Wednesday, February 24, 2010

Prepare for Slim Annuities

Frederick Sheehan is the author of Panderer to Power: The Untold Story of How Alan Greenspan Enriched Wall Street and Left a Legacy of Recession (McGraw-Hill, 2009).

Barclays Capital recently published its annual Equity Gilt Study. The paper includes data for asset returns in the United Kingdom back to 1899 and in the United States since 1925.

In the February 12, 2010 edition of the Financial Times, columnist John Authers wrote a summary of Barclays’ conclusions. In Authers’ words: “Barclays chose to look at how the bubbles of the past 10 years developed. Economic factors do not much help…. Rather, these bubbles were driven by shifts in the demand for equities and other assets – and these, in turn, were driven by demographics.” Barclays misses the elephant trumpeting in the middle of the room. It is no wonder the People are still dazed by the world’s financial meltdown.

Authers continued: “[T]he baby boomers aged, and the long bull market made them more confident, so they ‘over-invested’ in assets around the world.” Barclays explains the source of this overinvestment: “[T]he size of the pool of capital available to pour into Asian stock markets, or into internet stocks, was disproportionate to the availability of investment opportunities.”

There is no need to go on. The source of the bubbles is simple but not part on a college economics’ curriculum, nor taught in business school, nor explained by Wall Street. The overflow of funds invested by the baby boomers is a product of too much money and credit. Governments hold a monopoly on money. A private citizen (or company, including a bank) would go to jail for producing alternative and additional money. In the United States, the Federal Reserve, in concert with the Treasury Department, prints the money.

Credit is produced by the banking system (by and large, this explanation covers most of the ammunition that has brought the U.S., and the rest of the world, to such a state.) The Federal Reserve sets reserve requirements for banks. For instance, a 10% reserve requirement would limit a bank’s lending to $100 for every $10 on deposit. The Federal Reserve has the authority to increase or reduce bank reserve requirements at any time.

During the late, great bank meltdown, the abuse of credit was barely discussed. Nor, was it a topic at Ben Bernanke’s recent confirmation hearing. It was never mentioned by a member of the Federal Reserve in a public comment. It is still the rare commentator who addresses this fertilizer to bubbles, a great disservice since central banks around the world continue to overproduce money.

During the housing, commercial property, hedge fund, private-equity boom, banks had run out of proper projects to fund, so they financed subprime mortgage lenders, commercial property speculators who did not put a penny of their own money into a development, investment banks that wanted to leverage their portfolios at 30:1, hedge funds that wanted to leverage their portfolios at 40:1, and private-equity firms that bought companies and then leveraged their balance sheets at 6:1.

To whip all this finance into a soufflé, banks ballooned the world derivative trade to several hundred trillion dollars (note: trillion, not billion,). This expansion was (and continues to be) hugely profitable for banks. They lent money to a mortgage lender (mortgage companies such as New Century were not banks themselves; they needed a bank to fund loans). Commercial banks also lent to investment banks (such as Lehman Brothers), which then funded mortgage lenders.

The next step was for New Century to ship mortgages en masse to Lehman Brothers, Citigroup or any of the other too-big-to-fail banks. The banks then packaged several thousand home loans into an asset-backed security (ABS). This mortgage derivative was then sold to an investment manager. Despite talk today about the danger of derivatives, banks still are not required to hold one penny of reserves against these rumbling volcanoes.

Such relatively unimportant subjects as bank bonuses fill the air while the lethal state of finance is left to boil over.

Barclays proposes that aging demographics will reduce the number of bubbles in the years ahead. With this misdiagnosis, and central banks printing away, and without any apparent intention to tighten reserve requirements, we need to look elsewhere for a seer.

Sam Zell, who sold his property kingdom for $39 billion in 2006, sent out a holiday present to friends in 2005. He prefaced the theme of his gift: “The enormous monetization of hard assets has created a massive amount of liquidity….Together with [the rising demand for income in the developed world], these factors…are reducing the relative expectations on equity….”

A large part of the monetization Zell spoke of is the derivatives market: the ability of a bank to collect almost any object or receivable, securitize it, then sell it. A home loan or funeral-parlor receivable no longer sits on a bank’s books. It whirs its way to a pension fund manager’s portfolio, in the form of a derivative, where it may be leveraged (from credit originally lent by a commercial bank), then traded again, and possibly rolled into an even more leveraged and even more profitable derivative.

Zell’s holiday present included a song, the lyrics set to the tune of “Raindrops Keep Falling on My Head.”

It opened:

“Capital is raining on my head.
Everything is liquid, we're awash with cash to spend
The flood has drowned returns,
'Cause assets keep liquefying, monetizing, raining...

So I just did me some Econ 101
Seems like we've gotten out of

Liquidity abounds,
But relative yields keep falling as capital keeps raining….”

This basic “Econ 101” lesson is not part of the American college curriculum. As Federal Reserve chairman, Alan Greenspan never mentioned the possibility of too much credit creation. As a private citizen prior in 1959, Greenspan clearly understood the phenomenon. He explained to the New York Times: “[Greenspan’s] general conclusion was that instability of the general economy results from the flexibility of the banking system, which supplies credit for the stock market.” And sometimes, too much credit.

The current Federal Reserve chairman, Ben Bernanke, has never mentioned excess credit either. Unlike Greenspan, he probably never has nor will comprehend it. Thus, as long as he is chairman, Bernanke will continue to think he is solving a problem. Later in his song, Sam Zell explained the consequences of the current Fed chairman’s ignorance:

“The world is monetizing faster every day,
Illiquid assets alchemized
To currency in play
Competing for return.
Black gold prices rising, still more money chasing assets...
And this is one thing I know
To get things back to normal.
It's a long haul
That's global.
Yields won't improve 'til growth soaks up this liquid free fall….”

The consequence? Bubbles (if that’s the right word, it’s been so overused) and crashes galore, whether the average age of the population is 10 or 90. If it’s 10, too much money and credit will boost bubble gum prices to $100 a pack. If it’s 90, Lawrence Welk DVDs will sell for $1,000 apiece. Since the median age is in between, it may be the prices of stocks, gold, barbequed chicken, or parking tickets that rise.

It is difficult to know what and when but this much is simple: when the amount of money and credit produced exceeds the needs of the real, non-financial economy, these excess claims on goods and services cause price distortions. Some pockets of prices inflate while others deflate (since overinvestment in an area causes widespread losses, credit write-offs, and fire sales).

Whatever the case, it will be very difficult for the real return on investments to keep up with rising prices of necessities.

The final lines from Sam Zell’s warning:

“It's going to be a long time 'til returns meet expectations,
We need to be prepared for slim annuities…."

We can thank our central bankers for this future and their camp followers who make it so difficult for the average person to understand his own predicament.

Friday, February 19, 2010

Miami’s Municipal Woes (Again): Exiting Before the Tide Goes Out

Frederick Sheehan is the author of Panderer to Power: The Untold Story of How Alan Greenspan Enriched Wall Street and Left a Legacy of Recession (McGraw-Hill, 2009).

“Miami's tradition of unruly official behavior is finally bringing painful consequences. After years of reckless financial management and a bribery scandal that produced federal charges against three top city officials, South Florida's largest city stands on the edge of bankruptcy.”

-Time, December 16, 1996, “Gloom Over Miami”

The odor from low tides is often strongest near mud flats. Credit bubbles are similarly disposed. During the high tide of the telecom boom, Global Crossing and WorldCom borrowed with abandon. When revenues did not rise to cover borrowing costs, their lamentable accounting practices smelled like a clam digger’s paradise.

The municipal borrowing boom of the past decade is no different. States and municipalities borrowed $137 billion in 2003 and $215 billion in 2007. This scramble in itself was enough to cause concern. These were flush times. Tax receipts by states and local governments rose from $975 billion in 2003 to $1,304 trillion in 2007. (See The Coming Collapse of the Municipal Bond Market in the Articles section of the website for details.) Municipalities were borrowing at record levels when taxes were producing a flood tide of revenues.

This indicates mismanagement on a broad scale. The municipal bond holder might look at the telecommunications boom for similarities. The great telecom scramble in the 1990s ended after the millennium in a bad stench of bankruptcy, fraud, prison terms and the demise of one accounting firm (Arthur Anderson) that abetted these scandals.

Gary Winnick founded Global Crossing in 1997. He had no technology background. Winnick watched a video to learn how to lay cable. He was a good enough salesman (having developed his techniques with Michael Milken at the latter’s famous x-shaped trading desk at Drexel, Burnham, Lambert) to raise billions of dollars. He intended to build 71,000 miles of undersea, high-speed, fiber-optic cable, linking 159 cities in 19 countries and able to reach 85% of the world’s telecom market. According to Forbes magazine, Winnick made a billion dollars – for himself – in 18 months. Global Crossing filed for bankruptcy in 2002.

Bernie Ebbers was chosen as WorldCom’s CEO in 1985. The company was called Long Distance Discount Services, Inc. (LDDS), with headquarters in Hattiesburg, Mississippi. Ebbers was not much of a technology whiz either. At his trial in 2005, Ebbers told the courtroom: "I don't know technology and engineering. I don't know accounting.”

Ebbers spent money faster than he could raise it (a trait of soon-to-be-busted municipalities). An abbreviated list of the WorldCom family is a short tour through the 1990s. It bought Advanced Communications Corp. (1992), Metromedia Communication Corporation (1993), IDB Communications Group, Inc (1994), Williams Technology Group, Inc. (1995), MFS Communications Company (1996), UUNet Technologies, Inc., (1996), CompuServe (1997), and then the largest combination in U.S. corporate history ($37 billion) when it merged with MCI in 1997. It became the United States’ second biggest long distance telephone company (after AT&T).

WorldCom filed for bankruptcy in 2002. It is probably of little solace to investors that Ebbers is serving a 25-year jail term. Arthur Anderson, its accounting firm, a pillar of American corporate respectability, dismissed its 28,000 employees in 2002 as revelations of accounting fraud at WorldCom, Global Crossing, and Enron ruined the century-old company’s credibility.

The high tide of municipal finance is retreating. Occasional whiffs of the mud flats are drifting ashore. The Securities and Exchange Corporation (SEC) is probing the City of Miami’s “major bond offerings between 2006 and 2009 and questionable financial transfers to balance the budget.”

Continuing with the Miami Herald’s summary, the hometown newspaper reminded readers of its own investigation in July 2009 that unearthed “the root causes of an emerging financial meltdown [that] focused on a series of questionable money transfers from capital-project accounts to the general fund.”

Many bond investors rely upon rating agency evaluations. Given the agencies’ recent follies, there is already a degree of risk linked to this approach. (Many fund managers who bought WorldCom stock relied on the rating agencies and on Wall Street “buy” recommendations.) The Miami Herald ratchets up the risk profile: “[T]he SEC is exploring whether the city misrepresented its true financial condition when [the agencies examined the city’s books before the city] went to market to float bonds for major projects.”

The regrettable behavior has its precedents. In 1996, Miami suffered a fiscal crisis when the city “tried to hide a $68 million shortfall by shifting money between hundreds of capital accounts.” In January 2010, “Miami leaders are already projecting a $45 million budget shortfall this year that could force the city to deplete its reserves and sell key assets to stay afloat.” (Miami Herald, January 31, 2010)

This shell game seems to be in the municipal handbook. In When America Aged, Roger Lowenstein described the City of San Diego’s accounting manipulations in the mid-1990s. They were orchestrated by city manager Jack McCrery: “He moved expenses around, shifted personnel, offset one account against another. A favorite McCrery tactic was to charge the water or sewer departments for laying pipes under city streets, which effectively transferred costs from the general fund to water and sewer (which had the power to assess fees). [City of San Diego] council members complained they didn’t understand his machinations, that he never explained the budget… but the truth was they were happier not knowing what McCrery was up to.”

This happy ignorance is by no means a preserve of municipal fiduciaries. The Ebbers’ defense (“I don't know accounting”) will be a common excuse when state and city finances unravel. Recently, the star-studded and highly compensated Citigroup board was not familiar with SIVs or CDOs when it mattered, and sat by as Citi’s stock fell over 95% between 2007 and 2009.

If all goes well, municipal bond holders receive 4% non-taxable interest payments. It might be worth foregoing this coupon income until the tide starts to rise again. Zero percent (in Bernanke-starved money market funds) is better than a 20% loss.

Thursday, February 11, 2010

Alan Greenspan: Party Boy

Frederick Sheehan is the author of Panderer to Power: The Untold Story of How Alan Greenspan Enriched Wall Street and Left a Legacy of Recession (McGraw-Hill, 2009).

“It's important to remember that equity values, stock prices, are not just paper profits. They actually have a profoundly important impact on economic activity. And if stock prices start continuing down, I would get very concerned.”

-Former Federal Reserve Chairman Alan Greenspan, Meet the Press, February 7, 2010

Alan Greenspan is as confused in retirement as when he ran the Fed. Most mortals, quoted as often as Greenspan, would justifiably worry such contradictions of past contentions would ricochet around the media. Vice President Dan Quayle made front page news when he misspelled “potato.” This is the sort of trivial mistake the media can grasp, or, all it thinks its audience can understand.

Alan Greenspan’s about-face on the Fed’s capacity to battle stock market bubbles cost investors several trillion dollars, yet he remains a fixture on the Washington party circuit (Fortune, February 5, 2010). He can say whatever comes into his head since he is still feted by those who matter. He talks on Meet the Press (where he was deferentially addressed as “Dr. Greenspan”) and collects large fees as a dinner speaker.

Like Ted Williams’ head, Alan Greenspan’s reputation is frozen. The skull of the baseball great (Williams) was set in ice when he died. It is to come alive a century from now (or, something equally peculiar is promised). Likewise, Alan Greenspan’s foibles have been frozen into a series of clichés designed to leave the party circuit undisturbed.

The former chairman’s battered legacy actually flatters the man: his errors were “idealistic.” So, have another drink, Alan. We’re all idealistic in Washington. (Ayn Rand asked a half-century back: “Do you think Alan might basically be a social climber?”)

The banks take the blame. They deserve it, but financial firms are more a symptom than a source. The bank cliché is convenient for both politicians and the most malignant contributor to our national woes, the Federal Reserve.

Worse though, than the money lost in the stock market debacle, is the lost decade (and counting). After the stock market burst, Chairman Greenspan attempted to reflate the economy with his one-percent, adjustable-rate mortgage bubble. The consequences need no comment.

The most scandalous aspect of Greenspan’s declaration on Meet the Press last weekend is not that he denied the link between the stock market and the economy when he was Fed chairman (in 1999). Far worse is that long before 1999, he had consistently emphasized the link. His contortions can be seen in a three-act sequence:

Act #1: When Greenspan knew a plunging stock market could sink an economy.

December 28, 1959, in the New York Times, Alan Greenspan explained “that a break in stock market trends was not just a harbinger of boom or recession, as is commonly held, but a crucial factor in causing a boom or a recession.”

March 1959, in Fortune magazine: “[O]ver-confidence finds exuberant expression in a bull stock market…. Once stock prices reach the point at which it is hard to value them by any logical methodology, [Greenspan] warns, stocks will be bought, as they were in the late-1920’s – not for investment but to be unloaded at a still higher price. The ensuing break could be disastrous.”

March 28, 1995, at a Federal Reserve Open Market Committee (FOMC) meeting – GREENSPAN: “I think the downside risks [to the economy] are basically coming from the possibility of significant increases in stock and bond prices…..Ironically, the real danger is that things may get too good. When things get too good, human beings behave awfully."

STAGE NOTE: By 1996, fears were rising of a stock market bubble. The Wall Street Journal wrote on November 25, 1996: “Federal Reserve Board Chairman Greenspan isn't talking about the stock market these days. In fact, the word among Fed officials is: don't use the word ‘stock’ and ‘market’ in the same sentence. No one wants the blame for the crash.”

Greenspan gave his famous “irrational exuberance” speech (regarding the stock market) on December 5, 1996. He testified before Congress and the Senate in early 1997, warning both bodies (in his way) of the stock market bubble. The congressmen and the senators told him to mind his own business. He never discussed the bubble again in public, and even forbid the FOMC from talking about it in 1998.

Greenspan then hid in his own bubble.

Act #2: Greenspan couldn’t see bubbles and they might not matter anyway.

It was on June 17, 1999, that the Federal Reserve chairman unveiled his thesis: that the Federal Reserve could not identify a bubble ahead of time and it would therefore make no attempt to do so. This was entirely new and near the peak of the greatest stock market bubble of all time.

(FLASHBACK – FOMC meeting on September 24, 1996 – GREENSPAN: “I recognize that there is a stock market bubble problem at this point....We do have the possibility of raising major concerns by increasing margin requirements. I guarantee that if you want to get rid of the bubble, whatever it is, that will do it.”)

In his June 1999 testimony before Congress, he told Congress don’t worry, be happy:

“While bubbles that burst are scarcely benign, the consequences need not be catastrophic for the economy…. while the stock market crash of 1929 was destabilizing, most analysts attribute the Great Depression to ensuing failures of policy.” (Note: Greenspan had never before attributed the Depression to ensuing policy failures. For instance, see his interview with Fortune above).

The chairman’s contention became known as The Greenspan Doctrine in the media and among so-called economists. With little rebuttal, he contributed addenda to his Doctrine, such as in 2002, when he added a footnote to a speech in Jackson Hole, Wyoming. Discussing the aftermath of the 1987 stock-market crash: “[I]n line with later episodes, the failure of the collapse to have an economic impact seems to have contributed to subsequent higher stock prices.” According to this wrinkle, stock market crashes are good for stock prices. (The footnotes to Federal Reserve governor speeches contain amazing contentions.)

Act #3: Greenspan warns stock market bubbles can cripple an economy.

SETTING: Alan Greenspan retired from the Federal Reserve in early 2006. Among other post-retirement warnings that the stock market and the economy are Siamese twins:

Interview with Reuters, September 30, 2007: "[U]nless stock prices resume their pace of increase of earlier this year, U.S. consumer spending and GDP will be under pressure from declining household wealth."

Again, Meet the Press, February 7, 2010: “It's important to remember that equity values, stock prices, are not just paper profits. They actually have a profoundly important impact on economic activity. And if stock prices start continuing down, I would get very concerned.”

Why is he still on TV?

Whether it is appropriate to invite Greenspan on television is for the media to decide. More of a muddle is why he still attracts an audience. He is as consistently wrong as during his Fed chairmanship.

In October 2006, Greenspan claimed: “Most of the negatives in housing are probably behind us. It's taking less out of the economy."

On February 7, 2010, he told Meet the Press: “I don’t think [home prices will] decline from here. In other words, they seem to be bottoming out.”

On the same day, he also told Meet the Press: “The recession is over.”

Look out below.

Frederick Sheehan writes a blog at

Friday, February 5, 2010

Ben Bernanke: The Very Model of a Modern Pliant Bureaucrat

Frederick Sheehan is the author of Panderer to Power: The Untold Story of How Alan Greenspan Enriched Wall Street and Left a Legacy of Recession (McGraw-Hill, 2009).

Federal Reserve Chairman Ben S. Bernanke was a safe bet to win the Senate’s vote for a second term. “Safe” is what the senators want and Bernanke passed the test. He is not a man inclined to make bold decisions. A former university administrator, his institutional mind will be just as slow to foresee the next financial crisis as it was incapable of forecasting the last.

Despite obvious signs the financial system was about to burst, Congress had no desire to touch Fannie Mae, Freddie Mac, and the banks’ expanding mortgage securitization machine (i.e., derivatives), that made Washington and Wall Street so rich.

Having replaced Alan Greenspan as chairman on February 1, 2006, Bernanke performed according to script. He dismissed the worrywarts. In June 2006, Chairman Bernanke told an International Monetary Fund (IMF) gathering: “[O]ur banks are well capitalized and willing to lend.” In the same month, he stamped his imprimatur on the most destitute sector of the economy: “U.S. households overall have been managing their personal finances well.” In November 2006, he calmed fears about subprime lending. Before an audience promoting community development, Bernanke celebrated the rise of subprime mortgages: from only 5 percent of the market in 1995, 20 percent of new mortgage loans were subprime by 2005. (He did advise “greater financial literacy” for “borrowers with lower incomes and education levels.”)

In May 2007, Chairman Bernanke gave an appraisal one expects from a short-sighted bureaucrat: “[W]e believe the effect of the troubles in the subprime sector on the broader housing market will likely be limited, and we do not expect significant spillovers from the subprime market to the rest of the economy or to the financial system.”

Bernanke’s specialty is organization. Filing subprime mortgages into a manila folder appealed to the chairman’s tidy mind. John Cassidy discussed Bernanke’s strength in the New Yorker: “In 1996, Bernanke became chairman of the Princeton economics department, a job many professors regard as a dull administrative diversion from their real work. Bernanke, however, embraced the chairmanship…. [Bernanke] bridged a long-standing departmental divide between theorists and applied researchers….” A colleague explained Bernanke’s considerable skill: “Ben is very good at… giving people the feeling they have been heard in the debate….”

Bernanke gives senators the same feeling (with some admirable exceptions, who know Bernanke’s cordial and vague representations are a variant on his predecessor’s, Alan Greenspan). The IMF did not want to hear America’s banks were undercapitalized. The community developers did not want to know subprime lending was an odious racket that was bound to topple. The nation’s most revered economist assured audiences that all was fine.

On December 3, 2009, the Senate Banking Committee held a reconfirmation hearing (prior to the full Senate voting on Bernanke’s second term). The Fed chairman was given great credit for leading the nation through the recent financial crisis. Committee members congratulated Chairman Bernanke for his brilliant restoration of the U.S. financial system.

He was reprimanded, however, for not anticipating the crisis and expressed requisite contrition. Bernanke thought banks should have held more capital and that the banking system had not employed adequate risk management controls. Committee members nodded in solemn agreement.

In truth, the too-big-to-fail banks are bigger, more unstable, and even more undercapitalized than before the bubble burst in 2007. As for risk management tools, Bernanke is full of talk but has done nothing to restrain either the growth of derivatives or to require reserves be held against derivative exposure.

At the December 3 hearing, the Fed chairman stated that he did not see any asset bubbles emerging. This seemed to reassure the senators who ignored the fatuity of even asking his opinion given that he thought banks were well-capitalized in 2006 and did not see the housing bubble.

As night follows day, Bernanke ignores a signal akin to one the derivative markets offered ahead of the 2007 meltdown. Then, there were wide expectations of loan defaults. Investors hedged this risk in the credit-default swap (CDS) market. The CDS market grew from $14 trillion to $42 trillion from January 2006 to June 30, 2007. Any line of business growing at such a rate should alarm bank regulators.

Ben Bernanke, the nation’s leading bank regulator, did not understand that banks could not honor trillions of dollars of claims once the defaults occurred. It was the CDS market that left Bear, Stearns; Lehman Brothers; Goldman, Sachs; and AIG either insolvent or close to it.

Today, galloping derivative growth has moved to interest-rate protection. The fear is of a government bond bubble. Ten-year Treasury bonds yield 3.7% during the greatest money-printing experiment in the nation’s history. Investment managers are protecting themselves against a higher 10-year Treasury yield. (With interest-rate derivative contracts, banks will have to pay the purchasers if rates rise to a specified level.)

During the first six months of 2009, the volume of contracts offering protection against rising yields of Treasury bonds with maturities of 5 years or longer rose from $109 trillion to $150 trillion. When rates rise, banks may once again default on their commitments.

Bernanke aims to please. He told the senators in December 2009 a reevaluation of his zero-percent fed funds rate “will require careful analysis and judgment.” The chairman will raise the rate “in a smooth and timely way.” This paralysis to action fits the stereotype of a municipal data-entry clerk. Bernanke certified his tremulous loyalty when he told an audience on November 16: “It is inherently extraordinarily difficult to know whether an asset’s price is in line with its fundamental value…. It’s not obvious to me in any case that there’s any large misalignments currently in the U.S. financial system.”

Only an apparatchik could believe an economy with zero-percent interest rates is in balance. The purchasers of interest-rate protection (which is not cheap) believe differently, but Ben Bernanke is the man for the Senate. The chairman’s mandate for his second term is to ignore the obvious, deflect attention from the megabanks’ inherent instability, and to accept blame for his ignorance after the deluge.

Frederick Sheehan writes a blog at

Listen to interviews with Frederick Sheehan:

1 - Thursday, February 4, 4:30 – 5 PM EST, on Bloomberg radio with Pimm Fox on his show Taking Stock

2 - Saturday, February 6 with Jim Puplava at Financial Sense. The one hour interview will be posted at 3 PM EST:

3 - Sunday, February 7, 10 -11 AM EST, with Jim Campbell on Yale University radio WYBC – 1340 AM and streaming live at Simulcast on Yale’s Internet channel: