Thursday, April 29, 2010

The myth of "deregulation"

























Economist and professor Veronique de Rugy has published an important article entitled "We didn't deregulate."

There is a persistent trope that portrays the financial panic of 2007-2008 as the inevitable result of capitalism grown out of control, and argues that it was allowed to grow out of control in this particular instance because of "deregulation" -- the relaxation (in this case) of government regulations over the financial industry.

Professor de Rugy demonstrates that this trope is false. In fact, regulation increased after the banking crises of the late 1980s, and total real expenditures on finance and banking regulation increased steadily right up through the end of the most recent Bush presidency.

While proponents of what Professor de Rugy calls "the deregulation myth" often cite 1999's Gramm-Leach-Bliley (the act which removed the Glass-Steagall restrictions separating firms that conducted investment banking, commercial banking, and insurance underwriting) as the crucial deregulation that led to the financial crisis of 2007-2008, she points out that this act did nothing to loosen regulation of securities activity by depository institutions, and that the failures of Bear and Lehman were due to investment banking activity that they could have pursued whether Glass-Steagall had been repealed or not.

This is an incredibly important point to understand, because -- as we have argued before -- the urge to blame unbridled free enterprise for the failure, rather than government regulation, depends on this view. Milton and Rose Friedman, writing in 1979, noted that many of the twentieth century's greatest tragedies arose from a similar erroneous interpretation of the cause of the Great Depression, as we pointed out in "A failure of government, not of private enterprise," a post we published in October of 2008 and titled using a direct quotation from the Friedmans' 1979 essay.

The idea that a system allowing free enterprise is fragile and prone to breakdowns or explosions if not carefully regulated and guided by a wise government and regulatory agencies is actually the exact opposite of the truth. Well-intentioned government interference with free enterprise sows the seeds of disaster, as Professor de Rugy points out using the examples of the FDIC and the government-sponsored entities of Fannie Mae and Freddie Mac.

We have made this argument before in numerous previous posts, including:
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Tuesday, April 27, 2010

Being short is not automatically evil

























We have written before, in posts going back over a year and a half (see here and here), that while our investment philosophy does not involve short-term trading, we do not consider trading to be morally evil but in fact regard it as a necessary component of the markets which enable businesses to raise capital efficiently and allow investors to gain participation in the innovations and achievements of well-run businesses.

This is an important topic, because right now Washington politicians are vilifying Wall Street market makers at Goldman Sachs* for their market-making activities and their alleged failure to disclose everything they should have during those deals.

We are not defenders of Goldman Sachs or any other big Wall Street firm, and we do not know whether or not they broke the law or even did anything unethical. However, the attempt to paint their sales of complicated investment vehicles to sophisticated investors who wanted to place bets on the movement of the prices of securities as somehow "not acting in the best interest of their clients" is political grandstanding, and political grandstanding that can have serious negative consequences for everyone, including regular investors.

As the Wall Street Journal put it last week, the government is trying to paint the issue as a modern version of It's a Wonderful Life, when in fact the transactions in question were more like Alien vs. Predator. The deals in question were not being offered to small investors on Main Street, but to sophisticated trading firms that deal in derivatives and short positions as a matter of course.

While we do not advocate such trading schemes for investors, or pursue such strategies ourselves, we also think it is important to understand that short betting and derivative products are part of the natural landscape that enables the market to function efficiently. Allowing people to place bets on price movements -- including downward price movements -- serves the vital function of enabling liquidity in the markets, and also serves to keep people honest, as we explained in our August 2008 post "Give the traders a break."

Two other recent articles in the Wall Street Journal make this case effectively, and are well worth reading. The first is Holman Jenkins' "The War on the Shorts, Cont." and the second is Gordon Crovitz' "The Misguided Attack on Derivatives."

Investors should understand that the attempts by some in Washington and the media to portray short-term trading functions like short-selling and derivatives as evil are not accurate, and that to the extent that these functions are impaired, the mechanisms that allow investors to allocate their capital to good businesses (especially smaller companies, where liquidity is typically lower to begin with) will also be impaired.

Because we believe that allocating investment capital to well-run businesses in front of fertile fields of growth is the essential foundation of a family's investment plan, we believe this is a very important topic and that investors should take the time to understand it.

* The principals of Taylor Frigon Capital Management own preferred securities issued by Goldman Sachs (GS).

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Thursday, April 22, 2010

"Too big to fail" and the FDIC are connected
























The President today ended a national address calling for financial reform with a humorous counterattack against any potential criticism. He cited a quotation from Time magazine, saying:

"I read a report recently that I think fairly illustrates this point. It's from Time Magazine. And I quote:

Through the great banking houses of Manhattan last week ran wild-eyed alarm. Big bankers stared at one another in anger and astonishment. A bill just passed … would rivet upon their institutions what they considered a monstrous system… Such a system, they felt, would not only rob them of their pride of profession but would reduce all U.S. banking to its lowest level.

That appeared in Time Magazine – in June of 1933 [laughter from audience]. The system that caused so much concern and consternation? The Federal Deposit Insurance Corporation – the FDIC – an institution that has successfully secured the deposits of generations of Americans [more laughter from audience]."

The President's reference to that article from 1933 -- which can be found in its entirety here -- was meant to defuse any alarm caused by new government regulation proposals, by saying that the excessive alarm bankers voiced in 1933 over the creation of the FDIC is laughable from our enlightened perspective 37 years later.

However, we would argue that the selection of that quotation by the President actually cuts both ways. It could very well be argued that the bankers in 1933 were right on target with their concern -- and that misguided government regulations such as the creation of the FDIC lead directly to financial disasters such as the one we just experienced, the one the President is using as an argument for more regulation.

Reading a little further in that Time article from June, 1933 we find that opponents of the FDIC envisioned "deposits which they had spent a lifetime to build up and protect with their good names confiscated by the Government to pay for the mistakes and dishonesty of every smalltown bankster." Funny that the speechwriters decided to end their quotation before reaching that sentence!

In fact, scholars of banking point out that radical new changes in banking regulations in the US in the 1930s -- including the FDIC -- are directly connected with the phenomenon of government using taxpayer dollars to bail out institutions deemed "too big to fail."

Back in 1992 (and in essays he had written before that as well), banker and banking scholar Richard M. Salsman wrote "Banking without the Too-Big-to-Fail Doctrine" in which he demonstrates the essential connection between the FDIC (and other essential aspects of centralized banking) and the "too-big-to-fail" concept.

There, and in other publications, he argues that the creation of deposit insurance led inevitably to implicit backing by the Treasury and the Fed -- first to insured depositors, later to uninsured depositors and creditors, and finally to the securities industry (Wall Street brokerage firms). While Mr. Salsman was writing in 1992, it is clear that this is exactly what has happened in the past two years.

The logical connection between the FDIC and reckless behavior is fairly clear if you think about what it means -- suddenly, solid and conservative banks are no riskier to the customer than reckless, profligate, and/or unproven ones, and so customers become free to chase the highest interest rate on deposits without worrying about whether that bank is a solid business or not.

This changes the incentives for banks from competing based on solidity and solvency, to competing based on highest yield. The same types of changes take place throughout the financial system wherever bad loans and bad business practices are given a safety net of taxpayer dollars (think Fannie and Freddie, the Wall Street affair with synthetic products such as CDOs, and the entire mark-to-market episode we have detailed at length in previous posts).

This is a broad topic worthy of greater discussion and careful consideration beyond the scope of this particular post. The important point for today is the fact that increasing government intrusion into business activity is no laughing matter. The example of the creation of the FDIC in 1933 should be a warning against ill-considered government "solutions," not an argument for more of the same.
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Monday, April 19, 2010

It's a mad, mad, mad, mad world

























We recently published "The Investment Climate: April 2010" in the commentary section of our website.

In it, we summarize the current situation and provide some perspective on where we stand today.

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Wednesday, April 14, 2010

Greece and California





















California and Greece have some interesting similarities. Both have beautiful coastlines dotted with rocky islands. Both enjoy a famously Mediterranean climate, where it rains more in the winter than in the summer (a very rare phenomenon found in only a few places in the world). Both produce excellent grapes and olives and wine and olive oil and cheeses.

More importantly to investors, both illustrate a grave problem which fuels the degradation of the purchasing power of their money over long periods of time.

The problem both share involves their extremely generous pension promises to large numbers of citizens, which many fear will be unsustainably expensive going forward.

For instance, in Greece, civil servants can retire with 80% of their "pensionable salary" for the rest of their lives, and the average retirement age is 58 (the 80% number generally applies to pensioners who began service prior to 1993; after that, pensions were reduced to 2% per year of service prior to retirement -- which still works out to 74% of their salary for the rest of their life for someone who works from age 21 to age 58).

In California, government employees such as teachers and prison guards can retire at ages as young as 52 or 55 and receive a pension of 60% or more of what they earned for the rest of their life, along with medical benefits and a cost-of-living-adjustment causing the pension to rise each year to keep pace with inflation. Recent articles have appeared highlighting California state pensioners who make over $100,000 per year from their state pensions, and even some whose pensions give them over $200,000 per year for life. Department of Education data reveal that the median retirement age for public school teachers is 58 (another fascinating similarity with Greece).

While it may seem like a nice thing to provide large number of citizens with the ability to retire in their 50s and draw a substantial pension for life (with medical benefits), it is massively expensive. The same system is responsible for the collapse of two of the three US automakers, leading to the assumption of those companies' expensive benefit packages by the US taxpayer.

Bondholders -- those who loan to these entities -- have been getting nervous lately, particularly in Greece. Lenders get worried when they hear their credit card customers say, "I won't be able to make payments on this credit card anymore: my budget is just too crazy."

The usual solution when this happens to an individual is bankruptcy -- lenders and the borrower work out some amount that will be paid on each dollar (pennies on the dollar). The borrower's budget must be downsized as well -- extravagant expenses have to be slashed or eliminated.

However, such as solution is very painful, and politicians typically don't like to face the kind of pain it entails. Cutting expenses in the case of Greece or California means cutting pension benefits, and renegotiating pennies on borrowed dollars means angering bondholders, who will of course howl loudly.

Therefore, the other solution governments historically turn to in these kinds of situations is to print money. Since neither California nor Greece is allowed to print money themselves, this means begging either the U.S. Government or, in Greece's case, the European Union of which Greece is a member, to do it for them in order to keep their bondholders and pensioners from experiencing pain.

Inflating the currency spreads the pain to everyone who uses that currency, and spreads it out over long periods of time, so it is less noticeable. We have written about the almost unnoticeable manner that inflation slowly corrodes purchasing power in numerous previous articles, especially in last year's "Stand still, little lambs, to be shorn!"

What does all this mean for investors? It is a complicated question, and one that bears careful consideration and deliberation now and going forward. Certainly, inflation hurts everyone, especially those now living on a fixed income, and those who own long-term bonds.

Many think the answer is to rush into commodities such as gold. Gold's price certainly has risen sharply over the past year.

However, we have written before that we believe the best answer is to own well-run companies providing a valued service that are growing and have strong growth prospects for the future. Such companies are able to take a variety of actions to deal with inflation and continue to add value to their customers and their shareholders. We strongly believe, as did the late Dick Taylor who managed money in previous decades, that the ownership of great companies remains the best foundation for the preservation of purchasing power against the corrosion of inflation.

All investors should understand this important issue, and why it is not likely to go away anytime soon.

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For later posts on this same topic, see also:
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Tuesday, April 06, 2010

Recovery-bashing will backfire




















As champions of the free enterprise system, we are hard-pressed to find anything that current policymakers are doing that gives us comfort that they understand how the free enterprise system works.

However, we have always said that "we get by in spite" -- meaning, that the economy "gets by" in spite of policymakers, not because of their actions or interventions.

The current economic environment is a testimony to that fact, as it displays the resilience of our system even as it is under assault.

For all those other champions of free enterprise who find it necessary to downplay the current recovery, we would say that you risk making serious investment errors by taking this tack, and risk future damage to your credibility.

Economist Larry Kudlow makes this point beautifully in his latest post here.

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For later posts on the same topic, see here:

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