In class this week we discussed the Federal Reserve and watched the Frontline production, Inside the Meltdown. The film uncovered how the economy crumbled so fast after the housing bubble burst in 2007 and why Fed chairman Ben Bernanke and Secretary of Treasury Henry Paulson were forced to take action.
The film posed a puzzling question: should the banks have been allowed to fail - causing another great depression - or did the Fed do the right thing by intervening?
I am a firm believer in people taking responsibility for their actions so part of me is in favor of a policy involving moral hazard. However, when the consequences of those actions are so large that they will be detrimental to millions of innocent people, intervention is necessary. Even though the Fed and government eventually got involved they did not approach the situation in the best possible way.
I think there should have been a complete audit of the banking system - investment and commercial - once the Fed realized how much trouble Bear Stearns was in. I realize it was a rather chaotic time and quick decisions were necessary, but if the Fed and the government had a better understanding of the crisis then they could have attacked it more effectively.
The Fed believed that by bailing out Bear Stearns they would fix the entire toxic system. However, that was not the case and bailout after bailout pushed Henry Paulson to enact a policy of moral hazard with Lehman Brothers. Unfortunately for the market, Lehman Brothers was in worse shape than Bear Stearns and their failure caused the stock market to stall which stalled the entire economy. Banks lost confidence with the market and were refusing to lend any money. When people and businesses cannot get loans to buy houses, cars, start a business, etc. then they aren't spending money and in turn are not stimulating the economy. Also, when there is lack of confidence in the stock market then people want their money out quickly and stop investing which also hinders the economy. Maybe if Paulson had compared Bear Stearns' problems to Lehman Brothers at the beginning they would have let Bear Stern fail instead, or decided to bail out all of the banks with systemic risk, lessening the negative impact on the economy.
It seems throughout this financial crisis that a lack of knowledge is what continues to get the market into trouble. I can appreciate and understand why Wall Street does not want to be regulated, but if they aren't willing to share information then I don't believe they have earned that privilege. As we saw in the article "Swallowed by the London Whale", Ina Drew lost $6 billion dollars for JPMorgan and Chase because she was investing in these risky investments. Unfortunately, Drew and her team were unaware how toxic these investments were because they weren't given all of the details.
People like Alan Greenspan are huge advocates for an open, unregulated market. In theory this system makes sense, but unfortunately when you add in human emotion the system falls apart. Investors become easily blinded by greed and therefore overlook potential problems within the system. They also neglect to share information in order to get ahead. This is why it is necessary for the government to enact some form of regulation. I do not believe the system should be completely nationalized, but regulations with policies of full disclosure are necessary for the prevention of another market meltdown.
Friday, October 26, 2012
Sunday, October 14, 2012
The Warning, "Swallowed by the London Whale"
In class this week we watched the PBS production The Warning, which focused on the lack of regulation on Wall Street, particularly in the area of over-the-counter (OTC) derivatives. We also read the New York Times magazine article, “Swallowed by the London Whale”, which showed how investing in these OTC derivatives negatively affected JPMorgan and Chase.
As defined by the International Swap Dealers Association (ISDA), a derivative is a risk transfer agreement in which the value is determined by the value of an underlying asset. This underlying asset could either be an interest rate, a physical commodity, a company’s equity shares, an equity index, a currency, or any other tradable instrument parties can agree upon.
Derivatives fall into three categories: OTC, listed derivatives or futures, and cleared derivatives. An OTC derivative is negotiated privately between two parties and then booked directly. OTC derivatives are private swaps that take place in secrecy. As we saw in The Warning and in the New York Times article this posed a huge problem for investors. Even though OTC derivatives appeared to be a good investment, investors did not have all of the facts and ended up taking on too much monetary risk without fear of consequences. An open market is key to trading in order for investors to make knowledgeable and responsible trades. However, this wasn’t - and still isn’t - the case. Instead what remained was an accepted belief among investors that the markets were honest. Wall Street had too much freedom and they took advantage of that freedom which cost many companies and banks a lot of money.
There are many different views towards the regulation of Wall Street. People like Alan Greenspan believe government intervention in the markets will hurt the markets more than help them. This means sometimes allowing companies to fail in order for them to learn from their mistakes. Greenspan and his followers remained adamant about blocking all forms of governement regulation, including fraud. The then chair of the CFTC, Brooksley Born, had a different opinion. She looked heavily into OTC derivatives and saw how detrimental that time bomb would be if it went off.
Born uncovered the massive amounts of money flowing into and out of these OTC derivative trades and the lack of transparency within these black boxes. She was fearful of how risky these trades were and how much money they were handling. When the OTC derivatives market reached $595 trillion, Born was forced into action despite the resistance of big leaguers like Alan Greenspan. She petitioned for more regulation but unfortunately no one headed her warning and Born resigned.
JPMorgan and Chase is just one example of secret trading gone wrong. The company lost $6 billion dollars because they were taking great risks without completely weighing the consequences of those risks. However, blame is not to be placed purely on JPMorgan. Markets were holding back key information that investors at JPMorgan overlooked.
I believe some middle ground needs to be met. Greenspan's belief makes sense, but it does not account for human emotion. When people are given too much power, especially when it comes to money, people can get greedy and selfish. Companies do need to take some risk in order to receive reward, but they cannot effectively take those risks without all the facts. It would be like throwing a dart at a dark board you've never seen with your eyes closed.
As defined by the International Swap Dealers Association (ISDA), a derivative is a risk transfer agreement in which the value is determined by the value of an underlying asset. This underlying asset could either be an interest rate, a physical commodity, a company’s equity shares, an equity index, a currency, or any other tradable instrument parties can agree upon.
Derivatives fall into three categories: OTC, listed derivatives or futures, and cleared derivatives. An OTC derivative is negotiated privately between two parties and then booked directly. OTC derivatives are private swaps that take place in secrecy. As we saw in The Warning and in the New York Times article this posed a huge problem for investors. Even though OTC derivatives appeared to be a good investment, investors did not have all of the facts and ended up taking on too much monetary risk without fear of consequences. An open market is key to trading in order for investors to make knowledgeable and responsible trades. However, this wasn’t - and still isn’t - the case. Instead what remained was an accepted belief among investors that the markets were honest. Wall Street had too much freedom and they took advantage of that freedom which cost many companies and banks a lot of money.
There are many different views towards the regulation of Wall Street. People like Alan Greenspan believe government intervention in the markets will hurt the markets more than help them. This means sometimes allowing companies to fail in order for them to learn from their mistakes. Greenspan and his followers remained adamant about blocking all forms of governement regulation, including fraud. The then chair of the CFTC, Brooksley Born, had a different opinion. She looked heavily into OTC derivatives and saw how detrimental that time bomb would be if it went off.
Born uncovered the massive amounts of money flowing into and out of these OTC derivative trades and the lack of transparency within these black boxes. She was fearful of how risky these trades were and how much money they were handling. When the OTC derivatives market reached $595 trillion, Born was forced into action despite the resistance of big leaguers like Alan Greenspan. She petitioned for more regulation but unfortunately no one headed her warning and Born resigned.
JPMorgan and Chase is just one example of secret trading gone wrong. The company lost $6 billion dollars because they were taking great risks without completely weighing the consequences of those risks. However, blame is not to be placed purely on JPMorgan. Markets were holding back key information that investors at JPMorgan overlooked.
I believe some middle ground needs to be met. Greenspan's belief makes sense, but it does not account for human emotion. When people are given too much power, especially when it comes to money, people can get greedy and selfish. Companies do need to take some risk in order to receive reward, but they cannot effectively take those risks without all the facts. It would be like throwing a dart at a dark board you've never seen with your eyes closed.
Thursday, October 4, 2012
Global Inflation on the Rise
The annual rate of inflation across developed economies rose for the first time in a year this August. The inflation rise can be credited to sharp increases in energy prices. Stimulus measures by international banks were considered in fear of a global economic slowdown, but this positive development may lead the central banks away from additional stimulus measures as long as the inflation rise is sustained. Refraining from a bailout is ideal because it does not guarantee long term economic growth. However, economists have predicted that inflation might be higher in these next few months solely because of the price hike in energy and will eventually level out within by the end of the year.
A worldwide increase in inflation means prices are rising across the board. In the United States, gasoline prices have continued to climb despite a decrease in crude oil prices. The European Union is also seeing an increase in the energy market. Eurostat, the European Union's statistic agency, says producer prices rose 0.9% in August from July due to energy cost. The last time prices rose at a faster rate was in January 2011. Consumer confidence is also on the rise, encouraging markets to raise their prices because they know their consumers are willing to foot the bill.
The CPI which increased 0.6% on a seasonally adjusted basis in August indicated an increase in inflation. Since about 80% of that increase came from the gasoline index, it makes sense that energy is the main cause of this increase.
A higher inflation rate may also help lower unemployment. As the dollar regains its strength and consumer confidence continues to rise, consumers will spend more money which will cause manufacturers to create more supply and expand their companies. This will in turn create more jobs. Many reports say approximately 8.8 million jobs were lost when the economy started to recede. This number does not encompass the amount of people that were already unemployed at the time (5%). In order to return to full employment the United States would have to add more than 12.5 million jobs to bring the employment rate from 8.1% back to 5% as it was in 2006.
A higher inflation rate may also help lower unemployment. As the dollar regains its strength and consumer confidence continues to rise, consumers will spend more money which will cause manufacturers to create more supply and expand their companies. This will in turn create more jobs. Many reports say approximately 8.8 million jobs were lost when the economy started to recede. This number does not encompass the amount of people that were already unemployed at the time (5%). In order to return to full employment the United States would have to add more than 12.5 million jobs to bring the employment rate from 8.1% back to 5% as it was in 2006.
Monday, October 1, 2012
Top 5 for 9/23/12 - 9/29/12
Oil Futures Drop, Gas Rises After Explosion by Jerry A. Dicolo, September 27, 2012, Section 3, Page 4, www.wsj.com Crude-oil prices declined while U.S. gasoline futures surged 3.8% to $3.0874 a gallon in the wake of an explosion at a major refinery in Canada. Damage was minimal but the explosion turned the focus to low U.S. fuel supplies. Jerry Dicolo of the Wall Street Journal says, "U.S. Fuel stockpiles in the Northeast U.S. are their lowest since November 1990, according to the Energy Department." The explosion reminded the markets that supplies are low for this time of year. In order to compensate for the decreased supplies, prices will need to be raised in an attempt to discourage people from purchases large amounts of gasoline.
Data Suggest Trouble Ahead by Josh Mitchel and Ben Casselman, September 28, 2012, Section 1, Page 6, www.wsj.com The U.S. economy remains shaky despite positive gains in the housing market. Orders for durable goods dropped 13% in August from July, the biggest monthly decline in over three years. These goods are used to manufacture long-lasting products such as cars and televisions. Reports from the Commerce Department show a downward revision to the gross domestic product (GPD). The GDP was estimated at 1.7% but was seasonally adjusted to 1.3%. This revision is a reflection of cautious consumer spending and exports coupled with depleted farm stockpiles caused by the Midwest drought. Even though gains have been made in job creation and the housing market, progress is still not strong and quick enough to offset our economic slump. Increasing the consumer price index (CPI) is crucial to this process because when consumers are spending more money, manufacturers will need to produce more of their product.
Stocks Snap Losing Streak by Matt Jarzemsky, September 28, 2012, Section 3, Page 4, www.wsj.com U.S. stocks rose the most they have in two weeks. The Dow Jones Industrial Average great 0.5% in its largest daily increase since September 13, the day Federal Reserve announced a new bond buying program in an attempt to stimulate the economy. The gains are mainly due to global market strength, not because the U.S. economy is making significant gains. The amount of Americans applying for jobless benefits fell to the lowest levels since July, but durable-good orders plummeted 13% in August. There have been slight increases in the labor and housing markets, but not enough of an increase to offset the economy.
Higher Gas Prices Drive Up Spending by Conor Dougherty, September 29, 2012, Section 1, Page 2, www.wsj.com Depleted fuel stock piles in the U.S. has lead to higher gas prices forcing consumers to spend more on a necessary good. Unfortunately their income has not increased which will force consumers to cut back on other goods. As colder months approach, more people will also purchase gasoline to heat their homes. This will increase demand for gasoline which would bring down prices however if the supply is not there then prices will increase further to deter people from purchasing gasoline. The national average retail price of gasoline increased 47 cents a gallon since the start of July which is about 0.1%. Consumer spending accounts for 70% of economic demand, but with an unemployment rate above 8% and a decrease in annual household income many Americans are keeping their spending on a tight leash.
U.S. Steal, Union Make a Deal by John W. Miller, September 29, 2012, Section 2, Page 3, www.wsj.com The United Steelworkers union authorized a new three-year labor contract with U.S. Steel Corporation this Friday which will increase wages and decrease strikes. The contract includes a 4.5% wage hike over the next three years plus bonuses, no-strike provisions, and increased contributions from retirees toward their health-care plans. This deal comes despite difficult economic conditions, however U.S. Steel's CEO John Surma says the agreement is "in the best interests of our company, our employees and all of our stakeholders."
Data Suggest Trouble Ahead by Josh Mitchel and Ben Casselman, September 28, 2012, Section 1, Page 6, www.wsj.com The U.S. economy remains shaky despite positive gains in the housing market. Orders for durable goods dropped 13% in August from July, the biggest monthly decline in over three years. These goods are used to manufacture long-lasting products such as cars and televisions. Reports from the Commerce Department show a downward revision to the gross domestic product (GPD). The GDP was estimated at 1.7% but was seasonally adjusted to 1.3%. This revision is a reflection of cautious consumer spending and exports coupled with depleted farm stockpiles caused by the Midwest drought. Even though gains have been made in job creation and the housing market, progress is still not strong and quick enough to offset our economic slump. Increasing the consumer price index (CPI) is crucial to this process because when consumers are spending more money, manufacturers will need to produce more of their product.
Stocks Snap Losing Streak by Matt Jarzemsky, September 28, 2012, Section 3, Page 4, www.wsj.com U.S. stocks rose the most they have in two weeks. The Dow Jones Industrial Average great 0.5% in its largest daily increase since September 13, the day Federal Reserve announced a new bond buying program in an attempt to stimulate the economy. The gains are mainly due to global market strength, not because the U.S. economy is making significant gains. The amount of Americans applying for jobless benefits fell to the lowest levels since July, but durable-good orders plummeted 13% in August. There have been slight increases in the labor and housing markets, but not enough of an increase to offset the economy.
Higher Gas Prices Drive Up Spending by Conor Dougherty, September 29, 2012, Section 1, Page 2, www.wsj.com Depleted fuel stock piles in the U.S. has lead to higher gas prices forcing consumers to spend more on a necessary good. Unfortunately their income has not increased which will force consumers to cut back on other goods. As colder months approach, more people will also purchase gasoline to heat their homes. This will increase demand for gasoline which would bring down prices however if the supply is not there then prices will increase further to deter people from purchasing gasoline. The national average retail price of gasoline increased 47 cents a gallon since the start of July which is about 0.1%. Consumer spending accounts for 70% of economic demand, but with an unemployment rate above 8% and a decrease in annual household income many Americans are keeping their spending on a tight leash.
U.S. Steal, Union Make a Deal by John W. Miller, September 29, 2012, Section 2, Page 3, www.wsj.com The United Steelworkers union authorized a new three-year labor contract with U.S. Steel Corporation this Friday which will increase wages and decrease strikes. The contract includes a 4.5% wage hike over the next three years plus bonuses, no-strike provisions, and increased contributions from retirees toward their health-care plans. This deal comes despite difficult economic conditions, however U.S. Steel's CEO John Surma says the agreement is "in the best interests of our company, our employees and all of our stakeholders."
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