Couple music videos.

My Internet connection took the better part of an hour to upload, so they're all fuzzy-

Let's make some work

All too often it seems policymakers equate increased spending with job creation, or job creation with increased spending. The two are directly correlated, in a Keynesian macroeconomic sense, which is exacerbated by all kinds of negative feedback cycles during a recession (asset depreciation, liquidity traps, wage-demand spirals) but far from the same. But does it really cost $500,000 of direct government appropriations to create a job? That’s the not so pretty math update from the Recovery Act, which has spent about $350 billion so far and created some 700,000 jobs. Just as an employer creates jobs because of the marginal productivity of that job, and not tax rates, e.g. an employer will hire a worker at salary $X if they produce something worth >$X if the tax rate is 50%, but not hire if the salary exceeds the value of marginal product even if the tax rate is 0%- the government only drives organic job growth when it's profitable. Otherwise when the appropriation runs out, the job runs out. Employers would prefer to keep more of their profit, but they don’t care how much the government takes of non-existent profit. So tax rate arguments are of almost secondary importance- of primary importance is industry, market creation.

As DC turns to Job Creation: Act II, the focus should be less on throwing more money out the door, and more on making promising nascent growth industries profitable. Temporary government expenditures will create more temporary jobs, two or three year tax credits in long-term infrastructure driven sectors, like clean energy or biotech, will continue to not pencil out on 30-year amortized balance sheets. Profits won’t return to Main Street until new industries are profitable industries. America will only sustainably recover from the latest credit driven asset depreciation shock when there is either paradigm shifting technical innovation that changes the profit calculus (say of silicone being cheaper than coal, or server space being cheaper than a piece of paper; a hard bargain), or when the government just decides to change the calculus itself.

Congress could establish a set of 30-40 year tax credits and streamlined regulations (the one or two year stuff they’re used to releasing a couple months after the last temporary set expired doesn’t fool even the macabre neophyte investor class) that will spur private sector investment and growth. On my short list of such credits? for starters a $.03/kWh clean energy production tax credit, cheap leases on set-aside government land to build new energy infrastructure, 50% tax deductions on all mass transit investments, and 30% tax offset for all biotechnology investments. Tax attorneys could fill in the details. And perhaps most beneficial of all, tax credit driven job creation would change government receipts (perhaps offset by higher top-end marginal income tax rates), but not directly add to deficit spending. The annual $1.4 trillion deficit we run now mandates we not continue short-term stimulus spending into the long-term, only further raising the cost of capital and chocking off promising nascent industries. The bottom line is there needs to be a paradigm shift from spending to incentivizing, from direct expenditures and subsidies, to indirect industrial tax policy. That’s why the much heralded “Jobs Bill” Leader Reid and Speaker Pelosi are corralling should not fall into the trap of thinking the only way for the public sector to create private sector employment is too bequeath it money, rather it could simply make it profitable. For all the economic carnage out there, we should begin to focus a little less on triage, and a little more on getting well.

either way

those moments pass
like bullets through chest
legs detach
vains spread
eyes swoon dangerous
an ocean of drugs
a swelling ego
cut down a dumb world
there is no choice
just the pull
the cut of that voice
kindred souls
every hour after
just leaky containers
every single part
ephemeral remainders
every single time
every moment
to ever be timeless
to ever hold my heart
murderered either way

The President's Financial Regulatory Proposal

About two days a week throughout the fall last year there would be a black suburban parked on the street I walk from the red line to work. On these days I’d walk a little slower to see Treasury Secretary Paulson walk from a giant office building into the waiting car. I saw him the day after Lehman failed, the only thing fresh looking about him was his suit- and the day after the inauguration, with 8 foot high metal cage-like fences spilled down Penn Avenue as far as the eye could see, tons of trash blowing surreally in the freezing wind- this time looking more relaxed in his basketball shorts and unbuttoned shirt. It was pretty surreal to wake up and read the Journal or Times chronicling the latest historical market failure and then cross paths with its leading financial firefighter. A year later I’m afraid the sense of urgency of those fall months is fast diminishing. A tragedy of the last year is a terrible thing to waste. From the ashes of a failed regulatory system, that cost 3 million people their jobs and nearly as many their homes, and $7 trillion in wealth, is the promise to build a sleeker, more common-sense, more responsive regulatory system. And here many people will stop me simply with the semantics, “regulation” is a terrible word- so call it what you will. The basic concept though holds true in essentially every aspect of life. We don’t get on a jet plane and just hope the proper safety checks have been done and the pilot isn’t drunk, we “regulate” it, we don’t trust a stranger to deliver our new baby at a whim, we “regulate” it. So those who would notionally dismiss regulation as a bad thing should maybe stop flying or stop having kids.

The legal zeitgeist of these times is the President’s Financial Regulatory Reform proposal (http://www.financialstability.gov/docs/regs/FinalReport_web.pdf). In a little over two short months this entire white paper has been translated to authorizing language and sent to the Hill, where as usual it was met with a startling sense of complacency and criticism without much constructive feedback. If this can pass in some form by 2010 my hypothesis of complacency is proved wrong. If not, a similar asset bubble and burst cycle and all of the capital contraction, income decline and job loss and capital loss (repeat) is not just possible but probable. The impetus to correct a clearly insufficient financial regulatory regime – one that forced the government to choose between catastrophic failure and chaos or injecting huge of amounts of taxpayer dollars- is otherwise lost. Critics can say what they like about the choices made last year, but with Bear, Lehman, AIG, WaMu- those were the options. Here are some core tenets of the President’s regulatory agenda.

1) Capital ratios. A working group is currently drafting the details due out in a couple months. When the banks’ experienced severe asset valuation shocks they were forced to liquidate and perpetuate the cycle. With better loan loss provisioning this cycle could have been prevented. In practical terms, probably means going from tangible common equity ratios of 4% to 8%.

2) Resolution authority. The FDIC can repossess and either break up or auction off bankrupt depository institutions. There is no similar authority for non-depositories or holding companies that own depositories. The Fed can loan money to anyone or anything so long as it is last resort and there is sufficient collateral. If there isn’t, then there is no way to protect innocent bystanders from the consequences of large bank failure. The President’s proposal would permit the Fed with Treasury consent, to seize and efficiently break up large failing firms.

3) Preventing regulatory arbitrage. Under current law, thrift holding companies (banks with a higher share of mortgages created to facilitate liquidity in the housing market), industrial loan companies (like GMAC or GE Capital), credit card banks, trust companies and grandfathered non-bank banks are exempt from most supervisory requirements, simply because they were left out of the BHC Act. Firms (like Bear, Lehman, AIG, WaMu) simply owned one of these entities and could simultaneously avoid regulation while having access to the Fed’s lending if they got into trouble. This gave the public no risk management function but sole responsibility should they encounter significant risk. Heads I win, tails you lose. Financial companies should not be able to escape consolidated supervision by technicality.

4) Systemic risk regulation. The proposal creates a new category of Tier 1 financial companies which will be overseen by the Federal Reserve. These would be firms whose failure threatened the entire market, and would be subject to coordinated and robust prudential regulation. Bank holding companies consist of so many separate entities that they can have a dozen separate regulators each and allows firms to arbitrage the differences to their advantage.

5) Consumer financial protection. A central catalyst of the ’08 recession was the set of uninformed and stupid decisions consumers made- like buying houses they couldn’t ever afford or signing up for credit cards with early payback penalties. The proposal observes correctly that finance and economics have a distinct world view, one that does not manage the cultural, psychological and communications challenges inherent in good consumer advocacy. There are bright lines that could be established, but it takes clear authority and communication otherwise it will likely die in the interagency process as it has for decades. Without clear responsibility for common-sense consumer protection there can be no accountability. There are consumer protections for seatbelts, kids toys and lawnmowers, it's time for some for households' budgets too.

6) Office of National Insurance Regulator. The U.S. regulates the insurance industry essentially entirely at the State level and is the only G-20 country without a national framework for insurance oversight. There is clear executive will to do so, now we need legislative consensus.

7) Office of National Bank Supervisor. This would consolidate the Office of the Comptroller of the Currency (which regulates interstate banks) and the Office of Thrift Supervision to oversee all national banks. One office in Treasury would have sole authority for national banks and be able to provide consolidated prudential oversight rather than the current fragmented system.

8) Financial Services Oversight Council. This would force regulators to actually talk to each other and coordinate policy while closing gaps in regulation. In ’08 we saw a fundamentally ad hoc response among the Fed, FDIC, OCC, Treasury and others with predictable turf wars and inefficiencies. Before any major action, like designating a firm a Tier 1 Financial Holding Company or intervening in an institution’s distress, this council would meet to have an integrated approach. It would be a consensus building forum while avoiding the tenuous nature of decision by committee by giving the Treasury Secretary executive authority as the Chairman.

9) Central clearinghouse of derivatives. This would establish a central resolution, clearing and payment exchange for derivates. Most derivatives today are cleared by JP Morgan and Mellon Bank of New York, so creating a consolidated exchange would be eminently doable. By providing transparency in this market, it would not prevent dealmaking, hedging or economically valuable speculation, it would just provide basic information to inform the price discovery mechanism. It was a surprise to most of the world that AIG had a hedge fund grafted on top of it that had drunkenly bet the house on the U.S. housing binge. If people could have seen this, the asset valuation collapse could have been incorporate in prices in near real time and prevented a huge dis-equilibrium and subsequent quick collapse. Contrary to popular misconception, this proposal would not prohibit custom derivatives.

People on the Hill who have better ideas should put them forward, but a system that allowed the consequences of the last year is definitionaly in need of repair. Just ask a harried former Republican Treasury Secretary.

5 Pretty Convenient Truths about Healthcare

5) The government will not take over healthcare in the rather unlikely political event that a public option is passed. Four of the five bills out of committee have an individual mandate requirement that precludes individuals who are already insured, or offered insurance by their employer, from leaving for a public option. Additionally, there are strong tax incentives in place for employers to continue to offer competitive insurance. Adding one more public plan to the 2500 private ones in existence, and putting them on one central exchange for consumers to search, will definitionaly result in more competition and choice.

4) The cost curve must be bent. Medicare and Medicaid could be cash flow negative in 8 years. For true fiscal conservatives the most expensive thing government could do is continue on the present trajectory of healthcare spending growth (~1.5% above inflation) with no meaningful attempt at reform. Denying or obfuscating on the need for reform is the surest way to continue to grow the public debt. By not insisting on a public option, President Obama has wisely left negotiating room for moderate conservatives not ideologically opposed to reform.

3) There is reason to believe the government could run a pretty good health benefits plan. When private insurers make money they pass a significant portion onto their shareholders and (often a larger amount) to their executives. However because the government has no profit margin, any net income the government made would go right back into Treasury’s coffers to either provide more or cheaper insurance, or pay down the debt. Government already runs three of the largest insurance systems in the world in Medicare, Medicaid and Social Security – and you haven’t heard a single opponent of healthcare reform suggest repealing any of these (a classic inter-temporal allocation problem – people love the money already committed to them, but loathe the idea of spending future money for the same improvement). Additionally, the Federal government has unique comparative advantage in negotiating lower drug and procedure costs by virtue of its size. This is one reason why Senator Baucus’ attempt at political compromise with non-profit coops (in lieu of a public plan) is well intentioned but off the mark- these would be run at the State level and miss the huge economies of scale of a Federal plan.

2) For something as important and scientific as medicine and healthcare, there should be basic best practices established. The fact that there is such a disparity in healthcare utilization across both hospitals and regions, procedures for identical conditions (like $10,000 radiation versus $200,000 proton radiation with the same success rate for prostate cancer), and a wide divergence in collection rates is definitionaly inefficient. There can be only one best way. Creating comparative effectiveness research centers and expert panels to guide technical decision-making can improve both outcomes and reduce costs.

1) The majority of opposition to reform doesn’t come from people who actually disagree with true reform. Health is one of the most universal and personal concepts imaginable, and it is understandable that people who have good existing coverage would be intensely resistant to change. But herein lies a tremendous opportunity to explain that reducing cost growth by opening up competition is not the same as denying coverage, in fact it’s the opposite. Should be a good reason to tune in tonight.

Music Video

Come on down

When most people hear the word ‘mentoring’ they probably think of something like troubled teens breaking windows, or take your daughter to work day, or some medieval apprenticeship in axe smelting. Or maybe a couple junior partners ensconced in wing-backed chairs sipping vintage chardonnay while talking about penetrating market share. But they don’t usually conjure up images of themselves, at least not concrete ones. Mentoring has become a chore, a vehicle to log community service or pad a resume or atone guilt.

But for many young professionals, the familiar path for attempting to develop a meaningful career goes something like school, internship, cold calls, email solicitations, happenstance job postings, and submitting applications like buying lottery tickets. Getting a job you actually really want, or honing useful experiences in a field, is about as deliberate as falling through a trap door. It kind of either happens or it doesn’t. Harvard either sends you a big manila folder or a wafer-thin legal envelope. That principal either calls you for a second interview or fades into utter oblivion. You show up the first few weeks of work and either realize you found something that genuinely makes you happy and productive, or you realize you didn’t need the last 8 years of school to answer the phone when it rings or discuss 1970s cultural trivia with co-workers you can’t stand. It kind of just happens. And in the 21st century, innovations and widgets and databases designed to mute this uncertainty and randomness seem to just accelerate it. Now instead of a few job postings we’re not sure we’re interested in, we can see a thousand, or instead of five bosses we don’t know we want, we can network with fifty. But going in for that first face to face in some downtown office or stately board room while being offered free drinks and being peppered with questions still seems just as ice-cold evolutionary as antelope crossing the Serengeti. Degrees and core competencies and letters of recommendation may get you in the door, but you still either sink or swim. It’s all decided usually in matter of minutes or hours, or if you’re lucky days. There is rarely that trial opportunity, an environment that isn’t so clearly and awkwardly motivated by self interest. I want this job, you want to finish the paperwork and successfully close a headhunt, so just try to resist my effusive charm and unrestrained intelligence. The fact is most people think they’re more insightful and unique than they could ever hope to be, and so this shock and awe approach to dream career acquisition usually goes about as well as its military equivalent.

The reality is we can more easily follow a feed of Britney Spears’ daily caloric intake than vaguely describe what it is we want to do every day with job title ‘fill in the blank.’ We develop a better rapport with our cleaning ladies than we do with people we may potentially spend a majority of our waking hours with. Years of school and imagined lives and aspirations and resumes are crushed together in one giant professional particle accelerator, and it either spits out a job you like, or maybe consumes your life as fuel to swallow the universe whole in one giant eternal black hole. We test drive cars but not careers, we rate 30 second youtube clips but not vocations, we try on a pair of slacks at the mall but not a job offer, we scorn Wall Street bonuses but know we just wish it was us on the receiving end. And in these little gaps is where I think there is a role for mentoring. Mentoring can be more than trying to save people from entering the penal-justice system or reduce an uptick in attrition. Mentoring is where droves of teenage aspiring financiers can have a fail-safe environment to test their assumptions, and would be engineers can stress-test career pathways before they commit hundreds of thousands and years of their life. It's where people can actually pick up and hold that big shiny prize they've coveted forever. It's where people can discover what they want and what they like.

There’s a billion gray-haired professionals populating skyrise cubicle farms, slogging through subways in yellow sweat-stained polos, negotiating morning rush hour at the Starbucks drive-thru, sifting through folders of porn on the weekend, who deep down know they want more. And there are at least as many religiously, compulsively anally driven twenty-somethings whose main mental construct is centered around getting a usually painfully generic big break that will deliver them from their current stalled ascent up the career escalator. Seems like supply and demand groping for a market. And rather than unite them in a high-stakes, hire or fire, promote or shelf, judge or patronize, win or lose, zombie dance, how about actually try it, whatever it happens to be. This is why I created Plategro.com. And while I think it has a likelihood of success about the same as an AIG subprime mortgage getting paid back, I think it’s good to dream.

Ok, after seeing what Chase and Goldman and co have been able to do in the fixed income and commodities sectors this quarter, I officially rescind my last blog post. I want cap and trade to pass, I want it to be a volatile market, I want some index to short, I want as much consolidation as possible, and I want a bunch of government agencies with overlapping responsibilities and a slew of new regulations with no established case law whose fissures can be easily navigated. In the process there will be so much liquidity generated that banks will be able to underwrite lots of new clean energy investments. And with the intent of the cap being to actually incent new capital purchases, maybe it will be a sustainable boom not bubble. And as some have pointed out, the climate doesn't have a constituency, so how could we expect any different sort of political economy? Probably accurate. What was I thinking?

The Audacity of the Grand Bargain

Seventeen years after George H. W. Bush signed the United Nations Framework Convention on Climate Change, committing the U.S. to seek greenhouse gas emissions limits, one chamber of Congress finally passed the first U.S. climate change bill in history. Coincidentally this fell on my birthday- I always thought I was the climate messiah. Too bad the 1300 page American Clean Energy and Security Act of 2009 is full of so many complicated, unnecessary and potentially dangerous provisions. The proposal commits the U.S. to reduce emissions 17% below 2005 levels by 2020 and 83% below by 2050, sets up a 20% renewable energy portfolio standard by 2020, and establishes a menagerie of committees, criterias, offsets, definitions and standards on how to measure and verify everything, all to be figured out later when these regulations are drafted.

This bill hands out all rights to emit carbon dioxide and five other gases to industries for free, in direct contrast to Obama’s campaign pledge. The results are windfall profits and the potential for an energy driven asset bubble. It provides no assurances that the price placed on carbon will actually be one that makes clean energy profitable, which was exactly the experience in Europe when they established the same system in 2005. Credits were handed out for free, and in order to get votes everyone got a big piece of the pie (resulting in more credits being handed out than there were emissions), and the price has hovered at near $0 per ton ever since, while Europe has lived with a huge regulatory bureaucracy and burden while actually increasing its greenhouse gas emissions. And if the price of carbon gets “too high”, well then more permits are handed out for free to lower the price. And if the price is still too high, well then the cap no longer applies, so everyone paid a lot of money for a big complicated system that didn’t reduce emissions. Not to mention that we are in the midst of the worst recession in three generations, largely precipitated by an asset bubble and excessive speculation in the housing market, a market that has been studied and regulated for hundreds of years. This bill sets up a multi-trillion dollar market for the next 50 years, one in which the U.S. has no experience. The same people who pushed this through so voraciously will be the same ones decrying the excesses of carbon credit default swaps and derivatives in 10 years after we have seen another huge unsustainable bubble pop.

Then there is the issue of offsets, new emissions credits that can be generated when firms offset their emissions with something that captures carbon. Except, what exactly that means and who measures it will be figured out later by the Department of Agriculture. This will take years and many lawsuits to resolve, and even then the standards may be overly broad and subject to some very clever abuse by Wall Street, who frankly I put my money on over USDA any day of the week when it comes to cleverness. Not to mention the agriculture community is in large part the regulated party, a slight conflict of interest. Then there are the trade sanction provisions. This will allow the U.S. to bring action in the WTO and UN against countries who “artificially subsidize” their products by not attaching the same carbon price as the U.S. India and China have already drawn a line in the sand and said they will reciprocate any climate change tariff or quota and challenge our actions via arbitration, which typically takes about a decade to resolve. Of course by the time this is resolved we’re already supposed to have reduced emissions nearly 20%, so we’ll either have to march on with significantly high energy costs while India and China walk, or wait until a nasty trade dispute is resolved. And of course the bill raises $650 billion in new tax revenues, not to be recycled back to the American people.

Much superior to this convoluted grand bargain, we should place a price on carbon so it is the cheapest alternative, rebate it back to the American people, and cut out 1000 pages of special interests pay-offs in the process. If we want a clean energy economy, we don’t need the government telling every business and consumer exactly how much carbon they can emit every year for the next 50 years. And we don’t need dozens of new programs and thousands of new bureaucrats trying to figure out how much we’re emitting in the first place. All we need is for clean, renewable energy to be cheaper than dirty finite energy. If clean energy is cheaper, consumers will buy it, there will be demand pull. If clean energy is cheaper, it will represent a larger profit margin and greater return on investment for producers, there will be supply push. The price is the market maker, not the government. This bill could very well result in the grotesque situation of firms producing unprofitable products for consumers who are forced to pay more for them. Many people on the Hill act as though once you acknowledge the reality of climate change, there can only be one way to address it. There is no discussion of the multiple potential approaches and associated tradeoffs. Just one bill, and a lot of gray-haired men ramming it down everyone’s throat. The consequences of such little context for debate could be some very unintended consequences.

The Obama Administration is pushing hard on so many mega issues- health care, financial regulatory reform, energy and climate change, the largest budget in the history of the world, and now it looks like immigration too. The implicit tradeoff with this ‘boil the ocean’ approach, in contrast for instance to a more incrementalist one, is it requires engagement with the entire universe of very powerful special interests. You either have to commit to hard slow negotiations with the lobbies, and take very public and potentially damaging defeats in the process, or give them broad sway in order to get votes and flattering headlines, but live with policies you may come to regret. Obama and chief whip Emmanuel have consciously chosen to attempt to complete their entire agenda in what would be a truly historical first term (and guarantee for a second) in exchange for being very willing to play ball with the interests they want to regulate. The stimulus was a prime example. The White House sent a list of broad goals and top line numbers up to the Hill, and like throwing meat to a pack of ravenous dogs said, “fill in the details.” Lobbyists get a bloated bill full of new government contracts, Congress gets the support of their local haymakers, and the White House gets a resounding legislative victory. We also get a lot debt, a still increasing unemployment rate, and a bill the American people are increasingly souring on. If all that bill produces is a few hundred thousand jobs, and nearly a trillion dollars in new debt, that could be just the opening the GOP needs. (*POSTSCRIPT: Excerpt from Fall 2010 Paper: "Mr. Obama is already faced with the reality that voters have, fairly or not, decided that his first big effort to revive the economy, the $800 billion package enacted right after he took office, was a qualified failure, and that anything tagged as further 'stimulus' will be cast by Republicans as throwing good money after bad.")

And if all this climate bill produces is mountains of new regulations, costs, and system gaming, with few emissions reductions (like Europe), then the White House just gave the GOP a gaping hole to meander through. Obama said at the time he was pushing the stimulus, "my job depends on this bill"- he knew the risk he was taking. If politics is the art of the possible, then this is some very fine art. Perhaps it’s impossible to achieve much better, but we won’t know unless we try. The bill that was passed Friday shows more about how many people want to be Rahm Emmanuel’s friend, and who don’t want to cross Henry Waxman, than about who wants to actually usher in a clean economy in the most efficient way.

the royal treatment

The other day I tripped over a branch in Rock Creek Freeway (some would call it a park, but whoever thought putting a busy road absolutely parallel to a beautiful creek packed with birds, strollers and generally other important things should revisit urban planning school), except I didn’t realize I had tripped over this enormous Amazonian vine crossing the roadway until I had gotten off the ground to look back and indeed realize there was this freakish vine running across the road. In the time it took me to get up this erudite 60ish master of the universe gentleman type biking my way shouted at me “YOU should have picked that up!” To which I apologized profusely for tripping and agreed yes, I should have had some kind of pre-cognition that I was about to eat shit. Clearly being a selfish gen-y wasteoid meth addict, I had lazily chosen to trip over the vine rather than remove it. I really would have picked it up, just as soon as I realized it, and my face, was fucking there! I then asked him if he had any good stock tips, whether he was Yale ’67 or ’68 and inquired as to whether he wanted some grey poupon slathered on his ass.

This is my Mr. Rogers moment for why sometimes we need to look in the mirror, and see if the guy above is staring back. Because it’s too easy in high places like DC, with powerbrokers and lobbyists and lawmakers and Honorifics and executives sashaying through their populated schedules on the reg, to watch someone eat shit over a branch and blame them for not not de-littering the park. Sometimes this town can pass a $900 billion law before it can show kindergarten level humanity.

Majestic wonder

One of the most momentous and world impacting events of the 21st century occurred last week when Blink 182 reunited and took the stage once again. It included the usual incredibly choreographed and executed dance moves, poetic interludes and quaint heart wrenching double-necked guitar solos. All the hallmarks of punk rock mastery was there- most importantly perhaps telling the nation’s largest wireless carrier to go suck it, or how they’re planning High School Musical 5: The Tour.

Travis Barker is one of the most intense and effortless drummers to ever get behind the kit, Hoppus is a workaholic bassist and becoming a versatile producer, and Tom Delonge’s name rhymes, and when he wants can be one of the most irreverent and sensitive lead singers to ever strap one on. I have night sweats about turning into someone who goes to see John Foggerty or Styx 3-5 decades after their prime, where a concert feels like some previous generations’ past rock anthems were preserved on a slide and endlessly replicated in some tour promoter’s lab experiment, but Blink’s not there yet. Thomas is only 33 and still looks like he wants to push the boundaries, and they still have the youth to record new edgy, violent stuff.

Blink going on hiatus was unexpected, but I can’t help but feel they all got better in the interim. Travis started doing beats and drums with DJAM, and if there were any holes in his rhythmic Chinese wall he certainly plugged them. Mark became more of a musical philosopher, dishing out impressively thorough and researched podcasts and blogs while also becoming a producer. And Tom explored new synth sounds and still better dance moves. And I don’t think it’s a coincidence that Blink broke up within a month of George W. getting re-elected, when Tom’s brother was fighting in Iraq. It clearly permeated his playing and writing the next several years, and I don’t think them reuniting within a month of Obama taking office is random either. Blink springs eternal. But maybe I’m thinking too small. God himself may have reunited Blink. In the course of just a couple months, their long-time producer sadly died, two of their best friends were tragically and horrifically killed, and Travis literally walked away from a freakish plane crash. It was a reminder that sometimes there are causes and connections bigger and more important than you’ll know. That sometimes doing something because it feels right and good and crazy is enough, and maturity means often being okay with emotions, drama, egos and doubt- the hallmarks of immaturity. That you can still love people while you’re hating them. I guess this is growing up.

Stress Testing

Banks do stress tests all the time, you can’t plan for what you don’t understand or measure. And banking supervision is a full-time job. Balance sheets change in value daily, new assets come on the books daily, and the economy is fluid. Banks have full-time examiners who are continuously measuring their loan levels, estimating the potential loss exposure, and then requiring loss reserves accordingly. So the idea that these stress tests were rolled out as a big bold new policy, and then so publicly announced, seems off-base and represents an unnecessary policy risk.

One, the necessity of these “new" tests just show that the regulators failed to begin with, that they didn’t even know the basic exposure of the banks in the first place, and still didn’t. And two, the whole basis for the test is to prepare for contingencies, things that haven’t and very well may not happen. Like a “stress” case and a “worst” case. Chairman Bernanke characterized these cases as “unlikely”, yet they are the basis for requiring firms to raise more capital, either by selling off potentially valuable assets (like Citi did with its Japan brokerage), diluting existing shareholders by converting government loans to common stock, or by taking on more debt. All things that shouldn't be done simply because of unlikely assumptions. In addition, the tests created significant anxiety and hurtful market expectations for weeks preceding the tests. Once the results were leaked and it was clear the banks already had the ability to close the so called gap, the market cheered accordingly. But what if the gap was much larger, then this policy would have created a panic of sorts, causing many funds and investors to dump financials further- tangibly hurting the bank’s ability to raise capital, all because of hypothetical and “unlikely” assumptions about capital they might need should the situation deteriorate. Except that the reason for the deterioration could have been the anxiety created from the tests themselves. Thank goodness the banks had been stockpiling money for months anticipating this- if the gap had been larger this stress test would have just set back a huge rally by throwing its full weight behind assumptions and creating a self-fulfilling prophecy. To minimize this risk, the tests should have been called simulations and been completely internal between the supervisors and banks, so regulators could know exactly how much capital to inject under worsening conditions, and the banks could come up with a plan to execute in such an event. Instead, by forcing the banks to raise the money automatically, and practically broadcasting every discussion with the world, it was akin to evacuating a theatre full of people just as the curtain starts to rise because, well there’s no fire- but there could be.

This policy was a big roll of the dice and continues to show the youth of Treasury Secretary Geithner. These sorts of tests should not be confused with reality, and should be routine functions of the supervisors, not spectacles we all hold our breath for. Additionally, why they used tangible common equity as the definition of capital and not Tier I has yet to be answered. The big banks have 10%+ of capital they could access, but only about a third of it is common stock (considered a safe liquid asset). So, these tests probably understated their true capital level by about 70%. I’m glad this turned out as well as it did. But it’s only because we lucked out and didn’t have a full stampede out the door when the government yelled “fire!” in a crowded room.

The Markets could use some Pepto Bismol

As the stock market continues another whipsaw reversal of recent gains, counter intuitively 90 minutes after the largest deposit institution in the country reported double the profit from a year ago – I have one question: how is it possible that the markets, particularly financials, will not recover? Even disregarding the across the board strong profits of the remaining major financials in the last quarter, I defy anyone to explain how the fundamentals will not lead to a strong rebound in the mid-term (becoming shorter every day). Another interesting question is how much of the major bankruptcy and wealth destruction we’ve seen is a result of the bubble bursting versus people reacting to the bubble bursting? Washington Mutual for instance had significant write-downs on mortgages, but it also had $16b in withdrawals in its final week and a 90% drop in common share value over just 6 months. A situation like this will throw any company into trouble, whether it has a toxic or fortress balance sheet.

This is an especially interesting question because writedowns on assets are not losses. One, they are not realized, they don’t represent an actual outflow of cash, just a revised downward multi-year estimate which effects the current valuation, and two, they only really effect cash flow to the extent the market reacts adversely. Write-downs are serious and hurt balance sheets, but it is generally a very long-term signal with a lot of noise. Long-term because mortgages and bonds typically have a maturity lasting decades, and noisy because the characteristics of these securities as a whole is always changing based on the current underwriting standards of newly issued assets. But the market (read herd) takes this rather broad signal and immediately forces a translation into very short-term price signals. And I’m not sure the conversion factor is always spot on. To date the banks have written off several hundred billion in mortgages from their balance sheets, a significant shock no doubt, while the stock market has shed over $2 trillion in wealth. In other words, the market capitalization losses sustained is something like six times the actual writedowns. This is an even stronger shock when there is a run on existing contracts, from deposits to insurance product. The government realized in the 20s the unnecessary and preventable impact such reactions could have, and the FDIC has largely prevented it in commercial banks. That no such authority existed for multi-unit banking corporations like AIG or Lehman was rather remarkable considering how central to the financial system they had become.

Rather ironically, the only long term threat I see to robust bank recovery is the federal government. Unless people suddenly break a 10,000 year tradition, people will need shelters, likely, I know this is a stretch, in the form of houses. The rate of population growth and replacement dictates that about 1.3 million new homes need to be built in the U.S. as an annual baseline. In the last 12 months something like 400,000 were built. So the actual housing recovery timeframe is just a function of how big one thinks the bubble is, how big the surplus inventory is. I don’t think it’s much above 1 million, and we’ve already burned off about 900,000 of it. The rubber should finally hit the road soon. And once we get back to a supply-demand driven housing market, it’s hard to imagine that all these homes won’t require financing. In fact, 99.9% of them will. Pretty much everyone who doesn’t have a Louis-V with a milli in it like Lil Wayne will need the services of Bank of America or Citi or Wells Fargo. Thus, their first quarter earnings don’t seem to be mirage at all, more like a harbinger.

So there is more recovery in the pipeline, particularly when most of the recent earnings came from fixed-income arbitrage in a historically robust bond market. I have yet to hear anything close to a lucid argument that explains how housing and finance will not recover. And because prices have been falling for 16 months now, when it does turn it will likely have some strong inflection points. Balance sheets could reinflate relatively quickly as sideline homebuyers finally get on the field. The only potential long-term complicating factor here (assuming underwriting standards improve) then is the little issue of either servicing the government’s preferred stock loans, or worse selling off their common stock should they choose to convert it. The government should only consider converting their shares to equity if the stress tests show huge gaps that can absolutely not be filled any other way. And considering Citi, BoFa, JP Morgan, Wells all have 10% plus Tier I capital, and Treasury has $100 billion in the vault from TARP, and Goldman and Morgan already want to payback, I think the extent to which this has already been considered and bantered about as a serious idea is borderline irresponsible. We already know the market’s response to this rhetoric will dwarf the actual effects of any such real action. In fact, if the current sell-off continues investors can literally do whatever they want.

GM/White House need to think outside the box

The auto industry bailout should be a coordinated framework to re-imagine personal transportation in this country- including electricity providers and boutique next generation auto startups, not just two imperiled giants. Focusing simply on making GM and Chrysler cash flow positive with newly innovated offerings and lower debt burdens might do the job, but it ignores how integrated and market-infrastructure dependent the auto industry is. After this perfect economic storm, there will very likely be little space in the future for the government to intervene wholesale across the financial and auto landscape as they have in the last 6 months, and little opportunity to bridge the auto manufacturers and electricity producers’ interests.

The Administration only has so much credibility in lecturing the private sector how to make a buck, and only so much room to leverage the benefits of examining the sector in totality. By focusing on the manufacturers in isolation, the government risks supporting fuel efficient vehicles while leaving electric infrastructure developers on the sidelines. The Energy Department has $100 billion in new loan/grant authority, and could indirectly support the automakers by investing in companies like Better Place and Coulomb that develop the electric fueling stations that are a prerequisite for any true Detroit game-changers. The plug-in electric gas hybrid Chevy Volt will be substantially more expensive than an average car to begin with, curtailing sales and lengthening innovation cycles while stalling recovery. Costs will come down only with significant volume, which is a mere pipedream absent a national charging network. And in a world poised to add a billion new cars in China and India in the next 20 years, this is no longer just a matter of pristine design, but self-preservation. Making sure the market infrastructure is there when the new Volt rolls off the line is just as important as making sure they have competitive compensation agreements or streamlined supply lines.

Similarly, private startups operating today at the forefront of auto development, like Tesla Motors, could benefit from the breadth and relative financial depth of the big automakers, while the big automakers could benefit from their new platforms and next generation technology. Joint operating agreements or tech for equity swaps could speed up the bigs’ innovation while giving struggling and investment heavy startups (Tesla is asking for government cash) the market exposure they need to drive costs down. A note of caution however, this is not to say the government should impose anything. The big prize that awaits in the coming years and decades for clean energy winners, and the fierce competition among private actors it will engender, is a catalyst that should not be muted. However, the government and its auto task force is the perfect forum and moderator for getting these parties in a room to talk and see what pencils out. At a minimum they could talk about the non-exclusive aspects and infrastructure they will all need and brainstorm a general strategy, and at most cut some very lucrative deals.

It’s always the time for bold thinking, but very rarely is there the opportunity to actually implement it. The current public appetite for grand new economic architectures (whether TARP or TALF or the Legacy private-public partnership or the auto bailout or the Housing Plan or the Stimulus) is fast dissipating. Ad hoc investments in whatever the market would bare got the industry to this point, and ad hoc government negotiations and a spattering of tiny grants all over the place will just be further death by a thousand cuts.

A Simmer Down Now

Nobel winning economist and liberal zeitgeist Paul Krugman suggested today with a straight face that we return to a financial system, as he put it “like the 60s” - pure depository institutions saving and lending with little to no securitization or hedging. He also seemed to half-heartedly pick a fight with Larry Summers. I hope Larry will put down his 17th diet Coke of the day for a moment and take 20 minutes to draft a response for next week’s Financial Times. It would be a debate we would all benefit from. But then again maybe Summers thinks Krugman’s argument is too much of a straw man, too weak and unthreatening to solicit a response.

Krugman’s general sentiment is dead on, in that the financial system of the future cannot replicate the one we’ve just had. But this does not mean we have to roll back all financial innovation in extremus. This doesn’t mean we need to purge Wall Street or banks of anything that is a little complicated. I think more than anything else it means we just need more checks and balances, or in some places the creation of them, like over the counter trading. And it means we need to “keep it simple stupid.” The experiences of the last 6 months are not so much about the creation of new or wildly complicated financial products, as it is a reminder that firms need at least 5% or so cash on hand and need to verify the information their loans are based on (e.g. mortgage applicants). If these two things had been in place we wouldn’t be here today, and Krugman would not have the bully pulpit to adopt his pseudo neo-Ludite financial perspective.

Look at it from the perspective of a newly graduated college student with a decent job, who wants to buy her first house. The ability of this person to get a loan, and the interest charged on it is directly related to the willingness of banks to provide it. A typical bank will have 90% of their portfolio seeking a return in some respect. A good deal of these will be wrapped in recourse debt instruments to provide diversity, and often produce a margin via selling. This diversity represents more risk control for the banks and thus confidence to lend, and this margin represents more money the bank can lend, and thus more favorable credit terms for our post-collegiate house owning aspirant. And the security is only unsustainable, only contributes to a bubble, if the face value is below the current value of the future cash flows – e.g. if significant numbers of those who borrowed the consumer debt that stands behind the security will not actually pay up. This risk can be prevented quite easily with accurate information about the borrowers. This is widely applied today in the government’s new housing plan, which won’t deal with potential borrowers above a 38% debt/income ratio. Of course, to determine this you have to actually record this information. A greasy-haired condo pusher in El Paso wasn’t always accurately reporting this information to banks, surprise surprise! and banks were eager to make the deal anyway to push it up the chain. But this little scheme does not mean securities cannot be properly valued. In fact it just means the Fed needs to require actual records of income to be reported, as they did in February. So, securities can actually be worth more than their market price, and it’s good for the investor who sees a profit, good for the banks who generate more financing, and good for our college grad who can afford a slightly better house on better terms. Krugman would have us, in one radical fell swoop, nix this whole concept. Dangerous idea.

The other part of his argument attacks the big spooky market of derivates, e.g. futures, options and swaps- concepts that have only been around for hundreds of years- from farmers wanting to protect their crops from future unpredictable weather to British spice traders who didn’t want their global deals to be subject to the volatility of foreign exchange currencies. Derivatives just allow risk control, and if you happen to control this risk yourself, an incentive to do so in the form of profit. And yes, rules need to be in place. Like the degree of leveraging and collateral, or who’s trading where- tracking all this is in the works. Yet high finance is not the only place where Lord of the Flies will play out if there aren’t basic rules, and this caveat is no reason to pick on Wall Street. The credit default swaps (you will swap money for my asset if it turns out to totally suck) fiasco with AIG was not a result of the derivatives or futures system, but because they invested in a bubble (quite happily) and didn’t have nearly enough cash on hand to meet their obligations. Options and swaps are banks’ insurance, and without them they will understandably lend a lot less. Which means Krugman’s argument hurts just about everyone who wants to ever use money for anything. We require insurance for a $2,000 Datsun with 270,000 miles, it's the law, why would we not have insurance on $1 billion in mortgage loans? Or 20 million barrels a day of crude that we import? Or pensions? Or… Risk control is paramount and lowers the costs of financing and increases the availability of productivity enhancing capital. Keep it simple stupid.

Cap n’ Trade = Tax n’ Trade = Tax n’ (Bubble + Windfall)

There has been a lot of talk about a market-based cap and trade system as the ticket to a clean energy future. It’s a good solution. It could work. But it also carries significant risk, risk that a revenue neutral price signal (tax) would not. A recent MIT report highlights the expediency involved in getting climate policy right the first time. This 2009 study projects a median increase of 5.1 C (9.2 F) by 2100, up from a 2003 projection of 2.3 C. This kind of warming will have serious implications on everything from biodiversity to agricultural and forestry production to sea levels on a scale of meters. Any policy the United States seriously puts in place will take years. The EPA for instance has just completed a draft mandatory reporting rule for every producer that emits more than 25,000 pounds of GHGs a year, about 13,000 in the U.S. It has taken years of dialogue to get to this point. The rule still has to be finalized, then a registry set up ands tested, and then the actual cap would have to be developed, and then a tidal wave of litigation resolved. The point is, after all of this is sorted through, the system we get better work. Because of the potential for bubbles, price manipulation and windfall profits in a cap system, there is an elevated risk that it might not. The resultant public pushback and backlash in Washington could very well cause significant modifications if not outright repeal of such a system.

There are three basic issues with a cap system: 1) it’s just a nicer word for a tax because a cap creates scarcity which increases prices 2) even if the permits are auctioned off at the outset if can still result in huge windfall profits that can distort markets and create bubbles and 3) there is an implicit trade-off between price volatility and emissions reductions. This last point is because there is either a price ceiling or there isn’t. Without one, prices can be as high as the market will allow. In the case of the acid rain market, permits got above $1,000/ton and last year showed 75% year over year price volatility. This is far from good for businesses, investors or consumers. And this is in a market where there are readily available technological substitutes. Low sulfur coal is abundant. Scrubbers that capture SO2 and NO2 exist and are cheap. The same is not true for GHG reductions, so there is every reason to think that without a ceiling the price in the GHG market would be higher not lower than the already very high-priced and volatile acid rain market. However, if there is a ceiling, it is maintained in the same way the Federal Reserve targets interest rates, by open market operations with a reserve of credits. In the Fed’s case, reserves in cash, in the GHG market the reserves would be GHG credits. But what happens if you run out of these credits held in reserve? In other words, what happens if it takes more credits than have been set aside to deflate the price to the level prescribed in law? Well then you just create more permits, oh and there goes the whole point of the system – because you’re above the cap, e.g. you’re not reducing emissions which is a primary purpose of the system.

And it is often said that the issue of windfall profits, assigning private rights to a previously non-exclusive public good (like atmospheric emissions) that enriches the recipient of the now newly minted asset class, can be solved with a 100% auction system. Why is this an issue? Say the auction sells credits to the market at $5/ton CO2. The EU and Chicago Climate exchange (the largest U.S. exchange for GHG emissions) have historically traded CO2 at around $4 ton, so in all likelihood $5 is a very high initial assumption and it’ll be more like $2. But even if it’s $5, these permits will be held onto by the market until they appreciate. And the anxiety alone of a new energy scarce world will probably lead to significant appreciation right away. Not to mention that when a firm needs to buy these credits they have few short terms options and so it’s not hard to imagine them being bid up. Now if the price in the market is $20/ton, then there is a 300% windfall, the asset netted 3x what it cost, equivalent to a 75% subsidy. If there was no auction, the windfall would be infinite (something for nothing) – so it’s less windfall than without an auction, but still a windfall. Windfalls are basically strong subsidies, and subsidies distort price signals, create artificial value and expands the size of the market because of the elasticity of demand. So there is value creation absent new productivity, and absent new wealth creation these prices can not be supported indefinitely, they will have to fall. E.g. a classic boom and bust cycle – originating in windfall profits. In short, if firms get assets that trade at $20 for $5 they have a $15 profit margin, which is a good thing for the firm, but that $15 now has to be put somewhere. And because it was created simply by an actuarial identity, because the government said the credits will be sold for that price, and not because of $15 productivity gain, this $15 will contribute towards inflation and asset appreciation that is not sustainable in the mid-run.

Cap and trade can work, it is just that we must be sober about the risk it carries and think hard about getting it right. One approach would be to design a system that is entirely revenue neutral – so all that new money out there is offset by government spending. Another approach might be to smooth out price volatility by creating larger margin calls or position limits. Or, here’s another idea.

10 Things I Want to Do in No Particular Order and I’m not Sure Why (and maybe I don’t want to do all of them)

-Enter a hot tub from a rolling start, perhaps office chair.

-Play bass guitar to the moon with no shirt.

- Get a tattoo of a giant V on my shoulder, it would stand for many different things.

- Shoot a music video. I tried this a few years ago and had three police encounters.

-Take a company public- fuck this is nearly impossible.

-Shake Merritt Paulson’s hand.

-Bravely lose an eating contest.

-Ask someone reading a newspaper in the subway to name one thing they remember from the paper they read last week.

-Jazzercise.

-You know, that one thing we did that was really sweet.

Squeezing the Triggers

Former Treasury Secretary Paul O’Neil talks in his book about how in 2001-2 he and Fed Chairman Greenspan preferred a “trigger” approach to the then proposed Bush tax cuts. They wanted to cut taxes in phases depending on the future growth of revenues relative to budget needs. There was a current account surplus at the time, and so they had no problem cutting revenues, but they wanted to do it in parts so that if a budget deficit opened again they could achieve some balance between future needs and tax reductions, by not pulling the trigger on the rest of the cuts. It was a good idea because it was extremely policy neutral. It did not oppose tax cuts at all, and would have let trillions of dollars of them go forward, just so long as they were real cuts, not just an intergenerational transfer. I think the same idea of triggers could have been useful with the American Recovery and Reinvestment Act.

Congress could have developed three $250 billion segments, with only the contents of the first chunk really spelled out in the legislation. The first segment would be spent immediately, and the President and his advisers would submit a plan to spend the other two when they needed them, allowing them to adapt as the economic situation evolves. This would have focused funds on the areas where they can be spent the fastest, made passing the bill even quicker, allowed an opportunity for “lessons learned” in the remaining two sections, allowed the nation to essentially test how well the stimulus worked (for instance by comparing White House job creation estimates to reality), given control over the amount added to the deficit by not spending the whole amount if the economy began significantly rebounding, and essentially improved the package over time by seeing where the most jobs are created for the least amount of money and where investments enhance productivity the greatest.

Now anyone in favor of the stimulus would surely point out that it was so big because the challenges are so big, and two, passing it once was no sure thing, so why repeat it. On the first point, in all actuality there are very real constraints on how fast that volume of money can be spent. Infrastructure grants typically take 5 years to administer, any job in an emerging field (like green energy) by definition has a scarce labor market and so there needs to be new technical training and certification, which can take years. Even just obligating the money, e.g. signing contracts to spend it, is subject to either a formulaic application process, competitive bidding, or the state legislative process – all of which takes time. And then often there is design work or studies that have to be done before people can even be hired. That’s why the White House estimates about 75% of the funds will be spent within 18 months. That’s quick, and about as quick as it could be reliably done, but it’s by no means particularly streamlined. So long as the three triggers are pulled within a year or longer, the funds will get out the door at the same rate as the consolidated version, and because of learning and technology, it might even become more efficient. Right now Energy Secretary Chu, a brilliant Nobel chemist, has over $150 billion in credit authority that he can place basically anywhere he thinks will advance green technology and create jobs. And understandably, he’s still trying to figure out the best way to do it. This inevitably involves wading through thousands of applications from mainly promising sounding companies who applied via their states for a piece of the action. Figuring out which ones to give money is tough. Figuring out how to make all those loans into a cohesive system is tougher. And knowing if you spent the money as well as could be done, for instance that you didn’t deny the next Google of energy, is probably impossible. If the money was spent in waves, and appropriated in triggers, they could adapt their lending based on real results in the field and be surer that they’re making the best investments for the economy and for the future. The worst situation would be to invest in an idea or project that becomes obsolete, then people are unemployed all the same once it’s built, but then are stuck with a less productive economy because of antiquated technology, and now will have to pay higher taxes to pay off the debt from the stimulus. A triggered approach would provide real-time information to make the soundest investments.

On the issue of passing three parts, one has to look no further than the Troubled Asset Relief Program. It had two parts, where the President had to request to use the second half of the funds and get a majority vote to receive the funds. Now I think the TARP has been very successful given its point. There was a clear and present risk of systemic failure of the credit markets in early October. In the course of a week there was a string of huge financial institutions failing, and each one lost weakened the remaining. Since TARP passed and the banks recapitalized, there have been no major failures and now that basically seems out of the question. The point wasn’t to create a boom or solve every firm’s problems (in fact you don't want to do that because it deflates the important value of risk appreciation), it was to ensure the continued operation of the capital markets, and it did. Secretary Paulson and Chairman Bernanke had essentially a weekend to come up with a plan, and I think they did a brilliant job. And they structured it in a way that taxpayers will almost certainly see every dime back. So the stimulus could have been done in the same way, where the President has to submit a plan for spending the remaining section when he wants it, and then a 51% vote is required in Congress. Given the majority’s comfortable cushion, the request could be passed in an afternoon. Only the bill itself authorizing this structure would require 60%.

I also think that the stimulus bill could have been more creative, and not cheesy idealistic creative, but 21st century creative. Basic infrastructure is important. We need bridges and wastewater plants and sidewalks. States and localities already spend enormous sums on this every year and there are large revolving funds provided by the federal government annually in these areas. The stimulus needed $100 billion immediately going to the states to cover current deficits, and it needed money for basic infrastructure and schools and transportation. But how about incentives for new investments? What about a venture fund to invest in new research and companies? In a hyper-competitive and growing (on net over the 21st century the world will almost assuredly see the largest creation of wealth in history, China and India alone are on pace to pull almost half the world into the middle class) we must make long-term investments. As Friedman recently wrote, what about recruiting the best Ph.D’s from around the world by issuing more skilled worker visas, so they can build companies here and create new demand via buying surplus houses and supporting American businesses? The world becomes less brick and mortar every day, yet this bill seems to lay a lot of bricks. This stimulus is probably one of the greatest domestic policy achievements of a President in the first month in office ever. There is no perfect policy, yet this one is quite good. How good is very hard to know, unless you waited for some of the smoke to clear before pulling the trigger again.

Executive Compromise: The Contrarian View

There has been much populist celebration over President Obama’s recent freezing of bank executives’ salaries who receive federal money, and before that the freezing of his senior staff’s salaries. I’m not adamantly against this, but I don’t see how it accomplishes much of anything. So I’ll take the contrarian view – the usually more fun view. Firms already have every reason to avoid taking government money - because they’re not getting “bailed out” at all. They’re giving up huge stakes in their companies and the future profits that go with it, and assuming new debt to pay the government back. AIG gave up nearly 80% of its assets in the form of preferred stock and warrants. This means everyone who has parked money with them is now in the back of the line behind the federal government for dividends or shareholder privileges, experienced huge price dilution, and will likely see the government slowly and painfully liquidate their holdings. The shareholders don’t want that, the executives don’t want that, employees don’t want that, no one wants that – it’s a last resort. So the notion that they’re willing to basically give up the entire company so they can get their hands on public money just so they can get their holiday bonuses seems implausible. Also, Wall Street bonuses typically make up about a third of the NYC tax base in a given year. Without these bonuses, the city faces an even bigger budget gap, has to cut more services in a time where government purchases are needed to create demand, and ironically some of the very funds being loaned to banks in the first place.

And then there’s the whole issue of incentives. There are very few people who have the experience or capacity to run large financial institutions, let alone fix them when they are awash in problems, and it’s not like they have nothing better to do. The Jamie Dimons or Lloyd Blankfeins are not short on job opportunities. Cutting compensation 95%+ isn’t exactly the recipe for recruiting the best managers and thinkers in a time when they are most needed to sort through a menagerie of problems. The financial downturn was precipitated by a phenomenal disregard for basic due diligence. Most people put more effort into buying a used car than Citi did buying $100 billion of bonds, as Robert Rubin put it – “it was an afterthought.” Jamie Dimon largely protected JP Morgan in the summer of ’07 just by realizing he couldn’t really explain the slight uptick in defaults, and once they realized that they also realized they had no idea why the bonds were rated so high, so they divested. And diligence, as the word suggests, is not easy or particularly enjoyable. These firms will avoid further trouble only when they have executive committees that take their time and scrutinize their every step. If they’re not rewarded, if incentives are muted, it becomes less clear that they have a motivation to perform this diligence. Misaligned incentives (like in securities bundling or rumor-fueled short selling) got us into this situation; a system capable of preventing it will not emerge until these basic incentives are realigned. And last, the success or failure of these firms does not hinge on the value of their relatively meager salaries. President Obama has about 300 senior staff that earn about $180,000 a year and usually get a 5% annual pay increase. Assuming Obama keeps this freeze in place for 8 years this amounts to $24m in savings. The economic system is facing challenges on the order of millions of jobs and trillions of dollars. And during this time, good policy, and the hard-working men and women behind developing it, are more important than ever. Saving a few million bucks and cutting pay to the people you most rely on doesn’t seem to accomplish much.

What people really care about is “are they doing a good job”. People care about good decisions, good investments and good profits. If the firms were above water today, no one would raise a peep about their compensation. Targeting annual bonuses confuses the issue, which is ultimately one of bottom line performance, something that usually requires more compensation, not less.

Improving, not just saving, Social Security

Yeah, yeah, yeah. You’ve heard it all before. Social security is not looking so secure, but why does it really matter? I think most people would probably say because it would certainly be nice to get that monthly check in the mail once they’ve retired, particularly when 7.5% of every paycheck is taken out for it. Who likes to pay something for nothing? After all, the current system is projected to take in less money than it pays out around 2017, which means it will eat up the budget, which means even tighter capital markets and higher future debt. And then of course it’s projected to go bankrupt in 2040. It’s all very boring.

But the bigger reason we should fix social security - and not just patch it up with a million clever little ideas, say by lowering the inflation index or pushing back the retirement age, which will succeed only in postponing insolvency and making people work harder for less, but not really improve anything - is because of the enormous… opportunity cost! I wish it could cut aluminum cans in half or something, but we’ll have to settle for opportunity cost. Think about the difference between every dollar of your paycheck that goes into the Social Security Trust Fund, and then is subsequently spent immediately and preserved in the form of debt, versus every dollar going going into a well balanced mutual fund and earning interest. And then multiply over, oh, say four decades. Say on average you make a real income of $50,000 a year for the next 40 years, and the standard 7.65% of this is contributed to payroll taxes, this is $153,000 in principal. When that money goes into the Trust Fund, the government at best will nullify the deleterious effects of inflation, and worse yet, may actually lose purchasing power depending on the spread of government bonds versus inflation, or still worse, may decide never to pay it.

On the other hand, pick any ten year period of the stock market, any 10 year performance period of Wall Street, and the average returns will never be below 7%. Not during the Great Depression, not during S & L or dotcom, not now, not ever. Business cycles are real, they happen, but the ups and downs average to a healthy trend. Saying something is reliable because it has never failed is all you can really go on. For instance, people banking on the Social Security Trust Fund paying them out around the middle of this century often cite how much more reliable a Government IOU is because the government has never defaulted on its debt. True, but then the rationale of the safety of Wall Street is no less reliable. The government has never defaulted on its obligations. And Wall Street has never produced less than 7% per decade in returns, let alone a loss. So say over the 40 years you’ve contributed that $153,000 to the government and the market just hits the bottom of that 7% return, you still turn that money into over $600k. Assuming the best, this is a 400% difference from what the government would pay out, a very steep opportunity cost. Now there are no guarantees. And if people would like to play the “more conservative card” of just paying into the fund and getting a government guarantee, they should be able to. But, just like U.S. Senators, people should have the choice to contribute their income into actual funds. The Regular ol’ Person system could be essentially the same design as the Senators’. There would be a pension board that oversees 5 or so broad investment plans, divided by their equity/fixed income ratio, but all diversified and managed by professionals and overseen to regulate leverage and risk (something missing since about 2004 when the SEC removed net capital holding requirements). The point is people couldn’t just invest wherever the mood struck them, there would be a small menu of balanced funds to choose from. And because of the simplicity of the rules - 5 plans, no more than 10:1 or so leveraging, it would be clear whether funds were being abused/Madoffed in any way.

I hope that any future modification to Social Security does not reflexively deny individuals a choice in how their earnings are used. I think this is the compromise that can be struck - people who like the current system (retooled with some painful actuarial adjustments) can stay with it. But not allowing individuals a choice to place their payroll earnings into a balanced fund seems to me to be denying people an awful lot, and for nothing but the concerns of other people who would be unaffected. It would have the added benefits of freeing the government up from a lot of debt and providing much needed private capital injections to our financial institutions. A lot of this could be used to do things like deploy clean energy, build smart grids, in short create good jobs. And of course there are details, there always are. When money from current workers is placed in an investment fund, and not siphoned towards current retirees, there will have to be bridge financing in the form of more debt. Yet so long as much of Asia has a 30% savings rate, and so long as there are sovereign wealth funds, there will be ample capital to absorb a few more government securities. Plus, paying these off in the future will be easier than waiting for the system to slide into debt and paying then, as the pension system will be more sustainable and profitable thanks to new productivity from deeper capital markets and decreased government retirement obligations - meaning a broader economic base. And there will have to be cut off points for when people can make the transition. And there will have to be a little bit of private earnings skimmed by the Board as reserves to provide insurance to people who might pick particularly unlucky times to retire – in this way they would be guaranteed a minimal payment not below the regular system. Bueller?

But the point is, legitimate debate about the system doesn’t have to ruin anything. Those who think the government is the best universal retirement planner and want that legal guarantee can have it. And those who would prefer to fund government managed private investments with their money can do that. Now this is bipartisanship This isn’t a parlor room discussion or a game of gotchya between editorialists (oh how Stiglitz, Krugman, Summers, Brooks et. al. love to seem the smartest guy in the room). It’s a very pragmatic day-to-day kitchen table decision. And I think given the choice, people should be given more opportunity, not less.

On another note, the CBO recently scored the House stimulus bill. It estimates 7% of the energy investments will be spent within 2 years and less than 50% of the transportation dollars spent in 4 years. This is too slow to provide immediate stimulus and generally conforms with what the Council of Economic Adviser's new chair Christina Romer has shown in her work. I think the second half of TARP ($150b to buy up worst assets, $150b for continued recapitalization and $50b for mortgage refinancing, which could save 1m+), combined with a more focused $100b stimulus could have great effect.

"I always go through the process of hating it, hating myself, thinking I've fooled them, I can't actually do this." –Heath Ledger

When Heath Ledger is nominated next Thursday for his second Academy Award, exactly one year since his death, he will have fooled no one. In his final role he made vintage Jack Nicholson look bad, and he appeared to barely be trying. My favorite line in the Dark Knight is the baptismal bedside conversion of Harvey Dent into Two-Face, where the Joker slurs, “You know, they’re schemers. Schemers trying to control their worlds. I’m not a schemer.” This line belays the Joker as the twisted half-brother of Holden Caulfield, or Ben Braddock in the Graduate, or the American transcendentalist Thoreau - someone lost , but almost entirely because they are searching too hard to ever notice when they've stumbled onto something. The great irony is that one year after his death; Heath Ledger will have found what he always thought was alluding him. I hope now Heathy can get some rest.

Peace in the Middle East

Almost as reliable as the turning of pages on a calendar is the cycle of violence in the Israeli-Palestinian conflict. Here’s to ’09 being a peaceful year in the Middle East, but it’s looking all too predictable. Let’s be clear – the rockets being launched out of Palestinian territory that perennially kill innocent Israelis is completely unacceptable. It is tragic, it is wrong, and it is terrorism. The international community is in agreement that the goal is to stop this scourge (and I would add there are many other goals, but this is the most immediate). The debate among reasonable people seems to be what the best mechanism to achieve this end is. I would argue that there needs to be considerably more effort placed in pulling the rug out from under extremists by drying up their recruitment base and trying to fill the vacuum that is left by poverty and deprivation. The June '07 illiberal democratic election of Hamas is entirely predictable given the extreme living conditions in the West Bank and Gaza. Crippling poverty, hugely underproductive land, overpopulation, disease and little prospect for the future, not to mention connections to many family and friends who have died in previous violence, makes for the perfect platform for extreme ideologies to flourish. Reverse these conditions and you will almost certainly see a considerably more liberal democracy emerge and Israel achieve its objective of not having a terrorist organization ruling across its border. I think we have seen for decades that the current approach (heads of state signing pieces of paper and militaries launching offensives) has not produced a lasting solution. Decrees, promises, foreign observers, summits, envoys, seem to be trying to force a solution in many respects, rather than trying to actually build one . So long as the fundamentals on the ground remain the same for millions of people in Gaza and the West Bank, these top down solutions will likely continue to lack a mechanism capable of enduring stability and peace. It is imperative that sovereign countries protect themselves, yet so long as innocent blood is spilled on both sides, and so long as there is extreme poverty and deprivation (particularly in Gaza and especially under the current blockade) there will be no scarcity of people willing to give their lives for tragically backwards causes. This is exactly why Defense Secretary Gates, in an unprecedented move, lobbied last summer for a doubling of the foreign assistance budget for the State Department, because he knew it would translate into direct security benefits.

The best long-term approach to weakening radical extremists (like elements of Hamas) is to eliminate their resource base. Yes this means more traditional approaches like cutting off supply lines and raiding weapons caches, but even more it means providing an alternative of hope in the face of despair (and just as importantly, being seen as providing an alternative). Extreme poverty and deprivation is a surefire accelerant of extremism. Over a period of years if the international community, perhaps led by Israel, were to step up humanitarian relief and development assistance for its impoverished Palestinian neighbors, I think it is very likely that a vast majority of the extremist recruitment base could be dried up. Clothes, food, medicine, fertilizer, seeds, generators, schools, community centers, hospitals - basics - would help ensure another generation of youth is not caught up in the cycle of a false but often too attractive violent ideology. Extreme ideology feasts on the kind of fatalism brought upon by miserable conditions. Such assistance would literally be the physical embodiment of a neighbor’s compassion and would win hearts and minds from ideological zealots. Building an economy and investing in a viable alternative and moderate political coaltions will engender stability and a 2-state solution infinitely better than a team of pro negotiators and yet another rounds of furious document signing. One approach leverages a concrete mechanism to drive moderation, the other merely ordains it. Political parties are more an appendage of the prevailing situation and desires of the people than an apparatus capable of executing whatever U.S. statesmen broker. In other words, invest in a viable alternative, not simply agreeable language.

Ad hoc security crackdowns or another round of well-branded Summits will unfortunately fall short without treating the situation on the ground. Let's also be clear here - there will always be evil people for whom a military response is the only appropriate solution, and here Israel and the West must remain vigilant. Yet so to must the West realize that there are inherent risk factors that make it relatively much harder or much easier for extremists to operate. Opportunity and hope remains a vastly underutilized weapon in the war against extremism.