April 21 2009 2: The one thing we do well

Esther Bubley Those were the days my friend September 1943
Soldiers with their girls at the Indianapolis bus station

Ilargi: I'll start off today's second post with an important article by Charles Hugh Smith, important for those who still don't get why home prices are on their way to being shattered beyond recognition. As much as he explains it well, and concise (thanks!, I like the comparison to the Tulip bubble's non-recovery), John Carney at Business Insider does it even better in his comment on Smith which I’ll post below this. But Carney's piece also sticks out for me for another reason, one that is less positive. Here's Carney's conclusion:

This has important policy implications. It means that policies built around the confidence that house prices will recover are bound to be costly failures. Money spent to re-inflate the bubble will be lost. And until we become adjusted to permanently lower house prices, the broader economy will continue to suffer. For one thing, we're going to have to go back to creating wealth in ways other than selling our homes.

In other words: Carney claims that if Smith is right, policies need to be altered. That'll be a shocker for most, but still: as much as his words make Carney sound reasonable, he's way behind the eight ball. Like a thousand miles. John, trust me, by the time "we become adjusted to permanently lower house prices", the broader economy will no longer exist, at least not in a form that we would recognize as such. We're up higher than any of our ancestors could imagine, and we therefore have such an almost immeasurable depth to fall into.

First of all, there's nothing new here. The Automatic Earth has told people this would happen since way before we even started this site, when we were writing elsewhere. Yes, those policies built on the assumption that prices will recover are bound to be failures. Come to think of it, they already are. But they are also the only policies executed so far. There is a reason for that, and at the same time there is precious little reason to believe that will change.

The reason is simple: If the government(s) admit that housing will never come back, there are consequences attached that will become clear, but for which nobody is prepared: millions of bankrupt citizens, thousands of bankrupt banks, pension funds, market funds etc, and hundreds of bankrupt governments, be they at municipal, state or national level. And for none of this all do we have a plan B. None.

TAE has warned you all for a long time that home prices, and not just in the US, will come down 80% or more peak to trough. There's a simple explanation for that too: we're in the midst of the biggest credit bust by a million-mile long shot in the history of mankind. And that is something that both politicians and their voters will try to deny as long and as hard as they can. Nobody is prepared to face what they see as the worst case scenario. Not the 80%+ losses in home values, not the 25-50% unemployment levels, and not the hunger, disease and violence that are, and inevitably so, likely to result from all this.

The entire economical and financial systems are based on credit, it's the juice that has kept us going through the 20th century. And now it’s gone. It won't be back either, because overall people are already buried in debt, which means they don't want to borrow more, and no banks will volunteer to lend to them. Those same banks are even deeper in debt than individuals, something that would already have been glaringly and painfully obvious without the $12.8 trillion the US alone shoveled into the bottomless furnace.

Good analysis of the present situation by both Smith and Carney, even though they both miss out on reason number 1, the demise of credit altogether, in all its waning glory. But to say that policies must now change because of Smith's research is simply bogus. There is nothing new, nothing added to what we already knew 2-3-4 years ago. Today is too late to change policies, and 3 years ago in all likelihood was as well.

Sure, we should prevent people from the banking and financial sectors from making any additional decisions about where to go from here, but that won't happen either (nor so I think Carney is likely to agree). They themselves sure think they have the answers, this time around that is. The bankers control the Treasury, and investors and economists control all, including the "official" media and web discussions, that's going on right below that. And all they do is try to come out ahead of the crowd. No matter how blindingly clear the future reality shines them in the eyes, everybody who has a say, who has money, who has power, will bend his or her worldview to fit that picture that will make him or her come out of this well (we're so good at lying, we no longer stand a remote chance of figuring out what's real till we ram into a wall head first).

They are all terribly wrong, the "experts", and it's precisely because they're narrow-field experts. After all, there is no reason to assume reality will bend with them to match their preferred views, but being wrong won't stop them. No politician or economist sees him or herself panhandling in Lower Manhattan, or dying from an affliction that today is easily cured by anti-biotics, or being horribly mutilated by someone who can’t get his or her meds anymore, or, well, you get the idea. But it will all come to pass, and it's not just that.

Before the people who have their hands on the levers are done, they will have made everything much worse than it need have been. The laws of human physics say they must. It's the one thing we do well, might as well enjoy it. And it's not just the powerful among us, we all are guilty of being human. In today's first post, I added an article from New York Magazine about the "problems of the rich", Wall Street's privileged having a hard time adjusting to having less wealth than they are accustomed to having. Predictably, many reactions to an article like that are filled with a sense of righteousness that is fully misplaced. The difference between the über-rich and "normal" Americans is no bigger than that between the latter and a dirt farmer in Eritrea. It all depends on what you're used to. Whoever is without sin, you know the drill. It's easy to vent at the rich, but in the end it's only getting rid of the mote in thine own eye that will get thee anywhere.

You won't hear it from your "leaders" or from your favorite talking heads, but yes, it's true, home prices will keep on falling till a majority of mortgage holders are under water. By then at least half of them will be out of a job as well. What do you think will come after that? I'm going for reality TV without the screen.

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Those were the days

Once upon a time there was a tavern
Where we used to raise a glass or two
Remember how we laughed away the hours
And dreamed of all the great things we would do

Those were the days my friend
We thought they'd never end
We'd sing and dance forever and a day
We'd live the life we choose
We'd fight and never lose
For we were young and sure to have our way.
La la la la...
Those were the days, oh yes those were the days

Then the busy years went rushing by us
We lost our starry notions on the way
If by chance I'd see you in the tavern
We'd smile at one another and we'd say

Those were the days my friend
We thought they'd never end
We'd sing and dance forever and a day
We'd live the life we choose
We'd fight and never lose
For we were young and sure to have our way.
La la la la...
Those were the days, oh yes those were the days

Just tonight I stood before the tavern
Nothing seemed the way it used to be
In the glass I saw a strange reflection
Was that lonely woman really me

Those were the days my friend
We thought they'd never end
We'd sing and dance forever and a day
We'd live the life we choose
We'd fight and never lose
For we were young and sure to have our way.
La la la la...
Those were the days, oh yes those were the days

Through the door there came familiar laughter
I saw your face and heard you call my name
Oh my friend we're older but no wiser
For in our hearts the dreams are still the same

Those were the days my friend
We thought they'd never end
We'd sing and dance forever and a day
We'd live the life we choose
We'd fight and never lose
For we were young and sure to have our way.
La la la la...
Those were the days, oh yes those were the days

Music & Lyrics : Gene Raskin

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Why Housing Is Not Coming Back

Thefinancial MSM and government officials alike are looking for a recovery in the housing market to bubble valuations to "restart the economy." That is not going to happen--not this year, not in five years or even in ten years. Here's why.

The entire world is hoping that housing is about to "recover" and re-ascend its glorious bubble-era heights of valuation. But it's not going to happen. Why not? For several fundamental reasons:

1. Bubbles do not re-inflate in the asset class which just popped. It is simply a truism that bubbles never reflate, ever. Tulip bulb valuations did not rise to stratospheric heights after the Tulip Craze popped, and the Nasdaq dot-com bubble did not reinflate, either, for the very good reason that bubbles are never based on rational valuations--they are based on the psychological state of mania which cannot be reinstated once lost. Consider tech stock Cisco Systems (CSCO), a well-managed "real company" which continues to make profits providing real-world goods and services. It currently trades at around $17.50 a share, down from its dot-com bubble valuation of about $81/share. To "recover" its bubble-era valuation, Cisco would have to rise five-fold. That's not going to happen. Now that the mania has dissipated, Cisco is valued on more rational metrics like earnings, profits, etc.

The speculative mania always moves on to a new asset class. After the dot-com bubble popped,the speculative bubble moved on to housing. Now that the housing bubble has popped, the mania has moved to the bond market. When the bond bubble bursts (it's guaranteed that it will in the next two years, losing 50% or more in the process) then the only asset class which hasn't already been blown into a bubble is precious metals/gold. In other words: those wishing to catch the next speculative mania should be buying gold and silver, not stocks, housing or bonds.

2. Inflation sets the "recovery" target ever higher. While we are in a deflationary period right now, a serious amount of inflation occurred between Cisco's top in January 2000 and the present. According to the BLS Inflation Calculator, $81 in 2000 is $100 in current dollars. So Cisco would have to rise not to $81 to match its bubble-era valuation but to $100. The same is true for housing. Consider the possibility many see on the horizon, a period of high inflation caused by the insanely stupendous rise in paper money supply. I am not predicting such an inflation, just speculating on the effects it would have on bubble-era valuation calculations.

Let's say a house which sold for $100,000 in 1997 was valued at $400,000 at the housing bubble peak in 2006. I fully expect the property to retrace to its pre-bubble valuation, as that is the usual progression of bubbles and their demise. Now if inflation ramps up and ravages the value of the dollar, the price of a tangible good like a home might well rise more or less along with inflation, as people will be trying to turn their rapidly devaluing dollars into some tangible good as a means of preserving wealth. But if inflation is clipping along at 10% a year and the house returns to its bubble-era value of $400,000, does the $400,000 retain the same purchasing power as $400,000 in 2006? No.

For an example of how this works, consider the stock market in the inflationary period of the 1970s:



While the stock market went from 1,000 in 1966 to 1,000 in 1982 14 years later, inflation destroyed 2/3 the value of the dollar. According to the BLS, $1 in 1966 was worth 34 cents in 1982, meaning those who held stocks for those 14 years did not retain their wealth as the Dow Jones remained at 1,000--they lost 2/3 of their wealth. It is easy to foresee the same thing happening in housing should inflation ignite. Over the next 14 years, the house which sold for $400,000 in 2006 may well rise once again to that nominal price, but the inflation-adjusted value could well be closer to $100,000 when priced in 1997 dollars. This is why nominal prices in stocks, housing, bonds and gold are essentially meaningless. All assets have to be valued in terms of purchasing power, and as imperfect and flawed as any inflation/deflation gauge might be, it's still a better guide to purchasing power than nominal price.

3. Perhaps counter-intuitively, deflation also ravages bubble-era valuations. You might think that if inflation is tough on bubble-era valuations when priced in purchasing power (or some non-paper metric like gold), then deflation would be dandy. But deflation wipes out bubble-era valuations just as assiduously as inflation. In deflation, debt grows ever more burdensome as money becomes more valuable and wages and income drop. As a result, assets dependent on debt ( that is, real estate) drop in value. In deflation, real estate become a "capital trap" which loses value as cash gains in value. As incomes plummet, so do rents, i.e. the income stream which real estate earns, further impairing its value.

Deflation often accompanies depression, and nothing is more of a capital trap than an empty house or building earning zero income. Compared to that, cash earning interest looks very attractive. This creates another drag on housing valuations. So whatever the future holds, deflation or inflation (or periods of one following the other), housing will never return to its bubble-era valuations when measured by purchasing power/adjusted for inflation.

4. The fundamental driver of the housing bubble was once-in-a-lifetime low interest rates and loose/fraudulent lending.



Bond yields (and thus interest rates) tend to move in generational cycles of about 20 years-- occasionally as short as 17 years and as long as 27 years. The current decline in yields has now run 27 years which the historical maximum for such cycles, and thus we can safely predict that yields and interest rates will be rising for the next generation. Why would interest rates rise? Easy--the U.S. is borrowing trillions of dollars a year and once the rest of the world either runs out of cash or the desire to give us all their surplus capital then interest rates will rocket regardless of what the Fed or U.S. Treasury do. (Recall the analogy of the Financial Royalty standing knee-deep in a rising tide demanding the waters recede. Good luck with that, fellas.) As for loose/fraudulent lending--you know the story already. It isn't coming back.

So if the fundamental drivers of insanely low interest rates and insanely loose lending are not coming back, then precisely what forces will reinflate the housing bubble? The answer is: none. Demographics? As noted here many times, housing density (number of people per structure) has been falling for decades. As density rises, all future population growth can be easily accomodated with the existing housing stock. Speculative mania? That circus came to Housing Town and left, never to return in our lifetimes (if you're three years old you may live to see another housing bubble in your dotage). Those counting on a reinflation of housing to bubblicious heights to fuel another manic bout of borrow-and-spend will be sorely disappointed. Housing is never coming back if we define "coming back" as a return to bubble-top 2006 valuation as measured in purchasing power.

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5 Reasons House Prices May Never Recover

House prices will eventually stop falling, probably in about two years. But will they ever recover to the levels we saw during the heights of boom? In some areas, prices might climb that high again. But for most markets, such a recovery will probably never happen, and would take decades it were to occur. In an essay published today, Charles Hugh Smith explains that the bubble vaulations are probably never coming back.

• Once the bubble in an asset class pops, it never reflates. "It is simply a truism that bubbles never reflate, ever. Tulip bulb valuations did not rise to stratospheric heights after the Tulip Craze popped, and the Nasdaq dot-com bubble did not reinflate, either, for the very good reason that bubbles are never based on rational valuations--they are based on the psychological state of mania which cannot be reinstated once lost," Smith writes.
  
• Inflation destroys the gains anyway. Even if prices start to climb, they'll be battling against inflation. With all the new government debt being issued, we're likely to face a big jump in inflation. This will means that even if your house is worth as much as it was in 2006 four years from now, in real terms it will have lost value.
  
• If we somehow avoid inflation, deflation will mean house prices keep sinking. "In deflation, debt grows ever more burdensome as money becomes more valuable and wages and income drop. As a result, assets dependent on debt ( that is, real estate) drop in value. In deflation, real estate become a "capital trap" which loses value as cash gains in value. As incomes plummet, so do rents, i.e. the income stream which real estate earns, further impairing its value," he explains.
  
• The combination of low interests rates and loose lending that fueled the boom is dead. The government is pushing down interest rates, cramming down mortgages and halting foreclosures in hopes of re-inflating the housing bubble but it won't work. It took loose and even fraudulent lending to push prices as high as they went, and those practices are dead thanks to closer supervision and the financial collapse. What's more, interest rates are sure to climb higher again "once the rest of the world either runs out of cash or the desire to give us all their surplus capital."
  
• Demographics. All probable future population growth can be easily accomodated with the existing housing stock, which means that there won't be some population growth led surge in prices.

This has important policy implications. It means that policies built around the confidence that house prices will recover are bound to be costly failures. Money spent to re-inflate the bubble will be lost. And until we become adjusted to permanently lower house prices, the broader economy will continue to suffer. For one thing, we're going to have to go back to creating wealth in ways other than selling our homes.

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Geithner Says Banks Have 'Options' for Boosting Capital After Stress Tests

Treasury Secretary Timothy Geithner said banks found to need additional capital at the conclusion of regulators’ stress tests will have a range of options for shoring up their balance sheets. The Treasury chief, testifying before a congressional oversight panel today, said lenders will be able to take taxpayer money, raise funds from private investors or convert previous government investments from preferred to common shares. Each bank can chose the “best mix” of alternatives and will likely make different choices, Geithner said. “They’ll be balancing lots of different considerations,” he said. “That’s a process they’re going to have to undertake, and it’s going to require a fair amount of care and effort.” Geithner, in sometimes combative testimony, underscored that financial regulators are taking the lead in reviewing the 19 biggest banks. Those agencies -- and not the Treasury -- will also determine when the healthiest banks can pay the government back, he said.

The Federal Reserve is leading the assessments, with results due for release on May 4. The tests are designed to ensure that firms have enough capital to weather a deeper economic downturn over the coming two years. In a prepared statement for the hearing in Washington, Geithner said “the vast majority of banks have more capital than they need to be considered well capitalized by their regulators.” His comments stoked a rally in stocks, with JPMorgan Chase & Co. and Wells Fargo & Co. rallying more than 7 percent, helping spur the Standard & Poor’s 500 Financials Index to climb 5.7 percent as of 3:49 p.m. in New York. Geithner also said there were signs of “thawing” in credit markets and some indication that confidence was beginning to return. Even amid some improvement, bank reports show “significant declines” in commercial and industrial lending and consumer loans such as credit cards, Geithner said. Also, credit costs remain high, even if they recently have declined somewhat, he said.

Geithner, in a letter released today to the oversight panel’s chairwoman, Harvard Law Professor Elizabeth Warren, reiterated that the government has sufficient funds remaining in the $700 billion Troubled Asset Relief Program to aid U.S. banks. The oversight group was set up under the October rescue law to monitor the Treasury’s effort and has three members appointed by Democrats and two by Republicans. “We believe that even under the conservative estimate of available funds described here, we have the resources to move forward implementing all aspects of our Financial Stability Plan,” Geithner wrote. At the hearing, committee members were skeptical of the Treasury’s strategy for the bailout and questioned whether Geithner was doing enough to protect taxpayers. “The public and this panel have a right to know how Treasury defines success,” said Representative Jeb Hensarling, a Texas Republican. “For many it is difficult to discern.”

Hensarling said he was particularly concerned about the potential for nationalizing banks and about the expansion of a program that was conceived to help the financial industry but is now also aiding automakers and their suppliers. “Is there any firm that is beyond the reach for taxpayer bailout assistance?” he asked. “At what point does Starbucks get in line?” Committee members also urged Geithner to be more open about the Treasury’s plans. “You’ve left more questions unanswered than answered,” said John Sununu, a former Republican senator from New Hampshire, adding that the lack of details about stress tests and when banks can repay their TARP money has created uncertainty in the markets. Geithner said he would welcome firms returning TARP funds as long as regulators sign off. “The judgment about when institutions can repay is a judgment that the federal banking agencies have to make,” Geithner said. He added that they will weigh whether banks have enough capital to keep lending and whether the financial system as a whole “has the capacity to support the credit” needed to ensure an economic recovery.

Geithner also offered new details on the government’s plans for rules on executive pay for firms that have received taxpayer aid. The administration plans in coming weeks to release guidelines on compensation limits. The new regulations will be effective immediately, while there also will be a 60-day comment period. “We will engage in a thorough review of this issue,” Geithner said. “I anticipate that we will look for ways to orient compensation towards long-term performance.” In opening statements, Damon Silvers, a member of the oversight panel and associate general counsel for the labor- union federation AFL-CIO, said the Treasury yesterday provided about 10,000 documents dealing with the government’s rescue of American International Group Inc.

Geithner said he’s not worried about low initial interest in the Fed’s Term Asset-Backed Securities Loan Facility, a joint effort with the Treasury to fund the purchase of as much as $1 trillion in consumer and business loans. Geithner said participation has been “relatively good for an early program.” Still, the Treasury secretary warned the panel that lawmakers’ efforts to revise the terms of the bailout and place additional restrictions on companies is hampering the program. “If we’re going to get out of this crisis at less cost” and “risk to the taxpayer, we need the markets to be taking risk again,” Geithner said. “For them to be willing to take risk alongside the government, they need to have some confidence in the rules of the game, going forward.”

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Too Big to Fail Firms Must Be Broken Up, Economists Say

Instead of funneling taxpayer money into financial firms, it is time for the government to take the radical step of breaking them up into smaller, more transparent companies, top economists told U.S. lawmakers Tuesday. "We have little to lose, and much to gain, by breaking up these behemoths, which are not just too big to fail, but also too big to save and too big to manage," said 2001 Nobel Prize recipient and Columbia University professor Joseph Stiglitz, one of the witnesses testifying before the Joint Economic Committee of the U.S. Congress Tuesday morning. He argued that the U.S. financial sector is simply too large, and gigantic institutions are more likely to take excessive risks that backfire on taxpayers and distort markets.

Mr. Stiglitz also criticized the Treasury Department's $700 billion financial-rescue program for propping up large firms with subsidies while allowing smaller, community-based banks to collapse. He voiced skepticism that the Troubled Asset Relief Program would be successful because it paves the way for big banks to continue dominating the U.S. political and financial systems. Similarly, Massachusetts Institute of Technology Professor and Peterson Institute for International Economics Fellow Simon Johnson argued that policymakers need to overhaul antitrust laws to prevent the development of financial firms that are too large. Banks should be sold to new private-equity owners and broken up, Mr. Johnson said, adding that banks could be sold in medium-sized pieces and divided regionally or by type of business to avoid a concentration of power. "This may seem like a crude and arbitrary step, but it is the most direct way to limit the power of individual institutions, especially in a sector that, the last year as taught us, is even more critical to the economy as a whole than anyone had imagined," said Mr. Johnson.

Also on the panel was Federal Reserve Bank of Kansas City President Thomas Hoenig, who criticized the federal government's response to the financial crisis, saying the measures have focused too heavily on propping up large companies such as American International Group Inc. "Our actions so far risk prolonging the crisis while increasing the cost and raising serious questions about how we eventually unwind these programs without creating another financial crisis as bad or worse than the one we currently face," Mr. Hoenig said He argued that large ailing banks should be allowed to collapse. They could be temporarily operated as a conservatorship and then reprivatized, he said, adding, "We cannot simply add more capital without a change in the firm's ownership and management and expect different outcomes in the future."

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Bank of America CEO Loses Connecticut State's Support

Bank of America Corp. Chief Executive Officer Kenneth D. Lewis, lead director Temple Sloan Jr. and director Tom Ryan won’t get the vote of Connecticut State Treasurer Denise L. Nappier at next week’s board election. Nappier said she’ll cast her ballot against the three directors and called on Lewis, 62, to step down, according to an e-mailed statement today. The board should “substantially reconstitute itself by the next annual meeting,” she wrote. “It’s time to clean house and set the financial health of the company on a sustainable path,” Nappier said about management at the Charlotte, North Carolina-based bank. The state holds 3.2 million shares and has an unrealized loss of $57 million, she said. Investors cast ballots April 29 on whether to re-elect Lewis to the board and split his roles as chairman and CEO. He’s under fire after the bank spent more than $30 billion on takeovers including Merrill Lynch & Co. and posted a fourth- quarter loss. Directors are concerned the vote may be close and were counting on first-quarter results to bolster support for the bank, people familiar with the matter have said. Instead, Bank of America shares fell 24 percent after yesterday’s quarterly report.

Spokesman Scott Silvestri declined to comment on Connecticut’s action today. He said April 17 the bank’s officials “believe we have acted legally and appropriately in our disclosures around the Merrill Lynch acquisition and that the acquisition will ultimately create value for Bank of America Shareholders.” The bank swung to a profit in the first quarter from the fourth quarter’s $1.79 billion loss, with net income rising to $4.25 billion from $1.21 billion a year earlier, the lender said in a statement. After the results were released yesterday, spokesman Robert Stickler said the board was “100 percent” behind Lewis. The vote at the annual shareholder meeting includes the company’s executive pay package and a resolution to split the chairman and CEO jobs. Nappier plans to vote against the pay package and in favor of the split, citing lack of confidence in both Lewis and the board because of their handling of the Merrill Lynch takeover. “This board is in dire need of independent board leadership,” Nappier wrote. “One giant step in that direction would be the separation of the chair and CEO position.”

Lewis, CEO since 2001, has been criticized by shareholders including Jerry Finger’s Finger Interests LLC in Houston, as well as proxy advisers Glass Lewis & Co. and RiskMetrics Group Inc. for not telling investors that Merrill’s fourth-quarter loss was spiraling toward $15.8 billion before they voted to approve the takeover in December. Finger has said his firm controls about 1.1 million shares.
Bank officials have contacted some of the biggest shareholders to round up support for Lewis and received a “mixed” reception, according to the people familiar with the situation. “We’re not celebrating yet,” said Jonathan Finger, managing partner at Finger Interests, in an interview today, adding that he hasn’t spoken with Nappier. “It’s going to be a difficult battle, and I think it’s going to be a very close vote,” Finger said. “At this point there is a realistic opportunity to split the chairman and CEO.”

Nappier also opposed the re-lection of board members at American International Group Inc., the New York-based insurer rescued by the U.S. government with a package of $182.5 billion in capital, loans and asset guarantees. She cited executive compensation and bonuses in a March 31 letter. Connecticut is regarded as an activist investor and it’s not unusual for the state to take a public stance, according to Charles Elson, director of the Weinberg Center for Corporate Governance at the University of Delaware. “They’ve been active in compensation issues and whatnot for a long time,” he said.

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Citigroup Shareholders Wonder When U.S. Ousts Board

Citigroup Inc.’s board will likely survive a shareholder vote at today’s annual meeting, even after overseeing $28 billion in losses and a 77 percent stock decline last year. The U.S. government may be less forgiving. The Treasury Department, which will become the biggest shareholder in New York-based Citigroup when the bank converts as much as $52 billion of preferred stock into common shares as soon as next month, may order the resignations of some long- serving board members to show they’re accountable, according to Peter Sorrentino, a senior portfolio manager at Cincinnati-based Huntington Asset Advisors, which has about $13.3 billion under management, including 1.5 million Citigroup shares.

“There has to be a cleaning of all that was at Citigroup,” Sorrentino said. “Anyone who was involved with the board in the lead-up to the crisis is tainted.” Board members who “sanctioned the risks that were taken and the business practices followed” will likely be replaced by the government by the end of the year, he said. A government-mandated board overhaul is needed to boost the company’s stock price and raise shareholder confidence that the bank’s management won’t be hamstrung by decisions about subprime-related mortgages made under the current board, said William Smith, founder of Smith Asset Management Inc. in New York who holds 200,000 Citigroup shares and has been critical of management since early 2007. The board is “like a cancer,” Smith said. “Until there’s a clean slate and a fresh perspective on the board and in management, Citigroup will trade at a discount.”

Treasury Secretary Timothy Geithner said on April 5 that he’s prepared to oust executives and directors at banks that require “exceptional” assistance. Citigroup, led by Chairman Richard Parsons, 61, and Chief Executive Officer Vikram Pandit, 52, has already taken $45 billion of taxpayer money and may need more after the Obama administration reveals on May 4 how the 19 largest U.S. banks fared on stress tests being conducted by the Federal Reserve, according to Christopher Whalen, a managing director at bank-research firm Institutional Risk Analytics in Torrance, California. Whalen says Citigroup, the third-biggest U.S. bank by assets, will be “ranked as one of the lowest” in the stress tests, which are designed to gauge whether lenders have enough capital to withstand a continuing economic crisis. “The government needs to replace management at Citi,” Whalen told Bloomberg Television last week. “They need to clean out the board. It’s astounding to me that we haven’t done this already.”

Citigroup Chief Financial Officer Edward “Ned” Kelly wouldn’t discuss the tests in an interview last week. Parsons and Pandit declined requests for interviews. Speaking at today’s meeting at the Hilton New York hotel, Pandit told shareholders that the bank’s management has a “sense of urgency.” “I fully recognize the loss of value” that investors have endured, Pandit said. “Our own people have paid a dear and heavy price.” The bank reported a $1.6 billion first-quarter profit on April 17, thanks to trading gains and an accounting benefit for distressed companies. Since then, the stock has tumbled 27 percent to $2.94 in New York composite trading on concern that the company will return to losses as mortgage and credit-card delinquencies rise.

Four proxy-advisory groups, including New York-based RiskMetrics Group Inc.’s ISS Governance Services and San Francisco-based Glass Lewis & Co., have called for the removal of directors. The American Federation of State, County and Municipal Employees, which oversees more than $1 trillion in pension assets on behalf of 1.6 million members, is campaigning against six current and former members of the board’s audit and risk management committee. “If there were a board Hall of Shame, Citi’s would be in it,” said Richard Ferlauto, AFSCME’s director of corporate governance and pension investment. “The board has failed, and the directors have contributed to the lack of oversight.” Washington-based AFSCME opposes the re-election of Michael Armstrong, a former AT&T Inc. CEO; Alcoa Inc. Chairman Alain Belda; John Deutch, a former U.S. Central Intelligence Agency director; Andrew Liveris, CEO of Dow Chemical Co.; Xerox Corp. CEO Anne Mulcahy; and Judith Rodin, president of the Rockefeller Foundation in New York. RiskMetrics has advised voting against Armstrong, Belda, Deutch and Mulcahy. Glass Lewis urges shareholders not to re-elect all six directors opposed by AFSCME and to vote against Parsons, a former CEO of Time Warner Inc. who has been on the Citigroup board since 1996.

“Despite the fact that the board has many incumbent directors who have been successful in their respective fields and have been on the board for some time, their track record taken as a whole is dismal given that the company is currently surviving on federal assistance,” RiskMetrics said in an April 9 report. Citigroup board members didn’t return calls or declined to comment. In an e-mailed statement, Citigroup spokesman Jon Diat said the bank’s board of directors and audit committee have “diligently carried out their responsibilities during one of the most severe market downturns in decades.” Parsons, Pandit and the 12 other directors are expected to prevail in their re-election bids, shareholder advocates say. That’s because they are running unopposed, and brokerage firms and money managers tend to go along with the company’s slate, the advocates say. A “yes” vote only puts off the inevitable, William Fitzpatrick, a financial-industry analyst at Optique Capital Management in Racine, Wisconsin.

“The government’s doing everything it can to convey the message that the financial system is stabilizing,” said Fitzpatrick, whose firm oversees $1 billion and sold its 400,000 Citigroup shares last September. “If turnover at the executive level and board level can help convey that message to the general public, they’re going to go down that route, and they have the authority to do that.” Citigroup isn’t the only target of shareholder ire. Last week RiskMetrics recommended voting against Bank of America Corp. Chairman and CEO Kenneth Lewis, lead director Temple Sloan Jr. and four other board members seeking re-election. The board of Charlotte, North Carolina-based Bank of America, which also got $45 billion from the government, “failed to provide adequate oversight of management,” according to RiskMetrics. The bank’s shares have tumbled 79 percent in the past year. Denise Nappier, Connecticut’s treasurer, issued a statement today calling for Lewis to step down.

Parsons replaced Winfried Bischoff as chairman of Citigroup in January. He was head of the bank’s personnel and compensation committee during the four-year tenure of CEO Charles O. “Chuck” Prince, who was ousted in November 2007, as the first of the bank’s subprime-mortgage losses surfaced. As head of the compensation committee, Parsons approved giving Prince a $10.4 million parting bonus and five years of perks that included a free office, secretary, car and driver worth $1.5 million a year. He also led the committee that searched for Prince’s replacement, choosing Pandit in December 2007. Parsons was re-elected to the board last year with 69 percent of votes in his favor, the lowest among 14 candidates. Three months after the vote, he was promoted to lead director. Making Parsons chairman after he received the lowest number of votes illustrates that Citigroup’s board “just doesn’t get it,” said Dan Pedrotty, director of investment at the AFL-CIO, the largest U.S. labor federation.

Parsons, who was CEO of Dime Savings Bank of New York from 1991 to 1995, gets credit as one of only two sitting directors with banking experience, according to RiskMetrics. The other is Robert Ryan, 66, who joined the board and audit committee in 2007 and was a vice president at Citibank from 1975 to 1982. Parsons told RiskMetrics that the board “has taken steps to resolve its governance concerns,” including hiring directors with finance and banking experience and replacing the executive chairman with one from outside the company, RiskMetrics said in its report. Bischoff and three other board members, including former Treasury Secretary Robert Rubin, announced earlier this year they would be stepping down. Four outside directors have been nominated to replace them. They are Jerry Grundhofer, a former CEO of U.S. Bancorp; Mike O’Neill, a former CEO of Bank of Hawaii Corp.; William Thompson, a former CEO of Pacific Investment Management Co.; and Anthony Santomero, a former University of Pennsylvania finance professor who served as president of the Federal Reserve Bank of Philadelphia from 2000 to 2006.

Audit Committee“The slate of new directors coming on is quite impressive,” said Barclays Capital senior analyst Jason Goldberg in New York, who rates Citigroup shares “overweight.” “These are definitely the real deal.” The board needs more like them, said Robert McCormick, chief policy officer at Glass Lewis. “More fresh perspective is warranted,” he said. Instead of opposing the whole board, AFSCME is making what Ferlauto calls “a surgical strike” at the audit and risk management committee. “We’re hesitant to launch a campaign that would lead to an unknown situation in which the board would be rejected and there would be no leaders left at the company,” Ferlauto said. Deutch, 70, a nuclear-security specialist at Massachusetts Institute of Technology who was a CIA director under President Bill Clinton in the 1990s, has served on the Citigroup board since 1996 and has been a member of the audit committee for 11 years. He replaced Armstrong as chairman of the committee in July.

Mulcahy shouldn’t be re-elected because she is overextended as CEO of Xerox and a director on more than three boards, RiskMetrics said. Norwalk, Connecticut-based Xerox has plummeted 67 percent since the end of 2007 to $5.36 in New York Stock Exchange composite trading. Citigroup’s majority-voting rule requires directors to receive more than half of shareholder votes cast. When board candidates get less than 75 percent of votes in their favor, that’s a “call for them to step down,” since they’re running unopposed, Pedrotty said. “In this Soviet-style voting, where it’s vote for me or vote for no one, if a director can’t get that much they should resign,” he said. Results may be disclosed after today’s shareholder meeting, where Parsons and Pandit addressed investors.

Don’t look for any Citigroup board members to resign without the government’s nudge, said David Roberts, a former Northern Trust Corp. mutual fund manager who’s now principal of Harvest Investment Advisors LLC in Tallahassee, Florida. Citigroup was one of the 40 or 50 stocks among Harvest’s $15 million holdings until Roberts sold it in early 2008, he said. “If you have a board of 12 members, and one or two resign, what they basically are doing is saying, ‘Blame me,’ and that’s not going to happen,” Roberts said. “They don’t accept responsibility. There’s just a fundamental lack of people stepping up and saying, ‘You know what? I made a mistake.’”

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Bankers Rebuff U.S. on Chrysler Debt

They Propose to Cut What Car Maker Owes by 35%, Not the 85% the Treasury Wants; No 'Horse Trading,' Banker Says

A group of the U.S.'s biggest banks and other lenders rebuffed a Treasury Department request that they slash 85% of Chrysler LLC's secured debt, proposing instead to eliminate about 35% in exchange for a minority stake in the restructured auto maker. The lenders' counteroffer marks a significant act of brinksmanship as the banks and the Obama administration's auto task force duel over concessions to avoid liquidating the country's third-largest car company. Chrysler faces an April 30 Treasury deadline to seal an alliance with Italy's Fiat SpA that also requires concessions from lenders, as well as from the United Auto Workers union. Chrysler owes the lenders, which include banks such as Citigroup Inc. and J.P. Morgan Chase & Co., about $6.9 billion. But President Barack Obama and his auto team had demanded that the banks cut that to $1 billion, while gaining no equity stake in a restructured Chrysler.

In their five-page counteroffer, the lenders said they are prepared to cut Chrysler's first-lien debt by $2.4 billion, or down to about $4.5 billion, in exchange for a minority equity stake, likely to be around 33%, according to people familiar with the offer. The lenders also are demanding that Fiat pour some capital into Chrysler in exchange for whatever equity stake it would gain. That could be a source of conflict with the Italian auto maker, which has said it won't put cash in the deal and instead give Chrysler only technology. In making their case for a significantly smaller sacrifice than what the government wants, the lenders have argued that their fiduciary duty to their own shareholders and investors requires them to recoup as much as possible from Chrysler. The lenders have told Treasury officials that, if necessary, they could recover at least 65% of their loans to the company if it is liquidated in bankruptcy.

Importantly, the steering committee of Chrysler banks that made the counterproposal holds more than 66% of the $6.9 billion owed the car maker's lenders, said people familiar with the matter. This means the committee has the requisite amount of debt to control the votes of lenders if Chrysler files for bankruptcy, under U.S. bankruptcy code. There also must be approval from a majority of total holders in a group. The committee has eight members. The largest Chrysler bank-debt holders are J.P. Morgan, Citigroup, Goldman Sachs Group Inc. and Morgan Stanley. Those four hold about $4.3 billion of the debt, according to people familiar with the matter. Also on the committee are hedge fund Elliott Management, distressed-assets investor Stairway Capital Management, fund manager OppenheimerFunds and advisory and asset-management firm Perella Weinberg Partners. There are an estimated 45 lenders and funds that hold the Chrysler bank debt.

One person involved in the talks said the counteroffer essentially was final. "This is not seen as a horse-trading offer," this person. "This offer should be embraced by the administration." Many of the lenders were angered by the demands made by the head of the administration's auto team, Steven Rattner, who wanted the banks to forgive $5.8 billion of the $6.9 billion owed them in exchange for nothing. "What the government was asking for was completely without precedent in the history of bankruptcy in the United States," the person involved in the talks said. "Our reaction to their proposal was, 'Forget it.' " The dispute with the lenders is heating up as Mr. Rattner and his team haggle in Washington with the heads of Chrysler, Fiat and the UAW over the details of an alliance between the two car companies. The counteroffer also comes about one week after the government presented Chrysler lenders with more than 60 pages of business models and financial assumptions for a combined, restructured Chrysler. The government estimates that Chrysler in a few years would be back to the size it is today, once it merges with Fiat.

That government model projects Fiat-Chrysler wouldn't be able to start making payments on its debt until 2012, said several people familiar with the government projections. The government assumes that the $4 billion the Treasury lent Chrysler largely will be wiped out, as will $2 billion Chrysler owes Cerberus Capital Management LP and Daimler AG, Chrysler's last two owners. The government would then put in an additional $6 billion to fund the operations of Fiat-Chrysler. One assumption that upset some lenders, including some on the bank committee, was that Chrysler would pay about $3 billion to a UAW retiree health-care fund in 2009-10, said these people. The UAW-Chrysler fund would also get an unknown amount of equity in the new Chrysler. The fund had been owed about $10 billion from Chrysler, but it is behind the banks, Cerberus, Daimler and the U.S. in the order to be paid.

Lenders on the Chrysler bank-steering committee had originally hoped to make their counteroffer late last week, but differences of opinion between larger lenders like J.P. Morgan and Citi and the smaller bank-debt holders delayed the offer, said people familiar with the matter. The larger lenders were pushing for a counteroffer that was closer to the original government proposal than smaller lenders, such as hedge funds, were willing to agree to, said these people. This conflicting view is likely due to several things, such as the fact the larger banks paid full price for billions of Chrysler bank debt, while smaller holders bought theirs at a steep discount and would likely make a tidy profit even in a quick liquidation of Chrysler, said people involved in the talks. "Not everyone was on the same page. The big-bank view was 'Hey guys, the offer back can't be outrageous. This is the government,'" said one of these people. "There were others, smaller lenders, who wanted to be a lot more aggressive." In the end, the big banks "came closer to the smaller lender view," said another person familiar with the talks.

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Canada Cuts Rate to 0.25%, May Keep It There for Year

The Bank of Canada cut its key lending rate to a record low, and said it plans to leave it there for more than a year because inflation will remain below its 2 percent target. The target rate for overnight loans between commercial banks was reduced to 0.25 percent today, the lowest since the central bank was founded in 1934 and the lowest it can go, the bank said. Policy makers also kept the rate on overnight deposits from commercial banks at 0.25 percent, instead of the usual practice that would have reduced it to zero. “Conditional on the outlook for inflation, the target overnight rate can be expected to remain at its current level until the end of the second quarter of 2010,” the central bank said in a statement from Ottawa today. The central bank will provide updates at each future policy decision, starting June 4, on its commitment to leave the key rate unchanged.

The key rate has reached its “effective lower bound” during a deepening recession that will keep inflation below 2 percent until the third quarter of 2011, the bank said. Today is the first time since the central bank began publishing regular monetary policy reports in 1995 that it has said consumer prices won’t return to its goal within two years. The central bank said its rate cuts and promise to keep the benchmark rate at 0.25 percent are an “appropriate policy stance to move the economy back to full production capacity and to achieve the 2 percent inflation target.” Policy makers said they still have “considerable flexibility” to spur growth, including so-called quantitative and credit easing. The bank will publish guidelines for those policies in two days. Governor Mark Carney has said their use is not “preordained.” The Canadian dollar rose 0.3 percent to C$1.2354 per U.S. dollar at 1:20 p.m. in Toronto, from C$1.2391 late yesterday. Earlier it depreciated by as much as 0.9 percent.

The yield on the Canadian government’s 10-year bond was little changed at 2.89 percent. The price of the 3.75 percent security due in June 2019 fell 2 cents to C$107.49. “This statement is dovish in that it keeps it all on the table,” said Sacha Tihanyi, currency strategist in Toronto at Scotia Capital Inc., a unit of Canada’s third-biggest bank. “They are perfectly willing to undertake at least credit easing and possibly full-on quantitative easing.” Canada’s economy will shrink by 3 percent this year, the central bank said, revising a January prediction of a 1.2 percent contraction. Next year, output will expand by 2.5 percent, instead of the earlier forecast of 3.8 percent. The bank said inflation will turn negative and reach a low point of minus 0.8 percent in the third quarter of this year. “I have never seen the bank so easy-going about its mandate -- it’s quite something,” said Sebastien Lavoie, an economist with Laurentian Bank Securities in Montreal and a former Bank of Canada economist.

The Bank of Canada today announced several steps to keep the financial system functioning with interest rates close to zero, which can disrupt the operations of money-market funds and banks.
The central bank said it will keep the benchmark rate close to 0.25 percent by leaving an excess C$3 billion in the system that settles overnight commercial bank payments, up from the usual C$25 million in settlement balances. The central bank will also conduct purchase and resale agreements each day at its target rate as needed. Today is the first time the Bank of Canada hasn’t cut the bank deposit rate along with its overnight target rate since 1999, when the present interest-rate regime was created. Even with a record low overnight rate, the central bank’s April 13 survey of loan officers found those who said credit was more expensive outnumbered those who said it was cheaper by a record 80 percentage points.

Some loans will be cheaper after today, as the country’s five biggest banks trimmed the prime rates they charge their best customers by a quarter point to 2.25 percent. The world’s eighth-largest economy probably contracted by 5.8 percent in the first three months of this year, the most since 1991, according to a separate Bloomberg economist survey. Consumer confidence is also being eroded because companies have fired more than 2 percent of the country’s workers since October -- a total of 356,600 -- the fastest reduction since 1982. Companies from Finning International Inc., the world’s largest dealer of Caterpillar Inc. equipment, to Danier Leather Inc. have cut jobs after a plunge in prices for Canadian commodity exports has cut business and consumer spending. Thirteen of 25 economists surveyed by Bloomberg News predicted no rate cut today, with the other 12 calling for a cut to 0.25 percent.

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