Regulators of the World, Unite!

Tuesday, October 13th, 2009

With apologies to Marx and Engels, this may also sound like the clarion call for those responsible for regulating financial institutions.

We have already seen developed countries discuss how regulations on banking, derivatives, etc, can better be coordinated…all the better to keep the financial players from picking the best domicile for their activity.

And, now, we have the US Government looking to create a national office of insurance. Although the initial and ultimate authority of such a new department is still open for debate…even the insurance industry does not agree on what that should be…the trend is clear. Many regulators believe they must unite to throw off the yolk of the oppressive insurers who look for optimal domiciles or otherwise ‘game the system’. And, in some instances, insurers (some of who support an ‘optional federal charter’) are supportive of this view of the world.

Of course, in the insurance industry, the granddaddy of this approach is the National Association of Insurance Commissioners (NAIC), that trade association or regulatory body (I’m not sure even the NAIC agrees on which it is). The NAIC developed a unification tool called ‘accreditation’ to keep all its ‘members’ on the same page on key ‘model law’ issues. Yet, one of the most prestigious members, New York, takes the approach of a different Marx (Groucho), who said “I don’t care to belong to a club that accepts people like me as members.” New York remains ‘unaccredited’, preferring to buck the system, while still having a large hand in how it operates.

However, this misses something that we all should remember. Whether in banking or insurance, the regulators are ‘captured’ by the largest of those they regulate. In other words, the regulators must bend to the wishes of the largest firms they regulate, especially in difficult times.

If you don’t believe this happens in insurance, we have only to look at the topic of ‘permitted practices’, those actions that are OK for certain companies, but probably not for yours.

For example, the Insurance Underwriter recently reported that the number of life insurers using permitted practices increased from 25 companies in 2007 to 80 in 2008, and that the combined effect on surplus for those companies went from a reduction in surplus of $313 million in 2007 to an increase in surplus of $8 billion in 2008.

Capital out of thin air.

But, wait, there’s more.

The life industry is advocating relaxing capital requirements for many residential mortgage backed securities because using rating agency ratings are inaccurate. Their alternative would revolve around using third party modeling. But, isn’t the incorrect use of models one of the problems encountered by investors (and the rating agencies) in the recent financial crisis? Based upon continuing discussions, this proposal or something like it, may pass.

Regulators of the World Unite!

Indeed.

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The Race Is On: Why U,V,W Is Not Important

Tuesday, October 13th, 2009

Although you probably won’t hear this from the economic analysis or similar palaver at your quarterly investment manager meetings, the crucial issue facing the US economy today is not the letter of the recovery. In fact, you may feel like your friendly economist is telling you that the economy is brought to you by a letter, V, U, W, much like an old Sesame Street episode.

But, the sad truth is that the US economy is facing a series of races between desirable and undersirable outcomes.

Submitted for your approval, here are a few inconvenient, yet likely truths .

1 - We are saddled with large zombie banks focused on drinking the blood of risk free net interest margin (between US Treasury purchases and zero cost reserves provided by the Fed) at no additional cost of required capital. This blood is important for the ongoing existence of most of the zombies (who try not to act like banks by earning net interest margin on the difference between loan and deposit rates). These zombie banks realize they will slowly be losing body parts in the form of credit losses. Those losses are hidden from sight due to loosened accounting rules, but they will eventually surface. And when the do, look out. In fact, at year end, the FASB may require many SIVs and the like be put back on the balance sheet of sponsoring banks. Ouch!

So, the question here is which zombie banks will get enough blood to offset credit losses and at what rate. Thus, ‘more blood’ is the refrain from these zombies and the US Government is obliging.

The race is on.

2 - In response to the ‘Greatest Deleveraging in the History of the World’, the US Government has responded with the ‘Greatest Releveraging in the History of the World’. Add the increase in fiscal debt with the increase in monetary debt (Federal Reserve) to increased indirect and direct guarantees (FNMA, FHLMC, GNMA, FDIC) and there is little wonder why the economy is recovering. The Government can not only ‘print money’ (mainly in the form of bank reserves right now), but they can ‘encourage’ bank purchases of US Treasuries to bridge the divide of a record fiscal deficit by providing zero percent (reserve) financing at the Federal Reserve.

However, US Government actions are subject to public scrutiny and therein lies the rub.

The Federal Reserve was designed to be independent of the US Government (including the US Treasury) and acted as such for decades. However, the actions noted above call this into question. I recently read an article about China’s ‘bubble economy’ and how a key for future Chinese economic growth will be the development of an independent monetary authority. Undoubtedly, the same could be said for the US.

And, one wonders how a possible next stimulus bill (it may not be called that from a political perspective), or added funding for the FDIC, or a bailout of the FHA/VA, etc, will be received by a wary public. It should be noted that the on again, off again economic recovery during Japan’s lost decade was occasionally thwarted by those who felt the prior stimulus was ‘working’, so why vote for another one. It should also be noted that during the Great Depression, FDR’s calls for more aid for the unemployed was met with cries of concern about people just deciding to go ‘on the dole’. So, there is history on the side of those who think the releveraging of the US Government cannot continue unabated.

Of course, a growing economy can make the size of the deficit, national debt and even the Fed’s bloated balance sheet seem a lot more reasonable.

Thus, the race is on between economic growth (and it is on the way in a big way, per the reliable Economic Cycle Research Institute) and the limits to growth of the ‘greatest releveraging’ of the US Government.

3 - Most sentient economists believe that ‘sustainable growth’ of the US economy will not come from releveraging, but from remixing the components of GDP. Decreased participation from consumers would be offset by increased participation from net exports (now a negative contributor to GDP). However, changing the US from a net consumer of foreign goods and services to net producer of such is no easy task. Thus, step one is the slow downward glide of the US dollar, including increased pressure on countries with currencies tied to the USD (aka China). However, declining currency valuations can also mean eventual inflationary pressures.

So, the race is on between a declining dollar, fewer net exports and incipient inflation.

The discussion of whether this economy is brought to you by the letter U, V and W is truly not the point. The key point is how these races are won and lost, and how they will impact each other as well as many other segments of the economy. A careful consideration of each will assist all investors in determining how best to position their portfolios.

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Archive for October, 2009

Regulators of the World, Unite!

The Race Is On: Why U,V,W Is Not Important

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