Sunshine Notes

October 4, 2008, 6:02 pm

Will Paulson’s Two Plans Unplug the ‘Liquidity Trap’?

By Mark Sunshine

Editor’s note: Mark Sunshine, president of the commercial lending institution First Capital, writes a guest post about why we may be heading into what’s called a liquidity trap. This means that monetary policy, including interest-rate changes, can’t prevent a deep depression, but that the Treasury’s fiscal stimulus plans – including a little-noticed tax change pushed through last week – just might work.

Anyone who reads newspapers or watches TV knows that the banking system is in crisis. Credit is tight, banks are hoarding cash and short-term Treasury yields are almost 0 percent. The Fed has lost its ability to unfreeze the system and the normal circulation of money isn’t happening. Almost all of the monetary signs point to a potentially terrible new phase of deflation and dramatic economic contraction.

This week’s Fed monetary report showed that during the week ending Sept. 22, money supply (as measured by seasonally adjusted M2) increased by $165.5 billion to $7,900 billion. On an annualized basis this is an astonishing 108.94 percent growth rate. The Fed has been aggressively pumping money into the system in the hopes that radical monetary stimulus will restart lending. However, the newly created money is being hoarded by banks as they “stuff the mattress” with short-term Treasury notes.

Here’s why these events are distressing: When the Fed douses the monetary system with cash but banks hoard it, monetary policy no longer works and the economy starts to crash. This is called a “liquidity trap” and it occurs when interest rates are at or close to 0 percent and monetary policy is no longer effective. Newly minted money is injected into the banking system but trapped by financial institutions that are paralyzed by fear. When banks don’t recycle their money through normal lending activity, it doesn’t matter how much the Fed increases the money supply. Monetary policy just won’t work. Failing monetary policy usually means that we are going to have a recession, or worse.

Today we’re facing a similar problem. Despite the dramatic increase in money supply last week, it remains surprisingly difficult to get loans from tight-fisted and scared bankers. Corporate and consumer loan interest rates shot up to unheard-of levels compared to Treasury yields but still banks won’t lend. Financial institutions continue to express their fear through panic buying of short-term Treasuries as those yields dropped to almost 0 percent. Treasuries are the new “gold” of this millennium and have become the investment of choice for institutions that are afraid of taking risks.

The liquidity trap has neutered the Fed and its chairman, Ben Bernanke, because there isn’t much that the Fed can do with money supply or interest rates to make things better (despite reports that the Fed may cut interest rates again soon). Only fiscal stimulus – tax cuts or government spending hikes intended to increase demand — will unplug the system.

Treasury Secretary Henry Paulson’s plan, which is now law, is fiscal stimulus that will be injected directly into the banking system to supplement almost nonexistent private-sector lending with government cash and determination. Mr. Paulson may be shooting the right weapon at the right time because it will help rescue the banks while restarting corporate and consumer lending.

But Mr. Paulson’s fiscal-stimulus work didn’t end with the bailout bill.

With hardly anyone noticing, on Wednesday he pushed through very technical and obscure changes to tax regulations that provide a “tax subsidy” for acquirers of troubled banks. Just as automakers stimulate car sales through rebate checks, the Treasury is providing a form of tax rebate to acquirers of troubled banks. Everyone can thank Hank Paulson and his stealth tax-driven fiscal stimulus for the astonishing news that Wachovia was being acquired by Wells Fargo and not Citigroup. It was Mr. Paulson’s tax subsidy to Wells Fargo that provided the fiscal grease to make this deal happen. Pundits who point to the deal and proclaim that the “free markets work without government help” don’t understand the motivating effect of several billion dollars of tax benefits to Wells Fargo.

Hopefully Mr. Paulson’s fiscal moves will provide enough fiscal laxative to unplug the banking sector and get money flowing again. Only time will tell if he’s done enough or if more will be required from the next Treasury secretary.

• Copyright 2008
  The New York Times Company
  

Today I have to eat some humble pie.

I was wrong in my blog over the weekend about why we didn’t need an increase in FDIC deposit insurance limits. I clearly did not understand that such an increase is a good idea because it would provide the “grease” necessary to lubricate Congress and pass the Paulson plan.

Apparently, the price that the Administration had to pay to get approximately 8,000 small banks in the U.S. to support and lobby for the rescue bill is an increase in the FDIC deposit insurance limit to $250,000. And, with the support of small banks, passage of the rescue bill will probably happen. The New York Times wrote a great article today about the Independent Community Bankers of America lobbying effort and how they are putting together a grass roots effort to make sure that the bill is approved this time around (with the FDIC deposit insurance increase in the bill). When I wrote the blog this weekend I didn’t understand that it is still business as usual in Washington.

I was naïve about the Congressional political process when I suggested in my article that an increase in the FDIC deposit insurance limit wasn’t necessary because there were alternatives that depositors could employ that achieve the same result without the Federal Government taking on more financial liability. Also, I foolishly thought that the purpose of deposit insurance was to protect depositors (i.e., the beneficiaries of deposit insurance) and not the banks (i.e., the parties which deposit insurance is trying to protect the depositors against). I’m not sure why raising the insurance limits isn’t a little like increasing fire insurance limits on homes at the request of arsonists who are burning them down. But, then again, what do I know?

Clearly, I didn’t understand that the purpose of deposit insurance is to give a competitive boost to banks that otherwise can’t compete with better capitalized institutions.

And, it never occurred to me, as reported in the New York Times article and also in the Wall Street Journal, that there was a chance that the insurance limit would be raised without increasing the premiums paid by banks. If in fact fees paid to the FDIC for increased coverage are not charged, Congress and the Administration will be giving a direct subsidy to the banking sector and redefining the meaning of “free lunch”. Of course, sooner or later the taxpayers will pay, but in the meantime Congress will “kick the can” down the street until after the election. I guess it is OK to subsidize banks because this time it isn’t the bankers of Wall Street getting the benefit, but rather the bankers of Main Street.

Anyway, I am eating humble pie and apologize for not being “wise” to the ways of the world. I should have known better.

The newest discovery of TV “screaming heads” is that FDIC insurance limits are causing a quiet run on certain weak banks by large depositors. The screamers tell us that suddenly corporate depositors have discovered that keeping large deposits at weak banks is risky. They shout that BoA, Wells Fargo, US Bank and JP Morgan are going to vacuum up all of the corporate deposits and all other banks are uncompetitive. And, they warn that without raising the FDIC insurance limits, the banking industry will be ruined and national calamity will result.

Given the events of the recent months I understand why everyone is upset, but cooler heads and analytical thought needs to prevail, especially among those that have a national platform on which to speak.

I understand what happens when the U.S. is upset. The 1976 movie Network was fictional but reflected a national consensus that the little guy was getting “screwed” by big corporations and big government. Now, unfortunately, fiction is really close to reality. But just because we are “mad as hell” doesn’t mean that we should shout out bad ideas.

So, let’s look at FDIC insurance dispassionately and rationally.

The public policy behind FDIC insurance is to provide a safety net to small depositors who don’t have the ability to do bank credit analysis.

FDIC insurance works well for small depositors. No small depositor has lost money in a bank account since the FDIC was established and small depositors don’t’ have to be bank credit analysts. The $100,000 insurance limit covers the deposits of most citizens and businesses in America. And, for most depositors that have more than $100,000, it is easy to split up deposits between institutions so that each insured deposit is under $100,000.

FDIC insurance is supposed to protect depositors, not undercapitalized banks.

The rationale for expanding FDIC insurance is to protect undercapitalized and non-competitive banks from the harsh reality of their actions and financial position. That isn’t the purpose of FDIC insurance and the public mission of the FDIC shouldn’t be expanded to protect bad banks. Large depositors are supposed to evaluate the credit of their banks and not do business with banks that are crummy credits. The essence of market discipline is that bad credits can’t borrow money and it shouldn’t be any different for banks. If commercial banks want to deal with large businesses, then they need to make sure that they have the appropriate capital base and are a good credit risk. This isn’t the first time in American history that large commercial depositors have had to decide which banks are acceptable and which are not. Such is the meaning of market discipline.

The problem of $100,000 insurance limits isn’t even a real problem. There are good private and public alternatives that extend FDIC limits.

Banks that belong to Promontory Interfinancial Network can offer banking deposits up to $50 million that qualify for FDIC insurance. There are approximately 2,500 institutions that belong to Promontory and are able to provide FDIC insurance on very large deposits. Using a $1 million deposit as an example, through the Promontory system, the deposit is split up among 10 institutions and therefore gets the full benefit of FDIC insurance. By the way, Promontory’s most well known founders are Eugene Ludwig (former Comptroller of the Currency) and Alan Blinder (former Vice Chairman of the Federal Reserve). This is a very legitimate and well known system for extending FDIC insurance. In fact, in today’s local paper where I live, the Sun Sentinel, there are ads from banks that are in the Promontory system touting the fact that they can offer deposit services for up to $50 million. Banks that don’t offer this coverage are doing it by choice and the Federal government doesn’t need to change the FDIC insurance limits to compensate for this decision.

There are public alternatives as well. As an example, savings banks in Massachusetts belong to the DIF insurance pool which insures all deposits (regardless of size) and acts as a supplement to FDIC insurance. DIF is state sponsored and has existed since 1934.

And, there are a wide range of additional solutions that large depositors can utilize if they want to keep their deposits at banks that they are concerned about. There is private credit protection that can be purchased and effectively supplements FDIC insurance. So, for a fee this issue of FDIC limits goes away. And, by the way, the banks that are weak and accepting deposits can arrange for private insurance and credit protection for their customers. They don’t need the Federal government to compensate for their decision not to purchase private insurance.

The New York Times ran an article a few days ago about why journalists’ words matter. I don’t think that the NYT’s meant only “print journalists’ words matter; I think it meant all journalists’ words matter and that includes the numerous TV journalists whose primary selling point is that they are “mad”.

Let’s try to raise the quality of the economic discussion and debate. I know we are all mad and we want to do something about it but manufacturing problems that aren’t problems isn’t the answer. We have enough real problems to deal with first.

Hold on tight cos I’m afraid of heights and it’s time for blast off. Money supply is on a one way ticket to the moon and we are going along for the ride.

After 6 months of real money supply shrinkage, this week’s Fed release of money supply and its balance sheet points to a rapid acceleration of money supply growth. For the week ending September 15^th money supply (as measured by M2 on a seasonally adjusted basis) rose by approximately $21 billion.

Two things should be noted about the September 15^th number:

• The Fed numbers lag “real time data” by more than a week (which is normally irrelevant but since the week that followed was anything but “normal”…). The economy is living in “dog time” where every chronological year is equal to 7 years of “normal people” time. Let’s keep in mind it was only on Monday September 15^th that Lehman Brothers filed for bankruptcy and Tuesday September 16^th that the Treasury bailed out AIG. The latest money supply numbers are for the week that ended with the Lehman bankruptcy and don’t include the side effects of AIG or the subsequent emergency Fed measures.
• The number published by the Fed is an average of the 5 days ending September 15^th which means that if they were pumping liquidity into the market on an accelerated basis during the week (as I believe that they were doing) the published Fed number is understating the actual ending position of M2.

It is no surprise that the Fed was pushing liquidity. The Euro markets melted down because no one could find dollar based liquidity. LIBOR (my most hated index rate) shot up and overnight deposits in U.S. dollars were impossible to find.

It was hard to find any good economic numbers last week. Unemployment is rising (initial jobless claims rose to 493,000 for the week ending September 20^th) and second quarter GDP was revised downward (to 2.8% real growth but that is with the benefit of the stimulus package). August durable goods orders tanked and both new and existing home sales were down from already depressed levels.

It won’t be long before economists start to question if the Federal Reserve held the line on money supply too long and whether Treasury should have been both quicker and had a better thought out emergency plan.  Also, the world will debate why Paulson never laid the political foundation for a popular consensus for his actions. 

The lack of effective involvement by President Bush is scary.  Like a High School Senior who has already gotten into college, our President has already started the countdown to freedom and isn’t doing anymore hard work. 

Perhaps with some moderate rise in real money supply, a more gradual intervention by Treasury and a President that was engaged, the current crisis atmosphere could have been avoided.  I’m sure that for generations the events and policies of the last month will be hotly debated. 

Anyway, the trip is only beginning. See you on the moon.  When you land try not to crash.

If there’s one thing we know about U.S. recessions (and even depressions) is that although painful, they do eventually end and the markets and economy grow ever larger as a result.  The spirit of democracy and capitalism (and Americanism for that matter) is one of resilience and opportunity.  As we do mature as a nation, we still maintain eternal hope and strive to make our lives better.  Where else in the world can people with either little or no education, coming from poverty and other negative circumstances make millions, or even billions of dollars the old fashioned way? (”by earning it”, as John Houseman used to say)

What makes capitalism great is also its greatest threat: greed.  As ‘Gordon Gekko’ remarked, “Greed is good.” (but look at where it got him)  “Everything in moderation” is something that most Americans can’t accept and because of that, we work longer hours, we better educate ourselves, we find better and faster ways to do things, and we generally push the envelope.  Sure it gets us into trouble and sometimes burns us out, but we retrench, reevaluate, and recover to come back even stronger with new ideas in order to make a better life for us and our families.

The role of government in an ideal free market is that of a referee.  To keep the game fair by enforcing the rules and punishing those who break the rules and cheat.  Clearly, the government was ‘watching a different game’ (as they say) or wasn’t even on the field.  Now that there’s a riot on the field (think of an Irish soccer match), the refs are trying desperately to regain some control and have even begun fighting amongst themselves.  To take such a scenario further, eventually the rioters tire or work out their differences and everyone goes home while the refs continue to fight.  The next day, the refs start discussing plans on how to change the game completely to prevent such a riot from happening again.�

The problem wasn’t the game itself.   The problem was the refs (in this case the government) knowing that the game was getting out of control and doing nothing about it until the riot erupted.�

Why is it that I haven’t heard one non-politician say that the government bailout is a good idea?  Because it’s not.  That’s not to say that the government can’t get back into the game and restore order by assuring, insuring and ensuring that the crisis is only temporary.   But pumping money back into these companies who obviously can’t make good business decisions in the first place, seems ludicrous.  Would you lend money to someone with a gambling problem?  I wouldn’t.  Why would our government?�

I hate to say it, but the only benefactors of the bailout seem to be for the people who created this mess.  On the radio the other day, it was said that Paulson’s initial plan was soft on the executives of the troubled institutions because it was thought that those executives would not support the bailout plan.  Who are they to dictate any terms?  Why should anyone care what they think and why are they still even in positions to have an opinion?�

Reminds me of that old movie “It’s a Mad, Mad, Mad, Mad World.”  Except this isn’t the least bit funny.  But like the movie, this too will end.  But hopefully without long-ranging consequences that not only jeopardize our economy, but our “life, liberty and pursuit of happiness.”  And to our representatives in government I say, “caveat emptor.”

We need to kill mark to market accounting before it eats us alive. These accounting rules are like The Blob, an alien life form that consumes everything in its path as it grows and grows. Both the Blob and mark to market accounting crawl, creep and eat everything dead or alive in their path. We need to save ourselves by putting mark to market accounting into deep freeze while there is something left to save.

Before I proceed (and get flamed by angry commenters), I want to set the record straight. I believe financial statements should present a conservative, consistent and realistic report of results of operations, financial condition, cash flow and contingent liabilities and assets. Bad assets and poor management decisions should not be hidden behind accounting manipulations. Loan loss and other reserves should be conservatively determined and uncollectable assets should be promptly written off. Accounting rules shouldn’t drive business decisions, they should reflect them.

However, mark to market rules distort financial results and business decisions under the false cloak of conservatism. The rules make little sense, produce inconsistent results, lack a basis in reality and provide lots of room for abuse. They should be suspended immediately before more damage is done. And, the damage is a distortion of common sense business decisions and financial reporting. Mark to market rules are one of the worst manifestations of the “trader” mentality that spread from Wall Street to the rest of the country. Wall Street traders with severe attention deficit must have drafted these accounting rules because they push valuations and reporting of business decisions into the “moment” (which is worse than the short term) and use the equivalent of “financial sound bites” to determine value. The false premise that the price for which an asset can be sold for at this minute is the true value of the asset underpins mark to market accounting. One of the basic claims of the Paulson Plan, that only the government has the patient capital necessary to own financial assets and wait until they pay off at maturity, is the ultimate indictment of the crazy results of these accounting rules. 

And, like The Blob the rules keep on expanding and expanding in their application.  On January 1, 2009, all merger and acquisition transactions will be subject to mark to market accounting. 

So, let’s kill The Blob before it kills us.

Set forth below is “why” we need to get rid of these rules before they eat us alive.

1.  Mark to market accounting assumes that what people are willing to pay for an asset is always the same as the asset’s value. This assumption is wrong.

When assets are tradable, transparent and liquid, what people are willing to pay is the “real” value. But, when assets aren’t traded and are illiquid and opaque (like a private bonds or loans), market prices are a worthless measure of value because there is no market to establish value. Not all assets that have no trading market are bad assets; most of them are just private loans to individuals and businesses. Before mark to market accounting, loan loss and valuation reserves were established for uncollectable obligations and assets.

A few years ago I had an experience at an aircraft spare parts trading company that illustrates the limitations of market value accounting. At this company there were many spare parts that had an active bid/ask market and reasonable market values were quickly established without controversy.

However, in one corner of the hanger there were spare nose cones for Boeing 737’s. Each nose cone had a historical cost of $10,000. The current market value of each nose cone was less than $1,000 and was equal to its aluminum meltdown value (scrap metals dealers were the only buyers). However, if anywhere in the world a Boeing 737 broke its nose cone; my client would sell one of his cones out of inventory, usually for greater than $50,000.

Mark to market accounting would have valued the nose cones at around $1,000 per cone. Before mark to market accounting, $10,000 would have been their carrying value.

The above example illustrates three flaws with mark to market accounting.

• Mark to market accounting uses quick sale valuations which are non-going concern liquidation values for assets and are almost always lower than going concern valuations. However, a core GAAP assumption is that companies are going concerns and violation of that assumption destroys the value of financial statements.
• Valuing nose cones at melt value shifts income from the period of the mark down to the period of the sale (as well as inflates expenses during the period of the markdown). This distorts the income recognition principal that revenues and expenses should be recognized in the period incurred.
• Mark to market accounting distorts management decisions and market prices. The application of mark to market accounting stops management teams from investing in new assets that are subject to subsequent quick sale liquidation analysis. One of the problems in the current credit crisis is “banker refusal” to make loans to companies and consumers because of the risk of an immediate mark down upon origination. In the above nose cone example, if mark to market accounting is used, no spare parts trading company will replenish supply once their nose cones are sold. The application of mark to market accounting to nose cones will drive the market price of cones to $1,000 despite the ultimate realizable value of $50,000. This type of price distortion is currently driving the market for many financial assets.

2.  Inaccurate proxies and bottom feeders have become the “market” for accounting purposes.

By definition, assets without a liquid and trading market don’t have a market in which to determine market value. Accountants have been using “proxies” to estimate the market for illiquid assets. But the use of proxies is flawed.

• Often, accountants are using proxies that are themselves illiquid and thinly traded. Applying the principal of “garbage in, garbage out”, it is easy to see why estimating an asset’s market value based upon a proxy that doesn’t have a clear market value isn’t good.
• When accountants can’t find a market or a proxy, they are using distressed quick sale prices. Most illiquid assets are illiquid because they have individual qualities and can’t be valued without a lot of buyer work to understand the risks and benefits of the investment. Due diligence and analysis are inconsistent with quick sale analysis. Fundamental value investors don’t purchase assets in quick sales. However, bottom feeders “live” to purchase illiquid assets with limited due diligence. Bottom feeders hedge risk through low price. Since the mark to market rules favor quick sale prices and bids, valuations migrate to bottom feeder values regardless of the quality of the assets. Again, management decisions are distorted as accounting valuations migrate to bottom feeder prices.

3.  Sometimes the whole is worth more than the sum of its parts. Mark to market accounting values the sum of the parts.

Mark to market rules value each component part of a business rather than the business as a whole. When I was a kid, I decided to take apart the family lawnmower. Before I messed with the mower it was worth about $100. However, once it was spread apart across the floor of my parents’ garage, the mower had little value. Each part was just valueless junk. If I could have put it back together, the mower would have again been worth $100.

Mark to market accounting values each component part of a business or a portfolio on a stand alone liquidation basis rather than as a whole.

GAAP accounting continues to expand valuing each component part at its quick sale value. In January, 2009, changes to merger and acquisition accounting will be phased in and will continue this trend to “spare parts” valuation.

4.  Mark to market accounting isn’t uniformly applied across companies and industries. “Form over substance” is about to rule the day.

Further confusing investors, mark to market accounting has inconsistent application across industries and companies. As an example, insurers and banks account for similar transactions differently, as do banks and brokers.

Different accounting for the same transactions and investments confuse investors and is inconsistent with the objectives of GAAP.

And, mark to market accounting favors private companies over public companies. Private companies don’t have to worry about this ridiculous accounting rule and will over time be more likely to attract capital. Mark to market accounting is contributing to the destruction of the U.S. stock market and capital markets and is another unintended consequence of these rules.

Accounting should be the same for the same transaction regardless of the form or ownership structure of the company.

5.  Mark to market accounting allows management teams to manufacture earnings.

Mark to market accounting is a “double edged sword” – it can and has been used to manufacture earnings. It is no coincidence that Lehman Brothers failed after manufacturing $2.4 billion in pre-tax profits by “marking to market” its liabilities. Mark to market accounting assumes that a borrower, like Lehman, can go into the market and purchase its debt at the “market price” rather than repaying it in ordinary course. Sure…enough said about that.

Mark to market accounting needs to go. We need consistent, conservative and realistic financial statements and reject the bottom feeder trading valuations of mark to market accounting.

We need to kill The Blob before it eats us.

Mark Sunshine here…Yesterday I received the below e-mail from Winthrop Brown, a friend of mine who is a very senior and distinguished banking lawyer at Milbank Tweed.  He was concerned about misreporting of the Goldman Sachs and Morgan Stanley conversions to bank holding companies and e-mailed me a clarifying analysis. Apparently Win believes that it is important for the media to actually report real facts and analysis and not to pawn off “pop pundits” as authentic experts. I agree with my legal beagle buddy.

Set forth below is Win’s e-mail.

Mark,

The following are some quick thoughts on the regulatory aspects of the announcement by Goldman Sachs and Morgan Stanley that they will change their regulatory status. They are intended to correct some of the misstatements in today’s press reports. Please feel to use this as research for your blog

• Goldman Sachs and Morgan Stanley are not converting to banks. The ultimate parent companies are becoming bank holding companies. Goldman Sachs and Morgan Stanley’s broker-dealer subsidiaries will have the same status as the broker-dealer subsidiaries of Citi and JPMorgan, or as Merrill’s broker-dealer subsidiary will have as a subsidiary of BoA.
• By virtue of conversion to bank holding company status, Goldman Sachs and Morgan Stanley will not have access to a retail deposit funding base. They will not themselves become depository institutions. They each have depository institution affiliates, which they say they will expand, but regulations strictly limit the extent to which these depository entities can lend to or otherwise fund the operations of their broker-dealer and investment banking affiliates.
• The broker-dealer subsidiaries of Goldman Sachs and Morgan Stanley will not have access to the traditional discount window — only their depository banking affiliates will. The broker-dealer and investment banking subsidiaries of Goldman Sachs and Morgan Stanley will continue to have access to the Fed window on the special, temporary terms they did before the conversion but that access will not change as the result of their becoming bank holding companies. The Fed did expand the range of collateral that Goldman Sachs and Morgan Stanley could use in borrowing under the special access (as it did also for Merrill) but this was not a consequence of their change in status.
• The SEC will remain the primary regulator of Goldman Sachs and Morgan Stanley. The Fed will regulate the parent companies. The Gramm-Leach-Bliley Act of 1999 established the principle of “functional regulation” under which the Fed is supposed to keep its hands off the SEC-regulated operations of the investment banking subsidiaries of bank holding companies. The Fed has largely complied with this mandate.
• If the current banking affiliates of Goldman Sachs and Morgan Stanley are converted to national banks (as Morgan Stanley has announced it will), the Office of the Comptroller of the Currency will become the primary regulator of the subsidiary banks. The FDIC will have a relatively minor role in overseeing their operations. Neither will have any oversight over the broker-dealer affiliates of either company.
• The parent companies of Goldman Sachs and Morgan Stanley will become subject on a consolidated basis to the capital requirements that apply to bank holding companies. Goldman Sachs and Morgan Stanley were found by the Fed to have capital above the required level and the recent announcement of the Goldman/Berkshire Hathaway and the Morgan Stanley/Mitsubishi deals will further strengthen their capital position. Goldman Sachs and Morgan Stanley’s broker-dealer operations will continue to have to comply with the SEC’s net-capital rule on a stand-alone basis.
• The private equity operations of both companies will become subject to the so-called “merchant banking exemption” of the Bank Holding Company Act. The most important limitation of the exemption is that a portfolio investment may only be held for 10 (or, in some circumstances, 15) years. Other exceptions to the Bank Holding Company Act limit the extent to which the bank holding company may be involved in the management of its portfolio company. The two companies have two years to comply with these requirements. To the extent that the current private equity operations do not conform to these requirements after two years, the Fed is likely to give Goldman Sachs and Morgan Stanley additional time to comply.
• One can speculate about the extent to which these moves were pushed by the Treasury or the Fed. Goldman Sachs and Morgan Stanley could have applied to become bank holding companies under existing law at any time before the current crisis and their applications no doubt would have been approved. On the other hand, the applications were approved on a very expedited basis, suggesting cooperation from the Fed. The Fed is likely to have to grant waivers from its restrictions on affiliate transactions to the extent that Goldman Sachs and Morgan Stanley seek to move assets from their non-bank affiliates to the books of their bank affiliates; assurances that these waivers would be granted were undoubtedly given by the Fed.

Sunshine here again…Win has represented to me that he does not own any stock in Goldman Sachs or Morgan Stanley and I do not own any stock in either company.

Remember when you were a kid in the playground and your buddies caught you on that spinning metal wheel? They would spin the wheel faster and faster as you grabbed the metal bars for dear life and screamed Stop! Well I for one am feeling that same nauseated feeling as I watch Treasury Secretary Paulson spinning the Government bailout wheel faster and faster. Stop! Or at the very least, slow down.

While I am not qualified as an economist to eloquently discuss Credit Swap Derivatives, money supply or complex financial instruments beyond a rudimentary level, I do understand something about prudence. It is defined in Webster’s as “provident care in the management of resources; economy; frugality”. Where is the government’s prudence with regard to the $700 billion blank check Mr. Paulson is asking for and why is his plan the only plan deemed acceptable? We are being told our hair is on fire and either we act now, or perish. In truth, the vast majority of us have not even been singed. Are you scared yet? I am.

I’m scared because thoughtful and careful deliberations are absent. I’m scared because you can’t build confidence in Wall Street when the feeling on Main Street is that “the fix is in”. I’m scared because my generation is leaving one hell of a mess for someone else to fix. I’m scared because President Bush’s speech was full of snake oil. He said

“..as markets have lost confidence in mortgage-backed securities, their prices have dropped sharply, yet the value of many of these assets will likely be higher than their current price”

Really? You would have us believe that there are no smart investors out there willing to take that risk except the government. Please.

Or how about this gem?

“(the) money will flow back to the Treasury as these assets are sold, and we expect that much, if not all, of the tax dollars we invest will be paid back”.

So to paraphrase, we will break even at best or take a loss. So tell me, how is the government not overpaying? This smells.

So before we approve this so called bailout that will require us to print, borrow and tax our way out of, let us consider the idea floated by former Treasury Secretary Paul O’Neil. To paraphrase Mr. O’Neil, he describes it this way: Assuming the government can place an accurate valuation on all these troubled assets (which they claim they can), then let the government simply guarantee these assets against default at their proper value. No need to purchase and warehouse this paper. Just stand behind it like good ole EE Savings Bonds or T-Bills. Hmmmm.

A government guarantee would restore confidence in these assets, preserve the $700 Billion or a substantial portion of it, and protect the value of the dollar from devaluation leading to a devastating inflationary cycle. Rudimentary? Maybe. Simplistic? Possibly. Prudent? Absolutely.

While I don’t have confidence that the government will be able to properly value these assets, maybe we should let them try. This would create a contingent liability (guarantee) rather than an immediate cash outlay. And if they are hell bent on spending $700 Billion then start with our infrastructure. Invest in our future, our people, our livelihoods, our businesses.

The point here is that this is but one idea, from one bright individual (Mr. O’Neil, not I). There are thousands more out there. So I’m asking my government to slow down, deliberate with the noble intentions and please be prudent with our future.

“The sun is up, the sky is blue, it’s beautiful, and so are you. Dear Prudence….” (Lennon/McCartney).

The world changed. Lehman went extinct. What happened?

There are only 4 ways to increase profits:

1. Increase margins,
2. Increase sales volume,
3. Increase leverage, and
4. Control expenses.

Lehman became extinct because it evolved in the wrong direction when its environment changed. How Lehman approached these 4 choices explain its problems.

1.     Margins

Lehman’s evolutionary problem was a broken business model. The symptom of its broken business model was skinny margins.

In its heyday, Lehman was a bond house. It made markets in securities, mainly bonds. Before the internet revolution, Lehman’s competitive advantage was that its traders and sales force enjoyed access to information ahead of its clients. Lehman essentially sold the information distributed on its internal “squawk box” to its clients and trading partners in the form of wide bid-asked spreads and high commissions. This was a high margin business.

Then 2 things happened. First, Glass-Stiegel restrictions were lifted, and every big commercial bank wanted the margins of an investment bank. Second, the internet arrived and financial information became widely disseminated on-line and through Bloomberg terminals. The one-two punch of the internet revolution and competition from commercial banks essentially ended the juicy margins Lehman enjoyed during its heyday.

How did Lehman respond to its margin problem? It chose to enter new businesses (like mortgage lending and leverage loans), to swell its balance sheet dramatically (mainly by buying debt) and to increase leverage. These choices caused Lehman’s demise.

2.    Sales Volume

Faced with margin decline in its “bond house” sales and trading business, Lehman looked for other higher margin businesses. Lehman changed its role from intermediary to principal in several of these new businesses. For example, it started as an intermediary in mortgages, lending to mortgage lenders and selling mortgage bonds. It noticed that its clients were making good money originating mortgages. Lehman thought it could capture that margin, as well as feed its sales and trading desks. So it began to make mortgage loans and used its balance sheet to store many of the bonds it created when these mortgages were warehoused and securitized. Similarly, in its private equity and high yield businesses, it expanded from trading debt to storing more and more debt on its balance sheet. Lehman responded to its margin problem by expanding into new businesses and by expanding its balance sheet.

3.    Leverage

Responding to its margin problem, Lehman used its balance sheet and easy credit to lead it into new businesses. Its assets swelled as it bought debt, like mortgage backed securities, collateralized debt obligations and leveraged loans. Soon Lehman found itself with enormous leverage. At February 29, 2008, Lehman had $786 billion of assets and $24.8 billion of equity. Lehman’s leverage ratio was a staggering 32:1. Lehman’s drastic expansion of leverage grew its profits for several years. Historically, it’s been virtually impossible for a finance company to survive a recessionary financial crises with so much leverage. This time was no exception.

4.    Expenses

Controlling expenses has never been Wall Street’s competitive advantage. Like a bulimic, investment banks typically feast on expenses during good times, and heave them overboard during bad times, in a predictably repetitive cycle. But operating expenses were not the cause of Lehman’s demise. With such a huge balance sheet, even small impairments in asset quality caused losses that dwarfed expenses.

In sum, Lehman’s business model was severely challenged by the changed environment of the information revolution and increased competition from commercial banks. Lehman responded (evolved) by using its balance sheet to expand into new businesses. Despite a bloated balance sheet, it successfully avoided its enemies for a few years. Eventually, its big fat balance sheet and poor sense of direction slowed it down. When the storm hit, Lehman could no longer escape its demons. It became extinct.

Almost all paths of incompetence in the current crisis run through the office of the Chairman of the SEC, Chris Cox. McCain’s solution to fire Cox isn’t tough enough. Exile is better. Fortunately for Cox this isn’t the Stalinist Soviet Union or his fate could be a lot worse.

Cox’s failures are too numerous to count. However, I’ll give it a try. Below are what I think are his top 5 failings.

1. Failure to enforce disclosure laws and regulations.
   

   Disclosure rules and regulations protect investors by requiring companies to disclose everything that is needed for informed investment decisions. And, CEO’s and CFO’s are required to sign certifications that such disclosure is materially accurate, complete, and that their companies have adequate internal controls to ensure such accuracy and completeness.

   Enforcement of disclosure rules and regulations has been a joke. CEO’s lie to shareholders with impunity and without fear of SEC enforcement. It is impossible to conclude that SEC filings for Freddie, Fannie, AIG, Lehman, or Bear Stearns complied with SEC rules and regulations.

   However, instead of enforcement by the SEC, there is silence. While not all management actions are criminal, why hasn’t the SEC used its civil enforcement authority, i.e., assessing fines and penalties? How about protecting future investors by banning failed executives and boards of directors from serving in executive management at other public companies? 

2. Failure to enforce accounting standards.
   

   When Cox states that the SEC doesn’t have regulatory authority over capital adequacy of financial services companies, he isn’t telling the truth. The SEC has regulatory authority over the financial statements of ALL publically traded companies in the U.S. which of course includes the financials.  If Cox had required greater reserves and transparency of financial services companies it would have happened.  

   Every quarter all publically traded companies file reports with the SEC that are provided to shareholders and the SEC has review and comment authority. If the SEC deems financial disclosure inadequate, incomplete or opaque it has the authority to force the company to amend its filings. It also has authority to establish accounting standards for publically traded companies which means it can have different requirements than GAAP. 

   So when the AIG filed its last quarterly report and decided that it didn’t need to have loan loss reserves against defaulting mortgages and securities, the SEC had the ability to require additional loan loss reserves. When Freddie and Fannie decided to pretend that defaulted mortgage were good assets because it changed its accounting standards, the SEC could have just said “no”. When Lehman manufactured $2.4 billion of pre-tax income by pretending that it wasn’t going to repay its debts (one of the dumber aspects of mark to market accounting), the SEC should have protected investors with disclosure. 

3. Failure to supervise the rating agencies.
   

   Cox wants everyone to believe that despite being the rating agency’s only regulator, the SEC has no oversight or enforcement authority and cannot influence their performance. Once again, the SEC’s statements are false. Cox assumes that no one will take the time to read the Credit Rating Agency Reform Act of 2006 which states that the SEC has the right to suspend or revoke the license of any of rating agency for a wide range of reasons.  Rating agency regulation and reform is Cox’s responsibility. 

4. Failure to investigate and prevent market manipulation, i.e., naked short selling.
   

   Free markets are supposed to be honest markets. The naked short selling issue isn’t new and the SEC’s knee jerk emergency response is an embarrassment. The ban on short selling of 799 stocks is very similar to Putin’s actions this week to manipulate the Russian stock market. I haven’t a clue whether or not the uptick rule works, but I know that enforcing rules on naked short selling shouldn’t have required destructive and ill thought out emergency orders. In the middle of the 1800’s the legendary financial scoundrel, Daniel Drew, understood naked short selling was bad (as he lost his fortune covering a short squeeze) when he said, “He who sells what isn’t his’n, Must buy it back or go to prison.” Too bad Cox never took economic history in school (or googled economic trivia).  

5. Failure to protect small investors.
   

   It is no coincidence that according to the FT, stock ownership by individual investors is at an all time low. The average individual investor knows that their chances in the market aren’t good. And, the SEC doesn’t seem to care if the average guy is disenfranchised from the economic future of America. In addition to the above failures, Cox forgot that it was his job to make sure that brokers shouldn’t engage in deceptive sales practices (like in the sale of auction rate securities and the sale of Freddie and Fannie common and preferred stock to small investors because they were “guaranteed” by the government). Cox refuses to support private litigation by individual investors who were ripped off in the stock and bond market. If the SEC doesn’t protect the little guy, who will? 

It is hard to think of how anyone could have done a worse job than Chris Cox (other than engaging in illegal conduct). But, if anyone can think of things that I have missed please feel free to tell everyone reading this blog by commenting. I doubt that my list is complete.

OK. I admit it. Neither Ben Bernanke nor Hank Paulson looks like Smokey the Bear (although Smokey does resemble my dog, Kelly). But like firefighters trying to save the forest, the dynamic duo are feverishly trying to save the U.S. economy from an economic wildfire by drowning the crisis with liquidity.

Every week I write blog articles on money supply and its growth (or lack thereof). This week’s data again showed no real money supply growth and it has been approximately 6 months since money supply has materially increased. On an inflation adjusted basis, money supply has actually shrunk.

I am pretty sure that writing about money supply is the most boring and technical topic that anyone can imagine. So, why am I flogging money supply and M2 (and to be clear, it isn’t because I like being boring)? Set forth below is why, in the current environment, monetary policy and money supply are the most critical economic indicators we have.

Why does money supply matter to the economy?

Money is the medium of exchange for the purchase of goods and services in our economy. It is the grease that allows our economy to function and a primary measuring stick for how well the economy is performing. Too much money causes inflation (and a weakening Dollar) while too little money causes deflation (and a strengthening Dollar). Growing money supply (after adjusting for inflation) is necessary for economic growth. Shrinking money supply will result in a recession. A dramatic fall in money supply will cause a depression. Money is also used to ration credit. When money is tight, rationing is severe (i.e., high risk premiums) and not all firms can survive.

What should we look at when we look at money supply?

The Federal Reserve publishes two measures of money supply, M1 and M2. M2 is the broadest reliable measure of money supply and the better statistic.

The weekly money supply report is published every Thursday afternoon and discloses detailed information on M1 and M2. It is a report card of monetary policy and economic activity. While movements in any given week are usually not significant (the past week could be an exception to that rule), multi-month trends are very relevant.

However, money supply has its limitations as an economic statistic. It is not a precise instrument to measure economic activity and normally has limited predictive value.

But we aren’t in “normal times” and currently money supply statistics are the most accurate instrument of measurement that exists.

Why is money supply so important now?

Deleveraging is destroying the U.S. money supply and is the most obvious “symptom” of the underlying credit crisis. Troubled financial firms are “diseased” with bad assets, too much leverage and not enough equity. They are trying cure themselves by shedding assets so that their equity is large enough to support their remaining business. However, a side effect of shrinking balance sheets is money supply destruction. When one or two financial institutions simultaneously shrink their effect on money supply is immaterial. However, when all the banks and brokerages attempt to simultaneously shrink money supply falls at a catastrophic rate and a meltdown results.

How much is money supply shrinking?

Without Fed and Treasury intervention, the deleveraging of financials will result in at least $2 trillion of money supply shrinkage. That estimate has been calculated by university economists, the Fed and major private forecasting departments. Just this week JP Morgan published research on the $2 trillion shrinkage issue.

As an aside, I think I was literally first to publically estimate $2 trillion of shrinkage and its implications when I blurted it out FOX Business in February. 

What does $2 trillion shrinkage in money supply mean?

If left unchecked, $2 trillion shrinkage in money supply will result in a depression. GDP will quickly drop by more than 10% and a deflationary spiral will result. Paulson and Bernanke are using every means possible to prop up money supply and avoid this fate. So far, they have been able to stop money supply from dropping.

What are the Fed and Treasury doing to stop the $2 trillion shrinkage?

First, Bernanke and Paulson are fixing the underlying disease by injecting government equity into failing financial companies. Government equity slows the deleveraging process until the private sector is able to recapitalize itself.

Second, the Fed is injecting liquidity into the banking system so that adequately capitalized entities have cash to transact business in the ordinary course and don’t get caught up in the maelstrom of uncontrolled meltdowns at other firms.

What do I think of Fed and Treasury policy to date?

The Fed has done a pretty good job but is struggling to stay ahead of the crisis. Once it engaged in crisis management, Treasury has done a good job but they should have fully engaged a long time before they did.

The Bernanke and Paulson had a “breather” during the 5 months from the time of the Bear Stearns failure until the Freddie/Fannie failure and they should have used that time to implement a “forward leaning” policy which might have prevented some of last week’s hysteria. They talked about setting up an organized system for resolution of non-bank financials and then dithered while the economic forest fire burned in the distance. We still don’t have that system and they are now playing catch up.

After all, as Smokey says, “If you start a fire put it out. Only you can stop a forest fire.”

Given the events of the past few days it is once again time to examine the immortal question posed by children and traders alike, “are we there yet”?

Nope, not yet, we aren’t there yet, not even close. The bottom hasn’t been found in the credit markets or the stock market and, unfortunately, we still have a way to go.

I am not sure when the bottom will be found but we will know we are getting there when the U.S. economy makes it for 60 days without a run on a financial institution. After 60 days without a major financial crisis I will write “Hey kids, we’re there”. But until then, the trip continues.

When we get “there” I hope we don’t look back on the good old days of high leverage and spending beyond our means and wish we could go back to that simpler time; a time before mark to market accounting and accountability. I hope “there” is a happy place where the U.S. has a future because we have low unemployment, high productivity, low deficits and lots of investment and savings. But then again, I still believe in the tooth fairy.

In June I wrote that we weren’t there yet because we flunked the “60 day test” and because Lehman Brothers and other banks and investment banks “would have expired but for the unbelievable work of Bernanke”. I started getting terrible hate e-mail. So, I started using a food tester before I ate.

A little later in June I was on FOX Business Network and repeated that we weren’t there. Later that day several people that with uncontrollable anger syndrome called me on the telephone and randomly shouted obscenities at me. So, I stopped opening my own snail mail.

A few weeks later I wrote a series of blog articles on money supply and its implications that were published on Seeking Alpha. I suggested that economists were “making up data” that didn’t exist and Fed policy was going to result in credit rationing. I was called names on blogs and received comments from “on line screamers” who believe in screaming often, loud and with nasty language. So, I had my kids start using my wife’s maiden name at school.

But, despite the threats, the name calling and the blog screams, we weren’t there in June, July or August and still aren’t there in September. And, Fed policy that caused credit rationing didn’t include rations for Freddie, Fannie, Lehman and, now, maybe, AIG.

Since June when I first suggested that we had a way to go the Dow, the S&P 500 and the NASDAQ are down approximately 7.80%, 9.43% and 9.08%, respectively.

I’m sorry we aren’t there yet. And, I don’t like it when people call me names. I am sorry that so many people have trusted senior executives at their companies and those executives have let them down. I am sorry the regulators have let us down and I am sorry that investors are losing money.

But, we still aren’t there yet and until we have 60 days without a financial crisis we aren’t going to be there.

For non-professional investors that want to play the market I have some advice. Before buying stocks you need to answer a more fundamental question; red or black?

While most of the business media is focusing on Lehman and troubled financials, they are forgetting about next week’s Fed meetings and how monetary policy will respond to the crisis. After almost 6 months of shrinking real money supply (nominal money supply adjusted for inflation), Fed policy makers are going to decide whether to push the economy by once again increasing real money supply.

The last 6 months of shrinking real money supply has created a scarcity of funds that halted the drop in the value of the US dollar and deflated the commodity bubble. However, too few dollars also attenuated the credit crisis. Monetary policy didn’t cause Freddie and Fannie’s failure, Lehman’s meltdown or Washington Mutual and AIG’s problems. But, the coincident timing of these failures is a result of 6 months of restrictive money supply causing investor risk premiums to increase and the weakest institutions being “closed” out of the market.

For the last year the Fed has been trying to walk the economy across a monetary policy tightrope and knows that if we lean too far one way or another the economy will fall and break.

As our journey across the monetary tightrope started, the Fed pushed us by injecting liquidty into the financial sector through its “emergency” facilities so that troubled banks, brokerages and insurers could work out their problems without hurting each other. Increasing money supply (i.e., lots of liquidity being pumped into the banks) and a falling Fed Funds Rate bought time for the banks and brokerage to raise capital and deleverage. But, by the middle of March, the dollar was tanking, commodity prices were beginning to spin out of control and the US risked triggering global runaway inflation.

Beginning in the spring of 2008, the Fed started to push the economy in the direction of a more restrained monetary policy. Money supply growth stopped and the Fed made it clear that they were done cutting the Fed Funds Rate. The US Dollar strengthened, the commodity bubble deflated but stress in the financial sector returned. 

Now the economy is looking into a black hole of uncontrolled banking failures, potentially shrinking money supply, deflation and wealth destruction. Because of the fragile, and potentially insolvent status of many financial companies, if the Fed is too restrictive it risks creating a “domino effect” of financial failures which will destroy money supply and cause a depression.  Many economists, such as Milton Friedman, have written extensively that the Great Depression could have been avoided if the Fed had focused on maintaining the amount of money supply as bank failures took place. Instead, during the Hoover Administration bank failures resulted in more bank failures and the financial sector deleveraged at an uncontrolled pace.  Money supply plummeted and by the time the Fed realized what had happened it couldn’t stop the damage.

As we move foward into 2009 if we fall off of the monetary tightrope on one side the economy is facing a deflationary cycle and a possible depression and on the other side the economy Fed is facing runaway inflation and a possible depression.  So it is important for the Fed to keep us on the tightrope and keep us from falling.  The Fed needs to increase money supply and cut the Fed Funds Rate, but not by too much.  On the other hand, the Fed needs to be an agressive inflation fighter and keep monetary supply reasonably restrictive, but not by too much. 

The next move of the Fed will be to increase money supply which hopefully will have the effect of inflating (at least for a while) the banking sector. The Fed Funds Rate may be cut as well in an effort to pump operating profits into the banking sector.

For the week ending September 1, seasonally adjusted M2 (a broad based measure of money supply) remained essentially unchanged from the week ending March 24^th and on a non-seasonally adjusted basis is actually lower than the week ending March 24^th.  This trend of no money supply growth will not continue for much longer or the Fed risks repeating the mistakes of the Hoover era Fed. 

Last week I was a guest on FOX Business Network discussing the Fed’s next move and why. Take a look below at the segment.

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On the 7^th anniversary of the 9/11 attacks we need to remember how lucky we are to live in the United States and the terrible sacrifice that many have paid to defend our freedoms.

First Capital has decided to honor the memory of fallen Americans by providing financial backing and support to the 9-11 HelpAmerica Foundation.

The 9-11 HelpAmerica Foundation is a grass roots organization that provides support to families of solders who have been killed or wounded in the service of our country.

First Capital became aware of the 9-11 HelpAmerica Foundation when one of First Capital’s staff had a close relative who was killed in the line of duty in Iraq. 9-11 HelpAmerica was the family’s “first responder” and during their darkest hour helped ease the grieving process.

First Capital is sponsoring 9-11 HelpAmerica’s 7^th Annual Golf Tournament which will be held on Thursday, October 2nd at the Rio Hondo Golf Course in Downey, California.

I would like to encourage everyone reading this blog article to support the 9-11 HelpAmerica Foundation by either registering for the Golf Tournament or donating money on line at the 9-11 HelpAmerica’s website at http://www.911helpamerica.com/. If everyone only gives just a little bit to the foundation we will collectively make a big difference.

Registration is $165 per person and includes a dinner later that day. All proceeds of the golf tournament go to benefit 9-11HelpAmerica. Even if you don’t play golf, please make reservations to attend the dinner. Dinner is at 6:00 P.M. and tickets are only $50 per person.

We cannot bring back soldiers who paid the ultimate price to defend America or repair the broken bodies of those who are wounded.  But by supporting the 9-11 HelpAmerica Foundation we can help ease the pain of those that have suffered loss.

This morning on FOX Business Network I had the opportunity to discuss how lucky I am to be an American and the 9-11 HelpAmerica Foundation. Please take a look at the video below and then give to the 9-11 HelpAmerica Foundation.

Thank you in advance for your support.

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This morning on CNBC, Secretary of the Treasury Hank Paulson advanced the cause of reckless behavior when he inexplicably gave the management and boards of Freddie Mac and Fannie Mae a “get out of jail free” card. Amazingly, Paulson announced that he didn’t blame the respective senior executives and boards for the failures and that he felt “sorry” for them. It is almost as if immunity from prosecution was part of the conservatorship deal and absolution by Paulson was a necessary element of the takeover. And, because Paulson’s comments will be replayed in any future civil or criminal trial, he has effectively neutered any potential effort at investigation, enforcement and conviction.

Freddie and Fannie boards and management shouldn’t be given immunity and Paulson shouldn’t have preempted an investigation in the ordinary course to take place. There was no reason for Paulson’s “rush to innocence”.

The decisions that drove Freddie and Fannie into conservatorship were made by, and were the responsibility of, their respective teams. No one forced them to operate without adequate capital or in an unsafe and unsound manner. The regulatory minimum capital standards that Freddie and Fannie were trying so hard to meet were only minimums; it was the responsibility of their boards and management to ensure that they exceeded minimum standards. No one prevented them from “just saying no” to reckless and irresponsible behavior.

Instead discussing possible civil or criminal liability (including liability for allegedly lying to their shareholders), Paulson decided to express his empathy for the incompetent. Paulson’s statements sounded like conservatorship was inevitable; as if it was “written in the stars” that they would fail because of flaws in 1930’s legislation. Fatalism as an economic theory drove Paulson when he went out of his way to exonerate those in a position of responsibility and authority.

The meltdown of Freddie and Fannie was not inevitable and their debacle is a direct result of irresponsible and incompetent management. No one currently knows if civil or criminal violations took place or if prosecution is in order.

Unlike Paulson, I don’t feel sorry for the boards or management. I feel sorry for the common and preferred stock investors in Freddie Mac and Fannie Mae and for taxpayers that are holding the bag for these fiascos.

I would like to know if laws or regulations were violated. Notwithstanding Paulson’s statements today, if it is found that violations of law or regulation did take place, those responsible should be brought to justice. As former Treasury Secretary Snow explained this morning on CNBC, the markets “don’t work well when management isn’t held accountable for their own mistakes.” Paulson “feeling sorry” is the opposite of accountability.

Paulson’s message to executives of other companies about their responsibilities and liability is terrible. If executives perceive that the downside to incompetent and reckless behavior is that the Secretary of the Treasury “feels sorry” for the perpetrators and helps them get off without punishment, then the “head I win, tails you lose” attitude of the past decade has been reinforced. Although the Department of the Treasury has worked out a great plan for Freddie and Fannie (yes, I think the plan is essential and very good), Paulson’s comments were themselves careless and will come back to haunt everyone.

Overview

Last week’s economic data was dominated by the report of rising unemployment, increasing non-farm business productivity and the Fed’s “Beige Book” which is a summary of economic conditions by Federal Reserve Districts. Oh, by the way, money supply didn’t grow again.

Money Supply

Last week the Federal Reserve announced that money supply as measured by M2 marginally increased on a seasonally adjusted basis but declined on a non-seasonally adjusted basis. The rate of growth of money supply since the middle of March, 2008, continues to be very low and materially below the rate of inflation. Falling real money supply reflects a continuing hawkish Fed stance.

A hawkish Fed isn’t especially friendly for growth or employment but does have an anti-inflation bias.

Unemployment and Productivity

The biggest news of the week was the sharp rise in the unemployment rate (from 5.7% in July to 6.1% in August). New claims for unemployment for the week ending August 29^th were 444,000 which means that unemployment claims continue to signal a very weak economy, if not a recession.

Non-farm business productivity rose in the second quarter at an annual rate of 4.4%. Productivity improvement can be either very good news or very bad news. Unfortunately, the second quarter rise in productivity wasn’t good news. It was mostly a result of increased unemployment i.e., the same economic output being produced with fewer workers. Rising productivity is good news when accompanied by growing employment and a robust economy. The rising second quarter productivity numbers, because of the accompanied falling employment base, are a recessionary indicator.

Fed Beige Book

The Federal Reserve Beige Book Summary stated “Reports from the twelve Federal Reserve Districts indicate that the pace of economic activity has been slow in most Districts. Many described business conditions as “weak,” “soft” or “subdued.” Only one district, Kansas City, reported a slight improvement.

Summary

Last week’s economic data reflect the results of shrinking real money supply. Weak employment, weak economic activity and recessionary indicators all dominated the data just as predicted by monetarist when money supply falls on an inflation adjusted basis.

Money Supply

Last week the Federal Reserve once again announced that money supply as measured by M2 declined on both a seasonally and non-seasonally adjusted basis. For the week ending August 18^th, money supply shrank on a seasonally adjusted basis by $10.5 billion and on a non-seasonally adjusted basis by $8.9 billion. The rate of growth of money supply since the middle of March, 2008, has been very low which reflects a hawkish Fed stance.

Since March, 2008, after adjusting for inflation, money supply has been shrinking at a rapid pace and the strengthening of the Dollar and the decline in commodity prices are reflective of tight monetary policy. As stated years ago by Milton Friedman, the level of interest rates is less important than the rate of growth of money supply when trying to read economic “tea leaves”.

By holding the Federal Funds rate low but restricting money supply growth, the Federal Reserve is attempting to hold the line on inflation while encouraging an upward sloping yield curve (i.e., longer term Treasury securities paying higher interest rates than shorter term Treasury securities).

The upward sloping yield curve tends to increase the core earnings power of the banking sector which should help repair the damaged banking sector.

Ben Bernanke and the Fed remain on the inflation watch and continue to balance competing interests with expertise in monetary policy rarely seen in central bankers.

Last week I had lunch with Marty Schiffman who told me that “If I live 1,000 years, I will never understand that accounting rule! It’s dishonest!” Marty was, of course, talking about the application of mark to market accounting rules by major financial institutions. Marty Schiffman is not the “average” man on the street; he is the head of the Real Estate Group at Carl Marks and is a senior finance professional. In short, he knows what he is talking about. 

As I have written in several previous blog articles, mark to market accounting is perhaps the dumbest and most misleading set of accounting rules ever promulgated by FASB. In my prior blogs, THE EARNINGS ILLUSION – FAS STATEMENT 157 AND FAS STATEMENT 159 and FAS STATEMENT 157 AND FAS STATEMENT 159 – CORPORATE EARNINGS MEET THE WIZARD OF OZ, I discussed some of the more inane provisions of these two accounting statements including the ability of companies to manufacture earnings by pretending that they don’t have to repay their debts.At lunch, Marty told me that bad financial reporting causes a loss of confidence.  He doesn’t understand why mark to market accounting isn’t transparent.  He explained that as the result of the rule, investors practically have to have a PhD in forensic accounting in order to figure out corporate earnings changes in a 10Q.  Marty got really animated (and loud) when he told me that it was dishonest for financial institutions to mark their liabilities to market and manufacture earnings by pretending they aren’t going to pay back their debts.  

Of course, Marty and I agree that the integrity of financial statements and reporting is essential for investor confidence. The US banking and financial systems are based upon “confidence” which, if lost, will tank the systems.

We only need to look at the crisis that beset the US in 1933 to understand what happens when we lose confidence and stop believing. As Franklin D. Roosevelt stepped forward to address the nation in his first inaugural address, a loss of confidence had paralyzed the nation and was destroying the fabric of society.

Below are some of FDR’s timeless words from that famous 1933 inaugural speech which words seem entirely appropriate today:

“…[asset] [v]alues have shrunken to fantastic levels…our ability to pay has fallen…the means of exchange are frozen in the currents of trade…the savings of many years in thousands of families are gone..

…Yet our distress comes from no failure of substance… no plague of locusts… the