Deer In Headlights Financially Speaking

Deer in the Headlights, Financially Speaking By RICHARD H. THALER, Published: October 8, 2011 BY any measure, the global economy is facing unusually high levels of uncertainty and volatility. But human nature may be impeding our ability to turn the economy around.

Fear and anxiety don’t bring out the best in anyone. When normally loving spouses are lost in traffic and late for a flight, their conversation is rarely suitable for young ears, even when the children are in the back seat. Along with making people irritable, uncertainty can create paralysis. Some animals freeze when they are frightened. Acting like a deer in the headlights can be a good strategy if you are trying not to be seen, but it can get you run over. In humans, this behavior is illustrated by an experiment conducted by the Princeton psychologist Eldar Shafir. The subjects, who were graduate students, were told about an attractive deal for a spring-break vacation. They could get an especially good price if they bought their tickets now, rather than waiting a week. But, as part of the deal, the students wouldn’t hear the results of an important exam until the discount expired. That uncertainty caused many students to freeze: Although a majority said they intended to take the trip whether or not they passed the exam — either to celebrate their success or recover from failure — they didn’t want to buy the tickets until they found out the results. I worry that many Americans are now acting like Professor Shafir’s subjects. They know that there are investments they should be making, investments that are currently “on sale,” but they are waiting to see how things shape up before they act. Congress certainly suffers from this problem. The country has a long list of roads and bridges that are either dangerous or obsolete. We can begin the inevitable process of rebuilding this infrastructure now, when construction costs are low and borrowing costs are essentially zero, or we can wait. But why wait? Postponing will only make the projects cost more when we finally get around to starting them, and, in the meantime, we risk disaster if one of those bridges fails. Do we think we will no longer need bridges? If Greece defaults, American cars will not suddenly become amphibious. Congress is not the only place where we can see paralysis. Corporations are hoarding cash at record rates. The Federal Reserve recently reported that nonfinancial companies in the United States were holding more than $2 trillion in cash and other liquid assets — money that is earning next to nothing. A considerable amount of that cash has been accumulated in the last two years — and the totals exclude the substantial sums the companies hold abroad in foreign subsidiaries. Of course, it can be sensible for businesses to have a source of emergency cash, but many appear to be stockpiling so much that it’s hard to imagine what emergency they fear. To cite just one example, Google is holding more than $39 billion in cash. Google is far from alone. A recent survey of chief financial officers by Duke University reports that 55 percent of them say they won’t begin to deploy cash holdings in the next year. Many say they are waiting for economic uncertainty to decline.

Yet is such caution rational? As a shareholder, I would worry about a company that says it can’t find investments that can reasonably be expected to earn well above the tiny return of its cash. Investment does not necessarily have to involve increasing capacity. Are there no plants or equipment that need upgrading? No promising research-and-development opportunities to be explored? Not even any parking lots that need to be repaved and painted? I also do not buy the idea that companies need all this cash for acquisitions. If they really want to buy another business, they can issue stock to do so.

Loosening the purse strings just a little could have big effects on the economy. Suppose that American companies reduced their domestic cash holdings by just 10 percent and invested that $200 billion in productive investments. Using standard assumptions, these investments would spur growth in gross domestic product next year by about 1.3 percent and reduce unemployment by almost 0.7 percent. These investments would also increase tax revenue and generate long-term profits. Some people contend that uncertainty about government regulation is making businesses cautious, but no solid evidence supports this claim. Corporations always complain about regulators, but the fact is that corporate profits are strong in many sectors. Those piles of cash didn’t come out of thin air. SOME households are also displaying fearful investment behavior. I’m not referring to those that are struggling with debt and unemployment, but to the segments of our society whose finances have rebounded nicely. These folks are investing in United States Treasuries and money market accounts in record numbers. If you are among these more fortunate households, you may also be passing up attractive investment opportunities that will earn much more than the 0.01 percent you’re getting from your money market account. One such opportunity lies in making improvements to your home — assuming, of course, that you aren’t underwater on your mortgage. As a starting point, analyze ways to make your home more energy-efficient. Investing in insulation, windows, heating and air-conditioning and even solar collectors often provides excellent and highly predictable rates of return. Not only will you eventually make money, but you can pat yourself on the back with both hands since you’ll be helping to restart the economy while helping the environment. Some homeowners are already embracing this idea: one of the economy’s few encouraging signs is that residential remodeling permits were recently up 24 percent over the previous year. Sure, there is much to worry about these days. But freezing in place is seldom the right strategy. Personally, I am planning to hire someone to repaint my apartment. What about you? Maybe some new gutters? Richard H. Thaler is a professor of economics and behavioral science at the Booth School of Business at the University of Chicago.

17 Nations But Even More UnKnowns

17 Countries, but Even More Unknowns By GRETCHEN MORGENSON Published: October 8, 2011 -New York Times Sunday Money “THE direct exposure of the U.S. financial system to the countries under the most pressure in Europe is very modest.” That’s what Timothy F. Geithner, the Treasury secretary, told Congress last week, trying to allay concerns that American banks might be hurt by the escalating crisis in Europe. Investors have heard such assurances before, and they have learned to take them with a barrel of salt. Remember how the subprime crisis was going to be “contained”? As the situation in Europe deteriorates, our own financial institutions are coming under growing scrutiny from investors. American banks have made loans to European ones. Some have also written credit insurance on the debt of European institutions and troubled nations like Greece. So if a default were to occur, some banks here would be on the hook. Last week, officials at Morgan Stanley worked overtime trying to calm investors about the bank’s exposure to Europe. The company had $39 billion in exposure to French banks at the end of last year, not counting hedges and collateral. (Some analysts argue that the amount today is far lower, and at the end of the week, Morgan Stanley appeared to have relieved investor fears.) Whatever the case, American banks have been writing more credit insurance lately. As of the end of June, some 34 federally insured commercial banks had sold a total of $7.5 trillion of credit protection, on a notional basis, according to the Comptroller of the Currency. That was up 2.3 percent from the end of March.

To be sure, these figures represent the total amount of insurance written and do not reflect other offsetting trades that bring down these banks’ actual exposure significantly. For investors, the challenges in trying to assess the true exposures are real. Many of the risks in these institutions are maddeningly hard to plumb, and open to a range of interpretations. The fact is, investors must deal with significant gaps in the data when trying to analyze a bank’s exposure to credit default swaps. Even the people who set accounting rules disagree on how these risks should be documented in company financial statements. A recent report by the Bank for International Settlements noted: “Valuations for many products will differ across institutions, especially for complex derivatives which may not trade on a regular basis. In such cases, two counterparties may submit differing valuations for valid reasons.” Investors, therefore, have to trust that the institutions are being appropriately rigorous. To compute the fair value of derivatives contracts, financial institutions estimate the present value of the future cash flows associated with the contract. On this part, everyone agrees. But there are two subsequent steps in the valuation exercise that can produce wide variations on an identical exposure. First is the manner in which an institution offsets its winning and losing derivatives trades to come up with a so-called net exposure. Accounting rule makers disagree about the right way to approach this process. Standard setters in the United States allow an institution to survey all the contracts it has with a trading partner and compute exposure as the difference between winning trades and losing ones. International standard setters have taken a different view. They have concluded that investors are better served by knowing the gross figures of all of an institution’s trades, both the profitable ones and the money losers. Those favoring this approach say it gives investors more information and greater insight into the risks on the books, like how concentrated the bank’s bets are. A recent report from the Bank for International Settlements illustrates how different the exposures can be, depending on which approach is used. Posing three hypothetical examples, the report noted that while the gross values of various derivatives totaled $41, the same trades dropped to $17 after netting, as is allowed in the United States. THE second area where investors must rely on institutions to do the right thing involves the collateral that has been supplied to secure derivatives contracts. Banks reduce their exposure to a possible loss by the amount of collateral they have collected from a trading partner. But is the collateral solid? Is the bank valuing it properly? Can it be located quickly? This, again, is a gray area. The B.I.S., in its most recent quarterly review, highlighted these challenges. It said that gleaning information about collateral was difficult, and that arriving at a proper valuation was, too. Further problems arise when it comes time to pay off a bet in a bankruptcy and close out one of these trades. At such a moment, liquidating collateral can put pressure on other positions carried by an institution, the B.I.S. noted. It is unclear whether institutions’ portfolio and collateral valuations reflect this reality. Some investors who have been worrying about potential losses associated with European banks may have taken comfort in the results of financial stress tests conducted earlier this year by the Committee of European Banking Supervisors. Of the 91 top European banks tested — accounting for 65 percent of bank assets — only seven failed the toughest measures. But, as an August report by Dun & Bradstreet pointed out, these tests were not as stringent as they might have been. They only assessed the risks posed by deteriorating assets in banks’ trading accounts. The tests did not measure those assets carried in the so-called held-to-maturity accounts. “In order to give a more adequate picture of European financial sector risk beyond the short term,” Dun & Bradstreet said, “we believe the hold-to-maturity bonds should have been included in the stress tests.” There is clearly a great deal that investors do not know about exposures to Europe, notwithstanding the assurances from Mr. Geithner and others. Three years ago, investors were ignorant of the risks in faulty mortgage securities. If we’ve learned anything from that episode, it’s that what you don’t know can, in fact, hurt you.

Where Are the Bond Vigilantes?

SEPTEMBER 30, 2011 Where Are the Bond Vigilantes? During the Clinton administration, interest rates served to discipline government spending. That vital check is now missing. Wall Street Journal By RONALD MCKINNON In past decades, tense political disputes over actual or projected fiscal deficits induced sharp increases in interest rates—particularly on long-term bonds. The threat of economic disruption by the so-called bond market vigilantes demanding higher interest rates served to focus both Democratic and Republican protagonists so they could more easily agree on some deficit-closing measures. For example, in 1993 when the Clinton administration introduced new legislation to greatly expand health care without properly funding it ("HillaryCare"), long-term interest rates began to rise. The 10-year rate on U.S. Treasury bonds touched 8% in 1994. The consequent threat of a credit crunch in the business sector, and higher mortgage rates for prospective home buyers, generated enough political opposition so that the Clinton administration stopped trying to get HillaryCare through the Congress. In the mid-1990s, Democrats and Republican cooperated to cap another open-ended federal welfare program—Aid to Families with Dependent Children—by giving block grants to the states and letting the states administer the program. Interest rates came down, and the Clinton boom was underway. In contrast, after the passage of ObamaCare in March 2010, long-term bond rates remained virtually unchanged at around 3%. This was despite great doubt about the law's revenue-raising provisions, and the financial press bemoaning open-ended Medicare deficits and the mandated huge expansion in the number of unfunded Medicaid recipients. Even with great financial disorder in the stock and commodity markets since late July 2011, today's 10-year Treasury bond rate has plunged below 2%. The bond market vigilantes have disappeared.

Without the vigilantes in 2011, the federal government faces no immediate market discipline for balancing its runaway fiscal deficits. Indeed, after President Obama finally received congressional approval to raise the debt ceiling on Aug. 2, followed by Standard & Poor's downgrade of Treasury bonds from AAA to AA+ on Aug. 5, the interest rate on 10-year Treasurys declined even further. Since Alexander Hamilton established the market for U.S. Treasury bonds in 1790, they have been the fulcrum for the bond market as a whole. Risk premia on other classes of bonds are all measured as so many basis points above Treasurys at all terms to maturity. If their yields are artificially depressed, so too are those on private bonds. The more interest rates are compressed toward zero, the less useful the market becomes in reflecting risk and allocating private capital, as well as in disciplining the government. To know how to restore market discipline, first consider what caused the vigilantes to disappear. Two conditions are necessary for the vigilantes to thrive: (1) Treasury bonds should be mainly held within the private sector by individuals or financial institutions that are yield-sensitive—i.e., they worry about possible future inflation and a possible credit crunch should the government's fiscal deficits get too large. Because private investors can choose other assets, both physical and financial, they will switch out of Treasurys if U.S. public finances deteriorate and the probability of future inflation increases. (2) Private holders of Treasurys must also be persuaded that any fall in short-term interest rates is temporary—i.e., that the Fed has not committed itself to keeping short-term interest rates near zero indefinitely. Long rates today are the mean of expected short rates into the future plus a liquidity premium. The outstanding stock of U.S. Treasury bonds held outside American intergovernment agencies (such as the Social Security Administration but excluding the Federal Reserve) is about $10 trillion. The proportion of outstanding Treasury debt held by foreigners—mainly central banks—has been increasing and now seems well over 50% of that amount. Since 2001, emerging markets alone have accumulated more than $5 trillion in official exchange reserves. And in the last two years the Fed itself, under QE1 and QE2, has been a major buyer of longer-term Treasury bonds to the tune of about $1.6 trillion—and that's before the recently announced "Operation Twist," whereby the Fed will finance the purchase of still more longer-term bonds by selling shorter-term bonds. So the vigilantes have been crowded out by central banks the world over. Central banks generally are not yield-sensitive. Instead, under the world dollar standard, central banks in emerging markets are very sensitive to movements in their dollar exchange rates. The Fed's near-zero short-term interest rates since late 2008 have induced massive inflows of hot money into emerging markets through July 2011. This induced central banks in emerging markets to intervene heavily to buy dollars to prevent their currencies from appreciating versus the dollar. They unwillingly accept the very low yield on Treasurys as a necessary consequence of these interventions. True, in the last two months, this "bubble" of hot money into emerging markets and into primary commodities has suddenly burst with falls in their exchange rates and metal prices. But this bubble-like behavior can be traced to the Fed's zero interest rates. Beyond just undermining political discipline and creating bubbles, what further economic damage does the Fed's policy of ultra-low interest rates portend for the American economy? First, the counter-cyclical effect of reducing interest rates in recessions is dampened. When interest rates dipped in the past, at least part of their immediate expansionary impact came from the belief that interest rates would bounce back to normal levels in the future. Firms would rush to avail themselves of cheap credit before it disappeared. However, if interest rates are expected to stay low indefinitely, this short-term expansionary effect is weakened. Second, financial intermediation within the banking system is disrupted. Since early 2008, bank credit to firms and households has declined despite the Fed's huge expansion of the monetary base—almost all going into excess bank reserves. The causes are complex, but an important part of this credit constraint is that banks with surplus reserves are unwilling to put them out in the interbank market for a derisory low yield. This bank credit constraint, particularly on small- and medium-size firms, is a prime cause of the continued stagnation in U.S. output and employment. Third, a prolonged period of very low interest rates will decapitalize defined-benefit pension funds—both private and public—throughout the country. In California, for example, pension actuaries presume a yield on their asset portfolios of about 7.5% just to break even in meeting their annuity obligations, even if they were fully funded. Perhaps Fed Chairman Ben Bernanke should think more about how the Fed's near-zero interest rate policy has undermined fiscal discipline while corrupting the operation of the nation's financial markets. Mr. McKinnon is a professor at Stanford University and a senior fellow at the Stanford Institution for Economic Policy Research.

Very Interesting Analytics "Why it sucks to be middle class"

If you are seeking to understand some very important aspects of this recession in terms of numbers, income and job growth or lack thereof, this video really captures it in it's simplest form. If you have a business and want to get some basic analytics in terms of the buying power of the consumer rignt now this really sums it up. From CNN Money Reports. "Why it sucks to be middle class"

Warning From S&P on Munis

By JEANNETTE NEUMANN
Downgrades of bonds issued by state and local governments could increase this year, according to a report to be issued Monday by credit-rating agency Standard & Poor's.

The $2.9 trillion municipal-bond market has been thrown into tumult in recent months, in part because of growing fears that some state and local governments will default on their debt. Investors have pulled out record amounts from muni-bond mutual funds, while the yields on muni bonds, which move inversely to price, have hit their highest levels since the depths of the financial crisis.

A downgrade of a government borrower would likely put downward pressure on the price of its bonds, resulting in higher borrowing costs and potential losses for investors.

Standard & Poor's says it expects greater muni-market volatility this year, but cautions that a rise in borrowing costs wouldn't add to municipalities' credit concerns unless bond yields were to surge.

While rating downgrades may increase in 2011 compared with recent years, S&P says the majority of state and local government borrowers will maintain their medium to high investment-grade ratings. Read More

Bonds by Jack Hough (Author Archive)
$125,000 Muni Warning Yields Backlash
State and local government bonds have broadly fallen in price since late September, when celebrity analyst Meredith Whitney began publicizing a 600-page report predicting widespread defaults and a new financial crisis. Whitney recently told interviewers that the market turmoil is validating her thesis, but a rising chorus of dissenters say her statements are alarmist and unfounded, and that the fear they've helped stir is further straining municipal budgets by raising the cost of borrowing.

The matter is made more complicated by the unusual secrecy surrounding Whitney's report. Many key municipal players say they've been unable to obtain a copy. Some say Whitney's firm quoted them a price that they found shocking.

"I think it violates what are considered to be today's standards of research and transparency," says Iris J. Lav of the Center on Budget and Policy Priorities, a think tank. Lav and co-author Elizabeth McNichol published their own report last Thursday countering some of Whitney's arguments without naming her. Strained budgets are a "cyclical problem that ultimately will ease as the economy recovers," they argue, and long-term problems like pension shortfalls are fixable. According to Lav, state and local debt payments total only 4% to 5% of spending in most states, with no state over 7%.

Lav hasn't seen the Whitney report because "they want $25,000" for a copy. That might have been a relative bargain. A municipal researcher at one major financial firm says his employer was quoted $125,000 and declined to buy a copy.

Read more: Analyst's $125,000 Muni Warning Yields Backlash - SmartMoney.com

Bankruptcies Drop as Companies Heal

By Matt Krantz, USA TODAYSome companies can finally say, "Rumors of our bankruptcy were greatly exaggerated."
Despite widespread speculation the credit crunch was going to grind up whole swaths of companies and force them into bankruptcy, companies are showing their mettle and are defying these dire predictions.

A dramatic drop-off in the number of companies going bankrupt is one of the most stark signs yet of how the Darwinian killing off of businesses is easing as the economy heals.

Perhaps more important for the future, though, is that the number of companies at immediate risk of failing is also sharply declining. This strength of companies pulling out of the recession gives further credence to the belief that despite the economy's problems, there's a recovery going on. Continue Reading Story Here

AP: Surge in Bankruptcies Shows Signs of SlowingRALEIGH, N.C. (AP) —The growth in bankruptcies around the country slowed significantly in 2010 from its breakneck pace in recent years, with about a dozen states recording a decline in filings from consumers and businesses, according to an Associated Press tally Tuesday.
Filings collected from the nation's 90 bankruptcy districts showed 113,000 bankruptcies in December, down 3% nationwide from the same month a year ago. That followed a similar year-over-year decline for the the month of October. It had been four years since an individual month showed such an improvement. Continue Reading
FINANCIAL TROUBLES
A state-by-state ranking of percentage change in bankruptcy filings last year from 2009.

1. Hawaii 22%

2. Utah 19%

3. California 19%

4. Arizona 18%

5. Colorado 14%

6. Florida 13%

7. Wyoming 13%

8. Maryland 12%

9. New Jersey 12%

10. Alaska 11%

11. Massachusetts 11%

12. Montana 11%

13. Connecticut 10%

14. Illinois 10%

15. District of Columbia 9%

16. Delaware 9%

17. Wisconsin 9%

18. Oregon 9%

19. Washington 8%

20. Maine 8%

21. Idaho 8%

22. South Dakota 7%

23. Rhode Island 7%

24. New Hampshire 7%

25. New Mexico 7%

26. Missouri 6%

27. Georgia 5%

28. Vermont 5%

29. Texas 5%

30. Nebraska 5%

31. Oklahoma 4%

32. North Dakota 4%

33. Pennsylvania 4%

34. Minnesota 4%

35. Kansas 2%

36. Virginia 2%

37. Louisiana 2%

38. Nevada 1%

39. Ohio unch.

40. Arkansas unch.

41. Michigan -1%

42. New York -2%

43. Indiana -2%

44. Alabama -2%

45. Mississippi -3%

46. Kentucky -3%

47. Iowa -3%

48. North Carolina -4%

49. South Carolina -5%

50. Tennessee -8%

51. West Virginia -10%