Give Me A Break!

The Senate Investigations Sub-Committee looking into the financial collapse of late 2007 has released its findings.  Here is the opening of a CNBC story posted last night.

Conflicts of interest, excessive risk-taking and failures of government oversight triggered the financial crisis and helped push the country into the deepest recession since the Great Depression, concludes a new report by the U.S. Senate.

Getty Images The Goldman Sachs booth on the floor of the New York Stock Exchange

The two-year, bipartisan probe by the Senate Investigations Subcommittee examined the economic crisis and the role played by Wall Street in creating it.

The Republican and Democrat co-chairs of the committee agree on its findings.

"The report tells an inside story of economic assault that cost millions of Americans their jobs and their homes while wiping out investors, good business and [the] market," said Sen. Carl Levin (D-Mich).

"It shows without a doubt that lack of ethics in some of our financial institutions who embraced known conflicts of interest to accomplish wealth for themselves, not caring about the outcome for their customers," said Sen. Tom Coburn (R-Okla).  http://www.cnbc.com/id/42576329

All of this is true but, not surprisingly, they left out the part that Congresses controlled at different times by both major political parties and Administrations from both parties played in creating the economic and regulatory environment that made all of these "conflicts of interest, excessive risk taking and failures of government oversight" possible.  The government failures they cite were reserved for various regulatory agencies, such as the Office of Thrift Supervision and, to at a far lower level of culpability, Fannie Mae and Freddie Mac.

In the report, they also don't lay blame properly at the thousands and thousands of home buyers who bought far more house than they could afford to pay for ever in their lifetimes.  I guess Senators believe it's somebody else's fault when a borrower knowingly claims more income or fewer debts than they actually have in order to qualify for a nothing-down, declared-income mortgage that put them into a $500,000 house when what they could afford was a $250,000 house.

Give me a break.  Asking Congress to investigate and report on the financial meltdown associated with the collapse of the housing bubble/mortgage debacle is akin to asking Mr. Fox to investigate and report on the Great Chicken Coop Raid that decimated the flock.

How did this happen?

It started decades ago when the home loan business shifted from a market in which lenders approved, funded and collected the loans they made, to a market in which loan originators made and sold loans to packagers who securitized them as mortgage-backed bonds and resold them to investors, individual and institutional, all over the world.  This phenomenon grew and grew to a point that almost all mortgages were processed in this fashion.

Then the most recent real estate boom started and home values starting escalating really, really fast.  Loan originators kept making and selling loans with fewer and fewer requirements so more and more people could afford to buy homes, which is just what Congress intended.  Among other things, in 1999, a Republican-controlled Congress passed and then-president Clinton, a Democrat, signed a bill requiring Fannie Mae and Freddie Mac to make higher-risk loans to less qualified buyers.  That proved to be a really bad idea but at the time an overwhelming majority of our politicians of BOTH parties thought it was really the cool thing to do.

At the same time, the government decided it was cool to lower the capital requirements of these big financial specialty firms.  In some cases the new standard was an incredible leverage ratio of 30:1.  Yeah, if you realized that meant they had capital equal to a little over 3% of assets, you did the math correctly.  That meant if the value of their CDO (Collateralized Debt Obligations) portfolio fell by 4%, they were insolvent.

During this period, home buyers bought homes in which they planned to live and they bought vacation homes and they bought homes speculatively as investments.  They did so because the qualifying standards were relaxed more and more: No down payment required; no verification of income; no credit checks; crazy adjustable-rate mortgages with terms such as 3.0% for the first eighteen months, at which time the interest rate would jump to 10.0%.  People kept getting the mortgages and buying the houses because, hey, they had eighteen months to worry about refinancing or selling the house.  Besides everybody KNEW that the house was going to double in value in eighteen months--didn't they?

So they thought.  They were wrong.

The problem with that strategy was that as home values flattened and mortgage rates reset, homeowners and investors starting defaulting.  Oh, wait--that's not supposed to happen. No but it did.

As mortgages defaulted and home values fell, the collateralized mortgage obligations that included them began to fall in value and were required by SEC regulations, to be marked to market.  As bond holders needed cash, they needed to sell those bonds, NOW.  Other more well-capitalized holders were able to continue holding but they, too, had to mark the bonds to market, which caused their capital to fall.  The death spiral had started.

With me, so far?  OK, it's time to go back to Mr. Fox and the Chicken Coop.

The excessive risk taking, greed and stupidity cited by the Senate Investigations Sub-Committee in their report were real.  The SEC did a poor job of supervision of many of the big investment banks, such as Goldman Sachs, Bear Stearns and Lehman Brothers.  The OTS did a poor job supervising big savings banks, such as WAMU.

However, the failure of the Senate Investigations Sub-Committee to include Congress and various Administrations in the blame is ludicrous in the absurd.

The Budget Mess Is, Well, A Mess!

Our Federal Government has been broke for a long time.  That is, of course, if you define broke as spending (federal expenditures) far more money than you have (US Treasury) or are likely to earn (tax revenues).

If our Federal Government was a family in similar circumstances, it would have to do just what you or I would do in order to survive.  We'd cut spending to a level consistent with our ability to pay or borrow enough to pay the mortgage and buy the groceries until we could reduce spending or increase our income.

The problem with our Federal Government is it isn't a family and it doesn't play by the same rules that apply to you and me.  If the family wanted to borrow to cover its cash shortage, it could only borrow an amount consistent with its ability to repay and the loan would only be a short-term solution.  If the family overextended itself by borrowing more than it could repay, the house of cards would eventually collapse and foreclosure, bankruptcy and possibly homelessness could follow.  During the real estate boom during the middle of the previous decade a lot of folks learned all about this outcome.

Our Federal Government's rules are very different.  If it wants (notice I said wants, rather than needs) to spend more money than it has, it too can borrow.  The difference is, unlike most families, lenders seem willing to loan any amount for which the government is foolish enough to ask.  Our government, the borrower, and the buyers of US Treasury securities, the lenders, appear to believe the house of cards can and will never fall.  The reality is it would fall eventually but that's a longer-term problem.

There is, however, one real limit to how much the Feds can borrow.  It's called the Federal Debt Ceiling, which is about to be reached.

Since the government is unwilling (notice I said unwilling, rather than unable) to cut its spending to match its earnings and since the Feds are about to hit the Debt Ceiling, our government is about to stop paying many of its bills.  The only way to stop the shutdown is for Congress and the Administration to agree on a new, higher Debt Ceiling and various funding resolutions that will authorize payments.

Seems pretty simple, doesn't it?  It should be.  The problem is Congress can't agree on future spending and the Administration isn't helping.

Before I go any farther, I need to remind everyone this isn't a Democrat or Republican issue.  It's a national issue affecting all of us.

On one side (the Democrats) we had a proposal to trim the budget by a whopping $13 billion, to which the other side (Republicans) cried, "Foul!"  That's a lot of money, isn't it?  Not really.  It represents about 1/3 of 1 percent of the total proposed 2012 budget of $3.7 trillion.

On the other side (the Republicans) we had a proposal to trim the budget by an even more whopping $61 billion, to which the Democrats cried, "Foul!"  Come on--$61 billion out of a total budget of $3.7 trillion represents only 1.6% of spending.

Are the Democrats telling the Republicans and the taxpayers they can't find 1.6% of the budget to trim?  Could you reduce your family's expenditures by 1.6% next year.  Well, yeah.  We all can and have.

Quite frankly, the $61 billion reduction proposal is not nearly enough.  If it were three or four times that amount, it would be a good start.  The proposed 2012 budget deficit is $1.1 TRILLION.  That's an enormous 30% of proposed expenditures or 42% more than projected revenues.

Returning briefly to the $3.7 trillion budget figure, if you think that is a large number, you're right.  It is almost exactly double the total proposed expenditures of the Federal Government in 2001, only a decade earlier.

If the Federal Government shuts down on Friday, which is not improbable, remember why.  The Republicans didn't ask for nearly enough and the Democrats are rejecting reality as well as reasonableness.  It appears the only thing wrong with government is politics.

"It was the best of times, it was the worst of times;..."

"It was the best of times, it was the worst of times;......." at least according to Charles Dickens in A Tale of Two Cities.  I was thinking about that quote as I reviewed some of the recent economic news but realized that it didn't quite fit the circumstances.  Maybe I should paraphrase it to, "It was the worst of times, it was the not-quite-as-bad-as-it-might-be of times."

The bad?  Yesterday's release of the January 2011 S&P/Case Shiller Home Price Indices (http://www.standardandpoors.com/indices/sp-case-shiller-home-price-indices/en/us/?indexId=spusa-cashpidff--p-us----) showed another decline in the values of existing homes.  To be more precise, the twenty-city Composite Index posted its 57th consecutive monthly decline, showing a drop of 31% from its May 2006 peak.  Not all markets within the composite shared equally in the fall, as Las Vegas and Phoenix occupied the cellar at -58% and -55%, respectively.  While Chicago posted a decline approximately equal to the Composite at -30%, Denver and Dallas values have fallen the least at 10% and 7%, respectively.

All of this data is relative, given that not all of the markets hit their peak values at the same time and across the country not all home owners bought at the peak.  Closer to home, we bought our house in March 2005, and its value climbed fairly steadily for a couple of years.  Although the greater Charlotte Metropolitan Area has values down 16%, which isn't bad compared to the national average, our home is only down about 2% from the purchase price.

This continuing slide of home values means more pressure on an already over-burdened real estate market.  The continuing fall in values means more homeowners are under water on their mortgages and lower values continue to hold down the number of home sales in a market where there is already too much inventory.

When you're in a hole and want to get out, you first have to stop digging.  So far, that hasn't happened.

The good?  This morning ADP, the payroll processing giant, reported some positive employment information.  According to The Wall Street Journal (http://online.wsj.com/article/SB10001424052748703806304576232393531640116.html) ADP said the US economy added 201,000 private-sector jobs, with the average monthly gain over the past four months of 211,000.

This would be much better news if the unemployment rate wasn't expected to remain extremely high at 8.9%.  To move that 8.9% number, which represents about 15 million people out of work, down to about 4.5% over the next three years, the economy will need to create new jobs at a rate that's at least twice as fast as it has during the last four months.  Job growth at 200,000 per month is good enough to stop digging our hole any deeper but not good enough to bring the American employment picture back to a more normal view.

When larger numbers of people go back to work, they'll buy more goods and services.  Producing, moving and selling those goods and services will put even more people to work and larger numbers of them will buy some of those houses that have been sitting in inventory, losing value.  The taxes all of these new workers pay will help put our local governments, including school districts, back in the black, too.

In my opinion, private-sector job creation is the number one challenge facing us today.  Everything else is a distraction from that mission that we cannot afford.

The Real Estate Mess & Unanticipated Fallout

For decades, home ownership was part of the American dream.  We all wanted it, even those of us who rented apartments or homes wanted it.  It was the way of life to which we all aspired.

The federal government thought it was a pretty good idea, too, so it promoted home ownership with the deductibility of mortgage insurance, by exempting the capital gain on personal residences, by attacking banks for redlining practices, by passing and aggressively enforcing the Community Reinvestment Act and by forcing Fannie Mae and Freddie Mac into funding more and more sub-prime mortgages.  All of these--especially the latter two--helped to build the false economic prosperity of the decade 1995-2005.

For as long as I can remember, another part of the American dream was being able to obtain credit when we wanted and needed it.  We bought cars and refrigerators and washing machines on conditional sales contracts.  No self-respecting American could be happy without a wallet or purse full of credit cards.  The use and growth of consumer credit in part helped the American economy grow to become the biggest and strongest on the planet.

Along with mortgages and revolving credit lines came the responsibility to honor our obligations.  For generations, we Americans felt that obligation deeply and the overwhelming majority of borrowers honored those obligations.  If times got hard, we'd do without something else in order to make the mortgage or car payment.  We did so because of a sense of duty but also because we feared the stigma of default.  Bankruptcy was bad.  Foreclosure was terrible.  With them came dishonor and disgrace.  Didn't it?

In today's troubled times we have a long way to go before we recover.  Far too many homeowners have fallen behind on mortgage payments, far too many have suffered through default and far too many still are on the brink of foreclosure.

Some of these problems have been the fault of the homeowner, as many bit off more than they could chew, but most of them have been caused by lost jobs and reduced incomes.  There have been so many credit defaults and foreclosures that existing home values have been pushed to a nine-year low with an unsold inventory of almost nine months on the market.  It's a great time to buy if you're in the market but the market may not normalize for several more years.

A by-product of the current real estate mess is a troubling trend of people walking away from their obligations without concern or remorse.  I'm not referring to the people who simply can't pay the mortgage.  I'm talking about an increasing number who choose not to pay the mortgage.

I don't have statistics but the anecdotal evidence is that an alarmingly high number of people are continuing to spend money as if they had it.  They spend for vacations and electronics and cars while choosing not to make mortgage and credit card payments.  They continue to "run up" their credit card debt as high as they can to pay for their children's dance lessons and travel soccer teams, knowing they'll never be able to pay.  When the credit runs out, they walk out leaving the keys on the floor.  At least for them, bankruptcy and foreclosure have become acceptable solutions.

Why is this happening?  I won't offer any defense of this phenomenon but I will offer a partial explanation.  The stigma once associated with a credit default, bankruptcy or foreclosure has been lost.  So many good people have lost their homes through no fault of their own that some not-so-good people are taking advantage of the opportunity.  Shame on them.

I wish every reader well and hope that none of you ever face this dilemma personally.  I also hope that if you witness this sort of irresponsible behavior by others that you'll take a stand and tell the offenders how wrong their actions are.

Quo Vadis?

Quo Vadis is a Latin term meaning, "wither goest thou?".  I don't speak, read or write Latin and I don't make a habit of using it.  However, in this case, I'm applying it to the US economy and investment markets.

Given all of the recent turmoil in the Middle East (read that as concern about oil) and the earthquake/tsunami double tap that hit Japan, markets have been erratic at best and quite negative at worst.  There have been several bad days recently on world stock markets, including ours, but it might be helpful to put some of these recent loses into perspective.

Using the Morningstar US Market Index as representative of the entire US market, it was down 4.6% from its recent peak on February 18, and down 1.6% since the Japan earthquake and tsunami.  A total negative move of almost 5% is not insignificant--I know my portfolio certainly has taken the hit--but in a market where 1% daily movement, up or down, is the norm, it's not a lot.

In the long term, most market movement is rational, with investors making decisions based on the same known information.  In the short term, not so much.  Investors, even institutional investors, are people and people sometimes react irrationally.  In this case, I think (highly technical investment terminology) that many investors are overreacting.

The US economy runs a $60 billion annual trade deficit with Japan.  A lot of that is automobiles and auto parts, in spite of the fact that the Japanese auto makers are now manufacturing a fairly significant number of cars in the US.  The disruption in the Japanese auto industry, while having an extremely negative impact on the Japanese economy, may actually open a window of opportunity for US auto manufacturers to fill the void.  Further, reducing the US-Japan trade deficit is not a bad thing for the US economy.

I'm not saying that US investors should seek profit opportunity in Japan's disaster.  Far from it.  I've previously commented on the tragedy and how deeply concerned I am for the people of Japan.

What I am saying is don't overreact to short-term irrationality in markets.  Market corrections happen.  They also make comebacks.

So, where is the market going, right now?  It will have up and down days and it's likely that more of them will be down than up.  The problem is that I can't tell you on what day that will change and we'll begin to see more up days than down.

It is not improbable that I'll make some changes to improve quality or reposition my allocation tactically. When the turn comes, I want to be invested and not sitting on the sidelines.

Tragedy In Japan

For the first forty-six years of my life I lived in California, where I experienced several earthquakes first hand.  One of the biggies was the Northridge Quake in January 1994, with an epicenter only about ten miles from our home.  That was a shake I'll long remember but the quake was only a 6.7 (moment of magnitude) on the Richter Scale.  All the same, it was plenty big enough for me.  During that quake thirty-three people were killed, thousands injured and Southern California suffered tremendous damage.

In California we lived with the thought that "The Big One" might occur at any time but nobody dwelt on it.  If it happened, it happened.  We knew that if we were there when it did happen, there was nothing we could do about it.  Sound engineering preparation was our only hope, as the sky scrapers and highways in Los Angeles supposedly were designed to survive it.  For the most part they did survive the Northridge Quake but that was only a 6.7 shaker.  Luckily, we never got the big one.

Last year a 7.0 quake hit the island nation of Haiti with enough force (three times the shaking amplitude of the Northridge Quake) to demolish much of the country and kill a Haitian government estimate of 316,000 people.  As terrible as that tragedy was in loss of life, it was not the big one.  Much of the damage and resulting loss of life in Haiti would probably not have occurred if building codes and requirements had been similar to those in California--or Japan.

Japan got The Big One.  I saw a report yesterday afternoon that, although much of the media is still calling the Japan Quake an 8.9, the US Geological Survey had upgraded it to a 9.0.  If the relative measures of the Richter scale are to be believed and accepted, the Japan Quake would have had a shaking amplitude 100 times greater than the Haiti quake of 2010.

The toll of damage, injury and loss of life is far from finished in Japan but the Japanese people will be struggling with the aftermath for decades.  In the final tally, much of the damage and loss of life will have been caused by the tsunami, rather than the quake itself.  How much of the tally will have been caused by damage to the nuclear power plants is an unknown and may take decades to determine.

My heart aches for the people of Japan.

Unions in the News

I live in Union County, North Carolina, which is one of the most heavily Republican counties in one of the least unionized states in the country.  Go figure.  Although our professional football players are unionized, our teachers are not.  I'll come back to both of those professions a little later.

Shifting quickly to one of the most heavily unionized states in the country, the Wisconsin legislature found a way to pass restrictions on the bargaining rights of most public employee groups.  The pro-union forces thought they had the legislation blocked by playing hide-and-seek but the pro-taxpayer forces defeated them, eventually, by changing provisions in the controversial bill so that anti-democracy legislators could no longer block it by running away and refusing to vote.

It seemed as if the pro-union forces were saying, "If you won't let me win, I won't play.  In fact, I'll run an hide so I won't even have to watch the game and by doing so, prevent the game from being played."

The tactic worked for a while and managed to draw the attention of the entire nation.  Battle lines were drawn and large demonstrations were held in support of both sides of the issue.  Overlooked somewhere in all the rhetoric were many of the facts.

The Wisconsin bill was not anti-union per se.  It did not affect the bargaining rights of any workers at private companies.  It only applies to public employees who are paid by the taxpayers of a state that was going quickly bankrupt.  How bankrupt?  Very.

Wisconsin was facing an immediate revenue (read that as tax receipts) shortfall into the hundreds of millions of dollars and longer-term deficits into the the billions.  That's serious money the state didn't have, with the only means of getting it by taxing its citizens who didn't have it.  The new limits on public employee collective bargaining won't fix the entire problem and there will need to be many other shared sacrifices by the citizens of Wisconsin.  This is only one piece of the puzzle.

Although I haven't analyzed the Wisconsin budget, the biggest budget item for every state is employee expenses.  Salaries make up a large part of it but, according to most published reports, Wisconsin taxpayers, the majority of whom work in the private sector, were being asked to pay for healthcare and retirement benefits of public employees that were far in excess of anything offered in the private sector.  That's pretty tough to swallow if you're struggling to pay your mortgage, pay the power bill, put food on the table and put your kids through school.

Speaking of school, teachers have one of the most important and undervalued roles in our society.  They are critical to our children and our future and they are not overpaid.  In many situations they are underpaid.  Teachers in my family are bright, capable, caring professionals who are very good at their jobs and the children in their classrooms are lucky to have them.

 In Union County we have our own budget woes and we've had our share of cutbacks.  A county government has to do the same thing a family does when there's a shortfall of revenue--cut expenses.  I don't always agree with our school administration about where they cut or how they spend our money but none of that is the fault of the teachers.  Our schools are still open and our children are still being educated by a caring group of dedicated professionals who are not represented by a union.

In case you haven't heard, there's also a collective bargaining war being waged in the National Football League where the median annual salary approaching $1 million and the average salary well in excess of it.  I love football as much as anyone but that is collective bargaining gone insane.