Betting Grandma's Money

The Financial Crisis for Beginners
(or Grandmothers)

Mystified by the financial crisis?

Here's one of the simplest -- and most accurate -- descriptions I've encountered yet:

My mother is paying taxes to the government. The government is giving her money to the banks. The banks are gambling like they’re watching ‘Fast Money.’ But my mother didn’t sign up for that.

--Dylan Ratigan, quoted in "From CNBC Business Journalist to Critic of Bankers on MSNBC"; The NY Times (6/27/2010)

Unfortunately, it's really not much more complicated than that.

From 1934 to 1999, "betting with grandma's money" was illegal, thanks to a Depression-era law called The Glass-Steagall Act.

Wall Street got that law repealed -- and its legislative agenda enacted generally -- in the last 15 years or so.

"This Time is Different" & Financial Predictions

Cloudy Crystal Ball

To get some historical perspective on today's financial crisis -- and possibly divine some hint of where things go from here -- I've been skimming "This Time is Different: 8 Centuries of Financial Folly."

The co-authors, Kenneth Rogoff and Carmen Reinhart, are highly pedigreed economics professors; almost half of their exhaustively researched, 500 page book is devoted to various appendices, charts, and tables.

So what do other countries' experiences with financial crises, going back centuries, suggest for the U.S. now?

According to Rogoff and Reinhart, "the recent U.S. financial crisis . . . will remain in the hands of the fates as of this writing, and probably for some time beyond." (p. 217)

Translation?

"Hell if we know."

At least they're honest (more than can be said of Jim Cramer and half the yahoo's on CNBC).

The Hippo in the Coal Mine

California's Financial Mess

You have to wonder if California’s political paralysis foreshadows the future of the nation as a whole.

--Paul Krugman, "State of Paralysis"; The New York Times (5/25/09)

Just in case you've been enjoying a blissfully off-line Memorial Day weekend, the big story percolating on the leading op-ed pages and blogs at the moment is California's financial predicament. As in, it's out of money. Very soon.

Apparently, its three options are: 1) federal bailout; 2) bankruptcy; or 3) a dramatic cut in services coupled with tax increases. Or all three.

As Krugman notes, if it's true that, as California goes, so goes the country . . . we're in trouble.

Unfortunately, while there is only one Freddie Mac and Fannie Mae, and a handful of too-big-to-fail banks, auto makers, and insurers -- there are 49 other states, hundreds of big cities, thousands of counties, etc.

Bad Precedent

There really is no philosophical reason to extend aid to California and not to Colorado, or New Mexico, or . . . you get the idea.

So, what inexorably bubbles back up to the top of the agenda: the need for structural reform.

As cited in this blog and many others, the good news is, there's surprising consensus about the appropriate package of economic and political prescriptions (address the phenomenon of "regulatory capture," wield the nation's foreclosure laws as they were intended, open up the nation's sclerotic, two-party political system, etc.).

The bad news is, it's far from clear that doing any of the above -- on any realistic kind of timetable -- is politically viable.

Krugman again: "What’s really alarming about California, however, is the political system’s inability to rise to the occasion."

Is California "us??"

Required Reading

"Who's Who" Discussion of Financial Crisis

Best read of the weekend: a roundtable called "The Crisis and How to Deal With It."

Participants are a "who's who" of finance and public policy: Bill Bradley, Niall Ferguson, Paul Krugman, Nouriel Roubini, and George Soros.

Warning: their (quite sober) analyses are not for the easily spooked or faint of heart. Here's an excerpt from Nouriel Roubini:

There are only a few ways of resolving a [huge national] debt problem: either you default on it as countries like Argentina did; you use the inflation tax to wipe out the real value of the debt; or you have to raise taxes and cut government spending.

As depressing as the mess, its causes, and likely solutions are . . it's encouraging that someone out there has got a handle on what to do about it.

Now, if only they were in charge . .

"Does This Impress . . Floyd Norris?"

The Quick Way to Bank Profitability

If the roots of today's financial crisis were economic in nature, the vital signs to monitor would be such financial measures as the stock market, unemployment levels, and interest rates.

However, a growing chorus of commentators believe that today's dysfunctional financial system is ultimately a symptom of a political problem. As in, who makes the rules?

So, before investment banks could leverage their bets 35:1, the SEC had to give its ok; before AIG could write billions (trillions?) in exotic credit insurance, regulators had to look the other way; before Citigroup, Bank of America and others could bury hundreds of billions in liabilities in off-balance sheet entities, the Financial Accounting Standards Board ("FASB") had to allow it.

As President Obama has said, the dirty little secret of today's financial crisis isn't how many laws were broken . . but how few.

"Does This Impress . . . Floyd Norris?"

So, have trillions in Wall Street losses and bad bets (so far) weakened bankers' control over regulators? Hardly.

Here's the latest from Floyd Norris, the chief financial correspondent of The New York Times -- not just the unofficial dean of financial journalists, but as impeccable and unimpeachable a commentator as you'll find anywhere:

The world of accounting rulemaking is normally a staid and slow-moving one, with the board offering detailed rationales for changes and giving interested parties months to comment on them. Most comment letters come from people well versed in the accounting literature, arguing points that can seem arcane even if they could have a major impact on financial reports.

The process this time has been different in almost every respect. The board allowed only 15 days for comments, and said it would act after taking just a day to review the comments. Those comments arrived by the hundreds, including bitter reactions from investors. “Market value is market value. Stop letting the financial industry call a duck a whale,” stated an e-mail message signed by Diane Walser. “Who will benefit?” asked Roy Bell. “Only the very ones who already broke all the rules and have brought destruction to the world as we know it.”

--Floyd Norris, "Banks Are Set to Receive More Leeway on Asset Values"; The New York Times (3/31/09)

Leaving all the arcane accounting aside, the basic issue is whether the banks must write down their assets to market value, or use more subjective criteria (their own). The latter approach has been called, deservedly, "mark to management."

Suffice to say, the banks are prevailing.

The Tonight Show has a running bit, called "Does This Impress Ed Asner?," in which amateurs perform kitschy routines to try to win Mr. Asner's approval.

I propose my own version for the financial markets: "Does This Impress . . Floyd Norris?"

The banking industry's latest trick -- anything but the work of amateurs -- decidedly does not (disgust is more like it).

Recommended Reading

"Houston, We Have a (Political) Problem"

One of the very best pieces I've read -- out of perhaps thousands now -- analyzing the ongoing financial melt-down is "The Quiet Coup," by Simon Johnson. The article appears in the May issue of The Atlantic magazine.

Johnson, a former chief economist of The International Monetary Fund, has a "good news, (very) bad news" take on things.

The good (and surprising) news is that the financial crisis facing the U.S. isn't unique, and that similar crises have been successfully navigated by many other countries previously. In fact, precisely because of other countries' experience, there is a clear consensus about what to do (you can read the article for the details, but I'll give you a hint: it's nothing like the plan cooked up by Treasury Secretary Tim Geithner).

Un-do the Coup

The bad news is, whether or not a stricken country takes the necessary economic medicine is ultimately a political issue. In other words, does the country have the will to do what's necessary?

On that score, Johnson is decidedly pessimistic, because he's dubious that Wall Street will prescribe or take medicine that "gores its ox" -- and it is Wall Street that controls the decision-making apparatus.

The very bad news? He speculates that things may actually have to get much worse before interests hostile to Wall Street wrest back control ("un-do the coup??").

Here's hoping he's wrong . . .

"Alimony," Not Bailout

Can We Afford Wall Street?

I've got a way to make palatable the $3 trillion (or is it $4 trillion? Or $6 trillion?) injected into Wall Street (so far).

Don't think of it as a bailout, think of it as alimony. Yes, alimony.

As in, what you pay to divorce someone -- or in Wall Street's case, something -- that has become an increasingly expensive and bad match. Indeed, someone who is a parasitic drag on your daily existence and threatens your very well-being (no, I've never been through a messy divorce).

Lost in the uproar over AIG bonuses, second and third (and fourth and fifth) helpings of bailout money, etc., is the fact that modern Wall Street fails the most basic test for economic utility: cost-benefit.

Direct Costs

It's possible that, like a bad dream, "the current unpleasantness" will pass, and the Federal Reserve and Treasury will somehow be made whole on trillions in guaranties, "term facilities," equity "investments," open-ended loans -- and God knows what else taxpayers have spent on Wall Street's salvation. But I wouldn't hold my breath.

Assuming, conservatively, that Wall Street simply doesn't lose any more taxpayer money, the tab already easily exceeds $3 trillion.

Not only is that a staggering sum, it exceeds all the profits Wall Street has ever made, combined.

Warren Buffett famously observed that the airline industry, in almost a century of operation, has cumulatively operated at a net loss. The same is now true of Wall Street.

Indirect Costs

Sadly, all the money spent so far is just for clean up; it omits the long-term costs likely to result from the financial Chernobyl that modern-day Wall Street has become.

Such indirect costs are likely to include: ramped-up regulatory oversight (if you thought Sarbanes-Oxley was expensive and intrusive, just wait); billions in unemployment benefits to recession casualties; increased government transfer payments to destitute citizens whose savings and investments have suddenly been decimated, etc.

However, that's nothing compared to perhaps the biggest -- albeit incalculable -- cost of all: grievous damage to the trust and confidence that are the foundation of a capitalist economy (and fiat currency).

Benefits

On the plus side of the scale is . . . what, exactly?

Wall Street's investment bankers supposedly allocate capital -- wisely and efficiently -- to the most deserving.

Yet their recent track record in that department is abysmal: witness the billions directed to all the neophyte "dot.com's" that promptly crashed and burned, taking investors and the '90's bull market with them (notably spared: all the VIP's -- typically the banks' largest customers, and coveted future customers -- who routinely received allocations of shares at wholesale prices that they quickly flipped).

Commercial banks have hardly performed any better.

Until Glass-Steagall was dismantled a decade ago, they took in deposits, and then used that money to make profitable, socially productive loans to business and consumers.

At least that was the theory.

In practice, while many banks behaved conservatively, the biggest ones OD'd on toxic securities and are now either illiquid, insolvent -- or both. The cost to the FDIC (and ultimately, taxpayers): more hundreds of billions.

Alternatives

In today's high tech, Internet-based world, it's not at all clear what Wall Street's "value-added" is.

Google famously went public with very little help from Wall Street, using the Internet and something called a "Dutch Auction."

Was its IPO well-priced? Perhaps not: the stock quickly trebled, suggesting that it was underpriced.

However, that's one of Wall Street's dirty little secrets: it hardly matters how underwriters price an IPO, because they only set the initial price, and then only for a small percentage of a company's outstanding stock: once the stock begins trading, the market takes over.

But surely Wall Street's role in mergers and acquisitions is indispensable, right?

Actually, no. Warren Buffett, arguably one of the most successful M & A practitioners around, famously eschews Wall Street advice and deals directly with the target company's management.

So how about Wall Street's role helping to seed start-up companies?

Actually, it doesn't do that. Venture capitalists do. Coincidentally or not, their Silicon Valley headquarters is about as far away from Wall Street as you can get (in truth, the location is due to Stanford University, and the hub of entrepreneurs located nearby).

Finally, we've just had a decade-long experiment in letting fee-hungry banks (and Wall Street-created non-banks) decide who gets mortgages. The results haven't been pretty, to say the least. Of course, now that it's raining, as the saying goes, lenders predictably want their umbrellas back.

So what's a better way to decide who should qualify for a mortgage?

The Fair-Isaac Corporation, a for-profit entity, calculates a "FICO" score that already forms the foundation for most underwriting decisions. Take good FICO scores, add a relatively high down payment -- ideally 20% -- and, Voila!, you've got the makings of a credit-worthy borrower. An independent appraisal adds further protection.

Lump-Sum Payment

There's a name for something that doesn't create value, is levied involuntarily, and ultimately serves only to redistribute wealth: it's a called a "tax."

Aside from being manifestly unfair, the "Wall Street Tax" also saddles the U.S. economy with a cost that impairs its ability to compete in a "flat," hyper-competitive world marketplace.

A financial crash is a very high price to pay to learn we have a "legacy" financial system that is devouring our resources, and threatens our very way of life.

However, if the trillions we are now giving Wall Street hasten the arrival of a better, fairer, and more efficient system, the price will arguably be justified.

All that's left is to make sure that Wall Street knows it's received a lump sum payment. (Don't like "alimony"? Call it a severance payment.)

Preventing Financial Stroke

Tightening Credit Snares the Healthy, Too

Without doubt, credit was extended too freely over the past 15 years, and a rationalization of lending is unavoidable. What is avoidable, however, is taking credit away from people who have the ability to pay their bills. If credit is taken away from what otherwise is an able borrower, that borrower's financial position weakens considerably.

--Meredith Whitney, "Credit Cards are the Next Credit Crunch"; The Wall Street Journal (3/10/09)

Just like in a real stroke, in a financial stroke, the key to recovery is preventing damage to healthy "cells" far removed from the source of the damage.

As the financial melt-down weakens banks and tightens credit, one of the side effects is that heretofore good credit risks are finding their access to credit curtailed.

To pick just one of the multiple ways that can happen: lenders are now flagging credit files by zip codes. So if you live in a zip code where housing prices are falling especially fast, the bank issuing your credit card may dramatically raise your interest rate, or even cut you off altogether. Even if your credit is spotless.

Locking Barn Doors

Is there some logic to screening credit card customers by zip code? Sure.

For most families, home equity is one of their biggest assets (or at least, it was). If that's under siege, it's not a big leap to guess that the affected families' finances are also weakening, potentially putting creditors at risk.

But what sense does it make to give such families a downward shove?

Certainly, banks need to take defensive measures to guard against promiscuously issuing credit: one of the reasons we're in this mess is that banks exhibited far too little discretion a couple years ago (especially in hot housing markets).

Now, however, banks are predictably overshooting the other direction. Their actions take an already bad situation and make it much worse.

Ultimately, the best way to avoid stroke damage is prevention. If it's too late for that, then the next best course of action is to break the clot with blood thinner, the faster the better.

That's why getting credit flowing again is so critical to the economy's health.

Predatory Practices Persist

"Yeah, That Will Work" Department

I've been on a (very) brief family vacation -- Duluth water park and puppy scouting -- and returned to lots of mail, mostly business-related and bills. Including one from a large bank where I have had a credit card account -- and several other accounts -- for almost a decade.

Beginning later this month, the letter notified me, the interest rate on any unpaid credit card balance will be *28.99%! In fact, nowhere in the letter was the name of the bank even identified; rather, the correspondence, from "Cardmember Service" in ND, simply referenced the last 4 digits of my credit card (I had to check my wallet to realize which credit card account was affected)

Bad credit?

Hardly.

My wife and I have 800 credit scores, and just refinanced at 4 5/8% (we're part of the lucky minority that had enough equity and qualifying credit histories). And it's hardly like we are a new or unknown customer to the bank in question: our credit card account goes back years, and has never even incurred a late payment fee. We also have a mortgage with them -- also never late -- and multiple savings accounts.

Fortunately, it's not like it really affects us: we use credit relatively sparingly, and pay off the balance in full every month. (I also have several other credit cards that I can -- and quickly will -- switch my business to.)

But still.

What if we couldn't pay off the balance? The new rate would literally eat us alive in no time.

Predatory Practices Persist

At 29% compounded annual interest, $1 in debt balloons to $6(!) in seven years!

Clearly, anyone who fell into this pit would never be able to climb out. Is this how the banks propose to dig out of the crater they've dug for themselves -- and us, too?

Do the big banks really need to give people another reason to hate them right now??

*There are supposed to be usery laws on the books of most states. I can only guess that the card is issued from someplace like North or South Dakota, with a very "liberal" interpretation. In what has been called "a race to the bottom," some states compete for corporate business by gutting their consumer protection laws.

Revisiting Hoover

Financial Earthquake Likely to
Alter Presidential Reputations

[Dear Regular Readers: Sorry for the extended detour into macroeconomics, politics, etc. This blog's regular focus on Twin Cities real estate -- in the words of the public service address accompanying TV interruptions -- "will resume shortly . . . Please stand by."]

I certainly don't believe that history will vindicate George Bush's Presidency -- but I do think he was right to point out that posterity sometimes judges Presidents (and Presidencies) very differently than contemporaries do.

The best recent examples of that were Harry Truman, and, to a lesser degree, Dwight Eisenhower.

Both benefited from subsequent developments that cast their eras -- and the decisions they made -- in a more sympathetic light. (In Truman's case, it certainly helped that, unlike contemporaries, historians didn't automatically see him in FDR's shadow.)

Already, it's clear that the financial earthquake now in progress will have consequences for a number of U.S. Presidents, even some long departed from the scene.

Depending on what happens from here, the following is an instant snapshot of the Presidential reputations ripest for revisionism:

Reagan: down. Reason(s): seeds of current crisis sown during his terms?
Clinton: down. Reason(s): strengthening parallels between '20's and '90's. A loquacious Coolidge?
Hoover: up. Reasons(s): post-bubble Depressions not so easily avoided or combated.

Next post: back to local real estate!

Seed the Bottom of the "Food Chain"

Scorning the Financial Gods --
And Paying the Price

After the tech bubble, the healthy and natural progression dictated we enter recession. Alan Greenspan never allowed us to take that medicine, opting instead to inject the economy full of fiscal and monetary drugs. The resulting imbalances steadily built through the years and arrived at our doorstep with a thud. It’s not wise to mess with Mother Nature. We’re now witnessing the other side of risk gone awry and the cumulative comeuppance of a scorned business cycle.

--Todd Harrison, "The Future of Wall Street"; Minyanville (2/11/09)

If Harrison's take is right -- and I believe it is -- a couple conclusions and observations logically follow:

--Beware of cures that are worse than the disease (anyone else have deja vu right now?). Or, if you want a "folksier", Upper Midwest analogy: don't drive your car into the ditch -- or oncoming traffic! -- just to avoid a deer.

--The stage we're in now could be called "financial de-tox." It's perfectly appropriate -- and maybe even life-saving -- to use "financial methadone" ("hair of the dog," etc.) to help an acutely addicted patient wean themselves from their addiction (I put tax credits for home buyers, stimulus spending, federal aid to states, etc. in that category). Just be clear that that's what you're doing, and that such a strategy is temporary.

--There's something deeply ironic (if not foolhardy) about relying on an institution, The Fed, that helped cause today's financial melt-down to oversee its rescue. Ditto for too-big-to-fail financial institutions, GSE's ("government-sponsored enterprises") such as Fannie Mae and Freddie Mac, etc.

--Instead of breaking with past financial blunders -- and sequestering flawed institutions -- we appear to be doubling (if not quadrupling) down. In that vein, you'd speculate that, once the financial dust settles, there will be calls to strip the Fed of some of the vast new powers it now wields (and to unwind what now very well may be the world's scariest balance sheet -- ever).

"Financial Food Chain"

Life does go on after the meterorite kills off the dinosaurs, the forest fire clears away the old giants, etc.

However, we would do well to *mimic how nature regenerates herself after such cataclysms: not by resurrecting the species at the top of the old, collapsed food chain but by seeding -- literally -- those at the bottom.

The meek may not inherit the earth, but birds and all types of microscopic plants sure seem better adapted to -- indeed, capable of adapting to -- a new and dramatically leaner environment.

*Manufacturers are just now beginning to exploit the secrets of what's called "biomimicry" -- for example, studying how a spider makes silk that is stronger, ounce for ounce, than tensile steel, while using vastly less energy and creating none of the waste or pollution.

Financial Manslaughter -- or Murder?

How Culpable is Wall Street?

"The pressure on financial engineers . . . has been to compete to get new products out the door quickly, with their firms showing little patience for multi-year research and development. It's too bad these new products could not be labeled "beta" . . . to warn that products are not fully tested and still need work."

--Gordon Crovitz, "Time to Reinvent the Web (and Save Wall Street); The Wall Street Journal (2/9/09)

When the dust from the ongoing financial/credit crisis finally settles, the fundamental question society (and likely, judges and juries) must ask is, "did Wall Street commit financial manslaughter? Or is it guilty of something worse, like homicide?"

The difference goes not just to remedies and punishment, but to how we design our future financial system -- the current one's broken -- and prevent recurrences of the current melt-down.

So what's the difference between murder and manslaughter? The perpetrator's intention, and state of mind.

If you're speeding and driving drunk, and inadvertently veer off the road and kill a pedestrian, you're guilty of manslaughter. You may not have intended the result, our legal system says, but the decision(s) you made and your subsequent actions created the risk of harm. As a result, we're going to hold you accountable.

By contrast, murder requires premeditation. The gradations of murder -- first degree, second degree, etc. -- correspond to how cold and calculated (vs. impassioned and spontaneous) the actions were.

What's all this got to do with Wall Street?

Clearly, Wall Street decision makers created a system with enormous risk . . . and it crashed. (I don't buy the line that government is mostly responsible -- when it comes to financial regulation, Wall Street pretty much gets what it wants. Or more accurately: blocks -- or circumvents -- what it doesn't.)

The question is whether all the people at Citigroup, Goldman Sachs, AIG, Countrywide, Lehman Brothers, Fannie Mae, Freddie Mac, etc. who were essentially flooring the accelerator had reason to believe conditions were unsafe (watch for the incriminating e-mail's).

P.S.: backing up over the victim -- paying yourself billions in bonuses while the wreckage is still smoking -- definitely tilts the scales towards premeditation.

"Strategic Food Reserve"

Creative Responses to the Financial Crisis

I suppose it's just another a sign of our warped, contemporary values that we have a Strategic Petroleum Reserve ("SPR") -- heaven forbid our SUV's become idled -- but nothing equivalent for food.

Clearly, the ongoing financial crisis is going to be with us for awhile longer. In the meantime, wouldn't everyday Americans find it reassuring to know that the country has an emergency stockpile of food at the ready?

The implicit message would be that, come what may, society's basic needs are going to be met: no one's going to be allowed to starve. (Need an over-sized soup Kitchen? What better use for our mostly idle sports palaces -- subsidized if not paid for with public funds -- than to feed the hungry. I've even got a suggested name: 'Katrina Kitchens.'')

"Katrina Kitchens"

Once Americans feel that their basic, daily needs are provided for, they might actually relax a little bit. Once they're more relaxed, they're likely to . . stop panicking!

As FDR knew, step #1 in fighting a systemic economic collapse is addressing people's collective state of mind (curiously, a challenge made both easier and more difficult by the advent of the Internet).

While soothing words are definitely an important ingredient, so is concrete action.

Directing hundreds of (borrowed) billions towards insolvent, irresponsible banks fans people's anxieties. Taking obvious steps to safeguard the public's safety and welfare would do wonders to calm them.