Silent Casualty of the Financial Crisis

Investors, pension funds and over extended home owners have frequently been discussed as victims of the housing bubble meltdown and ensuing financial crisis but there is another group of casualties that is almost never mentioned. This other group is the savers who by and large played by the rules and invested their money safely and conservatively in CD's and deposit accounts. Following the financial turmoil, the Federal Reserve aggressively reduced interest rates in an effort to recapitalize the banks and to stimulate the economy to offset the economic slowdown that was an additional consequence of the financial turmoil. The lower Fed rate widened the rate spread (difference between what the banks pay for deposits versus the rate that they can lend at) enabling banks to make billions in additional profits. According to the IRS, in 2006 (most recent year for which data is available) individuals reported $222.26b in interest income on their tax returns and paid about $33.57 billion in tax on this income. Interest rates available on 1 year CD's have declined about 70% in the last year. A very general calculation would indicate that savers have lost about $155 billion per year in interest income and the Federal Government has lost about $23 billion per year in tax revenues due to these lower interest rates required to save the banks.

Response to Michael Jackson’s Passing

I think that the reason that music is so important in all human cultures is the ability of music to recall an emotional memory. Music can evoke the feelings of a previous love, a significant life event or a momentous decision in our lives and cause us to relive the event and perhaps to better understand our response to the event. However, especially with the music of pop stars, some fans make the mistake of assuming that the creator of the music has some keen insight and really understands the person, emotions and thoughts of the fan. Some fans transfer the sentiment, especially the sentiment of love, that the music evokes to the person who created the music rather than the person who created the emotional experience. I suppose that this is what explains the emotional outpouring following the passing of Michael Jackson. Michael Jackson was a stupendously successful musician whose style and skills influenced the music of those who followed and enriched the musical landscape. However, it seems to me that the fans are making him into something much more than he was. Although a skilled musician, he was a narcissistic, troubled, self absorbed individual who does not seem to me to be worthy of the adulation that he has garnered. I also find it troubling that so many people spend so much more time and effort staying current on the trivia of Michael Jackson’s life than on more important issues such as education, careers, public policy, etc. If only half of Michael Jackson’s fans spent as much time and effort understanding and speaking out on significant issues such as climate policy, the invasion of Iraq or health care reform then perhaps they could have made a more meaningful contribution to the quality of human existence.

I also believe that many people are exaggerating Michael Jackson’s contributions. As an example, I have heard it reported that Michael Jackson broke the race barrier that enabled subsequent black entertainers to appear on MTV when in fact Michael Jackson had nothing to do with MTV showcasing black entertainers. The Jackson Five were under contract to CBS Records in 1982 soon after MTV began broadcasting. CBS approached MTV requesting that MTV broadcast a Jackson Five music video for the song "Billie Jean". MTV refused stating that they had a policy of not broadcasting black entertainers. Walter Yetnikoff , then Chairman of CBS Records, threatened to pull other CBS artists from appearing on MTV and go public alleging that MTV was racist. Consequently, MTV changed their policy and broadcast the "Billie Jean” music video. It was Walter Yetnikoff, not Michael Jackson, who should be credited with breaking the race barrier.

Let’s keep things in perspective. Michael Jackson was a highly compensated singer. He didn’t cure cancer or make any significant contribution to the well being of humanity.

You Lost Your Job Due to a CDSs

Thousands of people have lost their jobs due to Credit Default Swaps (CDSs) and they don’t even know what a CDS is. A CDS is insurance that a borrower will repay a loan to the lender. Here is how the CDS leads to a job loss using as an example a fictitious company that I will call Acme, Inc. that makes pencils.

Business is good so Acme borrows $100 from Jones Investments to buy a machine to make more pencils. Acme agrees to pay the loan off over 12 months. Energy prices then increase so Acme is making less money on each pencil that it sells and is unable to pay off the loan as agreed upon. Due to the liquidity crisis, Acme can not find a bank to refinance the loan which would enable Acme to stretch out the loan repayment over a longer period of time, say 2 years, by which time Acme expects the market for pencils to improve.

Before CDSs, Acme would probably be able to modify the loan payment terms with Jones Investments because if Jones did not modify the payment terms the alternative would be that Jones Investments would end up with a used pencil machine which would be worth say $50 or Acme would be forced into bankruptcy in which case Acme’s assets would be sold off or the loan restructured in which case Jones would get back only part of the money owed to them, say $50.

However, Jones Investments, when they made the $100 loan to Acme, then bought 5 CDSs for $100 each from AIG on the $100 loan to Acme. If Acme can not pay back the loan per the loan terms, AIG will pay Jones $100 on each of the 5 contracts for a total of $500. Consequently, Jones wants Acme to default on the loan and wants to force Jones into bankruptcy. If Jones refinanced the loan for a longer term then Jones might only get $110 back on the $100 loan versus the $500 Jones will get if Acme goes bankrupt.

The way this scenario plays out is that Acme if forced into bankruptcy, all of Acme’s assets (tools, machines, vehicles, etc.) are sold for pennies on the dollar, Acme’s employees are now unemployed and Jones Investments makes a 500% profit.

The above example is not idle speculation. The above scenario is believed to have contributed to the refusal of GM bondholders and, more recently, to the debt holders of Six Flags Amusement Parks to refuse to a restructuring plan because they could make more money from their CDS contracts if the companies went bankrupt.

CDSs are not centrally cleared so it is almost impossible to determine who holds what CDS contracts. There is even the possibility that some lenders have actively worked to force companies into bankruptcy on which they hold CDS contracts by shorting the equity to force the stock prices down of borrowing companies.

There is the argument that the availability of CDSs lowers the borrowing costs for some companies so CDSs are good for the economy. However, since CDSs are not regulated and no reporting is required, it is impossible to know if this is true and almost impossible to determine if CDS holders are manipulating the market to force defaults.

Financial Crisis – January 2011 Headline

Based on developments in the financial markets and the lack of significant regulatory reform, following is a potential headline news story from the future.

AIG and several major investment banks are on the verge of collapse and have returned to the Fed requesting assistance to prevent a collapse of the US financial system. In late 2008 and 2009, the world financial system almost failed due to failed investments in the housing market. The Fed at that time pumped trillions of dollars of liquidity into the system which resulted in the Fed owning a large part of the major investment banks and AIG and the Fed also lowered interest rates to almost zero to assist the banks in re-capitalizing. Because of the low rates of returns available at that time on CD’s and government bonds, and the low interest rates charged on loans, investors borrowed hundreds of billions of dollars which were invested in corporate bond funds and purchased Credit Default Swaps (CDS) on 80% of bond purchases. With corporate bankruptcies having increased by 20% in 2010, a large percentage of the underlying bonds have defaulted and the investors are demanding that AIG and the investment banks honor their CDS obligations. AIG and the investment banks under-priced the insurance sold but the sale of the insurance significantly increased their 2009 and 2010 earnings. Although only $600 billion in bonds have defaulted, over $2 trillion in CDS insurance was purchased on the defaulted bonds. The 5 largest investment banks and AIG are requesting $1.5 trillion of capital which is required to cover the CDS obligations.

Health Care Reform - Round 1

In the area of the Obama Administration's effort to reform health care, the only change made to date is an agreement with the pharmaceutical manufacturers who will pay up to half of the drug charges for Medicare Part D recipients who are in the donut hole. In Medicare Part D, the government pays for the 1st $2,700 in prescription drug expenditures each year, the recipient then pays 100% of costs until the recipient has spent $4,300 after which Medicare pays for the rest of the expenditures. The recipient's annual expenditures between $2,700 and $4,300 is referred to as the donut hole and the pharamaceutical industry has agreed to pay for half of the prescription cost for brand name drugs only (not generics) for income eligible recipients purchased by the Medicare recipient while in the donut hole.

First, I find it unfortunate that the 1st agreement extends benefits for seniors (I'm a senior myself) who are the best served group in terms of medical care in the US and who have benefited to such a large extent from health care reform over the last few years such as the addition of Medicare Part D prescription drug coverage.

Second, I question what the Obama Administration has given the drug manufacturers in return for this change. I am concerned that the Obama administration has agreed to continue the current policy of not allowing Medicare to negotiate drug prices.

There is a group of people who are "dual eligible beneficiaries" in that they qualify for both Medicaid (health care for the poor) and Medicare (health care for seniors and the disabled). Prescription drug coverage for these dual eligibles was paid by Medicaid until 2006 after which the costs were paid by Medicare. For the top 100 drugs, Medicare paid $3.7 billion more than what Medicaid would have paid. Medicare Part D drug costs are about 30% higher than what is paid by Medicaid. For all drugs, if Medicare Part D paid the same price as Medicaid for all drug purchases, the total savings to the taxpayer over the next ten years could be as much as $156 billion.

Perhaps I'm too cynical but I'd bet that negotiated drug prices by Medicare has been taken off the table so I'll give round 1 to the health care providers.

Along these same lines, I'd also question why Medicare even pays for brand name drugs when there is a chemically identical generic. As an example, the statin drug for high cholesterol Zocor costs about $150 per month while the chemically identical generic Simvastatin costs about $6.00 per month. Medicare pays for Zocor while my Blue Cross plan only covers Simvastatin.

ROLE OF CORPORATE GOVERNANCE IN THE FINANCIAL CRISIS

It is likely that regulation can be established that will be at least moderately effective in preventing the financial industry from engaging in the practices that led to the most recent financial crisis. Regulations can be established that will reduce leverage, increase reporting, increase capital ratios and prevent the use of off-balance sheet entities. However, it is unlikely that regulation can address what is arguably the primary cause of the current financial crisis which was the failure of corporate governance. Executive management and the boards of directors either were unqualified to manage the business that they were responsible for or knowingly approved practices which had the possibility of destroying their businesses. Alan Greenspan, during congressional testimony in 2008, stated that he was against increased regulation as he relied on banking management to exercise their considerable skills in avoiding business endeavors that would risk the survival of their institutions. He found it illogical that the industry engaged in the risky practices that led to the failure or near failure of so many financial institutions. But, were their decisions really so illogical? It may be that the boards and CEO’s knew that they were risking the long term survivability of their businesses but they also knew that, at least for a short but indeterminate period of time, these risky business practices such as sub-prime mortgages and high leverage ratios would return significant profits. Any CEO who took the long term view and avoided the profitable short term risk would find his firm under-performing competitors resulting in lower share prices, lower CEO pay and the distinct possibility that he would be replaced and not survive in his position long enough for his caution to be proven the correct strategy.

Health Care Reform

I can understand some people disagreeing with the outlines of Obama's health care reform plan presented so far but I really can't understand how some people can claim that we have the best health care system in the world and should leave it alone. The US spends twice per capita as the next most expensive system and we have higher infant mortality and lower life expectancy than France.

With health care costs increasing at double digits each year, if nothing changes we will all be spending our entire income on health care in the not too distant future. The cost problem is particularly acute for people who have individual rather than group policies. I suspect that the health insurance providers such as Blue Cross are rapidly increasing premiums on individual policies so as to subsidize the group policies which is an area of the market that is more competitive. Large companies have more buying power and have the skill and expertise required to negotiate favorable rates compared to individuals. Additionally, $1,100 per year of health care premiums are attributable to the higher costs charged by health care providers to compensate for services provided to the uninsured which are not paid for.

Some object to a single payer plan arguing that such a plan would degrade the quality of health care. Medicare and the VA medical systems are single payer plans which provide excellent coverage at reasonable rates with the lowest administrative costs in the system. Some object to a public plan arguing that the US can not afford a public plan. The public plan should charge premiums adequate to cover costs and, without premium income going to profits, merger and acquisition expenses and with lower administrative costs, the public plan should be able to be self funding while still charging a significantly lower premium.

Major health care providers have promised to work to keep premium rates down. This is not good enough and it is likely that if the providers are able to reduce costs that the savings will go to their bottom lines rather than to reduced premiums. A public option would use competition to improve service and reduce costs and is the only option that would likely provide the benefits desired.

Following are some policy options that could be used to pay for a new system:

1 - Limit deductibility of company provided plans to $5,000 per year per employee.
2 - Revoke the Medicare part d (prescription drug coverage) or at least cover only catastrophic expenses. It never made sense to me that such generous benefits were provided without means testing.
3 - Tax the major ingredients used to make food that is unhealthy and significantly contributes to obesity, diabetes, hypertension, etc. that lead to higher health care costs. Taxing tobacco products uses the same argument to justify the taxes.
4 - Actively work to reduce fraud in the area of disability claims.
5 – Bilateral Social Security Agreements (totalization agreements) between the US Social Security Administration and certain foreign countries enables individuals to gain credit for US social security benefits for time spent working in certain foreign countries after paying into the US system for as little as 18 months. Modify these agreements such that only the years spent working in a foreign country as a US citizen are counted towards US social security benefit calculations.

Some policy options that would help to keep costs down might include:

1 - Do not allow health care insurers and possibly providers to include merger and acquisition costs in the calculations used to calculate premiums. Let them finance their mergers and acquisitions from their profits.
2 - Permit medicare and any new public plan to negotiate prices with pharma providers.

Climate Change Legislation / Energy Tax

I really do not understand the opposition to legislation intended to reduce emissions of carbon dioxide and other emissions in an effort to avoid potentially devastating climate change. The arguments against the legislation cite increased costs, the belief that global warming has not been conclusively proven to exist and the belief that any US legislation would not be effective unless other nations, especially India and China, adopted similar measures to curb emissions.

If global warming is in fact occurring, then the increased costs of curbing emissions now will be much less than the cost of dealing with the effects of global warming such as rising sea levels that will flood many major US cities, devastate food production and create more devastating weather patterns. Most of us pay each year for house insurance with little chance that we will ever experience an insured event such as a fire so perhaps we should look at any cost of climate legislation as an insurance policy. If your doctor told you that your son had a 50/50 chance of having a fatal disease, that there was a treatment that would probably cure the disease but that the cost of the treatment was expensive and that the treatment had to be administered before severe symptoms appeared, most parents would spend the money to ensure that their son lived. This is exactly the situation with the planet that climate change legislation is intended to address.

As far as US legislation not being effective if all other industrialized economies don't implement similar legislation, I think that this argument is primarily intended to avoid changes in energy policy entirely. Someone has to go first and if US legislation is delayed until there is a global agreement then it is likely that there will never be legislation enacted. It is not necessary that all countries agree, only that enough countries agree on a plan that will provide an incentive for those countries that are not part of the plan to modify their behavior. I think it likely that climate change legislation will quickly lead to reduced costs of meeting the lower emission standards and to more jobs for those countries who participate in the climate change effort.

One option for dealing with the issue of other countries not enacting legislation would be to impose an imported goods carbon tax in the form of a percentage of the value of the imported goods regardless of the type of good imported. The tax would be calculated for each country along the following lines:

1 - A core group of countries supporting climate change legislation would determine an emission quantity permitted based on total energy consumed. It should be fairly easy to determine a country's energy consumption based on imports and production (oil, natural gas, nuclear, etc.).
2 - The quantity of emissions permitted would be higher than emissions from hydroelectric but less than emissions from coal which would encourage a move to cleaner emissions.
3 - A cost for excess emissions would be established - call it a penalty.
4 - The cost for unit output would be calculated by dividing the country's total penalty charge by total GPD resulting in a penalty charge per $1 produced - call it a dirty energy tax rate. I realize that GPD is difficult to accurately calculate but a number that is close rather than perfectly accurate will suffice.
5 - This dirty energy tax rate will be charged by the importing country on all goods and services (no exceptions) imported from the country on which the penalty rate was assessed.
6 - The dirty energy tax proceeds will be used exclusively to reduce emissions in the importing country which will offset the excess emissions from the exporting country. Participating countries would need to agree not to reduce government expenditures below the level spent in some base year. Otherwise, the dirty energy taxes collected might lead to a reduction in what a country might otherwise spend for climate change from general tax revenues.
7 - The amount of permitted excess emissions produced would decline each year.

The use of this dirty energy tax would offset the increased costs that domestic producers incur to meet the more stringent emission standards, shift the source of imports from dirty energy countries to cleaner energy countries and promote research and development on better and cheaper methods of reducing emissions.

If we wait until all countries agree on a plan and/or until global warming is conclusively proven it will be too expensive or too late to correct the problem.

Evolutionary Shift In Auto Production?

Aspects of the bankruptcy reorganization of GM and Chrysler suggest a possible fundamental shift in world auto production. Up to about 50 years ago, auto production was highly vertically integrated. An auto company would design the vehicles, make all or most of the parts and assemble the vehicles. Over the last 30 years, auto companies increasingly outsourced or purchased many of the components used in the production of their vehicles from parts suppliers.

There is the possibility that a fundamental shift is occurring in auto production as a result of the bankruptcy reorganization. In some cases, the auto company might design and sell the vehicle but outsource the entire production and assembly process.

Magna, an auto parts supplier based in Canada with world wide operations which is currently a major supplier of parts to the auto industry, has bid for GM's Opel operation. Magna's business plan is to use Opel's factories to assemble vehicles for auto companies on a contract basis. Penske Automotive has bid for GM's Saturn arm. Penske does not plan to make the Saturn but, at least for the next couple of years, to contract the production of the Saturn to GM's existing factories.

There is the possibility that if the Penske and Magna deals go through that this will result in a major reduction of the vertical integration of the automotive industry and could lead to significant cost reductions. Some companies will design and perhaps sell the vehicles and contract out the production of the vehicle to firms that specialize in manufacturing. This probably will also lead to sales and support of the vehicles being performed by another set of companies. This production model will make it possible for new companies to enter the auto industry as these new companies will not need to finance the construction of a manufacturing capability.

Oil Prices

The Federal Reserve has pumped trillions into the financial system at the taxpayer's potential expense and all the taxpayer has received in return, so far are, higher oil prices. The increase in oil prices over the last few months has been almost entirely due to speculation. You hear the argument that oil prices have been increasing because it appears that the recession is ending and increased business activity will require more energy. However, oil prices for light sweet crude for July 09 delivery are currently over $70 per barrel. There is no one who believes that the economy will turn around and be in high gear within a month. Buyers of oil are currently renting unused oil tankers to store oil. Given that there is currently about 4.5 million bbls per day of capacity that is not being used, oil prices should be going down rather than up. The current situation with oil reminds me of the silver market in 1979 when the Hunt brothers bid up the price of futures contracts for silver expecting to create a shortage and then cashing in when they sold the silver at the higher prices. Now that liquidity is available, hedge funds and pension funds are again speculating on the price of oil.

When Congress enacted the Commodity Exchange Act of 1936, they did so with the understanding that speculators should not be allowed to dominate the commodities futures markets. Unfortunately, the US Commodity Futures Trading Commission (CFTC) has taken deliberate steps to allow certain speculators virtually unlimited access to the commodities futures markets through the use of swaps contracts. In 2007, hedge funds and other speculative investors were responsible for one-third of all trades on the Intercontinental Exchange, a key market for setting oil prices, up from 0.2 per cent of trades in 2002. Currently, the margin requirements are less than 5% on the purchase of an oil futures contract. Commodity futures were originally intended to be used by users of the commodity such as air lines who would lock in future fuel prices to enable planning by buying an oil futures contract.

Another argument for the increase in the price of oil is the weakening dollar since international oil prices are expressed in US dollars (USD). Over the last 6 months, the USD has slid against the Euro by about 10% while short term oil prices have increased by about 100%. Based on these facts, I'd estimate that about $31 per bbl of the current oil price is due to speculation.

Some market analysts have argued against enforcing the anti-speculative requirements of the Commodity Exchange Act stating that the speculative investors are absorbing risk from the system in that if the price of oil goes down that the speculators will take the loss. Let's see, the US government lends money to the investment banks and the investment banks lend that money to commodity speculators who bid up the price of futures contracts with a leverage ratio of over 20 to 1 at a 5% margin requirement (they buy $20 of oil futures for each $1 they borrow from the investment bank). As far as the argument that the speculators will absorb all of the losses if the energy price collapses, the reality is that if the energy prices collapse that the speculators will not be able to repay the loans from the investment banks who may then return to the US government for additional capital. The taxpayer ultimately will pay for any losses on commodities while the speculators will pocket the gains. The taxpayer actually loses twice in that we are paying higher prices now for energy.

The swaps loop hole must be closed at the CFTC.

Quality of Imports from China

Although cheap, my experience has been that many of the products imported from China are worthless. The products are usually so cheap that I usually just throw out defective items rather than making the effort to return them.

Over the last month, I have thrown out 2 pedometers. One had instructions in such poor English that I could hardly read them and the reset button which was supposed to just zero out the number of steps from my last walk reset the entire unit which wiped out the settings (date, time, etc.). I recently tossed out rechargeable batteries that were shorted out, a mop where the metal rusted out in less than a month and a small garden shovel where the metal handle bent the first time that I used it. I also returned two closet doors purchased from Home Depot that were badly warped and smelled so bad that I didn't want to keep them in my condo. I suspect that these molded closet doors were made out of the same toxic waste that the Chinese drywall recently in the news was made from.

I have been wondering why it is that so many products imported from China are so poorly made. I recently came across a recently published book entitled POORLY MADE IN CHINA by Paul Midler that explained why so many Chinese products are poorly made. Mr. Midler speaks Chinese fluently, has lived in China since 2001 and works as a consultant who assists western businesses with establishing subcontracting relationships with Chinese manufacturers. Basically, Mr. Midler attributes the low quality to the following reasons:

1. Chinese manufacturers will frequently bid less than the cost required to make a product to the customer's specification in order to win the contract. The Chinese contractor will then focus their efforts on reducing the cost of production by cheapening the packaging, modifying chemical formulas, substituting lower grade materials and/or subcontract out the work to job shops that do not meet the environmental, sanitation or work conditions contractually required by the customer.
2. Some Chinese manufacturers will bid less than cost for a contract to manufacturer a name brand product. The Chinese manufacturer will then make copies of the product and sell in countries with less rigorous intellectual property rights enforcement.
3. Product testing to ensure compliance with the specifications is spotty. The customers are concerned that product testing will require an expensive recall so are reluctant to look too closely.
   
4. Shoddy Chinese manufacturing methods are widely recognized to be the case in China. However, the press is largely controlled by the government which does not want to jeopardize export earnings, there are no rewards for whistle blowing to someone who reports a deviation from the specifications in the contract and job safety and environmental protection laws in China are not enforced where they exist.

China is not going to jeopardize their export earnings by addressing the practices that lead to poor quality. One option might for an independent American Company along the lines of Consumer Research or Underwriters Laboratory to test and affix a seal of approval to Chinese imports which meat the design specs of their US customers. I would be willing to pay a little more to ensure quality.

It is ironic that China is making so much money making such shoddy merchandise.

Budget Priority - NEO

First, I would like to state that I do not believe in little green men from Mars.

NASA runs a Near Earth Object (NEO) program with the mission of identifying planetary objects such as meteors and comets and the paths of these objects. The objective is to identify objects that pose a threat to the planet. Most objects have paths which can be projected into the future to determine whether an object will impact with the earth. Space is vast but the number of planetary objects is huge. It is clear that the earth and other planetary bodies such as the moon and Mars have repeatedly been struck but a large number of objects some of which created huge, destructive impacts. It is not a question of if Earth will be struck by a NEO but when and how significant of an impact will occur. Keep in mind that an asteroid impact 65 million years ago is credited by most scientists as being responsible for the extinction of all large animals including the dinosaur.

Even a relatively small impact by an object the size of say a football stadium would create havoc with the weather on a planetary scale such that the entire planet would experience a winter that would last for years. Imagine the consequences of this. Food and energy shortages would cause the world population to starve and/or freeze.

OK. A NEO impact might not happen for thousands of years but it is just as likely to happen next year. The world has the technology that is required to search for threats and could mount a program to develop the technology to deal with a threat. Fortunately, NASA runs a NEO detection program. Unfortunately, the program currently run by NASA has an annual budget and staff level that is less than what you would find in one McDonald's restaurant. NASA's budget for 2010 for NEO activities is $3.8 million.