Tuesday, November 27, 2007

Updates - SIVs, Citi, Social Security, Subprime, and Taxes

First thing to update is the status of this blog. I started it on October 2, not quite two months ago. Since then I have written 26 pieces for publication, but nothing substantial in the past week. The reason is that maintaining the level of publication I started out with has proved difficult as evidenced by the late payment notices I have been receiving (I have forgotten to pay the bills!). So I took some time off to catch up on the other pieces of life not reflected in the blog (bills, family, work, exercise, etc.). I will continue to post so long as I continue to have visitors, although there will be periods of quiet.

There have been some very interesting developments in the interim, and I am writing today to update the issues I have been writing about in November. If you have been following my blog (thank you) then these should be of interest to you. You can click on any of the topics below to go directly to that topic, or just read from the top.

Citigroup Subprime SIVs Social Security and Taxes Short Rant on policy and responsibility

On Citigroup:
It has been interesting watching this unfold. Citi announced today that it will receive a $7.5 billion capital investment from the Abu Dhabi Investment Authority. According to the press release

Each Equity Unit is mandatorily convertible into Citi shares at prices ranging from $31.83 to $37.24 per share. The Equity Units convert to Citi common shares on dates ranging from March 15, 2010, to September 15, 2011, subject to adjustment. Each Equity Unit will pay a fixed annual payment rate of 11%, payable quarterly.

11% seems high to me, about the same as Ford Motor Credit and GMAC high yield bonds give or take a point, and these are convertibles. Abu Dhabi ends up with a 4.9% interest in Citi post conversion.

Now the layoffs are coming in force, and there is a lot of speculation in the media about how many jobs. I heard today on MSNBC anywhere from 15,000 to 45,000. That could be a lot of layoffs and of course it comes just before the holidays.

The investment by Abu Dhabi reinforces the fact that America is currently on sale, as I wrote about in my first piece in November. Interestingly, this purchase is with dollars so the exchange rate is not the issue. Rather it is the price of oil.

Since I wrote that piece, the Fed chairman testified before Congress and released its (now quarterly) report on the economy. The report was pretty much as expected, as was the testimony. Of course some of the dialog during the testimony was simply amazing in that it will likely lead to a proposal by Congress to federally guarantee jumbo mortgages (just what we need – more obfuscation of the “market”). I believe I heard warnings of stagflation in the testimony as well. If you would like more detail on this you can find it here.

While on the subject of the overall economy, I have some anecdotal evidence of a slowdown. Each year my family drives 230 miles to visit relatives for Thanksgiving. Last year the trip took about 6 hours with traffic, each way being a very long drive. This year it took just over four hours each way with almost no traffic. I believe gas prices are beginning to have an impact.

On Subprime:
What is happening there? Well, for one thing the Federal Home Loan Banks have vastly increased their exposure over the past quarter to provide liquidity to the mortgage market. Freddie and Fannie did their part as well, although they have since disclosed problems of their own relating to poorly underwritten mortgages. I wrote abut these increased exposures here. In a pleasant surprise, Senator Schumer is onto this scheme and posted a letter to the Federal Home Loan Bank today. Details here. Other than that there have been increased calls for taxpayer help to bail out homeowners so as to avoid a real economic problem. I don't believe there should be any bailout, and you can read about my reasons for this here and here and here.

We now know that Citi has taken substantial assets onto its balance sheet relating to the SIVs, and HSBC announced that it is moving approximately $45 billion in SIV assets onto its balance sheet. I believe this is a blow to Citi and the whole MLEC plan because HSBC has taken the matter into its own hands and consolidated the problem. We should ask why Citi does not do the same, but the answer is likely to be one we don’t want to hear. Perhaps Citi does not have the equity to absorb such a move at this point. Whether Citi must consolidate these off-balance sheet entities is the subject of ongoing debate. According to a WSJ Online Edition article there MAY be a requirement to consolidate since Citi has taken over $32 billion in assets onto its balance sheet as of September 30 (as I discussed here). Sounds to me like a lot of intellectual wrangling over a pretty simple issue – if ultimately Citi will be forced to bail out these entities, whether for “reputational” or any other reasons, then they should be on the balance sheet. Of course that’s just my opinion.

The impact of all of this on the money markets is still uncertain. According to this WSJ article:

Efforts by HSBC to protect its SIVs are being watched closely by analysts and managers of money-market mutual funds, some of which have invested in debt issued by the two SIVs, called Cullinan Finance Ltd. and Asscher Finance Ltd. Janus Capital Group Inc. is estimated to have held about $606 million, or 2.7% of its money-market assets, in Cullinan and Asscher through the end of October, which has since been reduced. Federated Investors Inc. holds about $350 million in Asscher in its five largest money funds.

In other words, the mutual funds are still waiting to see whether they will be taking a hit on these. So far it appears they are winding down their exposure, but still have substantial assets tied to SIV structures.

On Social Security and Taxes:
I have been debating with people all week about my stance on Social Security, including the latest proposal by Fred Thompson to address the “crisis” we have. This Fox News Article reports his tax and Social Security plan as follows:

Thompson's proposal, announced on "Fox News Sunday," would allow filers to remain under the current, complex tax code or use the flat tax rates.
Asked whether the plan would cut too deeply into federal revenues, the former Tennessee senator and actor said experts "always overestimate the losses to the government" when taxes are cut.

"We've known for years any time we have lowered taxes and any time we've lowered tax rates, we've seen growth in the economy," Thompson said.

Thompson added that money would be saved by his Social Security reform plan. He proposed that workers younger than 58 receive smaller monthly Social Security checks than they are now promised. Individuals could contribute 2 percent of their paycheck to a personal retirement account, an amount that would be matched by the Social Security trust fund.

The retirement plan "faces up to the fact that Social Security is going bankrupt and we're going to have to do something about it," he said.

Well, first of all Social Security is only going bankrupt if the Federal Government decides not to honor its promise to repay what it borrowed from the Trust Fund (see my article on this topic here). If it does not, then it may be time to sell any treasury securities you have because they would no longer be “risk free”. (The Trust Fund does not own treasury securities, rather special IOUs from the federal government that are backed by the full faith and credit of The United States of America).

Next problem with this statement is the same old crap about the Laffer curve and taxes – if we can decrease taxes to grow the economy it will raise tax revenue. If this is true then why worry about Social Security? We can just cut taxes to pay for it! Ridiculous indeed. Now, to be fair, the article does not actually say that he believes a tax cut will result in higher tax revenue, but this is the argument we consistently hear from Republicans on this issue. I have yet to see any actual proof that the Bush tax cuts CAUSED tax revenues to increase. I have seen plenty of evidence that tax revenues have increased, but never any cause and effect proof. In other words, we do not know if it is the Bush tax cuts, fiscal stimulus from excessive borrowing, or normal economic growth from population growth and global growth that has caused tax revenues to increase. What we do know is that since the Bush tax cuts we are in a lot more debt and that is becoming a problem, especially when no one wants a tax increase to pay it down.

Finally, a flat tax has the potential to be regressive and could be another gift to the high-income population. In any event, a reduction in tax revenue is a problem at a time when we are at war (two wars, actually), and facing the need to begin repaying what has been borrowed from Social Security (not to mention the health care issues). At the end of the day, this boils down to paying for the Bush tax cuts and maybe even more tax cuts by reducing promised Social Security benefits relied on and paid for by lower- and middle-income retirees. It is a transfer of wealth from those with less to those with more. It is a sham. Again, that is just my (somewhat informed) opinion.

A short rant on policy and responsibility.
I think it’s about time we begin taxing to pay for our wars. Until now, we have fought this war in Iraq by borrowing the money and paying civilian warriors so as to avoid a draft and any tax increase. I wonder how long we would be in Iraq if we instituted a draft to get the soldiers we need and raised taxes to pay for it. I see uprisings on college campuses. I hear the cries of the high-income earners writing checks to the Treasury. My guess is we would already be gone. Isn’t this irresponsible? What happened to the party of personal responsibility? Isn’t keeping promises to taxpayers such as Social Security an act of personal responsibility? Isn’t managing the country in a fiscally sound manner an act of personal responsibility? How is it we get lectured on the values of personal responsibility by those who seem to ignore theirs? I shall continue to object.

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Schumer Gets It Right!

I have written a couple of articles that express a poor opinion of Senator Charles Schumer. In the interest of fairness, I want to also salute him for his attention to the taxpayer issues surrounding the Federal Home Loan Banks.

On November 13 I posted this article raising a red flag that the taxpayer bailout of the subprime mortgage debacle had begun through the Federal Home Loan banks. Today, Senator Schumer released this letter to the FHLBanks directly on point. I applaud Senator Schumer for his attention to this issue on behalf of all taxpayers and I hope that he continues to diligently protect taxpayer interests. Here is the letter:

November 26, 2007

Ronald A. Rosenfeld
Federal Housing Finance Board
1625 Eye Street NW
Washington, DC 20006

Dear Chairman Rosenfeld:

I write to express my serious concern over the lending practices of the Federal Home Loan Bank of Atlanta, specifically in regard to the significant volume of advances made to Countrywide Bank. I am concerned that the loans being pledged by Countrywide to secure these advances may pose a risk to the safety and soundness of the FHLB system as a whole. I urge you to conduct a careful review of FHLB Atlanta’s collateral evaluation policies, as well as Countrywide’s pledged collateral, in an effort to determine the risk that Countrywide’s collateral poses to the FHLB system. During the current market crisis, it is important that the FHLB system perform its critical mission safely without imposing additional risks on an already strained market.

According to the most recent SEC filings, FHLB Atlanta had made $51.1 billion in advances to Countrywide Bank, representing 37 percent of the Bank’s total outstanding advances as of September 30, 2007 and far exceeding advances made to the next largest borrower. Countrywide had pledged $62.4 billion of mortgages as collateral for the FHLB advances, representing 78 percent of its total mortgage loans held for investment at the bank.

I find these numbers alarming as reports continue to emerge about how Countrywide’s reckless and predatory lending practices were a leading contributor to today’s foreclosure crisis. Moreover, it is my understanding that Countrywide’s loans held for investment at the bank have been far from immune from the credit deterioration that has resulted from unsound lending. Countrywide reportedly held $27 billion of “pay option ARMs” as of September 30, 2007, accounting for over one-third of the loans held for investment by the bank. Countrywide’s option ARMs were (and may still be) often underwritten with less than full documentation – according to UBS Warburg data prepared for the Wall Street Journal, 91 percent of Countrywide’s option ARMs underwritten in 2006 were “low doc.” It has been reported that delinquencies on Countrywide’s pay option ARMS are skyrocketing, jumping nearly 75 percent in the last quarter.

Given this rapid deterioration in the credit quality of Countrywide’s option ARMs, I urge you to conduct a review of the loans that are being held as collateral for FHLB advances in an effort to determine if FHLB Atlanta has adequate collateral to secure these advances. I would also like an explanation of how any second lien mortgages during a time of property price declines could be viewed as adequate collateral for large FHLB advances.
Furthermore, I believe that you should consider preventing any further or continuing overnight advances based on collateral that does not meet the joint financial regulators’ guidance on nontraditional and subprime mortgage products (e.g., Interagency Guidance on Nontraditional Mortgage Product Risks and joint Statement on Subprime Mortgage Lending). This quarter, Countrywide reported that 89 percent of their 2006 originations of pay option ARMs did not conform to the joint regulators’ guidance, which increases the likelihood that Countrywide is pledging loans deemed predatory by the regulators as collateral for FHLB advances. Importantly, Fannie Mae and Freddie Mac’s safety and soundness regulator has specifically prohibited any new direct or indirect investment in loans that do not meet this guidance. As the mortgage crisis threatens to get worse from here, it is critical that the FHFB do the same.
Thank you for your prompt attention to this matter, and I look forward to working with you on these issues in the coming weeks and months. If you should have any questions, please contact David Stoopler on my staff at 202-224-6542.


Charles E. Schumer
United States Senator

You can view the original here.

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Sunday, November 18, 2007

The Social Security "Debate"

Revised November 29 - see additional information at end.

I am furious about this "crisis" in Social Security "debate" going on among politicians today, and here is why:

1. There is no immediate crisis in Social Security, yet the politicians keep arguing over how to fix it. I am really tired of this “debate” and I am very concerned that it will lead to higher taxes on my income. Social Security was “fixed” in 1983. The fix included an increase in the payroll tax that I have been paying virtually my entire professional career. In addition to that tax, the self-employment tax on small business and professionals was increased to over 15%, and I have paid that on many occasions as well. (Next time you hear anyone talking about how Democrats are against small business ask yourself how that can be true when it is the Republicans that placed this burden on these sacred cows.)

Here are some of the changes from the 1983 law from the Social Security Administration’s summary of the legislation:

Advances scheduled increases in Social Security tax rates. Social Security tax rates (which include the Hospital Insurance tax rates) for employers and employees will increase to 7.0 percent in 1984, {1} 7.05 percent in 1985, 7.15 percent in 1986-87, 7.51 percent in 1988-89 and 7.65 percent in 1990 and thereafter.

Provides for cost-of-living increases based on prices or wages--whichever is less--if the trust funds fall below a specified level.

Increases tax rates on self-employment income equal to the combined employee-employer rates and provides credits against tax liability to offset part of the increase.

Beginning in 1984, includes up to one-half of Social Security benefits as taxable income for taxpayers whose adjusted gross income, combined with half their benefits and any tax-exempt interest they may have exceeds $25,000 for a single taxpayer and $32,000 for married taxpayers filing jointly. Benefits received by married taxpayers filing separately are taxable without regard to other income. Appropriates amounts equal to estimated tax liability to the Social Security trust funds.

Raises the age of eligibility for unreduced retirement benefits in two stages to 67 by the year 2027. Workers born in 1938 will be the first group affected by the gradual increase. Benefits will still be available at age 62, but with greater reduction.

(Yes, it was RONALD REAGAN who first taxed social security benefits, NOT Bill Clinton.)

This is the deal we made, and the deal we have paid for dearly over the past 24 years. This is the deal we should get, and if we don’t get it then the funds we have paid in for our future benefits will have been confiscated and used for some other purpose. In other words, we will have actually had a regressive tax system placed on many of us for 25 years while taxes on high incomes have been cut (sold to us via the trickle down theory). In the end, those who went for the high incomes will not need social security and those who did not (the teachers and such) will be living in substandard conditions. This is the primary reason I am furious about this “debate”. There should be no debate. I have paid for my Social Security benefits and I want what I paid for, and if it means bringing tax rates on high incomes back to where they were because we have some larger fiscal problem then that’s exactly what we should do. (You can read my opinion about why tax increases should be on higher incomes here.) This means I want the payments I should get at the age I am entitled to get them under the current rules (the ones in effect while I have been paying for them).

2. There is no immediate crisis in Social Security and I am tired of the fear mongering being used to scare more tax revenue out of the middle class and upper-middle class. There is plenty of surplus in the Social Security system, and the only reason it would be in “crises” is if the United States Government decided not to repay the treasury securities owned by the Social Security fund. In fact, according to Social Security Administration data the combined OASI and DI funds have run a surplus since 1984. Here is what the OASDI Trustees Report has to say about the short term situation:

Both the OASI and the DI trust fund ratios under the intermediate assumptions exceed 100 percent throughout the short-range period and therefore satisfy the Trustees' short-term test of financial adequacy. Figure II.D1 below shows that the trust fund ratios for the combined OASI and DI Trust Funds reach a peak level in 2014 and begin declining thereafter.

In fact, in 2016 the fund represents 400% of the annual need. It should decline thereafter because us boomers will be dying off.

What about in the long term? This is what those using Social Security to scare us always point to. Here are some of the details:

Another way to illustrate the financial shortfall of the OASDI system is to examine the cumulative value of taxes less costs, in present value. Figure II.D4 shows the present value of cumulative OASDI taxes less costs over the next 75 years. The balance of the combined trust funds peaks at $2.6 trillion in 2017 (in present value) and then turns downward. This cumulative amount continues to be positive, indicating trust fund assets, or reserves, through 2040. However, after 2040 this cumulative amount becomes negative, indicating a net unfunded obligation.

If you count boomers to include all of those born between 1946 and 1963 (which is stretching it), then the youngest boomer alive in 2040 will be 77 years old, and the vast majority of us will be long dead. In other words, the Boomers will have paid for their benefits. How big a problem is the projected deficit for future generations? If all of the assumptions of The Social Security Administration turn out to be correct, then the total deficit after the fund “runs out” will be 0.7% of GDP through the end of the projected period ending in 2081. Now, until we fixed the system in 1983 we ran deficits all the time (that’s what happens when you have a large population of kids relative to working adults). In addition, one has to question the assumptions of the Social Security Administration that project increasing costs AND declining tax revenue after the boomers are all dead (go figure that one). So I don’t care about these projections of future deficits because (i) they are small, and (ii) they are unlikely. If the boomers will have saved and paid for their benefits through 25 years of payroll taxes, then the next generation can figure out how to do it for themselves. Does this sound like a crisis to you?

It seems to me that the crisis is a figure of someone’s imagination. If there is a crisis, it has to do with the overall fiscal health of our economy, and not Social Security. I want all politicians to stop using Social Security as a “crisis” that is in need of fixing as a way of garnering support from lower and middle class voters. We have real issues right now, including things like health care costs, deficits, wars, dismantling of constitutional protections, and so on. The real crisis for boomers is in health care costs, and we need to be doing more about that. So the next time you hear any politician campaigning on a Social Security plan, send them an email asking why they are spending time solving a problem that does not exist while ignoring the true problems we face. If enough people do this, then perhaps the politicians will think it’s a movement (a Thanksgiving reference for the boomers out there).

For those who are looking for clarity on the political obfuscation front, you can get a list of the changes to Social Security under the Clinton Administration by going here. Some changes include:

Contract With America Advancement Act of 1996 (P.L. 104-121).

This bill, signed by the President on March 29, 1996, made a change in the basic philosophy of the disability program. Beginning on that date, new applicants for Social Security or SSI disability benefits could no longer be eligible for benefits if drug addiction or alcoholism is a material factor to their disability. Unless they can qualify on some other medical basis, they cannot receive disability benefits. Individuals in this category already receiving benefits, are to have their benefits terminated as of January 1, 1997. Previous policy has been that if a person has a medical condition that prevents them from working, this qualifies them as disabled for Social Security and SSI purposes--regardless of the cause of the disability. Another significant provision of this law doubled the earnings limit exemption amount for retired Social Security beneficiaries, on a gradual schedule from 1996 to 2002. In 2002, the exempt amount will be $30,000 per year in earnings, compared to $14,760 under previous law.

The Personal Responsibility and Work Opportunity Reconciliation Act of 1996.

This "welfare reform" legislation, signed by the President on 8/22/96, ended the categorical entitlement to AFDC (Aid to Families with Dependent Children) that was part of the original 1935 Social Security Act by implementing time-limited benefits along with a work requirement. The law also terminated SSI eligibility for most non-citizens. Previously, lawfully admitted aliens could receive SSI if they met the other factors of entitlement. As of the date of enactment, no new non-citizens could be added to the benefit rolls and all existing non-citizen beneficiaries would eventually be removed from the rolls (unless they met one of the exceptions in the law.) Also effective upon enactment were provisions eliminating the "comparable severity standard" and reference to "maladaptive behavior" in the determination of disability for children to receive SSI. Also, children currently receiving benefits under the old standards were to be reviewed and removed from the rolls if they could not qualify under the new standards.

More data on SS:

The shortfall to "pay back" the trust fund: according to the Trustees Report referenced above, the largest annual amount required between now and 2040 is approximately $150 billion (see the link from "Figure II.D4.-Cumulative OASDI Income Less Cost, Based on Present Law Tax Rates and Scheduled Benefits"). That really isn't a problem for two reasons. First, the Office of Management and Budget projects fiscal 2008 total receipts of $2,574 billion, so the $150 billion is not a lot. But, it gets better. The OMB also projects that the budget, including all of these transfer payments, will be balanced by 2012. So, if the White House is correct, there is absolutely no issue.

The issue is health care, not SS.

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Wednesday, November 14, 2007

More Crap about Incomes

The United States Treasury – funded by your tax dollars – released a report (the “Report”) yesterday that is, in my opinion, a propaganda piece in the war against the middle- and lower-income classes being waged by the current administration and its allies. In my opinion the Report is crap.

That may sound like strong rhetoric to some, but it is well deserved. This report is being mischaracterized in the media with reckless abandon. For example, see this opinion piece in yesterday’s The Wall Street Journal Online Edition titled “Movin’ On Up”. Sounds cheery! Unfortunately it is the usual crap that I regularly read by those afraid of tax increases on higher incomes.

What the right is saying about the Report:

Based on the WSJ article above (the “Article”) as well as a quick search of the Internet, the Report is being referred to as proof of the success of the Bush tax policies and as evidence there is not really a growing income gap in the US. For example, the Article ends with these words of warning:

“All of this certainly helps to illuminate the current election-year debate about income ‘inequality’ in the U.S. The political left and its media echoes are promoting the inequality story as a way to justify a huge tax increase. But inequality is only a problem if it reflects stagnant opportunity and a society stratified by more or less permanent income differences. That kind of society can breed class resentments and unrest. America isn't remotely such a society, thanks in large part to the incentives that exist for risk-taking and wealth creation.

“The great irony is that, in the name of reducing inequality, some of our politicians want to raise taxes and other government obstacles to the kind of risk-taking and hard work that allow Americans to climb the income ladder so rapidly. As the Treasury data show, we shouldn't worry about inequality. We should worry about the people who use inequality as a political club to promote policies that reduce opportunity.”

Oooohhhh – better beware of the tax boogie person! He (or she) is coming to get you and will cause our economy to crash!

What the Report says:

In (my) summary, the Report says that if you look at a group of people in 1996, and then look at the same group of people in 2005, many of those people moved up in real income and many moved down. This demonstrates that there is plenty of income mobility in The United States, and is contrary to the many reports about a growing income gap. The Report points out that “Nearly 58 percent of households … in the lowest income quintile in 1996 had moved to a higher quintile by 2005” and “more than half of the top 1 percent of households in 1996 had dropped to a lower income group by 2005…Put differently, more than half of the households in the top 1 percent in 2005 were not there nine years earlier.” Sounds impressive.

What the report does not say:

I find it amazing that purportedly educated people can read the Report and come to the conclusions they do. I guess our educational system really is as bad as people say it is.

To get to the point, ask yourself a simple question. How many of the people that you know in the top 1% of income earners today will be retired in ten years? Ask yourself another question. Of all the people you know in the bottom quintile who are at least 25 years of age, how many are younger and should achieve substantial income growth over the next ten years of their careers? That’s right, these factors are NOT considered in the results. As noted in the Report, “The data also conclude that the incomes of many taxpayers at the highest income levels are very volatile.” Retirement can do that to your income. The report concludes “Economic growth resulted in rising incomes for most taxpayers over the period from 1996 to 2005. Median incomes of all taxpayers increased by 24 percent after adjusting for inflation. In addition, the real incomes of two-thirds of all taxpayers increased over this period. Further, the median incomes of those initially in the lower income groups increased more than the median incomes of those in the higher income groups.” Now I didn’t see a definition of “economic growth” but if it means the economic growth over time of individual households as they mature from young people to accomplished professionals then this makes sense. Unfortunately that is not the context in which it reads. There is a footnote, however, that says "By comparison, in the U.S. Census data (2006), median household real income increased by 5.4% from $43,967 to $46,326 over this time period in 2005 dollars." How much do you want to bet you will read the 24 percent number in the press and not the 5.4% number?

Now to be fair, the report does compare incomes within the group and to all taxpayers. Here is one line of what it says about the intra-group only comparison: "Nearly 60 percent of taxpayers in the top 1 percent in 1996 dropped out of the top 1 percent by 2005, although 87 percent of them remained in the top quitile." I wonder what percent of them retired? We don't know that from the report. It also makes one wonder what the results would look like if they were expressed in quartiles instead of quintiles.

I would have recommended that this report be used as a starting point for actual research into the movement among income categories by families in the United States. Unfortunately it is so biased it warrants nothing other than a trip to the trashcan.

I really hate it when my tax dollars are used to produce propaganda like this. It’s a disgrace, and it’s bi-partisan (both parties do it).

PS: For a good article about bipartisan reports on this topic, you can go here. Michael Gerson does the topic justice even from the conservative perspective.

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Tuesday, November 13, 2007

Taxpayer Bailout Act 1?

I was reading the WSJ today and came across an article here about how the Federal Government is putting up more of the cash for home mortgages. Now, if you have been reading my column up to this point you know that I have been warning of this for a while and that I am concerned that the taxpayers will ultimately pay for the mortgage meltdown (see my October 7 article and here and here).

I decided to do a little homework and I looked up the portfolio and guarantee growth of Fannie Mae, Freddie Mac, and the Federal Home Loan Bank portfolios from December 2006 to September 2007 (I can’t wait for the October numbers). What I found is that on a combined basis, these three entities (the Federal Home Loan Banks are considered one for this) increased their portfolios (for Federal Home Loan Bank this includes portfolio mortgages and investments) by over $640 billion in that nine-month period. Is this a lot? Well, it is an annualized compound growth rate (compounding monthly) of approximately 16%. In 2006 the growth rate was 7.7% for Fannie Mae, 8.4% for Freddie Mac, and 1.8% for the Federal Home Loan Bank. In September Freddie Mac's portfolio grew at a 23.3% rate, Fannie Mae's portfolio grew at approximately 14%, and the Home Loan Banks grew almost 30% from June 30 to September 30. Add to that the fact that total mortgage originations are expected to be down this year by 15%, and we see the massive shift to government program mortgages.

Of particular note is the Federal Home Loan Bank. Federal Home Loan Bank advances have grown from $619.8 billion at December 31, 2005 to $640.7 billion at December 31, 2006 to $824 billion at September 30, 2007. WOW! Just what are “advances” from the Federal Home Loan Banks? "FHLBank Advances. Advance lending is the FHLBanks' main business line. It currently represents about two-thirds of all the FHLBanks assets. These loans, known as advances, are well-collateralized loans used by members [that would be the banks as we know them] to support mortgage lending, community investment and other credit needs of their customers.” That quote is from here. In other words, secured loans to the banks backed by mortgage related collateral (I think). Now, I know critics will say that these are not subprime mortgages. This is just the government utilizing its tools to get the mortgage market liquidity machine running again. Unfortunately, I could not find any detail describing exactly what collateral is backing those additional $183.3 billion “advances” from the Federal Home Loan Banks or the FICO scores of the recently added GSE (Fannie and Freddie) loans, so for now that is open for uninformed debate. What is clear, however, is that the federal government has funded and/or guaranteed, either implicitly or explicitly, approximately $640 billion of mortgage loans since the 2006 year-end.

(Note: None of this includes Ginnie Mae which as of year-end 2006 had total outstanding government guaranteed mortgage backed securities of $410.5 billion. I have been unable to find any quarterly data on Ginnie Mae exposure. And according to HUD, the total dollar amount of single-family home mortgages guaranteed by the FHA was $342.6 billion at the end of September, up from $336.6 billion at the end of December 2006. Not a substantial increase but lets keep an eye out for the October report. You will find it here when it is published.)

The taxpayers are propping up the mortgage and real estate markets and could well be the ultimate big loser in the subprime mortgage meltdown. The data is not available yet to figure this out (at least not to someone with a computer and internet connection). The really scary thing is that most of the problem loans have yet to refinance. Even worse still (if you can believe it) is the idea floating around the halls of the Senate to back jumbo mortgages of up to $1 million with taxpayer guarantees. This is an outrage in my book, and a complete waste of taxpayer dollars even to be considering such a proposal (not to mention the distortions that such a program would create in the market). If you would like more information on this, go here and click on “stupidity”.

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Friday, November 9, 2007

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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Tuesday, November 6, 2007

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.

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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Sunday, November 4, 2007

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.


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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Saturday, November 3, 2007

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 Returns66,305,818 33,152,910
FilersAVG Bottom 50%AVG Top 50-25%
Income Tax Federal$432.47$3,084.37
Income Tax State$0$1,770.00
After Tax Income$13,047.32$36,443.43
Avg Annual Expend.$41,584.00$41,584.00
Times Expense Coverage0.310.88
Excess (shortfall)$(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 Returns31,826,793 1,326,116
FilersAVG Top 25-1%AVG Top 1%
Income Tax Federal$13,687.84$277,601.66
Income Tax State$6,691.06$88,777.56
After Tax Income$81,024.55$820,940.78
Avg Annual Expend.$41,584.00$41,584.00
Times Expense Coverage1.9519.74
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:

Apparel & Services$1,8864.5%
Personal Care Pr.&Srv.$5411.3%
Tobacco & Suppl.$3190.8%%
Cash Contributions$1,6634.0%
Personal Insurance & SSI$5,20412.5%
Less SSI$(4,823)-11.6%

(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 Returns66,305,818 33,152,910
FilersAVG 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 Returns31,826,793 1,326,116
FilersAVG 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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Friday, November 2, 2007

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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Thursday, November 1, 2007

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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