Stagflation and Stupidity

The two things I heard from Ben Bernanke’s testimony before the Joint Economic Committee yesterday: stagflation and stupidity.

On stagflation:
Mr. Bernanke’s testimony started out OK:

“On preliminary estimates, real gross domestic product (GDP) grew at an average pace of nearly 4 percent over the second and third quarters despite the ongoing correction in the housing market. Core inflation has improved modestly, although recent increases in energy prices will likely lead overall inflation to rise for a time.”

OK, 4% GDP growth with a little inflation pressure, not bad. Sounds like there should be a neutral policy with maybe a slight bias toward a rate hike. Not so fast. There’s a bit of trouble afoot in the credit markets. The Chairman acknowledged that investors got a lot of the risk calculation wrong on many financial instruments. He said “At one time, most mortgages were originated and held by depository institutions. Today, however, mortgages are commonly bundled together into mortgage-backed securities or structured credit products, rated by credit-rating agencies, and then sold to investors. As mortgage losses have mounted, investors have questioned the reliability of credit ratings, especially those of structured products.” (I hope Senator Schumer was listening to the part about the rating agencies as that point was absent from his report on the subprime mess – see my commentary for more on that.) The impact of this has not yet run its course.

“To be sure, the recent developments may well lead to a healthier financial system in the medium to long term: Increased investor scrutiny of structured credit products is likely to lead ultimately to greater transparency in these products and to better differentiation among assets of varying quality. Investors have also become more cautious and are demanding greater compensation for bearing risk. In the short term, however, these events do imply a greater measure of financial restraint on economic growth as credit becomes more expensive and difficult to obtain.”

In other words, the credit market issues are only beginning to spill over into the broader market, and the “short term” impact will be slower economic growth. He later made some comments that would suggest his estimate of short term is the spring of 2008, but he did not have much conviction on that point.

The Chairman then went on to review FED actions over the past few months leading up to the October meeting, including the injection of excess reserves into the system and 50 basis point reduction of the discount rate in August, and the September 50 basis point cut in the federal funds rate and discount rate. Then came the reasoning behind the 25 basis point rate cut in October (which I thought was a mistake).

“Looking forward, however, the Committee did not see the recent growth performance as likely to be sustained in the near term. Financial conditions had improved somewhat after the September FOMC action, but the market for nonconforming mortgages remained significantly impaired, and survey information suggested that banks had tightened terms and standards for a range of credit products over recent months. In part because of the reduced availability of mortgage credit, the contraction in housing-related activity seemed likely to intensify. Indicators of overall consumer sentiment suggested that household spending would grow more slowly, a reading consistent with the expected effects of higher energy prices, tighter credit, and continuing weakness in housing. Most businesses appeared to enjoy relatively good access to credit, but heightened uncertainty about economic prospects could lead business spending to decelerate as well. Overall, the Committee expected that the growth of economic activity would slow noticeably in the fourth quarter from its third-quarter rate. Growth was seen as remaining sluggish during the first part of next year, then strengthening as the effects of tighter credit and the housing correction began to wane.”

So, in the committee’s judgment, there is downside risk to the economy and, in fact, every expectation that economic growth will be anemic for the next couple of quarters. In addition to the outlook, however, there is also downside risk that could make things worse. “One such risk was that financial market conditions would fail to improve or even worsen, causing credit conditions to become even more restrictive than expected. Another risk was that, in light of the problems in mortgage markets and the large inventories of unsold homes, house prices might weaken more than expected, which could further reduce consumers' willingness to spend and increase investors' concerns about mortgage credit.” This is recession speak in my view. If the expectation is already for weak economic growth, worse than that likely means contraction. So we see some real concern here about the economy from the FED leading up to the October rate cut. So absent inflation concerns, the accepted strategy would be a rate cut. Lets look at what he had to say about inflation.

“The Committee projected overall and core inflation to be in a range consistent with price stability next year. Supporting this view were modest improvements in core inflation over the course of the year, inflation expectations that appeared reasonably well anchored, and futures quotes suggesting that investors saw food and energy prices coming off their recent peaks next year. But the inflation outlook was also seen as subject to important upside risks. In particular, prices of crude oil and other commodities had increased sharply in recent weeks, and the foreign exchange value of the dollar had weakened. These factors were likely to increase overall inflation in the short run and, should inflation expectations become unmoored, had the potential to boost inflation in the longer run as well.” Sounds like there is some upside risk to inflation here as well, so maybe a rate cut is a bit risky? Here is what the Chairman said about it:

“Weighing its projections for growth and inflation, as well as the risks to those projections, the FOMC on October 31 reduced its target for the federal funds rate an additional 25 basis points, to 4-1/2 percent. In the Committee's judgment, the cumulative easing of policy over the past two months should help forestall some of the adverse effects on the broader economy that might otherwise arise from the disruptions in financial markets and promote moderate growth over time. Nonetheless, the Committee recognized that risks remained to both of its statutory objectives of maximum employment and price stability. [emphasis added] All told, it was the judgment of the FOMC that, after its action on October 31, the stance of monetary policy roughly balanced the upside risks to inflation and the downside risks to growth.”

In other words, at the time of the rate cut there were risks that economic growth could slow significantly, and that inflation could become a problem. What has happened since the October 31 rate cut decision (only 8 days prior to the testimony)? According to the Chairman:

“In the days since the October FOMC meeting, the few data releases that have become available have continued to suggest that the overall economy remained resilient in recent months. However, financial market volatility and strains have persisted. Incoming information on the performance of mortgage-related assets has intensified investors' concerns about credit market developments and the implications of the downturn in the housing market for economic growth. In addition, further sharp increases in crude oil prices have put renewed upward pressure on inflation and may impose further restraint on economic activity. [emphasis added]”

There it is – stagflation. Slower economic growth AND inflation equals stagflation. Now, the Chairman did not say we are experiencing stagflation. If inflation does get worse, that could be because the economy continues to grow. If growth suffers, that could limit inflationary pressures. But both of those possible outcomes are now clouded by the specter of both slowing economic growth and inflation, or stagflation, because of rising oil prices plus the pressure on the dollar and its impact on prices of imported goods. The inflationary impact of the dollar decline is somewhat muted by our trade imbalance with China because the exchange rates of the currencies are manipulated, but I hate to count on that for economic security in the US. Ron Paul summed up the negative outlook by pointing out that so long as we inflate our way out of excess consumption the dollar will decline leading to inflation, and given the lose monetary policy of the recent past we are now without options to fight either inflation or slow economic growth unless we align consumption with output – i.e. recession. This is the Senators way of saying the credit binge must end somewhere, and it may just be here. That would mean that the FED is stuck between the proverbial rock and hard place. If it follows an expansionary policy of lower rates inflation could spiral up, and if it follows a contractionary policy to contain inflation it could depress an already shaky economy. What did Mr. Bernanke have to say about all of this?

“The FOMC will continue to carefully assess the implications for the outlook of the incoming economic data and financial market developments and will act as needed to foster price stability and sustainable economic growth.” Is it time to redefine “price stability” and “sustainable economic growth”? Maybe it is. For now we are “data dependent.”

On Stupidity:
Every now and again I here a stupid idea thrown about or I read a “report” to some congressional committee that makes no sense. I don’t mean an idea that just sounds different. I mean one that you hear with disbelief followed by a realization that you actually did hear what you thought you heard. You expect it once in a while, but when it comes directly from elected officials and their appointees, it takes on a whole different character.

Yesterday I witnessed an exchange between Senator Schumer and Ben Bernanke before the Joint Economic Committee of Congress. Senator Schumer pressed Mr. Bernanke on ways in which Congress could help the mortgage market, and whether increasing the caps on the size of mortgages that Fannie Mae and Freddie Mac can make (currently $417,000.00) would be helpful. Mr. Bernanke went on to say that the caps could be increased to $1 million per loan, and that to reduce the risk to Fannie Mae and Freddie Mac from this increased exposure, the federal government could guarantee those loans. That’s right, you read that correctly. The government sponsored entities set up to help expand affordable homeownership should be used as vehicles to make mortgages of up to $1,000,000.00, and your tax dollars should guarantee those mortgages. I almost broke the television set when I heard it. If you need verification, you can read about it in The WSJ Online Edition.
(I was going to forget about this whole exchange until it gained some validity through publication of this WSJ article.)

Lets start with the missions of Fannie Mae and Freddie Mac. First from Fannie: “Fannie Mae is a shareholder-owned company with a public mission. We exist to expand affordable housing and bring global capital to local communities in order to serve the U.S. housing market.


And here is Freddie Mac:

“Our mission strives to create:
· Stability: Freddie Mac's retained portfolio plays an important role in making sure there’s a stable supply of money for lenders to make the home loans new homebuyers need and an available supply of workforce housing in our communities.
· Affordability: Financing housing for low- and moderate-income families has been a key part of Freddie Mac’s business since we opened our doors. Freddie Mac’s vision is that families must be able both to afford to purchase a home and to keep that home.
· Opportunity: Freddie Mac makes sure there's a stable supply of money for lenders to make the loans new homebuyers need. This gives everyone better access to home financing, raising the roof on homeownership opportunity in America.”

In short, these entities exist to “expand affordable housing” by providing a “supply of money for lenders to make the home loans new homebuyers need and an available supply of workforce housing,” and “Financing housing for low-and moderate-income families” and “new homebuyers.”

Just what is “affordable housing?” Here is what The Department of Housing and Urban Development has to say about it: “The generally accepted definition of affordability is for a household to pay no more than 30 percent of its annual income on housing. Families who pay more than 30 percent of their income for housing are considered cost burdened and may have difficulty affording necessities such as food, clothing, transportation and medical care. An estimated 12 million renter and homeowner households now pay more then 50 percent of their annual incomes for housing, and a family with one full-time worker earning the minimum wage cannot afford the local fair-market rent for a two-bedroom apartment anywhere in the United States. The lack of affordable housing is a significant hardship for low-income households preventing them from meeting their other basic needs, such as nutrition and healthcare, or saving for their future and that of their families.”

Nope, doesn’t sound like a homebuyer with a $1 million mortgage to me.

What is “workforce housing”? According to Wikipidia, “Workforce housing is a relatively new term that is increasingly popular among planners, government administrators and housing activists, and is gaining cachet with home builders, developers and lenders. ‘Workforce housing’ can refer to almost any housing, but always refers to ‘affordable housing’.”
Nope, that doesn’t sound like a homebuyer with a $1 million mortgage either.

What are low- and moderate-incomes? Whatever they are, they are not applicable to the purchaser of a home with a mortgage of $1 million. I don’t even need to look that one up!

Mr. Bernanke is generally a very reasonable person in my view, although I disagree with FED action on occasion. In light of this, I decided to look up more about his position on Fannie and Freddie going outside the scope of their missions to provide mortgage financing for people purchasing homes in the $1 million range (actually with a mortgage of $1 million the purchase price could be as high as $1,250,000 at 80% loan-to-value). Here is what I found from a March 6, 2007 MSNBC report: “Federal Reserve Chairman Ben Bernanke urged Congress on Tuesday to bolster regulation of mortgage giants Fannie Mae and Freddie Mac, and suggested limiting their massive holdings to guard against any danger their debt poses to the overall economy.

“Bernanke has previously supported efforts to pare the two mortgage companies’ huge portfolios. This time, however, he was a bit more specific and recommended that their holdings might be linked to a ‘measurable public purpose, such as the promotion of affordable housing.’”

There is that phrase again – affordable housing. I wonder what caused Mr. Bernanke to do a complete about face on this issue between March and November from affordable housing only to non-conforming loans up to $1 million. I suppose if taxpayers guaranteed these $1 million loans they would not pose any additional danger to the overall economy (at least not immediately).

Now I must preface the balance of this piece with a thought about Senator Schumer. I always liked him and, it seems funny now, I have heard other people say the same thing about him. He is likeable. But since I started writing about issues of policy and economics, I have discovered that Senator Schumer shows up on the wrong side of many issues (that would be the side opposite mine). (I have written about such issues twice before here and here.) This is another good example because it appears Senator Schumer and Chairman Bernanke are concerned about the mortgage crises fall out on people with mortgages and homes valued at $1 million and more. This seems to be a little out of place given the current housing market crises impact on lower- and middle-income families. In addition to this incongruous line of thinking is the plainly stupid idea that the federal government should be guaranteeing mortgages in the $1 million range. Of course this leads me to the inevitable question – where do I apply!

I am against any taxpayer bailout of mortgagors who bit off more than they could chew. If you would like to read my opinion on this topic and my reasons for it you can see my post from October on that subject here. I am absolutely against any taxpayer guarantee of mortgages on non-conforming loans anywhere near the $1 million mark. In fact, I am dumbfounded by that entire exchange unless it was meant to soften us up for some other bailout proposal. At this moment in time, with two wars, a $9 trillion national debt, a falling dollar, inflation concerns, and tightening credit I believe there are much more important things to do with the credit of the American taxpayer than to put it behind purchases of $1 million homes. Focusing help on the wealthiest among us at a time when income distribution is coalescing at the top and raising taxes on high income is met with staunch criticism is indicative of a government that is completely out of touch. I am also concerned about the future unintended consequences that could result from this type of market manipulation and the distortions that it would create.

I am left hoping that Chairman Bernanke was not serious in his comments and/or Senator Schumer dismissed the concept out of hand. Unfortunately I have become a bit cynical in these times of mortgage meltdown and wealth transfers, and I fear there is a legislative proposal being prepared right now by one of Senator Schumer’s aids. I hope my fears prove unfounded.

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Open Questions for Citi

I took a few minutes to review the Citi third quarter 10Q that was released today to much fanfare. I have four basic issues/questions, and I invite anyone to provide answers for them. Here goes:

1. An issue. I searched the document for “SIVs” and came up with 33 hits. I then searched the second quarter 10Q for “SIVs” and guess how many hits I got? Zero. Nada. Zilch. So I guess this wasn’t anything important, that is until it became something important. (I also searched for “structured investment vehicle” and got the same result.)

I looked at some of the footnotes and I have a headache and three questions. Here they are numbered my points 2-4:

2. “Citigroup has no contractual obligation to provide liquidity facilities or guarantees to any of the Citi-advised SIVs and does not own any equity positions in the SIVs. The SIVs have no direct exposure to U.S. sub-prime assets and have approximately $70 million of indirect exposure to subprime assets through CDOs which are AAA rated and carry credit enhancements. Approximately 98% of the SIVs’ assets are fully funded through the end of 2007. Beginning in July 2007, the SIVs which Citigroup advises sold more than $19 billion of SIV assets, bringing the combined assets of the Citigroup-advised SIVs to approximately $83 billion at September 30, 2007. See additional discussion on page 46.

“The current lack of liquidity in the Asset-Backed Commercial Paper (ABCP) market and the resulting slowdown of the CP market for SIV-issued CP have put significant pressure on the ability of all SIVs, including the Citi-advised SIVs, to refinance maturing CP.

“While Citigroup does not consolidate the assets of the SIVs, the Company has provided liquidity to the SIVs at arm’s-length commercial terms totaling $10 billion of committed liquidity, $7.6 billion of which has been drawn as of October 31, 2007. Citigroup will not take actions that will require the Company to consolidate the SIVs.” From Citi's third quarter 2007 10Q pg. 7.

My question is, if “Citigroup has no contractual obligation to provide liquidity facilities or guarantees to any of the Citi advised SIVs…” then why does it provide “liquidity to the SIVs at arm’s-length commercial terms totaling $10 billion of committed liquidity, $7.6 billion of which has been drawn as of October 31, 2007.”? And, why wasn’t this $10 billion in liquidity facilities mentioned earlier? Sounds to me like Citi is not contractually obligated to provide the facility, and that means it can keep the SIV off of its balance sheet. But, in order to make the SIV work, someone has to backstop the liquidity, and guess who did that? Yup – Citi. Accounting hanky panky if you ask me. Of course this could all be perfectly legitimate according to the accounting rules, I guess. This could be a new facility, although why would Citi expose $10 billion into this market if it did not have to? If it isn’t new, then the question is why did “SIVs” not show up on the previous 10K? Is $10 billion in liquidity facilities to a managed entity immaterial? Was it lumped into that total “notional” exposure disclosure about VIEs (see below)?

3. Next up, the commercial paper question. From pg. 9 of the third quarter 10Q:

“ABS CDO Super Senior Exposures
Citi’s $43 billion in ABS CDO super senior exposures as of September 30, 2007 is backed primarily by sub-prime RMBS collateral. These exposures include approximately $25 billion in commercial paper principally secured by super senior tranches of high grade ABS CDOs …. Although the principal collateral underlying these super senior tranches is U.S. sub-prime RMBS, as noted above, these exposures represent the most senior tranches of the capital structure of the ABS CDOs.”

I want to point out the part that says “These exposures include approximately $25 billion in commercial paper principally secured by super senior tranches …….the principal collateral underlying these super senior tranches is U.S. sub-prime RMBS…” Looks like they had to purchase some of the commercial paper issued by those conduits. $25 billion of it, in fact. They don’t specifically tell us that’s where the commercial paper comes from. Guy Moszkowski - Merrill Lynch – Analyst asked the question on the conference call today. The answer he received from Gary Crittenden - Citigroup – CFO made no mention of conduits, only liquidity backstops for CDOs. I would like to know whether these were purchases of commercial paper from ABCP Conduits managed by Citi or not.

4. Finally, there is one other tidbit I would like to point out. Here is the disclosure I would like to know more about, from pg. 73 of the third quarter 10Q:

“As mentioned above, the Company may, along with other financial institutions, provide liquidity facilities, such as commercial paper backstop lines of credit to the VIEs. The Company may be a party to derivative contracts with VIEs, may provide loss enhancement in the form of letters of credit and other guarantees to VIEs, may be the investment manager, and may also have an ownership interest in certain VIEs. The Company’s maximum exposure to loss as a result of its involvement with VIEs that are not consolidated was $141 billion and $109 billion at September 30, 2007 and December 31, 2006, respectively. For this purpose, maximum exposure is considered to be the notional amounts of credit lines, guarantees, other credit support, and liquidity facilities, the notional amounts of credit default swaps and certain total return swaps, and the amount invested where Citigroup has an ownership interest in the VIEs. This maximum amount of exposure bears no relationship to the anticipated losses on these exposures.”

On its face this looks like a plain vanilla $141 billion no prob. But this amount was $91 billion at December 05, growing 19.8% in the ensuing twelve months to $109 billion at December 06. Since last September when this number was $93 billion, it has grown by 51.6% to $141 billion this September. In fact, in the three months since June 07 alone this number has grown by 29.4%, from $109 billion to $141 billion. I would like to know more about that number.

I hope these questions are eventually answered. Meanwhile, I remain cynical. My opinion, of course.

PS:
If you read my October post, Hocus Poke-us, then you know that banks are marking some liabilities to market. That maneuver resulted in a pre-tax gain to Citi of $466 million in the third quarter. Here is the note from pg. 6:

“Market Value Gains Due to the Change in Citigroup Credit Spreads
SFAS 159 provides companies the ability to elect fair value accounting for many financial assets and liabilities. As part of Citigroup's adoption of this standard in the first quarter of 2007, the Company elected the fair value option on debt instruments that are provided to customers so that this debt and the associated assets the Company purchased to meet this liability are on the same fair value basis in earnings. At the end of the third quarter, $28.6 billion of debt related to customer products was classified as either short- or long-term debt on the Consolidated Balance Sheet. Under fair value accounting, we are required to use Citigroup credit spreads in determining the market value of any Citigroup liabilities for which the fair value option was elected, as well as for Citigroup trading liabilities such as derivatives. The inclusion of Citigroup credit spreads in valuing Citigroup’s liabilities gave rise to a pretax gain of $466 million in the third quarter of 2007 and is reflected in the Securities and Banking business.”

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October Updates (November topics on your right)

This is an update on things I was blogging about in October. If you would prefer not to read this you can go directly to new pieces (and rants) that are filed under November on your right.

1. More news about subprime and the overall credit saga:

An article in yesterday’s WSJ Online Edition here discusses the issues homeowners face when trying to renegotiate their loan with a lender today. The main thrust of the article is that people are told that unless they are in default (a certain number of payments behind) they cannot help them. In other words, if you want to negotiate a better rate, first go into default. Anyone who has been following my take on this issue knows this comes as no surprise. You can find my rant about it here and in various other October posts. This post is more recent and deals with the response from some in Congress.

Things are getting a bit edgy, with people now talking about outstanding credit default swaps of $45 Trillion dollars and other possible credit market nightmares. At issue with these insurance policies on debt is whether any counter parties have actually reserved adequately in the event some corporate debt starts to go bad and there are calls for payment. This gets to the big question – is the credit problem limited to housing or did lenders make the same mistakes in other areas too? Also this week – rating agencies under scrutiny. I think that will become a bigger story, especially if the credit situation gets any worse. I wrote a piece about the rating agencies and the banking system in October that is posted here.

Speaking of credit, I have read a lot of discussion about whether the FED rate cut this week was justified, and there are lots of people on both sides of that issue. I posted my opinion on it last week here (I seem to have offended some sensibilities with the title – oh well).

In related developments, the Standard & Poor’s/Case-Shiller home price index report was recently released. You can get the WSJ Online Edition take on it here, but it was decidedly negative. Some commentators thought there could be a glimmer of hope as some of the numbers seemed to be deteriorating at a slightly slower pace. I’m not as optimistic as that. Here is a portion of the explanation of how data is used in this report to measure prices:

“When a specific home is eventually resold, the new sale price is matched to the home’s first sale price. These two price points for a specific home are called a “sale pair.” The difference in the sale pair is measured and recorded. All available sale pairs within the geographic market being measured are then aggregated into one index. Sales pairs are carefully screened for any data points that would distort the index such as foreclosures, non-arms length transactions, and suspected data errors where the order of magnitude of the change is substantially different from others in the region.

WEIGHTING OF SALES PAIRS

The indices are designed to measure the change in the price of homes that have not undergone significant changes in quality. Sales pairs are assigned weights to account for fluctuations in price that can be attributed to factors like extensive home remodeling, adding a home addition, or extreme neglect. For example, the indices assign smaller weights to sales pairs with large change in sales price relative to the community around them. The assumption is that this change is due to remodeling or neglect. Sales pairs are also weighted based on time intervals between sales. Sales pairs with longer time intervals are given less weight than sales pairs with shorter intervals to account for the probability of physical changes.”
Click here for the report.

Looks to me like the data could easily hide unusually high foreclosure rates and neglect, and there may be some of that now. The overall market could be worse than expected.

2. More to come on Citi and the SIVs:

From The WSJ Online Edition here:

“The SEC is reviewing how Citigroup accounted for certain off-balance-sheet transactions that are at the heart of a banking-industry rescue plan, according to people familiar with the matter. The review is looking at whether Citigroup appropriately accounted for $80 billion in structured investment vehicles, or SIVs, these people said.”

The article does not go on to say whether there is any suspicion they are not properly accounted for, but with the SEC coming in to take a peek one has to wonder. Last month I addressed some potential accounting issues relating to the M-LEC here and here.

I also had a post up here a while back with info about Citigroup but took it down because I did not want to be seen as expressing an opinion on a particular stock. Given recent events (the rapid decline in Citi’s stock price and more news about off-balance sheet entities) I decided to put just the part that follows reagarding disclosure of off-balance sheet items back:

“As mentioned above, the Company may, along with other financial institutions, provide liquidity facilities, such as commercial paper backstop lines of credit to the VIEs. The Company may be a party to derivative contracts with VIEs, may provide loss enhancement in the form of letters of credit and other guarantees to the VIEs, may be the investment manager, and may also have an ownership interest in certain VIEs. Although actual losses are not expected to be material, the Company’s maximum exposure to loss as a result of its involvement with VIEs that are not consolidated was $117 billion and $109 billion at June 30, 2007 and December 31, 2006, respectively. For this purpose, maximum exposure is considered to be the notional amounts of credit lines, guarantees, other credit support, and liquidity facilities, the notional amounts of credit default swaps and certain total return swaps, and the amount invested where Citigroup has an ownership interest in the VIEs. In addition, the Company may be party to other derivative contracts with VIEs.” Pg 67 of the Citigroup 2007 2Q 10Q available here.

Regarding that last sentence, does that mean the potential exposure is more than $117 billion? I know the “notional amount” is always looked at as some extreme, but these are extreme times, no? What is the potential exposure? If anyone can figure a probability of loss magnitude from reading the foregoing disclosure please let me know.

3. There was a very interesting piece on the Laffer Curve and republican politics titled “Tax Evasion, The great lie of supply-side economics”, wherein James Surowiecki discusses the fallacy of the current Republican mantra - tax cuts increase tax revenue. I have written about this here last month and it is one reason for writing the November piece titled Classless Warfare that you can find here. I recommend Surowiecki’s New Yorker article that can be found here.

4. Finally, the jobs report. This came in reporting surprising strength in new job creation. Unfortunately, as reported by Floyd Norris of The New York Times here it appears that 103,000 of the 166,000 new jobs are statistical creations based on a birth/death rate (of businesses) methodology adopted by The US Department of Labor Bureau of Labor Statistics. You can find that report here. The jobs picture may actually be worse than reported – surprise. Love those statistics.

So far in November I have posted two pieces. “America On Sale” is about the recent rate cut by the FED, and “Classless Warfare” is a rant that addresses some of the coverage of poverty in The United States and the fairness of the graduated tax system. Links to those posts are on your right.

I hope my first month’s attempt at this has provoked some thought. For a few minutes of cuteness, check out John's blog here. Please feel free to leave comments.

Mark Palermo
© 2007

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Classless Warfare

I was working last evening and had the television on in the background. I had the set tuned to CNBC and I heard parts of a debate over the poor in the United States. Some of the things I heard were stunning. For example, the poor really don’t have it so bad in this country. Even the poor have air conditioners. What? “Keep working,” I thought. Then there was tax debate, standard fair on this show, complete with the remark (paraphrased) “like the wealthy don’t already pay too high a share of the taxes.” After hearing that remark I could not continue to focus on what I was doing. The not-so-subtle class warfare was ringing in my head. Now, I must admit that I could do a lot more for those less fortunate than I, and I am not trying to claim I am any better than most who could do more than they do. But it annoys me when someone with a wide reaching public platform uses that platform to fight this kind of war against those without one. Especially when the ones fighting are among the most privileged people in the world and sound like they are complaining about it. Are they really that afraid of Congressman Rangel’s tax proposal? No class.

Before I get into the numbers, I want to be clear about things. I don’t want to leave the impression that I am against profits or high incomes or, for that matter, capitalism in general. I have worked in positions that pay very well, and I understand that there is a huge opportunity cost to get to these positions in the first place (for many of us) and that people in these positions work very hard. So if you fall into that category and you are reading this, understand I am not belittling what you have accomplished or what you do. I also understand that many, many people of means do amazing things to contribute to society and to improve the lives of the less fortunate, and I solute them and bow to their generosity. I have witnessed such acts and my heart skips a beat when I recall them. My rant is focused on those who have the audacity to sit in judgment over the adequacy of the standard of living of the least fortunate among us while at the same time complaining about their current tax burden. Now lets look at some of the numbers.

First of all, who says the 12.3% or so of the population (that’s approximately 36,500,000 people) living in poverty (see pg. 11 here: http://www.census.gov/prod/2007pubs/p60-233.pdf) have air conditioners? I want to see that report. If anyone can find it please send me a link. How low is the income level to be living in poverty in the United States of America? Can’t be too bad if those “poor people” have air conditioning, right? Well, for a family of three, two parents and one child, the threshold level is $16,227 per year (2006 number). On average the income for a family living in poverty is, of course, substantially below this threshold (that sometimes gets lost). So, most families of three included in the poverty numbers in the US live on less than $1,352 per month. We’ll see just how little that is in a minute. Granted, people in poverty in other countries may have even less still, but so what? Are we now globalizing poverty standards as well?

Looking at these numbers prompted me to do a little research, so I went to the Bureau of Labor Statistics (BLS) here: http://www.bls.gov/cex/csxann05.pdf and looked up some figures. First, the average “consumer unit” in the US is 2.5 people, and they make on average $58,712 before taxes (2005 numbers). They annually spend on average $41,548 (that’s about $800/week) per consumer unit before payroll taxes and pension savings. So, the average 2.5-person unit spends over 2.5 times the total income of the “wealthiest” 3-person unit in poverty. To get an idea what it would be like to be a rich poor person, imagine supporting three people on $314/week. If you are at 75% of the poverty threshold, then it’s about $236/week for three people. But hey, at least you would have air conditioning! (How absurd does that sound now?)

I think that’s a good place to begin a discussion of the tax issue. I went to those recently released IRS statistics here http://www.irs.gov/pub/irs-soi/05in05tr.xls to get income and tax numbers to work with, and I used the BLS statistics on consumer spending. I know there are a lot of “adjustments” that should be made to these numbers, but who benefits most from making all the adjustments is not clear to me. You can make them if you like, but I don’t think they change the bottom line. I also assume in every case the average income as reported to the IRS represents a family of 3, which is obviously not correct. But I am consistent between the categories (and unlike some, I am pointing that out to you right now).

I assume in each case a return filed represents a consumer unit that I define to approximate a working couple in New York State with one child. Incomes and taxes are based on the 2005 IRS statistics using averages in each category, and “Average Annual Expenditures” is based on the BLS report referred to above. New York State taxes are ballpark using standard deductions without dependant deduction.

Number of Returns	66,305,818	33,152,910
Filers	AVG Bottom 50%	AVG Top 50-25%
Income	$14,525.63	$44,501.95
Income Tax Federal	$432.47	$3,084.37
Income Tax State	$0	$1,770.00
SSI	$1,045.85	$3,204.14
After Tax Income	$13,047.32	$36,443.43
Avg Annual Expend.	$41,584.00	$41,584.00
Times Expense Coverage	0.31	0.88
Excess (shortfall)	$(28,536.68)	$(5,140.57)

My Times Expense Coverage shows how well the after tax income of each group covers the average consumer unit’s annual expenditures. If you are in the bottom 50% of all filers (that’s half of the returns filed), your after tax income covers about 31% of the average consumer unit expenditures. Now, I understand that many of these returns may be single folks, but even so you come up short because they can’t even cover one third of the average expenditures. The filers between the bottom 50% and the top 25% come up a bit short too. They cover about 88% of the average annual expenditures with their income. Those who are single in this category are doing OK. Those with families must be very budget conscious.

Number of Returns	31,826,793	1,326,116
Filers	AVG Top 25-1%	AVG Top 1%
Income	$109,270.95	$1,200,280.00
Income Tax Federal	$13,687.84	$277,601.66
Income Tax State	$6,691.06	$88,777.56
SSI	$7,867.51	$12,960.00
After Tax Income	$81,024.55	$820,940.78
Avg Annual Expend.	$41,584.00	$41,584.00
Times Expense Coverage	1.95	19.74
Excess (shortfall)	$39,440.55	$779,356.78

Moving on to those filers in the top range who do better than 75% of all filers but not as well as the top 1%, we see some real improvement. They cover the average annual expenditures by almost 2 times assuming they avoid the temptation to spend money on college (see expenditures table below). This 24% of filers may just be able to save some income for retirement. As expected, the top 1% do just fine, covering the average annual expenditures by a multiple of almost 20 times. That’s right, 20 times after tax.

Before we go any further, lets take a look at where those average expenditures are going:

	Dollars	Percent
Food	$5,931	14.3%
Alcohol	$426	1.0%
Housing	$15,167	36.5%
Apparel & Services	$1,886	4.5%
Transportation	$8,344	20.1%
Healthcare	$2,664	6.4%
Entertainment	$2,388	5.7%
Personal Care Pr.&Srv.	$541	1.3%
Reading	$126	0.3%
Education	$940	2.3%
Tobacco & Suppl.	$319	0.8%%
Miscellaneous	$808	1.9%
Cash Contributions	$1,663	4.0%
Personal Insurance & SSI	$5,204	12.5%
Less SSI	$(4,823)	-11.6%
Total	$41,584	100.0%

(From the BLS statistics.)

Well, I guess if everyone stopped drinking and smoking that would add a little – but not enough to cover expenses. Then again, they could forego that pricey $940/year education for three, or that extravagant $796/year/person entertainment expense (or whatever it works out to if you divide it by 2.5 instead of 3).

I ran a few other series of numbers showing how a flat tax would unduly burden the lower income levels but I decided to end my analysis of the numbers here because I believe just looking at the numbers I have already presented tells the story that needs telling. The high-income earners may pay a larger share of the income taxes collected in this country, but they do so because they can afford to. And if we need to collect any more anytime soon, I know exactly where I would go to collect it. You can be sure it would not place any further burden on the bottom 50% and it would be heavily skewed toward the top 1%. In fact, it would be skewed toward the top 1/2 % first. I don’t need elaborate models with charts and graphs to show me where the money is or how altering the tax code will shrink the pie and blah blah blah. Especially when the blended rate at the top is 23.13%. I just need a simple table showing the total after tax income per group and per filer within each group in 2005.

Number of Returns	66,305,818	33,152,910
Filers	AVG Bottom 50%	AVG Top 50-25%
Group After Tax Income (millions)	$934,459	$1,373,113
Per Filer	$14,093.17	$41,417.57

Number of Returns	31,826,793	1,326,116
Filers	AVG Top 25-1%%	AVG Top 1%
Group After Tax Income (millions)	$3,042,104	$1,223,579
Per Filer	$95,583.11	$922,678.71

I’m sure there are lots of interesting conclusions that can be reached using statistical analysis and assumptions, and these things should be done in order to arrive at actual tax policy. But for now it looks pretty simple to me. By the way - none of these numbers pick up all of those 36.5 million people living in poverty because they may not have filed a return with a positive adjusted gross income. Many don’t even make it to this level. They’re probably too busy playing around with those air conditioners to file a return anyway.

I think we should refrain from deriding the less fortunate by classifying them all into one giant group called “the poor” and discussing how they don’t really have it all that bad. Rather than declaring how unfair it is that the high earners pay a higher share (to support the very society that permits the attainment of such earnings in the first place), lets discuss how to improve the lot of all of those “others” whose daily toiling generates the income in the first place. I would like that conversation a whole lot better than the one I heard last evening.

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Making up Jobs

Some good investigating by Floyd Norris at The New York Times today. Many of the new jobs reported appear to be made up! Check out his blog here: http://norris.blogs.nytimes.com/2007/11/02/making-up-jobs/

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America On Sale

Today the Board of Governors of the Federal Reserve cut the federal funds target rate – the rate that banks borrow reserves from each other – by .25%, from 4.75% to 4.5%. The commentary was furious, with supporters and distracters arguing for and against. “It’s a bail out for Wall Street” and “Helicopter Ben to the rescue” on the one side. “It’s the right thing to do to dampen the impact of the housing downturn” on the other. I believe it was not the right thing to do, but rather than use platitudes and sound bites I think I found a straight forward way to show why I am uncomfortable with this FED action. (Please keep in mind that I am working with simple numbers and simple concepts, while those making these decisions have exponentially more data and brainpower than I.)

In theory, a reduction in the interest rate will spur consumers and businesses to borrow and spend, which in turn adds fuel to the economy. Here are the Household Debt Service Payments and Financial Obligations as a Percent of Disposable Personal Income numbers from the fed:

1980 Q1 = 15.90%
1990 Q1 = 17.28%
2000 Q1 = 17.67%
2007 Q1 = 19.28%
Average of quarterly data since 1980 Q1 = 17.30%
These numbers are from here: http://www.federalreserve.gov/releases/housedebt/default.htm

The ratio of debt service and financial obligations to our personal incomes appears to be at an historic high since 1980, as far back as this report goes. Our debt service and financial obligations ratio is now over 11% higher than the average of the past 26 years, and 21.3% higher than in 1980. Keep in mind that this ratio has expanded considerably during a period of very low interest rates. Should rates go up, this burden can get even worse. This cannot continue forever. At some point we need to de-leverage. If we keep putting it off, it will only be more painful when it ultimately occurs because it will take us longer to get back to a manageable debt service ratio.

Add to the debt service burden on consumers the high cost of energy and food and the declining value of homes and the picture looks pretty bleak. The last thing we need right now is higher prices added to our debt service burden.

Many pundits are claiming that the expanding global economy will save us from a recession, especially with the weak dollar spurring exports. The problem with this argument is that a falling dollar only adds to the inflation problem, as does strong global demand. Is this a time we should be lowering interest rates?

I believe we are paying for the delay of the inevitable recession through a loss of purchasing power and incremental debt service burden that will only make it worse when the correction comes. It does not seem this is the time to be encouraging more borrowing. In the interim, our assets are now dirt cheap in relation to many other currencies. America is ON SALE.

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Dirty Little Secrets of Subprime

I was reading through various blogs today when I stumbled upon Paul Krugman’s summary of the Report and Recommendations by the Majority Staff of the Joint Economic Committee (the “Report”) by Senator Charles Schumer, Chairman, and Rep Carolyn B. Maloney, Vice Chair. You can find the Report here: http://jec.senate.gov/Documents/Reports/10.25.07OctoberSubprimeReport.pdf. Since I have been writing on this drama for the past few weeks, I decided to get the Report and take a look under the hood. I found quite a few oil leaks. Unfortunately I believe this report to be another expenditure of taxpayer funds by Mr. Schumer to pull the wool over the eyes of the public and protect his wealthy constituents on Wall Street. By diverting attention away from those who profited from this adventure the Report attempts to back door a taxpayer bailout of the financial industry. Here are some of my issues with the Report:

1. The Report is stunning in the questions it does not answer. One such question is who is responsible? Of course, that would be investment banks, Wall Street attorneys, accountants, rating agencies, and mortgage servicers who collectively made a market for these mortgages that, from history, they knew (or should have known) were junk. None of these players in the game of wealth redistribution are mentioned in the Report. Instead, the blame falls to the state chartered mortgage bankers and the mortgage brokers. This is like concluding that the reason we have made so little progress in Iraq is because of the soldiers’ ineptitude rather than the generals or the administration. It’s like concluding the drug problem lies with the small time pusher but the cartels have nothing to do with it. The mortgage bankers did exactly what Wall Street wanted them to do – sell loans to feed the securitization machine. To now blame the foot soldiers and state regulatory failures for this mess is a disgrace. I would like the report to address where all of those HUD-1 statements executed at all of these home mortgage closings ended up? Mr. Jackson, please?

2. Another failure of the Report is it never asks the question “who profited from this disaster?” According to the Report, there are approximately $1.5 trillion in outstanding subprime mortgages. Of those, between 50% and 80% were securitized depending on the year in question from 2001 through 2006. If we assume 70%, the total of these loans that were securitized would be $1.05 trillion. Now, I don’t know how much profit is in these securitizations, but I assume that between attorneys, accountants, rating agencies, sponsors, etc., there has to be around 3% coming off of the top (probably multiples if we include servicing fees). That would be (1,050,000,000,000 x .03 = $31,500,000,000) $31.5 billion. It’s party time! It disgusts me that none of this is in this Report. How can it include worthy recommendations when it ignores the facts? If my percentages are off, it’s only because these numbers have not been made available in the Report. This is not to say that the mortgage bankers did not also profit from these transactions. I have seen many profit handsomely from them. The problem is where does that profit come from? It trickles down from the profits up the food chain on securitizing these mortgages. There has been a massive redistribution of wealth and, based on the recommendations of the Report (see below), Senator Schumer believes the taxpayers should pay the tab.

3. The report fails to observe some of the most obvious conclusions that can be reached from the data it presents. Here is one example: according to the Report, “As can be seen in Figure 10, between 2001 and 2006 adjustable rate mortgages (ARMs) as a share of total subprime loans originated increased from about 73 percent to more than 91 percent. The share of loans originated for borrowers unable to verify information about employment, income or other credit-related information (“low-documentation” or “no documentation ” loans) jumped from more than 28 percent to more than 50 percent.

“The share of ARM originations on which borrowers paid interest only, with nothing going to repay principal, increased from zero to more than 22 percent. Over this period the share of subprime ARMs that were originated as “hybrids” increased dramatically. The share of 2- and 3-year hybrid ARM’s accounted for more than 72 percent of all subprime ARM’s originated in 2005 (See Figure 12 in Appendix).”

At the same time, the Report discloses that these subprime ARM loans went to borrowers with, on average, lower FICO scores (624) than any other type of loan. Subprime fixed FICO scores were 636, near prime ARM 711, and near prime fixed 717. Why are the adjustable rate borrowers in these lower FICO scores? Because that’s how you get them to qualify for a loan, by basing their payment on the initial teaser rate or interest only payment. These were the loans being made toward the end of this debacle, and over 80% of them by dollar value were securitized in 2005 and 2006. All of this makes it painfully obvious that the mortgage machine was working its way down the food chain from qualified to unqualified borrowers, while all of the regulators did nothing but brag about how home ownership rates where going up and Wall Street collected fees. In my opinion, heads should roll. The Report does give this point lip service with the following “full” coverage of this topic:

“Because mortgage companies sell many of the loans they underwrite to the secondary market, they have an interest in underwriting loans that are desired by the secondary market investors.51 This observation has special weight because of developments in nonmortgage financial markets. In recent years, as hedge funds have proliferated and the market for structured financial products has expanded, there has been significant demand for highyield assets that can underlie collateralized debt obligations (CDOs) and other financial derivatives. Subprime mortgages have, until recently, been considered terrific assets to include in CDO structures. Hence subprime lenders have had a strong incentive to underwrite high-yielding subprime mortgages, whether or not these loans were best interests of the borrowers.” Yup, that’s it. The fault lands at the feet of the subprime lenders and no further up the food chain. Lets not examine what accounted for the strong incentive lenders had to originate these mortgages.

4. The Report shows a clear relationship between the rate of subprime mortgages and the rise in overall housing prices, yet it never actually makes this connection. In other words, the $1.5 trillion artificial increase in housing demand from subprime borrowers resulted in rising prices that kept subprime default rates artificially low until lenders got far enough down the food chain. Then the house fell down. What device enabled this run-up in subprime and housing prices and now defaults (subprime went from 2.6% of outstanding mortgages in 2001 to 14.0% in 2Q 2007)? The CDO and securitization machine that was making money from it.

5. The Report ignores the role of the rating agencies in this mess. In order to make these loans, they had to be securitized because nobody wanted to hold them in their portfolio. Apparently it was well known that these loans were highly risky. Well known to everyone except the rating agencies who rated tranches too aggressively and are now in the process of downgrading them rapidly. This should come as no surprise. As the Report shows, subprime default rates have always been high with the exception of the period of time when home prices were appreciating at unsustainable levels. This is painfully obvious from the statistics presented in the Report. But the next logical question is how did the rating agencies get this so wrong? Did they actually assume that home prices would continue to appreciate at levels we have only seen in the past for a short period following WW II? Here is what the Report has to say about this:

“Since underwriting deteriorated from 2001 to 2005, and the accelerating housing price boom was giving subprime borrowers important help (see Part II), a cautious analyst might have questioned whether the improvements in subprime performance could be sustained. The financial intermediaries who expanded the supply of these loans were apparently not troubled by this issue. The reasons for their lack of curiosity may lie in the strong incentives they had for expanding the subprime market.”

Who are these “analysts” and what were their strong incentives to expand the subprime market? Other than the mortgage bankers supplying food for the CDO market we have no idea from this Report. So, it is some unidentified “analyst” who is to blame for this massive screw up. Not the CDO wiz kid quants or the rating agencies, but some “analyst”. Please stop insulting our intelligence. Regarding the rating agencies, these issues are not new, and they are now coming to the forefront. The Connecticut AG has issued subpoenas to get answers to questions that many scholars have been asking for a decade regarding rating agency independence and the pseudo regulatory role they play. If you are interested in this issue a good place to start would be with Frank Partnoy’s research paper HOW AND WHY CREDIT RATING AGENCIES ARE NOT LIKE OTHER GATEKEEPERS. This paper can be downloaded without charge from the Social Science Research Network Electronic Paper Collection: http://ssrn.com/abstract=900257. You can also review my piece on the pseudo regulatory role, and the resulting house of cards, that rating agencies play in our banking system here: http://polecolaw.blogspot.com/2007/10/public-and-private-bank-regulation-or.html

6. Where is the SEC? One of the striking issues about this whole mess is that nobody seems to know exactly where all of these CDOs are. This gets us back to the SIVs and M-LEC that have been discussed at length in the media, and I will not re-hash all of my issues with that here. You can read my previous posts on that topic here: http://polecolaw.blogspot.com/2007/10/maybe-stalling-is-viable-master-siv_19.html and here: http://polecolaw.blogspot.com/2007/10/i-did-not-have-sex-with-that-siv.html. It seems to me that there are some people who actually know the answer to that question, whereas most of us do not. Doesn’t this create asymmetry in the markets? Can’t those who are in the know be putting on positions right now to their advantage based on this information? Think now is a good time to be in the markets? This shoe will drop in the woods, and none will hear it.

I could go on, but I think I have made my point that this Report is biased, and I for one am again angry at this snow job that appears to me intended to deflect attention from where the responsibility (and the profits) lie. Of course that's just my opinion.

Now to the recommendations. Total losses to homeowners could be as high as $164 billion (based on the assumption that the inflated real estate values are the real values). Of course, the recommendations do not include any mention of those on Wall Street. Instead, the first thing we should do is “increase FHA’s ability to refinance by passing the Federal Administration’s (FHA) Modernization Act of 2007, which would increase FHA’s capacity and flexibility to insure subprime mortgages that can be refinanced.” In other words, we should push the problem to the taxpayers. Are you ready for the $1.5 trillion bailout? Here it comes! Next, we should expand the capabilities of the GSEs Fannie and Freddie to help subprime borrowers through refinancing. Wait, isn’t that the same as recommendation 1? Taxpayer bailout. There are other recommendations such as educating borrowers, amending the bankruptcy laws, and so on. The bottom line – and I must give credit to a Newsvine friend for this quote – privatize the profits, socialize the costs.

All in all this Report is, in my opinion, another expenditure of taxpayer funds by Mr. Schumer to pull the wool over the eyes of the public and protect his wealthy constituents on Wall Street. By diverting attention away from those who profited from this debacle the Report attempts to back door a taxpayer bailout of the financial industry. This is the same financial industry that benefits from favorable and unjustifiable tax preferences, and represents the largest share of the top 1% income earners in the country. Unfortunately there is nothing new here. For another glaring example see my piece on another Schumer sponsored report here: http://polecolaw.blogspot.com/2007/10/tale-of-two-cities-new-york-and-detroit.html . Shell games at the highest levels of government.

Finally, there is a case in front of the Supreme Court right now that could have an impact on the ability of anyone to hold any third party responsible in this mess. The case, Stoneridge, deals with concepts of third party liability for investor harm. It is not exactly on point, but it is not far from it. Should the Court, as expected, rule in favor of no third party liability, good luck ever getting anyone responsible for this mortgage debacle to pay. You can get my take on Stoneridge here: http://polecolaw.blogspot.com/2007/10/subprime-socialization.html

Looks like all the lose ends are getting tied up nicely.

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