Anchoring in auctions

Why Things Cost $19.95

What are the psychological "rules" of bartering?

By Wray Herbert

(Scientific American) One of Alfred Hitchcock’s most enduring bits of cinematic comedy is the auction scene in the espionage thriller North by Northwest. Cary Grant plays Roger Thornhill, a businessman who has been mistaken for a CIA agent by the ruthless Phillip Vandamm. At a critical juncture, Thornhill is cornered by his enemies inside a Chicago auction house, and the only way he can escape is by drawing attention to himself. When the bidding on an antique reaches $2,250, Thornhill yells out, “Fifteen hundred!” When the auctioneer gently chides him, he loudly changes his bid: “Twelve hundred!” When the bidding on a Louis XIV chaise longue reaches $1,200, Thornhill blurts outs, “Thirteen dollars!” The genteel crowd is outraged, but Thornhill gets precisely what he wants: the auctioneer summons the police, who “escort” him past Vandamm’s henchmen to safety.

Clever thinking and good comedy. It is funny for a lot of reasons, and one is that Thornhill violates every psychological “rule” for how we negotiate price and value with one another. So much of life involves “auctions,” whether it is buying a used car or making health care choices or even choosing a mate. But, unlike Roger Thornhill, most of us are motivated by the desire for a fair deal, and we employ some sophisticated cognitive tools to weigh offers, fashion responses, and so forth—all the to-and-fro in getting to an agreement.

But how does life’s dickering play out in the brain? And is it a trustworthy tool for getting what we want? Psychologists have been studying cognitive bartering for some time, and several basics are well established. For example, an opening “bid” of any sort is usually perceived as a mental anchor, a starting point for the psychological jockeying to follow. If we perceive an opening bid as fundamentally inaccurate or unfair, we reject it by countering with something in another ballpark altogether. But what about less dramatic counter offers? What makes us settle on a response?

University of Florida marketing professors Chris Janiszewski and Dan Uy suspected that something fundamental might be going on, that some characteristic of the opening bid itself might influence the way the brain thinks about value and shapes bidding behavior. In particular, they wanted to see if the degree of precision of the opening bid might be important to how the brain acts at an auction. Or, to put it in more familiar terms: Are we really fooled when storekeepers price something at $19.95 instead of a round 20 bucks?

Janiszewski and Uy ran a series of tests to explore this idea. The experiments used hypothetical scenarios, in which participants were required to make a variety of “educated guesses.” For example, they had subjects think about a scenario in which they were buying a high-definition plasma TV and asked them to guesstimate the wholesale cost. The participants were told the retail price, plus the fact that the retailer had a reputation for pricing TVs competitively.

There were three scenarios involving different retail prices: one group of buyers was given a price of $5,000, another was given a price of $4,988, and the third was told $5,012. When all the buyers were asked to estimate the wholesale price, those with the $5,000 price tag in their head guessed much lower than those contemplating the more precise retail prices. That is, they moved farther away from the mental anchor. What is more, those who started with the round number as their mental anchor were much more likely to guess a wholesale price that was also in round numbers. The scientists ran this experiment again and again with different scenarios and always got the same result.

Why would this happen? As Janiszewski and Uy explain in the February issue of Psychological Science, people appear to create mental measuring sticks that run in increments away from any opening bid, and the size of the increments depends on the opening bid. That is, if we see a $20 toaster, we might wonder whether it is worth $19 or $18 or $21; we are thinking in round numbers. But if the starting point is $19.95, the mental measuring stick would look different. We might still think it is wrongly priced, but in our minds we are thinking about nickels and dimes instead of dollars, so a fair comeback might be $19.75 or $19.50.

The psychologists decided to check these lab findings in the real world. They looked at five years of real estate sales in Alachua County, Florida, comparing list prices and actual sale prices of homes. They found that sellers who listed their homes more precisely—say $494,500 as opposed to $500,000—consistently got closer to their asking price. Put another way, buyers were less likely to negotiate the price down as far when they encountered a precise asking price. Furthermore, houses listed in round numbers lost more value if they sat on the market for a couple of months. So, bottom line: one way to deal with a buyer’s market may be to pick an exact list price to begin with.

This isn’t all about money, however. Medical information, Janiszew­ski and Uy note, can also be offered in either precise or general terms: a physician might say that your chance of responding to a medication is “good” or that your chance of responding is 80 percent. The percentage is more precise, but many studies have shown that patients prefer vague generalities like “good,” so doctors tend to use them. But remember that life is an auction. In his mind, the patient is dickering with the doctor, so why not negotiate “good” up to “excellent”? When treatment choices are on the line, the auction house can indeed be a perilous place.

Falling public equity markets make SPACs look compelling

SPAC Attack
Posted on March 20, 2008

(The Deal) The IPO window is all but closed, while the SPAC door looks wide open.

SPACs, or blank-check public offerings, are here to stay, having represented 21% of cash raised in the IPO market in 2007, notes Deal contributor Joseph Bartlett. "The SPACs phenomenon is based on fundamental shifts in the U.S. financial markets, the first being the extended closure (since 2001) of the IPO window in the U.S. for small- and midcap companies."

So what are they, exactly? The Deal's Vyvyan Tenorio offers a primer:

As blind pools, SPACs don't have an operating business when they raise money in public markets. But they have 18 months from an IPO to complete a deal using about 80% of net assets. Up to 95% of the money raised is held in a third-party trust. Once a SPAC has identified a target, it has to notify shareholders and submit documentation to the SEC. Shareholders can approve it and sell or redeem their shares. If the SPAC fails to successfully make an acquisition, the trust is liquidated and the cash returned.

SPACs are an investment favorite of hedge funds (Amaranth Advisors LLC loved 'em before its spectacular implosion) and, of late, large institutional investors like mutual funds. She writes:

Clearly there's an appetite for SPACs among sponsors whose access to capital may be limited, and among hedge funds that hope to profit from arbitrage opportunities. SPACs have also opened avenues for well-heeled financiers such as Texas private equity pioneer Tom Hicks. In June, Hicks filed to raise $400 million through an IPO for a SPAC. [He wound up raising $552 million in October.] Hedge funds, too, are exploiting these vehicles to take themselves public. GLG Partners LP, one of Europe's largest hedge funds, went public in 2006 through a reverse $3.4 billion takeover of Freedom Acquisitions Holdings Inc., which raised $528 million late in the year.

And they're also a popular exit route for private equity firms, notes The Deal's John Morris. (For other ways PE firms can capitalize, see below.) Eleven SPACs have bought private equity-controlled U.S. companies since mid-2006, he says, citing a SPAC tracker.

THE GOOD, THE BAD AND THE FIXES

More generally, SPACs seek to overcome some of the problems involved in the back-door route -- reverse merger into a public shell. It's a two-step process, Sonnenschein Nath & Rosenthal LLP's Bartlett notes: An underwritten IPO followed by an acquisition, effectively a back-door IPO but with built-in safeguards, promising shareholders get a say in choosing the target. He lays out the plusses, particularly when compared to shells, and the minuses:

• It affords retail investors access to many advantages of private equity. While hedge funds typically buy the stock, any average investor can too.
• Investors buy what the SPAC has set out to do; whereas investors in a shell are bystanders.
• And shareholders can vote for a deal or against it and recoup much of their investment, which is far less common with shells.
• All told, a SPAC deal is still a reverse IPO, so if a company is to float successfully, why not use the traditional avenue? The road is shorter, cheaper and less risky. But the window, for now, is closed.
• Further, many deals involve proceeds that fall short of the amount deemed advisable to escape orphanage, a problem that can be countered with rollups.

The remaining issues are tougher, he notes:

• How attractive is a company willing to hang around an average of 218 days for a yes vote that may or may not come? "If it is any good, it should be snapped up quickly by financial and/or strategic investors."
• And a no vote can be catastropic. "Take a look at the stock price nosedive of targets left at the altar by LBO funds reneging at the last minute." (For more on buyouts gone bust, see a related Dealwatch.)
• Further, once proxy materials go out, anyone can take a peek: competitors as well as customers.
• The 18-month deadline imposes tremendous pressure to cut a deal.

So what are the fixes?

• For SPACs themselves, a team-up with a PE fund may be the best model. (See below.) Potential conflicts of interest surrounding the role of private equity investors in SPACs can also arise, but the shareholders always have the cash-out option.
• Meanwhile the SEC needs to regulate to prevent market manipulation (one SEC rule is that SPACs can't predetermine acquisition targets, a contested point because they're often industry-specific) and the average 218-day delay (also aimed at preventing abuse) from sign to close needs to be shortened.
• Finally, reliable data on post-closing stock performance is essential, he notes, to help investors decide which SPACs and targets will withstand the after market.

GAME PLAN

SPACs are trying to differentiate from the checkered past of blind pools, note William F. Griffin Jr. and Andrew D. Myers, shareholders with Davis, Malm & D'Agostine PC. There are investor protections: the aforementioned shareholder vote on acquisitions and cash-out option; management and frequently underwriters have skin in the game via stock and warrant purchase agreements and deferred fees, respectively; a relatively small amount of offering proceeds go toward working capital to consummate an acquisition.

So for a private equity investor, there are three ways to go about getting into the SPAC game, notes the SPAC lady herself, Tina Pappas, a managing director with boutique investment bank Morgan Joseph & Co.:

• Sponsoring a SPAC as an issuer: PE firms that have done so include: MBF Healthcare Partners LP, Steel Partners, LLM Capital Partners LLC, Camden Partners Holdings LLC and GSC Group, while several others are in registration.
• Exits for existing investments: 72 SPACs have more than $12.3 billion in capital looking for acquisitions. She calls a reverse merger one of the most compelling options.
• Co-investing in a SPAC acquisition: In an arrangement where an existing consortium of SPACs just need some more cash to complete a transaction, a firm could come in and perhaps be entitled part of the founders' 20% ownership right and warranty options.

A DIFFERENT ANIMAL

And in a then-recent twist, Tenoiro noted in July:

SPACs have now tapped the Rule 144A [under which an issuer can offer a private sale of securities to qualified institutional buyers, or QIBs, without government oversight] market for privately issued, unregistered securities, which coincidentally is an increasingly popular alternative for private equity firms looking to go public.

It affords more flexibility, she writes, as QIBs are perceived as sophisticated institutional buyers who don't need the same protections as individual or smaller investors. They're not subject to the long SEC review process (drawn out to guard against potential abuses). And how many 144A SPACs there have been is hard to say, given that they're private placements, she writes. "Not surprisingly, sources say investors in these offerings are essentially the same community of hedge funds that invest in SPACs."

And after the IPO come the mergers. McDermott Will & Emery LLP's Joel L. Rubinstein and Dennis J. White weighed in on the nuances in September. Unsurprisingly, competition for the listings is fierce. As The Deal's Donna Block noted Feb. 21: Nasdaq's move to institute new listing standards for special purpose acquisition vehicles is an attempt to capture American Stock Exchange listings. - Carolyn Murph

Programmers free thyselves

You weren't meant to have a boss
March 2008
http://www.paulgraham.com/boss.html

A few days ago I was sitting in a cafe in Palo Alto and a group of programmers came in on some kind of scavenger hunt. It was obviously one of those corporate "team-building" exercises.They looked familiar. I spend nearly all my time working with programmers in their twenties and early thirties. But something seemed wrong about these. There was something missing.And yet the company they worked for is considered a good one, and from what I overheard of their conversation, they seemed smart enough. In fact, they seemed to be from one of the more prestigious groups within the company.So why did it seem there was something odd about them?I have a uniquely warped perspective, because nearly all the programmers I know are startup founders. We've now funded 80 startups with a total of about 200 founders, nearly all of them programmers. I spend a lot of time with them, and not much with other programmers. So my mental image of a young programmer is a startup founder.The guys on the scavenger hunt looked like the programmers I was used to, but they were employees instead of founders. And it was startling how different they seemed.So what, you may say. So I happen to know a subset of programmers who are especially ambitious. Of course less ambitious people will seem different. But the difference between the programmers I saw in the cafe and the ones I was used to wasn't just a difference of degree. Something seemed wrong.I think it's not so much that there's something special about founders as that there's something missing in the lives of employees. I think startup founders, though statistically outliers, are actually living in a way that's more natural for humans.I was in Africa last year and saw a lot of animals in the wild that I'd only seen in zoos before. It was remarkable how different they seemed. Particularly lions. Lions in the wild seem about ten times more alive. They're like different animals. And seeing those guys on their scavenger hunt was like seeing lions in a zoo after spending several years watching them in the wild.TreesWhat's so unnatural about working for a big company? The root of the problem is that humans weren't meant to work in such large groups.Another thing you notice when you see animals in the wild is that each species thrives in groups of a certain size. A herd of impalas might have 100 adults; baboons maybe 20; lions rarely 10. Humans also seem designed to work in groups, and what I've read about hunter-gatherers accords with research on organizations and my own experience to suggest roughly what the ideal size is: groups of 8 work well; by 20 they're getting hard to manage; and a group of 50 is really unwieldy. [1]Whatever the upper limit is, we are clearly not meant to work in groups of several hundred. And yet—for reasons having more to do with technology than human nature—a great many people work for companies with hundreds or thousands of employees.Companies know groups that large wouldn't work, so they divide themselves into units small enough to work together. But to coordinate these they have to introduce something new: bosses.These smaller groups are always arranged in a tree structure. Your boss is the point where your group attaches to the tree. But when you use this trick for dividing a large group into smaller ones, something strange happens that I've never heard anyone mention explicitly. In the group one level up from yours, your boss represents your entire group. A group of 10 managers is not merely a group of 10 people working together in the usual way. It's really a group of groups. Which means for a group of 10 managers to work together as if they were simply a group of 10 individuals, the group working for each manager would have to work as if they were a single person—the workers and manager would each share only one person's worth of freedom between them.In practice a group of people never manage to act as if they were one person. But in a large organization divided into groups in this way, the pressure is always in that direction. Each group tries its best to work as if it were the small group of individuals that humans were designed to work in. That was the point of creating it. And when you propagate that constraint, the result is that each person gets freedom of action in inverse proportion to the size of the entire tree. [2]Anyone who's worked for a large organization has felt this. You can feel the difference between working for a company with 100 employees and one with 10,000, even if your group has only 10 people.Corn SyrupA group of 10 people within a large organization is a kind of fake tribe. The number of people you interact with is about right. But something is missing: individual initiative. Tribes of hunter-gatherers have more freedom. The leaders have a little more power than other members of the tribe, but they don't generally tell them what to do and when the way a boss can.It's not your boss's fault. The real problem is that in the group above you in the hierarchy, your entire group is one virtual person. Your boss is just the way that constraint is imparted to you.So working in a group of 10 people within a large organization feels both right and wrong at the same time. On the surface it feels like the kind of group you're meant to work in, but something major is missing. A job at a big company is like high fructose corn syrup: it has some of the qualities of things you're meant to like, but is disastrously lacking in others.Indeed, food is an excellent metaphor to explain what's wrong with the usual sort of job.For example, working for a big company is the default thing to do, at least for programmers. How bad could it be? Well, food shows that pretty clearly. If you were dropped at a random point in America today, nearly all the food around you would be bad for you. Humans were not designed to eat white flour, refined sugar, high fructose corn syrup, and hydrogenated vegetable oil. And yet if you analyzed the contents of the average grocery store you'd probably find these four ingredients accounted for most of the calories. "Normal" food is terribly bad for you. The only people who eat what humans were actually designed to eat are a few Birkenstock-wearing weirdos in Berkeley.If "normal" food is so bad for us, why is it so common? There are two main reasons. One is that it has more immediate appeal. You may feel lousy an hour after eating that pizza, but eating the first couple bites feels great. The other is economies of scale. Producing junk food scales; producing fresh vegetables doesn't. Which means (a) junk food can be very cheap, and (b) it's worth spending a lot to market it.If people have to choose between something that's cheap, heavily marketed, and appealing in the short term, and something that's expensive, obscure, and appealing in the long term, which do you think most will choose?It's the same with work. The average MIT graduate wants to work at Google or Microsoft, because it's a recognized brand, it's safe, and they'll get paid a good salary right away. It's the job equivalent of the pizza they had for lunch. The drawbacks will only become apparent later, and then only in a vague sense of malaise.And founders and early employees of startups, meanwhile, are like the Birkenstock-wearing weirdos of Berkeley: though a tiny minority of the population, they're the ones living as humans are meant to. In an artificial world, only extremists live naturally.ProgrammersThe restrictiveness of big company jobs is particularly hard on programmers, because the essence of programming is to build new things. Sales people make much the same pitches every day; support people answer much the same questions; but once you've written a piece of code you don't need to write it again. So a programmer working as programmers are meant to is always making new things. And when you're part of an organization whose structure gives each person freedom in inverse proportion to the size of the tree, you're going to face resistance when you do something new.This seems an inevitable consequence of bigness. It's true even in the smartest companies. I was talking recently to a founder who considered starting a startup right out of college, but went to work for Google instead because he thought he'd learn more there. He didn't learn as much as he expected. Programmers learn by doing, and most of the things he wanted to do, he couldn't—sometimes because the company wouldn't let him, but often because the company's code wouldn't let him. Between the drag of legacy code, the overhead of doing development in such a large organization, and the restrictions imposed by interfaces owned by other groups, he could only try a fraction of the things he would have liked to. He said he has learned much more in his own startup, despite the fact that he has to do all the company's errands as well as programming, because at least when he's programming he can do whatever he wants.An obstacle downstream propagates upstream. If you're not allowed to implement new ideas, you stop having them. And vice versa: when you can do whatever you want, you have more ideas about what to do. So working for yourself makes your brain more powerful in the same way a low-restriction exhaust system makes an engine more powerful.Working for yourself doesn't have to mean starting a startup, of course. But a programmer deciding between a regular job at a big company and their own startup is probably going to learn more doing the startup.You can adjust the amount of freedom you get by scaling the size of company you work for. If you start the company, you'll have the most freedom. If you become one of the first 10 employees you'll have almost as much freedom as the founders. Even a company with 100 people will feel different from one with 1000.Working for a small company doesn't ensure freedom. The tree structure of large organizations sets an upper bound on freedom, not a lower bound. The head of a small company may still choose to be a tyrant. The point is that a large organization is compelled by its structure to be one.ConsequencesThat has real consequences for both organizations and individuals. One is that companies will inevitably slow down as they grow larger, no matter how hard they try to keep their startup mojo. It's a consequence of the tree structure that every large organization is forced to adopt.Or rather, a large organization could only avoid slowing down if they avoided tree structure. And since human nature limits the size of group that can work together, the only way I can imagine for larger groups to avoid tree structure would be to have no structure: to have each group actually be independent, and to work together the way components of a market economy do.That might be worth exploring. I suspect there are already some highly partitionable businesses that lean this way. But I don't know any technology companies that have done it.There is one thing companies can do short of structuring themselves as sponges: they can stay small. If I'm right, then it really pays to keep a company as small as it can be at every stage. Particularly a technology company. Which means it's doubly important to hire the best people. Mediocre hires hurt you twice: they get less done, but they also make you big, because you need more of them to solve a given problem.For individuals the upshot is the same: aim small. It will always suck to work for large organizations, and the larger the organization, the more it will suck.In an essay I wrote a couple years ago I advised graduating seniors to work for a couple years for another company before starting their own. I'd modify that now. Work for another company if you want to, but only for a small one, and if you want to start your own startup, go ahead.The reason I suggested college graduates not start startups immediately was that I felt most would fail. And they will. But ambitious programmers are better off doing their own thing and failing than going to work at a big company. Certainly they'll learn more. They might even be better off financially. A lot of people in their early twenties get into debt, because their expenses grow even faster than the salary that seemed so high when they left school. At least if you start a startup and fail your net worth will be zero rather than negative. [3]We've now funded so many different types of founders that we have enough data to see patterns, and there seems to be no benefit from working for a big company. The people who've worked for a few years do seem better than the ones straight out of college, but only because they're that much older.The people who come to us from big companies often seem kind of conservative. It's hard to say how much is because big companies made them that way, and how much is the natural conservatism that made them work for the big companies in the first place. But certainly a large part of it is learned. I know because I've seen it burn off.Having seen that happen so many times is one of the things that convinces me that working for oneself, or at least for a small group, is the natural way for programmers to live. Founders arriving at Y Combinator often have the downtrodden air of refugees. Three months later they're transformed: they have so much more confidence that they seem as if they've grown several inches taller. [4] Strange as this sounds, they seem both more worried and happier at the same time. Which is exactly how I'd describe the way lions seem in the wild.Watching employees get transformed into founders makes it clear that the difference between the two is due mostly to environment—and in particular that the environment in big companies is toxic to programmers. In the first couple weeks of working on their own startup they seem to come to life, because finally they're working the way people are meant to.

Notes[1] When I talk about humans being meant or designed to live a certain way, I mean by evolution.[2] It's not only the leaves who suffer. The constraint propagates up as well as down. So managers are constrained too; instead of just doing things, they have to act through subordinates.[3] Do not finance your startup with credit cards. Financing a startup with debt is usually a stupid move, and credit card debt stupidest of all. Credit card debt is a bad idea, period. It is a trap set by evil companies for the desperate and the foolish.[4] The founders we fund used to be younger (initially we encouraged undergrads to apply), and the first couple times I saw this I used to wonder if they were actually getting physically taller.

Thanks to Trevor Blackwell, Ross Boucher, Aaron Iba, Abby Kirigin, Ivan Kirigin, Jessica Livingston, and Robert Morris for reading drafts of this.

Lower P/Es now may mean... lower P/Es in the future

MARKET MOVER

Are Low P/Es A Valid Reason To Buy Stocks?

With Earnings Shaky And Inflation Climbing, More Declines Possible

By TOM LAURICELLA
March 10, 2008

(WSJ) With the economy showing clear signs of recession and the credit markets in turmoil, the floor under stock prices seems to be getting thinner. Here is another reason to worry: Stock prices aren't as cheap as they seem, and based on other periods when inflation was accelerating and the economy weak, the market can struggle for prolonged periods.

Some argue stocks are attractively priced after a 17% decline in the Standard & Poor's 500-stock index since October. Based on earnings forecasts for 2008 collected by Reuters Estimates, the S&P 500 is trading at 13.2 times projected earnings, compared with an average of 16.5 times going back to 1989, according to data compiled by Morgan Stanley.

Price-to-earnings ratios reflect the amount investors are willing to pay for future earnings. When these ratios fall below long-term trends, conventional wisdom is that stocks are cheap and it is time to buy.

Until 2000, investors feasted on the combination of rising P/E ratios and rising stock prices. At the end of the 1980-82 bear market, S&P stocks changed hands at a price-to-earnings ratio of 8.7, according to Morgan Stanley's data. In the next 17 years, the ratio moved higher, topping out just shy of 30 in the spring of 1999. During that time, when the S&P rose an average of about 17% a year, roughly one-third of returns on the S&P 500 were the result of rising P/E multiples, according to Ibbotson Associates.

That period also featured a long downtrend in inflation and interest rates, which generally lead directly to higher multiples. Now, inflation is quickening, and interest rates, while heading down, can't fall much further. This suggests an environment less conducive to rising stock multiples.

That was the case in the most recent bull market, when price-to-earnings multiples actually fell even as the market rose. When the bull market began in early October 2002, the S&P 500 had finished the previous month at a P/E ratio of 17.6 when measured against the previous 12 months earnings. This past September, just before the market began its descent, the ratio was 16.8.

It is a similar story when looking at expected earnings, the basis on which stocks currently look cheap. At the end of September 2002, the S&P 500 was priced at 14.5 times the coming 12 months expected earnings, according to Morgan Stanley. This past September, after a five-year run in which the S&P 500 rose an average of more than 15% a year, the P/E on the index was 14.8 times the coming year's expected earnings.

"The growth in stock returns came mostly from earnings growth," says Peng Chen, chief investment officer at Ibbotson Associates.

Morgan Stanley analysts contend that stubborn inflation means investors won't be willing to pay big premiums for future earnings. Goldman Sachs Group strategists say that based on typical declines in P/E ratios in the past four recessions, stock multiples can go much lower.

Nicholas Bohnsack, of Strategas Research Partners, says it is a mistake for investors to assume multiples will head higher. There have been extended periods in which multiples went down or were flat, most recently in the 1970s, he notes. Today, he says, "We're in a secular period of multiple contraction," which features lots of "sideways, grinding of multiples."

Part of the problem is that the earnings side of the equation is looking shaky. Wall Street analysts predict a double-digit increase in corporate profits for 2008, but forecasts have been pared back. As of Friday, S&P 500 stocks are expected to generate $98.25 in earnings a share this year, down from the $101.87 a share predicted at the end of last year, according to Reuters.

Analysts have taken an especially sharp knife to estimates of first-quarter earnings, which now are expected at $22.58 a share, compared with the $23.64 forecast at the end of December. That means instead of rising at a 5.1% rate, first-quarter earnings are expected to be basically flat.

Another problem is inflation. In a number of recent sessions, the stock market has reacted positively to higher commodity prices on the theory that it will boost profits of energy and materials companies. But if inflation stays stubbornly high despite the U.S. economic slowdown, it would be a negative for multiples, because it reduces the value of future earnings.

Abhijit Chakrabortti, Morgan Stanley's chief global and U.S. equity strategist, says inflation is running about 0.8 percentage point above the long-term trend of 3.5%, and value for the S&P 500 should be reduced by the same amount. With that factor taken into consideration, he argues that current fair value for the index is about 17 times trailing earnings, not much above its present reading.

Ed Easterling, president of Crestmont Research, argues that record increases in earnings and profit margins in recent years make prices look artificially cheap. He prefers to look at the 10-year trends in earnings, from which he removes the impact of inflation and smooths out the short-term ups and downs in profit margins. That, he contends, provides a cleaner picture of stock valuations.

Mark-to-market apologist defends regime

The credit crunch

Mark it and weep

Mar 6th 2008
From The Economist print edition

Mark-to-market accounting hurts, but there is no better way

WITH memories of their drubbing in the dotcom bust still fresh, accountants have kept their noses clean in this financial crisis. Once again, though, they are being dragged into the fray. That is because they are enforcing fair-value accounting, in which assets must be marked regularly to the market price: that is, what they would be expected to fetch right now in a sale. Regulators and bankers fear that this “mark-to-market” approach is helping to turn a liquidity crisis into a solvency one. As holders of mortgage-backed securities and the like revalue their assets at fire-sale prices, they are running short of capital—which can lead to further sales and more write-downs. Are the beancounters ensuring a crash?

All accounting regimes are flawed, and fair-value is no exception. It is timely and transparent, but when markets collapse, prices become less reliable. How do you mark to market when there is barely any market? Some firms rely on credit-derivative indices, but these are far from perfect proxies (see article). Others cling to internal computer models, but their accountants are cracking down on them. Banks are also being asked by their auditors to put more assets into the fair-value regime's lowest bucket (for the most illiquid assets). This adds to their woes, since such assets carry a higher capital charge.

egulators worry that mark-to-market may create a “liquidity black hole”. Nerves jangle at every fire-sale, for fear that this will become the new benchmark for sticky assets. The fear is that value-at-risk systems force investment firms and banks to offload securities, leading to price falls and further sales. The temptation is to sell now, before the next lurch down. The result will be excessive write-downs—as the stable value of assets is above today's distressed level.

That is a damning list of failings. And yet, for all its pain, fair-value accounting is still the best way to value businesses. Especially if investors and regulators treat accounting rules sensibly: as a measuring stick, not a source of universal truth.

On that score the old system of historic-cost accounting was worse. In a crisis prices fall until bottom-fishers start to buy. Yet when assets were booked at their original price, rather than the market one, banks could delude themselves—and investors—that dross was gold. Under historic-cost accounting, the banks had every reason not to restructure assets, because that meant owning up to their losses. Look at Japan, where the economy was sunk for most of the 1990s by stagnant loans to “zombie” companies. Historic-cost left investors in the dark about valuations; it was also prone to fraud and fraught with moral hazard, since sloppy lending went unpunished.

The sticky end

Mark-to-market does not have to be as bad as its critics fear. Not everyone has gorged on toxic assets, and not everyone has to mark to market. This biodiversity means there will be buyers, even in the most strained markets, at the right price. Sovereign-wealth funds have poured money into troubled banks. This week PIMCO, a big fund manager, bought $1.5 billion of American municipal bonds, where yields have jumped as the crisis spread. Warren Buffett is also sniffing around.

The place for regulators to be subtle is not in reporting the figures, but in dealing with the problems they reveal. The task is to make markets resilient when the cycle turns. Central banks could offer more protection against crises in liquidity (see article). Thicker buffers could be built into the Basel II framework for bank capital. Securitised assets could be hauled from murky over-the-counter markets to exchanges, where values are clearer. Models for valuing complex securities will be refined. And regulators and accountants could ease up when banks risk a liquidity spiral—as in Europe in 2002, when insurers faced a solvency crisis over falling share prices.

It would be perverse to ignore market signals when finance is increasingly based on broad capital markets. Fair-value accounting is indeed flawed. To paraphrase Winston Churchill, it is the worst kind of accounting, except for all the others.

The credit fallout continues

The Federal Reserve's rescue has failed
By Ambrose Evans-Pritchard, International Business Editor
Last Updated: 12:56am GMT 03/03/2008

(Telegraph) Yields on two-year US Treasuries plummeted to 1.63pc on Friday in a flight to safety, foretelling financial winter.

The debt markets are freezing ever deeper, a full eight months into the crunch. Contagion is spreading into the safest pockets of the US credit universe.

It is hard to imagine a more plain-vanilla outfit than the Port Authority of New York and New Jersey, which manages bridges, bus terminals, and airports.

The authority is a public body, backed by the two states. Yet it had to pay 20pc rates in February after the near closure of the $330bn (£166m) "term-auction" market. It had originally expected to pay 4.3pc, but that was aeons ago in financial time.

"I never thought I would see anything like this in my life," said James Steele, an HSBC economist in New York.

No sane mortal needs to know what term-auction means, except that it too became a tool of the US credit alchemists. Banks briefly used the market as laboratory for conjuring long-term loans at Alan Greenspan's giveaway short-term rates. It has come unstuck. Next in line is the $45trillion derivatives market for credit default swaps (CDS).

Last week, the spreads on high-yield US bonds vaulted to 718 basis points. The iTraxx Crossover index measuring corporate default risk in Europe smashed the 600 barrier. We are now far beyond the August spike.

Sub-prime debt is plumbing new depths. A-rated securities issued in early 2007 fell to a record 12.72pc of face value on Friday. The BBB tier fetched 10.42pc. The "toxic" tranches are worthless.

Why won't it end? Because US house prices are in free fall. The Case-Shiller index for the 20 biggest cities dropped 9.1pc year-on-year in December. The annualised rate of fall was 18pc in the fourth quarter, and gathering speed.

As the graph shows below, US households are only halfway through the tsunami of rate resets - 300 basis points upwards - on teaser loans.
The UK hedge fund Peleton Partners misjudged this fresh leg of the crunch. After an 87pc profit last year betting against sub-prime, it switched sides to play the rebound. Last week it had to liquidate a $2bn fund.

Like many, Peleton thought Fed rate cuts from 5.25pc to 3pc (with more to come) would end the panic. But this is not a normal downturn, subject to normal recovery. Leverage is too extreme. Bank capital is too eroded. Monetary traction eludes the Fed. An "Austrian" purge is under way.

Credit Suisse says the cost of the credit debacle will reach $600bn. "Leveraged risk is a cancer in this market."

Try $1trillion, says New York professor Nouriel Roubin. Contagion is moving up the ladder to prime mortgages, commercial property, home equity loans, car loans, credit cards and student loans. We have not even begun Wave Two: the British, Club Med, East European, and Antipodean house busts.

As the once unthinkable unfolds, the leaders of global finance dither. The Europeans are frozen in the headlights: trembling before a false inflation; cowed by an atavistic Bundesbank; waiting passively for the Atlantic storm to hit.

Half the eurozone is grinding to a halt. Italy is slipping into recession. Property prices are flat or falling in Ireland, Spain, France, southern Italy and now Germany. French consumer moral is the lowest in 20 years.

The euro fetches $1.52 (from $0.82 in 2000), beyond the pain threshold for aircraft, cars, luxury goods and textiles. The manufacturing base of southern Europe is largely below water. As Le Figaro wrote last week, the survival of monetary union is in doubt. Yet still, the ECB waits; still the German-bloc governors breathe fire about inflation.

The Fed is now singing from a different hymn book, warning of the "possibility of some very unfavourable outcomes". Inflation is not one of them.

"There probably will be some bank failures," said Ben Bernanke. He knows perfectly well that the US price spike is a bogus scare, the tail-end of a food and fuel shock.

"I expect inflation to come down. I don't think we're anywhere near the situation in the 1970s," he told Congress.

Indeed not. Real wages are being squeezed. Oil and "Ags" are acting as a tax. December unemployment jumped at the fastest rate in a quarter century.

The greater risk is slump, says MIT Professor Paul Krugman. "The Fed is studying the Japanese experience with zero rates very closely. The problem is that if they want to cut rates as aggressively as they did in the early 1990s and 2001, they have to go below zero."

This means "quantitative easing" as it was called in Japan. As Ben Bernanke spelled out in November 2002, the Fed can inject money by purchasing great chunks of the bond market.

Section 13 of the Federal Reserve Act allows the bank - in "exigent circumstances" - to lend money to anybody, and take upon itself the credit risk. It has not done so since the 1930s.

Ultimately the big guns have the means to stop descent into an economic Ice Age. But will they act in time?

"We are becoming increasingly concerned that the authorities in the world do not get it," said Bernard Connolly, global strategist at Banque AIG.

"The extent of de-leveraging involves a wholesale destruction of credit. The risk is that the 'shadow banking system' completely collapses," he said.

For the first time since this Greek tragedy began, I am now really frightened.

Rare display of introspection in structured finance

Securitisation

Fear and loathing, and a hint of hope

Feb 14th 2008 LAS VEGAS
From The Economist print edition

Not all is lost for the structured-finance business. But it faces further discomfort before it can start to recover some of its past sheen

AS GAGS go, it was cheap. But irresistible. As a banker from Citigroup placed his chips on the roulette table, a watching wise-guy sniggered: “There goes another $15 billion.”

Even though it was held (as usual) in Las Vegas, this year's conference of the American Securitisation Forum (ASF), between February 3rd and 6th, was a subdued affair. First staged only in 2004, the event has become a mecca for those whose job it is to spin mortgages, credit-card debt and other bread-and-butter financial assets into tradable securities. But this time attendance was down—and tension up, as the neck-masseuses in the exhibit hall could attest. Black humour and self-deprecation replaced the self-congratulation of past years. John Devaney, a hedge-fund manager who had to sell his 142-foot yacht, Positive Carry, and his Gulfstream IV after making bad bets on mortgage bonds, told an audience: “I'd like to thank the market for dealing me a direct hit. As a trader if you don't get sucker-punched every once in a while, you don't understand what risk is.”

You might suppose that meeting in America's gambling capital would provide symbolism enough. But the conference Super Bowl party had plenty more. It was hosted by Countrywide, a big, troubled mortgage lender that has had to fall on the charity of Bank of America. And, as the guests digested the dramatic ending of the New England Patriots' long winning streak by the New York Giants, they may have sensed an uncomfortable parallel. After a quarter-century of growth that turned structured finance from a capital-market cog into an engine of growth, their business has been buckled by the crash in subprime mortgages and the successive blows throughout credit markets. Worse, some blame securitisation for causing the pile-up in the first place.

The limits of gonzo finance

Securitisation has greatly enhanced the secondary market for loans, giving originators, mainly banks, more balance-sheet flexibility and investors of all sorts greater access to credit risk. Both have embraced it. By 2006 the volume of outstanding securitised loans had reached $28 trillion (see chart 1). Last year three-fifths of America's mortgages and one-quarter of consumer debt were bundled up and sold on.

Along the way, banks cooked up a simmering alphabet soup. The ingredients included collateralised-debt obligations (CDOs), which repackage asset-backed securities, and collateralised-loan obligations (CLOs), which do the same for corporate loans, as well as structured investment vehicles (SIVs) and conduits, which banks used to keep some of their exposure off their balance sheets.

The breakneck growth of this business went into reverse last summer, when it became clear that defaults would undermine the structures built around America's mortgage markets. So tarnished has the subprime-mortgage market become, because of shoddy loan underwriting and fraud, that investors are likely to shun securities linked to it for months if not years. Securitisation of better-quality “jumbo” mortgages—too big to be bought by government agencies—is also at a near-halt. “Mortgages were traditionally seen as very safe assets. Now all but the very best are stamped with a skull and crossbones,” says Guy Cecala, of Inside Mortgage Finance, a newsletter.

CDOs are unlikely to regain a following in a hurry (see chart 2). Still less popular are CDO-squareds (resliced and repackaged CDOs) and higher powers. CLOs have also been battered as the leveraged loans they are linked to have tumbled in value. However, their collateral is sounder than that backing subprime CDOs, being based on company financials rather than the blandishments of mortgage brokers.

The prospects for SIVs are bleaker still. SIVs borrow short-term to invest in long-dated assets; and investors will no longer tolerate such mismatches in vehicles shielded from standard banking regulation. With the disappearance of the SIVs' funding sources, notably asset-backed commercial paper, banks had to bring over $136 billion-worth onto their books. That comes on top of over $160 billion, so far, of subprime-related write-downs, over a third of which has come at three banks: Citigroup, Merrill Lynch and UBS.

Though few bankers worked in structured finance, it was a huge earner, accounting for 20-30% of big investment banks' profits before the crisis, according to CreditSights, a financial-research firm. Banks such as Bear Stearns, Lehman Brothers and Morgan Stanley, which bought or built mortgage-origination businesses to fuel the securitisation machine, have rushed to close or pare them. Merrill, whose fees from CDOs alone peaked at $700m in 2006, said recently that it would stop packaging mortgages altogether.

Alongside the banks, the “gatekeepers” who were supposed to lend stability and credibility to the new originate-and-distribute model of finance have also been found wanting. Rating agencies' models underplayed the risk that loans from different lenders and regions could turn sour at the same time. Bond insurers, too, misjudged the risks lurking in CDOs. That failing has undermined the worth of their guarantees and strained their own credit ratings—and hence financial markets.

George Miller, the ASF's executive director, accepts that this crisis of confidence will lead to a degree of “re-intermediation” for a time, as some banks go back to balance-sheet lending. But he insists that it highlights the dangers of lax lending standards in a particular market rather than fundamental faults in securitisation itself.

A study by NERA, an economic consultancy, commissioned by the ASF before the crunch, offers some support for this view. Preliminary results, based on data from 1990 to 2006, suggest that increased securitisation leads to lower spreads in consumer credit and softens interest-rate shocks for banks, especially smaller ones. On the other hand, in a recent paper two economists at the University of Chicago's business school conclude that securitisation encouraged mortgage originators to lend to dodgy borrowers.

Stresses and strains

What is not in doubt is that the subprime crisis has exposed four deep flaws in the practice of securitisation. The first is that by severing the link between those who scrutinise borrowers and those who take the hit when they default, securitisation has fostered a lack of accountability.

A debate has been rumbling over how to ensure that lenders have more “skin in the game”. Some think they should set aside a sliver of capital even for loans they sell on. Andrew Davidson, a structured-finance consultant, suggests an “origination certificate”, guaranteeing the quality of the underwriting, issued by the lender and broker, which stays with the loan. Alex Pollock of the American Enterprise Institute thinks that securitisers should be required to guarantee the quality of their loan pools, as are America's government-sponsored mortgage giants, Fannie Mae and Freddie Mac. Others counter that most such exposures can be neutralised these days through derivatives markets.

The second flaw is the sheer lack of understanding of some instruments. Not long ago investors took too much on trust. They are now clamouring for more “transparency”. Some want a central trade-quoting facility for lumpy asset-backed products: regulators have approached the New York Stock Exchange. CME Group, which runs the world's largest futures exchange, is also looking to expand its clearing of over-the-counter securities.

Yet reams of information already accompany mortgage-backed securities sold in public markets. Even SIVs provide a steadier stream of data to investors than most of the banks backing them. So some interpret calls for greater disclosure as whimpering by investors who did not do their homework.

However, more information about the performance of loans after origination would help, particularly those in leveraged structures such as CDOs. This opens up opportunities: fewer banks were at the ASF conference this year, but more data-analytics firms turned up. Clayton, the largest mortgage-surveillance company, unveiled a partnership with Experian, an information-services firm, that will help mortgage-servicers to package subprime loans for modification under a plan backed by the ASF and America's Treasury. Later, it hopes to offer a swathe of data to buyers of structured products.

Understanding the underlying assets is, or should be, at the core of securitisation. Securitisation is really an arbitrage: with surplus collateral, assets can be bundled into an entity with a supercharged credit rating. But if investors fail to spot the jiggery-pokery with credit scores and the outright fraud that permeated the subprime market, that cushion of safety quickly disappears. Witness the speed with which losses have spread into supposedly safe, “super senior” tranches of CDOs.

This points to the third flaw: that some securities were poorly structured, often because their risks were not fully understood. The upper layers of a well-designed securitisation vehicle should be all but impervious to loss. But poorly structured deals, like those stuffed with subprime and marginally less iffy “Alt-A” loans in 2006 and early 2007, have crumbled as the weakness of the collateral becomes clear.

The fourth flaw was the market's over-reliance on ratings as a short cut to assessing risk. In the go-go years, people wrongly assumed that an AAA-rated mortgage bond—even one with a high yield—would never lose value. But the rating agencies, paid for their appraisals by the seller not the buyer, were compromised from the start. Moreover, their quantitative models appear to have ignored “fat-tail” risks—the possibility that large losses are likelier than standard statistical models predict.

Though the agencies do not have to suffer giant write-downs, they have paid a high price. Before the market imploded, almost half the revenue of Moody's, a leading agency, came from structured finance. Now the agencies are revising their rating criteria in a bid to head off tougher regulation. “Either deals get less complex or we have to find a better shorthand for measuring risk,” says Ron Borod of Brown Rudnick, a law firm. The rating agencies say they were never supposed to substitute for investors' own due diligence. That is disingenuous, given their past self-assuredness. Still, wise investors will take future ratings with a pinch of salt, as most hedge funds have long done.

As the market grapples with change, some is likely to be imposed from above. Separately, international regulators and the President's Working Group (comprising America's Treasury, the Federal Reserve and others) are looking into securitisation's part in the crisis. By co-operating over loan modifications, the ASF may have gained favour with the working group.

The industry is more worried about two bills in America's Congress. Securitisers can live with much of the one that has been passed by the House of Representatives. What alarms them is an “assignee liability” provision that would hold them partly responsible for lax lending by originators. This, they say, would send a chill through secondary markets, cutting credit to thousands of worthy borrowers. Precedent is on their side. Georgia introduced assignee liability, only to back-pedal after the state's subprime market started to seize up. Not all bankers are against it: in Las Vegas, Bianca Russo of JPMorgan Chase argued that some form of it was needed to counter the perception, if not the reality, that securitisation was harmful.

The other bill would allow bankruptcy judges to alter the terms of struggling borrowers' mortgages. The industry argues that this would be an intolerable violation of the sanctity of loan-pooling contracts. In addition, securitisers face probes by several state attorneys-general, the Internal Revenue Service, the Federal Bureau of Investigation, the Securities and Exchange Commission and the Justice Department, as well as lawsuits from investors and a rising number of stricken municipalities.

Bankers will tell you that the subprime meltdown was just that: the product of irresponsible lending to, and borrowing by, flaky consumers, not a broader crisis of securitisation. Maybe, but the severity of the credit crunch points to broader pain ahead. More will come from housing: much of the 30-40% of American home-equity loans that have been securitised looks wobbly, as does a growing chunk of the $800 billion of Alt-A paper outstanding. Loans for offices are an even bigger worry. The spread on the AAA tranche of an index tracking bonds backed by commercial mortgages has tripled since the turn of the year. New issuance is frozen.

Trouble is also brewing for securities tied to non-mortgage consumer assets, such as credit-card debt, car loans and student loans, which make up a good slice of the asset-backed market (see chart 3). Credit-card delinquencies are creeping up as the economy turns down. The sharp slowdown in card borrowing, reported recently by the Fed, will mean less raw material for securitisation. Standards for car loans dropped in 2006-07, though not as dramatically as they did for mortgages.

One ominous sign is that structured instruments tied to student loans are coming unstuck, although the loans typically carry a federal guarantee. Recent auctions of such securities by Citigroup, Goldman Sachs and others have failed. Normally the banks would have bought in whatever did not sell. But they have declined, because they dare not cram even more assets onto their already strained balance sheets.

Yet securities of these types should be more resilient than those tied to subprime loans. Their structures are tried and tested, having evolved, along with performance data in their markets, over many years. In contrast, subprime mortgages with only a short record were shoved into many-layered structures that depended on house prices holding up. “They started from the other end entirely, asking how can we create CDOs, backed by mortgage-backed securities, themselves backed by collateral with barely any history, and their stress tests assumed house prices would be stable and the loans in the pools uncorrelated,” says Mr Borod.

Encouragingly, credit-card receivables are still being bundled and sold. There are even shoots of hope in the mortgage market, thanks to a refinancing mini-boom in the wake of interest-rate cuts—though most new deals are backed by the giant agencies, Fannie Mae and Freddie Mac, not Wall Street (see chart 4).

Saunter down the strip

It is also worth remembering that securitisation has not been confined to consumer and corporate loans. In the past decade financial engineers have found ways to package and sell tobacco-settlement and mutual-fund fees, sports and fast-food franchise rights, life-insurance premiums, intellectual property, music royalties and much more. Hollywood studios use securitisation to help finance film-making. With intangible assets accounting for an ever-growing share of corporate value, this trend looks likely to continue.

That may be scant consolation to the banks whose bets have gone so spectacularly wrong. Their fingers are still being singed by mortgage-backed securities and CDOs that continue to burn. Those hoping for a recovery face a long wait, maybe 18 months or more for out-of-favour collateral such as non-agency mortgages. Some once-enthusiastic cheerleaders are turning gloomy: Bear Stearns said recently that its net short position on subprime loans and bonds had risen to $1 billion. Others are redeploying staff and capital to fee businesses that don't put a strain on the balance sheet, such as merger advice.

But it would be a mistake to write the obituary of structured finance. Even its sternest critics accept that securitisation has brought real economic benefits, and that it would be wrong to throw away the whole barrel because of a few subprime apples. Some students of financial innovation think the market will come back even more inventive after scorching its less attractive pastures. “As with past forest fires in the markets, we're likely to see incredible flora and fauna springing up in its wake,” says Andrew Lo, director of the Massachusetts Institute of Technology's Laboratory for Financial Engineering.

So it may just be a matter of hanging on. As any punter in Las Vegas will tell you, every losing streak ends eventually, if you can only stay solvent for long enough.

Should we worry about heavy borrowing from TAF?

How Non-Borrowed Reserves Became a Sexy Subject: Caroline Baum

Commentary by Caroline Baum

Feb. 8 (Bloomberg) -- Technically insolvent! This has never happened before! Without the Temporary Auction Facility, where would banks be?

When I got the fifth hysterical e-mail on the subject of -- sit down -- the decline in banks' non-borrowed reserves, I thought I was back in the Volcker era.

That would be Paul Volcker, chairman of the Federal Reserve from 1979 to 1987. Volcker knew interest rates had to rise significantly to slay the inflation dragon; he didn't know by how much. So he changed the Fed's operating procedure from targeting a price (the overnight interbank lending rate) to a quantity (the monetary aggregates -- specifically non-borrowed reserves).

``There is no relationship between non-borrowed reserves and anything the Fed cares about, be it inflation, employment or real GDP,'' said Paul Kasriel, chief economist at the Northern Trust Corp. in Chicago.

He said that 20 years ago, when I was just starting out, but I still remember his exact words. They came back to me when I learned of the latest obsession with this irrelevant statistic.

A few basics are in order. I promise not to make this too geeky.

Banks are required to keep a certain amount of funds in reserve -- as vault cash or on deposit at the Fed -- to meet unexpected deposit outflows. These are called required reserves (catchy, isn't it?). Sometimes depository institutions elect to hold more than is required. These are called excess reserves.

Sources and Uses

Congratulations. You have just completed the introductory course in the uses of reserves. What about the sources?

Reserves can be borrowed (from the Fed's discount window) or non-borrowed (supplied via the Fed's daily open market operations). It matters not one whit to the Fed where the banks acquire the reserves they require. If they borrow directly from the Fed, they don't need to tap the interbank, or fed funds, market.

What's caused the hullabaloo recently is the dive in non- borrowed reserves from $44 billion in early December to minus $8.8 billion at the end of January.

It isn't a mystery what happened. The Fed announced the creation of a Term Auction Facility on Dec. 12, enabling banks to borrow for 28 days versus a wide range of collateral. The minimum bid the Fed accepts is the expected funds rate one month out, which in the current environment means cheaper funding costs than the fed funds market.

So what would you do if you were a bank?

Lower Cost

Loans made through the TAF are categorized as borrowed reserves. The Fed had $50 billion of loans in place at the end of January, which ``caused the borrowed reserves figure to balloon and the non-borrowed figure to decline by a corresponding amount,'' said Lou Crandall, chief economist at Wrightson ICAP LLC in Jersey City, New Jersey, in a Feb. 6 commentary. (He's on the same e-mail lists I am.)

All of a sudden, people who never glanced at the Fed's H.3 statistical release are now experts on ``Aggregate Reserves of Depository Institutions and the Monetary Base.'' Their e-mails have the same sense of foreboding as the missives put out by the Black Helicopter/Tin-Foil Hat crowd.

``What if the Fed's rate cuts aren't motivated by the desire to stave off recession, rather to prevent a major banking crisis?'' one e-mail read. ``The Fed's not telling anyone what it's up to because it doesn't want to cause panic, but the evidence is there in its own data.'' (Gosh, you'd think it would do a better job of hiding it. Maybe send H.3 to join M3!)

Monopolist Provider

The writer of the e-mail directs his readers to the most recent H.3 report, which shows total reserves ($41.6 billion) less TAF credit ($50 billion) less discount window borrowings ($390 million) equals non-borrowed reserves (minus $8.8 billion). The negative number is really an accounting quirk: If banks borrow more than they need, non-borrowed reserves are a negative number.

This gentleman is overlooking the fact that the Fed is ``a monopoly provider of reserves,'' said Jim Glassman, senior U.S. economist at JPMorgan Chase & Co. ``This is a non-starter. There is no such thing as a banking system short of reserves. The Fed has absolute control over the supply.''

There may be times, such as late last year, when banks are reluctant to lend to one another for a period longer than overnight. ``And any one bank can have a problem'' funding itself, Glassman said. But in a world where ``the Fed can print money, there is no shortage,'' he said. ``The banks get the reserves they want.''

Low Priority Worry

Those hyperventilating over TAF borrowing may want to consider an alternate scenario.

``Suppose the Fed cut the discount rate so that it stood below the funds rate,'' Kasriel said. (He said this yesterday, not two decades ago.) ``Would these folks be upset if banks went to the discount window for funds? What's the difference? It's a difference without a distinction.''

In a commentary this week, Goldman Sachs Group Inc. senior economist Andrew Tilton dismissed the case of the disappearing non-borrowed reserves as ``evidence of the markets' obsession with the health of the financial system.''

Some of the concern is justified, he said, given banks' massive losses and writedowns on subprime loans.

Of all the things to worry about right now, this isn't one of them.

Asset inflation and its place in US economic policy

The debt delusion

The US economy relies upon asset price inflation and rising indebtedness to fuel growth - and this contradiction has global implications

By Thomas Palley

(Guardian) A second big American interest-rate cut in a fortnight, alongside an economic stimulus plan that united Republicans and Democrats, demonstrates that US policymakers are keen to head off a recession that looks like the consequence of rising mortgage defaults and falling home prices. But there is a deeper problem that has been overlooked: the US economy relies upon asset price inflation and rising indebtedness to fuel growth.

Therein lies a profound contradiction. On one hand, policy must fuel asset bubbles to keep the economy growing. On the other hand, such bubbles inevitably create financial crises when they eventually implode.

This is a contradiction with global implications. Many countries have relied for growth on US consumer spending and investments in outsourcing to supply those consumers. If America's bubble economy is now tapped out, global growth will slow sharply. It is not clear that other countries have the will or capacity to develop alternative engines of growth.

America's economic contradictions are part of a new business cycle that has emerged since 1980. The business cycles of presidents Ronald Reagan, George Bush Sr, Bill Clinton, and George Bush share strong similarities and are different from pre-1980 cycles. The similarities are large trade deficits, manufacturing job loss, asset price inflation, rising debt-to-income ratios, and detachment of wages from productivity growth.

The new cycle rests on financial booms and cheap imports. Financial booms provide collateral that supports debt-financed spending. Borrowing is also supported by an easing of credit standards and new financial products that increase leverage and widen the range of assets that can be borrowed against. Cheap imports ameliorate the effects of wage stagnation.

This structure contrasts with the pre-1980 business cycle, which rested on wage growth tied to productivity growth and full employment. Wage growth, rather than borrowing and financial booms, fuelled demand growth. That encouraged investment spending, which in turn drove productivity gains and output growth.

The differences between the new and old cycle are starkly revealed in attitudes toward the trade deficit. Previously, trade deficits were viewed as a serious problem, being a leakage of demand that undermined employment and output. Since 1980, trade deficits have been dismissed as the outcome of free-market choices. Moreover, the Federal Reserve has viewed trade deficits as a helpful brake on inflation, while politicians now view them as a way to buy off consumers afflicted by wage stagnation.

The new business cycle also embeds a monetary policy that replaces concern with real wages with a focus on asset prices. Whereas pre-1980 monetary policy tacitly aimed at putting a floor under labour markets to preserve employment and wages, it now tacitly puts a floor under asset prices. This is not a matter of the Fed bailing out investors. Rather, the economy has become so vulnerable to declines in asset prices that the Fed is obliged to intervene to prevent them from inflicting broad damage.

All these features have been present in the current economic expansion. Wages have stagnated despite strong productivity growth, while the trade deficit has set new records. Manufacturing has lost 1.8m jobs. Prior to 1980, manufacturing employment increased during every expansion and always exceeded the previous peak level. Between 1980 and 2000, manufacturing employment continued to grow in expansions, but each time it failed to recover the previous peak. This time, manufacturing employment has actually fallen during the expansion, something unprecedented in American history.

The essential role of asset inflation has been especially visible as a result of the housing bubble, which also highlights the role of monetary policy. Despite the massive tax cuts of 2001 and the increase in military and security spending, the US experienced a prolonged jobless recovery. That compelled the Fed to keep interest rates at historic lows for an extended period, and rates were raised only gradually because of fears about the recovery's fragility.

Low interest rates eventually jump-started the expansion through a house price bubble that supported a debt-financed consumer-spending binge and triggered a construction boom. Meanwhile, prolonged low interest rates contributed to a "chase for yield" in the financial sector that resulted in disregard of credit risk.

In this way, the Fed contributed to creating the sub-prime crisis. However, in the Fed's defence, low interest rates were needed to maintain the expansion. In effect, the new cycle locks the Fed into an unstable stance whereby it must prevent asset price declines to avert recession, yet must also promote asset bubbles to sustain expansions.

So, even if the Fed and US treasury now manage to stave off recession, what will fuel future growth? With debt burdens elevated and housing prices significantly above levels warranted by their historical relation to income, the business cycle of the last two decades appears exhausted.

It is not enough to deal only with the crisis of the day. Policy must also chart a stable long-term course, which implies the need to reconsider the paradigm of the past 25 years. That means ending trade deficits that drain spending and jobs, and restoring the link between wages and productivity. That way, wage income, not debt and asset price inflation, can again provide the engine of demand growth.

Exxon returns favour to Hugo Chavez - Sovereign debt swings towards distress

Exxon Venezuela asset freeze new blow to Chavez
Fri Feb 8, 2008 12:12am GMT

By Brian Ellsworth
CARACAS (Reuters) - Exxon Mobil's move to freeze billions of dollars of Venezuelan oil assets around the globe adds new complications to President Hugo Chavez's crusade toward socialism, which is already facing growing obstacles.

Fresh off a 2007 nationalization drive that led to a takeover of a large Exxon oil project in Venezuela, the leftist leader is struggling with the fallout over a December poll defeat, growing economic problems and discontent among supporters.

Chavez faces a potentially huge legal battle with one of the world's largest companies after Exxon's gambit, which freezes some of Venezuela's cash and blocks it from selling billions of dollars worth of assets.

But paying a settlement to the Texas energy giant could mean sacrificing millions of dollars needed for the social programs and suffering a humiliating defeat to a transnational company the anti-U.S. leader has described as "imperialist."

News of the court ruling prompted a sell-off of Venezuelan debt.

"It makes the actions you took a year ago fairly pricey," said Dino Barajas, an expert in energy law at Paul, Hastings, Janofsky & Walker LLP.

Exxon (XOM.N: Quote, Profile, Research) court filings revealed on Thursday show the company won rulings preventing Venezuelan state oil company PDVSA from selling assets such as refineries while also preventing Venezuela from withdrawing more than $300 million in cash from a U.S. bank account.

It was unclear exactly what the impact would be on the day-to-day operations of PDVSA, which critics say is weakened by government's demands it work on social projects, road repairs and food imports.

"Nobody really knows what is the real reach of these decisions, but it doesn't look good for PDVSA, or for the country, which depends on the company for everything, even importing food," said one Venezuelan investor, who asked not to be named.

Chavez launched a broad energy sector nationalization campaign in 2007 as part of a drive to create a socialist society.

Exxon is suing Venezuela for its takeover of the multibillion-dollar Cerro Negro heavy oil project, arguing the OPEC nation violated its contract and illegally snatched complete control.

Venezuela's Information Ministry said it could not comment on the information.

The news comes only months after Chavez lost a referendum that would have let him run indefinitely for re-election. He is now facing growing criticism over nagging shortages of basic groceries like milk and chicken.

The leftist government is also seeing a growing cash flow crunch at PDVSA, which finances the social programs that keep Chavez popular among the nation's majority poor.

A new obligation to pay billions of dollars in compensation to Exxon would put further strain on the finances of the company, which saw its debt rise by $13 billion in 2007 to reach $16 billion -- largely driven by the nationalization crusade.

Court papers suggest the move came as a surprise to PDVSA.

In the court documents, PDVSA's law firm complained that Exxon's lawyers had been "feigning continued cooperation in good faith while another law firm was working behind the scenes preparing this attachment."

(Additional reporting by Ana Isabel Martinez and Frank Jack Daniel; Editing by Christian Wiessner)