Author: Daniel Indiviglio

Over at the Baseline Scenario, Roosevelt Institute fellow Dan Geldon has an interesting guest post. He asserts that free market theorists ruined free market theory by fighting against excessive regulation. I think Geldon is close to making a good point, but doesn’t quite get there. There is a reason why the free market is having trouble these days, but I think it has more to do with the rationality constraint than not enough government intervention in contracts.

Geldon’s post is quite long and very hard to sum it up in only a few words. But he essentially argues that the free market would only work if the government is there to sort of ensure fairness, through regulation. I don’t entirely disagree with that assertion. For example, I think it’s beneficial to the free market when the government takes antitrust action when warranted. I also think it’s important that it ensures that firms can fail — no matter how large or interconnected — without taking the economy down with them.

So from a macro perspective, I see the need for the government to have its hands in certain aspects of the market. But Geldon calls for some more granular instances, like tighter control over contracts:

The corporate assault on comprehensible contracts is important because contract law has been the bedrock of capitalism for a long as there has been capitalism. By enabling free choice, meaningful contracts maximize economic efficiency. The assumption behind von Hayek and other theorists is that robust contract law facilitates a vibrant economic system and minimizes the need for government intervention in the economy. But that went out the window when von Hayek’s theory itself was used to manipulate contracts. Now that products and fine print have become so perverted and incomprehensible, how can anyone expect contracts to steer the market in economically efficient ways?

I’m not as convinced as Geldon that lawyers or bankers drawing up tricky contracts have pictures of von Hayek hanging in their offices. But I think that the freedom to contract is important to free market theory. So while I do understand the problem that Geldon explains, let me try to put it another way.

One of the base assumptions for free market theory is that the actors involved are rational. If that’s the case, precisely no one would ever enter into a contract that they don’t understand. As a result, these complex contracts would be mostly dead-on-arrival: those crafty bankers and lawyers would have no one to contract with, except for the other sophisticated parties who understand the contracts and won’t be fooled.

So what happened over the past few years? Well, we live in an imperfect world where not everyone is rational. So when investors or consumers enter into contracts that they don’t understand, they often lose. This is regrettable, but it’s also just. No one is forcing those investors and consumers to buy, say, collateralized debt obligations or option adjustable-rate mortgages. I have long held a sort of Darwinian view of economics. If you’re dumb enough to risk your money through a contract you don’t understand, then you deserve to lose it.

Unfortunately, life wasn’t that simple over the past few years. The mistakes of some cost many. But I would argue that this had more to do with a failure to provide for a more competitive landscape through the kind of macro regulation I support. For example, if you had an environment with higher capital requirements, lower leverage and all firms subject to failure, then the mistakes of some parties shouldn’t have affected the fate of all parties. Systemic risk mitigation is a legitimate regulatory goal. But I don’t see a place in that for contracts on a more granular level.

Then, Geldon addresses something a little different and makes a fantastic observation, but comes to a slightly off conclusion. Here’s the good part:

The greatest lesson from the crisis that we haven’t yet learned is that “industry interests” and “free-market interests” are not the same. In fact, they are more like oil and water, as the industry profits most in the absence of true market competition.

Geldon is absolutely right. Often industry will lobby government for anti-competitive advantage. That’s why big cigarette companies love current tobacco regulation, for example. But here’s his slightly off-base conclusion:

And so it should be no surprise that Wall Street has devoted itself to making contracts indecipherable, building boundless negotiating leverage and fighting for favorable breaks and regulation at every turn.

It’s just not this simple. As mentioned, much regulation actually benefits industries. For example, a consumer financial protection agency would likely end up benefitting big banks. They’ll understand the rules better for getting new products approved; they’ll be on better terms with regulators, which will increase the likelihood of getting their products through; they’ll have more resources through their scale to pay employees to deal specifically with CFPA issues. A CFPA would worsen competition for smaller firms in the consumer products space, but for whatever reason, big banks haven’t figured this out yet. So the idea that big banks are fighting a CFPA is actually folly on their part — ultimately they’d benefit. Smaller firms, however, would suffer.

And meanwhile, consumers and investors should simply ignore products they can’t understand, or work to gain additional knowledge to enhance their understanding before buying. Then the free market would function well, without the need for an agency of bureaucrats who could very well make the same mistake that naïve consumers would make through poor assumptions about finance. So actually, a well-functioning free market should conflict with a CFPA.

But Geldon is also right — when it comes to systemic risk, like with leverage. There, industry interest definitely does conflict with free-market interests. Banks would lobby for unlimited leverage, but the free market would incur unlimited systemic risk as firms grow larger, more interconnected and more highly leveraged.

Regulation is a complicated game, which is why I continue to say that it should be considered as follows: will a given regulatory effort enhance or stifle competition? A good litmus test is imagining whether smaller firms will be better-off or worse-off if a regulation is enacted. Enhanced government contract control clearly fails this criterion — smaller firms would be better off with greater flexibility. Those parties should have the right to take that risk freely, so long as the economy on a whole is protected if the contract goes awry.

A few months back, I noted that the Federal Housing Administration is running out of money. Consequently, it must increase its premiums and tighten its underwriting policies. According to a new report, that’s exactly what it’s doing. In fact, its new plan makes for significantly stricter standards. But I wonder if Congress will allow the FHA to make these changes.

Here’s the plan, according to FHA Commissioner David H. Stevens, via the Washington Post:

Under this plan, the agency would increase the up-front insurance premium that borrowers pay at the closing table from 1.75 percent to 2.25 percent of the loan’s value starting this spring.

While most FHA borrowers can continue to make down payments of as little as 3.5 percent when they take out a loan, those with a credit score of less than 580 will have to make a down payment of at least 10 percent, possibly starting in the early summer.

The agency also plans to propose limits on the amount of money sellers can kick in, including by paying closing costs or giving free upgrades. The agency will reduce seller concessions from 6 percent to 3 percent of the home’s value, in line with the industry norm, this summer.

Those changes might seem small, but they’re pretty significant. That 50 basis point premium hike will raise borrowers’ up-front payments by nearly 30%. For example, if the up-front premium payment was $1,750 for a $100,000 home, now it’s $2,250.

And for borrowers with worse credit, a 10% down payment is a much stricter standard. Let’s continue with the $100,000 home example above. The down payment would have been just $3,500, but will now be $10,000 for a borrower with poor credit.

The borrower will also be paying more in closing costs or losing upgrades. Again, for the $100,000 home, if a borrower had $6,000 in concessions, now he will only get $3,000.

Let’s think about that total picture. In the examples above, the total up-front costs for the same property increase from $5,250 to $15,250. That’s nearly a 300% increase in up-front costs, for those who like percentages.

I think this plan is quite sensible. The FHA is responding to its too-loose underwriting policies, which led to significant losses. For example, the idea that someone with a credit score below 580 could have made a down payment as low as 3.5% seems like sheer lunacy to me. 10% still seems too low, but at least it’s on the right track. The other measures also seek to enhance its portfolio’s credit quality.

But will this anger Congress and the President? I think it could. As I mentioned in my prior post about the FHA, it’s there to boost the housing market by helping relatively low-income borrowers get mortgages. Obviously, these new standards will make that end more difficult, which means fewer mortgages overall, but certainly fewer for less affluent Americans. Will Congress and the Obama administration object? Stay tuned.

This morning, CNBC had an unusually good interview with billionaire investor Warren Buffett. They talked to him about a variety of topics including Berkshire Hathaway’s 50-1 stock split, Wells Fargo’s earnings and the economic picture. I wanted to note a few of the most interesting things he said, which included President Obama’s banker tax, the stock market recovery and the Kraft-Cadbury deal.

Bank Tax

First, I was really surprised how adamantly opposed Buffett was to the bank tax. I wasn’t shocked so much because it’s such a great idea. Actually, I think it’s a pretty ridiculous idea, for the same reason that Buffett does. He says about the tax:

No, I don’t understand that. If it’s some kind of a guilt tax or something of that sort because banks were among the whole United States that were saved back in 2008, everybody was taken care of then. And the banks, basically, somebody like Wells, it’s cost them a lot of money to be in the TARP and it was basically forced upon them. (They) didn’t want to take the money, but really had no choice. So that’s cost Wells a lot of money. The government’s made a lot of money off Wells. They’ve made a lot of money off Goldman. They’ve made a lot of money off J.P. Morgan. And where they’re going to lose money, at least where its possible they’ll lose money, is in the auto companies. So if you’re going after the people you saved, you might say GM shareholders didn’t get saved, the GM bondholders didn’t get saved. What happened there is they kept employment. I’m the last guy to suggest that you should go and put a special tax on autoworkers. (Laughs.) If you’re really looking for the people who benefited from government losses, you’d have to look there. Or if you look at Fannie or Freddie. Are you going to go and tax the members of Congress who ran Freddie and Fannie?

So it’s not his logic that surprised me — I completely agree with him — but more that he’d so transparently reject an Obama administration proposal. You may remember, during the 2008 election, Buffett was a staunch supporter of Barack Obama. At the end of the day, Buffett is obviously more of an investor than a political operative, but I was still surprised that he wasn’t a little more diplomatic about his stance, given his allegiance to the administration.

Of course, it’s also important to remember that Buffett is a bank investor. So really, the tax on banks is a tax on Buffett. In fact, I would argue that the tax will affect bank shareholders more than bank employees, even though it was likely created mostly as a response to large banker bonuses. As I’ve noted in the past, those bonus numbers detract from the revenue that could be provided to shareholders in the form of dividends or firm growth. Yet, it’s hard for banks to pay its employees less, because they worry about their departure to hedge funds or other financial services firms that can offer better pay. As a result, it’s easier to provide shareholders with smaller dividends or slower growth, both of which ultimately hurt long-term investors like Buffett. For that reason, Buffett also implied that he’d like to see bonuses smaller, so to provide greater returns for shareholders — as you might expect.

Stock Market

Buffett also made a rather interesting remark about the stock market. He was asked whether or not its recovery since last spring is justified. I found this a very good question, since I have hypothesized that irrational exuberance is driving those stock gains, not fundamentals. I believe the economy has an awfully long way to go before the U.S. feels very low employment and overall prosperity again.

Yet, Buffett didn’t seem too concerned about the stock market’s recovery, despite weak fundamentals. And his reasoning made sense: he’s a long-term value investor. And in the long term, he believes the U.S. will be fine, and the stock market will ultimately go up. I completely agree, but that doesn’t change the fact that, in the short-term, there could still be a correction downward from recent highs. So really, Buffett didn’t answer the question about the current rally, because he doesn’t much care about it. He’s looking decades down the road, not at the next few years.

Kraft-Cadbury

Finally, there’s been a lot of talk about his stance regarding the Kraft-Cadbury deal. He owns a whopping 9% of Kraft, so his opinion should matter. He initially opposed the acquisition. He still does. But in this case, Kraft doesn’t need shareholder approval. Here’s his take:

Now they mentioned paying 13x EBITDA for Cadbury, but they’re paying more than that. For one thing, EBITDA is not the same as earnings. Depreciation is a very real expense. But on top of that they’ve got a billion-three they’re going to spend in terms of various rearrangements of Cadbury. They’ve got $390 million of deal expenses. They’re using their own stock, 260 million shares, or something like that, that their own directors say is significantly undervalued. And when they calculate that 13, they’re calculating Kraft at the market price, not at what their own directors think the stock is worth. So the actual multiple, if you look at the value of the Kraft stock, is more like 16 or 17, and they sold earnings at 9x. So it’s hard to get rich doing that. And I’ve got a lot of doubts about the deal.

That 9x earnings he’s talking about above was the price he earlier complained that Kraft recently sold a pizza business for to Nestle. Meanwhile, he sees Kraft buying Cadbury for around 16x or 17x earnings. In other words, Buffett sees Kraft buying high and selling low, which is precisely the opposite of what good investors do. It’s no wonder why Buffett isn’t pleased. And the market must agree, as Kraft’s stock is down 2.5% as I write this.

Buffet talks at length about the economy and banking as well. In case you want to see the entire 56 minutes, check out the two parts below.

Recently it’s become pretty clear that Apple and Google have taken the cozy relationship they had established over the past decade to frenemy status. Google’s Android operating system fueled a new army of smartphone competitors that stole some market share from Apple’s iPhone. In fact, more recently, Google unveiled a mobile device of its own, the Nexus One. Apple also spurred Google by rejecting its Google Voice application for the iPhone. The two former allies are becoming competitors. The most recent evidence of this? Apple may drop Google as the iPhone’s default search engine and replace it with Microsoft’s Bing search.

Bloomberg reports on the development:

Apple Inc. is in talks with Microsoft Corp. to replace Google Inc. as the default search engine on the iPhone, according to two people familiar with the matter.

The talks have been under way for weeks, said the people, who asked not to be identified because the details aren’t public. The negotiations may not be concluded quickly and might still fall apart, the people said.

Interestingly, this article only mentions the iPhone as where Apple would replace Google as default search engine, but doesn’t mention its plans regarding its other devices that run its Safari web browser. If it changes Google as Safari’s default search as well, then that could have an even greater impact on Google. Though, it’s a little unclear why this wouldn’t be Apple’s next step, if it decides to go the Bing route on the iPhone.

Whether Apple ultimately decides to replace Google’s search as the default on its iPhones or not, the report that it’s considering doing so is quite significant. The idea that Apple would even humor becoming a partner with arch-rival Microsoft shows just how big a threat it must view Google as. After all, these days Google is the Microsoft of the 1990s, and Apple must realize that.

And it’s not only Google’s search in Apple’s crosshairs. The article also says:

Apple is also working on ways to manage ads displayed on its mobile devices, a move that would challenge Google’s advertising business, one of the people said.

Apple’s smart to be taking these steps. It continues to try to find additional sources of revenue, and managing ads displayed is just another. While Google isn’t necessarily shaking in its boots over this news, it certainly can’t be pleased. But then, it sort of did move first by challenging Apple’s smartphone dominance.

Putting two news blurbs side-by-side this afternoon makes for an interesting observation. First, Senate Majority Whip Dick Durbin (D-IL) says that if Scott Brown wins the Massachusetts Senate seat, Democrats will consider using the so-called “nuclear option” an unusual, but not quite “nuclear” option called “reconciliation” to push through health care legislation. That would allow them to do so even without 60 votes. Meanwhile, a new Rasmussen poll indicates that Americans’ support of the health care bill is reaching new lows. Now only 38% of Americans favor it, while 56% are opposed. Are Democrats smart to take this route?

Here’s how Fox News reporting on what Durbin sees as possibilities:

First, he said the House could simply approve the Senate bill, sending it straight to President Obama’s desk.

Then, Durbin said, the Senate could make changes to the bill by using the nuclear option, known formally as “reconciliation,” a tactic that would allow Democrats to adjust parts of health care reform with just a 51-vote majority.

“We could go to something called ‘reconciliation’, which is in the weeds procedurally, but would allow us to modify that health care bill by a different process that doesn’t require 60 votes, only a majority,” Durbin said. “So that is one possibility there.”

Thus far, Democrats have stayed away from invoking the nuclear option. [And they would be here too. Despite what Fox News says, this isn’t actually the “nuclear” option as the article implies. See note below.] With 60 votes, they hadn’t really needed it. But if faced with the loss of their 60th seat in Massachusetts, they will no longer have the luxury of a filibuster proof majority. Desperate times may call for desperate measures.

But is this wise? As mentioned, the most recent Rasmussen poll indicates that support for Congress’ health care bill is at its lowest level yet. Do Democrats really want to alienate 56% of Americans and please just 38%? The poll further finds that 44% are strongly opposed to health care reform, while only 18% strongly favor it. Even Ross Perot got more strong support than that — 19% of the popular vote — in the 1992 presidential election.

Democrats would be using an extreme option to push through very unpopular legislation. I’m not a political strategist, but common sense dictations this to be pretty ill-advised. In liberal circles, there’s a feeling that, once Americans see how great health care reform turns out to be, they’ll change their mind. Yet, the benefits aren’t likely to kick in for several years, while the health care fund is built up. So even if they’re right that Americans end up liking the new health care framework ultimately, many Democrats in Congress may be out of work by then.

Democrats really appear to be in a lose-lose situation if Brown wins Massachusetts. If they push through health care reform with fewer than 60 votes, a strong majority of Americans will not be amused. Meanwhile, if they give up, then it would mark a huge defeat for the President and Democrats in Congress, and Republicans would celebrate. I wonder, though, if winning this battle would cause Democrats to ultimately lose a larger political war.

*Note: Sorry I got the terminology wrong — or more believed Fox News had got it right. Thanks to DaveInCalif for pointing that out. Reconciliation is not the same as the nuclear option. More here, if you are interested in details. Although not the nuclear option, reconciliation is also a rarely used procedural measure to avoid filibuster, so the rest of the logic in this post still works.

A few weeks ago, I commented on Bloomberg’s finding that the New York Federal Reserve urged AIG not to disclose some details about its bank swap payments to big investment banks. Since then, the Fed has asserted that it did nothing wrong. Today, there’s additional news: its chairman, Ben Bernanke, says that he’d welcome a full inquiry into the AIG bailout. I say, let’s have one — but don’t expect to find anything too dramatic.

Bernanke’s office released a letter (.pdf) today to the U.S. Government Accountability Office saying:

To afford the public the most complete possible understanding of our decisions and actions in this matter, and to provide a comprehensive response to questions that have been raised by members of Congress, the Federal Reserve would welcome a full review by GAO of all aspects of our involvement in the extension of credit to AIG.

This tells me that Bernanke doesn’t believe that Fed has anything to hide. Presumably, neither does then president of the New York Fed, Treasury Secretary Timothy Geithner. He said he’d testify too.

I think a full inquiry would be useful for two reasons. First, it would better illuminate how the Fed handles these kinds of situations. Not only is that a useful exercise for Congress, but it could also help shape its opinion on whether the Fed is ripe for more authority as the sole systemic risk regulator.

But second, it would put any fears to rest that the Fed broke any laws. I would be shocked — shocked — if it did so. If the Fed did have anything to hide here, it could just continue to deny wrongdoing, but resist a full inquiry, and eventually people would forget and move on. That’s not what it’s doing here.

Yet, that doesn’t mean the Fed necessarily acted as ethically as some might believe it should have in this circumstance. If it did, indeed, urge AIG to provide fewer details, then that won’t please Congress. But it also might be perfectly legal — and I’d bet any actions it took stayed within the confines of the law. Again, Geithner and Bernanke are hardly going to voluntarily provide evidence that the Fed broke laws. But whether the Fed exhibited questionable ethics in the process is quite another matter. I hope an inquiry will sort this out.

For the past several months, talk has been heating up about the imminent creation of a bipartisan debt commission, seeking to reduce the deficit and national debt. Pretty much everyone is in agreement that Washington’s tab is like a runaway train. But almost everyone with any sense also agrees that trying to force that train a sudden, grinding halt right now would throw the economy into chaos. But some concrete plans of how to tackle the problem once the economy can handle it would be nice, and that’s why a debt commission sounds like a pretty good idea. But several challenges lie ahead.

The first is fundamental: who should create it? The Obama administration is ready to do so with an executive order. But some fiscal responsibility advocates in Congress don’t think that’s such a good idea. The Wall Street Journal’s Real Time Economics blog reports that a group, including Sen. George Voinovich (R-OH), is urging the President not to go the executive order route. RTE explains the worry:

The commission is expected to be the centerpiece of a fiscal 2011 budget blueprint, out Feb. 1, that will be swimming in red ink. Voinovich, along with more than a dozen other senators, wants to create the commission with legislation, not the stroke of a presidential pen. That way, the commission’s mandate would have the force of law, and that mandate can force an up-or-down vote on the commission’s recommendations in Congress. An executive order cannot force a vote, and therefore, the senator believes, will be toothless.

I think that’s right. There are a few ways to make this commission worthless. One way would be for it to be seen as having no Congressional authority. Why does President Obama want to go this route? If giving him the benefit of the doubt that he actually wants an effective commission, then the reason must be that an executive order is the only thing that he feels will work.

The article goes on to say that the White House believes Democratic leaders Nancy Pelosi, David Obey and Charles Rangel will fight such a commission, because they won’t want their power watered down. After all, such a commission might actually (gasp!) force them to spend responsibly. Naturally, without a commission, they would exert little effort in striving to reduce the deficit.

And I don’t mean to single out the Democrats: the Republicans aren’t any better on the deficit front. They’ve developed deficit reduction as a major platform position — recently. You might remember that the Republican-controlled Congress under George W. Bush squandered the Clinton budget surpluses through tax cuts. They could have used that money to pay down the debt, but declined to do so. Then the U.S. became embroiled in a war in the Middle East and even more was spent, with less tax revenue to pay for it. That was all before the Great Recession added even more to Congress’s tab.

The problem is that Congress is a subprime borrower. They don’t make enough money (tax revenue) to pay for their spending, but continue to incur additional debt nonetheless. Unfortunately, the bankruptcy code for sovereigns isn’t quite as forgiving as it is for Americans.

I don’t mean to be melodramatic. The U.S. isn’t going bankrupt anytime soon, or probably ever. But the current path is unsustainable. Congress needs to see this unmistakable reality, authorize a debt commission and give it broad powers.

That commission should focus on a debt reduction plan that utilizes economic triggers. It should institute a mix of spending cuts and tax increases once the economy has certain characteristics. For example, it could say something like, “Once unemployment declines to 7 percent, increase taxes by x amount on y band of the population. At that time, also decrease all federal budgets by z percent.” When unemployment hits 6 percent, another trigger can hit, with more drastic debt reduction tactics. And by the way, the commission needs to figure out a way to prevent future Congresses from undoing its work here.

Instead, as Derek noted about a month ago, the commission is likely to take the opposite form: there’s talk that it would require a supermajority to pass the commission’s guidelines. Of course, getting those votes is a completely unreasonable expectation. So the commission’s findings and plans would probably end up collecting dust in the Congressional archives and would largely be ignored. So this is the sort of a constraint that would render a commission essentially useless.

Congress needs to show a little restraint when it comes to its usual love of spending and tax breaks and establish a commission that will produce a real, tangible plan to reduce the nation’s debt burden. If it doesn’t, then eventually its creditors will choose to stop providing the country with any more debt and will force its hand anyway. And that will be a very, very bad day.

I’ve written a few times about last week’s news that Google could exit China in response to its censorship and hacking. Human rights activists everywhere are hoping that other foreign firms will take similar stands. Could Google lead an exodus from the Asian superpower? I have my doubts, but a report from Bloomberg paints an even more pessimistic picture of that potential outcome.

Bloomberg’s article says that Google actually attempted to get other big firms on board to threaten to leave China. And these weren’t just any firms — they were the other firms affected by the hacking that drove Google’s decision. They said no. Bloomberg reported on Friday:

Google announced this week that it was one of at least 20 companies targeted in a “highly sophisticated” computer attack and wanted others to talk about the incident, the person said. The companies refused, and Google made the announcement by itself, the person said.

This is very discouraging news for Google’s effort. If any other companies are likely to exit China’s market, it would be those hurt by its hackers. Yet, even they aren’t on board. Given that fact, I’m not sure what firms would be.

It’s important to remember that not all firms are Google. In fact, very few firms are. Google will likely be just fine without a presence in China. Sure, it will lose potential revenue, but it’s a profit machine. With or without China, Google will be a-okay, particularly in the short-run.

But think about other firms. They aren’t in as comfortable a position as Google. They sure would like a billion potential consumers to sell their products to. They’d also like China’s cheap labor for their manufacturing. Leaving Asia’s most populous, fast-growing nation isn’t nearly as compelling a proposition for them. Even if they don’t like China’s politics, they need to be practical. Their refusal to join one of the most significant firms in the world, Google, in its decision to leave China after this vicious hacker attack shows just how scary the prospect of losing China’s business is for other companies.

Unfortunately, the result will probably be that Google’s decision will have very little impact on the Chinese government’s policies. Even if some other multinationals did follow Google, the Chinese government might have chosen to ignore them. But with other firms disregarding Google’s announcement, Chinese officials will likely view Google as the exception and not the rule anyway. So long as other firms comply with China’s rules, while only grumbling quietly, its government certainly won’t change its ways.

Today, Ted Kennedy’s Senate seat is up for grabs in Massachusetts. Shocking as it may seem, polls indicate that the Republican candidate Scott Brown actually has a shot at beating Democrat Martha Coakley. Like Megan, I have my doubts that this will happen. It just seems beyond belief that Kennedy’s seat could fall into the hands of Republicans.

Still, there’s been a lot of speculation regarding what a Brown win could mean for health care reform. But what about the broader business picture? What would a Brown win mean for the market and business?

Last Friday, CNBC investing pundit Jim Cramer proclaimed that the market would celebrate a Brown win. First he explained that if it causes health care reform’s failure, then the stocks of HMO’s, pharmaceuticals and medical device makers would all take a major hit. But then he continues (full video at end of post):

More important, though, I think investors who are nervous about the dictatorship of the Pelosi proletariat will feel at ease, and we could have a gigantic rally off a Coakley loss and a Brown win. It will be a signal that a more pro-business, less pro-labor government could be in front of us.

In general, I wouldn’t be so convinced that the market would be looking for one specific party or the other to lose its rubber stamp. In general, the market loves gridlock, no matter who is in power. And if Democrats lose their 60-seat filibuster-proof majority, then the investors and traders could be very pleased. Gridlock means less legislation and less political uncertainty. Suddenly political risk has a smaller effect in the equation.

But thinking about some of the major legislative efforts on Democrats agenda, I can also see where Cramer is coming from when singling out Pelosi & co., in particular. First, there’s health care. Although Congress’ reform push is a boon for the medical industry, it would be incredibly costly for everyone else in business. Cap and trade would put business in a similar situation. Some big firms who benefit from receiving the carbon credits for free from the government would benefit, but essentially everyone else — especially small business — would suffer. Pro-union legislation could also be pushed aside.

So my interpretation of the Democrats retaining their majority would be that big business would mostly be just fine, but smaller firms probably won’t fare as well. They’ll have more trouble competing if health care reform, cap and trade and stricter regulation triumph. If those efforts are in jeopardy, then the market could be pleased. A broader recovery in small business would also likely mean a faster economic recovery, since small business is a more major driver for job creation.

Then, there are taxes. They’ll have to rise before too long, given the nation’s deficit woes, but you can be pretty sure that Republicans will resist any tax increases with all their might. Again, the market would love such an outcome. Lower taxes mean higher corporate earnings, which bring higher stock prices.

But ultimately, I’d be surprised if we really had true gridlock, even with a Brown win. Instead, I think you’ll see legislation get through, but it will have a distinctive Republican influence. In the health care reform debate, Republicans had little voice regarding what the bill looked like. If Democrats lose #60, I’d expect that to change. That’s what we’re already beginning to see with the Senate version of financial reform. Other measures that also eventually pass could, again, be reshaped in order to drum up Republican support.

The market would still appreciate such an outcome. It prefers moderate action, because that changes the equation less, as opposed to strong partisan politics. And a Brown win might result in exactly the kind of inaction or weak action by Washington that investors would celebrate.

In its ongoing “What Went Wrong” series, the Big Think interviewed Nobel Prize-winning economist Vernon Smith last week. His responses provided a slew of interesting perspectives on the financial crisis and reform effort. But I wanted to specifically note what he thought to be the future of derivatives: political futures. Whether Professor Smith realizes it or not, the future is already here.

Smith was asked what he believed “might be the next application of derivatives and how might this change the way we live.” He responded:

So far as new applications of derivatives markets I think one possibility is we may see more people making, creating derivatives markets, betting markets on policy, public policy outcomes. We’ve already seen that with regard to the Federal Reserve. There is a market now in which people are able to make, take positions on the likelihood of a change in the Federal Reserve Bank policy at their next meeting of the Federal Open Market Committee, so and these markets are concerned with the question of what the Federal Reserve Bank rate will be set at. So I think we may very well see more of these kinds of markets and this could very well provide some indication of how the participants in these markets evaluate some of the policy proposals that governments are making.

In fact, the derivatives market has already begun to bet on political outcomes. I am familiar with several companies that already engage in this business, the most well-known of which is probably Intrade. For example, right now I can go to Intrade and buy a futures contract based on the outcome of the Massachusetts Special Election to replace Senator Ted Kennedy. Here’s how it would work:

If Intrade says that I can buy a derivative predicting that a Democrat will win the seat (presumably Martha Coakley) for 60 (indicating that this derivatives market predicts a 60% chance of a Democrat winning), then I can buy a derivative indicating that outcome for $6. After the election, if Coakley wins, I get $4. If she loses, then I lose my entire investment.

Of course, like any other liquid derivative, I can also sell the security before the election. Imagine that I had bought the derivative on Friday. But then, a big scandal had struck Coakley this weekend. Her probability of winning subsequently dropped from 60% to 20%. I might not think she has a chance to win at this point, so I sell the derivative to someone today who still thinks she has a chance, but a smaller chance, for $2. I would have lost $4 of my initial investment.

What’s the difference between this and, say, betting on sports? Very little. But what’s the difference sports betting and a derivative based on a company’s stock’s future price? Again, very little. But with financial derivatives, the claim is that there’s a useful business purpose for most derivatives. For example, let’s say I own company A and do a lot of business with company B. If I buy a derivative that bets against company B, then I could be hedging the profits I expect due to the relationship I have with it. If company B fails, and I lose those potential profits, then at least I’ll get some money from my derivative position to cover my losses. Compare that to sports, where the outcome probably has far less of a practical utility, usually.

But do political derivatives have real usefulness? As Washington becomes more and more involved in business and finance, I’d say that they certainly could. Let’s consider an example.

Let’s say that I’m General Electric and it’s 2008 — before the election. I’m trying to decide whether to invest in some new carbon capture technology. Clearly, if the Democrats win, cap and trade has a much better probability of passing, and I would profit handsomely from this investment. What if I could hedge my investment by purchasing a derivative that paid out with a Republican win? Now, if the Republicans win, cap and trade never happens, and the investment turns out to be a loser, but my net loss will be smaller thanks to my hedge. The derivative I purchased will have covered some or all of my investment’s loss.

You can bemoan the fact that these derivatives could be so useful, due to how entrenched politics has become in business, but that’s the reality we live. So I agree with Smith: political outcome-based derivatives are likely to become much more important as the relationship between business and politics becomes cozier and cozier. In fact, as companies like Intrade show, that future isn’t too far off.

The Wall Street Journal’s Real Time Economics blog reports that a bi-partisan deal may have been struck in the Senate regarding a non-bank resolution authority. I’ve argued hard for the creation of such a regulator, to insure that all firms can, in fact, fail — no matter their size. Unfortunately, the report’s description of the Senate’s new vision for the resolution authority has me very worried.

Here’s what it says:

It would create a “presumption” that large, failing financial companies would have to go through a new bankruptcy process. This is different than what the White House proposed, which would give the government immediate control to put large, failing firms through a government-controlled resolution. The Warner/Corker deal would give the government the option to still put failing firms through a government-structured resolution, but they would have to clear hurdles first and it would be a bit more complicated.

This new bankruptcy process is clearly being driven by Republicans. Back in July I was probably the only journalist around who actually took the time to read the Republicans’ dead-on-arrival financial regulation proposal. Obviously, they never had the votes for it to have a chance.

But, in fact, the Republican version’s very first section would create something it calls “Chapter 14” bankruptcy for non-bank financial institutions. In other words, what you’re seeing is the melding of this concept with the House and Treasury’s non-bank resolution authority.

Back in July, I criticized this aspect of the Republican plan, because it’s absurd. I won’t reiterate that argument here, so see that entry for details. But here’s the problem that I see in this new suggestion explained in the block quote above — it makes resolution slower and more cumbersome.

That’s exactly what you don’t want. In the complex world of finance, minutes and seconds matter. If you’ve got a robust, powerful non-bank resolution authority in place, then it will have the power and capability of resolving a large firm very quickly and efficiently. What you don’t want is a lot of barriers mucking that up. Do you really want courts involved? Do you really want to create “hurdles” and make it “more complicated” for the firm to be wound down? That would result in a less stable financial system.

What I find most striking about this development is the power that Republicans wield in the Senate when it comes to banking. I mean, the health care debacle already taught us that the Republicans can have an effect on politics in the Senate. Yet, when it came to health care reform, Republicans weren’t allowed at the table. But from this report, it looks like the Republicans might have far more influence in the financial reform debate than they did in the health care reform process. This news indicates that they’re shaping the Senate bill’s direction. I’m not sure why that would be, other than the possibility that the financial industry lobbyists have a great deal more power over Senate Democrats than even the health insurance lobby.

At any rate, this is very disappointing news. One of the aspects of the House bill I was most pleased with was its non-bank resolution authority. It looks like the Senate is on the verge of screwing that up. Instead, they would create a slow, clunky process that could possibly make things worse.

Over on his Washington Post blog, Ezra Klein has an early obituary for the Consumer Financial Protection Agency, based on a Wall Street Journal report that Banking Committee Chairman Christopher Dodd might not pursue it in the Senate’s version of financial reform. Klein compares the CFPA to the health care bill’s public option. I think that’s actually a pretty valid comparison. He then laments what could have been, if it only weren’t for the Republicans. I think a correction is in order, and I’m happy to provide one.

While Klein is right that Republicans make up the larger portion of lawmakers who oppose the CFPA, it’s simply incorrect to say that they could be responsible for the proposal’s failure. They actually do not have the power to kill it — Republicans alone lack the votes necessary to even filibuster in the Senate. But let’s look at more concrete evidence that there are also Democrats that oppose the measure.

I speculated that the CFPA had a difficult road ahead long before the WSJ’s article announced its fate looked bleak. Back when the House’s version of financial regulation was being considered, I noted an amendment considered that would have killed the CFPA in the bill. The vote barely failed. 223 Democrats voted to protect the measure — it survived by a mere 5 votes. What about the other 34 Democrats who could have voted to protect it? Some voted against it, some abstained. So not only Republicans seek to kill the CFPA — about 13% of House Democrats also don’t appear to be crazy about the idea.

In the Senate, you’ve got a similar situation. They haven’t voted on financial reform yet, but the Democrats have 60 votes, if you include independents Joe Lieberman and Bernie Sanders, who both caucus with Democrats. If they both go along, Democrats can avoid Republican filibuster and pass the CFPA without a single Republican vote. Of course, if Brown beats Coakley in Massachusetts, then all bets are off, and Republicans could filibuster. But last year when Senate Democrats could have stepped up to the plate and pushed the CFPA through, Republicans were powerless to stop them.

Yet, Klein says of the CFPA:

Kill it in a back room before the public has even turned their attention to the issue, and no one will know that it ever lived, or that Democrats fought for it and Republicans took directions from the banks and murdered it.

This statement is clearly false. In fact, Democrats would be responsible for its murder. If they all go along, it would pass. As a result, his anger would be better directed at Democrats, who purport to be the party of the people, for going along with the banking lobby.

That’s the real story here: the financial lobby’s power. While Republicans are certainly more susceptible to the business/banking lobbies, Democrats hardly ignore their campaign contributions and influence. That’s why health care was such a challenge, and it’s why the CFPA may, indeed, have a similar fate to the public option as Klein anticipates.

If you follow the news even vaguely, then you’ve heard about Google’s announcement that it may exit the Chinese market in response to hacker attacks originating in China that sought to access the private information of human rights advocates. I’ve argued that whether Google stays or not, such attacks aren’t likely to stop. So I don’t really see what Google expects to gain from leaving now, as opposed to months or years ago. But today a new wrinkle emerges: the attacks occurred as a result of an unknown flaw in Microsoft Internet Explorer.

Here’s the news blurb, via PCWorld:

Microsoft Security Response Center director Mike Reavey said in an e-mailed statement “This afternoon, Microsoft issued Security Advisory 979352 to help customers mitigate a Remote Code Execution (RCE) vulnerability in Internet Explorer. The company has determined that Internet Explorer was one of the vectors used in targeted and sophisticated attacks targeted against Google and other corporate networks.”

Am I the only one that finds this an interesting plot twist? Microsoft provided the window through which the Chinese hackers crawled through. A few thoughts about this:

First, what is Google doing using Internet Explorer? Shouldn’t it be running its own Google Chrome browser instead? Or at least Mozilla Firefox?

Maybe the excuse here is that it’s impossible for a software company like Google to entirely avoid using Internet Explorer. After all, if it wants to produce browser-agnostic software, then it needs to test its systems in all varieties. So it probably can’t avoid IE altogether, but I wonder if it’s planning to use it even less now, particularly for its external Internet usage unreleated to product testing.

Second, this story is another blow for Internet Explorer. The Google-China spat is big news right now, and this thrusts Microsoft in the center of it. As I mentioned a few months ago, IE is already beginning to give up small chunks of its market share each month to other browsers like Firefox and Chrome. Could this push firms affected by the Chinese attack to also begin exploring other browser alternatives? Will the rest of the Internet-using public take notice?

If Google really wants to live its “don’t be evil” mantra, then it might consider starting an antivirus unit of its own, and/or developing its Chrome browser to be virus proof. In my opinion, other than physical violence, there are few things more evil than computer viruses. They plague unsuspecting Internet users and lead to stolen identities, invasions of privacy, stolen property and incredible inconvenience.

I consider computer viruses technological weapons of mass destruction, and the hackers who create them terrorists. As these foreign-based attacks continue to become more common, the U.S. might want to consider putting more of its defense budget towards preventing them. I don’t begin to doubt that millions of dollars are lost each year because of virus attacks. Eventually that tally will reach the billions, if it hasn’t already.

Verizon Wireless took an important step in the evolution of mobile device service pricing. It decreased its voice prices, but increased the push for more customers to pay for data. I expect other service providers to follow. I believe this trend will continue towards a world where voice charges vanish entirely, but usage-based data charges become more common.

First, here’s the news, via the Wall Street Journal:

The carrier, which is jointly owned by Verizon Communications Inc. and Vodafone Group PLC, lowered the rates for its unlimited voice plan to $70 a month from $100. It also cut its baseline voice plan, which comes with 450 minutes, to $40. Unlimited text messaging costs $20 more for each.

First, the obvious: AT&T and others will follow. That’s how these things work. Verizon has begun a voice plan price war, which is sure to end with cheaper voice rates across the industry. But what about data?

At the same time, Verizon is pushing payment for data plans. Customers who buy a high-end smart phone, which can run applications and surf the Web, already have to pay $30 a month for an unlimited data plan. Now, a $10 plan for 25 megabytes will be required for those with slightly less advanced phones as well.

For some reason, most articles I’ve read on this don’t get the news exactly right. They say that the $10 plan results in a price increase on data. But the way I read Verizon’s website, and after speaking with one of its media contacts, I understand data prices staying flat or actually declining. Let me explain.

The new pricing scheme also eliminates a $19.99 plan for 75 megabytes of usage. So that makes it appear that they’ve increased their price by 50%. But that’s false. First of all, the $9.99/25 megabyte plan was also available before. Second, the old $9.99/25 megabyte plan charged 50 cents per megabyte for data overage. That’s been slashed to 20 cents per megabyte, which means that if you use 75 megabytes, then you pay $19.99 — which is the same as before. But that old $19.99 plan also charged 30 cents per megabyte after that while the new $9.99 plan keeps it at 20 cents per megabyte even after the first 75. That means overage is cheaper.

Of course, very heavy data users are still a lot better off with an unlimited plan for $30 per month.

But it’s true that Verizon did push the minimum $10 data plan onto more of its phones. So it’s herding more users to pay for data along with its voice price cut.

This makes sense. We’ve entered a technological framework where there really isn’t much distinction between voice and data — there’s only data. Applications like Google Voice allow smartphone users to make voice calls through data networks. So I would expect that voice prices will continue to decline, eventually reaching zero. Meanwhile, however, service providers will make sure that more customers are paying for data to replace those losses on voice revenue.

And I would expect those companies to eventually begin increasing the price of data for that reason as well. We’re already seeing the relative cost of data increasing here — since the price of voice declined while data’s stayed approximately constant. I also find it notable that Verizon pushed an incremental plan onto more phones — not an unlimited plan. While a cheaper alternative, it could mark a move towards getting consumers used to paying for data based on usage. There will likely always be high-priced unlimited plans for huge data hogs to enjoy, but these companies would certainly like to make more money off light users through incremental usage plans.

This week, a Federal judge lifted an import band on so-called “e-cigarettes” from China, much to the Food and Drug Administration’s dismay. E-cigarettes are little tubes that look like regular cigarettes, but convert liquid nicotine into an inhalable vapor that simulates the taste of tobacco. But unlike cigarettes, these devices contain virtually no cancer-causing carcinogens, according to their distributors. Why did the judge overrule the FDA here? And more importantly, why is the FDA so against e-cigarettes?

First, here was the judges’ reasoning, via the New York Times:

“This case appears to be yet another example of F.D.A.’s aggressive efforts to regulate recreational tobacco products as drugs or devices,” Judge Leon wrote.

With the passage of landmark tobacco legislation last year, he added, the Food and Drug Administration’s new tobacco division will be able to regulate the contents and marketing claims of e-cigarettes in the same way it is about to begin regulating traditional tobacco products. But the agency’s drug division cannot ban the devices, the judge ruled.

That seems like pretty good logic. But why does the FDA say it doesn’t want to allow e-cigarettes?

The Food and Drug Administration issued a brief statement: “The public health issues surrounding electronic cigarettes are of serious concern to the F.D.A. The agency is reviewing Judge Leon’s opinion and will decide the appropriate action to take.”

So the FDA narrative says it’s a safety concern. Yet, if the claims of the distributors are true — and these devices really do stimulate smoking, but without any of the cancer — why hasn’t the FDA rushed to study the devices for the several years they’ve been available? After all, if the FDA finds that they’re safe, and they catch on, they could prevent cancer in millions of Americans. Shouldn’t that deserve their being pushed to the front of the FDA’s queue?

The problem with this logic is that it assumes that the FDA’s only goal in regulation is ensuring Americans’ safety. Yet, if that was its only concern, then why would cigarettes remain legal at all? There are no health benefits, but they cause cancer. Instead, the FDA would rather regulate. Imagine how much money the government can make by taxing a product that people literally can’t resist.

Of course, big tobacco would certainly concur with the FDA’s decision to ban e-cigarettes. After all, it could seriously damage its business. As the NY Times article notes in its last sentence:

Traditional cigarette makers have not been involved in the fledgling industry.

These two parties seeing eye-to-eye shouldn’t be surprising. Despite the popular misconception that big tobacco and federal regulators would conflict, the two generally agree. Big tobacco actually fights for greater tobacco regulation.

But wait! Doesn’t big tobacco hate regulation? That is, after all, the prevailing narrative. It’s also naïve. I don’t want to run through the whole argument here about why big business, particularly big tobacco, generally loves to be regulated. Instead, I’ll just give you a just a taste by turning to Tim Carney, lobbying editor of the Washington Examiner.

Carney has argued, at length, in two books now (which I’d highly recommend, by the way), that big business loves regulation — it almost always ensures that smaller competition has a hard time gaining a foothold in the market. Regulation protects big businesses’ market share. If you want to better understand why big tobacco, in particular, loves regulation here’s an excerpt from an article he wrote back in 2007:

All regulation adds to overhead, which disproportionately hurts the smaller companies and is more easily absorbed by bigger companies. The Waxman and Kennedy bills would likely lead to federally mandated ingredient testing at the cost of the cigarette company.

It would also give the FDA authority to regulate nicotine and other ingredients. All of these costs will make it much more expensive to manufacture cigarettes, but Philip Morris, with its economies of scale, will be less affected. If legislation adds to your costs, but adds to your competitors’ costs even more, it’s a net gain for you.

One of the ways that the government managed to pass its recent tobacco reform bill was by enlisting big tobacco’s support. So the FDA and big tobacco have a symbiotic relationship. The government gets billions of dollars from excise tax revenue on and lawsuits related to cigarettes. Big tobacco gets regulation that makes it harder for smaller companies to compete. So the FDA needs to keep up its end of the bargain here and not allow a threat like e-cigarettes to take hold in the U.S. — even if they did turn out to be good for the American people.

That’s essentially the question asked by Gallup’s Well-Being Poll. Its results for 2009 are in. America’s well-being in 2009 looked an awful lot like it did in 2008. Actually, it looked identical — according to the Overall Well-Being Index Composite Score. Given what an awful recession the U.S. was in during 2009, you might suspect shenanigans. But the result kind of makes sense, when looking deeper into Gallup’s methodology.

In fact, most measures of well-being were down, while only one was up. Here’s a chart with the full results:

As you can see, the only sub-index score that actually increased year-over-year was the “Life Evaluation Index.” So what was this mystical category of well-being that was so substantially better in 2009 that it overshadowed all of the other categories’ decline? According to Gallup:

The Life Evaluation sub-index is based on the Cantril Self-Anchoring Striving Scale, which asks people to evaluate their present and future lives on a scale with steps numbered from 0 to 10, where 0 is the worst possible life and 10 is the best possible life. Those who rate today a “7” or higher and the future an “8” or higher are considered to be “thriving.” Those who rate today and the future a “4” or lower on the scale are considered to be “suffering.” The overall Life Evaluation Index score is calculated as the percentage of thriving Americans minus the percentage of struggling Americans.

I think that sort of makes sense, because it sounds like the Life Evaluation Index is more forward looking than the others. You may remember that 2008 was a year — particularly the second half — of great uncertainty and pessimism. The economic world as we knew it was crumbling around us. Americans likely didn’t know what to think about their future, but it didn’t look good.

In 2009, however, stability ensued. Even though unemployment increased and the recession continued, I find it completely plausible that people would have been more optimistic about the future in 2009 than in 2008. But given all that unemployment and recessionary agony, I’m also unsurprised that all those other sub-indices showed declines in 2009.

The Work Environment Index is particularly notable, since it had the largest decline. Gallup explains:

The Work Environment Index includes four items: job satisfaction, ability to use one’s strengths at work, trust and openness in the workplace, and whether one’s supervisor treats him or her more like a boss or a partner.

So what drove that down? How about unemployment increasing from 7.4% to 10%? It’s hard to have trust in the workplace or feel like your boss treats you like a partner when you’re worried a pink slip could be in your future. I know I never felt worse about my work environment when at a firm undergoing mass layoffs (before I came to The Atlantic!). And you can hardly use your strengths at work when there’s little to do there, in an economy that has come to a near-halt.

As the net job losses come to an end (let’s hope in 2010), this and other well-being factors might get better. But if 2010 turns out to be a completely stagnant year, that future optimism that held the line in 2009 could suffer and result in a lower overall well-being score for 2010. And if, somehow, we end up in a double-dip recession, then all bets are certainly off.

Foreclosure data tracker RealtyTrac released its final 2009 foreclosure statistics today. The results, as you can probably imagine, are ugly. The U.S. had 2,824,674 foreclosed properties. That’s a 21% increase from 2008 and a 120% increase from 2007. Yet, the results vary widely on a state-by-state basis. You may be able to guess a few of the worst-hit states, but the depth of their pain is rather astonishing.

There are a few different ways you could try to determine which states were the worst — depending on what measure you use. If you want to compare total foreclosures, then California ranked #1, with 632,573 foreclosed properties. Florida followed with 516,711. Arizona was a distant third with 163,210 foreclosures.

But since California and Florida are pretty highly-populated states, it isn’t necessarily fair to call them the worst, in my opinion. I’m more interested in how many foreclosures each state had per housing unit. That levels the playing field. Luckily, RealtyTrac provides that data as well. Now the worst state is Nevada, with a whopping one foreclosure for every 10 properties. Arizona follows with one foreclosure for every 16 properties. Florida is right on its heels with one foreclosure for every 17 properties.

And yet, not all states had it so bad. Some states actually had fewer foreclosures in 2009 than in 2008 and 2007. Nebraska actually had 42% fewer foreclosures in 2009 than in 2008, and 49% fewer in 2009 than in 2007. The other solid performance came from North Carolina. The state had 16% fewer foreclosures in 2009 than 2008, and 2% fewer in 2009 than in 2007. Six other states had fewer foreclosures in 2009 than in 2008, but all the rest had more foreclosures in 2009 than in 2007.

Flirting with 3 million foreclosures nationally in one year is pretty awful. That’s one in every 45 properties in the U.S. But at least 2009 experienced some housing demand. The government home buying incentives and low mortgage interest rates towards the end of the year did manage to conjure up (or at least pull forward) some demand for buyers. So those foreclosures didn’t all become excess inventory.

Yet, I worry that some home buyer fatigue may set in for 2010. In a recession this deep, there are only so many Americans left who have the interest and financial audacity to purchase a home, after the large number who purchased last year. So I have my doubts that this year’s housing demand can stack up to 2009. But I certainly hope that this is one of those times I’m wrong.

These days, it seems like every time we get some good news, we get some bad news to go with it. But for December, the bad news seems to be piling up on itself. Last week I wrote about the month’s negative unemployment report: the U.S. lost more jobs following some ever-so-slight job growth in November. But today’s news casts even more doubt on impending recovery. Retail sales and inventories both appear to be headed in the wrong direction.

Bloomberg/BusinessWeek reports:

Sales at U.S. retailers unexpectedly fell in December following a bigger gain than previously estimated the prior month, highlighting the risk that the largest part of the economy will be slow to recover.

The 0.3 percent decrease came after a 1.8 percent jump the prior month, Commerce Department figures showed today in Washington. Other reports showed inventories rose more than forecast in November and jobless claims climbed last week.

So retail sales reinforce the news that November was great. But they also confirm that December was not-so-great. Without solid consumer spending, it will be difficult for companies to justify more hiring.

And inventories rose more than thought in November. So, despite the decent sales that month, we still saw more production than purchasing. And given that December’s sales were weak, I’d expect that inventories rose even further last month.

Of course, 2009 is over, and thank God. But if it left excess inventory in its wake for the first part of 2010 to deal with, then that decreases the likelihood that we’ll see significant job growth towards the beginning of the year. Given December’s unemployment report, that’s probably not surprising, but does confirm our fears.

The New York Times has an article today with the headline, “Justice Department Fights Bias In Lending.” Without thinking too deeply about it, I assumed that this meant certain groups of Americans weren’t being given as many loans as others or worse terms. That led to my worrying that “bias” here could just be better termed “underwriting standards.” And, indeed, if the article did criticize lenders for not giving loans to individuals with lower incomes and/or worse credit records, then I would have been right.

But it actually involves the opposite situation: too many loans being given to people with low income and poor credit histories. The solution there, however, would probably more effectively addressed by additional regulation than the Justice Department.

To be sure, this is a counterintuitive concept. Why would lenders want to give more loans to people who would be less likely to pay them? Of course, you only need to look back to subprime mortgage fiasco during the housing boom to find an answer. Yet, then it was assumed that those loans actually would perform well, since the housing market was booming. Now that’s changed, but lenders are still giving out loans to borrowers who can’t afford them. Why?

The New York Times explains:

While past lending discrimination cases primarily focused on “redlining” — a bank’s refusal to lend to qualified borrowers in minority areas — the new push will instead center on a more recent phenomenon critics have called “reverse redlining.”

In reverse redlining, a mortgage brokerage or bank systematically singles out minority neighborhoods for loans with inferior terms like high up-front fees, high interest rates and lax underwriting practices. Because the original lender would typically resell such a loan after collecting its fees, it did not care about the risk of foreclosure.

What we’ve got here is an incentives problem. Many lenders ultimately sell the mortgages or other loans they originate to others, and along with them goes the default risk. One solution often mentioned is to force lenders to keep some skin in the game and retain a portion of the risk for the loans they originate. The problem with that idea, however, is that it will make credit more expensive, since lenders will have to hold additional capital against that risk.

But if we lived in a world where lenders weren’t able to collect up-front fees, then they wouldn’t originate as many bad loans — even if sold. Imagine the following scenarios where a mortgage broker originates a $100,000 loan to a borrower with poor credit:

Scenario 1 (with fees, subprime borrower):

The broker also gets a $5,000 fee for originating the loan. He then sells it to a bank that pays him $96,000 for the loan, the present value of the loan to the bank based on its internal cost of capital and default risk assumption. But that’s okay with the broker, because he still makes $1,000 on it, thanks to the fees.

Scenario 2 (without fees, subprime borrower):

The broker gets no fee for originating the loan. He then attempts to sell it to a bank. But the bank will only pay him $96,000 for the loan, given the inherent risk. Uh oh. The broker realizes that this isn’t a good business and immediately becomes a mailman instead — a good, clean living.

Sounds great right? Not necessarily. We may want a world in which you could still have honest mortgage brokers to originate good mortgages. Luckily, they probably won’t all opt to be mailmen, as I joked. Instead, imagine yet another scenario — the one we want!

Scenario 3 (without fees, prime borrower):

The broker gets no fee for originating the loan. He then sells it to a bank. That bank will pay him $101,000 for the loan, because it has good credit quality and, consequently, a much lower risk profile. That lower likelihood of default means the bank will profit on the loan through the interest payments that will continue for the life of the loan.

A framework without origination fees would result in the loan’s risk being taken better into account because the original broker could only profit by selling loans with present values that exceed their principal values. With fees, you have the bizarre situation where loans are sometimes originated with negative net present values. That makes no sense. Eliminating origination fees would get rid of the ridiculous incentive to originate as many loans as possible, no matter their quality.

Yesterday, I noted that the Obama administration would likely be imposing a temporary tax on big bank leverage. While I found it an odd short-term policy, I explained that there is an argument for a leverage tax in the long run, in order to reduce banks’ incentive for taking more unprotected risk. But I also said that I’d prefer a simpler approach instead, where regulators just created more conservative leverage requirements. I wanted to be a little more specific.

As a matter of fact, I’m not against the idea of banks who engage in higher risk activities needing to set aside additional capital to cover potential losses in a failure event — I’m actually for it. I’m more against the idea that this should be a tax. I share commenter Claudius’ view as to why. First, he quotes my saying:

The tax revenues could sit in a sort of “just in case” fund, to be used in times of financial emergencies. Then, if another financial crisis hits, any costs borne by the government in cleaning up the mess could be covered by the fund.

And he responds:

HAHAHAHAHAHAHAHA!!!!! Stop, my sides hurt! When has the Congress EVER allowed a pile of money to sit there ‘just in case’?!

I probably would have put it a little more diplomatically, but I think that point is right. Prime example: the Social Security fund. That’s how Congress treats money that has been “set aside.” In that case, Congress “borrows” from the Social Security fund. And then, through logic that only Washington can understand, pays itself interest on that money that it borrows from itself. So not only does it spend that money, but it incurs additional debt by spending that money.

The point is that neither Congress nor the Treasury should have control over an emergency fund like this. But that doesn’t mean there isn’t a strong argument for such a fund existing. The idea that a sort of insurance fund could cover the costs when firms get into trouble isn’t a novel one. That’s literally the Federal Deposit Insurance Corporation’s business. But it doesn’t collect its insurance premiums through a tax; it does so through an insurance premium on deposits.

So what I would ultimately suggest is a hybrid reform. First, you need some reasonable leverage limits put in place, but you have to allow banks to take some risk and use some leverage. Then, the higher a bank’s risk level within that framework, the more money that it should be required to pay into an insurance fund guarded by whoever turns out to be the soon-to-be-created non-bank resolution authority. That will probably be the FDIC. Given that it has a good track record of its deposit insurance fund remaining protected from the greedy clutches of Congress, I find no reason to believe another fund to pay for non-bank resolution would have a different fate.

Leverage may or may not be the right measure to evaluate the fees that banks should pay into that resolution fund. But I’d prefer broader criteria. One bank with 10x leverage could be riskier than another bank with 20x leverage, depending on how risky the assets are in its portfolio. So leverage alone isn’t enough to determine how costly resolution could ultimately be. As a result, I’d prefer a more rigorous, case-by-case approach to determine the how large assessments on these institutions should be to ensure taxpayers don’t get stuck with the bill for their resolution, if necessary.