12 December 2013

How to Fix America


We’ve got a moment of possible momentum here.  The unemployment rate is about to head back down into the 6%’s for the first time in five years; non-farm payrolls heading into the +200-thousand’s per month.  Housing - the thing that caused all this mess - has for about a year been in a real recovery now.  A bipartisan budget deal is on the table and the Speaker for the first time in a long time seems done with the more radical fringes of his party that have so paralyzed Washington, in my view.

The iron is hot.  I have been developing some ideas about how to set the course for our nation’s present and future.  I know I am but one voice.  But for those who would listen, this is what I propose we do.

There are way too many underemployed in this nation.  Although the trend has only briefly possibly begun to change, most hires in the past few years post-crisis have been into low-wage, low-skilled jobs.  Many of those hires however have skill-sets much more developed than their new job requires.  We have structural employment problems tied in no small part to business' reluctance to truly expand given sociopolitical uncertainty.

So I propose that we offer tax credits to small businesses (say under 50 or 100 employees) for hires above a certain pay-grade.  Why small business?  They are where most entrepreneurial activity occurs. Small is by nature poised to grow faster than large.  They are small enough to offer for their employees the fastest upward promotion mobility.  They are more invested in their employees, as each is that much larger a piece of their business. (Plus the business owner actually bumps into them weekly, if not daily, so it’s more of an emotional investment in each employee.  How often does that happen at IBM?)  They are the best place to cross-train and thus more broadly develop new skill sets.  They have a disadvantage to accessing capital markets versus large firms, so helping that lower common denominator improves the situation for all.  They are a large portion of business anyway – 50% of those employed in the US are at firms with under 500 employees each (35% under 100).

How do we pay for it?  It pays for itself.  We can nail down the numbers later, but for instance, say you hire a mid-level person for $45,000, versus a lower-level person for $28,000.  Or just promote her.  For individuals with no dependents using the standard deduction, $45,000 will pay about $9,100 in federal income and payroll taxes for 2013.  A $28,000 income would pay about $5,000.  So the $45,000 income pays $4,100 more taxes to the federal government.

If we offered a $4,100 tax credit to companies that hire people for $45,000 or more, it’s revenue neutral because we’ve moved someone out of a $28,000 taxpayer position into a $45,000 one (if not created a new one entirely out of thin air, which would be a revenue add, and an expenditure cut from no more unemployment insurance or food stamps or home heating assistance, health care credits, etc.).  And we can scale the credit up, for the higher the income (up to a point).  We can put safeguards in to protect the duration of their employment as well.

Yes, the employer is paying $18,100 more for that higher wage employee ($45,000 - $28,000 = $17,000, plus $1,100 more for the employer’s share of higher Social Security payroll taxes).  But the end result is, we are incentivizing business to expand; to use that pent up cash and invest in the projects they’ve been wanting to for a few years now.  That ultimately requires higher wage workers.  So we are offering them the incentive to take that shot and hire up where they previously would not , and receive an almost 10% reduction in the cost of higher-wage labor (the increased $18,100 labor cost is a tax shield anyway, because it's an operating expense deductible from pretax profit).

Second, I propose offering tax credits for those businesses that hire our Veterans.  We owe them far more than an ovation at the State of the Union or a pat on the back in the bar (or making them wait a year or more for their benefits).  These people already have the discipline and adaptiveness that, if hired, would raise the bar and set the standard for your other employees (making your employees a little nervous about performing to the best of their abilities is something I know every employer would appreciate).  Our Veterans don’t want a hand out.  They just want to work at the highest wage their skills can attract.

How do we pay for it?  Even during the so-called “sequester” (forced budget cuts due to failure of Washington to come up with budgets), we’re still spending ~$600-700 billion in defense and security.  We can’t find anything in there to offset this?

And to anyone pro-Defense that balks at cutting Defense budgets, I would humbly submit that we fought decade-plus long multiple engagements with no draft, forcing much higher numbers of redeployments than otherwise.  Our Veterans and those still actively serving, as well their families, are the ones who subsidized that for us with their above and beyond commitment to serve.  So I think the Defense Dept. – indeed all of us – should put some sober thought into finding how we can truly give back to them.

We can further incentivize businesses to add higher-wage employees and/or Veterans by offering them the ability to secure lower-interest loans, with implicit government sponsorship if they do so.  That gives them better access to capital markets to expand business.  I heard someone propose that the Federal government pick up the school loans for those that give two years of public service.  I like that idea as I think our younger people should have more skin in the game of our society, but I would submit we marry that idea to offering credits or loan support to businesses that hire them.

And finally, yes, let’s raise the minimum wage to ~$8-9 per hour.  But only after the unemployment rate drops below 6%.  This will incentivize those more liberal elected officials to pursue pro-business reforms.  And businesses should be healthy enough at that point to absorb the higher labor costs.

If we can get unemployment to or below 6%, with higher wage jobs, employ our Veterans, put more cash in the pockets of those who really need it, get the next generation more civically involved; and during a period of real, significant, sustainable job growth, then we have a whole lot to look forward to.

At that time, we can explore whether we need to raise taxes to reduce debts and pay for the rising social subsidies we’ve promised everyone.  And/or right-size those subsidies for future generations to a level we can afford.  Reform and simplify the tax code.  Close loopholes.  Lower Corporate tax rates.  Incentive our K-12 and secondary educational systems to promote math and science.  Explore public-private partnerships to nurture new technologies that will spawn the higher wage industries of America’s future.  And rebuild our infrastructure along the way.

All we need to do is get along, and it’s as good as done.

11 December 2013

Volcker Rule and the Faux Unwinding of Risk

Yesterday, a body of regulatory agencies finalized the tenets of the so-called Volcker Rule, which seeks to limit the ability for banks to engage in investing or trading deemed too risky.

So first of all, there are two kinds of banks – commercial banks and investment banks.  Commercial banks take deposits (our savings or checking accounts) and use the surplus funds to make loans to businesses, consumers and potential homeowners, earning a return in the process.  Investment banks perform a variety of other activities, some of which may be deemed riskier than making a plain-vanilla loan.  Mostly, they trade their own capital for profit, act as financial advisors in transactions and they engage in market-making in securities markets to facilitate liquidity for their corporate and institutional clients.

A commercial bank’s source of capital, as already alluded to, are the deposits that we give them to safeguard for us.  Those are insured by the FDIC, an industry self-funded entity, with an implicit guarantee provided by the Federal government.  In contrast, an investment bank’s source of capital is basically just like every other business’s.  They must have partners buy-in providing equity capital and/or borrow it by issuing debt in the public market.

The “cost of capital” for a commercial bank is the interest rate that they must pay on our savings account or the marketable equivalent through issuing certificates of deposit.  Both offer comparatively low interest rates.  In other words, the cost of bank deposits for the commercial bank is comparatively cheap.  Because the lender is unsophisticated (just every-day people opening a bank account), the funds are insured with a Federal back-stop and there had traditionally been a limit to the amount of risk a bank could take reinvesting those funds.

The cost of capital for an investment bank is much more expensive.  It must pay whatever the market demands.  And the market is sophisticated, the funds are not insured and the investing of the funds will be riskier.

So for example, in a normal investment environment (unlike now), commercial banks might have to offer savings deposit or CD rates somewhere around ~2.5-4%.  An investment bank would have to source capital through either issuing notes which would carry an interest rate more like ~6-8% or issuing equity, which would “cost” ~10-12% (by issuing equity, you give up a share in the earnings and profits of your business; basically if the stock tends to go up ~10-12% a year on average, you are giving that up, or “paying that out”).

The separation between commercial banks and investment banks ended in 1999.  President Bill Clinton and a Republican controlled Congress approved the Gramm-Leach-Bliley Act, which repealed the Depression Era Glass-Steagall provisions of the 1933 Banking Act, put in place expressly to separate such activity.

1999 forward, what this did was it allowed for banks to engage in riskier investing and trading, raising capital at a cheaper cost by using our deposits.  The banks could now use our savings deposits to do things riskier than make some loan to a business or consumer.  In other words, it mispriced risk.  They could now raise capital at a cost that did not account for the risk.  There was a reason why investment banks had to pay more for their capital.  They did riskier things.  Now, since 1999, they don’t have to pay more for taking more risk.

Banks (and most businesses) lever.  In other words, they have more stuff than money they have.  So they borrow the rest.  If investors give me $100 million to buy a basket of securities, I can buy $100 million in securities.  But what if I want to buy $1 billion in securities.  I need to borrow the other $900 million.  Say I can borrow it at 7%.  That means I owe $63 million every year to borrow ($900 x 7%).

So what if the $1 billion of securities I now own earn 11% in a year?  That means I made $110 million.  But I paid out $63 million to borrow, so my net return is $47 million.  That might sound like I’m not left with much of that $110 million.  But remember, I only have $100 million in actual funds.  So through levering, I actually earned 47% on my money by borrowing to invest in a butt-load of securities that really only appreciated by 11%.

Such is the power of leverage.  Not bad, huh?  Well it can be.  As leverage magnifies potential returns, it also magnifies potential losses.  If those securities dropped 10%, my funds would be entirely wiped out (before even paying for the cost of borrowing).  Indeed, if the securities just went nowhere that year, I lost $63 million of my $100 million fund just to pay for borrowing.

So lenders to funds that will engage in this sort of activity will charge a higher rate to protect themselves from the risks of their borrowers’ investing activities.  Charging a higher rate does two things.  It provides the lender more cushion or payment for the risk the borrower is taking.  And it eats up more potential profits of the borrower who is using the loan to lever.  The higher the cost to the borrower, the less they are incentivized to lever a lot, as it eats up too much profits at some point.

If I could now borrow at 3.5% instead of 7%, I could borrow twice the amount while still just paying that same $63 million.  But now my entire fund will be wiped out in just a 5.2% swing on the $1.9 billion of securities I now own, v. the previous 10% swing on the $1 billion.  Leverage and risk has become mispriced, because 3.5% does not adequately reflect the risks that I am borrowing to engage in.

Off the top of my head, earlier in the 2000s, bank leverage (I define as tangible investment assets as a multiple of tangible equity) was ~5-10x.  A $1 change in the stuff they were invested in, lost or made them ~$5-10 of their own money.  By 2007/8, it was ~25-35x.  Earlier on, they would invest in securities that might earn ~6-8%, but losses might be flat to 1%.  By 2007/8, they were in all sorts of esoteric crap that might earn 15-25%, but also might drop by 20% or more.  And that’s BEFORE the effects of levering.

So if a bank can now use really cheap deposit accounts to do this sort of stuff, they can lever up a whole lot and in really risky investments.  That’s what they’ve been able to do for over a decade now.  There were also a handful of significant dislocations of accountability for risk that allowed this to perpetuate.

In the 1980s, the investment banks all started going public.  As a result, the owners were now a bunch of public shareholders that really had no clue what was going on inside, especially given that regulation concerning public disclosure is really rather poor to this day.  Before this, the owners were a bunch of partners risking their own money.  Everyone was constantly looking over each other’s shoulders on the inside.

The other dislocation is, no one really understood or “owned” the risk of these complicated mortgage-related investments, as the bank or broker originating the loan would instantly securitize them and pass it on into a pool owned by many investors that really had no transparency and had nothing to do with the origination.  The creator of the investment did not care about how risky or transparent it was, because they earned a fee to create it, and then instantly passed their Frankenmonster on to anyone else.

Today’s now-approved Volcker Rule attempts to unwind some of that mispricing of risk.  It prohibits banks from using bank deposits to engage in deemed riskier investing and trading.  They can no longer invest in or form private equity funds (which borrow funds to acquire businesses) or hedge funds (which engage in a wide variety of sophisticated and generally riskier trading and investing).  Banks can no longer use their own capital to directly engage in that form of trading and investing.

But they are allowed to continue to use capital in market-making activities for their clients.  Which should be the case, but is generally misunderstood by the unsophisticated public.  When market-making, banks compete with each other to get the trade order and earn a commission or mark-up.

So for example, client Fidelity might suddenly call up Bear wanting to sell 20 million shares of Apple, unbeknownst to Bear a moment earlier.  If Bear can’t do the trade at the best price and in the time Fidelity wants, Fidelity will pass and go do it with Merrill who will.  So in order to be able to suddenly take down 20 million shares on a moment’s notice for one of the biggest clients around, Bear needs to be able to use its capital to set up various types of hedging trades to safeguard having to suddenly own 20 million shares of Apple.

This activity generally has a depressive impact on the share price of its client’s Apple position.  Which runs counter to the interests of the client, as they will have to sell the shares lower.  But if no market maker engaged in this hedging, no market maker would aggressively offer the best possible unwind for Fidelity.  And Fidelity would have to sell those shares ultimately at a much lower price over a much longer period of time, as they awkwardly pound the market lower trying to get out.

So Bear’s trading practices to protect itself is a necessary evil of sorts that client Fidelity accepts in order to get the best possible result, given the weight of the order.  And none of that is illegal.  Because as a market-maker, the bank does not have a fiduciary duty to the client, irrespective of the various front-running rules.  In fact, it’s only duty in market-making is to “know the client”.  That means make sure they are sophisticated, adequately capitalized and confirm that they aren’t running money for Al Qaeda.  All of these duties are to protect the market-making bank, not the client.

Fiduciary duties to the client only exist when securities subject to the Securities Act of 1933 are being issued in the primary market.  That means basically only for US stocks and corporate bonds being IPOd, or issued for the very first time.  For anything else issued for the first time – really complicated mortgage-related instruments for example – no such duty exists.  For the everyday market-making activity they blather on endlessly about on CNBC, that duty is not really there.  And institutional clients fully understand and accept that... Until they have to blame their own irresponsibility on someone else.

So sprinkle some loose rules and regulation, mispricing of risk, investing in misunderstood instruments, dislocation of accountability all allowing for banks to take on way too much risk and leverage using your life savings all relying on home prices going up forever but really went down ~20-50% perniciously since 2006… and you get the worst financial crisis of perhaps ever.

All they had to do was make all investment instruments subject to the 1933 Act.  It would shine all the sunlight that a common stock is exposed to on all those weird mortgage-related instruments, and it would force banks to apply the same duty of care when issuing them for the first time.  And they need to fully separate commercial banks from investment banks.  Salomon Brothers did just fine before it was a subsidiary of Citi.

But none of that happened really with Democrats Chris Dodd and Barney Frank’s namesake 2010 legislation which is supposed to right these wrongs, and which spawned this Volcker Rule.  Because it wasn’t really written by Frank or Dodd.  It was written by the banks.  A Republican couldn’t have asked for more.

And the banks are bigger than ever.

10 December 2013

Wages, Work and the Way

A Facebook post of mine this morning, which stimulated some agreement (read: a handful of people clicked "like"; but I'll take it).  And, as most FB threads go, it then went sideways into some ranting about how much subway tokens and pizza costs now.  So I figure I'd post to a broader (in theory) audience.  (Not the stuff about the subway tokens and pizza.) This is in connection to a Thomas Friedman New York Times op-ed column, whose piece I feel really nailed it, link...

http://www.nytimes.com/2013/12/08/opinion/sunday/friedman-cant-we-do-better.html?smid=fb-share&_r=0

My FB remarks: "You want to know where American wages are going? This is where they are going [ref: Friedman article]. You want to put more income into the average American's hands? Then we need to give them the skills worth paying for. McDonalds workers are not going to get the $15/hr they demand. Because they are not worth it. No offense.  It is a minimum wage skill.

"Math, science should dominate K-12. Universities need to stop preparing young adults for the 19th Century (it would also be nice if that not-really-fantastic-anyway undergrad degree didn't cost a kidney, each year). The Bronte sisters or Wordsworth are not going to help them in the 21st. We need more engineers and physicists. We need to prepare ourselves to compete with Klingons and Romulans, not Ottomans and Prussians. Flipping burgers or digging ditches is hard, honest work. The only job to be ashamed of is the one not done to the best of your ability. And for doing your best, you will be compensated to the best of your ability...

"... Friedman is a credible voice to me. Because he is able to take both ideologies to task - not always criticizing one party v. the other. His voice and its like should be paid attention to. Not the ones who simply exist to promote one camp v. the other. Those types are in our way. Move them aside...

"... I mean, I know we can do good things here. The handful of my friends that read this thread and clicked 'like' are across the political spectrum, for instance. So where there is agreement, let's build on that.

"1) Realign educational goals, 2) commit govt expenditure toward 21st C. infrastructure rebuild and 3) public-private partnerships to nurture new technologies and (when they have legs) release them as new private industries.  I think both the capitalist and socialist (or whatever other labels we might use for each other) can rally around these goals. And I think we can also readjust our tax codes and social subsidies to make them more efficient, affordable, bringing down debts along the way.  There are credible, bipartisan plans in Washington that address this.

"That's the best pathway for our success and survival. It will hand the strongest America ever to the next generation, in my view. And simply embarking down that path today will immediately improve our social psychology, jump-starting investment and jobs. The only thing standing in the way of all of that, is the will to be disagreeable."

If you agree with my sentiments here, please share this with your elected representatives and/or favorite pundits.  They are the ones who can change the social attitude, focus and thus, coarse of our nation.  You are the ones who will hold them to it.

06 December 2013

Jobs Update

So the jobs report was out this morning. Everyone’s saying it looked decent. About 200 thousand jobs created in Nov. The unemployment rate dropped to 7.0%. The government shutdown didn't even put the slightest dent into things.

The amount of jobs lost in the Great Recession and global financial crisis circa 2007-2010 is 2 ½ times the average lost in every post WW II recession preceding it. We have now spent 60 months with unemployment over 7%. During the economically challenged 1970s, unemployment was over 7% for a total of 30 months that entire decade. (To be balanced in presentation, we spent 74 months over 7% from the 1980-82 double-dip recession; but nowadays is still way worse.)

At the current rate in a little over half a year from now, we will have recovered all 8.7 million jobs lost in the worst recession in a generation. That will be a total drawdown/recovery period of almost 6½ years. Which will be triple the average duration of every post WW II recession before it. And about as anemic a recovery as that of the Great Depression, post-1934.

In those 6½ years, we will also have needed to generate enough jobs to keep up with population growth – about another 10 million jobs in that time. Which means, all the while through this "recovery", we have been adding jobs that barely even keeps up with population growth. Said another way, at this rate, we will never recover from the Great Recession of 2008/09.

Despite the fact that for over six years since late 2007, our central bank the Federal Reserve has been pumping unprecedented stimulus into the system to counter the depressive effects of the recession and global financial crisis. They have kept short term borrowing rates for banks at effectively 0% - free money for banks to lend. The Fed has nearly quadrupled the size of its balance sheet at this point, buying up treasury and agency securities in the open market, flooding the system with dollars.

Never before done on this scale, it would typically be very inflationary. Yet inflation has averaged at anemic levels below 2% for the past five years now. Too much inflation is bad. But a little is good. (Think of it as your pulse. You don't want it racing too fast, but it is nice to have one.) Too little is symptomatic of a depressive economic state. And in the face of the Fed’s colossal stimulus to date, it is exemplary of just how massively deflationary the full-on effects of the financial crisis would have been, had the Fed and government done nothing to counter it.

Stocks rally because the Fed is forcing investor capital into stocks with near 0% interest rates. Handing them too much cash through their stimulus efforts all the while. Profits are decent, so the market isn't overvalued. But sophisticated investment professionals understand that the economic landscape is still very precarious. When the Fed ends its stimulus, it will be a very bad year for stocks. But it will only be one year, so buy everything you like at that time (which is about nine months away, I'm guessing).

So when the talking heads apply a positive spin to pumping out 200 thousand jobs last month, they simply are being disingenuous or have no real understanding of this stuff.

The good news is, housing is now in a real recovery for about a year now.  It brought us down, so it will bring us out.  Banks still have housing assets marked on their balance sheets at unrealistically high levels.  This is why they don't make loans, despite the Fed handing them free money to do so for half a decade now.  You get home prices rising, lending activity up... Suddenly that $2 trillion in pent-up corporate cash goes to work - read: jobs.  And with that everyone's feeling a lot better.  The unprecedented vitriol in Washington (and power of certain radical third parties for that matter) will dissipate.  Politicians will not fear getting primaried for daring to cooperate.

Dogs and cats living together.  Ice cream for dinner.  You get the idea.  It's not gonna be that good, but anything just a little bit better than the past several years will be welcomed and appreciated enough, in my view, to get us back to the business of America.