Thursday, June 24, 2010

Is Alan Greenspan a National Security Risk?

(Reuters) - "Secretary of State Hillary Clinton on Thursday said 'outrageous' advice from former Federal Reserve Chairman Alan Greenspan helped create record U.S. budget deficits that put national security at risk."
-February 25, 2010

Alan Greenspan lamented U.S. budget deficits in the Wall Street Journal on June 18, 2010 ("U.S. Debt and the Greece Analogy"). For an analysis of Greenspan's flapdoodle, Barry Ritholtz covered the turf on his blog, The Big Picture. The former Federal Reserve chairman should have withheld comment, given his personal contribution to the nation's poverty-stricken state.

Testifying before Congress on February 25, 2010, Hillary Clinton bemoaned the advice of Alan Greenspan: "I remember as vividly as if it were yesterday when we had a hearing in which Alan Greenspan came and justified increasing spending and cutting taxes, saying that we didn't really need to pay down the debt -- outrageous in my view." Reuters continued: "Though she did not give a date, that hearing must have taken place during the presidency of George W. Bush...."

If only it were so simple. During his tenure as Fed chairman, Greenspan's budget positions changed more often than the weather. Always the opportunist, his self-serving opinions continue to bend the truth. During the Greenspan Boom, he was awarded the Presidential Medal of Freedom, the Department of Defense Medal for Distinguished Public Service, and the Enron Prize for Distinguished Service. Now, the Secretary of State looks ready to compile a dossier on his activities. The State Department need look no further. A review of his outrageous activities follows.

In February 2000, the last year of the (William Jefferson) Clinton Administration, Greenspan appeared before the Senate Banking Committee. He recommended the government use the federal budget surplus to pay down the national debt. He amplified: "The growth potential of our economy under current circumstances is best served by allowing the unified budget materialize, thereby reduce Treasury debt held by the public." Meaning: we should use surplus dollars collected by the Treasury Department to reduce the federal debt. (The Treasury can use surplus tax dollars to either purchase U.S. Treasury securities or reduce the size of new debt issues.) This fit the politics of the time. President Clinton was not proposing a tax cut.

One year later, Alan Greenspan worked for new management - the Bush Administration. President Bush wanted a tax cut to kick off his presidency. Greenspan marketed the tax cut as fiscally responsible, given recent surpluses. His advice was rendered on January 25, 2001, to the U.S. Senate Committee on the Budget. This was five days after George Bush's inauguration. The Wall Street Journal reported: "Giving a big boost to President Bush, Chairman Alan Greenspan reversed his long-held view and said he now sees room for significant tax cuts in the federal government's financial future.... '[O]ver the coming decade, the latest budget-surplus numbers show not only room for reductions, but even a need.'" The New York Times reported on the same day: "Alan Greenspan, the Federal Reserve chairman, gave his blessing today to a substantial tax cut.... In a clear shift from his previous position that reducing the national debt should be the focus of fiscal policy, Mr. Greenspan said improvements in the economy's long-term potential and the swelling surplus projections had 'reshaped the choices and opportunities before us.'"

In his testimony, Greenspan expressed concern "that continuing to run surpluses beyond the point at which we reach zero or near-zero federal debt brings to center stage the critical longer-term fiscal policy issue of whether the federal government should accumulate large quantities of private (more technically nonfederal) assets." [Greenspan's parenthesis.]

Here, the Fed chairman anticipated surpluses of such enormous quantity that there would not be a single U.S. Treasury security left to buy. The government could be forced to buy "nonfederal" assets, such as IBM bonds. Of the 100,000 most likely problems the government should consider, this was not one of them.

Greenspan was leaning on a bizarre computation from the Congressional Budget Office (CBO). In January 2001, the CBO had projected a federal budget surplus for the period of 2002 through 2011 of $5.6 trillion. This gem of infinite interpolation gave Greenspan the cover he needed. In 2002, the CBO reduced its surplus estimate by $5.3 billion, to $300 million.

Whether Greenspan's audience succumbed to his flight of fancy, another statement should have awakened its curiosity. Greenspan prefaced his tale of woeful surpluses by discussing "recent projections [which]... make clear that the highly desirable goal of paying off the federal debt is in reach before the end of the decade. This is in marked contrast to the perspective of a year ago when the elimination of the debt did not appear likely until the next decade." Since "a year ago" (actually, the 10 months between March 10, 2000 and when he spoke in January 2001), the Nasdaq had fallen 43%. Tax revenue had risen from 12.5% of personal income to 15.4% during the boom years. In 2000, this 2.9% increase equaled $237 billion - precisely the same as the total 2000 budget surplus. It suited Greenspan's purposes to express mystification during testimony: "We still do not have a full understanding of the exceptional strength in individual income tax receipts during the latter 1990s."

Greenspan could not have been blind to the source of the budget surpluses: capital gains, exercised stock options and bonuses. These tributaries had dried up. Without these flows, his fear of paying down the national debt, or even running a balanced budget, made no sense. And, while Alan Greenspan could claim that paying down the debt was a bad thing, it is a tribute to the man's sway that his audience accepted such a silly pretense approvingly.

The Greenspan Campaign for Re-nomination to Head the Fed in 2004 had kicked off its media blitz a year earlier, on February 11, 2003. The Boston Globe reported that Greenspan viewed Bush's (new) tax cut plan with suspicion: "Greenspan... used the opportunity to admonish the federal government for losing its 'fiscal discipline.'" In the chairman's words, a "return to fiscal discipline should be instituted without delay." That was the stick. The next day, on February 12, Greenspan offered Bush the carrot. The Wall Street Journal reported: "Federal Reserve Chairman Alan Greenspan muted his initially chilly reception of President Bush's tax cut plan, offering more praise for eliminating taxes on dividends and playing down the near term consequences for the Federal deficit." [Italics added.] On February 22, President Bush announced that he would reappoint Greenspan for a fifth term.

On April 30, 2003, having accomplished his mission and with Bush now committed to reconfirm him, Greenspan scolded the president. The New York Times reported: "Alan Greenspan...told Congress today that the economy was poised to grow without further large tax cuts, and that budget deficits resulting from lower taxes without offsetting reductions in spending could be damaging to the economy. Opponents of the large tax cut favored by President Bush took Mr. Greenspan's testimony as support of their position." [Italics added.] The dissembling was obvious; yet, no one questioned Greenspan's motives. No one questioned his logic either, but, few in Washington or Wall Street ever had.

On April 21, 2005, the chairman's bewildering tax and federal budget advice came full circle. At a Senate Budget Committee meeting, Democratic Senator Paul Sarbanes from Maryland pursued a ragged thread in the Greenspan tapestry. The senator contended that Greenspan's endorsement of the president's 2001 tax cut was the "green light" that George Bush needed. (This 2001 testimony is probably what Hillary Clinton remembered.) At this meeting, Greenspan replied that he had not "specifically" endorsed the tax cut plan. The chairman claimed: "[Y]ou will not find anywhere in the public record that I supported the [2001] tax cut."

After the New York Times published Greenspan's "blessing today to a substantial tax" on January 26, 2001, the Federal Reserve chairman never made a speech or provided testimony that his advice had been misunderstood. There was no reason for him to do so. Reading the January 25, 2001, speech today (available for anyone to judge on the Federal Reserve Board of Governors website, under "News and Events" and "Testimony"), his support is obvious. He was rooting for a tax cut.

This civil servant had made false statements to the people's elected representatives before. When a vote to balance the budget loomed early in Clinton's presidency, Greenspan said a Fed study showed a balanced budget would reduce interest rates. The Fed had conducted no such study. Greenspan testified to Congress in 1993 that tapes of Federal Open Market Committee meetings were destroyed after summaries were written. Thus, no transcripts existed. He later admitted to Banking Committee Chairman Henry Gonzales that he had known for years transcripts were kept but only remembered when a "senior staff member jogged my memory in the last few days."

To Sarbannes complaint, Greenspan deflected criticism with a tried-and-true tactic: flattery. The Wall Street Journal reported on April 22, 2005, that Greenspan told the senator "an alternative program of tax cuts and spending increases then proposed by the Democratic Party's leadership would have achieved the same desired reduction in surpluses." The logic of Greenspan's prevarications seemed to mean he had not specifically endorsed the Bush tax cut. Yet, he also told Senator Sarbannes that he "like many economists" had been wrong about the surpluses he warned of in 2001. Three years later, in 2004, the federal government set a new record with its first $400 billion deficit. So why was he now saying the Democratic Party's proposal would have "achieved the same desired reduction" since the budget surpluses had, instead, degenerated into record-setting deficits? We will never know. Greenspan had triumphed once again.

As presidential candidate in 2008, Senator Hillary Clinton fully understood her man. She proposed an "emergency group" to "deal with high-risk mortgages." Greenspan was one of those she would appoint to her brain trust. When an opponent questioned her strange selection of the former Federal Reserve chairman, Clinton offered an enigmatic endorsement. Greenspan had "a calming influence....Don't ask me why, because I never understand what he's saying."

Thursday, June 10, 2010

Markets Without Guardrails

Two significant changes are pushing markets towards a shakeout.

First, the bond markets are showing strains. For instance, both investment-grade and junk-rated companies are finding it more difficult to issue bonds. To put this in today's context, the momentum money that has pushed asset prices up since the spring of 2009 assumes, or believes, that governments will do whatever is necessary to sustain the upward march. Now there are doubts.

It looks as though institutions may be withdrawing funds from the global banking system as worries of European bank solvency rise. Recent spikes of interbank lending rates (such as LIBOR) suggest this.

The so-called recovery has been artificial. Pete Briger of Fortress Investment Group "poured cold water" on a recent private equity meeting in Boston, the SuperReturn U.S. conference. According to the Wall Street Journal, "the private-equity princes" basked until Briger spoke, when he stated what everyone in the room knew. He "said the improved environment is, in effect a charade, with everyone from central banks to large financial institutions 'in cahoots' to boost lending markets and consumer confidence." [The Journal's quotation marks, my italics.]

The second change is the rising volatility across markets, from currencies to stocks. To some degree, the greater frequency of stock markets rising or falling 2% or 3% in a day is attached to tighter credit market conditions.

A shakeout does not require a reduction of funding. "Charades," also known as bubbles, need ever greater amounts of funding to stay in place. If the pace of funding slows (for example, from a 10% to a 5% rate), the markets are apt to snap.

Prices in the stock market, for instance, flap around as computers decide whether the institution should be a buyer or seller at a certain level. This has led us into the unknown, as explained by the Financial Times: "An explosion in trading propelled by computers is raising fears that trading platforms could be knocked out by rogue trades triggered by systems running out of control."

This is a great worry, but nothing so nefarious is needed to ally a stock market crash. The buy-and-hold investor is in a lonely position. Only 3% of trading was by retail investors in U.S. equity markets during 2009. (For more on our perverted markets, see "blog" Should Investors Boycott the Stock Market?)

We have on our hands a deep-sea oil rig with the safety features for skimming oil off the water's surface. The technology for trading, such as described by the Financial Times, has not been matched by new technology to slay the monster, if necessary. There were such checks-and-balances in the days when stocks were traded on the floors of the exchanges.

At a Grant's Interest Rate Observer conference in November 1999, one speaker was not concerned about the stock market. (For those who were still in school, the Nasdaq had risen 150% over the previous 13 months.) One reason this speaker cited was "strong central bank leadership." Another speaker, Michael Steinhardt, did not think the Fed's leadership would be worth much when it was needed most. Steinhardt had started on Wall Street in the 1960s, the "Go-Go Years." Few investors had gone-and-got as profitably over the prior three-and-one-half decades as Steinhardt. He spoke about Wall Street's abandonment of controls, leadership and responsibility:

"The liquidity safeguards, historically, were the specialists' books, the retail system, and the institutional liquidity providers in the major brokerage firms. They were the mechanisms that the stock exchange itself had provided, and they were all structured for a system where trading was a very, very small fraction of what we're seeing today. Now there are no specialists' books; there is no serious liquidity provided by brokerage firms; and the trading mechanisms of the exchange are hardly relevant to the sorts of volumes that exist today. So yes, the Federal Reserve, if you define that broad context of liquidity in a financial sense, does still exist, but in a securities market sense, none of the former ones do."

The average buy-and-hold investor probably did not realize how the institutional framework was constructed to generate a harmonious flow of buy-and-sell orders and to protect the market from abuses. Now the institutions perpetrate the abuses and the guardrails no longer exist.

The "strong central bank leadership" was absent once the Nasdaq commenced its 78% collapse in March 2000, when the bubble had reached a level that no liquidity safeguards could have prevented. During the plunge, central bank leadership layered the world with paper in an effort to pump economies back up.

Now, that paper cannot be paid back. Since 2007, the world financial system has suffered periodic waves of deleveraging, during which times central bank leadership could not compensate for the discarded institutional mechanisms that had contained disruptions.

As Pete Briger of Fortress Investment Group said, the central banks and large financial institutions are "in cahoots." Their objective, "to boost lending markets and consumer confidence" is to draw the unsuspecting into markets. Beyond that, the institutions trade now to make money for themselves. Such notions as leadership and responsibility are gone with the wind.

Chances are good that volatility will keep rising until we reach a sharp market break. In simpler days, receding liquidity and less stable markets under bubble conditions meant "crash." This is still the likely course, but governments know asset prices are the hedgerows that shield fallow economies from view. Governments want to preserve the fa├žade. They will do what they can to push prices up. Speculators who see governments re-open vast credit lines (as they did in 2008) will probably reverse course in a fit of panic buying.

It looks, though, that central banks will respond after the fact rather than act preemptively. The Federal Reserve has reinstituted swap lines, but even that decision was in reaction to a problem the markets had already identified. Government will inflate, but probably after steep declines across markets.

Thursday, June 3, 2010

Should Investors Boycott the Stock Market?

Investing in stocks is marketed as believing in America. Imbedded is the assumption that buying stocks is a fair deal. An investor might make or lose money, but the same chance was taken by all participants.

Although they have received little notice, the recently released 2004 Federal Reserve Open Market Committee (FOMC) transcripts show how the Fed was channeling its attention and distorting markets for the benefit of favored institutional investors. (See "blog" The 2004 Fed Transcripts: A Methodical, Diabolical Destruction of America's "Wealth".) The 2004 Transcripts were not so much a revelation as a confirmation. The Fed's valiant attempt to prevent the economy from deflating (its claim at the time) by inflating asset markets is now a matter of public record. FOMC members explicitly stated they were working with hedge funds and pushing housing prices up.

We know how this ended. The Fed's policy was successful until 2007. Then all asset prices collapsed, along with the institutions (banks and brokerages) that believed the Fed could prevent prices from ever falling. The backstop was known as the "Greenspan Put:" the belief that Chairman Greenspan's Fed would always prevent market prices from falling.

A put option gives the buyer an option (a choice) to sell a security at a price previously negotiated with the seller. A put option is valuable if prices fall below the level of the negotiated price. An investor can buy a put with the right to sell the S&P 500 Index at 800. If the Index rises to 1100, the option is worthless. (Why sell it for $800 when it can be sold in the market for $1100?) If the S&P 500 Index falls to 600, the value of the put option is worth at least $200 to the owner of the put: the Index is trading for $600 but can be sold for $800. The put option is an insurance policy against a stock market collapse. The need for the average investor to understand such instruments will be discussed below.

The Greenspan Put begat the Bernanke Put, once the latter became chairman in 2006. Believers in the Put have reason for such faith. The 2004 transcripts show the FOMC toiled to fulfill this zeal. The zealots ignore the failure of the Put in 2007 and 2008.

The credit collapse of 2007 and 2008 ended as all government-sponsored market support programs have ended. In 2010, the federal government's interference in markets is ten-fold, or possibly, one-hundred-fold, greater than in 2004. Distortions created by Fed interference in 2004 (such as, the mortgage market) went hand-in-hand with the collapse in 2007. Given the Fed's iron grip on markets today, the imbalances are much greater. Investors need to plan now for when the contrivances shatter.

The busybodies' catalogue would start with their zero-percent federal funds rate. This is not only an inducement to borrow without fear, it is also part of the Federal Reserve's program to suck the unwashed into higher risk investments, such as the stock market and municipal bonds. Federal Reserve Governor Donald Kohn stated in the autumn of 2009: "[R]ecently the improvement, in risk appetites [have] respond[ed] to actions by the Federal Reserve and other authorities.... Low market interest rates should continue to induce savers to diversify into riskier assets...."(For more on this, see AuContrarian blogs: March 9, 2010: From the Greenspan Put to the Kohn Put: Our Brilliant Central Bankers and March 25, 2010: Government Authorities are Looking Out for Themselves - As Should Everyone.)

Investors should be aware of other means by which the Fed and other authorities are interfering with markets, since the mutations have created phony prices. Again, as we saw in 2007 and 2008, the compounding of illusionary prices finally collapsed.

Four sources of phony prices follow.

First, interest rates are distorted. At one percent (and less) speculators gamble and push up asset prices.

Second, is the housing market. It does not exist. The authorities have warned us. The latest was David Stevens, head of the Federal Housing Administration, who told an audience on May 24, 2010, the housing market is a "government-financed market" that is "purely on life-support, sustained by the Federal government." House prices will sink when the government runs out of lifeboats.

Third, the authorities have handed the stock market to institutions where the computers buy and sell. The Financial Times reported that only 3% of stock market trading is by retail customers. Tradebot, in Kansas City, Missouri, holds stocks for an average of 11 seconds. It made money every day for four years. (See: "Speedy New Traders Make Waves Far From Wall St," New York Times, May 16, 2010)

Fourth, the Federal Reserve is manipulating the currency markets, as Rainer Bruederle, German finance minister, disclosed on May 28. Angst should border on panic, given the man in charge of this operation. The last time the Federal Reserve did so, in July 2009, Congressman Alan Grayson asked Federal Reserve Chairman Ben Bernanke to whom the Fed had lent $500 billion. The chairman had no idea. Bernanke claimed, legitimately, loan collection was the responsibility of the central banks that had received the funds. His detachment is in keeping with the man's tendency to wander through vague abstractions, yet for those weighing the destination of their life savings, or, whether to buy a house or hide in a cave, Simple Ben is a dangerous obstacle to logical thinking.

In the 1970s, many in the United States knew little about personal finance other than the beauty of compound interest. It was during that decade when double-digit inflation chased those who were quick enough into certificates of deposits. The latecomers who did not adapt were left behind.

From certificates of deposit, the household has adapted to changing times (or, been left behind). Now, it is necessary to understand protection, which should not be confused with asset diversification. The put option described above is a potential instrument. There are other approaches; the costs of each should be weighed and this needs to be emphasized: all insurance is a cost.

This leads back to the title: "Should Investors Boycott the Stock Market?" In the current discussion: what is the cost of abandoning stocks, and, for instance, ducking inside a savings account?

For all Bernanke's faults, there is at least a consistency about the man. His mind is as inflexible as a Prussian border guard's. In 1999, he wrote: "A central bank can... extend loans to depositories, other financial intermediaries, or firms and households.... This may be particularly helpful in spurring aggregate demand should the financial sector be under stress and in need of liquefying its assets." [My italics.] If Bernanke sees the economy sinking, there is nothing to stop the mad professor who dreamt up this conflagration from electronically wiring $100,000 to every American's personal checking account. The Dow could pass 100,000 shortly after.

In conclusion, investors need protection on the downside and exposure to the upside. At the moment, the prospect of a stock market crash looks more likely.