Rep. Ackerman Tees Off On The SEC

Last week's congressional hearing on the Madoff scandal made for great theater. Harry Markopolos is the guy who tipped off the SEC 9 years ago (and a number of times subsequently) about the strong likelihood that Madoff was a fraud. His testimony was jaw-dropping. I hadn't realized just how detailed his evidence had been or how persistent he had been in making his case. I particularly loved how he stressed that it took mere minutes to figure out that something was amiss with Madoff and his purported performance. Harry also did a wonderful job of pointing out the amazing breadth and depth of ineptitude at the SEC. I'd encourage you to watch a recording of his testimony.

In the clip below, Representative Ackerman takes a nice swing at the sacrificial SEC lambs who drew the short straw and had to attend the hearing. As I pointed out when this scandal first broke, the ironic ultimate outcome of this incredible failing at the SEC will most likely be a significant boost in the SEC's budget. Nothing warrants increased government funding more than colossal failure!





Link to Video

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The Market Rubbernecker is affiliated with Aspera Financial, LLC, a registered investment advisor. Please read the disclaimer on the home page of the Market Rubbernecker site.

Time to Foreclose on Hillary's Housing Plan

Since this post is somewhat politically-related, I need to stress the following upfront:

• I have always been registered as an independent.
• I find both parties equally nauseating, ignorant, and polluted (but not in a scary Unabomber kind of way).
• I don't believe any of the three remaining Presidential candidates have a clue when it comes to economic policy.
• I tend to mumble a bit and spasm when I watch the debates.
  

With that out of the way I wanted to touch on Hillary's comment about the housing situation during last night's debate. She said,

I want to see us actually tackle the housing crisis, something I've been talking about for over a year. If I had been president a year ago, I believe we would have begun to avoid some of the worst of the mortgage and credit crisis, because we would have started much earlier than we have -- in fact, I don't think we've really done very much at all yet -- in dealing with a way of freezing home foreclosures, of freezing interest rates, getting money into communities to be able to withstand the problems that are caused by foreclosures.

To say that you would have prevented the largest housing and credit bubble we've ever seen from collapsing is the height of arrogance. She doesn't say that she would have prevented the bubble itself from happening. This thing was already uber-inflated a year ago when she claims to have started talking about it. So, though she wouldn't/couldn't have prevented the bubble she believes she could have prevented its deflation. I suppose she believes she could have prevented the tech bubble from bursting and Dutch tulips from collapsing.

Trying to prevent a bubble from popping is a terrible idea. Bubbles are not healthy for the economy in the long-term as they lead to gross mis-allocations of capital. In the case of housing, far more money was thrown at housing and mortgages than warranted by economic fundamentals. A bubble is not a state of equilibrium - that's what makes it a bubble. The quicker the bubble is popped, the quicker we return to sound economics. Trying to prop up a bubble only introduces further moral hazard and prolongs the ultimate damage.

Looking at her specific proposals, she first mentions freezing foreclosures. Keeping people in houses they can't afford serves no one. Many of these people were never qualified to be homeowners in the first place. Furthermore, the ability to foreclose is one of the reasons lenders are willing to make loans in the first place. Freezing foreclosures certainly isn't going to make more money available for mortgages. Think about what you would do if you were lending your money and all of a sudden the rules are changed so that the government, at its whim, can prevent foreclosures. Would you be as willing to lend? If you were still willing to lend, wouldn't you want to charge a higher interest rate? Wouldn't you severely tighten your lending standards so that you were only lending to those with the best credit and finances? Wouldn't you require a larger down payment? Hillary (and all politicians) love to talk about making homeownership affordable for more people, but this policy would do exactly the opposite.

How about freezing interest rates? Same thing. Imagine you're a lender and all of a sudden the government can come in and freeze the rates you charge people. You've logically been charging riskier people higher interest rates, but now the government steps in and doesn't allow those rates to adjust up (think ARMs). You might be less willing to make ARM loans. Either way, you've just had a big new risk introduced. Might you want to increase the interest rates you charge to compensate for this new risk?

Next, she mentions "getting money into communities". That's fairly vague, but it certainly entails spending tax-payer money to support a bubble. The government needs to get out of the way and let housing prices fall to market clearing levels. Housing prices in many communities never should have climbed as high as they did - virtually everyone agrees with this. So why must the politicians try so hard to keep them from falling? (that's a rhetorical question)

A Fed Chairman Worth Listening To

I don't agree with all of his views, but Paul Volcker is the best Federal Reserve Chairman this country has seen. He understood the role of the Fed, the importance of its independence, and he wasn't afraid to administer some much needed but politically unpopular medicine to this country as Chairman of the Fed from 1979 to 1987. Greenspan and Bernanke look like confused, spineless, political, patsies next to this guy. He's always worth a listen. The following is his April 8th speech to the Economic Club of New York:

Bloomberg Video of Volcker speech

Chocolate and Beer - Part 2

To recap Part 1, financial regulation failed miserably to recognize or prevent the current credit crisis and actually played an integral role in creating and fostering the credit bubble. Most politicians, regulators, and pundits are using this failure as an excuse to expand that which just failed - regulation. Unfortunately, our policymakers are far too busy trying to look “responsible” and “proactive” to actually expend any effort examining the role the regulators themselves played in creating the current debacle or questioning whether less regulation may actually be the better policy. I’m accustomed to being on the unpopular side of many arguments, and this one is no different.

I’ve been reading quite a bit lately from all corners that the current credit crisis is proof of the failure of free market economics. This is laughable since we’ve hardly been operating in a free market system. When it comes to the financial markets, we have many organizations involved in the regulation and manipulation of our markets, our financial institutions, our money supply, our interest rates, etc. Despite all of this, we are facing the largest financial crisis since the Great Depression. It’s important to understand that regulation has been prevalent and growing for many decades. Yet, here we are.

Then how may things have transpired in a truly free market? Most importantly, moral hazard would not be an issue if the free market had been in operation. Basically, moral hazard means that people will be less cautious if they know they’ll be bailed out. Bailing out is exactly what the Fed under Greenspan did repeatedly, and it’s exactly what the Fed under Bernanke is doing currently. It’s also what the federal government does when it passes legislation to bail out certain constituents. Financial actors aren’t stupid. Greedy? Yes. Stupid? No. They’ve realized for some time now that the Fed and government were effectively putting a floor under the financial markets (LTCM, Asian currency crisis, tech bubble). The Fed repeatedly demonstrated that it was willing to aggressively intervene during relatively modest financial dislocations. In such a world, the obvious course of action is to lever up as much as possible and swing for the fences. Heads you win, tails you don’t lose.

In a free market, the issue of moral hazard disappears because no one gets bailed out. There is no Federal Reserve, or Treasury or Congress standing ready to lower rates, print money, and use taxpayer dollars to “rescue” the imprudent. The losers fail. They go away. Long-Term Capital Management would not have been bailed out. The Fed would not have guaranteed $30 billion of questionable Bear Stearns assets. The strong prosper. The weak fail. A strong signal is sent to all market participants that there is a significant and definable downside to taking too much risk. This signaling has unfortunately been overridden by the regulators/politicians in our increasingly quasi-capitalistic system of democratic socialism.

It’s important to recognize that government and regulatory intervention in our markets has led to ever larger bubbles, misallocations of capital, and financial dislocations. Without the Fed manipulating interest rates and the money supply, ever-larger serial bubbles would not have been blown, the money supply would not have been so grossly inflated, inflation would be less of a threat (by definition), and the dollar wouldn’t be nearly so weak. We can recognize all of this, but we can’t go back and undo what’s already occurred. Given that fact and given the crisis we’re currently in, what might we expect from a free market from this point forward if regulation were magically eliminated today? The following are just a few reasonable realistic possibilities:

• Development of better risk models and more focus on risk management
• More aversion to and higher risk premia for complicated security structures
• Increased competition in the credit-rating market resulting ultimately in better analysis and modeling
• Insolvent financial institutions would be allowed to fail
• Increased financial statement disclosure
• More accountability for evaluating risk at all levels of distribution
• Credit-rating agencies being compensated by investors rather than by the companies they rate
• A strong call for financial institutions to increase their capital position
• A continuing trend of deleveraging
• Mortgage originators retaining more security exposure to better ensure adequate underwriting standards
• Opportunists taking advantage of illiquid markets to buy securities at deep discounts to their intrinsic value
• Unwinding of and more sensitivity to counterparty arrangements
• Development of more standardized derivative contracts and clearing arrangements
• A better and more symmetrical alignment of executive compensation with longer-term shareholder goals
• More critical analysis of credit insurer strength
• Clearer and more robust mortgage terms disclosure
• Fewer no-doc or low-doc mortgages and/or higher spreads on them
• Less opaque securitizations

All of these things would be healthy for the market and would lead to a strengthening of our financial system. Some variation of many of these suggestions as well as others can be expected to occur over the next 5 years without any government intervention simply due to the demands of various financial market constituents. None of this requires government intervention.

Now let’s look at just a few examples of free market success so far in this current crisis. First is the entry of Warren Buffett into the municipal bond insurance business. This is exactly what we’d expect to see - a strong player with extensive capital and an excellent reputation entering a failed industry that didn’t adequately price its insurance or assess its risk. Other individuals and firms are also exploring entering this market. Should we use taxpayer dollars to support the incumbents (for example, MBIA, SCA, and ABK) to the detriment of the newer and stronger players? No. The free market is filling the void and will be doing so with better risk modeling and a stronger capital position.

When asset prices finally start to adequately price in risk, liquidity tends to surface. For example, on April 1 Blackstone Group LP raised a record $10.9 billion to invest in property. It was also recently reported that another opportunity fund, Dallas-based Lone Star Funds, is raising up to $10 billion to invest in real estate. Lone Star managing partner John Grayken recently told the Oregon Investment Council, ``This is as good a distressed environment as we've seen in a long time. It's a race among a number of different lenders to play this.'' This week, we also learned that Citigroup is close to unloading $12 billion of bad loans to a group of private-equity firms at 90 cents on the dollar.

There are many other examples of capital being raised. UBS recently raised another $15 billion. Lehman raised $4 billion. Washington Mutual is raising $7 billion. Sovereign Wealth Funds (SWFs) have tossed about another $70 billion into investment banks over the past year. The point is that when prices fall enough to adequately (or more than adequately) discount the risk, private funding is made available. Capitalism does work (when allowed). The quicker this process unfolds the better for the financial system and the economy. The bailout efforts by the Fed and the government are simply dragging out this price-discovery process and delaying the eventual economic recovery. Of course, others could argue that this money is only forthcoming now because of the steps that the Fed has already taken. My contention, however, is that Fed actions have been hindering and delaying the price-discovery process, keeping asset prices higher than warranted, and therefore keeping further private funding from entering the market and prolonging the correction. Granted, it's impossible to know which view is correct since we can't rewind and play it twice.

We don’t need the government to “bail out” the market, but we’re going to get it, so let’s be clear about what a government bailout means. It means the government is stealing. They’re stealing from those who were prudent – those who bought a house and selected a mortgage that they could afford, those who have been living beneath or within their means, and those who decided to save versus play. The government is using these stolen funds to support/bailout/rescue/benefit/enrich those who speculated on rising home prices, those who gambled on always being able to refinance at low rates, those who took on too much debt, those who have lived beyond their means, and the millionaires running our financial institutions. If you’re in the former group, you should be irate. The government won’t be sending you a bill directly, but they will be increasing their borrowing and increasing the money supply during this bailout. You will suffer the depreciation of your dollar assets and higher inflation as a result.

What would I like to see the Fed/government do? Put their hands back in their own pockets, get out of the way, and sit down with a nice big cup of coffee and a copy of the Constitution (to be read – not to be used as a coaster). Let the market do its job - liquidate the bad debt and the imbalances that have occurred and eliminate the ubiquity of moral hazard. It’s healthy, and it’s in the long-term best interests of our country.

If only the government could bail out common sense.

Chocolate and Beer - Part 1

I admit it. The title is a little misleading. I’m actually going to discuss financial market regulation, but I wanted you to at least get past the title. Regulation is the dentist office of the financial world – nobody really wants to go there. In the mid-90’s, I was an MBA student at the University of Chicago. They have a bidding system for classes, and I was saving a bunch of points to bid on Merton Miller’s class. He was a Nobel Prize winner, and he only taught one class each year, so I was sure the class would cost me. The topic of the class was financial regulation, but he was a Nobel Prize winner! Amazingly, the class didn’t cost me a point since the class didn’t fill up – only about 20 of us signed up. So, I know that this isn’t the most exciting topic. If a Nobel Prize winner can’t fill a small class, I realize I probably lost most of you by the second sentence. No matter. I’ll soldier on if for no other reason than to spare my wife.

The chatter about the failure of the free market and capitalism has been steadily increasing as has the call for increased financial market regulation. This is hardly surprising given the news of the past six months: credit markets seizing up, rising foreclosure rates, the failure of the rating agencies, the collapse of Bear Stearns and a number of hedge funds, mortgage origination and appraisal improprieties, tumult in the “safe” muni market, etc. Furthermore, it’s an election year and you’d better show leadership and be full of ideas if you’re running for President. Time to put the baby down and draft some legislation.

So it’s no surprise that the call for increased regulation is on the rise, but I find it a bit ironic. The current credit bubble was caused, in some part, by regulation itself. Let’s start with the Federal Reserve, arguably the most prominent regulator of the financial system. Under Greenspan, the Fed rarely hesitated to cut rates in an attempt to forestall any whiff of a slowdown or financial dislocation. This came to be known as the Greenspan Put. Greenspan repeatedly and effectively placed a floor under the markets by lowering interest rates and increasing the money supply at any hint of instability (think Long-Term Capital Management and the tech bubble collapse). This encouraged risky behavior. The thinking was straightforward. If you take a big risk and you’re right, you win. If you take a big risk and you’re wrong, the Fed bails you out. It didn’t take long for folks to figure out that it paid to take risk. The Fed was distorting the real relationship between risk and reward and causing an ever greater misallocation of resources as normal market signals were subverted. This encouraged an increasing amount of risk to be taken with each cycle of easing. The low interest rates and increased money supply ultimately found its way to the housing market, resulting in the biggest housing (and credit) bubble we’ve ever seen. I’m not saying the Fed is singularly responsible for causing the bubble, but it did play an important part.

Another example of the role that regulatory interference has played in our current crisis is the effective oligopoly that the SEC (a regulator) has given to a handful of credit-rating agencies. These credit-rating agencies essentially faced no competition, and they made their money by charging fees to the very companies they were rating – an obvious conflict of interest. It’s not exactly clear to me why the SEC should even be involved in controlling the entry of new competitors. Had a free market allowed for the entry of new competitors we would have been much more likely to have seen some evolution in the relationship and incentive structure between the credit agencies, the firms they evaluate, and the investors who ultimately purchase the securities. We would also have been more likely to have seen some evolution in the risk models that somehow managed to bestow AAA ratings upon the Frankensteinian brew of mortgage-crapped securities known as collateralized debt obligations (CDOs). Eventually, people will learn that 1+1 does not equal 3. Let’s not forget that these are the same rating agencies that also managed to miss the fact that Enron, Worldcom, and Adelphia were frauds. So our regulators protected a few credit-rating firms (which had just recently shown their tremendous failings a few years prior) from contending with new competition. We need more of that?

Don’t forget about Fannie Mae and Freddie Mac. As the nation’s primary buyers and guarantors of mortgages, they had a front row seat to the excesses in the real estate market. Importantly, these two quasi-governmental agencies are highly regulated by the Office of Federal Housing Enterprise Oversight (OFHEO). According to their website, OFHEO’s mission is to “promote housing and a strong national housing finance system by ensuring the safety and soundness of Fannie Mae and Freddie Mac. OFHEO works to ensure the capital adequacy and financial safety and soundness of two housing government-sponsored enterprises (GSEs)…” Wow. Ensuring the safety and soundness? Ensure capital adequacy? In light of Freddie and Fannie’s deteriorating balance sheet and capital position, OFHEO hasn't been terribly effective. We need more of this?

Let’s not kid ourselves. There was plenty of regulation before this latest crisis. Yes, it’s true that the financial institutions were employing strategies and creating securities to move assets off-balance sheet and out of the purview of the regulators, but everyone knew that they were doing this – including the regulators. Where were all the warnings from the regulators about this? Where were the warnings from the regulators about the markets/firms/securities they did oversee? The fact is that all parties, including the regulators, knew what was going on, but everyone chose to ignore it since it seemed to be working. When it comes to derivatives, Greenspan himself had said "these instruments enhance the ability to differentiate risk and allocate it to those investors most able and willing to take it." So, seriously, had the regulators been in charge of regulating even these non-regulated instruments would anything have played out differently? The Chief Regulator himself was a fan!

The objective of this article is simply to look at just a few examples of the role the regulators have played in the current crisis. My main point is that we had plenty of regulation already, and it failed. Depending on how you look at it, it appears the regulators were either asleep at the switch, accomplices, or negligent. They failed to forestall the current crisis, and, in fact, pursued polices that (at a minimum) exacerbated it. Despite this, we’re hearing calls for more regulation. We’re hearing that existing regulation failed because there wasn’t enough of it, and it wasn’t structured properly, and it didn’t have enough bite. Do we really think that more government bureaucrats are the answer? It might help the faltering national employment figures, but is it really the solution? Don’t these folks get something like 150 days off a year? No wonder they’ve been so ineffective.

We’re also hearing that the free market failed. The fact is that we were never operating in a free market in the first place. A truly free market isn’t encumbered by all of these regulations. A truly free market doesn’t have an elite body of 12 setting short-term interest rates. A truly free market doesn’t use taxpayer dollars to bail out banks which made bad bets or homeowners who took on more of a mortgage than they could handle. A truly free market doesn’t struggle with the issue of moral hazard because it lets the losers fail. I know this may sound crazy given the current fear and fervor in the markets and political arena, but here’s my prescription – less regulation and more accountability. I’ll follow up on this in Part 2.