Текст книги "101 Things Everyone Should Know about Economics: From Securities and Derivatives to Interest Rates and Hedge Funds, the Basics of Economics and What They Mean for You"

Автор книги: Peter Sander

сообщить о нарушении

Текущая страница: 6 (всего у книги 14 страниц)

A corollary thought: if policymakers want people to save, they should increase—not reduce—interest rates. That would motivate people to save; in today’s environment the only thing that gets people to save is fear—that is not a path to economic health and well-being.

Why You Should Care

If you as an individual have cut your borrowing and spending, that’s a good thing. When economists and policymakers complain about the paradox of thrift, that shouldn’t influence you at all; it is not your responsibility to revive the economy!

36. RESERVE REQUIREMENTS

Reserve requirements oblige banks to keep a minimum fraction of their active demand deposits (largely, checking-account and other short-term account balances) set aside in reserve to meet customer withdrawals, written checks, and other routine transactions. The reserve requirement represents the “fraction” of the fractional reserve banking system (see #33) kept “at home” to meet customer demand.

What You Should Know

The Federal Reserve, specifically the Fed Board of Governors, mandates the reserve requirement. Today, it is 10 percent for transaction accounts exceeding $70.5 million at a given institution, and 3 percent for amounts between $12.4 million and $70.5 million. For the first $12.4 million, and for many other kinds of longer-term deposits like CDs or for corporate time deposits, the requirement is zero.

Such requirements make it easy for the banking system to generate considerable leverage, $10 or more for every $1 of deposits or Fed funds acquired. These requirements, however, are moderately high on an international scale; in the Eurozone the requirement is only 1 percent, and in the United Kingdom, Australia, and Canada, there is no set reserve requirement. This isn’t to say that banks in other countries are less regulated; they are just regulated differently.

Why You Should Care

The low reserve requirements give banks a lot of power to lend and effectively create money, but it’s easy to see how this leverage works the other way in times of crisis. Banks don’t have much of a cushion to work with, and thus must rely on the Fed for bailouts.

37. LOAN LOSS RESERVE

Any smart business or individual should set aside an emergency reserve of some sort in case something unexpected happens. The previous entry covered reserve requirements—minimum capital set-asides required by the Federal Reserve to cover unexpected withdrawals. But are these reserves, ranging from 0 to 10 percent of assets, adequate? Reserve requirements are there to protect against unexpected withdrawals, but what about the bigger elephant in the room—the potential default on bank loans? Where is the capital cushion to cover these losses? Isn’t this what really got us into the 2008–2009 credit crisis and the Great Recession that followed?

The short answer: indeed, banks were not sufficiently protected against bad loans. Banks do set aside so-called loan loss reserves to cushion against “normal” levels of loan defaults, but quite obviously most banks didn’t set aside enough to cover what actually happened.

What You Should Know

Banks set aside loan loss reserves on the balance sheet as a “contra,” or negative, asset. They book an expense every quarter known as a loan loss provision to put more funds in the reserve, then charge off the amount of a loan gone bad. The reserve helps avoid surprises. If a bank is accustomed to 1 percent of its loans going bad, and that amount indeed does go bad, the reserve covers it, and the charge-offs create no surprises in the financial statements. The bank remains healthy and continues to operate with the same amount of capital.

But if banks make riskier loans, or if their existing loans become more risky because of a declining economy, loan loss provisions should be increased by bank managers. They were, but probably not enough in these circumstances, as bank managers were reluctant to take even bigger hits to their bottom line by booking larger loan loss reserve provisions. As a result, bank capital positions declined, a factor leading to the bailouts that ultimately occurred.

Why You Should Care

Stronger, better-managed banks book adequate loan loss reserves to protect themselves, their depositors, and their shareholders. Growing loan loss reserves may reflect more conservative management—or may reflect a management worried about its loan portfolio. If you’re thinking about doing business with a bank, and especially investing in a bank, be careful about banks with loan loss reserves less than industry averages (as a percent of a loan portfolio) or with growing reserves—unless they give a credible explanation. Finally, the idea of such a “rainy day fund” applies not only to banks, but to other businesses and your own personal finances, too.

38. TIER 1 CAPITAL

The U.S. banking system, like others around the world, depends on its ability to lend as much money as possible, several times the original owners’ equity in the institution. If you have $1 to start a bank and can get $9 in customer deposits and/or loans from other banks or the Federal Reserve, you can lend out $10 to potential borrowers. You can make a lot of money on the $1 invested.

But what if one of your borrowers defaults on a $1 loan? You still owe your depositors $9, so your equity is wiped out. Perhaps you booked 1 percent as a loan loss reserve (see #37 Loan Loss Reserve), so you were prepared for a 10-cent loan to be written off. But $1? You’re in bad shape. $1.50? You’re out of business. This sort of scenario was common during the 2008–2009 banking crisis.

So if you’re a bank regulator, what would you look for as a sign of bank safety? The 10-cent loan loss reserve? That’s nice to have, and the larger the reserve the better. But is there a safety cushion beyond that? That’s where Tier 1 capital comes into the picture.

What You Should Know

Tier 1 capital is essentially the net equity in a bank (assets minus liabilities) plus the loan loss reserves. While loan loss reserves are set up to handle expected losses, Tier 1 capital is a better metric of how safe a bank is against unexpected losses.

The Tier 1 capital level is used together with a risk-adjusted measure of a bank’s loan portfolio to determine a capital adequacy ratio (CAR), or the ratio of the capital level to the loan base adjusted for risk. Investment analysts and bank regulators monitor the CAR ratio for banks to evaluate safety and to compare banks. The Tier 1 capital and CAR ratio received publicity in the media in postcrisis coverage of big banks like Bank of America, JPMorgan Chase, Morgan Stanley, Goldman Sachs, Wells Fargo, and Citigroup. The Tier 1 capital level was also one of the ingredients in the “stress testing” conducted by the Federal Reserve.

Based on the Federal Deposit Insurance Act, the law governing deposit insurance (see #45 FDIC), banks must have a Tier 1 CAR of at least 4 percent. Institutions with a ratio below 4 percent are considered undercapitalized, and those below 3 percent are significantly undercapitalized—but most investors and industry experts feel that a level closer to 10 percent is really adequate. Aligned to this thinking, in July 2013, the Federal Reserve Board recommended that the Tier 1 minimum for the eight “globally significant” U.S. banks be raised to 6 percent—and also announced that of the eight institutions in question, only Wells Fargo & Company currently complied with that measure.

Why You Should Care

Unless you’re in the banking business or are a bank investor, you don’t need to calculate Tier 1 ratios. But if you see a report that a major bank’s Tier 1 ratio is declining, that bank may be in trouble—about to cut its dividend to shareholders, or about to raise capital by selling more shares in the markets (both bad for investors). As a depositor, there probably isn’t much to worry about, because depositors only lose what is not covered by FDIC insurance, and after equity investors lose.

39. DODD-FRANK WALL STREET REFORM AND CONSUMER PROTECTION ACT OF 2010

It often takes crisis to bring change in American politics, and the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 is a crystal-clear example. “Dodd-Frank,” as it is more casually known, came to us as a direct consequence of the Great Recession. Introduced by Senate Banking Committee Chairman Chris Dodd and House Financial Services Committee Chairman Barney Frank in 2009, the bill became law in 2010 and is aimed mainly at consolidating and strengthening regulation in the financial services industry.

What You Should Know

The new law brought sweeping changes to the investment, financial services, and consumer finance industries, many of which are too detailed and focused on industry internals to matter to most, unless you work in the industry. Much of the new law’s provisions aim at avoiding or reducing the risks and regulating transactions central to the causes of the Great Recession. A new “Financial Stability Oversight Council” assesses risks and stresses, and provides for the Federal Reserve to more closely supervise “too big to fail” bank holding companies, giving us the “stress tests” occasionally reported in the news. An “Office of Financial Research” compiles data on the performance and risks of the financial system, and presents it to Congress, among others. New rules streamline the liquidation of banks, savings and loans, brokerages, and other financial institutions. The law beefs up reporting requirements for Registered Investment Advisers, and sets up new rules—and possibly a new regulatory body (still to be determined)—for hedge funds.

Importantly, the law as passed re-establishes the “Volcker Rule,” separating commercial and investment banking operations, and restricting what banks can invest on their own accounts (so called “proprietary trading”). The law also called for new regulation and standardization of the trading of credit derivatives, especially credit default swaps (see #69 Credit Default Swap). New rules give greater authority to the Securities and Exchange Commission (see #44 SEC) on a number of fronts, including the establishment of a “whistleblower bounty program” to encourage discovery of unfair securities practices. New oversight is now given to the credit rating agencies—Standard & Poor’s, Moody’s, and Fitch—to prevent conflicts of interest and other practices that led to the misrating of credit securities before the crisis. Finally, Dodd-Frank established the Consumer Financial Protection Bureau, adding new and centralized regulation to financial products and services, including new disclosure requirements and educational materials, and putting former Harvard professor and outspoken consumer advocate, and now Massachusetts senator, Elizabeth Warren, in charge.

Why You Should Care

The far-reaching Dodd-Frank legislation should curb many of the excesses that caused the Great Recession, and also serves to centralize authority and regulation. That helps lawmakers (and you, if so interested) know whom to go to in order to understand the latest of what’s happening in the industry, where the risks are, and to ensure compliance. For most of us, it’s a security blanket to know that the government is watching, and that many critical areas in the financial industry are no longer reminiscent of the “Wild Wild West”—there’s a new sheriff in town.

CHAPTER 5

Government and Government Programs

Whether or not you like the presence and cost of government, it plays a huge role in today’s economy. Governments provide money and monitor its supply, but go way beyond to create and implement various policies and programs to influence the economy, fix the economy, spend critical resources, and make it better for all of us.

Government agencies regulate economic activity, providing safeguards and a fair and level playing field for economic transactions to occur. Certain bodies of law, like bankruptcy law, create fair ways to dissolve failed economic entities, ultimately facilitating the sort of risk-taking necessary to make the economy work in the first place.

Want to understand the role and importance of the government in the economy? Just try to picture what it would be like without government. We would have no universally accepted currency, and no supervision and regulation of the markets and other economic activity—and no reallocation of resources to public programs and infrastructure, like roads and airports—that make the greater economy work.

40. U.S. TREASURY

It’s good to know where our money comes from and who’s managing it. Today, it’s sort of a joint venture between the Federal Reserve, our central bank, and the U.S. Department of the Treasury.

The Treasury department is part of the executive branch of the U.S. federal government and reports to the president. While the Federal Reserve (see #30 Federal Reserve) was created in 1913, the Treasury has been with us almost since day one, being created by Congress in 1789 to manage government revenue and currency.

What You Should Know

The Federal Reserve and the U.S. Treasury work together to create and implement money and monetary policy. The Federal Reserve is more the “brains” of the operation, deciding what policies to put into place with regard to employment, prosperity, and price stability; the Treasury is more “working man,” in place to carry out the programs.

The Treasury prints, mints, and monitors all physical money in circulation, including paper and coin currency. The U.S. Mint and the Bureau of Engraving and Printing are part of the Treasury. In addition, the Treasury is responsible for all government revenue generation through taxes—the Internal Revenue Service is part of the Treasury. Beyond raising money through taxes, the Treasury also raises money by creating debt securities—bills, notes, and bonds—to sell to the general public, banks, corporations, investment funds, and so forth.

So if the Fed decides to increase money supply, the Treasury puts the plan into place, although the Fed can also create more money by injecting money into the banking system directly, and has done that a lot recently. If Congress decides to change tax policy, the Treasury (through the IRS) carries that policy out. The Treasury does not decide on tax policy, nor does it create or change tax law.

The Treasury also performs other roles, such as measuring economic activity; providing economic and budgetary advice for the executive branch, Fed, and others; and producing other revenue through alcohol and tobacco taxes, postage stamps, and so forth. Until 2003, the Treasury also handled firearms regulation, customs and duties, and the Secret Service, but these functions have been transferred to the departments of Justice and Homeland Security.

Why You Should Care

Aside from the fact that its building is on the back of the $10 bill, and its original secretary, Alexander Hamilton, is on the front, it’s good to know what the Treasury is and does. Most of us have at least annual contact with the Treasury through the IRS at tax time. Additionally, it is the Treasury that issues U.S. securities, which we, or our banks or companies, may buy or sell occasionally. The Treasury carries out policies; it does not create them, so those that we agree or disagree with should be attributed to someone else in government. More recently, the Treasury and the Federal Reserve collaborated to create and implement federal bailout programs, like TARP, to safeguard the banking system from collapse and to strengthen it moving forward.

41. FEDERAL BUDGET

The federal budget, known more formally as the Budget of the United States Government, is a document prepared by the president and submitted to Congress for approval. The document outlines revenue, spending projections, and recommendations for the government fiscal year, which starts October 1 of the current year—so the 2013 federal budget covers the fiscal year beginning October 1, 2012 and ending September 30, 2013. Congress then adds its own budget resolutions (one each from the House and Senate). The budget is passed and signed into law; then individual appropriations bills are passed to actually fund government programs.

What You Should Know

The federal budget, by nature, outlines the nation’s spending priorities and is used as a tool to manage and solve social and economic problems on a large and small scale. Budgets don’t always cover emergencies, as discovered by additional fiscal year 2009 appropriations made for TARP and other economic relief in the wake of the financial crisis. Certain military operations like those in Iraq and Afghanistan may also be wholly or in part funded and administered outside the budget process.

The size of the federal budget has increased dramatically over the years. The 2013 budget calls for a budget of some $3.8 trillion, well more than double the 1999 level of $1.7 trillion. Some of that increase reflects inflation, but it also, more importantly, reflects an ever-growing role of government in the operation of our nation, as well as a continued solidifying and stimulating of the economic base in the wake of the financial crisis.

Has revenue growth kept up with spending growth? Indeed not; the 2013 deficit is projected at $901 billion, down from the $1.17 trillion in 2010 and the record $1.75 trillion in 2009. Budgets are typically construed as part of a longer-term plan, and President Obama had planned to reduce the deficit to $533 billion by 2013—but a lagging economic recovery and failure to resolve “gridlock” over tax and spending policy have delayed that reduction. The deficit that remains is still substantially larger than those of the worst years of the Bush administration. That said, the Bush budgets do not account for expenditures that occurred largely outside the budget—for example, the wars in Iraq and Afghanistan, which were funded by supplemental appropriations bills, instead of the original budget or routine appropriations process.

It’s interesting to look at the specific areas of revenue and expense in the 2013 budget, and how those specifics compare to the recession-riddled year 2010. Note the effects of the rebounded economy and the $80 billion in interest “income” derived from bonds purchased in Fed open market operations:

REVENUES ($2.902 TRILLION, (+21.9% VS. 2010))

$1.359 trillion: Individual income taxes (+28.1%)

$959 billion: Social Security, other payroll taxes (+2.0%)

$348 billion: Corporate income taxes (+56.8%)

$88 billion: Excise taxes (+14.3%)

$33 billion: Customs duties (+43.5%)

$13 billion: Estate and gift taxes (−35.0%)

$80 billion: Deposits of earnings and Federal Reserve System (not previously separated out)

$21 billion: Other (−44.7%)

Unfortunately, so-called “mandatory” expenditures continue to grow, and will probably do so until “entitlement reform” actually takes place. Sizeable increases in the Social Security, Medicare/Medicaid, and Interest on the National Debt lines drive the mandatory spending increase:

MANDATORY SPENDING (MANDATORY SPENDING: $2.293 TRILLION (+5.0% VS. 2010))

$820 billion (+18.0%): Social Security

$860.3 billion (+15.8%): Medicare and Medicaid

$246 billion (+50.0%): Interest on National Debt

Some restraint on spending growth is evident in the “discretionary” side:

DISCRETIONARY SPENDING (Discretionary spending ($1.510 trillion (+10.4% vs. 2010)).510 TRILLION (+10.4% VS. 2010))

$666.2 billion (+0.4%): Department of Defense (including Overseas Contingency Operations)

$80.6 billion (+2.4%): Department of Health and Human Services

$67.7 billion (+45.0%): Department of Education

$60.4 billion (+15.0%): Department of Veterans Affairs

$56.1 billion (+8.5%): Department of State and Other International Programs

$54.9 billion (+28.6%): Department of Homeland Security

$41.1 billion (−13.8%): Department of Housing and Urban Development

Note that these are just the seven largest line items: there are twenty-one more line items, some as large as cabinet departments, some more specific, such as $7.4 billion for the National Science Foundation.

Why You Should Care

Just as you should care about your own income and spending and budget accordingly to make ends meet, you also should care about whether the government is doing the same thing—whether it is using your tax dollars appropriately, and making good decisions. Budget talk can be contentious at certain times, dull at others, and complex always, but it’s in your best long-term interest to keep tabs on what’s happening. Budgets are usually proposed early in a calendar year; you should find a favorite news source and keep track of them. Budget detail is available at the U.S. Government Printing Office “GPO Access” website from the Office of Management and Budget—see www.gpo.gov/fdsys/browse/collectionGPO.action?collectionCode=BUDGET. The current and upcoming year’s budget documents, while long, are always an interesting read.

42. FEDERAL DEFICITS AND DEBT

After reading the previous entry on the U.S. federal budget, you might understandably be concerned about the excess of expenditures over revenue, and what that might mean for you and for the economy. Put simply, if you spent that much more than you earned, you’d be in big trouble—deep in debt or worse.

What You Should Know

Truth is, the size of the federal deficit and the load of debt it has created is of great concern, especially to fiscally conservative politicians and citizens. Such large deficits and debts sap our future economic strength and may hinder our ability to borrow, as we must service—that is, pay—interest and principal on our current debt. There was great concern that because of already existing debts, the United States may not be able to borrow its way out of the recent economic crisis and downturn. So far, those problems haven’t materialized, as U.S. debt obligations are still considered among the world’s most secure. China in particular needs to support our economy because of the degree to which our economy supports its economy. Now the concern is about what happens next time around, when we’re still further in debt.

Figure 5.1 speaks for itself. You can see the tremendous bulge in the size of the deficit and the increase in the national debt that occurred in 2009, as federal programs were put into play to alleviate the effects of the Great Recession. Economists consider part of the deficit as structural, recurring as part of government’s overall initiatives and priorities, and some of it as cyclical, as in the medicine applied to fix the banks, reduce unemployment, and so forth. You can see that as some of the economic stimulus takes hold, the deficits and increases in debt are declining slowly, but still considerably exceed earlier figures, and for that matter, any time in history.

Figure 5.1 Projected Deficits and Debt Increases, 2001–2012

Source: Congressional Budget Office, U.S. Treasury

If there is any good news about deficits and debt, it is that they are still moderate compared to the size of the national economy. Government spending in the United States runs about 25 percent of GDP, compared to figures of 50 percent and higher for many other developed Western nations. The deficits, while huge in absolute dollars, have run somewhere in the range of 3 to 5 percent of GDP historically—again, not a large number on the world stage, but with the recent increases in the deficits and accompanying moderation in GDP growth, the figure has risen to 6.2 percent most recently.

Why You Should Care

Different people feel differently about being in debt. Clearly, the rising levels of debt “put the burden on our children,” but that’s been said for years. It’s alarming to think that our national debt runs about $52,953 per person (that’s $212,000 for a family of four, up about 60 percent since 2009)—if you ran up such debt on your own you’d be in big trouble! But the government can print money, and other nations find it in their interest to support our debt. Inflation may take some of the sting out of the debt as well (see #34 Reflation). But it is still a big elephant in the room, one to be concerned about for the future, and it argues for all of us to reduce our spending habits and not get carried away trying to prevent economic downturns (see #59 Austrian School).

43. SECURITIES ACTS OF 1933, 1934, AND 1940

While the Great Recession was a big deal, and new legislation has emerged from it (see #39 Dodd-Frank), so far it has not been a watershed for new securities and investment laws, as were the 1929 stock market crash and the Great Depression. Those events brought Congress to pass a series of laws to regulate the heretofore largely unregulated securities industry. Many newer laws have come onto the scene, but the four “biggies” remain the set passed in 1933, 1934, and 1940.

What You Should Know

The four laws listed below set the ground rules for selling securities to the public and for trading those securities, and for investment companies and professional investment advisers. They also set up and defined the role for the Securities and Exchange Commission (see #44 SEC).

Securities Act of 1933 was designed to limit outright securities fraud; it requires disclosure of financial information for securities brought to public sale. It also prohibits “deceit, misrepresentation, or fraud” in the sale of securities. It is sometimes called the “truth in securities” law.

Securities Exchange Act of 1934 did two things. First, it created the SEC and empowered it to register, regulate, and oversee brokerage firms and firms otherwise dealing in securities transactions, and also set up a system whereby it could extend its reach by aligning with industry trade organizations like the Financial Industry Regulatory Authority (FINRA), formerly the National Association of Securities Dealers (see #82 Brokers, Broker Dealers, and RIAs), and the securities exchanges themselves. Second, it required regular financial reporting to holders of corporate securities.

Investment Company Act of 1940 regulates so-called investment companies—companies set up to invest in securities and then sell their own shares to the investing public. This law set the ground rules for mutual funds. Those ground rules include tax-free pass-through of income, a requirement that at least 90 percent of income generated is paid out, and limits to sales charges and fees. If you own a mutual fund, that fund is designed within and regulated by this law.

Investment Advisers Act of 1940 regulates professional investment advisers. This law requires advisers, within certain definitions and limits, to register with the SEC and conform to regulations designed to protect investors.

These laws provide a framework, but aren’t absolute in nature; the SEC can and does have authority to add rules to these laws to close gaps and accommodate new technology and methods.

Why You Should Care

While it’s easy to think that financial firms, investment funds, and advisers got away with murder during the recent crisis, you should know that there is a fairly substantial framework in which they operate. That said, the shortcomings of the SEC became apparent. As a prudent individual, you should always make sure any investment adviser you deal with is registered.

These laws don’t cover everything in the investment markets. If you’re thinking about hedge funds (see #72), realize they largely escape this framework because they are targeted toward certain qualified individuals, not the public at large. As we found out with the recent failure of MF Global, a commodities trading firm run by former New Jersey governor Jon Corzine, they don’t apply to commodities trading, either. That may change, and new laws may also emerge to counteract scandals like the Bernard Madoff debacle.

44. SECURITIES AND EXCHANGE COMMISSION (SEC)

The Securities and Exchange Commission is an independent public agency within the U.S. government, chartered primarily to enforce the major securities laws outlined in the previous entry. The SEC is a vital referee in a game that, without referees, might well go out of control, although it has been on the hot seat for some important “no-calls” and bad officiating in recent years.

What You Should Know

The SEC is a large and complex organization, but much of it is organized in the following four major groups, three of which loosely align with the major securities laws covered above:

Division of Corporation Finance primarily oversees proper disclosure of regular financial information to the public, like annual and quarterly reports and other required filings, and so centers its activities on the 1933 law.

Division of Trading and Markets concerns itself with “maintaining fair, orderly, and efficient” markets. As such, this division makes sure exchanges, brokers, and others involved in trading securities follow the rules, especially those set forth in the 1934 law.

Division of Investment Management ensures proper registration and disclosure for funds, investment advisers, and investment managers—primarily the 1940 laws.

Division of Enforcement investigates violations and takes civil or administrative action when appropriate.

The SEC got into trouble in the aftermath of the Bernard Madoff scandal. In its defense, it simply doesn’t have the staff to properly police the rapidly expanding and ever-faster-moving securities markets. The staff of 4,000 must sift through 90,000 complaints brought to the SEC each year; out of these, some 794 enforcement actions took place in 2012. In addition to the complaints coming in, staff has a responsibility to examine things on its own to ensure compliance. Some still say the SEC is too cozy with big players, choosing to assume they’re right or to look the other way, while spending too much time enforcing registration and other minor compliance issues with smaller brokers and dealers. Under the leadership of Chair Mary Jo White, and with the backing of certain provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (See #39), the agency has taken many steps, including hiring more agents and reviewing internal processes, to deal with these issues. Today’s SEC is generally considered more aggressive in its investigation and enforcement of compliance within the securities industry