The Oser View

Why ShoreBank Matters

Dualism, or in its theological aspect, Manichaeism, is the belief that the universe is divided between two starkly opposed but equally matched powers of Good and Evil.  Their battle plays out not only cosmologically, but in the life of every individual.  Although Manichaeism was declared a heresy by the Roman Emperor Theodosius I in 382 AD, the appeal of dualism remains deeply rooted in Western civilization.  (Traditional Eastern thought, with its multi-faceted gods and cycles of death and rebirth, is less prone to dualism.)  Dualistic ideas—God and Satan, Catholic and Protestant, North and South, Black and White—have long define the Western and especially American worldview.  The 20^th century reinforced America’s Manichaeism bent.  The Nazis and the ultra-militarist regime in Japan that initiated World War II were clearly evil.  They were opposed and bested by the Greatest Generation.  No sooner were those powers destroyed than another devil substitute, Stalinist totalitarianism, appeared as the avatar of Evil poised against the American Way.

 

But, a set of new and far more subtle ideas, deeply at variance with dualism, were beginning to appear as the 20^th century dawned. Leonard Shlain, in his first-rate book Art and Physics, demonstrates how artists throughout history have anticipated new discoveries about the physical world.  Artists are like powerful telescopes, able to reveal faraway and previously undreamt-of galaxies.  Schools of non-representative art such as Cubism, dissonant music like Stravinsky’s “Rite of Spring,” and modernist novels like James Joyce’s Ulysses, heralded a non-Newtonian revolution in physics. Relativity and quantum mechanics revealed a universe of discontinuities, non-linearity, and irrationality beyond anything ever before imagined.  The universe, instead of being an exquisitely perfect clock as Newton had supposed, is fundamentally unpredictable and ruled by probabilities.  The behavior of the tiny mass-less particles, from which all other matter is built, are weird beyond anything our human senses can perceive.  

 

Ideas so radical would have spread slowly in any case.  They literally require a rewiring of the human brain even to think about.  The wars, both hot and cold, that consumed the middle three-quarters of the last century, with their clear heroes and villains, undoubtedly delayed the process.  But over the past 20 years, which, not coincidently, have been marked with ambiguous and inconclusive conflicts, the dissemination of the probabilistic world view has been exponential.  Scores of books about the new physics for non-scientists have been published.  The next disciplines to fall in step were finance and economics.

 

As I wrote in my June 2008 commentary, the economist Hyman Minsky was a prophet ahead of his time.  His 1986 book, Stabilizing an Unstable Economy, argues against the ability of markets to be self-regulating.  He advanced the theory that capitalist market mechanisms are incapable of creating sustained, stable-price, full-employment equilibrium.  Rather, unpredictable and sometimes violent business cycles are inherent in capitalism, and are actually fostered by overlong periods of stability.  Ignored at first, Minsky’s ideas are finally moving into the mainstream, as can be seen in the title of Justin Fox’s recent bestseller, The Myth of the Rational Market.  Even more telling was Alan Greenspan’s great moment of self-understanding in October 2008 while testifying before a congressional committee. 

 

Greenspan: “I have found a flaw. “I don’t know how significant or permanent it is.  But I have been very distressed by the fact.”

Question: “In other words, you found that your view of the world, your ideology, was not right. It was not working?”

Greenspan: “Absolutely.  Precisely.  You know that’s precisely the reason I was shocked.  Because I have been going for forty years or more with very considerable evidence that it was working exceptionally well.”

 

Another new book, provocatively titled The Age of the Unthinkable, brings the new world view into the realm of international relations and, since international relations are really human relations writ large, into our own daily lives.  The author is Joshua Cooper Ramo, a whiz kid who is a managing director at Kissinger Associates and whose hobby is competitive aerobatics.   In his own words, “The main argument of the book is not particularly complicated: it is that in a revolutionary era of surprise and innovation, you need to learn to think and act like a revolutionary.” [i]  That word “revolutionary” is subject to many interpretations.  In the following passage, Ramo explains what he means by it.    

 

“Today the ideal candidates for foreign-policy power should be able to speak and think in revolutionary terms.  They should have an expertise in some area of the world—be it China or the Internet or bioengineering—where fast change and unpredictability are the dominant facts of life.  They should have experienced the unforgiving demands for precision and care that characterize real negotiations—as well as the magical effect of risk-taking at the right moments.  They should have mastered the essential skill of the next fifty years: crisis management.  And they should be inclined toward action, even action at times without too much reflection, since at certain moments instinct and speed are more important than the lovely perfection of academic models.”[ii]

 

Ramo is talking about foreign diplomacy, but the application of his remarks is much broader.  My first reaction to this passage was, “Sounds like the bond markets to me.”  Fast and unpredictable changes, risk-taking at the right moments, and especially, the need for action without too much reflection based on instinct and speed.  Yup, that’s how the bond markets work; or at least, that’s how I work in the bond markets.  But, when I read the passage a second time, I realized that it also reflected how ShoreBank operates.  ShoreBank is a revolutionary company, and it’s clear that Ramo uses the word revolutionary in the same way we do.  Our motto, “Let’s Change the World,” is said in a joyful tone, as one would say, “Let’s go to a party!” And it’s inclusive.  It means, let us work together as peers for changes we agree are beneficial.  Like Ramo, we believe that “small things can trigger a big change.”[iii]  We also believe that effecting change in this way requires looking at the world through the eyes of the people and communities where we work.  In other words, we try to see and then act from the inside out, rather than the outside in.  “In a fast-changing world, what really matters is often hidden in corners where the usual ‘experts’ don’t—or can’t—easily look.”[iv] 

 

The first necessary quality for achieving this new way of looking at the world is empathy, the ability to feel as others feel.  Ramo uses empathy to mean connecting with the environment, even when it’s uncomfortable or foreign.  It means being in a community and working with its values, rather than trying to impose your own.  It also means understanding that communities are constantly evolving or “shape-shifting” in Ramo’s words.  No matter how they change, they always tend toward greater complexity, in the scientific sense.  They become ever less amenable to modeling or anticipating.  “Patience,” says Ramo, “not persuasion would be the virtue,” because “no effort truly ends.”[v]     

 

This insight leads to the second necessary quality of resilience, the ability not just to react but to learn.  In this view, the more stress you can endure, the stronger you become.  Quoting an ecologist named C.S. Holling, Ramo writes, “A management approach based on resilience would emphasize the need to keep options open.  Flowing from this would be not the presumption of sufficient knowledge, but the recognition of our ignorance; not the assumption that future events are expected, but that they will be unexpected.”[vi]  When people who are trusted and treated as peers, they are empowered will respond with “an explosion of curiosity, innovation, and effort.”[vii]   This insight, multiplied in communities around the world has tremendous potential.  “The more something lends itself to invention and imagination, the more enduringly useful it becomes.  Practically, this means a dramatic, globe-defining effort to touch the lives of billions of people.”[viii]

 

ShoreBank understands the world as a complex, dynamic system, defying predictability and inherently unstable.  We seek to meet these challenges by working empathically, resiliently, and respectfully with ordinary people around the world.  We embed ourselves in communities for the long haul.  We are learners who have always intuitively understood that the people we serve have more to teach us than we have to teach them, and we have learned from them for decades.   Our business model sees the world through the eyes of our customers, whether they are apartment rehabbers on the South Side of Chicago, stall-keepers in Lahore, oystermen in Ilwaco Bay, or machinists in Minsk.  

 

We are risk-takers both by choice and by necessity.  Many years ago, at a strategic planning session, our in-house counsel remarked, “If ShoreBank ever woke up one morning and found itself too far from the edge, it would do everything it could to get back there as quickly as possible.”   We work at the edge because that’s where so many of our customers are.  Sometimes they go over and sometimes so do we.  The global recession has been brutal for people and communities with limited financial reserves.  Looking ahead, they will need ShoreBank more than ever.  Fewer institutions will be able or interested in working in these communities. Their recovery will be slower and their continuing struggles apt to be overlooked.  But ShoreBank will be there, providing credit, investment, training, collaboration, empathy, and resilience.    

 

Ramo could have been writing about ShoreBank when he described the revolution necessary for “a sensible international order—one that fits 2009, not 1989”:

 

It involves accepting that the most important things cannot be predicted with any great accuracy.  It involves radically refiguring the balance sheet of power in such a way that the aim isn’t to hoard power but to give away as much of it as possible…It requires harder truth telling than our leaders are used to and experimentation right up to the very edge of collapse.”[ix]  

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[i] Joshua Cooper Ramo. The Age of the Unthinkable.  New York NY: Little, Brown and Company, 2009. p.11.

[ii]  36-7.

[iii]  67.

[iv]  152.

[v]   223

[vi]  178-9.

[vii]  235.

[viii]  244.

[ix]  130-1.

The First Not-Bad News

The Bureau of Labor Statistics reported that the overall unemployment situation was unchanged from October to November.  The unemployment rate moved down slightly from 10.196% to 9.992% and non-farm payrolls dipped by a mere 11,000.  Job losses for September and October were revised downward, so over the last three months total net job losses were 261,000 compared to 921,000 in the three summer months.  Job losses in many sectors—manufacturing and construction especially—continue unabated, but for the first time in many months there are real signs of hope.  The most heartening is the growth in temporary help, which has moved from a low of 1.74 million jobs in July to 1.86 million in November, including an increase of 52,000 in October (see chart).  As employers begin feeling the need to add workers, they often start with temporary hires before feeling confident enough to add permanent workers.  Another hopeful sign is an increase in the average workweek for production and nonsupervisory workers by 0.2 hours to 33.2 hours, the highest level since February. 

Few people, except those who were recently hired, should be popping champagne corks just yet.  The true unemployment rate, including so-called “marginally attached” or discouraged jobseekers, remains stubbornly high at 17.2%.  Both the average and median length of unemployment continue climbing, to 28.5 weeks and 20.1 weeks respectively. But, while the November employment picture is still not good, it is the least bad since 2007.

October Retail Sales

The Census Bureau’s report this morning on October retail sales was decidedly mixed.  Total sales increased 1.4% over September, but mostly on “cash for clunkers” auto purchases.  Excluding autos, retail sales were up 0.2%.  Sales for the last three months are higher than for any three-month period since September through November 2008.

Nevertheless and even with stimulus, sales remain well below previous years.  Sales for the first ten months of 2009 are 8.2% less than the same period in 2008 and lower than any similar period since 2004.  Automobile sales are nearly 15% under last year.  Even with October’s boost, auto sales in September and October combined are almost 5% under September and October 2008.  In fact, sales in every major category, except the two most basic, health & personal care and food, remain significantly less than last year.    

In the silver lining department, gasoline station sales are down 30%.  The price of oil averaged $65.11 through October 31 this year compared to $107.55 in 2008.  Gasoline station sales account for about 9% of all retail sales.   

Shopping

Mr Economy had long been gravely ill, sick unto death some said.  He had endured emergency surgeries, including a dangerously botched removal of his Lehman.  He had received massive doses of stimulus, but still his unemployment temperature spiked to 10.2%.  His relations were frantic, his physicians perplexed.  All agreed that only one doctor had the cure for what ailed poor Mr Economy, but would she come in time?  And so, with the holiday season fast approaching, the cry goes out: “Where, O where is Dr American Shopper?”

 

Unfortunately, Dr Shopper isn’t in such great shape herself.  No less an authority than the legendary investor George Soros recently proclaimed, “The American consumer will no longer be able to serve as the motor for the world economy.”*  Before considering what prompted Mr Soros’ prediction, it’s useful to clarify an important point about modern consumer societies.  In the developed world, almost no one makes what he or she eats, drinks, wears or shelters in.  Our dependence on organized commercial and social networks for every necessity is nearly total.  But spending for the necessities is nowhere near enough to keep the economy healthy.  That requires spending enormous amounts on goods and services we want or like but that, in no sense of the word, do we need.  Consequently, when times get tough, it’s not a great hardship—at least initially—to cut back, even for those who don’t have to.

 

This brings us to Dr Shopper’s first problem, a lack of confidence about the future.  Two separate and highly regarded surveys of consumer sentiment are conducted monthly by the University of Michigan and the Conference Board.  While merely opinion polls, decades of research have clearly demonstrated their correlation to actual future consumer behavior and, by extension, to the economy itself.  This month, following a mid-year rebound, the surveys unexpectedly revealed falling confidence in both present and future economic conditions.  To quote from the Conference Board summary:

 

 “Consumers' assessment of present-day conditions has grown less favorable, with labor market conditions playing a major role in this grimmer assessment.  In fact, the Present Situation Index is now at its lowest reading in 26 years.  The short-term outlook has also grown more negative, as a greater proportion of consumers anticipate business and labor market conditions will worsen in the months ahead.  Consumers also remain quite pessimistic about their future earnings, a sentiment that will likely constrain spending during the holidays.” 

 

Despite the present high unemployment rate, more than 138 million Americans have jobs, compared to an average of 119 million during the long expansion between the 1991 and 2001 recessions.  The odds are that Dr Shopper has a job; the point is, she’s worried about keeping it, and her worry drives her spending decisions.  Of course, Dr Shopper doesn’t actually spend money she has in her pocket.  Rather, she* borrows the money to spend.  She has been borrowing a lot less recently.  In September, the most recent month for which data is available, the amount of consumer credit declined by $14.8 billion.  It was the twelfth drop in the last 14 months and the eighth in a row, the longest streak since the Federal Reserve began keeping track in 1943.  Since peaking at $2.581 trillion in July 2008, the amount of non-mortgage consumer debt outstanding has fallen to $2.455 trillion.  Eighty-six billion dollars of that $126 billion drop is in revolving debt, that is, credit cards.  More confident consumers would have spent that money. 

 

While credit card debt is falling, credit card costs are rising.  Bloomberg News reported that the average credit card rate is up to 12.64% from 11.84% in January.  Credit card issuers are raising rates and fees, while eliminating specials to get out in front of the Credit Card Accountability, Responsibility, and Disclosure Act, which takes effect in February.  New fees and higher rates are also needed to make up for greater losses.  Delinquency rates at the major companies are roughly double their recent lows, even at American Express, with its more affluent customer base.  According to Citigroup, worse is yet to come, with credit card charge offs expected to peak at 12% by next spring.

 

A second former source of consumer debt has dried up as well.   The Joint Center for Housing Studies of Harvard University reported that home equity fell by $2.5 trillion in 2008 and by nearly $5.9 trillion since 2005.  The result, as the chart to the left shows, was that homeowners took 200 billion less dollars out of their homes in 2008 than in 2006.  Undoubtedly, cash-out refinancing will fall further this year.  People who drained their homes of equity during the bubble period may not have realized it, but they were simply monetizing their gains, in the same way shareholders stock when the price rises.  Now, that home prices have fallen 28% on average, those gains have evaporated, for both those who cashed out and those who didn’t.  

 

The decline in home values is an obvious cause for the drop off in cash-out refinancing, but it’s not the only one.  Many refinanced mortgages wound up in private, non-government guaranteed loan securitizations, which were a casualty of the financial explosion of 2007, as well they should have been.  Private mortgage securitization was catalytic in creating the excesses of the housing bubble.  Mortgage bankers outdid themselves in dreaming up variant structures because anything and everything could be securitized.  But now, originators can sell almost nothing but plain vanilla 15- and 30-year fully amortizing fixed rated mortgages.  Discover Card CEO was quoted last spring as saying, “I view it as rolling back the clock.  Some of the innovations that have taken place in our business over the last 15 years will be rolled back.”  That’s true in spades with mortgages.  While the death of pay-option ARMs, interest-only mortgages, zero-down payments loans, and frequent refinancing is generally a good thing, it’s not an entirely good thing.  The stifling of innovation will protect many consumers, but, by enforcing thrift and prudence, it also dampens consumer spending. 

 

The combined impact of these various forces is apparent in the broadest measure of retail sales.  The Census Bureau’s monthly report shows that the total dollar volume of sales has fallen all the way back to the levels of 2005.  Monthly sales were between $370 billion and $380 billion from mid-2007 to mid-2008.  This year, they have averaged $342 billion, a decline of nearly 9%. 

 

Yet, there are beginning to be signs of resurgence.  The Wall Street Journal reported that retail sales increased during Octobers at both low-end discounters and high-end retailers.  TJX’s Marshall’s and TJ Maxx stores reported sales growth of 10% over September, while Nordstrom was up 6.5%.   

 

The graph below is helpful in understanding these changes, though it is a bit complicated.  It shows weekly percentage changes in same-store sales in large US general retailers open for a year or more.  The changes are measured against sales a year earlier.  The period covered begins with the week of November 13, 2007, and continues through the week ending November 3, 2009.  Compiled by Redbook Research Inc, the sample represents about 9,000 stores.  As you will see, sales comparisons turned negative about a year ago, rebounded in April and May 2009, before collapsing again in the summer.  The trend finally turned positive in mid-October, and retailers are expressing optimism that it will continue.

 

Economists like to use the metaphor “headwinds” to describe factors inhibiting growth.  A real headwind opposes the course of a large and powerful moving object, like an airplane.  Mr Soros’ opinion notwithstanding, there are few more powerful moving objects than the American consumer.  Shopping, after all, is our national sport.  It’s what we do.  It’s what we ARE.  And we are starting to go back to the mall.  Dr Shopper is on her way.  She may be slow in coming, but when she arrives, her healing touch will surely pull old Mr Economy through.

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* Though it would have been neater for my metaphor had he said “doctor” instead of “motor”. 

* I should note here that, having initially made Dr Shopper female, it would be confusing to change her gender now.  I am not implying any invidious distinctions between female and male shopping behavior. 

Unemployment Continues to Increase

The Bureau of Labor Statistics reported this morning that the unemployment rate rose to 10.2% and the “true” unemployment rate, which includes discouraged workers and those who want full-time work but can only find part-time jobs, rose to 17.5%.  The number of unemployed persons now stands at 15.7 million, more than double the recent low of 7.67 million in April 2008.  Total non-farm payrolls fell by 195,000 in October.  

The details of the employment reports offer little comfort.  Manufacturing employment fell by 61,000.  The sector has lost jobs for 23 months in a row and in 38 out of the last 39 months.   Fully one-third of the 17.3 million manufacturing jobs that existed in the US at the beginning of this decade are now gone.  The situation in construction is as bad, if not worse.  In October, there were less than six million construction jobs, down from a peak of 7.7 million in January 2007.  There are almost 800,000 fewer today than at the turn of the century

Yesterday, the Labor Department announced that US labor productivity rose an astonishing 9.5% percent in the third quarter.  It was the biggest productivity jump since 2003, but it came on the back on workers, whose hours of work fell by 5% from the second quarter.  In fact, the year-over-year decline in hours worked of 7.5% was the largest since record-keeping began in 1948.  As in all recent recessions,  business has been forced to find ways to do more at less cost.  

There are, however, two bits of good news in the data.  First, job losses in September and August were revised downward by 91,000.  Second, the pace of losses is clearly slowing.  The three-month average of monthly job losses is down to 188,000 from 428,000 in the second quarter and 691,000 in the first quarter.  It’s likely that most businesses are now working with as limited staffing as they can.  But, the question of when we will finally see employment increase remains to be answered.

The Fed Does the Right Thing

The Federal Open Market Committee, the Fed’s policy arm, today voted without dissent to keep the fed funds target rate at 0.00% to 0.25%.  While “economic activity has continued to pick up” and “activity in the housing sector has increased,” the overall economy remains weak.  “Low rates of resource utilization (Fedspeak for “not enough people have jobs”), subdued inflation trends and stable inflation conditions” permit the Fed to encourage business and personal borrowing by keeping the rate target at “exceptionally low levels…for an extended period.” 

This is extremely good news, particularly as the vote was unanimous.  The worst thing the Fed could do in this environment is raise the cost of borrowing too soon.  That the economy is no longer in the ICU does not mean it has returned to health.

Sales of existing homes increased to an annualized rate of 5.57 million units in September, the highest level since July 2007.  The bottom was an annualized rate of 4.94 million units in January.  Much of the recent increase is attributed to a rush to take advantage of the $8,000 first-time-homebuyer tax credit.  Low 30-year mortgage rates, which have averaged 5.0% the last couple of months, also spurred sales.  

The median value of the homes sold in September was $175,000, which is about the average for the year. The table below shows the average median value for the last few years:

 

Year	Price
2002	$163,900
2003	$177,100
2004	$193,200
2005	$218,200
2006	$222,000
2007	$216,600
2008	$197,200

The supply of homes for sale—that is, the inventory of unsold product—also improved.  From highs in the range of 4.5 million units, the number of unsold homes dropped to 3.6 million.   A normal level is about 2.5 million units.  

The bottom line is that home sales and values have reached a level of stability, roughly equivalent to 2002.  We believe that it will be some time before they can move substantially higher given the November 30 expiration of the homebuyer credit, the  recent rise in the 10-year UST Treasury yield (against which mortgage rates are set), and the continuing high level of unemployment.   

The Fed's Dilemma

 

On November 21, 2002, Ben S. Bernanke, then a newly-appointed Governor of the Federal Reserve Board, gave a speech to the National Economists Club that made him famous.  “Deflation: Making Sure ‘It’ Doesn’t Happen Here” was a speculation on how the Fed would attack the “purely hypothetical” danger of a prolonged and widespread decline in prices.  It may seem counterintuitive that lower prices for most goods and services are a bad thing, but as Bernanke pointed out, “Deflation is in almost all cases a side effect of a collapse of aggregate demand—a drop in spending so severe that producers must cut prices on an ongoing basis in order to find buyers.”  In other words, deflation and economic recession—or worse—almost invariably go hand in hand. 

 

In those happy, innocent days, Bernanke could reassure his audience that deflation was improbable for two reasons.  The first was the strength of the US economy, and particularly, “the strength of our financial system…Our banking system remains healthy and well-regulated, and firm and household balance sheets are for the most part in good shape.”  That, of course, was then. 

 

The second reason was the primary focus of Bernanke’s remarks.  He asserted that the Federal Reserve System was “the second bulwark against deflation in the United States.”  The Fed’s main tools for implementing monetary policy are setting a target interest rate for overnight borrowings between banks, called the fed funds rate, and then “enforcing that target by buying and selling securities in open capital markets.”  Lowering the rate effectively reduces the cost of borrowings of all sorts and thereby stimulates consumer spending, the primary driver of our economy.  But, there is an obvious, inescapable, and non-trivial difficulty: No matter what, interest rates cannot fall below 0%.  Economists call this fact the “zero bound.”  It’s kind of like the speed of light, an absolute limit.  Once a central bank reduces the overnight borrowing rate to zero, it has exhausted what Bernanke called “its traditional means of stimulating aggregate demand.”

 

Bernanke then enumerated a number of potential weapons the Fed could use against deflation when and if the zero bound was reached.  What made the speech so remarkable was that most of them had never been tried.  Even more remarkable is that most of them, in one form or another, were tried in 2007 and 2008.  As Bernanke suggested it might, the Fed has greatly expanded both the amount and variety of securities it buys in order to pump cash into the financial system.  Between June 27, 2007, and September 30, 2009, securities on the Fed’s balance sheet increased from $791 billion to $1.59 trillion. None of the growth was Treasury securities, which, until the crisis was all the Fed bought. Instead, the Fed bought debt obligations of Fannie Mae, Freddie Mac and other Government-Sponsored Enterprises (GSEs).  This spring the Fed announced that it would buy up to $1.25 trillion of mortgage-backed securities issued by the GSEs plus another $200 billion of direct GSE debt. Last month, it reiterated its intention to purchase the full amount by March 31, 2010.  

 

Another option Bernanke posited in 2002 would be to offer fixed-term loans to banks, secured by a wide range of financial assets.  During the financial crisis of 2007-08, the Fed did this, and more, offering loans not only to banks, but to money market funds, investment banks, and commercial paper issuers.  Federal Reserve loans outstanding ballooned from zero on June 27, 2007, to almost $1.5 trillion at the end of 2008, though it has since fallen back to $348 billion.  Cooperation with “fiscal authorities”—that is, the executive and legislative branches of government—was a third option.  Bernanke suggested broad-based tax cuts and greatly increased government spending, which the team of Bernanke, Henry Paulson, and Tim Geithner were foremost in promoting at the end of the Bush presidency. 

 

The one proposal Bernanke made that was not at all new was, ironically, the one that was not implemented.  “As suggested by a number of studies, when inflation is already low and the fundamentals of the economy suddenly deteriorate, the central bank should act more preemptively and more aggressively than usual in cutting rates.”  The phrase “as suggested by a number of studies” is essential in understanding Bernanke’s thinking.  As David Wessel notes in his outstanding recent book, In Fed We Trust, Ben Bernanke was still, in 2002, a life-long academic.  His specialty was the Great Depression.  Bernanke believed that a series of misguided monetary policy decisions by the Fed was a primary cause of the Depression in the first place and of its persistence through the 1930s. According to Wessel this belief, “dominated Bernanke’s thinking throughout the Great Panic.  He was determined that no future scholar would convict him of similar timidity or complacency in the face of a financial crisis.”[1] 

 

Bernanke’s determination to avoid blame was tempered by an equal determination, at least early in his chairmanship, to make his Fed more transparent and collegial than Alan Greenspan’s had been.  While laudable, the results were unfortunate.  Instead of acting “more preemptively and more aggressively” in the latter half of 2007, the Fed moved cautiously and, by early 2008, found itself seriously behind the needs of the financial markets and the economy for easier monetary policy.  Part of the reason is that it’s much easier to recognize a crisis retrospectively than prospectively.  But, the process was slowed by several Federal Reserve Bank Presidents, notably Richard Fisher of Dallas, Jeffrey Lacker of Richmond, and Charles Plosser of Philadelphia, who in speeches and Federal Open Market Committee (FOMC) meetings strongly opposed the initial easing of credit. Fisher, in particular, seemed slow on the uptake.  Wessel describes him as man of “little prescience” perpetually “fretting” about inflation.[2]  As a result, the Fed had to play catch up, finally bringing the target overnight lending rate to 0-0.25% in December 2008.  There it remains and is likely to do so “for an extended period” according to the latest FOMC statement.

 

But Fisher was not chastened; if anything, he has become a more hawkish inflation-fighter (now that no inflation exists to be fought).  On September 29, he told an audience at Texas Christian University:

 

As to the long-term dangers of inflation…I remain ever vigilant.  I have not hesitated in the past to vote against the majority of the FOMC when I felt they were being too accommodative, and I have been outspoken on the dangers of prolonged monetary stimulus in the future…I am not alone on this front.  I have faith my colleagues on the Federal Open Market Committee will stand and deliver in a timely way.  And I expect that when it comes time to tighten monetary policy, my colleagues and I will move with an alacrity that, if needed, will be equal in speed and intensity to that which we pursued monetary accommodation.

 

Them’s fightin’ words, and here’s why they’re scary.  The basic economy is not improving.  At best, we have flattened out to a lower level of economic activity.  As Fisher himself admitted in the same speech quoted above, “While housing is showing some signs of having reached a bottom, we need to recognize that the sector is still on life support.”  The employment picture is even gloomier.  The official 9.8% unemployment rate is at a 26-year peak, and the rate for adult men, at 10.3%, is the highest since records began in 1948.  The employment-to-population ratio fell to 58.8%, the lowest since women began to enter the workforce in large numbers.  In December 2007, the ratio was 62.7%.  The average time of unemployment is now a full six months and the median is 17 weeks.  The “real” unemployment rate, which includes people forced to work part time instead of full time and those too discouraged to even look for work, rose to 17%.  More than 26 million Americans are effectively out of work.  A senior Goldman Sachs economist recently predicted that all 8.3 million jobs created between 2003 and 2007 will probably be lost before the economy recovers.

 

So here’s the Fed’s dilemma.  If the economy remains weak for a prolonged period, as I expect it will, the Fed will have no choice but to maintain short-term interest rates at the zero bound.  And, since it has already tried all the novel remedies Ben Bernanke proposed in 2002, the Fed probably is out of ammunition.  But doing nothing for a long time is always an uncomfortable option.  It’s just not the American way.  The Fed will be pressured to do something, and that something most likely will be to raise interest rates to ward of future inflation.  Bernanke will be reminded relentlessly of what is now considered Alan Greenspan’s catastrophic mistake for keeping the fed funds rate too low for too long in 2003 and 2004.  Bernanke’s own recent statement that the recession is “probably” over could well come back to haunt him.

 

The first criticisms of accommodative monetary policy may come as early as October 28.  That’s when the initial estimate of third quarter Gross Domestic Product—the total output of goods and services produced by labor and property located in the United States—will be released.  After falling for four consecutive quarters and five out of the last six, an increase is virtually certain.  But the first stage of any recovery is fragile and no matter how much the economy grows in the next few quarters, it will take years to make up what has been lost.  No one can understand this better than Ben Bernanke, the student of the Great Depression.

 

The Federal Reserve, though differently constituted at the time, actually tightened credit by raising its discount rate—that is, the rate at which it lent directly to banks—twice in October 1931.  It didn’t begin easing credit conditions until early 1932, but tightened again in March 1933.  That tightening move was followed a month later by the start of an easing cycle that finally, in February 1934, brought the discount rate back to 1.50%, just where it had been in May 1931.  The whole schizophrenic process was pointless and destructive.  And here’s what nobody knew while the Fed was dithering.  In 1933, after three years of double-digit declines, US GDP fell just 3.9%.  It rose 17% in 1934, 11.1% in 1935, 14.3% in 1936, and 9.7% in 1937.  Nobody knew it because GDP metrics were not compiled until after World War II.  If the Fed had had GDP statistics in the 1930s, it wouldn’t have tightened credit in 1931, but it might well have in 1933.  After another year or two of growth it almost certainly would have.  This is the risk we face, that the Fed will be under increasingly intense pressure to restrict credit too soon.  Premature tightening is a classic recipe for plunging a recovering economy back into recession.  Sure, the economy had started growing again in the mid-1930s…but it was still the Great Depression.   

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[1] David Wessel, In Fed We Trust (New York: Crown Business, 2009), 41.

[2] See pages 134, 146, and especially 258.

He’s in the Jailhouse Now

“Mr. Madoff’s crimes were extraordinarily evil…   The breach of trust here was massive.” --US District Judge Denny Chin on sentencing Bernard Madoff to 150 years in prison. 
How did Bernie Madoff do it?  How did he perpetuate a God-only-knows how many billion dollar Ponzi scheme for two decades?  Most of the media focus has been on how he deluded investors, but he also slipped past three examinations and two investigations conducted by the Securities and Exchange Commission (SEC).  This month the SEC’s Inspector General (IG) issued its report on the botched handling of the Madoff affair. 

The SEC is a federal agency created in the aftermath of the 1929 stock market crash to enforce America’s first comprehensive regulations of securities.  Up through the Roaring Twenties, the financial markets were self-regulated.  Companies issued financial statements when and if they felt like it; smart operators were continually plotting to corner one market or another; and insider trading was taken for granted.  The SEC’s mandate was to stop all that.  To make sure that it did, President Franklin Roosevelt appointed Joseph P. Kennedy as the SEC’s first chairman.  Kennedy, the father of John, Bobby, and Ted, had been a none-too-scrupulous Wall Street operator himself.  Roosevelt was widely criticized for the appointment, but his reasoning was solid. “It takes a thief to catch a thief.”  It’s too bad there were no Joe Kennedy’s at the SEC when it looked at Madoff’s companies.  Instead, as the IG report concludes, “The SEC never properly examined or investigated Madoff’s trading and never took the necessary, but basic, steps to determine if Madoff was operating a Ponzi scheme. Had these efforts been made with appropriate follow-up at any time beginning in June of 1992 until December of 2008, the SEC could have uncovered the Ponzi scheme well before Madoff confessed.”

The IG’s report exonerates SEC personnel from “any financial or other inappropriate connection” with Madoff or his interests.  It also clears senior SEC officials from interference or direct attempts to influence the staff’s investigations.  The IG report details the many errors of commission and omission that allowed Madoff to escape discovery for so long, but it draws no conclusions as to how or why such a systematic pattern of error originated and persisted. The reader is left with the impression that the SEC is simply incompetent; a collection of Inspector Clouseaus whose buffoonery would be a good joke if it hadn’t cost so many people so much money.  This is a highly unsatisfying conclusion, calling in to question as it does the entire regulatory apparatus of the US securities markets.  The performance of the Madoff investigators and examiners certainly was incompetent, but, I would argue, their failure can be traced to two reasons that are deeply embedded in human nature.

The first reason has to do with Madoff’s purported investment strategy.  I am going to explain the strategy in the next few paragraphs.  I have simplified it somewhat by using a single stock and options on that stock, while Madoff claimed to use a basket of 30-35 stocks and options on stock indices.  The principles are the same, and besides, Madoff never actually executed the trades, so a little license in describing them won’t matter much.

On a given day, Bernie buys 100 shares of Coca Cola stock at $50 a share.  Simultaneously Bernie sells a “call” option to another investor, whom we will call Bob.  Bob’s option gives him the right but not the obligation to buy (or call away) Bernie’s 100 shares of Coke stock at specified price on some specified future date.  Bob pays Bernie a fee, called a “premium” up-front, and Bernie gets to keep it, no matter whether Bob exercises his option to buy the stock or not.  Let’s suppose that Bob’s option gives him the right to buy Bernie’s stock in three months at $60 a share, which is called the “strike price.”  Bob hopes that Coca Cola stock will be trading above $60 in three months.  If it is, Bob will exercise his option.  He will buy Coke at $60, sell it at the market price, and pocket the difference.  If Coke is trading below $60, Bob will let his option expire and simply be out the premium. 

Bernie now has three ways to make money.  He has received Bob’s premium; he will get any dividends declared by Coca Cola while he owns the stock; and the price of the stock can rise.  But, stock prices can fall as well as rise.  Bernie protects himself by buying a “put” option from a different investor, whom we will call Alice.  The put option gives Bernie the right but not the obligation to sell (or put to) Alice 100 shares of Coca Cola at $50 a share three months from now.  If, at that time, Coke’s stock price is under $50, Bernie will exercise his option and recoup his investment, minus the up-front premium he paid Alice.  If Coke is trading above $50, Bernie will let his option expire and simply be out the premium. 

The difference between the current price of Coca Cola, $50, and the strike price of Bob’s call option, $60, is large.  Such a big price movement in only three months is unlikely, and therefore, the option is “out of the money.”  As a result, the premium Bob pays is low, in the same way a life insurance premium for a healthy 21-year old is low. But, the put option Bernie buys from Alice is “at the money.”  The probability that Coca Cola stock will be trading near its current price of $50 in three months is high.  In consequence, the premium Bernie pays Alice is higher than the premium Bob pays Bernie for the call option.  Bernie is underwater the day he initiates his trades.  He has to significantly and consistently outperform the market to succeed. 

Bernie Madoff did claim that success. Over a period of more than 15 years, he reported an average annual return of 12%, with only seven losing months and no monthly loss greater than 0.55%.  The years Madoff claimed to be earning 12% included 2000, 2001, and 2002, when the S&P 500 stock index lost 9.13%, 11.8%, and 22.1% respectively. 

I hope the explanation of Madoff’s trading strategy is clear and easy to follow because—and here is the heart of the first reason for Madoff’s successful deception—it can be made extremely complicated and confusing.  My version of the price relationship between at-the-money and out-of-the-money options is accurate, but the mathematics behind the specific pricing and, especially, the forecasting of option values is frighteningly difficult.  A financial professional named Harry Markopolos made three separate complaints to the SEC, in May 2000, March 2001, and October 2005. In the last one, titled “The World’s Largest Hedge Fund is a Fraud” (and footnoted in the preceding paragraph), he writes, “Very few people in the world have the mathematical background needed to manage these types of products but I am one of them.” 

I am making a conjecture, but I believe something very like it must have happened repeatedly.  The IG report stresses that most of the people who investigated Madoff were young, inexperienced lawyers.  But, they worked for the SEC and so they were supposed to understand how the various securities markets work.  When Madoff “explained” his methods, quickly dropping into the jargon of “split-strike conversions” and “Black Scholes models,” I can imagine the SEC lawyers nodding their heads, each one too embarrassed to admit bewilderment, and each one assuming that all the others understood Madoff perfectly.  How human, and how comprehensible a weakness, especially when connected to the second reason: Who Madoff was perceived to be.

Bernie Madoff, in his glory days, was a really big deal.  He was one of the key developers of the NASDAQ stock market and had been chairman of its board and a Governor of the National Association of Securities Dealers.  He was a founding member of the International Securities Clearing Corporation in London.  His legitimate broker-dealer, ECN, was highly respected and, in fact, has not been implicated in the scandal.  And Madoff knew how to throw his weight around.  Here is an excerpt from the IG’s report:

“The other [SEC] examiner noted that ‘all throughout the examination, Bernard Madoff would drop the names of high-up people in the SEC.’  Madoff told them that Christopher Cox was going to be the next Chairman of the SEC a few weeks prior to Cox being officially named.  He also told them that Madoff himself ‘was on the shortlist’ to be the next Chairman of the SEC.  When the examiners would seek documents Madoff did not wish to provide, Madoff would become very angry, with an examiner recalling that Madoff’s ‘veins were popping out of his neck’ and he was repeatedly saying, ‘What are you looking for?...and his voice level got increasingly loud.’”

Junior examiners were told by higher-ups that Madoff “was a very well-connected, powerful, person.”  And, “when the examiners reported they had caught Madoff in lies, the Assistant Director minimized their concerns, stating ‘it could just be a matter of semantics.’” 

Bernie Madoff intimidated the SEC through bluster and rants, but most of all by the strength of his reputation as, in the words of an SEC branch chief, “the sort of people who are seen as reputable members of society.”  The intimidation factor went beyond posing.  Anyone managing tens of billions of dollars has true power.  In his 2005 report, Markopolos begged the SEC to keep his identity secret.  “I am worried about the personal safety of myself and my family.”  Certainly an SEC employee who got on Madoff’s bad side would have reason to fear for his or her career at least. 

Embarrassment at perceived ignorance and intimidation by power are strong dampers on human action and initiative.  I suspect that they were strong enough to stymie three SEC examinations and two investigations. 

The really astonishing part, though, is how easy it would have been to trip Madoff up.  If Madoff were really making the trades he claimed, there would have been independent third-party records confirming them.  The records would have been readily available to the SEC.  Time and again, the examiners failed to ask for them “‘because it can be tremendously voluminous and difficult to deal with’ and ‘takes a ton of time’ to review.”   But SEC examiners didn’t need “voluminous” records; they only needed the records of a day or two.  That’s all the IG asked for, and the records “immediately revealed” Madoff’s fraud.  The records would have “immediately revealed” the fraud to you or me too.  Imagine that you were being audited. The auditor asks to see the register where you keep a record of the checks you write, but never request your bank statement.  That’s all the SEC had to do, ask for the equivalent of Madoff’s bank statements. They never did.    

 

Call me Goofy

Call me goofy, but I am not ready to join the “recession is over” parade just yet.  While the economy has hit bottom, it is likely to stay bouncing along that bottom for many months at least.  A rapid and sustained recovery beginning this fall is an improbable scenario.

 

In a spirit of fairness, we will begin by looking at the four main arguments supporting a near-term end to the recession.  The first, and strongest, is the healing of the financial markets.  The Standard & Poor’s stock index is up 12% for the year and 40% from its March lows.  The flow of credit between banks has returned to normal as evidenced by the cost of borrowing.  The yield spread between three-month LIBOR, which represents the costs of funds for large banks, and three-month Treasury bill yields has fallen from an astronomical 4.6% in October 2008 to 0.29% last week.  Yield spreads between Treasury bonds and bonds issued by corporations and smaller governmental units have narrowed, making it cheaper for these entities to borrow.  While there are still exceptions—it’s still next to impossible to securitize mortgages without a government guarantee—the financial markets are back to business as usual.

 

The second argument is that the $787 billion of stimulus to be provided by the economic recovery act has barely begun to flow.  As more projects come on stream, the stimulus package will provide a substantial boost to growth.  The stimulus, though, is just that, “something that incites to action or exertion or quickens action.”  The question, that only time will answer, is whether stimulus-induced growth will be sustainable, or simply limited to projects whose jobs evaporate when they are completed.

 

The third argument, put forth cogently by FTN Financial Chief Economist, Chris Low, is that the traditional leader of economic growth—inventory rebuilding—will come to the rescue again.  Inventory fluctuations were once a primary lever of economic decline and recovery.  In the past, suppliers, caught by surprise, often needed many months to work off excess inventory when bad times hit.  Then, equally surprised, they had to rebuild inventories quickly when good times started to return.  The process tended to lengthen recessions with longer layoffs, but quicken recoveries with faster re-hiring.  “Just-in-time” inventory management, imported from

Japan

in the 1980s, changed all that, and inventory levels played a minimal role in the mild recessions of 1991 and 2001.  But, as Low points out, the current recession hit so hard and so fast that businesses had no time to manage inventories; they simply stopped making things.  The corollary is that when the economy begins to rebound, inventory rebuilding will also have to be faster and more robust, and, in Low’s words, “slingshot growth.”

 

The fourth argument is in the interpretation of the data.  Several recent government and private sector reports have been widely cited as evidence of an economic rebound. 

 

·        Housing starts in June rose by the largest percentage since 2004. 

 

·        New home sales increased 11%, the most since 2000. 

 

·        Pending sales of existing homes have risen nearly 20% from their January low. 

 

The story on the employment front is similar. 

 

·        Initial weekly applications for unemployment insurance have been below 600,000 for the last five weeks, after having been above that level since the last week of January. 

 

·        Most importantly, job losses in July were the smallest since August 2008. 

 

Government agencies and private groups pour out an endless stream of economic reports every working day. In each report, one number or percentage, the so-called “headline” number, stands out and seems to tell the whole story.  But underneath it are mounds of detailed information that tell a more nuanced tale. Often, their interpretation is not merely a result of honest differences of opinion but of political, ideological, and financial motives.  Also, the numbers themselves are far from reliable.  They are seasonally adjusted, based on incomplete samples, and subject to frequent revisions.  Finally, there’s the question of which data provide insights into the future and which merely offer a look in the rearview mirror. 

 

With all these caveats in mind, let’s take another look at the data noted above. 

 

·        Housing starts rose 3.6% in July, but, at an annualized rate of 583,000 units, they are barely a third of the average for the last 10 years and a quarter of the boom period, 2004-2005. 

 

·        Pending sales of existing homes have also risen, but they remain down more than 13% from the pre-recession average. 

 

·        The four-week average of initial unemployment claims has fallen to 555,000, from a recent high of 659,000, but that’s still terrible by any but the most recent standards.  From the end of the last major recession in the early 1980s to the beginning of the current recession, the four-week average of initial claims averaged 354,000 and never hit 500,000, except for one week at the peak of the 1991 recession.  

 

·        Job losses in July showed major improvement at “only” 247,000 compared to 741,000 in January.  But the worst month for job losses in the 2001 recession was October with 325,000, and there were only two other months when losses exceeded 200,000.  The worst month in the 1991 recession was February with 306,000 jobs lost, but again job losses exceeded 200,000 in only two other months. 

 

To the extent this data is reassuring, other data is less so.  As is well known, our economy runs on consumer spending, which accounts for 70% of Gross Domestic Product.  And the consumer is still not spending.  The Commerce Department reported recently that retail sales were down 9% between June 2008 and June 2009.  On an annualized basis, that’s a difference of about $405 billion.  Spending was down in almost all categories:

 

·        Furniture & home furnishings:          -12.6%

·        Electronics & appliances:                -11.5%

·        Building materials:               -13.0%

·        Clothing:                                         - 6.2%

·        Department stores:              - 9.4%

·        Non-store retailers:             - 6.7%

 

Consumer spending is off because consumer income is off.  Wages and salaries paid to US workers in June were $6.24 trillion on an annualized basis.  They have dropped every month since peaking at $6.58 trillion in August 2008.  Had wages and salaries continued to increase at their pre-recession pace, they would have been about $6.69 trillion in June.  That difference of $450 billion pretty much accounts for the drop in spending.

 

There is another dynamic at work too.  Americans are paying down debt and saving at record rates.  According to Goldman Sachs (and who could question them?) consumer and non-financial company debt fell 0.7% in the first quarter this year, marking the first contraction since 1952.  The Federal Reserve reported that total consumer debt excluding debt secured by real estate, after rising steadily for decades, has fallen $80 billion since peaking in July 2008.  We still owe more than $2.5 trillion, about where we were in October 2007.  As the chart below indicates, we would have to cut another $550 billion more to turn the clock back just five years.

 

 

 

Personal savings has spiked recently as well.  The Commerce Department reported that Americans socked more than $500 billion away in June and $680 billion in May.  Since May 2008, we have been saving about 4% of our disposable income a month, double what we saved in the boom years.

 

The increase in savings leads to a key question: Will we go back to our old free-spending ways when the recession finally does end or is our newfound frugality permanent?   Retail sales increased every quarter for seventeen years before the recession struck.  “Never bet against the American consumer” was economic dogma.  But things are different now.  Americans have been scared into saving and two powerful forces—one demographic and the other economic—could keep that trend in place for a long time.

 

The demographic trend is the aging of the Baby Boomer generation.  The older people get and begin to contemplate imminent retirement, the more prone they are to save, regardless of economic conditions.  A recession can only reinforce this tendency.  The economic trend is deflation, or at least the lack of inflation.  The most serious previous recession since the 1930s occurred at the beginning of the 1980s.  That recession, unlike today’s, was accompanied by double-digit inflation.  Inflation discourages saving because it erodes the value of money.  Who wants to put $1,000 in a CD if two years later its buying power has been reduced 30%?  When the value of money is rising or stable as it is now, savers have a powerful incentive even if interest rates are low.  Having been burned by the precipitous fall in stock prices and the even more catastrophic destruction of home equity, simply maintaining the cash you have is appealing. 

 

I hope I am wrong.  I hope the recession really is ending and recovery is beginning.  If so, dear readers, you will have every right and my cordial permission to call me Mr Goofy from now on.