Author: Daniel Indiviglio

Existing U.S. home sales declined in February by 0.6%, according to the National Association of Realtors. While the decrease is small, it fits in with a broader trend: for three months now we’ve seen existing home sales decline. As with all February data, snow was partially to blame. But it also appears to indicate that the home buyer credit is not conjuring up as much demand as hoped.

Here’s a chart that shows how this statistic has changed over the past 18-months.

As stated, those numbers are seasonally adjusted. So the decline of home sales in winter is already taken into consideration. In November, we saw a huge peak. That was the month when the first time home buyers’ credit was set to expire. After it was extended, presumably Americans’ sense of urgency to buy a home declined. So have sales, dramatically.

That extension is set to last until April. If you do a month-by-month timing comparison, you can see that in January 2010 and August 2009, three months prior to the program’s set expiration at the time, the levels were about equal. But February 2010 is quite a bit lower than September 2009, two months prior to the buyer credit’s scheduled expiration. To me, that continues to indicate that the demand for buying homes has weakened considerably and the home buyers credit might not be doing much to enhance sales.

Unfortunately, again, we’re faced with a month where the weather may have had some effect. I find it a little hard to believe that the snow could have been hugely significant, but it probably lowered sales a little. So we’ll have to wait until March data is available to see if there’s a spike similar to the level we saw in October 2009. If not, then a new normal in existing home sales may be stabilizing around the 5 million annualized rate. Worse news would be that the credit actually has been having a major effect, and existing home sales will decline still further after April, to a level somewhere below the 5 million mark.

When the U.S. government bailed out the financial industry, it placed some compensation limits on the firms who got public funds. This triggered a debate about whether such limits would cause executives to flee their constrained firms for others who weren’t under the government’s thumb. The numbers are in, and they indicate that nearly 85% of executives did not abandon their firm just because they pay was restrained. Does that mean pay doesn’t matter after all? Hardly.

Fifteen percent might not sound like much. But if you ask any company if they would mind losing the top 15% of their talent, I’m fairly confident they would all find that very, very bad. So I’d start by saying that I don’t find 85% retention as impressive as the large proportion might suggest.

Here’s what the New York Times believes caused most executives to stay:

The relative stability, at least within the executive suite, suggests that a soft job market, corporate loyalty and personal pride helped deter the feared management exodus at the companies hardest hit by the pay rules.

Let’s consider these three possibilities and add another:

Soft Job Market

I think that first aspect is, by far, the most relevant — and it shows why that this 15% was only the very best talent that departed. The pay limits were in place during late 2008 and the the early part of 2009 — a time when virtually no financial institution had much money to spend in order to attract new talent. There were also few greener pastures: most large financial institutions were under pay restraints simultaneously.

So you can be pretty confident than anyone who did manage to find a firm willing and able to pay them more during this time was a true superstar who will be missed. I don’t begin to doubt that there are other employees who would have liked to leave, but couldn’t do so, because there just weren’t many opportunities available. If you had pay limits placed on some firms during a time of economic expansion, I think you’d get a much, much higher rate of turnover. These restraints happened to be in place during the most severe financial crisis in decades.

Loyalty

I doubt corporate loyalty had much to do with it. After having spent some time working in finance, it was pretty clear that loyalty was rare — even irrational. There’s a feeling that no one’s job — particularly at a bank — is ever safe. If a firm needs to cut costs or decides to change strategy, it won’t hesitate laying you off, even if you’re a strong performer. As a result, it’s foolish to feel you should show any loyalty to your firm when you know it won’t show any loyalty to you. That’s why there’s so much turnover in finance.

Personal Pride

Personal pride, however, may have been a more significant factor. Those affected by the pay restraints were very high-level management. They’re the ones who were mostly blamed for the bank’s troubles, so they likely wanted to show that their actions didn’t kill their firm and wanted to help ensure its survival.

Promises and Handshakes

I would also add another possible retention method: unofficial promises of future reward. Let’s say that you were the CEO of a bailout bank in late 2008. One of your best executives is threatening to accept an offer at a British bank that is not under pay restraints. What do you do? You lament the government’s rules, but assure the employee that, as soon as the limits are lifted, she will be rewarded handsomely. Remember, no one expected these limits to last forever; indeed, the banks shed them as quickly as possible. I wouldn’t be surprised if you see some particularly big payouts over the next few years for executives who were under pay restraints during the crisis to sort of make up what was lost and reward for them for sticking with the firm.

Ultimately, I don’t think the 85% retention statistic shows that pay restraints had little effect on these firms. As mentioned, losing 15% of top talent is significant. But most importantly, the rules were in effect during a time when very few jobs were available anyway. That’s why I wouldn’t have expected to see a huge talent drain. Pride may have had a little to do with it, but I doubt loyalty played much of a role. There were also almost certainly verbal promises made for better payments once the restraints were lifted.

Yesterday, I wrote about the surprising news that it took the Senate Banking Committee all of 22 minutes to mark-up its 1,336-page financial reform bill. That averages to about 61-pages per minute. Who knew Congress could be so efficient?

News outlets I read yesterday weren’t clear on why mark-up was essentially skipped, consisting only of passing Chairman Dodd’s manager’s amendment (which lacked much substance and was mostly correcting technicalities) and then the final vote. Republicans and Democrats had nearly 500 amendments they had hoped to offer. So what happened?

I’m hearing that Dodd drove the speed in getting the bill out of committee for two reasons. First, he’s generally in a hurry. That’s already been made clear through his decision a few weeks ago to kill seemingly productive talks with committee Republicans to craft a bipartisan bill. He initially said he’d allow a measly week for markup (the House Financial Services Committee took several weeks to complete their markup). But he feared amendments would cause the committee process to take more than a week. With close to 500 amendments, he was probably right.

But the second reason was because he’s reported to have wanted to shield Senate Banking Committee Democrats from having to take hard votes. As a result, he told committee Republicans that all Democrats would simply vote in unison to kill any Republican amendments, so it would be a waste of their time to bother offering any of their changes. Indeed, that’s how the final vote went — strictly along party-lines. With a 3-vote edge, it’s pretty easy for Democrats to get a simple majority in committee.

Because of this, Republicans decided that it would probably be more productive to save their amendments for the floor of the Senate. After all, if committee Democrats would just oppose them anyway, then Republicans can’t possibly fare any worse by introducing changes before the entire chamber. Republicans, however, do remain optimistic that a bill will ultimately be agreed to.

So really, yesterday’s vote, while an important procedural step, isn’t so significant in terms of actually making tangible progress towards a final bill in the Senate. Instead, it just indicates that the committee punted to the floor. Even Dodd admits that some sections, including the entire derivatives portion, are still works-in-progress. Any time that would have been spent offering amendments in committee will just be spent doing so on the floor of the Senate — drawing out that debate much longer than it might have been if a cleaner, more bipartisan bill had come out of committee. So any sound bites you might hear by members of Congress or the Obama administration praising yesterday’s vote is pure rhetoric: nothing was actually accomplished. The committee just pushed its work onto the Senate floor.

Dodd can’t pass this bill without at least one Republican. He might believe he has a better chance at luring non-Banking Committee Republicans to vote for the bill with fewer changes than would have been necessary to get Republicans on the committee to go along. And he could be right. But I’m not at all convinced that he’ll necessarily have all 59 Democrats with him, so he may very well need several Republicans to come to his side. After all, even in the more liberal House, financial reform only passed by five votes, despite that chamber’s much stronger Democrat majority.

At this point, there’s no timetable for when the Senate will begin considering Dodd’s bill. But when it does, expect some intense debate and hundreds of amendments.

(Nav Image Credit: cliff1066/flickr)

Yesterday, I wrote about a problem I see looming for a non-bank resolution authority: the creation of a fund used to resolve big financial firms may give them a competitive advantage over smaller ones. The sort of obvious rejoinder to that criticism is that banks will have to pay into the fund, thereby incurring a cost that could serve to remove that competitive advantage. The New York Times notes that such bailout taxes are gaining support. I don’t think they’ll help matters much.

I don’t want to split hairs here. Whether you call it a “tax” or an “assessment” really doesn’t matter. If you’re forcing firms to pay a certain amount of money into a fund used to pay for the costs that would hit the U.S. economy if those firms fail, then the end result is the same. So even though the financial reform proposals out there don’t create any sort of punitive tax, they do require that big firms are assessed to pay into a resolution fund, proactively. Same thing.

The problem, however, is that this tax won’t level the playing field: these firms will still have a distinct advantage for two reasons.

First, the cost associated with failure might be more than the amount of money any given firm has been individually assessed. But the entire fund (or even more) can be used to pay the cost of a single firm’s failure. So whatever parties were doing businesses with that firm and receive money from that fund to cover the costs of resolution could potentially reap more benefit than any given firm paid for. That means the cost incurred by a firm could be less than the benefit derived. On an industry basis, the total cost may be equal to or greater than the benefit, but from the competitive standpoint of individual firms, any given systemically regulated firm will have an advantage in luring customers because of this special benefit.

Second, even if these systemically regulated firms incur greater costs due to these assessments, smaller firms will suffer disproportionately due to their competitive disadvantage. It’s unclear how great that competitive disadvantage will be. But under certain creditor or customer relationships, there may be an excessively large advantage obtained by doing business with a firm that has access to the resolution fund through its failure. For example, if swap counterparties will receive 100 cents (or even 60 cents) on the dollar if a systemically regulated firm goes bankrupt, then why would anyone ever want to be on the other side of a swap with a firm that isn’t systemically regulated? If you do business with the large firm, your obligation is essentially guaranteed by the U.S. government. That’s a huge barrier to competition.

Again, I’m a little unclear on what “costs” will be covered by the fund generated by bailout taxes. But you almost have to assume that certain types of creditors or customers would be covered. As I mentioned in my prior post — otherwise, what would be the point? Essentially, the financial landscape would be analogous to one where only some banks paid for depository insurance and other banks just didn’t have it. Who, in their right mind, would ever do business with a bank that didn’t have that insurance when others did? Even though the associated premiums cost banks something, the benefit derived would be far greater than that cost.

The Senate Banking Committee began the mark-up process of Chairman Dodd’s financial reform bill at 5:00pm Monday evening. The 1,336-page bill’s mark-up ended at 5:22pm passing through committee, with a vote of 13 to 10. All Democrats on the committee voted in favor, all Republicans against. The bill will now proceed to the Senate floor, where it will be debated and amended by the full chamber.

This is an odd turn-of-events. Democrats and Republicans are reported to have written up over 400 amendments to Dodd’s bill. None were offered in mark-up, but some were added to Dodd’s manager’s amendment (which I’m still going through). It quickly passed prior to the final vote.

I’m still completely unclear on why Republicans didn’t choose to bring up amendments in committee. Usually, that’s how these things are handled. Some reports indicate that there may have been internal disagreement on what strategy to take among Banking Committee Republicans. I have calls into Senators Shelby and Corker’s offices — who have led the Republican effort regarding this bill — and will update this post if they decide to comment.

As I mentioned earlier, as the bill heads to the full Senate, a wild battle should ensue. Here’s Dodd’s statement about the bill, released Monday evening:

For three years now, dating back to our first hearings on home foreclosures in 2007, this committee has been studying the causes and effects of the worst financial crisis since the Great Depression.

The effects are obvious.

Some of the most prominent financial institutions in our country have been destroyed or seriously weakened – but as bad as that has been the far worse damage has been done to millions of ordinary families across America who did nothing wrong but are paying a terrible price.

A staggering 8.4 million jobs have been lost, and the unemployment rate remains near double digits, and in far too many communities the rate of unemployment is over double digits.

Nearly 7 million have lost their homes to foreclosures. Millions more have lost their retirement funds, or their small businesses.

And, as our constituents have made very clear to each of us, Americans are frustrated and angry, and they want Answers.

How could this have happened? And what are we going to do to make sure it never happens again?

We must reform our regulatory structure so a crisis on Wall Street doesn’t wipe out working families and businesses.

We must create an early warning system so that we can spot unsafe financial institutions, products or practices and stop them before they threaten the stability of our whole economy.

We must protect American consumers and restore their faith in our markets and in the financial system.

Such comprehensive reform is, of course, an enormously complex undertaking.

I want to thank my colleagues, Democrats and Republicans, for the hard work they have already put in to get us to this stage in the process.

If all you do is watch cable news shows, you might get the idea that all we do here in the Senate is lob talking points at each other across the aisle.

But the truth is that a challenge like financial reform requires a lot of real and honest work.

And whatever happens from this point forward, the members of the committee should be recognized for the work they have done.

Working in bipartisan teams, members of the committee have tackled some difficult and important questions and produced a bill that will address serious problems.

The result is a bill that will update our regulatory system for the 21st century financial sector, so that we can keep pace with innovation and be ready for future crises before they happen.

This bill has 11 titles, and rather than go through each one let me briefly highlight the four critical pieces of this proposal.

1) It will end bailouts, ensuring that failing firms can be shut down without relying on taxpayer bailouts or threatening the stability of our economy.

2) It will create an advance warning system in the economy, so that there is always someone responsible looking out for the next big problem.

3) It will ensure that all financial practices are exposed to the sunlight of transparency, so that exotic instruments like hedge funds and derivatives don’t lurk in the shadows and businesses can compete on a level playing field.

4) It will protect consumers from unsafe financial products, such as the subprime mortgages that led to the financial crisis.

And, most importantly, it will restore our financial security so that our economy can create jobs and offer middle class families a chance to build wealth.

Today, a full three years after we began to study the crisis, and after a tremendous amount of discussion and study, we have a bill.

I know that there will be spirited discussion in the days and weeks ahead, but I expect that all the members of the committee and the full Senate will understand very clearly that we are moving forward.

The stakes are too high – and the American people have suffered too greatly – for us to fail in this effort.

And we will not fail. We will have reform this year.

Bloomberg has an article today with one of those fabulous headlines guaranteed to garner lots of clicks: “Obama Pays More Than Buffett as U.S. Risks AAA Rating.” So naturally, I nearly replicated it here. As it turns out, U.S. debt is becoming pricier to issue than that of some AAA-rated companies, billionaire investor Warren Buffet’s Berkshire Hathaway included. Is the bond market correct or crazy to require more yield for U.S. debt?

Here’s a blurb from the article:

Two-year notes sold by the billionaire’s Berkshire Hathaway Inc. in February yield 3.5 basis points less than Treasuries of similar maturity, according to data compiled by Bloomberg. Procter & Gamble Co., Johnson & Johnson and Lowe’s Cos. debt also traded at lower yields in recent weeks, a situation former Lehman Brothers Holdings Inc. chief fixed-income strategist Jack Malvey calls an “exceedingly rare” event in the history of the bond market.

What sticks out to me there is the term of the notes: two years. So essentially, these investors are betting that there’s a higher likelihood that the U.S. will default on its debt in the next two years than Berkshire, P&G, J&J and Lowe’s. Oh c’mon! Is there any chance of the U.S. defaulting so soon?

I doubt it, very highly. Even if you think that the U.S. government is on an unsustainable spending path (and I do), it’s pretty extreme to think that the nation will actually default on its debt. And it’s even crazier to think that will happen in the next two years. Private firms, on the other hand, could more likely experience some sudden shock leading to their bankruptcy in the short-term. 

When it comes to longer-term U.S. debt, I could, however, kind of understand if investors began to demand a higher yield. There’s a significantly greater likelihood, for example, that the U.S. could default 10 or 20 years down the road. Unless the government gets serious about deficit reduction and paying down some of its borrowing over the next decade, we’ll be in serious trouble. So if you think Washington is too dysfunctional to manage its spending, then you may think that default could one day happen. But in the next two years, I just don’t see it.

The Senate Banking Committee’s markup of Chairman Dodd’s financial reform proposal is set to begin tonight at 5pm. Reports indicate that mark-up may end tonight as well. Rather than actually hold legitimate mark-up of the bill, there may just be an up-down vote. This is troubling.

Shahien Nasiripour of the Huffington Post reports:

A key Senate Republican says that the committee responsible for authoring new rules to rein in Wall Street will vote on the proposed bill Monday evening, abandoning plans to debate the most ambitious financial reform proposals since the Great Depression and temporarily ignoring more than 400 amendments to the bill suggested by senators.

That Republican is Senator Bob Corker (R-TN), an ally of reform who was troubled when Dodd decided to ditch bipartisan efforts and ram the 1,336-page bill through as quickly as possible. This move would bring that speed to a new level. Republicans and others had assumed that mark-up would last at least a week. If the vote takes place tonight, as indicated, then there would be no mark-up at all.

I’m a little unclear as to why there won’t be mark-up. The article above doesn’t really make clear if this is the committee’s decision on a whole, or if Dodd is just trying to skip debate and bring the bill to the Senate floor as quickly as possible. I have requests in to both Dodd’s and Corker’s offices for comment, so I’ll update this if I hear anything new.

Even if the vote is held tonight, the bill should easily pass committee. Dodd has a 13-to-10 Democrat-to-Republican majority to work with. Unless he’s somehow alienated other Democrats on the committee, this should be the easy part.

The floor of the Senate will be a different story. There, Democrats no longer have a filibuster-proof majority. As a result, they’ll be forced to consider amendments and engage in debate.

I’m really disappointed that this effort is being rushed. It seems like providing at least some time for the committee to work out some of the kinks in the bill through mark-up would be prudent. After all, that is how these things generally work. The House bill was improved substantially through this process.

I’ve expressed my dislike for Dodd’s decision to push forward without bipartisan support as well. It feels a lot like the ugly health care debate all over again. But this sudden sense of urgency makes matters even stranger. After waiting until November — more than a year after the financial crisis hit its climax — to release an unrealistically ambitious draft, why the surprising rush?

After losing a bitter health care battle, Republicans will likely be practically foaming at the mouth, eager to assert themselves in whatever Democrats hope to accomplish next. Financial regulation will likely find itself in that awkward position. And that’s a shame. In the Senate, any eagerness to work together will be even more strained after Dodd snubbed their willingness to work towards a bipartisan compromise in committee. Passing financial reform is shaping up to be messy and difficult.

A set of luxury retailers reported earnings today. Tiffany & Co. and Williams-Sonoma both reported strong quarterly sales. Is luxury back?

Here’s a blurb from the Wall Street Journal on Tiffany’s:

In the Americas, sales rose 14% to $523.5 million. U.S. same-store sales rose 11%, including a 22% increase in the New York flagship.

Interestingly, analysts expected an even better result, so its stock is taking a beating today. But this is a pretty nice gain in sales for the company.

And for Williams-Sonoma, Reuters reports:

Net sales rose 8.1 percent to $1.09 billion, beating the analysts’ average forecast of $1.07 billion. Sales at stores open at least a year rose 7.6 percent.

The Williams-Sonoma Corporation owns not only its namesake stores, but also high-end retailers Pottery Barn and West Elm. It further expects same-store sales to rise 8% to 11% this quarter. Those are pretty strong results and expectations.

Does this data indicate that luxury retailers’ suffering is over? During the recession the rich were hit particularly hard. That took a toll on companies like Tiffany and Williams-Sonoma that rely on wealthier customers. Obviously, these are only two data points in a large market, but looking at these results, I think it’s hard to argue that luxury won’t be experiencing a pretty solid rebound, as they are very characteristic of the broader industry.

Other news we’ve been seeing recently about the rich getting richer would also indicate that luxury should be faring better. Let’s face it: these retailers don’t need unemployment to decline. As the stock market and corporate profits improve that should directly help their target population. And wealthy individuals with a lot of equity holdings or jobs in corporate management are definitely feeling much richer than they were a year ago. That should make them more comfortable buying more luxury goods.

Just as the wealthy generally recover more quickly coming out of a bubble-based recession, so should luxury.

Generally, when a family is defaults on their mortgage, they need to find a new place to live. But a non-profit financial institution, Boston Community Capital, is trying to change that. The lender, featured in an article by the New York Times today, purchases foreclosed homes at auction and sells or rents them back to their former occupants. It’s an interesting idea to be sure. It also raises some questions.

First, here’s a little more explanation from the Times on how the program worked for Jane Petion, who defaulted on a home with a $400,000 mortgage balance:

In December Ms. Petion signed a new mortgage on her house for $250,000, with monthly payments of less than half the previous level. She and her husband now have a mortgage they can afford in a neighborhood that benefits from the stability they provide. A nonprofit lender made the deal possible by buying the house from her original mortgage company and selling it to her for 25 percent more than its purchase price — a gain to hedge against future defaults.

Ripe for Principal Reduction?

My first observation here is — why didn’t the bank consider principal reduction in this case? The bank sold the home at auction for $200,000. The former homeowner then bought the home again for $250,000 from the non-profit lender. Wouldn’t the bank have been a lot better off if it had just re-written the principal balance to $250,000 instead of foreclosing? Its loss would have been $50,000 less. It also wouldn’t have had to pay the significant costs associated with foreclosure. I’m a little bit confused why there needs to be a non-profit lender out there to do what seems rational for profit-driven banks to do.

Credit Concerns?

Credit concerns might be one potential reason why banks might not be interested in doing what this non-profit lender will. The bank may be convinced that the borrower will just re-default. They may adhere to the old saying, “Fool me once, shame on you; fool me twice, shame on me.” It may be a punitive tactic where banks don’t want to allow a defaulted homeowner remaining in the home. They might not like the moral hazard involved.

And that raises a question: should Boston Community Capital be worried about the credit histories of these individuals? Presumably, after foreclosure, these borrowers have very poor credit scores. The article explains that they create the new mortgage at some premium over the auction price to hedge the credit risk involved.

I wonder what type of underwriting goes on at a non-profit with this mission. In fact, many of these borrowers may have relatively good credit histories other than the foreclosure. For some time, prime borrowers have been dominating the thousands of homeowners defaulting. Particularly when that’s the case, it could be a very smart bet to sell these individuals their home back at a price they can afford.

But What About Strategic Defaults?

The biggest problem I see here is what to do about strategic defaults. These involve people who willingly allow their home to go into foreclosure, even though they can afford to continue paying. They know the home is now valued less than the mortgage, so they don’t see the point in continuing to pay.

On paper, this would appear to sort of be the perfect type of borrower from the non-profit firm’s perspective. The only reason they aren’t paying their mortgage is because its price is too high — not because they can’t. After buying this person’s home at auction, he would be a very safe bet to pay the reduced mortgage price. Yet, presumably, this non-profit is out to help the kind of homeowner who is legitimately struggling. This presents an interesting sort of tension where the safer the borrower, the less you would probably want to help them.

I’ll be interested to see how this program ends up doing. Since so many of the struggling homeowners defaulting these days likely had a relatively clean credit profile up to now, it could actually go fairly well. I just hope the company isn’t also lumping strategic defaults in with families who were trying hard to live up to their mortgage obligation, but fell victim to hard times or tricky mortgage brokers.

I have one nagging concern about both financial reform proposals out there that I haven’t really addressed yet. Both bills seek to create a non-bank resolution authority. That sounds great. But in order to unwind a firm quickly and neatly, then you need to have some money to work with. Since it’s pretty likely that the firms being unwound can’t cover the entire cost involved — they are, after all, bankrupt — each proposal includes a resolution fund to help pay. I worry that access to this fund in the resolution process would still provide these firms a competitive advantage — even though they could fail.

The question, I think, is precisely what this resolution fund will pay for. We can be pretty sure that it won’t pay equity holders anything — they’ll be wiped out entirely. But with creditors, things get a little more complicated. Will they all be wiped out? If not, any who aren’t essentially hold debt with a government guarantee. Even if the firm is wound down by the resolution authority, those debt holders can be sure they’ll be made whole.

That would provide the firms who are subject to systemic risk authority a distinct advantage. It will provide them with cheaper borrowing costs. After all, if a creditor thinks that the debt of one firm will be paid for through the resolution fund if it fails, then she’ll charge less for that debt than for debt from a firm that isn’t subject to systemic risk regulation.

And what about derivative counterparties? Think AIG on this one. When it was bailed out, lots of banks collected big checks on payouts they were owed by AIG from derivatives they held that AIG backed. Presumably a resolution authority would seek to pay out some portion — if not all — of derivative obligations. As I see it, that’s kind of the point. Otherwise, you’d end up in a situation where a financial crisis could ensue once again. If counterparties don’t know that they’ll be made whole, their counterparties might get scared, liquidity freezes up, and we’ve got a big mess on our hands again.

The problem is that if you guarantee any aspect of a firm’s exposure, then that provides it an advantage. Imagine if AIG’s CDS was all paid back through resolution. Let’s say the failure plan even required it be paid out at 80 cents on the dollar, rather than at par. If I’m buying CDS, then that’s still a pretty good deal compared to a firm that isn’t big enough to qualify for access to the government’s resolution fund through failure. Big firms that do have access will certainly have a competitive advantage if any costs of resolution are covered.

And if no such costs are to be covered, then just what exactly is the purpose of the resolution fund — and how would a new resolution authority provide any more market stability than if the firm just failed the good, old fashioned way? I have trouble wrapping my mind around how this resolution authority could exist without some advantage being attained by those firms under its umbrella.

This is a major concern, because it would create a world where the big firms continue to grow more rapidly than the small ones — because they have a distinctive advantage. That’s precisely what we don’t want. One potential solution would be for all non-bank financial firms to have access to the resolution fund though failure, under the same set of rules. For example, Joe’s CDS shop’s clients would also get 80 cents on the dollar for the CDS he sold if it fails, just like AIG’s customers. This would kind of be like how all banks have the same depository insurance benefit currently.

Otherwise, breaking up large firms would be the only possible solution left. But I think that’s a pretty poor option in practice. I’m skeptical that regulators would even know how big is too big or how interconnected is too interconnected.

So for now, I still support the idea of a resolution authority, but I would like to hear more about how the playing field will be kept level. Someone needs to explain how a non-bank resolution authority can nicely wind-down only large firms without also giving those firms some competitive advantage over smaller ones. Otherwise, regulators must provide the same benefit to all firms. Current resolution authority proposals sound nice in theory; I just worry about their practical application.

A few weeks ago I wrote about an excerpt from former Treasury Secretary Henry Paulson’s book “On the Brink” that I found profoundly disturbing. It basically explained how banks sometimes knowingly acted irrationally, because they believed that competition gave them no choice. I was reminded of this excerpt when reading a new paper on the new Dodd bill by former investment banker and current Brookings Institution scholar Douglas Elliot. He too says competition makes banks do stupid things. He concludes that this is a reason why banks should support a consumer financial protection agency.

Elliot writes:

Ironically, banks themselves might be better off with a somewhat stronger consumer agency. Many of the worst practices leading up to the financial crisis came from non-banks that were significantly more weakly regulated than the banks were. An agency of adequate strength could create a more level playing field that should benefit the banks by shielding them from unfair competition coming from risky or shady operators.

So let me see if I understand. Non-banks were creating insane products that were bound to fail. As a result, banks felt pressured to do the same. Otherwise they would lose business. Yet, these bad products came back to haunt them.

But if a CFPA existed, then brilliant regulators would have reined in those misguided non-banks. Therefore, a CFPA would have prevented banks from feeling pressured to create these awful products, because it would have stopped the non-banks from making them too.

Right — or the banks could have relied on a little business acumen.

If banks know that products are harmful, then why would they sell them? Why wouldn’t they instead refrain from doing so, and then sit back and smile while they watch the rest of the industry burn?

Their profits will suffer in the short-term — true. But surely they won’t suddenly go bankrupt because they refuse to, say, originate option-adjustable rate mortgages for a few years while others do. In the meantime, the profits that the stupid firms are reaping are an illusion. In the long-run, those products will cause deep losses, even failure in some cases. At that time, the banks that relied on prudent risk management will look shrewd and their profits will ultimately be far greater than they would have if they bought into risky financial product fads.

I just find it so impossible to believe that we need a regulator to step in so that banks don’t make decisions that they know to be stupid. If they’re really that irrational, then they all deserve to fail. Eventually smarter people will start banks who understand that acting irrationally will lead to bad consequences.

Consequently, I don’t think this argument works particularly well to support a CFPA. The potential losses a bank will ultimately face should be enough to compel banks from knowingly developing stupid products that will result in long-term losses. Banks that do so will fail. (And the system needs to be repaired to make sure they can.)

That’s not to say there aren’t arguments that are more compelling for a CFPA. But they contradict this one. In fact, banks find products like overdraft protection and credit cards with arbitrary interest rate changes very, very profitable. Any losses that eventually result will be easily overshadowed by the profits they reap — otherwise they wouldn’t be engaging in such tactics. If you think they’re bad from a consumer perspective, then you can argue for a CFPA. But that’s different from saying that a bank is better off not charging fees that it has found to be quite profitable.

This week, former Federal Reserve Chairman Alan Greenspan released a fascinating paper he wrote for the Brookings Institution on the financial crisis. In it, he doesn’t so much wish to apologize for his monetary policy choices. He actually argues that they weren’t to blame for the crisis. Instead, he believes that lax regulatory supervision was more at fault.

Greenspan actually explains why he chose not to bother trying to pop the real estate bubble even though he saw one growing: because it didn’t work with tech stocks. He says:

I raised the spectre of “irrational exuberance” in 1996 only to watch the dotcom boom, after a one-day stumble, continue to inflate for four more years, unrestrained by a cumulative increase of 350 basis points in the federal funds rate from 1994 to 2000.

Indeed, bubbles are a very hard thing to stop. But surely, the Fed had more at its disposal than just the blunt instrument of the fed funds and discount rates to tackle a real estate bubble. What about regulatory changes? He appears to admit that there are some areas where expanded regulation could have helped. He says bank supervision:

– can audit and enforce collateral and capital requirements.
– can require the issuance of some debt of financial institutions that will become equity, should equity capital become impaired (see page 33.)
– can, and has, put limits or prohibitions on certain types of concentrated bank lending.
– can prohibit a complex affiliate and subsidiary structure whose sole purpose is tax avoidance or regulatory arbitrage.
– can inhibit the reconsolidation of affiliates previously sold to investors, especially structured investment vehicles (SIVs). When such assets appeared about to fail, sponsoring companies, fearful of reputation risk (a new insight?), reabsorbed legally detached affiliates at subsequent great loss.
– can require “living wills” that mandate a financial intermediary to indicate on an ongoing basis how it can be liquidated expeditiously with minimum impact on counterparties and markets.

Presumably, in retrospect, Greenspan would have liked to have done some of that since the Fed had supervisory power over many of the institutions that helped cause the financial crisis. The fact that it didn’t bother is one of the reasons why I’m so cynical about giving the central bank even more oversight and making it the systemic risk regulator. Its track record isn’t exactly stellar.

The last bullet point above especially caught my attention. One kind of amazing lack of foresight was that some institutions had grown too big to fail. Just because the Fed at the time never could have envisioned a world where, say, Citigroup failed, that doesn’t mean there shouldn’t have been a plan in place to make sure the market could handle the unlikely event. Not bothering ensuring that seemingly safe firms could fail would be like never having a fire drill just because you don’t think there will ever be a fire.

Greenspan also sees higher capital requirements as an important step in creating a more stable market. I agree. He says:

The most pressing reform that needs fixing in the aftermath of the crisis, in my judgment, is the level of regulatory risk adjusted capital. Regrettably, the evident potential for gaming of this system calls for an additional constraint in the form of a minimal tangible capital requirement. Pre-crisis regulatory capital requirements based on decades of experience designated pools of self-amortizing home mortgages among the safest of private instruments. And a surprisingly, and unfortunately, large proportion of investment portfolio decisions were essentially subcontracted to the (mis-)judgments of credit rating agencies.

And I would additionally argue that creditors and investors understanding the full extent of the leverage that financial institutions are under is almost more important than capital requirements. A big problem with banks was that there was an awful lot of hidden leverage in the system. If a bank’s current and potential debt and equity-holders fully understand how severe losses could deplete the capital of the firm, then some self-regulation of the market should follow. No investor would want to have exposure to a firm that would quickly fold due to insufficient capital if an economic shock hit.

A new poll by Rasmussen found that 56% of Americans oppose sin taxes on sodas and junk food. The only thing surprising about that statistic is that it isn’t higher. When pollsters ask questions involving more taxes — no matter the details — Americans tend to be strongly opposed. As Rasmussen breaks down the poll, however, it becomes even clearer how politically toxic a sin tax on unhealthy foods might be. But if the health care system embraced the free market, sin taxes wouldn’t be necessary.

The poll also reveals:

Only 17% believe the state and national politicians who favor sin taxes are more interested in public health than in finding another source of revenue for the government. Seventy-three percent (73%) say sin tax supporters are more interested in raising additional money for the government.

Ah, political cynicism: I know thee well. Moreover, Rasmussen finds 86% of people say it’s not the government’s responsibility to control what people eat. And I agree. Yet, a fair portion of that 86% does want the government to have some control over health care. But if the government cares about your health in reactive treatment circumstances, then shouldn’t it also be concerned with preventative care? Americans want to eat their cake and have others pay for their medical care for it making them fat too.

I think obesity is a huge problem in the U.S., but I tend to eat obsessively healthily. That’s my choice, which I believe is a rational one, because I’d rather live a long, healthy life. Yet, it may be irrational in the context of the current insurance-based health care system. In a setting where the government plays an even greater role in paying for health care, it’s even less rational. The less direct responsibility I have for my health care costs, the less I should bother trying to be healthy. I can eat delicious, decadent foods as much as I like, and the cost of care from associated medical problems will fall on others, not me.

If everyone had to pay their medical costs directly, then there would be a much greater incentive to try to eat healthily. But as long as insurance companies broadly cover everybody with similar premiums — or worse if government fully universalizes health care — then suddenly there’s a moral hazard to eat whatever tastes good, because a poor eater’s excessive health care costs won’t be paid by him anyway.

In a freer market, you wouldn’t need sin taxes on food, because the higher cost for eating unhealthily would have to be paid by individuals who choose that lifestyle. Those foods would be far less popular and obesity would decline.

If the government does want to play a role here, it should be in regulating the disclosure of foods’ health statistics and ingredients. But as far as I can tell, that’s pretty adequate at this time, though it could be better at some restaurants. You can try to correct too much government involvement in the market with even more, but wouldn’t it be easier to just let the market work?

Federal Deposit Insurance Corporation Chairwoman Sheila Bair said today she worries that Senate Banking Committee Chairman Christopher Dodd’s new financial reform bill (.pdf) could provide backdoor bailouts. She made the comments during a speech at the annual convention of Independent Community Bankers of America. In particular, she worries that Dodd’s bill gives the Fed the ability to continue bailing out out systemically relevant firms. I found this puzzling. I spent an enormous amount of time digging through the bill and didn’t remember seeing that. So I checked again, and I still think Dodd’s bill doesn’t do with Bair thinks.

In talking about ending too big to fail, here’s what Bair said:

However, we do have serious concerns about other sections of the Senate draft which seem to allow the potential for backdoor bailouts through the Federal Reserve Board’s 13(3) authority. We will work closely with the Senate to make sure there are no loopholes around the carefully crafted resolution procedures. If the Congress accomplishes anything this year, it should be to clearly and completely end too big to fail.

Here’s the excerpt from the Senate bill that I’m pretty sure she’s referring to (sec. 1151, pgs.1302-1303):

The third undesignated paragraph of section 13 of the Federal Reserve Act (12 U.S.C. 343) (relating to emergency lending authority) is amended–
     (1) by inserting ”(3)(A)” before ”In unusual”;
     (2) by striking ”individual, partnership, or corporation” the first place that term appears and inserting the following: ”financial market utility that the Financial Stability Oversight Council determines is, or is likely to become, systemically important, or any program or facility with broad-based eligibility”;

So the Fed does still have power to provide emergency lending authority, but instead of to an “individual, partnership, or corporation,” Dodd would change that to a “financial market utility.” So the question, then, is what’s a financial market utility? The bill defines that as (sec. 803 pg. 723):

The term ”financial market utility” means any person that manages or operates a multilateral system for the purpose of transferring, clearing, or settling payments, securities, or other financial transactions among financial institutions or between financial institutions and the person.

The way I read that, Dodd means a financial market utility to be something like a clearing house or payment system. For example, if DTC or CLS Bank somehow needed a bailout, then the Fed would step in and make sure business could continue. I don’t know about you, but I’d be very scared of a world where a major financial market utility, as defined above, failed. Chaos would ensue; financial markets would grind to a messy halt.

There’s no way to resolve a financial market utility as defined above without causing a major economic disturbance. No resolution authority could accomplish the task. That’s why Dodd wants these institutions regulated as utilities.

But I don’t think that provides a bailout to any big bank like Goldman Sachs or Citigroup. These banks don’t run clearing houses — and if they do, they shouldn’t. The Fed should be able to take over financial market utilities without saving any big banks in the process — just those who only serve a clearing house or payment settlement function. The purpose here would merely be to make sure that transactions could continue to be processed. That’s absolutely essential for financial stability.

Now, if I do not correctly understand the definition of a financial market utility above, and Dodd does mean for big banks to be shielded from failure, then I agree completely with Bair. But I don’t think that’s what’s going on in the bill. Indeed, why would Dodd have bothered striking “individual, partnership or corporation” if he meant for systemically relevant firms to receive emergency rescues from the Fed?

Update: I just spoke with Senate Banking Committee spokesperson Kristin Brost. She tells me that references to “financial market utility” from the Fed’s section have been removed from Dodd’s proposal — and Bair’s office was notified of this last night.

I’m going to have to wait to see the revised version after mark-up to see where this leaves us. I thought it made sense to keep such financial market utilities going. But maybe it was just the terminology that the FDIC worried about. Presumably, neither Dodd nor Bair wants the Fed to bail out individual institutions. I don’t either. I just hope this change allows the Fed to keep clearing houses, payment settlement systems, etc. going. That’s pretty important for financial stability. And such institutions should be regulated as utilities.

(Nav Image Credit: Peat Bakke/flickr)

There seems to be a bit of a debate going on between economists Stephen Roach, from Morgan Stanley, and Nobel Laureate Paul Krugman. It started with Krugman criticizing China’s manipulation of its yuan’s value. Then it extended into U.S. savings. I think there are kernels of truth in what each argue.

Bloomberg documents the debate in an article this morning. It all started with Krugman asserting that China shouldn’t depress the value of the yuan because it’s bad for global demand. The argument goes: if other nations could better compete with China’s relative prices, then they would have more jobs, and consequently, more demand for goods. That’s true.

Roach counters that China’s consumers will experience increased demand through its currency’s low value, and that’s good for the global economy. He thinks that’s a better way to reduce trading imbalances. He then says that the U.S. should tend to its own business, which should be encouraging savings.

Krugman counters saying his analysis would better reduce trade imbalances and adding that he wonders where global demand would come from if the U.S. spends less and saves more. He thinks that savings is a good idea in the long run, but not now.

That’s the abridged version, anyway. There’s a lot of economic analysis in-between that I’m glossing over. I’ll just consider their theoretical arguments in broad strokes. So who’s right? Both of them, at times.

I would give the global demand point to Krugman. All trading nations would be better off with floating exchange rates. That would best reduce trade imbalances, and global demand, on a whole, should benefit. China’s population may, indeed, experience more demand through higher employment in its nation, but with a devalued currency, it would be harder to afford imports. Besides, part of the reason for the yuan’s low value is that Chinese consumers save so much instead of spending. So trade imbalances would worsen here, as Krugman says.

Yet, Roach is probably right that the U.S. shouldn’t care very much. We aren’t the ones who would benefit much if China let its currency value float. The nations this would help are those that could compete with its manufacturing prowess. The U.S. is not one of those countries. Our wages would never come down to a level close to China’s, even if the yuan had a fairer value. As a result, our consumers would benefit far more through cheaper Chinese products. The idea that, suddenly, something like textile manufacturing will ramp up in the U.S. if China’s currency isn’t so undervalued is pretty ridiculous. Other developing nations, however, would certainly benefit and should be complaining.

On the U.S. savings issue, I would fall somewhere in between Krugman and Roach. Krugman is right that too much savings during an economic recovery will make it slower — especially for the U.S. which has an economy 70% reliant on spending. With that said, however, borrowing caused the recession in the first place. Americans are credit addicts and they need to break the habit. So a gradual increase in savings would be the start of a healthy paradigm shift. U.S. consumers shouldn’t get too thrifty yet, but some spending restraint would be prudent.

So ultimately, I would probably side more with Krugman, but there is some sense in what Roach says. The devaluation of the yuan is bad, but probably not as much for the U.S. as for other developing nations. Savings shouldn’t ramp up too quickly, but I’d find it hard to complain if Americans started down the road to better fiscal responsibility.

One of the worst hit industries during the recession was tourism. When times get tough, one of the easiest expenses to cut out of your budget is travel. That goes for leisure and business. But Calculated Risk has a chart based on HotelNewsNow.com’s weekly occupancy numbers indicating that the industry could be getting back on track (click on it for full size):

There’s a definite positive trend there developing for 2010, according to the 52-week rolling average (red line). Eyeing the graph, it looks like the industry hasn’t seen a vacancy increase this steep since at least 2006. It’s still only around 55%, however. As you can see that remains lower than any time shown prior to 2009. Though, I should note, that this upswing is also despite the awful weather that we’ve had for most of 2010 and in late 2009.

Clearly, the hospitality industry can’t celebrate this quite yet — it’s still got a ways to go. But this trend looks to be another piece of evidence confirming that a recovery is taking hold. If people are traveling more, then consumer sentiment and business must be improving.

In order to achieve a robust economic recovery, spending must ramp up. Yet, with unemployment so high, consumer sentiment has been rather weak. That’s hurt spending. But a recent Gallup poll offers some good news: spending in 2010 reached a new high last week. And that’s despite the fact that hiring doesn’t appear to be getting any better.

Here’s a chart from Gallup showing the spending change:

You’re looking for the light green line for 2010. Spending has been doing significantly better in March — now better than last year. Yet, as you can see, spending is still below 2008 levels, though it’s getting closer.

What’s causing people to open their wallets? Not more jobs. Gallup separately found the following about new hiring:

Hiring has been better this year than in 2009, but only slightly. And this year remains much worse than 2008.

So what is causing people to spend more this month? Perhaps it’s the better weather? If people are outside more, they’re probably going to shop more. Or it could be that Americans are finally feeling that the layoffs are over. That could mean the only people still uncomfortable spending are those who really can’t, because they remain unemployed.

At this point, last week’s uptick in spending is notable, but not a huge outlier. If this trend continues over the next several weeks, however, then we might have a legitimate paradigm shift on our hands. That would be a happy result, since a sustained increase in consumer demand could go a long way in creating jobs.

In 2009, CEOs had an even worse year than they did in 2008. Equilar, an executive compensation research firm, published a report today that found chief executive pay down around 13% in 2009 versus 2008. That might come as a surprise: in the second half of 2009 the U.S. economy wasn’t technically in recession, but it was for all of 2008. The report explains that Wall Street may be to blame: the public’s insistence that lofty discretionary bonuses should be rethought influenced boardrooms outside of finance.

First, there’s the shrinkage. This chart from the report tells most of the story: For performance and discretionary bonus payouts, the declines shown are 10% and 21%, respectively. You can begin to see a shift already: performance is being given more weight. The report also asserts that more market uncertainty has made performance bonus payouts more difficult. If you can’t be sure that a firm’s annual performance will reflect long-term viability, then it’s harder to determine how much you should pay an executive based on this year’s performance.

Trends in Performance Metrics

There were also several specific performance metrics Equilar saw gaining popularity in 2009. Here are some highlights:

Additional Holding Periods

More executives are being forced to wait for an extended period of time before collecting their bonus. This is likely a characteristic of firms recognizing that when economic cycles climax they sometimes skew how well a company is actually doing. Since clawing back a bonus once it has been given is generally pretty difficult, a holding period can ensure money won’t be paid out prematurely if things go bad.

Multiple Metrics

Performance-based pay is also taking more variables into account. This is another seemingly sensible evolution. A good CEO maximizes profit, but a great one helps usher success into all aspects of firm culture and competitiveness. As firms increasingly develop multifaceted strategies that extend beyond just making as much money as possible, utilizing additional metrics will help to evaluate performance.

Shift to Equity

Another probable result of the Wall Street bonus fallout — CEOs are increasingly accepting stock awards in lieu of more cash. And they should be: if your compensation is mainly in firm equity, then you have an even stronger motivation to ensure the firm does its best. CEOs should have a lot of their own skin in the game.

I think all of these trends are good ones. Despite the bad press of Wall Street pay over the past few years, incentive bonuses are generally a good idea. They just need to be structured properly. This extends beyond finance. The new metrics that Equilar cites appear to be a step in the right direction.

The Consumer Price Index was flat in February on a seasonally-adjusted basis, according to the Bureau of Labor Statistics. That’s after a very slight rise of 0.2% in January. Monthly consumer price inflation hasn’t been this low since March of last year. Today’s data reiterates the view that inflation should not be a concern in the near-term.

First, here’s the historical graph via BLS:

As you can see, inflation is quite low and has been for some time.

The ever-important core CPI — stripping out food and energy — was even lower, declining by 0.1%. A slightly deflationary core CPI makes for an even stronger argument that inflation shouldn’t be much of a worry right now in the U.S. economy. Generally, a systematic increase in core CPI is what concerns economists. That’s certainly not happening currently. Here’s a graph plotting the 12-month change of CPI and core CPI:

As you can see, core CPI (the red line) has been extremely stable and even appears to be trending down a bit.

Interestingly, energy prices were also deflationary in February, decreasing by 0.5% — the first decline since April. Another standout included apparel, which saw its prices fall by 0.7%. One of the biggest increases was in medical care commodities, where prices rose by 0.8% for the month.

There are some significant policy implications coming out of today’s data, especially if you pair it with yesterday’s PPI data. First, this supports the Fed’s view that inflation will be subdued for the time being. That should help support its desire to keep interest rates low for an “extended period.”

Of course, extremely low inflation will also lead politicians to pressure the Fed not to rein in its monetary supply too soon. There’s little reason to risk weakening the recovery or causing a double-dip recession through excessive monetary tightening with inflation this low.

Reports indicate that Google has teamed up with Sony and Intel to invade our televisions. The tech giants are working together to create new software integrated into TVs and set-top boxes. Details of the companies’ precise plans are limited, but from what we do know it sounds like a pretty smart endeavor.

The New York Times explains:

Some existing televisions and set-top boxes offer access to Web content, but the choice of sites is limited. Google intends to open its TV platform, which is based on its Android operating system for smartphones, to software developers. The company hopes the move will spur the same outpouring of creativity that consumers have seen in applications for cellphones.

Right now, some new televisions and Blu-ray players come equip with software that offers various internet widgets, but in my experience they’ve been quite limited — even frustrating. Google is right to see this as a new opportunity to assert itself in a market that’s bound to grow. If it succeeds in creating a superior product prior to other competitors, then that could also help the exposure of its Android operating system. If you like Android on your TV, you’ll like it on your phone, and vice-versa.

Speaking of competitors, the Times article indicates that Microsoft and Apple are also working on their operating systems for TV. Apple, in particular, could do very well here, especially if it finds a way to leverage its extensive iPhone application store for televisions. I know if I had my iPhone apps through my TV that would be far superior to the five or six lame widgets my TV’s software currently offers.

This also foreshadows where the future of TV is heading: to the Internet. YouTube, owned by Google, is already offered as a widget through many existing TV/Blu-ray operating systems. As the Internet becomes more integrated, traditional on-demand services through cable and satellite will suffer. One could imagine websites like Hulu even making viewers less dependent on those cable and satellite companies’ TV-watching services as well. One day, all our television viewing may stream from the Internet. It’s no wonder Google would want to be a major player in this market.