Friday, July 31, 2009

Is America Bankrupt?

(FYI: America is bankrupt...but is unable to acknowledge it yet, and has no systemic way to address this fact. Chapter 9 of the Bankruptcy Code is not appropriate for the scale. It will occur in pieces.)

Following Enron's [and Worldcom's] demise Congress enacted Sarbanes-Oxley (SOX) to ensure the transparency of management practices for public companies. Enron's financial engineers had created off-book derivatives that worked just like an off-shore toilet: they would dump all their "phantom" debt there, but unfortunate for Enron's executives, the flusher didn't work. The debt was actually real. Enron was able to hide its debt so long as its energy revenues were growing. Once that stopped the house fell down.

Whether it be SOX, GAAP or FASB, many if not most mortgage-backed securities have not been reported or posted through any central clearing, so that no one knows for sure how much of this debt there is, actually. Also, their valuations carry heavy future value and discounting to net present value is not a clear exercise. There's no central regulatory clearing for much of this paper. Which in large part has led us to this current crisis. And so we ask whether such unregistered securitizations amount to "fractional reserve banking." Fact is, "money" is only created when there's an interest rate yield...I loan you $1, you repay me $1 ten cents. When short terms rates are 0%, as they are right around now, no money's being created, and most importantly...no one's making any real money. It's high time we question the practice of mortgage securitization itself.

The global system, as exceedingly nuanced and complex as it is, could do with more accountability rules and transparancies. The very nature of securitization itself is to create "off balance sheet" leverage. Hence, many of these securities never found themselves registered on any publicly accessible balance sheet anywhere, hence by some estimates there's an estimated $62 trillion of CDOs, CDSs, SIVs and other variants of such securities floating around the globe's pensions and in other institutional portfolios (thanks to the Gaussian copula formula). Indeed, subprime mortgages showed the highest rate of default (followed by the Alt-As), and these were largely made by non-traditional lenders that entered the market just after 9/11 and practiced asset-based (versus income-based) lending. They were able to do so when the Fed lowered interest rates dramatically after 9/11. The result was a now infamous asset bubble...cheap dollars flowing into highly demanded/short supply assets. (Absent the asset bubble thanks to cheap dollars, might Iraq never have happened?) The Fed in essence simply post-poned the day of reckoning, which is now upon us. (One wonders if securitization itself is the problem, and needs to be reconsidered and its process redesigned.)

Now, many mortgage banks and lending institutions are reluctant to "take the hit" and seriously write-down these over-priced assets still on their books. California Congressman Darrell Issa believes such institutions should be forced to write down the values of these over-priced assets, albeit gradually. This is one variant of "mark to market," which with behemoth institutions is likely a better policy than relying on yield curve determinations made by private investors. He suggests that servicers and mortgage holders be compelled to allow short sales to the current default borrowers now living in those homes, perhaps by amending current bankruptcy law. FDIC head, Sheila Bair agrees. "Modify and issue 1099's for the difference," she suggests. Obama appointee, Professor Elizabeth Warren concurs with Issa that "there be a change in the bankruptcy code--it will force a wake up call," she says. One in 7 mortgages are soon to be in default, according a recent GAO Report. The bottomline is, carrying non-performing overvalued assets on the books--hoping for a market rebound--is denial, wishful thinking, and delaying any recovery.

Opponents say such steps will pose a moral hazard and give incentive for good mortgagees to default. They say default borrowers shouldn't be rewarded, no matter what. Yet is there really any intelligent alternative? We are living in 'Chi-merica' (Chindifying America). America's manufacturing supply chain for many industries is now in China. And many services are now being outsourced to India. Here, all the tax dollars spent on public roads and bridges over many years don't show up as off-sets on any grand balance sheet--instead, they've been expensed. (Which explains why conservatives over the years have been so eager to 'privatize' public assets.) Our global capitalist system has over-relied on asset appreciation--not real net earnings--to support inflated pension schemes and current levels of debt service. Hedge funds and unrestricted foreign ownership of U.S. assets have exposed vulnerabilities. Debt issuance rationales have typically relied on future earnings projections, which in a flattening earnings global scenario cannot and will not pan out. In China, all businesses must have a domestic partner--and only citizens can own real estate, which even so operates on a 100 year land lease. Mexico has a similar policy.

Yet, in the final analysis, America's paper is not worthless so long as willing ambitious American workers have steady jobs (to repay U.S. treasuries...IOUs). The real wages of U.S. workers, I submit, have been "Chinafied." In other words, a well-trained knowledge worker in China earns the equivalent of about $300 U.S. dollars (8 RMB/yuan = $1 U.S. dollar) per month. Why should a business analyst in China earn $300/mo., while a business analyst in the U.S. earns $5,500/mo.? (Indeed, it is an apples-to-oranges comparison given the many government subsidies in China that allow for the payment of lower real wages to workers, and also their near zero legacy/benefits costs.) In the U.S. many once privately held liabilities have been transferred to the public sector (i.e. Pension Guarantee...). For the most part, there's no real qualitative or productivity discrepancy, but rather "distortions" in the earning/price indices, which are now being "played out" and will continue until assets values (and overall debt) adjust to real net wage levels (resulting from globalization). Is there a global bottom, in this high volume, low margin world? Is there such a 'reality' as global equilibrium? The oceans have their tidal schedules...how about global capital flows? The distortions, largely, are a function of credit and excessive cost of money.

Two of 5 jobs until recently were connected to the real estate industry. This explains in part high recent unemployment figures. Many workers wonder: How does the stock market impact present and future employment? Many employees of public companies are just now realizing that as share prices of their companies drop, the debt-to-equity ratios of their companies goes up. In other words, leverage increases as share prices drop. Companies tend to borrow in relation to their net worth, not unlike home borrowers that refinance. Equity [and value] tend to be market-driven. (Home prices--like shares--are a function of demand, which equals cost/ availability of money and credit, job security--which is a global phenomenon nowadays--and comparative factors, i.e. supply of qualified buyers, inventories, etc.). Hence, diminishing share prices increases the likelihood of lay-offs. Indeed, as the equity side of companies drifts downward, proportionally more dollars are required to service existing debt. Which is another reason why consumers lack confidence to go out and spend. They're concerned about pink slips in January of next year. Globalization and outsourcing have indeed brought downward pressure on wages of U.S. workers. And the current account deficit (another all-time record high) affirms the fact that America as a service economy must re-examine its ability to generate real wealth. Many services have been reduced to commodity status. How about design and innovation?

If a large chunk of America's treasuries--held by China--were to end up near worthless paper (never mind the small amount of remaining gold in Fort Knox), China is in deep trouble. In fact, the entire global fiat money system is based on faith. Given China's diminishing surplus it's able to buy less U.S. paper. The fundamental question, given our excessive debt, is: what, really, is 'money' nowadays...in our era of fiat money? (The Economics 101 definition of M1, M2, M3, M4 no longer seem to be entirely accurate.) Is money a function of 'time,' i.e. $300=x/hrs. of labor? Think about it, after a $700+ billion bail-out (with more on the way) what is 'money'? What is 'securitized debt,' really? (It's an entirely different question than...what is the nature of money/securitized debt...? The CBO estimates that interest on the national debt will soon reach $750 billion per year by 2019. We're now in what amounts to a "liquidity trap," without sufficient real earnings, hence demand. The corollary of our debt debacle is...the very credit system itself. Are there viable alternatives to a credit-based system (and our global credit issuing institutions)? For years many analysts have pointed to "interest" as the root of all imbalance...the interest charged by the Fed to the Treasury in exchange for issuing currency. Is this a rational point? And, finally, to account for the asset base of public sector: how much, say, is a federal highway worth...on some balance sheet, when it's not revenue producing? (We haven't really valued these public assets as offsets.)

One thing's for sure: the "Laffer Curve" of supply side economics--once hailed as "voodoo economics"--has proven itself to be fundamentally flawed. It postulated that markets self-equilibrate. But they don't. And there's an additional, serious question: are neoclassic economic models up to addressing our current woes? A market is simply a clearing: it reconciles supply with demand. It does this based on various rule sets, as perameters. The deregulation that began in the Reagan-era gave rise to laissez-faire and Enterprise Zones, and they really haven't worked. Why? Because they're "top-down," disconnected big business approaches. People dream of becoming rich, but they must eat and feed their families first. Altitude has a way of blinding the elite, just as too much wealth can dull one's sense of urgency needed for entrepreneurship. These approaches generally don't properly seed things, and instead rely on various "magical" mis-conceptions of entrepreneurship, as though wealth is created from ideas alone. Recall monetarism and the Chicago School in Argentina? It didn't work there because it suggested that incentives alone motivate, which is not entirely correct. Wealth and capital formation have tended to stay at the top with these approaches, benefitting large and mid-cap enterprises. (Perhaps micro credit will become part of the solution, even in wealthier states where there are huge wealth disparities.)

Should today's policy solution be more in line with addressing Keynes (aka "Liquidity Trap") or Fisher (aka "debt deflation" or now stag-deflation)? Goal: to restore purchasing power (aggregate demand)--to create both jobs and community reinvestment pools to create local "bottom-up" capital formations--by reducing dollars now going toward debt service is one method to be considered. The community credit union model--not just a redevelopment agency--would be another innovative approach. Extreme conservatives will view this as "socialism," but in fact, markets like people are imperfect and prone to disequilibria and require periodic major recalibrations. America should likely have implemented an industrial policy years ago, like China, Japan and Europe did. Such strategies have not exempted them from business cycles, but many of their industries now require less retooling than ours do. (Let's not forget Vice President Cheney's infamous secret "Energy Policy Meeting" with Ken Lay and others back in 2002. Some of such policy--or lack thereof--is responsible for Detroit's woes today.) And also, America's current account deficit is proof that outsourcing, NAFTA, and WTO cause system-wide problems when "fair" trade is not in fact "fair"--indeed, America needs reciprocity in terms of honoring and abiding by "fair" trade agreements. Hyman Minsky and Irving Fisher come to mind, in their analyses.

Extreme conservatives, like former U.S. Senator Phil Gramm, have long thought that private managements of publicly traded companies "knew better." Now taxpayers are faced with serious consequences of these "private" mis-managements, accountable only to their shareholders. Serious consequences such as a looming inflationary depression. "Too big to fail," has too often meant "unable to coordinate an entire industry for radical restructuring." By the way, where is Big Oil in terms of the auto industry? Silent, to be sure. At the 2008 World Economic Forum in Davos, Switzerland, George Soros called for a "Global Sheriff" (aka a Currency Board) to monitor various inefficiencies in financial markets. He was laughed at for suggesting such--never mind the IMF's bleak performance record in recent years. As it turns out, however, he was prescient, and correct in his analyses starting as long ago as 12 years. In reference to re-examining assumptions, he says, "I contend that financial markets are always reflexive and on occasion they can veer quite far away from the so-called equilibrium. In other words, financial markets are prone to producing bubbles."

In his book "Financial Darwinism," Leo Tilman suggests we need "greater risk transparencies." Will any of us be surprised if the State of California is the next "shoe to drop"? A pre-packaged repudiation /bankruptcy-like scheme [managed by the Feds] may be the only way to mitigate its huge CalPers and Ballot Initiative legacy costs. That, or a referendum to renegotiate with more realistic actuarials in mind. Some huge major bankruptcies loom...due to unfunded pension liabilities and excessively high debt service requirements. And tough choices will be made...between funding for schools and other present services, versus excessive public pensions.
As Hyman Minsky noted, not all debt is equal. Hence, it may make sense, as the treasury issues new debt, to refinance and replace some of the older legacy debt. Debt, unlike dividends, is tax deductible. Still, a major debt-to-equity conversion is needed (which China must help with) if any stimulus package is to work. Once again, we need to restructure debt, seriously, even if it means discharging and repudiating a great deal of it. Debt holders will need to be willing to accept equity in replacement of their debt, no matter how painful. This, in order to avoid total default.

We rely on debt financing for everything, and FMV usually determines ratios. Example; 80/20 mortgage financing, but 80/20...of what? Perhaps FMV-based ratios are not prudential enough.
Perhaps "Cost-plus" methods should replace FMV-based ratios?

(We've proven that as a civilian socius, we are unable to run ourselves. Perhaps the military will be needed to run things. Or else, perhaps we'll descend into a Balkanization rules by gangs, not unlike a prison hierarchy.)

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2 Comments:

Anonymous Anonymous said...

The reason this couldn't be avoided comes from the fact that the Liquidity Trap finds its root in the very existence of Credit and the wide income/wealth disparity it creates.
People won't accept that we need to Opt Out of credit unless they are forced to. To this you must add the vested interest of people who have given credit to others.
Believe me I have told people of the coming crisis since spring of 1994. Nobody believed it, or even tried to understand it.
They thought "You are crazy" so loud, I could almost hear it.
What you are suggesting is a fix whose purpose would be to restore the capacity to grant credits: the problem is we have already too much liquidities and People have no interest in making loans.
People have to understand that what we have now is a break down of markets and a huge oversupply.
The only way a capitalist economy could be restored is by the physical destruction of most of our productive assets.
The only short run solutions are war or The Credit Free, Free Market Economy.
I know that the situation will degrade and we know that People will use my System.
The question is how much more sufferings they can bear.

MC Shalom

January 18, 2009 at 10:07 AM  
Blogger Greg Hall said...

Thanks MC. I appreciate your comment.

Greg

January 18, 2009 at 10:30 AM  

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