The New Economy

EUROPE TURNS RIGHT WHILE AMERICA TURNS LEFT

2009-06-10T13:46:00.000-07:00

The results are in, Europeans demonstrated a clear turn to the conservative side of the political spectrum in electing the new European Parliament. The Conservative bloc will have a 100 seat margin over the Socialists. This was a real boost to the current conservative governments in Germany, France and Italy and a real blow to the socialists governments in Spain and the UK.

The elections also saw real gains for the "Green" parties and their bloc in the Parliament as well as the "ultra-nationalists" who are often called the "far right." Hard to see where they will wind up in the Parliament with most assuming that the "Greens" will align with the Socialists and the "Ultras" with the Conservatives.

One of the major reactions was to contrast this win for the "right" with the Democractic victory in the last US election. One Spanish journalist lamented that while the "US moves forward on a progressive path, Europe chooses to stagnate." Of course the writer's political bent is clear. But the contrast did receive much commentary.

So what to make of the outcome? Hard to say that the swing to the right was the result of the "Global Recession" since Sarkozy, Berlusconi and Merkel have been at the helm long enough to be blamed for the economic downturn. Never-the-less the UK and Spanish governing parties quickly blamed the bad economy for their losses.

The gains for the "Ultras" were probably spurred by the anti-immigrant mood in Europe. The recession is a two edged sword here since immigrants taking jobs while locals are losing them in major numbers has generated much of the anger. On the other hand, the recession has already caused the number of new immigrants to fall off dramatically.

The Conservative gain fairly assures that European Commission President Manuel Barroso of Portugal will be installed for a second term. The only glitch here is that his re-election will be held off until the Lisbon Treaty, which reorganizes the European Union government, is adopted. The Irish, who stopped the Treaty by voting against it in a referendum last year, now want to approve it.

All of this indicates that a new, more powerful central European government will start life with a conservative flavor.

Now when and where did we start using the terms "left" and "right" to define our political parties?

Leo Cecchini
June 2009

AMERICAN WAKES UP TO THE "NEW ECONOMY"

2009-06-09T00:58:00.000-07:00

GM stands for “Government Motors,” the US Government comes out with new guidelines for executive compensation for companies slopping at the public trough, Jon Stewart of the “Daily Show” rails against Uncle Sam buying up failed businesses. The public is finally waking up to the salient fact of the “Financial Meltdown of 2008″ and “The Great Recession of 2009,” the economic upheaval has led to Uncle Sam becoming the largest shareholder in US private business and thereby acquiring even more control over the economy.

But of course readers of my blogs already know about this seminal event since it has been the theme of my series on the “New Economy.” I started by reviewing other definitions of the “New Economy” which included a service dominated economy, a global economy and an information/communication dominated economy. To these definitions I added, the “New Economy” means one in which Uncle Sam, who was already the single largest consumer, owned the central bank, and set the rules, has become the largest owner of the economy.

Let’s review that ownership. Uncle Sam already owned, or held the major share of, the traditional government parts of the economy - the military, cutting edge technology (NASA, NIH, CDC, etc), the road network, national lands, and, with his siblings the state and local governments, education, ports, public safety, and the lion’s share of health care. I realize I may have overlooked other parts, but you get the drift. To these he has now added the largest auto maker, the largest insurance company, parts of the major banks, and the mortgage industry. With President Obama’s health plan he will soon own most of the rest of the health care industry.

Wow! This should make every Libertarian and Republican froth at the mouth. And they do. Wait a minute, is Jon Stewart a Libertarian, or worse, is he a Republican?

While my political leanings are well known, usually compared to Attila the Hun, which is a great injustice, since he was a real socialist, if you doubt me, just check his administration, I am not concerned. In fact I applaud Uncle Sam expanding his investment portfolio. If the sovereign funds of such oil powers as Saudi Arabia, Kuwait and the United Arab Emirates are buying up the private sector, why not Uncle Sam? And the beauty of this is that, while sovereign funds must pay money for their purchases, Uncle Sam does it by giving a chit.
I was once a stockbroker and thus am very impressed by Uncle Sam’s portfolio - manufacturing industry, transportation, energy, finance, health care, education, security, communications, and, of course, Treasury bills. While others lament the debt he has incurred in acquiring this stake in the economy, I point to the reality that income from these investments could replace taxes to a large extent, and thus lighten, not increase, the burden on my purse.

Like it or not, we are into the “New Economy” in which Uncle Sam will have more control and say about what happens. Doubt me, just look at the new government guidelines for executive pay in such corporations as GM, Citibank, AIG, and more.

Leo Cecchini
June 2009

AFRICA IN THE RECESSION

2009-06-07T03:47:00.000-07:00

I read an article the other day about how Africa is fairing during the worldwide recession. The author pointed out that Africa is doing better than one would expect, because of its new position as a main supplier of basic materials to the major emerging economies of the world, with Brazil and China leading the pack.

It was almost 20 years ago that I left my last foreign service job in Mexico. In my parting review of Mexico I noted that Mexico, as well as most of the rest of Latin America, was well positioned on the development train and that I had no real concerns about Mexico and the rest of Latin America for the future.

At the same time I noted in other writings that most of Asia was also well along the road to economic success. However, I said that Africa was still the problem child. I had also spent time in the 1980s working in Mozambique, South Africa and Namibia so had some idea of what was going on. I urged that whatever foreign assistance was available, that it be directed to Africa.

Well foreign aid was not redirected to Africa. But something more important happened. China found that Africa offered the raw materials it needed for its rapidly growing industry. The Chinese then set about establishing companies, joint ventures in the main, in several African countries aimed largely at producing raw materials.

China’s effort to obtain raw materials from Africa was clearly evident in its development of petroleum supplies from Sudan. And no matter where you go in Africa today you will find the Chinese busily building similar businesses.

Brazil is a different partner for Africa. It enjoys plenty of its own raw materials. But it is short of petroleum. Enter Petrobras and its explorations in Africa.

I am pleased to report that the fledgling cooperation between African countries and major emerging economies promises to be the engine of Africa’s economic future. I no longer fear for Africa’s future and believe it has joined its fellow developing states in Asia and Latin America on the train to a better economy.

Leo Cecchini
May 2009

Categorized in Uncategorized

KRUGMAN ON DEBT

2009-06-07T03:41:00.000-07:00

I read an article by “Nobel Laureate” Paul Krugman in which he berates Americans for spending beyond their means by resorting to excessive borrowing and then chastizes the Chinese for not spending enough. I believe Mr. Krugman would have served us better if he had explored why this happens, rather than preach prudence to Americans and exuberant spending to the Chinese.

In my opinion the reason Americans have been happy to go into debt to buy is that they have confidence in their ability to earn more in the future and the underlying strength of the American economy. The Chinese spend less and save more because they do not have similar confidence. Of course the present state of the economy has gone a long way to undermining America’s confidence, but we are using record new debt to correct the situation in full confidence we will be able to meet future debt obligations.

More important it is important to understand the basic assumption of debt - you buy something on credit today that you will pay from future income, but you have the purchase today. The reverse would be to save today to buy tomorrow.

My parents used to say, “we don’t use credit, we pay cash for all we buy.” The net result is that our family missed out on some important items - no television, no automatic washing machine, no vacations. Of course my father conveniently forgot about having a mortgage on his home and a lien on his vehicle.

But let’s get real. The average new automobile costs $20,000. The median American household income is about $50,000. At a saving rate of 10% it would take four years to save enough to buy a new car, if the prices stay the same. The average home price is $200,000. Thus it would take 40 years to save to buy that house, and you can be sure the home price would be substantially more.

No, even the Chinese use debt to buy homes and cars. Buying on credit is a fact of life everywhere. The only question is the proper level of debt.

Krugman and most others blame the present recession on excessive debt. They keep crying that the credit house we built is collapsing around us. But hold the phone, we now know that 97% of bank loans are being paid on time. Hardly a cause for a major calamity. Moreover, the US Government is taking on unprecedented new debt to correct the slump.
No, the basic problem is that debt is part and parcel of our modern life but we are still uncomfortable with this fact.

Leo Cecchini
June 2009

The Economy and the Environment

2009-05-25T14:00:00.000-07:00

President Obama has linked the environment to economic recovery. He is concurrently taking action to correct the economy and address environmental concerns.

I am writing this blog while sitting in my home in Mallorca, Spain with the tallest mountain on the east end of the island rising directly behind me and the Mediterranean 50 meters in front of me. The house is surrounded by a "Nature Park" or nature preserve. The setting and the views are spectacular in all directions.

I recall about 20 years ago the Spanish government being worried by pollution in the Mediterranean ruining their tourism industry, you see Spain's coasts are the main seaside resorts for Europeans. I am giving to calling it the "Florida" of Europe. Spain's concern was echoed by other Mediterranean countries and the concern led to joint action to clean up the Mediterranean.

My initial reaction to an attempt to clean up a whole sea was total skepticism, how can you clean up thousands of square miles of sea? Well the effort was not to clean up the whole sea, but to clean up the coastal waters. I am happy to report that the effort worked. Twenty years ago I would find lots of flotsom and jetsom when walking along the water's edge. At times the sea itself was clogged with sea nettles who are a sure sign of sewer tainted water. Now the water's edge is clear of all trash and the sea nettles are a rare sight.

My thoughts about the environment also brought to mind another instance in which I was a direct participant. While running a public relations company in Turkey two of my people, an American expert in public relations provided by the US side of the joint venture and a young Turkish woman recently graduated from Ankara's Middle East Technical Institute, came to me to present a proposal for clients. They explained that a group of Turkish companies was worried by threatned new government plans to impose high taxes on plastic bottles that were causing a "solid waste problem."

My immediate reply was to say that Turkey was too poor to have enough such bottles to be of major concern and that there were plenty of sink holes throughout the country where they could be disposed.

I then looked at the details of the situation. I found that the problem was specific to one town in Turkey, Bodrum, a seaside town known in ancient times as Halicarnassus, the home of Herodotus, the universally acclaimed "Father of History." The town was also the site of one of the Seven Wonders of the Ancient World, the tomb of King Mausolus which gave the world the word, Mausoleum. The Mausoleum is long gone but you can see a full scale reproduction in New York City, General Grant's Tomb looking over the Hudson River. It is also the largest tomb in the USA.

But I digress. By 1990 Bodrum had become a popular seaside resort for foreign visitors and Turks with the foreigners staying in the newly built hotels and the Turks spending the summers at their phalanxes of new cookie cutter "villas." In season the town was chock a block with tourists.

Bodrum has a climate like that of Southern California, it never rains but when it does, "it pours, man it pours." These periodic floods served to sweep the town clean of all debris and trash carrying it out to the Mediterranean Sea. This should have been the end of the story but a popular treat for visitors to Bodrum was to take trips in glass bottom boats from which they could see the remains of sunken ancient Greek ships that were the backbone of Greece's commerce based economy.

Imagine looking through a boat bottom to see 2500 year old wrecks resting on the sea floor. And see those ancient amphoras that held wine and olive oil. And see those plastic bottles emblazoned with Hassan's Bleach, Hikmet's Detergent and Coca Cola. What, how did these modern bottles wind up among the amphoras of the sunken wrecked ships? Well the rains washed the bottles out to sea where they filled with water and sunk to the bottom with many falling among the wrecks.

Eureka I said, we are not dealing with trash pollution but "visual pollution." All that had to be done was to keep the bottles from being washed out to sea and spoiling the sight of ancient ships on the sea floor. We devised a PR campaign featuring bottle collection centers where people could bring their plastic bottles to be properly disposed of. The centers also took in glass bottles and other refuse since all was subsequently dumped into the sink holes. It worked.

These personal experiences with enviornmental concern led me to a clear realization, action to save the environment comes when problems threaten your pocketbook. I fear that President Obama will not have much luck with his environmental plans until he can show clear damage being done to our economy. It is no accident that he has linked the two. But he must make the link clear and urgent.

Leo Cecchini
May 2009

BULLASHEET

2009-05-17T12:23:00.000-07:00

Yes, the title is what I say is Italian for that famliar expletive for false information. Of course it is only this Italian-American's invention.

In his last item one of my colleagues writing in another blog site lays bare the truth of the "Financial Crisis of 2008" and "Great Recession of 2009." He writes that the largest US banks are not undercapitalized. More importantly, he notes that 97% of their loans are fully performing and thus only a small percentage of their securitized assets are "toxic," which is contrary to the conventional wisdom.

I have repeatedly stated for the last eight months that there was no real reason for the meltdown. The error came about when the "Wunderkinder," who created the securitized asset boom, got nervous about stagnant property sales. They translated the slump in the property market into destruction of the securitized assets built on mortgages and other loans. I kept saying that this was an error, foreclosures were never above 3% of the mortgages and that the assets built on these were being grossly undervalued. I should have used my colleagues number and stated that the glass was 97% full instead of 3% short.

Of course even a 3% default rate is cause for concern, but not sufficient to cause the massive panic that led to our current sorry state of affairs. To put it succinctly, we overreacted and in the process sunk our economy.

Fortunately some steady hands at the main tiller, Paulson, Bernanke, Geithner and others, steered the economy back to stability. We now see that our banks are sound and never did have the level of threat that was feared by many.

While the financial system is sound, the panic did ruin the economy in general. Securitized assets were erroneously marked to a non-existent market that resulted in massive devaluations that in turn ruined bank balance sheets and forced credit to dry up. Credit dried up, consumption went down. Consumption went down, unemployment went up.

While a sound financial system is necessary for economic recovery, it cannot do the job itself. We have to get people back to work and that is the aim of President Obama's stimulus package.

We were fed alot of "bullasheet" and it wrecked the economy.

Leo Cecchini
May 2009

RECESSION PROOF NORWAY

2009-05-16T10:21:00.000-07:00

I read an interesting article about how Norway has survived the current recession by saving and not spending. I had the chance to observe and learn about all of the Nordic peoples while at our embassy in Finland. I came to some short descriptions of each: Swedes viewed themselves as the leaders and trendsetters of the group, Danes saw themselves as fun lovers, far removed from their status as the most savage and barbaric people 1000 years ago - the Vikings, Finns wanted nothing more than to top the Swedes, and the Norwegians lived the motto of Gold´s Gym, “No pain, no gain.”

To understand how Norwegians came to this state, one has to remember that the country became independent only at the start of the 20th Century and at that time was one of the poorest of the countries in Europe. This nation of fishermen, lumbermen and farmers expended much blood, sweat and toil in building one of the highest standards of living in the world.

But a funny thing came in the 1970s, Norway found great reserves of oil and gas in its territorial waters. By now the country had already achieved one of the highest income levels in the world. Finding petroleum was the icing on the cake.

Fearing that the easy money from oil and gas exports would undermine their carefully built stolid pursuit of the good life, Norway chose to husband much of its petroleum income. The practice paid off. While all the world is desperately going deeper into debt to overcome the recession, Norway is simply dipping into its reserve funds.

Perhaps the Norwegians will now be able to lighten up a bit and be more like their fun loving cousins the Danes, who also enjoy a high standard of living, but spend less time at Gold´s Gym.

Leo Cecchini
May 2009

STRESSLESS

2009-05-12T14:45:00.000-07:00

Well the report is in, the 19 banks given a “stress” test by the Feds are all able to survive and continue as key financial institutions. Ten need to build up their asset bases and nine have adequate funds. The result was seen even before the report was released, financial shares on the stock exchanges rose like rockets at lift-off.

One thing not revealed in the public information about the tests was the role played by lifting the “mark-to’market” rules. While nothing was specifically said about this, clearly the banks would not have been able to perform so well if they had not been able to revise valuations of assets to “long-term” or “maturity” values, instead of marking them to notional markets.

Proof of how fast the banks have recovered enough to lend again, I am in Spain where its largest bank just issued a new Euro 1.5 billion securitized debt bond based on mortgages. Say what, aren’t these the “toxic assets” that caused the recession? Well yes, they are, but, as I have said all along, we now know that traditional sources of credit are not sufficient for our “New Economy.” We need securitized debt to regain where we were in 2007 and go beyond, even in Spain.

A major hurdle has been crossed. Now to the Obama stimulus plan.

Leo Cecchini
May 2009

ON THE MONEY

2009-05-06T02:46:00.000-07:00

Well no sooner did I write the last blog titled "Time to Invest" the mavens came out of the woodwork to confirm my notes. One guru on CNBC even pointed to my own portfolio as the best way to go, i.e. Bank of America, Citibank, Freddie Mac and such.

But none was as impressive as the coments from Jimmy Buffet's dad Warren at his annual meeting of his investment firm. He too spoke about investing in financial stocks. His most memorable line, however, was that, "if it takes a computer or calculator to determine how good a stock is, then I don't buy it."

For all of this last year I have been constantly hammering at the "wunderkind" with their electronic Ouija boards givine erroneous values to securitized debt and other derivatives, structured products and so on. People kept saying how could they be wrong, they are highly educated financial professionals. Well Buffet has called them out and they are now exposed as glib charlatans hiding behind the "smoke and mirors" of their trade.

By the way the stock market is rocking and rolling.

Leo Cecchini
May 2009

Time to Invest?

2009-05-04T12:24:00.000-07:00

There are signs that the economic recovery plans are kicking in. Credit is once more available for housing and other purchases. The Obama stimulus plan is coming on stream. Banks seem to be back on the hale and hearty list. For many now seems to be the time to strike and get in early on rebounding investments. So what do I advise?

PROPERTY. I have been flogging "short sale" and foreclosure low priced rental units. "Short sale" is a term invented to describe properties sold for less than the value of their mortgage balance with the bank taking the loss. I can sell you one of these for as little as $40,000 for a unit that has a gross monthly income of $800. That means $9600 for the year less taxes and insurance of maybe $3500 or a net of $6100 or 15%.

SECURITIZED DEBT. The bad boys of the recession are back and selling very well. The easiest way to get in on the action here is to buy Fannie Mae and Freddie Mac. You should also look for products from the TAFL program of the Federal Reserve Bank.

SILVER. Funny, lots of people like to hold gold in their investment portfolio. And commodities should do well over the balance of the year. I prefer silver. While gold doubled in value over the last five years, silver trebled in value.

STOCKS. Put your money in financial shares - banks, lenders, investment groups. They took the biggest hit during the recession and promise the biggest gains in the come back.

ANYTHING GREEN. The corporate world has glommed onto the environmental movement and sees "green" to be made in being "green." Check energy technologies, no matter how far fetched, since all will get development funds. Recycling companies loom large. Another good choice is transportation that provides more efficient use of fuel, e.g. railways.

BIOTECHNOLOGY. With stem cell research now open for Federal funding and waiting cloning in the wings any group engaged in this research should see a renewal of interest.

EDUCATION. Private education led by online universities is booming. Start your own school or put your money into one.

Maybe a bit early for the faint of heart but definitely the time for the steely nerved investor.

Leo Cecchini
May 2009

PRIVATE SECTOR FUNDS PUBLIC TAKOVER

2009-04-28T15:42:00.000-07:00

Over the last week while visiting friends and family in California I have come to more clearly see the exquisite humor in what has happened over these last several months due to our faltering economy.

I have repeatedly commented on how the Federal Government has taken on an even larger role in the economy. Already the largest consumer, it will be even more so with the new budget that will increase Uncle Sam's take from 20% to over 25% of output. Already the central banker, the Federal Reserve System, Uncle Sam now owns a substantial share of the private banking sector. Already the rules maker for the economy, Uncle Sam will now engage in a round of enacting even wider controls over the financial sector. And of course the new role for Uncle Sam, the single largest stock holder in corporate America.

I have reduced this event to a terse comment, "What it took the Bolsheviks a sea of blood to do in Russia, Uncle Sam has done for peanuts." What I mean is that the Bolsheviks seized the means of production by force, while Uncle Sam is doing it for a rather small price.

I say small price because Uncle Sam is doing all this with money borrowed at small cost, in the main for less than 1% interest. And his capacity to borrow is not yet exhausted. I calculate that he can double the national debt without causing serious harm.

So what do we have. Uncle Sam is borrowing funds from the private sector at ridiculously low cost and he is using the funds to buy up the private sector. In other words the private sector is funding the Federal Government to buy it out. As I said, I find this to be exquisite humor.

Leo Cecchini
April 2009

WE ARE ALL NOW GREEN

2009-04-20T19:49:00.000-07:00

President Obama has stated that economic recovery and future progress must be addressed at the same time as our energy supply and environmental concern, especially global warming. In fact he has linked the three as integral parts of the same problem.

I have no problem with global warming, the earth has been on a warming trend for the last 10,000 years. Now I say this as someone who lives at 18 inches above sea level on an island and has a second home so close to the sea that it is caked in salt residue after strong storms. I know hurricanes, having lost parts of both homes to hurricanes. The island I live on was actually the product of a hurricane in the early 20Th Century. I live my talk and I repeat I am not afraid of global warming, in fact I welcome it since the earth is basically a cold place.

I find that my friends are about evenly split between those who state unequivocally that global warming is a problem and we better do something about it immediately and those who deny that global warming is even occurring. Both sides have plenty of ammunition and supporters. Neither one has won the battle for public opinion. The average Joe is worried by cries that the sky is falling but is equally concerned that stemming global warming will cost him an arm and a leg.

As far as I am concerned the debate is over. The corporate world has now embraced global warming and is using it as the best marketing tool since the American dream of owning a home and a car. We are now constantly barraged by ads urging us to be "green." WalMart proudly announced that it intends selling millions of new light bulbs that use much less energy. Auto makers are flogging ad nauseum their "hybrid, electric, and new fuel" cars. We are urged to eat food grown without chemicals. In fact we are urged to eat less, period.

I wonder how the avid environmentalists view their cause being usurped by the very corporations that they held up as the villains causing all the ecological disasters. How will they deal with a march to global purity led by such bad guys as Exxon, DuPont, Dow, and so on? Talk about unintended results.

Leo Cecchini

April 2009

DIAMONDS AND MORTGAGES

2009-04-20T06:10:00.000-07:00

A reader raised an interesting point, while he finds my articles to give "lucid" explanations of the current economic drama he believes that most readers do not understand financial markets. In looking at how to better explain the way the financial markets work I struck on an idea, why not use the market for diamonds as a way to describe the mechanism?

Diamonds are valued by the familiar "4 Cs" - carat, clarity, cut and color. Let us consider carat or weight and clarity to determine the "intrinsic" value of a diamond while we can consider cut and color to determine the "subjective" value of a diamond.

The carat or weight of a diamond can be accurately determined by a scale. Turning to a mortgage we can call its carat or weight to be its balance due, times its interest rate, times the period for repayment of the loan. This can be readily and accurately calculated.

The clarity of a diamond means how clear it is of imperfections or flaws which can be readily seen with a microscope. Such flaws and imperfections determine the potential for the stone to break and can be accurately measured. Turning to mortgages we can consider "clarity" to be determined by defaults and foreclosures which can also be accurately measured.

The color of a diamond can range from white to blue to lemon to "root beer." The demand for certain colors changes over time and this the value goes up and down according to fashion. Likewise the cut of a diamond can be of several types with demand for a certain cut affecting the value. At present the most sought after cut is the "Leo" diamond (no, I had nothing to do with this, unfortunately). The point here is that cut and color constitute "subjective" valuation of a diamond that can change over a wide range.

Subjective valuation of mortgages has to do with perceptions of their reliability. Thus they are subject to variable measures, rather than constant measures. Last year sub prime mortgages were consider to be the weakest mortgages and their values were smartly reduced, no matter what the "intrinsic" value may have been. Now prime rate mortgages are causing concern and they are being devalued smartly.

Another subject valuation stems from the fact that no one knows the full scope and scale of "securitized debt" built on mortgages. At first we panicked and cut valuations to the bone. However, as we get a better handle on this pile of "toxic assets" we are able to better value them.

I have argued since last summer to drop the "subjective" values derived from "mark-to-market" rules and value mortgages and mortgage based assets to their "intrinsic" value. This was done on April 2 of this year. This change will lead to banks increasing the values of their mortgages and mortgage based assets and thus allowing them to lend again.

P.S. More notes on diamonds:

1. Diamonds are found throughout the world, from the frozen wastes of Canada and Siberia to the steamy jungles of the Congo to the deserts of Namibia to the gentle hills of Arkansas.

2. The main suppliers of diamonds are South Africa and Botswana where they are mined and Namibia where they are culled from the desert sands.

3. For the last 100 years the supply and thus value of diamonds was controlled by the De Beers organization owned by the Oppenheimer family of South Africa. De Beers has now changed to a market strategy of being the "supplier of choice" in the wake of intense competition from Russia and Australia.

4. I once met the late, legendary patriarch of the Oppenheimer family, Harry Oppenheimer on a visit to Washington DC. I caught his attention when in response to his direct question I said I was negotiating the entry of the first American mining company into Mozambique, his back yard.

5. The diamond market rests squarely on its symbiotic relationship with love and marriage. If the demand by women for a diamond as the visible symbol of their marriage should change to some other stone, the market for diamonds would, get ready, drop like a rock.

Leo Cecchini
April 2009

TAX DAY

2009-04-16T08:02:00.000-07:00

I should have published this item yesterday but better late than never.

I find the subject of taxes fascinating. If I had not been a diplomat I would most likely have had a career in taxes. Not the most glamorous of professions, in fact an often reviled one. Jesus Christ was reproached for "consorting with prostitutes and tax collectors." But a career with as secure a future as a mortician.

And taxes are the talk of today. I even saw President Obama's tax return spread around on the internet. Most likely you have just sent your return in.

My first thought is what my old tax teacher, who was one of those venerable professors who literally wrote the book on the subject, at least the one we used in his course, who said one warm afternoon, "There are two elements of a good tax, first they collect sufficient revenue and second they are easy to collect." Notice, he did not mention equity, fairness, income distribution and such. Just raise enough to pay the bills and don't waste time collecting them.

Well we know that taxes in the USA today do not raise sufficient funds, we pay allot of public expenses with borrowed funds. We also know that taxes in the USA are not easy to collect, just ask the current head of the IRS, Treasury Secretary Geithner. This has led to endless debate about improving our tax system, indeed it was a core feature of President Obama's election campaign.

I am partial to "taxes" raised by government monopolies. At different times governments have raised funds through government monopolies that sold goods, such as salt, matches, and tobacco to the public. This allows the government to raise taxes whenever it wants and it is easy to collect. However, it is difficult to control, since smugglers have always managed to steal some of the income.

A similar process was that of the Soviet Union. It owned the "means of production" or most of the industry in the country. It took its "taxes" from the sale of the products made. These "taxes" would have been profits in a capitalist system.

In general, however, taxes is a complex subject. I hear many Americans complain about the complex US tax code, they want a simpler formula. I reply that a thick tax code is the tax payer's friend, while a simple tax code favors the collector.

This complexity is made even more so when taken to the international arena. As a diplomat, I had to examine tax systems in other countries and at times help negotiate tax agreements between the USA and other countries. Let me assure you that there are more angles on taxes throughout the world than there stars in the sky.

So what to do? I personally go for the so-called "flat tax" that Steve Forbes used as his banner for his campaign for president a few years ago. As with all income taxes, it is a "direct" tax, rather than an "indirect" tax such as sales taxes. As income goes up, your tax payment increases, as opposed to a consumption tax.

It is generally calculated that for a flat tax to raise sufficient funds in the USA it would be about 15-17% of income. Interesting to note, Vice President Biden's joint tax return for 2008 showed that he paid about 17% of his adjusted income in federal tax. President Obama and his wife paid about 30% of their $2.5 million income in taxes.

Of course the complaint about the flat tax is that it is "regressive" which means it places a higher burden on low incomes than it does on high incomes, i.e taking 15% from an income of $20,000 means more hardship on the payer than taking 15% from an income of $1 million. But remember under our current tax system something less than 50% of income earners pay no tax. So the flat tax need only be applied to the wealthier half of the population.

Now I am sure some will also consider my comments here to be facile and I will admit that they only touch the subject. But when we do go about reorganizing our tax system let us keep in mind the words of my old tax teacher, "Make sure it collects sufficient revenue and that it is easy to collect."

Leo Cecchini
April 2009

JUST WHO ARE THE OBAMA SUPPORTERS?

2009-04-15T06:12:00.000-07:00

I have received comments from two readers who disagree with my take on the economy. One says he doesn't agree with anything I say another finds my comments on consumption to be "facile."

I am amused when fans of President Obama dump on his policies. In case I did not make myself crystal clear I support the president's policies except for a couple of technical problems. The president in his address on the economy yesterday noted the initial success of the Feds several programs to revive the credit market, which I have carefully explained in my columns, and fully support. He also emphasized the need to get his stimulus program up and running as soon as possible, which I have also described and support.

President Obama made it clear in his speech that we need to crank up consumption in order to put people back to work. Now I know that the Republicans are calling the stimulus plan "excessive" government spending that will really not put anyone back to work. The also drag out the bugaboo about future indebtedness burdening our progeny. I see the Republican strategy as simply one of shoring up their position for the next election. If the president's plans work they will say they worked because Republican amendments and additions made them better. If they fail the Republicans will be able to say to the voters, "We told you so."

I mentioned in a previous article that I was surprised by the many Obama supporters who oppose his "excessive" spending. I also mentioned that while the president enjoys strong support from the public his programs do not.

So I say to those who commented on my economic views that mine are exactly the same as held by the Obama team and I did not vote for them. And while I am certainly in no position to implement my suggestions, the president and his people can, and will.

Leo Cecchini
April 2009

SAVING MEDICARE

2009-04-14T09:58:00.000-07:00

One of the major initiatives of President Obama's plan to correct the economy is his overhaul of Medicare and Medicaid. All agree that the nation's health care is too expensive. We get the same level of health care as is received in Western Europe but at about 2.4 times the cost in Europe.

President Obama wants to get better return on the government's dollar from its expenditures on Medicare. He then points the finger at everyone's favorite whipping boy, the health care insurance companies, e.g. Blue Cross. He believes we can get more for our Medicare dollar by curbing the insurance companies.

Well his plan is what I call "penny wise, pound foolish." As a cost saving measure the president wants to do away with what are called, "Medicare Advantage" plans. Essentially for a fixed payment from Medicare, usually so much per participant per month, the health insurance company agrees to pay for all medical care for the participant. Obama sees a problem here, Medicare pays a fee for the participant, but the participant may not use any health care, or much less than the fee paid. Thus Medicare is paying for a service that is not used.

The problem is that the Obama administration does not understand basic insurance. What it is actually paying is an insurance premium to the health care insurer who then agrees to cover all "losses" which in this case means health care expenses.

What the Obama team also does not understand is that by paying the insurance premium they limit Medicare's exposure for that participant to the premium. If there were no such plan Medicare would have to pay the participant's medical costs, up to very high limits. Thus not paying the premium would in effect set Medicare up for unlimited losses, the very reason we use insurance.

Moreover, the health care insurer provides a limit on the cost of medical care. Those medical services that agree to its fee structure only receive what the insurer will pay. And this is a great savings. My latest medical service procedure was billed by the physician and his group for $5110. Blue Cross paid $2320 and I had to pay $120 in co-payment. In short Blue Cross saved Medicare $1768 and me about $1200.

Clearly the real culprit in sky-high medical costs are the health care providers, not the insurers. In fact the insurers are the only reason that health care costs have not gone even higher. Doing away with the very effective "Medicare Advantage" plan will simply insure that health care costs rise even faster, instead of bringing them under control.

Leo Cecchini
April 2009

"COOL IT" AND GLOBAL WARMING

2009-04-14T07:38:00.000-07:00

A response to my last item about the philosophy of the economy causes me to reflect on the concern about the environment. I am constantly amazed at the hubris of many "environmentalists." They really believe that mere mortals can do more damage to the world than cosmic forces. I suggest they see the latest "end of the world" film, "Knowing," which has mankind destroyed on earth by a massive solar flare. Or perhaps they could reflect on the billions of years of earth's history and the many times it was totally altered by cosmic forces.

Yes, we all want to live in a comfortable, safe, sound environment. I doubt anyone would say no here. The real question is economics, what are the costs and trade offs to achieve a particular environment. It comes as no surprise to me that the best book I have seen on the subject is the one done by a Danish economist named Bjorn Lomborg and titled, "Cool It." Lomborg does not deny that the earth is getting warmer or that man's activities has added to the warming trend. Instead he focuses on the results of the warming and the appropriate response to these.

A central point Lomborg raises is the concern about rising temperatures causing more deaths due to heat. He says yes, this will occur. But that has to be compared to the many more that will not die because of reduced cold. He notes that in Europe about 200,000 die because of excess heat each year while some 1.5 million die from excess cold. For Britain he shows that a 3.6 degree F increase in temperature will mean 2000 more heat deaths but 20,000 fewer cold deaths.

Lomborg's main concern is that the funds and energy being demanded for stemming the rising temperatures could be better used for other major problems that cause more harm to mankind. In short, he views the situation that of an economist, does the end justify the cost?

I go a bit further. I say global warming cannot come too soon. The earth is a cold place. The average temperature of the earth is 60 degrees F or 15 degrees C. At this temperature the unprotected human corpus expires in a matter of minutes or a few hours. Indeed, the largest use of fossil fuels goes to keeping the body warm - building shelter, heating those shelters, manufacturing clothes, producing food and so on. Therefore, upping the average temperature will actually reduce our need for fossil fuels.

My problem with many "environmentalists" is a lack of perspective. Yes, the earth is getting warmer, where's the news, it has been doing this for the last 10,000 years. The issue is what changes will this bring and what is the best way to handle the changes. As Lomborg and I maintain, lowering the deaths from hypothermia is a change for the good and needs no response.

Leo Cecchini
April 2009

A PHILOSOPHICAL LOOK AT THE NEW ECONOMY

2009-04-13T09:05:00.000-07:00

Well the economic story is moving past the technical debate about how to stop the downward spiral and start moving up again. We are now into a philosophical debate.

The cover story on the latest issue of TIME magazine was a piece by an author who has apparently made his mark as a latter day Savanarola, the 15th Century monk who tried to cleanse Florence, Italy of excess. Savanarola got rid of the Medicis but was soon burned at the stake for heresy. The TIME writer preaches against the excesses of our modern society and believes the current economic downturn will be the genesis of a more prudent society.

I fundamentally reject notions that we are engaged in excess consumption. In my book there is no excess demand, just short supply. What is wrong with all families owning their own home? What is wrong with wanting a modern home with the attendant conveniences? What is wrong with wanting quality education? What is wrong with wanting more leisure time to enjoy life? What is wrong with wanting to travel and explore the world? What is wrong with wanting good food? And on and on.

Again, my definition of economics is "the science of meeting the perceived needs of the people," with the operative word being "perceived." I eschew the endless debate about what constitutes the "proper level" of consumption. If the consumer wants it, how do we provide it? Of course I leave out demands for illegal items.

The salient feature of human history has been the desire to provide more for our heirs than we had for ourselves. We want a better world for our children. The difference between me and other economists is that they prefer that the parents determine what constitutes a better world, I leave it to the kids to determine what they want.

I expect to see more such talk about how to formulate our revived economy. But this is good, since it means that the bottom has been reached - "Been down so long, looks like up to me."

Leo Cecchini
April 2009

STIMULUS NOW!

2009-04-13T08:21:00.001-07:00

Well the New York Stock Exchange is again bullish, further evidence that suspending "mark-to-market" on April 2 is having a positive effect. But restoring the flow of credit is only half the battle. If we had taken this step last fall we may have avoided the economy's nose dive, but we did not and we now have to deal with widespread unemployment. Yes, restored lines of credit thanks to suspending "mark-to-market", Government action, e.g. the "TARP", the "TALF", are doing their work, they will induce consumption and thus production and thus employment. But we let the problem go too long and this road to recovery will be too slow for the public to accept.

No, we have to get President Obama's stimulus program moving fast. I hear many say that only a small portion of the stimulus will be spent on direct consumption, e.g. building new roads and schools. They complain that "transfer" payments, e.g. extended unemployment payments, are indirect consumption that may or may not occur. Give me a break, someone on unemployment will not use extra cash to pay for essentials? Do you really believe that this person will invest the extra pay in a CD?

The formula is fundamental and easy to understand, inject more funds into the economy, extra funds mean higher consumption than before the injection, higher consumption means higher production, higher production means higher employment. Again, I am not concerned about how the funds are spent, I leave that to those examining quality, I deal with quantity. Just get the money out there as soon as possible.

Leo Cecchini
April 2009

WINNING THE ECONOMIC WAR

2009-04-09T14:18:00.000-07:00

I reported last week the lifting of "mark-to-market" rules that I have been asking to do since last August. Now I see a rearguard action by the doomsayers based on the difference between "liquidity" and "involvency." The naysayers also warn that, while lifting "mark-to-market" rules have corrected the values for mortgage based assets, we still have problems with securitized non-mortgage debt.

During the "Financial Meltdown of 2008" and the "Great Recession of 2009" I have seen a constant debate between those involved about the exact nature of the financial crisis. Some say it is a lack of "liquidity" and others say it is a matter of "insolvency." Both arguments have merit.

The exact problem is that those valuing the securitized mortgages and the credit default swaps used to insure these investments, variously known as "securitized debt, derivatives, or toxic assets," were obstensibly marking their value to the "market." However, since there was no established market for these assets they marked them to "models" based on the property market.

As the property market went flat and then south, those doing the values devalued the mortgage based assets as much as 90%. This in turn savaged the balance sheets of those holding the assets. With their balance sheets out of kilter the holders, banks and other financial groups, had to borrow to compensate for the lost value of their mortgage based assets. But their balance sheets did not allow this borrowing. So for the "liquidity" crowd the problem was the inability to borrow and for the "solvency" crowd the holders were bankrupt since assets were clearly worth less than debt.

On April 2 the Feds lifted the "mark-to-market" rules that allowed valuations of the mortgage based assets to their maturity or long term value instead of the "market" that did not exist. It has worked immediately. I heard one expert say yesterday that the mortgage based assets had been corrected. However, he warned that there are still problems with non-mortgage securitized debt, essentially student loans, auto loans, credit card debt, and commercial debt that has been bundled and sold as "securitized debt."

I do not see any real problems caused by securitized non-mortgage debt. There is no market to mark against since, as with the securitized mortgages, there is no established market for trading these. But more importantaly, no one is valuing securitized non-mortgage debt to "models" based on the values of the underlying item, i.e. no one is valuing auto loans to the current prices or sales of autos. I suppose one could devalue student loans by saying that graduating students face a more difficult job market and will be less likely to find work. But this has not yet been done. So, unlike the securitized mortgages, there will be no panic devaluing of securitized non-mortgage debt.

No we have passed the first major hurdle. Now to implementing the Obama Stimulus Plan. More on that later.

Leo Cecchini
April 2009

BYE BYE "MARK-TO-MARKET"

2009-04-02T06:27:00.000-07:00

Well it has taken me since last fall to get the authorities to take action but here it is, the Financial Accounting Standards Board, FASB, has modified the "mark-to-market" rules allowing banks and others to value their "securitized debt" holdings to "models" instead of the "market." I use parentheses since the "markets" they were using were actually "models" based on the property market. The "models" they will now use are the long term or maturity value of the assets, reduced by actual losses.

I expect this to cause an immediate effect on the balance sheets of those holding "securitized debt" instruments. However, given the severe decline in the financial system, it may take some time for these improved balance sheets to translate into increased lending.

The other immediate effect will be to reinforce the Feds move to revive the "securitized debt" industry. Again, the Feds are pouring $400 billion into Fannie Mae and Freddie Mac to generate more mortgages that will be "securitized." The Fed TALF Program will also generate some $ 1 trillion in "securitized debt" based on non-mortgage loans, e.g. student loans, car loans and credit card debt.

While all of this is good, we will still need President Obama's stimulus package to jump start the stalled economy. Taken into account the combination of the various plans to revive the credit market and the direct stimulus to the economy, I would expect the US economy to be back to 2007 levels by the end of this year if not sooner.

Leo Cecchini
April, 2009

OBAMA IN THE LION'S DEN

2009-03-30T08:34:00.000-07:00

President Obama leaves soon to confront his counterparts among the G 20 countries. I say confront because in the main they have complained about Obama spending too much money to cure the economic crisis. We have the remarkable situation where leaders of such countries as Germany are calling the US too “socialist.”

I have stated several times that I support all of the President’s efforts to revive the economy except for the one to improve the personal balance sheets of property investors. I have also pointed out that all of these programs, except for the actual Budget for 2010, are being funded out of borrowed money, not current tax revenues. I also detailed the Feds’ borrowing potential and set it at up to $28 trillion, while the current national debt stands at about $11 trillion. To complete the basic equation I said the Feds are paying about 1% interest to borrow these funds. I do not view this as having borrowed and spent too much nor do I see this changing.

Yes, we will have to repay the borrowing and will do so most likely with new borrowing. But as I also said, the US has been in debt since 1791 and we will be so for the duration of the Republic. I also noted that the Feds have acquired some valuable assets with these borrowed funds and in all likelihood the future earnings from these will repay the borrowing, or at least a substantial part.

So I say to the Europeans who complain about Obama spending too much, why not do the same? Your economies are even more distressed than is ours. Do you plan to wait until your economy rises in the wake of a revived US economy as in the past, or will you work with us to improve the lot of all?

As for the natterings of the present EU President, the President of Czechoslovakia, thank God he is in a rotating position and will soon rotate out.

Leo Cecchini
March 2009

HOW TO MAKE "TOXIC" ASSETS "NON-TOXIC"

2009-03-29T13:27:00.000-07:00

Treasury Secretary Geithner's discussion of greater Federal control over the financial sector and his suggestion that the Feds should be able to seize any major financial group that is in danger of bringing down the entire economy is generating lots of controversy. As for seizing large financial institutions, the Feds have already done this by acquiring Fannie Mae and Freddie Mac,the insurance giant AIG, major stakes in GM and Chrysler and looking to take on more. Technically the Feds have not "seized" these key enterprises but bought them, or at least a major stake in them. How the Feds manage their new portfolio is open to discussion, but their ability to do this is no longer a question.

As for new rules for the financial sector, I have already outlined how the Feds will restart and manage the "securitized debt" market. We have come to learn that in order for our economy to operate at the level it achieved by 2007, it must have "securitized debt," as well as "traditional" sources of credit.

Until 2007 this market worked well as a private activity with no visible market or specific set of government rules. However, no one had a complete understanding of how large this source of credit had become, how it operated, who owned what and so on. In the absence of a visible market and a clear understanding of the total construct of securitized debt, valuations of the assets, the bundled loans that were sliced up and sold as "securitized debt," were done by "models" that used related or even tangential factors to make their valuations. I am given to calling these models, "electronic Ouija Boards," since they are no more reliable a device.

The securitized mortgages, which accounted for the largest part of all securitized debt, were valued against the property market. As soon as the property market started to falter, the securitized mortgage debt was devalued to whatever level the model used determined. Those using the models did not wait to see defaults and foreclosures due to non-payment of mortgages as the reason to employ the models, in fact the models in general do not even take these factors into consideration. They worked solely on the value of the property market.

I see those who point to greedy Wall Street mavens as the cause of the financial crisis, or aggressive mortgage brokers, or lax Federal regulators and other "bad guys." However, the decline in balance sheets of major lenders was caused by those using their imperfect models to drive down the value of mortgage based assets and thus leave the holders with "over leveraged" assets.

As contradictory as it may sound, the Feds are starting to revive the securitized debt market in order to restore our economic health. Many say this means using the same "toxic assets" again and this will lead to even more economic upheaval. However, they overlook the main issue. As a totally private sector activity we had no idea how large the securitized debt market was and how it operated. Under Fed leadership and control, the market will be visible and readily understood by all.

Leo Cecchini
March, 2009

HESTITATIONS ABOUT OBAMA'S RECOVERY PLAN

2009-03-23T12:45:00.000-07:00

I was at a dinner for my old Foreign Serice class Sunday where I heard two kinds of comments that gave me some pause. Some said the US economy had gotten too large and we were living beyond our means. For these the best remedy for the current economic plight would be for the economy to contract to something more in line with what we can afford. On the same path, but somewhat different, were those who were skeptical of the President's efforts to get us out of the mess with increased government spending. They do not want to pump up demand at this point since excess demand is what got us into this position.

As I have said before I do not get into arguments about what constitutes the appropriate level of consumption. I define economics as the science of satisfying the perceived needs of the people with perceived being the operative word. One man's necessity is another's excess.

I do support President Obama's multiple efforts to revive the economy with one exception, I do not support using public funds to improve home owner's equity. This is the idea behind the plan to force write downs of mortgages to lower present values of property. Yes, help stop foreclosures, but no, do not use public funds to improve an individual's property sheet.

I leave it to others to determine the "correct amount of consumption." However, I fully support the President's efforts to bring the economy back to its previous level and go beyond that.

Leo Cecchini
March 2009

"IT JUST GROWED"

2009-03-22T09:38:00.000-07:00

Three things have occurred in this last week that give substance to what I have been trying to describe this last year. First is the hoorah over the now government owned largest insurance company in the world, AIG, granting bonuses of some $160 million to the very people who overbought securitized debt and oversold credit default swaps. The public is outraged that the firm used part of its $170 billion in funds injected into it by the Feds to pay the bonuses.

This rather simplistic populist rebellion speaks to an early demonstration of what I call the "New Economy," which means one in which Uncle Sam is now the largest shareholder in the private sector. These funds were not "given" to the firm, they were used to essentially acquire it by the Feds. In the words of Congressman Barney Frank, "we own the company, we can now say who gets paid and how much," or something to that effect. I have been pointing to this development as the major effect of the "Financial Meltdown of 2008" and the "Great Recession of 2009."

One commentator has cast aspersions on this development calling it an unholy alliance of the elites of government and capital akin to the corporate state of Mussolini. Well call it what you will, the movement is well established and we are headed toward greater control of the economy from Washington instead of New York.

The second development is that it has become clear that the devaluation of "securitized debt" or what I call mortgage based assets, began well before the uptick in foreclosures due to non-paying mortgages. The "wunderkind" put their "models," which I am given to calling, "electronic Ouija boards," to work as soon as the property markets went flat, not even south, to devalue these assets to the point they left their holders with destroyed balance sheets. This in turn left them unable to issue credit.

Thirdly, we have all come to learn that we need more credit than is available from traditional sources. In other words making our banks and other financial institutions healthy will not cure the credit problem, we need to revive the "securitized debt" market. And the Feds are already doing this, witness the massive infusion of funds into Fannie Mae and Freddie Mac to issue mortgages and "securitize" these. Next is the "TAFL" program in which the Feds will "securitize" non-mortgage loans.

If I were a believer in conspiracies I would probably see all of this as some plot put together by socialists to take the economy out of the hands of the private sector and put it into the hands of government. But I know that socialists are not that good, witness their failure in Russia. No, it is like Topsy, "it just growed."

Leo Cecchini
March 2009

THE NEW ECONOMY FACT AND FICTION

2009-03-15T06:25:00.000-07:00

Well time to review what we have learned:

FACT: The US economy needs "securitized debt." Traditional sources of credit are not sufficient to make the engine run.

FACT: "Securitized debt" and the insurance on them, "credit default swaps," constitute what is called "toxic securities."

FICTION: These assets are being "marked-to-market." There is no market for them and they are being marked to notional values derived from "models" based on property markets.

FACT: Marking the "securitized debt" and "credit default swaps" erroneously, i.e. to notional values, has destroyed the balance sheets of those holding them, e.g. AIG Insurance.

FACT: The Federal Government is trying several methods to restore healthy balance sheets to the lenders.

FACT: The "TARP" program served to avert a total collapse in the financial system by restoring some of these balance sheets.

FICTION: The "TARP" has thrown tax money down the drain.

FACT: Through the "TARP" Uncle Sam has acquired a massive stake in our private financial institutions.

FICTION: President Obama's stimulus plan is a massive tax money giveaway.

FACT: President Obama's stimulus plan will save jobs by spending money.

FICTION: The Feds are wasting money trying to revive Fannies Mae and Freddie Mac (now owned by the Feds).

FACT: The Feds are providing funds to Fannie and Freddie to revive their "securitized debt" activities and thereby provide the credit needed to revive the economy.

FICTION: The Feds "TALF" plan will buy up worthless loans.

FACT: The "TALF" plan will buy up non-mortgage loans and issue these as "securitized debt."

FICTION: Uncle Sam is wasting tax payer money to the tune of $2-3 trillion.

FACT: Uncle Sam is borrowing money at cheap rates, maybe an average 1%, to buy up assets that will probably pay back more than their cost over the next 10 years.

FACT: The unintended result of the "financial meltdown of 2008" and "recession of 2009" will be to give Uncle Sam even more control over the economy. Already the largest consumer, 20% of the output to rise to 30% by 2010, the central banker, Federal Reserve, and rules maker, Uncle Sam is now the largest single owner of the private sector. Enter the "NEW ECONOMY."

HOW TO FRUSTRATE RECOVERY

2009-03-13T08:17:00.000-07:00

I see frequent commercials on TV with Muriel Siebert, the "First Lady of Finance," crowing that her firm has never invested in "derivatives" or "structured products." Well this is like a commodities trader saying he has never invested in futures.

We have all, except for perhaps Ms Siebert, come to realize that "securitized debt" has long since become the dominant source of credit for our very advanced economy. Without it, we falter. And we know this, because this is what is happening now, lack of credit has reduced consumption, reduced consumption has caused lower production, lower producton means people lose their jobs. Perhaps the best example is the auto market. GM is not the only maker in trouble, Toyota has also asked the Japanese government for help.

If everyone followed Ms Siebert and refused to invest in "securitized debt" there would be way too little credit to revive the economy. In sum following her lead would lead us to an even worse situation.

No, we must allow the Feds to put more funds into Fannie Mae and Freddie Mac to allow these engines of the mortgage industry to issue, collect and "securitize" more mortgages that will in turn revive the housing market. We must allow the Federal Reserve to implement its "TALF" program that will buy up non-mortgage loans including auto loans, student loans, commercial loans, credit card debt and so on. "TALF" will buy these loans, bundled them and sell them as "securitized debt." If this is not done, say goodbye to recovery, no matter how much stimulus President Obama puts into the mix.

Again, if we follow Ms. Siebert's lead we guarantee failure. Funny, while she eschews "securitized debt" she shills "tax-free" municipal bonds. As if not buying "securitized debt" does not do enough to frustrate the recovery, she wants to deny the Feds funds to do anything. I guess she was Herbert Hoover's advisor too.

Leo Cecchini
March, 2009

GET A JOB

2009-03-12T09:10:00.000-07:00

Perhaps my articles describing how the present economic slump is forcing the Federal Government to take an even larger role in the economy have been a bit too heavy on financial details for the average reader. But there is one lesson that all should understand.

Until now Uncle Sam has been the largest consumer of our economic output, central banker, and rules maker for economic activity. To this he has added becoming the largest investor in the private sector (he is already the largest investor in the public sector with state and local governments being the others). Uncle Sam now owns the core of our mortgage industry, the largest insurance company, shares in the principal banks, and shares in the auto industry. No doubt he will add more to his investment portfolio.

And if Uncle Sam was the largest consumer of our economic output before, the planned national budget will see his share of consumption rising from 20% of our output to 30% of our output. To put it in my quaint phrasing, “we all suck from the public trough, it’s just that some have longer straws.”

So what does mean for the most pressing issue of the day, how do I keep my job or get a new one? The answer is obvious, if you are in a federal government job, you are assured of continued employment. If not, then get one as soon as possible.

Contrary to the contraction in employment in the private sector and even state and local government, Uncle Sam is hiring like the straw boss at a new construction site. Who is he hiring? For starters he needs many more economists and financial people to oversee his new investment portfolio, restructuring of the financial regulations systems, handling his new “securitized” debt activities, and spending massive new amounts of money.

But expansion of the federal work force will go well beyond these. Uncle Sam will need people specialized in the arts to monitor and control the Stimulus Fund expenditures on the arts. He will need educators to guide his massive commitment to increased funding of schools. In my own bailiwick, Uncle Sam will hire 800 new diplomats, an increase of perhaps 20%. The list is virtually endless.

Any job seeker today will do well to check with federal government employment as soon as possible.

Leo Cecchini
March, 2009

MARK 2 MARKET

2009-03-11T13:47:00.000-07:00

Yes, the title is a double entendre. Let me explain.

I have steadily called for junking the “mark to market” rule for valuing mortgage based assets or securitized debt, the so-called “toxic” assets. These include mortgages bundled and sold as bonds and the infamous credit default swaps, a type of insurance for the bonds. There is no market for these instruments at this time. In the absence of a market those doing the valuations use their various models and Quija boards to determine values. The most prevelent model is to value mortgage based assets to the depressed value of property in the most depressed markets. I have asked that these assets be valued at their long term value, i.e. the mortgages held to maturity, minus the still small foreclosure rate now at 3%.

Those insisting on “mark-to-market” rules base their defense in predicting that if the assets are not valued this way, investors will not buy any. Well investors are not buying them now, so what would be lost?

Well the “mark-to-market” defense has been hit with two big blows. Fed Reserve Chariman Bernanke now calls for “fine-tuning” the “mark-to-market” rule. He does not want to suspend the rule, but rather adjust it to give a more accurate value to the assets. I modestly suggest he use my proposal, mark mortgage based assets to their maturity value, minus actual foreclosures.
At the same time well known Congressman Barney Frank has come out forcefully to change the “mark-to’market” rule and restore the “uptick” rule for selling shares short, i.e. selling shares at today’s price that you will deliver later, when the prices are lower. This is the classic bear market strategy, i.e. it works when stock values are declining steadily. The uptick rule serves to prevent short sales driving stock prices down too fast and too far.

These calls to battle will lead to a quick overhaul of these, and other rules, causing the plummeting stock market, and the economy itself, to fall faster and further than they should. Bernanke also called for major new Federal control over the financial markets.

So now our financial market will operate under revised and new rules which will yield a much changed market that I call, “Market 2.” Clever title, no?

Leo Cecchini
March, 2009
Categorized in Uncategorized

"TOXIC" ASSETS TO THE RESCUE

2009-03-09T10:14:00.000-07:00

If you haven’t noticed by now it should be abundently clear that the private sector hasn’t a clue how to recover from the economic slump in which we now find ourselves. The only “White Knight” with a lance long enough to slay this “dragon” is Uncle Sam. You might ask, “How can the government solve the problem when the best minds in the private sector are not able to come up with a solution?”

To understand why the Feds can succeed when “market economics” fail you have to go to the fundamental difference in how the Feds hold assets and how the private sector holds assets. The private sector borrows money to make investments and the return from the asset must be at least enough to cover the cost of the borrowing in order to make a profit. If the assets decline in value to less than what one owes he is technically bankrupt, i.e. liabilities exceed assets.

“Securitized” debt,the so-called “toxic” assets that have led to the economic slump, are mortgages and other loans bundled and sold as bonds with each bond representing a share of the total group of loans. In this they resemble mutual funds where the fund buys a group of assets and sells a share in the total amount to investors. The theory of combining these investments into packages to sell in pieces is that it distributes your ownership over a large group of assets instead of just one or two. This increases your chances for gain and reduces the potential for loss.

However, while mutual funds are traded on open markets, ”securitized” debt does not have such a market. In the absence of a visible market, “securitized” mortgages, have been devalued to the depressed value of the property market. However, the mortgage is not the underlying property. While the home may have dropped in value by 30% or more, the mortgage has only lost value due to foreclosures and defaults. Since foreclosures stand at 3% of mortgages and defaults stand at 7%, valuing these mortgages to the property has greatly exaggerated the loss.

So much for how the private sector holds assets. The Federal Government has a different position. The Federal Government does not borrow against the value of its assets, it borrows against the “full faith and credit” of the country itself. Since his ability to borrow is for all intentions unlimited, Uncle Sam can afford to hold assets as long as he likes. In short Uncle Sam can hold these assets as long as he likes without having to watch market conditions, since he has no intention of selling the assets nor do their value affect his ability to borrow.

But Uncle Sam does have to watch his earnings from the assets, since if they do not pay his low costs of borrowing, the deficit will have to be made up by taxes or additional borrowing. Fortunately the average return on the assets he has acquired and expects to acquire is still higher than his cost of borrowing, so he will not have to raise taxes or increase borrowing in the future to pay for a shortfall in earnings.

Now that we see the difference between how the private sector and the public sector, meaning here Uncle Sam, view assets we can now understand why the Feds can now propose curing the economic malaise by cranking up “securitized” debt again. This crisis has made everyone understand that the only way we can obtain the vast amount of credit required to drive our massive economy in today’s world is through “securitized” debt. Say what you will about how these debt instruments are “toxic” and so on, they are needed to make the engine work. To state it bluntly, the so-called “toxic assets” that are blamed for our ecomoic slump are now required to make the economy revive.

To reiterate, private owners of the debt instruments have to match these holdings or assets against their liabilities in order to see if they are still solvent. They do this by seeing what price they fetch in today’s market. The market now tells them that these instruments have lost allot of value. Thus they are judged to be not “solvent.” Uncle Sam has a different test, he only has to show that the average return on the assets, NO MATTER HOW THEY ARE VALUED, covers his small cost of borrowing to buy the assets.

While Uncle Sam can hold “toxic” and other assets without regard to the market for these assets, private investors, under present valuations, cannot do this. This why I have asked to suspend the “mark-to-market” valuations while private investors are forced to hold securitized debt instruments because at today’s “maket prices” they would lose their shirts if they sell them. This would put private investors on the same footing with Uncle Sam, i.e. hold the assets without regard to the market and focus on long term earnings from the assets. In the case of mortgage based assets this means the balance due on the loans, times the interest rate, times the duration of the loan, minus a 3% loss to foreclosures. Unfortunately this has not been done.

If it were not such a terrible problem I could find some humor in the situation. The way to save the economy is to go right back to creating massive amonts of “secritized” debt or “toxic” assets, the very thing blamed for the chaos. However, this time it can work without the problems caused by market valuations because the “securitized” debt will be controlled by the Feds. No, Uncle Sam will not become the sole holder of “securitized” debt, he will simply be its nexus and thereby in a position to make it work better.

To conclude with my constant reference to the “New Economy,” or one in which the Federal Government will play a greater role, this new development will add to making Uncle Sam’s control over the economy even more complete.

Leo Cecchini
March, 2009

BACK TO SANITY

2009-03-03T09:36:00.001-08:00

Well now we have Uncle Sam borrowing up to $3 trillion to fund the TARP, TAFL, Financial Stabilization Plan, Stimulus Plan,and so on. The borrowed funds are being injected into the economy to stop the bleeding and start the rebuilding. But no matter what he does, the body economic seems to slough off the effort and continue its nose dive.

And the dive is steep. Our concern with home foreclosures due to bad mortgages has turned to foreclosures due to loss of job, a much more serious problem. The only hope to stem job loss is President Obama’s Stimulus Plan that will put people back to work. Keep your fingers crossed.

At the same time the players have now come to finally recognize what I have been saying since last summer, you cannot revive the financial sector without dropping the “mark-to-market” rules. The balance sheets of all financial institutions were damaged by marking assets to markets that did not exist. Instead of marking to markets they were marked to models that were no better than notional ideas. These models have devalued assets well below any realistic value. FDIC Chairman Sheila Bair complained that 98% of all banks holding 99% of all bank assets have sound balance sheets but all are being devalued by these notional ideas. This has been the crux of the financial meltdown.

Uncle Sam has sought to build markets to which assets can be accurately valued. However, this has proven to be a difficult process and in any case too slow to correct the situation soon enough. Now we hear a chorus of calls for temporary suspension or a hiatus in marking assets to the market. The importance of this is that suspending this practice will allow balance sheets of financial institutions to recover lost ground instantly.

So here we are some $3 trillion of new Federal debt and nine months of wandering in the wilderness coming back to the reality that we have to value our assets at more realistic values. My particular call is that we value all mortgages and mortgage based assets at the maturity value of the mortgages minus the actual foreclosure rate. In this one case the value of the assets would increase by an average of some 25%. The total value of mortgages on owner occupied homes is some $13 trillion thus a 25% up tick in valuation would add $3.3 trillion to the balance sheets of those holding those mortgages.

If you drop “mark-to-market” rules for ”securitized debt,” originally valued by various observers at some $15 trillion, and further, to the “credit swaps” issued to insure these securitized debt instruments originally valued at $55 trillion, we can see a massive upward valuation in balance sheets, on an order far beyond Uncle Sam’s ability to borrow and spend.

Perhaps even more important, the new efforts by the Feds revive the “securitized debt” industry depend on correctly valuing the new financial instruments that will be created. Uncle Sam is feeding $400 billion into Fannie Mae and Freddie Mac to issue new mortgages that the two now government owned operations will bundle into bonds and sell as “securitized debt.” As a complementary effort the Feds will open the new “TALF” plan to buy up and securitize other loans including auto loans, student loans, credit card debt, and certain commercial debt. No sense doing this if ”mark-to-market” rules make these new instruments crash and burn at takeoff.

I believe it is a damn shame that we have had to go through all this trauma brought about by erroneous valuations of assets. When there is no market, it is foolish to follow “mark-to-market” rules. All this does is allow “wunderkinds” to pull out their electronic Ouija boards to value assets and in the process destroy the economy. It is long past the time to get a firmer grip on valuations of assets. But maybe not too late

ROBBING PETER TO PAY PAUL

2009-03-03T09:36:00.000-08:00

The Government has announced the details of the plan to bring home values more in line with the debt owed on them, you know, correct the many homes that are financially "underwater," (we used to use the term "upside down"). To be specific, the balance due on the mortgage is more than the value of the house on today's market. As I said before this is a very difficult process and there are few who are able to actually do it. But let's go through the numbers.

There are about 60 million homes in the USA that are owner occupied or some 68% of all homes. Of these two thirds have mortgages. The total value of these homes is estimated at some $20 trillion. Of the total about 8.3 million have negative equity, i.e. they are "underwater."

The latest plan is to reduce the monthly payment on the "underwater" loans to 31% of one's income. This can be done by reducing the interest rate or reducing the balance due. Reducing the interest rate is relatively easy, Uncle Sam can subsidize the interest rate to allow a reduction. But reducing the balance due is a goal just short of finding the "Holy Grail."

Using the numbers I cite above, and they are best estimates, not hard and fast facts, we can see the Government attempting to write down some $2.6 trillion in mortgage balances. The plan is to get the lenders to share this cost with the Feds. I fear, however, that any write down will require the Feds to compensate for the loss. Of course, there is a new Federal Law being considered to allow courts to mandate write downs of mortgage balances. The consequences of this are too dire to contemplate. Let's say for the moment that Uncle Sam will have to shoulder any write downs of loans. If the average write down is 30% that would mean an expenditure of some $800 billion. Still another big chunk of change for Uncle Sam to borrow.

I see two killer problems with this plan. First, just how does one insure that the cost of the home - mortgage, taxes and insurance - is less than 31% of income? I can see every Tom, Dick and Harry busily hiding income to show a lower income stream and thus force a loan write down. And if you think this doesn't happen, remember how many people created "phantom" income when they had to show sufficient income to get a mortgage in the first place. (The 31% rule is that used by the Federal Housing Authority, FHA, to give a loan.) The issue here is fraud and I see widespread fraud being committed to comply with this measure.

The second problem with this plan is that it will be seen as being inherently unfair to those who continue to pay their home costs without this relief. I can see Harry looking across the fence at Tom who gets his home costs reduced by one-third. Both bought their homes at the same price, at the same time with the same mortgage terms, taxes and insurance. However, Tom's income is less than Harry's, or at least that is what he is showing. Now the Feds will pay part of Tom's mortgage so that his house costs no more than 31% of his income.

Will Harry be mad, you betcha. Especially if Tom works alongside of Harry at the same job. The difference is that Tom and his mortgage advisor are smarter at hiding Tom's income. Harry will see this as a ruse to use his tax money to pay part of Tom's mortgage. And he will be right.

Of course I am simplifying the process. It is far more complex than any mortgage business done to date and is fraught with mistakes as well as the certain fraud. Moreover, if those granting mortgages got us into this mess, why turn to them to get us out? They don't have the capacity to do the job, so as far as I am concerned, the plan will be a dismal failure.

I fear that this plan could undermine the entire Obama recovery effort. I see the downside far outweighing potential benefits. I would urge the Obama team to reconsider this plan. Stay with working to prevent foreclosures, don't go to correcting personal balance sheets.

Leo Cecchini
March, 2009

NATIONAL DEBT - HOW HIGH CAN IT GO?

2009-03-03T08:17:00.000-08:00

I am watching the Senate grill Fed Chief Bernanke about his injections of funds into the economy in an effort to restore bank balance sheets to a sound state and prime the consumer pump. I am appalled by the shallow understanding of the situation shown by most of the members of the Senate's banking committee. Here is one worrying about his local banks not having access to the TARP funds when they do. Another worries about banks receiving money but are keeping on their failed executives. And other such trivia.

In spite of their shallow knowledge of the subject in which they set the standards, the Senators did have one question that was worth answering - how large a Federal debt can we support? Bernanke responded by pointing out the familiar fact that our federal debt to national income ratio at the end of WWII was debt amounting to 120% of GDP. He said we now have a ratio of 60% and said that we should try to keep it at that level. But he also said there is no way to know what the maximum debt could be since it depends on willingness to buy our debt, which means essentially Treasury Bills.

Bernanke did not mention it, but the debt is now owned in the main by the US Government itself, mainly through Social Security purchase of T-Bills. Foreign ownership accounts for about 25% of the debt, with China and Japan owning about 20% each of that 25% and the UK about 10%. The rest is owned by various investors.

The question of how large a debt we can support may be answered in several ways. First, the US central government debt as a share of national income ranks 23rd among the major national economies of the world. Using this yardstick, and it is the IMF's ruler, we have a long way to go to reach our limits to borrowing.

Another way to measure national debt would be to compare it to personal debt. The average American family has a debt to income ratio of over 100%, thus the national debt has not yet reached the level of personal debt. One should also note that the standard rule for issuing a new prime rate mortgage is that the home should not cost more than three times the buyer's income, e.g. someone with $100,000 income can buy up to a $300,000 home.

The rule I use in assessing a company's cash flow is that the firm's indebtedness should not exceed one year's gross income, e.g. a million dollar a year cash flow means you can borrow up to one million. I do not know if others use this same rule but it has served me well in providing accurate cash flow analysis.

Using the available measures - historical, international comparisons, personal indebtedness, business indebtedness - it would appear that the national debt can be 100% of GDP without causing alarm. Adding the expected up to $3 trillion that the Obama administration plans to spend this year to revive the economy to the current $11 trillion in national debt, we should wind up with a national debt to national income ratio of about 85%, which is within the 100% guideline.

But there is a dimension to this debate that transcends the debt to income ratio. The national debt is backed by the "full faith and credit of the Republic." This is the same backing for the bucks in your pocket. Does the "full faith and credit" of the USA mean one year's GDP, or more? The critical question here is, how long will the debt holders hold the debt? If they hold it ad infinitum, there is theoretically no limit to what Uncle Sam can borrow.

The other relevant question is how much does it cost Uncle Sam to carry his debt? I have pointed out that at present the Treasury is issuing bonds that pay less than the inflation rate, some with 1% interest. In other words it will cost Uncle Sam probably less than $200 billion a year to carry this expected debt of $14 trillion, a small part of the Fed's budget expected to be some $3 trillion in 2009.

There is another factor to consider. What are the alternatives for foreign holders of US national debt? Fortunately for the USA, unfortunately for the investor nation, there are insufficient alternative instruments available in which to place these funds. They have to hold US national debt.

What does all of this mean? First, Fed Chief Bernanke was correct in saying it is hard to see how far US national debt can go. If one uses debt service ratio, i.e. how much does it cost to pay the debt, Uncle Sam has a very long way to go since he is only paying 6% of his current income to pay the debt. Assume we let debt service reach 12% of the national budget we could have a national debt of twice what it is expected to be in 2009 or $28 trillion.

If I were the Fed Chairman I would respond that we are at a high debt level now, but we can support a much higher debt. I believe President Obama should keep this in mind as he presents more programs to save the economy.

Leo Cecchini
March, 2009

FULL CYCLE

2009-02-24T12:17:00.000-08:00

Most attribute the "The Financial Crisis of 2008" to "securitized or collateralized debt" or bundled mortgages which allowed credit to grow far beyond previous systems. These comprised the so-called "toxic assets" which the Feds now call "legacy assets." I use the term "mortgage based assets."

Well guess what, we will now go back to using "securitized debt" to revive the economy. The first will be securitized mortgages. Uncle Sam now controls Fannie Mae and Freddie Mac and thus over half the mortgages in the USA. The Geithner Plan calls for putting $400 billion into these two organizations to push home sales. These new funds will be used to, you got it, bundle new or reworked loans into securitized debt to be held by Fannie and Freddie or sold on with Fannie and Freddie guarantees.

To complement this move the Federal Reserve will now open its, "Term Asset Backed Security Loan Facility," (TABSLF). It will use this to buy up non-home loans, e.g. auto loans, commercial credits, credit card debt. It will then bundle these loans and sell them as "securitized debt."

What's that you say, we are headed right back to where we started the bust, "securitized debt." Yes we are, but with a big difference, the Feds will be in the driver's seat. Presumably the entire process will be transparent and valuations will therefore be more precise. More importantly, Uncle Sam will hold most of the debt. Again, he does not have to sell these bonds and can hold them to maturity. That means that the assets will not have to be "marked-to-market," but valued at long term or maturity values, the very thing I have been demanding from the beginning.

The rest of the world has now learned what I, and some others, have recognized for a long time, the US economy has been enjoying strong growth over the last two decades because of the innovative new ways of creating credit. Unfortunately the market analysts were not able to correctly value these new debt based assets. They valued the mortgage based assets on the property market instead of the mortgages themselves. By valuing them at the property market they devalued them by at least one third. If they had valued them to the mortgages themselves they would have devalued them by the actual loss to foreclosures, i.e. less than 3%. The result has been the "financial meltdown" followed by the "economic crisis."

We have come through a laborious process to arrive at the same place we were up until about a year or two ago. But again, this time Uncle Sam will be controlling the process, so it should be more sound.

Of course the bottom line is the "New Economy," or an economy in which the Federal Government will have even more control over its progress. As I have said repeatedly, Uncle Sam already was the central banker, rules maker and largest consumer of the economy. Now he owns the mortgage business, the largest and growing share of banking, the largest insurance company, much of the auto industry and more. His next big buy will probably be the health sector since no one else can put it on a financially sound basis.

Yes, we have a "New Economy" in which the private sector will be even more dominated by the public sector. I suggest you make your personal plans accordingly.

Leo Cecchini
February, 2009

SAVE OUR HOMES

2009-02-18T09:50:00.000-08:00

President Obama has unveiled his program to save our homes. The focus of the program is to stabilize home values, thus stabilizing the value of mortgages based on those homes, thus stabilizing the mortgage based securities. Whew, sounds like a complex, round-about route to doing what I have been demanding in my articles. I suggested simply revaluing mortgages to "maturity" values, instead of the "market."

But the Obama housing plan does have popular appeal. It is being sold by talking about saving your home, instead of such exotica as stabilizing values of mortgage based securities. It should sell well.

As for the details, there are parts that will work and parts that could be disastrous. First, the workable parts. Under the plan Uncle Sam will pump up to $400billion in new funds into Fannie Mae and Freddie Mac, the two mortgage giants that house over half the mortgages in the USA. Uncle Sam now owns these two outfits. This is almost a no-brainer, put more money into the two mortgage giants and mortgages will be more readily available. This program will do much to help.

I also like the provisions to forestall foreclosures. Several actions designed to do this have already been adopted by the government and private lenders in the last year. The Feds will do well to increase this effort by providing funds to make them work.

I have problems with the plan to combine public and private funds to lower the payment on mortgages not in danger of foreclosure. The intention is to help people with "underwater, upside down, or negative equity" situations, i.e. the house is worth less than the mortgage on the house. The plan calls for bringing the payment to less than 31% of the home owner's income. Not hard to see where this came from, that was the FHA rule used by mortgage brokers to give the loan in the first place, be it an FHA loan or otherwise. Of course this will help those who have seen their income go down or their mortgage payment go up smartly. But the vast majority of loans have not seen their cost go up and home owners, by and large, still see the same income.

The real problem with this measure is that it allows for substantial fraud. We all saw fraud in issuing mortgages. The fraud typically came in determining what constitutes 31% of a home owner's income. The fraud in issuing the loan involved including "phantom" income. The fraud in this new case will involve excluding unreported income. The way it will happen is that the mortgage broker will tell his client to hide income that does not show up in public records. Anyone in the middle of doing his taxes knows about this. If you need advice, just ask former Senator Daschle.

The next problem with this also comes from the complexity of melding public and private funds. The private lender will try to maximize the Feds payment for any loss due to bringing the loan payment to the magic 31% limit. Redoing one of these loans will take very skilled operators and there are very few of these. I can see mountains of complaints and infractions of law in this process.

As bad as this proposal may become, it pales in comparison with the idea of allowing mortgage balances to be decreased to the present value of a home. Again, a mortgage is not property. This could open a Pandora's Box of every mortgage holder trying to dump part of what he owes. The way it would work is to allow judges to decide that mortgage balances excess to home values are "unsecured" debt. Ridiculous. Mortgages are backed by promissory notes that say the borrower pledges all his resources to paying the debt, not just the collateral property. A very dangerous move.

While I have problems with some of the program, in sum this could be a good PR program. "Save our homes" has a good ring to it. But as I have said all along, ending foreclosures will not correct the mess, since the foreclosure rate is not really high, about 3%. It may help the individual home owner, but it is too uncertain and too late to correct the credit freeze. It could also cause even larger problems.

Leo Cecchini
February, 2009

AT WHAT COST?

2009-02-18T07:09:00.000-08:00

Let's review the cost of the massive federal government effort to revive (save?) the economy. First is the TARP plan adopted last fall at a cost of $700 billion. Now we have the Obama Stimulus Plan with a $789 billion price tag. The new Financial Stability Plan speaks of spending up to $1 trillion to buy up undervalued assets. This adds up to maybe a total cost of some $2.5 trillion, a sum equal to one-sixth of the US GDP (total output for the year) or just short of the current federal government budget.

Next let us remember that all of this cost will be paid from borrowed funds, not current income. In other words Uncle Sam's famous "national debt" will increase by maybe $2.5 trillion. The national debt now stands at some $11 trillion which is equal to 75% of the GDP.

What's that you say? We will burden our children, grandchildren, in fact our entire lineage with debt. Guess what, the United States of America has been in debt since the day it was born. In 1791 US Government debt amounted to some $75 million. We usually measure the size of the national debt against our national income. The highest point reached on this scale was at the end of the Second World War when US debt was equal to 120% of GDP. The USA has always been in debt, and will continue to be so for the duration of the Republic.

Back to the recovery plan cost. Uncle Sam will borrow up to $2.5 trillion. But at present the cost of this borrowing is relatively small, maybe 1% interest per year. This is because everyone is putting his funds into Treasury Bills that are considered as "good as cash" since they are backed by the Republic itself, just like the bucks in your pocket. So the actual cost of the borrowing will be $25 billion per year, a very small cut from the Federal budget for 2009 of over $3 trillion.

Let me make it perfectly clear, the cost of the recovery effort will be relatively small, less than 1% of the federal budget per year. I would suggest that the Obama team highlight this fact when it makes its pitch for public support.

As interesting as this may be it does not reveal the truly fascinating aspect of this process. As I have been saying for the last six months Uncle Sam is buying up the private sector at little or no cost. It took the Bolsheviks a sea of blood to do this in Russia. Uncle Sam is doing it for peanuts.

I can hear the chorus now, "socialism." Well if this be "socialism," so be it. The private sector has withdrawn from the battlefield leaving Uncle Sam to soldier on alone. Yes, the Financial Stability Plan calls for joining private with public funds to buy up undervalued assets. But I fear that the private sector will put few funds into this plan. Private investors ain't doing it now, so why expect them to do so in the future?

Where does it all end? I repeat that this is fascinating stuff. We are in the midst of creating a "New Economy" and no one really knows what the final product will be. Stick with me on this amazing journey.

Leo Cecchini
February, 2009

BYE BYE NEW YORK, HELLO DC

2009-02-17T12:04:00.000-08:00

As I have said many times, the financial meltdown and the resultant economic doldrums came about because of erroneous valuation of assets. The core false valuation is that given to mortgage based assets, the so-called "toxic assets." I have now come to realize that all "models" used by those valuing these assets rest on prices in the property market. I will repeat, a mortgage loan is not property, which is the collateral on the loan.

Let me put it in another way. A typical mortgage loan over its lifetime will pay back a total of twice the sale price of a home. At no time during the course of the loan will an increase in the value of the collateral property increase income from the loan. Nor would it be any less because the value of the property falls. The loan held to maturity will yield income equivalent to twice the selling price of the home, no more, no less.

But here is where those valuing the mortgage based assets make their error. They assume that negative equity will pump up defaults at rocket rates making the loans dicey propositions. They do not believe that people will continue to pay on a home loan when the property is worth less than the loan balance. They forget that homes are also shelters so the payer has to measure paying on the loan against paying for other shelter, e.g. renting a place. And he knows that no matter how little the value in his home, it is still more than the residual value on a rental, which is zero. Thus the actual foreclosure rate remains relatively small, 3% this year when it was 1.5% in 2005. In other words the assumption that negative equity will cause rampant defaults is wrong, wrong, wrong.

While they are erroneous, the real estate models used to value mortgage based assets and other assets have devalued these assets to as little as pennies on the dollar. This has led to the stymied credit market and the economic tail spin.

I know, you say those doing the valuations are savvy financial people who have lots of experience on which to base their models. Well they are the same people who got us into the mess so their "expertise" is suspect. And I offer that the most public spokesman for my line of reasoning is Steve Forbes and I challenge anyone to say he, with his highly respected publication empire, is not an expert.

And this false valuation has led to wholesale dismissal of President Obama's stimulus plan and Secretary Gheithner's financial stability plan. In the case of the stimulus plan, they bleat that it is insufficient to turn the situation around. The American people themselves have little faith in the plan but thank God have faith in Obama. Geitner's plan has been dismissed by all financial "experts" because they say it cannot work with their false valuations and they are correct. The only way it works is to drop the false valuations and allow assets to be valued correctly starting with mortgage based assets.

Fortunately the Federal Government does not think like private investors who view all assets as items to be sold. The Geithner plan will work because the Federal Government can buy assets, be they the mortgage based assets or shares in General Motors, and hold them until the economy recovers. As I have pointed out, the Feds are borrowing at essentially no cost, so it will cost nothing to hold these assets. And when the economy recovers, the assets will bring much higher prices on the markets. Uncle Sam stands to make the biggest killing on Wall Street in the history of the USA.

So forget the financial gurus and concentrate on Federal Government actions. The private sector has dropped the ball and has no idea how to get back in the game. The main result will be that the nexus of our financial system, and thus the economy, will gravitate to Washington, leaving New York City without its main source of income. Hold on to your DC suburban home and get rid of your New York coop.

THE GEITHNER BANK STABILIZATION PLAN

2009-02-13T09:00:00.000-08:00

I see allot of barbs being shot at Treasury Secretary Geithner and his plan to stabilize banks. Most come from financial leaders who favor forcing banks to devalue their balance sheets to the point where many go out of business for lack of sufficient reserves. Then the survivors will be able to buy up the assets cheap and extend their mini-empires. Of course collateral damage will be the US economy itself. And this is what worries the President and Geithner.

I have read Geithner's statement about the new "Financial Stability Plan." It works because the Feds continue to understand a basic point, the so-called "toxic assets" have a real value which I call the "maturity value," which means the balances due on the mortgages times the interest rate times the length of the payoff period (term) minus the loss due to defaults and foreclosures. Since the actual default rate on mortgages is 6% and foreclosures rate is 3% the loss is relatively minor. This stands in stark contrast to the current holder of these assets "marking them to the market" which means losses of up to 90%.

The key to each part of Geithner's plan is that the Feds will hold their asset purchases in "trust funds" instead of "investment portfolios." To explain let me use my pet analogy. You have a trust fund set up by your late Uncle Harry from which you receive $50,000 per year. You may not sell or take more from the fund. What is its value? The "mark-to-market" crowd say it would be zero since it may not be sold. But the value is actually $50,000 per year over your lifetime. The Feds look at acquiring "toxic" assets, investing more funds in banks, and other infusions of Fed funds as part of a trust fund, not an investment held to be sold.

Whatever infusions of Fed funds that occur, they will stay the course. And these funds will rebuild balance sheets thus allowing the lenders to provide credit once more.

With these understandings in mind let's look at the Geithner Plan.

FINANCIAL STABILITY PLAN.

This is essentially a continuation of the first use of the "TARP" funds, i.e. capitalize banks by buying shares in them or lending to the banks. It strengthens the balance sheets.

PUBLIC-PRIVATE INVESTMENT FUND.

This is a plan to combine public and private funds to buy up the so-called "toxic assets," or as I call them, "mortgage based assets," and the plan now calls, "legacy" loans and assets. The plan is looking at spending up to $1 trillion.

CONSUMER AND BUSINESS LENDING INITIATIVE.

This is a plan to inject as much as $1 trillion into lending for consumers and businesses. The vehicle will be the "Federal Reserve's Term Asset Backed Securities Loan Facility." Well would you believe, the Feds want to provide lending by "bundling" the loans into assets. Sound familiar, yes, the same thing as "mortgage based assets" or as the market valuation slaves insist on calling, "toxic assets."

Remember my litany, no credit, no buying, no buying, no production, no production, no jobs. Uncle Sam, now in the guise of Secretary Geithner, means to revive the economy by opening the credit lines again. He will do this by rebuilding the balance sheets of the lenders and by injecting massive amounts of funds into the system.

Of course I cannot conclude any piece without reminding you of the tectonic shift in the US economy - Uncle Sam is now the largest single investor in the economy. Added to his role as the largest single consumer, the central banker, and rules maker, Uncle Sam's control over the economy is at a new high. No wonder the Wall Street crowd worries about the nexus of the US economy moving from New York City to Washington DC. Being a native Washingtonian I welcome the move.

Leo Cecchini
February, 2009

CONVERSATIONS WITH A FORMER MORTGAGE BROKER

2009-02-09T10:07:00.000-08:00

John

There is another aspect of mortgages and their value as investments that will become more well known as President Obama implements methods to build bank balances. As a former mortgage broker, you probably know that the lender may have earned more from loan origination than from the loan itself. Moreover, the origination fees came up front, while the interest return is realized over the life of the loan. As the Feds buy up mortgage based assets, they will not see the income stream coming from these that made them the hot ticket item over the last decade. But even without the origination fees, mortgages and mortgage based assets earn better than most other bonds.

I personally favor insuring the so-called "toxic" assets rather than buying them. I believe as people come to understand that they have been devalued beyond any reasonable amount, they will see their intrinsic value and the market will grow rapidly.

I still believe that suspending the "mark-to-market" rules is the cheapest and most accurate way to correct the savage damage done to bank balances by rushing to devalue mortgage based assets to notional markets. But if Federal guarantees are needed to make the market slaves come on board, do it.

Meanwhile, the stimulus part of the President's rescue plan must also be implemented. The financial sector has done too much damage to the "real" economy and correcting the financial sector will not resurrect the economic body fast enough. We still need to put the "paddles" to the body to get it beating again.

Leo Cecchini

John

Negative equity means non-payment, that is the premise on which all mortgage based assets were sharply devalued. However, one has to remember that a home is also a shelter. The person who leaves that mortgage leaves the home and must find another place to live. He measures the payment for the mortgaged home against the cost of renting another place. Thus, in this case, he does not act like a normal investor who would drop paying too high a price for a devaluing asset. As long as the home owner pays, the mortgage maintains its value, in your case, $800,000 at whatever the interest rate. The return on the mortgage remains constant and is not affected by changes in the value of the underlying property.

More interesting, "investors" who bought properties at subprime rates, and these were the main users of subprime mortgages, continue to hold their "negative equity" homes because they rent them out and continue to earn money on the property. They too continue to pay with a small default or foreclosure rate. Again, the rental income is not affected by the value of the underlying property.

My point is that mortgages, and their associated properties, are not like other assets with a market that reacts to the usual rules. Moreover, the value of the mortgage is not the value of the property, since the property is only collateral. I insist, that as long as the foreclosure rate remains relatively low, we should continue to value the mortgages at their maturity value, i.e. the balance of the loan times the interest rate over the full term of the loan.

All of this is said in the context of the "financial crisis" scenario. Now that the panic has spread to the "real" economy we will see a different situation. As the unemployment rate goes up you can be sure that foreclosures will rise in tandem. The foreclosure rate during the "Great Depression" stood at something like 25%. The immediate problem is to get people back to work and the Obama plan may help here. For the long term, however, we must revalue the mortgages and the mortgage based assets to a more realistic level which is not the "market."

By the way, I have recently bought shares in Fannie Mae and Freddie Mac, so to anwer your question, I continue to invest in mortgages. Others continue to buy less risky mortgages. The point is that they still maintain their intrinsic value, i.e. they pay better than other debt instruments and that is why they were bundled and served up in large portions to investors as "securitized debt."

Leo

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I believe the reason that foreclosure rate only going from 1% to 2 or 3% is causing problem now is that in 2004 and 2005 prices were still going up or holding strong as the top did not come until late 2005. Therefore when the banks went to foreclosure they either sold it at the courthouse for a profit or took the property back and made money on the REO. Let me ask you if you look at one mortgage say in California that was originated in late 04 and the purchase price was $800,000 and was of course a neg am no down payment loan, now properties in this town are selling for 500,000 a 37% decline. Now this homeowner’s loan is going to adjust and the payments are going to double, they can’t refi because the houses next door are only selling for $500,000. There are billion, $ wise, of these type of loans. All the banks have these on their balance sheets, and this is why there is no market for the securities. What would you pay for a $800,000 note backed by a property worth $500,000?

John

John

Yes, the real problem is no one knows the full extent of what I call debt becomes asset becomes debt becomes asset structure we built. My point is that if a 1% foreclosure rate in 2004 and 2005 caused no problem, then a 2% rate should not bring down the house. I use the foreclosure rate in Lee County, where I sold homes, as my base number and it is the highest foreclosure rate in the nation. Do not confuse depressed value of homes with foreclosures. Loss of equity may induce many to stop paying their mortgages but that is a assumption. As I have laid out before, if you have a $1 million portfolio of mortgages backed by $100,000 in deposits or other reserves and there is a 2% foreclosure rate you stand to lose $20,000 in a year and reduce your reserves by that amount. You are still very solvent and earning on the $980,000 in other mortgages.

The problem is that those doing the valuations were panicked by the rising foreclosure rate and had no idea of the actual size of mortgage based securities. They simply devalued all mortgage based assets to the depressed value of the real estate market and they did not use a uniform valuation of the real estate market. I heard the CEO of BlackRock say they used the depressed value of the real estate market in Southern California as their bench mark.

My point remains that the underlying asset, mortgages, are still basically sound, so the assets built on them should not be devalued beyond the actual foreclosure rate. That is not what has happened. The result is an economy in the tank that has led to higher unemployment rates. And I will be the first to say that higher unemployment will lead to higher foreclosure rates. In essence we have built a self-fulfilling prophecy.

Leo C
----- Leo,

I understand that a very low percentage of loans are in default, but when you look at the market’s overall decline in value and add to that the leverage that some of the investment banks used it only takes a modest 5-10 percent decline in home values to wipe out all the capital. That is the real problem. There is not a liquidity problem it is a solvency problem. I agree that all the assets do not need to be marked to market because there really is not a market for some of the debt instruments and the majority are performing and can be valued at a discounted cash flow model. But with the securitization of the debt into different levels of risk it is nearly impossible to separate the good loans from the bad. From my experience here in Florida seeing first hand the amount of debt that lenders have on properties purchased between ‘04 and ’08 they are under water anywhere from 25% to 60% in certain areas. This amount of debt really gives no incentive for homeowners to continue paying their mortgage the best option for the lenders is to do an aggressive loan modification which includes principle reductions, which they have not been willing to do it will likely take tax payer money. There is a lot of moral hazard that could be created and could encourage a wave of new problems if not implemented correctly. I am attaching a report that really delves into how everything went wrong and what is happening now, it is a long read but lays it out pretty straightforward. If you are looking for the next shoe to drop I would take a look at what is going on in the credit card business. There models are not prepared for unemployment above 8%. Here is a little excerpt about leverage from the report:

…with Leverage?
How could $1.2 trillion in subprime mortgages outstanding cause such a large global financial disaster? Leverage
is certainly a part of the problem. If banks maintain a leverage ratio of 10:1, only $120 billion of capital can
support $1.2 trillion. With such a small amount supporting such risky loans, a 10 percent decline in the $1.2
trillion of assets could wipe out all of the banks’ capital. Of course, some institutions were more highly leveraged
than 10:1, and in some areas, home prices have fallen much more than 10 percent; so too has the value of the
subprime mortgages. (If the ratio were 30:1, which was the case with some firms, then the supporting capital
for $1.2 trillion would be only $40 billion.) These situations can force some institutions into insolvency if capital
cannot be raised to offset the decline in the value of assets.

THE OBAMA STIMULUS PLAN

2009-02-03T07:33:00.000-08:00

I got an email from a friend asking me what I thought about President Obama's stimulus plan. Here is my reply:

My summary comment on the stimulus plan is that it doesn't matter how you spend it - build bridges, improve classrooms, automate medical reports, put money into research, and so on. The money will be spent and thus enter the economy. I am not very interested in the debate about the "proper" or "best way" to spend it. Tax incentives such as rebates will also induce more spending. I am not so sanguine about giving business tax breaks since, with already holding large inventories, I don't see why any company is going to invest in expanding supply. And we certainly do not need investment in automation to reduce labor costs. But by and large I really don't care how the money is spent, just spend it.

If you read my articles you will see that I have found the financial crisis to be the unnecessary child of panic reactions to a relatively small uptick in the foreclosure rate on mortgages. This rate was just over 1% in 2004. It was just over 2% in 2008. But this caused analysts to devalue all mortgage based securities, as well as mortgages themselves, by up to 90%. "Panic" devaluation of assets worth up to $70 trillion, the estimated $15 trillion in mortgages and bundled mortgages, and the estimated $55 trillion in credit default swaps created to insure these bundled mortgages, blew a big hole in our credit system. All financial institutions saw their balance sheets fall dramatically thereby ruining the whole credit system.

The financial crisis has now infected the whole economic picture with rising unemployment the key issue. Higher unemployment will undoubtedly make the problem much worse, since that affects consumption, that does not require credit. Needless to add, those unemployed will have no chance to get credit.

While I don't really care how the stimulus money is spent, I do not see it as the solution to the basic problem. We have taken maybe $35 trillion off the books and balance sheets of financial institutions and other investors. That is equivalent to twice the 2008 GNP for the whole USA. Uncle Sam has deep pockets but not that deep. He cannot replace this loss.

No, the only way to restore the economy to a sound basis is to give a more accurate value to the mortgage based securities and their further derivatives. To do this we have to suspend the "mark-to-market" rules that call for valuing assets to the "market." At present there is no market for mortgages and mortgage based securities (well there is, but no one knows where it is). Since the actual foreclosure rate is still not high, about 3% now, the actual potential loss on these securities would be just that, 3%. Given this relatively low loss, I say it is proper, indeed vital, to value these assets to their "maturity value" which means a mortgage held for its full period. If we do this we would automatically restore trillions of dollars, maybe $30 trillion, to the economy, instantly. I know that this is dismissed by those who maintain that the market is the only true indicator of an asset's worth, but how do you deal with an asset that has no market?

I am not alone in calling for this remedy. Steve Forbes is perhaps the most visible promoter of chucking out the "mark-to-market" rules.

No matter how the "crisis" plays out, it has produced a major change in the US economy, which has led to what I call , "The New Economy." What I mean is that the crisis has forced Uncle Sam to buy up substantial parts of the private sector - banking, insurance, mortgages and even the auto industry. He is now the single largest shareholder in "Corporate America." Until now the Federal Government has been the largest consumer of the economy, a budget that equals 20% of the whole economy, the central banker and the rules maker for the economy. Now Uncle Sam is the main shareholder. This changes the whole equation.

I have also noted that Uncle Sam has acquired this massive share of the private sector at not cost. Since all investors are shoveling their funds into Treasury Bonds to the point that they go for interest rates less than inflation, i.e. Uncle Sam gets funds to invest at no real cost. We have the absurd situation in which private investors are putting their money into government debt so that the government can buy up the private sector. The ridiculous has become the sublime.

Leo Cecchini
January, 2009

LET ME MAKE IT PERFECTLY CLEAR

2009-01-31T06:17:00.001-08:00

A friend sent me an online video showing how poor regulation of Fannie Mae and Freddie Mac is to blame for our econ mic plight. Here is my reply:

Balderdash! Yes, Fannie Mae and Freddie Mac created the bundled mortgages that we call "securitized debt" or as I call them, "mortgage based assets" but the financial groups on Wall Street raised these to a size that went well beyond what the two quasi-government companies had envisioned. Worse, they did not create a transparent market in which a price could be established for them. So when a small uptick in foreclosures occurred, the analysts panicked because they had no idea how to properly include this in the valuation of the "mortgage based assets." In their panic they valued them to whatever formula they could invent and all the inventions were overblown doomsday scenarios. Net result, an economy in a tailspin.

Get off the fake valuations. A mortgage held to maturity yields a high return. If all defaults end in foreclosures the asset base will only deteriorate by 7%, ditto for current earnings. These fake valuations have devalued these assets by as much as 90%. There can be no recovery until they regain their true value.

Leo Cecchini
January, 2009

THE OBAMA PLAN: WILL IT SAVE THE ECONOMY?

2009-01-28T13:39:00.001-08:00

I watched Steve Forbes being interviewed at the World Economic Forum in Davos, Switzerland. His simple, straightforward cure for the financial crisis is the same that I have been preaching since last summer, suspend the "mark-to-market" accounting rules. I have added that the rules are not being followed anyway. The so-called "toxic assets" or mortgage based assets have no market, thus if mark-to-market rules were strictly followed, they would be marked to zero. But that is not what is being done. They are being marked to notional markets that may or may not reflect the actual value of the asset.

I have called for valuing these assets to their long term or maturity value instead of what they bring at sale in today's market. My reasoning here is that, since you cannot sell it, you continue to hold it. The assets do not vanish.

More importantly, I have noted that the actual default rate on mortgages in 2008 stood at 6% and the foreclosure rate was just over 2%. My argument was that the underlying asset, i.e. the mortgages themselves, were still performing well enough to value them to their maturity value.

The problem lies in the fact that when the holder of the toxic asset devalues it to a non-existing market or a notional market based on fear of massive foreclosures, it sharply reduces its value on the holders books. This leads to not having sufficient reserves to lend or borrow. Thus the failure of our financial sector, the so-called "financial crisis of 2008."

But we are now beyond the "financial" crisis. The crisis has now spilled over into the so-called "real" economy which means actual output of goods and services. In essence we have less credit, thus less demand, thus less production, thus lower employment or higher unemployment. Unemployment is now putting more pressure on ability to pay debts, most importantly mortgages. The default rate has now grown to 7% and the foreclosure rate to 3%.

Much of the debate over the new Obama plan to revive the economy revolves around the proper valuation of the "toxic" assets to be purchased by the Feds and housed in an "Aggregate Bank" (popularly being called the "Bad" Bank). The theory here is if the Feds buy the "toxic" assets they will establish a market for these assets and thus raise their value on the books of those still holding them.

This is good but a bit late. We don't have time to wait for establishing the market. Thus I insist, as does Steve Forbes, that we suspend "mark-to-market" rules. Valuing the assets at their maturity value would reestablish balance to the books of those holding the assets to a level where they can borrow and lend again, immediately.

As for the rest of President Obama's plan, we have let the financial crisis cause so much damage, we need to do more than simply reestablish credit channels. We need to put people back to work and keep the "real" economy moving. The plan will do this, no matter how the funds are spent. Build a bridge, build a road, refit a classroom, improve energy efficiency, spur research. All of these put people back to work and thus provide funds for them to buy and spur production of all goods and services.

Of all of Obama's plan I am most pleased to see the block of funds going to state and local governments to help them out of financial crisis brought about by the other end of the real estate decline, rapidly declining revenues from property taxes. It is no surprise that foreclosures for failure to pay taxes are running more or less the same as foreclosures for failure to pay mortgages. The Fed fund here will more than cover the anticipated shortfalls in state and local government budgets.

Most importantly, no matter how the drama is played out, we have a "New Economy" in which the Federal Government plays a much larger role than before. No longer is it just the main consumer of our output of goods and services, the Federal budget equals 20% of our GNP, or the rules maker and central banker, it has rapidly become the single largest share holder in our private sector - banks, insurance companies, mortgage companies, auto markers and more. Our economy will now be seriously affected by how the Federal Government acts as a share holder, a whole new dimension for government involvement in the economy.

Even more interesting is that the Feds are buying up the private sector with funds borrowed at no cost, i.e. Treasury Bonds or "T-bills" are being sold with interest rates less than the inflation rate. In other words Uncle Sam is buying these assets with today's dollars that he will pay back in the future at devalued dollars. All investors should have this situation.

And if you think the Feds have acquired a massive stake in the private sector so far, what would it be if they take the step being advocated by many to take over all the banks, i.e. "nationalize" the banks? I don't believe we are at that stage yet but who knows?

Leo Cecchini
January, 2009

CORRECTING THE FINANCIAL CRISIS AND THE NEW ECONMOMY

2009-01-21T08:37:00.000-08:00

The battle lines are drawn. The battle is to correct bank balance sheets and thus allow the financial system to return to its normal business of financing our economy. On the one side we find the "mark-to-market" warriors and on the other we find those who share my opinion that the market no longer values assets correctly.

I watched two Republican senators on TV today arguing for using "mark-to-market" rules to make banks immediately take the hit for estimated losses on "toxic assets" and thereby restore confidence in the financial system. I then watched the darling of many economists, Sheila Bair, head of the FDIC, state that the markets are not giving the correct value for assets. She noted that 98% of banks representing 99% of all assets have sound balance sheets. But as we all know, the market for their shares has tumbled. Her call is for us to get "correct values for our assets."

Ms Bair offered two ways to get better valuation for our assets. First, would be for the Feds to use their funds to buy up the so-called "toxic assets," the original idea of the TARP fund. The Feds would also get preferred shares in the financial institutions that sell these toxic assets to the Feds. The result would be what is being called an "aggregate bank." A second option would be to use Fed funds to insure these assets. Either way Bair would see Fed funds stabilizing the market for these assets and thereby establish a "market" to which these assets can be valued correctly.

If you have been following my line you will know that I have consistently stated that the markets are no longer able to give correct value to assets. I have consistently noted that mortgage based assets have seen their values drop by some 30% or more based on fears of rampaging defaults and foreclosures on these mortgages. I have also noted that according to the Mortgage Bankers Association, the only organization that represents a major part of mortgage lending, defaults in payment of mortgages is running at 6-7% and foreclosures are running at just over 2%. I do not believe that these still low rates for defaults and foreclosures merits the massive devaluation of mortgage based assets.

More importantly, I have noted that the devaluation has not been done in strict accordance with "mark-to-market" rules. Since the market for mortgage based assets, the so-called "toxic assets," has dried up all together, i.e. there are no sales, their values should be dropped to zero. But such is not the case, various organizations doing the valuations use varying rules. The CEO of BlackRock, a major source of valuation of these assets, said they use the depressed value of the real estate market in Southern California to devalue mortgage based assets.

While devaluing the mortgage based assets has caused enough of a calamity to those holding these assets, it has spread throughout all assets. Result, the yo-yo process of shares on the major stock exchanges. Worse, it has led to a general loss of confidence in the economy and the resulting fall in consumption, loss of jobs and so on.

There is no debate about the basic problem, we must get the balance sheets of banks and other financial institutions on a sound basis. Getting rid of all toxic assets sounds like a straight forward way to do this. The problem is, at what price do you get rid of the assets? Zero or some fabricated value? Mark them to an assumed market and what is that market? Have the government buy them up or insure them and thereby create a "market" for them? Both sound plausible. But they overlook the real problem, no one knows the full extent of these assets. I have heard estimates for "credit default swaps," the elaborate schemes to insure the mortgage based assets amounting to $55 trillion.

Can we really suffer a 30% devaluation of $55 trillion in assets, or a loss of $16.5 trillion, a sum equal to the GNP of the whole USA? Leaving aside the consideration of credit default swaps, can we really afford a 30% devaluation of an estimated $15 trillion in mortgage based assets?

More sobering, can the Feds really buy up the toxic assets? Lets say the Feds only have to buy 30% of the credit default swaps and/or mortgage based assets. That would mean an expenditure of $5 to $21.5 trillion, far more than the TARP of $700 billion or any other Fed fund suggested.

No, the only way to correct the balance sheets of the banks is to suspend "mark-to-market" rules since they no longer work. Then allow the holders of the assets to value them to their long term values, i.e. the return on the underlying mortgages held to maturity. The only adjustment to this really needed is to deduct a loss due to defaults, 6%, and/or foreclosures, 2%. This would not cost a single penny of public funds. I can already hear the chorus singing, "false valuation." Well we already marking them to a false valuation, a sentiment shared by Sheila Bair. And yes, suspending "mark-to-market" would deter investors from buying the assets. So what, they are not buying them now anyway.

CORRECTING THE FINANCIAL CRISIS AND THE NEW ECONOMY

All of this does not change the tectonic change in the economy I point to as formulating our "New Economy," the Federal Government has become the single largest shareholder in the private economy. We now have Uncle Sam joining the ranks of those investing in the economy itself. This changes the whole structure. We cannot now foresee the full impact of this participation by the Feds in the private sector. Will the Feds lead the economy? Deter its progress? Alter it to serve political ends? All of these are serious questions to consider. We are at the cusp of a new course for the American economy. Truly exciting stuff.

Leo Cecchini
January, 2009

THE NEW PRESIDENT AND THE NEW ECONOMY

2009-01-20T14:50:00.000-08:00

Well President Obama will be coming in at the beginning of what I call the "New Economy" which means an economy in which the Federal Government owns a substantial share of the private sector. If you have been following my articles you will know what he will face. But to refresh your memories and bring on board new readers let us look at the facts and fiction emanating from our economic slump.

HOUSING

1. Fact - over the last decade we have greatly increased home ownership in America, we have brought the "American dream" to more Americans than ever.

2. Fact - Housing prices have risen to levels that exceed income levels, the familiar average home price exceeds the capacity of the average income to afford. Of course this rests on a key assumption, housing costs should not exceed 30% of your income. But then, why 30%? This rests on more assumptions about how one should spend his income. It is not a hard and fast rule. Young ladies spend on average more than 40% of their incomes on clothes and accessories. Perhaps the average home owner can spend more than 30% on his home.

3. Fact - people have been using their homes as "ATMs" to spend beyond their means. Home owners have been borrowing against the equity in their homes to supplement their incomes.

4. Fact - This supplemental income allowed consumers to continue to be the motive force for economic growth.

5. Fact - The decline in housing values has caused this source of supplementalincome to dry up.

MORTGAGES

1. Fiction - subprime mortgages were given to people too poor to buy a home. In fact, these mortgages were given mainly to finance purchases of second and third homes by relatively wealthy middle class investors.

2. Fiction - the foreclosure rate for non payment of mortgages has grown faster than ever. Fact, the foreclosure rate for mortgages, according to the Mortgage Bankers Association, the most authoritative voice for this information, stands at 2% when it was 1% in 2005, well before the financial crisis. Yes, a 100% increase but still small. The foreclosure rate in the Great Depression was 25%. And foreclosures due to non payment of taxes run about the same as for non payment of mortgages.

3. Fact - with default rates on mortgage payments at about 6-7%, mortgages remain a good investment. To illustrate, say you hold mortgages that total $1 million. The average return will be $60,000 a year. With a 6% default rate you will earn only $53,700, not a major loss. Of course you are still at risk for the defaults that could wipe out $60,000 of your investment. But you will continue to earn on the remaining $940,000 investment in mortgages.

4. Fact - mortgages were bundled into bond issues that were sold to investors as "securitized debt" or "collateralized debt" and other terms. I refer to all of these as being "mortgage based securities." No one knows how much of these bonds actually exist, since many were used as collateral on loans taken out to buy more of these bonds. Since no one had a handle on the full extent of this debt come asset structure, the relatively minor increase in mortgage foreclosures was blown out of proportion and caused the value of these bonds to tumble.

5. Fiction - Mortgage based assets must be "marked to market." This is an accounting principle that is used to value your assets. Pretty straight forward, you value the asset at what it will bring in a market, in this case what this bond will bring in the bond market. In the panic caused by the relatively small increase in mortgage foreclosures these assets found their market dry up and no one was buying them, there is no market. If the rule was followed honestly the assets would have to be valued at zero. But such has not been the case, they have been arbitrarily devalued down to the depressed price of real estate in extreme locations, typically 30%.

6. Fact - The false "mark to market" for mortgage based assets caused big losses for almost all major investors. They saw their balance sheets fall 30% or more.

7. Fact - the Feds "TARP" plan of $750 billion has been aimed at correcting the balance sheets damaged by the arbitrary devaluing of the mortgage based assets. But it is rather a small assistance. I have heard estimates of $55 trillion in mortgage based assets and the "debt swaps" taken out to insure these assets. The amount of paper loss is staggering, 30% devaluation of $55 trillion equals $16 trillion in loss. Obviously multibillion dollar injections of capital cannot replace this loss.

8. Fact - suspending the "mark to market" rule for valuing mortgage based assets would allow the holder to value them at their "long term" value, i.e. the payment of the underlying assets, mortgages, over their full term. In other words, we should treat the mortgage based assets as investments to be held, not investments to be sold. This would allow financial institutions to pump up their balance sheets by trillions of dollars, not billions.

"BAIL-OUTS"

1. Fiction - the TARP and other US Government efforts to cure the financial crisis are hand outs to be repaid by the US taxpayer.

2. Fact - the TARP and other US Government funds have been used to acquire a ownership stake for Uncle Sam in several key private sector "industries." Uncle Sam has acquired large stakes in major US banks, an investment that has already grown by 3% in its first month. Uncle Sam now owns the core of our mortgage industry, Fannie Mae and Freddie Mac. Uncle Sam now owns our largest insurance company, AIG. And Uncle Sam has bought part of General Motors and Chrysler. I foresee these investments as paying back more than their cost and thus becoming a major new source of government revenue, which is good, since this will reduce government need to increase taxes.

3. Fact - In my articles on the subject we now have Uncle Sam as a major stake holder in the private sector. He already accounts for expenditures worth 20% of our GNP. He already sets the rules for interstate commerce and taxes on our output. Now he is the single major share holder in the private sector. Several have written about the "New Economy" in terms of moving to a service dominated economy instead of one led by manufacturing. Others have written about the "New Economy" in terms of "globalization." To these we can now add Uncle Sam being the main investor in the economy.

HOW TO SOLVE THE PROBLEM?

1. Fiction - stopping foreclosures and helping people stay in their homes will solve the economic mess.

2. Fact - stopping foreclosures and helping people stay in their homes is a good in itself, but not the cure for the economy.

3. Fact - the only way to revive the economy is to pump up demand.

4. Fact - increased Federal spending will pump up demand.

5. Fiction - Tax cuts for businesses will revive the economy - business has no incentive to spend on increasing or upgrading capacity when there is no demand for its products.

WHAT SHOULD PRESIDENT OBAMA DO?

First, continue to inject Federal funds into the economy either to pump up demand or correct balance sheets of major financial institutions or acquire more shares in the private sector or all three.

Second, take whatever action he can to ease credit. The cost to borrow is low, we need to make loans available.

Third, instead of using Fed funds to assist those with mortgage problems, use them to generate new mortgages. As much as it may sound like heresy, Uncle Sam could use his funds to get Fannie Mae and Freddie Mac back to issuing new mortgages.

Fourth, suspend the "mark to market" accounting rules.

UNCLE SAM FLEXES HIS MUSCLES

2009-01-17T07:47:00.000-08:00

I have reported that the major result of the "Financial Crisis of 2008" is that Uncle Sam has acquired a major stake in the private sector - banks, insurance, mortgages, and autos for starters. Many cry "socialism" and I guess there is a case to be made here. However, since Uncle Sam already has a budget equal to 20% of the GNP and debt of some $11 trillion it is already the 800lb gorilla in the economy. I have also noted that this new stream of government revenue will lessen the need to raise taxes to cover rising expenditures and I welcome it.

There is the concern that Uncle Sam will use his stake in the private sector to further political objectives. I postulate that he will act as any other investor, try to maximize his return, with an added objective, to promote general economic progress. But we already have a case of using his stake to further political aims. The US Senate is looking at the overseas operations of the banks and companies receiving Federal funds under the rubric of "tax havens." The assumption is that, if a company has an operation in certain countries, it is doing so to avoid paying US taxes.

This happens to be an area in which I have considerable experience. During my career in the Foreign Service and subsequently in international business I have come across a wide range of tax issues involving business that transcends national borders. For example, it is common practice for exporters manufacturing in what we call a "cost center" to send its exports through a third country or "profit center" en route to the customer in a second country. You guessed it, the "profit center" is a country with low taxes. Of course the "profit center" may be called a "distribution center."

While taxes may be the reason to funnel international transactions via a low tax country, there are other reasons. Business law may favor doing this as well. Most countries allow "temporary imports" which means a product may be imported and reexported without having to pay import duties. This is the back bone of the widespread practice of adding value to a product in a country to make it eligible for lower tariffs in another country. An example here would be bringing components from one country to another to be assembled into a product going to still another country. The country doing the assembly would have an agreement for lower or no tariffs in the recipient country. I have personally structured such an arrangement for a company.

Another example would be operating in a country that is part of a duty free consortium, e.g. the European Union. General Motors and Ford manufacture their cars for the European market in Europe and thereby avoid the high tariffs imposed on autos coming from non-EU countries.
You get the drift, the global economy is firmly rooted in the concept of companies operating in several countries for various reasons.

The Senate's attempt to examine the overseas operations of US companies receiving Federal funds is an example of the type of political baggage that comes with taking the "king's coin." As Uncle Sam gets deeper into his new role of being the major investor in "Corporate USA" we will no doubt see more politically motivated attempts to alter the course of "globalization." What next, exploring the "outsourcing" practices of companies receiving Fed funds? You betcha.

HOW TO MANAGE IN THE NEW ECONOMY

2009-01-09T13:19:00.000-08:00

WHAT TO DO, WHAT TO DO

We have examined the financial crisis of 2008 and its major effect of forcing a larger role for the Federal Government in the economy. In addition to its traditional roles such as setting monetary and fiscal policies, being the largest single consumer of our economic output, and promoting full employment, the Feds are now the most savvy and single largest investor in the US private sector. I have made my position clear, I like it, since Uncle Sam will now have a new income stream from his investments that will lessen his need to raise taxes.

But how does the individual manage his own economic affairs in this, "New Economy?" Where does a newcomer find a job when the unemployment rate is at a record level? What does a person do with the remnants of his retirement fund? What does he do about his investments in general? What does he do about his home that may be worth less than the debt on it?

EMPLOYMENT

Let's start with employment. I said in an earlier note that the obvious place to look for work is the Federal Government. I have seen reports that incoming President Obama will add vast numbers of new employees to the Federal Roles. Why? Well first we need people to monitor the huge new investment portfolio Uncle Sam has acquired in his effort to stop the financial crisis and get the economy moving North again. As I have mentioned, the Feds have now acquired a major stake in our largest banks, the largest insurance company in the land, the core of our mortgage industry, Fannie Mae and Freddie Mac, and a stake in our auto industry. Someone in the Federal service will have to keep track of these massive new investments. Others will have to lead further Federal expenditure to stimulate the economy.

Where will these jobs be housed? Well the Treasury, the Federal Reserve Bank, the SEC, FDIC, for starters. No doubt we will create new agencies to handle some of the job as well. Who will get the jobs? Well the obvious candidates will be economists, accountants, finance specialists, and business graduates. But he will also need labor specialists and other related skills. I see this being the greatest opportunity for a career in Federal Service since the New Deal came to Washington.

Two other major growth areas for new jobs are health care and education. No matter how badly the economy may fare, there is a major unfulfilled demand for these skills. An interesting facet of this high demand is that the highest demand for new talent in education is in post secondary education, led by the rapidly growing community colleges and less structured schools, e.g. online universities.

Another area of strong skills demand is the law, enforcement and litigation. A related area is security where employment is growing exponentially.

Certainly the other major leg of the "New Economy" - globalization, holds great job opportunities for those with knowledge of other languages and peoples, to how to operate in diverse societies.

INVESTMENT

As bad a rap as investment in real estate has taken, it is still better than investment in equities. The average value of a home has tumbled from its high point in January 2007 to January 2009 by 10-14%. Meanwhile the Dow Jones has lost 23% from its last high in 2006 to January 2009. Moreover, the house still provides that added benefit, shelter, not offered by shares in companies. So, before selling off the homestead, one should take a closer look at the alternatives for his funds.

But what to do with the funds you have in the "market?" Most investment portfolios allot the funds to several classes of investments that hopefully yield a good rate of return and a measure of security. However, the old maxim, the higher the risk, the greater the return may no longer be true. Who would have thought two years ago that that main stable element in ones portfolio, bonds, would be the most dicey proposition now? All bonds have been tainted by the mortgage based bonds that have been blamed for the whole mess.

The only exception to this situation is Federal debt, i.e. Treasury bills. Why? Because holding T-bills is still considered to be the same as "cash" and all advisers are screaming at you to put most of your portfolio in cash.

Where do I suggest you put your investment funds? Easy, follow the money. In this case follow Uncle Sam in his acquisition of private sector assets. My present portfolio consists of shares in the banks where Uncle Sam has taken a stake and, believe it or not, Fannie Mae and Freddie Mac. Through his purchases Uncle Sam is creating a base market for these assets from which they can grow.

There is one other factor to consider. The only way to make money in the financial markets now is to be a "day trader." The market will continue to experience dramatic ups and downs as the overall uncertainty gives rise to all kinds of bets on what will happen. Obviously the only mutual funds to consider are ones that do trade on a daily basis. My suggestion here is to put your funds in an internet trading service, e.g. Scottrade, and manage your account yourself.

RETIREMENT

Well the only safe bet here is to get into Federal Service. Many state and local government retirement schemes have suffered mightily from the financial crisis, needless to add private retirement funds have suffered even more. For most the reality is that you will have to pay more attention yourself to your retirement fund. How to do this? Well see the section on investment above.

HOW ABOUT ME?

Obviously it is impossible to cover every possible personal situation in a general discussion. Thus I will be more than happy to address individual situations and questions either through this column or in private correspondence. Please address your inquiries to leo@cecchini.org

Leo Cecchini

THE SHARPEST INVESTOR - UNCLE SAM

2009-01-08T08:10:00.000-08:00

Amazing, all are concerned about the cost to the tax payer of the massive Fed effort to stop the financial meltdown and revive the economy. And they have reason to be concerned, that effort is not coming out of current income, but out of debt. To make it crystal clear, the Feds are borrowing to finance this deficit spending. And this debt in the form of Treasury Bills (T-bills) is being scooped up like candy by kiddies.

The typical observer would assume that as Federal debt goes up, the cost for the Feds to borrow will increase. You know, the more you are in debt, the riskier additional loans become. But guess what, the cost for the Feds to borrow is currently "zero." Yes, it costs the Feds less than the inflation rate to borrow. When the cost of borrowing is less than the inflation rate, you have to borrow, since you will pay less for the loan in future dollars than the amount you receive now in current dollars. You really do get something for nothing.

Again, the way is works is that Uncle Sam issues bonds, T-bills, that investors buy and treat "as good as cash." He then uses the proceeds for the TARP and other new devices for him to acquire assets. He now owns major stakes in the largest banks, the heart of the mortgage industry, the largest insurance company, and major stakes in two auto makers. BUT MORE IMPORTANTLY, HE IS BUYING THIS STAKE FOR NO COST SINCE HIS BORROWING COSTS LESS THAN THE INFLATION RATE.

Wow, I sure wish I could get money for nothing to build my asset base. Who would turn this down?

Enter the naysayers. They warn that Uncle Sam is running up a monster deficit. Yes, the borrowing is against future income. But if the "zero" interest rate continues, the tax payer will pay less in future dolars, than the cost of financing the deficit in current dollars. The tax payer is getting more for his money than he would normally.

More importantly, the assets Uncle Sam is acquiring have a value. They provide current income and future capital gains. As I mentioned in an earlier note, Uncle Sam has already gained 3.2% on his TARP investment in major banks in one month! And as I also noted, Uncle Sam does not have to pay capital gains tax on future earnings nor any taxes on current income.

I predict that the assets being purchased by the Feds now, will, say over the next decade, pay back more than their present cost. In other words, Uncle Sam will wind up buying assets at no real cost, and these assets will pay off his borrowing to buy them. Who would have thunk that Uncle Sam would be the ace investor on Wall Street?

Leo Cecchini

BUY A HOME

2009-01-07T13:05:00.001-08:00

Well we have all learned that owning a debt as an asset can be a risky proposition. Bonds used to be considered to be safer investments than shares but that is no longer the case. Mortgage based bonds have been the bad boy of investment and have given a bad name to all bonds.

But then all investments are essentially debts. Issuing shares in a company is simply another way to raise capital instead of borrowing directly. The difference is that the "borrower" pays back from profits, rather than from operating income. We own a home, but in most cases that is simply a very large debt. Even a deposit in a bank is used to lend out to others since that is how the bank can pay you interest on the deposit.

We now have the rather absurd situation where the only investment being made by the private sector is in Federal Government debt instruments, i.e. T-bills. And this in turn is being used by the Feds to invest in shares in private companies. The result, Uncle Sam is becoming the largest single share holder in corporate America.

I chuckle at those calling for channeling Fed funding of the banking system to businesses in hopes that this will stimulate the economy. The old supply side argument about prodding the economy through investment. I chuckle because the concept of encouraging business investment, when demand for its output is down, makes no sense. Why build larger capacity when you are operating at low rates of capacity utilization? Witness the auto industry, that has to close plants, not build new ones. Yes, you can make your production more efficient, but to what purpose if no one buys your output?

No, the only way to stimulate the economy is to stimulate consumer demand. To do that we must incur debt. Very few automobiles are sold for cash. Very few vacation trips are paid in cash. Very few homes are sold for cash. Not even such items as large TVs and refrigerators are sold for cash. Yes, health care is paid in cash by insurance companies. But education is paid largely through loans.

So, what should we do? Well in spite of all the ruckus, the best way to stimulate demand is to invest in a home. Yes, invest in that very debt that is blamed for all the mess. But it gives you shelter, as well as an investment, something T-bills or shares in General Electric cannot offer. How to stimulate demand for homes? Yes, direct Federal funds to this activity. Make funds for home buying attractive once more.

Does this sound familiar? You betcha. This is what we have been doing for the last decade. As much as one may lament the property fed boom, it did keep the economy going well. And it is probably the only way to get it cranked up again.

I am not alone in calling for this, the entire "Economic Greek Chorus" is chanting that there will be no recovery until the housing market rebounds. A corollary will be to invest in mortgages, no, not direct purchase of mortgages, but to invest in those granting mortgages, or, dare I say it, mortgage based assets.

Leo Cecchini

GLOBALIZATION

2008-12-26T07:04:00.000-08:00

I share at at least one common experience with all my friends and colleagues in the Peace Corps Community, we have all had active roles in the global economy, some for just that two year period of service, for others, including myself, it has been a lifetime occupation.

As a US Government official I promoted American trade and investment with the world, negotiated and some times even wrote treaties and agreements to facilitate trade and investment, wrote investment climate statements for several countries that provided guidance for American investors, resolved trade disputes, provided US Government financing and other support for major exports, wrote the documents that allowed US banks and insurance companies to operate in other countries, and organized and conducted trade and investment missions and trade shows. I also wrote, negotiated, and implemented instruments to control exports to and imports from other countries, as well as controls over American investments in other countries and their investments in the USA.

In private business I established a new joint venture between an American and foreign firm. I reorganized and got formal operating permission for a new US company in a foreign country. I ran the US operation of a foreign firm. I reorganized a foreign company to outsource production to another country. I had my own company in the USA importing from abroad. I still sell US real estate to foreign buyers. I advise companies on international trade and investment. I have even been perhaps that quintessential operator in the global economy, a foreign currency trader.

No wonder I am a unabashed proponent of globalization and the global economy. It is in my blood. I cannot imagine a world without it and am certain that it is here to stay. I saw this future when I was 18 and am pleased to see that I was on the right track.

Why do I have such commitment to globalization? Beside being inevitable, I see its positive contribution to mankind's progress.I see the global economy as being a means to prevent strife and conflict between countries, if we work together, we are less inclined to wage war on one another. The prime example here is the European Union. This international economic union has served to pacify the region that produced the worse conflicts in mankind's history.

By working together countries achieve better results for themselves. A fundamental principle of the American economy is free competition. It insures the consumer the best product or service at the best price. The principle works on an international scale as well. Free movement of goods and services between countries insures that the consumer gets the best product or service at the best price. If you doubt this, check the origin of the clothes, shoes, watches, and other items worn by those protesting "globalization."

The global economy allows the transfer of resources from the rich to the poor countries. No better example of this than the monumental strides being made by the Chinese economy that is the direct result of greater participation in the global economy. The largest of the poor has pulled itself up the economic ladder, not through receiving large inputs of foreign aid, but by becoming a key player in the global economy. Ditto for India. One can also see this in the massive transfer of wealth allowed by the global economy from rich countries to the oil producing countries. And now that they are rich they are transferring wealth to the poor as well, e.g. the huge army of workers from less wealthy countries earning their livings in these.

Of course we have always had a global economy to some extent. Marco Polo did not visit China for a vacation. He was an international trader and he went to the source of some major trade goods to gain direct and better access to the supply. The Roman Empire lived on grain produced in Egypt.

No, we have always had a global economy. The difference now is that the fulcrum of our economic well being is no longer our domestic economy, but the global economy. It is no longer the icing on the economic cake, it is the cake. No better example of this is that the first step we took to manage our current financial crisis was to coordinate our actions with those of other countries. We have to, since the most flexible and mobile item in international trade is money. It flows like water sloshing from one shore to another.

Yes, the global economy and "globalization" are here to stay and constitute a major aspect of the "New Economy." No longer can government officials take actions and formulate policies that look inward, they must look outward first.

A classic example here is tariffs on imports. Believe it or not until the late 1800s the major source of revenue for the US Government was tariffs on imported goods. I have been in some countries where they charge tariffs on exports, as well as imports. Raising tariffs imposes a barrier on the free flow of goods and services. It prevents the consumer from getting the best product or service at the best price. Reducing or eliminating tariffs allows the free flow of goods and facilitates the consumer getting the best product or service at the best price.

So why have tariffs? First, to raise government revenue. My old tax teacher said there are two elements of a good tax, first it collects sufficient revenue to pay expenses and second it is easy to collect. Tariffs are probably the easiest tax to collect other than fees for government services such as registration of deeds. So they clearly comply with rule two of my tax teacher's maxim. But it is hard for them to provide sufficient revenue since they are applied to a relatively small part of the economy, i.e. imports. Far more revenue comes from a sales tax that is imposed on all goods and services. Tariffs are also used to protect fledgling industry in developing countries. The idea here is to raise the cost of imports to a level where you can make a price competitive product domestically. Obviously this distorts the most efficient use of resources, but it does allow a country to build an industrial base. The usefulness of this practice has occupied centuries of debate so I will let it stand at this simple statement.

Regardless of how you view tariffs, they do constitute a barrier to international trade. The US has several bilateral and multilateral agreements to reduce tariffs and I have worked closely with these. I remember when I returned from Mexico to Washington one of my Foreign Service colleagues working on the Mexican Desk warned me that the then being negotiated NAFTA Agreement was not a done deal and may not be adopted. I replied, "It doesn't matter if the agreement is adopted or not, since it is simply describing history, not setting a new course." By then 9 of the 10 largest Mexican exporters to the USA were US owned companies. Thus bilateral trade would continue to be dominated by US companies.

Now you can rant against bilateral and multilateral trade agreements but to change them simply frustrates the most efficient utilization of resources. More importantly, you make it harder for the consumer to get the best possible product or service at the best price. I am on the side of the consumer.

Along with tariffs there are a whole host of government actions that impinge on the global economy. But I see all of these being swept away by the irresistible demand to get the best possible product or service at the best price. The proof of this reality is that most of those protesting globalization are wearing attire made in China.

Leo Cecchini

SAVE OUR HOMES AND THE NEW ECONOMY

2008-12-23T11:51:00.000-08:00

As you all know I find the concern about foreclosures of mortgages overblown. The actual foreclosure rate for mortgages stands at 2% when it was 1% in 2004 and 2005, before the meltdown in the housing market. Most people are convinced that people will not pay on their mortgages if the house is worth less than the balance due on the loan. But this has not happened in a major way. I insist that the foreclosure rate has not increased to the extent that it should destroy the economy.

No, the actual case is that people have seen their home values decline to the point that they are worth less than the balance on the present loan. Therefore, they are not able to borrow more against their home. Thus they feel more poor and have cut back their consumption.

Regardless of the debate as to the real importance of declining home values and the actual rate of foreclosures, there is a way to make it easier for people to stay in their homes. We hear about auctions of homes with foreclosures due to nonpayment of the mortgages. What about the auctions of homes for nonpayment of taxes? As far as I can determine, the auctions for nonpayment of taxes run about the same rate as those for nonpayment of mortgages. So how to remedy this? Easy, the government simply suspends collection of all or part of taxes on the homes. This would make it easier for people to stay in their homes. And this is a direct action, instead of government lending to banks in the hope that the banks will lower interest rates on mortgages and thereby help people stay in their homes.

What's that, the property taxes are local taxes so I am asking local governments to rekindle the economy. Well Uncle Sam has a fund to use to encourage banks to lend more money to home buyers. Why not use that fund to compensate local governments for the loss of property taxes? It could be done the same way as with the banks, the Feds lend the local government money.

Now I hear lots of people say that those who lose their homes because of mortgage problems should not have bought the homes in the first place, they had no right to buy the home. So what about those who lose their home for failure to pay taxes? I guess they should never have bought the home since they cannot afford the taxes.

Local governments already reduce taxes for some home owners. Florida just adopted a law to reduce property taxes for many more home owners. Two comments here, first this has not reduced the rate of foreclosures due to nonpayment of taxes and it is unfair to those who must pay the taxes in full. Yes, I am familiar with the arguments for these lower taxes, but they do not reduce the rate of foreclosures due to nonpayment of taxes and they remain inherently unfair.

So how do I see the situation? Focusing on keeping people in their homes misses the point. The foreclosure rate is still relatively low. Curing this problem will not solve the overall economic slump. It will only allow people to stay in their homes, a good in itself, but not the solution to our economic problems.

As any good economist will tell you, the answer lies in pumping up demand. No demand, no production, no economy, which was my first lesson. Now one way to do this is for Uncle Sam to spend more, which he is doing and will continue to do. Another would be to have home prices increase, thereby increasing the ability of homeowners to borrow, as they have been doing in spades over the last decade. This also makes the home owner "feel more wealthy" and thus able to consume more. I guess the real debate should be over if we should stimulate the economy with public or private expenditure.

This then becomes the old debate about consumption. I come from the proposition that we cannot consume too much. I do not get into the debate about what is a "proper" rate of consumption since that has to do with value judgments, not economics. In fact my definition of economics is, "to satisfy the perceived needs of the people." The key word here is "perceived." I do not question the validity of the need, leaving this to my Neo-Calvinist friends.

I answer any discussion of what constitutes the "proper" level of consumption with Leo's "Magic Number," 2222. Now what does that mean? The human body survives on 2000 calories a day, 200 centiliters of water, and an ambient temperature of 22 degrees Celsius. Less than this and the corpus soon expires. Now we can get to the 22 degrees with clothing or shelter or heat, but below that temperature one expires in a matter of hours. My point is that anything over my number 2222 can be called excessive consumption.

Regardless of what constitutes the proper level of consumption,we need to pump up demand right now to revive the economy.

Leo Cecchini

WE'RE IN THE MONEY

2008-12-18T08:05:00.000-08:00

In my last blog I said Uncle Sam is now borrowing funds, i.e. selling Treasury Bonds (T-Bills), that pay "zero" or "negative" interest which means interest rates that are less than the inflation rate. He is using this "free" money to buy private sector assets. One example has been using the "TARP" fund to buy a large stake in major banks. Well that initial $250 billion buy has already delivered a gain for Uncle Sam. It is calculated that his stake in the banks has yielded a 3.2% gain in one month! Any investment adviser would be overjoyed to see his client's portfolio do so well.

And just think, Uncle Sam should wind up with maybe $3 trillion worth of assets. Now not all will pay as well as the bank shares, but we can expect an average rate of return of at least 5% per year (a truly modest estimate since he already earned 3.2% on the bank buy in one month). That would mean $150 billion a year, a good new revenue stream for Uncle Sam.

Even more stunning to contemplate is the fact that, when Uncle Sam sells these assets for a profit, he will not have to pay capital gains tax. For that matter, he will not pay one nickel in tax on any of his earnings.

As far as I am concerned I would applaud Uncle Sam buying as much of private sector assets as he can. It simply means that he will have less need to tax me. Think of the Vatican that earns more from its assets than from donations.

We are truly on the cusp of a dramatically "new" economy.

Leo Cecchini

UNCLE SAM AND THE NEW ECONOMY

2008-12-12T06:23:00.000-08:00

Events dictate that I rearrange my series schedule. Instead of discussing the role of "globalization" in the "New Economy," I will talk now about the effect of the growing role of government as the major stake holder in the private sector.

We are now on the verge of Uncle Sam moving from acquiring banks and other financial institutions, to acquiring manufacturing assets. The Senators who voted against the rescue for Motor City's motor makers did have an excellent point, they insisted that, for the companies to be competitive, they had to pay wages on the same scale as their hot competitors, i.e. Honda, Toyota, Nissan and BMW, PAY IN IN THEIR US FACTORIES. Anyone who wanted to understand whey the "foreign" makers were doing better simply had to look at the difference in wages they paid to their American workers and the wages paid by Detroit. By the way, weren't all those jobs in Honda America "outsourced" from Japan?

No matter, Uncle Sam with its massive influx of funds from T-Bills has enough dough to buy up General Motors. I guess that will give real meaning to that old line, "What's good for General Motors, is good for the USA." The main debate will be how the Feds deal with restructuring the auto makers after it becomes a major, if not the principal, owner of the companies. Then we will see our law makers duking it out over how a "publicly owned" business treats its work force. I believe this was the major hurdle Renault had to overcome to survive in the auto business, definitely a potential dilemma for incoming President Obama.

Funny, the Senators who voted against the auto rescue plan for fear of growing government control of the private sector, have acted to insure that this will happen in a more direct way. Instead of being a lender to the industry, Uncle Sam will be an owner. Talk about unintended results.

Now let's review the situation. The "Financial Crisis of 2008" - too early to call it "Great" - has allowed Uncle Sam to acquire a massive stake in our financial industry. He has acquired large stakes in the major banks and sundry financial groups, the largest insurance company, and the heart of our mortgage industry. Enter becoming the major owner of the very symbol of America's industrial might, the auto industry. And right around the corner lurk the aviation industry, energy, and health care. Who knows, maybe his future acquisitions will be Microsoft and Google? Well the Feds did create the Internet so this would not be Terra Incognita for them.

Now as you all know I am a solid Republican and avowed opponent of higher taxes. But then I fed too long at the public trough to fear "intrusive or insidious" spread of government in the private sector. We already learned a great lesson in the
1990's when the Republican Congress stopped Federal government spending - we all feed at the public trough, some of us are just closer to it. That short suspension of spending sent the economy into a tailspin. Republican legislators quickly learned that being against the government's growing influence in our economy was akin to being against motherhood.

I take a fundamentally different stance on government's growing ownership of the private sector. Rather than seeing it as a threat, as an opponent of higher taxes, I see this as the perfect solution to expected budget deficits. Instead of having to raise taxes, Uncle Sam will be able to pay for future spending increases out of his earnings on his investment portfolio.

You will remember that President Bush tried to move the Social Security System to a more fiscally responsible operation by allowing payees to invest part of their payroll taxes in the private sector. He was defeated by those crying out against breaking into the "Locked Box," led by Al Gore. Not to spend too much time on it, but you have to understand that, by law, all surplus Social Security funds, i.e. funds collected, but not required for current expenditures, may only be invested in US Treasury Bonds, i.e. Federal debt. This is usually described as using payroll taxes to fund current expenditures, but this is actually done by issuing bonds to Social Security, i.e. borrowing from Social Security. As an aside, I say to all those who lament our growing federal debt, that they should applaud that debt, since without it, there would be no place to invest surplus Social Security funds.

The problem with investing Social Security funds only in federal debt is that this yields relatively low earnings, since the bonds yield low returns - in fact, at the present they pay zero or negative interest. Those arguing for allowing payroll taxes to be also invested in the private sector simply wanted to make the fund operate like any other retirement system, i.e. have a balanced portfolio of investments that offers a higher, yet still conservative, rate of return. This higher rate of return would have allowed the Social Security System to continue to meet increasing expenses without raising the payroll tax.

Well "privatizing" Social Security didn't work. So what we could not do by formal plan, may be achieved by a circuitous route. As it acquires its massive pile of private sector assets Uncle Sam will have a major new income stream, i.e. earnings on those assets,. These new earnings will allow him to cover future increases in Social Security payments, as well as Medicare and Medicaid and other government expenses. For an old tax opponent like me this is great news.

Of course there remains the question of how the Feds will use their new control over private business? We have plenty of examples of poorly run state enterprises to cause concern. To be more specific, how will an auto industry, whose largest share holder is Uncle Sam, respond to labor demands? On the one side he will have to placate workers, who are voters, on the other side he will have to preserve his earnings as an investor that he will need to pay for public expenditures. I see a whole new branch of economics coming into fashion, "Government Management of the Economy" or perhaps, "Public Private Policy?"

Since I take great pleasure in seeing perverse humor, I smile when I contemplate Marx teaching Adam Smith and vice versa.

Leo Cecchini

THE SERVICE SECTOR

2008-12-10T09:29:00.000-08:00

Well the debate is over, while the slaves to market valuation of mortgage based assets continue to seek an uptick in the property market to save the economy, the march of history goes on in another direction, i.e. US Government gaining the largest single stake in the private sector. This will be a principle feature of the "New Economy" and certainly the most controversial. The debate here will range from the philosophical to the ridiculous to the sublime.

The market slaves still don't get it, the market, meaning the financial markets, with the New York Stock Exchange being the most visible, have failed to correctly value our assets. They have got it so bad everyone has given up buying equity and loans (bonds) and is shoveling his funds into US Government debt, i.e. Treasury bonds or "T bills." This tectonic shift has led to the ridiculous situation where the Feds are borrowing at zero or even negative interest, i.e. it costs the Feds nothing to borrow. Now I don't know about you but, if I am offered money for no cost, I will take it. And so will Uncle Sam.

Uncle Sam is using this money to acquire the largest single stake in the private sector. It is buying into banks, mortgage companies,insurance firms, and the auto industry. And it is doing this on borrowed funds.

One could call this "backing into socialism." Many cry that US Government ownership will ruin private business. I reply that Uncle Sam is merely becoming the largest share holder in the economy and will act as any other investor whose interest is making a return on his investment. Even more important, as profits from its investment portfolio grow, the government will have to rely less on taxes to pay its bills.

Although I do not foresee government taking an active role in running the businesses it acquires, as a long time government minion who subsequently entered private business by making a new business venture succeed beyond the owners wildest dreams, I would say government types can be good business managers.

But before looking at how this ownership transfer will affect the "New Economy" we should look at two other features that initiated the talk about the "New Economy" earlier, the so-called "post industrial economy" and "globalization."

Post Industrial Economy

In 1982 I gave a speech in Helsinki, Finland to a large audience of businessmen and related government entities. In the speech I made two predictions. First, that the US economy would recover from the slump it was in then, in 1983. I said that not many would see this coming but those who did would make big gains. What's that, did I take advantage of it? You betcha. I traded my house in Mallorca, Spain for a much larger one at a rock bottom price (sounds like today) in 1982 because I knew it was the time to act. Was I right, well read the history books, economic recovery began in November, 1982. How could the recovery be so precisely defined? Easy, that was when then Federal Reserve Bank Chairman Volcker dropped the Fed interest rates.

My second,and more profound, prediction in that speech was that there had been a major change in our economy. I noted that the main motor (yes, pun intended) for our economy in the 20Th Century had been transportation, with the automobile leading the way and aviation not far behind. In short the major stimulus to the economy was to transport the corpus from one place to another. Visible evidence of this was the fact that the largest corporations in America were auto makers and the ones supplying fuel for those cars.

But I predicted that we were on the cusp of a major change, and that in the balance of the 20Th Century and well into the next, the economy would be led by communications. Moving the corpus would be replaced by communicating ideas and information.

Now many argue that this transfiguration has been to an economy based on the computer, e.g. the "IT" or Information Technology" Age. I do not deny the importance of computers to all aspects of life, e.g. they run our cars, they run our assembly lines,they allow us to explore the frontiers of medicine, and so on. But then which is the more important invention, the computer or the internet?

And when I say communication I mean it in a broad context, the composer communicating with the listener, the author communicating with his reader, the entertainer communicating with his audience, the politician communicating with voters and so on. Moving the corpus has been replaced by moving information, ideas, concepts, wishes, desires, hopes, aspirations, joys, sorrows, and more, as the main motive force in the economy.

My prediction did not fall on deaf ears, present in my Finnish audience was a contingent from Nokia, which subsequently became the largest maker of cell phones in the world. No, I did not provide them direction, I merely confirmed what they had also already seen.

The importance of this lesson? A couple of decades back or thereabouts economists began to correctly understand that the US economy had changed in basic structure. No longer was the manufacturing sector the dominant motive force of the economy as agriculture had been until the beginning of the 20Th Century. The easiest why to see this was employment. Believe it or not, agriculture had been the largest employer until the beginning of the 20Th Century when workers began to leave the farms to work in factories in massive numbers. I really don't remember the exact numbers but I recall that in 1899 over half the workforce was in agriculture and by 1930 or so the number fell to less than 5% of the work force. Maybe I have compressed the time frame, but that was the massive shift that changed the face of our economy.

Manufacturing became the primary motor of the US economy. However, employment in manufacturing never exceeded 25% of our work force. During the course of the century employment in manufacturing fell to about 16% of the work force and has held steady there.

Enter the "post industrial economy" which is what many mean when they talk about the dramatic shift to that amorphous term the "service sector" as being the main economic activity. I call the term amorphous since the immediate image of the service sector is that of someone "flipping hamburgers at McDonalds." I would contend that the short order cook is actually in manufacturing, since he turns raw materials into a finished product.

How ever you define it, the service sector accounts for 80% of our work force. It is the dominant actor in our economy. As I have presented above, a leading service sector activity is communications. There are others with similar great growth expectations. Health care now accounts for about 20% of all consumption, more than food or shelter. And it will continue to grow exponentially as our population ages. Education is also growing rapidly, as we come to realize that this is a continuing requirement, and not something confined to a fixed period of our lives. We enjoy more leisure, so activities catering to this will continue to grow rapidly -travel, entertainment, sports, and so on. And, of course, perhaps the ultimate service activity, the government. The Federal Government budget is now equal to 20% of our national economy and managing this spending requires a vast army of workers. Its requirements for staff will grow even more with its new role of being the major share holder of "Corporate America."

The service sector is a major pillar of the "New Economy." Next we will look at the second pillar, "Globalization." Then we will see how this latest development, government acquisition of the private sector, will help formulate the "New Economy."

Leo Cecchini

IF YOU CAN'T BEAT "MARK TO MARKET," USE IT

2008-12-04T06:43:00.000-08:00

Treasury Secretary Paulson in speaking about a new program for the Feds to underwrite mortgages in an attempt to revive property sales, said, "Recovery in the housing market is key to solving the financial crisis. Such a rebound would restore confidence in the banking system and support the value of troubled assets backed by mortgages." At last, the point I have been making is out in front of the entire public, mortgage based assets are being valued at the depressed prices of the housing market, which is an error. They should be valued at their long term or maturity value.

Paulson understands the accounting error being made, but instead of calling for these assets to be priced at their long term or maturity value, he seeks to raise the value of the property market and thereby raise the value of mortgage based assets, what he calls"troubled" assets. In other words, "If you cannot correct the error, use it to your advantage."

I would still prefer marking these assets to their long term value, which would not cost a penny of public funds. But Paulson's program has added benefit, not only will it raise the value of the property market, and thereby allow the mortgage based assets to be raised in value, it will also induce home sales, which, as a realtor I applaud. Increased home sales will also counter the rise in unemployment, generate increased demand for attendant goods and services, and, in the process, push the economy to better performance.

And this is a proven formula. The economic doldrums of the late1970s to early 1980s was cured when then Fed Reserve Chairman Paul Volcker dropped the Fed funds interest rates and by doing so caused a boom in home sales. The proof that this happened - in 1982 we had 1 million new home starts, in 1983, after the decrease in the Fed lending rate, we had 1.8 million new home starts. Not hard to see what drove the recovery in our economy.

I am thinking of establishing a new school of economics, "property economics." No, not a school to teach the micro-economics of buying and selling property, but a macro-economic investigation of how the property market affects the national economy.

Leo Cecchini

THE NEW ECONOMY

2008-12-03T09:10:00.000-08:00

The New Economy

I watched closely a TV program with two analysts verbally slugging it out about the "mark-to-market" controversy which I have been repeatedly calling the accounting practice that has made us commit economic hara kiri. Fortunately the two were on split screens so they were not able to actually trade blows. The pro-mark-to-market man argued that the mortgage based assets, which remain at the core of our economic plight, have no value,since no one is trading them. The anti-mark-to-market man said that these assets have value since they continue to pay income because an overwhelming majority of mortgages are being paid on time, about 94% according to the Mortgage Bankers Association.

So what is the truth? Let us look at the "pro" side. The argument here is that these assets must be marked to a non-existent market. If this is the case they should be marked to zero. However, as we have seen, no one is marking to zero. Rather they are marking to notional markets. I believe they are marking to the depressed property market, a belief confirmed by one large investment firm, Black Rock, that stated it is marking to the depressed property market in Southern California. My belief is also supported by the fact that all commentators agree that the economy will not recover until the housing market turns upwards. The theory here is that as property values increase, the value of mortgage based assets, now valued to the property market, will go up and thereby improve the balance sheets of those holding these assets. Therein lies the contradiction of those insisting on "mark-to-market," there really is no value, since there is no market, i.e. there are no sales, but they say the value will increase if the housing market recovers, which may or may not induce sales of mortgage based assets. As I have been saying this is sheer nonsense, a point made by the anti-mark-to-market man.

The "anti" man said that the mortgage based assets still pay their expected return since most mortgages are being repaid. To illustrate, say we hold mortgage based assets with a face value of $10 million. At an average 6.5% mortgage interest we will collect $650,000 per year in income from these assets. At today's default rate of about 6.5% this income would be reduced by $42,250 leaving us with $607,750, not what I would call a serious hit and certainly not a cause for"panic" selling.

Let's use another analogy to see how this works. Say you have a trust fund set up by your rich uncle Harry. The fund pays you a certain amount each year but you cannot draw more from the fund nor may you sell it. What is the value of the fund? Clearly it is the income stream it provides to you. Valuing the fund to a "market" would be sheer folly since it may not be sold.

So what is happening now? The Feds are buying Fannie Mae funds and mortgages and perhaps other mortgage based assets, investing in banks, lendingto banks, and planning to guarantee mortgages. All of this serves to improve lenders balance sheets and allow them to once more extend credit. The Feds are using procedures that cater to the "mark-to-market" crowd by creating a market, Fed purchases, for mortgages and mortgage based assets. But the reason they are doing so is that they recognize the argument of the "anti-mark-to-market" side, the assets actuallyhave a good value.

Where does all this lead? As I have stated, the Feds are borrowing (T Bills) at all time low rates, 2-3%. They are buying assets that pay far higher returns, e.g. mortgages that pay an average 6-7%. They are lending at 5%+ interest rates. They are buying shares in major banks that could double in vlaue or more when the economy recovers. In short, the Feds are taking a position in the markets that gives very attractive current returns and incredible future earnings. Enter the "New Economy."

And what do I mean by the "New Economy?" Well we will have one in which the Federal Government will be a co-owner with private investors of our economy. Is this bad? Many cry, "socialism." But the reality will be that the organization that makes the rules will be the main player. Do I expect the rules to reflect this stake in the "game," you betcha. We will have a Federal Government that will be more business friendly since it will be the major benefactor of friendly behavior. The other major result is that with this new source of revenue, i.e. income from business ownership, the Feds will have less need to raise taxes, a distinct plus for the incoming Obama administration and its plans to cut taxes for the middle class, invest heavily in infrastructure to put people to work, and address the health care problem.

Now before you start crying that government ownership will lead to ruinous management of the businesses, remember, the Feds are not taking over management control, they are simply being investors. There is no reason to believe that the Feds will act differently from private investors. I would also point to the experience of Finland. In Finland the government owns several of its key industries and they work very well. While the Finnish government owns the businesses, they operate them as an investor seeking to maximize profits.

Fascinating.