The girls of Crossville, Tennessee
Ilargi: All right, OK, time for some fun. I’ve has this Dilbert cartoon sitting on my desktop for days now, and never got around to posting it. I'll put it at the bottom right here. More fun today: "Japanese housewives bet $125 billion that the Yen will crash. And AIG CEO Ed Liddy who tells Congress that AIG will pay back the, what is it, $180 billion by now?, in 3 to 5 years. There's one minor caveat, admittedly: ”That timetable is based on financial markets remaining stable or improving, Liddy said at a hearing in Washington. The New York-based insurer may need more time if markets worsen.... I mean, where to start? The last time I looked, AIG hadn’t started making money yet. And the last time I thought about it, being a counterparty to trillions "worth" of waiting-to-blow-up casino toilet paper doesn't rank you first in line for raking in hundreds of billions. I didn't watch the Liddy testimony, but I have to guess he walked out the building without cuffs on. And while telling nonsense under oath may not be the same as telling lies, performances like this turn the US Congress into nothing but a farce, a comedy theater and the laughing stock of global democracy.
But the butt plug of the day (at least so far, it's early yet) springs from Reuters for this great duo of headlines:
- European output dives; hopes shift to US shoppers
- U.S. retail sales fall again in April
What more can a poor boy want? Who runs their offices? This sort of weird reporting of course also allows us an all too rare glimpse at un-adulterated reality. Whatever "we" should pin out hopes on, according to the gold spinsters, is not there. If the American consumer is the only option left to lift the global economy, then there are no options left. It's simple: according to the US Census Bureau's, unadjusted ”Advance Monthly Sales For Retail Trade And Food Services" are down 10.6% since a year ago.
Consumer spending makes up over 70% of US GDP, and US GDP is estimated at $14.2 trillion (time to review that number by now, though!). So consumers are responsible for $10 trillion of the GDP, and they went AWOL to the tune of more than 10%, or an amazing $3000 per capita. And they are called upon to save the global economic system. I kid you not. And even as Wall Street is down 2.5% for the day so far, I bet you most people believe we will rise up again, who trust the White House economic team when they predict a 3.5% growth. Half a year from now. I'd like to see them explain that, but something tells me they won't be too eager to try.
Looking at all this, do you still think you know what's next?
US Census Bureau: April retail sales down 10.1%
The U.S. Census Bureau announced today that advance estimates of U.S. retail and food services sales for April, adjusted for seasonal variation and holiday and trading-day differences, but not for price changes, were $337.7 billion, a decrease of 0.4 percent (±0.5%)* from the previous month and 10.1 percent (±0.7%) below April 2008. Total sales for the February through April 2009 period were down 9.2 percent (±0.5%) from the same period a year ago. The February to March 2009 percent change was revised from -1.2 percent (±0.5%) to -1.3 percent (±0.3%). Retail trade sales were down 0.4 percent (±0.7%)* from March 2009 and 11.4 percent (±0.7%) below last year. Gasoline stations sales were down 36.4 percent (±1.5%) from April 2008 and motor vehicle and parts dealers sales were down 20.7 percent (±2.3%) from last year.
Retail sales drop unexpectedly in April
The Commerce Department said Wednesday that retail sales fell 0.4 percent last month. Many economists had expected a flat reading, and the April weakness followed a 1.3 percent drop in March that was worse than first estimated. Retail sales had posted gains in January and February after falling for six straight months, raising hopes that the all-important consumer sector of the economy might be stabilizing. But the setbacks in March and April could darken some forecasts because consumer spending accounts for about 70 percent of economic activity. The hope had been that consumers were starting to feel better about spending, helped by the start of tax breaks included in the $787 billion stimulus bill. Households had spent the fall hunkered down in the face of thousands of job layoffs and the worst financial crisis since the 1930s.
The latest retail data "are yet another illustration that, although the worst is now over, there is still no evidence of an actual recovery," Paul Dales, U.S. economist with Capital Economics in Toronto, wrote in a research note. While anecdotal evidence suggests some improvement in sales in recent weeks, "to offset the plunge in wealth, the household saving rate still needs to double from the current rate of 4 percent," Dales wrote. "With falling employment hitting incomes, this can only be achieved by a further retrenchment in spending." The jobless rate rose to 8.9 percent in April when a net total of 539,000 jobs were lost and 13.7 million people were unemployed, the Labor Department said last week. Wall Street tumbled after the weaker-than-expected retail sales report. The Dow Jones industrial average lost about 130 points in morning trading, and broader indices also fell.
In a separate report, the Commerce Department said business inventories fell 1 percent in March, a decline that matched economists' expectations. It marked the seventh straight decrease, the longest stretch since businesses cut inventories for 15 straight months in 2001 and 2002, a period that covered the last recession. Businesses are continuing to cut their stockpiles in the face of declining sales, a development that has intensified the current economic downturn. Still, the reductions in stockpiles held on shelves and in backlots eventually should help businesses get their inventories more in line with reduced sales. If that is the case, any strengthening in consumer demand should lead to increased production. The April retail sales dip came despite a 0.2 percent increase in auto sales, which fell 2 percent in March. Excluding autos, the drop in retail sales would have been 0.5 percent, much worse than the 0.2 percent gain economists expected.
Sales outside of autos showed widespread weakness last month. Demand at department stores and general merchandise stores fell 0.1 percent and sales at specialty clothing stores dropped 0.5 percent. Department store operator Macy's Inc. on Wednesday reported a wider loss for the first quarter due partly to restructuring charges. Still, the company expects to see an improvement in sales from its localization efforts beginning in the fourth quarter of 2009, and in the spring of 2010. Liz Claiborne Inc. reported a first-quarter loss that was worse than Wall Street expected. The apparel maker said its quarterly loss swelled on restructuring charges and a drop in same-store sales stemming from lower consumer spending and an extra week of sales in the year-ago period. Sales also fell in April at furniture stores, electronic and appliance stores, food and beverage stores and gasoline stations, according to the Commerce Department.
The performance at department stores and specialty clothing stores came as a surprise since the nation's big chain stores had reported better-than-expected results for April. Same-store sales, rose 0.7 percent last month compared with April 2008. It was the first overall increase in six months, according to the tally by Goldman Sachs and the International Council of Shopping Centers. For April, some mall-based clothing stores saw their declines level off and Wal-Mart Stores Inc., the world's largest retailer, had reported its same-store sales rose 5 percent, excluding fuel, which beat expectations. Same-store sales, or sales in stores open at least one year, is considered a key metric of a retailer's financial health. The chain store sales report last week showed that Gap, American Eagle and Wet Seal posted smaller sales declines at their established locations than analysts had forecast.
The Children's Place, T.J. Maxx owner TJX Cos. Inc. and teen retailer The Buckle saw bigger gains than expected. But luxury stores again were hard hit as their higher-end wares find fewer takers. Consumer spending grew 2.2 percent in the first quarter of the year, after posting back-to-back quarterly declines in the last half of 2008. Economists believe the overall economy, as measured by the gross domestic product, will show a decline of around 2 percent in the current quarter. That would represent an improvement from the steep declines of 6.3 percent in the fourth quarter of last year and 6.1 percent in the first three months of this year, the worst six-month performance in a half-century.
America’s triple A rating is at risk
by David Walker, former US comptroller general
Long before the current financial crisis, nearly two years ago, a little-noticed cloud darkened the horizon for the US government. It was ignored. But now that shadow, in the form of a warning from a top credit rating agency that the nation risked losing its triple A rating if it did not start putting its finances in order, is coming back to haunt us. That warning from Moody’s focused on the exploding healthcare and Social Security costs that threaten to engulf the federal government in debt over coming decades. The facts show we’re in even worse shape now, and there are signs that confidence in America’s ability to control its finances is eroding. Prices have risen on credit default insurance on US government bonds, meaning it costs investors more to protect their investment in Treasury bonds against default than before the crisis hit. It even, briefly, cost more to buy protection on US government debt than on debt issued by McDonald’s.
Another warning sign has come from across the Pacific, where the Chinese premier and the head of the People’s Bank of China have expressed concern about America’s longer-term credit worthiness and the value of the dollar. The US, despite the downturn, has the resources, expertise and resilience to restore its economy and meet its obligations. Moreover, many of the trillions of dollars recently funnelled into the financial system will hopefully rescue it and stimulate our economy. The US government has had a triple A credit rating since 1917, but it is unclear how long this will continue to be the case. In my view, either one of two developments could be enough to cause us to lose our top rating.
First, while comprehensive healthcare reform is needed, it must not further harm our nation’s financial condition. Doing so would send a signal that fiscal prudence is being ignored in the drive to meet societal wants, further mortgaging the country’s future. Second, failure by the federal government to create a process that would enable tough spending, tax and budget control choices to be made after we turn the corner on the economy would send a signal that our political system is not up to the task of addressing the large, known and growing structural imbalances confronting us. For too long, the US has delayed making the tough but necessary choices needed to reverse its deteriorating financial condition. One could even argue that our government does not deserve a triple A credit rating based on our current financial condition, structural fiscal imbalances and political stalemate. The credit rating agencies have been wildly wrong before, not least with mortgage-backed securities.
How can one justify bestowing a triple A rating on an entity with an accumulated negative net worth of more than $11,000bn (€8,000bn, £7,000bn) and additional off-balance sheet obligations of $45,000bn? An entity that is set to run a $1,800bn-plus deficit for the current year and trillion dollar-plus deficits for years to come? I have fought on the front lines of the war for fiscal responsibility for almost six years. We should have been more wary of tax cuts in 2001 without matching spending cuts that would have prevented the budget going deeply into deficit. That mistake was compounded in 2003, when President George W. Bush proposed expanding Medicare to include a prescription drug benefit. We must learn from past mistakes. Fiscal irresponsibility comes in two primary forms – acts of commission and of omission. Both are in danger of undermining our future.
First, Washington is about to embark on another major healthcare reform debate, this time over the need for comprehensive healthcare reform. The debate is driven, in large part, by the recognition that healthcare costs are the single largest contributor to our nation’s fiscal imbalance. It also recognises that the US is the only large industrialised nation without some level of guaranteed health coverage. There is no question that this nation needs to pursue comprehensive healthcare reform that should address the important dimensions of coverage, cost, quality and personal responsibility. But while comprehensive reform is called for and some basic level of universal coverage is appropriate, it is critically important that we not shoot ourselves again. Comprehensive healthcare reform should significantly reduce the huge unfunded healthcare promises we already have (over $36,000bn for Medicare alone as of last September), as well as the large and growing structural deficits that threaten our future.
One way out of these problems is for the president and Congress to create a “fiscal future commission” where everything is on the table, including budget controls, entitlement programme reforms and tax increases. This commission should venture beyond Washington’s Beltway to engage the American people, using digital technologies in an unparalleled manner. If it can achieve a predetermined super-majority vote on a package of recommendations, they should be guaranteed a vote in Congress. Recent research conducted for the Peterson Foundation shows that 90 per cent of Americans want the federal government to put its own financial house in order. It also shows that the public supports the creation of a fiscal commission by a two-to-one margin. Yet Washington still sleeps, and it is clear that we cannot count on politicians to make tough transformational changes on multiple fronts using the regular legislative process. We have to act before we face a much larger economic crisis. Let’s not wait until a credit rating downgrade. The time for Washington to wake up is now.
European output dives; hopes shift to US shoppers
Euro zone industrial output plunged and the Bank of England said on Wednesday the British economy needs a lengthy period of healing, putting the onus on the U.S. consumer to help drive a global recovery. Industrial production figures from China, supposedly a beacon of light during the world recession, also proved a disappointment, but at least they showed growth. By contrast production in the 16 nations which use the euro fell no less than 20.2 per cent in the year to March. Reminders abounded that any recovery may not be as swift and strong as financial markets had hoped, with the Bank of England forecasting a slower UK pickup than it had previously expected. “Now the economy requires a period of healing. That will take time,” Governor Mervyn King told a news conference to reveal the central bank's quarterly economic forecasts.
These showed the bank believes the UK recession hit a low point this spring, with GDP suffering an annual fall of around 4.5 per cent in the second quarter. Growth would resume early in 2010, reaching around 2.5 per cent in two year's time. Mr. King underlined that any recovery was far from certain to last despite all the emergency treatment given to world economic and financial systems, noting that in Britain interest rates were near zero and authorities had thrown hundreds of billions of pounds into supporting the banking system's malaise. Financial markets across the world have climbed in recent weeks as investors sensed the “green shoots” of a recovery but Mr. King was cautious about Britain's prospects, at least. “There are pretty solid reasons for supposing that there will be a recovery next year, but also pretty solid reasons for questioning if that will be sustained,” he said. “It would be extremely unwise for anyone to claim that they know what the future is to hold.”
Such caution shifted hopes for signs of revival to consumers, who account for a large chunk of economic activity. Markets expect a U.S. retail sales report at 1230 GMT to add to evidence that the crisis that battered financial markets, destroyed millions of jobs and pushed the world economy into recession, may be abating. Chinese shoppers seem to be pulling their weight. Retail sales grew 14.8 per cent year-on-year in April, slightly up from 14.7 per cent in March. However, other data on Wednesday showed China's factory output growth slowed last month, providing fresh evidence a day after poor export data that recovery in the world's third-largest economy is not yet on a rock-solid footing. “It is important not to attach too much importance to one particular data point and to recognize that any recovery in China is not going to proceed in a straight line,” said Brian Jackson, an economist with Royal Bank of Canada in Hong Kong.
Hopes will now be pinned on shoppers in the United States. Retail sales excluding the troubled auto sectors are seen edging up 0.2 per cent in April after a 0.9 per cent fall in March. Intel Corp. chief executive Paul Otellini was the latest company official to voice guarded optimism, saying the second quarter has been so far slightly better than expected for the technology bellwether. However, there were still plenty of warning signs that the road to full recovery would be long and bumpy. German car-parts group Schaeffler announced that it may have to cut roughly 4,500 jobs as the global slump eats into sales. Schaeffler showed how long some big companies may need to recover, forecasting that its markets would take up to five years to return to 2008 levels. Overall Europe produced mixed earnings reports, including a bigger then expected loss by Dutch financial group ING.
Governments kept up the drive to cure the banks' problems. Germany's cabinet approved a “bad bank” plan to relieve lenders of toxic assets, aiming to boost confidence in the banking sector where the economic crisis first surfaced last year. Finance Minister Peer Steinbrueck said the plan would target assets worth just under €200-billion. Despite the caution, the underlying sense of optimism about the world economy was evident in market action. The U.S. dollar fell, its safe haven appeal eroded by the optimism mixed with concerns about the United States' fiscal health. World stocks as measured by MSCI were little changed after two consecutive days of moderate losses.
Foreclosures: 'April was a shocker'
Foreclosures in April exceeded even March's blistering pace with a record 342,038 homes receiving notices of default, auction notices or undergoing bank repossessions, according to a regular industry report. One of every 374 U.S. homes received a filing during the month, the highest monthly rate that RealtyTrac, an online marketer of foreclosed properties, has recorded in four-plus years of record keeping. "April was a shocker," said Rick Sharga, a spokesman for RealtyTrac. "I would have bet on a dip because March foreclosures were so high. Instead, filings inched up 1% from March and rose 32% compared with April 2008. There were 63,903 bank repossessions, the last stop in the foreclosure process. More than 1.3 million homes have now been lost to foreclosure since the market meltdown began in August 2007.
The increasing foreclosures will force RealtyTrac to rethink its forecasts, according to Sharga. "We had been predicting 3.4 million filings for the year," he said, "but we'll blow those numbers out of the water." The lion's share of April's filings were ones in the early stages of the process, such as notices of default, according to James Saccacio, RealtyTrac's CEO. Bank repossessions actually fell 11% for the month, compared with March. That's due, according to Saccacio, to the many legislative and company moratoriums that have prevented the foreclosure process from starting on delinquent loans. Because fewer loans entered the process in past months, there had been fewer getting all the way to repossession. But now that those moratoriums are over, the volume of foreclosure filings is increasing.
"It's likely that we'll see a corresponding spike in [repossessed properties] as these loans move through the foreclosure process over the next few months," Saccacio said in a prepared statement.
Ten states accounted for 75% of all foreclosure activity, and they fell generally into two categories: one-time bubble markets and the rust belt. California, which easily outpaced every other state with with 96,560 filings. Other hard-hit former boom towns were Florida (64,588), Nevada (16,266) and Arizona (16,244). Those rust belts towns with the most filings were Illinois (13,647), Ohio (12,324) and Michigan (10,830). Georgia (11,521), Texas (11,314) and Virginia (6,254) filled out the rest of the top 10 list. Nevada, with one filing for every 68 households had the highest foreclosure rate in the land. Florida, with one for every 135 households ranked second; and California, with one for every 138, was third. Arizona, one in 164, was fourth; and Idaho was a surprising fifth, with one for every 255 households.
Las Vegas continued to be the worst-hit metro area. It had 14,073 filings in April, one for every 56 households and 20% more than in March. The Cape Coral-Fort Myers, Fla., area was second with one in 57, a 31% month-over-month rise. Merced, Calif., where home prices have plunged almost two-thirds from their peak, had the third-highest rate at one in 65. Five other California metro areas ranked in the top 10: Modesto was fourth, Riverside-San Bernardino fifth, Bakersfield sixth, Vallejo seventh and Stockton eighth. Miami and Orlando rounded out the list. Not helping, of course, is the steady erosion of home prices. The National Association of Realtors reported record home price losses Tuesday. "[The home price decline] will lead to more foreclosures," said Mike Larson, a real estate analyst for Weiss Research.
The loss of home values put many more mortgage borrowers underwater, meaning they owe more on their loans than their homes are worth. That increases foreclosure rates in two ways: Underwater borrowers have no home equity to draw on should to pay for unexpected expenses such as big medical bills or major car or home repairs. That's makes them more likely to miss payments. And when home values fall far below mortgage balances, homeowners often walk away from their loans. "There has been much more 'deed-in-lieu-of foreclosure' activity lately," said Sharga. This is a transaction in which borrowers simply tell their banks that they're not going to pay their mortgage and hand back their keys, and deeds, to their lenders. "People are making the rational financial decision to walk away from underwater homes," he said.
Foreclosures Weigh on Freddie Mac: $9.85 Billion Loss
Freddie Mac reported a loss of $9.85 billion for the first quarter as the costs of home-mortgage defaults mount and said it will need another $6.1 billion of capital from the U.S. Treasury. The government-backed mortgage company, based in McLean, Va., had a loss of $151 million in the year-earlier first quarter. Last week, Freddie's main rival, Fannie Mae, reported a loss of $23.17 billion for the first quarter and said it would need $19 billion from the Treasury. Federal regulators seized control of Fannie and Freddie, the two main providers of funds for U.S. home mortgages, in September as growing losses ate through their thin layers of capital. The Treasury has agreed to provide as much as $200 billion of capital apiece to Fannie and Freddie by purchasing preferred stock paying 10% dividends. The latest calls for capital by the companies bring Freddie's total to about $51 billion and Fannie's to $34 billion.
Freddie's loss was largely due to a provision for future credit losses of $8.8 billion, up from $1.2 billion in the year-earlier quarter. The company recorded a $306 million expense related to the maintenance and sale of foreclosed homes. Freddie also had $7.1 billion of write-downs on mortgage-backed securities packaged by Wall Street and private-sector lenders during the housing boom. Those securities are mostly backed by subprime and Alt-A loans. Alt-A loans typically allowed borrowers to avoid fully documenting their income or assets. But Freddie had gains of $3.8 billion on derivative contracts whose value is tied to movements in interest rates, the value of its guarantees of home mortgages and on certain securities. Freddie said that it expects "the coming quarters to be difficult" but that it sees "preliminary signs of slowing in home-price declines" as buyers respond to lower prices and the lowest mortgage rates since the 1950s. Freddie paid a dividend of $370 million to the Treasury on its senior preferred stock on March 31. Once the new capital is provided, the Treasury will be entitled to dividends from Freddie of about $5.2 billion a year.
Jim Vogel, an analyst at FTN Financial Capital Markets in Memphis, Tenn., said Fannie appears more conservative in its provisions for credit losses, which were about $20 billion in the latest quarter, or more than twice Freddie's total. Fannie owns or guarantees about $3.1 trillion of mortgages and related securities; Freddie's total is about $2.2 trillion. Freddie said 2.4% of all single-family mortgages it owns or guarantees are 90 days or more overdue. That figure is 11.5% for Freddie's option adjustable-rate mortgages, or option ARMs, a risky type of loan that allowed borrowers to make only minimal payments in the early years. The balance of such loans increases when borrowers choose to pay less than the normal interest due.
Banks Pass Stress Test - Regulators Fail Ethics Test
Last week, financial stocks enjoyed a powerful advance and short squeeze on the announcement of the results of the “stress test” of major banks. It is important to begin by noting that this was not a regulatory procedure with teeth. It was initially a response to Congressional demands to introduce greater objectivity into the use of public capital for these bailouts, and gradually morphed into nothing more than a “confidence building” exercise. And keeping with the emphasis on keeping the numbers happy, as opposed to providing full and fair disclosure, the Wall Street Journal reported on Saturday, “The Federal Reserve significantly scaled back the size of the capital hole facing some of the nation's biggest banks shortly before concluding its stress tests, following two weeks of intense bargaining. In addition, according to bank and government officials, the Fed used a different measurement of bank-capital levels than analysts and investors had been expecting, resulting in much smaller capital deficits.”
To some extent, it is not possible to get full and fair disclosure using the method that regulators used in the first place, since it relied on banks' self-estimates of their potential losses in a further economic downturn. These of course being the same banks that made the bad loans, and have already proved themselves vastly incapable of loss estimation and risk management. Moreover, the Fed only asked for loss estimates for 2009 and 2010, not beyond – “Each participating firm was instructed to project potential losses on its loan, investment, and trading securities portfolios, including off-balance sheet commitments and contingent liabilities and exposures over the two-year horizon beginning with year-end 2008 financial statement data.” This period specifically excludes the window where we can expect the majority of “second wave” mortgage losses to be taken, as it does not capture any losses that will emerge as a result of mortgage resets from mid-2010, through 2011, and into 2012. The “stress test” procedure also conveniently excludes any potential mark-to-market losses during 2009 and 2010, as banks “were instructed to estimate forward-looking, undiscounted credit losses, that is, losses due to failure to pay obligations (‘cash flow losses') rather than discounts related to mark-to-market values.”
Now, just think of this for a minute. Even if you assume that the “risk-weighted assets” of the banks are about two-thirds of their total assets (as the stress-test does), we're still looking at $7.8 trillion in total assets at risk in these banks, and despite being on the edge of insolvency only weeks ago, we are asked to believe that they will need less than 1% of this amount – $74.6 billion – of additional capital even in a worst case scenario. How do the stress tests arrive at this conclusion? 1) They underestimate potential losses by minimizing the horizon over which the losses would have to occur, excluding potential mark-to-market losses and restricting the loan losses to “cash flow” losses only; 2) They define capital well beyond tangible sources, to include about double what is available as Tier-1 common; 3) They include $362.9 billion in “resources other than capital” – essentially pre-provision net revenue expected to be earned by the banks over the coming two years to absorb potential losses; 4) They report the capital buffer that would be required after massive dilution in the common stock of these banks has already occurred.
As an example, Citigroup comes in with $119 billion in capital ($22 billion as Tier-1 common). Total assets are over $2.1 trillion, but the stress test assumes “risk weighted” assets of less than half that. Citi projects losses in 2009 and 2010 of $104.7 billion in a scenario where the unemployment rate reaches 10.3%. Citi assumes that it will earn $49 billion during that period which would partially absorb those losses, and that it will obtain $87 billion in Tier-1 from other capital sources, presumably including $33 billion of preferred that it would be willing to convert to common. Of course, Citi's entire market cap is only $22 billion, so the “$5.5 billion” that Citi is reported to need under the stress test is what it would require after a 5-to-1 dilution in its common stock (87+22/22). Essentially, we've got a company with a common equity buffer of just over 1% of total assets, that just 8 weeks ago was on the verge of receivership, and investors are urged to believe that there are enough voodoo dolls in the vault to make the company solvent even in a further weakened economy.
Great. Then no more government money should be needed. Outstanding. Not a dime more of public funds beyond what remains in the TARP. No need to use public money to buy toxic assets either. Believe me, I would be overjoyed if the madness of public bailouts of private bondholders was to stop. Unfortunately, I don't believe it for a second, because our regulators have clearly demonstrated that they do not want accurate public disclosure of losses (witness Ken Lewis' testimony a few weeks ago, the watered-down mark-to-market rules, and the “negotiated” results of the stress test). Our regulators want confidence. And they're willing to fudge the numbers to get it. If there wasn't a freight train of additional mortgage defaults coming, perhaps confidence building would be a good thing. As matters stand, encouraging confidence is equivalent to encouraging investors to throw good money after bad.
As for bank equities, it is problematic to treat the stocks simply as a discounted stream of future cash flows, because when capital cushions become thin, the only way to properly value these stocks is to treat them like options with an absorbing barrier at zero. Indeed, that is how bank stocks have been trading lately – not as equities, but as option-like securities. I doubt that investors in these companies fully recognize the potential for the spectacular advance in these stocks to vanish if the current confidence about bank balance sheets is not sustained. Meanwhile, we can expect an immediate rush by banks to capitalize on the recent advance by heavily issuing new stock, which would be fine, except that the quality of disclosure is in question. Investors should be sure to read the offering documents carefully.
Ethics, Distribution and Incentives
Over the past few weeks, I've heard a number of analysts suggesting that the bailouts aren't so bad because “we owe this money to ourselves,” and that in terms of present value, they are neutral for society as a whole. What's fascinating about these arguments is that they entirely miss the ethical and distributional effects of the bailouts. This isn't something that would be missed if the Treasury was to borrow a trillion dollars and then hand it over to a fur-coated pimp standing on a street corner in lower Manhattan, but it somehow escapes concern when the recipients are in the offices above the ground floor. It's amazing how quickly capitalists turn into socialists when they stand to lose money.
Here's the situation. A variety of investors provided capital to financial companies, with which they made irresponsible loans and took excessive risks. These activities resulted in real losses, which have largely wiped out the shareholder equity of the companies. But behind that shareholder equity is bondholder money, and so much of it that neither depositors of the institution nor the public ever need to take a penny of losses. Citigroup, for example, has $2 trillion in assets, but also has $600 billion owed to its own bondholders. From an ethical perspective, the lenders who took the risk to finance the activities of these companies are the ones that should directly bear the cost of the losses. We can always compensate those who we believe lost unfairly, were cheated, or whom we otherwise believe that there is a social interest in compensating. But those decisions should emphatically be made through the political process by our elected officials, not by the arbitrary decisions of bureaucrats that continue to erode the Constitutional separation of powers. As I wrote in March 2008, at the beginning of this downturn, when Bear Stearns was first rescued:"This is not water under the bridge, and the deal struck last week should not be allowed to stand if we care at all about the integrity of the capital markets. If the market was “certain to crash” in the event that Bear Stearns failed, then the market is certain to crash anyway, because Bear Stearns wasn't the last shoe to drop – it was one of the first. Unfortunately, we're standing in a shoe store. At the point where unelected bureaucrats pick and choose who to subsidize – who prospers and who perishes – in a free capital market, and use public funds to do it, more is at risk than just $30 billion. Instead, we cross a line, and stumble off a very clear edge down an interminably slippery slope."
As long as we don't have a disorganized Lehman-type liquidation, it would be appropriate to take insolvent institutions into receivership, write down the bondholder claims appropriately, then re-issue the companies back to the public. This was more difficult with the auto companies, because there is no regulator with unilateral receivership authority. Still, even Chrysler's holdout bondholders have now thrown in the towel, which will make it easier to restructure in Chapter 11. The process is more straightforward with banks – witness Washington Mutual – but additional authority from Congress would be helpful in order to deal with non-bank entities, including bank holding companies. To minimize the add-on effects of debt haircuts, it would also be helpful for Congress to impose strong capital requirements on newly originated credit default swaps, and to restrict their use to bona-fide hedging.
Notice that by bailing out the financial companies, there is a massive crowding out of private investment, because for every dollar of losses that should have been wiped off the ledger, we are forced to retain and service two dollars of overall debt – the debt securities owed by the financial companies to their bondholders continue to exist, and we now have an equal amount of new debt issued by the Treasury. The rescued bank debt is a drain on the public because it has to be serviced through a combination of higher interest rates to borrowers, and lower deposit rates to savers. Meanwhile, the Treasury debt is also a drain, because except for some income from the Treasury's holdings of preferred stock, the debt has to be serviced from tax receipts.
The bailout is not something “neutral” that cancels itself out, but instead amounts to a transfer of trillions of dollars of purchasing power directly and indirectly from those who didn't finance reckless mortgage loans to those who did. Farewell to the projects, innovation, research, investment, and growth that might have been financed by the savings and retained earnings of good stewards of capital. Those funds are being diverted to the careless stewards who now stand to be made whole. In short, these bailouts are emphatically not neutral to society as a whole, because they damage incentives and divert productive resources into hands that have proven themselves to be reckless and incapable. To believe that the bailouts are just money we owe to ourselves is to overlook serious ethical implications, as well as distributional and incentive effects.
Is it time to stress-test the Federal Reserve?
While not quite in the same league as Tina Fey's take on Sarah Palin, Saturday Night Live's spoof on the banks' stress tests last Saturday was pretty funny. Will Forte as Treasury Secretary Timothy Geithner explained that the stress test went from being a graded test, to a pass/fail, to a pass/pass-with-an-asterisk, to a pass/pass system, and then he congratulated all the banks for passing. Time will tell how useful the stress tests were, but few serious economists or analysts believe the banking problem is solved. In the meantime, there's a groundswell in Congress for closer scrutiny of the stress tester - the Federal Reserve itself. America's central bank is a curious public-private sector hybrid, largely free from any governmental oversight or control.
But as the steward of the nation's money, the Fed's actions in recent months to print hundreds of billions of dollars in new money seem to cry out for some sort of democratic review. Congress, after years of fawning over Fed Chairman Alan Greenspan as the maestro of monetary policy, has learned the hard way that, while trust is good, control is better. So there is a bill before Congress that calls for a full-scale audit of the Federal Reserve System -- the Federal Reserve Board based in Washington, and the 12 regional Federal Reserve Banks. That bill, H.R. 1207, now has 149 cosponsors and counting. It was introduced by Texas Rep. Ron Paul, now nominally a Republican, but a former leader of the Libertarian Party who is still best known for his strong libertarian principles.
Paul, as his fans well know, would just as soon abolish the Fed as look at it, but this issue gives him a chance to come in from the political fringe and at least start a process the could result in changing accountability at the Fed. Paul's bill directs the Government Accountability Office to audit the Federal Reserve Board and regional banks by the end of 2010 and present a detailed report to Congress. The audit would look at the Fed's actions during the crisis and its decision-making process. The 149 cosponsors include all but three of the 29 Republican members of the House Financial Services Committee, starting with ranking member Spencer Bachus of Alabama. While the bulk of the bill's supporters are Republicans, 20 House Democrats have also signed on as cosponsors. The companion bill in the Senate, S. 604, introduced by independent Bernie Sanders of Vermont, has no cosponsors yet.
House Financial Services Chairman Barney Frank, D-Mass., has promised that the bill will get a hearing in his committee. "I hope we're going to put some limitations on this power of the Federal Reserve to lend any money to anybody," Frank recently told an audience in Boston, "and to significantly increase the auditing and transparency at the Federal Reserve." Paul made it clear what he was after when he introduced the bill. "The Treasury gets hundreds of billions, which is huge, of course," Paul said in a speech on the floor, "and then we neglect to talk about the Federal Reserve, where they are creating money out of thin air, and supporting all their friends and taking care of certain banks and certain corporations. This, to me, has to be addressed." Paul has some support outside Congress as well. No less an authority than former Fed Chairman Paul Volcker thinks the Federal Reserve will come in for some congressional review after its emergency actions during the crisis.
"I think for better or for worse we are at a point where the Federal Reserve Act, after all that has been happening in the last year or more, is going to be reviewed," Volcker said last month in a speech at Vanderbilt University. Volcker said that the political system could not "tolerate" the degree of activity that the Fed has undertaken in conjunction with the Treasury Department, using emergency powers without any congressional authorization or review. At the same time, of course, the Fed is the leading contender to take on the role of monitoring systemic risk as part of the administration's proposed regulatory reform. Before that can happen, though, it seems likely that Congress will want to rein in the Fed and establish better oversight of its actions.
Why Obama's conservatism may not prove good enough
by Martin Wolf
"If we want things to stay as they are, things will have to change." Thus wrote the Sicilian writer Giuseppe di Lampedusa, in The Leopard. This seems to me the guiding principle of the Obama presidency. To many Americans, he seems a flaming radical. To me, he is a pragmatic conservative, albeit one responding to extraordinary times. In his own way, Mr Obama is following the path trodden by Franklin Delano Roosevelt. Nowhere is his conservatism more obvious than in the handling of the economic crisis. What we have seen unfolding, from the president's choice of Lawrence Summers and Tim Geithner as his principal policy advisers, to last week's "stress tests", is classic conservative policymaking. The aim is simply to get the show back on the road.
As Mr Obama told The New York Times: "I'm absolutely committed to making sure that our financial system is stable." Stability is a quintessentially conservative aim. Many radicals on the right and left insist that undercapitalised banks should be recapitalised right now. But Mr Obama sees this as far too risky. The results of the stress tests were a big step along the road the administration is taking. They impose enough pain to appear credible, but not enough to be disruptive. The 10 affected banks will easily raise the needed money: a total of $75bn (€55bn, £59bn). Their market valuations duly soared. Douglas Elliott of the Brookings Institution has provided a comparative analysis of how the US regulators reached their conclusions.* He contrasts their numbers with those of the International Monetary Fund, in its latest Global Financial Stability Report, and Nouriel Roubini of RGE Monitor and New York University. He also allows for the fact that the IMF and Mr Roubini look at all losses in US banking, while the tests apply to 19 institutions that hold some 70 per cent of US banking assets.
Estimated losses for 2009 and 2010 by the US regulators, the IMF and Mr Roubini are $535bn, $321bn and $811bn, respectively. So regulators were noticeably more risk-aware than the IMF, albeit less so than Mr Roubini. Against these losses are set the expected earnings (after dividends) over these years, plus a provision for 2011 losses. Here the regulators estimate earnings at $363bn, against an assumed $210bn for the IMF and Mr Roubini. This means the reduction in capital is estimated at $172bn by the regulators, $111bn by the IMF and $601bn by Mr Roubini. But, after allowing for planned capital-raising and excess earnings in the first quarter of 2009, the final reduction in capital is just $62bn for the regulators and a mere $1bn for the IMF, but as much as $491bn for Mr Roubini.
There are two important numbers in the above analysis: possible losses, and the buoyancy of earnings. Yet there is a final number of no less significance: how much capital does a bank need? The answer is: how long is a piece of string? Since many of these banks are deemed too big to fail, taxpayers are risk-bearers of last resort. The capital requirement depends partly on how well the government wants to be cushioned against possible losses and partly on how well bond-holders want to be insured against the possibility that government might refuse a rescue. At the end of 2008, the ratio of total common equity to US banking assets was 3.7 per cent. Without the explicit and implicit insurance provided by government, it would surely have been higher. As the IMF notes, in the mid-1990s, before the leverage boom, the ratio was 6 per cent. In the 19th century, before deposit insurance, it was much higher still.
The conclusions are three: first, the government's exercise is more conservative on losses than that of the IMF, albeit far less so than Mr Roubini's; second, most of the capital to be raised will come from the earnings of a banking system able to borrow on the favourable terms arranged by the central bank and then to lend more expensively to its customers; and third, the target capital ratios – Tier 1 risk-weighted capital of 6 per cent of assets and Tier 1 common equity capital of 4 per cent – are not especially onerous. The purpose of the exercise was indeed conservative: to make it credible, though not certain, that the existing banking system and assets can survive the likely battering. This has been done well enough to satisfy the markets. But these banks will also be unable to expand their balance sheet significantly in the near future.
The biggest question is how far this exercise will help restore the economy. Commercial banks provide only a quarter of financial sector credit in the US, down from close to 40 per cent in the mid-1990s (see chart). Much of the rest came from various forms of securitisation. Unless and until the latter markets reopen fully, private sector credit is likely to be constrained. How far that constraint is binding depends on how far highly leveraged borrowers are willing to borrow, particularly when the collateral against which they borrow has lost value. For this reason, it is the huge stimulus – the least conservative parts of the economic package – that will deliver the recovery. These are also the least upsetting to the interests of powerful lobbies, particularly in finance.
More radical approaches – allowing more banks to default, for example – would have increased uncertainty in the short run and so undermined the return to stability Mr Obama craves. But here the president must reckon on a longer-term danger: that the rescued financial system will, in time, start to lay the foundations for another and possibly still bigger financial crisis in the years ahead. Ensuring the rescue of a financial system packed even more than before with complex and "too-big-to-fail" institutions may well be the cautious response to this crisis. But it leaves the government with the even more onerous task of imposing effective regulation in future. Unhappily, the record of regulation of generously insured financial systems is extremely poor. The mobilised self-interest of highly rewarded players easily overwhelms the constraints imposed by far less well-rewarded and almost certainly less able regulators.
The more the crisis unfolds, the more evident it is that incentives in the financial system were (and are) badly distorted. I sympathise with the conservative approach to crises, but not if it leaves in place the plethora of perverse incentives that created them. At the end of this, then, there will be one big test: will the number of institutions thought "too big to fail" be as large as now and, if so, how will they be controlled? If the answers are still not clear, there will need to be yet more change.
Greenspan Sees 'Seeds of a Bottoming' in U.S. Housing
Former Federal Reserve Chairman Alan Greenspan said that the decline in the U.S. housing market may be bottoming and it’s “very easy to see” financial markets continuing to improve. “We are finally beginning to see the seeds of a bottoming” in the housing industry, Greenspan said today during a conference of the National Association of Realtors in Washington. The U.S. is “at the edge of a major liquidation” in the stock of unsold properties, which may help to stabilize prices, Greenspan said. Home-sales figures in recent weeks have shown a slower pace of decline, and the slide in property prices has eased, according to gauges including the S&P/Case-Shiller index.
The former Fed chief, who was among the first prominent economists to warn about the risk of a recession in 2007, said housing prices could fall another 5 percent without putting too much strain on the economy. “We run into trouble if it’s very significantly more than that,” Greenspan said. Housing prices remain “the critical Achilles’ heel” of the economy. While the housing bottom may not be obvious in prices, it is becoming clear in “significant regional differences,” where some of the hardest-hit areas are starting to show signs of improvement, he said. Greenspan said in congressional testimony in October that “a flaw” in his free-market ideology contributed to the “once-in-a-century” credit crisis.
Today, Greenspan said companies are having less trouble raising money. U.S. firms have sold bonds at a record pace so far this year, including a $3.75 billion offering today from Microsoft Corp., the world’s largest software maker. Wells Fargo & Co. and Morgan Stanley raised $16.6 billion in stock and bond sales on May 8, just a day after the government ordered them to raise capital, becoming the first banks to respond to the government’s mandate. “Company after company has been raising capital and they are getting far more than they expected,” said Greenspan, 83, who left the Fed in January 2006 after almost two decades at the helm and has returned to his former role as a private economic forecaster. With the expansion in market liquidity, “you begin to see, as we are seeing today, a very significant rise in the availability of money,” Greenspan said. As markets improve, “it’s very easy to see that it’s going to continue for an indefinite period,” he said.
U.S. home prices fell the most on record during the first quarter from the prior year as banks sold seized homes and foreclosures persisted at a high rate in California and Florida. The median U.S. housing price fell 14 percent during the quarter to $169,000 year-over-year, the National Association of Realtors said earlier today. U.S. banks held $26.6 billion of repossessed real estate at the end of 2008, more than doubling from a year earlier, according to the Federal Deposit Insurance Corp. in Washington. Greenspan’s decisions as a central banker have come under scrutiny in recent years after the fall in home prices triggered a collapse in mortgage financing and other credit. Under Greenspan’s leadership, the Fed left the overnight lending rate between banks at 1 percent from June 2003 until June 2004. Regional Fed presidents such as Gary Stern of Minneapolis and Janet Yellen of San Francisco have publicly questioned the Fed’s hands-off approach toward asset bubbles like the one that emerged in house prices during Greenspan’s tenure.
Former Fed Vice Chairman Alan Blinder, Stanford University professor John Taylor and other economists say Greenspan’s approach of keeping rates low for an extended period helped to foster the housing bubble. “I’ve always argued going back many decades that you do not capitalize a piece of real estate with overnight interest rates,” the former chairman said today in response to an audience question. The housing market is instead fueled by a decline in long- term interest rates, which started a full year before the Fed began cutting the federal funds rate, Greenspan said. “I think there is a recalibration of financial history that I find very puzzling,” he said. Referring to his critics, he said, “I can say that I respectfully disagree. They’re wrong.”
Even Pessimists See Signs of Recovery
As the global economy shows signs of recovery, even pessimists start forecasting a rosy outlook. The Associate Press quoted European Central Bank head Jean-Claude Trichet as telling a press conference in Basel, Switzerland on Monday, "We are, as far as growth is concerned, around the inflection point in the cycle." There have been significant signs of market recovery since mid-September last year, he added. George Soros, the Chairman of Soros Fund Management, who had been skeptical about economic recovery only a month ago, was also quoted by the German daily Frankfurter Allgemeine Zeitung on Monday as saying, "The economic free-fall has stopped. Asia should be the first region to pull out of the crisis and China is set to overtake the United States as the engine of world growth."
Even those who are typically pessimistic, such as Joseph Stiglitz, a professor at Columbia University, said on Thursday that the pace of recession is slowing down. Thomas Cooley, dean of the NYU Stern School of Business, who had been first to write an analysis report as the global economic crisis raised its ugly head last year, told CNN on May 6, "There are distinct signs of a recovery in the U.S. economy, parts of Europe and elsewhere. There is a definite sense that the worst is over." Signs of economic recovery can also be seen in the composite leading index (CLI) released by the OECD on Monday. The CLI of 30 OECD member countries averaged 92.2 in March, down 0.2 points from the previous month. But some of the major countries' CLI rose, showing that their economies were improving, the Wall Street Journal reported -- including France, from 96.8 to 97.9, Italy from 96.6 to 97.4, and China from 92.1 to 93.0.
Geithner says financial system healing
Tim Geithner, US Treasury secretary, said on Wednesday that “the financial system is starting to heal” as he pledged to recycle returned bank bail-out funds into small community banks. Citing improving lending conditions, easing concerns about systemic risk and lower leverage at banks, Mr Geithner said “a substantial part of the adjustment process” for the financial sector was now over. As some larger banks become confident enough to repay funds from the government’s Troubled Asset Relief Programme, the Treasury will recycle that money into smaller banks with under $500m in assets, Mr Geithner said. They will have six more months to apply for funds, and the Treasury will also increase the amount of money they can access from 3 per cent of risk-weighted assets to 5 per cent.
“As in any financial crisis, the damage has been unfair and indiscriminate,” said Mr Geithner in a speech to community bankers. “Ordinary Americans, small business owners, and community banks who did the right thing and played by the rules are suffering from the actions of those who took on too much risk.” More than 90 per cent of America’s 8,300 banks are small or mid-sized. The US government has already invested capital in the form of preferred stock in 300 small banks, although the vast majority of Tarp money has gone to the country’s largest financial institutions. A number of those large banks have said they intend to pay back Tarp funds, including Goldman Sachs, JP Morgan and Capital One Financial.
Mr Geithner pointed to a drop in spreads for corporate bonds, lower risk premiums in inter-bank markets and cheaper default insurance on the biggest banks as evidence that fear in the financial system was abating. “These are all welcome signs, but the process of financial recovery and repair is going to take time,” he said. Mr Geithner also said he would soon propose legislation to create a systemic risk fund to support financial institutions in times of crisis, backed by large financial institutions. It would be an “extraordinary mechanism for extraordinary situations,” he said, and would be kept separate from the Federal Deposit Insurance Corporation, which insures bank deposits. “With this authority, the financial costs of intervention would no longer fall to those institutions that played by the rules and made conservative and prudent choices,” he said.
Bernanke Says U.S. Banks Must Test More to Identify Other Risks
Federal Reserve Chairman Ben S. Bernanke said efforts by U.S. banks to raise capital are “encouraging” and called on firms to identify other risks through internal stress tests. The banks, especially those with “trading and investment banking businesses,” should keep monitoring “operational, liquidity and reputational risks,” which weren’t addressed by the exam concluded last week, Bernanke said in a speech yesterday at a Fed conference in Jekyll Island, Georgia. The remarks signal that the Fed and other U.S. regulators will keep a closer eye on firms such as Goldman Sachs Group Inc. and Morgan Stanley after last year’s collapse of Lehman Brothers Holdings Inc. and near-failure of Bear Stearns Cos. The Fed-led tests of the 19 largest U.S. banks showed last week that 10 firms need to raise a total of $74.6 billion in capital.
“Ideally, the stress tests used in the assessment program should be part of a broader palette of internal stress tests conducted by firms,” Bernanke said at the event hosted by the Atlanta Fed district bank. “Indeed, we do not intend that the capital assessments should be taken as all that those firms need to do.” Losses under more adverse economic conditions may total almost $600 billion over two years, the government said May 7. Treasuries were little changed after Bernanke’s remarks. The yield on the 10-year note fell one basis point to 3.17 percent as of 12:12 p.m. in Tokyo, according to BGCantor Market Data. “You wouldn’t expect Bernanke to say anything else,” said Dwyfor Evans, a strategist at State Street Global Markets in Hong Kong. “Any negative attached to the stress tests has been carefully managed by people like Bernanke.”
Capital One Financial Corp., U.S. Bancorp and BB&T Corp. said they will sell shares to repay government bailout funds after the tests showed the companies can weather a worsening recession without additional aid. Wells Fargo & Co., which the government said needed $13.7 billion in additional capital, raised $8.6 billion selling shares last week, more than planned. Goldman Sachs in April, before stress test results were released, said it would raise $5 billion to repay federal rescue funds. “If it helps reduce uncertainty among investors regarding future losses and capital needs, and thereby improves the banking system’s access to private capital, one of the key objectives of the program will have been achieved,” Bernanke said. “Initial indications are encouraging.”
Banks are “well ahead” in finding ways to increase capital and several have already announced plans to raise equity or issue long-term debt not guaranteed by the Federal Deposit Insurance Corp., Bernanke said. Bernanke didn’t discuss the economic outlook or monetary policy in his speech. In response to an audience question about Lehman’s failure, Bernanke said the central bank had no option other than letting the investment bank file for bankruptcy in September because regulators lacked the authority to wind down a non-bank firm. At the same time, he said that the financial system remains “fragile” and that he wouldn’t “advocate” letting systemically important firms collapse.
The Fed will help keep the U.S. dollar strong by containing inflation, and will withdraw credit from the financial system in a “timely” way, Bernanke said. He reiterated that he’s “certain” the dollar will be the main reserve currency for the “foreseeable future.” He said the dollar will remain strong “because the U.S. economy is strong” and because the Fed is committed to ensuring price stability. Central bankers are currently “being very aggressive” in expanding credit to avert the risk of deflation, “which I now believe is receding, but certainly needs not to be ignored,” Bernanke said. Balancing inflation and deflation risks is a “very difficult situation,” he said.
The Fed chief said May 7 the findings should reassure investors about the soundness of the financial system. Yesterday’s comments elaborate on statements Bernanke and regulators issued with the results. The U.S. government “stands ready to provide whatever additional capital may be necessary to ensure that our banking system is able to navigate a challenging economic downturn,” Bernanke said at the time. The Treasury has injected more than $200 billion of taxpayer funds into financial institutions in an effort to boost confidence and capital. Congress has increased scrutiny over the investments and passed legislation limiting bonuses at institutions supported by public cash.
The $700 billion Troubled Asset Relief Program, or TARP, was initially proposed as a vehicle to remove devalued mortgages and related securities from the banking system. Congress authorized the TARP in October. As confidence in banks waned, the Treasury switched to a plan for injecting capital into the institutions. For banks that want to exchange the government preferred shares for contingent common equity, the Treasury has indicated that such a move should be “either accompanied or preceded by” raising private capital or converting private securities into equity, Bernanke said.
“Whether the objectives of the assessment program were achieved will only be known over time,” Bernanke said. “We hope that in two or three years we will be able to reflect on the banking system’s return to health with a sharply diminished reliance on government capital.” The 19 banks in the test hold two-thirds of the assets and more than one-half of the loans in the U.S. banking system, regulators said. Bernanke spoke at Jekyll Island, the site of secret 1910 meetings among bankers and Senator Nelson Aldrich of Rhode Island that helped lead to the creation of the Fed system in 1913.
$5 billion Citi boost for strapped states and cities
Cash-strapped cities and states will get a $5 billion boost from Citigroup. The bank announced Tuesday that it will lend up to $5 billion to states and local governments, municipal agencies and universities and nonprofit hospitals to help finance construction and other capital projects. The money can fund the construction of schools, airports, roads, hospitals and other infrastructure projects. Municipalities can also use the three-year loans to refinance existing variable-rate debt. Only those with AA rating can access the funds. The initiative is part of four lending programs Citi unveiled in a report on how it's using government bailout funds. The Treasury Department has pumped $45 billion into the troubled institution. Citi now has $1.6 billion in outstanding loans to municipalities.
State and local governments, which depend on debt to fund capital projects, have suffered as the credit crisis pushed up interest rates to unaffordable levels. Many, such as California, had to put work on hold until they could once again access the bond markets. Nearly one in two city finance officers reported difficulties in gaining access to credit and bond financing, according to a National League of Cities February report. Rates have come down and financing is getting easier to obtain, but it's still not normal yet, said Sujit CanagaRetna, senior fiscal analyst at the Council of State Governments, a research group. Citi's financing won't help public officials cover their daily operating expenses, but it will help jumpstart some projects that have idled and lower the pricetag of some borrowing, experts said. While most municipalities favor issuing bonds over taking loans, they can put the money to work. Citi said it has made proposals to potential borrowers for more than half the funds.
While the rates depend on many factors, the loans might carry a floating 1.5% rate, rather than a variable rate of up to 4%. "Anything that will drive down the cost of capital is advantageous for state and local governments," said Bart Hildreth, director of the Kansas Public Finance Center. Since $5 billion is not a lot of money to spread around for construction projects, most recipients will likely use it to refinance existing debt, he said. Some might use it to get infrastructure programs off the ground before issuing bonds to cover the bulk of the costs. States and cities are already working to spend $27 billion on highway infrastructure, as well as billions more for airports, schools and public transit, as part of the $787 billion federal stimulus package.
Citi directors face growing pressure to resign
Citigroup came under growing pressure to overhaul its board on Tuesday after it revealed that two long-serving directors survived a shareholder vote largely thanks to a balloting rule that is due to be scrapped. The results, revealed in a regulatory filing, prompted dissident investors to call for the ousting of the directors, Michael Armstrong, former chief executive of AT&T, and John Deutch, former head of the Central Intelligence Agency. “We are calling on them to resign immediately. We believe the vote is a repudiation of their tenure on Citi’s board,” said Richard Ferlauto, director of pension and benefit policy at the American Federation of State, County and Municipal Employees, one of the unions that had called on Citi to change its board.
Mr Armstrong has been a director of Citi or its predecessors since 1989 and headed its audit and risk management committee in the run-up to the financial crisis. Mr Deutch, who has been on the Citi board since 1996, succeeded Mr Armstrong at the committee’s helm. Citi, which is selling a 34 per cent stake to the government as part of its latest bail-out, has replaced five of its 14 directors including Robert Rubin, former Treasury secretary and has indicated it wants to change one or two more. The filing showed Mr Armstrong and Mr Deutch received about 2.6m votes in favour of their re-election, about 72 per cent of the total votes. However, nearly half of the total votes came from brokerages, which usually back management proposals due to a 72-year old rule that allows them to vote on clients’ behalf. The provision, due to be axed by the Securities and Exchange Commission this year, states that brokers who do not receive instructions from clients 10 days before a vote can back management’s proposals.
Lynn Turner, a corporate governance expert and former SEC chief accountant, said that without brokers’ votes, Mr Armstrong and Mr Deutch would not have been re-elected. Citi said: “All of our directors received a significant majority of votes cast. It would undermine the principle of majority rule for a director who receives 70 per cent of the vote to resign because 30 per cent voted against him.” The bank declined to comment on the the number of brokers’ votes, which rose from 25 per cent of the total last year to 46 per cent this year. People close to the company said it was impossible to conclude that all brokers’ votes had backed the directors. They added that there was no way of telling that all brokers’ votes would have gone against the two directors had clients given detailed instructions to their brokers. Separately, Citi said it would use up to $5bn of the $45bn in federal aid it received for a new municipal lending programme.
AIG Plans to Repay Bailout Funds Within Five Years, Liddy Tells Congress
American International Group Inc., the insurer bailed out by the U.S., expects to repay the government in three to five years, Chief Executive Officer Edward Liddy told a Congressional panel today. That timetable is based on financial markets remaining stable or improving, Liddy said at a hearing in Washington. The New York-based insurer may need more time if markets worsen, he said.
Officials Knew of AIG Bonuses Months Before Firestorm
As American International Group chief executive Edward M. Liddy returns to Washington to face Congress today, new details are emerging about how long federal officials were aware of the company's recent bonus payments to its executives and of how inflammatory the payments could be. Documents show that senior officials at the Federal Reserve Bank of New York received details about the bonuses more than five months before the firestorm erupted and were deeply engaged with AIG as well as outside lawyers, auditors and public relations firms about the potential controversy. But the New York Fed did not raise the alarm with the Obama administration until the end of February. Timothy F. Geithner, who became Treasury secretary early this year, was the head of the New York Fed when it became aware of the bonus details. But his name is not among those of senior New York Fed officials mentioned in the summaries of phone calls, correspondence and other documents obtained by The Washington Post.
Those documents also illuminate who in the government, beyond the New York Fed, knew what about the bonuses at AIG's most troubled unit, and when. Key members of Congress began investigating the payments as long ago as October and, beginning in January, repeatedly warned the Treasury about the matter. In early February, Fed officials in New York sent details about the bonus program to their counterparts at the Federal Reserve in Washington, to prepare Chairman Ben S. Bernanke in case he was asked about the payments at a congressional hearing. By the time the Obama administration was fully engaged in early March, the New York Fed had determined that AIG was legally bound to pay the bonuses to its Financial Products division, the documents show.
Top New York Fed officials also huddled with AIG about developing a strategy to mollify angry lawmakers -- but that did little to quell the firestorm that ensued. The furor over the bonus payments at AIG -- the crippled insurance giant that is benefiting from a government bailout of more than $180 billion -- disappeared from public view as quickly as it erupted in mid-March. At the height of the controversy, the House passed a resolution that would tax the bonuses at 90 percent and the Senate introduced an even harsher bill, which it abandoned as AIG employees began promising to return the money. But even after the storm, the fallout remains. As the financial crisis demands their attention, senior Treasury officials have met several times a week since March to review, one by one, the bonuses of even lower-ranking AIG executives, sources familiar with the discussions said. Geithner attended some of the initial meetings.
AIG is still grappling with the legal and tax issues surrounding the bonuses while trying to stay afloat. And while employees of AIG's Financial Products division have said they intend to repay nearly a third of their $165 million in bonuses in response to the public outcry, it is unclear when or how much will be returned. After the initial $85 billion federal bailout of AIG in September, the New York Fed, which is accustomed to dealing with banks, struggled to understand a complex global insurance company. "They really didn't know us at all," said one AIG executive, who was not authorized to speak publicly. "We had a real education process with them. They were asking us questions on a gazillion different issues." By Sept. 29, the bonus matter first appeared on the radar of the New York Fed, which was designated as the primary contact for AIG, documents show. Senior officials from the New York Fed met with AIG officials to discuss the compensation plans in place at Financial Products, whose risky derivative contracts had brought the insurance giant to the brink of collapse.
AIG e-mailed officials at the New York Fed copies of the company's compensation plans, which detailed bonuses and retention payments, including those at Financial Products, documents show. The issue arose in scores of meetings and conference calls over the ensuing months. AIG also disclosed its retention programs in public filings. For the New York Fed, the primary contacts were Jim Hennessy, counsel and vice president, and Sarah Dahlgren, a senior vice president and head of its bank supervision group. Leading the effort at AIG was Anastasia Kelly, the company's executive vice president and general counsel. Ernst & Young participated as an outside auditor, along with New York law firms including Sullivan & Cromwell. Throughout the fall, the correspondence between New York Fed officials and AIG proceeded but without the urgency of later discussions. The company was still in danger of imploding -- along with the rest of the financial system -- so examining bonus payments to several hundred employees was not a top priority among the Fed officials. Geithner has said in interviews that he was getting regular updates as president of the New York Fed and was vaguely aware of the bonus issue but that he was not apprised of the specifics.
The spark that would grow into a political firestorm began in October when lawmakers began to request documents about the compensation at Financial Products. Rep. Elijah E. Cummings (D-Md.) in particular latched on to the issue. By January, AIG was feeling heat from lawyers at the House Financial Services Committee, and from the offices of Rep. Paul E. Kanjorski (D-Pa.) and Rep. Joseph Crowley (D-N.Y.), who one staff member noted in an e-mail to AIG was "very upset about these payments." Kanjorski has said that around this time his staff began calling the Treasury about the issue and sending letters, but communication was hindered by the transition between administrations. The frequency and urgency of the correspondence between AIG and the New York Fed ratcheted up. Fed officials openly debated with AIG officials over how to handle the coming storm and examined whether there was a legal way to escape making the bonus payments or at least delay them. "Did we think people were not going to like this? Sure," an AIG executive said. "But did we think it was going to be the Armageddon of compensation? No, we didn't."
The New York Fed officials continued to keep their bosses in Washington updated. On Feb. 9, Hennessey e-mailed the Fed in Washington, informing officials that the retention programs were devised in 2007 -- "another fact relevant to any question Bernanke gets on FP retention." Bernanke has said in congressional testimony that he was not made aware of the issue until around March 10. After his staff informed him about it, he tried to stop the payments but was counseled by Fed attorneys that there may be no legal way to do so. As the outcry on Capitol Hill grew louder, Hennessy of the New York Fed sent an e-mail to Stephen Albrecht, a Treasury attorney, on Feb. 28, documents show. The correspondence was intended to set off alarm bells: More than $160 million in bonuses would be paid in March to AIG's Financial Products unit, the e-mail stated plainly. "This was triage, Treasury triage," said the AIG executive, noting the department had been largely absent from the discussions to that point. "When they finally realized it was a heart attack and not the measles, it was too late." By that time, senior officials at the New York Fed and AIG were resigned that nothing could be done to stop the bonuses. On March 2, Hennessy received an opinion from an outside legal counsel concluding that AIG could be sued if it failed to make the payments as originally crafted.
That same day, the company posted a $62 billion loss for the first quarter of 2008, the largest corporate loss in U.S. history. The government announced its fourth bailout for the firm, raising the total rescue package to more than $180 billion. After growing convinced they could not restructure the payments, Hennessy, Dahlgren and top AIG officials focused on devising a strategy for presenting the matter to Capitol Hill. Senior Treasury officials have said they had been aware of the bonuses, but not their specifics, since early February. But the e-mails from Hennessy alerted the department that big trouble was on its way. Geithner said in interviews that he had been preoccupied with the financial crisis and was taken aback when he was told about the extent of the bonuses. But he said he took responsibility for not knowing about the details of the bonuses earlier. Geithner called Liddy on March 11, demanding that the company restructure the bonuses. Liddy began drafting a letter that bowed to some of Geithner's concerns. Because the letter was to be released publicly, Treasury officials reviewed drafts and suggested changes. The letter was released March 14. But it was too late. The bonuses to executives at Financial Products were already heading out the door.
Obama Said to Understate Chrysler '60-Day' Bankruptcy Schedule
Chrysler LLC’s bankruptcy might take as long as two years, not the two months President Barack Obama suggested as a target, an administration official said. The 60 days projected by the President at an April 30 press conference announcing the automaker’s bankruptcy only applies to a sale of Chrysler’s best assets to a new entity, said the official, who can’t be identified because the matter is confidential. Afterward, creditors would fight over unwanted factories and other assets to recover money, lawyers said. As a streamlined Chrysler is launched, the remaining entity will be saddled with debt and other liabilities, such as product-defect and asbestos-damage claims. Some claimants may be disappointed as creditors compete to squeeze payments out of the sale of discarded factories, such as the Detroit plant that makes the low-volume Dodge Viper sports car.
“The unsold assets and liabilities may take years to sort out due to the complexities of resolving thousands of commercial, tort, future asbestos, dealership and employee claims,” said Dewey & LeBoeuf LLP partner Martin Bienenstock, who has advised General Motors Corp. and Chrysler Financial on restructuring. The bulk of assets left in the old Chrysler will be eight factories, valued by Chrysler at $2.3 billion. Those with claims against them include the U.S. government, provider of a $4.5 billion bankruptcy loan, and lenders with an unpaid balance of $4.9 billion on a secured loan. Those lenders include JPMorgan Chase & Co., Citigroup Inc., OppenheimerFunds Inc., a unit of Perella Weinberg Partners and Reams Asset Management, whose clients included the Bill & Melinda Gates Foundation, bankruptcy court filings show.
Chrysler is on track to complete the Fiat deal within Obama’s two-month deadline. Over objections of some secured lenders, blamed by Obama for tipping Chrysler into bankruptcy, a judge last week scheduled the asset transfer for May 27. Chrysler’s most profitable assets, such as its Jeep brand and Dodge Ram pickups and related factories, would form a streamlined Chrysler run by Fiat, which would contribute fuel- efficient technology it values at $8 billion to $10 billion. Groups gearing up to pursue claims against the old Chrysler include retirees, unsecured creditors, consumer victims, and mesothelioma and lung-cancer sufferers, according to court filings. The old Chrysler’s balance sheet will have $611 million of “product liabilities,” according to court filings. The secured lenders, a group of about 45 creditors owed $6.9 billion, would get $2 billion that the government proposes to pay for assets securing their loans. That would give them about 29 cents on the dollar for their claims, 4 cents less than Obama offered them to keep the company out of bankruptcy.
The holdouts, including OppenheimerFunds and Perella Weinberg, said in a statement that they objected to the Fiat deal because it favored more junior creditors. They abandoned their opposition the week after Obama’s criticism. After the new Chrysler is created, the dissident lenders would join other secured creditors in the scramble to recover the rest of the loan from the assets of the old Chrysler. Jack Brown, a senior analyst at OppenheimerFunds, a unit of Massachusetts Mutual Life Insurance Co., didn’t immediately return a call for comment. Denise DesChenes, a spokesman for Perella Weinberg, declined to comment beyond the April 30 statement of her client, who withdrew its opposition to the administration buyout plan. “The secured lenders will stand in line behind the government when they try to recover more than the $2 billion they’ve been given in the buyout,” said Richard Hahn, co- chairman of the bankruptcy practice at Debevoise & Plimpton LLP, a New York law firm that isn’t involved in the Chrysler case.
He said the government would have a priority in the recovery line because it plans to provide reorganization financing. It plans to recover at least some of that so-called debtor-in-possession loan, said a second Obama official who declined to be named because the matter is confidential. Chrysler will shift $500 million of a $4.3 billion U.S. loan to the new entity, it said May 12; the rest would remain a claim in the main bankruptcy case. Chrysler’s suppliers already are scrambling to find out whether they will be chosen to sell to the new company. Bridgestone Corp.’s North American division objected in a filing to Chrysler’s proposed asset sale, saying that if it isn’t hired by the new company, it might not get paid for tires supplied while Chrysler is in bankruptcy. The new Chrysler will assume $1.5 billion in such trade debt, according to court filings. Meanwhile, the automaker plans to pay all “essential” suppliers of goods and services, which were owed about $2.3 billion before its bankruptcy filing, according to the documents.
Rejected auto suppliers’ claims against the old Chrysler might include unpaid bills and estimated future profit on canceled programs, said Max Newman, an attorney with Butzel Long in Detroit, which represents more than 60 unsecured creditors. “They will possibly be lumped in with other creditors who wait for whatever can be made from the liquidation of whatever is left in bankruptcy,” Newman said. “It will take years for all of those assets to be disposed of.” Chrysler has said it would shut unwanted factories, including a sedan plant in Sterling Heights, Michigan, a St. Louis-area pickup-truck factory, a metal-stamping operation in Twinsburg, Ohio, an engine factory in Kenosha, Wisconsin, and a Detroit axle plant, according to court filings.
Plants in St. Louis and Newark, Delaware, are already closed. If Chrysler cannot find a buyer for the plants, such as a real estate developer who has a new use for them, the factories might trigger cleanup costs for the old company and its creditors, instead of bringing in money from a sale or rental. With $39 billion in assets, Chrysler filed the fifth- biggest U.S. bankruptcy, according to Bloomberg data. The separate alliance with Fiat would create the world’s sixth- largest car manufacturer, run by Fiat Chief Executive Officer Sergio Marchionne and owned by an auto workers health-care trust, the U.S. and Canadian governments and Fiat, whose stake might rise over time to 51 percent, from 20 percent initially.
GM sinks to fresh low as Chapter 11 looms
General Motors' shares slid to their lowest level in more than 70 years yesterday amid increasingly loud signals that the Detroit carmaker is headed for bankruptcy protection within the next three weeks. The shares were trading at $1.10 at noon in New York, down almost a quarter, which gives GM a market value of less than $700m. By contrast, Toyota, which overtook GM last year as the world's biggest carmaker by sales, is valued at $120bn. GM is struggling to meet a June 1 deadline set by the US government to reach debt-exchange deals with unsecured bondholders and the United Auto Workers union. Fritz Henderson, chief executive, said on Monday that "given the objectives that we've set for ourselves, it is more probable that we would need to accomplish our goals in a bankruptcy". Chrysler, GM's smaller rival, filed for bankruptcy protection on April 30.
Six senior GM executives underscored Mr Henderson's warning by disclosing that they recently sold all their remaining GM shares. The bulk were sold by Bob Lutz, who retired as vice-chairman last month. Under the debt-swap offer, GM must garner the approval of 90 per cent of its bondholders. The challenge of doing so has been reflected in protest rallies in various parts of the US organised by a group of small bondholders. The bondholders are protesting the terms of the offer under which they would swap their $27bn claim for a 10 per cent equity stake, while the union, with a $10bn claim, would end up with 39 per cent. "I realise that we all have to make sacrifices, but bondholders have been singled out to lose the most," Chris Crowe, an electrician from Denver, said at a rally in Philadelphia yesterday.
One bondholder held a sign reading: "We are individuals, not institutions," to distinguish the group from hedge funds that have been criticised by lawmakers for precipitating Chrysler's bankruptcy. Efraim Levy, equities analyst at Standard & Poor's, noted that GM shareholders face two equally unpalatable outcomes. They will be wiped out if GM files for Chapter 11. But even if it manages to stay out of bankruptcy court, they would be left with just 1 per cent of the restructured company under the debt-for-equity proposal. The US government would own 50 per cent, with the rest split between bondholders and the UAW. Meanwhile, Ford shares slid by 13 per cent to $5.26 in early trading yesterday after the number-two Detroit carmaker unveiled plans for a share issue expected to raise close to $2bn. The proceeds could enable Ford to pay cash for a chunk of its contributions to a union-managed healthcare trust that would otherwise have been made in shares.
Pension deficit threatens GM's viability
General Motors of Canada Ltd. faces a pension shortfall of more than $7-billion, a gap that poses a major obstacle to a cost-cutting deal with the Canadian Auto Workers union, and a political challenge for Ottawa and Ontario. The federal government says the province has jurisdiction for settling the pension issue, and must also contribute one-third of the overall loan package that Canada could provide in collaboration with the U.S. government. However, Ontario officials say the pension deficit is part of GM Canada's overall financial problems, and needs to be solved as part of the overall restructuring package. Premier Dalton McGuinty acknowledged yesterday that the cost of saving GM's Canadian operations may be higher than he had anticipated, as he learned from Ontario's participation in $3.8-billion assistance provided to Chrysler LLC last month. Everyone involved in the GM restructuring should apply the lessons they learned by going through a similar exercise with Chrysler, he said.
“When we come together at the table, and when we're really honest with each other, then I think we can accept that we're going to have to do some things that we didn't want to do,” Mr. McGuinty said. “We came to the table with more money than we initially anticipated we'd have to come with for Chrysler.” Mindful of a potential political backlash if Ottawa is seen to be bailing out lucrative auto worker pensions, Industry Minister Tony Clement has insisted federal taxpayers will not be on the hook for GM Canada's pension shortfalls, which are regulated and guaranteed by the province. The Ontario government's position is that the shortfall in the pension plans is a significant component of the GM situation and cannot be isolated from the overall negotiations, said an Ontario government source who asked not to be named. “All of the parties – the unions, GM, U.S. Treasury and the Canadian and Ontario governments – are working together to try to keep GM viable now and sustainable in the long term,” the source said.
The Canadian and Ontario governments will decide how much money they are prepared to lend GM once the company and the CAW present their plans for restructuring the company's operations and cutting overall labour costs. Still, provincial Finance Minister Dwight Duncan warned that Ontario's Pension Benefits Guarantee Fund is not in a position to bail out the GM plan. He said it would be unfair to ask taxpayers to bail out any pension plans that are under water, including GM's, because about two-thirds of Ontarians don't even have a pension. GM Canada's plan had a deficit of $4.5-billion in its most recent public information released in November, 2007, but sources said the amount ballooned to more than $7-billion at the end of 2008 on declines in the stock market last year. Since then, the Toronto Stock Exchange's leading index has regained about 12 per cent of its value, paring the pension shortfall somewhat.
As well, the CAW says it already gave GM Canada $500-million worth of pension savings in March when the union agreed to freeze basic benefits and eliminate cost-of-living adjustments for retirees. Those changes won't come into effect, however, unless GM signs a final loan agreement with the federal and Ontario governments. GM Canada spokesman Stew Low said the latest public figures are still those from November, 2007. With government officials acting as mediators, the union and company are huddled in talks this week aimed at wringing out further cost savings after governments said a March agreement did not provide enough to make the company competitive and viable over the longer term. The Detroit-based parent, General Motors Corp., is negotiating with its United Auto Workers union to reach the level of concessions demanded by President Barack Obama in return for a U.S.-led bailout that would provide more than $30-billion (U.S.) in loans to the company.
Even with deals with unions and governments, GM is likely to file for bankruptcy protection in the United States – and its subsidiary may seek similar protection in Canada – to dramatically reduce its debt load.
A settlement of GM Canada's pension problem is likely to involve financial contributions from GM Canada and the Ontario government, plus a reduction in future benefits for unionized employees at GM Canada who are still working and will retire in future years. The fund will face a big hit in payouts over the next few years as the auto maker reduces its hourly work force to about 4,400 by 2014, from more than 10,000 now. Based on the November, 2007, shortfall of $4.5-billion in the funds, the deficit would amount to more than $1-million for every active GM worker by 2014.
Ambac expects subprime suits against banks to increase
Ambac, the bond insurer whose finances have been hit by guarantees on billions of dollars of securities linked to risky mortgages, expects growing numbers of lawsuits against the banks which acted as underwriters and managers of these securities. Last week, a British subsidiary of Ambac Financial filed court papers seeking $1bn in damages from JPMorgan Investment Management. As the investment manager for $1.65bn of assets in the name of Ballantyne, Ambac said JPMorgan placed the assets in "inappropriate securities", including risky mortgage-backed securities. MBIA, the largest bond insurer which, like Ambac, has lost its triple A credit ratings, recently sued Merrill Lynch, now owned by Bank of America, to avoid pay-outs on $5.7bn of collateralised debt obligations linked to mortgages. "It will be surprising to me if you didn't see more of these sorts of cases potentially from ourselves and others," said Douglas Renfield-Miller, executive vice-president at Ambac.
The lawsuits come as the losses on securities backed by mortgages continue to increase. As well as subprime mortgages, the other source of significant losses are so-called "Alt A" mortgages. Ambac said it was now assuming that the losses on such Alt A mortgages, which were long considered to be relatively high quality, would be similar to subprime mortgages. Accordingly, Ambac took an $830m charge to reflect a decline in the value of Alt A securities. It also set aside $740m for further losses on mortgage loans it has guaranteed. Its net loss fell to $392m in first quarter compared with $1.66bn in the first quarter of last year. The bond insurer expects further declines in US house prices. The lawsuits reflect broader concerns among holders of mortgage-backed assets.
It is clear that many of the assumptions underlying hundreds of billions of bonds backed by mortgages - which were assigned triple A credit ratings - were wrong. Many of the transactions were complex collateralised debt obligations that included the use of credit default swaps, which have contributed to hundreds of billions of dollars of write-downs at banks. "These questions are being faced by many investors in structured assets," said Joel Telpner, partner at Mayer Brown. "If there really was a problem, it can be difficult to prove who was to blame, whether it was the rating agencies, the underwriter or the originator of the assets." A spokeswoman said JPMorgan had received a court summons from Ambac but no formal complaint. "We believe that we managed Ballantyne's account appropriately and thus intend to contest vigorously any allegations that we did not," she said.
Japanese Housewives Lead $125 Billion Bet That Japan's Yen Will Depreciate
Individual investors in Japan increased bets to the highest in six months that the yen will weaken as the economy stabilizes, jumping back into a trade that was all but wiped out last year. Businessmen, housewives and pensioners held 153,326 margin contracts at the end of last month that will make money if the yen declines against currencies ranging from the euro to the Australian and New Zealand dollars, according to the Tokyo Financial Exchange. “Investors believe the worst of the global recession is over and higher-yielding currencies are bottoming out,” said Yoshisada Ishide, who oversees $1.8 billion as a Tokyo-based fund manager at Daiwa SB Investments Ltd., a unit of Japan’s second-biggest investment bank.
Individual investors, called housewives after the women who traditionally managed finances in Japanese families, have 1,434 trillion yen ($14.9 trillion) of savings, according to the Bank of Japan. They’re seeking higher returns after the central bank cut its benchmark interest rate to 0.1 percent. Investors who sell the yen against the euro would earn 3.4 percent by year-end, compared with 0.25 percent in one-year yen-denominated deposit accounts, data compiled by Bloomberg show. Investors are returning to the so-called carry trade, where they borrow funds in countries with low interest rates and invest the proceeds in ones with borrowing costs that are 10 percentage points higher, or more. The strategy contributed to the yen’s 18 percent slump against the dollar between January 2005 and June 2007. Investors abandoned the trade last year as losses and writedowns on securities tied to subprime mortgages exceeded $1 trillion and the September bankruptcy of Lehman Brothers Holdings Inc. froze credit markets.
Money managers retreated from higher-yielding assets to the safety of government debt and the currencies that are easiest to trade. The yen has strengthened 19 percent against the dollar since the Federal Reserve began cutting interest rates on Sept. 18, 2007. Now, investors are growing more optimistic. Finance ministers from the Group of Seven industrialized nations said on April 24 that they see “signs of stabilization” in the world economy and expect a recovery to take hold later this year. The U.S. Labor Department said May 8 that America’s employers cut 539,000 jobs in April, the fewest in six months. “Individual players, though they lost sizable amounts of money after Lehman went under, are beginning to reinvest in higher-yielding currencies thanks to the stabilization of global financial markets,” said Masahiro Suzuki, a businessman who has speculated in foreign-exchange markets for seven years.
Suzuki, who works for a trading company in Kobe, western Japan, said he plans to increase bets that the Australian dollar will appreciate compared with the yen. At the end of April, individuals held the most contracts betting on a yen decline compared with those expecting gains since October. The difference as 35 times more than this year’s low on March 4, according to data from the Tokyo Financial Exchange. The yen is this year’s worst-performer of the 16 most- traded currencies tracked by Bloomberg. It depreciated 17 percent against the South Africa rand, where the benchmark rate is 8.5 percent. Versus the Brazilian real, where the key rate is 10.25 percent, it’s down 16 percent. The bulk of the losses have come since Japan’s individual investors began increasing their bearish bets. Japan’s currency traded at 73.58 per Australian dollar as of 11:16 a.m. in London, from 73.78 in New York yesterday. It dropped to 76.18 on May 11, the lowest level since Oct. 6. The yen was at 57.77 versus New Zealand’s dollar from 58.44, and bought 96.15 per U.S. dollar from 96.45.
The yen will probably weaken to 100 against the greenback by year-end, according to the median estimate of 49 analysts surveyed by Bloomberg. The Japanese currency’s advance to a 13-year high of 87.13 per dollar on Jan. 21 this year wiped out almost all of the yen short positions. The housewives remained net sellers from Aug. 18 to Dec. 30, even as Japan’s currency rallied 22 percent versus the dollar. That resulted in a 17 percent loss. Carry trades may fail to bring the returns investors expect because the extra yield offered over Japan is too small to compensate for possible currency losses, said Akira Takei, a fund manager in Tokyo at Mizuho Asset Management Co., a unit of Japan’s second-largest bank. “There is almost no currency that we can call higher- yielding across the globe given the shrinking interest-rate gap between Japan and the rest of the world,” Takei said. “This is especially the case if investors have to hold these positions without any chance to hedge.”
The yen may gain to 91.50 per dollar based on recent trading patterns if ‘the green shoots of economy recovery “are not a flower but a short-lived weed,” strategists at Brown Brothers Harriman & Co. in New York said in a report yesterday. Japan’s 0.1 percent benchmark rate compares with 3 percent in Australia, 2.5 percent in New Zealand and 1 percent in the euro region. In August 2007, New Zealand’s official rate was 8.25 percent and Australia’s was 6.5 percent. The number of bets by individual investors against the yen started to accelerate in early April, according to data compiled by the Tokyo Financial Exchange and RBC Capital. “A very interesting dynamic is developing,” said Sue Trinh, a senior currency strategist at RBC Capital Markets in Sydney. “Leveraged yen short sellers are making a tentative return.”
The favorite bet is for the Australian dollar to strengthen versus the yen. Wagers on the Aussie more than tripled to 64,293 contracts in the five weeks to April 27, while those on the kiwi -- named after a flightless bird native to New Zealand and depicted on the one dollar coin -- rose to 36,454. Japan’s economy will shrink 6.2 percent in 2009, compared with 1.4 percent for Australia and 2 percent for New Zealand, the Washington-based International Monetary Fund said last month. The third-biggest carry trade is to buy the euro against the yen, Tokyo Financial Exchange data show. Bets on the single European currency’s gain reached 21,598 contracts on April 27. A weaker yen may bolster earnings at exporters such as Toyota Motor Corp., which on May 8 reported its first annual loss in 59 years and cut dividends. Japan’s automakers sell about half of their vehicles overseas. Exporters said they can remain profitable as long as the yen trades at 97.33 per dollar or lower, a Cabinet Office survey showed on April 22.
Traders’ expectations of fluctuations in major currencies are at the lowest level in eight months, indicating a smaller risk of exchange-rate fluctuations eroding carry-trade profits. “When the markets start calming down and volatility moves less, the Japanese will come back and start investing abroad again to earn a higher yield,” said Rajeev De Mello, the Singapore-based head of Asia investments at Western Asset Management Co., which manages $513 billion. Implied volatility on seven major currencies has fallen to 13.8 percent from a peak of 26.6 percent in October, a month after Lehman Brothers collapsed, according to a JPMorgan Chase & Co. index. The decline from an average of 15.4 percent over the past year has encouraged investors to resume carry trades. “We have argued for more than a month that one of the best risk-reward ratios is currently offered by carry trades, in particular long positions in high-yielding emerging-market crosses, funded in low-yielding majors,” Thomas Stolper, an economist at Goldman Sachs Group Inc. in London, wrote in a research report to clients on May 8. “Interest has been picking up in this theme and there is good anecdotal evidence of more risk taking in this area,” he wrote in the report.
German Cabinet OKs Bank Toxic Asset Offload Bill
The German Cabinet Wednesday approved a draft bill to help banks remove toxic assets from their balance sheets and to boost liquidity supply, with the potential costs of the measures to be met by the banks' owners. The draft bill, known as the bad bank plan, aims to let financial holding companies, banks and their subsidiaries transfer structured securities, such as asset-backed securities and collateralized-debt obligations, to a government-backed unit on a voluntary basis. At present, banks have to write off toxic assets from their balance sheets at the end of each quarter, which has caused their equity capital ratio to shrink over recent months. The government plan would allow private banks to offload toxic assets to a special-purpose vehicle, with a 10% reduction in their booking value. In return, the banks will receive a government-guaranteed bond amounting to the transfer value of those assets.
"We still have a situation in the financial market where the confidence is still strongly limited," said Finance Minister Peer Steinbrueck, pointing to the interbank market. "This is a necessary operation, but whether it's sufficient we yet have to see," he said. "If we don't do this... if we don't try to solve the problem as much as possible, then we have bigger problems than we already have." However, the government expects no extra burden to be placed on public finances as a result of the plan. The plan mainly focuses on commercial banks, which can transfer toxic securities acquired before Jan. 1, 2009, to this special-purpose vehicle. The plan is different to the models used in the U.S. and in the U.K.
The U.S. administration has opted for a Public-Private Investment Program, designed to extract up to $1 trillion in toxic assets from U.S. banks, while the U.K. has put £7 billion of capital into leading banks and offered insurance on hundreds of billions of pounds worth of toxic assets. BNP Paribas said in a research note that the outlined bad bank plan isn't sufficient to help overcome the deep weakness of Germany's banking sector, which results from structural problems and low profitability. "With the sharper-than-expected downturn in Germany hitting profitability and with asset quality on a deteriorating trend, the need to augment capital in German banks, or to find some way to conserve it, is becoming ever more pressing," the research note said. "That is why the measures taken so far are proving inadequate." According to the Bundesbank, banks have around €230 billion in toxic assets and around €40 billion-€50 billion have already been dealt with, Steinbrueck said.
For the remaining €180 billion-€190 billion, the government has already at its disposal a sufficient guarantee umbrella that is provided by the financial market stability fund, or SoFFin, he said. Banks will have to pay a risk-adequate guarantee fee to the government-owned financial market stability fund, or SoFFin, which guarantees the bond, and they will also have to pay an annual fee over a guarantee period of 20 years to the difference between the 90% booking value of the securities and the fundamental value of the assets, which is typically lower than the booking value, according to the draft bill. The government aims to implement the bill, which requires approval by the lower and upper houses of parliament, before the general elections take place in September. Institutes can apply for the transfer of such assets and receive the bonds up to six months after the bill has been enforced. The bill will become law once it has been signed by the president.
Non-bank ABCP seemed solid, Caisse says
Money managers at the Caisse de dépôt et placement du Québec figured there was no difference between non-bank asset back commercial paper and similar products backed by the Big Five banks in making the investments that later proved fatal to the provincial pension fund manager. Senior executive Claude Bergeron on Tuesday told the Quebec National Assembly's public finance committee, which is looking into the Caisse's $40-billion loss in 2008, that a team of four portfolio managers was responsible for the institution's money market, or short-term, investments. Two managers in particular looked after the investments in ABCP, but they made no distinction between paper issued by third-parties and paper backed by the chartered banks. Both shared identical triple-A credit ratings, while the non-bank ABCP had a slightly higher yield, Mr. Bergeron said.
With hindsight “it's easy to conclude that the Caisse shouldn't have bought non-bank ABCP,” said Mr. Bergeron, the Caisse's senior vice-president of legal affairs. “But there was not, in the market, a clear distinction between bank and non-bank commercial paper.” Bank-sponsored ABCP, which made up the bulk of the market for so-called structured products in Canada, was believed to have solid liquidity guarantees, since the chartered banks were expected to step in to provide cash if the market froze. Liquidity guarantees on the non-bank paper were far from secure, since they only applied in narrow circumstances. The difference only became clear in August of 2007, when the market for non-bank ABCP froze, leaving the Caisse with more than $13-billion in the suddenly toxic paper, or about 40 per cent of the total amount issued in Canada. The provincial pension fund manager has so far taken $5.9-billion in provisions for losses against its ABCP holdings, which remain largely illiquid.
Mr. Bergeron entered the fray only after the ABCP market collapsed as he and then Caisse CEO Henri-Paul Rousseau scrambled to hash out a restructuring deal in August, 2007. He did not participate in decisions that led to the purchase of non-bank ABCP. Despite warnings in July, 2007, that some of the assets behind the paper included risky loans such as subprime mortgages in the United States, Caisse money managers continued to buy non-bank ABCP almost every day until Aug. 10. In fact, they even ramped up their holdings of non-bank ABCP to replace cash that had been held in bank-sponsored ABCP that had not rolled over when the paper came due, Mr. Bergeron explained. Though the Caisse was a significant shareholder in Toronto-based Coventree Capital Inc., which created many of the so-called “conduits” that issued non-bank ABCP, Mr. Bergeron denied that the pension fund manager faced a conflict of interest in investing in non-bank ABCP. Only about 30 per cent of the Caisse's non-bank ABCP holdings were issued by Coventree conduits, he said, while 40 per cent were issued by National Bank of Canada entities.
“It is entirely false that the Caisse gave priority to purchases from Coventree,” Mr. Bergeron said, adding that the value of the Caisse's shareholding was minimal (worth only about $6.3-million) compared to its holdings of non-bank ABCP. Mr. Bergeron said Caisse managers had confidence in non-bank ABCP since they had never experienced a default on the paper in the preceding decade. And since Caisse investment rules did not put limits on the purchase of products with the highest short-term credit rating – R-1, or the equivalent of a triple-A rating on long-term debt – managers were free to buy as much of the paper as they saw fit. The Caisse has since changed the criteria for such investments. It now requires ratings from at least two agencies (non-bank ABCP was rated by only one, DBRS) and put in place a new process for approving investments in new products.
Earlier, Fernand Perreault, who recently stepped down as interim-CEO after the appointment of Michael Sabia to head the pension fund manager, attributed a “large part” of Caisse's poor performance in 2008 – relative to its Canadian counterparts – to accounting rules. The Caisse lost 25 per cent of its value overall, compared to a 19-per-cent loss at other large funds. As an investment fund, the Caisse is bound by stricter rules regarding the valuation of its real estate investments, compared to a pension fund manger such as Ontario Teachers Pension Plan, Mr. Perreault said. The rules, known as mark-to-market, require the Caisse to value its properties as if it intended to sell them immediately. As a result, the Caisse's real estate portfolio lost 22 per cent of its value in 2008, compared to a 3.4-per-cent loss for the benchmark Aon index. However, pressed repeatedly by Parti Québécois finance critic François Legault, Mr. Perreault was unable to quantify the impact of the accounting rules on the Caisse's 2008 results compared to Teachers and others.
“It's always difficult to make a comparison when one doesn't know how the others made their valuations,” conceded Mr. Perreault, who ran the Caisse's real estate division for several years before taking over as interim CEO after the sudden departure of Richard Guay in November. Mr. Guay, who served as chief investment officer under Mr. Rousseau, took over from his mentor in mid-September following Mr. Rousseau's departure for a senior position at Power Corp. of Canada. But Mr. Guay left on sick leave two months later, following the October market meltdown. Mr. Guay is set to testify before the public finance committee later Tuesday. The committee has set aside the whole day on May 19 to hear testimony from Mr. Rousseau. Former Caisse chairman Pierre Brunet, meanwhile, was to testify this week but has cited an undisclosed medical condition for refusing an invitation from the committee.
Canadian consumer bankruptcies soar
Consumer bankruptcies rose more than 34 per cent in the first quarter of 2009 from the same time a year earlier, with people in British Columbia and Alberta among the most distressed, according to a report released Tuesday. Total consumer bankruptcies numbered 27,542 in the first quarter of this year, compared with 20,466 in the first quarter of 2008, the Office of the Superintendent of Bankruptcy Canada said in its quarterly report. In Alberta, consumer bankruptcies were up 78.5 per cent to 2,353, and in British Columbia, they were up 58.8 per cent to 2,616, continuing the recent rise that credit counsellors and economists attribute to the fact that the recession hit the two Western provinces later, and with more speed, than the rest of the country. Business bankruptcies Canada-wide were down 13.8 per cent from the first quarter of last year, to a total of 1,430, although the reversal of fortunes in the oil patch was reflected in the Alberta business bankruptcy numbers, which were up 3.6 per cent to 114 in the quarter.
The number of Canadian consumers who filed for protection from creditors while they sorted out their financial problems also increased in the quarter – by 40.9 per cent to 8,001. The number of businesses that filed proposals to restructure their debts was up by 0.8 per cent to 366. Toronto-Dominion Bank economist Millan Mulraine said high debt levels and the sharp rise in unemployment explains the steep increase in personal bankruptcies. Businesses have fared better because they reacted quickly to the economic downturn, quickly cutting costs and shedding staff, Mr. Mulraine said. “Businesses tend to be hit pretty fast and they tend to restructure very quickly.” In Alberta, which has come off a long, sustained boom, “consumers – and businesses, to some extent – overextended themselves, not saving for a rainy day,” Mr. Mulraine said.
Crisis management: India must prepare for the worst
Visitors to India are dazzled by the chaos and unpredictability of life here, but those who observe its politics are bewildered by the opposite. Crises are visible from a distance and grow to size in full public view, yet still seem to catch the government by absolute surprise. We have to wait until May 16 – or perhaps even longer – to know whether India’s next prime minister will be the incumbent, Manmohan Singh, or his Hindu nationalist rival, L.K. Advani, or someone from a smaller party. But this much is already clear: the new prime minister will almost certainly have to deal with four emergencies in the course of his term.
Emergency One: Terrorism is a part of daily life in India now, but at some point during the new prime minister’s term there will be a spectacular strike – on a plane, temple, parliament or nuclear installation. When the strike takes place, it will be found that the local police did not have enough guns, walkie-talkies, training or manpower to fight back quickly. Co-ordination between local security agencies and elite commando forces in Delhi will prove to be poor. When the terrorists are overpowered, they will probably say that they received training and assistance from jihadists in Pakistan; they may even be Pakistani nationals. The government will immediately threaten to attack Pakistan, then realise that it cannot do so without risking nuclear war, and finally beg the US to do something. Once it is clear that the government has failed on every front – military, tactical and diplomatic – against the terrorists, senior ministers will appear on television and promise that, next time, they will be prepared. They should start preparing right now.
Two: The extent to which the global recession has hurt India’s economy has been masked by a government stimulus package. This spending has come at a cost – India’s fiscal deficit has shot up – and cannot be sustained after the elections, yet few observers within the country seem worried. There are signs of a nascent recovery and Mr Singh recently sounded almost gung-ho when he said that his government could improve the economy in just 100 days of a new term. International analysts worry about India’s fiscal health and are much less sanguine about the country’s prospects in the near future. Many young urban Indians have known nothing but a booming economy; the prospect of long-term unemployment could confuse and inflame them. Perhaps the economy will indeed return to robust growth. But the wise thing would be to prepare for a painful slowdown.
Three: In the past few weeks, the Naxals – Maoist guerrillas who operate in the desperately poor states of north and central India – have attacked a major aluminium mine, killed voters and policemen, and disrupted trains. The Naxal insurgency, which taps into the resentment of those left out or threatened by the economic boom, has grown steadily in the past five years. Yet most urban Indians still think of it as an obscure menace that is “out there” – far from the cities and towns. This is likely to change. The emboldened guerillas look set to escalate their war against the Indian state in the months ahead. Attacks on industries, mines, police stations and trains are likely to rise; a spectacular strike that grabs national and international attention is on the cards. Understaffed local police and corrupt regional politicians will not be able to deal with the Naxals without significantly greater assistance from New Delhi.
Four: India’s population continues to grow and demand for water – for irrigation, industrial and personal consumption – keeps mounting; yet no government has given enough thought to husbanding the country’s water resources. Tensions over the use of water simmer across India. Sooner or later, they will explode. In the months after a bad monsoon, for example, there could be a flare-up between neighbouring regions over the use of a shared river; this could lead to strikes and protests that paralyse parts of the country. There are, of course, many other emergencies that will confront the new prime minister – such as the children who die every day of malnutrition and the relentless spread of corruption – but these are not going to make the evening news, unless Danny Boyle is preparing a sequel to Slumdog Millionaire. But the four crises outlined here are likely to cause the next prime minister a few sleepless nights. He could make things easier on himself by planning for them right now.
Italian Banks Under Pressure
French and Swiss banks might be getting through the worst of the crisis, but banks in Italy, rather like their Spanish counterparts, are still feeling the lagging effects of the credit crisis as a deteriorating macro economic environment casts a shadow over their future. Italian banking giant UniCredit reported a 58.0% drop in first quarter net profits to 447.0 million euros ($612.4 million) on Wednesday, after being hit by a sharp rise in bad loans. Write-downs and provisions on loans totaled 1.6 billion euros ($2.2 billion) for the first quarter, more than than double the 664.0 million euros ($909.6 million) it booked a year ago. UniCredit also lacked the contribution of revenue from investment banking, a factor which has helped other European banks like BNP Paribas of France and Germany's Deutsche Bank offset losses on bad loans.
UniCredit's net-interest income rose, but only by 3.7%, as deposit spreads, which measures the difference between the euro zone's reference interest rate, the three month euribor rate and the rate the bank charges on its deposit base, declined. Trading revenues recovered from their lows last year, but the division still posted a loss of 93.0 million euros ($127.4 million), while its fees and commissions income declined by 25.0%, as volumes of assets under management declined. Shares of UniCredit fell 0.5%, to 2.15 euros ($2.95), in Milan on Wednesday morning.
Analysts are expecting similar trends to be seen in the rest of the sector. Ahead of the release of UniCredit results, Keefe Bruyette and Woods analyst Marcello Zanardo forecast that net interest income would continue to fall across the sector, due to the compression of deposit spreads, while lower banking fees would hit fee income. UBI Banca reported profits of 24.3 million euros ($33.2 million) earlier this week, sharply down from 219.3 million euros ($300.1 million), and Mediobanca reported a loss of 61.0 million euros ($83.4 million). A number of banks have sought state-backed funding this year, including Banca Popolare di Milano, Monte dei Paschi, Intesa Sanpaolo and UniCredit.
Ireland weighs on the euro
The lack of economic stimulus in Ireland raises questions over the country’s continued participation in economic and monetary union as well as the longer-term outlook for the euro, says Steve Barrow, strategist at Standard Bank. He argues that Ireland’s economic slump has seen such a sharp deterioration in its budget deficit – to about 12 per cent of gross domestic product – that its ability to use fiscal policy to cushion the blow is limited. “Worse than this, being a part of Emu means it needs to reduce this deficit over time.” While there have been interest rate cuts by the European Central Bank, Mr Barrow says it is real, or inflation-adjusted rates, that are key. “Inflation in Ireland has collapsed so real rates have risen.”
He estimates Irish GDP should fall about 8 per cent this year and says such weakness occurs in developing economies – where currency losses can provide stimulus. But against Ireland’s most important trading partner – the UK – the euro has risen 13 per cent in the past year. Mr Barrow adds: “Ireland’s tough position might not lead to default, bail-out or Emu withdrawal but we do think that it’s a situation that will weigh on the euro – particularly within Europe. This issue is a key reason why we think that sterling will eventually capture levels below 80p and why the Swedish krona and Norwegian krone look far better long-term bets than the euro.”