U.S. Highway 90 at Raceland, Louisiana
Ilargi: The US government and the Federal Reserve indicate that they will not let a big bank fail. They also hint that the uptick rule will likely be reinstated, which is great for banks that someone might want to short (many someones want to). Moreover, the drive to change fair value rules (were they ever executed?) gets so strong that blogger Karl Denninger, who's spent months clamoring for fair value and mark-to-market, today does a 180 and argues for a suspension of the all-too-rational principle. Thinking of a career in politics? Any idea of the damage a suspension would do? I think you do, Karl.
To top off today's party cake, Ben Bernanke once more reiterates (I know that’s double) that the recession "might end this year". Now, I watched Jon Stewart dig into Jim Cramer last night. Reading Bernanke's words this morning, my first thought was that I hope The Daily Show will do a similar "timeframe truth test" of Bernanke. Shrinking Ben has made so many ridiculous claims about the economy's health and its upcoming recovery since he took over, it should be a feast for the eyes and ears.
Nevertheless, all these nutty ideas and claims, pared with a "leaked" (HA!) internal memo from Citi CEO Vikram Pandit led the markets 5%+ higher today, with financials rising over 15% on average. Problem over, right, we can all get back to business?!
Not so fast, perhaps. Two things: 1) The major US banks are still insolvent, Citibank, Bank of America, HSBC Bank USA , Wells Fargo Bank and J.P. Morgan Chase, and hiding the value of their toxic assets doesn't change that one bit. 2) Changing any banking rule, whether it's fair value (in any guise), the uptick rule, or even a Glass Steagall repeal will make no difference anymore. The losses from blind greed wagers are enormous, and we can't avoid paying them, we can only make sure we execute the payment process the best we can. Problem is, we don't, we're doing the opposite: we refuse to even start the process. How do we get away with that until now? By using the present and future ability of the taxpayer to provide the capital to make good on all the losses of the billionaires and millionaires involved in institutions deemed liable to cause systemic risk, the infamous "too large to fail" idea.
Good luck with today's earnings. You will need them, because nothing has changed in the underlying factors. The US government can't even save Citi, because the by far largest part of its assets and liabilities are outside of America. For Citi to be saved, you'd need a kind of United Nations effort. And that won't happen, because countries across the planet have far too much trouble saving their own domestic banks. If you choose to believe Mr. Pandit when he claims Citigroup is healthy and profitable, and when you choose to believe Mr. Bernanke’s statement that no big banks will be allowed to fail, godspeed to you. Do check the latest US government contingency efforts for Citi though.
I think it's all just hot air, and that Citi's fate has long since been sealed. The delay to date merely serves to allow major shareholders and bondholders to transfer more of their losses to the public. That would be you. And for you, any suspension of fair value only makes things worse. But then, by now, you must be getting used to the idea of matters getting worse every single day. A one day Wall Street rally won't change that. Banks larger than governments will always be a bad idea, and we're about to find out how bad. Relevant, from a climate change piece:
"In science the truth is out there. It's there to be discovered. In politics often the truth is whatever is expedient to this or that project,"
I would add that what is true in politics is just as much in economics.
There is so much material today, and the quality is so high, I'll leave it at this and we'll talk tomorrow.
Too big to fail? 5 biggest banks are 'dead men walking'
America's five largest banks, which already have received $145 billion in taxpayer bailout dollars, still face potentially catastrophic losses from exotic investments if economic conditions substantially worsen, their latest financial reports show. Citibank, Bank of America , HSBC Bank USA , Wells Fargo Bank and J.P. Morgan Chase reported that their "current" net loss risks from derivatives — insurance-like bets tied to a loan or other underlying asset — surged to $587 billion as of Dec. 31 . Buried in end-of-the-year regulatory reports that McClatchy has reviewed, the figures reflect a jump of 49 percent in just 90 days. The disclosures underscore the challenges that the banks face as they struggle to navigate through a deepening recession in which all types of loan defaults are soaring.
The banks' potentially huge losses, which could be contained if the economy quickly recovers, also shed new light on the hurdles that President Barack Obama's economic team must overcome to save institutions it deems too big to fail. While the potential loss totals include risks reported by Wachovia Bank , which Wells Fargo agreed to acquire in October, they don't reflect another Pandora's Box: the impact of Bank of America's Jan. 1 acquisition of tottering investment bank Merrill Lynch , a major derivatives dealer. Federal regulators portray the potential loss figures as worst-case. However, the risks of these off-balance sheet investments, once thought minimal, have risen sharply as the U.S. has fallen into the steepest economic downturn since World War II, and the big banks' share prices have plummeted to unimaginable lows.
With 12.5 million Americans unemployed and consumer spending in a freefall, fears are rising that a spate of corporate bankruptcies could deliver a new, crippling blow to major banks. Because of the trading in derivatives, corporate bankruptcies could cause a chain reaction that deprives the banks of hundreds of billions of dollars in insurance they bought on risky debt or forces them to shell out huge sums to cover debt they guaranteed. The biggest concerns are the banks' holdings of contracts known as credit-default swaps, which can provide insurance against defaults on loans such as subprime mortgages or guarantee actual payments for borrowers who walk away from their debts. The banks' credit-default swap holdings, with face values in the trillions of dollars, are "a ticking time bomb, and how bad it gets is going to depend on how bad the economy gets," said Christopher Whalen , a managing director of Institutional Risk Analytics, a company that grades banks on their degree of loss risk from complex investments.
J.P. Morgan is credited with launching the credit-default market and is one of the most sophisticated players. It remains highly profitable, even after acquiring the remains of failed investment banker dealer Bear Stearns , and says it has limited its exposure. The New York -based bank, however, also has received $25 billion in federal bailout money. Gary Kopff , president of Everest Management and an expert witness in shareholder suits against banks, has scrutinized the big banks' financial reports. He noted that Citibank now lists 60 percent of its $301 billion in potential losses from its wheeling and dealing in derivatives in the highest-risk category, up from 40 percent in early 2007. Citibank is a unit of New York -based Citigroup . In Monday trading on the New York Stock Exchange , Citigroup shares closed at $1.05 .
Berkshire Hathaway Chairman Warren Buffett , a revered financial guru and America's second wealthiest person after Microsoft Chairman Bill Gates , ominously warned that derivatives "are dangerous" in a February letter to his company's shareholders. In it, he confessed that he cost his company hundreds of millions of dollars when he bought a re-insurance company burdened with bad derivatives bets. These instruments, he wrote, "have made it almost impossible for investors to understand and analyze our largest commercial banks and investment banks . . . When I read the pages of 'disclosure' in (annual reports) of companies that are entangled with these instruments, all I end up knowing is that I don't know what is going on in their portfolios. And then I reach for some aspirin."
Most of the banks declined to comment, but Bank of America spokeswoman Eloise Hale said: "We do not believe our derivative exposure is a threat to the bank's solvency." While Bank of America advised shareholders that its risks from these instruments are no more $13.5 billion , Wachovia last year similarly said it could overcome major risks. In reporting a $707 million first-quarter loss, Wachovia acknowledged that it faced heavy subprime mortgage risks, but said it was "well positioned" with "strong capital and liquidity." Within months, losses mushroomed and Wachovia submitted to a takeover by Wells Fargo , which soon got $25 billion in federal bailout money.
Trading in credit-default contracts has sparked investor fears because they are bought and sold in a murky, private market that is largely out of the reach of federal regulators. No one, except those holding the instruments, knows who owes what to whom. Not even banks and insurers can accurately calculate their risks. "I don't trust any numbers on them," said David Wyss , the chief economist for the New York credit-rating agency Standard & Poor's . The risks of these below-the-radar insurance policies became abundantly clear last September with the collapse of investment banker Lehman Brothers and global insurer American International Group , both major swap dealers. Their insolvencies threatened to zero out the value of billions of dollars in contracts held by banks and others. Until then, "we assumed everyone makes good on the contracts," said Vincent Reinhart , a former top economist for the Federal Reserve Board .
Lehman's and AIG's failures put in doubt their guarantees on hundred of billions of dollars in contracts and unleashed a global pullback from risk, leading to the current credit crunch.The government has since committed $182 billion to rescue AIG and, indirectly, investors on the other end of the firm's swap contracts. AIG posted a fourth quarter 2008 loss last week of more than $61 billion , the worst quarterly performance in U.S. corporate history. The five major banks, which account for more than 95 percent of U.S. banks' trading in this array of complex derivatives, declined to say how much of the AIG bailout money flowed to them to make good on these contracts. Banking industry officials stress that most of the exotic trades are less risky — such as interest-rate swaps, in which a bank might have tried to limit potential losses by trading the variable rate interest of one loan for the fixed-rate interest of another.
In their annual reports to shareholders, the banks say that parties insuring credit-default swaps or other derivatives are required to post substantial cash collateral. However, even after subtracting collateralized risks, the banks' collective exposure is "a big, big number" and a matter for concern, said a senior official in a banking regulatory agency, speaking on condition of anonymity because agency policy restricts public comments. In their reports, the banks said that their net current risks and potential future losses from derivatives surpass $1.2 trillion . The potential near-term losses of $587 billion easily exceed the banks' combined $497 billion in so-called "risk-based capital," the assets they hold in reserve for disaster scenarios. Four of the banks' reserves already have been augmented by taxpayer bailout money, topped by Citibank — $50 billion — and Bank of America — $45 billion , plus a $100 billion loan guarantee.
The banks' quarterly financial reports show that as of Dec. 31 :
— J.P. Morgan had potential current derivatives losses of $241.2 billion , outstripping its $144 billion in reserves, and future exposure of $299 billion .
— Citibank had potential current losses of $140.3 billion , exceeding its $108 billion in reserves, and future losses of $161.2 billion .
— Bank of America reported $80.4 billion in current exposure, below its $122.4 billion reserve, but $218 billion in total exposure.
— HSBC Bank USA had current potential losses of $62 billion , more than triple its reserves, and potential total exposure of $95 billion .
— San Francisco -based Wells Fargo , which agreed to take over Charlotte-based Wachovia in October, reported current potential losses totaling nearly $64 billion , below the banks' combined reserves of $104 billion , but total future risks of about $109 billion .
Kopff, the bank shareholders' expert, said that several of the big banks' risks are so large that they are "dead men walking." The banks' credit-default portfolios have gotten little scrutiny because they're off-the-books entries that are largely unregulated. However, government officials said in late February that federal examiners would review the top 19 banks' swap exposures in the coming weeks as part of "stress tests" to evaluate the institutions' ability to withstand further deterioration in the economy. Representatives for Citibank, J.P. Morgan and Wells Fargo declined to comment. Hale, the Bank of America spokeswoman, said that the bank uses swaps as insurance against its loan portfolio — they "gain value when the loans they are hedging lose value."
She said that Bank of America requires thousands of parties that are guarantors on these insurance-like contracts to post "the most secure collateral — cash and U.S. Treasuries, minimizing risk roughly 35 percent." The collateral is adjusted daily. Bank of America's report of an $80.4 billion exposure doesn't count the collateral and "also assumes the default of each of the thousands of counterparty customers, which isn't likely," Hale said. Counterparties are the investors on the other side of the deal, often other banks or investment banks. In response to questions from McClatchy , HSBC spokesman Neil Brazil said that the bank closely manages its derivatives contracts "to ensure that credit risks are assessed accurately, approved properly (and) monitored regularly."
How much of Citigroup could the FDIC actually take over?
FDIC chairman Sheila Bair doesn't think a full government takeover of Citigroup and other multinational financial institutions is practical or even possible. Here are her reasons, as summarized by Pete Davis: 1. The legal authority to take over large banks does not currently extend to multinational financial conglomerates; 2. The FDIC lacks the funding to conduct such a massive bailout; 3. Other countries have regulatory oversight of these financial conglomerates too, and they may object to a U.S. takeover.
This made me curious as to how much of Citigroup was a domestic commercial bank that the FDIC could take over, and how much was multinational financial stuff outside the FDIC's jurisdiction. So I took a look at the balance sheet from Citi's new 10K (with numbers as of Dec. 31, 2008). First, there's the division between Citigroup and Citibank. Citigroup has assets of $1.938 trillion, and liabilities of $1.797 trillion. Citibank has assets of $1.227 trillion and liabilities of $1.145 trillion. So right there, about 36% of the company's assets and liabilities are outside the bank.
Then there's the bank itself. Its balance sheet separates deposits in U.S. offices, which are insured by the FDIC, from deposits in offices outside the U.S., which aren't. Of $755 billion in deposits, $241 billion are in the U.S. and $515 billion outside (the numbers don't add up because I'm rounding). The first striking thing there that Citi's U.S. banking operation just isn't all that big: J.P. Morgan Chase has $722 billion in U.S. deposits (and $287 billion outside the country). Washington Mutual, which was not deemed by regulators to be too big too fail, had $182 billion in deposits, in the same territory as Citi's U.S. bank.
The second is that if Citibank's overall business breaks down along domestic/foreign lines pretty much as deposits do (which probably isn't quite the case, but close enough), that gets you to $392 billion in assets and $365 billion in liabilities. That's the part of Citigroup that the FDIC has the authority to take over. I bet the FDIC could handle it, at least if it gets the new $500 billion credit line it wants from Congress. But this would leave an entity (or entities) with about $1.5 trillion in assets and $1.4 trillion in liabilities to be taken over by foreign governments or fail in pretty much the same unruly manner that Lehman Brothers did.
To repeat: Citigroup has liabilities of $1.797 trillion. The deposits that the FDIC has some responsibility for (up to $250,000 per depositor) add up to $241 billion. So we have this reasonably sensible system for winding down troubled banks, but when it comes to the most troubled big banking company in the country, said system only covers a fraction of the overall operation. Which leads to a couple of conclusions: 1. I get why the administration is so reluctant to take over Citi completely. 2. I don't get why we all (I'm including myself in this) thought it was okay to allow the creation and growth of gigantic financial companies for which we had absolutely no plan for winding down in case of trouble.
Ready for the Worst at Citigroup
Hot on the heals of the February restructuring that gave the U.S. government 36% of Citigroup, more plans are being hatched to stabilize the bank, according to the Wall Street Journal. It's all off-the-record stuff with no sources named, and it's supposedly worst-case scenario planning -- just in case something unexpectedly bad happens. No one is saying they expect something bad to happen. The unnamed U.S. officials just want to be ready.
Meanwhile, Citi CEO Vikram Pandit tried to reassure his staff Monday that everything is fine, except the bank's share price of $1 and change. Citi's worth much more than that, according to Pandit, and the bank has been profitable in the first two months of 2009. So don't read too much into all this chatter about another rescue initiative. It's all good. If there was something to tell, you can rest assured that you'll find out eventually. You know, after it's been done and the government completely controls Citi and whatever shares you own are worth even less.
Forgive me for being pessimistic, but this bank doesn't exactly inspire confidence these days. Traders on our sister site, Stockpickr.com, say Citi's stock is no better than a lottery ticket. In fact, one investor said it's more like a discarded scratch-off lottery stub that shows it's already a loser. So it's not just me, folks. If the government thinks it's wise to be ready for the worst, investors should be too.
U.S. Weighs Further Steps for Citi
Regulators Plan for Contingency if Problems Grow at Wall Street Bank
Barely a week after the third rescue of Citigroup Inc., U.S. officials are examining what fresh steps they might need to take to stabilize the bank if its problems mount, according to people familiar with the matter. Federal officials describe the discussions, which are wide-ranging and preliminary, as "contingency planning." Regulators are trying to ensure that they are prepared if Citigroup takes a sudden turn for the worse, which they aren't expecting, these people say. Citi executives said they haven't detected signs of corporate clients or trading partners withdrawing their business, even though the New York company's shares are hovering near $1 apiece -- closing Monday at $1.05 on the New York Stock Exchange. Citigroup says it has a strong liquidity position and that its capital levels are among the highest in the banking industry.
The Citigroup discussions come as U.S. officials are conducting "stress tests" on the largest banks to determine their long-term viability under tough economic scenarios. Banking regulators and Treasury officials called Citigroup executives over the weekend amid rumors about the discussions, according to people familiar with the matter. They said the talks were geared toward future planning and that no new rescue was imminent. Citigroup CEO Vikram Pandit issued a memo to employees Monday as the company's shares hovered above $1, arguing the current price does not reflect the company's capital position and earnings power. Read the memo. The discussions include the Treasury Department, Office of the Comptroller of the Currency, Federal Reserve and Federal Deposit Insurance Corp. The FDIC backs many of Citigroup's deposits in the U.S., as well as a large amount of new debt issued by the firm.
Regulators say the planning should be seen as a normal function of government during a financial crisis. One possible future step could involve creating a "bad bank" to take distressed assets off the balance sheet of Citigroup or other troubled financial institutions. Differing approaches are still being considered. Treasury officials already are developing a public-private partnership to tackle that problem more broadly, and the two concepts could either run parallel or be merged. Following the latest round of government assistance, announced Feb. 27, taxpayers will own as much as 36% of Citigroup's common shares. Government officials are hopeful that the steps already taken will give Citigroup time to steady itself, but they realize that global financial markets are jittery about the company's prospects.
Last week, shares of banks fell to their lowest levels in decades, as broad stock and bond markets tumbled. In the credit-default-swap market, the cost of insuring against defaults by financial institutions is soaring. That reflects sagging confidence despite repeated bailouts of financial companies from banks to insurer American International Group Inc. Also complicating matters, U.S. officials don't have a template for winding down a company of Citigroup's size and complexity, which Federal Reserve Chairman Ben Bernanke made clear at a Senate hearing last week. "I'd like to challenge the Congress to give us a framework, where we can resolve a multinational complicated financial conglomerate like Citigroup, like AIG, or others, if that became necessary," Mr. Bernanke told the Senate budget committee.
Patience on Capitol Hill for repeated bailouts is growing thin. Sen. Richard Shelby of Alabama, the ranking Republican on the Senate banking committee, described Citigroup as a "problem child" in a television appearance Sunday, adding that some troubled banks need to be shut down. The Obama administration is trying to counter criticism that its efforts to stabilize financial markets have been unsuccessful. In a private meeting Monday night with House Democrats, Treasury Secretary Timothy Geithner said the administration's efforts were working, and said policy makers had "done more in weeks" to address problems than other countries had done in years, according to a senior House aide who attended the meeting.
Moody's Identifies 283 US Firms at Risk of Default
Moody's Investment Services, in a bid to jump ahead of the curve on corporate bankruptcies, has published a list of speculative-grade companies with the greatest risk of defaulting. The Bottom Rung is Moody's answer to those that have criticized the ratings agencies for being too slow in missing the credit problems that have plagued U.S. companies and have been responsible for the global economic downturn. The list provides ample evidence of a severe default cycle with 283 speculative-grade issuers included, compared with 157 a year ago. Of the 283 companies listed, nearly half belong to the media, automotive, retail, manufacturing and gaming industries. Moody's said that more than 23% of all U.S. speculative-grade companies are on the Bottom Rung list, compared with 9% two years ago.
Among the media companies listed as probable defaults are Sirius XM, Charter Communications, Spanish Broadcasting System, Radio One and Univision. It comes as no surprise that General Motors, Ford and Chrysler are featured on the list as well, in addition to several other auto-related companies including American Axle & Manufacturing, Cooper Tire & Rubber, Lear and Visteon. Retailers have been especially hit hard with the drop in consumer spending, with several names already closing shops amid bankruptcy, including Circuit City, Mervyn's and KB Toys. Moody's cites Bon-Ton Stores, Blockbuster, Rite Aid, Michael's Stores, Duane Reade and Harry & David, among others, as those with a speculative grade rating in danger of defaulting.
Champion Enterprises was among those manufacturing stocks on Moody's the Bottom Rung, while MGM Mirage and Harrah's Entertainment were among the gaming industry companies on the list. Several other well-recognized names were included on Moody's list, including Palm, Eastman Kodak, Advanced Micro Devices, Hovnanian and Six Flags. Also included are airliners AMR Corp., UAL Corp. and JetBlue Airways. Some of the inclusions on Moody's list have done their best to argue that bankruptcy is not a looming possibility. After completing a $530 million loan infusion from Liberty Media on Friday, Sirius XM CEO Mel Karmazin said that the transactions "resolve all of the uncertainty surrounding the company's and its subsidiaries' debt maturing in 2009."
Blockbuster spokeswoman Karen Raskopf told TheStreet.com last week that the world's largest movie-rental chain does "not intend to file for bankruptcy." Additionally, Eastman Kodak told the Wall Street Journal that any speculation about whether the company is less than financially sound is "irresponsible. Kodak is financially solid, and we are taking the right actions to ensure that we remain a strong and enduring competitor," spokesman David Lanzillo said to the Journal.
Ilargi: CNBC are a TV station that seems to forget there are tapes of their shows. I see columnists questioning why Stewart went after CNBC again, but that's an easy one: Cramer denied having said to buy Bear Stearns, and Stewart knew he had. Why have Cramer call you a liar, when you can fill a very rewarding 5 minutes showing you're not, and he is instead?
Jon Stewart "corrects" Jim Cramer
Obama's gamble--Towering financial inferno?
Much of the media are following the convention of assessing President Obama's first 100 days in office. The term was first applied to new American presidents during Franklin Roosevelt's spring of 1933. But Mr. Obama may wish to note the term 100 days derives from Napoleon's escape from Elbe in March 1815, his brilliant reforming of an army, his march through France, and his final defeat by the British and the Prussians at Waterloo. It's up in the air which precedent will apply to Mr. Obama. After 50 days on the job, the average of his job approval polls according to RealClearPoltics.com is 60.3 percent - almost precisely average for such data for presidents since Richard Nixon. So the polls don't tell us much.
Ronald Reagan's and Bill Clinton's numbers generally went up from this point in their presidencies; Mr. Nixon's and Mr. Carter's went down. So the polls don't tell us much. But these polls do not yet reflect the effect on public opinion of his budget announcements. There are two likely effects: one obvious and predictable, the other more delayed and more subtle. The first is that those who are to be more highly taxed begin to know who they are. By proposing limiting charitable donations and mortgage interest deductions - along with higher marginal and capital gains rates - for the upper middle class (and in effect most of small business), he not only threatens already hard-pressed charities and churches but pulls another support out from under real estate valuations.
By going straight at the nation's investors with tax increases, he risks undermining already flagging investor confidence. All this Mr. Obama presumably already knew was the political and economic price for getting his hands on more taxpayer dollars to spend. But vastly more dangerous to the Obama presidency (and the nation) was his decision to go full steam ahead to immediately start to transform health care, fight carbon dioxide energy sources with new taxations that will increase the cost of all energy, goods and services, and increase new expensive education entitlements as part of federalizing American education. It is this decision to not postpone those multiyear, multitrillion-dollar programs until the economy and the financial system is revived that exposes Mr. Obama's presidency to a possible catastrophic meltdown in its first term.
Not only is Mr. Obama failing to focus more or less exclusively on protecting the financial system and the economy that depends on it. He is letting his ideological ardor drive him to expend both his own and his administration's attention, along with the vast new tax dollars, on those programs, rather than on the financial and economic crises. Thus, and here is his political danger: If the financial system fails (and much of the economy along with it), it will be a fair, true and politically lethal charge against Mr. Obama that he didn't do all he could as soon as he could to protect us from the catastrophe. It was this decision that shocked even some of his moderate supporters such as David Gergen, David Brooks and others who are muttering in private.
And this misjudgment is only compounded by the slow and inept start of Treasury Secretary Timothy Geithner, the man with the line responsibility to fix it, and who only this last weekend got around to nominating some his vital sub-Cabinet officials. The failure of both Mr. Obama and Mr. Geithner, in the five months since the election, to come up with a plan to deal with the toxic assets and insolvency of major financial institutions may well look even more irresponsible if the derivatives crises in fact hit the world. The great whispered-about possible crisis that causes shudders among financiers and governments around the world is what to do about the more than quadrillion (1 thousand trillion) dollar notional value of the world's derivatives (what Warren Buffet called the financial WMD, weapon of mass destruction) - if that notional number becomes crystallized, and thus real.
By comparison, the U.S gross domestic product (GDP) is $14 trillion; U.S. money supply is $15 trillion. The GDP of the entire world is $50 trillion, the real estate of the entire world is $75 trillion, the world stock and bond markets are worth about $100 trillion. The notional $1.14 thousand trillion (as reported by the Bank of International Settlements in Switzerland) only becomes real (and frightfully dangerous) if either counterparty to the derivative goes bankrupt - and if the defaulter is a major institution. Then it would start a cascade of cross-defaults that might well infect and bring down the world financial system.
It may well be that the U.S. government has put up $180 billion to sustain the solvency of AIG because of its derivatives holdings. Our government may well need to spend trillions more before this is over on other tainted institutions and hope that is enough to hold off the derivatives catastrophe. By trying to fix the financial system and the economy inattentively and with one hand tied behind his back (as he fritters away both attention and trillions on new health care and education entitlements and carbon use), Mr. Obama is betting so much more than his presidency. His willingness to take that risk is the chilling lesson of the first 50 days. Taking that risk itself is the political equivalent of a dangerously leveraged derivative.
Tim Geithner's Black Hole
Pity Barack Obama's economic advisers. The blogs are now demanding their scalps, and Treasury Secretary Tim Geithner and his colleagues face a nasty dilemma: There are no solutions to the banking crisis without extraordinary political and financial risks. Thus, they have adopted a three-pronged approach, delay, delay, delay, in the hope that somebody comes up with a breakthrough. Here's the problem: Today's true market value of the U.S. banks' toxic assets (that ugly stuff that needs to be removed from bank balance sheets before the economy can recover) amounts to between 5 and 30 cents on the dollar. To remain solvent, however, the banks say they need a valuation of 50 to 60 cents on the dollar. Translation: as much as another $2 trillion taxpayer bailout.
That kind of expensive solution could send the president's approval rating into a nose dive. Consider: $2 trillion is about two-thirds of the tax revenue the federal government collects each year. The logical alternative -- talk show hosts' solution du jour -- is to temporarily restructure or nationalize the banks and leave taxpayers alone. Remove the toxic assets, replace management and cut the too-big-to-fail financial dinosaurs into smaller, nimbler entities. Then reprivatize these smaller banks and let the recovery begin. Oh, if it were that simple. I suspect Obama's advisers would like nothing more than to dismantle an irresponsible firm such as Citigroup. They are afraid to do so, for one reason: All the big banks are connected to a potentially lethal web of paper insurance instruments called credit default swaps. These paper derivatives have become our financial system's new master.
The theory holds that dismantling a big bank could unravel this paper market, with catastrophic global financial consequences. Or not. Nobody knows, because the market for these unregulated financial derivatives, amounting potentially to over $40 trillion (by comparison, global gross domestic product is now not much more than $60 trillion), is the financial equivalent of uncharted waters. Geithner has reason to be terrified. He was part of the Henry Paulson-led team that underestimated the devastating global-contagion effect of the collapse of Lehman Brothers. Geithner won't make the mistake of underestimation again.
Geithner also knows that the mood in Congress has changed. Were a global financial brush fire to break out as a result of bank restructuring or nationalization, today's populist Congress might just let it burn. Congressional anger is likely to intensify when policymakers realize that credit default swaps demand a stream of premium payments like a life insurance policy, not just a payment due at termination. And recent signs indicate that firms such as Citigroup, in recycling their taxpayer bailout funding, may have helped other financial firms, including some in Europe, meet these payment obligations.
In addition, Geithner worries that because the troubled insurance giant American International Group (AIG) is a conduit for the banks' use of credit default swaps, a collapse of AIG (as an unintended consequence of dismantling the big banks) could be catastrophic. AIG's more than 300 million terrified holders of insurance-related investments and pension funds, who have investments totaling $20 trillion (U.S. GDP is $14 trillion), could suddenly rush for redemptions -- the equivalent of a run on a bank. Geithner would face a worldwide insurance collapse to accompany his global banking collapse. Or again, maybe not. Nobody knows.
Here's another likely Geithner fear -- that Congress forces the banks' bondholders to take a hit. So far, only stockholders have lost out because of the banking crisis. One reason for the fragility in the credit default swap market of late is that markets fear that bank bondholders, who today are protected even before U.S. taxpayers, could soon see their status change. The worry is that if even bondholders are put at risk, U.S. and foreign investors alike would stop financing all corporate America. The administration says that won't happen, but market participants believe (probably correctly) that this White House can't control Congress.
So our Treasury secretary has no choice but to talk of bank stress-testing and other tactics to buy time before the big bank bailout. Notice that the president's budget already contains a contingency fund of up to $750 billion for a future bank bailout -- a politically shrewd number that roughly matches the size of the Paulson bailout. The true cost is likely to be two or three times as much, unless some last-minute intellectual breakthrough -- a tax holiday for derivatives? -- arises. The Obama team needs to remember that we got into this mess because of a lack of financial transparency. It's time to tell the American people what the stock market already knows: that the path to recovery will probably be expensive and politically unpopular, perhaps explosively so.
This dire situation could take us all down, which is why Obama should name a proven, world-class problem-solver who is not from Wall Street as his bank workout czar. James Baker, the former Republican secretary of state and Treasury secretary, comes to mind. Other possibilities: former Democratic senators Bill Bradley or George Mitchell. Perhaps the White House should name a team. In the end, at least one thing is certain: Our present position is unsustainable. The longer we delay fixing the banks, the faster the economy deleverages, the more credit dries up, the further the stock market falls, the higher the ultimate bank bailout price tag for the American taxpayer, and the more we risk falling into a financial black hole from which escape could take decades.
Credit Cards Are the Next Credit Crunch
by Meredith Whitney
Few doubt the importance of consumer spending to the U.S. economy and its multiplier effect on the global economy, but what is underappreciated is the role of credit-card availability in that spending. Currently, there is roughly $5 trillion in credit-card lines outstanding in the U.S., and a little more than $800 billion is currently drawn upon. While those numbers look small relative to total mortgage debt of over $10.5 trillion, credit-card debt is revolving and accordingly being paid off and drawn down over and over, creating a critical role in commerce in America. Just six months ago, I estimated that at least $2 trillion of available credit-card lines would be expunged from the system by the end of 2010.
However, today, that estimate now looks optimistic, as available lines were reduced by nearly $500 billion in the fourth quarter of 2008 alone. My revised estimates are that over $2 trillion of credit-card lines will be cut inside of 2009, and $2.7 trillion by the end of 2010. Inevitably, credit lines will continue to be reduced across the system, but the velocity at which it is already occurring and will continue to occur will result in unintended consequences for consumer confidence, spending and the overall economy. Lenders, regulators and politicians need to show thoughtful leadership now on this issue in order to derail what I believe will be at least a 57% contraction in credit-card lines.
There are several factors that are playing into this swift contraction in credit well beyond the scope of the current credit market disruption. First, the very foundation of credit-card lending over the past 15 years has been misguided. In order to facilitate national expansion and vast pools of consumer loans, lenders became overly reliant on FICO scores that have borne out to be simply unreliable. Further, the bulk of credit lines were extended during a time when unemployment averaged well below 6%. Overly optimistic underwriting standards made more borrowers appear creditworthy. As we return to more realistic underwriting standards, certain borrowers will no longer appear worth the risk, and therefore lines will continue to be pulled from those borrowers.
Second, home price depreciation has been a more reliable determinant of consumer behavior than FICO scores. Hence, lenders have reduced credit lines based upon "zip codes," or where home price depreciation has been most acute. Such a strategy carries the obvious hazard of putting good customers in more vulnerable liquidity positions simply because they live in a higher risk zip code. With this, frequency of default is increased. In other words, as lines are pulled and borrowing capacity is reduced, paying borrowers are pushed into vulnerable financial positions along with nonpaying borrowers, and therefore a greater number of defaults in fact occur.
Third, credit-card lenders are currently playing a game of "hot potato," in which no one wants to be the last one holding an open credit-card line to an individual or business. While a mortgage loan is largely a "monogamous" relationship between borrower and lender, an individual has multiple relationships with credit-card providers. Thus, as lines are cut, risk exposure increases to the remaining lender with the biggest line outstanding. Here, such a negative spiral strategy necessitates immediate action. Currently five lenders dominate two thirds of the market. These lenders need to work together to protect one another and preserve credit lines to able paying borrowers by setting consortium guidelines on credit. We, as Americans, are all in the same soup here, and desperate times are requiring of radical and cooperative measures.
And fourth, along with many important and necessary mandates regarding fairness to consumers, impending changes to Unfair and Deceptive Acts or Practices (UDAP) regulations risk the very real unintended consequence of cutting off vast amounts of credit to consumers. Specifically, the new UDAP provisions would restrict repricing of risk, which could in turn restrict the availability of credit. If a lender cannot reprice for changing risk on an unsecured loan, the lender simply will not make the loan. This proposal is set to be effective by mid-2010, but talk now is of accelerating its adoption date. Politicians and regulators need to seriously consider what unintended consequences could occur from the implementation of this proposal in current form. Short of the U.S. government becoming a direct credit-card lender, invariably credit will come out of the system.
Over the past 20 years, Americans have also grown to use their credit card as a cash-flow management tool. For example, 90% of credit-card users revolve a balance (i.e., don't pay it off in full) at least once a year, and over 45% of credit-card users revolve every month. Undeniably, consumers look at their unused credit balances as a "what if" reserve. "What if" my kid needs braces? "What if" my dog gets sick? "What if" I lose one of my jobs? This unused credit portion has grown to be relied on as a source of liquidity and a liquidity management tool for many U.S. consumers. In fact, a relatively small portion of U.S. consumers have actually maxed out their credit cards, and most currently have ample room to spare on their unused credit lines. For example, the industry credit line utilization rate (or percentage of total credit lines outstanding drawn upon) was just 17% at the end of 2008. However, this is in the process of changing dramatically.
Without doubt, credit was extended too freely over the past 15 years, and a rationalization of lending is unavoidable. What is avoidable, however, is taking credit away from people who have the ability to pay their bills. If credit is taken away from what otherwise is an able borrower, that borrower's financial position weakens considerably. With two-thirds of the U.S. economy dependent upon consumer spending, we should tread carefully and act collectively.
Nobody Says Mark to Market Doesn’t Matter After GE Plunges 54% in 2009
For more than a decade General Electric Co. could easily avoid disclosing the value of its real estate and business loans. Not any more. Since Jan. 2, GE lost 54 percent on the New York Stock Exchange, mostly because shareholders are no longer willing to accept whatever the Fairfield, Connecticut-based company tells them about its finance subsidiary unless it’s based on so-called mark-to-market accounting rules. The world’s biggest maker of jet engines and power turbines told shareholders last week that 2 percent of GE Capital Corp.’s assets are being valued based on market prices. The remaining $624 billion is being carried at levels that GE, the last original member of the Dow Jones Industrial Average, established in many cases years ago, according to CreditSights Inc.
"The notion of having 98 percent opaque and 2 percent valued with clarity is something that by its very nature would make investors nervous," said Robert Arnott, founder of Research Affiliates LLC, which oversees $30 billion in Newport Beach, California and owned 481,201 GE shares as of Dec. 31. "Having some clarity on what the other 98 percent is worth is valuable." Once the world’s largest company, with a market value of almost $600 billion, GE has plummeted to $78.3 billion in New York Stock Exchange trading. The shares posted two of the three worst weekly declines since 1980 during the past month as investors speculate the deepest financial crisis since the Great Depression will cause more writedowns and losses at its finance division than the $10 billion the company anticipates.
Last week, the stock fell below $6, the price of some GE light bulbs, for the first time since 1991. Yesterday, GE rose 5 percent to $7.41. "We recognize there is a need and an opportunity to do more" to improve disclosure and transparency, GE spokesman Russell Wilkerson said in an e-mailed response to questions. GE, which will hold a five-hour meeting with investors and analysts on March 19 to discuss the finance unit’s business, follows generally accepted accounting principles, which don’t require it to mark all assets to market, according to Wilkerson. In fact, the rules in many cases forbid it, he said. GE predicts the finance unit will earn $5 billion this year, more than forecasts by analysts surveyed by Bloomberg. Goldman Sachs Group Inc. analyst Terry Darling in New York expects the finance unit to break even this year as losses from loan losses swell in commercial real estate and in Eastern Europe.
GE’s forecast reserves relative to loans of 2.5 percent this year are still "thin" relative to banks, which means raising more capital is "inevitable," according to Darling. The gap between GE and the analysts reflects differing valuations for assets in the finance division. The unit is similar in size to the sixth-biggest U.S. bank, according to an estimate by CreditSights, an independent bond research firm based in New York. Most of its loans are senior secured debt tied to assets such as aircraft. GE Capital generated 48 percent of the parent company’s $18.1 billion in profit last year. That compares with about 20 percent in the late 1980s, according to Nicholas P. Heymann an analyst at Sterne Agee, a Birmingham, Alabama-based brokerage.
He estimated in a note on March 3 that GE may need more money to cover losses of between $21 billion to $54 billion in the next several years. That would be almost as much as Merrill Lynch & Co. wrote down, according to data compiled by Bloomberg. New York-based Merrill was acquired by Bank of America Corp. of Charlotte, North Carolina. Heymann’s "analysis is flawed and produces misleading estimates," according to GE’s Wilkerson. "The transparency is what you want," said Barry James, chief executive officer of James Investment Research Inc. in Xenia, Ohio, which oversees $1.3 billion. "I don’t think anybody knows what they’re worth."
The debate over the fair-value rule, which requires companies to assess assets every quarter to reflect a market price, divides finance industry executives. Banks say the rule, also known as mark to market, requires them to report losses from falling values even if they don’t expect to incur penalties because the assets aren’t for sale. The lower valuations can force companies to raise capital to comply with federal regulations. Blackstone Group LP Chairman Stephen Schwarzman, the American Bankers Association and 65 lawmakers in the House of Representatives urged that fair-value accounting, mandated by the Financial Accounting Standards Board, be suspended last September.
William Isaac, chairman of the Federal Deposit Insurance Corp. from 1981 to 1985, has called fair value "extremely and needlessly destructive" and "a major cause" of the credit crisis. Robert Rubin, the former Citigroup Inc. senior counselor and Treasury secretary, said Jan. 27 the rule has done "a great deal of damage." Goldman Sachs Chief Executive Officer Lloyd Blankfein, Lazard Ltd. Chairman Bruce Wasserstein and Treasury Secretary Timothy Geithner support fair-value accounting. Federal Reserve Chairman Ben S. Bernanke told Congress Feb. 25 that fair value is a "good principle in general" even if accounting rulemakers have to "figure out how to deal with some of these assets" that aren’t actively traded. Securities and Exchange Commission Chairman Mary Schapiro has said mark to market wasn’t a significant factor in the current crisis.
Blaming the rule "is a lot like going to a doctor for a diagnosis and then blaming him for telling you that you are sick," Dane Mott, an analyst at JPMorgan Chase & Co., wrote in a September report. GE, which may lose its AAA ratings from Moody’s Investors Service and Standard & Poor’s, will meet with analysts this month to make good on Chief Financial Officer Keith Sherin’s promise of a "deep dive" explanation of the finance unit. The company cut its dividend for the first time since 1938 last month to preserve $9 billion in cash. "Investors need the assets broken down so they can see what’s really there," said Craig Hester, president of Hester Capital Management, which oversees about $1.1 billion in Austin, Texas. "The market cares about whether GE is being honest. In the case of GE, there is fear."
Detox for Troubled Assets: Sheila Bair
The government's plan to strip banks of troubled assets could force some firms to record large losses, but the painful purge would help restore confidence in the banking system, according to Sheila C. Bair, chairman of the Federal Deposit Insurance Corp. Bair said yesterday that the effort might require more money than the $700 billion Congress has approved to aid the financial industry, but she added that taxpayers would probably reap an eventual profit on the asset purchases. She said the greatest challenge was persuading banks and taxpayers to accept the necessity of the costly program.
"This takes courage to do, but if we don't do it, history shows that this kind of mechanism -- recognize the losses, get at the root of it and move on -- this is how you jump-start the economy. The other option, just to park those assets on the balance sheet, I don't think that gets us very far," Bair said in a discussion with Washington Post reporters and editors. The government plans to partner with private investors to buy troubled assets, in part by providing financing at low cost. Bair and other federal officials said discussions were ongoing about the appropriate extent of the federal subsidy. A larger government contribution would allow investors to pay higher prices, limiting the losses that banks would record but also exposing taxpayers to greater risk.
The administration hopes to find the right balance and announce the details within the next two weeks, possibly as soon as next week, according to people familiar with the matter. Since the early days of the crisis, plans have circulated to buy troubled assets, such as distressed mortgage loans, from banks. The Bush administration requested $700 billion from Congress to fund such a program, then instead decided to inject most of the money directly into companies. Bair said yesterday that the original plan to buy assets faltered in part because of concerns about the cost. "What the pricing looked like, what the losses would be, I think that's what stymied this effort before," she said.
Bair, who remained in office after the election as the head of the independent FDIC, said the Obama administration appeared to understand the need for the program. She said buying troubled assets would create a clear strategy for ending the government's intervention in the banking system, something investors are eager to see. The government's approach would involve investment partnerships with money from both private investors and the government. The government would establish multiple funds to compete with one another, creating a market that would determine prices. Bair calls the initiative an "aggregator bank," though Treasury officials contend that the partnerships should be called "public-private investment funds."
The funds would use that capital to borrow more money, in much the way that a home buyer makes a down payment to take out a mortgage from a bank. In this case, the loan would be likely to come from the Federal Reserve. In a theoretical example, to raise $10 million, the government and the private investors might each contribute $1 million, and then borrow $8 million from the Federal Reserve. The government and private investors also could contribute different shares. Officials said the proportions remain under discussion. The funds would use the money to buy toxic assets from banks. The private investors would manage the funds and determine how much to pay for the assets. That would allow the government to benefit from their expertise and desire to maximize profits.
The plan emerged from discussions about creating a "bad bank," in which a company's troubled assets are split off and placed in a new company, leaving behind a "good bank." Bair said the term "bad bank" was misleading because the structure of the deal should benefit both sellers and buyers. "You end up with two healthy institutions," she said. "It's not a good bank and a bad bank; it's an aggregator bank with good upside potential because it bought at good discounts and you've got a clean balance sheet over here with an opportunity to raise private capital." Bair emphasized that banks forced to take large losses might not need more government money because, newly cleansed, they would be in position to raise money from private investors. She said the size of the write-downs actually could be a positive, by establishing that banks are free of their problems.
"The thing that really makes people gulp about this is the size of the hole, but we view that as a strength and not a weakness," she said. Other banks could be forced to raise money from the government. And she said it was possible that some banks would take losses too large to survive. A key issue that has derailed past plans to buy troubled assets is the large gap between the prices banks consider fair and what investors are willing to pay. Bair said part of that gap reflected the cost of borrowing money, because fear continues to hang over the financial markets. She said the government can eliminate that portion of the difference by providing low-cost financing. "One of the reasons that prices are distressed right now is because of the lack of financing to make purchases," Bair said. "The government, by providing low-cost funding, it will help to tease out that liquidity premium from the pricing and hopefully get the pricing a little higher."
Even so, the losses faced by banks could be steep, raising the question of how many banks will be willing to participate. The government already has made it easier for banks to borrow money and has provided banks with fresh capital. Some banking executives have questioned why they should sell assets at a loss rather than simply hold them and wait for prices to improve. General Electric's finance arm, which had been seeking to sell some commercial loans, is no longer looking for buyers. Morgan Stanley also decided not to sell commercial and subprime mortgages it had once considered selling.
Here Is What's Really Wrong With Sheila Bair's Bad Bank
The key to making the bad bank work is the gap between private interest rates and government interest rates, Sheila Bair argues in a revealing interview with the The Washington Post today. Bair says the "bad bank" would buy troubled assets at levels above what the market could pay because the costs of financing by the government are much lower than those by private investors. This is undoubtedly true. The question is whether or not this will be as effective as Bair hopes.
First, let's clear away all the confusing nomenclature. Bair likes to call it an "aggregator bank." Others prefer the term "public-private partnership" because they think they will be able to get private investors to invest alongside the government in the troubled assets purchased from financial institutions. Whatever you want to call it, and however it is actually managed, the idea is the same: have a government entity buy up assets from banks at prices above what they could get on the market. The banks would take some losses because they still have the assets marked at unrealistically high levels, but not as much as they would if forced to sell them privately.
Bair thinks the cost of financing purchases is at the heart of the difference between what banks think their assets are worth and what investors are willing to pay. She said the government can eliminate that portion of the difference by providing low-cost financing. "One of the reasons that prices are distressed right now is because of the lack of financing to make purchases," Bair tells the Washington Post. "The government, by providing low-cost funding, it will help to tease out that liquidity premium from the pricing and hopefully get the pricing a little higher." The biggest potential stumbling block is whether or not the difference in borrowing costs is enough to bridge the gap.
There are plenty of warning signs it won't be. If a bank holds on its books a mortgage backed security at 89 cents on the dollar that the market prices at 60 cents on the dollar, the gap is far too broad to be bridged by this kind of borrowing cost arbitrage. Even if the government paid the full borrowing cost difference to a bank, and let's say that was as high as 1500 basis points, the bank would have to huge losses on the sale. Many banks may be in such poor financial health that taking such losses could render them insolvent or below regulatory capital requirements.
Why doesn't Bair see this as a problem for her bad bank plan? On the one hand, she doesn't understand the severity of the problem at banks (which is frightening for someone in her position). On the other, it seems that Bair, like so many top officials in the Washington, is operating under the conviction that toxic assets are really worth much more than anyone is actually willing to pay for them. But since many bankers believe the very same thing, they'll be unwilling to part with the assets except at highly elevated prices. So we have a kind of dangerous contest where the bad assets will wind up in the hands of whoever is most confident the market is mispricing the assets.
Bernanke: We need improvements to fair value rules
"Audit regulators need more mark-to-market accounting guidance"
Federal Reserve Chairman Ben Bernanke on Tuesday argued that regulators should identify the weak parts of controversial mark-to-market accounting rules, which require daily revaluing of assets, and try to make some improvements. "We all acknowledge that in periods like this when some markets don't exist or are highly illiquid that the numbers that come out can be misleading or not informative," Bernanke said at a Council on Foreign Relations event in New York. "We need to provide more guidance to financial institutions about what are reasonable ways to address the valuation of assets that are traded at all in highly problematic markets."
Also known as "fair value" rules, mark-to-market is an accounting methodology that requires banks and other corporations to assign a value to a financial product, such as a mortgage security, based on the current market price for the product or similar product. However, the market for troubled mortgages securities and other illiquid assets owned by banks have frozen up, making valuation of these securities more difficult. Proponents of eliminating or adjusting mark-to-market rules argue that changes could help restore confidence in the overall economy by propping up the value of banks, which would expand lending again as a result. However, supporters contend that keeping the methodology intact is necessary because shareholders deserve to understand the troubled state of financial institutions.
Bernanke did not provide details about what kind of changes he would like to see to mark-to-market rules. Lawmakers on Capitol Hill will be considering alternatives at a House securities Subcommittee committee hearing Thursday to examine the regulations. One possible alternative would allow banks to develop a model and analysis of what they believe the illiquid assets are worth and what they forecast the securities will be worth in the following quarter. The financial institution would also be required to explain what a bid for that asset would be worth if sold today. As part of this measure, banks could say a particular asset is worth $80 based on their analysis, forecast it will be worth $90 next quarter, and it could be sold immediately for $50.
Big banks will not be allowed to fail, Bernanke says
Federal Reserve Board Chairman Ben Bernanke stressed Tuesday that major financial institutions would not be allowed to fail given the fragile state of financial markets and the global economy. In a speech in Washington, Bernanke repeated that a sustainable economic recovery will "remain out of reach" until the banking sector is stabilized. "In particular, the continued viability of systemically important financial institutions is vital to this effort," Bernanke said in a speech to the Council of Foreign Relations. "We have reiterated the U.S. government's determination to ensure that systemically important financial institutions continue to be able to meet their commitments," Bernanke said.
Some senior Republican members of Congress and even one president of a regional Fed bank are calling for the government to pull back from assisting a large financial institution. They are worried that the government is throwing good money after bad in propping up these troubled institutions, including Citigroup and American International Group. "Close them down, get them out of business. We've got to bury some big ones and send a strong message to the market," Sen. Richard Shelby, the ranking Republican on the Senate Banking Committee, said on ABC News over the weekend. Bernanke's comments could be viewed as a forceful response against that idea.
Bernanke met with President Obama and his top economic advisors on Monday behind closed doors to discuss the economic outlook and the financial market crisis. The Obama team has yet to spell out important details of how a public-private partnership will remove toxic assets, primarily mortgage securities, off the balance sheets of banks. Administration officials said the details could come within a few weeks. White House spokesman Robert Gibbs said Obama is pleased with the coordination between Treasury and the Fed in response to the crisis.
The bulk of Bernanke's address included a summary of his thinking about how to improve the regulation of financial markets. He spent some time describing the idea of one systemic regulator to oversee the entire financial market looking for signs of stress. Many members of Congress want the Fed to take that new role but Bernanke played it coy and said the issue would have to be solved down the road and depended on what Congress had in mind. Bernanke said the U.S. regulators failed in their duty to maintain a stable financial system leading up to the crisis, but added that the "details of the story are complex."
Bringing back uptick rule could soothe U.S. markets
Reinstating a rule designed to slow the pace of short selling could help calm volatile markets, preventing already battered stocks from snowballing further. Short selling, where an investor bets on a declining share price, has come under increased scrutiny, with opponents arguing it has exacerbated the sharp losses seen since the onset of the global credit and economic crisis. Bringing back the uptick rule, which would only allow short sales when the last sale price is higher than the previous one, would stem a stock's decline by preventing short sellers from piling on one after another, market-watchers said.
U.S. Rep. Barney Frank, chairman of the House Financial Services Committee, said on Tuesday that he expects the Securities and Exchange Commission will restore the rule in about a month. His comments added strength to a rally in U.S. stock markets, pushing the broad S&P 500 .SPX up more than 5 percent. Critics say banks have been especially hurt by short sellers betting their stocks have further to fall, serving to drive the shares down more than warranted. "If there's no uptick rule, the short selling can become overwhelming," said Bill Rhodes, founder and chief investment strategist at Rhodes Analytics in Boston. "When you get a tidal wave of pessimism, everybody wants to short, and what the uptick rule does is it creates a queue so you have to get in a line to do it."
The SEC repealed the uptick rule in 2007 because the agency found that changes in trading strategies made it ineffective. Since then, the world economy has unraveled as massive bank losses and write-downs have pummeled confidence and changed the landscape of the financial system; shares of major banks such as Bank of America have fallen to single digits and Citigroup has traded below $1. Federal Reserve Chairman Ben Bernanke has said in Congressional testimony that the SEC was looking at restoring the rule and that the measure might have had some benefit if it had been in effect in the current crisis. "I believe that what happened is a lot of things have been done the last few years which are fine for stable markets, but the real test comes when markets are unstable," said Subodh Kumar, chief investment strategist at Subodh Kumar & Associates in Toronto.
"Taking out the uptick rule during a time of stress exacerbates things." Following the collapse of Lehman Brothers and the government bailout of American International Group, some pundits and corporate executives blamed the market turmoil on short selling, a process which involves selling a borrowed stock in the hopes of buying it back at a cheaper price. Regulators responded by imposing a temporary ban on shorting financial stocks in late September, but markets continued to dive. That proves that imposing such rules have no effect on prices, said Scott Jacobson, chief investment strategist at Capstone Sales Advisors, in New York, who said the uptick rule would not calm markets as it would create an "artificial friction."
"Let's just say that the short seller is correct and the price should be lower. If you prevent that price from going lower through some artificial means, it will have to go there at some point in the future," said Jacobson. Whether bringing back the rule would help, analysts said the discussion by prominent policy makers signals it is not something to be taken lightly. "Bernanke is a person who's very careful with his words. On top of that, central bankers are known for being relatively obtuse for good reason," said Kumar, who favors reinstating the rule. "So when we put those two things together, and he specifically says that it is something to look at, in my opinion, that's more than just off-hand comments."
IMF Sees ‘Great Recession’ as Global Economy Shrinks
The International Monetary Fund expects the global economy to contract this year and the slump will be the worst "in most of our lifetimes," Managing Director Dominique Strauss-Kahn said. The global financial crisis that has slashed international trade can now be termed the "Great Recession," Strauss-Kahn said in a speech to African central bank governors and finance ministers in Dar es Salaam, Tanzania today. "The IMF expects global growth to slow below zero this year, the worst performance in most of our lifetimes," Strauss- Kahn said. "Continuing deleveraging by world financial institutions, combined with the collapse in consumer and business confidence is depressing domestic demand across the world."
The IMF had forecast in January that the global economy would expand 0.5 percent this year. The World Bank said in a March 8 report that the international economy was likely to shrink for the first time since World War II, and trade will decline by the most in 80 years. European governments from Dublin to Athens have committed more than 1.2 trillion euros ($1.5 trillion) to protect their banking systems and leaders pledged to spend a combined 200 billion euros to try and lift their economies out of the worsening slump. The U.S. is spending $787 billion on an economic stimulus package to revive its economy. The IMF is aiming to double its resources to $500 billion to better address the crisis, with Japan already pledging an extra $100 billion.
Strauss-Kahn said he is "confident" the Group of 20 countries will agree to this goal at a summit in April. He urged better coordination between leading nations to help boost the global economy and called on rich countries to "reject protectionism, both in trade and finance." "If one crisis amongst all crises in the world that requires some coordination, it is this crisis," Strauss-Kahn said. "It’s a global crisis, so the solution can’t be implemented by one country alone." Finance ministers from the 20 largest industrialized and emerging-market economies will meet in London this weekend, as the U.S. tries to push European governments to increase spending to stimulate their economies.
Poor countries may be worst hit by a slump in economic growth and trade because poverty will increase, the IMF managing director said. That increases the threat of political conflict and even war in some regions, he added. Economic growth of about 3 percent forecast for Sub-Saharan Africa may be "too optimistic" and the global crisis threatens to wipe out economic progress in the world’s poorest continent in the past decade, Strauss-Kahn said. "We have to be concerned that the remarkable gains achieved by Africa over the last decade are now under threat," Strauss- Kahn said. "As growth around the world has almost come a halt, demand for Africa’s products is plunging."
EU backs IMF funds, shuns US spending call pre-G20
The European Union on Tuesday backed calls for a doubling of the International Monetary Fund's crisis-fighting funds to $500 billion ahead of a key meeting of the G20 group of old and new economic powers later this week. At talks among finance ministers, the 27 EU countries also said exceptional government spending to combat world recession was as much as it would envisage for now, exposing a rift with Washington, which wants more done on that front. The EU position on both IMF funding and fiscal stimulus were contained in a document that mapped out a joint EU policy stand for G20 talks taking place in Britain on Friday and Saturday to prepare for a G20 summit on the global economic crisis on April 2.
The EU document said the IMF funding increase should be split fairly among IMF members, particularly those with large currency reserves -- in line with previous calls for countries like China and Saudi Arabia to pay a sizeable share. "EU member states support a doubling of IMF resources and are ready to contribute to a temporary increase, if needed," it said. "It is essential that the IMF has appropriate financial means to assist countries particularly affected by the current crisis," it said. The document also detailed the EU's position for the G20 on economic policy, regulation and the role of key international financial institutions.
It also made clear that Europe has no intention for now of increasing the fiscal stimulus governments have announced as their contribution to the battle against global recession. Larry Summers, one of U.S. President Barack Obama's chief economic policy advisers, called on Monday for more but got a blunt "no way" from Europe. Jean-Claude Juncker, chairman of a meeting of finance ministers from euro zone countries, led the response overnight at a news conference where he said: "The 16 finance ministers (of the euro zone) agreed that recent American appeals insisting Europeans make an added budgetary effort were not to our liking, given that we are not prepared to go further in the recovery packages we have put forward."
"The EU is doing its part to support demand," the document approved by finance ministers of the euro zone and the rest of the EU on Tuesday said. "The focus should now be on swift implementation of planned fiscal stimulus packages to avoid that the recession becomes entrenched," it said. The EU fiscal stimulus is worth between 3 and 4 percent of EU gross domestic product (GDP) in all and about one third of that is discretionary spending, it said. U.S. President Obama's $787 billion stimulus plan, for 2009-10 but a bit longer in the case of tax cuts, amounts to about 5.5 percent of the GDP of the United States, where the now global crisis began two years or so ago.
Even though there is general agreement on the need to double the IMF's resources, the debate is far from straightforward. The G20's emerging market countries, notably China, want their contribution linked to bringing forward a renegotiation of voting power within the IMF, to 2011 from 2013, one G20 official told Reuters on condition of anonymity. The exception is Saudi Arabia, which has a history of being more generous to the IMF than China. Saudi Arabia is not keen to open the voting debate as it risks losing out, the source said. African countries are also concerned about reopening the debate, as they might lose gains that were made in the 2008 round of discussions, the source said.
Several countries, including the United States, have not yet even ratified the existing 2008 agreement on IMF voting rights and Russia, which was unhappy with this deal, has proposed scrapping it altogether. The 2008 agreement took two and a half years to conclude and the developed countries, all in the G20 too, are not keen to get sidetracked onto this in the middle of the crisis. Europe and the United States could foot the bill without China but they are not keen to do this because they want everybody to chip in.
EU Finance Ministers Increasingly Gloomy About 2010
Hopes for an economic upturn in Europe in 2010 are fading. EU finance ministers now believe it is "highly uncertain" that the economy will start to recover next year, according to a newspaper report. But the EU has rejected US calls for fresh stimulus measures. Europe's finance ministers have become more pessimistic about the outlook for the European economy and now believe it's "highly uncertain" the much-predicted recovery in 2010 will materialize, according to an internal paper prepared by ministers for the European Union summit on March 19, German business daily Financial Times Deutschland reported on Tuesday. In mid-January, EU Monetary Affairs Commissioner Joaquin Almunia had forecast that the economy would start to improve in the second half of 2009. But many economists now believe that the economic crisis will be far worse and last longer than expected. Europe's economies are being hit by negative growth, historically low business and consumer confidence and faltering credit cycles, the document says.
"Negative spirals between the real economy and the financial markets are worsening the situation," it adds, according to Financial Times Deutschland. "All forecasts available are extremely gloomy. This is a deep recession, deeper than at the beginning of the 1990s," Jean-Claude Juncker, who is Luxembourg's prime minister and finance minister, told reporters on Monday. Juncker is chairman of the 16 finance ministers from euro zone, which consists of the states that have adopted the euro single currency. The European Commission predicted on Jan.19 that the euro zone economy would shrink 1.9 percent this year. The European Central Bank, however, forecast last Thursday the contraction could be between 2.2 percent and 3.2 percent. Nevertheless, the EU has rejected an appeal from the US government to launch additional economic stimulus packages. "We're not prepared to increase the economic programs," Juncker said. Stimulus measures undertaken so far should first be allowed to take effect, he added.
The senior economic advisor to US President Barack Obama, Lawrence Summers, had urged Europe in a newspaper interview on Monday to pump more money into the economy to keep on boosting domestic demand and help lift the world out of recession. The EU states have spent around 3.3 to 4 percent of their combined economic output to kick-start economic growth. In January Germany introduced a €50 billion ($63 billion) program, its second since the crisis escalated in late 2008. German Finance Minister Peer Steinbrück also rejected further measures. "We should concentrate on the measures that have already been decided," he said on Monday evening. Despite the worsening outlook, the finance ministers plan to set a timetable for reducing their national budget deficits, with most planning to start consolidating in 2010, according to Financial Times Deutschland. That will help prevent financial markets from punishing highly indebted governments by imposing higher risk premiums on their government bonds.
However, the document adds that countries with especially high budget deficits should be allowed longer grace periods to reduce the deficits. This is aimed at countries such as Ireland, which is expected to post a deficit of almost 10 percent of gross domestic product (GDP) in 2009, almost three times higher than the 3-percent limit set by EU rules. The EU finance ministers are meeting in Brussels on Tuesday to discuss cuts in sales tax for certain sectors and to agree on long-term economic and budget plans for a number of EU countries, including Germany. The German government expects a budget deficit of 4 percent of GDP for 2010, but plans to reduce it back below the 3-percent limit in 2012. But not everyone's happy with the EU's crisis management. The managing director of the International Monetary Fund, Dominique Strauss-Kahn, accused the EU of poor coordination in tackling the downturn.
"When the EU finance ministers sit together they always agree that one has to take quick and aggressive action to rescue the banks. But when they go back home the process suddenly becomes very slow, much too slow in my opinion," Strauss-Kahn told German daily Süddeutsche Zeitung in an interview published on Tuesday. "The coordination on a European level isn't especially good even in good times, but when times are bad it's really bad," said Strauss-Kahn. "They all still try to find national solutions. But there are no national solutions to a global crisis. Everything is going too slowly at the moment. The crisis in Eastern Europe is getting worse from day to day." He also warned that banks around the world may face further losses as not all risks have been located yet. So far, all that was known was the losses would add up to a "large sum," he said.
Separately, the European Union said it was ready to negotiate financial aid for EU member Romania to support its troubled economy. The aid is to come from a special EU fund that has already been tapped by Hungary and Latvia. "They (Romania) are interested in the cooperation we had with Latvia and Hungary," EU Commissioner Almunia told a news conference after Monday's meeting of finance ministers. Hungary and Latvia have received €6.5 billion from the fund and Latvia €3.1 billion as part of wider aid packages backed by the International Monetary Fund (IMF) after they suffered sharp declines in their currencies as well as their bond and stock markets. Many investors have been reducing their investments in Central and Eastern Europe because they fear the region may be hit especially hard by the financial crisis. "We will need to have conversations with the Romanian authorities, with the IMF. We will need to estimate financial needs and establish a list of conditions," Almunia said. The IMF and the EU have asked Hungary and Latvia to tighten their fiscal policies as a condition for the loan. Such a demand could lead to protests in Romania, where workers have already demonstrated against hardship caused by the crisis.
Calls to relax eurozone rules rebuffed
European Union countries hoping for milder terms on which to adopt the euro faced a rebuff on Tuesday from eurozone finance ministers, who said the credibility of Europe’s monetary union required sticking to EU rules. “Given the current volatility of the situation, this would not be the right time to launch a debate on this,” said Jean-Claude Juncker, Luxembourg’s prime minister and head of the 16-nation eurozone finance ministers’ group. The ministers’ decision is likely to be interpreted in some of the EU’s central and eastern European states, especially Hungary, as a sign that richer western European countries are failing to meet the challenge of helping their new democratic neighbours in the most difficult hour of their post-communist history.
Hungary last month raised the idea of shortening the two-year spell that a eurozone candidate country is obliged to spend in the EU’s exchange rate mechanism, known as ERM-2. The proposal has won support from Thomas Mirow, president of the European Bank for Reconstruction and Development, who said last week the waiting time should be reduced on condition that a candidate country met all the EU’s rules on budgetary discipline. The ERM-2’s purpose is to establish that a country’s currency is stable enough to justify eurozone membership. But Hungary contends that the world financial crisis is so serious that some economically battered central and eastern European states need the protection offered by the eurozone sooner rather than later.
At an informal EU summit on March 1, Angela Merkel, Germany’s chancellor, suggested that she was open to reconsidering the ERM-2 process, but not to relaxing other tests for eurozone candidate countries on budget deficits, inflation, interest rates and public debt. Mr Juncker said on Monday night that the eurozone finance ministers had agreed that careful adherence to the rules was essential, because the eurozone, unlike the US and other single-currency areas, lacked a central government and fiscal authority. “We have a monetary union which doesn’t have a central state. It must be based on a set of rules. They are made up of the [EU’s governing] treaty and the stability and growth pact, and there is no question of changing the criteria or changing the amount of time that an aspirant must stay in the ERM-2, to bring it down from two years to one year,” Mr Juncker said. “The credibility of monetary union is at stake,” he declared.
Mr Juncker was speaking after discussions during which EU policymakers confirmed that Romania was seeking a EU financial aid package similar to those arranged late last year for Hungary and Latvia, its fellow former communist member-states. The EU recently doubled to €25bn the resources of a fund that helps non-eurozone EU countries address their balance of payments problems. Hungary and Latvia have both drawn on the fund. But Mr Juncker made clear that eurozone finance ministers had no appetite for a much bigger, across-the-board financial aid package for central and eastern Europe, as proposed by Hungary. “We refuse to accept that they represent one bloc. That has no longer applied since the fall of the Berlin Wall,” he said.
Fresh pessimism sweeps over credit sector
Credit market indicators – barometers of stress since the financial crisis began 18 months ago – are once more flashing red. Heightened concern over the fate of US carmakers and worries about escalating losses at banks and financial institutions and at General Electric, the largest debt issuer in capital markets, are creating a grim mood. “There has been a strong repricing of credit risk as there is a panic almost about the financial sector,” Brian Yelvington, strategist at Creditsights, says. “So far, most of the pain of the problems at financial institutions is being taken by shareholders and taxpayers, but there are real concerns that the problems will be so large that the pain will shift to holders of bonds and other securities.” Debt from financial institutions – including some of the biggest banks such as Citigroup and Bank of America – is widely held by investors ranging from pension funds to insurance companies. Concerns about the value of these holdings have pushed risk premiums higher across the board. “We are in another round of the credit crunch where the intensity is spreading,” Mary Miller, director of fixed income at T. Rowe Price, says. “There is a lot of government support still to come, but the details are uncertain. “This uncertainty is worrying investors, because they do not know if they will or will not be included in the government support.”
In the credit sphere, high yield debt has been hit hardest as companies at risk of bankruptcy are punished. Fund data for the week ending last Wednesday show that US investors pulled $911m from high yield bond funds, making it their worst week since early in the fourth quarter of 2008, according to EPFR Global. The high yield credit derivative index for US companies set a series of record wides last week, driven by worries over carmakers and a forecast by Moody’s Investors Service of a 14 per cent default rate by the fourth quarter. The Markit iTraxx Crossover index of mostly sub-investment grade European credits hit a record wide of 1,170 basis points. US high yield debt has slipped 3.3 per cent so far this month, reversing early gains for the year, according to Barclays Capital. High yield in Europe has fallen 5.1 per cent in March, reducing its gain for the year to 3.5 per cent. Not even investment grade is escaping the selling pressure. The US CDX index – which tracks 125 investment grade credits – is trading at a risk premium of 250 basis points over US Treasuries, its widest level since last December.
This comes at a time when some investors have shunned equities and plumped for high grade credit exposure. The moves in credit come, however, as equity values continue to tumble. The deteriorating mood follows the Federal Reserve’s unveiling of a credit facility designed to restore securitised borrowing for credit cards, car and student loans. The inability of the Fed’s term asset-backed securities loan facility to boost confidence in banks and for asset-backed securities is adding to pressure on financials and credit markets. “The Fed’s delayed but still quite welcome debut of the initial version of the Talf programme to try to restart consumer ABS markets elicited almost no reaction from investors, a seemingly unduly pessimistic attitude about the potential for this programme to help unclog bank balance sheets,” Ted Wieseman, economist at Morgan Stanley, says. In spite of the Fed’s various liquidity programmnes, the money market’s benchmark rate, the three-month dollar London Interbank Offered Rate, has been rising.
Libor set a low of 1.08 per cent in mid-January and has been creeping up. The move gathered pace last week, when Libor rose 5 basis points to 1.31 per cent. The upward pressure comes amid uncertainty about the banking system, with government “stress tests” looming in April and banks having to contribute more money to the Federal Deposit Insurance Corporation. The end of March also marks the conclusion of the first quarter, with banks facing further writedowns from deteriorating credit and mortgage exposure. Forward measures of Libor show the market expects no alleviation in stresses in 2009. “This key gauge of bank balance sheet pressures is thus showing that investors see no prospect for improvement this year, a very pessimistic outlook for any medium-term easing in the credit crunch,” Mr Wieseman says. The renewed pressure in Libor is weighing on interest rate swap spreads, which reflect the credit quality of banks in the inter-dealer derivatives market. The two-year swap spread is back above 80 basis points, its widest level over the two-year Treasury yield since mid-December.
US Treasuries Fall on Concern $63 Billion Sale to Deter Investors
Treasuries fell on speculation the sale of $63 billion of securities this week will deter investors and as rising stocks reduced demand for the safest assets. The losses pushed the three-year yield to the highest level since Feb. 27 before the Treasury Department sells a record $34 billion of the notes today. It will also auction $18 billion of 10-year debt tomorrow and $11 billion of 30-year bonds on March 12. Billionaire Warren Buffett said government efforts to spur growth may lead to inflation. European stocks and U.S. equity futures advanced.
"Supply and the firmer tone in equities have taken a bit of the shine from the customary safe-haven bid in Treasuries," said Richard McGuire, a senior fixed-income strategist at Royal Bank of Canada in London. "There’s an ongoing tussle between supply and the mounting deflationary forces in the economy." Ten-year note yields increased seven basis points to 2.93 percent as of 10 a.m. in London, according to BGCantor Market Data. The 2.75 percent security due February 2019 dropped 18/32, or $5.63 per $1,000 face amount, to 98 15/32. A basis point is 0.01 percentage point. Treasuries may resume a rally that pushed the 10-year yield to a record low of 2.04 percent on Dec. 18 amid a deepening recession and the prospect of asset purchases by the Federal Reserve, McGuire said. The 10-year yield may drop to 2.7 percent by the end of March, he said. A Bloomberg survey of banks and securities companies projects 2.57 percent, with the most recent forecasts given the heaviest weightings.
The extra yield investors get for buying 10-year notes in Germany instead of the U.S. is disappearing. Bunds yield four basis points more than Treasuries, narrowing from almost 90 basis points on Dec. 30. German bonds outperformed Treasuries this year as the European Central Bank cut interest rates twice after the Fed set benchmark borrowing costs to as low as zero in 2008. Investors at the Treasury’s three-year sale on Feb. 10 bid for 2.67 times the amount of debt offered. The average for the past 10 auctions is 2.42. Three-year notes yielded as much as 1.42 percent today. Today’s decline eroded gains that pushed U.S. government securities up 0.7 percent in March as of yesterday, according to Merrill Lynch & Co.’s U.S. Treasury Master index.
Europe’s Dow Jones Stoxx 600 Index advanced 0.5 percent, rebounding from a 12-year low. Futures on the Standard & Poor’s 500 Index rallied 1.6 percent. Treasuries fell 3.6 percent in the first two months of 2009, the steepest loss in five years, as President Barack Obama’s government increased borrowing to record amounts to spur growth. Obama is asking Congress to pass a budget with a record $1.75 trillion budget deficit in the year ending Sept. 30. U.S. policy makers cut the target rate for overnight loans between banks to a range of zero to 0.25 percent in December and the Fed more than doubled its assets to $1.9 trillion in the past year. Buffett said yesterday on the CNBC television network that efforts to stimulate a recovery may lead to inflation rates exceeding those in the 1970s.
"The massive money printing we have and the massive deficits we have now will make it difficult when there are some price pressures for the Federal Reserve to actually increase interest rates," Marc Faber, publisher of the Gloom, Boom and Doom Report, said yesterday on Bloomberg Television. "We’re laying the foundation here for more inflation." Investor Jim Rogers, author of the books "Hot Commodities" and "Adventure Capitalist," said yesterday the government is "borrowing stupendous amounts" that will send Treasury yields higher.
U.S. gross domestic product will shrink in the first half of the year and grow at a 1 percent pace over the second half, Ed McKelvey, senior U.S. economist Goldman Sachs in New York, wrote in a report yesterday. The U.S. consumer price index was unchanged in the 12 months ended Jan. 31, according to the Labor Department, meaning bond investors aren’t losing anything to inflation now. The index climbed to 14.8 percent in March 1980, the most since the 1940s. U.S. yields indicate inflation forecasts rose this year.
The difference between rates on 10-year notes and Treasury Inflation Protected Securities, or TIPS, which reflects the outlook among traders for consumer prices, widened to 84 basis points from nine basis points on Dec. 31. The spread has averaged 228 basis points for the past five years. Government and central bank efforts have yet to restore credit markets to where they were before freezing last year. The difference between what banks and the Treasury pay to borrow for three months, the so-called TED spread, widened to 1.09 percentage points, from 91 basis points on Feb. 10. The spread averaged 0.27 percentage point from 2002 through 2006. The London interbank offered rate, or Libor, for three-month dollar loans, climbed to 1.31 percent yesterday, from 1.08 percent on Jan. 14.
A Merrill Lynch index of U.S. company bonds rated AA by Standard & Poor’s yielded 4.42 percentage points more than Treasuries, up from last month’s low of 3.64 percentage points set Feb. 16. The index yielded 61 basis points more than Treasuries at the end of 2006. Hedge funds may cut 20,000 workers worldwide this year, a record 14 percent of the industry’s jobs, as investment losses and client withdrawals erode fees, according to New York-based Options Group, an executive-search firm. Last year, Citadel Investment Group LLC, the Chicago-based firm run by Kenneth Griffin, cut about 150 people.
For Treasury Issues, Fear Factor is Crucial
A bad week for the U.S. economy and financial system means investors will be in a more risk-averse frame of mind as they deal with this week's flood of U.S. bond sales. That is one side of the conundrum facing the market and the Treasury Department these days. Any sign the U.S. economy is improving would make it harder for the Treasury to carry out its mammoth financing plan. "On a certain level for the Treasury auctions, the more people are worried about the world, the more people want flight-to-quality assets, the better for the Treasury auction," said Jonathan Lewis, chairman of the investment committee at Samson Capital Advisors in New York.
The Treasury Department plans to sell some $148 billion this week, comprising $85 billion of short-term bills, $34 billion in three-year notes, $18 billion in 10-year notes and $11 billion in 30-year bonds. Nagging concerns that issuance may overwhelm the market are likely to remain for months given the huge amount of Treasurys that must be sold to finance the government's rescue packages and the spending program. "There is a tipping point at which there's not enough worry in the world to absorb all the Treasurys," Mr. Lewis said.
In a related twist, traders and investors also are debating the likelihood that the Federal Reserve will step in to buy U.S. Treasurys following last week's decision by the Bank of England to print extra money to buy U.K. government bonds. So far, the extra money printed by the Fed has been used to target specific corners of the credit market. If, however, the interest rates on longer-term government bonds move too high for the Fed's liking, perhaps in response to the flood of supply, the central bank has suggested it might be tempted to step into the market. Countering that argument is that Fed Chairman Ben Bernanke has made it clear that for now, he doesn't believe this is an effective policy.
Jobless Rate in U.S. Will Reach 9.4% This Year, Economists Say in Survey
The U.S. jobless rate will reach 9.4 percent this year and remain elevated through at least 2011, threatening the nation’s longer-term growth potential, a monthly Bloomberg News survey indicated. The peak in unemployment surpasses the 8.8 percent estimated last month, according to the median of 54 projections in a survey taken from March 2 to March 9. The average rate for the next two years will exceed the 25-year high of 8.1 percent reached in February, the survey shows. "Even if things become less apocalyptic it doesn’t mean the unemployment rate will come down," said Michael Feroli, an economist at JPMorgan Chase & Co. in New York. "It’ll be a long- term restraint on growth. Even when the economy gets back to normal, what’s normal is going to be defined down."
The survey shows that the Obama administration’s forecasts, submitted with its budget proposal last month, are out of kilter with those of most analysts. The White House projected the jobless rate will decline to 7.9 percent next year; a worse performance means President Barack Obama’s $787 billion stimulus plan may not prove sufficient, analysts said. The unemployment rate in February was the highest since 1983, and employers cut 651,000 workers from payrolls, the government reported last week. The U.S. has already lost 4.4 million jobs since the recession began in December 2007. Federal Reserve policy makers in January estimated U.S. long-term growth potential at 2.5 percent to 2.7 percent, with an unemployment rate of 4.8 percent to 5 percent, a level that will be exceeded for at least four years, according to the Bloomberg survey. The jobless rate averaged 5.8 percent in 2008 and 4.6 percent in 2007.
The world’s largest economy will shrink 2.5 percent this year, the most since 1946, and expand 1.8 percent next year, according to the survey median. Both figures were lower than estimated last month. As unemployment rises, more Americans won’t be able to make mortgage or car payments, choking off growth and leading to even higher joblessness, said David Rosenberg, chief North American economist at Banc of America Securities - Merrill Lynch in New York, who projected the jobless rate would reach 10 percent by the end of the year. "We are really in a vicious cycle," he said. "This problem requires a massive positive shock to aggregate demand. The fiscal package as it is constructed falls short on that score." Stimulus "has to be a lot bolder that what we have seen right now."
Rosenberg proposed the federal government give a $1 trillion interest-free loan to state and local governments, which account for 13 percent of the economy and employ about 20 million people. "This comes down to the heart and soul, the fabric, of the national economy -- cops, teachers, school custodians, firefighters, highway construction workers," he said. While estimates for overall growth weakened, projections for consumer spending improved. Purchases, which account for 70 percent of the economy, will fall at a 1.7 percent pace this quarter, less than the 2.7 percent slump predicted last month. Economists also pared the projected decline for next quarter. Discounters such as Wal-Mart Stores Inc., the world’s largest retailer, are benefiting. Bentonville, Arkansas-based Wal-Mart last week said sales at stores open at least a year rose 5.1 percent in February as customers sought its lower prices on gasoline, groceries and electronics.
Same-store sales fell at companies ranging from department- store chains Macy’s Inc. and J.C. Penney Co. to luxury retailers Neiman Marcus Group Inc. and Saks Inc. AnnTaylor Stores Corp., whose main clientele is working women, said same-store sales dropped 24 percent in the quarter ended Jan. 31. "The financial crisis and rising unemployment" especially hurt the company, Chief Executive Officer Kay Krill said in a statement last week. She also cited "extremely weak macroeconomic fundamentals, including historically low consumer confidence and a broad-based decline in consumer spending." Steps to stem the slump in growth and unclog credit markets will bust the budget. Economists anticipate the federal deficit will equal almost 12 percent of GDP this year, more than doubling last year’s 5.8 percent share.
The efforts may still fall short, resulting in "a very anemic recovery that will deliver very few jobs," said Robert Carnell, chief international economist at ING Wholesale Banking in London. He predicts the jobless rate may keep rising into 2011. "The unemployment rate will tick up slowly but surely," Carnell said. "People coming into the labor force looking for a job will find it very difficult." Companies have been paring staff further in recent weeks. Dow Chemical Co. yesterday said it’ll eliminate 3,500 workers following its merger with Rohm & Haas Co. General Motors Corp. will cut 47,000 more positions globally, and FedEx Corp., the second-largest U.S. package-delivery firm, is axing 900 jobs in addition to more than 1,100 positions pared late last year.
U.S. Second-Quarter Hiring Plans Hit Record Low
Hiring plans by U.S. employers for the second quarter dropped to a record low, indicating the labor market will remain weak through the first half of the year, according to a private survey. Manpower Inc., the world’s second-largest provider of temporary workers, said its seasonally adjusted employment gauge for April through June plunged to minus 1 from 10 in the first quarter. That’s the first time the measure has been negative, according to Manpower spokeswoman Bethany Perkins. The U.S. economy lost more than 600,000 jobs each month from December through February, the longest series of losses that big since records began in 1939. Rising unemployment is fueling cutbacks in the consumer spending that makes up about 70 percent of the economy, leaving companies hesitant to expand.
"Companies are having great difficulty forecasting consumer demand right now and that’s a key impediment," Jonas Prising, Americas president for Milwaukee-based Manpower, said in a statement. "It’s like trying to make out the image in a stained glass window with no light behind it -- it’s tough -- so employers anticipate running lean until there’s more light." Sixty-seven percent of employers surveyed said they anticipate no change in their second-quarter hiring plans, Manpower said, the same as in the previous survey. The percentage of employers expecting to hire fell to 15 percent from 16 percent in the first quarter, and those expecting to cut payrolls increased to 14 percent from 13 percent. Four percent of respondents said they don’t know what staffing will be like during the quarter.
The net employment outlook fell in three of four regions of the U.S., on a seasonally adjusted basis, led by minus 2 percent in the South. The outlook was unchanged in the Northeast. Net figures are calculated by subtracting the percentage of employers that predict a decrease in employment from those that foresee an increase. The net jobs outlook fell in seven of 13 industries during the quarter, led by a 9 percent drop in mining, compared with four industries that were forecast to see contractions in the first quarter. The industry with the greatest anticipated gain for the April-through-June period was leisure and hospitality, which increased 14 percent.
Payrolls dropped by 651,000 in February and the unemployment rate jumped to 8.1 percent, the highest level in more than 25 years, the Labor Department said last week. Consumer purchases in the fourth quarter decreased at a 4.3 percent annual rate, the most since 1980, according to figures from the Commerce Department. The Manpower survey is conducted quarterly and has a margin of error of plus or minus 0.6 percentage point in the U.S. The company interviewed 31,800 employers in the U.S. for its national outlook, while the global survey consists of responses from almost 72,000 businesses worldwide.
Lawmakers Criticize 'Questionable' TARP Spending
Citigroup Inc., JPMorgan Chase & Co. and Bank of America Corp. were criticized by U.S. lawmakers for completing "questionable" transactions after getting funds from the $700 billion financial-rescue package approved in October. Democrats on the House Oversight and Government Reform Committee today cited the three banks, which got a combined $120 billion in Troubled Asset Relief Program funds, in a memo outlining Treasury Department "failures" in overseeing the aid. Neel Kashkari, the Treasury official who administers TARP, will testify March 11 at a committee hearing on the program.
"Under existing agreements between Treasury and TARP recipient financial institutions, Treasury has broad contractual authority to scour company books in search of, among other things, waste and abuse by TARP recipients. But in practice, Treasury is not doing so," the memo said. Lawmakers criticized former Treasury Secretary Henry Paulson and the Bush administration for failing to ensure the initial $350 billion of rescue funds was used to spur lending to U.S. consumers as the nation’s economy sank into the worst financial crisis since the Great Depression. Citigroup’s $8 billion loan to Dubai’s government, a JPMorgan $1 billion investment in India and Bank of America’s $7 billion investment in China Construction Bank Corp. were called misuses of U.S. funds in today’s memo.
"Bank of America had a preexisting option to buy CCB shares, which we had always planned to exercise," Scott Silvestri, a spokesman for the Charlotte, North Carolina-based lender, said in an e-mail statement. "We had built up liquidity in anticipation of making this investment. Our investment in CCB was disclosed and has been widely reported." JPMorgan, the largest U.S. bank by market value, began a global investment plan including projects in the U.S. and abroad before TARP was enacted. "Suddenly closing our doors internationally for business would hurt our shareholders, which includes the investment made by the U.S. government," Jennifer Zuccarelli, a spokesman for New York-based JPMorgan, said in a telephone interview.
Who’s next for the Dow?
Arzu Cevik, director at Thomson Reuters Strategic Research, writes: "With Citi shares trading below $1, the first time since 1970 that a "penny stock" traded on the Dow Jones Industrial Average, it is widely expected that it will be removed from the index. "The company was added to the Dow in 1997 when it was still known as Travelers, and the last company to be removed from the Dow was AIG last September (when its stock hovered above $1) and was replaced by Kraft Foods. "It’s also expected that General Motors may be removed from the Dow. GM shares are trading slightly above $1 and there’s speculation it may be headed toward bankruptcy.
"There are other stocks in the Dow that are now a part of Wall Street’s Dollar Menu. In fact, there are currently five Dow stocks trading in the single digit range. "Who will take their place in the Dow? Mostly likely, another company whose stock is faring better or relatively better in this recessionary environment. "There aren’t too many of those but if I had to guess, I’d say it would have to be a company with a strong brand name and one that is viewed as influential. Also, one whose shares aren’t trading in the single digits. "On the technology front, Apple and Google are possible contenders. In the pharmaceuticals/biotech world, perhaps Abbot Labs, Amgen, Bristol, Genentech and Gilead Sciences could be considerations. If terms of other industries and companies, perhaps Monsanto or Amazon?
"Some might argue about the relevance of the Dow as it doesn’t accurately depict what’s happening in the markets because of its limited number of stocks and because it is price-weighted rather than market-value weighted like the S&P 500. "However, there is still a prestige factor involved in being part of this elite group and any company added would see a boost in volume and possibly price. "The top editor at The Wall Street Journal, which is published by Dow Jones, decides on changes to the index. It was reported (by Reuters) that they are currently monitoring the situation ‘closely.’
Charles Dow Must Be Rolling in His Grave
Have you ever asked yourself why the Dow Jones Industrial Average contains non-industrial stocks? Why such a large weighting is given to financial companies such as American Express (AXP), Bank of America, Citigroup, JPMorgan and AIG? After all, you wouldn’t expect to see General Motors included in the healthcare index or Goldman Sachs in the home builder index.
The Wikipedia entry for the Dow Jones Industrial Average states that:
The average is computed from the stock prices of 30 of the largest and most widely held public companies in the United States. The “industrial” portion of the name is largely historical—many of the 30 modern components have little to do with traditional heavy industry.
We do not dispute the claim that the “industrial” portion is largely historical. Indeed, there are components which have little to do with industry. Financial companies, which do not produce anything, comprise a large weighting the in this average of American Industry.
Over the last 20 years, the Dow Jones has been reshaped into a basket of 30 conglomerate corporations with little regard for the actual business they’re in. Today’s Dow Jones would be unrecognizable to the man who created it over a century ago.
The index was first published in 1896 by Charles Dow, Founder of the Dow Jones Company and Wall Street Journal. Mr. Dow created and monitored a list of important industrial companies. Along with the Industrial Average, he created the Railroad Index (Transportation) which he tracked along with the industrial stocks to gauge the health of the economy.
The Dow Theory was created based on the notion that both indexes should rise together in a healthy economy. The concept was a simple one. While industrial companies made the goods, the rails transported those goods to market. One couldn’t function without the other.
The original Industrial Average contained 12 industrial (Producers of goods) stocks:
- American Cotton Oil Company
- American Sugar Company
- American Tobacco Company
- Chicago Gas Company
- Distilling & Cattle Feeding Company
- General Electric
- Laclede Gas Light Company
- National Lead Company
- North American Company, (Edison) electric company
- Tennessee Coal,
- U.S. Leather Company
- United States Rubber Company
Notice that all of the companies in the index were producers of goods. There were no financial or bank stocks included in the average. At the time of his death in 1902, Charles Dow’s industrial average contained 12 stocks which were comprised of industrial producing companies such as US Steel, US Rubber, National Lead, American Car and Foundry, etc. Still no banks.
The Dow Jones Begins to Change
80 years after the death of Charles Dow, American Express was added to the Dow Jones Industrial Average. This marked the first time that a financial stock was added to the century old index.
American Can, a manufacturer of tin cans merged with Commercial Credit Corporation and adopted the name Primerica.
JPMorgan was introduced to the Dow Jones in 1991 and replaced Primerica Corporation.
Travelers Group was added to the index. The company would later change its name to Citigroup.
AIG was added.
Bank of America was added.
We struggle to find an explanation as to why such changes were made. Was it because America became de-industrialized over the last quarter century? Was it merely a reflection of big business today, with companies such as General Motors and General Electric playing dominant roles in non-core businesses such as finance and banking? Or were these financial stocks added to the index in hopes of propping up its value with companies such as JPMorgan and AIG, whose earning power seemed indestructible? Our hunch is that it was a combination of each.
Since the premise of Dow’s Theory is based on the relationship between the producers of goods (Industrials) and the shippers of goods (Transportation) it is important that the underlying components of these two sister averages reflect their intended purpose. How can market technicians apply Dow Theory today when the industrial average is NOT made up of industrial stocks? The theory is obviously flawed and has been for the past 2 decades. This may explain some of the notable false, or late, signals given over the past 20 years.
Would Charlie Dow’s industrial index be trading at 6,500 today? The chart below suggests that it wouldn’t. Sure, in a bear market all stocks go down though some more than others. This collapse was led by the bank stocks. If the Dow Jones Industrial Average was made up of industrial stocks, as intended, it would have avoided the loss of nearly 100% in AIG, 97% in Citigroup, 92% in Bank of America, 80% in American Express and 57% in JPMorgan, all of which performed worse than the index itself.
Market technicians may need to rethink the application of Dow Theory and find an alternative measure to gauge industrial stocks. The Dow Jones Industrial Average of today is neither industrial nor consistent with the applications of its founder Charles H Dow.
Equities: Dead, or Just Resting?
The meltdown has left many wondering about stocks. BW Contributing Editor Chris Farrell thinks reports of their demise are exaggerated. These are truly scary times. The stock market has lost some $11 trillion in value since its October 2007 peak. Blue-chip companies like AIG and Citigroup are now penny stocks, while General Motors and Las Vegas Sands trade at less than 2 a share. It seems that everybody is scouring through the numbers, trying to figure out how far down is down—and how long this bear market will last. And if the stock market train wreck isn't enough, investing icon Warren Buffett has come along with a new warning. "A few years ago, it would have seemed unthinkable that yields like today's could have been obtained on good-grade municipal or corporate bonds even while risk-free governments offered near-zero returns on short-term bonds and no better than a pittance on long-terms," he writes in his latest annual letter to Berkshire Hathaway (BRKA) shareholders.
"When the financial history of this decade is written, it will surely speak of the Internet bubble of the late 1990s and the housing bubble of the early 2000s. But the U.S. Treasury bond bubble of late 2008 may be regarded as almost equally extraordinary." Great. What is the average saver in a 401(k)-type plan supposed to do? Abandon equities? Flee bonds? (Sales of home safes are up, but that's not recommended.) Two simple market stories reinforce a time-honored lesson for all investing seasons. You don't have a clue what investment will do well going forward, and neither do the experts. The first story: The old attitude of buying solid stocks as a cornerstone for one's life savings and retirement has simply disappeared. Younger investors, in particular, are avoiding stocks. In fact, the only reason the mutual fund industry has been able to survive the death of equities is the dramatic success of such funds which invest in T-bills, bank CDs, and other short-term paper.
Says Alan B. Coleman, dean of Southern Methodist University's business school: "We have entered a new financial era. The old rules no longer apply." Those thoroughly modern-sounding lines were plucked from one of the most famous cover stories in business journalism, BusinessWeek's August 1979 piece "The Death of Equities." Needless to say, BW's bold pronouncement became the favorite example of contrarians. (Type "The Death of Equities" into your search engine and you'll see what I mean.) Case in point: "By the end of the 1970s, things were so bleak on Wall Street that a pessimistic BusinessWeek cover proclaimed "The Death of Equities," Money magazine wrote last year. "That, of course, turned out to be one of the great buy signals of all time."
Really? The contrarian story doesn't stand scrutiny. Rereading it today, it's a well-reported, well-written article that thoughtfully looked at why individual investors were abandoning stocks nearly seven years after the Dow's peak and suffering through years of raging inflation. Here's the rub: The stock market didn't bottom out until August 1982—three years later. That's one long lasting contrarian indicator. Hopefully anyone who invested on the theory that magazine covers are useful contrarian indicators had very deep pockets and a long time horizon. The real lesson is that despite the gloom, the U.S. economy eventually recovered, inflation rates trended lower, businesses became more competitive, and innovation flourished, setting the stage for the bull markets of the '80s and '90s. A second story: Remember Dow 36,000, the book co-authored by James K. Glassman and Kevin A. Hassert? It was published in 1999. "The Dow Jones industrial average was at 9000 when we began writing this book," the authors write in their introduction. By their calculations "in order for stocks to be correctly priced, the Dow should rise by a factor of four—to 36,000… The Dow should rise to 36,000 immediately, but to be realistic, we believe the rise will take some time, perhaps three to five years."
Oops. The Dow Jones industrial average peaked at over 14,000 in October 2007, and it's down by more than 50% since then. Worse yet for Messrs. Glassman and Hassert, from 1999 to 2009 the S&P 500 is down 50% adjusted for inflation, calculates Michael Mandel, BusinessWeek's chief economist. Their notion that stocks were almost a riskless security over the long haul was nonsense. Stocks are riskier than bonds since equities represent the uncertain rewards for entrepreneurship, while bonds are long-term contracts that spell out when borrowers must make principal and interest payments. "There is no predestined rate of return, only an expected one that may not be realized," says Laurence Siegal, director investment policy research at the Ford Foundation. "The risk of holding stocks, then, is the possibility that in the long run, returns will be terrible." A close look at market history also shows that stocks did not always do better than bonds even with a 30-year time horizon before 1871, and after that bonds often outperformed stocks for 10-year periods. You don't even have to reach into the history books, either. From 1983 to 2008, the annual total return on stocks was 9.8% a year vs. an 11% average annual return on Treasury bonds. That should put to rest the "stocks for the long haul" dogma.
What is the individual investor trying to save for retirement to make of all this? The patterns of market history are such that stocks are sometimes seen as diamonds and bonds as zircon, and vice versa. Benjamin Graham, the investing legend, wrote in his 1949 masterpiece, The Intelligent Investor: "In the old legend the wise men finally boiled down the history of mortal affairs into the single phrase, 'This too will pass.' Confronted with a like challenge to distill the secret of sound investment into three words, we venture the following motto, MARGIN OF SAFETY." Diversification is one way to build a margin of safety. It's a hoary lesson oft forgott. The Talmud recommends it: "A man should always keep his wealth in three forms; one third in real estate, another in merchandise, and the rest in liquid assets." Shakespeare in The Merchant of Venice has Antonio explain to his friends why he wasn't spending sleepless nights worrying over his investments."Believe me, no. I thank my fortune for it,
My ventures are not in one bottom trusted,
Nor to one place; nor is my whole estate
Upon the fortune of this present year.
Therefore my merchandise makes me not sad."
The other way to build a margin of safety is to hedge, or employ strategies to mitigate risk. For instance, Professor Zvi Bodie of Boston University is a leading proponent of hedging with retirement savings. He argues that the basic money question for the future retirees of America is not "How much money will I make on my investments?" but "How much can I afford to lose?" Take the amount you can't afford to lose and eliminate the risk with default-free, inflation-and-deflation proof Treasury Inflation Protected Securities (TIPS). So, should we send flowers for the equity market and comfort its bereaved survivors?
Don't back up the hearse just yet. My own sense is that there is wonderful value in the stock market. When was the last time you heard a professional money manager go on television and say, don't buy my fund? That's what Steve Leuthold, the market historian, long-time money manager, and head of Leuthold Group did on Bloomberg TV late last week. His Grizzly Short Fund—a mutual fund that typically sells stocks short—sports a one- year return of 84% and a year-to-date return of 29%. So why is Leuthold recommending not to follow the hot fund? "These comparisons with the Great Depression are totally out of touch with reality, and pretty stupid," he says. I think he's right. But I'm well-diversified just in case.
Meltdown 101: Central banks boost supply of money
Every corner of the planet is reeling from the financial crisis, and central banks have responded aggressively by slashing borrowing costs. But the traditional weapon of making it cheaper to borrow doesn't seem to be enough: Interest rates in many parts of the world are at their lowest ever. Many of the world's central bankers are now looking at ways to boost the quantity of money instead of just tweaking the price of it. Some are implementing quantitative easing -- a term for expanding the supply of money in the economy. Instead of printing new banknotes, the central banks buy securities and other assets from commercial banks in the hope they use their newfound cash to lend to consumers and businesses. Here's a look at how central banks around the world are attacking the recession -- and the results so far:
• UNITED STATES: The Federal Reserve was quick off the blocks when the credit markets froze up in the fall of 2008, injecting hundreds of billions of dollars of liquidity into the money markets and slashing interest rates. By the end of 2008, it could not reduce interest rates any further, having taken the Fed funds rate to an all-time low of between 0 percent and 0.25 percent. The Fed's quantitative easing program has focused on programs to buy corporate debt and kick-starting consumer loans. Despite massively expanding, its activist strategist has not yet borne fruit, with the U.S. economy still languishing in one of its deepest recessions in generations and the financial sector dogged with solvency issues.
• JAPAN: With the key interest rate already at 0.1 percent, the Bank of Japan is again looking at other ways to get the world's second-largest economy back on track. The Bank of Japan has shifted its focus to thawing a corporate credit crunch. As well as boosting liquidity, the Bank of Japan has said it will begin buying stock holdings worth billions of dollars from financial institutions as Japan's big banks have been hit hard by slumping stock markets, which have depleted the value of their stock holdings. In the last quarter of 2008, Japan contracted at its sharpest rate in nearly 35 years in the fourth quarter as a collapse in exports hit businesses like Toyota Motor Corp. and Sony Corp.
• EURO ZONE: The European Central Bank has been criticized in many quarters for not cutting interest rates as fast as other banks even though inflation is well below target and the 16 countries that share the euro are contracting sharply. High-value exports have been hit particularly hard by the global downturn. In early March, the European Central Bank reduced its benchmark rate by a half percentage point to a record low of 1.5 percent and the bank's president, Jean-Claude Trichet, indicated that another cut was possible. However, he voiced opposition to getting borrowing costs down to zero percent. Trichet also has confirmed that the European Central Bank is investigating whether to boost the money supply in the euro zone, which accounts for more than 15 percent of the world's gross domestic product. But the European Central Bank faces difficulties with quantitative easing that other central banks don't have. The bank, for example, is barred by law form buying government bonds. Even buying assets in one country might open it to accusations of favoritism. The ECB has not just relied on interest rates though. It has, since the beginning of the credit crisis in August 2007, provided substantial liquidity by increasing short-term loans to banks to ease the logjam in money markets.
• BRITAIN: The Bank of England may have been slow to fathom the scale of the recession, but once it started cutting interest rates it did so aggressively. From a high of 5 percent in early October, the Bank of England slashed its benchmark rate for six months running, taking it down to 0.5 percent, its lowest level since its creation back in 1694. The Bank announced it is to embark on a program of quantitative easing -- first by buying up to 75 billion pounds of assets from the banks over the coming three months, in the hope that the banks may boost lending to businesses and households.
• BRAZIL: As the global crisis dries up credit and exports, Brazil's central bank slashed its benchmark Selic rate a full percentage point to 12.75 in January, its first cut since September 2007 and its biggest in five years. After five years of more than 3 percent annual growth, many analysts expect a contraction in 2009. The central bank is expected to cut rates another percentage point this week.
• MEXICO: The sagging peso, which has stoked inflationary pressures by making imports more expensive, has limited the central bank's ability to cut interest rates even though a slowing economy needs a much-needed boost. Higher rates can support a country's currency. The bank reduced its benchmark lending rate a quarter point to 7.5 percent last month, less than expected as policy makers held back to protect the peso. It was only the bank's second cut since 2006 even though the Mexican economy contracted 1.6 percent in the fourth quarter of last year. The bank has also sold billions in foreign reserves since October to protect the peso.
• CHINA: The People's Bank of China is focused on financing the government's 4 trillion yuan ($586 billion) fiscal stimulus. It's intended to reduce the country's reliance on exports, which have sunk amid sliding global consumer demand, and get domestic consumers to start spending. The central bank cut interest rates five times from September through December to 5.31 percent. However, bank lending is less significant in China than elsewhere as most private companies don't qualify for loans and rely on retained earnings, as do large state companies.
Bank of America, GE Sell $16.5 Billion of FDIC Debt
Bank of America Corp., the largest U.S. bank by assets, and General Electric Capital Corp. raised a combined $16.5 billion today selling bonds backed by the U.S. government as they seek to hold down borrowing costs. Bank of America, based in Charlotte, North Carolina, sold $8.5 billion of notes in its second-largest offering under the Federal Deposit Insurance Corp.’s Temporary Liquidity Guarantee program. The finance arm of General Electric Co. sold $8 billion of notes, also its second-biggest under the program. Financial companies are relying on the FDIC program as yields relative to benchmarks on their debt that isn’t guaranteed by the government soar to the highest on record. Banks have few alternatives to finance themselves at lower interest rates as investors grow concerned that they don’t have enough capital to absorb losses amid a deepening global recession, said Guy Lebas, chief economist at Janney Montgomery Scott LLC in Philadelphia.
"It’s so much cheaper to issue TLGP debt than unsecured that every bank out there is replacing maturing debt with TLGP deals," Lebas said in a telephone interview. "No financial issuer in their right mind would come with a non-FDIC debt issue right now. Markets are penalizing them very severely." The average yield over benchmark rates on financial company debt has risen 1.64 percentage points this year to 8.52 percentage points as of March 6, according to Merrill Lynch & Co.’s U.S. Financial Corporate index. That is the highest on record, the data show. The index doesn’t include FDIC-backed debt. Financial issuers marketed more than $16.5 billion in FDIC- backed debt today, bringing this month’s total to $18 billion and already eclipsing the $17.4 billion of issuance in February. Banks, seeking to reduce borrowing costs and diversify their funding, are using the government’s program to boost cash levels and reduce risk.
"GE ran into a few stresses in the last weeks and I think they’re likely to employ a more conservative funding mix going forward," Lebas said. GE Capital, based in Stamford, Connecticut, issued $4 billion of 30-year, 6.875 percent bonds in January without a government guarantee at 98.48 cents on the dollar to yield 400 basis points more than similar-maturity Treasuries, Bloomberg data show. The senior unsecured bonds traded at 72.319 cents on the dollar on March 6 to yield 9.74 percent, according to Trace, the bond price reporting system of the Financial Industry Regulatory Authority. Bank of America sold $4 billion of floating-rate notes due in September 2010 that pay three basis points more than the three-month London interbank offered rate, and $2.5 billion of floating-rate notes due in June 2012 that yield 20 basis points more than three-month Libor, Bloomberg data show.
The bank also sold $2 billion of 2.375 percent fixed-rate notes due June 2012 that pay 102.5 basis points more than similar-maturity Treasuries, Bloomberg data show. A basis point is 0.01 percentage point. Libor, a borrowing benchmark, is currently set at 1.31 percent. Bank of America spokesman Scott Silvestri couldn’t be reached for comment. GE Capital sold $4 billion of two-year, 1.8 percent notes priced to yield 86.7 basis points more than Treasuries, and $1 billion of two-year, floating-rate notes at eight basis points over three-month Libor, Bloomberg data show. GE Capital also sold $1.5 billion of three-year, 2.25 percent notes at 91.2 basis points more than similar-maturity Treasuries, and $1.5 billion of three-year, floating-rate notes at 20 basis points over three-month Libor, the data show.
"There was tremendous demand for the offering," said GE spokesman Russell Wilkerson. GE has now "pre-funded" about $41 billion of the $45 billion planned in long-term debt maturing this year. Bonds guaranteed through the FDIC program are rated Aaa by Moody’s Investors Service and AAA by Standard & Poor’s, their highest rankings.
AIG investor Broad abandons hope of recovery
Eli Broad, a former director and shareholder of AIG who joined other investors last year to hatch a plan to reclaim the insurer from federal ownership, said he has thrown in the towel. American International Group Inc, once the world's biggest insurer, had to be bailed out by the U.S. government last September after losses on bad mortgage bets. In exchange, taxpayers got roughly 80 percent ownership, heavily diluting the stake of shareholders. "If you look at what has happened, I think it is too late," said Broad, in an interview late on Monday.
"There were all these additional costs" from the federal bailout, which initially carried a heavy interest burden, said Broad. And, "a lot of good people left, and they were trying to sell units," irking customers who did not like the uncertainty, he added. AIG last week reported a record $61.7 billion fourth-quarter loss, and received new assistance from the U.S. government after a plan to sell assets to repay debts foundered. The U.S. said it will keep pumping cash into AIG as needed because of the threat to trading partners from a collapse. It has already put up to $180 billion at AIG's disposal.
AIG ran into a cash crunch after market declines and rating downgrades required it to post large amounts of collateral to counterparties of credit default swaps written by a financial products unit. Broad said the government's bailout of AIG had been "on the harshest of terms," and at the worst possible time -- in the wake of the collapse of Lehman Brothers. "I think the situation if it occurred today would have been met with a different answer," said Broad. AIG, under the terms of its initial government rescue, had to pay 8.5 percentage points above the three-month London Interbank Offered Rate on the government loan, equal to more than 11 percent, plus other fees. Terms have been eased since. A better approach, suggested Broad, would have been to offer government guarantees on toxic assets held by AIG, akin to what was done in the later rescue of Citigroup.
Broad and other shareholders including fund manager Shelby Davis of Davis Selected Advisors LP, money managers Dodge & Cox, Legg Mason, and the New York state common fund, last year sought unsuccessfully to convince the government to allow private investors to reclaim ownership of AIG. "The conversation was 'why don't you give us a chance to raise common equity, and if we do that you please give us the (government) equity back'," said Broad. Broad said he no longer was investing in insurance, and had more or less put AIG out of mind. "I don't have any hope (for AIG), not now," he said. Broad and business partner Donald Kaufman sold SunAmerica, a life and retirement business they had built into a Fortune 500 company, to AIG in 1999.
Broad, now 75, joined AIG's board and acquired significant stock in the $18 billion sale. While he donated his AIG shares to his philanthropic foundation, which has long since sold them, Broad said he lost the value of stock options that he had held off exercising, when AIG crumbled. The Bronx, New York-born Broad, who describes his early economic circumstances as "lower middle-class," told Reuters he would have considered buying back SunAmerica, where he still knows many employees, were he younger. He retired from corporate life a decade ago and now devotes himself to his foundation, which invests in education, the arts, and scientific research. He and Kaufman were also the founders of U.S. homebuilder KB Home.
It's not the Depression, top Obama adviser says
Former UC Berkeley economist and chairwoman of President Obama's Council of Economic Advisers Christina Romer acknowledged on Monday the parallels between today's economic contraction and the Great Depression but said that as bad as this one is, it "pales in comparison to what our parents and grandparents experienced in the 1930s." A foremost scholar of the Depression, Romer, 50, said the administration's actions to counter the steep economic slide should be viewed in their entirety - not only the $787 billion stimulus passed by Congress last month but also efforts to stem home foreclosures, "stress tests" to determine the soundness of banks and the flooding of credit markets by the Federal Reserve. And if all that turns out not to be enough, Romer promised, "We'll do whatever it takes."
Today's eerie parallels with the Great Depression include a crash in real estate and stock prices similar to the 1929 stock market crash, bank failures and the global spread of the economy's contraction. But as bad as the 8.1 U.S. unemployment rate is, Romer said it comes nowhere near the 25 percent rate of the 1930s. Many safety nets such as unemployment insurance and deposit insurance did not exist then, and the Federal Reserve allowed the money supply to contract sharply. Balanced budgets, not stimulus spending, were the norm. The Obama administration is increasingly turning to Romer, whose sunny visage and always-polite persona never wilts even under a Fox News interrogation, to respond to rising criticism of its policies.
Critics on the left say the administration's stimulus is too small and its interventions with banks too slow and ad hoc. Critics on the right accuse the administration of sowing uncertainty and leading the country toward European-style socialism. Speaking at the Brookings Institution, Romer expressed faith that the political system would be able to "power through" another expensive bank rescue if that is what is needed. One of the biggest headaches facing the administration is the widespread belief among independent economists that U.S. banks might need as much as $2 trillion on top of the $700 billion Congress allocated last fall. The four largest U.S. banks, Citigroup, Bank of America, JP Morgan Chase and Wells Fargo, are weighed down in varying degrees by bad mortgage loans and other "toxic waste."
The Treasury is conducting "stress tests" of banks to determine their health - a process Romer compared to the "bank holiday" that President Franklin D. Roosevelt declared during the Depression, ordering banks closed so their books could be checked and then closing 10 percent of them. Treasury Secretary Timothy Geithner has come under criticism for not announcing a concrete plan for the banks. There is wide agreement that the economy will not recover until the banks are fixed, much as Japan languished through the 1990s under similar circumstances. Congress has no appetite to spend more jaw-dropping sums on banks.
Romer acknowledged the hostility but said the situation would be much worse had the initial rescue not staved off a financial collapse. "No congressman likes to have to go back to his or her constituents and say, 'I know you don't see much, but it would have been much worse,'" Romer said. "But that's the truth." If more money is needed, she said, "We'll have to power though. These are difficulties, but I have great faith." She downplayed calls for a second economic stimulus, saying this one is big and needs to be given time to work. Although her estimate that it will save or create 3 million to 4 million jobs is less than the 4.4 million jobs already lost, she said the stimulus "is only one of the things we're doing. ... We think the totality of the program is exactly what the economy needs."
Getting the banks lending again would be the biggest stimulus of all, Romer said. The administration's $75 billion housing assistance plan could help lower some mortgage payments, and "we think we can prevent 3 million foreclosures. That's a lot of houses not dumped on the housing market and not pushing down housing prices." Further declines in housing prices feed back into the banks by causing their loans to deteriorate further. She downplayed fears about the big spike in federal debt so long as the economy is in recession, but said that over the longer term, the debt must be brought under control. She said her optimistic growth estimates used to formulate the administration's budget were made before the latest onslaught of bad news and that she would revise them later this year.
Romer, whose husband, David, still teaches at Berkeley, has done pathbreaking work on the Depression. In one 1992 article frequently cited by Republicans, she said fiscal policy was not the engine of recovery in the 1930s. To critics who conclude that she does not believe a government stimulus will work now, she said, "Nothing could be further from the truth," arguing that Roosevelt's policies were a big break from a tradition of balanced budgets, but were in fact small relative to the size of the downturn and reversed too soon.
Romer, who has also taught at Princeton, said a strong incipient recovery - 11 percent growth in 1934, 9 percent in 1935 and 13 percent in 1936 - was due in part to a temporary suspension of the dollar's link to gold that boosted the money supply and a big bonus given to World War I veterans. But the recovery was cut short by federal debt-reduction and monetary tightening in 1936 and 1937 that she said added two years to the Depression. "Had the U.S. not had the terrible policy-induced setback in 1937," she said, "we, like most other countries in the world, would probably have been fully recovered before the outbreak of World War II." A lesson is to "beware of cutting back on stimulus too soon."
Economic indicators, then and now
• GDP - National production fell 50% 1929-1933. Today, GDP is in positive territory, though it fell slightly last year.
• Consumer debt - In the '30s, outstanding debt was 9.6% of household income. In mid-2008, it was roughly 14.1%.
• Jobs - The national unemployment rate rose from 3.2% in 1929 to 24.9% in 1933. Last month, it hit 8.1 percent.
• Homes - Homeownership fell from 49% in 1929 to less than 44% by 1944. Today, the home ownership rate is 67.5%.
Developing economies are about to feel the pain
The World Bank’s estimate of negative global growth in 2009 looks right. Even if stimulus programmes and natural recoveries turn rich country economies around by mid-year, developing countries may well suffer capital shortages that could cause their economies to deteriorate later in the year. So far, developing countries have been coping with the global downturn better than wealthy ones. While the World Bank believes that global growth in 2009 will be negative for the first time since the Second World War, it estimates advanced economy growth will be minus 2pc, while African growth is expected to continue at a relatively robust 3.5pc. However, the World Bank is eloquent in identifying the principal problem for developing countries: the sharp reduction in funds flowing to them from international markets, expected by the Institute for International Finance to fall from $467bn to $165bn this year.
This decline will be worsened by the sharp decline in global wealth, estimated by the Asian Development Bank at $50 trillion. The World Bank expects developing countries’ external financing needs to exceed resources available by at least $268bn, and maybe as much as $700bn if private debt refinancing proves difficult. Since developing countries’ debt maturities in 2009 total $2.5-3 trillion, of which $1 trillion is private-sector debt, their funding squeeze is likely to be considerable, and will worsen as the year proceeds and reserves are depleted. Lack of funds could force developing countries into draconian deflation, hurting their economic performance and impeding any global recovery. The World Bank’s favoured solution is increased funding through multilateral institutions.
However, it correctly warns of the additional squeeze on developing country capital inflows applied by the massive stimulus-created budget deficits of the rich world. This squeeze would be worsened by major multilateral institution borrowing programmes, although such programmes and associated on-lending might transfer some pain from developing countries to rich countries’ private sectors. Wealthy countries and cash-rich impoverished ones like China may succeed in using stimulus to end their economic downturns. However those poor countries without China’s financial resources may find their economic prospects blighted by the West’s excessive borrowing.
Japan May Need to Buy Stocks, Ex-Bank of Japan Deputy Says
Former Bank of Japan Deputy Governor Toshiro Muto said the government and the central bank may need to buy shares temporarily to support the country’s ailing stock market. When global equities plunge, "it’s very meaningful for the government’s share-buying institution and the Bank of Japan to buy stocks to support the market," Muto said at a forum co- hosted by Bloomberg News in Tokyo today. "However, such purchases cannot last forever and should be justified only as a tool to avert a crisis."
The Nikkei 225 Stock Average is at a 26-year low, eroding banks’ capital and making them reluctant to lend. Finance Minister Kaoru Yosano said today that the government has a "strong will" to combat the credit squeeze resulting from the stock-market slump. Muto, currently head of the Daiwa Institute of Research, added that in principle equity values should be set by the market and authorities should avoid manipulating prices because doing so would hurt the stock market’s reputation. The government has already allocated 20 trillion yen ($203 billion) and the Bank of Japan has set aside 1 trillion yen to buy shares owned by banks. Yosano last month ordered lawmakers within the ruling Liberal Democratic Party to study ways to bolster stocks, including the feasibility of the government directly purchasing equities in the market.
Keidanren, Japan’s largest business lobby, yesterday called on the government to allow a public entity to sell state-backed bonds and funnel the proceeds into the flagging stock market. The Nikkei slid 0.4 percent today to 7,054.98, the lowest since October 1982, on concern shrinking global demand and rising fuel prices will weigh on company earnings. An unprecedented drop in exports since last quarter has forced Japanese manufacturers to cut production at a record pace and fire thousands of workers. The central bank forecasts the economy will shrink 2 percent in the year starting April 1, the worst in 60 years.
Muto said exports will drive Japan’s eventual recovery. Deflationary risks outweigh concerns about inflation in the world’s second-largest economy, he added. Muto served as the central bank’s deputy chief for five years following a 37-year career at Finance Ministry. He was the government’s first choice to succeed Toshihiko Fukui as governor last year, only to be rejected by the opposition- controlled upper house, which said his stint at the ministry may hamper the bank’s independence.
Credit Cards Raise ‘Canary in Coal Mine’ Alert at Canadian Banks
Krystal Koglin didn’t think twice when Toronto-Dominion Bank offered to boost the limit on her Visa credit card 11-fold a couple of years ago. She went on a spending spree, hitting department stores like Holt Renfrew, treating friends at restaurants, splurging on designer jeans and buying "needless things" on EBay Inc. "Being a young adult and irresponsible, I spent a lot of money that I shouldn’t have," the 24-year-old salon manager and BCE Inc. employee in Toronto said. "I couldn’t handle having the responsibility of a C$5,500 ($4,237) limit."
Toronto-Dominion and other Canadian banks are suffering from a rise in credit-card losses from clients such as Koglin, who cut up her Visa card in December after skipping payments. Four of the country’s biggest banks set aside 51 percent more cash on average in the first quarter for card losses, and these costs may rise further this year, bank executives said. "If there’s another shoe to drop, credit cards are going to be it," said John Kinsey, who manages about C$1 billion including bank stocks at Caldwell Securities Ltd. in Toronto. "It’s probably going to be the Achilles heel this year for the banks." Credit-card delinquencies and losses have risen with higher unemployment and personal bankruptcies, according to Moody’s Investors Service. Those trends will continue through 2009, even as issuers reduce credit limits and scale back on offers to entice clients.
Canadian card losses in the third quarter rose to 3.1 percent of average balances, the seventh straight period of year- over-year increases, according to Moody’s. By comparison, U.S. card losses rose to 6.6 percent of balances. Canadian Imperial Bank of Commerce, the country’s No. 5 bank, set aside C$152 million for card losses for the period ended Jan. 31, nearly double a year ago. Royal Bank of Canada earmarked C$83 million, a 28 percent increase, while Bank of Montreal reserved C$56 million for losses in its MasterCard portfolio, up 47 percent. Canadian Imperial, Canada’s largest card issuer, is "slowing growth" of credit cards, says Chief Executive Officer Gerald McCaughey. Cards were the second-biggest revenue generator for CIBC’s consumer bank in 2008, bringing in C$1.75 billion.
"The card portfolio continues to grow, but at a much slower rate," McCaughey told reporters after the bank’s annual meeting in Vancouver on Feb. 26. "In difficult times it’s quite normal that you would slow the growth of credit granting." CIBC has the most consumer credit-card loans among Canada’s five-biggest banks with C$10.5 billion, representing 6.3 percent of total loans, according to filings. Royal Bank of Canada has the second highest, followed by Toronto-Dominion, Bank of Nova Scotia and Bank of Montreal. Royal Bank CEO Gordon Nixon said he’s more concerned about rising defaults from credit cards than mortgages in the recession. Royal Bank had C$8.93 billion in credit-card loans as of Jan. 31.
"There is a natural deterioration in credit in a recessionary environment," Nixon said on Feb. 26. "Credit-card deterioration always happens much sooner and much more dramatically than you’d have in a mortgage portfolio because they are unsecured loans." Conservative lending practices and regulations allowed Canadian banks to escape the worst of the writedowns faced by U.S. banks from the collapse of the subprime mortgage market. The lenders don’t have such protection for credit cards, aside from charging interest rates as high as 19.75 percent on outstanding balances, compared with a prime rate of 2.5 percent on loans to their best customers.
Canadian banks will see "earnings headwinds" from significant increases in provisions for card losses, Dundee Securities Corp. analyst John Aiken said in an interview. A deteriorating credit-card business is a sign of worsening credit among consumers, which will hurt the banks’ other businesses, he said. "It’s definitely the canary in the coal mine," Aiken said. "If these customers aren’t paying their credit cards, that means they’re not buying anything else and you’ll see a ripple effect." Banks have been bracing for a slump as Canada struggles in its first recession since 1992. The economy will shrink by 1.2 percent this year, the Bank of Canada forecast. Companies shed a record number of jobs in January, pushing the jobless rate to a four-year high of 7.2 percent.
Credit-card balances at Canadian banks have risen by almost 40 percent since 2004 to C$49.9 billion as consumers took on more debt, Deloitte said in a report last month. Banks and issuers may post an additional C$800 million in credit-card losses this year, rising to about C$4 billion, the consulting firm said. Canadians owned 71.6 million cards issued by Visa Inc., MasterCard Inc. and American Express Co. at the end of 2007, according to The Nilson Report, an industry publication. "The impact of credit deterioration in Canada -- and I’m talking about all banks -- is going to be felt across everybody’s product groups, whether it’s in credit cards or mortgages," Bank of Nova Scotia Chief Risk Officer Brian Porter said in a March 2 interview.
Canadian Hiring Plans Drop the Most Since 1983
Canadian employers’ hiring intentions for the second quarter dropped the most since 1983, led by factories, retailers and builders, according to a survey by Manpower Inc. The net employment outlook, which subtracts the percentage of companies planning to reduce jobs from the percentage that say they’ll hire, fell by 17 points to 1 percent for the April to June period, the lowest level since 1994. The figures are seasonally adjusted. Hiring plans in retail and wholesale dropped 31 points to 3 percent, and fell 21 points to 10 percent in construction, according to Milwaukee-based Manpower. Manufacturers of durable goods have an employment outlook of negative 9 percent, and non- durable goods makers were at negative 5 percent. Both groups had their hiring prospects decline by 18 percentage points from the first quarter.
The results are less severe than during the last recession in the early 1990s, Lori Rogers, vice president of operations at Manpower’s Canadian unit, said yesterday by telephone from Toronto. There are better job opportunities now in services and government posts, she said. "There are still jobs for people, they just have to be flexible," Rogers said. "It doesn’t seem to be as bad as it was in 1991-92." In 1992, the overall index fell to negative and didn’t rise above zero until 1994. The survey of 1,900 employers has a margin of error of 2.2 percentage points, and was taken from Jan. 15-28. Today’s report of the decline in manufacturing doesn’t account for recent automobile layoffs, which may further depress the factory index in the future, Rogers said. Canada will probably report on March 13 that employers cut their payrolls by 55,000 in February, boosting the unemployment rate to 7.4 percent from 7.2 percent, according to economists surveyed by Bloomberg News.
French industrial production plunges
French industrial production plunged dramatically by an annual rate of 13.8 per cent in January, the biggest drop since the official series began in 1980, as the deepening recession slashed demand for manufactured goods. Insee, the French statistical agency, recorded a decline of 3.1 per cent on the previous month, far bigger than most analysts had expected. The average forecast of economists polled by Bloomberg was for a fall of 0.6 per cent. The scale of the contraction suggests that the eurozone’s second-largest economy, which has so far fared less badly than its neighbours, is set to follow them into a severe recession. January’s plunge was the sixth consecutive monthly decline in industrial output, the longest continuous contraction in the 29-year old statistic series. The figures underline the extent to which industry is bearing the brunt of the economic slump across Europe and around the world.
The figures suggest that the government’s revised growth forecast of minus 1.5 per cent for 2009 may yet prove optimistic. The French central bank on Monday predicted that gross domestic product would shrink by 0.6 per cent in the first three months of this year. Manufacturing output fell by 4.1 per cent in January, weighed down this time not be the stricken car industry but by a fall in electrical, electronic and transport goods. But while auto industry output was actually up by 1.6 per cent analysts noted there should have been a stronger rebound given the fact that many assembly lines were shut down for much of December. ”We have moved from a stage where we thought there was some signs of stabilisation at the start of the year and moved back to a scenario where things are continuing to deteriorate,” Jacques Cailloux, economist at Royal Bank of Scotland told Reuters.
China adds deflation threat to economic woes
China's consumer prices fell in February, adding the threat of deflation to the nation's economic woes, and officials warned the next few months look grim as the global downturn worsens. The 1.6 percent year-on-year fall in the consumer price index, announced by the government Tuesday, highlighted weakness in the world's third-largest economy as exports and consumer demand cool. Such a decline, if it continues, can drag down growth if consumers put off purchases in expectation of lower prices, forcing companies to cut wages and investment. "We expect negative CPI could persist for much of this year," Citigroup economist Ken Peng said in a report. But others said inflation might quickly turn positive again as the government pumps money into the stumbling economy as part of its massive stimulus plan.
A 1.9 percent decline in food prices, a major component of the index, and declines in international commodity prices helped to drag the index down. So did excess inventories for many industries. The government downplayed the likelihood of a deflationary spiral. It said the fall in the CPI — the first in more than six years — was due in part to inflation being very high in February last year, when the index's rise reached a 12-year high of 8.7 percent. Premier Wen Jiabao, the country's top economic official, said last week the government expects prices to rise 4 percent this year. A fall in consumer prices will be a relief to struggling Chinese households. But deflation could undermine the 4 trillion yuan ($586 billion) stimulus, which aims to reduce reliance on exports by encouraging China's own consumers to spend more.
The industry minister warned Tuesday that many industries suffer from overcapacity, which could lead to pressure to cut prices further. "Many industries have more supply than demand, so now that we are working to expand the capacity of these industries, they may face new problems because of shrinking demand," Li Yizhong said at a news conference. Although city dwellers rarely see evidence of falling prices on grocery shelves, some businesses say they are cutting prices. "We adjusted our prices downward by about 10 percent between December and February," said Zhai Zhi, a salesman at Synear Food Co., a maker of frozen dumplings and snacks based in central China's Henan province. Synear was cutting prices to match competitors and reflect lower costs, he said.
Officials also warned Tuesday it was too soon to say economic conditions were improving. They were unusually somber at a time when Chinese leaders have been highlighting positive economic signs and trying to boost public confidence. "We should not be overly optimistic. China's industry is still in its most difficult situation," Li said. "The international financial crisis has not bottomed out and it is having a more and more profound impact on China's economy." Power consumption, a key economic indicator, fell by 3.7 percent in January and February from the year-earlier period, according to Li. He said output of nonferrous metals also fell, indicating slack industry demand.
Trade fell again in February, Commerce Minister Chen Deming said at the news conference with Li, though he gave no details. In January, exports dropped by 17.5 percent while imports fell 43 percent. "It's fair to say in coming months we will see quite a grim picture," Chen said. The first CPI decline since December 2002 suggests Beijing can cut interest rates further as it tries to spur growth. Royal Bank of Scotland economist Ben Simpfendorfer said China faces a "more durable deflation problem" unless it revives private investment and consumption and reduces reliance on government spending.
Adding to the gloomy economic news, the government reported housing prices fell in February for a third month, reflecting a sales slowdown that analysts say could hurt the economy as demand for building materials and labor shrinks. Prices nationwide fell by 1.2 percent from the same month of 2008, with some areas suffering double-digit declines, according to the Cabinet's National Development and Reform Commission. Prices of newly built homes plunged by 17.4 percent in the southern financial center of Shenzhen, which borders Hong Kong.
Rousseau says Caisse de Dépot ABCP difficulties due to events beyond his control
Henri-Paul Rousseau strode to his own defence Monday, insisting the fruits of his nearly six-year reign at the Caisse de dépôt et placement du Québec left the pension fund manager so flush it can easily ride out a prolonged market downturn. But his rosy portrayal of his own management of the Caisse, delivered before an overflowing crowd that included dozens of Montreal business elites, failed to quell widespread criticism in Quebec that the heady returns earned by the pension fund manager in previous years masked a risky investment policy with flaws that became punishingly apparent when markets crashed.
The Caisse, Canada's biggest institutional investor, posted a minus-25-per-cent return in 2008, equivalent to a $39.8-billion loss – far underperforming the median return of minus-18.4-per-cent at large Canadian pension funds. But Mr. Rousseau said he is not to blame for that. Mr. Rousseau, who quit the Caisse in mid-2008 only months into his second five-year mandate, attributed the bulk of the pension fund manager's difficulties to events beyond his control that arose after his departure. His sudden move to a senior job at Power Corp. of Canada came before the global market meltdown left the Caisse scrambling to unwind billions of dollars in derivatives contracts and sell stocks to generate quick cash.
“No diversification policy or risk management policy on earth can protect you from that kind of synchronized effect, which happened for the first time in 80 years,” he told more than 700 people who paid up to $95 to hear his version of the Caisse debacle. “The financial history of 2008 was essentially written five months after I left. I don't believe I am trying to escape my own responsibility by pointing this out.” The hour-long speech – broadcast live on Quebec's all news channels – was a major happening in Quebec, where the fortunes of the Caisse are closely monitored by politicians and the public. The institution, which saw its net assets slide to $120-billion as of Dec. 31, manages the assets of more than two dozen provincial pension and insurance funds, led by the Quebec Pension Plan.
Mr. Rousseau's decision to plead his own case follows weeks of public debate about the Caisse and wrangling between the governing Liberals and opposition parties regarding parliamentary hearings into the 2008 debacle. Groups representing retirees have also called for a public inquiry. There has been palpable anger about management of the province's so-called “nest egg” and immediate reaction to Mr. Rousseau's speech suggests it is not about to dissipate. Pressed later by reporters, however, Mr. Rousseau said he had nothing to apologize for. “I won't take responsibility for the [global] financial crisis.” He also expressed doubts about the usefulness of a public inquiry. “What they'd find would be essentially what I've just said [in the speech] – whether [the inquiry] is public, private or extraterrestrial.”
Mr. Rousseau chalked up the Caisse's dismal 2008 performance to two major factors: strict accounting rules that forced the Caisse to write down the book value of its real estate assets, even though they continue to generate strong revenue, and a currency hedging policy that he actually deemed to be more conservative than the one followed by most other pension funds. Mr. Rousseau criticized so-called mark-to-market accounting rules that forced the Caisse to slash the value of its real estate holdings by 30 per cent, though hundreds of its properties will see rents increase this year. And though Mr. Rousseau took “full responsibility” for the Caisse's decision to invest $13.2-billion in now highly devalued non-bank asset-backed commercial paper, he minimized its impact on the Caisse's overall results.
The $3.9-billion writedown taken in 2008 on the Caisse's remaining $12.8-billion in non-bank ABCP, he stressed, represented only 10 per cent of the Caisse's overall losses last year. On top of that, he blamed the mid-2007 breakdown of the domestic non-bank ABCP market on a “small exception” in Canada regarding the lack of enforceability of liquidity guarantees provided by banks. And whereas central banks around the world rushed to support their own ABCP markets, he noted that the Bank of Canada stood on the sidelines. That froze more than $32-billion in toxic paper on the books of the Caisse and other investors. Half of the paper is held by Quebec-based institutions, an anomaly Mr. Rousseau dismissed as “one of life's mysteries.” Mr. Rousseau also called on the Bank of Canada to add non-bank ABCP to its list of eligible securities under the central bank's sale and repurchase policy.
The move would inject $15-billion into financial markets and free up institutions such as the Caisse to invest the funds elsewhere. The Caisse has taken a total of $6-billion in provisions against its non-bank ABCP. But Mr. Rousseau expressed confidence that its actual losses on the paper will come in well below that figure. Besides, he added, superior returns during his tenure left the Caisse with a $15-billion cushion over what it would have earned had it only matched its historical performance.
Worst collapse in UK manufacturing in four decades
The “horrendous” scale of Britain’s industrial recession has been laid bare by figures showing that manufacturing output is declining at the fastest rate since records began more than 40 years ago. In figures labelled by analysts as “shocking” and “a horror show”, Britain’s industrial production dived at record speed, underlining how hard the global downturn has hit producers and exporters. The statistics are doubly surprising because many economists had expected the weakness of the pound over the past year to have boosted their fortunes. Manufacturing output dropped by 2.9pc in January alone - well below City forecasts, and taking the annual rate of decline to 12.8pc - the biggest since January 1981, according to the Office for National Statistics.
Underlining how much of that has come since November, the quarter-on-quarter contraction was 6.4pc - the most severe since comparable records began in 1968. The broader industrial production total, which also includes mining and utilities, is also now falling at an annual rate of 11.4pc - again the worst since 1981. The slide in Britain’s industrial production is mirrored elsewhere throughout the world. A sudden freeze in export markets in November has meant that although most attention is still focused on financial markets and the banking system, manufacturers and exporters are proving the biggest victims of the global recession. According to Ross Walker, UK economist at Royal Bank of Scotland, the industrial production figures would have been even worse had it not been for a cold period which boosted output from power stations and gas plants.
“Manufacturing output contracted at a record pace - these data stretch back to 1968, aptly, a year of major social and economics upheaval,” he said. “The UK data also serve to emphasise the severe and highly synchronised collapse in industrial output globally (other figures published today showed industrial production slumping by 3.1pc in France and 2.5pc in Sweden in January). Industrial capacity is being eliminated at an unprecedented pace, with few signs of any imminent alleviation.” David Kern, chief economist at the British Chambers of Commerce (BCC), said: “The much worse than expected manufacturing figures show that the sector has so far failed to benefit from the sharp falls in sterling. Clearly, the essential rebalancing of the UK economy towards industry is not yet taking place.
“The critical priority is to ensure that the vital skills base within manufacturing is not lost during this recession. Urgent measures are needed to help viable and well managed firms hold on to their trained and skilled employees. A loss of this precious resource will cause immense long-term damage to the economy.” Peter Dixon of Commerzbank said the figures represented an “industrial output horror show”. He added: “Even assuming that industrial output remains flat in February and March (a heroic assumption if ever there was one), the industrial sector will subtract 0.8 percentage points off first quarter gross domestic product growth in what is now the biggest collapse in this sector in almost 30 years.”
Whites-Only U.K. Party Seizes on Economic Slump to Fuel Gains
On their weekly visit to a local community center, Alby and Ellie Walker sip tea and swap gossip with retirees, putting a friendly face on a growing force that’s alarming the U.K. establishment: a whites-only party. "We campaign all the time," said Alby Walker, 51. "We never stop." The Walkers are councilors from Stoke-on-Trent for the British National Party, which has captured nine of the 60 local assembly seats by styling itself as a party of "community champions" and exploiting fears about immigration.
They are capitalizing on the biggest economic slump in three decades and mounting job losses. The activists are attracting support to their party -- whose constitution bars all but "Indigenous Caucasian" people -- in poorer districts historically allied with Prime Minister Gordon Brown’s Labour Party as they target their first seats in the European Parliament in June elections. In Newcastle-Under-Lyme, which neighbors Stoke, the BNP won 20 percent in a municipal election on March 5. Unlike in the U.K. parliament, European elections are based on a proportional system that helps smaller parties, meaning the BNP needs about 11 percent to take a seat in the West Midlands region.
"The BNP has abandoned the old style of street confrontations and rallies in favor of community politics," said Matthew Goodwin, a researcher into far-right parties at Manchester University in northwest England. "First you get success in local elections and European before you get a breakthrough" at the national level. This strategy may be helped by Britain’s economic troubles. The economy contracted by 1.5 percent in the fourth quarter, the most since 1980, and 1.23 million people claimed jobless benefits in January, the most in a decade. When the BNP won a seat on the London assembly for the first time last year, their vote included 25.2 percent in the borough of Barking and Dagenham, a blue-collar community in East London and home to a Ford Motor Co. plant.
In the U.K. Parliament at Westminster, the borough’s two lawmakers are both Labour. In 1997, when Labour came to power, Labour held all the council seats in Stoke. "It’s areas where Labour has traditionally been strong where the BNP has been making a great deal of headway and exploiting fears and spreading their racist and fascist beliefs," former Labour minister Peter Hain told the British Broadcasting Corp. on Feb. 21. "We need to take them on at a grass-roots level." The Conservative Party has led Labour in opinion polls for 17 months, with a ComRes Ltd. survey done between Feb. 27 and March 1 showing a 16 point gap. Opposition lawmakers blame Brown for failing to effectively counter the BNP. "If Labour got their act together and started reflecting communities, getting their councilors to knock on a few doors and not treat their electorate with disdain, that would make a big difference," said Eric Pickles, the Conservative Party chairman.
Formed in 1982, the BNP denounces the main three parties as "liars, buggers and thieves" and refers to immigrants as "parasites," according to its Web site. One in nine U.K. residents was born abroad, the Office for National Statistics said on Feb. 24. The party has been led by Cambridge University law graduate Nick Griffin, 50, for the past decade. Since taking over, he has pushed its 10,000 members to leave behind the image of shaven- headed Nazi-saluting thugs that dominated British nationalist politics of the 1970s and 1980s. "We’re becoming a much more organized party, we’re much more professional in what we do and we’re picking up votes in traditional working areas," deputy leader Simon Darby said.
The BNP had representatives at all last month’s strikes sparked by a dispute over Italian contractors at Paris-based Total SA’s Lindsey refinery in the north of England. "There’s only one political party that means British jobs for British workers and that’s the British National Party," said Alby Walker. "When money becomes tight, people become more insular, they protect their own." Stoke ranks 63rd out of 64 in the Centre for Cities Economic Prosperity Index. It placed bottom for employment growth in the years 2006-2007 and has the third-lowest wages in the U.K. People earn an average of 373 pounds ($524) a week compared with 475 pounds nationwide, according to government figures analyzed by Centre for Cities, a research institute based in London.
"My mother and father voted Labour and I automatically did the same, but I wouldn’t do it again," said Pat Grocott, 69, a retired pottery decorator from Stoke, who says she now votes BNP. "Labour have lost touch with the community all together." There are about 9,200 people on the waiting list for 20,000 council-owned homes in the city and the BNP is profiting from claims that ethnic minorities are given preferential treatment, a claim denied by the local authority. Alby Walker, who runs a carpentry business, says he rarely talks about race to the ladies at the pensioners’ social club on the outskirts of Stoke. "Some of them don’t even know we’re BNP councilors," said Walker, as he organized repairs to a footpath while his wife helped set up a second hand clothing sale. "They just think thank goodness they’ve been elected because we’ve seen them more in the last two years than we saw the other lot in 20 years."
Irish economy to shrink 6pc, says central bank governor John Hurley
Ireland's economy will shrink by over 6pc this year, Central Bank governor John Hurley told a parliamentary committee on Tuesday. He said the fall, based on the central bank's latest unpublished estimates of Gross Domestic Product (GDP), "is likely to result in an unemployment rate averaging over 11pc for the year". Ireland is facing an emergency supplementary budget next month in a bid to curb a soaring deficit. The move follows a 24pc collapse in tax revenue in the first two months of the year. Mr Hurley told the parliamentary committee on economic regulatory affairs that Ireland's economic performance has deteriorated markedly.
"The contraction in activity has deepened significantly, there has been a sharp rise in unemployment and a rapid deterioration in the fiscal position. We face significant challenges and it is critical for present and future generations that we work together now to confront them," he said. "If we do so, our economy will recover and has the potential to grow solidly again in the medium term. Our economy's strengths are important in this respect. There is the capacity for a rebound in productivity growth, the Irish labour market continues to be more flexible than most and at the start of the crisis, public debt as a percentage of GDP was low," he added. Last month, the government introduced a €2bn (£1.8bn) austerity package of which the central feature is a €1.4bn pension levy on some 350,000 public servants. It triggered the largest public demonstration seen in the Irish capital for 30 years with an estimated 120,000 protestors taking to the streets.
Professor: Danish economy is a disaster
Professor Jørgen Goul Andersen says that the government has ignored the warning signs regarding the Danish economy. The Liberal-Conservative Danish government ignored disturbing economic developments, despite the fact that there were all sorts of reasons to act, and the Danish economy is steering towards a national economic disaster, according to Aalborg University Professor Jørgen Goul Andersen. "The current situation is a national economic catastrophe. The Tax Commission proposals should have been shelved until better times. Denmark has more use of a Crisis Commission," Jørgen Goul Andersen of the Department of Economics, Politics and Public Administration tells Reuters.
According to Goul Andersen, the population has been lulled into deception by the mantra that the Danish economy is ‘basically strong and sound’, as Prime Minister Anders Fogh Rasmussen has repeatedly said. But he adds that the outlook for the Danish economy is a lengthy weakening. He says that Danish GDP – not including investment in stockpiles – has dropped 4.8 percent since the fourth quarter of 2007. GDP growth for the past eight quarters is at the lowest average for all OECD countries, he says. "The economic decline in Denmark started long before the financial crisis, and the prospects for the Danish economy are actually more disturbing than in many other countries. Apart from several years of economic rashness and other self-made problems, there are now major problems with competitiveness and exports," Andersen says.
He adds that government has ignored many of the ground rules for responsible economic policy. "It was not sensible to introduce instalment-free loans at a time when the housing bubble was so extended. And it was not sensible to conduct an expansive financial policy which fanned the flames of an already overheated economy," Goul Andersen says. He points out that the government allowed the housing bubble, with its great indebtedness, to grow until it burst. Goul Andersen says that Denmark may now find it very difficult to improve its situation. He says that Denmark has been hit by the heavy depreciation of currencies in countries that are some of Denmark’s main export markets – Norway, Sweden and Great Britain – and that exports are now the major problem. He says that the new tax reform package is unlikely to improve the situation, among other reasons because the business community will have to finance some of the tax relief in the package, putting a further strain on competitiveness.
Romania Next EU State To Join Rescue Bailout List
Romania asked the EU's executive for aid on Tuesday to save it from a possible financing crisis, making it the latest member of the bloc to cry for outside help against the global economic storm. Its plea coincided with a signal by Hungary's central bank that it may have sold euros in the open market, boosting the forint and other currencies that have been battered since the global crisis hit emerging Europe last year. All of central and Eastern Europe is scrambling to stop an evaporation of foreign funds that has caused Hungary and Latvia to grab International Monetary Fund-led lifelines, raised the risk of lending default, and sparked some public unrest.
Romania's finance ministry said it and the central bank had started talks with the Commission, the IMF and other institutions to seek "medium-term foreign financial assistance", code-language for a financial bailout. It followed a call on Monday by President Traian Basescu for popular support for belt-tightening measures and an IMF loan. An EU source familiar with the talks said an agreement could be reached very quickly. "Negotiations will start very soon. When they are concluded will depend on conditions to be proposed for the aid package and whether the Romanian government accepts right away," the source said.
An IMF mission will arrive in Bucharest on Wednesday for two weeks. Mihai Tanasescu, Bucharest's representative to the Fund, said he saw a potential programme running at least two years. The European Commission has pledged to help struggling economies in the bloc's eastern wing on an ad hoc basis. But lacking broad support, it has baulked at a wider plan to cover the region as a whole and has so far let the International Monetary Fund lead bailout packages. Such deals require austerity steps that are all the more unpopular because they cut state spending in countries already facing a collapse in growth. On Tuesday, EU finance ministers backed a call from the IMF to double its crisis funds to $500 billion, with an emphasis that states like China and Saudi Arabia could pay a big share.
There have been no details on a potential bailout but economists say it could amount to around 20 billion euros, near the $25 billion of IMF, EU and World Bank money agreed in a bailout of Hungary last October. Romania's centre-left government, however, may yet struggle to meet the IMF's requirements, bound to include tough spending cuts for the country of 22 million. "A smooth process should not be taken for granted," Citigroup said in a report. "The mettle of the coalition government is likely to be tested by the difficult decisions ahead." The leu, which has lost 18 percent since last summer but has been stable in recent weeks, edged up but still trailed gains of as much as 1.9 percent in the forint, the Czech crown and Polish zloty following the Hungarian central bank statement.
"We are also active in the market, which means we buy forints against euros, but as to when and how much, as to how much we did yesterday and whether we did anything at all or what we are doing today -- we have not commented on that and will not comment on it in the future either," Hungarian central bank Governor Andras Simor told TV2 televsion. The bank said after a special meeting on Sunday it would start to channel EU funds into the market and was ready to use its entire tool kit to help the forint but it was not clear if Simor was referring to EU funds or an actual intervention. Ratings agency Moody's also said emerging European states should not be treated as if pressures on their creditworthiness were uniform. Moody's sparked a region-wide sell-off last month after warning its banks could face ratings downgrades.
After several years of booming growth, the 10 ex-communist states that have joined the EU since 2004 have been walloped by the economic crisis due to the dearth of foreign financing as well as a collapse in western demand that has hammered exports. The assets selloff has cut up to a third off the value of floating currencies like the Polish zloty and put governments with units pegged to the euro under pressure to devalue, a move that would hit millions who took loans in euros and Swiss francs in the belief they would soon join the euro zone.
Social unrest, including violent protests in Bulgaria and Latvia, has risen in some countries, and the latter country's government was forced to step down last month. This week, officials in Lithuania tried to reassure the public after people rushed to buy foreign currency due to devaluation rumours. In Estonia, the IMF backed Estonia's currency peg, but said it should aim to adopt the euro as quickly as possible, while Lithuania's prime minister said the litas would not stray from its peg, even if budget cuts were needed. "In this context, our main objective is to secure the stability of the litas, and that we can do by securing the stability of our financial system," he said.
1 in 50 U.S. children face homelessness
One in 50 children is homeless in the United States every year, according to a report released Tuesday. The report, by the National Center on Family Homelessness, analyzed data from 2005-06 and found that more than 1.5 million children were without a home. "These numbers will grow as home foreclosures continue to rise," Ellen Bassuk, president of the center, said in a statement. The study ranked states on their performance in four areas: the extent of child homelessness, the risk for it, child well-being and the state's policy and planning efforts.
The states that fared the poorest were Texas, Georgia, Arkansas, New Mexico and Louisiana. Connecticut, New Hampshire, Hawaii, Rhode Island and North Dakota performed the best. Homeless children have poor health, emotional problems and low graduation rates, the study found. "The consequences to our society will play out for decades," Bassuk said. "As we bail out the rest of our nation, it is also time to come to their aid." The report offers recommendations such as improved support to ensure that children's schooling is not interrupted when they lose their homes, and services to address the trauma of homelessness.
Other highlights in the report, "America's Youngest Outcasts: State Report Card on Child Homelessness:"
• 42 percent of homeless children are younger than 6.
• African-American and Native American children are disproportionately represented.
• More than 1 in 7 homeless children have moderate to severe health conditions, such as asthma.
• Approximately 1.16 million of homeless children today will not graduate from high school.
Credit Crisis Leaves Defaulted Student Loan Borrowers Stranded
Each month, some 15,000 defaulted student loan borrowers join the ranks of those who, despite having brought their defaulted student loans current, are being forced to remain in default and suffer the continuing stain on their credit. Take the story of Judy Ellis, reported in The Chronicle of Higher Education: After defaulting on her $40,000 student loan, Ellis made the nine on-time payments required to "rehabilitate" her loan -- bring it out of default -- and restore her credit. And yet her loan remains in default. "I've done what I'm supposed to do, and they're holding me hostage," Ellis said. "I want to make this right, and I want to move on."
Thousands of borrowers like Ellis, despite doing everything in their power to catch up on payments and rehabilitate their student loans, are currently in a default limbo with guarantors, the organizations that insure student loans against default. Before a defaulted borrower's student loan can be considered fully rehabilitated and the borrower's credit and loan status returned to good standing, the guarantor must resell the borrower's college loan to a new lender. But in the current credit freeze, no lenders are buying. In November, the sole commercial bank still buying rehabilitated student loans announced it would no longer do so. Although a few non-bank entities may still purchase some of these college loans, 19 of the nation's 35 guarantors currently have no buyers for their student loans.
Each month, the Chronicle reports, $150 million in student loan debt is being added to the growing backlog of student loans awaiting rehabilitation. Consumer advocates and guarantors are concerned that if something isn't done soon to help move these student loans out of default and restore borrower credit, borrowers may get tired of remaining in default and stop making payments on their student loans altogether -- which would lead to even more, snowballing defaults. "The last thing we want is for people to pack it in and say, 'Oh, never mind,'" said Michael Ryan, vice president of borrower services for American Student Assistance, the guarantor for Massachusetts. Although legislation passed last year gave the Department of Education the authority to purchase student loans from guarantors, the new law only authorizes the Department to purchase loans disbursed after 2003, while a majority of rehabilitated loans were issued before 2003.
They Tried to Outsmart Wall Street
Emanuel Derman expected to feel a letdown when he left particle physics for a job on Wall Street in 1985. After all, for almost 20 years, as a graduate student at Columbia and a postdoctoral fellow at institutions like Oxford and the University of Colorado, he had been a spear carrier in the quest to unify the forces of nature and establish the elusive and Einsteinian "theory of everything," hobnobbing with Nobel laureates and other distinguished thinkers. How could managing money compare? But the letdown never happened. Instead he fell in love with a corner of finance that dealt with stock options.
"Options theory is kind of deep in some way. It was very elegant; it had the quality of physics," Dr. Derman explained recently with a tinge of wistfulness, sitting in his office at Columbia, where he is now a professor of finance and a risk management consultant with Prisma Capital Partners. Dr. Derman, who spent 17 years at Goldman Sachs and became managing director, was a forerunner of the many physicists and other scientists who have flooded Wall Street in recent years, moving from a world in which a discrepancy of a few percentage points in a measurement can mean a Nobel Prize or unending mockery to a world in which a few percent one way can land you in jail and a few percent the other way can win you your own private Caribbean island.
They are known as "quants" because they do quantitative finance. Seduced by a vision of mathematical elegance underlying some of the messiest of human activities, they apply skills they once hoped to use to untangle string theory or the nervous system to making money. This flood seems to be continuing, unabated by the ongoing economic collapse in this country and abroad. Last fall students filled a giant classroom at M.I.T. to overflowing for an evening workshop called "So You Want to Be a Quant." Some quants analyze the stock market. Others churn out the computer models that analyze otherwise unmeasurable risks and profits of arcane deals, or run their own hedge funds and sift through vast universes of data for the slight disparities that can give them an edge.
Still others have opened an academic front, using complexity theory or artificial intelligence to better understand the behavior of humans in markets. In December the physics Web site arXiv.org, where physicists post their papers, added a section for papers on finance. Submissions on subjects like "the superstatistics of labor productivity" and "stochastic volatility models" have been streaming in. Quants occupy a revealing niche in modern capitalism. They make a lot of money but not as much as the traders who tease them and treat them like geeks. Until recently they rarely made partner at places like Goldman Sachs. In some quarters they get blamed for the current breakdown — "All I can say is, beware of geeks bearing formulas," Warren Buffett said on "The Charlie Rose Show" last fall. Even the quants tend to agree that what they do is not quite science.
As Dr. Derman put it in his book "My Life as a Quant: Reflections on Physics and Finance," "In physics there may one day be a Theory of Everything; in finance and the social sciences, you’re lucky if there is a useable theory of anything." Asked to compare her work to physics, one quant, who requested anonymity because her company had not given her permission to talk to reporters, termed the market "a wild beast" that cannot be controlled, and then added: "It’s not like building a bridge. If you’re right more than half the time you’re winning the game." There are a thousand physicists on Wall Street, she estimated, and many, she said, talk nostalgically about science. "They sold their souls to the devil," she said, adding, "I haven’t met many quants who said they were in finance because they were in love with finance."
Physicists began to follow the jobs from academia to Wall Street in the late 1970s, when the post-Sputnik boom in science spending had tapered off and the college teaching ranks had been filled with graduates from the 1960s. The result, as Dr. Derman said, was a pipeline with no jobs at the end. Things got even worse after the cold war ended and Congress canceled the Superconducting Supercollider, which would have been the world’s biggest particle accelerator, in 1993. They arrived on Wall Street in the midst of a financial revolution. Among other things, galloping inflation had made finances more complicated and risky, and it required increasingly sophisticated mathematical expertise to parse even simple investments like bonds. Enter the quant.
"Bonds have a price and a stream of payments — a lot of numbers," said Dr. Derman, whose first job was to write a computer program to calculate the prices of bond options. The first time he tried to show it off, the screen froze, but his boss was fascinated anyway by the graphical user interface, a novelty on Wall Street at the time. Stock options, however, were where this revolution was to have its greatest, and paradigmatic, success. In the 1970s the late Fischer Black of Goldman Sachs, Myron S. Scholes of Stanford and Robert C. Merton of Harvard had figured out how to price and hedge these options in a way that seemed to guarantee profits. The so-called Black-Scholes model has been the quants’ gold standard ever since.
In the old days, Dr. Derman explained, if you thought a stock was going to go up, an option was a good deal. But with Black-Scholes, it doesn’t matter where the stock is going. Assuming that the price of the stock fluctuates randomly from day to day, the model provides a prescription for you to still win by buying and selling the underlying stock and its bonds. "If you’re a trading desk," Dr. Derman explained, "you don’t care if it goes up or down; you still have a recipe." The Black-Scholes equation resembles the kinds of differential equations physicists use to represent heat diffusion and other random processes in nature. Except, instead of molecules or atoms bouncing around randomly, it is the price of the underlying stock. The price of a stock option, Dr. Derman explained, can be interpreted as a prediction by the market about how much bounce, or volatility, stock prices will have in the future.
But it gets more complicated than that. For example, markets are not perfectly efficient — prices do not always adjust to right level and people are not perfectly rational. Indeed, Dr. Derman said, the idea of a "right level" is "a bit of a fiction." As a result, prices do not fluctuate according to Brownian motion. Rather, he said: "Markets tend to drift upward or cascade down. You get slow rises and dramatic falls." One consequence of this is something called the "volatility smile," in which options that benefit from market drops cost more than options that benefit from market rises. Another consequence is that when you need financial models the most — on days like Black Monday in 1987 when the Dow dropped 20 percent — they might break down. The risks of relying on simple models are heightened by investors’ desire to increase their leverage by playing with borrowed money.
In that case one bad bet can doom a hedge fund. Dr. Merton and Dr. Scholes won the Nobel in economic science in 1997 for the stock options model. Only a year later Long Term Capital Management, a highly leveraged hedge fund whose directors included the two Nobelists, collapsed and had to be bailed out to the tune of $3.65 billion by a group of banks. Afterward, a Merrill Lynch memorandum noted that the financial models "may provide a greater sense of security than warranted; therefore reliance on these models should be limited." That was a lesson apparently not learned. Given the state of the world, you might ask whether quants have any idea at all what they are doing. Comparing quants to the scientists who had built the atomic bomb and therefore had a duty to warn the world of its dangers, a group of Wall Streeters and academics, led by Mike Brown, a former chairman of Nasdaq and chief financial officer of Microsoft, published a critique of modern finance on the Web site Edge.org last fall calling on scientists to reinvent economics.
Lee Smolin, a physicist at the Perimeter Institute for Theoretical Physics in Waterloo, Ontario, who was one of the authors, said, "What is amazing to me as I learn about this is how flimsy was the theoretical basis of the claims that derivatives and other complex financial instruments reduced risk, when their use in fact brought on instabilities." But it is not so easy to get new ideas into the economic literature, many quants complain. J. Doyne Farmer, a physicist and professor at the Santa Fe Institute, and the founder and former chief scientist of the Prediction Company, said he was shocked when he started reading finance literature at how backward it was, comparing it to Middle-Ages theories of fire. "They were talking about phlogiston — not the right metaphor," Dr. Farmer said.
One of the most outspoken critics is Nassim Nicholas Taleb, a former trader and now a professor at New York University. He got a rock-star reception at the World Economic Forum in Davos this winter. In his best-selling book "The Black Swan" (Random House, 2007), Dr. Taleb, who made a fortune trading currency on Black Monday, argues that finance and history are dominated by rare and unpredictable events. "Every trader will tell you that every risk manager is a fraud," he said, and options traders used to get along fine before Black-Scholes. "We never had any respect for nerds." Dr. Taleb has waged war against one element of modern economics in particular: the assumption that price fluctuations follow the familiar bell curve that describes, say, IQ scores or heights in a population, with a mean change and increasingly rare chances of larger or smaller ones, according to so-called Gaussian statistics named for the German mathematician Friedrich Gauss.
But many systems in nature, and finance, appear to be better described by the fractal statistics popularized by Benoit Mandelbrot of IBM, which look the same at every scale. An example is the 80-20 rule that 20 percent of the people do 80 percent of the work, or have 80 percent of the money. Within the blessed 20 percent the same rule applies, and so on. As a result the odds of game-changing outliers like Bill Gates’s fortune or a Black Monday are actually much greater than the quant models predict, rendering quants useless or even dangerous, Dr. Taleb said. "I think physicists should go back to the physics department and leave Wall Street alone," he said. When Dr. Taleb asked someone to come up and debate him at a meeting of risk managers in Boston not too long ago, all he got was silence. Recalling the moment, Dr. Taleb grumbled, "Nobody will argue with me."
Dr. Derman, who likes to say it is the models that are simple, not the world, maintains they can be a useful guide to thinking as long as you do not confuse them with real science — an approach Dr. Taleb scorned as "schizophrenic." Dr. Derman said, "Nobody ever took these models as playing chess with God." Do some people take the models too seriously? "Not the smart people," he said. Quants say that they should not be blamed for the actions of traders. They say they have been in the forefront of pointing out the models’ shortcomings. "I regard quants to be the good guys," said Eric R. Weinstein, a mathematical physicist who helps run the Natron Group, a hedge fund in Manhattan. "We did try to warn people," he said. "This is a crisis caused by business decisions. This isn’t the result of pointy-headed guys from fancy schools who didn’t understand volatility or correlation." Nigel Goldenfeld, a physics professor at the University of Illinois and founder of NumeriX, which sells investment software, compared the financial meltdown to the Challenger space shuttle explosion, saying it was a failure of management and communication.
By their activities, quants admit that despite their misgivings they have at least given cover to some of the wilder schemes of their bosses, allowing traders to conduct business in a quasi-scientific language and take risks they did not understand. Dr. Goldenfeld of Illinois said that when he posted scholarly articles, some of which were critical of financial models, on his company’s Web site, salespeople told him to take them down. The argument, he explained, was that "it made our company look bad to be associating with Jeremiahs saying that the models were all wrong." Dr. Goldenfeld took them down. In business, he explained, unlike in science, the customers are always right. Quants, in short, are part of the system. "They get paid, a Faustian bargain everybody makes," said Satyajit Das, a former trader and financial consultant in Australia, who likes to refer to them as "prisoners of Wall Street."
"What do we use models for?" Mr. Das asked rhetorically. "Making money," he answered. "That’s not what science is about." The recent debacle has only increased the hunger for scientists on Wall Street, according to Andrew Lo, an M.I.T. professor of financial engineering who organized the workshop there, with a panel of veteran quants. The problem is not that there are too many physicists on Wall Street, he said, but that there are not enough. A graduate, he told the young recruits, can make $75,000 to $250,000 a year as a quant but can also be fired if things go sour. He said an investment banker had told him that Wall Street was not looking for Ph.D.’s, but what he called "P.S.D.s — poor, smart and a deep desire to get rich." He ended his presentation with a joke that has been told around M.I.T. for a long time, but seemed newly relevant; "What do you call a nerd in 10 years? Boss."
Warning: Quants love the 'predictably irrational'
Warning: Quants, the grand magicians of the illusionary arts of neuroeconomics, behavioral finance, investment psychology and the "new science of irrationality," are working with Wall Street in a massive conspiracy to scam America's 95 million investors. They are your worst enemies. You cannot trust them. Their new books are deceptive and misleading, part of Wall Street's secret efforts to dominate, manipulate and control your mind, money and the markets. This is not a review of Hollywood TV thriller like "24" involving corrupt politicians and corporations. Rather, we are targeting an emerging culture that's far more dangerous than we just read in "Recipe for Disaster: The Formula That Killed Wall Street," Wired magazine's fascinating analysis of how "Wall Street turned to quants -- brainy financial engineers -- to invent new ways to boost profits. Their method for minting money worked brilliantly ... until one of them devastated the global economy."
Just one? No, the real story is far worse than in Wired: Maybe the "one quant and his one formula" did create a lethal virus that triggered the subprime-credit meltdown and devastate the global economy. But that's old news. Moreover, Wired suggests it will never happen again "if" we just increase data transparency, "empowering all investors," thus creating "an army of citizen regulators." Laudable, but unlikely. Not with 40,000 Washington lobbyists and Wall Street the biggest political donor: They hate transparency. But that's not the real reason quants will rule the Street. The real story: Quants are everywhere, hiding in the shadows. Wired's "one quant, one formula" plot is merely the tip of an iceberg dead ahead as the global economy recovers and a new bull market roars back. Quants are hiding in academia, research institutes, think tanks, and on Wall Street's payroll, locked up in proprietary-secret no-talk contracts.
Quant technologies influence everything Wall Street does "to" Main Street: Not just trading, portfolio management and market manipulation, but every aspect of the Street including financial planning and broker training, day-trading systems, data design and transparency, 401(k) retirement programs, marketing, advertising and branding, lobbying and government regulations, and so many other niches. The real story is far broader and much more interesting, offering clues to the next meltdown. But first, some context and history about how we got here, why this "Wall Street/Quant Conspiracy" is expanding. Don't be misled by their latest pop-psychology books and their cute titles: "Blunder: Why Smart People Make Bad Decisions;" "Blind Spots: Why Smart People Do Dumb Things;" "Sway: The Irresistible Pull of Irrational Behavior;" "Drunkard's Walk: How Randomness Rules Our Live;" "The Logic of Life: Rational Economics in an Irrational World;" "Nudge: Improving Decisions About Health, Wealth and Happiness;" "Predictably Irrational: Hidden Forces That Shape Our Decisions" and other misleading stuff on neuroeconomics. These books reflect the relentless dumbing down of Americans in the economics arena.
They read like press releases from a modern-day P.T. Barnum, the great 19th century circus impresario, Remember: "There's a sucker born every minute." Today, the "suckers" are America's 95 million investors because the quants message is grossly misleading. It goes like this: If investors simply learn and adopt the tips in these books they will understand why their decisions are "predictably irrational" and as a result, they will stop making the "big mistakes" irrationality creates, plus in the future they will have a defense against the manipulations of Wall Street and its quants. Wrong. Wall Street's army of quants are always light-years ahead of the suckers. Quants are constantly inventing new technologies, algorithms and marketing tools that'll run circles around America's 95 million "predictably irrational" investors.
The pros and academics who wrote these books should be embarrassed. There's little new we haven't already read many years ago in classics like Hersh Shefrin's "Beyond Greed and Fear: Understanding Behavioral Finance and the Psychology of Investing;" John Nofsinger's "Investment Madness: How Psychology Affects your Investing ... and What to Do About It;" Gary Belsky & Thomas Gilovich's "Why Smart People Make Big Money Mistakes and How to Correct Them: Lessons from the New Science of Behavioral Economics;" and many since. The new books are just rehashing ideas now part of our conventional wisdom as well as scientific literature. The real story reads like covert military special-ops, a dangerous war game played in the shadows: Yale's Robert Shiller exposed this game in his 2000 classic "Irrational Exuberance." Irrational exuberance put the spotlight on individual investors driven by a "herd instinct."
But that scapegoated the little guy. Their "exuberance" was not the cause of irrational markets. That's an illusion invented by Wall Street and its army of quants. "Irrational exuberance" no longer fits in a world that now includes the exploding new $683 trillion global "shadow banking system." Today MIT Prof. Dan Ariely's "Predictably Irrational: The Hidden Forces That Shape Our Decisions" more accurately profiles a market driven by millions of investors whose irrational behavior is being secretly "predicted" and manipulated by Wall Street's quants, armed with an arsenal of neuroeconomic WMDs. P.T. Barnum would love today's scenario! If he were here today he'd one-up Madoff, Sanford, the CEOs of AIG and all our clueless Wall Street bosses. Barnum would arm his team with powerful new neuroeconomic technologies that'd make his chutzpah irresistible.
And that's exactly what we better expect from the next generation of Wall Street leaders and quants, coming in the next bull market; investors won't even know they are being manipulated by the next army of quants. How did we get here? To understand how these new books mislead America's 95 million investors, you need a brief summary of the four stages and principles in their evolution:
1. Investors are "irrational," their irrationality leads to "big mistakes." For two centuries, Wall Street's "rational investor" theory was gospel. But after 30 years of research by many leaders in the neurosciences, Princeton psychologist Daniel Kahneman was awarded the 2002 Nobel Economics prize for proving that investors are irrational decision-makers who often act against their best economic interests.
2. Main Street's "irrational exuberance" does not "cause" bulls. In his 2000 book Shiller defined irrational exuberance as "wishful thinking on the part of investors that blinds us to the truth of our situation," creating a collective madness that turns investors into irrational mobs. Shiller's still "old school," still believes that Main Street investors are a blind mob driven by an "invisible hand," not quants' mind games.
3. Investment decision-making is now "predictably irrational." Chicago's behavioral finance genius Richard Thaler periodically edits Advances in Behavioral Finance, collections of cryptic quant research. He says Wall Street "needs investors who are irrational, woefully uninformed, endowed with strange preferences, or for some other reason willing to hold overpriced assets. We shall refer to these conditions collectively as 'irrational' ... it seems reasonable to equate nonpecuniary with irrational." And earlier, speaking as a true quant: "In the financial markets, if you are prepared to do something [predictably] stupid there are many professionals happy to take your money."
4. Knowing the new rules make you more vulnerable their scams. Bottom line, the new neuroeconomics pop-psychology books don't work, they are based on a false premise: That "predictable irrational" investors can teach themselves to become "less irrational." Wrong. Paradoxically, the more we learn about our irrational brains, the more we convince ourselves we're in control, acting rationally.
We forget that 88% of our behavior is driven by our subconscious mind: Preconceived rationales, family and tribal beliefs, primal convictions, honor codes and commandments, ideologies, dogma and other "irrational" ideas locked deep in our brains, stuff we can't see but quants can access, reprogram, take advantage of and manipulate. So we continue making irrational decisions and big mistakes. Amazing isn't it: Your brain really is your worst enemy. Even if you learn all the new rules from the new pop-psychology books your brain will unconsciously ignore the new neuroeconomic stuff you read and convince you that you're acting "rational." No wonder Wall Street's quants can easily predict behavior in advance and take advantage of America's 95 million investors, siphoning off hundreds of billions in extra fees and commissions annually.
Where The Bailout Was Born: One Year Ago
We just passed the first anniversary of an important, if little noted, meeting where the plans for what would become the government's attempted bailout of the banking system were first hatched. One year ago, a group of venture capitalists, Silicon Valley executives and professors at the Stanford Institute for Economic Policy Research met to discuss the looming crisis in finance and debate a possible bailout. It was early for such talk. Bear Stearns had not yet collapsed. Hank Paulson was still deriding the notion of a bailout and knotting his brow about moral hazard. But the group gathered at Stanford, which included Larry Summers and Long-Term Capital Management veteran and Nobel laureate Myron Scholes, saw what was coming: the government would eventually spend a lot of tax payer money in an attempt to clean up the credit mess. "I think they should at least be thinking about it," Myron Scholes said. "If you're going to do it anyway, why not do it sooner?"
A Debate Over Which Bailout And When
It wasn't a radical view. At the time, 32 of the 51 economists surveyed by the Wall Street Journal were predicting the some kind of government action to ease the credit crisis. But what is striking is how close Myron Scholes came to outlining what tactics the government would actually employ in the bailout. The mainstream view of those favoring a bailout was focused on mortgages and mortgage-backed securities. The idea was that the government might step in and buy up "illiquid securities" and mortgages, ease onerous terms for borrowers and arrest the decline in the value of bank assets. People thought something as minor as a slightly more robust Federal Housing Authority might be able to accomplish this. In retrospect, it's clear to see how this view vastly underestimated the size of the mortgage crisis.
Scholes Proposed Capital Injections
After scratching on a yellow pad while Summers talked about the state of banks and credit, Myron arrived at the idea a different idea for meeting the challenge facing the economy from the precarious position of the banks. He wanted to avoid having the government buy the mortgage assets held by banks, believing they would be better managed in private hands. Instead, he thought the government should make direct capital injections into banks. Here's how the Wall Street Journal described the view at the time:Mortgages and other bank assets aren't worth what banks thought. The losses erode the banks' capital cushion. Bank leverage...magnifies the effect.
In response, banks either (A) reduce lending and sell assets or (B) raise new capital on terms that dilute existing shareholders. Provided they can find investors willing to bet that bank assets eventually will be worth more than they are today, shareholders tend to prefer option A, the smaller bank. But that market solution could destroy value and produce a crippling credit crunch. Society prefers option B, hence exhortations from Messrs. Paulson and Summers for banks, Fannie Mae, Freddie Mac and others to raise capital.
Note that even this view is too optimistic. The "market solution" of selling mortgage assets at prices that were above March 2008 was was unavailable because many investors feared--quite correctly, as it turns out--that those assets would be worth less. Option B was attempted for a few months but it too quickly became unavailable as investors learned that the financial health of banks was far worse than the talk of "illiquid assets" had let on. Scholes proposed having the government invest in both debt senior to existing debt and in preferred shares senior to existing shares. This would balance the interest of the debt holders and the equity holders, avoiding advantaging one versus the other. What's more, Scholes proposed that the government make the capital available to all banks, not just the sickest. This is, actually, very close to what happened. The government did wind up buying preferred shares instead of buying mortgage backed assets directly. The program was extended to a broad range of banks, albeit not through an auction. And while the government didn't put new debt into banks, it guaranteed new debt from others coming into banks.
A Give Away To Shareholders?
At the time, this plan had its critics. Hyun Song Shin, a Princeton finance professor, called Scholes plan "self-serving" for existing shareholders, who he believed should be wiped out before the government put capital in any bank. The first move, he said, should be for the Treasury Department to summon the nation's top bankers to his office and strongly suggest they conserve capital by suspending dividends. And over at DealBreaker, I warned that the urge for a bail out was based on the dubious premise that the market was incorrectly pricing mortgage assets. The idea that selling assets in March of 2008 would "destroy value" was largely nonsense that could only be believed if you didn't understand that housing prices were coming down and mortgage assets linked to the housing bubble were going to be distressed for the long-term.
"Selling assets does not 'destroy value'--it reveals it, by providing a market price for the assets sold," I wrote. "All of the bailout solutions basically amount to attempts to avoid this price discovery." The commenters at DealBreaker weren't so kind to my view. "In a market with asymmetrical information (swaps sold to Alabama towns), when the percentage of goods that are crap surpass a certain threshold level, the market no longer works to "discover prices." It collapses," one wrote. "Good and bad securities alike stop being traded. Pretty contrary to what you learn in undergrad economics. Myron Scholes knows more than you."
Liquidity versus Solvency
At the heart of this early debate over the bailout were different views about the size and duration of the problem. The FHA bailout people believed that only a small percentage of financial assets linked to the very worst subprime mortgages were the problem. Many thought we were in a liquidity crisis rather than a solvency crisis. Others, including Scholes, thought that asset prices would rapidly recovery after banks were recapitalized. Some of us weren't so sure. As it turns out, however, Scholes did know more than me about one thing: he correctly predicted that the government would wind up making direct capital injections rather than buying up assets. He just seems to have over-estimated the efficacy of that program.
Regulating the new financial sector
by Willem Buiter
Financial regulation is a now-or-never proposition as the sector’s lobbying power is greatly diminished. This column argues that we should embrace robust regulation now, risking over-regulation. Correcting mistakes later would be better than risking another era of "self-" or "soft-touch" regulation.
It is necessary, for political economy reasons, to rush new comprehensive regulation of the financial sector. While it would be better, holding constant the likelihood of the measures being adopted and implemented, not to act in haste, there is now a unique window of opportunity – a period of extraordinary politics, in the words of Balcerowicz – to actually get the thorough regulatory reform we need. The reason is that the private financial sector is on its uppers – down and out – and will not be able to put together much of a fight, let alone its usual boom-time massive lobbying effort to veto radical measures. It is better to over-regulate now and subsequently correct the mistakes than to risk another era of self-regulation and soft-touch under-regulation of financial markets, instruments and institutions.
The objective of macro-prudential regulation is systemic financial stability. This has a number of dimensions:
• Preventing or mitigating asset market and credit booms, bubbles and busts
• Preventing or mitigating market illiquidity in systemically important markets
• Preventing or mitigating funding illiquidity for systemically important financial institutions
• Preventing or managing insolvencies of systemically important financial institutions
Other micro-prudential considerations (abuse of monopoly power; consumer protection; micro-manifestations of asymmetric information) should be left to the micro-prudential regulator(s).
Regulation will have to be comprehensive across instruments, institutions, markets and countries. Specifically, we must:
• Regulate all systemically important highly leveraged financial enterprises, whatever they call themselves: commercial bank, investment bank, universal bank, hedge fund, SIV, CDO, private equity fund or bicycle repair shop.
• Regulate all markets for systemically important financial instruments.
• Regulate all systemically important financial infrastructure or plumbing: payment, clearing, settlement systems, mechanisms and platforms, and the associated provision of custodial services.
• Do it all on a cross-border basis.
Self-regulation is to regulation as self-importance is to importance. The notion that markets, including financial markets could be self-regulating, by properly incentivising CEOs and Boards of Directors and through market-discipline, is prima facie suspect. We decide to regulate markets because of market failure. Then we let the market regulate the market. This is an invisible hand too far. The concept of self-regulation is especially ludicrous for financial markets. Finance is trade in promises expressed in units of abstract purchasing power (money). It scales up and down ferociously quickly. If Airbus or Boeing wishes to double the size of its operations, it takes 4 or 5 years to put in place another set of assembly lines. If a bank wishes to scale its balance sheet and operations ten-fold, all it has to do is to add a zero in the right places. Given enough optimism, trust, confidence and self-confidence, financial activity can, through leverage, be scaled up alarmingly quickly. Once optimism, trust, confidence and self-confidence disappear and are replaced by pessimism, mistrust, lack of confidence and fear/panic, the scaling down of bank activities can occur even faster. Such an industry cannot be left to its own devices.
The importance of public information
Regulation can only take place on the basis of independently verifiable (public) information. Regulators cannot rely on information that is private to the regulated entity. This means that the capital adequacy of the first pillar of Basel II has to be overhauled radically, as its risk-weighting of assets relies in part on internal bank models that are private to the banks.
The importance of cooperation of the Central Bank, Treasury and supervisor
Macro-prudential regulation, supervision and intervention require the close co-operation of the central bank, the supervisor/regulator and the Treasury (fiscal authority). To fulfil its macro-prudential role, the central bank requires the fiscal back up of the Treasury (ministry of finance). This is because by accepting private securities as collateral in its open market operations and at its discount window, and through the outright purchases of private securities associated with qualitative easing or credit easing, the central bank takes private credit risk on its balance sheet. To do this without becoming an active fiscal actor in its own right, the central bank will require a Treasury indemnity (guarantee) for the full amount of its private sector exposure. The fact that the Fed only has a Treasury indemnity for ten percent of its maximal exposure under the TALF means that the Fed is now a fiscal policy maker. This compromises its independence.
Tension with global financial markets
Since central banks, supervision/regulation, and taxation are almost everywhere national, there is an inherent tension with global financial markets and border-crossing financial institutions. We can expect to see the following:
• There will be a repatriation of border-crossing banks and other financial intermediaries, partly driven by market forces and partly by regulatory and other official interventions. This cross-border deleveraging can already be seen at work, especially where banks get tax payer support (at the national level) and commit themselves in return to lend to domestic households and enterprises.
• Cross-border branches (supervised and regulated by the country of the parent bank), with lender of last resort (LLR) and market maker of last resort (MMLR) access (if any) only through the parent bank in the home country, and with fiscal back-up (if any) only through the home country, will be a thing of the past.
• Even as regards subsidiaries, there will only independently capitalised, ring-fenced, autonomous cross-border subsidiaries, with regulation and supervision by host country, with LLR and MMLR support (if any) from the host country central bank and fiscal support (if any) from the host country Treasury.
Special problems for the Eurozone
There are special problems for Eurozone:
• There is one central bank (ECB/Eurosystem) for 16 countries
• Supervision and regulation remain at the national level
• There is no fiscal Europe/or fiscal Eurozone – no single supranational entity with tax and borrowing powers to back-up and if necessary recapitalise the ECB/Eurosystem, when it suffers losses as a result of Eurozone-wide monetary policy operations, liquidity operations and credit easing operations.
Fiscal Europe should back up the ECB
There is a clear need for a fiscal Europe to back up the ECB and to permit it to engage in qualitative easing/credit easing. This could come in one of three forms. In increasing order of likelihood these are:
• A supranational Eurozone-wide tax and borrowing authority, specifically dedicated to fiscal backing for the ECB/Eurosystem.
• A Eurozone-wide fund, funded initially by the 16 Eurozone governments (in proportion, say, to their relative shares in the ECB's capital, that the ECB/Eurosystem could draw on (subject to qualified majority support in the Eurogroup) if it were to suffer losses as a result of Eurozone-wide monetary policy operations, liquidity operations and credit easing operations.
• An ad hoc, hastily cobbled together fiscal burden sharing rule for the 16 Eurozone national governments, to restore the capital adequacy of the ECB/Eurosystem.
An EU-wide regulator
There is a need for Eurozone-wide and preferably for an EU-wide regulator/supervisor for border-crossing financial institutions (mainly bank-like entities and insurance companies). Colleges of national supervisors/regulators just won't do. Eurozone-wide or, preferably, EU-wide regulation with national supervision and enforcement is a poor second-best, because countries have been shown to cheat as regards the interpretation of EU-wide rules and regulations.
Close down tax havens
There is the need and opportunity to close down all tax havens and regulatory havens. Tax havens are defined as countries that have bank secrecy, which includes Switzerland, Austria, Luxembourg , and the usual micro-state suspects (bank secrecy or bank privacy is the legal principle according to which banks can protect personal information about their customers, even from the tax authorities and police authorities of these customers). The anonymity provided by bank secrecy promotes tax evasion, tax avoidance (or fraud), money laundering and hiding the proceeds of criminal activity. Regulatory havens are nations that offer companies the opportunity to avoid global standards for reporting, governance, auditing, transparency, openness, etc.
Tax havens and regulatory havens are key elements in the global regulatory and tax arbitrage games that have undermined government revenue bases and weakened global regulatory standards. The means to put tax havens out of business are simple – forbid banks, other financial institutions, and private persons from doing business with and engaging in transactions with banks and other financial institutions located in countries that have bank secrecy. To take care of regulatory havens, don't recognise and enforce contracts drawn up under their laws and do not recognise court judgements originating from tax havens.
Regulation financial innovation
Financial innovation in products and institutions is potentially beneficial and potentially harmful. There is a need to regulate financial innovation. I propose the model used in the US by the Food and Drug Administration for pharmaceutical and medical products.
• First, there is a positive list of financial instruments and institutions. Anything that is not explicitly allowed is forbidden.
• To get a new instrument or new institution approved, there will have to be testing, scrutiny by regulators, supervisors, academic specialists and other interested parties, and pilot projects. It is possible that, once a new instrument or institution has been approved, it is only available ‘with a prescription'. For instance, only professional counterparties rather than the general public could be permitted.
• Clearly, this approach to financial innovation would slow down financial innovation. It may even kill off certain innovations that would have been socially useful. So be it. The dangers of unbridled financial innovation are too manifest.
• Rating agencies should be turned into single-activity or single-product line firms. They should provide just ratings, not any other products or services, including advice. The conflict of interest in combining rating activities with advisory services or the sale of other lucrative services or products to customers looking for the best possible rating is obvious and inescapable. Chinese walls don't work and are aptly named. The Great Wall of China did not keep the barbarians out or the Han Chinese in.
• The quasi-regulatory role of the rating agencies in Basel II should be eliminated.
• The customer wishing to have his company, country, or instrument rated should not pay the rating agency, ex ante or ex post. Instead, the customer should pay the regulator, who would then allocates/auctions the individual rating activity among the population of competing rating agencies.
• Rating agencies should be paid in part in the securities they are rating. Such securities should be held to maturity and cannot be hedged by the rating agency.
Securitisation of transparent, relatively homogeneous assets or cash flows is a useful invention, but only if the originator of the underlying assets/cash flows is required to retain a material chunk of the first-loss or equity tranche.
Countercyclical capital and liquidity requirements
Countercyclical capital and liquidity requirements or leverage ratios should be implemented, based either on the balance sheet characteristics of individual banks (e.g. the proposals by Goodhart and Persaud) or based on the behaviour of economy-wide aggregates (GDP, credit growth, balance sheet growth, asset prices) in the host country. These requirements should apply to all highly leveraged institutions deemed systemically important.
Capital and liquidity requirements/ratios should be buffers, not floors. Requirements should be countercyclical. Violations punished according to a steep ladder of penalties.
Narrow banking vs. investment banking
The distinction between public utility banking/narrow banking vs. investment banking; (the rest) has to be re-introduced. I advocate a form of Glass-Steagall on steroids, with a heavily regulated and closely supervised narrow banking sector, engaged in commercial banking (taking deposits and making loans) and benefiting from lender of last resort and market maker of last resort support. The investment bank sector will also be regulated and supervised, but more lightly, and according to the same principles as other systemically important highly leveraged non-narrow bank institutions. Universal banking has few if any efficiency advantages and many disadvantages. Economies of scale and scope in banking are soon exhausted. They tend to be fat to fail, have a lack of focus, and suffer from span-of-control negative synergies etc. Universal banks or financial supermarkets use their size to exploit market power and try to shelter their risky, non-narrow banking activities under the LLR and MMLR umbrella of the narrow bank that's hiding somewhere inside the universal bank.
Penalise bank size
Splitting banks into public utility or narrow banks does not solve the problems of banks (narrow or investment) becoming too big or too interconnected to fail. It is therefore necessary to penalise bank size per se, to stop banks from becoming too large to fail (if they are interconnected but small, they are still not systemically important). I would penalise size through capital requirements that are progressive in size (as well as leverage).
Institutions’ contribution to systemic risk
The problem of the ‘swarming' of individually not systemically important institutions that collectively achieve critical mass as regards systemic stability has been analysed by Tobias Adrian and Markus K. Brunnermeier and in the recent Geneva Report by Markus Brunnermeier, Andrew Crocket, Charles Goodhart, Avinash D. Persaud and Hyun Shin. They propose a measure of an institution's contribution to systemic risk which they call CoVaR . It is the value at risk (VaR) of a financial institution conditional on other institutions being in distress. The increase of in an institution's CoVaR relative to its VaR is supposed to measure spillover risk among institutions. There are clearly deep conceptual problems with this measure. It jumps from correlation to ‘spillover' – which is effectively causation – without much thought about the difference between the two. And, like VaR, CoVaR is likely to be very different under conditions of extreme crisis than under the conditions prevailing on average during the sample that provided the data used to calculate the CoVar. But the problem of individually systemically insignificant institutions that can collectively achieve critical mass is one that has to be addressed by the regulator and supervisor if there are large numbers of small institutions.
Fair value accounting
There is no substitute for fair value accounting or even mark-to-market accounting. Companies must be required to use the strictest version of it for the inflation it requires. Even illiquid market prices are better than managerial discretion. Companies should not be able to move assets between the trading book, the banking book, and the "available for sale" book, unless the institution is in administration or in a special resolution regime. Regulatory forbearance should be used to mitigate the consequences of mark-to-market pricing when asset prices are depressed because of market illiquidity.
Remuneration is a matter of corporate governance. The incentive structure created by compensation packages does, however, influence the risk profile of a bank or other financial institution. It should be taken into account by the regulator/supervisor in determining capital requirements and liquidity requirements, assuming the regulator/supervisor understands the impact of the remuneration structure on bank risk taking.
Mixed public-private ownership
Given the manifest failure of the efficient market hypothesis, it is not at all obvious that systemically important financial institutions should be allowed to be listed companies. Financial institutions' stock market valuations have been notorious will-o'-the wisps and have, through stock options and other stock-market valuation-related executive remuneration components, contributed to the excessive risk taking during the recent boom. Partnerships, mutual ownership, cooperative ownership, and various forms of public and mixed public-private ownership may be more appropriate for financial institutions. Perhaps we should even consider removing limited liability for investment banks!
Top scientist: don't trust politicians on climate change
Politicians were willfully ignoring and misunderstanding the science of global warming, a government adviser said today. John Ashton, who is the Foreign and Commonwealth Office's special representative on climate change, warned scientists that they could not trust in the honesty of politicians. Speaking at the start of the climate change conference in Copenhagen, Denmark, Mr Ashton said that the truth could be lost to political expediency or mischief and urged scientists to couch their conclusions in terms that could not be misunderstood or go unheard. Delegates at the conference will again meet in the city later this year in an attempt to reach an international deal on how to combat global warming.
Mr Ashton, who trained as a physicist before becoming a diplomat, said that researchers had been tremendously successful in analysing climate science but had yet to succeed in making political leaders understand the importance of their discoveries. "In science the truth is out there. It's there to be discovered. In politics often the truth is whatever is expedient to this or that project," he said in the opening session of the conference. Urging the scientists to speak the language of politicians, he said: "We need to do this better to stand any chance of keeping cimate change on the right side of the last acceptable risk. There has to be much better communication between the world of science and the world of politics."
Of particular concern was the different meaning of the word uncertainty to scientists and politicians. To the former it meant uncertainty over the strength of a signal, to the latter it meant "go away and come back when you're certain". He said: "There are plenty of people who for reasons of either ignorance or mischief are ready to confuse one type of uncertainty with the other." Speaking outside the conference hall, he added: "There are plenty of people in the political world who are quite happy to abuse the [scientists' conclusions] to serve political purposes. Politics is a shark-infested sea.
"The more effort scientists put into how their message might be heard, how it might be manipulated and made mischief of, the better." Mr Ashton also told scientists that if they wanted to be listened to in the current political climate, they needed to show that tackling climate change was an economic opportunity. "Politicians around the world are going to be focussed on one big thing and that is going to be jobs, jobs, jobs," he said. "If we want to successfully respond to climate change we have to form it as part of the solution to the economic crisis."
Carbon emissions creating acidic oceans not seen since dinosaurs
Human pollution is turning the seas into acid so quickly that the coming decades will recreate conditions not seen on Earth since the time of the dinosaurs, scientists will warn today. The rapid acidification is caused by the massive amounts of carbon dioxide belched from chimneys and exhausts that dissolve in the ocean. The chemical change is placing "unprecedented" pressure on marine life such as shellfish and lobsters and could cause widespread extinctions, the experts say. The study, by scientists at Bristol University, will be presented at a special three-day summit of climate scientists in Copenhagen, which opens today. The conference is intended to update the science of global warming and to shock politicians into taking action on carbon emissions.
The Bristol scientists cannot talk about their unpublished results until they are announced later today. But a summary of the findings seen by the Guardian predicts "dangerous" levels of ocean acidification and severe consequences for organisms called marine calcifiers, which form chalky shells. It says: "We find the future rate of surface ocean acidification and environmental pressure on marine calcifiers very likely unprecedented in the past 65 million years." The scientists add that the situation in the deep sea is of even "greater concern". The scientists compared the current acidification rate with a giant prehistoric release of greenhouse gas, which geologists know caused widespread extinction of deep water species.
The summary reads: "Because the rates of acidification between past and future are comparable, and [because] there was widespread extinction of benthic organisms [lowest living], one must conclude that a similar level of extinction is more likely than not in the future." Concern about ocean acidification from carbon pollution has grown in recent years, but the issue receives much less attention than global warming — also caused by human carbon emissions. The Bristol study is one of the first to predict the consequences of acid waters by looking at past events. It says future deep sea acidification must be limited to 0.2 pH units to avoid the worst effects. The pH of surface waters, where the CO2 is absorbed from the atmosphere, has fallen by about 0.1 units since the industrial revolution, though it will take longer for the acid to reach deeper water.
Ocean acidification is one of the key topics at the Copenhagen summit, with a series of presentations scheduled to examine the impacts. Ken Caldeira, an expert on ocean acidification at the Carnegie Institution in California, will tell the conference that the next few decades could produce "profound" changes in the oceans. He will say: "The choice to continue emitting carbon dioxide means that we will be an agent of biological change of a force and magnitude exceeded only by the causes of the great mass extinction events. If we do not cut carbon dioxide emissions deeply and soon, the consequences of ocean acidification will stand out against the broad reaches of geologic time. Those consequences will remain embedded in the geologic record as testimony from a civilisation that had the wisdom to develop high technology, but did not develop the wisdom to use it wisely."
Other experts will report that acidification is already affecting marine life in the Arctic and Antarctic. They will also discuss a bizarre finding that acid waters carry sound more efficiently, so the ocean will be a much noisier place in future. The conference comes ahead of a year of high-level political discussions on climate change, which culminate in international negotiations in Copenhagen in December, where officials will try to hammer out a successor to the Kyoto protocol. Katherine Richardson, a marine biologist at the University of Copenhagen, who organised this week's event, has described it as "a deliberate attempt to influence policy". She said many scientists were concerned that politicians have not grasped the seriousness of the situation, despite increasingly gloomy predictions.
This week's meeting will publish an update to the 2007 report of the Intergovernmental Panel on Climate Change (IPCC). A number of studies published since the IPCC report was prepared show that carbon emissions are rising faster than expected and that existing greenhouse gas targets may not be enough to prevent catastrophic temperature rise. It will also assess whether projected sea level rises have been underestimated, and if there is still a realistic chance that average global temperature rise can be limited to 2C.