Thursday, January 01, 2009

We've Moved

We have moved the Alhambra Investments blog to our own domain:

Contrarian Musings

Please come check out the blog and our new website:

Alhambra Investments

Wednesday, August 27, 2008

Is Housing Stablizing?

There are plenty of people who will tell you that we are in a recession and several more who will tell you we are headed for some kind of new depression. They may ultimately be proven correct, but so far the economic statistics haven’t cooperated. Most of these people will also tell you that the housing market is the key to stablizing the economy. If real estate stabilizes, the mortgages on the books of all those banks that are in trouble will also stabilize and only then can the system start to heal. I’m not sure that is all it will take to stabilize the banking system, but it sure wouldn’t hurt. Taking a look at this map showing the four quarter change in real estate prices (from OFHEO) gives one some hope that the process is already well under way:

What this shows is that over the trailing four quarters, house prices have risen in 30 of the 50 states. California, Nevada and Florida are going through a real estate bust. The rest of the country? Not so much…

House prices may continue to decline and the economy may fall into a deep recession/depression. Anything is possible. But so far, I don’t see it.

This is cross posted at our new site (Don't forget to bookmark the new site):

AI Report

Monday, August 25, 2008

The Worst Tax

Richard Rahn has an article posted at the Cato Institute about the corporate income tax:

Rank the following taxes from best to worst: individual income taxes; payroll taxes, corporate income taxes, sales or consumption taxes, and residential property taxes. The vast majority of economists would rank the corporate income tax as being worst and the sales tax and residential property tax as the best.

Unfortunately, the corporate income tax is often the favorite tax of fiscally irresponsible politicians because it is not easily seen. In fact, the corporate tax is paid by workers in lower wages and fewer new jobs, by consumers in higher prices and by savers and investors in lower rates of return. The Organization for Economic Cooperation and Development (OECD), based in Paris and not known for favoring lower taxes, published a new study last month, "Tax and Economic Growth," which provides more evidence that the corporate income tax interferes most (as compared with other taxes) with proper resource allocation, productivity growth, and economic efficiency.

I think the corporate tax should be eliminated. It is ineffective and produces a small portion of the total tax take. It defies common sense to believe that the tax falls on some evil entity known as a corporation. All taxes, are paid by individuals as corporations just pass the tax along either to employees, customers or investors. If the goal is to increase job creation, I can think of no better way to do so than to reduce or eliminate corporate taxes.

The Root of the Housing Problem

Amity Shlaes has an article at Bloomberg that takes a different view of the housing problem:

Aug. 20 (Bloomberg) -- Everything will be all right if we just fix the housing problem. That was the hope investors clung to as they watched Fannie Mae and Freddie Mac crumble this week.

The presidential campaigns reflect a similar faith in housing's curative power. Senator John McCain recently suggested that not merely mortgage-loan defaults but also anxiety about those mortgages was our worst problem: ``Americans are uncertain about this crisis.''

``Three-Bedroom Ranch,'' a Barack Obama campaign commercial, suggests that America needs a ``plan to build'' for the middle-class rather than subsidize corporate interests. The candidates seem to believe that recovery is something with French doors and a new roof.

But what if houses aren't a haven but a prison? What if even a booming real estate market itself is a problem? That's the theory of a winning Phelps -- not Michael Phelps, the Olympic swimmer, but Nobel Prize economics laureate Edmund Phelps of Columbia University. Phelps deplores the collective energy Americans spend on family housing.

``It used to be said that the business of America was business,'' Phelps says. ``Now the business of America is homeownership.'' To grow optimally, he says, America needs to get beyond its house passion.

It seems obvious to me that since the government subsidizes home ownership, we probably invest too much in housing. The mortgage tax breaks, as well as the subsidy provided by a Federal Reserve keeping interest rates too low, traps too much of our capital in the housing market. If the government removes the subsidy, that capital would be invested in more productive activities.

Wednesday, August 20, 2008

Auction Rate Update

I haven't done an update on the auction rate security mess for quite a while, but now that some firms are starting to settle with their clients, it seems a good time to review.

The large brokers of auction rate securities, who were also the underwriters, have all mostly agreed to buy back auction rate securities from their clients. This was forced by Andrew Cuomo, the AG of the state of NY. Other state AGs have also been active in pursuing settlements. So if you are a client of Citigroup (Smith Barney), Merrill Lynch, UBS or JP Morgan, you will be getting your money back, probably by the end of the year - well that depends. It may be this year or more likely next year but possibly not until 2010. If you are a client of a smaller firm that wasn't among the underwriters, you aren't so lucky - yet.

The AGs forced these settlements by concentrating on the marketing of these instruments, which they said was fraudulent. Auction rates were sold as money market alternatives and clients were told that these were liquid instruments. That turned out not to be true and the firms were facing multiple lawsuits and arbitrations which they would likely lose.

Smaller firms used the same marketing tactics but have not joined the settlements for a variety of reasons. First, they probably don't have the money. Second, they can claim that they were depending on the underwriters to maintain a market and that they were victims as well. My guess is that the solution for the smaller firms will include admitting some guilt on their sales practice, but the underwriting firms will take the majority of the blame.

There is one other class of firms that really shouldn't be included in a settlement. Discount firms that didn't actively market the auction rates should not be held liable. Firms like Fidelity and Schwab were not out soliciting clients to invest in these things but just made them available. As such they really didn't do anything wrong. Full Disclosure: My firm uses Fidelity as our primary custodian.

That hasn't stopped the state of MA from pressuring Fidelity to buy back the securities:

NEW YORK (MarketWatch) -- After reaching deals with many of the top Wall Street banks over the auction-rate-securities mess, regulators are now turning their focus on brokerage firms not covered by those agreements.

Massachusetts Secretary of the Commonwealth William Galvin has written to Edward "Ned" Johnson, CEO of Fidelity Investments, asking that Boston-based Fidelity buy back the auction-rate securities that it sold to its clients.
"It is my hope that Fidelity will follow the industry trend and promptly repurchase these securities that it has sold to it customers, many of whom now find themselves unable to access money that they thought was as liquid as cash," wrote Galvin.

"Therefore, I request that Fidelity take immediate steps to resolve this matter on behalf of those customers."

Fidelity obviously does not agree:

Fidelity, though, stood firm in the face of Galvin's letter. "Fidelity is [not] the issuer, underwriter or sponsor of auction-rate securities," said Vin Loporchio, a spokesman for Fidelity. "We do not proactively market auction-rate securities. We believe the underwriters should stand by their securities."

I think Fidelity is right on this and the state would have a very hard time convincing a jury that Fidelity is liable.

One mystery is where the banks are getting the money to buy back these securities. They are already facing significant capital impairments from mortgage and private equity debt and would seem to have limited access to capital to use for this. Will the Fed be accepting auction rates at the discount window? I don't know but my guess would be yes. This will probably also force the issuers of auction rates, primarily fund companies like PIMCO, to come up with a solution. The banks cannot just carry this illiquid stuff on balance sheets already gummed up with illiquid mortgages. Expect to see signficant pressure on the fund companies to replace these and pay back the brokers/bankers.

Fannie and Freddie Death Watch

The Fannie Mae and Freddie Mac deathwatch continues today with the stocks both making new lows. It seems inevitable at this point that Hank Paulson will have to whip out the government check book and take these things over. The question seems more a matter of structure at this point.

This week's selloff was spurred by an article in Barron's over the weekend:

IT MAY BE CURTAINS SOON FOR THE MANAGEMENTS and shareholders of beleaguered housing giants Fannie Mae and Freddie Mac . It is growing increasingly likely that the Treasury will recapitalize Fannie and Freddie in the months ahead on the taxpayer's dime, availing itself of powers granted it under the new housing bill signed into law last month. Such a move almost certainly would wipe out existing holders of the agencies' common stock, with preferred shareholders and even holders of the two entities' $19 billion of subordinated debt also suffering losses. Barron's first raised the possibility of a government takeover of Fannie and Freddie in a March 10 cover story, "Is Fannie Mae Toast?"

As the Barrons article points out, the shareholders will likely be wiped out by any bailout - or at least they should be. The board of directors and managers will also likely get the axe. While that is necessary, it is not enough if taxpayers are asked to fund these two. The companies should not be operated as government agencies and allowed to just keep expanding their book of business.

Fannie and Freddie, if taken over, should be broken up and privatized. Even as semi-private companies Fannie and Freddie greased a lot of palms in DC. Imagine the potential for corruption if they become protected government entities. They are already the dominant players in the industry and if allowed to continue operating under the umbrella of explicit government guarantees, the number of competitors will just shrink further.

Furthermore, if taxpayer funds are used to prop these companies up now, then taxpayers should benefit when they are sold off. If we are to assume the downside of guaranteeing their existing mortgages, we should get the upside when they recover. The government should get some kind of equity kicker (warrants probably) when the companies are fully privatized. I would even go further and say that any equity retained by the government in these deals should be distributed to taxpayers rather than retained by the government. How can government be expected to regulate an industry in which it holds a stake?

Tuesday, August 19, 2008

How to Kill a Recovery

Amity Shlaes, author of The Forgotten Man: A New History of the Great Depression, lays out the non monetary mistakes made that turned the Crash of '29 into the Great Depression. They sound a lot like Obama's economic platform:

Giving in to protectionism - In Herbert Hoover's time, Sen. Reed Smoot and Rep. W.C. Hawley proposed a tariff that was to raise effective duties by as much as half. More than a thousand economists signed an open letter warning that the duties would "raise the cost of living and injure the great majority of our citizens."

Blaming the messenger - Punishing the stock market for the 1929 crash was popular in Washington in the early 1930s. Lawmakers attacked the practice of short selling; Senate Banking Committee counsel Ferdinand Pecora hauled J.P. Morgan and other Wall Streeters in for hearings. By 1934, Congress was creating the Securities and Exchange Commission. The Roosevelt administration also prosecuted business leaders, including former Treasury secretary Andrew Mellon and utilities magnate Samuel Insull. The new regulatory culture cut crime and protected investors. But the arbitrary nature of the assault petrified Wall Streeters.

Increasing taxes in a downturn - Hoover more than doubled income tax rates, taking the top marginal rate to 63 percent from 25 percent. FDR hiked the top rate to 90 percent. Perhaps worse, Roosevelt's Treasury crafted taxes to punish business, including an undistributed profits tax and an excess profits tax, that ultimately sucked cash from a capital-starved economy.

Assuming bigger government will bring back growth. There's a sense today that Washington has retreated too much from daily lives. Wall Streeters mutter that "the system" (the financial markets) doesn't work anymore. In the 1930s, people didn't just mutter that -- they believed it. Public-sector expansion seemed the only way to sustain America's promise. New Deal programs did much to alleviate the pain month to month -- many found dignity in six months of work at the Works Progress Administration, the Public Works Administration or the Civilian Conservation Corps. But economics is a competition for scarce capital. Such state solutions tended to suppress the creation of long-term private-sector jobs, as did the aggressive Wagner Act for organized labor.

Ignoring the cost of inconsistency. FDR spoke of "bold persistent experimentation." Obama speaks of "change." Both can do damage. What's more, the list of experiments is always finite. Our bailouts look reassuring, but even Washington cannot rescue the entire economy. And foreign investors wonder where Washington will stop. Already concerned about the inconsistent dollar policy, China is now troubled by the inconsistent rescues.

My greatest fear about the economy is the fiscal response out of Washington after the election. I have previously written about the Great Recession of 2010 and if we follow this path, I may have to change the title.

Wesbury Agrees

Brian Wesbury's Op-ed in today's WSJ sounds familiar:

The Fed's "dual mandate" -- to keep the economy strong and prices stable -- serves to support this mistake. In contrast, the European Central Bank has a single mandate: price stability. No wonder the dollar has been so weak relative to the euro. Imagine two football teams. One with a single mandate: win. The other with a dual mandate: win and keep your uniforms clean. It's clear that the one with the single mandate will have more success in achieving its goals over time.

It is this combination of denial of actual inflation, bad economic models and the political expediency of keeping interest rates low that makes a repeat of past policy mistakes likely. In the end, inflation can be controlled -- the Volcker-Reagan strategy of tight monetary policy and tax cuts still holds the key -- but only if policy makers find the courage.

From my article at RealClearMarkets the other day:

The problem then and the problem now is the supply and demand for US dollars. Soon after Reagan’s inauguration in 1980, the dollar started a rise that continued until the Plaza Accord of 1985. The trade weighted dollar rose roughly 50% and the price of oil fell by a similar amount. That rise was no accident. It happened because of the tight monetary policy of Paul Volcker and the growth promoting tax policies of Ronald Reagan.


The fist step should be to clarify the Fed’s mandate. Now, the Fed is tasked with maintaining growth and minimizing inflation. The only way for the Fed to truly accomplish the first goal is to concentrate exclusively on the second. It should also be made clear that inflation is defined as an expansion of the money supply and not a rise in price of an arbitrary basket of goods. The best way to accomplish currency and price stability is to adopt a gold standard but in the absence of political will for such a policy, a single mandate is a good first step.

It's nice to know that I'm in such good company.

Monday, August 18, 2008

Greenspan has a Good Idea

Greg Mankiw quoting from a WSJ article cites a proposal by Alan Greenspan to aid in the recovery of the housing market:

He did offer one suggestion: "The most effective initiative, though politically difficult, would be a major expansion in quotas for skilled immigrants," he said. The only sustainable way to increase demand for vacant houses is to spur the formation of new households. Admitting more skilled immigrants, who tend to earn enough to buy homes, would accomplish that while paying other dividends to the U.S. economy.

He estimates the number of new households in the U.S. currently is increasing at an annual rate of about 800,000, of whom about one third are immigrants. "Perhaps 150,000 of those are loosely classified as skilled," he said. "A double or tripling of this number would markedly accelerate the absorption of unsold housing inventory for sale -- and hence help stabilize prices."

So for once, Greenspan actually has a good idea. The housing market will only get better when the inventories are worked off and the best way to do that is to increase the pool of buyers.

Friday, August 15, 2008

A Strong Dollar will Reduce Oil Prices

I have a new article up at

In less than one month, oil prices have fallen nearly 22%. That drop happened during a period when our leaders in Washington accomplished exactly nothing of importance that could account for the fall. Sure, President Bush lifted the moratorium on offshore drilling, but that action will have no effect unless Congress follows suit.

Most likely the fall had nothing to do with the impending expiration of the drilling moratorium, but rather is a reaction to the recent strengthening of the US dollar. There has been a lot of discussion over whether the dollar has risen because oil has fallen or if the reverse is true, but based on history, it seems obvious to me that it is the dollar driving oil prices and not the other way around.

Read the rest by clicking on the title of this post.

Self Inflicted Wounds

The WSJ has an editorial today entitled, "American the Uncompetitive", which details the excessiveness of our corporate income tax:

The new international tax rankings are out for 2008, and congratulations to Washington, D.C., are again in order. Our political class has managed to maintain America's rank with the second highest corporate tax rate in the world at 39.3% (average combined federal and state).

Only Japan is slightly higher overall, though if you are silly enough to base a corporation in California, Iowa, New Jersey, Pennsylvania, or other states with high corporate levies, your tax rate on business income is even higher than in Tokyo. For the first time, the U.S. statutory rate is now 50% higher than the average of our international competitors, continuing a long-term trend as the rest of the world keeps reducing corporate tax rates. (See nearby chart).

A new OECD study, "Taxes and Economic Growth," examines national tax burdens and their impact on growth and incomes in member countries. It concludes that "corporate taxes are most harmful for growth, followed by personal income taxes, and then consumption taxes." The study adds that "investment is adversely affected by corporate taxation," and that the most profitable and rapidly growing companies tend to be the most sensitive to high business tax rates.

There is, of course, no such thing as a corporate tax. Taxes are always paid by individuals. If a corporation pays a tax it is coming from either their customers (in the form of higher prices), their employees (in the form of lower wages), or shareholders (in the form of lower returns). So, corporate taxes are ultimately just another way for DC to take money out of your pocket.

At a time when there is considerable debate about whether we will follow Japan's path of the last 15 years of stagnation, you would think someone in DC might look at the fact that our tax rate is about the same as theirs and ask if that might have an impact. Alas, no. Politicians are in populist mode and blaming corporations for all our troubles, from high oil prices to expensive health care.

If we want to attract capital to the US, and we must with our deficits, we have to make it attractive to investors. Frankly, I think the corporate income tax should be eliminated. In the editorial, the WSJ quotes a Tresury study:

The average European nation has tax rates on corporate income 10 percentage points lower than the U.S., but those countries on average raise 50% more as a share of GDP in corporate taxes than does the U.S., according to a 2007 study by the Treasury Department. Ireland with its 12.5% rate captures a higher share of its GDP (3.4%) in corporate taxes than the U.S. does (2.5%) with its 39.3% rate.

Doesn't that make it obvious that we are past the peak of the Laffer curve? Furthermore, considering the distortions caused by corporate taxes and the small amount of revenue collected, why not just eliminate the tax? I don't know if it would pay for itself, but it seems likely that higher growth would generate more personal income and thus more tax revenue from that source. In addition, eliminating the corporate tax would increase the demand for dollars and thereby reduce inflation. Finally, the real bonus is in the reduction of corruption on Capital Hill. With no corporate tax to avoid and no loopholes to create, the only losers here would be lobbyists and politicians. That's something that everyone should be able to get behind.