Wednesday, April 28, 2010

Is Our Own Debt Crisis Just Around the Corner?

As debt contagion sweeps across Europe, we might consider our own perilous situation. Unfunded pension plans are overwhelming states, and threatening our own crisis. We posted an important article today called "We Can No Longer Afford to Retire", which highlights the damage inflicted on retirement accounts: read here.

An estimated 78 million baby boomers will begin turning 65 in 2011, creating further pressure on the already over-burdened Social Security system. Two years ago, the federal government estimated that by 2017 Social Security would be paying out in benefits more than it was taking in. Four years ago the estimate had been 2019. It is now expected that more money will be paid out this year than the System will collect.

The scale is much larger than publicly perceived:

In an April 27th survey, Putnam Investments of Boston revealed that 40 percent fewer Americans expect to fully fund their IRAs this year than last year, and that “62 percent (believe) their savings are unlikely to provide them with a sizeable retirement nest egg”. With total retirement assets in the U.S. at about $18 trillion, that works out to around $175,000 per worker—nowhere near what will be required... Two years ago, Roger Lowenstein suggested in his book While America Ages that total cumulative retirement deficits are approaching one trillion dollars. A recent study by the Stanford Institute for Economic Policy Research would indicate that Lowenstein's number is too low. The Stanford study reviewed the unfunded liability for California ’s three largest pension funds—CalPERS, CalSTRS and the University of California ’s Retirement System—and determined that those three funds alone were underfunded by more than $500 billion

Our economic shift from consumption to savings is not just a response to a biting recession, but a generational turning point, where suddenly we cannot afford our own retirement, and the deficit is so great that the fix can be nothing less than a dramatic and lasting change to how we live our lives.

Tuesday, April 20, 2010

The Age of New Finance Comes Crashing Down

September 2008 changed everything. Or did it?

By month's end, Lehman had filed for bankruptcy, Merrill Lynch had sold itself, AIG was a ward of the state, and Morgan Stanley and Goldman Sachs were bank holding companies. By year's end, the government would invest directly in over 600 banks.

Credit flows, moreover, had dried up, paralyzing business activity across Main Street. Free market evangelists were crying 'Uncle', and dashing for cover under taxpayer money.

Presidential candidate Barack Obama campaigned—and won—on a platform of ending eight years of "extreme Republicanism". His stimulus bill would formally repudiate the doctrine of laissez-faire, and shift the country's economic alignment away from Friedman back to Keynes.

In his new book, "The End of Wall Street", Roger Lowenstein delivers an insider's view of the people both aggravating and abating the mortgage crisis that nearly bankrupted all of Wall Street's biggest firms.

It originates, he notes, in government overreach.

Most of the booms of recent decades were financed by private sector companies such as technology promoters, or Wall Street banks, or oil drillers. The U.S. housing boom of the early twenty-first century was different, thanks to its intimate relationship with the U.S. government... And though other industries—defense contractors, say, or public transportation—also depended on government, only in housing did the government so greatly disturb the natural supply and demand.

The subprime explosion could not have expanded as it did without Fannie Mae and Freddie Mac executing congressional mandates for affordable housing.

But while government ignited the flame, Wall Street poured on the gasoline. Financial engineers devised complex securities that, instead of shielding against risk, allowed it become an inferno.

What truly failed was the postindustrial model of capitalism. The market's tools for measuring risk simply did not work. And the most sophisticated minds on Wall Street proved no wiser than country loan officers.

Working from over one hundred interviews, Lowenstein adds personal dimensions to his narrative that help us understand how and why key players acted as they did. Most striking, perhaps, is his portrayal of Treasury Secretary Hank Paulson, whose take-charge style both aided and hindered the abatement process: why, for example, he chose to save Morgan Stanley and Goldman Sachs, but allowed Lehman to fail.

We view Paulson's transformation from free-market advocate to full-on interventionist, almost as if we were with him real-time.

Other actors that Lowenstein brings to life include the embattled Lehmen CEO, Dick Fuld; the soft-spoken Ben Bernanke; the prescient boss of JP Morgan, Jamie Dimon; and the disastrously disconnected Citibank bosses, Chuck Prince and Robert Rubin.

We learn that Stanley O'Neal spent nearly as much time on the golf course alone as he did in Merrill's CEO office, that Vikram Pandit would order a $350 bottle of wine for one glass because nothing else on the menu was sufficient, and that Joseph Cassano, head of AIG's Financial Products division, was able to walk away with his $34 million bonus and a $1 million per month consulting contract, in addition to the $280 million he had already earned.

Throughout, Lowenstein juxtaposes the chaos among Wall Street bosses and government officials with the lucid insight of Robert Rodriquez, CEO of First Pacific Advisors. Rodriquez had it right all along, and the track record to prove it. The core issue of the crisis was not liquidity. It was capital. For the system to survive, it would have to recapitalize, and, if private markets could not do it, then government would need to inject taxpayer dollars.

Has Wall Street changed, as Lowenstein argues? And is Friedmanesque capitalism done with?

Well, no. Still scorched by dramatic investment losses, no one's likely to play the leverage game anytime soon. And even when a new leadership generation emerges less fearful of debt's damaging flames, new rules will prevent the big banks from revisiting 30:1—or event 20:1—leverage ratios. (A new generation on Wall Street can come every few years, about as long as it takes a board to replace a CEO after some bad turn.)

Cheap financing and too-big-to-fail resuscitated Wall Street in 2009. If anything, capital is now more concentrated in fewer players, which means that even at lower leverage the scale would still be dangerously tipped.

All big firms are still publicly traded entities. Restricted stock notwithstanding, employees and shareholders, as before, are competing for different goals. Until each employee can be made to feel he is contributing directly to the firm's bottom-line, each person will seek entitlement, demanding what he believes he is owed. A partnership model would go a long way toward reversing this.

While Paulson and company may have been late to recognize the problem, that's just the way it is: regulators are nearly always one step behind. It would be naive to assume otherwise, unless regulation is so draconian that it chokes capital flow altogether.

For the electorate, the choice between Keynes and Friedman might belong to back-page academics, but the notion that big is bad is a top-line concern. Despite mounting economic recovery, confidence in government doing the right thing is slipping. For many, the big Wall Street firms are as soiled as Congress itself, and the two are now inextricably connected.

Friedman espoused a limited role for government, and a belief that free markets are the best route to more wealth for all. As with today's electorate, he likely would have scorned government overreach, both in abating and facilitating the crisis.

The point isn't that Friedmanesque capitalism failed or is over. Policy, these past ten years, morphed it into something else. Had capital truly become democratized, and not settled among massive institutions, the crisis may never have reached the point it did.

If the electorate continues its swing away from big government, and by association big banks, Friedman's revival could become a distinct, near-term possibility.