The best articles of the year.

Here is what I think are the most important articles on the Crash of 2008 and the aftermath.

First former IMF chief Simon Johnson's critique of the Wall Street Oligarchs control over Washinton, published in the Atlantic magazine.

The crash has laid bare many unpleasant truths about the United States. One of the most alarming, says a former chief economist of the International Monetary Fund, is that the finance industry has effectively captured our government—a state of affairs that more typically describes emerging markets, and is at the center of many emerging-market crises. If the IMF’s staff could speak freely about the U.S., it would tell us what it tells all countries in this situation: recovery will fail unless we break the financial oligarchy that is blocking essential reform. And if we are to prevent a true depression, we’re running out of time.

Michael Lewis wrote a story in Portfolio.com about the subprime fiasco and the hedge fund manager Steve Eisman who bet against it. An excerpt:

For Eisman wasn’t raising his hand to ask a question. He had his thumb and index finger in a big circle. He was using his fingers to speak on his behalf. Zero! they said. “Yes?” the C.E.O. said, obviously irritated. “Is that another question?” “No,” said Eisman. “It’s a zero. There is zero probability that your default rate will be 5 percent.” The losses on subprime loans would be much, much greater. Before the guy could reply, Eisman’s cell phone rang. Instead of shutting it off, Eisman reached into his pocket and answered it. “Excuse me,” he said, standing up. “But I need to take this call.” And with that, he walked out.

Finally, there is a new story in Rolling Stone by Matt Taibii which portrays Goldman Sachs as the parasite on the American people that they are.
It is a story about how Goldman Sachs is the cause of every major bubble in the US Economy from housing to internet stocks to oil prices to global warming.

Here is a good quote

In other words, the mortgages it was selling were for chumps. The real money was in betting against those same mortgages. "That is how audacious these assholes are", says one hedge fund manager. "At least with the other banks, you could say they were just dumb - they believed what they were selling, and it blew them up. Goldman knew what it was doing." I asked the manager how it could be that selling something to customers that you're actually betting against - particularly when you know more about the weaknesses of those products than your customers - doesn't amount to securities fraud. "It is exactly securities fraud," he says. "It is the heart of securities fraud."

and another

If America is circling the drain, Goldman Sachs has found a way to be that drain.

and another

The basic scam of the internet age is pretty easy for even the financially illiterate to grasp. Companies that weren't much more than pot-fueled ideas scrawled on napkins by up-too-late bong-smokers were taken public via IPOs, hyped in the media and sold to the public for megamillions. It was as if banks like Goldman were wrapping ribbons around watermelons, tossing them out of 50-story windows and opening the phones for bids. In this game you were the winner only if you took your money out before the melon hit the pavement.

Great stuff!

Update. Here is another very good one.

What is really going on in China

Chinastakes is one of the best places to read about economic trends in China. The latest article is a doozy.

Basically the Chinese are following America's example and flooding their economy with stimulus spending. In fact the majority of the stimulus is just the government directing their state run banks to lend money to anyone for any reason. Where is the money going to go when demand for manufacturing is plummeting? Speculative assets obviously. Here is the money quote.

“I began to invest my money in villas when orders began to decline in the second half of last year and my factory's production was cut by 1/3. The reason is simple. Under current economic conditions, investing in houses is safer than investing in factories,” said the owner of a private firm.

“Do you really think all those stimulus bank loans have entered the real economy?” queried a real estate dealer in Shanghai. “Of course not. They are still in enterprises’ hand, or have been invested in real estate and the stock markets. Some companies took money they scored on the stock market and invested in real estate soon after.”

Anyone with thorough knowledge of financial history knows how this is going to end.

UPDATE

Good story with links at
Zerohedge .

Whiney banks

The banks are whining again. This time about buying back their TARP warrants. Remember, the tiny amount of warrants were issued to make it look like the taxpayer was going to get a little bit of the upside from their investment" in the banks. Now that they want out of TARP, they also want to renege on their contract and get those warrants back.

Listen to the whining

“We shouldn’t have had to pay a dime,” said Sun Bancorp Chief Executive Thomas Geisel...Taxpayers deserve a return for the risk they took on, but it wasn’t a risk to invest in us.”

"You shouldn't have to pay a dime, Tom?". Did you not sign a term sheet giving you tax payer financed capital in exchange for warrants? Now you want those warrants cancelled for nothing in return? Please show me in the term sheet where it says that the warrants will be cancelled.

Jamie Dimon, CEO of New York-based JPMorgan Chase, said June 1 that that the U.S. should cancel half the warrants it holds “out of fairness.”

Ok, Jamie and why don't we reduce everyone's mortgage balance by half out of fairness. Can I pay back half my credit card balance? That sounds fair to me. 50-50. Even steven. Meeting you half way. Apparently contracts are sacred to bankers except for the ones signed between the banks and the taxpayer where the banks have made concessions.

Long Term House Prices

This is Bob Shiller's famous plot of the US housing bubble.

This is using Shiller's more accurate repeat sales method instead of median prices. You can see how house prices go up because everything goes up. This is called inflation.



Shiller made another study of repeat sales of identical properties along the canals in Amsterdam. This is also pretty fascination. There is no upward trend once corrected for inflation though there is lots of variation tracing the history of Holland. Here is a version in Dutch.


This is Bob Shiller's famous plot of the US housing bubble.

How banks plan to survive

The banks have a survival plan and the Fed and Treasury seem to be on board. It looks like this. They are going to earn their way out of trouble. Sure, the capital they have now is probably not truly there if they really took all the marks that they should. But they will write it down slowly over the next few years and replace it with earnings.

They think they will be able to do this because of a few things

• High interest rate spread. Their deposit cost is very low due to the Fed's zero interest rate policy.
  
• They can raise interest rates on loans.
  
• They can borrow cheaper in the capital markets because the government is guaranteeing their debt
  

Now lets look at these in detail to show how all of them are direct wealth transfers from individuals and businesses to the banks.

First, the Fed's zero interest rate policy (ZIRP), forces deposit costs down. People with money in the bank are now getting 0.25% or something instead of 3% or so that they were getting a few years ago. This punishes seniors and other savers including businesses with large cash balances. This results in about $200 Billion dollars per year of interest income getting shuffled from the savers back to the banks.

They can raise rates on loans. They are already doing this. Here are a couple links from the New York Times and ABC News talking about how they are increasing credit card rates on people with good credit. Why are they doing this? Simply because they can. The right question is why didn't they do this in the past. Well, the credit card business is very competitive and people frequently do balance transfers to get better rates. But in this deleveraging environment, no one wants new credit card customers. They would love it if their customers paid off their balance and dropped off the face of the earth. They are not growing these portfolios. They are trying to reduce them. So it is an easy problem for them. Raise rates and fees through the roof. Either you pay them and make them lots of money or you pay off your balance and they reduce their leverage and so reduce the amount of capital they need to raise.

How much does this get them? Well, there is $2.5 Trillion in US consumer debt. If they can raise interest rates (or fees) by 5%, that is $125B/year in extra income. And that is just consumer debt. Total household debt (minus consumer debt) is about $11.5 Trillion and there is another $7 Trillion of non-financial corporate debt. Banks owns about $5 Trillion of this. If they can squeeze another 2% interest rate out of that $5 Trillion, that is $100B/year. Again, if the borrowers don't like it, they can try to find a loan elsewhere. If they leave, the bank has successfully delevered. So raising interest rates on borrowers might get another $225B/year.

Finally, there is all the government guarantees on their debt and direct government lending. I won't estimate the impact on earnings other than to say that without it, they would probably cease to exists. Certainly the Wall Street "banks" would have failed just as Bear Sterns did without the access the discount window and other such programs.

So the impact of lower deposit cost and high interest rates creates a much larger spread which might be roughly $425B/year in extra income for the banks. This is money that is transfered from US individuals and businesses directly to the banks. Most estimates of US banks losses is around $1 Trillion. So the banks can replace this capital through higher interest income is roughly two years.

In summary, the Fed and the government have orchestrated a massive wealth transfer in favor of the banks. This, of course, is in addition to Federal bailout of the banks through the TARP and other such programs. The banks are able to so this because they have essential control over the US government and have power over the central bank with its ability to create money and determined interest rates that banks have to pay for deposits. The banks will probably survive and replace this $1 Trillion capital hole with our money but ownership of the banks will largely remain in the same hands.

There is perhaps a bigger point to be made here. Banks are really intermediaries between borrowers and lenders. They don't produce anything. When you deposit money in a bank, and your neighbor gets a mortgage from that banks, it is really you lending to your neighbor. The bank is a useful intermediary. It performs credit analysis and protects you (with final backstop from the FDIC) from losses. For this service, it collect a fee. But the fee that is collected is a cost to the greater society, i.e. the real economy. The economy therefore is better off with banks being less profitable. Large bank profits, result in capital piling up at the bank which leads to a need to produce more and more credit. This obviously leads to a credit bubble and a crisis when it collapses. At the top of the bubble financials produced 40% of all corporate earnings, without producing anything. This is up form the long term average of about 15%. Those bank earnings which could have been income or industrial earnings would have resulted in a stronger US economy. Instead we had a credit bubble. The lesson is that the banks should not be the dominant force in an economy. They should be the oil that greases the wheel not the wheel itself.

More real estate madness

Jess and I used to live in a funny neighborhood of LA called Montecito Heights. It was basically Mexico hidden away in the hills above downtown LA. This is East LA where Cheech and Chong come from.

We used to go for a walk from our place and pass this boarded up place that looked like a former crack-house. It was basically a wooden box on metal stilts hanging on the side of a steep hill. I would doubt that even cock roaches would sleep inside. Very gross. These pics are not so great but, believe me, it doesn't look better from close up.






Yes, that is a chain link fence two feet from the front door. They are not much for zoning in the Montecito hills. To get in the front door, you open up the chain link fence and walk across a piece of plywood into the front door. If the plywood was not there, you would tumble down the hill rolling underneath the house. Lovely!

I looked on Zillow today to see how much it is worth. They say $300K. But funnier still is that it sold near the top of the bubble at over $700K. What utter madness, this housing bubble!

Swine Flu

I had previously read a lot about the Flu of 1918 and so when I heard about the possibility of pandemic swine flu coming out of Mexico, I immediately got very worried. I expected people to start dying in the US. After a few days, no one died. The media started saying that the symptoms were mild, about the same as normal flu. So naturally, I calmed down a bit.

But maybe that was not the right reaction. There is the curious case of Dr. Gitterles. The doctor in Texas is saying that the situation is far worse than the authorities are saying. Read the email, especially this part

Since it is such a novel (new) virus, there is no "herd immunity," so the "attack rate" is very high. This is the percentage of people who come down with a virus if exposed. Almost everyone who is exposed to this virus will become infected, though not all will be symptomatc. That is much higher than seasonal flu, which averages 10-15%. The "clinical attack rate" may be around 40-50%. This is the number of people who show symptoms. This is a huge number. It is hard to convey the seriousness of this.

Taking this as face value, it means that the flu will likely spread around the world and infect maybe 20% of the world population or 1.2 billion people (60 million Americans) If the "clinical attack rate" is 40%, that means that 480 million people (24 million Americans) will get sick. Note that the US has only a million hospital beds. It has enough antiviral medicine (Tamiflu and Relenza) to treat about 50 million people. So we likely have enough medicine. But we don't have the capacity to treat so many people. In poor countries, they lack the medical capacity and the medicine. This scenario would likely lead to total chaos if not huge numbers of deaths.

The death rate is so far unknown but probably nothing like the 1918 virus. It seems to lack the key gene that made the 1918 flu do so much damage to the lungs. But viruses can mutate and it seems new viruses like this tend to mutate more easily. Who knows where that would lead. The 1918 flu started in a milder wave and came back as a much more deadly virus the following winter. How deadly can a flu get? The H5N1 bird flu killed 60% of infected people but thankfully did not spread easily between people. The death rate for the 1918 flu was probably about 3%.

For the time being, I am not going to freak out. But keep an eye on this and think about how you will respond if the facts begin to indicate that it is worse than we now think. Even if the death rate stays low, this could cause real problems.

Portfolio.com on Geithner

Portfolio.com has a cover story on Tim Geithner which is decidedly negative.

Another ray of hope

Neil Barofsky seems to be taking his job seriously as TARP watchdog.

He seems to be warning about the same kind of abuses that I am worried about. That is good news for Americans.

But it is bad news for bank stocks and probably bad news for the markets. It means that the banks are going to have a harder time swindling their way out of trouble and so the question of how to save the banks is back on the table. Sorry, it won't be by defrauding hard working Americans. On to plan B or it is M by now.

Strange NYTimes article

This New York Times article is certainly strange. Apparently the Obama administration is floating the idea that they have more ammo for recapitalizing the banks than everyone thinks.

Oh,really? What is the latest shennanegans? Well, remember that $350B in TARP money that Paulson put into the 8 largest banks. Well, that was preferred equity shares. That is sort of like a loan that never needs to be paid back (except on liquidation) where the company must pay a fixed dividend to these shareholders before paying the dividend to common shareholders. The yield (annual dividend over the price) was a measly 5%. What a great deal for the banks! But if times gets tight, it can stop paying both dividends without there being an event of default. The shares are non-cumulative so missed dividends never need to be paid back.

Because not paying the preferred dividend is not an act of default, this is considered equity not debt. Preferred equity is not counted any differently than common equity in the three capital ratios that are used by bank regulators although there are guidelines on how high the preferred portion can be - more than half is frowned upon.

These rules are well established in banking. Until now that is. Now the Fed wants to redefine what equity means. Now they want to pretend that all that matters is tangible common equity, bank regulation tradition be damned. So now you can increase the tangible common equity by converting the preferred equity to common equity. Presto, the banks have more capital!

Huh? This does not increase the total equity by one bit. It does nothing to change ASSETS-LIABILITIES which is the definition of equity. They have just shuffled the form of the equity. Really, they have just lowered the standard of acceptable capital levels and made it so that the banks fit the lowered standard.

While they are at it, maybe they can change the definition of liabilities as well. They can redefine it as all debts except those to the federal government. There you go again, instant improvements in capitalization! Just ignore those liabilities when calculating capital ratios.

Honestly, what a joke! Do they really think the market is going to buy this nonsense. The market knows what capital means and they know these banks ain't got it.