The House of Representatives is set to vote today on a measure that would effectively tax MORE than 100% of some Americans’ income.  In an attempt to placate the public’s wrath over bonuses paid to employees at AIG and other TARP recipients, Congress will seek to cut off bankers’ noses to spite America’s face.

As we examine this issue, let’s keep in mind that at many companies, particularly on Wall Street, the term “bonus” is nearly interchangeable with the term “compensation.”  The difference is just semantics.  The rationale for paying the bonus is to have a carrot for employees to strive for during the year (over which time these employees receive comparably less in the form of a salary, or draw).  No performance, no carrot.  While it’s certainly true that some bonuses have been paid for subpar performance, the overwhelming majority are paid as the result of success.

Paying a higher salary and lower (or zero) bonus removes the incentive to perform and increases risk to shareholders, including (now) the government.  The less profitable a given company, the less likely the government is to continue receiving its preferred stock dividend, via the TARP program, and ultimately the return of its original investment.  (Recall that many of these firms were forced, essentially at gun point, to take these government funds whether they wanted them or not — the strings were attached later).

While it is clearly Congress’s intent to strip TARP firm employees of any “excessive” compensation, the effort is misguided.  The vast majority of these “bonus” recipients have generated profits for their respective firms, often far outweighing the losses of their colleagues that Congress is endeavoring to punish.  To paint them all with the same broad brush does a great disservice to the good performing employees as well as to the Treasury’s collective wallet.

Let’s look at this from another angle.  Take General Motors.  Here is a company that has lost tens of billions of dollars, not for one quarter or one year, but year after year after year.  This company has also received billions of dollars of taxpayer money — money that GM was NOT forced to take, unlike the situation at many banks.

Would it be just as fair for Congress to enact legislation confiscating taxing 90-100% of the wages of UAW workers because the company for which they work was (is) a financial disaster?  Similarly, how about the workers at GM subsidiaries such as OnStar?  Many of these employees (one of which is a close friend of The Lamb) received bonuses for contributing to OnStar’s success despite the fact that GM was hemorrhaging money like a broken Vegas slot machine.  If these employees can escape the Congressional tax assessor, why should bank employees whose units were profitable labor under an exorbitant tax regime?

The illustrious Charlie Rangel, Chairman of the House Ways and Means Committee that is shepherding the bill, in explaining how he arrived at the 90% federal tax rate for TARP bonuses, explained, “we figure the local and state governments will take care of the other 10 percent.”

This reminds The Lamb of (in)famous Ohio State football coach Woody Hayes.  Leading archrival Michigan (Go Blue!) 42-14 late in their annual football death match in 1968, the Buckeyes scored a meaningless touchdown to go up 48-14.  Rather than kick the extra point, Hayes elected to attempt a two-point conversion in order to hang half a hundred on The Lamb’s alma mater.  The attempt was good and tOSU won 50-14.

After the game, a reporter asked Hayes why he had decided to go for two.  The old coach growled, “Because they wouldn’t let me go for three.”

In their vindictive attempt to punish successful employees for the failures of a minor few, Congressman Rangel and his legislative cohorts are demonstrating a poorer sense of fair play than Coach Hayes did over 40 years ago.  If they succeed, The Lamb is one alumnus who won’t be singing Hail to the Victors.

More than 200 years ago, a French Canadian named Julien Dubuque became the first white man to settle in what would later become the state of Iowa.  At that time, the area was inhabited by the Mesquakie Indian tribe and the main industry was the mining of lead.  Though not the first miner in the area, and certainly not one of the indiginous people, Dubuque was nevertheless one of the more productive miners in the area.

Fortunately for Messier Dubuque, national origin was not a qualification for working with the Mesquakie.  Fast forward a few hundred years.  Enter Senator Chuck Grassley.  The honorable gentleman from Iowa has introduced legislation that prohibits American companies from “replacing laid off American workers with foreign workers.”

Of what long-term remunerative benefit is this to the American or global economy?  Shouldn’t job openings go to the most qualified applicant (acknowledging, of course, that “qualified” includes valid H-1B visas, etc.)?  Augmenting the quality of a company’s workforce increases productivity and profitability, generating greater tax revenue for the government (while lowering the tax burden for others) and maximizing value for shareholders.

Furthermore, according to Jeff Segal of breakingnews.com, “many visa holders eventually settle permanently in the U.S., make money and pay lots of taxes.”  Why discourage that?

In a weak economy, especially, the government should take actions to ease, not restrict, the employment of the best and brightest minds from working in the United States.  They should resist temptations to practice discrimination which would keep both innovation and productivity from an American economy when it most needs it.  Hindering competition will simultaneously lower the quality of work while raising its cost for producers — a cost which is inevitably passed on to consumers in the form of higher prices and lower quality goods.

But what of the argument that foreign workers are simply providing the innovation/productivity that would otherwise have been produced by domestic wage earners, and thus “steals their jobs and compensation?”  This week’s Economist, citing a study by Harvard economist William Kerr and University of Michigan (Go Blue!) economist William Lincoln, argues that access to employment of foreign workers actually has synergistic effects on domestic innovation:

When the federal government increased the number of people allowed in under the programme by 10%, total patenting increased by around 2% in the short run. This was driven mainly by more patenting by immigrant scientists. But even patenting by native scientists increased slightly, rather than decreasing as proponents of crowding out would have predicted. If anything, immigrants seemed to “crowd in” native innovation, perhaps because ideas feed off each other. Economists think of knowledge, unlike physical goods, as “non-rival”: use by one person does not necessarily preclude use by others.

Senator Grassley’s legislation is frighteningly reminiscent of the infamous 1930 Smoot-Hawley Tariff Act, but with a side order of xenophobia.  Smoot-Hawley greatly exacerbated the country’s economic recession by restricting the international flow of goods via record tariffs, decreasing imports and exports by over 50%, and contributing to the decade-long Great Depression.

The dangers of protectionism, both economic and social, are risks the country can ill-afford.  While prejudice against foreign workers and foreign goods might serve political expediency, it is a short-sighted and ineffective solution to economic trials, even if it does garner a few extra votes in Dubuque, Iowa for Mr. Grassley.

"Speak American, son."

Over fifty years have passed since Ayn Rand penned her classic criticism of government interference in economic matters,  Atlas Shrugged.  For those unfamiliar with this seminal work, it illustrates how government’s proliferation of myriad programs and regulations sabotages the creativity and production of the very economic well-being it desires to improve.

Friday, Congress ratified, and the President is about to sign, the $787 billion economic stimulus bill.  Concealed in the bowels of this 1,000+ pages of legislation is a restriction on executive compensation — thank you, Senator Christopher Dodd of Connecticut.  Proudly announcing his vanquishing of Wall Street gluttony, Dodd crowed:

“The decisions of certain Wall Street executives to enrich themselves at the expense of taxpayers have seriously undermined public confidence in efforts to stabilize the economy.  These tough new rules will help ensure that taxpayer dollars no longer effectively subsidize lavish Wall Street bonuses.”

While at first blush, curtailing pay packages for employees at firms receiving government (taxpayer) funds might make sense, a closer examination reveals more problems than solutions.

James F. Reda, an independent compensation consultant, responded to the new legislation (via The New York Times):

“These rules will not work.  Any smart executive will (a) pay back TARP money ASAP or (b) get another job.”

This highlights just two of the major difficulties with government dictating how companies compensate their employees.  Talented workers will abandon a company shackled by government handcuffs for greener pastures at hedge funds or foreign banks.  This exodus would occur at the very time when their abilities are most needed to help ensure that TARP money is protected and paid back to the government.

Perhaps more importantly, do we really want to incent banks to return TARP money before it is fiscally optimal for them to do so?  Prematurely returning TARP funds carries with it the dual disadvantages of weakening banks’ capital structures and reducing the amount of money available for lending.  The latter cancels out the very purpose of replenishing bank capital — ameliorating the dearth of credit in the system, thereby turning off the lending spigot.

Many of the banks that received TARP funds did not want the funds to begin with.  Back in October when nine bank CEO’s were summoned to Washington, then-Treasury Secretary Paulson stuck a $125 billion gun at their collective heads, ordering them to take the funds.  Furthermore, the money was not given to the banks.  Uncle Sam received preferred stock, paying a 5% dividend (for 3 years, then stepping up to 9% for as long as the firms retained the funds).  Given that the government’s 3-year cost of capital at the time was less than 3%, taxpayers stand to earn more than 2% annually on their money.

If bonuses are limited, companies will be forced to pay higher salaries in order to lure the top professionals to their firms.  This will simultaneously raise banks’ fixed costs, increase their risk, and diminish the incentive for employees to work harder to maximize shareholder value as well as their own remuneration.  Commission-based employees such as loan officers will have little reason to maximize credit availability once their commission compensation approaches the government imposed ceiling.

Dagny Taggart knows how they feel.

As the country (world) remains mired in an economic morass, there are as many opinions as to how to extricate ourselves as there are beggars at the collective government trough.  That said, the two most oft-mentioned problems dragging down the economy are the decline in real estate values (both residential and commercial) and the rotting of so-called “toxic” assets on banks’ balance sheets.

The Lamb has written about the former problem.  He remains adamantly opposed to the unilateral rewriting of mortgage terms, especially the reduction of any principal amounts.  Regarding the latter situation, the consensus view now is that, for better or worse, the FDIC will run a so-called “bad bank” that will purchase these toxic assets from banks.  The banks, with cleaner balance sheets, would then feel more comfortable lending, and this, the thought is, will help jump-start the economy.

As has been noted since the initial days of the government’s Troubled Asset Relief Program (TARP), the primary difficulty with a government asset purchase program is coming up with the “correct” price to pay for these assets.  Paying too low a price will leave the banks undercapitalized and do nothing to solve the problem.  Conversely, paying too high a price would saddle taxpayers with losses and reinforce moral hazard issues.

The Lamb discussed the latter problem back in September when the TARP was first brought into existence.  In a nutshell, The Lamb argued against paying 125 cents for a dollar bill.  So, how does this Bad Bank come up with the “right” price to pay for these assets?  The “right” price being one that is acceptable to the banks selling these assets, but one that also carries it with it taxpayer protection.

No financial institution should be forced to sell assets to Bad Bank that it doesn’t want to sell.  Banks that want to sell assets to Bad Bank should submit the asset and the amount of it that they are interested in selling.  Bad Bank would then bid for assets in a ratio equal to the amount of TARP money the Treasury has already invested in these banks in the form of preferred stock (i.e. — banks that have received the most TARP money would be able to sell the most assets).  This would have the effect of bolstering/protecting the preferred stock positions that the Treasury (taxpayer) has already taken.

In order to achieve transparency and reduce the use and risk of taxpayer funds, all Bad Bank bids should be public.  Additionally, any ready, willing and able third party should be allowed to “top” Bad Bank’s bid for any asset.  This will keep as great a portion of the troubled assets as possible in private hands, minimizing the role of the public sector.

Arriving at Bad Bank’s bid price for assets could be done by any of several proposed methods.  As Treasury Secretary Timothy Geithner detailed in his January 21 hearing in front of the Senate Finance Committee, Bad Bank could:

“Look at how the market is pricing similar assets; use computer model-based estimates from independent firms; and seek the judgment of bank supervisors.  They all have limitations.  I think you need to look at a mix of those types of measures.”

Whichever method or combination of methods is used, they must provide positive convexity (the upside for a given degree up-move in the assets’ values is greater than the downside for the same degree down-move) to Bad Bank, hereafter called Convexity Bank.  All increases in asset values will be retained by Convexity Bank.  However, if after a set period of time (say, three years), a given asset has declined in value (as determined by an auction), the bank that originally sold the asset will then have to issue to Convexity Bank common equity in the amount of 110% of the asset’s decrease in market value.  The same downside protection would not be afforded the hypothetical ”private” buyer mentioned earlier.

While this may seem to be a bad deal for banks, let’s remember two things.  First, banks have argued that current market prices are not reflective of the potential value of these troubled assets due to extreme and unprecedented market conditions.  This would be an opportunity for them to sell at prices above otherwise-available market bids.  If the banks’ assessment of the situation is correct, they will have succeeded in selling these assets at prices above what the current market price would be in the absence of Convexity Bank’s bid.  Second, banks will not be forced to sell any assets they don’t want to, or at prices they don’t want to.  They would be free to take the risk themselves.

Since common shareholders are the ones that will most benefit from the disposal of these bad assets, they are the ones that should bear the risk of the assets’ decline in value via the risk of future share dilution.  This plan solves the problem of clearing troubled assets from banks’ balance sheets while also addressing the trillion dollar question of determining the “right” price for Convexity Bank to pay for the assets in question.  Furthermore, this plan alleviates the major risk of taxpayers subsidizing the bad investment decisions of banks while aiding in protecting the hundreds of billions of dollars that they have already invested via preferred stock.

When is a guarantee not a guarantee?  Well, the United States federal government would like you to believe that the answer is “never.”  When the feds say that certain debt is guaranteed, they would like the global investing public to have no fear, to suspend any fancy security analysis they might be tempted to undertake, to just close their collective eyes and “wave ‘em in.”

Unfortunately, the law of unintended consequences is a tricky thing.  Last month, Uncle Sam essentially turned what had been an implicit backing of Fannie Mae and Freddie Mac (GSEs) senior debt into an explicit one (see the post Fannie, Freddie, and Sam).  The Lamb is almost always against government interference in the operation of free markets.  However, he applauded this move in part because the feds had done almost nothing over the decades to disabuse the public of this implicit backing and because the consequences would have been catastrophic.

Following the GSE “bailout,” the feds turned to Corporate America and decided to effectively insure the continued steady issuance/financing in the commercial paper market.  Not done razing the bastion of capitalism, the government last week sought to guarantee certain senior unsecured bank debt.  Enter FDIC Chairman Sheila Bair:

The [FDIC now] guarantees new, senior unsecured debt issued by any bank, thrift or holding company, which will help banks fund their operations. Both term and overnight funding of banks has come under extreme pressure, with the costs of funding ballooning to several hundred basis points.

This guarantee will allow banks and their holding companies to roll maturing senior debt into new issues fully backed by the FDIC. However, guaranteed maturities cannot extend beyond three years. The ability to tap into this program expires at the end of June 2009.

The FDIC guarantee is not exactly like having the full faith and credit guarantee of the United States government (this is fodder for another post), but it will have the same deleterious effect on certain parts of the capital markets.  As more and more types of debt are guaranteed, the relative value of that guarantee diminishes.

Let’s venture back to the effectively “full” guarantee of the GSEs.  Prior to this event early last month, GSE asset-swap spreads (the yield differential between GSE debt and the swaps curve) were trading near their highest level ever, almost even with the swaps curve (i.e. – costing the GSEs more than ever to borrow money). 

After the GSE guarantee was announced, these spreads decreased dramatically, hitting all-time low levels of around fifty basis points lower in yield than swaps (i.e. – making it cheaper than ever to borrow money). 

However, following last week’s bank debt guarantee proclamation, these spreads rocketed higher.  By Friday, the GSEs’ funding costs had reached all-time high levels of thirty bps higher in yield than swaps, making it incredibly expensive for the GSEs to fulfill their newly assigned duties and costing taxpayers more money.

Think about how incredible this is.  These spreads usually move just one or two basis points per week, with a long run average of around 20 basis points lower than swap rates.  Yet, in the course of less than two months, the GSEs’ relative funding costs have gone from average levels to all-time low levels to all-time high levels!

GSEs Relative Cost of Funding

What are the GSEs’ duties and why do we care?  Good questions.  Answers:  around a week ago, federal regulators ordered Fannie and Freddie to purchase $40 billion of distressed mortgage-backed securities every month, in addition to their regular purchases.  The more expensive it becomes for Fannie/Freddie to finance these purchases, the more it ultimately costs taxpayers. 

Regardless of your opinion of the wisdom of these purchases, the devaluation of the “sacred” federal government guarantee has caused a kind of self-defeating paradox.  Guaranteeing all has become worse than guaranteeing none.  Since bank debt has always traded at higher yields than GSE debt, investors who seek out this guarantee will now eschew GSE debt in favor of bank debt.  And why not?  They’ll be buying debt with essentially the same ultimate credit (the United States Government), but be gaining incremental yield for free!

Uncle Sam is fighting himself and the American taxpayer will be the big loser.

"Which Bonds?" Indeed

Dear Mr. Keynes:

You must be very pleased with yourself, John.  Your ideas, rejected by many for at least a generation, appear to be making a vaunted comeback.  As part of the recently announced Bailout Bill, those of us that are still alive will be lending money to select financial institutions on very generous terms — generous for them. 

The revised bank rescue plan announced yesterday by the Treasury includes some measures that would make you grin from ear to ear (if you were still alive).  Allow The Lamb to rev up his seance machine and relay to you the plan’s highlights.

The Treasury will lend our money to select banks in the form of preferred stock that will earn us returns far lower than what was/is available in the market.  Through last week, the preferred stock of these banks was trading roughly at yields between 10% and 20%. 

But why, John, would we want to earn these 10-20% market rates when your friend Secretary Paulson is willing to put our money at risk for just a 5% return for three years? 

Oh, and what happens if these banks don’t want to pay us back in three years for whatever reason?  Well, then they can simply delay repaying us for as long as they want, giving us the same 5% for the following two years, and then 9% after that, a rate still below the prevailing market rate.

Additionally, the Treasury will guarantee for nearly four years hundreds of billions of dollars of senior unsecured debt and commercial paper that these banks issue through June 2009, regardless of its maturity.  Hmmm, what do you think that will do to our cost of financing the country’s deficit?  That’s right, it will make it that much more expensive — in essence, a double-whammy for us taxpayers.  Furthermore, this will have a “crowding out” effect on other corporations that do not enjoy the governement guarantee, making it ever more expensive for them to borrow.

And John, that gentle sobbing that you hear emanating from the next cloud over?  That’s your idealogical opposite, Milton Friedman.  This rescue plan is causing him and his ideas great discomfort.  The notion that the government would forcibly dictate such onerous terms to taxpayers would be anathema to him.

If you listen closely, John, you may hear him mournfully recounting his thoughts on the matter:  “Only government can take perfectly good paper, cover it with perfectly good ink and make the combination worthless.”

Sincerely,

The Lamb

It is said that capitalism without losses is like religion without hell.  According to a 2003 Harris Interactive poll, 69% of U.S. adults believe in a repository of eternal punishment and damnation.  But if Uncle Sam has his way, no one will be forced to visit or remain there.

The FDIC recently expanded its insurance for eligible bank accounts from $100,000 to as much as $500,000.  In fact, a married couple can now have up to $1 million insured at each FDIC-insured depository institution — $250,000 for each spouse’s individual account, plus $500,000 held in a joint account.

Want even more coverage?  No problem.  The FDIC now also insures trust accounts for amounts well into the millions.  And if you’re fortunate enough that you need even more coverage, all you have to do is start the process all over again at a different bank!

Why does The Lamb see this as a problem?  Isn’t more insurance good for everyone?

For everyone?  No.  The FDIC is not some amorphous entity that magically provides funds to make whole depositors at failed banks.  The FDIC is us.  We’re the insurer.  Or, to put it another way, those that don’t have funds that go bad effectively pay those that do.  

Now, you may argue that the FDIC is funded by insurance premiums that banks pay on deposits.  While that is technically true, the FDIC has only a fraction of the funds it will need to bail out depositors of the thousands of banks expected to fail in the coming year or two.  In fact, the recent “bailout bill” (The Lamb forgets what we’re officially calling it now) allows the FDIC to borrow UNLIMITED amounts of money from the U.S. Treasury (read: us) to help it maintain solvency.

All of this is IN ADDITION to Uncle Sam’s recent insuring of trillions of dollars of money market fund assets (see the post 2 + a + 7 = 50,000,000,000).  Our government is creating a system in which failure is all but impossible.  While this may look good in theory, it generates terrible moral hazards. 

The Lamb believes that investors should be free to invest wherever they please.  However, if an investment sours, those who made safer (and lower yielding) ones should not be forced to ride to the rescue.  There simply must be negative repercussions for poor investment decisions.

The preceding is exemplary of The Lamb’s Rule #2:  Know and understand what you own, and what you owe.

If investors want investments with guaranteed principal repayment, great.  There are trillions of dollars of them available for purchase.  They’re called United States Treasury bills, notes, bonds, and inflation-protected securities.  Investing in them is easy (see the post Safety and Soundness) and can be done by going to the Treasury Direct website.

Are the nominal yields on Treasuries (particularly T-bills) generally lower than those of money market funds and bank deposits?  Yes.  And they should be, given the full-faith-and-credit nature of the investment. 

Put your money wherever you want.  Take whatever risks you want.  Feel free to stretch for that last basis point.  But if things go wrong, don’t take others to hell with you.  Real or not, it doesn’t seem like a very nice place to be.

The Lamb has always been fascinated by the concept of hyperinflation — the rapid and extreme rise in the price of goods and services — (and by Michigan Football’s inability to stop a spread offense, but that’s another story).  The most fundamental causes of (hyper)inflation are an increase in the supply of money and/or a (corresponding) decrease in that money’s value.

Perhaps the most dramatic example of hyperinflation occurred in Germany during 1923-24.  Following World War I, the Allies forced Germany to sign the punitive Treaty of Versailles.  Among other things, the Treaty forced Germany to admit responsibility for the war and to pay for its damages.  The German economy, in tatters following the war, was unable to generate enough money to pay its debts.  The country embarked on a crash course of currency creation, running its printing presses non-stop.

This had the effect of quickly eviscerating the value of the German currency.  At the beginning of 1923, it took 9000 German Marks to buy one U.S. dollar.  One year later, the rate was 100 trillion marks to the dollar.  The country was futilely attempting to print its way out of debt, but only succeeded in making its currency next to worthless:

In Germany one morning in early 1924, a woman was on her way to the bakery to buy bread for her family.  Suddenly, a man accosted her, grabbing the bag she was dragging behind her which carried the trillions of marks she needed to buy bread.  As she begged him to return her money, he emptied the bills onto the street and replied, “Keep the money, I just want the bag.”

One Trillion Marks -- Almost Enough For Bread in 1924

Segue back to this side of the pond.  Congress has passed and the President has signed the now (in)famous $700 billion bailout/stimulus/rescue plan.  Now, $700 billion (the final tab could be less) may not be huge when compared to our roughly $14 trillion economy.  Yet, this spending/printing of dollars is all too typical of America’s solution to economic problems (see 1980’s Chrysler loan guarantee, 1989’s Savings & Loan bailout, and this year’s massive Bear Stearns backstop and AIG rescue, just to name a few).  Uncle Sam has even committed money to protecting over $2 trillion in money market fund assets — see the post 2 + a + 7 = 50,000,000,000.

One may argue that the Feds undertook a similar strategy in the 1930’s to counteract the consequences of the Great Depression, with relatively few ill effects from runaway inflation.  While we can debate the wisdom of New Deal programs, the fact is that the United States was a creditor nation then (an idea that is a distant memory now) and, more importantly, was on the gold standard.  Our current system of fiat money leaves us far more susceptible to a rapid decrease in the value of the dollar.

The Fed, under its last two Chairmen, has been more concerned with deflation than inflation.  They have targeted a low federal funds rate, or as The Lamb calls it, “growth at any cost.”  In fact, Fed Chairman Bernanke has given speeches bemoaning the dangers of deflation. Unfortunately, by the time inflation rears it ugly head the next time, it may already be too great to contain.

The deadweight loss created by the Troubled Asset Relief Program (TARP) is just the latest in a tragedy of financial errors — see the post Brother, Can You Spare 7 Trillion Dimes? And when considered alongside our roughly $800 billion current account debt (cumulative trade deficits) and our $10.1 trillion national debt (not to mention future expenditures for entitlement programs like Medicare and Social Security), you get total debt of nearly 80% of the U.S. gross domestic product (GDP) and rising…

Now, not even The Lamb, as long-term bearish as he is on the U.S. Dollar, believes that we are on the cusp of hyperinflation.  Though the Dollar has been on a terrible slide this decade (see chart below of the U.S. Dollar Index, courtesy of fxstreet.com), it has shown signs of life the past few months.

Look Out Below.....

However, the recent strengthening of the greenback is due largely to the ubiquitous need of corporations and banks to make outright purchases of needed dollars that they are unable to borrow in the credit markets for their ongoing financing activities.  The dollar may very well continue to rise until lending in the money markets returns to equilibrium.

But if/when the dollar restarts its slide, it may be swift. That may be a good time to put The Lamb’s Rule #7 into action — If you’re gonna panic, make sure you’re the first.

Severe inflation would have a few tertiary advantages for some.  Homeowners’ existing fixed-rate mortgages would effectively be wiped out as the dollar’s value plummeted, essentially producing mortgage-free homes.  Other hard assets, from cotton to coffee and from silver to soybeans, would also rise in value on a dollar-basis.  Those that owned these “real” assets would enjoy a modicum of protection from the ravages of breakneck inflation.

However, there would be a catastrophic downside.  Interest rates would soar and those lenders that hadn’t already been forced into bankruptcy would be wary of lending at all but the most punitive of terms.  Furthermore, the price of goods and services would soar as sellers sought to stay one step ahead of our crashing currency.  Commerce would screech to a halt.

Let’s remember, a slowing economy, even a recession, is not the end of the world.  It’s called the business cycle.  This country, actually most countries, go through periods of economic contraction.  This is a natural way for the economy to build a stronger and more stable base from which to maintain long-term growth.  As painful as economic slowdowns might be, they are far less deleterious than the flip side — runaway price increases.  See Zimbabwe’s current 531 billion percent inflation as a savage example.

Call The Lamb Chicken Little, but he’ll take a weak economy every now and then if it means he’ll never be emptying out a bag packed with cash just to make it easier to carry.

Disclosure: The Lamb owns UDN and CYB, two exchange-traded funds expressing bearish views on the U.S. Dollar.  The Lamb also owns GLD, a trust that buys and holds gold bullion.

One of The Lamb’s favorite movies is Trading Places with Dan Aykroyd and Eddie Murphy. In one scene, Aykroyd’s character, the haughty Louis Winthorpe III, is desperately trying to obtain money by selling his fancy watch to the only buyer around — a pawnbroker, played in a great cameo role by Bo Diddley:

Pawnbroker: I’ll give you fifty bucks for it.
Louis Winthorpe III: Fifty bucks? No, no, no. This is a Rouchefoucauld. The finest water-resistant watch in the world. Singularly unique, sculptured in design, hand-crafted in Switzerland and water resistant to three atmospheres. This is the sports watch of the ’80s. Six thousand, nine hundred and fifty five dollars retail!
Pawnbroker: You got a receipt?
Louis Winthorpe III: It tells time simultaneously in Monte Carlo, Beverly Hills, London, Paris, Rome and Gstaad.
Pawnbroker: In Philadelphia, it’s worth 50 bucks.

This scene is exemplary of The Lamb’s Rule #4: an asset is only worth what someone else is ready, willing, and able to pay for it. While it is fine to boast that an asset is “singularly unique” and “sculptured in design,” the best bid was $50 dollars, so Aykroyd’s watch was worth $50.

(Sidebar: if you haven’t seen Trading Places, (1) Aykroyd sold the watch to the pawnbroker for the proffered $50; and (2) You should proceed immediately to your nearest church/temple/mosque for a full confession).

Many of us have heard the bobbleheads on CNBC and elsewhere prattle on recently about the lack of pricing transparency in certain asset classes. They’ve placed part of the blame for the economic carnage currently engulfing America’s financial institutions on the opaqueness of credit default swaps and other assets that don’t actively trade on exchanges.

But now, these same critics are supporting proposals to allow firms to inflate the marks-to-market of many of these same assets to levels above their true current market levels. They state that forcing firms to mark their positions at what they consider “fire-sale” prices (what others might call “current market” prices) is the root cause of the problem, not the fact that these assets have simply decreased in value.

They assert that suspending mark-to-market pricing, also known as fair-value accounting, will alleviate pressure on these firms who now find themselves with assets on their books which they bought voluntarily and whose values have since declined.

Fortunately, the SEC and the Financial Accounting Standards Board (FASB) are trying to hold the line against this lunacy. From the above Bloomberg.com article:

JP Morgan Chase analyst Dane Mott: “Blaming fair-value accounting for the credit crisis is a lot like going to a doctor for a diagnosis and then blaming him for telling you that you are sick.”

Invesco’s Diane Garnick adds, “Suspending the mark-to-market prices is the most irresponsible thing to do. Accounting does not make corporate earnings or balance sheets more volatile. Accounting just increases the transparency of volatility in earnings.”

To grasp the gravity of the risk of suspending/eliminating fair-value accounting, look at the enormous volume of assets that firms had on their books as of August 15, 2008, which they listed as so-called Level 3 assets, or those in which values may be based on management’s expectations of what they will (may?) eventually be worth:

[Click on each graph for a clearer view]

(Graphs via econompicdata.blogspot.com)

Notice that the seven firms taken over by Uncle Sam (or nationalized, or bailed out, or forced into a merger, etc.) — Freddie Mac, Fannie Mae, Merrill Lynch, AIG, Lehman Brothers, Wachovia, and Indy Mac — had nearly half a trillion dollars worth of Level 3 assets as of August 15, 2008!

Notice also that five of the seven firms with the highest amount of Level 3 assets as a percentage of equity as of this same date (Freddie Mac, Indy Mac, Merrill Lynch, Fannie Mae, and Lehman Brothers) have since been “Uncle Sam’d.”  Freddie’s Level 3 assets were ten times more than its equity and Indy Mac’s Level 3s represented nearly 100% of its total assets!

Against this backdrop, do we really want to allow firms to value such a large amount of assets at something other than current realizable market values? Is inflating these values really going to give the public a better understanding of these firms’ true financial conditions?

No one is saying that firms shouldn’t be allowed to raise the prices of assets on their books if/when buyers emerge at higher levels. But until that happens, firms should only value their assets at what Bo Diddley or anyone else is ready, willing and able to pay for them.

This summer, Congress passed and the President signed the Hope for Homeowners program, providing for the insuring of up to $300 Billion in new home loans.  As the FHA Factsheet states: 

“From September 2007 to June 2008, FHA has guaranteed more than $93 billion of mortgage capital, [helping] more than 290,000 families obtain safer, more affordable mortgages.”

The above math works out to over $320,000 per family in loan guarantees.  While The Lamb is not in favor of this program, he believes that if the FHA is going to provide these guarantees, there is a better way to put the money to work.  Using this same arithmetic, the $300 Billion (not to mention any further aid that Congress is threatening to add to the currently proposed overall Bailout Bill) from the Hope for Homeowners program could provide this same $320,000 for each of over 900,000 first-time-buying families that have been fiscally prudent and not yet purchased a home that they (correctly) deemed was overpriced or potentially beyond their means.

Assuming a relatively conservative 20% down payment, the FHA could help each of these 900,000 families to purchase a home costing $400,000, nearly double the July 2008 median national home price, or aid 1.8 million families in purchasing $200,000 homes.  This would have the additional benefit of helping to alleviate bloated inventories from the nation’s housing stock– a far greater economic lift than the refinancing of existing mortgages that may eventually default anyway.

The Lamb sympathizes with those at risk of losing their homes.  However, he believes that if this $300 billion is to be spent at all, families that made the difficult decision to delay their American Dream of home ownership are the more deserving of what is essentially a loan guarantee backed up by everyone’s future tax payments. 

Even Otter should be able to sympathize with that: