My Visit to the U.S. Treasury

I previously thought that I could reveal almost nothing of my visit last week to the US Treasury. As it is, I can talk about it, but not quote any officials there, nor say who was there from the Treasury.

The first surprise was that only bloggers were there. I expected reporters from major papers, but that was not the target audience. The closest thing to mainstream media would have been Megan McArdle, who presumably said she would be there (there was a placard for her), but did not show. The rest of us were independents:

• Marginal Revolution — Tyler Cowen
• Interfluidity — Steven Randy Waldman
• Kid Dynamite’s World
• Naked Capitalism –Yves Smith
• Financial Armageddon — Michael Panzner
• Accrued Interest
• Across the Curve — John Jansen

As all bloggers there will note, those from the Treasury were kind, intelligent, funny… they were real people, unlike the common tendency to demonize those in DC.

Bailouts

Treasury officials said that they were trying to reduce the footprint of the rescues/bailouts as much as possible, doing it at a rate that would not jeopardize the recovery. Their goal is to put in place regulations that will prevent future disasters once the current disaster is past.

David: Well, yeah, that’s what to do if you can. The question is what will happen to the markets when you start to remove significant stimulus from critical areas, as I said to my pal Cody a year ago. Much of that is not in the domain of the Treasury, but the Fed.

The Treasury understands that the troubles of 2008 came from poor credit regulation and tight coupling in the financial system.

David: We over-encouraged single family housing as a goal for Americans. When debt was too high for cash flows from average American households to afford residential housing, the prices of housing began to fall, and the foreclosure process began, as foreclosures happen once someone is inverted on their mortgage. Residential real estate prices overshot by a lot. We should be surprised that there are problems now?

I would not only eliminate the tax credit for new buyers, but I would phase out the interest deduction for mortgage interest. Get people financing with equity, not debt, even if it means the economy is sluggish for a few years. It will bring a longer-lasting self-sustaining recovery. Debt-based systems are inherently fragile because fixed commitments remove flexibility from the system.

To the Treasury I would say, “Markets are inherently unstable, and that is a good thing.” They often have to adjust to severe changes in the human condition, and governmental attempts to tame markets may result in calm for a time, and a tsunami thereafter.

Those that understand chaos theory (nonlinear dynamics) were less surprised by the difficult markets that we have faced. We saw it coming, but could not predict exactly when the system would face crisis. Bears are often right, but with significant delays.

The government is not the majority player in the system, but is the biggest player. At critical points their willingness to offer support helped lead to a market rebound.

Now, in the actions of the government, there is some “making virtue out of necessity.” In supporting Fannie (FNM) and Freddie (FRE) in February 2009, they did not have much choice, unless they were to let them fail, which might have been a good thing. As it is, F&F seem to be black holes where the government is unlikely to recoup their investments.

The Stress Tests

As for the bank stress-testing, one can look at it two ways: 1) The way I looked at it at the time — short on details, many generalities, not trusting the results. (Remember, I have done many such analyses myself for insurers.) or, 2) Something that gave confidence to the markets when they were in an oversold state. Duh, but I was dumb — the oversold market rallied when it learned that the Treasury had its back.

One interesting thing that a Treasury official said at the meeting was that unemployment did not have a big effect on foreclosures. Unemployment has a big effect on credit card defaults, but not foreclosures. I disagree.

As a multi-purpose quant, I have learned over the years that it is impossible to estimate an option curve/function when the variable in question has only been “in the money” or “out of the money.” (As an example, one can’t estimate the withdrawal function on deferred annuities because haven’t had a large sustained rise in interest rates since the product was created.) With mortgage debt, over the last 70 years, real estate values have never fallen enough to make default a reasonable choice until now. Thus in the past, when unemployment hit, one could sell, rather than default. As I have said before, foreclosure typically occurs when someone is inverted on their mortgage, and a life event happens: death, divorce, disability, disaster, disemployment, change in financing terms, or deciding that it is worthless (and doing a strategic default).

But now residential real estate values have fallen. When someone loses their job, the option to default becomes real. Do a short sale, and give the bank a hit.

With stress-testing, the devil is in the details. How do you turn unemployment, housing prices, etc., into losses tailored for each individual company? Different underwriting standards can make quite a difference in the results. I would have been more than happy to dig through detailed stress testing models. That was my job once.

When the Treasury announced the stress-testing results, it was at a time when the gloom was thick. It was a positive to the market that the government would not require huge amounts of extra capital, and in most cases, no extra capital. Thus the market rallied.

With many simple asset classes that were under stress, the Fed and Treasury offered guarantees that would enable them to easily survive the panic. Absent the guarantees, most short assets would have been “money good,” but there would have been significant doubt for a brief time.

As I commented to a Treasury staffer after the meeting, with financing rates so cheap to buy financial debts, regardless of what kind, it is no surprise that corporate bond spreads have tightened, while there is still little lending to finance growth in the real economy. That is why there is such a gap between Wall Street and Main Street.

Main Street sees unemployment and low capacity utilization. Wall Street looks at bond spreads and P/Es. Those are not the same things. The current stimulus has emphasized healing the financial sector in an effort to avoid contagion and depression. It does not directly address slack in the real economy. The real economy funds the bailout of financials, but does not directly benefit. Thus the disconnect between Main Street and Wall Street.

Many financial measures and companies have rebounded, but little expansion has occurred in the real economy. Even with companies that have done bond offerings, they have often used the proceeds to bolster the balance sheet, rather than expand capacity. Safety first is the watchword.

Perhaps a change happens when companies with a lot of cash appear as takeover targets in a sluggish market. Easier to grow market share through acquisition rather than organically, and what’s better, their cash helps pay for the deal.

Housing Initiatives

It seems that the low end of the housing market has bottomed. Government programs have something to do with it. The tax credit has made a difference in the short run, as has the efforts of the Fed to support the mortgage markets through the purchase of RMBS.

Mortgage modifications are advertised by the Treasury, but the results are small. Away from that, I will say that successful modifications occur more likely when there is some degree of principal forgiveness.

The Nature of a Liquidity Trap

Go back in history over the last 25 years. How did the Fed manufacture recoveries? They lowered interest rates enough so that borrowers would be willing to borrow and refinance assets that had cash flow streams that were not financable in the higher interest rate environment, but financable in the lower interest rate environment.

With each successive rescue, interest rates at the trough were lower than before, inviting borrowers that were increasingly marginal to buy assets, borrowing money at cheap rates to pay them off over time. We thought we saw the bottom, 2002-2004, but no. The Fed Funds rate can go to zero, and what’s more the Fed can buy longer dated Treasuries, Agencies, and Mortgage Bonds, lowering interest rates on the longer end of the yield curve. This allows even more marginal borrowers to buy assets. If they face some hiccup in their cash flow, they will default, and quickly. If you doubt this, consider the high currently expected rate of default on FHA loans originated over the last two years.

Yes, low rates can get them to buy, but it cannot get them to hold on. But wait, these are criticisms of the Fed, not the Treasury. Mostly so, but what of the expensive housing tax credit and cash for clunkers. Those belog to the Treasury. They are not economic programs — the costs far outweigh the benefits. But wait. Those shouldn’t be pinned on the Treasury; Congress, bought and paid for, are pushing these programs on behalf of their lobbyists.

If so, where is the administration to shame Congress over such behavior? Where is the President who should press for a line-item veto? Let the Treasury, backed by Obama, ascend to the bully pulpit, and say that such programs are a waste of taxpayer dollars.

The Fed and Treasury have been able to touch of a speculative rally in financial assets, which benefits financials, but with weakness in end-user demand, the lower rates do nothing to stimulate investment in plant and equipment.

All that said, there are three things that could go wrong here:

1. Contrary to the expectations of the Fed, inflation could rise, and cause the Fed to tighten.
2. All of the excess dollar claims could lead to greater depreciation of the dollar.
3. Defaults could cause credit spreads to widen.

Those have not gone wrong yet, but they are all threats.

The Biggest Financial Problem

Surprise! Over-indebted countries do default on their debt more often than less-indebted countries. During the current crisis, we have two mechanisms running to blunt the troubles. The government is running a large deficit, and the central bank is sucking in longer-dated bonds to lower interest rates. I talked about why lower interest rates are not necessarily a blessing yesterday. Today’s thoughts are on deficits.

After the meeting, I said to one Treasury staffer, “One of the quiet casualties of this crisis is that you lost your last bit of slack from the entitlement systems.”

“What do you mean?”

“Just this: Prior to the crisis, Social Security and Medicare would produce cash flow surpluses for the Government until 2018. Now the estimates are 2016, and my guess is more like 2014. The existing higher deficit takes us out to the point where the entitlement systems go into permanent negative cash flow. This means that the US budget is in a structural deficit for as far as the eye can see, fifty years or more, absent changes to entitlements.”

He looked at me and commented that it would be the job of a later administration. No way to handle that now. To me, the answer reminded me of what I say to myself when I go on a scary ride at Six Flags with my kids. There is nothing we can do to change matters. The only thing to adjust is attitude. So, ignore the fact that you are afraid of heights, and enjoy the torture, okay?

Would that I could do that with the present situation. The long term problems are too numerous, and the present crisis saps attention from what is arguably a larger problem. Medicare, Social Security, unfunded Federal pensions and retiree healthcare, underfunded state pensions and unfunded retiree healthcare, and underfunded corporate pensions (flowing to the PBGC) are the crisis of the future. We are talking underfunding and debts equivalent to 4x GDP in total.

The deficits may be helping out areas of our economy for which there is already too much capacity — autos, banks, housing, but isn’t aiding the parts of the economy that don’t have excess capacity. The one advantage to Americans is that a decent amount of the debt is absorbed by the neomercantilists, who will get paid back in cheaper dollars (if at all) than the goods that they provided originally.

This all feels like the Japan scenario. Low interest rates, low growth if any in non-protected sectors, soggy debt-laden protected sectors, excess capacity in areas not salable to the rest of the world, high government debt, and a demographic crisis. Also speculation using cheap leverage for carry trades.

Making Money or Not

Few areas of the US government are designed to make money. One of the main points that Treasury made to us was that the TARP would cost little, or might make money. TARP is a piece of a larger puzzle. My question is this, counting in all of the bailouts, including all stimulus programs, what is the cost to the taxpayer? Now, I ask my readers what they know here. E-mail me with any comprehensive pieces that you have seen, or put it in the comments, so that all can see.

When I look at the bailouts, AIG, Fannie, and Freddie have sucked up /are sucking up resources. With respect to the GSEs, I appreciate the view that the Administration views Fannie and Freddie as a hole in the system that they can use to funnel money to housing without asking Congress for approval. Certainly their financial result show it. Fannie lost a lot of money last quarter and is begging for help. Freddie lost less, but is not asking for money now, but they likely will in the future. As for the Treasury, they have opted to not maximize the value of Fannie by allowing her to sell of tax credits to others, notably Goldman and Berky. They are not interested in maximizing the value of the GSEs, only of using them for their policy goals.

One slide the Treasury showed us was that they thought they were making money across all of the TARP bailouts that they did. Also, that their guarantee programs had made money as well.

True, so far the guarantee programs have made money. That does not mean that the government should be in that business, as it may encourage greater risk taking later, because they think the government will rescue them in times of trouble. In England, at least some think it is a bad precedent.

TARP may be doing okay, but the same moral hazard argument applies. Also, bailouts may come after shareholders have lost a lot, but management teams may (and seem to be now) benefit disproportionately from the bailout. Away from that, the losses from the GSEs, Auto companies, and AIG swamp other gains. That’s what it seems to me. Does anyone else know better? Please put it in the comments, for all to see.

Away from that, consider how the FDIC is basically broke, and that the FHA is not far behind. This crisis is not over.

A Place of Agreement

One place where I can agree with the Treasury is that there should be only one regulator of depositary institutions. The insurance industry can choose among states, but for the most part there are states for big companies,and states for small companies. The states willing to regulate the big insurance companies have done a great job relative to the banking regulators. There are few failures. AIG died for non-insurance reasons. Penn Treaty was a basket case long before the crisis. Who else died?

Having one regulator for banks will remove the ability of the banks to choose the weak regulator. It raises the risk that the one regulator will be corrupted. That’s a lesser risk, because with many regulators, the odds that one will be corrupt are high, and corrupt institutions will go to them to be regulated. With one regulator, politicians can more easily watch the troubles, and can more easily assign blame.

I have no objection to one national insurance regulator either. That said, many states will object, because they have differing standards. But does Congress really want to do insurance law? It takes up a lot of time and is complex.

So, what did I learn that I did not already know? Not much, except:

• The Treasury wants to convince the public that it is doing its best, but that Congress is a slave to the Financial Services industries.
• When asked about the latest bailout of GMAC, they said that didn’t qualify as a financial — the aid was to help the auto companies. (If so, send it directly, and let GMAC expire.)
• They said that they worried about the same things we did, though they had to maintain public confidence, and did not think it was as likely as we thought.
• They did not bring up the GSEs.
• They pointed at the financial markets as evidence of recovery, and did not speak of the real economy, which is weak.
• There is no acknowledgment of what could go wrong in the long-run. They are only playing for the next 3-7 years, at most. Everything is done to goose the next year.
• That the Treasury is trying to reduce its footprint in the economy is welcome news to me.
• They said that they were trying to be wise stewards of the economy, but that Congress had questionable motives.

Final Note

I have found interesting the commenters that automatically assume that being willing to go to the Treasury and eat one cookie equals compromise. There are a lot of scared and frustrated people in the US, and they see their prosperity ebbing, and are looking for someone to blame.

Let me try this — as the world has gone capitalist, the edge of the US has been eroded. Now we face a world where doing certain jobe should pay the same, regardless of where they are located. Wages in the US will converge with those from the rest of the world, adjusted for capital investments.

Throughout human history “middle classes” have been abnormal. The current adjustment in the US may be showing the once large middle class that it is not a normal thing, and is hard to maintain.

There is no conspiracy. The US Government is up against economic forces larger than it can combat. The rest of the world is out-competing the US, and the US has a shrinking portion of the pie as a result.

Comments

[a fat panda:]

"Let me try this — as the world has gone capitalist, the edge of the US has been eroded. Now we face a world where doing certain jobe should pay the same, regardless of where they are located. Wages in the US will converge with those from the rest of the world, adjusted for capital investments."

There is a component of what you say, but you are not looking at productivity.

Work isn't a commodity. I did a lot of work in IT during the boom, and we offshored a lot of work thinking that a programmer is a programmer, and wow look at the savings. The problem is that programmers (in this case) aren't commodities. We offshored work to someone who was 12 hours out of sync, forced to work US hours, changed jobs on average every 6 months, and communicated primarily via email, and expected them to complete the same amount of work. We replaced a short walk down the hall with massive change control processes in the development cycle because communication problems were causing delays.

The one thing that management(s) never could understand. The most expensive component of software is not using it. We spent quarters to save nickles. Genius.

Nov 10 09:42 PM

[THofler:]

Wow. What state do you live in David? Maybe you could run for Chris Dodd's senate seat.

"Markets are inherently unstable, and that is a good thing."
I'll have to think about that some more, but I agree with the first and disagree wih the second part. There are lots of physical systems that operate around a stable equilibrium even when that equilibrium is very dynamic & changes rapidly. It would be nice if our markets were one of them. And this is very much better than when systems go unstable &/or deviate widely from equilibrium.

While I'm sure there are many nolinear forces at work in our markets & that some of them are powerful, I think most of the crisis can be described by a linear feedback system. There are a great many positive (unstable) feedback elements in our markets and economy, and the only powerful negative (stablizing) feedback element is the Fed's monetary policy. I see the Fed as being like the little Dutch boy putting his fingers in the dike as more and more positive feedback elements bring the whole system down.

I can't give you the detail you seek regarding "... what is the cost to taxpayers?" But at what point will we be forced to see all this varied activity as a giant power grab to redistribute wealth?

Isn't the Community Reinvestment Act a redistribution from investors to lower income home buyers?

Isn't the GSE conservatorship a redistribution from taxpayers to deadbeat home borrowers?

Isn't the auto corp. bailouts (& TARPing of GMAC) a redistribution from bond investors and taxpayers to the UAW?

Isn't Obamacare a redistribution from above median taxpayers to below median taxpayers (or nontaxpayers) and to favored provider groups?

Isn't cap and tax a redistribution from taxpayers to favored energy and green jobs providers?

And oh yeah, isn't the AIG bailout a redistribution from taxpayers to Wall Street fat cats and their investors? Ooops! The Fed was responsibe for that gaffe. Let's fix them. Let's dismantle half of the Fed's authority to regulate banks. Heck maybe we can threaten to set monetary policy in congress.

Nov 10 10:09 PM

[hehateme1304:]

I wish you could vote for Treasury Secretary. You would win my vote. Your articles are extremely thought provoking and well written. I enjoy reading your articles. Keep up the stellar work.

Nov 10 11:23 PM

[TheSnail:]

Merkel=The Midnight Rambler

Nov 11 12:01 AM

[David Merkel:]

This was originally seven pieces, and made more sense as seven individual pieces, as I wrote them at my blog.

Yes, I write late at night. I have many responsibilities, and it is my only time that I *can* write. I do my best for readers, but I make no claims for perfection.

And, though I normally like the editing done to my pieces, this one really took out critical stuff that was in the originals. I do not like what was done with my original work. The seven pieces should have been published sequentially, unmodified. You did a disservice to readers because it left out a lot of data on the interactions between me and the Treasury.

Next time I write something in parts, please, publish each part separately. You have done readers no favor by publishing one integrated account, because the separate accounts included links and references to the other seven bloggers who I got to know and appreciate.

Nov 11 12:34 AM

[untrusting ...:]

THofler,
Interesting that you theorize about redistribution of wealth, but you fail to want to take into account all the taxpayer/government subsidies that tend to benefit large corporate business and thus enable the high compensation and benefits of public company executives and other vested interests.

Consider the following:
1) Air travel - massive support of airport construction, airport operations, airport security. One can certainly argue that business benefits hughly from this government support, probably more so than the average American individual.
2) Education and Universities - massive government support of educational system via grants, research funding, student loans, etc. One can certainly argue that business is a hugh beneficary of
this type of much better personnel without paying much of the cost of the education.
3) Justice system - the entire judicial system is a hugh cost to taxpayers. One can certainly argue that it functions to protect property rights, contracts, protection of assets, etc. and one can argue that it hughly benefits business and corporations with them only paying a small fraction of the costs that benefit them.
4) US military - yet another major cost of government. Many many benefits to corporate america via protection of their international interests, implied threat to enforce international business interests, massive contractual relationships and profitability via the military-industrial complex, etc. One can certainly argue that business benefits hughly from the military, but yet business pays only a small fraction of the cost associated with the benefits received.

And one could on and look at many areas such as agriculture, energy, state department, national transportation and infrastructure, etc. all of which have large benefits to business which one can certainly argue they do not pay the real cost for.

Furthermore, you talk about redistributions, implying that somehow the wealthiest and business sectors are somehow paying more now in 2009 than they were in previous decades. However the facts simply don't line up with you implications. Consider some of the following:
1) Individual Federal income taxes - from the 1900's to about 1985, the top marginal tax brackets on high income earners generally ranged from about 50-90%, far higher than they are now. Let alone reduced capital gains taxes which overwhelmingly benefit the top few percentage of American society. Just do a search on historic federal income tax rates and you will see that tax rates on the top incomes are far less today.
2) Corporate Federal taxes - same type of shift in corporate taxes. The tax rates on corporate income are far less today than they were in decades past.
3) Executive and management compensation - Up to about 1985 in the US, the average compensation of public company executives and management was something like 40-100x the compensation of their average employees. Today it is hundreds to thousands of times the compensation of their average employees. If you call that income redistribution, you would be right only if you classified it as massive wealth transfer to a small segment of oligarchs and public company executives.

If you were objective in talking about wealth redistribution, you would quote the national statistics that show that the top 1% and next 9% control the vast majority of the assets and household wealth in the US. Further, you have to explain how a Lloyd Blankefield, Jamie Diamond, or a Jim Paulson "earns" more in one year than tens of thousands of average Americans combined will earn in a lifetime. Somehow that just doesn't fit with the concept of wealth redistribution from the wealthy to other 90+%.


On Nov 10 10:09 PM THofler wrote:

> Wow. What state do you live in David? Maybe you could run for Chris
> Dodd's senate seat.
>
> "Markets are inherently unstable, and that is a good thing."
> I'll have to think about that some more, but I agree with the first
> and disagree wih the second part. There are lots of physical systems
> that operate around a stable equilibrium even when that equilibrium
> is very dynamic & changes rapidly. It would be nice if our markets
> were one of them. And this is very much better than when systems
> go unstable &/or deviate widely from equilibrium.
>
> While I'm sure there are many nolinear forces at work in our markets
> & that some of them are powerful, I think most of the crisis
> can be described by a linear feedback system. There are a great many
> positive (unstable) feedback elements in our markets and economy,
> and the only powerful negative (stablizing) feedback element is the
> Fed's monetary policy. I see the Fed as being like the little Dutch
> boy putting his fingers in the dike as more and more positive feedback
> elements bring the whole system down.
>
> I can't give you the detail you seek regarding "... what is the cost
> to taxpayers?" But at what point will we be forced to see all this
> varied activity as a giant power grab to redistribute wealth?
>
> Isn't the Community Reinvestment Act a redistribution from investors
> to lower income home buyers?
>
> Isn't the GSE conservatorship a redistribution from taxpayers to
> deadbeat home borrowers?
>
> Isn't the auto corp. bailouts (& TARPing of GMAC) a redistribution
> from bond investors and taxpayers to the UAW?
>
> Isn't Obamacare a redistribution from above median taxpayers to below
> median taxpayers (or nontaxpayers) and to favored provider groups?
>
>
> Isn't cap and tax a redistribution from taxpayers to favored energy
> and green jobs providers?
>
> And oh yeah, isn't the AIG bailout a redistribution from taxpayers
> to Wall Street fat cats and their investors? Ooops! The Fed was responsibe
> for that gaffe. Let's fix them. Let's dismantle half of the Fed's
> authority to regulate banks. Heck maybe we can threaten to set monetary
> policy in congress.

Nov 11 01:53 AM

[MarkitWacha:]

kudos.

Tell it like it is, even when that's what people don't want to hear. Even when free speech is threatened under Obama's regime.

"if you tell the public something often enough, they'll begin to believe it" -- Goebbels

"the truth is the enemy of the State" -- also by Goebbels (propagandist Nazi)

Long: TBT, DBC

Nov 11 12:42 PM

[Gregman2:]

fwww.c-span.org/Watch/...

Nov 11 08:57 PM

[jimmy46:]

"Throughout human history “middle classes” have been abnormal. """"

The rich life the masses in amerika have had the last 70 years has been due to cheap energy.
As we see an end of that, it'll be dog eat dog as the rich resume their oppression of everyone else.

Nov 11 09:36 PM

[ObjectiveFu...:]

David, I am deeply glad that the Treasury is listening to you.

Very interesting closing comment about a prosperous middle class being an anomaly in human civilization.

Since the days of Athens, an energetic, prosperous yeomanry is essential to building and sustaining a society of laws in which a broad mass of citizens:

(a) can choose to earn a living in a different way than their fathers, by dint of their own creativity and hard work
(b) can enter and reasonably enforce arms-length contracts with strangers
(c) are free from arbitrary (i.e. unpredictable) confiscation of wealth by authorities.

There may be some merit in the Jared Diamond view that such yeomanries are merely the accidental by-products of cheap or plentiful resources (e.g. olive trees plus a long coastline), but the fact remains that the economic and social wealth (and perhaps, happiness) they generate is substantial. And that such "anomalies" are worth fighting to keep and expand.

Even societies which don't (or no longer) hit the Jeffersonian ideal and are dominated by a ruling "in group" (oligarchy, nobility, priesthood) -- shore themselves up by cultivating some form of meritocratic talent pool -- e.g. the mandarins of imperial China, the Jesuits, or Communist institutes.

Of course, the extent to which this "social talent pool" can, or should be, kept in being artificially by means of subsidies or wealth transfers (entitlements), is certainly open to debate. At a certain point, it becomes a matter of bribing the mob with bread and circuses.

Nov 12 11:10 AM