Wednesday, July 15, 2009

Rein in Goldman

One problem with Goldman Sach's huge earnings is that it shows that they are taking too many risks. The various articles about it say that they continue to take huge risks, although they are clearly winning. The WSJ said that they had reduced their leverage, but they still made too much money to be trading conservatively. It illustrates the need for stronger regulation. Goldman can't control itself. Arguably its traders are smart enough to beat the market on a regular basis, but unfortunately for our financial security if Goldman can trade wildly, so can everyone else, which includes whoever will replace Lehman, Merrill Lynch, etc. Goldman is still doing what Wall Street firms were doing a year ago when they almost destroyed the global financial system. They shouldn't be allowed to continue to do that. Government has to cut back their margins, leverage, portfolio size, something, so that they are not too big to fail, and also not big enough to destroy the world.

Another problem, illustrated particularly well by Matt Taibbi in Rolling Stone, is that while playing the market has been good for Goldman, it has not been good for America. He says Goldman is responsible for many of the recent financial bubbles, including the oil bubble that ran gas over $4 per gallon last year.

An additional problem is the excessive compensation. It's not good to have such huge differences in wealth. It makes America look and act like a banana republic. The rich guys -- capital -- control everything, including the government, while the poor guys -- labor -- suffer for the mistakes of the rich guys, e.g., in almost destroying the global financial system. Maybe it should be okay for individuals to trade like Goldman does with their own money, but a bank should not be able to. That would somewhat limit the number of fantastically rich people. But also a more progressive income tax would cut down the gap. It looks to me like Reagan destroyed the wonderful America that existed for about 30 years after World War II when he significantly reduced taxes on the rich. Obama's election may show how uncomfortable a slight majority of Americans has become with this situation.

No Second Stimulus

The US faced a genuine crisis at the end of George Bush's term. It looked like the financial system could collapse. But Bernanke, Paulson and Geithner took some drastic action that prevented the economy from self-destructing. So, now we are just in a regular, cyclical recession. Let it go.

It's as if a huge fire threatened to destroy a city. They called out all the fire departments in the region, and the put the fire out. There's a lot of destruction, but the rest of the city is no longer going to be destroyed. The extra firemen can go home.

The bankers and economists who run the government thought they had eliminated the business cycle, but it turned out that their attempts only postponed booms and busts and thus made them worse when the next one came. The only Fed chief who has faced up to a recession is Paul Volker. Greenspan tried to get out of them painlessly and created more pain in the process. Bernanke hasn't been tested, yet. We don't know whether he has an exit strategy, and if he does, whether it will work. In any case, the exit should be painful to reduce the risk and depth of the next recession. Nobody wants to inflict pain. It doesn't seem fair that the middle and lower classes should pay for the recession created by the supposed barons of Wall Street, but that's the way it is. A few of them will suffer, but many, like the employees of Goldman Sachs, will continue to profit munificently.

Rather than a stimulus, the US needs more of a social welfare net, more unemployment benefits, more medical care for lower classes, something like they have in Europe. Tax breaks for small business are not the answer, no matter how loud the Republicans scream that they are. But neither are a lot of make-work jobs. We just need to care for those who need it while the economy recovers on a regular cycle. In the meantime, we need to hold down inflation and support the dollar with some fiscal and monetary discipline.

Tuesday, July 14, 2009

Foreclosure Ain't What It Used To Be

The WSJ ran on op-ed claiming that the problem with foreclosures is not so much sub-prime mortgages as it is no-money-down mortgages. The more I think about it, the more I agree. If you have no skin in the game, foreclosure is not so bad.

In the old days, you had to make a 20% down payment; you would probably have to save for years to get enough for the down payment. Then if you lived in the house for a while, you would make substantial progress paying off the mortgage. Your mortgage might be 50% or less of the value of your house. So, if you lost you job and lost your house, you lost a lot of savings. On a $200,000 house, you might lose $100,000 which would represent years and years of savings.

During the housing bubble you could buy a house for nothing down and perhaps get a mortgage that didn't even require you to make full interest payments, so that the principal owed would get bigger as you lived in the house. In addition, because of the income tax mortgage deduction, the government subsidized this arrangement. Because of the income tax deduction and the negative interest payments, you might actually be able to buy a house more cheaply than you could rent a comparable one. But because you have no skin in the game, it's really comparable to renting. You can walk away and lose no more than if you walked away from a rental unit.

Under these conditions, it makes sense to walk away from a house if the payments get to be too much, or if you think they are too high for the house in the current market. You might get a black mark on your credit history, but that's nothing compared to losing hundreds of thousands of dollars that you had saved over decades.

Now the government is trying to prevent foreclosures, based on the old notion of the hardship it caused, when today it causes much less hardship. Many of the people facing foreclosure have just been scamming the system, getting government subsidies for living in houses that they can't afford. Now the government is concerned that can't continue to live in these same houses and is coming up with new subsidies to keep them there. It is a strong disincentive to people who bought their houses the old-fashioned way.

In helping prevent foreclosures, the program should look at how much equity home owners have. If they have negative equity, it's probably more of an indication that they paid no money down and got concessionary interest rates, which means they probably don't deserve to be bailed out. They've just been renting. The government should not go to any great pains to bail them out. But if someone has a lot of equity and is going into foreclosure because he lost his job or had huge health expenses, then some help is merited.

Thursday, July 2, 2009

Disturbing Financial Thoughts

Wednesday's Financial Times was full of disturbing op-eds. The worst was "Debt Is Capitalism's Dirty Little Secret," but there was also "Britain Has Sunk Itself into a Fiscal Black Hole," "Tightening Capital Rules Could Increase Risk-Taking," and "The Cautious Approach to Fixing Banks Will Not Work." The first one got me when it said:

excessive lending was the only way to maintain the living standards of the vast bulk of the population at a time when wealth was being concentrated in the hands of an elite.
The amount by which the elite has benefited is startling, and illustrates the problem with lightly regulated free markets: the rich get much richer while the rest do not get richer at all. According to Société Générale economists, the inflation-adjusted income of the highest-paid fifth of US earners has risen by 60 per cent since 1970, while it has fallen by more than 10 per cent for the rest. As was recently pointed out in the New York Review of Books, the Walton family, of Wal-Mart fame, is wealthier than the bottom third of the US population put together – about 100m people.
It does appear that the US has chosen to follow the Latin American socio-economic model of great income disparity, rather than the European model, which provides some modicum of social equality. I think we used to follow the European model after World War II, partly as a result of everyone serving in the military together, rich and poor. The Korean War was probably the beginning of the end of that model. I remember my dad stayed in the National Guard after WW II, and he was called up for Korea. But the well connected social elites who stayed in and were the colonels and generals were not called up. Then the Vietnam War put the nail in the coffin of social homogeneity, if it needed one. Basically only the poor and uneducated served, with a few exceptions that proved the rule. We've seen some of the exceptions run for President without success: Gore, Kerry, McCain. The veterans all lost to those who did not serve in Vietnam. Of course, all three have become fantastically wealthy and have more in common with the Waltons than with the 100m in the bottom third of the US.

But, the op-ed is interesting in positing that the growth in debt among the lower classes helped keep the lid on social unrest as these great changes have been taking place in American society. We are not back to having slaves and serfs, yet, but we may be on the way to that in a generation or two. Tennessee Ernie Ford sang, "I owe my soul to the company store," in "Sixteen Tons." Now it's, "I owe my soul to Visa," or Bank of America or CitiBank, or whoever. The lower classes are losing their independence, and with the loss of financial independence comes loss of political independence. So far this change has taken place like the proverbial frog placed in a pot of water brought to a gradual boil; he never knows what's happening to him before he dies. But as this change becomes more apparent, perhaps as the "stimulus" phases out to prevent inflation, perhaps there will be some kind of political awakening. Then the test will be whether the American system can suppress the uprising, as Iran is suppressing its uprising today, whether the political/economic system will reform enough to release these pressures, or whether they will be expressed through violence.

If America follows the traditional Latin American model, it will let inflation run wild. The wealthy elites won't care, because they will own land, gold, commodities, art and other capital assets and tangibles that will increase in value along with inflation, while wages will probably lag inflation, although periodic wage increases may keep the working classes happy for a while.