Thursday, January 27, 2011

The GSEs and The Financial Crisis

The Financial Crisis Inquiry Commission's proceedings and report are a really sad commentary about the low quality of inquiry and debate in our political and economic system. From the beginning of the mortgage meltdowns in the 2001-2006 Nodoc/Lowdoc mortgages until today, we have effectively been chloroformed into forgetting how we got here.

In his testimony before the Senate Banking Committee, Professor John Coffee of Columbia University expanded upon a presentation I heard in Minneapolis:

"The evidence is clear that, between 2001 and 2006, an extraordinary increase occurred in the supply of mortgage funds, with much of this increased supply being channeled into poorer communities in which previously there had been a high denial rate on mortgage loan applications. With an increased supply of mortgage credit, housing prices rose rapidly, as new buyers entered the market. But at the same time, a corresponding increase in mortgage debt relative to income in these communities made these loans precarious. A study by University of Chicago Business School professors has found that two years after this period of increased mortgage availability began, a corresponding increase started in mortgage defaults--in exactly the same zip code areas where there had been a high previous rate of mortgage loan denials."

Professor Coffee's testimony is clear, factual and follows the chain of events. To conclude that the Fannie Mae had no part, or was a minor player in the meltdown would require a Soviet-style inquiry process populated by our own government and quasi-government apparatchiks. That's exactly what we got. Wall Street continued to securitize this junk with AAA ratings, given by agencies interested in nothing more than market share. To paraphrase Charles Prince, "As long as the music's playing, you've got to dance." The shadow banking system did so, until the music stopped. Here we are years later: in denial, still searching for the guilty, and still dealing with the wreckage.

Friday, January 21, 2011

Scrap Cap and Trade

With all the back-and-forth about alternative energy sources, the whole issue of a carbon tax has been forgotten. I've always been sceptical about the whole notion of a "cap and trade" system, which like a lot of trading systems are good for the traders and little else. Professor William Nordhaus of Yale has long pointed out the technical and institutional weaknesses of a cap and trade system.

He makes a simple, but incisive point that economic institutions are very familiar with the design and collection of taxes, but totally new to international cap and trade systems. The recent issues in Europe have made his point.

Until there is some sort of tax that "internalizes the externalities" by raising the price of carbon, it seems to me that the field of alternative energy will swing back and forth to the "source du jour"--wind, biomass, solar, you name it. Once a carbon tax were in place, then relative prices would have to reset to include the market's estimated value of energy sources including their effect on carbon emissions, the greenhouse gas that started the whole climate change controversy.

Oddly enough, given the huge expansion in North American and global natural reserves, natural gas would become much more attractive relative to coal or petroleum and the switching process should begin in earnest. In the case of the U.S., electric utilities would begin the switchover that they have been hesitant to make. Switching over to natural gas (something we've discussed in previous posts) would also probably start a mini-boom in capital spending and non-residential construction. And, some of corporate excess cash would go into investment instead of to dividends and share buybacks. All this would be good for the recovery and hopefully for new jobs.

The carbon tax hasn't had a strong, visible voice in the political and economic markets for some time. Hopefully, one will emerge soon.

A Capital Spending Boom?

My former colleague, Alliance Bernstein U.S. Economist Joe Carson's current Perspectives bulletin notes some interesting harbingers of a U.S. economic recovery that will look different from previous recoveries in our business cycle history.

In previous cycles over the past fifty years, the annualized rate of recovery in real GDP six quarters after the cycle trough has been about 5.5%, of which 3.6% came from recoveries in housing and in personal consumption expenditures. ("New Mix Growth Story is Intact, 1/21/2011) Growth in investment and exports generated 1.9% annualized on average.

The current upturn's rate is 5.1%, which is comparable to the historical average, but the composition of contributors to growth is quite different, according to Carson's analysis. In the current upturn, 3.2% at an annualized rate over six quarters is coming from investment and exports, more than double the historical average rate. This is quite striking.

U.S. merchandise exports are going to emerging markets, versus a declining trend of export shipments to developed markets. "In our view, U.S. manufacturers will increasingly realize that they must upgrade their aging capital stock to maintain their competitive edge globally and boost production." This is music to our ears! Less financial engineering and more fundamental investment with the huge cash hoard of Corporate America.

He cites examples of Union Pacific Railroad, Intel and Ford Motor, all of which have publicly announced plans to increase capital spending by 25% in their network, build a new fab in Oregon, and build a new transit van plant in Missouri, respectively.

What if we were to scrap the current tax system: simplify it, get rid of outmoded deductions, lower rates and broaden the base? Add these and other fundamental improvements, like training our workforce, and you have a real reason for stock market valuations to start higher.

Thursday, January 20, 2011

What Do We Want China To Do?

I was impressed by the way Chinese President Hu worked the line of dignitaries at the White House before the formal meetings with President Obama. He looked relaxed, engaged, and comfortable shaking hands, and he seemed genuinely pleased to see Vice President Biden. Depending on the day, President Obama looked pensive, relaxed, stressed and confused.

We are not going to talk down the Chinese currency. Decades ago, this was called "jawboning,' and it didn't work under President Nixon and it won't work now. The Chinese will not make any significant efforts to move off their policy. Let's save a few trees and stop writing or talking about this.

Now, we trot out our business leaders with various special pleadings for their industries. Ladies and gentlemen, please go back to your offices and work on your businesses. Software piracy and intellectual property issues are real issues now, and they cast a pall over future economic relations. Going back to the days of Microsoft Office and Lotus installations on diskettes, there were all kinds of protections, in the form of keys, to prevent multiple installations and copying of the applications. There were also widely available $20 key breakers for sale on the street that unlocked these applications. I'm not sure that the solutions to illegal downloads can be strictly technological, as the hackers are now unconstrained and more clever than the corporate code writers. Unless the Chinese become convinced that it is in their long run interest to become a part of the global institutional system around organizations like WIPO, there is little hope here.

On the other hand, noise about making other currencies the basis for global trade is, for the medium term future, just posturing, as analysis by Professor Peter Kenen and others have argued. We shouldn't get exercised by this.

American companies doing business in China will have to do it on their terms, not ours, no matter what the final communique from the White House says. Carving out a stake in their market will ultimately involve loss of control over partnerships and joint ventures, and impacts on the brands. The companies will just have to quantify what these trade offs are worth and factor it into the NPV of the whole investment project. Wishing is not going to change anything here either.

We have to take the initiative on things we can control: our fiscal lack of discipline, our perpetual list of subsidies and ineffective social programs, the bloated, inefficient and unfocused structure of our public and private universities, the technical training of our workforce, the rediscovery of our manufacturing heritage, and shrinking of the risk in our increasingly concentrated financial sector. If we did any of these things, you can believe that the Chinese leadership would sit up and take notice.

Thursday, January 6, 2011

State Pensions Funds: Bad Moon Rising?

Donald J. Boyd of the Rockefeller Institute of Government is quoted in today's New York Times on the huge losses in state pension funds, "It is truly astounding. They ($477 billion in losses) don't translate immediately into budgetary stress for states. But what does happen is through the wizardry of actuarial valuations, they will drive pension contributions by states and localities up considerably in the coming years, and that's true despite the good stock market of 2009, and the relatively good stock market of 2010."

His characterization omits something important. Localities have already felt this pain through problems with the retirement plans for police and firefighters. State laws call for the cities to make up shortfalls, and in my city, the cost of this shortfall has already been borne by the taxpayers. Our City's problem is now sitting invisible to all except career government insiders at the State level, where it will be papered over with propaganda about public employees being scapegoats. The New York Times story lays out the issue with state pension fund shortfalls well. My issue comes from reading the Conference Board's "2010 Institutional Investment Report," which covers 2009 data.

In the early stages of the financial crisis we read many stories about states and municipalities creating problems for themselves by buying auction-rate securities, which promised above money market returns with no additional risk. Of course, these were unsuitable investments for the clients pushed on to them by unscrupulous brokers. City managers and state officials later filed suit whining that they never understood the risks of what they were buying.

The Conference Board report notes, "....many of these (hedge fund) investments are not publicly traded and lack an efficient quotation system. As a result, the value of alternative asset classes, as represented at the end of 2009, might not yet fully reflect the losses incurred by the public market during the 2008 financial crisis."

Among the Top 10 defined benefit plans ranked by the level of hedge fund investments at year-end 2009, fully 8 are public plans! As a percent of defined benefit assets, they are:
  • Pennsylvania Retirement (12.8%)
  • California Public Employees Retirement (2.8%)
  • Massachusetts PRIM (10.9%)
  • Pennsylvania Public School Employees (7.6%)
  • Virginia Retirement (7.2%)
  • New Jersey (4.3%)
  • New York State Common Fund (2.3%)
  • University of California (6%)

Going way down the list of the Top 200, one finds the Missouri State Employees Fund with 25% of their assets in hedge funds. I wonder what their board of trustees talks about? Another small detail is that Pennsylvania Retirement and Massachusetts PRIM have the bulk of their hedge fund assets in the "fund of funds" category which are expensive and more fraught with valuation and liquidity issues.

Hedge funds certainly have their place, and most of the top Ivy League endowment funds have used them very effectively in meeting the budgetary needs of their institutions, for which the endowments often provide as much as a third of the annual operating budget. However, these plans have access to the best funds, the best managers, and the best pricing. Their business school faculties, as at Yale, Dartmouth and others provide tremendous analytical horsepower to the internal management teams. They also have influential and knowledgeable alumni oversight from the financial services industry. In this context, the asset class makes perfect sense. For state and public employee retirement plans, I would say they are another set of land mines that deserve more transparency and public scrutiny, and we shouldn't pass the problem on to the general taxpayers. On that point, as John Fogerty writes, "I see trouble on the way."