Unintended consequences, volume 1

President Obama announced today that the government will restrict compensation at firms receiving government bailout funds to $500,000 a year. It intelligently allows exceptions for the granting of restricted stock that could not be sold until government funds are repaid. However, it faces it's share of unintended consequences.

First, it could very well force out key talent. To cite but one example, a trader that made $10M in profits for a bank last year could decide that they would rather work at a hedge fund, where the fund could pay substantially more. The trader's bank would lose out on that $10M in profits at a time when they desperately need to find ways to generate profits. Another line of reasoning is this: many of these banks executives are worth millions of dollars. For $500K a year, many could decide they are better off retiring than dealing with grueling 15 hour work days, incredible stress, and now, reduced pay.

Second, it could incentivize banks to pay back government funds quickly. The government would like to be paid back, but at the moment they would rather have the bank lend out those funds to get credit working again. Already Goldman Sachs has indicated it intends to pay back TARP funds rapidly. Wells Fargo has been one of few big banks loaning out money, but with restrictions imposed, it might decide it is better off paying back the government than issuing new loans. By paying back those funds, they reduce their ability to make loans dramatically, prolonging the credit crisis that TARP aimed to fix.

Third, this makes the already dubious policy of forcing government funds on banks even more suspect. The Wall Street Journal reported that Wells Fargo did not want bailout funds, and was essentially required to accept them. While the dilution was bad enough, the additional restrictions Obama is now imposing restrict the compensation of the banking executives that got it right by making smart, prudent loans. While the Obama administration has indicated the condition can be waived under certain circumstances, the fact that Wells Fargo - a successful bank that can help the U.S. emerge from the crisis - is encumbered by government regulation at all demonstrates how seemingly sensible legislation can slow the recovery.

Should this proposal be scrapped in its entirety? Probably not. But the government would be better suited to splitting funds into two types: a solvency bailout complete with restrictions and a lending fund with few restrictions. The solvency funds would be available to firms as a last resort to catastrophic banktrupcy, and could carry heavy restrictions and punitive interest rates/equity ownership stakes. AIG, Citigroup, GM, Chrysler, and other seriously impaired businesses would be the recipients of these funds. These funds would not be designed to spur new lending, but instead would be targeted to preventing the collapse of key institutions. Simply knowing the these funds exist for the purpose of recapitalizing insolvent financial institutions would alleviate some market uncertainty and would help restore lending.

The second type would be to explicitly encourage lending, and would have one simple restriction: net loans outstanding must increase by 90%* of the capital provided to the bank by the next quarter. The interest rate would be low, and the term long. The government loan would have to be double-guaranteed, collateralized by the new assets the bank acquires AND guaranteed by the parent bank's equity. Otherwise healthy institutions - like Wells Fargo - could access these funds voluntarily, and the incentive to obtain long-term, low cost financing that could be used to facilitate profitable lending operations would create strong incentives to take advantage of this program. Yes, this program would be providing a subsidy to healthy banks, but the benefits of restarting lending operations would make the money well spent. Not only would this remove restrictions from banks that should have never faced them, it would jump-start lending and provide specific accountability for some proportion of the TARP funds.

*Or whatever percentage is appropriate given the banks typical loan loss reserve ratio. A second restriction would be that recipients of bailout funds could not recieve the lending funds.

Obamanomics arrives: policy priorities for the new President

President Barack Obama faces a long economic "to-do" list in his first term. The first 100 days must focus on stabilizing the economy by fixing the financial sector and passing a well-crafted stimulus bill. These policies will set the tone for the longer-term reforms required to address budget deficits, regulatory reform, and waning U.S. competitiveness.

President Barack Obama faces a long economic "to-do" list in his first term. The first 100 days must focus on stabilizing the economy by fixing the financial sector and passing a well-crafted stimulus bill. These policies will set the tone for the longer-term reforms required to address budget deficits, regulatory reform, and waning U.S. competitiveness.

1. Fix the Banks
Obama must first fix the nation's banks if he hopes to fix the American economy. Wall Street is directly linked to Main Street: businesses unable to obtain credit cannot make payroll, service debts, or invest in new job creation. President Obama must recapitalize the banking sector, clearly articulating principles for when and how the government would intervene. Bailouts should be used only when market-failure could trigger a contagious downward spiral, and should be structured to prioritize limiting economic damage first, safeguarding taxpayer investments second and minimizing inefficiencies and distortions third. With this commitment to stability and Federal Reserve liquidity flooding into banks, lending and job creation will return as the economy stabilizes. Public opposition to the first bank bailout program may make President Obama hesitant to act, but failing to do so is a recipe for failure.

2. Craft a smart stimulus bill
If the President's first economic challenge is courage in the face of opposition, the second will be to seize the opportunity - and avoid the pitfalls - that his stimulus plan presents. How the $825 billion of proposed funds are spent - on tax cuts, transfer payments, local government grants, or investments - must balance boosting employment with investing in future growth prospects, while easing the burden on those most impacted by the recession. Numerous interest groups, some of which expect payback for votes delivered in November, will seek to push their constituents' interests over these national priorities. Succumbing to these interests or trying to make the recession painless is the fastest way to ensure that government inefficiency and the rejection of free markets stain Obamanomics with the mark of failure. The President proposed significant accountability to minimize these failures in implementing the policy but first must determine the optimal mix of tax cuts, transfers, grants and spending.

Taxes
Tax cuts that incentivize investments in future GDP growth deliver tremendous value. They act quickly, align the nation for the future, and prioritize free-market efficiency. Obama's earned income, college tuition, and first-time homebuyer credits for individuals and his business tax credits all meet these criteria. These should be retained and expanded. Conversely, Obama's plan to provide lump-sum tax cuts unrelated to GDP boosting investments - similar in nature to the failed 2008 rebate check strategy - is $140 billion better used to bolster government investments in infrastructure and education.

Spending
The $550 billion of spending outlined by President Obama includes transfer payments, grants to local governments, and investments. Transfer payments (largely extended unemployment insurance, food stamps, and college aid exceeding $100 billion) provide an immediate boost to growth and a cushion to those most impacted by the recession. Obama should extend these transfers, but must ensure that individuals have a clear path back to fruitful employment by creating jobs and providing education and job retraining programs.

The $200-plus billion in grants to local governments to maintain healthcare, education, and public safety service levels shield governments from recession much as transfers shield individuals. These grants advance worthy goals, but they allow government officials to avoid reducing costs or increasing efficiency as recessions normally force officials to do. Obama should only deliver grants to local governments that are willing to improve efficiency and cut costs before turning to grant money.

The remaining $200-plus billion is allocated to a laundry list of investment projects. Projects should be reprioritized using an investor's mindset, calculating the amount and timing of future benefits produced relative to the cost of the project. High return-on-investment projects should be prioritized, whether the return comes as GDP growth, better healthcare outcomes, or a cleaner environment.

Implementing this approach will require political courage, for some projects may be politically unpopular. To cite but one example, the plan devotes $650 million to subsidizing TV converter boxes, generating minimal economic benefits but politically popular amongst recipients. Those funds would be better spent boosting the measly $25 million allocated to charter schools - a move that benefits predominately inner-city students but might anger teacher unions who strongly supported Obama. President Obama must muster the courage to demand sacrifices from close supporters as well as those with different ideological views to pass the most effective stimulus bill.

3. Start planning to fix the deficit -- including entitlements
President Obama's short-term economic challenges seem formidable until confronted with the long-term problem of balancing the government's budget deficits - including the rapidly growing entitlement programs. President Obama rightfully notes that the issue has been ignored for too long. With near-record high popularity - and hopefully a track record of competence, cooperation, and fairness gained from his stimulus bill - the President has a strong position to negotiate long-term solutions for the consolidated Federal budget. While the President's chances for re-election may hinge on the success of his stimulus plan in diverting economic decline, the history books will focus on his resolution - or lack thereof - of this critical issue.

4. Get the regulation right
History is less likely to remember the President for regulatory reform, but the economy will certainly notice. The financial sector regulatory failure of the past two years exemplifies the need for reform. Institutions overseen by numerous different agencies failed, and the response from the Federal Reserve, Treasury Department, FDIC, and various smaller agencies seemed muddled at best. Instinctively, politicians called for more regulation. But it is not more regulation that is necessary but better regulation. Consolidating regulators, assigning exclusive jurisdiction, and focusing on fewer but more important rules lowers costs and increases effectiveness. The potential for dramatic (if underappreciated) impact on the economy earns regulatory reform a place on the President's to-do list.

5. Put government on business's side
That to-do list has so far focused on government bailouts, stimulus, and regulation. However, business, not government, drives long-term economic prosperity, and America's business environment has deteriorated relative to other nations. American businesses seem constrained by the government instead of supported by it. This must change; supporting business competitiveness should be an explicit government goal. The Obama Administration should enlist the private sector in developing a strategy to address American competitiveness. Whether investing in education and infrastructure, reforming regulatory, administrative, and judicial processes, or tailoring tax laws, government support of business is critical to growth. Encouraging businesses to invest and innovate is the only way to ensure long-term economic success. The new Administration must find ways to encourage private investment and innovation to sustain the recovery the stimulus will hopefully spark.


The President has noted that in crisis lies opportunity. Mr. Obama should seize the opportunity before him to not only lead a short-term recovery but enact policies that set a course for generations of American prosperity.

FOMC Holds Target Rate Near Zero With Explicit Inflation Targeting

On January 28, 2009 the US Federal Open Market Committee (FOMC) announced that it planed to keep the target rate between zero and ¼ %. The announcement comes in the wake of the continuous stream of weak economic news. The low rate is likely to persist well in to 2009 with the committee noting that it anticipated a slow turnaround with considerable downside risks. It appears the FOMC is concerned with the low inflationary environment, noting that inflation remains below the sufficient level for strong economic growth. The Fed is concerned that the US will enter a deflationary environment similar to that of Japan in the 1990’s.

The Fed is officially targeting an inflation range of 1.5-2.0% per the FOMC’s semiannual report to lawmakers. Ben Bernanke is a proponent of inflation targeting having co-authored the book “Inflation Targeting: Lessons from the International Experience.” The book highlights a few key benefits of inflation targeting, (1) countries achieve lower inflation rates and lower inflation expectations, (2) price shocks have a reduced impact on sustained inflation; (3) lower nominal interest rates as a result of lower expectations; (4) better transparency and public understanding of monetary policy; and (5) accountability for policy makers. Interestingly, Bernanke notes in his book that inflation targeting has become a popular tool for central banks as result of economists’ belief that monetary policy is not an effective tool for spurring the economy in the short-run.

The book presents three main reasons for the adoption of inflation targeting in the early 1990’s by a host of industrialized nations including New Zealand, Canada, and the United Kingdom. First, economists are less confident in monetary policies ability to alter short-run changes in the economy. Secondly, low stable inflation is required for sound economic growth and price stability is essential for imposing accountability on central banks. The book further points out a break-down in the trade-off between inflation and unemployment. If inflation inhibits economic growth, moderate-to-high rates of inflation may actual result in higher rather than lower unemployment rates.

Inflation targeting is a relatively new phenomenon, replacing former Fed Chairman Alan Greenspan’s FOMC tool of interest rate targeting informally re-enacted in mid-1980’s (potentially as early as October 1982). Interest rate targeting through the fed funds rate was the result of Greenspan’s assertion there was not a stable relationship between the borrowed reserves and the fund rate. The Fed now believes explicit inflation targeting is the best tool to mitigate the delicate balance between (1) a deflationary (Japan 1990s) economy and (2) an inflationary (US 1970s) economy. The Fed has aptly phrased the paradox as the Two-Headed Dragon.

No bailout for Blago

Rod Blagojevich, the Illinois Governor accused of attempting to sell President Barack Obama's vacated Senate seat, just can't catch a break. While the government is busy bailing out everyone in site, page 14 of the recently introduced bailout bill tells Blago exactly what Congress thinks of him:

1 SEC. 1112. ADDITIONAL ASSURANCE OF APPROPRIATE USE
2 OF FUNDS.
3 None of the funds provided by this Act may be made
4 available to the State of Illinois, or any agency of the
5 State, unless (1) the use of such funds by the State is
6 approved in legislation enacted by the State after the date
7 of the enactment of this Act, or (2) Rod R. Blagojevich
8 no longer holds the office of Governor of the State of Illi
9 nois. The preceding sentence shall not apply to any funds
10 provided directly to a unit of local government (1) by a
11 Federal department or agency, or (2) by an established
12 formula from the State.

The impeachment process is proceeding apace in Illinois, but can not conclude this sad debacle fast enough...

(Hat Tip: Sid Shenai for finding this text in the 647 page H.R. 1 document)

Revisiting the Securities that Caused the Meltdown

Now that the country is headed for, in the best case, a pretty terrible recession it is perhaps a good time to look back and reflect on the housing bubble that really perpetrated this current mess.

The origins are easy enough to understand: cheap credit and a society whose government which was pushing home ownership, even on to those who could not afford it. What is not as well understood is how these toxic assets, mortgages to less than credit worthy borrowers, spread their way through the financial system and past safeguards the government had put in place in order to protect the solvency of the banking and insurance system.

The main culprit in this story is the vehicle known as a Collateralized Debt Obligation, or CDO. Every loan, in addition to having a certain yield, also has a certain idiosyncratic probability of default. This, in turn, translates into a credit rating assigned by a rating agency, which are then relied upon by the constituents which make up the financial system in order to properly guage the risk of the assets on their balance sheets. A CDO is a pooling of these loans, designed to take advantage of the fact (assumption is perhaps more appropriate) that the defaults of these instruments are not correlated, and therefore a portion of these assets become more valuable than if they were owned individually.

Take a simple example: if there are two $1 bonds in a pool and each has a 50% probability of default, the expected value of the pool is $1. If the defaults are uncorrelated, there is actually only a 25% chance that (50% times 50%) that pool will be worth $0. Said another way, there is a 75% chance the pool will be worth at least $1. Is the first $1 of the pool not worth more than the second dollar of the pool? Is the first $1 of the pool not worth more than each of the underlying assets? That is the ultimate logic behind the CDO. Thus, the first $1 of the CDO would be sold to an investor as a highly rated instrument (a senior tranche), and the second $1 of the CDO would be sold as something rated closer to junk status (a junior tranche).

There are ways here to rinse and repeat. One can imagine a scenario where there have been several hundred or even several thousand CDOs created in this manner, all with more assets and more tranches than the simple example above. Is it not possible to take junior tranches from a set of these uncorrelated CDOs, pool them together, and then engage in the same process as above? In fact, this is what the investment banks did when they created Collateralized Mortgage Obligations, or CMOs. Obviously, the supply did not exist in a vacuum. In an easy credit environment, yields were at all-time lows, and many institutions were clamoring to find new assets which were highly rated (to satisfy internal or external risk management) and promised better yields than those that were traditionally available.

So what went wrong? Let's revisit our assumptions. It turns out that the mortgages that made up the underlying asset pool were correlated. Most of the speculative home buying (which provided the supply of assets) were actually taking place in three major geographies: California, the Southwest, and Florida. Additionally, in the face of a severe economic event (see financial crisis, or asset bubbles bursting) most assets are correlated. One observes this phenomenon where asset prices everywhere more or less mirror the US equity market in severe negative events. Furthermore, many of the mortgages themselves may not have been priced properly due to lax origination standards and outright fraud. If one takes the simple CDO above, perfect correlation means that both tranches are actually worth exactly the same. In some sense, the "AAA" rated structured credit instruments are nowhere near investment grade status, while the lowest tranches of those same instruments may have actually been priced fairly attractively.

Thus, by the time everything was said and done, the market for purchasing these AAA rated securities had dried up, and the underwriting investment banks ended up holding these as assets on their own balance sheets. These securities were marked to market one fated day last fall, and the rest, as they say, is history.

For a more in-depth read, refer to this working paper by Joshua Coval, Jakub Jurek, and Erik Stafford. Josh and Eric are on the faculty of the Harvard Business School, and Jakub is on the faculty of Princeton University.

Ranking State Recession Risk

The unending drumbeat of comparisons between today’s crisis and the Great Depression has helped to foster a sense of shared apocalypse, a constant reminder that we are all chained to the oars of the same sinking ship. While it is true that a devastating economic depression would eventually sink the entire country, the unfortunate reality is that one part of the boat would go under first.

Last Thursday the Wall Street Journal published an article that broke out TARP handouts (née “investments”) on a state-by-state basis. Not surprisingly, the states that play host to the headquarters of large banks were the biggest winners. New York led all states with roughly $80 billion in TARP receipts, nearly $30 billion more than the next two states combined (North Carolina and California). As lawmakers begin drafting legislation to hand out more than a trillion dollars to other troubled industries, many questions remain unanswered. How should recipient industries be chosen and compared against each other? How should the disbursements be structured? What kinds of demands can/should the government make?

Perhaps most importantly, what is the metric by which the success of this stimulus package should be judged? One might be tempted to throw out macroeconomic measurements like U.S. GDP growth, the unemployment rate or even the stock market. But a 1% growth in GDP will not constitute success if it results from the average of 3% growth in the Southwest and a 2% decline in the Midwest, nor will surging employment in Houston offset the socio-political impact of emptying Detroit. Success will be measured on how the stimulus package helps those regions, states and communities that are bearing the brunt of this recession.

So which states are on the sinking end of the boat? One approach is to look at state GDP by industry, and stack rank the economic risk based on composition. Starting with the industry classifications provided by the Bureau of Economic Analysis these industries can be further grouped into three buckets based on their level of economic risk in the current global environment:

At Risk: Each recession has its particular victims and this one is no different. The Real Estate, Construction, Financial Services and Automotive sectors have been the hardest hit so far. State and Local government spending has also suffered mightily, as elected leaders try to cope with a collapse in property tax rolls and a frozen market for public debt. As in any recession, General Manufacturing has severely retracted, as has the Travel and Entertainment industry.

Neutral: A number of industries are bound/cursed to follow the general direction of the economy, even if they aren’t leading the way into a recession. These include Media, Professional Services, Technology/Software, Publishing, Transportation/Warehousing. This high beta-ness applies to general retail sales as well. Given the confluence of this crisis and the turnover in the national government, consumers are still holding their breath, and will closely follow the recovery of at risk sectors.

Safe: While nearly every industry eventually feels the negative effects of a recession, some industries are relatively insulated by nature. These include utilities, education, health care, mining, oil/gas production and last but certainly not least….federal spending. In a stark contrast to the dustbowl Great Depression, the agricultural sector remains remarkably stable.

Using these classifications, one can create a “Recession Risk Index” to apply to each state based on their industry mix. This Index measures the proportion of a state’s economic output comprised of at risk industries, adjusted for the cushion provided by safe or countercyclical industries. The calculation is straightforward:

(% of GDP made up of “At Risk” industries) – (% of GDP made up of “Safe” industries)

For full data results, click here

The results, displayed on the map below, serve as a directional if not scientific approach for disbursing bailout funds. EVERY state will be dragged down into the abyss of a protracted recession, but those states in red and yellow will sink first and fastest. They have greatest exposure to industry risk and the least amount of protection provided by diversification. If the bailout package is truly meant to be preventative, the approach above might be one worth considering.

As a brief aside on electoral politics, try comparing this map with that of the 2008 presidential election. Economic anxiety can be a powerful political lubricant for squeezing incumbents out the door.

High Risk: > 85th percentile

Moderate Risk: 50-80th percentile

Low Risk: 15-50th percentile

Very Low risk: <15th>