The Criterion Theater in Washington, D.C. Now playing: "The Revenge of Tarzan"
Ilargi: Well, stocks are up 3%, and word is it's on account of the merriment among homebuilders, whose confidence index went from 14 to 16, which is only 78% below its peak, and only has to rise 16 times that 2 it went up today to get back to 50, which stands for nothing, neutral, that sort of "sentiment". So if a 2 point gain provides a 3% rise in the stock markets, getting to that dull 50 might well give us 16 times a 3% rise. See? I think they're all completely nuts, even though my math is easily as lousy as theirs. More than anything, it makes me think of Groucho's impeccable and irrefutable logic:
Well, art is art, isn't it? Still, on the other hand, water is water. And east is east and west is west and if you take cranberries and stew them like applesauce they taste much more like prunes than rhubarb does. Now you tell me what you know.Mr. Marx not only encapsulates the way my brain functions these days (yeah, yeah, I admit it, and ever since the nurse first slapped my derrière), he also has down to a T the fashion in which the US government is run. You know, lots of words, and fast ones too, images of nice things most people like, like juicy fruits, and in the end you have no idea what just went on.
Pay caps for fat cats? Off the table. Too good to believe (hey, how's that for a nice new tack on "change you can believe in") deals for corporations that you-know-who pays for (you don't know yourself either?) and grand visions of the government getting out of the way of those indispensable private investors, fine gentlemen they are, so they can help YOU reach new heights in material fulfillment that will make your all your pores ooze with unparalleled happiness once YOUR money has lifted the nation out of the mayhem THEY landed it in.
The best way to deal with all of it may just be to promote more confusion. It works for the guys who come out as winners so far, we might as well give it a try.
Challenge for state bonds and bills
During the past 18 months, the financial crisis has produced a string of unprecedented challenges for governments in the Organisation for Economic Co-operation and Development, as they have tried to get the banking sector back on its feet. However, many OECD governments face unprecedented challenges in the markets for bonds and bills, as a result of the explosive growth in their borrowing needs. In some countries, the financing of expected deficits in 2009 is likely to reach levels that were last seen during or around the two world wars and the Great Depression of the 1930s. The question that bedevils almost every government is how to raise new funds, while also managing rapidly growing debt stock. Can they implement their issuance plans smoothly, without encountering absorption problems?
The numbers illustrate the scale of the challenge. Amid an unusually uncertain economic outlook, the borrowing needs of OECD governments are expected to reach almost $12,000bn in 2009, up from about $9,000bn in 2007. Net funding requirements are expected to jump from about $1,600bn in 2008 to $2,600bn in 2009. North America will account for 64 per cent of OECD gross issuance in 2009 (down from more than 65 per cent last year), while Europe will account for 19 per cent (up from 17 per cent). The estimated share of emerging OECD and Asia-Pacific governments is down slightly. The 2009 funding outlook is, however, surrounded by an unusually high degree of uncertainty because the exact timing and strength of the recovery are so unclear.
This rapid and massive increase in government issuance can be expected to push down the prices of government debt and raise yields. Additional competition for funds will come from the issuance of government- guaranteed bank bonds. There are factors offsetting the trend towards higher yields. Falling output is damping inflation expectations, official interest rates are low and risk aversion is encouraging investors to seek safe, liquid instruments. Quantitative easing policies in some OECD countries and the high demand for government paper for use as high-quality collateral are also damping yields.
But the risk is that when the recovery gains traction and risk aversion falls, yields will start to rise. As a result, sovereign debt managers need to start considering a timely and credible medium-term exit strategy to avoid future "crowding out" and issuance problems. There are already signs that issuance conditions are becoming more challenging. There have been reports of weaker demand at some recent government bond auctions, leading to postponements, failures and cancellations. Thus far, such outcomes can best be interpreted as "single market events" and not as unambiguous evidence of systemic market absorption problems.
But the future could be challenging, since rising issuance is occurring in tandem with increasing overall debt levels. In 2007, for example, total marketable government debt for Japan, the US and the eurozone stood at $18,500bn, double the level of a decade before. In 2009 it is projected to be more than $21,000bn. Contingent debt is also on the rise. For 2009, for example, the issuance of government guarantees for financial institutions is estimated at more than $3,300bn. So what can debt managers do? Liquidity pressures, rising borrowing requirements and risk-averse investor behaviour are already forcing debt managers to modify their fundraising strategies. Most notably, they are becoming more flexible and opportunistic.
The maturity of debt is becoming shorter. Debt managers are using a wider range of instruments, including bills and notes, and there is a growing use of foreign liabilities. This shift, while understandable, creates risks. Issuance programmes are becoming less predictable, which is not desirable in the long term. A transparent debt management framework and strong communication policy are instrumental in reducing the market noise that can unnecessarily lift borrowing costs. The other main challenge is roll-over risk. Thus far, governments have primarily responded to their increased borrowing needs by tapping the short-term debt markets. Almost 60 per cent of gross borrowing needs for 2009, for example, will comprise short-term debt (with a maturity of one year or less).
This trend is lowering average maturities and creating more challenging repayment schedules. Therefore many OECD countries need to rebalance their issuance programmes further, by selling more long-term instruments. Debt managers appear to recognise this and are confident that pension funds and insurance companies will support demand at the long end of the yield curve. This shift reflects the clear need for the fiscal authorities and debt managers to create a more sustainable and balanced medium-term issuance profile – before conditions become more challenging still.
'Green Shoots' Rests on Shaky Theme Like Decoupling, Bank of America Says
Sightings of so-called green shoots in the debt markets and economy will turn out to be no more valid than the debunked view that the U.S. slowdown wouldn’t spread, Bank of America Corp. strategists said. While government moves to ease the flow of credit have eliminated the risk of an immediate surge in borrower defaults, weak economic growth and "unintended consequences" of the actions will create a "protracted credit cycle," probably with a high level of defaults through 2016, according to a May 15 report by Bank of America credit strategists in New York led by Jeffrey Rosenberg. "Like last year’s ‘Decoupling’ theme that global market performance could un-tether itself from the problems in the U.S., ‘Green Shoots’ underlying premise, a quick return to normalized credit markets and normalized earnings, rests on a shaky fundamental foundation and an overly optimistic view of global economics," the analysts wrote.
Declining interest rates on mortgages and business loans led Federal Reserve Chairman Ben S. Bernanke to tell "60 Minutes" on March 15 that he sees "green shoots" in some financial markets, and that the pace of economic decline "will begin to moderate." Other commentators have picked up on the phrase as markets rallied. The Standard & Poor’s 500 Index climbed 31 percent to 882.8 through last week from March 9. The difference between yields on high-yield, high-risk corporate bonds and U.S. Treasuries has narrowed to 11.6 percentage points, from 16.8 percentage point, according to Barclays Capital index data.
The Bank of America strategists, who wrote that they were wrong at the start of this year in failing to predict the improvement in credit markets, recommended that investors now bet against corporate yield spreads through credit-default-swap indexes. "The price for that near term stability is long term below trend growth and above historic norm unemployment -- the Great Recession," they wrote. "If that is the cost for choosing stability in some sense then the ‘worst’ -- in the form of a protracted recovery -- is still in front of us."
Geithner Says Government Shouldn’t Set Caps on Pay
Treasury Secretary Timothy Geithner ruled out setting specific limits for compensation as the Obama administration considers proposals to better align executives’ pay with companies’ long-term performance. "I don’t think our government should set caps on compensation," he said in answering questions at an event at the National Press Club today in Washington. "What I think we need to do is make sure we put in place some broad constraints on the incentives compensation systems create." Geithner’s remarks indicate the administration’s proposals may focus more on principles than on specific prescriptions for how financial companies compensate their executives. Federal Deposit Insurance Corp. Chairman Sheila Bair made similar comments last week, while calling for broad application of guidelines to include traders as well as corporate chiefs.
The Obama administration is implementing pay restrictions on banks receiving government aid, which were set by Congress as part of this year’s $787 billion economic stimulus legislation. The administration also is reviewing ways to toughen supervision of financial markets and companies to avoid a repeat of a crisis that has cost almost $1.5 trillion in credit losses since 2007. Geithner said incentives in pay packages contributed to the turmoil. "We had a crisis magnified by the fact that people were paid to take a huge amount of short-term risk, and that’s something that’s preventable," he said. "We shouldn’t be setting broad caps, I think we should be trying to get the incentives better."
As the credit bubble expanded, "returns were so appealing, so powerful they basically overwhelmed all the checks and balances that were in place," the Treasury chief said. Changes are needed to ensure that, "if the returns do not materialize" over the long term, then a compensation package "is at risk" for a period of time, he said. The FDIC’s Bair said last week that regulators should make sure bankers, at all levels, are paid in ways that are tied to their long-term performance. "I don’t think prescriptive rules or dollar limits are appropriate," Bair said on Bloomberg Television’s "Political Capital with Al Hunt" in a May 15 interview. "I do think principles about long-term performance and not rewarding risky behavior with short-term profits -- I think those types of principles should be embraced by bank management."
Geithner today also endorsed so-called "say on pay" proposals and other efforts to boost transparency on corporate pay policies. "That kind of disclosure can help a lot," he said, adding that there is also a role for regulators. "Supervisors do need to supervise" to make sure banks have the right compensation incentives in place, he said. Geithner said separately that the administration is in touch with California and other state and local governments having trouble balancing their budgets. While there will be efforts to help those governments, he disputed the prospects of a "federal bailout" for municipal bond markets. "I wouldn’t use the word bailout or federal," Geithner said. "I would say we’re in close consultation with the people who are looking at ways to make sure these markets are working so that states and munis can meet their needs."
The House Financial Services Committee has scheduled a May 21 hearing to consider four bills related to the municipal-bond market. Municipal financing has seen a "significant improvement" after a "traumatic adjustment" caused by the financial crisis, Geithner said. He said states now need to address their long- term budget problems, some of which predated the credit-market woes. The Treasury secretary also said that the U.S. economy has stabilized, even while many people may not feel a turnaround immediately. "Unemployment is going to keep increasing for a while," he said. "It’s not going to feel better for a long time for millions of Americans."
The U.S. economy lost 539,000 jobs in April, the smallest drop in six months, as the worst recession in half a century started to ease and the federal government stepped up hiring for the country’s next census. Still, the unemployment rate jumped to 8.9 percent, the highest level since 1983. The economy has lost 5.7 million jobs since payrolls started dropping in January of last year. Geithner said a trip to Beijing in two weeks is part of the Obama administration’s efforts to build ties with China, the second biggest U.S. trading partner and the largest foreign holder of U.S. government debt. "We’ll talk about how they’re doing in strengthening their economy, shifting to a more balanced domestic demand-led growth, and they’re going to want to hear from us in terms of how we’re in getting our economy out of the crisis," Geithner said. The U.S. also will continue to encourage China to take a more active role in international organizations, he said. "We want them to have a seat at the table," Geithner said. "We want them to feel invested in making the system work."
Ilargi: Geithner completely ignores a question about how his children will feel about the deficit he's racking up, mutters something about a "sustainable medium term deficit?!", and does himself one better by proclaiming that if they're not careful, there's s risk that "the government will crowd out private investment". After the recovery has been firmly established, that is, mind you. Politics is the art of looking ahead, after all.
Geithner: Financial System Failed Consumers
Treasury Secretary Timothy Geithner says the U.S. Financial system failed to protect consumers and investors and suggests that the regulatory system will need changes to prevent another crisis in the future.
Geithner's gift to Wall Street
As the first TALF-backed deals for Ford, Honda and Harley's debt hit the market, professional investors see an opportunity to make a killing.
Imagine if you were not really in the market for a house but the government came along and said that it would finance 94% of a home's purchase price with a mortgage rate of less than 3%. Still not interested? Wait, Uncle Sam has some additional sweeteners: if you do the deal and buy the house for only 6% down, you also get the equivalent of rental income every month to the tune of at least an annualized yield of 10% of the purchase price. But wait there's still more: if, say, after two years, you decide you don't want the house any longer, you can just walk away from it. No need to pay the balance of the mortgage (it won't affect your credit rating), and you can keep the rental income received to date.
That's essentially the deal that Treasury Secretary Timothy Geithner has offered qualified professional investors who participate in the so-called TALF (Term Asset-Backed Securities Loan Facility). Two months into the program as the first TALF- backed deals hit the market, you can see why the likes of hedge fund Fortress Investment Group are drooling over it. "I'm a big believer in the impact that TALF can and should have," Fortress CEO Wes Edens said on a May 6 investor call, adding that he expects that Fortress will be "a big participant" in the TALF program "three to six months from now."
The first few TALF deals -- one for Ford Credit (the financing arm of the automaker), another for American Honda Receivables Corp., a third for the student loan company Sallie Mae and a fourth for motorcycle icon Harley Davidson -- shed some light on our tax dollars at work. "I've had accounts that dropped everything they were doing to take a look at this TALF financing," one Wall Street trader explained. "It was like nothing they had ever seen. It beats any financing that the private sector could ever come up with. I almost want to say it is irresponsible." For instance, Prudential Financial, Inc., the large insurer and investment manager, borrowed $786 million from the TALF as of March 31 and put up only $50 million to do so, some 6.4% of the deals.
In case you're not totally conversant with the alphabet soup of financial remedies emanating from the Obama Administration, here's a brief refresher: Geithner and the Federal Reserve announced the launch of the TALF in March. The TALF is a $200 billion (on its way to $1 trillion) non-recourse lending program to private investors as a way to encourage them to buy newly underwritten securities backed by auto loans, credit-card receivables and student loans, among other asset classes. (The TALF program is set to extend, in June, to the issue of new commercial real-estate mortgage-backed securities.)
These securitizations were once upon a time a key component of the so-called "shadow" financing system that helped raise trillions of dollars of capital worldwide. Of course, the securitization and sale of mortgage-backed securities was one of the leading causes of the current financial crisis as the people who took out the underlying mortgages started to default upon them in unexpected numbers. Still, Geithner has determined, correctly, that getting these securities circulating again is crucial to restoring the health of the credit markets. The Treasury designed the program, but it is the Federal Reserve that provides the government's share of the capital. "The increase in the TALF is expected to help stimulate both new issuances and the removal of assets from bank balance sheets," Credit Suisse wrote to its shareholders on May 8.
Investors interested in borrowing from the TALF program have to be approved by the Treasury and then, once approved, have to set up an account with a broker-dealer that is subject to a variety of the usual terms and conditions. The investor then must indicate a desire to buy, say, at least $10 million of one of the dozen or so deals, worth an aggregate of around $25 billion, which have come to market since the TALF program was set up in March. An early test for TALF was a May 5, $1.5 billion car-receivables securitization for American Honda Receivables Corp. and underwritten by JPMorgan Securities (JPM, Fortune 500) and BNP Paribas Securities. Investor demand for the deals so far is said by one trader to be "strong" and the deals are selling well. The real market test, though, of TALF will come when the first deals involving CMBS (Commercial Mortgage Backed Securities) start coming to market in the next few months.
The way the TALF works in practice is this: The amount of equity an investor has to put up, or the "haircut" as the TALF documents call it, depends upon the assets involved, the term of the loan or lease of the underlying asset (say, a car) and the credit quality of the underlying borrower. A loan to buy a three-year security backed by a group of credit-card receivables from high-quality borrowers would require an investor to put up 6% of the capital -- a 6% "haircut" -- and then can borrow the rest from the TALF through his brokerage account. To buy a two-year high-quality credit-card receivable security, a borrower would put up 5% of the face amount of the securities purchased. Auto receivables require as 12% equity investment for a three-year security. Small business loans require 5% down. Student loans require 10% down for a three-year deal.
An investor interested in a $10 million slice of three-year credit card receivable would put up 6% of the money -- $600,000 -- and borrow the balance of $9.4 million from the TALF at a rate of three-year LIBOR plus 100 basis points (Attention K-Mart shoppers, that's 2.85% at this moment.) Depending on all sorts of assumptions, the yields on these investments are said to be in the 11% to 15% range, especially attractive since the TALF loans are non-recourse to the borrowers -- you can just walk away and lose only your underlying equity investment and the collateral but you are not held responsible for the unpaid portion of the TALF loan itself.
In addition, the TALF loan is not marked-to-market so if the underlying collateral deteriorates in value, the investor is not required to put up more equity. What's more as the car payments or credit-card payments on the underlying security are made, the payments are distributed to the government and the investor on equal footing -- that means the investor starts getting paid back at the same time as the government even though the government is the senior secured creditor and even though an investor has put up only a small fraction of the original money. One private equity investor, who would not normally have looked at investing in such a deal but did, called this particular aspect of the TALF "shockingly good." But who will the TALF deals be shockingly good for -- the players on the field or those of us in the bleachers? If what Geithner calls "our lending facility with the Fed" does its job and jumpstarts the credit markets then the extraordinary concessions the government has made to attract private capital may have been worth it.
US homebuilder confidence climbs
US homebuilder confidence rose to an eight-month high in May and has doubled since falling to a record low at the beginning of the year as buyers responded to new incentives to break ground. The National Association of Home Builders’ index of homebuilder sentiment rose from 14 to 16 this month, in line with economists’ expectations, and offered a fresh sign of life for the stricken US housing market. However, the figure remains 78 per cent below the peak of hopefulness reached in June 2005, when the index rose to 72, and is still well below the mark of 50 that indicates "good" conditions.
"Builders are responding to what they perceive to be some of the best home buying conditions of a lifetime," Joe Robson, NAHB chairman, said yesterday. The National Association of Realtors said last week that the median price of an existing home fell by 13.8 per cent to $169,000 (€125,259, 110 407in the first quarter of this year from the same period in 2008. Foreclosures and distressed sales made up nearly half of all transactions in the first quarter and are likely to rise further as job cuts continue to spread. Homebuilder sentiment improved the most in the west and north-east, while inching up slightly in the south and staying flat in the mid-west. Sales conditions and expectations of sales for the next six months also improved, while traffic of potential buyers was flat.
David Crowe, NAHB’s chief economist, noted that greater affordability and a new tax credit for first-time buyers are succeeding in luring people back to the market. Home prices have suffered record drops in the last year and remain nearly 30 per cent below their peak in July 2006. Economists argue that restored homebuilder confidence means that inventories are now slim enough to suggest that the market for new homes may have bottomed. The US government has thrown billions of dollars at the housing crisis, with programmes to modify troubled mortgages and others to help homeowners refinance into new loans even if their homes are worth less than they owe.
The Mortgage Bankers Association estimates that lenders could originate as much as $2.78 trillion of new mortgages this year as homeowners take advantage of lower interest rates. "We’ve kind of tip-toed to the abyss and said we’re not jumping," said Brian Bethune, an economist at IHS Global Insight. A return of homebuilder confidence signals that new home construction could start to rebound. New residential building hit a record low in 2008 but spiked in February before slipping again in March. Economists expect that the number of housing starts in April, to be revealed today, ticked up. The slump across global commercial property markets has accelerated in the first quarter of this year, according to a survey released today, with the emerging markets in particular struggling under the combination of capital value and rental falls,
A disaster of historic proportions is still unfolding in the US labour market, where the pace and depth of job losses already make this the worst recession in half a century. The economy has lost more than half a million jobs in each of the past six months. Even if output soon bottoms out, unemployment is likely to continue to rise from its present level of 8.9 per cent to at least 9.5 per cent and probably higher. Meanwhile, long-term unemployment is also soaring, bringing with it the danger that the US may suffer a permanent increase in structural unemployment of the kind experienced in many parts of Europe after previous recessions.
Huge job losses have become so familiar that the loss of 539,000 jobs in April – with 611,000 private sector positions gone – was hailed by some as good news. The rate of job losses was slightly lower than earlier this year. But by any historical standard this was a horrific figure, worse than the worst month for job losses in each of the past four recessions. Even adjusting for the size of the labour force, which has grown in recent decades, this recession stands out as a jobs killer, with a 4.2 per cent decline in employment to date. Economists tend not to worry too much about the implications of past job destruction for near-term growth. Unemployment is seen as a lagging indicator of economic activity. Most recessions end not when the economy stops losing jobs but when initial unemployment claims peak and turn down.
Unfortunately that has not yet happened. In the week to May 9 – the latest for which data are available – 637,000 workers filed new unemployment claims, pushing up the closely watched four-week moving average. Meanwhile, high unemployment is starting to put pressure on the wages of those still in work. Moreover, there is at least some chance that this time the economy will struggle to turn without a more or less simultaneous improvement in the jobs market. Most recessions are driven by business inventory and investment cycles. Today it is the household sector that is overstretched. Households have lost $16,700bn in net worth since mid-2007, according to BCA Research. Disposable personal income is already high relative to earned income and banks are still tightening consumer credit.
Given this, households may struggle to support even moderate increases in consumer spending – probably necessary to underpin recovery – without concurrent gains in labour income. Suppose this fear is unfounded. What then? The US may still have to deal with a painful legacy of long-term unemployment. In the past year alone the number unemployed for more than six months has nearly tripled, to 3.68m. The longer people are out of the workforce, the greater the danger that their skills atrophy and they become unemployable at wages they would accept. Past recessions have tended not to raise the structural unemployment rate as much in the US as in Europe, where the labour market is less flexible and benefits are more generous. But this time may be different. With unemployment likely to remain high for years, periods of joblessness could become very long.
Structural changes under way in sectors such as construction, autos, finance and the media may leave unemployed workers with skills unusable elsewhere. Moreover, US workers may not be able to move in search of work as they have famously done in the past, owing to falling house prices, which have trapped about a fifth of households in negative equity. Ground zero for all these problems is the Midwest, with its higher-than average unemployment, skill-specific automobile industry and depressed house prices. The Obama stimulus aimed to create demand for workers, ease the pain of unemployment and facilitate retraining. But more may need to be done.
Options include tax breaks or subsidies for hiring, wage insurance to top up salaries of workers accepting a step-down in pay, incentives for job-sharing, subsidies to help people with negative equity to move house, and tax breaks to bring jobs to their communities. At the same time, the administration needs to be careful that efforts to limit the human cost of joblessness do not end up discouraging workers from taking jobs at reduced wages. Europe has plenty of experience of unemployment. Does it have any answers to offer?
The ungovernable state
As California ceases to function like a sensible state, a new constitution looks both necessary and likely
On May 19th Californians will go to the polls to vote on six ballot measures that are as important as they are confusing. If these measures fail, America’s biggest state will enter a full-blown financial crisis that will require excruciating cuts in public services. If the measures succeed, the crisis will be only a little less acute. Recent polls suggest that voters are planning to vote most of them down. The occasion has thus become an ugly summary of all that is wrong with California’s governance, and that list is long. This special election, the sixth in 36 years, came about because the state’s elected politicians once again—for the system virtually assures as much—could not agree on a budget in time and had to cobble together a compromise in February to fill a $42 billion gap between revenue and spending.
But that compromise required extending some temporary taxes, shifting spending around and borrowing against future lottery profits. These are among the steps that voters must now approve, thanks to California’s brand of direct democracy, which is unique in extent, complexity and misuse. A good outcome is no longer possible. California now has the worst bond rating among the 50 states. Income-tax receipts are coming in far below expectations. On May 11th Arnold Schwarzenegger, the governor, sent a letter to the legislature warning it that, by his latest estimates, the state will face a budget gap of $15.4 billion if the ballot measures pass, $21.3 billion if they fail. Prisoners will have to be released, firefighters fired, and other services cut or eliminated. One way or the other, on May 20th Californians will have to begin discussing how to fix their broken state.
California has a unique combination of features which, individually, are shared by other states but collectively cause dysfunction. These begin with the requirement that any budget pass both houses of the legislature with a two-thirds majority. Two other states, Rhode Island and Arkansas, have such a law. But California, where taxation and budgets are determined separately, also requires two-thirds majorities for any tax increase. Twelve other states demand this. Only California, however, has both requirements. If its representative democracy functioned well, that might not be so debilitating. But it does not. Only a minority of Californians bother to vote, and those voters tend to be older, whiter and richer than the state’s younger, browner and poorer population, says Steven Hill at the New America Foundation, a think-tank that is analysing the options for reform.
Those voters, moreover, have over time "self-sorted" themselves into highly partisan districts: loony left in Berkeley or Santa Monica, for instance; rabid right in Orange County or parts of the Central Valley. Politicians have done the rest by gerrymandering bizarre boundaries around their supporters. The result is that elections are won during the Republican or Democratic primaries, rather than in run-offs between the two parties. This makes for a state legislature full of mad-eyed extremists in a state that otherwise has surprising numbers of reasonable citizens. And that is why sensible and timely budgets have become almost impossible, says Jim Wunderman, president of the Bay Area Council, an association of corporate bosses. Because the Republicans are in a minority in the legislature, they have no sway until budget time, when they suddenly hold veto power thanks to the two-thirds requirement.
Because in the primaries they have run on extremist platforms against other Republicans, they have no incentive to be pragmatic or moderate, and tend simply to balk. What was unusual about this year’s deadlock was only its "record lateness", says Mr Wunderman, which amounted to an "anti-stimulus" that negated much of the economic-recovery plan coming from Washington, DC. "No real conversation is possible on anything that matters," he says, whether it be California’s fraught water supply, its barbaric prison conditions or its teetering public education.
Representative democracy is only one half of California’s peculiar governance system. The other half, direct democracy, fails just as badly. California is one of 24 states that allow referendums, recalls and voter initiatives. But it is the only state that does not allow its legislature to override successful initiatives (called "propositions") and has no sunset clauses that let them expire. It also uses initiatives far more, and more irresponsibly, than any other state. Direct democracy in America originated, largely in the Western states, during the Populist and then Progressive eras of the late 19th and early 20th century. It came to California in 1911, when Governor Hiram Johnson introduced it. At first, it made sense.
The Southern Pacific Railroad dominated politics, society and the courts in the young frontier state, and direct democracy would be a welcome check and balance. The state in 1910 had only 2.4m residents, and 95% of them were white. (Today it has about 37m residents, and less than half are white.) A small, homogenous and informed electorate was to make sparing and disciplined use of the ballot to keep the legislature honest, rather as in Switzerland. Sparing and disciplined it stayed until the 1970s. But then came a decade of polarisation and voter mistrust.
In 1978 Californians sparked a nationwide "tax revolt" by passing Proposition 13, which drastically limited property taxes and placed a permanent straitjacket on state revenues. That launched an entire industry of signature-gatherers and marketing strategists that now puts an average of ten initiatives a year on the ballot, as Mark Baldassare, the boss of the non-partisan Public Policy Institute of California, has calculated. In 2003 direct democracy reached a new zenith—or nadir, some might say—when Californians "recalled" their elected and sitting governor, Gray Davis, and replaced him with Mr Schwarzenegger.
The minority of eligible Californians who vote not only send extremists to Sacramento, but also circumscribe what those representatives can do by deciding many policies directly. It is the voters who decide, for instance, to limit legislators’ terms in office, to mandate prison terms for criminals, to withdraw benefits from undocumented immigrants, to spend money on trains or sewers, or to let Indian tribes run casinos. Through such "ballot-box budgeting", a large share of the state’s revenues is spoken for before budget negotiations even begin. "The voters get mad when they vote to spend a ton of money and the legislature can’t then find the money," says Jean Ross of the California Budget Project, a research outfit in Sacramento. Indeed, voters being mad is the one constant; the only proposition that appears certain to pass on May 19th would punish legislators with pay freezes in budget-deficit years.
More than half of the initiatives don’t pass, and some that do are sensible. But much of the system has been perverted into the opposite of what Hiram Johnson intended. It is not ordinary citizens but rich tycoons from Hollywood or Silicon Valley, or special interests such as unions for prison guards, teachers or nurses, that bankroll most initiatives onto the ballots. Then comes a barrage of television commercials, junk mail and robo-calls that leave no Californian home unmolested and the great majority confused. Propositions tend to be badly worded, with double negatives that leave some voters thinking they voted for something when they really voted against. One eloquent English teacher in Los Angeles recently called a radio show complaining that, after extensive study, she could not understand the ballot measures on grounds of syntax.
The broken budget mechanism and the twin failures in California’s representative and direct democracy are enough to guarantee dysfunction. The sheer complexity of the state exacerbates it. Peter Schrag, the author of "California: America’s High-Stakes Experiment", has counted about 7,000 overlapping jurisdictions, from counties and cities to school and water districts, fire and park commissions, utility and mosquito-abatement boards, many with their own elected officials. The surprise is that anything works at all. As a result, there is now a consensus among the political elite that California’s governance is "fundamentally broken" and that the state is "ungovernable, unless we make tough choices", as Antonio Villaraigosa, the mayor of Los Angeles and a likely candidate for governor next year, puts it. What are those choices?
Incremental reform, says one set of analysts. Darrell Steinberg, a thoughtful Democrat who is the current leader of the state Senate, says that the dysfunction is often overstated, since the system was deliberately designed "to ensure that change occurs slowly". He believes that several piecemeal reforms already slated will fix most of the problem. So does California Forward, a bipartisan think-tank supported by several of the state’s éminences grises. A change to districting rules should end gerrymandering, starting next year. And there is talk of open primaries in which people vote irrespective of their party affiliation, and then elect a candidate in a run-off between the top two vote-getters, whether from the same party or not. Together, these two steps would make the state’s representative politics more moderate, says James Mayer, California Forward’s director. Representatives should also have longer terms in office, he thinks, to reduce the permanent turnover that pits greenhorn legislators against savvy and entrenched lobbyists.
Many others, however, now believe that California needs to start from scratch, with a fully-fledged constitutional convention. California’s current constitution rivals India’s and Alabama’s for being the longest and most convoluted in the world, and is several times longer than America’s. It has been amended or revised more than 500 times and now, with the cumulative dross of past voter initiatives incorporated, is a document that assures chaos. Calls for a new constitution have resurfaced throughout the past century, but never went far. That changed last August, as the budget negotiations were once again going off the rails, when Mr Wunderman of the Bay Area Council renewed the call for a convention and received an astonishing outpouring of support. Mr Schwarzenegger has called a constitutional convention "a brilliant idea" and thinks it is "the right way to go". (The new constitution would take effect well after he leaves office.) Most encouragingly, says Mr Wunderman, nobody, not even the so-called special interests, has yet come out against a convention.
To the extent that there is scepticism at all, it is not about the idea of a new and cleaner constitution but about the process that might lead to it. If a convention set out to rewrite the entire constitution, it would end in the usual war over hot-button social issues such as gay marriage or the perennial Californian fight over water. And there is concern that "the nutwings are the ones who will show up, not the soccer moms," as Ms Ross of the California Budget Project puts it. The same partisan extremists bickering about the same controversies would lead nowhere. To address these concerns, the Bay Area Council, which has become the driving force behind the scheme, has put forth two ideas. First, delegates to the convention should be chosen through the general jury pool to ensure that the whole population, as opposed to partisans or voters, is represented. Second, the scope of the constitutional convention would be explicitly limited to governance issues and the budget mechanism and would exclude all others.
This should enable reform in the most vital and interconnected areas. These are: reducing the two-thirds requirement for budgets and taxes; mandating two-year as opposed to annual budgets; giving local governments more access to local revenues; creating less partisan districts and primary elections; disciplining the process of direct democracy with new rules about signature collection; and introducing a "sunset" commission, as Texas has, that would gradually retire overlapping jurisdictions and offices to achieve something more manageable.
The plan is to introduce voter initiatives in next year’s ballot calling for a constitutional convention, to have the convention the following year, and to put the new constitution on a ballot in 2012, when it would take effect. In the meantime both the incrementalists, such as California Forward, and the wholesale reformers, such as the Bay Area Council, are backing the propositions on next week’s ballot. Even if they succeed, this would only temporarily reduce the urgency for radical reform; failure would cause intolerable pain.
Californians head to the polls Tuesday to decide the fate of six ballot initiatives, all of which are ostensibly designed to combat the Golden State's budget crisis. If the polls are right, all but one of these measures will crash and burn -- and by wide margins. A reckoning for liberal tax and spend governance may finally be arriving. We have some sympathy for Governor Arnold Schwarzenegger, who was elected to fix this mess six years ago. His original mistake was to accept a token bipartisan fix when he was most popular, and once the unions crushed his reform initiatives in 2005 he had little leverage over the Democrats who run the legislature. So he's now decided to settle for the lowest common denominator reform that both parties can agree to, which isn't nearly enough considering the magnitude of the state's fiscal and economic problems.
By far the most consequential initiative is Proposition 1A, which is favored by most of the Sacramento political class. Prop 1A creates a rainy day fund of up to 12.5% of the budget and imposes a new annual spending cap. It would divert 3% of revenues during economic boom years into the rainy day fund that can only be spent during recessions. Mr. Schwarzenegger is correct that this is a sensible reform, because for 40 years the state has endured revenue booms and busts. Alas, the cap is far weaker than the Gann Amendment that passed with 74% of the vote in 1979, as the sister initiative to Proposition 13, and helped usher in a decade of budget surpluses. The Gann Amendment -- until public unions neutered it in the early 1990s -- imposed a ceiling on spending at the level of population growth plus inflation; when revenues exceeded that limit, the money was returned to taxpayers.
By contrast, Prop 1A allows revenues and thus spending to grow each year at the average rate of growth of tax receipts over the previous decade, or at the rate of population growth plus inflation, whichever is greater. Revenues above that amount are pushed into the reserve fund to be spent at a later date. This gives incentives to legislators to raise taxes whenever possible, because the spending cap rises along with revenues. Prop 1A also allows the legislature to raid the rainy day fund to pay for "capital outlay purposes" -- roads, bridges, schools and even pork projects. Even to get this minimal spending cap, voters must also approve a two-year $16 billion extension of this year's tax hikes. The 0.25% income-tax surcharge (to 10.55%) and the near doubling of the car tax would be extended through 2013, and the one percentage point sales tax hike (to 9%) would be extended through 2012.
Even worse is Prop 1B, which would divert $9.3 billion from the rainy day fund to the education spenders in Sacramento and thus exempt half the general fund budget from any belt tightening. This would refortify the teachers unions, which have spent $2.7 million to pass the measure and are the very group most responsible for California's fiscal mess. Teacher pay and benefits are already 35% above the national average. Then there are the gimmick Propositions 1C, 1D and 1E, which would raid trust funds and use any surpluses to pay current general fund bills. The preposterous 1C would raise $5 billion today by securitizing future lottery revenues. That would add more than $350 million of new debt payments annually for at least the next 20 years. What's next, selling the silverware in the Governor's mansion?
Given all of this trickery, it is no wonder polls show Props 1A-E are likely to lose. The only initiative ahead in the polls, Prop 1F, would block pay raises for lawmakers if they fail to balance the budget. One recent poll found that 72% of Californians agreed that "if the measures on the special election ballot are defeated, it would send a message to the governor and the legislature that voters are tired of more government spending and higher taxes." That's a good message to send. California politicians have operated for years as if the purpose of government is not to provide reliable public services at low cost, but to feed public employee unions. Sacramento also needs to rethink its highly progressive antigrowth tax code, where the tax rates are the highest outside of New York City. The Golden State now ranks worst or second worst on most ratings of state business climate. This drives away entrepreneurs and high-income taxpayers, which in turn leads to lower revenues.
If the voters do reject these false fixes, there will be wails of despair in Sacramento. Assembly Speaker Karen Bass, who never saw a spending or tax increase she didn't like, says "California, frankly, is going to be in a world of hurt." Mr. Schwarzenegger says he will be forced to release 30,000 criminals from jail, and to lay off teachers, troopers and firefighters. Look for the state to ask Washington for another bailout "stimulus." But voter rejection may be precisely the jolt of reality that California needs to inspire real reform. Start with a new Gann Amendment to cap total spending, and add a flat-rate income and sales tax of 5% or 6%, which is roughly the national average and will stop driving business from the state. A flat tax would help to stabilize revenues over time, avoiding boom and bust. Drilling for oil offshore would also bring in billions of dollars of revenues. This kind of reform will only come from Golden State voters who aren't yet on the public dole or the public payrolls. Howard Jarvis led such a charge 30 years ago. It needs to happen again for California to break out of its tax and spend death spiral.
The Rise and Fall of Detroit
by Alec Baldwin (yes, that one)
When I was growing up, some kids dreamed of owning cars like a Trans Am, Camaro, Firebird, Corvette, Chevelle or GTO. Stock or tricked out, owning one of the fastest street cars that American automakers turned out was a dream come true. Mustangs were for the West Coast. Chevy ruled the road on Long Island in the1960's and 70's. Back then, in the middle class neighborhood where I grew up, foreign cars were for foreigners. As fuel economy began to become an issue, NOBODY in my neighborhood gave a thought to buying a Japanese car. Nobody.
OPEC appeared and gas shortages came and went. You went Ford, Chevy, Chrysler. That was it. I have a feeling that it was like that in most American middle class neighborhoods back then. The fact that we have arrived where were are now is painful. Americans, who are being asked to invest billions upon billions of dollars in US automakers and their employees' futures, have already been investing in those companies, against their better interests, for decades. Now Chrysler is dead, GM is on critical life support and Ford has cancer but may beat it.
What do you care?
The heads of these corporations did not spend the last thirty years lying in bed each night, sleepless. They did not turn their spouses in the wee hours and say, "How do I serve the automotive needs of the American public and better protect their health and safety AND help them conserve energy?" They never said that. Instead, they spent billions of dollars attempting to bribe the Congress to avoid putting in seat belts and air bags, installing catalytic converters and reaching more ambitious fuel efficiency standards. For the most part, they succeeded. Congress approached those issues with the same combination of sentiment, fealty and fear that Detroit's customers accepted. It was said to be "bad for Detroit." Little did we know that falling for that bull for so long was what was bad for Detroit. Now, the American automotive industry, once the industrial pride of this country and a source of so many great paying jobs that changed the economic fortunes of millions of Americans in assembly, parts, dealerships and service, is about to go away.
What do you care?
I feel horribly for every single man and woman who will suffer as the result of this heartbreaking turn of events. I was the voice of Chevy Tahoe TV spots for five years in the early 90's. I drove a Tahoe then and loved it. Now, I drive a Prius. I've owned Mercs, Chevys, Fords and Jeeps. I'm in the market for a new car now. I'll probably get a hybrid from a Japanese company, manufactured at a transplant factory in the American South. (Read the excellent recent article in the New Yorker by Peter Boyer about the path the Big Three and the UAW took to get here.) I'd like to buy an American car, but I'd feel like a fool doing that now. The leadership of the biggest automakers made sure of that.
There can be only one legitimate response to this crisis. Let energy conservation and fuel efficiency rule the day. Let the carmakers go under. In the same way we have subsidized Big Oil by destabilizing the governments of petroleum rich countries, or outright invading them, we have subsidized Detroit long enough. Just as every barrel of oil is undervalued because we do not factor in that portion of the defense budget that helped bring that oil to market, so we have undervalued our government's, and therefore our, complicity in producing cars that not only were inferior, but drove Detroit itself right off a cliff.
From the ashes of such great innovation, hard work, beautiful design and extraordinary branding-as-myth-making, let's have better cars. From the ashes of arrogance, greed and corporate cowardice, let's have better cars. Until then, pull the plug.
BLS Has One Letter Too Many
The big news, of course, is that the Bureau of Labor Statistics at the Department of Labor reported that non-farm payroll employment continued to fall in April, and 539,000 jobs were lost, which probably explains why they later note that "Overall, private-sector employment fell by 611,000" and that "the unemployment rate rose from 8.5 to 8.9 percent." Nevertheless, since December 2007 (when the recession began), they figure that 5.7 million jobs have been lost, and "since September 2008, manufacturing has lost 1.2 million jobs," which is Very, Very Bad (VVB), because manufacturing is how economies work; you make something that somebody wants at a price that gives you a profit.
The really ugly news is that all of these job losses were are all private-sector jobs, since government hiring still goes up and up, every month, helping to make things worse and worse. Later on we get the surprising news that "The civilian labor force participation rate rose in April to 65.8 percent, and the employment- population ratio was unchanged at 59.9 percent." I don't know what "civilian labor force participation rate" means, actually, but judging from my own experience and watching other people at work over the years, we are a lazy bunch of whiners, and we seem to participate in actually working about two-thirds of the time, so this 65.8% thing looks about right to me! Hahaha! But it was the "employment-population ratio" being unchanged that got me, as it seems that, mathematically, the only way that it can stay unchanged when employment is falling is if the population went down!
I was also surprised to see that the BLS reported that "Average weekly earnings, total private" is $614.53, whereas the average workweek is 33.2 hours. Now, I look at this and I scratch my head in puzzlement, and after grabbing a calculator and beating it into submission by repeatedly punching in $614.53 a week times 52 weeks to find the "average" annual income, I see that the average income is $31,955.56 a year. And yet when you look at the salaries of those who get paid through taxation or self-imposed fees on customers and/or taxpayers, they make at least twice that! And sometimes it is whole multiples of that, as it is not uncommon for some agency or college or city manager butthead to pull down a quarter million bucks a year! Sometimes more! Hahaha!
My disrespect for "public servants" who make more than their employers (the taxpayers) while doing an obviously poor job aside, in the category of "professional and business services", that industry lost 122,000 jobs in April. The report notes that "Half of the April decline occurred in temporary help services," which is a particularly bad omen. To make sure that you understand that inflation in healthcare will continue at its staggering pace, the report also notes, "Health care employment grew by 17,000 in April. Job gains in health care have averaged 17,000 per month thus far in 2009, down from an average of 30,000 per month during 2008." Of course, employment in federal government jobs "rose by 66,000 over the month largely due to the hiring of temporary workers for Census 2010 preparatory work," which means that these people will be on the payroll in 2009, 2010, and probably 2011 as they fan out to identify where everybody lives and force them to answer a lot of embarrassing questions, like, "Would you describe your house as a 'pigsty' or an 'eye-sore?" and the wife and kids are yelling out over your shoulder, "It's a hell-hole! An ugly hellhole!"
The Really, Really Bad News (RRBN) is when you look at the U-6 estimate of unemployment, which includes "Total unemployed, plus all marginally attached workers, plus total employed part time for economic reasons, as a percent of the civilian population plus all marginally attached workers," and which was 15.8%! No wonder, then, that John Williams at shadowstats.com figures that unemployment is actually running closer to 20%! There were also some big downward revisions for prior months, and the laughable Birth/Death Model assumed, for no particular reason that anybody can actually discern, that another 226,000 "hypothetical jobs" were created in April, including 76,000 jobs in leisure & hospitality, 65,000 on professional & business and 38,000 in construction! Hahaha! Things are looking bad for everything except gold, silver and oil, which is good because they are all cheap as hell right now! Whee! This investing stuff is easy!
FASB Approves New, Tighter Off-Balance-Sheet Rules
Accounting rulemakers gave final approval Monday to changes that will require companies to bring more of their off-books assets onto their balance sheets. The moves by the Financial Accounting Standards Board had long been expected; the board okayed draft versions of the changes in September. The changes take effect early next year for most companies. Among other moves, FASB's changes abolish "qualifying special-purpose entities," or QSPEs, a popular type of off-balance-sheet vehicle in which some large banks hold hundreds of billions of dollars in securities and other assets.
It'll be harder to keep those assets off the balance sheet under the new rules, and more disclosure will be required. The new approach will also make securitization - the packaging and selling of loans, receivables and other assets - more difficult, since it's typically done off-balance-sheet through QSPEs. Some observers think the current, looser off-balance-sheet rules played a role in the financial crisis, by leading companies to hold more risky securities and to spread the risk of questionable assets like subprime mortgages throughout the financial system.
Inheriting $4.8 Trillion Will Leave You Broke
Sometimes, a single word pops up so frequently in the mouths of politicians that you can be sure that it has been tested and retested with focus groups. When a word gets overused, it’s because political operatives have launched a blizzard of conference calls reminding everyone to recite the party line. You can say one thing about House Speaker Nancy Pelosi and her party: They are disciplined. Their magic word is "inherited," and never before in the history of American politics has a word been so abused. The Democrats must have a kangaroo court somewhere that issues heavy fines to those who fail to use it when on television.
If you are a channel flipper, you might start on one channel where Pelosi is saying, "In 2007, the new Democratic Congress began to restore our nation’s fiscal health while inheriting a fiscal challenge of historic proportions." You might then flip and see Senate Majority Leader Harry Reid saying, "It’s going to take a lot of work to clean up the mess we inherited." Turn to the next channel, and there’s White House budget director Peter Orszag saying, "We inherited these twin trillion-dollar deficits." Here’s the problem. If something is the unvarnished truth, then party discipline is unnecessary. Every sensible analyst will state the key words over and over again anyway. It’s only when a party is on shaky ground that it relies on such transparent tactics.
So let’s explore that ground. The issue of inheritance is a bit muddy. President George W. Bush and the Republicans controlled all of the branches of government until the 2006 midterm elections. In 2007, the Democrats began their reign in both the House and the Senate. Policies adopted prior to 2007 could reasonably be dubbed an inheritance. Policies that changed thereafter could not. There is an easy way, therefore, to establish how much of the current budget mess is accurately referred to as an inheritance. Just as Nancy Pelosi was taking over as House Speaker, the Congressional Budget Office made a long-run budget forecast. That forecast established the Democrats’ inheritance.
If we compare the current outlook to that one, then we can identify the impact of Democratic policies, and accurately assess the blame. While doing so, we need to remember that Bush shares in that blame, since he signed into law the bills passed by the Democratic Congress. To be fair, it is important to note that a big part of the budget mess is attributable to a falloff in tax revenue that is largely the recession’s fault. To be conservative, let’s just look at what the Democrats have done to spending since they took power, and see what the current budget outlook would be if they had simply kept spending on the path that they "inherited."
Back in January 2007, the CBO thought that spending this year would be about $2.9 trillion. Instead, spending is now looking like it will be about $4 trillion. Sure, you might say, that’s the result of sensible Keynesian stimulus and the costs of the financial bailout. But what happens next is almost as striking. In 2007, the CBO thought that spending would gradually increase from $2.7 trillion to about $4 trillion in 2017. According to President Barack Obama’s May budget numbers, we now expect to spend $4.7 trillion in 2017, about $800 billion more in that year alone. Extrapolating out the 2007 CBO forecast, our government plans to spend about $5.6 trillion more between 2009 and 2018 than was projected to be spent when the Democrats took over control of Congress.
To put that number in perspective, at the start of the 2007 budget year, Democrats inherited $4.8 trillion in outstanding government debt. That means that all of the deficits that have been run through all of history, funds that were used to finance the Vietnam War and the Iraq War and everything else in between, would be smaller than the spending increases of Democrats over the next 10 years if they are permitted to stay in power and keep up this pace.
Given how huge the Democratic spending binge has been, these numbers have an astonishing impact on the budget outlook. If the Democrats had simply kept spending on the same long-run course they inherited, the budget would show a surplus of $70 billion for 2019, assuming that revenue would be the same as currently forecast. In Washington, it is unacceptable socially to assert that anyone is telling a lie -- unless, of course, he is named Bush. So let’s say it is a pure, flat-out, bald-faced and shameless misstatement to claim that the budget outlook is an inherited problem. The mess is largely attributable to the Democrats’ own policies. That’s why they keep saying "inherited" over and over.
Morgan Stanley approved alleged insider trade
Morgan Stanley compliance officers approved the trades of investment banker Du Jun, who is at the centre of Hong Kong’s highest profile insider dealing trial, a court in the territory heard Monday. In February 2007 Samantha Ng, a former Morgan Stanley compliance manager, signed off on an application by Mr Du to buy shares in Citic Resources, a unit of China’s largest investment conglomerate, after, she said, she confused it with sister company Citic Pacific. "That’s the only Citic stock I know from my memory," Ms Ng told the court on Monday. Last week the court heard the recording of an initial telephone conversation between Mr Du and Ms Ng.
Mr Du, who worked in Morgan Stanley’s fixed income department, had been a member of two project teams, codenamed Jumbo and Colorado, that advised Citic Resources on a bond offering and potential hedging deal. Ms Ng also said she was unaware that Morgan Stanley had won a verbal mandate to advise Citic Resources on the issuance of $1bn in bonds, which were used to finance the purchase of an oil field in Kazakhstan. As a result, the company appeared on a Morgan Stanley watch list and bankers advising it – who were said to have been "brought over the wall" – were not supposed to trade in it.
"If I knew [Du Jun] was over the wall, I would inform him he cannot trade," Ms Ng said.
Hong Kong prosecutors allege Mr Du spent HK$86m ($11m) acquiring shares in Citic Resources from February to April 2007 while in possession of material and non-public information related to the company. In the charges laid against Mr Du, the Department of Justice alleged: "[Citic Resources] was in fact on the watch list and the defendant knew it because of the e-mail, which he had opened and read on February 9, 2007." In addition to taped phone conversations, the prosecution has also produced e-mail records that it says show not just when Mr Du opened his e-mails, but how far he scrolled down each one. Mr Du denies all the charges. Mr Du asked Ms Ng for her approval to buy Citic Resources shares on February 13. In a telephone conservation that was played in court on Monday, Ms Ng asked Mr Du whether he was "working on anything in particular on this company, or I mean, for your day-to-day work"?
"It’s not my daily job," Mr Du replied. Mr Du, who is said to have had close relationships with senior executives at major Chinese companies, said he had been contacted by colleagues from the investment banking division as they wanted to "leverage my relationship". "It’s just more like a, the relationship thingy," Mr Du told Ms Ng, who approved the trade later that day. Ho Sheng-ching, former chief operating officer of Morgan Stanley’s fixed income department, had previously referred Mr Du’s requests to compliance. "I thought he could explain to them first hand what his involvement had been and they would be better placed to dig further if they had to because they had access to the watch list which I did not have access to," Ms Ho said in testimony last week. The trial continues.
America requires a dose of healthcare reality
Last week, after meeting groups representing hospitals and insurance companies, Barack Obama announced a breakthrough on reforming US healthcare. It was "a historic day", he said. The providers had made "an unprecedented commitment" to curb the system’s costs, running at 16 per cent of gross domestic product. They had agreed, he said, to reduce growth in healthcare spending by 1.5 percentage points a year, enough to save $2,000bn (€1,480bn, £1,320bn) over the next decade. Exactly how was something of a mystery. Was this an aspiration, a target or a forecast? Within hours all parties began clarifying the declaration to the point of meaninglessness. The producer groups, facing agitated members demanding an explanation, denied they promised anything. White House officials repeated the president’s assertion, then withdrew it saying he had misspoken, then affirmed it again.
Political slapstick is routine on this issue. What matters is whether the administration, the healthcare industry and the US electorate are moving any closer to facing the hard choices that Mr Obama is always telling the country he is willing to confront. So far the answer is no. The president is right that costs need to be better controlled. Nobody disagrees. The US spends vastly more than any other country on healthcare, yet fails to insure tens of millions of its citizens. Expenditures are growing faster than inflation and faster than the economy’s trend growth. Yet judged by health outcomes the system gets mediocre results at best. The US is closer to a consensus than ever before that something must be done. But what? Leaders of the House of Representatives have promised to complete a reform bill by the end of July. With that detail decided, all that remains is to work out the main points.
Cost control can and should be part of the answer, but not the larger part. Too much is expected of a new emphasis on preventing illness, bringing information technology to bear and reforming the way services are delivered. All these should be done – to improve outcomes and value for money. Experience suggests that they will do little to curb spending. The deepest of these delusions is believing that subsidies to make health insurance near-universal will pay for themselves, through fewer visits by the uninsured to expensive emergency rooms rather than relatively cheap primary-care doctors and nurses. There will be some savings of that kind, but wider insurance will raise the consumption of health services. That is the idea, after all. No health-policy scholar I am aware of believes this change will come close to paying for itself.
Near-universal healthcare will require higher taxes. The administration said so in its budget, setting aside a "downpayment" of $600bn over 10 years. Most analysts think that comprehensive reform will cost $1,500bn or more. Even without healthcare reform, Mr Obama’s long-term budget does not balance. So count on it: US taxes are going up. A simple way to raise a lot of money would be a value added tax, which I have advocated for the US before. But at a recent congressional roundtable, health-policy scholars representing a wide range of opinion mostly preferred a different approach. They wanted to eliminate, or at least cap, the income tax exemption for employer-provided health insurance.
This would raise surprisingly large sums. Eliminating the tax break altogether would yield some $250bn a year, Jonathan Gruber of the Massachusetts Institute of Technology told the roundtable. Even capping the exemption at quite a high level – denying the tax break to insurance plans costing more than a certain amount – could go a long way to meeting the cost of wider coverage. Most of the other economists giving evidence agreed. But in a rare show of comity, the Senate finance committee’s most senior Democrat and Republican were united against. This was not going to happen.
If you are to raise taxes, there is a lot to be said for scrapping the exemption.
This is a tax increase that is broadly based, raises average rates more than marginal rates, affects those on high incomes more than those on low, and removes a subsidy for over-consumption of medical services. Its fatal flaw, politically speaking, is that it has another even greater advantage: it would encourage employers to drop health insurance altogether and force more workers to buy insurance for themselves. By itself, this would leave the old and the sick at a disadvantage: losing their group coverage, they might find insurance unaffordable or unavailable. But as long as they were guaranteed affordable coverage – through subsidies, community rating, government plans or other means – breaking the link between employers and health insurance would make excellent sense. This link is, among other things, a principal cause of economic insecurity in the US: if you lose your job, you face the risk of a health-related financial catastrophe.
The standard counter-argument concerns the division of spoils between capital and labour: if an employer drops its health insurance, income is surely transferred from workers to the company. Not so. This is a fallacy, and there is plenty of evidence to prove it. What counts is total labour costs: wages plus benefits. If companies save money by dropping insurance, the labour market will clear with higher wages. Unfortunately voters do not believe it; nor do politicians of either party. This is a great shame. If US health insurance is to remain predominantly employer-based, Mr Obama’s "comprehensive health reform" is going to be a lot less comprehensive, and affordable, than it ought to be.
France claims lead on recovery in Europe
France is four months ahead of other European countries in its economic recovery plan, according to the minister in charge of the €26bn fiscal stimulus announced by President Nicolas Sarkozy in December. In an interview with the Financial Times, Patrick Devedjian, minister for economic recovery and a close adviser to Mr Sarkozy, said France had managed to speed ahead because its centralised system allowed the government to mobilise resources more quickly. He said three-quarters of the €26bn ($35bn, £23bn) would be spent in 2009, and projects that did not use their funding in time would have it withdrawn. €10bn of the funding has already been disbursed to projects ranging from a €2m restoration of Beauvais cathedral to the construction of a naval surveillance ship in Nantes. "In terms of our recovery plan, we’re four months ahead of other countries in Europe," said Mr Devedjian. "I know this because I have discussed it with the other European ministers. They have told me of the problems they face. They are behind because they cannot mobilise fast enough."
Mr Devedjian countered the claims of economists who have warned that the gestation time for infrastructure projects would slow France’s investment-heavy stimulus. He claimed the government had avoided that by specifically selecting projects that could be launched without any delay. "That is why we chose to focus on accelerating projects that were already planned," said Mr Devedjian. "Every region had projects that were basically ready to go but lacking some part of the funding." The German economic ministry dismissed suggestions its stimulus programme was working too slowly. It said: "National, regional and local governments are together making sure the programme is implemented rapidly. We are already seeing the first positive effects. The first excavators are already at work." Mr Devedjian criticised the UK for focusing on consumption, rather than investment. "If you look at the results of the attempt to boost consumption in the UK – the VAT [value added tax] cut – it has not given results so far ... My advice for Gordon Brown would be: investment. More investment." However British retail figures through the recession have remained relatively buoyant, allowing its Treasury to argue that the year-long cut in VAT from 17.5 per cent to 15 per cent has helped to maintain demand in the economy.
Analysts said France could be ahead in implementing its stimulus owing to the government’s controlling stake in companies such as RTE, Europe’s biggest power network, and La Poste, the French mail monopoly, which have agreed to accelerate long-term investment under the plan. In December, RTE said it would raise investment in 2009 by 20 per cent, up from a likely 5 per cent before the crisis. Alain De Serres, senior economist at the OECD in Paris, said: "It’s not inconceivable that Mr Devedjian is right, France may be ahead in terms of infrastructure spending. But there are other factors that need to be taken into account. In all these government recovery plans, you need a variety of instruments to stimulate the economy, with some having a more rapid impact than others." Mr De Serres warned that France's biggest private companies were unlikely to see a substantial impact in 2009, since a large part of the stimulus was aimed at improving cash flow for small businesses and individual traders. Lafarge, the world’s largest cement maker, countered Mr Devedjian’s claim, noting said it did not expect to see significant benefits from the French plan until 2010. "We are late in the chain . . . We imagine we’ll start seeing some effect late in 2009, but the full bulk of the results will come in 2010."
Siemens chief sees surge from Germany
Germany will emerge from the economic crisis to spearhead a fresh wave of industrialisation, according to the chief executive of Siemens, adding to the number of high-profile voices defending the country’s reliance on exports. Peter Löscher, head of Europe’s largest engineering group, told the Financial Times that infrastructure programmes launched worldwide and the push for a green modernisation would spur growth in the industrial sector. He said: "We will certainly see more and not less industrialisation as a result of the current economic crisis. "Countries with a highly innovative industrial structure such as Germany will draw large advantages from this."
The Austria-born manager, the first from outside the company to head the German conglomerate, also took aim at critics of Germany’s dependency on exports as he countered the notion that a shift towards services would help escape recession. He said: "Over many years, the belief was that one could differentiate by becoming a service economy. This model is no longer sustainable". Germany’s economy, which contracted at a record 3.8 per cent in the first quarter and is expected to shrink by up to 6 per cent this year, has been hit harder than most other European countries. Economists and central bankers have blamed the country’s dependency on exports for its plight. But Angela Merkel, chancellor, recently said the indebted country with its shrinking population could not afford to boost consumption at the expense of exports. She said: "The German economy is very reliant on exports, and this is not something you can change in two years. "It is not something we even want to change."
Industrial products such as cars, machinery and medical devices, which are mainly manufactured to be sold abroad, make up almost a quarter of Germany’s gross domestic product – much more than in most other European countries. In the UK, industrial products account for only 13 per cent of the economy. There, the financial crisis has stoked up an opposite debate on whether Britain should re-industrialise. "Just take look at Spain, which has been celebrated as the job engine of Europe," said Mr Löscher, who used to work there and whose wife is Spanish. "The country now turns out to be too much dependent on construction and tourism. It lacks highly innovative sectors that could help it come out of the recession." Spain’s unemployment rate has shot up dramatically after a bursting property bubble had dented its domestic demand.
Europe would regain importance as a production site as a consequence of the structural shift towards green products, Mr Löscher said. But he added: "We have to be much more innovative as we are more expensive in our production." He gave the example of Siemens’ plant in Berlin, which is soon to be extended to build a new generation of highly efficient gas turbines. The turbines have been developed and will be produced in Berlin, and they will be tested at German utility company Eon. Later, the turbines would be produced and sold around the world, Mr Löscher said.
China Forecast Is Too Rosy for Investors
For those of us who got scorched staying in U.S. stocks last year, China’s markets look like a surefire way to make up lost ground. The Shanghai Composite Index has gained about 45 percent this year through May 15. Its cousin Shenzhen Composite Index has soared 60 percent. Compare that with the 5 percent loss for the Dow Jones Industrial Average this year and it’s not hard to make a case to stampede into Chinese stocks and exchange-traded funds. Yet international exuberance can be misleading as many analysts caution that investors are inflating a bubble. One optimistic theory suggests that as one of the few countries with economic growth, China will rescue shrinking Western economies with its lending and burgeoning domestic consumer markets, which could become the world’s largest.
A more plausible view is that China will simply follow the lead of the U.S., which is showing "green shoots" of a recovery, according to Federal Reserve Chairman Ben Bernanke. It’s easy to be conflicted between these two points of view because the future looks so bright for the world’s most populous country, so much so that few financial advisers will steer you away from it as a long-term holding in your portfolio. Even Goldman Sachs Group Inc. is sanguine over China’s prospects. The firm last month raised its forecast for the country’s economic growth to 8.3 percent from 6 percent. Analysts cited the positive impact of the Chinese Central Bank cutting its benchmark rate five times since September and the country’s $586 billion stimulus package.
Goldman Sachs’s optimism is at odds with the World Bank forecast for Chinese growth of about 6.5 percent this year. China’s economy expanded 6.1 percent in the first quarter. While there’s a consensus that China is still expected to have the most robust economy in the world in 2009, it won’t revive Western housing, labor and credit markets. "As long as we are in a recession, they are going to have problems," Jim Trippon, publisher of the Houston-based China Stock Digest, said in reference to China. The perception that the Chinese may be willing to spend more on consumer items and save less -- their personal-savings rate is more than 30 percent -- may be off base as well.
One of the reasons Chinese families save a lot is due to inadequate health care. They don’t have strong social safety nets, so they have to spend heavily for out-of-pocket expenses. Like most families, they are far more likely to spend on medical expenses than on appliances and cars. Some help is on the way. Part of the Chinese stimulus is currently being spent on their health-care system, which will take years to build. There are also concerns about China’s financial industry. Chinese banks tripled first-quarter lending to $670 billion and many of these loans may well go bad. As it stands now, China’s financial relationship with the U.S. is complex, strained and symbiotic. The Chinese buy supertanker-sized portions of U.S. Treasury debt, which in turn finances everything from the Bush-era tax cuts to President Barack Obama’s almost $800 billion stimulus plan.
China has increased its foreign-exchange reserves from about $340 billion in 2003 to almost $2 trillion at the end of March. About $1.2 trillion is invested in the U.S. economy. A weakening dollar and the threat of inflation -- once the U.S. finances all its debt -- erode the value of Chinese holdings. They won’t hold on to U.S. paper forever as America’s currency reflects the crippling $11 trillion national debt and projected $1.8 trillion federal budget deficit. If the Chinese decide to divest themselves of dollars --and they will over time -- that is bearish for the U.S. economy. "The People’s Bank will continue to invest carefully," Zhou Wenzhong, China’s ambassador to the U.S., said this month at a Chicago Council of Global Affairs event. "We hope the economy will pick up and the dollar will remain strong."
Chinese stocks also have become pricey. The price/earnings ratio for the Shanghai Composite was 26.57 on May 15, almost double what it was for the Standard & Poor’s 500 Index. Companies may be doing better in China than their U.S. counterparts, but not that much better on a relative basis. To avoid mutually assured destruction, the Chinese will need to build a domestic economy strong enough to withstand the loss of American exports. Their middle class will also need to expand to much more than one quarter of their population. Some 800 million still live in relative poverty in rural areas. Don’t be distracted by one country’s returns. Did you also know that stock markets in Brazil, Malaysia, Singapore, Sweden and Vietnam are having good years? A better wager is to invest in many markets through an exchange-traded fund such as the Vanguard Total World Stock Index Fund, which tracks almost 3,000 stocks around the globe. This, of course, isn’t a risk-free approach since a few sick countries can always spread an economic pandemic in an interconnected world.
UK Foreign Secretary: China ready to join US as world power
David Miliband today described China as the 21st century's "indispensable power" with a decisive say on the future of the global economy, climate change and world trade. The foreign secretary predicted that over the next few decades China would become one of the two "powers that count", along with the US, and Europe could emerge as a third only if it learned to speak with one voice. The remarks, in a Guardian interview, represented the most direct acknowledgement to date from a senior minister, or arguably from any western leader, of China's ascendant position in the global pecking order.
Miliband said a pivotal moment in China's rise came at the G20 summit last month in London. Hu Jintao, China's president, arrived as the head of the only major power still enjoying strong growth (expected to be 8% this year), backed by substantial financial reserves. "The G20 was a very significant coming of economic age in an international forum for China. If you looked around the 20 people sitting at the table … what was striking was that when China spoke everybody listened," Miliband said. "China's indispensability in part comes from size, but a second part is that it wants to play a role."
Hu helped bolster Gordon Brown's position against protectionism, and China's economic stimulus package (equivalent to 16% of its GDP over two years) is widely seen as among the world's best hopes for a recovery. "Historians will look back at 2009 and see that China played an incredibly important role in stabilising global capitalism. That is very significant and sort of ironic," Miliband said. "There's a joke that goes: 'After 1989, capitalism saved China. After 2009, China saved capitalism.'" Signals from Beijing since the London summit that it is considering tough concerted action to reduce CO2 emissions, have raised hopes of reaching a workable international pact to contain climate change.
Miliband compared China's potential role in the coming years to the role the US claimed for itself in the 20th century, recalling a 1998 boast by Madeleine Albright, then US secretary of state. "China is becoming an indispensable power in the 21st century in the way Madeleine Albright said the US was an indispensable power at the end of the last century," Miliband said. "It has become an indispensable power economically, and China will become an indispensable power across a wider range of issues." But in contrast to America's 20th-century ascent, which eclipsed Britain, Miliband said China would not displace the US but rather join it at "the new top table", and because of its low per capita income, it would not rival the US as the world's leading superpower for at least a generation.
At the G20 summit, some commentators argued that the most important axis was a "G2" of the US and China. Whether that could be expanded to a "G3", Milband argued, would be up to Europe. "I think that there is a scenario where America and China are the powers that count," the foreign secretary said. "It is massively in our interests to make sure that we have a stake in that debate, and the most effective way of doing so is … to ensure we do it with a European voice." A report by the European Council on Foreign Relations argued that China was exploiting the EU's divisions and treating it with "diplomatic contempt". The report, published in advance of Wednesday's EU-China summit in Prague, said that European states, dealing with China individually, lacked leverage on issues such as trade, human rights and Tibet.
"Europe has not been sufficiently strategic in its relationship with China," Miliband said. "I think a significant part of that is institutional. The EU-China relationship is a good case for the Lisbon treaty. At the moment, at every EU-China summit, the EU side is led by a different presidency and every year there's a different set of priorities. "Miliband denied Britain had allowed human rights to slide down the agenda with China, saying there was a constant dialogue between the two countries on the issue. "It's a mature relationship that does take these issues seriously," he said.
Joseph Cassano: the man with the trillion-dollar price on his head
They were frightened for a long time, then suddenly they were angry. For millions of Americans, anxiety about a jobless, debt-laden future turned to disbelief when it emerged that AIG, the company at the centre of the world’s financial crisis, was handing out £300m in bonuses. It was the superpower’s Sir Fred moment. Just as Britain reacted with fury to the disclosure that Sir Fred Goodwin’s pension pot had been doubled as his bank neared collapse, so the US was shocked. The death threats came soon after. "I want them dead!" said one of a stream of messages that caused AIG staff to travel in pairs, park in well-lit areas, and dial 911 if followed. "I want their spouses dead! I want their children dead! I want their children’s children dead! I want the earth upon which they have walked salted so nothing will ever grow again!"
This was one of the greatest bailouts in history, after the biggest corporate loss in history, during the most serious challenge to world stability since the 1962 Cuban missile crisis. And here was AIG, the recipient of so much taxpayers’ money that the cheques exceed the value of the gold reserves in Fort Knox, paying bonuses to the very people who engineered the catastrophe. Protesters toured the posh houses on Long Island Sound, an estuary northeast of New York City, with letters for AIG executives describing the plight of homeowners. But they were in the wrong place. Because the man who knows most about AIG’s troubles lives in a stucco-fronted house 3,000 miles away. Some call him Patient Zero: the virus that infected the world financial system was transmitted from a genteel square near Harrods. If you wait patiently in Knights-bridge you will see him, and he appears not to be a risk-taking type.
He puts on his red crash helmet and cycles greenly off across the city, politely declining to comment on global calamities. This does not look like a person waiting at the curtains for the arrival of the FBI. Can one man in London really be to blame for the collapse of capitalism? Until now, the economic crisis has been seen as a giant intellectual error, and AIG’s multimillionaire employees in England were simply the people who made the biggest mistakes. The first to own up to misjudgment was Gordon Brown’s friend Alan Greenspan — once so revered in his role as America’s central banker that to be photographed with him was as flattering as being seen now with President Obama. "I have found a flaw," said Greenspan, referring to his free-market philosophy, after the banks started falling over. "I don’t know how significant or permanent it is. But I have been very distressed by that fact."
Others have repeated this innocent-sounding explanation for the wrecking of so many lives. "There is no fail-safe way to offset this human tendency to collective error," says Lord Turner, chairman of the Financial Services Authority (FSA). And it is true, of course. Now and again, historical forces come together in a way that is mutually reinforcing, and individual changes that are powerful in themselves become so strong that their effects are wrongly seen as permanent. If 150m people — 2Å times the British population — stop tilling the land and start making things, as happened in China between 1999 and 2005; if the Chinese recycle their export earnings into cheap credit; if interest rates stay low for reasons that seem important at the time (the millennium bug, the tech-stocks crash, 9/11); if new ideas allow you to spread financial risk? well, by now you know the explanations. It became easy to imagine that the world was growing rich because we understood the universe better than our ancestors, until we didn’t.
There is, however, an alternative reading. This says that the furore over bonuses is a convenient distraction from the real causes of the crisis, which go to the heart of how the world is run. There is dishonesty in this collapse, on a scale that is almost too vast to comprehend. There are conflicts of interest in American finance and politics that make our own, dear House of Lords look like beginners. There are frauds so large, and so long-standing, that it can be hard to see them for what they are. And all these things were allowed to thrive in an intellectual atmosphere that tolerated no dissent. This reading is optimistic for those who believe in free markets, even if it is pessimistic for the US. "Capitalism has not failed," says Bernard-Henri Lévy, the French philo-sopher. "We have failed capitalism." The thesis can be tested through Patient Zero.
The official version is that Joseph Cassano, who occupies the stucco-fronted house near Harrods, brought down a safe and stable company — and by extension, the world — with incompetent gambles. "You’ve got a company, AIG, which used to be just a regular old insurance company," Obama explained during a recent TV appearance. "Then they decided — some smart person decided — let’s put a hedge fund on top of the insurance comp-any, and let’s sell these derivative products to banks all around the world." Ben Bernanke, the chairman of the Federal Reserve, adds: "This was a hedge fund, basically, that was attached to a large and stable insurance company." Cassano, who ran AIG’s financial-products division in London, "almost single-handedly is responsible for bringing AIG down and by reference the economy of this country", says Jackie Speier, a US representative. "They basically took people’s hard-earned money, gambled it and lost everything. And he must be held accountable for the dereliction of his duty, and for the havoc he’s wrought on America. I don’t think the American people will be content, nor will I, until we hear the click of the handcuffs on his wrists."
This account is as satisfying as it is easy to understand. It treats the blowing up of the world financial system like a global version of Barings, the bank that collapsed in 1995, with Cassano in the role of Nick Leeson. Operating from the fifth floor of a polished white stone building in Mayfair, Cassano’s unit sold billions of pounds of derivatives called credit-default swaps (CDS), allowing banks to buy risky debt without attracting the attention of regulators. AIG took the fees, but did not have the money to pay up if the loans went bad. By the time the music stopped, European banks had protected more than $300 billion of debt with this bogus "insurance". And that is just one corner of a web of risk extending to over 1,500 big corporations, banks and hedge funds. In a 21-page paper known as the Mutually Assured Destruction memo, AIG claims that if the bailouts stop and the company is allowed to go bust, it will take the world with it. Cassano must have played with handcuffs as a child: he is the son of a Brooklyn cop. Now he waits for the fallout.
But the official version overlooks many things, including episodes of fraud at AIG that go back at least 15 years. It fails to explain why Public Enemy No 1 was allowed to leave the company on generous terms, with a retainer of $1m a month and up to $34m (£23m) in bonuses. And it does nothing to tell us why other big companies, whose profits looked as smooth and certain as AIG’s in the good times, are also fighting for survival. When Forbes published its first list of the world’s biggest companies in 2004, AIG ranked third, after Citigroup, the dying bank, and General Electric, the industrial giant now drowning in its own debt. If you can think of a risk to insure, AIG was there: the company even made plans to survive a nuclear holocaust. It was built into a behemoth by one of the 20th century’s corporate titans, Hank Greenberg. Less famous than the other insurance legend, Warren Buffett, Greenberg gave shareholders a return of 14% a year, and was equally loved. "I just think you are the most stupendous, unbelievable person in the entire industry, the entire world," one investor told an annual meeting, without irony.
But Greenberg faced a problem. Insurance is not like iPods, where if you invent the market, growth comes fast. Over time, it performs in line with the economy. In 1987 he found an answer: AIG would enter a joint venture with Howard Sosin, a pioneer in the new "Frankenfinance" of derivatives trading. You can thank Sir Isaac Newton for Frankenfinance. By showing in the 17th century that the universe conforms to natural laws, he encouraged our age to see money as a branch of physics. Starting in 1952, two generations of economists worked to show that people are like molecules, whose behaviour can be predicted in ways that are stable over time. Science then infected everything, from how much capital banks need to protect themselves against insolvency, to the risk in credit-default swaps. But there was a flaw: the City’s faux physicists never go back far enough in their analysis, because the data on the Bloomberg terminal cover a tiny period of history. "Real scientists tend to be much more sceptical about their data and their models," says William Janeway, an MD of the private-equity firm Warburg Pincus and a Cambridge University lecturer. "They had all of the maths, but none of the instincts of good scientists." There is also the 4x4 effect: if you give people a safer car (read, a safer world through financial innovation), they tend to drive faster. But we are getting ahead of ourselves.
To start with, AIG trod carefully in the new, scientific universe. Sosin’s idea was to buy financial risk from people who did not want it, then sell the risk to others in a series of "hedges" so that AIG kept the fees but not the risk. If a big organisation wanted to lock in an interest rate, for example, AIG would promise to pay the difference in costs if rates rose, then pass the risk to other parties in separate contracts. Sosin supplied the nerds and the models, AIG supplied the reassurance of its AAA rating, and for a long time the alchemy worked. AIG Financial Products (AIGFP), a unit with 0.3% of AIG’s 116,000 employees, made over $1 billion in profits between 1987 and 1992, a vast sum at the time. But Sosin left. And so did his successor, a mathematician named Tom Savage. When Savage departed in 2001, Greenberg put in charge a man he saw as "smart, tough and aggressive": the unit’s chief operating officer, Joseph Cassano.
The new leader had no background in Frankenfinance; his degree, from Brooklyn College, was in political science. The cop’s kid had ascended through what is called the "back office": his expertise was in supervising the contracts and running the lawyers and accountants. This did not matter, Greenberg thought. Underlings had the right maths, and besides, Greenberg’s AIG held everyone, Cassano included, to account. The London team would be scrutinised. Which was just as well, as the huge intellectual error meant nobody else was in charge. "Why did no-one see it coming?" asked the Queen last November, on a visit to the London School of Economics. Well, they did, ma’am. Charles Bowsher, head of the US government’s General Accounting Office, testified as long ago as 1994 that "the sudden failure or abrupt withdrawal from trading" of large dealers in derivatives "could cause liquidity problems in the markets and could also pose risks to others, including? the financial system as a whole". It took another 13 years, but that is exactly what happened.
One regulator tried to act on Bowsher’s warning, but she was silenced. Brooksley Born, who monitored the futures markets, tried to extend her remit to unregulated derivatives. Alan Greenspan and Robert Rubin, the then Treasury secretary, persuaded Congress to freeze her already limited power, forcing her departure. Rubin had come into government from Goldman Sachs; when he left he went back to banking, and pushed for Citigroup to step up its trading of risky, mortgage-related investments. For his advice, he earned over $126m (£84m) and then, as Citigroup collapsed, became an adviser to Barack Obama. After Greenspan stepped down from the US central bank in 2006, he became a consultant to Pimco, the world’s biggest bond fund, where his insights have been praised by his boss. "He’s made and saved billions of dollars for Pimco already," said Bill Gross last year. Greenspan is also an adviser to Paulson & Co, a hedge-fund group that has made billions from the collapse in American housing.
The lightness of touch reached a level that defies belief. America has an Office of Risk Assessment, set up in 2004 to co-ordinate risk management for the main regulator, the Securities and Exchange Commission (SEC). Jonathan Sokobin, its director, says it is charged with "understanding how financial markets are changing, to identify potential and existing risks at regulated and unregulated entities". According to its website, it also helps to "anticipate, identify and manage risks, focusing on early identification of new or resurgent forms of fraud and illegal or questionable activities? across the corporate and financial sector". By early 2008, this office was reduced to a staff of one. "When that gentleman would go home at night," says Lynn Turner, the SEC’s former chief accountant, "he could turn the lights out. We had gotten down to just one person at the SEC responsible for identifying the risk at all the institutions." The $596-trillion market in unregulated derivatives, including $58 trillion in credit-default swaps, was being watched by one person. That’s when he wasn’t looking at the rest of the corporate world, of course.
We are in a hotel in London, sitting on cracked red leather sofas. The interview is with one of the finest analysts of financial statements on the planet. Where you or I see pages of numbers, he sees a narrative. Sometimes the theme is a company’s potential for growth. Sometimes it is the prospect of self-destruction. And at times the story does not make sense, because the figures are hiding a fraud. Charles Ortel, managing director of Newport Value Partners — a firm that provides research to professional investors — is explaining the potential for fraud in insurance. Insurers share their big risks with others. Imagine it is September 12, 2001, and you get a report on the previous day’s terrorist attacks. You don’t know your loss, because it takes time for victims to come forward and costs to be calculated. You decide it’s $12 billion and do a deal with another insurer: I will write you a cheque now for $9 billion, and we agree my liability is capped at $12 billion. If the eventual losses are higher, the second insurer will pay. In the meantime, it is free to invest the $9 billion. Insurers make much of their money from investing premiums while they wait for a claim.
The second insurer can book some of the $9 billion as income. It shouldn’t, because it is exposed to risk. But there’s flexibility in how the numbers can be treated. If the second insurer is not having a good year, the flexibility creates the temptation to book phantom earnings, illegally supporting the share price. In the past, AIG has admitted episodes of improper accounting. One question has not been answered. Was Cassano’s team simply the dumbest in the room, betting on an ever-rising housing market against the likes of Goldman Sachs? Or was the world financial system brought down by fraud — a fraud made possible by the gradual but relentless takeover of public life by the insiders’ club of finance?
In 2001, with AIG trading at $85 on the New York Stock Exchange, The Economist decided to commission some research on the company’s true value, and chose the little-known firm Seabury Analytic to do it. This was deliberate. The magazine’s New York bureau chief, Tom Easton, had been around long enough to know that nobody on Wall Street ever says "sell", except perhaps when a market is about to go up, and that the big security firms could not be trusted to give a candid view of AIG. The research, which took five months, was the work of a team led by Tim Freestone, who is speaking here for the first time. Most analysts are upbeat: their colleagues’ bonuses depend on fees from the company under scrutiny. But Freestone’s firm (now called Crisis Economics) is independent. He judged that AIG was highly overvalued, and he would later realise that its shares were supported by an ability to stifle criticism. In his report for The Economist, however, he was tactful.
To justify the share price, he said, "it would have to grow about 63% faster than [its] peers for the next 25 years. If investors believe that AIG can sustain this type of performance for that period of time, then AIG is properly valued". Any investor who believed that would need to be certified. After the article came out, researchers from the big banks contacted him, incredulous that he had dug deeper than the industry norm and dared to release the findings. They seemed to be in awe, and at the same time jealous; nobody breaks the rules like this — not without paying a price. A delegation from AIG arrived at his office and presented him with a letter that seemed to renounce the story and to condemn its distortion of his research. He was intrigued to see the author’s name at the end of the letter — why, it was his name, and the AIG contingent was awaiting his signature. The company also sent its executives on a private plane to The Economist headquarters in London to demand a retraction. Legal threats followed. "I assumed AIG was attempting to railroad us out of business," says Freestone, who did not sign.
Greenberg was forceful when it came to his share price. He was often on the phone to Richard Grasso, the head of the New York Stock Exchange, with expletive-laden threats to move AIG to the Nasdaq unless the exchange did a better job. Grasso would then be seen on the floor of the exchange, talking to the market-maker for the stock. Grasso says he never asked the market-maker to bid the shares higher, which is just as well: both men could have gone to jail. What does all this have to do with Joseph Cassano? Seabury Analytic’s research suggests that when Cassano took over the Frankenfinance unit, the parent company was in trouble. "Its ‘distance to default’ was much closer than anyone realised," says Freestone, whose models would later identify AIG and three peers — Lehman Brothers, Merrill Lynch and Bear Stearns — as insolvent when the markets saw everything as fine. He is not alone in his view.
Another authority believes that as the man in Mayfair wrote his credit-default swaps, AIG was already doomed. "AIG’s foray into CDS was really the grand finale," says Christopher Whalen, managing director of Institutional Risk Analytics, an expert on banking who has testified before Congress. Towards the end, it looked much like a Ponzi scheme, "yet the Obama administration still thinks of AIG as a real company that simply took excessive risks". In other words, there was never a chance AIG would honour its contracts: its income was nowhere near enough to cover the payouts. Whalen has a reputation to protect: he is global risk editor of The International Economy magazine, co-founder of the Herbert Gold Society, a group of current and former employees of the US Treasury and the Federal Reserve, and regional director of the Professional Risk Managers’ International Association. His assertion is not an impulse. It comes from months of talking to forensic specialists such as Freestone, insurance regulators "and members of the law-enforcement community focused on financial fraud".
As evidence of dishonesty, Whalen points to AIG’s occasional habit of using secret agreements to falsify financial statements — either its own or those of other companies. In 2005, a former senior executive at the insurer General Re pleaded guilty to a conspiracy to misstate AIG’s finances, after General Re paid $500m in premiums for AIG to reinsure a nonexistent $500m risk. The transaction was a sham; the only economic benefit to either party was the $5.2m fee paid by AIG for Gen Re’s help. When the $500m in loss reserves were added to AIG’s balance sheet in 2000 and 2001, Greenberg was able to claim an increase in reserves, when in fact they had declined. "They’ll find ways to cook the books, won’t they?" John Houldsworth, the former executive, said in a recorded phone conversation with Elizabeth Monrad, his chief financial officer. She observed that "these deals are a little bit like morphine; it’s very hard to come off of them".
Similarly, in 2003 AIG was fined $10m for helping a telecoms company, Brightpoint, hide $11.9m in losses with a "non-traditional" insurance product that AIG offered for "income statement smoothing". Brightpoint paid $15m in premiums, and AIG refunded $11.9m in fake insurance claims. The ruse allowed Brightpoint to spread its loss over three years, overstating its 1998 net income by 61%. And in 2005, AIG restated five years of financial statements, admitting that they had exaggerated its income by $3.9 billion. Whalen believes that at some point between 2002 and 2004, AIG concluded that the game was up for secret agreements, and that other methods of enhancing revenue were needed. "The thing I haven’t satisfactorily answered," Whalen adds, "is whether AIG was so unstable coming out of 2000, 2001, that Cassano was trying to cover up a wounded, dying beast.
Was he doubling up, to try and hit a home run and save the house? It looks like it, because otherwise it was just greed on his part, and he was writing as much of this crap as he could to inflate his bonus." If he is right, the implications are profound. Any bank that thought it was protected by credit-default swaps with AIG would have been exposed from the start, putting taxpayers at risk. The banks’ credit traders would — or should — have realised that AIG was never likely to pay out. "The key point that neither the public, the Fed nor the Treasury seems to understand," says Whalen, "is that the CDS contracts written by AIG were shams, with no correlation between fees paid and the risk assumed. These were not valid contracts but acts to manipulate the capital positions and earnings of financial companies around the world."
The investigation into the General Re affair prompted AIG to oust Greenberg in 2005. He has always denied wrongdoing. In fact, he is suing AIG, claiming his successors abandoned risk controls and destroyed the firm. The old man’s departure meant the brakes were off for Cassano; the new CEO, Martin Sullivan, had risen through the "property and casualty" side of the business. As he is fond of pointing out, he is not an accountant. Who would scrutinise the financial-products team now? The pace of CDS deals suddenly accelerated, until Cassano halted them for ever, all in the space of a few months. He had realised that sub-prime mortgages accounted for an increasing proportion of his trades, and that the underwriting standards were shocking. No model, however carefully constructed, can protect you from that. It was too late: the bomb on AIG’s books was ticking.
For the world to go truly insane, leading to what the Bank of England has called "possibly the largest crisis of its kind in human history", two things are needed. The first is the intellectual capture of the Establishment, so that everyone — politicians such as Gordon Brown, regulators such as the SEC and the FSA, and academic and media commentators — is persuaded that a new way of thinking is in the public interest. The second step is when vested interests exploit the intellectual capture and take it to extremes. Alpha males such as Cassano push at boundaries. You could say it is their evolutionary purpose. That is one reason we need governments, to protect us when male ambition reaches too far. But our governments were mesmerised by our bankers. "From 1973 to 1985," says Simon Johnson, a former chief economist at the IMF, "the financial sector never earned more than 16% of [US] corporate profits. In the 1990s, it oscillated between 21% and 30%, higher than it had ever been in the post-war period. This decade, it reached 41%." The whole point of financial companies is to allocate your savings to those who can use the money best. If they are taking 41% of the profit in an economy, something is out of balance. These figures reveal an enormous transfer of wealth.
Which brings us back to bonuses. In August 2007, as the financial crisis broke, Cassano claimed everything was fine. "It is hard for us, and without being flippant, to even see a scenario, within any kind of realm or reason, that would see us losing $1 in any of those transactions," he told investors, as his CEO listened in on the call. But it seemed to be a different story inside AIG. The company had hired Joseph St Denis, a former SEC official, as part of an effort to improve its internal controls. Cassano shut him out. "I have deliberately excluded you from the valuation of the super seniors [a type of debt] because I was concerned that you would pollute the process," St Denis recalls Cassano saying. The auditor resigned in protest, yet the minutes of AIG’s audit committee show no sign of concern.
In the final three months of 2007, AIG lost over $5 billion. Under the terms of the bonus scheme, top executives should have had their pay cut for poor performance. When the compensation committee met in March 2008 to award bonuses, however, the Essex-born CEO urged it to ignore the losses. The board approved the change, even though losses were growing by the month, and Sullivan pocketed $5.4m. He was also awarded a golden parachute worth $15m. He was out of the company three months later, with a severance package worth $47m (£31m). That is $39,500 (£26,000) for every day he was in charge. Pension funds and other savers holding AIG shares lost $58.4m (£39m) a day during his tenure.
In seven years, the 400 employees in Cassano’s division were paid $3.5 billion. Cassano received $280m. When the losses became public, AIG parted company with him immediately. But he wasn’t fired: he "retired", with a contract paying him $1m a month for nine months, and protecting his right to further bonus payments. "Joe has been a very valuable member of the AIGFP senior management team for over 20 years," said Sullivan, who was soon to leave the scene himself. "He has had a great career with us, and we wish him the very best in the future."
Cassano’s division then imploded. As house prices fell, credit ratings were cut and bankers began to panic, AIG posted the biggest quarterly loss in corporate history: $61.7 billion. This is equivalent to losing $28m (£19m) an hour, every hour, for the final three months of 2008. But by now, the company’s problems were the property of the American taxpayer, creating extraordinary new conflicts of interest. Hank Paulson, the Treasury secretary in the outgoing Bush administration, was an ex-CEO of Goldman Sachs. He received tax benefits of about $200m (£133m) for taking on a government role. When the US decided to bail out AIG, the chief beneficiary of the rescue was? Goldman Sachs, which received $12.9 billion of public funds via the insurer. The new CEO, Edward Liddy, whose task is to wind down the company and to close $1.6 trillion in trades that are still outstanding from the Cassano era, is ex-Goldman Sachs. He even has $3.2m in the bank’s shares.
AIG tried to keep secret its payments to Goldman Sachs and others, somehow imagining you could have $182.5 billion of taxpayers’ money and not say how you were using it. And so the task facing Obama is even greater than we imagine. Intellectually, the president might see what is required, but execution still depends on the very club that helped bring about the collapse in the first place. "It is not outright fraud that has caused the most damage to the market," says Tim Freestone, the analyst first to see AIG’s troubles. "It is the suppression of information, wittingly or unwittingly, by most of the market’s players." A rush to regulation is not the answer, he adds: each new rule creates a minimum target for compliance, with unintended results. The challenge is to confront the keiretsu, the interlocking relationships that give insiders such an advantage.
Bankers and politicians like to blame the catastrophe on this or that cause, which swelled into a tsunami nobody could have foreseen. But as Simon Johnson points out, each reason — light regulation, cheap money, the promotion of homeownership — has something in common. "Even though some are traditionally associated with Democrats and some with Republicans, they all benefited the financial sector." AIG’s early trades showed genuine brilliance; their later CDS deals, many of which were not even "hedged", were as foolish as can be. Was it fraud? Yes, in the widest sense — but it was fraud as wilful ignorance, in which a whole industry is based on false assumptions, and each participant has little reason to question the system as long as it continues to make him rich. "There is no need to have an overt conspiracy, or to be incompetent," says a thoughtful internet poster called Anonymous Jones. "Unfortunately, those ultimately bearing the risk — savers, taxpayers — did not have as strong a personal incentive to keep watch over the system, and those in charge of the financial sector ran roughshod over the entire enterprise, extracting profits far in excess of any value generated by their actions. When there are enormous incentives for each participant to cheat, the efficiency of any market breaks down."
In recent weeks, Cassano has grown a beard and changed his crash helmet, which is no longer red but silver. The disguise might not be enough; prosecutors are said to be close to criminal charges. They think he misled investors, an easier case to make than that of knowingly risking the financial system. "To date, neither AIG nor AIGFP is aware of any fraud or malfeasance in connection with the underwriting and creation of the multi-sector CDS portfolio," says AIG, referring to the trades under scrutiny, "as opposed to what, with hindsight, turned out to be bad business decisions." If they were bad decisions, they had a context. "Once people who push boundaries understand that the police don’t want to issue tickets," says Charles Ortel, "they start pushing. ‘If you’re not going to arrest me for going 10 miles over the speed limit, well, I’ll try 20. If I can do 20, I’ll try 30. And then I’ll try flying a plane on a road.’"