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.

Random Thoughts

• Any "reform" coming out of Washington is not that.  This is because Congress and the regulatory bodies are captive to the groups they regulate.  Regulatory Capture is nothing new, but it will cost us more.  TARP and OTC derivative "reforms" are there to benefit a handful of broker dealers.  Credit Card "reform" does not really hurt the major issuers.  Education "reform" will never injure the teacher's unions, etc.  This leads to a fundamental question about regulation - more regulation begets more regulatory capture.   Simple principle based systems may be the way to go.
• Requiring U.S. based corporations to immediately pay U.S. income tax on foreign earnings is a major job killer if current rates stay.  Most countries tax on a territorial basis (i.e. you earn in our country, you pay tax in our country), while the U.S. taxes on worldwide income (regardless of where it is earned, if you are a U.S. based group of companies).  You will see a lot a major multinationals "invert" whereby their corporate parent becomes domiciled overseas and the U.S. operations become a subsidiary in order to avoid this onerous tax burden.  You will see a lot of talent, jobs, etc move overseas - the type of people and jobs this country needs to compete going forward.   Obama and Congress' punitive measure will be a huge gain for Hong Kong, Singapore, Dubai, Zurich, Dublin, and other less taxed and regulated financial centers.
• How the heck does changing fuel economy standards to 39 mpg by 2016 keep any jobs here?   The current cost structure for the big 3 means that they have a $1,500-$2,000 legacy cost per car for retiree pension and health care benefits (this will probably drop a bit, but the bailout of GM and MOPAR is really a bailout of the UAW as they have not made the same degree of concessions as everyone else).  So the government will force the automakers here to build cars no one wants to buy at a price where they can make a profit without a huge taxpayer subsidy.   The new generation of fuel efficient cars of the big 3, few will be manufactured here because of the labor costs.  We, the taxpayer, will be on hook for propping up the UAW.  The more sensible solution would be to jack up fuel taxes - but that won't happen, or just let the market solve it - as the spike from last summer showed that people will switch to smaller, more fuel efficient cars.
• State governments will always have structural deficit problems until they get rid of defined benefit pension plans and generous retiree health care benefits for government employees.   The problems that the Big 3 have with the UAW pension and benefits is a precursor of what will happen to state and local governments unless this is addressed.
• I went to a mayoral candidate's debate the other day, and both the Democrat and Republican repeated pledges to "invest", whether it be "light rail", "affordable housing", or "good schools".   Most of the questions were about neighborhood issues, where the candidates pandered.   I stood up, and was the only one to ask "You talk about 'investing' in this and that, but I have not heard a single word of how you are going to pay for this.  When I hear politicians talk about 'investment', I cringe as I know my taxes will go up to pay for this.  How are you going to pay for this without going into debt or raising my taxes?"
• For a good read on the follies of "light rail" and "smart growth", get Randall O'Toole's "Best Laid Plans". Seems that the common theme over light rail plans in the U.S. is that they go at least 50% over budget and never meet their overly optimistic ridership projections and are bound to be a money pit.

The illusion of CDS regulation

I cannot recommend enough reading through the Institutional Risk Analytics newsletter.   This is the source for understanding bank solvency and the regulatory issues surrounding the current banking problems.  This particular piece discusses how the major investment banks have hijacked the process of regulating credit default swaps.  Another prime example of how regulators are held captive by the industries they regulate.  Here's a tidbit:

Why such a desperate battle for the OTC derivatives markets? For the world's largest banks, the OTC derivatives markets are the last remaining source of supra-normal profits - and also perhaps the single largest source of systemic risk in the global financial markets. Without OTC derivatives, Bear Stearns, Lehman Brothers and AIG would never have failed, but without the excessive rents earned by JPMorgan Chase (NYSE:JPM) and the remaining legacy OTC dealers, the largest banks cannot survive. No matter how good an operator JPM CEO Jamie Dimon may be, his bank is DOA without its near-monopoly in OTC derivatives -- yet that same business may eventually destroy JPM.

The key thing for the public and the Congress to understand is that the "profits" earned from these unregulated derivatives markets are illusory and do not cover the true risk of OTC derivatives. Put another way, on a systemic basis, risk-adjusted profits from OTC derivatives are not positive over time. As with the current crisis, the net loss from the periodic collapse of what is best described as gaming activity gets off-loaded onto the taxpayer, thus OTC derivatives must be seen as any other speculative activity, namely a net loss to the economy and society. But unlike taking a punt on a pony at the racetrack, bank dealings in OTC derivatives vastly increase systemic risk, make all banks unstable and threatens the viability of the real economy.

Bubbles

This is an interesting Vanity Fair article on the financial implosion in Iceland.  

Bubbles can happen anywhere.   They have happened in all sorts of places, in "laissez-faire" countries like the U.S. and U.K., France under the Bourbons, collectivist Iceland, Japan, Holland, Albania.. etc.

The only thing you need for any kind of financial bubble is people.  No amount of regulation or absence thereof  will prevent it.  Mass movements have their own lives, and no amount of reason will fix it.

If you haven't read it, get Charles Mackay "Extraordinary Popular Delusions and the Madness of Crowds."

This is not about "greed" or "capitalism" - it is about human nature and how people, when caught up in a moment, can ignore reason, common sense, reality, and let their animal spirits get the better of them.  When it comes to finance, people disregards such concepts as "reversion to the mean", and "markets can remain irrational longer than I can remain solvent".    

Hubris takes over voila - bad stuff happens.

The quiet coup

From the Atlantic for your reading:  "The Quiet Coup"

Essentially - the U.S. government is an oligarchy with financial interests not unlike Russia or any third world country.

The mythical "Systemic Risk"

Does anyone have a definitive idea on what "systemic risk" is?   If so, should we even try to regulate it as it is now obvious that existing regulatory regimes and human nature have shown otherwise.

The solution is to acknowledge that many believe that there is the existence of systemic risk, but that it cannot be controlled.  Prudence, in the sense of being prepared for things that we cannot predict or forecast, should be the guiding principle.

There should be two frameworks - regulatory and non.   Two rules for non-regulated:  Cannot be a publicly traded company and will not get bailed out.  In other words, these non-regulated firms would normally be partnerships where the owners have all their capital at risk and then some.   They are generally free of oversight except that they will not be bailed out.  

The regulated companies have their deposits and custodial accounts guaranteed for a fee.  In return, they are limited in the amount of leverage they may use,  cannot use off balance sheet financing, and cannot engage in trading from their own account except as a market maker (i.e. no proprietary trading).   The only derivatives that these firms may trade are those that go through a clearinghouse with adequate margin rules.

This keeps the "traditional" banking and investment banking side in their roles, but limits their leverage and scope of business in return for being insured by the government.   The other players not covered are the wild West, whereby the players are on the hook for their losses and are not publicly traded (think the big 4 CPA firms or Goldman Sachs before it went public as a structural model).  

Think this is fair enough for everyone to understand ..

AIG - the key question

I guess the best way to describe this is that when you rush things, stuff gets screwed up.

During that meeting, between the Geitner, Paulson et. al. in late 2008 when it was decided that the Treasury was going to end up owning AIG, why weren't the 10 largest CDS counterparties brought in and given this simple option:

"The United States Treasury will not step and and save AIG unless all CDS counterparties agree to take a 20% haircut".  This is done where AIG could not match off counterparties with offsetting swaps.

AIG at the time had $4.7 trillion in outstanding credit default swaps.  I think that most  of the counterparties would rather take a guaranteed 80 cents on the dollar than try their luck in bankruptcy court.

Of course, that would assume that Treasury would try to be the best stewards of taxpayers' money.

Hank Grenbeerg sues AIG

This is incredible - if Greenberg is correct in saying that Tim Geitner barred AIG's former chairman and largest shareholder from discussing the company's rescue while Goldman Sachs, AIG's largest CDS counterparty is allowed. This is disgraceful and a clear conflict of interest. Geitner should resign and GS should not be bailed out .

Mr. Market Miscalculates

The title of this post references a book recently written by James Grant, publisher of Grant's Interest Rate Observer and a frequent reference of this site.  After reading his book (insightful and witty read), some things really struck me and warrant some discussion.

The credit bubble, which for all intents and purposes, has burst, has been the culmination of 20 plus years of credit growth in excess of GDP, fueled by easy money, and a paper currency not backed by anything.

People with advanced degrees are no better at predicting the future than you and I.  Why we put faith into central bankers with regards to economic forecasts, inflation forecasts is a fool's errand.  Targeting one aspect of monetary policy (e.g. inflation) will only beget more of it, as one becomes so fixed on the measure (in this case "core" CPI) that one ignore the other moving parts that will contribute (i.e. excess money channeled into financial assets and easy credit).  

A gold standard, with its faults, is better than the blind faith put in oracles, as it has a built in corrective mechanism.  If a country's economy or government issues too much debt, people will demand a higher return or convert their debts for gold.  Either the borrower has the choice of de-leveraging, go broke on higher rates, or exhaust their gold reserves.    Nations cannot have perpetual current account deficits with gold, they are forced to live within their means.  Gold is a hedge against nations deliberately debasing their currency as way of avoiding the hard choices with structural issues (eg. health care in Canada, Social Security and Medicare in the U.S.) and reducing the scope of government.

Alan Greenspan, who once was a believer in Gold back in the days he hung around with Ayn Rand, oversaw this credit bubble and long-term debasement of the currency.    Grant goes back through history, and shows that monetary arrangements never last long.  Bretton Woods lasted barely twenty five years, and the years of the U.S. dollar being the world's reserve currency and totally backed by nothing  will in all likelihood be not much longer.  This will only be expedited by Obama's massive expansion of the U.S. Federal government, leading to equally massive and unheard of deficits.   The tax projections outlined in his budget will not pay for this.   Even if he taxed all income over $200,000 at 100%, he would still run deficits.   His choices are to increase taxes on everyone or keep running deficits, debase the dollar, and let everybody's standard of living decline gradually.    Sooner or later, the creditor nations, who are generally no friends of America, will demand a higher return than the paltry rates they are getting right now.   They will rightfully want to be compensated for currency risk, inflation risk, and credit risk.    With that in mind, interest rates have nowhere to go but up, and up a lot they will go.

People can talk about "new paradigms", "new economies", "great moderations" in markets and economics, but the reality is that there is nothing really new in economics and markets.   This is because there is one constant:  human behavior.   People have their prejudices, change their mind on a dime, are irrational, myopic, emotional, greedy, feaful, prideful, to name a few things.  This is why models do not work:  even through people as a whole are constant, their behavior within their range of behavior what they do can swing wildly and without explanation.   This is why "markets can remain irrational longer than I can remain solvent."

A subset of this notion is the hard reality that the vast majority of the time, everything reverts to the mean.  If one has several years of above average returns, it becomes increasingly likely that it will correct itself back to the long-term trend line.   The stock market, commodities markets, and housing markets are bearing this out.   Specifically, think about the stock market during the tech bubble with its 20%+ returns, and how people were predicting Dow 10,000 (James Glassman really looks like a chump now!) and how with the internet and technologies were going to have the prosperity go on forever in an environment of low interest rates and inflation.   Excuse me, if the markets give us 20% annual returns for the foreseeable future with low inflation, wouldn't that imply that by simply investing my money and using the power of compounding interest, I could just put in $10,000 and be a millionaire in 20 years and never work again; but if everybody was retired due to their stock market riches, who would be working for the businesses who trade on the indices that require the 20% perpetual returns???  See the inherent problem with bubble returns - when returns start exceeding fundamentals, you plant the seeds of a crash, and eventually the return to normalcy.