The Best Laid Plans Of Mice and Men

Los Tres Amigos: Obama, Geithner, Orzag

Los Tres Amigos: Obama, Geithner, Orzag

The Obama Administration just handed Congress a $3.6 trillion budget.  The budget is one of the best ways of seeing what a President lays out as priorities and can be linked to many campaign promises.  While it demonstrates a vision, what remains after congress hacks through it tends to be a more reliable gauge of the direction since compromise will shortly rule the day.  I’m going to outline some of the major points and point you to some media coverage.  We’ll have to watch over time what gets sold out and haggled away.  That will really show the priorities and not just the posturing.

The overall tone of the budget shows a more activist government in the areas of health and education mostly paid for by families making over $250,000 a year, singles making more than $200,000 and various  business interests. The WSJ has the numbers here.

As expected, tax increases will rise for singles earning $200,000 and couples earning $250,000, beginning in 2011 — for a total windfall of $656 billion over 10 years. Income tax hikes would raise $339 billion alone. Limits on personal exemptions and itemized deductions would bring in another $180 billion. Higher capital gains rates would bring in $118 billion. The estate tax, scheduled to be repealed next year, would instead be preserved forever, with the value of estates over $3.5 million — $7 million for couples — taxed at 45%.

Businesses would be hit, too. The budget envisions reaping $210 billion over the next decade by limiting the ability of U.S.-based multinational companies to shield overseas profits from taxation. Another $24 billion would come from hedge fund and private equity managers, whose income would be taxed at income tax rates, not capital gains rates. Oil and gas companies would be hit particularly hard, with the repeal of multiple tax credits and deductions.

There is a shift away from the oil and gas industry reliance as well as removal of some of their tax privileges.  One of the more ambitious plans is that of an emissions trading program.  Under this scheme, the government will set a cap on the allowable amount of green house gases and businesses will have to buy permits if they want to pollute above their allotment.

In one of the budget’s most ambitious proposals, the president plans to cap the emissions of greenhouse gases, forcing polluters to purchase permits for emissions that would be slowly brought down to 14%  below 2005 levels by 2020 and 83% below 2005 levels by 2050. The sale of those permits, beginning in 2012, would reap $646 billion through 2019.

One of the most interesting things is the percentage of federal debt in relation to GDP.  It’s at an historic high unlike anything seen for a long time.  This is especially interesting coming after a “Fiscal Responsibility” Summit.   The deficit estimates are based on pretty optimistic numbers  which makes that summit look like even more of a marketing event

hats off to bb for this one ... WHOA!!!

hats off to bb for this one ... WHOA!!!

from the land of Oz.

The president blamed the nation’s economic travails on the administration that preceded him and on a nation that lost its bearings. His budget plan projects a federal deficit of $1.75 trillion for 2009, or 12.3% of the gross domestic product, a level not seen since 1942 as the U.S. plunged into World War II.

I’m still wondering if we’re going to be able to float all that debt. Again, however, these are preliminary numbers and I’m certain Congress will bargain them down and around to other places.  What the Administration compromises on will tell its true agenda.  Republicans and business interests are not likely to go quietly into the night on any of this.

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Quantifying the Unquantifiable

I found this neat article on 13 tipping points by Market Watch’s Paul Farrell.  I managed to read it in between multi-napping and watching the Dow go down in response to the the State of the Union Address and bad  numbers coming out of housing.  Then, I watched the market return to a more neutral position following Ben Bernanke’s second day of congressional testimony .  I decided it might be a good idea to talk about how information comes into markets and how markets react to that information using his article.

The article is subtitled why “Obamanomics may backfire, triggering the next Great Depression”.  It’s actually less about Obamanomics than it is about the number of unquantifiable ‘shocks’ to the macroeconomy that may lurk out there and panic or entice Wall Street.  These shocks (called so because they shock the economy and frequently appear unforeseeable) represent a huge amount of risk but can’t be easily written into the mathematical models.  They wait out there like a cat ready to pounce on an unsuspecting mouse.  Farrell’s basic point is that we don’t know right now if the stimulus package will work because there is too much unquantifiable risk out there.  However, just because the mouse is unsuspecting, I always think that there must be ways of detecting that big old cat. Hence, I research.

Usually the chance of the shock can be added into a model using Bayesian ‘dummy’ variables.  They take on either a 1 or 0 value and are ‘weighted’ by the probability of realizing the event.  So, the 13 variables that Farrell lists could be used to cause a negative shock (using a negative one for the occurrence of the event) times its Bayesian probability (say something like a 20 % chance of occuring vs a 80% chance of not occuring).   Shocks can also positive impact by using a positive 1 for the occurrence of the event say like a technological advance that just suddenly happens.

Farrell identifies these 13 things that are possibilities that haven’t been “quantified” by most Wall Street Risk models because these models focus on getting at the risk and pricing of an asset using asset-related events, rather than macroeconomic-related events.  Here’s his list.  It’s a basic what’s what of tinfoil hat scenarios.

  1. Massive debt: government, private; Fed printing money, tax increases
  2. Population: exploding demand, resources depleting, conflict, rebellion
  3. Lobbyists: feeding frenzy, 40,000 run Washington, sabotaging democracy
  4. Derivatives: $683 trillion hiding in shaky global “shadow banking system”
  5. Petro czars: Exxon, Saudis, Chavez, Iran — all vulnerable, unstable, risk
  6. Universal health care: 46 million uninsured; costs inflating debt
  7. War on drugs: massive global failure: Afghan, Mexico, Latin America.
  8. Deflation? Inflation? Stagflation? 1970’s sideways market ahead?
  9. Entitlements: Social Security, Medicare, drug benefits may soon sink us
  10. Politics: “Grand Obstructionist Party” Or “New Contract with America?”
  11. Savings: sabotaging consumer spending, the engine driving the economy
  12. Climate change: Pentagon sees increasing tension, triggering new wars
  13. Socialism and nationalization: will free markets return, or sink us?

tippingpointUsing Malcom Gladwell’s idea from the Tipping Point (a book club selection that Readers of the Confluence will recognize,),  Farrell isn’t sure if any of these dicey situations will actually reach that critical place where the event impacts everything it touches.  Hence, becoming one of Gladwell’s Tipping points.

More significant, although invariably left out of Wall Street’s equations, true economic tipping points will grow to a “moment of critical mass, the threshold, the boiling point,” according to author Malcolm Gladwell, where “change” (whether positive or negative) is “unstoppable.” And although left out, these macroeconomic variables can account for over 90% of the risk in an economic equation or derivatives contract, as we’ve discovered so painfully this past year.

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It’s Mardi Gras: You know, the Party before Penitence?

dscn0382I’m sitting here watching the kids get their costumes together for the big day of celebration called Fat Tuesday.  That’s the day when you pull out all the stops because you know lean days (no meat, no alcohol, no fun) starts tomorrow.  I guess I must be in hyper-metaphorical mode because it’s really striking me this year as a good fable.  Tonight at midnight, the Krewe of Klean will take to the streets of the French Quarter to shovel all the leftovers into the dump trucks. The police will ride their horses down Bourbon street and announce that the Party’s over.  They arrest anyone who want the party to continue at that point.  You can either spend Ash Wednesday doing penitence in your bed or the Parish Prison.

When I first got out of graduate school I went to work at a small bank.  I was soon lured to the biggest Savings and Loan in the middle of the country.   I’d been working on loan pricing models and arranging bank income statements into an exercise called spread management and asset-liability matching.   Big time company working for a big time CEO!

I have to admit, the only person that I really knew that was a CEO was my dad and he was great.  His employees loved him.  He gave them wonderful benefits and when they had sick children or they were gravely ill,  he gave them time off with pay.  His office manager was openly gay.  His mechanics and body technicians were a diverse group for small town Iowa.  Most of them worked for my dad the entire 30 years and loved him as much as I did. From the time he bought it when I was one, until he retired when I was in my 30s, the entire employee base was my extended family.  So, I entered the business world thinking this was the model for management and boy, was I wrong.

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WTF? Pre-Determined Stress Tests?

I finally have a bit of time to catch up on reading.  I’m hosting 10 of my youngest daughter’s college friends for Mardi Gras in a very small house and it’s as wild as it sounds.  I read this on Naked Capitalism and just didn’t even know what to say.   So I’m going to throw it to you. Now mind you, this is an economics site and not a political one.

We have been skeptical that the pending Treasury stress tests on banks, designed to ascertain their state of health, were inadequately staffed and therefore could not do the job properly. Our big concerns were that they had too few bodies to e test financial data versus underlying documentation adequately (usually done on a sampling basis) and they lacked the expertise (and perhaps the mandate) to vet risk models (which we all know have performed impeccably over the last two years.

Is it a test if the results are pre-determined? Apparently Team Obama thinks so.

I’ve been wondering what exactly this stress test was going to be myself and how they were going to pull it off.    I’ve worked in commercial banks, savings and loans, and at the Fed as well as the educational background and I’ve been scratching my head since it was first announced. No wonder the Obama administration is sounding so firm on the no nationalization issue. They’ve planned what they’re going to get ahead of time.

bank_crisis_03 This report and picture from CNBC.

Said one high-level official, “I think the market is missing that the whole intent of this process is to show that the banks have enough capital for even worse outcomes than we currently envision and to show there’s a program in place to give banks access to that capital if they need it.”

Yes, read it again. The process is to show us that the banks are okay.  No wonder there’s no discussion of the Swedish or German approach to Banking crises.  We’re going to be ‘shown’ everything is okay even under the ‘worse’ outcomes.  Details on the worst scenarios are supposed to be out on Wednesday, but really, we’ve heard this before. Remember I mentioned in my last thread that much of the definitions had to do with what type of stock (common, preferred, some hybrid) winds up flowing from the Treasury to the target banks?  Here’s another on the money paraphrase from the CNBC story.

The key misunderstanding in markets, officials believe, is how the public-private partnership will work and the way that new government capital, in the form of mandatory convertible preferred shares will become common equity.

One official said the public-private partnership will be voluntary so there will not be no mandate that banks offload assets at a loss. The official added that additional government capital will go into the banks as mandatory convertible preferred. Those shares remain preferred until realized losses and capital needs trigger conversion to common. As a result, the official said, the government may end up with a large stake in a given bank over a period of time, but it wont’ happen overnight.

May I suggest some new Savings Vehicles for the Obama Years?


It Ain’t Over until the Eagle Grins

atlant-fed-eaglePaul Krugman’s column in yesterday’s NY Times talked about the economic outlook report released by the Federal Reserve’s monetary policy ‘deciders’, the Open Market Committee.  He’s been obsessing on one little sentence.

But my eye was caught by the following chilling passage (yes, things are so bad that the summarized musings of central bankers can keep you up at night): “All participants anticipated that unemployment would remain substantially above its longer-run sustainable rate at the end of 2011, even absent further economic shocks; a few indicated that more than five to six years would be needed for the economy to converge to a longer-run path characterized by sustainable rates of output growth and unemployment and by an appropriate rate of inflation.”

I used to participate every so often  in the gleaning of the data for the Atlanta Fed’s report back in my days which were back in Greenspan’s days at the Fed.  (Bill was President and all was well in the world, so completely different environment than now.)  It’s a rather interesting exercise that combines the sweat of wonky economists dropping numbers into black boxes and anecdotal evidence gathered by holding meetings with business folk out in meeting rooms to gauge what’s going on in reality-based USA.  The anecdotes  we try to catch are things like: Are you hiring?  Are you buying inventory?  Are you expanding your business?  What are your customers saying?  How happy is every one in your city?  You just basically chat them up after you’ve plied them with food and booze. We used to have the meetings at the Gulf Coast Casinos.  I’m not sure what the other Feds do, but I’m sure I’d love to be around for some of them as the ones down here could be pretty interesting.

Each of the Fed Banks print their assessment of the economy.  Some stick to their regions.  Some have particular interests.  For example, the St. Louis Fed is considered to be the center of the monetary policy wonks.  San Francisco Fed tends to focus on issues dealing with the Pacific Rim.  You can visit each of the sites and get a feeling for not only the country’s outlook, but the area where you live.

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Mortgaged Home, Sweet Mortgaged Home

farm-1933-for-saleObama announced more details on his bailout plan that was focused more on borrowers instead of the lenders.  He released a four page fact sheet here.  There are three portions and The Economist does a pretty good job of summarizing them here.

First, the administration will increase the number of homeowners able to refinance at current, low mortgage rates. Borrowers whose mortgages are owned or guaranteed by Fannie Mae or Freddie Mac will be able to refinance a loan up to 105% of the home’s value (up from 80%, previously). This is expected to help about 4 to 5 million households who owe nearly as much or more than the value of their homes. This seems like a reasonable step to take, though as Calculated Risk notes, it’s a bit of a lottery. Those whose mortgages haven’t been purchased by Fannie or Freddie are basically out of luck.

The second part is the one that’s grabbed headlines; the president has dedicated $75 billion toward efforts to prevent foreclosures. Chief among these efforts is a plan to reduce monthly payments for troubled borrowers. For those spending greater than 38% of their income on mortgage payments, up to 43%, the government will ask lenders to reduce interest rates to bring payments down to the 38% level. The government will then match lender dollars, one-for-one, in bringing down interest payments until the borrower is only spending 31% of income. Both borrower and lender will be eligible for $1000 payments when payments are reworked, and if the planned payments are made. If it’s necessary to reduce principle, then Treasury will provide assistance with this, as well.

This portion of the plan has drawn criticism, since many homeowners with too-large payments are those who took on irresponsible loan structures or who simply purchased too much house—who behaved irresponsibly, in other words. Ideally, officials would no doubt prefer not to help such borrowers (just as they’d no doubt prefer to let bankers who’d made bad decisions go under). But frankly, that’s not a top concern of mine. Rather, I’m interested in whether or not this is the best way to use $75 billion to halt foreclosures.

The Economist has two concerns.  The first is that it may just delay foreclosure rather than solve it because:

… interest payments are being reduced first, and principle written down only as a last resort (such that many who take advantage of the programme will nonetheless remain underwater). Perhaps, but by trying to leave principle alone, the government is avoiding excessive transfers of wealth to borrowers. A shared-equity plan might have been better, but this will halt some foreclosures and incent homeowners to stay in their homes longer.

The second issue there are enough incentives in the bill to rework the payments.  On this point, they say:

Presumably, it’s already in the interest of lenders to reduce payments rather than foreclose, so it’s unclear whether $1000 is going to alter the balance. This, I think, is a more serious point. The housing plan passed last year to help rework problem mortgages seriously underperformed—where some 400,000 borrowers were deemed to be eligible, actual applications numbered in the tens.

The third portion of the plan seeks to “strengthen” Fannie and Freddie and to keep mortgage credit available and loan terms to ensure housing affordability.   The amount  scheduled for this is $200 billion.

David Leonhardt of the New York Times had this to say. His  blog thread concentrates on who is most likely to benefitfarm-foreclosure from the plan.  If you watched Obama’s speech, supposedly  the plan won’t help the ‘irresponsible’ speculator.  Leonhardt questions if the plan can successfully separate the homeowner is trouble by purchase motives.

But the lines aren’t quite as clear as Mr. Obama suggested. In fact, his plan will end up helping a fair number of people who bought homes that they should have known they would never be able to afford. The core of the plan gives banks a financial incentive to reduce many mortgage payments to no more than 31 percent of a borrower’s income.

Which homeowners will benefit from this reduction?

Certainly, some who took out a reasonable mortgage and later lost their job will be helped. But people who bought too much house — and banks that allowed people to do so, or even encouraged them to do so — will also benefit. As distasteful as this may be, it’s the only way to make a serious dent in foreclosures and, in the process, to help the financial system.

These same political calculations help explain the public emphasis that the White House is giving to the relatively modest steps it is taking to help underwater homeowners — those with a mortgage worth more than the value of their house — who can afford their monthly payments.

The actual details of the plan aren’t due out until March 4th when it goes into effect.  Market Watch had some interesting statistics for the plan today.  Here are the number of homeowners the plan itself says it will help.

The bill is supposed to help s many as 9 million households in fending off foreclosures:

  • Allows 4 million–5 million homeowners to refinance via government-sponsored mortgage giants Fannie Mae and Freddie Mac.
  • Establishes $75 billion fund to reduce homeowners’ monthly payments.
  • Develops uniform rules for loan modifications across the mortgage industry.
  • Bolsters Fannie and Freddie by buying more of their shares.
  • Allows Fannie and Freddie to hold $900 billion in mortgage-backed securities — a $50 billion increase

Moral Hazard and Corporate Governance

I usually stick with the Economics side of my degree instead of the Finance when I blog because macroeconomics is highly linked to politics and policy.  Today, I’m going to switch over to the one field specialty I took in graduate school that’s not considered economics.  (My economics fields are monetary and international.)  My finance field is corporate finance.  The two theories I spend time researching  in the corporate area are two that are frequently at the middle of financial crisis.

Moral Hazard is a  problem in situations where there are multiple parties, differing levels of information about the situation, and differing levels of exposure to the risk inherent in the situation.   Evaluating how folks operate in different risky situations with varying amounts of information  using mathematical models is basically a big old exercise in calculus that I’m not going to do here.  The theory is a useful one that explains,as an example, why you drive faster if you’ve got a seatbelt on and are insured.  Basically, between seatbelts and insurance, you don’t feel as ‘at risk’ so you behave in a riskier way.

Corporate Governance Laws and Executive Compensation packages are designed to overcome the moral hazard implicit in one of the most basic moral hazard models.  It’s called the  principal-agent problem.  Basically this theory shows the problems that can occur when the owner(s) of a firm (the principal) hire managers (the agent) to run the firm.   The owners (like common stock shareholders) don’t have the same level of information about firm performance that the executives do.  They have to rely on the executives for information.  Also, the owners can loose lots of money if the executives make bad decisions and slack off and don’t work as hard as they should.  In this model, the principals have to find a contract that will force the agents to act in their interests.  They must force them to work hard and return the maximum wealth to the shareholders.  That’s what corporate governance laws and executive compensation packages are designed to do: align the interests of the executives and the shareholders.  If designed properly, they should eliminate the moral hazard problem.  Corporate Governance creates a more transparent environment where the executives can’t hide information.  Property designed executive compensation packages reward the executives for doing their best by shareholders.

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