Jim’s Random Notes

The President unveiled his new budget today: 3.83 trillion dollars. The numbers fairly boggle the mind. The total budget works out to just about $12,500 per person in the United States, or about $47,500 per family. Or $34,800 for each of the 110 million taxpayers in the country. Of course, 41% (about $1.56 trillion) is deficit spending, meaning that 41 cents of every dollar the government spends in fiscal year 2011 will be paid for (supposedly) in the future. But with an existing debt of $12.5 trillion, this year’s budget will push the accumulated national debt past $14 trillion: about the same as the U.S. Gross Domestic Product. Interest on the debt alone amounts to about $175 billion per year, or about $2,200 per family, 25% of which ends up in the treasuries of other countries that hold U.S. debt securities.

This year, total government debt will exceed total income for the entire country. The White House budget office says that debt will remain at that level through 2019 (that is, debt will roughly equal GDP), but those projections rely on GDP growing faster than most analysts say it can. At $14 trillion, national debt is almost 20% of all household and business assets in the entire country. If government spending continues at this rate, the accumulated federal debt alone will exceed total assets in 20 years or so. That doesn’t include the approximately $40 trillion (currently) in debt owed by local and state governments, corporations, and individuals.

I won’t try to lay the blame for this situation on the President. Not on the current President, and not on the former Presidents. Undoubtedly, they all have contributed to it by proposing budgets that fund pet projects or further their own agendas, but that’s to be expected. No, the real blame lies with Congress for approving such outrageous spending over the decades, and with us–the American voter and taxpayer–for continuing to allow it.

The President on Wednesday announced a proposed spending freeze on domestic discretionary spending as a way of trying to get the deficit under control. As laudable as that is (any freeze or decrease in government spending gets my vote), it’s pretty difficult to take it seriously. He’s talking about a projected “savings” of about $250 billion over the next 10 years. That’s less than 3% of the total debt expected to accumulate over that period, or about 1% of total spending. And it’s highly unlikely that Congress will approve even that miniscule spending reduction.

The President is in a tough spot because there are programs he positively cannot touch. Even if he were willing to forego re-election, there’s no way Congress would approve cuts in those programs. Doing so is tantamount to political suicide. What programs? I’m so glad you asked.

The following numbers are from the FY 2010 budget

• Social Security is 19.63% of the budget. 13% of the people in this country are over 65 years of age, and a very large percentage of them vote. Need I say more?
• Medicare is 12.79% of the budget. See above.
• Unemployment, welfare, and other “mandatory spending” is 16.13% of the budget. Almost untouchable, regardless of which party controls Congress.
• Medicaid and associated programs: 8.19%. Ditto.
• Interest on the national debt: 4.63%.  Can’t have us defaulting on our debt.

When you throw in the Department of Defense share of 18.74%, the total comes to 80.11% of the budget that the President has almost no control over. The budget is 20% over revenue before the President even gets to attempt spending reduction. Think of that: if you cut out military and all government spending other than the programs I mentioned above, we’d still have a budget deficit.

This is nothing new, by the way. I remember the same math being presented to me in 1981 or 1982. If anything, the President has fewer options today than Reagan did back then.

I see three ways out of this mess: Reduce spending, raise taxes, or somehow increase GDP by about 50% so that current tax rates will cover the deficit. In the current climate, spending reductions and tax increases are political suicide, and a 50% increase in GDP is impossible. Tax increases are less suicidal in most cases, and they have the “benefit” (in political terms) of pissing off fewer people, so that’s the route Congress will likely take in an attempt to prevent the inevitable. Even so, there’s no way they can make up a 40% budget deficit (or even a 20% deficit) with tax increases.

No. I guess I don’t see any way out of this mess. Our spending is out of control and there isn’t anybody in a position to slow or stop it.  It’s a frightening thought.

In a speech before a joint session of Congress in September, the President said that his “preferred” package for health care finance reform legislation would carry a price tag of around $900 billion. He also said that he will not sign a bill that raises deficits.

On October 29, the Congressional Budget Office released a preliminary analisys of the Affordable Health Care for America Act (H.R. 3962). According to the summary in that analysis, “enacting H.R. 3962 would result in a net reduction in federal budget deficits of $104 billion over the 2010-2019 period.” Sounds good, right? Let’s take a look.

On page 2, under Estimated Bugetary Impact of H.R. 3962:

According to CBO and JCT’s assessment, enacting H.R. 3962 would result in a net reduction in federal budget deficits of $104 billion over the 2010-2019 period (see Table 1). In the subsequent decade, the collective effect of its provisions would probably be slight reductions in federal budget deficits. Those estimates are all subject to substantial uncertainty.
(Italics are mine)

That section goes on to summarize the costs and benefits of the bill. Total costs are estimated at $1,055 billion, partially offset “by $167 billion in collections of penalties paid by individuals and employers.” (Penalties for not maintaining the mandated health insurance coverage.) The projected net cost is $894 billion. So how do we get from a net cost of $894 billion to a surplus of $104 billion? “[S]pending changes, which the CBO estimates would save $426 billion, and receipts resulting from the income tax surcharge on high-income individuals and other provisions, which JCT and CBO estimate would increase federal revenues by $572 billion over that period.”

So the President and Congress weren’t entirely truthful when they said that they’re going to pay for this program by cutting waste, fraud, and abuse. They’re going to do what politicians always do: raise taxes and hope for the best. Oh, and they’re going to force employers to either offer health insurance coverage or pay a penalty equal to eight percent of their payroll. What used to be an incentive–an added benefit of employment–has now become a federal mandate. If employers were smart they’d just pay the 8% penalty. That has to be less expensive than the health insurance plans most of them provide.

What the press, the White House, and members of Congress won’t tell you about is what else the CBO report says. For example, under Effect of H.R. 3962 on Discretionary Costs, the report says:

CBO has not completed a comprehensive estimate of the discretionary costs that would be associated with H.R. 3962. Total costs would include those arising from the effects of H.R. 3962 on a variety of federal programs and agencies as well as from a number of new and existing programs subject to future appropriations.

In other words, there are hidden costs. What are they? The report doesn’t say in detail, but it gives a few examples:

• $5 to $10 billion to the Internal Revenue Service for “implementing the eligibility determination, documentation, and verification processes for subsidies.
• $5 to $10 billion to Health and Human Services for “implementing the changes in Medicare, Medicaid, and CHIP as well as certain reforms to the private insurance market.
• “Costs of a number of grant programs and other changes in Divisions C and D of the legislation. CBO has not completed a review of those provisions.”
• And the big one:
  As noted in the previous section and in Table 1, funding for the proposed Public Health Investment Fund and Prevention and Wellness Trust would also be subject to future appropriation action. The bill would authorize appropriations totaling about $34 billion for those purposes (of which approximately $33 billion would be spent over the next 10 years). The Committee on the Budget has directed CBO to count such spending as direct spending for purposes of budget scorekeeping in the House of Representatives.

I like that last sentence. The Committee on the Budget told CBO not to count $34 billion of costs associated with this legislation. At least the CBO is up front about it. It’d be interesting to ask the Committee members about that one, wouldn’t it?

Anyway, if you add up those costs, which the CBO identified as “major”, but not all inclusive, you end up with an additional $44 to $54 billion, plus whatever those grant programs would cost. That $104 billion “savings” is now $50 billion. Even less when you include the grant programs and other costs that this preliminary report doesn’t specifically mention.

Oh, and then there are Important Caveats Regarding This Preliminary Analysis. The first item is particularly interesting. The report is based on preliminary legislation rather than the bill as actually introduced. Also, “the analysis does not reflect all of the provisions of the bill.”

In other words, there are MORE hidden costs.

The final section, estimating effects of the legislation beyond the first ten years, says that it will decrease deficits slightly. But it also has a few caveats of its own:

These longer-term projections assume that the provisions of H.R. 3962 are enacted and remain unchanged throughout the next two decades, which is often not the case for major legislation. For example, the SGR mechanism governing Medicare’s payments to physicians has frequently been modified to avoid reductions in those payments, and legislation to do so again is currently under consideration in the Congress. The bill would put into effect (or leave in effect) a number of procedures that might be difficult to maintain over a long period of time. It would leave in place the 21 percent reduction in the payment rates for physicians currently scheduled for 2010. At the same time, the bill includes a number of provisions that would constrain payment rates for other providers of Medicare services. In particular, increases in payment rates for many providers would be held below the rate of inflation (in expectation of ongoing productivity improvements in the delivery of health care). Based on the extrapolation described above, CBO expects that Medicare spending under the bill would increase at an average annual rate of roughly 6 percent during the next two decades-well below the roughly 8 percent annual growth rate of the past two decades, despite a growing number of Medicare beneficiaries as the baby-boom generation retires.

The long-term budgetary impact of H.R. 3962 could be quite different if those provisions generating savings were ultimately changed or not fully implemented. If those changes arose from future legislation, CBO would estimate their costs when that legislation was being considered by the Congress.

In other words, any projected savings is wishful thinking.

Honestly, you should read the report. It’s only 27 pages long, and about half of those are tables of numbers. Just reading the report without the numbers should be enough to convince you that this bill, like all the others, is a budget buster.

And, of course, that analysis was based on the bill as introduced on October 29. It was hailed as an “894 billion dollar” package. Today, the press is saying a “1.2 trillion dollar” package. I’m unable today to find any information about the additional $330 billion or how it’ll be offset by revenue so that the legislation remains budget neutral.

Not to be outdone, the Republicans published their own plan for health care finance reform. It has no chance of being passed, which is a good thing. The CBO estimate says that it will cover fewer people and will save $68 billion over 10 years. In other words, it’s just a way for Republicans to say, “See? We have a plan!”

Nobody in Congress has the courage to stand up and say, “Stop!” Where’s the voice of moderation here? Congress will mandate billion dollar multi-year environmental impact studies before doing something trivial, but now wants to push through, without sufficient study, legislation that will have a huge impact on every citizen in the country. Why? Because they can and because they think it will get them votes. For all their pronouncements about it being “good for the country” and “the right thing to do,” that’s all they’re really interested in: re-election. Otherwise they’d be much more concerned about the real costs of what they’re so eager to support.

The President has said publicly that he will not sign (or did he say that he would veto it?) a bill that “adds one penny” to the budget deficit.  It’s probably too much to expect the President to subject any legislation to extensive real world analysis, so I’ll have to be content with the CBO’s final report.  But if, as I suspect, the bill that will be presented for a vote in the House on Saturday turns out to require deficit spending, I will expect the President to keep his word.

A few weeks ago I said that Cash for Clunkers is a wreck.  Now that the program has ended, let’s see the results.

The people responsible for Cash for Clunkers are hailing its success.  I’m still having trouble understanding what the goals of the program were beyond a “feel good” measure designed to make people think they’re getting something for nothing from the Obama administration.  By that metric, the program was certainly a success:  people will remember that Uncle Sam helped them buy a car.  Although they might be a little less enthusiastic when they realize that the $4,500 rebate is taxable.

Transportation Secretary Ray LaHood said that U.S. consumers and workers were “the clear winners” under the program:

Manufacturing plants have added shifts and recalled workers. Moribund showrooms were brought back to life and consumers bought fuel-efficient cars that will save them money and improve the environment.

Let’s take a look at those three “successes”:

“Manufacturing plants have added shifts and recalled workers.”  Surprisingly true.  But with car sales almost certainly going back to below pre-handout levels, I can’t imagine that those workers will be fully employed for very long.  Manufacturers will rebuild their inventories, find that people still aren’t buying cars, and then lay off the workers again.

“Moribund showrooms were brought back to life.”  Well, yeah.  But with no more giveaways, those showrooms are going to be empty of customers yet again.

“…consumers bought fuel-efficient cars that will save them money and improve the environment.”  This one is full of specious reasoning.  According to press reports, the most popular new vehicle purchased under the program was the Toyota Corolla.  So let’s use it for a little thought experiment.  But first, let’s construct our “average” purchaser under the program.

We’ll assume that the “average” person drives 40 miles to work and back each day, plus cruising around here and there.  Give him 300 miles per week.  Also assume that his clunker was paid off and it got 10 miles per gallon.  So he’s burning 30 gallons of gas a week.  At $2.50 a gallon (current price in the Austin area), that’s $75 per week in gas.

A new 2010 Toyota Corolla lists for between $15,350 and $20,000.  I’m going to assume that the cars were bought from dealers’ inventories and that there was a relatively even mix of feature packages, so the average price for a car was $17,500.  With the $4,500 rebate, the price of the car is $13,000.  I’m going to ignore other incentives  and tax, title, and license, figuring that they’d likely cancel each other out.  And since the car will be destroyed, there is no trade in value.  By the time everything’s said and done, the buyer owes the dealer $13,000 for the car.

The new Corolla gets an estimated 35 MPG on the highway and 27 MPG in the city.  Let’s be generous and assume that the guy will average 30 MPG in all of his driving.  So at 300 miles per week, he’s burning 10 gallons of gas a week at a cost of $25.  Quite a savings over the $75 per week he was burning in the other car.  So his monthly outlay for gas is now $100 rather than $300.  Such a deal!

Except we forgot to pay for the car.  If he pays that $13,000 balance in cash, it’ll take him 65 months (almost five and a half years) to make up the difference with his $200 per month savings in gas.  If he gets a loan for that $13,000 (figure 5 years at 5.25%), his monthly payment is $250.  So he’s saving $200 per month but it’s costing him $250.  That new car that was supposed to save him money is costing him $50 per month.  Oh, and don’t forget the $1,000 that rebate is going to cost on next year’s tax return.  That’s another five months of “savings”.

Granted, there’s some savings for maintenance because the new car is under warranty.  But that savings will be easily offset by the increased cost of insurance on the new car.  I’ll call it a wash.

I purposely was very generous with the numbers here in an attempt to make it look like a good deal.  I just couldn’t make it work out.  In general, you will not come out ahead by buying a new car in the hope that it will “pay for itself” by saving on gas.  Unless you drive a lot more than 500 miles per week.

The claim that the new cars will “improve the environment” is wishful thinking.  At best, driving the new car will cause less harm to the environment than will continuing to drive the new car.  And that statement is based only on the differences in fuel efficiency between the two cars.  It does not take into account the environmental costs of manufacturing the new car or disposing of the old car.

There’s no doubt that the Cash for Clunkers program stimulated some economic activity.  Whether that was good is another matter entirely.  They say that $2.8 billion in incentives were passed out.  We’ll round that up to $3 billion to include the cost of administration and other expenses that were incurred but they’re not telling us about.  Reports say that almost 700,000 new cars were purchased.  If we figure an average price of $20,000 (lots of Camrys were purchased under the program), that $3 billion resulted in $14 billion in direct economic activity.  But if we assume that the average loan on those cars was $15,000, then there is $10.5 billion in new consumer debt out there.  Not a good thing, in my opinion.

Certainly there are people who benefited from the program:  car dealers and manufacturers got a boost, as did those workers who got recalled to the manufacturing plants.  Companies making auto loans couldn’t be complaining.  But it’s not all roses.  Car salvage yards are grumbling a bit because their margins have been slashed:  apparently dealers are paying less per car to have them hauled off.  And used car sales have plummeted.  Only 700,000 cars using one-third the gas probably won’t affect gasoline retailers much.  But if it was seven million, I can imagine that convenience stores that depend on gasoline purchases for a large part of their profit would feel the squeeze.

Those who supported Cash for Clunkers can go ahead blindly believing that it was unquestionably a good thing.  I’m skeptical.  As I showed above, the “deal” almost certainly didn’t result in a savings for most buyers.  More importantly, I disagree with the idea that it’s government’s responsibility to prop up a sagging industry.  I also don’t believe that the immediately visible positive effects of this program will in the long term offset the negatives that I’ve outlined.

In a very thinly reported move last week, the Federal Reserve announced that it will spend up to $600 billion buying up obligations of government-sponsored enterprises, and mortgage backed securities, many of which were the original targets of the $700 billion “bailout” plan back in October.

To me, the most interesting thing about this move is that it won’t cost the Federal Reserve anything. Well, whatever it costs for paper, ink, and the electricity to run the presses while they print up $600 billion in crisp new bills. That’s right, they’re going to “pay” for those assets by increasing the amount of money. Not a bad racket if you can get it. All of a sudden the Fed has $600 billion to spend that it didn’t have to get by running, hat in hand, to Congress. Nope. Just print up the bills and nobody’s the wiser. Never mind that the dollars you’re holding today are worth slightly less than they were yesterday.

Something similar is happening when the Treasury injects money into the banks. In exchange for their $25 billion, a bank gives the government shares of stock. They’re special non-voting shares, which is a good thing, but they’re new shares that dilute the value of existing shares. Stockholders end up paying for it in two ways: the value of their shares is diluted, and they have to pay increased taxes to offset the government expense (or, if new money is printed, pay the hidden tax of inflation).

How about a simple example to illustrate the concept. Imagine that your neighborhood creates a lawnmower co-op. For $10, you get one of 10 shares in the co-op. But the co-op falls on hard times–needs to upgrade the mower, maybe. The co-op issues 10 new shares, bringing the total number of shares to 20, and sells those shares to new members at $5 each. All of a sudden, your share of the co-op is worth 50% less. That’s bad enough, but you also get hit with an assessment from the co-op for increased maintenance costs. That’s pretty much what’s happening to stockholders when the banks take the bailout money.

I thought, back in September, that Bernanke, Paulson, and company had a real plan, backed up with solid reasoning, and some idea of what effects their proposed policies would have on the financial system and the economy. I didn’t agree with their ideas, but I thought I could at least respect their reasoning. But three months later, I’m not so sure. I think that they, just like Congress and the Bush Administration in general, are trying anything in an attempt to get a short-term boost, regardless of the long-term consequences.

The best bet for everybody would be for governments to step back and take an honest critical look at the situation, study possible responses and their likely outcomes, announce a plan, and then stick with it. The current whac-a-mole approach is worse than doing nothing (which, come to think of it, still doesn’t sound like a bad idea). Changing approaches every few weeks does nothing but add uncertainty, causing people to overreact and creating chaos when the thing we need most right now is stability.

Congress never ceases to amaze me.  Following the unexpected defeat of the measure on Monday, the Senate decided to take a crack at writing something that could pass.  The Senate’s technique was nothing short of brilliant.  Rather than debating the need for the measure and perhaps rewriting provisions to make it more palatable, they did what any good politician would do:  they added bribes to sweeten the deal for those Representatives who voted against it. 

Because the House is responsible for introducing legislation that deals with budgetary matters, the Senate didn’t introduce this as new legislation. Instead, the Senate greatly amended existing legislation, H.R.1424, which apparently has been bouncing around between the House and the Senate for 18 months. The Senate bill now contains the original enacting clause:

To amend section 712 of the Employee Retirement Income Security Act of 1974, section 2705 of the Public Health Service Act, section 9812 of the Internal Revenue Code of 1986 to require equity in the provision of mental health and substance-related disorder benefits under group health plans, to prohibit discrimination on the basis of genetic information with respect to health insurance and employment, and for other purposes.

And then:

Strike all after the enacting clause and insert the following:

And there follows the 110 pages of the House’s Emergency Economic Stabilization Act of 2008 and 350 more pages of additional legislation.  The bill, now 451 pages long, contains three divisions:

Division A: The Emergency Economic Stabilization Act of 2008.

This is pretty much the same legislation that failed to pass in the House on Monday.  A notable addition is Section 136, which temporarily raises the FDIC and National Credit Union Share Insurance Fund deposit insurance limits from $100,000 per account to $250,000 per account.  The idea behind this move is to reassure businesses and prevent them from moving their deposits from small banks to larger banks that are viewed as more secure.

Division B: Energy Improvement and Extension Act of 2008

Provides tax incentives and credits for renewable energy, investments in cleaner coal technology and biofuels, plug-in electric cars, energy conservation, and many other things.  It’s a scattershot energy bill that’s been working its way through the legislature as H.R.6049 since May of this year. 

DIvision C: Alternative Minimum Tax Relief Act of 2008

This part began life in June 2008 as H.R.6275, to provide relief from the alternative minimum tax for middle- and low-income taxpayers.  The original version was a few dozen pages long.  The new version is almost 200 pages in length and includes all manner of personal and business tax cuts, credits, and deductions.  And then there are the miscellaneous provisions, among them:

• The Paul Wellstone and Pete Domenici Mental Health Parity and Addiction Equity Act of 2008 states that health insurance companies have to provide the same level of coverage for mental health benefits as they do for medical and surgical benefits.
• A reauthorization of the Secure Schools and Community Self-Determination Act of 2000,
• Disaster relief legislation.

If you read the Table of Contents for each of the divisions, it becomes very clear that the Senate in its infinite wisdom targeted certain provisions to individual parties and even individual states in an attempt to win over those who voted against the original bailout plan.  In doing so, they had to be careful not to add something that would cause members who originally voted for the plan to vote against it.  Honestly, though, I don’t think there was much chance of somebody changing his vote from “aye” to “nay.”

Estimates place the cost of new provisions at about $105 billion, a very large part of which would fit under the category of “pork barrel projects.”  Both McCain and Obama voted for the measure, despite recent public statements about the evils of pork barrel spending.

It’s now five minutes to noon in Washington.  Party whips have been making the rounds in the House, trying to get members’ commitments to support the bill.  The House is set to convene at noon, and will be voting on this bill.  I’d like to think that those who voted against it on Monday will stand their ground, but I fear that politics will once again trump good sense.

Since Paulson, Bernanke, and Company aren’t forthcoming with layman’s explanations , I thought I’d take a little closer look at the problem to see if I could understand what’s happening here. What I found is that the problem is very large—potentially catastrophic. I’m also astounded by the hubris that got us into this mess, but that’s a topic for another time.

The fundamental problem today is that there is a lack of confidence in the financial system. Not so much by you and me, but by banks that lend money and large institutions that buy the banks’ debt for investment purposes. Investors demand more documentation and higher interest rates, which causes the banks in turn to charge higher interest rates and to be more careful in selecting borrowers. Ultimately, fewer individuals and companies will qualify for loans, and those who do will end up paying higher interest rates. Credit hasn’t dried up, but it’s a lot less available than it was previously. Creditors and investors got burned (in large part by their own greed), and now they’re being very (perhaps overly) cautious.

A key factor in the lack of confidence is that financial institutions’ portfolios have large numbers of assets that are difficult or impossible to value. A simple example would be mortgage backed securities. A mortgage backed security is, in essence, a bundle of loans that a lender has packaged up and sold as a single investment instrument. The price the bank asks for the package is based on the quality of the mortgages that make it up: their face value, the interest rates they pay, their maturities, the quality of the collateral backing them, and the credit worthiness of the borrowers. Industry rating agencies such as Moodys and Standard & Poor’s assign ratings that give some indication as to the risk level of such securities. Investors demand higher interest rates (or, sometimes, lower prices) for more risk.

But there’s a problem. It’s exceedingly difficult to know the real value of even one mortgage. Imagine the difficulty involved in computing the real value of a box that contains 100 mortgages. If you buy the box directly from the originating bank then you can have some confidence in the box’s value. Assuming, of course, that you trust the bank and the rating agency. But if you as an investor want to sell that box on the open market, you’re subject to the whim of the market. When things are going well, that’s a good thing. People are willing to spend $1,000,000 on that box of low-risk loans that pay an average of 5% interest because they have confidence that they’ll get their payments and that they can re-sell the box if they need the cash.

But the market can go sour. If a bank starts reporting higher levels of loan defaults, then every box of loans that the bank sold becomes less valuable because the probability of the box actually paying the stated interest or being sold at face value is lower. You could find that the market value (the price people are willing to pay for) your million-dollar box of loans is only $900,000.

Because of the difficulty in valuing mortgage backed securities (and many other investment vehicles), a very commonly used method of determining their value is mark to market. The box’s value is what people are willing to pay for it. Generally accepted accounting principles state that financial institutions use mark to market in determining their assets’ values. And transparency laws on the books insist that banks and other regulated financial institutions calculate the value of their assets on a daily basis.

Now, imagine that you’re a small bank. You take deposits from customers and lend money to individuals and local companies. You also buy high-quality (i.e. low-risk) mortgage backed securities to invest the depositor’s money. You’re very conservative with your investments, always get good documentation from your borrowers, and everything’s going great. Whenever you need a little cash to meet depositors’ demands, you sell one of those securities on the open market. This is how the financial system works when people have confidence in it.

But if the bank from whom you bought those mortgage backed securities starts seeing a higher than usual number of loan defaults, the value of the security you’re holding in your vault declines. As that bank’s troubles deepen, so do yours because it becomes increasingly difficult to sell those securities–not only at face value, but at all. If the originating bank defaults, you could very well end up unable to find a buyer for your box of loans. At any price.

You know that if you could open the box and show the individual loans to potential buyers, you could at least salvage some value from your investment, but that’s not the way it works. Your investment is essentially worthless. And since you have to report your financial condition on a daily basis, it doesn’t take long for the public (your depositors) to find out and begin demanding their money. You’re wiped out, and you didn’t do anything wrong.

I’m not just spinning a fantasy here, by the way. Such things do happen, and they have a cascade effect. As more securities become worthless, investors become less inclined to buy any securities. Institutions who hold those securities are unable to sell them in order to meet other obligations, and the financial system grinds to a halt.

That’s it in a nutshell. I’m sure there are economists who will say that the problem is more complex than that. In some ways, that’s true. I haven’t mentioned the more creative investment vehicles (like tranches) and the mania that helped get us where we are. I’ve tried to concentrate on what the problem is, rather than what caused it.

The problem, then, is that financial institutions are holding securities that nobody wants to buy. The securities’ values, based on mark to market, are essentially zero because there is no market for them. The truth is that some of those securities are very valuable and some really are worthless. But right now there’s no way for buyers to know which is which. The point behind the bailout is to create a market—to buy securities and by doing so restore some investor confidence so that they, too, will begin buying.

So that’s the problem and the rationale behind the proposed solution. Whether the proposed solution is right or even necessary is still a matter of some debate among economists, and also in my own mind.

I was pleasantly surprised yesterday when the House failed to pass the Emergency Economic Stabilization Act of 2008.  (Be patient.  That site is getting hit pretty hard right now.  You might be better off visiting your favorite news site for the full text.)  From news reports over the weekend and yesterday, I was pretty sure that it was going to pass.  It’s interesting to note that approximately 40% of Democrats and about two-thirds of Republicans voted against the bill.

What would be much more interesting to me is why the bill didn’t pass.  News reports contain nothing but a bunch of partisan sniping.  Some say that Speaker Pelosi’s comments before the vote angered Republicans.  If true, that doesn’t say much for those representatives whose feelings were hurt, or for Rep. Roy Blunt, who was dumb enough to put forward the suggestion.

I wonder how many voted against the bill because it was unnecessary, or because it was bad legislation.  I also wonder how many members’ votes were cast in response to constituents’ support or opposition.  According to an Associated Press analysis, 13 of the 19 most vulnerable (in the upcoming election) Republicans and Democrats voted against the bill.

And that brings me to the real point I’ve been struggling with:  where should a Congressman’s loyalty lie?  Should he be more concerned with the good of the country, or should he be more concerned with satisfying the whim of his constituents so he can get re-elected?  On the same note, do we elect our Congressmen because we trust them to do what’s best for the country while keeping our interests in mind, or do we elect them to bring home the bacon?

I need to think more about that one.

In all the hype surrounding this mess, I’ve heard a lot of alarmism, but very little hard fact.  Paulson and Bernanke warn us of “dire consequences” if we don’t provide some assistance.  I’d like to trust them, but I trusted President Bush and his advisers when they told us that we needed to invade Iraq.  I trusted that they had credible evidence of nuclear or biological weapons development and that they actually had a plan to transition Iraq into a stable, functioning democracy.  It turns out that they had no credible evidence and their “plan” amounted to “kill the bad guys and everybody else will join hands singing Kumbaya.”

So excuse me if I’m skeptical when the administration all of sudden decides that the economy is in grave danger and the only way out is to spend 700 billion dollars.  This is the same administration (and largely the same Congress) that has been ignoring the problem for the last few years, insisting that there is no cause for concern.  Bernanke and Paulson may very well be smart guys.  But their association with the current administration makes them suspect in my eyes.  They’ll have to provide me with a whole lot more evidence than their vague warnings of “dire consequences” before I’ll believe what they have to say.

Have you read the text of the Bush Administration’s proposed 700 billion dollar bailout of financial institutions?  If you don’t want to wade through the three-page proposal (although it is written in reasonably clear English), this summary will tell you all you need to know.  (Thanks to David Stafford for the link.)

When that proposal was presented, Congress was given the opportunity to exercise its most important obligation under the Constitution:  to serve as a check on the Executive branch.  Were Congress seriously interested in doing what’s best for the economy, for the taxpayers, and for the country, they would have just said, “No.”  Instead, they view the proposal as a starting position and are taking this opportunity to ingratiate themselves with their constituents and extend government’s control over private lending.  You doubt that?  Consider:

• Democrats are pushing for legislation that allows bankruptcy judges to rewrite mortgages to “ease the burden” on homeowners who are facing foreclosure.  This contentious issue probably will be dropped in favor of getting a bill passed.
• Democrats want any proceeds of the bailout to go into a fund designed to pay for housing for poor families.  This is the old shell game.  On one hand, they’re telling us that we’ll “get back” much of that $700 billion when the assets are sold.  The reality is that any proceeds will go into the general fund, which Congress can squander at their whim.
• Lawmakers on both sides have agreed in principal to limit pay packages for executives whose companies benefit.  This is largely a symbolic move, as executive pay is a drop in the bucket compared to the amount of money we’re discussing.  But it looks good to the voters.  “I voted to limit executive pay!”
• Absent the “No” that they should give, Congress is right in insisting that it be given more control over the bailout than what the proposal allows.  But I doubt that they’ll exercise restraint.  I fear that they’ll make a serious power grab.  For example, Representative Barney Frank has said: “we’re now the biggest mortgate holder in town, and we can do serious foreclosure avoidance.”  That frightens me, as I think it should frighten anybody.

I’m not convinced that this bailout is at all required.  Were Congress to do the right thing—nothing—markets would take an immediate tumble, rebound a bit, and then financial institutions and others affected would get back to business.  Sure, it’d be a struggle.  But the relatively short-term pain involved will be much less than the long-term pain that this bailout legislation will undoubtedly cause.

Needed or not, I’m certain that it doesn’t have to happen within the next week, as Secretary Paulson and Federal Reserve Chariman Bernanke insist.  I’m always nervous when Congress acts at all, and I get very, very scared whenever Congress rushes through legislation to “address a serious problem.”  Eight years of an administration and a Congress that have both lost all concept of the term “fiscal restraint” has taught me that much.

Join me in a little thought experiment.

Seal a 100 dollar bill in an envelope, affix a price tag to the envelope, and write $110 on it.  Then put it up for sale, telling potential buyers that if they spend $110 on this envelope, they can turn around and sell it for more.  Don’t worry about what’s in it.

Somebody buys it, affixes a new price tag that says $125, and sells it to somebody else who also increases the price and turns it over.

This goes on for some time, with each new buyer swapping out the price tag.  Somewhere along the way, somebody gets the bright idea of putting 10 envelopes into a larger, fancier-looking envelope.  Why not make 10 times the profit in a single transaction, right?

And the party goes on.  The fancy envelopes beget pretty printed shoeboxes and the prices go up again.  Nevermind the party poopers screaming, “But what’s in the box?”  Nobody cares what’s in the boxes.  They must be valuable, right?  People keep paying more for them.

One day, the holder of a refrigerator-sized package wrapped in gold paper and sporting all manner of ribbons and bows tries to sell it for $100,000,000, and fails.  The lender who floated him the loan to buy the thing takes it back and decides to sell it at a loss just to get it off the books.

But the lender finds out that he can’t sell it at any price.  A lot of people have been having trouble selling their pretty boxes and envelopes.  Not only that, but lenders have a lot of money tied up in those pretty boxes, meaning they don’t have any money to lend for other purposes.

Desperate, the lenders start trying to sell their assets at ever-lower prices, trying to get something out of them.  But nobody’s buying.  Nobody wants a pretty box that he can’t resell at a higher price.

Finally, the lender finds a buyer who says that he’ll be happy to buy the box, provided he can open it beforehand to see what’s inside.  The lender reluctantly agrees and looks on as the potential buyer opens the box and pulls out 100 pretty shoeboxes.  Inside each shoebox there are 10 fancy envelopes, each of which contains 10 plain white envelopes holding a single hundred dollar bill each.  The lender’s $100,000,000 “asset” is worth $1,000,000.

My dad used that little parable (also known as the last sucker theory or, more commonly, the greater fool theory) to explain the events leading up to the savings and loan crisis in the late 1980s.  It’s equally apt in explaining much of the current financial meltdown, what with the mortgage backed securities that were “backed” by worthless mortgages, investment firms that were leveraging their investments 35-to-1, and all the while knowing that they were just riding the wave—hoping they weren’t the ones holding the box when somebody demanded that it be opened.

Debra called while I was on my way to lunch this afternoon. Somebody purporting to be the Capital One fraud department had left a message on the home answering machine saying that it was imperative that I contact them. They left a toll-free callback number. That got me to thinking, though. How could I trust the number? Anybody could call and say that they’re Capital One.

So I called the customer service number on the back of my card. After wading through several levels of menus and going around the loop twice, I finally started hitting ‘0′ until I got a real person on the line. After verifying my identity, the woman confirmed that the fraud department had called, and she transferred me to them.

Ten minutes on hold later, I got to verify my identity once more and the representative asked me about some possibly fraudulent charges: one for over $1,000 at the Boeing Store, and one for a two-year subscription to Experts Exchange–neither of which I had authorized. The card is of course being canceled and I’ll receive a replacement in the mail soon. But it got me to wondering about several things.

• Why were the charges refused? Perhaps the Web sites asked for the 3-digit security code and when the number entered wasn’t correct, they reported possible fraud? Or maybe the shipping address was different from my home address. I’m curious how Capital One decided that those charges were possibly fraudulent. It’s not inconceivable that I would have made those purchases.
• How the heck did somebody get hold of my credit card number? I guess that in itself isn’t terribly difficult, but you’d think that somebody who was buying a two-year subscription to Experts Exchange would be smart enough to know that he couldn’t make the purchase without the card security code and a confirmed home address.
• How many people would call a number left on an answering machine from somebody purporting to be the fraud department? I think it’s terribly irresponsible for Capital One to leave a callback number. I honestly thought the answering machine message was a scam. It would be more reasonable to say something like, “Please call the customer service number printed on the back of your card and ask to speak with the fraud department.”

Regardless, I’m happy to see that they were able to identify those unauthorized charges and prevent somebody from having fun at my expense. I hope they can track down the miscreant before he does real damage to somebody’s credit.

Almost two years ago in The Housing Bubble, I warned that the then-current home building boom was unsustainable and that soon we would begin to see record numbers of defaults and foreclosures. I said then that I hoped I was wrong. I wasn’t.

Last Tuesday, the Mortgage Bankers Association released their Latest MBA National Delinquency Survey (for the end of 2006) and issued a press release that summarizes the report. According to the report:

• The delinquency rate for all home mortage loans was 4.59 percent. This represents an increase in deliquencies for all loan types, but particularly for subprime and FHA loans.
• The percentage of loans in the foreclosure process was 1.19 percent of all loans outstanding. This, too, is a significant increase over the 2005 numbers.
• The foreclosure rate for subprime loans was 4.53 percent, up from 3.86 percent a year before.

Things are getting bad. Mississippi has an overall delinquency rate of 10.64 percent. Louisiana 9.1 percent, and Michigan 7.87 percent. Foreclosures in Ohio are at 3.83 percent. In Illinois, 6.22 percent of all subprime loans were in foreclosure at the end of 2006 (source). It’s almost certain that the numbers are much worse now, almost three months later.

The not surprising part of this whole mess is, now that the things many analysts had predicted and warned about two and three years ago are coming to pass, people are starting to look for somebody to blame. It couldn’t be their own dang fault for taking on the risk of getting a subprime loan. Of course not. It’s predatory lending practices or the government’s fault:

The Administration and Congress helped create the sub-prime crisis by ignoring warning signs and, as a result, they bear some responsibility for assisting the families facing payment shock and foreclosure…

This Administration and the previous Congress allowed the horse not only to gallop out of the barn but jump over the cliff as well…

We call on this Administration and this Congress to take the reins back by immediately allowing FHA to play a role in helping borrowers and passing legislation to protect not only borrowers but also the nation’s overall economy.

The denial is almost over, and the anger has begun. It’s time to find a scapegoat. I said two years ago that this was going to be worse than the fallout from the late 1980s S&L crisis. It’s going to be much worse than I ever imagined.

(Note 2007/04/18: I closed comments on this entry because it has attracted a large amount of comment spam.)