Sunday, July 26, 2009

WUVL - The Shape of Our Upcoming Recovery

NYU Economics Professor Dr. Nouriel Roubini, sometimes called "Dr. Doom" for his less than rosy economics predictions, says the US recovery from its current recession will be in the shape of a W. W's, for those who are sharpening up their penmanship skills in preparation for the oncoming Fall semester, go down, up, down, up. He says he thinks we'll have a "double dipper" recession. Did I mention he made his reputation as a gloomy guy? His current fear is that the weary consumer will fail come to the rescue after the effects of government spending start to pull us out of the recession, and back we'll fall. He, by the way, is a professor of economics at the Stern School of Business. Every adjective associated with this guy seems to be depressing, but I guess there's something to be said for consistency.
Others, less gloomy but none too optimistic, say that this recession will resemble a U. Down we'll fall, and stay at an elongated bottom, then, finally, we'll move up. This elongated bottom will be caused by extended unemployment and cautious spending. After an extended period where inventories are sold off, housing prices bottom, and liquidity is restored to the banking system, we will then turn the economic corner after the last optimist has thrown in her towel.
The V proponents are the rosy predictors, who say the economy has hit bottom and is due to bounce right back up again. Those who are out of work tend to disagree with these rosy predictions. The V's cheerily respond by saying that the beginning of such a recovery is "jobless," to which the jobless respond with expletives which have been deleted for purposes of keeping this discussion family-friendly.
Then, rivaling Dr. Roubini for the doomsday scenario, is the L shaped recovery. I don't actually understand how this is a recovery at all, as it illustrates falling, then moving sideways. I suppose that one could argue that the fact that it doesn't fall forever would account for some degree of positivity. The L's argue that we have a "new normal" that is slower growth, higher joblessness, a lengthy period of stagnant prices and other depressing economic predictions. L's are not fun at parties.
Numbers - Not Letters
I've chosen to describe the recovery without the use of an illustrative letter. My experience with economics presents a problem that causes me to avoid using neat lines to illustrate anything. Economics is messy.
One often overlooked fact in the current GDP projections is our international trading trends. From 1950 to 1980, Gross Domestic Product averaged almost 4%. From 1980 to now, it has been almost 3%.
Source: Bureau of Economic Analysis
Trade and the Weakening Dollar
Economist Jim Paulson of Wells Capital Management in Minneapolis points out that trade deficits, i.e., the excess of imports to exports, fueled by the US consumer since the 1980's has enriched emerging nations, who provided our voratious consumerism with relatively cheap imports during that period.
Now that we are cutting back and repaying our debt, demand from those newly rich emerging markets is likely to increase the amount we export, just as our demand decreases. Further, our "strong dollar policy" in the recent past made our exports more expensive to emerging markets. Now, our dollar's weakened position as we lower rates to fuel our economic recovery, will make our exports even cheaper for those newly rich markets.
Economist Edward Yardeni of Yardini Research agrees with Paulsen, noting that, as of May 2009, "US exports of goods and services had actually risen by $1.9 billion from the previous month. . . while US imports continued to slide."
Source: Barron's Magazine, July 20, 2009
So, conceding that the weary US consumer is unlikely to once again come to the rescue of the US economy, there is legitimate reason to see light at the end of the tunnel. The shape of things to come?
Perhaps not a WUVL, but an unexpected increase in a rarely followed sector of the economy - exports, from an unexpected consumer group - emerging countries. The sky may actually not be falling, and those who predict a "new normal" of GDP growth in the 1% - 2% range, may have overlooked a piece of economic data that could increase their predictions from 33% - 50%, and even better, silence the WUVL's and those who join them in using letters to describe economics.
Pardon me for sounding like a dinosaur, but economics is made up of numbers - not letters.

Sunday, July 19, 2009

Health Care Legislation

In the current debate about health care, facts are few and opinions are many. Here are some facts that may help you form your own opinion.

What We're Spending Now

The US Department of Health and Human Services' Center for Disease Control, using data from the Organisation for Economic Co-operation and Development , notes spending on health goods and services plus health-care infrastructure as a percentage of Gross Domestic Product as follows:
  1. United States - 15.3%
  2. Switzerland - 11.3%
  3. France - 11%
  4. Germany - 10.6%
  5. Belgium - 10.3%
  6. Portugal - 10.2%
  7. Austria - 10.1%
  8. Canada - 10%
  9. Netherlands & Denmark - 9.5%
  10. Sweden - 9.2%


US health care costs have more than tripled in inflation-adjusted terms over the last 20 years to their current level of 15.3%.

What We'll Be Spending If We Do Nothing

Further, if current policies remain unchanged, that percentage will increase to 25% of GDP in 2025, and 49% in 2082.

Long Live the Rich, and the Poor Die Young

Yet, according to the NY Times, government research shows “large and growing” differences between the lifespan of Americans, based on their wealth. Admitting researchers in disagreement for reasons for this growing disparity, they do agree that a part of the explanation lies in whether an individual has health insurance.


Expand Access and Curb Costs - One Out of Two

The Administration 's main objectives stated earlier this year were:

  1. Expand access to health insurance, and
  2. Curb runaway costs for the economy has a whole.

Current House legislation being considered, however, "significantly expands the federal responsibility for health-care costs," says Douglas Elmendorf, director of the Congressional Budget Office. The Senate Finance Committe has not yet released their verion of the bill. As both versions of health care legislation advance, expanding coverage has been embraced while few compromises have been made with pharmaceutical companies where savings were to have been made.

Allegations that the CBO has not "credited" such proposals as "preventative care measures" have been asserted. Those assertions are correct. It is apparent that preventative care will result in lower long term health costs. It is inappropriate, however, to assign a dollar amount to that cost savings, as that amount would be impossible to quantify.

One more quantifiable compromise would be to reduce the federal tax subsidy that encourages employers to offer large health-insurance policies, but that proposal has been opposed by labor unions (that have these tax-advantaged plans).

Where We Are Now

Current legislation has not yet achieved the goal of cutting costs in a way that will prevent unsustainable increases in health spending. Special interests on one side - particularly labor unions - are at odds with

  • AMA (that wants increases in Medicare payments to doctors)
  • Insurance companies (that want to prevent a government-run competitor in the marketplace)

Whatever your opinion, it is time to contact your Congressional representatives. Achieving both access and cost containment is critically important in solving this problem. The link below is provided for your convenience in doing so.

Wednesday, July 15, 2009

A Look at the Deficit and the National Debt

If you ask the average person the difference between the deficit and the national debt, you're likely to get a blank stare. While you are much smarter than the average Josephine, we'll go over that anyway, just in case you were asleep during that session of your Econ class.

The Deficit

The deficit is the amount of money we're spending THIS YEAR that exceeds the amount we brought in. The national debt is the sum total of all the deficits we've had. From 1749, we've had a total of about $6.3 trillion dollars in deficit spending. When you add interest paid on borrowing to pay that debt, it climbs to about $9.5 trillion. Since 1900, we've had 31 years where our income exceeded our expenses The other 79 years have had deficit spending. This year, the projected deficit is $407 billion. Last year, it was $410 billion.

For those who are politicizing current spending, here's a little perspective
  • 1999 - $125 billion surplus (Clinton)

  • 2000 - $236 billion surplus (Clinton)

  • 2001 - $128 billion surplus (Bush)

  • 2002 - $157 billion deficit (Bush)

  • 2003 - $377 billion deficit (Bush)

  • 2004 - $412 billion deficit (Bush)

  • 2005 - $318 billion deficit (Bush)

  • 2006 - $248 billion deficit (Bush)

  • 2007 - $162 billion deficit (Bush)

  • 2008 - $410 billion deficit (Bush)

  • 2009 - $407 billion deficit - projected (Obama)

While it is admittedly very large, the deficit this year is currently projected to be less than the deficit last year.

So, now we're hearing many pundits, talking heads and others screaming about the size of the deficit. Some of those people are saying that we simply cannot afford to spend money on programs such as the stimulus, health care reform, etc. because of the size of the deficit. Without commenting one way or the other, one wonders where those were voices last year, when the deficit was $3 billion larger.

The National Debt

Our national debt is fast approaching $10 trillion dollars. For those not familiar with very big numbers, that's ten thousand billion. It looks like this - $10,000,000,000,000. No doubt about it. That's one big number.

Again, as a matter of perspective, here is the cumulative amount of the national debt for the last decade.

  • 1999 - $5.605 billion (Clinton)

  • 2000 - $5.628 billion (Clinton)

  • 2001 - $5.769 billion (Bush)

  • 2002 - $6.198 billion (Bush)

  • 2003 - $6.760 billion (Bush)

  • 2004 - $7.354 billion (Bush)

  • 2005 - $7.905 billion (Bush)

  • 2006 - $8.451 billion (Bush)

  • 2007 - $8.950 billion (Bush)

  • 2008 - $9.654 billion (Bush)

  • 2009 - 10.413 billion (projected) (Obama)


The national debt is projected to rise by 7.8% this year. That is the same percentage it rose between 2007 and 2008. Again, without commenting one way or the other, where was the outrage last year? Why is the 7.8% rise this year so much worse than the 7.8% rise last year?

How Much Do I Owe?

Those who express outrage regarding the national debt sometimes express the debt in terms of the amount that is owed by every man, woman and child in the US. Currently, that amount is nearly $34 thousand. Again, to gain some perspective, let's look at a couple of facts.

In 1960, the national debt was $290 billion and the population was 179.3 million. Every American owed about $1620 - $5432 in today's dollars.

In 1970, the national debt was $380.9 billion and the population was 203.3 million. Every American owed $1873 - $4908 in today's dollars (less than the prior decade).

In 1980, the national debt was $909 billion and the population was 248.7 million. Every American owed $3665 - $7479 in today's dollars.

In 1990, the national debt was $3.206 billion and the population was 248.7 million. Every American owed $12,879 - $20,589 in today's dollars. Big jump.

In 2000, the national debt was $5.629 billion and the population was 281.4 million. Every American owed $20,002 - $24,980 in today's dollars.

In 2009, the national debt is projected to be $10.413 billion and the population is 306.9 million. Every American owes about $34,000. Big jump again, but not as big as it was from the '80s to the '90s.

Population information was obtained from

Debt as a Percentage of Gross Domestic Product

Realistically, the national debt will never actually be paid to zero. We've had debt since 1900. The way to evaluate debt is as a percentage of GDP.

  • 1970 - 8.9%
  • 1980 - 15.6%
  • 1990 - 40%
  • 2000 - 50.7%
  • 2009 - 73%

That is what is making people nervous. Let's put this in terms we can all relate to. Say that you have a mortgage that is $3500 per month, and your after-tax income is $4795 per month. After paying your mortgage, you will have about $1300 for everything you need. You're spending 73% of your income on your debt. Scary.

We can all agree that we're in a lot of debt. But let's not pretend that it happened this year. This problem has been mounting for a long time, exacerbated in the 1980's and in the current decade.

As always, I welcome your comments and suggestions.

Tuesday, July 14, 2009

Unemployment - A Commentary

The previous article is one that provides data with respect to the current unemployment situation as compared with previous economic cycles and in previous Presidential administrations from Truman to date. This is my personal opinion about that data, and a response to criticisms regarding the adequacy of the stimulus program signed on February 17, 2009 to address the unemployment problem.

As stated previously, 10% of the stimulus money has been spent. Asking whether the program is successful at this point is analogous to asking whether your outfit is appropriate after having put on your panties. There is not sufficient information available to answer the question. If the administration is correct in its allegation that, by early August, 500,000 jobs will have been created or saved by the $75 billion spent thus far, job losses will be 2 million instead of 2.5 million. 10% of the stimulus will have improved job losses by 20%.

Some allege that the fact that the unemployment rate is at 9.5% shows that the stimulus program is a failure. Data show that to be false, based solely on the fact that unemployment rates are well within historical parameters of previous recessions. Further, in the recession ended November, 1982, unemployment averaged 9.8% for a full year after the recession ended. It is, as has been said by countless pundits, a lagging indicator.

Others say that stimulus money could have been put to better use by lowering business taxes. It is true that the US has on of the highest business tax in the world, second only to Japan. Those who hold this opinion feel that lowering business taxes would result in immediate hiring. History shows that opinion to be false.

In reviewing hiring behavior in prior recessions, data show that businesses rely upon increasing productivity of existing staff as the business cycle improves, delaying the necessity to add new staff until the cycle is well past recessionary levels. Consequently, it would be more likely that businesses would use tax savings for other purposes.

While the success of the stimulus package is certainly not a given at this point, those who suggest that there is sufficient data to opine that it is a failure are relying upon 10% of its expenditures and five months in order to draw this conclusion. Further, those who believe that the funds would better serve the unemployment situation with lowering business taxes are at odds with historic recessionary hiring trends.

Monday, July 13, 2009


The latest "doom and gloom" prediction is centered around the unemployment rate.

Misery Index

The Misery Index consists of adding the unemployment rate to the rate of inflation, or the percentage of those out of work plus the percetage by which prices are rising.

Historically, the misery index has been

  • Truman Administration (1948 - 1952) Average 7.88 (High 13.63, Low 3.45)

  • Eisenhower Administration (1953 - 1960) Average 6.26 (High 10.98, Low 2.97)

  • Kennedy Administration (1961 - 1962) Average 7.14 (High 8.38, Low 6.40)

  • Johnson Administration (1963 -1968) Average 6.77 (High 8.19, Low 5.70)

  • Nixon Administration (1969 - 1973) Average 10.57 (High 13.61, Low 7.80)

  • Ford Administration (1974 - 1976) Average 14.93 (High 19.90, Low 12.66)

  • Carter Administration (1977 - 1980) Average 20.27 (High 21.98, Low 12.60)

  • Reagan Administration (1981 - 1988) Average 11.19 (High 19.33, Low 7.70)

  • Bush I Administration (1989 - 1992) Average 9.68 (High 12.47, Low 9.64)

  • Clinton Administration (1993 - 2000) Average 8.80 (High 10.56, Low 5.74)

  • Bush II Administration (2001 - 2008) Average 8.10 (High 11.47, Low 5.71)

The time weighted average Misery Index since 1948 is 9.64. The current Misery Index is 9.8: Unemployment is 9.5, and Inflation is .3. To put this into perspective, we are now 1.6% higher than the average since 1948.

Unemployment Rate

Some economic theorists have used the unemployment rate to justify their opinion that

  • The stimulus package isn't working
  • There should be another stimulus package, i.e., the stimulus package wasn't sufficient

Let's take a look at that hypothesis.

Of the $787 billion dollar stimulus package, approximately $75 billion, or about 10%, has been paid out. The Obama administration estimates that the stimulus package will have helped create (or save) 500,000 jobs in the two hundred day period from signing the bill February 17 to early August. 10% of the stimulus package will therefore have improved the number jobs lost by 20%. In other words, without the stimulus package, the jobs lost in the two hundred days since the stimulus package was in effect would have been 2.5 million instead of 2 million.

The Obama administration believes the government will ultimately meet its spending targets, increasing spending toward the end of the year as states fund their projects. Ultimately, the measurement of success is whether the economy improves, and, as shown below, it may be too early to make that judgment.

To use consistent time measurements, since 1948 there have been eleven recessions. Let's look at each, and the accompanying rate of unemployment.

Nov. 1948 - October, 1949 (11 months) - Average unemployment rate 10.69%

July 1953 - May, 1954 (10 months) - Average unemployment rate 4.43%

Aug., 1957 - April, 1958 (8 months) - Average unemployment rate 5.69%

April, 1960 - Feb., 1961 (10 months) - Average unemployment rate 5.94%

Dec. 1969 - Nov.,1970 (11 months) - Average unemployment rate 4.88%

Nov. 1973 - Mar. 1975 (16 months) - Average unemployment rate 6.09%

Jan. 1980 - July 1980 (6 months) - Average unemployment rate 7.07%

Jul.,1981 - Nov. 1982 (16 months) - Average unemployment rate 9.09%

Jul, 1990 - Mar. 1991 (8 months) - Average unemployment rate 6.225%

Mar. 2001 - Nov. 2001 (8 months) - Average unemployment rate 4.813%

Dec. 2007 - Jun. 2009 (18 months) Average unemployment rate 6.76%

(Note: Data are not available for July. Most economists opine that the the third quarter 2009 will be flat, and fourth quarter will show a slight increase in GDP)

For comparison purposes, the two most severe recessions in the period under review were Nov. 1973 - Mar. 1975 and the current one. The last five months of those recessions averaged an unemployment rate of 7.72 and 8.88, respectively. The last five months of this recession was 15% worse than the 1973 - 1975 recession.

Further, the average unemployment rate in the last five months of the recession ended Nov, 1982 was 10.18%, and it averaged 9.8% for the year after that recession was over.

Our current numbers are well within historical precedents, and to assert that the stimulus program is ineffective at this point is not supported by data, obtained from the U.S. Bureau of Labor Statistics.

In our next discussion, we'll talk about the deficit to see whether the alarm expressed by some over its size is warranted.

Friday, July 10, 2009

President Obama's Financial Regulation Proposal - Part V

A smart businesswoman in the Portland area asked for a synopsis of this proposal, saying, "It seems like everywhere we read doom and gloom doom and gloom. I would like to read some kind of balanced piece for once." Thanks for the suggestion, Kelly. Parts I through IV of the proposal were discussed in the three previous posts. Here's the fourth, and final installment.

Raise International Regulatory Standards and Improve International Cooperation

As we discussed previously, without international cooperation, money will move to countries with the most lax regulation and continue the type of high risk/high reward behavior that caused our current crisis. A good example is Stanford Financial, which is under investigation for defrauding investors, where the Texas founder operated freely in the Caribbean. Last April, the G-20 issued a declaration which included:
  1. Strengthening the 1988 "Basel Accord" to include financial institution capital requirements that are consistent throughout the world
  2. Define "capital" consistently, i.e., what can and cannot be used to substitute for cash in meeting capital requirements
  3. Define how leveraged a financial institution may be
  4. Set accounting standards that are similar throughout the world.

To improve oversight, the G-20 is working on contracts, to be available this Fall, to standardize and centralize the clearing of derivatives, e.g., credit default swaps, options, etc., as well as strenthening the oversight of all goals stated in the declaration.

So, where's the "gloom and doom?"


The US is pushing for financial reforms to address problems that we caused. This weakens our negotiating position for countries that object to more stringent financial requirements, at a time when they are weakened because of buying our Auction Rate Securities and the like.

Some countries are telling us to clean up our mess before telling them what to do. It's hard not to see their point.

Overall, these proposals are strong, having defined the root causes of the problems we face and providing logical, if sometimes politically based, solutions. The weaknesses in the proposal seem to be outweighed by the strengths. To attack the weaknesses without providing a superior solution IS politically based, and to fail to address these problems will all but guarantee that they are repeated.

The full draft of these proposals can be found at I welcome your comments and discussion about any points in this proposal. And thanks, Kelly, for your suggestion to discuss this important issue.

Thursday, July 9, 2009

President Obama's Financial Regulation Proposal - Part IV

A smart businesswoman in the Portland area asked for a synopsis of this proposal, saying, "It seems like everywhere we read doom and gloom doom and gloom. I would like to read some kind of balanced piece for once." Thanks for the suggestion, Kelly. Parts I, II and III of the proposal were discussed in the two previous posts. Here's the third installment.

Creation of the Consumer Financial Protection Agency

The seven government agencies named in the prior post did not prevent or address financial problems adequately during the recent crisis. The administration has proposed the creation of the Consumer Financial Protection Agency as one solution. The creation of this agency was discussed in the prior post. In addition to this agency, the administration also seeks to create "resolution regime" for failing Bank Holding Companies and so-called "Tier 1" (too big to fail) Financial Holding Companies.

Resolution Regime

This "regime" will be led by the Treasury Department, and can act only after
  • consulting with the President, and
  • having obtained the approval of 2/3 of the Fed board, and 2/3 of the FDIC board (if the failing institution is a bank) or 2/3 of the SEC commissioners (if the failing institution is a brokerage firm)

This, with the previously discussed increased capital requirements for "too big to fail" financial institutions, is the solution proposed to avoid situations like those seen recently with AIG and Bear Stearns. Again, the Treasury is the "big boss" when institutions that are large enough to cause widespread financial harm are seen to have significant developing problems.

As the "big boss," the Treasury now must approve loans made by the Fed to such institutions.

Where's the doom and gloom?

MORE Power for the Treasury?

Many people, as discussed before, are uncomfortable with the Treasury Department in the position as the "regulator's regulator." Now, the Fed has to consult with Treasury prior to authorize lending practices related to "too big to fail" institutions.

In reality, the Treasury Secretary was consulted in every instance when action was recently taken by the Fed. This provision makes that practice mandatory.

More Power for the President?

The Treasury must consult with the President before initiating the resolution regime for failing institutions. Some worry that the President may take the initiative and pressure Treasury to take such action. Those who make such accusations fail, in my opinion, to consider that 2/3 of the Fed board and 2/3 of either the FDIC board or SEC commissioners must also approve taking such action. The checks and balances, in this case, seem to be in place to assure that the Executive Branch not have undue influence in making these decisions.

I look forward to your comments, and will address the final part of these proposals in the next post.

Tuesday, July 7, 2009

Obama Administration Financial Regulation Proposal - Part III

A smart businesswoman in the Portland area asked for a synopsis of this proposal, saying, "It seems like everywhere we read doom and gloom doom and gloom. I would like to read some kind of balanced piece for once." Thanks for the suggestion, Kelly. Parts I and II of the proposal were discussed in the previous post. Here's the second installment.

Protect Consumers and Investors

The Administration seeks to protect consumers against fraud and promote understanding of financial products, like credit cards, savings vehicles, mortgages, and the like. This goal is addressed through the creation of the CFPA (Consumer Financial Protection Agency), which is charged with the responsibility to ensure that consumer protection regulations are "written fairly and enforced vigorously." This new agency will have no jurisdiction over financial products governed by the Securities and Exchange Commission or the Federal Trade Commission, but both existing agencies will have new authorities and resources.

When non-traditional mortgage lenders entered the mortgage market after new mortgage securitization produces were developed by Wall St., the regulatory framework that protected consumers of banks and thrifts did not cover those new lenders. Countrywide Mortgage, for example, incented its sales staff to sell mortgage instruments that were not necessarily risk appropriate for borrowers. While other more traditional mortgage products were available, loan agents were encouraged by amount of incentive paid by product to sell Adjustable Rate Mortgages through "no-doc" (no, or low documentation required) programs that had high up-front fee structures.

And, with respect to credit card lending, certain "fine print" issues have arisen that clearly show that, if given the power to raise interest rates for situations unrelated to current repayment history (like applying for additional credit elsewhere), financial institutions can, and will, categorically raise expenses. In the past, this situation could have been rectified by the market, i.e., customers could merely close accounts with more onerous conditions and transfer them to institutions with more consumer friendly agreements. But, as credit lines froze, such alternative credit providers were unavailable.

The mission of this new Consumer Financial Protection Agency is to ensure that

  1. Consumers have the information they need to make responsible financial decisions

  2. Consumers are protected from abuse, unfairness, deception and discrimination

  3. Consumers' markets operate fairly and efficiently with ample room for sustainable growth and innovation

  4. Traditionally underserved consumer markets have access to lending, investment and financial services

The CFPA will be the "consumers' seat at the table" as regards the

  • Truth in Lending Act
  • Home Ownership and Equity Protection Act

  • Real Estate Settlement and Procedures Act

  • Community Reinvestment Act

  • Equal Credit Opportunity Act

  • Home Mortgage Disclosure Act

  • Fair Debt Collection Practices Act

All those Acts were in place during the mortgage crisis. The Administration proposes to solve the lack of understanding by consumers that played some part in this crisis by creating another agency and ensuring a "consumer voice," noting that its mission is to provide "a floor, not a ceiling." This means that the Agency will represent minimum and consistent standard


  • No more "mandatory arbitration clauses."

  • Requiring "plain English" disclosures.

  • Holding brokers to a "fiduciary" as opposed to "suitability" standard.

  • Holding companies responsible to clients, as well as investors.

  • Require "non-binding" shareholder votes for executive compensation.

  • Increase retirement savings incentives.

So where's the "doom and gloom" here, you ask? Well, it certainly isn't in the rhetoric.


I add my voice to this groan. Government agencies are expensive, unwieldy and, judging from the number which existed prior to the crisis, ineffective. The fact remains that, even with those seven agencies listed above, the housing crisis ensued.

I hesitate to unilaterally cry, "Poor little consumer" in every case. Many borrowers who KNEW they couldn't afford a $400,000 house with a $50,000 annual salary, bought one anyway. I cringe at the thought that the we as consumers are too stupid to make up our own minds. Then, I look at my credit card statement, and pause. It's ridiculous. It's incomprehensible.

So, what's the answer? The fact is, it doesn't matter. The consumer has screamed to the top of Congress that every Tom Dick and Harry financial whatever has received a squillion dollar bail-out, and she the individual is left to mind her finances properly and pay her bills on time with no help. Consumer protection is going to be written in this proposal as a political reality.

It is my hope that we don't over-correct. It is my hope that we do not swing to the extreme of the so-called "nanny state," and attempt to hold everyone's hand, make doing business more costly, and become non-competitive in world financial markets. But, reality is reality and consumer protection is the current political reality.

As a matter of full disclosure, I come from the financial industry. As a matter of fuller disclosure, I spent years in "Regulatory Compliance," which was charged with the responsibility of taking recently promulgated regulation and integrating it into daily operations. I admit to reading regulations and thinking, "Have the persons who wrote this EVER been in an actual business?" I admit to seeing the regulatory pendulum swing wildly back and forth, and hating the tendency to over-regulate after a crisis. I predict that this legislation will be analogous to affirmative action, where administrations will use it as a political symbol as "pro-consumer" and "pro-business" stands that will result in its being more or less consumer friendly. It will undoubtedly, however, be expensive. Read on.

It Will Make Financial Institutions Less Profitable

Absolutely right. Between the increase in capital and liquidity requirements discussed in the prior post and the increase in regulation that will require new forms, new procedures, new training, etc., etc., banks will definitely be less profitable. And, since one of the stated goals of this new agency is to give access to traditionally underserved markets, i.e., the poor, non-English speaking residents, etc., the expenses inherent in this proposal will likely result in higher fees paid by the rest of us. Speaking for myself, I will pay higher fees in order that the most vulnerable of us not be subjected to the usurious rates charged by "payday loan" and "rent to own" firms, but I am speaking only for myself. Banking is going to cost more, just as health care will cost more as we insure the uninsured. This is a social, as opposed to business issue. If you think that the poor should not have access to basic financial services, this is not the time to voice your opinion. You're not in the majority

Non-Binding Executive Compensaton Shareholder Votes

Non-binding means that you are not bound by what I say. Non-binding votes by shareholders about executive compensation is a paper tiger. By this, the Administration seeks to let shareholders tell executives that they think they're getting paid too much, but stops before giving them any power to do anything about it. In some ways, I like this, as "capping compensation" is basically wage controls, and anyone who lived through the 1970's will tell you how well that worked out. Also, imagine the press you'll get if you're one of those executives. The 24-hour business channels will be all over you, forcing you to justify your compensation, and making you say why you should have your job. It's an interesting solution. I'm on the fence on this aspect of the proposal, but think public outcry a far superior recommendation than salary caps. We shall see.

That said, this part of the financial proposal has some potential land mines, and I'll be watching it very closely. Hopefully, we won't over regulate and make a bad situation worse.

Obama Administration Financial Regulation Proposal - Parts I & II

A smart businesswoman in the Portland area asked for a synopsis of this proposal, saying, "It seems like everywhere we read doom and gloom doom and gloom. I would like to read some kind of balanced piece for once." Thanks for the suggestion, Kelly.

Since there are five key objectives in this proposal (which is 87 pages long), I'll do this in a series that will include
  • Supervision and Regulation of Financial Firms
  • Regulation of Financial Markets
  • Consumer and Investor Protection
  • Government Tools to Meet Objectives
  • International Standards and Regulation.

We'll start with the first two - Supervision and Regulation of Financial Firms and Regulation of Financial Markets. Please feel free to comment on this, and all subsequent articles.

Supervision and Regulation of Financial Firms

To fix a problem, it must first be properly defined. The proposal notes that leverage, or borrowing, by consumers and financial institutions alike, expanded dramatically during the housing bubble. This is an inarguable fact. People were borrowing more and more money against houses with prices that were rising at an unsustainable pace. Lenders were lending more and more money against these (and other) assets, with declining lending standards. Neither consumers nor lenders were prepared for the inevitable fall in prices. The root problem, however, was that no regulatory body had sufficient jurisdiction (or power) to address these problems.

The specific problems were:

  • Capital and liquidity standards were too low
  • The widespread effect that financial institutions would have on the entire financial system if they failed
  • Splintered, fragmented regulatory bodies, none of which had responsibility or authority for the overall system
  • Insufficient oversight for investment bankers (brokerage firms)

Capital standards are the required amount of money that must be put aside, and are based on assets. At its worst, some investment banks were leveraged 47:1. That means for every $47 dollars it had in loans, swaps, etc., it had $1 in actual cash. In other words, that would be like putting $8500 down on a $400,000 house, and thinking you had a sufficient down payment.

The second issue is"too big to fail," which basically means that, if that particular financial institution failed, it would severely damage the entire financial system. This type of systemic risk was present in AIG, a mammoth insurance company. Because of the number of credit default swaps (unregulated inter-financial institution agreements to cover loan amounts, if the borrower defaulted) and other risks assumed by the company, had the government allowed it to fail, the result would likely be catastrophic for, not only the US, but the world-wide financial markets.

Regulatory oversight for financial institutions was very like the issue that arose after 9/11, when the CIA, FBI and local law enforcement agencies in total may have had the intelligence to prevent the attacks, but had no inter-communication, and in some cases competing and proprietary interests. Insurance companies are state regulated, and every state is different. Banks are regulated by the either the Comptroller of the Currency or FDIC and the Federal Reserve Bank, thrifts, by the OTC, and investment bankers, by the SEC. There's no coordination. So, when investment bankers went into the mortgage business, the OTC had no jurisdiction.

And, speaking of the investment bankers, they were convinced that, since the overall housing market hadn't fallen for 50 years, it followed that a geographically diverse portfolio of mortgages would be safe no matter how little the down payment, whether income was verified, etc., etc. After all, an overall rising market would protect investors. They even convinced the rating agencies that reviewed their portfolios that they were right. The fact that this business needs more oversight could not be more apparent in hindsight.

So, the Administration proposes seeks to put the Treasury Department in charge. They'll be the "big boss" over all the other agencies, and have the authority to stop these problems before they become systemic. A Financial Oversight Council, consisting of the heads of supervisory agencies, will be established to identify such risks before the problems become too large, and agencies will be consolidated in order that responsibilities not overlap or compete, with the Fed responsible for implementing more stringent standards for the operation of these companies.

All financial institutions will have more stringent capital requirements and executive compensation standards. Capital requirements for reserves covering potential loan losses will be set by both accounting standards boards and the SEC.

Regulation of Financial Markets

The problem having been defined, the Administration seeks to address these issues through the following regulatory reforms.

  • Strengthening of "firewalls" between banks and their affiliates to curtail conflicts of interest
  • Closing loopholes in bank regulation (to prevent financial institutions from changing their charter from one type of bank to another to enable certain practices)
  • Eliminating the thrift (the old "savings and loan") charter and unifying those institutions under the supervision of commercial banks
  • Hedge funds will no longer be unregulated
  • Insurance companies will be regulated on the federal, instead of state level
  • The future of Federal "agencies" (Like Fannie Mae and Freddie Mac) will be considered
  • Regulating "over-the-counter" instruments, like credit default swaps, derivatives and commodities
  • Strengthen regulation of securitization markets (like "asset backed securities" that consist of mortgages)
  • Tie compensation with long term performance
  • Provide means to eliminate conflict of interest by the Rating Agencies

That's a synopsis of the proposals. So, where is the "doom and gloom?"

Too Powerful Treasury

First, many people feel that this proposal gives the Treasury too much power. I agree that the "regulator's regulator" is a powerful position. But, I have heard no one provide an alternative. In reading this objection by many authors, I have noticed a common thread. Generally, the objectors seemed more concerned about the current Treasury Secretary than the fact that Treasury is the agency in charge. After all, what is the alternative? The Fed? Another agency? I agree that, as with all complex issues, often the key players are more important than the structure in which they operate. But, that argument is fallacious in criticizing the structure.

Reinstate Glass-Steagall

Many feel that strengthening firewalls between banks and their affiliates is an inadequate solution, and want the Glass-Steagall Act, repealed under the Clinton Administration, to be reinstated. While that may or may not be a valid point, the fact is that those who recommend this action do not say how it will be accomplished. Since most investment bankers now operate under a commercial bank charter, would you require that the banks divest themselves of the investment banking portion of their operation? This would require a new board of directors, management team, central operation, etc. Who would pay for the additional expense this would require?

Government Has No Business in the Compensation Business

Many object to "capping" executive pay. I am one of these people. However, close reading of the proposals does no such thing. It ties compensation with long term, as compared with short term objectives. While I concur that this will be difficult, allow me a bit of pontificating. Short term financial goals can be achieved by taking action that is not necessarily in the best long term interests of a company.

As an example, lax underwriting standards for mortgages may allow people who really can't afford a home to qualify to buy one. When one significantly increases the demand for something, many more people are bidding on that thing, and the price goes up. That is called demand-push, and that pushes up prices. At some point, demand will level off. During the "push" prices - and profits - increase. If "everybody's doing it," and you are the company that is NOT, your profits are lower, and your stock is less valuable. However, your decision not to participate (if you survived), was in the long term interests of your company, your stockholders and the economy.

It's not going to be easy to change the short term profit motive, but it's worth a try.

Banks, Especially Multi-National Banks, Will Be Less Profitable

With stricter capitalization requirements, this is undoubtedly true. After all, if you're putting more money aside to cover potential problems, that money will not be earning what it would if it were invested. But, the profitability that was derived from participation in the unsustainable rise in housing prices cannot be considered "the norm." To compare properly regulated bank profits with those derived during the housing bubble is inappropriate when considering that the goal is long term sustainablility as compared with short term profitability.

These are the major objections I've seen raised and what I believe to be an appropriate response. Feel free, as mentioned before, to comment, and I'll do my best to answer.