Monthly Archives: February 2014

“In December 2008, Citi was effectively insolvent. (It’s) equity-to-assets ratio, measured in market value—the best single comprehensive measure of a bank’s financial strength—fell steadily from about 13% in April 2006 to about 3% by September 2008. And that low value reflected an even lower perception of fundamental asset worth, because the 3% market value included the value of an expected bailout.”, Charles W. Calomiris and Allan H. Meltzer, February 12, 2014

“Yet at a Senate hearing in January, Elizabeth Warren asked a bipartisan panel of four economists (including Allan Meltzer ) whether the Dodd-Frank Act would end the problem of too-big-to-fail banks. Every one answered no.”, Calomiris and Meltzer, WSJ

“I don’t have anything to add here (I agree with this article. I think 15% is about right on equity, too much more and it could hurt lending rates to consumers and institutions and the economy.), other than to point out the relative unfairness of IndyMac being a ‘not too big to fail’ institution vs. Citi. We were not bailed out (and I am okay with that) and as a result, given our home lending focused business model, we failed and I got personally (civilly) sued by the SEC, FDIC, and numerous private plaintiffs for over $1 billion! (Not a single allegation against me was ever proven in a court of law, because I never did anything wrong. Every single allegation that was heard on the merits by a court of law, I won (was dismissed). It has taken away five years of my professional life and it is an event that I will probably never fully get over. Think about this: in 1993 IndyMac’s predecessor was a money-losing, mortgage reit; a shell of a public company with no business whatsoever and three employees and I built it into a major thrift and home lender by the time of the financial crisis. The Citi guys like CEO Charles Prince and Chairman Robert Rubin inherited a fabulous, diversified, worldwide banking franchise and drove it to insolvency and it would have failed like IndyMac, but for being “Too Big To Fail” and receiving tens of billions in government funds and massive other assistance. And yet neither Prince or Rubin, to my knowledge, have been sued by anyone. And they are just one of a myriad of examples I could cite (and I would include the heads of the FDIC, Fed, and FHA in that list). That’s not right.”, Mike Perry, former Chairman and CEO, IndyMac Bank

How Dodd-Frank Doubles Down on ‘Too Big to Fail’

Two major flaws mean that the act doesn’t address problems that led to the financial crisis of 2008.

By 
CHARLES W. CALOMIRIS And
ALLAN H. MELTZER
Feb. 12, 2014 6:44 p.m. ET 
 

The Dodd-Frank Act, passed in 2010, mandated hundreds of major regulations to control bank risk-taking, with the aim of preventing a repeat of the taxpayer bailouts of “too big to fail” financial institutions. These regulations are on top of many rules adopted after the 2008 financial crisis to make banks more secure. Yet at a Senate hearing in January, Elizabeth Warren asked a bipartisan panel of four economists (including Allan Meltzer ) whether the Dodd-Frank Act would end the problem of too-big-to-fail banks. Every one answered no.

Dodd-Frank’s approach to regulating bank risk has two major flaws. First, its standards and rules require regulatory enforcement instead of giving bankers strong incentives to maintain safety and soundness of their own institutions. Second, the regulatory framework attempts to prevent any individual bank from failing, instead of preventing the collapse of the payments and credit systems.

The principal danger to the banking system arises when fear and uncertainty about the value of bank assets induces the widespread refusal by banks to accept each other’s short-term debts. Such refusals can lead to a collapse of the interbank payments system, a dramatic contraction of bank credit, and a general loss in confidence by consumers and businesses—all of which can have dire economic consequences. The proper goal is thus to make the banking system sufficiently resilient so that no single failure can result in a general collapse.

Part of the current confusion over regulatory means and ends reflects a mistaken understanding of the Lehman Brothers bankruptcy. The collapse of interbank credit in September 2008 was not the automatic consequence of Lehman’s failure.

Rather, it resulted from a widespread market perception that many large banks were at significant risk of failing. This perception didn’t develop overnight. It had evolved steadily and visibly over more than two years, while regulators and politicians did nothing.

Citigroup‘s equity-to-assets ratio, measured in market value—the best single comprehensive measure of a bank’s financial strength—fell steadily from about 13% in April 2006 to about 3% by September 2008. And that low value reflected an even lower perception of fundamental asset worth, because the 3% market value included the value of an expected bailout. Lehman’s collapse was simply the match in the tinder box. If other banks had been sufficiently safe and sound at the time of Lehman’s demise, then the financial system would not have been brought to its knees by a single failure.

To ensure systemwide resiliency, most of Dodd-Frank’s regulations should be replaced by measures requiring large, systemically important banks to increase their capacity to deal with losses. The first step would be to substantially raise the minimum ratio of the book value of their equity relative to the book value of their assets.

The Brown-Vitter bill now before Congress (the Terminating Bailouts for Taxpayer Fairness Act) would raise that minimum ratio to 15%, roughly a threefold increase from current levels. Although reasonable people can disagree about the optimal minimum ratio—one could argue that a 10% ratio would be adequate in the presence of additional safeguards—15% is not an arbitrary number.

At the onset of the Great Depression, large New York City banks all maintained more than 15% of their assets in equity, and none of them succumbed to the worst banking system shocks in U.S. history from 1929 to 1932. The losses suffered by major banks in the recent crisis would not have wiped out their equity if it had been equal to 15% of their assets.

Bankers and their supervisors often find it mutually convenient to understate expected loan losses and thereby overstate equity values. The problem is magnified when equity requirements are expressed relative to “risk-weighted assets,” allowing regulators to permit banks’ models to underestimate their risks.

This is not a hypothetical issue. In December 2008, when Citi was effectively insolvent, and the market’s valuation of its equity correctly reflected that fact, the bank’s accounts showed a risk-based capital ratio of 11.8% and a risk-based Tier 1 capital ratio (meant to include only high-quality, equity-like capital) of about 7%. Moreover, factors such as a drop in bank fee income can affect the actual value of a bank’s equity, regardless of the riskiness of its loans.

For these reasons, large banks’ book equity requirements need to be buttressed by other measures. One is a minimum requirement that banks maintain cash reserves (New York City banks during the Depression maintained cash reserves in excess of 25%). Cash held at the central bank provides protection against default risk similar to equity capital, but it has the advantage of being observable and incapable of being fudged by esoteric risk-modeling.

Several researchers have suggested a variety of ways to supplement simple equity and cash requirements with creative contractual devices that would give bankers strong incentives to make sure that they maintain adequate capital. In the Journal of Applied Corporate Finance (2013), Charles Calomiris and Richard Herring propose debt that converts to equity whenever the market value ratio of a bank’s equity is below 9% for more than 90 days. Since the conversion would significantly dilute the value of the stock held by pre-existing shareholders, a bank CEO will have a big incentive to avoid it.

There is plenty of room to debate the details, but the essential reform is to place responsibility for absorbing a bank’s losses on banks and their owners. Dodd-Frank institutionalizes too-big-to-fail protection by explicitly permitting bailouts via a “resolution authority” provision at the discretion of government authorities, financed by taxes on surviving banks—and by taxpayers should these bank taxes be insufficient. That provision should be repealed and replaced by clear rules that can’t be gamed by bank managers.

Mr. Calomiris is the co-author (with Stephen Haber ) of “Fragile By Design: The Political Origins of Banking Crises and Scarce Credit” (Princeton, 2014). Mr. Meltzer is the author of “Why Capitalism?” (Oxford, 2012). They co-direct (with Kenneth Scott ) the new program on Regulation and the Rule of Law at the Hoover Institution.

Copyright 2013 Dow Jones & Company, Inc. All Rights Reserved

“The recent turn has been abrupt. The flop reflects a broader turning point in one of the U.S.’s biggest recent asset booms. From 2009 to mid-2013, average prices for agricultural land in the U.S. rose by half, while in Iowa, Nebraska and some other Midwest farm states, prices more than doubled….”, Wall Street Journal, February 12, 2014

“As land prices were soaring, some economists and lenders raised alarms. The Federal Advisory Council, a group of 12 banking leaders that advises the Fed, wrote a year ago that farmland prices were “veering further from what makes sense from a production standpoint,” amounting to “a bubble resulting from persistently low interest rates.””, Wall Street Journal

“Again, here is another example of the truth being revealed. This asset price boom (It’s a potential bubble, that may go bust, but no one seems to know for sure. Just like the U.S. housing market pre-bust.) has nothing to do with U.S. bankers, as land has a debt to asset ratio of just 10.3%. But it is a huge asset boom and potential risk. What’s driving it? The Federal Reserve’s own agricultural advisory council says it is caused by “persistently low interest rates”. That’s what many believe (despite the Fed’s denials) was a major cause of the unsustainable U.S. housing bubble. The Fed itself attributes the U.S. housing bubble and bust to massive flows of emerging market capital into U.S. financial institutions and highly-rated U.S. debt securities, like MBS. I agree. I think they were both major causes of the pre-financial crisis asset bubbles and I believe those causes (and the myriad of new asset bubbles, like this one, and busts, here in the U.S. and around the world), act to refute the government and plaintiff’s lawyers contention that it was reckless bankers and disclosure securities fraud that were the primary cause of the U.S. housing/mortgage bubble and bust and financial crisis.”, Mike Perry, former Chairman and CEO, IndyMac Bank

Falling Property Values Hint at Trouble on the Farm

Plummeting Prices for Corn Are Threatening a Yearslong Boom for U.S. Growers

By

JESSE NEWMAN and
JACOB BUNGE
Feb. 12, 2014 11:00 p.m. ET
Potential bidders at a farmland auction in Burnettsville, Ind., last month. Jesse Newman for The Wall Street Journal

Broker Pat Karst thought the farm being auctioned late last month would be scooped up. The 98-acre plot was of decent quality, and the volunteer fire station in Arlington, Ind., where his firm was holding the sale, was packed with farmers.

Instead, the evening ended with the latest in a spate of failed auctions, after the top bidder dropped out far below the asking price. “The moral of the story is: unrealistic expectations from sellers and more caution on the side of the buyer,” said Mr. Karst, who acknowledged he, too, thought the property would fetch a higher price than offered.

The flop reflects a broader turning point in one of the U.S.’s biggest recent asset booms. From 2009 to mid-2013, average prices for agricultural land in the U.S. rose by half, while in Iowa, Nebraska and some other Midwest farm states, prices more than doubled, according to U.S. Department of Agriculture data from last August. That helped fuel economic prosperity across the Farm Belt while stoking fears about a possible bubble.

 

Now there is mounting evidence the boom is fizzling out. Farmland prices in Iowa fell 3% over the second half of last year, and those in Nebraska fell 1%, according to estimates from the Farm Credit Services of America, an Omaha, Neb., lender that calculates weighted averages based on land quality. Reports from U.S. Federal Reserve Banks across the Midwest late last year showed prices flattening or slipping from the previous quarter. A monthly survey of Midwestern lenders by Omaha-based Creighton University in January found the outlook for farmland and ranchland prices was the weakest in more than four years.

Despite the falling property values, agricultural analysts say a repeat of past farm-belt collapses is unlikely. Farmer income is expected to remain strong and debt levels are low, according to USDA figures.

Prices for corn, like in the Illinois field pictured here, are falling on the back of a bumper 2013 crop that followed a historic drought. Jesse Newman/The Wall Street Journal

But prices have plunged for corn, a key U.S. crop. After rising to all-time highs in 2012—driven by growing demand and tight supply because of a historic drought—prices for the biggest U.S. crop dropped 40% last year, thanks to a record harvest of 14 billion bushels. The Federal Reserve warned in January that corn prices, then around $4.28 a bushel, won’t cover farmers’ anticipated cost of raising the crop this year. Prices have since climbed to about $4.40 a bushel, compared with about $8.31 in August 2012.

Soybeans, the nation’s No. 2 crop, have also lost value. Meanwhile, with the Fed scaling back its stimulus efforts, buyers of U.S. farmland face the prospect of higher interest rates after years of cheap borrowing.

The shifts have forced farmers to recalculate the value of productive land. Greg Plunk, a third-generation Illinois farmer who added 80 acres to his farm over the past two years, said he would be more careful with further purchases. “Profits will be tighter, there’s not going to be near the returns, and guys will have to be careful how much expenses they’ve got into an acre,” said Mr. Plunk, 53 years old.

Falling land prices could cause economic ripples, curbing farmers’ ability to borrow money to buy new acreage, crop supplies or machinery. Land secures many of those loans. Mark Jensen, chief risk officer at Farm Credit Services of America, said half of its $20 billion portfolio consists of real-estate loans secured by farmland. As credit quality deteriorates, farmers will use more land as collateral, he said.

A pullback in farmers’ spending could curtail construction of grain bins and livestock facilities as well as purchases of new machinery. Tractor company Deere & Co. predicted Wednesday that sales of farm equipment in the U.S. and Canada this year would decline 5% to 10% from 2013.

The farmland boom began roughly a decade ago. Prices slumped briefly in 2009, amid the recession, then rebounded, thanks in part to historically low interest rates. Overall, values of some fertile Midwestern land nearly tripled over the past decade.

The recent turn has been abrupt. “There was lots of land around here selling for close to $10,000 an acre, but it’s tapered off quickly,” said Kevin Kremer, 56, an Indiana farmer who recently won a tract of land for roughly $8,800 an acre at an auction in Burnettsville, Ind.

Winter is typically the busiest time in the county-fairground buildings and American Legion halls where fast-talking auctioneers deal swaths of land. But this season has seen a growing number of “no sale” auctions. After the unsuccessful 98-acre auction by Mr. Karst last month, the land sold a week later for $880,000, about 10% less than what the sellers wanted.

In Iowa, the biggest corn and soybean-producing state, 6.7% of farmland auctions failed in 2013, more than double the 2012 percentage, according to Farm Credit Services of America. The total number of auctions fell 30%.

As land prices were soaring, some economists and lenders raised alarms. The Federal Advisory Council, a group of 12 banking leaders that advises the Fed, wrote a year ago that farmland prices were “veering further from what makes sense from a production standpoint,” amounting to “a bubble resulting from persistently low interest rates.” The same group noted this past December that “prices are flat and may be receding.”

So far, the sputtering growth is prompting more caution than panic. But economists are watching closely. “The question is, if there’s a fall, how fast the fall happens,” said Nathan Kauffman, Omaha branch executive of the Federal Reserve Bank of Kansas City, who tracks farmland prices.

The economic picture in the Farm Belt is expected to worsen. The USDA forecast Tuesday that U.S. farm incomes will dive 27% this year from 2013, to $95.8 billion, which would be the lowest level since 2010. Last year’s total was the highest since 1973 on an inflation-adjusted basis, but the continued slump in grain prices is expected to this year outweigh the benefits of having more corn and soybeans to sell. Still, even with the expected decline, the USDA reckons incomes will remain $8 billion above the previous 10-year average.

Michael Duffy, professor of economics at Iowa State University in Ames, Iowa, projects lower income for farmers could drive the price of farmland down 20% to 25% over the next several years.

Other observers point to factors that could cushion or reverse the market decline, including an unexpected resurgence in the price of corn and soybeans. Some buyers say they are waiting to pounce if prices fall, which also could help keep any decline from turning into a rout.

“We think this next 12 months is going to be the best window we’ve had in the past five years” to invest in farmland, said Greyson Colvin, managing partner at investment manager Colvin & Co., which owns about 7,000 acres of farmland.

Adding comfort, today’s agricultural sector looks markedly different than it did during the last farmland bust, in the early 1980s. Then, a roughly 50% drop in land values and rising interest rates led to high levels of debt when viewed as a percentage of farmers’ assets. That forced many farmers out of business and spurred failures among dozens of agricultural lenders. Farmers’ debt-to-asset ratio is currently estimated at 10.3%, less than half what it was in 1985, according to the USDA.

But a sharp fall in property prices could affect a farmer’s balance sheet, said Mr. Kauffman, the economist. “If land values do drop, that could have some important implications for solvency.”

Write to Jacob Bunge at jacob.bunge@wsj.com
Copyright 2013 Dow Jones & Company, Inc. All Rights Reserved
 

“The fact is they (Asian countries) bulked up on savings, held back on consumption and investment, and amassed huge caches of foreign reserves. Sunk into Treasury bonds, these reserves drove a speculative boom in the “emerging market” of the moment: American subprime mortgages.”, Eduardo Porter, New York Times, February 11, 2014

“It was a wave of money that — to the confusion of Alan Greenspan, the Fed chairman at the time — the Fed seemed powerless to manage. When it did stop, as all such waves do, the housing bubble came to a cataclysmic end. Is there anything to be done about the new unstable order? International monetary cooperation has broken down,” said Raghuram G. Rajan, India’s central bank chief.”, Eduardo Porter

“After more than five years, the truth is finally emerging in article after article, by both conservative and liberal authors and publications. Here is a New York Times article discussing the fact that the bubble in U.S. housing and mortgages was caused by emerging market excess reserves being invested in the U.S. mortgage securities. (Greenspan and Bernanke have also made this same argument, which I have discussed thoroughly on this blog at Statements, #78, #82, #96, and #130.) In other words, it wasn’t caused by bankers or disclosure securities fraud, as some in the government and plaintiffs’ attorneys would have you believe. Wall Street, bankers, and mortgage lenders were rationally responding to these investors enormous demands for U.S. financial assets; especially highly-rated debt securities, like MBS. These institutional investors created the demand and caused the bubble and when they abruptly pulled back, the bubble burst. As the article points out, just like is occurring today in emerging market debt and currencies around the world (and its clear to all that lenders have no involvement in this new crisis). For a free and fair marketplace to work properly, buyers and sellers need to be responsible for their own decisions, whether they later enjoy gains or suffer losses. For markets to work, sophisticated institutional investors who later suffer losses as a result of purchasing assets at the top of an asset bubble, and then claim to be deceived by sellers, should not be given the benefit of the doubt by courts or the press (as they seem to be). These investors had the opportunity to conduct as much due diligence as they wished before purchase and were free to decline to purchase any security, at any time. And after purchasing a security, they could have conducted additional due diligence and did not. The reality is most of these investors elected to not perform due diligence and relied solely on the government-anointed National Statistical Rating Agencies and the Wall Street underwriters. My strong belief is that the vast majority of investor losses occurred not because of underwriting or other lending errors or inadequate disclosures (Most of the errors cited have been relatively minor technicalities, which would have not caused the loan to default if home prices had not declined so dramatically. I haven’t seen one case where a plaintiff has developed a statistically valid sample of material underwriting or disclosure errors to support their claims.), but from an asset bubble bursting. A bubble that virtually no one, including our government economic experts at the Fed, saw coming (because if they did, as Greenspan has pointed out, it would have been arbitraged away).”, Mike Perry, former Chairman and CEO, IndyMac Bank

ECONOMY

A World Unprepared, Again, for Rising Interest Rates

FEB. 11, 2014

Eduardo Porter
ECONOMIC SCENE

MEXICO CITY — I was living in São Paulo in 1997 when, out of the blue, an investment banker I knew in London called to ask about Brazilian cocktails. He didn’t want one. He needed a name for a potential economic crisis, in the vein of Mexico’s Tequila affair in 1994 and Thailand’s Tom Yum Kung debacle, which was unfolding at the time.

As unlikely as it seemed to most Brazilians then, the crisis did arrive. A default by the Russian government in 1998 set off a run on Brazilian bonds, as investors rushed to pare their holdings in emerging markets by selling the most liquid among them.

Suffering from large trade and budget deficits and a shrinking stock of foreign reserves, Brazil was forced a few months later to sever the real’s link to the dollar and let it sink.

That’s when it dawned on me that we weren’t living in my parent’s economy anymore.

The stable American economic order lasted more than three decades from the end of World War II, when economic cycles were essentially driven by the Federal Reserve’s raising and lowering of interest rates to combat inflation. It started to crumble with the severing of the link between gold and the dollar and the twin oil crises of the 1970s. That ushered in an era of footloose capital, unshackled by three decades of increasing deregulation, that led to the global tides that, for better and worse, now drive economic ups and downs.

José Ángel Gurría, head of the O.E.C.D., advised developing countries: “Reforms, reforms, reforms and more reforms.” Ruben Sprich/Reuters

That Brazilian morning 17 years ago has come to mind again as the Fed has started gradually reducing the amount of money it pumps into the economy. The move could hardly have been a surprise, because the Fed announced as early as last spring that it would begin doing so by the end of 2013.

If anything, the Fed’s action has had an easing effect on domestic interest rates. While higher than in the spring, yields on Treasury bonds were lower last Friday than they were a month before.

And yet around the world, financial markets have swooned as if struck by lightning.

The reasoning behind investors’ abrupt change of heart makes a certain sense. China’s economic slowdown will blunt the exports of commodity producers, weakening their trade balances. Macroeconomic management in many developing countries has been poor. Budget and trade deficits in some are way too high.

Still, there is a deeper dynamic at play. The pullout of capital from developing countries around the world has an eerie resemblance to the seemingly unlikely financial wave that emerged from Asia, crossed through Russia and Eastern Europe and ended up walloping Brazil.

That’s hardly the only precedent. As Carmen M. Reinhart, a renowned international economist at Harvard’s Kennedy School, put it, capital bonanzas, inevitably followed by financial crises, are “older than the hills.”

Problem is, the cycles of boom and bust seem to keep getting worse. Whether the Fed continues removing monetary stimulus at the same pace or it pauses, perhaps worried by sluggish job growth, long-term interest rates eventually will rise. The world, evidently, is not prepared. And it’s even less prepared for the bigger crisis that we seem doomed to suffer after this one.

Lawrence Summers, President Obama’s former top economic adviser, recently articulated an idea that suggests booms and busts, each one bigger than the last, might be with us for a while.

At a speech at the International Monetary Fund last November, he said that the global economy was suffering from “secular stagnation,” persistent low growth caused by the fact that there are more savings around than profitable investments to be made.

There could be several reasons, including slowing labor force growth or declining productivity. Cautious consumers and businesses burned by the crisis might be prone to save more and invest less. Income inequality might blunt consumption.

Regardless of the cause, a persistent savings glut would make bubbles much more likely. “In an era of secular stagnation, when equilibrium interest rates are low, there will be more financial stability problems,” Mr. Summers told me.

This rings a bell. Asian countries emerged from the 1990s intent on never suffering like that again. It’s debatable whether their primary motivation was to build trade surpluses or to amass financial war chests against future attacks. The fact is they bulked up on savings, held back on consumption and investment, and amassed huge caches of foreign reserves.

Sunk into Treasury bonds, these reserves drove a speculative boom in the “emerging market” of the moment: American subprime mortgages.

It was a wave of money that — to the confusion of Alan Greenspan, the Fed chairman at the time — the Fed seemed powerless to manage. When it did stop, as all such waves do, the housing bubble came to a cataclysmic end.

Is there anything to be done about the new unstable order?

“International monetary cooperation has broken down,” said Raghuram G. Rajan, India’s central bank chief, a couple of days after he was forced to raise interest rates to keep the rupee from sinking. “Industrial countries have to play a part in restoring that, and they can’t at this point wash their hands off and say, ‘We’ll do what we need to and you do the adjustment.’ ”

Andrew G. Haldane, executive director for financial stability at the Bank of England, also seemed to suggest that international cooperation was the answer. “What is going on with the head-to-head combat is people pursuing policies of individual countries,” he said. “What is at stake is the system as a whole.”

Yet it is questionable what coordination could achieve. “It’s not reasonable to think that somehow a cooperative solution will be found where everybody adjusts the policy slightly differently and the world is much better off,” said Donald Kohn, a former vice chairman at the Fed who is now at the Brookings Institution.

Mr. Kohn pointed out there were risks involved in committing to a coordinated course of action and then having circumstances change.

What’s more, it’s not even clear what governments should do about presumed bubbles. Should they “lean against” them by raising interest rates as they emerge, potentially sacrificing investment and jobs along the way? “The conversation tends to presume that you are going to do the leaning right,” Mr. Summers warned. “It is likely to be substantially imperfect.”

The world’s top economic authorities hold out hope that finance can be harnessed to prevent such wild lashings in the future. “Macroprudential rules” — from taxes on short-term foreign loans to countercyclical loan-to-value ceilings on mortgages — are the talk of the town.

Banking regulators have huddled periodically in Basel, Switzerland, since 2009 to hash out rules to limit the leverage of big financial institutions. The logic is that banks will make more prudent investments if they have to set aside more reserves that will raise the cost of credit, and they will be in better shape if their investments go awry.

But José Ángel Gurría, a three-decade veteran of Mexico’s financial crises who now heads the Organization for Economic Cooperation and Development, may have the best advice for a developing country standing in the headlights of foreign capital flows: “Reforms, reforms, reforms and more reforms and after that reforms of the reforms.”

It’s old advice. It does nothing about curtailing fickle capital spinning on a dime. But it makes sense to go swimming with a bathing suit to avoid undue exposure when the financial tides, inevitably, recede.

Email: eporter@nytimes.com;
Twitter: @portereduardo
A version of this article appears in print on February 12, 2014, on page B1 of the New York edition with the headline: Unprepared, Again, for Rates to Rise. 

“I find that mandate (the Fed’s dual mandate: stable prices and full employment) both operationally confusing and ultimately illusory. It implies a trade-off between economic growth and price stability, a concept that I thought had long ago been refuted not just by Nobel Prize winners but by experience.”, former Fed Chairman Paul Volker, 2013

“That’s exactly what I have been saying in many of my statements about the Fed’s monetary policy on this blog. Only I would go farther. I strongly believe this dual mandate (“full employment” was added in the 1970s), while well-intended, is one of, if not the most important driver of irresponsible Fed monetary policy and monetary and economic instability. Also, I had never thought of the fact that the Fed’s 2% inflation target per year is essentially a 20% devaluation in the U.S. dollar every 10 years. Also, the fact that Yellen talked Greenspan into 2% inflation to essentially “fool” workers into thinking they were getting a raise (and business into thinking their profits had risen), when they really weren’t/hadn’t (because workers’ nominal raise essentially was fully offset by nominal price increases throughout the economy). Wow! I think you can see how the Fed’s manipulation of money can cause all sorts of nominal price confusion and lead market participants: consumers, businesses, lenders, and investors to make the wrong economic decisions. Ms. Shelton’s OpEd on the Fed below is excellent. Not only did it uncover the “gem” which I used for the title of this posting, but here are a few more.”, Mike Perry, former Chairman and CEO, IndyMac Bank

I Love These “Gems” from Ms. Shelton’s February 11, 2014, WSJ OpEd on The Yellen Fed:

“The stock market’s volatility since the first of the year (2014) has awakened fears that the Fed’s efforts to improve economic performance through its bond-buying and near-zero interest-rate policy have worked instead to distort capital flows and misprice financial assets.”

“Is it possible that economic growth has actually been impaired by the Fed’s unconventional monetary policies?”

“The nation was still on a gold standard (from the Fed’s founding in 1913 until 1935), so the notion of deliberately expanding or contracting the money supply to affect economic performance wasn’t considered a viable government option.”

“The Fed’s rise to prominence and influence really began in 1935 under President Franklin Roosevelt. The year before, Roosevelt had devalued the dollar from $20.67 to $35 per troy ounce of gold by executive proclamation.”

“Even as Ms. Yellen insists that the Fed is pursuing “highly accommodative” monetary policy to achieve specific economic growth objectives, it is clear that her approach also bails out federal deficit spending. She can hardly argue that emergency conditions still warrant extraordinary measures by the Fed…”

“During Tuesday’s hearing, she referred several times to the need to raise the inflation rate to 2% or even higher—which means her definition of price stability would let the dollar lose more than 20% of its value each decade.”

“…Ms. Yellen talked then-Chairman Greenspan out of his goal of driving inflation down to zero. In true Keynesian fashion, she reasoned that workers want higher nominal wages even when higher prices negate them; better to accept the money illusion benefits of 2% inflation than to risk slipping into a deflationary spiral with rising unemployment.”

“It is ironic that concern for wage earners serves to justify money pumping by the Fed that ends up largely benefiting people who have hefty stock-market portfolios, especially at a time when “income inequality” is a major White House theme.”

“Perhaps one of our elected representatives on Capitol Hill can explain to Ms. Yellen that when the low-grade fever of perpetual inflation becomes a full-blown economic malady—when the next financial bubble bursts with horrible consequences for the real economy—average Americans will pay the biggest price.”

OPINION

Judy Shelton: The Markets Love Yellen—for Now

The new head of the Federal Reserve says monetary policy won’t change, unless it does.

By 
JUDY SHELTON
Feb. 11, 2014 8:00 p.m. ET

Janet Yellen proved on Tuesday that she has mastered the art of Fed-speak. Testifying before the House Financial Services Committee for the first time as the chairwoman of the Federal Reserve, she said she expects “a great deal of continuity” in policy, including the “taper” of the Fed’s quantitative easing, while saying the bond-buying program is “not on a preset course.” Markets cheered, with the Dow Jones Industrial Average surging nearly 200 points.

Ms. Yellen is the 15th head of the Fed since its establishment a century ago. She inherited an extremely difficult predicament from predecessor Ben Bernanke. The stock market’s volatility since the first of the year has awakened fears that the Fed’s efforts to improve economic performance through its bond-buying and near-zero interest-rate policy have worked instead to distort capital flows and misprice financial assets.

Fed Chairwoman Janet Yellen testifying at a House Financial Services Committee hearing Tuesday. EPA

Is it possible that economic growth has actually been impaired by the Fed’s unconventional monetary policies? Can the world’s dominant central bank continue each month to purchase $65 billion in Treasurys and mortgage-backed securities without doing further damage? If it tapers further, does it risk sparking global financial turmoil?

Worries about the boom-and-bust consequences of manipulating interest rates are nothing new. The perils of monetary “stimulus” were hotly debated in the 1930s by economists John Maynard Keynes and Friedrich Hayek. When confronted with rising unemployment amid economic depression, the political compulsion to act results in higher government spending and easy money.

But over time, does government intervention retard the natural workings of free markets to deliver prosperity? This question is at the heart of any discussion about the appropriate role of the Federal Reserve. One hopes Ms. Yellen will address it when she testifies before the Senate Banking Committee on Thursday.

In 1913 the Federal Reserve’s relatively modest purpose was to provide emergency supplies of currency to local banks to satisfy unanticipated customer demands for cash. The nation was still on a gold standard, so the notion of deliberately expanding or contracting the money supply to affect economic performance wasn’t considered a viable government option.

The Fed’s rise to prominence and influence really began in 1935 under President Franklin Roosevelt. The year before, Roosevelt had devalued the dollar from $20.67 to $35 per troy ounce of gold by executive proclamation. Now he initiated a reorganization of the Fed that would shift power from regional bank districts to Washington, D.C. Roosevelt appointed Marriner Eccles as chairman of the Fed’s Board of Governors and authorized him to conduct national monetary policy through the newly centralized banking system.

Eccles was initially an advocate for government stimulus to spur the economy during slack periods to reduce unemployment. He embraced the Keynesian formula for running government deficits and surpluses over the business cycle. But he became increasingly uncomfortable the following decade with the assumption that the Fed would forever absorb excess government spending by injecting more money into the system—and thus inflict future higher prices on the population. By the time Eccles stepped down in 1948, he was fiercely opposed to the administration’s inflationary war financing.

The lesson Ms. Yellen might draw from the Eccles experience—his name adorns the Fed’s formidable headquarters on Constitution Avenue in Washington—is that stimulus isn’t meant to be permanent. At some point government expenditures must be paid for with tax revenues.

Even as Ms. Yellen insists that the Fed is pursuing “highly accommodative” monetary policy to achieve specific economic growth objectives, it is clear that her approach also bails out federal deficit spending. She can hardly argue that emergency conditions still warrant extraordinary measures by the Fed—especially after testifying that economic recovery has “gained greater traction” in the past seven months. It has been 4½ years since the recession presumably ended. So why is Ms. Yellen sticking with the notion that the Fed intends to suppress interest rates far into the future?

During the nomination process, President Obama made it clear that, given a choice between reducing unemployment or keeping prices stable, he wanted a Fed chief who would lean toward the former. Unfortunately, this makes it more difficult for Ms. Yellen to convincingly assert the independence of monetary policy from political considerations.

During Tuesday’s hearing, she referred several times to the need to raise the inflation rate to 2% or even higher—which means her definition of price stability would let the dollar lose more than 20% of its value each decade. Ms. Yellen might keep in mind what happened to Arthur Burns, who ran the Fed under President Richard Nixon and was considered a Republican loyalist.

While Burns was an eminently qualified economist, his reputation was tarnished by the perception—borne out by the Nixon tapes—that he succumbed to presidential pressure to conduct expansionary monetary policy to spike economic growth in the run-up to the 1972 election.

Paul Volcker took over the Fed in 1979, a tumultuous period as inflation ultimately reached 13.5% in 1981 before it was squeezed out through monetary discipline. If Ms. Yellen were to listen to Mr. Volcker, she might get a different take on whether tension actually exists within the Fed’s so-called “dual mandate” to achieve both maximum employment and price stability.

“I find that mandate both operationally confusing and ultimately illusory,” Mr. Volcker said in a speech to the Economic Club of New York last year. “It implies a trade-off between economic growth and price stability, a concept that I thought had long ago been refuted not just by Nobel Prize winners but by experience.”

Then again, Ms. Yellen is credited with successfully convincing Alan Greenspan that mild inflation does little harm, and is actually a good thing. She was relatively new to the Fed Board of Governors in 1996, but Fed meeting transcripts reveal that Ms. Yellen talked then-Chairman Greenspan out of his goal of driving inflation down to zero. In true Keynesian fashion, she reasoned that workers want higher nominal wages even when higher prices negate them; better to accept the money illusion benefits of 2% inflation than to risk slipping into a deflationary spiral with rising unemployment.

It is ironic that concern for wage earners serves to justify money pumping by the Fed that ends up largely benefiting people who have hefty stock-market portfolios, especially at a time when “income inequality” is a major White House theme.

Perhaps one of our elected representatives on Capitol Hill can explain to Ms. Yellen that when the low-grade fever of perpetual inflation becomes a full-blown economic malady—when the next financial bubble bursts with horrible consequences for the real economy—average Americans will pay the biggest price.

Ms. Shelton, an economist, is author of “Money Meltdown” (Free Press, 1994) and co-director of the Sound Money Project at the Atlas Economic Research Foundation.

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“Annual earnings dropped for the first time since Rackspace went public. The stock price has plunged more than 55% over the past 12 months. Rackspace is far from dead, but its business of offering Web hosting and other cloud-based tech services has undergone a big shift since Amazon’s AWS operation got into the game with that company’s usual playbook of driving down prices.”, Heard on the Street, WSJ, February 11, 2014

“It seems that Amazon’s strategy is to use money-losing price concessions to crush competitor Rackspace and muscle its way to the top of the web hosting business. This price war is costing Rackspace investors billions in stock market losses. But we don’t know for certain what is going on because Amazon doesn’t publicly disclose to investors it AWS division’s revenues, costs, and profits. I don’t think that’s right, as I discussed on November 13, 2013, Statement #85: “Does Amazon Have a Special Exemption from the SEC in Complying With the Securities Disclosure Laws?””, Mike Perry, former Chairman and CEO, IndyMac Bank

 

HEARD ON THE STREET

Rackspace is Under an Amazonian Cloud

By 
DAN GALLAGHER
Feb. 11, 2014 3:07 p.m. ET

Ironically, with its latest attempt at reinvention, Rackspace Hosting is borrowing from the slogan of the big rival helping to make that reinvention necessary.

The corporate graveyard is littered with those who tried to compete against Amazon.com. Rackspace is far from dead, but its business of offering Web hosting and other cloud-based tech services has undergone a big shift since Amazon’s AWS operation got into the game with that company’s usual playbook of driving down prices.

AWS has made a brand of the term “re:invent,” but it is Rackspace that is in flux. Chief Executive Lanham Napier is stepping down. The company on its fourth-quarter earnings call Monday vowed to focus on corporate customers who need more of a high-touch cloud partner than those who prefer Amazon’s cheaper, do-it-yourself offerings.

It is the right move, but Rackspace now has to regain lost momentum. Revenue growth for 2013 was 17.2% compared with 27.7% average annual growth over the prior three years. Annual earnings dropped for the first time since Rackspace went public in August 2008. The stock price has plunged more than 55% over the past 12 months, including a sharp dive Tuesday following the results.

Rackspace also has to fight a perception challenge, as Amazon’s AWS has become the go-to name for many businesses. In a recent survey by Jefferies, 57% of respondents were considering using Amazon in their deployment of cloud-based services compared with just a third for Rackspace.

And despite Tuesday’s selloff, Rackspace is no bargain. The stock still trades at around 55 times forward earnings, a slight premium to its five-year average. Trying to avoid getting into a price war with Amazon is wise. To pay a stock-price multiple assuming Rackspace can pull that off without mishap is less so.

—Dan Gallagher

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“…the financial crisis hammered the Harvard endowment and exposed its weaknesses, including a lot of illiquid investments. The endowment declined by 27.3% in its fiscal year ended in June 2009 and still hasn’t gotten back to its pre-crisis peak of $36.9 billion.” Andrew Barry, Barrons

“Mendillo has restructured the endowment to improve liquidity and has successfully pushed for initiatives such as greater direct real-estate investments, which have produced strong results. Overall, returns have been good, not great, during her tenure. Harvard was up 1.7% annually in the five years ended in June 2013, ahead of its benchmarks in a policy portfolio—or targeted asset allocations—by 0.5 percentage points, but behind endowments at peers such as Stanford. Part of this reflects a weak performance in fiscal 2009, which had a lot to do with the portfolio left by her predecessor, Mohamed El-Erian, who recently quit a top job at Pimco. Harvard’s return in the past four years, arguably a more telling measure of Mendillo’s performance, looks better at 10.6% annually, 1.4 percentage points above the endowment’s benchmark.”, Andrew Barry

“El-Erian made a mess of Harvard’s endowment and then left, and yet somehow Bill Gross decided to hire him to co-run Pimco. And the past several years, the business talk shows and publications were filled with “expert” interviews and quotes from El-Erian. Well, now we know how his tenure at Pimco turned out. Not that different than Harvard. Not good. I am betting with his track record and pedigree, he will probably land on his feet, maybe with a top spot at The Federal Reserve, in the Obama administration, the IMF, or the World Bank? Just look at former FDIC Chair Sheila Bair. Under her tenure, the FDIC insurance fund (for which she was responsible) became insolvent. Yet now that “experience” qualifies her to become an independent director of Banco Santander!” Mike Perry, former Chairman and CEO, IndyMac Bank

Interview  | SATURDAY, FEBRUARY 8, 2014

Lessons Learned at Harvard

By ANDREW BARY  

Slammed in the financial crisis, the university’s endowment has been tweaked, in part to add liquidity.

Jane Mendillo has one of the most prominent jobs in the investment world. As the CEO of Harvard Management, she oversees the $32.7 billion Harvard endowment, the largest university endowment in the country.

She began the job at an inauspicious time, in July 2008, just months before the financial crisis hammered the Harvard endowment and exposed its weaknesses, including a lot of illiquid investments. The endowment declined by 27.3% in its fiscal year ended in June 2009 and still hasn’t gotten back to its pre-crisis peak of $36.9 billion.

Mendillo has restructured the endowment to improve liquidity and has successfully pushed for initiatives such as greater direct real-estate investments, which have produced strong results. Overall, returns have been good, not great, during her tenure. Harvard was up 1.7% annually in the five years ended in June 2013, ahead of its benchmarks in a policy portfolio—or targeted asset allocations—by 0.5 percentage points, but behind endowments at peers such as Stanford. Part of this reflects a weak performance in fiscal 2009, which had a lot to do with the portfolio left by her predecessor, Mohamed El-Erian, who recently quit a top job at Pimco.

image

Jason Grow
“We’re looking at investments over a five-to-10-year time frame, and in that context, emerging markets are attractively priced today.” —Jane Mendillo

Harvard’s return in the past four years, arguably a more telling measure of Mendillo’s performance, looks better at 10.6% annually, 1.4 percentage points above the endowment’s benchmark.

Harvard’s endowment remains widely diversified, with a modest 11% in U.S. stocks, and 55% allocated to alternative investments, including private equity, hedge funds, real estate, and natural resources. The Harvard model was distinctive a decade ago, but has since been widely imitated by foundations, endowments, and many individuals.

Harvard’s unusual hybrid approach combines an internal team of investment managers, who run about a third of the portfolio, and outside firms, who manage the rest. Most big endowments farm out nearly all of their money. Harvard’s strategy has lifted its returns, but also led to some unfavorable publicity about high compensation for top-performing internal managers. Harvard Management (HMC) is part of the university, which must disclose the compensation of its top-paid employees each year. Mendillo made $5.3 million, and one of her colleagues netted $6.6 million in 2011, the most recent year for which data are available.

Mendillo came to Harvard after running the Wellesley College endowment for six years. Before that, she spent 15 years at Harvard Management. Barron’s spoke with her recently at HMC’s Boston offices. She discussed stocks, bonds, and private equity, as well as the endowment’s returns and how individuals can invest like Harvard Management.

Barron’s: What have been your biggest accomplishments in five years running the endowment?

Mendillo: Since the financial crisis in 2008 to 2009, we’ve rebuilt and restructured the portfolio. We’ve also rebuilt the team here at HMC.

Can you talk about specifics?

We’re doing most of our real-estate investing in direct deals and joint ventures, instead of through private funds, and that gives us a lot more control over buy-and-sell decisions and leverage. Probably 50% of our real-estate portfolio is held directly. There’s been a huge difference in the performance of our direct investments and our legacy real-estate portfolio. The direct investments have added a lot of value. We’ve invested in a range of assets, including senior-living facilities and projects that couldn’t be funded by the original developers.

What did you learn from Harvard’s experience in the financial crisis?

It was a stressful period for us and for a lot of portfolios. The liquidity in the endowment was not what it should have been. We now have fewer investments locked up for multiyear periods with outside managers, and that was one of my goals coming in.

Harvard has a widely diversified portfolio. In the past few years, a simple approach of buying the S&P 500 or using a 60/40 mix of stocks and bonds has done as well or better than the Harvard endowment. Does your strategy still make sense?

It does. If you are a long-term investor, you want to be diversified across markets and geographies. That’s our approach. In one particular year, the S&P 500 may beat our portfolio and may beat every endowment portfolio. And in another particular year, a 60/40 stock/bond portfolio may beat our portfolio. But over time, there is a really significant difference between our portfolio and a 60/40 portfolio.

What are the numbers?

In the 10 years ended June 30, Harvard’s endowment returned 9.4% annually, versus 6.8% for a 60/40 mix of global stocks and bonds. That difference of almost three percentage points is worth billions of dollars of value to the endowment. When there’s a year or two in which the 60/40 portfolio beats the endowment portfolio, people love to write about how the endowment model may be inferior, but that’s very short-term thinking. The evidence looking back, and, I think, looking forward, is that being more diversified is going to pay off.

What about volatility?

There’s a lot more volatility in the stock market and in a 60/40 portfolio than there is in our diversified portfolio. So not only has the portfolio added a lot more value over the last 10 and 20 years than a 60/40 blend, but the portfolio has done it with less volatility.

image

Harvard has just 11% of the portfolio in domestic stocks. Why would you want such a small allocation to the world’s biggest equity market and some of the best companies?

We want equity exposure, but we’ve spread it across U.S. public equities, private equity, and international markets, and that has created a lot of opportunity.

You’ve talked about some of the challenges now in the private-equity industry.

Private equity is a much more crowded place than it was 10 or 20 years ago. So you need to be choosy and pick the right managers and opportunities. It has been estimated there is a trillion dollars of dry powder in the private-equity industry today.

So that’s money committed by investors, waiting to be deployed?

That’s right. That is going to create a competitive environment for private-equity managers who are putting money to work. It will drive up deal prices and drive down returns to more modest levels.

How much added return do you need in private equity, in return for tying up your money for five or 10 years?

We should be getting an incremental return for that illiquidity—and we call that our illiquidity premium—of at least 300 basis points [three percentage points] annually on average over what we are expecting in publicly traded stocks.

Given the hurdles for private-equity managers, why does Harvard have such a big allocation there?

Our portfolio is a combination of private equity and venture capital. It’s worldwide. We have positions in some very good funds. If we were building a private portfolio from scratch today, it would be very difficult to get to a 16% allocation, which is our policy-portfolio allocation in the asset class, because of the overcrowding and all that dry powder.

The endowment is critical to the financial health of the university. About 5% of the endowment each year is used for the university operating budget.

It’s actually a little bit north of 5%, and the endowment delivers about 36% of Harvard’s operating budget. To support that spending rate and to protect against inflation, we need to generate about an 8% annual nominal return over time.

Is that hard to do, given low rates?

Just about everybody would say that it is harder today than it was 10 or 20 years ago. Part of that is the interest-rate environment and part of that is that less-efficient asset classes are more crowded.

Over the next five to 10 years, can the endowment return 8% to 9% annually?

I certainly hope so. I think we’re well positioned to do that.

Why such a low allocation to bonds, at about 11%?

Bonds are traditionally a stabilizer in the portfolio. But with interest rates where they are, the potential return on bonds seems asymmetric. There seems to be more downside, more chance that interest rates are going to go up than that they are going to go down further. The coupon [interest rate] on the bonds just isn’t that attractive. So over time, we have taken money out of bonds and put it into other places in the portfolio.

You manage the bonds in-house?

That’s right.

What portion of the Harvard endowment is run internally?

It’s about 30% to 35%. Fixed income is a great example. We manage all of our money in fixed income through an internal team here, and they’re active traders. They look across markets globally for opportunities, and they’ve been really successful. So although our allocation to fixed income has declined, we’ve added a lot of value, relative to our benchmarks, and we are very happy with that.

When your internal managers do well, they can get paid millions of dollars annually. That led to some criticism in the Harvard community. Does it bother you?

The compensation issue has cropped up from time to time. There is a big difference between what we pay for our fixed-income management and performance through our internal team and what we would have to pay for the same performance from an outside manager. The cost for an outside manager would be a multiple of what we pay for inside management. Overall, our approach has been very cost-effective for the university.

How can an individual invest like Harvard?

Individuals shouldn’t try to be as complicated as Harvard, and they need to keep their investment horizon in mind. Harvard has been around for almost 400 years. It is going to be around for another 400 years, at least. We have a very long-term horizon, and so we can afford to be opportunistic and illiquid with a lot of the portfolio. Individuals have a shorter time horizon, and they may have different sensitivities, including a need for income. So if they want to invest like Harvard, they should be diversified.

Which means?

That means a mix of assets: stocks and bonds, as well as other assets like real estate. I’d also suggest that they invest across geographies. Although things have looked very good in the U.S. equity market in the past year or two, that can change.

Anything else?

Individuals should do research before they make investments. I’m surprised by the number of individuals—even smart and sophisticated individuals—who will make investments in their personal portfolios that they haven’t really investigated. We do a tremendous amount of research before we invest any money on Harvard’s behalf.

What do you think of emerging-market equities now?

Given our long-term view, emerging markets look attractive. There is a lot of consternation out there about emerging markets, and there is good reason for some of it. But those concerns really are for the next six months or a year or two. We’re looking at investments over a five-to-10-year time frame, and in that context, emerging markets are attractively priced today.

Harvard often is compared with other endowments, including those of Yale, Stanford, and Princeton. While Harvard’s performance has been good relative to your benchmarks, it has trailed some of your peers. What’s happening?

The difference between Harvard’s performance and our peers’ performance is something the press is always going to be interested in. But other institutions may have different risk profiles and different needs. So we think our policy portfolio meets Harvard’s needs, and we are very happy when we beat that and add value, which we did last year [by more than two percentage points] to the tune of over $600 million. So I’m pretty happy about that.

How much longer do you want to spend running the Harvard endowment?

This is a great place to be for someone in my field. It’s the best job in the world. I’d like to be here for as long as I’m adding value.

Thanks, Jane. •

E-mail: editors@barrons.com

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“The Peterson Institute of International Economics estimates that 39% of the increase in U.S. income inequality is because of this imbalanced trade. Yet Washington keeps negotiating so-called free-trade agreements that seem to open the U.S. market while leaving others relatively closed.”, Clyde Prestowitz

“Like most Americans, I have mixed feelings on free trade. On the one hand, I believe in free markets and fair competition and ultimately with the fact that we have to compete with the world. The positive is that it forces American business and labor to work hard together to innovate and stay “lean and mean”. We can’t live in fantasy land. It’s a fact that we ultimately have to compete with the world. The “water” in our glass is a lot fuller than most of the worlds’, so when we place our glass next to other countries and then eliminate the glass (free trade), what happens? The “water” equalizes, doesn’t  it? On the other hand, I agree that in the short-run ”free trade” can hurt American labor and our economy. That’s about as much as I know about free trade. But I do know that the U.S.’s roughly $1/2 trillion annual trade deficit means that we are selling U.S. assets each year to pay for the net foreign goods and services we purchase. What assets get sold? Mostly it’s government securities like U.S. Treasuries, Fannie, Freddie, and Ginnie, and debt in U.S. financial institutions. Our huge trade deficits essentially keep U.S. dollar-denominated financial assets flowing throughout the world and encourages the U.S. (at all levels in both the private and public sectors) to pile on more debt. There are many economists, including former Fed Chairman Greenspan and Bernanke, who believe that the huge inflow of foreign investment into the U.S. pre-crisis, lowered risk premiums and inflated asset prices and was a major contributor to the U.S housing and mortgage bubble and bust and the financial crisis. I agree. There are some economists though that have linked the U.S.’s long-term foreign trade imbalance to the massive foreign investment (pre-crisis) into U.S. financial institutions and U.S. debt (see statements #78, #82, and #96 on this blog). I think they are related and I think they were a major source of instability and cause of the financial crisis.” , Mike Perry, former Chairman and CEO, IndyMac Bank

latimes.com/opinion/commentary/la-oe-prestowitz-sotu-trade-deficit-20140130,0,1832709.story

Op-Ed

The all-too-real costs of free trade to average Americans

The country is not better off when trade deal gains go only to the very rich.

By Clyde Prestowitz

January 30, 2014

 

In his State of the Union message, President Obama suggested apprenticeships, tax reductions on new investments, and building new infrastructure as ways to increase jobs and reduce inequality in America.

But he said virtually nothing about what is probably the single biggest cause of lost jobs and stagnating earnings for all but the richest of America’s citizens: the U.S. current account deficit, which includes the trade deficit.

Although the Federal Reserve Bank says we’re in the midst of a recovery, and the official unemployment rate has fallen below 7%, the economy is far from being out of the woods. That official rate — technically known as U-3 — doesn’t begin to tell the real story. It is only one of six unemployment measures kept by the U.S. government and counts all those who say they are unemployed and looking for work. But it does not include those discouraged unemployed workers who have given up looking for a job or those who would like to work full time but are only able to find part-time work. The rate that includes all those people — U-6 — is about 13%. Granted, that is below the 17% of 2010, but it is still far above the 8% of 2007, as we navigate what is being called a recovery — albeit an abnormally slow one.

Perhaps even more disturbing is the dramatic increase in the gap between the incomes of the wealthiest 5% of Americans and the rest. Virtually all of the benefit of the present “recovery” is going to those in the top income brackets. As far as the rest are concerned, it’s still the Great Recession.

Since 1973, the wealthiest 1% of Americans’ share of GDP has risen from about 7.7% to more than 19%. Meanwhile, the inflation-adjusted earnings of the median American household have been essentially unchanged.

As this was happening, the U.S. trade deficit rose from virtually nothing in the early 1970s to about $540 billion in 2012. Take advanced technology goods as an example. Here the trade deficit over the last decade has accumulated to more than $500 billion, and this is the area in which the United States is supposed to be the world leader.

The Information Technology and Innovation Foundation has estimated that more than 60% of the 5.7 million U.S. manufacturing jobs lost over the last decade were because of rising imports of manufactured goods. The Peterson Institute of International Economics estimates that 39% of the increase in U.S. income inequality is because of this imbalanced trade.

Yet Washington keeps negotiating so-called free-trade agreements that seem to open the U.S. market while leaving others relatively closed. A major reason for this is the classic economists’ argument that the generally lower consumer prices that may arise from imports will exceed the more limited wage losses that may occur in a few specific industries, and therefore, on balance, free trade will always and everywhere be a win-win arrangement. In other words, despite the millions of jobs lost as a result of the rising U.S. trade imbalance, the overall U.S. economy is supposed to be better off today than 10 years ago because of lower prices for consumers. The argument is that the wage losses occur only in a limited number of industries, while the lower prices are available to the entire population.

This simplistic analysis is incomplete and wrong. Its key assumption is that the economy is at full employment. In such a situation, workers who lost jobs in a few industries would lose wages only for a limited period until they found new jobs at the same wages as the old jobs. Thus there would be no overall downward pressure on wages and only limited and temporary wage losses for a relatively small part of the labor force, while the whole population would be benefiting from lower consumer prices.

Well, it is clear now, after a long and deep recession, that the economy is not always at full employment and that even if workers find new jobs, the pay is often lower than at their old jobs. Indeed, most of the jobs created in the last year have been in low-wage industries such as retailing and food service.

This means that there is overall downward pressure on wages from the loss of jobs to imports, and that the losses might well outweigh the gains for consumers. Indeed, the average American has not seen much in the way of real income gains over the last 40 years as the trade deficit has mounted.

Moreover, it’s clear that those gains that have been achieved have gone overwhelmingly to the very tiny, richest percent of the population. Statistically, it may look as if the GDP has risen. But the country is not really better off if all the gains have gone only to the top half of 1% of the citizens.

As former IBM chief scientist and former Sloan Foundation President Ralph Gomory and former American Economics Assn. President William Baumol noted in their groundbreaking book, “Global Trade and Conflicting National Interests,” free trade is not always a win-win proposition. It can be win-win under some circumstances, but it can also be a losing proposition under other circumstances. For the United States, the latter has too often been the case.

In the past, the president has called for the doubling of exports. He would have done better Tuesday night simply to call for balancing U.S. trade, which by creating 5 million jobs would bring America to full employment and greater equality.

Clyde Prestowitz is president of the Economic Strategy Institute and served as counselor to the secretary of Commerce in the Reagan administration.

Copyright © 2014, Los Angeles Times

“Mr. Hamman suggested a $1 billion prize for nailing every game in the NCAA tournament. Before coming to terms, SCA and Mr. Buffett, along with his reinsurance-business chief, Ajit Jain, set about answering a tough question: What was the chance of a winner? Mr. Buffett said the odds can’t be calculated.”, Wall Street Journal, February 10, 2014

“I think Warren Buffett is a hypocrite whose long track record of success (and nerdy persona) may be affecting his business judgment. I think it irresponsible to force the shareholders of Berkshire to take on a $1 billion insurance risk for a one-time fee of around $10 million plus or minus. (He should make this bet personally, if he wishes.) Who cares how mathematically improbable his paying out the $1 billion is? Pre-financial crisis models showed the odds (of a crisis) to be astronomically low too and yet it happened. Plus, with 10 million entrants, the connectivity of the web, and supercomputers how do you know for sure there hasn’t been collusion? This is exactly the sort of “tail risk” that prudent financial institutions are not supposed to be taking on post-crisis. And no it is not the same as insuring against unpredictable hurricanes, typhoons, and earthquakes, as Buffett has claimed in an earlier article. Those events have occurred (and the risk can be modeled to a much greater extent), the insurers have earned billions in fees and will continue to do so, and there is a social value to this type of insurance (protecting people and institutions from catastrophic risks). A “Final Four” insurance contract is not that dis-similar to a lot of derivative securities he says he despises: “Weapons of Mass Destruction”. While I am at it, does anyone else notice that Buffet seems to be enamored with cute women? Notice how Buffett seems to love the attention of the ladies at CNBC? Was he the nerd who never got the cute girl when he was young? That is pretty harmless, but it seems to me this tendency has now become a management risk for Berkshire shareholders. He has hired a cute, very young lady, with virtually no experience, and appointed her Chairman of some of the major corporations he has purchased. I don’t care how well he has performed as an investor and how well Berkshire has performed. It seems to me, that he is taking on risks that are not prudent; both insurance and management risks. Has this always been the case or is this new since he became a celebrity?”, Mike Perry, former Chairman and CEO, IndyMac Bank

Buffett Bails, Yahoo Left at the Court In $1 Billion ‘March Madness’ Contest

By 
REED ALBERGOTTI, 
BEN COHEN and 
ANUPREETA DAS
Updated Feb. 10, 2014 12:09 a.m. ET

Last year, Yahoo Inc. drew up plans to offer $1 billion for predicting the winner of every March Madness game. Then, a nearly identical offer emerged, backed by Warren Buffett.

Now comes a lawsuit, opening a window into the obscure business of such prizes, and the insurance companies that make them possible.

The dispute in state court in Dallas is narrow: Does Yahoo owe Dallas-based SCA Promotions roughly $4 million for canceling the Internet company’s plans once Mr. Buffett backed a separate contest?

Companies like SCA work with sponsors like Yahoo to offer prizes for stunts with long odds, such as half-court basketball shots or fan field-goal kicks. Then, the sponsors pay a much smaller sum to insure against the possibility of actually having to pay out. The contests often involve intricate calculations of odds for rare human achievements.

The following narrative is based on interviews with Mr. Buffett and the president of SCA, Bob Hamman, who both gave a similar account of the events, along with court papers filed in connection with the suit.

The story began last summer at Mr. Buffett’s lunch table, when longtime bridge buddy Mr. Hamman mentioned the big prizes he has helped organize and underwrite for unlikely feats, like $1 million for irrefutable evidence of Bigfoot.

Mr. Buffett, whose Berkshire Hathaway Inc. insures such offers, was intrigued. He and Mr. Hamman began discussing other deals. Mr. Hamman suggested a $1 billion prize for nailing every game in the NCAA tournament.

Promotional contests pegged to a perfect bracket have proliferated in recent years, typically for rewards between $1 million and $10 million. This bet would raise the stakes dramatically.

After the lunch, Mr. Hamman started assembling a deal. SCA would strategize and coordinate. Mr. Buffett’s Berkshire Hathaway would take on the risk, and earn a fee for doing so.

Before coming to terms, SCA and Mr. Buffett, along with his reinsurance-business chief, Ajit Jain, set about answering a tough question: What was the chance of a winner?

Mathematically, there will be more than nine quintillion possible outcomes, once the NCAA field is set next month. But not all will be equally likely. In the early rounds of the 68-team tournament, the teams viewed as the strongest are paired against the weakest, mismatches that can lead to thrilling upsets and disrupt even sophisticated prediction models. (Mr. Buffett’s challenge, like most, ignores the four initial “play-in” games, requiring the winner to correctly predict 63 games.)

Even among statisticians, there is little consensus on how to set the odds for a perfect bracket. ESPN has hosted a bracket contest for the past 16 years, drawing more than 30 million entries, collectively. No one has picked a perfect bracket, a spokeswoman said.

Mr. Buffett said the odds can’t be calculated. “Any math professor who says the odds are a quintillion to one, they better have tenure,” Mr. Buffett said Wednesday, adding that the professor shouldn’t apply at Berkshire’s insurance department if he loses his university position.

Last fall, Messrs. Buffett and Hamman took the idea to Yahoo, a big player in sports fantasy leagues, to negotiate a fee. Mr. Buffett’s team worried about a surge of entrants, up to 10 million. With more entrants, the chance of a winner increases.

Mr. Buffett wanted a premium for more entries. The two sides couldn’t reach an agreement and Mr. Buffett withdrew from the talks.

Some say he was needlessly fretting. “I wouldn’t even bother insuring it,” said Andrew Becker, an astrophysicist at the University of Washington. Mr. Becker estimates the odds of a winner are so slim that the premium should be less than a dollar.

Mr. Hamman of SCA had a different worry: computer hackers. “A significant percentage of the risk is just a data-security problem,” he said.

For its part, the NCAA, the governing body of college sports, fears that big bucks will tempt participants to alter the outcome of games.

“Two fundamental principles of college athletics are the integrity of the game and the well-being of the student-athletes,” an NCAA spokeswoman said, adding that the contest “poses a potential threat to both of these important values.”

Mr. Hamman would have preferred to work with Mr. Buffett, his bridge friend of many years. But he kept negotiating with Yahoo, which eventually agreed to pay him $11 million to insure against a winner. according to the SCA lawsuit. Mr. Hamman worked with other deep-pocketed insurers to mitigate the risk.

In late November, Mr. Buffett attended a Detroit event sponsored by Goldman Sachs that included Detroit Mayor Dave Bing, a former NBA star. Mr. Buffett mentioned the $1 billion promotion to Dan Gilbert, founder of Quicken Loans Inc. and owner of the NBA’s Cleveland Cavaliers.

Quicken and Berkshire reached a deal; Mr. Buffett declines to discuss the fee. Mr. Hamman was caught off guard when Mr. Buffett and Quicken released details of their contest on Jan. 21. The contest is limited to 10 million entries. Quicken reserved the right to expand the pool.

Yahoo executives cooled on the idea once they learned Mr. Buffett was backing a competing contest, according to people familiar with the deal. On Jan. 27, Yahoo canceled its plans, according to Mr. Hamman.

A Yahoo spokeswoman declined to comment.

Yahoo had already paid $1.1 million to SCA, according to the suit. The contract specifies that Yahoo would have to pay half of the $11 million fee if it canceled the contest. Yahoo claims SCA violated the contract by breaching the confidentiality of the deal, according to a letter sent by Yahoo.

SCA is asking for $4.4 million in the suit, which it says is what remains to be paid beyond the $1.1 million.

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“This debate is fundamental, and the answers affect nearly everyone. Are speculative market booms and busts — like those that led to the recent financial crisis — examples of rational human reactions to new information, or of crazy fads and bubbles? Is it reasonable to base theories of economic behavior, which surely has a rational, calculating component, on the assumption that only that component matters?”, 2013 Nobel Laureate in Economics, Robert J. Shiller

“Prior to the 2008 financial crisis, “rational market theory” was the mainstream view of economists and financial regulators and the SEC and FASB (GAAP accounting) largely required that financial instruments be marked to market (and still do). Also, class action securities disclosure fraud law continues to be based on “rational market theory” and most econometric/financial models to this day assume “rational markets”. As a result of the financial crisis, many are now questioning “rational market theory”. Clearly, I think it is appropriate, with the benefit of hindsight, to question this foundational economic theory. However, was it really fair of the FDIC-R to sue me for negligence and allege that I, alone, should have known that the U.S. housing and mortgage markets were going to collapse in the second half of 2007 and so I should have been reducing IndyMac’s mortgage lending volume, even more than I was already doing, beforehand? I don’t think so. These markets involved millions of individual buyers, sellers, and borrowers and trillions of dollars in economic transactions. In addition, these markets had thousands of Realtors, builders, appraisers, lenders, bankers, and institutional investors and scores of others (title and escrow companies, law firms, mortgage insurers, FHA, Ginnie Mae, Fannie Mae, Freddie Mac, bond insurers, national statistical rating agencies, government financial regulators like the Federal Reserve and FDIC) participating. How was I alone, a leader of one, mid-size financial institution, supposed to go against the grain of this entire marketplace and predict that it was an unsustainable bubble about to burst? To this day, our top economists can’t agree as to whether markets are rational or not or somewhere in between. Let alone decide on what practically needs to be done, if they did agree. But the FDIC thought I should be able to figure this all out by myself in a few months in 2007. That’s not fair or right.”, Mike Perry, former Chairman and CEO, IndyMac Bank

BUSINESS DAY

The Rationality Debate, Simmering in Stockholm

JAN. 18, 2014

John Sposato

Economic View

By ROBERT J. SHILLER

Are people really rational in their economic decision making? That question divides the economics profession today, and the divisions were evident at the Nobel Week events in Stockholm last month.

There were related questions, too: Does it make sense to suppose that economic decisions or market prices can be modeled in the precise way that mathematical economists have traditionally favored? Or is there some emotionality in all of us that defies such modeling?

This debate isn’t merely academic. It’s fundamental, and the answers affect nearly everyone. Are speculative market booms and busts — like those that led to the recent financial crisis — examples of rational human reactions to new information, or of crazy fads and bubbles? Is it reasonable to base theories of economic behavior, which surely has a rational, calculating component, on the assumption that only that component matters?

The three of us who shared the Nobel in economic science — Eugene F. Fama, Lars Peter Hansen and I — gave very different answers in our Nobel lectures. Mr. Fama’s speech summarized his many years of research in strong support for the notion of economic rationality. He marshaled evidence suggesting that share prices respond almost perfectly to information about stock splits and that interest rates “contain rational forecasts of inflation.”

Mr. Hansen seemed to occupy a centrist position in the debate. In his lecture, he spoke of “distorted beliefs” that he said help account for some otherwise incongruous empirical evidence about financial markets’ behavior. He emphasized mathematical models that contain elements of rationality but also take into account features like animal spirits, beliefs about rare events, and overconfidence, all of which I view as being more or less irrational.

My own talk seemed to put me at one extreme, with Mr. Fama occupying the other. I said that aggregate stock price movements were mostly irrational, but I don’t believe I was as radical as some might imagine, because I still advocated a free-market system, with innovations to make it work better.

I was the most willing of the three of us to incorporate ideas about nonrational or irrational behavior from other social sciences: psychology, sociology, political science and anthropology.

I’ve been studying Nobel lectures of our predecessors, and the debate doesn’t seem new. Judging from their words, many laureates — includingHerbert Simon in 1978, Maurice Allais in 1988, Daniel Kahneman in 2002,Vernon Smith in 2002, Elinor Ostrom in 2009 and Oliver Williamson in 2009 — have questioned whether economic actors are rationally pursuing self-interest, as traditional economic theory assumes.

It is hard to sum up all this discussion, however, because of a basic problem: defining “rational.” Christopher Sims, a Nobel laureate in 2011, has proposed that inattention to the facts can be rational, if you define the word broadly. Rational people know that their time is limited and realize that they cannot know everything. They must choose what they pay attention to.

Mr. Sims’s argument suggests that it may be rational for busy people not to balance their checkbooks if they feel they don’t have the time, though they know they will make mistakes as a result.

But if people feel that the work of balancing a checkbook is just too unpleasant, it’s less obvious how to classify their behavior. Some kinds of inattention are even harder to categorize. What about people who decide they don’t have the time to read the news thoughtfully enough to consider whether they will buy a house during a boom, and thus make decisionsbased on nothing more than hearsay and emotions?

Such questions aren’t confined to economics. Political science has a similar conflict. People often seem emotionally involved — even irrational — when talking politics. In their 1996 book, “Pathologies of Rational Choice Theory,” Donald Green and Ian Shapiro, two political scientists, describe their colleagues’ “highly charged debates about the merits of rational choice theory.”

Other sciences are approaching such questions in novel ways. Brain-imaging techniques are improving our understanding of the cognitive neuroscience of attention, revealing the physical structures that allow us to process information as well as we do, and giving material form to some of the abstract notions in Mr. Sims’s theory of rational inattention. This research, identifying physical structures that underlie our thinking, has a welcome concreteness.

Neuroscience is also showing important links between people’s emotions and behavior they consider rational. In his 1994 book “Descartes’ Error,”the neuroscientist Antonio Damasio considered the admonition of the philosopher Descartes to keep emotions away from our rational thinking. Mr. Damasio examined research finding that emotional pathways in the brain are interlinked with our calculating, ostensibly rational counterparts.

The neuroeconomist Ernst Fehr at the University of Zurich — who I hope will someday become a Nobel laureate himself — has used functional magnetic resonance imaging, or fMRIs, to study people playing games involving economics and finance. His summary of his and many colleagues’ research shows unequivocally that there are links between rational and emotional decision-making. When a game player makes an apparently calculated, rational decision to take an aggressive action against his opponent, emotional and social pathways light up as well, suggesting that the decision wasn’t entirely rational.

The question is not simply whether people are rational. It’s about how best to describe their complex behavior. A broader notion of irrationality may someday be reconciled with one of rationality, and account for actual human behavior. My bet is that real progress will come from outside economics — from other social sciences, and even from information sciences and computer engineering.

ROBERT J. SHILLER is Sterling Professor of Economics at Yale.

A version of this article appears in print on January 19, 2014, on page BU6 of the New York edition with the headline: A Debate Simmers in Stockholm. 

“Yelp sells ads through a mix of a self-service model similar to Google’s and a “full-service” model using a sales force. The company doesn’t disclose how much revenue comes from each method, but said it plans to invest more in the business in the coming year to capture more market share.”, Heard On The Street, Wall Street Journal

“Where is the SEC on these types of simple and yet important, material non-disclosures? Just pick up and read any financial publication; they seem to be everywhere. Yelp needs the SEC to tell them: “Look, you need to disclose this information to investors pronto, it’s important and material.” But it seems to me that the SEC really doesn’t have a mechanism for this to occur. Again, I think this is related to the fact that the SEC is “overrun” by lawyers who seem to be mostly focused on “buffing” their resumes with securities fraud cases. I think securities fraud tips are the primary purpose of the SEC’s relatively new hotline. And private securities fraud disclosure lawsuits, under the securities laws, require a stock loss to have occurred first. My fairly experienced view is that most of these private securities fraud cases are completely bogus. The plaintiffs lawyers literally track public companies whose stocks have declined enough during a period of time (I bet they even utilize economic formulas that include percent and dollar value declines, in deciding on how big a claim they can file, yet trying to beat their competitors to the punch in filing a suit.) and then hunt through the companies public filings for a non-disclosure issue like the one above. The Yelp “non-disclosure” most likely has nothing to do with securities fraud, but it probably should be disclosed to investors. (It seems important and material to me and the author of this short article.) I believe the SEC needs to develop a program that encourages non-lawyers: private institutions, financial analysts, and even individuals to raise these types of important disclosure issues with them and earn a fee commensurate with their value. (Assuming the SEC requires the company or the industry to improve their disclosures, as a result.) And I think that fee should be a simple and considerable amount, say one million dollars (paid by the company or industry). If the disclosure is important and material, it’s worth one million. (If the SEC doesn’t like this idea, I have another: require public companies to maintain on their public websites a section for interested parties to request certain public disclosures be made and for the company to respond. And then require annually the company to file in their 10-K or “Annual Public Disclosure 8-K”, these requests and their response. In this way, it is not some analyst or shareholder privately asking for the disclosure to be made and being turned down. It is all out in the open and the SEC knows; placing a lot of pressure on the company to disclose it or justify why they had not.) Either way, not only should it improve public company disclosures, but it might occur before the company’s stock suffers a decline and therefore either help investors avoid losses and/or help prevent multi-million dollar frivolous class action securities fraud lawsuits from be filed.” Mike Perry, former Chairman and CEO, IndyMac Bank

No Law of Large Numbers for Yelp

By
DAN GALLAGHER
Feb. 6, 2014 3:46 p.m. ETFor a small company, Yelp commands some big numbers.For instance, there’s the 67% revenue-growth rate year over year that the online-review site has averaged each quarter since it went public in March 2012. There is also the site’s 120 million average monthly visitors in the fourth quarter, up 39%. And 53 million of those are coming from mobile, up 60% in the fourth quarter.

There’s another big number: 17.5 times. That’s the multiple of 2014 revenue at which Yelp’s stock trades. It makes Google‘s 5.6 times and even Facebook‘s at 14 times look cheap. And they’re established Internet powerhouses also targeting the same local business segment Yelp does to increase ad sales.

Yelp’s opportunity is significant. Janney Capital estimates the local online advertising market in the U.S. at north of $130 billion. Yelp is a well-known brand that made only $233 million in revenue last year. The company also noted in its earnings call late Wednesday that only 4% of its revenue came from international markets that accounted for about 21% of traffic to the site.

But growth won’t come cheap. Yelp sells ads through a mix of a self-service model similar to Google’s and a “full-service” model using a sales force. The company doesn’t disclose how much revenue comes from each method, but said it plans to invest more in the business in the coming year to capture more market share. It projects earnings before interest, tax, depreciation and amortization to jump by about 90% in 2014 following last year’s sixfold surge.

Despite the fact that Yelp is going up against big, rich rivals, Wall Street mirrors these high hopes, expecting revenue growth to average 43% over the next three years. As a business, Yelp does have good growth potential. Its stock looks like it’s already there.

Write to Dan Gallagher at dan.gallagher@wsj.com

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