Old Corner Bookstore, first brick building in Boston, Massachusetts
Ilargi: I realized after posting yesterday's list of questions that these things can be fun, and informative too. So I decided to list institutions and people that nned to either disappear entirely or seriously have their wings clipped if we ever wish to make a first step towards functioning democratic and economic systems in our societies. Of course there's no way I can be complete -and I'm not trying-, if only because I’m mostly focused on where I live, North America. But that's not just alright, it's more than fine. Just as with the PPIP plan, it's a feature, not a bug. In this case it means you get to nominate your own ready-for-renovation and/or condemnation parties.
- Freddie Mac
- Fannie Mae
- Goldman Sachs
- Morgan Stanley
- General Motors
- Archer Daniels Midland
- Robert Rubin
- Larry Summers
- Tim Geithner
- Ben Bernanke
- Sheila Bair
- Dick Cheney
- Benedict XVI
- Mark Carney
- Silvio Berlusconi
- Gordon Brown
Moody's Downgrades All Local US Governments
Moody’s Investors Service assigned a negative outlook to the creditworthiness of all local governments in the United States, the agency said Tuesday, the first time it had ever issued such a blanket report on municipalities. The report signaled how severely the economic downturn was affecting towns, counties and school districts across the nation. While Moody’s regularly reports on the financial strength of various sectors of private industry, its analysts have in the past considered America’s tens of thousands of towns and local authorities too diverse for generalizations. The report suggests that the ratings of many governments could be downgraded in the coming months, something that would make it more expensive for them to borrow money to finance their operations.
In the most extreme cases, municipalities might default on some of their obligations, as Jefferson County, Ala., has been threatening to do for a number of months. Vallejo, Calif., declared bankruptcy last year and is being closely watched to see if it will set a legal precedent that other towns could follow. Moody’s did not report on individual cities or towns, but its overview offered a general note of caution for investors who have bought municipal bonds seeking a safe stream of income in difficult financial markets. In a special report made public on Tuesday, the agency cited revenues that are falling almost everywhere as a result of the economic downturn. But it also discussed the problems some municipalities had created for themselves by using complex financial products that seemed to be saving money at first, only to send costs soaring during the credit crisis.
In former boom states like California and Florida, the sharp decline in housing prices is translating into falling property-tax revenue, while in towns in Michigan, Indiana and Ohio, revenues are off because of the collapse of the auto industry. Many local governments in New York, New Jersey and Connecticut will lose significant revenue because they rely on the banking and financial services sectors for their tax bases. Moody’s said any municipality relying heavily on tourism, gambling or manufacturing was probably at risk of feeling a pinch. The report suggested conflicts ahead between taxpayers struggling to keep their own households afloat and elected officials charged with balancing budgets, making their payrolls and protecting their credit ratings. “Taxpayers, worried about their own financial condition, are more resistant than ever to increasing property or other local taxes,” the report observed.
The report’s publication coincided with the downgrading by Moody’s of the credit of the State of Illinois to the A level from double-A. Moody’s said Illinois was having difficulty managing its cash, and in recent weeks had been trying to push its scheduled pension contributions into the future. The state pension fund is already seriously underfunded. The Federal Reserve chairman, Ben S. Bernanke, warned that local governments had probably lost their ability to lower their borrowing costs by linking their bonds to derivatives. Such bond packages had become popular in the last few years because they appeared to offer cities both the lower borrowing costs of variable-rate bonds and the predictability of fixed-rate bonds. But the structures broke down during last year’s market turmoil, leaving some municipalities staggering under more debt than they can afford.
Mr. Bernanke said he was aware that some governments with low credit ratings were completely shut out of the short-term financial markets, while others were stuck with a type of derivative called interest-rate swaps that no longer made sense for them. Mr. Bernanke offered his remarks in a letter to members of Congress who had asked the Fed to create a facility to breathe new life into segments of the municipal bond market that were still paralyzed. But Mr. Bernanke said municipal debt had “unique characteristics” that made it “unlikely” that the Fed could be of much help. He suggested that instead, Congress could consider setting up some other form of assistance for municipalities unable to restructure or refinance their debt, like a federal bond reinsurance program. The bond markets took the Moody’s report in stride on Tuesday, apparently because institutional investors were already familiar with the problems described. New York City brought bonds to market on Tuesday and ended up selling much more than initially planned. “New York City is potentially a poster child for economic woe, but that didn’t seem to bother investors,” said Thomas G. Doe, president of Municipal Market Advisors. The Moody’s report “creates headline risk and a lot of confusion for investors,” he said, “but it’s not a sounding of the alarm for default.”
Twitter: A night with the bears
Sprott, Roubini, Whitney and others offer advice to investors
On Tuesday night, we tried a little experiment — use Twitter to cover A Night With The Bears at Toronto's Lord Elgin Theatre. Put on by Sprott Asset Management, the event put four of the world's most pessimistic market watchers — Eric Sprott, Meredith Whitney of Meredith Whitney Advisory Group, Nouriel Roubini of New York University and Ian Gordon, author of The Long Wave Analyst newsletters — in the same room to share their views on the economy and the markets. For those not familiar with Twitter, it's a website that allows you to broadcast your thoughts 140 characters at a time. Anyone can create an account at www.twitter.com, and create a list of friends and colleagues to follow. Here are the tweets (the term for each update) that ensued, taken directly from my Twitter account
• Heading out with ace reporter Brian Milner. Not depressed yet!
• Fancy elevator worked by hand at Elgin Theatre, woo!
• Bar service to reporters sitting in their chairs•! Oo la la.
• Press conference delayed, they must be busy bearing things up.
• No statements, bears right into questions.
• Roubini: No growth in economy for two years. Really easing into the gloom.
• Roubini: world has converged on my worst case numbers.
• Whitney: Not fair to ask about BofA CEO. He's a good CEO basically. Too disruptive to fire him.
• Freelancer congratulates bears on their 'good' calls over last year.
• Roubini: Zombie banks!
• Whitney: Mortgage relationships are monogamous.. I don't know what that means, but sounds important.
• Roubini: recovery will be weak and shallow. PS, CDN economy fundamentals are strong.
• Reporter asks if Roubini is ever happy with life in general. He says yes, and then glares at reporter.
• Sprott sees economy bottoming in 10 to 20 years. Now THAT is bearish!
• Press conference ends, panellists ready to freak out 1,500 audience members.
• As a complete aside, this is one well-dressed and attractive crowd.
• From Milner: everyone received a ticket on arriving.. Gold, silver, black. Tells you where to sit (and what Sprott thinks of you?)
• Sprott: bears more correct, logical and brave.
• Another aside, Eric Sprott is really, really tall.
• Whitney: banking system sounded fabulous when she started career. But, not so much now.
• Whitney: shadow banks! Trillions in loans! And that's saying nothing about credit cards. To get out - break market share of 5 big lenders.
• For a bear, Whitney says 'fabulous' an awful lot. Ps - "none of you know financials like we do," she says.
• Whitney: you will see credit ripped out of people's wallets. 10 million more will lose homes.
• Whitney: Credit card $4.2 trillion outstanding. If you cut credit, it is a pay cut. Everyone this room will have credit reduced. Bearish!
• Can't decide if the guffawing is gallows humour or a result of open bar. Uh oh, here comes Roubini. Laugh time is over!
• Roubini: forget v recovery. Maybe a U. Or an L. Only thing certain - optimists are knuckleheads (I'm paraphrasing)
• Roubini: USA looks bad, rest of world looks worse. Guffawing has tapered off. Also calls it a possible near recession.
• Roubini: only thing not collapsing is govt spending.
• Roubini: use quantitative easing. Do fiscal stimulus. Take radical action on banks and homes. When insolvent, fold. Start over.
• Roubini: this a bear market rally. Market has predicted six of the last zero recoveries, he says. Guffaws are back!
• Roubini: half of hedge funds go bust by next year.
• Roubini leaves on high note, jokes about light at end of tunnel... And hopefully it is not the train (har har)
• Whitney and Roubini done. Lots of people leave ahead of Gordon and Sprott.
• Gordon: starts with chart. Explains theory. My neighbours look confused. Everyone waits for his trademark 'Dow will hit 1000' line.
• Gordon: I saw this coming a lonnnnnnnnng time ago. What's more, It was easssssssy to predict. Also, this will be worse than depression.
• Gordon: Depression! Depression! Also, this is a depression.
• Gordon has called for so many things to collapse, 140 characters seems woefully inadequate. Summary: everything will collapse. Everything!
• There we go: Gordon calls for Dow 1000, says to buy gold.
• Sprott: I don't know if I can take any more of this. His good news: after QA, bar will be open.
• Sprott: if someone offered me BCE place for a dollar, I would not buy it because it would bankrupt me.
• Sprott: capital ratios aren't worth anything. Ignore that noise. It is not a depression, it is a collapse.
• Sprott: derivatives will melt the system.
• Sprott: how to survive. Short market. Buy bullion. Look at agriculture.
• Roubini would buy China etf. Gordon buy japan. Sprott south africa. Whitney says any mineral rich, politcally stable country.
• First questioner from audience takes opportunity at mic to compliment BNN host/mc Kim Parlee (I'm your biggest fan!!)
• That's a good place to end, Twitterland. Bonne nuit - bonne nuit to you all.
• Parting gifts: Sprott sales literature, Sprott pamphlet, Sprott chocolate wrapped in gold (with a sprott logo).
Kotlikoff: Scrap the Summers-Geithner plan
It's one thing for the US Treasury Department to overpay banks for their toxic assets on the prayer that bank shareholders will do something besides pocket it - something that will help the economy. It's another thing to set up a complex leveraged auction scheme to surreptitiously make the transfer. And it's yet a third thing to set up a scheme that will lead the banks to overbid for their own toxics to garner even larger windfalls and end up with the toxics still in their hands.
Suppose the government tells the market that it will match dollar for dollar bids to buy a toxic asset called Troubled from Seamy Bank. Absent the subsidy, Troubled would be worth $1 billion - only 20 percent of its $5 billion face value. With the subsidy, bidders will offer $2 billion since their net cost is just $1 billion, which is Troubled's true value. Seamy Bank's profit from the "sale" equals $1 billion (the $2 billion it receives less the $1 billion it hands over in the form of surrendering title to Troubled.) But suppose Seamy Bank isn't happy with getting just $1 billion for free and sets up a special investment vehicle called Rescue Inc. Rescue bids $5 billion (the assumed maximum bid). It does so by putting up $2.5 billion of its own money and using $2.5 billion provided courtesy of Uncle Sam's subsidy. But where does Rescue get the $2.5 billion? From Seamy. Seamy gives Rescue $2.5 billion, but takes in $5 billion, so its profits are $2.5 billion. And we the taxpayers are bilked for $2.5 billion rather than simply $1 billion.
Since raising its bid doesn't cost it anything, Seamy will bid as much as it can. Troubled can be worth nothing, and Seamy will still bid the maximum $5 billion and pocket $2.5 billion. The real icing on the cake is that Seamy still ends up owning Troubled, but via its subsidiary Rescue. Once Troubled is back on Seamy's books, Seamy can "sell" it again and pocket another $2.5 billion. It's possible that some fine print in the plan by Lawrence Summers, director of National Economic Council, and Treasury Secretary Timothy Geithner of the toxic-owning banks would preclude explicit hyper-self-dealing of the type just described. But when there is free money on the ground, people on Wall Street figure out ways to pick it up. What we need is trust and transparency.
Those banks that are insolvent based on market values of their assets should be taken over by the FDIC and reorganized. Over time we need to adopt Limited Purpose Banking, which would make all banks, insurers and financial companies operate as pass-through mutual funds, which would never be allowed to gamble at the public's expense. Under Limited Purpose Banking, banks sell safe as well as risky collections of securities to the public. Banks act as middlemen, connecting lenders with borrowers and investors with savers. Banks never own financial assets, never borrow short to lend long, and are never in a position to fail.
A new government agency - the Federal Financial Authority - would rate, verify, supervise custody, disclose, and clear all securities purchased, held, and sold by LPB mutual funds. The authority would eliminate insider rating, a key cause of our financial mess. S&P, Moody's, etc. could still operate, but the public would have an independent assessment of financial products. LPB banks would market cash mutual funds, which would only hold cash and be valued at $1 per share. All other funds would break or exceed the buck. Owners of cash mutual funds would be free to write checks against their holdings. These cash mutual funds would represent the checking accounts under LPB and, since they'd hold a dollar of cash in reserve to back each dollar of deposits, there'd be no need for FDIC insurance and no chance of bank runs. LPB would include insurance mutual funds. Contributors would get paid off in proportion to the losses they experience.The Summers-Geithner plan needs to be scrapped. Limited Purpose Banking is the right financial fix, and the sooner we implement it, the sooner we'll really recover.
Laurence J. Kotlikoff is a professor of economics at Boston University.
Congressional Panel Suggests Firing Executives, Liquidating Failed Banks
A congressional panel overseeing the U.S. financial rescue suggested that getting rid of top executives and liquidating problem banks may be a better way to solve the economic crisis. The Congressional Oversight Panel, in a report released yesterday, also said the Treasury may be relying on too rosy an economic scenario to guide its $700 billion bailout, and declared that the success of the program after six months is "mixed." Three of the group’s members disagreed with at least some of the findings. "All successful efforts to address bank crises have involved the combination of moving aside failed management and getting control of the process of valuing bank balance sheets," the panel, headed by Harvard Law School Professor Elizabeth Warren, said in its report.
Treasury Secretary Timothy Geithner has revamped the Troubled Asset Relief Program to focus on injecting capital into banks and removing up to $1 trillion in illiquid securities from their balance sheets via public-private investment partnerships. The government is also working to unfreeze credit markets through a Federal Reserve program that provides loans to investors in some asset-backed securities. Warren, in an interview on Bloomberg Television, said yesterday that while "things may be getting a little better" under Geithner, the Treasury still needs to be more transparent about how it is spending the taxpayers’ money. "We still have a long way to go, a very long way," she said. In the report, Warren’s panel said "it is possible that Treasury’s approach fails to acknowledge the depth of the current downturn and the degree to which the low valuation of troubled assets accurately reflects their worth."
The group said it was offering an examination of "potential policy alternatives" for the Treasury and not endorsing any shift at this time. Still, it said a bank liquidation would be "least likely to sap the patience of taxpayers" and "provides clarity relatively quickly" to the markets. "Allowing institutions to fail in a structured manner supervised by appropriate regulators offers a clearer exit strategy than allowing those institutions to drift into government control piecemeal," the report said. The report also said that past successful financial rescues were accompanied by governments’ "willingness to hold management accountable by replacing -- and, in cases of criminal conduct, prosecuting -- failed managers."
Two of the panel members, New York State Superintendent of Banks Richard Neiman and former New Hampshire Senator John Sununu, issued separate findings. "We are concerned that the prominence of alternate approaches presented in the report, particularly reorganization through nationalization, could incorrectly imply both that the banking system is insolvent and that the new administration does not have a workable plan," the two wrote. Sununu and the five-member panel’s other Republican appointee, Representative Jeb Hensarling of Texas, dissented from the entire report. The oversight panel was set up under the rescue law passed in October. It has three members appointed by Democrats and two by Republicans. The group’s reports are required by the legislation.
Does AIG Really Need to Pay Its Counterparties in Full?
Since AIG's bailout, the company has forked over $52 billion to Goldman Sachs, Deutsche Bank and others who bought credit default swaps. The payments have raised a chorus of disapproval, with many arguing that AIG's new owners -- that'd be taxpayers -- shouldn't be paying out the full contracts. Treasury Secretary Timothy Geithner has countered that the government's hands were tied and AIG had no choice but to pay out the full value of the swaps, which are complicated financial bets that often function like insurance but can also be more like a bet with a Vegas bookie. "We came into this crisis as a country without the tools necessary to contain the damage of a financial crisis like this," Geithner told George Stephanopoulos on ABC's "This Week." The government, he said, "had no meaningful ability to come in [and] change contracts where necessary."
Geithner went on to tell Stephanopoulos he is asking for more authority to renegotiate such payouts in the future, but the question asked by members of Congress, expert observers and plenty of disgruntled taxpayers remains: Did Geithner really have to pay out on the contracts at full value? Though the $52 billion is already out the door, the debate is much more than academic. AIG has said it has hundreds of billions of dollars more in overall exposure with counterparties. It turns out, Geithner does have options -- but each carries risks. Part of the problem is though the federal government now officially owns about 80 percent of AIG, it has been struggling to avoid the appearance of actually taking control, said Roger J. Dennis, a dean of the law school at Drexel University. "They're not managing AIG, so they can't really go in and order AIG's management to say, 'As you unwind these swaps, force the counterparties to take a haircut.'"
Of course, given that AIG is relying on the government for a lifeline, can't Geithner engage in some more informal type of persuasion? "Clearly he could have gone in and as a practical matter jawboned the AIG people to try to get haircuts," Dennis said, using an industry term for getting discounts on contracts. "But could he have ordered them? Under the current conditions, probably not." Another option is to break the contracts and let the counterparties -- many of which are themselves beneficiaries of federal bailouts -- sue the federal government, if they dare. "I don't see why it would have been necessary to pay out to the counterparties at all," said Timothy Canova, a professor of international economic law at Chapman University in California. Such a suit may not fare well in court because some legal questions swirl around whether the bulk of credit default swaps are legally enforceable.
Some of the swaps function like insurance policies on corporate bonds. Purchasers of such credit default swaps know that even if the bond issuer defaults, they will limit their losses. But many other swaps are more like bets (akin to buying "insurance" on another person's house), and it is unclear from a legal perspective if there is enough of an insurable interest to make the contracts enforceable. "I say let them litigate it and let the courts decide whether they have any kind of insurable interest," Canova said. If the federal government is willing to renegotiate contracts with, say, the United Auto Workers, it should also be willing to force haircuts on elite institutions, Canova added. "The Treasury is willing to exercise its muscle to change contracts with ordinary workers," Canova said, "but when it comes to gambling debts for Wall Street, those are somehow sacrosanct."
A third option, advocated most prominently by Lucian Bebchuk, director of the Program on Corporate Governance at Harvard University, is for AIG to simply file for Chapter 11 bankruptcy. A bankruptcy court would then have powers to renegotiate the company's swaps and demand substantial concessions from counterparties. Of course, just because Geithner can exercise these options, does not mean they're a good idea. There's no equivalent to an open stock exchange for credit default swaps, meaning no one knows how far-reaching the effects of AIG's refusal to pay all or some of its obligations would be.
"Many people think the domino effect is overstated," said Burt Ely, president of Ely and Company, a financial services consultancy, referring to the idea that stopping the payments could in turn topple firms AIG made deals with. "But the problem is, no one knows." It's also unclear how to prioritize the many different kinds of counterparties AIG may have, said Dennis of Drexel University. Would you, for example, force the same haircut on state and local governments as, say, Deutsche Bank? "If you start to push people to take haircuts, even if they don't take deep ones, it creates the kind of uncertainty in the marketplace that the bailout was supposed to ameliorate," Dennis said.
Why didn't Fed force big banks to take less of AIG bailout?
The Federal Reserve Bank of New York in November chose not to pursue tough negotiations with large foreign and domestic banks and instead allowed them to receive 100 cents on the dollar in government funds to settle tens of billions of dollars of exotic financial bets guaranteed by American International Group. At the time, Timothy Geithner, now Treasury Secretary, headed the powerful New York Fed. On his watch, the decision was made to forgo a reduced payout — called a "haircut" in industry parlance — to creditors of AIG to prevent financial chaos around the world, the officials told McClatchy. Had the Fed negotiated a reduction of just 10 cents to 15 cents on the dollar, it could've saved between $2 billion and $3 billion.
The revelation sheds new light on last month's disclosure by AIG that it used loans from the New York Fed to pay more than $17 billion to foreign creditors such as France's Societe Generale and Credit Agricole, and Germany's Deutsche Bank. U.S. investment banks, including Goldman Sachs and Merrill Lynch, also were paid $10 billion in what amounted to a back-door bailout of the troubled institutions that had financed the insurer's risky investments. The real reasons behind these decisions weren't revealed at the time. And like the Obama administration's decision last month to allow more than $165 million in controversial bonuses to AIG executives, their disclosure is fueling new criticism.
At issue is the Fed's handling of nearly $30 billion that AIG owed on complex insurance-like financial instruments known as credit-default swaps, which are unregulated products that the company issued to guarantee often risky investments. AIG had at least $440 billion in credit-default swaps outstanding when the New York Fed and the Treasury Department rode to the rescue of its creditors in September with an unprecedented $85 billion cash infusion — a bailout that has since been revamped and grown to some $180 billion. The rescue, which gave the Fed control of almost 80 percent of AIG, was designed to prevent what Fed Chairman Ben Bernanke has since said could've been a collapse of the global financial system.
The decision to extinguish some of AIG's credit-default swaps, however, was made in mid-November, after the waters had calmed. Gerald Pasciucco, the new chief executive of AIG's Financial Products division, which sparked the company's meltdown, recently told McClatchy that Fed officials made the decision to pay full value, but he declined to elaborate when pressed. Pasciucco is negotiating the sale of the remaining $1.4 trillion in the division's business. The decision to pay full contract value is the latest example of the Fed appearing to be "very much out of sync with the attitude of the public and the taxpayers," said John Coffee, a Columbia University law professor who testifies frequently before Congress on matters of corporate finance. The Fed could have offered 85 cents on the dollar — saving billions of dollars — and claimants would've had little recourse but to sue, he said.
Once the Fed decided against bankruptcy for AIG, it was logical to presume that the company would fully honor its swaps contracts, a senior Fed official said. By then, AIG had been downgraded by credit-rating agencies. The downgrade meant that AIG had to post $35 billion in collateral with various swapholders _and the company faced catastrophe, another Fed official said. Both officials requested anonymity to speak freely. After the Fed intervened in September, it made attempts to convince some of AIG's foreign counterparties to accept a reduced payout. They declined. New York Fed officials worried that U.S. defaults on the swaps would lead to "a cascade of other defaults" by firms around the world that had counted on full payouts, one of the officials said.
The idea of a discount was met with "a very hostile reaction" and warnings that such a stance would be viewed as a default, officials said. They pointed to the global financial chaos after the 1991 collapse of the Bank of Credit and Commerce International. Authorities in England and Luxembourg seized Pakistan-based BCCI, and its creditors scrambled for assets across the globe. Once the decision was made to fully pay AIG's foreign counterparties, including $2.8 billion to Deutsche Bank and $6.9 billion to Societe Generale, the officials concluded that it would be discriminatory to pay less than 100 cents on the dollar to U.S. banks holding the same contracts.
"I was concerned that people would say the Fed used its power to exploit some domestic financial institutions," said Thomas C. Baxter, the general counsel of the New York Fed, in a telephone interview. At that time, he said, it was easy to explain "why an entity you kept out of bankruptcy was paying its legitimate and lawfully incurred debts. That didn't seem hard." That, however, was before public anger mounted over Wall Street rescue efforts. Columbia's Coffee countered that "you could have asked everybody to scale down their expectations at least 10 or 15 percent, and that wouldn't have been discriminatory. And if you asked Congress, I think they would have been much more in favor of being discriminatory towards foreign banks, because this is funded with U.S.-taxpayer-funded dollars."
In bankruptcy, he said, the swaps might've been settled at 20 cents on the dollar. In other words, the government had leverage and chose not to use it. "So I think that there has been an absence of hard bargaining here, and it is because the Fed puts its highest priority on its loyalty to the banking system and tends to subordinate economizing with taxpayer dollars." The payouts also have fueled allegations of unnecessary back-channel bailouts on top of the publicly disclosed taxpayer-funded efforts. New York Insurance Commissioner Eric Dinallo, the most vocal advocate for regulating credit-default swaps, told Congress on Oct. 18 that regulators were working in a vacuum. "Because the credit default swap market is not regulated, we do not have valid data on the number of swaps outstanding," he said.
Ilargi: Two weeks old, but a good background insight into the reinsurance, "side letter", shenanigans AIG was/is involved in, along with its counterparties.
Eliot Spitzer with Fareed Zakaria (03-22-2009)
Will the PPIP Bankrupt the FDIC?
Yesterday's New York Times had a very interesting article on the role the FDIC will play in the Public-Private Investment Plan, Treasury Secretary Geithner's new and improved version of the original TARP "Cash for Trash" plan. The Times article focuses on one element of the plan, which is the FDIC's guaranteeing of the non-recourse loans to the public private partnerships. The first question that springs to mind is: Why the FDIC? The simple answer is that it is an end-run around Congress. This is, however, not what the FDIC was set up to do. It was set up to guarantee bank deposits, which lowers the economic impact if a bank fails, and also helps prevent bank failures by minimizing the potential bank runs. Being able to do this at all requires a very broad interpretation of the FDIC's mandate (see the NYT article for details). It appears that the FDIC is getting into this a bit blind, or is not being straight with the taxpayers. Here is a key quote from the article:"So how is the F.D.I.C. planning to insure more than $1 trillion in new obligations? This is where things get complicated and questions are being raised. The plan hinges on the unique, and somewhat perverse, way the F.D.I.C. values the loans. It considers their value not as the total obligation, but as 'contingent liabilities' -- meaning what it expects it could possibly lose. As the F.D.I.C's charter dictates: 'The corporation shall value any contingent liability at its expected cost to the corporation.' So how much does the F.D.I.C. think it might lose? 'We project no losses,' Sheila Bair, the chairwoman, told me in an interview. Zero? Really? 'Our accountants have signed off on no net losses,' she said."
If only America's inventors, entrepreneurs, artists, musicians and film industry had the creativity of our accountants, then America would once again be the undisputed master of the world. The idea that there would be no net losses from this program is optimistic to the point of insanity. The plan is set up so that on each individual transaction, if the private investors win and make money, then the Treasury/FDIC makes money (mostly the Treasury) and vice versa. Except only in the wins private investors make out like bandits, while collectively the government makes modest profits -- and on the losses, the private investors lose a little bit, and the government loses big. On the government side, the losses would be mostly borne by the FDIC while the Treasury would get most of the gains.
The more transactions there are, the higher the probability that overall the program loses money. After all, having four out of five coin flips turn up heads is not all that astonishing, but if it happened 400 out of 500 times, you just might want to have a close look at the coin. Does Ms. Bair have a two-headed coin she plans to use for this exercise? In a broader sense, the PPIP program will only be "successful" if it loses money. The idea is to get the toxic assets off the banks books at prices that are not so low as to totally wipe out bank capital. Without the government support, private investors are not willing to buy the assets for anything close to what the banks can afford to sell them for, at least over the short term. The hope is that over the long term these securities will work themselves out, and the winnings on the assets that work out will help offset the losses.
The whole aim of the program is to raise the level of bids that private investors will make for the assets. Unless you think that all the hedge funds out there are totally irrational, that means that the idea is to get the PPIP to overpay for the assets, but by a lesser amount than the government would if it went about this solo. If it were not about raising the bids to higher than economic levels, then Citigroup or Bank of America could simply sell the assets today for what current market participants are willing to pay. It's not like there are no vulture investors who would be interested in owning the assets. They just want to own them at a price that makes it likely that they will profit from them. The only way that the FDIC would not lose significant amounts is if there are very few "coin flips," or if the plan is a complete flop and fails to close the bid-ask spread enough to create a functioning market. The latter is a real possibility now that FASB knuckled under political pressure and relaxed the mark-to-market rules, thus reducing the incentive for the banks to sell off the toxic assets.
The FDIC could end up guaranteeing up to almost $1 Trillion in very risky non-recourse loans, for which they will get a small fee, and they are projecting no net losses! Seriously, Shelia, there is this bridge I have in lower Manhattan, a real landmark property -- care to make a bid on it? Are the accountants that signed off on "no net losses" the ones that signed off on Enron's books or the ones that signed off on WorldCom's? Does Bernie Madoff's bean counter have a new gig? After the FDIC runs up at least tens of billions of losses from this program, its coffers will have to be replenished. After all, it's not like the FDIC is going to be sitting around with no calls on its capital from its normal operations. There have already been over 20 bank failures this year, and there are sure to be many more. Normally, it would do this by assessing a levy on the banks. But is this the time to be depleting bank capital by dramatically increasing FDIC insurance premiums?
For starters, it is moral hazard writ large, as smaller community banks -- most of which do not hold large amounts of these toxic legacy assets (they may have other problem loans, most notably in commercial real estate) -- have to subsidize their larger competitors who screwed up royally. More likely what will happen is that about a year from now, the FDIC will come to Congress with its hat in hand and say, "Bail us out, or everybody's checking account will be at risk!" Congress will then have no choice but to hand over the funds. That's not the way it's supposed to work -- spend the money first, then ask Congress for the appropriation. The PPIP program is relatively well designed, but far from without flaws. It will aid in real price discovery (provided it isn't totally gamed) and does allow for the Treasury to participate in the upside of the deals that work out. While I still would prefer the "Swedish Solution", if we are not going to go down that path, then the PPIP is probably the best we can hope for. Still to pretend that the expected cost of this is zero is simply disingenuous. A little honesty and transparency would be nice.
'No-Risk' Insurance at F.D.I.C.
The Federal Deposit Insurance Corporation was set up 76 years ago with the important but simple job of insuring bank deposits. Now, because of what could politely be called mission creep, it’s elbowing its way into the middle of the financial mess as an enabler of enormous leverage In the fine print of Treasury Secretary Timothy F. Geithner’s plan to lend as much as $1 trillion to private investors to help them buy toxic assets from our nation’s banks, you’ll find some details of how the F.D.I.C is trying to stabilize the system by adding more risk, not less, to the system It’s going to be insuring 85 percent of the debt, provided by the Treasury, that private investors will use to subsidize their acquisitions of toxic assets. The program, extraordinary in its size and scope, is the equivalent of TARP 2.0. Only this time, Congress didn’t get a chance to vote.
These loans, while controversial, were given a warm welcome by the market when they were first announced. And why not? The terms are hard to beat. They are, for example, "nonrecourse," which means that if an investor loses money, he owes taxpayers nothing. It’s the closest thing to risk-free investing — with leverage! — around. But, as we’ve learned the hard way these last couple of years, risk-free investing is an oxymoron. So where did the risk go this time? To the F.D.I.C., and ultimately, to us taxpayers. A close reading of the F.D.I.C.’s statute suggests the agency is using a unique — some might call it plain wrong — reading of its own rule book to accomplish this high-wire act. Somehow, in the name of solving the financial crisis, the F.D.I.C. has seemingly been given a blank check, with virtually no oversight by Congress. "Nobody is paying any attention to how they’re pulling this off," said a prominent securities lawyer who has done work for the government. Not surprisingly, he, along with others I asked to review the program, declined to be quoted by name. "They may not be breaking the letter of the law, but they’re sure disregarding its spirit."
The F.D.I.C. is insuring the program, called the Public-Private Investment Program, by using a special provision in its charter that allows it to take extraordinary steps when an "emergency determination by secretary of the Treasury" is made to mitigate "systemic risk." Simple enough, but that language seems to bump up against another, perhaps more important provision. That provision clearly limits its ability to borrow, guarantee or take on obligations of more than $30 billion. The exact legalistic language says that it "may not issue or incur any obligation" over that limit. (You can read a highlighted version of the F.D.I.C.’s charter at nytimes.com/dealbook.) So how is the F.D.I.C. planning to insure more than $1 trillion in new obligations? This is where things get complicated and questions are being raised. The plan hinges on the unique, and somewhat perverse, way the F.D.I.C. values the loans. It considers their value not as the total obligation, but as "contingent liabilities" — meaning what it expects it could possibly lose. As the F.D.I.C’s charter dictates: "The corporation shall value any contingent liability at its expected cost to the corporation."
So how much does the F.D.I.C. think it might lose? "We project no losses," Sheila Bair, the chairwoman, told me in an interview. Zero? Really? "Our accountants have signed off on no net losses," she said. (Well, that’s one way to stay under the borrowing cap.) By this logic, though, the F.D.I.C. appears to have determined it can lend an unlimited amount of money to anyone so long as it believes, at least at the moment, that it won’t lose any money. Here’s the F.D.I.C.’s explanation: It says it plans to carefully vet every loan that gets made and it will receive fees and collateral in exchange. And then there’s the safety net: If it loses money from insuring those investments, it will assess the financial industry a fee to pay the agency back. But think about this for a moment: if the program doesn’t work — and let’s hope it succeeds — the F.D.I.C. would be forced to "assess" banks it is hoping to save, possibly bankrupting them in the process. After all, if the F.D.I.C. starts losing money, it will probably be because the broader economic environment is deteriorating further. So those fees will a new burden at a time when key financial players can least afford them.
Ms. Bair said that she can not imagine the F.D.I.C. losing money on the scale I suggested in my doomsday scenario. She said that before announcing the program, the F.D.I.C.’s lawyers determined that the statute allowed it to guarantee loans by valuing them as contigent liabilities. "That’s how we’ve interpreted it," she said, adding that the determination was made back in October when the F.D.I.C. first introduced the Temporary Liquidity Guarantee Program, which is also backed by the F.D.I.C. She also defended her agency saying that the F.D.I.C. has not experienced mission creep: the various programs that it is participating in are meant to insure the stability of the financial system, which she says was always the goal of the agency. She also pointed out that under the Temporary Liquidity Guarantee Program, so far, the agency hasn’t lost a dollar — and more important, she said, the program has worked to stabilize the banking system. All true, but that has come as the burden on the F.D.I.C. has increased as it pays out more to cover losses of failed banks.
In a letter to the financial industry last month seeking an assessment that could be as much as $27 billion, Ms. Bair wrote, "Without these assessments, the deposit insurance fund could become insolvent this year." Ms. Bair seems to recognize that the borrowing limit of $30 billion makes her job difficult. And two officials with a lot of sway in this area have sought to raise the F.D.I.C.’s borrowing limit (by $100 billion, according to a bill introduced by Representative Barney Frank, and by $500 billion, in a bill introduced by Senator Christopher Dodd). But then again, who needs a borrowing limit when the potential liabilities from the new program seem to be zero? If the P.P.I.P. program works — and again, it’s in everybody’s interest to cheer it on — it will be a boon for the economy and participating investors, who will likely make off like bandits. If the program fails, however, there will be heavy losses on us. In other words, taxpayers could be the ones stuck with billions of dollars in "contingent liabilities." And these days, whenever anybody talks about risk-free investing, it’s not hard to hear the famous line uttered by Joseph J. Cassano of A.I.G. in 2007: "It is hard for us, without being flippant, to even see a scenario within any kind of realm of reason that would see us losing one dollar in any of those transactions."
Dr. Doom lashes out at Cramer
CNBC's Jim Cramer has another feud on his hands.
Just weeks after The Daily Show host Jon Stewart took Mr. Cramer to task for trying to turn finance reporting into a "game," famous bear economist Nouriel Roubini criticized Mr. Cramer on Tuesday for predicting bull markets. "Cramer is a buffoon," said Mr. Roubini, a New York University economics professor often called Dr. Doom. "He was one of those who called six times in a row for this bear market rally to be a bull market rally and he got it wrong. And after all this mess and Jon Stewart he should just shut up because he has no shame." Mr. Cramer recently wrote in a blog that Mr. Roubini is "intoxicated" with his own "prescience and vision" and said Mr. Roubini should realize that things are better since the stock market's recent bottom in early March. The Standard & Poor's 500 index has rallied 17 per cent since then.
Mr. Roubini said in 2006 that the worst recession in four decades was on its way. He has attracted attention for his gloomy – and accurate – predictions of the U.S. financial market meltdown. Mr. Roubini said the latest surge is just another bear market rally following the pattern of other rallies after the government intervened. He expects the market will test the previous low because of worse than expected macroeconomic news, disappointing earnings and because banks will fail after the stress tests come out. "Once people get the reality check than it's going to get ugly again," Mr. Roubini said. Mr. Roubini said Mr. Cramer should keep quiet. "He's not a credible analyst. Every time it was a bear market rally he said it was the beginning of a bull and he got it wrong," Mr. Roubini said in an interview with The Associated Press.
Mr. Cramer has conceded he made some wrong calls, like most people watching the market. But he went on Today last October telling people that if they needed money in the next five years, take it out of the stock market. Anyone who heeded that advice saved money, he said. Mr. Roubini said he supports Treasury Secretary Timothy Geithner's plan to remove toxic assets from the banks. Mr. Cramer recently wrote that Mr. Roubini and Nobel laureate New York Times columnist Paul Krugman are both on "the nationalization jihad." "He keeps insulting me personally and saying a bunch of lies," Mr. Roubini said. "He doesn't even know I was supporting it so he says lies."
Mr. Roubini made the comments before appearing with bank analyst Meredith Whitney and Canadian bears Ian Gordon and Eric Sprott at a Toronto event titled A Night with the Bears. They all correctly predicted the current financial meltdown. Ms. Whitney, among the most bearish of bank analysts, said that some of the 19 banks undergoing government stress tests may not pass. "I think the big banks will get through and some of the smaller banks may not," Ms. Whitney said in interview with The AP. Mr. Gordon, author of The Long Wave Analyst newsletters, told the event's audience of 1,500 that he expects the Dow Jones industrial average to plummet to 1,000 based on the idea that economic events repeat themselves in regular sequence every 60 years or so. Mr. Sprott, a Canadian hedge fund owner, told the predominantly business crowd that systemic risk remains and that investors should buy gold.
A Risky Bankruptcy Looms for GM
Washington dreams of a quick resolution in court, but GM hastens to cut a deal with the UAW and bondholders to avert a drawn-out process. The chance that General Motors ends up in bankruptcy to fix its problems appears more likely, people close to the company's plans said on Apr. 7. GM would like to avoid going to bankruptcy court, but the company is making preparations to file for protection. One of its biggest tasks before any filing is cutting a new deal with the United Auto Workers on health-care liabilities, these people say. For months, GM and its legal advisers have examined a quick bankruptcy in which the auto giant enters court and splits into two companies—a "good GM" with Cadillac, Chevrolet, Buick, and GMC—and a "bad GM" that has Hummer, Saturn, some shuttered factories, and a load of debt. The good GM would emerge quickly, sources say, while bondholders would be left to collect some portion of their collective $28 billion in debt from the assets in the bad GM.
Before executing such a deal, GM would need to strike a deal with the union that would bring wages in line with those at Japanese plants in the U.S. and get the UAW to take stock instead of cash for a big chunk of a health-care trust to pay retiree benefits, beginning in 2010. GM owes the UAW $20 billion for the health-care trust, called a Voluntary Employee Benefits Assn., or VEBA. GM has offered half in cash and half in stock to reduce its debt. But the Treasury Dept. said on Mar. 31 that GM needs to reduce that liability by much more. Treasury also concluded that GM needs to slash its $28 billion in bond debt by more than the two-thirds discount that was in GM's original plan. GM has offered its bondholders two-thirds of their bond value in stock and the rest in cash. One source close to the situation says the Treasury Dept.'s Auto Task Force wants to see GM wipe away far more than half of the UAW liabilities to become viable and qualify for more loan money. That means GM needs the union to take much more than half the value of the remaining union health-care liabilities in stock.
GM is negotiating with the UAW to give the union equity in the new company should GM file for bankruptcy protection. If GM can reduce that $20 billion burden, use bankruptcy to ditch most of its $28 billion in bond debt, and consolidate down to its four core brands, the company could be viable, say sources close to GM and Treasury. At the same time, GM management wants to avoid bankruptcy by cutting its long-term obligations to the union and creditors out of court. All of that requires the union and bondholders to take stock in GM. While GM's shares trade at just 2 now, management has made the case that with less debt and without constant bankruptcy speculation, it would be worth far more. But all sides involved have been debating the company's true value. If GM can slash those liabilities in or out of court, the government would then be more willing to loan GM upwards of $30 billion that the company needs to stay afloat until car sales rebound. The task force has said a GM bankruptcy could be done speedily, but skeptics contend it will be difficult to execute such a case quickly, given the company's size and complexity. Creditors could hold up bankruptcy proceedings. Striking a deal with the union beforehand is no snap, either, says Dennis Virag, president of Automotive Consulting group in Ann Arbor, Mich. "A fast bankruptcy is an oxymoron," Virag says. "I think people in Washington grossly underestimate the difficulty of taking GM in and out of bankruptcy." Perhaps, but it's looking far more likely now.
Bank of America CEO Lewis should keep his job: Meredith Whitney
Well-known bearish bank analyst Meredith Whitney said Bank of America Corp. should keep Chief Executive Ken Lewis despite what she calls the mistake of buying Merrill Lynch. Ms. Whitney said Mr. Lewis has done a great job stewarding the bank as a low-cost operation but said he made one major mistake. She said he's a good bank manager but acted more like a good citizen than a good steward of shareholder capital when he bought Merrill. But she said that doesn't mean he can't run Bank of America effectively. She said if others were to run, it would be seen as too disruptive internally. Ms. Whitney made the comments to reporters before appearing with economist famous bear economist Nouriel Roubini and Canadian bears Ian Gordon and Eric Sprott at a Toronto event titled "A Night with the Bears" on Tuesday night. They all correctly predicted the current financial meltdown.
Ms. Whitney made many forecasts in 2007 — particularly about Citigroup Inc. — that ended up coming true. She predicted that Citigroup would need to oust then-CEO Charles Prince, sell off assets and slash its dividend to raise cash. Ms. Whitney left Oppenheimer & Co. to start her own stock-advisory firm last month. Many bank analysts are skeptical about the outlook for Bank of America. It is still absorbing two troublesome acquisitions: the brokerage Merrill Lynch and the mortgage lender Countrywide Financial. "I think he made a mistake of acting more a good citizen than a good steward of shareholder capital, but does it mean he can't effectively run Bank of America, I think he can," Ms. Whitney said.
SEC To Unveil Short-Selling Proposals At Public Meeting Wednwsday
The U.S. Securities and Exchange Commission is expected to unveil two types of proposals to limit short selling Wednesday, with some aimed at imposing market-wide sales restrictions and others targeting particular stocks that are in rapid decline. The commission is expected to unveil the proposals at a public meeting in Washington. The two market-wide restrictions the SEC may opt to propose include a rule similar to the old "uptick" rule and a modified uptick rule similar to Nasdaq's former bid test. In addition, the SEC is also eyeing three different types of "circuit-breaker" models, which would impose various restrictions on short sales for the remainder of a trading session if a particular security declines by 10%. If a circuit breaker is triggered, then traders could be subject to either an uptick restriction, a bid test restriction, or an outright short-selling ban on a particular security for the rest of the day, according to an SEC document summarizing the proposals.
The SEC will vote Wednesday on which types of rules they intend to propose, and the public will have 60 days to comment. An SEC official said the staff is proposing to give the industry three months to implement any new rules. At that pace, any possible new rules wouldn't go into effect until autumn at the earliest. The SEC has been under tremendous political pressure in recent months to restore the uptick rule amidst fears that short selling is driving down stock prices and exacerbating the financial crisis. The Depression-era uptick rule, which the SEC abolished in 2007, prevented traders from short selling unless the price of the stock from the most recent trade was higher than the previous price. Short selling is the sale of borrowed shares by an investor hoping to profit by buying an equal number of shares later at a lower price to replace the borrowed stock. Also, Nasdaq used to have its own short-sale price restrictions known as a bid test, which prohibited short-sales on many securities at a price lower than the highest national prevailing bid. All the short-sale price test restrictions were rescinded in 2007, however, after economic studies found they had little impact.
The proposed uptick rule to be unveiled Wednesday would prohibit anyone from short selling below or at the last sale price, unless the price is above the next preceding different price. The proposed "modified uptick rule" would prevent short selling at a down bid price. An SEC staffer who spoke on the condition of anonymity Tuesday afternoon said there are advantages and disadvantages to uptick versus bid test rules.
"There is a slight delay before the last sales price is reported, so they may be reported out of sequence," she said. "The bid is a little more up to date." The SEC could opt to approve one of the proposed rules individually, or in certain cases possibly impose a market-wide price test in conjunction with a circuit breaker that triggers an all-out trading ban, SEC officials said. All of the proposals on the table would allow for certain exceptions to the rules. Many of the exceptions that would apply are similar to those set forth in the old rules, including exceptions in cases where someone has an ownership interest in the security.
But a staffer said that none of the proposed rules would contain a market maker exception because she said the exception wasn't ever used much, if at all, when price restrictions were in effect. The proposals would also require trading centers to measure upticks or bids in penny increments, which is the current trading increment. One of the proposed circuit-breaker rules is similar to a recent proposal outlined by NYSE Euronext, Nasdaq Omx Group, BATS Exchange Inc. and the National Stock Exchange. None of the circuit breaker proposals would be triggered if the price of a security reaches the 10% threshold within 30 minutes of the end of regular trading hours.
Japan's Current Account Surplus Shrinks 56% as Demand for Exports Tumbles
Japan’s current-account surplus narrowed in February as the global recession eroded demand for the nation’s exports. The surplus shrank 55.6 percent to 1.117 trillion yen ($11 billion) from a year earlier, the Ministry of Finance said in Tokyo today. The median estimate of 24 economists surveyed by Bloomberg News was for a gap of 1.07 trillion yen. Japan had a 172.8 billion yen deficit in January, its first in 13 years. The world’s second-largest economy is headed for its worst recession since 1945 as plunging overseas demand forces companies from Nissan Motor Corp. to Panasonic Corp. to cut production and fire workers. Confidence among Japan’s biggest manufacturers fell to a record low in March and executives signaled more spending and job cuts, the Bank of Japan’s Tankan survey showed last week. "The return to a surplus from a deficit doesn’t mean Japan’s economy is recovering," said Junko Nishioka, an economist at RBS Securities Japan Ltd. in Tokyo. "The declining trend for exports is still ongoing and Japan’s economy may have shrank at a double-digit pace in the first quarter."
The yen traded at 100.42 per dollar at 9:29 a.m. in Tokyo from 100.66 before the report was published. The currency has lost 9.7 percent of its value this year, providing some relief to exporters by making their products more competitive overseas. The world’s second-largest economy probably contracted at an annual 10.9 percent pace in the first quarter, according to the median estimate of 13 economists surveyed by Bloomberg News. That would follow a 12.1 percent contraction in the fourth quarter, the sharpest since 1974. Exports tumbled 50.4 percent in February from a year earlier, the most since comparable data were made available in January 1985, the report showed. Imports slid 44.9 percent, also a record drop, helping Japan post a trade surplus. Shipments to the U.S., the country’s biggest market, plunged an unprecedented 58.4 percent in February from a year earlier, and exports to Europe and Asia dropped, according to a separate trade report released last month. Today’s figures don’t include regional breakdowns.
Toyota Motor Corp. and Nissan led a 56 percent decline in Japan’s domestic vehicle production in February, the biggest drop since at least 1967, according to the Japan Automobile Manufacturers Association. Panasonic, the world’s biggest consumer electronics maker, said in February that it plans to eliminate about 15,000 jobs and predicted its first loss in six years. The income surplus, the difference between money earned abroad and payments made to foreign investors in Japan, narrowed 34.1 percent to 1.1 trillion yen from a year earlier, today’s report showed. The seasonally adjusted current-account surplus widened to 673.4 billion yen in February from a month earlier, today’s report showed. The current account tracks the flow of goods, services and investment income between Japan and its trading partners. It includes trade not shown in the customs-cleared balance.
Fed Requests for TALF Loans Drop 64% to $1.7 Billion
The Federal Reserve’s requests from borrowers for loans to buy asset-backed securities fell 64 percent from last month as investors balked at visa limits and possible political efforts to tax earnings.
Investors sought $1.71 billion from the Term Asset-Backed Securities Loan Facility to purchase securities backed by auto and credit-card loans, the New York Fed bank said today on its Web site. The Fed provided $4.7 billion in loans last month to purchase securities in the TALF’s first monthly round. The decline hinders Fed Chairman Ben S. Bernanke’s efforts to lower borrowing costs and extends a slow start for a program that the Obama administration is using as a cornerstone of plans to revive credit and end the recession. The Fed is struggling to lure investors, such as hedge funds, that are wary of government restrictions or the risk of future intervention.
"It is a big disappointment," said Stephen Stanley, chief economist at RBS Securities Inc. in Greenwich, Connecticut. "There are some folks who have decided they just don’t want to play in any government programs." The total amount of securities eligible for TALF loans in April plunged to about $2.6 billion from $8.3 billion in March. The number of securities deals was unchanged at four. CarMax Inc., a Richmond, Virginia-based used-car seller, and Deerfield, Florida-based World Omni Financial Corp. sold about $1.59 billion in bonds backed by auto loans eligible for purchase with TALF loans. World Financial National Bank, a subsidiary of Alliance Data Systems, sold $560 million of TALF- eligible credit-card-backed debt. Cabela’s Inc., a Sidney, Nebraska-based chain that specializes in hunting and fishing equipment, sold about $425 million in bonds backed by payments on its store card for TALF.
TALF investors are subject to a provision in February’s $787 billion fiscal-stimulus law that makes it tougher for recipients of federal bailout funds or Fed emergency loans to hire skilled workers from abroad. Companies that apply for a visa on behalf of a foreign worker can’t dismiss employees in similar positions 90 days before and 90 days after requesting the visa, and have to prove they attempted to recruit a U.S. worker first. The Fed released guidance on March 31 confirming that the provision applies to firms that borrow through the TALF. The Treasury is providing funds from the Troubled Asset Relief Program to protect the Fed from losses on securities posted to the TALF as collateral. "The Treasury and the Fed have got to do some listening to the concerns of the private sector and do something to address those concerns," said John Ryding, founder of RDQ Economics LLC in New York and a former Fed economist. "It’s not a problem with the program in principle."
Ryding said the coming expansion of the TALF to include older, distressed mortgage securities will be more important than the first phase, which only includes newly issued securities tied to consumer and business loans. "It’s important that these programs work," Ryding said. The investor concerns are a "significant question mark," he said. Separately, the $8.3 billion of TALF-eligible securities issued last month was "encouraging," Bernanke and New York Fed President William Dudley said in an April 1 letter to Elizabeth Warren, head of a congressional panel overseeing the U.S. financial rescue. Spreads above comparable benchmark rates were lower than previously issued asset-backed securities, and that narrowing "has reportedly generated a renewed enthusiasm for ABS following the program’s initial success, with more issuance being developed," Bernanke and Dudley wrote in the response posted on the New York Fed’s Web site.
The Fed failed to get any borrowing requests to buy securities backed by leases of business equipment, loans extended by residential-mortgage servicers to cover missed payments by homeowners, or so-called "floorplan loans" that finance items other than autos for dealers. The Fed added those loan types for this month’s round of funding. "This is still a work in progress," said James Grady, managing director in New York at Deutsche Asset Management, which has about $240 billion in assets under management. At the same time, "there has been some headway," he said. RBS’s Stanley said the low volume of TALF loans doesn’t necessarily signal a credit contraction because financing appears to be more available for auto purchases, for example. Weaker consumer demand for credit could also be limiting demand for TALF deals. The pace of borrowing by U.S. consumers fell in February. Consumer credit fell by $7.48 billion, or 3.5 percent at an annual rate, to $2.56 trillion, the Fed said today in Washington. Credit increased by $8.14 billion in January. The Fed’s report doesn’t cover borrowing secured by real estate. The central bank will provide this month’s loans April 14. The Fed authorized as much as $200 billion in loans for the first phase of the TALF, and the Fed and Treasury announced plans in February to expand the program to as much as $1 trillion.
Sharp casts doubt on Japan’s future as exporter
Japan’s future as a leading exporter was thrown into doubt on Wednesday by Sharp, one of the country’s biggest manufacturers, which warned that core production would have to be transferred offshore because of the cost of investment and the strength and volatility of the yen. Mikio Katayama, Sharp’s president, said that in the future "exports from Japan will not make sense even in the most advanced technological fields." The company said it planned to make a gradual transition in many of its own business lines to a model of "local production for local consumption". Sharp is one of the first large manufacturers to respond to the yen’s strength with a shift in strategy rather than just cost cuts. If Sharp and others change their business models to manufacture overseas it could lead to a fundamental change in Japan’s export-dependent economy.
While Sharp already has many foreign assembly plants, the new strategy would mean core components being produced abroad in some business lines, with local partners owning majority stakes in its overseas subsidiaries. One model could be Sharp’s announcement last November that Enel, Italy’s largest energy company, will take a majority stake in a new Y100bn ($1bn) venture to produce solar panels in Europe. Sharp said its new business model would make it less vulnerable to fluctuations in the yen, the need for huge capital investments, trade barriers, or competition from foreign rivals with lower labour costs or access to government subsidies. Alongside the strategy announcement, Sharp warned that its operating loss for the year to March 2009 would be Y60bn — double its previous estimate — because of a Y30bn provision to write down the value of unsold inventories. Sharp also announced further restructuring provisions as part of its plan to cut Y100bn from fixed costs in the current financial year and higher losses on its securities portfolio.
Sharp did not give any forecasts for the new financial year but said that it has seen a sudden rise in demand in the last few weeks, especially from China, and that its main plant producing liquid crystal panels for televisions was now running at full capacity. "From Sharp’s viewpoint the Chinese market is expanding," said Mr Katayama. Mr Katayama’s comments are some of the first positive ones on electronics demand this year. Some LCD factories have been running at utilisation rates of 50 per cent or below, but Mr Katayama said that a large order had come in. David Gibson, an analyst at Macquarie Securities in Tokyo, said, "I think there’s a question: are the orders shifting from somewhere else or are they a genuine returning of demand?" Mr Katayama also said that production at Sharp’s new Y380bn LCD plant at Sakai in Japan, which will be the world’s largest and most advanced, is to start in October, six months earlier than originally planned. Sony is still expected to invest in the Sakai plant but nothing has yet been agreed.
U.S. to Offer TARP Aid to Life Insurers
The Treasury Department has decided to extend bailout funds to a number of struggling life-insurance companies, helping an industry that is a lynchpin of the U.S. financial system, people familiar with the matter said. The department is expected to announce the expansion of the Troubled Asset Relief Program to aid the ailing industry within the next several days, these people said. The news will come as a relief to a number of iconic American companies that have suffered big losses made worse by generous promises to buyers of some investment products. Shares of life insurers have fallen more than 40% this year. Their troubles led to a string of rating-agency downgrades that, in a vicious cycle, made it more difficult for some insurers to raise funds. The life-insurance industry is an important piece of the U.S. financial system. Millions of Americans have entrusted their families' financial safety to these companies, so keeping them on solid footing is crucial to maintaining confidence.
If massive numbers of customers sought to redeem their policies, it could cause a cash crunch for some companies. And because insurers invest the premiums they receive from customers into bonds, real estate and other investments, they are major holders of securities. If they needed to sell off holdings to raise cash, it could cause markets to tumble. The decision by the Treasury Department adds a third industry to the banks and auto companies that have already received bailouts from the government. While American International Group Inc. is a major insurer and is the biggest recipient of government money, its problems weren't caused by its life-insurance operations, but derivative bets that went bad. Only insurers that own federally chartered banks will qualify for the program. Treasury had said last year that life insurers could be eligible for TARP funds if they owned bank-holding companies, but it hadn't officially decided to give funds to these companies as it focused much of its energies on banks and auto makers.
The life-insurance companies will have access to Treasury's Capital Purchase Program, which injects funds into banks. How much money would now be available to the insurers, and which particular insurers would be beneficiaries, remains unclear. The Treasury says it has about $130 billion remaining in TARP money. A number of life insurers, including Hartford Financial Services Group Inc., Genworth Financial Inc. and Lincoln National Corp., struck deals last fall to buy regulated savings and loans so they could call themselves banks and qualify for government funds. Hartford and Lincoln have applied for TARP funds. Genworth said it has applied with the Office of Thrift Supervision to approve its thrift purchase as a step toward gaining access to the federal funds. Prudential Financial Inc., which owned a thrift before the crisis struck, has also applied for the funds. MetLife Inc., the biggest publicly traded insurer by assets, owned a federally chartered bank before the crisis struck. It has not commented on whether it has applied for TARP money.
"We look forward to the official word from Treasury," said Whit Cornman, a spokesman for the American Council of Life Insurers. As life insurers waited for months to learn whether they would get federal funds, many resorted to contortions to bolster capital. Hartford recently said it plans to infuse $20 million into a cash-strapped Florida thrift it agreed to purchase for $10 million to qualify for federal aid under TARP. Hartford has estimated that it would be eligible for $1.1 billion to $3.4 billion in funds if Treasury accepts its application. Not all insurers have been openly struggling, and some retain triple-A ratings, including Massachusetts Mutual Life Insurance Co., New York Life Insurance Co., Northwestern Mutual Life Insurance Co. and TIAA-CREF. Life insurers had for a time seemed to be somewhat immune from the credit crisis, since they tend to invest in relatively safe assets in order to match their liabilities. These companies got into trouble for two main reasons, both tied to the weak financial markets.
First, many of the roughly two dozen insurers that dominate the variable-annuity business made aggressive promises on these popular retirement-income products, guaranteeing minimum returns, no matter what happened to the stock market. With the market's decline, the issuers are on the hook for big payouts, though most of the payments won't come due for 10 or more years. Second, the insurers also have lost money on the investments in bonds and real estate that back their policies. Insurers own 18% of all corporate bonds outstanding, according to the American Council of Life Insurers, and investors have been warily watching trading patterns in some securities for signs of a liquidation. For example, a bond issued by Jeffries & Co., a securities firm, has fallen in value recently though the company is healthy. Traders have noted that the biggest holders of that bond are insurers.
TARP funds won't necessarily mean the industry is out of the woods. A steep fall in the stock market would put a great deal of pressure on companies with sizable variable-annuity businesses, because they must set aside funds to meet their obligations. While stocks have recovered somewhat recently, easing pressure on insurers, another swoon could revive concerns about their capital. Many life insurers also hold large portfolios of residential mortgage and commercial real-estate assets. While most of the assets are highly rated, further downgrades of those assets could put considerable pressure on insurers, forcing them to take additional write-downs. Access to TARP funds should provide significant breathing room to life insurers, helping them avoid further credit-rating downgrades and the need to raise capital under onerous terms. That, in turn, could be good news for capital markets. Due to their capital constraints, some insurers have been hoarding cash rather than purchasing bonds, adding to market stresses.
It remains to be seen whether extending funds to insurers will spark the kind of populist anger that accompanied assistance to banks and auto makers. Consumers may be relieved to see a boost to some of the companies they count on for their financial security. The action comes with members of the House and Senate away from Washington on a two-week recess, which should initially damp criticism from lawmakers of both parties who are fatigued over the seemingly unending government bailouts. Members of the House voted this spring to impose a punitive tax on bonuses paid by AIG, while members of the Senate went on record demanding greater disclosure of Federal Reserve efforts to rescue banks. Any life insurer that gets TARP funds will have to comply with the strict executive-compensation rules required by Congress.
'I Want You,’ Uncle Sam Says to Unemployed Wall Street Analysts
Uncle Sam to Wall Street: I want you. Underscoring Washington’s appeal as the financial industry shrinks, about 400 finance professionals have signed up for a New York job fair this month featuring nine federal agencies ranging from the Federal Deposit Insurance Corp. to the FBI and the Securities and Exchange Commission. That’s double the tally at similar events last year, organizers say. Attendees at the April 24 event will include Virginia Donner, 43, who called a friend at the Federal Reserve after losing her job at a hedge fund in Greenwich, Connecticut. "When you’re looking for work and your industry has kind of imploded, you have to look at what your skills are and then figure out who’s hiring," she said.
The job-seekers are among 23,300 people who lost industry work in New York in the year through February as banks worldwide announced almost $870 billion in losses and writedowns. The credit crisis that claimed Lehman Brothers Holdings Inc., Merrill Lynch & Co. and Bear Stearns Cos. may cost another 23,000 jobs over the next year, New York City estimates. Unemployed Wall Streeters "are sick of the insecurity," said William Drawbridge, director of marketing and development at the New York Society of Security Analysts, which is organizing the job fair. "Government jobs are stable jobs. This is a good out for them."
The SEC, criticized in recent months for having too many lawyers and not enough analysts as it failed to unearth Bernard Madoff’s Ponzi scheme, is in the market, according to Chairman Mary Schapiro. "We have a phenomenal opportunity right now to bring in much more current and useful skill sets, with people who have lost jobs on Wall Street and are anxious to do something, and do something very constructive," Schapiro told Congress during a March 11 hearing. Granted, the government pays less than the banking industry, where associates with three years on the job can earn as much as $120,000 a year, according to Alvin Kressler, executive director of the analysts’ association. About 40 percent of the group’s members earn between $175,000 and $190,000 a year.
A government employee in New York can earn between $76,000 and $153,000, according to the U.S. Office of Personnel Management’s Web site. In Washington, government salaries range from $59,000 to $127,000. "Nothing pays as well as Wall Street," said Laura Richardson, 45, who lost her job as an analyst at BB&T Capital Markets in McLean, Virginia, two months ago. At the same time, "there are no long-term guarantees on Wall Street." Richardson said she’s considering making the trek to New York for the job fair to seek a government role, seeking a job "to help fix the problem." She added that she’s ready to do "Whatever I can do to help prevent this from happening again." Other local jobs are becoming scarce.
New York City had a record month-to-month increase in its unemployment rate in February, climbing to 8.1 percent from 6.9 percent in January, the state Labor Department said last month. The city’s jobless rate was the highest since October 2003, and the financial industry shed 2,700 jobs last month. New York City will probably have lost 46,000 financial jobs by the second quarter of 2010 from the beginning of 2007, according to the city’s Office of Management and Budget. "The government does provide some good benefits, a good health program," said John Palguta, vice president for policy at the Partnership for Public Service. "If anybody is worried that the government may simply not be able to afford them, either they were making well over $200,000 a year or they’re wrong."
Dallas Fed President Fisher: Fed Duty Bound To Clean Up Mess
A senior U.S. Federal Reserve board member on Wednesday launched an impassioned defense of the institution's extensive efforts to salvage the U.S. economy and financial system. "We are the central bank of the largest economy in the world, and we are duty bound to apply every tool we can to clean up the mess that our financial system has become and get back on the track of sustainable economic growth with price stability," said Richard Fisher, president of the Dallas Federal Reserve Bank, in prepared remarks for a speech to be delivered in Tokyo, Japan. The official suggested that whilst economic data is grim, the lack of confidence is perhaps more pervasive. "The men and women who operate our businesses and create and sustain employment have assumed a defensive crouch," Fisher said. They are doing all they can to cut costs and avoid risk, and the "result is an American economy in stasis," he said.
"There is presently a palpable lack of circulating confidence in the business community in America," Fisher said. This environment justifies the broad range of instruments rolled out by the Fed to combat the various challenges facing both the economy and credit markets. He acknowledged that these have nevertheless raised concerns about future inflation, the strength of the dollar, and the independence of the central bank itself.
Fisher said the Fed board, including Chairman Ben Bernanke, are well aware of these concerns and "each and every one (is) determined not to violate the basic tenets of Federal Reserve sanctity." Inflation is "an evil spirit that rots the core of economic prosperity and must never, ever be countenanced," Fisher said, painting himself as one of the most hawkish members of the Federal Open Market Committee, which sets interest rates in the U.S. For the next couple of years, however, "inflation is unlikely to present a serious threat," he said. The Fed's actions have raised some concerns about the eventual impact on the U.S. dollar and U.S. government debt. "We realize that this may give rise to some apprehension among large holders of Treasurys and agency paper such as your government and others in the Asian Pacific region," Fisher said.
Yet Treasurys have been more of a safe haven over the past year than other government debt, and the U.S. should retain a competitive edge going forward, he said. Major rivals in Europe or Japan face even more substantial economic and financial challenges of their own, Fisher said. Short-term fiscal spending enacted by Congress should jump-start the economy while laying the groundwork for permanent structural reform, Fisher said. "If these policies don't jump-start the economy, then I am confident that the reaction within fixed-income markets will force those with the power to tax and spend, the Congress, to readjust their fiscal policies," he said. As for the credibility of the central bank, Fisher said his colleagues "feel it necessary to guard our ongoing independence," and is working with the Treasury Department on an appropriate framework. As part of this, "the Federal Reserve is in the process of acquiring the tools to short-circuit any inflationary consequences of its balance sheet growth," Fisher said.
Ilargi: Two weeks old, but a good background insight into the reinsurance, "side letter", shenanigans AIG was/is involved in, along with its counterparties.
Eliot Spitzer with Fareed Zakaria (03-22-2009)
Fighting Recklessness with Recklessness
Last week saw a continuation of the impenetrably misguided policy response to this financial crisis, which seeks to address the downturn by encouraging more of what got us into this mess in the first place. The U.S. Treasury's toxic assets plan, for instance, looks to "leverage" public funds (with the FDIC providing the "6-to-1 leverage") in order to defend the bondholders of mismanaged financials who took excessive leverage. At the same time, the Treasury plans to limit the "competitive bidding" to a few hand-picked "managers" who will be encouraged to overpay thanks to put options granted at public expense. This is a recipe for the insolvency of the FDIC and an attempt to bail out bank bondholders using funds that have not even been allocated by Congress. The whole plan is a bureaucratic abuse of the FDIC's balance sheet, which exists to protect ordinary depositors, not bank bondholders.
On Thursday, the stock market cheered a move by the Financial Accounting Standards Board (FASB) to relax FAS-157 (the "mark-to-market" accounting rule), allowing nearly insolvent financial companies to use more discretion in the models they use to assess fair value. Of course, the irresponsibly rosy assumptions built into these models have been a large contributor to this near-insolvency, because they virtually ignored foreclosure risks. Notably, the one thing policy-makers have not done is to address foreclosure abatement in any serious way. The only way to get through this crisis without enormous collateral damage to ordinary Americans is by restructuring mortgage obligations (ideally using property appreciation rights), restructuring the debt obligations of distressed financial companies (ideally by requiring bondholders to swap a portion of their debt for equity), and abandoning the idea of using public funds to purchase un-restructurable mortgage debt ("toxic assets").
Look. You can play hot potato with the toxic assets all day long, and only outcome will be that the public will suffer the losses that would otherwise have been properly taken by the banks' own bondholders. You can tinker with the accounting rules all you want, and it won't make the banks solvent. It may improve "reported" earnings for a spell, but as investors who care about the stream of future cash flows that will actually be delivered to us over time, it is clear that modifying the accounting rules doesn't create value. It simply increases the likelihood that financial institutions will quietly go insolvent. I recognize that the accounting changes may reduce the immediate need for regulatory action, since banks will be able to pad their Tier 1 capital with false hope. But we have done nothing to abate foreclosures, and we are just about to begin a huge reset cycle for Alt-A's and option-ARMs. As the underlying mortgages go into foreclosure, it will ultimately become impossible to argue that the toxic assets would be worth much even in an "orderly transaction."
Meanwhile, in a bizarre convolution of reality reminiscent of Alice in Wonderland, the Financial Times reported last week: "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 plan to revive the financial system." And why not? They can put up a few percent of their own money, and swap each other's toxic assets financed by a bewildered public suddenly bearing more than 90% of the downside risk. The "investors" in this happy "public-private partnership" keep half the upside while ordinary Americans take the downside off of their hands. Some partnership.
With regard to the economy, there is quite a bit of optimism that the recent market advance represents a forward-looking call that the economy will recover in the second half of the year. Indeed, some analysts have noted that year-over-year consumer spending has only declined very slightly, hailing this as evidence that economic concerns are overblown. The difficulty is that consumer spending has never declined on a year-over-year basis, except in this downturn, so that slight decline is actually the worst showing for consumer spending in the available data. Likewise, capacity utilization has plunged to levels seen only in 1974 and 1982, both which were accompanied by far deeper valuation extremes than at present.
I recognize that given the depth of the recent decline, it seems as if stocks must be at once-in-a-lifetime valuations. Unfortunately, this is an artifact of the previous level of overvaluation. The depth of a bear market often has a loose relationship with the extent of the prior bull market (and particularly with the level of valuation of the prior bull), but there is very little relationship between the depth of a bear market and the subsequent bull. If we assume that the long-term fundamentals of the economy have not been affected in any meaningful way by this economic downturn, then stocks are most likely priced to deliver long-term returns between 9-11% annually over the coming decade, with outlier possibilities of as much as 14% if the market ends the coming decade at historically overvalued levels, and as little as 4% if the market ends the coming decade at historically undervalued levels. Far from being once-in-a-lifetime values, prospective 10-year returns on the S&P 500 are not far from their historical norms here. Stocks are about fairly valued.
The only way that stocks could be considered extremely undervalued here is if we assume that the record profit margins of 2007 (based on record corporate leverage) are the norm, and will be quickly recovered. While we never rule out the potential for surprising strength or weakness in the markets or the economy, the assumption that profit margins will permanently recover to 2007 levels is equivalent to assuming that the past 18 months simply did not happen. Still, given sufficient evidence of broad improvement in market action (which we take as a measure of risk tolerance and economic expectations), we wouldn't fight the combination of roughly fair values and a willingness of investors to bear risk. We've been carrying small "contingent" call option positions for a good portion of the recent advance. This helped to compensate for our low weightings in financials, homebuilders and other low-quality sectors that have enjoyed frantic short-covering.
Still, with only about 1% of assets currently in those calls, our stance is still characterized as defensive here, as we are otherwise fully hedged. Again, we won't fight a broad improvement if it continues sufficiently, but if I were to make a guess, it would be that the potential downside in the S&P 500 from these levels could approach 30-40%. That is not a typo, and it is not a possibility that should be ruled out. I have no idea how long investors will remain enthusiastic about trillion dollar band-aids and eroding the integrity of our accounting rules. I do know that at the end of the day, what matters is the long-term stream of deliverable cash flows that investors can actually expect to reach their hands. It's exactly that consideration that makes it clear that we will sink deeper into this crisis until we observe debt restructuring on a large scale. If we don't restructure the debt, the debt will fail, because for many borrowers, the cash flows aren't there, and it is not possible to service the debt on existing terms.
As of last week, the Market Climate for stocks was characterized by fair valuations (modestly but not significantly undervalued on measures based on prior earnings, still overvalued on measures that do not rely on a reversion to above-average profit margins in the future). Market action is demonstrating some favorable signs, particularly evident in breadth-based measures such as advancing versus declining issues, and we are willing to carry some call option exposure on that basis, but the overall price-volume behavior still appears more consistent with a standard bear market rally punctuated by periodic short-squeezes. Suffice it to say that we've got some amount of exposure to further market strength, but that we are skeptical that the recent advance has important information content about a pending economic recovery. So far, it looks very much like the interim advances often observed during periods of ongoing market weakness.
In bonds, the Market Climate last week was characterized by moderately unfavorable yield levels and relatively neutral yield pressures. The Strategic Total Return Fund continues to have the majority of its assets in medium term Treasury Inflation Protected Securities, with about 25% of assets allocated across precious metals shares, foreign currencies, and utility shares. I continue to believe that it is too early to purchase distressed corporate debt – the view that this sector is a bargain is predicated on the belief that the economy has worked its way through this deleveraging cycle and is ready to rebound in the months ahead.
Interestingly, though there is a lot of chatter in the stock market about the hope for improving economic conditions, it seems that the bond market didn't get the memo. Credit spreads have moved sideways or have even widened in recent weeks, including corporate-corporate spreads like AAA versus Baa. Many credit default swaps actually blew to new highs last week, though the additional jump the day before the FASB announcement seemed to me to be a speculative pop on the possibility that the FASB would leave mark-to-market alone. In any event, the non-uniform features of the recent advance don't appear particularly healthy. One gets a stronger signal about investors' risk preferences when a stock market advance is coupled by broad sector leadership (not just battered junk stocks), narrowing credit spreads, and a wide range of other elements of market action.
Credit Default Swaps ‘Big Bang’ Loosens Bank Grip as Pimco, Primus Gain
JPMorgan Chase & Co., Goldman Sachs Group Inc. and the eight other banks that have dominated the credit-default swaps market for a decade are now ceding some power to their clients as regulators push for transparency. Pacific Investment Management Co., Elliott Management Corp. and three other investment firms will join 10 dealers this week on a committee that will make binding decisions for the first time on how contracts are settled. Such decisions have influenced payouts and, at times, had the potential to almost double the amount investors made or lost. The committee may help boost confidence in the $28 trillion market, where banks, hedge funds, insurance companies and investors speculate on the creditworthiness of borrowers or hedge against losses on debt. Market decisions, while not binding, were made previously during conference calls between dealers, with no clear rules in place to ensure all sides were being considered.
"It’s largely in the past been seen as a closed-door process," said Brian Yelvington, an analyst at debt research firm CreditSights Inc. in New York. With the committee, "the transparency and the fact that you should get some consistency gives people a lot more confidence than they’ve had," he said. The committee is part of a broader effort being pushed by regulators including the Federal Reserve Bank of New York to curb the risk of systemic losses from the privately negotiated market, where outstanding contracts ballooned to as much as $62 trillion at the end of 2007. The overhaul, dubbed the "Big Bang" because it’s considered a cataclysmic shift for the market, aims to bring a fresh set of standards to existing and new trades. The 2,023 entities that had signed up as of late yesterday in New York, as measured by the International Swaps and Derivatives Association, will agree to abide by the committee’s decisions and auctions that determine the value of underlying securities. The auctions effectively set the size of the payout when borrowers default.
Both the auction and the credit-swaps committee are necessary for another effort pushed by regulators: moving the derivatives through clearinghouses designed to absorb the failure of a dealer collapse. Without a panel to make binding decisions, clearinghouses would be at risk of having a firm on one side of a trade disputing a so-called credit event while the other side demands payment. After more than a week of debating, dealers last month overruled some objections and declared a credit event for contracts guaranteeing the debt of a unit of Montreal-based AbitibiBowater Inc., North America’s biggest newsprint maker. Credit-default swaps pay the buyer face value if a borrower defaults in exchange for the underlying securities or the cash equivalent. The Fed began pushing for clearinghouses last year after the near-collapse of Bear Stearns Cos. in March 2008 and the failure of Lehman Brothers Holdings Inc. in September triggered concern that banks were too interconnected.
Dealers probably lost "hundreds of millions" of dollars because of failed trades with Lehman, Moody’s Investors Service said last year. Lehman’s collapse also triggered a panic that other firms could fail, prompting the U.S. to provide capital to the nine biggest banks and guarantee new debt for three years. Rules of the new committee will require an 80 percent majority among the 15 members before a credit event can be declared. Credit events allow a firm that bought protection against default to demand payment from its counterparty. Matters failing to get an 80 percent agreement would be sent to a panel of arbitrators. The International Swaps and Derivatives Association, or ISDA, will serve as secretary of the committee and will be required to publish each matter brought before the committee on its Web site, including information on the firm that brought it and how each member of the committee voted.
Market participants "know that even if they aren’t in the room themselves, they’ll at least understand how the decisions were made and can have more confidence that the decision is correct," said Jason Quinn, co-head of high-grade and high- yield flow trading at Barclays Capital in New York. Barclays is one of the 10 dealers on the committee. Along with Newport Beach, California-based Pacific Investment, known as Pimco, which manages the world’s biggest bond fund, and Elliott Management in New York, the swaps committee will include representatives from Rabobank International, Legal & General Investment Management Ltd. and Primus Asset Management Inc. "The inclusion of buy-side firms makes the process stronger," Thomas Jasper, chief executive officer of Bermuda- based Primus Guaranty Ltd., said in a statement. The firm, which manages about $22 billion in credit-default swaps, is the parent of Primus Asset Management.
Spokespeople for the other firms didn’t return calls for comment, declined to comment or couldn’t immediately be reached. Investment firms have "long been an intrinsic part" of "decision-making processes," ISDA Chief Executive Officer Robert Pickel said in a statement. "This community constitutes over a third of our membership.’ The other dealers with votes on the committee for U.S. and European markets are Deutsche Bank AG, Morgan Stanley, Bank of America Corp., UBS AG, Citigroup Inc., Credit Suisse AG and Royal Bank of Scotland Group Plc. Disputes are now largely settled outside the courts, said Robert Claassen, chairman of the derivatives and structured products group at New York-based law firm Paul Hastings. "There have definitely been some disagreements, they just haven’t ended in litigation, so you don’t hear about it," Claassen said. "People settle."
After the government seizure of Washington-based Fannie Mae and Freddie Mac of McLean, Virginia, triggered settlement of credit swaps linked to the mortgage-finance companies last year, a group of investors fought to have included in the settlement so-called principal-only bonds, some of which traded at almost half the value of most of the companies’ debt. Because investors have the option to deliver the cheapest eligible securities, allowing the bonds to be covered by the derivatives would have led to a larger payout than the 0.1 cent to 8.5 cents on the dollar that dealers set at an auction used by more than 650 entities. "Within the new framework, a committee member has to make a decision regardless of his firm’s involvement in the decision," Yelvington said. "This should encourage everyone to be looking for fairness and consistency so that everybody knows how the game is played."
Ilargi: Kinf of nice, not entirely new, or maybe it is for the FT. NB: I think the editor wrote the headline; Taleb would not claim there could be a black swan free planet.
Ten principles for a Black Swan-proof world
1. What is fragile should break early while it is still small. Nothing should ever become too big to fail. Evolution in economic life helps those with the maximum amount of hidden risks – and hence the most fragile – become the biggest.
2. No socialisation of losses and privatisation of gains. Whatever may need to be bailed out should be nationalised; whatever does not need a bail-out should be free, small and risk-bearing. We have managed to combine the worst of capitalism and socialism. In France in the 1980s, the socialists took over the banks. In the US in the 2000s, the banks took over the government. This is surreal.
3. People who were driving a school bus blindfolded (and crashed it) should never be given a new bus. The economics establishment (universities, regulators, central bankers, government officials, various organisations staffed with economists) lost its legitimacy with the failure of the system. It is irresponsible and foolish to put our trust in the ability of such experts to get us out of this mess. Instead, find the smart people whose hands are clean.
4. Do not let someone making an "incentive" bonus manage a nuclear plant – or your financial risks. Odds are he would cut every corner on safety to show "profits" while claiming to be "conservative". Bonuses do not accommodate the hidden risks of blow-ups. It is the asymmetry of the bonus system that got us here. No incentives without disincentives: capitalism is about rewards and punishments, not just rewards.
5. Counter-balance complexity with simplicity. Complexity from globalisation and highly networked economic life needs to be countered by simplicity in financial products. The complex economy is already a form of leverage: the leverage of efficiency. Such systems survive thanks to slack and redundancy; adding debt produces wild and dangerous gyrations and leaves no room for error. Capitalism cannot avoid fads and bubbles: equity bubbles (as in 2000) have proved to be mild; debt bubbles are vicious.
6. Do not give children sticks of dynamite, even if they come with a warning . Complex derivatives need to be banned because nobody understands them and few are rational enough to know it. Citizens must be protected from themselves, from bankers selling them "hedging" products, and from gullible regulators who listen to economic theorists.
7. Only Ponzi schemes should depend on confidence. Governments should never need to "restore confidence". Cascading rumours are a product of complex systems. Governments cannot stop the rumours. Simply, we need to be in a position to shrug off rumours, be robust in the face of them.
8. Do not give an addict more drugs if he has withdrawal pains. Using leverage to cure the problems of too much leverage is not homeopathy, it is denial. The debt crisis is not a temporary problem, it is a structural one. We need rehab.
9. Citizens should not depend on financial assets or fallible "expert" advice for their retirement. Economic life should be definancialised. We should learn not to use markets as storehouses of value: they do not harbour the certainties that normal citizens require. Citizens should experience anxiety about their own businesses (which they control), not their investments (which they do not control).
10. Make an omelette with the broken eggs. Finally, this crisis cannot be fixed with makeshift repairs, no more than a boat with a rotten hull can be fixed with ad-hoc patches. We need to rebuild the hull with new (stronger) materials; we will have to remake the system before it does so itself. Let us move voluntarily into Capitalism 2.0 by helping what needs to be broken break on its own, converting debt into equity, marginalising the economics and business school establishments, shutting down the "Nobel" in economics, banning leveraged buyouts, putting bankers where they belong, clawing back the bonuses of those who got us here, and teaching people to navigate a world with fewer certainties.
Then we will see an economic life closer to our biological environment: smaller companies, richer ecology, no leverage. A world in which entrepreneurs, not bankers, take the risks and companies are born and die every day without making the news.
In other words, a place more resistant to black swans.
US Treasury Begins Aid Programs for Auto Suppliers
The U.S. Treasury Department began financing-support programs through General Motors Corp. and Chrysler LLC aimed at helping auto-parts makers survive the industry’s sales slump.
GM will get $2 billion under the programs, which guarantee payments owed to suppliers, Dan Flores, a spokesman for the automaker, said today. Chrysler will be able to use $1.5 billion, according to a person familiar with the situation. “These efforts, backed by U.S. Treasury resources, will help stabilize the auto-supply base and restore credit flows in a critical sector that employs more than 500,000 American workers,” Jenni Engebretsen, a department spokeswoman in Washington, said in a statement. The federal government is trying to avoid supplier shutdowns as GM and Chrysler operate with $17.4 billion in Treasury loans and face the possibility of bankruptcy protection. U.S. sales of new cars and light trucks tumbled 38 percent in this year’s first three months, and automakers have scaled back production, squeezing partsmakers.
The government initially made $5 billion available for any U.S. automaker that wanted to participate. Ford Motor Co. declined to take part, saying it had enough funding to pay its suppliers. The support programs are open to accounts receivable for goods shipped after March 19 that meet required commercial terms, the Treasury said. “This program will help suppliers access much-needed liquidity during these very difficult economic times,” Flores said in an e-mail. Suppliers of Detroit-based GM and Auburn Hills, Michigan- based Chrysler will have accounts receivable guaranteed by the government for a 2 percent fee, or paid immediately for a 3 percent charge. ADAC Automotive Inc., a closely held maker of automotive products such as door handles and blinkers, will apply, Chief Financial Officer Tom Kowieski said. The Grand Rapids, Michigan- based supplier gets about 19 percent of its revenue from Chrysler and 16 percent from GM.
Lear Corp., the world’s second-largest maker of auto seats, is waiting for details of the program before deciding whether to participate, spokesman Mel Stephens wrote in an e-mail. Dana Holding Corp., a truck-axle producer that exited bankruptcy in 2008, isn’t pursuing any federal assistance, spokesman Chuck Hartlage said in an e-mail. Supplier stocks rose on the Treasury announcement. American Axle & Manufacturing Holdings Inc., a Detroit- based maker of axles for GM, rose 6 cents, or 4.3 percent, to $1.46 at 10:32 a.m. in New York Stock Exchange composite trading, after surging as much as 26 percent. TRW Automotive Holdings Corp., the world’s biggest maker of vehicle-safety equipment, gained 40 cents, or 7.5 percent, to $5.71 and increased as much as 13 percent. The Bloomberg U.S. Auto Part/Equipment Index rose 1.6 percent. The 14-company index includes suppliers such as Livonia, Michigan-based TRW and Southfield, Michigan-based Federal Mogul Corp.
Canada Boosts Part Makers Insurance, Backs Warranties
The Canadian government will increase its fund for insuring auto-parts makers’ sales by C$700 million ($567 million) and guarantee consumers’ warranties on new General Motors Corp. and Chrysler LLC vehicles. The federal government will give Export Development Canada the funds to insure parts makers’ account receivables, Industry Minister Tony Clement told reporters today in Ottawa. He said the "downside risk" for the government on this insurance is C$185 million at most. "The recent global credit situation has pinched these companies’ cash flow to a trickle," Clement said. The new insurance funding "expands a significant tool at the disposal of our auto-parts suppliers."
Canada last week extended deadlines for GM and Chrysler to work on their restructuring plans and said it won’t provide long-term loans until the overhaul is complete. Clement said today the government is taking the steps so that the market would continue to operate amid uncertainty surrounding GM and Chrysler. "There used to be a phrase in the auto sector: too big to fail," Clement said. "I don’t think that phrase exists anymore." Canada’s decision to force GM and Chrysler to rework their plans followed a similar announcement by U.S. President Barack Obama’s administration. Canada said Chrysler must enter an agreement with Fiat SpA before the end of April and GM has 60 days to rework its plan because the company’s current restructuring wouldn’t leave it viable.
The government guarantee of new vehicle warranties, similar to one announced last week by the U.S. government, is a "way to assure the buyer that if you buy a GM or a Chrysler product, your five-year warranty will be acted upon," Clement said. Still, "if you bought a car yesterday, clearly you felt that your warranty would be in place and that was part of your decision-making." GM, which has about 12,000 workers in Canada, said in a statement it "welcomes today’s announcements," adding "we remain focused on taking all necessary steps, working with the governments and all our stakeholders to quickly and successfully complete our restructuring in this challenging market."
Canada to split with U.S. on mark-to-market rule
Canada is set to split with the United States over its response to the financial crisis and reject a move to let banks duck losses by inflating the value of troubled assets, according to people familiar with the matter. The country's top accounting watchdog reached the decision during a closed-door board meeting on Monday, giving a thumbs-down for now to a U.S. move to loosen accounting standards. The decision, due to be announced this week, is a big blow to Bay Street and means Canadian companies will have to record hits on distressed assets that are hard to sell. Shares in Canadian banks rallied last week along with Wall Street after Washington's politically charged decision to ease so-called mark-to-market rules that experts said could goose bank profits by 20%.
Bay Street executives had lobbied for Canadian authorities to follow the American lead, and will be bitterly disappointed by the decision to break with Washington and align with Europe. "There would be deep concern if the Canadian accounting sector failed to move in step with the U. S. because of the close ties the Canadian industry has to our neighbours," said a person in the banking industry. "A lot of big Canadian companies are raising money in the U.S. and if there is divergence it would be viewed negatively," the person said. Banks are expected to try to overturn the decision and seek political intervention to persuade the Canadian Accounting Standards Board to change course. The pressure will likely begin this week when chief executives of top banks start a series of meetings on the fallout from the financial crisis with Jim Flaherty, the Finance Minister.
The one-on-one sessions will provide CEOs with a chance to make direct personal appeals to the Minister, as Ottawa develops the next phase of its response to the crisis following a summit of world leaders in London. The international community has been split by attempts to ease mark-to-market rules, which banks argue force companies to take losses on troubled assets that will likely bounce back, exacerbating the crisis. Auditors, analysts, and institutional investors tend to argue the bid to loosen the rules amounts to financial chicanery and will only further dent confidence in banks' books. The American decision was blasted by the European industry as an example of "political interference [which] will only serve to further destabilize confidence in the system."
The U.S. changes will make it easier for companies to price assets using their own internal models rather than market prices, and allow them to recognize only part of any losses in their income statements. A smaller first step in this direction was taken last October by the United States, and followed by the Canada's accounting watchdog, under political pressure. But Canada's accounting board on Monday decided the American action was not in the "public interest," according to people familiar with the deliberations in Toronto. The watchdog will instead move in step with an international body with strong support in Europe. The international umbrella organization is currently not scheduled to revisit its rules on mark-to-market accounting for many months, but is due to meet later this month and could yet strike a compromise.
French workers hold 4 managers in factory
Workers were holding four managers at a British-run factory captive Wednesday after keeping them overnight in a dispute about closing the plant, a company official said. Employees at French plants belonging to Sony, Caterpillar, 3M and German auto-parts maker Continental have held bosses in recent weeks in response to proposed job cuts and plant closings. They have let them go within a day or two, often after winning some concessions. The tactic of holding managers has long been used in France, though sporadically, and has drawn new attention amid the economic downturn. French President Nicolas Sarkozy denounced the tactic. "What is this story about going and holding people hostage?" he asked Tuesday. "We are in a state of laws, there is a law that applies, I will ensure it is respected."
Employees of Britain's Scapa Group PLC barred the senior managers from leaving Tuesday after negotiations over terms of the factory closure broke down. Workers blocked the entrance to the site with a truck, said Scapa's European finance director, Ian Bushell, who described it as a "non-aggressive action." The plant in Bellegarde in the foothills of the French Alps makes adhesive tape for the auto industry, which is suffering its worst crisis in decades. Employee representatives could not be reached for comment. "Our primary concern is always for the safety of our people," Bushell said by telephone from the company's global headquarters in Greater Manchester. "Our secondary concern is that we should immediately have a re-engagement of negotiations with the union."
The Scapa site in Bellegarde employs 68 people. Plans to close the plant were drafted in response to a faltering auto market, Bushell said. Tuesday's negotiations centered on job transfers or layoffs that would accompany the closing. Negotiations were slated to resume Wednesday afternoon at the mayor's office. Steep labor costs have made France a target for several recent factory closings. Bushell insisted that labor costs in France were not a reason for the Scapa closure. Scapa has plants throughout Europe and North America, as well as China and Malaysia.
Ilargi: The funniest thing about this one is that Reuters filed it under its "Lifestyle" section.
Almost half of French approve of locking up bosses
Almost half of French people believe it is acceptable for workers facing layoffs to lock up their bosses, according to an opinion poll published on Tuesday. Staff at French plants run by Sony, 3M and Caterpillar have held managers inside the factories overnight, in three separate incidents, to demand better layoff terms -- a new form of labor action dubbed "bossnapping" by the media. A poll by the CSA institute for Le Parisien newspaper found 50 percent of French people surveyed disapproved of such acts, but 45 percent thought they were acceptable. "They are not in the majority ... but 45 percent is an enormous percentage and it demonstrates the extent of exasperation among the public at this time of economic crisis," Le Parisien said.
On March 31, billionaire Francois-Henri Pinault was trapped in a taxi in Paris for an hour by staff from his PPR luxury and retail group who were angry about layoffs. Riot police intervened to free him. Le Parisien found that 56 percent of blue-collar workers polled approved of bossnappings while 41 percent disapproved. Among white-collar workers, 59 percent were against the practice while 40 percent thought it was acceptable. "These hostage takings, we know how it starts but no one knows how far it can go," said Xavier Bertrand, a former labor minister now secretary-general of the ruling UMP party. "Our country must avoid entering a spiral of violence," he said in reaction to the opinion poll, adding that bossnappings "cannot be tolerated."
Ireland Doesn’t Need Bailout, Finance Minister Says
Ireland’s Finance Minister Brian Lenihan said the country doesn’t need any bailout from the European Union and that he will continue to cut spending to control a ballooning deficit. "We don’t need any bailout here," Lenihan said in a interview with Bloomberg Television from Dublin today. "There are good elements" in this economy, "but we’ve had a crisis in the public finances." Ireland’s budget deficit is set to soar to 10.8 percent of gross domestic product this year, more than three times the European Union limit, even after the government announced a plan to cut spending and increase taxes. The economy will shrink by 8 percent in 2009 and tax receipts may drop 16 percent, according to finance ministry forecasts.
"We had to introduce some emergency taxation measures to shore up our revenue base," Lenihan said. "But where the real heavy lifting has to take place is on expenditure. We’ll keep doing that." The government also said it will buy as much as 90 billion euros ($119 billion) of real-estate loans from the country’s biggest lenders in an effort to salvage the banking system. The government will pay an "economic price for these assets which ensures that both the developers and the banks take a significant loss where they were originally purchased at very inflated prices," Prime Minister Brian Cowen told parliament in Dublin today. Assuming the toxic loans will result in a "very significant increase in gross national debt," Lenihan said in his emergency budget yesterday. The increase will be offset by the sale of some assets transferred to the government.
The difference in yield, or spread, between Irish and German 10-year notes widened to 215 basis points today from 204 yesterday. The spread widened from 40 basis points a year ago as investors demanded higher premiums to lend to smaller European economies amid the global financial turmoil. Credit-default swaps on Irish government debt rose to 237 basis points today from 225 yesterday, according to CMA Datavision. They reached a record 393 basis points on Feb. 17. "The bond markets are paying more attention to the bad loan rescue package," said Padhraic Garvey, head of investment- grade debt strategy at ING Group in Amsterdam. The loans are the "worst stuff" on the banks’ books and "this is effectively going to be taken over by the Irish government."
Moody's downgrades Irish banks
Moody’s Investors Service has downgraded its financial-strength rating on 12 Irish lenders, citing rising losses on property loans. The losses are likely to "significantly weaken the capital positions" of most banks and building societies, Moody’s London-based analyst Ross Abercromby said in a statement on Thursday. The rating on each bank was downgraded by at least one level. "A key risk to the Irish banks in the current environment is their large exposures to residential and commercial development, given the substantial reduction in asset prices and even higher falls in land values," the statement said.
Ireland’s government on Wednesday said it will transfer as much as €90bn (£81bn) in risky real estate loans from the country’s banks to a new asset management company to remove "systemic risk". Financial Minister Brian Lenihan said he is prepared to take equity stakes in the banks if the transfer results in substantial losses. "If the result of taking these losses means that the banks need further investment from the state, that will be done by the way of ordinary shares," Mr Lenihan told RTE Radio today. "In other words, the state will take majority control of these institutions." Allied Irish Banks, the country’s biggest lender by market value, plunged as much as 39pc in Dublin trading, and was 31pc lower at 10.38am, its biggest intraday decline since January 19. Bank of Ireland slumped 28pc to 69 cents and Irish Life & Permanent fell 6pc to €1.55.
German Exports Sink 23.1%
German exports slumped 23.1% in February from a year earlier, indicating that a sharp decline in global demand is hurting German industry, official data showed. Total goods imports declined 16.4% over the same period, the Federal Statistics Office reported Wednesday, as the euro zone's largest economy remains mired in recession. February's collapse in exports almost matches January's fall, when exports dropped 23.2% on a year-to-year basis, the sharpest decline since records began in 1950, an economist at the statistics office said. Total goods exports, adjusted for workday and seasonal factors, fell 0.7% from January, while imports decreased 4.2% over that period. Economists said Germany is in the middle of a severe recession, and gross domostic product will decline around 5% this year.
The weakness in demand for German goods was wide-spread. Exports to other European Union countries fell 24.4% year-to-year, while imports from those countries dropped 14.8%, the data showed. German exports to other euro-zone nations declined 22.5% from a year earlier, while imports from the region were down 13.1%. Exports to countries outside the EU, which are affected by the euro's exchange rate, fell 20.6% from a year earlier, while imports from those countries declined 19.2%. Germany's trade surplus widened to €8.7 billion ($9.29 billion) in February from a revised €7 billion in January, as imports dropped more than exports. The country's current account surplus more than doubled to €5.6 billion from a revised €2.3 billion in January. Economists polled by Dow Jones Newswires had expected a trade surplus of €7.4 billion and a current account surplus of €5.6 billion for February.
Party Ends for Russian Rich After $230 Billion Losses
Champagne and caviar are out in Moscow, and vodka and pelmeni dumplings are back in. Rich Russians, stung by the end of the biggest economic boom in their history, are tempering the opulent lifestyles that made the city of 10 million the bling capital of Europe. Demand for private jets and $500,000-a-week yachts has collapsed, while a survey by restaurant consulting group Restcon found revenue at high-end eateries has halved. Luxury-clothing boutiques selling brands such as Alexander McQueen and Stella McCartney are closing down. "A new lifestyle mentality is taking shape," said Roman Trotsenko, 38, the millionaire founder of airport builder Novaport. "People aren’t really in the mood to party."
Moscow had 74 billionaires a year ago, more than any other city in the world. Now it has 27, according to Forbes magazine. The 25 richest Russians lost a combined $230 billion during six months last year as the value of their companies plunged along with commodity prices, according to Bloomberg calculations. The government expects the economy to shrink 2.2 percent this year after expanding about 7 percent a year since 1999. Unemployment is at a four-year high of 8.5 percent. The proportion of people who consider themselves "poor" has doubled to 14 percent in the past year, according to the All- Russian Center for the Study of Public Opinion in Moscow. "You just can’t party when others are starving," said Boris Teterev, president of Rolls-Royce Motor Cars Moscow, which opened in 2004 to cater to Moscow’s nouveau riche.
Trotsenko said Russians are increasingly spending more time with their families, on trips to theaters and museums and "home parties" with vodka and pelmeni. Conspicuous consumption was socially acceptable during the boom, when unemployment was falling and wages were rising, said Trotsenko, who is worth $70 million, according to Finans magazine, a Russian competitor of Forbes. Teterev, 55, who has a personal fortune of $200 million, according to Finans, envisages Rolls-Royce sales will fall by as much as a third this year. That’s about twice the rate of decline that Milan-based industry group Altagamma predicts for Russia’s $5.7 billion luxury market as a whole. "Spending just isn’t fashionable anymore," said Kirill Shishkov, co-owner at Teorema Holdings, which develops residential and commercial property in St. Petersburg. Shishkov, 37, who spoke by mobile phone en route to the Swiss Alps, also is among the 400 Russians who are worth at least 2 billion rubles ($60 million) each, according to Finans.
While part of the change in spending behavior is due to shrinking fortunes, politics is playing a role, said Alexander Dobrovinsky, a corporate and divorce lawyer whose clients have included the ex-wife of billionaire Alexei Mordashov, 43, chief executive officer of steelmaker OAO Severstal. Many oligarchs are seeking state protection from Western creditors and don’t want to irritate the Kremlin with outlandish behavior at a time when the government has declared social spending its top priority, Dobrovinsky said. "The private jets are still there, but the names of the owners have been scratched off," said Dobrovinsky. President Dmitry Medvedev spelled it out last month, saying the wealthiest Russians need to focus more on their businesses and less on personal spending to help the country weather the worst economic crisis in a decade.
"People became very wealthy in a very short time," Medvedev, 43, a lawyer by training, said in a March 15 television interview. "Now it’s time to repay debts, moral debts, because this crisis is a test of maturity." Medvedev was voicing support for what state television and talk radio call the "anti-glamour revolution." Alexander Lebedev, 49, said many of his fellow billionaires "accumulated huge debt buying all those mega-yachts and private jets" and will struggle to pay it back. "Medvedev is not going to reeducate them, but real life will," said Lebedev, whose assets, including 29 percent of airline OAO Aeroflot, are worth $1.9 billion, according to Finans. A lot of the decline in spending is simply down to image, said Teterev at Rolls Royce. "People who lost their money now pretend it’s trendy, but if you have resources, you will never get rid of your driver or your cleaning staff," he said.
There’s also evidence the Russian party is just moving elsewhere, away from the Kremlin’s gaze. "We’re sold out this season," said Alexi Usati, owner of Retrohunt, a Namibian company that offers Russian clients "hunting and safari adventures" for $150,000 each. There’s no sign of crisis, either, at Most, a French restaurant a block from Red Square that recently charged a couple $16,000 for dinner. "Our guests are used to this lifestyle," General Manager Mikhail Dolgi said. Moscow authorities last month allowed dozens of people to demonstrate downtown against ostentatious spending, with placards saying, "Glamour is a party during the plague." "The glamour lifestyle is promoted by those who agree with the pro-American lifestyle and want to destabilize our society during these difficult times," said Alexander Bovdunov, a spokesman for Eurasia Youth Union, which organized the event.
In February, Medvedev banned his staff from vacationing abroad without permission after three Kremlin officials were spotted partying in the glitzy French ski resort of Courchevel, according to the Kommersant newspaper. Mikhail Prokhorov, then CEO of OAO GMK Norilsk Nickel, embarrassed the Kremlin two years ago by flying in a planeload of women for a private party and getting arrested on suspicion of pimping. He was cleared of any wrongdoing because the judge ruled there wasn’t enough evidence. Prokhorov, 43, now Russia’s richest man, appears to have gotten the message and is even leading the charge against the same opulence he displayed in Courchevel. Snob, his lifestyle magazine for jetsetters, last month declared the new motto for Moscow: "Fast, Slick and Cheap." Snob told its readers that "saving money is the trendiest thing to do at the moment."
1819: America's First Housing Bubble
"Beautiful credit! The foundation of modern society! Who shall say that this is not the golden age of mutual trust, of unlimited reliance upon human promises?"
– Mark Twain, The Gilded Age
With little interest in and even less knowledge of history, the modern American finds anything he considers tragic to be an utterly new crisis of unfathomable proportions and, as befits a great nation, one completely new to mankind's historical experience. As any patriotic American knows, we ooze uniqueness. Yet, despite Congressman Barney Frank's blubbering insistence that our nation's current financial mess is a "new phenomena," today's "housing/credit/confidence crisis" is anything but. Our ancestors had already seen all the broken dreams and ignorant greed surfing high on a wave of paper money and hollow credit — more than once before. The America of 1819 and the financial panic its citizens experienced was only the first of what is America's true national pastime: speculative mania.
Examining how the men of 1819 responded to the crisis and, most importantly, what the results of their actions were, may give us an idea or two (or none) to help solve the current crisis. Should we solve it — and I have no doubt that we will — then we can write down our own warnings, born of harsh experience, so that generations not yet born may completely ignore them too. From the Roaring Twenties to the "great moderation," America has always shown a flair for labeling things, and speculative manias are no exception. Historians remember the ignorant, blissfully happy times that preceded the Panic of 1819 by the same label as those who lived through them — the Era of Good Feeling.
Like so much of what is fatal to civilized society, the Panic of 1819 was birthed in the turmoil of war, specifically the War of 1812, a now-largely-forgotten episode best remembered for delivering Francis Scott Key's hard-to-sing and harder-to-listen-to "Star-Spangled Banner." As in every war, the host government's first battle was to pummel the local currencies, which in 1812 America consisted mostly of state bank notes redeemable in gold, or at least promised to be. Wars are always expensive and the government's inability to print paper money at will is a huge disadvantage to them. The America of 1812 adhered to a gold standard; it had to go, and by 1814 it went.
By that year, not being able to redeem in gold all the promises of gold they had printed, the state bankers were in a fine mess, and the politicians, instead of throwing them into jail for fraud, granted them legal immunity to continue the swindle. After all, these banks were printing like mad in part to buy all those government bonds, to lend those same politicians credit in time of war and, as you doubtless know, twenty-gunned frigates like the Hornet didn't come cheap. Now freed from having to actually raise money (gold) prior to issuing paper promises for it, the banking system's highly inflationary printing binge went into overdrive. During the war's three years, domestic prices rose by 25% and import prices by 70%.
From 1811 to 1815, banks multiplied like mushrooms on a dung heap, lending out credit they didn't have as if it were manna from heaven. Where actual money in bank vaults had decreased by 9.4% during that period, paper bank notes and deposits, all with claims on that money, had increased by 87.2%. Keynes himself would have been proud. By December 1814, the British, having decided that Napoleon was more interesting to fight than America, signed the treaty that ended the War of 1812. This outbreak of peace was accompanied by an upswing in trade between the two nations' businessmen. British manufacturers were eager to begin trade again and the flood of goods and the easy availability of credit made Americans ravenous consumers. Imports, which stood at $12.9 million in 1814, reached $151 million within two years, and this during a period when imported goods, freed from the wartime risk of getting deliberately sunk in transit, were rapidly falling in price (Dupre 2006, p. 280).
During this orgy of consumption, "merchants throughout the country overextended themselves…aid[ed] in their efforts by the availability of bank credit" (Dupre 2006, p. 271). Whatever in 1819 qualified as a widescreen TV, I'm sure Americans had plenty of it because fusspots from that time, much as in ours, moaned about the people's sad attraction to wasteful spending on trivial luxuries. America as a whole was importing far more than it was exporting, as our exports were flat in volume and rising only in terms of depreciating paper bank notes.
In addition to our ancestors' heightened attraction to imports, "the sudden availability of vast new reaches of territory, combined with the loose money left over from the war" (Brands 2006, p. 66) ignited a real-estate mania in America, particularly along the young nation's frontier areas. Illinois, overrun with fevered buyers, was the epicenter with Ohio not too far behind. Cincinnati laid claim to being the Las Vegas of the mania, and, according to one historian, most of it was subsequently repossessed. As 1815 came to a close, the proliferation of paper bank notes and credit had the financial system of the United States in a mess — a direct result of the political establishment deliberately allowing the state banks to counterfeit with impunity. Now, seeing the orgy of speculation, stockjobbing, and pursuit of luxury imports that their policies had created, Congress stepped in to clean up the mess.
Amidst much hypocrisy, backroom dealing, bribery, threats, and displays of great oratorical skill, they proposed for themselves more money and power: another central bank, America's second go at the institution. (We are now on our fourth.) The new Bank of the United States was up and running by 1816, with the ostensible purpose of bringing the state banks' inflation to heel. Instead, the men who ran the new central bank promised not to demand redemption of any state bank paper notes until over one year later. And they bailed out the insolvent state banks with $6 million in taxpayer money. The more things change, the more they stay the same.
To add injury to insult, the men who ran the central bank "jumped on the inflationary bandwagon" themselves (Dupre 2006, p. 271). Printing paper and promises with Bernanke-like abandon, within two years of its creation they had loaned $41 million worth of gold promises and issued paper bank notes redeemable in gold worth $23 million, all on top of just $2.5 million worth of gold (Dupre 2006, p. 270), a level of leverage insane enough to make a Lehman Brothers risk manager feel right at home. "Flood[ing] the market with bank notes it could not now redeem" (Dobson 2002, p. 105) between 1816 and 1818, the supply of paper bank notes and credit on the US market grew by 40.7%, "most of it supplied by the Bank of the United States" (Rothbard 2007, p. 87). The Philadelphia and Baltimore branches of the bank would prove to be the most profligate — and the most corrupt — of all.
The economic dislocations gained steam throughout 1816–1818, and prices in real estate, land, and slaves floated upward on credit. As 1818 feverishly arrived, though, it was only the greatest of the fools who were buying. The music would soon come to an end since the postwar prosperity was built on a foundation of nothing more than pieces of paper with promises scribbled on them. In the actual vaults, there was precious little money (the pledged gold) at all. Soon enough this became a problem, as notes from the Bank of Kentucky promising gold wouldn't sit well with a merchant from Liverpool, England. Foreign merchants demanded payment in money, not paper. Plus, payment was coming due for the Louisiana Purchase and the French also wanted gold, not paper. The central bank was responsible for coming up with that money. Foreseeing disaster, it slammed on the monetary brakes.
So recently the Johnny Appleseed of credit, the Bank of the United States now returned as a loan shark's heavy. In one hand they held the state bank notes, with the other they demanded the gold pledged by them, which the state banks had little of. When it was realized that many paper bank notes were just that, their values began to collapse, many to zero (the same amount of gold you could get for it), and the money supply contracted at a ferocious rate. From the fall of 1818 to the beginning of 1819, demand liabilities at the central bank fell from $22 million to $12 million (Dupre 2006, p. 272) and the total money supply fell about 28% (Rothbard 2007, p. 89).
Insolvent banks and overextended debtors alike collapsed, while prices, no longer pumped up by the bubble, raced downward to their equilibrium. As the money supply cleansed itself of the bad apples, time and effort had to be paid so that the flow of funds could adjust back to their best uses, following prices as their guideposts. It was a massive, countrywide downturn, and introduced a slowly industrializing America to a new experience — mass unemployment. Compared to now however, the state and federal politicians did basically nothing to "help" the economy recover from the Panic of 1819, yet by 1821 the economy had begun to get back on its feet, which must seem a stunning outcome to anyone burdened with a degree in economics.
The response of America's intellectual and political elite to the Panic of 1819 was, in most ways, vastly different from what it has been so far in our current "Great Unmoderationing." Although we live under the same legal constitution and within the same lines on the map, the America of 1819 had a citizen who was, culturally speaking, utterly alien to the modern American; that they adhered to a gold standard, however imperfectly, is but one example of this difference. To reap the benefits of a gold standard requires a character and sense of honor that modern Western man no longer possesses. The 1819 man is so fascinating because he had enough character and honor to realize he had made mistakes and to clean them up far more quickly than we. In times of crisis, he had the advantage of firm principles to guide him.
That's not to say that it was an era of perfect laissez-faire; human beings are not capable of it and likely wouldn't want it if they were. A powerful voting bloc arose that clamored for continued government intervention since it was political manipulation of the markets that had created them in the first place. They desperately needed its continuance to sustain them. They demanded taxpayer money to lessen the blow of their mistakes, legal attack on their competitors, and license to disregard their pledge to the rule of law. These people fell into three broad categories: the debtors looking for relief, businessmen seeking protectionist measures, and the politicians wanting power. Their arguments read like today's New York Times, and there is no need here to repeat them — you're no doubt already familiar with them.
It is the unusual that grabs the attention, and the ideas and beliefs of the majority of our ancestors on how best to clean up the mess of 1819 are vastly different from almost everything I see and hear today. From CNBC's cute little money honeys to newspaper op-eds to my coworkers on the trade desk, all cry that the government must do something. Many of the elite from 1819 believed the exact opposite — that government must do nothing. The newspaper editors of 1819 in particular led the fight against continued government intervention in the market and, most surprising to a denizen of 2009 America, many politicians at both the state and federal level joined them. Dodo birds of a political kind once roamed our nation's capitals.
In 1819 America, nobody blamed the effects for the Panic of 1819, they rightly blamed the cause; they blamed (in Caroline Baum's words) the "friendly central bank." As Professor John Dobson points out, "the [central] bank's policies fueled inflation, and it was popularly viewed as a major contributor to the Panic of 1819." After this encounter with central banks, "hard money leadership was abundant and influential" (Rothbard 2007, p. 207). The urge to bail out debtors was fought against not only from a practical but from a moral level as well. Besides Tennessee state representative Robert Allen warning his colleagues that "if people learn that debts can be paid with petitions and fair stories, you will soon have your table crowded" (Rothbard 2007, p. 43), the pages of the influential Pennsylvania Aurora argued that any such bailouts would not only be economically unsound, but unjust, being a special privilege to the debtor (Rothbard 2007, p. 56).
While the federal government was a heavy player in the housing speculation — having offered over $23 million in "affordable" but now mostly delinquent loans by 1819 — for the most part it was the state capitals, where much of political power still resided in America's pre-Lincoln days, that were the scenes of battle. And not all the states were clamoring for intervention. The Massachusetts legislature in 1820, referring to hastily passed monetary laws that forced people to accept worthless paper bank notes as if they weren't, stated "the exchange value of notes must be regulated by the community itself, according to public wants and needs" (Rothbard 2007, p. 99), plus many thought that such monetary measures were pure hubris. Virginia state politician William Selden warned, "Money itself is an article of transfer. Human legislation on the subject is worse than vain" (Rothbard 2007, p. 54).
Even many businessmen had the sense of justice to stay above the fray, the United Agriculture Society of Virginia, for example, flatly claiming, "we design not to harass our representatives with high wrought pictures of distress which their wisdom could not have anticipated and cannot remove" (Rothbard 2007, p. 287). More paper money, in the view of many, was not the solution, as "bank notes came to represent the speciousness of a speculative economy driven by the hot air of credit," which enabled merchants to extend easy credit "almost at the door of every consumer" (Dupre 2006, p. 285). Having experienced its operation personally during the latter part of the Revolutionary War, the men of 1819 understood the law of marginal utility and knew it applied to money as well as any commodity.
The Pennsylvania Union derided plans to lend and borrow prosperity back, claiming that overextended credit was the very source of the panic and that "instead of looking for relief in the restriction of the credit system, we are to look for its extension" (Rothbard 2007, p. 105). Rather than printing more paper money, claimed the Southern Patriot, it might be better to protect property, and called for "the rigid enforcement of specie payments" (Rothbard 2007, p. 90). Besides the foolishness of monetary manipulation, the debasement of currency and the spur to gambling it engineered, the uncertainty that such artificial injections caused to business was well noted. Preceding by almost two hundred years the thesis of Amity Shlaes's The Forgotten Man, the New York Daily Advertiser lamented in 1820 "the shock which business of every description receives from these measures … is more than a counterbalance to any monetary relief" (Rothbard 2007, p. 51).
During the Panic of 1819's initial stages — as panicked legislators passed interventionist laws to soothe panicked voters — it was more than anything the uncertainty of the rule of law, the lifeblood of any economy, that was in short supply. Capital hates uncertainty in the law and flees from it in a blink. The passage in some states of various interventionist measures during the initial stages of the panic gave way to the realization of their immorality, unconstitutionality, and ineffectiveness, and within a few years they were repealed or struck down in court. The men of 1819 realized that a "free market" in order to work must be just that — free. They had in them what we completely lack: a trust in the American people to manage their own affairs. A trust in "free markets" is, at base, a trust in the people. Many look at freedom as a luxury today — one that we can't afford and dare not try. Our trust in ourselves is dead, but it wasn't always.
In May 1820, a Virginia representative of Congress wrote "let the people manage their own affairs … the people of this country understand their own interests and will pursue them to advantage" (Rothbard 2007, p. 32). Who in Congress today, the only place that matters politically, would dare express such heresy? In my lifetime, I have never seen nor heard such thing and that's why the Americans of 1819 — with their many held ideals long dead to my time — are fascinating. In order to hear them you need to stretch out flat on their graves and put your ear to the ground — dig up their bodies if you think it will help. But you'd better be quick about it: in the next row of graves, I spy Bernanke, Obama, and Krugman, shovels in hand, frantically digging up FDR, Lord Keynes, and the rest of the Keystone Kops.
The Panic of 1819 lasted about three years — the Great Depression lasted well over a decade. When looking for solutions to our current mess, we should study a winning team; instead we seem determined to channel FDR, the same arrogant fool who took an economic downturn and stretched it into a decade-plus tragedy. Along with our having grown a sad, deep distrust of ourselves, we have lost any sense of humility and become a nation stuffed to the rafters with the hubristic strut of The Expert. We have forgotten that "men plan and God laughs." And while every dawn brings Washington, D.C., to birth another plan to pile on top of the others, the American of 1819 had studied economics and absorbed the ultimate lesson of the science — that when it comes to some things in this lunatic asylum, the best plan of action is no plan at all.
Ilargi: Steven Chu is the winner of the 1997 Nobel Prize in physics and the present U.S. Secretary of Energy. Did I mention that Chu is also completely clueless? Whenever someone touts cellulosic ethanol, stop listening to them. But yes, it's scary to have this sort of out of the loopy loops guy running your energy department.
Pulling The Plug On Oil
by Steven Chu
It's no accident that we've become dependent on oil, which is one of the highest energy-density fuels found in nature. In fact, long before humans turned to oil for transportation, migrating birds were using a similar form of energy—stored oil in the form of body fat—to journey thousands of miles. Strictly from a physicist's perspective, burning oil for fuel can be understood. But from any other perspective, our dependency on oil is dangerous and shortsighted. Today, we import roughly 60 percent of our oil. This is a huge drain on our economy because any dollar we send overseas for oil is a dollar we can't reinvest in America. The American people, meanwhile, are at the mercy of price spikes. And, while we can't predict oil prices from year to year, we know they will rise in the long run as the developing world starts to use energy like we do.
Our oil dependency also weakens our security because much of the world's oil is controlled by regimes that do not share our values. With oil prices low, the world is now jockeying for position to guarantee long-term access to oil and gas, creating a potentially destabilizing international situation. Finally, we must move beyond oil because the science on global warming is clear and compelling: greenhouse-gas emissions, primarily from fossil fuels, have started to change our climate. We have a responsibility to future generations to reduce those emissions to spare our planet the worst of the possible effects.
For our economy, our security and our environment, we must free ourselves from foreign oil. We must depend not on the oilfields of the Middle East but on the farm fields of the Midwest and on our vast wind and solar resources here at home. After decades of excuses and inaction in Washington, President Obama is taking serious steps toward energy independence. By transforming how we use energy, we can create new jobs and entire new industries based on America's resources, America's ingenuity and America's workers. Through his American Recovery and Reinvestment Act, President Obama is making a down payment on a clean-energy future. We will double our alternative-energy capacity over the next three years. The Recovery Act also begins to modernize our nation's electric grid, so we can move clean energy from the places it can be produced to the places it will be used. And we will create jobs and cut energy bills by helping working families weatherize their homes.
The most direct way to reduce our dependency on foreign oil is to simply use less of it, starting with the cars and trucks we drive. Nearly 70 percent of our oil use is for transportation, and more than 65 percent of that amount is for personal vehicles. President Obama has already ordered new fuel-efficiency standards for 2011 model-year cars and trucks, and we can all do our part by starting to make personal changes immediately. All Americans can strike a blow for energy independence by choosing to buy fuel-efficient cars, take public transit or join a carpool. These steps will save families money and will help keep oil more affordable by reducing demand. For the longer term, energy independence means changing how we power our cars and trucks from foreign oil to new American-made fuels and batteries.
We will continue to need high-energy-density fuels for years to come. But we can develop new liquid biofuels that will be direct replacements for gasoline and diesel fuel. These will be next-generation biofuels made from high-energy grasses such as miscanthus and from agricultural wastes. In 2005 the Oak Ridge National Laboratory outlined an achievable strategy (known as the "Billion Ton" study) for using biomass to replace 30 percent of our transportation fuels, and the science has advanced since then. When we have new biofuels that can be blended at any level with gasoline and that are safe for both engines and the environment, the importance of oil as a strategic resource will plummet.
We must also move toward running new vehicles on electricity—and to generating that electricity from clean, renewable sources like solar and wind power. We are pursuing electrichybrid vehicles with batteries that can be charged in ordinary wall outlets. President Obama recently announced $2.4 billion in funding to put America's manufacturers to work producing these plug-in hybrid vehicles and the battery components they run on. The Department of Energy is also researching potentially revolutionary advances in battery technology. With these investments, we can create new jobs and make sure the next generation of biofuels and fuel-efficient cars are made right here in America. We can seize our own energy destiny and start meeting America's energy needs with America's resources.
Ilargi: If science needs to save our food supplies, we might as well give up.
Impending skills shortage in agricultural science puts world food supply at risk
Low numbers of UK students and researchers working in the agricultural sciences mean that we may not have the resources needed to ensure sufficient food-crop production across the globe in the near future. The warning comes from the Royal Society which is conducting a major study exploring how science can enhance global food-crop production.The issue was highlighted by UK delegates at a two-day workshop * on food-crop production at the National Institute for Plant Genome Research in Dehli, India attended by scientists from India, Brazil, South Africa and Mozambique. The Royal Society has today published a report of this meeting outlining the challenges discussed by attendees.
According to the scientists, a decline in students pursuing agricultural sciences as well as a decrease in the number of university departments teaching these subjects has been a consequence of almost two decades of reducing public investment in agricultural research and poor career prospects. The UK faces a potentially serious skills shortage. Areas of research affected include plant breeding, plant pathology, agronomy, crop physiology, agricultural entomology, weed science, post-harvest biology, soil science and agricultural engineering. Professor Ian Crute, Director of Rothamsted Research and a member of the Royal Society's food-crop production working group said:
"The United Nations has said that food production must increase 50% by 2030 if the demand resulting from population growth and greater prosperity in the developing world is to be met. Advances in agricultural science will be a vital component of our capacity to tackle global food shortages. Unless we address the decline in researchers working in this area now, we may not have enough scientists to train the next generation and provide the necessary innovations to produce the increased yields and improved nutritional quality which will be required to avert severe food shortages 20 years from now. UK scientists are some of the best in the world and a skills shortage here will not only affect our ability to respond to the need for elevated food production at home but globally as well."
The UK has always been at the forefront of development in science and technology applied to agriculture and food production. Jethro Tull invented the seed drill in 1701 and at Rothamsted, during the latter half of the 19th century, the partnership of Sir John Lawes FRS and Sir Henry Gilbert FRS laid the foundation for the application of scientific principles to sustainable arable agriculture with their experiments on crop nutrition. Advances in plant breeding after the Second World War made the UK self-sufficient in high quality wheat for bread-making. Today researchers such as Professor John Picket FRS are studying the chemical signals given off by organisms that relate to interactions like germination cues or food and host attractants, to potentially provide new chemical tools for managing pests and beneficial organisms in crops.
Commenting on the impending skills shortage, Professor John Beddington, Government Chief Scientific Advisor said: "We face a major challenge to feed sustainably a global population set to soar beyond 8 billion by 2030, whilst also managing the world's burgeoning demand for energy and water, radically reducing greenhouse gas emissions and coping with those climate changes that we cannot avert. Only with a major contribution from science and engineering can we hope to succeed. The Royal Society's findings on key skills gaps are therefore a cause for concern. It is vital that we attract fresh talent to our universities and to our industries, to develop and apply the solutions that will be critical in the decades to come."
The Royal Society's study, which is due to be published in November, will assess a wide range of biological approaches which have been proposed for improving crop yields and quality and have the potential to enhance nutritional value, minimise waste, increase resource-use efficiency, and reduce reliance on non-renewable inputs. The report will set out the steps which governments should take now, to ensure that, in the coming decades, the farmers of the developed and the developing world are better equipped to feed their growing communities.
Food inflation set to collapse under its own weight
Food inflation may be about to collapse under its own weight, according to a report from CIBC released Monday. The inflated prices have been the source of much of the overall consumer price increases in recent years as demand for energy and fertilizer has soared alongside the demand for meat in places like China and India. But CIBC senior economist Benjamin Tal says that the rising prices will themselves bring about their own collapse. "The current disconnect . . . is an early sign of the upcoming changes in the economics of food." Those changes will be the "relocalization" of production, bringing consumers and producers closer together.
Organic will emerge as an economic alternative to fertilizer-assisted production, which is vastly more energy-intensive, he says. The net effect of these sweeping changes will be that "the cost to produce those goods will lead to lower food prices," Tal said. But Tal adds food prices are still gaining ground in most parts of the world even as consumer prices are now largely static or falling across the global economy. The inversion is a reflection of still-elevated production prices, he says. Oil, for example, which is used at every step of the cycle from fertilizer production to getting produce to market still trades at about $50 U.S. a barrel — a full $15 higher than the long-run average, Tal says.
Electricity Grid in U.S. Penetrated By Spies
Cyberspies have penetrated the U.S. electrical grid and left behind software programs that could be used to disrupt the system, according to current and former national-security officials. The spies came from China, Russia and other countries, these officials said, and were believed to be on a mission to navigate the U.S. electrical system and its controls. The intruders haven't sought to damage the power grid or other key infrastructure, but officials warned they could try during a crisis or war. "The Chinese have attempted to map our infrastructure, such as the electrical grid," said a senior intelligence official. "So have the Russians." The espionage appeared pervasive across the U.S. and doesn't target a particular company or region, said a former Department of Homeland Security official. "There are intrusions, and they are growing," the former official said, referring to electrical systems. "There were a lot last year."
Many of the intrusions were detected not by the companies in charge of the infrastructure but by U.S. intelligence agencies, officials said. Intelligence officials worry about cyber attackers taking control of electrical facilities, a nuclear power plant or financial networks via the Internet. Authorities investigating the intrusions have found software tools left behind that could be used to destroy infrastructure components, the senior intelligence official said. He added, "If we go to war with them, they will try to turn them on." Officials said water, sewage and other infrastructure systems also were at risk. "Over the past several years, we have seen cyberattacks against critical infrastructures abroad, and many of our own infrastructures are as vulnerable as their foreign counterparts," Director of National Intelligence Dennis Blair recently told lawmakers. "A number of nations, including Russia and China, can disrupt elements of the U.S. information infrastructure."
Officials cautioned that the motivation of the cyberspies wasn't well understood, and they don't see an immediate danger. China, for example, has little incentive to disrupt the U.S. economy because it relies on American consumers and holds U.S. government debt. But protecting the electrical grid and other infrastructure is a key part of the Obama administration's cybersecurity review, which is to be completed next week. Under the Bush administration, Congress approved $17 billion in secret funds to protect government networks, according to people familiar with the budget. The Obama administration is weighing whether to expand the program to address vulnerabilities in private computer networks, which would cost billions of dollars more. A senior Pentagon official said Tuesday the Pentagon has spent $100 million in the past six months repairing cyber damage. Overseas examples show the potential havoc. In 2000, a disgruntled employee rigged a computerized control system at a water-treatment plant in Australia, releasing more than 200,000 gallons of sewage into parks, rivers and the grounds of a Hyatt hotel.
Last year, a senior Central Intelligence Agency official, Tom Donahue, told a meeting of utility company representatives in New Orleans that a cyberattack had taken out power equipment in multiple regions outside the U.S. The outage was followed with extortion demands, he said. The U.S. electrical grid comprises three separate electric networks, covering the East, the West and Texas. Each includes many thousands of miles of transmission lines, power plants and substations. The flow of power is controlled by local utilities or regional transmission organizations. The growing reliance of utilities on Internet-based communication has increased the vulnerability of control systems to spies and hackers, according to government reports. The sophistication of the U.S. intrusions -- which extend beyond electric to other key infrastructure systems -- suggests that China and Russia are mainly responsible, according to intelligence officials and cybersecurity specialists. While terrorist groups could develop the ability to penetrate U.S. infrastructure, they don't appear to have yet mounted attacks, these officials say.
It is nearly impossible to know whether or not an attack is government-sponsored because of the difficulty in tracking true identities in cyberspace. U.S. officials said investigators have followed electronic trails of stolen data to China and Russia. Russian and Chinese officials have denied any wrongdoing. "These are pure speculations," said Yevgeniy Khorishko, a spokesman at the Russian Embassy. "Russia has nothing to do with the cyberattacks on the U.S. infrastructure, or on any infrastructure in any other country in the world." A spokesman for the Chinese Embassy in Washington, Wang Baodong, said the Chinese government "resolutely oppose[s] any crime, including hacking, that destroys the Internet or computer network" and has laws barring the practice. China was ready to cooperate with other countries to counter such attacks, he said, and added that "some people overseas with Cold War mentality are indulged in fabricating the sheer lies of the so-called cyberspies in China."
Utilities are reluctant to speak about the dangers. "Much of what we've done, we can't talk about," said Ray Dotter, a spokesman at PJM Interconnection LLC, which coordinates the movement of wholesale electricity in 13 states and the District of Columbia. He said the organization has beefed up its security, in conformance with federal standards. In January 2008, the Federal Energy Regulatory Commission approved new protection measures that required improvements in the security of computer servers and better plans for handling attacks. Last week, Senate Democrats introduced a proposal that would require all critical infrastructure companies to meet new cybersecurity standards and grant the president emergency powers over control of the grid systems and other infrastructure.
Specialists at the U.S. Cyber Consequences Unit, a nonprofit research institute, said attack programs search for openings in a network, much as a thief tests locks on doors. Once inside, these programs and their human controllers can acquire the same access and powers as a systems administrator. The White House review of cybersecurity programs is studying ways to shield the electrical grid from such attacks, said James Lewis, who directed a study for the Center for Strategic and International Studies and has met with White House reviewers. The reliability of the grid is ultimately the responsibility of the North American Electric Reliability Corp., an independent standards-setting organization overseen by the Federal Energy Regulatory Commission. The NERC set standards last year requiring companies to designate "critical cyber assets." Companies, for example, must check the backgrounds of employees and install firewalls to separate administrative networks from those that control electricity flow. The group will begin auditing compliance in July.