Obama Administration Making the Banker's Error

The Obama administration is already finding itself having to defend its economic projections of a strong economic recovery. We're still in the middle of a mess that stemmed in no small part from the refusal of bankers to consider the worst case scenario, from admitting that things could be far worse. So why is the current administration doing the same? For the same reason: It is unpleasant to ask people face reality.

But Obama was elected on the idea of a change in the past and some respect for the truth ... at least, that is the marketing angle his staff used. The only way to escape the danger of the overly optimistic is to use a range of scenarios: good, realistic, and bad. The bad one has to be really bad, take into account the worst that could happen. The realistic should be just that. Presenting only one scenario that tends toward the optimistic is to whistle past danger. To do what has been foolish in the past only continues the foolishness.

The Inversion of Finance

There's an interivew with FedEx's CEO Fred Smith in the Wall Street Journal online, and he makes one of the most intelligent and perceptive comments about the financial services industry that I've yet to see:

He attributes the financial crisis to "the intersection of four long-term developments." Reckless mortgage lending policies; high energy prices; mark-to-market accounting rules; and national policies that favor what he calls "the financial sector over the industrial sector."

"Rather than in our business where you have to have a dollar of equity for, 10 cents or 15 cents of debt," he explains, "it's exactly the opposite in the financial sector where you have one dollar of equity for 10, 25, 50 times risk." "Things became so flipped upside down," he explains, that "the assets at these banks became the liabilities and the liabilities became the assets. These people were making these fantastic returns -- at places like Fannie Mae and Freddie Mac -- but in reality they weren't adding a lot of value. I have said time and again that there is a fundamental tendency in good times in the financial sector to over-leverage. Our national policies actively encouraged all this debt."

The concept of assets becoming liabilities and liabilities becoming assets is so completely apt as to be startling in its simplicity.

I'm not sure I agree with his appeal to change the tax structure allowing capital purchases to be treated as out-of-pocket expenses. The question is whether you drive accounting rules by tax policy or tax policy by accounting rules. The reason for amortization is to more throughly match up expenses with revenues. At the same time, to be fair, once you've paid for that Boeing 777, you're not getting to return it and the money is gone. But what if it's financed and you're paying over time. It doesn't seem reasonable to allow the immediate expensing of the entire amount.

He mentions that he things the corporate tax rate should be lowered, and that at 38% it's even higher than Germany's 25%. My question would be not what the tax rate is on the books, but what the average realized tax rate is. I have a suspicion that most large corporations are managing to write off enough that the effective tax rate is far lower.

Bailout: Just the Beginning

Ah, should have known this was going to happen. According to the Financial Times, all sorts of people are pressuing the U.S. Treasury and the Federal Reserve to provide further help to the economy, possibly a mix of a rate cut, letting money markets borrow money to fund their holdings, and maybe even offering unsecured loans to regulated banks. In other words, the U.S. government is going to become like a parent who always bails out the troubled child until things get so bad that it's no longer possible. I'm sure some would liken the current situation to the intervention of a doctor, but unfortunately the illness was the result of the stupidity of the institutions in danger. How is curing the symptoms going to change the underlying behavior? It's not, and chances are that the cash is not going to travel much farther than the banks and their largest customers - the ones they want to keep happy. I'm already hearing stories from small business owners suddenly finding their credit lines pulled. Many will make it through, but when you remember that the majority of employment in the country comes from small businesses, it makes you wonder whether it's the economy that's getting a bailout, or the most elite piece.

Wall Street and the Wages of Estimation

Last week, the New York Times blog Bits had a piece about Wall Street analysts "lying" to their computers. Written by a journalist who has covered both the Internet and trading and finance, it indicates how little many reporters know about the mathematical processes they write about -- otherwise there might have been much earlier warnings of the problems now facing the world's economy.

Yes, the current meltdown is supposed to be a "once in a hundred years" event, as the president of a consulting firm told the reporter. However, these black swan events, when considered together, happen far more frequently than every hundred years. That's because when you have potential events that are independent of each other, but still capable of creating financial cataclysm, the cchance of at least one of them happening is the sum of the separate chances of a given one happening.

So already experience and math suggest that the surprise at an unusual event should have the same tone as Captain Renault being "shocked, shocked" at the gambling at Rick's in Casablanca. The concept of adding probabilities for independent events has literally become math in grade school, or at least high school.

Now for the other revelation:

The people who ran the financial firms chose to program their risk-management systems with overly optimistic assumptions and to feed them oversimplified data. This kept them from sounding the alarm early enough.

Top bankers couldn’t simply ignore the computer models, because after the last round of big financial losses, regulators now require them to monitor their risk positions. Indeed, if the models say a firm’s risk has increased, the firm must either reduce its bets or set aside more capital as a cushion in case things go wrong.

In other words, the computer is supposed to monitor the temperature of the party and drain the punch bowl as things get hot. And just as drunken revelers may want to put the thermostat in the freezer, Wall Street executives had lots of incentives to make sure their risk systems didn’t see much risk.

I'm sure there's something to this, but let us get at a more fundamental issue: many complex problems in math and engineering and science are too tough to easily solve. What people do, then, is simplify. You put the world into models and approximations that you have a prayer of solving. You drop factors that seem tiny in comparison with the rest of the problem in an attempt to simplify the equations even more. You employ numeric methods to get closer and closer to the "real" answer ... as close as you need.

Unfortunately, your answer is simply an approximation, nothing more. It may be acceptible for your uses if the real world conditions are forgiving enough. But when things get hairy -- you're trying to predict the behavior of materials in the face of quantum mechanics effects or trying to understand how an incredibly complex system, such as the weather or global finance, will behave -- then approximate may not be good enough. If a chip fails, well, you head back to the drafting board. When an economy fails, then you end up with huge banks and investment companies going out of business, oil prices swinging by $25 in a single day as short-sellers have to cover their positions, and governments begging for the right to spend $700 billion of taxpayer money to get their croneys out of the frying pan.

Banks, Bankruptcies, and Economic Reality

Bettors, speculators, and con men have one thing in common: more often than not they forget the saying, "There's no free lunch." The phrase can be traced back to bars offering free lunch. Of course, you had to pay for liquor or beer (which might be marked up). So there really was no free lunch. Somehow, somewhere, someone paid for the meal in another coin.

To the list of believers in economic fairy tales we can apparently add a good number of businesspeople. As the Financial Times notes, Merrill Lynch has lost $14 billion, after taxes, since the beginning of 2007.

This is equivalent to about a quarter of all the profits, adjusted for inflation, made in the course of the bank’s history as a listed company since 1971 – the highest ratio of recent losses to historical profits among its peers.

That mirrors the precipitous growth in profits preceding it. Between 2003 and 2006, the bank racked up $21bn in profits, more than a third of its total between listing and the credit squeeze. Backed by a buoyant global economy, investment banks could buy up, repackage and sell on assets, while deploying little capital and pushing profitability and leverage to historic highs.

Merrill had gone looking for free lunch in the form of securitized debt obligations - turning groups of loans, like subprime mortgates, into bonds that it could sell ... at least for a while. Relatively little captial went into schemes that promised wealth beyond the dreams of avarice.

But the bill has come and someone had to pay. That payment has extended to all manners of people. Bankruptcy filings have hit the million mark this year, up 29 percent from last year. But as a society we've collectively enjoyed a spree, since at least the early 1980s, of living high off borrowed funds. Sated to a point of bursting and staggering drunk from the bar, we forgot that the bill would come.

Toxic Banks: Not Just US Problem

I've heard some people remark that the credit crunch has shown the weakness of US banks as compared to the rest of the world (which generally means Europe, when it comes to the financial industry). I found that hard to believe, because it seemed that some of the names hit hardest were European banks. So I was interested to read in the Financial Times Lex column (sorry, no free link) that sub prime credit write downs by banks have totaled $493 billion worldwide. Of that, $250 billion was in the US, but $221 billion was in Europe, with $22 billion elsewhere.

And yet, the European economy has not taken the same hit as that of the US. The housing bubble in the US has been one factor, but there's been a similar bubble in many parts of Europe - Spain, Denmark, the UK, and Ireland. I'm guessing that the relative strength of the euro has been the reason. But it seems that won't be lasting long:

The US and European economies are of similar size, as are their banking industries, which both have market capitalisations of about $1,000bn. Yet European banking stocks have outperformed since the credit crisis began. So far, US banks have suffered most. The worst is yet to come in Europe.

Those in the US looking for economic salvation by investing overseas are likely to find that the safety is only temporary. Ah, well, misery loves company.

Home Prices Fall - No Surprise

Two major housing price indexes, a 20-city and 10-city compilation by Standard & Poor's and Case-Shiller, both hit record declines. But there's no surprise if you've been even cursorily following the economic churn in the country.

The "value" that people perceived was a result of demand, over-supply of money, speculation, and a general economic hysteria. Not being grounded in anything truly substantial, it was waiting to evaporate, and now we're seeing that happen. But I actually think this is good news for the economy, getting back to a more realistic state that might allow more moderate but supportable growth.

Pushing a Rope

Well, looks like everyone from the president to the Fed's chairman is ready for economic stimulus. There's only one problem, as I heard Robert Reich state well on Marketplace Morning Report. I have my own way of thinking about it. A rope can be a great tool to get something moving, but only if you are pulling on it hard enough. Push, and the mass of fiber collapses.

The problem with current proposals to stimulate the economy is that the people in charge are forgetting this simple yet telling physical experience. To put a few hundred into the hands of many, given the rise in energy and food prices, means that they might almost, but probably not quite, stay where they were. That's just holding the rope, not pulling. The richest part of the populace would have more free capital, but there's only so much they can consume; there are just not enough of them to make a difference.

Trying to get businesses to invest is like pushing the rope. Companies spent 15 to 20 years relearning the lesson that it makes no sense to invest in infrastructure, capacity, and inventory that you don't need. Make the money available, and corporations won't invest money in stimulating ways because for them it is a waste. Instead, they'll look for other places to park the cash that might offer some return.

And to stimulate the economy, the government and the Fed effectively have to loosen the money supply, reducing the value of the dollar and burying the country under the weight of even more debt and unsupported currency. Better we should realize that sometimes you have to wait out unpleasant news rather than get a nasty rope burn trying to finagle your way out of it.

Waiting For the Shoe to Drop

We usually hear that we should wait for the other shoe to drop - that one event has happened, and its completion will catch up with us as certainly as reading glasses chase the middle-aged. But there is an assumption that people are cognizant enough to recognize that forces beyond their control are at work. This comes from experience and an interest in avoiding as much pain and suffering as possible.

Unfortunately, business has become an area where people prefer to remain blissfully unaware becasue they're after the Big Kill. They think that some things are too good to be true, but they want them anyway, and so plunge head first and will hear nothing of the rocks sitting at the bottom of the shallow pool below.

It would seem foolish that all these people with a library of degrees among them and more money than people can conceive of move on in such ways. But we are all creatures of emotion, and the dark side that drives greed and desire is exactly the part that harbors other weaknesses. So they ignore reason and move ahead, no matter what their experience tells them.

That's why we're waiting for the first shoe to drop - or at least for the echoes to catch up with us. Everyone seems to be watching each other for a clue. The US market is down, so Asia and Europe reacts, but then the US says, "Well, maybe it's not that bad after all." But Bank of America's earnings are down something like 95%. This is not the sign of a mild recession, but rather the a sign that something is seriously wrong. The banks have made unbelievably foolish mistakes and they now want to hide under a rock and not take chances. However, if the financial institutions that form the foundation of our economic system are cracking, what are the chances that everyone else will be if not well, then only mildly affected? Just how big a shoe - or boot - is waiting for its time to fall?

The Recession Slide

Everyone seems to be using the term these days. Greenspan says we're doing it. Pundits say we're doing it. I understand that those who feel in a position to influence the economy - generally those who make a profit off how the public perceives it - are loathe to use the R word, lest they create a general perception that creates the condition it describes. But people I know have been tightening their belts for some time, now. Gas has been pretty far up for over a year, heating a house in winter is expensive, people fear losing their jobs, foreclosures are at a high, and everything gets more expensive. What the hell did the experts think about public perception? That everything was fine and dandy? People badly want things to be better, and yet see a greater and greater share of the common wealth being held by the relatively few. To play into fear and hope for your own purposes is a dangerous and dirty business. Those who are at the top of the economic food chain should remember that there have been periods of reckoning, whether a depression or heavy-handed regulatory interference, because politicians are even more scared of the public than the well-to-do. You can win for a long time at some games, but eventually your number comes up and you have to pay. Better to deal more honestly with things than to try putting a bright face on for too long.

Credit Crunch and Trickle Down Economics

We're starting to see the beginning of credit crunch fall-out. From the tech sector, Cisco Systems mentioned that if large banks are having to write down billions of dollars because of bundling debt into securities and getting rating agencies to give a better credit rating than the individual loans could often get, chances are they won't have money to spend on things like new technology. As a Financial Times story quoted:

“If there is a concerted slowdown in financial services you are going to have a big problem,” Richard Parower, managing director at J&W Seligman, said.

Makes sense, and investors agreed by suddenly knocking the NASDAQ composite down. Stocks recovered, more or less, but in a way that doesn't matter. Banks buy less and are wary of deals, which means that law firms don't get all the money they were used to. As things slow, there will be a drop in spending, and in jobs, probably. Tech and finance will affect virtually everything. Energy costs are hitting everyone and everything and food is getting more expensive, so consumers will have less to spend. Borrowing can't cover it, as the dollar is no longer so attractive a deal for those countries like China that are brining in the cash.

Personally, I'm steering more of my own writing business to publications that serve sectors that have some cushioning against recession, like legal, food, and I'm even considering getting a foot into the health care door. Now's the time to take stock of where things will go and to seek out the relative safety you might find.

Christmas in October

According to the New York Times, a number of retailers are extending their holiday marketing back into early October:

Shattering records for an early start, Wal-Mart is cutting prices on toys in mid-October, but the company is not calling it a holiday sale. L. L. Bean has started advertising free shipping — but it is shying away from the H word. And Toys “R” Us is marketing a temporary store in Manhattan, but consumers have to study ads to find the name: Holiday Express.

According to the article, what has pushed them back this far is the expectation of a lackluster holiday shopping period. So much for the day after Thanksgiving. This offers more evidence that there could be a broad economic slowdown, I think, or at least for a lack of business confidence, which can become the same thing. I see why retailers are about holiday sales, as many see 60% of their business from September to December. But I don't see a logical reason why worries transform into a strategy of starting the sales earlier. When you have the sales start so early, you lose the chance of getting anyone to pay higher prices at all. The result is a self-fulfilling prophesy of lower dollar sales and lower margins.

You can't solve a problem that stands outside the realm of efforts you currently make by doing more of the same. maybe retailers need to do something completely different and find a way to deliver value that isn't offering goods for less. Why not offer a shopping service, where people can call teh store, say what they want - maybe even get gift suggestions - and have all the stuff put together for them so they can simply pick it up? That does sound suspiciously like an online shopping facility, which is fine. Just add a little bit extra service and position it as what it is - a way of getting what you need done without getting strung out. Let a number of retailers work together on a holiday season gift registry, so you don't have to guess what Aunt Mildred wants, and you don't have to go to a particular store. Have a recovery zone in stores, where consumers can sit, rest, and get a free cup of coffee and cookie or other snack.

I won't expect to see any of this from now to the end of December. Businesspeople seem wed to continuing things they way as they have always gone, or to treat sales as a zero sum game, where the benefits go to either you or the customer. And zero is exactly what happens.

Stock Market High Evidence of High Investors?

I shake my head, looking at the new Dow record: 14087.55. With Citigroup and UBS melting down, with other financial services firms only showing strength when the financial reports don't include the late summer, with housing taking a beating and Wal-Mart and Target and Home Depot feeling the pinch, with the Supply Management index being weaker than was expected (though still just above the contraction level), you might not think this was a time to be betting on stock market prices sitting at high levels. But, even as top grade bonds are doing well, so are equities. The Financial Times has an "explanation" from an analyst:

“Everyone’s expecting bad news but, once it’s out, it’s either not as bad as everyone thought or at least it’s out in the open,” said Richard Sparks, senior equity analyst and equity options trader at Schaeffer’s Investment Research.

“The expectation is still that there will be a rate cut when the Federal Reserve meets at the end of this month. The market has decided that it is going to happen.”

If ever there was proof that people are completely and unrepentantly nuts, this is it. There will be a Fed rate cut at the end of the month because the market has decided that there will be a Fed rate cut at the end of the month. If Sparks is right, then investors are walking right past investing, long beyond betting, and walking into the heart of the Faithful. Look at what the analysts are saying (again from the FT article):

The most significant economic data to come are the September payrolls figures due at the end of the week. Investors expect a rebound in job creation after the decline of 4,000 for August – the first fall in four years.

“We continue to expect overall payroll employment to be up 125,000 in September and look for little change in manufacturing jobs,” said Ted Wieseman, economist at Morgan Stanley.

Homebuilder stocks rose sharply on Monday after an analyst at Citi Investment Research said recent share price falls meant it was time to buy into the sector.

When you make your living leading the Faithful, I guess you can't afford to show doubt, even when that oncoming light in the tunnel is getting larger, and rounder, and there's the sound some equate to the roar of a tornado. The train is coming.

Greenspan and Trusting the Market

In a 60 Minutes interview, Leslie Stahl asked former Fed chairman Alan Greenspan whether he knew what was going on in the sub-prime lending market. His answer?

While I was aware a lot of these practices were going on, I had no notion of how significant they had become until very late. I didn't really get it until very late in 2005 and 2006.

Huh? An economist with his experience didn't understand that lenders will be happy to take outrageous risks if they think they can sell off the loans and not have to deal with the defaults? It's not as though no one brought it up. According to the CBS story, former Fed governor Ed Gramlich said that he had proposed examining the lending practices, but that Greenspan rejected the idea. Apparently that is the case:

"I thought that…we would not be capable of doing what he was suggesting," Greenspan says.

"But if sitting on them, taking some regula-what…" Stahl asks.

"Well, I think not," Greenspan replies.

"Even looking into it?" Stahl asks.

"It's nothing to look in to particularly because we knew there was a number of such practices going on, but it's very difficult for banking regulators to deal with that," Greenspan says.

So, he knew they were going on. I cannot - simply cannot - believe that Greenspan couldn't see the writing on the Wall Street, not after warning about irrational exuberance. No way to check on this? Not even with all the intellectual power and computing systems that the Fed has? Couldn't find a way to do some random checking on credit scores that were probably part of the lending record versus the size of loan and verified income? No way to see how many of the loans depended on lenders not verifying income, maybe? I don't believe it. This wouldn't be rocket science. and then there was this interchange:

"Just remember we raised interest rates at every meeting from June of 2004 till I got out of office," he says.

"You raised rates in 2004. But only after you held interest rates at historically low level for three years, while the bubble, the housing bubble was forming," Stahl points out. "And that you had 13 rate cuts in that period of time."

"It was our job to unfreeze the American banking system if we wanted the economy to function. This required that we keep rates modestly low," Greenspan explains.

Unfreeze the banking system? This sounds dubious. American companies had clearly over-invested in the 1990s and it would take them years to digest all that spending. Low interest rates weren't needed for investment - they were needed to get consumers to spend.

Perhaps Greenspan truly believed in the market the way I see many treat it, almost as a form of religion. Free everything up and it will all work out. I somehow don't think he's try to rig the system to let certain people take advantage. When asked about the major American car companies, he replied, "I would suggest they focus on selling, creating better cars for their customers," rather than depend on lowered interest rates. Perfectly sound advice. They aren't selling because they aren't producing products that consumers want most.

But there's a problem with the market-cures-all vision of unfettered capitalism. Depending on a market isn't relying on some invisible, rational, impartial mechanism that evens out the bumps. It means trusting to human greed, fear, and emotional goads that cause people to do the most unbelievably stupid things. Lending large sums at high interest rates, which will only go up, to people who will be unlikely to maintain payments is stupid business. It's hoping that enough of the money will come in to cover the losses. This isn't business; it's gambling.

As happens with most such decisions, what people do is rationalize why what they want to do really makes sense. Maybe that's what Greenspan was doing - hoping that things would work out as they were "supposed to."