Author: Daniel Indiviglio

Senate Banking Committee Chairman Christopher Dodd (D-CT) has made two impassioned, and at times angry, speeches on the chamber’s floor in as many days disputing speeches earlier in the week by Senate Republican Leader Mitch McConnell. The minority leader’s speeches contained two major objections to Dodd’s financial reform: it is a partisan bill and it will impose costs on taxpayers to provide more bailouts. Dodd vehemently disagrees on both points.

Is It Partisan?

In his speech yesterday, Dodd reiterated his bipartisan approach. He explained the process used in the Banking Committee where he divided up the work into bipartisan groups of Senators to tackle. Ultimately, the strategy broke down due to disagreements and delays that frustrated Dodd. So he decided to move ahead without a true compromise. But he did leave in some of the Republican-driven components.

So to call the bill a purely partisan effort is not accurate. Currently, the bill does not have bipartisan support, but Democrats did not draft the bill behind closed doors and tell Republicans they had no say. While Dodd did not necessarily take all of their ideas into account, he did include some of them. Even now, sources indicate that Dodd continues to work with Republicans in an effort to achieve a bipartisan compromise.

This contrasts with the House’s financial reform strategy. There, Democrats did draft a bill themselves, which was eventually passed without a single Republican vote. It did have some Republican-led amendments, but any that passed had Democrats on board. Far less effort, however, was exerted in reaching across the aisle to get the House version of the bill done, however. No bipartisan process was employed.

Will It Cost Taxpayers?

Whether or not the Dodd bill provides some wiggle room for the government to still provide bailouts is a debate for a later time. It’s a complex question. But even if the bill does provide for a bailout, would taxpayers be on the hook?

According to the text of the “Orderly Liquidation Fund” section of the bill (.pdf), it’s hard to see how. Dodd seeks to have the FDIC wind down systemically significant firms — sort of like they already do for depository institutions. If there are costs in doing so, his legislation orders the regulator to utilize a $50 billion fund. That is paid for through assessments on the very large firms that it could be used to resolve. Again, this is very similar to how the FDIC’s depository insurance works. Banks get assessed, and if they fail, then the insurance fund pays back depositors.

And the FDIC’s insurance fund costs taxpayers nothing — so neither should the Orderly Liquidation Fund. Even in the event that a deep financial crisis hits causing the FDIC to burn through its $50 billion and need more cash, it could just temporarily borrow that funding from the Treasury. Once the crisis subsides, it can then assess banks to pay back the Treasury. Taxpayers will not bear the cost. 

Dodd spoke Thursday afternoon on this point, saying that McConnell either hasn’t read his bill or is intentionally distorting the truth. Dodd also added that the fund was a Republican idea to begin with that he incorporated into the bill. There are reasons why Republicans might object to the way Dodd set up his resolution authority, but worrying about taxpayers bearing the cost of big bank failures doesn’t appear to be a legitimate criticism.

During a recession, cutting discretionary spending is one step consumers take to deal with their uneasiness. Since it’s just a matter of will and not need, cutting non-necessity expenditures is one of the last temporary behaviors to change once the recovery begins. Dining at restaurants is perhaps the quintessential kind of discretionary spending that gets hit when consumers pull back: for most Americans, it’s easy enough to get cheaper food at the grocery store and cook. Yet recent data shows that even the market for dining out appears to be improving.

Yesterday’s retail spending numbers showed that expenditures at “food services and drinking places” increased in March. Spending was up 0.3% from February and increased 3.2% compared to a year earlier. Granted, the weather may have had something to do with it: no one wants to go out to eat when it’s cold and awful outside, and March provided unusually delightful weather to much of the U.S.

But the New York Times reports on some additional data that shows March’s improvement for restaurants might be more than a blip. One industry analyst the article quotes says that the month’s sales gain may seem small, but it reversed 10 months of negative sales. It’s hard to believe that only weather would have driven such a substantial change. The Times additionally notes that hiring began in the first three months of 2010 in the food service industry, after layoffs plagued the sector for all but three the 25 months of the recession prior to this year.

Yet the restaurant recovery might not be felt everywhere. The Times also reports:

Buddy McClain, who owns 71 Sonic stores in the South, said that while sales were not growing, they had finally stopped falling in March at his Mississippi and Alabama outlets.

But in Florida, a state hit hard by the recession and the collapse of the real estate market, year-to-year sales comparisons have been negative for 17 consecutive months. In March, he said, sales at his Florida stores were 15 percent below the already reduced levels of a year ago.

This could imply that regional economies will come out of the recession at differently times. Indeed, as March’s foreclosure data shows, a handful of states are doing far worse than the others. The top 10 states account for more than two-thirds of foreclosures. March’s state-by-state unemployment data, which will be released tomorrow, may shed additional light on this possibility. But in February, some of the usual suspects most damaged by the housing market’s collapse did suffer from additional unemployed residents, including 21,600 more in Florida — a larger increase than in any other state. Arizona, Nevada and California also saw gains.

Americans are feeling a lot better about the U.S. economy this week, according to a pair of indices tracked by Rasmussen. Investors are very bullish on the recovery. Separately, consumer sentiment has also risen. Both indices are at their highest level since early September 2008 — prior to the climax of the financial crisis.

The first statistic, the Rasmussen Investor Index, measures the daily economic confidence of investors. It rose on Thursday to 103.2, its highest level since early September 2008. It was as low as 52.5 in 2009, but reached 150.9 in 2004.

Rasmussen’s Consumer Index increased to 86.3 today. This is also the highest it has been since September 2008. It fell to 54.7 in 2009 and peaked at 127 in 2004. While it’s hard to strictly compare these two indices, investors’ confidence appears to be relatively higher than consumers’ sentiment. Given how much better the stock market has done than the broader economy, this makes sense.

This news is important because it shows that investors and consumers have psychologically moved beyond the crisis. Sentiment is a very important indicator in economics: it reveals how much money consumers are willing to spend and the amount of cash investors are willing to put into the market. Both actions are necessary for things to improve. So barring additional unforeseen negative economic developments, this trend is another sign that the recovery is underway.

Foreclosures soared to 367,056 in March up 19% from February and 8% higher than March 2009, according to foreclosure data specialist RealtyTrac. That’s the highest level the firm has seen since it began issuing foreclosure reports in 2005. This is a jarring verdict for the U.S. housing market’s supposed recovery. Until March, foreclosures had increased in only one of the prior seven months.

For a visual of how bad this month was compared to those for the past two years, check out the following chart:

RealtyTrac also documents state-by-state foreclosures. Here were the ten worst by foreclosures per housing unit:

As you can see, all but two in this list had more foreclosures in March than February. Some had drastically more, including Georgia up 46%, California up 36% and Nevada up 34%. Nevada continued to be the state with the most troubled housing market last month. In March, one in every 76 housing units in Nevada received a foreclosure filing. California also had a particularly poor month, with its rank rising from fourth worst in February to second worst last month. The top 10 states accounted for more than two-thirds of all foreclosures in March.

RealtyTrac’s March report also includes some analysis on 2010’s first-quarter. It isn’t pretty. During the quarter 932,234 properties received foreclosure filings. That’s a 7% increase from the fourth quarter of 2008 and 16% higher than the first quarter of 2009. One in every 138 U.S. housing units filed for foreclosure in the first quarter of this year.

State-level data for the quarter is also troubling. Again, Nevada was the worst by foreclosure density with one foreclosure for every 33 housing units. Arizona and Florida followed with one foreclosure for every 49 and 57 housing units, respectively. California had the largest in number with 216,263.

It’s pretty hard to glean anything positive from today’s report, but RealtyTrac CEO James Saccacio does so in a roundabout way. He notes that increases in foreclosure activity were skewed towards the final stage of foreclosures, with real estate owned (REO) foreclosures increasing 9% for the quarter. From this, he concludes:

This subtle shift in the numbers pushed REOs to the highest quarterly total we’ve ever seen in our report and may be further evidence that lenders are starting to make a dent in the backlog of distressed inventory that has built up over the last year as foreclosure prevention programs and processing delays slowed down the normal foreclosure time line.

This is good for two reasons. First, delays are shorter. That should allow the housing market hit a bottom sooner, so that the economy can move forward with greater confidence. Second, the month’s high number of REOs ate into some of the shadow foreclosure inventory, an uncertainty that threatens to undermine the economic recovery. If Saccacio is right, then high levels of foreclosure activity should continue for several months until that backlog is cleared, but then drop to a lower “normal” as the rate of new foreclosures slowly declines.

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Too slow, ineffective and unaccountable.

That’s how the Troubled Asset Relief Program’s Congressional Oversight Panel (COP) describes the Treasury in regard to its HAMP foreclosure prevention effort in a report (.pdf) released today. It follows another critical oversight report on the program issued last month by the Special Inspector General of TARP the with many of the same findings. While the COP places some hope in recent changes to HAMP, overall it’s very displeased with the Treasury’s progress thus far.

The COP report lists three main complaints:

Timeliness

The committee asserts that the Treasury isn’t quick enough to determine necessary changes, institute them and generally stop foreclosures. It says that even Treasury’s March revisions won’t be felt until early 2011, by which time millions more Americans will have lost their homes.

Sustainability

Here, re-default is the worry. We’re beginning to get a taste of that from March’s HAMP report. But re-defaults have barely begun. COP is concerned that temporarily lowering mortgage interest rates to achieve smaller payments won’t be enough. First, underwater homeowners may not find it worthwhile to modify if principal is left alone. Second, in five years when the mortgage’s interest rate goes back up under the program’s conditions, borrowers may find their home unaffordable again and re-default. COP writes:

The redefaults signal the worst form of failure of the HAMP program: billions of taxpayer dollars will have been spent to delay rather than prevent foreclosures.

Accountability

This echoes one of the SIGTARP concerns. COP wants the Treasury to measure itself on real success and clear goals — not half-victories and moving targets. The committee also expresses concern about Treasury’s oversight of servicers participating. COP calls for strict enforcement if HAMP rules aren’t followed.

Will Banks Go Along?

Treasury’s March changes really only address the sustainability criticism. If principal reductions do ramp up, then modifications will have a better chance of succeeding. That is, if banks go along.

Some banks are resisting principal reductions. In fact, two of the biggest players in the mortgage market — JP Morgan and Wells Fargo — are open about their dislike of this tactic for modifying mortgages. They said so at a committee hearing Tuesday before the House Financial Services Committee. The two other big banks, Citigroup and Bank of America were mum on the subject, though Bank of America did start a small program to begin principal reductions in March.

It’s easy to understand why big banks fear principal reductions — they will create big, immediate losses. According to its quarterly report (.pdf) issued today, JPMorgan lists $247 billon in mortgages and home equity loans on its balance sheet. Of that $79 billion are considered “impaired,” bought through its Washington Mutual acquisition. The report indicates that the charge-off rate for non-impaired loans is running at 4.9%, while their delinquency rate is at 7.3%. Meanwhile, its impaired portfolio’s delinquency rate is 28.5%. If JPM started writing down a lot of principal from its portfolio to modify loans, then some very large losses would result very quickly, given these ugly statistics.

The Treasury released (.pdf) its March update for its Making Home Affordable Program (HAMP), which seeks to prevent foreclosures. The progress continues to be slow. It offered an additional 57,337 trial modifications and 60,594 more permanent modifications. Those numbers indicate a slight decline in trials and small increase in permanents. The report also includes some troubling data on modification failures.

Here’s a chart showing the progress:

Trial modifications continue to steadily decline. Although permanent modifications experienced a modest increase, this number may have trouble growing as new trials continue to slow.

The report contained some other interesting data as well this month.

First, it appears that the new principal reduction push announced in March hasn’t had much effect yet. In fact, the number of mortgage modifications that utilized principal forbearance actually declined from 27.8% to 27.6% from February to March.

Next, the increase in failed modifications is worrying. There were 88,863 cancelled trial modifications through February. That shot up to 155,173 in March — an increase of 75%. March’s 66,310 trial modifications cancelled essentially erase all of the month’s 57,337 new trials offered, resulting in a net negative number of trials for the month with 8,973 fewer. The large number of cancellations also shows that more trials failed (66,310) than were made permanent during the month (60,594), with a net failure rate of about 5,716. Permanent modifications were also plagued by more cancellations. 1,499 permanent modifications cancellations were reported through February. The number rose to 2,879 in March. That’s an increase of 92%.

Finally, it doesn’t appear the Treasury changed the report very much in response to the Special Inspector General of the Troubled Asset Relief Program’s scathing report. One major concern was its performance metrics, particularly noting that the Treasury measured its success by modifications offered instead of modifications made permanent. Rather than eliminate this metric, the Treasury just shifted it from page four to page six of the report, without replacing it with a better measure of success.

Manufacturing and trade inventories in the U.S. increased in February by 0.5% on a seasonally-adjusted basis, according to the Commerce Department. This increase is small, but larger than January’s 0.2% rise. The inventory-to-sales ratio, another important data point the report provides, remained flat at 1.27. Its value implies that economic expansion and hiring should follow as sales increase.

Here’s a chart showing the inventory-to-sales ratio since 2001, provided by the report:

During the recession, inventories rose while sales declined. That created an imbalance resulting in layoffs. The height of the peak shows part of the reason why unemployment increased so much. At that time, firms ramped up firing to try to match the lackluster demand for goods. Since the start of 2010, however, it looks like the balance is finally getting back to around where it was from 2005-2007.

It’s important to note that this is February’s data — it does not take into account the relatively strong retail sales data also released today from March. It showed retail sales rose by 1.8%. In February, retail sales only increased by 0.2%. This indicates that, unless manufacturers, retailers and wholesalers ramped up their inventories in that month more than sales increased, the ratio should have declined in March. The lower it goes the more need for additional workers to match the demand for products.

Also notable is which sectors saw their retail inventories increase or decline:

Most rose just a bit since January, with all major categories growing less than 1% except autos and parts. Yet that same sector experienced a big 6.7% increase in retail sales during March. So much of that additional February inventory probably got depleted by consumers buying cars last month. Meanwhile a few products actually saw inventories decline further. Clothing and furniture were two notable categories in February where inventories didn’t keep up with purchases.

The decline in inventories from February 2009 shows the massive depletion that stores felt was necessary to respond to weak consumer demand at that time. All categories except food are vastly lower than they were a year ago.

Today’s data is also encouraging because it shows that any business expansion we’ve seen in the first part of 2010 isn’t outpacing consumer demand, with inventory levels remaining nearly flat. Considering how strong retail sales were in March, there’s also reason to believe that inventories will fall during the month — unless more hiring produced additional goods to compensate for the increased buying. Given the current balance of inventories and sales, there’s little reason to believe U.S. businesses should engage in many more mass layoffs unless consumer demand unexpectedly weakens significantly.

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U.S. Retail sales increased in March by 1.6% over February and 7.6% from a year earlier on  a seasonally-adjusted basis, according to the Commerce Department. Sales also beat consensus estimates, which predicted a month-over-month rise of 1.3%. Optimism about retail sales in March had been driving Wall Street’s rally, so this news must come as an even more pleasant surprise to stock traders. Today’s data paints a hopeful picture about consumer sentiment.

The March report shows sales increased almost across-the-board. Here are some major components and their month-over-month rise:

As you can see, only electronics and gas stations saw a decline in sales versus February. That latter group could be mostly due to gasoline prices declining in March by 1%, which could allow for flat or increasing gallons sold but result in a decline in gross sales. Auto and parts sales were up significantly, 6.7%. In fact, they accounted for 1% of the month’s increase.

One notable rise was with sales of building materials. The 3.1% increase could indicate that construction and home improvement are gaining their footing. If so, this would be very good news to an industry that has lost 2.1 million jobs since the height of the housing boom.

That chart also shows the dramatic increase in sales from a year earlier. All categories are up, most by more than 2%. The largest increase was gas sales, which were up 26.4%, but that could be mostly due to the price of gasoline increasing by 41% over the same period. The second most impressive category was autos and parts, which saw a 14% rise. Interestingly, building looks less impressive over the longer time horizon, coming in with a slight 0.5% increase.

The following chart also demonstrates how sales have changed since the recession began in December 2007:

This shows that sales fell a very long way during the recession. They still have a ways to go before they rise to pre-2008 levels. Still, the past year has clearly been a time of improving consumer sentiment.

The Consumer Price Index (CPI) rose just 0.1% in March on a seasonally adjusted basis, according to the Bureau of Labor Statistics. That matched consensus expectations and continues the trend of very low inflation. CPI was flat in February. Today’s data reiterates the narrative that inflation is not much of a concern at this time.

First, here’s a chart showing CPI over the past year:

As you can see, it has been quite low for some time and has been still lower over the past few months.

To accentuate that point, the so-called “core” inflation — that which excludes food and energy — was flat in March. That’s even less than February’s tiny 0.1% increase (revised up from a 0.1% decline). Runaway core CPI is generally what can drive economists’ views on whether inflation is a concern.

The following chart demonstrates just how low core inflation has been since the start of the recession, utilizing a 3-month average to smooth the bumps and better show trends:

Note that the vertical axis has very low numbers. Core CPI barely even peaked above 0.25% during this time. Since the start of 2010, it has been extremely low.

This month, food and energy didn’t have much effect on broader CPI, since food prices increased by only 0.2% while energy prices were flat. The only major component with a price level that ticked above 1% this month was electricity, which rose by 2.1% month-over-month. The biggest price decline was from gasoline, which dropped 1%.

In a longer-term context, CPI’s 12-month change tells mostly the same story. It has been very stable recently hovering in the 2% range. Core CPI appears to be forming a downward trend in 2010, now approaching 1%:

Very low inflation and virtually non-existent core inflation suggests most Federal Reserve bankers and other policymakers probably won’t view inflation as a short-term concern. As Fed Chairman Ben Bernanke provides Congress with an economic outlook this morning, he will likely use the data showing very low inflation to reiterate his view that the central bank can safely leave interest rates low for an extended period. With other economic concerns like high unemployment and a struggling real estate market still worrying, inflation this low doesn’t warrant monetary tightening in the near-term.

Lehman Brothers may have exerted an unusually strong influence over a firm that it sold assets to and then used to obtain funding from third-parties according to a New York Times article today. The piece attempts to have a sort of “aha!” flavor to it, pointing out the fishy relationship between the bank and the firm Hudson Castle. But does the article deliver enough evidence to indicate clear wrongdoing?

First, it’s important to understand what was going on. Here’s an example explained through a diagram provided by the Times:

A simplified explanation: Lehman sold assets to a Special Purpose Vehicle (“Fenway”), which was owned by Hudson Capital. It then sold commercial paper to Lehman, which Lehman used as collateral for a loan from JPMorgan. That provided Lehman with cash the needed.

Things would have been much simpler if JPMorgan had just loaned Lehman money based on Lehman’s own assets, but JPMorgan didn’t want to take on risk associated with the troubled bank. However, JPMorgan didn’t mind being exposed to Fenway, because it didn’t realize that some portion of Fenway’s assets (it’s unclear how much) were actually Lehman’s.

There are two potential problems with this relationship:

First, JPMorgan was presumably unaware that Fenway’s commercial paper was tied to Lehman. Whether or not Lehman did anything wrong here, however, depends on the circumstances. If the now-failed bank intentionally misled JPMorgan or withheld information, then Lehman acted improperly. But if JPMorgan just failed to do its own due diligence, then it only has itself to blame.

Second, you may notice the dotted line that connects Lehman above Hudson Capital in the diagram above. The New York Times bases most of its article on the idea that Lehman had a strong influence over Hudson. The piece implies that Hudson was controlled by Lehman, though backs off from stating this as clear fact. If Lehman did control Hudson, then the situation is very shady. Lehman shouldn’t be selling assets to an entity that’s really an extension of itself only to borrow based on those assets through that entity’s cleaner name.

Unfortunately, the New York Times doesn’t present particularly compelling evidence that Lehman controlled Hudson in the years leading up to the crisis. From the article we know that after 2004:

• Lehman’s business accounted for one-tenth of Hudson’s revenue.
• Lehman had one Hudson board seat.
• Lehman was Hudson’s largest shareholder, but owned only a quarter of the firm.
• Hudson’s president was a former Lehman employee, and brought several other former Lehman employees with him.

While some of these points hint at impropriety, they do not prove Lehman controlled Hudson. Prior to 2004, the relationship between these two firms appeared to be a little cozier, according to the article. Lehman controlled Hudson’s board at that time. The Times also cites a 2001 memo that suggests Lehman had an “unusual level of control” over Hudson. But that control appears to have dissipated after 2004, which is the time period that actually matters in the context of the financial crisis.

Of course, it is possible that Lehman did, in fact, control Hudson and deserves punishment. But if that’s the case, then the New York Times needs some more compelling evidence to prove its point. Without that, the article boils down to a lesson in the dangers of complexity. Financial reform proposals should seek to bring clarity and better disclosure to the shadow banking system to avoid situations like this. If Lehman had been forced to disclose the nature and extent of its relationship with Hudson to its shareholders and clients, then the Times article may never have needed to be written.

The Federal Deposit Insurance Corporation is trying to do its part to respond to the crisis. It has proposed to change how it charges large financial institutions for depository insurance. The FDIC wants additional measures of risk to dictate its assessments on institutions over $10 billion in size. That sounds sensible. But why limit the change to big banks?

Small Banks Can Take On Big Risk Too

Here’s what the press release says will change:

Under the proposal, risk categories and long-term debt ratings would no longer be used. The FDIC would continue to use the supervisory ratings as a factor in measuring risk. The FDIC would replace the financial ratios currently used with a scorecard consisting of well-defined financial measures that are more forward looking and better suited for large institutions. The proposal also includes questions about how to incorporate other risk measures, like the quality of underwriting or risk management practices, in the future.

These changes make a lot of sense. Debt rating was an aspect of finance found to be deeply flawed during the financial crisis, both for bonds and firms. Regulator risk categories had some problems too. A broader set of variables used to evaluate riskiness would force more aggressive firms to pay more for their insurance. Think of it like auto insurance: aggressive drivers often end up paying higher premiums than cautious drivers. Since there are many ways by which a firm can engage in risky behavior, there should be a number of variables taken into account, as the FDIC indicates.

Yet, this doesn’t only go for large institutions — why not apply the same standard to small banks? For example, if a regional bank in Florida had become heavily involved in subprime lending and engaged in very lax underwriting standards during the housing bubble, then shouldn’t it have paid more to the FDIC for depository protection? The savings and loan crisis demonstrated that lots of little bank failures can add up.

Moreover, mostly smaller and mid-size banks failed. Only a few large depository institutions went bust during the crisis, and most of those were ultimately acquired. Obviously, the cost of unwinding bigger firms is greater, but so is their relative premium based on their larger depository base. So why does the FDIC seek to only penalize big banks here?

Today’s proposed rule change seeks to put pressure on large banks to behave more prudently. If they don’t, they’ll have an added cost for their depository insurance. The goal is a safer industry, both through changes in risk appetite and additional cushion in the FDIC’s depository fund to cover failures.

This all sounds great. But again, it’s unclear why across-the-board changes aren’t sought. Directing bank strategy away from aggressive behavior would also be a positive change for smaller institutions. The FDIC should not worry disproportionately about risky behavior on the part of big banks. The loss its resolution fund faces from a hundred banks of $5 billion in assets failing should be similar to that of one firm of $500 billion in size.

The FDIC is right to put additional emphasis on how bank risk is considered to determine depository insurance premiums. But it’s perplexing why the regulator only thinks risk-taking matters for large banks. This rule change would create a system where large banks are penalized for aggressive risk taking while small banks are not.

Gross Assessments Won’t Rise?

The press release also said:

The proposal also would alter the assessment rates applicable to all insured depository institutions to ensure that the revenue collected under the proposed assessment system would approximately equal that under the existing assessment system. Chairman Bair said, “By better differentiating risk among large institutions, the proposal would reduce insurance assessments paid by lower-risk institutions–both large and small.”

The massive wave of bank failures following the crisis has caused some headaches for the FDIC. This was documented in a nice chart in this month’s edition of The Atlantic. Its fund used to wind down institutions and pay out customers got so low that it forced a prepayment of bank assessments through 2012 to ensure it had enough cash to cover claims. That move implies that it didn’t assess firms enough prior to the crisis. So why wouldn’t the FDIC want to collect higher gross premiums going forward? The crisis proved that its fund’s size wasn’t sufficient to guard against severe financial turmoil.

In 2008, the government took historic measures to stabilize the financial industry by providing the Treasury unprecedented power to bail out the banks. Almost immediately after, the controversial move was despised by free-marketers everywhere. However, more pragmatic economic observers noted that they were unsavory, but unavoidable. 18 months later — surprise! — they actually appear to have worked pretty well. Andrew Ross Sorkin notes this revelation in his New York Times column today. Considering the underlying causes of the financial crisis, this should not be a shock.

Stabilizing the Market

The first important objective of the bailout was to stabilize the financial markets. That happened relatively quickly. It should have: when the U.S. government makes a choice to essentially prevent an industry from failing that goes a long way in calming markets. As soon as investors realized that the risk they feared would be covered by Uncle Sam, there was far less fear about banking. The credit crunch then began to lessen.

Several months later, the government decided to conduct a series of stress tests on the largest banks. That confirmed to the market that the Treasury would stand behind these firms. Again, investors were relieved and less worried about risk. The stress tests, thus, made it even less likely the bailouts would fail.

The Causes of the Crisis

Uncertainty drove the credit crunch. Investors and traders suddenly realized they didn’t fully understand some of the securities they owned, many of which relied on a troubled housing market. They also didn’t know how big the losses were that would hit banks that also held these bad assets.

But most banks had limited exposures to these toxic securities and the broader mortgage market. Home prices can only fall so far, so the losses slowed. When the credit crunch hit its climax, many of these assets had to be marked to prices that already reflected very serious loss levels. So some of the bank losses were unrealized at the time they were taken. That would provide banks some cushion going forward and even cause some institutions to see gains if losses turned out to be lower than anticipated.

So once investors got comfortable with the banks again, and the housing market’s bleeding slowed from a hemorrhage to a drip, they got much better. There was no systematic problem in their business models; they just made some really poor assumptions about what would happen in the real estate market. Once that mistake was in their past, they could go back to business as usual.

Not All Bailouts Worked — Yet

It should be noted, however, that not all of the bailouts worked, yet. The big banks that were given money have largely survived, because they didn’t have flagrant business strategy flaws that would limit their future profitability. Firms that the U.S. may lose money on, including Fannie, Freddie and the auto companies, are a different story. There, problems were driven by their business models. Consequently, those bailouts could ultimately fail, unless reorganization strategies work extraordinarily well and these companies manage to pay back the government over an extended time period.

Just because the bank bailout worked doesn’t mean bailouts, in general, are harmless. One statistic that’s hard to track is the damage caused to smaller banks by the government’s implicit guarantee of the bigger ones. Even though the bailout succeeded in stabilizing the economy, government support of private firms does have significant negative consequences. That’s why reform is so important to minimize the need for such bailouts in the future.

The U.S. trade deficit grew by 7%, or $2.8 billion, in February, according to the Bureau of Economic Analysis. The trade deficit, which stood at $39.7 billion for the month, is the measure of how many more goods and services were imported than exported. February’s reading was a little higher than economists’ forecast of $38.5 billion. While both inflows and outflows of goods and services increased, imports grew a marginal $0.3 billion while exports rose by $3.0 billion. This data says a few things about the economic recovery in the U.S.

First, some may find troubling that the $3 billion increase in imports wasn’t for goods and services produced in the U.S. Any import growth wastes consumer demand that could be stimulating the U.S. economy, instead of those abroad. February’s $183 billion in imports would have gone a long way in improving the health of American companies if spent on domestic products.

Second, anyone who believes that exports are the answer to how the U.S. will experience a strong recovery may want to rethink that theory. In 2010, exports have so far been essentially flat. The following chart demonstrates this point:

Although there were some decent gains in exports in the last three quarters of 2009, so far 2010 isn’t continuing that growth. It should also be noted that all of these statistics are seasonally adjusted, so the time of year shouldn’t be a big factor.

If this trend continues — imports increasing while exports remain flat — then that could limit the steepness of the economic recovery in the U.S. If more consumer spending is increasingly benefiting firms abroad, growth for U.S. companies will be smaller than it would have been if that additional spending was on domestic goods and services instead. And U.S. firms aren’t making up that ground through their exports so far in 2010.

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Economist Paul Krugman wrote a piece Monday afternoon in which he appears to argue that it’s impossible to fix the too big to fail problem, so we should just learn how to live with it. He says breaking up the banks won’t help and the government swearing it won’t bail any out firms doesn’t work. On the surface, he’s completely right. Neither of these tactics necessarily accomplishes a safer financial system. However, these options aren’t entirely useless if refined. Krugman’s alternative, which would cater to the systemically risky firms, is also useful to consider.

Breaking Up Firms

Krugman argues that lots of smaller firms failing isn’t necessarily any better than if one big one fails. That’s quite right: the economy would be approximately as much trouble if 100 financial insitutions with $20 billion balance sheets simultaneously failed as it would be if one with a $2 trillion balance sheet failed. He specifically notes the problem of bank runs here.

Yet, size does matter on some level. In particular, the second part of the so-called Volcker rule suggests that financial firms should have liability concentration limits. In other words, each institution would be limited to the amount of exposure it would have to certain types of products, firms and/or industries. While this doesn’t directly call for smaller banks that would likely be the result. If lots of smaller banks develop diverse liabilities, then any one product, firm or sector won’t bring it down. No single economic shock should cause a financial firm to incur losses so great that its capital base can’t withstand them. (Of course, higher capital levels will also help here.)

Ending Bailouts

He’s also right to say that the government can’t simply say, “Okay, that’s it: no more bailouts. Sorry guys!” We saw how poorly that strategy worked with Lehman. It triggered a financial crisis.

But just ending bailouts by deeming it so is different from developing a new regulatory framework which would anticipate and defuse scenarios where a bailout might be sought. Through various mechanisms like a non-bank resolution authority, failure plans, etc. the possibility of unavoidable of bailouts become more distant. Of course, Krugman is right to believe that it’s impossible to say that the government will never have to bail out a firm no matter what. Unfortunately, the future is too unpredictable to make so strong a stance. But that doesn’t mean a system shouldn’t be developed which attempts to accomplish that end.

Krugman’s Solution

Here’s what he suggests:

What is true is that there are bailouts and then there are bailouts. What has to be protected in a crisis are bank deposits and things like bank deposits — basically, bank-created money. Money market accounts and “repo” — very short-term loans in which businesses often park their funds — have to be protected to avoid 1930-31-type collapses. On the other hand, bank shareholders and long-term bondholders can be made to pay a price without collapsing the system.

Here, he appears to be arguing that financial institutions should be more utility-like, with some aspects of their business being protected. Whether he intends to be doing so or not, that sort of goes along with the argument that a non-bank resolution authority would have to insure certain kinds of transactions to avoid a crisis through resolving firms. It would have to worry about these “costs” just like the FDIC has to worry about the “cost” of backing up a bank’s deposits. But if such a system is created, then it must apply to all financial institutions, not just the big ones. Otherwise, smaller ones will be left with a competitive disadvantage not having the same insurance benefit.

Yale Economist and housing market guru Robert Shiller published a piece in the New York Times on Sunday pondering why so many are bullish on the U.S. housing market. He notes that home prices have improved recently, but doesn’t find much reason to assume that they’ll continue to do so. Indeed, major obstacles stand in the way of stable home price appreciation going forward.

Shiller points to a few indicators to support his fear that home prices could stop rising or even begin to fall again. One is the National Association of Home Builders index for prospective home buyers, which he says suggests home prices will decline. He also believes consumer psychology is very different now compared to 2006 regarding the resilience of the housing market.

He continues by noting that the recession appears to be over and the government is pulling back its emergency measures. He then asserts:

Recent polls show that economic forecasters are largely bullish about the housing market for the next year or two. But one wonders about the basis for such a positive forecast.

Momentum may be on the forecasts’ side. But until there is evidence that the fundamental thinking about housing has shifted in an optimistic direction, we cannot trust that momentum to continue.

Shiller is right to be worried about the market’s awakening. Much of it isn’t the kind of buying you want to see in a stable environment. Some reports indicate that speculative home buying has begun to heat up again. For example, house flipping is said to be regaining popularity. Even though home prices haven’t begun rocketing upward, this might indicate that they would be even lower in some regions were it not for investors making speculative bets on real estate.

Like stocks, housing prices are based on expectations. But also like stocks, fundamentals must eventually catch up to forecasts. Those indicators remain mixed at best.

Foreclosures are still increasing. Americans continue to lose their homes in troubling numbers, some due to unemployment, others willingly through “strategic defaults,” and some due to the subprime mortgage products that started the mess in the first place. If interest rates do increase in the months to come that could also put pressure on adjustable-rate mortgages, which have benefitted from the ultra-low rates the market has experienced over the past year.

The Obama administration’s mortgage modification program has slowed foreclosures, but has failed to permanently prevent most. In fact, some of its meager success may turn out to be fleeting if re-defaults ramp up. Since most of the permanent modifications through March were done by temporarily lowering interest rates instead of principal, it’s pretty likely we’ll see many of those ultimately fail.

Then, there’s the shadow foreclosure inventory. Most of the published foreclosure data is only part of the story: banks continue to hold back properties in an attempt to stabilize the market. If all severely delinquent and defaulted homes were suddenly listed for sale, prices might quickly reverse their positive trend.

Finally, no one has any idea what will happen come May. At that time, the home buyer credit will be gone and the Federal Reserve will not have purchased any mortgage securities for several months. By then, the only government support the housing market will be left with will really be the Treasury’s foreclosure prevention program. As mentioned, through March, the effort’s results have been weak. So unless consumer buying sentiment improves significantly without any government incentive, it’s hard to see how housing inventory won’t increase quite a bit at that time. If it does that would consequently put pressure on prices and prove Shiller’s point.

Earlier today, the Dow hit 11,000 for the first time since September 2008, up 68% from 13 months earlier. That appears to indicate that Wall Street is pretty comfortable asserting that the U.S. is in the midst of a strong economic recovery. Yet, a report from Bloomberg today might suggest otherwise: investors are increasingly hedging their bets. Do stock traders believe in their own optimism — or do they smell a bubble?

Bloomberg reports:

The biggest rally in seven decades has left investors so skittish that even forecasts for a 30 percent surge in U.S. earnings are failing to keep them from hedging bets on equities.

The premium on options that insure against losses in the Standard & Poor’s 500 Index over those wagering on gains, known as skew, rose to the highest level since June 2008, data compiled by Bloomberg show. Traders sought protection as shares rallied for six weeks, pushing a measure of momentum that compares stocks with their 50-day average to the most bearish reading in 13 months, according to Bespoke Investment Group LLC.

This news is a little troubling. If the market was in broad, unquestioning agreement on the strength of the U.S. recovery, then such hedging wouldn’t be as prevalent. Instead, investors are protecting themselves from a market reversal. They may not have faith in their optimistic forecasts.

This hedging behavior could indicate that traders worry stocks are getting a little carried away. After all, a 68% return in a little more than a year is quite a rally. It could be that investors know they are enjoying the upside of an unsustainable bubble. If that’s the case, then they would want to continue to participate in the gains, but have some protection for when the market falls back to earth.

Yet, this data doesn’t necessarily indicate cynicism — it could just be smart investing. As mentioned, the market has increased a lot over the past year or so. Even if investors believe in the U.S. economy’s ability to sustain these gains, it’s prudent to take some action just in case they’re wrong. After all, if they really believed a market correction was looming, they would be shorting the market — not merely hedging their long bets. But if this trend continues, then it could indicate more and more stock traders are becoming skeptical that the rally can endure.

A new Treasury investigation will conclude that the FDIC and Office of Thrift Supervision (OTS) are both to blame for failing to properly supervise Washington Mutual (WaMu) prior to its spectacular failure, according the New York Times. The newspaper managed to secure a draft the report early, so the document’s precise findings remain unclear at this time. But according to the Times, the regulators often clashed over the bank before its major inadequacies became apparent. 

Overall, OTS did a poor job evaluating the bank. The NY Times reports:

Although regulators found problems with the quality of the mortgages it had originated and with the wholesale loans it bought through outside brokers and banks, the office consistently deemed WaMu “fundamentally sound,” giving it a rating of 2, the second-highest on a five-point scale used to assess a bank’s condition, from 2001-7. Moreover, the office relied on WaMu’s own tracking system to follow up on regulators’ findings.

The office did not lower the rating to 3 (“exhibits some degree of supervisory concern”) until February 2008, and to 4 (“unsafe and unsound”) until September 2008, days before WaMu collapsed. “It is difficult to understand how O.T.S. continued to assign WaMu a composite 2 rating year after year,” the report found.

The FDIC recognized some of the problems the OTS overlooked, but failed to act:

But the report also leveled unexpectedly sharp criticism at the F.D.I.C., which by July 2008 concluded that the bank needed $5 billion in capital to withstand future potential losses. The report said the F.D.I.C., which had questioned the Office of Thrift Supervision’s assessments of the bank’s soundness, could have stepped in earlier and acted as the primary regulator, but decided “it was easier to use moral suasion to attempt to convince the O.T.S. to change its rating.”

So much for the benefits of regulator coordination? That pressure on the part of the FDIC obviously failed to do the trick quickly enough. When the bank eventually did run into trouble, the OTS wanted to rehabilitate it, while the FDIC wanted a more aggressive effort to reduce the cost of WaMu’s potential failure.

Ultimately, the report concludes that the FDIC should make its own risk assessments of systemically risky banks going forward, says the Times. That seems sensible, given this lesson courtesy of Wamu.

But this incident also could have some broader consequences for the financial reform push in Congress right now. The legislation seeks to eliminate some bank regulator overlap. This incident indicates that is probably a good idea. Moreover, both the House and Senate versions of regulation would abolish the OTS. The WaMu debacle would support this move as well.

Yet would the FDIC have acted if it was the bank’s sole regulator? Then it wouldn’t have needed to pressure OTS to revise its ratings. Maybe, maybe not. If the FDIC was so certain that WaMu’s situation demanded more aggressive action, then it’s hard to imagine why it would have sat back and waited for OTS to get its act together. Instead, it probably just did not want to appear to be too aggressive of a regulator. That problem could persist even if overlap is eliminated. A lesson from the crisis is not only that regulators need to pay more attention, but that they must enforce the consequences of their findings. Observation isn’t enough to avoid another crisis if paired with inaction.

The Dow Jones Industrial Average has surpassed 11,000 today for the first time since September 2008. Yet, the U.S. could still be in recession, according to a statement released today by the National Bureau of Economic Research’s Business Cycle Dating Committee. The group of academic economists declined to declare the recession over. According to the stock market, however, Wall Street would beg to differ. Who’s right? Possibly neither.

Those Conservative Economists

The economists cited above have reason to be reluctant in asserting that the U.S. is in recovery: they don’t want to be wrong. Their discipline is coming out of a very difficult time period when a near-depression caused them to question some of their very base assumptions. The last thing academics want to do is wave a “Mission Accomplished!” flag, only to look absurd again if they’re wrong.

But it’s also reasonable to remain cautious. Unemployment hasn’t shrunk by much; underemployment remains frighteningly high. Although those are lagging indicators, they have an effect on consumer spending. The housing market also remains fragile. Foreclosure rates are still stubbornly high, and it’s hard to gauge how much demand there will be for home buying when the government credit expires in April. Finally, GDP has increased significantly, but much of that could be due just to government stimulus, so it’s hard to determine how much sustainable economic growth has occurred.

With that said, it’s sort of crazy to say the U.S. isn’t in recovery.* GDP growth has been positive for several quarters, some of which appears to be driven by legitimate business activity not directly related to government spending. The financial markets are far healthier than they were 18 months ago. And even the jobless numbers went positive in March, which looks more like a reasonable tick in the trend than a blip. If the U.S. economy sunk again to negative GDP growth in late 2010 or early 2011, would anyone really doubt that the U.S. experienced a double-dip, as opposed to concluding that the 2007 recession is still underway?

Those Crazy Traders

On the other hand, equities have experienced an incredible bull market over the past 13 or so months. On March 9, 2009 it hit a low of 6,547. Today, it soared to 11,020 around noon. That marks a whopping 68% rise over that period. Clearly, traders are betting the recession is well behind us.

But the stock market is a strange beast. It’s not as much about fundamentals as it is about expectations. That should be pretty obvious through the fact that the U.S. economy isn’t 68% better now than it was 13 months ago. Expectations, however, have gotten considerably cheerier. Only the most pessimistic forecasters predict a double-dip at this point. Last week, some economists also began revising their views that unemployment would be as prolonged as was initially thought. They believe the U.S. could be in for a steeper recovery than anticipated.

An argument against that view can be found here. Even if the U.S. is in recovery, structural changes in the economy could prolong joblessness. The unusually high underemployment should also be considered. Although optimism that the U.S. is in recovery seems warranted, a 68% rise in equity prices could involve some irrational exuberance, as the fundamentals aren’t likely to pick up to match such growth in the near-term.

Somewhere In-Between

So Wall Street and the academic economists may both be wrong. The truth may be somewhere in the middle. While the worst appears to be behind the U.S. economy, a steep recovery doesn’t seem particularly likely, given the indicators explained above. So there’s probably reason to be optimistic about the improvement in the economy, if not yet reason to be ecstatic.

* Update: Just to be clear, the economists aren’t saying that we’re still in a recession, just that they aren’t ready to declare that it’s over yet. They generally have a significant lag time between when a recession actually ends and when they declare it over. So their stance isn’t altogether surprising. But it is notable that they certainly aren’t jumping on the runaway recovery train that Wall Street appears to be riding on.

The Internal Revenue Service is spending more time auditing smaller businesses instead of larger ones, according to a new report out today by the Transactional Records Access Clearinghouse (TRAC). Since 2005, the IRS has cut the time it spends auditing firms with assets of $250 million or more by 33%. Meanwhile, the IRS has increased the hours it spends on businesses with assets of $5 million or less by 34%. Yet the report also shows that auditing big firms is much more lucrative than examining the tax returns of smaller ones. Why is the IRS moving in this direction?

Bigger Firm Audits More Profitable

This chart shows how much more money the IRS makes spending its time looking at larger firms:

As the dollars-per-hour figure clearly shows, audits of the larger companies are far more profitable: the IRS earns a whopping $8,329 more per hour auditing firms with assets of $250 million or more than those smaller. This data makes it seem strange that the IRS would make such a shift. Its boss, the U.S. Treasury, collects far more money per hour from the bigger firms.

The Bigger They Are, The Harder the Audit

The report explains that this is due how much longer it takes auditors to examine the bigger firms than smaller ones. Since IRS employees are under pressure to meet quotas, they are steered away from spending more time on the bigger firms — even if that time pays off better. That can be seen pretty clearly by the following two charts. This one shows that the number of firms audited in various size categories isn’t that vastly different across most of the spectrum:

But the hours spent vary greatly:

The IRS Mission?

This raises the question: should the IRS be trying to spread out its effort over roughly the same number of firms of various sizes, or focus on those where it can make the most money? According to its mission:

The IRS role is to help the large majority of compliant taxpayers with the tax law, while ensuring that the minority who are unwilling to comply pay their fair share.

That’s not really a mandate to act like a profit-seeking entity: it’s to catch the firms who aren’t paying what they should be. That could be interpreted to make sure you catch the largest number of firms instead of collecting the most in unpaid taxes. Perhaps the IRS should altar its mission to specifically seek profit, but such an assertion could be controversial.

Auditor’s Instinct?

What this report fails to explain is the judgment factor on the part of IRS agents. It’s plausible that its auditors targets firms where they suspect incorrect taxes to have been paid. Since big firms have very sophisticated tax experts working for them, they should make fewer mistakes. If the IRS is focusing on those they strong suspect of not paying their taxes properly, then that could explain why it has had such dramatic success in its hourly earnings for big firms. After all, large companies have more revenue, so their mistakes would cost them more. But if those big firms are paying their taxes properly, then very time consuming audits could prove a huge waste of time.

More Evidence Reform Is Needed

One clear lesson from this report should be that the tax code needs simplification. If the IRS could spend less time on all audits, it could cover a larger number of firms. A less complex tax code would produce that end. Instead, the IRS feels pressure to spread its scarce resources over smaller businesses so that it can cover more ground. With tax code reform, the IRS could review more companies in less time, which would better ensure that more firms are paying what they owe.

(Nav Image Credit: mdid/flickr)

The Neighborhood Stabilization Program (NSP) isn’t something you read a lot about in the news. Most headlines are grabbed by some of the government’s more well-known interventions such as the home buyer credit and the Treasury’s foreclosure prevention program. But all three are part of Washington’s unprecedented effort to prop up the ailing U.S. residential real estate market. The NSP is a smaller endeavor, but its methods could be more effective than any of the others in staunching the housing market’s bleeding while also creating jobs.

The NSP was first implemented through the Housing and Economic Recovery Act of 2008 (.pdf) during the Bush administration. It allocated $4 billion to “redevelopment of abandoned and foreclosed upon homes and residential properties.” The Obama administration stimulus from 2009 added another $2 billion to the same effort. Through the program, municipalities can purchase foreclosed or abandoned homes, get them renovated and then subsidize their sale to new home buyers with low to moderate incomes.

Such government efforts are controversial, to be sure. Anyone who believes the government shouldn’t be involved in propping up the housing market might oppose the program. But even critics can probably appreciate its lack of moral hazard — the homes sold though this program have already been foreclosed. For it to be effective its funds should be used to accomplish three main goals: reduce the foreclosure inventory, increase employment and revitalize neighborhoods.

Individual municipalities have some flexibility over how they implement the program. A good case study can be found in Pompano Beach, a city in south Florida’s Broward County. The NSP’s 2008 legislation awarded the city $4.3 million in March 2009 due to its extremely high concentration of foreclosures.

How the Program Works

Interim Director Miriam Carrillo and Community Development Specialist Linda Connors of the city’s Housing and Urban Development program provided a hypothetical example of how the program works:

• First, city representatives review foreclosed properties and bid accordingly. Imagine they obtain one for $64,000 (which is their average purchase price).
• Next, they need to bring the house up to code. So they put $50,000 into its renovation (again, the average cost). In total, they would have spent $114,000.
• Then, they find a qualifying buyer (for example, a family of four with an annual income of between $56,950 and $85,440).
• That buyer independently obtains pre-qualification from a bank for a mortgage of $84,000 to purchase the home (average sale cost is between $80,000 and $150,000).
• The stimulus funding covers the $30,000 difference (and can cover up to $80,000 per transaction).
• The subsidy is kept as a 2nd lien that disappears after 20-years, but must be paid before that if the house is sold. This is meant to prevent flipping.

How well does this program stack up to the criteria mentioned earlier?

Reduces Foreclosure Inventory

Only city residents who do not currently own a home are allowed to purchase a property through the Pompano program. That means each house sold necessarily reduces inventory. The new owners also must occupy the home. Having fewer properties for sale will result in house prices stabilizing more quickly.

Increases Employment

Another nice aspect of the Pompano program is its officials’ decision to renovate the homes before sale. Through a competitive process, the city selects contractors to fix up the houses. South Florida’s economy was heavily reliant on real estate during the bubble. As a result, the housing market’s collapse brought on very high unemployment. As of February, the Miami-Fort Lauderdale-Pompano Beach metropolitan statistical area had an 11.3% unemployment rate — higher than the national average of 9.7%, according to the Bureau of Labor Statistics. The construction jobs associated with this program will help employ some of those workers who would be otherwise jobless.

Revitalizes Neighborhood

The program also helps not only the homes it buys and renovates, but those in the surrounding area. When some of a neighborhood’s homes increase in price and become more attractive, the other homes also benefit by their values increasing as well. Again, this will help home prices to stabilize.

Other Features

The program’s design is also good from a fiscal soundness perspective. The funding allocated is all that will be spent: the city takes on no risk. Since private banks fund the mortgages, once the house is sold, the city can’t lose more money than what has been allocated. The government lets banks worry about the creditworthiness of the individual, since the bank will be the one that incurs a loss if the new borrower defaults. And due to the subsidy, the borrower begins with a nice chunk of equity right-off-the-bat, which should lessen default risk.

Of course, Pompano’s program is just one example of many neighborhood stabilization endeavors going on throughout the U.S. The details of other programs may vary, but the objective is the same: reduce foreclosure inventory and stabilize local economies.