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Why Tax Cuts are Disproportionate

Kevin Williamson writes Blue Voodoo in National Review.

Excerpts:

 The cartoon version of conservative economic thinking — that we should subsidize gazillionaires in order to create work opportunities for yacht painters, monocle polishers, and truffle graters — is fundamentally at odds with the facts. The supply-siders may have wrong economic ideas, but they do not have those wrong economic ideas. President Ronald Reagan, for example, loved to boast of the number of poor and modestly-off Americans his policies had removed from the federal tax rolls entirely. George W. Bush promised that he’d take the poorest fifth of taxpaying U.S. households off the federal tax rolls; Heritage estimates that he succeeded in doing so for about 10 million low-income households.

One of the perverse consequences of conservatives’ success in lowering the federal income-tax burdens of those on the left half of the earnings bell curve is that we have finally arrived at the point where our critics are partly correct: Most conservative plans for tax cuts at this point in history do disproportionately favor the wealthy and the high-income, for the mathematically unavoidable reason that they pay a steeply disproportionate share of federal income taxes, making it very difficult to design a tax-cut plan that does not disproportionately benefit them. It’s hard to cut taxes without cutting them for the taxpayers.

HKO

The more progressive the tax system is the more that the economy is dependent on the wealthy and thus subject to the same volatility. Tax cuts will favor the rich if the lower income have paid no taxes.

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Leveraging Ignorance

John Paulson

The Greatest Trade Ever by Gregory Zuckerman is the story of John Paulson and a handful of other traders who took positions against the mortgage market and made fortunes in a very short period of time.  Their primary method was to buy credit default swaps.  These swaps acted as insurance against the default of mortgage backed bonds, and were sold very cheaply by those who held the mortgage securities in order to spice the yield.

The trade started with the observation that housing prices were a bubble.  Housing had advanced far beyond a trend line and would have to drop 40% or more just to return to the trend line.  They also noted the tremendous growth in subprime mortgages, variable rate mortgages, LIAR loans, interest only loans and other varieties of mortgages that strongly indicated a much weaker ability of borrowers to fulfill their commitments.  In searching for the right tool to profit from shorting the mortgage market these investors stumbled across the credit default swaps.  The market for these swaps was very thin and most of the brokers did not know about them or fully understand them.

At the time John Paulson and other were taking these positions against the mortgage market,  most of Wall Street thought them fools and were too willing to find investors willing to sell swaps on their positions.  Given that housing was constantly rising it seemed like easy money to sell swaps to those who foresaw Armageddon in the housing market.  Major firms like Lehman, Bear Sterns, and almost all of the major names had huge positions in collateralized debt obligations or CDOs; interest bearing securities backed by pools of mortgages.

But very, very few could visualize this house of cards the way Paulson and the other contrarians did, and even fewer still were confident enough in such a contrarian position to make such strong trades, putting a lot of money where their mouth was.

The first to see the opportunity was Michael Burry.  Trained as a doctor, Burry retained an interest in trading and eventually started his own fund, but he had a difficult time attracting traders who both understood his position and had the nerves and patience to endure the trade.

The big Kahuna in the trade was John Paulson who was able to attract investors to two funds and was able to maintain control to ride the trade to its peak.  Paulson’s two funds averaged a gain of 440% in a year that the stock market was up only 3.5%. His firm racked up a profit of $15 billion and his personal take was almost $4 billion.

With the exception of Greg Lippman at Deutsche Bank, these traders were outside the mainstream of investing, unassociated with the big name Wall Street firms. This speaks volumes about the level of group think in the industry even when markets move to extremes.  Well paid analysts sporting sophisticated mathematical models were assuring their investors and the public that the housing market was sound and even if prices stopped climbing that there was very little risk in the market.

Government agency  leaders such as Fed Chief Bernanke, retired Fed Chief Greenspan, and Treasury chief Hank Paulson (no relation to John, at least none was noted in the book) assured the public that nothing drastic was afoot.

When markets move to extreme it often pays to be a contrarian.  But the market did not move precisely timed with their trade. Early in the trade the markets moved against them and their racked up losses.  Even when housing prices declined they could not figure out why the securities derived from mortgages did not drop with the housing market.  Investors in their funds became very nervous, and many headed for the exists. But eventually the thinking proved correct and their bets earned huge returns.

Did these traders contribute to investor losses?  To the extent that firms had to make good in the credit default swaps they chose to sell to Paulson and others, yes.  But the same firms made money on the swaps as they sold them. They just made bad bets.

Seeking more securities to trade in a thinly traded market, Paulson encouraged Goldman to create a CDO with low quality mortgages just so he could short it.  Goldman was held to account for this action, but no charges were brought against Paulson.

While such trades are rare, and those with the nerves and ability to capitalize on them are very, very few, this book is an excellent look at the thinking of contrarians.  While it shows the value of truly independent thinking, it equally shows the danger of blind groupthink that grips our government and financial institutions.

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And Now for the Rest of the Story…

The outcome of the 2008 election centered around the financial collapse that hit just months before the vote.  Even the most committed capitalists were taken by surprise at what seemed like a significant failure of capitalism.  Outrage was magnified as taxpayer dollars were used to bail out Wall Street millionaires.  In the months before the election we had little insight as to what caused this catastrophe.

Three years later we have collected insights from several good books on the subject.  With the clarity of hindsight we see that there was much more than Wall Street greed involved.  This is not to excuse the behavior of the self proclaimed financial masters of the universe who created self acknowledged crappy products as long as they could find suckers somewhere on the planet to buy their crap.  Their hubris rationalized absurd leverage because they bought into the “this time it’s different” mindset that seems to accompany every financial collapse.  They replaced an old school philosophical understanding of risk with a delusional mathematical certainty based on mathematical models that had soon to be realized severe limitations when applied to human action.   It is amazing what people will believe when they get paid outrageous sums.

But this was not enough to explain what happened.  As Thomas Sowell noted, blaming this collapse on greed is like blaming an airplane crash on gravity.  Greed has always been with us; why would it show so strongly at this time?

This excess was fed by the very institutions that claim to protect us.  Rating agencies gave higher ratings than merited because of implied government guarantees. Worldwide investors poured money into this market because because of the high scores from the ratings agencies.  But the center of the implosion was the housing market and this bust was the direct effect of Federal housing policies and the two Macs; Freddie and Fannie.  Wall Street served the political aims of a government that thought everyone should own a home, regardless of whether they could afford it.  To facilitate this objective Freddie and Fannie threw prudent lending out the window.

At The American Peter J. Wallison and Edward Pinto write Why the Left Is Losing the Argument over the Financial Crisis, 12/27/11.

Excerpts:

To the extent that we have had any success in challenging the conventional narrative about the causes of the crisis, it is because fair-minded people are persuaded by facts, not invective. Our argument is and has been that the financial crisis would not have occurred but for government housing policy implemented principally through Fannie and Freddie and the Department of Housing and Urban Development (HUD). Although there were a number of such policies, the most important were the affordable housing requirements first imposed on Fannie and Freddie in 1992 and expanded and tightened by HUD through 2007.

All told, after adding the SEC’s new data to our original estimates, there were approximately 28 million subprime and Alt-A loans outstanding on June 30, 2008, before the financial crisis, with a value of approximately $4.8 trillion. This was half of all mortgages in the United States. Of these loans, over 74 percent were on the books of U.S. government agencies and firms subject to government housing finance policies. This shows where the demand for these low quality loans came from. Fannie and Freddie were themselves exposed to more than 13 million subprime or Alt-A loans, or 65 percent of the government total.

HKO further comment:

We are only now beginning to see Washington take responsibility for their role in this crisis.  Any effort, law, or regulation that seeks to either solve this problem or prevent such a crisis from being repeated, that does not acknowledge and address this important factor is doomed to fail.

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This is Rich

George Soros is closing his hedge fund to outside investors because of the new financial regulations.  He will be returning investor’s money.

Excerpt from Soros to close Quantum fund to outsiders by Dan McCrum:

Quantum, which will continue to manage about $24.5bn of Soros family money, blamed the decision on new financial regulations requiring hedge funds to register with the Securities and Exchange Commission.

“An unfortunate consequence of these new circumstances is that we will no longer be able to manage assets for anyone other than a family client as defined under the regulations”, Jonathan and Robert Soros, Mr Soros’ sons and Quantum’s co-deputy chairmen, wrote in a letter to investors on Tuesday.

New regulations require hedge funds with more than $150m under management to report details about investments, employees and investors, and also makes them subject to possible inspections by the SEC. Mr Soros’ decision contrasts with his own reputation as an advocate for both government and corporate transparency.

HKO Comment:

The Dodd Frank Bill increases regulation and oversight of the sectors that had little to do with the collapse such as hedge funds, and does little to regulate the sectors that most precipitated the collapse, most notably Fannie and Freddie which the bill’s authors had most defended from the requests for oversight prior to the collapse.  We seek the protection of the government, yet fail to ask who will protect us from the government.

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Deregulating Glass-Steagall

The Glass-Steagall Act was passed in 1933 in response the Crash of 1929.  It built a wall of separation between investment banking and commercial banking. It sought to isolate the purpose of providing loans for mortgages and small businesses from the far more speculative and leveraged investments of investment banking.  The intent was to isolate the losses from financial speculation from the businesses on Main Street.

In 1956 the Glass-Steagall Act was extended by the Bank Holding Company Act to separate insurance and banking.  Banks could sell insurance policies but could not underwrite them.

Some argued effectively that modest diversity in banking could reduce risk, and that the Glass-Steagall act could actually be making banks riskier.

In November of 1999 the Glass-Steagall Act was effectively repealed by the passage of the Gramm-Leach-Bliley Act (signed by President Clinton), which removed both the wall between commercial and investment banking and the wall between insurance underwriting and other banking services.

Clinton signs repeal of Glass-Steagall Act

This was major deregulation, and its wisdom in hindsight given the financial collapse is seriously questionable. Perhaps the assumption of transparency was valued too highly and perhaps regulators and Alan Greenspan thought market discipline would be sufficient.

Banks were restricted in many ways and had to compete with investment products like money market funds. The market was eroding the walls before they were officially demolished. There were also concerns about the ability of our financial centers to compete in global financial markets.  Yet the excesses that led to the original passage of the Glass-Steagall in 1933, quickly re-emerged when it was repealed.