Saturday, December 24, 2011

Veering from the playbook.

House Republicans, just days after standing their ground, decided instead to head home for Christmas dinner.

So much for the principles that brought them to power in 2010. So much for ending business as usual in the nation’s capital.

But their language changed by the end. Gone was the moral outrage, the appeals to end the mindless spending that was bankrupting the nation. This week, the House Republican talking points led with the insistence that America’s working men and women deserved more than a two-month payroll tax holiday. Somehow, the Tea Party-spawned House Republicans had morphed into demagoguing Proletarian heroes.

But this was an important moment. After all, when the current House majority seized the reins, they were clear that their mission was to curtail spending as the singular path to curbing massive fiscal deficits, while not impeding the morally righteous task of cutting taxes. Specifically, the House Republicans changed “Paygo” rules that had been in effect for many years—whereby tax and spending measures must be budget-neutral over a 10-year period, as scored by the Congressional Budget Office—to provide instead that such constraints should not apply to tax cuts.

This perspective—that deficits are not a function of the mix of revenues and expenditures but rather a function of spending alone—is a odd vestige of the Reagan era, when cutting taxes emerged as the sine qua non of the modern Republican Party and liberated the GOP from its stodgy traditions of fiscal prudence and school marmishness. At the time of the Reagan revolution, when marginal tax rates where high, one could make a fairly reasoned argument of the supply-side premise, that cutting taxes would increase revenues. But that argument was bound up in the facts and economics of that era, and only attained that status of a moral imperative in the ensuing years.

But in the debate regarding extending the payroll tax cut, for reasons that are unclear, the House Republican did not merely forsake their rule that tax reductions are morally self-justifying, they went to the mattresses to demand that they be paid for like any other legislation of Democrat-inspired spending.

Then, suddenly, they got up off the mattresses, changed their votes and went home.

Fast forward to late next year and the implications of the House action looms large. At the end of 2012, the Bush-era tax cuts are set to expire just like the payroll tax cut that was just extended. Under the House Paygo rules, Republicans would no problem demanding that such tax cuts remain permanent, despite the $4 trillion of projected costs over ten-years. But the payroll tax debate should cast the stance of the House Republicans in a new light. This month, for the first time in recent memory, the Republicans took a stand against tax cuts because of the fiscal implications of those cuts.

For the first time in recent memory, Milton Friedman and the Republican Party of my grandfather were redeemed. This was a significant point that should not be lost.

Because the simple truth is that to extend the Bush tax cuts is wrong.

Little if anything has been said in the public debate over those tax cuts to remind the public about why they had an expiration date to begin with. After all, changes in the tax code tend to be eternal, and ability to rely on the rules of the tax system is a bedrock principle of our economy. But the Bush-era tax cuts had to expire if they were going to comply with the fiscal rules in place when the cuts were enacted into law. To meet the ten-year Paygo scoring rules, the Bush-era tax cut legislation provided for rates to return to the levels in effect in 2001 after seven years in order to pay for the largesse that was bestowed upon taxpayers over the period the cuts were to be in effect.

Oddly, in the debate over extending those tax cuts, up until now the Democrats and Republican essentially had to act under different political rules. Democrats, because they are the party of wanton over-spending and fiscal profligacy, had to justify how extending the tax cuts would be somehow fiscally justifiable. Republicans, because their brand includes the long-defunct notion that they are the party of fiscal prudence, felt no such constraint, and they have felt free to argue that the cuts be made permanent, whatever the fiscal impact might be.

The argument in Congress that the Bush-era tax cuts should be extended has given the lie to the notion that Congress is subject to any rules, even the ones it places on itself. The argument that tax rates should not be increased in the face of a recession is utterly disingenuous. Those arguing to gut the 2001 and 2003 tax bills now would be doing so regardless of our economic condition.

Look back at the historical record. Even as the Bush-era tax cut legislation was being considered, Republican leaders assured their base that by 2010 those cuts would be made permanent, as the Republicans pledged from the outset to attack as taxers any who would let the cuts expired. That is to say, even at the moment of the original legislation, those who supported those tax cuts eschewed any intention of adhering to the fiscal rules that Congress had imposed on itself. At the time, the cynicism was breathtaking. But as political calculation, it was prescient.

This month, House Republicans veered from the Republican orthodoxy on cutting taxes without offsets in favor of their Tea Party anti-deficit principles when they demanded spending cuts if the payroll tax cut was to be extended. For the first time in recent memory, Republicans returned to pre-Reagan principles and demanded that tax cuts be paid for.

A cynic might argue that this was not a change from the Republican playbook. They might suggest instead that we have seen the emergence of a codicil to the principle that tax cuts are morally self-justifying that suggests that such cuts must be paid for if the benefit accrues to working class Americans. Or perhaps the House leadership simply got caught up in needing to oppose anything that Democrats supported, and lost sight of the fact that they were in the odd position of opposing a tax cut.

In acting to demand that the payroll tax cut extension be paid for, will the House Republicans apply the same rule to extending the Bush-era tax cuts? That would be a game changer. But it is more likely that the House Republicans will get their act together, and once again the $4 trillion cost—and profound hypocrisy—of extending the Bush-era tax cuts will be subordinate to the higher moral principle of cutting taxes—without regard to cost.

Sunday, December 18, 2011

Neoconservative denouement.

With the end of the war in Iraq, one chapter of the Neoconservative history is ended. Its outcome will not be known for decades to come.

In his famous 2003 interview in Vanity Fair magazine, then-Deputy Secretary of Defense Paul Wolfowitz was forthright in explaining that while their public case for going to war in Iraq was based on weapons of mass destruction, they chose the WMD argument because it was the most salable. It was the rationale for the war, but not the reason.

Some, such as Dick Cheney, saw the war in Iraq was a means to achieve American control over oil fields whose development Saddam was ceding to Russian, Chinese and French companies, and putting boots on the ground within striking distance of both Saudi and Kuwait oil fields, to deter future threats to America’s interests in the region.

Others, such as Donald Rumsfeld, saw Saddam as a proven threat to the region, who would be increasingly allied with international terrorism as a strategic threat to America’s interests. That group—that garnered sympathy in the outgoing Clinton administration—viewed action in Iraq as imperative both to forestall further aggression by Saddam, and to prevent an alliance with terrorist groups that had declared war on America and the west years earlier.

For Wolfowitz and his Neocon brothers-in-arms, however, the motivation was more idealistic. Iraq was an opportunity to bring a reformation to the Arab world—to end centuries of oppression and dictatorship dating back through the Ottoman Empire and the Caliphates, and set it on a path toward modernization, democracy and freedom.

It is ironic that a decade later—after a cost of thousands of American and Iraqi lives and trillions of dollars of total projected costs—the argument that was chosen to sell the war was the easiest to have been proven wrong. For Wolfowitz and his brethren that is OK, because WMD was never really the reason. It was simply the rationale.

Today, as winter sets in following the Arab Spring, it is hard not to reflect on the Neoconservative casus belli. One cannot point to the evolving democracy in Iraq and suggest a direct cause for democratically inspired movements that have shaken the Arab world. The contemporaneous evolution of communications technologies that have been so evident in media coverage of the Arab Spring certainly suggests a range of changes in the world that might have been causal factors. Yet images of Iraqis exercising their new-found rights of suffrage had to have an effect.

The devolution of the Arab Spring as the early excitement gave way to the increasing violence in Iraq should have been anticipated. Even as the commentariat pronounced a new world order, real world factors were bound to counter the idealism of the moment—whether the military in Egypt or the tribalism in Libya, or the Algerian history of one man-one vote-one time that looms in the background as the Muslim Brotherhood and other Islamist parties loom to seize power in a matter of months through the ballot that they failed to achieve after decades of armed struggle.

This is a dissatisfying outcome. In an era of instant news and communication, the notion that it may take generations for new political and social dynamics to evolve is hard to accept. Through the Iraq war, we have created turmoil in the region. We have let the jinni out of the bottle and when things begin to look worse for it—when new regimes become hostile, when women’s rights are suppressed, when all those leaders across the Muslim crescent who graduated from American universities take power and rail against us to play to their local electorate—there will be little we can do.

But we already know that living in a world of increased freedom can pose difficult challenges. We have been down this road before.

If our experiment in spreading democratic freedom across the Muslim world seems like it may have rough moments, we need only look back at our now-decades old experiment in spreading economic freedom, known as free trade.

Just as the Neoconservative vision held that building democratic institutions across the Muslim world was critical to addressing the long-term threats that emanated from that region, Richard Nixon’s openings to China and the Soviet Union began a process of bridging the west and the Communist world through economic engagement as a strategy to mute the risks of military—and ultimately nuclear—conflict.

While we may have to wait fifty or a hundred years to see how the Neocon strategy of democratization of the Muslim world pans out, we are beginning to see the impact of our free trade strategy.

By and large, free trade has worked. At least with respect to the muting of military and nuclear conflict. Russians are now deeply engaged in their own economic and political development, even as they struggle to migrate toward a system based on laws in lieu of tsars and commissars. China, meanwhile, has embraced free trade with a vengeance—or a free trade world to be more specific. A quarter century ago, according to U.S. Census data, our trade with China was negligible. Since that time, through an unrelenting mercantilist strategy China has seized the advantages available to a provider of low-cost labor to become our largest trading partner—and each year our trade deficit and job losses have grown.

The price of our free trade policy on the American worker and middle class was not unanticipated. Most famously, 1992 Presidential candidate Ross Perot described the “giant sucking sound” of jobs that would be drained from this country with the advent of free trade agreements supported by Democrats and Republicans alike. And the economics of his statement were unarguable. Lower labor costs, lower regulation and reduced enforcement of environmental laws had been the basis of the rise of the Sunbelt and the decline of the industrial Midwest domestically, and Perot was suggesting nothing other than the same dynamics would lead to the internationalization of the deindustrialization of America.

But few warned the American people. Across the punditocracy of the time Ross Perot was roundly derided as a crank and a scold. But Perot's followers, the political antecedents of the Tea Party, knew a con job when they heard one.

Many may not care for Paul Wolfowitz and his friends that imposed a bloody and costly war upon the Iraqi and American people. But in his ideological fervor Wolfowitz is part of a uniquely American tradition. Few empires have offered their lives and treasure that other nations might be lifted up. And in that sense, the Neoconservative aspirations were an outgrowth of the highest rhetoric of John F. Kennedy.

With the advent of free trade, America willingly and deliberately sacrificed the livelihoods of its working class as the price of raising people out of poverty from Xinjiang to Sochi. With the Iraq war young American men and women gave their lives that future generations from Mosul to Tunis might see their lives transformed. But like free trade, there will likely be more pain yet to come, and the next chapters of the story will play out over decades. A remarkably unsatisfying outcome.

Saturday, October 08, 2011

The missing voice on Wall Street.

Whatever one’s view of Occupy Wall Street—and how quickly those on the right and those on the left have gone to their respective corners and hammered out their talking points—it is a positive step that there might be some thought given to where we are and where we are going. But so far, one group has been fairly quiet, if the point is to address the undue political clout and financial power—to say nothing of economic risk—now manifest in our leading banks. It is the voice of the American banker.

Not Jamie Dimon, the CEO of JP Morgan, who continues his reign as the doyen of US banking—nor Goldman Sachs CEO Lloyd Blankfein, who occupies a very different role in the public imagination—but rather the leaders of 7,500 other banks across the country. These are the banks that continue to play the critical role of commercial banking in our economy—they take deposits and make loans.

As a result of two decades of consolidation, the commercial banking industry in the U.S. has become increasing concentrated. Today, the four largest banks, JP Morgan, Citibank, Bank of America and Wells Fargo, comprise just over 40% of the total assets of the U.S. commercial banking system.

Contemporaneous with this consolidation was the integration of investment banking and commercial banking, with the final removal of Depression-era restrictions two decades ago. Legislated changes in 1999 and 2000 paved the way for the new focus on trading within the commercial banking world, and the explosive growth in derivatives.

But the purpose and rationale for a publicly-supported commercial banking system remains its depository and lending functions. Banks take deposits, which are federally guaranteed, and they use a combination of these deposits, equity and debt capital, and loans from the Federal Reserve Bank to make loans—to judiciously allocate capital across the productive sectors of the economy.

A quick scan of the list of highest loan/deposit ratios among bank holding companies published by American Banker illustrates the richness of the banking sector, with institutions ranging from Bank of America to Big Sandy Holding Company, the owner of Mile High Banks in Colorado that boasts 160 shareholders. The ratio of loans to deposits may not be the most appropriate metric for assessing bank performance in their public mission, but to a lay person it seems to be a reasonable start. Wells Fargo and Bank of America, both commercial banks with deep roots on Main Street, are among the top 200 banks in that ranking, while neither JP Morgan nor Citibank, both banks culturally rooted in Wall Street, appear on the American Banker list.

JP Morgan and Citibank are at the top of another list—this from the Bank Trading and Derivatives report published by the Office of the Comptroller of the Currency, the lead federal regulator of the commercial banking system. JP Morgan and Citibank are ranked one and two here, with a combined $134.2 trillion of total outstanding derivatives contracts, or 54% of the total $249.3 trillion of derivatives in the commercial banking system. Add the third and fourth ranked banks, Bank of America and Goldman Sachs, and those top four hold $191.1 trillion, or 77% of the total derivatives exposure in the banking system. By comparison, those four banks hold 46% of the total risk-based equity of all banks that participate in the derivatives market.

Without doubt, certain derivative products play a valuable role in commerce, trade and commercial risk management. Commercial, industrial and agricultural clients—the traditional clientele of the commercial banking sector—reasonably need to hedge interest rate exposure, foreign currency risk and commodity prices. But the $134.2 trillion of contracts for JP Morgan and Citi alone far exceeds the levels of economic activity that one might imagine being hedged—the $89.6 trillion of interest rate hedges is six and one-half times our national GDP, the $10.4 trillion of foreign exchange hedges are five times the dollar value of the imported goods and services that domestic firms might conceivably want to hedge in a given year, and JP Morgan’s $6.1 trillion book of credit derivatives approximates the total value of corporate debt outstanding in the U.S. economy.

Does this matter? Beyond the shock value, are there valid reasons to reassess the appropriateness of this volume of derivatives business and the potential financial risks that it entails? Does the fact that one-quarter of commercial banks do no derivatives business at all, and only one percent of US banks have enough derivatives exposure to warrant public concern, suggest that the extent of the derivatives exposure of the top banks is not necessary for assuring effective and efficient client service? This is not a question of government meddling in private affairs. Quite the contrary, the commercial banking system has been constructed based on a system of deposit insurance and access to loan capital from the Federal Reserve. Accordingly, these banks are engaged in businesses that are directly supported by public resources and guarantees, and therefore can expect public scrutiny.

The argument JP Morgan would make is that their “derivatives book” is fully balanced, with every positive exposure balanced by a negative exposure. That is to say that for all their long positions in a given currency, or interest rate movement or General Motors bond, they have an offsetting negative position. They are not “net long” or “net short.”

Similarly, their derivatives book is balanced with respect to counterparty credit exposure. For every position where they might be taking, for example, Deutsche Bank risk, they have a balanced and opposite position that theoretically keeps them neutral and protected against counterparty credit events.

Thus, in the case of JP Morgan, as reported to the OCC, its total $78.1 trillion derivatives portfolio actually leaves it with total net credit exposure of $361.0 billion, or just 2.71 times their risk-based capital. So, the theory goes, despite the eye-popping numbers, JP Morgan, and by extension other banks active in the derivatives business, are managing their affairs. And, they would submit, the risks are manageable.

But the theory seems to miss two salient points.

The first point reflects the corruption of the culture of commercial lending as banks embrace the trading culture that is central to the derivatives world. The mission and purpose of the commercial banking system is the efficient allocation of capital across society. Commercial banking has been seen as a sleepy world of bankers with green eyeshades, pouring over financial statements, even as Jimmy Stewart, playing George Bailey in Frank Capra’s 1946 movie “It’s a Wonderful Life,” portrayed the iconic Main Street banker, who made America work.

And that remains the mission of America’s commercial banks. They invest in Main Street businesses, small businesses that grow from the dreams of their founders, businesses too small to issue stock or access the bond market, and they partner with them from one decade to the next.

Commercial banking is a slow business that takes time. This is a sharp contrast with the world of derivatives trading. Derivatives trading is a form of securities trading with magnified, and in certain cases unlimited, leverage. As noted above, derivatives contracts have two primary risk attributes, event risk—did interest rates move against your bet, or did GM go belly up—and counterparty risk—this was the AIG problem, where AIG could not perform on its end of the derivative contracts and there was a scramble among counterparties to get what they could.

As in the AIG episode, the collateralization provisions of the standard derivatives contracts now constitute the largest area of risk exposure. With the downgrades of Bank of America and Wells Fargo this month, and the turmoil in the European banking system, it is easy to imagine an AIG-type event on the horizon. Many have forgotten that AIG did not collapse because of housing bond defaults. It collapsed because it was downgraded from double-A to single-A, and that downgrade triggered a collateralization event that required AIG to post $180 billion of collateral.

Unlike a hypothetical loan to a local restaurant that is collateralized by their real estate and equipment, AIG did not pledge specific collateral to its counterparties. Like every financial institution, AIG was highly leveraged and its outstanding obligations were many times its available capital resources. Accordingly, as—Goldman Sachs demonstrated when it pulled $7 billion out of AIG in advance of other creditors—in a derivatives credit event, time is not your friend and counterparties have to move quickly to protect your interests.

This stands in stark contrast to the commercial lending world. If that restaurant were to have a cashflow problem, the bankers from Mechanics Bank would not come crashing in—You, grab the pans, I got the Fryolator—to get a jump on Mission National Bank or Union Bank. Rather, the rules governing commercial lending, foreclosure and lender liability result in the need for a senior lender to exercise prudence and carefully consider the impact of its actions on the borrower—as well as dealing with competing interests of other creditors, equity holders and management—even as it seeks to protect its financial interests. This results in a slower process that is more deliberative and enables the workout of complex situations. In contrast, in a derivatives event everything has to be done over a weekend, to avoid spooking the markets. To put it simply, in the derivatives world, you grab the Fryolator first, and ask questions later.

The second point builds on the first. If commercial banking is an operational business that takes time and attention, investment banking and trading are transactional worlds of urgency and short attention spans. Profits and bonuses are the immediate imperative, and relationships and character—the core of commercial banking—are relatively unimportant. In the past two decades, the culture of investment banking—the culture of Wall Street—imposed itself on the world of commercial banking. Dating back to Salomon Brothers merger with Philipp Brothers and culminating in Sandy Weill’s assault on Citicorp, Wall Street’s pursuit of capital created the world today, where a handful of leading commercial banks are imbued with the culture of Wall Street and increasingly largely diverted from the traditional, slow function of commercial lending.

Which leads to the question that should be addressed: Why?

Why should American banking be captive of the political clout and financial interests of four or six or eight firms? It simply is not in the interest of the overwhelming majority of commercial banks to let federal policy be driven by the political power of or risks related to that handful of firms. Two of those firms, Goldman and Morgan Stanley, only became commercial banks in the wake of the financial collapse in 2008 in order to gain access to the resources of the Federal Reserve Bank, and have no business remaining bank holding companies now that the crisis has ebbed. Whatever one believes about the fairness of public dollars and protection being used to support those two large investment banks, that time is past and the linkages with the public purse should be firmly severed.

This is a question that is not being asked, but that must be asked. As our political parties fight for access to Wall Street money, the ability to make sound policy that serves the larger interest of assuring a sound and effective commercial banking system has been undermined. Nor is Occupy Wall Street raising the questions that must be asked in a way that will reach the wide range of legislators the need to take notice.

What is missing from the new focus on Wall Street is the voices of the American banking community. Through consolidation and crisis we have gone down a path that has undermined the effectiveness and stability of our commercial banking system. Derivatives trading—now central to the profitability of those largest banks—entails uncharted and unknowable risks to the financial system, and it is part of a cultural shift that has impaired the effectiveness of those banks in serving their primary function of commercial lending. The Dodd-Frank and Sarbanes-Oxley laws were created at moments of crisis in response to the egregious practices of a small number of market participants, but now constitute enormously expensive regulatory regimes that constrain and impair the effectiveness of thousands of banks that simply have not heretofore been part of the problem.

Occupy Wall Street might make good media, but if we are to address the serious challenges that confront us about the structure and direction of our commercial banking system, the voices that must be heard above the din are those of Main Street bankers across the country whose future success is critical to our long-term economic recovery.

Wednesday, October 05, 2011

So little, too late.

Three years ago, it all fell apart. A decade of borrowing and greed finally culminated in the collapse of Wall Street, and it has taken three years for any visible protests to bubble to the surface. Occupy Wall Street, as they call themselves, is just now making it onto the news.

How is it that after Americans have watched their retirement savings disappear, after a 31% decline in housing values and an estimated $7 trillion of lost assets on the balance sheets of American homeowners, only a couple of hundred people manage to show up and protest what Wall Street power and arrogance has done to America, and how little has been done to exact retribution on behalf of a bewildered nation.

One casualty of our political wars has been the absolute loss of accountability for the excesses and the collapse. Reasonable regulation of the financial sector has long since given way to the imperative of political fundraising. During the Clinton years, Democrats gleefully won over Wall Street money—traditionally a Republican entitlement—as the Rubin-Summers cabal trampled thoughtful opposition and engineered the 1999 and 2000 laws that loosened regulation of financial services and gave the green light to unchecked derivatives trading. Today, Republicans have won back Wall Street’s affections through their opposition to the Dodd-Frank regulation, while disingenuously trumpeting to the world that they oppose too-big-to-fail.

The simple fact is that through unbridled financial largesse—the financial services sector was unmatched in its level of political contributions over the past decade—concentration of power and market share in the financial industry has continued to grow, even as little has been done to alleviate the risk of future financial crises.

Few across the political landscape would actually let our large banks fail. That is not a political argument or observation, it is simply a fact of the world that we live in. Since 2008, as our major financial institutions became insolvent, our Government has bent over backward to assure that the public’s money was poured onto the balance sheets of the private banks. While TARP has become the piƱata for the right, that program’s $700 billion authorization paled beside the $16 trillion in loans made by the Federal Reserve Bank—to American and foreign banks alike—to sustain the liquidity of the global financial system.

In another era—perhaps on another planet—insolvent banks would be allowed to fail. Their assets would be sold off, depositors in insured accounts would be protected, and bank bondholders and equity holders would lose out. It was called capitalism. The paramount responsibility of investors was to assess risk and make investments. Those who were astute evaluators of risk would do well. Those who were not, would not. It was the way it was supposed to be. And the benefit to society was an efficient allocation of capital and economic growth.

Not so today. Barely 20 years after the fall of the Berlin Wall—the supposed triumph of the capitalist west—capitalism has been reduced to a shell of its former self. In today’s world, investors are protected from the risks they assume. In today’s world, the largest financial institutions are insulated from the consequences of their own worst behavior, and even in the wake of the global financial collapse engineered by their own excesses, the political parties continue to vie for their dollars—even as they continue to utter pious obeisance to such notions as accountability and responsibility. In today’s world, millions of American households lost trillions of dollars of equity in their homes as values collapsed, while at the same time the Federal Government has engineered the restoration of trillions of dollars of bank capital in the name of restoring confidence in the financial system.

Last week, London-based trader Alessio Rastani stunned the world by pronouncing that he prays for another recession. “As a human being,” Rastani pronounced, “I don’t want a recession, but as a trader it creates good conditions to make money.” Anyone who has been paying attention might have noticed that traders tend to find ways to benefit from the world's ills, yet for some reason, Mr. Rastini’s comments were deemed to be news.

Last month, Vermont Senator Bernie Sanders was excoriated for publishing oil trading data from the Commodity Futures Trading Commission that detailed the trades of leading Wall Street firms that participated in the speculative trading frenzy that pushed oil prices through the roof in advance of the 2008 election. Sanders was derided by industry figures for actions that would “have a chilling effect on derivatives trading in the U.S.” and the ensuing news stories focused on whether Sanders had broken any laws, while largely ignoring that the data Sanders released confirmed what had previously only been conjecture: It was Wall Street traders rather than Chinese demand and other market forces that led to the spike in energy prices in 2007-08, which drained American checkbooks and dominated the early debate in the run-up to the 2008 presidential primaries.

In our digital world, Occupy Wall Street’s protests have been rendered quaint. The earnest youth chanting slogans are an artifact of decades past as they hunker down in lower Manhattan. They seem to miss the point that Wall Street is no longer a physical place, but has ascended into metaphor. Wall Street is no longer the buildings that line Wall and Broad, or even the gleaming new Goldman Sachs edifice across the way. Rather, it is the mind set of banks and hedge funds, the traders and derivatives architects, that seek competitive advantage and lucre as they move from one target to the next where a windfall might be had, with little or no regard for the havoc and destruction that increasingly lie in their wake.

For months we have followed the morality play of Greece, a nation and a people that must be brought to their knees for their willful profligacy in order to protect the balance sheets of the European banks that have been the major buyers of Greek debt. Now, the story line has evolved, it is about Contagion, a public health metaphor that aptly labels the seriousness of the risk, while at the same time seemingly suggesting an unknown cause. This week, Moody’s Investors Service downgraded Italy by three notches, from the pristine Aa2 to the pedestrian A. Unlike the Greece saga, this downgrade did not suggest poor fiscal management on Italy’s part—indeed, Italy is a country that heretofore has balanced its budgets—rather, Moody’s action reflected its fear that “financial market shocks” could undermine Italy’s fiscal position.

So we have come full circle. Once, as in the case of Greece, it was poor fiscal management that led to deteriorating financial position and ultimately drew traders like sharks smelling blood in the water. But now, as Moody's highlighted in its downgrade of Italy, it is the financial assault itself that Moody's suggests would undermine the ability of a major global power to manage its fiscal affairs.

Financial market shocks. Contagion. These are not natural phenomenon, but the cumulative actions of an industry run amok, an industry now preying upon the world that that has nurtured its growth.

Early on in the financial crisis, we debated the question of moral hazard and the consequence that if we did not let banks fail, bad behavior would be rewarded. But we are way past that stage. Now, the greater risk is understood to be the interconnectedness of each bank to the others. This is the lesson we took from Lehman Brothers and AIG: Where once failure was important to the effective functioning of capitalism, now it is deemed to be unacceptable. The global financial system is now an organic whole, daisy chains of hundreds of trillions of dollars of linked derivatives that could come tumbling down and crater the world financial system if even one major bank were to be held accountable for its own financial and risk management decisions.

It has been three years, and what have we learned? Perilously little.

Nothing that Mr. Rastani said should have surprised anyone. As Moody's made clear this week, the continuing, unfettered conduct of Wall Street now directly threatens the stability of major industrial countries. It has undermined the core principles of our economic system and corrupted our democracy. The question facing Occupy Wall Street is whether anyone in America is paying attention anymore.

Tuesday, August 30, 2011

A man of joy.

Peter Terpeluk was my friend. And he died last week.

Like gay lovers in an earlier era, Peter and I kept our relationship quiet. He was a big Republican muckety-muck, fundraiser and lobbyist extraordinaire, former Republican National Committee finance chairman. I was, he liked to tell me, his favorite Liberal.

Peter was among the most unfailingly joyful people I have ever known. An odd thing to say about a D.C. insider—it not being a place where joy would jump out of a word cloud. To watch Peter pacing in his office, however, bouncing from one call to the next to the next, was to watch a person completely and profoundly in his element. How he kept the pieces sorted out was a mystery to me. But he would laugh as he reflected on the world of his choosing. The world of his making.

Peter was appointed Ambassador to Luxembourg by W. It was the culmination of his life. From borough manager in Pennsylvania, he worked his way through the Republican ranks, until the final honorific was his for life.

Ambassador Terpeluk. It was, he assured me, a great gig. “You gotta do it,” he insisted, seemingly oblivious to the realities of the world that precluded the rest of us from applying to be, for example, Ambassador to Iceland.

Peter was a giver. He was a bundler. He knew who to call and when to call them. He introduced people. He had a sense about people. As Wayne Berman—a peer and collaborator at the peak of the Republican money world—assured me years ago, Peter was the best. Along with Bill Timmons, the best lobbyist in DC.

Peter believed in the Republican Party. Though not on any particular issue I can think of. He was a party man, not an issue man. Like most Democrats. This nation is split in half by party people, more so than issues. Don’t ask me why, I don’t get it. But Peter was unfailingly friendly. While I heard him disparage Democrats to no end—Clinton was white trash. Obama was a joke—on a personal level, I never heard him utter a mean word. It was never personal, it was strictly business. Or rather, it was strictly politics.

But there was something that mystified me about Peter jumping on early with Rick Perry. George H.W. Bush and W. were both unfailingly amiable people. And Ronald Reagan as well. They each in their own way radiated an optimism and embrace of the nation beyond its political borders. These were the people who brought Peter to politics and to the seat of power. And like Peter, their politics was played hard, but not with a mean or harsh tone.

Not so with Rick Perry. If he has a weak spot, it is not intelligence—the great Democrat blind spot—but his apparent meanness. Not meanness of policy, but of attitude. Of affect.

Among Peter’s last words to me of Perry—It could be a movement. Won't know for a long while—indicated that he saw Perry to be of Reaganesque potential, but that he was not sold yet. I suspect that it was the lack of joy, the meanness of spirit in Perry’s public demeanor that had give him pause. Perry can connect with the anger of the Tea Party and may yet, as Peter predicted, run the table in the primary season, but to win the Presidency, Perry will have to show something more, something better. America does not vote mean. Or if it does, that is when it will be time to fear for our nation.

Optimism is the touchstone of leadership. It brings out a sense of hope, and from hope comes joy. Even in the face of adversity.

And joy—deep down beneath that Republican exterior, with the tie pins and those starched, French-cuff shirts—was the defining wellspring of Peter Terpeluk’s character. I will miss him.

Wednesday, August 17, 2011

And so it starts.

I watched Texas Governor Rick Perry over the weekend. Gotta say, great start. Perry should rip Mitt Romney apart. He delivers a great vision speech. And the primaries lay out well for him. Iowa and South Carolina should be easy, and New Hampshire will be discounted, because even if Romney wins there, he will be viewed as a favorite son.

A Republican friend, close to Perry, demurs. "We will win New Hampshire. I have never been with a political person like this in my life. He is the best guy working a room ever. Better than Reagan. That speech went right into the living rooms like RR used to do."

My son reads this, and has the perfect new age response: "I should put some Intrade money on him while it's cheap." But the Perry contract is not cheap. He just announced and he is already at 38, eight points over Romney.

I have had two reactions. I listened to Perry's stump speech. He is delivers a great speech. He has a very strong voice. Clear vision on opportunity and the future. As my friend said, it goes right through the medium—radio, TV—to the person. Visceral. He has a power and passion that elude Romney, who is the epitome of Just Words. Seemed apparent to me that Perry can run away with the nomination. 

Then I took a look at Perry's other words. Not his record—as that really matters little, ironically, despite how it will be spun and debated—but his temperament. And boy is he out there. There is a reason Karl Rove and the Bush family have fought this guy. He is the opposite of their notion of a conservative Republican. W worked hard to convey a sense of being a unifying figure, the Compassionate Conservative and all that. In that regard, Dick Cheney really was his undoing, the Sith Lord who brought him under his wing, taught him the arts of war—domestic and international. In contrast, Perry just either says what he wants with no regard for outcomes, or says what he wants with full regard for outcomes. I suspect it's the latter.

The bit about Texas and secession is notable. When Texas joined the union, it had the right to choose to divide up into six states—to have more senators. It did not have the right to exit. Yet secessionism remains such a visceral touchstone of American Nativism, something that Perry has played well. Does it matter that Texas has no such right? Does it matter that we fought a long civil war over the this issue? Of course not. This is politics, not political science.

Playing the secession card is directly linked to Perry's comments on the Fed.  "If this guy [Bernanke] prints more money between now and the election, I don't know what y'all would do to him in Iowa, but we—we would treat him pretty ugly down in Texas." His unwillingness to acknowledge those comments as grossly inappropriate—and instead to simply retort "Look, I'm just passionate about the issue"—tells you exactly why he is cut from a different bolt of cloth than the Bush clan. He also knows that they—Karl Rove and others—have no choice but to come around. Perry knows well that, in the famous words of Toby Ziegler, "They'll like us when we win."

I had my own personal, visceral reaction to Perry's attack on Ben Bernanke, rooted in my own family history in Alabama, where by grandmother taught me that the rules by day were different than the rules by night. Filtered through my own rendering of family and national history "I don't know what y'all would do to him in Iowa, but we—we would treat him pretty ugly down in Texas," translated into "I don't know about y'all —but we know how to handle Jew bankers down in Texas."

I know, I need to have my filters cleaned. But even if this reaction was unfair and unreasonable, it reflected my larger reading of Perry. As a politician who can reach out and grab his audience by the jugular, he is head and shoulders above the rest of the pack.

So, if my first reaction was that he can run away with the nomination, my second reaction is that he may well run away with it. At 38, the Perry contract on Intrade may still be cheap.

Never before could I imagine that monetary policy could generate such heat. I mean, does any politician really understand the workings of monetary policy and the mechanics of money creation in a digital age? I don't think many people do. But Perry's words, like his words on secession, had nothing to do with the facts of the matter, but rather the roots of popular distrust of federal institutions, to say nothing of Wall Street and bankers.

And never before could I imagine that a leading presidential contender could verbally threaten a high public official—much less a thoroughly decent man of his own political party. Virginia Governor Bob McDonnell—who governs a state where one must understand history and language and code, provided an understated assessment of Perry's words—"I thought the remarks probably were something that could have been said differently."

But McDonnell was speaking to a different time, before Tea Party anger swept away the Republican Establishment as it was, and before all notions of temperance and self-restraint were swept out of the public square. Today, Rick Perry is in perfect alignment with his audience. His words are pitch perfect. He will not be admonished by Bob McDonnell or Karl Rove for intemperance. Intemperance is his brand.

It is particularly odd to see Karl Rove and the Bush loyalists so far outside the mainstream of their own party, unable to channel the currents of conservative opinion in a direction of their choosing. But this is indeed a different time, and so far they have found themselves powerless to stop it.

Saturday, August 13, 2011

Questions of character.

One week after the downgrade of the United States bond rating, the markets have returned a verdict of sorts. In a week of staggering volatility, stocks declined by 2% while money flooded into the downgraded U.S. Treasury market, reducing yields on the 10-year by 0.30%. While the S&P action certainly amped up the already-white hot political climate, the actual report offered little new insight. By the end of the week it was evident that the correction in the equity markets that had been underway since July was continuing, as was the global flight to quality that continues to favor U.S. Treasury bonds.

The dramatic rally in bonds was more notable than the stock market decline. After all, S&P's pronouncement was supposed to cast a pall over U.S. Treasuries and send investors scurrying to the sidelines. Of course, if global investors have learned nothing else, it is that there are no sidelines. The near-death experience of the world financial system in 2008 showed that in a pinch the United States Federal Reserve remains the back-stop and liquidity source of first and last resort, and since 2008 the universe of "risk-free" investment alternatives has dwindled. The very concept of a united Europe is under assault, much less the notion that the euro would emerge as the reserve currency alternative to the dollar. Even keeping holding cash in a bank has become problematic for institutional investors, as banks are beginning to charge fees for accepting large deposits rather than paying interest.

At the end of the day, the markets shrugged off the S&P downgrade because it was a non-event. Is the United States facing significant financial challenges? Certainly. Was this news? Certainly not. Does U.S. sovereign debt now rated AA+ constitute a greater default risk that any number of triple-A rated corporate bonds? That would seem to be a silly question, yet S&P seemed to be saying yes, while the markets this week said no. In the world today—a world where risks abound—the U.S. Treasury remains the benchmark for very simple reasons. In a crunch, there is nowhere else to go.

But in S&P's view, there was a material change. In the old rating agency adage, bond ratings reflect both an issuer's ability to pay and its willingness to pay. What had changed was the casual willingness of some debt ceiling combatants to embrace default as an acceptable outcome, even as others wielded the threat of default for leverage. This Friday, a senior director for S&P confirmed that the factor that led to the downgrade of the U.S. credit rating was not a material change in the financial circumstances as much as evident changes in the willingness to pay, or, more frankly, the willingness to not pay. “People in the political arena were even talking about a potential default... That a country even has such voices, albeit a minority, is something notable. This kind of rhetoric is not common amongst AAA sovereigns.”

It did not used to be this way. In fact, until recently such rhetoric was inconceivable—in old Yankee terms, credit was a point of moral character. This dramatic shift in acceptable political speech emerged earlier this year when Newt Gingrich advocated the use of bankruptcy by states as a strategic option. Gingrich's argument—which sent the municipal bond market reeling—established the principle that it is now acceptable for national political figures to disavow our moral and legal obligation to pay our debts, if it serves the interest of the pursuit of partisan political advantage.

A lingering question about our political system has been whether we are able to face up to long-term fiscal challenges and make needed changes in advance of market pressures forcing the issue. In some respects, we would seem to be making progress. After all, for the first time in the twenty years since the creation of the Concord Coalition, the issues of the long-term fiscal health of the United States and the affordability of entitlement programs are now active subjects of debate in the public square. The problem evidenced by the debt ceiling debate, however, is that for all of the debate and sense of urgency, there appears to be almost no willingness in Congress to taking the next step: Owning the problem, and doing something about it.

The debt ceiling bill that finally emerged—with the oxymoronic title The Budget Control Act of 2011—was a perfect Congressional compromise: It cut no spending and raised no revenues. For the only fiscal year over which this Congress has authority, Fiscal Year 2012, it reduced the deficit by a grand total of $21 billion. After talk of $4 trillion here and $2 trillion there, the final legislation—with apologies to Everett Dirksen—did not even add up to real money. The rest was in the out-years. Or kicked over to a debt commission which may or may not achieve its purpose—time will tell.

Congress has a well-established tradition of being long on rhetoric and short on action when it comes to dealing with budget issues. Dating back to the Gramm-Rudman-Hollings Act a quarter century ago, Congress prefers to set out-year targets but never actually specify what and how to cut. It is notable that Gramm-Rudman had the same 50-50 automatic cuts in defense and non-defense programs in the event targeted cuts were not achieved. It is also notable that none of those spending cuts ever materialized.

Now, once again, the arguments are high on rhetoric and devoid of substance. As a follow-up to the debt ceiling debate, John Boehner and Eric Cantor are pushing for a balanced budget amendment. Yet—like so many demagogues before them—neither Boehner nor Cantor have proposed how they would balance the budget—which, it is important to point out, the Paul Ryan Plan did not do. And this week, at the Republican presidential debate, Michele Bachman reasserted her stance in opposition to raising the debt ceiling, but none of the moderators saw fit to ask how Bachman would have proposed to allocate the limited federal resources if the debt ceiling bill had not passed.

At the Republican debate, only Ron Paul made a substantive point on this issue, when he advocated ending our war policy and spending. But every candidate, particularly if they choose to ride the balanced budget amendment wave, should be obligated to describe the specific choices they would make to actually balance the budget. It is not hard to do, as there is abundant data about choices and trade-offs readily available. The Congressional Budget Office provides detailed data for evaluating alternative policy choices, and weighing the long-term budget impacts. And earlier this year, this easy online tool was created that allows anyone to build their own budget solution.

We now have a window of several months before the commission created by the debt ceiling bill is obligated to put its recommendations on the table—and Congress is obligated to vote up or down—or automatic cuts are supposed to go into effect. The question is whether we ever get there, as both political parties are itching to make 2012 the showdown election, and both believe that they will be in a better negotiating position after that election. Republicans believe that Obama is beatable, and they can win the Senate with a continuation of the 2010 election trend. Democrats believe that the younger, more diverse electorate of 2008 will turn the tide away from the 2010 turnout that was uniformly older, whiter and richer. Therefore, both parties will be willing to kick the can a few more years down the road, and avoid once again making those choices that Congress has proven, time and time again, that it is loath to make.

The question remains whether this is our political system working as it should—as the more optimistic observers have concluded—or whether S&P's observation is correct, that our political rhetoric is evidence of a deeper weakness—that political imperatives now trump all other considerations—and that Congress is no longer be capable of making serious budgetary choices that are necessary for the long-term well-being of the nation.

Sunday, July 31, 2011

Big time bluff.

Granted, the tea party came to Washington and changed the nature of the debate. Last December, two debt commissions reported out long-term solutions to the issue of chronic budgetary reliance on debt. Both commission reports recommended a balance of actions affecting expenditure and revenues. Both commissions projected long-term moderation in debt levels. President Obama could have embraced his debt commission, and as Senator Judd Gregg noted on one senior RNC official, had Obama endorsed his commission, Senate Republicans would have been hard-pressed not to fall in line.

But last December was eons ago in the life of Washington, and while that path not taken might have seemed immoderate at the time for the President and Democrats, it is a stark reminder of how far the tea party has moved the debate in a few short months.

But for the tea party—the House radicals and their fellow travelers—the end of Debt Ceiling Crisis of 2011 may loom as the great opportunity lost. Their goals were not to move the debate or incrementally shift the culture, but rather to make radical change, to stop the spending and impose a balanced budget on the nation. Rhetorically at least, they have been unmoved by arguments that rapidly curtailing federal spending would send an already weak economy into a tailspin. Instead, their stance has ranged from the moralistic—that the accumulation of debt must stop—to the contrarian—that based on their own economic calculus a cut-back in federal spending would have curative powers on the private sector and stimulate economic growth.

This week, pointing to the risks of credit downgrades and sovereign default, John Boehner finally brought his caucus into line behind a debt ceiling bill, and it now appears that before the August 2nd deadline, the political parties will agree on some deal that purports to reduce the trajectory of national spending by some trillions of dollars over ten years. But as the numbers are crunched, the reality will look increasingly marginal. And the House radicals find themselves complicit in a process that was closer to business as usual than to radical change.

As the denouement approaches, and a resolution to the debt crisis appears to be at hand, one has to ask how many of the participants continue to believe that a default on U.S. Treasury obligations was ever at risk. Yet that was the hammer held over the heads of the House radicals.

The meaning of a default U.S. Treasury bonds is narrow and specific: It means that principal on maturing Treasury bonds or interest due on any outstanding bonds is not paid when due. A default on our Treasury bonds has been the hammer hanging over negotiations, yet such a default would not be caused by a failure to raise the debt ceiling.

While there appears to have been little public discussion of the process by which default would be averted, it is actually not complicated. First, all maturing Treasury bonds would be rolled over (refinanced) into new bonds, as is currently the practice with all maturing Treasury securities. Refinancing the principal amount of maturing obligations does not impact the par amount of bonds outstanding subject to the debt ceiling, it simply replaces old maturing bonds with new bonds on a dollar for dollar basis. Second, unlike current practice, interest due on such obligations would have to be paid from resources other than the issuance of new bonds. Whether through Federal Reserve credits—effectively the creation of new money—or the utilization of tax receipts flowing into the Treasury, the approximately $15 billion per month of interest payable on outstanding Treasury obligations—a relative pittance—would be prioritized over other uses of funds, as both common sense and the 14th Amendment would dictate.

Two months ago, Tim Geithner made clear that the default argument was a ruse.

I think there are some people who are pretending not to understand it, who think there's leverage for them in threatening a default. I don't understand it as a negotiating position

Ironically, notwithstanding Geithner's assertion that there would not be a circumstance leading to a default, and lack of any risk premium priced into U.S. securities in the Treasury bond or credit default swap markets, for the past two months the debate over the debt ceiling has continued under the specific pretense—the leverage suggested by the fear of default—that Geithner dismisses.

Default has not been at issue in the current debacle in Washington, DC. Rather, it is the fear of default that has been used so effectively as the hammer by the so-called "adults" in the political establishment. Why the language of default risk persists is itself an interesting question, as a bi-partisan spectrum of Congressional leaders and pundits continue to push the default crisis paradigm. More curious still is why it continues to hold sway.

This week, that leverage was brought to bear in full force on the radical members of the House Republican caucus, as those House members finally cow-towed to their elders. Just at the moment of their greatest power, the recalcitrant House members were brought to heel by the John McCains and Mitch McConnells who knew well that a rapid deceleration of federal spending would hurt Republican constituencies as well as Democrat, and who had much to fear of a failure to raise the spending cap. If the House radicals had held firm for one more week—and no default transpired—the Washington debate would have been turned on its head. Instead of raising the debt ceiling to resolve a purported crisis, in such a post-August 2nd world with no threats of default and bond market calamities, raising the debt ceiling would only be done once there was explicit agreement on what actually spending warranted incurring new debt.

In such a post-August 2nd world—where no default had occurred—the debate would return to a debate on spending—which has always been the central issue. But in that new world, the debt ceiling would remain in place, effectively forcing a balancing of revenues and outlays unless the votes could be cobbled together to specifically authorize new debt.

And what an odd world that would be—and we already began to see hints of the arguments that would be made: Soldiers in Afghanistan are worried they may not get their paychecks. The first argument for "patriotic" spending. Then it will be the Medicare recipients. Then Medicaid. And the farmers. Mortgage brokers. Defense contractors. Voting blocks. Major contributors.

What would that world look like, when every tax cut, every tax expenditure, every spending program and every military venture was on the table. Each one with a voting block, each one with a constituency, but each one having to be justified in the full light of day: Are we willing to pay for this? Or are we willing to vote to borrow money for this?

That is the world no one wants to see. And when the House radicals wake up on Wednesday, and see the rare opportunity that passed them by—and that it was their own leadership that sold them out—there should be hell to pay.

Friday, July 15, 2011

Full faith and credit.

Everyone wants in on this act. Particularly the bond rating agencies. Having been caught asleep at the switch in the run-up to crises past, Moody's and Standard & Poor's are loath to let it happen again. Going back to the Drexel Burham/Michael Milken affair, they affirmed the strong ratings on Executive Life just before the junk bond world collapsed. Same with Orange County, California, before losses in its investment pool drove it into bankruptcy. They threatened the bond insurance companies with downgrades if they did not bulk up their balance sheets with housing bonds, and we are all know how that ended up...

Now, Moody's and S&P want to play in the Treasury bond/debt ceiling game of high stakes poker in Washington. This week, both rating agencies piled on, threatening the United States with downgrades on its bonds if the debt ceiling matter is not promptly resolved. These pronouncements tend to have consequences, as the leadership of united Europe has found out. Greece has become yesterday's news, as over the past two weeks Portugal and Italy have seen their bond prices tumble and interest rates skyrocket as the markets responded to rating agency comments on their fiscal fortunes. Outraged European central bankers, struggling to find an effective solution to the crumbling of the Eurozone, attacked the bond rating firms for hidden political motivations and threatened to take action to "break the oligopoly."

And what of the Treasury market? How did U.S. Treasury bond market respond to the threatened downgrades?

Not even a whimper. Actually, a rally of sorts. Yields on the benchmark 10-year Treasury declined by four basis points this week. As buyers bid up the prices, yields fell from 2.95% to 2.91% today, down from just over 3% a week ago. Europe's pain—much to their undying chagrine—continues to be our gain. From the bond market perspective, the debt ceiling debate seems almost to be a sideshow against the backdrop of the disintegration of Europe, even with only two weeks to go until Armageddon.

It's the new reality TV. Everyone is watching, everyone is talking about it, but if the markets are a measure of the real world, this most important and urgent of matters seems to have become part of the entertainment-cable-Internet-popular culture other-world that consumes our lives, but isn't really part of our lives.

Perhaps it is because we tend to believe that an actual default on U.S. Treasury obligations is simply beyond of the realm of possibility. We see all the actors yelling and screaming in Washington, playing their assigned roles, but we know deep inside that they cannot actually let the world unravel around them. Just because they are scared of Grover Norquist?

There is another point of view, which is that this is not about our debt at all, but a tug of war for which the debt ceiling is just a dramatic point of leverage. It is not about debt, because some would argue—though few appear to be listening—that constitutionally there is no crisis. The 14th Amendment would seem to be quite clear—to a lay-person—that the full faith and credit of the United States obligations cannot be questioned—and therefore cannot be undermined even by Congress. The counter-argument that has been offered is that the Constitution gives only to Congress the power to borrow. But the simple fact is that all of the bonds on which people suggest that we might default were borrowed with the full authority of Congress. And once authorized and issued, the obligation to repay cannot be questioned—or so it would seem.

Perhaps the bondholders who are lining up at the Fed window in D.C.—even as they are running from the same in capitals across Europe—know what seems to have eluded the bond rating agencies, which is that the debt will be paid and that the market—as is its wont—has already priced in the risk of default on our bonds, and it is a small price indeed. From a practical standpoint, the principal due on maturing Treasury bonds can be "rolled over" into newly issued Treasuries, with no debt ceiling impact. It is all the other "obligations" that are at risk. All of those obligations—the ones that impact the lives and livelihoods of all but the holders of our bonds—that are only valid if each Congress chooses to make good on the commitments of some prior Congress. And those obligations are indeed at risk, for the simple reason that as a nation we have consistently determined that we are not willing to tax ourselves for the goods and services that we seem to want, and with no action on the debt ceiling we will have neither the tax revenues nor the bond proceeds to pay for all of them.

The issue is not default. The issue is spending. In the view of House Republicans and Tea Party activists, spending should come down dramatically. Sacred cows should be slaughtered. Entitlements should be reconceived. The New Deal and the Great Society have run their course. But for the Senate Republicans the motivations are more complex. The plan put forward by Senator Mitch McConnell skillfully serves a larger set of interests and would allow the status quo ante so dear to Senators to survive. His plan would essentially would take Congress out of the debt ceiling game, and give his colleagues the best of all outcomes: The spending would continue while someone else—the President—would take the blame.

Right now, both the President and Senate leaders believe that the fear of default should provide enough motivation to get something done—along with the cover each side needs to take steps that might otherwise be unthinkable: Cutting entitlements, raising taxes, trimming the military. But so far, the House leadership is not biting. For the Democrats, the McConnell proposal may well emerge as a middle ground of sorts. But for the House Republicans and the Tea Party—those who truly want to reduce the size of government—McConnell's success would constitute a stinging defeat, an historic moment lost, and a movement scorned.

The ultimate question is what the President plans to do on August 2nd if there is no agreement. One must presume that there is a plan in place: The 14th Amendment will be upheld, the bonds will be paid, the full faith and credit of the nation will be reaffirmed—and massive cuts and sequesters will be put into effect.

As great as the fear of default might be, both the President and Mitch McConnell must fear even more what would happen next. If the markets are right, and no default ensues, the motivation to reach a middle ground or face-saving solution will dissipate, and each side will once again be captive to their base. Caught in a lie—that he knew there would be no default—the President would lose the high ground. Vindicated for their obstinance, the House leadership will have even less reason to negotiate.

That may well be the endgame that true believers among the new breed of House Republicans have in mind. And it does not make them crazy, just strategic. If they believe that default will not be allowed to occur—as a matter of Constitutional obligation and proven bi-partisan deference to the bond markets—then reaching August 3rd with no agreement might reasonably be their goal. In three weeks, they can achieve their objective of an America forced to live within her means. And ironically, from that perspective the only thing the President could do to stop them would be to allow a default to occur even when it is within his power and authority to prevent it.

Sunday, June 19, 2011

Jerry Brown's challenge.

On the streets of Greece and in the legislative chambers of Sacramento, people are grappling with the same issues: Are we willing to pay for those things that we want. And what are the consequences if we don’t.

This week, Governor Jerry Brown vetoed the budget sent to him by the Democrat majority of the California legislature. In his incoming State of the State speech five months ago, Brown suggested that it was time to address the State’s long-standing fiscal problems and produce a balanced budget. Brown proposed a Solomonic solution of sorts to close the $25 billion gap in the State’s budget: Half the budget gap would be closed by budget cuts, the other half through revenue actions which would be submitted to the public for a vote. Specifically, he proposed to ask voters to approve the extension of existing taxes that are set to expire.

The Golden State has now endured literally decades of budgetary trials and gimmickry, and seen its credit rating decline along with its fiscal resources. But for all the rhetoric about decline and bankruptcy, California’s problems are political, not economic. Yes, its economy has suffered as high costs have pushed industry inland and off-shore, but it remains a vibrant economy that is home to several of the nation’s strongest economic drivers and export industries: entertainment, technology, aerospace and agriculture.

The chart below illustrates the budget situation in California. Interestingly, the data suggest that California’s history is not a story of government spending run amok. The General Fund budget, which funds core services—including public safety, transportation, support for public and higher education, transfers to local governments and bond debt service—has declined relative to State personal income and GDP growth. As this graph shows, the steady growth of the State economy has not been matched by growth in the budget, and General Fund spending has dropped significantly in recent years. The dotted lines across the top indicate the impact on taxpayers, as General Fund expenditures per $100 of personal income declined 32% over the past three decades, from $7.43 per $100 of personal income in 1980 to approximately $5.05 this coming year.


Jerry Brown is providing a test case to see if our political establishment is—just this once—capable of setting aside party interest in favor of a broader and essential urgency. While the Democrat majority agreed to significant budget cuts, thus far, Republicans in Sacramento have declined to meet him halfway. Brown’s effort to find partners willing to seize the opportunity to chart a course toward real fiscal solvency and responsibility have been stymied by Grover Norquist, the anti-tax Jeremiah of the Republic establishment, who flew to California early on to pronounce that even a vote to put the revenue measures on the ballot would constitute a violation of the Republican anti-tax shibboleth.

Our political challenge, in California and nationally, is that too many people see more opportunity in exacerbating our problems than in solving them. It is too easy to rail against the debt and decry raising the debt ceiling, all the while conveniently ignoring one’s own complicity in the problem.

Over the past 30 years, Americans have become used to not having to pay for the government services we expect and desire—like the Greeks whose profligacy we so easily disdain. And this is a universal affliction, indifferent to political party. As illustrated below, federal personal income taxes paid—the purple line—have not kept pace with the growth of national income and GDP since 1980, while federal outlays have grown steadily. Like Californians, Americans have seen personal income taxes decline modestly as a share of national income. From 2009-2011, personal income taxes have ranged from 9-10% of personal income, slightly below the average level since 1980.

Of course, the difference between California and the nation is that national spending is not constrained by actual tax collections, but only by the political will to borrow and investors’ willingness to lend. Accordingly, as this graph illustrates by the divergence and convergence of the green and purple lines, instead of constraining spending, declines in tax receipts (the purple line) have simply led to increasing levels of public debt (the green line) and conversely, increases in tax receipts have led to moderating debt levels. Over the past twenty-five years, we have not had to weigh priorities, but instead have chosen as a matter of course to borrow rather than pay out of pocket for those things that we want. Year after year, we choose not to raise taxes to fund growing military, healthcare and other program costs, or to reduce spending to offset the impact of tax cuts.


It is in the proclivity to borrow rather face up to the limited nature of financial resources that America is more like Greece than California. And it is the ready availability of capital from foreign investors that makes our national problem differ from both.

Imported capital—that funds the "current account" deficit that comprises our budget and trade deficits—has supported economic activity in much the same way borrowing on credit cards allows households to live beyond their means. And like households that allowed increasing debt to mask the reality of their economic condition, U.S. economic growth has become dependent upon borrowed funds. As illustrated in the graph below, U.S. GDP growth has been 4% or greater for much of the past three decades, however, the share of that growth that has been supported by borrowed resources has grown.


While our economic growth has become more tenuous and entitlement costs have accelerated, Americans have abdicated their personal responsibility for our predicament. We will willingly vote for those who promise to cut our taxes or to expand our entitlements, but have shown no serious interest in addressing the the imbalances that have built up in our name. And lest one be fooled by the rhetoric, the Tea Party caucus of House Republicans have proven themselves no different, as they imposed pay-go rules on spending increases but not on tax cuts.

In California, Jerry Brown has proposed putting the question of the funding and size of state government to the voters. Voting for pain is simply not part of the democratic bargain. Yet that is what Jerry Brown is demanding. Let the voters choose. Treat us like grownups, and insist that we bear the consequences.

On the other side of the pond, as they seek to resolve the Greece situation, European leaders have come to believe that the Greek polity will never willingly take the steps to reduce spending and increase taxes that European bankers are demanding. What remains to be seen is what the consequences of that unwillingness will be, for Greece and for the concept of European union.

And for us. Because in our unwillingness to accept collective responsibility for the economic situation of our own making, we may have more in common with Greece than the grownups of Jerry Brown's imagination.

Friday, June 10, 2011

Housing market blues.

Last week was but one more setback in hopes for a robust economic recovery. For two years now, economists, pundits and politicians have been looking for evidence that we have put the economic collapse behind us. Yet just last week, the sharp decline in the Case-Shiller Home Price Index and poor jobs report pointed to a stalling in any meaningful economic recovery.

The Case-Shiller index history, shown below in a graphic from the New York Times, illustrates the extent of the asset bubble in residential real estate that we experienced over the past decade, and how far prices still have to fall to be within historical ranges.

Even with the sharp contraction in prices that we have realized since the unraveling of the mortgage bond market almost three years ago, housing prices remain high by historical standards, and thus it is curious that this week Standard & Poor's would express puzzlement at the lack of a sustainable recovery. Its report "Global Housing Still Faces a Puzzling Future," begins: "Since the first-time homebuyer tax credit ended last year, the recovery of the U.S. housing market has been something of a tease." Unfortunately, that S&P should be puzzled is itself more of a puzzle than the housing market.

In fact, with the expiration of the first-time homebuyer tax credit and looming end to the quantitative easing efforts by the Federal Reserve to hold down long-term interest rates, the housing market is only now being left to face the brunt of post-crisis market forces without those two forms of federal support. As that support falls away, it is hard to be optimistic about the direction of the housing market, and if a rebound in housing is a prerequisite for a sustained economic recovery, we could have a hard road ahead.

In their write-up, S&P projects that when all is said and done, home prices will fall 35% from their pre-crisis peak, meaning that we have another 15% downside to go. Yet by historical standards, this will not produce "cheap" prices as S&P suggests, but rather return prices to within historical norms. But whatever bottom is ultimately reached in housing prices, a resurgent housing market will also require an environment that provides reasonable expectations for asset price stability, if not appreciation. And this appears unlikely to happen any time soon.

Over the past 30 years, the housing sector benefitted from declining interest rates and liberalizing standards for residential real estate lending. Just 30 years ago, my wife and I purchased our first house in Philadelphia. A 2,400 square foot twin, we purchased it for $37,000. 30-year mortgage rates at the time were 19% the day our offer was accepted. We were required to put down 20% and the result was a monthly payment just under $500.

Real estate is a peculiar market. While people talk mostly about the sale price, what matters most to the buyer is the monthly carrying cost of the mortgage, as well as the down payment. That is to say that affordability is only partially related to the sale price.

This was evident in the growth in property values in that Philadelphia neighborhood over the ensuing three decades. Since that day when we purchased our first home, long-term mortgage rates have declined fairly steadily. There were bumps and plateaus along the way, but the decline in mortgage rates led to a long-term, explosive uptick in home prices.

Five years after we purchased our home, with mortgage rates down to 10%, we sold it for $86,000. While the price was well over twice what we paid for it, the new owner's monthly payment of $600 was only slightly more than our $500 in real terms (adjusted for inflation). And the value of the homes on our block continued to increase as long-term rates continued downward. Over the ensuing years, as mortgage rates fell to 8%, the selling price of twins on that street increased to over three times their value in 1982. And by the time we reached the pre-crash years, and mortgage rates fell to the 6% range, the price of those homes topped out over $220,000, or six times what we paid, yet the monthly carrying cost of required to by a home at that price was only $1,200 per month, still almost the same as our $50o per month payment in 1982, adjusted for inflation over the ensuing quarter century.

As mortgage interest rates continued to decline from their 1982 peak, the market grew a fevered pitch. As a real estate broker said to my wife and I when we moved to California in 1990, "You just have to get on the escalator." Prices would go up, they would never go down. Americans borrowed more as rates declined, and, believing that prices could only go up, they committed more of their income to buying bigger homes: From 1982 to 2007, the median size of a new American home grew by approximately 50% and the percentage of household disposable income Americans spent on mortgages increased by 30%.

This was the phenomenon we lived through. As interest rates fell, lower cost mortgages allowed home values to skyrocket, even as homes remained affordable at the higher prices. The graphic below illustrates the trends that conspired to support the price escalation captured in the Case-Shiller Home Price Index (shown here as the green solid line). As mortgage rates fell (blue dashed line plotted against the right axis), the mortgage value that could be supported for a constant payment grew (solid red line, left axis), while at the same time the percent of household income families used to pay their mortgages increased (purple dotted line, right axis).

The financial crisis was built on the conclusions people drew from this decades long trend in price appreciation. Many--Standard & Poor's famously among them according Michael Lewis in The Big Short--concluded that home values would never decline across the board. The mortgage lending markets bought into this notion, as down payments--the traditional protection for lenders agains declining values--all but disappeared.

But if declining rates were the driver of price appreciation, what does this portend for the housing market if we have reached the floor in long-term interest rates? The factors that could drive interest rates and mortgage carrying costs upward--economic growth, a domestic debt crisis, waning international buyer interest in our securities, sunsetting of QE2--seem more likely to transpire than those that would push rates lower--reduced U.S. borrowing, depression, deflation, renewed global economic collapse. As such, if a driver of the housing market has been steadily declining long-term interest rates, perhaps it is no longer reasonable to expect the housing market to be a driver of our economy for the simple reason that it is no longer reasonable to expect interest rates to continue to fall.

Standard & Poor's should not be puzzled. We are on the downside of the bubble now, and that should have a fundamental impact on the prospects for recovery of the housing market. If prices can fall, the psychology of home buying is very different, and for all the reasons that prices rose over the past decades, they could well continue to fall going forward if interest rates trend upward. Today, a $200,000 mortgage at 4.5% costs just over $800 per month. An increase in mortgage rates by just 1.5% to 6% increases that monthly payment by 33%, while a return of mortgage rates to the 8% level of the mid-1990s increases the monthly payment by 45%. Accordingly, rising rates would reduce home affordability and assert downward pressure on prices--just as falling rates pushed home values upward over the past several decades--and even just the risk of future price uncertainty should affect buyer confidence.

And there are other reasons home ownership may have lost its patina, further suppressing demand. Babyboomers, downsizing now that the kids are gone, may rationally choose to rent rather than own, if price appreciation will no longer be a given. And for them and their children in today's workforce, mobility may be of greater value than the rootedness of owning one's home. You only have to ask the residents of Michigan, who found themselves unable to move to pursue opportunity, tied down by the equity they hope still remained in their homes.

Home ownership is part of our identity. For some it is a rite of passage to adulthood, while for others it is what binds a family and neighborhood together. Those are attributes without financial measure. As such each spring, homes will be spruced up for sale, and buyers at a Sunday open house will find the place of their hopes and dreams. That is not going to change. But the interest rate driven growth in values of the past quarter century is behind us, and those looking for a sustained rebirth of the housing sector--waiting for the escalator to start once again--may have a while to wait.

Thursday, May 26, 2011

Dominican Daydream

Rashi, our Australian Shepherd, followed me dutifully in to the kitchen, looking up expectantly as I opened my laptop to check the scores before we went out. The Red Sox had clobbered Cleveland. The Phillies, after Halladay gave up a 3-1 lead, were in extra innings with Cincinnati. Each team had just scored in the 10th to leave the scored tied at 4-4.

That is when Rashi's long night started. That is when Wilson Valdez earned himself a permanent place in Phillies, and baseball, lore. Perhaps it is too soon to speak the name Dave Roberts--the journeyman outfielder whose stolen base in the bottom of the ninth inning of an elimination game launched the Red Sox to the championship in 2004--but Wednesday night's game was the stuff kid's dreams are made of.

The game wore on. Inning after inning, the late relievers for each side handled their opponents with little threat of a resolution to the contest. By the end of the 18th inning, the Phillies last pitcher, Dennys Baez was spent, and there was no one left in the bullpen.

Enter Wilson Valdez. A 33-year old utility infielder from the Dominican Republic, Valdez had never pitched an inning as a professional baseball player. Not in the major leagues. Not in the minor leagues. But he was game to give it a shot, and Phillies manager Charlie Manuel had nowhere else to go.

Valdez proceeded to live a dream. The game was six hours hold, but the Philly faithful were hanging in. Fans--including many who clearly were going to be tired in school the next day--chanted his name as he faced the heart of the Reds line up.

And he looked the part. He looked like an infielder who had been handed the ball. One of his first pitches went wide to the backstop--he was not crisp. But he settled in, and one could slowly see the kid emerge, as the fantasy that happened to be real unfolded. He became the Dominican youth channelling Pedro Martinez, the Dominican legend who himself spent a few fading months in a Phillies uniform. Wilson and Pedro. Similar slight build. Right handers.

OK. Maybe that is the end of the comparison. One a slam dunk Hall-of-Famer. One, not so much. But on Wednesday night--or make that Thursday morning--Wilson Valdez channelled Pedro in his imagination. He was dealing.

He had clearly practiced the moves. Standing on the mound, right foot on the rubber, peering in for the sign. Like he had done it a thousand times before--just not for real.

He was a bit shaky at first, facing reigning National League MVP Joey Votto. His first batter as a major league pitcher. But Valdez was inhaling the wonder of the moment. A few pitches in, he shakes off the sign from Dane Sardinha. Hard to imagine what he was shaking off, actually. The 86 mile an hour fastball or the 88 mile an hour fastball. Perhaps he was clearing his head, checking to see if he was really there.

No. He was shaking off Sardinha because that is what a kid does, living out that moment. Top of the 19th. Facing the heart of the order. It is a mind game, me vs. the batter... Votto, perhaps not quite believing the situation, flied out lazily to center.

Then Valdez faced Scott Rolen, stirring the fans into a greater pique of frenzy. Go Wilson Go!

Scott Rolen! The scriptwriter made a great choice. Rolen came up in the Phillies organization. A powerful third basemen, heir to the hot corner legacy of Michael Jack Schmidt. Heir now as well to the boos that rained down on Rolen, the player who abandoned the city and the team, back in the days before the parade.

Valdez, still fighting for control of his pitches, located a fastball on Rolen's shin, and located him on first base.

But then, Valdez settled in. The outcome was never in doubt. It never is in those situations. Who misses that shot at the buzzer when you are a kid?

Valdez showed no fear. He was facing the heart of the order. He gave in to his inner Pedro, ceded his Dominican soul to his childhood hero. He peered in to Jay Bruce. Bruce, the powerful slugger, leading the National League in home runs.

Really, could it get any better this? First, the league MVP goes down. Next, he hits Rolen. Now he is facing down Bruce?

So he drops down, wheels in from the side. Pure Pedro. His teammates are in awe.

He is feeling it. He is dealing. Bruce takes him deep, but not deep enough. Flies out the the warning track in deep center.

Then with two outs, it comes down to Carlos Fisher. Relief pitcher. An easy out for any pitcher in the majors.

If he was facing a just any major league pitcher.

But he was facing Pedro Martinez.

It was over. As Fisher skied a pop up behind second base, Valdez was already trotting off the field as the ball landed in Placido Polanco's glove. It doesn't get any better than this.

If you weren't watching, it all ended in the bottom of the 19th. Phillies scored, and won 5-4.

The long night ended. Finally, Rashi got her walk. And Wilson Valdez became the first player since Babe Ruth to start a game in the field and win it on the mound.