Muwabi Economic Forum

I know it’s been a long time since I last posted. Still alive… just taking a break from blogging for a while. As I pursue new professional endeavors, my time is simply too limited to post regular, quality material in blog form. I’ve constantly struggled with that constraint throughout the last two years of working on this website. As long as I’m committing my time and effort to such a website, I want to add something unique and insightful at least once a day. Over the last nine months, time only allowed one post a night with some better than others. This is not how I intend to represent myself going forward.

I’ve been exploring a number of different ideas lately. When I read consensus opinion and look at both media and informational tools available online, I see a number of opportunities to improve the availability of quality information. I have no doubt I’ll be back in some capacity to capitalize on these opportunities with a newfound investment of time and the application of an actual business model. When this actually occurs may be in the next few weeks or it may be years down the road.

In the meantime, I’m done with the current format for a while. I’ll probably do a few guest blogs on other sites here and there (I already have one in the works). Any time I do so, I’ll post a link here on the Muwabi website. I might also throw a stray post or link out there too. We’ll see what kind of time I have.

In the meantime, it’s been fun. If anyone wants to contact me about potential ideas or anything else, I’m always happy to talk. My email is danperry@muwabi.com.

Last October, the dollar was hitting tremendous lows and there were forecasts everywhere for the Euro to become the next reserve currency. I completely disagreed with the economic consensus, the crowded Euro trade, and the notion that the Euro was a superior currency to the dollar. Putting it exactly, I said the following…

Evaluating Currencies

The EU can warn all they want but has no power to dictate internal spending. If one or two member nations were the problem, the EU would have tools to seek corrective action but it cannot impose punitive measures against every EU country. All the countries listed still have budget deficits and show no signs of making fiscal responsibility a priority. As the recession lingers and their deflation fighting measures prove ineffective, expect to see even more stimulus and spending. Governments around the world are doing exactly the same thing we see in the United States. Europe has the extra incentive of looking for alternative measures in the absence of monetary tools.

These examples only prove how the EU’s strength is fragile. Considering each country is different and has their own unique needs on interest rates, trade, employment, etc I expect there to be dissension on these issues going forward. The EU hasn’t been around long enough to confront these problems and it can go in any number of directions. Assuming the EU has infinite staying power is a mistake, however, I don’t believe any sort of break-up is forthcoming any time soon…

When stimulus efforts inevitably fail, the crisis will revert right back to the tipping point. Whether this escalates into crisis mode or it gets delayed indefinitely, these losses aren’t going anywhere and the Euro’s value will be affected. A stock market decline could be the spark toward the former.

In this article I certainly had no kind words for the dollar but saw it as a better alternative to the Euro, yen, or pound. Five months later, we’re seeing the Euro sink every day on mere rumors. While I think a full blown dissolution is unlikely at this stage, there is certainly a reasonable possibility. Let’s take a closer look…

Europeans debate exiting euro

As Europe struggles to emerge from its fiscal crisis, a notion long considered taboo is gaining currency: could countries be kicked out of the euro or be given an easy way to leave?

Germany’s leader this week called for new rules that would allow for expulsion, and many people in debt-ridden countries like Italy and Greece are increasingly blaming the euro for their woes.

Read this article in full and think about it with common sense and I think voluntarily exiting the union carries little risk. My prediction is Germany will be the one to consider exiting the Euro. If they are unable to expel or control problem members, the benefits of sticking as the de facto bailout party are very minimal. The German people and government have been very clear about not offering bailouts and imposing strict restrictions on its Euro partners. As the Greece, Italy, Spain, and Portugal problems continue to escalate, Germany will have little appetite for dealing with them. Either the economic pact will naturally implode or Germany will throw its hands up and say “Not my problem”. At this stage, it seems unlikely to accelerate to such drastic consequences but the possibility is very obvious to the casual observer.

Even though the smaller, more troubled nations are committing suicide by leaving, they are still very upset with the European alliance…

Berlusconi: Euro ’screwed everyone’

Silvio Berlusconi launched an astonishing attack on the euro yesterday when he blamed the Europe’s single currency for Italy’s economic woes in the starkest comments to date, saying it “screwed everybody”.

The Italian Prime Minister has frequently blamed the euro for pushing up prices and choking off exports. Yesterday the billionaire claimed that his main political foe, the former prime minister Romano Prodi, had brought Italy to the brink of disaster by negotiating bad terms for its entry into the single currency. He told a conference of his Forza Italia party: “Italy is not at a disastrous point, but I can say that Prodi’s euro screwed us all,” trying to score points against his opponent in the run up to the campaign for next year’s general election.

Of course Bersculoni’s analysis conveniently managed to exclude Italy’s debt/GDP ratio over 100%, negative fertility, rampant political corruption, and unfavorable business environment in Italy’s economic woes. The point, however, is that blame will inevitably be placed on the easiest target rather than the true source. If and when the crisis spreads beyond Greece, the chances of a cohesive response are not so guaranteed.

In concluding this post, Judy Shelton wrote a good article in the WSJ about the feasibility of the current single currency system…

One Currency Doesn’t Require ‘One Europe’

The creation of the euro was either the greatest historic achievement of the last century—or its worst delusion.

Not to be glib, but the answer is both: The euro represents a magnificent step toward fulfilling money’s highest purposes—to serve as a medium of exchange, a unit of account, and a store of value—but it’s also fraught with problems borne of wrongly commingled economic objectives and political aspirations.

Hence, Europe’s single currency is proving both a boon and a bane to free market capitalism. While it facilitates economic transactions across borders and helps to optimize investment, the euro’s vulnerability to the bad behavior of individual member nations calls into question its ultimate dependability.

Another solid read in its entirety.

The important point of this post is to demonstrate how the dollar’s gains versus the Euro should be just the beginning. Even with outrageous deficits and now the addition of health care, we’re still in a better fiscal place than both the UK and Japan while having a more solid currency base than Europe. The dollar will eventually see its day of reckoning but there are plenty of events bound to precede it.

In my week’s absence in the beautiful country of Costa Rica, I certainly missed a lot. God bless the peaceful, tropical atmosphere to keep me away from this mess. Since I know there’s been no shortage of analysis (some very good, while others wasting time on the usual political BS), I want to try to sort through the nonsense and highlight what really took place. I think a good starting place is to clear the myths of the health care bill…

Fact Sheet: The Truth About the Health Care Bill

Among my favorites:

4. The bill will make health care affordable for middle class Americans.

6. This bill provide health care to 31 million people who are currently uninsured.

9. This bill employs nearly every cost control idea available to bring down costs.

13. The bill prohibits dropping people in individual plans from coverage when they get sick.

15. This bill will stop insurance companies from hiking rates 30%-40% per year.

18 The bill will end medical bankruptcy and provide all Americans with peace of mind.

This is a good read. I cannot guarantee accuracy since I decided not to read the thousands of pages for this bill. However all the good, non bias sources I’ve read seem to confirm these myths stated above. Next let’s go to a more broad overview of costs…

The Real Arithmetic of Health Care Reform

ON Thursday, the Congressional Budget Office reported that, if enacted, the latest health care reform legislation would, over the next 10 years, cost about $950 billion, but because it would raise some revenues and lower some costs, it would also lower federal deficits by $138 billion. In other words, a bill that would set up two new entitlement spending programs — health insurance subsidies and long-term health care benefits — would actually improve the nation’s bottom line.

Could this really be true? How can the budget office give a green light to a bill that commits the federal government to spending nearly $1 trillion more over the next 10 years?

The answer, unfortunately, is that the budget office is required to take written legislation at face value and not second-guess the plausibility of what it is handed. So fantasy in, fantasy out.

In reality, if you strip out all the gimmicks and budgetary games and rework the calculus, a wholly different picture emerges: The health care reform legislation would raise, not lower, federal deficits, by $562 billion.

Again, I’d be wary about placing firm belief in these numbers. I think the importance of this article is a demonstration that Obama and CBO estimates are far from certain. In fact, like all government economic estimates, I’d be cautious of overly optimistic assumptions. Considering this bill does absolutely nothing for costs, I expect total costs to run toward the higher end of estimates.

Finally let me recap the arguments I made when health care legislation appeared to be dead…

Health Care Fails

Source: CBO Budget

1) Health care is almost perfectly inelastic. This isn’t unique to US health care but helps explain why almost every country has significant health budget problems. People will pay any cost to seek treatment for life threatening or severely life altering conditions.

2) Despite claims to the contrary, our health system has no resemblance to a free market system. Most of the population has a system where their employers pay premiums and thus the consumer has little concern over cost. We have a Medicare/Medicaid government sponsored system with no rationing for some of the population. Then the remainder is left to fend for themselves and try to pay for insurance despite cost being driven up by the rest of the non free market system.

3) Since our system is built upon an insurance model, nobody cares about the prices. Most of the time, people don’t even know what health bills actually costs because it gets sent straight to the insurance company. This

4) Because most people expect their employers to supply medical coverage and wouldn’t work somewhere without this benefit, employers have no bargaining power over the insurance companies. Since the insurance companies can effectively charge whatever they want, they are unconcerned with rising prices. Given their free reign, they may even have incentive for price inflation.

5) There is zero competition for health care. Sure, doctors can compete based on quality and reputation but part of economic competition is charging appropriate prices. If consumers bought any other service (from auto maintenance to landscaping to computer repair), they would demand a price bid and compare among other local competitors. I’m willing to bet that nobody has ever called the doctor’s office and ask how much a visit will cost. I also guarantee it’s incredibly rare for someone to demand a price before any procedure or treatment. If nobody questions or compares prices, competition simply does not exist and there is no check on prices.

6) Losses from the uninsured guarantee health care providers will raise prices above break even cost. The insured are subsidizing the uninsured. While this might occur in any business (for example paying a premium because most businesses have to account for theft, depreciation, etc), health care becomes excessive. Because health care is such a necessary and expensive service, these losses are exponentially higher than any other business.

7) Health care providers are paid based on the amount of procedures provided rather than the quality of care. Since patients don’t check prices or what services are being charged, they are in no position to argue. If a doctor makes a mistake, they are paid just the same as if they did a perfect job. If a doctor wants to run several unnecessary tests, nobody will argue or check its necessity. In any other industry, excessive or non-quality performance would not go rewarded.

8 ) Malpractice insurance is unreasonably high because doctors are frequently sued for small mistakes or unavoidably adverse results. While most of these lawsuits don’t stand much chance of winning unless real malpractice has occurred, there is a big risk of excessive judgments or arbitrarily decided punishment. As long as malpractice is such a big concern, doctors have extra incentive to order unnecessary tests and charge large fees.

9) In today’s technologically driven society, there is no excuse for not having a universal patient information infrastructure. So much money is wasted on insurance paperwork and records management and passed on to the patient’s costs.

10) Prescription drug costs are out of control when the government is so willing to protect the big pharmaceuticals. Rather than focusing on improving their drugs or providing treatment for all conditions, pharmaceuticals are able to make ridiculous profits on certain drugs protected by their biggest buyers: the US government. Allowing generics to compete on price would drive down costs substantially.

I could come up with so much more but I think these are the major reasons for such outrageous health care costs. Rather identifying these problems and attempting to craft a solution, Democrats focused on coverage while Republicans fought for the systematic status quo. Neither of these approaches were realistic in dealing with the health care costs and hence we are left to choose between disastrous legislation or nothing at all. This is unacceptable given the horror stories in health care today and the prospect of the above graph representing our future.

The structural deficit due to Medicare and other health costs have not been addressed in the least. Meanwhile, all these other causes are completely ignored guaranteeing continued cost appreciation. Since cost is such a major problem, all of Obama’s stated goals are doomed to failure. One thing I can guarantee is we will be debating health care reform throughout the rest of this decade.

Now let’s proceed to the good things. I am absolutely happy to see millions more Americans receive coverage. I’ve said it over and over: it is unacceptable for people in our country to lack insurance and be forced into bankruptcy over their health. While we don’t address this in it’s entirety, this was a positive step for coverage. There were also plenty of logical provisions here. Restricting discrimination due to pre-existing conditions and extending the age for young adults to stay on their parents plan are good steps. I also think most American will be surprised to see how little this actually affects them. Most middle class Americans satisfied with their employer sponsored plan really won’t see any consequence here.

With such sparse good comments over a $1 trillion bill, it’s pretty clear I think there’s a lot of waste. Even though I don’t support such a plan, I think extending Medicare to all would have even been better policy here. The fact is, health care must be reformed and this just doesn’t do it. Neither does the Republican alternative. Historic… definitely not. At the same time, Armageddon it’s not either. It’s just another obligation we cannot fulfill and another broken system.

Throughout history, accessibility to resources has been the absolute indicator of wealth, prosperity, and survival. This is why Saudi Arabia is one of the richest nations despite being located in the middle of a desert. This is why major cities have always been built around convenient water transportation routes. This is why Brazil, Chile, Russia, and Australia have such thriving economies. While the world remains fascinated by the wealth attained by athletes, bankers, actors, and tech entrepreneurs, these pale in comparison to access to the most vital human resources. If I had to rank the two most important of these natural resources, there is no question the top two would be water and oil. Imagine if there was a shortage of either of these resources. Imagine if prices skyrocketed. It would create an adverse scenario that would make the banking crisis look like a picnic. These are two resources required for every human to maintain their lifestyle. Thus the two most important world issues should be examining their supply…

Peak oil production predicted for 2014

Predicting the end of oil has proven tricky and often controversial, but Kuwaiti scientists now say that global oil production will peak in 2014.

Their work represents an updated version of the famous Hubbert model, which correctly predicted in 1956 that U.S. oil reserves would peak within 20 years. Many researchers have since tried using the model to predict when worldwide oil production might peak.

Some have said production already peaked. One earlier model by Swedish researchers suggested that oil would peak sometime between 2008 and 2018. And other researchers have argued there are decades to go before oil production goes into irreversible decline. The only thing they all agree on: Oil is a finite and very valuable resource.

Global crisis of water scarcity

A decade ago, it was predicted that a third of the world’s population would be facing water scarcity by 2025. But this threshold has already been reached. Two billion people live in countries that are water-stressed and by 2025, two-thirds of the world population may suffer water stress, unless current trends alter.

Even more dramatic, wars will be fought over water this century, just as wars were and are still being fought over control of oil these past decades.

“The global population tripled in the 20th century but water consumption went up sevenfold,” noted Maudhe Barlow of the Council of Canadians and an expert on the global water crisis in her book Blue Covenant.

“By 2050, after we add another 3 billion to the population, humans will need an 80% increase in water supplies just to feed ourselves. No one knows where this water is going to come from.”

With crises in the two most critical resources looming, one might logically expect tremendous awareness, concern, and preparation for these events. It is thus extremely concerning when we see the following…

Gallup: Environmental concerns hit 20-year low in U.S.

Americans are now less worried about several environmental problems than at any time in the past 20 years, partly because they believe conditions are improving, according to a Gallup Poll released today.

Their concern for each of eight environmental problems fell from a year ago and in all but two areas – global warming and maintenance of the nation’s fresh water supply — reached an all-time Gallup low.

“It also may reflect greater public concern about economic issues, which is usually associated with a drop in environmental concern,” Gallup says in its release, adding that another factor may be “greater action on environmental issues at the federal, state, and local levels.”

I’m glad Gallup included the observation about how there is a trade-off between environmental and economic concerns. People have every right to be concerned about their immediate economic situation, however, they should also realize that environmental aptitude represents the biggest threat and opportunity to their own well-being. The threats imposed by deteriorating environmental conditions for water and oil resources are well documented in the articles above. There is also tremendous opportunity to solve these problems and create a new source of incredible wealth. If I were advising someone on a long term investment strategy, I would tell them to stop worrying about whether Microsoft or Apple has a more attractive stock or when the Fed will raise interest rates. Instead, I’d tell people to learn as much as possible about these resources and what types of emerging technology exists.

I’m generally going to end with this. I don’t need to paint a doom scenario regarding these resources because anyone can easily imagine life without clear access to them. Instead, I will reiterate my plea that a Manhattan Project type effort needs to happen sooner rather than later. There is just too much threat and opportunity to take this issue any lighter than that. For the individual, this has just as much impact. Demand attention to these issues free of political bickering (which has unbelievably happened with global warming). At the same time, educate yourself about these topics, monitor them closely, and secure your own resources through investment. It’s about as guaranteed as one can get.

Normally I might do a review but I can succinctly describe the book such that a review is unnecessary. Plain and simple, Too Big To Fail by Andrew Ross Sorkin is the best book written about the financial crisis to date and I can confidently state it will be the best when it’s all said and done. In fact, I think it’s one of the best books I’ve ever read. It is by far the most thorough, well researched, well written book imaginable about this topic. It’s also far from dry as some non fiction books end up being, as it is written as a narrative with actual dialogue and suspense.

That’s about all I need to say about the book. A few months ago I posted a link to the Vanity Fair excerpt, which provides a good sample of what the book is all about. You can find this post Too Big To Fail.

As I was reading, I wrote down a number of my observations. Let me share…

1) This book was really written without an editorial bias. As much as people criticize the Treasury and Fed for never considering the taxpayer, this book puts an exclamation point on it. All the dialogue between Paulson, Geithner, Bernanke, Bair, and the major bank CEOs mentioned the taxpayer approximately zero times. Decisions are almost framed about how the market will perceive government actions and how it will impact Wall Street. I don’t blame bank CEOs for looking after their own firm but the US Treasury should at least conjure up an ounce of consideration for the people paying for these bailouts. Even if they still decide money is required, at least they have a full spectrum of all stakeholder views. Reading this makes one realize exactly how valid these criticisms are (even if it’s pretty obvious without the book).

2) With all the recent revelations about Lehman’s bankruptcy, Dick Fuld looks much more like an incompetent figure than one rooted in corruption. Everyone around him could plainly see Lehman’s true worth and yet to the last day, he truly believed the world was against him. Amazing how an otherwise intelligent person can get caught up in his own delusions.

3) One minor grievance with the book is the omission of why Paulson absolutely had to save AIG. There’s a tremendous amount of material about why he refused to save Lehman but then saving AIG was portrayed as a foregone conclusion. My suspicion is this is due to Geithner and the NY Fed being unwilling to submit to interview, as they took the principal role in AIG’s bailout.

4) Sticking with the AIG topic, it’s really amazing how far under the radar AIG’s problems were. Warning signs were everywhere but Geithner didn’t take AIG seriously until after Lehman failed. Not that losses would have been contained any better but I think this is the primary reason their bailout became such a mess. The government didn’t blow Lehman… they were out in front of this for months and it simply never resolved itself. AIG is a true instance of lack of preparation.

5) As much as Paulson claims to be Mr Free Market, his first reaction always seemed to be how the government could step in. I’m curious to read his book and see whether there was a conflict between his true ideology and the demands of that specific position or whether his natural instincts were simply in favor of a closely managed system. Perhaps the series of events eventually required his intervention, however, I’m talking about the initial instinct.

6) One of the biggest criticisms of Paulson was how his solution always revolved around consulting his old Wall Street colleagues. This book certainly illustrates that to the extreme. Paulson never bothered consulting leading economists or policy makers. I’m not saying they would have offered anything better but his first and only discussions were with Wall Street CEOs. His Treasury staff was littered with former colleagues. The nature of the problems and the pure quantity of good people from the industry is a good reason. However a diversification of opinion could have really made a difference, even going so close as to look into traditional bankers (rather than exclusively investment bankers and traders).

7) Paulson seemed to be very frustrated when he got branded a socialist. His policies during the bailout sure didn’t help but I think the label would have been less impacting if he was more forthcoming from the start about how severe this situation was. Of course his sole consideration was on how the market would react so he couldn’t be as honest as he should have been.

8) Along similar lines, the Treasury always talked about the “optics” of a deal (whether in saving Lehman or the potential Goldman purchase of Wachovia). Rather than concerning themselves about how things appear, they simply should have been honest and said “we’re saving the system at all costs” or “we’re letting the market decide and will only serve as a transaction broker.” Rather than worrying about how one act will be perceived versus another, they should have simply done the right thing for legal, moral, or systemic reasons and been very up front about those motives.

9) One thing I never really knew was how the British government really did stop Barclays from rescuing Lehman. Paulson and Bob Diamond had a deal in place but their regulators shut it down. I’m not sure if this was a revelation of this book or not but I was always of the perception that the American CEOs couldn’t hammer out a deal and this scared Barclays off. The British rejection took both Diamond and Paulson by complete surprise. Interesting to consider how things might have been different had they proceeded with that deal. Ironic that they ended up being right, as Barclays bought Lehman’s best assets for virtually nothing during the bankruptcy proceedings.

10) As much as I believe Paulson mishandled a lot during that year, he made an absolute brilliant move in getting the 9 major banks to accept TARP money. Bringing them in and strong-arming them was absolutely a great tactic in getting them on board. Without their cooperation, Paulson was absolutely correct that there would be a major stigma in accepting the funds. As much as I disagree with TARP the policy, he really demonstrated here why he made such a successful CEO.

11) Interestingly enough, Paulson’s Treasury staff came up with the ideas for TARP after Bear Stearns failed. This includes the initial TARP proposal and the modified one.

12) Even though he was only mentioned toward the end, I really liked Wells Fargo Chairman Richard Kovacevich. He was very reluctant to purchase Wachovia because Wells didn’t like the risky assets they specialized in. I’m curious why they ultimately made their bid and whether they wish they trusted their initial suspicions. Then they were the biggest dissenters about signing on to TARP. Seems like they were the long voice of reason but still got caught in the crazy Wall Street game in the end.

I’m sure I could go on and on but I think everyone will have different interpretations. I’ll end by reiterating my observation from my previous post. As much as I disagree with the way this was handled by Paulson, Geithner, and Bernanke, they put in a tremendous amount of work and did prevent an absolute collapse. Preventing collapse wasn’t all that difficult considering the resources at their disposal but I have to at least applaud their tireless pursuit of what they believed was correct. I cannot question their patriotism and desire to save the system they believed was so important to our country. My criticism is not of their motives but mostly of their methods. I’m sure more revelations will come out in the next few years and I’m anxiously awaiting them.

A very interesting study from the Heritage Foundation/Wall St Journal displays a ranking based on economic freedom. They use business freedom, trade freedom, fiscal freedom, government spending, monetary freedom, investment freedom, financial freedom, property rights, freedom from corruption, and labor freedom as variable in their rankings. Here’s the link to the rankings:

2010 Index of Economic Freedom

Click on the ‘Explore the Data’ button at the top and you can filter rankings based on each of these variables. Considering all the political discourse about this very subject, it is interesting to see a non biased source rate our economic freedom versus all other countries. Not surprisingly, we rate very high on individual freedoms but much more poorly on fiscal and monetary freedom. This is generally the case of most highly industrialized nations. I’d be very curious to see how we ranked in each of the last ten years and how that has changed over time. It would also be interesting to compare the success/failure of these economies compared to their trend up and down the list. I’ll refrain from issuing much more comment. This is much more interactive… enjoy.

I’m reactivating the spam filter due to heavy volumes of spam on the site. I’m going to look into a better filter for users to enter math problems, etc. In the meantime, if the site blocks your post just send an email to danperry@muwabi.com and I can release it from the filter. Thanks

Remember when Dick Fuld was screaming about how the short sellers ruined his firm. He kept insisting Lehman was misunderstood and the subject of a speculative conspiracy to destroy him. Many in the media actually gave him the benefit of the doubt, while John Mack and plenty others repeated his same lines rather than looking at their own balance sheet. I do have some sympathy for Mack, as his firm was on solid ground and in trouble due to panic. However, it was obvious that Lehman and Bear were fully deserving of the scrutiny at the time. Now the Lehman bankruptcy report has emerged and concludes Lehman had been insolvent for a lengthy period of time, while hiding dismal conditions through manipulative accounting among other things. Seems like those short sellers weren’t so bad after all. I don’t think excerpting the following article does it justice so I’d encourage a full read…

We hedge fund managers are on your side

Hedge funds are not seeking to dictate economic affairs. Rather we are preoccupied by price. A market-based economy like ours requires a pricing mechanism to allocate resources and ensure that we all prosper. Get it wrong and we endure the calamity of the technology bubble and the sleazy debacle of the American mortgage crisis.

It’s not that hedge fund managers are bitter and seek to wreak havoc. It’s just that we believe that recurring and periodic recessions reveal the economy’s winners and losers. And through our endeavours, hedge funds attempt to discover the identity and inadequacies of the poor businesses. During hard times, such businesses typically go bust, allowing us to make an investment profit by betting on that eventuality, and ensuring that successful and prudently managed businesses prosper.

Or rather that was how it was supposed to work. But our political leaders have gone to considerable cost to avert this normal business cycle.

Fearing that the huge scale of reckless bets within the banking system threatened another depression, our politicians have used public funds to bail out the economy’s losers. And in doing so they run the danger of creating a plutocracy: a society ruled by the wealthy. Consider that fact that in Latvia school teachers have had to take a 35 per cent pay cut so that the Swedish banks who funded the real-estate bubble are repaid their imprudent mortgages.

I really agree with everything in this article. I do encourage the proper regulation of derivatives and a return to reasonable leverage, disclosure, and transparency. However, investors or speculators as many like to call them, are not at fault in the crises of the last few years. If we didn’t have investors looking into credit conditions or taking short positions, we’d be less likely to expose the Lehmans and Greek bonds of the world. Having parties incentivized in looking for the bad in a market and exerting pressure to price it accordingly is just as important as having investors looking for value. Where regulators, policy makers, and the media grossly failed, these “speculators” were there to exposure. I’d really like to see this blame of speculation be eliminated from public discourse. It truly distracts from the real structural problems the global economy continues to face.

We all know last year’s stress tests were a joke. As they were taking place, the unemployment rate went higher than even the most adverse scenario. We also know accounting changes have allowed banks to mark assets to extremely favorable valuations. Connecting the dots, we get the following…

Principal Writedowns and the Fake Stress Test

Again, this is data as reported to the government by the major banks during the stress test of 2009. So what’s going on here? The four major banks have about $477 billion in junior liens, either in the form of a second mortgage or a home equity line of credit. If you go to the Fed Funds data online, you’d see that there’s about a trillion dollars of 2nd/Juniors out there, so the four major players have about half the market.

The four major players each report that they expect to have a 13-14% loss on these items under an “adverse scenario”, with Citi reporting a 20% loss under an adverse scenario. That means of the $477bn, $68.4 bn is junk that’ll never be collected on. This, combined with all the other expected losses (see the link to the stress test for the rest) meant that the four biggest players needed around $53bn to be raised.

This is some really good analysis and I’d highly encourage everyone to check out this link. The revelations here are not particularly surprising, but definitely represents the type of reporting we should be seeing out of the media. Kudos to Mike Konczal for his work here.

Since the stress tests told us very little and regular financial reports out of the largest banks hardly inspire much confidence, we should be pushing for more transparency. Although the UK will probably be playing similar games, they are doing a second round of testing…

FSA tells banks to stress-test for two more years of recession

British banks and building societies have been ordered by regulators to check that they could withstand another two years of recession, millions more people losing their jobs and a steep fall in house prices.

The Financial Services Authority has asked financial institutions to stress-test their balance sheets to ensure that they are strong enough to cope with a return to prolonged recession.

Britain inched out of recession in the final quarter of last year but the FSA wants to be sure that the financial system is robust enough to cope with a further 2.4 per cent fall in GDP between now and the end of 2011.

Since the financial system is supposedly stable, yet significant risks remain, I’d like to see a true stress test. Not the dog and pony show Secretary Geithner staged last year but one providing true insight for investors and economists. Specifically, the tests should focus on the following:

1) Unemployment under a scenario of 10% for the next three years. An adverse scenario where unemployment slowly rises to 13% until 2012 when it steadily falls.

2) Increase estimates of CRE losses 30% higher than current forecasts

3) Take true writedowns on all real estate loans, especially these second mortgages and home equity loans.

4) Assume estimates are correct and say 30% of US residential homes will be underwater.

5) Assume current conditions, yet interest rates rise to 3% by 2012.

6) Assume a stock market decline of approximately 30%.

7) Assume several sovereign defaults over the next few years cause Treasury yields to rise dramatically.

All these scenarios would reveal a deeply insolvent financial system, thus there’s no chance such a stress test would ever occur. Still, it’s nice to imagine a system where we make realistic adverse scenarios instead of models assuming perpetual growth, inflation, and improving economic conditions.

If I were to rank some of the major contributors of the financial crisis, the incompetence and downright fraud in credit ratings would be near the top. It amazes me we still haven’t seen accountability from these people or any change in the structure of their rating evaluation system. Remember, AAA labels were placed on the most toxic CDOs and the rating agencies even had A ratings on Lehman and Bear Stearns a week before their bankruptcies. These are just some of the many examples of their destructive performance. Now as sovereign debt looks prime for defaults, the ratings agencies are at it again with the same investment grade marks.

Connecticut Attorney General Richard Blumenthal shares my opinion and is taking legal action…

Connecticut Sues Moody’s, S&P Over Subprime Ratings

Connecticut Attorney General Richard Blumenthal said he is suing Moody’s Corp. and Standard & Poor’s because they were “catering to the investment banks and other issuers” of structured debt securities.

“The rating agencies said they were objective and independent, knowing that they were heavily influenced by their bank clients,” Blumenthal said in a Bloomberg Television interview today.

The suits, which Blumenthal’s office said were served and not filed today, joins a claim filed by Ohio Attorney General Richard Cordray in November. Ohio sued Moody’s, S&P and Fitch Ratings on behalf of five Ohio public employee retirement funds, claiming improper ratings of mortgage-backed securities cost the funds more than $457 million.

Blumenthal told Bloomberg Television in November that he was considering suing the credit rating companies.

“We want money back for our taxpayers as a consequence of these misratings,” Blumenthal said in the November interview. “They gave AAAs to financial instruments that deserved much, much less. They were the enablers to this structured finance debacle.”

Kudos to Mr Blumenthal for trying to bring some accountability to this behavior. I’d be curious what a lawyer thinks of this lawsuit. In my opinion, if they can prove actual fraud (which I strongly believe took place), they do have a case. Damages are clearly defined and intent to deceive shouldn’t be much problem with the power of subpoena. The only problem I have is the pension funds never should have invested in these instruments in the first place. Even though the credit agencies have an obligation to define risk, a conservative retirement account should not be speculating in derivatives they know nothing about. Since I have a major problem with both sides in this case, I don’t really care who wins. I’m just hoping this case makes it to trial so we can see if any revelations come to light during the discovery process.

Meanwhile, any controversial subject can’t make it very far without some ludicrous government action completely aiming to solve the wrong problem with the wrong solution. It would almost be fit for the Comedy Channel if it wasn’t so serious…

Senate Bill on Finance to Include Agency That Tracks Financial Risk

Senate Banking Committee members from both parties said on Wednesday that they had agreed to include in their regulatory overhaul bill a new Office of Research and Analysis that would provide early warnings of possible systemic collapses.

The proposed agency, which has sometimes been referred to as the National Institute of Finance, is intended to give federal regulators daily updates on the stability of individual firms as well as that of their trading partners, including hedge funds.

By standardizing financial instruments and reporting mechanisms, the agency would give regulators a broader view of the health of participants in the financial markets and the potential for problems to spread. The idea’s supporters say that kind of information was lacking in recent years as the housing bubble burst and troubles spread from firm to firm.

Allan I. Mendelowitz, a former director of the Federal Housing Finance Board who was a founder of the group, said in an interview that regulators were unable to assess expanding risk in the recent crisis in part because they relied on independent contractors, like the credit rating agencies, for data…

If a security was rated triple-A by the ratings agencies, for example, as were many mortgage-backed securities, regulators wrongly assumed that it posed little systemic risk, Mr. Mendelowitz said.

The agency would require a vast array of computing capacity, supporters said, and it would probably take a couple of years to establish data standards and build analytical models. But it could immediately begin to assess counterparty risk based on existing data.

Rather than credit agency reform, let’s have bureaucrats do the job for them. Rather than addressing the underlying causes of the crisis, let’s try to do better next time. Rather than address too big to fail, we’ll just monitor things more closely. Let me point out what should be obvious. More economic bureaucrats that couldn’t see an obvious crisis will be responsible for trying to get it right next time. They will create new models with no regard for financial innovation, changing trends, or obvious assumptions. Instead the models will rely on the false mainstream assumptions that asset prices always appreciate, fiscal and monetary policies create equilibrium, and the fundamentals of the economy are still strong. Even if they magically gained a single shred of competence and foresaw risks, their warnings would be ignored by the parties benefiting from the next big bubble. Like those that warned everyone this time, they will be cast aside and laughed at. Even if they create enough concern, government policy will almost certainly not address the underlying causes. After all, they can’t correctly diagnose and remedy this disaster two years after it blew up in our faces.

This bill is yet another example of senseless regulation and waste of taxpayer dollars. Instead they should be focused on solving too big to fail, implementing many of Volcker’s proposals, allowing the deleveraging process, cleaning up the government’s balance sheet, addressing a structural trade deficit, plugging the regulatory gaps, and imagining how to fix a fractional reserve/inflation targeting/Ponzi monetary system. Chances are, both the credit agencies and this new systemic risk regulator will not direct their focus to any of these topics.