Thursday, September 4, 2008

Should the Treasury Intervene? Give Me a Break!


U.S. stocks plummeted today following weak retail sales figures and a spike in unemployment insurance claims. The S&P 500 dropped for a fourth day, decreasing 38.15 points, or 3 percent, to 1,236.83, sinking the most since June 6. The Dow jones industrial Average lost 344.65, or 3 percent, to 11,188.23. The Nasdaq Composite Index slipped 74.69, or 3.2 percent, to 2,259.04.

Today was one of those 'puke days' where everything puked red. You know it is a bad day for stocks when all the UltraShort ETFs are rallying like crazy (click on image above to enlarge). These ETFs are designed to produce double the inverse returns of the stock indexes so, for example, when the Nasaq loses 3 percent, the QID rallies 6% (learn more about proshares here).

Canadian stocks also tumbled today. The Standard & Poor's/TSX Composite Index fell 2.5 percent to 12,814.14 in Toronto. Canada's equity benchmark, which derives about two-thirds of its value from energy, materials and financial stocks, has fallen 7 percent in three days and is 15 percent below its June 18 record.

According to Bloomberg:

Canadian stocks declined for a third day, sending the main index to the lowest since March, on concern that commodities and resource-related equities have further to fall as hedge funds and traders exit positions.

Another reason why stocks sold off today was that PIMCO's Bill Gross warned of a "financial tsunami" in his monthly investment outlook, There's a Bull Market Somewhere?.

According to Mr. Gross:

So the lesson must be to go forth and find the bull market, wherever it is. Almost always – but not now because in a global financial marketplace in the process of delevering, assets that go up in price are rare diamonds as opposed to grains of sand. For the past several months our PIMCO Investment Committee blackboard has continued to display the following lesson plan:

What Happens During Delevering
  1. Risk spreads, liquidity spreads, volatility, term premiums – they all go up.
  2. Delevering slows/stops when assets have been liquidated and/or sufficient capital has been raised to produce an equilibrium.
  3. The raising of sufficient capital now depends on the entrance of new balance sheets. Absent that, prices of almost all assets will go down.
Mr. Gross goes on to write:

This rarely observed systematic debt liquidation is what confronts the U.S. and perhaps even the global financial system at the current time. Unchecked, it can turn a campfire into a forest fire, a mild asset bear market into a destructive financial tsunami. Central bankers, of course, adopting the cloak and demeanor of firefighters or perhaps lifeguards, have been hard at work over the past 12 months to contain the damage.

And the private market, in its attempt to anticipate a bear market bottom and snap up “bargains,” has been constructive as well. Over $400 billion in bank- and finance-related capital has been raised during the past year, a decent amount of it, by the way, having been bought by yours truly and my associates at PIMCO. Too bad for us and for everyone else who bought too soon. There are few of these deals now priced at par or above, which is bondspeak for “they are all underwater.” We, as well as our SWF and central bank counterparts, are reluctant to make additional commitments.

Step 2 on our delevering blackboard therefore has stalled and is inevitably morphing towards Step 3. Assets are still being liquidated but there is an increasing reluctance on the part of the private market to risk any more of its own capital. Liquidity is drying up; risk appetites are anorexic; asset prices, despite a temporarily resurgent stock market, are mainly going down; now even oil and commodity prices are drowning. There may be a Jim Cramer bull market somewhere, but it’s primarily a mirage unless and until we get the entrance of new balance sheets, and a new source of liquidity willing to support asset prices.

New balance sheets? Is this now some Deloitte & Touche metaphor? Hardly. What I mean, what our blackboard and our Investment Committee point out is that to ultimately stop this asset/debt deflation, a fresh and substantial new source of buying power is required. This became all too obvious as the Treasury’s attempt to entice additional capital into Freddie and Fannie came up empty. Yet this same dilemma is and will continue to confront all highly levered institutions in the throes of asset liquidation. Without a new balance sheet, their only resort is to sell assets, which in many cases leads to further price declines, or ultimately debt liquidation/default.

And he concludes by stating:

The bill for our collective speculative profligacy, obvious in the deflating asset markets, can be paid now or it can be paid later. Those aspiring for a perfect 800 on the Wall Street policy exam would conclude that the tab will be less if paid up front, than if swept under a rug of moral umbrage intent on seeking retribution for any and all of those responsible. Now that the Fed has spent 12 months proving that it “knows something…knows something,” it is time for the Treasury to do likewise.

I am not going to get into why I believe Mr. Gross's remedy is worse than the disease but I will highly recommend you read The Financial Ninja's critical blog entry, Bill Gross: Big Bet, Big Fail? as well as Naked Capitalism's blog entry, Bill Gross Says Nothing Is Going Up So Treasury Must Intervene.

A far more difficult and important article to read when assessing bailouts is Michael Hudson's excellent article in Counterpunch, The Next Big Bailout.

I quote the following:

A deeper problem is that Fannie and Freddie underwrote and insured a debt increase whose continued exponential growth is unsustainable, because it causes domestic debt deflation. What Mr. Greenspan called “wealth creation” – pumping up housing and stock market prices on credit – was actually debt creation. Asset prices are a function of how much banks will lend. If they lend more money on easier and easier terms, property prices will continue to soar.

This is why the economy is facing debt deflation. More and more money will be diverted from being spent on consumption and paying taxes, in order to pay creditors. This will shrink the domestic market, squeezing profits, and also will squeeze state and local finances.

The government will not solve this problem by providing yet more loans for stronger parties to buy the existing supply of homes otherwise in foreclosure. The dream is to keep housing high-priced to support the mortgage lenders, not for prices to fall so that new buyers do not need to run so heavily into debt to afford housing.

Supporting real estate prices thus entails keeping the existing volume of debt on the books, and indeed running up even more debt. This levies an enormous charge on the economy to pay interest and amortization. These payments leave less available to be spent on goods and services or paid in taxes. The economy shrinks, leaving it even less able to carry its debt burden. Many individuals no doubt will default on their credit card debt, auto debt and other debts, but the largest remaining debt consists of pension and health care obligations to the private and public sector work force.

This problem has been growing beneath the view of most public media. Private-sector pensions are insured by the federal Pension Benefit Guarantee Corporation (PBGC), which is substantially undercapitalized. A much larger problem is state and local pension programs. not only are underfunded; they have no insurance at all. The expectation was that public-sector pensions would be paid out of rising property tax revenues and capital gains. But taxing property now threatens to cause defaults on mortgage payments. This is the corner into which the economy has painted itself by trying to preserve the exponential growth of mortgage debt.

To cap matters, this threatens to push state and local budgets into deficit at a time when their pension and medical insurance payments are soaring. On the expense side of their balance sheet, localities must spend more money to cope with the consequences of empty houses being stripped of building materials, occupied by squatters, burned down and generally becoming a source of blight. On the fiscal income side, states and localities are facing populist political pressure crafted by large real estate interests and promoted with the usual flow of crocodile tears on behalf of retirees and other homeowners whose debt squeeze prompts them to support politicians promising to reduce property taxes.

At first glance the connection between bailing out Fannie Mae and, behind it, the real estate market to keep prices high for American homeowners might not seem closely linked to corporate, state and local pension plans. So let us trace the linkage. Bailing out mortgage lenders ultimately must be achieved at the expense of state and local property tax revenues. Revenue that is used to pay interest is not available to pay taxes. If debts are to continue to grow exponentially and extract more carrying charges, this forces a tax shift onto labor and industry.

For the past century the financial sector has made steady incursions to take over what used to be the role of government. Today’s libertarian anti-tax “free market” rhetoric is simply a cover for the financial sector’s replacement of elected democratic government. Forward planning is being distorted to serve the financial sector, not aiming to promote long-term growth and raise living standards, and certainly not to protect the public sector’s fiscal position.

One of the lesser-known features of this week’s real estate bailout is the endorsement of “negative mortgages.” These debt agreements add the accrual of interest onto the principal. The cover story is that this enables low-income homeowners to keep their houses with a lower carrying charge, borrowing the interest rather than paying it. But this means that what used to accrue to homeowners or their heirs as a “capital” (land-price) gain henceforth will accrue to the mortgage lender. For over a century, the main way that most American families have become rich has been by the free lunch of exponentially rising land prices. What is to rise exponentially in years to come is now their debt overhead. It is the financial sector that will get the free lunch of land-price gains.

Adding the interest charge onto the principal is how Ponzi schemes work. They cannot work for long, because no real economy can keep up with “the magic of compound interest.” The Bush-Paulson bailout plan calls for mortgages to become larger and larger, regardless of whether property prices keep pace. The interest is to accrue to the federal government as mortgagee at first, but this innovation is really a test run. It is the path of least resistance for private banks to start making mortgage loans that give them a return in the form of “capital” gains as well as interest.

These gains consist of the inflation of land prices in cases where state, local and federal government fails to capture this gain for the economy at large. So the scheme obliged the public sector to turn elsewhere than property for its revenues – namely, to consumers and industry.

Dr. Hudson goes on to write:

At the root of America’s pension and health care problems is an ideological opposition to public services and taxation at the national level. In the aftermath of World War II, corporations opposed “socialized medicine.” This left companies to pay for health care out of their earnings rather than leaving it to government to organize and pay out of the general tax base. This probably made sense to the vested interests when they bore the brunt of progressive taxation.

But they seem not to have noted that this attitude has ceased to be self-serving now that the richest families have shifted the taxes onto the lower brackets. General Motors recently has protested that health care costs more money per auto than steel. Yet someone must pay for health care and retirement. If not the government, then who – besides one’s employer? So one wonders just what General Motors wants more: the luxury of an obsolete anti-Bolshevist rhetoric, or to make consumers pay for their health care and Social Security as “user fees” without the upper tax brackets taking the responsibility that they take in countries with more progressive tax systems.

In retrospect it would seem that companies did not act in their self-interest when they insisted on taking responsibility on themselves for providing medical care whose price has soared, largely because the medical profession itself has been taken over by financialized health management organizations (HMOs) in the insurance sector (an increasingly prosperous element of the FIRE sector). They have put doctors as well as patients on rations – fee-for-service in the case of physicians, and rationed care for the hapless insured. And this is supposed to be the free market alternative to centralized planning!

The explanation for companies acting this way is to be found in the era of progressive taxation. More than two centuries of classical economic analysis had shown the logic of taxing predatory wealth (land ownership, monopoly rights and financial claims on the economy) rather than labor and industry. The objective was to tax all forms of income that were not necessary for production to take place. Above all were rights to land, which is provided by nature, for the purpose of charging an access fee, and other extractive property rights and financial charges loaded on top of what actually is needed to be spent on production.

The early income tax captured such “unearned income.” The wealthy classes thus opposed public provision of services, including medical care as well as basic infrastructure, in an epoch when they were the major parties being taxed. But being sclerotic and rigid, the rentier classes failed to shift their attitudes toward public service as they moved to free themselves from taxation. Ever since the United States enacted its first modern income tax in 1913, finance and its major clients – real estate and monopolies – have lobbied to distort the tax code to make their gains tax-exempt.

Rather than declaring taxable income, they count as a cost of production interest and over-depreciation for real estate, as well as payments to corporate shells in offshore tax-avoidance centers. The finance and property sectors also take their returns in the form of capital gains rather than as profits, trading through financial hedge funds whose revenue is taxed at only half the rate of normal income.

The wealthiest 1% take their returns in the form of bonuses, not wages, and enjoy a cut-off point of only $102,000 for FICA Social Security and Medicare wage withholding. When Wall Street Journal editorials assert that the richest 1% earn “only” a small portion of taxable income, all this really means is that a shrinking portion of their economic returns are deemed subject to the income tax. Their buildup of wealth takes a form not classified as “income.” Inherited wealth meanwhile is the great loophole for avoiding ever having to pay capital gains that have accrued on real estate and other assets rising in price.

If the rentier classes act flexibly, they will see that as they shed their national, state and local fiscal burden, it is time to “socialize of the risks” as a travesty of true socialism by passing the costs of pensions and health care off of companies and localities onto the federal government. After all, now that labor and consumers are paying the lion’s share of taxes, is it not all right to extend public spending to take over areas of cost hitherto borne by corporate business and other private-sector employers? This promises to be the next big political fight.

But ideological sloganeering dies slowly, and corporate business and the financial sector continue to oppose “big government” even as they are un-taxed. That is the problem with the vested interests: they live only for themselves in the short run. The financial mentality is opportunistic (“after me, the deluge”), caring little about the future. Labor cannot enjoy this luxury. It needs to look to how it will live after its working years end and health care becomes a rising expense. This perspective involves a more far-sighted economic and social contract.

Meanwhile, property taxes continue to be phased out as the basis for state and local finance. The tax burden is being shifted onto income and sales levies that fall on consumers, not on the preferred tax status of high finance and property. For many years now, the political drive to un-tax real estate led cities such as San Diego and entire states such as New Jersey to pay their work force in the form of retirement and health care obligations rather than current wages, while borrowing from the rich rather than taxing them. The income hitherto paid as property tax was available either to pledge to bankers for loans to buy property rising in price as it was untaxed.

All this was fiscal and economic madness from a long-term vantage point – not the madness of crowds, but that of self-serving lobbying by the financial sector. The result has been a trend that cannot go on for long. But having managed to free themselves from progressive wealth and income taxation, the vested financial and property interests evidently believe that they can pull the same trick again and free themselves from the obligation to live up to the pension and health care promises that corporate and public-sector employers have made to their work force.

Such evasion requires a populist rhetoric. Malthusian doctrine worked well two centuries ago, so why not try it once again? Blame population growth – in this case, not the tendency of the poor to have more children, but the ability of employees to live beyond the retirement age at which they were supposed to die if they had conformed to the models used so hopefully by their employers in explaining their financial position. The claim is being made that paying business and public-sector commitments to labor will bankrupt both. There is no mention of debt payments to bondholders for funds borrowed to cut progressive taxes on the rich. Nor is the burden of high housing and other real estate prices that the July 30 bailout of mortgage lenders aims to create.

Something has to give, but it is this old worldview. No doubt when the next financial crisis hits we will see all the usual journalistic adjectives: “unexpected,” “surprising everyone by the depth of the problem,” etc.

Give me a break! Can no major media see the obvious trends at work?

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