The Economy

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The Bat-Signal
The Bat-Signal

Having saved the world from itself over 60 years ago and put a man on the Moon 25 years later, Americans are a proud lot. But, time waits on no one. As the country's vaunted financial infrastructure reports over $400 billion in write-offs and credit dries up, the transportation infrastructure watches its airlines charge for carrying a suitcase while bridges collapse, and its social security infrastructure sinks slowly into the abyss of insolvency, dare we ask, “what's next”? Try energy. Meeting America's energy needs and moving toward a low carbon future look increasingly distant.

This article could as easily be about the financial or transportation infrastructure as it is about energy. Or education or healthcare or immigration. We're reasonably good at fixing specific problems, considerably less adept at developing policy over broader areas. The reasons are many but one is key: our central government has sought—and failed—to fix and do everything. Blame it on the media, personalities, or simply good intentions gone bad. But, debate, compromise and principled consensus have become ever more difficult in Washington. The end result is the country's real challenges remain unsolved.

THE ENERGY CONUNDRUM

America knows it has an energy problem, but the question is, how do you fix it? The National Conference of State Legislators’ recent 2008 Energy Summit offered several ideas. Says Kentucky State Senator Rodky Adkins, “there is no strategy to get from A to Z. And as all of you know, the lead times on these projects are enormous.”

The fact is, says, Dr, Howard Gruenspecht, Deputy Administrator, Energy Information Administration, “we didn’t build much of anything in the 1990s. What’s been happening is that we’ve been living off the coal and nuclear power we built in the 1980s.”

Most (if not all) Americans care about what they pay at the pump. But, there’s a lot more: heating homes in the winter, cooling them in the summer; generating enough electricity to turn on light bulbs, run the dishwasher, and power up the computer; and, then there’s street lamps, Big Macs, shops on Main Street, and our entire industrial and commercial core.

Over centuries, fossil fuels have fully integrated themselves into the US and world’s economies. Says Gruenspecht, “coal dominates the energy mix in the US. Today, it is about 50%; natural gas is 21%, and nuclear accounts for 19%. Renewable energy is about 2.7%.” And over the next 25 years, those percentages won’t change much, though renewable energy could grow to about 7%. Some say these percentages are skewed, and that the percentage of renewables—solar and wind, for example—could increase to 20%. But, they offer little in the way of proof. And other than being a great investment for venture capitalists, that still leaves the US dependent upon fossil fuels for over 80% of its energy needs.

CLIMATE CHANGE

There is, of course, this problem—meeting the country’s energy needs. There is also the issue of, how do we do it? Naysayers abound, but there is a growing consensus that overuse of fossil fuels has endangered the planet’s survival. Dr. Michael Maddox, CERA, notes that, “there’s a huge conundrum as we try to deal with climate change and energy needs together.” Susan Tomasky, President, AEP Transmission, asks, “most basically, when are we going to reduce carbon emissions from the economy?”

If you do something about climate that will dramatically change what you do about energy. Coal, for example, emits more C02 than other forms of energy. At higher prices, it takes a lot of natural gas to offset costs of substitution.

Power demand is increasing despite gains in efficiency. Says Gruenspecht, “over time, growth in demand for electricity has slowed down to about 1.1% annually because of market saturation and improved efficiency. But, we still expect it to grow. By 2030, it will be about 25% above today’s demand.”

The US has lost a lot of energy-intensive businesses to outsourcing. The decline also has to do with structural changes in who’s using electricity. For example, statistics show that electricity per individual has gone down. But, per household, it has gone up. Why? We live in bigger homes with smaller families. And, the saturation of other appliances has grown significantly.

CHANGE WE CAN BELIEVE IN?

Says Tomasky, “fundamental changes need to happen over the next several decades: it can be done piecemeal or as a country, but are we going to take an overall look at the issue(s)?” She adds, “we will have to use all sources to meet demand plus a significant component of energy efficiency.”

Dr. Brian McLean, US Environmental Protection Agency (EPA), notes that, “changing the path will require transformational efforts. It will require a portfolio of technologies and policy tools.”

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In terms of electricity, today’s grid was largely built in the 1950s and 1960s, mostly by local companies. It is outmoded and almost at capacity. Says Tomasky, “if we are to change the existing grid, we will need a new type of transmission system. We will need a sophisticated Extra High Voltage (EHV) network: one with a lot of off-and on-ramps to add load and generation resources.”

She cautions, though, “EHV has to serve a regional purpose. It will not get built if we have to go state-by-state. It also requires a conscious public policy decision—this is a critical part of our solution.” And, she notes, we will be making these decisions in the context of increasing commodity and material costs.”

Wind represents over 50% of the small percentage of renewable energy in the current mix, but its growth has been largely driven by the production tax credit. The main reason is that the numbers stand right on the cusp of commercial viability. Once that’s solved, we will have to move wind-generated power from the southwest to where the customers are. To that end, for example, Texas approved a $4.93 billion investment to integrate wind into the state’s power grid.

Have the resources been mobilized? Says Tomasky “we will have no problem building a transmission system if the path has been identified.”

ENERGY EFFICIENCY

Another big issue is energy efficiency. Policy initiatives include codes striving for zero net energy buildings; conservation and demand reductions; using clean energy like solar and wind; and advancing the use of ‘smart’ devices, programmable thermostats and heat pump water heaters for example. All of this will require considerable customer education.

And, then there are the policies that state governments have put in place: system benefit funds, high performance building requirements, energy efficiency resource standards, and appliance and vehicle efficiency standards for example. Then there are financial incentives — tax credits, for example.

PRICING

That leads to what all of this will cost—billions if not trillions. At a macro level, there are the policy questions. On a micro level, we have to make sure that use of an asset reflects its scarcity.

Dr. William Shobe, University of Virginia, says that it’s better to use a price signal that allows all users to understand what they get for what they’re paying. He thinks that we are currently underpricing electricity. “Why are electricity prices so low? It doesn’t reflect the true marginal cost of production,” namely the externalities of carbon emission.

Economists have historically advocated two acceptable price signals: charge for the goods directly or cap use and let those who need it trade the resource among themselves.

This has given rise to creating assets in CO2 via a cap. But, this has far reaching consequences: for starters, who “owns” the carbon asset—federal, state or local governments? And, things work against each other: there’s more efficiency but more appliances, higher incomes and more technology working against it.

What about fossil fuels? Should we encourage offshore drilling, coal mining, and natural gas exploration? Says Steve Bossart, US Department of Energy, “in the short term, the aim is to use all available resources. In the long term, we have to go to sustainable energy.”

What about nuclear energy? The lone plant that is far enough along in the US could be commissioned by 2015—seven years from now. The plutonium waste issue remains unsolved. And, granted that the waste problem exists, the world is currently building 30 nuclear plants: do we as a country want to be part of that debate?

ROLE OF THE STATES

Finally, there is the question of how these issues get solved. There’s tremendous variation across the country and between states. Congress has been gridlocked on energy policy, while certain issues are better dealt with at the state level, e.g., building codes and utility regulation. Broad participation will be needed. Action will be needed by federal, state and local governments, by industry and individuals.

So, where does all this leave the US? And, remembering, that energy is just one among many issues clamoring for attention and resources. Hard to say, but Commissioner Gordon might warn, “time to put up the Bat-Signal!”

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Economic policy covers a multitude of topics—interest rates, employment, inflation, and GDP growth to name a few. It’s about the environment, agriculture, and energy. But, mostly, it’s about budgets: deciding how much money goes where and then how to raise it.

As the US ponders its economic future, PT spoke with three different sources about their take on what lies ahead: Wilbur Ross, one of the country’s experts on bankruptcies and restructuring; Georges Sudarkis, an investment officer with ADIA, the world’s largest state fund; and Vic Miller, a leading authority on federal budgets. To read what they had to say, check out the three new articles in this May 2008 issue of Policy Today.

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Feature Story

Wilbur Ross

Highly regarded within the field or bankruptcies and restructuring, Wilbur Ross is Chairman and CEO of W R Ross and Co. of New York. His successes include automotive, coal, and steel manufacturers. Now, Ross is focusing on the financial services sector.

At a recent conference, Ross provided a very sobering view of the financial black hole that American banks and consumers have dug for themselves.

Opening on a lighter note, Ross said, “I recently happened to find myself at the Federal Reserve Bank in Boston. At the reception desk hangs a carefully done sign, which informs the visitor, ‘The Federal Reserve Bank of Boston does not cash US Government Pay Checks.’” Ross continues, “someone had written in magic marker pen below, ‘what do they know that we don't know.’” That tells you a little bit about the state of confidence in the US today.”

Ross said he believes “the present financial crisis is about four(4) times as severe as the 1986-1990 S&L crisis, about two and a half times worse than the 10 year Japanese crisis, and about twice as big as the Asian crisis as 1998-1999.”

Further he says, “the IMF has forecast cumulative losses of some $945 billion, but that excludes high yield bond losses, which will add another $150 billion to that total. So, I believe the probable total damage from this crisis is something on the order of $1.1 trillion. For most financial institutions, each $1 of equity supports at least $12 of lending capability. Therefore, these losses are equivalent to removing about $13 trillion of lending power from the system,” just about the annual GDP of the US. “That's one reason why you don't hear much anymore about the worldwide liquidity excess that was supposed to save us from every imaginable financial crisis.”

Lender psychology has also changed

Says Ross, “the other important change has been in the psychology of lenders: for several years, no lender had been afraid of anything. Now, every lender is afraid of everything. Banks don't want to lend money to other businesses, and they especially don't want to lend money to each other. And, that's why the premium for interbank lending has sextupled over the past year.”

He points out that in the 3 years from June 30 2004 to June 30 2007, the top 10 European and American banks more than doubled their total assets, “partly because they had to take onto their own balance sheets the SIVs and other little pockets in which they had been hiding loans before. Now every bank wants to shrink its balance sheet.”

Another time bomb: CDs

“There's another huge but unclearly defined time bomb called credit derivative swaps, in which one party contracts to pay another party in the event that a particular debt instrument defaults. These have been growing amazingly rapidly - 37% in the second half of 2007 alone and now cover an amazing $62 trillion worth of underlying debt. The gross amount of CDs' outstanding is $455 trillion notional value of contracts.” Ross explains, “the reason that's seven (7) times the underlying amount is that an entity that wrote credit protection on a particular security at one point in time may well buy the same kind of protection to lock in the spread.” According to the International Swaps and Derivative Association (ISDA), offsetting trades means that if you netted out all of the trades against each other, the net credit extension is $2.3 trillion, still a huge amount.

“This is problematic because it's largely an unregulated global industry not conducted visibly on an exchange nor through a clearing house mechanism—and, it mainly covers corporate debt. Because it is a daisy chain, in which 37% of the players put up no collateral capital whatsoever, defaults could suddenly create a problem that is tens or even hundreds of trillions of dollars in size. So far it has not really blown up. I hope it doesn't. But, it's one of the risk factors that one should think about in evaluating US and Western European credit markets.”

How did this systemic compounding of risk happen? Says Ross, “it's three-fold. First, historical concepts of risk management were discarded. Instead of operating on the traditional basis of ‘risk adjusted returns,’ many lenders were operating on the basis of ‘risk ignored returns.’ They were seeking returns and not really focusing on the risk component.”

Two most dangerous words: financial engineering

Second, are what Ross calls, “the two most dangerous words in the lexicon of Wall Street, ‘financial engineering.’” Brilliant young mathematicians with elaborate computer programs believed that they could forecast the probability or severity of default on newly created securitizations. And, they believed they could do it so well that they could bundle together $1 million of underlying low quality securities and slice and dice them into tranches that would create a collateralized debt obligation with a trading value of $1 million and $30,000 ” which would do to the packagers and distributors of the paper.”

Initially, originators retained the lowest tranches but as the securitizations grew so rapidly, they began to put too much of their own capital at risk. So they developed a new and extremely toxic product, called a CDO squared. This consisted of taking the lower, unwanted tranches of the initial securitizations, bundling them together, into a new CDO, selling the highest tranches of those (which turned out to be most of the whole thing), get it rated AA and AAA — and then sell it off. The same accounting magic turned the same million dollars into $1 million and $20,000—the fee again spread among the same parties.”

“What made this occur was the rating agencies acceptance of the black boxes' output. They were given a AAA rating. That generous allocation of credit rating is what created the extra trading value, because the AAA and AA tranches could trade at lower yields than the underlying securities.”

There were some inherent flaws in all this says Ross. “First, historic modeling implicitly assumed that tomorrow would look a lot like yesterday. But, the truth is, that major credit crises come about when tomorrow turns out very different from yesterday. Second, in subprime and most other forms of mortgage lending, anyone that did field due diligence would have known that the endemic deterioration of lending standards made it 100% certain that tomorrow would not look like yesterday, and instead, would look far worse. But back then, no one wanted to interrupt the party.

Turns out, says Ross, “CDOs have not performed well. During the first three months of 2008, 4,485 of these issues have been downgraded. And a 1,000 of those were previously rated AAA. Many of these AAA tranches were held by banks. These downgrades help to explain why banks have already written off $230 billion worth of their CDOs.”

Where do we go from here?

“So, that's how we got to where we are now. The scariest part of where we are now is what has happened to the American consumer. Consumer spending represents 70% of our total economy. It's really the engine that drives our economy.”

Ross points out that, “median income has dropped from $61,000 to $60,500 over the past year . It actually went down. But Americans, like people everywhere, would like to improve their standard of living. So, the solution they found to median income not going up was borrowing. So, they decided to first load up with consumer debt. For the past several years, Americans had no net savings. When that ran out, people started using their homes as a kind of ATM with a bedroom. That worked well as long as property values were going up. But, now housing prices are going down, not up.”

Wealth effect is now a poverty effect

In those years, even if people didn't take out a bigger mortgage, they felt wealthier as their house prices went up. Now, we have kind of a poverty effect as the value of the house declines. Each 5% decline in home values erases $1 trillion of American's net worth. The Federal Reserve Board estimates that for every $100 change in home values, consumer spending changes by $3.75 and many economists think the ratio is higher--$7.00 per $100. If they're right, a 5% property value decline would cut consumer spending by as much as $70 billion per year.”

“In the 12 months ended March 2008, bank repossessions of houses rose 129% from the year earlier period. And, it's not over yet. Delinquencies and foreclosures are rising rapidly; inventory is now more than 6 months supply on a nationwide basis.”

Says Ross, “Moody's estimates that by June 30, 10.6 million homeowners, 21% of all those with first mortgages outstanding, will have no or negative equity value in their homes. Meanwhile, it's very hard to get a mortgage. Lower interest rates don't help too much because it makes little difference whether you're turned down for an 8% loan or a 6% loan.”

V-shaped recovery?

“One bright spot, the weak dollar will begin to reduce our balance-of-payments deficit in the economy, albeit one that is a small fraction of consumer spending. And, one that is largely offset by the implosion of employment in real estate and mortgage industries, which created about 17% of job growth in 2006.”

“I believe we have entered a consumer and credit-driven recession that will cause at least another year or more of stagflation. But, I don't believe that it will reach the levels of the end of the world or Great Depression.

“I wish that I could agree with those who see a sharp V-Shaped recovery in the second half of the year, but I simply think that's wishful thinking.”

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