“It's a Wonderful Life,” but It's the 21st Century

Some things don't change. Some do.

The last two postings discussed a number of timeless financial management lessons one can learn from “It's a Wonderful Life.”  However, some things change.  Generally, what changes is how to accomplish things that make sense rather than the things one should try to accomplish.   

What hasn't changed is the first rule of investing: “don't lose the capital.”  For banks loans are investments.  The most important thing in lending is to get paid back.  Now, all investments have risk, and some loans will default.  Yet, starting with a loan that one expects will default makes no sense.  That hasn't changed.

In the November 19, 2012, WALL STREET JOURNAL, there was an article entitled “For 'Credit Invisibles,' A Market Takes Shape: FirmsDevising New Methods to Score the Previously Shut-Out.”  It addressed a topic that is highly visible in “It's a Wonderful Life.”  Specifically, the issue it addresses is that without debt it is hard to get a loan.  Nothing demonstrates that one will pay back the loan better than paying back loans.

In the movie “It's a Wonderful Life” the solution is implied rather than explicitly stated.  One should recall that many of the customers to whom Bailey Building and Loan lends aren’t strangers.  As George explains to his customers during the run on Bailey Building and Loan, their money has been lent to their neighbors. 

In fact, a loan to a friend of George’s, Ernie the cab driver, plays an important role in the movie.  Potter uses it as an example of why Bailey Building and Loan should be closed down.  It results in George responding with one of the most memorable parts of the movie, a speech that is often quoted. He points out that the majority of people at that point in time had no credit histories.

Experian Information Solutions Inc., the large credit bureau, estimates there are 64 million credit invisibles in the U.S.  The term “credit invisibles” refers to those who can't access loans based upon their credit score.  The credit score has become the replacement for George’s firsthand familiarity with the borrower.  That there is a segment of the population that does not have access to credit is not new.  What is new is that it is no longer the majority of the people referenced by George in “It's a Wonderful Life.”  The estimate of 64 million is a lot of people, but it doesn't represent the majority referenced in George's speech.
So while the portion of the population may have changed, the issue is the same.  As is pointed out in “It's a Wonderful Life,” more important than that firsthand familiarity with the borrower is “character.”  George makes explicit reference to it at one point.  

The issue for a lender isn't whether the borrower is a friend (or whether they're in the majority).  The issue is whether the borrower has the character to pay back the loan.  As the WALL STREET JOURNAL article points out, “some of those consumers [the credit invisible] are worth the risk.”  In a world that is fair, people with the character to pay back their loan should have access to credit.  The article goes on to describe some of the steps being taken to try to identify those consumers who have the character to pay back the loan.

It's interesting that some of the proposals to address this issue involve looking at things like rent and utility payments.  Of course those would have been known to Bailey Building and Loan.  But, to harken back to the theme of this year’s first postings on “It's a Wonderful Life,” one finds that there always advocates for bad financial management.  For example, the WALL STREET JOURNAL article states: “Consumer advocates have objected to the proposal, saying it may penalize low-income customers who occasionally skip payments.”  One has to wonder how people can consider themselves a consumer advocate when they are advancing the notion that people who are having trouble paying their rent and utilities should get into debt. 

A substantial portion of the “credit invisible” has gotten there because of previous experience not being able to manage credit.  That's a major difference between the issue currently faced by financial institutions trying to make lending decisions and Bailey Building and Loan.  Bailey Building and Loan was mainly dealing with people who never had credit.  By contrast, the article in the WALL STREET JOURNAL highlights a very different issue.  It notes that many of the people who are credit invisible have tarnished, incomplete or nonexistent credit files."  As one of the people interviewed for the article says, “when you have bad credit, it's hard to ever get credit again.”

Lest the difference be misunderstood, George makes explicit reference to the fact that one of his customers experienced financial difficulties.  He uses it as an example of why they should want to keep Bailey Building and Loan going.  He points out that Potter would have evicted the customer.  So, the difference is partially quantitative, but one should doubt that George is referring to problems that resulted from previous use of credit.  In the 1920s and 30s, such problems were not common among much of the population.

So, let's inventory.  Both in the “It's a Wonderful Life” and now, banks have to deal with the issue of how to identify those with the character to repay a loan.  Now banks have access to extensive records on previous debt payment that weren't available in the 1920s and 30s.  But those records only go so far in identifying creditworthy customers.  There is still a substantial portion of the population that should be able to manage credit but who do not have access to credit.  It's currently a much smaller portion than it was 20s and 30s, but it is, nevertheless, a substantial number of people. 

The reason why credit is denied to many people is no longer just lack of previous credit experience.  An issue that is much more important now than it was in the 20s or 30s is how to address the people who have previously failed in their credit management experience.  Further, there is now a substantial group of “consumer advocates” who seem more interested in getting people into debt than in the well-being of consumers.

While many things have changed, one thing remains important.  As the WALL STREET JOURNAL article states about efforts to address the issue: “Those efforts could offer a reprieve to millions of Americans who have been denied credit, not to mention deliver a windfall to banks scrambling to find new sources of revenue.”  Improvements in the ability to identify individuals with the character to repay their loans have tremendous benefits both to the individuals involved and to banks.  What is often overlooked is that missteps in identifying the individuals with that character have tremendous cost.

Comparing “It's a Wonderful Life” to current issues surrounding how to identify individuals who will repay their loans highlights one aspect of the issue.  It makes it quite obvious that the issue is timeless: it has always existed.  It also isn't unique to developed economies. 

Much of the world experiences the difficulty of identifying individuals with the ability and character to repay their loans in a way that is similar to “It's a Wonderful Life.”  Consumer credit markets are new in many parts of the world, and credit bureaus, and the associated credit files, don't exist.  When it comes to access to consumer credit, a substantial portion of the world's population exists in a state similar to George Bailey's customers.

In many respects in the developing world the situation is the inverse of the US.  The US is trying to figure out how to identify those worthy of credit after a period of excessive ability of credit.  In the developing, world the problem arises from the total absence of consumer credit.

Given the difference in the issues being addressed, it isn't too surprising that lenders in the developing world are seeking approaches that avoid the reliance on credit history.  For example, Lenddo.com is developing analytic techniques that focus on measuring the financial responsibility of a consumer from information other than his or her previous credit history.  In developing economies where consumer credit markets don't exist, such techniques are vital.

If there is any doubt that the problem is the same (i.e., judging the character of the borrower) it should have been eliminated by the founder’s presentation at TEDxWallStreet.  The presentation, entitled “How Facebook, Twitter, Google+ and LinkedIn will change Finance” is quite explicit about the nature of the problem.

A good deal of The Hedged Economist’s career focused on how to use information in lending decisions.  Lenddo.com’s approach is intriguing and represents a significant effort to return to character lending.  It has the potential to provide tremendous benefit to consumers in developing economies. So, a disclosure that The Hedged Economist is an Angel investor in Lenddo.com should not be surprising.

“It's a Wonderful Life,” and the “Fiscal Cliff.”

Addressing the fiscal cliff without politics.

Continuing with the theme of the last posting “It's a Wonderful Life’ and It's Good Financial Advice,” it's worth looking at the fiscal cliff from the perspective of the financial management wisdom of “It's a Wonderful Life.”

On November 3, 2012, the WALL STREET JOURNAL had a piece entitled “Tackling Investor Ignorance.”  It was an interesting effort to try to point out a major financial problem.  They deserve to be congratulated for addressing the issue.  As they stated: “The financial crisis exposed greed, reckless decisions and regulatory failures. Now we can add another shortcoming to the list: the ignorance of too many small investors.”  It's about time someone pointed that out.  

To me, it seems obvious from the start.  You can’t have a financial crisis like we had if only one side participates.  It took all players, which seems fairly obvious given that the problems uncovered were systemic.

There are many key pieces of information relevant to financial management that the fiscal cliff discussions indicate the public lacks; enough to justify a separate posting.  For now, however, let's focus on one not mentioned in the WALL STREET JOURNAL article.  It's one that's much in the news.  It has to do with tax rates, and in particular the Bush tax cuts.  For readers who just can't live without politics, I'd recommend a WALL STREET JOURNAL opinion piece entitled “Obama'sMiddle-Class Tax Flip: After a decade of bashing by Democrats, the Bush tax cutsget strange new respect.”

It points out the new orthodoxy being advanced by many analysts of the fiscal cliff.  Much of the fear of the fiscal cliff originates from the belief that the middle class benefits mightily from the Bush tax cuts and cannot afford to see them expire, thus, the insistence on preserving “middle-class tax breaks.”  This is a stark contrast to the original complaint that Mr. Bush's tax cuts favored the rich over the middle class.  That original complaint morphed into the orthodoxy we know today: Tax cuts for the rich came at the expense of the middle class.

What's clear is that a large number of people don't understand the tax rates they pay.  There are undoubtedly many people who know more about the rate paid by Warren Buffett than their own rate.  That ignorance may facilitate politicians’ demagoguing tax rates, but creating the opportunity to demagogue the issue is done at the expense of the public's ability to manage their own finances.

The WALL STREET JOURNAL article on financial ignorance lists budgeting as one of the areas where the public's financial management skills are weak.  Two years ago this blog pointed out the crucial role of budgeting in the movie “It's a Wonderful Life.”  Specifically, in a posting entitled “Investing Part 3: Setting the volume,” it noted that “…George avoids the clutches of the evil banker, Mr. Potter, due to the astute financial management of Miss Davis who only withdraws $17.50 rather than the $20 withdrawals of the customers before her….she knew she could get by for $2.50 less than the previous customers. That she leaves that $2.50 in the Bailey Building and Loan is crucial. George squeaks by with $2 left at the end of the day.”

Now, the logical question is: how can the public be expected to be able to project their cash flow and budget if they don't know how much of their cash flow will be taken for taxes?  One can't know what his or her taxes will be without knowing how taxes work. 

One can't just blame the public for their ignorance if there is a concerted effort to create misinformation on the part of many spokespeople on the topic of taxes.  Further, one can't blame the public if in late December the government still has not decided what income tax will be due in the current year.  That is exactly the situation many people in the middle class are facing. How the Alternative Minimum Tax (ATM) will be applied this year is undecided, and the ATM could apply to a substantial portion of the middle-class.  A public which understood how their taxes work wouldn't tolerate such deception and mismanagement.

Reaching a reasonable compromise about how revenue should be raised is impossible among people who don't know how revenue is currently being raised.  In a public which knows more about others’ taxes than how their own taxes work is in no position to address the issue.  Not knowing what your tax rate is or how your taxes work is a significant deficiency in the public's financial skills.  It's one that the public as portrayed in “It's a Wonderful Life” would find unacceptable.

“It's a Wonderful Life” and It's Good Financial Advice.

Wisdom for the season.

Back on March 30, 2010, this blog posted “WallStreet doesn’t run the world.”  It discussed an important point.  It stated, “Consumers and investors, as in the general public, have an immense advantage over many institutional investors….”  The subtitle of the posting, “Time, liquidity and control,” pretty much summarized the reasons.  The posting went on to discuss how the chatter and behavior of Wall Street created advantages for the individual investor.  This posting focuses on how the chatter from Washington creates advantages for individual investors.

The chatter out of Washington is often very right for Washington, but can actually spell disaster for the general public.  More often than not, the chatter contains or implies terrible financial advice. At this time of year, one need go no further than the classic Christmas movie “It's a Wonderful Life” for much better sources for financial education. 

It's good to start with the basics.  In that regard, it's worth noting the financial behavior of the customers of Bailey Building and Loan.  It's a stark contrast with the chatter from Washington.  The customers of Bailey Building and Loan all have a savings account.  As one customer says, all of their money is in the savings account.  The emphasis should be on “all.”  Their first venture into finance is to set up a rainy day fund, a reserve, or whatever you want to call it.  The point isn't that you should have a savings account at a savings bank.  The point is you should have a reserve.  It could be with the savings bank, a regular bank, a brokerage firm, money market fund, a short-term bond fund, or just some money in a safe deposit box.

Contrast that to the Washington chatter reported in the WALL STREET JOURNAL in a report entitled “Bank of America Backs Down On NewFees.”  The new fees referenced in the title are “the fees that were under consideration for year's end would have applied to the bank's base of 50 million customers, but most of them would have been able to avoid additional charges because of their higher average balances and use of other products.”  So, customers who had set up a rainy day fund or a reserve at Bank of America wouldn't be charged a fee.

Let's consider the absurd response to the very consideration of the fees.  The article reports “the fees are unpopular with customers, regulators and many legislators…. Levying new charges opens banks up to criticism that they are punishing lower-income customers with policies that encourage users to hold larger balances and use multiple products.”  One might logically ask: “How in the world can it be considered “punishing” customers to encourage them to have a rainy day fund in the form of “larger balances?”  It would be far more logical to argue that Bank of America is only encouraging them to avoid financial practices that are characteristic of many peoples’ financial mismanagement.

Most financial planners, and certainly any financial planner worth listening to, would emphasize that setting up a rainy day fund is the first step in financial management.  That's true across a range from the simplest plans designed to help those with no financial planning experience to the most sophisticated financial management discussions.  So, the Washington chatter clearly encourages poor financial management.

Unfortunately, a substantial number of people haven't realized how stupid the posture out of Washington is. Most Americans lack a sufficient cushion.  Almost half of Americans lack a three-month stash of cash to cover emergencies, according to a survey conducted in June by Bankrate.com.  However, perhaps people are starting to wise up: the current figure is an improvement from 2006, when a similar poll found that 61% of Americans lacked such a cushion.  Nevertheless, it still shows that not enough Americans are prepared for the unexpected.

So, right out of the gate, Washington is encouraging financial mismanagement among consumers.  Now, let's look at it from Bank of America’s perspective.  Remember, they were not just encouraging the consumer to have a rainy day fund.  They were also willing to waive the fee if the consumer used other Bank of America services.

Again, let's look at the experience from “It's a Wonderful Life.”  Keep in mind that the customers of Bailey Building and Loan are not just customers for savings accounts.  George Bailey makes explicit reference to the fact that some of those customers, perhaps all, have mortgages with Bailey Building and Loan. 

Bailey Building and Loan, as those familiar with the story may recall, survives the depression and the associated bank runs.  So perhaps, the better advice from Washington would be for banks to encourage customers to develop multiple relations with the banks.  It certainly would make for a more stable financial system.  It's not a stretch to argue that a substantial amount of the financial crisis was due to lending to individuals without having adequate familiarity with the customer.

It is not just Bailey Building and Loan that benefits from the practice of having multiple relationships with a customer.  No one outside of the ownership of Bailey Building and Loan bails out Bailey Building and Loan.  No one loses their deposits, and the run does not necessitate massive foreclosures.  The wizards in Wall Street and Washington could learn something from this simple parable.  Perhaps, Bank of America did.

So, let's inventory.  There is advice there for you and me as consumers: start with a rainy day fund.  There is advice there for you and me as borrowers: deal the financial institution that takes a holistic view of your finances.  There's advice there for banks: taking a holistic view of consumers will result in financial stability.  There is advice there for bank regulators: recognize the stability of financial institutions with multiple relationships to their customers and reward them. 

It's Not Ideology.It's Waste.

Would you spend your money this way?

One has to shake their head in disbelief.  There is no way that the government can pretend that this is other than wasted resources.  However, note that this is from one day’s news coverage. Both of the items discussed in this posting refer to material from the WALL STREET JOURNAL dated December 6, 2012.  Is it any wonder that the public stops reading newspapers and following current events when this sort of stupidity is routinely displayed?

The first item concerns a report entitled “U.S. Gas Exports Clear Hurdle,” and subtitled “Study Citing Benefits Could Hasten Approvals From Obama Administration.”  The article reports that “Shipping some of the newly abundant U.S. natural gas overseas would benefit the nation's economy more than keeping it all at home, according to a long-awaited government study that has the potential to reshape the global energy market.”

Think about that for a minute.  We are using sanctions against energy exports from Iran in order to punish them and force them into submission.  Yet, we need to do a study to find out that we shouldn't do the same to ourselves? 

But one doesn't have to look to our current foreign policy to realize the insanity of requiring the study.  Anyone who is the least bit familiar with American history realizes that we have done tremendous damage to the US economy in the past when we embargoed our own exports.

If current foreign policy and American history are not your strengths, try current trade discussions.  Populists and even some economists bemoan our lack of exports and criticize foreign governments for protective actions.  We criticize foreign nations for exporting too much to us, and in some cases insist that they put quotas on the amount they can export, not for their own benefit, but for our benefit.

The money spent on that study represents waste, but the waste doesn't end with the money spent on the study.  One has to wonder about the lost opportunities associated with the fact that this study was “long-awaited.”  Why would it take so long to reach an obvious conclusion, unless there were opportunities for the government to shake down energy producers and consumers for campaign contributions in the interim period. 

So, we've got the waste of the study, the waste of the delay, and the wasted resources used in lobbying.

The disclosure is in order.  The Hedged Economist is not a particular advocate of natural gas exports.  In fact, although highly skeptical of natural gas exporting, it isn't rocket science to see that this whole article reflects nothing but waste.

The second item is a little more subtle and could be subject to misinterpretation.  That isn't surprising since it's taken from the opinion page.  The particular item is entitled “Playing Chicken in Oil-Patch Politics,” with a subtitle “Another green gambit by the Obama crowd to stop the energy boom.”  So, it might be good to begin with the blanket statement that these comments are not in any way associated with an advocacy position.  One doesn't need to take a position on the issue to see the stupidity of what's being reported.

A little background is in order.  The piece points out that “The U.S. Fish and Wildlife Service recently announced that it will formally consider listing the Lesser Prairie Chicken—whose habitat includes some of the nation's major energy fields—as a threatened species under the Endangered Species Act.”

It goes on to report that “This summer, after months of research, Fish and Wildlife conceded that listing the Dunes Sagebrush Lizard as threatened or endangered wasn't warranted….As it happens, the habitat of the Lesser Prairie Chicken largely overlaps that of the Dunes Sagebrush Lizard.”

Understand, The Hedged Economist is all for leaping lizards and lesser chickens.  In fact, one could say that the author is even favorably disposed toward greater chickens.  That's not the issue.

Here is the issue.  The piece goes on to report that “… another issue of concern is the funding behind these efforts to list certain animals as endangered. Texas Land Commissioner Jerry Patterson testified to Congress in June that taxpayer money is being spent in litigation over these listings. For instance, the petition to list the Dunes Sagebrush Lizard was originally filed by a radical environmental group, the Wild Earth Guardians. Interestingly, this group collected $680,492 in tax money (as grants and the like) from Fish and Wildlife between 2007 and 2011. During that time the group sued the federal agency 76 times over alleged environmental violations.”

It goes on to express the opinion that “By filing an outlandish number of lawsuits, groups like the Wild Earth Guardians are trying to overwhelm Fish and Wildlife resources and force settlements that the groups can dictate, instead of letting the courts decide.”  One might surmise from the fact that the article was written by a member of the Texas Railroad Commission (which is the state's primary regulator of energy production and exploration) that the opinion isn't pulled out of thin air.  However, the motives of the author of the opinion piece, Fish and Wildlife, and the Wild Earth Guardians are not the issue.

The issue is: Why in the world is Fish and Wildlife giving grants with taxpayers’ money to advocacy groups?  The Hedged Economist is clearly an advocate.  A review of posts on this blog should demonstrate a strong advocacy for economic rationality.  Why doesn't the government subsidize The Hedged Economist?  Certainly, economic rationality should rank high in the government's objectives.  But, The Hedged Economist would be quick to point out that subsidizing advocacy, even for rationality, is not a rational behavior.

The point is that government subsidies to advocates are essentially a waste.  If an action makes sense, the rational behavior is to take the action, not to provide subsidies to somebody to advocate the action.  That seems particularly obvious if the advocate’s approach to achieving his or her objectives is to screw up the workings of a government agency, as the piece contends is the case in this instance.

This posting is written with a full understanding that we just elected a president who has displayed considerable hostility toward fossil fuels.  Therefore, one can't object to the president pursuing his objective of inhibiting energy production.  That isn't the point of the posting.  The point is that if making fossil fuels scarce and expensive is the president's policy; let him pursue it in a rational, less wasteful manner.

Election Results and Employment Data.

The votes have been cast

This analysis was written before the election results were available.  Given the political silly season, it was deliberately not posted until after the election. That should make accusations that it was politically motivated less likely.  The media likes to portray the economy as being an appendage to politics.  A lot of that has to do with the fact that most of the reporters don't know how to analyze the economy.  That's even true of the financial press. 

Covering politics is a lot easier, especially when just picking out your favorite pollster and presenting his or her results is a substitute for analysis.  If that fails, just read the different candidates’ press releases.  However, there is an economy, and although affected by politics, the causality runs both ways.  Who is elected is as much a function of the economy as economic performance is a function of who was elected.

The posting entitled “The Day the Data Died,” noted it was more likely that the employment report for September was just wrong than that it was deliberately manipulated.  That probably was not a popular position among the most zealous Republicans.  However, it also pointed out that the employment report was well short of showing that the economy was recovering.  It was even more absurd for Democrats to view it as confirming the effectiveness of current policies.  If that were the case, it would have happened long before now.

All indications are that the assessment that the report was in error rather than fudged was correct.  More importantly, the combination of the September and October report make it fairly clear where we stand in the employment cycle.  Given that nothing stupid is done to reverse it, employment growth is now comfortably self-sustaining and should accelerate. 

This blog has generally avoided the practice of talking about employment reports each month.  Many commentators have to fill space, and the employment report provides them with an excellent opportunity.  However, this blog has taken the approach that if one doesn’t have anything to say, then don’t say anything.  Most of the time the employment report for any given month says nothing: what matters is the trend across multiple employment reports.

Thus, postings on this blog that have addressed the employment report have been about equally distributed between those posted before the report and those written after the report.  Often, knowing what to look for in the report ahead of time is a good way to identify an emerging trend.  Consequently, what to anticipate is sometimes more important than trying to interpret data after-the-fact.  However, “The Day the Data Died” actually did both.  It assessed the September numbers to the extent of commenting on whether the data was fudged or just wrong.  That's an issue that would not have existed but for this administrations acknowledgment that it viewed fudging numbers as an election tactic.  But, it also concluded by identifying what to look for in the October data as confirmation of an improving trend.

The reason for the curious posture of spanning two reports reflected the fact that interpreting the employment report for September without knowing the October results was impossible.  The September report was one of those anomalous reports that occur periodically during a business cycle.  The data anomaly is however a cyclical phenomenon.  It has to do with people finding jobs, starting businesses or creating jobs rather than finding work at the existing employers who are a part of the employer survey.  The magnitude of the anomaly would indicate that it was the result of both that cyclical phenomena and sampling error in the household survey.

The exact statement in the last posting was:
 “The bottom line, however, is that the employment report can contain data that is just wrong. It's much easier for one month’s report to contain a number that is wrong than for the report to show a false trend. Thus, next month’s report will eliminate the ambiguity introduced to the interpretation of this month’s employment report.”

“Clearly, another drop in the unemployment rate without confirming data will only confirm that the administration is cooking the books. Confirmation should come in the form of a pickup in employment in the employer survey, a reduction in the rate of combined unemployment and underemployment, and revision to this and previous month’s anemic showing in the employer survey. Of less importance, but also telling, is whether the increases in employment in the employer survey disperses to include more industries.”

The report for October didn't show an unsupported drop in the headline unemployment rate.  To the contrary, the rate rose.  It rose for the right reason: increased labor force participation.  The combined unemployment and underemployment rate actually fell, and there were revisions upward to the September report and the previous few months.  The dispersion across industries wasn't dramatic, but that's a minor confirmation of the validity of the September employment gain.  Also, job growth reflected in the employer survey rose and job growth in the household survey declined.  That shrinking in the gap between the two surveys would indicate that the employment picture is still less robust than in other recoveries.  But, that is totally consistent with the anemic recovery in other indicators.

So basically, while someone now has reason to crow about the election results, there is no reason to crow about the employment results.  They are a continuation of weak recovery that can't get enough traction to be robust against political folly.  It may be sufficiently robust to reduce the likelihood of political folly.   

LIBOR 4: The Gift that Won't Stop Giving.

The search is on, or let's just make up news.

One would think that at some point the media would realize it has already beaten the dead horse to death.  However, even the WALL STREET JOURNAL is prone to falling into the trap of trying to make news out of a dead issue.  Granted, LIBOR is not a dead issue, but it's one that the media is unable to cover in a technically meaningful way.  As consequence, they end up saying the absolute silliest things.  On September 28, 2012, the WALL STREET JOURNAL gave major coverage to an article entitled "LIBOR Furor: Key Rate Gets New Scrutiny.”  But the subtitle for the article points out just how far the media is stretching to keep this story alive.  The subtitle was "Banks Often Don't Change the Quotes That They Submit."

My initial reaction was "Well da!  Hasn't the Fed been holding interest rates unchanged for some time now?  Why would anyone expect banks not to appreciate that the Fed will hold borrowing costs fairly stable?"  Given the silliness of the entire issue, the article becomes worth reading in order to understand how reporters get themselves so confused.

When one does start looking at the article, it becomes an even stranger report.  The first thing strange is the shifting and ill-defined timeframe that is the focus of their concern.  The article states:

"From the start of 2012 through the end of August, the 18 banks on the main U.S.-dollar LIBOR panel left their daily estimated rates unchanged on average 87% of the time, according to the analysis of data from Thomson Reuters Corp. and S&P Capital IQ.”

Between the start of 2012 and August, one might wonder when that 13% of the time when the estimates changed occurred.  Interest rates just did not fluctuate during that period.  So it's worth investigating how the reporter arrived at this twisted logic. It is a reputable paper so it's reasonable to assume that it wasn't just to fill space.  There had to be some logic, and the article goes on to explain that logic.  It goes on to state:

"For around a third of the banks, there was only a weak to moderate correlation—if any—between their LIBOR submissions since January 2009 and the rates on their one-year credit-default swaps, or CDS, which insure against the risk of the firms defaulting. Banks, for their part, argue that there are valid reasons why CDS prices may behave differently from LIBOR."

The first thing to note is that the timeframe has changed.  We're now talking about since January 2009.  However, what is stranger is that the reporter clearly believes that the CDS market is somehow more reflexive of what the market rate should be than Fed guidance.  Put bluntly, this either represents an absurd assumption about the efficiency of markets or reflects a significant distrust of Fed statements. 

Further, it ignores the institutional framework that surrounds the CDS market versus the actual lending market.  CDS’s can be used in a variety of ways, not the least of which is hedging the tail risk implied by actual loans.  One would not expect the return or payment from an individual insurance policy to represent the individual policy’s premium cost.  The purpose of insurance (such as CDS’s) isn't to get back your premiums.  It's to lay off certain risks. 

The conditions under which the underlying assumption of the logic that the CDS market and the actual lending market should be highly correlated require eliminating from consideration all use of CDS's other than as a way to make money.  If 1) the purpose of all CDS transactions and the purpose of all loans are to make money, and 2) people making the CDS transactions and the lending decisions have the same risk profiles, and 3) the leverage implications of the CDS are similar to those of the loan, then, and only then, would one expect a high correlation between the CDS market and the lending rates.

Clearly, not all CDS transactions are intended as a speculation that will make money.  Some are, in fact, insurance against a particular risk made with the hope that there will never be a payoff.  So, the first necessary condition is not met.  It would be incredibly naïve to assume that the risk tolerance of people buying and selling CDS's are the same as those taking out or making loans.  So, the second necessary condition for the whole argument to have any merit is violated.  Finally, anyone who has ever used an option knows that it has different leverage implications from an actual long or short position.  So, the third necessary condition, also, isn't satisfied.

It's important to remember that it is only for "around a third of the banks" that "there was only a weak to moderate correlation."  So, for about two thirds of the banks, there was more than a moderate correlation.  Given the multiple uses to which one could put a CDS if one were a bank, that seems like a very reasonable portion.

Most of the balance of the article consists of quotes from various authorities that a reporter feels are supportive of his thesis.  Consequently, the balance of this posting addresses each of those quotes in turn.  They can be skipped by anyone who can see the flaw in the logic of the article.

The first of those quotes is from Andrew Lo.

“There's a concern that if you're going to base financial decisions on a particular interest rate it should be a measure that responds to changes in market conditions, and that's not LIBOR.”

This quote is the reason that the article being discussed was written on September 28 and this posting isn't being made until late in October.  Andrew Lo is no lightweight when it comes to understanding financial markets.  The Hedged Economist has referenced his work as summarized in A RANDOM WALK DOWN WALL STREET.  One suspects that his quote has been taken out of context because the general thesis of A RANDOM WALK DOWN WALL STREET is that markets are not totally efficient in the sense of conforming to the stronger form of the efficient market hypothesis.  Thus, the low correlation between lending markets and credit default swaps should not be surprising. 

Nevertheless, the quote from Andrew Lo caused me to postpone posting this discussion until after I had been able to work through the mathematics and prove to myself that mathematically, there is no reason why credit default swaps and LIBOR rates should be correlated.  For them to have high correlation one would have to believe that the distribution of the probability of collecting on a CDS is the same as the potential loss from a default on the total loan to the banks involved. 

Even if one is willing to make the oversimplifying assumption that the probabilities associated with both are normally distributed, it seems unreasonable to assume that they have the same distribution.  Further, in fact, mathematically, the distributions are not normal.  Both distributions are leptokurtic with a negative skew.  No one could reasonably argue that the kurtosis and the skew are the same on both distributions.  Yet, mathematically those are the conditions that have to be met.  So, not only is there a logical institutional reason that one would not expect LIBOR and CDS markets to be perfectly correlated, mathematically, it can be shown that the conditions under which they would be highly correlated don't exist.

It took some time to work through the math, but I'm comfortable with the statement that it's totally unreasonable to expect a high correlation between LIBOR and CDS’s.  Andrew Lo’s comment, however, is just fine.  There is absolutely no reason that credit default swaps should be priced based upon LIBOR.  LIBOR and the credit default market are measuring different phenomena.

The next quote includes some statements that quite frankly don't make sense without substantial justification that isn't provided. Darrell Duffie, a finance professor at Stanford University, is quoted as follows: 

“One would expect LIBOR submissions to change frequently if the rate reflected accurately what it's supposed to measure.”

The problem is that Professor Duffie doesn't define what he thinks LIBOR is supposed to measure.  That isn't a difficult question to answer, and if one accurately answers it, his next statement doesn't make sense. 

“This year's frequent ups and downs in credit markets mean each bank's LIBOR submissions could be expected to change ‘most days.”

Again, Professor Duffie doesn't indicate what credit markets he's referring to.  If it is the credit market for interbank borrowing, which is what LIBOR supposed to represent, there clearly was an anchor that precluded frequent ups and downs in short run interest rates.  So, he's referring to a market other than the one LIBOR measures.  It is highly likely that he is focusing instead on LIBOR’s use in the CDS market.  But that's a use of the rate not what the rate is supposed to represent.  As Andrew Lo pointed out, the use may be inappropriate.  That does not mean that LIBOR was wrong.  It may have been wrong, but the data Professor Duffie sites is totally irrelevant to that issue.  He then goes on to point out the stability in the rates as if that were an indictment:

“Instead, banks leave their rates unchanged most of the time. The analysis shows the number of submissions that stay the same from day-to-day has shot up since the financial crisis, with some firms leaving their estimates unchanged for months on end.”

Curiously, he then points out why LIBOR shouldn't be expected to change much from day-to-day.

“There's not a great deal of new information for banks to use each day”

He then goes on to point out what he thinks is responsible for the absence of changes day-to-day even after he's presented the reason.

“Instead, their herd instincts take over and they tend to avoid changes that could make them stick out from the pack.”

The hollowness of that argument is reflected in the fact that, for the majority of banks, there was correlation between their LIBOR submissions and the credit default swap market.  As stated above in this posting, it's about the right portion.  But it's the correlation not the volatility that's relevant.

The next quote is interesting.  The periods being referenced change dramatically.  It involves a comparison of 2005 and this year.  In 2005 there was considerable uncertainty regarding what would be done with interest rates.  One might remember that there was discussion of the potential that interest rates needed to be raised in order to cool the housing bubble.  The discussion was public and often took place at the Federal Reserve Board meetings.  Given that one would expect LIBOR to fluctuate more in 2005 than it did in “the last year.”  That's exactly what the quote shows.

“Banks on the three-month U.S.-dollar Libor panel on average left only 29% of their submissions unchanged in 2005, compared with 75% last year and 87% this year to the end August, the analysis shows.”

The final quote and associated comment are spot on.

“There are a number of factors that can affect movements in CDS prices, meaning they shouldn't necessarily go in exact lock step with LIBOR.

But Raghu Sundaram, a finance professor at New York University, said he ‘would expect a degree of co-movement’ between LIBOR submissions and CDS spreads, as stress on a bank should increase both.”

One can't argue with Professor Sundaram, but the issue is how much co-movement, and, as stated above in this posting, the co-movement seems to be about right given the fact that there are as many factors as there are that affect lending rates and CDS’s differently.

Interestingly, the article concludes with a response from HSBC and French banks that seems to indicate that they have a good understanding of how their borrowing rates interact with the CDS market in general.

What's really strange about this sorry effort to find malfunctioning in LIBOR where there wasn't any is that clearly, there were periods when LIBOR markets weren’t functioning.  Interbank lending was frozen along with much of the financial system.  However, as discussed in "LIBOR 1: Scandal!  Or Is It?” the problem with the period when LIBOR wasn't functioning is that it doesn't provide much support to the scandal mongers.

The September 28, 2012 article discussed above was accompanied by one entitled “U.K. Unveils Plans For LIBOR Overhaul.”  One might expect a lengthy discussion of their overhaul plans.  However, what they do is far less important than that they base it on a realistic assessment of the situation they're facing.  There is no doubt that if they can divorce themselves from the political and public relations impact of their decision, they are perfectly capable of developing effective changes. 

My only comment is that the discussion in the article doesn't provide an encouraging summary.  For example, reference to removing the British Banking Association’s role in setting LIBOR is presented as if it's a punishment for the role of the BBA in the scandal.  Since the BBA was one of the first organizations to express concern about LIBOR and to indicate that they felt it was too important to be left in the hands of the BBA, one suspects the whole issue is going to be played for the bleachers rather than to improve financial markets.

A few weeks after these articles appeared in the WALL STREET JOURNAL, there was another article that made reference to the fact that a banker, had pleaded guilty to encouraging his staff to make this a submittal that would reflect well on their back.  That represents effective reporting.  Trying to manufacture a scandal doesn't.

The Day the Data Died.

Be careful what you say.

After hearing the employment report for September, some of the words of Don McLean’s “American Pie” came to me in a slightly altered form.  This blog has only sparingly discussed employment reports.  The reason is quite simple and is summarized in the e-mail exchange mentioned below.

A former state treasurer forwarded the e-mail with this comment:  “[a friend of his] thinks the 7.8 is proof things are getting better. You may enjoy my reply, and perhaps use the explanation in your blog.”  His reply is shown below:

On Oct 7, 2012 11:15 AM, ….he wrote: 
“The number is Obama's sound and fury... CNN should have told you that... the number is meaningless.
Last night I went to sleep at 190 pounds. This morning I woke up at 189. Proof that my diet is working, or is it all sound and fury so I can have a donut for breakfast?” 

One doesn't even need to address the content of the employment report to realize that his response is correct.  The unemployment rate is much quoted, despite being the most meaningless statistic in the employment report.

That said, the unemployment rate isn't totally meaningless, but it can only be interpreted in the context of the other content of the total report.  Other data from the employer survey, including the change in employment, the change in hours worked, the wage changes reported, and the industry composition of the employment change, are far more important than anything resulting from the household survey. 

Looking just at the household survey, the unemployment figure is much less important than changes in the labor force participation rate, or for that matter, the number of people identifying themselves as employed.  Further, the household survey does not result in just an unemployment rate.  The unemployment rate is estimated in a number of ways.  Other than the so-called “headline number,” the most widely quoted number is the total unemployed and underemployed.  That is shown both as a number and as a rate.  Consistency within the household survey is an important criterion for judging how to interpret a headline unemployment rate.

However, there is one other result than can be derived from the combined employer survey and household survey.  In various postings The Hedged Economist has alluded to the fact that at some point in the recovery, the household survey should start providing employment growth numbers that seem inconsistent with the numbers generated from the employer survey.  The usual response at that point is to question the household survey.  That's exactly what is happening now.

The July 31, 2010 posting entitled “Unemployment map: The geography of a recession” recommended:

“My suggestion is ignore the unemployment rate and focus on the change in employment if you want to measure how an economy is doing. Notice the term was employment; not jobs. It is the failure to realize that employment and jobs aren't synonymous that is the Achilles heel of this recovery.”

This blog’s posting on August 4, 2010 in a posting defending an employment report entitled “An article about a fiction and the employment report,” discussed the issue when it was the employer survey that was being questioned.  At that point, someone was pointing to the employer survey which showed employment gains that were clearly not sustainable given the total employment report and the administrations claims that the recovery was gaining steam. The comment at that time was:

“Problem is he never bothers to show whether ‘companies continued to slash jobs and hold off hiring for months, even years, after profits returned’ is anything new. It’s not. Recoveries don’t come from having the same set of employers hire back people. Recoveries have always come mainly from new or different companies hiring. Interestingly, it tends to be smaller companies and often start-ups from the current or the last cycle….”

The posting went on to note that any talk of economic recovery at that point was extremely premature.  It stated:

“The picture isn’t pretty. The evidence that the needed churn isn’t happening is there. In addition to the behavior of the two different measures of employment, Friday’s report included other data with telling implications: namely, the revisions. The BLS is aware of the limitation of the employer survey (i.e., not adequately representing new and small businesses). It tries to adjust the data to correct for the undercount using what is called the business birth-death model. That adjustment has its primary impact on the last few months of data. The data is then revised when better, some would say real, data become available. Those were the months for which the employment data were revised down. The unavoidable implication is that fewer jobs are being created by new and small business than they expected. This absence of churn among employers deserves more attention.”

The September employment report gives every indication that the policy failures that were the reason the August 2010 report didn't signal the beginning of employment recovery are becoming less important. But, as economists are fond of saying," the recovery is quite fragile."  Put differently, the private sector has healed and is recovering and has reached a point where that recovery could easily become self-sustaining.  What is infinitely apparent is that there are new headwinds, or, I should say, a continuation of the headwinds that undermined the recovery in 2010.  One doesn't have to be a strong partisan to realize that the Obama administration has been anything but friendly to small business.

That said, judging just from the employment report, the recovery is continuing its anemic pace and is poised to accelerate.  That, however, is not a forecast.  This administration has repeatedly undermined the recovery.  To illustrate, if the data could be accepted at face value the employment report itself would quicken the pace of recovery.

It should be pointed out that the suspicion reflected in that last statement is not the normal posture of The Hedged Economist.  My normal posture is reflected in a January 5, 2011 posting entitled “Reality and the jobs numbers.”  It states my normal response to charges of intentional misrepresentation in the employment numbers:

“For those who see political conspiracies everywhere it is interesting to note that the undercount in December coincided with the hearings on extending the 99 week emergency unemployment benefits. I’m amused by the conspiracy theorists. They seem to be part of a massive delusion that government is always in control of its every activity right down to the details. I hate to pop anyone’s bubble, but governments make mistakes. It’s very likely someone just got the number wrong. That they were out of touch with the private economy around them shouldn’t be surprising: they’re government employees after all....This month the news in the employment report released on Friday will be in the sector detail and the household survey.”

That quote should make it quite apparent that in most instances, the best approach is to dismiss such charges as just political rhetoric.  It is, however, interesting how frequently they have arisen during this administration, especially given how inconsistent the employment recovery has been.  That in of itself would not be enough to justify questioning the number.  However, this administration has made it clear by its own statements that it considers generating phony government statistics a legitimate campaign tactic.  That justification comes from none other than Austan Goolsbee, former chairman of the Obama administration's Council of Economic Advisers. Back in 2003, Mr. Goolsbee himself, commenting on a Bush-era unemployment figure, wrote in a New York Times op-ed: "the government has cooked the books."  Clearly, he thinks cooking the books is a campaign tactic.

Even this administration's willingness to admit that it views fudging the numbers as a legitimate campaign tactic is not enough reason to dismiss the good news contained in the employment report.  This is especially true given that inconsistencies between the employer survey and the household survey are a cyclical phenomenon.  The more troubling problem with the employment report is the inconsistency within the household survey.  For the drop in the unemployment rate to represent the positive news on employment growth that will occur at some point during the recovery, it needs to be accompanied by a similar drop in the combined unemployed and underemployed.  It also should have been preceded, as opposed to accompanied by, an increase in the labor force participation rate.

The bottom line, however, is that the employment report can contain data that is just wrong.  It's much easier for one month’s report to contain a number that is wrong than for the report to show a false trend.  Thus, next month’s report will eliminate the ambiguity introduced to the interpretation of this month’s employment report.

It's worth noting in passing that accusations of cooking the books did not originate with Goolsbee's charges in 2003.   They played an important part in Clinton's ability to convince the public that we were not recovering from the recession during his campaign against the first President Bush.  In that instance, after the election the data confirmed that we were in fact recovering.  In this current instance, there is still another employment report before the election.

Thus, the report for October employment needs to confirm this report for September.  A perfectly logical question to ask is what would constitute confirmation.  Clearly, another drop in the unemployment rate without confirming data will only confirm that the administration is cooking the books.  Confirmation should come in the form of a pickup in employment in the employer survey, a reduction in the rate of combined unemployment and underemployment, and revision to this and previous month’s anemic showing in the employer survey.  Of less importance, but also telling, is whether the increases in employment in the employer survey disperses to include more industries.

Bottom line, Jack Welsh’s comments were justified.  The September employment numbers warrant questioning.  Whether they were fudged isn't a political question.  It is question of fact that will be proven over the next few employment reports.  It will be proven, regardless of who wins the election, and woe be to the incumbent if, in fact, they were fudged.  Perhaps the administration will be able to find someone to blame for the error.  Even if they do, the number of people they can fool will decrease.  They'll be undermining their party by their obvious ducking of responsibility for the data their administration generates.