The Bear's Lair: World capital of Ponzi

By MARTIN HUTCHINSON  |  Dec. 20, 2004 at 9:46 AM
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WASHINGTON, Dec. 20 (UPI) -- Fannie Mae's accounting mishaps, the renewed protest over stock option expensing and the attempt not to count the transition costs of social security reform all emphasize one thing: Washington DC, whether or not the world capital overall, is unquestionably the world capital of Ponzi financing schemes, swindles that work for a year or two and then deluge everyone in losses.

Fannie Mae's accounting problem was quite simple: it claimed "hedge accounting" for its derivatives contracts, choosing several weeks after the derivative was bought whether to accrue it at market value or "freeze" it as a hedge of its liabilities -- thus profitable derivatives were accrued and loss-making ones frozen. The accounting rule is quite clear; I have to say Fannie Mae's accounting was borderline fraud, and has resulted in a $9 billion restatement of its net worth, on the basis of which Fannie Mae's equity and several hundred billion dollars of debt guaranteed by it had traded for more than 3 years.

The stock at $69 Friday was only $11 off its 2004 high, which proves that investors in the 1995-2004 bull market don't care about fraud, so long as the management and brokers tell a good story. In reality, to get back to the (inadequate) capital ratios required by its regulators, Fannie Mae is likely to have to sell about $300 billion of mortgage backed securities, real money in any language. Chief Executive Franklin Raines should certainly go; the question is why the Board of Directors isn't forced to resign en masse, and Fannie Mae stripped of its power to build an asset portfolio.

The whole Fannie Mae mess results from the company having an implied but not explicit guarantee of its liabilities from the federal government. That keeps its liabilities off the federal deficit, but results in bizarre cross-subsidization of Fannie Mae's activities, made much worse when its management gets performance-related bonuses and decides to push the envelope of its legal status. The deception involved in the "now you see it, now you don't" guarantee of U.S. housing finance is of the same type as that perpetrated by Charles Ponzi, who attracted money to his scheme by pretending to be arbitraging international postal rates.

It is by no means certain that the Fannie Mae mess will end up in bankruptcy, like Ponzi's -- draconian regulation of Fannie Mae and its sister Freddie Mac, combined with a smooth ride in the bond market for the next decade or two, may allow disaster to be avoided. But in the market for financing housing, which has been shown around the world to be one of the simplest and safest assets to finance without government involvement, it was appallingly foolish to run these risks in the first place.

The U.S. social security system was set up as a pretty obvious Ponzi scheme in 1935; it has always relied, like Ponzi's original scheme, on there being enough "new" working members paying premiums to pay for the pensions of retirees. Its liabilities have never been fully funded and its "trust fund" is fictional, since the system's current annual surpluses are spuriously counted against the federal budget deficit, which would otherwise in 2004 have been 5 percent of gross domestic product instead of 3.5 percent. Further, the problem is getting steadily worse, because we are living longer, while the adverse political effect of the 1982 extension of the retirement age (40 years in advance, by 2 years) made the system the lethally dangerous "third rail" of U.S. politics. Third rail or not, an attempt to "reform" it by making it actuarially sound will in the long run improve rather than damage its shaky actuarial position.

Where the George W. Bush administration goes wrong is in seeking to pretend that the transition costs incurred when part of the social security payments are made into private accounts should not be counted as part of the federal budget deficit. Since the current social security surpluses are counted in the federal budget, the transition costs should be, also. Alternatively, if you want to take the transition costs out of the budget, you must take the current surpluses out also. Either way, the additional couple of trillion dollars of federal debt incurred over the next decade or two should not be difficult to finance, provided the budget itself is in decent shape. Contrary to the fears of the opponents of reform, the financial markets are not assuming that social security benefits will be dropped sharply by 28 percent the year the "trust fund" runs out.

On the other hand, the benefits claimed for the reform are pretty shaky, as well. The diversion of 2 percent of U.S. payrolls into the stock market would undoubtedly support stock prices (and thereby increase fixed asset investment.) However stock prices are already too high compared to their long term average, so that any such diversion in current market conditions would leave tens of millions of middle income taxpayers sitting on thumping losses when they came to retire.

Un-expensed stock options are perhaps the most Ponzi-esque of all Washington-designed financing schemes, since they involve paying top management extravagant remuneration while pretending to stockholders and regulators that you haven't done so. This mess resulted from the 1993 Budget, which prevented companies from tax-deducting any salaries paid to top management over $1 million, from the successful thwarting by Senator Joseph Lieberman (D.-CT) in 1995 of a previous attempt to reform stock option accounting, and from a willingness by bloated tech sector top management to pressurize Senators and Congressmen to perpetuate the scam.

Forcing the Financial Accounting Standards Board to allow falsified accounts to be filed, to the direct cash benefit of your campaign contributors, is corruption in any language. The FASB has already delayed until June 2005 the implementation of its new ruling that properly accounts for stock options; it is to be hoped that Senate Banking Committee Chairman Richard Shelby (R.-AL) and others will prevent Congress from thwarting this essential reform.

Even if the election last month had gone the other way, it should not be thought that Washington's penchant for financial chicanery would have abated. James K. Galbraith, professor at the University of Texas and leading Democrat economic guru of the Keynesian persuasion, spoke Thursday at the New America Foundation, but offered no return to financial probity. He celebrated the late 1990s as a triumph of the "Atari Democrats," claiming that the pro-growth wing of the party had been trying to kick-start tech investment for 20 years, and that Bill Clinton and Al Gore's shilling for the Internet from 1993 was a major cause of the amazing run-up in stock prices in the late 1990s. This he regarded as a triumph; it allowed the United States to achieve for a time investment without saving, a Keynesian economic miracle if ever there was one.

Going forward, Galbraith proposed a three part strategy. First, U.S. defense spending should be slashed, since an activist foreign and security policy only annoys foreigners (sound economically, whatever one might think of its strategic implications.) Second, the Nirvana of the late 1990s should be re-created in the energy sector, by creating a bubble of investment in energy-saving technologies -- presumably thereby allowing the Atari Democrats to be reborn as Enron Democrats!

The idea that you can create stock market bubbles at will, and enjoy them without any adverse after-effect, is particularly prevalent just now, in both political parties; that kind of thinking is what you get when M3 money supply expands by almost 10 percent per annum for a decade. In reality, even though you can delay economic nemesis by rampant money creation and fiscal laxity, as Bush and Fed Chairman Alan Greenspan have done, nemesis always gets you in the end.

Finally, Galbraith wants to solve the U.S. trade deficit by creating a new source of foreign purchasing power through forgiving the debt of all those countries that have mired their economies in poverty -- not the successful emerging markets such as China and India, which he regards as a competitive threat, but the unsuccessful ones in Latin America, Africa and the Middle East.

Clearly the United States can export goods by giving them away, perhaps entering the name of all Third World inhabitants in a gigantic raffle, the prize for which is a Boeing, but it's not clear in what way this would solve the trade deficit problem, although in a Keynesian world it would doubtless help unemployment. Even this bizarre policy would have less damaging economic effects than Galbraith's proposal, which achieves the same result but launders the money spent through the most corrupt and inept Third World governments, rewarding them for their corruption and ineptitude and penalizing those governments that have successfully fought through poverty to achieve economic competence.

One victory for financial sanity: we learned last week that Alan Greenspan, funny-money demigod of the late 1990s, has turned down the opportunity to be Treasury Secretary in succession to John Snow. Be thankful for small mercies!


(The Bear's Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that, in the long '90s boom, the proportion of "sell" recommendations put out by Wall Street houses declined from 9 percent of all research reports to 1 percent and has only modestly rebounded since. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)


Martin Hutchinson is the author of "Great Conservatives" (Academica Press, 2005) -- details can be found on the Web site

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