Neches, Texas. Mexican migrants drinking cold drinks and buying candy at filling station where the truck taking them to their homes in the Rio Grande Valley has stopped. They had been picking cotton in Mississippi
Ilargi: During Treasury Secretary Timothy Geithner's confirmation hearing(s) last week, most of the media attention was focused on his tax evasion, with a side dish of illegal domestic help (by now sort of required for that sort of position). What largely slipped through the critical cracks -or what's left of them- was Geithner's ideas about the toxic assets inside the banks he's tasked with 'saving' now.
In view of the fact that by now there's a general recognition blossoming in the main media (what took you so long?) that all bank bail-outs so far have been utter failures, and that another $2-$4 trillion will be needed and provided for further rescues (which will not nearly be enough either), it might be good to revisit the issue once again. Let's see what Geithner had to say, and compare that with some other ideas.
Here’s what Geithner said before the Senate Finance Committee. When asked how assets should be valued, he outlined three possible alternatives: 1) look at how the market is pricing similar assets, 2) use computer model-based estimates from independent firms, and 3) seek the judgment of bank supervisors. Then he commented: "They all have limitations. I think you need to look at a mix of those types of measures."
As for no 2), we've seen independent institutions, i.e. rating agencies, fail to provide adequate valuations for years. Doesn't look good, does it? As for no 3) bank supervisors (regulators), you got to be kidding. They too have been screaming failures. That leaves us with number 1): the market. But so far everyone has refused to let the market put a value on the assets. And Geithner apparently wants to prolong that situation.
The reason should be obvious: the market's values don't please Wall Street. While the Dutch government volunteered to underwrite an ING portfolio of US mortgage backed securities at 90 cents on the dollar, 'experts' Keefe, Bruyette & Woods claims the value is close to 65 cents, and still others say it's 80 cents. How any of those are even possible with home prices themselves down 40-50% in many areas, you tell me. But that is of course not where the main problem lies: the big kahuna gorilla is that the entire market for MBS is dead, apart from what the US government buys through its affiliates Fannie Mae and Freddie Mac.
Now the ING portfolio was said to consist of some $40 billion of what has essentially become toilet paper. That is a lot of pocket change, but it's overseeable. The picture changes with a recent report (PDF) from the US Office of the Comptroller of the Currency. It says this:
Credit risk is a significant risk in bank derivatives trading activities. The notional amount of a derivative contract is a reference amount from which contractual payments will be derived, but it is generally not an amount at risk. The credit risk in a derivative contract is a function of a number of variables, such as whether counterparties exchange notional principal, the volatility of the underlying market factors (interest rate, currency, commodity, equity or corporate reference entity), the maturity and liquidity of contracts, and the creditworthiness of the counterparties.
Credit risk in derivatives differs from credit risk in loans due to the more uncertain nature of the potential credit exposure. With a funded loan, the amount at risk is the amount advanced to the borrower. The credit risk is unilateral; the bank faces the credit exposure of the borrower. However, in most derivatives transactions, such as swaps (which make up the bulk of bank derivatives contracts), the credit exposure is bilateral. Each party to the contract may (and, if the contract has a long enough tenor, probably will) have a current credit exposure to the other party at various points in time over the contract's life. Moreover, because the credit exposure is a function of movements in market rates, banks do not know, and can only estimate, how much the value of the derivative contract might be at various points of time in the future.
The notional amount of derivatives contracts held by U. S. commercial banks in the third quarter decreased by $6.3 trillion, or 3%, to $175.8 trillion.
These are the OCC's numbers for the big 3 US banks:
Notional Amount Of Derivative Contracts, Top 25 Holding Companies In DerivativesThe total assets of these three banks are $3.9 trillion, which is a somewhat questionable number, since we don't know what the assets -which they largely valued themselves- are. But it's still, as Martin Weiss pointed out, 43 times the amount the banks have thus far received in government assistance. However, even more significant is that JPMorgan's derivatives amount to 400 times its alleged assets. Talk about leverage. Which bookie allows you to bet 400 times what's in your wallet?
September 30, 2008, In $ Millions
- JPMorgan $91,339,207
- Bank Of America $39,979,154
- Citigroup $38,186,196
So is there no-one protesting this? Well, we have the American Society of Appraisers, one of the organizations whose work it is supposed to be to do valuations. The ASA wrote a report on January 20 to Office of the Comptroller of the Currency, Federal Reserve System, Federal Deposit Insurance Corporation, Office of Thrift Supervision and National Credit Union Administration, concerning a new set of guidelines issued by the US government ('2008 Proposed Interagency Appraisal and Evaluation Guidelines"). ASA writes:
“Our organizations have strong objections to what appears to be the dominant feature of the Guidelines – the exemption of more than a dozen categories of real estate related financial transactions from the professional appraisal requirements of Title XI of FIRREA. Although the November 19, 2008, Federal Register request for comment on the Guidelines states that they “are intended to clarify the Agencies’ real estate appraisal regulations and promote a safe and sound real estate collateral valuation program,” we have reluctantly concluded that they do neither.
We believe the approach to valuation issues reflected in the Guidelines is fundamentally flawed; and is inconsistent with the safety and soundness of bank regulatory reforms promised by the incoming Administration. As a consequence, we are unable to support them and respectfully urge that they be withdrawn and reconsidered so that our recommendations and the recommendations of other stakeholders can be carefully studied and significant revisions made to the current draft.1 “
The organization specifies (in key points):
• The Guidelines Fail To Promote Safety and Soundness:
• The Guidelines Obscure Rather Than Clarify Supervisory Expectations:
• The Guidelines Ignore The Current Distress Of The Banking System And The Mortgage Markets; And The Importance of Reliable Valuations To The Government’s Mortgage Relief Programs :
• While We Generally Support Improvements Made By The Guidelines To The Performance Of Appraisals, We Urge The Banking Agencies To Recognize That The Improvements Could Cause Some Regulated Institutions To Rely Increasingly On Valuation Approaches Whose Requirements Are Far Less Rigorous – But Also Far Less Reliable:
• The Wide Latitude Provided Regulated Institutions With Respect To How Collateral Property Should Be Valued, Not Only Jeopardizes Safety and Soundness, It Also Represents A Highly Inefficient And Ineffective Way For The Agencies To Perform Their Regulatory Functions:
• The Guidelines Fail To Address The Responsibilities Of Appraisal Management Companies (AMCs) Relative To The Agencies’ Appraisal Requirements:
I lifted out one category:
Mortgage-Backed Securities: We would characterize appraisal exemption number 13 (“Transactions Involving Underwriting or Dealing in Mortgage-backed Securities”) – an “unlucky number” for U.S. taxpayers. Given the crisis in our nation’s mortgage markets, the dire economic effects of “toxic” mortgage-backed securities and the importance of the value of the properties collateralizing mortgages (whether or not bundled and sold as securities), we urge the Agencies – particularly the Federal Reserve Board – to immediately revisit the public policy basis on which this exemption exists and eliminate it. We can think of no better protection for issuers of and investors in mortgage-backed securities than a requirement for professional appraisals of properties which collateralize the mortgages comprising the securities.
Obama's stimulus plan is not for banks. The next bank bail-out will follow soon. My guess is that it will add up to $2 trillion in public, and $4-5 trillion in reality. When looking at the numbers above, though, as well as the reservations by the real number crunchers, it becomes ever clearer that the risks are huge that any subsequent bank bail-out will go the same way as the multi-trillion dollar ones that have preceded it. Tim Geithner, in his hearing, has made it very clear that he has no intention of coming clean. And while there are lingering questions about the potential losses from derivative positions, we know it'll be between 0% and 100%. Even if, just for the 3 biggest US banks, it would be 1%, that would be a $1.78 trillion loss. However, the more volatile the market becomes, and the more money is lost by these institutions across the board of their activities, the higher the derivative risks and losses will also be. There is in that situation no reason to discount the possibility that 10% or 20% will be lost. At 20%, we'd be looking at 3 times annual US GDP. And then we would have a big smelly whopper of a problem. If and when Geithner and the bankers want to prove that this is not so, they should know what to do. My money is on the notion that they won't, because they know what I know. And that to me gives a whole new "shine" to the term "confirmation hearing".
The mark-to-market valuation will happen sometime down the line. That much is clear. The politicians and bankers want that point to be so far away that it will allow them to do a miraculous Lazarus act on their gambling debts. But Tim Geithner is not Jesus Christ, and neither is Jamie Dimon or Hank Paulson or Ken Lewis. Nor is Barack Obama for that matter. Still, they all feel they're entitled to perform this disastrous passion play at the cost of your trillions, the ones you never knew you had.
And now you really don't. That is what's being confirmed.
New US Bank Bailout Could Cost $2 Trillion
Government officials seeking to revamp the U.S. financial bailout have discussed spending another $1 trillion to $2 trillion to help restore banks to health, according to people familiar with the matter. President Barack Obama's new administration is wrestling with how to stem the continuing loss of confidence in the financial system, as it divides up the remaining $350 billion from the $700 billion Troubled Asset Relief Program launched last fall. The potential size of rescue efforts being discussed suggests the administration may need to ask Congress for more funds. Some of the remaining $350 billion of TARP funds has already been earmarked for other efforts, including aid to auto makers and to homeowners facing foreclosure.
The administration, which could announce its plans within days, hasn't yet made a determination on the final shape of its new proposal, and the exact details could change. Among the issues officials are wrestling with: How to fix damaged financial institutions without ending up owning them. The aim is to encourage banks to begin lending again and investors to put private capital back into financial institutions. The administration is expected to take a series of steps, including relieving banks of bad loans and distressed securities. The so-called "bad bank" that would buy these assets could be seeded with $100 billion to $200 billion from the TARP funds, with the rest of the money -- as much as $1 trillion to $2 trillion -- raised by selling government-backed debt or borrowing from the Federal Reserve.
The administration is also seeking more effective ways to pump money into banks, and is considering buying common shares in the banks. Government purchases so far have been of preferred shares, in an effort to both protect taxpayers and avoid diluting existing shareholders' stakes. A Treasury spokeswoman said that "while lots of options are on the table, there are no final decisions" on what she described as a "comprehensive plan." She added: "The president has made it clear that he'll do whatever it takes to stabilize our financial system so that we can get credit flowing again to families and businesses." Treasury Secretary Timothy Geithner said Wednesday that he wants to avoid nationalizing banks if possible. "We'd like to do our best to preserve that system," Mr. Geithner said.
But given the weakened state of the banking industry, with bank share prices low and their capital needs high, economists say the government probably can't avoid owning at least some banks for a temporary period. Stock-market investors have grown confident that the bailout plan will help the banks without wiping out their investments. Just over a week ago, investors dumped bank stocks, sending shares of some of the most vulnerable down to their lowest levels of the financial crisis. But as fears faded that the banks would be nationalized, financial stocks have rallied, and soared nearly 13% on Wednesday.
In one of the steps under discussion, the government may shift how it injects money into banks, choosing to buy common shares. Bolstering banks' common equity is important because when a bank takes a loss, it has to subtract that amount from the value of its common equity. As losses mount, investors increasingly believe banks need to find ways to bolster this first line of defense on their balance sheets. But buying common shares raises the likelihood that weaker banks will become largely government-owned. Bank share prices are so low that any sizable government investment in a bank would give the U.S. effective control of it.
The best approach is to have banks "under pretty heavy government control as briefly as possible -- basically long enough to take off the bad assets and recapitalize -- and sell the back to full private control as quickly as possible," said Adam Posen, deputy director of the Peterson Institute for International Economics in Washington. Another way being considered for the government to inject money into banks is the purchase of convertible bonds -- in which the government would be paid interest now but have the option to get common equity later. That would give banks a chance to pay back the bonds as they recover, and avoid government control. Some critics of this approach say it would do little to solve the banks' current shortage of common equity.
The government is also likely to create a "bad bank" that would buy distressed assets from firms, helping them to avoid more damaging write-offs. The tricky question is figuring out how much the government should pay for these assets. That issue helped scuttle the Bush administration's plan to buy distressed assets. If the U.S. pays too high a price for the assets, it would essentially be shortchanging taxpayers. But if it pays too little, banks would have to take further losses. Another option under discussion is insuring some of the assets against further losses. That is the route the U.S. has taken in its rescues of Citigroup Inc. and Bank of America Corp. Insuring the assets would limit the amount the banks could lose but wouldn't remove the securities and loans from their books. The government would cover any losses in the assets' value beyond agreed-upon levels.
Charles Calomiris, the Henry Kaufman Professor of Financial Institutions at Columbia University, said that approach is preferable since it leaves the assets in private hands while giving investors confidence to put money into the institution. "You have to eliminate prospective stockholders' concern that there's a bottomless hole at the banks," Mr. Calomiris said. "Getting them off the books solves that problem, but insuring against the downside would have a huge positive effect and might end up costing nothing."
Bank bailout could cost $4 trillion
The cost of the bank bailout is likely to be much higher than $700 billion. While the Obama administration hasn't asked Congress for more money yet, some experts warn that government spending on support for struggling financial services companies will ultimately reach into the trillions of dollars. The first half of the controversial $700 billion program to help banks has already been spent -- mostly on buying up preferred shares of troubled banks. Part of the remaining $350 billion may be used to purchase troubled assets from bank balance sheets and place them in what Federal Deposit Insurance Corp. chief Sheila Bair has dubbed an "aggregator bank."
And while taxpayers will surely recover some of that sum eventually, more money is likely to be needed in order for the bank rescue to work.
"The amount of working capital you'd expect the government to take into this would be around $3 trillion to $4 trillion," said Simon Johnson, a senior fellow at the Peterson Institute for International Economics and author of its Baseline Scenario financial crisis blog. Johnson, who until last year was the chief economist at the International Monetary Fund, said that banks will need more rounds of capital from the government because their cushion against losses is too thin. He also said that there is a need to get rid of some of the toxic assets weighing on financial institutions before they can recover.
With that in mind, he thinks that the net cost to U.S. taxpayers for a broadened bailout would be about $1 trillion to $2 trillion, or between 5% and 10% of U.S. gross domestic product. He said this figure is "in line with the experience" of other nations that have tried massive banking system restructuring. Johnson isn't the first to estimate that the final cost of a bank bailout will be well north of $1 trillion. FBR Capital analyst Paul Miller said in November that just the top eight U.S. financial institutions alone needed at least $1 trillion in new common equity. But calls for a comprehensive response from the government have increased in recent weeks following the free fall of bank stocks.
The KBW Bank index has dropped 35% in January after a 50% plunge in 2008, as investors worry that the government may be forced to nationalize some banks -- and wipe out shareholders in the process. Shares of Citigroup and Bank of America have been particularly hard hit. "The big banks are a hope trade right now," Johnson said. Though the Obama administration hasn't said it will need more money beyond the second $350 billion installment of the Troubled Asset Relief Program, or TARP, officials have not ruled out the possibility of asking Congress for further funds. Vice President Joe Biden said on CBS' "Face the Nation" Sunday that the first task for the likely new Treasury secretary, Timothy Geithner, will be to assess whether the remaining $350 billion in funds available under TARP will be enough to stop the bleeding. Geithner said last week that he didn't yet see the need for more money, but stressed that the Treasury may have to "act flexibly" if the problems in the economy and the financial sector deepen.
While officials will have to spend huge sums upfront to show the market that they won't let important institutions fail, Johnson said taxpayers won't have to end up on the hook for the entire amount of money that's being injected into banks. Johnson said the government could get warrants in banks receiving assistance that would convert to common shares once the government sells them. He also said the government could hire private equity managers to oversee the assets the government takes on -- and sell them when the time is right. These arrangements, he said, should allow the Treasury to extract some gains for taxpayers when the economic free fall ends and the banking system starts to recover.
Some observers believe asset values are so depressed right now that as long as the government has a well designed plan that restores investor confidence, taxpayers should profit from the financial bailout "I think we have seen prices fall to a point where the government could very easily make money, though I'd be very happy if we end up breaking even," says Gary Hager, president of Integrated Wealth Management in Edison , N.J. If the history of previous banking system rescues is any guide though, there's also a good chance that removing toxic assets from bank balance sheets could leave taxpayers with a significant tab. When Congress created the Resolution Trust Corp. in 1989 to clean up the mess left by the collapse of the savings and loan industry, legislators gave the RTC $50 billion to close or resolve troubled institutions.
But the RTC wound up needing three additional infusions of taxpayer funds over six years, as regulators confronted an industry whose health was much worse than feared. In the end, taxpayers took a $124 billion loss on the RTC's operations, according to a 2000 study published by FDIC researchers Timothy Curry and Lynn Shibut. The RTC resolved 747 institutions, with total assets of $394 billion, according to the study. That means taxpayers lost 31 cents on each dollar of assets handled by the RTC -- an institution that, because it was simply disposing of the property of failed institutions, didn't have to pay for assets it later sold. In contrast, the widely discussed aggregator bank would be paying institutions that participate for their assets. Details of how the aggregator bank would decide how much to pay for toxic assets have yet to be determined. But whatever method the aggregator bank uses, it could mean significantly higher startup costs than the RTC had. So expect to see the Obama administration coming back to Congress for more money...soon.
The Bank Bailout Is Broken
Last year, as the U.S. financial system began to unravel, former Treasury Secretary Hank Paulson used to talk about the bazooka in his pocket. It was a metaphor designed to calm investors anxious about the government's willingness to spend massive taxpayer dollars to save the financial system if really needed. But Paulson's weapon jammed. For despite an array of lending programs by the Federal Reserve and the $700 billion Troubled Asset Relief Program (TARP) passed by Congress during his tenure, Wall Street firms and banks still collapsed left and right last fall.
Now the Obama Administration is effectively saying: Forget the bazooka, let's bring out the heavy artillery. The President's economic advisers believe it is time to hit the reset button on existing bailout programs, and think big. There's no choice given the deepening recession that's driving up jobless rates and home and credit-card defaults. All that in turn is contributing to multibillion-dollar quarterly losses at the likes of Citigroup and Bank of America. One big piece of that effort, of course, is the controversial $819 billion package of spending and tax cuts that were approved by the Democratic-controlled House of Representatives on Jan. 28. At the same time, the Fed is ramping up programs to buy securities backed by car, credit-card, and student loans as well as mortgage-backed paper to help thaw the credit markets.
Fixing the banks, Obama advisers argue, will require a more innovative approach than the capital injections into lenders that the Bush team settled on. Fed lending and government cash transfers help, but Bush's advisers backed away from tackling the array of toxic assets that have caused a massive erosion of capital on bank balance sheets and have made extending loans to all but the most creditworthy borrowers unthinkable. "Money is moving throughout the system, but there is increasing recognition that these institutions don't have enough capital to withstand the losses from all the crazy loans they have," says Frederick Cannon, a banking analyst with Keefe, Bruyette & Woods.
New Treasury Secretary Timothy F. Geithner is exploring the creation of a government-funded "bad bank" to buy up mortgage-backed securities and other troubled assets from banks in hopes of boosting their capital levels so they can begin lending again. Daniel Clifton, Washington policy analyst for Strategas Research Partners, says Treasury is considering starting the bank with $100 billion from TARP, then adding leverage from the Fed and the Federal Deposit Insurance Corp. so $1 trillion in funding is available to buy bad assets. Ultimately, he adds, Administration officials believe they could need up to $2 trillion.
Fixing the banks will almost certainly require far more than $700 billion in TARP funds. Goldman Sachs analyst Andrew Tilton figures U.S. financial institutions will suffer more than $1 trillion in loan losses—about half of which have been recognized so far. The problem isn't only with residential mortgages. Add in commercial real estate and other poorly performing loan categories, and the banks may hold some $5 trillion in "troubled assets" on their books, he says. New York University's bearish economics professor, Nouriel Roubini, estimates that additional private and public capital of $1 trillion to $1.4 trillion will be needed to recapitalize the banks.
Another idea being considered by Treasury and White House officials would offer banks federal guarantees that limit their losses on bad assets backed by dud loans, as with Citi and BofA. While this might cost taxpayers as much as buying the banks' assets, guarantees would allow the Administration to avoid the difficult and politically risky step of potentially overpaying for assets now trading at fire-sale prices. In extreme cases, authorities also could put capital directly into the banks in exchange for common equity—pulling off a thinly veiled nationalization of the worst banks. Analysts say a combination of remedies is likely. "They'll need to create a mix of options," says Karen Shaw Petrou of Washington research firm Federal Financial Analytics. Prying more money out of Congress for expanded bank bailouts will be tough. Yet it's hard to see the economy recovering without healthy banks. Getting there won't come cheap.
Thinking the Impossible: Could Bank of America Go to Zero?
Just about all of us recognize Bank of America's familiar red and blue flag logo. Millions of Americans have accounts there. Bank of America, along with Citigroup and JP Morgan Chase, are arguably three largest banks in the US. All have serious problems. The thought of Bank of America's common stock becoming worthless was unthinkable just a few weeks ago. Now, however, the mega-banks are again in big trouble. Most US and European banks have dropped to new lows within the last week or two. Back in September, the month of the Merrill deal, Bank of America common was between 30 and 35. On January 23 of this year it touched 5.2. How could "America's Bank" get in such dire straits?
Under normal conditions, the index committee removes from the index a DJIA component which drops below $10. These aren't normal conditions. So, Bank of America and Citigroup remain on the DJIA. Removing two of the top banks (not to mention General Motors) from the DJIA is politically undesirable at this time. Maybe a reverse split? Acquisitions of Countrywide Financial and Merrill Lynch were, at the time, thought to be advantageous to Bank of America. Toxic assets held by these two companies, as the recession has deepened, are now found to be significantly larger than originally thought. This week we have John Thain, ousted Merrill chief, and Ken Lewis, Bank of America's CEO, trading blame over the possible $50 billion mistake.
Nouriel Roubini (as re-published through John Mauldin) says the US banking system needs $1.4 trillion to recapitalize and in its current state is insolvent:
The US banking system is borderline insolvent in the aggregate and it will take a huge amount of public financial resources and complex and time-consuming work-out of insolvent institutions to restore its financial health and allow it to lend again in ways that support sustained economic growth. The US Dept. of Treasuries OCC's Quarterly Report (see page 23) shows just how deeply the mega-banks are into derivatives. Bank of America has assets of $1.836 trillion and derivatives of $39.979 trillion, (mostly swaps). With the demise of the Shadow Banking System (non bank financial institutions), trading derivatives is much more difficult. If marked to market, one wonders just how much of a loss would be realized in this $39.979 trillion portfolio.
Nobody, who will talk about it anyway, seems to know. It wouldn't take much to wipe out $1.8 trillion in assets. Not surprisingly, there is a major confidence problem. With a continually slumping housing market, commercial real estate problems accelerating, increasing credit card debt defaults and a deep recession that's driving foreclosures to record levels, you can only guess. Investors don't like guessing. There are more reasons why Bank of America could go to zero. If the bank is insolvent, the US government will have to use not only TARP2, but also a TARP3 and a TARP4. Imagine the bickering in Congress. Someone, somewhere, somehow, sometime, has to own up to the toxic assets. Only the US government (taxpayers) can do this (lucky us). With government funding, dilution can wipe out the common stock holders. With politicians calling the shots, you can forget dividends and other "extravagances" such as bonuses, private jets, etc.
The establishment of a "bad bank" to hold toxic assets is now being talked about, and Wall Street hails it as a possible solution. But how do you determine the price to pay for the toxic assets? Face value is a bad deal for tax payers, while mark to market is a bad deal for the banks. Either way, today's common shares may not be worth much, if anything. Eventually, the US government may "nationalize" the mega-banks along with some of the regionals. The Obama administration will have to keep the depositors happy and calm at all costs. They have to do this to avoid major social unrest; everything else is secondary. The toxic assets end up in a bad bank worth who knows what. Then the mega-banks emerge somewhere down the line as recapitalized private entities. The FDIC will keep depositors and some bond holders happy (we hope). Everyone else: good luck and fasten your seat belts.
The Federal Bailout Hasn't Fixed Bank of America
Bank of America's spectacular fall from grace has driven home two key points. First, even lenders that seem relatively safe from the credit storm can find ways to steer right into it, resulting in multibillion-dollar losses and brutal share sell-offs. Second, Washington's $138 billion rescue package of the Charlotte lender, cobbled together on the fly, is failing. As the Obama Administration moves to change strategy to stabilize the banks, it will have to think bigger. The bailout, as it's currently structured, has amounted to little more than a temporary tonic to help BofA digest its controversial acquisition of brokerage giant Merrill Lynch. "It's a Band-Aid," Leslie Rahl, president of consulting firm Capital Market Risk Advisors, says of the government's remedy for ailing banks. "It's a camouflage, as opposed to a real solution."
For all the weekend meetings on Capitol Hill to craft the rescue packages, Washington still hasn't addressed the underlying problem: Billions of dollars of toxic securities and loans languish on banks' balance sheets. "It's like a cancer that you have to cut out," says Frank Partnoy, a law professor at the University of San Diego. The surgery won't be cheap. BofA will need another $80 billion to withstand coming losses and build up a healthy amount of capital, estimates Paul J. Miller Jr., an analyst at research firm FBR Capital Markets. To be sure, no bailout could possibly solve all of the banks' problems, many of them self-inflicted. CEO Kenneth D. Lewis, under fire from angry shareholders, probably wouldn't be in this mess if he hadn't agreed to buy Merrill just after BofA's $4.2 billion purchase of mortgage lender Countrywide Financial and its $21 billion acquisition of banking chain LaSalle Bank.
From the outset there was trepidation among BofA's rank and file about the Merrill purchase, particularly since the deal was forged during the same mid-September weekend that Lehman Brothers was filing for bankruptcy. One BofA derivatives expert, fresh off a 14-hour day, was summoned to a law office at 2 a.m. to inspect Merrill's numbers. In all, BofA had just 24 hours to check the books and make a decision. "It would take much more time than we were given to value [Merrill's illiquid] assets," says a senior BofA employee who works closely with management.
History shows that BofA's diligence was less than what was due. Lewis' advisers inside and outside the company expressed doubts about the Merrill deal, then valued at $50 billion—far more than its $27 billion market value at the time. But Lewis was ultimately swayed by his director of corporate planning and strategy, Gregory L. Curl, the architect of previous transactions. By the time the deal closed, Merrill's market price was less than $20 billion. A BofA spokesman says the due diligence on the Merrill transaction was adequate, noting that losses grew dramatically in December because of "market phenomena."
Now the hastily arranged deal is laying bare a host of problems. Investors are growing impatient: Since October, shares of BofA have fallen by around 70%. And some insiders are losing faith in Lewis and his senior management team. Employees on the trading floor are riffing on Lewis' dictatorial style, referring to the CEO as Kim Jong Il, the North Korean leader. On Jan. 28, BofA's directors issued a statement backing Lewis. So far, the government's solution to the problems at BofA and Merrill has been to throw money at them. The U.S. promised the two banks $25 billion back in October. BofA also raised $10 billion from private investors. In November the Federal Reserve quietly bought about $3.3 billion of collateralized debt obligations from Merrill through an entity called Maiden Lane III.
But BofA and Merrill have been burning through the fresh capital. Despite a combined $18 billion loss in the fourth quarter, they paid out $2 billion in dividends to shareholders. Merrill doled out a reported $4 billion in employee bonuses. And BofA upped its stake in China Construction Bank by $7 billion, to $19 billion, in November—only to cut it two months later, by $2.5 billion. With the banks' capital cushion wearing thin, Lewis turned for more money to the government, which complied in January, giving the bank $20 billion and providing guarantees on $118 billion in assets.
The terms of that deal only exacerbate BofA's woes. Most of the government's cash came in exchange for preferred stock, a special type of equity that requires the bank to pay a hefty dividend to the owners. The Treasury did so to protect taxpayers, figuring the government would get at least some return on their money. The downside is that BofA will have to pay out $5 billion a year to the government, which owns $49 billion worth of the bank's preferred equity. That's cash the bank needs to rebuild its capital base, a critical step before it can even think about boosting its lending. The stopgaps prolong the healing process for BofA and the broader economy.
Likewise, the loan guarantees may forestall the purging of bad assets and further delay a recovery. The government has forced BofA to cover the first $10 billion in losses on its $118 billion loan guarantee of the toxic assets—largely securities backed by corporate loans and commercial mortgages. The hefty deductible discourages the bank from cleansing its portfolio, which would mean taking more writedowns and raising more capital. Why so? It's not unlike an auto insurance policy that has a $1,000 deductible. If there's a car accident and the repair costs total $3,000, the owner must pay the first $1,000. An individual who lacks the money is likely to continue driving the clunker as long as possible.
More important, the guarantees don't cover some $500 billion of problem assets, according to analyst Richard Ramsden of Goldman Sachs. It excludes $92 billion of loans made by Countrywide, one of the largest suppliers of subprime mortgages to borrowers with poor credit. As the recession grinds on, analysts also expect more credit-card debt and business loans, particularly those to retailers, to rot at BofA. With so many dubious assets on the bank's balance sheet, there are growing concerns about whether it is effectively, if not technically, insolvent. At last count, Bank of America's assets exceeded its liabilities by about $210 billion, or roughly 10%. A financial institution is considered insolvent when its assets don't cover its liabilities—and a regulator can take over a bank even before that happens. "We are a very liquid bank," says BofA spokesman Robert Stickler.
But there are questions on both sides of the ledger. A small decline in the price of the company's assets could bust the bank. The liabilities may also be understated: The tally doesn't include BofA's obligations to preferred shareholders, an increasingly large group. Already, Wall Street is questioning whether BofA is actually worth the $210 billion on its books. The stock recently traded at 7.35, which puts the company's value at roughly $47 billion. Time is running out for BofA. Top talent is fleeing, not only legacy bankers from the commercial bank but also top Merrill brokers. Some employees are even volunteering for layoffs, so skeptical are they of the bank's future. Now, critics inside and outside the company wonder if Lewis' days are numbered. Says FBR's Paul Miller: "If there are any other big surprises—another big loss—I think the wall of protection will crumble around Lewis." Regardless of Lewis' future, one thing is certain: The government can no longer afford to take half-measures or move slowly to prop up BofA and other banks. The economic recovery is hanging in the balance.
US 'bad bank' idea heats up, financial shares soar
The Obama administration is increasingly focused on the possible creation of a "bad bank" that would let U.S. financial institutions move toxic assets off their books, an idea that cheered Wall Street and helped drive financial shares higher on Wednesday. Richard Parsons, who spoke with U.S. President Barack Obama earlier Wednesday, said at a conference in New York that Obama is looking at an "aggregator" bank. Parsons said such a bank could potentially take trillions of dollars of assets off banks' balance sheets. Obama is also thinking about how to fix the economy more broadly, Parsons said. The economy faces "a death spiral, and it only gets worse if there's no intervention," he added. Parsons, the incoming chairman of Citigroup Inc, said he was speaking as a private individual, not on behalf of Citigroup or any other entity.
Sheila Bair, chairman of the Federal Deposit Insurance Corp, has floated the idea that her agency should manage such a bad bank, two industry sources told Reuters. Bair contends the FDIC is best positioned to run such a government entity because it has years of experience disposing of the least valuable assets of failed banks, according to one of the sources, who has direct knowledge of Bair's thinking. An FDIC spokesman declined to comment directly, but said the agency continues to provide its "best thinking on potential policy decisions" to the White House and Treasury Department. "Sheila Bair seems to be offering her agency as a logical manager of this plan because it is the FDIC's traditional role and it is their expertise," said John Dearie, executive vice president at the Financial Services Forum, who previously held roles at the New York Federal Reserve. Financial stocks traded higher on optimism that Obama will swiftly act to stabilize the ailing banking sector. The Standard & Poor's index of financial stocks .GSPF rose 13 percent.
"Any sort of credible plan for dealing in a definitive way with these toxic assets is music to the ears of equity investors," Dearie said. Laura Tyson, an economic adviser during Obama's election campaign, fueled speculation Wednesday that creation of a bad bank was near. She said repairing financial markets and revitalizing lending will require governments to remove bad assets from banks and recapitalize them. "The natural next step is, which is real simple, you take the bad assets out, the balance sheets are hit really hard, you recapitalize banks with different rules, and they go out again and lend," Tyson said in a panel discussion at the annual meeting of the World Economic Forum in Davos, Switzerland.
For weeks, top U.S. policymakers have been discussing the idea of a bad bank, also known as an aggregator bank. The Obama administration had hoped to reveal a comprehensive plan by the end of this week to stabilize the financial system, according to industry sources. The timeline is still fluid, they said. U.S. Treasury Secretary Timothy Geithner said Wednesday the administration is "looking at a range of options" to repair the financial system, and decisions could be made public "relatively soon." Geithner said last week the administration was reviewing the option of setting up a bad bank, but that it is "enormously complicated to get right." Nonperforming loans on U.S. banks' balance sheets are seen as a key reason why banks are reluctant to resume lending. The lack of credit has contributed to a year-long recession sparked by the collapse of the housing market.
A series of government efforts to clean up the mess have fallen short, as evidenced by banks such as Citigroup and Bank of America Corp coming back to the government for more money in return for partial public ownership. Goldman Sachs economist Jan Hatzius has estimated total credit losses may exceed $2 trillion globally, and banks have so far recognized less than half that much. A senior International Monetary Fund official said Wednesday that bank balance sheets must be cleansed to revive lending, but it will be hard to put a value on the bad assets. "It is more easier said that done, that's for sure," said Jaime Caruana, head of the IMF's financial and capital markets division. Douglas Elmendorf, the new head of the Congressional Budget Office, said Wednesday that a "bad bank" plan would be fraught with challenges as policymakers try to pay the right price.
"Pricing should give financial institutions an incentive to solve their problems on their own if they are in a position to do so, and should mean shuttering institutions that have little prospect of recovery," he told the Senate Budget Committee. At a Citigroup conference in New York, KeyCorp Chief Executive Henry Meyer said the Cleveland-based regional bank would consider moving some assets to a bad bank as long as the assets were assigned fair rather than "low-ball" values. U.S. lawmakers have yet to see details of how a bad bank option would be carried out, indicating the White House is still formulating its plan and working out the details. At the Financial Services Forum, Dearie said other issues include how a bad bank would be financed, who would run it, and what the ripple effects would be on banking. "The devil is in the details," Dearie said.
U.S. Draft Law Would Ban Most Trading in Credit Swaps
Draft legislation that would change how over-the-counter derivatives are regulated might prohibit most trading in the $29 trillion credit-default swap market. House of Representatives Agriculture Committee Chairman Collin Peterson of Minnesota circulated an updated draft bill yesterday that would ban credit-default swap trading unless investors owned the underlying bonds. The document, distributed by e-mail by the committee staff in Washington, would also force U.S. trading in the $684 trillion over-the-counter derivatives market to be processed by a clearinghouse.
"This would basically kill the single-name CDS market," said Tim Backshall, chief strategist at Credit Derivatives Research LLC in Walnut Creek, California. "Given the small size of many issuers’ bonds outstanding, this would make it practically impossible for the CDS market to exist." U.S. regulators and politicians are stepping up pressure on banks to use clearinghouses and agree to increased oversight of the OTC markets to improve transparency amid the credit crisis. Bad bets on credit-default swaps led to the U.S. takeover of American International Group Inc. in September. As much as 80 percent of the credit-default swap market is traded by investors who don’t own the underlying bonds, according to Eric Dinallo, superintendent of the New York Department of Insurance. Dinallo last year proposed outlawing so-called "naked" credit-default swap trading. He shelved the proposal in November because of progress by federal regulators on broader oversight of the market.
Credit-default swaps are financial instruments based on bonds and loans that are used to speculate on a company’s ability to repay debt. They pay the buyer face value in exchange for the underlying securities or the cash equivalent should a borrower fail to adhere to its debt agreements. Proposals that would impair the credit-default swaps market "are likely to prove counterproductive to efforts to promote lending and return the credit markets to a healthy, functioning state," said Greg Zerzan, the counsel and head of global regulatory policy at the International Swaps and Derivatives Association, which represents participants in the privately negotiated derivatives industry. "This is a bad idea," said Robert Webb, a finance professor at the University of Virginia and a former CME trader. "It is reminiscent of the opposition in the 19th Century to futures trading in the belief that speculators were controlling the market and driving agricultural prices down."
European Union Financial Services Commissioner Charlie McCreevy said today he wouldn’t support a ban on trading credit- default swaps without owning the underlying bonds. Speaking in an interview at the World Economic Forum in Davos, Switzerland, McCreevy also said he favored creating a clearinghouse for OTC derivatives. The proposal "looks more like overregulation than better regulation, which is what the market needs," Aaron Low, a principal and fixed-income strategist at hedge fund Lumen Advisers LLC in Singapore, said in an e-mail. "It will effectively reduce liquidity and price transparency." Forcing interest-rate swaps and credit-default swaps through a clearinghouse, which would establish prices for the privately traded contracts, may reduce how much banks are able to make from them.
As much as 40 percent of profit at Goldman Sachs Group Inc. and Morgan Stanley comes from OTC derivatives trading, according to CreditSights Inc. Estimating the new income that exchanges such as CME Group Inc. could earn from processing the OTC trades is difficult because clearing fees and volumes aren’t known yet, said Bruce Weber, a finance professor at the London Business School. JPMorgan Chase & Co. held $87.7 trillion of derivatives as of Sept. 30, more than twice as much as the next largest holder, Bank of America Corp., which had $38.7 trillion, according to data from the Office of the Comptroller of the Currency.
Of the holdings at New York-based JPMorgan, 96 percent were in the OTC market, compared with 94 percent for Bank of America. The largest positions at JPMorgan and Bank of America, based in Charlotte, North Carolina, were in interest-rate swaps. Banks enter into interest-rate swaps with clients such as cities or hospitals that sold bonds and seek protection against adverse moves in interest rates. They also hedge their exposure to rates in the inter-dealer market. The OCC data only included U.S. commercial banks, so Morgan Stanley and Goldman Sachs Group Inc. weren’t listed at the time. Both New York-based investment banks converted to banks regulated by the Federal Reserve on Sept. 21.
A provision in Peterson’s bill, which will be discussed in hearings next week, allows for the U.S. Commodity Futures Trading Commission to exempt certain OTC contracts that are too customized or don’t trade frequently enough to be cleared. Funded by its members, a clearinghouse adds stability to markets by becoming the buyer to every seller and the seller to every buyer. The standardization necessary to process a contract in a clearinghouse may harm the market and drive the trading overseas, Weber said. "It’s a big deal because the OTC market has developed almost as an alternative to the exchange market with its clearinghouses," he said. "It would be advantageous for places like London, Hong Kong or Singapore where OTC trading wouldn’t have that kind of restriction."
Weber said that if price transparency is what Chairman Peterson wants, it can be achieved in other ways, such as putting OTC derivative prices on a system such as Trace, the bond-price reporting system of the Financial Industry Regulatory Authority. Peterson’s draft bill would also authorize a study by the CFTC to determine if OTC trading influences prices on exchange- traded contracts such as oil. If the commission found such an influence it would be authorized to set limits on the size of positions held by OTC traders.
Fan and Fred's Lunch Tab
It seems a lifetime ago, but it's only been six months since the Congressional Budget Office put a $25 billion price tag on the legislation to bail out Fannie Mae and Freddie Mac. At the time, then CBO Director Peter Orszag told Congress that there was a "probably better than 50%" chance that the government would never have to spend a dime to shore up the two government-sponsored mortgage giants. So much for that. In the past few days Fannie and Freddie have requested a combined $51 billion from the Treasury to compensate for losses in their loan portfolios. This comes on top of the $13.8 billion that Freddie needed in November. The latest requests take the tab to $70 billion or so -- but that's not the end of the story by a long shot. Earlier this month, CBO released its biannual budget outlook. And largely ignored underneath the $1.2 trillion deficit estimate for fiscal 2009 was the little matter of a $238 billion charge for rescuing Fan and Fred.
To put that in perspective, $238 billion is more than the entire federal budget deficit in fiscal 2007. The CBO's $238 billion estimate represents its guess of the long-term cost of paying for the guarantees that Fannie and Freddie write on their mortgage-backed securities. Nor is that just a post-bubble hangover. The last $38 billion of that is for losses on new business this year. And for all anyone knows, that number, like the earlier estimates, is wildly optimistic. For starters, that $238 billion doesn't include $18 billion that the CBO expected the Treasury to lend the wonder twins this year. But in any case we're already well beyond $18 billion on that score: As of this week they've already requested $70 billion since the fiscal year began -- and we still have eight months to go. So you can add $70 billion to the $238 billion, which gets us to $308 billion -- and even that might be conservative. Rajiv Setia, an analyst at Barclays, figures the duo will need $120 billion from Treasury this year alone, which would mean another $50 billion on top of the $70 billion already requested.
Back when the bailout was being debated last July, Senator Jon Tester (D., Mont.) worried that the Fan and Fred bailout could cost $1 trillion. Given that the two companies combined have more than $5 trillion in debt and mortgage backed securities outstanding, Mr. Tester's guess isn't looking worse than anyone else's. At that same time, Senator Kent Conrad (D., N.D.) said that the CBO's $25 billion estimate would be "very helpful to those who want to advance this legislation." And no doubt it was. A spokeswoman for Fannie promoter Barney Frank said then, "we especially like that there is less than a 50% chance that it will be used." The CBO had figured that there was a 5% chance that losses would reach the $100 billion cap on the credit line created by the July law. Now CBO's best guess is more than double that. The bigger picture here is that politicians like Mr. Frank have been telling us for years that Fannie and Freddie's federal subsidy was a free lunch. We are now slowly, and painfully, learning the price of Mr. Frank's famous desire to "roll the dice" with Fan and Fred. Keep that in mind the next time you hear a politician propose a taxpayer guarantee. The only sure thing is that the taxpayers will pay.
U.S. Moves to Bail Out Credit Union Network
In the latest effort to prop up a sector of the finance industry, federal regulators on Wednesday guaranteed $80 billion in uninsured deposits at the powerful institutions that service the nation's credit unions -- a maneuver that shows how the economic crisis continues to ripple across the U.S. Regulators also injected $1 billion of new capital into the largest of these wholesale credit unions, U.S. Central Federal Credit Union of Lenexa, Kan., after the firm on Wednesday posted an unexpected $1.1 billion loss for 2008. U.S. Central serves essentially as a main clearinghouse for the others in the network. The vast majority of regular credit unions -- the bank-like cooperatives familiar to millions of account-holders nationwide -- are considered financially sound. Wednesday's moves affect only these wholesale credit unions, which number 28 and operate in the background to service regular credit unions.
In general, credit unions are considered to be among the most conservatively managed financial institutions. Nevertheless, a few of the wholesale credit unions have been hurt by losses on mortgage investments. As a result, regulators took action to minimize the chances of pain spreading. The National Credit Union Administration, the industry's federal regulator, announced the steps late Wednesday after a special board meeting called at short notice. "We are trying to institute confidence in the system, and we think this will do so," said Michael E. Fryzel, NCUA's chairman, in an interview. Mr. Fryzel also said the agency will hire investment-management firm Pimco to evaluate the investment portfolios of the wholesale credit unions. The goal will be to gauge the depth of the industry's losses on mortgage-backed securities and other investments.
Though smaller than the likes of Citigroup or Bank of America, credit unions reach into virtually every community in the nation. Some 90 million Americans held accounts at credit unions at the end of 2007, according to an industry trade group. Credit unions, some affiliated with individual corporations, trade groups or geographic regions, are common sources for auto loans, mortgages and other products. The little-known network of wholesale, or "corporate," credit unions affected by Wednesday's move provide financing, check-clearing and other tasks for the retail institutions. These wholesale credit unions are owned by their retail credit-union members. Some of the biggest wholesale credit unions have been grappling with substantial paper losses on investments, primarily mortgage-backed securities. As of the end of November, five of the largest such institutions posted unrealized losses on their investments of $11.6 billion, up from $9.4 billion just a month earlier and about double the level of last May.
U.S. Central, the institution that posted the loss Wednesday, said it was due to a decision to writedown $1.2 billion in losses on its portfolio. U.S. Central previously had reported $5.6 billion in paper losses on its investments, but until recently believed it wasn't necessary to write down some of those on a permanent basis. NCUA's Mr. Fryzel said regulators found out about the losses on Monday, and immediately began to plan how to cope. He said the size of the losses "gave us greater concern" that other wholesale credit unions might accelerate their withdrawal of funds from U.S. Central. NCUA's board voted to inject $1 billion in new capital into U.S. Central. The money will come from the industry's $7 billion insurance fund, which is funded by a fee on credit unions and is separate from that run for banks by the Federal Deposit Insurance Corp.
Mr. Fryzel said the fund had been used to bail out retail credit unions, but had never before been used to recapitalize one of their wholesale brethren. To further shore up confidence, the NCUA also issued the blanket guarantee of the $80 billion in uninsured deposits in the network of wholesale credit unions. (Depositors in federally insured retail credit unions already have their accounts guaranteed up to $250,000.) Mr. Fryzel said some retail credit unions had been withdrawing funds from the corporate system, and the guarantee is designed to keep that trend from accelerating in light of the U.S. Central losses. NCUA said the initial guarantee would last through February 2009. After that, each wholesale credit union would be included on a voluntary basis for a new guarantee program that would last to Dec. 31, 2010. Mr. Fryzel said he expected all the wholesale credit unions would join that voluntary program.
Although the guarantee covers far more in deposits than the industry's $7 billion insurance fund, Mr. Fryzel said it was backed by the "full faith and credit of the United States government." To fund the $1 billion bailout of U.S. Central, regulators are increasing the insurance fee levied on all credit unions. David Dickens, an executive vice president at U.S. Central, said the $1.2 billion write-down came after further deterioration in some of its mortgage-backed securities. He stressed that the bonds continue to pay principal and interest, but that the company believes it will eventually suffer some losses on the securities. He put the current estimate of the losses at $420 million, but said accounting rules require U.S. Central to write down the bonds to their current market value, which he said is artificially depressed.
Major ratings agencies recently downgraded debt of some of the biggest wholesale credit unions, citing risks associated with investment losses. In downgrading U.S. Central in late December, Moody's Investors Service said the company's ratings would have been even lower if not for the "very high prospect" that it would be bailed out by the U.S. government and other wholesale credit unions. Moody's also noted that U.S. Central's deposits shrank by 22% between October 2007 and October 2008. Banking experts say that's a sign that other credit unions were nervous about U.S. Central's financial health. For the most part, the troubled wholesale credit unions have insisted that their investments are more conservative than those that have wreaked havoc on Wall Street. Some have retained outside firms to value their holdings. In hiring Pimco to evaluate those same investments, NCUA's Mr. Fryzel said he wants an independent check. "I'd feel a lot better if the individuals who are giving those numbers are working directly for me," he said. He said the valuations would "give us a pretty good idea of what other actions the board needs to take."
Jobless Claims For Americans Hit Record
The number of people receiving unemployment benefits has reached an all-time record, the government said Thursday, as layoffs spread throughout the economy. The Labor Department reported that the number of Americans continuing to claim unemployment insurance for the week ending Jan. 17 was a seasonally adjusted 4.78 million, the highest on records dating back to 1967. A department analyst said that as a proportion of the work force, the tally of unemployment recipients is the highest since August 1983.
The total released by the department doesn't include about 1.7 million people receiving benefits under an extended unemployment compensation program authorized by Congress last summer. That means the total number of recipients is actually closer to 6.5 million people. Meanwhile, the tally of Americans filing new jobless benefit claims rose slightly to a seasonally adjusted 588,000 last week, from a downwardly revised figure of 585,000 the previous week. That's close to the 26-year high of 589,000 reached in late December, though the labor force has grown by about half since then.
The Labor Department's report comes as large corporations from virtually all sectors of the economy are announcing massive layoffs. Starbucks Corp. on Wednesday said it would cut 6,700 jobs. The coffee company also said it would close 300 underperforming stores, on top of 600 it already planned to shut down. Time Warner Inc.'s AOL division is cutting up to 700 jobs, or about 10 percent of the online unit's work force. And IBM Corp. has cut thousands of jobs in its sales, software and hardware divisions in the past week, without announcing specific numbers. Boeing Co., Pfizer Inc., Home Depot Inc. and other U.S. corporate titans also have announced tens of thousands of job cuts this week alone. Companies have announced more than 125,000 layoffs in January, according to an Associated Press tally.
Employers cut 15,300 more jobs
The job market took another savage beating after several companies announced cost cutting plans that involved thousands of job cuts. Ford Motor Credit (FCZ), the financing arm of the struggling U.S. automaker, announced Wednesday it will cut 1,200 jobs, or 20% of its workforce. The company said the cuts were necessary due to slumping car sales. On Wednesday, Aircraft maker and defense contractor Boeing Co. was one of the largest casualties of the day, saying it would cut an additional 5,500 jobs this year, bringing its total cuts to 10,000 as the company struggles with dwindling demand for new aircraft. Earlier this month, Boeing announced plans to shed 4,500 jobs in its Commercial Airplanes division. But the additional job cuts will be across various other parts of the company. Coffee chain Starbucks Corp. also said it would be cutting up to 6,700 jobs, mostly due to store closings and a slower rate of store openings.
Meanwhile insurance giant Allstate Corp. said it would be cutting 1,000 jobs over the next two years, Internet company AOL, a division of CNNMoney.com parent Time Warner, intends to cut 700 jobs, according to an internal memo, and health care company Abbott Laboratories said it would be cutting 200 positions. Electronics parts maker Jabil Circuit announced plans to eliminate 3,000 jobs on a global basis, and Japanese automaker Nissan said it would be cutting 110 U.S. jobs as it closes four regional offices. Computer maker Dell Inc. also said it would be reducing the size of its workforce, but did not specify by how much. Wednesday's announcements bring the total number of job cuts this week to more than 100,000. On Monday alone, seven companies from a broad range of industries announced a total of 71,400 job cuts. The news comes on the same day the Labor Department reported that the total number of mass layoffs in 2008 was the highest level since 2001. The government defines mass layoffs as those that involve "at least 50 persons from a single employer."
New home sales plunge to lowest on record
Sales of newly constructed homes plunged in December to the lowest level on record, going back to 1963, according to a government report released Thursday. The U.S. Census Bureau reported that new home sales fell to an annual seasonally adjusted rate of 331,000 in December. That's down 14.7% from a revised 388,000 annual rate in November. The December sales pace was 44.8% below the same month a year ago, when the annual rate of new home sales was 600,000.
December's sales pace was much lower than the consensus estimate of 400,000, according to economists surveyed by Briefing.com. The median sales price - which measures the price at which half of the homes sold for more and half sold for less - was $206,500, down 9% from $227,700 a year earlier. The average sales price was $246,900, 13% lower than the $284,400 average of a year earlier. At the end of the month, there were a seasonally adjusted 357,000 homes for sale, which represents an inventory level of 12.9 months at the current sales pace.
For all of 2008, 482,000 new homes were sold, which is 37.8% less than the year prior. In 2007, 776,000 new homes were sold, according to the report. While the number of new homes sold plunged in December, the number of existing homes sold in the month showed a surprise jump, according to a report released earlier in the week. The number of existing homes sold in December rose 6.5% from the previous month, to an annual rate of 4.74 million units, according to a report released Monday from the National Association of Realtors. Plunging home prices brought buyers back into the market, with foreclosure homes offering extreme bargains.
U.S. Durable Goods Orders Decline for Fifth Month
Orders for U.S. durable goods fell in December for a fifth month, the longest slide since at least 1992, reflecting a collapse in business investment that’s likely to prolong the recession. The 2.6 percent drop was worse than economists had forecast, a Commerce Department report showed today in Washington. Excluding automobiles and aircraft, orders decreased 3.6 percent, also more than anticipated. The Labor Department said separately that the number of Americans collecting jobless benefits soared to a record 4.776 million. Today’s reports reflect efforts by companies from General Motors Corp. to Caterpillar Inc. to downsize amid a pullback in both domestic spending and demand from overseas. The Federal Reserve yesterday warned that a prolonged global downturn may push the U.S. to the brink of deflation.
"There is lots of pain," Ward McCarthy, a principal at Stone & McCarthy Research Associates in Skillman, New Jersey, said in a Bloomberg Radio interview. The economy was "deteriorating over the course of the fourth quarter and that deterioration has continued into the first quarter," he said, anticipating that the unemployment rate may exceed 9 percent for the first time since 1983. Stocks fell, with the Standard & Poor’s 500 Stock Index down 1.6 percent to 860.53 at 9:33 a.m. in New York. Treasuries were little changed, with benchmark 10-year notes yielding 2.69 percent. The Labor Department report showed that initial claims for unemployment insurance increased to 588,000 last week, exceeding economists’ forecasts, from 585,000 the previous week.
Congress yesterday took a step toward passing the stimulus package that President Barack Obama is pressing to help save or create about 4 million jobs. The House passed an $819 billion package, shifting attention to the Senate. Lawmakers aim to get the legislation to Obama by mid-February. Economists had projected a 2 percent drop in durable goods orders, according to the median of 75 estimates in a Bloomberg News survey. The reading for November was revised to a decline of 3.7 percent from a previous estimate of a 1.5 percent fall. Excluding transportation equipment, orders were forecast to fall 2.7 percent in December. For all of 2008, orders for durable goods slumped 5.7 percent, the biggest decrease since the 2001 recession. Bookings for non-defense capital goods excluding aircraft, a proxy for future business investment, decreased 2.8 percent and the previous month’s gain was revised down. Shipments of those items, used in calculating gross domestic product, rose 0.9 percent after falling a greater-than-previously estimated 1.4 percent in November. Automobile bookings decreased 5.2 percent and orders for commercial aircraft dropped 44 percent.
Boeing Co., the world’s second-biggest commercial-airplane maker, yesterday said a drop in travel and tight credit signals customers may continue to cancel or defer orders in 2009. The Chicago-based company reported a fourth-quarter loss and said it plans to cut 10,000 jobs. It also disclosed that a customer canceled all 15 of its orders for the new 787 Dreamliner plane. The U.S. economy contracted at a 5.5 percent annual pace last quarter, the worst performance since 1982, after shrinking at a 0.5 percent pace in the previous three months, economists project a Commerce report tomorrow will show. A slump in business investment, together with continued declines in consumer spending and housing, accounted for the deterioration. The Fed yesterday left the benchmark interest rate as low as zero and said it was prepared to purchase Treasury securities to resuscitate lending should circumstances warrant such action. Policy makers also warned that inflation may recede too quickly and that downside risks to growth "are significant."
GM, which already closed most of its 22 plants in North America this month, said it’ll eliminate shifts in the second quarter at plants in Ohio and Michigan, cut about 2,000 jobs, and reduce output at 13 other U.S. and Canadian factories. Chrysler LLC, Ford Motor Co. and Toyota Motor Corp. are also scaling back North American production. Ford, the only U.S. automaker not tapping federal loans, said today it used up $5.5 billion in cash in the fourth quarter and will tap a revolving credit line after the worst annual performance in its 105-year history. Today’s report also showed demand slumped for metals, machinery and computers. Exports are declining as the global economy faces the first simultaneous recession in the U.S., Japan and the euro region in the postwar era. The International Monetary Fund yesterday projected financial losses worldwide will swell to $2.2 trillion, double the current count, almost bringing economic growth this year to a halt.
Caterpillar, the world’s largest maker of bulldozers and excavators, said this week it is cutting 20,000 jobs and profit this year may trail analysts’ average forecast. The Peoria, Illinois-based company cited "significant order cancellations" in the fourth quarter. "We are expecting recessionary conditions to persist in most of the world throughout the year," Chief Executive Officer Jim Owens said on a conference call with analysts, adding the company is looking at "seismic adjustments" in 2009 sales and revenue. Unfilled orders last month dropped 1.3 percent, the biggest decrease since October 2002, today’s report also showed. The decrease indicates manufacturing will be slow to rebound even after the economy starts to recover.
Ford Burns $5.5 Billion in Cash, Taps Revolving Loan
Ford Motor Co., insisting it can survive without federal loans, said it burned $5.5 billion in cash in the fourth quarter and will tap a revolving credit line after the worst annual performance in its 105-year history. The second-biggest U.S. automaker posted a full-year loss of $14.6 billion, eclipsing 2006’s record of $12.6 billion. Cash in Ford’s automotive business fell to $13.4 billion, the company said today in a statement. "These losses are not sustainable," Sean Egan, president of bond ratings firm Egan-Jones Ratings Co., said in a Bloomberg Television interview. "Even if they draw down their lines and the money from the government, it begs the question of whether or not the overall situation is going to improve."
Ford posted a quarterly net loss of $5.9 billion. Excluding discontinued operations and costs Ford considers one-time expenses, the loss was $3.27 billion, or $1.37 a share, wider than the $1.24 average of 11 analyst estimates compiled by Bloomberg. The year-earlier net loss was $2.81 billion. While reiterating that it doesn’t need federal aid like General Motors Corp. and Chrysler LLC, Ford revised its forecast for 2009 U.S. industrywide sales to a range of 11.5 million to 12.5 million vehicles, from 12.2 million. The company said this year’s cash drain will be less than in 2008 as capital spending and inventories shrink. "We are not tapping the revolver to fund operations. We are not tapping the revolver to stay above minimum cash levels," Chief Financial Officer Lewis Booth said in an interview at company headquarters in Dearborn, Michigan. "We are doing it to ensure that it’s there."
Ford fell 5 cents, or 2.5 percent, to $1.98 at 9:44 a.m. in New York Stock Exchange composite trading. The shares plunged 70 percent in the 12 months ended yesterday. The credit line will give Ford access to $10.1 billion in cash this quarter. Ford also said the United Auto Workers union had agreed to end the so-called jobs bank, in which employees are paid even when there is no work, following similar steps for GM and Chrysler. Ford has about 1,500 workers in the program. Ford’s quarterly revenue plunged 34 percent to $29.2 billion as the recession dragged down the company’s U.S. vehicle sales by 30 percent, hastening the cash drain. Total liquidity at year’s end was $24 billion, Ford said. This year, Ford is adding $2 billion to liquidity by converting money set aside for a union-run fund covering retirees’ health care into a note payable at the end of 2009. The UAW agreed to the change to strengthen Ford’s cash position, the automaker said.
The company has managed to forgo the federal loans doled out to GM and Chrysler because Chief Executive Officer Alan Mulally decided to borrow $23 billion in 2006, securitizing all of Ford’s assets, including its trademark blue oval logo. Still, Ford’s cash burn in the past two quarters totals $13.2 billion. The company reported having $18.9 billion on Sept. 30. Ford won’t specify its minimum cash needs to stay in business. GM, the largest U.S. automaker, has said it needs at least $11 billion in cash on hand to pay bills, while No. 3 Chrysler has put its threshold at $2 billion to $2.5 billion. Both said they would have been out of operating funds as soon as this month without the emergency aid they received in December.
Ford’s sales outlook "is still too rosy," said John Wolkonowicz, an analyst at IHS Global Insight in Lexington, Massachusetts. "They’ll need money from the government by midyear. But when they do put their hand out, it won’t captivate the media nearly as much, and it will go by with less fanfare." U.S. auto sales may fall this year to 10.5 million vehicles, the lowest since 1982, based on industry forecasts, after tumbling 18 percent in 2008. The company has said that after annual losses this year and next, 2011 should see a break-even result or a profit before taxes and excluding special items. Chairman William Clay Ford Jr. said on Jan. 11 the automaker wouldn’t seek federal loans "unless the world implodes." "They should go to the U.S. government very quickly," said Egan, whose bond-rating firm is based in Haverford, Pennsylvania. "They are going to need the cash, perhaps not immediately, but certainly within the next two quarters, and get it while they still can.
Ford asked for a credit line in December of as much as $9 billion as U.S. lawmakers tried to craft an industry rescue package. When that measure failed, the U.S. Treasury granted $17.4 billion in loans to GM and Chrysler. Ford has been in contact with the Treasury about ways to bolster finance arm Ford Motor Credit, a U.S. government official said on Jan. 16. Ford Credit said yesterday it will eliminate 20 percent of its workforce, or about 1,200 workers, as part of a cost-cutting move. The Treasury Department also provided a $6 billion bailout to GMAC LLC, the lender affiliated with GM, and $1.5 billion in loans to Chrysler Financial. Ford’s 7.45 percent note due in July 2031 gained 1 cent to 23.25 cents on the dollar, yielding 32 percent, according to Trace, the bond-pricing service of the Financial Industry Regulatory Authority.
Fed eyes moves against deflation
Despite the Federal Reserve's historic moves to ease monetary policy, forecasters expect consumer prices to post a rare decline this year – a potential threat to economic recovery. The challenge: Reviving the confidence of businesses and consumers tends to be much harder when prices are falling. In a deflationary climate, the predisposition is to postpone economic activity, because things are expected to become even cheaper. That basic psychology, as well as the obvious distress in America's banking system, is something Fed policymakers have been weighing in recent meetings. "Ben Bernanke is rightly concerned about deflation right now," says Desmond Lachman, a financial expert at the American Enterprise Institute in Washington. "Getting inflation back into the system … is not going to be sufficient," but it would help to resolve the financial crisis. This idea can seem counterintuitive. The Fed's typical worry is about keeping inflation from running out of control. And it was the runaway rise in US home prices that helped set the stage for the current crisis.
Economists aren't of one mind on the right course for central bankers now. Some are concerned that efforts to revive growth could sow the seeds of an inflation problem down the road. Yet in rare times, deflation can become a much bigger problem than inflation. Recent indicators suggest at least a risk that this may be one of those times:
• On Tuesday, consumer confidence fell to a historic low, as measured by the Conference Board in a survey going back to 1967. The confidence of chief executives to make new business investments has also plunged in recent months.
• Standard & Poor's reported another monthly decline in its Case-Shiller home price index. A 20-city national average is down 25 percent from the home price peak reached in 2006.
• The consumer price index shifted down sharply as the recession deepened last fall. The bulk of this relates to a reversal in oil prices, but markdowns by holiday retailers were a sign of the new times.
A tally of about 50 forecasters by Blue Chip Economic Indicators finds the consensus expectation for consumer prices this year is deflation of 0.4 percent. Declining energy prices help the economy by easing what had been a rising burden on consumers. In that sense, the recent price drop is not a bad thing. The risk is if a deflationary psychology takes root. Consumers and business would defer decisions, which could deepen the recession and push prices down further. How does a distressed homeowner sell, when buyers are waiting for prices to fall further? Why would a "vulture" investor offer to buy a distressed bank's high-risk mortgages, if they're expecting still lower prices in the future? In a financial crisis, deflation hits debtors especially hard. The burden of their debts is rising relative to a decline in the overall consumer price level. Some economists say a little inflation would help turn the psychology that's part of the current crisis. "If inflation rises, nominal house prices don't need to fall as much [for the market to stabilize]," Harvard University economist Kenneth Rogoff wrote recently in Toronto's Globe and Mail newspaper.
So, what can the Fed do? It has already cut its short-term interest rate effectively to zero. It has also moved to supply liquidity to financial markets – buying everything from mortgage-related securities to short-term debt issued by industrial firms. The result is to help stabilize the financial system, but buying assets has also had the effect of adding to the money supply. While the Fed hasn't emphasized this point, these policies amount to what economists call "quantitative easing" of monetary policy. By boosting the quantity of money, it fuels potential future inflation. One idea, some economists say, is to keep expanding the money supply. Another might be for the Fed and Treasury to signal that they expect inflation to pick up once again, such as by investing in the Treasury's inflation-protected bonds. In its meeting this Tuesday and Wednesday, Fed-watchers generally expect little new action, as the Fed waits for President Obama's economic team to define its approach the banking crisis. "If you start to break the deflationary cycle, then people will shift out of cash," says Brian Bethune, an economist at IHS Global Insight in Lexington, Mass. "Then people will start to think about buying stocks and buying houses."
Bailing out the states: How it will work
Struggling with gaping budget deficits, states are eagerly awaiting the hundreds of billions of dollars coming their way from Capitol Hill. States could get more than two-thirds of the $819 billion stimulus package approved by the House Wednesday, according to some estimates. The vast majority of the money will be allocated for specific programs, such as highways, unemployment, Medicaid, government bond tax incentives and education. But governors will also get some funds to plug their budget gaps, estimated at $91 billion for fiscal 2009. These deficits have forced states to make harsh spending cuts, especially to education and social service programs. The federal funds aim to help mitigate these reductions, as well as stimulate the economy and support residents suffering from the downturn.
Even though much of the federal money is targeted for specific purposes, the funding will relieve some general budget pressures. For example, state officials will use stimulus funds for education and Medicaid and then direct their own tax revenues to other state spending needs. "There will still be some cuts, but those cuts will be significantly reduced," said Pennsylvania Gov. Edward Rendell, who heads the National Governors Association. States will receive a nice chunk of change. California, for instance, could get a total of $63.4 billion, 12.3% of which can be used to balance its budget, according to the Center for American Progress. Gov. Arnold Schwarzenegger said earlier this month that California is "in a state of emergency" and faces insolvency within weeks in the wake of a projected $42 billion deficit.
The states will also benefit from the increases in food stamp, unemployment and other aid -- as well as the infrastructure measures that put people back to work. Some of this money will come back to the states as income and sales tax revenue, giving a much needed boost to their budgets. While lawmakers and economists debate whether the stimulus package -- and accompanying tax cuts -- will turn around the national economy, experts interviewed say the states should be the ones to put the money to work. "They can distribute the money rapidly and into programs that voters have supported in the past," said Kevin Hassett, director of economic policy studies at the American Enterprise Institute.
Still, even with the federal assistance, states are in for rough times. Recessions usually pummel state budgets for 18 months after the national economy starts to turn around. The current recession began in December 2007 and is not likely to end soon. "It's a Band-aid," said Michael Bird, federal affairs counsel at the National Conference of State Legislators. "It gives the states a little bit of relief from some of the budget cutting they've had to do. But states will continue to make cuts. We are still headed downhill." The Senate is expected to vote on its version of the stimulus package next week and, if they differ, the two chambers will have reconcile their bills thereafter.Here's how the House would allocate some of the funds to the states:
Infrastructure: provides about $35 billion to build highways, construct commuter and light rail systems, purchase buses and modernize existing transit systems. Half the money must be allocated to projects within six months.
Education: provides billions for a wide range of education programs, from $20 billion for renovating schools to $26 billion for maintaining services for disadvantaged and special education students. Another $39 billion will go to prevent cutbacks in public education funding.
Medicaid: provides $87 billion in additional federal matching funds to help states maintain their Medicaid programs, often one of their costliest expenditures. Separately, states will receive another $8.6 billion to extend Medicaid coverage to the unemployed whose families have low incomes.
Unemployment: provides $500 million to administer unemployment insurance benefits and allows states to elect to increase benefits by $25 per worker. Provides an additional $4 billion for job training and youth services.
Government bond incentives: reduces costs of issuing tax-exempt government bonds and creates new bonds for development in hard-hit economic areas and for school construction.
International Air Cargo Traffic Plummets 22.6%
In the biggest decline ever, global international cargo traffic plummeted 22.6 percent in December compared with a year earlier, according to the International Air Transport Association. Asia-Pacific carriers, accounting for 45 percent of international cargo, led the December decline with a 26 percent contraction compared to the previous year. "The 22.6 percent free fall in global cargo is unprecedented and shocking. There is no clearer description of the slowdown in world trade.
Even in September 2001, when much of the global fleet was grounded, the decline was only 13.9 percent," said Giovanni Bisignani, IATA's director general and CEO." Air cargo carries 35 percent of the value of goods traded internationally. Even with recent capacity cuts of about 1.5 percent, the international load factor fell 2.4 percent to 73.8 percent. "Airlines are struggling to match capacity with fast-falling demand. Until this comes into balance, even the sharp fall in fuel prices cannot save the industry from drowning in red ink," said Bisignani. Full year international air freight traffic contracted 4 percent for the year compared to 4.3 percent growth in 2007.
Even so, that recessionary figure was mild until December's collapse of the freight business. Declines of 20 percent to 30 percent in export and import volumes have been reported across Asia, North America and Europe as the global recession plumbed new depths in December. "Keep your seatbelts fastened and prepare for a bumpy ride and a hard landing," said Bisignani. Airlines registered $5 billion in losses in 2008. For 2009 IATA is forecasting a further loss of $2.5 billion. Industry revenue is expected to contract by $35 billion.
ATA Truck Tonnage Index Plummeted 11.1 Percent in December
The American Trucking Associations’ advanced seasonally adjusted For-Hire Truck Tonnage Index plunged 11.1 percent in December 2008, marking the largest month-to-month reduction since April 1994, when the unionized less-than-truckload industry was in the midst of a strike. December’s drop was the third-largest single-month drop since ATA began collecting the data in 1973. In December, the seasonally adjusted tonnage index equaled just 98.3 (2000 = 100), its lowest level since December 2000. The not seasonally adjusted index edged 0.6 percent higher in December. Compared with December 2007, the index declined 14.1 percent, the biggest year-over-year decrease since February 1996. During the fourth quarter, tonnage was down 6.0 percent from the same quarter in 2007.
ATA Chief Economist Bob Costello said the December reading confirms that the United States is in the thick of a recession. "Motor carrier freight is a reflection of the tangible-goods economy, and December’s numbers leave no doubt that the United States is in the worst recession in decades," Costello said. "It is likely truck tonnage will not improve much before the third quarter of this year. The economy is expected to contract through the first half of 2009 and then only grow slightly through the end of the year."
Note on the impact of trucking company failures on the index: Each month, ATA asks its membership the amount of tonnage each carrier hauled, including all types of freight. The indexes are calculated based on those responses. The sample includes an array of trucking companies, ranging from small fleets to multi-billion dollar carriers. When a company in the sample fails, we include its final month of operation and zero it out for the following month. This assumes the remaining carriers pick up that freight. As a result, it is close to a net wash and does not end up in a false increase. Nevertheless, some carriers are picking up freight from failures, and it may have boosted the index. Due to our correction mentioned above, however, it should be limited.
Trucking serves as a barometer of the U.S. economy, representing nearly 70 percent of tonnage carried by all modes of domestic freight transportation, including manufactured and retail goods. Trucks hauled 10.7 billion tons of freight in 2006. Motor carriers collected $645.6 billion, or 83.8 percent of total revenue earned by all transport modes. ATA calculates the tonnage index based on surveys from its membership and has been doing so since the 1970s. This is a preliminary figure and subject to change in the final report issued around the 10th day of the month. The report includes month-to-month and year-over-year results, relevant economic comparisons, and key financial indicators. The American Trucking Associations is the largest national trade association for the trucking industry. Through a federation of other trucking groups, industry-related conferences, and its 50 affiliated state trucking associations, ATA represents more than 37,000 members covering every type of motor carrier in the United States.
Europe warns U.S. over 'Buy America'
The European Commission signaled on Thursday it may contest a "Buy America" provision if it is included in the final version of an $825 billion package to kick-start the U.S. economy. "If a bill is passed which prohibits the sale or purchase of European goods on American territory, that is not something we will stand idly by and ignore," Commission spokesman Peter Power told a regular news briefing. Power said the European Union executive, which oversees trade policy for the 27-member bloc, "will be carefully studying the details of the bill before we can say that the U.S. are violating any trade agreement".
European steel confederation Eurofer called earlier for Brussels to tackle Washington over the issue at the World Trade Organization (WTO).
"Our view is that if passed this would be a clear violation of their WTO (World Trade Organization) commitments on government procurement rules," Eurofer said in a statement to Reuters. The U.S. House of Representatives on Wednesday passed the provision, which requires public works projects funded by the bill to use only U.S.-made iron and steel. House leaders included the language despite strong objections from the U.S. Chamber of Commerce and other business groups which said it would set a bad example for other countries considering their own economic stimulus plans.
"It is a protectionist measure which goes against the commitment made to the G20 to keep markets open," Eurofer said. "It is against the interests of the U.S. consumer since the U.S. has a deficit in steel and must import to meet consumption needs." After a boom period driven by infrastructure projects in China and other developing countries, some U.S. steelmakers have cut production and could see losses in the first quarter as the global economic slump saps demand. The Buy America steel measure specifically covers airports, bridges, canals, dams, dikes, pipelines, railroads, mass transit systems, roads, tunnels, harbors and piers.
Russian prime minister Vladimir Putin calls for end of dollar stranglehold
Russian prime minister Vladimir Putin has called for concerted action to break the stranglehold of the US dollar and create a new global structure of regional powers. "The one reserve currency has become a danger to the world economy: that is now obvious to everybody," he said in a speech at the World Economic Forum. It is the first time that a Russian leader has set foot in the sanctum sanctorum of global capitalism at Davos.
Mr Putin said the leading powers should ensure an "irreversible" move towards a system of multiple reserve currencies, questioning the "reliability" of the US dollar as a safe store of value. "The pride of Wall Street investment banks don't exist any more," he said.
For all his bluster, Mr Putin's bargaining power is weakening by the day. Russia's foreign reserves have fallen by 34pc since August to $396bn (£277bn) after months of capital flight and the collapse in the price of Urals crude oil to $45 a barrel. The rouble also fell to a record low yesterday after sliding for weeks in a controlled devaluation. Mr Putin said: "We are witnessing a truly global crisis. The speed of developments beats every record, and the strategic difference from the Great Depression is that under globalisation this touches everyone. This has multiplied the destructive force. It looks exactly like the perfect storm."
The Soviet Union avoided depression in the 1930s due to its totally closed autarkic system, although the regime inflicted other terrible hardships. However, Mr Putin's own government in Russia is facing mass protest as unemployment surges and austerity measures start to bite. The Kremlin expects the Russian economy to contract by 0.2pc this year. Expecting a deep global downturn, it has redrafted its budget plans based on oil prices at $41 this year, entailing drastic cuts in public spending.
China and Russia blame US for financial crisis
The premiers of China and Russia accused America of sparking the economic crisis as the Davos political and business summit made a gloomy start. Wen Jiabao and Vladimir Putin both blamed "capitalist excesses" for the global downturn, as one followed the other to the podium at the opening of the World Economic Forum last night. The Chinese premier began with a speech asserting that the worst recession since the Great Depression had been caused by blind pursuit of profit. In a thinly veiled attack on America, Mr Wen blamed "inappropriate macroeconomic policies of some economies" and "prolonged low savings and high consumption". He blasted the "excessive expansion of financial institutions in blind pursuit of profit and the lack of self-discipline among financial institutions and ratings agencies", while the "failure" of regulators had allowed the spread of toxic derivatives. The Chinese leader called for faster reform of international financial institutions and for a "new world order" for the economy.
Mr Putin, the Russian premier, following him to the podium, accused bankers, regulators and politicians of turning a blind eye to the "perfect storm" that was building before their eyes. "This pyramid of expectations would have collapsed sooner or later. In fact it is happening right before our eyes," said Mr Putin. "Although the crisis was simply hanging in the air, the majority strove to get their share of the pie, be it one dollar or one billion, and did not want to notice the rising wave." Mr Putin said that he would not criticise the United States, but then added: "I just want to remind you that just a year ago, American delegates speaking from this rostrum emphasised the US economy’s fundamental stability and its cloudless prospects." Condoleezza Rice, when US secretary of state, gave a speech in Davos last year saying the US economy was safe.
Mr Putin went on: "Today investment banks, the pride of Wall Street, have virtually ceased to exist. In just 12 months they have posted losses exceeding the profits they made in the last 25 years. This example alone reflects the real situation better than any criticism. "The existing financial system has failed. Sub-standard regulation has contributed to the crisis, failing to duly heed tremendous risks." Mr Wen said that the crisis had posed "severe challenges" for China, which has pursued a mirror image policy of investing heavily in the United States and buying up US debt, just as America was plunging deeper and deeper into the red. The effects of the downturn have hit Chinese jobs and overseas markets, causing some social unrest. Four million migrant Chinese workers have so far been thrown out of work. Mr Wen said that China now needed 8.0 percent growth in 2009 to maintain social stability, while the International Monetary Fund predicted 6.7 percent for this year.
Both Mr Wen and Mr Putin called for greater cooperation in international affairs from new US President Barack Obama - conspicuous by his absence from Davos, as he battles to get his $825 bn fiscal stimulus package through Congress. The prospects for co-operation between the US and China have seemed to recede in recent days, after the new US Treasury Secretary Timothy Geithner last week revealed that Mr Obama believes China has been manipulating its currency, deliberately refusing to allow it to rise in value against the dollar in order to gain an edge in trade. "In meeting the international financial crisis, it is imperative for the two countries to enhance co-operation, that is my message to the US administration," Mr Wen said. Both the Chinese and Russian premiers also spoke out against protectionism, and said that excessive government intervention would harm recovery prospects.
Gordon Brown, Chancellor Angela Merkel of Germany and the Japanese prime minister Taro Aso - who have between them spent hundreds of billions of dollars battling the crisis - were also among about 40 heads of state or government who will speak this week. There were plenty of other critics among the record attendance at Davos of the bank recapitalisations and fiscal stimulus packages that wealthy countries have put in place to counter the crisis.
Trevor Manuel, South Africa’s Finance Minister, described wealthy nations as adopting a "lemming-like approach, trying to get to the precipice without knowing what their money would buy". The economic turmoil has overshadowed efforts to highlight other key issues at the conference, including climate change, conflicts around the world and poverty alleviation campaigns, but Ban Ki-moon, the UN Secretary General, was due to speak about the Gaza conflict in Davos today.
US-China currency war eclipses Davos, and threatens the world
Turning a corner in the labyrinthine corridors of the Davos nerve-centre, I ran smack into Chinese premier Wen Jiabao - followed by a regiment of retainers and senior offices in full regalia. They have not quite adapted to the "sport" dress code of capitalism in Alpine retreat. Jeroen van der Weer - a Davos stalwart - wears horrendous corduroy trousers (pink sometimes) with a 1950s-era Tyrolean woolly. I dread to think how they react to Swiss prices if they venture into the restaurants. Mr Jiabao smiled at me benignly, but he is not in a good mood. Indeed, he is fuming over the remarks by US Treasury Secretary Tim Geithner that China was "manipulating" its currency to gain market share. Reports were circulating this afternoon in Davos that Mr Jiabao erupted into a tirade after lunch at the mere mention of Mr Geithner's name.
Mr Geithner - the first US Treasury chief who can actually speak Chinese, and Japanese, nota bene - is clearly operating under instructions from President Barack Obama. If his resolve fails, Hillary Clinton is there at Foggy Bottom (State Department) to renew the broadside against Beijing - at least judging by her Sinophobe reflexes in the campaign. This has the makings of an almighty superpower bust-up. It is fast becoming the theme of Davos 2009. It may soon be the burning issue of our times. We will all learn how to pronounce Renminbi. The Bush Administration -- in its day -- deflected all attempts by Congress to crack down on China's currency policy. Perhaps sagely, perhaps not.
There is no question that Beijing has pursued a mercantilist strategy of conquering US and European markets by holding down the yuan/renminbi. It has a monthly trade surplus of $40bn, the highest ever recorded by any country. Or put another way, China is exporting its surplus capacity to the rest of the world. It has become a global deflation machine. Even so, Mr Geithner is playing with fire. Beijing has amassed reserves of $1.9 trillion. From what we know, most of this money is held in the form of US Treasuries and other bonds. Creditors exercise power. Don't be fooled by claims that China could not deploy this weapon without damaging its own interests. All kinds of things can and do happen when tempers flare, and they were flaring today.
The IMF's chief economist Olivier Blanchard said it was unwise to "obsess" over the exchange rate in this fragile climate. "It is probably not the right time to focus on the Chinese exchange rate, given that it is not a central element of the world crisis. There are many other things we should be thinking about. It is an item on the list, but it is not at the top of the list." Stephen Roach, head of Morgan Stanley Asia, offered a harsher verdict, calling it pure folly to pick a fight with Beijing. "The Chinese economy most likely contracted in final quarter of 2008 and most likely in this quarter too. China has hit a wall," he said. "A country that is contracting doesn't take kindly to its major trading partners saying you have to increase the value of its currency. What they are being told to do is tantamount to economic suicide," he said.
Quite. This conflict needs to be handled with extreme care. There is a battle going on within the Chinese Communist leadership over currency policy. A bloc within the central bank has long argued that China itself is the victim of a policy that fuels domestic inflation and leaves the country dangerously dependent on the goodwill of export markets. Wen Jiabao, speaking as I write, says that China's fiscal stimulus package of $600bn will be worth 16pc of GDP over two years. If so, that is huge. China is now doing its part to shore up the global system, even if he rather annoyingly continues to blame "low-savings" countries for the crisis - skipping over the role of Asia in stoking a credit bubble (Takes two to tango). Be that as it may, China's fiscal blitz is the beginning of a shift in strategy that should - over time - start to boost domestic demand enough to eat into the trade surplus. Mr Jiabao said it was "imperative that China and the US step up their co-operation". He pleaded with the West not to retreat into protectionism. Washington - and above all Capitol Hill -- would be well advised to listen. Vladimir Putin speaks next. The autocrats are lining up.
Vladimir Putin attacks Western rescue packages
Vladimir Putin, the Russian Prime Minister, launched a swingeing attack on Western financial rescue packages yesterday, calling for a new world order to reverse the financial crisis. On his first visit to the World Economic Forum in Davos, Mr Putin called the crisis a "perfect storm" that had arisen from a world dominated by the US. He said that only a rebalancing of global power could cure the problem and that financial stimulus packages of the kind agreed by Washington and London could lead them down a path well-worn by Moscow while doing little to aid recovery. "Interference of the State, the belief in the omnipotence of the State: that is a reaction to market failures," Mr Putin said in his keynote address at the opening of the four-day meeting. "There is a temptation to expand direct interference of state in economy. In the Soviet Union that became an absolute. We paid a very dear price for that."
Mr Putin’s speech came as Russia said it was halting plans to site missiles in Europe as a gesture of goodwill to the Obama Administration. Moscow had begun to deploy the weapons in the Baltic as a reaction to the Bush Administration’s decision to forge ahead with a defence shield in Eastern Europe. He offered an olive branch to President Obama, saying: "We wish the new team success. I hope they are willing to co-operate constructively." Mr Putin’s main theme was the strengthening of multilateral co-operation to tackle not only the financial crisis but conflicts such as the war in Georgia and the Israeli assault on the Gaza Strip — a theme that echoed calls from Kofi Annan, former UN Secretary-General, for an overhaul of international institutions such as the United Nations Security Council to better address the needs of an interconnected world.
There was a danger, Mr Putin said, that military action was being used by countries as "another way of distracting from economic situation". In solving these regional disputes, he said, "multilateral institutions turned out to be as ineffective as financial institutions . . . We cannot rule out this happening in future." The thinly veiled underlying theme was Russia’s return to pre-eminence as a world power as a result of the diminishing American clout that might result from the global meltdown. On the need for energy independence and security, Mr Putin proposed the expansion of Russian gas and oil supplies to Asia and Europe — a statement that might surprise the Balkan countries that were denied power by Gazprom, of Russia, this month.
He called for the expansion of the range of reserve currencies and said that the diversification of financial centres was an assault on the historical pre-eminence of the US dollar and more recently, the euro, at Russia’s expense. Mr Putin also talked of the need to stabilise oil prices, a reminder of the damage that plummeting crude prices have done to the Russian economy — and to the Prime Minister himself. He is constantly rumoured to be plotting his return to the presidency and has seen his own popularity come under unprecedented assault amid Russia’s economic woes. Russian military commanders recommended late last year that Moscow should consider scrapping plans to update its nuclear arsenal to properly fund its ailing conventional military. Many analysts see Moscow’s offer to stand down its missiles not so much as an act of goodwill as the result of a cashflow problem. "Militarisation does not help to solve problems," Mr Putin told the audience. "We are against spending more money on military efforts."
His comments on the dangers of state bailouts were well-received by many analysts, who have warned that stimulus packages will fail without a co-ordinated international response to bring in global regulation. It was an ebullient performance for Mr Putin at a depressed, chagrined Davos. The US is thinly represented, with Mr Obama keeping his top team at home and many bankers out of work. The appearance of Wen Jiabao, the Chinese Premier, and Mr Putin, on their first visits to Davos, underlined the shifts in global power that the latter sought to highlight. He drew laughs for his mockery of business leaders’ failure to predict the crisis, saying: "As winter comes to Russia unexpectedly every year, it happens this time again with the global economy." Yet he bristled at the suggestion that Russia could be helped to build on its technology advances by the outside world. "We are not an invalid, we don’t need help," he growled. "Pensioners need help, development countries need help. We do not need help."
BP sees further crash in oil demand, OPEC behind the curve
The worldwide recession is likely cause a far deeper slump in demand for crude oil this year than recognized so far by the OPEC cartel, according to BP's chief executive Tony Hayward. "Things depend entirely on the global economy and success in resolving the banking crisis, but the pessimistic view is that there will be no growth in the world this year. Demand loss of perhaps 1m barrels per day is likely," he said, addressing an energy panel at the World Economic Forum in Davos. Abdalla El Badri, OPEC's secretary-general, said the group of oil exporters is expecting further "demand destruction" of just 200,000 barrels per day this year.
If Mr Hayward is right, the supply glut on the market will almost certainly push oil prices even lower in coming months – perhaps below $30, as Goldman Sachs and Merrill Lynch both now expect. The cartel has already announced three sets of cuts totalling 4.2m bpd since prices began to collapse from their summer peak of $147 a barrel – although there is intense scepticism in the markets over the level of compliance by countries that depend heavily on oil revenues to fund their budgets. "We'll have to see how the market reacts, but if there is a problem we will not hesitate to take more off the market," said Mr Al Badri, speaking in Davos.
"I'm really concerned. We don't want a repeat of the 1980s where we did not invest and laid off a lot of qualified people, and then when demand picked up we were short of materials and skilled manpower." "We're not happy with oil at $40 or even $50. We can't get a decent income for our countries, and $50 does not permit us invest. If we don't invest we're going to have a problem in three to four years," he said. OPEC's view is that $60 to $80 is a sustainable range. Mr Haywood said the violent swing in prices is storing up inevitable trouble. "The big challenge is to recognize that when the economy recovers, demand is going to recover very fast. It won't be long before we run into supply constraints." "The energy industry needs to invest a trillion dollars a year for the next twenty years. It is crucial to continue to invest during the downturn," he said.
The Davos panel called for fresh rules to prevent hedge funds and traders running amok with the oil market. "For every barrel that is actually sold, 30 barrels are traded on Wall Street," said Mukesh Ambani, chairman of India's Reliance Industries. "We need an over-arching regulation to make this transparent. We need to know who is buying and selling," he said. OPEC's Mr Al Badri said some form of code was needed to restrain the funds. "When I was in my office looking at $147 a barrel , I was not happy at all. It was not based on any fundamentals. The price was created by speculators and nothing else. There was no queue of customers wanting our oil. Some countries were giving discounts, so something strange was going on." "We can't eliminate speculators but we do need a guideline to prevent damage to demand," he said.
Opec pledges to push oil back above $50 a barrel
Opec members need an oil price above $50 a barrel to make exports worthwhile, the head of the cartel said today, adding that more production cuts were possible this year. "We are not happy with $40 even $50 a barrel," Abdalla Salem El-Badri, Opec Secretary-General, told a panel discussing energy security at the World Economic Forum in Davos. Even $50 did not guarantee a "decent income for our countries", he said, adding: "I hope that the price will pick up ... a $50 price will not permit us to invest." Asked about further cuts by the cartel, he said: "If we still have some downward problems [on prices], Opec will not hesitate to take some quantity out of the market.
"We cannot tell at this time before our next meeting on March 15." New York’s main futures contract, light sweet crude for March delivery, traded at $41.63 a barrel today, while Brent North Sea crude for March fell 68 cents to $44.22. Since September, Opec has announced cuts of 4.2 million barrels per day (bpd), including a reduction of 2.2 million bpd on December 17 in Algeria. There had been doubts about the discipline of Opec members and their willingness to reduce output by the agreed amount, but Mr Bardi said that all the oil would be taken off the market. "For the information I am seeing at this time, it would be about 100 per cent," he said of the cuts. "I think we will take out 4.2 million barrels per day."
Tony Hayward, the chief executive of BP, told the panel that Opec countries needed a price of about $60-$80 per barrel to balance their budgets and invest in social programmes. "A price somewhere between $60-$80 would be appropriate," he said. He also explained that a high price was needed to encourage investment in new oil fields that will be required to meet future demand, particularly from energy-hungry India and China. Mr Badri concurred, saying that the lessons from past oil price crashes had to be learned. "We... don’t want what happened in the 1980s where we did not invest and laid off very qualified people and when the demand picked up we were paying the price of shortages" of materials and people, he said. "If we don’t invest now we will have the problem" of a supply crunch in the future when demand picks up, he said.
Royal Dutch Shell swings to $2.8 billion loss
Royal Dutch Shell on Thursday swung to a $2.8 billion loss, as the tumble in oil prices hurt the value of inventories that it has yet to sell. Shell said adjusting for that impact, or what it calls current cost of supplies, its profit would have dropped 28% to $4.79 billion. Production was basically flat at 3.41 million barrels a day, but it sold oil and gas for 31% less than it did a year ago. Demand for Shell products decreased throughout its business, with chemical product volumes dropping 20%. Shell also recorded net one-off gains of $897 million, mostly on asset sales. Stripping out those gains, and the Hague-based oil giant missed analyst profit estimates by around $200 million.
Shell shares moved marginally higher in late morning trade in London. CEO Jeroen van der Veer called the results "satisfactory" given the pressure on oil and gas demand. He said the focus will be on paying progressive and competitive dividends -- 40 cents a share for the fourth quarter, and 42 cents for the first quarter of 2009 -- and making significant investments for future profitability. The fourth quarter dividend is up 11% from the year-earlier quarter, and the planned first-quarter dividend represents a 5% increase. The dividend news was cheered by analysts. "If the group maintains that rate of growth throughout 2009, at current exchange rates the shares will yield 7% in 2009," said analysts from U.K. brokerage Killik & Co., which kept a buy rating on the firm. Unlike rivals, Shell isn't slashing spending. Shell is looking to spend between $31 billion and $32 billion on capital in 2009, vs. the $32 billion it spent last year.
Cheap debt junkies have to go cold turkey as supply dries up
It has become a depressingly familiar tale. On Monday, the shoe chains Barratts and PriceLess filed for administration, as did Sofa Workshop and the gay retail chain CloneZone. Land of Leather and childrenswear retailer Adams, already in administration, announced a swathe of store closures. The high street is beginning to look like a smile with missing teeth. But it is not just retailers that are buckling under the weight of recession. In recent months there have been company failures in industries from oil exploration to car dealerships, newspapers and the leisure industry, including the first new racecourse in Britain for 80 years. Just as consumers became addicted to borrowing, so much of corporate Britain has become bloated by cheap debt.
Private equity firms have been widely condemned for loading debt on to the balance sheets of businesses such as Debenhams to pay themselves hefty dividends. But shareholders have also acted as cheerleaders, encouraging boards to "sweat" their balance sheet or face being condemned as poor managers. Many are also guilty of raising debt for deals at the top of the market, others with a nervous glance over their shoulder, ramping up their borrowings and handing money to shareholders to avoid being victims of a private equity takeover themselves. Like previous recessions most companies are facing a sharp drop off in demand. Unlike previous recessions the banks are at the heart of the crisis and are unwilling to lend more or even to refinance debts.
Many of Britain's companies are like junkies being forced to go cold turkey after their dealers, the banks, have suddenly cut off supplies. Figures published by accountants Deloitte yesterday showed the number of firms in administration in the fourth quarter of 2008 was up 30% on the same months in 2007. "We started to see an increase in the number of insolvencies at the beginning of last year, starting with small regional property firms," said Richard Fleming, head of restructuring at the accountants KPMG. "But we are only just starting here. In two years' time, there will be an awful lot more insolvencies. The difference between this and the previous recession is that the financial services sector is in utter turmoil. It is the repayment and refinancing of debt that is the big issue faced by corporations now." He said companies had been going under in the past few months at "hyper-speed".
The first hit have been in the front line of consumer spending. Notable casualties have included the music retailer Zavvi, furniture retailer Ilva, fashion groups MK One and Miss Sixty, which controls the Energie brand, home decor chains Fads and MFI and of course Woolworths, the collapse of which has scarred almost every high street in Britain. "Customers are short of spare money and are nervous of spending what spare money they have got – especially now that many people have fears about their jobs," said Richard Dodd at the BRC. What begins on the front line soon spreads to suppliers. That is already becoming evident in house building, which has been thrown into turmoil. The building materials group Wolseley admitted this week its debt has climbed to £3bn amid a profit slump. The company has already cut about 15,000 jobs since the middle of 2007 and is likely to need further cash if it is to survive.
The beginning of a recession at least can be characterised as a Darwinian exercise, a winnowing out of the weakest businesses. Chris Higson at the London Business School posed the question of whether the "right" companies are failing. "The first ones that go are the fragile ones, the ones that were hanging on by their fingernails," he said. "Woolworths is everyone's favourite example. No one could really understand how it had survived so long. It had lost its franchise. Its profit margin in the past few years was so low it had no margin for error." The other reason for the failure of Woolworths, Higson said, is common to many retailers. When the business was still owned by Kingfisher, it sold off its property and leased it back to Woolworths, stripping equity from its balance sheet, saddling the chain with high ongoing commitments on lease payments and offering it very little flexibility in a downturn. "Woolworths is not the only one that sold its shops and leased them back," he said. "This is very much something that has happened over the past 10 years. It is often blamed on private equity but everyone was doing it."
But the "true disaster", he said, had been the withdrawal of the banks. A 20% drop in sales would have pushed Woolworths further into loss, but in normal circumstances "it could have survived with the help of a friendly bank. Traditionally the banks have absorbed the shock of a recession but they are not now able to do that. The banks have exited the scene. There is nobody to help." In the last recession, interest rates were at 15%, making even small debts difficult to deal with. Even so, he said, there is "no doubt" that many companies are more vulnerable in this recession than in previous downturns. Recession also cuts off other sources of cash: there is little appetite in the equity markets and companies trying to sell assets are doing so at just the moment when there are few buyers. Governments are showing some willingness to step in, but resources are limited.
Some of the most highly indebted quoted companies include Sports Direct, Ladbrokes, Next and Intercontinental Hotels. "Consumer debt is so stratospheric that any business that has dependency on the consumer will have trouble," said Fleming. "We are starting to see hotel groups under pressure, travel and leisure, anything associated with the consumer." The sectors that tend to suffer are those that have high fixed costs and can't quickly be reshaped. The classic examples are airlines and hotels. XL, the third largest package holiday group, has been the first domino to fall. After the last recession, accounting firms became the largest hotel operators in the country. The head of restructuring at one large investment bank said there was some complacency among boards until Lehman Brothers went under in September. "People suddenly thought if it could happen to Lehman, it could happen to them."
Investors that specialise in buying distressed debt at a discount in the hopes of profiting from a restructuring, are looking widely – at auto parts firms, chemicals, financial services, retail, media, property and construction. "There will be very few sectors that don't get adversely affected," said Kevin Hewitt, head of FTI Corporate Finance. One of the most heavily indebted industries is house building. During the boom, builders were encouraged to use debt to expand more quickly, buying land and leveraging their return on investment. "There was a backdrop of a supply and demand imbalance, there was a low stable interest rate environment. It felt like you didn't need to make moribund returns, you could leverage up and sweat your assets," said Mark Hughes, an analyst at the City firm Panmure Gordon. "The sensible ones like Bellway or Berkeley kept a lid on it."
Oakdene Homes became the first publicly quoted house builder to file for administration last week after failing to negotiate new debt terms with its banks, which were demanding repayment. Barratt Homes and Taylor Wimpey, both involved in consolidation at the peak of the market, are shouldering the heaviest debt: Barratt has £1.4bn and Taylor Wimpey £1.5bn. The absolute number is not necessariliy the one that counts. Banking covenants are often tied to gearing – debt as a proportion of capital or assets – so even if the homebuilders continue to pay off their debts, they might still be in danger of defaulting as the value of their land falls. Hughes reckons the banks could step in by exchanging the debt for a stake in the firm, potentially seizing control.
The behaviour of the banks is also likely to limit the growth of many businesses as recession ends. Perversely, the companies that have been best managed are now having their banking facilities curbed. Bovis is having its facility cut from £220m to £160m by 2011, leaving it with less flexibility to pursue opportunities as they arise. So far it has been mostly small or medium sized firms that have gone bust. In downturns larger companies tend to turn the screws on smaller firms. But in previous recessions, large corporations have also gone down and experts think this will be no different. As it wears on, it won't only engulf badly run companies. It is not about virtue, said Higson. "When a hurricane arrives, where your house happens to be and how it is built determines whether it will collapse."
UK 'must cut spending or raise taxes,' say experts
The Government will have to raise taxes or cut spending by £20bn a year by 2015 to meet its own targets for restoring public finances, the Institute for Fiscal Studies said yesterday. In its Green Budget, the think-tank's annual report of economic policy, it predicted Government income from taxes would be significantly lower than the Treasury's forecast, as the recession takes its toll on the finances of households and companies, leading to the £20bn shortfall. "In current circumstances, the cost of doing nothing, should action be required, is larger than the cost of acting, only to find it was unnecessary and can subsequently be reversed," the report said. Even with the extra funds, public debt could take more than 20 years to get back to pre-credit crisis levels, it added.
Without painful fiscal tightening, the IFS said public net debt could rise to more than 60 per cent of GDP, way above the 40 per cent Gordon Brown set as a fiscal rule in 1997. Even if public finances evolve as the Government hopes, the fiscal squeeze will have to remain in place until the early 2030s, before debt as a proportion of income returns to below the 40 per cent target, it said. Using the Treasury's own figures, the IFS estimates the credit crunch will cost the state the equivalent of 3.5 per cent of GDP, or about £50bn in today's money, in lost tax receipts and extra spending on social security.
The think-tank described a Government at risk of losing credibility with financial markets as it raises debt to levels not seen since the Second World War in an effort to cushion against the worsening crisis. Most economists now forecast a more severe recession than the one expected by the Chancellor in November's pre-Budget report, the IFS said. Then, the Government signalled spending cuts and tax increases starting in 2010/11 and raising 2.6 per cent of national income by 2015/16. The IFS said its estimate of required extra funds amounts to about another 1.3 per cent. The body also accused Labour of repeating the actions of the Conservative governments that preceded it, further undermining Gordon Brown's claims of "no more boom and bust".
The IFS said: "The evolution of public finances since 1997 mirrors the first 12 years of Conservative government after 1979: three years of impressive fiscal consolidation, eight years of drift (masked by economic overconfidence), and then a big jump in borrowing thanks to recession and newly discovered structural weaknesses." The IFS predicts Government and Bank of England measures to stimulate the economy would allow Britain to avoid a long and deep recession but the recovery will be extremely slow. It said the Government's £37bn recapitalisation of the banking sector and the extra support announced last week could yield a profit for the taxpayer but added: "The downside risks are huge... Taxpayers are more likely to make big losses than big profits."
The Treasury has been able to fund rising public sector debt relatively cheaply because of high demand for liquid, low risk Government bonds. But the IFS warns the Government's recent loss of credibility could increase borrowing costs, leading to further tax rises or spending cuts, though it said demand for Government debt was likely to remain firm, helping keep yields relatively low. The report said Alistair Darling's 2.5 point cut in VAT was a better boost for the economy than critics claimed and could prompt people to buy 1.2 per cent more goods and services. The £20bn the Government needs to raise each year is the equivalent of 4p on income tax, or about £650 a year for each family in the UK. Alternatively, it is a sizeable chunk of a year's £111bn health budget or of the £83bn spent on education.
UK annual house prices plunge 16.6 per cent
The average price of a house is 16.6 per cent lower than this time last year after a further 1.3 per cent fall in January, according to figures published today by Britain's biggest building society. The January fall recorded by the Nationwide is lower than the 2.5 per cent slump in value seen last month, but is still well ahead of the fall of 0.4 per cent reported in November. Martin Gahbauer, the Nationwide's senior economist, said that although the quarterly trend was improving, it was "too early to say that this marks the start of a sustained improvement in the short-term trend". The latest decline, which will push more homeowners into negative equity, which is where the value of a house falls below the level of mortgage debt, leaves the average price of a typical house at £150,501, down from £153,048 in December.
Mr Gahbauer said that the number of house sales had remained poor in recent months, with mortgage approvals falling to a record low of 27,000 in November, and partial figures for December suggesting only a small improvement since then. "House purchase approvals have historically been a good lead indicator of house price movements, and we would not expect to see a stabilisation of property prices until approvals recover significantly from current levels," he said. "In the past, approvals have tended to move in line with new buyer inquiries at estate agents. More recently, however, the relationship between buyer inquiries and approvals has broken down, with buyer inquiries recovering quite strongly in recent months while approvals have shown little sign of recovery." He suggested that the failure of rising inquiries to translate into approvals may be due to an unwillingness to commit in a recessionary environment of rising unemployment.
He said that tighter lending criteria and the still high price of houses relative to earnings could also be factors. But he added: "The increasing level of inquiries suggests that activity levels have a reasonable chance of recovering from their recent lows once an end to the recession is in sight and/or the recent government interventions lead to an improvement in the availability of credit." Commenting on the figures, Howard Archer, chief UK and European economist for IHS Global Insight, said: "The housing market started off 2009 with a further marked drop in prices, and it seems set for another very difficult year given that current largely unfavourable fundamentals are likely to persist for some time to come."
Economic outlook just gets worse and worse
The world faces its worst recession since the Second World War, with the UK on course to be bottom of the international growth league among the major advanced economies, according to the latest forecasts from the International Monetary Fund. The British economy will shrink by 2.8 per cent this year, says the IMF, with dire implications for jobs, house prices and the public finances. As recently as November, the IMF forecast a relatively mild downturn of 1.3 per cent in the UK. In its latest World Economic Outlook, the IMF now sees economic activity contracting by around 1.5 per cent in the US, 2 per cent in the eurozone, and 2.5 per cent in Japan. Two of the brightest stars in the economic firmament, China and India, have seen their growth forecasts slashed, to 6.75 per cent and 5 per cent respectively. The global economy as a whole is perilously near to shrinking, with a mere 0.5 per cent growth predicted – the lowest since the 1940s. "We now expect the global economy to come to a virtual halt," said Olivier Blanchard, the IMF's chief economist.
The International Labour Organisation said global unemployment and poverty are set for a "dramatic increase" in the coming year. The UN agency added that in a worst-case scenario, recorded unemployment could rise by more than 50 million from the 2007 level to a total of 230 million, or 7.1 per cent of the world's labour force, by the end of 2009. The scale of economic decline forecast for Britain by the IMF suggests that the jobless figure would exceed three million within a year, surpassing peaks last experienced in the 1980s. Yesterday, the Institute for Fiscal Studies said Britain faces a £20bn-a-year "double whammy" of tax rises and spending cuts to restore public finances to order – it will take until 2029 for government debt to recede to levels seen before the credit crunch. It warned taxes would rise and spending would be cut whoever wins the next election.
As Gordon Brown spoke of the "deep world recession", the reports added to jitters among Labour MPs. They are starting to express concern that the Government's blizzard of initiatives are cutting little ice with the public and are urging Mr Brown to find "new language" to explain his measures. One senior Brown ally told The Independent: "He needs to use simpler language to explain the measures we are taking. He keeps repeating phrases like 'global recession', but that is too much jargon. He needs to say, 'We're facing problems. The whole world is facing problems. But we're helping to sort it out.' The average man is not going to understand our message if it contains too much economics." Opposition parties seized on the double blow to Mr Brown's efforts to reassure his MPs. George Osborne, the shadow Chancellor, said: "Gordon Brown cannot answer the simplest question of all: if Britain is well prepared as he claims, why are we facing the worst recession in the world?"
Vince Cable, the Liberal Democrats' Treasury spokesman, claimed the IMF report exposed Mr Brown's "lie" that Britain is well placed to deal with the recession, because it faces a bigger slowdown than Europe and the US. "The Prime Minister likes to pretend Britain is simply the victim of a global crisis, but many of the UK's problems are clearly home grown," he said. Alistair Darling, the Chancellor, warned of a grim start to 2009, forecasting "a lot of downsides" in the period ahead. In an interview with the New Statesman published today he insisted: "We will get through it." Stephen Timms, the Treasury minister, conceded the Government would need to revise forecasts for the public finances this spring. "Things are changing and we will need to update them when we get to the Budget," he said.
Today, Mr Brown will try to paint an upbeat picture of a post-recession Britain as Lord Carter, the Communications minister, outlines plans to make high-speed broadband available to all. In a speech in London, the Prime Minister will say the digital economy is currently worth £50bn a year in Britain alone and will grow rapidly in the future. "Even at this difficult time for the economy, we will not turn our backs on the future, we will build bridges to the future. From the digital economy to fuel-efficient cars, from pharmaceuticals to renewables, Britain must invest in the industries of the future even as we fight our way out of what the IMF has described as a 'global economic slump'." The IMF's downbeat view found ready agreement among the elite financiers and economic thinkers gathered at the World Economic Forum in Davos, Switzerland. George Soros, who "broke the Bank of England" in the ERM crisis of 1992, said the size of the problem facing the world's financial system is "significantly larger than in the 1930s".
Nouriel Roubini, professor of economics at New York University, added: "There is nowhere to hide... We have for the first time in decades a global synchronised recession. This is not your traditional minor recession." The IMF says tax cuts and public spending and borrowing boosts all over the world will be useless unless the financial system is rebooted. Its managing director, Dominique Strauss-Kahn, warned: "If there's not a restructuring of the banking system, all the money you can put into [monetary and fiscal] stimulus will just go into a black hole." The good news for the economy yesterday came from supermarket chain Asda, which confirmed it would be creating 7,000 new jobs this year with many of the positions aimed at the long-term unemployed. BSkyB also announced it would be hiring 1,000 staff after increasing its revenue in the second half of last year.
George Soros has been selling off sterling
George Soros, the billionaire investor famed for "breaking the Bank of England" has launched another assault in recent months, cashing in as Britain's currency slid. The hedge fund manager, whose assault on sterling in 1992 was seen as responsible for causing the UK to leave the Exchange Rate Mechanism and forcing up interest rates to double-digit levels, said he had been selling off sterling in recent months. It comes with experts warning that the slide in the pound over the past year has been the worst ever seen by the UK currency, and with others predicting that the UK may have to seek emergency funding from the International Monetary Fund as a result.
Speaking at the World Economic Forum in the Alpine Swiss town of Davos, Mr Soros said he had foreseen the recent fall in the pound, which has slid from over $2 against the dollar to below $1.40 in recent weeks. However, he indicated that he did not expect it to fall much further - a comment which caused sterling to leap yesterday by more than 1 per cent to almost $1.44. Mr Soros said: "I did actually have a short position in sterling and it was one of the trades I carried out. But sterling did fall from around $2 to about $1.40 and at that level the risk-reward balance is no longer compelling. I'm not saying won't fall any more though - it will continue to fluctuate" Mr Soros also warned that the scale of the current economic crisis was now potentially even worse than the Great Depression in the 1930s and urged Western nations to set up "bad banks" to absorb their toxic assets.
Japan faces up to the prospect of ‘peak fish’
Japan’s little secret is out. All over Asia, and indeed the rest of the world, people are discovering what the Japanese have known for centuries: fish is good for you. This may seem a relatively benign discovery as far as cross-border proliferation goes. But in the case of seafood, as with any finite resource, it raises awkward questions about how spoils should be divided and what happens if competing interests cannot be reconciled. Seafood has formed a crucial part of the Japanese diet for millennia, providing the main source of animal protein for a nation with little tradition of eating meat or drinking milk. Other countries have long prized an aquatic diet; some Chinese cuisine emulates the taste and texture of fish with ingenious use of vegetables. Now, as China and others become richer, they have converted dietary aspiration into reality.
Per capita consumption of fish in China has soared: from a mere 3.6kg in 1970 to 27kg in 2009. That is still some way off Japan, where people on average get through 67kg a year. But it might not be long before China catches up. Can the world sustain such an appetite? The emergence of Japan as a global force in the 1970s changed the structure of global finance and manufacturing. That foreshadowed the challenges China now presents; only China has 10 times the population of Japan . When it came to Japan’s predilection for fish, globalisation initially worked in its favour. It sent an advanced fishing fleet to trawl the world’s oceans. Japan Airlines began a lucrative trade flying freshly caught tuna from America’s Atlantic seaboard to Tokyo. Until then those fish, highly prized in Japan, were pet food in the US. Such initiatives brought the Japanese a huge variety of fish all year round.
Then the rest of the world realised it could charge Japan for fish caught in its waters. Worse, it developed a taste for the Japanese diet. Sushi has caught on from Houston to New Delhi. Consumption of fresh fish is on the rise the world over. Japan is still the world’s biggest importer by some way. It has gone from being a net exporter in 1964 to importing more than 40 per cent of its fish requirements today. But Japanese buyers are now regularly outbid in auctions. This month, two sushi bar owners, one from Hong Kong, paid $104,000 (€78,800, £73,800) for a 282lb blue-fin tuna, the highest price in years. (If the artist Damien Hirst had cut it in two, it might have been worth more still.)
Each year, about 100m tonnes of fish, 5 per cent of the 2bn tonnes of seafood biomass, are hauled from the oceans, according to a recent study published in Science. Many conservationists espouse “peak fish” theories, suggesting that catches have reached a limit, or gone beyond. That may not be true for all species. But for some it is undeniable. In November, the International Commission for the Conservation of Atlantic Tunas, which includes Japan, sliced the 2009 blue-fin quota by a fifth. Japan gobbles 90 per cent of all blue-fin. Some scientists say the quota must be halved to let stocks recover.
Japan’s fishing industry faces crisis. The number of fishermen has sunk to 200,000 from a peak of 1m. That is still too many, compared with 10,000 in Norway. Too many boats chasing too few fish have devastated fish resources. By 2006, according to the Japan Economic and Social Research Institute, more than half of Japan’s fishing grounds had dangerously low stocks. Masayuki Komatsu, professor at the National Graduate Institute for Policy Studies, says Japan needs a science-based quota system and a sustainable fisheries plan predicated on the concept that fish are a common property of the Japanese people not bona vacantia, ownerless goods belonging to whoever nets them first. Today’s policies stem from a desire to protect jobs and the notion that fishermen know better than scientists, he says.
It is far from Japan’s problem alone. Lida Pet-Soede of environmental group WWF says the Chinese taste for grouper, a top-predator reef fish, is destroying reefs and imperilling ecosystems. China is still only the world’s sixth biggest importer, producing most of its own fish, a lot on farms. Aquaculture may be part of the solution, though it is no panacea; artificially raised fish also need feeding, whether on marine products or on competing food sources, such as soyabeans. In any case, as the taste of Chinese and other emerging consumers turns to international varieties, fish stocks will come under increasing pressure.
Fish resources are devilishly difficult to manage internationally. Many fish species migrate wantonly across territorial waters. Indonesians have an economic incentive to grab juvenile tuna in their waters before they head for the high seas to be snagged – more rationally – as mature adults by stronger fishing nations. The idea of a war over fish is no more preposterous than that of a conflict over water or petroleum. Nor, sadly, is the prospect of humans irreparably damaging, even destroying, a renewable resource. Jared Diamond, an evolutionary biologist, wonders what was going through the mind of the Easter Islander who cut down the last tree, thereby condemning his civilization to virtual extinction. It may have been: “We need more research, your proposed ban on logging is premature and driven by fear-mongering,” he speculates in his book, Collapse. It would be a tragedy if we come anywhere near asking the same question about the planet’s fish.
Iceland's central bank keeps rates on hold at 18%
Iceland's central bank kept its benchmark interest rate unchanged at 18% on Thursday, as the tiny island nation struggles to respond to a financial crisis that has devastated its economy. "The main task of monetary policy at this time is to contribute to exchange rate stability and foster the appreciation of the króna," Sedlabanki said in a statement Thursday. Iceland's GDP is expected to contract by just over 10% during 2009, rather more than was estimated in November, while unemployment is likely to peak at 11% in the first quarter of 2010 and remain high longer than projected, the central bank also said. Iceland was plunged into crisis last October as its once-vibrant banking sector collapsed, sending its currency into a nosedive and unemployment soaring
Angola revenue could sink by 50 percent: World Bank
Falling oil prices and OPEC production cuts threaten to slash Angola's revenues by as much as 50 percent and hamper post-war reconstruction projects, the World Bank said Tuesday. The warning comes as the country, Africa's biggest oil producer and current OPEC president, said it may convene the 12-member cartel for an emergency meeting if the price of oil drops below 40 dollars a barrel. "In a pessimistic scenario of oil around 40 US dollars and 13 percent cut in production for the entire year, total revenues in 2009 could decline by as much as 50 percent compared to 2008," said Ricardo Gazel, senior economist at the World Bank in Angola.
"Although the savings from previous years give the government some room for manoeuvre, it is likely that under such a hard scenario, the government may decide to make dramatic budget adjustments, with substantial impact on public investment in order to avoid a drastic deterioration of fiscal and debt indicators." Around 85 percent of Angola's income comes from oil and much of the money is being invested to rebuild the country after three decades of conflict which ended in 2002. Despite the oil revenue, more than two thirds of Angola's population still lives on less than two dollars a day, although there are ambitious plans in place to tackle poverty and improve the country's terrible health record.
The government has pledged to build one million new homes for slum dwellers and ex-combatants, and more than one third of the 42-billion-dollar (32-billion-euro) spending plan has been allocated for social projects including health and education. Large investments are also being made into diversification of the country's economy, increasing productivity, mass training schemes and re-launching the once profitable agricultural sector. But now with crude at rock bottom and substantial production cuts enforced by OPEC (Organisation of Petroleum Exporting Countries) of which Angola holds the rotating presidency, Angola's double digit GDP growth is expected to come to an end and spending plans are at risk.
Oil minister Jose Botelho de Vasconcelos said OPEC, which Angola joined in 2007, was not due to meet until March but said it was "possible" the cartel could meet sooner. "If there is a sudden fall in prices, then the members of OPEC will hold a meeting," he told a local newspaper. Last month OPEC agreed to cut output from member countries by 2.2 million barrels of oil per day in a bid to push up prices which have fallen by one hundred dollars amid the global economic slowdown. "I believe that GDP growth for Angola in 2009 will be less than 6 percent, not the 11 percent the government has forecast," Angolan economist Alves da Rocha told AFP.
"And I believe that in April we will have a new budget and the public investment programme will be cut by as much as 40 or 50 percent and many social projects the government has planned will be stopped." The economic strain will be a worry for Angola's ruling MPLA (Popular Movement for the Liberation of Angola) which won a landslide victory (81.64 percent) in the September 2008 legislative elections, partly due to their ambitious social spending pledges. A presidential poll is expected later this year and President Eduardo dos Santos is hoping to extend his 29-year rule.
What Red Ink? Wall Street Paid Hefty Bonuses
By almost any measure, 2008 was a complete disaster for Wall Street — except, that is, when the bonuses arrived. Despite crippling losses, multibillion-dollar bailouts and the passing of some of the most prominent names in the business, employees at financial companies in New York, the now-diminished world capital of capital, collected an estimated $18.4 billion in bonuses for the year. That was the sixth-largest haul on record, according to a report released Wednesday by the New York State comptroller. While the payouts paled next to the riches of recent years, Wall Street workers still took home about as much as they did in 2004, when the Dow Jones industrial average was flying above 10,000, on its way to a record high.
Some bankers took home millions last year even as their employers lost billions. The comptroller’s estimate, a closely watched guidepost of the annual December-January bonus season, is based largely on personal income tax collections. It excludes stock option awards that could push the figures even higher. The state comptroller, Thomas P. DiNapoli, said it was unclear if banks had used taxpayer money for the bonuses, a possibility that strikes corporate governance experts, and indeed many ordinary Americans, as outrageous. He urged the Obama administration to examine the issue closely. “The issue of transparency is a significant one, and there needs to be an accounting about whether there was any taxpayer money used to pay bonuses or to pay for corporate jets or dividends or anything else,” Mr. DiNapoli said in an interview.
Granted, New York’s bankers and brokers are far poorer than they were in 2006, when record deals, and the record profits they generated, ushered in an era of Wall Street hyperwealth. All told, bonuses fell 44 percent last year, from $32.9 billion in 2007, the largest decline in dollar terms on record. But the size of that downturn partly reflected the lofty heights to which bonuses had soared during the bull market. At many banks, those payouts were based on profits that turned out to be ephemeral. Throughout the financial industry, years of earnings have vanished in the flames of the credit crisis. According to Mr. DiNapoli, the brokerage units of New York financial companies lost more than $35 billion in 2008, triple their losses in 2007. The pain is unlikely to end there, and Wall Street is betting that the Obama administration will move swiftly to buy some of banks’ troubled assets to encourage reluctant banks to make loans.
Many corporate governance experts, investors and lawmakers question why financial companies that have accepted taxpayer money paid any bonuses at all. Financial industry executives argue that they need to pay their best workers well in order to keep them, but with many banks cutting jobs, job options are dwindling, even for stars. Lucian A. Bebchuk, a professor at Harvard Law School and expert on executive compensation, called the 2008 bonus figure “disconcerting.” Bonuses, he said, are meant to reward good performance and retain employees. But Wall Street disbursed billions despite staggering losses and a shrinking job market. “This was neither the sixth-best year in terms of aggregate profits, nor was it the sixth-most-difficult year in terms of retaining employees,” Professor Bebchuk said.
Echoing Mr. DiNapoli, Professor Bebchuk said he was concerned that banks might be using taxpayer money to subsidize bonuses or dividends to stockholders. “What the government has been trying to do is shore up capital, and any diversion of capital out of banks, whether in the form of dividends or large payments to employees, really undermines what we are trying to do,” he said. Jesse M. Brill, a lawyer and expert on executive compensation, said government bailout programs like the Troubled Asset Relief Program, or TARP, should be made more transparent. “We are all flying in the dark,” Mr. Brill said. “Companies can simply say they are trying to do their best to comply with compensation limits without providing any of the details that the public is entitled to.” Bonuses paid by one troubled Wall Street firm, Merrill Lynch, have come under particular scrutiny during the last week.
Andrew M. Cuomo, the New York attorney general, has issued subpoenas to John A. Thain, Merrill’s former chief executive, and to an executive at Bank of America, which recently acquired Merrill, asking for information about Merrill’s decision to pay $4 billion to $5 billion in bonuses despite new, gaping losses that forced Bank of America to seek a second financial lifeline from Washington. A Treasury Department official said that in the coming weeks, the department would take action to further ensure taxpayer money is not used to pay bonuses. Even though Wall Street spent billions on bonuses, New York firms squeezed rank-and-file executives harder than many companies in other fields. Outside the financial industry, many corporate executives received fatter bonuses in 2008, even as the economy lost 2.6 million jobs. According to data from Equilar, a compensation research firm, the average performance-based bonuses for top executives, other than the chief executive, at 132 companies with revenues of more than $1 billion increased by 14 percent, to $265,594, in the 2008 fiscal year.
For New York State and New York City, however, the leaner times on Wall Street will hurt, Mr. DiNapoli said. Mr. DiNapoli said the average Wall Street bonus declined 36.7 percent, to $112,000. That is smaller than the overall 44 percent decline because the money was spread among a smaller pool following thousands of job losses. The comptroller said the reduction in bonuses would cost New York State nearly $1 billion in income tax revenue and cost New York City $275 million. On Wall Street, where money is the ultimate measure, some employees apparently feel slighted by their diminished bonuses. A poll of 900 financial industry employees released on Wednesday by eFinancialCareers.com, a job search Web site, found that while nearly eight out of 10 got bonuses, 46 percent thought they deserved more
Efficient market hypothesis is dead - for now
I have to report the sad passing of the efficient market hypothesis. The theory was officially declared dead yesterday at the World Economic Forum in Davos. There were no mourners. The announcement was made at a brainstorming session that involved many of the world's top economists, politicians and business leaders ... together with a few bankers wearing dark glasses and false beards. Asked which policy assumption had most contributed to the global financial crisis, the most popular answer by far was the belief that markets are self-correcting. (Nassim Nicholas Taleb, author of The Black Swan, said it was that markets "robustify" themselves, which amounts to the same thing ... I think.)
In recent years, the belief in efficient markets has dominated economic policy and financial regulation in the Anglo-Saxon world and increasingly across the globe. Its death, if confirmed, is a momentous event. At the very least, it will cause anguish among countless MBA graduates who have paid good money, worked long hours and consumed large quantities of cold pizza to learn about something nobody now believes in. The efficient market theory (or more precisely, the closely related efficient banks theory) has already been given a bit of a kicking by one of its greatest supporters, Alan Greenspan. The former Federal Reserve chairman has said that the big mistake he made was assuming that banks' self-interest would prevent them doing anything that would threaten their own survival.
It was a good thing Mr Greenspan wasn't at Davos yesterday. He would have been set upon. When it comes to the sins of bankers and regulators, the mood among Davos types is just as ugly as it is among the general population. John Neill, chief executive of Unipart, was given one of the day's biggest rounds of applause when he declared that bankers who were involved in developing toxic products that caused massive damage to the global economy should be punished. If you knowingly make other kinds of toxic products, you go to jail. Why should bankers be different, he asked. Regulators also came in for a battering. But the Davos consensus on what needs to be done was concerning. Asked what the top priority should be in terms of financial regulation for the forthcoming G20 meeting, half the delegates at the session said it was addressing the lack of an international regulatory framework.
This echoes the oft-repeated call by politicians, including Gordon Brown, for better international regulatory co-ordination. Yet, as Lord Turner, chairman of the Financial Services Authority, told me yesterday, international standards and better co-ordination would have made little difference to the course of the credit crisis. It would not have improved the Federal Reserve's regulation of Citigroup or the FSA's regulation of Northern Rock. Moreover, coming up with an international regulatory framework will be extremely difficult. Unlike in trade, for example, there is no treaty-based international organisation in which such a framework can be hammered out. It will take a very long time. So long, in fact, that it is unlikely to be finished before the efficient market hypothesis rises again from the dead. As it surely will.
Veteran Schmidt's wisdom of the ages
He celebrated his 90th birthday just before Christmas and still chain-smokes (13 during one recent TV interview I watched). Helmut Schmidt, the former German social democrat chancellor who is rated Germany's best politician of all time, is still bestowing his wisdom on all who care to listen.
In a recent issue of Die Zeit, the weighty weekly where he acts as publisher and regular columnist, Schmidt laid the blame for the financial crisis and global recession squarely at the door of the Anglo-Saxons – the Americans and the British. It's a view echoed by one of his successors, Angela Merkel, and her finance minister, Peer Steinbrück, for whom Schmidt is a role model.
"How can we escape a case of depression?" is or should be required reading not only in Canary Wharf and the Taunusanlage in Frankfurt but also in Whitehall and Westminster – and in Paris, Madrid, Rome and Brussels. It excoriates bankers and governments alike. It's not as if Schmidt, known as Schnauze (or, politely put, "snappy" for his ability to maul others' arguments), hates the Brits or the Yanks. Older readers may recall his decisive intervention at Labour's 1975 special conference on the then EEC referendum in which, wearing a black cap and smoking, he successfully urged the UK to stay in. He was born in and lives in Hamburg, a notably Anglophile city despite being turned to rubble by the RAF at the end of the second world war.
Franz Müntefering, the SPD chairman who likened hedge funds to locusts, this week labelled bankers "gangsters", "beatniks(!)" and "pyromaniacs".
Schmidt is equally blunt: "What we're dealing with, above all in New York and London, is a combination of high intelligence mixed with mathematical gifts, extreme selfishness and self-enrichment with an absence of sufficient power of judgment and sense of responsibility. You can name this disease: unconstrained greed." That's the bankers. "At the same time, we've seen, however, a nonchalant ignorance among governments and official bodies, an unprecedented negligence on the part of the entire political class which recklessly relied on the self-healing power of financial markets instead of intervening at the right time. That holds above all for the USA and Great Britain." So that's the politicians.
Schmidt's views on the "false god of market radicalism," an ideology he ascribes to Gordon Brown, are shared by an array of German (and other European) commentators. "Britain stares into the abyss" was a recent headline in Handelsblatt, the business daily. "Great Britain is heading in the direction of bankruptcy" that on a recent commentary in the Süddeutsche-Zeitung (SZ) newspaper that flirted with comparing GB to Iceland and began by pithily saying: "The Queen is worried." At the last EU summit, in mid-December, Merkel and her foreign minister and deputy chancellor/rival, Frank-Walter Steinmeier, distanced themselves very sharply from Brown by reminding reporters that, over the last decade, Germany had deliberately not put all its eggs in the financial services basket but continued to opt for a balanced economy – and a key role for manufacturing.
That, too, was the view of Andreas Oldag in the SZ. London's banking metropolis, he wrote, "was the golden calf around which British politicians, lobbyists and business representatives danced". It "embodied the decisive break-out of the British economy from the sick man of Europe in the 1970s to the modern services society". A strength now turned to weakness. Mainland Europe is under no illusion that the worsening financial crisis and recession will be shallower and shorter than in the UK, for which the IMF and European commission are forecasting a 2.8% contraction this year. But, mixed with a large dose of schadenfreude at the demise of a once-hectoring, lecturing know-it-all-best, it hopes it might emerge relatively healthy. Certainly not poorer, as commentators such as Howard Davies are predicting for Britain. But, then again, maybe.
What's clear, too, is that the main eurozone countries – Germany, France and Italy – are adopting different approaches to escaping a "case of depression". Sarko, like Charles de Gaulle after the second world war, is reinstating national planning and nationalisation in France, counting on state aid to fill the gap left by frozen credit markets. In rudderless Italy, suffering its fourth recession in seven years, Silvio Berlusconi is muddling through with scatter-gun aid to banks, industry and families. Germany, ruled by a conflict-ridden grand coalition ahead of September's general election, has been forced to run up, reluctantly, the biggest budget deficit since the foundation of the federal republic 60 years ago.
But what's striking is that, after being bounced by Brown (and the markets) into bank recapitalisation schemes three months ago, their stimulus packages are more proactive and far-reaching than his. There's even the sense, palpable at this week's annual meeting of Siemens, that the packages, certainly in Germany, are beginning to work. There's talk, foolish and premature though it may be, of recovery in the second half of this year. But not in Britain.
Schmidt is clear: billions for the real economy don't stand a heck of a chance without strict regulation of financial services. His Zeit article sets out a six-point plan for curbing the banking excesses that occurred and ensuring no repeat, in the likely absence of an early global agreement and prospect of a new financial architecture taking months, if not years, to put in place.
But he admits that his scheme, heavily reliant on restrictions and sanctions and designed to cut down the role of the banks and boost that of regulators, is bound to run into "refined arguments" from within the industry. And, in a memo that could be written for Downing Street, he adds: "Of course, a few market-radically inclined governments will give in to this protest, particularly as they find themselves in the unpleasant predicament of requiring the experience and expertise of the very-same wrongdoers." Out of all this argument and anxiety emerges one certain outcome: Britain will no longer be allowed to sit on the sidelines of Europe, loftily and arrogantly pushing forward its model economy and diplomatic prowess. Whoever takes power in 2010 will find the UK's place and influence in the EU and the world diminished.
The game changer
by George Soros
In the past, whenever the financial system came close to a breakdown, the authorities rode to the rescue and prevented it from going over the brink. That is what I expected in 2008 but that is not what happened. On Monday September 15, Lehman Brothers, the US investment bank, was allowed to go into bankruptcy without proper preparation. It was a game-changing event with catastrophic consequences. For a start, the price of credit default swaps, a form of insurance against companies defaulting on debt, went through the roof as investors took cover. AIG, the insurance giant, was carrying a large short position in CDS and faced imminent default. By the next day Hank Paulson, then US Treasury secretary, had to reverse himself and come to the rescue of AIG.
But worse was to come. Lehman was one of the main market-makers in commercial paper and a large issuer of these short-term obligations to boot. Reserve Primary, an independent money market fund, held Lehman paper and, since it had no deep pocket to turn to, it had to “break the buck” – stop redeeming its shares at par. That caused panic among depositors: by Thursday a run on money market funds was in full swing. The panic then spread to the stock market. The financial system suffered cardiac arrest and had to be put on artificial life support. How could Lehman have been left to go under? The responsibility lies squarely with the financial authorities, notably the Treasury and the Federal Reserve. The claim that they lacked the necessary legal powers is a lame excuse. In an emergency they could and should have done whatever was necessary to prevent the system from collapsing. That is what they have done on other occasions. The fact is, they allowed it to happen.
On a deeper level, too, credit default swaps played a critical role in Lehman’s demise. My explanation is controversial and all three steps of my argument will take the reader to unfamiliar ground. First, there is an asymmetry in the risk/reward ratio between being long or short in the stock market. (Being long means owning a stock, being short means selling a stock one does not own.) Being long has unlimited potential on the upside but limited exposure on the downside. Being short is the reverse. The asymmetry manifests itself in the following way: losing on a long position reduces one’s risk exposure while losing on a short position increases it. As a result, one can be more patient being long and wrong than being short and wrong. The asymmetry serves to discourage the short-selling of stocks.
The second step is to understand credit default swaps and to recognise that the CDS market offers a convenient way of shorting bonds. In that market the asymmetry in risk/reward works in the opposite way to stocks. Going short on bonds by buying a CDS contract carries limited risk but unlimited profit potential; by contrast, selling credit default swaps offers limited profits but practically unlimited risks. The asymmetry encourages speculating on the short side, which in turn exerts a downward pressure on the underlying bonds. When an adverse development is expected, the negative effect can become overwhelming because CDS tend to be priced as warrants, not as options: people buy them not because they expect an eventual default but because they expect the CDS to appreciate during the lifetime of the contract.
No arbitrage can correct the mispricing. That can be clearly seen in US and UK government bonds, whose actual price is much higher than that implied by CDS. These asymmetries are difficult to reconcile with the efficient market hypothesis, the notion that securities prices accurately reflect all known information. The third step is to recognise reflexivity – that is to say, the mispricing of financial instruments can affect the fundamentals that market prices are supposed to reflect. Nowhere is this phenomenon more pronounced than in the case of financial institutions, whose ability to do business is dependent on confidence and trust. That means that “bear raids” to drive down the share prices of these institutions can be self-validating. That is in direct contradiction to the efficient market hypothesis.
Putting these three considerations together leads to the conclusion that Lehman, AIG and other financial institutions were destroyed by bear raids in which the shorting of stocks and buying of CDS amplified and reinforced each other. Unlimited shorting was made possible by the 2007 abolition of the uptick rule (which hindered bear raids by allowing short-selling only when prices were rising). The unlimited selling of bonds was facilitated by the CDS market. Together, the two made a lethal combination. That is what AIG, one of the most successful insurance companies in the world, failed to understand. Its business was selling insurance and, when it saw a seriously mispriced risk, it went to town insuring it, in the belief that diversifying risk reduces it. It expected to make a fortune in the long run but it was destroyed in short order.
My argument raises some interesting questions. What would have happened if the uptick rule on shorting shares had been kept, in effect, but “naked” short-selling (where the vendor has not borrowed the stock in advance) and speculating in CDS had both been outlawed? The bankruptcy of Lehman might have been avoided but what would have happened to the asset super-bubble? One can only conjecture. My guess is that the bubble would have been deflated more slowly, with less catastrophic results, but that the after-effects would have lingered longer. It would have resembled more the Japanese experience than what is happening now. What is the proper role of short-selling? Undoubtedly it gives markets greater depth and continuity, making them more resilient, but it is not without dangers. As bear raids can be self-validating, they ought to be kept under control. If the efficient market hypothesis were valid, there would be an a priori reason for imposing no constraints. As it is, both the uptick rule and allowing short-selling only when it is covered by borrowed stock are useful pragmatic measures that seem to work well without any clear-cut theoretical justification.
What about credit default swaps? Here I take a more radical view than most people. The prevailing view is that they ought to be traded on regulated exchanges. I believe they are toxic and should be used only by prescription. They could be used to insure actual bonds but – in light of their asymmetric character – not to speculate against countries or companies. CDS are not, however, the only synthetic financial instruments that have proved toxic. The same applies to the slicing and dicing of collateralised debt obligations and to the portfolio insurance contracts that caused the stock market crash of 1987, to mention only two that have done a lot of damage. The issuance of stock is closely regulated by authorities such as the Securities and Exchange Commission; why not the issuance of derivatives and other synthetic instruments? The role of reflexivity and the asymmetries identified earlier ought to prompt a rejection of the efficient market hypothesis and a thorough reconsideration of the regulatory regime.
Now that the bankruptcy of Lehman has had the same shock effect on the behaviour of consumers and businesses as the bank failures of the 1930s, the problems facing the administration of President Barack Obama are even greater than those that confronted Franklin D. Roosevelt. Total credit outstanding was 160 per cent of gross domestic product in 1929 and rose to 260 per cent in 1932; we entered the crash of 2008 at 365 per cent and the ratio is bound to rise to 500 per cent. This is without taking into account the pervasive use of derivatives, which was absent in the 1930s but immensely complicates the current situation. On the positive side, we have the experience of the 1930s and the prescriptions of John Maynard Keynes to draw on. The bursting of bubbles causes credit contraction, the forced liquidation of assets, deflation and wealth destruction that may reach catastrophic proportions. In a deflationary environment, the weight of accumulated debt can sink the banking system and push the economy into depression. That is what needs to be prevented at all costs.
It can be done – by creating money to offset the contraction of credit, recapitalising the banking system and writing off or down the accumulated debt in an orderly manner. They require radical and unorthodox policy measures. For best results, the three processes should be combined. If these measures were successful and credit started to expand, deflationary pressures would be replaced by the spectre of inflation and the authorities would have to drain the excess money supply from the economy almost as fast as they had pumped it in. There is no way to escape from a far-from-equilibrium situation – global deflation and depression – except by first inducing its opposite and then reducing it.
To prevent the US economy from sliding into a depression, Mr Obama must implement a radical and comprehensive set of policies. Alongside the well-advanced fiscal stimulus package, these should include a system-wide and compulsory recapitalisation of the banking system and a thorough overhaul of the mortgage system – reducing the cost of mortgages and foreclosures. Energy policy could also play an important role in counteracting both depression and deflation. The American consumer can no longer act as the motor of the global economy. Alternative energy and developments that produce energy savings could serve as a new motor, but only if the price of conventional fuels is kept high enough to justify investing in those activities. That would involve putting a floor under the price of fossil fuels by imposing a price on carbon emissions and import duties on oil to keep the domestic price above, say, $70 per barrel.
Finally, the international financial system must be reformed. Far from providing a level playing field, the current system favours the countries in control of the international financial institutions, notably the US, to the detriment of nations at the periphery. The periphery countries have been subject to the market discipline dictated by the Washington consensus but the US was exempt from it. How unfair the system is has been revealed by a crisis that originated in the US yet is doing more damage to the periphery. Assistance is needed to protect the financial systems of periphery countries, including trade finance, something that will require large contingency funds available at little notice for brief periods of time. Periphery governments will also need long-term financing to enable them to engage in counter-cyclical fiscal policies. In addition, banking regulations need to be internationally co-ordinated. Market regulations should be global as well. National governments also need to co-ordinate their macroeconomic policies in order to avoid wide currency swings and other disruption. This is a condensed, almost shorthand account of what needs to be done to turn the global economy around. It should give a sense of how difficult a task it is.
THE SOROS INVESTMENT YEAR:
Positions I took were too big for ever more volatile markets
Although I positioned myself reasonably well for what was coming last year, one thing I got wrong cost me dearly: there was no decoupling between markets of the developed and developing worlds. Indian and Chinese stocks were hit even harder than those in the US and Europe. Since we did not reduce our exposure, we lost more money in India than we had made the year before. Our Chinese manager did better by his stock selection; we were also helped by the appreciation of the renminbi. I had to push very hard in my macro-account to offset both these losses and those incurred by our external managers. This had its own drawback: I overtraded. The positions I took were too large for the increasingly volatile markets and, in order to manage my risk, I could not go against the market in a big way. I had to try to catch minor moves.
That made it difficult to maintain short positions. Although I am an experienced short-seller, I got caught several times and largely missed the biggest down-draught, in October and November. On the long side, where I stuck to my guns, I lost an enormous amount of money. I was impressed by the potential in the new deep-water oilfield in Brazil and bought a large strategic position in Petrobras, only to see it decline by 75 per cent at one point in time. We also got caught in the developing petrochemical industry in the Gulf. We did get out of our strategic long position in CVRD, the Brazilian iron ore producer, in time for the end of the commodity bubble and shorted the other big iron ore groups. But we missed an opportunity in the commodities themselves – partly because I knew from experience how difficult it is to trade them.
I was also slow to recognise the reversal of fortune for the dollar and gave back a large portion of our profits. Under the direction of my new chief investment officer, we did make money in the UK, where we bet that short-term interest rates would decline and shorted sterling against the euro. We also made good money by going long on the credit markets after their collapse. Eventually I understood that the strength of the dollar was due not to people choosing to hold dollars but to their inability to maintain or roll over their dollar obligations. In a very real sense the strength of the dollar, like the fever associated with sickness, was a measure of the disruption of the financial system. This insight helped me to anticipate the downturn of the dollar at the end of 2008. As a result, we ended the year almost meeting my target of 10 per cent minimum return, after spending most of the year in the red.