Getting Back to Reality

The extraordinary increase (as a percentage move) in the 10 Year T Note yield shows the artificiality and the fragility of market values, everything being propped up by the Federal Reserve in the absence of any sound fiscal policy.  The recent Fed minutes merely hinted at the possibility of reducing asset purchases before the end of this year, and bond investors were left without their bungee cord:

Bill Gross, the "bond king," persuasively writes about the problem in his January letter, a long discourse on why "helicopter money" rained down by the Fed to save the financial system has to end badly in some way.

The artificiality of it all hasn't escaped the notice of corporations, many of which have loaded up their balance sheets with cheap debt, while holding mounds of cash, even to the point of paying massive dividends to their shareholders with borrowed funds.  The poster child for this is Costco which paid its shareholders $3 billion and borrowing the funds to do it.  Of course that was before the laughable fiscal cliff deal, which raised taxes on dividends to 20% from its present 15% but only for high income taxpayers.  They were talking about taxing dividends as regular income which must have freaked out the five largest shareholders who are corporate officers or directors, their take on the special dividend with borrowed funds being almost $12 million.  What a country! Borrow the money to pay your top people a huge bonus that is taxed at only 15%.  It truly is the microcosm for the contrived and completely unpredictable financial landscape of today.

A few days ago Barry Ritholz suggested a positive way of using today's manipulated market -- that is to upgrade and repair our aging infrastructure. Many of our roads are atrociously maintained and bridges are crumbling, not to mention aging water systems, power plants, and a railroad transportation system which is truly 3rd world quality.  As Ritholz says: At some point in the future, your kids are going to ask — “Wait, you could have upgraded _______ and it only would have cost you 2.5% in borrowing costs?!?”

 
Isn't that where we should be putting borrowed money to work, creating jobs?

Play Ball!

Build it and they will come. But how? It took my first visit to the new Yankee Stadium in the Bronx to clearly see the growing disparity between the haves and the have-nots. We can build a stadium while our infrastructure is allowed to crumble.

My son, Jon, and I had been talking about going to the new stadium for some time, my having taken him to his first Yankee game at the old stadium. And when I used to go there decades before as a boy, I sat in the bleachers – 50 cents a seat. In those days my Yankee heroes, Mantle, Rizzuto, Berra, Ford, etc. made salaries that hardly approached six figures.

When we went to games with our sons in the 1980’s, occasionally we would go to the Stadium Club before the game and one time Bill White and Phil Rizzuto (after they became announcers for the Yankees) were having dinner at the next table. Phil was joking with Bill, calling him a huckleberry, when he asked the fellow diners whether anyone had some aspirin. My wife produced her handy pill box and offered Phil a couple so we talked for a while with him – my father graduated from the same high school as Phil and in about the same year. I wonder whether today’s players would be as friendly now that they are paid the same as elite entertainers.

The trip to the stadium on the New Haven railroad, changing at 125th street for a short express to Yankee Stadium at 153rd street, underscored the new two-world order, the trains the same ones I rode on to Grand Central some 30 years ago, on tracks that were built long before that, the air conditioning barely working, the transportation infrastructure hanging threadbare. The return trip was even worse, typical delays, waiting at 125th Street station, and making a connection that was so packed the standing room only did not even provide a space for putting down one’s bag. Amazingly, everyone just seemed resigned to this reality, along with the extreme shuddering of the train because of the poorly maintained track bed, conditions that would not be tolerated in most other advanced countries. Perhaps not coincidentally, the day we went to the stadium there was a major water main break in the Bronx, 100 year old pipes bursting and creating a river in the streets. Maybe we can get another 50 years out of them?

While the funds or motivation for rebuilding our infrastructure seem to be lacking, that does not apply to tearing down the old Yankee Stadium to rebuild one with Disney-like features. Good seats are now all corporate owned at astronomical prices and as an individual you can bid on those that are posted on such sites as StubHub, but with after tax dollars while corporate holders buy them as a deductible corporate expense. Why bother closing such tax loopholes that subsidizes professional sports?

The prices for food and drink are commensurately expensive, a cup of $12 beer or an $8 hot dog. A Yankee cap is a mere $27. Perhaps that is what is meant by trickle-down economics –corporations buy tax-deductible seats at preposterous prices, that revenue (with those from broadcasting) shifting to MLB owners and players, and then trickling down to those people employed at the ball park to move hugely inflated priced merchandise and food to the masses. Everyone wins!

But if one can look past those economic realities, there is the intrinsic beauty of the ball field, a near facsimile of the old stadium and its rich history, and that certain feeling when, after the national anthem, “play ball!” settles in one’s mind, harking back to a time of innocence. It is nice to remember, and to share the day with my son, but sad as a society we have become so divided, with no clear vision of economic priorities.

Engineering Failures and World-Wide Consequences

The similarities between the BP oil spill disaster in the Gulf of Mexico and the ongoing nuclear Fukushima Daiichi crisis in Japan are striking.

Both were unimaginable before they happened. Both the nuclear facility and the oil rig had what was thought to be containment and shut down protection, as well as redundancy features, in the event of a serious accident. In each case, these systems failed. The response to each event was similar, a series of improvisational Hail Mary attempts to mitigate the damage, resembling a disaster movie in slow motion. Each catastrophe has long term consequences to the earth's ecosystem and human health, way beyond the immediate geographic area of its origin. The lack of contingency planning in Gulf crisis is evident again in the Japan disaster.

Surely, given the facts of Chernobyl and Three Mile Island there are commonalities with Fukushima Daiichi. No doubt the first line of defense in the construction of a nuclear facility or a deep water drilling rig has to be containment and redundancy features and bulletproof regulatory oversight, first at the national level, but perhaps with international participation as well. Too bad the UN is not a more effective institution. It needs to be in this area.

Any country that constructs these engineering marvels, for drilling oil in the deepest of oceans, or generating nuclear power, facilities that have world-wide consequences when they fail, should be required by the world community to maintain a national task force with readily available and deployable equipment to deal with catastrophic failure (rather than totally relying on the company responsible such as Tokyo Electric Power or BP). How much time was lost in dealing with Fukushima Daiichi when the tsunami destroyed its redundant pumps and power generating equipment?

Perhaps this may be oversimplification, but if we have the technology to create these engineering leviathans, we should also have the resources for a nuclear (and deep water drilling rig) immediate response task force, a small army trained for this once in a generation disaster, with the necessary deployable equipment (such as generators that could have been airlifted immediately to the Fukushima Daiichi site allowing the resumption of core cooling systems). We only need the universal will. Meanwhile, we all helplessly watch this terrible disaster unfolding in Japan.

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Volcker, Stiglitz, Hussman….

Here’s some positive news from or about people who can help point us in the right direction. First there was the big news that Paul Volcker will finally take a key role in addressing economic reform, particularly with the reinstatement of some of the key features from the Glass-Steagall Act. Joseph Stiglitz touches upon that need as well as other issues in an extract from his new book, Freefall; Free Markets and the Sinking of the Global Economy in a piece entitled “Why we have to change capitalism”

We now know the true source of recent bank bonuses: “free money” profits: According to Stiglitz, “the alacrity with which all the major investment banks decided to become ‘commercial banks’ in the fall of 2008 was alarming – they saw the gifts coming from the federal government, and evidently, they believed that their risk-taking behaviour would not be much circumscribed. They now had access to the Fed window, so they could borrow at almost a zero interest rate; they knew that they were protected by a new safety net; but they could continue their high-stakes trading unabated. This should be viewed as totally unacceptable.” Also, Stiglitz puts the bailouts in the context of the bigger picture: “the failures in our financial system are emblematic of broader failures in our economic system, and the failures of our economic system reflect deeper problems in our society. We began the bailouts without a clear sense of what kind of financial system we wanted at the end, and the result has been shaped by the same political forces that got us into the mess. And yet, there was hope that change was possible. Not only possible, but necessary.” As a consequence he argues for “a new financial system that will do what human beings need a financial system to do.”

Meanwhile, the Financial Times carried an excellent piece on Paul Volcker now that he is again front-and-center, Man in the News: Paul Volcker. For too long now Volcker inexplicably had been pushed off the center stage. Last March, as the market was in complete free fall, my tongue-in-cheek piece about “the new era of the 177K” asked, “Where is Paul Volcker to lead the way back to the 401K?”. Per the Financial Times: “this week the towering former Fed chief stood by Barack Obama’s side as the president embraced what he dubbed the “Volcker rule” banning proprietary trading – over the reservations of some of his most senior economic advisers.”
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Then, John Hussman, the economist who runs his own mutual funds, and each Monday blogs about his views, published, today, a lengthy, carefully reasoned Blueprint for Financial Reform.
This is an extraordinarily detailed eight point plan/proposal and rather than giving the bullet points here, go to the link. It deserves careful consideration by our elected officials. Needless to say, he sides with Volcker. Hussman for Chairman of the Federal Reserve or bring back Volcker?
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I've argued that in addition to financial reform, the main economic focus must be job creation: “a true recovery requires jobs, jobs, jobs – and how are they going to be created – by banks trading energy futures? What happened to the commitment to the infrastructure? Our roads, utilities, and public transportation are falling apart. Alternative energy seems DOA. Aren’t these the areas our financial recourses should be focused on, ones that will create jobs, in construction, technology, and finance, and can lead a true economic recovery we can pass on with pride to future generations?”

Green shoots first, then…..

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Well Worth Noting…

Two interesting articles, one an interview with Richard Koo, a former economist with the Federal Reserve Bank of New York and now chief economist of Nomura Research Institute, which appeared in this week’s Barron’s Magazine, A Japanese Rx for the West: Keep Spending and the weekly commentary of the economist and mutual fund manager John Hussman, Timothy Geithner Meets Vladimir Lenin

Koo’s views might seem to be counterintuitive – government needs to increase deficit spending on a three to five year plan while the private sector is repairing its balance sheet. Japan failed to recognize the dangers of “a balance sheet recession” and the USA could make the same mistake. I would agree, provided spending is focused on our infrastructure or alternative energy, or on myriad other public projects that resonate in our economy, creating jobs while fixing our roads and public transportation, encouraging energy independence, reducing greenhouse gases, and improving our educational system. Such investments are aimed at Main Street, not Wall Street. I would imagine Koo would be the first to note that bailouts of irresponsible investment bankers do not constitute the kind of government borrowing he means.

Koo contends that while the private sector repairs its balance sheet, writing down debt on devalued assets, it is imperative for the Federal government to borrow because even if interest rates are zero, the public sector cannot be induced to borrow: “The only way the government can turn this economy around is to do the opposite of the private sector -- borrow the money the private sector saved and spend it, which means fiscal stimulus. That's what saved Japan from entering a Great Depression.”

In effect we can’t make businesses borrow by giving capital to the banking system which only encourages more reckless economic behavior – it has to be spent elsewhere, and what better place than our infrastructure and energy independence?

John Hussman, meanwhile, writes about the very kind of borrowing we must eschew, especially as it is being done without our elected constituency’s input: the Treasury’s recent announcement that it would provide Fannie Mae and Freddie Mac UNLIMITED financial support for the next three years, reminding us that it was Vladimir Lenin who said: “The best way to destroy the capitalist system is to debauch the currency.”

As Hussman notes, “in a single, coordinated stroke, the Treasury and the Federal Reserve have encroached on spending powers that are enumerated for the Congress alone.” And perhaps worse, “…homeowners who have been diligently making their payments will keep their homes, and homeowners who took out mortgages they couldn't afford will keep their homes as well with no adverse consequence to the lenders – since the underlying loans are now owned largely by the Fed, and the Treasury has pledged its unlimited support. Why pay one's debts if it becomes optional, and the Treasury stands to absorb unlimited losses at public expense?”

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Headline Tedium

Bailouts, bonuses and Madoff. Are we getting tired yet of the endless litany of related headlines such as the Wall Street Journal’s recent “Bank Bonus Tab: $33 Billion; Nine Lenders That Got U.S. Aid Paid at Least $1 Million Each to 5,000 Employees”?

The rock star of these “fab” financial “leaders” is Andrew Hall who makes a bundle for himself trading energy contracts for Citigroup's energy-trading unit Phibro LLC, with compensation approaching $100 million for 2008. It is interesting to read Sunday’s New York Time’s front page article on his activities and compensation. No doubt he is a talented individual and I suppose if Citigroup didn’t want his operation’s expertise in “taking advantage of unusual spreads between the spot price of oil and the price of an oil futures contract,” other firms would be lining up to pay his price. That is the American way. We know how to lavish money on our superstars, whether from the media or sports, or in this case, dice-rolling trading moguls.

The Times refers to his compensation as “his cut of profits from a characteristically aggressive year of bets in the oil market.” It also says “the company, for example, often wagers that the price of oil will rise so fast during a particular period, say six months, that it can make money by storing oil in supertankers and floating it until the price goes up. “ Finally, “right before the first Gulf War, Phibro placed an elaborate bet that the price of oil would spike and then go down faster than others were anticipating. The company earned more than $300 million from the gamble.” I emphasize bets, wagers, and gamble, as these words cut to the heart of the matter. Arbitrage and hedging can be a means of controlling risk or it can magnify risk to the point of endangering the entire financial system. Is this what our banks should be doing: betting, gambling and waging? Heads they win, tails the taxpayer loses? I have to wonder what the consequences would have been if Mr. Hall’s trades had gone disastrously against Citigroup. Would he have been personally at risk for the same $100 million he “earned” being on the right side? Do we want our banks, the bedrock of our financial system engaging in such activities – aren’t these the domain of the individual entrepreneur and private capital? To what extent does such “trading” create spikes such as $147 for a barrel of crude oil while there is a glut of the commodity?

Then there is the continuing rhetoric about having to reward the financial superstars that got us into this mess in the first place, or they will “walk.” I like Warren Buffet’s homey comments on this topic so I quote from his 2006 letter to his Berkshire Hathaway shareholders. Although this is aimed at CEO pay in general, which is also absurdly high in many (but not all) corporations, it applies to our banks and other financial service firms as well:

“CEO perks at one company are quickly copied elsewhere. ‘All the other kids have one’ may seem a thought too juvenile to use as a rationale in the boardroom. But consultants employ precisely this argument, phrased more elegantly of course, when they make recommendations to comp committees. Irrational and excessive comp practices will not be materially changed by disclosure or by ‘independent’ comp committee members….Compensation reform will only occur if the largest institutional shareholders – it would only take a few – demand a fresh look at the whole system. The consultants’ present drill of deftly selecting ‘peer’ companies to compare with their clients will only perpetuate present excesses.”

Another mind-boggling headline “Picowers Rebut Suit Tied to Madoff Fraud” is from Saturday’s Wall Street Journal. and The New York Times version of the same “Big Investor Counters Charges in Madoff Case.” According to the Madoff bankruptcy trustee, Irving Picard, Picower’s accounts posted gains of more than 100 percent a dozen times between 1996 and 2007, with one gaining 950 percent, but this counter suit contends the latter was “only” 37.6 percent and none of his accounts earned more than 100 percent “in any single year.” But the $5.1 billion Picower withdrew over the years may have represented a return greatly exceeding any reasonable return during the same period. How a knowledgeable investor (presumably Picower qualifies) could believe that Madoff can “guarantee” steady returns of 10 to 12 percent a year and be satisfied by the statements received from Madoff to bear out those returns is beyond me. I still think the “idea” of creating a new reality TV show, something we seem to be better at than regulating financial Ponzi schemes (either private or government sponsored) might be just the ticket to fund the innocent victims of Madoff.

On the eve of President Obama’s inauguration, I had written the following: “The winners in this economy were not only the capitalists, the real creators of jobs due to hard work and innovation, but the even bigger winners: the financial masters of the universe who learned to leverage financial instruments with the blessings of a government that nurtured the thievery of the public good through deregulation, ineptitude, and political amorality. This gave rise to a whole generation of pseudo capitalists, people who “cashed in” on the system, bankers and brokers and “financial engineers” who dreamt up lethal structures based on leverage and then selling those instruments to an unsuspecting public, a public that entrusted the government to be vigilant so the likes of a Bernie Madoff could not prosper for untold years. Until we revere the real innovators of capitalism, the entrepreneurs who actually create things, ideas, jobs, and our financial system will continue to seize up. That is the challenge for the Obama administration – a new economic morality.”

I haven’t changed my view and I fear that while we bail out banks, insurance companies and their like, leaving present compensation practices in place, we just continue to perpetuate financial risk taking, swinging for the fences, making “bets and wagers” that will just dig us into a deeper future hole. As the headlines attest, the “challenge” remains. A true recovery requires jobs, jobs, jobs – and how are they going to be created – by banks trading energy futures? What happened to the commitment to the infrastructure? Our roads, utilities, and public transportation are falling apart. Alternative energy seems DOA. Aren’t these the areas our financial recourses should be focused on, ones that will create jobs, in construction, technology, and finance, and can lead a true economic recovery we can pass on with pride to future generations?

On the Mark

Here are two must read entries recently posted by a fellow blogger, someone I’ve mentioned before. As Mark states in his mission statement: “Raise $7M from readers to launch a real mutual fund. By providing a transparent platform for a virtual growth mutual fund, I'll create a mechanism by which readers can view my thought process & results in creating a 3-year return. I'll invest in 30-50 positions with secular growth trends with economic commentary thrown in.” He’s been doing this for more than a year now but the recent economic turmoil has delayed the launch. In the meantime, his readers have benefited from his interesting commentary and frequently prescient predictions.

The posts below were written before yesterday’s Federal Reserve announcement of historic interest cuts to near zero and its pledge to buy stressed securities and perhaps even long-term treasuries. The question is whether this will indeed lead to borrowing and spending, especially if unemployment rates continue to ramp up and if business confidence does not improve. If successful, we then have to deal with the inflationary implications of money creation and a deficit in the untold $ trillions. (Is borrowing good? Isn’t that one of the reasons we got into this mess in the first place?)

In spite of FDR’s attempt to work our way out of the Depression with the New Deal, it finally took the enormous deficit spending of WWII and of course the employment of millions by the military and by the industries needed to support the war effort, thereby ending the worst economic downturn in our history. It also required people to rally, sacrificing, working towards a common goal.

In other words, it takes more than spending. Perhaps that is another distinction between today’s economic crisis and what we faced during the Depression. Can President-elect Obama successfully make our decaying infrastructure and need for energy independence our “war?” Will we pull together or pull apart?

http://www.fundmymutualfund.com/2008/12/13-outlier-2009-predictions.html
http://www.fundmymutualfund.com/2008/12/recovery.html