Circus posters, Lynchburg, South Carolina
Ilargi: On Monday, Martin Luther King Day, US stock markets will be closed. The next day, Obama will be inaugurated as the 44th President of the USA. And the markets will be open on that day. Obviously, the expectations are that the optimism involved will lead to solid market gains. But today, after Bank of America’s new US government funding, and Citi's announced break-up -which will enable it to dump toxic assets, while there were some profits in the morning, bank stocks started plummeting around noon. There may be optimism, but there certainly is no confidence. Or belief for that matter. Looking out over the rapidly deteriorating financial landscape, and the newly reported giant bank bail-outs, I doubt I'm the only one to start considering the possibility that Obama may wind up going into the history books as the man who bankrupted America.
If Bank of America gets a $120 billion government guarantee against their toxic asset losses, on top of Citi’s almost $300 billion guarantee last year, it is becoming increasingly evident that losses will be far bigger than that. Why else would such provisions be provided? There's only one answer: because these losses are real, and they are so today, not some time tomorrow. Which in turn indicates that when tomorrow comes, more guarantees will be needed. There is no way that Bank of America has only $120 billion in potential or even already incurred losses on and off its sheets.
All of which points to a development that is devastating for the American public . While nobody requires to see how big the losses are, or even demands to see the paper they come from, there is a silent move towards transferring the colossal losses to the public purse from the corporate one. The new approach, which gains popularity fast, is called a 'bad bank' or an 'aggregator bank'. Once it’s established, in one form or another, we won't find out about Wall Street’s losses until the next bail-out. And that will be just another incomplete number as well.
This process, if it occurs at all, which is a very bad idea to start with, should at least play out in absolutely transparent circumstances. The reason that doesn't happen is clear: if people knew what was going on, what sort of debts are being unloaded upon them, none of it would not be accepted. And apparently, this is not the end; in fact we haven't seen anything yet. Bloomberg reports: "President-elect Barack Obama’s advisers see an increasingly grave banking crisis and are considering proposals far more sweeping than any steps that have been taken so far". Yeah, just check your wallet. This one too is on you.
Not surprisingly, we still live in a one-dimensional world. None of the $8+ trillion so far thrown at the US economy has helped that economy one bit. It has merely helped to -temporarily- hide losses at institutions , and to allow the richest part of the nation to get out without much damage. For the (wo)man in the street, things have only gotten worse, and a lot, even if (s)he doesn't yet realize that. But once the rich have covered their positions, there'll be no more reason to hide anything. Tellingly, US mortgage rates are at historical lows, but sales are still going down. There's more than one part of the country where foreclosure sales make up the majority of the total housing market.
What is being presented as daring efforts to save the economy and get people working and spending again, will in reality turn out to be biggest ever drama for the American people, and the most daring crime against them in the history of the nation. As for "get people working", it is becoming clear that unemployment will rise to levels no-one dared mention until recently, apart from a few such as me. To wit: Circuit City just announced the loss of another 30.000 jobs. As for the spending, people will have much less to spend in the years that lie ahead than they have in generations.
Barack Obama has only one answer to the trillions in public funds wasted in the past year and a half: he pushes Double or Nothing. America has become a country that has in its entirety adopted the philosophy and lifestyle that have established its darkest (that’s why they need the bright lights) and seediest corners: Las Vegas and Atlantic City. For all the talk of redemption and salvation, there is only one real religion that governs the US: the dual deity of money and gambling. As many who've walked the shadier alleys in Vegas can tell you, that is the sort of belief system that you can rely on to deliver you into bankruptcy. It’s one religion that holds the promise of a certain outcome. And it's all America has left.
The more black holes D.C. fills, the more open up
When I was a kid, black holes fascinated me. The idea that you could have an area of space so massive … so dense … that it could suck in and absorb ANYTHING that got too close — even light — seemed ludicrous. Like pure science fiction. But they’re real. These days, black holes aren’t so fascinating. But unfortunately, they are very, very real. And they keep popping up throughout the financial sector … Bear Stearns. Lehman Brothers. AIG. Fannie Mae. Freddie Mac. Subprime residential mortgages. Alt-A loans. Conventional home loans. Commercial real estate loans. Student loans. Credit cards.
The Federal Reserve and Treasury Department keep coming up with new whiz-bang "solutions" to deal with these black holes. They keep opening up Washington’s checkbook, allowing our tax dollars (or newly minted ones) to spiral toward their center. But every time they do, another market or institution implodes somewhere else. Suddenly, there is a new, giant money-sucking black hole to focus on! In fact, I see three right now that are opening up — and that could torpedo the markets and the finances of our nation …
Black Hole #1 — Federal Home Loan Banks following Fannie, Freddie, private banks over a cliff? Unless you follow the banking industry closely, you probably haven’t heard of the Federal Home Loan Banks. But the FHLBs are vitally important as a source of funding for U.S. banks both large and small. There are 12 of them spread around the country — in Atlanta, Boston, Chicago, Cincinnati, Dallas, Des Moines, Indianapolis, New York, Pittsburgh, San Francisco, Seattle, and Topeka. You’ve probably never heard of Federal Home Loan Banks. But after the federal government, they’re the biggest borrowers in the country! FHLBs sell debt into the capital markets to raise money, using their AAA ratings to borrow cheaply. They use that money to make advances to banks that are members of the system and take collateral in exchange — often mortgages or mortgage-backed securities.
The banks use the money they get from the FHLB, along with cash raised elsewhere from their own debt sales and depositors, to make loans. The banks are required to own stock in the FHLBs, and that stock helps capitalize the regional FHLBs. So what’s the problem? The FHLBs own billions and billions of dollars worth of mortgage backed securities. Those securities have plunged in value. So just like their banking customers, FHLBs are facing potentially huge write-downs on their portfolios. They may also be losing money on derivatives they employ. And that’s what is stressing the system. Specifically:• The Seattle FHLB just warned that it may miss one of its capital targets. It may be barred from paying dividends on the stock member banks hold in it, potentially impacting those institutions counting on the money.
• The San Francisco FHLB also said earlier this month that it was facing impairment charges, and that it wouldn’t pay a fourth-quarter dividend as a result.
• Moody’s recently warned that eight out of the 12 FHLBs could ultimately face capital problems thanks to losses on their $76 billion of mortgage securities not backed by Fannie Mae and Freddie Mac.
Now here’s where it gets really interesting: While many investors have never heard of the FHLBs, they collectively have roughly $1.25 trillion — with a "T" — in debt outstanding. That makes them the biggest borrowers in the U.S.— behind the federal government! If you thought it was expensive to bail out Fannie Mae and Freddie Mac (The Treasury has pledged to inject up to $200 billion in capital into the two of them), just you wait. Should the FHLBs need a bailout, there’s no telling how much it will cost! In other words, we’re looking into the maw of yet another gigantic black hole!
Black Hole #2— Insurance industry’s capital and surplus cushions are eroding fast … It’s not just the banks that are in trouble. The insurance industry is taking a pounding, too. Losses on residential mortgage securities, commercial real estate investments, and other holdings are hammering capital levels throughout the sector. The insurers are also getting hit because they guaranteed minimum returns on variable annuities — and the market subsequently tanked. Take the life insurance sector … The industry’s so-called statutory surplus, or difference between assets and liabilities — plunged 24%, or $76.8 billion, last year to $237.3 billion, according to research firm Conning & Co.
In an effort to rescue their collapsing balance sheets, some insurance firms are trying to get government bailout money by buying up teeny-tiny thrifts and banks. For example, Lincoln National, an insurance firm with $173 billion in assets, is purchasing the miniscule Newton County Loan & Savings of Indiana (total assets: $7 million). That transaction could give Lincoln access to $3 billion in TARP assistance. But that’s mere peanuts compared to what the ultimate cost may be … One estimate says the insurance industry may have to raise up to $50 billion in capital. Unless market conditions ease up, that kind of money just won’t be available from private investors. And that means we’re staring square in the face at yet another black hole— one that Washington is already being called upon to fill.
Black Hole #3— Pension funding picture deteriorates dramatically … Then there’s the dismal picture for the nation’s pension funds. States, corporations, municipalities … they’ve all promised benefits to retirees based on assumptions about the returns for various asset classes. But those returns are being blown to smithereens, causing funding shortfalls of epic proportions. The PBGC is $11 billion in the red. And with so many companies in bankruptcy, it may need a government bailout to rescue failed pension plans. The consulting firm Mercer recently estimated that the pension funds of big U.S. companies are underfunded to the tune of $409 BILLION! At the end of 2007, they were running a $60 billion surplus . That huge swing could drive up corporate borrowing costs and drive down corporate earnings.
It could also lead to reduced business investment as companies are forced to divert money from equipment and facilities budgets to their pension funds. Advisory firm Watson Wyatt recently estimated that U.S. corporations will have to boost pension fund contributions to $111.2 billion in 2009 from $50.5 billion last year. Now it’s true that the government-backed Pension Benefit Guaranty Corporation (PBGC) insures the basic benefits for more than 29,000 plans. But with so many companies falling into bankruptcy these days, it’s increasingly likely the insurance premiums the PBGC receives won’t be enough to cover its obligations.
The agency was already running a deficit of more than $11 billion as of September 30. And that number is poised to rocket higher. Result: Yet ANOTHER black hole the government will have to fill somehow, either by bailing out the PBGC or bailing out corporations. So at this point, I think it’s reasonable to ask three simple questions …
- Can the government continue its policy of bailing out anyone and everyone?
- Can the Fed and Treasury afford to keep filling black hole after black hole, without a heck of a lot to show for it … except more black holes? Heck, even the black holes they thought they had filled are opening up again! Just look at Bank of America. The firm got a whopping $25 BILLION in bailout money several weeks ago, and now it’s back in Washington begging for billions more!
- At what point are policymakers just going to have to give up and let more banks fail, more companies fail, and more asset markets trade down to where they are going to go anyway, rather than waste hundreds of billions of dollars trying to retard the process?
Some food for thought the next time you hear yet another speech out of Washington promising the sun, the moon, and the stars — if only we bail out (fill in the blank).
Citi Mortgage Losses 'Rapidly Approaching' Historic Peak
Citigroup Inc. said consumer delinquencies and subsequent loan losses accelerated in many parts of the world. Chief Financial Officer Gary Crittenden said during a conference call with investors, "Loss rates in [credit] cards have now surpassed their historic highs while in first mortgages the rate is rapidly approaching the previous peak." The CFO said, "Our assumption on employment has changed, and based on current data, we believe that unemployment could peak as late as the first half of 2010. This implies that we will most likely continue to add to our reserves until the end of 2009 and could see the end of significant additions by the end of this year."
However, there was a silver lining: "In our consumer businesses we are bending the curve on losses," said Chief Executive Vikram Pandit. Pandit said the company's decision to split some troubled assets and certain capital markets-reliant consumer businesses would create a unit with about $850 billion in assets, leaving the core Citi with about $1.1 trillion - half the size of a year ago. He said Citi is in no rush to sell the assets it plans to combine into Citi Holdings, a separate unit it will create to stem its continuing ills. "In fact we hope to make an announcement regarding the CEO for this unit shortly. Our goal is to maximize its value by running these businesses well," Pandit said.
"It is our goal that approximately 80% of our profits will be driven by Citicorp and based on an analysis we have done, we expect Citicorp to be profitable in 2008 and, going forward," Pandit said. He said Citicorp might have generated $10 billion in earnings last year, compared with an $18.7 billion loss for Citigroup. Still, Pandit said Citi continues "to look at all options dispassionately."
Citigroup Posts $8.29 Billion Loss and Will Split
Citigroup capped a devastating 2008 by announcing Friday that it would split into two entities and that it had posted an $8.29 billion loss for the fourth quarter. Citigroup’s rival, Bank of America, also posted a loss, just hours after receiving a new infusion of government support. Underlining the depth of the problems that have emerged from its acquisition of Merrill Lynch, Bank of America said Merrill had a fourth-quarter net loss of $15.31 billion, or $9.62 per diluted share, "driven by severe capital markets dislocations," before the acquisition was completed.
Even as Bank of America was coping with the challenge of absorbing Merrill, Citigroup was announcing the latest steps in dismantling its own financial supermarket. Citigroup confirmed that it would divide, for management purposes, into two separate businesses — Citicorp and Citi Holdings. "We are setting out a clear road map to restore profitability and enable us to focus on maximizing the value of Citi," it said in a statement with the earnings. Citigroup also issued a statement from its lead director, Richard D. Parsons, signaling that changes in its board were in the offing. Mr. Parsons, the former chairman of Time Warner, has been widely expected to become Citigroup’s next chairman.
Citigroup’s loss, which amounts to $1.72 per share, compares to the $9.8 billion, or $1.99 a share, it lost at the same time last year. Peter Dixon, an economist at Commerzbank in London, said the decision to split the financial giant was "an indication that the era of big financials is at an end for now." Reports emerged early this week that Citigroup was accelerating moves to dismantle parts of its troubled financial empire. But some Wall Street analysts and investors questioned whether the plan, which included the announcement on Tuesday that it would split off its prized Smith Barney brokerage, goes far enough to address Citigroup’s immediate troubles.
The bank has reported a loss for five consecutive quarters and announced a further $7.78 billion in write-downs in securities and banking for the fourth quarter. Revenue was $5.6 billion during the quarter, down 13 percent, lower across all regions. The bank also said Friday that its head count had been reduced by approximately 29,000 since the third quarter and approximately 52,000 for all of 2008. Analysts estimated on average that Citigroup would break even on a per-share basis, according to a survey by Bloomberg News. Both Citigroup and Bank of America had moved their earnings announcements forward from next week to address increasing anxieties among shareholders and pressure from the federal government to address their growing difficulties.
Bank of America’s earnings were released just after the government agreed early Friday to provide an additional $20 billion infusion of capital into the bank and to cover the bulk of up to $118 billion in losses, largely arising from the bank’s Merrill acquistion. . Overall for 2008, Bank of America posted a net profit of $4.01 billion compared with net income of $14.98 billion a year earlier. It said earnings were driven reflected "the deepening economic recession and extremely challenging financial environment, both of which significantly intensified in the last three months of 2008." Bank of America’s net revenue during the quarter rose 19 percent to $15.98 billion from $13.45 billion a year earlier. The bank also said it would pay a dividend of just 1 cent for the first quarter.
As for Citigroup, it posted $5.6 billion in revenue, down 13 percent on a same quarter a year earlier, reflecting the "difficult economic environment and weak capital markets." All regions suffered. For the full year 2008, Citigroup reported a net loss of $18.72 billion. With unemployment rising and evidence of a global slump, the bank is bracing for another dismal year. The company’s stock has dropped by almost half in the last week, closing Thursday at $3.83, down 70 cents, or 15 percent on the day. With nearly every part of the company suffering a massive blow, Vikram Pandit, the chief executive, is rolling out a new strategy that will divide into a "New Citi" and "Legacy Citi" that aims to focus its executives’ attention on its stronger remaining businesses while winding down its money-losing operations.
Even so, Mr. Pandit agreed to split off Smith Barney, its valuable retail brokerage arm, to raise capital so that it could offset the fourth quarter’s massive losses. "I have no doubt we will emerge from the current environment stronger, smarter, and better positioned to realize the full earnings power of this great franchise," Mr. Pandit said in a statement with the results. Mr. Pandit is also hosting a noon town hall meeting at Citigroup’s Park Avenue headquarters to address demoralized employees. The bank’s break-up plan comes after a stern regulatory warning it received in late November, when its rapidly deteriorating share price prompted the government to give it a second cash infusion, of $20 billion.
Citigroup’s first cash infusion from the government came in October in a $25 billion capital injection from the Troubled Asset Relief Program, or TARP. Eight other banks also received capital infusions to stabilize them as the global financial crisis deepened. With its receipt of a second lifeline from the government in November, Citigroup began operating under what is known as open-bank assistance, which involves a loss-sharing arrangement devised by the FDIC and an investment by the Treasury typically reserved for deeply troubled institutions. Since then, federal regulators have been leaning hard on Citigroup to shake up its board and shrink the sprawling company to address a credibility gap with its investors.
For Citigroup, the changes draw a somber curtain over the one-stop shop created in 1998 when the company’s architect and former chief, Sanford I. Weill, merged the insurance giant Travelers Group and Citicorp, then the nation’s largest bank. The deal brought traditional banking, insurance and Wall Street businesses, like stock underwriting, under one roof. But the company came under repeated fire from shareholders for lackluster results; its stock price has fallen more than 76 percent since it was formed. And the fourth quarter was no different. In bailing out Bank of America early Friday, the administration, the Federal Reserve and the Federal Deposit Insurance Corp. also agreed to take part in a program to provide guarantees against losses on approximately $118 billion in various types of loans and securities backed by residential and commercial real estate loans.
Bank of America had been pressing the government for help after it was surprised to learn that Merrill would be taking a massive fourth-quarter write-down, in addition to Bank of America’s rising consumer loan losses. The second lifeline brings the government’s total stake in Bank of America to $45 billion and makes it the bank’s largest shareholder, with a stake of about 6 percent. The program is modeled after the larger one engineered to stabilize Citigroup, but it, too, appears to have had limited success. Under the terms, Bank of America will be responsible for the first $10 billion in losses on a pool of $118 billion in illiquid assets, including residential and commercial real estate and corporate loans, and that will remain on its balance sheet.
The Treasury Department and the Federal Deposit Insurance Corporation will take on the next $10 billion in losses. The Fed will absorb 90 percent of any additional losses, with Bank of America responsible for the rest. In exchange for the new support, Bank of America will give the government an additional $4 billion stake in preferred stock. It has also agreed to cut its quarterly dividend to a penny, from 32 cents, accept a loan-modification program and put more stringent restrictions on executive pay. With losses mounting in the financial industry, other banks may eventually feel compelled to turn to the government for assistance, and the program could be used for other big banks. Taxpayers could end up guaranteeing hundreds of billions of dollars of banks’ toxic assets.
"The financial services sector still needs more equity," said Frederick Cannon, the managing director at Keefe, Bruyette & Woods. "TARP was announced in mid-September and most of the initial decisions were based on the state of the economy then. The economy has gotten a heck of a lot worse." Kenneth D. Lewis, Bank of America’s chief executive, had earned a reputation for taking big bets that helped transform NationsBank, a small lender, into a consumer powerhouse with bicoastal branches — and was often accused of overpaying. It snapped up Bank of America and took on its name, then followed with flashy deals for FleetBoston Financial in 2003 and then the credit card giant MBNA in 2006. That was followed by US Trust and LaSalle Bank of Chicago a year later.
Last year, Mr. Lewis’s bank also bought Countrywide Financial Corporation, the troubled mortgage giant that has come to symbolize many of the excesses of the subprime mortgage era. That made Bank of America the biggest player in every major financial service but wealth advice. The Merrill deal has not been easy for Mr. Lewis to digest. Clashes from combining the two strong cultures of each firm have complicated the merger. Merrill Lynch’s 16,000 brokers prided themselves on their loyalty to "Mother Merrill." Analysts say Bank of America’s managers are groomed like cogs in a giant money-making machine.
Paulson, Bair Raise 'Aggregator Bank' for Toxic Debt
The heads of the U.S. Treasury and Federal Deposit Insurance Corp. gave further momentum to the idea of a new government-backed bank to remove toxic assets from lenders’ balance sheets. "A lot of work has been done on an aggregator bank" and other ways of using the $700 billion financial-rescue fund "to let it go further when it comes to dealing with illiquid assets," Treasury Secretary Henry Paulson told reporters today in Washington. FDIC Chairman Sheila Bair praised the idea in an interview on CNBC, saying it might have "some merit."
Today’s remarks come days before President-elect Barack Obama takes office, and signal a readiness among regulators to undertake what’s likely to be the most radical effort yet to unfreeze lending. Fed Chairman Ben S. Bernanke earlier this week urged a "comprehensive plan" to address illiquid assets, floating the idea of a "bad bank." Investors continue to question banks’ viability even after officials committed the first $350 billion from the Troubled Asset Relief Program and after a doubling in the Fed’s balance sheet to $2.1 trillion. Bank of America Corp. today required a further $20 billion injection of taxpayer funds and government backing for a $118 billion pool of bad assets.
Paulson and Bernanke sought to end a series of ad-hoc interventions with financial companies last September, by urging lawmakers to approve the TARP. While the initial plan was to use the TARP to purchase illiquid assets, Paulson instead used the money to buy stakes in banks. The Fed chief said Jan. 13 that the bad assets are a "barrier’ to investment and are holding back lending. Obama’s advisers see an increasingly grave banking crisis and are considering proposals far more sweeping than any steps that have been taken so far, according to people who’ve discussed the outlook with them.
"They need to do something dramatic," said Harvard University Professor Kenneth Rogoff, a former chief economist at the International Monetary Fund. He is a member of the Group of Thirty counselors on financial matters, a panel that includes Treasury Secretary-designate Timothy Geithner and Lawrence Summers, incoming director of the National Economic Council. The Senate yesterday approved the release of the second half of TARP, and Obama’s Treasury could use much of it to back a bigger campaign to buy the illiquid assets. The FDIC, which has authority to take "any action" with insured deposit-taking firms deemed necessary to counter "adverse effects on economic conditions or financial stability," could also play a role.
"We think by leveraging TARP funds in this way, you could have a significant capacity to acquire troubled assets," Bair, who is set to stay on under Obama, said today. Officials could "require those institutions selling assets into this facility to contribute some capital cushion themselves." The Standard & Poor’s 500 Financials Index slid 5.1 percent to 133.28 at 12:01 p.m., extending its decline this month to 21 percent. Charlotte, North Carolina-based Bank of America lost 10 percent, and is down 43 percent this week, after today announcing its first loss since 1991. Paulson listed several ideas under consideration to help sustain ailing banks and stabilize markets. Those include broadening the Fed’s Term Asset-Backed Securities Loan Facility, a $200 billion program aimed at reviving consumer lending.
Paulson also urged the Obama administration to extend efforts to stabilize the financial system and work with Congress to pass a stimulus package. House lawmakers yesterday began work on an $825 billion economic-recovery package. "In the short term, the focus has to be on programs like the TARP and stimulus because we need to get this economy going," Paulson said. Shoring up banks’ longer-term financing and strengthening efforts to address the housing crisis would also help stabilize the financial system, the departing Treasury chief said. Lower mortgage rates and foreclosure mitigation efforts will help slow the decline in house prices, helping investors figure out how to value home-loan-related assets.
Investors also need sources of longer-term funding to feel confident investing in the types of assets that have been the most troubled, he said. "Many investors say they would love to come in and buy mortgages but they can’t get the funding," Paulson said. "If there is term funding, then it’s easier for people to come in." Paulson will depart when Obama takes office Jan. 20. Treasury Undersecretary Stuart Levey will become the department’s acting chief pending the Senate confirmation of Geithner, the New York Fed President. Geithner is scheduled to appear at a confirmation hearing Jan. 21.
Near panic in markets over fears of further US bank write-downs
America's biggest banks were battling to head off an investor rout, following fears that their battered finances would need a further boost from the US government. Bank of America saw its share price slump 20% at one point before closing down 18% at $8.32, while Citigroup dived 18% and closed down 15.5% at $3.83. The falls wiped out the gains the two banks had made since a faltering recovery began in November. Bank of America was locked in, discussion with US treasury officials, following its request for a loan. Meanwhile, Citigroup is expected to report its deepest quarterly deficit yet, after suffering net losses for four consecutive quarters.
The prospect of further write-downs on toxic assets held by the banks and a collapse in profits were blamed for the near panic selling in New York early in the session. But the wider market recovered later in the day on hopes the seriousness of the situation would prompt further US ?government intervention. Speculation about a pending Senate vote on, authorising the remaining $350bn (£238bn) from the government's financial bail-out fund helped the Dow close up 12 points at 8212. Concerns that the US banking system was in bigger trouble than politicians and regulators had previously thought sent UK bank shares tumbling, dragging down the FTSE 100 index 1.4% to 4121.
Lloyds TSB plunged to its lowest value since 1989 following successive days of share price falls. The bank, which officially absorbs HBOS on Monday, crashed 11.69% to 103p. Barclays was also hammered by a wave of selling to finish the day at 130.4p, down 8.23%. HSBC, which is believed to be under pressure to raise further capital, slipped 7% to 567p. The share price falls posed a problem for Gordon Brown, who may be forced to bring forward plans for further rescue measures. Proposals to package toxic assets into a single "bad bank" are not currently thought to be on the agenda, it is understood the Treasury is considering offering to underwrite a proportion of bank assets to prevent the need to raise further capital. The insurance policy would be paid for by the banks, but would avoid the need for the government to increase its share-holdings, which exceeds 50% in the case of Royal Bank of Scotland.
Ministers are keen to avoid full nationalisation of any bank, preferring at least a veneer of private-sector involvement. But continued speculation that nationalisation is a real prospect in the US and the UK, coupled with what is in effect a freeze on dividend payments as a price for further government funds also worried investors, many of whom have hung on to their holdings through the worst of the credit crunch and were hopeful of a recovery later this year. Economic data in recent days showing the US and Europe faced a long and deep recession appeared to be at the heart of the decision by investors to sell bank shares.
Analysts said hopes of a recovery in the latter half of the year were hit by figures showing sharp declines in manufacturing output and services coupled with rising unemployment. A prolonged recession would delay any recovery in the value of assets held by banks, in particular property, which is expected to continue falling this year and possibly into next year. Without a recovery in asset values, banks would be forced to make further write-downs. Citigroup is expected to hive off riskier businesses as part of a rescue package, while Bank of America could be forced to sell parts of Merrill Lynch, the investment bank it bought last year.
Citigroup could create a "bank within a bank" to contain its worst-performing assets in an effort to protect the rest of the operation and allow a revival in lending. Unwanted assets worth as much as $600bn – a third of its asset base – could be ringfenced, according to US reports. Nick Parsons, chief strategist at the capital-markets house NabCapital, said: "Many investors held firm last year and saw their investments decline by 30% or 40%. They have learned from that and when they see a longer recession looming they are more prepared to sell."
Circuit City to shut down
Bankrupt electronics retailer Circuit City Inc. said Friday it has asked for court approval to close its remaining 567 stores and sell all its merchandise. The company said it has 30,000 employees. In a filing with the U.S. Bankruptcy Court for the Eastern District of Virginia, Circuit City - the No. 2 electronics retailer after Best Buy - said it had reached an agreement with four companies to start the liquidation process. The company said the sale would begin Saturday and run until March 31, pending court approval.
Bank of America given $138 billion rescue package
Bank of America was today given a new injection of $20bn (£13.5bn) by the US government and a guarantee of $118bn on potential losses on toxic assets that have threatened to overwhelm the financial system. The bank, which received $25bn after buying the ailing investment bank Merrill Lynch in September, will take the money from the controversial $700bn troubled asset relief programme (Tarp) agreed by Washington at the end of last year. BoA employs more than 8,000 people in the UK and has begun slashing jobs, with 1,900 jobs set to go at Merrill Lynch in London, according to reports.
Last night the US Senate voted to release the remaining $350bn of emergency funding after lobbying by the president-elect, Barack Obama. The US government will take a stake in BoA in return for the aid, which is designed to absorb the losses on mortgage-related assets inherited from Merrill Lynch. The bail-out makes BoA the biggest recipient of taxpayer money next to Citigroup, another stricken banking giant. The two firms report quarterly results today. The deal follows heavy losses on Wall Street yesterday, when BoA saw its share price slump 20% at one point, before closing down 18% at $8.32, while Citigroup dived 18% and closed down 15.5% at $3.83. The falls wiped out the gains the two banks had made since a faltering recovery began in November. Stockmarkets in Asia rebounded today as investors welcomed the BoA bail-out, with Japan's Nikkei climbing 2.6%.
The BoA rescue matches that given to Citigroup, which is expected to report its deepest quarterly deficit today, after suffering losses for four consecutive quarters. In return for the bail-out, BoA agreed to cut its dividend to 1 cent per share from 32 cents, and cap executive pay - mirroring a concession made by Citigroup when it was rescued in November. The dividend cannot be increased without government approval in the next three years. Majority Democrats yesterday also proposed increasing to $825bn Obama's plan for a second package to stimulate the economy through a combination of federal spending and tax cuts. Passage of both measures would leave Obama with a $1.175tn war chest to use against the most dramatic slide in the US economy since the Great Depression in the 1930s.
In another attempt to shore up the banks, the US government's Federal Deposit Insurance Corp said it would propose lengthening the term on bank debt that it is prepared to guarantee to 10 years from three years. Banks must use the proceeds for new consumer lending. "They'll be back for more money" from Tarp, said Senator Bob Corker, a Tennessee Republican. He said "our banking system is going to lose hundreds of billions of dollars" and taxpayer money was "going down the drain". Concerns that the US banking system was in bigger trouble than politicians and regulators had previously thought sent UK bank shares tumbling yesterday, dragging down the FTSE 100 index by 1.4% to 4121.
Economic data in recent days showing the US and Europe faced a long and deep recession appeared to be at the heart of the decision by investors to sell bank shares. Analysts said hopes of a recovery in the latter half of the year were hit by figures showing sharp declines in manufacturing output and services coupled with rising unemployment. A prolonged recession would delay any recovery in the value of assets held by banks, in particular property, which is expected to continue falling this year and possibly into next year. Without a recovery in asset values, banks would be forced to make further write-downs.
Citigroup is expected to hive off riskier businesses as part of a rescue package, while BoA could be forced to sell parts of Merrill Lynch. Citigroup could create a "bank within a bank" to contain its worst-performing assets to try to protect the rest of the operation and allow a revival in lending. Unwanted assets worth as much as $600bn – a third of its asset base – could be ringfenced, according to US reports. Nick Parsons, chief strategist at the capital-markets house NabCapital, said: "Many investors held firm last year and saw their investments decline by 30% or 40%. They have learned from that and when they see a longer recession looming they are more prepared to sell."
December US industrial production drops 2 percent
Industrial production dropped by a bigger-than-expected 2 percent in December, Federal Reserve data showed on Friday, capping a dismal year for manufacturing as the recession took hold. Economists polled by Reuters had expected a 1 percent decline in December after a revised 1.3 percent drop in November, initially reported as a 0.6 percent dip. For the fourth quarter as a whole, total industrial production fell 11.5 percent at an annual rate. Compared with December 2007, industrial production was down 7.8 percent. Capacity utilization fell to 73.6 percent, which was 7.4 percentage points below its average level from 1972 to 2007.
Another fall in US consumer prices sparks fears of deflation
Consumer prices in the US fell sharply for the third month in a row in December, sparking fears of deflation. The US Labor department said the Consumer Price Index dropped by 0.7% last month, after falling 1.7% in November. For the year, consumer prices edged up by just 0.1%, the smallest annual change since 1954. Consumer prices rose by 4.1% for all of 2007. Nigel Gault, chief US economist at IHS Global Insight, said: "Inflation, seemingly so worrying just a few months ago, has vanished. Deflation is now the threat. The 12-month CPI inflation rate peaked at 5.6% in July, and has now plunged to just 0.1%."
Much of the decrease was down to the huge drop in oil prices from their peak of $147 a barrel in July. US light crude is currently $35.48 a barrel. Energy costs fell 8.3% in December, and were down 21% for the year. This is the biggest decline since records began in 1958. The cost of petrol plunged 43% last year, also the biggest decline on record since 1937. Meanwhile, US industrial production dropped 2% in December, driven by a 7.2% contraction in motor vehicle output. Economists had expected a drop of 1%. Industrial production has plunged 7.8% over the past 12 months.
Paul Ashworth, senior US economist at consultants Capital Economics, said: "With many vehicle assembly plants now temporarily closed, further steep declines in production in Q1 appear inevitable. December's decline wasn't just due to the problems in the autos sector either. The contraction was widespread, with all sectors registering declines. "The only good news is that the production of business equipment recorded a 1.8% increase last month, following a 2.9% gain the month before. Together, those gains suggest the decline in business investment in Q4 may not have been quite as bad as we feared. Overall, more woeful news on activity – Q4 was awful, Q1 will probably be equally as bad."
U.S. 'Bad Bank' Plan Gets Momentum to Revive Lending
Renewed questions about U.S. banks’ viability are pushing regulators toward a new plan that would remove toxic assets from bank balance sheets, in what may become the biggest effort yet to unfreeze lending. <President-elect Barack Obama’s advisers see an increasingly grave banking crisis and are considering proposals far more sweeping than any steps that have been taken so far, according to people who’ve discussed the outlook with them. "They need to do something dramatic," said Harvard University Professor Kenneth Rogoff, a former chief economist at the International Monetary Fund, and member of the Group of Thirty counselors on financial matters, a panel that includes Treasury Secretary-designate Timothy Geithner and Lawrence Summers, incoming director of the National Economic Council.
Federal Reserve officials are focusing on the option of setting up a so-called bad bank that would acquire hundreds of billions of dollars of troubled securities now held by lenders. That may allow banks to reduce write-offs, free up capital and begin to increase lending. Paul Miller, a bank analyst at Friedman Billings Ramsey & Co. in Arlington, Virginia, estimates that financial institutions need as much as $1.2 trillion in new aid. Other steps that may be under consideration include providing further guarantees for toxic assets that remain on the banks’ books, as officials did for Citigroup Inc. in November and with a $118 billion backstop for Bank of America Corp. today, or purchasing selected investments. Federal Deposit Insurance Corp. Chairman Sheila Bair yesterday played down the alternative of nationalizing lenders.
A move could come soon after Obama is sworn in on Jan. 20. Adding urgency to the deliberations is a deepening slide in financial shares. Citigroup yesterday sank below the level it reached when regulators mounted a rescue of the lender in November. Bank of America fell to an 18-year low as the company sought more aid from the government. "A lot of the trouble in all this is that once you got into a financial mess, people don’t know where the bodies are buried," Paul Krugman, the Princeton University professor who won this year’s Nobel Prize for economics, said in an interview with Bloomberg Radio. "People think ‘Who knows what I’m getting into?’" by lending or trading with others, he said.
Citigroup Inc. today posted an $8.29 billion fourth-quarter loss, completing its worst year, as the credit crisis eroded mortgage-bond prices and customers missed more loan payments. The company plans to split in two. Bank of America Corp., the largest U.S. bank by assets, posted its first loss since 1991 and cut the dividend. The fourth-quarter loss was $1.79 billion, or 48 cents a share. The Senate yesterday voted to allow the release of the remaining $350 billion from the Treasury’s financial-rescue fund, giving Obama a source of funds to implement a new bank program. The departing Bush administration used most of the first $350 billion of the Troubled Asset Relief Program for buying stakes in banks. The declines in bank shares show that the strategy has failed to shore up the banking system’s solvency.
A big new initiative "is going to be necessary," said Peter Wallison, who was U.S. Treasury general counsel under President Ronald Reagan and is now a fellow at the American Enterprise Institute in Washington. "Once they have stable capital, once they feel they are not going to be run on by people who doubt the quality of their capital position, they will start lending." Obama’s Treasury could use much of the funds to back a bigger Fed campaign to buy the illiquid assets, Wallison said. The FDIC, which has emergency authority to take "any action" with insured deposit-taking firms deemed necessary to counter "adverse effects on economic conditions or financial stability," could also play a role. In the case of Bank of America and Citigroup, U.S. officials opted to insure the illiquid assets on their balance sheets, without offloading them into any special units.
"Troubled assets continue to mount at insured commercial banks and savings institutions, placing a growing burden on industry earnings," John Bovenzi, the FDIC’s chief operating officer, told lawmakers Jan. 13. It’s "vitally important" to set up a program "capable of managing these assets until the economy and the banking industry are stabilized," he said. Fed Chairman Ben S. Bernanke called for "a comprehensive plan to stabilize the financial system and restore normal flows of credit," in a Jan. 13 speech in London. He outlined options including a bad bank, "which would purchase assets from financial institutions in exchange for cash and equity." Bernanke was in Europe for meetings with his counterparts from the world’s largest central banks to discuss the state of the global economy and financial markets. He met with U.K. Prime Minister Gordon Brown the next day. European policy makers are also struggling to restart lending in their region, with some considering purchases of toxic assets. The U.K. and Germany this week announced new programs to guarantee loans to companies.
"Buying toxic assets from banks is a good thing because I think confidence comes back into the banking system when you are certain -- or more certain -- that you have no time bombs ticking," said Josef Ackermann, chairman of the Institute of International Finance, the Washington-based group that includes most of the world’s large banks. Ackermann, who is also head of Deutsche Bank AG, Germany’s biggest bank, said "the real challenge here" is determining the price at which to remove the assets. He added, in a conference call with reporters Jan. 14, that Deutsche Bank doesn’t need to unload illiquid assets into such a bad bank. Switzerland in October relied on the mechanism to aid UBS AG. The Swiss National Bank and UBS set up a special unit to buy as much as $60 billion in toxic investments from UBS. Zurich- based UBS provided $6 billion in capital, which will be used as first protection against losses. It isn’t clear how stockholders or bond owners would be treated in a bad-bank scenario. In the case of UBS in Switzerland, there was no direct impact on either.
In the U.S., the initial proposal for TARP was to buy hard- to-value assets such as subprime residential mortgage-backed securities, debt linked to commercial mortgages and collateralized debt obligations. Departing Treasury Secretary Henry Paulson abandoned it in favor of capital injections as a faster method of deploying the funds. A more radical alternative would be the nationalization of some banks. Sweden used that option during a crisis in the 1990s. It took over two of the most troubled banks, Nordbanken AB, now part of Nordea AB, and Gota Bank, which later became a unit of Nordbanken. In addition, the government created a bad bank that bought troubled assets at a discount, while leaving financial institutions to manage their more-liquid holdings. Bair indicated government takeovers aren’t being actively considered. "I’d be very surprised if that happened," she told reporters in New York.
The Obama economic team has been signaling plans to take bold action soon after taking office on Jan. 20 to address the problems in the banking industry. "We must act with urgency to stabilize and repair the financial system," Summers said in a letter to Senate Majority Leader Harry Reid yesterday. Summers declined to specify how Obama will use the TARP, except for a mortgage-foreclosure prevention effort of $50 billion to $100 billion. "How do you use this next round of money in the most efficient and effective way? This is a Rubik’s Cube of a problem where there is no easy solution," said John Douglas, a former FDIC general counsel who is now a partner at the Paul, Hastings, Janofsky & Walker law firm in Washington. "Doing something sooner rather than later to instill confidence is important."
Harsh economic realities await the Obama team
The realisation is growing that Barack Obama may already have made a terrible mistake – before he's even entered the White House. Five weeks ago, this column raised questions about several members of the incoming President's then newly-unveiled economics team. Weren't they among those history would likely judge as most responsible for causing this crisis? That observation was lost at the time amid the cacophony of praise as mainstream commentators gushed over Obama's "star-studded" line-up. But since then, among bloggers and others with the "audacity" to think for themselves, the notion that Obama's economics team could become a political liability has started to gain real momentum.
The point at issue is the Glass-Steagall Act – passed in 1933, in response to the Wall Street crash. Named after the two Democrat senators who sponsored it, Glass-Steagall prevented commercial banks – which take deposits from ordinary households and firms – from engaging in high-risk speculative activities undertaken by investment banks. Or at least it did until 1999 when, after millions of dollars of political donations from Wall Street, it was repealed by President Clinton. That repeal, more than any other single factor, unleashed the forces that culminated in this financial crisis. Investment banks took over commercial banks using their retail deposit base, on which there was an implicit government guarantee for risky speculative trading – not least in opaque derivatives. Wall Street's example, in turn, led to the scrapping of similar regulations in financial centres elsewhere. And we all know what happened next.
One of the main proponents of scrapping Glass-Steagall was Clinton's Treasury Secretary Larry Summers. Removing this crucial banking firewall, he proclaimed at the time, would "better enable American companies to compete in the new economy". All the repeal achieved, though, was to allow Wall Street firms to engage in recklessly risky behaviour while growing "too big to fail" – sparking today's grotesque taxpayer-funded bail-outs, to say nothing of the freezing-up of interbank markets, blocking of worldwide credit channels and the resulting global slump. Despite his key role in enacting this historic blunder, Summers is to be Obama's chief economic advisor. Last week, in yet another soft-focus newspaper profile of Summers, one of his academic friends claimed that "when the facts change, Larry changes his mind". Well, Larry, the facts on Glass-Steagall have changed. You and your buddies goofed. So when are you going to reinstate the safeguards upon which the stability of global banking depends?
Bank troubles raise fears of growing bailout
The banks may need a bigger bailout. The government is mulling another multibillion-dollar aid package for Bank of America Corp., raising the possibility that much more taxpayer money will be needed to keep the banking industry from edging back toward the abyss. Investors took the news badly. Bank of America shares fell as much as 28 percent to their lowest level in 18 years before closing down 18 percent. Citigroup Inc. shares fell to a near 16-year low, closing down 15 percent, amid concerns about its stability. A grim earnings outlook from JPMorgan Chase & Co. escalated the pessimism. Its shares lost 6 percent.
But the sense of panic that has hovered over Wall Street in recent days does not seem to have breached Capitol Hill. Lawmakers, wary of pushback from constituents, reluctantly released the second $350 billion in the Treasury's financial rescue fund Thursday after assurances that $50 billion to $100 billion would be spent to try to reduce foreclosures. Many lawmakers have resisted giving banks more money. The bank sector's tumble stoked investor fears that a darkening economic outlook is hurting government efforts to resuscitate the banking industry. And it raised the possibility that the $700 billion financial rescue package -- the largest in history -- might need to swell even further.
"The perception on Wall Street is that things are getting worse and that the banks are bearing the brunt," said Jack A. Ablin, chief investment officer at Harris Private Bank in Chicago. Bank of America and the Treasury Department were near an agreement that will provide $15 billion to $20 billion in new government support to the bank, a source close to the discussions said Thursday. The source said the injection of fresh capital will come from the government's $700 billion rescue fund and will be similar to assistance provided last November to Citigroup. The source spoke on condition of anonymity because the agreement had not been completely finalized. An announcement was expected later Thursday.
Bank of America already received $25 billion under the government's Troubled Asset Relief Program, or TARP. The move to provide more money for Bank of America would support the growing consensus among financial experts that Treasury's bailout program so far won't be enough to stabilize banks reeling from bad mortgage loans and falling home prices. As the recession deepens, consumers and businesses are increasingly defaulting on other loans, such as those involving credit cards and commercial real estate, analysts say. "It was getting better for a while, but now it's just going to hell," Bert Ely, an independent banking consultant said. "The worse it gets, the more the government is going to have to do -- and the problem is, we just don't know.
"There may have to be additional TARP money put on the table. ... There's nothing magic about the $700 billion number. That could be increased to a trillion, a trillion and a half in a flash." The prospect of pumping more taxpayer money into Bank of America raised troubling questions about whether other banks may need more capital infusions. "Will we need TARP 2.0?" asked Vincent R. Reinhart, former director of the Federal Reserve's monetary affairs division. "The first half wasn't used effectively, so we're certainly going to need the second half. But it probably won't be enough." He said the fact that some of the money will be used for mortgage relief will mean there will be less money "to deal with the banking problem."
House Financial Services Committee Chair Barney Frank, D-Mass., said the problems in the financial sector could mean "we have to do more." "Things have been worse than anticipated, there's no question," he said in an interview Thursday on C-SPAN. He compared the financial system to a patient under emergency care, saying, "You don't say, 'Well, that didn't work, I'm cutting it off.'" But more government intervention into the banking sector would likely upset Republican lawmakers and could further unnerve investors worried about the health of major banks. "If the government has to step in, it may very well mean the government will have to take precedence over other shareholders," effectively wiping them out, Reinhart said.
Investors are also wary about what Bank of America would have to give up in return for more bailout money. One possibility: The government could require the bank to slash its quarterly dividend paid to investors, analysts said. A similar restriction was imposed on Citigroup as a condition of its rescue. "The market is very troubled by that," said Edward Yardeni, an independent banking analyst. "Banks don't really have any value to shareholders if they can't pay dividends. It's not a growth industry." The dour sentiments followed a troubling fourth-quarter earnings report from JPMorgan. It reported earnings of $702 million in the October-December quarter; analysts had expected it would break even. Nonetheless, JPMorgan Chief Executive Jamie Dimon called the quarter "very disappointing" and said the bank could suffer more losses from bad loans if the economy worsens.
During a call with journalists, Dimon said the crisis in the financial industry has "gone way beyond normal." "Everyone is struggling with this extreme environment we have ... We don't know exactly the outcome," he said. Investors were closely watching JPMorgan's performance for clues on how other banks are weathering the crisis. At Citigroup, analysts are bracing for dismal fourth-quarter earnings numbers due Friday. Analysts polled by Thomson Reuters, on average, predict a per-share loss of $1.19 for the fourth quarter -- which would be Citigroup's deepest deficit yet. The bank has posted net losses for four consecutive quarters. The New York-based bank has laid off thousands of employees and jettisoned several businesses to raise badly needed cash, including its prized retail brokerage, Smith Barney. Wagner reported from Washington. AP Economics Writer Jeannine Aversa in Washington and business writers Madlen Read in New York and Ieva M. Augstums in Charlotte, N.C., contributed to this report.
Congress OKs release of final $350B of bailout
Congress laid the foundation for President-elect Barack Obama's economic recovery plan on Thursday with remarkable speed, clearing the way for a new infusion of bailout cash for the financial industry while majority Democrats proposed spending increases and tax cuts totaling a whopping $825 billion. Two days after Obama personally lobbied for release of $350 billion in bailout funds, the Senate narrowly turned aside a bid to block the money. Across the Capitol, Speaker Nancy Pelosi, D-Calif. said, "Immediate job creation and then continuing job creation" were the twin goals of the separate stimulus legislation. It recommends tax cuts for businesses and individuals while pouring billions into areas such as health care, education, energy and highway construction.
She and Senate Majority Leader Harry Reid, D-Nev., have pledged to have the economic stimulus bill ready for Obama's signature by mid-February. Both houses debated Obama's call to release another $350 billion from the financial bailout package, but the Senate vote was the triumph he had sought. Despite bipartisan anger over the Bush administration's handling of the program to date, Democratic allies of the incoming president prevailed on a 52-42 roll call. The vote followed a commitment by Obama to use as much as $100 billion of the funds to help homeowners facing foreclosure proceedings. The money will be available in less than two weeks, at a time when there is fresh evidence of shakiness among banks.
The 44th president-to-be was at his transition office across town from the Capitol -- and President Bush relegated to the role of virtual onlooker -- as events played out at the dawn of a new Democratic era in government. Obama has called for swift and bold action to confront an economic debacle unrivaled since the Great Depression. The president-elect, who travels to hardhit Ohio on Friday to promote his economic program, also announced he would convene a "fiscal responsibility summit" in February to focus on long-term problems with the economy and the skyrocketing costs of benefit programs such as Social Security and Medicare. "We've kicked this can down the road and now we are at the end of the road," he said in a Washington Post interview posted on the newspaper's Web site.
In remarks on the Senate floor, Reid called the vote a victory for Obama, whom he said exhibited courage by seeking release of the money. "This was a test of leadership at a time when leadership is desperately needed," he said. Obama said in a statement he was gratified with the result, adding, "I know this wasn't an easy vote because of the frustration so many of us share about how the first half of this plan was implemented." Earlier, he hailed the stimulus blueprint as "a significant downpayment on our most urgent challenges." The outlines of the economic stimulus measure reflected a change in political priorities, with an emphasis on spending and tax breaks designed to encourage production of alternative energy sources, make federal buildings more energy- efficient and weatherize homes.
At the same time, more traditional anti-recession spending was built in. There was more than $130 billion for health care, much of it to help states cope with the rising demand for Medicaid, the health care program for the low-income and a recession-era refuge for the newly laid-off. More than $100 billion was ticketed for education, in part to help local school districts avoid the impact of state budget cuts. Billions more would increase spending for food stamps and unemployment benefits and finance expanded worker retraining programs. A written summary showed $30 billion for highway construction, $10 billion for mass transit and rail, and $3 billion for airport improvements. In all, the outline called for $550 billion in new spending and $275 billion in tax cuts. And the $825 billion total is virtually certain to grow as the legislation advances through Congress.
Initial Republican reaction was negative -- and played on Obama's popularity to make a point. "At first glance, it appears that my Democratic colleagues think they can borrow and spend their way back to prosperity with a half-trillion dollars of new spending and less tax relief than President-elect Obama has been talking about," said Republican Rep. John Boehner of Ohio, the party's leader in the House. Democrats hold expanded majorities in both houses as the result of last fall's elections, and enactment of the stimulus measure is scarcely in doubt. At the same time, lawmakers made clear they will not hesitate to substitute their own priorities for Obama's.
The president-elect's call for a business tax credit for each new job created was jettisoned by Democrats who questioned its value and preferred to use the money elsewhere. They agreed to Obama's separate proposal for a tax cut of $500 per worker and $1,000 per working couple. The documents made public did not say whether the money would come in the form of a one-time check or an adjustment in paycheck withholding. The measure does not include money to help middle- to upper-income taxpayers ensnared in the alternative minimum tax, which was originally designed to prevent the extremely wealthy from avoiding payment of taxes but now threatens more than 20 million tax filers. Several officials said the Senate was likely to include that provision in its version of the bill, a step that could push the overall total close to $900 billion.
Money for the financial bailout was a tougher sell by far. Several newly elected Democrats campaigned as opponents of the program, which was launched last fall with an initial $350 billion, and lawmakers in both parties have expressed unhappiness with the Bush administration's management of the effort. On the vote, 45 Democrats, six Republicans and one independent lined up behind Obama, while 33 Republicans, eight Democrats and one independent sought to block use of the funds. Among them was Sen. John McCain, who campaigned vigorously for creation of the original bailout program as Republican presidential candidate last fall. Obama lobbied Democrats in private earlier in the week not to stand in the way of release of the remaining $350 billion, and a top aide followed up with a written commitment to Reid.
In it, Lawrence H. Summers, pledged that $50 billion to $100 billion would be dedicated to a "sweeping foreclosure mitigation plan for responsible homeowners." In search of Republican support, Summers also said that apart from a commitment to help the Big 3 automakers survive, the new administration did not intend to intervene financially in individual industries outside the financial sector. While the Senate vote assured the money would be available, the House debated a measure to attach conditions on its use. A vote was delayed.
ECB delivers stealth cut in overnight rate to record 1% as slump deepens
The European Central Bank has cut interest rates half a point to 2pc and quietly agreed to let its overnight rate drop to an all-time low of 1pc, adopting a stratetgy of "stealth easing" to shore up Europe’s credit system. Jean-Claude Trichet, the ECB’s president, said the unanimous decision follows a "very significant slowing down of the economy", a belated admission that Europe has already plunged into the worst recession since World War Two. The headline rate is now back to levels last seen after the dotcom bust, but remains well above the levels in the United States, Japan, Switzerland, Sweden, and Britain. Julian Callow from Barclays Capital said the ECB was quietly shoring up the money markets by letting its overnight EONIA rate fall to 1pc from next week. "There is more easing here than meets the eye. This is becoming the ECB’s effective interest rate," he said. A chorus of critics dismissed the cuts as too little, too late. Ben May at Capital Economics said the ECB was still "dragging its heels" and ensuring an "unnecessarily deep and prolonged downturn". It would eventually be forced to cut rates to near zero.
Erik Nielsen, Europe economist for Goldman Sachs, said the ECB had "fallen hopelessly behind the curve" as powerful deflationary forces engulf the eurozone. Both the M3 money supply and private bank lending contracted in November, heralding a severe crunch in coming months. Inflation has been negative for five months and there is a risk that European households will tighten their belts abruptly as unemployment begins to jump in earnest. "The ECB would do well to line up the defences in case of a deflationary attack - and make it explicit that it will fight such a scenario aggressively," he said. The majority of the "shadow ECB" - a committee of private economists and academics from across Europe - voted for a full point cut this week, and many have been scathing in their judgements. "The ECB is still acting as if inflation was the key problem when in reality it is now deflation," said Angel Urbide, chief economist for Tudor Investment. Europe’s industrial data has been dire for weeks. Berlin gave warning yesterday that the German economy may have contracted at annual rate of 8pc in the fourth quarter of last year. While this is not as bad as Japan (-12pc), it is also unprecedented in modern times and matches the pace of damage in 1930. Deutsche Bank fears that the economy could shrink by 4pc this year.
Germany’s BDI industry federation said the economics profession was talking Europe into slump. "Catastrophe scenarios of minus 4pc are not only improbable, but also irresponsible," said the group’s president, Hans-Peter Keitel. Mr Trichet said the bank had already taken radical steps to shore up the credit system. "We have doubled our balance sheet since July 2007. This is extremely substantial," he said. The ECB is loathe to cut the headline rate much lower - although Mr Trichet did not rule it out - fearing that it will run out of ammunition. "The ECB would be very, very, keen to avoid being put in a position which for us would not be appropriate, namely a liquidity trap," using the term to mean zero rates (which is not what Keynes meant by the expression). This marks a clear difference in doctrine from other central bank around the world. Fed chief Ben Bernanke reiterated his view in London this week that policy-makers have a nuclear arsenal available even after rates fall to zero. They can print as much money as they want. ECB officials have made no secret of their aversion to this approach. Board member Lorenzo Bini Smaghi said it may prove extremely hard for central banks to extricate themselves from this trap. There will be a temptation to keep rates low for too long, leading to trouble in the bond markets as inflation revives.
Marek Belka, head of European operations at the International Monetary Fund, said Europe’s leaders should beware of complacency as the crisis overwhelms the banking system and spreads deeper into ex-Communist bloc. "While Europe has very few toxic assets of its own, European banks owned a lot of bad US assets, and were more highly leveraged than American ones. So we can expect more deleveraging in Europe than in the United States," he said. IMF data shows that European banks have 75pc as much exposure to US subprime debt as American banks themselves. On top of this they also have huge exposure - $1.6 trillion by some counts - to Russia, Ukraine, the Balkans, and Central Europe. Deutsche Bank, Dexia, Deutsche Postbank are among the most leveraged lenders in the world. The shock profits warning at Deutsche Bank this week has revived concerns that Europe’s banks have yet to face up to the full damage from the credit crisis. "Losses should be recognized up front and banks should be recapitalized as soon as possible," said Mr Belka. The Fund has already had to rescue Iceland, Hungary, Ukraine, Latvia, Belarus, and Pakistan, and has warned that several more states will need emergency loans. This week it had to shoot down rumours that Ireland might need a rescue. The fire is moving closer to the eurozone itself.
Sovereign default in the eurozone and the breakup of the eurozone: Sloppy Thinking 101
A recent (January 13, 2009) column in the Financial Times by John Authers provides a good example of a logical slip on the banana peel of an alleged link between the external value of the euro, the likelihood of the eurozone breaking up and sovereign default by a eurozone national government. Versions of this fallacy can be found all over the place, even in the writings of those who ought to know better. The relevant passages from Authers' The Short View follow in full:"Greece has always been treated as a peripheral eurozone member, not only in geography. Even before last year's civil unrest, its bonds traded at a significantly higher yield than those of Germany - showing a higher perceived default risk. The market is nervous about other nations on the eurozone's periphery, notably Ireland and Spain, which grew overextended during the credit bubble. A eurozone country defaulting and leaving the euro is close to an unthinkable event. But Friday's news from Standard & Poor's that Greece and Ireland were on review for a possible downgrade, followed yesterday by Spain, left many thinking the unthinkable. The spread of Greek bonds over German bunds is 2.32 percentage points, almost 10 times its level of two years ago. Spanish spreads yesterday rose above 90 for the first time. An Intrade prediction market future puts the odds on a current eurozone member leaving the euro by the end of next year at about 30 per cent. The euro dropped more than 1 per cent against the dollar within minutes of the Spanish news, and is down 9.8 per cent in the last few weeks."
Three issues are being linked in this passage. The emergence of high levels of sovereign default risk premium differentials between different eurozone member states, the external value of the euro and the likelihood of the eurozone breaking up. There is no self-evident link between these three issues. The first is neither necessary nor sufficient for the second or the third. More than that, the threat or reality of sovereign default by a eurozone member state is much more likely to reduce that country's incentive to leave the eurozone than to increase it.
It is obviously true that market perceptions of sovereign default risk in the eurozone (as reflected in CDS rates) are rising across the board and are now very high indeed by historical standards. According to Markit, on 12 January 2009, Germany's 5-year CDS rate was 44 basis points, France's 51 basis points, Italy's 155 basis points and Greece's 221 basis points. The same is true, of course, for the US, with a CDS rate of 55 basis points and and for the UK, with a 103 basis points CDS rate. Sovereign CDS markets may not be particularly good aggregators and measures of default risk perceptions because issuance is patchy and trading is often light, but the numbers make sense.
In addition to the average level of sovereign default risk premia rising across the world, the differentials between the sovereign default risk premia of the various eurozone members have risen. The spreads on the yield on 10 year government bonds over Bunds on January 12 was 88 basis points for Austria and Belgium, 52 basis points for France, 90 basis points for Spain, 105 basis points for Portugal, 135 basis points for Italy, 171 basis points for Ireland and 233 basis points for Greece. These numbers are not directly comparable with the spreads between the CDS rates reported earlier, both because they refer to default risk over different horizons (5 years for the CDS and 10 years for the government bonds) and because the government bonds are traded in liquid, organised markets while CDS are traded over the counter.
Greece and Ireland were put on credit watch (on a negative outlook) last week by the Standard & Poor's, and this week Portugal and Spain followed. The actual downgrade today of the Greek sovereign debt rating by Standard & Poor's from A to A minus, only five days after the country was put on credit watch by the same rating agency, will no doubt increase both the level of the Greek sovereign default risk premium and the spread over Bunds of the Greek sovereign 10-year bond yield. The ECB has adopted the (self-imposed) rule that it will not accept as collateral in repos and at the marginal lending facility (its discount window) sovereign debt rated lower than A minus.
If the ECB/Eurosystem stick to this rule, the next downgrade of Greek sovereign debt could have a major impact on the Greek government's marginal funding costs. The three countries remaining on credit watch - Ireland, Portugal and Spain - are likely to suffer actual downgrades in their credit ratings in the very near future. It is surprising to me that Italy has not even been put on a negative outlook as yet. I expect this will not be long in coming as the eurozone economies continue to deteriorate, increasing government deficits, and rising default risk spreads undo the beneficial effect on sovereign funding costs of declining risk-free interest rates.
It is certainly possible that a eurzone government will default on some of its debt in the near future. It will no doubt be presented as a 'restructuring' of part of the sovereign debt, but the markets and the courts interpreting the covenants associated with CDS for the non-performing sovereign debt instruments will recognise what happens as an event of default. Would a eurozone national government faced either with the looming threat of default or with the reality of a default be incentivised to leave the eurozone? Consider the example of a hypothetical country called Hellas. It could not redenominate its existing stock of euro-denominated obligations in its new currency, let's call it the New Drachma.
That itself would constitute a further act of default. If the New Drachma depreciated sharply against the euro, in both nominal and real terms, following the exit of Hellas from the eurozone, the real value of the government debt-to-GDP ratio would rise. In addition, any new funding through the issuance of New Drachma-denominated sovereign bonds would be subject to an exchange rate risk premium, and these bonds would have to be sold in markets that are less deep and liquid that the market for euro-denominated Hellas debt used to be. So the sovereign eurozone quitter and all who sail in her would be clobbered as regards borrowing costs both on the outstanding stock and on the new flows.
A sharp depreciation of the nominal exchange rate of the New Drachma vis-a-vis the euro would for a short period improve the competitive position of the nation because, with domestic costs and prices sticky in nominal New Drachma terms, a nominal depreciation is also a real depreciation. Nominal rigidities are, however, less important for eurozone economies than for the UK, and much less important than in the US. Real rigidities are what characterises mythical Hellas, as it does real-world Greece, Italy, Spain, Portugal and Ireland. The real benefits from a nominal exchange rate depreciation would be eroded after a year - within two years at most - before you could say cyclical recovery.
The New Drachma would be a little currency in a big global financial market system - not an instrument to be used to gain competitive advantage or to respond efficiently to asymmetric shocks, but a source of extraneous noise, excess volatility and persistent misalignments, rather like sterling. A eurozone member state faced with the prospect of sovereign default, or just having suffered the indignity of sovereign default, would be immensely relieved to be a member of the eurozone. The last thing it would want to do is give up the financial shelter provided by membership in the eurozone to try and emulate Iceland, New Zealand or the UK.
Was the depreciation of the euro that more or less coincided with the sovereign credit warnings and the Greek downgrade (although it started earlier) due to increased concern about the fiscal sustainability of some eurozone member states? Who knows? And what is more: who cares? The eurozone member states no doubt welcome the weakening of the euro, which had become the world's second most overvalued currency, just as UK Ltd welcomed the decline in sterling, which reached more than 25 percent from its previous peak until the recent weakening of the euro. Depending on the fiscal measures taken by the sovereigns of the fiscally challenged nations, and depending on the response, if any, of the ECB to the threat or reality of sovereign default, any response of the euro can be rationalised.
I view the widening of the sovereign risk spreads inside the eurozone as a welcome development. With the revised Stability and Growth Pact effectively emasculated as a fiscal discipline device, it is essential for national fiscal discipline in the euro area, that the market believes (1) that national sovereign debt is indeed just national, not joint and several among all eurozone member states, and (2) that the ECB will not bail out ex-ante or ex-post a eurozone member state that gets itself into fiscal problems. The very low sovereign risk premium differentials in the early years of the eurozone were worrying to me, because it seemed to indicate that the markets believed that a fiscally incontinent government would be bailed out by the other eurozone national governments or by the ECB. The new larger and healthier sovereign risk premium differentials indicate that the markets may be able to provide more fiscal discipline than suggested by the early years of the common currency. That is good news indeed. So we may well see sovereign defaults by EU national governments, both inside and outside the eurozone. But it is more likely in my view that Scotland will leave the sterling monetary union (and the United Kingdom) and adopt the euro as its currency than that an existing eurozone member will leave the eurozone. We shall see.
A New Menace to the Economy: 'Zombie' Debtors
Call them "zombie" companies. Many more has-been companies will be feeding off taxpayers, investors, and workers—sapping the lifeblood of healthier rivals. Zombies. Seen one lately? If not, you may soon, because they are about to menace the U.S. economy. In financial lingo, zombies are debtors that have little hope of recovery but manage to avoid being wiped out thanks to support from their lenders or the government. Zombies suck life out of an economy by consuming tax money, capital, and labor that would be better deployed in growing companies and sectors. Meanwhile, by slashing prices to generate sales, zombie companies can drag healthier rivals into insolvency. Sometime in the past few months, zombies went from being a latent risk to a genuine threat—one that is likely to increase in the months ahead. The Bush Administration has already ladled out billions of dollars in assistance to weak banks and automakers.
As the economy goes into what may become the worst economic downturn since the Great Depression, the Obama Administration will come under even more pressure to prop up sick financial and nonfinancial companies to save jobs. The debate will center on wounded giants such as Citigroup, General Motors, and insurer American International Group. Other sectors with their hands out include steel, airlines, retail—and homeowners, who may be the scariest zombies of all. Hard choices lie ahead, so it's important to have a sturdy framework for making them. The right approach, say those who have studied the matter, is to prop up a company if its core business is healthy but its financing sources have temporarily shut down. Otherwise, let it go. Postponing the decision by supporting sick and healthy alike will only make the eventual pain greater and reduce growth.
"If an institution is poorly managed and does not have a reasonable plan for working out its problems, they ought to go ahead and shoot it," says William M. Isaac, a former Federal Deposit Insurance Corp. chairman who now heads bank consultancy Secura Group. Japan was plagued by zombies during its lost decade of slow growth in the 1990s. Weak Japanese borrowers used the proceeds from new loans to pay interest on old ones—a process called "evergreening" that kept banks from having to acknowledge losses. In the '80s, the U.S. airline industry was pulled down by Eastern Airlines, which was allowed to keep flying (and charging low fares) while in bankruptcy court. That doesn't help anyone. "At some point, you need to wake up and accept the fact that, 'Oops, that's not going to work,' " says Stéphane Téral, an analyst with Infonetics Research who tracked the demise of scads of telecom carriers in the early 2000s.
Protecting zombies can stunt long-term growth by blocking what economist Joseph Schumpeter called "creative destruction"—the painful but necessary reallocation of resources from declining companies and sectors to rising ones. That turns out to be crucial. In the U.S. manufacturing and retail sectors, a huge share of productivity gains have come from such reallocation, says economist Steven J. Davis of the University of Chicago Booth School of Business. Case in point: the growth of hyperefficient Wal-Mart (WMT) at the expense of mom-and-pop shops, which were allowed to die. The absence of such reallocation could slow productivity growth. The problem with the current bailout is that the government may be giving money to companies that don't have a long-term future: zombies. On paper, for example, the Treasury Dept. says it invests Troubled Asset Relief Program (TARP) money only in "healthy banks—banks that are considered viable without government investment" because "they are best positioned to increase the flow of credit in their communities." That's the right idea. In practice, though, the criteria aren't so stringent.
Banks like Citigroup still aren't strong enough to lend. "The bailout model is socialism," says R. Christopher Whalen, senior vice-president for consultancy Institutional Risk Analytics. He advocates selling failed institutions in pieces, as was done to resolve the savings and loan crisis in the late '80s and early '90s. In fact, Washington may be moving toward something like that with Citigroup. When a big employer runs into trouble, it's tempting to keep it going at any cost. Economists call this "lemon socialism"—the investment of public money in the worst companies rather than the best. The impulse is misguided, says Yale University economics professor Eduardo M. Engel. "You don't want to protect the jobs," he says. "What you want to protect is workers' income during the transition from one job to another." There's already a powerful and underused weapon against zombies: bankruptcy law. Bankruptcy courts liquidate the weakest companies while allowing the potentially viable ones to extinguish enough of their debts so they can make money again. Even GM, which is staggering now, could emerge as "a new, revitalized company" if it goes through a cleansing bankruptcy reorganization that changes its obligations to dealers, workers, and retirees, says economics professor Edward W. Hill of Cleveland State University.
Right now, the biggest zombie problem may lie in housing. Millions of homeowners are juggling mortgages they can't afford to pay alongside other debts: credit cards, auto loans, and so forth. In struggling to keep their heads above water, they're slashing consumer spending, which is harming economic growth. Until 2005, bankruptcy filings would have lowered their consumer debts, freeing up more money for mortgages. But a law passed that year has exacerbated the zombie problem by making it much harder to discharge bad debts. Halfhearted modifications of loan terms haven't helped much. According to a new study by Alan M. White, a Valparaiso University School of Law professor, only one-third of modifications of subprime and near-subprime mortgages in November 2008 involved reductions in the monthly payment, often because late fees got tacked onto principal. As a result, he writes, "many modifications are temporary."
That's the zombie condition. Looking ahead, economists are trying to devise ways to make the financial system more resilient and less likely to breed zombies. A group of 16 top financial economists calling itself the Squam Lake Working Group on Financial Regulation is quietly working on a plan it hopes will get the attention of regulators in Washington and other capitals. Kenneth R. French of Dartmouth College, who helped organize the first meeting at New Hampshire's Squam Lake in November, says one goal is to invent a way to shut down or restructure failing institutions with a minimum of collateral damage to other firms and the general economy. Recessions cause great harm, but they can also do some good if they force a needed reallocation of resources toward the most promising sectors. "If we can ride this wave the right way, this is going to be great for the future of the American economy," says Massachusetts Institute of Technology economics professor Daron Acemoglu. Right. Just as long as the zombies don't get in the way.
How to fix finance
With the fires still raging, scorching industry after industry, it might seem premature to ask what should rise from the ashes. But policymakers are understandably keen to start work on redesigning their financial systems. If 2008 was the year when the flaws in the old model became painfully clear, 2009 is likely to be the one when governments embrace re-regulation in an effort to fix it. A weighty report published on Thursday January 15th is sure to play a crucial role in shaping the agenda. The Group of Thirty’s "Financial Reform: A Framework for Financial Stability" is important both because of the concreteness of its 18 recommendations and because of who was involved. The authors were led by Paul Volcker, a former head of the Federal Reserve who, as an economic adviser to Barack Obama, has the president-elect’s ear. Other members of the G30 include Tim Geithner, Mr Obama’s nominee for treasury secretary, Larry Summers, another economic adviser, and Jean-Claude Trichet, president of the European Central Bank. Although they recused themselves from direct participation, they are understood to support the bulk of the findings. "Everyone stands behind the report in spirit. No one disowned it," says an insider.
And muscular stuff it is. Under the proposals, banks that are deemed systemically important would face restrictions—in the form of "strict" capital requirements—on high-risk proprietary activities, that is bets made using their own money. While this would not quite mean a return in America to the separation of commercial banking and investment banking that ended with the repeal of the Glass-Steagall act in 1999, it would strongly encourage the investment-banking arms of universal banks to focus on client businesses, such as merger advice, rather than trading. One reason for separating these functions is that they seem to be "unmanageable in financial conglomerates", says Mr Volcker. The report also calls for raising the level at which banks are considered to be well-capitalised. This should be expressed as a broad range, it says, with the expectation that banks will operate at the upper end when markets are frothy.
The recommendations concerning non-bank financial institutions—the so-called "shadow" banking system that has contributed so much of the pain—are no less radical. One proposal is sure to make the hair stand up on hedge-fund managers' necks: pools of private capital that live on borrowed money should have to register with a regulator and produce regular reports, disclosing things such as leverage and performance. The biggest of them would even be subject to capital and liquidity standards. The report even recommends bank-like regulation for money-market funds that give assurances about maintaining a stable net-asset value, as most presently do. And it calls for legislation in America to set up a mechanism for dealing with non-bank failures, the lack of which has caused no end of regulatory consternation. For banks and non-banks alike, the report calls for a more refined analysis of liquidity in stressed markets and more robust contingency-planning. Central banks should have a stronger role in policing such things, the authors argue, and need to be especially vigilant in good times, when credit is expanding quickly.
They should also be more involved in supervising bank safety and soundness—although, to safeguard central-bank integrity, the role of chief firefighter is best played by others once trouble ignites. Central bankers "need to be more concerned about financial stability, but less involved in crises," says Tommaso Padoa-Schioppa, one of the G30. Of the other areas covered by the report, three are particularly eye-catching. It advocates a formal system of regulation for over-the-counter derivatives, such as the type of credit swaps that sank American International Group, an insurer.
It urges regulators to force banks to hold on to a significant portion of credit risk when they package loans into securities and sell them on, in order to curb reckless underwriting of mortgages and other debt. And it calls for a rethink of certain accounting principles that may exacerbate downturns through pro-cyclicality, including the practice of marking assets to the current market value; "more realistic guidelines" are needed for illiquid instruments and distressed markets. It also wants to see more flexibility in guidelines for loan-loss reserves. Some regulators take a dim view of banks that squirrel away extra reserves in good times, on the grounds that this constitutes earnings manipulation, even though it leaves them better prepared to ride out the bad times.
The other important message is that a global crisis requires a global fix. International co-ordination should go beyond rule-making to closer harmonisation, including enforcement, say the authors, and more needs to be done to curb the uneven application of international rules at national level—although they shed little light on how this could be achieved. It is quite a package. At the press conference to unveil the document Mr Volcker was typically modest, insisting it was more an agenda for discussion than a hard-and-fast blueprint. But, given his closeness to Mr Obama, it is hardly far-fetched to imagine much of it becoming official policy. All that talk of the biggest overhaul of financial regulation since the 1930s just took a step towards reality.
Fed should get out of bank bailout biz: Volcker
The Federal Reserve is risking its independence by helping to bail out the financial industry, an influential group of former bankers led by former Federal Reserve Chairman Paul Volcker said today. Mr. Volcker is now an adviser to President-elect Barack Obama. The recommendation by The Group of Thirty followed a similar one yesterday by The Committee on Capital Market Regulation, which was established with the support of Treasury Secretary Henry Paulson in the fall of 2006 to help reform the regulatory system.
The report today of The Group of Thirty said that central bank liquidity support operations should be limited to forms that do not entail lending against or the outright purchase of high-risk assets, or other forms of long-term direct or indirect capital support. "In principle, those forms of support are more appropriately provided by directly accountable government entities," the Group of Thirty said. "In practice, to the extent the central bank is the only entity with the resources and authority to act quickly to provide this form of systemic support, there should be subsequent approval of an appropriate governmental entity with the consequent risk transfer to that entity."
The Committee on Capital Market Regulation said that the Treasury should take over financial responsibility for rescuing troubled financial institutions to avoid compromising the Fed’s ability to conduct monetary policy and set capital reserve requirements. The committee cited the recent work of Kenneth Kuttner, a professor at Williams College, in warning that the Fed’s lending activities during the financial crisis threaten to make the central bank more dependent on the Treasury for support. Why? Because all the lending jeopardizes the Fed’s ability to finance its own operations.
The committee added that the bank’s efforts could end up "tarnishing its image and financial credibility" in the event that the Fed ends up with minimal or negative capital, and thus make it more subject to political pressures. The recommendation by the committee, which is chaired by Harvard law professor Hal Scott, echoed criticism that Mr. Volcker made in a speech following the Fed’s financing of J.P. Morgan’s acquisition of investment bank Bear Stearns last March. Mr. Volcker, however, seemed more concerned about the influence of banks—not politicians—on the Fed.
A third report on financial regulation was issued on Wednesday by the General Accountability Office offering its own assessment of what should be done to improve financial regulation in light of the financial crisis. The GAO report observed that regulators’ objectives already conflict in some cases and recommended that Congress establish clearer priorities for their efforts. Some critics of financial regulation said the GAO was being too easy on regulators and suggested that Mr. Volcker’s concern was closer to the mark than that of the Committee on Capital Market Regulation.
"The GAO pretends to assume that regulators wanted to fulfill their stated missions of protecting the financial system," Robert Waldmann, a professor at the Center of Economics and International Studies in Rome, wrote today on the financial blog, Angry Bear. "Given that their budgets came from those who wanted to game the financial system and who chose the most compliant regulators," Mr. Waldmann wrote, "there is no reason to imagine this is so."
Filling the Holes in Krugman's Analysis
Although many free-market economists were aghast that Paul Krugman won the Nobel (Memorial) Prize in Economics, I have come to realize that he is every bit as brilliant as that august award indicates. For some time now, Krugman has said we are in "depression economics" mode, where the normal rules of scarcity and tradeoffs don't apply. In this universe, it makes sense to have one group of workers dig holes, and another group fill them back up. Sure, when all is said and done, there is nothing tangible to show for this effort, but at least it "creates jobs." So what I've come to realize is that in these last few months Krugman has implemented his own private-sector stimulus plan.
He has been working furiously, cranking out fallacious articles and blog posts, which then provide work for people like Bill Anderson and me, as well as thousands of other bloggers who still can't understand why it's bad for families to save more. A clever chap, this Dr. Krugman, no? Today my make-work will fill in two holes in a recent Krugman blog post. The first flaw is his belief that output generates employment (rather than vice versa), and the second is his belief that government spending is a measure of real output. In his post, Krugman goes through some "stimulus arithmetic" to see how much spending the incoming Obama administration needs to avert a serious recession:
The starting point for this discussion is Okun's Law, the relationship between changes in real GDP and changes in the unemployment rate. Estimates of the Okun's Law coefficient range from 2 to 3. I'll use 2, which is an optimistic estimate for current purposes: it says that you have to raise real GDP by 2 percent from what it would otherwise have been to reduce the unemployment rate 1 percentage point from what it would otherwise have been. Since GDP is roughly $15 trillion, this means that you have to raise GDP by $300 billion per year to reduce unemployment by 1 percentage point. We already see the problem. Regardless of whatever correlations Okun may have found, it is quite obvious that to increase real output — to crank out more units of goods and services — you must first get more people working to create the products. In other words, higher real GDP is associated with lower unemployment, because more people are working and thus producing more output.
But because Krugman ignores supply and insists on viewing everything through the prism of aggregate demand, he thinks that government spending gives businesses the incentive to hire workers. That is how he manages to reverse cause and effect and think that changes in output ("real GDP") drive changes in unemployment. By making sheer "spending" the primary consideration — rather than focusing on the important economic problem of channeling scarce resources into those lines most desired by consumers — Krugman worries about "multipliers" and how tax cuts aren't nearly as potent in boosting GDP as government spending:
Now, what we're hearing about the Obama plan is that it calls for $775 billion over two years, with $300 billion in tax cuts and the rest in spending. Call that $150 billion per year in tax cuts, $240 billion each year in spending. How much do tax cuts and spending raise GDP? The widely cited estimates of Mark Zandi of Economy.com indicate a multiplier of around 1.5 for spending, with widely varying estimates for tax cuts. Payroll tax cuts, which make up about half the Obama proposal, are pretty good, with a multiplier of 1.29; business tax cuts, which make up the rest, are much less effective.… Let's be generous and assume that the overall multiplier on tax cuts is 1. Then the per-year effect of the plan on GDP is 150 x 1 + 240 x 1.5 = $510 billion. Since it takes $300 billion to reduce the unemployment rate by 1 percentage point, this is shaving 1.7 points off what unemployment would otherwise have been.
I confess that I have not delved into this "multiplier" literature, but I am very skeptical that the models being estimated have adequately dealt with the causality problem mentioned above. In any event, we don't need to rely on sophisticated econometric critiques. Suppose the government borrows an extra $750 billion and spends it on "infrastructure." Assume for the sake of argument that the loss of this money from private capital markets, as well as households' increased savings (because they fear higher future tax burdens), does not totally cancel the increased government spending. In other words, suppose that total "spending" really does go up because of the government's move. Unemployment really does go down.
Even so, does this mean the plan was a success? Hardly. This is because aggregate measures of gross output are bogus when they include government expenditures. Even though purists can (rightfully) point out all sorts of methodological problems, it sort of makes sense to add up how much a family spends on rent, dining out, clothing, and other items, in order to measure the family's total "consumption" over the year. The justification for adding up expenditures to get a gauge of total production is that a household will only spend its limited dollars on things that are more valuable than the dollar bills needed to purchase the items. So if a man spends $10,000 on a car, it sort of makes sense (though not really) to say he is consuming ten times as much as someone who buys a $1,000 computer. Correspondingly, we can justifiably claim that the car manufacturer and computer company together must have produced $11,000 worth of goods.
But what happens when the government spends $10 million on refurbishing an airport? Does that mean the community in question is now that much richer, as if a thousand new cars had appeared from heaven? Of course not. Politicians and bureaucrats don't have the incentive to economize on their spending, to make sure every dollar counts. On the contrary, President-elect Obama has specifically said that state and local governments need to "use it or lose it" when it comes to possible stimulus aid. They are going to throw those billions at anything that moves. In the final analysis, even if a government "stimulus" plan managed to bring down unemployment, it wouldn't represent a true economic recovery. To the extent that the newly hired laborers — such as the construction workers fixing up the airports — seem genuinely richer, it would only be at the expense of taxpayers, whose share of the federal debt had increased.
Although a bit crude, it may clarify things to imagine three groups in the economy:
1. the taxpayers
2. the unemployed
3. the capitalists
What Krugman wants to do is have the capitalists give (say) $750 billion of their wealth right now to the unemployed. The unemployed are definitely fond of this plan. But why would the capitalists do it? It seems as if they're out $750 billion, doesn't it? Ah, the capitalists go along because the government promises that over the coming years, it will force the taxpayers to fork over the equivalent of (say) $800 billion of their wealth to the capitalists. Say what you will about this game, but it has not made all three groups richer. Notice that the capitalists and the unemployed can refuse to go along with the stimulus plan. But the taxpayers have no choice; armed men ultimately throw them in jail if they refuse to play along. In conclusion, Paul Krugman reverses cause and effect in his analysis, and he also fails to note the difference between private and government expenditures. But hey, at least he provided me with an hour's worth of employment.
The failure of financial regulation
The regulation and supervision of the banking system rest on three pillars: disclosure to ensure market discipline, adequate capital and effective supervision. Did the regulatory philosophy governing our financial markets withstand the test of the recent crisis? My conclusion is that all three regulatory pillars failed. First, let’s look at disclosure. Was adequate information available before the crisis erupted? The information on the subprime exposure was out there for anyone who had the determination to collect and analyse the (sometimes patchy) data from quarterly 10Q reports filed with the Securities and Exchange Commission for US banks, supplemented by rating agencies’ and investment banks’ research reports. Using public domain data, I developed a fairly comprehensive picture, as early as October 2007, of the exposure to subprime of the top 20 largest banks in the word, the five biggest investments banks, and all the banks that had an exposure in excess of $10bn. The estimated losses were reasonably consistent with the ensuing subprime losses.
For example, Citigroup disclosed the subprime exposure in Form 10-Q for the third quarter of 2007, submitted to the SEC for the public to read. It lists on-balance sheet subprime and off-balance sheet exposure (in asset-backed commercial paper conduits and structured investment vehicles) of $223.4bn. In this context, it is notable that Citibank’s tier one (equity) capital at the end of the third quarter of 2007 was $92.3bn and the subprime exposure accounted for 242 per cent of tier one capital! Public information already pointed to the need for major write-offs. For example, on December 1, 2007, Moody’s Investors Service downgraded 20 SIVs sponsored by firms including Citigroup and on December 5, 2007 Markit’s ABX-AAA Index fell to 77.22. Therefore, there was considerable evidence that subprime losses would exceed 20 per cent. What are the implications for solvency? A 20 per cent loss on subprime will halve capital, while a decline of 41 per cent will wipe out tier one capital. And note that, so far, this discussion has not mentioned other sources of risk for Citi, such as leveraged buyout loans, commercial real estate and credit card debt.
Similar data were available bank by bank to a larger or lesser extent. Invariably the disclosure in the US was far better and more frequent than in Europe, and there was considerable information regarding the subprime exposure of US-based institutions. Nevertheless, even with the limited disclosure, it was evident that numerous banks, such as HBOS and UBS, were poorly capitalised as a result of the losses. What can we conclude about disclosure based on the information that was publicly available? Several conclusions strongly suggest themselves:
- First, the situation was quite precarious and ample warnings available in the public domain in the autumn of 2007.
- With the resources available to the regulatory agencies, they should have been able to construct the information and react in a timely fashion. Instead, the response was late and haphazard.
- Finally, the fact that the data were publicly available, but not used by investors to value and discipline banks, discredits any shred of trust that markets are efficient.
A second central question to ask is how effective were the regulatory safeguards? Informed analysts knew that Basel I has glaring deficiencies that virtually encourage the creation of off-balance sheet instruments that contributed to the subprime crisis. See for instance "New Bank Capital Requirements Helped to Spread Credit Woes" (David Wessel, The Wall Street Journal, 30 August 2007. I will not go into technical arguments, but assure the unfamiliar reader that the incentives were similar to the landing strip lights at an airport to guide the banks to create Special Purpose Vehicles off balance sheet. Until recently I was not fully aware of the glaring deficiencies of Basel II. In December 2008 I read a compelling book written by Daniel Tarullo, President-elect Barack Obama’s nominee to the board of governors of the Federal Reserve. In Banking on Basel- the Future of International Financial Regulation (Institute of International Economics, October 2008) he points out that: "Thus, there is a strong possibility that the Basel II paradigm might eventually produce the worst of both worlds—a highly complicated and impenetrable process (except perhaps for a handful of people in the banks and regulatory agencies) for calculating capital but one that nonetheless fails to achieve high levels of actual risk sensitivity".
Tarullo notes as well that the Basel Committee itself implicitly acknowledged in spring 2008 that the revised framework would not have been adequate to contain the risks exposed by the subprime crisis. To add to the irony, it appears that the institutions that failed were Basel II compliant. I add to Tarullo’s critique, (without going into the gory technical details) that Basel II is basically a form of regulatory forbearance. Intuitively, while Basel II keeps the minimum capital at 8 per cent, while allowing finer granularity via the use of internal models, and therefore lowers capital requirements. It is reasonable to conclude that 15 years of deliberations by the Basel Committee have yielded a poor outcome and soul searching is warranted. A final question we need to ask is how effective was the supervisory apparatus in this crisis? Based on the discussion in the first section we know that the regulatory authorities in the critical financial centres potentially had information on the subprime exposure (and hence potential losses) on an institution by institution basis. Equally some organisations warned about the potential losses! For instance in January 2008 the International Monetary Fund published its $1tn estimate for the losses. Equally, some investment banks, such as Deutsche Bank and Goldman Sachs, generated bank by bank estimates. It is reasonable therefore to infer that the regulatory agencies would have taken notice of those estimates as early as the autumn of 2007. For a long time the regulatory and supervisory apparatus was silent.
We need to question why didn’t any regulator add up the potential size of the losses on the sub prime exposure, based on publicly available information, and verify them with on-site examinations? Why wasn’t there a far more forceful response from the supervisory agencies? Equally, we should have expected credit rating agencies, investment research and investors to respond more forcefully. In this context, one can only express puzzlement and disappointment at the tepid regulatory reaction. Only after the monumental policy mistake of allowing Lehman Brothers to fail, did the authorities grasp the full significance of the problems and we witnessed a systematic effort to manage and contain the crisis. What is a possible explanation? Martin Wolf’s recent column reminds us of Keynes’ view that there is a safety in collective action, even if it wrong. "A sound banker, alas, is not one who foresees danger and avoids it, but one who, when he is ruined, is ruined in a conventional way along with his fellows, so that no one can really blame him." Arguably Keynes’ words apply to regulators as much as to bankers. The conclusion is disconcerting. The entire safeguards system, consisting of disclosure, regulation and supervision failed. I hope that collectively the international financial community will come up with a better approach to financial regulation.
Banks Reel Anew on Deutsche, HSBC News
More market turmoil as previously secure banking giants run into trouble. Fresh turmoil hit the banking sector as Deutsche Bank issued a profits warning and analysts suggested that HSBC could need a massive injection of fresh capital. Deutsche Bank, Germany's biggest lender, said it would post a net loss of about €3.9bn (£3.5bn) for 2008, compared with net profit of €6.5bn a year earlier—its first annual loss for five decades. The bank suffered a record €4.8bn loss in the fourth quarter as the financial crisis battered its debt and equity trading operations. The news alarmed the market about the prospects for other big banks as Deutsche had been relatively unscathed by the credit crunch.
Josef Ackermann, the chief executive, said he was "very disappointed" by the loss, adding that the bank had "scaled back or exited trading strategies most affected by market turbulence". The bank said its credit trading business and own-account dealing in bonds and shares suffered from "exceptional market conditions". It joins Goldman Sachs, Morgan Stanley and Credit Suisse in reporting fourth-quarter losses after September's bankruptcy of Lehman Brothers shattered confidence in financial markets. Deutsche Bank shares fell 8 per cent, taking this year's fall to 21 per cent. The news hit shares in Royal Bank of Scotland, which fell nearly 15 per cent and was the worst performer in the FTSE 100, closely followed by Barclays. Both UK banks are heavily exposed to the debt markets that helped trigger the shock loss at Deutsche Bank.
Confidence in Barclays was also hit by a second day of massive job losses. Barclays said it would slash 2,000 jobs in its retail and commercial banking operations, following Tuesday's announcement of 2,100 redundancies in its investment banking and wealth management businesses. The shares were also hit by speculation that a boardroom row over valuing toxic assets drove the resignation of the bank's deputy chairman, Nigel Rudd. HSBC shares fell 8 per cent to a near 10-year low of 588.75p after Morgan Stanley analysts said Britain's biggest bank's profit would fall "sharply" this year and would not recover until 2011 at the earliest. They said the bank, which is the only UK lender not to raise fresh capital, could need up to $30bn (£20.6bn) to shore up its reserves against losses.
"Recent recapitalisations by UK and European banks mean the capital premium afforded to HSBC is being diluted. In addition, accounting and capital measurement issues mean that, in our view, HSBC's 7.3 per cent core capital is overstated relative to peers," the analysts said. HSBC was the first bank to warn of rising defaults on sub-prime loans in the US and has written off billions of dollars of those assets. But it was the best-performing UK bank stock last year because of its limited exposure to toxic credit investments, its strong balance sheet and liquidity. Concerns about its capital position have grown as the economy has worsened and others have boosted their buffers. HSBC declined to comment but UBS analysts came to the bank's defence, criticising Morgan Stanley's arguments and predicting about $10bn of capital raising by HSBC from existing shareholders.
Britain's banks were also hit by disappointment over the Government's plans to shore up lending to businesses by providing £20bn of loan guarantees. Traders said the market wanted the Government to come up with a "bad bank" plan that would allow lenders to park their toxic assets and clean up their balance sheets. Adding to jitters was tonight's end to the ban on short-selling financial stocks. The Financial Services Authority insisted it would press ahead, saying: "The FSA will allow the ban on short selling stocks in UK financial sector companies to lapse on Friday. These changes will take effect at 00:00:01 on 16 January 2009, permitting short selling of these stocks on Friday."
New jobless claims rise, economy keeps shrinking
The number of newly laid off workers seeking unemployment benefits rose more than expected last week, the latest sign the economy is shrinking and unlikely to rebound anytime soon. The figures came a day after the government said retail sales dropped sharply in December and the Federal Reserve issued a gloomy economic assessment. Economists said the reports illustrate that the economy remains stuck in a downward cycle: Consumers initially cut back spending in response to the housing and credit crises, slowing the economy and leading companies to lay off workers, which spurs even more caution among consumers.
President-elect Barack Obama's administration hopes a massive stimulus package will jolt the economy back to life. House leaders on Thursday proposed legislation with $825 billion of federal spending and tax cuts. But some analysts think the recovery will stay sluggish, even with the stimulus. "We're not looking for a speedy recovery by any means," said Carl Riccadonna, senior U.S. economist at Deutsche Bank. The Labor Department said Thursday that first-time requests for unemployment insurance jumped to a seasonally adjusted 524,000 last week, above analysts' expectations of 500,000 new claims. The increase is partly due to a flood of requests from newly laid-off people who delayed filing claims over the holidays, a Labor Department analyst said.
Companies from a range of industries announced more job cuts Thursday. MeadWestvaco, which makes paper and plastic products, said it will cut some 2,000 employees, or about 10 percent of its work force, as it accelerates cost savings. Software company Autodesk Inc. said it is cutting 750 jobs, or about 10 percent of its employees, as it prepares to report a fourth-quarter loss. And on Wednesday, Google Inc. said it was closing three engineering offices and cutting 100 recruiters as the recession dampens hiring. Computer equipment maker Seagate Technology also said it will eliminate 2,950 jobs, or 6 percent of its work force. The rise in initial jobless claims came after two weeks of declines that economists said largely reflected the holiday-related distortions in the data. Analysts have said retailers did not hire as many temporary seasonal workers this year, due to the recession, and so there weren't as many subsequent layoffs.
But the jump in last week's numbers, combined with the slew of new layoffs, could signal the resumption of an upward trend in claims that was evident last year. Ian Shepherdson, chief U.S. economist for consulting firm High Frequency Economics, said in a research note that claims could reach 750,000 later this year. "The experience of previous deep recessions suggests claims are nowhere near their peak, and we doubt that peak will be reached before the fall of this year," he said. Other companies that have announced layoffs recently include: pharmaceutical company Pfizer Inc., mobile phone maker Motorola Inc., and industrial conglomerates Textron Inc. and Cummins Inc. The Labor Department last week said the unemployment rate jumped to 7.2 percent in December, a 16-year high. Employers cut a net total of 524,000 jobs last month, bringing last year's total to a staggering 2.6 million.
The financial markets fluctuated Thursday, falling sharply in early trading but recovering in the afternoon. The Dow Jones industrial average inched up more than 12 points, while other indices also rose slightly. Robert Dye, senior economist at PNC Financial Services Group in Pittsburgh, said a large stimulus package and lower gas prices could put more dollars in consumers' pockets and help jump-start the economy, but not until the second half of this year at the earliest. Dye estimates that the roughly $2 per gallon drop in gas prices since last fall could save consumers roughly $200 billion this year. Mortgage rates, meanwhile, have dropped to their lowest levels in decades, lowering payments for homeowners who refinance their mortgages. Still, Riccadonna estimates the economy shrank by 6.5 percent in last year's fourth quarter and will drop by 3.7 percent in the current quarter. The economy won't see healthy growth until 2010, he said.
Separately, the Labor Department said wholesale prices fell by 1.9 percent in December, closing out a year in which prices dropped by the largest amount in seven years. Energy prices last month dropped by 9.3 percent, reflecting a record 25.7 percent plunge in the cost of gasoline. Economists were concerned last fall that price declines could become so pronounced that the country could face a debilitating bout of falling prices, or deflation, something not experienced in the U.S. since the Great Depression. But most believe that threat is still remote. They have confidence that the Federal Reserve, which last month cut a key interest rate to nearly zero, has the tools needed to keep deflation from becoming a problem.
GM cuts outlook; new loans needed?
General Motors Corp. said Thursday that it is developing a more aggressive turnaround plan based on lower expectations for industry sales this year -- an approach that experts said is more realistic but could signal GM will need to ask for more federal money.GM's U.S. sales assumptions for 2009 have been lowered by 1.5 million vehicle sales, to 10.5 million, compared with the predictions the automaker used in its December viability plan to Congress.
The new figures will serve as the basis for GM's restructuring plan as it plots out how it will become viable, something the automaker must show the federal government as part of the terms of the federal loans. "At this juncture, I'm not sure anybody can accurately project what's happening in the auto industry," Fritz Henderson, GM president and chief operating officer, said. "What we've concluded is the most important thing we can do as we develop our plan for liquidity and viability is to develop our plan around conservative estimates." Erich Merkle, a longtime industry analyst in Grand Rapids, noted that GM had sought $18 billion but only got $13.4 billion. "I would be shocked if they didn't have to ... ask for more money," he said.
Auto suppliers could be next to seek federal loans
Advocates for auto suppliers, which are grappling with steep production cuts that have slashed revenue in the first half of the year, are crafting a plan to ask for federal support. The proposal, which could include federal guarantees of bank loans to auto suppliers, comes at a time when loans have run dry for most players in the auto industry. It has been particularly tough for suppliers who use the money they're owed by Detroit automakers as collateral for their loans. In January, as automakers cut production, and in some cases extended traditional holiday plant shutdowns, suppliers have had little money coming in.
"There's a real question of how we are going to be able to have sufficient capital to ramp up next month," said Ann Wilson, senior vice president of government affairs for the Motor & Equipment Manufacturers Association, which counts the Original Equipment Suppliers Association, known as OESA, among its members. In 2008 alone, nearly 40 automotive firms -- mostly suppliers -- filed for bankruptcy protection. In 2007, about a third of suppliers were in financial distress. As industry volumes have plummeted and credit to suppliers has tightened, nearly half of the suppliers are in trouble, said Dave Andrea, OESA's vice president of industry analysis and economics.
"Addressing the financial distress within the supply base," Andrea said, is critical now "that the loan guarantees have been provided to our major customers." One option for the short term could be the use of federal money to backstop bank loans to suppliers, Andrea said. But farther into the future, suppliers likely will need aid -- either through direct loans or through loan guarantees -- to pay for new programs. In the long term, as bankruptcy financing has dried up, suppliers likely will need federal help to pay for Chapter 11 restructurings, Andrea said.
UK treasury plans 'bad bank' to buy toxic assets
A state owned "bad bank" to buy up tens of billions of pounds of toxic assets from high-street banks with taxpayers' money could be set up, under plans being drawn up by the Treasury. Gordon Brown is preparing a new multi-billion pound rescue package for the banks which is expected to be announced next week. In his strongest hint yet that a "bad bank" is a serious option, the Prime Minister said that "action" on toxic debts, which are blamed for the failure of high-street banks to resume normal lending, is now essential. Ministers will spend this weekend locked in talks with senior bank executives, who are thought to be resistant to the "bad bank" proposal.
However, Mr Brown has been warned by City experts that the scheme may have to be quickly introduced to prevent the economic and financial crisis worsening. Amid scenes not seen since before the last banking bailout in the autumn Bank shares fell sharply yesterday amid growing fears over the levels of bad debts. The controversial "bad bank" scheme, which would involve taxpayers having to take on billions of pounds in risky assets, is increasingly seen as critical if banks are to begin lending again. Banks may receive billions of pounds in taxpayers' money and the Government may take further stakes - or the right to purchase shares - as part of the package. The Bank of England is also expected to offer tens of billions in credit to banks to fund new loans for homeowners and businesses. The plans could be introduced internationally in co-ordination with the new American administration and European governments. On Thursday, bank shares around the world dropped sharply.
Barclays fell in value by 8 per cent, Lloyds was down 11 per cent and RBS by 4 per cent following reductions earlier in the week. In America, shares in Citigroup, the world's largest bank, and Bank of America fell by more than 20 per cent at one point as speculation mounted that they would be seeking further Government assistance. Speaking in Berlin after meeting Angela Merkel, the German Chancellor, Mr Brown indicated for the first time that the Government was planning to act over toxic bank debts. "We must secure the widest possible transparency and the necessary renewal of trust in the banking system," he said. "That is an essential element of rebuilding the global financial system. It will also require us to take action on impaired assets in the banking system. It will mean that we will have to have new standards of surveillance and supervision for global financial institutions."
A Government source added: "Ministers are astounded by the scale of the losses that the banks have to write off. It isn't yet clear to the public quite how irresponsible some of the decisions made by bankers have been. The details are still sketchy." The toxic bank scheme is set to be the latest audacious attempt by the Government to tackle the global credit crisis. Two banks have already been nationalised, and a further three banks have sold stakes to the Government worth £37 billion. The Bank of England has also offered high-street banks tens of billions of pounds in Government loans. However, although the previous bailouts may have prevented high-street banks from collapsing they have failed to pave the way for banks to begin lending normally again. Homebuyers and businesses have complained they are unable to obtain credit.
Banks argue that because of the extensive bad debts on their balance sheets they are effectively unable to take on more debts and resume normal lending. Therefore, until their balance sheets have been "cleaned" and the toxic assets removed the credit crisis is likely to continue. The issue is thought to have become urgent over the past few weeks as banks are currently preparing to announce their financial results for 2008. The scale of bad debts at some banks may be so high that it is difficult for the financial result statements to be signed off by accountants. Specialist auditors are understood to be currently analysing the balance sheets of RBS, HBOS and Barclays to calculate the value of their toxic assets. The assets are mostly complicated financial instruments which are linked to sub-prime mortgages and commercial debts.
However, they are notoriously complicated and opaque - and are therefore difficult to value. Banks are likely to receive a small fraction of the assets' original value from the Government. A senior Government source said: "We are looking at the unprecedented nature of the losses on the balance sheet. In short we do not know what they are worth. "All the assets on the balance sheet have got to be valued to the best of our ability. Auditors have been brought in to work this out." The scheme could cost the Government tens of billions of pounds - which could be financed by the issuing of new bonds or gilts. However, much of the money may be retrieved if the assets can eventually be sold on or the debts are repaid. The Government may also take further stakes in the banks and therefore profit if bank share prices rise . It is hoped the "bad bank" will expose the taxpayer to less of a risk than full-scale nationalisation of other banks which it was feared may also become necessary if the current financial turmoil continues.
Treasury officials are understood to have been studying a "bad bank" scheme introduced in Sweden in the early 1990s which may provide a blueprint. The Swedish Government set up a series of state-owned financial vehicles that bought bad banking debts. The equivalent of about four percent of the country's entire economy was spent on buying up the toxic bank debts. Specialists were employed by the Government to run the new bad banks and sell-off or run down the bad debts. After many of the loans were successfully restructured, renegotiated and then sold on again, the Swedish Government lost about half of its original investment, about eight billion dollars. Paul Volcker, the former head of the Federal Reserve appointed by Barack Obama to help advise on the financial crisis, said yesterday that the banking system was still a "mess".
UK jobless rise of 40,000 in a week just 'tip of the iceberg'
The unemployment total has risen by more than 40,000 in little over a week, with experts warning that this is only the "tip of the iceberg". In one of the darkest days for UK employment in recent memory, companies said they planned to cut over 3,400 jobs, including Barclays and Jaguar Land Rover. A further 6,300 jobs are also under threat with companies struggling to stay afloat in the face of an almost unprecedented slump in business activity over Christmas. Households were warned to brace themselves for repeated waves of redundancies lasting all the way until 2011 as the UK sinks into the deepest recession since the Second World War. The number of confirmed job losses in the past 10 days alone has mounted to over 40,000, with a swathe of businesses joining Woolworths in either closing down or slashing back their workforces. News of the latest cuts came as shares in London fell sharply despite the Government's announcement of a £21.3bn package of guarantees for lending to small and mid-tier companies.
Barclays announced it is to cut a further 2,100 jobs – on top of the 2,130 it announced on Tuesday – with the latest round of redundanciess coming from its retail and commercial banking branch. The bank is one of the few UK institutions to have avoided so far having to call on the Government for emergency cash injections but has acknowledged that its balance sheet has been compromised by the financial crisis. Elsewhere, Jaguar Land Rover, the troubled car maker, is cutting 450 jobs as it and other manufacturers see their sales slide. The company, which has been appealing for government support following steep falls in new car sales, said it had axed staff to "help address the immediate challenges posed by the credit crunch". Chief executive David Smith said it was "critical" that the company "becomes a more efficient and dynamic organisation".
Administrators for music, DVD and games retailer Zavvi closed 18 of its branches, resulting in 353 job losses, while pharmaceuticals group Pfizer said it will cut up to 240 UK jobs and manufacturing group Fenner cut 290 positions. Freemans Grattan, the home shopping company, owned by the German mail order company Otto Group said it would undertake a restructuring that would lead to significant job losses among its 3,800 staff. A spokesman said the job losses will run into "four figures". Denby Pottery said its 700-strong workforce could be at risk, while telecoms equipment group Nortel filed for bankruptcy protection, which could affect 2,000 UK staff. A number of economists now expect unemployment to mount tolevels seen in the early 1990s. Capital Economics predicts that the number of people out of work will rise to 3.5m – some 11pc of the workforce. John Philpott, Chartered Institute of Personnel and Development chief economist, said: "You can't necessarily judge the full picture from the redundancies that we're seeing. "A lot of jobs will also be lost by simply not re-hiring staff when they leave. The redundancies are just the tip of the iceberg."
UK distressed business numbers up by nearly 300%
Ailing companies more than trebled in number last year according to business rescue specialist Begbies Traynor, which warned 2009 would be "grim" for the financial health of corporate Britain. The firm's Red Flag Alert survey found a 245pc leap in the volume of businesses with "critical problems" in 2008 compared with 2007. 5,651 businesses in this category face a high risk of insolvency. It also revealed the number of companies showing early signs of financial stress averaged a staggering 65,728 per month in the final quarter of 2008.
These businesses usually have overdue or insolvent accounts, or have a county court judgement or other court action against them. Advertising, construction and transport were the worst hit sectors last year with retail and automotive also seeing a huge up tick in problems. Nick Hood, a partner at Begbies Traynor, said the rapid increase in distressed companies was worse than ever before. "The twin evils pulling businesses under are the speed and velocity at which things are deteriorating and the volatility in the commercial markets. "In an average year there are about 12,000 insolvencies. With the worse example being 1992 when 30,000 went under. At this rate there will be more than 36,000 companies facing administration this year, and that number will probably get even worse. It is going to be a very grim 2009," he said.
Two-month shutdown for Honda UK
Honda has announced that it plans to stop production at its plant in Swindon for the months of April and May, because of a collapse in global sales. The carmaker, Japan's second-largest, announced in November that the plant would shut during February and March. Honda said that there were no plans for redundancies and that it intended to "safeguard employment" for those workers who wanted to stay. Earlier on Friday, Honda said that it would cut jobs and production in Japan. "The European car market is not showing any signs of recovery yet and, therefore, we have to reduce our production output further," said David Hodgetts, director of Honda UK Manufacturing.
"We will continue to take prompt and flexible counter-measures to ensure that we can meet these challenges with this severe market situation," he added. The halt in production amounts to 35 working days. Honda employs 4,200 people in the UK and exports the Civic to 60 countries worldwide. Honda announced earlier on Friday that it would cut 3,100 temporary jobs in Japan and reduce domestic production by 56,000 vehicles, to combat a dramatic slump in global car sales. Rivals Toyota and Nissan have also announced production cuts this week. EU business ministers are meeting in Brussels on Friday to discuss ways to help carmakers through the economic downturn.
Anglo Irish Bank Nationalized Following Loan Scandal
Anglo Irish Bank Corp.shares were suspended today after the government seized control in the wake of a scandal that forced the resignations of its chief executive officer and chairman. Irish Finance Minister Brian Lenihan said late yesterday that a proposed 1.5 billion-euro ($1.97 billion) cash injection was no longer "appropriate" and that he was taking the "decisive step of public ownership." Ireland led a surge in European government bond risk after the announcement.
The nationalization adds Anglo Irish to the list of banks now owned and part-owned by European governments in the wake of the financial crisis that dragged the global economy into recession. The U.K. owns Royal Bank of Scotland Group Plc and took over Northern Rock Plc, while Iceland’s government seized control of its three biggest lenders. The German government agreed to take 25 percent of Commerzbank AG as part of an 18.2 billion-euro bailout. "Moving this particular bank into full public ownership is the right, the correct decision, in these circumstances," Prime Minister Brian Cowen said on the Irish radio station RTE. It was made "in the best interests of the economy."
The government’s takeover legislation will provide "fair compensation" for shareholders depending on how an assessor values the company, according to Lenihan. "If the assessor decides the bank is worthless, then compensation will be nil." Anglo Irish shareholders attending an extraordinary general meeting in Dublin today criticized the bank’s management and board of directors, and shouted "Out, out, out!" The meeting was originally scheduled to allow shareholders to vote on the proposed 1.5 billion-euro government package.
Lenihan said there were "no difficulties" at Allied Irish Banks Plc and Bank of Ireland Plc, which are to receive 2 billion euros apiece under the bailout plan. The country’s financial regulator said in October that the six lenders covered by a state guarantee have about 39 billion euros in speculative property loans. "The bad loans in Anglo are not substantially any greater from the bad loans in the other two financial institutions, although of course Anglo Irish Bank has a smaller balance sheet," Lenihan said. "That’s why the existence of bad loans puts Anglo Irish in a far more fragile position."
"There have been very significant structural differences between Bank of Ireland and AIB on one side and Anglo on other," said Kevin McConnell, head of research at Bloxham Stockbrokers in Dublin. "Anglo Irish has always been recognized as most aggressive in commercial property. It was going to be most exposed to commercial property sector downturn." Bank of Ireland fell as much as 19 percent in Dublin and was down 5.8 percent as of 11:40 a.m. Allied Irish fell 16 percent. Anglo Irish shares closed last night at 21.7 euro cents, a 98 percent decline since Jan. 1 last year.
The nationalization comes less than four weeks after the government agreed to the initial bailout which would have given it a 75 percent stake in Anglo Irish. The bank, which was founded in 1964, said in a statement that it will "work fully with the government" and that customer deposits are safe. Credit-default swaps linked to Irish government debt jumped 36 basis points to a record 257 today, according to CMA Datavision prices. A basis point on a contract protecting $10 million of debt from default for five years is equivalent to $1,000 a year.
Credit-default swaps, contracts conceived to protect bondholders against default, pay the buyer face value in exchange for the underlying securities or the cash equivalent should a country or company fail to adhere to its debt agreements. An increase signals deterioration in the perception of credit quality. Already facing mounting losses on property loans, Anglo’s woes increased last month when Chairman Sean Fitzpatrick quit after failing to fully disclose 87 million euros in loans from the bank over an eight-year period. CEO David Drumm left a day later and Finance Director Willie McAteer resigned last week. Lenihan said late yesterday that "unacceptable practices" damaged the company’s reputation.
The loan scandal at the bank also hit Ireland’s financial regulator, whose CEO Patrick Neary retired on the same day that an inquiry showed the agency failed to take "appropriate and timely" action. "The bank is open for business," Lenihan said. "I would expect a board I will appoint to review the business plan and formulate a realistic plan for my approval." Donal O’Connor, who was named chairman after Fitzpatrick’s departure, will stay in the role. The lender has yet to name a new CEO.
Ireland: Things fall apart
Ireland has been unceremoniously shaken out of its New Year hangover. First Waterford Wedgwood, owner of the luxury crystal and china brands, was placed in receivership. Days later Dell, one of the country’s most important foreign investment companies, announced it was closing its Limerick computer factory and relocating to Poland. Then, on Thursday night, the government moved to nationalise Anglo Irish Bank, the country’s third-largest lender. It represents a triple shock for an economy already struggling with rising unemployment and a spiralling budget deficit. After a decade or more in which Ireland outpaced its European Union partners, many commentators are now wondering whether the one-time "Celtic tiger" is destined for a protracted period as one of the continent’s also-rans. The bitter joke doing the rounds in Irish financial circles runs: "What is the difference between Iceland and Ireland? Answer: one letter and about six months."
The crisis that Brian Cowen, prime minister, and his coalition government face is being likened to that of the 1980s, when the national debt quadrupled before economic reforms provided the platform for Ireland’s subsequent take-off. "We’re either in 1982, where the diagnosis was made but where there was no political will to take action, or 1987, when the politicians eventually tackled the issues," says Alan Barrett, chief economist at the Economic and Social Research Institute, a leading Dublin think-tank. Recalling the 1980s – a decade when close to one in five were out of work, 10 per cent of the population emigrated and the top rate of tax stood at 70 per cent – has huge resonance for Irish politicians and policymakers. "Decline is not inevitable, but our economic circumstances are serious and challenging," says Don Thornhill, head of Forfás, the government’s economic planning agency.
Once one of Europe’s poorest and most peripheral economies, Ireland by 2006 enjoyed higher per capita income levels than any of the 27 member countries of the European Union with the exception of Luxembourg. Supported by EU budget assistance, low corporate taxes and a labour force boosted by a spike in the working-age population, it became a key European location for US foreign investment. At one point it was claimed that every fifth job created in the EU was in Ireland. The economic story of the 1990s was largely about export growth and convergence, as Ireland’s output per head caught up with the rest of the EU. The growth of the past few years, by contrast, was driven by large-scale construction investment and historically low interest rates. Liam Brewer, managing director of Cargocare, a Dublin-based haulier and vice-president of the Irish Road Haulage Association, says the obsession with property "created a false sense of success in the country".
The housing boom saw government coffers gorged with tax receipts – property taxes as a percentage of total taxes increased from 6.9 per cent in 1998 to 15.7 per cent in 2006. Government spending rose sharply, with a 40 per cent increase in public sector employment since 2000. Consumers, meanwhile, became dangerously indebted: Irish household borrowings now stand at €36,500 ($48,200, £33,100) twice the eurozone average. In 2006, Bertie Ahern, Ireland’s then prime minister, had approvingly observed that the "boom is getting boomier". But by that point a housing correction was overdue. The only surprise was the pace of the adjustment, with housing completions collapsing from 88,000 homes in 2006 to fewer than 30,000 forecast for this year. Forecasters were wrong-footed – not least the government. "The mistake was to interpret what was rare as something permanent," says Philip Lane, professor of macroeconomics at Dublin’s Trinity College university. "Whatever the auctioneers tell you, most of the ‘For Sale’ signs have been up for six or seven months. It’s like a ghost town out in those new housing estates," says John Walsh, who runs a family shoe business in Tralee, County Kerry. "No one knows what the next six months holds."
Liu Qin, who moved to Dublin from Shanghai in 2001 and works with her boyfriend Feng at a Dublin restaurant, is also pessimistic. "I’m going home," she says. "What’s the point in staying? Feng now gets less than €10 in tips. And this is an expensive place to live." Ireland became the first eurozone economy technically in recession in September after two quarters of negative growth. That month, with concerns mounting about the health of the country’s banks, the government ignored the complaints of other EU member states and guaranteed the entire €440bn liabilities of its six domestic financial institutions. As officials assessed the impact of the property slowdown on the public finances, Brian Lenihan, the finance minister, brought forward his budget from December to October only to see pensioners and school teachers take to the streets in protest at his planned spending cuts. In late December, Mr Lenihan returned to the banking crisis, announcing a €5.5bn recapitalisation, including – controversially – €1.5bn for Anglo Irish Bank, which only days earlier had admitted that for eight years it had systematically failed to disclose €87m of personal loans to its chairman by temporarily transferring them to another Irish bank.
The perception of incompetence, coupled with mounting public unease about the impending cuts in public services, had seen the government’s poll ratings slip to an all-time low. Ruairi Quinn, a former finance minister and one-time Labour party leader, said last week that Mr Lenihan "frankly is not up to the task at all." International investors have also given Ireland poor marks. Today only Greece in the 16-member eurozone is considered a worse credit risk and pays more to borrow in international debt markets. Last week, Standard & Poor’s downgraded Ireland’s debt outlook from stable to negative and warned it might cut its sovereign debt rating. Mr Cowen, meanwhile, was this week forced to deny reports that he had warned trade unions the country might have to call in the International Monetary Fund if the economic crisis worsened.
So what has gone wrong? Mary McAleese, the Irish president, says the country has become "consumed by consumerism". She told a US audience last month: "Somewhere along the line, we began to think that we weren’t happy with deferred gratification. We had to have it now and in this moment, and I think we have paid a very, very big price for this radical shift." The general government deficit is now forecast to be 9.5 per cent of gross domestic product in 2009 – and that assumes €2bn in savings from planned reforms. Without these savings, the government calculates the deficit will hit 10.5 per cent this year and remain in the 11 to 12 per cent range through to 2013.
The increased government borrowing needed to finance such deficits could see Ireland’s debt-to-GDP ratio jump from 24.7 per cent in 2007 to more than 80 per cent. Such an increase in public debt would not just entail much higher debt service costs but could damage investor perceptions of Ireland. The government’s policy options are limited. Mr Lenihan said last week there was little scope in the short-term for new taxes. But economists believe tax increases will have to be part of a medium-term fiscal consolidation. In the short term, the main saving is likely to be through cuts in the public pay bill. When the new national wage agreement was announced in September, it envisaged a nine-month public- sector pay freeze in a package worth 6 per cent over 21 months. Enda Kenny, leader of Fine Gael, the conservative opposition party, says the pay freeze should remain in place until 2010 but signalled his party would not support the government on pay cuts except for those earning more than €100,000.
Any move to cut wages is likely to trigger a wave of strikes by public-sector workers. Paddy Power, the bookmakers, this week offered odds on which group would be the first to take industrial action, under the heading: "Strike while the economy’s shot." The related challenge is to see Ireland regain competitiveness. According to the National Competitiveness Council, a think-tank, Ireland suffered a 32 per cent loss of international cost competitiveness between 2000 and 2008, largely as a result of higher wage inflation than its main trading partners and the euro’s appreciation. John Fitzgerald, research professor at the Economic and Social Research Institute, says: "Without further action to deal with the underlying competitiveness problem, Ireland could be left with a legacy of very high unemployment for many years to come." As an economy contracts, allowing a currency to weaken is one way to make the adjustment. But as a member of the eurozone, Ireland does not have that option.
"Where a free floating independent currency does not exist, then economic pain is usually felt through other price mechanisms such as asset prices and wages," says Michael O’Sullivan, head of global asset allocation at Credit Suisse Private Bank in London. With inflation low, economists say wages will have to fall in absolute terms. This will be politically difficult. Ministers have agreed to "surrender" 10 per cent of their salaries, while several private companies have introduced pay cuts and ended bonuses. The government clearly hopes this will influence the public sector unions. But without an agreement, Ireland’s problems could get much worse before they get better. The economic crisis offers one crumb of comfort for Ireland’s centre-right government: it might improve its chances of persuading voters to back the European Union’s Lisbon reform treaty in a second referendum vote later this year. Under pressure from EU partners, Dublin agreed to a second vote in the hope that a Yes would clear the way for long-planned institutional reforms.
Voters decisively rejected Lisbon in the first referendum last June, dealing a blow to the government of Brian Cowen, prime minister, which backed the treaty. While public opinion has since appeared to have shifted slightly, opposition to Lisbon – which critics say will reduce Ireland’s influence and undermine its social ethos and military neutrality – remains considerable. Mr Cowen has repeatedly warned voters that the benefits of EU and eurozone membership could be at risk in the event of a second No vote. "Without being members of that union I would hate to think where we would be. We have seen unfortunately where Iceland were when they had to stand alone," he said last week.
Turkey's central bank slashes interest rates by 2%
Turkey's lira strengthened after the central bank slashed its benchmark interest rate by 200 basis points to 13% on Thursday, saying that the domestic economic slowdown has intensified. The rate cut was much higher than most analysts had expected. The central bank cut rates by 125 basis points in December. After the rate decision Thursday, the Turkish lira rose 1.3% against the euro and added 0.4% against the U.S. dollar. "The latest forecasts suggest that ongoing problems in international credit markets and the global economy will last longer than previously envisaged," the central bank's monetary policy committee said in a statement on Thursday. "Therefore, downward pressures on both domestic and external demand and inflation will continue."
Significant drops in oil and other commodity prices have reduced inflationary pressures, the committee said. As a result, the central bank "has judged that moving forward a sizeable portion of the rate cuts envisaged for the coming months would help offset the tightening in financial conditions." Any future rate cuts will depend on the outlook for inflation, the bank said. Win Thin, senior currency strategist at Brown Brothers Harriman & Co., said that "75 basis points was expected today, but data since the last meeting clearly supported a more aggressive stance as inflation is easing while the economy is slipping into recession."
Gross domestic product growth was only 0.5% in the third quarter, said Thin, who expects a year-on-year contraction in the fourth quarter of 2008 and in the first half of this year. With the euro zone in recession, countries like Turkey that depend on exports are going to suffer, Thin said. "We look for further rate cuts in 2009, on the order of 200 to 300 basis points total at least still to go, but the risk is for more given the aggressive cuts seen so far," he said. The Turkish lira has been weakening recently along with other high-yielding, emerging markets currencies. Thursday's rate cut is unlikely to help the lira, since emerging markets are trading as an asset class, Thin said. "Turkey still has some of the weakest fundamentals in emerging markets, and will undoubtedly be one of the hardest hit if the current pessimism intensifies," he said.
China’s Economy Faces 2009 'Hard Landing,' Fitch Says
China faces an economic "hard landing" and the risk of social unrest with growth slowing to 6 percent or less this year, the weakest pace since 1990, Fitch Ratings said. James McCormack, the Hong Kong-based head of Asian sovereign ratings for Fitch, gave the estimate in a teleconference today. That would be less than half of the 13 percent pace that pushed China past Germany to become the world’s third-biggest economy in 2007, according to revised statistics released this week. As many as 4 million migrant workers lost their jobs last year as factories closed and that figure may jump by another 5 million in 2009, according to Credit Suisse AG.
"The 6 percent number is already what we would call a hard landing in China, meaning rising unemployment and the need for an aggressive policy response," McCormack said. "Social unrest is a big unknown." China’s economy, the biggest contributor to global growth, is running out of steam as exports wane and the property market cools before a 4 trillion yuan ($585 billion) stimulus package kicks in. The slowdown is hurting companies from toy, clothing and electronics makers to airlines and property developers. The key one-year lending rate may fall to about 3 percent from 5.31 percent by the middle of the year and the government may also hasten spending, McCormack said.
Exports may decline 6 percent in 2009 from a year earlier because of the global recession, he said. That compares with a 17.2 percent gain last year and the 2.8 percent drop in December. China faces its biggest "employment adjustment" since reforms of state-owned enterprises in the 1990s, so social stability "is clearly an issue," McCormack said. "There is a question of how easy it is to redeploy millions or tens of millions of unemployed factory workers to infrastructure construction products that may be located elsewhere in the country." Waning exports have led to protests by fired employees, an exodus of 600,000 migrant workers from the manufacturing hub of Guangdong last year, and an urban unemployment rate estimated at more than 9 percent by the Chinese Academy of Social Sciences.
Company sales and profits are falling. China Southern Airlines Co., the nation’s largest carrier, reported a "drastic decrease’" in demand last year and sales slid for China Vanke Co., the largest publicly traded real-estate developer. The CSI 300 Index of stocks fell 64 percent in the past year. The economy grew 9 percent in the third quarter of 2008, the slowest pace in five years, as recessions in the U.S., Europe and Japan reduced the appetite for Chinese goods. The fourth-quarter number is due next week. Central bank Governor Zhou Xiaochuan and Liu Mingkang, the chairman of the China Banking Regulatory Commission, both acknowledged this week that the government risks missing its 8 percent target for creating jobs and maintaining social stability.
Will China lead the world into depression?
Oh no! Albert Edwards at Societe Generale has issued another terror alert: Sell everything. Hide in a bunker with plenty of whisky. The S&P 500 index of US shares is about to crash through its half-century support line to 500. "Technicals say it is time to bail out. Cut equity expose and prepare for rout. US depression looking likely. While China's 2009 implosion could get ugly." Mr Edwards -- who is of an "Austrian" persuasion, ie hates excess debt -- was one of the very few economists to see this whole crisis coming, and to issue warnings clearly and emphatically (unlike others who now claim to have been seers, but in fact hedged).
He said interests rates would be slashed to zero and that bond yields would fall to the lowest in history. All this has occurred. The key argument is that markets have been sold a pup on the China growth miracle and have massively underestimated the risks for the global FX and trading system as this unravels. "The Chinese economy is imploding and this raises the possibility of regime change. To prevent this, the authorities would likely devalue the yuan. A subsequent trade war could see a re-run of the Great Depression.... Do you really trust politicians to "do the right thing"? Mr Edwards has been tactically bullish on equities since the end of October when the MACD (Moving Average Convergence /Divergence Oscillator) for the S&P 500 broke upwards.
This technical indicator broke down again two days ago. He said the CBOE put/call ratio had dropped to the lowest level in a year (a contrary indicator). Don't ask me to explain. I am a technical dolt. While a "deflationary quagmire" lies in store, this will not be a repeat of Japan's Lost Decade. Fed stimulus a l'outrance points to an inflation denouement down the road (2-3 years?)… hopefully not hyper. He notes that China's electric power output has fallen for three months. The OECD's leading indicator for China has fallen off a cliff. Exports have collapsed across Asia. "We continue to emphasize our long-held view that emerging economies are particularly vulnerable to a reversal in the global liquidity pump."
Mr Edwards said investors have a "touching faith" that China's authorities are in control of events. "Could the economic situation in China become so bad that it threatens the regime itself? Of course it could. But before being swept away in a tidal wave of worker unrest it has one key tool in its economic armoury it has used before. MEGA-DEVALUATION. China has a track record of such things. At the end of 1993 the authorities devalued the yuan by 33pc." A replay would be the surest root to a Smoot-Hawley II. "Amid confidence that the ongoing, massive, monetary and fiscal stimulus will prevent a repeat of the Great Depression, will it instead be competitive devaluation and implosion of world trade that we should watch out for." This is not my view. I believe the Chinese leadership will hold the line and behave responsibly, as they did in 1998. I wouldn't want to bet the farm that Albert Edwards is wrong. What do you think? Comments from China especially welcome.
Schwarzenegger Says Deficit has 'Incapacitated' State
Governor Arnold Schwarzenegger said California has been so "incapacitated" by a fiscal crisis that threatens to leave it unable to pay bills within weeks that the only issue he and lawmakers must consider is how to fix it. Schwarzenegger, in his State of the State address, said he is withholding all his policy proposals on issues including health care, education and infrastructure until the financial problems are dealt with. The governor also said he and lawmakers should go without pay for every day they fail to enact a budget past its due date.
The national recession, housing-market collapse and tumbling stock prices have torn a $42 billion hole in the state’s budget, the largest shortfall in its history. Political paralysis over how to fix it has left California out of money and preparing to issue IOUs for only the second time since the Great Depression. Officials say Wall Street’s credit crisis means the governor can’t borrow the billions needed to avoid the cash shortage "I will not give the traditional State of the State address today, because the reality is that our state is incapacitated until we resolve the budget crisis," said Schwarzenegger, a 61-year-old Republican. "The truth is that California is in a state of emergency. Addressing this emergency is the first and greatest thing we must do for the people. The $42 billion deficit is a rock upon our chest and we cannot breathe until we get it off."
The deficit and cash shortage developed rapidly after Schwarzenegger signed the current year’s budget in September. Since then, he’s called lawmakers into three special sessions and twice declared fiscal emergencies. On Jan. 7, he vetoed the only plan that has reached his desk from those special sessions. Schwarzenegger’s fellow Republicans have blocked his proposal to raise taxes, which can’t be done without a two- thirds vote. Democrats, who control both chambers of the Legislature, have balked at deep spending cuts and proposals to ease environmental regulations and labor rules. Last month, Schwarzenegger proposed a mix of spending cuts, tax increases and borrowing, as well as an economic stimulus package, efforts to curb home foreclosures and streamlined government operations.
State finance officials are preparing to withhold payments to thousands of vendors and say they will likely have to issue IOUs to people who are expecting tax refunds. To conserve cash, Schwarzenegger has ordered state offices shut for two days a month and all workers to take two days of unpaid leave each month. The impasse forced a state panel on Dec. 18 to halt funding for $3.8 billion of construction on schools, roads and other public works, a decision officials said might cost tens of thousands of jobs. "So now the bulldozers are silent. The nail guns are still. The cement trucks are parked," Schwarzenegger said. "This disruption has stopped work on levees, schools, roads, everything. It has thrown thousands and thousands of people out of work at a time when our unemployment rate is rising."
California, the biggest borrower in the municipal market, shares with Louisiana the lowest credit ratings among the states because of perennial fiscal shortfalls and legislative gridlock. It is rated A+ by Standard & Poor’s and Fitch Ratings, the fifth-highest grade, and an equivalent A1 at Moody’s Investors Service. The governor has been holed up in marathon meetings with senior lawmakers all week, trying to come to an agreement. He called the talks "serious and good faith negotiations." Nevertheless, Schwarzenegger said lawmakers and governors shouldn’t be paid if they fail to pass a budget on time. While the state’s constitution requires lawmakers to send the governor a budget by June 15 and the governor to sign it by July 1, those deadlines have been met only four times in the last 20 years.
"I mean, if you call a taxi and the taxi doesn’t come, you don’t pay the driver," Schwarzenegger said. "If the people’s work is not getting done, the people’s representatives should not get paid either. That is common sense in the real world." Schwarzenegger, a multimillionaire, has declined his $212,179 a year salary since he was elected. Lawmakers each make at least $116,208 a year plus $162 per day per diem; legislative leaders make more depending upon their position. At least one lawmaker bristled at Schwarzenegger’s suggestion that he and his colleagues forgo pay. "We’re all perplexed as to what the governor has given up as a result of the budget situation the state faces," said Senator Dean Florez, a Fresno Democrat. "It’s really the luxury of the super-wealthy to ask others to give up their pay."
Bonds due in 10 years yield about 53 basis points, or 0.53 percentage point, more than general obligation bonds rated A+, the most since early 2004, according Bloomberg municipal bond yield indexes. California general-obligation bonds maturing in 2038, with a stated interest rate of 5.25 percent, traded at 77 cents on the dollar to yield 7.12 percent on Dec. 26, according to the Municipal Securities Rulemaking Board. As the overall tax-exempt market rebounded this month, they were priced to yield 5.26 percent yesterday.
Gap between WTI and Brent raises questions
The global oil market was thrown into disarray on Thursday as the spread between the world’s most important oil pricing benchmark, Nymex West Texas Intermediate, and other international reference prices, including North Sea Brent, ballooned to record levels. Costanza Jacazio, an oil analyst at Barclays Capital in New York, said the WTI price system was now in disrepute. "WTI has become about as useful as a chocolate oven-glove," said Ms Jacazio. "It has for the moment lost any claim to be a meaningful indicator of broader market conditions."
Nymex February West Texas Intermediate fell $1.88 to $35.40 a barrel after touching a low of $33.70. ICE February Brent, which was due to expire at the close of Thursday’s session fell 39 cents to $44.69 a barrel, while the March Brent contract lost 44 cents to $47.18. Brent crude prices at one point traded at a record premium of $11.56 a barrel over the February WTI contract, with the US benchmark coming under pressure after crude stocks climbed to record levels at Cushing, Oklahoma, the key hub of America’s oil pipeline network. Crude stocks at Cushing, the delivery point for WTI, have reached 33m barrels, the highest level since records started in 2004. Local supply, demand and inventories in Cushing, have a large direct – and, according to many, excessive – impact on WTI prices, often overshadowing global trends.
Mars blend, an important US crude benchmark for the local physical market, surged to a premium of $3 a barrel above WTI, well beyond the traditional discount of $4-$5. Meanwhile, Light Louisiana Sweet, another US grade, traded at a multi-year premium of $9.90. The surge in premiums for Mars and LLS highlighted that weak WTI prices are the result of local factors at Cushing, rather than poor overall demand in the US, traders said. This rare weakness in WTI prices has proved much more severe than a previous episode in early 2007 and is causing hefty losses to long-only, passive inventors in commodities, which use Nymex contracts to gain exposure to energy prices.
It is also hindering some unsophisticated hedging strategies, which also rely on Nymex WTI futures. The price spread between WTI for immediate delivery and forwards contracts also widened to extreme levels, deepening the market condition known as "contango", where future prices are higher than spot prices. The surge in inventories at Cushing also widened "time spreads" – the price difference for immediate delivery and forwards contracts. Nymex February WTI traded $7.30 a barrel below Nymex March WTI. The time-spread between March and April stood at a hefty $4.30 a barrel, triggering warnings from some traders that the WTI market was suffering a "contango bubble".
Bear market intensifies for crude; prices tumble
Oil prices flirted with five-year lows Thursday as unemployment benefit claims rose and OPEC cut demand expectations for 2009. Any belief that energy prices had bottomed out were wiped away early in the day as crude plumbed new depths for the year and more government data suggested the economy may be worsening. "The bull oil era is officially over," said Phil Flynn, an analyst at Alaron Trading Corp. Light, sweet crude for February delivery fell 5 percent, or $1.88, to settle at $35.40 a barrel Thursday on the New York Mercantile Exchange. Prices fell as low as $33.20 Thursday and only gave up steep losses when the Dow Jones industrial average rebounded.
Crude prices have fallen so fast, the cost for retail gasoline has yet to catch up. Pump prices nudged up again overnight. An oil industry report Thursday showed just how much energy use eroded over the past year. For all of 2008, U.S. petroleum deliveries -- a measure of demand -- fell 6 percent to 19.4 million barrels a day, with declines for all major products made from crude, according to the American Petroleum Institute. That trend appears to be ongoing this year, with millions now out of work and bad jobs data continuing to roll in. The Labor Department reported first-time requests for unemployment insurance jumped to a seasonally adjusted 524,000 in the week ending Jan. 10. Analysts had expected 500,000 new claims. An analyst with the Labor Department said the increase is partly due to a flood of requests from newly laid off people who delayed filing claims over the holidays.
"It was very predictable that January was going to be ugly, but I'm not sure if anyone thought it would be this ugly," said Tom Kloza, publisher and chief oil analyst at Oil Price Information Service. Kloza said trucking companies have seen a huge drop in business as orders dry up, just one example of how demand for energy has fallen away. OPEC lowered its energy demand forecast for 2009, with investors already shrugging off production cuts of 4.2 million barrels a day by member countries. The Organization of Petroleum Exporting Countries said in its January report that it expects world demand for crude will fall 180,000 barrels per day in 2009, compared with the previous year. Sustained job losses, bankruptcies and massive government bailouts have drowned out news of OPEC supply cuts that just six months ago would have sent crude prices soaring. "I don't think there's anything they can say at this point," said analyst Stephen Schork, who doesn't expect a sustained rally in oil prices during the first half of this year. "They didn't have control of oil prices when it was on the way up," he said. "They don't have control of it when it's on the way down."
Flynn said oil prices should rise as trading moves to the higher March contract, simply because those supplies do not have to be delivered for more than a month. U.S. oil inventories have been rising for months, an indicator that the recession severely cut into energy demand. The Energy Information Administration said Wednesday that crude inventories grew by 1.2 million barrels for the week ended Friday after jumping 6.7 million barrels the previous week. According to the EIA, gasoline inventories rose by 2.1 million barrels and distillates increased by 6.4 million barrels. On Thursday, the government reported that the draw on natural gas inventories was less than expected, suggesting that the industry is pulling back production sharply and using less energy. Refineries are cutting back production because profit margins are next to nil.
Storage facilities could be flooded with crude as the February contract comes to a close Tuesday, leaving little excess capacity. "We're running out of places to put it," he said. "There's more oil out there now than we've had in a long time." Crude prices jumped in next month's contract by about $8 per barrel, suggesting how little room there is to take delivery. Crude levels at Cushing, Okla., the delivery point for Nymex, are at five-year highs. Even if oil prices rebound, it will likely be short-lived if there is no sign of an economic recovery soon. "We need something showing that people are being active again, that the job losses have stopped," Flynn said. "It's all well and good to give money to the auto industry, but if we don't sell cars, it doesn't help." He expects oil prices to move toward $25 a barrel.
The International Energy Agency, a 28-country group that advises governments on energy security, releases its demand forecast on Friday. Prices at the pump rose overnight from $1.792 to $1.7999 a gallon, according to auto club AAA, the Oil Price Information Service and Wright Express. A gallon of gasoline one year ago cost $3.05. In London, the February Brent crude contract fell 39 cents to settle at $44.69 a barrel on the ICE Futures exchange. In other Nymex trading, gasoline futures rose less than a penny to settle at $1.1742 a gallon. Heating oil rose 2.4 cents to settle at $1.4871 a gallon while natural gas for February delivery fell 12.7 cents to settle at $4.843 per 1,000 cubic feet.
US Mortgage Rates Fall to Record Lows
Rates are at their lowest level in decades, but mortgages remain elusive for most homeowners and hopeful buyers. Mortgage giant Freddie Mac said on Jan. 15 that rates on 30-year fixed-rate mortgages fell below 5% this week — the lowest level since it began surveying lenders in 1971. The average rate on a 30-year fixed-rate mortgage was 4.96%, with a fee equal to 0.7% of the mortgage, for the week ending Jan. 15, 2009. It was down from last week when it averaged 5.01 percent and has been falling for 11 straight weeks. Keith Gumbinger, a vice-president at research firm HSH Associates in Pompton Plains, N.J., said it makes sense to refinance now—if you can qualify.
"We're near 50-year-low interest rates," said Gumbinger, who estimates that rates haven't been this low since 1961. "How much lower do you think they can get?" Interest rates began dropping after the Federal Reserve and the Treasury Dept. announced on Nov. 25 that the government would buy up to $500 billion of mortgage-backed securities backed by Fannie Mae, Freddie Mac, and Ginnie Mae. The lower interest rates have triggered a flurry of refinancing activity as homeowners with good credit and equity in their homes—an unusual combination these days—rush to lock in. The Mortgage Bankers Assn. said on Jan. 14 that for the week ending Jan. 9, its refinancing increased jumped 25.6%, hitting a level not seen since June 2003.
Mortgages for home purchases have also increased, but it could be some time before the lower rates translate into a huge rise in new mortgage applications. The process of buying a home takes time, and winter is typically slow time for the housing market. Homeowners looking to refinance at today's low rates face more challenges than they did during the boom. Television producer Lisa Aliferis and her husband recently refinanced their San Francisco Bay Area home, knocking their annual interest rate down from 5.5% to 4.8%. Even though their credit scores were excellent and they were borrowing just a fraction of what their home is worth, Aliferis and her husband struggled for weeks to nail down a rate that made the refinancing attractive.
Even then they had to pay three-eighths of a percent of the loan in fees and sign the papers in just three days. "It was a chore," Aliferis says. "I don't know what it would be like if we didn't have good credit scores." Dana Johnston, a mortgage broker at Broker One in Los Altos, Calif., says his office is inundated with calls from people looking to refinance, but actually getting them a new loan is difficult. Part of the problem is that their home equity may be less now because home prices have fallen. That may require them to pay higher rates or take out mortgage insurance.
More documentation of income and assets is now required, and banks are no longer counting income from nonrecurring sources such as stock sales, Johnston says. Having a FICO score of at least 680 is now required. Subprime loans are almost nonexistent. In the past, borrowers could decrease their rates steeply by paying higher fees up front. Now, the spread between those fees and the interest rate is much tighter, so there is less incentive to do so. Another big change is that lenders are offering the lowest rates sometimes for just a few hours a day. In the past, lenders would update their loan pricing once a day. Now banks send new rate quotes as many as four times a day. "The problem is funding capacity is so limited, banks may get too many requests and raise rates within an hour," Johnston says.
Expect to pay up to a point if you want a rate below 5%, said David Zugheri, co-founder of Envoy Mortgage in Houston. But refinancing can still be attractive even with a fee. A borrower paying 6.25% can recoup a 1% fee in about a year if he can lock into a new 4.75% rate, he said. "All in all, the really good interest rates come with a cost," Zugheri said. Freddie Mac spokeswoman Eileen Fitzpatrick is in the process of refinancing now. She was able to reduce her rate from 6.6% to 5.1%. Fitzpatrick said she could have gotten a lower rate but was unwilling to pay a point. Mortgage rates are likely to remain flat for the rest of the year, hovering between 5% and 5.25%, according to Freddie Mac projection. "The interest rate was 5.21% in June 2003," Fitzpatrick said. "I never thought it would go below that."
The bottom for investment banking is slipping from view
After Lehman Brothers went bust, it felt like investment banking had hit rock-bottom. The failure of the US firm sent the industry into a tailspin. Losses piled up and the streets of Manhattan and London were strewn with discarded bankers. But the upheaval doesn’t seem to have marked the trough. It now looks as though it was merely a signpost to steeper descent. December is turning out to have been devastating. Would-be survivors already have revealed deeper worries. Deutsche Bank, which had navigated the crisis more deftly than most, lost nearly 5bn euros in the fourth quarter on bad bond and equities trades. Barclays, which had been aiming to maintain flat headcount to grab market share in investment banking, made 2,100 redundant from the division on Tuesday – and another 2,100 the next day from its retail and commercial bank. Bank of America, which rode to the rescue of Merrill Lynch, is reportedly close to receiving billions of dollars more of taxpayers’ funds to help it shore up the stumbling Herd. Even JPMorgan’s investment bank posted sizeable losses.
Most aspects of the business have suffered. Prime brokers will be reeling from the news that a record $150bn – or 10pc of the industry’s assets – was yanked out of the hedge funds they service last month alone. It was the worst December for equity issuance since 2002, according to Thomson Reuters, and November and December were the two worst months for M&A since September 2004. Jamie Dimon, the JPMorgan boss, has even suggested the formerly lucrative businesses of leveraged lending and securitisation will never come back. These could be especially bad omens for Goldman Sachs and Morgan Stanley. The bank holding companies formerly known as investment banks already have suffered losses and slashed jobs. But their quarters began – rather than ended – in December. This means if the emerging snapshot of the markets is accurate, Goldman and Morgan Stanley may have started off in yet another hole. More broadly, the growing pile-up of bad news suggests conditions throughout investment banking could get worse before they get better. Profits will be more elusive than previously thought. Job losses will mount. The bottom once in sight may have slipped from view.
Madoff's fund probably never made a single trade
Bernie Madoff’s investment fund may never have executed a single trade, industry officials say, suggesting detailed statements mailed to investors each month may have been an elaborate mirage in a $50 billion fraud. An industry-run regulator for brokerage firms said on Thursday there was no record of Mr. Madoff’s investment fund placing trades through his brokerage operation. That means Mr. Madoff either placed trades through other brokerage firms, a move industry officials consider unlikely, or he was not executing trades at all.
"Our exams showed no evidence of trading on behalf of the investment advisor, no evidence of any customer statements being generated by the broker-dealer," said Herb Perone, spokesman for the Financial Industry Regulatory Authority. Mr. Madoff’s broker-dealer operation, Bernard L. Madoff Investment Securities, underwent routine examinations by FINRA and its predecessor, the National Association of Securities Dealers, every two years since it opened in 1960, Mr. Perone said. Mr. Madoff, a former chairman of the Nasdaq Stock Market who was a force on Wall Street for nearly 50 years, allegedly confessed to his sons the firm’s investment-advisory business was "basically a giant Ponzi scheme" and "one big lie," according to court documents.
He estimated losses of at least $50 billion from the Ponzi scheme, which uses money from new investors to pay distributions and redemptions to existing investors. Such schemes typically collapse when new funds dry up. Each month, Mr. Madoff sent out elaborate statements of trades conducted by his broker-dealer. Last November, for example, he issued a statement to one investor showing he bought shares of Merck, Microsoft, Exxon Mobil and Amgen, among others. It also showed transactions in Fidelity Investments’ Spartan Fund. But Fidelity, the world’s biggest mutual fund company, has no record of Mr. Madoff or his company making any investments in its funds.
"We are not aware of any investments by Madoff in our funds on behalf of his clients," Fidelity spokeswoman Anne Crowley said in an e-mail to Reuters. Neither Mr. Madoff nor his firm was a client of Fidelity’s Institutional Wealth Services business, their clearing firm National Financial or a financial intermediary client of its institutional services arm, she said. "Consequently, his firm did not work with our intermediary businesses through which firms invest their clients’ money in Fidelity funds," she added. There also appear to be discrepancies between monthly statements sent to investors and the actual prices at which the stocks traded on Wall Street.
For example, his November statement showed he bought software maker Apple’s securities at $100.78 each on November 12, about a month before his arrest. But Apple’s stock on that day never traded above $93.24. The statement also showed he bought chip maker Intel Corp at $14.51 on November 12, but Intel’s highest price on that day was $13.97. "You could print up any statements you want on the computer and send it out to a client and the chances are the client wouldn’t know, because they are getting a statement," said Neil Hackman, president and chief executive of Oak Financial Group, a Stamford, Connecticut-based investment advisory firm.
To some, the numbers did not add up. About 10 years ago, Harry Markopolos, then chief investment officer at Rampart Investment Management in Boston, asked risk management consultant Daniel diBartolomeo to run Madoff’s numbers after Mr. Markopolos tried to emulate Mr. Madoff’s strategy. Mr. DiBartolomeo ran regression analyses and various calculations, but failed to reconcile them. For a decade, Mr. Markopolos raised the issue with the Securities and Exchange Commission, which has come under fire in Congress in recent weeks for failing to act on Mr. Markopolos’s warnings.
Folks Are Flocking to the Library, a Cozy Place to Look for a Job
The financial crisis has caused a lot of withdrawals at the public library. A few years ago, public libraries were being written off as goners. The Internet had made them irrelevant, the argument went. But libraries across the country are reporting jumps in attendance of as much as 65% over the past year, as newly unemployed people flock to branches to fill out résumés and scan ads for job listings. Other recession-weary patrons are turning to libraries for cheap entertainment -- killing time with the free computers, video rentals and, of course, books.
Last Friday, there was a particularly long waiting list of 157 to check out the popular vampire novel "Twilight," by Stephenie Meyer, from a branch of the Stockton-San Joaquin County Library here in Tracy. This central California town has been ravaged by mortgage foreclosures, and area libraries report a surge of traffic. Shamika Miller huddled over a laptop at the Tracy branch. Laid off from her job as a bookkeeper at Home Depot more than a year ago, Ms. Miller, 29 years old, says she has visited the library "if not every day, every other day" since October to check job listings with her computer. "I come here, first of all, because it's a free Wi-Fi spot," says Ms. Miller, who supports a 10-year-old daughter on her unemployment compensation. And, she says, "there's something about the library that helps you think, at least for me."
At the Ferguson Library in Stamford, Conn., "it's not unusual for us to have 40 or 50 reserves on a popular book," says spokeswoman Linda Avellar. At the Randolph County Public Library in Asheboro, N.C., a 25% increase in visitors over the past six months from a year ago has been hard on 14-year-old carpeting that officials say needs to be replaced now rather than in six years, as planned. This isn't the first time library attendance has spiked in a downturn. The 1987 and 2001 recessions saw similar jumps, librarians say. But few people thought that libraries would again be in such favor after so much information flooded the Web. One big draw: Most libraries have put in free computer and Wi-Fi service. And they've begun stocking DVDs and videogames. With the recession weighing on them, "people recognize what a great value the public library is," says Jim Rettig, president of the American Library Association in Chicago.
Librarians are turning into job counselors -- and even social workers -- as they have to deal with a sometimes-desperate new class of patrons. "They are frustrated, overwhelmed and thought they would not be job hunting again in their lives," says Jan Perrier, head of reference and adult services at the Roxbury Public Library in Succasunna, N.J. "I had one woman just so overwhelmed she sat in front of the PC and cried." Many jobless people are reporting to the library as they used to report to the office. Career books are in particularly great demand at the Morris County Library in Whippany, N.J. "The shelves are bare," says Lynne Olver, chief librarian there. She says attendance in "Career Resource Seminars" that the library has held for many years jumped to 745 in 2008, from 472 in 2007. Others come in to escape their troubles for a while. Wesley Martin on Friday tapped his hands to the beat of a hip-hop video he was watching on one of the Tracy library's computers. "This is just a chance for me to get out of my house," said the 33-year-old, who lost his job at a discount store a month ago.
The sheer numbers of jobless visitors are overwhelming some libraries at a time of funding cuts by cash-strapped local agencies. The library in Winter Park, Fla., reports a 25% increase in checkouts of its books and other materials over the past 15 months, even as its budget for stocking new items has been cut 12%. Some libraries are cutting their hours, reducing staff or even being closed altogether because of budget problems. The Schenectady County Public Library in Schenectady, N.Y., says it has had no money to replace four librarians who have left in the past two years. "As a result, we recently found that it is taking up to five days to reshelf books, as just one tiny example of the impact," says Karen Bradley, a reference librarian there. The Randolph County library in North Carolina can't afford to replace those rugs: "We are just going to have to live with the worn carpet for now," says Suzanne Tate, the library's director.
An average of 230 people a day line up to use the library's 27 computers. To help manage the traffic, the library has taken to bumping users off if they try to stay on for more than the one-hour limit. But the patrons keep coming. "Many times a day there is a line of people waiting to get on one of our three computers," says Mary Wright, director of the Marks-Quitman County Library in Marks, Miss., who says many of the new patrons are laid-off workers from nearby casinos. Tracy library officials have ordered nine more Internet-access computers. For now, patrons have to line up at a kiosk to make a reservation to use one of the 11 existing terminals, says Kathleen Buffleben, the supervising librarian.
At a checkout counter nearby in the Tracy library, Brandon Perry, 24, and his fiancée, Chardenac Van Rooter, 21, were applying for library cards Friday to aid in their job searches. The couple, who were with their 1-year-old daughter, said they support themselves largely on part-time restaurant work by Mr. Perry, who was laid off as a heavy-equipment operator at a ski resort a year ago. On top of their other troubles, the couple said they were forced to move into a homeless shelter a few weeks ago after a relative's home where they were staying was foreclosed on. "Now," says Mr. Perry, "we just want to go to Hawaii. We don't have a computer, so we'll start coming here to find a job there."