Tag: government

It’s the Leverage, Stupid!

Category : Political Science & Economics
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With the stock market looking toppy and the unemployment rate still on the rise, the “green shoots” are starting to look rather brown (or more like a mirage) and some are calling for a second stimulus.  For now, leave the ridiculous fact that only a tiny percentage of first stimulus has been spent so far and let’s look at the facts.  The economic crisis was caused by excess leverage, first by consumers, then by companies, now by the government.  Is a second stimulus with more leverage what we really need?  If it is, will the Obama administration make a case for it that doesn’t use phony statistics like “jobs saved or created?”

To borrow from Bill Clinton’s first presidential campaign, Its the Leverage, Stupid!  Consumers borrowed huge amounts of money to live lavish lifestyles or to just keep up with the monthly bills.  The consumer savings rate peaked in the 1970s around 15%, but declined consistantly during the 80s and 90s.  It even went negative in 2007, right before the financial crisis.  This meant that consumers were, on average, spending more than they made.  Consumers resorted to using their homes as ATMs, borrowing vast amounts of money to keep the party going.  Clearly it was not sustainable.

Banks and non-bank banks stoked the flames and let the party rage on.  Banks offered mortgages to people who shouldn’t have had them, manufactured huge bets on CDOs and made billions moving money around.  After the government removed many of the leverage regulations, banks continued to go wild.  Other companies and hedge funds joined the fray, borrowing billions of dollars  for leveraged buyouts that left balance sheets riddled with debt.

When the economy started to slow down and the stock market fell out of bed, companies and consumers who were strapped with debt and little savings faced the brunt of the downturn.  Companies began to deleverage, cuting costs and jobs to be able to stay in business.  US consumers, scared by huge declines in net worth stemming from the stock market collapse and the real estate downturn, started to save, bringing the savings rate up to around 7%.  

The US government, which had started to run larger deficits during the Bush years, stepped in to fill the void.  The Bush administration pushed the first bailouts through and the Obama administration passed even more bailouts and a huge stimulus package.  The $740bn+ stimulus package pushed much of the spending two to three years down the road, funding tons of pork-laden projects that are probably unnecessary and have nothing to do with stimulus.  These programs saddle the government with even more debt at a time when the rest of the world is concerned about the value of the dollar.  The government should have advocated for $200-300b of immediate spending, or better yet, returned money to the people so that they could pay down their own debts.  Instead, we have record amounts of debt and even more leverage, not even taking into consideration the unfunded liabilities of Medicare and Social Security that will require even more leverage.

Now, as the stock market and the economy as a whole are showing signs of getting worse, there are calls for a second stimulus.  I fear that Congress will pass another massive bill, but most of the money won’t be spent fast enough and there will be even more waste.  I’m worried that many of the projects will be useless and ineffective at turning the economy around.

The only way to fix the problem and get through the bear market is to deleverage.  We need to squeeze the leverage out of the system, stop the insanity and go back to more rational debt levels.  With another round of mortgage resets set to take place late this summer, we are likely to have many more foreclosures in the next year.  Instead of spending money on projects in the future, the government should have made it easy for mortgage holders to renegotiate their mortgages in exchange for the bank having the rights to some of the upside of the house when the market turns.  This type of solution removes debt (leverage) from the consumers and bad debt (leverage) from the financial institution and saves consumers money right away, with a lower mortgage payment.  The government will have to spend a little more money, but it would be rational, compared to the huge stimulus package and bail outs that we have seen so far.

The government should be helping (forcing) companies to convert debt to equity in institutions that have bad balance sheets.  Instead of bailing out investors and companies who made bad decisions, the government should be converting debt to equity to shore up balance sheets and make the companies deleverage.

I think we are on the verge of another downturn in the stock market and rising unemployment.  The press seems to think (or hope) that the worst is behind us.  Most people are turing bullish and many Americans have come back into the market.  I fear that we face a repeat of the stock market’s performance during the Great Depression, where there was a prolonged bear market rally and then a second crash that wiped out more market value than the initial crash.

China and the rest of the world are already starting to pick at the reserve status of the dollar.  If the US keeps leveraging and then decides to inflate away the problem, the US dollar may lose its reserve status.  The government must make sure they do not make the crisis worse than it is.  Its not a Republican or Democrat issue. Its an American issue.  I am not confident that the government will make the right decisions.  With GoldmanSachs alums holding many key government jobs, I fear that they will do what they know best: continue to leverage and try to pick up the pieces later.  If you want to go farther, read Matt Taibi’s blog and latest piece in Rolling Stone.

I hope I am wrong, but I don’t see the US coming out of this without lots more pain.  What do you think?

Enron Documentary is Incredibly Interesting

Category : Books
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I just watched The Smartest Guys in the Room, a documentary about the rise and fall of Enron.  I have a special interest in Enron, as I margined my entire stock portfolio and shorted it in my 10th grade mock stock competition for a few days, but relented to my partners advice that it couldn’t fall any more and went long Enron, only to finish dead last.  If we would have stayed with the original trade, we would have had a free trip to New York!  But enough of that.

The documentary has interviews with the journalist who first started to question Enron’s meteoric rise, former employees and executives and plenty of video from the companies many meetings and pep talks.  It is really well done and very interesting, notching an Academy Award Nomination in 2006.  If you are at all interested in the Enron story, or corporate fraud in general, check out this documentary.

The most interesting part of the documentary centered on Enron’s role in the blackouts that plagued California in winter 2001 and summer 2002.  I was always skeptical about claims of meddling and corporate scandal in the blackouts, but the documentary painted a very explicit case that showed overt meddling that caused up to $30b of losses in the California economy, the recall and end to the political career of Gray Davis and ultimately the election of The Governator to California’s highest office.

The documentary showed audio of Enron traders telling power plants to shut down, which caused rolling blackouts.  The traders also were taped diverting power from California power plants to other areas to try to drive up the price.  It worked.  Power was $40 per unit before they started their shenanigans and spiked to $1000 per unit at their peak and Enron made billions.  This part of the business was pretty much the only successful part, but was clearly unethical, if not illegal.

The rolling blackouts caused huge economic damage to California’s economy, ended a political career, caused traffic accidents and many other consequences so that Enron could make money.  Add this business practice to their cooking the books, it was pretty clear that Enron was very corrupt.  It was also interesting to see how complicit investment banks, ratings agencies, the Bush Administration, accountants and journalists were in allowing Enron to get away with fraud for so long.

There are many parallels to the current financial crisis in that so many people were blinded by greed, derelicting their moral and fiduciary duties.  They turned a blind eye to poor business practices and extreme risk taking.  Its interesting to see history repeat itself so quickly.  Check out the documentary.  Its playing for free on Mark Cuban’s HDnet channel for the next few weeks.

Perverse Government Incentives

Category : Political Science & Economics
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In 2001, President Bush decided to lower the estate tax as part of his tax cuts and stimulus after 9/11.  The death tax, as some call it, is a tax on people’s estates valued over a certain amount.  In 2001, the limit was $675,000 and anything over that amount was taxed at 55%.  The Bush Administration’s plan was to phase out the estate tax by 2010 by both raising the amount that was protected and lowering the tax rate.  The yearly table from wikipedia shows that 2009 estate tax limits are $3.5m in assets, above which anything will be taxed at 45%.

In 2010, the estate tax is completely repealed.  The Bush Administration’s plan ends in 2010, meaning that in 2011, the estate tax will go back to $1m and 55%, unless Congress passes another bill to change it, which is doubtful with this economy and the Democrats in power.  Whether you think the estate tax is a good idea or not, the current situation sets up some perverse incentives that could save or cost people millions.

Imagine a person with a father who has $10m in assets who is sickly and may die in 2009.  If the father were to die in 2009, $6.5m of the money would be taxed at 45%, or close to $3m, but if the father were to live until Jan 1, 2010, the person would save all of that money.  The government’s monetary incentive is to keep older, sick people alive, even if it against the person’s best interest.  The father might even try to hold on longer than he normally would, just to save the extra money.

Now fast forward to December 2010.  The same person from the example above would not have to pay any taxes if their father were to die before the end of the year.  If the father were to live until 2011, $9m of the $10m estate would be taxed at 55% or almost $5m.  People would have the incentive to make sure that their parents died before the tax rate changed.  Now imagine super rich people who have billions.  The difference is real money.

Now I don’t think that most people will be influenced by these incentives, as most people care more about their family than money, but I can see situations where someone might (Mom, if you read this, don’t worry!).  The estate tax changes are just another example of government policies creating unintended incentives and consequences.  Hopefully nobody tries to “take advantage” of these changes.

New Ideas to Reinvigorate Shrinking Cities

Category : Political Science & Economics
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London’s Telegraph had an interesting story over the weekend about an innovative program that Flint, Michigan is using to combat its huge drop in population.  The article, titled US Cities May Have to be Bulldozed to Survive, explains that the program’s goal is to demolish tracts of vacant housing and return the land to nature, while moving the residents of non-vacant housing closer to the city center.

Flint, sixty miles north of Detroit, was the original home of General Motors. The car giant once employed 79,000 local people but that figure has shrunk to around 8,000.  Unemployment is now approaching 20 per cent and the total population has almost halved to 110,000.  The exodus – particularly of young people – coupled with the consequent collapse in property prices, has left street after street in sections of the city almost entirely abandoned.

Dan Kildee, the creator of the program, has received support from the Obama administration and a group of charities that want to expand the program to other cities, mostly in the Midwest and Rust Belt.  I was recently in Detroit and saw block after block of abandoned buildings, which created huge, rundown holes in the city.  It would be interesting to see this program in action there as well.

I think that this is a great idea and will have a decent chance of working.  The program should appeal to both Republicans and Democrats, as shrinking cities should lower costs and make cities more environmentally friendly.  Lately, we have not seen many new, innovative ideas coming out of our government.  Instead, politicians have mostly tried to push any big decisions toward the future and government has not gotten much done.  

The American model worked so well in the past because local governments and states acted as labs of democracy, creating new, innovative policies and programs.  Some failed and others succeded.  The successful ones often spread nationwide.  Hopefully, ideas like this that start on the local level and have a chance to spread will reinvigorate both our shrinking cities and our political process.