When Will They Ever Learn

Earlier today I saw an advertisement, on MSN.com, for Lending Tree. The ad said “IF YOU BOUGHT YOU HOME BEFORE….YOU CAN TAKE CASH VALUE OUT OF IT TODAY”. (or similar wording). My problem with this ad is that the thinking displayed here is part of what  set off the great recession.

When congress eliminated the tax deduction for interest with the exception of Mortgage Interest, bank and bank like institutions started to hawk Second Mortgages and tied other debt (eg. Credit cards) to home equity. The selling point was ..why wait until you sell to get the value out of your home. Its value has grown take your equity out now though either refinancing or home equity loans…. 

When the housing boom took off many people followed this advice and borrowed against their equity. When the housing crunch hit, many people found that they now owed more on their homes than the houses were worth. They were underwater. The home owners now had less wealth and, as a result, reduced their spending. This reduction in demand led to the Great Recession.

Now, we are again finding lenders pushing people to turn their home equity into cash. Will we be starting the cycle all over again? Just as was said in the song Where Have All The Flowers Gone: “When will they ever learn.” In an age of deregulation, if there is money to be made while creating a crisis, there are firms and individuals who will create a crisis to earn profits.

WHY HEALTH CARE IS SO EXPENSIVE

One of the current trends in health care is hospitals acquiring (taking over) private medical practices. This means that doctors are now employees. This has many advantages for doctors in that they now have set work hours and are able to plan their free time because they are only “on call” at per-determined times. They also no longer need to acquire business management skills because they are no longer managing their own businesses. Hospitals now have the advantage of having doctors on the payroll who can be told to order tests from and admissions to the hospital which owns the practice.

How does this lead to higher health care costs? If the doctors’ offices are located in the hospital’s facility a patient seeing the doctor is charged not only the fee for seeing the doctor but also a “Facility Charge” for the hospital. This is akin to going to a restaurant and at the bottom of the check there is an extra fee for your share of the owners rent for the restaurant. Medical care is the only place where this absurdity is a normal practice.

I recently received a letter from a local hospital telling me that my insurance carrier is no longer covering hospital charges at their facility. However, they were quick to point out that they still had a doctors’ contract with my carrier. At first I felt comfortable that I could stay with my current physician who I had been using for more than 20 years. However, I called the physician’s office to find out about the “Facility Charge”. I was referred to the billing office. The account representative in billing told me that I would now be liable for the $125.00 Facility Charge every time I saw my doctor.

Think about this for a minute. Nowadays, a doctor’s fee of $95 to $125 per visit is the norm (at least in my area). On top of this the Hospital Corporation is adding a $125 Facility Charge. This means that a simple office visit will now cost between $220 and $250. Is it any wonder that people do not go to the doctor when they should? Refusal to pay the Facility Charge, I understand, is one of the reasons that my insurer no longer has a hospital contract with the one that owns my doctor’s practice. Since I have a high deductible plan, an office visit early in the year will now cost me $220 instead of $95. Unfortunately, I am now looking for a new doctor.

In addition to this, the hospitals give one doctor charge for taking an x-ray and an additional doctor charge for reading it. Why do we need two radiologists? There are all sorts of other charges that fall into this category. 

Many recent surveys of medical costs and outcomes indicate that the United States has the highest per capita medical cost and the worst medical outcomes in the western world.  Looking at the current hospital based practice model and its associated charges, high costs combined with poor results are almost a given.

Perhaps the time has come for a single payer system that would have the economic power to control costs and encourage better performance.

THE (IN)EFFICIENCY OF THE FOR PROFIT SECTOR

I recently received an unsolicited phone call from the Dean of a For Profit University asking me to teach a course starting the following week. The assigned professor had resigned abruptly. I agreed and was told that I would need to send in copies of my transcripts and a Resume. I promptly replied emailing copies of the requested documents and made an appointment to handle the I9 and W4 requirements.

I then receive an e-mail stating that I have to use the University’s on-line application. The process required me to:

1.      Cut and past my resume.

2.      Download that same resume.

3.      Down load copies of my educational transcripts which had already been sent to the dean.

4.      Enter, separately, details of my academic history which were already on both the copied and downloaded resumes, the downloaded transcripts, and the resumes and transcripts forwarded to the local dean.

5.      The application also required me to hand enter my last ten years of employment history which were already on both the downloaded and copied resumes as well as the copy sent to the dean..

6.      After completing this process, I received an e-mail stating that I was required to sign into a third party background checking site which asked for the same information which I had typed into the University’s application. This information was, also, already contained in my transcripts and resume.

7.      Another e-mail soon followed which said I was now required to list four references on another third party site. These items were, again, already listed on the main application site.

8.      At this point I wrote back saying that the school already had the information for items 6 and 7. Therefore, if they wanted them done they could do them themselves. After all, they had recruited me.

9.      Their response was, in effect, do it or else. I replied that given we were at an impasse HR should inform the local dean that the process was at an end.

10.    They don’t seem to believe it because I keep receiving e-mails to contact the third party sites. 

Given the all the repetition in the process, we cannot believe the oft quoted assumption that for-profit means efficiency. In effect, given the fact that the school may not be able to find a quick replacement, they will probably loose approximately $12,000 after deducting their cost for my salary.

STANDARD OF LIVING vs. COST OF LIVING

The major problem with the debate regarding changing to the Chained CPI from the Fixed Weight CPI has to do with the fact that both are referred to as Cost of Living measures. They are not. The Fixed Weight CPI can be thought of as the cost of maintaining your standard of living. The Chained CPI is the cost of living at your current level. When I, and most of my friends, think of inflation and the cost of living we usually are thinking in terms of the cost of maintaining our living standard.

Those who want to use the Chained CPI argue that peoples' buying patterns have changed and the Chained CPI would reflect the change. But, people change their buying patterns for several reasons. One reason is that price changes alter our buying patterns. On the other hand we alter our buying because our tastes and preferences change. If  the only change was due to tastes and preferences I would support the use of the Chained CPI because the change would represent maintenance  of our Standard of Living. However, if we change because of higher prices we are lowering our standard of living; the Chained Index does not reflect this while the Fixed Rate Index does. 

Using the Fixed Weight CPI to adjust Social Security, Veterans Benefits and other government payments allows Seniors and Veterans to maintain their standard of living. The use of the chained index would lead them to fall behind. It is also deceptive to the public in general. For an extreme example: If the cut in food stamps mean that are large portion of the urban population has to eat dog food, because they can no long afford meat and chicken made for human consumption, the cost of dog food would be put into the Chained CPI to reflect how people are spending their money. This would lead to either shrinkage in the Chained CPI or a perceived lower level of price growth. The Chained CPI advocates would claim that the cost of living is shrinking or not growing and start saying how well off we all are. However, are we really better off eating dog food?

 ECONOMICS BECOMES A RELIGION

In his July 14, 2012 Blog Paul Krugman stated that economists' refusal to acknowledge the errors in their "...prognostications..." despite empirical evidence is a form of intellectual corruption. I have to disagree. I believe that the problem occurs because economics has moved from the world of science to the  realm of religion. I first stated this on August 8, 2011 (The Sophistry of the Job Creator Argument) when I wrote"...they have turned their economic philosophy into a religion..." This is based upon the oft stated argument that "...religious dogma is the continuation of belief despite empirical evidence to the contrary..." The sophist of the right have continued to worship the "...'Confidence Fairy' (thank you Dr. Krugman),' Say's Law' (Supply Creates its own demand), and the myth that Investment Demand is derived from something other than the demand for the goods and services the investments produce (ie.unlike the demand for other production inputs, investment is not a Derived Demand).

The religious nature of their argument is proven when we see governments such as Britain's engage in the supposed confidence building policies that the sophists advocate but, subsequently, business investment and surveyed confidence continue to fall. The dogma that reducing the cost of capital though tax breaks is all that is need is to increase investment is shouted loudly despite empirical evidence that tax cuts don't improve investment (Tax Breaks Don't Boost Investment, CFO On Line, April 2004). Lastly, if Say's Law was workable in a down economy, our historically low interest rates would be leading to extremely high rates of investment spending.

As I look at the state of the American view of science, I fear for our future because the religionization of science is not confined to the economic realm.The rejection of "Climate Change", the insistence that "Intelligent Design"  be taught as science, and Dr. Krugman's observation of economists rejection of empirical evidence are all symptoms of the movement  toward the religionization of the sciences. When dogma dominates governmental policy we end up with the equivalent of an economic inquisition where empirical data is thrown into a dust bin and decisions are made based upon belief instead of evidence.

This problem is not confined to the realm of Macroeconomics. It is also prevalent in Financial Economics. Although he doesn't use the religious analogy, Emanuel Derman, in his book "Models Behaving Badly" identifies many areas in Financial Economics where belief trumps evidence. I addressed this same problem July 5, 2009 in my Blog Post: "Profit vs. Value" and I plan to address it again in a future Blog Post.

In Who’s Interest?

The current protest, known as “Occupy Wall Street”, has engendered a growing number of epithets from the far right. Paul Krugman called it: “Panic of the Plutocrats.” The conflict arises from the fact that the interests of the plutocrats and the interests of the general investors are at odds with each other.

The Plutocrats that Krugman mentioned are comprised of three groups: The first group is the Brokerages who make more money as trading increases. Most of the stock analysts, who make recommendations, work for the brokerage firms and are prone to recommend trading as opposed to investing strategies because these increase the profits of the brokerages that they work for. Included in this first group are the stock brokers themselves who make their living off the numbers of trades they receive commissions on. The second group is comprised of the traders who have a shorter perspective and merely buy and sell based upon small movements in share prices. Neither of these groups adds any real economic value to society. They engage in financial asset swaps ignoring and some times discourage real value creation because it can lead to short-term reductions in profits. The third level of plutocrat is made up of corporate executives who, along with the boards of directors, are charged with looking out for the interests of the shareholder. There are, however, two classes of common stock ownership in most publicly traded companies. Looking out for the interest of two separate classes may lead to mutually exclusive goals.

The two groups of share holders may be classified as the investor and the trader. The investor has a long-term perspective wherein stock is purchased on the basis of expected growth and profitability over time. The trader, on the other hand, is looking for short-term profits that will lead to rapid rises in the company’s share price resulting in a rapid resale of the shares. The value of a company’s shares is often thought of as the discounted present value of future profits. The conflict between the two classes of shareholders comes from the fact that a trader puts an exceptionally high discount on future earnings thereby reducing the present value of those earnings. The trader wants it all now. As a result, a trader will put pressure on companies not to reinvest in themselves because reinvestment could lead to short-term profit reduction and leave less cash available for current distribution to the trader. This is exemplified by the last time the government allowed a tax free repatriation of foreign earnings (As of 2003)_. Companies, rather than investing in new plant and equipment, engaged in Stock Buy-Back programs which merely raised the price of stocks so traders could cash in. This lack of reinvestment is the same as disinvesting. In other words, by not reinvesting, the firm is headed toward a long-term decline. This is in direct opposition to the interests of the longer term investor.Update Jan 2019: The analysis of the 2017 tax law for 2018 shows that companies continued to use repatriated cash for stock buybacks and dividends rather than Capital Investment. 

Executives and boards are under severe pressure from broker/analysts to maximize short term profits. There is however a positive relationship between higher risk and high returns. Needing higher returns means that managements are constantly engaging in higher risk activities. Boards, looking out for the interests of traders rather than investors, issue contracts to executives that reward the high risk/return trade off and insulate management from the potential downside if the risks don’t payoff as projected. On top of all of this, companies can leverage profits up through increased borrowing. The downside is that the company is stuck with fixed cash payouts during an economic downturn. This could be harsh enough to force the company into bankruptcy. Traders don’t care. They are usually in and out so quickly that they have made their profits before the collapse. It is the investor who is stuck with worthless stock.

UPDATE AS OF 12/16/11: The New York Times has an article - "Amazon Says Long Term and Means It" which points out my contention that the market is dominated by organizations with short time horizons and therefore punishes firms such as Amazon because it has a long time horizon."Whatever they might say about long-term shareholder value, this is simply too much for many of today’s investors, many of whom are hedge funds, pension funds and institutions who measure their results — and earn their pay — based on quarterly benchmarks. “If you look at the average length of ownership of a stock, the period is declining,” Mr. Devitt said. “Amazon is marching to a different drumbeat, which is long term. Are they doing the right thing? Absolutely. Amazon is growing at twice the rate of e-commerce as a whole, which is growing five times faster than retail over all. Amazon is bypassing margins and profits for growth.” Also, according to another section of the article: " In October, when Amazon reported strong third-quarter revenue growth and earnings that were pretty much what the company had predicted, but indicated it would be spending more to support continued growth, investors hammered its stock. Amazon shares dropped nearly $30, or 13 percent, to $198 a share in just one day, Oct. 25. "

In addition, short-term profitability can be increased by reducing the company workforce. This lowers cost in the short-run but, because the layoffs are often aimed at higher paid workers, also means that the most skilled and productive workers are lost. In addition, historical knowledge is lost and firms end up repeating past mistakes because nobody still around remembers that certain activities did not work. On a national level this approach leads to falling real incomes, high levels of unemployment, and slow growth with high volatility in the value of 401ks.

Looking at all of this, is there any wonder that there is a growing anti-Wall Street movement in this country? Although the Occupy Wall Street movement has not expressed its discontent in the terms described here, the problem has gotten so bad that the participants have developed a visceral understanding of the underlying cause of the economic problems facing us all.

Hooray for the SEC

The SEC has recently announced that it will be looking into the practices of Hedge Funds that seem to be consistently beating the market. The financial sector has begun to scream its collective head off at the “…effrontery of the SEC for targeting success….” They say that the successful firms are merely identifying inefficiencies in the market and are making money by capitalizing on those inefficiencies.

Efficient market theories say that this is possible in the short term, identifying market inefficiencies brings about efficient markets because those inefficiencies disappear due to the identification. However, it is hard to believe that one or more firms can consistently identify problems in a manner that lets them beat the market in the long run. According to the efficient markets theorists, long term returns in excess of the market return can come about from either trading on inside information, e.g. Raj Rajaratnam or by outright lying, ala Bernie Madoff. Either way, the means would be illegal.

In terms of the finance industry, the insistence that the market can be beaten on a consistent basis is a negation of the theory of efficient markets. Wall Street is constantly touting that the small player, the middle class saver and 401k or IRA owner, can trust in the future of their investments because the market is efficient. However, the existence of long term gains in excess of market returns is a strong indication that markets may not be efficient. Wall Street’s screaming is understandable only in the self-serving context that legal scrutiny would reduce its profits.

The Street cannot have it both ways. Either markets are efficient and long term gains in excess of the market need to be scrutinized or they are inefficient and the small player needs to stay out of the big boys’ game. In either case, Wall Street profits will suffer.

It All Nets to Zero

Earlier today I watched the Governor of Virginia, Bob McDowell, expound upon the virtues of lowering taxes to stimulate employment growth. He said that every state with a Republican governor had lowered taxes and seriously increased employment.(He neglected to mention New Jersey which cut taxes and had an increase in unemployment) Therefore, the Federal Government should do the same and we'd all be better of. What he neglected to say is that this only works if you have a higher tax state from which to steal jobs. This is how it work: Assume two states with equal, including state taxes, employment costs to employers: State Goniff decides to cut its business taxes in half while state Schlemasel keeps everything the same. A business located in Schlemasel moves to Goniff in order to lower its cost. The unemployment rate in Goniff drops while the rate in Schlemasel increases. For the USA, unemployment remains unchanged. It is a zero sum game with one state winning and another losing.

The only way to make this cost cutting technique work on a national scale would be to eliminate the middle class entirely. This means paying computer programers $5,000 per year,as they do in India, or using sweat shop techniques, as it is reported are used in China. The "New Republicans" appear to be well on the road to this approach. All you need to do is listen to what they say and understand the implications.

Lets Give Them What They Ask For

Mitt Romney and the U.S. Supreme Court have stated that Corporations are people. If that is so, then we should carry their options to their ultimate conclusions:

1. Corporations should be subject to the all of the rules for personal income taxation.

2. When convicted of a felony, instead of just being subject to a fine, the company should be put into a receivership, for the term of the normal prison sentence for the crime. The receiver would allow only those actions which would allow the company to continue to live and disallow those actions which would allow the company to prosper.

3. Executives of companies which are convicted should be charged as accessories to the crime and be subject to conviction and punishment as any accessory would when a crime is committed by a real person.

Let's see what the right thinks about these rules.

Update 9/27/11 I just saw a great Bumper Sticker


"I'll Believe Corporations Are People When Texas Executes One"

The Pre-Ordained Failure of the Super Debt Commission

When I opened my copy of today's "The Morning Call" (Allentown, PA) I found that the lead article was a piece about Sen (R) Pat Toomey's recent meeting with local business people in Pottsville, PA. Toomey asked the loaded question of who felt that government regulations had worsened their businesses in recent years. Obviously, what followed was a litany of woes cited by the business people. They attacked labor laws and environmental laws as being costly and burdensome. What they did not address was who would pay the costs of the damages caused by the absence of the rules they criticized.Shortly after reading this I heard that Toomey has been appointed to the Super Debt Commission which is designed to create policies to reduce the Federal Deficit.

The problem ignored by Toomey is that businesses generate costs that are not included as cost of production because the consequences are external to the production process. Polluted water means that drinking water facilities have to be more robust to reduce the industrial pollution. Air pollution increases the incidence of lung diseases and subsequent medical costs. The costs of mitigating these problems are put on people who may not even be consumers of the products. Regulation puts the cost of the damages into the cost of the goods or services produced. This way, consumers pay the true cost of the products they use.

I have often heard business people state that they would not pollute because they and their families also live in this world. It may sound like a good argument until you begin to question specific actions. Several years ago a Vice-President for Manufacturing (at an unnamed company) was complaining to me that a certain state's (also unnamed) water rules were unreasonable. He said that the water his company used had come from the ground and, after being used and treated, what went back in was completely potable. I asked him if I could go to the water return system, get a glass of water, and serve it to him. His response was: "...you mean you want me to drink it?" When I said yes, his reply was: "no way in hell will I drink that stuff!" I then asked how he could state that the water was potable if he wouldn't drink? He sputtered and asked me to leave his office.

Toomey, and the rest of his Regressive cohorts play on a well known problem in the realm of public choice. The problem is that governments must create programs that come out somewhere in the middle of the public wants. This means that everybody is unhappy. Lets face it, when you want a cell phone there is a wide variety of models available. You can pick what you want. When the government tries to set policies regarding the parts per million that of a pollutant that are acceptable nobody is happy because some people think the level is too low and some think it is too high. The same applies to average classroom sizes in schools. In elementary schools I have seen studies indicating that 15 - 18 pupils would be optimal.However, I went to school in an era when our average class size was between 35 and 40. Most of my classmates went on to college and have entered fairly high level professions. If a school district sets a class size at 23, the only people who will be happy are those that think 23 is appropriate.

The right wing in this country, including Toomey, play up on this dissatisfaction with government decisions in an attempt to convince people that government can't do anything right. If Toomey and his cadre of conservatives continue to pander to this discontent and they only accept spending reductions, I expect that the commission is predestined to failure.

I Hope I'm Wrong

As I read the news and listen to the commentators I begin to fear that a prediction I made during the election campaign of 2010 will come true. At the time I told those who asked for a forecast:"...if the Tea Party gains significant control in the new congress we can expect 14% unemployment by the time of the 2012 election." I based my conclusion on a belief, which has proven itself in the recent debt ceiling debate, that right wing obstructionism would prevent any governmental ability to bring us out of the economic doldrums.

I pointed out, at the time, that the bulk of the stimulus ended up replacing tax income that state and local governments lost during the recession; with the expiration of the stimulus spending and the subsequent cuts in state and local spending accomplished through layoffs we could expect to see a rise in unemployment and a possible double dip recession. As we have seen, the new debt ceiling legislation not only eliminates the renewal of the stimulus package, but it also cuts additional spending from the federal budget. This lowered level of spending means that there will be fewer jobs in many different sectors with a subsequent reduction in consumer spending. In addition, extended unemployment benefits have also been eliminated. Unemployment benefits act as an automatic stabilizer in that they allow the unemployed to maintain at least a minimal level of spending.

The evidence that my prediction for an economic downturn may come true came in yesterday's announcement that worker productivity dropped and today' announcement by the FED that economic growth has been less robust than they had thought.A reduction in productivity is usually an indicator that firms will be laying off more people. It is a sign that they have more workers than they need. If we add slower economic growth and state and local layoffs to this scenario it is not unreasonable to expect growth to turn negative. Given the prevailing attitude in the House of Representatives getting any type of government stimulus into effect will be virtually impossible. In the absence of government intervention to stabilize the economy we can expect an accelerated downturn.

Some might ask what the FED can do. Bernanke has said the FED will do all in its power to stabilize the economy. The problem is that the Fed's greatest tool is the ability to raise and lower interest rates. The problem is that lowering interest rates is a method of stimulating business investment and consumer purchases of homes of durable goods. Business investment is not only dependent upon the interest rate but is also dependent upon demand for the goods and services produced. If consumers are not working, or expect that hey might be laid off, they will not be buying durable goods and houses. As a result the demand that is necessary to set off business investment will not be there. Add to this the fact that banks might not want to lend if they foresee a downturn. Excess reserves, funds that banks can lend, are already extremely high and in the event that bankers are less than enthusiastic about economic prospects can go higher.

All in all, the more I observe about what is going on the more pessimistic I get. I truly hope that I am wrong and that somehow our elected representatives will wake up and do the right thing as opposed to the dogmatic. If so my predictions would not come true. If they follow the current course there is a high probability that I will be right.

The Sophistry of the Job Creator Argument

About an hour ago I was on the treadmill in the gym watching Rep. Phil Gingrey (R, 11th GA) explain how he disagreed with the 63% of the American public that believes that the recent debt ceiling agreement benefited the rich at the expense of the middle and lower classes. He used the argument that people making more than $250,000 were the entrepreneurial job creators and that higher taxes would stifle job creation by this class. This is an argument that has been coming up since the Bush administration and it appears to me that hearing it while on a treadmill is extremely appropriate.

Once again, the right wing is showing that their approach to economics is religious rather than reasoned. I state this because someone once said that religion is the suspense of reason and reason based upon research shows that taxes do not have the effect that the Gingrey and his cohorts claim:

1. Around the time of the 2010 election a small business association asked its members what it would take to get them to hire more people. The response was: an increase in the demand for the goods and services that they produce.

2. A article published in CFO.com (April 2004)reported on a study entitled "Tax Breaks Don't Boost Investment". The research looked at 275 companies that were given tax breaks to stimulate investment. The smaller companies, which were closer to the entrepreneurial level, actually decreased their investment by an average of 13%. The researchers conclusion was that demand was the true determiner of planned investment.

I believe that there are only two possible explanations for the Right's persistence in their opposition to tax increases: as I stated earlier they have turned their economic philosophy into a religion or they believe that its okay because they've got theirs and '...to hell with everyone else...'. This holds true especially in light of the fact that S&P included the seeming impossibility of raising taxes in the current environment as one of their reasons for downgrading U.S. Government debt.

Capitulation

Barack Obama has just given the Tea Party the Victory that they need to sell themselves in 2012 election. They can point to what has been done and say "See what we have done. Elect more of us and we'll do even better". They've already stated that this "compromise" didn't go far enough, and they mean it.

What could Obama have done? In his first two years he could have used the regular congressional sessions to obtain the needed legislation. However,he was just too accommodating to use the Bully Pulpit and the presidential "...aura..." against the Blue Dogs of his own party let alone the opposition.

In the current deal my contention is that he was open to being snookered because he truly believed that the Republicans were willing to deal. He never realized that their only goal was to see that he didn't get re-elected "...come hell or high water..." I'm afraid that he still doesn't get it. He lost not only the battle but the war.

Hello 19th century. The Republicans (... Tea Party...) want to repeal every piece of social legislation since Teddy Roosevelt. Yes, I said Teddy. There has been talk of repealing child labor laws and the anti regulation attitude will lead to the end of anti trust legislation. Remember, they see the 19th century as a Golden Age just as they falsely see the Antebellum South with slavery resulting in stable families for African Americans. They are deluded and are very good at using Goebbels methods to convince average Americans that their warped views are accurate.

For the first time I'm actually pessimistic about the country's future. In the past when my students asked about the country's economic problems I talked about the resilience of the American people and our can do attitude. Now, with our leadership believing that most of the unemployment is structural and a belief by most people who are working that the deficit is our highest priority, I think we are in for a long period of decay:

1. Reducing payments to education will reduce our competitiveness and leave our workers unprepared for the newer high tech jobs. Our best bet will be to teach students how to say "Would you like to Super Size That?"in several languages (Chinese,Spanish,and Hindi).
2. Without investment in our infrastructure we will be unable to ship our goods, keep our water clean, and maintain our cities.
3. The failures in the items listed above can lead to the USA resembling a 3rd world nation.

Ignoring Downside Risk - Again

As I listen to, and read about, the debate about raising the debt limit, I am stuck by the fact that we making the same mistakes that got us into the financial crisis of 2008. That is, we are under playing the downside risk that comes from being wrong. A good chunk of the problem that led to the financial meltdown resulted from the assumption that housing prices could not fall; therefore, it was not necessary to measure the downside risk that would come from falling house prices. People therefore invested in dubious financial instruments that could only cause problems if real estate prices dropped.

Tea Party members of congress have essentially said the same thing about default. They are saying that any negative would be short term. They believe that the market knows that USA credit is sound and there would be no consequences from default. What they fail to see is that the world and the markets may not act the way the Tea Partiers suppose. Lets look at some potential consequences of default:

1. The Government could still borrow to replace debt that is maturing as long as it does not exceed the debt limit. This will lead to:

A. Buyers demanding higher interest rates because they are
unsure of the payment of interest.Increasing the deficit.

B. Because the debt sells at auction this higher interest
means that the actual collection from the auction could be
substantially less than the debt being incurred.Increasing
the deficit.

C. To offset this the government could put a higher coupon
rate on the debt. But this will result in higher annual
interest payments. Increasing the deficit.

D. Most of the debt is short term and is sold at discount.
Higher interest rates mean the discount is deeper, interest
payments are higher, and the deficit increases.

2. Rating agencies lower the rating on US debt to AA from AAA. This leads to further increases in the interest on US debt because:

A. Many Fixed Income mutual funds require that they have a
certain percentage of their portfolios in AAA debt. This
means that they would have to dump some of their USA
Securities onto the market thereby lowering the price
of US debt and raising interest rates.

B. Many insurance companies are under similar NAIC rules that
would cause similar restructuring.

C. Many countries have their reserves in U.S.Dollars that
are invested in U.S. Government Securities. They might be
tempted to move to the Euro, the Pound, or the Yen.

D. Oil and many other commodities are priced in U.S. Dollars.
If these move to other currencies, the price effects for
U.S. consumers could be extremely uncomfortable.

E. All of the preceding items 2 A - D would lead to negative
effects on the U.S. economy. A shrinking economy means
automatic decreases in tax collections and automatic
increases in other programs. All leading to an increase in
the deficit.

The Tea Party actions, instead of helping, would lead to a long term worsening of the debt problem. There is an old saying: "Be careful of what you wish for. You may get it"

They're At It Again

Einstein is credited with the statement:"...Insanity is doing the same thing over and over again expecting different outcomes...". I guess this is an apt description of the IMF. Let me explain: Yesterday, July 19th, an IMF representative said that any arrangement for a EURO bailout of Greece needs to be structured so that credit insurance will not kick-in.

It appears that European banks have continued to issue Credit Default Swaps, a form of insurance against financial instrument defaults,despite the experience of AIG in the last financial crisis. The IMF is worried that exercise of the provisions of the swaps will sink Europe's banking system.However, nobody has instituted regulations to prevent the issuance of these swaps.If the consequences of people collecting on these pseudo insurance policies are so dire then they should be banned.

The problem with banning Credit Default Swaps is that too many people are making money on them; in the event that they have to be paid on, everyone is sure that governments will bail out the issuers to prevent a financial collapse. Adding to the problem is the fact that the Swaps are in fact financial instrument and not insurance policies. They are securities which can be bought and sold on the open market. The current owners of these securities probably do not own the bonds (Greek Debt) that are being insured. Therefore,they do not have an insurable interest in debt which may default. However,if there is a default,they would get paid anyway.

Now to get back to who is making money:

1. The issuing institution is paid to write the securities.
2. The debt issuer gets a lower interest rate because the buyers of the debt can buy the Swaps.
3. The buyers of the Swaps can then sell them at a premium if it looks as if they will ever have to be paid off.
4. The original issuer gets paid off by various governments in order to avoid collapse.
5. Brokerages make commission money buying and selling the swaps to 3rd parties
6. The losers are the tax payer and the unsophisticated buyers who are holding swaps which will never be paid on because of government bailouts to the debt issuers.

So, our governments keep allowing these transactions because the Swap issuers are the same people who make large donations to their campaigns. On top of this, the government officials in charge of regulating these activities usually came from the offending financial institutions and will probably return to them when they leave government service.

"WE HAVE THE BEST GOVERNMENT MONEY CAN BUY"