SDUSD Mess Update

Erica Holloway, blogging at sdrostra.com, has an update on the fiscal mess of our local San Diego school district. I posted on November 2 on the same subject. A few quotes from Erica's article:

School district officials and board members say that without a serious, life-saving infusion of state revenue or drastic cuts, such as closing schools, the state could take over the district due to fiscal insolvency, or bankruptcy.

After the utter failure of the school closure plan, Sheila Jackson, schoolboard member, takes full responsibility for the board's failure to put together a reasonable process.

It’s not appropriate for people to come to us and be upset. We didn’t even know what the criteria was, we didn’t even tell the staff which direction we wanted.

Good going there Sheila. In any other kind of electoral situation, she would be a shoo in for recall or at least wouldn't get re-elected. But in an electoral system plagued by general voter apathy towards the schools, the teachers unions are able to hand pick the board. VOSD had this to say about her statement.

But the board was highly involved in setting those criteria. The trustees had discussed and voted on the criteria at least three times in the previous two years

Last July, Jackson and her colleagues voted unanimously to approve a 37-page document that precisely lays out the process by which schools would be chosen for closure. The document includes a four-page board policy detailing all the criteria by which schools should be selected.

They also labeled Jackson's statement "huckster propaganda" with a picture of Pinocchio sporting a very long nose.

Financial Regulation and Efficient Markets

Mark J. Perry (left) authors the Carpe Diem blog, on my favorite blog list. If you only read one economics blog, that would be the one. He exposes myths that surround economic thought, and is my counterweight to Krugman, along with Greg Mankiw. Recently, he authored an article that takes an approach to financial regulation that I have been advocating for some time. (Yes, I am bragging, but sometimes it's good to get confirmation about one's approach to the issues.) The article argues that what is really necessary for more effective regulation of banks is higher capital requirements. Along with co-author Robert Dell, they discuss the inadequacy of risk assessment in capital markets.

Through coincidental timing these concepts dovetail nicely with Roman Frydman's (right) concepts advanced in his latest book. Interestingly, Frydman ultimately argues for greater regulation of banks, but I believe that his work can be used to show that while regulation is possible and even necessary, it can be accomplished at lower cost and with greater transparency than accrues to the Dodd-Frank bill.

But a word of caution. For many years, as a libertarian, I subscribed to theories of efficient markets that underpinned my beliefs regarding financial regulation. Events and research have shown that markets are not always efficient in this sense, asset prices do not always accurately reflect all publicly available information. How can this be? There is no incentive for a prospective buyer to pay more for an asset than it is worth, nor for a seller to receive less, so market forces should force prices to equilibrium reflecting known information. Empirically, we have seen that this does not happen. Bubbles exist, the most recent one in housing, before that in technology stocks and the original one in tulips. However, in libertarian thought, there is a strong belief that since markets are efficient, governments should never try to "outsmart" the markets in an attempt to prevent the collapse of bubbles that bring with them attendant economic calamity. If we give up the efficient markets argument, we must make the argument for non-intervention with more subtlety.

As to why markets aren't always efficient, Frydman hypothesizes that investors focus on a subset of all available information because of the uncertainties surrounding the relationships between given information, and more importantly the greater uncertainty of how other investors will respond to new information. He claims that these processes can never be fully modeled. He goes on to argue that central banks and regulators should intervene to limit excessive asset-price swings on the upside, just as they have on the downside. However, it is not explained how the central bank is to understand to any greater degree of certainty than investors as a group, what the correct range for an asset class would be.

Our response to the call for greater market intervention on the part of the federal government is countered not by citing efficient market theory, but only that government is prone to the same forces that cause investors as a class to make mistakes. That would be the end of it except for the fact that we have socialized the costs of asset price bubbles in our country, so we still cannot ignore the issue, even as Tea Partyers. Assets in a bubble are bought with loans from banks, or are used to secure loans from banks that in turn are insured by the public at large. Both the deposit insurance schemes and the operations of the Federal Reserve socialize these costs to the public as a whole through the government. (Even though deposit insurance is paid for by the banks, it is well understood that the government would not let the fund go broke.) This is the real problem addressed by the Dodd-Frank bill. However, the approach is unlikely to be effective because it relies on a shifting set of risk measurements that Frydman has shown might be subject to the same psychological forces that caused the asset bubble in the first place.

Perry and Dell point out that the issue of insolvency of these financial institutions can be easily rectified by strict capital reserve requirements. They show that actual capital reserves have fallen over the last century, despite various standards and treaties. Requiring more adequate reserves prevents bankruptcy and reduces the chance that your tax dollars or even worse, inflation will be used to make up these losses. Further, with reduced complexity of regulation, the cost to banks' operations will go down:One sensible reform is to reduce those subsidies to put debt and equity on a more equal footing.

Another is to substantially reduce regulatory costs, which, for depository institutions, may well exceed the cost of corporate income taxes. For example, the bank-affected provisions of the 2001 Patriot Act have not (to the best of our knowledge) led to the conviction of a single terrorist, but in 2003 raised the average labor costs of opening a new account from $7.75 to $22, according to an industry consultant.

Time does not permit an examination of the role of credit rating agencies in this space, but suffice to say that increased reserves would reduce dependency on this legally protected oligopoly.

Financial Reform That Isn't

Why am I not surprised that the financial reform bill fundamentally reforms nothing?

Judd Gregg unloaded on the bill:

“The bill is a disaster because it doesn’t address the fundamental underlining causes of the economic issue, which were real estate and underwriting,” he said. “This bill became, ‘I want to score the most points against Wall Street.’ Most of the initiative of this bill wasn’t directed at solving the problem, but it was directed at scoring political points."

As previously discussed in this blog, the ultimate issue is how the bill deals with to big too fail. The linked article claims that this bill gives the feds new powers and "authorizes regulators to impose restrictions on large, troubled financial institutions. It also creates a process for the government to liquidate failing companies at no cost to taxpayers." Color me skeptical, lacking supporting detail, given prior regulatory failure, and political incentives in the bill to turn banks into engines of social justice, I don't see any hope for change at all. I think things will get worse. Note that financial markets have reacted to this "reform" bill as a non-event, focusing on the collapse of socialism in Europe instead.

Meanwhile, gold is hovering near record highs against all major currencies, the traditional investor response to global instability. Debt caused by socialist and quasi-socialist policies is the common ingredient fueling loss of confidence world wide. The Democrats in Congress are doubling down on these failed policies like some compulsive gambler convinced that the next card turned over will be the ticket to a lifetime of riches.

The fight is not over on the final details. But the fundamental approach seems flawed, whether you prefer the House or the Senate version:

The firms would face tighter regulation, such as having to keep higher capital reserves. If they failed, certain creditors would be made whole to protect the financial system, but shareholders and unsecured creditors would bear losses and pay the costs of winding them down. It would create a $150 billion fund financed by large financial companies to pay for the dissolution of failing companies. The Senate version originally included a $50 billion fund, but that was removed after critics said it would encourage bailouts and possibly limit the government's ability to assess more fees on firms.

The problem with either version is that they either implicitly or explicitly guaranty to creditors of big firms that they will be bailed out by the feds. This perpetuates To Big Too Fail as follows. The surety provided by the feds to creditors lowers the cost of capital of the "too big" firms. This yields a competitive advantage to these firms that encourages them to just keep growing bigger and to take bigger risks. Ultimately the moral hazard of To Big Too Fail is not addressed. Creditors to large firms need to realize the same risks as any other creditor in the market place.

We need a law that explicitly prevents the federal government from bailing out more firms. To prevent contagion, we may need an orderly way to divest the assets are still performing, even as the holding firm is bankrupt. Part of the problem is that in the chaos of a massive bankruptcy, assets cannot be properly valued to allow creditors to receive a just portion of the divested assets. Slowing this process may be necessary, it prevents a form of fraud for you libertarians, but I remain adamantly opposed to my taxpayers ponying up to prop up this process.

This is why I oppose this so-called reform, even though it continues to be incrementally improved, it does nothing to fix the underlying issues behind this crisis, in fact, the consumer protection agency looks like a way to double down on Fannie and Freddie foolishness.

Some Practical Financial Reform

Temple of Mut has an excellent piece on the "financial reform" proposed by Democrats and some practical proposals to actually implement some reform that is minimally intrusive. She also points to the best headline I have seen on the subject (from BizzyBlog):

‘Financial Reform’ Is a Massive Power Grab

Her practical reforms include limiting the oversight of financial derivatives to credit default swaps (not to instruments that have served markets well, such as cocoa futures) and limiting the amount of borrowing against the appraised value of a home, to limit the financial exposure. The money quote:

It matters much less to me who is responsible for the problems, because there is plenty of blame to go around. It matters to me that the problem be fixed on a permanent basis as best we can, in order to eliminate risk going forward for everyone involved. I think one thing we have learned from the financial crisis is that what happens on Wall Street impacts the average American much more than previously imagined. Financial liquidity freezes mean loans are not made and businesses fail. A credit crisis is not a good thing. Having unsold homes is not a good thing. Losing your job is not a good thing. Losing confidence that you are being told the total situation about a financial product is not a good thing. And especially ballooning our federal deficit to bail out selected companies at the expense of hard-working American taxpayers is not a good thing.

More Picking Winners and Losers

If there was any doubt as to why corporations and unions contribute large sums to political campaigns, today's news should dispel any doubt.

1. Ben Nelson (D-NEfarious) quietly introduced a change to the current financial reform legislation that would hugely benefit Berkshsire Hathaway, Warren Buffet's conglomerate investment vehicle, headquartered in Omaha. Berkshire Hathaway has large exposure to derivative contracts that the bill, as previously written, would have required reserves against potential losses against to be set aside. Now the bill will only apply to new derivatives. This probably makes sense, but why does it take lobbying by a firm led by one of the nation's wealthiest to make a change. Because it's about who wins and loses. No amount of campaign finance reform could stop Buffet from influencing this legislation. All he would have to do was to drop a few lines in his newsletter about what an idiot Ben Nelson was, and Nelson's opponent would be showered with cash. Unless were going to totally end free speech in America,.... (never mind, I don't want to give the left any ideas.)


2. Meanwhile the WSJ editorial pages discuss UPS latest attempt to compete with FedEx, by saddling FedEx with the same Teamster problems that plague UPS. What does Congress have to do with this? The rules for organizing unions at airlines and railroads are different for trucking companies. Under the Railway Labor Act, unions must organize nationally, which has been an impediment to unionization of FedEx. Meanwhile the teamsters strikes have often caused havoc at UPS including the infamous 1997 strike. The Chair of the House Transportation Committee, James Oberstar (D-mORalizing) has tried to change these rules to favor the Teamsters and UPS. So why wouldn't FedEx, UPS and the Teamsters all be pouring cash into key elections? For FedEx, their very survival as a company might be threatened.

3. As previously discussed on these pages, the current financial reform bill makes permanent the idea that the federal government will become the permanent Bailout King. Obama says otherwise, but why would his bill include a $50 billion dollar "resolution" fund, if it wasn't intended to be used to bail out companies that are in trouble. Obama says this won't cost tax payers a dime, because it will be paid for by taxes on financial firms. But how are those firms and their shareholders not taxpayers? And how is it that those expenses won't be passed along to consumers, since they will be a cost of doing business for every financial firm?

Obama wants to make this guy look small time.

4. Closer to my home of San Diego, a $228 million dollar redevelopment project downtown has been stalled, again, by the Coastal Commission. If you were a developer, spending money putting plans together, and having bid a project, wouldn't you be tempted to spend a little coin to influence the membership of the commission? I would think so.

None of this is to say that regulation is always bad, or government has no role. But we can see that the side effects of regulation and picking winners is to cause financial capital to be converted into political capital in our economy. That should cause us to regulate cautiously and minimally. It should mean that we try to limit the size and scope of government. It means, we should adopt the Tea Party agenda.

Harry Reid Wants to Seize a Bank Near You

Supposedly, Harry Reid is close to invoking a cloture vote on a financial regulation bill. This is an opportune time for the Republicans to truly grasp this issue and say no to more Democrat inspired crony capitalism. The GOP appears fearful that they will be tarred with a pro-Wall Street taint if they oppose the supposed increased regulation of the financial sector. As my readers are aware, I am no fan of the cozy relationships that allow the banks and other financial firms to get away with gambling with taxpayer backed dollars and then receiving bailouts when things head south. But the "Restoring American Financial Stability Act of 2010" does not such thing. Instead it grants the administration, of either party in power, the authority to take over any darn business it feels like. From the WSJ,

The federal government would get the power to seize teetering financial giants and dismantle them, just as the Federal Deposit Insurance Corporation now seizes failing banks.

The Republicans need to unite, now, against that one aspect of the bill. Think about the horrible power we are investing in the federal government. First, let's say your a big bank executive and you criticize the administration; whose to say if you aren't "teetering;" perhaps an emergency audit might show you are, so watch what you're saying. Second, and more worrisome, is that whole "dismantle" option. Whose to say how much dismantling is really dismantling. What if you are Bank of America and you just bought Merrill Lynch. Let's say that it turns out that was a dud buy. Let's say you make some big campaign donations. Let's say you get "dismantled" by the government buying Merrill Lynch and taking it off your hands.

I really don't care that much about the rest of the bill; it's probably crap too, but on the same order of crappiness that we are currently living with, so who cares. I just want the stinking bailouts to end. Is that too much to ask? Call your congresscritter and let them know that we just want the bailouts to stop. We want all power to bail out financial firms stripped from this legislation.

P.S. What is wrong with Republicans? The no bailouts argument is compelling and easy to understand. They could be kicking butt by making it. Instead they are cowering in abject fear that a vote on this stupidity will make them look bad. Well of course it will; if they continue to act stupid.

Programming Note

Out of town for a few days, so blogging will be light. We have two big issues in the Congress right now, Cap and Trade and Financial Reform. My sense is that Cap and Trade won't pass unless significant sweeteners for coal state Democrats are thrown in the mix, in which case, it won't actually do much to reduce Carbon Dioxide emissions. We should oppose this bill for those reasons and because it will be one more way for the Congress to rewards special interests and continue to rake in campaign cash from same. I intend to eventually post about how the simplicity and fairness of the tax system contribute to economic growth; it is not sufficient to merely go for reductions in taxation and spending, although they are important as well. Cap and trade, like the health care Obamanation is another step in the wrong direction.

On financial reform, I blogged on Sunday on this issue. We should remain vehemently opposed to the Dodd's bill because it keeps Too Big To Fail alive and well, permanently entrenching crony capitalism in our system.

Financial Reform?

Financial reform appears to be next on the Obama agenda. This is going to be present a tough political issue for a movement dedicated to smaller government that remains within its constitutional bounds. The bank bailouts, followed by reports of fat bonuses for top banking executives makes them a ripe target for retributive justice through by means of increased regulation. However, the nature of the reform matter deeply. First, we have to ask ourselves if the current regulatory regime is actually inadequate. Initially, it appears obvious that the current system failed. But while that is true, it doesn't mean that the current laws failed in their entirety. The Senate banking committee has conducted a yearlong investigation into the failure of Washington Mutual. I don't always believe everything I read from the Senate, this has some interesting facts:

A year-long Senate probe presented at a hearing Friday concluded that the OTS had identified a pattern of errors, poor risk management and even fraud at Washington Mutual. Yet it took no action to stop the bank from dumping toxic mortgages into the financial system because the bank was a huge moneymaker that paid fees amounting to 15 percent of the agency's budget, the panel said.
.....
Yet OTS examiners refused to lower Washington Mutual's asset quality ratings even though its practices were unsatisfactory because "WAMU was making money and loans were performing," Thorson said. This assessment runs counter to OTS guidelines, which state that demonstrating profitability is not sufficient if an institution has a high exposure to risk, Thorson said.

In this case, there was an office with a specific responsibility to regulate the quality of the banks' loans, but failed. But why do we need such oversight? Because WaMu could package the loans and sell them as securities, while continuing to rake in fees on servicing the loans. Fannie and Freddie played a big role here in enabling this behavior by securitizing mortgages. They did not see their role as anything other than increasing the number of mortgages. Look what happens when that goal was challenged:



Enter bailout nation, in which the government has apparently pledge unlimited funds to bailout not just the dud loans of the nation's banks but apparently the banks themselves as well as their parent corporations.

So what is happening with the legislation? The biggest issue is that "too big to fail" is alive and well, as one might expect in legislation built under Chris "Countrywide" Dodd's tutelage. From the Wall Street Journal:

The Dodd bill, instead, still gives regulators the authority to rescue essentially the entire financial industry. While much debate has centered around the FDIC's new "resolution" authority for failing firms, there's been almost no discussion around a separate FDIC program under which the agency can guarantee corporate debts. To Mr. Dodd's credit, this provision has improved slightly. In an earlier draft, the Fed and the new systemic risk council could have applied FDIC debt guarantees even if the FDIC itself opposed such bailouts.

Now the FDIC has to be on board, but the core problem remains—an even more explicit taxpayer backstop than anything Fannie Mae and Freddie Mac enjoyed during the housing bubble, and one that's available to a virtually unlimited number of firms. Federal regulators can create a "widely available program" to guarantee the debts of not just banks, but their parent companies as well, and all of their affiliates.

Fannie and Freddie were rolling the dice with an implied backstop, but this legislation would allow regulators, without a vote of Congress, to explicitly put the full faith and credit of the U.S. government behind Goldman Sachs, JP Morgan and Morgan Stanley, among others. This list could have more than 8,000 names on it, because any bank or company that owns a bank, or is a affiliated with a company that owns a bank, is eligible.

Sorry this post got so long, but I wanted to air out a big part of the problem. Big Government's regulation and unaccountable bailout are at the root of the financial crisis. I remind the constitutional professor that occupies the oval office of Article 1, Section 9 of the United States Constitution:

No Money shall be drawn from the Treasury, but in Consequence of Appropriations made by Law; and a regular Statement and Account of the Receipts and Expenditures of all public Money shall be published from time to time.

Time to oppose this legislation with some simple arguments:

END THE UNCONSTITUTIONAL BAILOUTS.

TOO BIG TO FAIL? TOO BAD.

Pelosi, Tea Parties and Financial Reform

I am sure that most of my readers have seen the HotAir column linking to the video where Pelosi alternately trashes the Tea Partiers as "astroturfing Republican hijackers" and then claims to have something in common with them:

But, you know, we share some of the views of the Tea Partiers in terms of the role of special interest in Washington, D.C., as — it just has to stop.

So Democrats are somehow above taking money and cutting deals with special interests? This is her claim? My rebuttal, Take Geithner . . . please! He is but one of many Democrats with ties to special interests that are in positions of authority with regards to financial regulation.

At least 25 senior Obama administration officials previously held executive or board-of-director posts with some of the globe’s biggest financial houses, according to a new analysis for Portfolio.com by the Center for Responsive Politics (CRP), a campaign-finance watchdog group. (To see a full list of the officials with previous jobs on Wall Street, click here.)

Now the Bush administration was not better, and neither were any previous administrations. I'm not sure that you can adequately populate government staff without individuals knowledgeable about the industry. However, this often leads to a condition known as regulatory capture, where the regulators appear to be regulating for the benefit of the industry, not the general public. To some extent this process is inevitable, see Public Choice theory. Now this doesn't excuse Pelosi for her continued mendacity and slander against our movement, but it points out the complexity of the situation.

So how can we bring about financial reform? Much of what we are protesting in the Tea Party is the close ties between Big Business, especially Wall Street and Big Government the end result of which is taxpayer bailouts of risky behavior. The end result is the exact opposite of justice, the stockholders and the taxpayers get screwed and the bankers get bonuses. We don't begrudge the bonuses, we just don't think we should pay for them through the bailouts.

I am still working out a Tea Party position on bailouts that is cogent and deals with this complexity in a simple way. Here are some things to think about. First, we should demand that politicians allow at least some big banks to fail. The bankers have called the government's bluff and keep raking in the chips. Second, we should say, ok, if you're going to be too big to fail, fine, you're going to have to keep increasing your reserves so that you don't fail. (No time to fully flesh this out today, but I think reserve requirements should scale up once a firm reaches a significant market share. This will act as a brake on unbridled growth by one institution as well.)

Third, we should demand transparency for all financial assets. In October 2008, I had a chance to talk to some municipal bond traders. We were arguing about the need for a bailout, me contra, as you might expect. Since we got dug in our positions; I asked a different question, because even then it was obvious that the mortgage backed security free-fall was the real killer, roiling the markets. I asked if there had been transparency and good information about the underlying value of the assets backing the securities, would this problem have occurred. They agreed that it would not have because market forces would have come into play earlier, so their would have been more time for big firms to adjust.

In summary, we should demand an end to "too big to fail." We should demand transparency in the way that assets are priced. Finally, we should demand that banks can't take risks when their risks are subsidized, such as through deposit insurance. I welcome the comments of those more knowledgeable in this field than I.

Stupid Column of the Week

I continue to be amazed at lefty dismissal of the Tea Party as rubes or worse. Frank Thomas, continues in his "What's the Matter with Kansas" style in today's WSJ. He puts the money quote up front:

The free-market system blunders into recession; its victims flock to the free-market banner. And here we go again.

News flash, Mr. Frank, the collapse of so many financial institutions had nothing to do with the free market capitalism and everything to do with the crony capitalism of too big to fail. Even we really had a free market, then these firms would have gone under. (For a pretty reasonable historical perspective by an outsider on the Tea Party movement see Walter Russell Mead's Do Soldiers Drink Tea? The publication, the American Interest, seems a little too CFR for my readers, but it was still a good article.)

The reason the victims are flocking to the free-market banner is that those who truly espouse it's principles, like Ron Paul, have said all along, that too big to fail is a recipe for disaster and financial institutions should be allowed to fail.

Now I happen to not quite fully agree with Ron Paul, but he is clearly closer to the truth than Thomas Frank. It is time to add a plank to the Freedom Coalition agenda, my personal Tea Party agenda, about financial regulation. I just need to get a little more free time together for blogging. But my idea will be simple, if a financial institution is too big to fail, then it is too big to fail; and will have to have ever increasing reserves to ensure that it doesn't fail.

Meanwhile, see you Free-Marketeers on Harbor Drive on Saturday with your Gadsden Flags.