Blame the Commodity Futures Modernization Act

Recently there was an interesting article related to one of the main culprits of the financial crisis. Below is a summarized version of the article. Thought it would be interesting to share as it demonstrates what members of Congress have the ability to do when not working in the best interests of citizens.

In the waning days of the 106th Congress and the Clinton administration, Congress met in a lame-duck session to complete work on a variety of appropriations bills that were not passed prior to the 2000 election. There were other, unmet priorities of some lawmakers that were under consideration as well. One of those priorities was a 262 page deregulatory bill, the Commodity Futures Modernization Act. An act that basically removed regulations that had been in place since the 1930’s to avoid a financial meltdown. The Commodity Futures Modernization Act of 2000 essentially made trading in derivatives and credit default swaps legal and unregulated. The Act was tucked into a bloated 11,000 page conference report as a rider, with little consideration and no time for review. This bill would be viewed only eight years later as part of the failure of our political system bringing on a historic, global financial crisis.

The saga of the Commodity Futures Modernization Act begins in 1998. At the time, the economy was booming, stocks soared, and new instruments of trading were found to make more money while evading the oversight of regulatory bodies. Two of those growing instruments were derivatives and credit default swaps.

The chairman of the Commodity Futures Trade Commission (CFTC), Ms. Brooksley Born wanted her regulatory commission to have power to oversee financial derivatives. While previous legislative attempts had been made earlier, Born’s efforts were the most direct and threatening to the financial industry. During an April 1998 meeting of the President’s Working Group on Financial Markets, Federal Reserve chairman Alan Greenspan, Clinton Treasury Secretary Robert Rubin (and later Secretary Larry Summers), and Securities and Exchange Commission (SEC) chairman Arthur Levitt opposed Born’s efforts for regulation.

Soon afterwards, Born released a “concept” paper with ideas of what regulation of derivatives and swaps could look like under the CFTC’s oversight authority. The response to Born’s paper was swift. The financial industry responded fiercely in opposition to Born’s ideas. Born felt that an unregulated derivatives market could “pose grave dangers to our economy.” In the end, Born lost her battle and, in May 1999, asked to be replaced as CFTC chairman. The new chairman, William Rainer, was more amenable to the positions of financial industry leaders and the major government officials.

Later that year, the President’s Working Group on Financial Markets released a report calling for “no regulations” of derivatives and swaps and began crafting a program to make that possible. Meanwhile in Congress, lawmakers were still up-in-arms over Born’s attempts to regulate the financial derivatives market and began working to pass their own set of deregulatory language. Leading the charge in Congress were Sens. Phil Gramm (R-TX) and Richard Lugar (R-IN) and Rep. Thomas Ewing (R-IL). In May of 2000, Rep. Ewing introduced his Commodity Futures Modernization Act of 2000. While Ewing’s bill sailed quickly through the House, it stalled in the Senate, as Sen. Gramm desired stricter deregulatory language be inserted into the bill. Gramm opposed any language that could provide the SEC or the CFTC with any hope of authority in regulating or oversight of financial derivatives and swaps. Gramm’s opposition held the bill in limbo until Congress went into recess for the 2000 election.

During a lame-duck December session, Gramm and Ewing sought to strike a compromise on the Commodity Futures Modernization Act. The day after the Supreme Court ruled in favor of Gov. Bush, December 14, Ewing introduced a new version of the Commodity Futures Modernization Act. On December 15, with little warning or fanfare—aside from the overshadowed discussions on the floors of Congress—the new, compromise version was included as a rider to the Consolidated Appropriations Act for FY 2001, an 11,000 page omnibus appropriations conference report.

The final language contained some new sections not in the original Ewing bill that, for all intents and purposes, exempted swaps and derivatives from regulation by both the CFTC, which had already implemented rules that it would not regulate swaps and derivatives, and the SEC. Also, hidden within the bill was an exemption for energy derivative trading, which would later become known as the “Enron loophole” – this loophole would provide the impetus for Enron’s nose dive into full blown corporate corruption.
While the unregulated market in derivatives and swaps did not cause the economic downturn itself, it was a propellant of the crisis, accelerating the collapses of major financial companies across the globe. As of June 30, 2008, the global derivatives market had exploded to roughly $600 trillion by some estimates. When the credit crisis and the mortgage meltdown began to take hold, major firms found out the swaps made their investments far riskier than they could handle.

Bear Stearns, Lehman Brothers, and American International Group (AIG) all collapsed due to problems with the unregulated market of credit default swaps. The major banks were also heavily involved with credit default swaps. A report from the Comptroller of the Currency recorded in the third quarter of 2007 that the top banks in the credit default market were JP Morgan Chase, Citibank, Bank of America and Wachovia.

In the end, the country would have been better served had Congress not taken the 262-page Commodity Futures Modernization Act and inserted it into a bloated 11,000 page conference report. There was a reason the laws were passed in the 1930’s and if there was a case where Congress should have given more time and debate to an act, this was it.


Click to link to news article regarding Brooksley Born and her vindication -

http://www.bloomberg.com/apps/news?pid=20601109&sid=aXcq.r6xLf4g&refer=home

Shadow Inventory of Homes

Unfortunately the housing market is still trying to find a bottom. Since this is the main cause of the current crisis, it is likely that a better housing market or at least a stable housing market that will begin to turn things around for the economy. Foreclosures are stilling running at record rates, although they do seem to be leveling off. However, a strange occurrence is happening and one which might explain the leveling off in foreclosures. It is referred to as the "shadow inventory" of foreclosed homes. According to RealtyTrac, a company who compiles nationwide statistics on foreclosures and home sales, believes that there are in the neighborhood of 600,000 to 700,000 properties nationwide that banks have repossessed but not put on the market for sale.

RealtyTrac suggests there could be several factors influencing this "shadow" market. First, it's likely there are just so may homes that it's hard to get them on the market and sold. Normally there are roughly 150,000 - 200,000 foreclosures a year. Recently, they have been running about 80,000 per month or 8 times normal levels.

With banks under a considerable amount of stress, it could be that banks are deferring sales to put off having to acknowledge balance sheet issues and losses. They also don't want to flood the market with foreclosures, driving prices down further.

Eventually banks with need to address this "shadow inventory" of homes on balance sheets.

Civilian Employment to Population Ratio

The employment-to-population ratio is defined as the proportion of an economy’s working-age population that is employed. A high ratio means a large portion of the country's population is employed, while a low ratio means there is a low level of employment (high level of unemployment) or people are out of the labor force, such as retirees.

As an indicator, the employment-to-population ratio provides information on the ability of an economy to create jobs and stimulate economic growth; it ranks in importance with the unemployment rate. Basically, working age population is defined as persons aged 16 years and older.

The rise in this ratio typically corresponds to favorable economic conditions. From the 1950's until the middle of the 1970's, the percentage of the working age population employed ranged from roughly 55% to 58%. However, from the 1980's through the 1990's, the ratio expanded at a rapid pace and reached a high of close to 65% at the end of the 1990's. From around 1982 to this high reading, the ratio gained roughly 8%. This high level of the employment ratio corresponded with one of the most robust growth periods in the US economy, with a small set back during the recession in the early 1990's.

Unfortunately, since the peak at the end of the 1990's, the employment to population ratio has been declining and has recently reached levels not seen in 30 years. It is on track to be the sharpest drop on record. Of course, our population has increased in the last 30 years, so the impact is more meaningful than it would have been in the 1970's for example. In order for the US to have sustained, robust economic growth in the future, this ratio will likely need to increase at a meaningful rate as the economy recovers; otherwise we could see relatively mild economic growth.

2009 Tax Law Changes for Individuals

New tax laws went into effect Jan. 1, and we thought we would share how the laws will affect tax obligations for 2009.

Some of the changes to the Internal Revenue Code that affect individuals, starting in 2009, are as follows:

1. For taxpayers age 70½ and older, payouts from individual retirement accounts and other retirement plans can be skipped without penalty. The same rules apply to heirs of inherited IRAs.

2. There are new rules on turning a second home into a main residence and then attempting to sell that home and take advantage of a $250,000 tax exemption ($500,000 for married couples). The new rules will make some of the gain ineligible for this exclusion. The amount that would be taxable is based on the ratio of time after 2008 that the home was used as a second home or rental property to the total time the seller owned the home. The balance of gain remains eligible for the exclusion.

3. Casualty losses are now subject to a $500 floor, up from $100 in 2008.

4. Income caps are raised for tax-free EE bonds used for education purposes. In order to qualify, parents who are married must file a joint return. The exclusion starts phasing out at $104,900 of adjusted gross income and is gone when AGI reaches $134,900 (the range for single filers is $69,950 to $84,950).

5. The estate tax exemption has gone up from $2 million to $3.5 million, but the tax rate remains at 45%.

6. The annual gift tax exclusion has been raised from $12,000 to $13,000.

7. U.S. taxpayers working abroad have a higher exclusion tax this year. It is now $91,400. This is a bigger incentive for Americans to work overseas.

8. The standard mileage rate for business driving for 2009 is now 55 cents per mile, and 14 cents a mile for miles driven for charitable purposes.

As always, every person's tax situation is unique and all changes in tax code should be considered when it comes time to file a return. Please check with your accountant if you have specific questions.

Lower Volatility is Key

After the move in the market this past week, the big question for investors is whether the market has undergone a sustained change in character. Has the bear market ended, at least for now? Is the market going to move higher?

Investors have some good news and a number of strong fundamental arguments to support the recent rally. This week, the accounting standards board made some changes in the mark-to-market accounting rules and optimism that the G-20 economic conference may actually be a bit ahead of the curve in addressing some of our most pressing problems is a big positive.
Probably the biggest potential fundamental positive is all the stimulus money and liquidity that is being plowed into the economy over the past few months. As of April 1st, most Americans will be seeing an extra few dollars in their paychecks each week with the changes in withholding tax.

The big problem we face is that after a quick move up off the March lows and the fast and furious action of the past week, we have a lot investors acting on emotion again. Most folks are worried about being left out and missing a big move, after wanting out just a few short months ago. It doesn't help when so many market pundits have called "the bottom."

It presents a real conundrum for any prudent investor who has seen big swings in the market over very short periods of time. The market was down over 20% in just 18 days in Feb/Mar and is now up roughly 20% in the last 18 days. Volatility is extremely high as uncertainty still lingers. This poses a problem for investors who are looking to build longer term positions in the markets.
Once again the market is at a particularly interesting juncture as earnings season starts in earnest. We should hear plenty of comments in the next few weeks about how the economy is affecting business. That won't necessarily send us lower, but the recent rally is going to increase expectations, and that will make for more volatility.

Institutions have been stepping into the markets the last few weeks, as this is why the markets have snapped back after down days. This is a positive sign and hopefully it continues. However, the volatility and daily swings are something institutions need to see less of if we are to see real sustained buying.

Long Term Trend Chart 4/2/2009

Above is a long term monthly chart of the S&P 500 Index going back to 1995. With all the recent volatility and news, it is sometimes helpful to take a big picture look at the market. When markets move lower and volatility increases, it often takes a period of time for the market to "adjust" to new price levels before moving into a long-term uptrend again.

Notice the red and blue price lines right below the monthly chart of the S&P 500. These lines basically measure average prices over a rolling period of time, in this case monthly. The red line measures a shorter term average price and the blue line a longer term average price. The newest monthly price is added and the oldest monthly price is dropped from each average each month. These lines essentially show us if prices are moving higher on average or lower on average over a long period of time. When the red line (shorter term average) crosses the blue line (longer term average) to the downside, prices are moving lower on average and vice versa when the red line crosses up through the blue line.

When the red line crossed the blue line in 2003 (which was accompanied by institutional accumulation), the trend in the market changed and a long-term upward trend developed. Currently both the red and blue lines are still moving lower, so the long-term average price of the index is moving lower, despite the recent 20% rally in the index. If the recent 20% rally also corresponded with a red to blue crossover, as it did in 2003, we could assume the average price on a long term basis was beginning to move up and it would likely mean a change in trend in the markets.

Based on the current readings, it will likely take several more months of stable prices or base building in the index before the red and blue lines begin to stop moving down and then begin to curl upward as they did in 2003. While we can try to anticipate a change in trend, the markets can change direction on a dime in the short term. Remember, the downside in the markets last year erased the previous five years of gains. This doesn't mean the market can't move higher and it may continue to do so. However, from a risk/reward standpoint, it's better to wait to become more aggressive when the long term risk/reward setup is in our favor. Once the average price lines begin to flatten out and stop going down, we can begin to look more favorably at the markets.

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Welcome to the BAM Weekly Bulletin! Be sure to check back each week for the latest economic news, important financial and tax tips, market updates, and relevant financial information.