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You can almost watch his mind at work. If you give long hard consideration to the topic of inflation, you have to conclude that there seems no reason for it to be a bad thing. It may take a little time, but the price of everything will eventually read just to a new higher level, and relationships will go on undisturbed. At first glance, inflation is just a harmless numbers game. You can understand the power of inflation; everybody likes a little of it for his own personal benefit. If everybody enjoys a little of it in his own sphere, then the whole world is pushed to a higher numerical level.

After long consideration, Hayek came to see that the disruptions of inflation are caused by the uneven speed of penetration throughout an economy or nation. If the price of oil goes up, the price of transportation goes up, then the price of home heating. But those who take the train or who heat their homes with coal are not affected so soon. Mortgages carry a fixed interest rate for thirty years, until the unwisdom of such agreements becomes clear; but it takes time. The process of inflation creates winners and losers, and disruption in the culture of payments. The speed of payment is itself a factor in the virtual size of the monetary pool. In the long run we're all dead and it all settles out, unless we set in motion a universal scramble to get out the door before others get there. Inflation is just as much an evil as collectivism, and somehow the two are usually seen together. The Road to Serfdom sits on the shelf, right next to The Austrian Theory of the Trade Cycle, and Other Essays .

http://www.philadelphia-reflections.com/blog/1262.htm

Health Maintenance Organizations (HMO)

HMO

It's an ancient wrangle whether a manufacturer should actually own its suppliers, or the reverse; or instead whether it's healthier for industry components to stand at arms length from each other. At issue is not only what is best, but what is fair. If industry mergers seem sufficiently unfair, it will be proposed they should be illegal. That's the main substance of a lot of antitrust argument. Unfortunately, what is valid in good times may be reversed in a downturn. A prosperous supplier of materials often acts as a "cash cow", saving a merged enterprise from bankruptcy. Unfortunately, within a different economic climate one badly failing supplier can bring down the whole merged enterprise. There's also organizational friction; a temporarily prosperous unit may get to thinking it should boss the less prosperous units around. At the very least, the cash cow resists use of its cash reserves to help "losers". Several centuries of experience have thus left a minefield of old laws, traditions, and ingrained prejudice to undermine any broad standards for what is best. In no field is this more true than the Medical Industry.

Eighty years ago in Houston, the first Blue Cross health insurance company was started for a single group of school teachers to pay for service in a single hospital. That expanded to other subscribers and other hospitals, soon making it more workable for insurance, subscribers and hospitals to stand at arms length, allowing for a variety of local combinations. During World War II, combat in the Pacific led shipyards to be built on the West Coast, but westward migration of steel workers was hampered by lack of local medical facilities for them and their families. Taking advantage of the loophole provided in the wartime wage and price controls, Kaiser Industries attracted medical personnel by building hospitals, paying salaries, and offering physicians ready-made medical practices. Because of various licensing laws, Kaiser's medical enterprise was divided into two corporation, Kaiser and Permanente, so a specialized corporation within the Kaiser-Permanente Foundation could accommodate the licensed practitioners. The salaried nature of the physician organization immediately caused trouble with local fee-for-service practitioners, who were thus excluded from a large population in their neighborhood when they could not readily adjust to varying mixtures of the two payment methods. Their reaction, led by an obstetrician in Stockton, California, was also to organize dual-corporation structures which were exclusively fee-for service. Because Kaiser had a Foundation, they also called their organizations Foundations for Medical Care. Then, as now, it proved difficult to run a practice with two different reimbursement philosophies in the same waiting room; in time, friction between the two styles tended to increase as doctors who were more comfortable with each style tended to segregate themselves. Since offers of salaries are more immediately attractive to newly-trained physicians, they flocked to California to serve the steelworkers who were in need of doctors. Fee for service, on the other hand, allowed the gradual assembly of a more durable practice composed of patients who could test what they liked before making a permanent allegiance. Essentially, the transients went to Kaiser, more permanent settlers used fee-for-service.

Thus, it came about that several models for health care reform were tested in a few smallish towns of central California. These demonstration experiments may perhaps not meet everyone's standard for scientific purity, but at least they were public examples with the dumber features knocked away. They certainly provided a laboratory where ideas could develop about topics that otherwise were merely opinions and unsupported conjecture. The Foundations demonstrated that physician-dominated organizations could contain costs and maintain quality in a satisfactory way; there had previously been doubt about their ability to contain cost. The Kaiser organization showed that salaried practice performed acceptably as well, both to most staff physicians and to a majority of the patients; there had been doubt about the willingness of the public to limit choices to a panel of assigned physicians, mostly young and usually from elsewhere. Finally, the two systems seemed to be able to live together more or less peacefully; indeed, the California public seemed reassured that two systems apparently kept each other in check.

The first main difference rested on the system of quality control. The local Foundations developed review systems based on peer review and peer pressure; these worked remarkably well, particularly in constraining non-physician costs like pharmacy, tests, and hospitalizations. Cost and quality control in the Kaiser system was more rule-bound and quicker to apply discipline, kept within bounds however by the ability of both patients and staff to jump ship for the other system. Aside from professional peer review, the Kaiser system experimented with owning hospitals, laboratories, pharmacies. Here, the experience directly paralleled the experience of manufacturing industry with its suppliers; when reimbursement was generous suppliers generated welcome revenue. When reimbursement was constrained and substandard, ancillary service losses were unwelcome. Taken overall, the Houston experience was repeated, that ownership of such facilities was mostly a headache. Indeed, subsequent experience has shown the two systems usually co-exist nicely within independent ancillary facilities.

The Stockton, or Foundation for Medical Care, approach grew popular in the West. The variant which grew up in Utah was locally popular, and attracted the attention of Senator Wallace Bennett. The Bennett Amendment to the Medicare Act then picked out the peer review system as the secret of success, and set up a nationwide system of Professional Standards Review Organizations (PSRO) to conduct peer review of Medicare and Medicaid patients. The drawing of boundaries around these organizations was the most difficult part, and sometimes the boundaries were inept. Rural districts were adamant that the standards of big-city medical schools were not to be applied to their scattered resources, and urban areas saw themselves as ancient Rome surrounded by hostile tribes. Although these difficulties were foreseen, it is not always possible to draw a line that will separate the cultures, particularly where the outward migration of suburban housing was more rapid than the construction of suburban medical facilities, leaving the medical culture unstable. The PSRO system was quite successful in many areas, but caused trouble in others that was not adequately addressed. The central concept of the review system was that the doctors who worked together could quite readily identify the outliers, and better than anyone else could judge whether the local situation was justified. True, some practitioner might try to abuse the system to the disadvantage of his competitor, so no adverse decision was final until there had been an opportunity for outside appeal. There might even be a few circumstances requiring still higher appeal. The system was new and untried, but it produced eminently satisfactory results from the point of view of the Federal Government paying the bills. As former President of one of the largest PSROs in the country, I will assert that there was remarkably little friction or resistance in the medical community. My very good friend, the President of the New York City PSRO says much the same, and most people would say that if you can carry off a new system in New York without a lot of argument, it must work pretty smoothly. The Government wanted to eliminate unnecessary Medicare costs, particularly in hospitals, and it wanted to maintain peace with the medical profession. Hospital costs are obscured by the wide gap between posted charges and true underlying costs, compounded by disagreement about the proper assignment of overhead charges. Charges were not the assignment of the PSRO, utilization was. Days of hospitalization per thousand enrollees fell from roughly 1000 days per thousand to roughly 200 days per thousand, and that satisfies me at least that we were doing our job; physician peer review was doable.

It is likely, however, that peer review was much more apt to produce friction in rural districts. Philadelphia has had more than a hundred hospitals for more than a century. Birds of a feather tend to flock, so the sorting-out process was already far advanced by the application of constrained referrals to practitioners who failed local standards. Mixing members of different hospital staffs on appeals committees was easy in the big cities, and the naturally censorious tendencies of many physicians could be safely counted on to produce adversary balance. Most committees seemed visibly pleased, even relieved, to discover generally good quality in their competitors' practices. However, in the much smaller and more scattered institutions in the nation's regions with low population density, these informal arrangements cannot stretch as well. When there is only one specialist in a field, for example, it is sometimes hard to know whether he is a good one or not, but always easy to say whether you like him or not. Where the population thins out, much greater wisdom is required to make judgments, the number of close cases is greater, and the limited supply of judicious reviewers is similarly stretched. At least that is my surmise, based on knowing the background of most of the AMA delegates who eventually voted 105-96 to condemn the program in a standing vote. The result was the Dornenberger Amendment, which much weakened the system, when instead it should have triggered a more profound analysis and reconsideration.

Perhaps we spend too much time here describing a technical process. It is, however, at the heart of what makes the Foundation approach (sometimes called IPA or Independent Practice Association) superior to the HMO. It is now perfectly clear that both doctors and patients vastly prefer the IPA approach to the HMO, and any reasonable politician would jump at it. But there is one fear, summarized by the slogan that the Fox is guarding the Henhouse. In both systems, an attempt is made to combine the insurance with the delivery of health care. In the IPA, the physicians are taking the financial risk that aggregate income will exceed aggregate costs; it's a risk contract. In the case of an HMO, the employer or the government is taking the financial risk and therefore wants to control it. If revenue is good, the doctors will prosper in an IPA; the insurance company intermediary will prosper in an HMO. Doctors will care about that little difference, but why should the rest of the country care?

Because the prospect is overwhelmingly likely that future revenues will be constricted until something hurts, and when you starve with a tiger, the tiger starves last. In the case of an HMO, the insurance middlemen will starve last, and the quality of health care will starve fairly early. That's an unwise design. When we get to the point where Congress cuts the budget and watches to see what happens, Congress will cut it some more if nothing bad happens; it will back off only if something bad happens, so something bad is certain to happen. In designing the system, you need to design the internal review authority so it will cut the waste, inefficiency and luxury first. The reviewer, no matter who it is, will cut himself last, so you need to arrange the incentives for waste to be cut before the reviewer suffers, and quality of care only after the reviewer has suffered. If you wonder why a whole lot of special interests hate physician-dominated review systems, a short answer will be found in this synopsis. A special exception must be devised for rural health systems, which do have a unique problem.

To return to the well worn slogan about foxes and henhouses, we have overlooked the central question. Who's the fox, and who is the hen?

http://www.philadelphia-reflections.com/blog/1268.htm

OUR NICE HOUSING BOOM COLLAPSES

Three Basic concepts at work:

• Steep yield curves (the normal situation) are good for banks; inverted curves (a rarity) are not. The 2006 inversion was caused by the bond market accepting abnormally low long-term interest rates, so the "spread" between risky loans and safe ones displayed a diminished "risk premium".
• The Federal Reserve then lowered short-term rates by printing more currency.
  This caused an inverted yield curve to return to its normal shape, but the 2006 problem was caused by too much(Chinese) money and this action added to it. The banks were rescued, but the currency was inflated.
• This innovative response will probably become a standard readjustment.
  But it only keeps the ship from tipping over after a sudden wave; it doesn't address the approaching storm.

Risk premiums soared in August 2007. What seemed safe, abruptly was risky, only available at higher prices.

What happened in August?....The "risk premium" --and, consequently, mortgage interest rates-- suddenly went back to normal. About $90 billion of foreclosures seemed probable. We had built far too many houses for people who couldn't afford them. Surplus houses remain for ten years, depressing all real estate prices, making everybody feel poor. Recession, anyone?

What did the Federal Reserve do? To protect the banks, Bernanke dropped short term interest rates. (This steepens the yield curve.) As the panic spread, he dropped rates some more (This floods the country with money). Inflating the currency cheapens the dollar, which robs foreign investors. Foreigners sold stock to escape, prices fell. Seeing prices fall, everybody else sold stock. 1929, anyone?

So what? They're only foreigners. If Bernanke raises interest rates, we may get a recession. If he keeps them low, we may get hyperinflation. So, he probably hopes to drop them for a couple months, then raise them again. Jimmy Carter got "stagflation" trying this sort of thing. Green eyeshades, anyone?

Remember how naughty "redlining" was? Well, now we bash the banks for "stupid mortgages". Banks issued cheap mortgages for inflated real estate -- and immediately sold the "subprime loans" to investment bankers as "collateralized bonds". We are still uncertain who holds these things, but at least $40 billion were in the hands of Wall Street when the music stopped. Wall Street had to sell perfectly good (?) stock to pay their debts. Blue chips, anyone?

Why was the risk premium so low? The Far and Middle East had something to do with it. But mainly, securitization led to undue emphasis on statistics. In a housing boom, foreclosure rates seem to go down but are really only being diluted by new loans. The fall of BNP Paribas was a sudden wake-up. Then, the computers of the "quants" exposed a flaw in their programs when they detected heavy selling of perfectly good stock, and announced the End of the World..

Thank heaven it happened before things got serious.

WWW.Philadelphia-Reflections.com/blog/1331.htm

http://www.philadelphia-reflections.com/blog/1331.htm

Making Money (8): Virtual Money

When money was tangible you had to guard it, now that it's mostly virtual you have to verify it. Hardly anybody can, and that's a problem.

When money and wealth were wampum, precious metals, and paper currency, these physical objects required physical protection. It was all a big nuisance, with six-guns on the belt, bank vaults and appraisers of one sort or another. But now that wealth is merely a bookkeeping entry on someone's computer, things may be even more nuisance because verification is almost beyond us. Counterfeiting of the computer variety must be left to institutions to detect or deflect, causing them to introduce firewalls of various sorts that also block legitimate inspection by customers. "Trust but verify" doesn't work so well in this environment. Let's use a personal example, slightly fictionalized to protect the innocent.

Several software products now exist to download transaction information automatically from various institutional sources to a customer's home computer; they are either free or cost a nominal amount, and are quite "user friendly". In my case, however, the reports they generated were quite significantly at variance from the monthly reports which were issued directly by my counterparties. Dear Sirs, Please explain.

What I soon discovered was that everyone blamed someone else, and everyone blamed me for bothering them. Quite obviously, I had little understanding of these specialized accounting niceties, and quite obviously I had too much spare time on my hands. Telephone help desks, often located in India, will not give out telephone numbers for incoming calls, and are programmed to check the size of your account before placing you in a call-back queue. The first call is usually taken by a trainee whose job it is to screen out the silliest sort of help request, and then to refer to a supervisor if things rise in complexity. Supervisors have supervisors. That's if you are lucky. More commonly, the tedious software business has been farmed out to a vendor, and the contracting agency has neither the necessary understanding of the issue, nor any ability to fix it. From the sound of it, the vendor often gives the contracting agency the same sort of isolation treatment that they would give a customer if he could find their telephone number. And guess what. At the end of the day, one of those high-handed defensive linemen -- turns out to have been at fault.

Let's explain one problem. On the surface, we were talking about a $40,000 difference in account balances; one may have been correct, but a second one must have been wrong. That rises to lawsuit level, so the matter got intensive study. It turns out the stock broker had misinterpreted instructions for a "sweep-account" system. When a stock in your portfolio pays a dividend, the amount of the dividend is subtracted from that stock's line item, and added to the line item of your money-market fund. That's fine, but there is one exception. When the money market fund itself pays a dividend, subtracting that dividend cancels out the addition, and the dividend essentially disappears from your net worth. Was this intentional? Certainly not; no one could stay in business doing that. It's not even a highly stupid error, since you can easily see yourself making the same oversight of the one implicit exception to the rule of sweep accounting. Because this "bug" in the program involved one institution making a mistake and transmitting it to a second institution, the systematic error did not unbalance any books, until it reached mine. But since I did not detect the error for five months, there must be dozens, hundreds, maybe thousands of customers who did not detect it. Ouch. Do the math yourself to judge whether this was a serious error.

This illustration, only one of several on my personal report, leads to at least two larger principles. The first is that the transformation of money from tangible to virtual has occurred so rapidly that bullet-proof safeguards have not had time to emerge. After a century of use, most people cannot balance their checkbooks, but enough people can balance them so that systematic errors are not likely to slip past. When enough people with home computers repeatedly test the internal complexities of their virtual money accounts, confidence will develop that the system is probably working. Confidence is an important matter; it is possible to imagine quite a bank panic if the public suddenly got the idea that virtual money is maybe a mere vapor. In fact, the securitized credit panic of 2007 is a little like that. With a few new regulations and a lot of computer programming it surely will be possible to know who owns how many bum mortgages. That innovative mortgage system got ahead of its tracking verification, and we now just have to hope nothing serious happens before that gets fixed.

The second important lesson is that our health insurance system has a similar problem of far greater size and complexity. We are here talking about at least ten percent of Gross Domestic Product, in which one daily unit of measurement is in truckloads of insurance claims forms. Stocks and bonds are admittedly complicated, but compared with thousands of different diagnoses, drugs, procedures and hospitals -- verifying financial transactions is trivial compared with measuring medical ones. With a twenty billion dollar budget and ten years of lead time, we might have a shot at it. Except for the fact that during the ten year interval, medical care will have changed so much you will have to start over on the project.

http://www.philadelphia-reflections.com/blog/1349.htm

Gloomy Future for Banks

Banks pay depositors modest interest rates, lending to borrowers at higher ones. This is known as lending long and borrowing short.

One of the many Joseph Nicholson's in Philadelphia once surprised me by criticizing Paul A. Volcker as merely a tool of the banks. That distinguished Chairman of the Federal Reserve had always been, and still is, one of my heroes for rescuing the nation from inflation. Instead of wringing his hands at inflation, Volcker had the courage to jolt short-term interest rates right up to 8%. It must have caused a lot of pain to some people, but in retrospect it was exactly the right thing for him to do. How could anyone complain about his helping the banks, when he was helping the world economy for everybody?

The answer is that the old Quaker felt 8% was too little, Volcker should have gone higher. In fact, banks always have comparatively little at stake in whether interest rates are high or low. Their profit lies in maintaining a steep yield curve. Which is to say, as long as short-term rates are safely lower than long-term rates, the banks make a profit. It may be hard to recollect, but typical interest rates facing Volcker were then about 18% for long-term loans. Joe Nicholson had a point when he complained that a 10% profit seemed too generous, but for Volcker to raise short term rates to say 15% would have been seen as the act of a madman. In fact 8% did turn out to be adequate for curing inflation, so this episode had a happy ending for both inflation and bank profits. Borrowers commonly feel that banks are greedy, but remember they must accumulate reserves. If the yield curve becomes "inverted" for a protracted time (that is if ninety-day rates are higher than ten year rates) refusing to make loans is the only alternative to spending reserves. If that fails there can be bankruptcy, usually triggered by runs on the bank by depositors in a panic.

Long term rates are set by the bond market, short term rates are set by the Fed. This limits the traditional ability of the Federal Reserve to sustain the viability of banks to one simple tool, keeping short term rates below whatever rates the bond market sets for long loans. In recent years, however, banks have a new competitor for deposits in the form of money market funds. The new formula for what banks want in their Christmas stocking is for the Federal Reserve to set short-term rates well below the market-set rate for long-term rates; but mind you, only slightly below the market-set rates for money market funds. Caught between these two implacable limits, the Federal Reserve has small room for safe maneuver. It is disquieting to hear that fluctuations of market-set interest rates are very difficult if not impossible to understand. Alan Greenspan called them a "conundrum".

And so, when you see pictures of the Federal Reserve Chairman riding off in a long limousine, he may look fully equal to the responsibility of keeping the world from financial collapse. Someone on the sidewalk once muttered that a man with a beard always looks like he's hiding.

http://www.philadelphia-reflections.com/blog/1351.htm

Report Identity Theft to the Secret Service

The Internet provides new blessings, but new problems as well. Identity theft has now ballooned from a rarity to a fairly serious issue. After initial turf confusion, the issue has been assigned to the U.S. Secret Service. If it happens to you, that's where you make your anguished call. (1-877-ID-THEFT) or www.consumer.gov/idtheft

There's a certain logic to regarding identity theft as a modern form of counterfeiting, which has been with us since the days of William Penn. Shirley Vaias, representing the Philadelphia regional Secret Service, recently addressed The Right Angle Club of Philadelphia on the topic. It makes sense to learn the Service is headquartered on Independence Mall, across from the Mint. The crude forms of printing in the 18th Century made counterfeiting easy, and ever since the early days, there's been a race between improvements in technology and improvement in counterfeiting. We now have paper with little red fibers in it, watermarks, serial numbers, color-shifting inks, microprinting of secret messages in the portraits, special magnetic strips, and probably lots of other clever things we aren't told about. The Bureau of Printing and Engraving is changing the currency, one bill at a time, and recently there was a new ten-dollar bill. A counterfeit version was in circulation within six hours.

ATM machines are equipped with counterfeit-recognition devices, and special gadgets are provided for banks and retail stores, but one detection device traditionally catches most fake bills. After handling huge amounts of currency, bank tellers catch a counterfeit just by the feel of the paper. Color photocopiers are getting better and cheaper, but of course they can't change the serial numbers, so they aren't as smart as they seem. About one hundredth of one percent of the currency in circulation appears to be fake, so you are pretty safe, but the possessor of a bad bill is deemed to be the one out of luck. The consequence is that many citizens suspect a bad bill, take it to a bank, and have it instantly confiscated without recourse. That would seem to discourage reporting a counterfeit, encourage passing it off to an unsuspecting friend, and overall seems terribly unfair; but it results from the wisdom of the ages. Experience shows honest citizens are indeed tempted to try to pass the money on. While the banks don't enjoy being policemen, the effect is that counterfeits will circulate until they hit a bank, and thus confiscation is fairly comprehensive.

As the printing of money gets more complicated, the special presses needed to produce good money has became a monopoly of certain German companies, who sell the machines to other countries. Some of the American presses thus got into the hands of some Russians, who sold them to the North Koreans. So for a while at least, the North Korean government was printing American currency. It provoked vigorous countermeasures, the nature of which is confidential.

A bill of any denomination costs the government about half a cent to produce, and lasts about four years in circulation. When tons of old bills are retired from circulation, the serial numbers are recycled; to an outsider, that sounds like an impossibly tedious job, but they say they do it. There's also the issue of seignorage, a term for the profit the government makes when paper currency gets destroyed in one way or another, costing less than a cent to replace. Just how profitable the currency business is, cannot be accurately determined, because a lot of it is buried or hidden in mattresses and might someday resurface. But there is a substantial profit, which like any shrewd businessman, the government weighs against the cost of detection. Bail bonds and casinos are big sources of bad money, as could be readily imagined, and hence it is in their interest to get pretty sophisticated (and extremely unpleasant) about detection. On balance, however, it can be expected that legalized gambling in Philadelphia will promote more counterfeiting in the local economy, and hence is an offsetting cost of the tax revenue.

Over the centuries, governments have learned how to cope with counterfeiting, and there is actually much less of it than a century ago. You win some and you lose some; life just goes on. With internet identity theft, however, the criminals are developing techniques faster than governments have learned to combat them, and it is governments who struggle to catch up. Unfortunately, everybody takes a business-like approach to the matter, asking whether the precautions cost more or less than the losses. It would seem that if money continues its migration from paper currency to bookkeeping entries, it will eventually seem unsatisfactory for only one party in a transaction, a bank let us say, to keep the books while the public simply trusts them. Eventually, each individual will be forced to seek the protection of some sort of computerized system keeping the counter-parties honest, on behalf of the public, and to prevent a paralysis of commerce. Identity theft is getting expensive enough to warrant the effort.

Just how to do all that is not too clear. So, in the meantime, just let the Secret Service figure it out.

WWW.Philadelphia-Reflections.com/blog/1359.htm

http://www.philadelphia-reflections.com/blog/1359.htm

What's a Repo?

On St. Patrick's Day, 2008, Bear Stearns became insolvent and was given to J P Morgan. The Federal Reserve assumed all risks. Effectively, the fifth largest investment bank in America was nationalized for $2 a share, because no private bank would buy it at any price. A year earlier it was worth $170 a share, even one trading day earlier it sold for $26.

At the heart of this catastrophe were "repo's", or repurchase agreements. (They should not be confused with repossessions of cars and other hard goods bought on time, which are also called repo's.) Although most people had never heard of the high-finance version of repo's, the volume of these instruments had grown to $5 trillion by January 2005, presumably even several times larger than that when they caused the nationalization of Bear Stearns. Newsmedia accounts offered the guess that 16% of the resources of the whole financial sector were caught in open repo's when the music stopped. Repo's must be awfully good, or awfully bad.

They were both of these things at once. Like so many innovations in the post-computer era, they offered a major cost saving to an inefficient transaction system, but were so successful they overwhelmed the institutions which flocked to their reduced cost. The unanticipated difficulties might have been imagined, but they were not adequately guarded against. Essentially, these loans limited exposure to a few days, a feature that made them appear quite safe. Unfortunately, tons of these loans could expire simultaneously if a rumor got started and everyone held off using them for a week. With a run on a bank, at least people have to take action to withdraw their money; but with these things, simple inaction quickly led to massive cash shortages at the bank. Speeding up the loan process had made it cheaper, but made it vulnerable.

Consider the inefficient complexities of a bank loan. The bank wants collateral, perhaps 80% of the value of the loan. The ability of the borrower must be investigated, a clear title assured, and papers arranged for transfer in case of defaulted collateral. Lawyers must organize the agreements, and it all takes time, costs money. To go through all this for a one-week loan for anything less than huge transactions is simply not practical. So the idea was devised to sell the collateral to the lender at a discount, together with a repurchase agreement to buy it back at full price. For safety sake, the discount could be greater than the interest cost, and part of it returned if all went well. The collateral could be held by a third party, who essentially guaranteed the details while the collateral itself never moved. Bear Stearns had perfected these variations at such favorable prices they dominated the market for them with hedge funds; the margin for error narrowed when interest rates dropped, cash got scarce when investors got uncomfortable, the whole hedge fund industry was suddenly paralyzed, and everything connected to hedge funds was frozen secondarily. Much of this was handled automatically by computers, so huge volume made it impossible for anyone to know who might be insolvent. It seemed comparatively harmless to decline to play this game for a few days, but it was not harmless if most people decided to do so at the same time. The daily variations of interest rates and/or duration generate a ("Gaussian") normal distribution curve for the risk, predicting serious deviations will occur once every two centuries. But when events --even false rumors -- suddenly get everyone's attention at once, small daily fluctuations no longer bear much relationship to the frequency of violent fluctuations. Once-in-a century events start to happen every few years. At those times, the public stops speaking with a million voices and shouts in unison. Quite often, there is no cataclysmic event to trigger it. Like the conversational babel of a dinner party, it can all stop at once for no particular reason.

The mathematics of this matter could be taught to a tenth-grade math class. It starts to get beyond everybody's anticipation however when two such Black Swan events happen at the same time. In this case, an unanticipated pause for a few days bumped into the rule that non-bank institutions must mark their portfolios to the market every day. But for days at a time in this crisis, there could be no trading in certain issues; there was no market to mark to. How then can you demonstrate your solvency -- what might your competitors be hiding during these unannounced market holidays? And, since banks are in the same pickle but aren't required to mark to market, how can you trust them to pay bills? When you see European banks, who must obey new rules called Basel II, go bankrupt and get nationalized, how can you be sure American banks, who needn't obey Basel II until 2009, are any safer bet?

Progress is progress, but how much of it can we cope with?

The 'repo' market from Marketplace on Vimeo.

http://www.philadelphia-reflections.com/blog/1420.htm

HowTo Create A Subprime Derivative

http://www.philadelphia-reflections.com/blog/1439.htm

Hedge Funds in Delaware

Trimming the Hedge

Some day a shrewd observer of the passing scene will notice the peculiar quality which attracts some businesses to the state of Delaware, and coin a catchy phrase like Delaware Attractiveness to describe it in a nutshell. It surely underlies the way major national corporations predominantly incorporate under the laws of Delaware; other states don't like that. It probably accounts for the unusual accumulation of national credit card companies in that little state. Right now, it must be surmised to account for 24% of American hedge funds locating in Delaware. Just what is Delaware Attractiveness?

James Madison

James Madison, the main author of our national Constitution, disliked taxes and debt and celebrated the ability of taxpayers to move to a different state if their home state raised taxes too high, or accumulated too much debt, with its embedded prediction of higher taxes later. The right to migrate away acts a a discipline on state governments tempted to abuse their power. A good example now exists in New Jersey, where one percent of the population pays 42% of the taxes, and that one percent is moving out of New Jersey as fast as it can. Eventually, 42% of taxes will be dumped on those who remain, and eventually something will be done about New Jersey state expenditures.

So conversely, little Delaware once had relatively few corporations, and had little to lose by lowering corporation taxes. Soon, these low taxes attracted corporations from other states to incorporate in Delaware, and a good thing for everybody except the beleaguered governors of other states who had to look elsewhere for feathers to pluck. When credit cards were invented, they were attracted to Delaware by low taxes and gentle regulation. They were clean non-polluting businesses who employed a lot of rural labor made available by dramatically enhanced agricultural productivity. One member of the Delaware Chamber of Commerce once mused, if it would attract the right sort of business, any hampering state legislation could be changed over a weekend.

Adlai Stevenson

This spirit of the American Liechtenstein has now attracted 24% of hedge funds to Delaware before most people know what a hedge fund is, or if they know are still in the tentative stage of thinking they are a good thing to stay away from. Without delving into the full complexity of the subject, it can be said that a hedge fund locks the investor's money up for several years, and tells the investor very little about what it is doing with his money. One hedge fund operator stoutly defended the need to keep others from knowing his positions, illustrating how competitors who knew his positions would destroy him by "front-running", typically by flooding his positions with sell orders about ten minutes before or after the closing bell on the stock market. You can see how that might be ruinous, but you can't see how it differs from the situation of everybody else, like the big mutual funds. It is thus tempting to regard the ability to front-run, and the ability to avoid having it happen to you, constitute a business advantage, an "edge". There may be more to it than that, but such other features are cloaked in the secrecy which hedge funds enjoy, so secrecy is the business plan of hedge funds, apparently more tolerantly treated in Delaware than elsewhere. The price which hedge funds pay for their right to secrecy is the limitation imposed on them by the regulators as to who may be their customers. Somehow, a customer must be defined as a rich sophisticated person, who knows what risks are involved, and can afford to lose his money. Being in a small, closely-knit community where word of mouth is trusted, adds some degree of safety too. Adlai Stevenson once made an observation about such things.

"In the past it was said, a fool and his money are soon parted. But nowadays -- it could happen to anyone."

http://www.philadelphia-reflections.com/blog/1453.htm

Securitization: Pass the Hot Potato

Fannie Mae Corp.

It would be pardonable to say that since securitization of home mortgages is a generally good thing, we might overlook any minor differences in approach between Fannie Mae (FNMA) and CDOs (Collateralized Debt Obligations), and let the customers decide which approach is preferred. Unfortunately, they both encompass a fatal flaw that has somehow escaped adequate notice. As mortgages pass from one holder to the next in sequence, both the buyer and seller seek to avoid the worst-risk mortgages and retain for themselves the best-risk ones. Get stuck with too many bad-risk properties, and you will go broke. When the credit markets suddenly woke up to this reality in August 2007, it was impossible to know who was holding good stuff and who was holding toxic mortgages. The markets "froze", which is to say most traders just walked away from participation until the situation clarified.

Rising house prices

Furthermore, with existing systems this seems to be something that will inevitably happen. A small-town bank tries to sell every mortgage it originates to an aggregator, but a few mortgages just aren't salable. The small town bank might well be able to sell mortgages to people who can't afford a house, but the aggregator is wise to the world, and won't buy the worst of them, so they silt up in the hands of the originating bank. Some originating banks may be deft enough to hold on to the very best risks and sell the rest, but a lot of banks will be turned away by dealers who are smarter than they are. At every step in the chain there will be the same contest, so eventually everybody comes under suspicion. Add to this trap the irony that an environment of rising house prices simply increases the size of the defaults when the pyramid finally topples, and it may temporarily blind everyone to the risks being run, thus making it all worse. Somehow or other, the average down payment on the mortgages you hold must be larger than the average drop of house prices in a slump, else you will be transferring the risk from the homeowner to yourself. A strong case can be made that the fault in the recent crash was not predatory lending; it was failure to demand adequate down payments.

Bear Stearns

However you define an "adequate" down payment, it is clear that the recent rise of house prices particularly in the regions of greatest overbuilding, put a conventional 20% down payment completely out of reach of many first-home buyers. Since house prices have declined 20% and may decline 20% more, a determination of lenders not to lend more than 80% would have prevented a lot of overbuilding. If mortgage aggregators had refused to purchase mortgages that lacked an adequate down payment, the originating banks would soon have stopped issuing them. Consequently, the necessary fortitude should have been applied at the last step before securitization. It's possible to believe the people at Bear Stearns now wish they had done so.

If we then turn to the GSEs, the significant extra risk of Fannie Mae is political. Holding $5 trillion of debt more or less guaranteed by the U.S. Government, the Secretary of the Treasury repeatedly told congressional hearings that assuming its default would double the national debt. Double the national debt is what is meant by being "too big to be allowed to fail." Since this appalling situation willy-nilly relieves Fannie Mae of any worry about collapsing, the only way to force Fannie Mae to insist on adequate down payments is by Congress passing a law that they must. Congress seems to lack the political will to pass such rules in an election year, or probably any other year. The mandate for fifty years has been for Fannie Mae to make housing "affordable" and keep homeowners from losing their homes. It would be an unimaginable tragedy if Congress ran away from this dilemma, and accepted the hyper-inflation which would result from suddenly doubling the national debt. Unimaginable, but likely.

http://www.philadelphia-reflections.com/blog/1498.htm

Bank s: Fragile and Dangerous

A bank can't function without deposits, and it can't function unless it can sell shares. So a bank will collapse if there is a run, or if the price of its stock declines severely; public opinion has a lot to do with the success of a bank. What's more, banks have a lot of dealings with each other, so a panic can quickly spread from one bank to another. That's known as counterparty risk. The laws require a bank to maintain a certain ratio of equity to assets, which is to say a ratio of the collective worth of its stock compared with the collective worth of its outstanding loans. The intent of this rule is to make sure the stockholders lose every dime of their investment in the bank, before the depositors lose anything. Facing the total loss of their investment in almost every serious difficulty, bank stockholders are very twitchy.

If the bank is doing poorly for some reason, the stockholders get wind of it, and the price of the stock declines as stockholders sell out. The effect of this is to bring the "capital ratio" below the required level, and the authorities will require the bank to sell more stock. That will in turn dilute the value of the stock of the existing shareholders, decreasing the stock value. So the effect of a sharp drop in share prices will have almost the same risk to the bank as a run on the cash by the depositors, because now the shareholders will sell more stock in the hope of getting out before it declines further in value. This happened in 2008 with the stock of Fannie Mae, which dropped from about $70 a share to $10 in a few weeks, prompting the Federal Reserve to offer to loan cash reserves, and if necessary to buy the stock. After that, it sent investigators to measure the solvency of Fannie Mae.

This historic episode illustrates the valuable role of the stock market in sensing trouble before regulators are aware of it, and helps explain to Congressmen who want to pass abusive legislation that "The stock market won't let you do that." A week or so earlier, Senator Charles Schumer (D, New York) had made public a letter expressing his concern about IndyMac, another large bank, with the immediate result that there was a run on that bank which made it collapse. So, not only are there banking situations which Congress does not dare meddle with -- there are even situations which the Senate Banking Committee does not dare talk about openly. Naturally, this sort of situation wounds the egos of Congressmen, but a number of left-leaning and high-handed foreign countries have in the past nationalized their banks, with disastrous results. When a bank gets to a certain size, it is as fragile as a land mine. And just as dangerous to tamper with.

http://www.philadelphia-reflections.com/blog/1500.htm

World Finance, Columbus Day 2008

Prime Minister Gordon Brown

With voters watching three weeks before the 2008 American presidential election day, finance ministers and their political masters met to decide a basic question: dare they risk disaster to save the existing system, or play it safe by sacrificing small banks to rescue big ones? That is, guess if the situation is so bad only strong rowers can be allowed in the lifeboat, or whether things are really manageable enough to try to save everybody but at the risk of worse consequences for failure. For example the credit default swap mystery; there are $60 trillion notional value insurance policies in existence to cover $20 trillion of bonds. Is that massive double-counting, or an actual disaster so severe it makes every other consideration trivial? Answer quick, please, the ship looks like it might sink. At first it seemed strange a Labor government in England would propose saving only the strong, until you realize that Prime Minister Brown is protected from his Left, while the Democrats in America want to use a fairness argument to win their election. A Republican lame-duck president must do the deciding, a man who has been shown to be both a tough politician and a fearless gambler; playing things safe is not his style. The Dow Jones average soared a thousand points in a day's trading on the prayer that things were finally under control. But take a look around.

Little Iceland and Switzerland are proud to house some enormous banks. But if those banks approach failure, their homeland treasuries are far too small to bail them out.

On the other hand, little Hungary has a negligible banking system, so Hungarians commonly borrow money from foreign banks. The national currency devalued by half in this crisis, so most Hungarian mortgages doubled in price. Reserve systems based on national governments suddenly look obsolete.

Try another approach. Little Ireland went ahead and guaranteed all deposits in its financial institutions. Money from England and the rest of Europe immediately poured in to enjoy that guarantee, forcing other grumpy nations to match the unwise Irish offer. There's a sense that nations are losing control of their affairs.

Europe consists of 27 nations, of which fifteen are in the Euro zone. There's a common currency and a constrained central bank, but can this gaggle of geese possibly agree on concerted action in this crisis? America was once in this situation under the Articles of Confederation, but even after almost losing the Revolutionary War, George Washington was nearly unable to get the colonies to form a union. Even after this experience, the Southern Confederate States later adopted the same system of a central currency without a central government and really did lose their war.

Are we to infer from Prime Minister Brown's attitude toward banks that he might soon suggest ditching little nations in order to save bigger ones?

www.Philadelphia-Reflections.com/blog/1525.htm

http://www.philadelphia-reflections.com/blog/1525.htm

Financial Institutions of the Future

Things which normally dominate newspaper front pages, like presidential elections and World Series baseball, are now found back among the brassiere ads displaced by the stock market, credit market, banking and investment crisis of 2008. However, like the wake of a ship at sea, the past could be pointing to the future. Contemplate all the mighty financial institutions which have simply vanished.

It may even be trivial to say that Lehman Brothers and Bear, Stearns have disappeared. The fact is every investment banks has disappeared.

And that's not all by a long shot. Savings and Loans have disappeared. Small commercial banks, and even most of the pretty big ones have disappeared. We may soon be left with half a dozen major banks, and no lesser ones. Commission-based stock brokerage is now a rarity. Insurance? Well, the longevity increase of thirty years over the past century gave life insurance an enormous unearned windfall; when that flattens out, will such institutions still prosper? Individual corporate stocks are quickly vanishing into the homogenized soup of index funds, just as securitized debt was digesting home mortgages before the current uproar. The ranks of stock analysts are thinning out; it no longer matters much if they have a conflict of interest with nonexistent investment banks and stock brokers. All of this disappearance of institutions is in the recent past, and it mostly isn't coming back. Perhaps hedge funds and private equity companies will take over, but it is really too soon to say if they will survive, either.

Credit cards have been over used and abused; that can be corrected. But the credit card system is supported by exorbitant fees charged to participating merchants; the card industry could easily disappear if the merchants devise a way to escape this private taxation; merchants universally wish to do so. The currency version of money is trying to disappear as fast as practical ways can be devised to measure value and transactions electronically. The remorseless pressure behind reducing all transactions to electronic form is created by the greatly reduced cost of it. And that pressure is magnified by electronically speeding up transactions; the faster money turns over, the more its virtual size increases. The converse of course is that a slow-down reduces its size. Like a giant tuna, the money supply dies of lack of oxygen if it slows down.

It can be seen in retrospect that banks are dying because everybody else stole their products by providing cheaper alternatives, mostly with computers. In the process, the national economy gets more uniform, less dependent on local agencies. Something of value has been lost, of course, particularly the local assessment of the capabilities and requirements of local customers; somehow, that seems to be expendable. But one thing, perhaps two, cannot be dispensed with.

For fifty years, we have grown accustomed to the idea that the electronic records of our institutions are accurate. That's definitely not so. Even a reliable firm makes a myriad of errors in its many transactions, catches them with redundancy and cross-checks, and presents the cleaned-up product once a month or maybe even once a day. But even though the illusion of flawlessness is maintained for the customer as much as humanly possible, it is not inherently flawless. Systemic breakdowns will always expose uncorrected flaws caught in process, while disincentives are created by this one-sided system to spend money perfecting and refining its quality control. It's better than the old manual systems, of course, but its flaws are constantly exposed by the remorseless external pressure to do things faster, in bigger volume, in greater complexity. We approach the point where every individual needs to maintain a duplicate computer system to verify his accounts. Individual telephone bills, for example, require the aid of a computer to explain what another computer produced, brokerage transactions need computerized counterparty challenge to expose hidden fees and costs. We all know how lack of transparency brought securitized mortgages to their knees. We will soon learn that the meaning of credit default swaps defies even expert comprehension. The mysteries of university tuition discounts, hospital insurance and even supermarket discounts cry out for safeguards to generate transparency. It may be true that even billionaires like Warren Buffett do not bother to check the accuracy of all accounts presented to them, trusting the fairness of the counterparty. But that does not contradict the need for balance. Institutions of independent public accounting are surely going to make an appearance in the future, telling people what they have and what they are paying for.

The other component which seems to be missing in our transaction system is a well-developed and widely available profession of financial advisors, equipped with electronic tools to provide their badly needed services affordably and accurately. Not only do agents and advisers need some tools, they need the political power to force high-handed vendor systems to permit universal customer verifications; the hooks and portals to their private systems need to be developed to make this system workable, and that will not be willingly forthcoming. But they must be provided, because any independent advisor/auditors need to be subject to constant reverse-confirmation if we are to escape creating a gigantic imperfect-agency problem. But the fact remains that a vendor is not an agent of the customer; his ultimate duty is only to provide an arms-length transaction with transparency. It is the customer's duty to secure his own verification system. When that occurs, it will become part of the third party duty to consent to safeguards against his own imperfect agency. But that's for later. At the moment, independent auditors of the sort needed, scarcely exist.

Much can be gained by searching to correct the flaws of the past whose significance is suddenly apparent. With a stroke of genius, the 2008 reforms of the Bush administration offered a government guarantee of safety for bank accounts which pay no interest. The light finally dawned that businesses use banks for settling up accounts and are more or less indifferent to the interest paid on deposits. When there is a bank panic or a run on a bank, deposits are shifted from bank accounts to Treasury bills in order to find safety; that's now unnecessary. If a bank account pays no less interest than a Treasury bill and is just as safe, why move it? Under the traditional system, deposits seeking safety depleted the loan capacity of the bank and erected a barrier to recovery from the slump that often caused the problem. Why didn't we think of this before?

One of the sources of panic in 2008 was the enormous size of credit default swaps, several times larger than the entire American stock market, many times larger than the national debt. How could we allow such a vast over-insurance to occur? But as some appreciation of the large amount of credit swapping with foreign nations began to grow, things calmed down. If that should unravel the mystery, it is certainly far easier to determine the proportion of international swapping than to set up detailed accounting reports for $60 trillion of default insurance, particularly when the record-keeping intermediaries suddenly go bankrupt.

As soon as the calamity of mortgage-backed securities made its appearance, hands were wrung that originating banks were not required to retain a piece of the mortgage. It seems sensible to impose this requirement on the only party in the chain with the opportunity to evaluate and screen the risks, face to face. So, we can probably expect legislation with the effect of requiring originating institutions to retain "a piece of the action". The principle may need to be extended into other areas, as well. Investment banks until fairly recently were partnerships, not corporations. The capital of an investment bank was supplied from the personal resources of the partners, who usually retired at quite an early age rather than retain big risks without actively coping with the constant pressures of hands-on oversight. Investment banks found they could not raise enough capital from rich partners who were constantly tempted to cash out, so they incorporated and sold stock to the general public. The consequence was the managers were placed in the position of taking big risks with other people's money, and able to pay themselves huge salaries without the constant snooping of rich partners at the next desk. For the time being, investment banking has been totally absorbed into other institutions, but the culture shock of mixing risk takers with risk avoiders will surely lead to something else. Like originating banks with mortgages, the originators of IPOs need to acquire some personal risk of their own, because their essential innovations will always race ahead of the imagination of underpaid plodding regulators. Instead of making a game of outwitting the regulators, investment banking must place much more reliance on the examples within their midst, of rich young kids turning themselves into paupers by assuming the wrong risks.

While we are wallowing in the idea of reconfiguring world finance to avoid the mistakes of the past, some thought should be given to goals. Alan Greenspan was able to win every argument with his reputation of guiding the economy through eighteen years without a major recession. Now that we have resigned ourselves to a return of the business cycle, maybe we should ask whether it is wise to go eighteen years, or even five years, without a correction. Some of this has to do with election cycles, so it isn't easy. But perhaps we have learned that perpetual prosperity is a mirage, small frequent readjustments are better.

http://www.philadelphia-reflections.com/blog/1526.htm

Philosophy Means Science in Philadelphia

American Philsophical Society Seal

In the age of the Enlightenment, science was called natural philosophy; that accounts for the present custom of awarding PhD. degrees in chemistry and botany. The sort of thing which interested Ralph Waldo Emerson was called moral philosophy, and you will have to visit some other place than the A.P.S. if that is what interests you. Roy E. Goodman is presently the Curator of Printed Material (some would say he was chief librarian) at the American Philosophical Society, founded in 1743 by Benjamin Franklin who was clearly the most eminent scientist of his day, having discovered and explained the nature of electricity.

Roy E. Goodman

Roy Goodman is descended from cowboys and rodeo stars, but in spite of that he gave an entertaining talk recently at the Right Angle Club about this society devoted to useful knowledge, this oldest publishing house and scholarly society in America, once the home of the U.S. Patent Office, and scientific library and museum. They have many rare items in their collection, but the unifying theme is not rarity, but curiosity. You might say some of the items reflect the whimsy of Franklin, but it would be more fair to say it is an enduring monument to Franklin's universal curiosity about all things.

Nobel Prize Medal

There are about 900 members of APS, about 800 of them Americans, about 100 of them winners of a Nobel Prize. Let's just make a little list of a very few notables in the past and present membership. Start with the first four Presidents of the United States, add Alexander Hamilton and Lafayette, David Rittenhouse and Francis Hopkinson and you get the idea that Founding Fathers got in early. Robert Fulton, Lewis and Clark, Alexander Humboldt, John Marshall were early members, and more recent ones were Madame Curie, Ruth Patrick, Margaret Mead, and Louis Pasteur. The idea of the Society seems to have come from John Bartram, who suggested it to Franklin because he knew Franklin got things done. In later years, Jonathan Rhoads for years loomed over the organization as its president, no doubt making it willingly jump through his hoop.

R.A.F. Penrose Jr.

There is so much to say about APS it might be better to end on a curious note rather than be comprehensive. A member of the rich patrician Penrose family which included the famous political boss Senator Boies Penrose, was R.A.F. Penrose, Jr, a geologist who developed huge copper mines in Utah. He obviously exploited the commodity asset class during his life, but sold all mining stock in the nineteen twenties and bought government bonds before the 1929 stock crash. When Penrose died in 1931 in the depths of the depression, he left $4 million each to the APS and the American Geological Society, with the specification that it only be invested in common stock. For those who are untutored in investing matters, let it be said that the temper of the times was that no one but a fool would buy common stock in 1931. In retrospect, it can now be seen that if someone had the courage to buy any common stock at all at the time, he would have later become immensely rich. Penrose of course did not live to gloat over his achievement, but suffice it to say the APS now owns four large buildings near Independence Hall, and does not seem to be hard up for funds. Since 2009 looks likely to resemble 1931 in its financial climate, there may be useful knowledge, there.

www.Philadelphia-Reflections.com/blog/1537.htm

http://www.philadelphia-reflections.com/blog/1537.htm

Taking Risks Demands Its Price

Someday, books will be written about who discovered what, and sold what, to make S & P futures suddenly go up and down 300 points in ten minutes on August 17, 2007, soon followed by violent volatility in many other markets. Confusion reigned for a few days, but within a week there was general agreement about the difficulty: the "spread" of interest rates between risky loans and very safe ones had been too narrow for months, and was reverting back to normal. Risk had been mispriced; a risky loan was just as risky as it ever was, as everyone should have realized. If the risky borrower was unwilling to pay higher interest rates, why would any lender bother with him? Since this had been obvious all along, why had lenders temporarily believed otherwise, charging rates scarcely higher for dodgy loans than for well-secured ones?

Alan Greenspan (in 1996) had called this question a conundrum, but it's getting easier to understand. The emergence of prosperity in one decade among 200 million impoverished Chinese had resulted in wealth which found its way into international markets, much like a gold rush or the discovery of oil. Sudden huge wealth often cannot be easily assimilated, hence was available to loan at cheaper rates. The globalization of world finance has vastly improved the speed of markets to absorb money gluts, but in this case had the unfortunate effect of spreading it out into less sophisticated corners of the world economy. It particularly affected residential mortgages, which proved to be the weakest link in the chain of lending and borrowing. Ten years of low interest rates pushed up the prices of existing homes, tempting builders to overcharge for new construction, and inexperienced buyers to pay those inflated prices with cheap mortgages. Between them, Congress and the banks had devised ways to exploit this situation, making the collapse worse when it came. The interest on home mortgages was preferentially tax deductible, so it became the favorite way to borrow. Banks made it easier to refinance at a lower rate as the spread gradually narrowed. To make it even easier, reverse mortgages converted home ownership into an ATM machine with tax deductibility. Because home prices were steadily rising, banks were willing to reduce down payments, on the assumption that home equity would soon rise to represent the amount formerly required as a down payment. As it would have, perhaps, if home owners had not promptly drained it out the back door of reverse mortgages. Second homes became a cheaper way to have a vacation; steadily rising prices encouraged outright speculation, called flipping. Congress reinsured mortgages, eventually most of them, through FNMA, and then pressured Fannie Mae to insist on spreading the joys of home ownership to people who could not afford the no-down-payment houses they were romanced into buying. Investment banks offered to buy the mortgages from the local originating banks in order to package them into securitized bundles, which thus deprived the originating banks of any incentive to reject eager buyers, no matter how dubious their credit standing. What is more, this process provided a conduit for spreading bad credit risk into the equity markets, including the equity of the banking system itself, and creating the temptation for hedge funds to start runs on the banks in novel forms. There once was a time when customers lined up at the bank door to make withdrawals in a bank run. Since investment banks obtain their deposits by borowing wholesale, they simplified the process of starting a bank run when the speculative process reversed. Which it did on August 17, 2007, possibly not spontaneously, but certainly inevitably.

Home mortgages were once loans for thirty years; even now, they extend for many years. Homeowners stay in one house for an average of seven years. For legal reasons going back two hundred years, they are non-recourse loans, meaning the house alone is at risk to the mortgage lender, who may normally not pursue the homeowner for assets other than the foreclosure, even if the other assets are considerable. In a housing bubble, this creates a special hazard for lenders during the inevitable decline of house prices back to normal. As house prices fall, as they should and will, many home owners will find it is cheaper to walk away from a foreclosure than to pay off the mortgage. It has been calculated that potentially as many as 50% of mortgages might eventually find themselves in this squeeze. The situation differs from a car loan, for example. Every new car is worth 20% less than the sale price, immediately after the sale. But this does not tempt car buyers to walk away from their loan, because the car loan is a recourse loan. The uncomfortable prospect is that financial reverses alone might not be the reason homeowners submit to foreclosure. If this particular antisocial behavior loses its stigma, a very large proportion of mortgages could be foreclosed on owners who are perfectly able to pay them off.

For all these reasons, house prices are the main bubble in an economy overstimulated by cheap money, and mortgage financing is at the root of a banking crisis. The banking system itself is precarious, because it too responded to the temptation of abundant credit at abnormally low interest rates. The process took the form of over-leveraging in order to magnify profits in a competitive market. Greed was not the only motivation; corporate raiders in the form of Private Equity could swoop down on any company unwise enough to accumulate internal cash. The new owner would then substitute debt for cash, and the prudent company (under new management, of course) was no better off than if it had itself over-leveraged. The Federal Reserve limits commercial banks to loaning thirteen times their stockholder equity, but investment banks had the foolhardiness to borrow thirty times equity. A decline of only three percent in the value of their loans, wipes them out. The Federal Reserve Bank of New York, by the way, is leveraged at over a hundred times its equity. The Fed can print money to pay its debts, of course, but the result is a falling value of the dollar in international exchange and ultimately, world inflation. No one predicts the half-way point in this decline to be sooner than two years, which means a recession lasting at least four years. The first two efforts of public officials to halt the decline, the purchase of toxic debt and direct lending to banks, have been abandoned as failures, and the Barney Frank/ Chris Dodd offer for Congress to repurchase mortgages was simply pathetic, with only two hundred responses when over two million were anticipated. If the public loses faith in the ability of the government to do anything about the matter, prices can be expected to overshoot on the downside, not just return to normal. House prices do need to decline, but slowly enough to avoid a panic. And American banks and businesses need to reduce the extent of their borrowing, but without measures which impair the ability of new businesses to make loans, or the ability of shaky businesses like the Detroit auto industry, to survive.

In closing, a word is needed to explain why the foreclosure of $100 billion of California and Florida bungalows should threaten a collapse in the trillions. Economists have fallen into the habit of equating interest rates with risk; the more risk, the higher interest rates become. That's true, but risk is not the only factor affecting interest rates. Since they are essentially the rent paid for the use of someone else's money, interest rates respond to the supply of money interest rates, just as supply and demand of rental housing affects rents. The flood of liquidity from developing countries into the world economy pushed interest rates down, but somehow that was taken to imply that risk had decreased. When interest rates go up again, for whatever reason, money will effectively evaporate. The best example of this relationship is in the bond market. When interest rates go up, the principle value of existing bonds declines. With interest rates of 5% as an example, bond prices go up and down twenty times as much as the interest rate, but in the opposite direction. To repeat: when general interest rates rise, money in the economy disappears about twenty times as fast. That's a succinct description of what started to happen, when the prevailing risk premium returned to its normal higher level, on August 17, 2007.

http://www.philadelphia-reflections.com/blog/1549.htm

Go to Delaware, Elephants?

Dead Elephant

No one is supposed to know where elephants go to die, but if they are smart as people say they are, my suggestion is to search for dead elephants in the state of Delaware. Most taxes, and estate taxes in particular, are considerably lower, there. At least this was the message Christopher J. Topolewski, Esq. conveyed to the Right Angle Club recently. His firm, West Capital Management, has prepared a table comparing the taxes in the three states that come together at the southeast corner of Pennsylvania, which for residents of the Philadelphia area are within easy commuting distance of each other. Although Delaware has a marriage penalty (one couple is taxed more than the sum of two singles), it has no estate tax at all, no sales tax, and a property tax rate only half that of Pennsylvania, only a quarter of that in New Jersey. For residents of New Jersey there is almost no tax which is not lower in Delaware, but Pennsylvanians would have to be careful to die or cohabit, since ordinary income tax and capital gains taxes are higher in Delaware than Pennsylvania. If you must die (and who doesn't?), go die in Delaware.

This was a situation specifically contemplated as a way to discipline greedy state governments, by James Madison when he was formulating the U. S. Constitution. And there is evidence it is working. By happenstance I once encountered an offical of New Jersey taxation, who told me that 76% of New Jersey taxes are paid by 1% of the population. And that 1% was moving out of the state as fast as it could. West Capital reports that taxation as a percent of income is 1.23% in Delaware, 3.46% in Pennsylvania, and 5.82% in New Jersey. Armed with this information, it becomes easier to understand why New Jersey would depose a governor who had been Co-chairman of Goldman Sachs, during a financial crisis. If a financial whiz can't change this, maybe it can be done with a meat ax.

This is a time of growing restlessness about public spending, and Tea Party revolts are likely to accelerate during the remaining nine months before the next election. Conjecture is growing about a coming deadlock between a Republican Congress and a Democratic President, lasting at least two more years. What might emerge from a strong third party congressional delegation is too arcane to discuss.

It seems almost inconceivable that professional politicians would demonstrate such a forest of tin ears as to let this happen, but the rest of Mr. Topolewski's talk just heated up the fire. His long-scheduled talk was designed to give guidance about the new estate tax laws, but he fould himself confounding his audience with the news that there are no new estate tax laws; in fact, there will be no estate tax laws at all after this year unless they emerge from the congressional gridlock we already have. Which apparently will be followed by a gridlock we can scarcely imagine. Imagine asking your lawyer to write a will which straddles the contingency that there will be no law, that there will be a continuation of the present one, or will be a new law of quite uncertain wording. One of the suggestions offered is to allow your executor the discretion to accept or disclaim certain provisions.

And that brings up an old story. William Penn was the largest private land owner in the history of America, possibly the whole world. He had a trusted agent, who gave him an enormous pile of papers to sign. A busy rich man like Penn is regularly confronted with a discouragingly large number of routine legal documents to sign. So, Penn signed them all, not noticing that one of the various papers in the pile gave the entire state of Pennsylvania -- to his agent. The outcome of the ensuing uproar was that Penn spent six years in debtors prison.

http://www.philadelphia-reflections.com/blog/1776.htm

Copyright © 2004 - 2010 George R. Fisher, MD. All rights reserved.

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