January 2, 2009
Editor
Donald R. Byrne, Ph.D.
dbyrne5628@aol.com
Associate Editor
Edward T. Derbin, MA, MBA
edtitan@aol.com
Note: To print
a hard copy of this newsletter, click on the following link for a PDF download…
The Financial Fiasco of Two-Thousand Eight (FFTTE)
--- Financial rescue or Gang Rape of the Taxpayer?
WHAT WENT WRONG WITH THE
A SHORT HISTORY OF THE
It has been
more than three-quarters of a century since the start of the Great
Depression. That horrific period began with a collapse of the financial
system. Before it was over, 40% of all commercial banks (nearly 10,000 of
them) had been permanently closed, many a result of
The Glass-Steagall Act (enacted in 1933 --- 1999) http://www.federalreserve.gov/boarddocs/testimony/1998/19980617.htm forced the divestiture by commercial banks of most of their other non-depository activities such as insurance, investment banking (broker, dealer, and underwriter), etc. Since checkable deposits were rapidly becoming the more popular form of medium of exchange money (referred to as M-1 money nowadays), deposit insurance was enacted with the establishment of agencies such as the FDIC (About the FDIC - http://www.fdic.gov/anniversary/about.html).
Beginning with the McFadden Act 1927, through current http://www.fdic.gov/about/learn/learning/when/1920s.html
Even prior to the Great Depression, Congress had passed the McFadden Act to prevent the concentration of financial power. Interstate branching by commercial banks was no longer allowed by the passage of this Act.
Interest rates,
primarily those paid and charged by commercial banks, came under the
jurisdiction of the FED in the now long departed Regulation Q as well as
federal usury ceilings on loans. The Federal Reserve System (FED), the
central bank of the
The list of
changes made by the
Some of this legislation proved helpful and continues on today. Much of the change that occurred in the 1930s has gradually been eliminated or significantly overhauled by legislative, regulatory, and judicial activities.
The separation of commercial banking activities from other activities such as investment banking is now gone and thru the establishment of holding companies, many financial services are housed under the roof of giant holding companies such as Citigroup.
In theory, fire walls of separation between the subsidiaries of the holding company were to be established and maintained, but in practice, those walls have often proven to be more like combustible papier-mâché.
Interest rate ceilings on deposits are a thing of the past. Usury ceilings on consumer loans at the federal level have been eliminated.
The formerly-called thrift institutions (credit unions, savings banks, and savings and loan associations) have been given the power to create checkable deposits, that part of M-1 or medium of exchange money that facilitates around 90% of the legitimate transactions of the American economy (the other illegitimate part of the economy is referred to as the underground economy where activities are illegal and indictable).
Deposit insurance has been gradually raised from $2,500 in January 1934 to the newly established ceiling of $250,000.
Congress was not directly responsible for all of the changes. The inflation of the 1970s, especially the roaring inflation of the late 1970s, caused enormous and rapid changes in the landscape of the financial markets. The explosion of change in the markets led to many new financial products and processes such as: securitization, asset-liability management, the growth and increased use of the external currency markets (e.g. Eurodollars), stripping of coupon bonds, adjustable rate mortgages, heightened cash management practices such as swept balances, an increasing variety of derivatives, etc. etc. These changes grew to enormous importance as inflation peaked at the end of 1979 beginning of 1980 at an annualized rate approaching 20%.
The era of managing interest rate risk; the sinister and for many, the hard-to-understand risk that faces both the investors and those seeking to acquire the credit, was placed on a par with the management of the many other types of financial risks such as credit or default risk. Along with the inverse relationship of interest rates to security prices and the born-again version of the Fisher effect, Rational expectations, concepts such as duration became the hot topics as rampaging inflation drove market interest rates upward to near record levels and caused the collapse of the prices of virtually all financial securities (Fisher Effect - http://byrned.faculty.udmercy.edu/2003%20Volume,%20Issue%203/Fisher%20Effect.htm) .
To quell the chaos, Paul Volcker was called to lead the FED out of its errant ways and to restore the fight against inflation to the numero-uno priority of monetary policy. By the spring of 1980, the FED’s new policy of monetary restraint forced the nation into one of its sharpest declines in history. While not lasting as long as the Great Depression of the 1930s, it was very intense and lasted two and one-half years. The inflation rate was driven down to 4-5%, but the unemployment rate peaked above 10%. The rest of inflation was to be eliminated more gradually, with a “soft landing” a few years later.
Social engineering of the financial system has increased to more precarious heights from its relatively humble New Deal beginnings. Legislation such as the Community Reinvestment Act have forced financial institutions such as commercial banks and other depositories, mortgage bankers, and other financial intermediaries to make what would normally be classified as bad or junk loans, especially in the area of residential mortgage lending. Vested interests, in this case community activists such as those from groups like Acorn, effectively use the CRA to force financial mortgage lenders to make significant numbers of what traditionally were called bad loans.
THE CONVERSION OF THE
This brief
review of the
The two major
sparks, so to speak that caused the ignition are the cartelization of the
From the Newsletter
January 5, 2006
(The Killing Fields: Weak links in an otherwise strong economy)
http://byrned.faculty.udmercy.edu/2006%20Volume,%20Issue%201/2006%20Volume%20Issue%201-b.htm
ENERGY COSTS
As we spelled
out in a previous issue of this newsletter and referenced in the prelude, the
recartelization of the American oil industry and environmental resistance have
kept the energy industry being able to develop and expand to meet the needs of
consumers. American businesses and households have been trapped in a
virtual killing field of high-energy costs; with little hope of any relief in
the near term. While critics lump the
RISING MORTGAGE INTEREST RATES
In addition to the rising energy costs and insecurity in the labor markets, households are now facing an additional burden of rising interest rates, affecting their mortgages. As short-term rates are driven up by the Federal Reserve actions in the Federal Funds rates, it influences other short-term interest rates to rise as well.
In the area of variable rate mortgages (ARMs), the Fed’s actions are gradually triggering the adjustment clauses in these mortgages. This increases the monthly payments, reducing further the disposable income available to purchase other goods and services and also reduces the cushion protecting homeowners from defaulting on mortgages.
In this very newsletter, again back in January 2006, we warned of the dire results of two “Killing Fields” that were devouring the public’s discretionary income. Those two factors that were to ignite the explosion of the financial system were the historically high energy prices reflected in the price of crude oil peaking around $145 per barrel and rising mortgage payments resulting from the FED’s ill advised policy of monetary restraint in 2004. The financial fiasco came to be, with the collapse of the housing market and the revelation of unacceptably bad behavior of the financial services industry led by the greed kings, the investment banking industry.
The (Re)
cartelization of the
As the 1970s and 1980s clearly showed us, when the world economy grows; in unison, the demand for energy, especially oil, surges. Recall that in 1973, OPEC took control of the production and pricing of its crude oil production from the so-called Seven Sisters, ordering them to cut production and raise prices by 300% from $3.50 per barrel to $14.00 per barrel. Again in 1978 OPEC reduced production and doubled prices from $19 to $38 per barrel. In real dollars, that price was not surpassed until 2008.
In the first illustration
How does world expansion affect demand for normal goods such as energy (income elasticity)?
How does price elasticity of demand decrease as demand increases? The first graph helps show how this in turn can translate into increased market/monopoly power of firms.
In the second illustration
How does the contraction of the world
economy affect the demand for normal goods
(income elasticity)?
Typically,
these oil shocks would last less than two years as the threat of escalating
inflation would cause the FED to launch a policy of monetary restraint that
would slow the economy and reduce the market power of OPEC as a result.
The cartelization of the
This
cartelization of the
CONSOLIDATION IN THE OIL INDUSTRY
ALLOWING THE MERGERS IN THE DOMESTIC OIL INDUSTRY
Report: GAO-04-951T
Mergers and Other
Factors that Affect
Released: July 15, 2004
Click here to download full report (a must read)
http://www.gao.gov/new.items/d04982t.pdf
Statement of Federal Trade Commission Chairman Timothy J. Muris on the (above) GAO Study on 1990s Oil Mergers and Concentration
The FTC Defense (2004)
http://www.ftc.gov/opa/2004/05/gaostatement.shtm
The FED and its Ill-Advised Policy of Monetary Constraint Beginning in mid-2004
The corporate mindset of the FED changed significantly in 1980 as they were severely criticized for allowing inflation to accelerate to the brink of run away inflation in the late 1970s. The FED would no longer be reactive, not proactive but would become preemptive in coping with potential inflation. It showed this in 1998 when it began a policy of monetary restraint, fearing what they believed was an overheated economy growing at what their Chairman considered an unsustainable rate. Phrases like irrational exuberance and the wealth effect were uttered by the Federal Reserve Chairman and were repeated on hundreds of newscasts.
March 2008 – Newsletter
http://byrned.faculty.udmercy.edu/2008%20Volume,%20Issue%201/2008%20Volume%20Issue%201.htm
Enter the FED in 2004
Now, cloaked in paranoia concerning inflation and still on a guilt trip emanating from the late 1970s when they failed to stem accelerating inflation, they shifted to a pre-emptive strategy instead of a reactive or proactive one. The FOMC (Federal Open Market Committee), the real focus of the FED’s authority and power, divined that with any significant growth, inflation could not be far behind.
Despite deflationary effects of significant growth rates in productivity, paranoia drove the FOMC to slow the economy. Asset prices became a topic of interest for FED officials, among them Alan Greenspan. Housing prices were especially of concern to the former chairman.
“Our forecasts and hence policy are becoming increasingly driven by asset price changes. The steep rise in the ratio of household net worth to disposable income in the mid-1990s, after a half-century of stability, is a case in point. Although the ratio fell with the collapse of equity prices in 2000, it has rebounded noticeably over the past couple of years, reflecting the rise in the prices of equities and houses.”
Remarks by Chairman Alan Greenspan
Reflections on central banking
At a symposium sponsored by the Federal Reserve Bank of Kansas City, Jackson Hole, Wyoming
August 26, 2005
http://www.federalreserve.gov/Boarddocs/Speeches/2005/20050826/default.htm
The rapidly
rising tax revenues resulting from several years of tax rate increases
recommended by the Treasury Secretary Robert Rubin were turning the Federal Government
Budget deficit into a surplus and applying a heavy duty braking to the
Apparently the FED learned nothing from that experience since they repeated their mistake again in mid-2004 with the same results on economic growth. This time, their pressuring of short-term interest rates triggered the resetting of interest rates on ARMS and the resulting glut of foreclosures ensued. Now the borrowers, already stripped of discretionary income by record high energy prices, could not cope. This included prime, and above prime borrowers, not just sub-prime borrowers.
The first
collapse in 2000 was a result of bad economic policy by the FED (monetary
policy) and by Congress (fiscal policy). The FED once again began a
policy of monetary restraint in 2004, in order to preempt what it saw as a
potential problem of inflation. The culprit was a supply side shock
coming from OPEC’s restriction of supply in the face of a rising world demand
for oil and its refined products. This time around, the upward movement
of prices was supported by the newly cartelized
The data shows clearly that this time, most of the other non-oil related markets were much more competitive, especially at the retail level and firms had a difficult time in passing on the energy related costs. The CPI data shows that prices at the retail level did not reflect the rise in those at the producers’ level as shown in the PPI data. In some industries such as light vehicles, already anemic profits suffered intensely as a result. Nonetheless, the FED decided to pursue a restrictive monetary policy. Fortunately, by 2003, fiscal policy had turned expansive, but the trade balance was still in large deficit and depressing. The FED influenced the Fed Funds rate upward from 1% to 5.25% or a 425% increase. Other short-term interest rates followed, such as the one year Libor. This began to trigger the resetting of ARMs mortgages and the foreclosures that soon followed.
This was bad policy by the FED based upon increasingly irrelevant theories of how the economy works. Now, after all the damage, the FED has reversed itself and influenced the Fed Funds rate back down to below 1.00% in December of 2008.
Let’s ask the questions:
If the FED (Federal Open Market Committee - FOMC) had not pursued that restrictive policy of monetary restraint five years ago which was based on pre-empting inflation, would ARMs interest rates have been reset upward and mortgage payments increased and the flood of foreclosures occurred?
We think not.
Bad theory leads to
bad policies and disastrous consequences. It caused the collapse of the
Had the FTC (Federal Trade Commission) opposed the recartelization of the American oil industry in the 1990s, could rising mortgage payments in the last five years have been made more easily?
Again, these were bad policies by government agencies mandated to help not harm the economy.
The sparks of bad policy by the FED and the FTC ignited the powder keg and gave us the Financial Fiasco of 2008 (FFTTE).
Like most
problems in life, some of the roots of the current financial chaos began years
ago and are often lost among those of more recent origin. After having
briefly reviewed the more recent history of the
Despite all the newscasts and the ranting and raving of the so-called experts, both legitimate and the think-they-ares and wannabes, confusion still reigns. Even with the passage of legislation estimated to cost three quarters of a trillion dollars, critics are already calling for its repeal since it does little to identify and address the underlying problems that caused the financial fiasco of 2008 (Financial Fiasco of Two-Thousand Eight---FFTTE). Now we find the auto industry holding its hand out for rescue from it and the UAW’s misbehavior over the decades. The so-called financial legislation is loaded with what are often referred to as “earmarks” virtually unrelated to the ongoing financial chaos.
We ask for your patience as this issue of the newsletter attempts to systematically clarify why it all happened.
The Roots of the Financial Fiasco of 2008 (FFTTE)
How the powder keg that finally exploded was constructed.
1) The use and abuse of LEVERAGE
In the financial services industry, firms use a high degree of what is called, financial or debt leverage (high ratio of debt or liabilities to assets which is the same as a low capital to asset ratio) to offset low operating leverage (or ratio of profits to assets). To earn a reasonable return on owners’ equity (or the ratio of profits to owners’ equity), the low capital ratios are necessary. But this results in a vulnerability to bankruptcy and hence requires the avoidance of any serious degree of risk taking. This basic condition has obviously been ignored at best and not understood by highly rewarded executives, at worst. The same can be said for the regulators and for Congress that habitually passes laws treating these business firms as though they were not-for-profit charities.
2) The GREED FACTOR
Research shows the long-term real rates of return on the average of stock (equity capital investment) is about nine or ten percent over long periods of time. Yet firms are expected to provide rates of return of 20 or 25 percent, if not higher. This can only be achieved with market power (lack of significant competition in the firm’s product markets) or chasing yield which means bearing high degrees of risk. The 30 to nearly 35 percent return on equity of some major oil companies in the last few years, is not due to the genius of their corporate leaders, but rather it is due to the re-cartelization of the American oil industry that occurred in the 1990s as the anti-trust authorities (Anti-Trust Division of the Justice Department and the Federal Trade Commission) stayed on the sidelines for the most part, mumbling about the Chicago School of economic thinking, for their failure to act.
The major oil
companies in the
In the case of the federal agencies such as Fannie Mae, insuring formerly uninsurable mortgages were pressured by Congressmen from both Houses of Congress, and community groups like ACORN, using legislation such as Community Reinvestment Act to threaten mortgage lenders to make bad loans or else law suits would soon follow. It is not risk if it never will materialize. Of course it was risk and it did materialize.
3) The DEMISE of the COMMERCIAL LOAN DOCTRINE of bank management
Commercial banks, as do other depositories (such as credit unions and savings banks) not only have low capital ratios as examined above, but also have liabilities that are very short term in maturity. The checkable deposits that they create in the process of credit creation are payable on demand. The time deposits, while not checkable and not payable on demand have on average, very short term maturities. The time deposits include passbook savings deposits as well as certificates of deposits. Some depositories, primarily large commercial banks, incur other liabilities, usually called borrowed or purchased funds. These other liabilities are usually short term in maturity and carry higher yields, and if they become a significant source of funds, are frowned upon by regulators. In their heyday, significant reliance on these funds to maintain required reserves at mandated levels, caused those banks to be called, go-go banks.
Because of the average shortness of maturity of their liabilities, and their low capital ratios, adherence to the commercial loan doctrine called for bank lending to be short term and self- liquidating. Short term lending was standard practice to match the short term maturity of their liabilities and self liquidating to compensate for the low capital ratios, and as a consequence, their inability to bear serious degrees of risk from whatever source. Working capital loans and not competing with the bond and stock markets to supply long term funds, was the intent of the commercial loan doctrine.
As the money markets developed, bank management philosophy changed to what many analysts called the Shiftability Doctrine. Dedicate a portion of the assets to money market securities, which are short term in maturity and low in both credit and interest rate risk, and the rest of the portfolio can be shifted to longer maturities, on the average. Of course, as time has shown, when liquidity is needed and short term securities such as Treasury bills are sold, quite often every institution is doing the same and the prices of those securities fall sharply. Such liquidity is akin to road service in inclement weather. The earliest the service will be there to help you is the following day, since everyone else is calling for the same service. Money markets have at times behaved like the real estate market in the last two or three years. With all the foreclosures, the supply greatly increases and gluts the market causing housing prices to decline by 15% and even more in some markets.
As the financial markets further developed, other sources of funds materialized: federal funds, Eurodollars, repurchase agreements, brokered CDs, etc. Now the argument was that liquidity could be purchased by issuing new types of liabilities, allowing an even greater latitude of maturities on the asset side, and banks especially, shifted to the now popular asset-liability management philosophy (ALM). This lengthening of the asset maturities led such institutions into the lair of the insidious interest rate risk, reflected in the inverse relationship of financial securities prices to interest rates, as we shall see shortly. The parallel development of marking to the market and in certain accounting applications, the lower of cost or market, exacerbated the threat of insolvency. This occurred when interest rates rose either as a result of inflation (the Fisher effect to be examined shortly), or from the FED’s restrictive monetary policy which we have seen, helped collapse the economy in the very late 1990s and again in May 2004 through August 2007.
4) Another risk to threaten solvency: The INCREASE IN INTEREST RATE RISK
Owning equity or long-term debt securities for investment purposes and for trading purposes is inherently risky in terms of interest rate risk (inverse relationship of security prices to interest rates) even if those securities credit or default risk, or its equivalent beta for stock, is very low. The longer the term to maturity and the lower the coupon rate or its equivalent, the greater the percentage decline in the market price of the security for a one-percent rise in interest rates.
Two components of Interest Rate Risk
The two components of interest rate risk are the price risk and the reinvestment risk.
The price risk is greater the longer the time to maturity and the lower the coupon rate.
The reinvestment risk is greater the higher the coupon rate.
This is what helps drive the inverse relationship. The combination of the coupon rate and the time to maturity determine the duration of the financial asset. Of course, the determination of these values is more precise for debt securities such as bonds where there is a contractual relationship and much less precise for equities such as common stock, where there is no contractual guarantee of the cash flow.
Interest rate risk should not be confused with credit or default risk. The only link between the two is a result of the risk premium reflecting the probability of default. The higher that probability, the higher is the coupon rate and hence, the smaller the interest rate risk. Other than that, the two types of risks, interest rate risk and credit or default are not related.
Long-term U.S. Government bonds have little credit or default but have a significant degree of interest rate risk.
You can eliminate the reinvestment risk part of interest rate risk by investing in zero coupon or pure discount debt securities such as bonds since there is nothing to reinvest, but as the coupon interest rates decreases, the price risk increases.
Variable or adjustable rate loans reduce interest rate risk but often increase the credit risk, since some of the interest rate risk is shifted and shared by the borrower (potential for higher monthly payments) instead of being borne entirely by the lender (real interest rate falling as inflation increases). But for sharing in the bearing of interest rate risk, the borrower must be given a reward in the form of a lower interest rate for an initial period of time (usually 2, 3, or 5 years) before the rate can be adjusted upward (or downward) usually once or twice per year, and the payment increased (or decreased). More to follow later...
5) TRANSFORMATION of the FINANCIAL LANDSCAPE resulting from the roaring inflation of the 1970s.
The decade of the 1970s caused a tremendous change in the financial landscape, both in terms of the markets and the way both borrowers and lenders reacted to inflation. After the Korean War inflation, the American economy experienced a twelve year period of near price level stability (1952-1964). Virtually all the economic sectors were lulled into sleep concerning the issue of inflation. So what, you say. When inflation is occurring, the nominal or the market rates of interest you observe diverge from their real or price level adjusted interest rate counterparts. The real interest rate becomes less than its nominal interest rate counterpart, by the actual rate of inflation. By 1979 nominal mortgage rates were near 20% and the inflation rate averaged for that entire year, about 15%. This meant that real mortgage interest rates were about 5%. In those days, most were fixed rates and were often for periods running 30 years in maturity.
As the public began to understand and adjust to such high inflation rates, any delusion that the nominal or market rates were the same as their real interest rates counterparts, had dissipated. The behavior pattern of most of the public was approaching that of Rational Expectations. Writing around 1900, an American economist, Irving Fisher, argued that the nominal or market interest would be higher than its real interest rate counterpart by the actual rate of inflation, so the real interest rate was not influenced by inflation, only the nominal or market rates of interest were so influenced. The participants in markets would adjust the nominal interest rate upward by the expected rate of inflation when inflation was occurring and expected to continue.
They would adjust the nominal interest rate downward when deflation was occurring, and expected to continue. The market expectations of inflation would be correct and equal the actual rate of inflation. This is the Fisher Effect. The same reasoning is found in the Rational Expectations theory as referred to a bit earlier.
As inflation continued into the late 1970s, market rates of interest increasingly reflected these high and rising inflation rates. That is why mortgage rates rose toward 20% nominal levels and Treasury Bill rates rose well above 14% nominally. In reality, their real interest rate counterparts were much lower, by the actual rate of inflation. Given the inverse relation of security prices to (nominal or market) interest rates, the security prices in all financial markets, including the bond and stock markets fell dramatically. The Bears were in charge and inflation had vanquished the Bulls.
6) TOO BIG TO FAIL and TOO SMALL TO CARE doctrines
With the collapse of most of the savings and loan industry and some other depositories in the late 1970s and early 1980s, the collapse of the (wholly owned by the U.S. Government) Federal Savings and Loan Insurance Corporation (FSLIC) was not far behind. There were three such federally owned insurance corporations, the Federal Deposit Insurance Corporation (FDIC), the Federal Savings and Loan Insurance Corporation (FSLIC), the National Credit Union Administration’s (NCUA) insurance subsidiary. Only the FSLIC failed, although the FDIC showed signs of going the same path and was saved by the collapse of market rates of interest and the economic recovery that began in mid-1982.
A problem that continues on today is that insufficient premiums were collected to fund widespread failures of the depositories. Even worse, the FSLIC adopted the TOO BIG TOO FAIL Doctrine. At the time, the insured portion of deposits was only up to $40,000 (http://www.fdic.gov/about/strategic/report/2000AnnualReport/pg97.html). FSLIC exceeded that limit and of course ran out of funds and began to borrow from the U. S. Treasury. FSLIC went belly up, so to speak. The resulting bail out of FSLIC and its debt in the amount of $124 billon is still carried by the Treasury today as part of the National Debt.
(http://www.fdic.gov/bank/analytical/banking/2000dec/brv13n2_2.pdf)
The Cost of the Savings and Loan Crisis: Truth and Consequences
(2000)
The savings and loan crisis of the 1980s and early 1990s
produced the greatest collapse of
As of December 31, 1999, the thrift crisis had cost taxpayers approximately $124 billion and the thrift industry another $29 billion, for an estimated total loss of approximately $153 billion. The losses were higher than those predicted in the late 1980s, when the RTC was established, but below those forecasted during the early to mid-1990s, at the height of the crisis.
In this most recent Financial Fiasco of 2008 or FFTTE (or as cynics say, Phhhttt in the vernacular), the U.S. Treasury has been mandated by Congress to bail out far less worthy belly uppers such as the investment banker gang, ignoring the huge bonuses paid to the very people that were promoting the sales of the junk securities that are so much a part of the Financial Fiasco of 2008 (FFTTE).
TOO BIG TOO FAIL or TOO MUCH PAC MONEY TO BE LOST
So much for pushing the argument that “the National Debt is too large”, when the same politicians bellowing out this argument are signers of the so called Bailout Bill which will raise that debt significantly and lead to the argument that taxpayers must come up with more bail out money in the form of higher taxes.
“Do not do what we do, do what we say”.
“Talk the talk but do not walk the walk”.
The interpretation of the “lower the National Debt argument” must be, increase the tax burden of the taxpayers.
What about the several million households that lost their homes in foreclosure?
TOO SMALL TOO CARE
As the soon to be beheaded, Marie Antoinette advised her advisors, “If they have no bread, give them cakes” or as found in Scripture, do as Dives did to Lazarus and give them crumbs.
All of those fat bonuses paid to the investment bankers, earned mostly from their sales efforts that helped cause the FFTTE (phhhtt), would go a long way toward healing the households who lost their homes.
7) CONFUSING HEDGING with SPECULATION or perhaps cloaking speculation with a veil of hedging
“If it looks like a duck, walks like a duck and, and quacks like a duck, it is probably a duck”, goes the popular saying. One of the first and most infamous of the so-called hedge funds, LTCM (Long-Term Capital Management http://en.wikipedia.org/wiki/Long-Term_Capital_Management), managed and counseled by so-called experts including some Nobel prize winners, was allowed to become so large and so risk laden, that the FED, our beloved central bank, bailed them out under the now seemingly etched in granite, TOO BIG TOO FAIL Doctrine.
What was learned from that episode? Apparently nothing... Perhaps something was learned by the street-wise big hitters. If you are going to fail, be big and fail big, otherwise the Doctrine of TOO SMALL TO CARE will be invoked instead of the TOO BIG TO FAIL Doctrine.
Hedging is an act of reducing risk and paying a cost to achieve a greater degree of financial certainty. Speculation is an act of taking on risk (financial uncertainty), usually for a fee or reward. They are not the same. Securitization, the using futures contracts, and other such efforts can be used to hedge, but they can also be used to speculate. It is not the job of the FED, or the Treasury Department, or Congress to bail out speculators. Much of the price excesses in the real estate and oil markets were a result of speculative activities that did not prevent price excesses but that aided in those excessive price swings. The literature concerning destabilizing speculation is neither new nor scarce.
Destabilizing Speculation – nothing new under the sun…
http://www.federalreserve.gov/pubs/feds/1997/199722/199722pap.pdf
The 1934 U.S. Congress established Federal margin authority with three apparent objectives: to reduce the use of “excessive” credit in securities transactions; to protect investors from over-leveraging; and to reduce the volatility of stock prices. The Congress evidently believed that a federal margin policy could be used to control the amount of credit allocated to “unproductive” investment in the stock market and thereby reduce the effects of destabilizing speculation on stock prices. The view prevailing in Congress held that there existed a fixed pool of credit available to support investment activities, and any credit that was used to purchase stocks was credit that was unavailable to finance productive investments in new plant and equipment. Moreover, it was widely believed that stock-related credit supported the activities of speculators whose trading activities allegedly created unnecessary volatility in the stock market.
8) EFFICIENT MARKET HYPOTHESIS and those who claim they can consistently beat the market
There is a heavily researched, widely accepted, and highly credible theory that no one (nor no group) can consistently beat the market. It is called the Efficient Market Hypothesis or EMH. A similarly researched and widely held theory of much value is the Capital Asset Pricing Model or CAPM. These theories support the growing use of indexing and undermine the belief that expert analysts and active fund managers can consistently beat the market.
Yet these
analysts continue to urge buying and selling and churn fund assets as though
they can consistently beat the market. “
Could it be to generate “buy” and soon after “sell” recommendations, leading to significant commissions and fees?
What about all the various types of buy recommendations before the FFTTE?
When the market fully recovers – and then some, as it will, what about all of the sell recommendations that drove the market downward by nearly one-third?
What about all the fees the investment bankers received on mergers and acquisitions that more than anything else, reduce competition in markets such as crude oil, thereby preventing the free market capitalist system from achieving those great goals of equity and efficiency, the economic welfare conditions given the public when competition is vigorous? Huge bonuses to the investment banking industry rest heavily on reducing competition through mergers and acquisitions and the ignorance of investors who believe analysts who can readily beat the market in a consistent manner. If this is not so, why the recent record crude oil prices and prices at the pump and why the current collapse of the markets and why the need to bail out those same investment banking firms?
Discussing Risk: some major factors that cause interest rates to differ
Click on above link to view discussion on risk (major factors that cause interest rates to differ)
9) CONFLICTS OF INTEREST
Conflicts of interest abound in the financial services industry. Investment bankers are allowed to trade on their account while at the same time act as brokers and dealers for their customers in the same securities. Rating agencies have been cited in investigations by the SEC for altering their review methods in order to generate more revenue for their firms. Conflicts of interest are not new but in recent years have made the headlines. The accounting profession has had its Enron type scandals. They must bill the clients they audit. The problem was exacerbated by combining auditing with management consulting. This increased the pressure on the auditors as more fees were at stake with management consulting bundled with auditing. It is akin to self regulation, which often means no regulation.
10) Accounting practices such as marking to market and lower of cost or market can accelerate swings in the financial markets, especially downturns which are aggravated by such practices. So-called conservatism makes it even worse as a practice of lower of cost or market is applied to the asset side of the balance sheet but rarely to the liability side, exaggerating a downturn and reducing the owners’ equity as a result.
Accounting is not a precise science; rather it is an art of estimating. When is revenue realized? What method of depreciation is appropriate? What inventory valuation method best estimates the real cost of goods sold? The problem becomes even more daunting when the value of the dollar is changing due to inflation or deflation. The very measuring stick they use is changing. Minimizing taxes in earlier years to take advantage of the time value of money is ever present especially when tax rates are high. Show Wall Street analysts the best numbers to encourage buy recommendations, transfer pricings to reduce overall tax liabilities are similar problems facing accountants.
11) DERIVATIVES: the savior of hedgers or the cause of financial dysentery?
Derivatives have been around a long time. They enable farmers and cereal manufactures to make certain the uncertain. Farming is risky enough without having to face the potential of severe price fluctuation at harvest time. Cereal grain futures enable the farmer to focus on farming and the cereal manufacturer to focus on cereal making. A similar argument can be made for business engaging international trade. The foreign exchange futures market can reduce the risk. In the financial world, fluctuations in asset values are especially correlated with changes in interest rates as explained above. Lending funds to finance mortgages for long periods of time, is very risky (interest rate risk). This is true even when the borrower is a prime borrower. Mortgage initiators can securitize mortgages and reduce and eliminate the interest rate risk for themselves. Adjustable rate mortgages or ARMs can also reduce this risk for the lender whether or not the mortgages are securitized and whether or not the borrower was classified as sub-prime or prime. Much of the securitization of mortgages involves mortgage pools. Many of these pools are insured by federal agencies (such as Fannie Mae and Freddie Mac) on a “with” or “without” recourse basis. The former insures the originator against interest rate risk and the latter against both interest rate and credit or default risk. Some of these pools are financed by certificates of participation but some are financed by such securities as bonds. They have become known as collateralized debt obligations or CDOs, etc.
Now we are venturing into the derivatives on derivatives. Futures options have been around for a while. They combine two types of derivatives, the futures contracts and the options contract. What is important to know is that for gamblers, indistinguishable from speculators, the derivatives on derivatives increase the leverage and benefit those who want to speculate, more that those who want to hedge. Unfortunately, there is no guarantee that speculation is a stabilizing factor. It can be a de-stabilizing factor. Some, not most, of the run up in oil prices was caused by speculation. While not strictly a derivative, short selling of stocks has exacerbated downward swings in the stock market by speculators, where for a period of time, they are akin to self-fulfilling prophecies. A problem with derivatives is that they can mask the degree of risk of the underlying asset. When rating agencies are under pressure to generate fees, this masking can take on an art form. What is a sub-prime mortgage? It depends upon the definer. Not all agree. Does it depend upon the borrower or the characteristics of the loan agreement, or both? As a rating agency, which definition is most influential in your rating methodology when it comes to a CDO or collateralized debt obligation?
Some information on CDOs – Collateralized Debt Obligations
November 2007
Wall Street's money machine breaks down
The subprime mortgage crisis keeps
getting worse-and claiming more victims
http://money.cnn.com/magazines/fortune/fortune_archive/2007/11/26/101232838/index.htm
“Merrill's structured-finance team gets to work creating a variety of bonds that will be backed by the interest and principal payments the CDO collects on the asset-backed securities it owns.”
12) The New Paradigm and the sparks that ignited the powder keg
This Newsletter was started nearly six years ago in order to apply what the editors and others have argued is a New Paradigm of behavior model that is increasingly useful in examining the behavior of the macro economy (http://byrned.faculty.udmercy.edu/2003%20Volume,%20Issue%201/Newsletter%20Introduction.htm). As competition has increased in much of the economy (some notable exceptions such as crude oil and its refining), the biases toward recessions and inflationary episodes it had resulting from lack of competition, have lessened. This means that monetary and fiscal policies based upon the old model of demand side macroeconomics is at best of little value and at worst it can result in harmful macroeconomic policy effects. This happened in 1998-99 when the FED adopted a policy of monetary constraint and aggravated an economy that was already stressed by rising federal government surpluses due to several years of tax rate increases often referred to as Rubinomics (http://en.wikipedia.org/wiki/Rubinomics), after one of the Secretaries of the Treasury who convinced Congress of the wisdom of such a policy. The rising trade deficit also increased the stress on the overall economy.
The
The following is from the 2003 Newsletter (note: data from NIPA has been adjusted since publication)
FISCAL AND MONETARY POLICY – TWIN POLICY DISASTERS
In the first issue of this newsletter we argued that there were two major occurrences leading to recession:
(1) Significant rise in federal receipts as a percent of National Income…
(2) …and the FED’s change to a monetary policy of restraint, leading to rising short-term interest rates.
The “twin policies” brought the nation’s economy to its knees: witness a positive growth of 7.1 percent to a three-quarter long recession, where the GDP collapse bottomed out at a negative 1.6 percent (real GDP).
As pointed out above,
the
Something to keep in mind…
The Federal Reserve pays 90% of its profits as taxes to the U.S. Treasury
In 2007, there were $365 billion paid in corporate taxes to the Federal Government. The Federal Reserve paid $35 billion of that total, or nearly 9.5% of the total of all corporate taxes collected.
Some Alternative Solutions to Ill-Conceived Bailouts
1) Give the Fed the power to suspend marking to the market and the lower of cost or market rule. Give the FED the power to protect from bankruptcy (chapter 11) when liquidity crises occur.
If the argument is that the Treasury and the FED will make lots of profits, from, the acquisition of troubled assets, then wasn’t the mark down misleading and unjustified?
2) Bring back a version of the Glass-Steagall Act: the goal – to separate investment banking from other financial services like the depositories, and insurance companies.
3) Eliminate investment bankers trading on their own account.
4) Legislation to restrict rating agencies from altering methodologies for rating the securities.
5) A new rule for FED instituting monetary policy to avoid their mistakes in 1998 and again in 2004. Preemption assumes the FED through the FOMC understands the way the economy and the financial markets work.
They obviously do not.
Some objective rule should replace much of the FED’s independence.
6) Modernize the trading of stocks, bonds and other securities so that investment bankers do not touch and therefore charge fees and commissions on every trade.
Such modernization should incorporate the advances generated by the revolution in information technology.
7) Implement greater restrictions and clearer guidance to the anti-trust authorities on merger and acquisitions when markets would become less competitive including Four Firm Concentration Ratio and Herfindahl Index measures.
8) Clarify rules on speculation in areas such as futures contracts and short selling.
9) Shift the management of depositories such as commercial banks back toward the commercial loan doctrine.
10) Eliminate the forecasting of profits by firms and their need for “guidance” to investors.
FINAL COMMENTS…
If the argument is that the Treasury will make lots of profits, then wasn’t the mark down misleading?
Why not a move to chapter 11, until market prices reflect reality and not a credit crunch?
For those who will not see such a return when the liquidity crunch is over, too hell with them – let them go under.
POSTSCRIPT…
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