The Great Financial Crisis in the fall of 2008 led us on this path.  Perhaps it started with the best of intentions to save the financial system, but the unintended consequences of intended financial actions has negated any good from these efforts.  Let’s look at the particular elements of this sad condition:

• Zero Interest Rates – When a market sets interest rates, important information is conveyed to market participants.   Interest rates in a free market environment measure risk of repayment, a fair rate of return and the potential for inflation.  When the Federal Reserve anchors interest rates at near zero for “an extended period of time,” investors can no longer make long-term rationale investment decisions. Thus, money is likely to be mal-invested in uneconomical projects or speculation increases in economically sensitive commodities such as oil, metals and grain.
• Suspension of Mark to Market Accounting – At the start of the financial crisis, Congress leaned on the Financial Accounting Standards Board to suspend “mark to market” accounting (that is, the valuing of an asset in the most honest way, that is, taking into account its impairment or loss of value) .  In its most basic form, this is just plain dishonesty.   This dubious practice spread to banks in Europe as well.   Thus, there is no transparency in bank balance sheets; we (and even the banks themselves) simply can no longer believe the numbers on any institutional balance sheets. The result is that European banks are no longer willing to lend to one another.   Why?  These banks are now leveraged as much as 50-1, thus only a 2% drop in asset prices puts them at risk of failure.  We know that sovereign European bonds have dropped much more than 2%.   Thus, it is likely there is little or no real collateral to support a loan. See Art Cashin Exposes the Behind the Scenes Panic in Europe. With housing prices continuing in decline in the United States, I would suspect that many US banks too are hiding losses, and are in more dire straits than they or the Administration admits.
• Stress Tests – To reassure the public, both the Federal Reserve and the European Banking Authority ran stress tests on large banks.  Dexia (Belgium’s largest company) passed the most recent round of these “stress tests,” and then failed within three months.   Irish banks failed four months after their 2010 round of these tests.  See How Did Europe’s Bank Stress Test Give Dexia a Clean Bill of Health?  Bank of America and Citigroup shares have plummeted in 2011.  The Federal Reserve performed similar stress tests on these and other major American banks.  How credible were our “stress tests?”
• Eroding the Sanctity of Brokerage Accounts – The collapse of MF Global revealed that a brokerage firm could appropriate segregated customer accounts for its own uses.  It appears that MF Global circumvented US laws on account segregation by pledging customer accounts against a repo agreement in London.  Now, customers may never recover their monies.  See MF Global: The SERIOUS Issue Reaches Mainstream Media.  Karl Denninger points out that the standard brokerage agreement permits hypothecation and re-hypothecation, meaning that your brokerage account can be pledged to support a brokerage company or bank loan.  Since derivatives have preference over depositors, customer’s segregated accounts funds are at risk.
• Eroding the Sanctity of Real Property – To speed securitization of mortgages, the banks created an alternative mortgage registration system which bypassed centuries-old rules of settled property law.  A recent report documents the disastrous consequences:

… “thanks to the Mortgage Electronic Registry System’s (MERS) failure to accurately complete and/or publically record property conveyances in the frenzy of banks securitizing home loans and ins subsequent foreclosure actions, neighbors of a foreclosed property (with a sequential conveyance) as well as a foreclosed property itself will have unclear boundaries and clouded/unmarketable titles making it difficult, if not impossible, for these homeowners to sell their properties and for subsequent purchasers to obtain title insurance on the property.”

The report goes on to point out that courts have criticized the MERS model as flawed and have ruled against MERS’ stance to foreclosure. MERS is described as being “wholly inaccurate and not allowing homeowners to fight foreclosures because it [MERS] shields the true owner of a mortgage in public records.” See Study Claims that MERS Destroyed the Chain of Title and Consequently, the Housing Market

And worse yet, in sorting through the avalanche of subsequent foreclosures, mortgage servicers have filed fraudulent affidavits and false documentation. See e.g., Nevada Files First Criminal Charges in Robo-Signing Case

• Greek Credit Default Swaps – In good faith, buyers purchased credit default swaps on Greek bonds to hedge against a potential default.   The European authorities strong-armed banks and other investors to accept “voluntary” 50% haircuts on Greek bonds.  Because of this “voluntary” characterization the credit default swaps were not triggered.  With Spain, Ireland, Italy, Portugal and other countries suffering huge losses on their bonds, is it likely that investors will invest in these bonds when the hedge of a credit default swap can be negated through European financial authority fiat?   See Credit Default Swaps Useless as Hedge Against Default
• Federal Reserve Intervention in Markets – So far, when stock markets have faltered, the Federal Reserve has come to the rescue through quantitative easing (QE1& 2) or Operation Twist.  Thus, investors cannot know the true value of any stock since the Federal Reserve will not allow it to fall to a market-determined price.   Similarly, with zero interest rates and purchase of mortgage- backed securities, the Federal Reserve will not allow house values to fall to market clearing prices.
• Failure to Prosecute – Outside of a handful of insider trader prosecutions there has been no attempt to prosecute the malefactors of Wall Street. Excuses range from opining that the practices were legal, to the difficulty in building a case.  In the Savings and Loan crisis of the early 1990s the same difficulties existed, yet 1100 prosecutions were brought with 800 banks executives sent to jail.  See In Financial Crisis, No Prosecutions of Top Figures

Real World Consequences

We have eliminated price discovery from our markets.  We have neither permitted stocks to fall nor interest rates to rise.  Instead of prosecuting the banks that caused this problem, we shower them with interest free loans from the Federal Reserve so they can speculate or earn risk free profits by re-depositing funds with the Federal Reserve.  Thus, capital is being diverted from sound investments and used for speculative purposes or worse.

European financial authorities have destroyed the efficacy of hedging sovereign bonds in their handling of the Greek bond haircuts.  And thus another important market is being destroyed.

More ominously, Karl Denninger reports that in the wake of the MF Global failure, farmers are eschewing the hedging of crops through commodity futures and instead selling directly to food companies.  Thus, price stability will be diminished and consumers will ultimately pay higher prices.

The failure to “mark to market” and run honest stress tests has resulted in a freezing of interbank loans (a classic credit squeeze) and resulted in a silent run on banks, as UBS reports (bold face type in original text):

European banks are making great use of the ECB’s overnight deposit facility. Last night they parked $590 billion at the ECB breaking the record they had set the night before. They are clearly unwilling to lend to other European banks, highlighting the distrust and fear in the interbank marketplace.

The distrust on the streets is said to be growing also. Barroom gossip says that safe-deposit boxes are in a demand that borders on frenzy. They allow you to take your Euros and covert them into something of value (gold, Swiss Francs, etc.) and sock it away in a safe place.

 Others are said to be buying property in London and elsewhere lest you awake one day and discover that your Euros have reverted to drachmas or lira.

 Savvy bankers are said to be setting up personal and communal trusts domiciled in places like the Bahamas, the Caymans or the Isle of Jersey. Some banks are offering depository accounts denominated (and repayable) in alternate currencies like the dollar or the yen.

 We think a Lehman-like event would most likely be triggered by a run on a bank or a series of banks. The scramble for currency (value) protection among the public could turn into that bank run in the same way that a crowd can instantly turn into a mob. Watch the money flows out of Greece and Italy very carefully. The pot continues to bubble. See Art Cashin Exposes the Behind the Scenes Panic in Europe

If the Administration, The Federal Reserve and the European Authorities had set out to destroy capitalism, free markets and the current financial system, they could not have done a better job.   Free markets and a free people are intertwined.  The road to financial nihilism is ultimately a very dangerous path.

Related posts:

1. Elements of an Unstable Financial System
2. Surfing the Financial Crisis
3. Watershed Event in the Financial Crisis – SEC v. Goldman

Dimon was responding Wednesday to a question at an investor conference about the hostile political environment towards banks.

“Acting like everyone who’s been successful is bad and that everyone who is rich is bad — I just don’t get it,” said Dimon at the conference, which was organized by Goldman Sachs Group Inc.

Dimon said he’s worked on Wall Street for much of his life and contributed his fair share.

“Most of us wage earners are paying 39.6 percent in taxes and add in another 12 percent in New York state and city taxes and we’re paying 50 percent of our income in taxes,” Dimon said in defense of his fellow Wall Street bankers. See Jamie Dimon Rails Against “Rich is Bad” Talk

Are We Bashing the Rich or the Well Connected?

America is a land of opportunity.  Children of poor immigrants can grow up to be President, entrepreneurs, brilliant scientists or even CEOs of Fortune 500 companies.  Thus, Americans venerate a Steve Jobs or a Bill Gates.  Not that these individuals are without detractors, but they are admired for starting from scratch, innovating, and filling a market need.  Often these individuals single-handedly create the market for their products and services. See All Millionaires are not Created Equal

Let’s examine why Jamie Dimon and other bankers are less admired and often vilified.  Note the deft sleight of hand in Mr. Dimon’s answer to the question: the question posed concerned the hostile environment toward banks.  Mr. Dimon’s response is that he does not understand why the public thinks that everyone who is successful is bad.  He in fact never answered the question of why everyone hates banks.

At the core of the hatred of banks (and perhaps Mr. Dimon himself) is crony capitalism.  Mr. Dimon’s “success” is owed largely to the unholy alliance between the Bush and Obama Administrations and the Too Big to Fail Banks.  Let’s examine the blessings the government has bestowed on Mr. Dimon:

• Bear Stearns – JP Morgan Chase and Mr. Dimon merged with the “failing” Bear Stearns, paying $10 per share for a company that had recently traded at $93 per share.  The Federal Reserve then made a $29b non-recourse loan to JP Morgan secured only by the mortgage backed securities of Bear Stearns.  Thus, the Federal Reserve could not seize JP Morgan Chase assets, if the Bear Stearns collateral proved insufficient to repay the loan.  See Seeking Fast Deal, JP Morgan Quintuples Bear Stearns Bid, Wikipedia

• Secret Loans from the Federal Reserve – From 2007-2009, the Federal Reserve made $7.7 trillion of secret loans to 190 financial institutions, resulting in profits of $13b.  These loans were at below market rates, virtually free, ensuring profit for the banks. Bloomberg, which made the Freedom of Information Act request, estimated that JP Morgan profited in the amount of almost $458m.  Mr. Dimon did not disclose these loans or the banks’ need to his shareholders:

JPMorgan Chase & Co. CEO Jamie Dimon told shareholders in a March 26, 2010, letter that his bank used the Fed’s Term Auction Facility “at the request of the Federal Reserve to help motivate others to use the system.” He didn’t say that the New York-based bank’s total TAF borrowings were almost twice its cash holdings or that its peak borrowing of $48 billion on Feb. 26, 2009, came more than a year after the program’s creation. See Secret Fed Loans Gave Banks $13 Billion Undisclosed to Congress

• Zero Interest Rates – The zero interest rate policy of the Federal Reserve continues to permit banks to borrow at below market rates, thus enhancing bank profits at the expense of savers.
• Compensation – While being rescued by the Federal Reserve, JP Morgan Chase’s board awarded Mr. Dimon a $17m bonus for 2009. In 2010, Mr. Dimon made $20.8m.  JP Morgan partisans will argue that this was modest compared to industry peers.  Should US taxpayers, those of us who ultimately stand behind these loans, reward executives with large compensation packages?  Unlike the situations of most of the rest of us, JP Morgan Chase makes available to its top executives tax advantageous programs such as the permitting tax deferral of compensation, 401k plans, a defined benefit pension plan and use of the company plane.  If terminated without cause, Mr. Dimon would receive cash and stock awards valued at $16.7m. See Are CEOs Paid too Much: Not All of Them; JP Morgan Chase CEO Gets $17 Million N0-Cash Bonus; Elements of Executive Compensation (JPM); JP Morgan Chase 2010 proxy

Being Rich Isn’t the Problem

Yes, there is income inequality and we have heard endlessly about the elite 1% profiting at the expense of the 99% of ordinary Americans.  But the real hostility goes deeper than just these income disparities.   There is a good reason why Mr. Dimon chose not to discuss the hostile environment toward banks.  He is well aware of why it exists:  the American public has been treated to the spectacle of secret loans to banks; CEOs have been permitted to keep their jobs after nearly destroying their own banks and the US economy; too generous executive compensation practices and perquisites continue which ignore the fact that taxpayers needed to bail out these institutions (and will probably have to do so again);  banks still fail to undertake serious loan modification programs for underwater homeowners; they hoard excess reserves at the Federal Reserve rather than make loans to stimulate the real economy; they attempt to impose fees on cash withdrawals from ATMs;  and finally and disgracefully,  these banks have not been  prosecuted.

Mr. Dimon, the focus is on you and other bankers, not necessarily “the rich.”   Perhaps we need more hard hitting articles like the Bloomberg piece on secret loans to banks, to focus the attention on the true issues, not bogus articles of class warfare.   Unfortunately, neither the press nor the Administration has been rough enough on Mr. Dimon.

Related posts:

1. The Meal Was Great…Part II
2. Are We a Socialist Country?
3. The Failure of Extrapolation

It is too easy to blame this behavior on the decline in morality evinced by Wall Street scandals and the behavior of our political class.  A deeper point needs to be addressed.  We have become a society of numbers and meaningless symbols.   How much do you make per year?  What school did you attend?  How much is your house worth?

Hiring by the Numbers

For much of my career, a significant part of my responsibility was the hiring and supervision of attorneys in a large legal department.   At best, hiring is a crap shoot.  Despite a glossy resume, one can never tell why someone is in the job market at any given time, or how that person will actually meet the standards and fit the profile of the job for which they are interviewing.  Usually complicating the decision making process is  the legal department’s need to hire  experienced attorneys with a minimum ten years experience. In this environment a new hire was expected to perform at an extremely competent level with little or no training or supervision, the proverbial “hit the ground running” paradigm.

One of my peers hired strictly by the numbers.  A candidate had to be a graduate of one of the top 41 law schools, and had to have more than a 700 LSAT.  My colleague preferred a candidate to have a background as a prosecutor with US Attorneys’ Office or the Judge Advocate General.

After a while, I broke the code on my colleague’s idiosyncratic requirements.  I discovered that he used the Gourman Report of Graduate Programs.  Dr. Gourman does not reveal his exact methodology or statistics.  Generally, the Gourman Report methodology asks university graduate departments to rate each other, and assess which they think are best in their field.   By definition then, this questionable methodology yields a self-reinforcing cycle of the top programs continuing to nominate each other in a reciprocal and mutual admiration society.  See Caveat Emptor: The Gourman Report for a critique of the report’s methodology.   The same large prestigious universities continue to populate these lists.  Page 1 of the Gourman Report list of law schools had exactly 41 names; my colleague’s law school alma mater happened to be number 41.  Thus, I deciphered my colleague’s “scientific” method of hiring and the inherent folly of using numbers to find good people.  (Soon thereafter, for amusement I confronted him and pointed out that to be really scientific he would have to find the Gourman report related to the year that the candidate graduated law school to really ascertain whether he was hiring a true “top 41” candidate.)

In another example of this folly, we later merged with a company which would only hire candidates who had combined SATs over 1500, LSATs over 700, a top 15 law school degree (thank goodness for Gourman) and experience in a prestigious law firm or prosecutor’s office.

I am still amazed that I was ever hired, promoted or retained after we completed several major mergers.  I fit none of these criteria nor did many of the best attorneys in our legal department.

The Hard Work of Hiring; the Harder Work of Assessing Job Performance

The SATs are primarily predictors of how well one will perform on tests like the SAT’s.  Since they were instituted as a method of evaluation, they have been repeatedly called into question as predictors of college success. Further, how well one performs in college and law school is not a total predictor of how well one performs in that first law job.  At each step, real life intrudes, essential character and temperament inserts itself into the process, and a lawyer has either learned to practice law competently or not.

No short cuts or quantitative formulas exist in making hiring decisions.  Generally, every candidate I interviewed had a good academic and work record.   Intelligence, analytical prowess and certainly test numbers were merely table stakes to get in the door.  Other more important factors determined whether or not an attorney would be successful in a corporate environment.  In evaluating candidates, I tried to ferret out the following:

• Can they work under pressure, or under attack?
• Can they take on a project with minimal supervision?
• Are they willing to put in long hours, including nights and weekends, to accomplish the job?
• Are they patient and persistent; can they see a project to its conclusion?
• Are they creative; have they ever displayed ingenuity? Can they work with and lead a team of lawyers and business people?
• Do they communicate clearly in speech and writing?
• Can they accept criticism?
• Do they respect subordinates as well as superiors?
• Do they display emotional intelligence; can they intuit the atmosphere as well as the facts of a situation?
• Is integrity clearly a part of their makeup?  Has it ever been tested?

The Education Testing Service and testing results cannot measure any of the above-listed factors.  And in my 32-year corporate career I firmly believe that one cannot be successful on a long-term basis without meeting the above criteria.

Despite conducting rigorous interviews and extensive background checks, an honest hiring supervisor will admit that it is difficult to judge these non-numerical factors.  Further, if a hiring supervisor is correct 50% of the time, he or she has beaten the odds.  I was lucky and was able to hire many attorneys who rose through the corporate ranks and became senior corporate leaders.  Some went to the “best” law schools, some did not. I was also required to ask some of my hires to leave.  While difficult each time, that too is the nature of hiring and corporate management.

Looking for the Easy Way Out

This returns us full circle to the Long Island SAT/ACT cheating scandal.  As a society we look for the easy way out in decision making.   Perhaps those Long Island students were thinking: if I can just achieve a high enough test score, I can attend a prestigious university which will guarantee me access to a great job or graduate program, which in turn will assure my success in life.  Success is more complicated than that.

We have deteriorated to a society of numbers and brands.  The ideal political candidate goes to the right schools, has the right tickets punched on his or her resume, gets elected to the right office and now is the right candidate for higher office.  We fail to delve into the more important factors of character, grace under pressure, emotional intelligence and integrity.  The epiphany, long since necessary for all of us, is that we entrusted our money and our government to Wall Street and Washington charlatans who went to all the right schools, held  all the right jobs and had all the right  connections.  And look what happened.

Given all of this, it is no surprise we now have a group of students on Long Island willing to sell their souls for $3500 or less.

Related posts:

1. Mission Creep
2. Ask Your Congressional Representative to Do Nothing
3. Labor and Employment Laws: The Hidden Job Killer

Retirement ended these excuses.  In retirement I have embraced the notion that I’d like to try things outside of my comfort zone.  What is anyone going to do, fire me?  Not likely, and so what if they did.  And after years of competitive corporate life, my mindset in this project was that I wanted to excel at raising money and do better than past campaigns for this organization.     The short answer is I succeeded, but it was not easy.

Attitudes towards Charity

The Bible is clear that there is an obligation to tithe.   Numbers 18:21; Deuteronomy 14:29.   Mormon and Orthodox Jewish believers take upon themselves the obligation to tithe.  But my guess is that this obligation is followed more in the breach.

We live in a society of self-indulgence and immediate gratification.  During the boom period of the 1990’s onward, our peers built McMansions and bought luxury cars in record numbers.  Any societal self-governor of modesty, self-restraint, and proportionality disappeared.  The ethic became, I want it, I want it now and I deserve it, so why wait?

While pampering ourselves, how much did we think about charity? Charity is a mindset.  A clergyman explained the sin of Joseph’s brothers who cast him into a pit.  The brothers probably had cause to be angry at Joseph as he flaunted his new coat, told of self-aggrandizing dreams, and denigrated his brothers and parents.  Nevertheless, after the brothers cast Joseph into the pit, they sat down to a feast.  They ignored Joseph’s cries and continued to enjoy their meal.

Ignoring the Cries

It is easier to avert our eyes from the need to give charity than to focus squarely on the need to give. Before we began this charity campaign, I spoke to a professional fundraiser.  He said I would soon learn that there are a thousand reasons not to give charity:  “I have kids in college…I am supporting my mother-in-law in a nursing home…I don’t like how the charity allocates funds” and so on.

But the next time we  take an expensive vacation, buy Stub Hub tickets at exorbitant prices to a “must see” concert or  sporting event, go out to a lavish dinner or upgrade a 3-year old car to an even more expensive model, maybe we should think about whether or not we could do with less.

During the campaign, many people who did not have a lot of money made small contributions.  I was more heartened by these small gifts than larger contributions from the rich.  I knew that the rich person was making little or no sacrifice while the poor person’s smaller contribution was financially significant. Maybe the old adage is true: “give until it hurts.”

Every day I go out of my way to personally contribute a dollar or some change to a poor person.  It obviously helps that poor person, but it also helps me to remember that I have had a blessed life: here but for the grace of the Almighty go I.  So when each of us sits down to our Thanksgiving feasts, maybe we can stop for a moment and listen to the cries of whatever brother Joseph we encounter in our own lives.

Related posts:

1. Wildfires and the Economy
2. “My Word is My Bond”
3. That Time of Year

The Potent Director Fallacy

Robert Prechter in Conquer the Crash coined the term the “potent directors” fallacy.  The fallacy in a nutshell:

 It’s nearly impossible to find a treatise on macroeconomics that does not assert or assume that the Federal Reserve Board has learned to control both our money and our economy. Many believe that it also possesses immense power to manipulate the stock market. The very idea that it can do these things is false. It is what I call the ‘Potent Directors’ Fallacy.”

In reality — the Fed has no such power.  See The Fed is Not in Control: Potent Directors Fallacy

Prechter catalogs the stop and start policies of the Fed which led to the internet stock boom and crash.  The centerpiece of poor policy making was the post internet boom decision to slash the federal funds rate thirteen  times from 2001-2003, which led to the housing boom and the subsequent seventeen   increases from 2004-2006, which led to the housing bust.

Even the start of QE1 could not stop the 2008-2009 plunge in the stock market.  The market did not bottom for several months until March 2009.  QE2 petered out in June of this year, the economy slowed, and once again the market declined.

Perception Management

Charles Hugh Smith points out that we have stopped serious policy making.  Instead policy makers have focused on managing the perceptions of stock market investors and consumers, and now deal in marketing.   American and European central banks and politicians wish to project the illusion that they are still in control.  In his critique of the endless reassurances from Angela Merkel and Nicholas Sarkozy that European banks can be recapitalized and the Euro saved, Smith exposes the vague programs of both of these leaders and our Federal Reserve Bank:

Merkel and Sarkozy’s dog and pony show is perception management ripped right from the Federal Reserve’s playbook. The ontological foundation of the Fed’s playbook is this: the problem is all perception. If the great unwashed populace of debt-serfs perceives that all is well and secure, and the Mommy State has tucked them safely into bed, then they will once again start borrowing and spending without a care for either reality or the future. See The Uncredible Dog and Pony Show: Merkel and Sarkozy

 Fundamentally, the perception management approach is incorrect.  Rather, we must look at the facts of our situation, the bottom line as it were, the areas of real inequities, incompetence and fraudulent policy.  At some point, we must lift the fog of spin surrounding what is really happening:

The problems of the global economy are not based in perception, but in the reality of prices, balance sheets and income statements, vast concentrations of wealth and power, precarious systemic imbalances, ruthless exploitation, and command economies mismanaged by Central State/Bank policy and manipulation.  See The Uncredible Dog and Pony Show: Merkel and Sarkozy

Cargo Cults, Deus Ex Machina and Other Delusions

On October 10, we had yet another monster rally based on vague bank rescue plans.  Previously markets have rallied on yet another in the endless series of Greek bailouts or speeches from Ben Bernanke hinting at QE3.  Each time investors are sucked into markets only to have their hopes dashed by reality.

Sometimes, great literature uses a plot device known as deus ex machina.  An inextricable problem is solved through a contrived, unexpected or implausible intervention.  In Lord of the Flies, a naval officer suddenly appears to rescue the wayward boys stranded on an island.  Similarly, “cargo cults” appeared during World War II, wherein primitive societies observed Japanese and American soldiers unloading manufactured goods from airplanes.  After the war, the natives would establish elaborate religious rituals, such as building landing strips or copies of radios emulating the Japanese and Americans, hoping that “cargo” would soon land.

Financial media watch every move of the Federal Reserve, and European central bankers and politicians hope to divine when the recovery will appear.  Each time the “solutions” deliver less than promised and the economy and markets sink.  Why does anyone continue to believe the central bankers and politicians?  Why is there so little independent thinking and critical analysis? How far have we progressed from belonging to our own version of a cargo cult?

Related posts:

1. Exploding Myths, Eroding Confidence
2. Perception is Reality
3. Wildfires and the Economy

Also simply put, credit growth unsupported by income growth has distorted the economy.  In essence, the “easy money” fostered in a lax credit environment has sent the wrong signals to the real economy.  Some examples:

Real Estate

Lax bank lending and governmental programs encouraged homeowners to take on more debt.  The mantra was that house prices always rose. So bankers were eager to lend too much and borrowers were anxious to borrow too much, both believing that house price inflation would sustain the process.  Both parties ignored simple economic principles.  Incomes have been stagnating for more than ten years.  The housing boom expanded the supply of housing beyond demand.  Worse, the peripheral costs of owning a home (taxes, insurance, utilities and the like) ate into the income available to service those over-sized mortgages.   Loans were secured with little or no money down.

In the commercial real estate market, we massively overbuilt.   Again we mistakenly believed that inflation would bail out lenders and owners.   The demographic trend is for large companies to reduce use of commercial space.  Increasingly, employees work from home and technology requires fewer workers and less commercial space.  Internet shopping further lessens the need for brick and mortar retailers.  As with homes, the peripheral costs of commercial ownership kept rising.

Government

A falsely expanding, credit driven economy also sends false signals to government and their employees.   Tax receipts were on the rise from real estate transfer fees, expanding income taxes and capital gains from a rising stock market.    But these gains were bogus, a chimera.  And they did not benefit the average consumer.    Why shouldn’t the largesse of rising tax receipts be shared with employees, who also happen to be a powerful voting bloc?   Politicians were all too willing to grant pay increases, job security guarantees and costly pension and post-retirement benefits to government employees, especially those represented by powerful public unions.  Soon total compensation packages for public employees exceeded their private sector counterparts.

Sovereign Debt

And so the good times seemed to roll. What better way to finance government projects and even foreign wars than through inexpensive sovereign debt?  Dick Cheney once loudly proclaimed that “deficits don’t matter.”  Republicans and Democrats seemed to compete to see which party could run the largest deficits.  Believing that debt could be paid off through ever rising tax receipts, the government made more promises (like expanding Medicare coverage to include prescription drugs).   What were they thinking?  Borrow today and worry about repaying and credit collapse tomorrow?

Macro Trends

The credit binge occurred against a background of unfavorable macro economic trends.   First, US and European population growth, and therefore the supply of workers, slowed.  Second, free trade and free movement of capital and technology has exposed the American worker to foreign competition.  Seventy-dollar an hour (fully-loaded cost) Big Three unionized auto workers cannot compete with their Asian counterparts.   [Heritage Foundation study].  Third, technology has viciously cut into employment in the retailing, telecommunications, banking, insurance, travel and other industries.   Software programs now perform the job functions formerly executed by highly-paid skilled workers.  Fourth, zero interest policy has cut the income of savers and pension funds, impoverishing a class of consumers who supported the economy in the past.  Fifth, regulation is on the rise, increasing business operating costs.

The Debt Bubble

Thus, we have inflated a giant credit bubble without the resources to repay these debts. It is happening both here and in Europe.  Each government maneuver to save a bank (Bank of America) or a country (Greece) is merely an attempt to hide the real problem or shift it from private parties to taxpayers.  We undertook debt that we cannot repay.   We need to write off or restructure this debt, and yes, it will result in losses to the government and major financial institutions.  Restructuring could take the form of increasing the time to repay, reducing the interest rate or swapping equity for debt.  This outcome is unfortunately unpleasant but necessary.

Governments continue to conjure exotic, “cutting edge,” “outside the box” programs which merely delay the day of debt reckoning.   We borrowed too much and we now need to pay the piper.

Related posts:

1. Zero Interest Rates Equals Zero Jobs
2. It Isn’t That Easy to Avoid a Crisis
3. Endangered Icons

History

On August 1, 1930, two immigrant brothers opened a furniture store in Paterson, NJ.  Five years later they built a bigger store on Main Street in that city. The store remained there for over sixty years.

In 1975, I began my clerkship for a Superior Court Judge sitting in Paterson.  I walked by Bograd’s every day on the way to the government parking lot.  At that point, my wife and I were married for three years, but we had always lived in student housing.  We had our first rental apartment, which needed furnishing, at that same time.  Bograd’s carried quality brands that we could only dream about but could not afford.   Even then, our belief was that we should save and buy quality goods rather than settle for inferior goods.  Bograd’s represented quality, albeit at higher than department store prices.  We window shopped a lot more often than we bought.

At about the same time, Paterson was becoming a dangerous city, where once had been a prosperous town.  The population declined nearly 5% in the 1970’s.  White residents fled to nearby suburbs and now make up only 13% of the population.  Poverty is rampant, with 29% of families below the poverty line.  As in many urban areas, quality stores abandoned Paterson for the suburbs of Bergen and Passaic counties.  Bograd’s, however, held out until 1996 when it moved to a warehouse showroom in a suburban area near major highways.

The End of an Era

Instead of the traditional “going out of business sale,” the Bograd family calls their closing event “Bograd’s Last and Best Sale.”   Even though the store will no longer be operating, Mr. Bograd and his company  will  “be around after the sale is over operating out of our warehouse until every order is delivered, every customer satisfied.”

Below is a summary of the company’s decision to close.   It is a microcosm of what ails small American businesses.  I will provide commentary on each item:

• We cannot and will not compete with stores who have lowered their standards by selling low quality merchandise.  We have always sold high end American-made furniture, often pieces signed by the craftsman while our competitors are bringing in low quality pieces from Indonesia and China. Comment – US free trade policy has permitted the importation of low quality, often shoddy, low price furniture.  How can a high quality US manufacturer expect to compete with near slave labor, foreign work conditions?  One cannot compare beautifully finished high end domestically made furniture and imports from China.
• We will not employ a low quality, low paid sales force that cannot provide outstanding customer service.  Comment – Customers view items like furniture as disposable, so quality service is no longer factored into the price.  Only low price matters.  The US educational system produces employees without the educational background or mindset to invest years in developing expertise in high-quality furniture manufacturing or sales.
• Given the state of the mortgage market we cannot refinance our store which we own or obtain favorable financing terms from our supplier.  Mentioning that we are in the furniture industry ends discussions with lenders.  Comment – The failure to resolve our banking crisis and forcing the banks to write off bad loans has tightened credit markets.  Tight credit has had the most impact on small businesses.  Banks would rather hold excess reserves with the Federal Reserve than take on more risky lending.
• As a small business we receive no support from any level of government.  Comment – Complex business regulations coupled with the uncertainty of Obamacare make it almost impossible for a small business to succeed.  Government policy openly favors large enterprises, who also happen to be major campaign contributors, at the expense of the small business person.
• Decline in trust between and among retailers, banks, and suppliers. Comment – Government policies which created the housing bubble and other speculative bubbles inevitably lead to an economic bust.  Stop-and-start economic policies destroy trust between economic parties. See Bograd’s Fine Furniture Latest Victim of Tough Economy, Eight Decades of Selling Furniture Coming to a Close, Bograd’s Historic Closing Sale – The End of an Era

Left unsaid is a major change in our culture and values.   As young adults we understood that to buy quality furniture we would need to save and defer our major purchases. When we bought a house, rooms remained empty until we could afford quality furnishings.  In a culture of instant consumer credit and shoddy goods, that ethic of saving and deferring gratification has eroded, placing a firm like Bograd’s at a disadvantage.

American Jobs Act

The much awaited announcement of President Obama’s American Jobs Act does little for the small business person. Small business is the lynchpin for both creating new jobs and for economic recovery in general.  Like Bograd’s, there are thousands of small businesses hanging on by their economic finger tips.   A large labor union (teacher, police or fire) or a large financial business (banks, insurance companies) gets the government’s attention and fiscal favor, but  if one is a small business, I guess one might  just fade into economic history, like the 81-year old Bograd’s.

Gresham’s Law says that bad money drives out good money.  In the case of Bograd’s Fine Furniture, bad furniture drove out quality furniture.  We have flawed government policy to thank, and a consequent culture which would rather spend today than invest in the future.

Related posts:

1. Tis’ the Season for Deflation
2. Single Malt Scotch Index Redux
3. The Meal Was Great…Part II

When we examine the headlines, this oft-quoted phrase becomes increasingly relevant.  We accept public policy errors with barely a whimper.  We are either too comfortable with the status quo or paralyzed by fear of the unknown.  Worse, perhaps we have lost our ability to question critically.  Maybe all the aforementioned are true at once.  Let’s examine some of the current insanity.

Living on Flood Plains

Our family was raised near the Passaic River in New Jersey.  In high school in 1970, my brother did an in-depth study of flooding in the Passaic River Valley.   Even then, after relatively modest storms, flooding of the towns of Lincoln Park and Wayne, NJ, was all too common.  My brother interviewed then State Senator (later Governor) Thomas Kean.  Kean was well aware of the problem and had worked with the Army Corps of Engineers to devise a plan to stop the flooding.  A new dam was needed, but the project withered from political opposition.   Now, more than forty years later, the area routinely floods in these and other Passaic River towns.  No dam has been built.  Worse, overbuilding since the seventies has intensified, leaving more families in harm’s way.   Now, with full media drama, we are treated to heroic emergency rescues, and heart rending scenes of home evacuations and lost possessions.

My guess is that many of these homeowners will receive sizeable checks from federal flood insurance programs.  We the taxpayers are subsidizing the choices of individuals to build homes on flood plains.   Although I believe there is a role for a federal emergency response, Ron Paul was right to question the need for a federal response to Hurricane Irene. Even the liberal Huffington Post recognized the insanity in some of these programs.

Federal disaster relief programs have their faults. The National Flood Insurance Program, originally designed to force homeowners to take financial responsibility for living in flood plains, has encouraged development in unsafe areas. So too have federal levee and flood control programs. See A Natural Disasters History Lesson for Ron Paul

Insanity is to encourage overbuilding in flood plains, watch hurricanes and lesser storms destroy houses, and then having taxpayers reward reckless builders and homeowners with monies from the Treasury.  We need to at least begin the process of requiring our citizens to acknowledge the risks they take in their choices.  Financial responsibility should reside with the homeowner not the taxpayer.

Boards and CEOs

Much hoopla surrounds the naming of a new CEO for a major American company.   Too often, we find out later that the Board of Directors never fully investigated the candidate to explore the “soft issues” such as management style.  And then comes the consequences for the company and its shareholders.  We have two recent cases of high profile executive terminations:  Jeffrey Kindler at Pfizer and Robert Kelly at Bank of New York Mellon.

In both instances the Board discovered after the CEO was ensconced that his abrasive management style was alienating other key senior managers.  The result was dysfunctional management decision making.

This woeful tale occurs quite often.  The Board becomes enamored of a brilliant, seemingly charismatic executive.  But if the Board did its homework, it would discover that sometimes an executive is a brilliant individual contributor, but a mediocre or too often a terrible manager.   Given the hierarchical nature of corporations and the fear of losing one’s job, subordinates do not speak out about their bosses.  Or if the rare employee has the courage to speak out, the Board rationalizes complaints:  such employees are disaffected complainers, or sore losers in the climb to the top.

When corporate performance inevitably founders, the mass exodus of senior talent or the disclosure of a scandal catapults the Board into action.    Horrors!  All those complainers may have been correct.  Secret sessions occur, the Board develops some backbone and fires the executive, but tells the world that the executive is retiring or resigning to spend more time with their family.  Worse, Boards do not deal harshly enough with a mistake in hiring:  they reward the offending executive with a large severance package and a proclamation of gratitude for taking the company to a new, higher level.  The end result: a cynical group of employees and shareholders.

See Inside Pfizer’s Palace Coup, Robert Kelly: Bank Fired Him Because of His ‘Abrasive’ Management Style Lowered Morale

QE3

Wall Street continues to beat the drums for a third round of quantitative easing from the Federal Reserve.  Peter Tchir of TF Market Advisors debunks the effectiveness of QE2.  The stock market may have gone higher but that may have been related to the problems in Europe that lowered the value of the dollar or the lower stock price levels then (1050 S&P 500) versus   now (1215 S&P 500).   The “wealth effect” related to rising stock prices did little to improve the lot of the average American.  Unemployment remained high, house prices did not recover and wages stagnated.  Finally, there were dramatic increases in commodity prices raising the cost of key items such as food and energy.  Yet, the Federal Reserve continues to hint at QE3 and major investment banks view it as a given.  See QE3, What’s not to Like?

Repeating Insanity

What has happened to critical questioning of key institutions: Congress, the Executive Branch, the Federal Reserve and even corporate boards of directors?    Policy initiatives are floated every day in the press, one crazier than the next, and few pundits ask why? As crises seem to occur without respite, my guess is that this obtuseness will not serve us well.

Related posts:

1. The Meal Was Great; Our Outlook, Not As Good
2. Over Compensating
3. This Dimon Doesn’t Have it Rough Enough

• Unplugging from Civilization – When you have no power you are virtually unplugged from civilization.  You lose internet, lights, land line telephone service if you use any type of phone requiring a plug to operate, refrigeration, television and other modern conveniences.   You still have limited use of a cell phone, but the battery only has a limited charge.  The same problem occurs with a laptop.  It is kind of refreshing.  We are way too dependent on electronic gizmos controlling our lives.  Yes, there is a downside with spoiled food and not being able to watch the Yankees.  However, there is an upside, some quiet time to read and think.  Natural light is rediscovered as I moved around from rooms facing east to those facing west in order to read during the day.
• Rediscovering Community – Suddenly, neighbors you barely know or speak to are providing information on tree damage, road closures and the state of power repairs.  More people are on the street, just walking.  Neighbors are happy to share food, water and help with tree limb removal.
• Not Underestimating the Power of Nature – When the storm passed through on Sunday morning everyone breathed a sigh of relief.   There was much scorn heaped on The Weather Channel and news outlets for “hyping” the storm because the winds fell short of hurricane force.   The jubilation and finger pointing was short lived.  Power failures started 12 hours after the storm hit.   Tree damage and flooding were constant dangers for 3 days after the storm.  As I write this blog five days after the storm, many local roads are still not open and many in my state still have no power.
• Paying a Price for Deregulation – Local utilities (electricity, natural gas, telephone and water companies) are deregulated in my state.  When these utilities were heavily regulated they were well-staffed.  One could argue they were over-staffed, but there were always sufficient emergency crews to respond to a natural disaster.   Starting my career with a regulated utility, I always thought we were at our best in the face of a hurricane or flood.  In a deregulated world, with no ability to pass costs through in a “cost plus” regulatory model, staffing for such emergencies is a by-gone luxury and we the public now pay the price.  Ask folks at the Jersey Shore or Westchester if they would like those bad old, regulated utilities back.
• Feeling Vulnerable – There is nothing like a power blackout to heighten one’s sense of vulnerability.    Sitting in a suburban home with no working alarm, fire detection equipment or street lights outside is a reminder that the house can be robbed and the occupants injured.   Our small city did not change its policing of darkened areas.  Few if any police patrols passed our home during the blackout.  Suddenly, our quiet, peaceful neighborhood seemed a lot scarier and threatening.  Further, who could be sure of a police response in the event we still were able to use a cell phone to call for help?
• Relying On Our Government – The governor of my state and nearby states issued evacuation orders.   These officials were later ridiculed for overreacting.  As a corporate executive I learned the lesson that one can only operate on the best information available at any time.   After the fact, one will always look either prescient or foolish.  But, in matters of safety, it is better to be prudent.   These governors should be commended for taking bold action. In the end, the flooding and power outages more than justified the evacuation decisions they made.

It is the current political fashion to bash government.   I will leave you with a final thought drawn from a Biblical source, the Ethics of the Fathers: “Pray for the welfare of the government, for without fear of governmental authorities people would swallow each other alive.”

Related posts:

1. Fraying at the Edges
2. As Camden Goes, So Goes the USA?
3. Bailout Nation Lives: Revisited, a Short Update

In March 2010, Mr. Berkowitz gave an interview to Barron’s.  He described his rationale for investing in the big three mentioned above:

The financial system in the United States doesn’t work without Citigroup and Bank of America and, hence, the government’s involvement. But what’s nice about the government is that at the end of the day, it will make a profit on all of its investments in these companies.

There are just certain institutions that are interwoven into the fabric of the United States. That’s the case with Citigroup and Bank of America, which make up a key part of our banking system. The same is true for AIG in the insurance area.  See After the Apocalypse

Mr. Berkowitz believes that these “too big to fail” financial institutions are essentially in partnership with the government and will be assured profitability and ever rising stock prices.  When I realized this, I firmly decided that he was wrong and that his strategy would ultimately fail.

On Tuesday, Bank of America closed at $6.30 down almost 2% on the day and nearly 48% for the year.  (After Thursday’s announcement of Warren Buffet taking a stake in the preferred stock of the company the price has recovered to the mid $7 range.)  Fairholme Fund is down nearly 13% this year.  While of course I am skeptical of Mr. Berkowitz’s strategy, I urge the more important point about the havoc the government has fostered, the risks of investing in any financial firm, and the folly of blind faith in guru investors.

What is Wrong with Bank of America?

The short answer is that no one knows for sure.  But there are two ominous signs: the drop by nearly half of the yearly stock price, and the soaring cost of insuring Bank of America debt in the credit derivative market (385 basis points –August 23).  Yves Smith of Naked Capitalism summarizes the distress in the stock:

• An analyst believes that the company will need to raise $40-50b in additional equity diluting current shareholders
• The company is having difficulty in selling assets which would improve their financial position (China Construction Bank, Merrill Lynch)
• The company is unable to complete a broad settlement of mortgage litigation
• The stock is susceptible to manipulation by high frequency traders
• The company’s second liens are overvalued
• Commercial loans are impaired, and have not been recognized as such.
• Management has overstated good will from the Countrywide and Merrill Lynch transactions
• There are undetermined European exposures, especially to the debt of foreign banks.  See Why is Bank America’s Stock Cratering Yet Again? It’s the Extend and Pretend Endgame

Extend and Pretend

It was governmental policy to suspend mark to market accounting policy.  Basically this permitted the banks to make their own value determinations for mortgages and other potentially impaired assets.  Ms. Smith points out how pernicious this policy is:

We are now seeing the downside to extend and pretend. Years of regulatory forbearance mean that investors know the marks on the balance sheet of a beast like Bank of America (and frankly all the other big banks) have a ton of air in them. And now that the economy is looking seriously wobbly and the odds of son of Credit Anstalt are well above zero, it means big banks are at real risk of getting seriously whacked in a major stress event. Worse, with Dodd Frank (supposedly) barring bailouts and Tea Partiers on an anti-bank, anti-Fed, anti-spending warpath, it might not be so easy for the authorities to rescue a big bank if a run started…. See Why is Bank America’s Stock Cratering Yet Again? It’s the Extend and Pretend Endgame

Credit Anstalt refers to the 1931 failure of an Austrian bank which set off a chain of European bank failures, deepening the Great Depression of the 1930’s.

Investors are wary that Bank of America could collapse just as Lehman and AIG did in 2008.

Understanding Banks

This brings us to gurus and financial analysis.   Mr. Berkowitz is not the only guru piling into Bank of America stock.  John Paulson (who worked with Goldman Sachs to short the mortgage market during the 2008 financial crisis) and David Tepper, both considered two of the best hedge fund managers, also bet heavily on Bank of America, Citicorp , AIG and other financial stocks.   But in a brilliant analysis, Steve Waldman, author of Interfluidity, points out that it is near impossible to evaluate large, complex, financial institutions:

Bank capital cannot be measured. Think about that until you really get it. “Large complex financial institutions” report leverage ratios and “tier one” capital and all kinds of aromatic stuff. But those numbers are meaningless. For any large complex financial institution levered at the House-proposed limit of 15×, a reasonable confidence interval surrounding its estimate of bank capital would be greater than 100% of the reported value. In English, we cannot distinguish “well capitalized” from insolvent banks, even in good times, and regardless of their formal statements.  See Capital Can’t Be Measured

Thus, it is hubris to posture on the investment potential of Bank of America or other financial institutions.   Thinking about Mr. Berkowitz’s comments in Barron’s, it appears that his investment was faith-based, meaning that he relied on the government bailing out Bank of America, again and again ensuring stock market profits.  Government is often an unreliable business partner.

Some Lessons

Extend and pretend accounting games are catching up with the “too big to fail” banks.   European banks are already in shambles. Distrust between and among banks is high and growing.  This can lead to a dramatic loss of liquidity when least expected. And thus could begin the next wave of financial crisis.

Investment gurus usually have one or two good ideas during their investment lives.  Investors who follow the recommendations of these gurus once the financial environment is radically different do so at their peril.   It pays to be skeptical.

Finally, reliance on government to protect investors is folly.  Remember it is the government that coaxed Bank of America into purchasing the troubled Countrywide and Merrill Lynch companies.   In the current Tea Party-dominated congressional environment will another TARP be enacted to save the banks?  With Rick Perry calling money printing by Ben Bernanke treasonous, will the Federal Reserve be able to step in and save the banks?

At the moment the market is putting much weight on the Buffet purchase of Bank of America preferred stock. Investors should think critically about this purchase.  First, it gives lie to the claim of Bank of America management that it did not need to raise additional capital.  Second, the Buffet deal came at a high price to current shareholders. It was a costly financing.  Third, it is merely a small down payment on the much larger sums of money that the company must raise to maintain appropriate capital ratios.  I wish Mr. Berkowitz and other investors much luck, but I think we have not heard the end of Bank of America’s troubles.

Related posts:

1. Bank Bailout v. Rule of Law
2. It Isn’t That Easy to Avoid a Crisis
3. A Canary In The Mine