for financial institutions.? One should want them to apply to the Treasury for a regulator, and the Treasury assigns the regulator that will minimize risks to the nation.

As for changing governance of the Fed, Dodd’s bill misses the point.? We don’t care who governs it. We do care what their goals are.? We want them to minimize goods and asset inflation, while not letting the economy go fallow through capital or labor unemployment.

I’m not crazy about Dodd’s plans to select members of the FOMC by a vote from the Fed Board.? That just centralizes power in the hands of incompetent Fed Board members.

Personally, if I can’t eliminate the Fed, I would rather its members be democratically elected each congressional cycle.? Yes, initially the electorate would make errors, electing those that promise greater prosperity, but eventually they would realize that they need to elect those that will restrain inflation, regardless of the consequences.? I trust the people of America more than the elites that have mismanaged it.

My Visit to the US Treasury, Part 7 (Final)

Posted on 10 November 2009 by David Merkel

Things have been busy for me, so this final part should be short.? What did I learn that I did not already know?? Not much, except:

The Treasury wants to convince? the public that it is doing its best, but that Congress is a slave to the Financial Services industries.
When asked about the latest bailout of GMAC, they said that didn’t qualify as a financial — the aid was to help the auto companies.? (If so, send it directly, and let GMAC expire.)
They said that they worried about the same things we did, though they had to maintain public confidence, and did not think it was as likely as we thought.
They did not bring up the GSEs.
They pointed at the financial markets as evidence of recovery, and did not speak of the real economy, which is weak.
There is no acknowledgment of what could go wrong in the long-run.? They are only playing for the next 3-7 years, at most.? Everything is done to goose the next year.
That the Treasury is trying to reduce its footprint in the economy is welcome news to me.
They said that they were trying to be wise stewards of the economy, but that Congress had questionable motives.

May I go back to my original questions:

Haven?t low interest rates boosted speculation and not the real economy?
We are looking at big deficits for the next seven years, but what happens when the flows from Social Security begin to reverse seven years out?? What is your long-term plan for the solvency of the United States?
We talk about a strong dollar policy, but we flood the rest of the world with dollar claims.? How can we have a strong dollar?
None of your policies has moved to reduce the culture of leverage.? How will you reduce total leverage in the US?
Why did you sacrifice public trust that the Treasury would be equitable, in order to bail out private entities at the holding company [level]?? People now believe that in a crisis, the government takes from the prudent to reward the foolish.? Why should the prudent back such a government?
If we had to do bailouts, why did we bail out financial holding companies, which are not systemically important, instead of their systemically critical subsidiaries?
We are discussing giving tools to regulators for the tighter management of the solvency of financials.? There were tools for managing solvency in the past that went unused.? Why should we believe the new ?stronger? tools will be used when the older tools weren?t used to their full capacity?? (The banks push back hard.)

I’ve answered 1 and 2.? The rest are unanswered.? Here are the brief answers.

3) No, there is no strong dollar policy.? Wait for the day when we are net exporters (and our relative wages will be lower then.)

4) They are doing nothing to? reduce total leverage in the US.? My own guess is that it is increasing.

5) And there is the question, aside from fairness, were the bailouts Constitutional?? A narrow reading of the Constitution says no, but our government does many, many things that violate a narrow reading of the Constitution.? The fairness question was not raised either, the bloggers there were attacking effectiveness, not fairness.

6) This is my guess — we bailed out holding companies because it was the simplest way to do it.? More thought would have led to a cheaper solution, but thought is rare during a panic.

7) I have no answer to point 7.? There is no good reason to hand over stronger tools to a culture that has not used weaker tools.

Aside from all that, we could have spent more time on international issues.? There was the joke at the beginning of the session that one fellow tasked with raising money was “fluent in Mandarin.”?? From the chuckles, I gauged it to be a joke.

But that might prove to be the most significant point economically.? The Treasury is putting pressure on the Dollar through high debt issuance, and the Fed through the creation of short-term credit to heal various debt markets.? The benefits are going to debtors, not creditors.? What value should the creditors assign to the Dollar?? The simple answer should be less than previously.? Yet, nations follow many noneconomic goals, many of which benefit the US as the reserve currency in the short-run.

The ultimate answers are complex, because they rely on how other nations will act.

Final Note

I have found interesting the commenters that automatically assume that being willing to go to the Treasury and eat one cookie equals compromise.? There are a lot of scared and frustrated people in the US, and they see their prosperity ebbing, and are looking for someone to blame.

Let me try this — as the world has gone capitalist, the edge of the US has been eroded.? Now we face a world where doing certain jobe should pay the same, regardless of where they are located.? Wages in the US will converge with those from the rest of the world, adjusted for capital investments.

Throughout human history, “middle classes” have been abnormal.? The current adjustment in the US may be showing the once large middle class that it is not a normal thing, and is hard to maintain.

There is no conspiracy.? The US Government is up against economic forces larger than it can combat.? The rest of the world is out-competing the US, and the US? has a shrinking portion of the pie as a result.

My Visit to the US Treasury, Part 6

Posted on 7 November 20098 November 2009 by David Merkel

Now, none of us knew when we came that only bloggers were invited.? Personally, I expected it to be a broader press briefing that some bloggers could come to as well.? “Deep background” is well understood to the press, but new to bloggers.? My blogging friends at the meeting can correct me, but all of us were surprised that it was only bloggers at the meeting.

My only clue that they might have treated us nicer than some other gatherings, was that some staffers not at the meeting came in after the meeting to raid some cookies.? Now, maybe that is normal regardless there.? I’ve seen the same things in corporate settings.? The e-mail announcement, “Open season in room 406!”? That said, the chocolate chip cookies were all gone. :(? I had one, as did Tyler, I think.? Maybe the Treasury officials had the rest.

Personally, I am comfortable with the restrictions on reporting from the meeting.? The Treasury’s high-level staff sound the same tune.? It doesn’t matter if we identify them or not, they reflect the policies of the Obama Treasury.? With restrictions on not identifying who said what, to me it does not matter, because they were senior Treasury officials.? We can quote, or approximately quote.? We can’t tie it to a single person.? That doesn’t affect us much.? We know what they think, and we can write about it.? We just can’t say exactly who said it, or whether they were there.

Making Money or Not

Few areas of the US government are designed to make money.? One of the main points that Treasury made to us was that the TARP would cost little, or might make money.? TARP is a piece of a larger puzzle.? My question is this, counting in all of the bailouts, including all stimulus programs, what is the cost to the taxpayer?? Now, I ask my readers what they know here. E-mail me with any comprehensive pieces that you have seen, or put it in the comments, so that all can see.

When I look at the bailouts, AIG, Fannie, and Freddie have sucked up /are sucking up resources.? With respect to the GSEs, I appreciate the view that the Administration views Fannie and Freddie as a hole in the system that they can use to funnel money to housing without asking Congress for approval.? Certainly their financial result show it.? Fannie lost a lot of money last quarter and is begging for help.? Freddie lost less, but is not asking for money now, but they likely will in the future.? As for the Treasury, they have opted to not maximize the value of Fannie by allowing her to sell of tax credits to others, notably Goldman and Berky.? They are not interested in maximizing the value of the GSEs, only of using them for their policy goals.

One slide the Treasury showed us was that they thought they were making money across all of the TARP bailouts that they did.? Also, that their guarantee programs had made money as well.

True, so far the guarantee programs have made money.? That does not mean that the government should be in that business, as it may encourage greater risk taking later, because they think the government will rescue them in times of trouble.? In England, at least some think it is a bad precedent.

TARP may be doing okay, but the same moral hazard argument applies.? Also, bailouts may come after shareholders have lost a lot, but management teams may (and seem to be now) benefit disproportionately from the bailout.? Away from that, the losses from the GSEs, Auto companies, and AIG swamp other gains.? That’s what it seems to me.? Does anyone else know better?? Please put it in the comments, for all to see.

Away from that, consider how the FDIC is basically broke, and that the FHA is not far behind.? This crisis is not over.

A Place of Agreement

One place where I can agree with the Treasury is that there should be only one regulator of depositary institutions.? The insurance industry can choose among states, but for the most part there are states for big companies,and states for small companies.? The states willing to regulate the big insurance companies have done a great job relative to the banking regulators.? There are few failures.? AIG died for non-insurance reasons.? Penn Treaty was a basket case long before the crisis.? Who else died?

Having one regulator for banks will remove the ability of the banks to choose the weak regulator.? It raises the risk that the one regulator will be corrupted.? That’s a lesser risk, because with many regulators, the odds that one will be corrupt are high, and corrupt institutions will go to them to be regulated.? With one regulator, politicians can more easily watch the troubles, and can more easily assign blame.

I have no objection to one national insurance regulator either.? That said, many states will object, because they have differing standards.? But does Congress really want to do insurance law?? It takes up a lot of time and is complex.

The Final Note for Now

Things always look best for a borrower immediately after his most recent loan.? So it is for most programs in our economy that favor giving loans in this crisis to stimulate demand.? So it was in the 70s and 80s with lesser developed countries.? The finances looked great after the loans, but after they had spent it away on consumption, things looked much, much, worse.

So it is with government programs that interfere with the free market through offering cheap lending terms.? They give a temporary lift that leads to greater problems once the subsidy is spent away.? So it is now with government subsidies and loans.

Other Posts

Two more posts on the meeting, one from a blogger who was there:

A Sit Down With Senior Treasury Officials – Part II

and one who was not, somewhat critical, but constructively so:

Treasury and the?Blogs

As for me, I’m glad I went.? I have a better zeitgeist of the US Treasury.? I am not more impressed, nor less impressed with them.? I do want the Federal Reserve to consider inviting us to meet with them.? They are far less accountable than the Treasury, and many of us would like to counsel them on their behavior that seemed smart at the time, but will likely prove destructive to the republic.? Dare you invite us, Ben, or do you have less courage than the Treasury?

My Visit to the US Treasury, Part 5

Posted on 7 November 20097 November 2009 by David Merkel

One other blogger took his nameplate with him — I’m not sure who; the rest left theirs.? But this is what was in front of each one of us as we sat down to discuss matters at the US Treasury.? Treasury officials had similar nameplates.? It dictated where we would sit as well.? From the front of the room on the left, for bloggers it was Financial Armageddon, (Megan McArdle — not there), Accrued Interest, and Across the Curve.? On the right, Naked Capitalism, Kid Dynamite, Interfluidity, Me, and Marginal Revolution.? Aside from putting the two bloggers with the most traffic at the front, there did not seem to be any rhyme or reason to the seating.

The Treasury officials presenting generally sat in front, a few sat to the side and behind us.? It made for an interesting dynamic during the portion of the meeting where some bloggers disagreed over whether derivatives should be exchange traded or not.? The folks from the Treasury grinned.? See?? These aren’t easy questions to answer!? For me, with a middle view (bring interest rate swaps to exchanges first and see how they work, then try other instruments that are less liquid), I found the exchange to be a waste of precious time, but it was revealing of the attitudes of those in the Treasury.? I knew what the bloggers thought already.

The Biggest Financial Problem

I’ve written a number of pieces on why debt matters. (Or, where is the breaking point?)? I am in the process of reviewing This Time is Different: Eight Centuries of Financial Folly — a book that deals with the reality of sovereign defaults over the last 800 years.

Surprise! Over-indebted countries do default on their debt more often than less-indebted countries.? During the current crisis, we have two mechanisms running to blunt the troubles.? The government is running a large deficit, and the central bank is sucking in longer-dated bonds to lower interest rates.? I talked about why lower interest rates are not necessarily a blessing yesterday.? Today’s thoughts are on deficits.

After the meeting, I said to one Treasury staffer, “One of the quiet casualties of this crisis is that you lost your last bit of slack from the entitlement systems.”

“What do you mean?”

“Just this, prior to the crisis, Social Security and Medicare would produce cash flow surpluses for the Government until 2018.? Now the estimates are 2016, and my guess is more like 2014.? The existing higher deficit takes us out to the point where the entitlement systems go into permanent negative cash flow.? This means that the US budget is in a structural deficit for as far as the eye can see, fifty years or more, absent changes to entitlements.”

He looked at me and commented that it would be the job of a later administration.? No way to handle that now.? To me, the answer reminded me of what I say to myself when I go on a scary ride at Six Flags with my kids.? There is nothing we can do to change matters.? The only thing to adjust is attitude.? So, ignore the fact that you are afraid of heights, and enjoy the torture, okay?

Would that I could do that with the present situation.? The long term problems are too numerous, and the present crisis saps attention from what is arguably a larger problem.? Medicare, Social Security, unfunded Federal pensions and retiree healthcare, underfunded state pensions and unfunded retiree healthcare, and underfunded corporate pensions (flowing to the PBGC) are the crisis of the future.? We are talking underfunding and debts equivalent to 4x GDP in total.

The deficits may be helping out areas of our economy for which there is already too much capacity — autos, banks, housing, but isn’t aiding the parts of the economy that don’t have excess capacity.? The one advantage to Americans is that a decent amount of the debt is absorbed by the neomercantilists, who will get paid? back in cheaper dollars (if at all) than the goods that they provided originally.

This all feels like the Japan scenario.? Low interest rates, low growth if any in non-protected sectors, soggy debt-laden protected sectors, excess capacity in areas not salable to the rest of the world, high government debt, and a demographic crisis.? Also speculation using cheap leverage for carry trades.

I’ll try to tie this up in another post or two.? Sorry if this is verbose.

My Visit to the US Treasury, Part 4

Posted on 6 November 2009 by David Merkel

So, who did I recommend for the next meeting at the Treasury? (I think there will be one.)

Economists View http://economistsview.typepad.com/
Cafe Americain http://jessescrossroadscafe.blogspot.com/
Market-Ticker http://market-ticker.denninger.net/
Econbrowser http://www.econbrowser.com/
Greg Mankiw?s Blog http://gregmankiw.blogspot.com/
Carpe Diem http://mjperry.blogspot.com/
Credit Writedowns http://www.creditwritedowns.com/
Gregor Macdonald http://gregor.us/
Jeff Miller http://oldprof.typepad.com/
Floyd Norris — NYT http://norris.blogs.nytimes.com/
Market Beat — WSJ and their real time economics blog, deals, and real estate blog… http://blogs.wsj.com/marketbeat/
FT Alphaville — http://ftalphaville.ft.com/
James Pethokoukis — Reuters http://blogs.reuters.com/james-pethokoukis/ (also Matt Goldstein and Rolfe Winkler at Reuters)
Curious Capitalist — Time http://curiouscapitalist.blogs.time.com/
Matt Taibbi — http://trueslant.com/matttaibbi/ (And others at the same site)
Trader Mark http://www.fundmymutualfund.com/
Dealbreaker http://www.dealbreaker.com/
The Epicurean Dealmaker http://epicureandealmaker.blogspot.com/
Ultimi Barbarorum http://ultimibarbarorum.com/
Zero Hedge http://www.zerohedge.com/ (ask for Tyler Durden or Marla Singer)
The Reformed Broker http://thereformedbroker.com/
Crossing Wall Street http://www.crossingwallstreet.com/index.html
Cody Willard http://cody.blogs.foxbusiness.com/

Add to that good ideas from my readers:

Warren Mosler
Bill Cara

Now, Treasury responded to me, thanking me for the list, but said that the mainstream media bloggers already have access.? Fine with me — I was just gauging talent and reach.

The Nature of a Liquidity Trap

Go back in history over the last 25 years.? How did the Fed manufacture recoveries?? They lowered interest rates enough so that borrowers would be willing to borrow and refinance assets that had cash flow streams that were not financable in the higher interest rate environment, but financable in the lower interest rate environment.

With each successive rescue, interest rates at the trough were lower than before, inviting borrowers that were increasingly marginal to buy assets, borrowing money at cheap rates to pay them off over time.? We thought we saw the bottom, 2002-2004, but no.? The Fed Funds rate can go to zero, and what’s more the Fed can buy longer dated Treasuries, Agencies, and Mortgage Bonds, lowering interest rates on the longer end of the yield curve.? This allows even more marginal borrowers to buy assets. If they face some hiccup in their cash flow, they will default, and quickly.? If you doubt this, consider the high currently expected rate of default on FHA loans originated over the last two years.

Yes, low rates can get them to buy, but it cannot get them to hold on.? But wait, these are criticisms of the Fed, not the Treasury.? Mostly so, but what of the expensive housing tax credit? and cash for clunkers.? Those belog to the Treasury.? They are not economic programs — the costs far outweigh the benefits.? But wait.? Those shouldn’t be pinned on the Treasury; Congress, bought and paid for, are pushing these programs on behalf of their lobbyists.

If so, where is the administration to shame Congress over such behavior?? Where is the President who should press for a line-item veto?? (I like Wisconsin’s version. 😀 )? Let the Treasury, backed by Obama, ascend to the bully pulpit, and say that such programs are a waste of taxpayer dollars.

The Fed and Treasury have been able to touch of a speculative rally in financial assets, which benefits financials, but with weakness in? end-user demand, the lower rates do nothing to stimulate investment in plant and equipment.

All that said, there are three things that could go wrong here:

Contrary to the expectations of the Fed, inflation could rise, and cause the Fed to tighten.
All of the excess dollar claims could lead to greater depreciation of the dollar.
Defaults could cause credit spreads to widen.

Those have not gone wrong yet, but they are all threats.? More tomorrow, when I discuss difficulties with entitlement programs.

My Visit to the US Treasury, Part 3

Posted on 5 November 2009 by David Merkel

Going back to bank stress-testing for a moment, one interesting thing that a Treasury official said at the meeting was that unemployment did not have a big effect on foreclosures.? Unemployment has a big effect on credit card defaults, but not foreclosures.? I disagree.

As a multi-purpose quant, I have learned over the years that it is impossible to estimate an option curve/function when the variable in question has only been “in the money” or “out of the money.”? (As an example, one can’t estimate the withdrawal function on deferred annuities because haven’t had a large sustained rise in interest rates since the product was created.)? With mortgage debt, over the last 70 years, real estate values? have never fallen enough to make default a reasonable choice until now. Thus in the past, when unemployment hit, one could sell, rather than default.? As I have said before, foreclosure typically occurs when someone is inverted on their mortgage, and a life event happens: death, divorce, disability, disaster, disemployment, change in financing terms, or deciding that it is worthless (and doing a strategic default).

But now residential real estate values have fallen.? When someone loses their job, the option to default becomes real.? Do a short sale, and give the bank a hit.

With stress-testing, the devil is in the details.? How do you turn unemployment, housing prices, etc., into losses tailored for each individual company?? Different underwriting standards can make quite a difference in the results.? I would have been more than happy to dig through detailed stress testing models.? That was my job once.

When the Treasury announced the stress-testing results, it was at? a time when the gloom was thick.? It was a positive to the market that the government would not require huge amounts of extra capital, and in most cases, no extra capital.? Thus the market rallied.

With many simple asset classes that were under stress, the Fed and Treasury offered guarantees that would enable them to easily survive the panic.? Absent the guarantees, most short assets would have been “money good,” but there would have been significant doubt for a brief time.

As I commented to a Treasury staffer after the meeting, with financing rates so cheap to buy financial debts, regardless of what kind, it is no surprise that corporate bond spreads have tightened, while there is still little lending to finance growth in the real economy.? That is why there is such a gap between Wall Street and Main Street.

Main Street sees unemployment and low capacity utilization.? Wall Street looks at bond spreads and P/Es.? Those are not the same things.? The current stimulus has emphasized healing the financial sector in an effort to avoid contagion and depression.? It does not directly address slack in the real economy.? The real economy funds the bailout of financials, but does not directly benefit.? Thus the disconnect between Main Street and Wall Street.

Many financial? measures and companies have rebounded, but little expansion has occurred in the real economy.? Even with companies that have done bond offerings, they have often used the proceeds to bolster the balance sheet, rather than expand capacity.? Safety first is the watchword.

Perhaps a change happens when companies with a lot of cash appear as takeover targets in a sluggish market.? Easier to grow market share through acquisition rather than organically, and what’s better, their cash helps pay for the deal.

Housing Initiatives

It seems that the low end of the housing market has bottomed.? Government programs have something to do with it.? The tax credit has made a difference in the short run, as has the efforts of the Fed to support the mortgage markets through the purchase of RMBS.

Mortgage modifications are advertised by the Treasury, but the results are small.? Away from that, I will say that successful modifications occur more likely when there is some degree of principal forgiveness.

Tonight, I will pick up on the risks of low interest rates in part 4.

Who was Invited?

I’ve been in touch with staffers at the Treasury.? One of them gave me a list of the invitees.? Here is the list of those invited that did not come:
Abnormal Returns
Alea
Barry Ritholtz
Clusterstock
Free Exchange at The Economist
Paul Kedrosky
Andrew Leonard
Calculated Risk
Yglesias
Megan McArdle
Mike Konczal
Baseline Scenario
Mish
The Audit at Columbia Journalism Review
Credit Slips
Prudent Investor
Brad Delong
Felix Salmon

If you were in the Treasury’s shoes, who else would you have invited?? E-mail me, or put it in the comments.? Tomorrow I will mention who I thought would have been good additional guests.

Continuing Coverage

Here is a list of posts to date on the meeting:

Friday in Vegas (Kid Dynamite):
“A Sit Down With Senior Treasury Officials – Part I”

Naked Capitalism:
“Curious Meeting at Treasury Department”

The Aleph Blog:
“My Visit to the US Treasury, Part 1”
“My Visit to the US Treasury, Part 2”

Across the Curve:
“Bond Market Open November 04 2009”

Accrued Interest:
“Financial Regulation: How Would You Have It Work?”

Michael Panzner
Treasury Officials Meet With Financial Bloggers

A Few Observations of My Own

Interfluidity
Sympathy for the Treasury

That’s all for now.? Until this evening and part 4.

My Visit to the US Treasury, Part 2

Posted on 4 November 20094 November 2009 by David Merkel

Before I start this evening, to all my fellow bloggers out there, if you were invited to the gathering at the US Treasury and did not come, I have a request and a question:

If you were invited, send me an e-mail.
Tell me why you decided not to come, if you would.

If present trends continue, I can tell you that bloggers are not pushovers for the US Treasury, but neither are they deaf or heartless.? Since my last post, here are the responses to the gathering:

As all bloggers there will note, those from the Treasury were kind, intelligent, funny… they were real people, unlike the common tendency to demonize those in DC.? As for me, I live near DC, and I am an economic libertarian, but I have many friends at many levels inside our bloated government.

They have to do their jobs.? If there is a conspiracy, it is well-hidden.? There are simpler ways to understand the mess that comes out of national politics.? We get the result that is least offensive to the most, and pleasing to few.

We had a good discussion, but I am not the one to put myself forward.? I made some comments, but did not get to ask my questions.? My personality was not the dominant one.

What I propose to do in this series of articles is go through the main arguments of the US Treasury from the handouts that they gave us (sorry, I can’t scan them and put them out for view), and try to give a fair rendering of what they have done.? My audience is dual: I am addressing those who read me in the blogosphere, and those at the Treasury.

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Treasury officials said that they were trying to reduce the footprint of the rescues/bailouts as much as possible, doing it at a rate that would not jeopardize the recovery.? Their goal is to put in place? regulations that will prevent future disasters once the current disaster is past.

David: Well, yeah, that’s what to do if you can.? The question is what will happen to the markets when you start to remove significant stimulus from critical areas, as I said to my pal Cody a year ago.? Much of that is not in the domain of the Treasury, but the Fed.

The Treasury understands that the troubles of 2008 came from poor credit regulation and tight coupling in the financial system.

David: we over-encouraged single family housing as a goal for Americans.? When debt was too high for cash flows from average American households to afford residential housing, the prices of housing began to fall, and the foreclosure process began, as foreclosures happen once someone is inverted on their mortgage.? Residential real estate prices overshot by a lot.? We should be surprised that there are problems now?

I would not only eliminate the tax credit for new buyers, but I would phase out the interest deduction for mortgage interest.? Get people financing with equity, not debt, even if it means the economy is sluggish for a few years.? It will bring a longer-lasting self-sustaining recovery.? Debt-based systems are inherently fragile because fixed commitments remove flexibility from the system.

To the Treasury I would say, “Markets are inherently unstable, and that is a good thing.”? They often have to adjust to severe changes in the human condition, and governmental attempts to tame markets may result in calm for a time, and a tsunami thereafter.

Those that understand chaos theory (nonlinear dynamics) were less surprised by the difficult markets that we have faced.? We saw it coming, but could not predict exactly when the system would face crisis.? Bears are often right, but with significant delays.

The government is not the majority player in the system, but is the biggest player.? At critical points their willingness to offer support helped lead to a market rebound.

Now in the actions of the government, there is some “making virtue out of necessity.”? In supporting Fannie & Freddie in February 2009, they did not have much choice, unless they were to let them fail, which might have been a good thing.? As it is, F&F seem to be black holes where the government is unlikely to recoup their investments.

As for the bank stress-testing, one can look at it two ways: 1) the way I looked at it at the time — short on details, many generalities, not trusting the results.? (Remember, I have done many such analyses myself for insurers.) or, 2) something that gave confidence to the markets when they were in an oversold state.? Duh, but I was dumb — the oversold market rallied when it learned that the Treasury had its back.

I’m tired, and that’s enough for the evening.? I’ll pick this up tomorrow.

My Visit to the US Treasury, Part 1

Posted on 3 November 2009 by David Merkel

This will have to be brief, because I am tired.? I have had to deal with family and work issues today, and only now have time to blog.

You might have seen my fanciful post, Fallowhaven, Part 1.? I wrote that because I thought I could reveal almost nothing of my visit to the US Treasury today.? As it is, I can talk about it, but not quote any officials there, nor say who was there from the Treasury.

My surprise was that only bloggers were there.? I expected reporters from major papers, but that was not the target audience.? The closest to mainstream media would have been Megan McArdle, who presumably said she would be there (there was a placard for her), but did not show.? The rest of us were independents:

As I write now, only John Jansen has commented on the meeting, and only briefly.? I have a lot to say about the meeting, but I can’t get it into one post.? I will spread it out over several posts, and try to explain the? views of the Treasury, are where they make sense, or not.

I appreciated being able to meet my fellow bloggers.? Putting faces to the names is special.? Would that I could bring all of the major investment/finance/economics bloggers together for a gathering.? There would be many disagreements, but it would sharpen us all.

More tomorrow –? I want to talk about the successes and failures of the current rescue, and how the Treasury views them.