Chicago, pedestrians on Washington and Dearborn
Ilargi: Standard and Poor's says there's just simply not enough money. Mike Mayo says bank losses will increase until they outdo those in the 1930's. Meredith Whitney says banks will be forced soon to aggressively start selling assets. Yes, that is despite the $12.8 trillion in various bail-out plans so far. And yes, there's the $2 trillion in consumer credit card lines that will be withdrawn this year. Remember that consumer spending is over 70% of US GDP. When will America go hat in hand to the IMF?
And you are still thinking rally? The only way there could be a rally, and the only reason why there would be, lies in the potential for the largest investors which have an incestuous bloodline to Wall Street banks which have an incestuous bloodline to Washington, to make a large profit. And the only way that could possibly happen would be for you and your pension funds to aggressively buy into the stock markets. They won't make a killing off each other, they're coming for your reserves.
And you are still thinking rally? Feeling lucky today? Don’t. The deck is stacked against you in more ways than you care to know. It doesn't matter how smart you think you are, or how lucky. Just get out of the game. Sure, it may take another two weeks or two months, or even five, but this baby's going to blow you all the way to kingdom come.
From Bubble to Depression?
Bubbles have been frequent in economic history, and they occur in the laboratories of experimental economics under conditions which -- when first studied in the 1980s -- were considered so transparent that bubbles would not be observed. We economists were wrong: Even when traders in an asset market know the value of the asset, bubbles form dependably. Bubbles can arise when some agents buy not on fundamental value, but on price trend or momentum. If momentum traders have more liquidity, they can sustain a bubble longer. But what sparks bubbles? Why does one large asset bubble -- like our dot-com bubble -- do no damage to the financial system while another one leads to its collapse? Key characteristics of housing markets -- momentum trading, liquidity, price-tier movements, and high-margin purchases -- combine to provide a fairly complete, simple description of the housing bubble collapse, and how it engulfed the financial system and then the wider economy.
In just the past 40 years there were two other housing bubbles, with peaks in 1979 and 1989, but the largest one in U.S. history started in 1997, probably sparked by rising household income that began in 1992 combined with the elimination in 1997 of taxes on residential capital gains up to $500,000. Rising values in an asset market draw investor attention; the early stages of the housing bubble had this usual, self-reinforcing feature. The 2001 recession might have ended the bubble, but the Federal Reserve decided to pursue an unusually expansionary monetary policy in order to counteract the downturn. When the Fed increased liquidity, money naturally flowed to the fastest expanding sector. Both the Clinton and Bush administrations aggressively pursued the goal of expanding homeownership, so credit standards eroded. Lenders and the investment banks that securitized mortgages used rising home prices to justify loans to buyers with limited assets and income. Rating agencies accepted the hypothesis of ever rising home values, gave large portions of each security issue an investment-grade rating, and investors gobbled them up.
But housing expenditures in the U.S. and most of the developed world have historically taken about 30% of household income. If housing prices more than double in a seven-year period without a commensurate increase in income, eventually something has to give. When subprime lending, the interest-only adjustable-rate mortgage (ARM), and the negative-equity option ARM were no longer able to sustain the flow of new buyers, the inevitable crash could no longer be delayed. The price decline started in 2006. Then policies designed to promote the American dream instead produced a nightmare. Trillions of dollars of mortgages, written to buyers with slender equity, started a wave of delinquencies and defaults. Borrowers' losses were limited to their small down payments; hence, the lion's share of the losses was transmitted into the financial system and it collapsed.
During the 1976-79 and 1986-89 housing price bubbles, the effective federal-funds interest rate was rising while housing prices rose: The Federal Reserve, "leaning against the wind," helped mitigate the bubbles. In January 2001, however, after four years with average inflation-adjusted house price increases of 7.2% per year (about 6% above trend for the past 80 years), the Fed started to decrease the fed-funds rate. By December 2001, the rate had been reduced to its lowest level since 1962. In 2002 the average fed-funds rate was lower than in any year since the 1958 recession. In 2003 and 2004 the average fed-funds rates were lower than in any year since 1955 when the rate series began. Monetary policy, mortgage finance, relaxed lending standards, and tax-free capital gains provided astonishing economic stimulus: Mortgage loan originations increased an average of 56% per year for three years -- from $1.05 trillion in 2000 to $3.95 trillion in 2003! By the time the Federal Reserve began to slowly raise the fed-funds rate in May 2004, the Case-Shiller 20-city composite index had increased 15.4% during the previous 12 months. Yet the housing portion of the CPI for those same 12 months rose only 2.4%.
How could this happen? In 1983, the Bureau of Labor Statistics began to use rental equivalence for homeowner-occupied units instead of direct home-ownership costs. Between 1983 and 1996, the price-to-rental ratio increased from 19.0 to 20.2, so the change had little effect on measured inflation: The CPI underestimated inflation by about 0.1 percentage point per year during this period. Between 1999 and 2006, the price-to-rent ratio shot up from 20.8 to 32.3. With home price increases out of the CPI and the price-to-rent ratio rapidly increasing, an important component of inflation remained outside the index. In 2004 alone, the price-rent ratio increased 12.3%. Inflation for that year was underestimated by 2.9 percentage points (since "owners' equivalent rent" is about 23% of the CPI). If home-ownership costs were included in the CPI, inflation would have been 6.2% instead of 3.3%.
With nominal interest rates around 6% and inflation around 6%, the real interest rate was near zero, so household borrowing took off. As measured by the Case-Shiller 10 city index, the accumulated inflation in home-ownership costs between January 1999 and June 2006 was 151%, but the CPI measured a mere 23% increase. As the Federal Reserve monitored inflation in the early part of this decade, home-price increases were no longer visible in the CPI, so the lax monetary policy continued. Even after the Fed began to slowly raise the fed-funds rate in May 2004, the average rate remained low and the bubble continued to inflate for two more years. The unraveling of the bubble is in many ways the most fascinating part of the story, and the most painful reality we are now experiencing. The median price of existing homes had fallen from $230,000 in July to $217,300 in November 2006. By the beginning of 2007, in 17 of the 20 cities in the Case-Shiller index, prices were falling. Serious price declines had not yet begun, but the warning signs were there for alert observers.
Kate Kelly, writing in this newspaper (Dec. 14, 2007), tells the story of how Goldman Sachs avoided the fate of many of the other investment banks that packaged mortgages into securities. Goldman loaded up on the Markit ABX index of credit default swaps between early December 2006 and late February 2007, as their price dropped from 97.70 on Dec. 4 to under 64 by Feb. 27. But the market was not yet in free-fall: The insurance on AAA-rated parts of the mortgage-backed securities (MBS) remained inexpensive. By mid-summer 2007, concern spread to the AAA-rated tranches of MBS. At the end of February 2007, the cost of $10 million of insurance on the AAA-rated portion of a mortgage-backed security was still only $68,000 plus a $9,000 annual premium. Housing-market conditions deteriorated further in the first half of 2007. Case-Shiller tiered price sequences in Los Angeles, San Francisco, San Diego and Miami all show serious declines by the summer of 2007. Prices in the low-price tier in San Francisco were down almost 13% from their peak by July 2007; in San Diego they were off 10% by July 2007. Startling developments began to unfold that month. Between July 9 and Aug. 3, 2007, the cost of insuring AAA MBS tranches went from $50,000 upfront plus a $9,000 annual premium for $10 million of insurance to over $900,000 upfront (plus the annual premium).
Once the cost of insuring new mortgage-backed securities skyrocketed, mortgage financing from MBS rapidly declined. Subprime originations plummeted from $160 billion in the third quarter of 2006 to $28 billion in the third quarter of 2007. Mortgage-backed security issuance fell comparably, from $483 billion in all of 2006 to only $30.7 billion in the third quarter of 2007. Other measures of new loan originations were falling at the same time. The liquidity that generated the housing market bubble was evaporating. Trouble quickly spread from the cost of insuring mortgage-backed securities to problems with credit markets generally, as the spread between short-term U.S. Treasury debt and the LIBOR rate increased to 2.40% from 0.44% between Aug. 8 and Aug. 20, 2007. Since U.S. Treasury debt is generally considered secure, but a bank's loans to another bank carry some risk of default, the spread between these rates serves as an indicator of perceived risk in financial markets.
In one city after another, prices of homes in the low-price tier appreciated the most and then fell the most; prices in the high-priced tier appreciated least and fell the least. The price index graphs for Los Angeles, San Francisco, San Diego and Miami show that in all of these cities, prices in the low-price tier have fallen between 50% and 57%. Moreover, housing prices have continually declined in every market in the Case-Shiller index. According to First American CoreLogic, 10.5 million households had negative or near negative equity in December 2008. When housing prices turned down, many borrowers with low income and few assets other than their slender home equity faced foreclosure. The remaining losses had to be absorbed by the financial system. Consequently, the financial system has suffered a blow unlike anything since the Great Depression, and the source is the weak financial position of the people holding declining assets.
Earlier, during the downturn in the equities market between December 1999 and September 2002, approximately $10 trillion of equity was erased. But a measure of financial system performance, the Keefe, Bruyette, & Woods BKX index of financial firms, fell less than 6% during that period. In the current downturn, the value of residential real estate has fallen by approximately $3 trillion, but the BKX index has now fallen 75% from its peak of January 2007. The financial sector has been devastated in this crisis, whereas it was almost completely unaffected by the downturn in the equities market early in this decade. How can one crash that wipes out $10 trillion in assets cause no damage to the financial system and another that causes $3 trillion in losses devastate the financial system?
In the equities-market downturn early in this decade, declining assets were held by institutional and individual investors that either owned the assets outright, or held only a small fraction on margin, so losses were absorbed by their owners. In the current crisis, declining housing assets were often, in effect, purchased between 90% and 100% on margin. In some of the cities hit hardest, borrowers who purchased in the low-price tier at the peak of the bubble have seen their home value decline 50% or more. Over the past 18 months as housing prices have fallen, millions of homes became worth less than the loans on them, huge losses have been transmitted to lending institutions, investment banks, investors in mortgage-backed securities, sellers of credit default swaps, and the insurer of last resort, the U.S. Treasury.
In an important paper in 1983, Ben Bernanke argued that during the Depression, severe damage to the financial system impeded its ability to perform its economic role of lending to households for durable goods consumption and to firms for production and trade. We are seeing this process playing out now as loan funds for automobile purchases have withered. Auto sales fell 41% between February 2008 and February 2009. Retail and labor markets too are now part of the collateral damage from the housing debacle. Housing peaked in early 2006. Losses from the mortgage market began to infect the financial system in 2006; asset prices in that sector began to decline at the end of 2006. Meanwhile, equities and the broader economy were performing well, but as the financial sector deteriorated, its problems blindsided the rest of the economy. The events of the past 10 years have an eerie similarity to the period leading up to the Great Depression. Total mortgage debt outstanding increased from $9.35 billion in 1920 to $29.44 billion in 1929. In 1920, residential mortgage debt was 10.2% of household wealth; by 1929, it was 27.2% of household wealth.
The Great Depression has been attributed to excessive speculation on Wall Street, especially between the spring of 1927 and the fall of 1929. Had the difficulties of the banking system been caused by losses on brokers' loans for margin purchases in 1929, the results should have been felt in the banks immediately after the stock market crash. But the banking system did not show serious strains until the fall of 1930. Bank earnings reached a record $729 million in 1929. Yet bank exposures to real estate were substantial; as the decline in real estate prices accelerated, foreclosures wiped out banks by the thousands. Had the mounting difficulties of the banks and the final collapse of the banking system in the "Bank Holiday" in March 1933 been caused by contraction of the money supply, as Milton Friedman and Anna Schwartz argued, then the massive injections of liquidity over the past 18 months should have averted the collapse of the financial market during this current crisis.
The causes of the Great Depression need more study, but the claims that losses on stock-market speculation and a monetary contraction caused the decline of the banking system both seem inadequate. It appears that both the Great Depression and the current crisis had their origins in excessive consumer debt -- especially mortgage debt -- that was transmitted into the financial sector during a sharp downturn. What we've offered in our discussion of this crisis is the back story to Mr. Bernanke's analysis of the Depression. Why does one crash cause minimal damage to the financial system, so that the economy can pick itself up quickly, while another crash leaves a devastated financial sector in the wreckage? The hypothesis we propose is that a financial crisis that originates in consumer debt, especially consumer debt concentrated at the low end of the wealth and income distribution, can be transmitted quickly and forcefully into the financial system. It appears that we're witnessing the second great consumer debt crash, the end of a massive consumption binge.
Time to Brace for Trouble as Profits Debacle Starts
What's wrong with this picture? Earnings season is here again, and it's going to be dismal. Yet the markets are zooming into this period on the heels of the most aggressive four-week rally in more than 70 years. So, even though pretty much every investor acknowledges just how ugly things are, they could be setting themselves up to be disappointed. And, if the past eight years are any guide, they probably will be. Investment research group Bespoke Investment Group LLC in Harrison, N.Y., looked at all earnings seasons going back to mid 2001 and found that investors who bought the Standard & Poor's 500 on the first day of the season and sold on the last day would have lost 26.6%. By contrast, those that did the inverse would have garnered a return of 7.1%.
The numbers look particularly pertinent this quarter, considering that the Dow Jones Industrial Average has gained about 21% in the last four weeks and the S&P 500 is up an impressive 23%. The last two earnings seasons, which admittedly played out during times of intense market distress, have seen the S&P 500 decline by 8.53% and 9.32% respectively, Bespoke's research shows. The first-quarter reporting period unofficially begins with Alcoa's results on Tuesday and draws to a close six weeks later, when Wal-Mart Stores gives its numbers on May 14. Analysts are expecting earnings will decline 37% from the year-ago period. All 10 groups in the S&P 500 show a year-over-year profit slide, a uniform decline that hasn't happened in the 10 years Thomson Financial has been tracking such data.
The key to keeping the stock rally going won't so much be whether first-quarter earnings meet or beat those expectations. Instead, the gains will be more dependent on what company executives say about the second, third and fourth quarters. "What everybody is hanging their fundamental hopes on at the moment is the compilation of less-worse information," said Linda Duessel, equity-market strategist at Federated Investors. "We want to hear that we fell off a cliff, and we're done falling, maybe." What companies say may very well determine whether stocks can pull out of their 18-month slump -- the Dow industrials are still down 43% from their October 2007 peak -- and turn the recent bear-market rally into a legitimate bull run. The Dow closed at 8017.59 on Friday and the S&P 500 ended at 842.50.
The recent market rally has been predicated on hopes that the spate of stable economic data, along with a few optimistic comments from corporate executives, are a harbinger of better demand and improved profits later in the year. Investors were treated to a few glimmers of hope early in March, including the spate of announcements from banking executives such as Citigroup Chief Executive Vikram Pandit and Bank of America CEO Kenneth Lewis, both of whom stated that their struggling franchises had earned profits in January and February. Those comments were among the catalysts for investors to return to the market, particularly to the banking stocks, which have outperformed the broader market since the bear-market low hit on March 9.
The financials component of the S&P 500 is expected to show a 40% year-over-year decline in profits. Some will again report losses. Citigroup, for instance, is expected to lose 33 cents a share, according to Thomson Reuters, but that compares favorably with a loss of $1.02 a share a year ago. The enthusiasm displayed by Messrs. Pandit and Lewis was somewhat tempered several days ago, however, when Mr. Lewis, along with J.P. Morgan Chase's CEO Jamie Dimon, noted that March had been a more difficult month. Investor confidence in the banking sector has increased, but investors have been burned before. So any signs that the banks are still struggling will test that faith. Elsewhere, various reports on industrial production, housing, real estate and manufacturing suggest that the economy has at least stabilized. If companies in other sectors of the economy can point to renewed activity, through signs of improved order flow or shipments, it will help fuel the recent optimism.
"The question is, do companies make some significant forward-looking comment that's much different than expected, and what do we hear about business activity in April?" said Jim McDonald, chief investment strategist at Northern Trust in Chicago. The early signs are mixed. Housing figures have improved, but homebuilders Lennar and KB Home have already reported continued losses, and KB Home said it doesn't anticipate a meaningful improvement in market conditions for the rest of the year. Investors will be particularly attuned to the results from companies that serve as bellwethers for global demand as various world powers, including the U.S., Japan and China, attempt to jump-start economic growth through fiscal stimulus and the reduction of interest rates through monetary policy.
Sectors seen as proxies for economic growth include the materials, energy and industrial sectors, which are expected to show year-over-year declines in profit of 81%, 57% and 40%, respectively. Investors will be looking at companies such as Caterpillar, which surprised investors in January with news of 20,000 layoffs and buyout offers for an additional 25,000 U.S.-based employees. In March, the industrial giant announced plans to lay off another 2,500 workers. Manitowoc last week said trends in its crane business are softer than expected, and it withdrew forecasts for 2009. A spate of similar commentary during earnings season from these sectors, along with technology, would curb investor enthusiasm. "Another downturn in both industrials and financials could be a negative surprise," said Mr. McDonald.
For the year, S&P 500 operating earnings are forecast at $62.36 a share, according to S&P, a gain of 26% over 2008, when profit was $49.49 a share. Depending on the forecasts delivered in the next few weeks, that number may be ratcheted down. Since investors have already been exposed to such a run of pessimism ahead of earnings, it leaves open the possibility that the market could advance further if earnings clear a lowered bar. After an electrifying four weeks, that prospect seems much less likely. "What we're going to look for is for the S&P companies to say, 'We think that the first quarter was the worst one, and things should start to improve now,'" Ms. Duessel says. "Otherwise," she says, "we're all going to start to get sad again," and the S&P could fall toward 660 or 600.
Mike Mayo Says Loan Losses at Banks Will Exceed Levels Seen in Great Depression
Mike Mayo, who left Deutsche Bank AG to join Calyon Securities, assigned an "underweight" rating to banks on expectations that loan losses will exceed levels from the Great Depression. "While certain mortgage problems are farther along, other areas are likely to accelerate, reflecting a rolling recession by asset class," Mayo wrote in a report today. "New government actions might not help as much as expected, especially given that loans have been marked down to only 98 cents on the dollar, on average." The 46-year-old Mayo gained a reputation for independence at Deutsche Bank for his willingness to put a "sell" rating on banks and to criticize investors and companies for trying to curb objective analysis. At Deutsche, Mayo had "sell" or "hold" ratings on all 18 companies he covered, according to data compiled by Bloomberg.
Mayo said in the report that he expects loan losses to increase to 3.5 percent by the end of 2010. Mortgage-related losses are about halfway to their peak, while credit card and consumer losses are only one-third of way to their expected highest levels, Mayo wrote. The changes to mark-to-market accounting rules will impact banks’ balance sheets by one-third or less and will have no impact on the economics of bank troubles, Mayo wrote. Banks committed the "seven deadly sins" of banking in trying to compensate for lower natural growth rates and will now feel the costs of those actions, Mayo wrote. Mayo gave "sell" ratings to BB&T Corp., Fifth Third Bancorp, KeyCorp, SunTrust Banks Inc. and U.S. Bancorp, while "underperform" ratings were assigned to Bank of America Corp., Citigroup Inc., Comerica Inc., JPMorgan Chase & Co., PNC Financial Services Group Inc. and Wells Fargo & Co.
Why this will not be a normal cyclical recovery
The rare nature of this recession precludes a cyclically normal US recovery. Instead, we are consigned to a slow, painful climb-out, as are nations such as Japan and Mexico that depend on US demand. The implications for US policy include a likely second round of stimulus, much more federal capital for the banking system and stunning budget deficits that will slow key initiatives for President Barack Obama, such as healthcare and energy reform. What is unusual is that this is a balance-sheet driven recession, centred on the damaged financial condition of both households and banks. These weaknesses mandate sub-normal levels of consumer spending and overall lending for about three years.
In contrast, most postwar recessions had a different sequence – rising inflationary pressures, a monetary tightening to counter them and, then, a slowdown in response to higher interest rates. This was the pattern of the sharp 1980-81 slowdown. None of that happened here. Instead, we saw a housing and credit market collapse that caused enormous losses among households and banks. The result was a steep drop in discretionary consumer spending and a halt to lending. To see why recovery will be slow, we can look at the balance sheet damage. For households, net worth peaked in mid-2007 at $64,400bn (€47,750, £43,449bn) but fell to $51,500bn at the end of 2008, a swift 20 per cent fall. With average family income at $50,000, and falling in real terms since 2000, a 20 per cent drop in net worth is big – especially when household debt reached 130 per cent of income in 2008.
This debt derived from Americans spending more than their income, reflecting the positive wealth effect. Households felt wealthier, despite pressure on incomes, because home and financial asset values were rising. Now that wealth effect has reversed with a vengeance. The crisis and unemployment have frightened households into raising savings rates for the first time in years. They had been stagnant at 1-2 per cent of income but have surged to nearly 5 per cent. With reduced incomes, only cutting discretionary spending can produce higher savings. This explains why personal consumption expenditures fell at record rates at the end of 2008. Consumer spending, however, has approximated 70 per cent of US gross domestic product for the past decade and dominates our economy. But household balance sheets will not be rebuilt soon. Home values will keep falling through mid-2010 and there is no precedent for equity markets, still down 45 per cent from their peak, to make those losses up in just two years. It is illogical, therefore, to expect a full snap-back in the consumer sector in 2010 or 2011. This alone mandates a drawn-out, weak recovery.
The second key sector is the financial one. According to the International Monetary Fund, western financial institutions, mostly in the US, have realised $1,000bn of losses on US-originated assets since the crisis began. The IMF has estimated that unrealised losses may amount to another $1,000bn. With residential and commercial real estate steadily declining, this is possible. This is why the banking sector cannot make new loans. These losses are eating into banks’ capital and shrinking their capacity to add assets. Funds from the Troubled Asset Relief Program are only replacing lost capital, not increasing it. When might they end? With key categories of toxic assets still losing value, the answer is: not soon. The scale of lending needed to support a normal cyclical recovery will not materialise.
A third constraint on recovery may involve the federal balance sheet. The fiscal and monetary engines are currently on full throttle. But, within two years, concerns over budget deficits and inflation may revive, compelling the Federal Reserve to raise interest rates and Congress to adopt deficit reduction steps. These actions, contractionary by definition, could occur before a full recovery has asserted itself. On that basis, the federal balance sheet would also limit a full recovery. This weak outlook is likely to force a second injection of spending rises and tax cuts in 2010 to prod demand. Despite public opposition, substantially more federal capital will be required for banks. The deficit outlook will worsen, perhaps to $1,000bn annually over 10 years. That will force a slowing of Mr Obama’s investment plans. That is a shame, because those investments are needed, but this balance sheet recession will be too deep.
S&P 500 Can’t See Enough Money to Feed Stocks’ Rally
Investors are depending on banks more than at any time in at least 60 years to lead the U.S. out of the longest earnings slump since the Great Depression. American companies will end more than two years of declining income by the fourth quarter, according to analyst forecasts compiled by Bloomberg. Banks will be responsible for all of the 76 percent rebound in the final three months of the year, because without financial companies, the gain turns into a 4.5 percent decline, the data show. Rathbone Brothers Plc, MFS Investment Management and TD Ameritrade Holding Corp. say the reliance on banks is making them increasingly concerned that the 25 percent gain by the Standard & Poor’s 500 Index since March 9, the steepest rally since 1938, will dissipate. While rising home sales and durable- goods orders show the economy may be bottoming, unemployment and consumer debt as well as prospects that banks will be forced to write down more loans may halt the gain in equities.
"People should not get carried away," said Julian Chillingworth, the London-based chief investment officer at Rathbone Brothers, which had more than $14.6 billion in assets under management at the end of last year. "We first need to see genuine signs of economic recovery." Futures on the S&P 500 fell 0.5 percent to 836.70 at 7:55 a.m. in New York after Mike Mayo, the New York-based analyst who left Deutsche Bank AG to join Calyon Securities, recommended selling banks because of his forecast that loan losses will exceed levels from the Great Depression. In 11 recessions since 1938, stocks have rebounded an average of five months before a recovery in earnings, according to data compiled by Bloomberg. The economy has contracted for 16 months, equaling the two longest slumps -- between 1973-1975 and 1981-1982 -- since the Great Depression.
The earnings decline that has lasted for six straight quarters will get worse before it gets better, with profits at S&P 500 companies decreasing for three more periods, Bloomberg data show. Companies from Microsoft Corp. to DuPont Co. already said profits will be disappointing. Analysts predict banks, brokerages and insurers will earn about $21 billion in the last three months of 2009, compared with a loss of $65 billion a year earlier, according to estimates compiled by Bloomberg. Financial companies led the stock market’s plunge from a record high in October 2007 as Bear Stearns Cos. collapsed, Lehman Brothers Holdings Inc. went bankrupt and the government set aside at least $218 billion to prop up American International Group Inc. and Citigroup Inc. All four firms are based in New York. Since the S&P 500 reached a record, financial shares have lost 73 percent, the biggest slump among 10 industry groups.
Almost $1.3 trillion in bank losses tied to subprime mortgages froze credit markets and led to a 6.3 percent U.S. economic contraction in the fourth quarter. The S&P/Case-Shiller Composite-20 Home Price Index tumbled 29 percent from a 2006 peak and the U.S. unemployment rate jumped to a 25-year high of 8.5 percent in March. The first-quarter earnings season starts tomorrow with Alcoa Inc., the largest U.S. aluminum maker. The New York-based company will report an adjusted loss of $368 million, after making $341 million in the year-earlier period, analyst estimates show. For S&P 500 companies, profits will probably fall 37 percent, according to estimates from more than 1,700 securities analysts compiled by Bloomberg. Earnings may drop 31 percent in the second quarter and 18 percent in the next before gaining in the last three months of the year, they predict. The 76 percent jump would be the biggest quarterly increase in earnings in more than two decades, based on Bloomberg and S&P data.
Getting there will depend on financial companies. Bank of America Corp. and New York-based JPMorgan Chase & Co., the two largest U.S. banks, are already saying business wasn’t as strong in March as the first two months of the year. Kenneth Lewis, chief executive officer at Charlotte, North Carolina-based Bank of America, said on March 12 that the lender was profitable in January and February. On March 27, he said "the trading book was not as good" in March. JPMorgan CEO Jamie Dimon told CNBC on March 27 that the month had been "a little tougher" than in January and February. Dimon had said on the bank’s Feb. 23 conference call with investors and analysts that the lender was "solidly profitable quarter to date."
Bank of America may bounce back from an adjusted $1.59 billion fourth-quarter loss a year ago to earn $1.92 billion in the last three months of the year, analyst estimates show. JPMorgan, whose profit plunged 76 percent in the fourth quarter of 2008, may report gains of 317 percent and 222 percent in the third and fourth quarters. Analysts overestimated bank profits for at least six consecutive quarters, data compiled by Bloomberg show. Earnings may not materialize this time either because of declines in commercial real-estate values, which have yet to fully reflect the economic slowdown, according to Arlington, Virginia-based Friedman Billings Ramsey Group Inc. "Clearly, vacancy rates are going up," said Larry Adam, Baltimore-based chief investment strategist at Deutsche Bank Private Wealth Management, which has $232 billion in client assets. "I don’t think it’s just close your eyes and buy. The economy isn’t as good as some people are saying."
Commercial property loans in default or foreclosure jumped 43 percent in the first quarter as the contraction reduced occupancies and the credit crisis stymied refinancing, data from New York-based research firm Real Capital Analytics Inc. show. Commercial real estate values have fallen at least 30 percent since the 2007 peak and may drop 11 percent more this year, Frankfurt-based Deutsche Bank AG’s real-estate unit said in a March 25 report. The decline may force banks to increase loan-loss provisions and write down the value of commercial property loans, which Citigroup, Bank of America and JPMorgan are all carrying at 100 percent of face value, according to estimates in a March 24 report by Richard Ramsden, an analyst at New York- based Goldman Sachs Group Inc. After losing more than half its value, the S&P 500 took 19 trading days to rally 25 percent starting March 9, the sharpest since President Franklin D. Roosevelt’s New Deal policies helped pull the U.S. out of the Great Depression.
In the past month, the S&P 500 has bounced back from a 12- year low as confidence increased that $12.8 trillion pledged by the administrations of Barack Obama and George W. Bush and the Federal Reserve to rescue the financial system will end the recession. The S&P 500 climbed 3.3 percent to 842.50 last week. Stocks gained as Treasury Secretary Timothy Geithner unveiled a plan on March 23 to finance as much as $1 trillion in purchases of banks’ distressed assets to end the 20-month freeze in the credit markets. Economic reports in the past month persuaded some investors the worst of the recession was over. Sales of new and existing homes unexpectedly rose in February, according to the Commerce Department and the National Association of Realtors, while durable-goods orders increased. "I’d be a buyer before I’d be a seller," said Leo Grohowski, chief investment officer at Bank of New York Mellon Wealth Management, which oversees $139 billion in New York. "This is more than an oversold bounce. We are seeing some very, very early signs that the economy may be bottoming."
Stephanie Giroux, chief investment strategist for TD Ameritrade, the Omaha, Nebraska-based online brokerage with $210 billion in client assets, isn’t convinced. The government’s plans to kick-start growth don’t guarantee a rebound in earnings and stock prices because consumer spending, which accounts for about 70 percent of the U.S. economy, will stagnate for years as Americans pay debts and businesses cut jobs, she said. The unemployment rate may rise to 9.4 percent by year end, according to economists’ estimates compiled by Bloomberg, as companies from Detroit-based General Motors Corp. to Microsoft and DuPont fire workers to cope with plummeting demand. A controlled bankruptcy by GM would squeeze production and may help eliminate about a third of the 3 million jobs in the auto industry, Joseph LaVorgna, the New York-based chief U.S. economist at Deutsche Bank, wrote in a report on March 30.
Americans’ debts have remained near all-time highs even as they reduced spending, because people thrown out of work are depleting savings and tapping credit cards. U.S. household borrowing, which has ballooned almost 11-fold since 1980, equaled $13.8 trillion at the end of 2008, or 0.5 percent less than the record reached earlier in the year, according to data compiled by Bloomberg. "You’ve taken a big engine of growth out of the system for a while," TD Ameritrade’s Giroux said in an interview. "We are going to be confronted with sub-par growth as we dig out of this hole. The consumer has really driven growth in the economy, and the stock market is a proxy for that growth." Software makers and chemical producers are also being hit by diminishing sales.
Microsoft, the world’s largest software supplier, said in January it would cut as many as 5,000 workers in the first companywide firings in its 34-year history. Sales and profit will probably drop as the recession reduces demand, the Redmond, Washington-based company said. Analysts project Microsoft’s profit fell 22 percent in the three months ended in March and will slip 17 percent this quarter, versus year-earlier periods. DuPont, the third-biggest U.S. chemical maker, lowered its full-year profit forecast in January and eliminated 8,000 contractor jobs as global demand deteriorated and sales to the automobile and homebuilding industries declined. Wilmington, Delaware-based DuPont’s earnings dropped 58 percent in the first quarter and will tumble 42 percent in the current period, estimates compiled by Bloomberg show. "The market doesn’t have any evidence now that it’s not getting worse," said James Swanson, Boston-based chief investment strategist at MFS, which oversees $134 billion. "We still are dealing with much worse unemployment and much worse housing numbers. This stock-market rally that we’re seeing, people need to be cautious about it."
Rebounding Ruff rubbishes rally
Dead cat bounce? A rebounding top-performer is skeptical about the stock market rally. Ruff Times, edited by veteran Howard Ruff, is up 20.4% over the year to date through March, according to the Hulbert Financial Digest's count, compared to a negative 10.56% for the dividend-reinvested Dow Jones Wilshire 5000. It's part of a marked pattern where hard-asset letters have been rebounding strongly in 2009. Ruff's rebirth, nearly 30 years after his glory days in the last gold rush that peaked in 1980, was one of the striking features of the late lamented bull market -- particularly because he was presciently pessimistic about financial conditions. But, paradoxically, that didn't help Ruff navigate the Crash of 2008.
However, that was then, and this is now. Ruff's record doesn't matter to new investors who are now able to ride his rebound. And, somewhat like the International Harry Schultz Letter, Ruff may have been a victim of the HFD's ruthless monitoring method. Ruff stubbornly refuses to maintain a true model portfolio, simply listing stocks in which the HFD is consequently compelled to keep him fully invested at all times. Ruff wrote recently: "The stock market has made a dead-cat bounce, even though the returns are spectacular for short-term investors, which I am not. The long-term problem with the stock market is two-fold: 1) its earnings will decline as business sags deeper and deeper into this recession which will depress stock-market prices; and 2) the price/earnings ratio (PE) is still way above the typical PE at the bottom of bear markets. The stock market will have its ups and downs and literally suck Wall Street investors into short-term rallies as they try to pick 'the bottom.'"
"What's left of Wall Street believes the stock market will sooner or later get well. They believe you will eventually make a lot of money in the stock market. Perhaps you can make some short-term profits, but I don't trust such short-term calls; I don't make them, and you can't depend on them. I'm in for the long haul, and the long haul says down, down, down, regardless of short-term rallies." Ruff's conclusion: "Sell into these rallies. The stock market is toxic and will be for several years." But Ruff does offer a qualification: "Certain industry groups will do quite well over the next few years, if that's what you want to do, but you will have to be a short-term trader. Oil service companies, uranium mining, and gold and silver mining stocks should do very well. I would bet for the long haul on the uranium mining stocks, and the gold and silver mining stocks. Their long term prognosis is excellent."
What Ruff is looking for, quite simply, is hyperinflation. He prefers silver to gold, but writes: "Gold and silver are not just to make money, although they will do that, but also to preserve the value of all your assets. Liquidate as much of your assets as possible and buy gold and silver at these depressed and even manipulated low prices." This is the first time I've seen Ruff mention the radical gold bug thesis that the gold price is being manipulated. Normally, he prefers the common or garden gold bug thesis that the currency is being debased.
AIG's CDS Hoard: The Great Unraveling
The process of unwinding AIG's credit default swaps isn't rocket science, but it is messy and expensive. Here's why. Credit default swaps got AIG (AIG) into its current mess. Unraveling them might get U.S. taxpayers out of it. But it won't be easy or cheap. The white-hot furor over AIG's retention bonuses seems to have died down a bit. Last week the House of Representatives passed a watered-down version of the bill that was supposed to tax those payments out of existence. But AIG isn't leaving the bull's-eye anytime soon. The Government Accountability Office said on Mar. 31 that AIG should demand concessions from its trading partners and employees. On Apr. 2, deposed AIG Chief Executive Hank Greenberg paid a visit to Capitol Hill, blaming his successors for the company's failings and calling its government bailout a failure. And New York State Attorney General Andrew Cuomo is probing the $165 million bonus payments and the billions AIG transferred to such banks as Goldman Sachs and Société Générale. Amid all this hubbub, AIG's employees plug away, trying to wind down the beleaguered company's remaining credit default swaps, which are basically insurance policies purchased against the default of various forms of debt.
So what's so hard about unwinding a CDS? And does it really take a financial rocket scientist, chained to a seat by a fat retention bonus? Or could it be done by some of the vast army of recently unemployed Wall Street workers? Part of the problem is that not only are the financial instruments themselves complicated, but they involve tangled relationships of companies and investors, each with their own interests. AIG owns $1.5 trillion in derivatives, including CDSs, interest rate swaps, and currency swaps, among others. And these trades overlap in a large web across all its companies. Since everyone knows that AIG needs to rip up its contracts, its partners are holding out for the best deal possible. The nastiest, most complicated, and most controversial types of AIG's CDSs have largely been taken off the company's books. Those swaps were customized by the insurance company to protect financial institutions from default in illiquid pools of mortgage-backed securities, the now infamous collateralized debt obligations, or CDOs. When the value of the CDOs tanked and AIG's credit rating was cut, the insurance company was forced to pay billions of dollars in collateral to companies known as "counterparties"—money it didn't have. To exit the contracts, AIG used Federal Reserve and Treasury Dept. cash to pay the counterparties 43¢ on the dollar for the securities (which now reside on the Fed balance sheet as Maiden Lane III). Then the company paid off $26 billion in insurance on the same CDOs to Goldman Sachs ($5.6 billion) and Société Générale ($6.9 billion), among others. This cost taxpayers $46 billion.
That's not the end of the story, unfortunately. AIG's remaining credit default swaps may not be as toxic. Many of the remaining swaps are, in fact, what the industry calls "plain vanilla"—fairly standard, liquid contracts. But that doesn't mean they'll be easy to get rid of. There is no centralized market for derivatives, so AIG's traders in Wilton, Conn.; London; Paris; and Tokyo can't just look at a PC screen and see the current price, as a trader would do with a stock. Instead they look at the available data on such things as interest rates and the earnings of the companies whose debt is insured, and then use mathematical models to determine what they want to pay. Next they reach out to other traders to gauge what might be a reasonable price. At the same time, the trader has to figure out the overall impact the trade will have on AIG's book. "It's like you're flying blind in a 747," says Marc Groz, a hedge-fund risk manager who now heads up risk management firm Topos. "You can only see what the instruments are telling you." Because they are contracts between two parties, AIG's credit default swaps can't simply be sold. Some will expire on their own, like the $234 billion of swaps that are expected to come off the books in the next year and a half. Others will be terminated at the request of the owner. AIG can opt to let the contracts expire. But $34 billion worth of CDSs is set to run down over the next five—or more—years, which would seem to run counter to its avowed plan to wind the contracts down as quickly as possible. If AIG wants out, it will have to go back to the other side of those trades and negotiate an exit.
That won't be easy—or cheap. CDSs are still trading, but the spreads—the difference between what dealers are willing to pay to buy or sell—have widened, making it more expensive to get out. "The Street knows they have to unwind positions," says TABB Group's Kevin McPartland, an analyst who specializes in derivatives. "It gives AIG little pricing power." Working those deals doesn't necessarily require the same hands that put them together in the first place. But it's not a task for just any newly minted MBA. Wall Street has largely abandoned the shoulder-to-shoulder battle of the exchange floor for a more formula-driven mode of trading. Steely nerves are still required, but so is an acumen for high-level math. Such skill sets are not necessarily uncommon on Wall Street but they're still in demand, despite waves of industry layoffs. "The vast majority of professionals at AIG are just doing their jobs," says Rob Sloan, head of U.S. financial services at Egon Zehnder. "And many could get jobs elsewhere." AIG declined to make its employees available to walk through its swap-unwinding operations, which are conducted through the financial products unit known within the company as FP. The company also declined to say just how far down it has managed to cut the pile. "FP's employees have made tremendous progress unwinding FP's trading positions, business books and lowering its risk," AIG said in an e-mail. "Despite this progress, the risks in the books at FP are still large, and require the skills and professionalism of the traders, marketers and support functions."
Steve Forbes interviews Meredith Whitney
Welcome, I'm Steve Forbes. It's a privilege and pleasure to introduce you to our featured guest, Meredith Whitney, founder of the Meredith Whitney Advisory Group and the stock analyst who was among the first to warn of the severity of the banking crisis as it unfolded. She'll tell us where the banks stand now. But first....
An exasperated Abraham Lincoln once remarked that his Civil War General George McClellan had "got the slows." In McClellan, Lincoln had a brilliant strategist but a too cautious fighter. He frequently exaggerated the threats before him and then he froze up on the battlefield, prolonging the war and disappointing his president.
Ben Bernanke, does this sound familiar?
At a time when the U.S. and global financial systems are under the most intense stress since the 1930s, Bernanke's leisurely pace is a reminder of how the derisive phrase "banker's hours" originated.
Bernanke has applied his formidable intellect to understanding the causes of The Great Depression. But we need him now to act faster, more urgently to the current crisis.
Last November, he promised that the Fed would buy $500 billion in mortgage-backed securities. Four months later, he still hadn't fulfilled that pledge. Then, in a blare of headlines, he promised to purchase more than $1 trillion in debt securities in order to get the credit system working again. But, like McClellan, he has failed to act. The Fed has actually removed billions in liquidity from our financial markets from December through early March. If Ben Bernanke can't conquer his instincts towards inaction, then he should step down. The damage caused by his dithering is becoming increasingly intolerable.
In a moment, my conversation with Meredith Whitney.
[01:54] The Running On The Banks
Steve Forbes: Well, thank you very much for joining us, Meredith. Back in the summer of 2008 when a lot of people thought we were out of the woods on the financial crisis, you said no, the worst was to come. First of all, why did you think there was such devastation in the banking sector that was unprecedented? And are we finally climbing out of the thing?
Meredith Whitney: What worried me last summer, summer of 2008--
Because you were alone on that. You were virtually alone on that.
I was alone, I felt very alone. And the scariest thing, I think, I've seen yet, was what happened to IndyMac in the summer, in July, when you had a run on the banks. And what I knew at the time, was that there would be runs on other banks, and those that were heavily weighted towards commercial deposits.
So, at the time, it was a guarantee of $100,000 or below. And so, the commercial deposits, that which you pay your payroll through, there was your 30-plus percent of the banking system, 35% of the banking system, uninsured. And so, if you look at what was, who had the most exposure to the commercial deposits, obviously, those were the first to flight.
So, what you saw then was an effective on the bank of Washington Mutual, and an effective on the bank at Wachovia, and NatCity and some others. And so, what we didn't see was, all of those deals were done inside of the third quarter. So, what you didn't see was what happened to their deposits inside of the third quarter. So, July was part of the third quarter.
And by September, Wachovia and Washington Mutual were part of another entity. We never saw how bad things were. But I saw that on the come. I also knew that it was clear that the banks were carrying bad math assumptions. So, one key variable in evaluating your mortgage, what your mortgage portfolio is worth is, No. 1, what employment is.
But No. 2, where you think home prices are going to go. And as an example, Wachovia, which was, I put a sell rating on Wachovia in July. And the stock was $9 or something. It was a pretty wild call. But I knew that they were expecting home prices to decline by 21%; 60% of their exposures were in California. Case-Schiller is now down 30% in the top 10 MSAs. So, it was clear that they would have to play catch-up. And it is also clear that the banks still have to play catch-up. The banks, all the big banks anyway, carry their mortgage books with an assumption that home prices would decline peak-to-trough 30%, 31%.
Well, we're already there. So, what you'll see in first-quarter results is a catch-up to what now the future of market is doing, viewing the peak-to-trough home prices to be 37%. So, you're constantly having to reevaluate your reserves against loans. That puts earnings pressure on companies.
And it creates an environment where it's almost impossible to regenerate your own capital, to grow your own capital. So, you've got to have your hands out for other people's capital. And it's been sovereign wealth fund's capital. It's been U.S. investor's capital. It's been our taxpayer's dollars as capital. And I don't see that ending anytime soon.
Now, in January and February, it seemed, at least to an outsider, that even regardless of what the books said, the banks seemed to be doing very well on a cash-operating basis, the rollover alone. You were paying fees. You are paying fees. You were paying 10,000 points above LIBOR. Do we have a disconnect here? Where on a cash basis, the banks are doing well; where in a statutory, regulatory basis, they're still not out of the woods?
Well, on a cash basis and on a trading basis, they're doing, facilitating transactions. January and February, it's all relative, right?
[05:45] Shun Bank Stocks
Relatively good months. On an accrual basis, that's where you get into problem areas. Because your loan is only as good as it pays you back. And so, the loans are paying back less. As I said, one of the two main assumptions that goes into valuing any of your loans, accrual-based loans, is home price appreciation, but also unemployment.
A lot of the banks were carrying seven-and-a-half to eight percent unemployment. We're already over 8%. So, there are going to be big true-ups this quarter. Some parts of the business are OK. And what's interesting, for a Goldman Sachs, 70% of the capital markets competition has gone away, or dramatically pulled in their horns.
So, it's a smaller pie. But you're getting more of a market. And the government actually is churning a lot of fees for Wall Street. So, there's trading activity there. I don't know how sustainable it is because bank revenues, cash-based revenues on the non-accrual-based loans, should correlate to some multiple of the GDP and global GDP. And as we know, the global GDP is coming down.
So, you're staying away from bank stocks still?
I am staying away from bank stocks still.
Any hope for the regionals? Is there some difference between the regionals and the five biggies?
I have a view of what I want to happen. And I don't know how much, how many legs it has in D.C. Because it's hard. But there are small regionals. And by regionals, I mean, well below the top 100 banks, or even, well, let's say safely, the top 50 banks, that have clean balance sheets, that want to lend, that have ample deposit bases.
But they don't have scale. So, the best thing about this market is, you have 8,000-plus banks that are healthy and want to lend. The worst thing about this market is, they don't matter because they don't have any market share. So, two-thirds of the lending market for both mortgages, and then for credit cards, is dominated by the top five banks. So, you've really got to dislodge that to make any material improvement in the system. And I don't think the government is prepared yet to dislodge that because it's too disruptive and too uncertain of an economy.
Now, does "dislodge" that mean force-feed capital to the regional banks so they can move in to where the big ones can't?
It's ultimately going to happen anyway. Because lending will go back to where my deposits fund your mortgage and your deposits fund my mortgage. That's where it's going to go. Because as we know it, the shadow-banking industry, in terms of securitization as a vehicle to fund loans is not coming back, right. Maybe it comes back in three, five years. I don't know.
But for certainly in the next couple years, it's not coming back. So, to fulfill that you can't expect that type of liquidity to come back. So, the regional banks are going to have to pick up a larger percent of market share, a larger percent of the movement within consumer liquidity.
They're not equipped yet. And the large banks aren't also equipped to lend with the veracity that they did before. They still have shrinking capital bases. So, I think, and they're risk averse, too. So if you're the greatest correlation between defaults and borrowers is distance, right--or lender and borrowers, is distance. So, you've got to get closer to your borrower to understand, really, the sensitivities of that borrower. And the big banks, you know, won't be able to do it. They'll have to pass some market share onto the smaller ones.
So, would you buy some of the smaller ones now? Or you've just got to wait for this thing to start to shake out even more?
You know, I bet most people couldn't even name some of the smaller ones. I think that on pullbacks, you can buy a basket of small stocks that are clean, obviously non-TARP-based stocks.
Is there an ETF that does small names?
I'm sure there is. I'm sure there is, rounding our names. But if you buy them as individual stocks, you're going to have a big liquidity premium. And it's probably not the best thing for an individual investor. What I'm looking forward to on the long side is when these big banks get disaggregated. So, when a Citigroup sells portions of its business, it's because they'll call it, say, non-corp. But really, the next wave is banks sell stuff to raise capital. So, you can't raise capital through taxpayer dollars. So, you sell stuff to raise capital, and recent fabulous combinations from that. I'm still crossing my fingers and hoping for an American Express/Citi credit cards and retail deposit combination. That's a great growth vehicle.
[10:27] Credit Card Crisis
But talking about credit cards, you've been sounding the alarm talking about a squeeze that banks are--and gee, American Express already has--and other banks have, cut back on your lines. You may not have used them. But you may have thought you had $10,000. Now you have what, $500?
This is the most interesting topic for me out there, which is credit card lines. So, there are about $4.6 trillion in unused credit card lines. And there are about $840 billion of used credit lines. So, in the fourth quarter alone, I'm sorry, now of course it's $4.2 trillion. In the fourth quarter alone, half a trillion dollars of lines were cut from the consumer, half a trillion.
And this is before any type of regulatory changes. So, banks are cutting lines for a couple of reasons. No. 1, risk aversion. No. 2, they don't want to hold regulatory capital against unused lines when they are so capital-dependent. And No. 3, which is also risk dependent is, where I have a monogamous relationship with you as a mortgage borrower, I have multiple relationships with my credit cards.
So, when, you know, cameraman A cuts my credit card line, I have more exposure to you and cameraman B. So, you don't want to be the last one holding the hot potato. So, you pull your line. And I'm stuck with fewer lines. And my borrower's, my lender's stuck with more exposure to my line. That's the last place he wants to be.
So, the credit card version of a run on the bank?
I haven't thought about it, but that's exactly right. And when you get a pay cut, 90% of Americans use their credit card to--
Tide them over?
Tide them over and as a cash-flow management vehicle. So, when your credit card line gets cut, it's the equivalent of getting a pay cut.
And there's a regulation coming along from the Office of Thrift Supervision, can you explain that?
That's going to throw a real wrench into people's access to credit card capital.
I'm sure you will get shivers up your spine, unintended consequences. This is "Unfair and Deceptive Acts and Practices." And there are a lot of good things that it does. This is regulation to protect the consumer. And that's passed by, it's already passed. It's just a question of, it's supposed to go into effect by mid-2010.
It may get accelerated by Congress before that, but passed by the Office of Thrift and Supervision, National Credit Union Association, and who am I forgetting, the Fed, all three regulatory bodies that govern credit cards. So, what happens is, to protect the consumer, they say OK, well you're going to need a grace period through which to pay your credit card bill. So, you go on vacation. You come back. "Wait, I have to pay my bill in two days?" Oh, now you get a required 21-day grace period.
And there are other things it does in terms of, if I give you a teaser-rate product and you make a payment, right now it goes, your payment goes to the low-interest-rate part of the credit card portion. Going forward, it'll go to the high-interest credit card payment. So, you can ultimately get out of debt.
The unintended consequence it risks doing, and I think it will do, is I, as a lender for your credit card, an unsecured lender for your credit card, monitor your credit bureau monthly. And so, I know when you're late with your phone bill, your utility bill, your sacrosanct cable bill. Right, for a man, it's all about the cable bill. And so, I'm going to monitor that and change your rate accordingly. Well, going forward, after this is adopted, I can look at your credit bureau, but I can't do anything to you unless you're late with me.
And the obvious risk here is, by the time you're late with me, you've maxed out your credit card bill in Mohegan Sun or Atlantic City--sorry, New Jersey native--and I'm left holding the bag. My natural instinct is to cut your line. And that's what's going to happen. But the half-a-trillion dollars of lines that were cut last year were well in advance, and, I would say, had nothing to do with the UDAP proposal. So, that's more on the come. Now, I think there's going to be $2.7 trillion in lines reduced. So, a 50% cut of the lines outstanding.
That's going to have the scariest impact on the economy, I think.
And that's ongoing now?
So, we talk about housing and whatnot. Your ability to transact is essential to preserving commerce.
Now, so is what happened in January and February in retail sales, was that sort of an anomaly, sort of a little catch-up from what people didn't do in the fourth quarter of last year? Or why were they relatively good?
Well, the consumer has money. Well, most consumers still have money. There's over $7 trillion in cash on consumer-balance sheets. But they're spending at lower-end stores. They're not "living la vida loca" at Neiman Marcus and Saks Fifth Avenue. And there's no sense of urgency to buy.
So, I think the consumer appreciates a deflationary pressure in the market. Now it's, by and large, a willingness impact on the consumer. When unemployment goes over 10%, it will be an ability-based issue. So, all of this is still very much a willingness issue. And you've seen how much consumer spending is contracted. You know, we've got the benefit of lower oil prices now. We've got the benefit of other factors. The good thing is the consumer came into this on much better footing than consumers come into prior recessions.
And so, if they ever got the economy moving, the consumer could get back in action pretty quickly?
I think so. And also, supply management's so much better. Productivity is so much better. You know, the "starve the beast" mentality, it forces a lot of businesses to make streamlined improvements.
And you look at the financial sector, for example, it, despite the incredible profits of the industry, it's pretty fat. And I can say this--a lot of stuff is given away for free. If Wall Street were ultimately downsized peak-to-trough by 50%, I think Wall Street would be a lot more profitable.
[17:06] States and Munis
Now, one of the other areas you worry about is state and municipal spending.
Well, grim reading. But that there's going to be cutbacks there. They're obviously raising taxes. But what kind of impact do you think that's going to have on the broad economy?
Well, I should be asking you this, because you're more of an expert than I am.
No, I get the information from you and then recycle it.
OK, 12% of the U.S. GDP comes from state and local spending. And the states and the local municipalities are just as guilty as the over-levered consumer. Because when you look at the big states that are under-funded, and most notably California, Arizona, but Florida's behind it and you've got over 34 states under-funded for 2009 and then for 2010 budgets. They built infrastructures that were dependent upon 2006 sales-tax receipts, home property sales-tax receipts. And those infrastructures, expenses, are not supported by the current income-tax structure. And it's going to be painful. So, you start by cutting derivative jobs, then you're closer into the marrow.
And California, that has been well ahead of the curve in terms of addressing its budget issues, has already shown you what type of job cuts and pay freezes and furlough exercises they've done, you know, giddy-up for the rest of the country catching up. And the issue with the banks, which is an aside from what you brought up is, the government can't bail everyone out.
So, they've focused on bailing the auto guys out. They focused on bailing AIG out, the banks. But the state and local governments are right behind them. And so, California's going to default? I don't think so. Everyone's got their hands out. So, the government's got to be very judicious about how they spread taxpayer dollars.
[19:02] When Banks Will Lend
You mentioned banks reluctant to lend. And you've talked about it in the past. JP Morgan is emblematic of that. What will it take to get them to loosen up again?
It's just sentiment, you know, sentiment.
Animal spirits, as Keynes would put it?
That's right. On the economy, without the government dole and the government wrap programs, cost of capital is still expensive. So, to lend above that cost, that hurdle rate or cost of capital, is tough. And I think that you have so much. One thing that I look at which is a pretty good barometer, is home-ownership rates. So, home-ownership rates peaked right on 70%. There is still over 67, just about 67 and a half, percent. They probably have to go.
And you think it should go back to what, 64%, 65%?
Yeah, yeah. So, if that happens, you've got still more pressure. So, who's going to lend in that environment? Now, there are monthly reports that the banks have got to give the treasury, the lending reports. And they will all show you positive numbers. But the loans that they're making are not big enough to offset the loans that are naturally running off, paying off, and the loans that are charging off. So, they're net lending is down.
So, we're still in a deflationary environment? Liquidity's still being sucked out of the system, in essence?
Yeah. The mortgage industry shrunk for the second quarter in a row last year. And that's never happened before.
[20:31] Where's The Fed?
Now, this raises an interesting question. The Fed is supposed to be the people who pump out liquidity when the system seizes up. Yet, between December and early March, they withdrew $400 billion. They shrank their balance sheet $400 billion. Now, they're starting to ramp it up a little bit. But it looks like it's still not equaling the decline in liquidity.
Yeah. How do they do it? A lot of what the Fed has done with respect to the agency paper, they've been sort of a back-door lender or had given money to the banks on a back-door basis. So, they're buying what now, $750 billion of agency paper? Who was the largest holder of agency paper? The banks.
So, that was an interesting movement. Once they announced that repurchase program or the intent-to-repurchase program, it's difficult to tell when. But if you look at the fourth quarter, the banks increased their exposure to agency paper. And whether that was because they got TARP money, or whether that was because the government said they were going to start buying agency paper, who knows. But it was a material increase in agency paper.
So, should the Fed be doing a lot more since velocity is dead? People are holding onto cash the way people do food when they fear a famine. Should the Fed say, "Hey, this is an unusual environment, how about a trillion, 2 trillion, 3 trillion?"
I feel like they are. So, you've got the $800 billion in TARP that's been all but used where $100 billion or so is left. Then you have so many different liquidity programs. I look at the fed agency program as a different version of TARP. It's directly benefiting the banks. So, I think that they're pretty stimulative.
[22:24] Geithner's Gambit
So, are we at a state where there's nothing government can do? We just have to wear through this storm?
Clearly, when you have so much in the way of trillions of dollars of assets underwritten with bad math, you just have to run that off. I was surprised to learn last week.
So, the Geithner plan is not going to, other than enrich some hedge funds, not going to do very much in terms of hastening this process?
It all depends. I mean, the obvious, the private partnership program is obviously conflicted in terms of what price do you pay? You can't blatantly rip off the taxpayer. And you can't force people to buy overvalued securities or banks to sell at what they deem to be undervalued levels.
So, it may move. Even if $1 of that program trades, and it still could set a base for an observable market index that allows all the banks to write up their assets. And as you look at what happened with Smith Barney and Morgan Stanley with that transaction in the fourth quarter, not that much money transacted. But Citi was able to write up that transaction by $6.5 billion on their balance sheet.
That's not so bad for a day's work, right? And nothing really has to go on. But you just have one trade in the market. And people can mark accordingly. If that's all, it can either be wishful thinking or the government could be really clever. I don't know which one it is yet.
[23:50] Dumb Risks
Well, hope they figure it out right, to replenish bank balance sheets. So, what has all this taught us about risk and what can we take from that in the future?
It comes in many forms. I guess the lesson is, when an industry gives you lemons, sometimes it's just lemons. It doesn't turn into lemonade. How we got here is, margins collapsed to such a level that banks felt entitled to make all these sorts of profits. So, you've got a cruddy business.
So, how do you make, lever it, right? Take a bad business and lever it. And, you know, great things come. How about finding good businesses? So many great things about financial services were product innovation, and really good product innovation. Because I think that there were so many great things that came out of the securitization industry in terms of distribution of low-cost funding and low-cost borrowing for more Americans. Globally, distribution of lower-cost borrowing for more citizens of the world, that's great financial innovation. But leverage is not great financial innovation. It's one of the oldest--
It's like an up market. It makes you look like a genius.
That's exactly right. So, I think, we had really dumb risk this time. It wasn't clever risk. It wasn't calculated risk. It was just dumb risk. And that's probably what's so frustrating about it.
Painting the pig?
[25:20] No Recovery
So, what is the one still big, misplaced assumption out in the marketplace today when you look at it, despite what's happened in the last year and a half?
Well, it's sort of nice that people have hope that a lot of these government plans will work. A misplaced assumption could be that something can change and you'll have a V-shaped recovery inside of 2009. I don't see that happening. I don't see an L-shaped recovery, either.
I think that we're just better than that. I think that we'll be innovative. This is notwithstanding the government making this a socialist state, which I'm hoping that they won't. It will be somewhere in the middle. So, it's not all bad, and it's sure as heck not all good from my vantage point. But it's not all bad. Resourcefulness can make you a lot of money in this market.
So, your bold prediction for the future is? How do you see this all shaping out? Is it going to be two years of a slog, three years and then suddenly we pull out? Or it'll be a gradual buildup and people say, "Hey, things are starting to get better?"
It all depends. It'll be really curious to see which industries lead us out of this cycle, and what areas of innovation this country then becomes famous for. Because no doubt in my mind, the single greatest export over the last 40 years from the United States was the financial services industry.
Not technology. It's the financial services industry. So, we've got to find a new export. And that'll be curious. I don't know what that is. A bold prediction is, our entire economy has got to reshape, redefine and restructure itself. And that of course can't take a year. It can't take two years.
It'll take several years. And we're going to be better and stronger for it. Because we got so addicted to this crack pipe of housing leverage. That's not a business. That's making, again, something great out of something that's pretty simple, right. Let's do great things with greatness, right, to be redundant. But let's find really innovative solutions and build an economy around it.
So, your bottom line is, there's more to growth than borrowing?
Yes, yes. You say it so much more eloquently than I do.
Not at all. Meredith, thank you so much.
Thanks so much
The London summit has not fixed the crisis
by Wolfgang Münchau
For the first time since the crisis erupted two years ago, global leaders went a few millimetres beyond what was expected of them. The decision by the Group of 20 developed and emerging nations to commit $1,100bn (€816bn, £741bn) in new funds for international institutions is no doubt substantial. It will allow the International Monetary Fund to deal with the current and future torrent of balance of payment crises more effectively. But the London summit comprehensively failed to do what it set out to do. Not one of its resolutions will move the world a small step closer to resolving the global economic crisis. As world leaders return home, they will be confronted by the reality of the decisions they have not taken. They will return to economies in which bankruptcies and unemployment are about to rise to the highest levels since the Great Depression. They will face an outraged public that seeks to exact revenge on bankers and banks. The longer they wait, the harder it will be to take the needed decisions. Many of those decisions, such as the recapitalisation of the global banking system, will become a lot more expensive, and politically difficult, if we procrastinate while the economy deteriorates further.
The forward looking indicators do not tell us the situation is getting better. US house prices are down 30 per cent, and have further to fall. Countries with large current account deficits are cutting consumption of imported goods. One of the results will be that the combined export surpluses of Japan, China, and Germany will shrink dramatically. World trade has been collapsing faster than during the Great Depression. The monetary indicators are also absolutely awful. In Europe, both real and nominal growth of M3, a broad measure of money, is falling on a month-by-month basis – with no turnround in sight. Whether you look at this as a Keynesian or a monetarist, you come to the same conclusion: the world economy is in serious trouble. The monetary authorities are close to having exhausted their ammunition. Money market interest rates are close to zero almost everywhere – and that includes the eurozone. We are now all moving towards what the Federal Reserve calls credit easing, a policy designed to alleviate bottlenecks in specific pockets of the credit market. The US and UK have adopted those policies, and the eurozone will follow suit with some delay. It will probably happen next month. And then what?
Not much, actually. Governments are now in a wait-and-see mode – wait until those existing stimulus packages kick in, and see how the economy responds. The US administration will wait until the public-private partnership, proposed by Tim Geithner, the US Treasury secretary, takes off. It will see how fast and effective the programme to buy "legacy assets" from US banks turns out to be. Chances are that it will succeed on its own limited terms, but it will not solve the problem of an undercapitalised banking sector. And US taxpayers may not like the idea that they are spending billions of dollars and have not saved the banks. I would expect that, as we return from the summer holidays, governments will start to discuss a new round of stimulus and bank rescue packages. The politics of bank rescue are toxic. A former European finance minister reminded me that, from a political perspective, there is nothing in it for a rational politician. Handing over hundreds of billions of euros to the banks is akin to political suicide, no matter how you do this.
But this only makes the need for co-ordinated global policy action even stronger. If you undertake this gargantuan political act while others are not, you bear all the political costs and reap none of the benefits. Bank rescue is a task that will test even the most gifted political orator. The best way to do it is as part of a global effort. The public would only accept it if it believes there is a realistic chance that the aid will solve the problem and in return they will insist on a minimal degree of fairness. The real problem with the US bank rescue plan is that it may exhaust the public’s sense of fair play. The G20 summit has ducked the important question of bank rescue beyond a few meaningless and self-congratulatory statements. Instead, our leaders showed more interest in future crises than in the current one. But the probability that another crisis may break out soon, is inversely related to the length and depth of this one. The longer this crisis lasts, the more absurd the G20’s order of priorities will seem. If the crisis shows no sign of ending in the autumn, our great leaders may gather for another desperate summit, in another city, facing another set of protesters, producing yet another series of desperate but ineffective pledges to save the world economy, embedded in another pretentious communiqué. The London summit has shown us what "We, the leaders of the Group of Twenty" can do, and what they cannot. The G20 has shown that it can fix international institutions, but not the biggest economic crisis in our lifetime.
China's Dollar Deception
We are in a race between economic recovery and economic nationalism. At last week's Group of 20 summit, leading nations agreed to roughly $1 trillion of additional lending, mostly through the International Monetary Fund, to help end the worldwide slump. But beneath the veil of consensus, countries are maneuvering to protect their economies and blame someone else for the crisis. Will the world economic order overcome these stresses or give way to a global free-for-all, characterized by rampant protectionism and nationalistic subsidies and preferences? Emblematic of the tension is a recent proposal by Zhou Xiaochuan, governor of the People's Bank of China (PBOC), to replace the dollar as the world's major international currency. In a paper, Zhou argued that today's crisis reflects "the inherent vulnerabilities and systemic risks" of the dollar-based global economy. The PBOC is China's Federal Reserve; Zhou is no obscure bureaucrat.
It may surprise Americans that, up to a point, his analysis is correct. The dollarized world economy developed huge instabilities -- vast trade imbalances (American deficits, Asian surpluses) and massive, offsetting international money flows. But Zhou's omissions are equally revealing. To wit: China is heavily implicated in the dollar system's failings. By keeping its currency artificially depressed -- as an aid to exports -- China abetted the imbalances it now criticizes. The Chinese denounce American profligacy after promoting it and profiting from it. Low prices for imported goods (shoes, computers, TVs) encouraged overconsumption. From 2000 to 2008, the U.S. trade deficit with China ballooned from $84 billion to $266 billion. China's foreign exchange reserves are now an astounding $2 trillion.
It's not just that exchange rates were (and are) misaligned. American economists have argued that a flood tide of Chinese money, earned from those bulging trade surpluses, depressed interest rates on U.S. Treasury securities and sent investors searching for higher yields elsewhere. That expanded the demand for riskier securities, including subprime mortgages, and pumped up the housing bubble. So China's policies contributed to the original financial crisis, though they were not the only cause. For decades, dollars have lubricated global prosperity. They're used to price major commodities -- oil, wheat, copper -- and to conduct most trade. Countries such as Thailand and South Korea use dollars for more than 80 percent of their exports. The dollar also serves as the major currency for cross-border investments by governments and the private sector. Indeed, governments hold almost two-thirds of their $6.7 trillion in foreign exchange reserves in dollars.
But overreliance on the dollar can also backfire, as it now has. It is not just that countries have suffered declines in exports to a slumping U.S. economy. They've also lost dollar loans needed to finance trade with third countries. "When the crisis hit, U.S. banks cut back on dollar credit lines to foreign borrowers," says David Hu of the International Investment Group, an investment fund specializing in trade finance. The extra loans endorsed at last week's summit aim to offset these losses. Given the dollar's drawbacks, why not switch to something else, as Zhou suggests? The trouble, as even he concedes, is that there's no obvious replacement. The attraction of an international currency depends on its presumed stability, what it will buy and how easy it is to invest. The euro (27 percent of government reserves) and the yen (3 percent) don't yet rival the dollar. As for China, it hasn't made its own currency (the renminbi, or RMB) automatically convertible for Chinese investments.
We're stuck with the dollar standard for a while. To work, it requires that countries with huge trade surpluses reduce the export-led growth that fed the system's instabilities. The Chinese increasingly recognize this. "They're very aware of the need to promote consumer spending," says economist Pieter Bottelier of Johns Hopkins University. In November, China announced a 4 trillion RMB ($586 billion) "stimulus." In addition, says Bottelier, the government is improving health and pension benefits to dampen households' need for high savings. But China also has a default position: promoting exports. It has increased export rebates; engaged in currency "swaps" with trading partners (the latest: $10 billion with Argentina) to stimulate demand for Chinese goods; and stopped the RMB's slow appreciation.
China seems comfortable advancing its economy at other countries' expense. Zhou's pronouncement provides a political rationale for predatory behavior: If we're innocent victims of U.S. economic mismanagement, then we're entitled to do whatever is necessary to insulate ourselves from the fallout. Down this path lies growing mistrust. The larger point is that the world economy is suspended between the lofty rhetoric of last week's summit and the gritty realities of national politics. Protectionism is rising. A World Bank study found that 17 countries in the G-20 have recently adopted discriminatory policies. Though still modest, they "open the door for a lot of other opportunistic measures," says Gary Hufbauer of the Peterson Institute. And the deeper the recession, the greater the danger.
Warren Buffett, champion of bailout, is also leading beneficiary
Billionaire investor Warren Buffett has been lauded for his plainspoken denunciation of the greed and foolishness behind the economic crisis. He's pushed the massive federal bailout of imploding banks as the essential response to an "economic Pearl Harbor." When Buffett speaks, people in high places listen. He's so highly regarded that in a fall debate, both presidential candidates said they'd consider him for Treasury secretary. A Sacramento Bee examination of regulatory records has found that his extensive holdings in financial firms have made Buffett, the world's second-wealthiest person behind Microsoft Chairman Bill Gates, one of the top beneficiaries of the banking bailout.
Just 28 companies received more than 90 percent of the funds so far disbursed to financial firms by the $700 billion Troubled Asset Relief Program. Buffett's company, Berkshire Hathaway, hasn't received any of that federal aid, but Berkshire, based in Omaha, Neb., owns stock valued at more than $13 billion in the top recipients of TARP funds, including Goldman Sachs Group, US Bancorp, American Express and Bank of America, which analysts all thought were in deep trouble before TARP was approved in October. That total, The Bee found, ranks Berkshire fifth among all investors in TARP-assisted companies. Berkshire's TARP holdings constitute 30 percent of its publicly disclosed stock portfolio, and that proportion reflects at least twice as much dependence on bailed-out banks as any other large investor.
Berkshire, for instance, is the largest shareholder in San Francisco-based Wells Fargo, which got $25 billion — 91 percent of the TARP funds invested in institutions headquartered in California. Buffett increased his bank holdings in September, while he was arguing in the media that Congress should approve the bailout to prevent the collapse of the global financial system. "If I didn't think the government was going to act, I would not be doing anything this week," Buffett told CNBC after investing $5 billion in Goldman Sachs. "I am, to some extent, betting on the fact that the government will do the rational thing here and act promptly." The more the bailout props up these financial companies, the more secure Berkshire's and other shareholders' investments in them are.
Berkshire shares have risen sharply with the financial sector stock rally in recent weeks, but they're still down nearly 40 percent since September. In Friday trading, they closed at $92,490 a share. "People can draw their own conclusions" about Buffett's stake in the bailout, said Richard Coppes, an expert in business ethics at the international law firm Jones Day, and a former general counsel of the California Public Employees' Retirement System. "But it shows one reason Buffett is so intensely interested in TARP." Buffett, whose company is also the largest investor in Goldman Sachs and American Express, declined to be interviewed. In a February letter to Berkshire shareholders, he said that without government intervention, the consequences for the economy would have been "cataclysmic."
"Like it or not," he wrote, "the inhabitants of Wall Street, Main Street and the various Side Streets of America were all in the same boat." Experts agree that preserving a functional banking system, TARP's goal, benefits everyone. In dispute is whether the bailout was the fairest and best approach. Some say that large shareholders such as Buffett have been the primary, and perhaps only significant beneficiaries of TARP. Bank stocks have recovered significantly in recent weeks — Goldman's share price has more than doubled since November — and no TARP bank has failed. Critics, however, worry that TARP propped up Wall Street against bankruptcy at the expense of taxpayers. The Treasury Department expected TARP to get loans flowing again, but the market has barely thawed, and unemployment has surged.
Thomas M. Hoenig, the president of the Federal Reserve Bank of Kansas City, recently advocated a government takeover of moribund banks until their balance sheets can be cleaned up. "Shareholders would be forced to bear the full risk of the positions they have taken," Hoenig said, "and suffer the resulting losses." Foreign firms also have gained much from the U.S. bailout. The Bee's examination of federal data found that foreign investment firms hold more than $31 billion in TARP-assisted financial companies. That lends credence to U.S. concerns that some European countries should more forcefully stimulate their own economies. The Europeans agreed to loans and trade guarantees at the G-20 economic summit last week in London, but not to the stimulus package sought by President Barack Obama.
"It shouldn't just be the obligation of the U.S. to bail out the global system," said Richard C. Ferlauto, the governance and pension director for the American Federation of State, County and Municipal Employees, AFL-CIO, whose members' pension assets total more than $1 trillion. "Each country has to step to the plate proportionately." The Bee also found that many of the leading TARP recipient companies cross-own large shares of other TARP banks. Northern Trust received about $1.5 billion in government investments, yet its holdings in other TARP-assisted banks are about four times that amount. State Street got $2 billion, and holds nearly $24 billion in shares of other TARP recipients. Each company has a stake in at least a dozen California banks, large and small, that received TARP funds.
Those commingled interests are partly responsible for the financial meltdown, Ferlauto said. "Ownership interlocks among these large financial institutions meant that no one was willing to rock the boat," he said, in the period leading up to the financial meltdown. "There needs to be a lot more transparency on the part of large financial institutions as to how they act as fiduciaries of other financial companies," he added. "It's collusion of ownership." To be sure, most of the investments by banks in other banks are investments of private clients managed by the banks. Those clients, however, aren't disclosed to regulators — another way that some beneficiaries of the bailout are shielded from public scrutiny.
When told of The Bee's findings, Robert Kuttner, the author of a recent best-seller on the economic crisis, said they reveal a bailout program designed out of public view, and one that "reeks of favoritism and special treatment." "TARP was designed that way," Kuttner said, "to concentrate power with almost no effective oversight. That, to me, is the scandal." The lack of clear criteria for awarding TARP funds continued after the recent change in government, according to Kuttner and other experts. "The Obama administration said it would offer transparency and openness. But the single most important thing they are doing is being done largely behind closed doors, and the design is by, for and in the interest of large banks, hedge funds and private equity companies," he said. "Because there are no explicit criteria, it's very hard to know if a Citigroup or a Goldman got special treatment."
The Bee's findings follow a recent controversy over some Buffett holdings that may have contributed to the economic crisis. Berkshire owns more than 20 percent of Moody's, a top credit rating agency, making it by far the largest stakeholder. Moody's has been faulted for enabling the global crisis by overvaluing mortgage assets. Although Buffett has been outspoken about the need for government intervention in the crisis caused by the mortgage meltdown, he's said nothing publicly about the role of a company in which his firm is a minority holder. Buffett also has decried "credit default swaps" — which are similar to insurance policies, in which mortgage bonds and other financial instruments are insured against default — as "financial weapons of mass destruction." He criticized the profligate use of these unregulated financial tools, or derivatives, widely blamed as a root of the credit collapse.
Yet Berkshire has issued tens of billions of dollars in derivatives. In a letter to shareholders, Buffett justified derivatives as relatively safe and likely to yield vast profits. Leading economists, however, said that Berkshire's credit default swaps are much the same as those that sank American International Group, the insurer at the epicenter of the derivative fiasco. "I assume that (Buffett) is being more responsible than they were," said Dean Baker, the co-director of the Center for Economic and Policy Research in Washington. "But this is a difference in quantity, not quality." Simon Johnson, a professor at MIT's Sloan School of Management and the former chief economist for the International Monetary Fund, said that despite the banking collapse, financial leaders such as Buffett have retained surprising control over the government. "There's this general presumption that Wall Street knows best. But they may not know best for the taxpayer," Johnson said. "We've gotten into the habit of deferring to them a little too much — including Warren Buffett."
Banks as Bidders and Sellers: Financial Nostalgia
So according to the FT, it appears that the banks selling assets will also be able to bid on each other’s assets.
US banks that have received government aid, including Citigroup, Goldman Sachs, Morgan Stanley and JPMorgan Chase, are considering buying toxic assets to be sold by rivals under the Treasury’s $1,000bn (£680bn) plan to revive the financial system.
The plans proved controversial, with critics charging that the government’s public-private partnership - which provide generous loans to investors - are intended to help banks sell, rather than acquire, troubled securities and loans.
I brought this up when the plan was first released, via a marginalrevolutions’ post in that link, but the idea seemed so absurd that I didn’t mention it in any subsequent posts. It is apparently staying, and we need to consider what this will do to the process.
I was out at “Debaser Night”, a 90s-music dance party in San Francisco, with some friends. A riot grrl rock cover bank opened, followed by lots of great singles. I was getting a bit nostalgic. A friend of mine, who used to be on an energy trading desk back in the early 2000s, was listening to me talk about the government plan. He couldn’t believe what I was telling him about letting the banks that are selling auctions also bid on them. In the middle of my explanation, he had his own wave of nostalgia: “Man does that bring back memories….”
Before we go there, what will happen with these banks when they can bid on each other’s assets? Let’s do a thought exercise. Let’s say you are a bidder for Bank A. You know your banking asset is worth $50, and you also know the asset Bank B has is worth $50. You call your buddy up, the trader at B, and make a deal. Happens all the time. You go to bid, and you bid $80 for B’s asset. Then you wait. If B doesn’t come through, you are screwed out a lot of money. And hey, isn’t this wrong? Well, you are pretty sure one of those Rubin-protégé government whiz-kids has given someone who knows someone you know a wink-wink about this. You take a drink, steady the nerves. Then, the bid comes back for your asset - $80 from B. You have each bid up each others assets and traded them. And now the government is screwed. Let’s chart out that payment:
Yup. Bad news. Bank A pays $6.50 for its new asset because of the leverage , and it loses all of that. It also loses the $50 from not having the asset anymore. However it gains $80, net profit - same as Bank B. The government has paid $73.50 for a $50 asset, twice. (See previous for how the levered non-recourse loan turns into a put option.) We tend to call this collusion if you and I did it. No price discovery, no movement of the assets from the banks balance sheet to private investors.
So why did my energy trading friend get all nostalgic? “Because what you are telling me brings back some great memories from what Enron was up to back in the day. All of us energy traders back then watched with our jaws on the floor. 2000 was a hell of a year.”
It is August, 2000. Let’s say you are a trader for Enron. You know your energy in California is worth $50, and you also know the energy that Reliant Energy has is worth $50. You call your buddy up, the trader at Reliant, and make a deal. Happens all the time - you even have a nickname for it, The Daisy Chain Swap. You go to bid, and you bid $80 for Reliant’s energy. Then you wait. If Reliant doesn’t come through, you are screwed out a lot of money. And hey, isn’t this wrong? Well, you are pretty sure one of those Rubin-protégé government whiz-kids has given someone who knows someone you know a wink-wink about this. You take a drink, steady the nerves. Then, the bid comes back for your energy - $80 from Reliant. You have each bid up each others assets and traded them. And now the government is screwed, because it has to pay you $80. Let’s chart out that payment:
You can go ahead and replace an Enron subsidiary for Reliant in that example, as I did in the chart. Enron did, and the banks are probably going to now. My friend was very excited telling me all the strategies Enron deployed - “Forney Perpetual Loop”, “Ricochet”, “Ping Pong”, “Black Widow”, “Red Congo”, “Get Shorty”, the whole works - and how all of them will be reliable guides for gaming the legacy asset market here. Buy assets high, write them down, then pay back with “fees.” Got it. Create SIV to bid up the profits. Brilliant.
What is really exciting, from the evil point of view, is the idea that we are going to get to see one giant, massive, Enron Death Star put into play:
The Death Star strategy (yes, they called it that) was where Enron would take a fee for relieving a congested market of its excess supply by moving it elsewhere. Just like our legacy assets! There are too many of them, it is clogging up trade, let’s get them to someone else who wants them. However Enron would just move the energy in a circle, collecting a fee for not doing what it was supposed to. As their memo famously said, they are paid “for moving energy to relieve congestion, without actually moving any energy or relieving any congestion.” And, it appears, that the large banks are gearing up to do just that; with the Geitner Death Star that they’ll just be collecting a large fee to run them in a circle, without actually moving any of them off their collective books. For old time’s sake, I hope they route their loan bids through Oregon and then Utah before putting them back right where they started.
Mind you that was the electrical grid of California - this appears to be at the scale of the entire financial market. In case you are wondering, traders out there are licking their lips to try and find ways to game this even better than Enron. It appears the public will get to invest in these vehicles too. Direct Democracy in the 21st century means that all of us get to take part in collusion and ripping off taxpayers - we are the ones we’ve been waiting for!
I’m not the biggest Enron junkie - else I would have seen this connection sooner. If any people who know their playbook of strategies want to leave a comment with a move that could be made by the PPIP bidders, I’d be much obliged. And please, tell your representatives to keep the selling banks and their subsidiaries from bidding. I’m still hoping this part is a bad dream
U.S. Treasury Extends Deadline for Public-Private Fund Managers
The U.S. Treasury Department gave investment firms an additional two weeks to apply to become fund managers for the portion of the government’s Public-Private Investment Program that will handle securities. Fund managers now have until April 24 to submit applications, the Treasury said in a statement in Washington. The department said it expects to inform companies of preliminary decisions by May 15. The Treasury also said it will consider opening the program to additional fund managers once the initial process is completed. Today’s guidelines apply to the department’s program for illiquid securities. Treasury Secretary Timothy Geithner last month proposed the effort, which seeks to spur investors to buy -- and banks to sell -- the toxic real-estate assets clogging banks’ books.
Bank of England, ECB, SNB Agree on Currency Swaps to Give Fed Liquidity
The Federal Reserve and four other central banks announced a currency swap arrangement that will give the U.S. central bank access to as much as $285 billion in euros, yen, British pounds and Swiss francs. "Should the need arise, euro, yen, sterling and Swiss francs would be provided to the Federal Reserve via these additional swap arrangements with the relevant central banks," the Fed said in a statement today. "Central banks continue to work together and are taking steps as appropriate to foster stability in global financial markets." The plan, if used, "would enable the provision of foreign currency liquidity" by the Fed to U.S. financial institutions, the U.S. central bank said.
The currency swaps have been authorized through Oct. 30 by the Federal Open Market Committee and are not yet implemented. They mirror the dollar swap lines the Fed has established with 14 other central banks to provide U.S. currency to foreign markets and open a safety valve for U.S. banking institutions that may need access to foreign currency. If drawn upon, the arrangements would let the Fed provide as much as 30 billion pounds ($44 billion), 80 billion euros ($107 billion), 10 trillion yen ($99 billion) and 40 billion Swiss francs ($35 billion), the statement said.
Central bank currency swaps don’t carry exchange-rate risk because the reversal, which could be as long as three months later, uses the same rates, the Fed says. All told, the Fed’s balance sheet reported $308.8 billion in central bank liquidity swaps April 1. Lou Crandall, chief economist at Wrightson ICAP LLC in Jersey City, New Jersey, said the swaps add to the Fed’s capacity to provide liquidity, and don’t appear to point to any immediate constraints in foreign exchange markets. "The statement is clearly not tied to any immediate operations," Crandall said. "It is mainly preemptive."
The real unemployment rate? Try 15.6%
An 8.5% unemployment rate is unmistakably bad. It's the highest rate since 1983 -- a year that saw double-digit unemployment, nearly 30 commercial bank failures and more than 15% of Americans living below the poverty line. But the real national unemployment rate is far worse than the U.S. Department of Labor's March figure, announced today, shows. That's because the official rate doesn't include the 3.7 million-plus people who are reluctantly working only part time because of the poor labor market. And it doesn't include the workers who have given up scouring want ads for seemingly nonexistent jobs. When those folks are added to the numbers, the unemployment rate rises to 15.6%. In March 2008, that number was 9.3%. The Bureau of Labor Statistics began tracking this alternative measure in 1995.
"The situation out there is very grim," says Heather Boushey, a senior economist at the Center for American Progress, a left-leaning think tank. "We have seen the mounting of job losses faster than any point since World War II. I have never seen anything escalate this bad." Even the Department of Labor's expanded unemployment measure doesn't fully capture how difficult the job market is for American workers. It doesn't include self-employed workers whose incomes have shriveled. It doesn't look at former full-time staff employees who have accepted short-term contracts, without benefits, and at a fraction of their former salaries. And it doesn't count the many would-be workers who are going back to school, taking on more debt, in hopes that an advanced degree will improve their chances of landing a job.
Here's another way to look at the unemployment figures: More than 5 million people have lost their jobs since the start of the recession in December 2007. And more than 13 million people are unemployed. That's the highest number the U.S. has seen since it began tracking unemployment after World War II. For every job out there, more than four people are competing for it, says Boushey. Mitch Feldman has seen the results of such intense competition firsthand. As president of New York executive placement firm A.E. Feldman Associates, he has watched lawyers accept paralegal jobs after failing to find any companies that are hiring. He has seen Ivy League-educated financial professionals accept lower-paid contract work after searching in vain for banking jobs.
"When some of the big investment banking firms had layoffs a year ago, those people were looking for permanent jobs," but now they're taking six-month and yearlong contracts, says Feldman. "And they're competing with other contractors who were on contract before. More supply, less demand, and the prices go down." Some unemployed workers have become so frustrated by the difficulty of landing a job that they're exiting the labor market altogether. Prior recessions saw a spike in the number of women choosing to be stay-at-home moms rather than continue to compete for work. This recession has seen a large spike in the number of laid-off men opting to become stay-at-home dads -- or at least stay at home. Once people stop looking for work, they're no longer entitled to unemployment benefits.
The employment situation on the horizon looks even worse. Typically, unemployment peaks six months to a year after the economy starts to recover, says Rebecca Blank, an economist with the Brookings Institution, a Washington, D.C., public policy think tank. Boushey believes the unemployment rate could reach double digits by the end of the year. So, even if the recent stock market rally is a harbinger of economic recovery, that doesn't mean that unemployment rates will fall soon. Nor is an economic recovery a guarantee that unemployment will drop below 4%, as it did during the boom in 2000. The way some economists see it, the U.S. has entered a downward spiral that could result in higher unemployment for the foreseeable future.
Right now, unemployment has helped fuel consumer cutbacks that have, in turn, pinched businesses' revenues. That has forced them to cut jobs in an effort to stem profit losses, continuing the cycle. Eventually, the hope is that government spending will employ more people and give businesses more revenue, leading to more spending and more hiring -- reversing the cycle. But it might not happen that way. Spooked consumers, still reeling from an attack on all their assets, may simply not spend like they once did -- regardless of how much money the government pushes into the economy. Instead, they might save money in preparation for the tax increases they assume are inevitable or put it in safe assets like long-term Treasury bonds.
Businesses might also curb their spending. Instead of responding to sales increases with hiring, they could invest in relatively cheaper technology to replace eliminated positions. Economists don't have to go back very far to find an example of a recovery that didn't push unemployment back to its prior lows. The lowest unemployment fell after the 2001 recession was 4.4% in December 2006 (it hit that number again in March 2007). That was significantly lower than the 6.5% high in 2003. But it wasn't close to the sub-4% rates seen in 2000. That sort of recovery was what economists call a jobless recovery. "We weren't really growing wages and income for people in the bottom half of the economic distribution," says Alan Berube, an economist with the Brookings Institution.
Not time to pause
Japan is in economic freefall. Its reliance on foreign consumer demand means the country has been cut apart by the world recession. Its political leaders must be aggressive in pushing through measures required to kick-start growth and to move it away from its mercantilist economic strategy. With domestic consumers loath to spend and the yen weakened by the carry trade, Japan has relied heavily on exports since the turn of the century. In 2001, exports made up a little over 10 per cent of the country’s output. By summer 2008, they peaked at more than 18 per cent. But Japan’s specialities are whizz-bang electronics, hi-tech machinery and cars. Global appetite for such goods was the first thing to disappear as the world economy started to sour.
The unwinding of the carry trade means that, on a trade-weighted basis, the yen is 20 per cent stronger than last summer. Exports have crashed through the floor, nearly halving in the year to February. New investment has followed it into the abyss. Output fell in the fourth quarter of 2008 by 3.3 per cent, the steepest drop since 1974. The OECD expects a decline of 6.6 per cent in 2009. Inflation is at zero per cent. Unemployment rose to 4.4 per cent in February, up from 4.1 per cent in January. Through this crisis, as before, the Bank of Japan has been overly hesitant. It must reflate the economy; after months of fiddling with micro-cuts in interest rates, it is, finally, edging towards unconventional measures. It must be bolder, and boost the supply of money to the economy by a greater degree. It is time for Japan to return to formal quantitative easing.
The government, on the other hand, now seems to see the depth of Japan’s predicament. It is preparing a further stimulus – its third this year – to be unveiled in April. From the current vague plans, the content seems good; putting money in the wage packets of low earners who have not enjoyed income growth for years is socially fair and will help increase domestic demand. Health and social care are also perfect areas for public investment in an elderly and ageing economy. Taro Aso, the prime minister, had trouble getting budgets through the Diet earlier in the year because of his weak position in the governing coalition. He seems to have done enough to quell this parliamentary mutiny, delaying the need for an election. Japan’s political paralysis has, for the time being, cleared up. But Mr Aso must now be brave and use his authority to push through the stimulus measures he has proposed. Japan can ill afford to wait.
Experts brace for new wave of foreclosures
A new crushing wave of foreclosures is expected to wash through Riverside County's fast-growing suburbs, a second housing bubble that is about to pop, it was reported today. "We have unsustainable debt taken out during the housing bubble and it hasn't popped yet,'' Chris Sorenson, a Temecula-based mortgage and real estate expert, told one local newspaper. The corridor between Perris and Rancho California, and the nearby Moreno Valley area, are poised for a second wave of homeowners to walk away from upside-down condos and houses, the experts said.
In February, the last month for which figures are available, one newspaper reported that a record 1,550 homes in southwest Riverside County entered the foreclosure process, up from 1,441 foreclosures in January, according to ForeclosureRadar, a Northern California real estate tracking firm. Since January 20, at least 16,000 homes in southwest Riverside County have fallen into foreclosure, according to several real estate tracking companies. The first wave of foreclosures was triggered by adjusting subprime loans made during the 2004-2007 boom, the North County Times reported, when buyers with less-than-excellent credit scores got hit.
Now, purchasers with good credit records who bought more house than they can afford are finding their "Alt-A'' and "Option-Adjustable Rate Mortgage'' loans are resetting. Although interest rates are low now, homeowners are finding themselves severely upside-down, and faced with the option of buying a new mortgage for a balance that may be 50 percent more than the house is worth. Rampant unemployment also means many formerly-stellar mortgage holders can no longer qualify to borrow any money, said Bruce Norris, founder of the Norris Group in Riverside. He told the North County Times that the current unemployment rate is almost 12 percent in the Riverside-San Bernardino county area.
How many houses will tumble into foreclosure in the coming months is uncertain but the potential economic disruption is great, said Sorenson, who is being retained by the county to lead a series of classes for owners seeking to avoiding foreclosure. About 337,000 houses in Riverside County were purchased from 2004 to 2007, before prices began to dive. Almost all of them now are worth less than their owners paid for them. The coming wave of foreclosures is a "big problem,'' Mason Gaffney, an economics professor at UC Riverside, told the North County Times. "More banks are going to show up with negative equity.'' Gaffney said that will likely mean a shortage of available commercial loans, which is what businesses need if the economy is to revive.
Moreover, the economics professor told the paper that the crush of foreclosures has damaged the traditional real estate market as potential buyers focus on finding bargains. Nationally, a banking and mortgage system already choking on hundreds of thousands of foreclosures soon will be forced to take in more, the North County Times reported. Figures compiled by the group show that some 700,000 homes across the country stand in what's called a "shadow inventory,'' dwellings that have been taken back by banks but not yet given to an agent. "When you have an adjustable rate and lose your job ... we will have a lot more foreclosures and people leaving the state to find jobs,'' Norris said.
Rattner Rises as Obama's Mr. Fix-It
Steven Rattner arrived in Washington six weeks ago with a reputation as a finance whiz who amassed a fortune on Wall Street. His ability to size up troubled firms, he and others said, was just what President Barack Obama needed to plot a rescue of General Motors Corp. and Chrysler LLC. A look back at his years in New York, though, suggests that a broader blend of skills -- deal maker, Democratic political fund-raiser and networker extraordinaire -- proved crucial in positioning him for the job. Ever since turning down a post in the Clinton Treasury Department, Mr. Rattner, 56 years old, has sought a return to the corridors of power that he first covered as a young newspaper reporter in the Carter years.
Mr. Rattner's recent deal-making experience -- investing in companies at private-equity firm Quadrangle Group LLC, largely in the media industry -- has been mixed. Amid a brutal fund-raising climate, Quadrangle recently delayed plans to raise $2 billion to start a buyout fund. Its media hedge fund folded late last year. Several investments are struggling, including ones in Spanish cable operator Ono and the publisher of men's magazine Maxim. Most private-equity funds have hit hard times during the financial crisis, making Quadrangle no exception. Overall, its performance has outperformed the stock market, according to an investor presentation. The firm scored a coup last year when New York City Mayor Michael Bloomberg selected it to manage his multibillion-dollar fortune.
Mr. Rattner faces a large task: figuring how to rescue the failing GM and Chrysler. He leads a growing auto task force within the administration, numbering a couple of dozen, in charge of one of the most ambitious industrial restructurings ever taken on by the federal government. In four months, the two auto companies have already gobbled more than $17 billion in government aid. Mr. Rattner says the job doesn't require the skills of a turnaround expert. Instead, he says, "this is an investment decision" not unlike the many he made at Quadrangle or earlier, during his years as an investment banker at Lazard Freres & Co. "This job fits as naturally as any with the arc of what I've done during my career," Mr. Rattner said on Friday, sitting at the same table in his corner office at Treasury where, a week earlier, he fired GM Chief Executive Rick Wagoner.
"We have to decide whether to invest a certain number of more billions into these entities," he said. "It is very similar to what we do in private equity. You take a company, you analyze it inside and out, you break down all of its components, you evaluate the management, you evaluate its competitive position -- and you decide whether to invest in it or not." All of the president's calls thus far, including threatening GM and Chrysler with bankruptcy if they can't work out their problems, flowed directly from conclusions presented to the White House by Mr. Rattner and his team, administration officials say. That included the need to oust Mr. Wagoner.
Mr. Rattner grew up in Great Neck, N.Y., on Long Island. After Brown University, where he edited the college newspaper, he took a job as a reporter at the New York Times. After stints in the Washington and London bureaus, he jettisoned a promising journalism career for investment banking. He was tagged as an up-and-comer, first at Lehman Brothers, then Morgan Stanley and finally at Lazard. He ascended to the No. 2 spot at Lazard before leaving to start Quadrangle. Along with three colleagues, he started the firm in March 2000, at the height of the tech bubble. They set up shop in a swank office on a floor of the landmark Seagram's building on Park Avenue. Mr. Rattner was the firm's headliner. One former colleague called him "Quadrangle's brand manager."
Mr. Rattner was already looking at opportunities in Washington. Prominent Washington lawyer Vernon Jordan had introduced him and his wife, Maureen White, to President Clinton and Hillary Clinton on Martha's Vineyard four years earlier. After the 1996 election, Mr. Rattner was offered a senior policy job at the Treasury, which he turned down. He promised his Quadrangle co-founders he would stay at the firm for five more years. To raise Quadrangle's first $1 billion fund, Mr. Rattner turned to the big pension funds, but also tapped his old Lazard clientele, including billionaire telecom investor Craig McCaw; Comcast Corp. President Brian Roberts, and Henry Kravis, co-founder of private-equity firm Kohlberg Kravis Roberts & Co. The firm started slowly, with relatively small investments in publishing and video distribution. It looked at but never closed on two baseball ventures, first involving the New York Yankees' TV network and then in a long brawl over ownership of the Boston Red Sox.
Some early deals, like a minority investment in Cablevision, the New York cable giant, made big profits for Quadrangle. An investment in a company that produced DVDs for exercise guru Richard Simmons and others flopped. The media and communications sectors have been particularly hard-hit by the financial crisis, but Quadrangle's investments are largely in subscription-based rather than advertising-driven businesses, buffering it somewhat against the downturn. Investments that are holding up well include Get AS, a Norwegian cable company, and Hargray, a South Carolina-based rural telecom outfit. The firm's highest-profile loss was a $250 million wrong-way bet on Alpha Media, the publisher of men's magazine Maxim, made in June 2007 at the market peak. Crushed by the declining advertising market, the company recently shut down its other title, music magazine Blender. Quadrangle invested about $90 million of equity and borrowed the rest.
Alpha presents another awkward issue for Mr. Rattner. One of the main lenders in the deal is Cerberus Capital Management LP, the private-equity firm that owns Chrysler and stands to lose a lot of money as a result of Mr. Rattner's decisions in his new job. Cerberus controls a large chunk of Alpha Media's $125 million in senior debt and could end up owning the company. Quadrangle has written down its Alpha investment and is no longer butting heads with Cerberus over the magazine company, say people familiar with the situation. In November, Quadrangle wound down a two-year-old, $500 million media-focused hedge fund struggling with weak performance and investor redemptions. The firm also agreed last year to let the managers of its $3 billion distressed-debt fund, a collection of Mr. Rattner's former Lazard colleagues, buy out Quadrangle's share of the fund. It was a blow to Quadrangle, as private-equity firms view distressed-debt investing as complementary to their core buyout businesses. Joshua Steiner, Quadrangle's co-president, has said the firm gained distressed-investing knowledge working with the team.
The firm's two private-equity funds -- a $1 billion vehicle launched in 2000 and a roughly $2 billion fund started in 2005 -- have posted solid results, delivering net annualized returns of 10.7% and negative 1%, respectively, as of the end of 2008. That outpaces the S&P 500 stock-market index by about 5% and 20%, respectively, over those periods, based on a formula that adjusts for when the investments were made and when profits were returned to the funds' backers. But even as Mr. Rattner helped build Quadrangle, his attention was shifting toward Washington. In 2004, he was an adviser and major fund-raiser for Sen. John Kerry. The Rattners have carved out a role as a Democratic power couple, hosting fund-raisers at their Fifth Avenue apartment overlooking the Metropolitan Museum of Art. They were both major supporters of Mrs. Clinton, and when she lost the primary race to be the Democratic candidate for president, they threw their support behind Mr. Obama.
Roger Altman, a Wall Street financier who was the Treasury Department's point man during the first Chrysler bailout in 1979, says Mr. Rattner is well-suited for his new job. "Steve has a brilliant grasp of finance, and that is the single-most important ingredient here," said Mr. Altman, a longtime mentor who lured Mr. Rattner to Lehman Brothers in 1982. The Obama administration, partly to allay concerns among the United Auto Workers union, first picked union adviser and former investment banker Ron Bloom to lead the auto team. Mr. Rattner was then appointed a week later as head of the task force and has become the effort's most public face. Mr. Bloom remains a key part of the task force. There are signs Mr. Rattner is putting down roots in Washington. He occupies a spacious office in the basement of the Treasury. Out one window, through the thick security bars, he can see Treasury Secretary Timothy Geithner's car, and a portion of the White House. He has rented a condo in Foggy Bottom, a short walk from the White House, though he still flies back to New York on weekends. If his gamble with GM and Chrysler pays off, friends predict that he could move up in the department.
At Quadrangle, Mr. Rattner's former partners will learn this month how its investors feel about a post-Rattner era. Private-equity firms typically call for capital from their investors over time. Mr. Rattner's departure triggers a clause under which investors can stop the firm from making new investments. Though its first fund is fully invested, the firm's second fund, at roughly $2 billion, is still about $500 million uninvested. Mr. Rattner has pleaded with Quadrangle investors, including large pension funds such as the California Public Employees' Retirement System, to stick with it. Mr. Rattner says he has no worries about Quadrangle's future, largely because of the team he left behind. "I have complete confidence that they will continue to build the firm and take it to new heights," he said.
Obama Team's Finances Released
Recently released financial records paint a contrasting picture of the Obama administration: a cabinet composed largely of politicians and government employees who have been on the public payroll for years, and a White House staffed with numerous aides who received substantial compensation over the past year from firms that could have a big stake in administration policies. The financial disclosures follow criticism by President Barack Obama and some of his officials that some financial firms have paid overly generous compensation to their top executives. White House spokesman Ben LaBolt said Sunday that "the president searched the public and private sectors in order to find an experienced team that could bring change to Washington and get our economy back on track. Many of his advisers took large pay cuts and sold substantial assets in order to serve the president at this critical moment for our nation."
Well-paid White House staff include chief economic adviser Lawrence Summers. He earned about $5.2 million from hedge-fund firm D.E. Shaw & Co. in the past year, and received more than $2.7 million in speaking fees from financial firms and other groups. Other White House staff members received generous payments from the private sector, too. National-security adviser James Jones reported $900,000 in salary and bonus from the U.S. Chamber of Commerce, as well as director fees from a number of corporations, including $330,000 from Boeing Co. and $290,000 from Chevron Corp. His deputy, Tom Donilon, earned $3.9 million as a partner at the law firm O'Melveny & Myers LLP, where his clients included Citigroup Inc., Goldman Sachs Group Inc. and Obama fund-raiser and hotel heiress Penny Pritzker. Mr. Donilon was formerly a top official at government-backed mortgage finance company Fannie Mae, which has received large amounts of financial assistance from the U.S. government.
Carol Browner, assistant to the president for energy and climate change, disclosed $450,000 in "member distribution" income, plus retirement and other benefits, from The Albright Group, a consulting firm whose principals include former Secretary of State Madeleine Albright. Ms. Browner's financial disclosure indicates that she has resigned from the firm and will receive a $369,000 payout over three years, based on a longstanding company formula. White House Social Secretary Desiree Rogers collected more than $1 million for her work as president of two gas companies for part of 2008. Later, she earned a $350,000 salary from Allstate Financial as president of its social-networking division, and $150,000 in board fees from Equity Residential, a real-estate investment trust in which she also holds at least $250,000 in stock.
The 16-person Obama cabinet, by contrast, includes a large number of former governors and lawmakers who haven't made much more than their official salaries for years. Among them are Vice President Joe Biden, who had among the lowest net worth of any senator when he served in the U.S. Senate; Treasury Secretary Timothy Geithner, a former Federal Reserve official; and Interior Secretary Ken Salazar, a former U.S. senator from Colorado and state attorney general. Agriculture Secretary Tom Vilsack was a former Iowa governor; Labor Secretary Hilda Solis was a member of Congress; and Kathleen Sebelius, the nominee for Health and Human Services secretary, is now governor of Kansas. Others include housing secretary Shaun Donovan, a former New York City housing commissioner; Transportation Secretary Ray LaHood, a former congressman; Education Secretary Arne Duncan, a former Chicago schools head; and Homeland Security Secretary Janet Napolitano, a former Arizona governor.
Some of Mr. Obama's cabinet members are financially well off, including Secretary of State Hillary Clinton and Commerce Secretary Gary Locke, a former Washington governor and international trade lawyer. And many of the president's White House staff had relatively modest incomes before joining the White House staff. One possible explanation for the predominance of former public servants in the cabinet is the greater ease they generally enjoy in gaining Senate confirmation; senior White House staff members typically don't require confirmation. Mr. LaBolt, the White House spokesman, rejected that idea: "Not at all," he said. Julian Zelizer, a history and public-affairs professor at Princeton University, said that in the midst of a financial crisis, the administration wants an inner circle of policy advisers "who can think and talk like Wall Street," whereas "for the cabinet, you want people who can sell ideas to the public and Congress, so governors and legislators are better for the job." White House aides also must abide by strict rules against conflicts of interest. Mr. Summers, for example, has severed all ties to his former employer and would be barred from working on matters directly affecting D.E. Shaw, a senior administration official said, but he remains an active adviser on broad financial policies because of his depth of knowledge and experience.
Brooksley Born: Prophet and Loss
Brooksley Born warned that unchecked trading in the credit market could lead to disaster, but power brokers in Washington ignored her. Now we're all paying the price.
Shortly after she was named to head the Commodity Futures Trading Commission in 1996, Brooksley E. Born was invited to lunch by Federal Reserve chairman Alan Greenspan. The influential Greenspan was an ardent proponent of unfettered markets. Born was a powerful Washington lawyer with a track record for activist causes. Over lunch, in his private dining room at the stately headquarters of the Fed in Washington, Greenspan probed their differences. "Well, Brooksley, I guess you and I will never agree about fraud," Born, in a recent interview, remembers Greenspan saying. "What is there not to agree on?" Born says she replied. "Well, you probably will always believe there should be laws against fraud, and I don’t think there is any need for a law against fraud," she recalls. Greenspan, Born says, believed the market would take care of itself.
For the incoming regulator, the meeting was a wake-up call. "That underscored to me how absolutist Alan was in his opposition to any regulation," she said in the interview. Over the next three years, Born, ’61, JD ’64, would learn first-hand the potency of those absolutist views, confronting Greenspan and other powerful figures in the capital over how to regulate Wall Street. More recently, as analysts sort out the origins of what has become the worst financial crisis since the Great Depression, Born has emerged as a sort of modern-day Cassandra. Some people believe the debacle could have been averted or muted had Greenspan and others followed her advice. As chairperson of the CFTC, Born advocated reining in the huge and growing market for financial derivatives. Derivatives get their name because the value is derived from fluctuations in, for example, interest rates or foreign exchange. They started out as ways for big corporations and banks to manage their risk across a range of investments. One type of derivative—known as a credit-default swap—has been a key contributor to the economy’s recent unraveling.
The swaps were sold as a kind of insurance—the insured paid a "premium" as protection in case the creditor defaulted on the loan, and the insurer agreed to cover the losses in exchange for that premium. The credit-default swap market—estimated at more than $45 trillion—helped fuel the mortgage boom, allowing lenders to spread their risk further and further, thus generating more and more loans. But because the swaps are not regulated, no one ensured that the parties were able to pay what they promised. When housing prices crashed, the loans also went south, and the massive debt obligations in the derivatives contracts wiped out banks unable to cover them. Back in the 1990s, however, Born’s proposal stirred an almost visceral response from other regulators in the Clinton administration, as well as members of Congress and lobbyists. The economy was sailing along, and the growth of derivatives was considered a sign of American innovation and a symbol of the virtues of deregulation. The instruments were also a growing cash cow for the Wall Street firms that peddled them to eager takers.
Ultimately, Greenspan and the other regulators foiled Born’s efforts, and Congress took the extraordinary step of enacting legislation that prohibited her agency from taking any action. Born left government and returned to her private law practice in Washington. "History already has shown that Greenspan was wrong about virtually everything, and Brooksley was right," says Frank Partnoy, a former Wall Street investment banker who is now a professor at the University of San Diego law school. "I think she has been entirely vindicated. . . . If there is one person we should have listened to, it was Brooksley." Speaking out for the first time, Born says she takes no pleasure from the turn of events. She says she was just doing her job based on the evidence in front of her. Looking back, she laments what she says was the outsized influence of Wall Street lobbyists on the process, and the refusal of her fellow regulators, especially Greenspan, to discuss even modest reforms. "Recognizing the dangers . . . was not rocket science, but it was contrary to the conventional wisdom and certainly contrary to the economic interests of Wall Street at the moment," she says.
"I certainly am not pleased with the results," she adds. "I think the market grew so enormously, with so little oversight and regulation, that it made the financial crisis much deeper and more pervasive than it otherwise would have been." Greenspan, who retired from the Fed in 2006, acknowledged in congressional testimony last October that the financial crisis, which he described as a "once in-a-century credit tsunami," had exposed a "flaw" in his market-based ideology. He says Born’s characterization of the lunch conversation she recounted does not accurately describe his position on addressing fraud. "This alleged conversation is wholly at variance with my decades-long held view," he said in an e-mail, citing an excerpt from his 2007 book The Age of Turbulence, in which he wrote that more government involvement was needed to root out fraud. Born stands by her story. Robert Rubin, who was treasury secretary when Born headed the CFTC, has said that he supported closer scrutiny of financial derivatives but did not believe it politically feasible at the time.
A third regulator opposing Born, Arthur Levitt, who was chairman of the Securities Exchange Commission, says he also now wishes more had been done. "I think it is fair to say that regulators should have considered the implications . . . of the exploding derivatives market," Levitt told STANFORD. In a way, the battle had the look and feel of a classic Washington turf war. The CFTC was created in the ’70s to regulate agricultural commodities markets. By the ’90s, its main business had become overseeing financial products such as stock index futures and currency options, but some in Washington thought it should stick to pork bellies and soybeans. Born’s push for regulation posed a threat to the authority of more established cops on the beat. "She certainly was not in their league in terms of prominence and stature," says a lawyer who has known Born for years and requested anonymity to avoid appearing critical of her. "They probably thought, ‘Here is a little person from one of these agencies trying to assertively expand her jurisdiction.’"
Some of the other regulators have said they had problems with Born’s personal style and found her hard to work with. "I thought it was counterproductive. If you want to move forward . . . you engage with parties in a constructive way," Rubin told the Washington Post. "My recollection was . . . this was done in a more strident way." Levitt says Born was "characterized as being abrasive." Her supporters, while acknowledging that Born can be uncompromising when she believes she is right, say those are excuses of people who simply did not want to hear what she had to say. "She was serious, professional, and she held her ground against those who were not sympathetic to her position," says Michael Greenberger, a Washington lawyer who was a top aide to Born at the CFTC. "I don’t think that the failure to be ‘charming’ should be translated into a depiction of stridency." Others find a whiff of sexism in the pushback. "The messenger wore a skirt," says Marna Tucker, a Washington lawyer and a longtime friend of Born. "Could Alan Greenspan take that?"
Greenspan dismisses the notion that he had problems with Born because she is a woman. He points out that when he took a leave from his consulting firm in the 1970s to accept a job in the Ford administration, he placed an all-female executive team in charge. It was not the first time that Born, 68, had pushed back against convention. Her doggedness over a career spanning more than 40 years propelled her into the halls of power in Washington. She was a top commercial lawyer at a major firm, as well as a towering figure in the area of women’s rights, and a role model for women lawyers. She was on Bill Clinton’s short list for attorney general. One of seven women in the Class of 1964 at Stanford Law School, she graduated at the top of her class, and was elected president of the law review, the first woman to hold either distinction. She is credited with being the first woman to edit a major American law review. In the early 1970s, at a time when women had few role models at major law firms, she became a partner at the Washington, D.C., firm of Arnold & Porter, despite working part time while raising her children.
She helped establish some of the first public-interest firms in the country focused on issues of gender discrimination. She helped rewrite American Bar Association rules that made it possible for more women and minorities to sit on the federal bench, and she prodded the group into taking stands against private clubs that discriminated against women or blacks. She was used to people trying to push her around, or being perceived as a potential troublemaker. She remembers being shouted down during an ABA meeting in the 1970s when she proposed that the organization take a position supporting equal rights for gay and lesbian workers. A former ABA president stood up and said, "that the subject was so unsavory that it should not be discussed . . . and was not germane to the purposes of the ABA," she recalls. She lost that fight, although the group reversed its stand years later. "She looks at things not just from a technical perspective or the perspective of an insider. She looks at the perspective of outsiders and how people without power are going to be affected," says Esther Lardent, a Washington lawyer who worked with Born on various ABA matters. "That is a theme constantly running through her life and career." "She is a very polite and low-key person but she is never somebody who steps back from a disagreement or a fight if it is a matter of importance to her," Lardent adds. "Did that make people uncomfortable? Did that make the men who dominated the leadership fail to take her seriously enough? I am sure that was the case."
She was born in San Francisco. Her mother, an English teacher, and her father, the head of the city’s public welfare department, were both Stanford graduates. An early mentor was her mother’s best friend from Stanford, Miriam E. Wolff, JD ’40, who became a deputy state attorney general and judge and the first woman to ever head a major port. Born entered Stanford with the thought of being a doctor, but switched majors after a career counselor interpreted her answers on a series of vocational tests. In those days, women were assessed for their interest in nursing or teaching, men for the professional jobs, including law and medicine. The tests were even color coded—pink for women, blue for men. Born says she insisted on taking both. Her mother, who had a master’s degree in psychology, felt that was the only way her daughter’s professional interests could be evaluated properly. She scored high on being a doctor—and low on being a nurse. But rather than suggest she pursue a career as a physician, the counselor said the test proved that her interest in medicine was not genuine and that she was really only interested in making a lot of money. Born quit premed and majored in English.
"It was a turning point. What can I say? I was 18 years old. I didn’t know any better," Born says. "Unfortunately, I was, you know, a member of the society as it was then. I was hurt by the advice, and kind of believed in it. I don’t believe in it now. It is ridiculous in retrospect." A decade later, one of the public-interest firms she founded challenged the tests as discriminatory. Law school was welcoming and intellectually stimulating, even if some people were still getting used to the idea of having women around. Male law students got their own dormitory; women were left to make their own housing arrangements in off-campus boarding houses or apartments. "I also had . . . one student in my class tell me I was taking the place of a man who had to go to Vietnam and was risking his life because of me, which was sobering to say the least," she recalls. Making a mark in the classroom could also be a challenge. Some professors refused to call on women, thinking it rude or unbecoming. She remembers an episode in her first year when her professor appeared to have the class stumped after quizzing several men about a problem. "The little girl has it!" she recalls the professor declaring, after she blurted out the right answer.
"I was very worried that I would not do well and that I would disgrace myself, and women," Born says. "I worked very hard during my first year because I was afraid I would flunk out." In those Darwinian times in law schools, that was not an idle concern: professors tried to weed out all but the most qualified students, and about a third were dismissed from school after the first year. That would not be her fate. "She was off the charts," says Pamela Ann Rymer, JD ’64, a judge on the federal appeals court in Pasadena. "Brooksley never wore it on her sleeve. She is not quiet, but she is a very unpretentious kind of person, just plainly and obviously with a brilliant mind." Despite her grades, Born was passed over for a clerkship on the U.S. Supreme Court, the most coveted opportunity for a young lawyer. Stanford’s top students were good candidates for the clerkships, but a faculty committee decided to recommend two men for the positions even though Born had a superior academic record. It was a bitter introduction to a gender-biased legal culture. "They were sure I would understand that it would be unseemly for women to be clerks on the Supreme Court," she says of the committee members. "I felt very disappointed and angry."
Undaunted, she headed to Washington, and arranged an interview on her own with Arthur Goldberg, then one of the most liberal members of the high court. Goldberg would not hire her either but recommended her to a judge on the federal appeals court in Washington. Henry Edgerton, who wrote an opinion that became a basis for the landmark Supreme Court decision in the Brown v. Board of Education school desegregation case, gave her a clerkship. (Law school professor emerita Barbara Babcock also clerked for Edgerton.) A year later, taken with the Washington scene and its place on the front lines of the civil rights movement, Born scrapped plans to return to San Francisco. "I wanted in," she says. Arnold & Porter, a firm with a liberal tradition of public service, offered her a job, and she started work the same day that a former name partner of the firm, Abe Fortas, was sworn in as a justice of the Supreme Court. The firm was one of a few that were beginning to hire women and treat them on par with men. But there were challenges, especially for those interested in a career and a family. Many firms up to that point refused to hire women who were married or who were interested in children.
The lone woman partner at Arnold & Porter at the time was married to Fortas and was renowned for her "misanthropic toughness," including a preference for "thick cigars," according to Charles Halpern, an associate with Born at the firm in the 1960s. "Our swimming pool has two deep ends," Halpern recalls her once saying, "so that people aren’t tempted to drop by with their small children for a swim on a hot summer day." Born soon faced a difficult choice. She took a one-year leave when her then-husband got a Nieman fellowship at Harvard, where her first child was born. Returning to Washington, she tried to juggle full-time work and child rearing but it quickly became apparent that the arrangement didn’t work. "I went to the partner I was working with the most and said I just didn’t think I could do this," she says. "I thought I had to resign." To her surprise, the partner suggested she work three days a week with the understanding she would not be considered for partner until she returned full time. In 1974, when she had a 4-year-old and a 2-year-old, she was still working part time. The firm promoted her anyway. The family-friendly development was a stunning breakthrough at a time when law firms were focused on billable hours and the bottom line, and little else. It further raised her profile.
"When I met her I was in awe of her because the idea that she could be a partner in that firm was just unbelievable," says Tucker, her longtime friend. The women bonded after being asked to teach a course on women and the law at two Washington-area law schools, and being horrified at what they found during their research. "We were surprised to find the degree to which discrimination was embodied in the law," Born says. "It was a real consciousness-raising experience." Lawyer Marcia Greenberger sought out Born in the 1970s when she was named to start a new women’s rights project in Washington. Born agreed to chair an advisory board for the project, and became a guiding force, mentor and opener of doors, leveraging her contacts and credibility, Greenberger says. One of the first broad-based challenges to how universities were implementing Title IX—the 1972 law requiring equal programs and activities for women and men—was brought after Born passed along the name of a colleague who was incensed at the poor athletic facilities his daughter was forced to use at her school. Born also helped win Ford Foundation grants that enabled the project to hire its second lawyer. What is now called the National Women’s Law Center today has a staff approaching 60 and a budget of almost $10 million. Born remains chair of its board of directors.
Clinton named her to head the CFTC in 1996. She was not without experience: at Arnold & Porter she had represented the London Futures Exchange in rule making and other matters before the commodities agency. She also knew how markets could be manipulated, having represented a major Swiss bank in litigation stemming from an attempt by the Hunt family of Dallas to corner the silver market in the 1980s. "Brooksley had the advantage of knowing the law and understanding the fragility of the system if it weren’t regulated," says Michael Greenberger, her former adviser at the CFTC. "She could see that the data points, by lack of regulation, were heading the country into a serious set of calamities, each calamity worse than the one before." Under a Republican predecessor, the CFTC had in 1993 largely exempted from regulation more exotic derivatives that involved just two parties. The thinking was that sophisticated entities negotiating individually tailored derivatives could look out for themselves. More generic derivatives still had to be traded on exchanges, which were subject to regulation. By 1997, the over-the-counter derivatives market had more than doubled in size, by one measure, reaching an estimated $28 trillion, based on the value of the instruments underlying the contracts. (It has now reached an estimated $600 trillion.)
And some cracks were already surfacing in the landscape. Several customers of Bankers Trust, including Procter & Gamble, sued for fraud and racketeering in connection with several OTC derivative deals. Orange County, Calif., had gone bankrupt in part because of an OTC derivative-trading scheme gone awry. What is more, all the growth had taken place at a time of economic prosperity. Some people were beginning to ask what would happen if the market suffered a major reversal. "The exposures were very, very big and if it was your job to worry about things that could go wrong, and I think it was, this is one of the things you couldn’t help but notice," says Daniel Waldman, a Washington lawyer who was the CFTC general counsel under Born. "It was only your blind faith in the participants that could give you much comfort because you really did not know much about the real risks." "There was no transparency of these markets at all. No market oversight. No regulator knew what was happening," Born says. "There was no reporting to anybody." She chose what she thought was a middle ground, circulating a draft "concept release," to regulators and trade associations, which was intended to gather information about how the markets operated. She and her staff suspected the industry was trying to exploit the earlier regulatory exemption.
But even the modest proposal got a vituperative response. The dozen or so large banks that wrote most of the OTC derivative contracts saw the move as a threat to a major profit center. Greenspan and his deregulation-minded brain trust saw no need to upset the status quo. The sheer act of contemplating regulation, they maintained, would cause widespread chaos in markets around the world. "We would go to conferences and it would be viciously attacked," Waldman says. "They would just be stomping their feet and pounding the tables." With Born unlikely to change her mind, the industry focused on working through the other regulators. Born recalls taking a phone call from Lawrence Summers, then Rubin’s top deputy at the Treasury Department, complaining about the proposal, and mentioning that he was taking heat from industry lobbyists. She was not dissuaded. "Of course, we were an independent regulatory agency," she says.
The debate came to a head April 21, 1998. In a Treasury Department meeting of a presidential working group that included Born and the other top regulators, Greenspan and Rubin took turns attempting to change her mind. Rubin took the lead, she recalls. "I was told by the secretary of the treasury that the CFTC had no jurisdiction, and for that reason and that reason alone, we should not go forward," Born says. "I told him . . . that I had never heard anyone assert that we didn’t have statutory jurisdiction . . . and I would be happy to see the legal analysis he was basing his position on." She says she was never supplied one. "They didn’t have one because it was not a legitimate legal position," she says. Greenspan followed. "He maintained that merely inquiring about the field would drive important and expanding and creative financial business offshore," she says. CFTC economists later checked for any signs of that, and came up with no evidence, Born says.
"It seemed totally inexplicable to me," Born says of the seeming disinterest her counterparts showed in how the markets were operating. "It was as though the other financial regulators were saying, ‘We don’t want to know.’" She formally launched the proposal on May 7, and within hours, Greenspan, Rubin and Levitt issued a joint statement condemning Born and the CFTC, expressing "grave concern about this action and its possible consequences." They announced a plan to ask for legislation to stop the CFTC in its tracks. At congressional hearings that summer, Greenspan and others warned of dire consequences; Born and the CFTC were cast as a loose cannon. Reverting to a theme Born claims he raised at their earlier lunch, Greenspan testified there was no need for government oversight, because the derivatives market involved Wall Street "professionals" who could patrol themselves. Summers, Rubin’s deputy (and now director of the National Economic Council), said the memo had "cast the shadow of regulatory uncertainty over an otherwise thriving market, raising risks for the stability and competitiveness of American derivative trading."
Born assailed the legislation, calling it an unprecedented move to undermine the independence of a federal agency. In eerily prescient testimony, she warned of potentially disastrous and widespread consequences for the public. "Losses resulting from misuse of OTC derivatives instruments or from sales practice abuses in the OTC derivatives market can affect many Americans," she testified that July. "Many of us have interests in the corporations, mutual funds, pension funds, insurance companies, municipalities and other entities trading in these instruments." That September, seemingly bolstering her case, the Federal Reserve Bank of New York was forced to organize a rescue of a large private investment firm, Long Term Capital Management, which was a big player in the OTC derivatives market. Fed officials said they acted to avoid a meltdown that could have impacted the wider economy. But the tide of opinion that had risen up against Born was irreversible. Language was slipped into an agriculture appropriations bill barring the CFTC from taking action in the six months left in her term. "I felt as though that, at least, relieved me and the commission of any public responsibility for what was happening," she says. Clinton aides sounded her out about a second term, but she said she wasn’t interested and left the agency in June 1999. A year later, Congress enacted the Commodity Futures Modernization Act, which effectively gutted the ability of the CFTC to regulate OTC derivatives. With no other agency picking up the slack, the market grew, unchecked.
Some observers say now the episode and infighting showed how even a decade ago a patchwork system of regulating Wall Street was badly in need of reform. "The fact that the . . . issue created such a threat to the marketplace to me confirmed the fact that something was not right," says Richard Miller, a lawyer and editor of a widely read newsletter on derivatives. "How could we have a system that hangs together by such a narrow thread?" Miller testified at the time that the idea Born proffered should at least have been considered. The Obama administration has pledged an overhaul of the financial system, including the way derivatives are regulated. Worrisome to some observers is the fact that his economic team includes some former Treasury officials who were lined up in opposition to Born a decade ago. Born, who retired from her law firm in 2003, is not playing a formal role in the process. An outdoor enthusiast, she was planning a trip to Antarctica this winter, as the Obama team was settling in. "The important thing," she advises, "is that the new administration should not be listening to just one point of view."