Zuni elder Si Wa Wata Wa
Ilargi: As you may have gathered by now, I read a lot. A whole lot. Today is no exception, as you can see from the amount of material below. I like to see what everyone is saying, especially when opinions differ a lot. Still, I knew beforehand what I thought, and what I would write about. I’ve known this one since I first started writing about finance a few years ago.
The credit - or financial- crisis we are drowning in today was caused by one thing: bankers and other financial institutions treated their deposits and other solid assets as items that could be put on casino tables as collateral for bets. Anything they could claim ownership of was laid out right there in front of the dealer, and the dealer accepted it. This was possible because regulators, and governments in general, loosened definitions of ownership (is that really yours, sir? ), and allowed their fat fingered bankers to bet 10-20-100 more than they actually showed the dealer, who in turn assumed the government would be good for it.
This part of the casino has now been closed; the tables are empty, the chips are missing, and Mr. Luciano is out looking for kneecaps.
The answer of the governments is both surprising and predictable. They gamble. The only money left in the world belongs to the people who have voted their representatives into power. That money is now put on a new table, with a new dealer, and, if you like, a new game, and it carries the promise to make up for the losses incurred at those now closed tables.
There are many politicians, evidently the majority of them, who simply don’t understand, who walk into the new casino and think it’s a house of parliament, or something else they feel comfy in. They don't know the games being played, they don't know where they are, they are utterly clueless, but they have hundreds of billions of dollars in public money that they can put on the tables. And they do, pressured by shady soft-talking 'experts' who they think know far more than they do, even though the experts are paid by the bankers whose losses will supposedly be made good on by their voters’ money now at risk as the wheel spins.
Yesterday’s rate cut by Bernanke's Fed is the clearest -though by no means the first- signal that the entire gamut of political action has run its course, and it hasn't helped one bit. The answer: double or nothing. When one idea fails, 3 of the same ideas will surely solve the issue. They are gambling with other people's money, and that is always easy. It’s your money though, and the chances of winning are miniscule. They just don’t know what else to do. Every politician is a mini-Bernie Madoff. Addicted to power, fame, money and attention. The combined stakes we see today are at least a 1000 bigger than Madoff's paltry $50 billion.
But this is not the only way to approach the failed system. They could simply let the failed banks fail. You don't, as they like to make you believe, need those banks. You need access to your money. Your government can give you that. Instead, it tries to use your money to save banks you don't need. And those banks are so deep in debt that I can guarantee you all of your money will be lost, and the banks will still in the end go under. How to solve this? For one, expose all the losing assets in the banks. Let the ones who have too many bad assets die.
If you need one reason why all assets must be put on the table, valued and either sold or written down, look no further than AIG, which has already received $158 billion from the Treasury, last week revealed $10 billion more in losses outside of the Treasury deal, and today adds yet another $30 billion. One of two things is true: either Paulson has been lying and hiding what he knew about AIG when he opened the spigot, or he simply didn’t know what he was pouring the money into. In both cases it's insane that he is still on the job.
The Fed decides to play the record till the needle is scratching, and the hole still means there is no more music. Claims that they can still print as much money as they want are ludicrous. They can’t, US foreign debt is far too high, and besides, all countries are in the global economy. They're all in the same boat: they need international trade. That is not possible with indefinite money-printing. Either you buy stuff abroad, or you print money. Can't do both. The bond market decides the fate of a currency, not a government.
The people in charge of our governments and economies have a vested interest in saving the system. That system cannot be saved, it’s bankrupt. All that has been done to “save” it has a direct negative effect on you. And the effect got a lot worse yesterday.
It's your lives that are being gambled away.
I was thinking after posting the above, and feel it is good to point out something. Quite a few voices, including me, have been pointing out that central bank/treasury policies so far have been nothing but trying to get out of debt by issuing more debt. But what I wrote above points to an extra, and more perverting, dimension. The people, elected or not, who have access to all of our money, are now trying to make up for gambling losses by .. gambling. And that's much worse.
They don't know that measures will work, they make it up as they go along. You can stick Bernanke being a 'scholar' of the Great Depression where the sun don't shine. He's done everything wrong so far, from the taxpayer's point of view. His friends are doing fine, mind you, trillions of dollars in losses have been transferred to your tabs. Gambling with other people's money is an ugly thing, and it never ends well. The rate cut to zero is a herald of things getting completely out of hand. Again, from the point of view of the taxpayer, not the banker. The anonymity of the taxpayer, combined with his complacency, makes him an easy victim. But even there, there's limits. You just wait.
Update 6.00 PM EST: Whistling past the graveyard. Can't halt it all for a month or more and still come back. One down, two to go.
Chrysler to close all 30 plants for one month
Chrysler will halt its manufacturing operations this Friday for at least a month, to match production levels with consumer demand, and the move will affect its plant in Windsor, Ont. Operations at the Windsor plant - which makes minivans -- could be shut down until Feb. 2, according to reports. The closures affect all of the company's 30 plants across North America, and employees at most of those plants will not return to work until Jan. 19 at the earliest.
At a recent meeting, Chrysler dealers expressed concern that consumers could not buy vehicles because of a lack of financing, as a result of the worldwide credit crisis. "The dealers have stated that they have lost an estimated 20 to 25 percent of their volume because of this credit situation," the company said in a statement Wednesday.
The temporary closures will affect about 46,000 workers in the United States alone. Those employees will get state unemployment benefits and supplemental payments from the company, according to ABC News.
Bernanke Goes All In
If Ben Bernanke weren't an economist and central banker, we'd guess he'd be a poker player on one of those cable channels, with dark shades and a penchant for betting all his chips in Texas Hold 'Em. The Federal Reserve Chairman certainly does like to go all in on monetary policy, never mind the risks. If the current Fed believes there are limits to monetary policy, you can't tell from yesterday's Open Market Committee statement. The 10 members voted unanimously to take its target fed funds rate down to between 0% to 0.25%, from 1%. With Treasury bills already trading at close to zero as the world flees toward safe investments, the practical impact of this rate cut is negligible.
However, the committee also promised to inject money into the economy through a policy that economists call "quantitative easing." This means adding to the Fed's balance sheet through the direct purchase of government bonds or other assets from banks. The theory is that this will prompt more lending and investment. As the nearby chart shows, the Fed has already moved in this direction since the credit markets seized up in late September. With the velocity of money collapsing as the recession deepens, the Fed is trying to put a floor under the economy by pledging an unlimited supply of dollars. Another goal is to fight the risk of deflation, or falling prices, as long as the economy continues to shrink. And judging from yesterday's rally in stocks and bonds, many investors like the idea.
The unhappy truth, however, is that markets have cheered previous Fed easing, only to be disappointed over time. Former Fed Vice Chairman Alan Blinder captured the point when he told the Journal yesterday that "The Fed gets an 'A' or 'A-minus' for effort and not very good marks for results." The remark comes with some ill grace from Mr. Blinder, who has cheered the Fed's easing nearly every step of the way. But he's right that the real test of policy is whether it contributes to economic growth, not whether Mr. Bernanke can dazzle the spectators with pyrotechnics. And on that score, the results of monetary policy this decade have been miserable. First, the Fed created the credit mania and housing bubble by keeping interest rates too low for too long. Mr. Bernanke was a Fed Governor at the time, and he still publicly acknowledges no error.
Then in autumn 2007, the Fed sent rates falling rapidly again, inspiring a second bubble, this time in commodity prices, that has only deepened the recession. Former Fed Governor Frederic Mishkin defended that decision on these pages on Monday by noting the economy would have been worse had the Fed not cut rates. This is impossible to know. But we did notice that Mr. Mishkin somehow managed not to mention the nearly year-long commodity spike. Now the Fed is embarking on a further monetary adventure and asking the world to believe that this time it will work. We sincerely hope it does. And if a lack of liquidity is the problem in some credit instruments, the Fed's direct purchase of those assets should contribute to a credit thaw. It has already contributed to a decline in mortgage rates.
However, the larger economic problem today isn't an overall lack of liquidity. It is fear and uncertainty. Banks, consumers and business are dug in their foxholes, conserving their cash until they believe the worst has passed. Meanwhile, investors around the world are deleveraging to reduce risk and cut their losses, a process that the Fed can do little about. More than merely additional Fed liquidity, what the economy really needs is a revival of economic confidence. We've argued for more than a year for a major tax cut, but the Obama transition is focusing on spending "stimulus" instead. Down this road lies more disappointment. The other lift could come from more aggressive financial plumbing, with Treasury and the FDIC pushing banks to confront their losses and closing or merging institutions that are bound to fail. The Obama Treasury could do worse than to turn the TARP -- Troubled Asset Relief Program -- into the resolution agency that Paul Volcker and others originally envisioned.
As for the Fed, the $2.2 trillion question is whether it is willing to act fast enough to withdraw all of this excess liquidity once the economy turns up. Mr. Mishkin and his intellectual comrade, Mr. Bernanke, insist the Fed will. But we've heard that before. And we also know that the Fed relies on the lagging economic indicator of unemployment, rather than forward-looking price signals, to set policy. It's no accident that the dollar has weakened in recent weeks, and that yesterday it took another hit. The world's investors are saying they aren't sure they can trust Mr. Bernanke's monetary bet.
Bernanke Attacks the Recession with Overwhelming Force
The Federal Reserve cuts the funds rate to 0.25% and announces unconventional measures to revive the economy. Call it Ben Bernanke's "shock and awe" campaign. On Dec. 16, the Federal Reserve announced that it is attacking the recession with a more powerful arsenal than ever, including a cut in the federal funds rate to a historic low of just zero to 0.25%. The central bank is counting on a show of overwhelming force to vanquish the recession and get Americans borrowing, spending, and working again. The stock market climbed after the announcement, with the Dow Jones industrial average closing up 359.61 points, or 4%, at 8,924. Prices had been up slightly before the announcement in anticipation of powerful Fed action. The consensus Wall Street expectation was a half-point cut. Ten-year Treasury notes rallied on the expectation that the Fed will be buying even more of them. Their yield, which goes down when prices go up, fell to a new low of 2.3%, from 2.5%, on Dec. 15.
"Whatever it takes—that's what we do," wrote Wachovia (WB) Chief Economist John Silvia, paraphrasing the rate-setting Federal Open Market Committee. Silvia said the committee went "where no FOMC has gone before." Usually the Fed names a particular rate for its target for the federal funds rate—most recently it was 1%. This time it named a ceiling, namely, no more than one-quarter percent. Anything below that level, down to zero, is acceptable to the Fed. That alone is a historic change. It's a measure of the severity of the financial crisis that there were no dissenters from the Fed vote. Even inflation hawks such as Philadelphia Fed President Charles Plosser and Dallas Fed President Richard Fisher voted "yes" on the measures.
The language in the statement released by the Fed was unusually strong. The central bank eschewed any effort to be even-handed about the risks of recession vs. inflation. The economic downturn is clearly Enemy No. 1. Said the Fed: "Labor market conditions have deteriorated, and the available data indicate that consumer spending, business investment, and industrial production have declined. Financial markets remain quite strained and credit conditions tight. Overall, the outlook for economic activity has weakened further." As for inflation, the Fed said, "inflationary pressures have diminished appreciably" and should "moderate further in coming quarters." In an attempt to impress the markets with its resolve, the Fed made clear that it won't ease up on easy money until it is sure that its objectives have been reached. The Fed statement said it "anticipates that weak economic conditions are likely to warrant exceptionally low levels of the federal funds rate for some time."
With no more room to cut interest rates, the Fed is turning more and more toward buying up debt in an effort to drive down interest rates. It is targeting Treasuries, the corporate debt of Fannie Mae and Freddie Mac, and mortgage-backed securities. In recent months its assets have zoomed from around $800 billion to $2.2 trillion. In a conference call with reporters after the 2:15 p.m. ET announcement, a senior Fed official tried to draw a distinction between what the Federal Reserve is doing and what the Bank of Japan did in its efforts to stimulate the Japanese economy during the "Lost Decade of the 1990s." The official said that Japan's central bank focused on the liability side of its balance sheet, emphasizing the expansion of cash and bank reserves in order to flood the banking system with money to lend. In contrast, the official said, the Federal Reserve is putting its attention on the asset side of the balance sheet—buying up assets such as Treasuries and mortgage-backed securities in an attempt to drive down rates and improve the health of the overall economy and, in particular, the housing market. On the same day that the Fed made its move, the U.S. Commerce Dept. announced that new-home building starts in November fell by 19%, the sharpest monthly drop since March 1984.
The distinction between the Japanese and American approaches is subtle because, as any accounting student knows, the asset and liability sides of the balance sheet are mirrors of each other. But under Bernanke, the Fed is clearly hoping that targeting certain key market interest rates will get lending and borrowing going again. By its charter the Fed is not allowed to make loans or accept collateral that could expose it to a big chance of loss. That's where the Treasury Dept. comes in as a partner. In its Dec. 16 statement, the Federal Reserve served a reminder that it has a big new program in the wings in conjunction with Treasury. Starting early next year, the Fed will lend up to $200 billion to "facilitate the extension of credit to households and small businesses." To hold down the risk of losses by the Fed, the Treasury Dept. will absorb the first $20 billion in losses.
The End of the Fed as We Know It
The Federal Reserve threw up its hands and officially "exhausted its most fundamental tool for managing the economy," as the Washington Post puts it. The central bank cut its benchmark interest rate to as low as zero and announced that it would aggressively move to implement new programs to fight the recession. The Fed went further than many expected and cut its target for the overnight federal funds rate from 1 percent to a range of zero to 0.25 percent. The Wall Street Journal also points out that the discount rate, which is the interest rate that banks have to pay on loans they receive from the Fed, will drop to half a percentage point, "a level last seen in the 1940s." What does this mean? "For the foreseeable future, interest rates are nearly meaningless as a tool of economic policy," the Los Angeles Times bluntly states. The New York Times and LAT both say the announcements mean that the Fed has now officially entered a new era.
Although it may be shocking and historic that the Fed would cut a key interest rate from 1 percent to nearly zero, the truth is that the move is largely symbolic. For weeks, the federal funds rate has been trending far below the 1 percent target. The "difficulty in managing the rate may be one reason the Fed, for the first time, gave a range for its rate target," notes USA Today. "They're at such a low level that it's gotten really hard to control the funds rate," an economist tells the WP. "This cut is essentially saying 'Let's get this over with.' " In an accompanying statement, the Fed made it clear that it's ready to use unconventional means to help American consumers and businesses get credit. Investors liked what they heard and sent the Dow Jones industrial average up 4.2 percent.
In its statement, the Fed made it clear that it won't be shy about printing money to thaw the frozen credit markets. Essentially, "the Fed is stepping in as a substitute for banks and other lenders and acting more like a bank itself," the NYT helpfully explains. In normal times, the Fed can spur spending by lowering its official rate. But this hasn't been working well for months because even though the official rates are low, banks remain fearful about lending money. The Fed now says it is ready to expand efforts to buy mortgage-related securities and is exploring whether to purchase long-term Treasury bonds, which could help lower long-term borrowing costs. The WSJ says Fed officials came to their decision after two days of meetings where lots of time was devoted to other steps the central bank could take to fight the recession. Federal Reserve Chairman Ben Bernanke spent much of his academic career studying these questions, "and the Fed is now employing almost every prescription he laid out in the past," notes the WSJ.
Of course, the new strategy carries risks. There's no guarantee that it will work, and, as an added bonus, it could create higher inflation. But officials aren't too worried about that now, particularly since the consumer price index plunged 1.7 percent in November, a new record. The dollar fell sharply yesterday for the second straight day, which, as the NYT points out, reflects a fear that there could soon be lots of freshly printed dollars in the markets. President-elect Barack Obama used the Fed's announcement as an opportunity to tout a massive stimulus package. "We are running out of the traditional ammunition that's used in a recession, which is to lower interest rates," Obama said. "It is critical that the other branches of government step up, and that's why the economic recovery plan is so essential."
While the rapidly declining prices have brought about fears that the nation will fall into a deflationary spiral, the NYT's David Leonhardt says the trend could actually help ease the pain of the recession. The reason for this is what economists call the "sticky-wage theory," which says that businesses won't cut wages during an economic downturn. Pursuing such a move is seen as such a big morale killer that most executives prefer to lay off workers. Although workers are likely to take indirect pay cuts, the drop in prices means real income of those lucky enough to still have jobs won't be dropping too much and could "soften the blow" of the recession for many American families. In another sign of the toll that the recession is taking on Americans, the WP reports that welfare rolls are surging for the first time since the system was redefined more than a decade ago. This trend is notable because welfare rolls usually don't see much increase during economic downturns. Now, welfare rolls are climbing in at least a dozen states. Some think this means that "welfare will awaken from years as a political issue so sleepy that President-elect Barack Obama did not mention it during his campaign," notes the Post.
When welfare was redefined, a lot of emphasis was placed on finding jobs, but now many of those applying for assistance are people who used to live a comfortable middle-class existence and can't find work at all. Many of those signing up for welfare "shouldn't be receiving assistance if there [were] jobs out there," one Maryland official said. "The problem is, what we are seeing here is something that looks more like 1936 than 1996." Not surprisingly, several states decided to use the welfare money for other purposes during the economic boom and now risk running out of funds. The Securities and Exchange Commission acknowledged yesterday that it had been warned several times about red flags in Bernard Madoff's investments but failed to uncover what could end up being the largest financial fraud in history. The SEC will immediately open an internal investigation to try to figure out why it failed to investigate these warnings. In a front-page piece, the WSJ notes the investigation will examine the relationship between a former official at the agency and Madoff's niece. The former official, who headed one of the teams that looked into the investment firm, married Madoff's niece last year. But a representative of the former official says their relationship began "years after" his examination of Madoff.
The NYT gets word that the White House has written up more than a dozen memos to help guide Obama if an international crisis breaks out before he gets a chance to settle into the Oval Office. The contingency plans lay out several possible scenarios, including a cyberattack and a North Korean nuclear explosion, and outline steps that Obama could consider. These contingency plans are on top of the dozens of memos that the Bush administration has drafted to outline issues that Obama's team will have to deal with when it gets to the White House. Administration officials are careful to emphasize that they're just trying to be helpful and in no way intend to dictate policy. "It's not exhaustive, and it's not exclusive, and it's not prescriptive," a White House spokesman said. Members of Obama's team appreciate the effort that Bush is making to ensure a smooth transition in a time of war. "This doesn't absolve the Bush administration of some of their judgments they've made over the years, but this is the right thing to do," one Democrat said.
Things aren't so lovey-dovey in other parts of the transition. The WSJ notes that transition officials are already discussing how to undo several Bush measures relating to abortion and reproductive health. While several issues are being discussed, it's still not clear which Obama will prioritize, but it seems to be a safe bet that one of his first actions will be to lift Bush's limits on embryonic stem-cell research. Abortion-related issues could be thornier since the president-elect has suggested he wants to strike a middle ground. When the country says goodbye "to its sports-obsessed president who doesn't like tough questions," it will welcome "another sports-obsessed president who doesn't like tough questions," writes the Post's Dana Milbank. When Obama introduced his pick for Education secretary, there was lots of talk about basketball but, taking several cues from the Bush playbook, the president-elect refused to answer any questions about the scandal that has engulfed Illinois Gov. Rod Blagojevich.
"I have no sympathy for Madoff," writes the NYT's Thomas Friedman. "But the fact is, his alleged Ponzi scheme was only slightly more outrageous than the 'legal' scheme that Wall Street was running, fueled by cheap credit, low standards and high greed." After all, it was legal for banks to give risky mortgages to people who couldn't afford them, bundle a group of them into bonds, and then receive premium ratings for these bonds. "If that isn't a pyramid scheme, what is?"
Ilargi: Sign o’ the times: Record OPEC cut leads to record oil price drop. At least you can't say I didn't say so. OPEC is gone, or its clout if you will. By now, there's a huge supply glut, and that will get worse (or bigger) through the next year.
Oil Falls to 4-Year Low on U.S. Supply Gain, OPEC Skepticism
Oil fell to the lowest level in more than four years after the U.S. Energy Department said supplies climbed for the 11th time in 12 weeks and OPEC failed to convince traders that the glut in crude will diminish. Inventories rose 525,000 barrels to 321.3 million barrels last week, the U.S. Energy Department said today in a weekly report. The Organization of Petroleum Exporting Countries agreed to cut output by 4.2 million barrels a day from September levels. "There is nothing bullish in these numbers,” said Nauman Barakat, senior vice president of global energy futures at Macquarie Futures USA Inc. in New York. "The OPEC announcement looks big on first glance but really isn’t. They are playing with smoke and mirrors.”
Crude oil for January delivery declined $1.54, or 3.5 percent, to $42.06 a barrel at 1:30 p.m. on the New York Mercantile Exchange. Futures touched $40.20, the lowest since July 14, 2004. Prices have tumbled 72 percent from a record $147.27 on July 11. Inventories may have gained because the oil market is in contango, where crude for future delivery is more expensive than near-month prices, encouraging stockpile increases. U.S. supplies have climbed 11 percent since Sept. 19. Supplies at Cushing, Oklahoma, where oil that’s traded in New York is stored, climbed 21 percent to 27.5 million barrels, the highest since May 2007. "The big build at Cushing shows that in a contango market everyone who can is taking delivery, which makes it much more difficult for OPEC to hold it together,” Barakat said.
OPEC’s 11 members with quotas will trim current production by 2.46 million barrels a day to 24.845 million barrels a day, the group’s president, Chakib Khelil, said in Oran, Algeria. OPEC has held four meetings in as many months. "They are facing the distinct possibility of oil falling to $30 a barrel and even lower,” said Addison Armstrong, director of market research for Tradition Energy in Stamford, Connecticut. "They have to bring supply down further because they aren’t getting any help on the demand front until the second half of next year at the earliest.” The cut is larger than a 2 million barrel reduction indicated yesterday by Saudi Arabian Oil Minister Ali al-Naimi. OPEC’s rate of compliance with a previous output cut is more than 85 percent, al-Naimi told reporters today before the ministerial meeting that decided production targets.
"I think the market gave every signal that there had to be an additional cut of at least 2.5 million barrels if OPEC expected to bolster prices,” Armstrong said. "There is such a lack of trust when it comes to compliance that it was impossible to agree to what was needed. This lack of trust gives members every incentive to cheat on quotas.” Russia cut oil exports by 350,000 barrels a day last month and may reduce supply a further 320,000 barrels a day next year, in collaboration with OPEC, if prices remain weak, Russian Deputy Prime Minister Igor Sechin told OPEC ministers during opening speeches at today’s meeting. "I think the jury should still be out,” said Sarah Emerson, managing director of Energy Security Analysis Inc., a consulting firm in Wakefield, Massachusetts. "We will have to see their compliance. If they come close to their objective, we believe they will forestall a further decline in prices.” Brent crude oil for February settlement rose 39 cents, or 0.8 percent, to $47.04 a barrel on London’s ICE Futures Europe exchange.
Welcome to ZIRP
There's nothing bullish about this folks. Nor is there any common sense behind this. Bernanke clearly thinks (from the FOMC statement) that he can "restart borrowing." After all, that's what he really means when he says "The Federal Reserve will employ all available tools to promote the resumption of sustainable economic growth." Again, the graph:
From 1980 The Federal Reserve has defined "economic growth" as "borrow faster than you grow output." This, as I have repeatedly shown, leads to declaring growth that never really happened. Bluntly - Bernanke and the rest of the FOMC need their lithium dose increased. We are here because of excess credit creation which The Federal Reserve caused, and their solution is more borrowing? That gives new life to the statement "when all you have is a hammer, everything looks like a nail."
Unfortunately the impact of this decision was a total implosion in the TNX (or 10 year Treasury); in other words, a total flattening of the yield curve. And since banks borrow short to lend long, this means that the very foundation of that which allows banks to make money is being systematically destroyed at the same time. Worse, this is causing the dollar to get slammed - at least for a little while. Japan suddenly looks prudent compared to us, and the Yen is screaming.
What comes next? Do you really want to know? These sorts of actions ignite wars. Choose between a trade war (about 75% chance) and a shooting war (the other 25%). The dollar weakness, by the way, won't last. Either sort of war puts every other nation in the world in worse shape than us, which over time leads to the same place - "we're screwed but they're screwed worse." The only nations that won't be are those who are intelligent enough to repudiate this stupidity in public and back up their mouth with acts. That's likely to be a short list. Bernanke needs to be removed from office and Congress needs to grow a pair and shut this crap down while we still have an economy left to save.
Ultra-low US rates undermine repo market
Extremely low short-term interest rates in the US are sharply eroding the functioning of the government repurchase or repo market, a foundation stone for the financial system and trading Treasury debt. While the Federal Reserve reduced its benchmark interest rate from 1 per cent to a new range of zero to 0.25 per cent on Tuesday, short-term market rates have been trading at close to zero per cent in recent weeks. Driven by a flight to safety by investors and expectations of rate cuts, such conditions are creating problems in the repo market, where investors borrow Treasuries in return for short-term cash loans.
This activity allows traders to sell Treasuries without owning them in the first place, while owners of government debt can fund their portfolios by lending Treasuries. When rates tumble to low levels, it reduces the economic incentive to lend securities. The reduction in liquidity in the $5,800bn Treasury market comes at a time when conditions have become strained as the calendar year draws to a close. The problems also come as the US Treasury prepares to issue a massive amount of new government bonds for the current financial year. "Low rates are having a corrosive effect on the repo market, which will impair liquidity in Treasuries," said Michael Cloherty, strategist at Banc of America Securities. "We are getting close to a situation where structural damage caused by low interest rates outweighs any benefit from easier monetary policy.
"In a [financial] year where the Treasury is facing a net financing need of roughly $1,800bn, lower trading volume is a major concern." Problems in repo impair general trading across the Treasury market. A rise in so-called failed trades, where a borrowed security is not returned in a timely fashion, becomes a drain on the balance sheets of dealers. Low interest rates are also hampering the ability of dealers in financing positions by matching the different needs of clients, known as matching offsetting trades. "The zero per cent interest rate environment is effectively eliminating the dealer matched-book business and crippling dealer intermediation in the repo market," said Scott Skyrm, senior vice-president at Newedge, a repo broker dealer.
‘Helicopter Ben’ confronts the challenge of a lifetime
Central banks may soon resort to their most powerful weapons against deflation: the printing press and the “helicopter drop” of money. It is a time for which Ben Bernanke, chairman of the Federal Reserve, has long prepared. Will this weaponry work? Unquestionably, yes: used ruthlessly, it will eliminate deflation. But returning to normality thereafter will prove far more elusive. Mr Bernanke delivered a celebrated speech on the topic in November 2002, when still a governor.* He spoke quite soon after the US stock market bubble burst in 2000. Policymakers then feared the US might soon follow Japan into deflation – sustained declines in the general price level.
Yet Mr Bernanke then insisted “that the chance of significant deflation in the US in the foreseeable future is extremely small”. He pointed to “the strength of our financial system: despite the adverse shocks of the past year, our banking system remains healthy and well-regulated, and firm and household balance sheets are for the most part in good shape”. The words “pride” and “fall” come to mind. Six years and a housing-cum-credit bubble later, chairman Bernanke must be sadder and wiser. Mr Bernanke’s view was also that “the best way to get out of trouble is not to get into it in the first place”. The fear that reversing deflationary expectations would prove hard explains why the Fed has cut its official interest rate so quickly since the crisis broke in August 2007. Is deflation a realistic likelihood? Core measures of inflation strongly suggest not. But one measure of expected inflation – the gap between yields on conventional and index-linked?Treasuries – has collapsed to 14 basis points. Moreover, yields on 10-year US Treasury bonds are already where Japan’s were in 1996, six years after the latter’s crisis began. (See the charts, which start one year before respective asset price peaks.)
Why then should central banks fear deflation? First, deflation makes it impossible for conventional monetary policy to deliver negative real interest rates. The faster the deflation, the higher real interest rates will be. Second, as explained by the great American economist Irving Fisher in the 1930s, “debt deflation” – the rising real value of debt as prices fall – then becomes a lethal threat. In the US, whose private sector gross debt soared from 118 per cent of gross domestic product in 1978 to 290 per cent in 2008, debt deflation could trigger a downward spiral of mass insolvency, falling demand and further deflation.
Already, the Fed has adopted a host of unconventional actions to keep the economy afloat. By December 10 the Federal Reserve’s balance sheet had reached $2,245bn (€1,663bn, £1,490bn), a jump of $124bn over a week and $1,378bn over a year. It held a wide range of government and private paper, including $476bn in Treasury securities, $448bn in “term auction credit”, $312bn in commercial paper and $233bn in “other loans”, which includes $57bn of credit to AIG alone. If it keeps going, the Fed may become the largest bank in the world.
Does it face any constraint? Not really. As Robert Mugabe has shown, anybody can run a printing press successfully. Once the interest rate hits zero, the Fed can perform much further easing. Indeed, it can create money without limit. Imagine what would happen if an alchemist could transform lead into gold, at no cost. Gold would not be worth much. Central banks can create infinite quantities of money, at no cost. So they can reduce its value to nothing without difficulty. Curing deflation is child’s play in a “fiat money” – a man-made money – system. So what might central banks do? They might lower longer-term interest rates by buying as many long-term government bonds as they wish or by promising to keep short rates low for a lengthy period. They might lend directly to the private sector. Indeed, they might buy any private asset, at any price and in any quantity they choose. They might also buy foreign currency assets. And they might finance the government on any scale they think necessary.
Alternatively, the fiscal authorities can run a deficit of any size they wish and then finance it by issuing short-term paper that the central bank would have to buy, to keep interest rates down. At the zero-rate boundary, fiscal and monetary policies become one. The central bank’s sole right to make monetary policy is gone. But the reverse is also true: the central bank can send money to every citizen. This is the helicopter drop proposed by the late Milton Friedman. At this point, one might wonder why Japan has struggled with deflation for so long. I have little idea. But the explanation seems to be that the Bank of Japan did not wish to take such drastic measures and the Ministry of Finance did not dare to force the point. Such self-restraint will not deter the US authorities. So will the Federal Reserve drown the world in dollars, whereupon we will be able to wake from the nightmare? As Willem Buiter shows in a recent blog, “Confessions of a Crass Keynesian”, the answer is No.
Once inflation returns, the central bank will need to sell assets into the market, to mop up the excess money it has created in fighting deflation. Similarly, the government must reduce its deficit to a size it can finance in the market. Otherwise, deflationary expectations may swiftly turn into expectations of above-target inflation. This may also happen if the debt sold in efforts to sterilise the monetary overhang is deemed beyond the government’s ability to service. Countries without a credible currency may reach this point early. As soon as a central bank hints at “quantitative easing”, flight from the currency may ensue. This is particularly likely when countries remain burdened under a huge overhang of domestic and foreign debt. Creditors know that a burst of inflation would solve many problems in the US and the UK. The US may manage the danger of resurgent inflationary expectations. The UK is likely to find it more difficult. Avoiding deflation is easy; achieving stability thereafter will be far harder.
Ironically, we are where we are partly because the Fed was so terrified of deflation six years ago. Now, a credit bubble later, Mr Bernanke has to cope with what he then feared, largely because of the Fed’s heroic attempts at prevention. Similar dangers now arise with the drastic measures that look ever more likely. This time, I suspect, the result will ultimately not be deflation but unexpectedly high inflation, though probably many years hence.
Banks Show No Signs of Easing Credit in Step With Fed’s Rates
For all their efforts to liquefy credit markets, the Federal Reserve and the Treasury show no signs of ending the 18-month freeze, as evidenced by the unprecedented gap between what banks and the U.S. government pay to borrow money. The difference between the London interbank offered rate, or Libor, that banks charge each other for three-month loans and Treasury bill rates is six times wider than before markets began to seize up in June 2007. Even though the so-called TED spread narrowed to 1.82 percentage points yesterday from 4.64 percentage points in October, prices of contracts to borrow money months from now show investors don’t expect lending to recover until at least the second half of 2009.
“If you take a full assessment of the credit markets, conditions have certainly eased from their worst, but they still are at extraordinary tight levels, which are far from normal,” said Michael Darda, the chief economist at MKM Partners LP in Greenwich, Connecticut. “Short-term funding spreads are all still very wide relative to historical norms. There is a massive pullback going on in the private sector.” While the Standard & Poor’s 500 Index is up 23 percent from last month’s low and the Fed promised to use all tools at its disposal to end the longest recession in a quarter century, investors remain wary of any securities except Treasuries. As banks hoard cash, businesses are struggling to refinance debt and consumers can’t get loans, restraining an economy forecast to shrink 4 percent this quarter, according to the median estimate of 79 strategists surveyed by Bloomberg.
Consumer credit fell $6.4 billion in August and $3.5 billion in October, making 2008 the first year with at least two declines since 1992, according to Fed data. August’s decline was the biggest in at least 65 years. Bond sales by companies rated below investment-grade fell 57 percent to $63.3 billion this year from 2007, according to data compiled by Bloomberg. The extra yield investors demand to own the debt instead of Treasuries rose to a record 21.4 percentage points yesterday from 1.32 percent 18 months ago. Instead, investors are committing more money to government bonds. Treasury three-month bill rates fell below zero percent for the first time last week, meaning investors were willing to pay the government to protect them from further losses. Yields on 30-year Treasuries dropped as low as 2.73 percent yesterday after the central bank cut the main U.S. interest rate to a target range of between zero and 0.25 percent from 1 percent.
Personal bankruptcies rose 34 percent in the third quarter from the same period of 2007, according to the American Bankruptcy Institute in Alexandria, Virginia. Moody’s Investors Service predicted in November that corporate defaults in the U.S. will surge threefold to 11.4 percent in the next 12 months. “There are a lot more requests for loans than we are granting, particularly from real estate developers who are desperately trying to raise money,” said Wes Sturges, president of Bank of Commerce, a Charlotte, North Carolina, bank with $107 million in assets. “We can’t do that because they are tied so closely to the housing economy.” Traders don’t expect lending to improve until mid-2009 at the earliest, based on the difference between Libor and the expected average federal funds rate over the next three months, known as the Libor-OIS spread. The spread, now at about 1.68 percentage points, may narrow to about 1 percentage point by June, forwards contracts show. Former Fed Chairman Alan Greenspan said in June that the measure was the best way to tell when lending returned to “normal.” He said it would need to narrow to about 25 basis points, or 0.25 percentage point, for that to happen.
“There is no demand coming from the interbank market at all,” said Patrick Jacq, a senior fixed-income strategist for Paris-based BNP Paribas SA, France’s largest bank. “Banks are borrowing straight from the Fed and hoarding that cash till they need some and then returning to the Fed. We don’t expect a return to normal conditions in the coming six months.” The average spread was less than 10 basis points this decade through June, 2007, when markets started to unravel as losses on subprime mortgages caused two Bear Stearns Cos. hedge funds to collapse. Banks suddenly became wary of lending to each other amid concern that the same securities that ruined Bear Stearns would cripple other banks. Financial institutions reported almost $1 trillion in losses and writedowns since the start of 2007, according to data compiled by Bloomberg.
Fed Chairman Ben S. Bernanke and Treasury Secretary Henry Paulson are taking steps to make it easier for banks and companies to get cash through $8.5 trillion of commitments. The Treasury’s $700 billion Troubled Assets Relief Program is providing capital to the biggest U.S. banks. The Fed more than doubled its assets since August to $2.21 trillion with emergency-lending programs. Libor, which rose as high as 4.82 percent on Oct. 10, tumbled to 1.85 percent yesterday, the lowest level since September 2004. Even if banks aren’t providing each other with loans for that long, the rate sets values for financial contracts valued at $360 trillion, according to the Bank for International Settlements in Basel, Switzerland. Commercial and industrial loans at banks surged to $1.61 trillion in the week ended Oct. 22 from $1.51 trillion on Sept. 10 as companies wary of losing access to capital in the wake of Lehman Brothers’ collapse drew on lines of credit arranged before markets seized up.
Blockbuster Inc., the world’s largest movie-rental chain, borrowed $135 million from its credit line in October to ensure the Dallas-based company has enough cash in case access to credit worsens, Chief Financial Officer Thomas Casey said. “We said to ourselves, it’s prudent for us to come up with a backup plan that says in a worst case scenario that we want to be able to continue to fund the business” through August 2009, when the revolving credit facility expires, Casey said on a Dec. 10 conference call with analysts. The increase in loans doesn’t mean credit is getting easier. The Fed said last month that large businesses faced the tightest lending standards on record over the previous 90-day period as the risks of a deeper economic downturn increased. About 85 percent of domestic banks tightened lending standards on commercial and industrial loans to large and mid- size firms, the highest since the survey began in its current format in 1991, the Fed said in its latest quarterly Senior Loan Officer Survey conducted between Oct. 2 and Oct. 16. “There isn’t a community banker in America who doesn’t want to make good loans,” said James McKillop, chief executive officer of the Independent Bankers’ Bank of Lake Mary, Florida, which provides loans to 350 community banks in Florida and Georgia. “But finding loans that they feel are going to be good is becoming more and more difficult.”
Mr Bernanke correctly judged the risk of deflation
US consumer prices are dropping at the fastest rate since January 1932 on a strict dollar for dollar basis. New house building fell by 18.9pc in November to 625,000, the lowest since records began half a century ago. It is not yet clear whether America is sliding into a deflation trap but the risk is grave enough to justify radical measures as insurance against a potentially disastrous chain of events.
The sort of deflation now spreading across North America, Japan, and parts of Europe is not the benign variety of the late 19th century when prices slid gently for year after year. Debt levels are much higher today, so the deflation effect is that much more dangerous. The danger is a self-feeding downward spiral as the `real’ burden of debt keeps rising into the slump, as Irving Fisher dissected in his great opus "The Debt-Deflation Theory of Great Depressions". US inflation was minus 1.7pc in November, and minus 1pc in October. This entirely vindicates the brave decision by Ben Bernanke at the US Federal Reserve -- and our our own Mervyn King at the Bank of England -- to "look through" the oil spike earlier this year and keep his focus on the underlying forces at work in the global economy.
While Mr Bernanke may have been caught flat-footed by the onset of the credit crisis in the summer of 2007, he has since moved with impressive speed. The string of emergency rate cuts this year have now brought America to the brink of zero. They may prevent the current credit crash from metastasizing into a full-blown depression. We do not yet know for sure. It takes a year or so for the effects of monetary policy to feed through the economy even when the banking system is functioning. It will take even longer this time. But matters would undoubtedly be worse if the Fed’s backwoodsmen had succeeded in imposing a liquidation squeeze on the US economy, as they did from 1930 to 1932.
Mr Bernanke has not run out of ammunition yet. He has a nuclear arsenal, and has begun to use it. The Fed is already buying mortgage debt. It has infinite means of injecting stimulus into the economy by `quantitiative easing’, if needs be. It can ultimately print money and hang it on Christmas trees. Mr Bernanke correctly judged the risk of deflation. His critics did not anticipate this price collapse. The burden is now on them to explain why they are sure that deflation can safely be left to run its malign course.
Bernanke's Japanese edge
In 1999, an American economics professor by the name of Ben Bernanke addressed an issue that at the time was fascinating mainly to other economists: What do you do when you cut interest rates to the bone and nothing happens? That was the problem facing Japan. Confronted with an economy that was down and refusing to get back up, the Bank of Japan (BOJ) had reduced rates nearly to zero, just as the U.S. Federal Reserve is doing now. Nothing happened. What to do? Mr. Bernanke, a student of the Depression and of Japan's "lost decade" of the 1990s, grappled with the question in a paper. "Having pushed monetary easing to its seeming limit, what more could the BOJ do? Isn't Japan stuck in what Keynes called a ‘liquidity trap'?"
To the contrary, he said, "there is much that the Bank of Japan could do to help promote economic recovery in Japan … a more expansionary monetary policy is needed." What he meant was a policy of "quantitative easing" – flooding the banking system with money with the aim of easing pressure on banks, persuading them to start lending again and prevent a downward spiral in prices. That is precisely the policy that the Bank of Japan adopted from 2001 to 2006, becoming the only modern central bank to, in effect, print money while at the same time keeping rates at rock bottom. Now, faced with a crisis of his own, Mr. Bernanke, as chairman of the Fed, appears to be embarking on a similar course – and no one is quite sure where it will lead. When the Fed announced yesterday that it was cutting rates to between zero and 0.25 per cent, it noted that it was buying up mortgage-backed securities and was considering whether to buy long-term Treasury securities.
That was a strong signal that Mr. Bernanke is about to put his academic theories into practice, with trillions of dollars and the fate of the world economy at stake. Ever since a 2002 speech in Washington where he talked about what to do if deflation hit the United States, he has been musing about how central banks might pump money into a failing economy if interest rate cuts weren't working – then considered a remote possibility at best. In that speech, which earned him the nickname "Helicopter Ben," he referred to the remark by the renowned Chicago economist Milton Friedman that governments could theoretically just drop piles of money from helicopters. That helicopter drop is now on. Since the crisis began, the Fed has moved aggressively to thaw frozen credit markets and get banks lending into the marketplace again.
Among other measures, Mr. Bernanke has turned to quantitative easing since mid-September, essentially printing billions upon billions of dollars and pumping them into the financial system – at a level far in excess of what's required to maintain the Fed's target interest rate for interbank borrowing. The Fed has also created emergency loan programs and last month announced that it would intervene directly in the moribund mortgage market by acquiring up to $600-billion (U.S.) in direct debt and mortgage-backed securities from Fannie Mae, Freddie Mac and the Federal Home Loan Banks. The mere announcement has already caused mortgage rates to fall sharply. In yet another step, the central bank also intends to lend up to $200-billion to holders of securities backed by credit-card debt, car loans and small business loans. The measures have more than doubled the size of the Fed's balance sheet to over $2-trillion. It might go much higher. "Could they go to $3-trillion or $4-trillion? If that's what they need to do to avert deflation, Bernanke said that's what they're going to do," said U.S. market strategist Ed Yardeni of Yardeni Research.
But will it work? Japan pumped about ¥25-trillion of reserves into its financial system during its five-year experiment with quantitative easing, or about $340-billion (Canadian) at today's exchange rate. During that period, Japan did rebound from its 1990s stagnation, enjoying its longest postwar expansion in the early part of this decade. However, economists differ strongly about whether quantitative easing deserves the credit. Bank of Japan governor Masaaki Shirakawa said earlier this year that the policy had "limited impact" because banks spooked by the long, hard decade before still refused to lend and companies to borrow. Economist Richard Koo of Tokyo's Nomura Research Institute argues in his book The Holy Grail of Macroeconomics that turning to quantitative easing at a time of zero interest rates is like "a shopkeeper who, unable to sell more than 100 apples a day at 100 yen each, tries stocking his shelves with 1,000 apples." He argues that heavy government spending, not interest rate cuts or printed money from central banks, is the best way to get economies to bounce back from a severe crisis such as the current one.
Others argue that by pumping so much money into the economy so fast, the Fed could reignite inflation. That would force it to ratchet up interest rates again, choking off lending and growth in the midst of a recession. "It's dangerous to have all this quantitative easing," said Robert Brusca, chief economist with Fact and Opinion Economics in New York. "You wouldn't take your twins and send them to the backyard and say, ‘I'm going to give you a stick of dynamite and you matches. Whatever you do, don't strike the match.'" But Mr. Bernanke has been suggesting for several years that central banks could try increasing the money supply through other means if cutting interest rates alone didn't work. In a 2004 paper, he noted that "even if the price of reserves (the Federal funds rate) becomes pinned at zero, the central bank can still expand the quantity of reserves. … Some evidence exists that quantitative easing can stimulate the economy even when interest rates are near zero." That theory is about to be put to the test.
Morgan Stanley suffers $2.3 billion loss
Morgan Stanley reported a massive $2.3 billion loss for the fourth quarter Tuesday, far worse than what analysts were expecting. The nation's No. 2 investment bank posted a net loss of $2.3 billion, or $2.24 a share, during the fourth quarter. Including results from discontinued operations, the company said it lost $2.34 a share. Either way, the results were substantially worse than what analysts were anticipating. Consensus estimates were for a loss of $298 million, or 34 cents a share, according to Thomson Reuters. Just a month ago, analysts were widely expecting Morgan Stanley to report a narrow profit for the quarter. But they steadily lowered their earnings expectations for the firm given the ongoing volatility in the financial markets.
Morgan Stanley shares, which have lost more than 60% of their value since Labor Day, fell nearly 5% in early morning trading Wednesday. John Mack, Morgan Stanley's chairman and CEO, blamed the quarter's results on unprecedented turmoil that has roiled the stock and credit markets and the entire financial services sector. "These exceptional market conditions profoundly impacted our performance this year, especially in the fourth quarter," Mack said in a statement. Nearly all of Morgan Stanley's key businesses were hit hard during the quarter. Revenues in its investment banking-related division tumbled from a year ago, as did revenue from the company's prime brokerage business, which caters to hedge fund clients. Morgan Stanley's asset management division was squeezed during the quarter by principal investment losses in its real estate and private equity businesses and fewer management and administrative fees.
Employees at Morgan Stanley suffered as a result, as the bonus pool was cut in half from a year ago, the company said. Earlier this month, Mack opted to forgo his annual bonus for 2008, representing the second straight year he would not collect one. Following the collapse of Lehman Brothers in mid-September, Morgan Stanley has scrambled to shore up its capital position. The company raised nearly $25 billion in capital during the quarter, the bulk of which came from a $9 billion investment from the Japanese financial firm Mitsubishi UFJ and $10 billion from the U.S. government as part of the bank bailout. The New York City-based firm has made it clear it is looking to bulk up on deposits as a way of shoring up its funding sources. It has been widely reported that Morgan Stanley is looking at potential acquisitions of regional banks and has hired two retail banking veterans to help with those efforts.
At the same time, Morgan Stanley has scaled back on leveraged bets by cutting back on its residential mortgage origination business and its proprietary trading unit, which uses the firm's own money to make investments. As a result, Morgan Stanley's total assets are down by more than a third so far this year to $658 billion, the company said Wednesday. While painful, Wednesday's fourth-quarter numbers still paled in comparison to the same period a year ago. The company recorded a $3.59 billion loss during the same period in 2007 as a result of massive writedowns on its mortgage-related securities. Morgan Stanley's disappointing results come a day after rival Goldman Sachs reported a $2.1 billion loss, its first since the company went public in 1999
Paulson does not expect any more major financial institutions to fail during current crisis
Treasury Secretary Henry Paulson said Tuesday that he did not expect any more major financial institutions to fail during the current credit crisis. Paulson also said he had no plans to ask Congress to make the second half of the $700 billion financial rescue fund available before the administration of President George W. Bush leaves office on Jan. 20. In an interview on CNBC, Paulson said he believed the actions taken by financial authorities in the United States. and other countries would allow all the systemically important institutions to remain viable. The administration has obligated almost all of the first $350 billion in the financial rescue package approved by Congress on Oct. 3. There had been speculation that the Bush administration would ask for approval to begin using the second $350 billion in the bailout bill before leaving office.
But Paulson said Tuesday he believed the government had a "lot of firepower" at its disposal currently, including the rescue program and multibillion-dollar loan programs being used by the Federal Reserve and other banking authorities. For that reason, he said he did not see a need to request authorization from Congress to tap the second half of the rescue package. The Fed on Tuesday said it had reduced the federal funds rate, the interest that banks charge each other, to a range of zero to 0.25 percent. That is down from the 1 percent target rate in effect since the last meeting in October. The aggressive move was greeted enthusiastically by Wall Street, and the Dow Jones industrial average closed more than 4 percent higher.
Separately, the Treasury Department announced that it had provided an additional $2.45 billion in direct purchases of bank stock involving 28 more banks. The new group of banks brings to 116 those that have received government support through stock purchases. The administration announced in mid-October that the stock purchases would be the major way it planned to use $250 billion of the rescue program. The amount distributed to the banks so far totals $167.76 billion, Treasury said. In his interview, Paulson said a top priority for his remaining weeks in office was making sure the transition to the incoming administration of President-elect Barack Obama flows smoothing during what has turned out to be the country's most serious financial crisis since the 1930s. The Bush administration is continuing to look at ways to deal with the mortgage crisis, Paulson said, but had not yet decided to implement a proposal to try to boost housing activity by buying bonds and lowering mortgage rates to 4.5 percent.
Paulson said he was spending a lot of time on the effort to fashion a government lifeline for the Detroit auto companies. The companies that need government loans to avoid bankruptcy "will get the money as quickly as we can prudently do it," Paulson said. "We need to do it, but we need to do it right." Paulson refused to speculate exactly when the support from the government's $700 billion rescue program might be awarded to General Motors, Chrysler or Ford Motor, but said the administration was working to make sure the taxpayer was protected and that the companies presented a credible plan to achieve long-term viability.
AIG Writedowns May Rise $30 Billion on Swaps Not in U.S. Rescue
American International Group Inc., which already has suffered more than $60 billion in writedowns and losses, may have to absorb almost $30 billion more because of flaws in the way its holdings are valued. An examination of AIG’s credit-default swaps guaranteeing more than $300 billion of corporate loans, mortgages and other assets not covered by a $152.5 billion federal rescue shows the New York-based insurer may value some of its positions at levels that don’t reflect distress in the markets, according to an analyst at Gradient Analytics Inc. and a tax consultant who teaches at Columbia University Business School in New York. Executives at two firms that have similar investments say they account for the securities differently than AIG does.
"Every time I look at their statements I find something new," said Donn Vickrey, executive vice president of Gradient Analytics in Scottsdale, Arizona. He estimated that AIG may need to take at least $28 billion in additional writedowns on swaps covering European corporate loans and prime residential mortgages, as well as collateralized loan and debt obligations. "It looks like they haven’t written down these positions fully yet, and that could be a real problem," said Vickrey, who predicted correctly, as early as February 2008, that the company would have to report increases in its writedowns on its swaps. Robert E. Lewis, AIG’s chief risk officer, said the company has properly valued all of its swaps and underlying assets and doesn’t need to take additional writedowns. The U.S. rescue plan announced in November, the government’s second effort to save AIG, covers only its most troubled credit-default swaps, about 20 percent of the $377 billion on the insurer’s books as of Sept. 30. Under the plan, a new government-backed entity will acquire collateralized debt obligations with a face value of $72 billion that had been insured by AIG swaps. An initial transfer of $46.1 billion of CDOs was announced on Dec. 2. A second fund bought troubled residential mortgage-backed securities with a face value of $39.3 billion, AIG said on Dec. 15.
Wider losses may cast new doubt on whether the federal funds will be enough to prop up AIG, the biggest U.S. insurer by assets. The U.S. package almost doubled from the $85 billion approved in September to save the company from bankruptcy. Previous miscalculations about the swaps contributed to the ouster of Chief Executive Officer Robert Willumstad and his predecessor, Martin Sullivan. In November 2007, when AIG reported a $352 million loss on its swaps, it said it was "highly unlikely" the insurer would have to make payments on them. And last December Sullivan assured investors that losses from swaps on U.S. subprime mortgages were "manageable." Credit-default swaps are contracts that protect investors who buy bonds or other securities. If a debt issuer or borrower misses payments, the seller of the contract -- in this case, AIG -- covers some or all of the losses. Even if a borrower doesn’t default, accounting rules may require insurers to write down the swap contracts when the value of the underlying assets drops.
AIG swaps not covered by the government program include guarantees on $249.9 billion of corporate loans and residential mortgages, most of them made by banks in Europe, according to the company’s third-quarter 10-Q filing. There are also swaps covering $51 billion of collateralized loan obligations, or CLOs, and $5 billion of lower-rated mezzanine tranches. Writedowns on these AIG holdings total less than $1.5 billion so far this year, according to company filings, compared with $20 billion for the swaps guaranteeing the $72 billion of CDOs being acquired under the federal rescue. The declining market value of many of the underlying assets and a deepening recession may force AIG to take further writedowns, Vickrey said. Credit-default swap prices on the Markit iTraxx Europe index of 125 investment-grade companies set a record on Dec. 5, indicating increased investor concern about possible defaults.
Based on the loss AIG has reported, as well as indexes showing declines in the value of European corporate loans and prime mortgages, Vickrey estimated that AIG may face at least $15.6 billion of additional writedowns on its swaps with the banks. He said other swaps not covered by the government rescue, including those on CLOs and mezzanine tranches, may result in another $12.6 billion of losses. "That’s based on what we know currently, and it could be higher," he said. Estimating the size of future writedowns is difficult because AIG doesn’t disclose details about many of the underlying assets. Lewis, the AIG risk officer, said in an interview that the company has "limited information" on which to base the value of most of the European loans and mortgages it has guaranteed. Though some assets underlying the swaps appeared to be declining in value, Lewis said the insurer followed accounting rules in providing its best estimates for the value of the assets and other securities on its books. "Our methods have been thoroughly vetted and externally evaluated," Lewis said.
AIG’s view on valuing its swaps with European banks turns on an interpretation of accounting rules involving risk transfer. Lewis said the insurer normally marks the value of the assets underlying swaps to market levels since it is taking some risk in the transactions. The swaps with the European banks are different because they didn’t insure against losses, he said. Instead, they were bought to take advantage of European accounting rules that allow the banks to use the swaps to reduce the capital they’re required to set aside as loss reserves. The swaps are kept in place only until new accounting rules, known as Basel II, are phased in. Those rules eliminate the ability of financial institutions to reduce the capital they need to set aside by buying swaps. Once the rules kick in, Lewis said the swaps will be terminated. Lewis said the insurer had unwound $95 billion of these regulatory-capital swaps without any losses as of the end of the third quarter. And Gerry Pasciucco, hired from Morgan Stanley on Nov. 12 as interim chief operating officer of AIG’s financial- products subsidiary, said the company continues to "experience early terminations according to our schedule at par." As a result, Lewis said, even if the assets underlying the remaining swaps fall in value, AIG isn’t required to mark them to lower market levels.
That’s because, as the insurer said in its third-quarter filing, it "estimates the fair value of these derivatives by considering observable market transactions." And the only relevant transactions are the swaps AIG has successfully unwound with the European banks, according to the filing. AIG’s interpretation of accounting rules is different than that of Robert Willens, CEO of Robert Willens LLC, a corporate tax and accounting advisory firm in New York, and a professor at Columbia. He said AIG can’t have it both ways, calling the transactions swaps and then saying there’s no risk. "If these are bona fide swaps, you look at them like any other transaction of this type with a transfer of risk," Willens said. "If they do that, there would probably be very substantial writedowns because of what we’re seeing in the markets. If you’re using a different paradigm and saying there’s no risk transfer, these aren’t credit-default swaps. You’re getting a fee for renting the counterparty your name. There’s no third approach. The purpose of the swap is totally irrelevant."
Stephen Ryan, a professor of accounting at the Stern School of Business at New York University, said that if the swaps reduce potential losses faced by European banks there must be some transfer of risk and AIG must mark the assets to market by looking at a broad array of similar credit-default swaps, not just other swaps that were unwound without losses. "I can’t believe the banks’ intent affects the contractual terms" of the swaps, Ryan said. While Elias Habayeb, chief financial officer of AIG’s financial-services division, acknowledged that valuing the underlying assets by referring to market indexes could produce writedowns, it would be misleading to do so because the swaps were intended to be terminated in a short period of time. "Had we marked them down to the iTraxx or CDX indexes in our accounting," he said, "that would not have made sense because we would have had to book a gain on redemption." Two other companies that sold swaps to European banks also disputed AIG’s interpretation of accounting rules. C. Robert Quint, chief financial officer of Radian Group Inc. in Philadelphia, and Steven Kennedy, a spokesman for Bermuda-based Primus Guaranty Ltd., both rejected the idea that how a swap is used can affect its accounting treatment. They said their firms mark their swaps to market to reflect price declines.
"We did some of that business, but we’re an insurance company, so we don’t care what purpose the counterparty is using the swap for," Quint said. Lewis said AIG would only have to revalue the underlying assets if the banks that bought the swaps no longer used them to meet capital requirements. That’s what happened in this year’s second quarter with one European bank that purchased a swap to cover $1.6 billion of mortgage-backed securities. When AIG determined the purpose of the swap wasn’t to reduce capital requirements, it took a loss of $397 million, equal to about 25 percent of the face value of the assets, according to company filings. AIG spokesman Nicholas Ashooh said the case was unusual because the swap covered mortgage-backed securities, not just pools of mortgages like the other European swaps. He added that even if other swaps required writedowns, the losses wouldn’t necessarily be 25 percent of face value. Ashooh also explained that, under the terms of most of the swaps, the European banks would have to absorb about 10 percent to 15 percent of any losses from defaults before they could turn to AIG. That also reduces the insurer’s risk, he said.
That’s not how Vickrey of Gradient Analytics sees it. While the logic might be sound under normal circumstances, he said these aren’t ordinary times. With economies shrinking and markets falling, the European banks that bought the swaps may face such high levels of defaults on their corporate loans and mortgages that they would need to alter the purpose of the swaps, requiring revaluations. AIG acknowledges such a possibility in its 10-Q filing. "Given the significant deterioration in the credit markets and the risk that AIGFP’s expectations with respect to the termination of these transactions by its counterparties may not materialize, there can be no assurance that AIG will not recognize unrealized market valuation losses," the company said. AIGFP is the insurer’s AIG Financial Products unit that sold the swaps. Valuing mortgage-backed securities and collateralized debt obligations was a challenge even before the credit crisis. The bankers who originated the securities and the agencies that rated them used sophisticated models that relied on assumptions about the future, including market liquidity, default rates and the risks of markets moving in tandem in the event of a credit squeeze. Calculations in the models have proven flawed, meaning many of the securities were improperly rated and priced long before the current crunch hit. Traders and salesmen had little understanding of the assumptions used in the models -- among them that house prices wouldn’t drop across the U.S. -- or how they might affect the performance of the securities.
"It’s not that all of the models are wrong,’ said Tanya Styblo Beder, chairman of risk-management adviser SBCC Group in New York. "The problem is that people made simplifying assumptions so the calculations were manageable and then had no warning labels to help the users understand the ramifications of these assumptions." Gerald Rosenfeld, deputy chairman of Rothschild North America Inc. and co-director of New York University’s program in business and law, said the current market meltdown is the fourth in 20 years exacerbated by a reliance on flawed computer models. The first was the stock market crash of 1987, when a computerized product called portfolio insurance contributed to an unanticipated cascade of selling, he said. "We’ve had something like four 50-year events in the last 20 years because of this blind faith people put in the supposed accuracy and precision of models that, for the most part, their creators never intended," Rosenfeld said. "I don’t think we’ve really identified the over-reliance on the models and the way they were the trigger points in all of this." In a paper titled "The Economics of Structured Finance" that will be published in the Journal of Economic Perspectives, a group of Harvard Business School professors says the greatest problem in the market for CDOs and other structured securities isn’t the decline in value of the underlying assets because of the credit crunch. It is that the securities were overpriced from the start because the models failed to assess the risks, the professors said.
"Almost lost in the shuffle and the talk of default rates has been the initial mispricing of these securities," said Joshua Coval, a professor of business administration at the Harvard Business School and one of the paper’s authors. In effect, Coval said, investors bought the CDOs and related assets at inflated prices from the start. The mispricing also increased losses for companies that sold credit-default swaps, since they guaranteed that values would not decline significantly from their inflated levels. "The drop in price is due to market awareness that credit risk was mispriced at the outset," said Janet Tavakoli, president of Tavakoli Structured Finance in Chicago. "The practice was widespread." Even if the credit markets were to stabilize, the valuations of structured securities are still far from where they should be, said Laurie Goodman, a former head of fixed- income research at UBS Securities LLC, who recently left to join Amherst Holdings LLC in Austin, Texas. "The losses we’ve seen so far are a fraction of what we’ll be seeing," she said
Obama Works to Overhaul TARP
The incoming Obama administration is considering a series of initiatives to combat the financial crisis, including some efforts to help banks that the Bush administration has tried with limited success. Among the plans being discussed are injecting more capital into banks, creating a market for illiquid assets clogging the books of financial institutions and helping borrowers who are having trouble making their mortgage payments. On Tuesday, members of President-elect Barack Obama's economic team briefed Mr. Obama on ways to address the financial crisis and also on plans for an economic-stimulus package.
While Treasury Secretary Henry Paulson has seized on equity investments in banks as Treasury's primary mechanism to help resolve the financial crisis, the Obama team is developing a broader approach that would likely incorporate multiple remedies. The new administration is "trying to put components together that...will be complementary...while recognizing there's no easy answer," said a person familiar with its plans. The Obama team, hoping to avoid the criticism leveled at Mr. Paulson by lawmakers that he lacks a consistent strategy, is also working to come up with a way to cogently explain the rationale behind its approach.
One key distinction will be in the approach to helping homeowners facing foreclosure. Mr. Paulson and the White House have resisted calls to embark on a government rescue of homeowners. The Obama team, by contrast, sees that as a critical leg of its financial-crisis rescue plan, people familiar with the matter said. Democratic lawmakers are pushing for Mr. Obama to take steps quickly to help at-risk borrowers. Details of the Obama foreclosure plan aren't known, in part because they are still being hashed out. In a fresh sign of the magnitude of the financial crisis, the Federal Deposit Insurance Corp. braced for more bloodletting in the U.S. banking industry. The five-member board of the FDIC, which is in charge of unwinding failed banks, voted Tuesday to increase the agency's 2009 budget to $2.24 billion, an increase of $1 billion, compared with 2008, and said it planned to beef up its bank-examination and supervisory staff by more than 500 to 6,269. It would pay for the increase by levying higher fees on banks.
While it is unclear exactly what the Obama financial rescue will look like, it is expected to continue Mr. Paulson's attempts at addressing the lack of capital at financial institutions. That could mean additional equity injections, as well as an effort to have the government boost the value of troubled assets, such as mortgage-backed securities. "We are looking at a number of initiatives that will allow us to move aggressively and responsibly to address the economic and financial crisis both on Wall Street and Main Street, including programs to provide targeted foreclosure relief," said Stephanie Cutter, an Obama spokeswoman. Mr. Paulson initially planned to help financial institutions by purchasing troubled assets through the $700 billion Troubled Asset Relief Program approved by Congress in October. Banks are struggling with a glut of those assets, which continue to fall in price, forcing the banks to write down the losses and take a financial hit.
But Mr. Paulson jettisoned that idea in favor of taking $250 billion of equity stakes in banks, arguing that was a quicker and more effective way to encourage banks to lend money to consumers, businesses and each other. However, the credit crisis has continued despite Treasury's efforts, prompting criticism from lawmakers and Wall Street. On Tuesday, Mr. Paulson acknowledged that banks aren't lending enough money despite the government infusion, but said the U.S. didn't want to nationalize the industry and dictate the loans banks make. Much of the Obama team's financial rescue package likely won't be known until the new administration takes office next month. Some of it depends on whether Mr. Paulson seeks the second half of the promised $700 billion. Treasury's initial $350 billion batch is rapidly dwindling and could be further drained by aid to struggling U.S. auto makers.
Lawmakers have made it clear that if Treasury wants to get the next tranche, it will need to come up with a foreclosure-mitigation plan and enact stricter requirements on banks that get government funds. Mr. Paulson has said he wants the Obama team to support any new programs, but the Obama team has yet to engage with Treasury on current efforts. Mr. Paulson, in an interview with CNBC on Tuesday, said the government had enough "firepower," and suggested he had no current plans to tap the second tranche. Some lawmakers want Mr. Paulson to request the funds. House Financial Services Chairman Barney Frank (D., Mass.) said he has told the Obama team it should work with Mr. Paulson to request the second $350 billion and embark quickly on a foreclosure-prevention plan. "My hope is for them to agree with Paulson that he should request the second $350 billion as soon as we [Congress] reconvene," Mr. Frank said in an interview.
Fed move aimed at spreads, not deflation-official
The Federal Reserve's dramatic policy action does not signal increased concern about deflation, but determination to improve lending conditions by narrowing spreads, a senior Fed official said on Tuesday. The official spoke in an unprecedented conference call with reporters after the Fed announced it was cutting the benchmark federal funds rate target to a range of zero to 0.25 percent and that it would use all available tools to protect growth. His identity was withheld under the ground rules for the call and the remarks were to be used only in reported speech. The Fed official did not preface his remarks with a statement, and reporters went straight into questions in what was effectively an off-the-record press conference. The official said the fourth quarter would be very weak and this would extend into the first quarter of 2009, with U.S. growth picking up slowly over the course of the year. This outlook, he stressed, was consistent with private forecasts.
He also said that the Fed expects inflation to moderate, but deflation was not a major concern at this juncture. In addition, the official stressed the Fed was not pursuing Japanese style quantitative easing measures by targeting the asset side of its balance sheet. Rather, he said the Fed was buying securities and making loans to improve mortgage and credit market conditions. This happens to also expand its balance sheet as it sought to narrow yield spreads between Treasuries and private credit markets, such as the market for mortgage-backed securities, but was distinctive from what happened in Japan, he said.
The Bank of Japan's quantitative easing strategy during the country's decade of economic stagnation and deflation in the 1990s has been criticized for being too little, too late. The senior Fed official was also at pains to stress that future credit action would be a collaborative and cooperative process between the Federal Open Market Committee and the Fed Board of Governors in Washington. The FOMC, the policy-setting committee of the Federal reserve, is made up of the Fed Board and the presidents of the 12 regional Federal Reserve banks. The Fed Board, led by Chairman Ben Bernanke, has initiated a number of dramatic actions since the collapse of the country's subprime mortgage market last year, including the rescue of investment bank Bear Stearns.
These measures were taken under emergency Fed powers enshrined in U.S. law; the 'unusual and exigent circumstances' contained in paragraph 13.3 of the Federal Reserve Act. Tuesday's decision by the FOMC was unanimous, with none of the voters dissenting against the decision to lower the target for the funds rate from 1 percent. This was despite uneasiness voiced by some members of the FOMC in recent weeks about the scale of the Fed's market intervention and policy easing. The U.S. recession began a year ago and some economists expect output to contract by over 6 percent at an annualized rate in the fourth quarter. The official said the observation in the policy statement accompanying the rate decision -- that weak economic conditions warranted exceptionally low interest rates -- highlighted the conditions the Fed would set to alter policy. This was distinct from the 'considerable period' language the Fed used when rates were at 1 percent in 2003-04. Asked about the decision to target a range on the funds rate, the official said that this was to realistically reflect its ability to manage reserves at the moment, given sharp day-to-day volatility on the effective funds rate.
The European Central Bank faces a mutiny
For the first time since the launch of monetary union, an ECB board member has dared to confront the hegemonic Bundesbank bloc in public. For those of who think the ECB has gravely misread this global crisis and risks repeating the errors of 1930s - and that is the opinion of a few Nobel laureates who have spoken to the subject - this is a glorious moment.
Athanasios Orphanides, the Cyprus governor, has thrown down the gauntlet. His latest speech in Larnaca - only in Greek unfortunately - rebuts the ECB obscurantism that has so shocked economists, and so dismayed those who fear that the ECB's Brüning-Luther drift into debt deflation will reduce Europe to a bonfire of riots and a splintered bedlam of neo-fascists, marxists, and assorted tribal reactionaries. Who cares about the Cyprus governor? Well, Orphanides is a 17-year veteran of the US Federal Reserve and just about the only member of the ECB council who has published scholarship of world renown. In other words, he is more than a match for the haughty duo from the Bundesbank - Axel Weber and Jürgen Stark - and everybody in the tight-knit fraternity of central banking knows it. His speech is finally to say to the Old Guard: enough, we have endured your view of the world for long enough, step down, make way.
Yes, Buba was a great bank once. It was a bulwark against the "crass Keynesianism" of the 1970s, but we are not in the 1970s now. We are in a world where an oil shock briefly obscured a immensely powerful debt deflation as the excesses of a 30-year credit addiction finally implode under their own force. The Bundesbank/ECB misread this. They were distracted by the trivial, and neglected the essential. It led them to commit a shocking blunder by raising rates into the storm in July. The harsh truth is that every generation has to earn respect afresh. No institution can claim hereditary prestige, whether it is Oxford University, the US Supreme Court, or Buba. The current crew in Frankfurt have quite simply blown it.
Yes, the Greenspan easy-money experiment was worse in its deeper effects. (This is not a defence of Anglo-Saxon stupidities). But then Buba/ECB did a 'Greenspan-lite' themselves from 2002 to 2006, fueling the Club Med and East Europe property bubbles. Hard-money men? Give me a break. They were too loose in the bubble, and have been too tight since this bust began. This is plain error. No amount of ideological bluster can disguise that. But I digress. The Buba bloc laid out its doctrine and the end of last month. To be precise, it was delivered by Lorenzo Bini-Smaghi from the ECB's executive council, but encapsulates the Bundesbank view. He said - or implied - that it would be dangerous for the ECB to follow the lead of the Fed (and now the Canadian, British, Swedish, and Swiss central banks) in embarking on radical stimulus.
"There is a risk that policy makers run out of ammunition too early and remain without a means of escape." He likened it to a spaghetti western. The good guys in the cavalry lose if they empty their revolvers too early, and are then surrounded. This caused consternation. There were audible groans across the City. "Central banks don't run of ammunition. They have a nuclear arsenal," said Erik Nielsen, Europe economist at Goldman Sachs. Undaunted, Weber and Stark have since been on the circuit promoting this preposterous metaphor. Weber warned against letting interest rates fall below inflation, which sets an effective floor near 2pc right now (no matter that the time-lag effect on inflation is so long as to make it utterly useless as a guide in this fast-moving crisis... but these guys are frankly robots).
They have also been up to their old tricks of trying to tie the hands of the ECB's governing council in advance, signalling to the markets that there will be no January rate cut. This becomes self-fulfilling. The bank cannot then disappoint the market. Except that this time Orphanides has dropped a neutron bomb on their heads. "I would like to stress that the view that monetary policy becomes ineffective and cannot contribute further to credit growth when the short-term rate reaches zero, or very low levels, is a fallacy." "Zero short-term rates are not an obstacle for the further boost of monetary expansion if this is judged to be necessary. Of course, monetary policy is more complicated and difficult in cases where short-term rates are already at low levels. However, this fact does not restrain the effectiveness of monetary policy." He politely advised the Bundesbankers to stop messing around.
"We're in the middle of an extremely crucial economic phase where economic activity rates are slowing down, financial values are fluctuating and the uncertainty in the financial markets is continuing. It is alarming that, unfortunately, a vicious cycle has been created between the financial system crisis and the slowdown of economic activity in the real economy. This development imposes determined decisions of macroeconomic policy." The mutiny is gaining shape. Portugal's Vitor Constancio picked up his dagger on Friday, warning of a "significant recession" that will kill inflation. He said central banks most certainly can cut to zero, and try 'quantitative easing', if need be. "Besides interest rates, central banks have other instruments that are still available and, in this context."
More surprising, Nout Wellink from the Netherlands has inched into the rebel camp. "There are more degrees of freedom for the ECB to react further to what's happening in the economy." 'I myself am more pessimistic with respect to 2010 - or perhaps it's better to say more realistic - than most international organizations. Most start with the assumption that world trade will pick up in the second half of 2009. If you analyze the figures then you see that this is highly unlikely on the basis of the present data for Europe," he said. So too has Malta's Michael Bonello. "Of course we continue to review the whole range of instruments we have at our disposal. Direct intervention in the credit markets in the shape of quantitative easing could be considered."
So what matters? One many, one vote in the ECB council. Or the unwritten law that the Bundesbank cannot be overuled in EMU because the euro derives its status from the D-Mark legaccy? We will soon find out. In the Orwellian language of the ECB this yawning rift is described by Jean-Claude Trichet as "consensus". The term is "unanimity" when disputes are kept to a level where nobody feels strongly enough to oppose a vote. Isn't it beautiful?
EU loosens state subsidy rules amid financial woes
EU regulators said Wednesday they would loosen rules on state subsidies to allow governments to pump more money into cash-strapped companies that can't get funding from banks during the credit crisis. The European Commission said it would -- just for two years -- allow governments to give most payments of up to 500,000 euros ($684,500) to companies "to relieve them from current difficulties" without checking with regulators. This is more than double the current threshold of 200,000 euros ($273,800). Larger payments often trigger an EU investigation that can take months of checking if the payment can be justified. States could also guarantee loans at a reduced premium, the EU executive said.
This is a major concession as regulators usually insist that state loans and guarantees follow market rates. Many EU nations led by France have claimed the EU has been too strict on how far governments can go to help out their economies and their banking sectors as a financial crisis chokes lending. EU Competition Commissioner Neelie Kroes bowed to their worries, saying: "We must fight the crisis, not each other." Regulators said they understood that the drying up of the lending market meant that even healthy companies might not be able to get finance and this would seriously endanger their business.
They will also allow risk capital aid of up to 2.5 million euros ($3.42 million) each year for small businesses, up from the current 1.5 million euros ($2.05 million) limit -- as long as at least 30 percent of total funding comes from private investors. The European Commission said it expects financial markets and business lending to return to normal in the foreseeable future and would only allow these looser rules until the end of 2010. EU nations will have to tell regulators about lending and spending programs that fall under the new rules.
Merkel Announces New Measures to Boost Economy
German Chancellor Angela Merkel has pledged billions of euros in fresh public infrastructure investments to boost the flagging economy. The measures, to be announced after Barack Obama's Jan. 20 inauguration, will come on top of the €32 billion package launched earlier this month. German Chancellor Angela Merkel has pledged to pump billions of euros into road building and repairs in a second economic stimulus program on top of the €32 billion ($44 billion) one agreed by the government earlier this month.
Merkel was cricized heavily over that first economic package after closer scrutiny revealed that most of the measures had already passed and that the new intiatives were worth only €5 billion a year. Now, the chancellor is beefing up those initial efforts, and a new program of measures is to be presented shortly after Barack Obama's inauguration as US president on Jan. 20, Merkel said on Tuesday. "It's obvious that everything will be done in the area of infrastructure that can be done quickly," Merkel said in a speech at the ZEW economic institute in Mannheim, in southwestern Germany. "I think it will amount to an additional few billions," Merkel said, adding that Germany's regional states should start presenting their road building plans so that construction or repair work could start early next spring.
Merkel added that she was opposed to issuing vouchers to boost consumption. She said the German government knew that the initial stimulus package would not suffice to shore up the economy. Merkel said that once the new president of the world's largest economy was in office the time would be right for Germany to initiate its second stimulus program. Until then, the government will decide which infrastructure projects to speed up.
Carmakers cut output as Europe sales fall 26%
European new car sales dropped by a quarter in November, data showed on Tuesday as more vehicle makers announced output cuts and the Big Three U.S. players waited for the government to throw them a lifeline. Volkswagen's Spanish car maker Seat and world number two truckmaker Volvo became the latest companies to announce temporary production halts in response to falling sales as the global economic slowdown batters the industry. Governments are rushing to support car manufacturers struggling to cope with falling sales and difficulties shifting their stocks of unsold vehicles.
On Monday, France said it was ready to take action following a meeting with top industry executives in return for commitments to keep production in the country.. 'There's always a certain amount of posturing, but later, outsourcing can be dressed up as new production,' said one Paris-based analyst who declined to be named. 'I think PSA is less willing to make concessions than Renault,' he added, noting the French government's stake in Renault. In the U.S., the Bush administration could act as early as Wednesday to approve an automaker bailout from its bank rescue fund, with conditions likely to reflect at least those approved by the U.S. House of Representatives last week, key lawmakers and other sources said on Monday.
GM and Chrysler LLC, which is owned by Cerberus Capital Management, have said they need immediate cash injections to survive. Ford is seeking a government line of credit it could use if its financial position deteriorated more than expected in 2009. Carmakers are also seeking help from their suppliers: Toyota Motor Corp plans to ask Nippon Steel Corp and other steelmakers for a 30 percent price cut, the Nikkei business daily reported on Tuesday. Meanwhile, the world's fourth-largest steelmaker POSCO said on Tuesday it may cut output next year if market conditions continue to worsen.
In a further sign of the financial constraints hitting auto manufacturers, Fuji Heavy Industries said it would withdraw its Subaru team from the world rally championship. Fellow Japanese carmaker Suzuki Motor Corp announced its exit a day earlier, leaving only Citroen and Ford chasing the manufacturers' title. Honda Motor Co, Japan's No.2 automaker, this month quit Formula One racing, saying it needed to conserve cash for its core-automaking business. European new passenger car registrations dropped 25.8 percent year-on-year according to the ACEA industry body on Tuesday, the seventh consecutive monthly drop. ACEA said the last time registrations fell so sharply was in 1999 and in 1993, before EU enlargement, when the data only covered the 15 EU member states plus the European Free Trade Association countries. November's data referred to the 27 EU member states, plus the EFTA countries and excluded Malta and Cyprus, ACEA said.
Separately, Seat said it would further cut production at its main plant in Catalonia in the first half of 2009 in response to diving sales. The maker of the Ibiza and Leon said that between Feb. 2 and June 30 it would halt work at its Martorell plant near Barcelona for seven to 29 days on various production lines. General Motors said on Monday it would temporarily shut down assembly lines at three of its Mexican car factories. The decline in November sales was not just in passenger cars -- truck sales also fell, leading Volvo to stop production for 20 to 25 days in the first quarter of 2009.
Honda Slashes Forecast as Sales Collapse, Yen Surges
Honda Motor Co., Japan’s second- largest automaker, slashed its full-year profit forecast by 62 percent as the yen surged to a 13-year high against the dollar and car sales in North America and Europe plummeted. The company expects net income of 185 billion yen ($2.08 billion) for the year ending March 31 compared with an earlier forecast of 485 billion yen, it said in Tokyo today. Operating profit may total 180 billion yen, compared with a previous estimate of 550 billion yen. Honda may report a half-year operating loss for the first time in at least in 11 years, as the global recession cripples sales in the U.S., Japan and Europe. The yen’s 26 percent gain against the dollar and 30 percent rise against the euro this year has hammered Honda’s profit, forcing it to cut jobs, lower management pay and withdraw from Formula One motor racing.
"The stronger yen is a huge blow for Honda and other Japanese automakers, because they are already hit by the global slowdown," said Koichi Ogawa, chief portfolio manager at Tokyo- based Daiwa SB Investments Ltd., which manages $28 billion. "Earnings slumps by automakers will deepen the recession." Every 1 yen gain against the dollar and euro cuts Honda’s annual operating profit by 18 billion yen and 3 billion yen, respectively. President Takeo Fukui called the current rate of 88.83 yen to the dollar "abnormal" and called on the Japanese government and Bank of Japan to take "swift action." "The environment is worsening day by day, and we see no sign of a recovery," Fukui said at a press conference today in Tokyo. "Our task is to respond to a sharp drop in sales." The stronger yen will cut the company’s operating profit by 360 billion yen this year. Honda will lower capital spending to 650 billion yen from 710 billion yen. It will also pay 11 yen per share in dividends for the third quarter, half its forecast.
Honda fell 4.2 percent to 1,891 yen at the 3 p.m. close on the Tokyo Stock Exchange. The shares have dropped 50 percent so far this year compared with a 44 percent decline for the benchmark Nikkei 225 Stock Average. Honda’s vehicle sales in the U.S., its biggest market, plunged 32 percent in November, the most since 1981, prompting deeper production cuts. In Europe, November sales dropped 34 percent as tighter credit and rising unemployment hurt consumer sentiment. Industrywide vehicle demand has plunged in the U.S., forcing General Motors Corp. and Chrysler LLC to seek emergency government loans to avoid running out of cash. The failure of one the U.S. carmakers would also threaten some of the suppliers that Honda uses in the country. The company is open to an alliance with other carmakers, if "beneficial for Honda’s customers," Fukui said.
Honda lowered its vehicle sales forecast for the year ending March 31 to 3.65 million vehicles from 4.015 million. Sales in North America may total 1.59 million vehicles, down from its previous estimate of 1.735 million units, Honda said. European sales may be 365,000 vehicles, compared with its earlier estimate of 415,000. At home, Honda expects to sell 570,000 units, down from its previous projection of 620,000. The company will cut global production by 314,000 vehicles for the current fiscal year, it said today. It also will cut at least 1,210 temporary jobs in Japan. Toyota Motor Corp., Japan’s biggest automaker, will shed 3,000 temporary workers by March 31. Nissan Motor Co. will eliminate 2,000 positions.
Honda will delay a number of projects beyond 2010 to cut production and capital spending. These include the opening of a factory in Saitama Prefecture, north of Tokyo, the formation of a research facility in Tochigi and plans to expand output in India. The carmaker’s Yachiyo Industry Co. unit will also delay the start of full operations at a minicar plant beyond 2010. Honda also scrapped plans to introduce the luxury Acura brand in its home market, axed the development of the V10 NSX sports car and delayed the introduction of diesel-powered models. The company will set up a venture with GS Yuasa Corp. to develop, make and sell lithium-ion batteries next year. The automaker plans to develop mid- and large-sized hybrid cars. It also aims to sell an entry-level model that’s smaller than the Fit compact within the next three years, Fukui said.
Madoff fraud could burn early pullouts: 'fraudulent conveyance'
Disgraced money manager Bernard Madoff's suspected $50 billion (33 billion pound) fraud scheme looks set to burn even those who pulled their investments out long before the scandal rippled into the global financial system. Such investors may have counted themselves fortunate, withdrawing their money years ago to buy a house or to pay for a daughter's education, and may have even sighed with relief because they ended ties with Madoff long before the scandal erupted late last week. But they, too, could face trouble, lawyers say. Because of a legal concept known as "fraudulent conveyance," they could be forced to return their profits and even some of their initial investments to help offset losses incurred by others entangled in the long-running Ponzi scheme.
A Ponzi scheme is an illegal investment vehicle that pays off old investors with money from new ones, and relies on a constant stream of new investment. Such schemes eventually collapse under their own weight. "There were no profits. It was just other people's money," said Brad Alford, who runs investment adviser Alpha Capital Management LLC in Atlanta. Alford is well versed in fraudulent conveyance after one of his clients withdrew money from a $450 million scheme by Connecticut hedge-fund company Bayou Group LLC a year before it collapsed in scandal. "We ended up settling with the estate, giving back all the profits and half of our principal." Bankruptcy-receivership practices make all investors vulnerable, he added. "Once they can go into bankruptcy they can go back six years. Anything past your principal, I'm guessing, is fair game to be brought back in."
Philip Bentley, a lawyer at Kramer, Levin, Naftalis & Frankel LLP, who defended investors sued in 2006 by lawyers representing the Bayou estate, said he expected the court-appointed trustee now in control of Madoff's U.S. operations to look hard at who withdrew money from Madoff. "The trustee is going to look very closely at redemptions and seriously consider bringing suits just because the trustee's job is to bring in assets any way he can," Bentley said. "Potentially the numbers are enormous." But the judge could decide to limit how many years back the estate can demand investors return their money, said Jay Gould, a former investment-management attorney at the Securities and Exchange Commission who heads the hedge-fund practice at Pillsbury Winthrop Shaw and Pittman LLP.
"In this case, because of the magnitude of the losses and the scope of the great number of people who were defrauded, this could be a situation where people say 'you know we are just going to draw the line here at six months or at one year or at this,'" he said. "But that's not certain. You really are working with people who have obligations," he said. "The receiver has an obligation under the law to pursue all the assets wherever they happen to be within the bounds of the law." The law could shock investors who innocently entrusted their money with Madoff, a 70-year-old Wall Street legend, long before he was accused of defrauding banks, charities and rich individuals whose assets he managed at Bernard L. Madoff Investment Securities LLC, which he launched in 1960.
"I'm sure it will be a surprise to those who had no idea about his position but wanted to buy a house, and took the money out," said Tamar Frankel, who teaches securities law, corporate governance and legal ethics at Boston University. Alford said he expects several types of lawsuits, including one focused on fraudulent conveyance and another against so-called feeder funds, or hedge funds set up by outside investment advisory firms that marketed Madoff's investments to high net-worth individuals and pension funds. And he expects a third group of lawsuits to focus on litigation against advisers for entrusting 50 to 100 percent of their money with one manager. He said this could defy the "prudent man rule" that enjoins money managers to handle investors' money as they would their own. "I think the lawsuits are going to be staggering. This is going to go on for years and years," he said.
Put Madoff In Charge of Social Security
Where was the SEC? Such is the plaint lofted in the wake of the Bernie Madoff scandal. Huh? When has the Securities and Exchange Commission ever found a fraud except by reading about it in the newspapers? Anyway, who said the agency was supposed to prevent investors from losing money or relieve them of having to perform due diligence? Mr. Madoff's many honorable and accomplished clients chose to deal with their man outside the institutional checks that come from, say, a heavily regulated bank or a highly transparent mutual fund, perhaps one whose parent is also publicly traded and doubly subject to the checks of a watchful stock market. That was their choice.
It is common to wax nostalgic for a time when a man's word was his bond, business was done on a handshake, etc. This is poppycock. It has always been a client's job to sort out the dealer who could be trusted from the one who couldn't. Personal connections may give comfort, but are no substitute for true institutional checks or true experience of a man's character, which many of Mr. Madoff's clients seemed not to have. Instead, they went on "reputation," which is to say they acquired their faith in Mr. Madoff more or less the way people acquire their faith in global warming and many other things, from people equally as ignorant as they.
What makes the Madoff story interesting, though not evidence of systematic failure of the regulatory or legal system, is that Mr. Madoff and some of his clients had dealt on a basis of trust for more than a generation. True Ponzi schemes, in which early investors are paid a "return" out of funds deposited by later investors, tend to falter at the first market downturn. Waning investor enthusiasm dries up new funds required to pay off earlier investors. The scheme collapses. In all likelihood, Mr. Madoff was not running a pure Ponzi scheme, but had real assets. He was operating a blind pool, in which investors had no real idea what they owned or how it was performing, relying on Mr. Madoff who reported metronomic returns, brooked no nosiness into his methods, and seemed always willing to pay off investors who wanted to withdraw their money.
He may have been casual from the start about what money he used to pay withdrawals. It is almost inconceivable, though, that he could have built a true Ponzi scheme to a height of $50 billion, in which there were never any real assets, just his superhuman 40-year juggling act to ensure new investors were recruited as needed to provide funds to meet withdrawal requests from earlier investors. If so, he is a genius who should immediately be put in charge of the Social Security and Medicare trust funds. It was Mr. Madoff himself who apparently applied the word "Ponzi" to his crime, in his distraught confession to his sons. His "$50 billion" in reputed losses also appear to be little more than hearsay, his own tremulous characterization of the long-running disaster he'd wrought.
More likely, his firm devolved into a Ponzi scheme only when serious losses hit and he decided not to level with investors but to gamble on a resurrection. The hoped-for rebound, as they frequently do, failed to materialize. His losses grew. Then came a flood of redemption requests amid the current credit crisis. Mr. Madoff's jig was up. His decision-making at this crossroads probably wasn't helped by the fact that, in the early 2000s, just as the long bull run was ending, the press began asking questions about the improbable consistency of his reported returns -- making it an awkward moment to stop reporting consistent returns. Conscious of his standing in the community and seeing jail beckoning, all he could think to do was double down.
There are costs and benefits to everything, including the cumbersome apparatus of firms that subject themselves to intrusive monitoring and conform to standards of transparency. Mr. Madoff's clients chose to avoid those costs. For that matter, they chose to forgo lower but safer returns, as many rich people do, by entrusting their fortunes to T-bills. The herding automatons of the media can never encounter lawbreaking in the financial markets without concluding that it demonstrates the necessity of more laws against lawbreaking. Congress, now in the process of convincing itself it should run the auto industry, no doubt will see in Mr. Madoff proof that Congress is needed to manage rich people's money and ordinary people's too. Then we'll all be in the same position as Mr. Madoff's clients.
Madoff Scheme Was 'Impossible' to Do Alone
Bernard Madoff’s alleged Ponzi scheme, which might have cost investors $50 billion, couldn’t have been carried out alone, said Arpad ‘Arki’ Busson, chairman and founder of Swiss investment firm EIM SA. "For the amount of money and number of accounts, it’s practically impossible that he was doing this alone," said Busson, whose $11.5 billion fund of hedge funds had about $230 million invested with Madoff. "What’s mind-boggling is the amount of assets and the amount of time he was doing it." EIM, which manages accounts for mostly institutional clients, invested with funds that had managed accounts overseen by Madoff. EIM will likely write down its stake to zero, Busson said. Madoff was arrested Dec. 11 after he told his sons that Bernard L. Madoff Investment Securities LLC was a fraud, according to the U.S. Securities and Exchange Commission.
"There’s only so much due diligence you can do, and in hindsight you always wish you could have done it differently," Busson said in a telephone interview. "Catching a fraud like this is practically impossible. He seemed like a very experienced, knowledgeable and trustworthy man, like the best con artists always are." About two-thirds of EIM accounts had no holdings with Madoff, while no single account had more than 5 percent, Busson said. EIM, based in Nyon, Switzerland, gained comfort with Madoff because one of the feeder funds produced a statement of accounts that showed "every trade" and that was audited by PricewaterhouseCoopers, Busson said.
Madoff’s history showed he was "not someone from the boondocks," Busson said. Madoff had been head of the trading committee at the Securities Industry Association, Wall Street’s biggest trade group, and served as chairman of the Nasdaq Stock Market, advising on new stock-market rules in response to the growth of electronic trading. Unlike most hedge funds, Madoff’s business was regulated by the SEC, giving investors an added layer of protection, Busson said. "I knew the SEC was all over this shop. As a broker-dealer, you file quarterly statements," he said. "The main reason we got comfort is that it was SEC-regulated, and it was doing 10 percent of the volume on the New York Stock Exchange and Nasdaq."
Madoff ran his investment advisory business from a separate floor of his firm’s New York offices, keeping financial statements "under lock and key," prosecutors said. Early in December, he told one employee that clients wanted to redeem about $7 billion and that he was struggling to free up the funds, the government said. EIM was in the process of "trimming back" its holdings with Madoff when the fraud came to light, Busson said. He thought an employee was joking when he called and said Madoff had been arrested, Busson said. The complexity and duration of the fraud made it unlikely that he could have operated it alone, particularly because Madoff took vacations, he said. Busson said he last saw Madoff in July at an airport in Nice, on France’s Mediterranean coast.
SEC Official Married into Madoff Family
A top Securities and Exchange Commission compliance official who worked for the SEC when it found no problems at Bernard Madoff's firm in 2005, later began to date and married Madoff's niece, who was a compliance lawyer for the company. A spokesman for Eric Swanson, who has since left the SEC, said Swanson "did not participate in any inquiry of Bernard Madoff Securities or its affiliates while involved in a relationship" with Shana Madoff. The failure of the SEC to detect the alleged fraud carried out by Madoff, estimated by Madoff himself at $50 billion, has raised questions about the SEC's performance. "The Securities and Exchange Commission failed the American people," said Senator Charles Grassley (R-IA).
Since 1992, the SEC has at least twice dismissed concerns about Madoff's firm, following complaints. At a business roundtable meeting last year, Madoff boasted of his "very close" relationship with a SEC regulator, chuckling as he said, "in fact, my niece even married one." A spokesman for Swanson, the former SEC official who married Madoff's niece and compliance lawyer, said Swanson met the niece "through her trade association work in the industry. Throughout his career, Eric has displayed the highest ethical standards and his reputation has been and continues to be above reproach." Madoff formally registered with the SEC as an investment adviser in 2006, but the SEC failed to conduct the standard review that normally follows such a new registration.
Madoff made headlines last week when an unsealed criminal complaint in federal court in New York charged that he has been running a decades long Ponzi scheme that defrauded investors of $50 billion dollars. A former chairman of NASDAQ, Madoff was an investment advisor who catered to a handful of high net worth clients, one of whom told ABC News that Madoff was so sought after that, as recently as two months ago, he was turning down potential new business. His handful of clients routinely expected -- and received -- double digit returns, up market or down. According to a SEC document filed in Jan. 2008, and cited in the complaint, the firm had between 11 and 25 clients for the fiscal year ending Oct. 2007 and managed about $17 billion in assets in 23 different accounts.
Bernard Madoff Investment Securities, in addition to that private client practice, is also a market maker that trades with other dealers in bonds, the S&P 500 and NASDAQ, according to Bloomberg News. The firm was the 23rd largest market maker on NASDAQ in October, handling a daily average of about 50 million shares a day. The firm specialized in handling orders from online brokers in some of the largest U.S. companies, including General Electric Co. and Citigroup Inc., Bloomberg News reported. But on Dec. 10, Madoff allegedly told senior employees at his firm that his entire business was a fraud. According to the federal complaint, Madoff told those employees that he was "finished" and that "it's all one big lie." Madoff estimated "the losses from the fraud to be at least approximately $50 billion," the complaint states. At that time Madoff also told those employees that he intended to surrender to authorities, but before he did he planned to use $200-300 million he had left to make payments to "selected employees, family and friends," the complaint states.
Madoff started his business in 1960 with $5000 in savings. He resides in New York City and, according to clients, also maintains a posh waterfront home. Known to his clients as Bernie, he has a long and significant history on Wall Street and has been a chairman of the board of the NASDAQ and was a founding member of the board of the International Securities Clearing Corp. in London. The Web site for Madoff's firm, in its company profile, says, "Clients know that Bernard Madoff has a personal interest in maintaining the unblemished record of value, fair-dealing, and high ethical standards that has always been the firm's hallmark." Madoff was arrested last Thursday morning by FBI agents and charged with criminal securities fraud by federal prosecutors in Manhattan. The complaint states that he used "manipulative and deceptive practices." The complaint cites two senior employees in describing how Madoff kept his client records "under lock and key" and how he left them in the dark about how he managed the private client funds.
One of those employees, in interviews with the FBI, said that Madoff was "cryptic" in his statements. This, according to clients, is in keeping with the aura that Madoff cultivated among his clients, some of whom have kept funds under management with him for generations. But by the first week of December, when clients began clamoring for redemptions -- to the tune of $7 billion -- the complaint states that Madoff began a struggle to obtain the necessary liquidity. The stress began to show, the employees said. In a meeting at their boss's Manhattan apartment -- held there following a confrontation in the office Wednesday because Madoff wasn't sure "he would be able to "hold it together" if the conversation took place in the office -- the employees came away believing that Madoff was "saying, in substance that he had for years been paying returns to certain investors out of the principal received from other, different investors."
The next day, Dec. 11, Madoff spoke with FBI agent Theodore Cacioppi and invited the agent and another agent to his apartment. Cacioppo stated in the complaint that he told Madoff he came by to see if "there's an innocent explanation." "There is no innocent explanation," Madoff replied, according to the sworn complaint. Madoff's lawyer, Dan Horwitz, a partner at Dickstein Shapiro in New York, said his client is cooperating fully with the federal investigation. "Bernie Madoff is a long-standing leader in the financial services industry and he is cooperating fully with the government investigation into this unfortunate set of events," Horwitz said. Madoff was released on $10 million bond following a court appearance in Manhattan. He is expected back in court today.
Taxpayers face new pain as Gordon Brown's bank bail-out fails to stop credit crunch
Taxpayers face paying billions of pounds more to prop up Britain's banks because Gordon Brown's bail-out has failed to stop the credit crunch, the Bank of England Governor has warned. In comments which raise the ultimate prospect of wholesale nationalisation of the British banking system, Mervyn King said that "additional measures" are now needed to solve the crisis. The £500bn rescue plan unveiled by the Prime Minister in October and since copied throughout the world is not encouraging banks to lend more to families and businesses, he said. It is the most stark warning yet from the Governor that all his and Whitehall's efforts to bring the crisis to an end have not succeeded.
Banks now need extra support from the taxpayer if they are to return to normal lending, he indicated. Facing the worst financial crisis in living memory, UK banks have slashed the amount they lend out to homeowners, resulting in higher interest rates and tougher conditions for homeowners. The Bank's efforts to combat this by cutting interest rates by 3 percentage points in only eight weeks have not succeeded. Although three banks - Royal Bank of Scotland, HBOS and Lloyds TSB - have been part-nationalised, Mr King's comments indicate that more may now need to be done: including bringing the banks into full public ownership.
In a letter sent to the Chancellor, Alistair Darling, Mr King said the UK is trapped in a vicious circle, as the financial turmoil is "exacerbated by the further tightening in the supply of credit to households and businesses... Additional measures, building on the Government's package to support the banking system announced in October, will probably be required to underpin lending to households and companies." Mr King's warning will revive fears for the survival of the banking system, which had lain dormant since the events of October. Asked recently about whether to rule out the wholesale nationalisation of the banking system, Mr King said it would be "a very serious error to rule out measures which may eventually prove necessary".
Although senior policymakers view such an eventuality as a last resort, it has come significantly closer. The bank bail-out has not had the desired effect in kick-starting lending, although it has, so far, prevented the banks from collapsing entirely. Peter Spencer of the University of York warned that full-scale nationalisation is now "almost inevitable". He said: "There are a number of other measures you can try first - further interest rate cuts, and various tweaks to Alistair Darling's [bail-out] plan. However, the real problem here is we still don't know the scale of what we're dealing with. We need regulators to go into the banks and have a really good look round [at the scale of the so-called toxic debt on their balance sheets]. "I suspect they will discover that another £50 billion or so of capital is needed. If that happens then the banks will effectively be nationalised. The whole thing is very scary, but I think it's almost inevitable. "However, there is a difference between grabbing and hospitalising the banks. This would be a temporary measure for a few years."
Mr King's warning that the bail-out is not working is a blow for the Prime Minister, whose reputation has been boosted both at home and overseas after his bail-out scheme was adopted by a range of different countries around the world. He was forced to step in to rescue British banks after the collapse of investment bank Lehman Brothers triggered what Mr King has described as the worst UK financial crisis since the start of World War One. With HBOS and RBS close to collapse, the Government had to spend £50 billion pumping cash directly into them by buying up shares. It spent a further £250 billion on a credit guarantee scheme to help fund banks, and extended the size of the Special Liquidity Scheme - designed to ensure banks are not brought down by US mortgage debt - to £200bn. At a total of £500 billion, the money at risk equates to £15,770 for every UK taxpayer.
It also raises the worrying prospect that the Government will have to borrow even more in the coming years to keep the economy afloat. The Treasury is already heading next year for its worst budget deficit since the Second World War, sparking fears about Britain's credit-worthiness. The pound has slumped sharply against both the dollar and the euro in recent months, sparking fears that sterling could soon hit parity - with a pound being valued at the same level as one euro. Experts have warned that the pound's slide is a signal that foreign investors may be abandoning the UK, fearing that it is facing a worse recession than its fellow Western nations. Mr King warned in his letter that Consumer Price Index inflation, yesterday confirmed at 4.1 per cent, would drop sharply in the coming months as the effect of the VAT cut and the broader recession make themselves felt.
According to the Treasury's own forecasts, the UK will experience deflation next year, with prices falling across the economy as consumers cut back on their spending. Mr Darling this week announced that he was cutting the cost of guaranteeing banks' debt, and is expected in the coming days to unveil a scheme to guarantee lending to companies. Although these schemes are likely to ease some of the financial stress, analysts have warned that they may not go far enough. According to Arturo De Frias, banking analyst at bank Dresdner Kleinwort: "Governments need the banks to keep on lending in order to avoid a vicious circle and prevent recessions from becoming depressions. Governments also want banks to keep lending margins low in order to avoid triggering even more bankruptcies. But banks cannot lend cheaply in a recession and recapitalise simultaneously."
Sterling fall is a life-saver for UK economy
The sharp slide in the pound has been a godsend for the UK economy and may have helped Britain avert a much more serious crisis, according to the German bank Dresdner Kleinwort. "If the currency had not gone down so far, think how much worse it could have been. A weaker sterling is just what you need in the current situation," said David Owen, the bank's chief economist for developed markets . He said exporters taking advantage of the 20pc fall in sterling to boost profit margins, giving them a vital cushion to help survive the collapse in lending. This is the same pattern seen after the ejection of the pound from Europe's Exchange Rate Mechanism in 1992.
"Export margins are going through the roof, and this helps not just manufactuiring but also service exports. Profits are holding up surprisingly well. With banks threatening to cut off credit lines, these companies need all the help they can get," he said. "We have been in a train-wreck since August 2007 and it is going on and on. Credit insurance is drying up. We are hearing anecdotal evidence that banks are telling custormers not to rely on them for finance next year. If credit lines are cut off, even good companies will go into receivership," he said.
The concern is that there may be two more shoes to drop in this crisis. The wave of corporate defaults has hardly begun, and inventories are still too high for this stage of the cycle. "The good thing is that the authorities have thrown an awful lot of ammo at this problem. We're effectively moving towards zero interest rates in all the major economies. But we know from Japan that the central banks can pump liquidity into the system but that doesn't guarantee recovery if the banks won't lend," he said. The risk is that foreign investors stop buying Gilts and other forms of British debt, setting off a pound exodus that could spin out of control - as happened to Iceland's krona. UK bond auctions have held up well so far.
Mr Owen said newspaper columnists fretting about a sterling crisis should remember what happened early 1930s when Britain was the first major economy to leave the Gold Standard and reflate through devaluation (and rate cuts). While the episode was humiliating at the time, it was a key reason why the UK economy contracted by just 5pc during the Great Depresssion compared to 15pc for France and 30pc for the US. Stephen Jen, currency chief at Morgan Stanley, said sterling is a "high-beta" currency, meaning that it is highly-geared to the global economic cycle. It shoots up during good times and plunges during bad times. It should return to health if and when the world emerges from economic winter. The Bank of England's view is that sterling has served its purpose well in this crisis, acting as a shock-absorber.
Bank of England resisted deeper interest rate cuts for fear of a run on the pound
The Bank of England resisted cutting interest rates further this month on fears it would trigger a run on the pound and spread alarm about the state of the economy, it emerged this morning. Minutes from the meeting of the Bank's Monetary Policy Committee showed some members believed the rapidly deteriorating state of the economy merited a deeper cut than the 1 percentage point all nine members of the MPC voted for on December 4. Today's news sent sterling tumbling to a new low of almost 92p against the euro and left it more than a cent weaker against the dollar. "The Committee discussed whether a larger cut was warranted," the minutes said. "Financial markets had priced in a cut of 100 basis points and there was a risk that going further could cause an excessive fall in the exchange rate. There was also a risk that an unexpectedly large cut could undermine confidence in the economy more widely."
Sterling was also knocked this morning by news that overall unemployment in the UK rose to 1.86m in October, while the number of people claiming jobless benefits jumped to 1.07m last month. Economists now expect a further interest rate cut in January. As retailers desperately discount to get shoppers onto the high street, the economic news so far this month has remained bleak. "The claimant count numbers are completely shocking – this recession is clearly going to be painful. Once again the MPC debated a larger cut than they finally made. A further cut of at least 50 basis points is likely in January," said Hetal Mehta, senior economic advisor to the Ernst & Young ITEM Club. Howard Archer, chief economist at IHS Global Insight, said that the bank rate is likely to fall below 1pc next year: "We expect interest rates to fall to a low of 0.50pc in the second quarter of 2009 and then stay there for the rest of the year. However, it is far from inconceivable that interest rates could come all the way down to zero."
The minutes showed that the MPC was concerned about how little impact both fiscal and monetary policy measures were having on markets. The comments echoed those made yesterday by the Bank's Governor Mervyn King, where he said in a letter to the Chancellor on inflation that "additional measures" are required to ensure that both households and companies had access to credit. "No doubt the Monetary Policy Committee will cut rates further when they meet in January, but it is likely more creative measures will be required by both the Treasury and the Bank of England," said Ben Read, managing economist at Centre for Economics and Business Research. "However with the credibility of UK fiscal and monetary policy now under serious scrutiny across the international markets, each policy option comes with potentially serious consequences for the credit worthiness of UK plc."
Canadian cities in rapid decline
Canadian cities are losing their economic momentum, and the slowdown is intensifying, the Canadian Imperial Bank of Commerce said Wednesday. Falling home sales, fewer housing starts, rising unemployment and an increase in personal bankruptcies have contributed to the decline, economist Benjamin Tal said in an economic snapshot of Canadian cities. CIBC's metropolitan economic activity index measures several economic variables – and most of those are less favourable than a year ago, Mr. Tal said.
The economic momentum of Canada's cities has been slowing for the past two years, he noted, “but the pace at which the index has been softening has accelerated dramatically over the past six months.” The only positive indicators in the report were lower business bankruptcies, higher non-residential building permits and stable population growth. The loss of momentum was most pronounced in Western Canada.
Edmonton and Calgary, which topped the economic activity rankings last year, ranked behind Regina, Toronto, Saskatoon and Vancouver this year, Mr. Tal said. “A notable softening in labour market activity, population growth and housing market activity clearly played a significant role in the worsening position” of Edmonton, Calgary and Vancouver, he said.
Canadian PM's economic flip: 'I've never seen such uncertainty'
Stephen Harper has delivered his bleakest forecast yet for the Canadian economy, warning yesterday the future is increasingly hard to read and conceding the possibility of a depression. "The truth is, I've never seen such uncertainty in terms of looking forward to the future," the Prime Minister told CTV News in Halifax. "I'm very worried about the Canadian economy." When asked whether a depression might be possible, he answered: "It could be, but I think we've learned enough about depression; we've learned enough from the 1930s to avoid some of the mistakes that caused a recession in 1929 to become a depression in the 1930s." A recession is often defined as two consecutive quarters of shrinking economic output.
The definition of a depression is less established, but is considered to be a prolonged recession where output declines by more than 10 per cent. Mr. Harper also confirmed in the interview that his January budget will push Canada into a deficit and include billions of dollars in spending, which he hopes to combine with provincial spending to boost the Canadian economy. "Obviously, we're going to have to run a deficit," he said. "We're talking about spending billions of dollars that was not planned." Mr. Harper's darker forecast was yet another shift in tone for the government on the economic story. Last Friday, for example, his ministers appeared to deliver contradictory messages on the speed with which the government should be reacting to the crisis.
Hours before Industry Minister Tony Clement called a hasty Toronto news conference to buck up the Ontario auto industry, the message emerging from Finance Minister Jim Flaherty was a plea to be patient with the Harper government as it planned a stimulus package. "This is not a sprint," Mr. Flaherty told an audience in Saint John, preaching the virtues of "thoughtful consideration" before acting with stimulus. Later that day, however, Mr. Clement, signalled that Ottawa was indeed moving quickly to help out auto makers, announcing the general outlines of a package that could lead to $3.4-billion in Canadian aid. "The seriousness of the situation dictates that we be here this evening," Mr. Clement said of his last-minute appearance.
As chief salesman for Tory economic policies, Mr. Flaherty is often the one left taking the blame for conflicting messages on how the Conservatives will respond to the faltering economy. This was the case in the Nov. 27 fall fiscal update. On Nov. 23, after months of insisting his government had already done much to stimulate the economy, Mr. Harper abruptly changed tone after an international leaders meeting in Peru. He warned reporters that "it may well be necessary to take unprecedented fiscal stimulus." Four days later, however, Mr. Flaherty's economic update offered only a modest injection of assistance, while also announcing billions of dollars in budget cuts - the very opposite of fiscal stimulus. "They moved in the wrong direction," IHS Global Insight managing director Dale Orr said yesterday. The update prompted calls for Mr. Flaherty's resignation from some critics - and unease within the Tory caucus. Aside from a lack of stimulus, the update also contained two politically explosive measures: a move to scrap per-vote subsidies for political parties and a bid to ban public-sector workers from striking.
"It was just outrageous and absolutely improper," said University of Western Ontario economics professor emeritus David Laidler, a member of the C.D. Howe Institute's monetary policy council. "I was frankly very surprised because I thought Flaherty was a pretty competent guy." Prof. Laidler, who emphasized he was speaking only for himself, said he thinks Mr. Flaherty should have stepped down after he was forced to withdraw the more controversial items in the face of unanimous opposition party rejection of the update. "He should have resigned either because they were his policies and they were rejected so firmly he had to withdraw them - or they weren't his policies and he shouldn't have allowed them in his statement."
But one senior Tory aide said that Mr. Flaherty is not likely to lose his job because his office is compliant with the Prime Minister's wishes. Mr. Flaherty spent an hour yesterday meeting with Liberal MPs John McCallum and Scott Brison, who said he conceded that the relatively rosy economic projections in last month's controversial fiscal update have been overtaken by worsening conditions. "He certainly admitted that the economic situation has deteriorated since receiving the forecasts [for the Nov. 27 fiscal and economic statement.] He does agree that the forecasts were too rosy [given the deterioration,]" Mr. McCallum told The Canadian Press.
Canadian PM's pessimistic talk makes bad situation worse, critics say
Prime Minister Stephen Harper was accused yesterday of exacerbating the economic downturn by spreading pessimism when he should be taking a leadership role by disbursing hope. Mr. Harper, who said in a television interview on Monday that he has never seen such uncertainty about the future, came under fire for giving in to fear at a time when Canadians need their Prime Minister to offer a more positive outlook – both to relieve anxiety and to keep consumers spending. "I think human behaviour drives recessions and recoveries, and confidence in the future drives human behaviour," said Liberal MP John McCallum, a former chief economist for the Royal Bank of Canada. "Especially during difficult times, leaders have to inject confidence and hope into their citizens and Stephen Harper has done precisely the opposite with these comments."
Mr. Harper told CTV on Monday that he had "never seen such uncertainty" about the future and that he was personally "very worried" about the Canadian economy. He wouldn't rule out a depression, saying it "could be" possible, although he quickly added he believed the world had learned enough from the 1930s to avoid another one. Peter Donolo of the Strategic Counsel polling firm said Mr. Harper may have erred in trying to demonstrate to Canadians that he feels their fear. "Part of political leadership, national leadership, is giving people a sense of confidence and a sense of hope," Mr. Donolo said. "My guess is he's trying to compensate for what was widely perceived to be a lack of empathy about people and their economic anxiety." He said Mr. Harper's message has been inconsistent. "He's been ricocheting around like a rubber ball from, ‘Don't worry, be happy' to, ‘The sky is falling.'"
However, economists said such comments from Mr. Harper might have scared Canadians six months ago but they predicted consumers are mostly inured to dire talk after months of awful economic developments. "Under normal conditions that could possibly send a chill into consumer and business confidence, but I would say under present circumstances it would probably land only a glancing blow because people have been so battered with bad news in recent months that there's very little one can say any more to spook consumers," said Douglas Porter, deputy chief economist at BMO Nesbitt Burns. Robert Fairholm, director of Canadian forecasting at the Centre for Spatial Economics, said he thinks Mr. Harper is reflecting prevailing views. "Consumer confidence has already dropped to deep recession levels – so will his comments push them further down? I suspect not," he said. "People are already extremely worried.… I don't know if anybody is really hanging on the Prime Minister's words."
The PM's evolving views
Oct. 7: "I think there are probably some great buying opportunities emerging in the stock market as a consequence of all this panic."
Asked whether he would unequivocally rule out a deficit under his government: "Yes. ... Yesterday I think I was asked one question about whether we would run a deficit and I said, 'No.' That's my answer."
Oct. 11: "The fact of the matter is independent analysts, including the International Monetary Fund, say that Canada is not going to go into recession with the current world environment and its current set of domestic policies. We're the one country that's going to continue to show some growth."
Nov. 23: "The most recent private-sector forecasts suggest the strong possibility of a technical recession the end of this year, the beginning of next. "I am surprised at this. I am also further surprised, more importantly, by deflationary pressure that we're seeing around the world. This is a worrying development, one of the reasons why it may well be necessary to take unprecedented fiscal stimulus."
Dec. 15: "The truth is, I've never seen such uncertainty in terms of looking forward to the future. .... I'm very worried about the Canadian economy."
Asked whether the situation could turn out to be a depression: "It could be, but I think we've learned enough about depression; we've learned enough from the 1930s to avoid some of the mistakes that caused a recession in 1929 to become a depression in the 1930s."
Gazprom has plenty in reserve and Russia needs cash
Earlier this year, Gazprom was the third-largest company in the world by market cap. It was well on its way to achieving its stated-goal of a $1,000bn (£654bn) valuation by 2015 – but these plans have been derailed by recent events. The credit crunch, troubles with the rouble and an increase in tensions after the conflict in Georgia prompted a flight of capital out of Russia. Gazprom is now valued at $100bn, a shadow of the $348bn seen earlier this year.
These falls demonstrate the risks associated with investing in Russian groups like Gazprom. Russia is an emerging market, so it was a major victim of global deleveraging. The country also has a commodity-based economy – and the price of oil and metals has slumped. The conflict with Georgia also increased talk of political risk, especially with Gazprom, as the Russian government owns a 50.002pc controlling stake. Commodity prices should recover in time – and so should investor appetite for risk. So, the main question mark concerns political risk. The biggest fear for a Western investor is an asset grab. What is there to stop the Kremlin nationalising the company and wiping out your shareholding in a couple of years? Well, Questor feels there are actually quite a lot of reasons why this won't happen – and events over the last few months give an indication as to why this is unlikely to occur.
This year, the Russian market slumped as investors withdrew from investments perceived as risky. This meant the government had to spend $200bn of the country's oil wealth propping up its markets. Russia spent $50bn of its gold and forex reserves financing foreign corporate debt and cut company tax rates to 20pc from 24pc, hitting its tax revenues for years to come. The Kremlin also pledged 350bn roubles (£8.3bn) to buy shares and corporate bonds and injected 450bn roubles into its banking system. The central bank also had to regularly intervene in the currency markets to support the rouble. Should the Kremlin ever attempt to grab foreign stakes in a company such as Gazprom, the consequences for its economy would be even worse. Every dollar, pound and euro would be removed from the country immediately – and it would lead to financial chaos of unprecedented proportions. It would not be in Russia's interest to do this.
Russia also needs Europe as much as Europe needs Russian gas. Petrodollars are essential if the country is going to continue to invest and grow. That's why Questor feels political risk fears have been overplayed. That said, any investor willing to invest in a Russian company should do so with their eyes wide open. There is patently a higher degree of risk involved than in an investment in a UK group. Questor believes that the current valuation does not take into account the one fundamental attraction of this company – it has the largest gas reserves of any company anywhere in the world. Gazprom has 60pc of Russia's total gas reserves under its stewardship – or 17pc of the world's total. The company pumps 20pc of all the gas produced in the world every single day, yet it is one of the most lowly-rated energy groups on the planet, trading on a December 2008 multiple of just three times.
The main challenge the company faces is that its reserves are relatively undeveloped – and therefore a lot of capital expenditure is needed. In 2009, the group plans to invest $33bn in its operations. Its second-quarter results should be released within the next few weeks. Analysts expect net income to jump 181pc to $11.2bn on total revenues up 70pc to $35bn compared with last year. The third and fourth quarter should also be bright, as the company has been selling its gas at record prices and cost inflation will not be as severe. Although gas prices should ease next year, the company has substantial earnings leverage in the former Soviet states. It has been supplying gas at a discount and it in the process of raising prices in most of its markets.
Putin’s lucky run in danger of running out
For the eight years that he ruled Russia as president, Vladimir Putin enjoyed a fantastic run of luck. He presided over constant economic growth, steadily rising commodity prices – especially for oil and gas – and weak political opposition. Today, he remains the most powerful man in the country, although he has ceded the presidency to his loyal supporter, Dmitry Medvedev, and taken the job of prime minister. But that means he is directly responsible for the economy when a sharp recession is in prospect. For the first time since he came to power, Mr Putin seems to be losing his sure touch. "What Putin achieved [as president] was control and certainty," says Masha Lipman, editor of Pro and Contra Journal at the Carnegie Centre in Moscow. "He had absolute political power. He felt so confident that he even ventured this change of power. Suddenly there is a tremendous and rapidly increasing uncertainty, that is not of his own making. To a control freak, this is a disaster."
The result is that suddenly the signals from the Kremlin, where Mr Medvedev sits, and the White House, just down the Moscow river, where the prime minister has his office, are confused. A month ago, Mr Putin insisted there was no crisis. Then his ministers admitted to "certain difficulties". Last week, Mr Putin set up an anti-crisis commission, headed by Igor Shuvalov, his deputy prime minister and chief economic adviser. Last week, Andrei Klepach, a deputy economy minister used the word recession. He was promptly reprimanded by Alexei Kudrin, finance minister, who forecast growth next year of 3 per cent. There is clearly an effort to play down the problems. Economic analysts from the big banks and financial institutions in Moscow have been warned not to spread alarm, or risk losing their privileged contacts. The overall picture is unclear, but most tangible indicators are gloomy.
Pavel Teplukhin, president of Troika Dialog Asset Management, points to a 20 per cent drop in railway freight traffic between October 2007 and October 2008, and a drop in electricity consumption of between 3 and 5 per cent over the same period. The iron and steel sector has been hard hit, with the big steel plant at Magnitogorsk, in the Urals, cutting production by up to 30 per cent. There are two big dangers for Mr Putin. One is a substantial forced devaluation of the rouble. The other is a sharp increase in unemployment. Mr Putin came to power after the last forced devaluation of 1998, which wiped out the savings of Russia’s nascent middle classes. He has staked his political reputation on not having another, saying he would not be the prime minister who devalued the rouble.
In reality, the central bank has already allowed a gradual devaluation in recent weeks, amounting to 8.8 per cent. Instead of stabilising the currency, it seems to have aggravated the flight into dollars. Most bankers are convinced there will have to be a one-off devaluation early in 2009. "The latest story is that Putin will quit as prime minister and become speaker of the Duma [state parliament], making Kudrin the man who will devalue," said one senior banker. But most observers think the "father of the nation" would lose all public confidence – still running at almost 80 per cent – if he dared to quit as such a critical time. As for unemployment, Mr Putin is less sanguine: "I am still hoping that we won’t have mass unemployment," he told TV viewers. "Although looking at the labour market, we can of course expect more people to lose their jobs temporarily."
Unemployment did not happen in Soviet times. Now dismissal is possible, and no one is sure the fledgling social security system can provide a safety net. But Masha Lipman dismisses the likelihood of mass political protests. "Society is extremely fragmented and apathetic. I am sure there will be more protest rallies here and there, but they will be local. For the Russian people to reach out to each other will take a tremendous shock." The greatest political danger for Mr Putin is different. Hitherto he has kept power by maintaining a balance between the factions around him, representing different arms of industry and the security services. As long as the economy grew, they could all be kept happy. Today, he may be forced to choose between them, who gets help in repaying the huge foreign debts accumulated by the likes of Gazprom and Rosneft. There may not be enough to go round. That is when the factions will start fighting.
Unmade in China
Juyi Shoes is the sort of entrepreneurial company that has helped turn China from a poor rural country into a manufacturing powerhouse. In 1988, Li Anlian borrowed money from relatives to start a workshop making shoes from spare bits of leather. Managed these days by her son, the company now employs 3,800 and produces 10m pairs a year for clients that include Zara of Spain. Many of Ms Li’s neighbours have similar stories. Juyi is based in Wenzhou, a city 250km south of Shanghai whose resilient entrepreneurs have made it the standard-bearer of China’s private-sector economy. By some estimates, the city has 300,000 small businesses. But there is one thing about Juyi that does not quite chime with Wenzhou’s reputation for rugged individualism. An entire floor of the company’s office is given over to celebrating the Chinese Communist party and one of the rooms for party members boasts six imposing framed portraits: in order, Marx, Engels, Lenin, Stalin, Mao, Deng.
China this week celebrates the 30th anniversary of its "reform and opening up" policy, when Deng Xiaoping loosened controls on the economy and unleashed a long stretch of high-octane growth that has pulled tens of millions out of poverty. Concerts, seminars and speeches will mark the event. Yet the anniversary is taking place during a period of soul-searching about whether the impressive run of growth can continue and whether Chinese capitalism can survive its deep contradictions. In the short term, Wenzhou is a useful weather vane for the health of the global economy and the strength of consumer demand. A slump in export hubs such as Wenzhou means depressed consumers elsewhere. Beyond that, the fate of Wenzhou’s entrepreneurs will be an important test of China’s ability to move on from low-cost manufacturing and build a more sophisticated economy.
The immediate threat is from the global slowdown – news that Chinese exports declined in November heralds tough times ahead. But the weak economy has also reignited a debate about whether the entrepreneurial dynamism at the root of China’s success is being stifled by the remaining government controls over the economy. After three decades of reforms, the financial system is still dominated by the party-state, which means that funding often follows political connections rather than business acumen. "China’s financial system has not opened up enough," says Yao Xianguo, dean of the College of Public Administration at Zhejiang University. "Big private companies increasingly rely on the government while smaller firms suffer from their inability to get loans from state-owned banks." Wenzhou helps demonstrate how capitalism flourished from nothing after Deng took over. Little known outside the country, the city is legendary within China – evidenced by the many explanations for its success. Isolated by mountains on three sides, Wenzhou businesses just got on with it, some people say, at a time when Beijing still frowned on capitalism.
Some also say Mao refused to put important state-owned companies in the region because its location across the strait from Taiwan made it vulnerable to invasion, meaning it had to create its own economic base. Churches with red neon crosses dot the city’s skyline, prompting theories that Wenzhou’s business culture is rooted in a form of protestant individualism. Whatever the reason, the city’s factories have become a global force in light manufacturing. For anyone who uses a cigarette lighter, there is a 70 per cent chance it was made in Wenzhou. Something similar goes for light switches, zippers and even sex toys. Nearby towns are big producers of hinges, plugs, bras, socks and ties. Tales of cunning entrepreneurs abound. Nan Cunhui repaired shoes until he and a few friends started to make light switches from spare parts in the evenings. From that he has built up Chint, China’s biggest manufacturer of electrical power equipment, with sales of $2.3bn (£1.5bn, €1.7bn) a year. (One of his friends in the early business left to found his own company, Delixi, which is now the second biggest Chinese company in the industry.) "The interesting thing is that the guys at Chint and elsewhere started off as peasants and have got where they have all on their own," says Xie Jian, professor at Wenzhou University’s City College. Manufacturing success, he argues, has often come despite rather than because of the authorities in Beijing: "The companies have always been one step ahead of the government."
Wenzhou’s private sector is also rooted in the city’s network of informal banks. Many of the factories got off the ground using money raised by a handful of relatives and family friends from underground banks, which exist in a legal grey area, tolerated but not formally approved by the authorities. This combination of light manufacturing and extended-family microfinance can be found elsewhere in China in smaller versions but it is often referred to as the "Wenzhou model". Yet that model is under pressure. As exports drop off, low-cost manufacturing companies are particularly feeling the pinch. Gaining an accurate picture of what is happening to Wenzhou’s industry is difficult – there have been few reports of bankruptcies among companies or underground banks, unlike the export hub in Guangdong in southern China. But Zhou Dewen, head of the association that represents the city’s small and medium-sized companies, says production has stopped or been cut at 20 per cent of Wenzhou’s factories, while exports have fallen 15 per cent this year. "We have actually had a very strong year but the impact from the crisis is only just beginning," says Lin Kefu, vice-president of Chint.
In Shuangyu, a Wenzhou suburb where the narrow streets once hummed with small workshops making shoes, the signs of the slowdown are visible – closed doors at some and large piles of inventory at others. Ye Yonglin, who owns Dilun Shoes, says that most of the factories have had to cut back. "If you are a small company and do not have regular contracts with clients or some edge in terms of quality or branding, you are suffering badly at the moment," he says.
Building a brand and investing in technology cost money, however, and that is where the slump among Wenzhou manufacturers collides with one of the biggest debates about the future of economic reforms in China. The Wenzhou model of informal financing, though useful for starting factories from scratch, is not so effective at taking companies to the next stage. Not only do loans in the informal market tend to be small but interest rates are also high – borrowers can pay as much as 40-50 per cent a year. Formal finance in China is dominated by the state. The main commercial banks provide the bulk of the credit in the country and they mostly lend to other state-owned companies. So as private businesses grow and require more capital or land, some feel the need to get close to the various arms of the party-state.
In Wenzhou, this has led to an odd courtship over the last decade: companies looking for official patrons and the Communist party, nervous about the creation of a new power base, seeking to penetrate the private sector. The homage to the party and Stalin at Juyi Shoes is one example, but Chint boasts it was the first Wenzhou company to set up a party cell, even if founder Nan Cunhui has not been accepted as a party member. State media reported last year that 3,400 party cells had been established in Wenzhou businesses. Forging close contacts with government is good business in any country – witness the photos of handshakes with the president-of-the-day in US executive suites. But for Yasheng Huang, a professor at MIT and author of a new book, Capitalism with Chinese Characteristics, it is part of a broader trend of the party-state smothering the country’s entrepreneurial instincts. The problem is not the photos with senior leaders, he says, but all the backroom deals that entrepreneurs have to enter if they want political protection. According to Prof Huang, China has not seen a gradual transition from state control to capitalism over the last three decades. Instead, the real boom in entrepreneurship came in the 1980s when controls in rural areas were relaxed. But since the 1990s, the state has reasserted more control over the nascent private sector and focused more on government-led urban investment. By starving private companies of funding, he argues, China is risking a decline in its productivity that will damage future growth.
"One of the reasons Wenzhou is now in trouble is that the companies do not have enough capital to modernise," he says. "China today resembles an oligarchic version of state-led capitalism" which could become "crony capitalism built on systemic corruption and raw political power". Prof Huang’s thesis has its critics, who point out that policies such as joining the World Trade Organisation in 2001 did a huge amount to stimulate the private sector. But his book has come at a time of intense debate within China about liberalising the financial sector – including tentative proposals for legalising underground banks. The idea is opposed by some of the big state-owned banks, which fear more competition, and by some officials who worry it could lead to an explosion in new bank credit. There is also ideological opposition to ceding more state control of finance. But supporters say it will provide a shot in the arm to the economy at a crucial time by providing more and cheaper credit to well-run smaller companies "One of the most important things the government could do to help the economy is to legalise the underground banks," says Mr Zhou from the small companies association in Wenzhou.
China’s leaders will rightly boast this week about the economy’s achievements over the last three decades. Yet if they are to sustain that growth record, they face some tough questions about just how much of the commanding heights of the economy they wish to keep controlling. At a Communist party meeting on December 18-22 1978, Chinese leaders took the first steps away from collective agriculture. In official histories, the meeting began the transition from a command economy, which later became known as "reform and opening up". In fact the timeline is a little hazy. Many of the decisions had actually been taken at a separate meeting the month before and peasants in Anhui province had already started dividing up communal land among themselves. But the December meeting has gone down in history as the victory of Deng Xiaoping (left) over the Maoists. In the following three decades, China introduced a series of further reforms – most products are now based on market prices, swaths of state-owned companies have been privatised and China joined the World Trade Organisation in 2001. Liberal economists have called for two further totemic reforms – allowing farmers to use their land as collateral and reducing state control of the financial system.
The Lessons From 30 Years of Chinese Reform
Thirty years ago this week, Deng Xiaoping and the Chinese Communist Party turned their backs on Maoism and embarked on a reform program that led to the most remarkable period of wealth creation the world has ever seen. From today's vantage point this process appears surprisingly smooth. But it hasn't been, and still isn't. Above all, there has never been total agreement in Beijing about the wisdom or course of reform. Nor has there been a clear road map. Rather, especially under Deng, it was a fairly personal process. He could launch reform because in 1978 China was in a state of ideological and economic exhaustion, and internal opposition to "following the capitalist road" was weak. The adoption of pragmatism as a guiding principle was popular because people were so fed up with political campaigns and class struggle.
Deng also played a crucial role as "paramount leader" at key moments in the 1980s and early '90s, pushing through changes using his personal prestige when reform seemed to founder. In the early stages, economic reforms created many winners and very few losers, as private enterprises started small, coexisting with the state-owned industrial dinosaurs. In Deng's famous phrase, China's policy makers adopted a gradualist approach, "crossing the river by feeling for the stones." Small-scale experiments often led to success on a national scale, such as allowing farmers to keep what they produced from private plots and the establishment of special economic zones along the coast. The major involvement of foreign enterprises in the Chinese economy was never planned. It simply evolved. But the lack of a reform blueprint also led to some notable failures. China's stock market remains dysfunctional because it started as a no-cost source of money for state-owned enterprises. Allowing the market to become a viable source of capital for entrepreneurs would hurt these companies and those who own their overpriced shares.
This gradualist approach, and the underlying lack of consensus, had political consequences. During the 1980s, reformist and hard-line forces within the Communist Party still fought over the pace of reform, and intellectuals had a modicum of freedom to debate. The crackdown after the 1989 Tiananmen Square massacre sharply reined in that debate, but within a few years economic reform and growth were back on track. By the mid-'90s, the party successfully recast itself as a collection of society's elites from all backgrounds, including entrepreneurs. The only competition over policy was between technocratic elites and leaders of patronage networks, while the government bought the allegiance of intellectuals with improvements in their lifestyles.
China became a remarkably laissez-faire economy in the late 1990s and early 2000s. The government's revenues as a share of GDP shrank to around 11%, from 31% in 1978. At the same time, Beijing unilaterally cut tariffs and joined the World Trade Organization, while shrinking the public sector. In the space of a few years starting in the 1990s, inefficient, state-owned enterprises shed about one-third of their workforce, by some estimates 60 million jobs. As a result, for about three decades the "socialist market economy" churned out double-digit growth year after year. Unfortunately this run is coming to an end, and not just because of the global financial crisis. Today the pendulum is swinging back toward ideological competition and big government. With the country still without a true consensus on the virtues of free-market reform, the communists-turned-capitalists are morphing into European-style social democrats.
In the late 1990s, the bureaucrats set out to re-establish their power. Beijing fixed a target of restoring national revenue to 20% of GDP by improving the tax collection system. Last year, revenue hit 20.8% of GDP, growing by 32.4%, far ahead of economic growth of 11.4%. Spending has risen just as fast, and this is now part of an ideological shift back toward statism. Government leaders portray themselves as the answer to every problem, expressing their willingness to use public resources to help those left behind by the new prosperity, rather than counting on new businesses to create jobs. While China's social safety net remains small in comparison to European countries, it is expanding rapidly. Given that China remains a poor country and has a rapidly aging population, this may not be sustainable.
Meanwhile, after welcoming foreign trade and investment to a degree seldom seen in a developing country, Beijing is quietly shifting tack to impose some nontariff barriers to foreign products and investment. The state is pushing the creation of new national champions, enterprises that are tied to the government by various ownership structures and enjoy generous financing from the state-owned banks. A new labor law goes far beyond basic workplace protections, incentivizing workers to organize and instigate disputes with management. All of this is reducing the opportunities open to the true private sector, which has been the engine of China's rapid growth. As growth slows and the politically well-connected cadre managers enjoy the lion's share of opportunities, inequality and resentment grow. If this prompts the government to expand spending further to buy off the discontented, the virtuous cycle of economic reform could turn into a vicious cycle of ever greater government intervention.
In the political sphere, the close alignment of government and business elites means that any emerging opposition to the Communist Party will likely be antibusiness. We already see evidence of this. Among intellectuals, a nationalist movement advocating greater government control of the economy -- known as the "new left" -- is the hottest trend. None of this means that China is necessarily going to reverse course after 30 years of reform. But the straight-line projections some have drawn of the country's growth are too optimistic. The drawbacks of the Communist Party's monopoly on power are becoming more evident, as vested interests protect their control of the economy by holding back development of the banking system and stock market. The coming year is expected to be critical, both economically and politically. China's export-dependent economy is especially vulnerable to a global slowdown. But the Communist Party has shown itself adept at adjusting to new challenges. We can expect that the feeling for the stones will continue, even as the pace of reform slows.
Risky, Ill-Timed Land Deals Hit Calpers
At the height of the property bubble, California's giant pension fund, Calpers, made a fateful decision: It aggressively poured money into real estate. As a result, today it's one of the biggest owners of undeveloped residential land in America. Partly because of these investments, California Public Employees' Retirement System is struggling to avoid one of its worst annual declines since its 1932 inception. Calpers has lost almost a quarter of its assets since July 1, the start of the current fiscal year. The problems come at a time of uncertainty for the nation's largest public pension fund, which has been without its top two executives for nearly half a year. Calpers is poised to appoint a new chief executive as early as this week, people familiar with the matter said.
Calpers is now warning California's cities, towns and schools that they may have to cough up more money to cover the retirement and other benefits the fund provides for 1.6 million state workers. Some towns are already cutting municipal services, and at least one is partly blaming the Calpers fees. Calpers in recent weeks said it expects to report paper losses of 103% on its housing investments in the fiscal year ended June 30. That's because Calpers invested not only its own money, but billions of dollars of borrowed money that must be repaid even if the investment fails. In some deals, as much as 80% of the money invested by Calpers was borrowed. In the latest wrinkle: To generate sorely needed cash, a troubled Calpers venture known as LandSource recently started the process of selling land during the worst property market in a generation. Calpers could potentially lose nearly $1 billion on LandSource, a $2.5 billion deal completed early last year, and one of the priciest U.S. residential-land transactions ever. LandSource is now under bankruptcy-court protection.
With $239 billion in assets as of June, Calpers's portfolio was bigger than the government-run funds of Russia, South Korea, Dubai and Chile combined. In recent years, Calpers became much more aggressive than other pension funds in making nontraditional investments -- real estate, foreign stocks, even forestland. Unless Calpers's returns bounce back by June, the fund says it expects that the rates it charges governments to participate in the pension could rise starting in 2010, leaving them with less money to spend on other services. Alicia Munnell of the Center for Retirement Research, Boston College, says the economic slump will likely force other pension funds besides Calpers to pass on the financial pain. "Even under the best-case scenario...taxpayers are still going to have to put more money into pension funds." Calpers points out that its commercial properties, including a chunk of Time Warner Center in New York, haven't been nearly as hard-hit as residential investments, which are valued at about $6 billion. Together, residential and commercial holdings total about one-tenth of the fund's overall $182.6 billion portfolio. Its real-estate portfolio fell 14.4% for the 12 months ended in September, underperforming its benchmark, which rose 5.3%.
Calpers stresses that it's a long-term investor and can earn back the declines in the future, just as it erased declines suffered in the dot-com bust a few years ago. "No one in the marketplace knew how swiftly the housing market would fall -- not the Federal Reserve, not the Treasury," said Ted Eliopoulos, head of Calpers's real-estate portfolio, in an interview. The fund has also added "checks and balances" on property-investment decisions, Mr. Eliopoulos said. "Calpers has always attempted to learn from downturns," he said. The details of Calpers's housing deals, and the identities of some of the home builders it invested with, are only starting to come to light. That's because investments were often made through ventures with opaque names like "Hearthstone Path of Growth Fund," and Calpers doesn't detail many of their holdings. Calpers says its investments were done with "customary oversight" and were "appropriate for the asset class and typical the industry."
In recent years Calpers invested in: Three large parcels near Phoenix, one of the nation's hardest-hit property markets. Last month, Calpers effectively walked away from one of the three, after having invested $140 million. On one of the others, to start earning a return, Calpers's investment partner recently started selling ground water from the property. A massive block of land with room for about 8,000 units near the small town of Mountain House, Calif., the nation's most "underwater" housing market by one measure. (Nearly 90% of homeowners there owe more on their mortgages than their homes are worth, according to mortgage-research firm FirstAmerican Corelogic.) As of June 30, Calpers valued the investment at negative $305 million, reflecting the fact that it has repaid borrowed money used in the deal. About 10,000 acres near Jacksonville, Fla. The plan was to sell timber from the property, as well as residential lots. But as real estate collapses, it could take five years before the venture can start selling lots.
Just one particularly bad year for investments can have serious consequences for California governments in the retirement system. Calpers recently estimated that if its declines for the current fiscal year are greater than 20%, it would trigger an increase of 2% to 5% of an employer's payroll. Currently, the average employer-contribution rate for public agencies, including cities and counties, is 13% of payroll, Calpers said, which is already on the high side for state pension funds, according to industry analysts. A 5% increase in California's rate would be the largest increase to hit public employers since the dot-com bust. Any rate increases aren't a certainty, Calpers says, since the fund could still earn back its declines. Real-estate losses aren't the primary reason Calpers is taking a hit. Its biggest declines have been in the stock market: Its stock portfolio is down 41% so far this fiscal year. But Calpers has targeted less money in bonds, and about double the allocation to private-equity investments and real-estate deals, than the average public pension fund, according to Calpers documents and an industry survey.
Calpers got more aggressive in real estate amid the tech-stock selloff of 2000-02. Its board decided to increase its investments in real estate and private equity, shifting some money out of safer, but lower-yielding, holdings like bonds. Robert Carlson, a former Calpers board member who left the board earlier this year, said publicly at that time, "We believe taking no risk is the biggest risk you can take." Land purchases are among the riskiest real-estate investments. Not only can property values swing wildly, but unlike, say, a stock, land can take months or years to sell. Amplifying the risk, many of Calpers's land investments used borrowed money. Investing borrowed money acts as a lever: In a rising market, it lifts overall returns since you're profiting not only on your own capital, but the borrowed money too. But in a falling market, that leverage amplifies losses. To help it identify promising real-estate investments, Calpers turned to a small circle of partners it had previously done deals with since 1992, albeit on a much smaller scale.
"The early investments had worked very well," says Barry Gross, president of Developers Research, an Irvine, Calif., advisory firm that had consulted on several earlier and smaller Calpers land investments. "Calpers said, 'If we can do it with 300 houses, let's do it with 3,000.'" Michael McCook, then head of Calpers's real-estate investments, proposed boosting returns by investing more borrowed money. "I told them it would help in the good times, and it would hurt in the bad times," Mr. McCook recalls telling the board in 2002. Investing borrowed money is common in land-buying partnerships. Mr. McCook says he felt Calpers would be at a disadvantage when vying for a piece of these deals if it were unwilling to boost returns in a similar way. Calpers already used borrowed money in commercial-property deals. Between 2001 and 2002, it raised the amount permitted to an average 50% from 25%.
In residential-property deals, traditionally Calpers hadn't used much borrowed money. But in 2005, the trustees sanctioned use of borrowed money in residential deals at an average rate of 60%. Since the average rate applies to Calpers's entire housing portfolio, some individual deals used as much as 80% borrowed money, Mr. McCook recalls. That level is more aggressive than many pension funds or land developers would use, industry consultants and developers say. Calpers says that other public pension funds have invested borrowed money at the same level. The increased use of borrowed money corresponded with the peaking property market. In 2004 and 2005, housing prices were jumping as much as 30% a year in some places. Until last year, the Calpers strategy worked. Through its housing partners, the fund pursued big, complex deals with large home builders. Returns on housing investments were an impressive 16% average annually from 2004 through 2006.
In a typical deal, Calpers would provide the funding to its partners, who would team up with a home builder to buy land. Most of the equity would come from Calpers, while the home builder would put down 10% to 15%, in exchange for the right to eventually buy the land in full. Home builders like to do this because it lets them essentially control land without having it weigh down their balance sheets. And Calpers hoped for big returns by selling that land to the builders in a booming market. Calpers's investment partners worked with major home builders including Hovnanian Enterprises Inc. and Beazer Homes USA, according to two people familiar with the matter. As the property market soured, deals that once looked smart revealed a dark side, because Calpers agreed to terms that exposed it to more of the risk in bad times. For instance, Calpers guaranteed $1.7 billion in debt across several deals. Typically, home-builders are the guarantors -- that is, they're on the hook in the event of a default. By being guarantor, Calpers used its rock-solid reputation to obtain lower borrowing costs. But today, as projects struggle, the guarantees mean Calpers is pouring additional cash into projects from which it might otherwise prefer to walk away.
As the U.S. property market crested, the deals got bigger. The biggest was LandSource, the $2.5 billion venture now in bankruptcy-court protection. In LandSource, Calpers teamed up with Lennar Corp., the giant Miami-based home builder. Lennar was known in the industry for its sophisticated use of land deals. The LandSource deal took shape in 2006, when Victor MacFarlane, one of Calpers's long-time real-estate investors, asked Lennar if it would be interested in selling a big stake in its 15,000-acre Newhall Ranch, north of Los Angeles. Newhall Ranch's co-owners, Lennar and LNR Property Corp., a unit of Cerberus Capital, were willing to sell. Around the same time, Lennar's CEO, Stuart Miller, was warning that the weak housing market could worsen. Discussing land purchases in a September 2006 conference call, Mr. Miller said: "Right now there's no evidence of opportunities to jump in and buy something strategic.''
The LandSource deal involved $970 million from a Calpers-funded venture, along with $1.5 billion in borrowed money. Lennar and LNR each received $707 million in cash and each retain a 16% stake. The Calpers-venture, which was co-managed by Mr. MacFarlane's firm and Weyerhaeuser Realty Investors, a unit of the giant timber company, took a 68% stake. Mr. MacFarlane, the man proposing the deal, was highly regarded among Calpers top brass. "Victor MacFarlane was well-known and liked by board members and the CEO," says Russell Read, then Calpers's chief investment officer, who stepped down in June and now heads C Change Investments, which invests in companies that promote new technologies for protecting the environment. Mr. Read takes responsibility for giving LandSource the go-ahead at Calpers. "We based it on our research, our judgment and on MacFarlane's track record," he says. It turned out to be a bad moment to buy land. In the summer of 2007, just a few months after LandSource closed, the U.S. housing market entered its historic free-fall. LandSource filed for bankruptcy protection earlier this year. Mr. MacFarlane declined to comment. Previously, he has said he knew the market was in decline but viewed LandSource as a long-term investment that would pay off over a decade or more. A Calpers spokeswoman said in recent days, "We are monitoring [LandSource] in the bankruptcy process and protecting our interest." A lawyer for LandSource says the venture is planning to sell smaller parcels, but preserve the large Newhall Ranch.
Amid the losses, Calpers is making some changes in its investment-decision process. In February 2007, shortly after Mr. Eliopoulos became head of Calpers' real-estate group, the fund set a new policy requiring deals to be vetted three times -- by the internal investment committee, an independent fiduciary and, finally, by an outside consultant. Previously, much of the oversight came from Calpers' staff and consultants. Calpers is creating a new computer database to more closely track "balance and diversification" in the real-estate portfolio. It also is proposing to reduce the maximum amount of borrowed money that can be used in housing deals, and cut back on loan guarantees. George Diehr, vice-president of Calpers' board, said that in the future the fund will have less of its money invested in residential property, although that's partly because its current holdings have fallen in value. "Certainly, there remains a possibility that additional properties will be sold," he said. "We're doing the analysis now."
'The Obama Administration Will Be Very Cautious'
In a SPIEGEL interview, US foreign policy expert Strobe Talbott discusses the daunting foreign policy challenges facing Obama, the next president's desire to turn Americans into global citizens and the prospects for reinvigorated trans-Atlantic relations.
SPIEGEL: Mr. Talbott, Barack Obama will be confronted with a world beset by problems when he takes office on Jan. 20. Which priorities should be at the top of his agenda?
Strobe TALBOTT: I know what will be uppermost on the agenda -- the international financial crisis. Still, there is real danger in simply extending the motto of the Clinton presidency: "It's the economy, stupid." It would be understandable for the new government to make its slogan, "It's the international economy, stupid," but I would still consider that to be risky and probably a mistake.
SPIEGEL: Does a more urgent problem exist in these times than protecting prosperity and social security?
TALBOTT: This is a deep crisis and if it is not solved, globalization will turn sour on us all. But there are some other urgent issues that cannot be put on the back burner: climate change, the danger of nuclear proliferation, world poverty, global health protection and the prevention of international pandemics. These issues should not be de-prioritized because of the financial crisis.
SPIEGEL: And are you confident that Obama won't lose his way in the thicket of wars and crises -- including Russia, Pakistan, Afghanistan, Iran, Iraq, India, Georgia and Israel?
TALBOTT: I think Obama gets this big time. There are strong indications that he has an acute understanding of these problems. Just think of his remarkable election night speech at Grant Park in Chicago. He basically said, "We have some tough problems, do not expect them to be handled quickly, not in a year and maybe not in four years." He summed it up in three phrases: two wars, a planet in peril and an international financial crisis. I checked with people familiar with the way his mind works, and the order in which he put those was no accident.
SPIEGEL: How will Obama manage to take the country on an international journey that entails sacrifices for the American population? Effective climate protection, after all, requires smaller cars and less energy use.
TALBOTT: Obama is pretty good at reconciling the reconcilable. That does not mean that he can reconcile the irreconcilable, but he always finds ways to lower tensions and diminish polarization.
SPIEGEL: When it comes to culture, doesn't America -- with its large domestic market and fixation on itself -- seem like one of the least globalized countries in the Western world?
TALBOTT: There is no question that the population of the United States takes its sovereignty very seriously. We don't have a tradition of transnationalism like you do in Europe. I know many people on your continent who identify as European just as easily as they identify as being German, British or French. But this European culture is only 60 years old.
SPIEGEL: Will Obama attempt to shift from an American identity to a global one?
TALBOTT: He has already begun to do so. In his speech in Berlin's Tiergarten, he called himself a citizen of the world. This was sentiment for which Socrates was put to death. In the United States, nobody gets put to death for saying that, but as a self-characterization, it certainly has a radioactive touch.
SPIEGEL: He is not the first American to describe himself as citizen of the world.
TALBOTT: John F. Kennedy did it, and so did Ronald Reagan, but they both waited until they got to the White House. I think it is further evidence that Obama was out in front when he said the United States needs to think of itself as a communal citizen of the world. He will not, however, come at everyone with the grim message that we all have to change our way of life, that we need to take the metro, for instance, or buy small cars.
SPIEGEL: Because the average American can only handle positive messages?
TALBOTT: You can make fun of us all you want. But our people are right to ask: What are the benefits for us and for our country?
SPIEGEL: And what is the answer?
TALBOTT: America will get stronger if it both invents and makes use of innovative technology. America does not simply want to be green. America wants to make money off being green. It wants being green to reduce our dependency on Arab oil and to strengthen national security. Unlike the view of the Bush administration, in Obama's understanding there is no tension between energy, economic and environmental policy.
SPIEGEL: Won't the focus on global governance that you recommend for the US be undercut by the constant cost-benefit calculations of domestic policy?
TALBOTT: For a President Obama, a lot depends on combining domestic and foreign policies. An active climate policy would promote and renew America's leadership role, and the respect we would gain globally would reflect positively on us. America doesn't like being unpopular, but we will accept that if necessary. Still, we much prefer being liked.
SPIEGEL: In Europe, the expectations for an Obama administration are probably even higher than in the United States. What will change for the Germans, the French and the British?
TALBOTT: The issue of finding the right policy for Afghanistan is going to be tough. Obama will try to persuade the Europeans that we have to fight the war in Afghanistan together. The Clinton name is also a global brand, and that will prove effective. Hillary Clinton comes off the Senate Armed Services Committee and understands the needs of NATO.
SPIEGEL: Which means that the pressure on the German government to deploy its troops in southern Afghanistan, where the Taliban insurgency is gaining ground, will increase?
TALBOTT: All parties are realistic and know about Germany's special historical sensitivities. They will speak respectfully with Chancellor Angela Merkel and Foreign Minister Frank-Walter Steinmeier. The Obama administration will practice politics as the art of the possible.
SPIEGEL: Another crucial issue in trans-Atlantic relations are ties with Russia. In Germany, nobody in a position of authority wants another confrontation with Russia.
TALBOTT: I expect that the United States and Europe will come closer together in their Russia policy. Just take the question: Should Georgia become a member of NATO?
SPIEGEL: Which President Bush supported and Chancellor Merkel spoke out against.
TALBOTT: I expect that the United States will return to its original position, which says that any addition of a new member state must enhance the security of the alliance as a whole. That principle would argue against the inclusion of a state such as Georgia, which is, in one sense or another, divided against itself.
SPIEGEL: Are you pleading for an end to NATO's so-called "eastward expansion"?
TALBOTT: No. I will always remember a conversation I once had with Chancellor Helmut Kohl. He told me that it was in Germany's interest to no longer be on the eastern edge of the West. I believe he was right. Therefore, we should not close our doors to future member states. The point now, with regard to Georgia and also to Ukraine, is to find artful words that exclude no one. That could help us in our relations with Russia to lower the temperature a little below the boiling point.
SPIEGEL: Perhaps if America didn't have plans to install a missile shield. Bush considers it absolutely necessary, and Moscow considers it unacceptable. How will an Obama Administration deal with this?
TALBOTT: I think Obama should be taken by his word here. He says that if this technology works, it should be deployed. He has not yet elaborated on what the criteria will be. This gives him time and latitude to study his options. He does not want to, and will not, repeat the mistakes of the Bush administration. On coming into office, it adopted the slogan "ABC" -- anything but Clinton's way, meaning everything is permitted except Clinton's policies. This attitude was wrong, and our new slogan should not be ABB -- anything but Bush's way.
SPIEGEL: It sounds like you aren't expecting any kind of about-face in US foreign policy, but rather selective changes at best.
TALBOTT: The new Obama administration will be very cautious. It will listen. It won't break with the past out of principle.
SPIEGEL: So Poland and the Czech Republic, which for Bush always were front line states against Putin's Russia, do not have any reason to worry about being alienated?
TALBOTT: It would be a great mistake if the new administration were to tell Poland and the Czech Republic, "Well, thanks for all that, but forget about your agreements with the United States. Russia doesn't like them." That will not happen.
SPIEGEL: Do you view Russia and Putin as being synonymous?
TALBOTT: Today's Russia is no longer the Russia of the Cold War, which means that more than one person is in a position of authority. President Dmitry Medvedev understands better than others in Moscow that Russia is a strong state in terms of its size, its military capability and its natural resources. But he also knows that the Russian economy is much too dependent on what it can dig and pump out of the ground.
SPIEGEL: Do you focus more on him than on Putin, who, is considered to be Moscow's ruler by the West?
TALBOTT: I focus on the effects of the new reality. I clearly remember August of 1968 when Soviet tanks rolled into Prague. Nobody then would have been allowed to say: "This will have serious consequences for the Soviet stock market." Whereas two days after Russian tanks rolled into Georgia, it was quite different. Today, Russia is part of a global system.
SPIEGEL: And the government in Moscow also accepts that?
TALBOTT: This summer, President Medvedev made a remarkable speech at the Russian Foreign Ministry in which he stated that Russia has always said what it doesn't like about Western policy in general and American policy in particular. But the time had come to say what they want to see and what the alternatives are. I am confident that President Obama will take him at his word. Next year's Munich Security Conference will be more fascinating than ever because for the first time all parties will meet.
SPIEGEL: And what is your forecast?
TALBOTT: We will soon have a very high level dialogue on a new European security architecture.
Surprise! Credit Card Traps
Tommy Newsom believed he had done everything right. Each month he paid his Bank of America credit card bill on time. The balance was relatively high -- about $5,000 -- but he paid at least the minimum due. Then earlier this year, he received a letter from his credit card company. "They were going to double the interest rate on my credit card, and that upset me," he said. "Because there didn't seem to be, in my mind, a legitimate reason for doing that." Newsom's interest rate went from 14 percent to 28 percent, which increased the monthly minimum payments. "It makes a difference, $40 or $50 more," he said. "We watch what we do closer than we had. We live paycheck to paycheck."
Newsom is the sole breadwinner for his wife and grandson, having worked 47 years at the same private electricity company outside Dallas. But there were unexpected expenses that put his credit card to use more than he would have liked. "In a two-year time frame we went through five operations in my family, and obviously I had a lot of medical bills. And what free money I had went into medical payments and some of the things I might not necessarily charge, I did charge," Newsom said, "and ran up the balance higher than I would have liked. Because I was just trying to pay off the medical balances and had to use the credit card quite a bit."
Newsom called Bank of America looking for answers. "Essentially, what they finally told me was the rules allow them to do it, so they were going to," he said. "Period." Newsom was given the chance to "opt out" or close the account, but at the time he was not in a position to do so. "It was tied to my overdraft privileges at the time and to do so, I would have lost those privileges and would have had to go to another bank," he said. The increase in the interest rate meant he was able to pay off only the minimum amount each month. He has not been able to lower the original balance. In the last 10 months, he's paid about $1,600. But the balance remains near $5,000. "You feel like you are at the bottom of a bottomless pit, and you are trying to crawl your way out of it, but there's a long way to go," he said.
Bank of America would not comment directly on Newsom's case but sent "Nightline" a statement that reads, in part: "We do periodically review the credit risk for each account and may reprice individual accounts based on that risk assessment. That review takes into account a customer's performance with us as well as external credit risk indicators." Newsom, like many credit card holders, is finding increased interest rates, lower credit limits and changing fees. Americans on average have $8,000 in debt and own seven or eight credit cards. The total amount of consumer debt is close to $1 trillion. This is coming at a time when the mortgage crisis and unemployment have pushed people to the financial edge.
"The economy has weakened. The mortgage crisis has weakened the economy," said Scott Talbott, a lobbyist with Financial Services Roundtable, which represents 100 of the nation's largest banks. "You see a lot more unemployment, so there is a lot more risk in lending now. And so credit card companies are responding to that risk by increasing rates for some Americans and decreasing lines of credit for others." Ed Mierzwinski of U.S. PIRG, a Washington, D.C., consumer advocacy group, said credit card companies had been unfairly targeting its customers. "The last few months, banks have been tightening credit, tightening the screws on customers," he said. "They've started using unfair practices -- hair-trigger late fees, charging late fees when you were just one day or one hour late. In addition, the worst practice that people hate is they are raising your interest rate to a penalty interest for no reason at all."
But Talbott said Americans have been relying far too heavily on their credit cards. "Credit cards have really become a staple for most Americans, and for some, they've become a lifeline," Talbott said, adding that credit cards were meant for emergencies, but more Americans have started using them for day-to-day expenses. "The problem is that credit cards are really designed for short-term financing. They are not designed for long-term borrowing. And what more Americans are doing is using credit cards for long-term financing." Ann Lee retired to Florida and started a small travel agency. This month her bank -- Chase -- cut off one of her credit cards, eliminating a $15,000 line of credit. "We are always working about 18 months in advance, and I need a cash flow and I use my personal credit cards to handle my cash flow," she said. "It's easier than a small-business loan for me."
Lee said that in her travel business, she had to place deposits to hold cruise ship slots and hotel rooms, and had to guarantee those deposits with a credit card. So, she said, she maintains high balances on the three cards she uses for her company. But, she said, in 45 years she had never paid her bill late. She had the credit scores to back that up. But this fall, she ran over the limit on one of her credit cards -- not the one that was canceled. The card that was canceled was a backup card that had a zero balance. Lee said that's part of the game the banks play. And she's not a typical credit card holder. Before retiring, she worked for GMAC -- the financing arm of General Motors -- for 34 years, helping people obtain car loans. "It's David against Goliath," she said. "The bank card companies, they are writing their own rules. And we have to live by them or take our business elsewhere. And I would say the majority of the people, they are stuck. It's kind of a conundrum. Where does it end?"
Though Lee said she didn't need that card, she was still angry. She said she wrote a letter to the CEO of Chase and got a phone call in reply from the company. She said the company offered to reinstate the card but only after doing another credit check. When contacted by "Nightline," Chase would not comment on a specific customer's case but issued this statement: "We constantly evaluate the cost of our business, including the risks and funding associated with credit card loans. When necessary, we make changes to credit lines, pricing or terms based on the costs to us of making loans, including borrower risk and market conditions. We are working hard to provide consumers impacted by these changes with alternatives." "It's kind of at a tipping point, and if enough people feel, stand up and say enough is enough something will be done about it," Lee said.
And people are speaking up. The Federal Reserve proposed changes to credit card rules this past spring and received more than 62,000 comments on its Web site from the public -- the most ever on any issue. This week the Federal Reserve will vote to approve sweeping changes that could help people like Tommy Newsom, who has found a better rate elsewhere and is in the process of leaving Bank of America. "The most important thing the Fed will do is say there will be no more retroactive interest rate hikes unless a consumer has been at least 30 days late," Mierzwinski said. Other changes include requiring companies to allow sufficient time to make payments, and reducing or eliminating some fees. For now, the House has passed a bill with a credit card holders' bill of rights, but the Senate has not.
The banks say self-regulation has already eliminated some credit card practices that were considered abusive, but increased regulation could lead to further reductions in the availability of credit. "It will reduce some fees, but it will also provide a better understanding, a clearer understanding between the consumer as well as the credit card lender so you avoid those gotcha moments going forward," Talbott said. Talbott adds that banks have already taken steps to eliminate some credit card practices that were considered abusive but warns that increased regulation could lead to further reductions in the availability of credit.
But consumer advocates want even more protection. In Washington, the House has passed a bill with a credit cardholders' bill of rights, but the Senate has not. "If the Fed does this, that's a major step," Mierzwinski said. "We're hoping Congress will then adopt the rule as a law because the law is more permanent."
Executive Pay Limits May Prove Toothless
Congress wanted to guarantee that the $700 billion financial bailout would limit the eye-popping pay of Wall Street executives, so lawmakers included a mechanism for reviewing executive compensation and penalizing firms that break the rules. But at the last minute, the Bush administration insisted on a one-sentence change to the provision, congressional aides said. The change stipulated that the penalty would apply only to firms that received bailout funds by selling troubled assets to the government in an auction, which was the way the Treasury Department had said it planned to use the money.
Now, however, the small change looks more like a giant loophole, according to lawmakers and legal experts. In a reversal, the Bush administration has not used auctions for any of the $335 billion committed so far from the rescue package, nor does it plan to use them in the future. Lawmakers and legal experts say the change has effectively repealed the only enforcement mechanism in the law dealing with lavish pay for top executives. "The flimsy executive-compensation restrictions in the original bill are now all but gone," said Sen. Charles E. Grassley (Iowa), ranking Republican on of the Senate Finance Committee.
The modification reflects how the rapidly shifting nature of the crisis and the government's response to it have led to unexpected results that are just now beginning to be understood. The Government Accountability Office, the investigative arm of Congress, issued a critical report this month about the financial industry rescue package that said it was unclear how the Treasury would determine whether banks were following the executive-compensation rules. Michele A. Davis, spokeswoman for the Treasury, said the agency is working to develop a policy for how it will enforce the executive-compensation rules. She would not say when the guidance would be issued or what penalties it might impose. But she said the companies promised to follow the rules in contracts with the department.
The final legislation contained unprecedented restrictions on executive compensation for firms accepting money from the bailout fund. The rules limited incentives that encourage top executives to take excessive risks, provided for the recovery of bonuses based on earnings that never materialize and prohibited "golden parachute" severance pay. But several analysts said that perhaps the most effective provision was the ban on companies deducting more than $500,000 a year from their taxable income for compensation paid to their top five executives. That tax provision, which amended the Internal Revenue Code, was the only part of the law that contained an explicit enforcement mechanism. The provision means the IRS must review the pay of those executives as part of its normal review of tax filings. If a company does not comply, the IRS can impose a tax penalty. The law did not create an enforcement mechanism for reviewing the other restrictions on executive pay.
If a firm violates the executive-compensation limits, department officials said, the Treasury could seek damages, go to court to force compliance, or even rescind the contracts and recover the bailout money. "We therefore have all the remedies available to us for a breach of contract," Davis wrote in an e-mail. Legal experts said those efforts could be complicated if the Treasury outlines the penalties after companies have received bailout money. David M. Lynn, former chief counsel of the Securities and Exchange Commission's division of corporation finance, said courts have sometimes placed limits on the government's ability to impose penalties if there was no fair warning. "Treasury might find its hands tied down the road," said Lynn, who is also co-author of "The Executive Compensation Disclosure Treatise and Reporting Guide."
Congressional leaders are also concerned that the Treasury might simply choose not to enforce the rules or be unwilling to impose financial penalties that could further weaken a firm and send the economy deeper into a tailspin. The Bush administration at first opposed any restrictions on executive pay, congressional aides said. The original three-page bailout proposal presented to lawmakers in September contained no mention of such limits. "Treasury was pretty clear that they thought doing this exec-comp stuff would limit the effectiveness of the program," said a Democratic congressional aide involved in the negotiations, who, like others interviewed for this story, spoke on condition of anonymity. "They felt companies might not take part if we put in these rules."
Congressional leaders disagreed. By the morning of Saturday, Sept. 27, the final day of marathon negotiations on the bill, draft language relating to taxes and containing the enforcement provision applied to all companies participating in the bailout programs, Democratic and Republican congressional aides said. But then Treasury Secretary Henry M. Paulson Jr. and his deputies began pushing for the compensation rules to differentiate between companies whose assets are purchased at auction and those whose assets or equity are purchased directly by the government, the aides said. Congressional leaders from both parties thought Paulson wanted the distinction for extraordinary cases like American International Group, which the government seized in September. He wanted to be able to push executives out of companies that the government controlled and have the flexibility to bring in strong new executives, said one senior congressional aide.
"The argument that they were making at the time is that the direct investment was going to be used only in circumstances where the company was AIGed, so to speak," said a senior Democratic congressional aide. Davis, the Treasury spokeswoman, confirmed that the Treasury pushed to place fewer restrictions on executives at companies receiving capital infusions, but she gave a different explanation. She said many of those firms are more stable and are being encouraged to participate in the bailout to strengthen the overall system. "The provisions for failing institutions should come with more onerous conditions than those for healthy institutions whose participation benefits the entire system," she said. Lawmakers agreed to the Treasury's request that the measure apply only to executives at companies whose assets were bought by the government through auctions. In the executive-compensation tax section, a new sentence saying that eventually was inserted.
Meanwhile, Paulson repeatedly told lawmakers that he did not plan to use bailout funds to inject capital directly into financial institutions. Privately, however, his staff was developing plans to do just that, Paulson acknowledged in an interview. Although lawmakers hailed the rules as unprecedented new limits on executive pay, several were unhappy that the law was not stricter. Under pressure from Congress, the Treasury issued regulations in October on executive compensation and applied the tax-deduction limits to all companies receiving bailout funds, although the legislation did not require it for firms that received direct capital injections. But the Treasury failed to issue guidelines requiring the IRS or any other agency to enforce the rules, and it also failed to explain how the restrictions would be enforced.
The Treasury's regulations also instructed firms to disclose more compensation information to the Securities and Exchange Commission. But officials at the SEC do not think they have the authority to force companies to disclose the kind of pay information required by the bailout law, according to people familiar with the matter, though they hope companies will cooperate. John Nester, an SEC spokesman, declined to comment. Senators on the Finance Committee have expressed concern to Paulson and are now considering whether they should amend the law to apply the enforcement mechanism to all firms participating in the bailout.
Economic crisis has made safety net for poorest families even weaker
The prolonged economic downturn is increasing the hardship on people at the very bottom of the income scale in the Pittsburgh area even as it threatens to pull more people from the middle class into the ranks of the poor. As families lose their homes, workers lose their jobs and retirement savings are threatened, lines have grown longer at shelters, soup lines and food banks here and across the country. "We've seen a higher percentage of people using our shelter and eating our meals who come from a more middle-class background who have fallen on hard times," said Steve Rorison, a manager at Light of Life Rescue Mission on North Avenue. "The majority of homeless who come through our door are hardcore, so when someone comes in from a more middle-class background they stand out a bit in the way they express themselves and carry themselves," Mr. Rorison said.
Poverty rates tend to rise in every recession, and the uncommon severity of this economic slide could signal more trouble ahead for people of lesser means, said Ann Chih Lin, co-author of a recently released book "The Colors of Poverty," published by the Russell Sage Foundation in New York. Dr. Lin, an associate professor of political science at the University of Michigan, said the downward migration of the middle class is hastened by the nation's massive foreclosure wave. For many families, their home is their major source of wealth. When they lose it, they have little else.
Also in a slower economy, the poor become more exposed to cascading crises in which one problem leads to another keeping them in a hopeless cycle of need, she said. "If you lose a job in a bad economy, it will take you longer to find one and in that period of unemployment, any other bad event such as sickness, a child doing poorly in school or difficulty with a landlord will make things worse. Each new setback is that much harder to recover from. "Suddenly you are not dealing with one crisis -- job loss -- but more," said Dr. Lin. "The likelihood that a financial crisis will be extended by another crisis is greater. Those new crises in and of themselves make it harder to get out of poverty."
Charity leaders in Allegheny County recently joined forces to create an emergency fund to help more than two dozen nonprofit organizations that started seeing an unprecedented spike in demand for their services. Aid requests at Pittsburgh-area agencies have jumped 73 percent in the past six months while support for the same agencies is falling, according to a report by the Forbes Funds. Those who help support the charities are also hurting from the economic downturn, which in turn leaves more without the help they need. "The bulk of our giving comes during the holiday season and we've experienced a 25 percent budget shortfall in November," said Beth Healey, public relations director for Light of Life. "That's an indication to us of how the economy is affecting our donors. If this continues, it will affect the poor and destitute we serve."
Pittsburgh households that are turning to human services agencies for the first time, according to the Forbes Fund report, are most often those with incomes of up to $42,200 living paycheck to paycheck and barely making ends meet. "An increasing number of these households in this income range have fallen into poverty," the report said. Although the foreclosure crisis has not affected the Pittsburgh area as intensely as many other major cities, a significant number of homeowners here will suffer from higher adjustable interest rates in the next few years and many residents will need help rebuilding their credit ratings after being foreclosed on.
The cascading problems triggered by the economy can already be seen at Family Links in Shadyside, which operates a shelter for children aged 21 and under. Lenny Prewitt, a senior program manager, said when families break up, many of them end up at the shelter after having to fend for themselves. "In an indirect way, we are seeing the effects of what is going on in the economy," Mr. Prewitt said. "There's no way to quantify it, but we know there are families being hit by financial hardship and their core gets dissected and the family is scattered."
Poverty as a way of life shows no signs of slowing down. In 1980, the poverty rate in Allegheny County was 9.2 percent, climbing to 11.5 percent in 1990. In 2005, the latest year figures are available, the poverty rate in this county hit 12.4 percent. And with the arrival of the winter months, local human service agencies are especially concerned about an expected influx of residents needing help for basic needs such as utilities that are close to being shut off and homes on the verge of default. "The poor are like a fever," Dr. Lin said. "It's a symptom that something more fundamental is wrong. That there's an infection somewhere we haven't discovered yet. "We should care about the poor because of the fact that if their families, schools, jobs or health is bad it suggests something is wrong with the system at large."
Global grain rush under way as rich nations snap up farmland overseas
Wearing flowing red robes and pitching his own trademark desert tent, Libyan leader Moammar Gadhafi paid a visit to Ukraine last month in search of a remarkable deal to help feed his oil-rich but soil-poor people. Under a proposed agreement with Kiev, Libya would lease 247,000 acres of Ukraine's rich black land to grow wheat. The harvest would then be shipped back to Libya, giving the desert nation a more secure supply of food in the face of predictions about higher food prices and potential shortages in decades to come. Ukraine, in turn, would get access to Libyan oil fields, helping free it from dependence on Russia for its energy needs. Around the world, food-poor but cash-rich countries, spooked by last season's high food prices, are racing to snap up rights to farmland in developing countries and breadbasket nations. They're aiming to boost their own food security and cash in on what might prove one of the few sound investments left in a world in financial crisis.
South Korea's Daewoo Logistics announced last month that it has signed a 99-year lease on 3.2 million acres of land in Madagascar, which it will use to produce corn and palm oil for shipment home. China, which already farms more than 100,000 acres of land in Australia, is buying or leasing huge swaths of farmland in the Philippines, Laos, Kazakhstan, Myanmar, Cameroon and Uganda, according to Grain, a sustainable-agriculture group based in Spain. Gulf states—Saudi Arabia, the United Arab Emirates, Bahrain and others—also have locked up millions of acres in Indonesia, Pakistan, Sudan and Egypt. In the U.S., a similar buy-up of land occurred in the late 1980s when Japan purchased more than half a million acres of farmland in California, Montana, Colorado and Florida. In contrast to the latest rush, however, the main purpose was to raise cattle for Japan's beef appetite, rather than grain.
"It's literally all over" that rich countries and corporations have been looking for land in recent months, said Carl Atkin, head of research for Bidwells Agribusiness, a British company that has helped broker some of the land deals and advises farming investment funds. The rush to buy or enter long-term leases on land has been fueled in part by the low levels of world grain stocks, despite record harvests this year, and by a growing sense that world markets cannot be trusted to supply adequate grain. Important grain producers like India, Vietnam and Indonesia within the last year cut off exports of key crops such as rice and wheat to ensure supplies at home, boosting prices worldwide and raising concerns about potential shortages.
Now countries like Saudi Arabia say they would prefer to be in charge of their own grain production rather than relying on their vast cash reserves to buy what they need, particularly when cutting out the middleman can reduce costs by 20 percent or more, experts say. Fast-developing countries like China, in turn, see demand for food at home outstripping their ability to produce it in years to come and want to line up supplemental supplies with some of their huge foreign currency reserves built up through trade surpluses. "The food and financial crises combined have turned agricultural land into a new strategic asset," said a report from Grain. In particular, with President-elect Barack Obama promising to press ahead with biofuels, "the medium-term drivers are very strong" for investment in agricultural land, Atkin said. It might seem incongruous that a country like Sudan, which receives millions of dollars in food aid each year, would be interested in selling or leasing fertile soils to other hungry nations. But "there are good reasons for it," said David Hallam, head of trade policy with the UN Food and Agriculture Organization.
First, governments of cash-strapped developing nations — some of them racked by corruption — rarely turn away offers of foreign investment, even in as politically sensitive a sector as land. Many of the same governments have failed to make the road and port improvements that their countries desperately need to get crops to market effectively, and farmers there lack access to credit, fertilizer and expertise that could boost yields. New investment, everyone hopes, will create long-lasting gains in production. For decades, food security experts have been decrying the lack of investment in agriculture in developing countries, particularly those in sub-Saharan Africa, as a major impediment to eradicating hunger and boosting grain production worldwide. Now, with rich nations suddenly stepping up with billions of dollars, analysts are hopeful that some of the investment could finally bring the production boosts the world has been waiting for. "When wealthy countries, whatever their motives, say, 'We're interested in investing in ag projects in a poor country,' then it's not a bad thing," Hallam said. The only question, he said, is whether they operate the projects as "cooperative joint ventures" that keep local farmers on their land but producing more, or colonial-style extractive industries.
Some of the early projects show signs of an extractive focus. Daewoo, for instance, has said it will hire South African workers to run its farms in Madagascar, rather than local residents, which suggests job creation and transfer of technology from the project may be minimal in Madagascar and that thousands of people with tenuous rights to the land they now farm may be pushed off it. Crop experts also warn that past efforts to create huge-scale corporate grain farming have regularly failed, one reason family-owned farms continue to predominate in the United States, one of the world's biggest grain producers. They point to the Soviet Union's disastrous collective farms and the collapse of a variety of large-scale colonial farming efforts in Africa as indications of what could go wrong. "That's the nightmare scenario, that [investors] jump in, lose their money, the operation shuts down, and five years later you have recriminations and rusting machinery" as well as more landless peasants, said Steve Wiggins, an African agriculture expert with the Overseas Development Institute, a British think tank.
Just how much security the new land investments may provide countries and corporations also remains uncertain, experts say. Future governments in countries now renting or selling land may well fail to abide by deals their predecessors cut, particularly if they face food or land shortages at home. "If you're a risk analyst you'd say these bits of paper are not going to be worth very much in the medium term and certainly not in the long term," Wiggins said. Still, the farmland buy-up shows few signs of slowing, particularly as cash-rich countries, businesses and investment firms struggle to find good buys in a bad market. "I can see why these projects are still of huge interest," Atkin said. "The case for ag land is pretty good when so many other things aren't doing so well at the moment."
Ethanol Bailout Next?
A couple of weeks ago, I started hearing "rumors" in my circle about the recent (and not unexpected) financial struggles and closings of ethanol facilities. It was time to revisit ethanol.
It doesn't take a rocket scientist to understand the futility of ethanol and the even more offensive taxpayer sponsorship of such irresponsibility. Never mind how ethanol might be affecting the food supply. After pouring billions of taxpayer dollars into a politicized pipe dream, our "chickens are coming home to roost".
On October 31st, VeraSun Energy, Inc , the nations 2nd largest producer of ethanol with a capacity of 1.64 billion gallons per year , announced that it had filed for Chapter 11 bankruptcy. This was after collecting revenues of $1.084 billion and a net loss of $476.1 million in the 3rd quarter ending September 30th. According to the press release, it intended to continue operations but since that time has closed 2 plants and has delayed indefinitely the opening of it's 110 million gallons per year (MMGY) facility in Janesville, MN.
On November 26th, Boot Hill Biofuels was taken into involuntary bankruptcy by a creditor. Construction of the 110 MMGY plant, scheduled to begin in June of 2007, was still on hold. (Wichita Eagle, Dec. 9, 2008, "Involuntary Bankruptcy Sought Against Boot Hills Biofuels")
On November 28th, Pine Lake Corn Processors of Iowa ceased production at its 30 MMGY facility in Steamboat Rock.
On Friday December 12th, Gateway Ethanol's 55 MMGY plant in Pratt, KS went into bankruptcy after no bidders could be found. (Hutchinson News Online, Dec.12, "Ethanol Plant In Pratt Up For Sale") Gateway filed for Chapter 11 protection in October estimating that it owes between $50 and $100 million. (Associated Press, October 7, 2008)
In early December, Altra Biofuels of California, after securing over $250 million in debt and equity financing to build facilities capable of producing 500 MMGY of ethanol, shut down its Coshocton, OH (50-100 MMGY) facility after only 10 months of production. It also closed its Cloverdale, IN plant at about the same time. (Hoosier Ag Today, Dec. 8, 2008)
So what happened?
- Cellulosic ethanol is still unproven on a commercial scale.
- Ethanol from corn is questionable at best. Even at a just $2.00 per bushel, feedstock cost alone for a gallon of ethanol (at 2.8 gal/bu.) would be $0.71 per gallon BEFORE adding any other costs of production, refining or distribution.
- Thanks to a number of factors including the adulterated demand for corn created by ethanol, corn skyrocketed to more than$7.00/bu. this past summer. That places feedstock cost at $2.50/gal or more.
- Many refiners, expecting high corn prices to continue, forward-contracted corn at those inflated prices.
- Corn at this writing is down to about $3.00 (still 50% higher than its historical average). Oil is down to the $40 range from $140 and gasoline is retailing for a $1.50 after adding all the costs, taxes and profit to it. $2.50 ethanol can't and won't pencil.
Corn growers planted their crop at a time when input costs were driven by the $7.00 market price of corn. Many covered their investment by forward contracting the sale of at least part of their crop. When corn and oil collapsed, refiners were unable to honor their commitments to the growers and the grower has gotten stuck sitting on a $7.00 crop in a $3.00 market. Can we not comprehend how government intrusion has so corrupted these markets?
On December 19th, 2007 President Bush signed HR 6, "The Energy Independence and Security Act" which calls for usage of at least 36 billion gallons of ethanol per year by 2022. To add insult to injury, it also authorizes a "new" $200 million to install blender pumps. (ACE Press Release, December 19, 2007)
- 36 billion gallons of ethanol from corn would consume ALL of our corn crop (over 12 billion bushels, 78 million acres, in a GOOD growing year).
- 36 billion gallons of ethanol from much haloed Switchgrass at 1,150 gallons per acre would require 31 million acres. (DOE Bioenergy Feedstock Development Program).
- 36 billion gallons of ethanol represents 25% of our 2007 Motor Gasoline Consumption of 142 billion gallons and 11% of our 317 billion gallons of total petroleum consumption (DOE - EIA).
- The United States has 343.521 million acres of arable land (excluding Alaska, 2008 CIA Factbook).
No matter how you figure it we're being asked to convert AT LEAST 10% of our arable land to biofeedstocks, disrupting the economy for 25% of our gasoline and 11% of our total petroleum.
The much referenced Billion Ton Vision is a study published by the DOE in April 2005. It concludes that we need (and can) produce 1 billion tons annually of sustainable biomass to displace 30% of our petroleum. It goes on to state explicitly that the purpose of the study was NOT to:
"assess the economic competitiveness of a billion-ton bioenergy and bioproducts industry, and its potential impacts on the energy, agriculture (food and feed production), and forestry sectors of the economy"
Short version? Yeah, we can find a billion tons of biomass, but we can't say that it's feasible. I submit that we would be astounded at what it will take to gather, store, process and dispose of a billion tons of biomass, much of it subject to the fickleness of nature, and all for (only) a theoretical 30% of our petroleum usage, never mind the disruption to the environment and economy.
For the 6 years ended in 2007, the taxpayer has provided an excise tax exemption of $12.03 billion on production of 23.589 billion gallons of ethanol (51 cents/gallon), (Renewable Fuels Association). It is impossible to calculate how much funding has been provided for Research and development, but I venture to say that it is much more than the tax exemption. We've been subsidizing for over 30 years and it is still not viable.
On December 4th, the American Coalition for Ethanol, a trade group of 1,500 advocates asked Congress to include text in the "Auto Bailout Bill" that would "guarantee that fuel retailers can dispense 15 percent ethanol blends and require auto companies to stand by warranties for car owners that choose to use such blends". Fortunately, it was not inserted.
Secretary of Agriculture Ed Schafer has already said that he would consider using USDA Rural Development Funds to assist ethanol producers that have "suffered losses in the volatile corn futures markets". Rural Development funds have been used in the past to promote ethanol and biodiesel plants. (DesMoines Register, Oct. 18, 2008
After pouring 10's (maybe 100's) of billions into a political pipe dream, that has brought the grain industry to the brink of collapse; considering the "no mis-managed, corrupt, government regulated, collapsing industry left behind" policies that have been implemented in the last few months, it is safe to say that there will be some kind of effort to save an industry that nobody wants. not even the environmentalists! But, then again, whatever the people want, Congress is going to do the opposite. (Can we say TARP?)
The USDA, on November 12th announced it was accepting applications for the Biorefinery Assistance Program.
"The Biorefinery Assistance Program provides loan guarantees for the development, construction and retrofitting of viable commercial-scale biorefineries producing advanced biofuels. The maximum loan guarantee is $250 million per project subject to the availability of funds. Preference will be given to projects where first-of-a-kind technology will be deployed on a commercial scale. Advanced biofuels are defined as fuels that do not rely on corn kernel starch as the feedstock." (USDA Press Release 0298.08)
Wow, $250 million per project. Non-corn starch. I bet that made the corn growers real happy!.
The futility of it all can be illustrated by a statement from American Corn Grower's Association (ACGA) President Keith Bolin at the ACGA Convention on January 18th, 2008 defending the 54 cent per gallon tariff on imported ethanol:
"The $0.54-per-gallon tariff on ethanol imports is the only way to recoup the $0.51-per-gallon blender's tax incentive which is paid to the petroleum companies to use ethanol."
Did I miss something?
Changes 'amplify Arctic warming'
Scientists say they now have unambiguous evidence that the warming in the Arctic is accelerating. Computer models have long predicted that decreasing sea ice should amplify temperature changes in the northern polar region. Julienne Stroeve, from the US National Snow and Ice Data Center, told a meeting of the American Geophysical Union that this process was under way. Arctic ice cover in summer has seen rapid retreat in recent years. The minimum extents reached in 2007 and 2008 were the smallest recorded in the satellite age. "The sea ice is entering a new state where the ice cover has become so thin that no matter what happens during the summer in terms of temperature or circulation patterns, you're still going to have very low ice conditions," she told the meeting.
Theory predicts that as ice is lost in the Arctic, more of the ocean's surface will be exposed to solar radiation and will warm up. When the autumn comes and the Sun goes down on the Arctic, that warmth should be released back into the atmosphere, delaying the fall in air temperatures. Ultimately, this feedback process should result in Arctic temperatures rising faster than the global mean. Dr Stroeve and colleagues have now analysed Arctic autumn (September, October, November) air temperatures for the period 2004-2008 and compared them to the long term average (1979 to 2008). The results, they believe, are evidence of the predicted amplification effect.
"You see this large warming over the Arctic ocean of around 3C in these last four years compared to the long-term mean," explained Dr Stroeve. "You see some smaller areas where you have temperature warming of maybe 5C; and this warming is directly located of those areas where we've lost all the ice." If this process continues, it will extend the melting season for Arctic ice, delaying the onset of winter freezing and weakening further the whole system. These warming effects are not just restricted to the ocean, Dr Stroeve said. Circulation patterns could then move the warmth over land areas, she added.
"The Arctic is really the air conditioner of the Northern Hemisphere, and as you lose that sea ice you change that air conditioner; and the rest of the system has to respond. "You start affecting the temperature gradient between the Arctic and equator which affects atmospheric patterns and precipitation patterns. "Exactly how this is going to play out, we really don't know yet. Our research is in its infancy." The study reported by Dr Stroeve will be published in the journal Cryosphere shortly.