Senator George P. Wetmore, Rhode Island, in Washington DC, riding a Krieger electric landaulet, produced in France
Ilargi: So how angry do we think the public will get over the bonuses at AIG? In Washington, the spin doctors and pollsters are running overtime, that's for sure. Obama runs the risk of severe damage to his status if he can't solve this one in way the public deems satisfactory. And he'll provide the Republicans, who were roadkill just a few months ago, with a new and solid way back into the people's favor.
Still, the true outrage should not be directed against a bunch of bonuses, no matter how unethical they may be. That they are the target of the outrage today is somewhat disconcerting. $180 billion in taxpayer's money has gone to AIG, alongside tens of billions more that went to Citi, Bank of America, JPMorgan, Morgan Stanley, Goldman Sachs. What is now becoming obvious is that the AIG bail-out is nothing but a hidden additional vehicle to push extra funding into the vaults of the major banks.
There are plenty voices claiming that credit derivatives are something “good", since they supposedly can spread risk around, but the reality is that they are just another instrument that enables more gambling and more leverage. The amounts of money from the AIG bail-out that went to these banks points to one clear issue: no risk was spread in any substantial fashion, it all ended up inside AIG’s financial unit, the same one whose "best and brightest" bonuses are the cause of the outrage.
In other words, the anger applies to -at most- 0.1% of the money the US government has put into AIG. Mind you, we still have no way of knowing how big the losses will eventually be. The total credit default swaps figures were at $62 trillion not so long ago, so there may be much more yet to follow. And none of these losses were caused by innocent mistakes. It was very clear at AIG that insuring tens of trillions of dollars in swaps was a disaster waiting to happen, simply because the amount of money and risk involved was hundreds of times higher than what the company possessed in "real" assets. There may have been a few dim folk at the trading desks who thought the swaps would bring in money forever, but surely not all, let alone the managers. Who incidentally are the receivers of last week's bonus pay-out.
A similar situation of course existed at the banks that bought AIG's "insurance" (it's not really insurance, which is why AIG wasn't compelled to hold reserves against them). It's not just fractional banking on steroids, which would be bad enough, it's simply betting. And the majority of those best and brightest have known that very well all along. their bets went bad, and they received trillions of dollars of your money. And I can't guarantee you that they're not still playing the same wagers, after all that's where the big paydays came from.
It's high time to divert your attention from AIG bonuses, and to focus on the entire system. The one that's cost you $2 trillion, not just $165 million. Time to look at Goldman Sachs and Morgan Stanley, at the people who run those operations. At the role played in the whole scheme by the revolving door crowd of Henry Paulson, Tim Geithner, Robert Rubin, Lloyd Blankfein etc etc., who were all actively involved in the creatively innovative deals of the past decade that have led to the government spending $2 trillion on their firms. Actually, there are the very people who, once they entered government, obtained the power to spend your cash to cover the losses they had incurred -for their companies- while working in the private sector.
The present anger is being controlled by spin doctors. You're being played. They are very good at what they do. They want nothing more than for you to focus on a bunch of AIG minions, so your attention can be drawn away from their masters. Are you going to let that happen? The AIG bonus receivers should be fired, of course. But many of the higher-ups need to be prosecuted. The problem is that they presently hold the reins of power. Perhaps that is where your anger would be far more useful.
Whitney: Banking Woes Likely to Get Worse in 2009
A surge in borrower defaults and unemployment pressures will make 2009 an even uglier year for banks than last year, analyst Meredith Whitney said. She predicted "breakups and M&As on a grand scale" as the industry seeks to remake itself in the face of all its capital pressures.
"I don't think this year is going to look any better than last year," Whitney said in an interview Tuesday on CNBC. "In fact it will look worse because there's so much credit coming out of the system." Whitney, a former analyst at Oppenheimer who recently opened her own firm, is renowned for calling out the problems with banks' toxic assets before the issue became widespread.
As some have been predicting the worst may be over for the banking sector, Whitney countered that many of the statements about some of the big banks showing profits ignore the burden that additional writedowns will pose through the year. In particular, she said Citigroup's statement that it had turned a profit the first two months of 2009 might came back to haunt it once a fuller picture was presented. Consumers also will face pressure as unemployment grows and banks and credit card companies start calling in credit lines to avoid getting stuck with even more bad debt.
"The probability of more people going into default is higher, so the banks are going to have a tough time," she said. As a solution to some of the banking system's woes, Whitney said the government should focus less on ever-changing rescue plans and instead start helping smaller institutions ramp up their community lending to local businesses and homeowners. "You can re-energize the local lending scene and then supercharge those banks," she said. "You supercharge those so they're able to gain critical mass and start getting loans on a super-regional basis to businesses, to homeowners that qualify. At least that mitigates some of the capital that's surely going to come out of the market."
The financial sector has been under pressure since the onset of the credit crisis last fall. But recently major banks like Citigroup, JPMorgan Chase and Bank of America, have said early results are showing signs of hope. Whitney predicted that some of the largest institutions will be remade this year in a way not seen before. Those mergers and acquisitions will see companies come together to create unique syynergies--she used a blending of Citi and American Express as a hypothetical case where one business' strength could compensate for another's weakness. "You're going to have some growth vehicles that come out of it but they're not going to look anything like today's version of these gobbledygook banks," she said.
In addition to the natural activity that will take place, Whitney said banks also will need help from Washginton. She urged policy makers above all to be consistent. "Any game that you want to plan as a corporation, the rules are changing all the time," she said. "You can't function as a business operator if the rules are changing." Displaying leadership and managing expectations will be the key. "They need to show leadership by saying, 'OK, what's the world going to look like in five years?' and look backwards from that," Whitney said. "In five years you know that the big banks are going to have a lot less control and power than they have now. We have to disaggregate, dislodge that market share dominated by five main players."
"Let's invigorate and supercharge some of the smaller players to get them to a medium-enough size so they can start making loans and they can start moving the needle." And she called on government leaders to harness the American spirit to rebuild the economy, similar to the way so many people come together to wear the color of the Irish on St. Patrick's Day. "There's a spirit that can't be dislodge by the economic turmoil," she said. "Now is a great opportunity to capture that spirit as opposed to set expectations too high which is what (Treasury Secretary Timothy) Geithner did with the original plan and then just disappoint. People will give you the benefit of the doubt until you keep disappointing them."
Political Heat Sears AIG
President Barack Obama said Monday that he would "pursue every single legal avenue to block" $165 million in bonuses to American International Group Inc. employees who were in part responsible for the insurance giant's near collapse. But hours later, administration officials said the payouts made Friday couldn't be extracted from their recipients without a legal fight that would cost the taxpayers even more. Instead, officials said the White House will focus on ensuring taxpayers recoup the cost of the bonuses and, going forward, executive compensation at AIG would be on a much tighter leash. As leverage, the government said it would apply new rules to the next round of AIG bailout funds, a $30 billion infusion pledged earlier this month.
Mr. Obama's statements came as his administration grappled with how to manage a bipartisan firestorm that erupted after the weekend news of the bonuses, and word from his aides Sunday that they couldn't do anything to stop the payments. The confusion that seemed to mark the White House's AIG response Monday illustrates the bind that Mr. Obama finds himself in. He needs to convince Americans he shares their mounting fury over the hundreds of billions of taxpayer dollars being pumped into companies like AIG. At the same time, he needs the executives and employees of those companies to help the government untangle the current financial mess. "This is a corporation that finds itself in financial distress due to recklessness and greed," Mr. Obama said Monday, his voice rising in anger. "Under these circumstances, it's hard to understand how derivative traders at AIG warranted any bonuses, much less $165 million in extra pay."
At issue are retention bonuses for employees of AIG's financial-products division, whose credit default swaps brought AIG to the brink of collapse. The government controls AIG through an 80% equity stake and as a major lender and doesn't have legal authority to freeze payments on its own. The U.S. has committed $173.3 billion to AIG, including $70 billion from Treasury's rescue fund. New York Attorney General Andrew Cuomo said at a news conference Monday that AIG told him the company had already released the bonuses in question on Friday. Mr. Cuomo has subpoenaed the company seeking more information about the payments and their recipients. "We are in ongoing contact with the attorney general and will respond appropriately to the subpoena," said an AIG spokeswoman
The $165 million is the latest installment of a retention program that is slated to pay the unit's employees about $450 million. AIG had previously paid out $55 million, and an additional $230 million is pending for 2009. An administration official said that on Friday Treasury Secretary Timothy Geithner discussed the bonuses and compensation going forward with AIG's government-appointed chief executive, Edward Liddy. Mr. Liddy informed Mr. Geithner he intended to pay out the bonuses, and the Treasury secretary said there was nothing he could do legally to stop that.
The official also said that Treasury has determined there is no way the government can actually extract the money from the individuals who already received the bonus payments. The government would face lawsuits with the potential of significant damage payouts and lawyer fees that could easily exceed the cost of the bonuses. Instead, the administration said it will use a $30 billion installment of bailout funds approved March 2, to bring some pressure to bear on AIG. The official said before AIG can draw down funds from the $30 billion, new rules would be written into AIG's contract to ensure no government money goes toward paying financial-products division bonuses. The cost of bonuses already paid would be recouped for the taxpayer.
In a letter to Mr. Geithner dated Saturday, Mr. Liddy said the firm will "use best efforts" to reduce the pending payments by "at least 30%." For Mr. Obama, AIG's announcement -- that it would pay more than $100 million in bonuses to the executives involved in the exotic financial instruments that helped trigger the broader financial crisis -- has become a critical political test. The president's budget blueprint for this year includes a $250 billion placeholder to cover as much as $750 billion in additional bailout funds. But anger over the bonuses could make it harder for the administration to extract any additional funds it needs from Congress.
President Barack Obama and U.S. Treasury Secretary Timothy Geithner Monday outlined a plan to free credit for the nation's struggling small businesses by raising federal loan guarantees and bolstering bank liquidity. The Senate Banking Committee's top Republican, Richard Shelby, said the government's handling of AIG is compounding the negative sentiment toward more rescue money. "There's been no accountability, no transparency to speak of," he said in an interview. "Whatever we've gotten...we've had to extract it piece by piece, little by little. There's too much secrecy."
On Monday, nearly 80 House Democrats wrote Mr. Obama to say they were pleased that he intended to block the bonuses, and hinted that a failure to do so would have consequences. "For the sake of the President's ability to continue to take the steps that may be necessary to rebuild our economy, there must be a stronger response than simply decrying this development," the lawmakers wrote. But administration officials also worry that taking too hard a line with AIG and other companies could discourage top financial experts and institutions from joining the government efforts to fix the financial system. That's one argument that AIG itself has used to justify the bonus payments: that if certain executives leave at this point, their departures would complicate efforts to wind down the financial-products division.
The unit's books contain many transactions that are "difficult to understand and manage," according to an AIG document explaining the retention plan the company submitted with the Saturday letter to Mr. Geithner. "This is one reason replacing key traders and risk managers would not be practical on a large scale," the document continued. The controversy over the AIG payouts is the latest manifestation of a political tempest the White House has struggled to manage. Over the administration's objections, Congress imposed strict compensation limits for executives at firms receiving federal bailout money. In turn, administration aides have spent the past month trying to craft rules that would appease lawmakers without discouraging top talent from working for those companies. Payments to other recipients of federal funds, from banks to auto companies, are being closely watched on Capitol Hill, and could touch off future protests.
White House aides said that administration officials had been consistent in their statements on the issue over the past few days. But the tone did appear to shift. Appearing Sunday on ABC's "This Week," the president's top economic adviser, Lawrence Summers, called the bonuses "outrageous," yet left the impression that little could be done. "The easy thing would be to just say, you know, 'Off with their heads,' and violate the contracts," he said. "But you have to think about the consequences of breaking contracts for the overall system of law." A little more than 24 hours later, the president seemed to promise much bolder action. Then by late afternoon Monday, White House and Treasury officials echoed the Summers position that nothing could be done about payments already made.
Asked why Mr. Obama's language was more pointed than Mr. Summers's comments, White House senior adviser David Axelrod said in an interview: "The president and Larry aren't identical twins." While Mr. Summers must weigh how the AIG bonuses and their fallout could impact the economy and the markets, Mr. Axelrod said, "The president's job is to speak for the country. The president explained himself in simple and direct sentences." How the AIG bonuses will be resolved "is now in the hands of the lawyers at Treasury," Mr. Axelrod added.
AIG Pay Madness Needs a Stop From Geithner
Treasury Secretary Timothy Geithner is unhappy that American International Group Inc. is paying tens of millions in bonus payments to some of its traders. So why doesn’t he forbid them? The company says it’s afraid of being sued. But contrary to what lawyers and legalistic bureaucrats will tell you, there are worse things than lawsuits. Stiffing taxpayers to pay gluttonous derivatives traders -- and in the midst of an economic crisis -- is among them. To judge by his recent comments, even President Barack Obama is looking for a way to cancel the bonuses. Besides, this is a lawsuit the government just might win. AIG is doling out $165 million to traders in the very group that caused the company to fail. The payments are part of a $450 million bonus pool that AIG agreed to early last year, when it was beginning to take on water, and when it feared that high- flying traders would jump ship.
Since then, AIG has been bailed out four times by the federal government. The taxpayers have provided AIG with $173 billion in investment and loans. That’s enough money to run the entire state of New Jersey for six years. Although other companies have gone on the federal dole, of all the government’s corporate stepchildren, AIG is making the least progress. Citigroup Inc., which got three bailouts, at least operated at a profit during January and February, according to its chief executive officer, Vikram Pandit. Morgan Stanley, which got a bank charter last September, is off the critical list. But the news at AIG keeps getting worse.
Ben Bernanke, the normally even-tempered Federal Reserve chairman, has said he is fuming over the way the regulated insurer used its high-rated balance sheet to run a hedge fund- type operation that helped to derail Wall Street. Lawrence Summers, the president’s top economic aide, says of all the outrages, AIG is the worst. So why is the government allowing AIG to use its taxpayer lifeline to pay seven-figure bonuses? Seven employees will get at least $3 million and one will get $6.5 million. What kind of company pays such bonuses for a year in which it lost $99 billion -- the biggest loss ever by a U.S. corporation?
My inner jester says, "Maybe they got the sign wrong," that is, maybe the employees will be paying back the company? No such luck. Edward Liddy, AIG’s CEO, says he reviewed the bonus agreement, and the contracts are airtight. Liddy says the bonuses are "distasteful," but if he doesn’t pay them, he can’t retain "the best and the brightest talent." In that case, he should let that "talent" go. All it has done is lose the taxpayers oceans of money. It’s time to consider folding the non-insurance part of AIG for good. Liddy, though, works for Geithner. The U.S. government owns almost 80 percent of AIG’s stock. Assuming the checks haven’t been cashed yet, here is what Geithner should say to Liddy: "Sorry, Ed. We’ll keep track of what we promised, and maybe in a couple or three years, if AIG is earning money, and a pool exists (outside of taxpayer funds) to pay bonuses, then OK."
If its traders end up suing to get their full bonuses, the company (and the government) could claim that the promised bonuses were a "fraudulent conveyance." This defense is usually employed in bankruptcy cases. Under the theory of fraudulent conveyance, it is illegal to transfer assets that are needed to pay creditors. So, if the owners of a highly leveraged company give themselves a big dividend, leaving the corporation unable to service its debts, the creditors can sue to reclaim the funds. True, AIG wasn’t insolvent when the bonuses were negotiated. But it could argue that it was facing such a dire situation that it didn’t have the money it agreed to pay. Thus, the promised bonuses exposed its creditors to potential loss.
The U.S. government, which loaned the company billions of dollars, might claim this invalidates the contracts. Granted, this would be a tough case. And contracts shouldn’t be breached lightly. This is why it would be much smarter, on all sides, to renegotiate the bonuses. Pay a very modest portion now and give the employees a chit for the rest to be redeemed later. Employees who are unhappy with such a compromise can take it to a judge. AIG then would have the option of filing for bankruptcy, rupturing the contracts, and putting an end to the derivatives business for good.
Geithner & Co. never should have allowed it to get this far. When the government agreed to the first rescue, in September, the U.S. could have demanded a waiver of bonuses as a condition. That rescue was enacted under incredible time pressure. But Henry Paulson, Treasury secretary then, did take the time to insist on the resignation of Robert Willumstad, AIG’s top executive, while denying him any golden parachute. Willumstad, who recognized that the situation was larger than himself, had the grace to agree. It will be interesting to see if the million-dollar traders have the same sense of perspective. Of course, the only way to overhaul corporate pay, and to end such outrages, is to regulate bonuses before they are agreed upon. One remedy I have proposed would require big bonuses to get prior shareholder approval.
Now read about Ronald Logue, the CEO of State Street Corp. He received total pay of $28.7 million in 2008. The company’s stock fell 51 percent last year and his bank took $2 billion in federal bailout money. This year, the stock is down 36 percent. Nice work, if you can get it.
How to Stop AIG's Bonuses
AIG's decision to pay out at least a hundred and sixty five million dollars in bonuses takes the bank bailout program's abuse of the public trust to a whole new level. This act simply cannot be allowed to stand. The only question is how to stop it. "Sanctity of contracts" has for some time been TARP's equivalent of Harry Potter's magic wand, the thing you waved to make difficulties disappear (for financiers, of course; if you are an ordinary worker with a pension contract, by contrast, the magic doesn't work for you).
AIG clearly takes the Treasury, the Federal Reserve, and the Obama administration for fools, who can be counted on to roll over yet again at the first whisper of the magic words. There is no reason for agents of the people of the United States, whose money AIG plays with, to be so sheep-like. Remember that this is a firm that is 79.9% owned by the United States government. It is therefore quite possible to abort this outrage by decisive exercise of public authority. Within existing law, there is more than one way to do it, but a direct solution is readily at hand:
Firstly, the US trustees in charge of the firm must immediately instruct the corporate treasurer to make no payments of any bonuses. They also need to order him to issue stop payment orders on any checks that fly out the door at the last minute, as with Merrill Lynch. Then the trustees need to split off the derivatives unit from the rest of the firm and separately incorporate it. This step leaves AIG's other businesses free to operate as usual. If the recipients of the bonuses refuse to waive them, then the derivatives unit should at once be thrown into bankruptcy, terminating all obligations to pay them.
Right now, press reports suggest that the firm's top management waited until the last minute to inform the government of what was happening. AIG CEO Edward Liddy, accordingly, should be asked to resign at once, for the sake of public confidence and to send a clear signal that gaming the system is unacceptable. It is also past time for an investigation of the validity of AIG's past accounting and securities disclosures and its executive compensation program by the Office of Thrift Supervision, the Securities and Exchange Commission, and the FBI.
This leaves open the question of how to deal with all other obligations of the derivatives unit, including the notorious credit default swaps. We, like most independent analysts, are mystified by the determination of the Federal Reserve and Treasury to keep paying these off at 100% of their face value. But that's an issue for tomorrow. Today the task is to stop a grotesque abuse before it is too late. The path we outline here would do it, without throwing markets into turmoil. Nothing less than public confidence in the United States government as a whole is now at stake.
Wall Street Pursues Pay Loopholes
Some Wall Street firms are looking for ways to sidestep tough new federal caps on compensation. In response to expected bonus restrictions, officials at Citigroup Inc., Morgan Stanley and other financial institutions that got government aid are discussing increasing base salaries for some executives and other top-producing employees, people familiar with the situation said. The crackdown, part of the economic-stimulus package passed by Congress and signed into law by President Obama last month, limits bonus pay for the top five executives of any recipient of taxpayer capital through the Troubled Asset Relief Program, plus the 20 next-highest-compensated employees.
The discussions are at an early stage, partly because the government hasn't yet issued specific rules on the bonus payments that will be allowed at companies that received TARP aid. The talks also are proceeding cautiously because of the political volatility of pay, bonuses and perks on Wall Street, including outrage over American International Group Inc.'s promise to pay $450 million in bonuses to employees in the insurer's financial-products unit. Most traders and bankers on Wall Street get a base salary of anywhere from $200,000 for managing directors to $1.5 million for a chief executive. But the lion's share of their pay comes in the form of a bonus, a tradition that began when most firms were private partnerships and partners shared directly in the annual income of the firm.
As banks and securities firms wrestle with growing regulation of compensation practices, substantially increasing the base salaries of top employees could become a popular response, some industry officials say. A larger salary would reduce the relative importance of bonuses but also help financial companies increase those payments, since they usually are calculated as a percentage of total annual compensation. "The trend is to increase the base pay in light of the reduced bonuses," said Scott Talbott, senior vice president of government affairs at the Financial Services Roundtable. "Without the revenue" that top performers provide, he adds, "these companies can't survive." Under the forthcoming rules, bonuses could come to no more than one-third of the total annual compensation paid to employees covered by the restrictions. Some compensation experts view the bonus limits as a mistake that turns the notion of pay for performance on its head, despite Wall Street's culpability for the recession and credit crisis.
"These are not bureaucratic positions where you're paying individuals high salaries," said Michael Karp, chief executive of Options Group. "How can you pay a banker a really high salary without knowing what kind of revenue that person generates?" Still, critics are ready to pounce on any potential maneuver around the federal limits. Raising base salaries would play into "a long and dishonorable tradition of responding to any attempt to curb pay excess by just putting it in a different pocket and calling it something else," said Nell Minow, editor of the Corporate Library, a research firm focusing on corporate-governance issues. Any attempt to get around bonus curbs "can expect pushback from shareholders," she predicted. At Morgan Stanley, discussions about raising base pay levels are preliminary, and the New York company hasn't fleshed out a formal strategy, according to people familiar with the matter.
Citigroup officials have considered designating which 25 executives will be subject to bonus limits, people familiar with the discussions said. In that scenario, the new rules might not apply to lower-ranking yet still highly lucrative traders and investment bankers, these people said. "We will comply with the restrictions, in addition to the substantial changes we have already made to our compensation structure," said a Citigroup spokeswoman. Citigroup has received $45 billion in taxpayer-funded capital do far, while Morgan Stanley has received $10 billion. The latest U.S. rescue of Citigroup will leave the federal government holding as much as 36% of the company's common stock.
Inside banks and Wall Street firms, some executives are hopeful that the Treasury Department will water down the curbs on bonuses, inserted into the stimulus bill by Sen. Christopher Dodd (D., Conn.), during the department's rule-making process. One possibility that banks would applaud is that the pay restrictions apply to top executives and other managers, instead of less-senior but crucial rainmakers. Treasury officials are expected by the end of March to issue guidance on how to interpret the new law. A Treasury spokesman declined to discuss the agency's opinion of raising base salaries.
The Dodd provision sent shockwaves across Wall Street. Some bankers and compensation experts contend that top revenue-producers could bolt to non-U.S. banks or hedge funds that aren't subject to TARP-related restrictions. "It's possible we will lose some people," J.P. Morgan Chase & Co. Chairman and Chief Executive James Dimon said in a recent speech. "I'll be very sorry if that happens." Raising base pay at J.P. Morgan isn't being discussed, people familiar with the matter said. Wells Fargo & Co., the San Francisco bank that got $25 billion in government capital, disclosed last week that it increased the base salaries of CEO John Stumpf and two other executives. A bank spokeswoman declined to comment on the raises. A person familiar with the matter said the increases were decided at about the same time that the new curbs were signed into law.
Good idea that turned bad
by Gillian Tett
A couple of years ago, one of the more brilliant minds at Merrill Lynch made a striking confession. "The problem with credit markets is that we still don’t understand correlation," he told British academics. "That is unfortunate because correlation is central to the credit world." It is a problem haunting AIG with a vengeance – not to mention its bruised counterparties, such as Merrill Lynch. As the list of AIG’s counterparties emerged on Sunday, politicians have – unsurprisingly – expressed outrage at the size of its liabilities. What is equally striking, however, is the all-encompassing list of names which purchased insurance on mortgage instruments from AIG, via credit derivatives.
After all, during the past decade, the theory behind modern financial innovation was that it was spreading credit risk round the system instead of just leaving it concentrated on the balance sheets of banks. But the AIG list shows what the fatal flaw in that rhetoric was. On paper, banks ranging from Deutsche Bank to Société Générale to Merrill Lynch have been shedding credit risks on mortgage loans, and much else. Unfortunately, most of those banks have been shedding risks in almost the same way – namely by dumping large chunks on to AIG. Or, to put it another way, what AIG has essentially been doing in the past decade is writing the same type of insurance contract, over and over again, for almost every other player on the street.
Far from promoting "dispersion" or "diversification", innovation has ended up producing concentrations of risk, plagued with deadly correlations, too. Hence AIG’s inability to honour its insurance deals to the rest of the financial system, until it was bailed out by US taxpayers. AIG, for its part, blames this outcome on an unforeseen outburst of "systemic risk" (or, as its website says: "It is the quintessential ‘knee bone is connected to the thigh bone’" where every element that once appeared independent is connected with every other element."). The real problem, though, is that AIG – like other institutions – has been extraordinarily complacent about trying to analyse correlations of risk. Before the summer of 2007, almost no one inside AIG worried about the fact that subprime mortgage contracts all tended to look very similar. Nor did they notice that these subprime loans were being bundled into similar types of collateralised debt obligation structures, with similar trigger points – and then insured by AIG with similar deals.
After all, when the credit markets were benign, such similarities barely appeared to matter: AIG just collected the fees. But what has become clear in the past 18 months is that those endemic similarities created the propensity for a deadly "tipping point" to occur: once one contract turned sour, numerous other deals turned sour, too. Hence those eye-poppingly large losses. But what is most shocking of all, is that no one inside AIG – or in the ratings or regulatory world – appears to have spotted those risks before. That was partly due to a paucity of holistic thought. Another practical problem, though, was an information gap. Before this week, companies such as AIG insisted that the details of their credit derivatives deals were "confidential".
As a result, it was almost impossible for outsiders to spot those correlated exposures – until it was too late. And therein lies an important moral. Notwithstanding the disaster at AIG, the basic idea of using derivatives contracts to share risk is not stupid; on the contrary, risk dispersion remains a sensible idea, if used in a prudent, modest manner. But diversification can only occur if potential correlations are monitored – and that oversight can only take place if the business of risk transfer is made as visible as possible. That means that regulators and investors should demand dramatically more disclosure about credit derivatives deals and about their counterparties, too. The type of transparency seen at AIG this week, in other words, is not just badly overdue; it now needs to be replicated on a much bigger scale.
AIG Bonus Bombshell Raises New Questions About Goldman Sachs
Decisions made during the final months of the Bush administration created an environment in which the most politically connected investment banks, Goldman Sachs and Morgan Stanley, not only flourished, but saw their competitors laid waste, with firms like Lehman in bankruptcy, and others, like Merrill Lynch and Bank of America, forced to merge in desperate hope of surviving. Two recent news stories raise some interesting questions about Goldman Sachs. In the opaque world of investment banking and federal regulation, these reports shed light on the difficulty of determining where to draw the line between routine complex financial transactions and problematic conflict of interest and favoritism.
The first story ran on the cover of last weekend's Barron's: "Resurrection on Wall Street". It documents in some detail the success of Goldman Sachs and Morgan Stanley as "Wall Street's sole standouts." The highly favorable story, which only peripherally refers to the government support each institution has received, concludes that they are both "making attempts to adapt to the new financial realities. Combined with the decline of their competitors, that makes them good bets for investors now." For a couple of banks trying to boost their stock, what more could you ask for?
The second story, which was covered on March 15 by most news outlets, was based on the disclosure by the American International Group, Inc. (AIG) of massive payments to domestic and foreign financial institutions, and to 20 states, using money provided by U.S. taxpayers through the federal bailout. While most news stories focused on payments made to non-U.S. institutions, fueling populist anger, one of the more interesting aspects of AIG's disclosure statement is the fact that Goldman Sachs, at $12.6 billion, is the single largest beneficiary of AIG largess.
The roots of the linkage between Goldman Sachs and AIG go back to the closing months of the Bush administration, as the financial meltdown reached crisis proportions and key decisions were made that are now reaping the whirlwind. Remember who played a key role in deciding to bail out AIG? Henry Paulson, the Goldman CEO-turned George W. Bush Treasury Secretary. Paulson, according to a September 27, 2008 New York Times piece by Gretchen Morgenson, led a team of regulators and bankers in early September to determine what to do with the most severely wounded financial institutions.
One of the participants in those meetings was Lloyd C. Blankfein, Paulson's successor at Goldman Sachs. Out of those meetings came the controversial and heavily criticized decision to allow Lehman Brothers, a Goldman competitor, to go belly up, and to bail out AIG. Starting with $85 billion from the Fed, taxpayers have pumped a total of $170 billion into the giant insurance company. The bailout was crucial to Goldman in that it permitted AIG to pay off its $12.6 billion debt to the firm, $8.1 billion of which was to cover AIG-backed credit derivatives.
At a hearing of the House Financial Services Committee on February 11, 2009, Goldman Sachs CEO Lloyd Blankfein denied that his firm had a major stake in bailing out AIG. Blankfein told the panel that "with respect to our dealings with AIG, we were always fully collateralized and had de minimis or no credit risk at any given moment because we exchanged collateral....We had transactions with them. And if they had gone the wrong way, they would have owed us money. We assumed they'd pay it, but if they defaulted, they wouldn't pay us. We insured against that default. We didn't win money from it. We wouldn't have made money. But it would have protected our down side."
Throughout the past six months of economic crisis, Goldman has taken full advantage of what the government has to offer. On October 28, 2008, Goldman and eight other banks were the first to receive federal bailout money under the Treasury Department's Troubled Assets Relief Program (TARP). which was initiated by Paulson. On November 25, 2008, Goldman became the first bank in the nation to benefit from the Federal Deposit Insurance Corp.'s Temporary Liquidity Guarantee Program (TLGP), issuing $5 billion in government-secured debt at 3.367%, substantially less than the market rate facing banks which issued unsecured debt. All told, Goldman has issued a total of $20 billion in government-guaranteed debt under TLGP. In their dealings with banks, both Treasury and the Fed have been subject to relatively minimal disclosure, in order to protect the proprietary interests of financial institutions, especially to prevent rumors of illiquidity or excessive debt from threatening a bank's viability.
The banking and insurance industries have traditionally been among the most politically influential sectors. That was especially true during the George W. Bush years, when regulatory policies and tax legislation -- especially cuts in the rates on dividend and capital gains income -- produced a corporate bonanza. In the 2004 election, these financial interests demonstrated their gratitude by contributing hundreds of thousands to the Bush-Cheney '04 campaign. Employees of Morgan Stanley gave Bush more than any other company, $600,480; followed by Merrill Lynch, $580,004; PricewaterhouseCoopers, $513,750; UBS Americas, $472,075; Goldman Sachs, $390,600; MBNA Corp, $356,350; Credit Suisse Group, $331,040; Lehman Brothers, $329,725; Citigroup Inc, $320,620; and Bear Stearns, $309,150.
The consequences of the decisions made in the private meetings chaired by Republican Treasury Secretary Hank Paulson back in September 2008, are just now coming to light, even if transparency is modest at best. Clearly, when regulators and the regulated are trusted to reach decisions behind closed doors -- decisions involving the financial viability of major banks -- those who are regulated, operating out of public view, will do all they can to insure that their interests are protected.
Obama Administration Must Stop Bonuses to AIG Ponzi Schemers
It's time for some righteous populist anger from the Obama administration--not just in words, but in deeds--to stop the looting of the Federal Treasury by Wall Street executives using taxpayer money to pay bonuses to the very people who manipulated markets and were instrumental in bringing the international financial system crashing down on the heads of hundreds of millions of people in America and around the world. If the Obama administration doesn't stop AIG from paying hundreds of millions of dollars in bonuses, it will enable a popular uprising (led, unfortunately, by hypocritical Republicans posing as populist leaders) which will block the Obama administration from taking the actions necessary to save the financial system. It could destroy Obama's presidency and lead to a decade-long depression.
Instead, while AIG prepares to use hundreds of millions of dollars in taxpayer money to pay bonuses to the very executives at AIG's Financial Products Unit who designed, managed and marketed the credit default swaps which were little more than a Ponzi scheme, the Obama administration sends out Tim Geithner, Austan Goolsbee, and Larry Summers to lamely express fake anger to the media while defending the payments on the grounds of the "sanctity of contracts". As Larry Summers timidly told George Stephanopoulos, "The easy thing would be to just say...off with their heads, violate the contracts. But you have to think about the consequences of breaking contracts for the overall system of law, for the overall financial system."
Even first year law students in Contracts 101 learn that there are numerous exceptions to the "sanctity of contracts". As any working lawyer will tell you, contracts are legally abrogated every day--a big part of our court system is given over to litigating disputes over the enforceability of various commercial contract provisions. If Treasury Secretary Geithner is rolling over and passively taking the advice of lawyers hired by AIG's Chairman that there are no legal defenses and counterclaims to paying the executive bonuses, then he's talking to the wrong lawyers. He and President Obama need to bring in the best litigators in the country and give them the mandate to find every available legal argument for not paying the bonuses, and then force every employee of AIG's Financial Products Unit who is unwilling to give up their bonus to hire expensive lawyers to sue for it, and vigorously defend these lawsuits through trial and up the appeals ladder, if necessary, for years, before even considering paying any such claims.
Let's clearly understand what the executives of AIG's Financial Products Unit did: As several commentators have noted, AIG's Financial Products Unit is a hedge fund grafted onto an insurance company. I would go even further--It's all-but a Ponzi Scheme grafted onto an insurance company. AIG's principal business is selling insurance including casualty, auto and life insurance. In fact it's the largest insurance company in the world. Insurance is a highly regulated business. When a company sells insurance, government regulators require it to set aside financial reserves to pay claims. For example, if an insurance company sells fire insurance, it uses actuaries to calculate the amount of fires which are likely to occur and the likely costs of paying claims on these fires, and is required to set aside enough money to pay these potential claims. It also invests these reserves and profits from these investments. AIG's regulated insurance business was profitable and would not require AIG to take $170 billion and counting in Federal bailouts.
AIG's Financial Products Unit was instrumental in creating and marketing a new type of insurance product which purported to insure investors in mortgage-backed bonds and derivatives against losses to their investments if the homeowners who took out these mortgages defaulted on their payments. Only AIG didn't call these products "insurance policies". They called them "credit default swaps," instead. Because AIG and other big financial institutions claimed that credit default swaps were not insurance but a form of financial security like a stock or a bond, they were not required by regulators to put aside reserves against losses.
This worked out pretty well for AIG and its high-paid executives during most of the past decade while the real estate bubble kept home prices rising, allowing homeowners to continually refinance their mortgages and make their payments--AIG profitably collected billions of dollars of premiums on the credit default swaps it sold, hardly ever had to pay any claims, and gave executives hundreds of millions of dollars in bonuses for keeping the circus operating. (It worked out pretty well for Bernie Madoff, too, who could continue to pay earlier investors from the proceeds paid in by new investors, until the financial markets crashed and investors started asking for their principal back.)
In fact, credit default swaps were little more than an (arguably) legal Ponzi Scheme which, because reserves against losses were not set aside, relied on a constant flow of new premiums to pay-off any potential losses, as well as to pay the oversized bonuses to the executives who created and sold them. In selling credit default swaps, many of which insured sub-prime mortgages, AIG executives did not perform due diligence on the viability of the underlying mortgages to determine the actual risk that mortgagees would default if the housing market stopped rising.
As a result, last September, when the housing bubble burst, and increasing numbers of homeowners stopped making their mortgage payments, the counterparties to AIG's credit default swaps demanded that AIG post hundreds of billions of collateral to secure the counterparties against the potential losses to their insured bond and derivative portfolios. AIG didn't have the money, because it had failed to put aside adequate reserves and because it had already paid out the premiums it had received in the form of bonuses to its executives and as dividends to its shareholders. Because these counterparties were some of the largest banks, investment houses and hedge funds in the world, the Federal Reserve under Ben Bernanke and (then) Tim Geithner, and the Treasury Department under Hank Paulson and (now) Tim Geithner, decided that AIG was "too big to fail" since AIG's failure to pay-off the losses on its credit default swaps to these other "too big to fail" financial institutions would lead to a cascade of huge bankruptcies which would bring down the international financial system.
So far the Federal government has given AIG $180 billion to back up its credit default swaps to these counterparties, with no end in sight, and we, the taxpayers, now own 80% of AIG. Meanwhile, the AIG executives who created this disaster demand hundred of millions of dollars in bonuses and the Obama administration throws up its hands and says there's nothing it can do, as though it is powerless but to listen to AIG's Chairman and his lawyers that the bonuses must be paid. Under these circumstances, I have no doubt that smart lawyers, hired by the Obama administration, can find numerous legal arguments for refusing to pay the contractual bonuses to AIG executives. Without having seen these contracts, here are a few legal arguments off the top of my head: Most executive contracts provide that the executive is in breach if s/he engages in gross negligence or willful misconduct.
According to the New York Times, most of the AIG executive contracts under which the bonuses are to be paid were entered into in early 2008, after the real estate bubble had started to burst and subprime mortgages started to default in large numbers. There is a strong argument the AIG executives responsible for designing and selling credit default swaps were grossly negligent (if not willful) in failing to perform due diligence on the risk of loss that the underlying bonds would default and setting aside sufficient resources for paying claims if defaults happened. Instead, they pocketed hundreds of millions of dollars in bonuses off of the premiums from prior-year's credit default swaps and made no provisions for setting aside funds for paying potential claims. This may not only have constituted gross negligence or willful misconduct--It may even have constituted criminal negligence or fraud.
If President Obama wants to avoid a populist uprising that could sink his administration, he needs to tell Geithner and Summers to stop defending the legality of the AIG bonuses and bring the full force of the federal government down on the heads of any executives of AIG's Financial Products Unit who have the nerve to claim a bonus. (As Robert Kuttner has pointed out, "the outrage over the the AIG bonuses is a sideshow. The larger problem, both financially and policially, is the entire stragegy for rescuing the banks." But if Obama doesn't act forcefully to stem popular outrage by halting the AIG bonuses, he may never have a chance to get the policy right on the financial rescue.)
Obama should go on national television, explain to the American public how AIG executives used the phony insurance policies of "credit default swaps" to game the financial system, and anounce that any executive of AIG's Financial Products Unit who claims s/he's entitled to a bonus will have to hire a lawyer and sue for it--and that the government will insist that every such suit go to trial and if the government loses at trial, be appealed for years before any claims are paid. Moreover, the government will require AIG to countersue every executive that claims a bonus for gross negligence and/or fraud and will seek damages and a refund of prior year bonuses. In addition, Obama will instruct the FBI to investigate the AIG executives for criminal fraud. And he will instruct the IRS to conduct full-scale audits on the last 7 years of their tax returns to insure that they properly paid the government everything it was due on their huge incomes. He will use every legal resource at the disposal of the Federal government to make their life a living hell if they continue to claim bonuses on their ill-gotten gains.
Rhetoric denouncing the bonuses is not enough. Decisive action by the Obama administration to stop payment of the bonuses is required. Anything less threatens to destroy the credibility of the Obama administration with the American people and derail Obama's efforts to prevent a depression.
U.S. Bailouts Add to Risk of Depression, Jim Rogers Says
The U.S. risks sending the world into a depression as its bailouts of failed companies rob healthy businesses of capital, investor Jim Rogers said. "The U.S. is taking assets from competent people and giving them to incompetent people," said Rogers, chairman of Singapore-based Rogers Holdings and the author of books including "Investment Biker" and "Adventure Capitalist." "That’s bad economics." The U.S. government should let American International Group Inc., whose fourth-quarter loss was the worst in corporate history, go bankrupt, Rogers added in a Bloomberg Television interview today. Congress approved a $700 billion bank bailout package in October, and President Barack Obama’s administration has suggested it may need an additional $750 billion.
The U.S. is repeating the mistakes made by Japan in the 1990s and risks creating "zombie banks" by rescuing failed financial services companies that should have been allowed to go under, Rogers said. New York-based AIG has received $173 billion in government aid, and had earmarked $1 billion in retention pay for about 4,600 of the company’s 116,000 employees so they won’t leave. The Treasury this week intends to provide more information about a $1 trillion plan to remove distressed mortgage assets from banks’ balance sheets. The Federal Reserve is also scheduled this week to start the first phase of a $1 trillion program to revive the market for securities backed by consumer and business loans.
Oil prices may rise to record levels in the future because of depleting reserves and a lack of major field discoveries, Rogers said. Crude oil in New York hit a record $147.27 a barrel in July and traded at $46.98 at 12:13 p.m. Singapore time. "Reserves of oil are going down all over the world," Rogers said. "The price of oil has to go much, much higher. I don’t know if the oil price will go up to record level in three years or five years. I don’t know when but I know it is." People should be prepared for inflation as governments worldwide are printing money to prop up economies at a time when commodities supply is under pressure, Rogers said. "We’re going to have serious, serious inflation down the road," said Rogers, who owns gold and silver. "I wish I knew when." Calls to return to the gold standard, when currencies were backed by bullion owned by governments, are flawed because it is "not going to solve our problems," he also said.
Obama to Avoid Auto Bankruptcies
The leaders of President Barack Obama's auto task force are focused on restructuring General Motors Corp. and Chrysler LLC outside of bankruptcy court, despite suggestions from some experts that a Chapter 11 filing would be the best way to revamp their troubled operations. Steven Rattner, a private-equity executive leading the team, said Monday that "I don't think that bankruptcy is necessarily a better place for any company." "It sometimes becomes a necessary place for some companies, but it's certainly not a desired place and it is certainly not our goal to see these companies in bankruptcy, particularly considering the consumer-facing nature of their businesses," Mr. Rattner said in an interview.
GM had said in December when its U.S. loans were granted that bankruptcy could mean an end to the company because many consumers wouldn't buy a vehicle from a car maker in Chapter 11. But the company has since softened that stance. Administration officials also said the team doesn't plan to recall early the $17.4 billion in government loans given to GM and Chrysler -- something allowed under the loans' terms if the companies don't prove by March 31 that they can be viable long term. The administration officials said the two auto makers had already spent the cash, and that asking for the funds to be returned immediately would trigger their collapse.
By emphasizing that bankruptcy was not a preferred option, and by removing any threat of putting the auto makers in default by recalling the loans, Mr. Rattner's team will ease some of the pressure that has been on GM, Chrysler and their constituents to make immediate and sweeping concessions. The team, however, didn't rule out bankruptcy as a potential option altogether. The car companies, along with bondholders, unions and suppliers, have been renegotiating contracts to meet certain requirements set out by the Bush administration when the loans were approved in December. Those conditions include eliminating two-thirds of unsecured debt outstanding, and renegotiating the terms of multibillion-dollar health-care trusts established with the United Auto Workers union.
Because the U.S. Treasury has the broad power to call back the loans, GM and Chrysler have been rushing to craft bankruptcy contingency plans that could be executed as soon as April 1. Teams of advisers and attorneys have created a variety of scenarios under which the two companies could survive while under court protection. GM and Chrysler submitted plans on Feb. 17 that were designed to explain how the companies intended to return to health in the coming years. The plans included details of how the two companies will work with unions, bondholders, suppliers and dealers to fix their structural issues. Mr. Rattner indicated the Treasury is taking a close look at requests by GM and Chrysler for an additional $22 billion in loans. "They do need more money," he said. At the same time, he said the Obama administration would not "put these companies on an intravenous drip-feed that lasts forever."
By the end of the month, the government plans to lay out its view on the companies' viability and what the industry should look like in future years, Mr. Rattner said. However, those plans won't include a comprehensive fix for the two companies. That, he said, will largely be left to the stakeholders, such as unions, management and investors. Earlier Monday, Mr. Rattner met with GM Chief Executive Rick Wagoner and Chief Operating Officer Fritz Henderson at the Treasury Department. A GM spokesman said the meeting was essentially a fact-finding expedition on the part of the auto task force, and no concrete decisions were expected.
Bernanke May Need 'Massive' Asset Purchases to Counter Deeper Contraction
Chairman Ben S. Bernanke and Federal Reserve policy makers may have to ramp up their purchases of mortgage securities and other assets after the economy and job market deteriorated further since they last met. The Federal Open Market Committee, gathering today and tomorrow in Washington, needs to redouble its efforts after the central bank’s balance sheet shrank 17 percent from a $2.3 trillion December peak, Fed watchers said. The retreat came even as Bernanke acknowledged the chance that the unemployment rate will exceed 10 percent for the first time in a quarter century.
"It takes massive balance-sheet expansion to generate significant easing in financial conditions," said Andrew Tilton, an economist at Goldman Sachs Group Inc. in New York who used to work at the Treasury. "More needs to be done." This week’s FOMC meeting could mark a shift toward more aggressive monetary expansion to fight deflation after demand waned for many of the Fed’s existing programs. One top consideration is an increase in the pace and size of a $600 billion program to buy bonds issued and backed by U.S. housing agencies such as Fannie Mae, analysts said. Other measures could include everything from purchases of Treasuries to corporate bonds, Tilton said. The Fed has already agreed to work with the Treasury on implementing a program to revive consumer and business loans, which the Obama administration has said could reach $1 trillion.
The Fed is scheduled to issue its statement around 2:15 p.m. tomorrow. The yield on the benchmark 10-year Treasury was unchanged at 2.953 percent at 9:34 a.m. in London. "The FOMC statement is the natural place to announce when such an increase would occur," said Michael Feroli, an analyst at JPMorgan Chase & Co. in New York and former Fed economist. "Doing so at the March meeting would have the added benefit of showing the public that the Fed can respond when the outlook deteriorates." The Bank of Japan said today it will buy subordinated debt from banks in an effort to spur lending and the Bank of England has started buying government bonds to boost the money supply.
Financial markets have diverged since the FOMC last met Jan. 27-28, with stocks rallying even as credit markets remained distressed. Equity investors were encouraged by signs in the past week that a depression will be averted, with Bernanke playing down that scenario in a television interview with CBS’s 60 Minutes that aired March 15. The Standard & Poor’s 500 Stock Index has risen 11 percent since March 9. The Bloomberg U.S. Financial Conditions Index is still about five standard deviations below the average of the 1992 to 2008 period. Standard deviation measures how much a value varies from the mean. Investors demand an average of 6 percentage points more than corresponding U.S. Treasuries to buy investment-grade U.S. corporate bonds, according to data compiled by Merrill Lynch & Co. That’s up from 5.40 percentage points when the FOMC met Jan. 28.
Consumer borrowing costs are also elevated. The rate on 60- month loans for new cars climbed to 7.32 percent, close to a seven-year high, as of March 13 from 7.08 percent when central bankers last gathered. "The more they expand, the better markets are going to be," said Richard Schlanger, a vice president who helps invest $13 billion in fixed-income securities at Pioneer Investment Management in Boston, referring to U.S. central bankers. Total assets held by the Fed stand at $1.90 trillion, down from a record $2.31 trillion in December. Credit outstanding in four Fed liquidity programs, such as loans to banks and primary dealers and a facility for commercial paper, has shrunk $118 billion in two months.
"They need to make it clear they want to move aggressively," said Ethan Harris, co-head of economic research at Barclays Capital Inc. "The economy warrants a faster move and the markets do, too." Bernanke calls the Fed’s policies "credit easing" to contrast with the "quantitative easing" used by the Bank of Japan earlier this decade, which targeted reserves injected into the banking system. The Fed’s current focus is on purchases of mortgage securities and a program designed to boost consumer lending called the Term Asset-Backed Securities Loan Facility, known as TALF, which could grow to $1 trillion.
Bernanke’s view is if the Fed provides liquidity, credit will flow and lower the price of loans, feeding pent-up demand for homes, cars, credit-card borrowing and capital expenditures by business in the depths of the worst recession in a generation. Analysts are skeptical. "The concern about the TALF is not so much the investor interest in it, but the availability of eligible" securities to buy, given lack of consumer demand for new debt, said Tilton of Goldman Sachs. Consumers will borrow if they see solid job prospects and rising wealth, economists said. Right now, neither condition is in place.
The unemployment rate in February was 8.1 percent, up almost 2 percentage points in the past six months. Household wealth fell by a record $5.1 trillion last quarter. Personal savings as a percent of disposable income has risen every month since August. A less effective TALF would lead the Fed to use its authority to purchase assets and expand the supply of money, some Fed watchers said. "I would be surprised if they didn’t continue buying another $500 billion of mortgage-backed securities in the second half given the downside risks to the economy and the fact that the mortgage market is still in a shambles," said Christopher Rupkey, chief financial economist at Bank of Tokyo-Mitsubishi UFJ Ltd. in New York.
Deflationary forces not easing
U.S. wholesale prices rose in February for the second straight month, but the details of the Labor Department's report show deflation can't be ruled out. The producer price index increased 0.1%, led by a 1.3% rebound in energy prices. Core prices, which exclude food and energy goods, rose 0.2% for the month. Those moderate numbers are pretty good news because they hint that prices may be stabilizing, not falling into a deflationary spiral that could extend and worsen the global recession. But elsewhere in the PPI report, deflation lurked. Prices of crude goods (mostly commodities) fell for the seventh straight month, down 4.5%. Prices of intermediate goods (which are partially processed goods) fell for the seventh straight month, down 0.9%. Prices of core intermediate goods fell 0.6% in February and are now down 0.1% in the past year, the time they've been negative since 2002. As recently as last summer, core intermediate prices were rising at a 12% pace.
Falling prices are most apparent for industrial materials. Over the past six months, farm product prices have fallen at a 35% annual rate. Chemical prices are falling at a 25% rate. Metals prices have fallen at a 38% rate, including an 80% annualized drop in copper scrap prices. Commodity prices are ruled by the forces of global supply and demand, so their path will be determined largely by how deep the global slump turns out to be and how quickly it turns. It takes more than dropping commodity prices to get persistent deflation in consumer prices. Labor costs need to fall as well. That hasn't happened yet, but as the unemployment rate inevitably rises, the pressure on workers to accept wage cuts will increase.
Deflation: why is it so dangerous?
With the economic news seemingly becoming worse by the day, there has been much talk about the possibility of deflation – a prolonged period of falling general prices. But why would this be so bad? After all, surely deflation is good for households if it means that the cost of the goods and services is becoming cheaper? There are a few reasons it's not that simple. First, prices tend to be influenced by the state of the economy. If demand is greater than the supply of goods and services then prices rise. If demand is weaker –as is the case at the moment – then prices can drop. So falling prices tell us something about the fragile shape of the economy. A fall in prices is bad news for companies that make or sell the products we buy. Imagine a retailer having to cut prices to shift stock, but at the same time paying more for imported goods because of the fall in pound’s value. This causes profits to turn to losses, meaning some retailers will go to the wall, and many will cut staff.
Deflation, therefore, doesn’t just mean lower prices – it also means higher unemployment and lower wages. It will become much more difficult for those people who’ve lost their job or had to take a pay cut to continue repaying their debt. Some might be forced to sell their house to pay off the mortgage – but the more people who do this, the more house prices may fall (causing negative equity). And if house prices fall that can be a blow to confidence leading to a weaker economy which in turn might perpetuate deflation. It is easy to see how a vicious cycle can develop. Consider the situation in which we have deflation, and more importantly we think it is going to continue. There is, then, little incentive to spend money today – we may as well wait until tomorrow when prices will be lower. And tomorrow we might think the same again, deferring our purchase indefinitely. This is what happened in Japan in the 1990s - deflation came, and shoppers disappeared. Economic growth turned to economic contraction, and we witnessed what became known as Japan's "lost decade". Following a brief interlude where growth returned, a second lost decade seems to be in the making.
Even worse was the Great Depression. In the 1930s share prices tumbled leading to an economic slump of epic proportions – and, of course, deflation and falling wages. The crash that led to that depression was caused by investors buying shares with borrowed money, pushing their prices up to ever unsustainable levels. This time round it was excesses in the housing market and the financial sector. Governments are now trying to spend their way out of recession, attempting to fill in the gap left by households and firms. The Bank of England is helping too by bringing interest rates down to exceptionally low levels – making it less desirable to save and thereby encouraging spending. It is still very uncertain as to how all of this stimulus will affect the economy. The pressing need is to avert a period of deflation, but the risk is that too much policy easing could cause exactly the opposite.
Small Business Loans Plan Criticized by Congress Watchdog Agency
President Barack Obama is set to release a plan Monday raising the federal guarantee on small-business loans up to 90%, but a study by Congress's watchdog agency contends that insufficient oversight is in place for that program. The Small Business Administration's "credit elsewhere" program lends to small businesses that can't otherwise get credit, such as through conventional loans from private banks. Hundreds of banks provide loans under the program, formally known as 7(a), with the federal government currently guaranteeing between 50% and 85% of each loan, up to $2 million. Mr. Obama's plan, aimed at helping troubled small businesses, will increase that guarantee to as much as 90% of a loan. The plan also will temporarily eliminate many of the loan fees that help pay for the program and cover potential defaults.
And Mr. Obama on Monday will instruct the government to purchase small-business loans bundled and sold on the secondary market. Small businesses have accounted for about 70% of the new jobs created over the past decade, but credit is drying up for them amid the economic downturn and credit crunch. Under the "credit elsewhere" program, before issuing a loan lenders must provide supporting documentation from potential borrowers to show that they couldn't get loans elsewhere. The study by the Government Accountability Office found that few of the participating banks are sufficiently documenting borrower need. Eric R. Zarnikow, associate administrator for the SBA's office of capital access, said in a letter to the GAO that the agency "will work with its incoming Administrative leadership to use the findings presented by the GAO to create more-specific guidance for lenders around documenting compliance."
Government watchdogs fear the potential for another debacle, similar to what happened in the mortgage crisis, in which poorly documented loans were granted by mortgage brokers, then shuffled off to banks and hedge funds as securities. By eliminating the upfront fees for banks and lenders while increasing guarantee levels, watchdogs say, the administration could be creating incentives for banks to rush credit out the door. The bank's only risk would be the 10% of the loan left on its books, and that could be eliminated by selling the loan on the secondary market, where it could fetch a premium because of government backing. "According to the GAO investigation, I think we have nothing more than a large, unregulated pot of money that lenders are going to scramble to get their hands on," said one congressional investigator familiar with the report and the administration's plan.
According to the National Association of Government Guaranteed Lenders, the largest banks in the SBA program are Bank of America Corp., with 10,878 outstanding loans worth $336 million in 2007, the last year for which figures are available; J.P. Morgan Chase Bank, with 8,548 loans worth $491 million; and Capital One Financial Corp., with 6,309 loans valued at $312 million. A Bank of America spokesman said the bank would have no comment on the GAO report. J.P. Morgan and Capital One couldn't be reached for comment Sunday. Taxpayer exposure would also increase with the larger loan guarantees and the federal purchasing of bundled loans on the secondary lending market, analysts said Sunday.
To the Obama administration, such risks are necessary as it seeks to tackle what could soon become the longest recession since World War II. While the SBA typically guarantees $20 billion in loans a year, new lending is likely to fall below $10 billion in 2009, according to administration statistics, suggesting that even with federal backing, banks are leery of lending to small businesses. "This has been one of the most-devastating aspects for job growth -- that small businesses, which previous to this crisis had the funding they needed to grow jobs, have completely lost that," White House economist Austan Goolsbee told "Fox News Sunday." "And so we're trying to reignite through direct intervention the small-business credit market."
In its study, the GAO looked at 97 lenders and found that 31, or nearly a third, had failed to show that the loan recipient had tried to get a loan without a federal guarantee before turning to an SBA lender. Even on the loans that had some justification, "the explanations were generally not specific enough to reasonably support the lender's conclusion that borrowers could not obtain credit elsewhere," the GAO report said. The SBA's 7(a) program, by far its largest, guaranteed more than 69,000 loans valued at about $13 billion in the 2008 fiscal year ended Sept. 30.
Rated F for Failure
When Standard & Poor’s, the bond-rating agency, lowered General Electric’s rating to AA+, from AAA, last week, many were shocked at the tarnishing of one of America’s most revered corporations. But the real scandal is how long it took S.&P. to make that minor change — and that the other major ratings firm, Moody’s, still hasn’t — even though G.E.’s dividend has been slashed by two-thirds and its stock price had fallen below $7, from nearly $40 a year ago. Why, more than a year into the crisis, do regulators and investors continue to rely on ratings?
No one has been more wrong than Moody’s and S.&P. Less than a year ago both gave high ratings to 11 of the largest distressed financial institutions. They put the insurance giant A.I.G. in the AA category. They rated Lehman Brothers an A just a month before it collapsed. Until recently, the agencies maintained AAA ratings on thousands of nearly worthless subprime-related securities. The reason for this continued reliance on ratings is simple: bad regulation. We have seen up close how legal rules that depend on ratings pervert the process. One of us worked at Moody’s, and was a frequent in-house critic of how the agencies put troubled companies on artificial "watch lists" while they maintained overly optimistic letter ratings. The other of us worked in Morgan Stanley’s derivatives group, which designed risky structured products that nevertheless obtained high ratings.
These deals were the ancestors of the highly rated subprime mortgage derivatives at the center of the crisis. The trip down the dysfunctional regulatory path began after the 1929 crash, when Gustav Osterhus, an examiner at the Federal Reserve Bank of New York, proposed a system for weighting the value of a bank’s portfolio. He felt regulators needed to be able to express a portfolio’s "safety" with letter symbols. Since then, the number of financial regulations based on ratings has skyrocketed. Money market funds can buy only bonds rated in the top two categories. Banks’ capital requirements are lower for highly rated securities. Even federal highway financing depends on credit ratings.
Over time, ratings became valuable not because of their accuracy but because they "unlock" markets; that is, they are a sort of regulatory license that allows money to flow. Moreover, institutional investors came to rely on ratings for contracts that don’t even need regulatory approval. Trillions of dollars of derivatives payments depend on ratings. Much of the panic at A.I.G. stemmed from ratings "triggers" embedded in credit default swaps, in which billions of dollars of payments depended on how Moody’s and S.&P. labeled A.I.G.’s credit risk. This has left us in a ratings trap. As more regulators and institutions rely on ratings, the agencies have become increasingly reluctant to downgrade. Even a one-notch downgrade of A.I.G. before it hit the shoals would have saddled it with an extra $8 billion of obligations.
It is no coincidence that when government officials were debating the fourth round of A.I.G. bailouts this month, they quietly called on the rating agencies to ensure that they would not downgrade the insurer. In a crisis, downgrading debt can be like firing a bullet into a company’s heart. The system is rife with conflicts of interest. The ratings agencies get a fortune from corporations to evaluate their bonds and naturally don’t want to bite the hand that feeds them. Nor do they want to admit a mistake or antagonize investors who might have to sell after a downgrade. The only way out of the trap is to reduce reliance on ratings. First, regulators should undo the regulation web they began creating during the 1930s. The Securities and Exchange Commission has called for eliminating reliance on ratings, but that proposal has stalled in the face of intense lobbying.
For their part, investors should stop putting ratings-related language into financial contracts. The terms of credit default swaps and other derivatives should be free of ratings-based triggers. Banking supervisors should insist that loan contracts not refer to ratings. Fund sponsors, pension plan administrators and insurance regulators should remove ratings-based criteria. The financial markets can function without letter ratings. Instead of relying on arbitrary letters, regulators and investors should consider all of the information available about an investment, including market prices. Finally, regulators and investors should return to the tool they used to assess credit risk before they began delegating responsibility to the credit rating agencies. That tool is called judgment.
FDIC-brokered bank deals set to surge
Merger and acquisition activity may have dried up in the banking space, but the appetite for deals brokered by a top banking regulator is increasing as more and more weak banks succumb to the deepening recession. With bank failures expected to rise further, experts say healthier banks could start to look aggressively at acquiring weaker ones as early as the second half of this year, in deals assisted by their regulator, the Federal Deposit Insurance Corp (FDIC). "For sure there's going to be more bank failures, more FDIC receiverships and so more opportunities for healthy banks to acquire these insolvent banks in assisted transactions," Lawrence White, an economics professor at New York University's Stern School of Business, said by phone.
Experts believe there will be no dearth of such opportunities for banks and see 100 to 200 bank failures this year, up from 25 banks in 2008 and just three in 2007. So far this year 17 banks have failed. "The FDIC is going to be making available for merger by the end of the year at least 100 banks and maybe more," White said. When a bank fails, the FDIC, which insures up to $250,000 per depositor, is named receiver and is responsible for liquidating its assets. For banks that have been prudent in their lending and in the portfolios they maintained, an FDIC-assisted deal poses an attractive alternative to traditional acquisitions, as acquiring banks can pick up deposits at relatively low or zero premium and also be shielded from toxic assets.
FDIC spokesman David Barr said there was interest by banks in acquiring potential bank failures, but that the interest varied considerably. "It all really is based on the franchise value of that troubled institution," he added. In recent weeks, community banks, including FirstMerit Corp and First Midwest Bancorp Inc, have said they were eyeing potential FDIC-assisted acquisitions. "I think it would be tough to find a regional bank that would not have an interest in doing an FDIC-assisted deal," Oppenheimer and Co analyst Terry McEvoy said. But U.S. banks are not the only ones eyeing such deals. Foreign banks such as Canada's Toronto-Dominion Bank had earlier this month expressed interest in FDIC-assisted deals.
FDIC Chairman Sheila Bair has said the number of bank failures could increase and the agency has set aside $22 billion for expected payouts from its deposit insurance fund this year. The regulator said its watch list had 252 problem banks, with combined assets of $159 billion, in the fourth quarter. Small banks, which currently do not have access to capital markets and are constrained by revenue and geographic diversification, face the biggest challenges, making them the likeliest targets for FDIC-assisted acquisitions, analysts say. "I think it's mostly going to be smaller versions of IndyMac, Washington Mutual, PFF Bank and Trust -- just guys who got in over their head in local lending on properties that are now way under water and are going to pay the price," White said.
Washington Mutual, by far the largest U.S. bank failure, as well as failed California thrifts IndyMac Bancorp and PFF Bank all specialized in exotic mortgages, causing those banks to become insolvent as the housing crisis gained momentum and dragged the economy into recession. Morgan Keegan and Co analyst Robert Patten estimated at least 500 to 1,000 banks, predominantly in the small-cap space, will need to be acquired over the next two to three years. New York University's White said, "Any place where there's been a weak housing market and lots of foreclosures, there's probably a local lending institution that is hurting and that's where you're going to see the FDIC action."
But in the end, for an FDIC-led deal to take place, much would depend on whether the healthy banks, which regulators look to as consolidators, can give up capital. "While the Fed wants all these consolidators to start picking up their weaker sisters, these larger banks care for how they allocate their own capital because they are also working through a capital environment," Patten said."So we're at this catch-22." Faced with mounting capital constraints, financial institutions around the world have unleashed a slew of measures to bulk up their capital, including cutting or eliminating dividend payments.
Oppenheimer's McEvoy believes regional banks with strong capital levels are in a better position to do FDIC-assisted deals, and cited KeyCorp and Comerica Inc as good examples. Analysts, however, agree that the larger banks will not be driving merger and acquisition activity in the sector, saying they have "enough on their plate right now." But other than JPMorgan Chase & Co, Citigroup Inc, Wells Fargo and Co and Bank of America Corp, the rest are open game, analysts say.
CFTC Chairman Nominee Gensler Wins Committee Approval
Gary Gensler, President Barack Obama’s choice to head the Commodity Futures Trading Commission, was endorsed by a Senate committee, clearing the way for a full Senate vote on his nomination. Agriculture Committee members gathered for the vote at a room in the Capitol after voting on other legislation on the Senate floor. Kate Cyrul, a Committee spokeswoman, couldn’t provide the final tally for the vote today. She said there were "no negative votes" on Gensler’s nomination. Senator Tom Harkin, an Iowa Democrat and chairman of the committee, has previously expressed concerns about Gensler’s "deregulatory orientation." Harkin voted in support of the nomination today.
Gensler, 51, was a Treasury official during the Clinton administration and is a former Goldman Sachs Group Inc. partner. Harkin and others on the committee had questioned Gensler’s role in 2000 legislation that exempted credit-default swaps from regulation by the agency. Credit-default swaps are blamed in part for the current financial crisis. The CFTC is responsible for regulating $5 trillion in daily trading of futures contracts including transactions for crude oil, foreign currency and agriculture products. Gensler’s nomination still requires approval from the full Senate. Harkin said he didn’t know when a Senate vote would be scheduled. Gensler was nominated to the position by Obama on Dec. 18.
U.S. credit card defaults rise to 20 year-high
U.S. credit card defaults rose in February to their highest level in at least 20 years, with losses particularly severe at American Express Co and Citigroup amid a deepening recession. AmEx, the largest U.S. charge card operator by sales volume, said its net charge-off rate -- debts companies believe they will never be able to collect -- rose to 8.70 percent in February from 8.30 percent in January. The credit card company's shares wiped out early gains and ended down 3.3 percent as loan losses exceeded expectations. Moshe Orenbuch, an analyst at Credit Suisse, said American Express credit card losses were 10 basis points larger than forecast.
In addition, Citigroup Inc -- one of the largest issuers of MasterCard cards -- disappointed analysts as its default rate soared to 9.33 percent in February, from 6.95 percent a month earlier, according to a report based on trusts representing a portion of securitized credit card debt. "There is a continued deterioration. Trends in credit cards will get worse before they start getting better," said Walter Todd, a portfolio manager at Greenwood Capital Associates. U.S. unemployment -- currently at 8.1 percent -- is seen approach 10 percent as the country endures its worst recession since World War Two, leaving more than 13 million Americans jobless, according to a Reuters poll of economists.
However, not all were bad surprises. JPMorgan Chase & Co and Capital One reported higher credit card losses, but they were below analysts expectations. Chase -- a big issuer of Visa cards -- reported its charge-off rate rose to 6.35 percent in February from 5.94 percent in January. The loss rate for the first two months of the quarter is 126 bps from the previous quarterly average compared to an estimate of a 145 bp increase, Orenbuch said. Capital One Financial Corp's default rate increased to 8.06 percent in February from 7.82 percent in January. Analysts estimate credit card chargeoffs could climb to between 9 and 10 percent this year from 6 to 7 percent at the end of 2008. In that scenario, such losses could total $70 billion to $75 billion in 2009.
"People underestimated the severity of the downturn we are experiencing and I wouldn't be surprised to see them north of 10 percent," said Todd, who added American Express was most exposed to higher credit card losses, given its sole reliance on the industry. Credit card lenders are trying to protect themselves by tightening credit limits, rising standards, and closing accounts. They have also been slashing rewards, raising interest rates and increasing fees to cushion further losses. Meredith Whitney, one of Wall Street's best known and most bearish bank analysts, estimates that Americans' credit card lines will be cut by $2.7 trillion, or 50 percent, by the end of 2010 -- and fewer Americans will be offered new cards.
"We believe that the US credit card industry will feel additional credit pain over the next 12-18 months. Until lenders like Capital One show stabilization, followed by trend-bucking improvement over a several-month period, we will continue to remain bearish on credit card lenders," said John Williams, an analyst at Macquarie Research. Todd said credit card issuers shares -- which are down up to 60 percent in 2009 -- will remain under pressure until the end of 2009, or early next year, when bad loans could start to redeem.
Credit Card Issuers Choke U.S. Businesses With Rate Hikes, Limit Cuts
Susan Woodward isn’t renewing the lease on her music boutique and internet cafe in Jackson Hole, Wyoming, after nine years. The reason: doubling interest rates on her credit cards. "My business is seasonal, so we count on credit to stock the store at the end of the slow season and prepare for the busy season," said Woodward, who canceled her Citibank and Capital One credit cards in February after learning that rates would climb to 19 percent from 10 percent. She said she always made timely payments and kept low balances.
Almost three-quarters of U.S. companies with fewer than 500 employees are experiencing a deterioration in credit or credit- card terms at a time when half of them depend on credit cards as a primary source of financing, according to a December survey by the National Small Business Association, a trade group with more than 150,000 members. The increase in credit-card costs has forced some business owners to stop using their cards, and at the same time declining credit limits are cutting their access to cash, said Todd McCracken, president of the Washington-based NSBA. Twenty-eight percent of small businesses surveyed by the NSBA said they had their card limits or lines of credit lowered in the second half of 2008.
Bank loans are drying up as an estimated 70 percent of U.S. banks have tightened standards for small-business loans, based on a Federal Reserve January survey of senior loan officers. Financial institutions may slash $2.7 trillion in credit- card lines by the end of 2010, according to a report published last week by Meredith Whitney, chief executive officer of Meredith Whitney Advisory Group LLC in New York. Small-business owners often use business and personal credit cards, with 41 percent relying on a combination of both, based on data compiled by the NSBA.
"Small businesses in particular are getting squeezed on multiple credit fronts," said Alan Blinder, an economics professor at Princeton University and former vice chairman of the Federal Reserve. "Some businesses are forced to turn to very expensive forms of credit or not get credit at all." Independent businesses with fewer than 500 employees created 60 to 80 percent of new jobs annually in the U.S. during the last decade, according to the Washington-based Small Business Administration’s Web site.
President Barack Obama and Treasury Secretary Timothy Geithner said yesterday the U.S. will free up credit for small businesses by raising federal loan guarantees on Small Business Administration lending and increasing bank liquidity. "Small businesses are the heart of the American economy," Obama told a gathering of small-business owners, community banking executives and lawmakers at the White House. He said the measures announced yesterday are a "first step" of a continuing effort to help small business.
The Fed plans to start disbursing funds on March 25 from its Term Asset-Backed Securities Loan Facility program, or TALF, to prop up the market for consumer and small-business loans. "If it succeeds, the TALF can be an important step in both preserving what’s left of consumer and small business lending and restoring those markets," Blinder said. If card limits are slashed or interest rates are increased, small-business owners should try to decrease the balances on all of their cards, not just one, so the ratio of debt to available credit is lower, a key in determining credit scores, said Jeff Van Winkle, an attorney in Grand Rapids, Michigan who represents small-businesses owners.
Borrowers should also ask vendors if they will extend credit so they can defer payment to the vendor, without penalty, instead of to the credit-card company, Van Winkle said. Vendor financing may not be an option for Ralph Soto, who owns a construction company in Lutz, Florida. Twenty percent of the suppliers he uses won’t extend credit or are reducing credit lines, which has prevented him from bidding on certain projects that require up-front funding. Soto, 41, said the rates on cards issued by Capital One Financial Corp. and Visa Inc. have both tripled, forcing him to cancel the card. "If lenders don’t manage risk, they won’t have the funds to lend to anyone else," said Ken Clayton, senior vice president of card policy at the Washington-based American Bankers Association. One significant way to manage risk in these economic circumstances is to reduce credit lines, Clayton said.
Charge-offs, which are loans the banks don’t expect to be repaid, were 7.1 percent on average in January compared with 4.6 percent a year earlier, according to data compiled by Bloomberg. Consumers are falling behind on credit-card payments as U.S. unemployment reached 8.1 percent in February, the highest level in more than a quarter century. New York-based Citigroup Inc. may cut credit lines by $600 billion and Charlotte, North Carolina-based Bank of America Corp. by $500 billion, according to Whitney. She estimated New York-based JPMorgan Chase & Co. and American Express Co. would decrease lines by $300 billion and $100 billion, respectively.
American Express, the largest credit-card company by purchases, said yesterday payments at least 30 days past due rose to 5.3 percent of all loans last month. Some customers will have their interest rates increased to reflect the current risk environment, said Pam Girardo, a spokeswoman for McLean, Virginia-based Capital One. Customers were notified in writing with a minimum 45-day notice and can opt to decline the changes and close the account, she said. A Citigroup spokesman, Samuel Wang, declined to comment on the specifics of Woodward’s case. Woodward, 41, said three other stores along the main square in Jackson Hole are already empty, an unprecedented sight in her more than 20 years living there.
Since American Express reduced Jim MacRae’s credit limit from $25,000 to $1,500 and San Francisco-based Wells Fargo & Co. nearly halved his business line of credit, he has been forced to require more than a 50 percent deposit from customers who buy office furniture from him. He can no longer afford to keep inventory in stock and sales have dropped by about 80 percent, he said. "The stimulus package isn’t giving the companies I sell to the feeling that everything is going to be okay," said MacRae, 59, who lives in Newport Beach, California. "Instead of buying office furniture, they’re laying people off."
Congressmen Push to Restore Uptick Rule
Congress is increasing pressure on the Securities and Exchange Commission to reinstate a rule that limits bearish bets on stocks as their prices fall. Sen. Ted Kaufman (D., Del.) and Sen. Johnny Isakson (R., Ga.) introduced a bill late Monday that would require the SEC to restore the "uptick" rule, which prevented traders from initiating a short sale unless the price of a stock in its most recent trade was higher than the previous price. In a short sale, investors borrow shares and sell them, hoping for the price to fall.
The SEC scrapped the rule in 2007 after several economic studies showed it had little effect. But, since the sharp fall in financial stocks last year, the agency has been under pressure to bring it back. Some investors hope reimposing the uptick rule will limit selling frenzies in stocks, especially in those of financial companies. The SEC has scheduled a meeting for April 8 to vote on proposing a return of the Depression-era rule. The legislation is the latest push from Congress to influence the agency. Rep. Gary Ackerman (D., N.Y.) introduced legislation in January to force the SEC to reinstate the uptick rule.
Other Democrats, including Rep. Barney Frank of Massachusetts and Sen. Charles Schumer of New York, also support the idea. SEC chief Mary Schapiro has said she is in favor of revisiting the rule. The views of the other four SEC commissioners aren't clear. Only one was serving when the agency voted to abolish the rule. The SEC is also expected to propose alternatives to the uptick rule, such as implementing circuit breakers if a stock falls by a certain amount. If triggered, a trader wouldn't be able to short the stock for a predetermined period.
Pension Bills to Surge Nationwide
Many state and city governments reeling from financial woes are about to get whacked again, this time by an unforeseen increase in their pension bill thanks to market declines. In an effort to stave off tax increases, New Jersey lawmakers on Monday will consider a bill that would allow municipalities to defer payment of half their annual pension bill, due April 1, for one year. Those towns, counties and schools that opt to defer would face a higher pension bill for years to come. Other states and municipalities are facing similarly difficult choices. In Pennsylvania, the state employees and public teachers pension funds both have warned that employer contribution rates could surge seven-fold from about 4% of payroll to 28%, starting in 2012. The Detroit police and fire pension plan might have to double employer contribution rates to 50% of payroll by 2011, according to the fund's outside actuary.
Two of the nation's biggest public pension funds, New York State Common Retirement Fund and the California Public Employees' Retirement System, also have warned state employers to brace for future rate increases. "It's going to be huge showdown" between taxpayers and public employees, said Susan Mangiero, president of Pension Governance Inc., a consulting and research firm in Trumbull, Conn. "The anger is more acute today when people are feeling economic hardship." The specter of higher pension bills comes as many states and cities are struggling to balance their budgets or, in some cases, avoid drastic measures, such as filing for bankruptcy protection, amid falling tax revenue, foreclosures and rising unemployment costs.
In most states, retirement benefits for public employees are guaranteed by law, so governments have little choice but to pay them in full. During bull markets, that wasn't a problem. But with the median rate of return for a public plan of negative 25% in 2008, according to Wilshire Associates, many plans now may be unable to meet their obligations without further injections unless markets rebound significantly, analysts said. The Detroit police and fire pension plan, where employees are ineligible for Social Security so the benefit plan is more generous and costly, employer contribution rates could double to 50% over the next three years unless the markets turn around, said Norman Jones of Gabriel, Roeder & Smith in Southfield, Mich., the fund's outside actuary.
For future New York City police and firefighters, Gov. David Paterson and Mayor Michael Bloomberg have proposed a minimum retirement age of 50, where no minimum currently exists. They also want to raise to 25 from 20 the number of years these employees must serve before they can collect full benefits. Proposals pending elsewhere would move new public employees to a 401(k) plan. Some state lawmakers believe they would save money with a 401(k), which requires employees to pay a higher percentage of the contribution rate than they do under defined-benefit plans, said Alicia Munnell, director of the Center for Retirement Research at Boston College. Municipal unions said they would oppose such a shift, and note that such efforts have failed in the past, including four years ago in California. "It's not a program that is attractive to state employees," said Richard Ferlauto, director of corporate governance at the American Federation of State, County and Municipal Employees. "It's doesn't work because you wouldn't be able to hire people."
But soaring pension costs are emboldening critics of public plans. They said local governments cannot afford to pay what are often perceived as generous benefits to government employees when the 401(k) plans held by others have shrunk, and as taxpayers already are looking at higher taxes and fewer services. The pain is about to start in Wisconsin. The state has an unusual policy of adjusting the amount of benefits paid based on the pension fund's performance. Now, for the first time in 25 years, the majority of retirees will receive a benefit reduction. This month, Wisconsin officials said that beginning in May nearly 150,000 retirees will face at least a 2.1% decrease in benefits, after the pension fund had a 26% negative return in 2008. About 35,000 of retirees who held a portion of their retirement savings in an optional fund that invests entirely in stocks will be hit harder. Depending on how much of their savings they earmarked for the all-stock fund, their overall retirement income could be cut by up to 40%, according to a spokeswoman for the State of Wisconsin Investment Board.
Jim George, a 64-year-old retired elementary-school teacher in Milwaukee, estimates that his $3,700-a-month benefit check will be slashed by about $600. He is talking with his wife about where they will have to cut back: their annual January vacation to Florida, eating dinner out, maybe their high-speed Internet connection. "It's going to make things tight," he said. His brother John George, a retired teacher in Madison, Wis., faces the 2.1% benefit reduction. But with the markets reeling this year, he is worried about what future cuts might look like. "The stock market and my pension fund are a daily worry," he said. Optimism, in part, contributed to this quandary: Legislatures from Pennsylvania to California boosted employee benefits after the stock market boom years of the 1990s, which has added to their burden now.
Most pension funds also took the step of enacting smoothing policies, in which the benefit determination is based on average returns over five years. This was intended to dilute the impact of a particularly bad year. For the most part, this policy has worked to limit sudden or severe rate increases at most pensions. "But these polices weren't meant to accommodate losses as big as pension funds suffered last year," said Ms. Munnell of Boston College. The college's Center for Retirement Research estimates that the average public plan's liabilities, if based on year-end 2008 market prices, now exceed its assets by 35%. For public funds in worse financial shape, including funds in Connecticut, West Virginia and Indiana, due to stock-market declines liabilities exceed assets by 50% or higher, according to the center.
Some states may decide it is easier to cut public employee benefits than it is to raise taxes, especially during hard economic times. In the Virginia General Assembly, a bill would freeze the current pension plan starting in July and replace it with a 401(k) plan for all future hires. A state senator in Pennsylvania introduced a similar bill in 2007, and it went nowhere. But this year it is attracting attention. If employer contribution rates in Pennsylvania jump as high as 28%, "the pension system is just not manageable," said Pat Browne, the Republican state senator who sponsored the bill. He said he expects it to be voted on this year. "We need to get it passed quickly if we are to phase out the existing plan in time to make an impact."
MGM Mirage, GM Lead Wave of Filing Delays as Valuations Plummet
Casino owner MGM Mirage said it needed more time to complete its annual report to assess its finances. Newsprint maker AbitibiBowater Inc. attributed its delay to an impairment charge, and General Motors Corp. was slowed by debt refinancing. More companies are citing fluctuating asset values and mounting debt as reasons for late 10-K filings with the U.S. Securities and Exchange Commission. About 83 companies have postponed 2008 reports this year, based on filings compiled by Bloomberg as of yesterday’s market close. Others will probably follow later this month as the deadline for smaller companies looms, said Mark Grothe, a research analyst with investment advisory firm Glass, Lewis & Co. in New York.
Falling real estate and portfolio values, the financial crisis and tighter credit restrictions are complicating the annual review, making it harder for auditors to ensure that writedowns are valued properly, he said. "Prices have declined everywhere and it requires adjustment to the values the companies have held on the books," Grothe said in a telephone interview. "Today, those assumptions don’t seem as possible as they did a year ago." Of the companies that have delayed their 2008 annual reports, 33 cited debt refinancing, impairments or bankruptcies. That compares with 81 late filers a year earlier, nine of which gave impairments and bankruptcies as reasons. Companies are trying to determine impairments under a fair- value rule that requires them to revalue assets every quarter to reflect a market price regardless of whether they plan to sell.
The U.S. real estate market lost $2.4 trillion in value last year, according to First American CoreLogic, a provider of mortgage and economic data in Santa Ana, California. The Standard & Poor’s 500 Index fell 38 percent, while the Dow Jones Industrial Average lost 34 percent. "Fair-value accounting and having to recertify goodwill impairments all become harder to do in a market that isn’t giving good, predictable information," said David Martin, a former SEC lawyer and partner at Washington-based Covington & Burling LLP. "Value in the open market is much harder to discern."
Montreal-based AbitibiBowater said its fourth-quarter loss of as much as $238 million will include a $296 million charge related to asset and goodwill impairments and a mill closing. The company cited the writedown in delaying its annual report. "We’ve had multiple priorities," Seth Kursman, an AbitibiBowater spokesman, said yesterday in a telephone interview. "The upcoming debt maturities and the sale of assets and other activities that have been going on here have had to take top billing versus the release of the information." Carrizo Oil & Gas Inc. also cited an impairment in postponing its report, according to a regulatory filing. GM and Carrizo have since filed their 10-K reports while MGM and AbitibiBowater haven’t, according to Bloomberg data through yesterday. GM and MGM Mirage said they had no comment beyond the filings. Carrizo had a writedown of more than $138 million and that flowed through the company’s bookkeeping and caused the delay, said Richard Hunter, vice president of investor relations. "As soon as we got all of that taken care of and accounted for, we were able to file," Hunter said.
MGM Mirage, the casino operator controlled by billionaire investor Kirk Kerkorian, borrowed the remaining $842 million under its senior credit facility last month. The company said one reason for its delayed 10-K was the need to assess the consequences of that decision. MGM Mirage has been hurt by falling gambling revenue and lacks funds to finish building its Las Vegas CityCenter casino, hotel and residential development. MGM is scheduled to report earnings later today. This week’s deadline for companies with $75 million to $700 million in outstanding stock will probably accelerate the wave of delays, Grothe said. Companies with a market capitalization of more than $700 million had to file their 10-K annual reports by March 2, 60 days from the end of the calendar year. The smallest companies must file by the end of the month.
"Small companies often don’t have the systems in place like the larger companies," Grothe said. "They don’t have the accounting staff to handle it." Late filings can trigger penalties from lenders, and companies often will seek waivers to avoid breaching debt covenants, said Eli Bartov, an accounting professor at New York University’s Leonard N. Stern School of Business. If companies aren’t able to negotiate waivers, fees and additional interest payments can range from $10,000 to $1 million, depending on the size of the loan and the company, Grothe said. Stocks also can be removed from exchanges, and companies may have to rewrite prospectus documents tied to share issues if they delay regulatory filings.
The SEC may take legal action, including a civil law suit, against companies who are delinquent in bringing the filings into compliance. In 2008, the regulatory agency brought 111 late filers before administrative judges, accounting for 16 percent of its total legal actions. It filed no civil suits last year. Delays may signal financial trouble, including the need to restate earnings, particularly if it’s the first time a company has postponed, Grothe said. Restatements are traditionally the biggest reason for tardy reports, although accounting changes under the Sarbanes-Oxley Act have limited the need for corrections, he said. "Late filings are the first red flag that there’s something wrong at the company," he said.
Mortgage Fraud Up As Credit Tightens
Mortgage fraud jumped by 26 percent last year even though fewer loans were issued nationwide, and Maryland ranked among the top five states with the most serious problems, according to an industry study released yesterday. The study by the Mortgage Asset Research Institute concluded that fraud is more prevalent than it was at the height of the lending boom. The group singled out the most troubled states based on cases it gathered from roughly 600 lenders, mortgage insurance firms and mortgage investors, as well as federal data on loan originations.
Rhode Island topped the list, followed by Florida, which had held the No. 1 slot in 2007. Incidents of fraud in Rhode Island were three times what would have been expected given the number of loans made last year, the report said, although the authors said they weren't sure why. Next on the list were Illinois, Georgia and Maryland, which landed on the top-10 list for the first time in the study's 11-year history, up from No. 15 in 2007. The state had the highest percentage of fraud on tax returns and financial statements.
But Sarah Bloom Raskin, Maryland's commissioner of financial regulation, said the report's findings do not mesh with information that has been released by other sources, including the FBI and mortgage financier Fannie Mae, which have not ranked Maryland or Rhode Island near the top of their lists. "I have no idea where [the report's] numbers come from, and I don't rely on their report as a benchmark," Raskin said. "It doesn't make sense. In Maryland, we've got some of the toughest laws in the country." The Mortgage Asset Research Institute, an arm of information company LexisNexis, prepared its report for the Mortgage Bankers Association.
By most accounts, mortgage fraud is rising as lenders clamp down on who qualifies for a mortgage. Home loan originations dropped to $1.49 trillion last year after peaking at $3.95 trillion in 2003, said Guy Cecala, publisher of Inside Mortgage Finance. They were down 39 percent from $2.3 trillion in 2007. "I don't think there's any denying that mortgage fraud is not going away any time soon, and it has risen as a percentage of loans," Cecala said. The authors of yesterday's report attributed the spike in fraud incidents in part to more aggressive reporting by lenders. But they also said that the tighter lending environment is enticing borrowers and real estate industry professionals to act illegally.
"The data suggest that the economic downturn may have created more desperation, causing more people than ever before to try to commit mortgage fraud," said Denise James, one of the authors. The most common type of fraud continues to be misrepresentation of income and other key facts on loan applications. That kind of fraud represented about 61 percent of all the cases reported in the study, followed by fraud on tax returns and then appraisals. The incidents used to reach the study's conclusions were reported voluntarily and in the aggregate without revealing details about cases. The findings were released at a mortgage fraud conference hosted by the Mortgage Bankers Association.
Filling out the top-10 list were New York, Michigan, California, Missouri and Colorado. John Courson, president and chief executive of the mortgage bankers group, said his organization wants the federal government to set aside $31 million for the next five years to help the Justice Department and FBI combat mortgage fraud. John S. Pistole, deputy director of the FBI, told a Senate panel last month that the number of FBI mortgage fraud investigations jumped to 1,600 in fiscal 2008 from 881 in fiscal 2006.
Shovels Are There, but the Readiness May Not Be
On a warm afternoon last month, a week before the stimulus bill became law, Vice President Joseph Biden strolled out onto a narrow, 79-year-old bridge over the Conodoguinet Creek. He poked his shoe through a hole in a rotting girder, tore off a piece of rusty metal, and examined a crack in the concrete deck. "Is this a shovel-ready project?" Mr. Biden asked Scott Christie, the state transportation official charged with deploying economic-stimulus money. "It's ready to go," Mr. Christie answered. "I literally have the plans in the car right now." It turns out, though, that shovel-readiness is in the eye of the beholder. Soon after his visit, Mr. Biden found out that his model stimulus project wouldn't see a shovel for almost four more months, possibly longer, knowing how such timetables slip. In North Middleton, a White House eager for action had run up against locals eager to avoid disruption. The locals won.
States are quickly assembling their construction wish lists. But it takes time to advertise for contractors, collect bids, check the numbers, pick a winner and get work underway. A typical paving project -- easy roadwork -- takes close to three months from the time the money is approved to the arrival of work boots on the ground, according to the American Association of State Highway & Transportation Officials. "It is not an instant process," says a spokesman. President Barack Obama and Mr. Biden know their unprecedented $787 billion emergency spending package has to put hard hats on America's streets soon -- or their administration risks losing credibility. On March 3, the president announced the release of the first $28 billion for road and bridge projects. A New Dealish logo to identify construction financed with stimulus money is ready.
Last month, even before the bill became law, Mr. Biden turned to Pennsylvania Gov. Ed Rendell to find the perfect illustration of just how fast the money could produce results. Mr. Rendell was happy to oblige. Every two weeks he receives a confidential report from Pennsylvania's Department of Labor listing factory start-ups and jobs created, alongside plant closings and layoffs. One of the latest reports lists 2,941 positions lost, and 1,143 created. "I'm almost scared to open them," Gov. Rendell says. To help Mr. Biden, the governor asked his Department of Transportation to come up with a list of projects. Mr. Christie had some paving in mind. But the Route 34 bridge, which had been on the state's to-do list for more than a decade, had infrastructural sex appeal. Road resurfacing just isn't "as glamorous as seeing a hole in a bridge," says Mr. Christie.
North Middleton, with a population of less than 12,000, is a bedroom community for Harrisburg and Carlisle. The bridge is a key corridor for commuters and an important access way for the North Middleton Volunteer Fire Co., whose main station is about 1,000 feet from the bridge. Mr. Biden flew to Pennsylvania on Feb. 11. Security agents closed the bridge to traffic before his motorcade arrived. "What are you going to show me that we're going to be using the stimulus money for?" Mr. Biden asked Mr. Christie that day. "I've got a great example of a bad bridge," Mr. Christie responded. The state lists the bridge as "fracture critical," meaning that if one of the two metal support girders broke, the entire structure would collapse. The green-painted girders are perforated with rust, the deck buckled with cracks. Putting up a new bridge would cost about $1.8 million and generate 50 to 60 jobs, according to state estimates.
On the bridge, Messrs. Christie and Rendell told Mr. Biden that they expected to start demolition in April. From their yellow ranch home -- the first house on the north side of the bridge -- Creedin Cornman, 84 years old, and his wife, Reba, 77, noticed the commotion. Mr. Cornman remembers a rainy night in the 1960s, when he fish-tailed his International Scout and hit one of the girders. The door flew open and his poodle escaped. "I left my mark on that bridge," Mr. Cornman recalls with a hint of pride. (The poodle was fine). The stimulus package "sounds good," says Mr. Cornman. "You have to start somewhere." Mrs. Cornman isn't so sure. "I don't know -- it's a lot of money," she says.
On the day of Mr. Biden's visit, Chester "Chet" Schlusser, 76, watched from the bed of his pickup truck while a Secret Service agent kept watch on his yard. The day before, the state had written Mr. Schlusser a letter offering him $8,200 for a sliver of his property to make room for the new bridge. The government included a blue brochure titled, "When Your Land is Needed for Transportation Purposes." Mr. Schlusser says he's inclined to sell the parcel. He worked in bridge construction for 10 years, and, stimulus or not, doubts the project will get going quickly. "People aren't geared up to start on a moment's notice," he says. On Feb. 18, the day after Mr. Obama signed the stimulus bill into law, a Biden aide called the state's Department of Transportation to see when the ground-breaking would take place.
But April wasn't looking likely. Unbeknownst to the officials gathered on the bridge, at a public meeting on the project the previous summer, the head of school transportation had requested that construction not overlap with more than one school year. Two bus routes for the local high school crossed the bridge, and the school district wanted to minimize the disruption that a long detour would cause. The only way to make that work was to begin construction after school let out on June 10. The state agreed to add language to the construction contract pushing back the start date. It plans to seek bids early next month, open them on April 30, review them for a few weeks and issue a "notice to proceed" by early to mid-June. Work could then commence on the site and be completed by year's end.
"To do it much sooner would be to go against what we've been trying to do all along, which is hold it to a single school season," says Timothy Bolden, of Gibson-Thomas Engineering Co., the new bridge's designer. News that construction would have to wait for months came as a shock to the White House. "The vice president was impatient," says a senior White House official. "He wanted it done." At a White House event on Feb. 23, Mr. Biden brought up the delay with Mr. Rendell. The governor, unaware of the school issue, reassured the vice president that the project was on track. "America didn't get in this mess overnight, and the cannot turn it all around overnight," says Annie Tomasini, a Biden spokeswoman. "But we are moving forward with unprecedented speed." On Feb. 27, Messrs. Biden and Rendell met again on the sidelines of an event in Philadelphia. This time, Mr. Rendell confirmed that construction wouldn't begin until late June. "If we want to be smackers and make sure stimulus rolls over everything, we could have started it in April," says Mr. Rendell. "We acceded to the request of the school district." Still, he says, "I wish it hadn't been the bridge the vice president walked on."
Canada's Factory Sales Plunge 5.4% in January to Lowest Since 1999
Canadian factory shipments fell in January for a sixth straight month on a record drop in sales of cars and parts. Factory sales dropped 5.4 percent to C$41.7 billion ($32.8 billion), the lowest level since May 1999, Statistics Canada said today in Ottawa. Economists surveyed by Bloomberg News predicted a decline of 5.8 percent, the median of 16 estimates. The Bank of Canada earlier this month cut its benchmark lending rate to a record 0.5 percent, and said it is looking at how to implement policies beyond interest rate moves if needed to revive an economy hit by a deeper-than-expected recession. Manufacturers cut 104,300 workers in the year ending February 2009 as demand from the U.S. plummets. Statistics Canada revised the drop in December's shipments to 8.2 percent from the originally reported 8 percent drop. In January, sales were down in 14 of the 21 industries tracked by the statistics agency.
The value of transportation equipment sales fell 27 percent in January, as vehicle shipments tumbled 46 percent and sales of parts dropped 27 percent. Primary metals sales fell 10.5 percent as prices declined. Factoring out price changes, manufacturing sales fell 6.4 percent, the biggest decline since the current series started in 1997, the statistics agency said. Inventory levels rose 1.2 percent in January to C$67.1 billion. The inventory-to-sales ratio climbed to a record 1.61, compared with the three-year average of 1.32. Unfilled orders for manufacturers declined 3 percent as aerospace manufacturers reported cancelled orders. New orders fell 6.7 percent to C$39.6 billion, the lowest level since December 1998, led by the transportation equipment industry's 39 percent drop, the agency said.
EU consumers buy into lower inflation
Eurozone consumers have seen a far steeper slowdown in inflation rates for goods and services they buy regularly than in headline inflation rates, a trend that could encourage them to keep spending in the recession. The steep deceleration in inflation rates for frequent, out-of-pocket purchases – or froopp – is shown in a new indicator compiled by Eurostat, the European Union’s statistics unit. The statistics confirm what economists have long suspected: that official inflation data frequently understate changes in those prices noticed most by consumers. This can lead to different perceptions between consumers and policymakers about inflation trends. So-called froopp inflation, covering prices of items bought at least once a month and paid for using cash, cards or cheques rather than automatic bank transfers, has fallen in recent months to an annual rate of just 0.8 per cent in February, compared with a headline inflation rate confirmed by Eurostat on Monday at 1.2 per cent.
The decline reflects steep falls in energy prices and could give consumers a psychological boost at a time when the eurozone’s 16 economies are under pressure. Last year, when oil prices were soaring, froopp inflation hit annual rates of almost 6 per cent, far higher than the 4 per cent maximum reached by the headline inflation figures. At the time, eurozone politicians faced pressure to counter falls in consumers’ purchasing power. "We are now seeing the reverse phenomenon," said Peter Vanden Houte, eurozone economist at ING in Brussels. Along with government measures aimed at stimulating the economy, lower froopp inflation would help boost spending, he said. Eurozone "core" inflation, excluding energy and unprocessed food prices, stood at 1.7 per cent in February.
UK home reposessions up two thirds in a year
Home repossessions increased by 68% last year as the economic downturn left many people struggling to pay their mortgage, figures from the Financial Services Authority show. A total of 46,750 properties were repossessed by lenders during the year, up from 27,900 in 2007, the City watchdog said. There was also a steep jump in the number of people who fell behind with their mortgage repayments during the final quarter of the year. Around 68,000 people got into arrears during the period, a 13% jump compared with the previous quarter, which had seen a 10% rise.
The FSA said borrowers were increasingly struggling to clear their arrears, and this led to the total number of people who were behind with repayments steadily increasing since early 2007. At the end of last year, 377,000 homeowners were in arrears, 10% more than in the third quarter and 31% higher than at the end of 2007. The number of mortgages that were in arrears as a proportion of all loans also increased significantly during the year to 3.37%, up from 2.26% 12 months earlier. The FSA's figures for repossessions are considerably higher then those reported by the Council of Mortgage Lenders, which said 40,000 people lost their homes during 2008, the highest level since 1996. The difference is because the FSA covers all regulated lenders, whereas the CML includes only its members. The FSA also includes both first and second charge mortgages, while the CML looks only at first charge loans.
But the FSA figures did show a slight fall in the number of homes that were repossessed during the final quarter of 2008, with 13,028 properties taken over by lenders during the period. This was 436 fewer than during the previous three months, although the figure was still 60% higher than a year earlier. The fall may be due to the introduction of the Government's pre-action protocol in November, under which courts are allowed to grant repossession orders only as a last resort if all other measures have failed. A pick-up in the number of repossessed homes that lenders were able to sell meant the number of such properties held by banks and building societies rose by only 1% during the final quarter to 27,903, although this was 88% higher than a year ago.
GM rescue moves up a gear in UK, but stalls in Germany
General Motors is making faster progress in Britain than Germany in winning support for its European rescue programme, it emerged on Monday. Top level talks between GM European executives, the prime minister and Lord Mandelson, Business Secretary, are said to have produced a more enthusiastic response than the reception in Germany, where political in-fighting has slowed progress on GM's plans to spin off its European business, backed by state aid. Reassurances about the future of the Vauxhall plant at Ellesmere Port on Merseyside, where GM wants to make a European version of a US battery-driven car, along with qualified assurances about the Luton van plant are understood to have made the government more favourably disposed towards the GM plan.
Gordon Brown said on Monday he had talked with German Chancellor Angela Merkel about the crisis facing the European car industry, but had not discussed any specific aid for GM. He has also spoken to Carl-Peter Forster, GM's European president "in the last few days", while Lord Mandelson, has had discussions with Bill Parfitt, chairman of GM in Britain. A GM spokesman said the talks with the government were "constructive and progressive." GM is seeking €3.3bn (£3.04bn) in state aid, mainly from the German and British governments, to support its plans for a partial spin-off of the Opel operations in Germany and Vauxhall. Decisions on Opel, GM's European flagship, are crucial to the success of the plan. The Merkel administration has reservations and has sent Karl-Theodor Guttenberg, economics minister, to ask Rick Waggoner, GM chairman, whether GM would hive off Opel completely. Rival Ford is making further production cuts in Europe, with a reduction from three to two shifts at its factory in Valencia. British plants have escaped the latest cost cutting measures.
German March Investor Confidence Unexpectedly Rises
German investor confidence unexpectedly rose to the highest level in almost two years in March after the European Central Bank reduced borrowing costs to a record low. The ZEW Center for European Economic Research in Mannheim said its index of investor and analyst expectations increased to minus 3.5 from minus 5.8 in February. That’s the highest reading since July 2007. Economists expected a drop to minus 8, according to the median of 39 forecasts in a Bloomberg News survey. The ECB on March 5 lowered its key rate by 50 basis points to 1.5 percent to stem the worst economic slump in 60 years.
In Germany, Chancellor Angela Merkel’s coalition has agreed to spend about 80 billion euros ($104 billion) to stimulate economic growth. Germany’s benchmark DAX share index has gained 8 percent this month, paring its decline this year to 17 percent. The euro rose almost half a cent to $1.3021 on ZEW’s report. "Expectations are getting ahead of themselves," said Kenneth Broux, an economist at Lloyds Banking Group Plc in London. "Investors are looking at equity markets to provide a slightly more confident outlook, but in the economy there’s no sign that we’re near the bottom." ZEW’s gauge of current conditions fell to minus 89.4 from minus 86.2 in February. That’s the lowest since September 2003.
There are signs Germany’s recession is deepening. Industrial output dropped 7.5 percent in January from December, the biggest decline since data for a reunified Germany began in 1991, and factory orders plunged 38 percent from a year earlier as export demand slumped. Unemployment rose in February for a fourth straight month, pushing the jobless rate to 7.9 percent, while business confidence dropped to a 26-year low. German gross domestic product may drop 3.7 percent this year instead of the 2.7 percent projected in December, the Kiel-based IfW institute said on March 12. The ECB expects the economy of the 16 euro nations to shrink about 2.7 percent this year and to stagnate in 2010.
Volkswagen AG, Europe’s largest carmaker, on March 12 predicted a first-quarter loss and lower profit and revenue this year. Chief Executive Officer Martin Winterkorn said it will be "one of the most difficult years" in the company’s history. BASF SE, the world’s largest chemical company based in Ludwigshafen, said last month it will accelerate plant closures and eliminate at least 1,500 jobs. "Demand for chemical products has not picked up since the start of 2009," BASF CEO Juergen Hambrecht said. "A reversal of the trend is not yet in sight." "Things will get worse before they get better," said Carsten Brzeski, an economist at ING Group in Brussels. Still, "the pace of contraction should slow down significantly in the summer months, when most measures of the fiscal package and the aggressive monetary easing find their way into the economy."
Merkel’s government has crafted two economic packages since late last year, including a 100 billion-euro fund to boost company liquidity and 82 billion euros in stimulus measures, such as investment in infrastructure and an incentive to scrap old cars to buy new, energy-efficient vehicles. The ECB has cut its key rate by 2.75 percentage points since early October, the most aggressive easing since the bank took control of monetary policy a decade ago. ECB President Jean- Claude Trichet indicated earlier this month that policy makers may lower borrowing costs further. A drop in energy costs is also boosting purchasing power and may bolster company and consumer spending. "The bottom of the recession is likely to be reached this summer," ZEW President Wolfgang Franz said in a statement today. "The economic situation is extremely bad, but we see the first rays of light."
Germany takes long view
For Germany, with its ageing population, a trade surplus is the country’s way of saving for old age. As Europe’s largest economy slides into its steepest recession since the 1930s, the government is not exactly exhorting citizens to go out and spend and chip away at the surplus. This has provoked incomprehension across the Atlantic, for Germany is a dramatic example of the perils large economies face when they rely heavily on exports for growth. In contrast to the US and the UK, the German government has focused its crisis management on businesses rather than consumers based on the expectation that the downturn, while severe, would be short, and that global demand would recover by mid-year. Angela Merkel, chancellor, described her policies as "creating a bridge to the next upturn". Ms Merkel doubts that cautious German consumers – as betrayed by their high saving ratios – could develop US shopping habits overnight. Many economists agree that, given the limited size of its public coffers – the public sector deficit could reach 6 per cent of gross domestic product next year – and the sheer scale of the shortfall in global demand, Berlin has little alternative but to wait for a revival. Once global growth resumes, Germany could be well placed to take advantage of it. Compared with other export nations, its industrial products are geared more towards developing countries’ demands.
China lost billions in diversification drive
China has lost tens of billions of dollars of its foreign exchange reserves through a poorly timed diversification into global equities just before world markets collapsed last year. The State Administration of Foreign Exchange, the opaque manager of nearly $2,000bn (€1,547bn, £1,429bn) of reserves, started making huge bets on global stocks early in 2007 and continued this strategy at least until the collapse of the US mortgage finance providers Freddie Mac and Fannie Mae in July 2008, according to analysts and people familiar with Safe’s operations.
By that point Safe had moved well over 15 per cent of the country’s $1,800bn reserves into riskier assets, including equities and corporate bonds, according to people familiar with its strategy. Safe never discloses its holdings except to the top Chinese leadership so it is impossible to know exactly how much it has lost from diversifying before markets crashed. But judging from the subsequent fall in global stock prices and a conservative estimate that Safe held about $160bn worth of overseas equities, Chinese losses on those investments would exceed $80bn, or more than 50 per cent, according to Brad Setser, an economist at the Council on Foreign Relations in New York.
Total holdings of US equities by all Chinese entities reached $100bn by the end of June last year, more than triple the total of Chinese holdings in June 2007, according to an annual survey published by the US Treasury. In mid-2006, Chinese holdings of US equities totalled just $4bn. Chinese investors are mostly barred from investing abroad and Safe is the only entity with the resources and the authority to make such large-scale offshore portfolio investments. “Safe has built up one of the largest US equity portfolios of any foreign government entity investing abroad, including the major sovereign wealth funds,” Mr Setser said. “It appears Safe began diversifying into equities early in 2007 and, rather than being deterred by the subprime crisis, it continued to buy.”
China’s leadership has not commented on the equity losses but Wen Jiabao, prime minister, expressed concern about the value of China’s large holdings of US assets on Friday and warned the US to take measures to guarantee its “good credit”. Safe uses a Hong Kong subsidiary when investing in offshore equities in the US and other countries, including the UK, where this subsidiary took small stakes last year in dozens of UK companies including Rio Tinto, Royal Dutch Shell, BP, Barclays, Tesco and RBS. As part of its diversification in early 2008, Safe also gave some money to private equity firms such as TPG and to hedge funds on a managed account basis. This gave the Chinese government ultimate approval for how its money was invested, according to people who have worked with Safe.
The large shift into global equities appears to have started at around the time that Beijing approved the establishment of China Investment Corporation, the country’s official sovereign wealth fund, which has been widely criticised in China for incurring paper losses of around $4bn on high-profile investments in Morgan Stanley and Blackstone. The bulk of Safe’s holdings remain in US Treasury bills and much of the loss on its riskier assets will be offset by gains on long-term bills, according to Mr Setser. “They are a lot more cautious and risk-averse now and have basically returned to buying government bonds,” said someone who works with Safe.
Ford Forecasts Russian Sales May Plunge 50% as Economy Falters
Ford Motor Co., whose Focus is the top-selling western car in Russia, cut its industry forecast for the country, saying sales may plummet as much as 50 percent this year in what used to be the second-fastest growing auto market. "All the indications are that even now demand is continuing to soften," Nigel Brackenbury, Ford’s managing director for Russia, said in a telephone interview yesterday from Moscow. "There is substantial inventory in the market place that was built in 2008."
Carmakers are bracing for a far steeper decline than the 19 percent predicted just two months ago by the Association of European Businesses, an industry group that includes automakers. Volkswagen AG and Toyota Motor Corp. estimate Russian sales will plunge by as much as a third as interest rates on car loans climb to more than 20 percent and the economy falters. The Russian slump is cutting off one of the last growth areas for western carmakers at a time when the global industry is in a tailspin. For nearly a decade as oil prices climbed, Russian consumers increasingly bought more expensive foreign models, spurring double-digit sales gains second only to China, according to Boston Consulting Group. Now, Russians are buying cheaper cars without the extras, if they’re buying at all.
Russian car sales in the first two months of 2009 dropped 36 percent to 252,314 vehicles as the ruble depreciated and interest rates rose. Russia may slide into recession this year after ten years of uninterrupted growth as the global economic slowdown erodes demand for the country’s oil and gas. Elena Shapochanskaya typifies the Russian consumer’s current wait-and-see mood. She had planned to buy a western brand this year, putting in an order for a car from PSA Peugeot Citroen costing 350,000 rubles ($10,027) before deciding to cancel it. "It’s the crisis - that scary word that everyone is afraid of," the 25-year-old Moscow consulting firm employee said in explaining her decision. "There’s an uncertainty at work, and they’ve cut our bonuses."
Ford’s Brackenbury said his internal forecast last month was for registrations to fall by a third. Deteriorating market conditions, such as slowing sales, fewer visits to dealers and a lower volume of phone calls, convinced him to cut his estimate. Ford, which stopped production at its St. Petersburg plant for one month from mid-December to mid-January, is looking at further adjustments to "plan realistic inventories," he said. Toyota, the world’s largest automaker, said yesterday it will idle its Russian factory for one week because of the sales drop. Russia’s Economy Ministry predicts the economy will contract 2.2 percent in 2009. The ruble has slumped about a third against the dollar in the last six months.
Interest rates on car loans have advanced to as high as 21 percent from about 12 percent previously, said Mikhail Pak, an analyst at IFC Metropol in Moscow. Carmakers say 90 percent of customers pay for their cars with cash because of the high rates. It was about 50 percent in 2008. "People are having difficulties getting credit," Tor Berge, Toyota’s vice president for Russia, said in an interview. "It also shows that a lot of people are trying to put their rubles into a car to sort of secure their money." The Russian government has responded to the car sales drop by pledging to spend about 220 billion rubles to aid the industry, offering to subsidize loans on car purchases and making plans to upgrade at least 12 percent of the federal car fleet. The government also raised import duties on cars and trucks to encourage domestic production.
Foreign carmakers as a result are scaling back sales of imported models and focusing on cars produced at their own Russian factories. Ford will build about 80 percent of the cars it sells in Russia this year locally, while Volkswagen, Europe’s largest carmaker, will produce about 70 percent in the country. That compares to 50 percent last year, they said. "Russian automakers will fare relatively better than foreign companies as they benefit from the weaker ruble, government aid and higher import tariffs," said Ilya Makarov, a transportation analyst with UBS AG in Moscow. Domestic producers such as OAO AvtoVAZ, the nation’s biggest carmaker and builder of the Lada, "are also less exposed to the volatile markets outside Russia," Makarov said.
The impact of the collapsing car market is also being felt beyond the country’s borders. In recent years, 70 percent of Russian car imports passed through neighboring Finland’s ports. Now, cars meant for Russia, are piled up in the Nordic nation. "The excess that built up in the autumn is sitting out in the parking lots and the automakers are wondering if they can sell them or what else to do with them," Jukka Ryky, managing director of the Freeport of Finland, said. "Our parking lots are nearly full. Everywhere else is full too. Temporary lots are being used around Europe."
Anatoly Alexeyev knows the situation all too well. A sales manager at a dealership south of Moscow, Alexeyev says visits have dropped 20 percent since the beginning of the year. Those that do buy are opting for cheaper Russian models as opposed to western brands. "Prices on foreign cars have increased significantly" as a result of the decline in the ruble, he said. "There is a shift toward Russian cars." Western carmakers say there’s no sign of a recovery taking hold and that a turnaround won’t come until after the economies in the U.S. and western Europe pick up and demand for oil increases. "It might be at the end of the year that the market starts to come back," Frank Wittemann, the Volkswagen brand’s Russia chief, said. "It really depends on what the oil price does."
Saudi Spending Climbs Despite Wide Slowdown
As leaders from the Group of 20 nations tussle over how big to make their stimulus packages, one member is busy outspending everyone: Saudi Arabia, where royal extravagance can't hide decaying public infrastructure. The largest of the Persian Gulf petro-states, Saudi Arabia spends heavily to stimulate growth in good times and bad. Recently, the kingdom ramped up government outlays in an effort to counter the effects of falling oil prices, a freeze in local bank lending and a plummeting stock market. Jeddah, Saudi Arabia's commercial capital on the shores of the Red Sea, is a city crumbling at the edges. Beggars waving alms bowls are a common sight along the beach road, which is scarred with potholes. The city suffers periodic brownouts, and residents rely on private water deliveries to make up for limited public services.
While members of the Saudi royal family fly in private planes out of a glitzy VIP airport, at the regular terminal, leaky toilets and broken light fixtures resemble infrastructure commonly found in underdeveloped countries. Breakdowns in public services are common throughout Saudi Arabia, where the population has doubled over the past 20 years. Only one in 10 Saudis own their homes. Middle-class families frequently complain their children's public-school classrooms are overcrowded, and students attend in half-day shifts. The International Monetary Fund estimates Saudi Arabia's stimulus spending will amount to 3.3% of the kingdom's gross domestic product this year.
Saudi Arabia now boasts foreign-currency reserves of $350 billion, according to official data, though some outside estimates are higher, putting it third behind China and Japan. The kingdom's banks are also still robust, thanks to restrictive lending controls. European nations and the U.S. are counting on Riyadh to pitch in some of its excess reserves to boost funding for the IMF. While it's unclear how willing Saudis will be, the kingdom is spending massively at home to bolster its sharply slowing economy. The IMF expects Saudi Arabia to grow 0.8% this year, down from a previous forecast of 4.3% just a few months ago and growth last year of 5.5%. That may not be fast enough to continue to lift living standards in this nation of 28 million. Per capita income in the world's largest oil exporter puts Saudis behind the average household wealth of their much smaller Gulf Arab neighbors.
When oil prices hit historic highs last year, Saudi King Abdullah, who is both the chief of state and head of government, embarked on a infrastructure-building boom. In November, the king announced plans to spend an additional $400 billion over the next five years on infrastructure. In January, as the global credit crunch froze most outside financing, Riyadh announced a 13% increase in spending this year, projecting its first fiscal deficit in seven years.
Economic woes delay U.S. nuclear power expansion
The sputtering global economy and frozen credit markets have shrunk the first wave of a highly touted U.S. nuclear power renaissance. Nuclear industry advocates had predicted more than a dozen new reactors worth $100 billion or more generating at least 15,000 megawatts of power in the United States by 2020. Then the economic slump hit. Now, Cambridge Energy Research Associates expect four to eight new reactors providing 5,000 MW to 10,000 MW by 2020. The Nuclear Energy Institute, an industry advocate, said four units will be in service by 2016 and as many as eight by 2018.
"Recent market developments are influencing the pace of new power plant projects in the U.S. industry-wide," said Danny Roderick, vice-president for nuclear plant projects at GE Hitachi Nuclear Energy. "The global financial climate is causing some U.S. customers, primarily ones that are relying on the capital markets to finance their projects, to reprioritize needs and consider options for the construction of new nuclear power plants," Roderick said. The number of new units after that first wave will depend upon whether developers can bring them on-line near schedule and within budget.
The impact of the credit crunch remains hard to gauge. Companies in line for new reactor licenses have several years before they have to build a new unit, which can cost between $5 billion and $12 billion, said Jone-Lin Wang, head of CERA's global power group. The U.S. Nuclear Regulatory Commission says it has received applications for 26 new reactors. Already, reviews for four of those have been suspended, although not for reasons related to the sour economy, the commission said. "The economy has not affected what the NRC expected" in license applications, spokesman Scott Burnell said. Still, Wang said it was easier for companies to spend millions of dollars to develop an application for a nuclear license, than it was to fork over the billions to build a plant.
The last new U.S. nuclear power reactor built went into operation in 1996, but construction on that unit began before the Three Mile Island incident in 1979 helped slam the brakes on the industry's first phase of widespread growth. The first new reactors are likely to be the two or three that get U.S. federal loan guarantees, analysts said. The U.S. Energy Department expects to name recipients of $18.5 billion of the loan program sometime after May. Critics of nuclear power point to massive cost overruns in the 1970s when many of the 104 U.S. reactors now in service came on-line. Those generate about 100,000 MW of power, 20 percent of U.S. electricity. A megawatt is enough electricity to power about 800 average homes.
Nuclear power is often seen as attractive because it can offer baseload power without carbon dioxide emissions that come from fossil-fuel natural gas and coal power plants. Those attributes mean nuclear power is in the cards, particularly as utilities replace older, dirtier coal-fired plants, said Dimitri Nikas, analyst with credit rating agency Standard and Poor's. Last week, U.S. Energy Secretary Steven Chu told the Senate Budget Committee: "I believe nuclear power is an essential part of our energy mix. It provides the clean baseload generation of electricity." Nikas and other analysts said the recession will delay the growth of U.S. electricity demand, but not stop it. In 2011, the NRC will likely issue its first operating license needed for construction, NEI said.
A quest for other ways
Asia: dependence on the west is just one flaw
Ten years ago, when Asia was in the midst of its home-grown financial crisis, capitalism as practised in that continent was everybody’s favourite punchbag. Though it was hard to generalise about economies ranging from Indonesia to Japan and from Singapore to China, many academics formed general principles about where Asia had gone wrong. Asian economies were said to be too dependent on foreign capital flows and too keen on funnelling state resources through tightly controlled banks instead of relying on more creative and efficient capital markets. Many practised a form of "crony capitalism" in which the interests of the state and favoured businesses, often family-controlled, were too intertwined. Managers were shielded from shareholders instead of being prodded to make efficiencies and align their interests with those of their investors. Governments, in general, took too close an interest in economic decision-making, misallocating capital and hindering the creative forces of the market.
Now the boot is on the other foot, find Asian policymakers, regulators, bus?inessmen and politicians – some of whom had resented the lectures and some of whom had taken them to heart. Not a few are starting to lecture the west about its casino capitalism and its credit-fuelled, asset-bubble growth model. Adding to that sense of superiority is the fact that Asian governments – notably those of China and Japan – are the biggest holders of US Treasury securities and Fannie Mae and Freddie Mac paper. Having in effect bankrolled America’s disastrous spending binge, they want the satisfaction of being able to tell the west where it went wrong. Wen Jiabao, China’s premier, told a less-than-ebullient audience in Davos – once a Mecca to the ideas of untrammelled capitalism – about the west’s "unsustainable model of development characterised by prolonged low savings and high consumption". He pilloried western banks, chunks of whose near-worthless stock are now owned by Chinese state institutions, for their "blind pursuit of profit and lack of discipline".
In similar vein, Prakash Javadekar, senior spokesman for India’s Hindu nationalist opposition Bharatiya Janata party, describes American capitalism as "nothing but overindulgence". Eisuke Sakakibara, a former Japanese finance minister, predicts that the world will never return to the consumption patterns that led to the credit collapse. "After this recession is over, things will be very different," he warns. "The American age is over." Kishore Mahbubani, dean of Singapore’s Lee Kuan Yew School of Public Policy, has been a prophet of that decline. He says Asians have learnt many of the virtues of western capitalism, including its general trust of free markets. But after suffering through the Asian crisis and the lectures of the International Monetary Fund – some of whose strictures are now being ignored by western governments – he says Asians have added some lessons of their own. These include: "Do not liberalise the financial sector too quickly, borrow in moderation, save in earnest, take care of the real economy, invest in productivity, focus on education." Contrasting Asia’s performance of the past 10 years with that of much of the west, he says: "While America was busy creating a financial house of cards, Asians focused on their real economies."
Indeed, Asians have some things right. Their banks were, with some exceptions, not permitted to indulge in the foolhardy practices that have led so many western institutions to the brink of bankruptcy. Individuals, companies and some governments have continued their propensity to save. Executives – with the exception of some family tycoons who use their companies as piggy banks – have generally eschewed the sort of remuneration packages that have become so discredited in the west. Yet these alleged strengths often carry as many drawbacks as advantages. High savings rates, which owe as much to poor welfare systems as to noble qualities of sobriety, have throttled domestic demand. For every successful management team untroubled by activist shareholders there has been another running its company into the ground. Even putting such quibbles aside, a number of fundamental difficulties exist in what might loosely be called Asian-style capitalism. First, the region depends on the western hyper-demand for which it now exhibits so much disdain. For much of last year, the idea persisted that Asia could escape the financial crisis. Asia, as Mr Mahbubani says, was concentrating on the real economy, busily making consumer electronics, machine tools and container ships. However, it was westerners who were buying them.
Japan is a case in point. This year, it is expected to perform worst among the Group of Seven industrial nations, its output shrinking by as much as 6 per cent. The sharpest contraction since the second world war has arisen even though its banks bought little toxic paper and the country ran big trade and current account surpluses. As Peter Tasker of Dresdner Kleinwort in Tokyo says: "It seems so unfair." Second, it takes a very short memory to conclude, as some are now doing, that governments are better allocators of capital than the private sector. Japan proved equally prone to creating asset bubbles as the US, even though its banking system was under much closer state guidance. In China, too, the clumsiness of the state is evident. Last year, Beijing grew worried that the economy was overheating and acted to cool things down. The result was a collapse in property prices and a shock to consumer sentiment, which hit economic performance even before the ef?fect of falling exports was felt. "They thought they were fine-tuning," says Arthur Kroeber at Dragonomics, a research firm in China. "So regulation doesn’t work, just like deregulation doesn’t work. China remains a 19th-century boom-and-bust economy."
Finally, some Asian economies, such as India, may escape the worst simply because they are poor countries still not fully integrated into the global economy. India’s restrictions on foreign investment and protection of the domestic financial industry have probably done as much harm as good. When it comes to the energy sector and to the distorting effect of state subsidies, India could have done with more deregulation, not less of it. Likewise, China, even now, has not ditched ambitions to make its financial industry more sophisticated. Fang Xinghai, director general of financial services at Shanghai municipality, says China may even speed up financial re?form now it is more aware of the potential pitfalls. Stephen Roach, chairman of Morgan Stanley Asia, says China has prospered to the extent that it has emulated US practices, not avoided them: "The stunning record of Chinese economic development is an explicit endorsement of capitalism – a development model that hinges critically on the ownership transition from state-owned enterprises to privately held companies." Amid the crisis – as Washington adopts command-economy style nationalisations, directed lending and state bail-outs – it might be tempting to conclude that the US is edging towards a more Chinese style of capitalism. But in the long run, however discredited western capitalism now appears, the movement is far more likely to be in the opposite direction.
Europe: actions seldom both collective and effective
This could have been Europe’s moment. An economic crisis caused by unfettered US capitalism should have shown the value of things the Continent does best: harnessing free markets, laying down rules and running generous welfare systems. The point was not lost on Europe’s political class. As the crisis gathered terrifying speed last September, Nicolas Sarkozy, French president, declared that "laisser faire capitalism is over" and heralded the return of the interventionist state. Across the Rhine, Peer Steinbrück, German finance minister, had a few months earlier confidently informed interviewers that Europe’s biggest economy would escape largely unscathed – though he added that "if the sky falls in, we are all dead". That caveat was to prove wise. The economic sky has indeed fallen in, delivering European capitalism a nightmare as horrible as that being experienced across the Atlantic. Germany’s economy is contracting faster than those of the UK or US. Past top performers, such as Spain, look stuck in protracted recessions. Across the Continent there is mood of despondency. For many the best hope is of a reasonably swift US recovery that, once again, lifts growth across the world.
As a result, the European approach to capitalism, which seeks to combine free markets with social solidarity and regulation, faces its biggest trial since the second world war. The test will be whether, having devoted much of the past decade to attempting reform, the Continent can prevent any slipping backwards and generate the internal dynamism needed to power growth in a modern industrialised economy. To Europe’s critics the answer is relatively clear. While in the decades after 1945, its economies performed strongly in their drive to catch up with the US, they have since failed to generate sufficient self-sustaining growth. Social safety nets might help soften the effects of a downturn but do not change underlying weaknesses. "Is anybody saying that there has been some increase in the dynamism or innovativeness of these economies?" Edmund Phelps, Nobel prize-winning economics professor at Columbia University in New York, asks pointedly. "The US has better chances of pulling out of this slump in the next few years than do the countries of continental Europe, because of its greater dynamism."
Europe never had a single economic model. Instead, the Continent offers a variety of approaches, ranging from the pro-market and lightly regulated British and Irish economies to the more protective instincts of Mediterranean and the Nordic tradition of blending the better elements of several models. But since the launch a decade ago of a monetary union that, except for the UK, includes the Continent’s biggest economies, the models have converged. Financial integration and globalisation have encouraged a drive towards liberalising markets. The lessons of recent history also show that crises can spur advance. The euro was born out of the foreign exchange turmoil of the early 1990s. On a different level, but equally telling, the banking crisis that hit Nordic countries at the same time created the conditions for Finland’s Nokia, then a conglomerate, to focus on mobile telephony – a move that turned it into a global champion. Jorma Ollila, then chief executive, later recalled how the deep recession "forced us to restructure for the new economy much earlier than other European countries. We had to be radical."
Could the current crisis pave the way for a similar European revival? It is not yet clear that Europe as a whole has found a better way of operating than other parts of the world. Even prior to the crisis, extensive welfare was often associated with sluggish growth and stubbornly high unemployment. At the level of European Union-wide economic management, meanwhile, the jury is still out as to whether the current arrangements are up to the challenge. EU rules on public finance limit governments’ room for manoeuvre; monetary operations are clearly separated from fiscal policy, posing a further handicap should the crisis deepen. "We had a system that was built for good weather, not storms," says Jean Pisani-Ferry, director of the Bruegel think-tank in Brussels. Values that appeared virtues – predictability, decentralisation and a focus on crisis prevention – have rapidly lost their allure. "In a crisis you need the exact opposite – a lot of centralisation and a lot of discretion in policymaking."
Paul De Grauwe, professor of economics at Belgium’s Leuven university, warns that the 27 EU countries lack ways of boosting their overall firepower by acting collectively. "If the whole thing gets out of hand in the sense of leading to depression and mass unemployment, then the whole structure is at risk. I can see politicians in some countries saying, ‘this is a lousy system, let’s change it’." But the pressures of crisis management need not undo completely the reforms of recent years. Until 18 months ago, Europe’s biggest countries appeared to be benefiting from financial integration and the disciplines imposed by capital markets on governments and businesses. Germany, for instance, had turned decisively away from its "Rhineland capitalism" model, in which business strategies were driven collectively by managers, local politicians, bankers and trade unions. Extensive restructuring had boosted international competitiveness, creating powerful export industries. Such trends will not now be thrown into reverse, says Dirk Schumacher of Goldman Sachs in Frankfurt. "Unless the government takes a large number of stakes in industrial companies – which is unlikely – we are not going to see a return to the old Deutschland AG. Investors and capital markets will still have the biggest say over how corporate Germany is run."
Handicaps remain. Lamed European banks and capital markets will no longer provide an impetus to economic growth – in fact, they may find themselves facing significantly tougher regulation. Trust in the financial system was never high among continental Europe’s politicians, especially in powerful left-of-centre parties. Small innovative business is also unlikely to lead any revival of European capitalism. "If you ask students in this country what their dream is to be when they are 40 or 50, they don’t dream of becoming independent entrepreneurs," says Sixten Korkman of Finland’s Etla research institute. "They are not as bad as perhaps in France, where everyone wants to be a civil servant, but you would like to see more of the kind of venture capitalism, of entrepreneurship that you have typically in the US – much more than in any country in Europe." But he argues the Nordic economies’ social welfare systems could offer lessons to the rest of the world on how to reduce worker anxiety at a time of crisis and rapid change and on enabling economies as a whole to restructure. For health insurance and pensions, "if you rely on individual or company solutions, it is not only socially undesirable but it is also bad for business. It is more efficient to have a broader basis." Finland’s push into new technologies was helped also by strong links forged between academics, business and government funding. So all is not lost for Europe’s economic model. Still, as Mr Korkman accepts: "Nokia is rather unique. We would need a few more."
Has a Comedian Just Saved America?
As testimony to how Orwellian life has become under the outrages of Wall Street hubris, last week saw a comedian, who poses as an anchor on a fake news show, grab the reins of the Wall Street investigation from the actual investigators in Congress. Either Jon Stewart is the smartest man in America or he has incredible instincts. In a week’s time, he has zeroed in, like a heat-seeking missile, on the core of Wall Street’s malady. How insightful of Stewart, host of Comedy Central’s "The Daily Show," to rationalize that the core of Wall Street’s corruption might well be the same core that it has drawn the darkest curtain around: trading. Stewart is the son of an educational consultant mother (Marion Leibowitz), physicist father (Donald Leibowitz) and trading technology guru brother (Larry Leibowitz) an executive at the New York Stock Exchange. He’s got a smart family and he’s equally smart, advancing the national debate on a comedy channel.
After a week of explosive commentary and video clips of questionable reporting at the cable business network, CNBC, Stewart interviewed Jim Cramer on Thursday, March 12. Cramer hosts CNBC’s "Mad Money" show which promotes itself as an advocate for the small investor while, at the same time, suggesting lots of buying and selling of specific stocks. Stewart used the highly anticipated interview to show a devastating clip revealing Cramer to be the embodiment of the market manipulators that he rails against on his show. Acknowledging on the clip that he would never say something like this on TV, Cramer states: "You know, a lot of times when I was short at my hedge fund and I was positioned short, meaning I needed it down, I would create a level of activity beforehand that could drive the futures. It doesn’t take much money."
Allow me to translate: You know, a lot of times when I was making a large bet that prices would decline in a specific stock or bond or derivative when I worked in the largely unregulated world of private money called hedge funds, and I needed to give that decline a little unseen assistance to make my bets profitable, I would go into the futures market to trade. That’s because I could put down as little as 4 to 10 percent of the money I needed for the trade and borrow the balance in what is called a margin account.
The academics and economists (none of whom ever worked a day on Wall Street) have been telling us in OpEds and speeches and testimony before Congress that the crumbling Wall Street structure results from bundled subprime mortgages, collateralized debt obligations, credit default swaps, and asset backed securities. Trillions of dollars of taxpayers’ funds have been spent on the premise that these toxic assets are the problem. The fate of a nation has been staked on that analysis: that if we get these assets off the balance sheets of the major firms, the credit spigots will begin to flow once again, the banks will once again trust each other and lend to each other, and investors will resume buying stocks and bonds with their confidence in the system restored.
Stewart’s weeklong commentary and clips helped to dramatically expose this logic as bogus. None of the toxic instruments would have grown to a problem capable of collapsing the country’s financial system if their trading had been regulated, transparent and fairly reported on by mainstream media. The security instruments were never the problem; how they were traded was the problem. For example, the mortgage and debt securities were, in reality, junk bonds but they were traded as triple A. They were not traded on an exchange where price discovery would have shown them to be junk bonds, they were traded in an opaque over the counter market. In the case of credit default swaps, they were traded in a market created by the very firms who needed to hide for as long as possible (while executives reaped windfall compensation and bonuses) the dubious pricing of the securities and gargantuan amounts being issued.
Wall Street is supposed to have an early warning system that if something is amiss it will self correct in time to avoid a collapse of the system. That early warning system is known as price action. In other words, the trading price of Citigroup, Merrill Lynch, Lehman Brothers, Bear Stearns, Freddie Mac, Fannie Mae and AIG should have begun a downward trajectory years ago as these firms loaded up on leveraged junk. There is only one possible scenario, in my opinion, to explain why this did not happen: trading in the market was rigged. Thanks to Jim Cramer, the public now knows how easy it is to get stock prices to move up or down.
To be a fair marketplace, the trading price of stocks and bonds must represent the composite wisdom of all market participants who have the same opportunity to ferret out information from public sources. When trading is internalized at the big Wall Street firms (meaning they are allowed to match customer stock orders in-house), when they are able to create and clandestinely operate their own trading venues off the radar screens of the regulators, when they are able to create offshore vehicles like Structured Investment Vehicles to hide bets gone bad, there is no longer any composite wisdom. There is only dumbed down information which the public possesses from CNBC and the superior information available to those operating inside the clandestine system.
The big Wall Street firms that taxpayers are bailing out even gobbled up some of the largest specialist firms. Those are the folks who are required to maintain fair and orderly markets on the regulated stock exchanges. But here’s what the specialists are really doing, according to charges disclosed on March 4, 2009 by the Securities and Exchange Commission (SEC):"…from 1999 through 2005, the firms violated their basic obligation as specialists to serve public customer orders over their own proprietary interests. As specialist member firms on one or more of the regional and options exchanges, the firms had a duty to match executable public customer or ‘agency’ buy and sell orders and not to fill customer orders through trades from the firm's own accounts when those customer orders could be matched with other customer orders. However, the firms violated this obligation by filling orders through proprietary trades rather than through other customer orders, thereby causing millions of dollars of customer harm."
The $70 million in disgorgement and penalties the SEC charged 14 specialist firms (some of which are owned by Wall Street powerhouses like Goldman Sachs and Citigroup) is now effectively coming out of the taxpayers’ pocket since these are two firms enrolled in the taxpayer cash for toxic asset trash bailout bonanza. In other words, the public investor is now paying back the money that was stolen from the public investor in the continuing Wall Street saga of heads I win, tails you lose. Is it any wonder it takes a comedian to deal with this stuff.
The speed at which Congress begins daily sessions investigating trading of both toxic and non toxic securities will determine the speed at which this country begins to rebuild from the ashes.
After the 1929 crash and as the nation entered the Great Depression in the early 1930s, the Senate convened hearings by the Committee on Banking and Currency that peeled back month after month from 1932 to 1934 previously impenetrable layers of trading fraud. Each layer of fraud opened a window into the next layer. The hearings did not focus on assets, toxic or otherwise, it focused on the trading of assets: how Wall Street created dark pool operators (today’s hedge funds) to trade on inside information and manipulate prices; how some of the most respected men on Wall Street had participated in trading frauds; how some of the largest firms were secretly manipulating stock prices; how respected business columnists were taking bribes from Wall Street players to move trading prices.
I’ve often pondered just how it was that every large brokerage firm had the same idea at almost the same time in the early 1990s: to put a TV set airing CNBC in every stockbroker’s office. The managers came around and offered the broker a deal they couldn’t refuse: a deeply discounted price on the TV and the firm would install it hanging from the edge of the ceiling so it wouldn’t take up precious desk space. Out of 55 brokers in my office at the time, only myself and one other broker declined. Can you think of any other industry that wants its workers sitting around watching TV instead of working? Unless, of course, what CNBC is telling brokers to buy and sell is actually considered part of the work day by the Wall Street masters. As you ponder that, consider this excerpt from testimony given at the Friday, June 3, 1932 Senate hearings:William A. Gray, Counsel to the Committee: So that the committee may understand the matter which I am now going to present, permit me to say that I am going to show by Mr. Lion himself that he is a publicity man, and that for a period of three years he was acting for numerous brokerage houses in the city of New York, that he furnished through various journals, including radio speeches, publicity for certain stocks, pools which were then being operated by the brokerage houses, he being paid for such by cash and by being given calls on the particular stocks in questions, at prices that he could sell them to his advantage, the brokerage house of course giving him credit for same in an account which he carried and settling with him the same as they would settle with any other person who had actually bought and sold, he not being required to put up any cash at all. Now, Mr. Lion, please give us your full name.
Mr. Lion: David M. Lion…
Mr. Gray: What is your business?
Mr. Lion: Financial publicity.
Mr. Gray: How long have you been engaged in that business?
Mr. Lion: Five years or more.
Mr. Gray: Prior to engaging in that business and for the past five years have you at any time conducted a paper of your own?
Mr. Lion: Yes.
Mr. Gray: What was the name of that paper?
Mr. Lion: The Stock and Bond Reporter…
Mr. Gray: How long did you continue the use of the radio for the purpose of disseminating information about stocks?
Mr. Lion: I used it all of 1929…
Mr. Gray: Now, you did not do your own radio talking, did you?
Mr. Lion: No, sir.
Mr. Gray: What was the name of the man you employed to do your radio talking?
Mr. Lion: I employed William J. McMahon…
Mr. Gray: Who is he?
Mr. Lion: He was an economist…
Mr. Gray: Each of his talks was devoted to a particular stock, wasn’t it?
Mr. Lion: No.
Mr. Gray: Sometimes only one stock?
Mr. Lion: Yes, sir…
Mr. Gray: But when he ended up his talk as a usual thing he referred to a particular stock and boosted it. That is true, isn’t it?
Mr. Lion: Yes, sir.
Mr. Gray: And he was a salaried man on your staff for that purpose, wasn’t he?
Mr. Lion. Yes, sir.
Jon Stewart has opened the floodgates. Let the hearings begin.