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Talking the Economy: Alex Pollock, Bruce Bartlett and Josh Rosner

Institutional Risk Analyst

Christopher Whalen

June 21, 2010

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Institutional Risk Analytics

In this issue of The Institutional Risk Analyst, we feature snippets from some of the interviews that IRA co-founder Chris Whalen has done for his upcoming book, Inflated: How Money and Debt Built the American Dream, which is scheduled for release in November by John Wiley & Sons. But first we wanted to talk about an exciting new product just launched by IRA as part of the professional version of The IRA Bank Monitor ratings and analytics tool, the IRA Counterparty Quality Score (CQS).

The IRA Bank Stress Index (BSI) developed several years ago by IRA CEO Dennis Santiago is designed for consumers of banking services and segments the US banking industry into gradations of righteousness. The A+ through F ratings generated by comparing the BSI results for a particular bank with the benchmark year of 1995 are really showing you segmentation of the top 30% of all banks.

Once you fall below that threshold in the BSI, the system gives you an "F." It may seem arbitrary to say that banks which fall into the bottom 70% of the quarterly BSI survey are "bad," but remember that this is a tool tuned primarily for retail users who need to make safe asset allocation decisions. Our typical user among the 30,000 plus registered users of our retail ratings product ( is a small business or retiree with single-digit millions of dollars at risk and/or operational/business exposure to a bank who want to be safe above all. The classic example of the latter is an insurance company that uses bank letters of credit to offset regulatory capital requirements. Sound familiar? Think AIG and GenRe.

But as we have learned over the years since we first launched The IRA Bank Monitor, there are other business case needs for bank ratings. Commercial credit and investment consumers of ratings have very different priorities than the "safe and sound" bias of the BSI rating method. For that reason, we created CQS as a second rating system that looks at the US banking industry in gradations of badness.

Instead of focusing on the top 30% of the industry, we instead describe the top 90 % of the industry in shades from 8-1, the former being the best grade and one being the lowest. Instead of asking the question is this institution a safe, exemplary bank, the CQS instead asks: Just how bad is this bank?

Dennis is going to be writing a longer discussion of the methodology involved in the CQS ratings system. IRA's bank analytics products range from ratings for individual use to automated widgets like the Move Your Money lookup tool to drive traffic on your web portal. Please contact Dennis or anyone in our sales department at (310) 676-3300 if you wish to discuss your ratings and analytics needs.

Talking to The IRA: The Outlook for the Economy

Now to our feature this week, namely excerpts from several interviews conducted over the past month. First was our conversation with Alex Pollock of AEI:

The IRA: So Alex, a lot of people liked your rant about abolishing FASB. Got a good bit of mail on that one.

Pollock: I don't think it's a rant. I think it is a calm statement of what has to be done. As Schumpeter said, progress in capitalism means turmoil.

The IRA: But what do you do when a society like the US does not want to be inconvenienced with balancing budgets or going through a recession? We seem to live in a fantasy world where the only progress is made via a grudging admission of the truth. Ed Kane at Boston College makes this point regarding bank supervision and the Fed. We keep coming back to literally metaphors like Faust and The Matrix to explain our national dysfunction when it comes to the economy.

Pollock: It is always easier to borrow as long as someone will lend to you. When the lenders stop lending, that's what forces the change. Witness Greece and the EU.

The IRA: But is there any brake on the US when we can lend to ourselves? So long as the Fed is able to make it all better via quantitative easing and other forms of currency inflation, there does not seem to be any political brake on the US as there was in the 1970s and 1980s.

Pollock: You cannot really lend to yourself…

The IRA: But the Fed did buy the Treasury and agency market in 2009. The same quantitative easing that was used in the 1930s, incidentally. The St Louis Fed has an excellent monograph by Richard Anderson on this period. Here's an excerpt: "In early April 1933, Congress sought to prod the Fed into further action by passing legislation that (i) permitted the Fed to purchase up to $3 billion in securities directly from the Treasury (direct purchases were not typically permitted) and, if the Fed did not, (ii) also authorized President Roosevelt to issue up to $3 billion in currency. The Fed began to purchase securities in the open market in April at the modest pace of $50 million per week."

The IRA: If you inflate the $2 billion in Fed purchases of securities between 1933 and 1936, plus Treasury purchases of gold with newly minted greenbacks, the total quantitative easing from the Great Depression in today's nominal dollar totals into the double-digit trillions, far larger than the Fed's latest exercise in currency inflation. Maybe we have not spent enough funny money to "jump start" the American economy, to use the Big Media Newspeak.

Pollock: Quantitative easing is only a temporary solution. European banks buying sovereign debt is another example.

The IRA: But currency inflation is definitely the flavor of the month in policy circles. We noted last week that Martin Wolf in the Financial Times is openly calling for monetization of fiscal stimulus in the UK.

Pollock: Currency inflation is another way of creating a default. In the end there are only two choices: debt is paid or it is default upon. There are implicit defaults and explicit defaults. We are all headed for implicit default -- that is my summary of the situation.

The IRA: So what is your take on financial reform?

Pollock: I don't see any. I call this type of legislation regulatory effluence bills. There is massive new regulation, but I don't know that this constitutes reform in any meaningful way.

The IRA: Thanks Alex

Next we featured part of a conversation with Bruce Bartlett, who was domestic policy adviser to President Ronald Reagan and a Treasury official under President George H.W. Bush.

The IRA: Bruce, how do you explain the financial crisis to normal people?

Bartlett: We had a housing bubble for various reasons. When the bubble burst, the tendency to spend by consumers fell significantly. We know from empirical analysis that for each $100 increase in people's wealth, they spend $5-10 annually of that increase. This varies in terms of the type of wealth. They tend to spend more of housing wealth because consumers view this as more permanent. We had about a $10 trillion increase in housing wealth during the 2000s. This added somewhere between $500 billion to $1 trillion annually in spending. When the bubble burst, people cut back their spending by that same amount. That by itself was enough to bring on a recession, but it had another effect that is very important. As the spending fell, the rate of velocity of money in the economy also fell from a historical level of 1.9 to 1.7. This has the same, identical effect as a shrinkage of the money supply.

The IRA: It is called deflation.

Bartlett: Yes. We had a fall in velocity that resulted from a fall in consumer spending that resulted from a decline in home prices. Thus the question becomes how do you turn that around? Keynesian theory is the only response that makes sense under these circumstances. Monetary theory does not work in these circumstances because you are pushing on a string. You can't force people to spend it and that is the problem. There are unused reserve balances in banks sitting there gathering dust so we have to find some way of getting people to spend again because velocity of money in the financial system goes back up and monetary policy becomes effective again and we can go back in the other direction. When you are in a trough and people are reluctant to spend, there is only one institution that can respond and that is government.

The IRA: So why didn't the Obama stimulus work? The White House claims success, but all we see in the markets is deflation. Our friend David Kotok of Cumberland Advisers put out a piece last week saying that the BP spill and the related moratorium put in place by the Obama Administration will cost 1 million jobs in the oil sector.

Bartlett: The theory of what Obama did was quite correct, the trouble was in the implementation. Not enough of the stimulus stimulated spending and a lot of it was just transfers that had zero economic effect. The second problem is that the state and local governments had massive fiscal contraction that offset 100% of the federal stimulus.

The IRA: We see state and local governments around the country cutting back on current spending and also pension and benefits commitments. In New York, for example, we see mostly Democratic office holders leading an effort to repudiate pension commitments to public sector workers. This has to have a negative impact on consumer spending, as you pointed out, because it is reducing the perception of future wealth. And this is precisely the same reaction that you saw in America 100 years ago in times of economic crisis, namely cutting consumption and spending. Intellectually, we may have the Keynesian overlay for policy, but the human response to a reduction in income and wealth is to behave more conservatively.

Bartlett: The state and local governments did not have any choice. So we have no real support from monetary policy and, because of the reduction in spending by state and local governments, we have no net stimulus. All we can do is slowly work our way out.

The IRA: Very slowly. So long as the banking industry is charging off $2 in bad loans for every $1 in new loans made, credit available to fund future investment or current consumption is going to keep shrinking. That is the other part of the analysis that policy makers do not seem to understand. Thanks Bruce.

We now turn to our conversation with Josh Rosner, who is long overdue for a full blown interview with The IRA. We'll be coming back to Josh after the Congress completes its work on regulatory reform.

The IRA: So Josh, we want to sit you down for a longer discussion after the regulatory reform circus ends in Washington. How do you see the outlook for the economy?

Rosner: There are three issues or "headwinds" as I like to describe them, factors that were once positives for the economy or tailwinds, but are now a drag on the economy. I have discussed these in speeches and with clients for several years, but only wrote about them in a limited way.

The IRA: Do tell.

Rosner: The first issue is the two-income household. Beginning in the inflation of the 1970's, as wages under-paced asset price increases, we moved from one to two income families. This boosted current growth and real estate prices for decades, but we have reached the limit of this "fix" to support employment and real estate prices. Now the tailwind of two income families has become a headwind that is a drag on the economy.

Household income data series don't properly account per per capita income per household. The shift has made household finances more fragile. It used to be if the family wage earner lost his/her job the other could replace some of that income, with spending rebalanced to two-incomes there is less household margin of safety in case of job loss.

The IRA: Elizabeth Warren has described this phenomenon in her book, The Two Income Trap. We could always take the kids out of school and put them to work. Then we can have a four income household. Hell, why not just close all the schools and sell the kids into indentured servitude in some friendly Middle Eastern nation? We can securitize the remittances from the children and use the proceeds to boost home values. Could be a whole new market for Wall Street.

Rosner: Not likely, but your comment illustrates the problem. We turned homes from savings vehicles to speculative vehicles - supporting equity extraction with the mortgage interest deduction exacerbated this. Unless we roll back child labor laws there is nothing left here in terms of expanding income to support future economic growth or to even stabilize house prices at current levels.

The IRA: Agreed. What else?

Rosner: The second issue is the democratization of credit. Beginning in late 1970's the move from charge cards to consumer revolving debt issuance changed the consumption patterns of an entire nation. The monthly debt service cost, not the value of the good or service, became the criteria used for making a purchase. Beside just super-charging consumption it commoditized luxury goods. Remember when the family on your block that owned a Caddy or Mercedes really was financially more wealthy? By the 1980s, the consumption function had shifted upward because of the expanding availability of credit. That trend is now reversed as banks, individuals and households are de-leveraging. The tailwind that drove consumption in the 1980-2007 period is now a big headwind.

The IRA: Yup. As our friend Jerry Flum, CEO of Credit Risk Monitor (CRMZ) likes to remind us, consumer debt is about pulling future purchases into the present. You can see this working against housing and consumer spending right now. That's why we have a down 9% estimate for residential home prices in the forward-looking survey that Bob Shiller started in May.

Rosner: The third headwind is demographic. Coming out of the recessions of the late 70's and 80's we were supported by the fact that the largest generation in US history was coming to peak earnings potential. These boomers are now moving to become the largest tax on the social safety net. The largest generation in U.S. history will retire with less equity in what has historically been the largest retirement and intergenerational wealth transfer asset for most families - their homes. In many cases, these people will have no new personal savings when they reach the end of their working lives and will essentially become wards of the state. This increased burden on the US Treasury, in a decade, is the largest unconsidered impact of the current crisis. I think we should create immediate incentives to saving in the home by replacing the mortgage interest deduction which incents equity stripping, with a principal tax credit based on annual paydown of mortgage principal.

The IRA: Incentivize savings instead of spending? Isn't that un-American? Thanks Josh.

Questions? Comments?

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