Monday, February 9

The Hedge Fund ‘Transparency’ (Regulation)

On January 29, Senators Grassley and Levin introduced The Hedge Fund Transparency Act, a revision to Grassley’s previously proposed legislation – Hedge Fund Registration Act of 2007 (S.1402). The 2009 Act calls for an amendment to the Investment Company Act of 1940. While titled a ‘transparency’ act, the proposed bill effectively broadens the regulatory authority of the SEC. The Act of 1940 defines an investment company and details the regulation set forth by U.S. Securities and Exchange Commission (SEC), primarily overseeing traditional mutual funds and closed-end funds. The act as currently written allows hedge funds to avoid being listed as investment companies because they are not open to the general public and often via pooled entities have fewer than 15 investors. Hedge Funds are only open to “qualified purchasers” or sophisticated investors (pension funds, endowments, wealthy individuals, etc) and thus are allowed to engage in higher risk, higher reward investments without the regulatory burden of the SEC.

As mentioned, hedge funds are currently not “investment companies” and are thus not subject to SEC oversight. Under the proposed bill, hedge funds would qualify as investment companies, but with special qualifications reducing the required level of disclosure and amount regulation. The availability of mutual funds to retail investors warrants the high degree of regulation and disclosure. The act would require all hedge funds to disclose the following:

(a) List the companies and natural individuals who are the beneficial owners of the fund
(b) Explain the ownership structure
(c) List of affiliated financial institutions
(d) Minimum investment commitment required from an investor
(e) Total number of investors in the fund
(f) Name of the fund’s primary accountant and broker
(g) Current value of the fund’s assets and assets under management (AUM) – effectively disclosing returns

Grassley and Levin provide three arguments for amendment, two of which have some merit. First, hedge funds have exploded by number of firms (10,000) and assets under management ($1.8 trillion), thus hedge funds play a significant role in the financial markets. Second, pension plans, endowments and charities invest in hedge funds leaving working class Americans and all sector of the economy susceptible to hedge fund activity. Last and most importantly, hedge funds have become commingled with the regulated financial sectors; many financial services holding companies of federally insured banks and insurance companies are also owners of hedge fund affiliates. As the funds encroach on the regulated and insured sectors, the ripple effects become severe, as exhibited in 2008. Levin highlighted in his speech on the Senate Floor such effects: Bear Sterns two affiliated hedge funds failed, Merrill Lynch’s investments in Bear Stern’s funds contributed to ML’s failure, with ML’s demise imminent, Bank of America (a FDIC insured depository institution) acquired ML. Bank of America, which received TARP funds, is now further susceptible the volatile and secretive hedge fund world. It is murky how the proposed disclosure would have prevented our current financial meltdown. Listing affiliated financial institutions would provide retail investors with some information regarding the potential risk to public listed firms; however, assessing the magnitude of losses would likely prove difficult.

It is important to note that hedge funds are not completely without regulation. Institutional investment managers, hedge funds qualify, with over $100 million in capital invested in exchange traded securities are required to report via Form 13F a listing of security holdings within 45 days of quarter-end. Said listings are available to the public via EDGAR.

The proposed regulatory requirement do not appear to onerous for the funds, nor is the mild disclosure likely to materially impact the funds ability to quietly build positions – often a key to ‘generating alpha’. Levin concluded his speech with the following remarks “The ‘Hedge Fund Transparency Act’ will protect investors, and it will help protect our financial system.” In analyzing the proposed legislation, it is unclear how the small amount of transparency will protect investors. Hedge funds will be subject some oversight by the understaffed SEC, but it is difficult to ascertain if the proposed level of disclosure would have reduced the carnage in the markets in 2008. Levin further noted that “It is time to bring hedge funds under the federal regulatory umbrella”, which indeed this entry-level regulation will open up hedge funds to further regulation in the future. Restrictions on holdings and leverage would be particularly negative for fund managers. Hedge funds are at the top of a slippery slope of regulation which will hopefully not continue the US march toward less competitive capital markets.

Sunday, February 8

Obama’s Fiscal New Year’s Resolution: Don’t Repeat the New Deal Tax Hikes

President Obama is starring the greatest economic problem since FDR took office in 1933. FDR’s New Deal provided America with a few much needed institutions, including the SEC and the FDIC; however, critics of the New Deal highlight stifling tax hikes as a coagulant to the economic recovery. A few of the New Deal-esque policies (oversight, transparency, and employment stimulus) will provide a good template for the new administration; tax policy should be avoided at all cost.

The New Deal and Great Depression coincided with the rise of a new economic theory developed by John Maynard Keynes focusing on demand side stimulus. FDR simultaneously slashed unnecessary expenditures from the Government Budget, while implementing new projects to raise employment. A similar proposition has been presented by Obama, a careful examination of the each budget line item with the promotion of infrastructure projects, most notably the digitalization of medical records. The New Dealers felt a rise in spending with out a coinciding rise in tax receipts would create budget deficits that would impair the economic recovery in the medium term. FDR targeted Corporate America and America’s rich to provide the additional revenue; favoring income taxes over consumption taxes.

FDR took his pound of flesh from corporations through the Undistributed Profits Tax (UPT), essentially taxing corporations on ‘excessive’ retains. The controversial, short lived tax initiative has been widely criticized for reducing investment. Corporations were forced to dividend retained earnings or pay hefty federal taxes (upwards of 80%). The combination of higher taxes on the investment savvy rich and newly cash strapped corporations resulted in a substantial decline in investment in the laste-1930s. Capital investment will be a crucial patch to resurrect the sinking USS Economy. American industries are becoming less competitive in comparison to the low cost countries. Investment in America’s competitive industries, high tech, biotech, and pharmaceuticals can promote job development and hopefully a little labor mobility for the skilled engineers and factory workers in Detroit.

While there is no doubt American could use a little of the Japanese thriftiness, kick starting consumption is one option for short-term stimulus. The Obama administration needs develop tax neutral policies to promote investment and consumption. While it’s possible that the Bush capital gains and dividend holidays provide some incentives, these holidays should be allowed to lapse in 2010. But what to do in 2009? A few alternatives are examined.
- Depreciation and R&D tax credits – the trickle down often proves slow, but investment will increase labor productivity and eventually provide employment for the jobless Americans. Again, the US has proved competitive in biotech and high-tech industries.
- Repatriation Holiday – The American Jobs Creation Act of 2004 included a provision for multi-nationals to take an 85% deduction on repatriated income of foreign subsidiaries. This was a widely criticized move, as it may incent companies to shift jobs overseas. The repatriation would need to be a one-time plan to not have substantial negative revenue impact in the coming decade.
- Payroll tax on foreign nationals – Levy punitive payroll tax on US corporations with a labor force of greater than X% (say 10%) foreign nationals.
- Tax gaming – The US gaming industry has lobbied to be apart of the bailout, but typically when state budgets get tight, the states levy taxes on the gaming industry. A similar federal tax could be imposed on the gaming industry.
- Payroll tax on waistlines – Sedentary lifestyles and poor eating habits have contributed substantial to the healthcare burden on the US government. The US could again borrow from Japan, taxing corporations based on employee fitness.
- Restructure the AMT – The alternative minimum tax was morphed from its original intention to target a few hundred of the wealthiest Americans to more than 23 million in 2007. The AMT is hurting the struggling middle class.

The above list is by no means exhaustive, but is food for thought. The FED is generally thought to be pushing on a string; in the middle of the worst economic crisis since 1930, every sector of the US government appears to pushing on a flimsy string. Obama needs to reduce the wasteful spending proliferating the recent stimulus bill. Prudent spending with thoughtful tax incentives and revenue neutral policies will hopefully mitigate a difficult economic environment.

Saturday, February 7

Reading the fine print

Ever wonder what exactly is going into the stimulus bill? Taxpayers and legislative voyeurs are strongly encouraged to visit and contribute to, an admirable effort to engage the public and shine some light into this massive spending effort.

As of this morning, it appears that the swing-vote trifecta of Sens. Olympia Snowe, Susan Collins and Arlen Specter have leveraged their new-found power and crafted a legislative compromise that will allow passage of the stimulus package. On Thursday evening, Sen. Specter (R-PA) spoke on PBS' NewsHour with reporter Ray Suarez. Sen. Specter was surprisingly diplomatic and gracious- surprising for a curmudgeonly old lawyer who has consistently been ranked as one of the "meanest" senators in Washingtonian Magazine's annual poll of capitol hill staffers. He brought up an excellent point that crystallizes the debate about this stimulus bill
RAY SUAREZ: We just heard from the director of the Office of Management and Budget, Mr. Orszag, who told my colleague, Jeff Brown, that they've been wrestling all along with the balance between tax cuts that get into people's hands right away, but sometimes aren't very stimulative, versus spending that rolls out over a longer period of time, but you get a good bang for the buck.Are you close? In the package that's being presented by the bipartisan group, are you close to striking a balance that you can support?

SEN. ARLEN SPECTER: Well, I think we'd be better off with more tax cuts. They are more immediate. And there are many items in this stimulus package which do not go to stimulate the economy.I think -- and I've been on the Appropriations Committee for all of my 28 years -- a lot of these items ought to be taken up in regular order in Appropriations. And we ought to be directing the stimulus package to things that will stimulate the economy now.When we are burdening the taxpayers with this tremendous additional burden, we ought to be very, very sharply focused. We ought to have a lot more in that on highways and bridges and mass transit, high-speed rail. We ought to be looking to energy items.But there's a great deal of this bill on items I have long supported, but that ought to be in the regular appropriations process.
Many supporters of the bill have argued that the package should include long-term investment items that will not necessarily stimulate now, but will benefit the economy greatly in the long term. Spector's argument- which seems quite reasonable- is that if those are long-term investment items that won't serve as short-term economic stimulants, why not take them up in the normal appropriations process?

The budget is going to be hashed out in the next 3-6 months anyway, so why not utilize the more thorough process it entails? This would insure that Congress properly prioritizes whatever spending level is eventually authorized. The risk of pursuing this shotgun wedding approach is that many deserving yet underrepresented spending opportunities might get passed over, while inefficient yet well-represented pork projects gobble up all the funds.

From a political perspective, one has to question President Obama's decision to let Congress drive this process from the outset. In the last week he has belatedly stepped in to shepherd the bill's passage, leveraging his popularity and rhetorical skills. But during the last month, Harry Reid and Nancy Pelosi's mismanagement of the process galvanized the Republicans and allowed them to build a unified front of opposition. Two months after receiving an electoral drubbing, congressional Republicans seem to have more momentum than the victorious Democrats.

On the flip side, Obama stands to gain from Sen. Reid and Speaker Pelosi's mistakes. As a relative newcomer to Washington, one of Obama's biggest weaknesses is his lack of power within his own party. The existence of a consistent, well-reasoned and occasionally victorious Republican opposition could prevent the kinds of excesses that we saw in 2002-2006, when a completely ineffective Democratic opposition and a weak president allowed power-crazed Republicans to run amok, eventually destroying their own majority.

Wednesday, February 4

Unintended consequences, volume 1

President Obama announced today that the government will restrict compensation at firms receiving government bailout funds to $500,000 a year. It intelligently allows exceptions for the granting of restricted stock that could not be sold until government funds are repaid. However, it faces it's share of unintended consequences.

First, it could very well force out key talent. To cite but one example, a trader that made $10M in profits for a bank last year could decide that they would rather work at a hedge fund, where the fund could pay substantially more. The trader's bank would lose out on that $10M in profits at a time when they desperately need to find ways to generate profits. Another line of reasoning is this: many of these banks executives are worth millions of dollars. For $500K a year, many could decide they are better off retiring than dealing with grueling 15 hour work days, incredible stress, and now, reduced pay.

Second, it could incentivize banks to pay back government funds quickly. The government would like to be paid back, but at the moment they would rather have the bank lend out those funds to get credit working again. Already Goldman Sachs has indicated it intends to pay back TARP funds rapidly. Wells Fargo has been one of few big banks loaning out money, but with restrictions imposed, it might decide it is better off paying back the government than issuing new loans. By paying back those funds, they reduce their ability to make loans dramatically, prolonging the credit crisis that TARP aimed to fix.

Third, this makes the already dubious policy of forcing government funds on banks even more suspect. The Wall Street Journal reported that Wells Fargo did not want bailout funds, and was essentially required to accept them. While the dilution was bad enough, the additional restrictions Obama is now imposing restrict the compensation of the banking executives that got it right by making smart, prudent loans. While the Obama administration has indicated the condition can be waived under certain circumstances, the fact that Wells Fargo - a successful bank that can help the U.S. emerge from the crisis - is encumbered by government regulation at all demonstrates how seemingly sensible legislation can slow the recovery.

Should this proposal be scrapped in its entirety? Probably not. But the government would be better suited to splitting funds into two types: a solvency bailout complete with restrictions and a lending fund with few restrictions. The solvency funds would be available to firms as a last resort to catastrophic banktrupcy, and could carry heavy restrictions and punitive interest rates/equity ownership stakes. AIG, Citigroup, GM, Chrysler, and other seriously impaired businesses would be the recipients of these funds. These funds would not be designed to spur new lending, but instead would be targeted to preventing the collapse of key institutions. Simply knowing the these funds exist for the purpose of recapitalizing insolvent financial institutions would alleviate some market uncertainty and would help restore lending.

The second type would be to explicitly encourage lending, and would have one simple restriction: net loans outstanding must increase by 90%* of the capital provided to the bank by the next quarter. The interest rate would be low, and the term long. The government loan would have to be double-guaranteed, collateralized by the new assets the bank acquires AND guaranteed by the parent bank's equity. Otherwise healthy institutions - like Wells Fargo - could access these funds voluntarily, and the incentive to obtain long-term, low cost financing that could be used to facilitate profitable lending operations would create strong incentives to take advantage of this program. Yes, this program would be providing a subsidy to healthy banks, but the benefits of restarting lending operations would make the money well spent. Not only would this remove restrictions from banks that should have never faced them, it would jump-start lending and provide specific accountability for some proportion of the TARP funds.

*Or whatever percentage is appropriate given the banks typical loan loss reserve ratio. A second restriction would be that recipients of bailout funds could not recieve the lending funds.

Obamanomics arrives: policy priorities for the new President

President Barack Obama faces a long economic "to-do" list in his first term. The first 100 days must focus on stabilizing the economy by fixing the financial sector and passing a well-crafted stimulus bill. These policies will set the tone for the longer-term reforms required to address budget deficits, regulatory reform, and waning U.S. competitiveness.

President Barack Obama faces a long economic "to-do" list in his first term. The first 100 days must focus on stabilizing the economy by fixing the financial sector and passing a well-crafted stimulus bill. These policies will set the tone for the longer-term reforms required to address budget deficits, regulatory reform, and waning U.S. competitiveness.

1. Fix the Banks
Obama must first fix the nation's banks if he hopes to fix the American economy. Wall Street is directly linked to Main Street: businesses unable to obtain credit cannot make payroll, service debts, or invest in new job creation. President Obama must recapitalize the banking sector, clearly articulating principles for when and how the government would intervene. Bailouts should be used only when market-failure could trigger a contagious downward spiral, and should be structured to prioritize limiting economic damage first, safeguarding taxpayer investments second and minimizing inefficiencies and distortions third. With this commitment to stability and Federal Reserve liquidity flooding into banks, lending and job creation will return as the economy stabilizes. Public opposition to the first bank bailout program may make President Obama hesitant to act, but failing to do so is a recipe for failure.

2. Craft a smart stimulus bill
If the President's first economic challenge is courage in the face of opposition, the second will be to seize the opportunity - and avoid the pitfalls - that his stimulus plan presents. How the $825 billion of proposed funds are spent - on tax cuts, transfer payments, local government grants, or investments - must balance boosting employment with investing in future growth prospects, while easing the burden on those most impacted by the recession. Numerous interest groups, some of which expect payback for votes delivered in November, will seek to push their constituents' interests over these national priorities. Succumbing to these interests or trying to make the recession painless is the fastest way to ensure that government inefficiency and the rejection of free markets stain Obamanomics with the mark of failure. The President proposed significant accountability to minimize these failures in implementing the policy but first must determine the optimal mix of tax cuts, transfers, grants and spending.

Tax cuts that incentivize investments in future GDP growth deliver tremendous value. They act quickly, align the nation for the future, and prioritize free-market efficiency. Obama's earned income, college tuition, and first-time homebuyer credits for individuals and his business tax credits all meet these criteria. These should be retained and expanded. Conversely, Obama's plan to provide lump-sum tax cuts unrelated to GDP boosting investments - similar in nature to the failed 2008 rebate check strategy - is $140 billion better used to bolster government investments in infrastructure and education.

The $550 billion of spending outlined by President Obama includes transfer payments, grants to local governments, and investments. Transfer payments (largely extended unemployment insurance, food stamps, and college aid exceeding $100 billion) provide an immediate boost to growth and a cushion to those most impacted by the recession. Obama should extend these transfers, but must ensure that individuals have a clear path back to fruitful employment by creating jobs and providing education and job retraining programs.

The $200-plus billion in grants to local governments to maintain healthcare, education, and public safety service levels shield governments from recession much as transfers shield individuals. These grants advance worthy goals, but they allow government officials to avoid reducing costs or increasing efficiency as recessions normally force officials to do. Obama should only deliver grants to local governments that are willing to improve efficiency and cut costs before turning to grant money.

The remaining $200-plus billion is allocated to a laundry list of investment projects. Projects should be reprioritized using an investor's mindset, calculating the amount and timing of future benefits produced relative to the cost of the project. High return-on-investment projects should be prioritized, whether the return comes as GDP growth, better healthcare outcomes, or a cleaner environment.

Implementing this approach will require political courage, for some projects may be politically unpopular. To cite but one example, the plan devotes $650 million to subsidizing TV converter boxes, generating minimal economic benefits but politically popular amongst recipients. Those funds would be better spent boosting the measly $25 million allocated to charter schools - a move that benefits predominately inner-city students but might anger teacher unions who strongly supported Obama. President Obama must muster the courage to demand sacrifices from close supporters as well as those with different ideological views to pass the most effective stimulus bill.

3. Start planning to fix the deficit -- including entitlements
President Obama's short-term economic challenges seem formidable until confronted with the long-term problem of balancing the government's budget deficits - including the rapidly growing entitlement programs. President Obama rightfully notes that the issue has been ignored for too long. With near-record high popularity - and hopefully a track record of competence, cooperation, and fairness gained from his stimulus bill - the President has a strong position to negotiate long-term solutions for the consolidated Federal budget. While the President's chances for re-election may hinge on the success of his stimulus plan in diverting economic decline, the history books will focus on his resolution - or lack thereof - of this critical issue.

4. Get the regulation right
History is less likely to remember the President for regulatory reform, but the economy will certainly notice. The financial sector regulatory failure of the past two years exemplifies the need for reform. Institutions overseen by numerous different agencies failed, and the response from the Federal Reserve, Treasury Department, FDIC, and various smaller agencies seemed muddled at best. Instinctively, politicians called for more regulation. But it is not more regulation that is necessary but better regulation. Consolidating regulators, assigning exclusive jurisdiction, and focusing on fewer but more important rules lowers costs and increases effectiveness. The potential for dramatic (if underappreciated) impact on the economy earns regulatory reform a place on the President's to-do list.

5. Put government on business's side
That to-do list has so far focused on government bailouts, stimulus, and regulation. However, business, not government, drives long-term economic prosperity, and America's business environment has deteriorated relative to other nations. American businesses seem constrained by the government instead of supported by it. This must change; supporting business competitiveness should be an explicit government goal. The Obama Administration should enlist the private sector in developing a strategy to address American competitiveness. Whether investing in education and infrastructure, reforming regulatory, administrative, and judicial processes, or tailoring tax laws, government support of business is critical to growth. Encouraging businesses to invest and innovate is the only way to ensure long-term economic success. The new Administration must find ways to encourage private investment and innovation to sustain the recovery the stimulus will hopefully spark.

The President has noted that in crisis lies opportunity. Mr. Obama should seize the opportunity before him to not only lead a short-term recovery but enact policies that set a course for generations of American prosperity.

Wednesday, January 28

FOMC Holds Target Rate Near Zero With Explicit Inflation Targeting

On January 28, 2009 the US Federal Open Market Committee (FOMC) announced that it planed to keep the target rate between zero and ¼ %. The announcement comes in the wake of the continuous stream of weak economic news. The low rate is likely to persist well in to 2009 with the committee noting that it anticipated a slow turnaround with considerable downside risks. It appears the FOMC is concerned with the low inflationary environment, noting that inflation remains below the sufficient level for strong economic growth. The Fed is concerned that the US will enter a deflationary environment similar to that of Japan in the 1990’s.

The Fed is officially targeting an inflation range of 1.5-2.0% per the FOMC’s semiannual report to lawmakers. Ben Bernanke is a proponent of inflation targeting having co-authored the book “Inflation Targeting: Lessons from the International Experience.” The book highlights a few key benefits of inflation targeting, (1) countries achieve lower inflation rates and lower inflation expectations, (2) price shocks have a reduced impact on sustained inflation; (3) lower nominal interest rates as a result of lower expectations; (4) better transparency and public understanding of monetary policy; and (5) accountability for policy makers. Interestingly, Bernanke notes in his book that inflation targeting has become a popular tool for central banks as result of economists’ belief that monetary policy is not an effective tool for spurring the economy in the short-run.

The book presents three main reasons for the adoption of inflation targeting in the early 1990’s by a host of industrialized nations including New Zealand, Canada, and the United Kingdom. First, economists are less confident in monetary policies ability to alter short-run changes in the economy. Secondly, low stable inflation is required for sound economic growth and price stability is essential for imposing accountability on central banks. The book further points out a break-down in the trade-off between inflation and unemployment. If inflation inhibits economic growth, moderate-to-high rates of inflation may actual result in higher rather than lower unemployment rates.

Inflation targeting is a relatively new phenomenon, replacing former Fed Chairman Alan Greenspan’s FOMC tool of interest rate targeting informally re-enacted in mid-1980’s (potentially as early as October 1982). Interest rate targeting through the fed funds rate was the result of Greenspan’s assertion there was not a stable relationship between the borrowed reserves and the fund rate. The Fed now believes explicit inflation targeting is the best tool to mitigate the delicate balance between (1) a deflationary (Japan 1990s) economy and (2) an inflationary (US 1970s) economy. The Fed has aptly phrased the paradox as the Two-Headed Dragon.
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