Unintended but Predictable Consequences

Obama and the Democrats are shocked and furious that Bank of America wants to charge customers a monthly fee for using a debit card, now that the Dodd-Frank financial services legislation reduced the fees retailers pay to banks for debit cards.

So now bank customers can pay for debit card usage directly when retailers did before. While retailers in principle should lower prices to reflect lower costs, that may not happen.

This is a terrible deal for consumers, all due to the predictable consequences of Dodd-Frank.

Was increasing consumer costs so Wal-Mart could have lower costs the change voters had in mind when they voted for Obama? No, but it is what they've gotten.

Free Lunches Aren't So Free

General Motors announced that it is withdrawing its application to borrow $14.4 billion in loans from the federal government.

The loans are part of the government's $25 billion program to lend money at below-market interest rates to auto companies to subsidize their investment in more fuel-efficient cars.

But GM has decided that there is a price to pay for government handouts, since many car buyers have shunned bailed out GM and Chrysler, preferring to buy cars from Ford which didn't take government money.

While it may be optimistic to believe that GM's example will deter others from seeking bailouts in the future, it is good to see that the stigma from government bailouts will make others think twice before pursuing them again.

TARP Returns

The federal government sold its remaining shares in Citigroup, resulting in a total profit of $12 billion on its $45 billion investment in Citigroup during the financial crisis.

As I wrote at the time, the government's investment in financial services companies under TARP is very different than its bail out of GM, Chrysler, Fannie Mae, and Freddie Mac. The two biggest American banks, Citigroup and JP Morgan, combined to make $88 billion from 2005-2007, while in that same period the two biggest auto makers, General Motors and Ford, lost a staggering combined $65 billion. Recall these years exhibited strong economic growth.

The significance of this vast difference in pre-crisis financial performance is that the TARP investment in the big banks had a much better chance of turning a profit than the TARP investment in the auto companies.

And that is exactly how things have turned out to date.

American Leadership, or Not

Many countries believe the Fed's recent round of quantitative easing is designed to depress the value of the U.S. dollar relative to other countries, and thereby to increase American exports by making goods produced in America cheaper in foreign currency terms.

This had led to much outrage expressed by international leaders, with Brazilian leaders saying the U.S. is engaged in a "currency war." Germany's Finance Minister Wolfgang Schaueble not only thinks QE2 is bad policy but says it violates the Obama administration's international commitments. Schaueble said: "These huge economic problems cannot be solved with more debt. That was the joint policy all developed nations, even the United States, agreed on at the G20 summit in Toronto."

Schaueble went on to say the United States should follow Germany's example of how to deal with the financial crisis - in which Germany cut government spending!

And how does Barack Obama feel about the Fed's QE2 policy in light of this international criticism of American policy? He supports the Fed's actions.

The U.S. dollar has a unique role in the world economy as the global reserve currency. Many nations (through their central banks holding most of their foreign currency reserves in dollars) and individuals look to the dollar as the ultimate safe store of value; the dollar is the currency used to price many commodities (such as oil); and is the benchmark for setting interest rates.

Having the global reserve currency provides the United States great financial flexibility. For decades, China and Japan have been sending America products that fill our homes, and in returns we have been sending them dollars that fill their central bank reserves. It also allows the federal government to run huge deficits and confidently believe it can easily borrow the money to support such debts.

However, the price for having the reserve currency is that the United States has a global responsibility to manage our financial affairs in a prudent manner. Huge budget deficits, a housing-led financial crisis, and debasing the dollar through QE2 all contradict the required prudence.

This is why there is such international outrage directed at the United States, for understandable reasons.

What do we need to address this problem? Stop QE2, cut government spending dramatically to reduce the budget deficit, approve the free trade agreements with South Korea and other nations that the Democrats have stalled for several years, and implement policies that promote economic growth through lowering tax rates and reducing regulatory burdens such as ObamaCare.

Solutions exist which can improve the economy, ease international tension, and restore American leadership to the world. Unfortunately, Barack Obama is not the man for such a job.

Surprise, Surprise

The Federal Reserve has recently began another round of what it calls quantitative easing (dubbed in the press QE2, to reflect the second time the Fed has engaged in this policy since the financial crisis began and as a play-on-words with the famous passenger liner). And the amounts are huge; the Fed is spending $900 billion on this effort: $600 billion in new money and $300 billion by reinvesting proceeds from previous bonds it bought that have matured.

Quantitative easing is a fancy term for printing money, since it means that the Federal Reserve will buy bonds on the open market from investors and pay for it with newly created money (in the modern era, such vast amounts of newly created money are in the form of electronic credits deposited to an investor's account, not printed dollars - although such credits could of course be converted into dollar bills if desired).

The Fed's stated goal is to lower interest rates of U.S. government bonds, since, all else being equal, by adding its demand to the market, the price of bonds should rise (and interest rates decline as bond prices rise). This is the application of the laws of supply and demand to the bond market. And lower interest rates on government bonds tend to lead to lower interest rates on mortgages and loans to corporations, to higher stock prices, and to greater risk taking on the part of investors who seek higher returns away from government bonds.

But the problem with the Fed printing money is it raises the specter of higher inflation in the future, since, all else being equal, more money in circulation means prices should rise. This is the application of the laws of supply and demand to the money supply and the economy's price level. Further, if investors believe inflation will increase in the future, they will demand higher interest rates on bonds today to compensate them for investing their money at a fixed rate of return.

So some factors suggest QE2 will lead to lower interest rates, and other factors suggest it will lead to higher interest rates. The Fed is betting that lower interest rates will predominate, while many have criticized the Fed for downplaying the risks from higher inflation.

So who is right? Well, so far, QE2 has led to higher interest rates! That could change with new market conditions, but so far the Fed's plan is not doing what it intended.

Repentant Sinners

If Barney Frank doesn't waffle, his recent statement that Fannie Mae and Freddie Mac "should be abolished" may be the best thing a Democrat has said in a long time.

If Canada can have home ownership rates above those of the U.S. without their equivalent of a Fannie Mae or tax subsidies for mortgage interest, so can we.

And then we can avoid a housing-led financial crisis in the future.

The More Things Change, the More They Remain the Same

Fannie Mae and Freddie Mac, the two government-sponsored entities that were designed to promote home ownership, have been the biggest drain on the government's coffers by far in the TARP bailout. The government has poured $148 billion into them so far, on top of guaranteeing trillions of dollars of their debt.

These staggering losses are a manifestation of their seminal role in fueling the housing bubble and ensuing financial crisis. The government used them to subsidize housing, and in Democratic Congressman Barney Frank's words, he wanted to "roll the dice" with Fannie and Freddie to promote home ownership among low income people.

That "role of the dice" led to our catastrophic financial crisis.

So you might think, in a rational world where the Obama Administration claims it wants to prevent future financial crises, that the government would recognize that subsidizing the housing industry and mortgages should end, so bubbles are less likely to develop and so taxpayers are no longer on the hook for bad mortgage loans.

But the power to influence and control the housing industry, and to direct subsidies to favored constituents, is to tempting to the Obama crowd. Treasury Secretary Timothy Geithner has kicked off the administration's discussions of "housing reform" by saying that ther government should retain a role in the the mortgage finance business. Moreover, Geithner says one reason for this need for a government role is that 90% of new mortgage loans made over the past three years have had government support - suggesting that the private market can't provide sufficient mortgage lending.

What it really means is that it is hard for private mortgage lending to compete with government subsidized lending. Canada, which despite its left-oriented government policies has no equivalent to Fannie and Freddie, has no problem providing private mortgages with home ownership rates at or above those of the United States.

The government needs to end its myriad of subsidies for housing: it needs to wind down Fannie Mae and Freddie Mac and other government-sponsored mortgage supporters; it needs to repeal the Community Reinvestment Act which promotes non-economic lending; it needs to end the mortgage interest deduction to reduce the incentives to borrow; and it needs to end the favored tax treatment of capital gains on housing vs. other investments.

That Was Fast

Often the negative consequences of the government's intervention in the market takes some time to become apparent. But the egregiousness of Barack Obama's assault on the free enterprise system is so pervasive that we often see the impact in remarkably, and sadly, short order.

As example, a couple weeks after the passage of the healthcare bill, a number of prominent companies reported large write-offs due to the increased costs the healthcare bill will impose on them. When Congressmen claimed this was false, because "everyone knows the healthcare bill will reduce costs and not increase them", Congress began an investigation.

That investigation was quietly and quickly shelved when corporate documents submitted in response to the investigation revealed that many companies had done analyses that showed they could save money by terminating their health benefits for employees, paying the penalties in the healthcare bill for doing so, and letting employees get government-provided health insurance.

Now we have immediate consequences from the recently passed legislation imposing new regulations on the financial services industry.

The new law makes credit rating firms, such as S&P and Moody's, liable for the quality of their ratings decisions. Previously, such ratings were considered opinions, and since the ratings are estimates of what may happen in the future, an opinion is what they are. But now, if investors lose money on a bond which was rated by a credit rating agency, the credit rating agency could be sued by investors and win damages. Since there are trillions of dollars in bonds issued each year, credit rating agencies could go bankrupt based on the vagaries of the economy and markets.

In response to this risk imposed by the new law, the credit rating agencies are prohibiting the use of their ratings in the offering materials given to potential investors for new bond issuances. But some bonds, particularly those related to consumer loans such as mortgages, auto loans, student loans, and credit card debt, are required by law to include such ratings in their offering documents.

The predictable result?

A number of bond offerings have been put on hold, as participants digest the implications of the new law. The firms are investigating if there are ways to get around the rules through the issuance of private bonds, at the price of lower liquidity for new investors and higher borrowing costs for issuers of debt.

This will reduce the capital available to expand the economy, increasing borrowing costs, impairing job creation, and reducing economic growth.

But it is good deal for trial lawyers, who must be salivating at the opportunity for new revenue streams from litigating future bond defaults.

You might think, in a world of thoughtful and honest government, such an important part of the financial services law was heavily debated, so its consequences were well understood. But if you thought that, you haven't been paying attention to government policy the past two years. This provision was added to bill on June 30, when the law passed.

Such is how our freedom is being eroded, in last minute deals to pay off favored constituents that impose dramatic costs to the economy.

Speaking Truth to Power

Warren Buffet gave testimony this week to the Financial Crisis Inquiry Commission, which was created by Congress to investigate causes of the financial crisis.

In discussing how Moody's could have been so wrong, in hindsight, about credit ratings on mortgage-backed securities, Buffet said that 300 million other Americans also made the same mistake - including himself.

One of the fallacies behind the desire for giving regulators more power is that somehow regulators didn't have enough authority to stop banks from making bad loans in the run-up to the financial crisis. The various bank regulators have a great deal of power to change the behavior of banks under their jurisdiction - but there is no reason to believe that a regulator will have greater insight into the quality of a mortgage or other investment than the market or Warren Buffet.

In other words, if a brilliant investor like Warren Buffet doesn't see a bubble, why would you think a regulator will see it and, moreover, demonstrate the tenacity to stop what market participants otherwise believe to be reasonable investments?

The real cause of the crisis was the Fed's deeply accommodating monetary policy, and the government's push to get Fannie Mae and Freddie Mac and banks operating under the Community Reinvestment Act to increase lending to weaker credit risks.

None of that is being addresses in the financial regulatory legislation in Congress.

Never Forget

This Wall Street Journal column reminds us of one of the key ingredients of the financial crisis: the opposition by Democrats to limiting the size of Fannie Mae and Freddie Mac.

Democrats used the power of the filibuster in the Senate to oppose reforms of Fannie and Freddie, because they wanted those firms to aggressively lend money to subprime borrowers to promote home ownership among poorer Americans. Barack Obama was voted with his fellow Democrats against reforms that would have cut taxpayer losses and lessened the extent of the financial crisis.

In other words, Democratic opposition to reforms were directly related to the cause of the crisis: the extension of too much credit to subprime mortgages. Or as Barney Frank put it, he wanted to "roll the dice" with Fannie and Freddie.

Trillions of dollars of losses later, massive unemployment, government bailouts, the socialization of greater swaths of American industry, and looming massive tax increases are the result.

Cause and Effect

This Wall Street Journal article highlights one of the sad facts of government regulation and intervention in the economy: one act of government intervention often creates the demand for additional intervention later on.

In 1936, the federal government anointed the ratings on bonds provided by the credit rating firms of the day (Moody's, Standard, Poor's, and Fitch) as the basis for determining whether assets held by banks were of high quality.

Once the idea took hold, the government expanded its use including Securities and Exchange Commission rules in the 1970's that made the ratings agencies a more important part of the financial marketplace.

While it sounds like a good idea, the problem was (and is) that it reduces the need for banks to make their own determination of the credit quality of an investment. It allows regulators to substitute the judgement of the rating agencies for their own when assessing credit risk.

Because investors and regulators relied so heavily on these ratings, banks took on more risk than they otherwise would have. While it isn't the fundamental cause of the financial crisis, it certainly contributed to it.

The government, having made the financial crisis worse with its original regulations, now is using the financial crisis to increase its regulations - no doubt sowing the seeds for future losses due to forseen and unforseend effects from new regulations.

With respect to the ratings agencies, the government needs to get out of the business of promoting their role on assessing investments. If there is a market demand for their services, then let that demand determine their role in deals. Perhaps it looks similar to what occurs today. Perhaps their business model changes.

And in all cases, investors will be forced to be more thoughtful in their investment decisions rather than letting the agencies be their "crutch".

The Persecution of Goldman Sachs

If a person wants to buy a home, should he not do so because of the very fact that the seller wants to sell and therefore most "know something" to make it a bad purchase?

If someone wants to make an investment, such as in stocks, bonds, or a certificate of deposit, should she not do so because the seller wants to sell and therefore buying the investment is too risky?

If you think these are ludicrous perspectives on commonplace transactions, you are right.

But fundamentally, that is the essence of the SEC's allegations against Goldman Sachs it in the Abacus transaction involving subprime mortgages.

The Abacus deal required some parties to be "long" the deal (meaning they think the investment will increase in value) and others to be "short" the deal (meaning they think the investment will decrease in value). The SEC alleges that Goldman Sachs didn't disclose material information by not disclosing the name of the investor who was "short" the deal.

The "long" investors specialized in mortgage investments, managing billions of dollars, and as Warren Buffet said about the incident, knowing who the "short" is in the deal is irrelevant to making a proper investment decision.

Putting it another way, if you buy (taking the "long" position) a stock through your broker, you never know who the seller (analogous to taking the "short" position) is. Does that mean you shouldn't buy the stock until you know the name of the seller? Why would that matter? Clearly, the SEC doesn't think that is important since billions of shares a day are traded in the United States without the buyer knowing the identity of the seller.

This reflects a fundamental fact about economic transactions: the buyer and seller have different views on the items being bought/sold, and transact with one another to allow each to have their own view realized. Differences of opinions are fundamental to many economic transactions, particularly financial ones.

Even Bill Clinton concluded that Goldman Sachs broke no laws in the Abacus deal.

Moreover, it is worth noting how unusual the SEC's process was in deciding to bring the case. Goldman Sachs last spoke to the SEC in September 2009, and next heard from the SEC in April 2010 when the lawsuit was announced. Normally, the SEC notifies a party of its intent to sue them and then tries to negotiate a settlement before publicly disclosing the case.

Adding to the unusual nature of the case, the SEC's commissioner voted 3-2 to commence the lawsuit, with the three Democratic commissioners voting in favor of the suit and the two Republican commissioner opposing it. Again, such a partisan split isn't the norm for such prominent SEC suits.

If the SEC lawsuit against Goldman is so baseless, and was pursued in such an unusual manner, what might have motivated the agency to bring the case as it did?

First, one of the relatively unreported aspects of the matter - and a scandal of first order in its own right - is that on the same day the SEC announced its suit against Goldman, the SEC posted to its website, buried in a hard-to-reach link, an investigative report in its handling of the Bernie Madoff ponzi scheme.

The report revealed that the SEC's investigative arm had recommended that its enforcement arm pursue Madoff for orchestrating a ponzi scheme, but the enforcement division declined to do so because it preferred easier to win cases against more prominent firms. Literally, the SEC's shocking negligence cots investors many billions of dollars in a real, unambiguous fraud.

But that story got lost due to the sensational charges against Goldman Sachs. So the case against Goldman allowed attention to be deflected from the SEC's failure.

In addition, the partisan nature of the commissioners' vote highlights that the suit against Goldman serves a useful purpose for Democrats seeking to pass their financial services regulatory bill.

The SEC's gambit worked. It hid the Madoff report and whipped up the frenzy against Wall Street to help secure Senate approval of the new regulatory bill.

Only a small thing like justice got trampled in the process.

Political Capital

The Wall Street Journal reports on the efforts to save ShoreBank, a Chicago-based bank that is on the verge of being taken over by the FDIC due to bad loans it made. ShoreBank lends to poor communities.

Remarkably, Goldman Sachs, Citigroup, JP Morgan, and Bank of America have tentatively agreed to invest money as part of a $125 million capital raising process to stave off insolvency.

A person involved in the process to save the bank said: "Sometimes a bank like ShoreBank has to rely on karma, and the planets seem to have aligned to provide some karma with respect to this particular deal."

And here I thought that capital raising was about providing attractive returns for shareholders, and not about karma.

In reality, this is about Wall Street firms, facing intense government and PR scrutiny, looking to appease a politically-connected bank and score points with the Obama administration and Democrats.

It takes the phrase "political capital" to a disturbing, new level.

Where's the Outrage II?

Coming Oon the heels of Freddie Mac asking for another $10.6 billion from the federal government to cover its first quarter losses, Fannie Mae has requested another $8.4 billion.

Since the Obama administration is using Fannie and Freddie to prop up the housing market while keeping their liabilities off the balance sheet of the U.S. government, Obama will continue to fund their losses without looking to reduce taxpayer losses.

The financial "reform" legislation that Obama and the Democrats want to pass has no reforms of Fannie and Freddie, despite their seminal role in the financial crisis and their staggering losses.

Where's the Outrage?

Freddie Mac, one of the two government-sponsored mortgage companies that played a central role in creating the financial crisis by spurring lending in lower credit quality mortgages, announced another $6.7 billion loss and asked the government for another $10.6 billion.

If this were Citigroup, Goldman Sachs, or any other private company, it would be a major news story and lead to cries of outrage directed against Wall Street, the company, and management.

So why is the story on the back pages of the Wall Street Journal and the New York Times?

Here's a hint. Precisely because it was created by the government to spur mortgage lending; precisely because Democrats blocked regulatory reform of Freddie Mac and its related company Fannie Mae; and precisely because blaming Wall Street helps avert attention from the government's role in the financial crisis, the press doesn't want to make a big deal about the catastrophic losses Freddie and Fannie have experienced.

Freddie and Fannie have cost taxpayers $136 billion, with more losses projected. Meanwhile, TARP funds invested in Wall Street banks will likely turn a profit.

Financial Tabloid

The Wall Street Journal is an excellent newspaper on many levels, but it does have a character flaw: its coverage of Wall Street includes tabloid-like stories such as the one it ran recently on Goldman Sachs.

In the story, the Journal discusses a hamburger-eating contest among Goldman's mortgage traders after bonuses were paid in December 2007. It is ostensibly part of the story's theme, which is Goldman's "take-no-prisoners attitude".

Or the guys were just having some silly fun.

Moreover, the story only lets the reader know on the back pages in the second half of the article that any money wagered was donated to charity.

The public may have a prurient interest in the behavior of some on Wall Street. It doesn't mean it is the proper journalistic target of one of the nation's leading newspapers.

SEC Malfeasance

You have no doubt hear all about the big news coming out of the Securities and Exchange Commission last Friday.

If you think I'm referring to its lawsuit against Goldman Sachs, that's because the SEC got away with its Goldman bomb to deflect attention from its malfeasance in the Standford Group's $8 billion Ponzi scheme.

The SEC's own inspector general investigated the SEC's actions (or more accurately inactions) regarding Stanford. And the report, buried on the SEC's website, paints a devastating picture of the regulatory agency defaulting on its core mission - to protect investors from fraud.

The SEC's investigators believed Stanford was a Ponzi scheme in 1997 and referred the case to its enforcement division to prosecute. If the SEC had done this, most of the $8 billion of money lost would have never occurred - since Standford's Ponzi scheme grew in size and scope over the next 11 years.

When the inspector general asked why the case against Stanford wasn't brought, he was told the SEC preferred to bring cases against prominent firms that we easy to win.

Naturally the Democrats response to the financial crisis is to give more money and authority to such a bankrupt organization.

And when the SEC does bring case, such as the one against Goldman Sachs, don't assume it does so for honorable reasons.

Interest Rates and Housing

I started writing this column in November 2008 after witnessing a staggering distortion of the recent historical record regarding the cause of the financial crisis.

The left was blaming Wall Street, bankers, derivatives, and capitalism in general for the crisis when it was a gross exaggeration at best and an outright lie at worst. Instead, one needed to look at key economic factors that led to the crisis, with the housing bubble being the central problem - and the Federal Reserve's low interest rate policy and the government's promotion of housing, particularly subprime borrowers through "rolling the dice" (Barney Frank's words) with Fannie Mae and Freddie Mac.

Recent history is an interesting thing to discuss, since everyone lived through it - unlike debating historical events from decades or centuries ago. But clearly many people don't, or didn't, appreciate the government's role in creating the financial crisis, so it is useful to observe now a new housing bubble potentially being created - in Canada.

The Wall Street Journal reports on the explosive growth in housing prices in Canada recently despite a drop in personal income. Canada's housing prices grew more slowly than America's during the 2000-2006 boom, but it has continued to grow and its cumulative increase is now up 90% since 2000 as compared to less than 50% in America.

And what is fueling the boom? Naturally, the low interest rates that Canada's central bank implemented to address the economic slow down.

Housing prices are, and always have been, extremely sensitive to interest rates. It is true today in Canada as it was in America in the 2000s.

Let's hope Canada's boom doesn't get out of control and create large losses in its banking sector. And if it does happen, it will demonstrate that even well understood bubbles and looming credit losses are difficult for regulators to stop or prevent.

Here We Go Again

The Wall Street Journal reports that academics and housing experts believe the U.S. government should retain the part public entity / part private company aspect of Fannie Mae and Freddie Mac, with Fannie and Freddie promoting loans to low-income borrowers and the government insuring mortgages.

This is exactly the type of government intervention in the housing market that caused the financial crisis.

It is said that "people who forget history are doomed to repeat it."

And then there are those who never learned the "history" of our recent financial crisis to begin with.

Tarped Again

Bank of America is finding it difficult to recruit a new CEO, made more challenging by the prospect of pay czar Kenneth Feinberg needing to review any new employment agreement.

One possible candidate turned down an approach out of fear Feinberg wouldn't approve buying out his unvested stock at his current employer, which is a common and necessary practice to induce an executive to leave his current employer.

So the Obama administration has made it harder to recruit a CEO where the government has a huge investment, making it more difficult for BoA to succeed and make that investment a success.

This is what government intervention produces in the economy. And this type of behavior is what Obama wants to inflict on our healthcare system.