March 28, 2008 4:28PM

The Reality Check That Bounced

By Elizabeth MacDonald

Oliver Stone is doing a movie about George W. Bush.

That bit of news was a fitting end to last week’s kaleidescopic developments, straight off the fiction shelves.

Before I get to the week that was, I want to thank all of you who weighed in about my blog about listening to presidential candidate and Congressman Ron Paul. I am so deeply appreciative and grateful for all of your comments, I read them all and I am impressed with and admire your knowledge and passion.

I came here to Fox Business, the sister network to Fox News, just last October, and Fox Business gave me the honor of starting this blog this year. One thing rings through all of your responses–you deeply love this country and you are deeply worried. I hear you. Again, I thank you.

Please be aware that I am a flawed individual who is aware of my many limitations (on an hourly basis), please tell me when I am off the rails. I will do my level best. Know that I listen to everybody. I try to think things through, as I get an allergic skin reaction to knee-jerk, autopilot thinking.

I would like to see Dr. Paul debate all of the presidential candidates, not just John McCain (should Dr. Paul run as a third party candidate?). Though I may not agree with everything he says, I also don’t agree with what the other candidates say as well. Dr. Paul deserves a fair hearing, this country ought to hear what he has to say, especially about monetary and fiscal policy.

Here’s a recap of the week’s headspinning highlights: the Treasury Department plans to propose Monday that the Federal Reserve should get more oversight authority of all of the players in the financial markets, letting the central bank examine the books of any financial institution, not just banks; planned Congressional hearings into the Federal Reserve’s historic rescue of Bear Stearns and its handouts to investment banks, which it doesn’t regulate; the overleveraged, underwater Fannie Mae and Freddie Mac now needing to raise a total of $20b more via dilutive stock offerings, a whopping two-thirds of their market caps; scary talk about more bank write-downs; the weakening dollar; and oil veering toward $120.

But just as thinking that Oliver Stone’s movies are historically accurate is like thinking that the movie “Gone With the Wind” is a documentary, it is just as precarious to believe the fiction that the Bear Stearns-JP Morgan deal midwifed by the Fed signals the bottom of the market, as some media pundits wildly suggest.

It’s also just as cavalier to believe the analysts’ estimates of the writedowns in the financial sector stemming from the housing and credit crisis are etched in stone. They are all over the map, with stocks in Citigroup (C), Merrill Lynch (MER), Lehman Bros (LEH), Goldman Sachs (GS), JP Morgan Chase (JPM) and UBS (UBS) getting whipsawed (to get a handle on it, see my prior blog, “The Answer to Who’s Next on Wall Street”).

The writedowns will be sizable, to be sure, but the question is this: Might some of the writedowns be overstated, given cash flows are still coming in from loans backing these securities, securities the firms are being forced to write down because widespread panic has frozen the market for them?

And the broader policy issue: Will the Treasury secretary’s plan really put more guardrails on a free market that’s turned into a free-for-all? When will Congress stop its neat after-the-fact refereeing exhibited now in dealing with Wall Street’s very expensive, very messy, and personally enriching experiment at satisfying the government’s 100% homeownership dream? Will the Fed’s costly moves to revivify the financial’s balance sheets deadened by Frankenstein securities they created really work?

*THE REGULATORY FREIGHT TRAIN: Congress is hopping on it now, with the Treasury planning more oversight powers at the Federal Reserve of all financial institutions, not just banks. The Fed may become the sole regulator for both commercial and investment banks, following the collapse of Bear Stearns.  For now the proposals are taking the shape of letting the central bank scrutinize the books at all institutions–no sign yet of tough proposals, like whether credit derivatives would have to be listed on, say, the Commodities Futures Exchange, engendering more oversight.

Also hearings on Capitol Hill that may take a closer look at the Federal Reserve’s actions on Wall Street, including the forced nuptials between Bear Stearns (BSC) and JP Morgan Chase (JPM). No surprise that Jamie Dimon, who runs JP Morgan, is on the board of the New York Federal Reserve, which provided a $29b non-recourse backstop to the most illiquid parts of Bear’s balance sheets, now only protected by a $1bn cushion of first loss collateral from JPMorgan. Non-recourse, meaning, the Fed can’t hit up JP Morgan for this money, it has to auction those securities off and take a gain or a loss on them, not JP Morgan.

Tighter capital requirements for investment banks may also be in store–argument being if they can have access to the discount window, then they ought to face the same capital reserve requirements regular banks must meet. If the Fed is going to run with the wolves on Wall Street, then Wall Street needs to be tamed.

Also, as it stands now, the capital reserve levels the investment banks face from the Securities & Exchange Commission are roughly a third of what the Fed requires. Remember, banks in Japan dropped into a black hole in the ’90s because they didn’t have to set aside a sufficient amount in capital reserves to back their lending. The collapse of the banking sector in Japan led to that country’s lost decade of the ’90s, which it only surfaced from several years ago.

And despite what you hear that the Fed is only charged with printing money and that this backstop doesn’t hurt taxpayers, it does. The Fed gets to print money, with the US taxpayer paying the interest on the treasury bonds that the governement gives the Fed in exchange for printing a similar amount of dollar bills. The Fed also turns over to government coffers what it earns on the investments it holds in its portfolio. Taking a hit from Frankenstein securities means less money coming in those coffers from the Fed.

And printing more money to make up the difference–which taxpayers pay for in the form of inflation. Watch this quote: In 2002, then Fed board member Ben Bernanke, now the Fed chairman, said in a speech, “the U.S. government has a technology called a printing press…that allows it to produce as many U.S. dollars as it wishes at essentially no cost.”

*BEHIND THE BANK WRITE-DOWNS: The market is volatile because the accounting rules the financials use to book these write-downs for their securities backed by mortgages and other credit act more like a weathervane, auditors and accounting pros say (for the heated debate about what’s driving the record write-downs, see my prior blogs on the controversial accounting rules to book them, the fair market rules, “The Answer to Who’s Next on Wall Street,” “What’s Really Rocking the Stock Market,” and “In the Weeds”).

You’d have to have the training of a tornado forecaster at the National Weather Center to say with any certainty what the write-downs are going to look like, and some of these estimates already have been dreadfully wrong.

That was certainly true for the recent, way off-the-mark write-downs expected at Goldman Sachs and Lehman Bros., which came in lower than estimated. There will be losses, we just don’t know the size. No one does–hence the record volatility. Transparency works–so long as it’s accompanied by common sense.

Fights are breaking out between the companies and auditors, because the accounting rules say the companies have to get a price-tag for these securities that are backed by loans based on what the market says they are worth. That’s called ‘marking to market.’

Sounding like an Abbott and Costello routine, you can’t mark something to market when there is no market to market these securities in. “Everyone seems to be clueless when it comes to projecting how much still needs to be written off and how much longer this [market distress] will continue,” says economist Ed Yardeni. One thing you can bet on: More write-downs–again no one knows the dollar amounts–and thus more shotgun weddings between damaged financials.

*INFLATION: New numbers purport to show that inflation is not a problem. Not. Talk to any middle class family struggling with health care costs and tuition expenses, and they’ll tell you it is. Why is inflation a problem? Too many dollars, rising demand for commodities, plus, again, zero oversight, no where, none, for things like health care and tuition costs.

*GDP: GDP growth came in at a low six-tenths of a percent. Don’t know if that’ll get revised downward–if it does it’ll mean the tip of a recession. I saw a great study that says GDP should be considered on a per capita basis, to show how truly productive a country’s workers really are and to get a better window on how much an economy is growing.

In Japan, GDP per head increased at annual rate of 2.1% in the  past five years to ‘07, a bit better than the US’s 1.9% and a lot better than Germany’s 1.4%, the study says. And despite all the talk about Brazil and Russia being on fire, check this out. On this basis, Brazil increased 2.3% per capita per year since ‘03, a touch faster than Japan. Russia comes in at 7.4% per capita, but that’s because its petrodollars are pouring in while its population has been on the decline.

*THE DEMOCRATS AND TAX CUTS: In his speech on the economy last week, to punish what he thinks is “the investor class” on Wall Street, Democratic presidential hopeful and Senator Barack Obama says he wants to raise taxes on dividends and capital gains; so does Democratic presidential hopeful Senator Hillary Clinton. The presumptive Republican nominee, John McCain, still backs the Bush tax cuts.

Set aside for now the fact that the Bush tax cuts on capital gains and the death tax alone raised more revenue than President Bill Clinton’s tax hike on the upper bracket, analysts note.

For some time now, the Democrats have had no more sense than a flock of geese. That’s because hiking these taxes hurts Main Street, the most important investor class of all. Many senior citizens live entirely on dividend income alone; the middle class desperately needs its 401K and IRA money like never before because Social Security is in a ditch (thanks to the Democrats changing the law in the ‘60s so it could, for the first time, get its mitts on Social Security funds to spend on pork and to buy votes).

The Democratic candidates, in their blinkered concretism, stubbornly refuse to acknowledge human behavior. Investors sit on assets, including stocks, rather than sell and pay the capital gains tax, because capital gains taxes are voluntary. You don’t have to pay until you sell. Higher capital gains taxes keep frozen all sorts of economic activity. Hike taxes, you also get tax avoidance schemes going viral too–and massive loopholes written into the colossally inefficient tax code, a big tangled pile of barbed wire as it is. But we’d rather be a nation of tax lawyers and accountants. Both Obama and Clinton want to make it even more confusing with gimmicky credits that won’t buy you a bag of groceries for a month.

Obama and Clinton want to hurt Main Street with more taxes. “Why is Barack Obama so hell-bent on pursuing policies that would wreck America’s retirement savings?” asks Ryan Ellis, tax policy director at Americans for Tax Reform. ”Because, by and large, he doesn’t have any skin in the game.”       

How so? Obama is not part of the investor class because he’s reported no dividend income on his tax returns from 2001 to 2004, and just $2,754 in dividend income on his 2005 tax return and $1,188 on his 2006 return (Clinton has yet to release her returns).

Where are the John F. Kennedy tax-cutting Democrats? Lower taxes help the economy. Even the former Soviet satellite states like Estonia and Lithuania have enacted flat taxes. Lowering rates in our anti-growth, anti-entrepreneur tax code is the best non-inflationary liquidity in the galaxy. But as the Heritage Foundation notes, though we won the Cold war, Russia has a flat tax while we’re still stuck with America’s museum of mass confusion, the IRS.

*SILVER LINING: Weekly initial unemployment claims. In previous deep recessions, they tended to rise rapidly, over 400,000 toward 500,000, notes Yardeni. In the 1990-1991 recession, jobless claims hit 496,000 on a four-week moving average basis; in 2001-2001, it hit 489,000. The latest four-week average was only 358,000. Sigh of relief. For now.