Next Financial Crisis

If you have been irritated by the current financial crisis and the ensuing bank bailout then you are really going to hate the next financial crisis which is already being formed thanks in large part to the remedy for the current crisis.

The major goal of the US Treasury is to enable the US banking sector to make sufficient profits to offset the losses suffered by the banks over the last 2 years thereby restoring the banking sector to financial health. Secretary of the Treasury Geithner would probably prefer to just give the banks a no strings attached check in an amount equivalent to what the banks have lost over the last 2 years but realizes that this would be politically unacceptable. So, he is pursuing a more convoluted approach which essentially accomplishes the same thing. The banks are borrowing hundreds of billions from the Federal Reserve and paying 0.25% (one quarter of one percent) and then lending the borrowed money to the US Treasury and being paid 2% plus (about 3.5% on a 10 year bond, less on 2's and 5's). The banks are also using the borrowed funds to buy foreign government bonds which are paying much more such as Brazilian bonds that are paying in excess of 8%. The banks are making a fortune using the money borrowed from the fed to make low risk, low cost loans to the US and foreign governments which explains in part why the banks have borrowed so much but lent so little to US businesses and consumers.

The problem is that the banks are doing the same thing now that got them in trouble a couple of years ago. They are currently borrowing short term and lending longer term and pocketing significant profits. However, if interest rates increase and/or the dollar strengthens significantly over the next couple of years, the banks are going to take massive losses. I'm sure that the fed realizes this but is focused on fixing the short term problem even if the fix leads to a larger, longer term problem. The current method of resolving the financial crisis is analogous to giving a heroin addict more heroin to avoid the pain of with drawl.

The really disappointing thing is that having suffered such a huge hit to the economy over the last couple of years due to the financial crisis, the US Congress is not able to develop any effective financial reform. Increasing the disclosure requirements on consumer loans is not going to make any significant difference to financial stability.

Are Seniors Paying their Fair Share of Taxes

I was reading a piece this morning about income growth slowing which was attributed in large part to Social Security (SSA) recipients not receiving a cost of living increase in 2010 due to the fact that prices (CPI) did not increase in 2009. On the face of it, I didn't think that an annual increase in SSA payments would make that much difference in gross income on a monthly basis but proceeded to check my assumptions. Per the Social Security Administration, payments to social security recipients in 12/2009 were $55.9 billion so a 2% increase in payments in 1/2010 would have amounted to only about $1.2 billion of additional income in 1/2010 which is a very minor amount in an economy of $13.6 trillion.

However, what I did notice was that per the Social Security Administration trustees, the total payments to social security beneficiaries in 2007 was $585 billion. Per the IRS, total social security income in 2007 reported by taxpayers was $382 billion or $203 billion less than paid by SSA. In some cases, the income of a recipient would be so low that they are not required to submit an annual tax return but I would be surprised if $203 billion was paid to people who are not required to submit a tax return. I would hope that the IRS and the SSA are exchanging info to ensure that recipients are paying their fair share of takes.

What I also noticed was disability payments in 2007 were $99,086,000,000 ($99.1b) made to 8,920,371 recipients. In 1990, there were 4,265,981 disability recipients which represented 10.71% of total social security recipients while in 2009 there were 9,969,398 disability recipients which represented 18.5% of total social security recipients. Are Americans really getting sicker and more disabled to the tune of almost twice what they were just 20 years ago or is there an issue with fraud and perhaps extreme generosity. Based on the experience of some people I know, it appears that anyone with a good lawyer can qualify for disability. For a program that we taxpayers are paying $100 billion per year (more when you add in Medicare for which disabled individuals qualify), I think that it is time to review the goals of the program with the way that it is being implemented.

In the context of the current health care reform debate and the Republican claims that a public option would lead to rationing and Washington bureaucrats determining the health care that you get, I think it more likely that our elected representatives would provide more than the private insurance industry and more than what the taxpayer can afford.

Supreme Court Decision on Campaign Finance

In a 5 to 4 decision in Citizens United v. Federal Election Commission announced on 1/21/2010, the US Supreme Court essentially ruled that corporations have the same first amendment rights as individual US citizens. The specific impact was that existing campaign finance restrictions for corporations were invalidated and that any corporation could spend any amount they wanted to support any candidate for any US political office. The ruling would have the impact that even foreign corporations could spend money to affect the outcome of a US election.

I really don't understand how the Supreme Court arrived at their decision but then I am not a US constitutional law specialist. The US Declaration of Independence states that "... all men are created equal" and endowed "with certain inalienable rights". The preamble to the US Constitution speaks in terms of "We the People of the United States". It seems to me that the protections in US law should only apply to US men and woman - nothing here about corporations, either foreign or domestic.

Supreme Court Justice Alito who votes with the right leaning justices and disagrees with the Supreme Court rulings on abortion (Roe v Wade) never-the-less has supported the court's view that a fetus is not a ‘person’ within the meaning of the Fourteenth Amendment. Justice Alito has stated that the US Constitution clearly states that the rights enumerated therein apply to men and therefore not to fetuses. So I wonder how it is that US constitutional rights that he believes don't apply to the unborn off spring of US citizens apply to corporations, both foreign and domestic.

In any case, the US Supreme Court has ruled and we need to play by the rules and accept this ruling. However, I believe that there are some options that the US Congress has to mitigate the effect which would be:

1. Remove the tax deductibility for lobbying and campaign related efforts for corporations.
2. Bar tax exempt status for any Political Action Committee (PAC) that accepts any funding from any source other than an individual US citizen. If the PAC accepts funding from a corporation then they lose their tax exempt status.
3. For financing from a corporation, make them pay an equal amount which would be made available to PAC's with an opposing point of view to provide a balanced perspective. If needed, the money could be collected via import taxes on imports from the foreign company.
   

Financial Crisis - Who is Responsible

Congress has established the Financial Crisis Inquiry Commission (FCIC) to determine what caused the financial crisis that required a massive taxpayer bailout of the financial sector. Although various legislators and news pundits have pointed the finger at a number of decisions and institutions, it seems clear to me as I have stated in previous posts that unregulated derivatives were the root cause of the problem.

Some have blamed the Federal Reserve under Alan Greenspan for keeping interest rates too low for too long. In 2003, the Fed kept interest rates low to combat high unemployment rates that were persisting in the recovery from the bursting of the dot.com bubble. Although I agree that Greenspan bears significant responsibility for the financial crisis, his responsibility in my opinion does not derive from his role as Fed Chairman or for keeping interest rates low. Low interest rates are an appropriate economic method for increasing employment and full employment is a legally mandated objective of the Federal Reserve. Just because interest rates were low does not justify bankers taking unreasonable risks. If a bank manager forgets to lock the bank door and a thief walks in and steals money, the thief can not argue innocence blaming the theft on the bank manager.

Some people have argued that the Community Reinvestment Act (CRA) which required all federally chartered banks to increase mortgages to low and moderate income neighborhoods was responsible for the problem mortgages that caused the financial crisis. The CRA only applied to deposit taking banks covered by FDIC insurance and FDIC covered institutions wrote less than 20% of all sub-prime mortgages. In any case, the CRA was passed by Congress in 1977 - more than 30 years prior to the financial crisis - so if the CRA was responsible we should have seen problems earlier.

Some people have blamed Fannie Mae and Freddie Mac for the financial crisis. Fannie and Freddie buy mortgages from primary lenders to make more money available for mortgages thereby increasing home ownership and lowering mortgage interest rates. However, at the height of the financial crisis in 2006, Fannie and Freddie collectively held only 24% of all sub-prime mortgages. Also, keep in mind that Fannie and Freddie never wrote a single mortgage in their history. They only buy mortgages written by other lenders. Also, Fannie and Freddie were subject to much tighter restrictions on the types of loans that they could purchase than the lenders such a Country Wide.

Some people have argued that revoking the major provisions of the Glass Steagall Act in 1999 which separated commercial bank and investment bank activities was responsible. Although I believe that major portions of the Glass Steagall Act should be reimposed, I don't believe that the abolition of the Act was responsible since the Act only applied to deposit taking institutions who wrote and held a small percentage of the sub-prime mortgages and did not apply to the big investment banks such as Goldman.

About 80% of the sub-prime mortgages that caused the financial crisis were lent by unregulated organizations like Country Wide and sold by unregulated investment banks such as Bear Stearns. Consequently, although the Federal Reserve interest rate policies in the 2000's, Fannie and Freddie, and the CRA contributed a little to the problem, they were not responsible for the 2008 financial crisis.

The next step in determining the cause of the crisis requires that we look at what happened to these sub-prime mortgages. The investment banks packaged these sub-prime loans into Collateralized Debt Obligations (CDO's) which eventually came to represent a significant percentage of the portfolios of pension funds, money market accounts held by mom and pop savings accounts, college endowments and charities as well as large investors. Many of the largest buyers of these CDO's could only buy highly rated financial instruments. The way that the investment banks were able to get these CDO's rated highly buy the rating agencies (Moodys, S&P) was to purchase Credit Default Swaps (CDS) primarily from AIG. The CDS's were essentially insurance whereby if the sub-prime borrowers did not pay back their mortgages then AIG would pay for the loss. Consequently, at least on the face, the CDS essentially made investing in sub-prime mortgages risk free. Now the problem with the AIG insurance was that AIG never had sufficient reserves on hand to pay any significant amount in claims. What AIG did was essentially equivalent to me personally selling hurricane insurance to condo owners in Florida and spending the premiums I collected on yachts and vacations in years when there were no hurricanes and then when a hurricane hit, since I wouldn't have any money to pay the claims, I would just go bankrupt and sail off on my yacht.

In summary, if AIG did not sell the credit default swaps (or was required to keep adequate reserves to pay claims), the investment banks would not have been able to sell the sub prime CDO's to investors so there wouldn't have been any demand for sub-prime based mortgage investments so lenders would not have been able to sell the junk to anyone and would not have written the sub-prime mortgages and we would have avoided the financial crisis caused by the sub-prime mortgages. The rating agencies and the investment banks could reasonably be said not to have exercised due diligence for not checking out AIG's ability to pay off in the case of a claim.

OK, so if the root cause was the availability of credit default swaps sold primarily by AIG, who is responsible? When reading the following, keep in mind that a credit default swap is a type of financial instrument called a derivative. If I had to pick one person responsible for the financial crisis I would pick former president Bill Clinton.

Brooksley Born is a Stanford educated attorney with over 30 years experience as an attorney specializing in financial instruments and derivatives. She is a personal friend of Hillary Clinton who at Mrs. Clintons suggestion was considered for the position of Attorney General by President Clinton. President Clinton interviewed her and declined to nominate her because he found her personality colorless but did nominate and appoint her as chairperson of the Commodity Futures Trading Commission (CFTC) in 1994. In her role at the CFTC, Ms. Born became seriously concerned that unregulated derivatives, especially credit default swaps, posed the potential to cause a significant financial crisis. The CFTC consequently initiated a process to develop comprehensive regulations for the derivatives markets. Clinton's Council of Economic Advisors led by Alan Greenspan and Larry Summers with the support of then Treasury Secretary Robert Rubin and SEC Chair Levitt had a fit, threatened to have Born removed as CFTC chair and eventually persuaded Congress to pass a law that prevented the CFTC from regulating derivatives. Although Greenspan and Summers were the two who spearheaded the effort to prevent the regulation of derivatives, Greenspan and Summers reported to the President who supported their efforts. If Clinton had taken the time to understand the threat and supported Ms. Born, there is a good chance that derivatives would have been regulated, AIG would not have been able to sell swaps which would have caused the rating agencies to rate packages of sub-prime mortgages as junk which would have prevented the purchase of these investments by some of the largest purchasers which would have prevented the investment banks from selling them which would have prevented the lenders from writing sub-prime mortgages.

What concerns me at this time is that the regulations being proposed following the 2008 financial crisis do not address the causes of the crisis. The big money has been effective in removing the regulation that would make the system reasonably safe. I'll post more details on the proposed regulation at a later time but at this time I would have to say that with the changes made in response to the 2008 crisis that the financial system is even more at risk than previously.

Afghanistan Troop Surge

The administration's announcement of a troop surge of 30,000 US Military personnel in Afghanistan announced 1n 12/2009 appears to have been designed as an attempt to please both the progressive Democrats who argued for a withdraw of the US military from Afghanistan and the Republicans who argued for a larger surge. Predictably, the announced surge please neither group.

The President's justification for the US presence in Afghanistan was primarily to prevent Al-Qaeda from reorganizing and establishing a base from which attacks on the west could be planned. There are two arguments against this objective even of the US's strategy in Afghanistan is successful which are:
1 - Even if the surge is effective, it is likely that Al-Qaeda would move to another failed state such as Somalia, Sudan or perhaps Yemen.
2 - Arguably, the $100 billion plus per year that will be spent in Afghanistan by the US military alone in pursuit of the military operation would provide more security to the west if even a fraction of this military budget was spent on intelligence and surveillance. Recall that most if not all of the terrorist attacks in the west after 9/11 were executed by local cells that were inspired by but not supported by the Al-Qaeda leadership in Afghanistan. Consequently, if Al-Qaeda in Afghanistan was completely eliminated, the attacks in London, Spain and other locations would have still occurred.

In any case, the military effort is designed to fail in that the goal is to build a government from the top down when in fact the strategy should be to build from the bottom up. The US strategy is to build a central government capability including a central military and police force. Afghanistan has never had an effective central government and is a tribal society with power vested in the village elders. To control the entire country and gain the support of those Afghans in the best position to defeat the radical Taliban and Al-Qaeda, the US needs to work at the village level with the Shuras. The majority of Afghans do not support the radical Taliban or Al-Qaeda but they also view the Karzai government as corrupt and a threat and will never support any force that supports the Karzai government.

In support of the above argument, consider the activities of the Central Asia Institute (CAI) founded by Greg Mortenson which has been built about 200 schools in Afghanistan since 1999. Only 1 of these schools has ever been attacked and when this school was attacked, the village elder organized a militia which went after the Taliban who attacked and killed or jailed the Taliban involved in the attack. CAI only builds a school when invited to do so by the village and the village provides general labor used in the construction and security for the school and staff. CAI provides skilled labor used in the construction, materials, teacher training and school supplies.

For significantly less than the $100 billion annual cost, the US could establish relationships with the villages and build institutions at the village level which would benefit the Afghans and stop the Taliban and Al-Qaeda in Afghanistan.

Healthcare Reform DOA

First, I would like to note that I voted for President Obama and firmly believe that US healt hcare reform needs a major overhaul. At this point, I am forced to conclude that the current health care reform is a complete failure and should not be passed.

The current legislation does nothing to reduce costs and it appears that health care providers are raising costs more than they would have otherwise. It is likely that if the legislation currently passed in the House and Senate passes that the reform will cause more harm than good.

The cost of the proposed reforms in both the House and the Senate are intentionally and significantly understated. The CBO has scored both plans for the 10 years following passage and the CBO actually shows a savings for the Senate plan. However, both plans include 10 years of income and 6 or 7 years of expense in that premium subsidies don't start until 2013 or 2014 for the House and Senate plans, respectively. The cost projections are a financial gimmick intended to sway the general public. Medicare currently faces a financial shortfall and I agree that Medicare reform is necessary to keep the current Medicare system operational. However, any savings in Medicare should be used to shore up Medicare's finances rather than to fund general health care reform. Using Medicare savings to fund the current reform is a bit like a shell game in that additional funds, probably from the government, will be needed to shore up Medicare at some point in the near future.

The mandatory insurance for individuals which will result in 94% of the population being covered by health insurance falls well short of the mark. 6% of the population still equates to over 20 million people who will remain uninsured will still result in significant cost shifts to those who do have insurance.

The process for developing the reform was severely flawed. The administration proudly claims that they have entered into an agreement with the drug makers who will contribute $80b (recent discussions indicate that this amount might increase to $140b) over 10 years to the reform effort. Given that the drug makers have US revenues of about $320b per year and it is likely that the drug makers will just increase costs to makeup for the reduced costs to Medicare recipients, this agreement may actually make costs higher for non-Medicare recipients. Much the same situation exists with the hospitals.

The current proposals for reform should be discarded and congress should start from scratch.

Ayn Rand, Greenspan and Tea Parties

Ayn Rand was an author whose books typically sell 200,000 to 300,000 copies per year but over the last year sales of her books were about 2,000,000 copies. Rand, from St. Petersburg Russia, experienced the aftermath of the Bolshevik revolution during her teenage years. The Bolsheviks quickly implemented state control of almost every facet of life down to the number of calories that a person would consume. In her books, capitalist owners of corporations are the heroes and are persecuted by the masses. In addition to being an author, she is noted for espousing a plotical philosophy that she called Objectivism which essentially was a Libertarian philosophy that rejected any state involvement in virtually every aspect of life especially economic life. She firmly believed that state control and socialism would cause to a profound loss of liberty. For reasons that I can't pretend to understand, many Americans, especially those in the Tea Party movement, believe that the Obama administration has a hidden objective of imposing a socialist system in the US. Why so many fervently believe in the socialist intent of the Obama Administration when Republican US president's in the last 100 years have imposed price controls, appropriated land for a national parks system or highway system, etc, is a mystery to me.

Keep in mind that in Rand's view, all industrialists were heroes. Her role models were the 19th century US industrialists who are sometimes called the robber barons. Very few would want to return to an economics system where monopolies, cut throat competition with management tactics that included arson, price fixing and physical violence or control of politics by the few was the norm. I personally see little difference between the many of the 19th century industrialists and the Bolsheviks.

The political philosophy of Rand is not new. The economist Hayek made the same arguments but the novels of Rand are a much easier read than economics books and the philosophy of Rand gives voice to the beliefs and fears of many of those in the Tea Party movement which explains the recent rise in her book sales.

What is surprising to me is that someone as notable as Alan Greenspan who certainly could handle an economics book developed such a close personal relationship with Rand and support her political economy philosophy without apparent reservation. Greenspan was such a Laissez Fair capitalist that he even argued against laws that made fraud in financial markets illegal. He believed that the markets would punish those who engaged in fraud so no laws were required. If there had not been laws against fraud, Bernie Madoff would certainly have seen his investment business go bust but he would have just retired to his yachts and Manhattan penthouse rather than going to jail.

Rand developed her life's philosophy and world view based solely on her personal experience with the aftermath of the Bolshevik revolution which was an extreme but never-the-less local affair. I can't help but believe that her world philosophy would have been exactly reversed if she experienced the mid 19th century work houses in Britain rather than the Bolshevik revolution. But I guess that this wasn't an option because another author, Charles Dickens, already had this covered in his book Oliver Twist.

My point is that something as complicated as government is never a black and white issue and that any world view formed on a single event in a single location is bound to be distorted, limited and of no use.