While we're at it - let's cripple the US debt markets - TEFRA proposals

Here is some commentary on Barney Frank's latest proposal to now destroy the US corporate debt market overseas. This is rather arcane stuff, but has massive ramifications. All in the name to have a stealth tax grab to fund the welfare state here.

Morrison Foerrster (a top tax law firm in New York) has this to say

The Bill – Sanctions on Issuances of Bearer Bonds

The Bill would end the practice of selling bearer bonds to foreign investors under TEFRA C and TEFRA D. Thus, with respect to issuers of foreign targeted bearer bonds, the Bill would repeal the exception to (i) a denial of interest deduction for interest on bearer bonds and (ii) the 1% excise tax on the principal amount of the bonds.[1] In addition, interest paid on such bonds would no longer qualify for treatment as portfolio interest, thereby subjecting such interest to a 30% withholding tax, and any gain realized by a holder of such bonds would be treated as ordinary income.

This provision would apply to debt obligations issued after the date which is 180 days after the date of enactment of the Bill.

If enacted, the collateral damage from the Bill in the capital markets could be substantial. In the first instance, U.S. issuers would have to revise their existing programs to prohibit bearer debt. More importantly, they would have a harder time raising capital in foreign jurisdictions to the extent investors in those jurisdictions are unwilling to provide the non-U.S. person certification required for registered debt (i.e., IRS Form W-8). Also, U.S. issuers could not raise debt capital from jurisdictions (e.g., Switzerland) where investors are legally barred from certifying as to residency. Finally, foreign issuers would no longer have the protection against the excise tax of TEFRA C or TEFRA D compliance and would instead run whatever risk exists that the U.S. would attempt to impose an excise tax on a purely “foreign-to-foreign” debt offering.

No, the recession is not over. Yes, it will get a LOT worse before it gets better

Don't let the recent economic numbers showing 3% + GDP growth in the US fool you. That number was a blip, primarily caused by the cash for clunkers subsidy. Things are a lot worse, and will be a lot worse - and here's why.

The stock market is considerably over-valued and will go through a significant decline. As of today, the Dow is around 9,700 and the S&P 500 is 1,036. Based on my criteria for fair value (Graham-Dodd value investing style) - we need to see at least a 20%-30% decline before we're in that territory. The reason I need to see a significant decline in valuations in order to see value is simple.

A stock is traditionally valued by determining the present value of future earning and assigning a multiple to those earnings to come to a stock price. But, both parts of this equation show that stocks are significantly overvalued. Future earnings look to be significantly lower. With credit contracting, consumers must defer spending in order to service debt, depressing earnings. With taxes, both personal and corporate going up in the future to pay for massive government spending, deficits, and entitlements - this will depress both consumer spending. It will also be a double hit for companies as not only do they get hit with lower sales due to depressed spending from taxes, and higher corporate taxes will lower earnings.

Second, inflation - which will happen - as you cannot print all this money to finance massive deficits without eventually causing it, will require a higher discount rate - thus depressing the net present value of earnings. Third, higher interest rates that are a result of inflation will also increase borrowing costs and thus lower earnings as well. Finally, with inflation being a long term issue, bond yields will eventually have to rise to account for this. This will depress the earnings multiple as it is directly related to interest rates. Low interest rates mean that earnings yield (the inverse of P/E) will be low. High interest rates mean that P/Es must drop. If long term Treasury rates hit 10% for example, the earnings yield on stocks must be at least 10% to compensate for the risks of owning stocks. This would imply a P/E of 10. Currently, the S&P 500 has a P/E of 15.44 - so with the outlook for interest rates going up - and earnings being depressed, the market will eventually have to drop significantly to reflect this reality.

Many more banks need to fail in order to get his financial mess cleaned up. The Treasury's actions in propping up de facto insolvent banks will only delay the inevitable. When you look at many of the largest banks, and you bring the liabilities for they bad CDOs back on the books, many of them are technically insolvent. What needs to happen is that bondholders for these banks need to have their debts converted into equity in order to shore up the capital to cushion these losses. Alas, the Treasury and Obama administration seem loathe to force conversions or resolutions of these Zombie banks . These inefficient banks are sucking up capital that can be better deployed better by well run banks that did not make these foolish risks.

Instead, we are now have a cabal of large banks that have the government privilege of being "too big to fail". They will have an implicit advantage in their funding costs due to their preference, and they will be able to take on additional risky behavior due to this preference. This will come at a cost to the economy as a whole, as capital will be inefficiently used to prop them up that could be used to fund other ventures.

Couple these facts with a Federal reserve that is abrogating its duties to provide a sound currency and a Congress intent on creating a welfare state via the printing press - things look pretty bleak in the near term.

The solutions, albeit unpleasant, are simple:

It is apparent that we cannot trust people with the responsibility of being guardians of currency. Fiat currency run by bureaucrats in a central bank have devastated wealth over the past century. The since the inception of the Federal Reserve in 1913 - the U.S. dollar has lost 95% of its value. Same story for the Pound Sterling. We should not be ascribing oracle like powers to men like Alan Greenspan, nor any bureaucrat. We need to go back to a gold standard. The gold standard tempers politicians. When money is backed by gold - politicians cannot print debt recklessly to bribe the electorate. If a government issues too much debt, bondholders can start demanding payment in gold rather than paper - depleting a nation's reserves. We would never be in hock to China as we are now if we had to worry about them one day demanding all our gold in lieu of paper. Gold means that politician and bureaucrats cannot debase currency and lower our standards of living. A gold standard forces governments to live within its means.

If we need a financial regulatory regime - we need to scrap the complex BASEL II schemes. BASEL II allows financial institutions to game the models, allowing excessive risk to be taken. The model itself is flawed - just due to the fact that people are not rational all the time. Complex regulation create regulatory capture, with the revolving door of experts moving back and forth between government and industry, lining their pockets at each step. Today, for all intents and purposes, the U.S. Treasury department and Federal Reserve is an agent of Goldman Sachs. Rather than make more and more complex rules - let's make a simple set of rules that apply to everyone. Simple rules for capital, and what activities may be allowed in order for a institution to be eligible for deposit insurance. Those activities not listed are not allowed and may be pursued by other firms at their own risk - if the screw up, let them fail.

Finally, we need a massive rollback on the scope of the government. A nation created on the notion of free-born citizens, free to succeed or fail and live their lives as they see fit - does not need a government that promises them a utopia free of pain or risk. This means rolling back entitlements, regulation, and the related spending. We need to remove the ability of politician and bureaucrats to meddle in private arrangements, and the opportunity for favoritism by special interests.

We can fix this now, when it will hurt a good bit, or we can fix it later, when it will be a lot more painful. Like it or not, it will need to be fixed, because all of this is not sustainable.

Arbitrage and Monopolies

I cannot think of a more worthwhile read for those who are interested in credit markets and banking (and don't have the money to subscribe to Grant's Interest Rate Observer) than The Institutional Risk Analyst.

This week's article discusses credit arbitrage and bubbles. I think the key passage of this essay is:

The "bank monopoly" problem was well-outlined in Adam Smith's treatise and well-documented in the past decade by the Cruikshank Report in the U.K. (March, 2000). In simplest terms, whenever the arbitrage process that balances markets is monopolized, crises become commonplace. It is almost definitional that a financial market monopolist cannot "hedge" its "bets." As with the famous Hunt brothers' attempt to corner the silver market, when a monopolist buyer decides to sell, there are no other buyers, so the value of the monopolized commodity falls rapidly. When that commodity is loans, the result is a financial crisis. It is the alternation of "shoot the moon" and "fire sale" which arises when government policy monopolizes credit markets that causes financial markets to vacillate between euphoric bubbles and climactic crises.

I think that it is foolish for policy makers to believe that they can regulate or legislate away volatility, and absolve the markets of booms and busts. Economic booms and busts are offshoots of human behavior: human creativity, fears, greed - all these aspects lead to the change for better or worse.

Jails and Prisons - controlling the population

This a very thoughtful article on maintaining order in jails from the City Journal. It brings up something that I have thought a lot of, and that is prison reform.

I am a big believer of locking up violent criminals for a long, long time. However, I think how prisons are run today is disgraceful. Gangs are the de facto rulers of many institutions. Drugs and contraband are rampant. Rapes are prevalent. We should have prisons where contraband and rape is rare, violence is minimal, and the guards control the prison, not the prisoners.

I think that it is something that needs to be addressed, but is not a priority. The electorate generally wants people locked up for crime, which is understandable. But, the current prison, as construed, just encourages recidivism, and in many cases is just another criminal location.

This is very interesting to read, and I hope it puts some spotlight on real prison and jail reforms that work.

Net migration out of New York State - and some advice.

A great little article from a great periodical City Journal on the hemorrhaging of people out of New York state. Living in North Carolina - I cannot believe how many Buffalo ex-pats there are down here. It is great as I have a fondness for the city.

However, I have one piece of advice for all the New England refugees down here. Please remember that it was voting for tax and spend big government politicians in your home states that destroyed your economies, and thus the reason why you're down here. We don't want those policies here.

Elucidating Senator Kay Hagen (D-NC)

I was listening to a radio interview with North Carolina Democratic senator Kay Hagen. To say the least it was amusing. She vacillated on whether she would vote for tax increases to pay for a public option. She vacillated on whether she'd vote for any bill with a public option.

What I found was most annoying was her assertion that the present proposals would cut costs by encouraging people to avoid the emergency room and visit their primary physician.

I can tell you that the opposite will happen - based on my experiences in Canada. Assuming we have a "public option" that will pay like medicare - i.e. below market rates, we will eventually see a doctor shortage as prospective doctors will see the hassles and pay not worth the time to go through the education and training required. In Canada, the provincial governments deliberately created a shortage of doctors - believing that doctors, via their billings, were the prime cost driver of public health care. The provincial governments limited the spots in medical schools and capped billings by doctors.

There are three levels of doctor shortages in Canada. If you're in a major metropolitan area - you have to book your appointment with your G.P. several months in advance. If you're in a minor city (i.e. around 100,000) - you may or may not get a doctor. In my case - I called in a few favours from some school friends to get a doctor. So your rolodex is your friend in socialized medicine.

If you're in a rural era - you're SOL. Some practices have lotteries to see which people will become patients. The rest are stuck with the emergency room.

So what happens down here is that if you force everyone to be paid at Medicare rates under a "public option" - you'll have fewer doctors practicing and those without one will be forced to the emergency room - which will raise costs. Go to an emergency room in Canada - most of the people are there for stuff that a G.P. should do - but they don't have one. Because people don't pay out of pocket - they'll abuse the E.R. You see it here with medicaid recipients clogging the emergency rooms.

So Kay Hagen doesn't know what the heck she's talking about.

So much for Keynes

Over the past year or so, much of the press and the political class have been talking about how Keynesian policies are making a comeback. Things like government spending to stimulate the economy, etc are all in vogue now.

Although I think Keynes general theory does not work, I understand the intuitiveness of his theory. I think that the key premise of the his theory is that government needs to be counter-cyclical to the economy. In other words, governments should be hiking taxes/cutting spending/removing stimulus in up cycles and increasing spending/cutting taxes/adding stimulus during downcycles. The premise being, that government would temper the excesses of up cycles by pulling excess capital out of the market by fiscal policies and the severity of down cycles would be minimized as well.

Once again, the destroyer of most economic and political theories is once again - human nature. Recent history has shown how politicians cannot help themselves. During the up cycles through 1991-2007, federal and state governments slashed taxes and ramped up government programs - goosing an economy fueled by artificially low rates. Now, that times are tough - these same governments are cutting spending and raising taxes (at least on a state level, the federal government is raising taxes and increasing spending), which will not help one bit.

The problem is that politicians are incapable of not expanding the scope of government: they are addicted to increasing spending and incapable of cutting it. The taxes are just the result of this problem. This is why Keynes belief that government spending must be counter-cyclical cannot be a reality.

Missing in the "health care reform debate"

I'm not the only one to notice that when the Democrats talk about how medical costs are spiraling out of control and how the government needs to fix it - they never mention the direct and indirect costs of lawsuits on costs. Notice that this is not addressed at all? Obama talks about all these "unnecessary tests being done of dubious worth" - but what he doesn't mention is that many doctors do all these questionable tests as a form a defensive medicine, i.e. to protect themselves from lawsuits. Simple example - you can thank people like John Edwards for the increase in Caesarian sections - all the lawsuits alleging cerebral palsy from normal childbirth have led more and more OB/GYNs to avoid the lawsuit risk and just go with the C-section. Yes they cost more - but it avoids all the litigation costs and the increase in malpractice insurance. Unless this is addressed - no other reform will reduce costs.

Boy I miss these ads.

I certainly would rather see these ads than all the Viagara, Cialis, KY Jelly, Yaz, Trojan, and Valtrex ads currently running.

Market tidbits

• The equity markets are quite overvalued.  When the S&P 500 was below 800, I started seeing some decent valuations of various non-financial equities.   This is a bear market rally, in the sense that earnings can not, and will not, support the valuation levels of today.
• Don't let bank earnings fool you - a good chunk the Q1 profits by the major banks were derived by mortgage origination fees from people refinancing into 4.5% 30-year fixed mortgages.  Pretty well anybody who was creditworthy who could refinance pretty well did.  Second, thanks to the Federal government going trillions of dollars into debt, long-term rates are on the upswing (I have posted earlier that I think this is the beginning of a 20-30 year trend) along with mortgage rates - so that revenue will dry up.  There are still unrealized credit losses in the commercial loan sector and some parts of the home mortgage market.
• Obama's tax proposals will be another job killer.   Corporate tax increases like the elimination of parts of the foreign income deferral (a.k.a. Subpart F of the Internal Revenue Code), personal income tax hikes, possible cap and trade legislation, talk of a VAT, etc - this will depress earnings as the economy tanks.
• Bank stress tests mean nothing - due to two key issues.  First, nobody really knows the fair market value of the CDOs now on the books of these entities, and second, the problem now are Credit Default Swaps.  Credit Default Swaps helped down AIG, LEH, and Bear Stearns, and there is a real need for regulatory reform here.   The problem is that JP Morgan and Goldman Sachs are playing the Treasury and Fed in order to keep their market share and revenues from this business.   See the Institutional Risk Analyst for more on this.