There seems to be an amazing amount of misunderstanding of the basics of fiscal policy, even among people who should know better. Leave on one side the remarkable parade of economists who think that the savings-investment identity proves that government action can’t increase spending; PGL points us to a higher-level fallacy: the widespread belief that Ricardian equivalence doesn’t just say that tax cuts have no effect — which it does — it also says that private consumption automatically offsets any rise in government spending, which is just wrong.
Justin Wolfers suggests that this is because economists just haven’t been thinking and writing about fiscal policy. Maybe. But in my own neck of the woods, that isn’t true. In the New Open Economy Macroeconomics, which dates back to classic work by Obstfeld and Rogoff in the early 90s, both fiscal and monetary policy are usually analyzed.
And by the way: these are extremely buttoned-down models, with lots of intertemporal maximization, careful attention to budget constraints, and at most some assumption of temporary price rigidity. Nobody who was at all familiar with this literature could make the logic mistakes that are coming fast and furious from the fresh-water economists.
What this reveals, I think, is just how insular part of the macroeconomics profession has become. They just don’t read anything that doesn’t come from their cult circle; they just weren’t aware of major bodies of work that didn’t happen to be in their preferred style.
This insularity is asymmetric. Ask a PhD student at Princeton what a real business cycle theorist would say about something, and he or she can do that; ask a student at one of the freshwater schools what a new Keynesian would say, and I doubt that he or she could answer. They’ve been taught that there is one true faith, and have been carefully protected from heresy.
It’s a sad story.
Wednesday, January 28, 2009
Wednesday, January 21, 2009
Missing Fraudster Nadel Was 'Top US Manager' In 2003
One of the notable aspects of the Bernie Madoff case is that very few people knew who he was. Despite his stellar gains, he never got any kind of public recognition. The only articles about his performance were skeptical, like the ones in Barron's and Mar/Hedge.
Conversely, one of the newly emerge Mini-Madoffs, Art Nadel, actually was recognized as a top US money manager, in 2003. The award was given by newsletter The Wall Street Digest, according to Reuters.
Some, like 68-year-old Tony Hagar, say they were drawn to his funds by The Wall Street Digest and the upbeat report by its editor, Donald Rowe, and now question how much due diligence the investment newsletter industry conducts.
"He seemed to indicate that they were a reasonable investment. They put out a letter that says these folks have done substantially well, and that Don Rowe had looked at them closely," said Hagar.
Hagar is right to wonder how much due diligence was done here. We're guessing none to little. So far this no mention of Nadel or his award at The Wall Street Digest's "In The News" section of their website.
Conversely, one of the newly emerge Mini-Madoffs, Art Nadel, actually was recognized as a top US money manager, in 2003. The award was given by newsletter The Wall Street Digest, according to Reuters.
Some, like 68-year-old Tony Hagar, say they were drawn to his funds by The Wall Street Digest and the upbeat report by its editor, Donald Rowe, and now question how much due diligence the investment newsletter industry conducts.
"He seemed to indicate that they were a reasonable investment. They put out a letter that says these folks have done substantially well, and that Don Rowe had looked at them closely," said Hagar.
Hagar is right to wonder how much due diligence was done here. We're guessing none to little. So far this no mention of Nadel or his award at The Wall Street Digest's "In The News" section of their website.
Saturday, January 17, 2009
Markets can do anything they want
The selling over the past few days smacks of panic, yet again.
Some of this melt-down is forced selling as de-leveraging continues in the realms of the Masters of the Universe. Some of this selling is due to bear raids that are specifically designed to wreck the financial stocks and force the government to come in and wipe out the equity of bank stock holders. And some is just sheer panic.
It is incredible to me that people are willing to throw out everything and run and hide in the so-called “safety” of the Treasury market while opportunity beckons across risky assets unlike anything seen in decades. As the government gets ready to run trillion dollar deficits for as far as the eye can see, investors are so cowered that they are willing to accept 2% a year for a decade.
There is this theory in finance known as “The Efficient Market Hypothesis.” This theory postulates that the market is an efficient processor of information, whether it is all information (the strong form theory) or merely all widely known information (the semi-strong form theory), and that information is priced into stocks. Because stock prices are a reflection of all or all known information, the market is "efficient."
But consider what we have gone through over the past decade – The Asian Contagion, the collapse of Long-Term Capital Management, the Tech Bubble, the Credit Bubble, the Housing Bubble, and now the Treasury Bubble as investors were recently accepting T-bills with negative yields.
The market is not a wise, all-knowing processor of information and seer of the future.
The market is an idiot.
Everywhere I look, I read that it is the end of the world. All the news is bad. Everything is horrible. It is the Great Depression all over again. And so on.
Yes, the economy is bad. Yes, things are bleak. Yes, the world has changed. Who on God’s Green Earth does not know this already?
But is it really the end of the world?
Economic growth is driven primarily by technological progress. Advances in technology make things cheaper and lowers the cost curves of producers, freeing up resources for investment and expansion. This process is usually known as “productivity growth.” And unless the American public has become collectively lazy and stupid all of a sudden, the technological advancement and productivity growth that has made this country the richest nation the planet has ever seen will continue.
This is not to minimize the problems in the economy. We may be on the brink of a true depression, if a depression is defined as a 10% contraction in economic activity. We must continue to de-lever. We have some very serious problems we must work through.
But we are working through those problems. Many of the dominoes that had to fall have fallen. Dominoes remain standing but we are nearer the end of the decline in asset prices than the beginning.
This decade so far has been the worst decade for stocks. Ever. Valuations for stocks are attractive and the expected return from equities is at the highest level in decades. Credit markets are improving and governments are flooding the financial system with liquidity.
The most powerful force in asset markets is reversion to the mean. We have overshot the mean on the downside.
Can the market go lower? Of course. Markets can do anything they want.
But others can bet against reversion to the mean. I’m not.
Some of this melt-down is forced selling as de-leveraging continues in the realms of the Masters of the Universe. Some of this selling is due to bear raids that are specifically designed to wreck the financial stocks and force the government to come in and wipe out the equity of bank stock holders. And some is just sheer panic.
It is incredible to me that people are willing to throw out everything and run and hide in the so-called “safety” of the Treasury market while opportunity beckons across risky assets unlike anything seen in decades. As the government gets ready to run trillion dollar deficits for as far as the eye can see, investors are so cowered that they are willing to accept 2% a year for a decade.
There is this theory in finance known as “The Efficient Market Hypothesis.” This theory postulates that the market is an efficient processor of information, whether it is all information (the strong form theory) or merely all widely known information (the semi-strong form theory), and that information is priced into stocks. Because stock prices are a reflection of all or all known information, the market is "efficient."
But consider what we have gone through over the past decade – The Asian Contagion, the collapse of Long-Term Capital Management, the Tech Bubble, the Credit Bubble, the Housing Bubble, and now the Treasury Bubble as investors were recently accepting T-bills with negative yields.
The market is not a wise, all-knowing processor of information and seer of the future.
The market is an idiot.
Everywhere I look, I read that it is the end of the world. All the news is bad. Everything is horrible. It is the Great Depression all over again. And so on.
Yes, the economy is bad. Yes, things are bleak. Yes, the world has changed. Who on God’s Green Earth does not know this already?
But is it really the end of the world?
Economic growth is driven primarily by technological progress. Advances in technology make things cheaper and lowers the cost curves of producers, freeing up resources for investment and expansion. This process is usually known as “productivity growth.” And unless the American public has become collectively lazy and stupid all of a sudden, the technological advancement and productivity growth that has made this country the richest nation the planet has ever seen will continue.
This is not to minimize the problems in the economy. We may be on the brink of a true depression, if a depression is defined as a 10% contraction in economic activity. We must continue to de-lever. We have some very serious problems we must work through.
But we are working through those problems. Many of the dominoes that had to fall have fallen. Dominoes remain standing but we are nearer the end of the decline in asset prices than the beginning.
This decade so far has been the worst decade for stocks. Ever. Valuations for stocks are attractive and the expected return from equities is at the highest level in decades. Credit markets are improving and governments are flooding the financial system with liquidity.
The most powerful force in asset markets is reversion to the mean. We have overshot the mean on the downside.
Can the market go lower? Of course. Markets can do anything they want.
But others can bet against reversion to the mean. I’m not.
Wednesday, January 7, 2009
Marc Faber Jan. 07, 2009
This morning, Marc Faber, managing director of Marc Faber Ltd. and publisher of the monthly investment newsletter The Gloom Boom & Doom Report talked with Bloomberg’s Carol Massar, Erik Schatzker, and Ellen Braitman about the outlook for industrial commodities and gold prices, as well as government intervention in the economy, his outlook for the financial markets, and his investment strategy for technology stocks. Notable excerpts from the exchange included:
2009 Outlook
Well, economically it will be very bad. We have a contracting economy, globally, everywhere. And, I mean, not mildly contracting, but falling off a cliff. However, after this fall off of a cliff, the news in the next 3 months could look somewhat better than expected. In other words, there could be some rebound from the lows in economic activity.
U.S. Economic “Stimulus” Proposals
Well, it may help a little bit, temporarily. But in the long run, it’s a disaster. Any government intervention into the economy is basically bad, in particular, an intervention that is designed to support prices. The Federal Reserve, and the Treasury, both actually want to support asset prices. Most cartels that have been designed to support prices eventually broke down and prices collapsed.
Industrial Commodities
Gold is now very expensive compared to industrial commodities. Actually, it’s at the highest level in 30 years or more. And so right now, as of today, I would rather buy a basket of oversold industrial commodities.
Crude Oil
I would say, the long-term demand for oil is there. The supply won’t be there. So, long-term, I think the price will be much higher than it is today.
World War III
Everybody talks about monetary and fiscal policies, but nobody talks about the worsening geopolitical situation in the world. I think World War III has already begun.
FREE VIDEO: How to connect the market dots in 2009
Blue Chip Companies
I think in every industry, the leading companies emerging from the crisis, whenever the economy recovers, will be very strong.
Asian Stocks
If someone has no money in Asia, now you can buy top-quality companies at reasonable PE’s.
BRIC (Brazil, Russia, India, China) Stocks
Prices are now down to attractive levels as an entry-point, as a trading opportunity, like the metal stocks I mentioned. So, I think I would buy these BRIC countries for a rebound, looking for a rebound of around 30% from the present level.
Long-Term Outlook
Well, I’m very bearish long-term because I think that Treasury bond yields will go up a lot, and the trade of 2009 is to short U.S. government bonds- big time… I think it will take 5 years until the world recovers.
2009 Outlook
Well, economically it will be very bad. We have a contracting economy, globally, everywhere. And, I mean, not mildly contracting, but falling off a cliff. However, after this fall off of a cliff, the news in the next 3 months could look somewhat better than expected. In other words, there could be some rebound from the lows in economic activity.
U.S. Economic “Stimulus” Proposals
Well, it may help a little bit, temporarily. But in the long run, it’s a disaster. Any government intervention into the economy is basically bad, in particular, an intervention that is designed to support prices. The Federal Reserve, and the Treasury, both actually want to support asset prices. Most cartels that have been designed to support prices eventually broke down and prices collapsed.
Industrial Commodities
Gold is now very expensive compared to industrial commodities. Actually, it’s at the highest level in 30 years or more. And so right now, as of today, I would rather buy a basket of oversold industrial commodities.
Crude Oil
I would say, the long-term demand for oil is there. The supply won’t be there. So, long-term, I think the price will be much higher than it is today.
World War III
Everybody talks about monetary and fiscal policies, but nobody talks about the worsening geopolitical situation in the world. I think World War III has already begun.
FREE VIDEO: How to connect the market dots in 2009
Blue Chip Companies
I think in every industry, the leading companies emerging from the crisis, whenever the economy recovers, will be very strong.
Asian Stocks
If someone has no money in Asia, now you can buy top-quality companies at reasonable PE’s.
BRIC (Brazil, Russia, India, China) Stocks
Prices are now down to attractive levels as an entry-point, as a trading opportunity, like the metal stocks I mentioned. So, I think I would buy these BRIC countries for a rebound, looking for a rebound of around 30% from the present level.
Long-Term Outlook
Well, I’m very bearish long-term because I think that Treasury bond yields will go up a lot, and the trade of 2009 is to short U.S. government bonds- big time… I think it will take 5 years until the world recovers.
Tuesday, January 6, 2009
Obama's Big Tax Plan
Boy was I wrong! $300 billion in tax cuts are probably on the way -- and soon.
More Stories
Lessons From the Madoff Scandal
A Year Worth Forgetting
Fed's Balance Sheet Is Ballooning Fast
Right after the election, I was virtually certain that upper-income individuals would face higher federal income tax bills as early as this year. And I didn’t see anything very good on the business tax horizon, either. But after two more months of horrifying economic data, it’s a whole new ball game.
Now, President-elect Obama is proposing a $775 billion economic stimulus package that does not appear to impose higher taxes on anybody or anything for 2009. Instead, it looks like we will immediately see some of the “middle-class tax cuts” Obama promised, plus some unanticipated business breaks too. All in all, these tax cuts could add up to $300 billion (or more) over the next two years.
As Congress mulls over the Obama proposals, more details will emerge. Until then, here are some guesses about what might be coming.
Individual Tax Breaks
New Credit for Middle-Class Workers
We will likely see a new credit of up to $500 for working singles and up to $1,000 for working couples. The credit will probably be delivered via reduced federal payroll tax withholding, so it will take a few months for most workers to collect the full benefit in the form of bigger paychecks. When a similar-sounding credit was pitched during the campaign, it was to be phased out for singles earning over $75,000 and for couples earning over $150,000, but it appears those income limits may be moving targets now. How the credit might be extended to self-employed folks remains to be seen.
Liberalized Earned Income Credit
During the campaign, Obama pledged to increase the number of individuals who are eligible for the earned income credit and provide larger credits to noncustodial parents who fulfill their child support obligations, low-income married couples, and families with three or more children. Earned income credits are “refundable,” which means taxpayers can collect them even if they don’t owe any federal income tax (in other words, the government pays you instead of the other way around). There’s a good chance the upcoming stimulus package will include this change.
Business Tax Breaks
New Five-Year Loss Carry Back Allowance
Businesses might be allowed to "carry back" tax losses incurred in 2008 and 2009 to the previous five years. That way, taxes paid on earlier profits that were wiped out by recent losses can be reclaimed immediately as tax refunds. Under the current rules, losses can generally be carried back only two years and excess losses must be carried forward to future years -- which means those losses can’t do any tax-saving good until future profits are earned. With many companies facing uncertain prospects, extending the loss carry back period to five years would be good tax policy in my opinion.
Extended Section 179 Deduction Allowance
Thanks to the Section 179 deduction privilege, many small and medium-sized businesses can depreciate most or all of the cost of qualifying new and used assets in the first year they are put to use. Most depreciable assets (other than real estate) qualify for this deduction -- including equipment and most purchased software. For tax years beginning in 2009, the maximum Section 179 deduction was scheduled to drop from $250,000 to only $133,000. The upcoming stimulus package could extend the $250,000 allowance or perhaps make it even bigger.
Extended First-Year Bonus Depreciation
Last year, businesses were allowed to claim 50% first-year bonus depreciation for qualifying new (not used) assets that were both purchased and placed in service during calendar 2008. But this valuable break expired on Dec. 31. Unlike the Section 179 deduction, first-year bonus depreciation was available to even the largest businesses. The upcoming stimulus package could extend the first-year bonus depreciation deal through 2009.
New Jobs Credit for Employers
The stimulus package could include new tax credits for employers that hire more workers and perhaps even for those that forgo laying off workers. Details are cloudy, but a range of $40 to $50 billion worth of tax savings is being mentioned. (During the campaign, the Obama tax plan included giving businesses a $3,000 credit for each new full-time job created in the U.S.)
More Details to Come
For what it's worth, everything you’ve read here is nothing more than informed speculation. That said, there’s little doubt that we will soon see a whopping stimulus bill that includes some major tax breaks. Once the dust settles, we'll help you understand what it all means.
More Stories
Lessons From the Madoff Scandal
A Year Worth Forgetting
Fed's Balance Sheet Is Ballooning Fast
Right after the election, I was virtually certain that upper-income individuals would face higher federal income tax bills as early as this year. And I didn’t see anything very good on the business tax horizon, either. But after two more months of horrifying economic data, it’s a whole new ball game.
Now, President-elect Obama is proposing a $775 billion economic stimulus package that does not appear to impose higher taxes on anybody or anything for 2009. Instead, it looks like we will immediately see some of the “middle-class tax cuts” Obama promised, plus some unanticipated business breaks too. All in all, these tax cuts could add up to $300 billion (or more) over the next two years.
As Congress mulls over the Obama proposals, more details will emerge. Until then, here are some guesses about what might be coming.
Individual Tax Breaks
New Credit for Middle-Class Workers
We will likely see a new credit of up to $500 for working singles and up to $1,000 for working couples. The credit will probably be delivered via reduced federal payroll tax withholding, so it will take a few months for most workers to collect the full benefit in the form of bigger paychecks. When a similar-sounding credit was pitched during the campaign, it was to be phased out for singles earning over $75,000 and for couples earning over $150,000, but it appears those income limits may be moving targets now. How the credit might be extended to self-employed folks remains to be seen.
Liberalized Earned Income Credit
During the campaign, Obama pledged to increase the number of individuals who are eligible for the earned income credit and provide larger credits to noncustodial parents who fulfill their child support obligations, low-income married couples, and families with three or more children. Earned income credits are “refundable,” which means taxpayers can collect them even if they don’t owe any federal income tax (in other words, the government pays you instead of the other way around). There’s a good chance the upcoming stimulus package will include this change.
Business Tax Breaks
New Five-Year Loss Carry Back Allowance
Businesses might be allowed to "carry back" tax losses incurred in 2008 and 2009 to the previous five years. That way, taxes paid on earlier profits that were wiped out by recent losses can be reclaimed immediately as tax refunds. Under the current rules, losses can generally be carried back only two years and excess losses must be carried forward to future years -- which means those losses can’t do any tax-saving good until future profits are earned. With many companies facing uncertain prospects, extending the loss carry back period to five years would be good tax policy in my opinion.
Extended Section 179 Deduction Allowance
Thanks to the Section 179 deduction privilege, many small and medium-sized businesses can depreciate most or all of the cost of qualifying new and used assets in the first year they are put to use. Most depreciable assets (other than real estate) qualify for this deduction -- including equipment and most purchased software. For tax years beginning in 2009, the maximum Section 179 deduction was scheduled to drop from $250,000 to only $133,000. The upcoming stimulus package could extend the $250,000 allowance or perhaps make it even bigger.
Extended First-Year Bonus Depreciation
Last year, businesses were allowed to claim 50% first-year bonus depreciation for qualifying new (not used) assets that were both purchased and placed in service during calendar 2008. But this valuable break expired on Dec. 31. Unlike the Section 179 deduction, first-year bonus depreciation was available to even the largest businesses. The upcoming stimulus package could extend the first-year bonus depreciation deal through 2009.
New Jobs Credit for Employers
The stimulus package could include new tax credits for employers that hire more workers and perhaps even for those that forgo laying off workers. Details are cloudy, but a range of $40 to $50 billion worth of tax savings is being mentioned. (During the campaign, the Obama tax plan included giving businesses a $3,000 credit for each new full-time job created in the U.S.)
More Details to Come
For what it's worth, everything you’ve read here is nothing more than informed speculation. That said, there’s little doubt that we will soon see a whopping stimulus bill that includes some major tax breaks. Once the dust settles, we'll help you understand what it all means.
Monday, January 5, 2009
The End of the Financial World as We Know It
AMERICANS enter the New Year in a strange new role: financial lunatics. We’ve been viewed by the wider world with mistrust and suspicion on other matters, but on the subject of money even our harshest critics have been inclined to believe that we knew what we were doing. They watched our investment bankers and emulated them: for a long time now half the planet’s college graduates seemed to want nothing more out of life than a job on Wall Street.
Related
Op-Ed Contributors: How to Repair a Broken Financial World (January 4, 2009) This is one reason the collapse of our financial system has inspired not merely a national but a global crisis of confidence. Good God, the world seems to be saying, if they don’t know what they are doing with money, who does?
Incredibly, intelligent people the world over remain willing to lend us money and even listen to our advice; they appear not to have realized the full extent of our madness. We have at least a brief chance to cure ourselves. But first we need to ask: of what?
To that end consider the strange story of Harry Markopolos. Mr. Markopolos is the former investment officer with Rampart Investment Management in Boston who, for nine years, tried to explain to the Securities and Exchange Commission that Bernard L. Madoff couldn’t be anything other than a fraud. Mr. Madoff’s investment performance, given his stated strategy, was not merely improbable but mathematically impossible. And so, Mr. Markopolos reasoned, Bernard Madoff must be doing something other than what he said he was doing.
In his devastatingly persuasive 17-page letter to the S.E.C., Mr. Markopolos saw two possible scenarios. In the “Unlikely” scenario: Mr. Madoff, who acted as a broker as well as an investor, was “front-running” his brokerage customers. A customer might submit an order to Madoff Securities to buy shares in I.B.M. at a certain price, for example, and Madoff Securities instantly would buy I.B.M. shares for its own portfolio ahead of the customer order. If I.B.M.’s shares rose, Mr. Madoff kept them; if they fell he fobbed them off onto the poor customer.
In the “Highly Likely” scenario, wrote Mr. Markopolos, “Madoff Securities is the world’s largest Ponzi Scheme.” Which, as we now know, it was.
Harry Markopolos sent his report to the S.E.C. on Nov. 7, 2005 — more than three years before Mr. Madoff was finally exposed — but he had been trying to explain the fraud to them since 1999. He had no direct financial interest in exposing Mr. Madoff — he wasn’t an unhappy investor or a disgruntled employee. There was no way to short shares in Madoff Securities, and so Mr. Markopolos could not have made money directly from Mr. Madoff’s failure. To judge from his letter, Harry Markopolos anticipated mainly downsides for himself: he declined to put his name on it for fear of what might happen to him and his family if anyone found out he had written it. And yet the S.E.C.’s cursory investigation of Mr. Madoff pronounced him free of fraud.
What’s interesting about the Madoff scandal, in retrospect, is how little interest anyone inside the financial system had in exposing it. It wasn’t just Harry Markopolos who smelled a rat. As Mr. Markopolos explained in his letter, Goldman Sachs was refusing to do business with Mr. Madoff; many others doubted Mr. Madoff’s profits or assumed he was front-running his customers and steered clear of him. Between the lines, Mr. Markopolos hinted that even some of Mr. Madoff’s investors may have suspected that they were the beneficiaries of a scam. After all, it wasn’t all that hard to see that the profits were too good to be true. Some of Mr. Madoff’s investors may have reasoned that the worst that could happen to them, if the authorities put a stop to the front-running, was that a good thing would come to an end.
The Madoff scandal echoes a deeper absence inside our financial system, which has been undermined not merely by bad behavior but by the lack of checks and balances to discourage it. “Greed” doesn’t cut it as a satisfying explanation for the current financial crisis. Greed was necessary but insufficient; in any case, we are as likely to eliminate greed from our national character as we are lust and envy. The fixable problem isn’t the greed of the few but the misaligned interests of the many.
A lot has been said and written, for instance, about the corrupting effects on Wall Street of gigantic bonuses. What happened inside the major Wall Street firms, though, was more deeply unsettling than greedy people lusting for big checks: leaders of public corporations, especially financial corporations, are as good as required to lead for the short term.
Richard Fuld, the former chief executive of Lehman Brothers, E. Stanley O’Neal, the former chief executive of Merrill Lynch, and Charles O. Prince III, Citigroup’s chief executive, may have paid themselves humongous sums of money at the end of each year, as a result of the bond market bonanza. But if any one of them had set himself up as a whistleblower — had stood up and said “this business is irresponsible and we are not going to participate in it” — he would probably have been fired. Not immediately, perhaps. But a few quarters of earnings that lagged behind those of every other Wall Street firm would invite outrage from subordinates, who would flee for other, less responsible firms, and from shareholders, who would call for his resignation. Eventually he’d be replaced by someone willing to make money from the credit bubble.
OUR financial catastrophe, like Bernard Madoff’s pyramid scheme, required all sorts of important, plugged-in people to sacrifice our collective long-term interests for short-term gain. The pressure to do this in today’s financial markets is immense. Obviously the greater the market pressure to excel in the short term, the greater the need for pressure from outside the market to consider the longer term. But that’s the problem: there is no longer any serious pressure from outside the market. The tyranny of the short term has extended itself with frightening ease into the entities that were meant to, one way or another, discipline Wall Street, and force it to consider its enlightened self-interest.
The credit-rating agencies, for instance.
Everyone now knows that Moody’s and Standard & Poor’s botched their analyses of bonds backed by home mortgages. But their most costly mistake — one that deserves a lot more attention than it has received — lies in their area of putative expertise: measuring corporate risk.
Over the last 20 years American financial institutions have taken on more and more risk, with the blessing of regulators, with hardly a word from the rating agencies, which, incidentally, are paid by the issuers of the bonds they rate. Seldom if ever did Moody’s or Standard & Poor’s say, “If you put one more risky asset on your balance sheet, you will face a serious downgrade.”
The American International Group, Fannie Mae, Freddie Mac, General Electric and the municipal bond guarantors Ambac Financial and MBIA all had triple-A ratings. (G.E. still does!) Large investment banks like Lehman and Merrill Lynch all had solid investment grade ratings. It’s almost as if the higher the rating of a financial institution, the more likely it was to contribute to financial catastrophe. But of course all these big financial companies fueled the creation of the credit products that in turn fueled the revenues of Moody’s and Standard & Poor’s.
These oligopolies, which are actually sanctioned by the S.E.C., didn’t merely do their jobs badly. They didn’t simply miss a few calls here and there. In pursuit of their own short-term earnings, they did exactly the opposite of what they were meant to do: rather than expose financial risk they systematically disguised it.
This is a subject that might be profitably explored in Washington. There are many questions an enterprising United States senator might want to ask the credit-rating agencies. Here is one: Why did you allow MBIA to keep its triple-A rating for so long? In 1990 MBIA was in the relatively simple business of insuring municipal bonds. It had $931 million in equity and only $200 million of debt — and a plausible triple-A rating.
By 2006 MBIA had plunged into the much riskier business of guaranteeing collateralized debt obligations, or C.D.O.’s. But by then it had $7.2 billion in equity against an astounding $26.2 billion in debt. That is, even as it insured ever-greater risks in its business, it also took greater risks on its balance sheet.
Yet the rating agencies didn’t so much as blink. On Wall Street the problem was hardly a secret: many people understood that MBIA didn’t deserve to be rated triple-A. As far back as 2002, a hedge fund called Gotham Partners published a persuasive report, widely circulated, entitled: “Is MBIA Triple A?” (The answer was obviously no.)
At the same time, almost everyone believed that the rating agencies would never downgrade MBIA, because doing so was not in their short-term financial interest. A downgrade of MBIA would force the rating agencies to go through the costly and cumbersome process of re-rating tens of thousands of credits that bore triple-A ratings simply by virtue of MBIA’s guarantee. It would stick a wrench in the machine that enriched them. (In June, finally, the rating agencies downgraded MBIA, after MBIA’s failure became such an open secret that nobody any longer cared about its formal credit rating.)
The S.E.C. now promises modest new measures to contain the damage that the rating agencies can do — measures that fail to address the central problem: that the raters are paid by the issuers.
But this should come as no surprise, for the S.E.C. itself is plagued by similarly wacky incentives. Indeed, one of the great social benefits of the Madoff scandal may be to finally reveal the S.E.C. for what it has become.
Created to protect investors from financial predators, the commission has somehow evolved into a mechanism for protecting financial predators with political clout from investors. (The task it has performed most diligently during this crisis has been to question, intimidate and impose rules on short-sellers — the only market players who have a financial incentive to expose fraud and abuse.)
The instinct to avoid short-term political heat is part of the problem; anything the S.E.C. does to roil the markets, or reduce the share price of any given company, also roils the careers of the people who run the S.E.C. Thus it seldom penalizes serious corporate and management malfeasance — out of some misguided notion that to do so would cause stock prices to fall, shareholders to suffer and confidence to be undermined. Preserving confidence, even when that confidence is false, has been near the top of the S.E.C.’s agenda.
IT’S not hard to see why the S.E.C. behaves as it does. If you work for the enforcement division of the S.E.C. you probably know in the back of your mind, and in the front too, that if you maintain good relations with Wall Street you might soon be paid huge sums of money to be employed by it.
The commission’s most recent director of enforcement is the general counsel at JPMorgan Chase; the enforcement chief before him became general counsel at Deutsche Bank; and one of his predecessors became a managing director for Credit Suisse before moving on to Morgan Stanley. A casual observer could be forgiven for thinking that the whole point of landing the job as the S.E.C.’s director of enforcement is to position oneself for the better paying one on Wall Street.
At the back of the version of Harry Markopolos’s brave paper currently making the rounds is a copy of an e-mail message, dated April 2, 2008, from Mr. Markopolos to Jonathan S. Sokobin. Mr. Sokobin was then the new head of the commission’s office of risk assessment, a job that had been vacant for more than a year after its previous occupant had left to — you guessed it — take a higher-paying job on Wall Street.
At any rate, Mr. Markopolos clearly hoped that a new face might mean a new ear — one that might be receptive to the truth. He phoned Mr. Sokobin and then sent him his paper. “Attached is a submission I’ve made to the S.E.C. three times in Boston,” he wrote. “Each time Boston sent this to New York. Meagan Cheung, branch chief, in New York actually investigated this but with no result that I am aware of. In my conversations with her, I did not believe that she had the derivatives or mathematical background to understand the violations.”
How does this happen? How can the person in charge of assessing Wall Street firms not have the tools to understand them? Is the S.E.C. that inept? Perhaps, but the problem inside the commission is far worse — because inept people can be replaced. The problem is systemic. The new director of risk assessment was no more likely to grasp the risk of Bernard Madoff than the old director of risk assessment because the new guy’s thoughts and beliefs were guided by the same incentives: the need to curry favor with the politically influential and the desire to keep sweet the Wall Street elite.
And here’s the most incredible thing of all: 18 months into the most spectacular man-made financial calamity in modern experience, nothing has been done to change that, or any of the other bad incentives that led us here in the first place.
SAY what you will about our government’s approach to the financial crisis, you cannot accuse it of wasting its energy being consistent or trying to win over the masses. In the past year there have been at least seven different bailouts, and six different strategies. And none of them seem to have pleased anyone except a handful of financiers.
When Bear Stearns failed, the government induced JPMorgan Chase to buy it by offering a knockdown price and guaranteeing Bear Stearns’s shakiest assets. Bear Stearns bondholders were made whole and its stockholders lost most of their money.
Then came the collapse of the government-sponsored entities, Fannie Mae and Freddie Mac, both promptly nationalized. Management was replaced, shareholders badly diluted, creditors left intact but with some uncertainty. Next came Lehman Brothers, which was, of course, allowed to go bankrupt. At first, the Treasury and the Federal Reserve claimed they had allowed Lehman to fail in order to signal that recklessly managed Wall Street firms did not all come with government guarantees; but then, when chaos ensued, and people started saying that letting Lehman fail was a dumb thing to have done, they changed their story and claimed they lacked the legal authority to rescue the firm.
But then a few days later A.I.G. failed, or tried to, yet was given the gift of life with enormous government loans. Washington Mutual and Wachovia promptly followed: the first was unceremoniously seized by the Treasury, wiping out both its creditors and shareholders; the second was batted around for a bit. Initially, the Treasury tried to persuade Citigroup to buy it — again at a knockdown price and with a guarantee of the bad assets. (The Bear Stearns model.) Eventually, Wachovia went to Wells Fargo, after the Internal Revenue Service jumped in and sweetened the pot with a tax subsidy.
In the middle of all this, Treasury Secretary Henry M. Paulson Jr. persuaded Congress that he needed $700 billion to buy distressed assets from banks — telling the senators and representatives that if they didn’t give him the money the stock market would collapse. Once handed the money, he abandoned his promised strategy, and instead of buying assets at market prices, began to overpay for preferred stocks in the banks themselves. Which is to say that he essentially began giving away billions of dollars to Citigroup, Morgan Stanley, Goldman Sachs and a few others unnaturally selected for survival. The stock market fell anyway.
It’s hard to know what Mr. Paulson was thinking as he never really had to explain himself, at least not in public. But the general idea appears to be that if you give the banks capital they will in turn use it to make loans in order to stimulate the economy. Never mind that if you want banks to make smart, prudent loans, you probably shouldn’t give money to bankers who sunk themselves by making a lot of stupid, imprudent ones. If you want banks to re-lend the money, you need to provide them not with preferred stock, which is essentially a loan, but with tangible common equity — so that they might write off their losses, resolve their troubled assets and then begin to make new loans, something they won’t be able to do until they’re confident in their own balance sheets. But as it happened, the banks took the taxpayer money and just sat on it.
Related
Op-Ed Contributors: How to Repair a Broken Financial World (January 4, 2009) This is one reason the collapse of our financial system has inspired not merely a national but a global crisis of confidence. Good God, the world seems to be saying, if they don’t know what they are doing with money, who does?
Incredibly, intelligent people the world over remain willing to lend us money and even listen to our advice; they appear not to have realized the full extent of our madness. We have at least a brief chance to cure ourselves. But first we need to ask: of what?
To that end consider the strange story of Harry Markopolos. Mr. Markopolos is the former investment officer with Rampart Investment Management in Boston who, for nine years, tried to explain to the Securities and Exchange Commission that Bernard L. Madoff couldn’t be anything other than a fraud. Mr. Madoff’s investment performance, given his stated strategy, was not merely improbable but mathematically impossible. And so, Mr. Markopolos reasoned, Bernard Madoff must be doing something other than what he said he was doing.
In his devastatingly persuasive 17-page letter to the S.E.C., Mr. Markopolos saw two possible scenarios. In the “Unlikely” scenario: Mr. Madoff, who acted as a broker as well as an investor, was “front-running” his brokerage customers. A customer might submit an order to Madoff Securities to buy shares in I.B.M. at a certain price, for example, and Madoff Securities instantly would buy I.B.M. shares for its own portfolio ahead of the customer order. If I.B.M.’s shares rose, Mr. Madoff kept them; if they fell he fobbed them off onto the poor customer.
In the “Highly Likely” scenario, wrote Mr. Markopolos, “Madoff Securities is the world’s largest Ponzi Scheme.” Which, as we now know, it was.
Harry Markopolos sent his report to the S.E.C. on Nov. 7, 2005 — more than three years before Mr. Madoff was finally exposed — but he had been trying to explain the fraud to them since 1999. He had no direct financial interest in exposing Mr. Madoff — he wasn’t an unhappy investor or a disgruntled employee. There was no way to short shares in Madoff Securities, and so Mr. Markopolos could not have made money directly from Mr. Madoff’s failure. To judge from his letter, Harry Markopolos anticipated mainly downsides for himself: he declined to put his name on it for fear of what might happen to him and his family if anyone found out he had written it. And yet the S.E.C.’s cursory investigation of Mr. Madoff pronounced him free of fraud.
What’s interesting about the Madoff scandal, in retrospect, is how little interest anyone inside the financial system had in exposing it. It wasn’t just Harry Markopolos who smelled a rat. As Mr. Markopolos explained in his letter, Goldman Sachs was refusing to do business with Mr. Madoff; many others doubted Mr. Madoff’s profits or assumed he was front-running his customers and steered clear of him. Between the lines, Mr. Markopolos hinted that even some of Mr. Madoff’s investors may have suspected that they were the beneficiaries of a scam. After all, it wasn’t all that hard to see that the profits were too good to be true. Some of Mr. Madoff’s investors may have reasoned that the worst that could happen to them, if the authorities put a stop to the front-running, was that a good thing would come to an end.
The Madoff scandal echoes a deeper absence inside our financial system, which has been undermined not merely by bad behavior but by the lack of checks and balances to discourage it. “Greed” doesn’t cut it as a satisfying explanation for the current financial crisis. Greed was necessary but insufficient; in any case, we are as likely to eliminate greed from our national character as we are lust and envy. The fixable problem isn’t the greed of the few but the misaligned interests of the many.
A lot has been said and written, for instance, about the corrupting effects on Wall Street of gigantic bonuses. What happened inside the major Wall Street firms, though, was more deeply unsettling than greedy people lusting for big checks: leaders of public corporations, especially financial corporations, are as good as required to lead for the short term.
Richard Fuld, the former chief executive of Lehman Brothers, E. Stanley O’Neal, the former chief executive of Merrill Lynch, and Charles O. Prince III, Citigroup’s chief executive, may have paid themselves humongous sums of money at the end of each year, as a result of the bond market bonanza. But if any one of them had set himself up as a whistleblower — had stood up and said “this business is irresponsible and we are not going to participate in it” — he would probably have been fired. Not immediately, perhaps. But a few quarters of earnings that lagged behind those of every other Wall Street firm would invite outrage from subordinates, who would flee for other, less responsible firms, and from shareholders, who would call for his resignation. Eventually he’d be replaced by someone willing to make money from the credit bubble.
OUR financial catastrophe, like Bernard Madoff’s pyramid scheme, required all sorts of important, plugged-in people to sacrifice our collective long-term interests for short-term gain. The pressure to do this in today’s financial markets is immense. Obviously the greater the market pressure to excel in the short term, the greater the need for pressure from outside the market to consider the longer term. But that’s the problem: there is no longer any serious pressure from outside the market. The tyranny of the short term has extended itself with frightening ease into the entities that were meant to, one way or another, discipline Wall Street, and force it to consider its enlightened self-interest.
The credit-rating agencies, for instance.
Everyone now knows that Moody’s and Standard & Poor’s botched their analyses of bonds backed by home mortgages. But their most costly mistake — one that deserves a lot more attention than it has received — lies in their area of putative expertise: measuring corporate risk.
Over the last 20 years American financial institutions have taken on more and more risk, with the blessing of regulators, with hardly a word from the rating agencies, which, incidentally, are paid by the issuers of the bonds they rate. Seldom if ever did Moody’s or Standard & Poor’s say, “If you put one more risky asset on your balance sheet, you will face a serious downgrade.”
The American International Group, Fannie Mae, Freddie Mac, General Electric and the municipal bond guarantors Ambac Financial and MBIA all had triple-A ratings. (G.E. still does!) Large investment banks like Lehman and Merrill Lynch all had solid investment grade ratings. It’s almost as if the higher the rating of a financial institution, the more likely it was to contribute to financial catastrophe. But of course all these big financial companies fueled the creation of the credit products that in turn fueled the revenues of Moody’s and Standard & Poor’s.
These oligopolies, which are actually sanctioned by the S.E.C., didn’t merely do their jobs badly. They didn’t simply miss a few calls here and there. In pursuit of their own short-term earnings, they did exactly the opposite of what they were meant to do: rather than expose financial risk they systematically disguised it.
This is a subject that might be profitably explored in Washington. There are many questions an enterprising United States senator might want to ask the credit-rating agencies. Here is one: Why did you allow MBIA to keep its triple-A rating for so long? In 1990 MBIA was in the relatively simple business of insuring municipal bonds. It had $931 million in equity and only $200 million of debt — and a plausible triple-A rating.
By 2006 MBIA had plunged into the much riskier business of guaranteeing collateralized debt obligations, or C.D.O.’s. But by then it had $7.2 billion in equity against an astounding $26.2 billion in debt. That is, even as it insured ever-greater risks in its business, it also took greater risks on its balance sheet.
Yet the rating agencies didn’t so much as blink. On Wall Street the problem was hardly a secret: many people understood that MBIA didn’t deserve to be rated triple-A. As far back as 2002, a hedge fund called Gotham Partners published a persuasive report, widely circulated, entitled: “Is MBIA Triple A?” (The answer was obviously no.)
At the same time, almost everyone believed that the rating agencies would never downgrade MBIA, because doing so was not in their short-term financial interest. A downgrade of MBIA would force the rating agencies to go through the costly and cumbersome process of re-rating tens of thousands of credits that bore triple-A ratings simply by virtue of MBIA’s guarantee. It would stick a wrench in the machine that enriched them. (In June, finally, the rating agencies downgraded MBIA, after MBIA’s failure became such an open secret that nobody any longer cared about its formal credit rating.)
The S.E.C. now promises modest new measures to contain the damage that the rating agencies can do — measures that fail to address the central problem: that the raters are paid by the issuers.
But this should come as no surprise, for the S.E.C. itself is plagued by similarly wacky incentives. Indeed, one of the great social benefits of the Madoff scandal may be to finally reveal the S.E.C. for what it has become.
Created to protect investors from financial predators, the commission has somehow evolved into a mechanism for protecting financial predators with political clout from investors. (The task it has performed most diligently during this crisis has been to question, intimidate and impose rules on short-sellers — the only market players who have a financial incentive to expose fraud and abuse.)
The instinct to avoid short-term political heat is part of the problem; anything the S.E.C. does to roil the markets, or reduce the share price of any given company, also roils the careers of the people who run the S.E.C. Thus it seldom penalizes serious corporate and management malfeasance — out of some misguided notion that to do so would cause stock prices to fall, shareholders to suffer and confidence to be undermined. Preserving confidence, even when that confidence is false, has been near the top of the S.E.C.’s agenda.
IT’S not hard to see why the S.E.C. behaves as it does. If you work for the enforcement division of the S.E.C. you probably know in the back of your mind, and in the front too, that if you maintain good relations with Wall Street you might soon be paid huge sums of money to be employed by it.
The commission’s most recent director of enforcement is the general counsel at JPMorgan Chase; the enforcement chief before him became general counsel at Deutsche Bank; and one of his predecessors became a managing director for Credit Suisse before moving on to Morgan Stanley. A casual observer could be forgiven for thinking that the whole point of landing the job as the S.E.C.’s director of enforcement is to position oneself for the better paying one on Wall Street.
At the back of the version of Harry Markopolos’s brave paper currently making the rounds is a copy of an e-mail message, dated April 2, 2008, from Mr. Markopolos to Jonathan S. Sokobin. Mr. Sokobin was then the new head of the commission’s office of risk assessment, a job that had been vacant for more than a year after its previous occupant had left to — you guessed it — take a higher-paying job on Wall Street.
At any rate, Mr. Markopolos clearly hoped that a new face might mean a new ear — one that might be receptive to the truth. He phoned Mr. Sokobin and then sent him his paper. “Attached is a submission I’ve made to the S.E.C. three times in Boston,” he wrote. “Each time Boston sent this to New York. Meagan Cheung, branch chief, in New York actually investigated this but with no result that I am aware of. In my conversations with her, I did not believe that she had the derivatives or mathematical background to understand the violations.”
How does this happen? How can the person in charge of assessing Wall Street firms not have the tools to understand them? Is the S.E.C. that inept? Perhaps, but the problem inside the commission is far worse — because inept people can be replaced. The problem is systemic. The new director of risk assessment was no more likely to grasp the risk of Bernard Madoff than the old director of risk assessment because the new guy’s thoughts and beliefs were guided by the same incentives: the need to curry favor with the politically influential and the desire to keep sweet the Wall Street elite.
And here’s the most incredible thing of all: 18 months into the most spectacular man-made financial calamity in modern experience, nothing has been done to change that, or any of the other bad incentives that led us here in the first place.
SAY what you will about our government’s approach to the financial crisis, you cannot accuse it of wasting its energy being consistent or trying to win over the masses. In the past year there have been at least seven different bailouts, and six different strategies. And none of them seem to have pleased anyone except a handful of financiers.
When Bear Stearns failed, the government induced JPMorgan Chase to buy it by offering a knockdown price and guaranteeing Bear Stearns’s shakiest assets. Bear Stearns bondholders were made whole and its stockholders lost most of their money.
Then came the collapse of the government-sponsored entities, Fannie Mae and Freddie Mac, both promptly nationalized. Management was replaced, shareholders badly diluted, creditors left intact but with some uncertainty. Next came Lehman Brothers, which was, of course, allowed to go bankrupt. At first, the Treasury and the Federal Reserve claimed they had allowed Lehman to fail in order to signal that recklessly managed Wall Street firms did not all come with government guarantees; but then, when chaos ensued, and people started saying that letting Lehman fail was a dumb thing to have done, they changed their story and claimed they lacked the legal authority to rescue the firm.
But then a few days later A.I.G. failed, or tried to, yet was given the gift of life with enormous government loans. Washington Mutual and Wachovia promptly followed: the first was unceremoniously seized by the Treasury, wiping out both its creditors and shareholders; the second was batted around for a bit. Initially, the Treasury tried to persuade Citigroup to buy it — again at a knockdown price and with a guarantee of the bad assets. (The Bear Stearns model.) Eventually, Wachovia went to Wells Fargo, after the Internal Revenue Service jumped in and sweetened the pot with a tax subsidy.
In the middle of all this, Treasury Secretary Henry M. Paulson Jr. persuaded Congress that he needed $700 billion to buy distressed assets from banks — telling the senators and representatives that if they didn’t give him the money the stock market would collapse. Once handed the money, he abandoned his promised strategy, and instead of buying assets at market prices, began to overpay for preferred stocks in the banks themselves. Which is to say that he essentially began giving away billions of dollars to Citigroup, Morgan Stanley, Goldman Sachs and a few others unnaturally selected for survival. The stock market fell anyway.
It’s hard to know what Mr. Paulson was thinking as he never really had to explain himself, at least not in public. But the general idea appears to be that if you give the banks capital they will in turn use it to make loans in order to stimulate the economy. Never mind that if you want banks to make smart, prudent loans, you probably shouldn’t give money to bankers who sunk themselves by making a lot of stupid, imprudent ones. If you want banks to re-lend the money, you need to provide them not with preferred stock, which is essentially a loan, but with tangible common equity — so that they might write off their losses, resolve their troubled assets and then begin to make new loans, something they won’t be able to do until they’re confident in their own balance sheets. But as it happened, the banks took the taxpayer money and just sat on it.
Thursday, January 1, 2009
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