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Chairman Bernanke Advocates Tax Reform

Reform Coming in 2011?

By The Children’s Home Society of Florida Foundation

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Chairman of the Federal Reserve [the FED], Ben Bernanke met January 7th 2011 with the Senate Budget Committee. He spoke on the topic of tax reform during 2011. According to sources, Mr. Bernanke noted, “Greater clarity and certainty is obviously beneficial, and to the extent you can create more certainty about where the tax code is going to be over the next couple years, that would be helpful.”

Budget Committee Seems to Agree

Chairman Bernanke and the Senate members of the Budget Committee all noted that with the current weak economy and high level of unemployment, it is a very key year for potentially reforming the tax code. Sen. Ron Wyden (D-OR) joined with Sen. Judd Gregg (R-NH) to introduce the bipartisan Tax Fairness and Simplification Act of 2010. Sen. Wyden noted, “The big idea for economic growth in our country is fundamental tax reform, where you go in there and clean out this job-killing, thoroughly discredited mess.” Senate Budget Chair Kent Conrad (D-ND) agreed that the tax code “is just completely out of date.” He responded, “It does not take account of the world that we live in today.”

Assessment

In the House, the new Chairman of the Ways and Means Committee, Dave Camp (R-MI), also showed interest in tax reform during 2011. He suggested that it will be necessary to “streamline the tax code that today is too costly, too complex and too burdensome for families and employers.”

Editor’s Note: Both House and Senate Finance Leaders will be holding hearings this year on tax reform. Because 2011 is not an election year, it is a potentially good year for major tax reform. As was evident from the tax bill that was signed in December 2010, tax reform will require compromise between the Senate, the House and the White House. However, with the unemployment rate currently at 9.4%, there is now a growing consensus on the need for continued improvements in the tax system in order to reduce unemployment.

Conclusion

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On Stock Market [Mis]Timing Strategies

Do They Come Up Short?

Dr. David Edward Marcinko MBA CMP™

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[Publisher-in-Chief]

Stock market investment rules are notorious for showing profit when tested on the same sample period from which they were developed, and then failing when applied to a new period. According to Professor Roger C. Vergin, it’s dangerous to use the same data to both discover and test the rules.

Of Marty Zweig

Using the “Zweig Strategies” developed by Martin Zweig and published back in 1986 in Winning on Wall Street (WOWS), Professor Vergin shoots some rather sizable holes in Zweig’s indicators by testing them against the 10-year period since WOWS was published. Zweig’s models are applied to various periods from 19 to 33 years, ending in 1985, and they claim to outperform a buy-and-hold strategy with annual rates of return as much as eight times as large, according to some measures. When the author ran these strategies for the 10-year period ending Dec. 5, 1995, not only did they not outperform a buy-and-hold strategy, but they trailed the market averages by a significant amount—9% vs. 14.4% for buy-and-hold.

The “Z” Indicators

Zweig’s indicators include a prime rate indicator, a Federal Reserve indicator, an installment debt indicator, a 4% indicator (market momentum), a monetary model, and a “super” model, which Zweig referred to as “the only investment model you will ever need.” 

Vergin corrects for inconsistencies in the evaluation criteria from one strategy to the next in WOWS and runs the numbers for the original test period first. Zweig’s strategies still outperform buy-and-hold. But, when run against an independent time period, as the author has done, the wheels fall off. Vergin runs the Zweig Strategies against the S&P 500, the Value Line Index, and an index developed by Zweig called ZUPI (all NYSE stocks).

Assessment

Over the 10-year period, none of the six Zweig Strategies outperformed a simple buy-and-hold strategy when compared against any of the three indexes mentioned above. They produced an average return of 9% compared to 14.4% for buy-and-hold.

In fact, Dr. Burton Malkiel’s [personal communication] conclusion in his book A Random Walk Down Wall Street, was that: “market timing is likely, not only to not add value, but to be counterproductive” seems to have borne out again.”

Note: “Market-Timing Strategies: Can You Get Rich?” by Roger C. Vergin. The Journal of Investing, Winter 1996, pp. 79–85, Institutional Investor, Inc. [212] 224-3185)

Conclusion

And so, your thoughts and comments on this ME-P are appreciated. By trying enough patterns against past events, one can always find simple rules that “would have” worked well in the past. But, do they hold up against differing periods of time; like say 2008-09? … At least not yet! What do you think?

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Behind the Financial Reform Push

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Of Worries on Warring Regulators

By Jeff Gerth, ProPublica – April 14, 2010 12:07 pm EDT

Backers of financial regulatory reform are gearing up for the final stretch in a yearlong effort to construct a new, streamlined architecture. But, recent reports and testimony about the financial crisis suggest a crucial ingredient in any new structure is in short supply: cooperation among the watchdogs.

Office of Thrift Supervision

A proposal to eliminate one regulator seen by many as particularly weak—the Office of Thrift Supervision—could alleviate some friction. A soon-to-be-released federal examination of the Washington Mutual collapse found that OTS resisted efforts by a more skeptical regulator, the Federal Deposit Insurance Corporation, to take a closer look at WaMu, according to an account in The New York Times [1].

Reform legislation pending in the Senate [2] (PDF) would also create new agencies, including a financial stability council to assess risk and a consumer protection watchdog. To work as envisioned, the agencies would need new levels of information sharing and decision making. By contrast, history suggests agencies can be stingy with what they know and eager to point blame at sister regulators.

Fall of the House of Lehman

Lehman Brothers, the investment bank that collapsed in September 2008, presents a case in point.

A lengthy examiner’s report [3] for the judge overseeing Lehman’s bankruptcy found that the Federal Reserve Board and the Securities and Exchange Commission kept crucial data from each other even though they had “overlapping” functions. The heads of the Federal Reserve and the SEC reached a formal sharing agreement in July 2008, but the two regulators “did not share all material information that each collected about Lehman’s liquidity.”

SEC Queries

The SEC, asked by the Federal Reserve Bank of New York to provide data on Lehman’s commercial real estate exposure and liquidity, “affirmatively declined to share” the information because it was still in draft form, the bankruptcy report found. The reserve bank never turned down an information request from the SEC, but bank officials “did not perceive any duty to volunteer” information about a $7 billion shortfall in Lehman’s liquidity they uncovered in August 2008.

The reason? The report says it was “because the SEC did not always share information” with them. One official at the Federal Reserve Bank of New York told the examiner “there was not a warm audience” for information sharing between the New York Fed and the SEC.

Lehman fell under the scrutiny of the Fed after it was allowed to tap Fed lending facilities, normally reserved for banks, in the spring of 2008.

Oh … the Irony

Ironically, examiners at the Office of Thrift Supervision, which regulated Lehman’s bank subsidiary, concluded in July 2008 that Lehman had violated its own risk limits by placing an “outsized bet” on commercial real estate. But, the OTS appears as a bit player in the autopsy of Lehman’s collapse; top Federal Reserve officials “considered the SEC to be Lehman’s regulator,” the bankruptcy report found.

One of those officials, Timothy Geithner, was president of the Federal Reserve Bank of New York from 2003 until early 2009, when he became secretary of the Treasury. Shortly after he joined the cabinet, Geithner was asked by a senator about the Fed’s supervisory responsibility [4] in connection with the collapse of institutions like Lehman and the insurance giant AIG.

“I just want to point out,” Geithner told the Senate Finance Committee, “the Federal Reserve was not given responsibility for overseeing investment banks, insurance companies, hedge funds, non-bank financial systems that were a critical part of making this crisis so intense.”

networking_0

Fed Responsibilities

The Fed is responsible for supervising bank holding companies, such as Citigroup. Those holding companies include investment banks and, as a sister regulator quietly pointed out last week, the Fed shared responsibility with the SEC for overseeing the risky practices of Citigroup’s broker dealer.

John C. Dugan, who oversees nationally chartered banks as comptroller of the currency, told the Financial Crisis Inquiry Commission [5] (PDF) last week that most of the problems that led to a massive bailout for Citigroup took place under the umbrella of the weaker holding company regulated by the Fed—not at Citibank, the banking subsidiary under Dugan’s authority.

Most of the losses, Dugan said at the end of a lengthy report to the commission, were in subprime lending, leveraged loans and the structuring and warehousing of CDOs (collateralized debt obligations) that are supervised, either all or in part, “by the Federal Reserve.”

Geithner has acknowledged [6] that he could have done a better job of supervising Citigroup during his tenure at the New York Fed.

Assessment

If the Senate bill becomes law, Geithner would sit atop the new financial stability council, whose members will include representatives of several different agencies—including the Fed, the SEC and the Office of the Comptroller of the Currency.

Conclusion

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How One Hedge Fund Helped Keep the Bubble Going

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On the Magnetar Trade

By Jesse Eisinger and Jake Bernstein, ProPublica – April 9, 2010 1:00 pm EDT

In late 2005, the booming U.S. housing market seemed to be slowing. The Federal Reserve had begun raising interest rates. Subprime mortgage company shares were falling. Investors began to balk at buying complex mortgage securities. The housing bubble, which had propelled a historic growth in home prices, seemed poised to deflate. And if it had, the great financial crisis of 2008, which produced the Great Recession of 2008-09, might have come sooner and been less severe.

Precise Timing

At just that moment, a few savvy financial engineers at a suburban Chicago hedge fund [1] helped revive the Wall Street money machine, spawning billions of dollars of securities ultimately backed by home mortgages.

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When the crash came, nearly all of these securities became worthless, a loss of an estimated $40 billion paid by investors, the investment banks who helped bring them into the world, and, eventually, American taxpayers.

Yet the hedge fund, named Magnetar for the super-magnetic field created by the last moments of a dying star, earned outsized returns in the year the financial crisis began.

The Magnetar Trade

How Magnetar pulled this off is one of the untold stories of the meltdown. Only a small group of Wall Street insiders was privy to what became known as the Magnetar Trade [2]. Nearly all of those approached by ProPublica declined to talk on the record, fearing their careers would be hurt if they spoke publicly. But interviews with participants, e-mails [3], thousands of pages of documents and details about the securities that until now have not been publicly disclosed shed light on an arcane, secretive corner of Wall Street.

According to bankers and others involved, the Magnetar Trade worked this way: The hedge fund bought the riskiest portion of a kind of securities known as collateralized debt obligations — CDOs. If housing prices kept rising, this would provide a solid return for many years. But that’s not what hedge funds are after. They want outsized gains, the sooner the better, and Magnetar set itself up for a huge win: It placed bets that portions of its own deals would fail.

Chance Enhancement

Along the way, it did something to enhance the chances of that happening, according to several people with direct knowledge of the deals. They say Magnetar pressed to include riskier assets in their CDOs that would make the investments more vulnerable to failure. The hedge fund acknowledges it bet against its own deals but says the majority of its short positions, as they are known on Wall Street, involved similar CDOs that it did not own. Magnetar says it never selected the assets that went into its CDOs.

Magnetar says it was “market neutral,” meaning it would make money whether housing rose or fell. (Read their full statement. [4]) Dozens of Wall Street professionals, including many who had direct dealings with Magnetar, are skeptical of that assertion. They understood the Magnetar Trade as a bet against the subprime mortgage securities market. Why else, they ask, would a hedge fund sponsor tens of billions of dollars of new CDOs at a time of rising uncertainty about housing?

Key details of the Magnetar Trade remain shrouded in secrecy and the fund declined to respond to most of our questions. Magnetar invested in 30 CDOs from the spring of 2006 to the summer of 2007, though it declined to name them. ProPublica has identified 26 [5].

Independent Analysis

An independent analysis [6] commissioned by ProPublica shows that these deals defaulted faster and at a higher rate compared to other similar CDOs. According to the analysis, 96 percent of the Magnetar deals were in default by the end of 2008, compared with 68 percent for comparable CDOs. The study [6] was conducted by PF2 Securities Evaluations, a CDO valuation firm. (Magnetar says defaults don’t necessarily indicate the quality of the underlying CDO assets.)

From what we’ve learned, there was nothing illegal in what Magnetar did; it was playing by the rules in place at the time. And the hedge fund didn’t cause the housing bubble or the financial crisis. But the Magnetar Trade does illustrate the perverse incentives and reckless behavior that characterized the last days of the boom.

Major Players

Magnetar worked with major banks, including Merrill Lynch, Citigroup, and UBS. At least nine banks helped Magnetar hatch deals. Merrill Lynch, Citigroup and UBS all did multiple deals with Magnetar. JPMorgan Chase, often lauded for having avoided the worst of the CDO craze, actually ended up doing one of the riskiest deals with Magnetar, in May 2007, nearly a year after housing prices started to decline. According to marketing material and prospectuses [5], the banks didn’t disclose to CDO investors the role Magnetar played.

Many of the bankers who worked on these deals personally benefited, earning millions in annual bonuses. The banks booked profits at the outset. But those gains were fleeting. As it turned out, the banks that assembled and marketed the Magnetar CDOs had trouble selling them. And when the crash came, they were among the biggest losers.

Assessment

Of course, some bankers involved in the Magnetar Trade now regret what they did. We showed one of the many people fired as a result of the CDO collapse a list of unusually risky mortgage bonds included in a Magnetar deal he had worked on. The deal was a disaster. He shook his head at being reminded of the details and said: “After looking at this, I deserved to lose my job.”

Magnetar wasn’t the only market player to come up with clever ways to bet against housing. Many articles and books, including a bestseller by Michael Lewis [7], have recounted how a few investors saw trouble coming and bet big. Such short bets can be helpful; they can serve as a counterweight to manias and keep bubbles from expanding.

Magnetar’s approach had the opposite effect — by helping create investments it also bet against, the hedge fund was actually fueling the market. Magnetar wasn’t alone in that: A few other hedge funds also created CDOs they bet against. And, as the New York Times has reported, Goldman Sachs did too. But Magnetar industrialized the process, creating more and bigger CDOs.

Conclusion

Several journalists have alluded to the Magnetar Trade in recent years, but until now none has assembled a full narrative. Yves Smith, a prominent financial blogger who has reported on aspects of the Magnetar Trade, writes in her new book, “Econned,” [8] that “Magnetar went into the business of creating subprime CDOs on an unheard of scale. If the world had been spared their cunning, the insanity of 2006-2007 would have been less extreme and the unwinding milder.”

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Tim Geithner’s Letter Shows Opposition to Fixed Capital Requirements for Banks

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In Financial Reform Bill

By Marian Wang, ProPublica – April 2, 2010 2:10 pm EDT

Remember how earlier this week, in a post about financial reform and liquidity requirements [1], we noted how vague [2] Treasury Secretary Tim Geithner was being with The New York Times about setting hard and fast rules about how much cash should be required to hold?

Here’s what we excerpted from the Times on Tuesday: Mr. Geithner insists that if there is one change that needs to be made to the banking system to protect it against another high-stakes bank run like the one that claimed the life of Lehman Brothers, increasing capital requirements is it.

Bank

Pinning Down Geithner

But try pinning down Mr. Geithner, or anyone else in the Beltway, on how much capital banks should be required to keep, or even how the word “capital” should be defined, and certainties disappear.

Turns out he had a lot more to say on the subject than what he told the Times. Mike Konczal [3], blogging for Ezra Klein, unearthed a letter Geithner sent to a lawmaker in January, explaining his hesitancy—really, his opposition—to setting fixed capital requirements in current financial reform proposals. From the letter [4]:

Although the Administration strongly supports imposing a simple, non-risk-based leverage constraint on banks, bank holding companies, and other major financial firms, we do not believe that codifying a specific numerical leverage requirement in statute would be appropriate.

Assessment

So when Geithner said, “We have not made a judgment yet on the number,” what he really was thinking—if this letter is any indication—is that as far as financial reform legislation itself goes, he doesn’t want a number, period. And when it comes to actually imposing tighter capital requirements on financial institutions, he wants the Treasury, the Fed or some combination of regulators to have a free hand to pick and change the number. In other words, pretty close to the way things are now.

Conclusion

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Data Show Little-Known Bank Regulator Goes Easy on Enforcement

Office of the Comptroller of the Currency

By Marian Wang, ProPublica – March 29, 2010 12:51 pm EDT

The New York Times business section had a piece recently about a little-known bank regulator [1] called the Office of the Comptroller of the Currency. It points out that while the Federal Reserve has shouldered most of the criticism directed toward bank regulators, because of its relative obscurity, the OCC [2] has escaped much of the scrutiny.

[picapp align=”none” wrap=”false” link=”term=John+C.+Dugan&iid=5559429″ src=”b/6/1/5/House_committee_examines_a74a.JPG?adImageId=11861248&imageId=5559429″ width=”380″ height=”500″ /]

John C. Dugan

The Times piece focuses mostly on John C. Dugan, the former bank lobbyist who heads the agency. It highlights criticism that Dugan is too pro-bank, and goes back and forth between criticism and Dugan’s response. Mr. Dugan bristles at the notion that he is too easy on banks and says his agency’s record on consumer protection has been “vigorous and sustained.” He says it is a “cheap shot” to suggest that his lobbying years color his viewpoint and that it demeans his employees and his years of public service. In point-counterpoint situations, what’s often helpful is hard data [3]. The Times brings it into the story later on, with statistics on the OCC’s formal enforcement orders against banks.

Assessment

The OCC has both formal and informal enforcement orders against banks. The Times’ chart shows that the agency rarely takes formal enforcement action against banks, and even more rarely doles out actual penalties to the banks in the form of fines, restitutions or refunds to consumers. The agency defended its small number of enforcement actions, saying it works closely with banks [4] to fix problems while they’re small, so as not to require stronger measures.

Conclusion

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