Fifth Avenue and 42nd Street, New York. Horses and motorcars shared the streets
Ilargi: Yesterday, when talking about Fannie Mae's new $23.2 billion loss, I wrote: And, yeah, I know what you're saying, I’m not so sure I want to know the whole picture on their securities portfolio either. Doug Noland , who's -much- braver than I am, decided to take a look anyway:
Today from Fannie: “In March, Fannie Mae provided $93.3 billion in liquidity to the market through Net Retained Commitments of $5.4 billion and $87.8 billion in MBS (Mortgage Backed Securities) issuance… March refinance volume increased to $77 billion, nearly twice the refinancing volume reported in February and our largest refinance month since 2003. We expect that our refinance volumes will remain above historical norms in the near future… Fannie Mae began accepting deliveries of refinance mortgage originations under the Making Home Affordable program in April 2009.”
Fannie’s “Book of Business” (retained mortgages and MBS guarantees) expanded at a 12.3% rate during March to $3.144 [trillion] (largest increase since February 2008). Fannie MBS guarantees grew at a 15.4% annualized pace during March to $2.640 [trillion]. The $31.4 billion increase in guarantees was the largest in 13 months. The company’s “New Business Acquisitions” jumped to $92.8 billion from February’s $53.8 billion and January’s $28.8 billion.
The current wave of mortgage refinancings is the strongest since the powerful – and system reliquefying - 2002/3 refi boom. The few analysts that even care are generally discounting the systematic impact of refinancings. They argue that there is today dramatically less equity available to extract and spend. From an economic perspective, I don’t have a big issue with this analysis. But from a systemic risk perspective, the unfolding refi boom is anything but inconsequential. By the end of the year, I would not be surprised to see upwards of $1.0 [trillion] of “private” mortgage exposure having been shifted to the various government-related agencies (Fannie, Freddie, Ginnie, FHA, and FHLB). The wholesale transfer of various private sector risks to “Washington” is a key facet of the Government Finance Bubble.
Nowhere is such redistribution accomplished as effectively and surreptitiously as when the mortgage marketplace is incited to refinance by (Fed-induced) collapsing yields. Think in terms of our government placing its stamp of guarantee on hundreds of billions of risky, illiquid and unappealing mortgage securities – transforming them into coveted “money”-like agency securities. Such dynamics work wonders… Previous holders of these mortgages receive cash, while the entire marketplace benefits from higher mortgage/MBS prices.
Noland is a little cautious here, but if you add up the numbers, or annualize them if you wish, Fannie Mae is on track to "add liquidity" to the market to the tune of $1 trillion, all by itself, most of which will consist of mortgage backed securities, or MBS. Now, we all know by now that MBS is not what you would call the hottest commodity out there, in fact they're hardly trading at all, and if they are, it's mostly at huge discounts. But even if that were not so, we need to wonder why a government agency would issue MBS. And there's the catch again, of course: the administration treats Fannie Mae as a private enterprise, whose securities "are not covered by the full faith and credit of the nation" etc. Still, the same administration ordered Fannie and Freddie last year to buy $40 billion in mortgages every month. That sort of order does not say that Fannie is an entirely independent entity. What it does say is that the US government has deliberately created a murky grey territory in which murky grey debts and losses can be dumped.
Once more: why do Fannie and Freddie buy mortgages off the banks in the first place? Who does that kind of "policy" benefit?
- Homebuyers? It's easier to get a loan if a bank can transfer the risk, but the easier it gets, the higher home prices will remain for the time being, only to sink inevitably afterwards, so who buys now, buys too expensive. At best a two-edged sword.
- Homeowners? Artificially elevated prices, the result of Fannie's market interference, raise the chances of staying above water on a loan, and staying in the home, but only for a while. And down the line the hurt will be all the more harder. Not as bad as for buyers, but nothing to be envious of.
- Taxpayers? While some taxpayers are home owners and -buyers, it should be clear that Fannie and Freddie, once born from do-gooder (but grossly misconceived) ideas to put buying a home within reach of hard working families, have turned into a perverted vehicle to keep home prices high, while the risk that they will drop in the future is loaded off to everyone. Some of the losses of AIG and the main Wall Street banks could still conceivably be kept away from Joe Blow. Fannie and Freddie's losses cannot, and claiming they're private enterprises is just grandstanding. Note that Fannie and Freddie's loan portfolio's are $6 trillion, and that number does not include their securities issuance, which, looking at today's numbers, is an order of magnitude larger.
- Banks? Yes, that's why F&F do what they do, why they were established in the first place, and why they will become the most hated entities in the US economy. Once people figure out their own government has conspired to bleed them in favor of the banks, watch out. If the banks didn’t have Fannie and Freddie to sell their mortgage loans (re: the risk) to, how many houses do you think would be sold in the US today? Are you familiar with zero on the Kelvin scale?
Yes, let's see transparency. To get there, we need to, as I’ve suggested multiple time before, close down Fannie and Freddie, put the loans back on the lenders' balance sheets, and see what happens. Just for the fun of it. Now, that would be an experiment that deserves the name "stress test".
Short Sales: Banks Blocking Way Out Of Foreclosure Crisis
Brett Ellis, a real estate agent in Fort Myers, Fla., was thrilled when he got an offer for a property in Bell Tower Park in May 2008. "It was a gorgeous property on the corner lot," Ellis told the Huffington Post. The owner, who had lost his job, wanted to sell the apartment for a loss rather than go into foreclosure, a strategy known as a short sale. The offer was for $350,000, and Ellis, who is a certified distressed property expert trained in executing such sales, knew it was as good an offer as he was going to get in this market.
He immediately sent the paperwork into the bank. He waited for four months. The bank finally told him it wouldn't take anything less than $400,000 -- a price Ellis was sure he could never get. In September, the buyer's agent called to say, "You know what, we gotta move on, we gotta buy something else." Now the property is sitting vacant as it slides into foreclosure. Its former owner's credit is destroyed, and the house is losing value every day. "God knows what the condition is today," Ellis said, adding he'd be surprised if the property is worth more than $290,000 when it resurfaces on the market. Add in the legal expenses involved in a foreclosure, and the bank cost itself a hundred thousand dollars more that it otherwise would have.
It's a scenario that plays out constantly, everywhere in the United States. In a time of collapsing real estate values, where one in five homes are now under water, a short sale is increasingly the only option before foreclosure. It is less damaging to credit scores and spares the homeowner the shame of foreclosure. It is also a better option for banks: According to one analysis, short sales resulted in loan losses of only 19 percent, compared with an average loss of 40 percent on homes sold after foreclosure. So why aren't these sales more widely used? The broad answer is that the American financial system simply can't handle a collapse of this magnitude. The fates of the banking and real estate industries are intertwined. But they don't work together -- and the result is that they end up working against each other.
The more precise answer is related to securitization, the method by which banks bundle together different mortgages and slice them up and sell the pieces to various investors. Securitization makes negotiating a real estate sale that results in a loss nearly impossible. "The most significant aspect is that so many of the banks' mortgages have been securitized, put together and bundled, sold off to Iceland or China or some godforsaken place," said Dave Liniger, founder and chairman of global real estate company Re/Max, in an interview with the Huffington Post. "The bank has to go through all of the various people who are stakeholders and it becomes a very lengthy process, and the bank is turning off the realtors by not even getting answers back to them, sometimes for months."
Banks have little incentive to untie those bundles. Since mortgages are listed on the banks' balance sheets at the value of the original loan, if they complete a short sale they must record a loss on their balance sheets. That would explain why banks drag the process out as long as possible. In Ellis' case, the property is sitting vacant a year after the first offer, allowing the bank to list the original value on its balance sheet all along. According to research firm Campbell Communications, only 23 percent of short sale transactions are actually completed. "Three out of four potential short sale transactions fail, principally because the mortgage servicer takes too long to respond to the offer," said Tom Popik, author of a February survey of real estate agents. "When these same properties are later sold it further depresses real estate prices."
Congress has had as much success untangling this mess as real estate agents. "We've been trying to figure out probably for close to two years now why so few mortgages are being modified when it seems to make absolute business sense for the person holding the mortgage to modify rather than foreclose or to take a smaller loss selling it rather than a bigger loss foreclosing on it," said Rep. Brad Miller (D-N.C.). Miller points his finger at securitization. Once the mortgages are bundled and sliced up into different pieces, known as tranches, the owners of the pieces get paid back according to a certain pecking order. Senior investors get paid back first and if there's a loss, the most junior investors won't get anything. It's those investors who are blocking short sales.
"The people with the least senior tranches have no reason to agree to the modification because they take a complete loss and the people in the most senior tranches don't lose anything. So they've managed to structure their mortgages in a way that makes it almost impossible to modify or sell short," said Miller. Miller sponsored legislation to reform the bankruptcy code to allow judges to rewrite those contracts, taking away the ability of junior investors to sue and encouraging them to negotiate. But the House-approved measure died in the Senate, 51-45, killed last week by Republicans and 12 Democrats, leaving it 15 votes short of the 60 needed to overcome a filibuster. Dave Liniger of Re/Max said the provision would have changed the bargaining landscape.
Lenders would have had much more of an incentive to take a loss on a short sale rather than see a judge unilaterally change the terms of a mortgage. "It was a negotiating ploy more than anything," Liniger said. "It's disappointing," said Financial Services Committee chairman Barney Frank (D-Mass.) of the banks' tendency to foreclose rather than agree to a sale. "I've heard that and I've been trying to press the banks not to do that." Without bankruptcy reform, the only power the government has is persuasion. "In the absence of bankruptcy [legislation], you're talking about contracts that we cannot abrogate," he told the Huffington Post. "That's why bankruptcy was so important." Is there any chance Congress will return to it? "Excuse me, what planet were you on last week? The vote was 45 to 51. Why would you ask that? Do I think there's a likelihood we could overturn 45-51? No," said Frank. "I wish it weren't the case," he added. "Maybe there's some kind of compromise."
Sen. Dick Durbin (D-Ill.) isn't confident. "The purpose of the debate last week was to try to create some impetus for the banks to start renegotiating these mortgages in a positive way and the industry fought it," Durbin, who last week concluded banks "frankly own the place," told the Huffington Post. "I think many of the banks have not operated in good faith when it comes to this mortgage foreclosure issue." Homeowners are the big losers of the banks' battle against the bill. But real estate agents are now losing real money as commissions fall through, making them a potential lobbying counterweight to the banks. The National Association of Realtors wants the rules changed: "We are advocating measures that would help streamline the process when using FHA, Fannie or Freddie," said NAR spokeswoman Mary Trupo in a statement to the Huffington Post. "We are hoping that new process and regulations are put in place."
Fannie Mae just wrapped up a pilot program to test a process for streamlining short sales by partnering with local listing providers in Arizona and Florida to pre-approve 400 properties for short sales. The government-backed mortgage firm is still evaluating feedback from brokers, but overall the program was a success, and a new short sale initiative is in the works for this year. "Short sales are one of the tools to avoid foreclosure if all other workout options are exhausted. It's always in the best interest of the homeowner, the community, and the investor to avoid foreclosure," said Fannie Mae spokeswoman Amy Bonitatibus in a statement to the Huffington Post. Liniger says Re/Max recently trained 5,000 employees in short sales.
Lita Smith-Mines, a lawyer who specializes in real estate on Long Island, told the Huffington Post she and her colleagues often see short sales turn into foreclosures because the bank won't play along--even when losses are as small as $25,000 and the offer is as high as it will get. And much higher, in this market, than the bank will get from a foreclosure auction. The legal costs of foreclosure alone typically run to $50,000. "There's no common sense when it comes to lenders. They have their paperwork and if you don't slot perfectly in, they just say no," she said. "A lot was taken on the front end [during the housing boom], but they're not giving anything back on the back end," she said. Smith-Mines, though, said she isn't surprised. "If they actually cared about borrowers, we wouldn't be in this mess in the first place."
A Surge in Botanists
What's all the excitement about? Simple: the economy has stopped falling off a cliff and -- Glory Hallelujah! -- it's now merely rolling briskly downhill. (We couldn't resist cribbing that description from Société Générale's Albert Edwards.) No guarantee, mind you -- economies being notoriously quirky -- that on the way down, if it espies another nice-looking cliff, the blamed thing won't decide to take a leap off that one. You doubt that's reason enough for the stock market to go racing for the moon and, in just a couple of months, rack up a 37% gain? Come to think of it, you're right to be skeptical, and we feel sheepishly negligent. For not only are things getting worse more slowly, but equally as important in the remarkable revival of euphoria is that investors en masse, taking a leaf from Federal Reserve Chairman Ben Bernanke, have become budding botanists, able to espy green shoots of recovery in virtually every compost pile.
We're also a tad remiss in not mentioning that the dread stress tests, designed by the famed financial-testing firm of Bernanke, Geithner & Co. to determine how much of a pulse the nation's 19 largest banks still have, proved not to warrant much dread after all. Just by way of example, disclosure that Bank of America was in need of $34 billion in fresh capital promptly sent its shares soaring 17% on Wednesday. Who can blame shareholders for wistfully wondering how high the stock would have jumped had the bank needed $68 billion? Geithner, Bernanke & Co., nothing if not adept at the care and feeding of investors, sought to take any possible sting out of what they found as they combed through the murky balance sheets of the banking behemoths (the Environmental Protection Agency might have been a better choice, considering the toxic material involved). They did so by cunningly contrived leaks, designed more for reassurance than revelation, in the weeks leading up to D- (for disclosure) Day as to the likely results of their examinations. By last Thursday, when the "scores" on the stress tests were actually released, those leaks had become veritable geysers.
As Philippa Dunne and Doug Henwood, proprietors of the Liscio Report, shrewdly observe, the highly publicized exercise made it look as if Washington's aim was "to restore confidence in the financial system before restoring the financial system." And the stress test itself struck them as being "precooked, with just enough talk of raising fresh capital to be credible, but not so much as to induce fear." The presumed point of the two-month probe was to determine how the banks would hold up, were the economy to confound the expectations that the worst was over and, instead, suffer further declines. The "worst-case scenario," as the cliché goes, that the Fed crew was able to dream up was one in which the unemployment rate, already a hair under 9%, would rise to 10.3% next year, housing prices would fall another 22%, and the economy -- which has been shrinking at more than a 6% annual rate the past two quarters -- would contract at a 3.3% pace.
Undeniably, that represents something less than a heartening prospect. But to call it a worst-case possibility for the economy is a good deal less than a creditable postulate; rather, it bespeaks a surprising failure of imagination on the part of the same folks who've been able to spot plantlets of recovery in even the most unforgiving data. Should worse come to worse, those fearless (or feckless?) forecasters allow that the major banks could take a $599 billion hit. However, our financial guardians decided that it would be enough to dissipate any stress in banking by requiring the 10 big lenders that got less-than-passing grades to come up with a total of nearly $75 billion. That may sound like a lot of money -- because it is -- but to a populace that has become inured to seeing trillions tossed at the banks like confetti, it's not apt to cause a whole heck of a lot of angst.
While gratification at what the stress tests showed evoked widespread relief, touching on giddiness, not everyone was satisfied, much less elated. Ah well; there are always some chronic doubters in every crowd, we suppose. Just by way of example, Barry Ritholtz, chief of the eponymous Ritholtz Capital, seems more than a tad aghast at the idea that Messrs. Geithner and Bernanke, after duly weighing the results of their not-exactly-stressful tests, have concluded that banks will be fine in the future with 25-to-l leverage (Tier 1 capital equal to 4% of risk-weighted assets). And while 25-to-l leverage may have been appropriate for depository banks in the relatively sedate days before the Glass-Steagall Act was dismantled, it seems more than a little much to Barry in "today's toxic-asset-laden banks." As to the cause of the seemingly generous standard, he suggests it may have something to do with the Treasury's new role as "shareholder and cheerleader for bank profitability." That explains at least why Tim and Ben never leave home without their pom-poms.
And then there's Chris Whalen, who, via his Institutional Risk Analytics, keeps a gimlet eye on the banks -- big, small and in between. Institutional Risk Analytics sounds wonderfully authoritative, but it's a mouthful, so we'll content ourselves with referring to the service as IRA. By whatever name, we find it always worth perusing, not least for Chris's caustic take on the financial scene. As it happens, IRA performs its own stress tests on some 7,600 banks using the vital statistics compiled by the Federal Deposit Insurance Corp. and it has even fashioned a stress-test index. Its latest ratings of bank safety and soundness -- the handiwork of the outfit's Dennis Santiago -- tell a much less comforting tale than does the Washington version. More specifically, IRA's bank-stress index, which stood at 1.8 at the end of the final quarter of '08, shot up to 5.57 in the first quarter of this year (the benchmark year, 1995, equals 1). Behind this sharp increase in stress is the startling number of the nation's banks -- 1,575 -- that wound up in the red in the first quarter.
In a follow-up report, Chris comments that it's "pretty clear that the condition of the U.S. banking industry is continuing to deteriorate, and we are still several quarters away from the peak in realized losses for most banks." Indeed, he adds, "We're not even on the right block to make the turn." And, not surprisingly, he feels strongly that this isn't the time for investors to go ga-ga over financials. In case you're wondering, there's no evidence that he's color-blind and just can't see all those green shoots littering the financial landscape.
Perhaps the most eloquent expression of how delusional Wall Street has become was its response to Friday's report on what happened to employment -- or, more importantly, unemployment -- in April. Payrolls shriveled by 539,000, less than the 550,000 to 600,000 guesstimates of the seers as well as March's initial tally of 633,000. That was enough for the choristers to start humming Happy Days Are Here Again. A slightly more careful look suggests rather emphatically that they're not. The unemployment rate extended its doleful rise, hitting 8.9%, the highest level since 1983. The jobless ranks have swollen by 5.7 million since the recession got underway in December 2007, and there are now 13.7 million people out of work.
Moreover, our favorite measure of unemployment -- favorite because we think it a truer gauge -- is the Bureau of Labor Statistics' U-6, which includes the likes of workers laboring part-time because they can't land full-time jobs, rose to a fresh peak of 15.8%. That means 24.7 million people are effectively unemployed. It's a figure that doesn't get too much notice -- maybe it's just too depressing -- but it should. For that matter, bad as it is, 539,000 doesn't do justice to the severity of the payroll shrinkage. For one thing, it was puffed up by the 72,000 federal census takers signed on by Uncle Sam. And for another, it includes 226,000 supposed jobs, or 60,000 properly adjusted, courtesy of what David Rosenberg calls the Alice-in-Wonderland birth/death model. Ex this pair of extraordinary items, he points out, the headline number would approach 670,000.
In one of his valedictory scribblings (David's leaving Merrill Lynch and returning to the glories of his native Canada and money management), he also notes that private-sector employment sank by 611,000 in April, and did so across a wide swath. "The data," he contends, "just don't square with the conventional wisdom permeating the investment landscape." Take the notion that we're enjoying a commodities boom; If so, it seems more than passing strange that natural resources shed 11,000 jobs last month. Or, how do you reconcile the burst of enthusiasm for leisure/hospitality stocks with 44,000 busboys, bell captains and bartenders being laid off? Or retailers' giving pink slips to 47,000 workers -- atop the 167,000 slots they let go in the first quarter -- if they thought anything more than the timing of Easter underpinned their April results?
Looking ahead, David scoffs at the idea that the "jobs data are about to get better because the markets have enjoyed a nice two-month rally." Among the reasons he's skeptical: the still record-low workweek, at 33.2 hours; the 66,000 downward revision to the back data (which, he avers, tends to feed on itself); the 63,000 slide in temp-agency employment; and the high levels of both initial and continuing jobless claims. All of which, he believes, foreshadow a further 550,000 payroll plunge when the May data roll out early next month. To David, as to us, the present buoyant mood on the Street is obviously more the result of rose-colored glasses than of green shoots.
Improving markets helped banks pass stress test
U.S. bank regulators breathed a huge sigh of relief in early April when improving financial markets looked set to push the nation's 19 largest banks through the gauntlet of tough "stress tests" in reasonably good shape. In early March, a month after Treasury Secretary Timothy Geithner announced the tests on February 10 to help restore investor confidence in the major banks, the scene was much bleaker: major stock indexes had slumped to 12-year lows on persistent fears about the financial weakness. It looked possible that a major bank might need an emergency government rescue even before the stress test results could be announced.
But since the trough, markets improved steadily with rising share prices and volumes, better liquidity and other signs of stabilization, and regulators gained comfort that capital markets would be willing to fill any holes the stress tests unearthed at banks. "It looked to us by mid-March, and early April, that this might work," said a senior U.S. regulatory official, who spoke on condition of anonymity because of the sensitivity of the tests. Stress tests released on Thursday showed the largest banks had a $74.6 billion gap to make up to ensure they could withstand a worst-case scenario regulators set for them. Nine of the 19 banks tested already had the necessary buffer and would not need to raise any more.
Morgan Stanley and Wells Fargo sold more than $15 billion of shares and bonds the next day, and Bank of America Corp announced plans to sell 1.25 billion shares as investors reacted positively to the relatively small size of the shortfall. If by the middle of next week banks are half-way to raising the needed capital, and a half dozen or so of the banks needing to augment their buffers have done so, regulators would be pleased, the official said. In particular, such a development would likely signal the administration would not have to ask Congress to replenish its bailout war chest.
The stress test idea germinated in early September as officials at the Federal Reserve and the New York Fed, including Geithner who was then president of the New York Fed, took part in conference calls to discuss deteriorating financial markets. But the crisis intensified with the collapse of Lehman Brothers and the Fed rescue of American International Group, and the stress test idea was put on the backburner. By the time the administration of President Barack Obama took office, however, there was breathing room to try the idea. Regulators at the Fed, the Office of the Comptroller of the Currency and the Federal Deposit Insurance Corp teamed with researchers and statisticians to design a model that would test the 19 banks at once according to the same standards, and then make the results public, an unprecedented undertaking.
As regulators refined the model, they ironed out bugs in the test and settled disputes among officials at different regulatory agencies including at regional Fed banks. Disagreements included whether a particular bank's assets were of higher quality than average and what bank earnings were likely to be over the next two years, particularly if a bank had acquired a troubled asset, such as another financial institution that was in trouble. Regulators shared the all-but-final version of the tests with all 19 banks on April 24 at the regional Feds that govern the districts in which the banks are headquartered. Regional Fed bank presidents participated in most sessions, but Fed board officials did not.
Early market reaction this week showed the announcement of the stress test results, which some had feared would destabilize vulnerable banks by exposing weaknesses, had stoked enthusiasm. U.S. stocks rose on Friday, led by financial shares. The release of the stress test results "has given people a little bit of confidence that the government can help to solve this part of the financial crisis," said Richard Sparks, senior equities analyst and options trader at Schaeffer's Investment Research in Cincinnati. "There's a sense that the government actually has a logical plan ... even if things got worse, these companies will be able to survive," Sparks said.
Banks Won Concessions on Tests
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. The overall reaction to the stress tests, announced Thursday, has been generally positive. But the haggling between the government and the banks shows the sometimes-tense nature of the negotiations that occurred before the final results were made public. Government officials defended their handling of the stress tests, saying they were responsive to industry feedback while maintaining the tests' rigor.
When the Fed last month informed banks of its preliminary stress-test findings, executives at corporations including Bank of America Corp., Citigroup Inc. and Wells Fargo & Co. were furious with what they viewed as the Fed's exaggerated capital holes. A senior executive at one bank fumed that the Fed's initial estimate was "mind-numbingly" large. Bank of America was "shocked" when it saw its initial figure, which was more than $50 billion, according to a person familiar with the negotiations. At least half of the banks pushed back, according to people with direct knowledge of the process. Some argued the Fed was underestimating the banks' ability to cover anticipated losses with revenue growth and aggressive cost-cutting. Others urged regulators to give them more credit for pending transactions that would thicken their capital cushions.
At times, frustrations boiled over. Negotiations with Wells Fargo, where Chairman Richard Kovacevich had publicly derided the stress tests as "asinine," were particularly heated, according to people familiar with the matter. Government officials worried San Francisco-based Wells might file a lawsuit contesting the Fed's findings. The Fed ultimately accepted some of the banks' pleas, but rejected others. Shortly before the test results were unveiled Thursday, the capital shortfalls at some banks shrank, in some cases dramatically, according to people familiar with the matter. Bank of America's final gap was $33.9 billion, down from an earlier estimate of more than $50 billion, according to a person familiar with the negotiations. A Bank of America spokesman wouldn't comment on how much the previous gap was reduced, though he said it resulted from an adjustment for first-quarter results and errors made by regulators in their analysis. "It wasn't lobbying," he said.
Wells Fargo's capital hole shrank to $13.7 billion, according to people familiar with the matter. Before adjusting for first-quarter results and other factors, the figure was $17.3 billion, according to a federal document. "In the end we agreed with the number. We didn't necessarily like the number," said Wells Fargo Chief Financial Officer Howard Atkins. He said the company was particularly unhappy with the Fed's assumptions about Wells Fargo's revenue outlook. At Fifth Third Bancorp, the Fed was preparing to tell the Cincinnati-based bank to find $2.6 billion in capital, but the final tally dropped to $1.1 billion. Fifth Third said the decline stemmed in part from regulators giving it credit for selling a part of a business line.
itigroup's capital shortfall was initially pegged at roughly $35 billion, according to people familiar with the matter. The ultimate number was $5.5 billion. Executives persuaded the Fed to include the future capital-boosting impacts of pending transactions. SunTrust Banks Inc. also persuaded the Fed to significantly reduce the size of its estimated capital gap to $2.2 billion, after identifying mathematical errors in the Fed's earlier calculations, according to a person familiar with the matter. PNC Financial Services Group Inc., saw a capital hole materialize at the last minute. As recently as Wednesday, PNC executives were under the impression they wouldn't need to find any new capital, according to people familiar with the matter. Thursday morning, the Fed informed PNC that it had a $600 million shortfall. Regulators said other banks also were told they needed more capital than initially projected.
The Fed's findings were less severe than some experts had been bracing for. A weeklong rally in bank stocks continued Friday, with the KBW Bank Stocks index surging 10%. Investors were especially relieved by the relatively small capital holes at regional banks. Shares of Fifth Third soared 59%, while Regions Financial Corp.'s $2.5 billion deficit led to a 25% leap in its stock. With the stress tests, government officials were walking a fine line. If the regulators were too tough on banks, they risked angering their constituents and spooking markets. But if they were too soft, the tests could have lost credibility, defeating their basic confidence-building purpose. All the back-and-forth is typical of the way regulators traditionally wrap up their examinations of banks:
Regulators often present preliminary findings to lenders and then give them time to respond. The process can result in changes to the regulators' initial conclusions. Some of the stress-test revisions, for instance, were made to account for the beneficial impact of the industry's strong first-quarter profits. On Friday, some analysts questioned the yardstick, known as Tier 1 common capital, that regulators chose to assess capital levels. Many experts had assumed the Fed would use a better-known metric called tangible common equity. According to Gerard Cassidy, an analyst with RBC Capital Markets, the 19 banks' cumulative shortfall would have been more than $68 billion deeper if the government had used the latter metric, which accounts for unrealized losses. Federal officials said their projections reflected the most comprehensive analysis ever conducted of the industry.
The test results showed that the 19 banks faced a total of $599 billion in losses over the next two years under the government's worst-case, Depression-like scenario. The Fed directed 10 banks to add a total of nearly $75 billion to their capital buffers to insulate themselves from potential losses. Banks pressed ahead on Friday with plans to fill their capital holes by tapping public markets. Wells Fargo raised $7.5 billion in stock through a public offering. The bank originally planned to raise $6 billion, but expanded the offering, which was valued at $22 a share, due to robust demand. Shares of Wells Fargo rallied $3.42, or 14% to $28.18. Morgan Stanley, which is facing a $1.8 billion capital hole, raised $4 billion by selling stock. Shares of Morgan rose $1.06, or 4%, to $28.20.
Five Reasons The Bank Stress Tests Are Unreliable
A simple guide to why the stress tests weren't stressful enough:
- The stress test allows for a debt-to-net capital ratio of 25 to 1. That is far higher than the 12 to 1 ratio that the SEC required of banks before a fateful decision in 2004 to allow the five largest investment banks to increase those ratios. That decision helped lead to their decision to take on more leverage, including making large bets in subprime mortgage bonds, spurring the current financial crisis.
- The 8.5% loss rate for commercial real estate portfolios is likely too generous. Default rates have quintupled since the beginning of 2008 and experts say it is just the beginning of that market's collapse.
- The earnings we saw in the first quarter will be tough to repeat. Several of the banks benefited from one-time events, and the industry is also benefiting from cheap money from the Fed.
- According to the Wall Street Journal, skepticism is also in order because the government is allowing some banks to simply shift more of their capital to common equity, rather than raise new money. This is despite the fact Wall Street has shunned bank stocks for most of this year, with banks like Citigroup, for example, seeing its shares drop under $1. "The government is effectively saying most large banks were solidly capitalized even when investors fled earlier this year," the WSJ reported.
- The government is relying on the banks to determine their risk-weighted assets, which we are going to have to take at face value. This measurement can also leave out unrealized losses on some securities, which the banks could be forced to mark down in the future.
US banks claim line softened on $74 billion
US banks have been given government assurances they will be allowed to raise less than the $74.6bn in equity mandated by stress tests if earnings over the next six months outstrip regulators’ forecasts, bankers said. The agreement, which was not mentioned when the government revealed the results on Thursday, means some banks may not have to raise as much equity through share issues and asset sales as the market is expecting. It could also increase the incentive for banks to book profits in the next two quarters. The banks have 28 days to announce their capital-raising plans and until November 9 to implement them. Wells Fargo and other banks that will have to raise capital told the Financial Times that if operating profits were greater than the government’s stress-case forecast for the second and third quarter, they would receive credit for the difference.
That, in turn, would reduce the need to raise fresh equity from other sources. A Federal Reserve official said the 10 banks that need a combined $74.6bn in equity would be expected not to assume that their earnings would be higher than in the stress test when presenting their capital-raising plans. However, the official declined to comment on whether banks could take credit for such earnings as they materialised and adjust their capital-raising plans accordingly by November. During the tests, policymakers made adjustments after first-quarter operating revenues were stronger than forecast, reducing demands for equity by nearly $20bn compared with original estimates based on data for the end of 2008. Morgan Stanley and Wells on Friday moved to plug their equity needs, raising $11.5bn as investors returned to the battered financial sector. Analysts said the test results held few surprises and persuaded many investors to return to the sector. The S&P 500 rose 2.4 per cent to 929.23. Morgan Stanley and Wells also gained, even after pricing their equity issues at discounts of more than 10 per cent to Thursday’s close.
Morgan Stanley, which has to add $1.8bn in equity, sold $4bn in equity – doubling the amount it had planned to offer in response to strong investor demand. The bank also raised $4bn in non-government-backed debt. Wells Fargo, which needs to fill a $13.7bn capital shortfall, raised $7.5bn in equity, up from a planned $6bn. Washington has emphasised the need to wean banks off government aid by re-opening capital markets. By providing details on asset quality and future losses from the stress tests, regulators hoped to dispel uncertainty about the sector. However, analysts cautioned that some of the 10 banks requiring capital, such as GMAC , General Motors’ finance arm, would find it difficult to sell equity and could end up with a large government stake. Tim Geithner, Treasury secretary, told Reuters the administration would provide "substantial support" to GMAC.
Regulators Fight Banker Envy, Stockholm Syndrome
Everyone over the age of 45 remembers the photo of heiress Patty Hearst wielding an M1 Carbine when she and three comrades robbed the Hibernia Bank in San Francisco on April 15, 1974. Hearst had been kidnapped by the Symbionese Liberation Army, a left-wing guerilla group, two months earlier. By the time her photo was captured by Hibernia’s internal security camera and beamed across the world, Hearst had adopted a new name (Tania) and a new mission (the SLA’s). Diagnosis (and legal defense): Hearst was suffering from what psychologists call Stockholm Syndrome, a phenomenon where captives identify with their captors in order to survive.
Diplomats have been known to manifest the symptoms of Stockholm Syndrome: They "go native" when they’re posted to a foreign country for a long time. Regulators don’t have diplomatic immunity either. "Regulatory agencies come to identify themselves with the industry they’re regulating," says Neal Soss, chief economist at Credit Suisse in New York. "There’s a bit of promotional flavor to it." Promotion is one thing. Regulators understandably want their industry to be competitive internationally. When Japan was home to the largest banks in the world in the 1980s, regulators in the U.S. and Europe lowered capital standards so their banks could compete, says Robert Eisenbeis, chief monetary economist at Cumberland Advisors and former research director at the Federal Reserve Bank of Atlanta. "Sometimes it looks a lot like regulatory capture when regulators are just looking out for the interests of their constituents," he says.
Sometimes, not always. A clear case of a regulatory capture was the relationship between the now-defunct Federal Savings and Loan Insurance Co. and the S&L industry, according to Eisenbeis. The FSLIC, which provided deposit insurance to thrifts, "was charged with promoting the S&L industry and homeownership," Eisenbeis says. "It was guaranteed they’d be captured." Then there’s the case of Fannie Mae and Freddie Mac, the two housing finance agencies that were captured -- even before they were seized by the federal government last September to avert collapse. Fannie and Freddie "used their clout to enforce capture, to escape regulation," Eisenbeis says. They took advantage of a weak regulator and powerful allies on Capitol Hill to "raise regulatory capture to a new level," he says.
How did we get into a mess requiring massive government intervention and investment in the banking industry if regulators were doing their job? Late yesterday, the government released the results of stress tests on the 19 biggest banks following several delays, a week of previews and repeated assurances from Treasury Secretary Tim Geithner that the outcome would be "reassuring." The Obama Administration’s soft rollout of the test results defused the negative news, starting with Bank of America’s failing grade (pupil needs $34 billion of additional capital). Nine of the 19 banks have enough capital to withstand the most adverse scenario, according to the government’s report. Ten banks need to raise a combined $74.6 billion of capital.
Last week, there were concerns the tests might be compromised when it was learned regulators were briefing the banks on the results and giving the banks an opportunity to respond. What kind of test is subject to the test-taker’s review? Did the banks succeed in "helping" regulators see the results in a more flattering light? "I don’t think regulatory capture infected the stress tests," says economist Bob Litan, vice president for research and policy at the Kauffman Foundation in Kansas City and a senior fellow at Washington’s Brookings Institution. "The Fed people are very professional, and the taxpayers are on the hook." Rather, the sorry state of the banking industry that prompted the government to run stress tests -- something regulators do all the time -- is the result of "a massive collective regulatory failure," Litan says.
What a relief to know regulators weren’t shielding their charges from public scrutiny. They were just "negligent and incompetent," says Bert Ely, chief executive of Ely & Co., a bank consulting firm in Alexandria, Virginia. How did it happen that a handful of regulatory agencies and a gaggle of regulators on the premises of the big banks failed to identify the degree of risk? Bank regulators aren’t bad people. They don’t decide to close their eyes and look the other way while their charges cook the books. The regulatory capture may be entirely unconscious. Imagine a regulator from the Office of the Comptroller of the Currency posted to JPMorgan Chase & Co. He goes to work each day and observes bankers wearing expensive Italian suits and English shoes pulling down 30 times his salary. (OK, they used to.) Our regulator starts to think, gee, I can do his job. Maybe they’ll hire me.
There’s something besides "banker envy" that allowed losses to balloon, Litan says. "Basel told regulators to outsource risk judgment to the rating agencies and to the bankers themselves," he says, referring to the international capital adequacy requirements for industrialized nations developed at the Bank for International Settlements in Basel, Switzerland. Just think about the inherent conflicts. Rating agencies were paid by the issuers of the securities, not their investors. That was the first line of defense against risk. Check. Bankers that took the risk with other people’s money were charged with assessing that risk. That was the second line of defense. Check. Bankers used intricate equations and models to come up with their risk assessment. The model is only as good as the assumptions that go into it. Check mate.
Then there were 33: Regulators seize, sell Westsound Bank
State and federal regulators have seized Westsound Bank and sold its deposits to Kitsap Bank, the state Department of Financial Institutions announced Friday. The Bremerton-based bank operated nine branches, mostly on the Olympic Peninsula. It was the nation’s 33rd institution insured by the Federal Deposit Insurance Corp. to fail this year, and the second bank to fail in Washington state. “This unfortunate event is the result of very poor lending practices during the past several years,” said Brad Williamson, bank director for the Department of Financial Institutions, in a prepared statement. “While the current management team worked diligently to overcome problems with the bank’s portfolio, a combination of the downturn in the local real estate market and the overall economic situation combined to make it impossible for the institution to continue.”
The regulatory intervention followed numerous warning signs that Westsound was struggling. The bank’s parent company, WSB Financial Group disclosed “substantial doubt” about its ability to continue operating in a regulatory filing last month. The bank was hard hit by losses on construction loans. Bad loans at the bank totaled $131.8 million at the end of December. As of March 31, Westsound had $334.6 million in total assets and $304.5 million in total deposits, the FDIC said. State regulators seized the bank Friday and put it into receivership under the FDIC. The FDIC then reached an agreement with Kitsap Bank to assume most of Westsound’s deposits. Kitsap Bank will also buy $49.3 million worth of cash, cash equivalents, marketable securities and loans secured by deposits, according to the FDIC. The deal with Kitsap Bank excluded $9.4 million in brokered deposits at Westsound, regulators said. The FDIC said it will pay brokers directly.
Shutting down Westsound is expected to cost the federal Deposit Insurance Fund about $108 million. Westsound’s branches were located in Clallam, Kitsap, Jefferson and Pierce counties, along with a branch bank in Federal Way. Terry Peterson, Westsound’s president and chief executive, was hired in April 2008, just before DFI and the FDIC issued a joint cease-and-desist order against the bank for lack of safety and soundness. At the time, Peterson said he was working toward making Westsound viable. Kitsap Bank, based in Port Orchard, operates 26 offices and branches on the Olympic Peninsula and in Pierce County.
The Real Memo Out Of The Bureau Of Lies And Statistics
"We're leveling off! We're leveling off!"—so is the hope of TTT, Helicopter Ben, Larry the Wall Street Lackey and the rest of Team Obama. "This recession is leveling off!" No it's not: The unemployment figures just released by the Bureau of Labor Statistics are totally cosmetic: We lost a whole lot more than 531,000 unemployed. First, the "seasonal adjustment", which is a black box that can tweek me into looking like Dumbo the flying elephant. They're knocking off ±65,000 workers for no clearly discernible reason. Second, notice that the Census Bureau hired 60,000 people last month. Those workers (by definition) are temporary, and are a net cost to the economy, as they will not be adding marginal utility to any economic sector, the census being merely a social expenditure.
Those two items alone turn 530,000 new unemployed into 655,000. Now notice how, once again, previous months' figures have been readjusted. This time, the readjustments weren't so bad—a mere 30,000 more unemployed in February, turning that month's official totals to 681,000, and another 30,000 for March, making that month's official number 699,000, just shy of that magic 700,000 monthly number (BTW, remember back in the good old days when 300,000 monthly unemployed was"shocking"?)
But notice too: When those more realistic numbers were released, the markets were more or less copacetic—at least they weren't nervously contemplating another suicidal round of cliff-diving, as we currently are. Ever since the October '08 release of Sept. '08 unemployment, when arguably the BLS numbers had a role in triggering the sell-off of that very nasty month, the unemployment numbers have been generally rosy whenever there's been general nervousness in the markets around the time of the number's release. I know this sounds crazy-man paranoid, but bear with me: Every time the markets have been nervous,the BLS numbers look pretty good, or at least not that bad, relatively speaking—and then the next month the figures are very quietly revised, sometimes by as much as 35% on the upward side.
I will bet one double Quarter Pounder with cheese and bacon that next month, the revisions of the April numbers will be on the order of an additional 85,000 unemployed. My guess is that, discounting the Census Bureau hirings, April saw 680,000 newly unemployed workers. That would mean that unemployment isn't accelerating—but it's still growing fast enough to scare the hell out of anyone sane. And anyway, what industry or sector of the economy will be able to absorb all of those unemployed workers in the near-term future? Now wait for May and especially June numbers, when 2 million new college grads can't find steady work. This baby ain't over yet.
Three Items Missed on the April Jobs Numbers
In the worst downturn since the Great Depression, losing just 539,000 jobs in a month may seem like good news, but there is less cause for optimism than most reporters recognized. First, most reports did note the one-time event of 62,000 people being hired for the 2010 Census. The Census will be employing part-time workers for much of the next year, but this hiring will not be repeated (or at least not at this rate) in future months. So, the net of Census job loss was 601,000. This is still an improvement over the 680,000 average job loss for the prior five months.
However, this comparison ignores the fact that we are comparing revised data from the prior five months with unrevised data for April. The revisions for the last five months have all been negative in a big way, adding an average of 86,000 to reported job loss. We don't know whether the revisions will be that large again in April, or even that they will be negative, but a word of caution is certainly in order.
Second, It is worth noting that the number of jobs imputed for new firms not included in the Labor Department's survey continues to outpace the number for 2008. There were 226,000 jobs imputed for new firms in April of 2009 compared with just 176,000 for April of 2008. Given the health of the economy in 2009 compared with 2008, this seems unlikely. Third, wage growth appears to have collapsed with the average hourly wage reportedly increasing by less than 0.1 percent in the April data. This is consistent with a sharp slowing of the rate of wage growth reported in the Employment Cost Index for the first quarter.
This is very disturbing. Wage growth had been holding up earlier in the downturn, which meant that workers (at least those who still had jobs) were seeing increased purchasing power and were therefore able to sustain their consumption. It now seems that weakness in the labor market has brought wage growth to a halt. This is likely to further reduce consumption and demand more generally. In short, while we can always say that this report could have been worse, there was not much to celebrate here.
Goldman Sachs Shareholders Rebuff Firm’s Board for First Time
Goldman Sachs Group Inc. shareholders rebuffed the board of directors for the first time since the firm went public in 1999, voting to back a proposal that would let a simple majority enact changes at the company. "It’s really an arm-wrestle between the board and shareholders in terms of who will have a say," said Eleanor Bloxham, president of the Corporate Governance Alliance in Columbus, Ohio. The vote is "a major signal from shareholders in terms of their involvement," she said. Goldman Sachs, based in New York, requires a vote of 80 percent of outstanding shares to take action such as removing a director or amending by-laws. It had argued that the rule protected minority investors from "coercive" tactics, including a potential change in control of the firm.
Lloyd Blankfein, Goldman Sachs’s chairman and chief executive officer, faced more than an hour of questioning from shareholders at the company’s annual meeting yesterday after the stock dropped 61 percent last year and the company took $10 billion of U.S. bailout funds. Goldman Sachs was the most- profitable and highest-paying securities firm before converting to a bank last year amid the worst financial crisis since the Great Depression. Goldman Sachs lags behind some competitors in adopting simple majority voting. Morgan Stanley, which was the second- biggest U.S. securities firm after Goldman Sachs until both converted to banks last year, proposed an end to the so-called supermajority requirement at last year’s annual meeting. The proposal by California-based investor James McRitchie won support from 75 percent of shares voted and 54.7 percent of outstanding shares, said Greg Palm, co-general counsel at Goldman Sachs.
It will require an amendment to the company’s charter that will need investor approval at next year’s shareholder meeting, said spokesman Lucas van Praag. It was the first time shareholders rejected a board proposal since Goldman Sachs went public a decade ago, he said. If it’s approved in 2010, Goldman Sachs, the fifth-biggest U.S. bank by assets, will have to eliminate any requirements in which more than a majority vote of shareholders is required to take action. Two proxy advisory firms, RiskMetrics Group and Glass Lewis & Co., advised shareholders to support the proposal. The Council of Institutional Investors, a trade group that represents pension funds with combined assets exceeding $3 trillion, also considers simple majority voting among "best practices." "The majority vote standard resonates with many shareholders right now," said Amy Borrus, the deputy director of the Council of Institutional Investors. "Investors want to be empowered to influence the board that is supposed to represent their interests."
All 12 of the Goldman Sachs’s board members won re-election at the meeting and three other shareholder proposals were rejected, the firm said. Shareholders also voted in favor of the company’s executive compensation for 2008 in a non-binding advisory vote that was a requirement because the company received $10 billion from the U.S. Treasury’s Troubled Asset Relief Program last year. A shareholder effort to get such a "say on pay" vote included on the proxy last year was opposed by the board and failed to win a majority of votes. "It’s virtually inevitable that Congress is going to mandate this" say on pay requirement in the future, Timothy Smith, a senior vice president at Walden Asset Management in Boston, said at the meeting. "We are appealing today that the board exercise leadership and adopt it as your own policy."
Shadow-Banking System Next Up for De-Stressing
For better or worse, stress tests of the 19 largest U.S. banks are done. Investors and the government feel they have a better handle on banks’ financial health and can move on. That gives officials room to address another pressing task on the financial crisis to-do list: Fixing the so-called shadow banking system, or non-bank lending markets. At the heart of this market is securitization, which in recent years provided about 25 percent of the funding for consumer loans and 50 percent for mortgages. Securitization is a process in which banks or other firms package loans into securities. The securities are sold to investors, giving lenders money to make new loans. While helping to increase credit, the process fueled the financial crisis by passing dodgy assets from banks and others to investors.
Although industry groups have been trying to bring this market back to life, those efforts aren’t enough. The government has to get involved, setting rules that restore confidence among investors and possibly even helping to create a more-formal market structure, perhaps along the lines of a stock exchange. Unless that happens, securitization will continue to rely on government backstops. Yet the economy needs this process to function again on its own. To get an idea of how much lending capacity is at stake, consider that between 2005 and 2007 more than $8 trillion in securitized products were issued globally. With securitization markets paralyzed since August 2007, banks have to pick up the slack. Any expansion in lending requires more capital, though, putting pressure on banks.
Securitization started in the 1970s and initially was used in mortgage markets. By moving loans off their balance sheets, or securitizing them, banks were able to lend more. The process created securities that were supposed to be less risky because they were based on a large pool of debts. A few loans might go bad, but not thousands or tens of thousands. They were also sliced and diced to offer investors varying levels of return and risk. For years, the process worked fairly well, helping to lower borrowing costs for homeowners and consumers. The process went off the rails earlier this decade as shoddy lending practices, inadequate disclosure, a lack of monitoring and flawed ratings allowed banks and others to unload increasingly toxic debts through securitization.
At the same time, the securities being sold became mind- numbingly complex. Collateralized debt obligations, which were pools of securities that themselves packaged thousands of loans, were the epitome of the problem. When the housing bubble popped, investors realized they didn’t understand what they owned. That caused them to refuse to buy any packaged loans that weren’t backed by the government or mortgage giants Fannie Mae and Freddie Mac. So what can be done? For starters, the government, not just industry, needs to get involved. "Given the profound breakdown in the market, I’m not convinced that an industry-run solution will work," said Rod Dubitsky, director of asset-backed research at Credit Suisse Group.
Next, the government needs to insure that investors can get a real sense of what it is they are buying. That means making the system more transparent. Proposals on this front are wide-ranging. Richard Field, founder of financial consulting firm TYI LLC, advocates real- time disclosure of the performance of debts underpinning securitized products. Without this, he says, investors are given a brown paper bag and told there is a $100 bill inside, yet aren’t allowed to look inside to see if this is true. Some worry daily disclosure would result in information overload, though there is broad agreement that investors require more standardized information about key elements of securitized loans, as well as a clearer picture of actions taken by those who service the debts.
Investors also need to know that someone is monitoring this information flow and gauging its reliability. In the past, there was no policing of the system, no enforcement mechanism, Dubistky said. Changing that might require some sort of audit function, or an independent clearing house for information provided by banks. In addition, the government would have to mandate that institutions provide information. "This market needs a stick, it doesn’t need a carrot," said Ann Rutledge, a principal at R&R Consulting, which specializes in structured finance. Securitization markets also need structure, perhaps an exchange-like setting, to provide the sort of standardization and rules that help trading of stocks and options.
None of this will make enough of a difference, though, if investors don’t feel that they can once again trust ratings companies. That makes a revamp of the way the raters operate -- a question under debate by legislators -- a top priority. Yet any change has to go beyond the question of who pays rating companies’ fees, R&R’s Rutledge added. Ratings for securitized products should be dynamic, changing as more information is gathered about the performance of underlying loans, she said. Finally, it may be necessary to see that folks who create securitized products have some skin in the game. Already, some regulators and international organizations are proposing that banks hold on to a chunk of whatever they sell to investors. With such changes, and government guidance, investor trust just might return.
Muni Bonds Need Better Oversight
As our nation's leaders rush to rewrite our financial regulatory structure, they risk committing a major error if they don't carefully consider the workings of the municipal- bond market. The opacity of this market is unrivaled and thus presents a significant threat to our economy. Defenders of the status quo argue that the risk of large-scale municipal- bond defaults remains low, and that the market has not had an "Enron moment." In fact, we have had a major municipal bond-related debacle at least every decade: the New York City fiscal crisis in 1975, the Washington Public Power System defaults in 1980, the Orange County California derivatives crisis in 1994, and the San Diego pension fund fraud in 2006. Just last year, New York Attorney General Andrew Cuomo imposed fines and penalties on bankers who told investors that risky securities were safe investments. Throughout every decade we have had pay-to-play scandals.
We need major reform, beginning with industry-wide oversight. For the past three decades, the Municipal Securities Rulemaking Board has overseen only one slice of the market: the bankers and others who sell municipal bonds. There is no central regulator over municipal issuers other than the Internal Revenue Service, which limits itself to a narrow band of concerns. No regulator holds all market participants accountable. The Securities and Exchange Commission (SEC) is prevented from regulating the municipal market because of restrictions established by Congress, including a 34-year-old relic called the Tower Amendment. We need a cop on the municipal-market beat with the tools to do the job right.
Reform should require that municipal-bond issuers follow effective and consistent accounting standards issued by an independent board backed by SEC jurisdiction and enforcement. All relevant disclosure requirements that apply to the corporate bond market should also apply to the municipal market. A review of disclosure rules would also include a review of whether ratings agencies actually bring rigor, transparency and uniformity to the process of assigning ratings to municipal securities. Currently, the Governmental Accounting Standards Board issues accounting guidelines, but the board isn't independently funded and doesn't have the power to enforce its own standards.
There should also be a "plain English" standard on disclosures and other documents so investors and issuers understand their risks and responsibilities. Those documents should be distributed on a system at least as fast and searchable as the SEC's EDGAR database, and should be updated when any material information arises. Failure to file disclosure documents on time should carry a meaningful penalty to issuers, many of whom now routinely fail to file on time or at all. And though it would be unpopular with elected officials, the chief executive officer and chief financial officers of public-sector entities -- including mayors, county chairs and governors -- should personally certify the accuracy of the information in offering documents and subsequent disclosures. Likewise, CFOs of issuers should certify they have done a thorough and independent analysis of their proposed transactions and not just defer to the views of underwriters, ratings agencies and other intermediaries who are usually conflicted.
Conflicts in the municipal market often arise from pay-to-play practices that are widespread. As SEC chairman in the 1990s, I routinely called for an end to pay-to-play. Half-measures were taken and underwriters are now subject to SEC rules. But the lawyers, advisers and asset managers who routinely interact with issuers continue to win municipal-bond business by employing politicians' friends, donating to bond campaigns, contributing to charities, or picking up the check for entertainment. Banning such payments is a good start. Simply requiring that all lawyers, advisers and underwriters disclose all payments received from working on bond transactions -- as well as their political and charitable contributions -- would go a long way.
We need stronger accountability standards throughout the industry. All unregulated advisers should be regulated and licensed, and all professional participants in the bond market should be held accountable to the SEC. Advisers in particular should have a conflict-free duty of trust and care to the borrower. Issuers should require written certification from underwriters and financial advisers that the recommendations and information they present are accurate, reliable and consistent with high financial principles -- not just "market conventions," which merely institutionalize the status quo. The magnitude of risks should be calculated and fully disclosed. Finally, Congress should repeal the Tower Amendment and earlier exemptions so that the SEC can regulate the market the way it regulates other markets. Roughly a third of those buying municipal bonds are small investors: They need the SEC's full protection.
Arthur Levitt Jr. was chairman of the Securities and Exchange Commission from 1993 to 2001
Are AIG FP Employees Using Bailout Cash To Get Jobs Elsewhere? Looks Like It, Says AIG Source
Remember the rumors that AIG Financial Products had "thrown in the towel," handing over massive portfolios of derivatives to the trading desks of major investment banks to unwind in a process that gave the beleaguered banking sector a profitable first quarter? We first heard them back in March from the blog Zero Hedge. Then, sure enough, the banks began reporting first quarter earnings that for the most part beat expectations -- all thanks to record and near-record revenues for their trading operations. Then the fixed income chief at the hedge fund BlackRock essentially confirmed the story to Bloomberg Radio in a wry interview we partially transcribed.
And now we've heard from an anonymous executive at AIG who is "familiar" with AIG FP... Our source says it "is becoming assumed throughout the industry that AIG FP finding new ways to roll over" -- which is to say, using bailout money to offer counterparties on its trades generous terms in closing out its contracts with the massive issuer of credit default swaps and other exotic derivatives options. While he did not want to name names or go into detail about any specific transactions, he said we should watch for signs of AIG FP employees being rewarded for their generosity with jobs working for their old counterparties under eyebrow-raising terms -- "like if you have a noncompete," the source explained, "and you go to a competing firm doing something far below you for an extreme salary."
An exodus of employees at AIG Financial Products has already threatened to cost taxpayers hundreds of billions more dollars. And to think some executives might be hastening their departure from the zombie insurer by squandering billions of taxpayer dollars is...while perhaps unsurprising, still a little nuts. "The staggering thing," our source says, "is the size of these deals."
Systematic Risk Regulators and the Power of Arithmetic
The current craze in DC policy circles is to create a "systematic risk regulator" to make sure that the country never experiences another economic crisis like the current one. This push is part of a cover-up of what really went wrong and does absolutely nothing to address the underlying problem that led to this financial and economic collapse. The key fact that everyone must always remember is that the story of the collapse was not complex. We did not need great minds sifting through endless reams of data and running incredibly complex computer simulations to discover the underlying problem in the economy. We just needed some people who understood the sort of arithmetic that most of us learned in 3rd grade.
If the people at the Fed, the Treasury, and in other key positions had mastered arithmetic, and were prepared to act on their knowledge, they would have taken steps to stem the growth of the housing bubble. They would have prevented the bubble from growing to the point where its inevitable collapse would bring down both the U.S. economy and the world economy. Just to repeat the basic facts: house prices began to diverge sharply from a 100-year long trend in the mid-90s as wealth created by the stock bubble began to exert upward pressure on real estate prices. After having tracked the overall inflation rate for 100 years, house prices were substantially outpacing inflation.
There was no remotely plausible explanation on either the supply or demand side for the run-up in house prices. Income growth was good, but not extraordinary in the late 90s. In the current decade, incomes actually fell slightly after adjusting for inflation. On the supply side, we built houses at near record rates in 2002-2006 indicating that there were no substantial constraints on building. As another tell-tale sign that we were seeing a bubble, inflation-adjusted rents were not rising, indicating that there was no underlying shortage of housing driving up prices. Finally, housing vacancy rates were hitting record levels as early as 2002. At their peak in 2006, inflation-adjusted house prices had risen by more than 70 percent, creating over $8 trillion in housing bubble wealth. There was no way that the loss of this much wealth ($110,000 for every homeowner) would not lead to a severe recession and create the sort of financial crisis that we are now seeing.
In normal times houses are highly leveraged with down payments rarely exceeding 20 percent. In the bubble years, it was common for homebuyers to borrow the full value of their home and sometimes even a few percent more. It should have been obvious to any serious economist or financial analyst that when the bubble burst, there would be hell to pay in the financial sector. In short, all the evidence was right there for anyone who cared to see it. We didn't need some super-genius to solve the mystery. We just needed an economist who could breath and do arithmetic. But the DC policy crowd tells us that if only we had a systematic risk regulator this disaster could have been prevented.
Okay, let's do a thought experiment. Suppose we had our systematic risk regulator in 2002. Would this person have stood up to Alan Greenspan and said that the country is facing a huge housing bubble the collapse of which will sink the economy? Remember, before the fall Greenspan was known as "the Maestro." Politicians, reporters and economists worshipped every pearl of wisdom that came out of his mouth. In fact, when he announced his plans to retire in 2005, many of the world's leading economists and central bankers gathered at Jackson Hole, Wyoming to debate whether Alan Greenspan was the greatest central banker of all time. Alan Greenspan said that there was no housing bubble; everything was just fine. Would our systematic risk regulator have said that Greenspan was nuts and that the whole economy was a house of cards waiting to collapse?
Anyone who believes that a risk regulator would have challenged the great Greenspan knows nothing about the way Washington works. The government is run by people who first and foremost want to advance their careers. And, the best way to advance your career in Washington is to go along with what everyone else is saying. If that was not completely obvious before the collapse of the housing bubble, it certainly should be obvious now. How many people in government have lost their jobs because they failed to see the bubble? How many people even missed a promotion? In fact, the top financial officials in the Obama administration, without exception, completely missed the housing bubble. One might think it was a job requirement.
This lack of accountability among economists and economic analysts is the core problem that must be tackled. Unless these people are held accountable for their failures in the same way as custodians and dishwashers, there will never be any incentive to buck the crowd and point out looming disasters like the housing bubble. The reality is that we have a systematic risk regulator. It is called the Federal Reserve Board. They blew it completely. We will do far more to prevent the next crisis by holding our current risk regulator accountable for its failure (fire people) than by pretending that we somehow had a gap in our regulatory structure and creating another worthless bureaucracy. And of course we should teach our economists arithmetic.
Ilargi: The story behind the video (with poor sound quality): On February 9, Bloomberg ran an article entitled U.S. Taxpayers Risk $9.7 Trillion on Bailout Programs . Referring to the article, Rep. Alan Grayson asks Federal Reserve Inspector General Elizabeth Coleman about the trillions of dollars lent or spent by the Federal Reserve as well as the trillions of off-balance sheet obligations. The Inspector General, tasked with overseeing and auditing the Fed, responds that her office does not know and is not tracking it. If Geithner and/or Obama have the audacity to mention transparency even just one more time, here's all you need to know. US Inspectors General have the following description :
Inspectors General of the Cabinet-level agencies can be removed only by the President. In other agencies, known as "designated federal entities," like Amtrak, the U.S. Postal Service and the Federal Reserve, the agency heads appoint and remove Inspectors General. Inspectors General are appointed based on their integrity and experience in:
While by law, Inspectors General are under the general supervision of the agency head or deputy, neither the agency head nor the deputy can prevent or prohibit an Inspector General from conducting an audit or investigation. The conduct of the Inspectors General is overseen by the Integrity Committee of the President's Council on Integrity and Efficiency (PCIE).
- accounting, auditing, financial analysis;
- law, management analysis, public administration; or
Is Anyone Minding the Store at the Federal Reserve?
Scenes From The Ninth Circle Of Financial Bureaucracy
We've been poring over the report -- hit piece? -- on the SEC issued today by the Government Accountability Office, and we're starting to understand why Hank Paulson wanted to shut the place down and put all those "enforcers" out of their Kafkaesque misery. The agency got more tips from FINRA -- the financial industry's self-regulator -- than it had the resources to pursue, it lost 11.5% of its lawyers since 2004, and the staff lacked in-house expertise on pretty much all the fancy financial instruments without which we would not have this crisis (in addition to "government securities" which seems a bit sad, the SEC being a division of the government). The agency's revenues were in a downward spiral, with corporate penalties falling 39% in fiscal year 2006, only to fall another 48% in 2007, only to fall another 49% last year.
But as the foil for a cabal of deep-pocketed financiers with $87,000 rugs in an absurdist comedy in the Office Space vein about how the crisis happened, the SEC as depicted in the GAO report is perfect. We excerpted some of our favorite bits:
Investigative attorneys spend half their days moving boxes and waiting in line at Kinko's:Investigative attorneys with whom we spoke concurred that having little or no administrative or paralegal support causes them to spend considerable time on non-legal duties such as copying, filing, document-scanning, preparing exhibits, making travel arrangements, soliciting bids for court reporters, and logging and processing documents submitted by respondents. For example, one attorney told us such duties can take 2 to 3 hours daily. Another, who joined the agency from private practice, said that investigative attorneys can spend up to half their time on tasks handled by support staff in their previous position. One attorney told us of plans to spend a day assembling document storage boxes. Because there is insufficient in-house copying capability, confidential documents sometimes are sent to non-secure outside copy shops. Frequent equipment breakdowns mean attorneys must search for working copiers and scanners, a number of attorneys told us.And 40% of their time drafting internal memos:Some attorneys estimated that they spend as much as a third to 40 percent of their time on the internal review process, thus making it harder to meet the division's emphasis on bringing cases on a timely basis. A number of attorneys told us that the effect of the intensive review process is to create a culture of risk aversion, an atmosphere of fear or insecurity, or incentives to drop cases or narrow their scope. In one instance, an attorney closed a case rather than go through a review with another division. In two other cases, charges were dropped or reduced because the matters had taken so long that people were unable to recall earlier considerations of evidence. In another situation, it took 2 1/2 months to prepare a paragraph requesting permission to send a Wells notice; in another case, staff prepared multiple drafts of a Wells memo over 3 years before finally closing the case because it was so old. Finally, one investigative attorney told us that a company under investigation offered to pay whatever penalty amount Enforcement asked; 5 months later, the matter still remained open, with an action memorandum in its tenth draft. Some attorneys noted that such delays may encourage violators.Nice use of understatement!
Once all those internal memos are completed, they have almost no value internally because the system is run on a proprietary case tracking system called CATS that is incompatible with all their other computer systems (which are all incompatible with one another) and which no one bothers to update or fix when it's broken, both because their old information technology contractors no longer work there and because it is, in the staffers' own words, "severely limited and virtually unusable." Plus:While downloading of information from computer hard drives has become a basic evidentiary technique, some investigative attorneys told us there can be lengthy delays for information technology support staff to retrieve the contents from hard drives obtained during an investigation. For example, one attorney told us about a case in active litigation in which Enforcement had to seek an extension of time for discovery because after 6 months, only two of a number of hard drives had been downloaded.And:Some investigative attorneys suggested that Enforcement would benefit from a divisionwide system for sharing information, such as litigation documents or legal analyses...And um, this sounds like it could be a problem.Several attorneys said that another significant shortcoming is that the investigative staff does not have access to real-time trading information...Currently, when attorneys need such information, they manually query hundreds of broker-dealers, a process that initially produces only incomplete records. Or, they might request data from a regulated entity such as FINRA.But if it's hard to get any work done, it's near-impossible to make any of that work pay off for the taxpayer:An attorney told us that a company confessed and was willing to pay the penalty sought, but it still took more than six months to complete the settlement because the commissioners lacked consensus. Another attorney told us that a company agreed to a settlement, announced it publicly, and escrowed money for the payment, but the matter took a year to win Commission approval. One attorney cited a case that went on and off the Commission's meeting agenda eight times...Several Enforcement attorneys told us that even when they presented cases in which a corporation had agreed to pay a penalty, the Commission might lower or eliminate the amount. One attorney described a case in which a company proposed a settlement with a higher penalty than was approved by the Commission, which required the attorney to return to the company and explain that the Commission wanted a lower amount. Another described a case in which the Commission halved a proposed penalty. Yet another described having conducted the required nine-factor analysis, and arriving at a proposed penalty range of $10 million to $35 million.And you knew there'd be catchy jargon to describe this process:As described by one attorney, investigative staff sought to identify the "maximum minimum amount" the Commission will approve.And this might go some way to explaining why the agency chose the most cataclysmic year in financial history to go after billionaire Mark Cuban for an $800,000 insider trading case:One attorney said there has been relatively more focus on modest cases like small Ponzi schemes, insider trading, and day trading, because such cases were thought to stand a better chance of winning Commission approval, compared to more difficult and time-consuming cases like financial fraud.
David Rosenberg: Thank You, Yes It's Just A Sucker's Rally
Merrill's economist David Rosenberg left the firm yesterday (planned for several months). And he went out swinging. David has maintained from the beginning that the recent rocket rally off the lows is just a suckers' rally, and he reiterated that view as he walked through the doors.
Some excerpts from his swan song, which was published Thursday:
Market likely to peak the end of the week [Yesterday]. Just as the clock is winding down on my tenure at Merrill Lynch, the equity market is winding up with an impressive near-40% rally in just nine weeks. For those that were still long the equity market back at the March 9 lows, a good ‘devil’s advocate’ exercise would be to ask yourself the question whether you would have taken the opportunity, if the offer had been presented, to have sold out your position with a 40% premium at the time. What do you think you would have said back then, as fears of financial Armageddon were setting in? We haven’t conducted a poll, but we are sure at least 90% of the longs at that point would have screamed “hit the bid!”
Are we at risk of missing the turn? Fast forward to today, and within two months optimism seems to have yet again replaced fear. Are we at risk of missing the turn? What if this is the real deal — a new bull market? This is the question that economists, strategists and market analysts must answer.
Risk is much higher now than it was 18 weeks ago. The nine-week S&P 500 surge from 666 at the March lows to 920 as of yesterday has all but retraced the prior nine-week decline from the 2009 peak of 945 on January 6 to the lows on March 9. We believe it is appropriate to put the last nine weeks in the perspective of the previous nine weeks. To the casual observer, it really looks like nothing at all has happened this year, with the market relatively unchanged. But something very big has happened because the risk in the market, in our view, is much higher than it was the last time we were close to current market prices back in early January, for the simple reason that we believe professional investors have covered their shorts, lifted their hedges and lowered their cash positions in favor of being long the market.
Employment, output, income, sales still in a downtrend. Considering what transpired from an economic standpoint, the decline in the first nine weeks of the year was rather appropriate in the midst of the worst three-quarter performance the economy has turned in roughly 70 years. The rally of the past nine weeks appears to be rooted in green shoots. While it may be the case that the pace of economic decline is no longer as negative as it was at the peak of the post-Lehman credit contraction, the reality is that employment, output, organic personal income and retail sales are still in a fundamental downtrend.
Need to see an improvement in the first derivative. We have evidence that the consumer, after a first-quarter up-tick that was front- loaded into January, is relapsing in the current quarter despite the tax relief (didn’t we see this movie last year?). Not until improvement in the second derivative morphs into improvement in the first derivative with respect to the important economic data will it really be safe to declare what we are seeing as something more than a bear market rally, as impressive as it has been.
This is a bear market rally that may have run its course. The investing public is still holding tightly to their long-term resolve, but much of the buying power at the institutional level seems to have largely run its course, in our view. That leaves us with the opinion, as tenuous as it seems in the face of this market melt-up, that this is indeed a bear market rally and one that may well have run its course. We have “round-tripped” from the beginning of the year and there is real excitement in the air about how these last nine weeks represent evidence that the economy will begin expanding sometime in the second half of the year.
Growth pickup will likely prove transitory While it is likely that headline GDP will improve as inventory withdrawal subsides and fiscal policy stimulus kicks in, our view is that whatever growth pickup we will see will prove to be as transitory as it was in 2002, when under similar conditions the market ultimately succumbed to a very disappointing limping post-recession recovery. So yes, there may well be some improvement in the GDP data, but it is based largely on transitory factors. We strongly believe it is premature to totally rule out the end of the vicious cycle of real estate deflation – residential and now commercial – that we have been experiencing since 2007. Balance sheet compression in the household sector will continue to pressure the personal savings rate higher at the expense of discretionary consumer spending. This is a secular development, meaning that we expect it will last several more years.
Chances of a re-test of the March lows are non-trivial. To reiterate, it seems to us likely that the risk in the market is actually higher today than it was back at the same price points in early January, and we say that with all deference to the stress tests (which given the less-than-dire economic scenarios, along with the changes to mark-to-market accounting, were destined to reveal healthy results). While the consensus seems gripped with the burden of trying to decide if there is too much risk to be out of the market, we actually still believe that the chances of a re-test of the March lows are non-trivial, especially if the widely touted second-half economic rebound fails to materialize...
The data flow is less relevant this cycle than in the past. This was not a manufacturing inventory cycle, which makes the data flow less relevant than in the past. Real estate values are still deflating and the unemployment rate is still climbing; these are critical variables in determining the willingness of lenders to extend credit. And as we just saw in the Fed’s Senior Loan Officer Survey, while there may be a ‘thaw’ in the financial markets, banks are still maintaining tight guidelines. In fact, the weekly Fed data are now flagging the most intense declines in bank lending to households and businesses ever recorded.
The best case is that this is a bear market rally. All of this has not precluded an elastic band bounce from an egregiously oversold low in the S&P 500, and perhaps we will even test the 200-day moving average of 960 (as the 10-year note yield and NASDAQ just did). But we still do not believe what we are seeing fits the hallmark of a new bull market. In our view, the best case is that this is a bear market rally, but one that clearly has more legs than its predecessors this cycle.
David Rosenberg:Green Shoots Or Rose-Colored Glasses?
Just like yet another posthumous multi-platinum Tupac record, David Rosenberg resurfaces on Zero Hedge... Although, unlike Tupac, this is almost guaranteed the last incarnation of Rosie while a Merrill employee, doing what he does best - talking about employment trends and the consumer.
This is a boom compared to the post-Lehman collapse
Only the most ardent optimist would lay claim that the employment report today was a green shoot. Yes, yes, the -539,000 was broadly in line with ‘whispered’ estimates and certainly is less negative than the -707,000 average over the prior three months. If the benchmark for economic revival is the aftermath of the Lehman collapse when the credit market froze, suppliers went AWOL and consumers became comatose, then indeed, this looks like a virtual boom.
Nothing in today’s jobs report gives us that much comfort
But, in fact, all that has changed is the slope of the line when it comes to employment, output, spending or income. It is no longer pointing straight down in Wile E. Coyote fashion, but the fundamental trend is still down. Green shoot advocates miss the point. Recessions only end when the improvement in the second derivative morphs into something less fragile and more agile like improvement in the first derivative. Real cyclical bull markets only start once we are within 4-5 months of that improvement in the first derivative. Nothing in today’s jobs report gives us that much comfort.
January’s 741K decline was likely the worst we will see
At the risk of shooting the green shooters, let’s really assess the situation. Barring a catastrophe, it certainly looks as though the -741,000 print we saw in January was very likely the worst decline we will see in this recession. We won’t dispute that. But when you look at other cycles in the post-war era, what we see is that four months after the largest payroll decline, the losses are either negligible or we are actually swinging to positive job growth.
Employment has never been this weak before at this stage
So, the most appropriate way to examine the data is to see what the labor market looks like at this stage – four months after the biggest monthly collapse – and we have news for you: We are losing 539,000 jobs, or 0.4% of the workforce. In fact, employment has never been this weak before at this stage – a full four months after the worst figure. Not once. This post-credit collapse/asset-bubble burst cycle remains an enigma, and we strongly believe that investors today who are buying stocks and selling bonds in anticipation of a sustained reflation trade are going to end up as disappointed as they were under similar conditions in 2002.
Headline was actually worse than revised forecasts
As for the payroll report, the headline data was flattered by the addition of federal Census workers, which bolstered government payrolls by 72,000. The BLS birthdeath adjustment, when properly adjusted, also ‘skewed’ the number by nearly 60,000. So basically, adjusting for the Census workers and the Alice in Wonderland B-D adjustment, the headline payroll figure was really closer to -670,000. This means that the number was actually quite a bit worse than the post-ADP revised forecasts were calling for (shhh …don’t tell Mr. Market).
Widespread declines in private sector payrolls
Private sector payrolls actually sank 611,000 in April. The declines remain remarkably widespread with the diffusion index at 28%, which means we still have nearly four industries shedding their labor requirements for every industry that is bulking up on staffing (though admittedly a moderate improvement from the prior few months). Moreover, the data just do not square with the conventional wisdom permeating the investment landscape at the present time.
You couldn’t tell we are in the midst of a commodity boom from this report, with employment in natural resources down 11,000. And, we can see what an exciting 34.4 print on the ISM employment index brought manufacturing workers last month – 149,000 additional pink slips. If the tech sector is back in revival mode, as we are told, then someone forgot to tell the HR departments at the firms that dominate this space because payrolls were cut 12,000. This was even worse than the 8,000 decline in March.
We keep hearing about how the real estate market is nearing some sort of bottom, and yet construction payrolls fell 110,000 and there were also 15,000 fewer real estate agents putting up ‘For Sale’ signs. The leisure/hospitality stocks have been really hot of late. Here, we see that this industry laid-off 44,000 busboys, bell captains and bartenders last month in one of the worst numbers this sector has turned in during this down-cycle.
We would only have to assume that retailers were not fooled by the late timing of Easter in artificially underpinning their April sales results because they shed 47,000 workers on top of the 167,000 folks who were let go in the first three months of the year. We keep hearing about how global exports and trade flows are now on a renewed uptrend, but again, there was no evidence of this in the payroll report considering that transportation services/warehousing employment tumbled 38,000. This was the very worst showing since right after 9-11.
Green shoots for some economists, perhaps, but yellow weeds for any rational observer of what is really going on in the most crucial market of all for the economy – the labor market. Even sectors that had been solid growth performers are now feeling the spreading impact of this new world of frugality. Job gains of 15,000 apiece in education and health care are but a fraction of what were seeing before the credit collapse.
Amount of labor market slack is growing by the month
What is important about the employment data is that it provides us with so many clues as to what the inflation backdrop really looks like. So many market pundits draw their conclusions from the CRB index but there is no commodity that is any match for the labor market when it comes to determining the sustainability of any inflation pressure in the system. Even though the headline employment data are becoming “less negative”, if that is what turns you on, the reality is that the amount of slack in the labor market is growing by the month.
The unemployment rate jumped from 8.5% in March to a 26-year high of 8.9% last month – hard to believe it was sitting at 5% on the nose just this same time last year. Even here, the ‘official’ jobless rate grossly underestimates the degree of excess capacity in the labor market. The U-6 unemployment rate, which includes all forms of resource slack in the jobs sphere, edged up to a new lifetime high of 15.8% April from 15.6% in March.
Slack in labor market filtering into wages
This growing slack in the labor market is filtering through into wages. We see that average hourly earnings barely eked out any increase at all in April. This suggests that in real terms, personal income fell at least 0.1% during the month. That would make it four declines in a row for this critical 90% chunk of the economy. Not only that, but the steep slide in manufacturing payrolls – even with a pickup in overtime – spells for another 1.2% decline in industrial production for April. This, in turn, would take the capacity utilization rate – the ‘unemployment rate’ for industrialists – down to a record low 68.5% from 69.3% in March.
We maintain our constructive stance on Treasuries
As economists relying on data back to 1950, we have to admit that at no time have we ever seen the broad unemployment rate so high and the CAPU rate so low, and to think that any worker has any bargaining power or that any business has any pricing power given the massive amount of spare capacity in the labor and product markets is truly unfathomable. So it is against this deflationary backdrop that we maintain our constructive stance on safety and income and at a reasonable price, acknowledging that the Treasury market has moved aggressively against our view over the near-term. We are not swayed.
The duration of unemployment is surging
We can also see the strains from other pieces of the report. The male unemployment rate hit the 10% mark for the first time since June 1983. For both genders, the average length of time it is taking the ranks of the unemployed to find a new job has risen to 21.4 weeks from 20.1 weeks in March and 19.8 in both January and February – this is the highest level on record. The share of the unemployed who have been out of work for at least 15 weeks jumped 43.5% in March to 45.9% in April. The comparable figures for those who have been out of work at least a half-a-year jumped to 27.2% from 24.2% and up 5 percentage points since the turn of the year.
Job openings are practically non-existent
So, beneath the headline, what is so painfully obvious is how hard it is to find a new job – openings are practically non-existent. And what is truly grim is that the longer someone is out of work, the more discouraged they become, and over time, completely disengaged. For example, the number of permanent job losses has now approached almost six million for the first time on record and is up 176% over the past twelve months.
Most of these jobs lost will not be coming back
So, sadly enough, not only have we lost 5.6 million payrolls this cycle, shrinking the workforce by more than 4%, but the fact that there are so few opportunities as businesses adjust their production schedules to a new and permanently lower sales trendline, the data within the data reveal that most of these jobs are not going to come back anytime soon. While it is part of human nature to be hopeful, we can’t imagine that anyone can really put any sort of positive ‘spin’ on this report, but whoever does ostensibly didn’t get to Table A-8 on the complete unemployment picture.
We’re out of the hurricane, but it is still raining
There may be a growing sense that because the stock market has enjoyed a nice bounce, credit spreads have come in and new issue activity has perked up, that somehow things are going to get better in the real economy. Not so fast. We may be out of the hurricane, but it’s still raining outside. The economy bottomed in the summer of 1932 but the Depression did not end for another nine years and as a reminder, by the end of that decade, after seven years of grandiose New Deal stimulus, the unemployment rate was still at 15%, consumer prices were deflating at a 2% rate and we still had yet to reach the pre-Depression peak in GDP.
We must brace ourselves for a much more frugal future
Better does not mean good, and we must all brace ourselves for a much more frugal future. This does not mean the world falls apart. It means that lifestyles are going to change: frugality replaces frivolity, the family budget plan includes more savings for retirement and education, attitudes towards credit and discretionary spending shift, and owning the largest home on the block and the flashiest car is no longer going to be fashionable.
Focus on high-quality securities
For investors, this means focusing on high-quality securities – not the ‘junk’ that has led the way in this impressive but, in our view, still-vulnerable rally in risky assets. For those that missed the big nine-week move, don’t worry. Be patient. The story was right – the tortoise always wins the race.
Another 550,000 payroll plunge in May
As for the near-term employment outlook, some believe that the jobs data are about to look better because the markets have enjoyed a nice two-month rally. We will forecast the data on the tried, tested and true leading indicators on the ground. The still record-low workweek, at 33.2 hours, the 66,000 downward revisions to the back data (which tends to feed on itself) and the 63,000 slide in temp agency employment, coupled with the levels of both initial and continuing jobless claims, are foreshadowing a further 550,000 payroll plunge when the May data roll out in early June. That green shoot just turned into a dandelion!
Needles in the proverbial haystack
We don’t want to finish up on such a dour note. As with every report, there were some needles in the proverbial haystack. For example, the Household survey showed a 120,000 employment pickup but in reality, it was only a modest retracement from the 861,000 slide in March, not to mention the cumulative 2.5 million jobs lost in the first four months of the year. Even here, there is less than meets the eye, because three-quarters of the gain in the Household survey was people taking on a second job. Again, as we peel off the layers of this onion, we learn that whatever good news there may have been wasn’t so good. Best to stop there … and smell the weeds!
Bank of England braced for third wave of financial crisis
The Bank of England is concerned that the UK's banking system is heading for a third wave of crisis that could snuff out fragile signs of recovery in the economy. On Thursday the Bank surprised the City by announcing that it would pump an extra £50bn of new money into the economy despite recent stockmarket rallies. Now the Guardian has learned that this increase in quantitative easing was driven by fears in Threadneedle Street that the credit crunch is still sucking the life out of the British economy and the banking sector remains in deep trouble. The new mood of caution chimes with comments from business leaders yesterday, who warned that apparent green shoots in the economy had shallow roots.
Richard Lambert, director general of the CBI, said: "The fact is that for all the injections of taxpayers' money, the credit markets are still not working properly." Bank of England officials are concerned that big banks now supported by the taxpayer, such as Royal Bank of Scotland and Lloyds Banking Group, are struggling to increase lending volumes, as they had promised in return for help from the government. The governor, Mervyn King, and several other members of the Bank of England's monetary policy committee are said to be unconvinced by talk of green shoots that has helped propel the FTSE 100 share index up by more than 20% over the last month. Fears of a false dawn echo the mood at the beginning of the year, when apparent recovery in financial markets was wiped out by a second wave of crisis led by RBS and Lloyds.
This week both banks again warned of sharp increases in bad loans to British business customers. RBS said yesterday it was seeing little sign of green shoots. Continued weakness at these banks may prevent the increase in lending that ministers are desperate to see, and dash hopes of a pre-election recovery for Labour. The Bank of England is also worried that continued stresses in the global financial system will suck money out of the UK as cash-starved international banks bring money back home. Foreign banks are thought to be withdrawing funds from Britain once loans expire, rather than roll them over. In return for support from the government, both RBS and Lloyds had pledged to increase lending to homeowners and businesses to compensate for declining foreign lending.
Instead Stephen Hester, chief executive of RBS, said yesterday that demands for loans had contracted as customers "quite properly" try to reduce their borrowings as the recession bites. King presents the MPC's latest quarterly inflation report next Wednesday and speculation was rife in the Square Mile last night that the report would contain gloomy forecasts for economic growth and inflation, which will probably be projected as being below its 2% target in two years' time, even though it is currently at 2.9%. Last year King was criticised by some experts for failing to cut interest rates fast enough as the economy slid into recession.
But from September, when US investment bank Lehman Brothers collapsed, he led the MPC in slashing rates to an all-time low of just 0.5% and embarked on the unconventional quantitative easing in March, a policy the European Central Bank said on Thursday said it would follow. Poor lending decisions by HBOS, now part of Lloyds, and RBS, along with the rapid deterioration in the economy, mean that the two banks in which the government has major stakes could alone account for £25bn of bad debts by the end of the year. Both banks believe these losses will count towards the "first loss" they must bear before their insurance – through the government's asset protection scheme – kicks in. The extent of the rise in bad debts has surprised some commentators who now believe the taxpayer could be on the hook for losses under the asset protection scheme faster than first expected.
There has been some evidence of a small increase in mortgage lending in Britain, but it is not nearly strong enough to prevent house prices, which are down nearly a quarter from their 2007 peak, falling further. And unemployment is expected to continue rising well into next year, something that is likely to restrain consumer spending. Many economists have been encouraged by some better figures on consumer confidence and forward-looking surveys into thinking that the 1.9% contraction in the economy in the first quarter of the year – the worst for three decades – will not be as severe in the second quarter. But they say that this only marks a slower pace of contraction, not a rapid return to growth. Few share the chancellor's belief that the economy will recover strongly in 2009, and nor does the Bank of England.
Does Gordon Brown's regret selling half of Britains' gold reserves 10 years ago?
A decade ago Gordon Brown started to sell-off Britain's gold reserves - at the time the price of gold was $282 an ounce, today it is $900-plus. On May 7, the Treasury said it was to hold a series of auctions to sell-off half of Britain's 700 tons of gold reserves with the proceeds being invested in foreign currencies, including the euro. At the time the Treasury said it wanted to "achieve a better balance in the portfolio" by increasing the proportion of reserves held in foreign currency. With nearly 50 per cent of the net foreign currency reserves invested in gold, the exposure to a single asset was too great, it said.
At the time gold was trading around $282 an ounce. During the course of 17 auctions, between July 1999 and March 2002, the Treasury raised £2.2bn at an average price of $276.60 an ounce. Today gold is trading at around $900 an ounce. John Mulligan at the World Gold Council said: "The announcement that Gordon Brown was going to sell off (415 tonnes) of the UK’s gold reserves occurred on 7 May 1999, but the gold was actually sold in stages, totalling 395 tonnes, between 1999 and 2002. The price (pm fix) on the day of the announcement was $282.40 / oz. or £172.84. "The announcement had a negative impact on the price which slid to a low of 252.80 in $ terms (on 20 July 1999; its £ low came a few months later), before gradually recovering and rising fairly consistently ever since.
10 years later, yesterday, the gold price (pm fix of 7 May 2009) stood at $912.25 / £606.43 per ounce (a rise in value of 223pc, or 251pc in sterling terms). The Treasury has defended its decision as a way of diversifying reserves and cutting risk. It said as a result of the programme, a one-off reduction in risk of approximately 30pc was achieved and that the auction programme 'scored well on value for money grounds'. Mark Dampier, head of research at Hargreaves Lansdown said: "This has to be one of his worst clangers and I'm not sure he thought much about the decision. Before you buy or sell something it's common sense to see what the price has done - by looking at the price chart going back 20-25 years. Gold had peaked at about $850 and come all the way down."
Leak discounted in sudden rise of the loonie
Jim Flaherty got a lesson in what global markets can do with a little rumour and innuendo as a big bet on the Canadian dollar in London, England, Friday morning resulted in the federal Finance Minister defending his discretion in Hamilton by early afternoon. Most currency traders in Toronto and New York had barely settled into their chairs yesterday when the loonie suddenly took flight, soaring 0.7 per cent between 6 a.m. and 7 a.m. ET. The move startled analysts at BMO Nesbitt Burns, RBC Dominion Securities, Scotia Capital and other brokerages because it came before the official release of Statistics Canada's latest employment figures, a report that most had anticipated would show another drop in hiring.
To many analysts and traders, a big purchase of Canadian dollars made little sense. When the Statscan report ended up showing the first increase in employment in six months, those same analysts and traders started speculating that some London hedge funds might be profiting from leaked information. One Toronto brokerage phoned Statscan to express its concerns, forcing Geoff Bowlby, the agency's director of labour statistics, to spend the day checking his security measures. He found no breaches. "I have to come to the conclusion that this was a good bet in the market," Mr. Bowlby said in an interview. "I haven't seen anything. Am I 100-per-cent sure? Almost."
Mr. Bowlby's conclusions came too late to save Mr. Flaherty from questions about the Statscan report and a call from the Opposition to review the situation, giving life to a concern of some market participants that the Finance Minister is less than careful in his treatment of market-sensitive data. "The move earlier today is the first time I said to myself, ‘Maybe there's a hole [where information is leaking],' but who knows?" said David Watt, a currency strategist at RBC in Toronto. The episode highlights the sensitivity of investors who have been rocked by months of market turmoil.
Mr. Watt conceded that it was possible that people took a "punt" and got it right, and that any major purchase of the currency at that hour would be amplified because trading is light. The speculation about a leak ignored the fact that Canada's currency was in the middle of its sixth-consecutive weekly gain, the longest winning streak since November, 2007. Conspiracy theorists also overlooked oil's jump to $58 (U.S.) a barrel from $57.25 in the two hours prior to the release of the jobs data. The loonie, which rose 1.8 per cent to 86.90 U.S. cents yesterday, tends to rise and fall with commodity prices.
If there are leaks, Mr. Flaherty said they aren't coming from him. "I keep those numbers confidential," the minister told reporters after a speech to the Canadian Club of Hamilton, adding that no concerns of that sort had been brought to his attention. Mr. Flaherty is among the few outside Statscan who gets a look at major economic data before release. In the case of the employment survey, he receives it at 5 p.m. on the previous day, along with the Prime Minister and the head of the human resources department. Officials at Finance, the Privy Council Office and Human Resources obtain the data at 2 p.m. to prepare briefing notes for their bosses. In recent months, Mr. Flaherty, who prides himself on a certain degree of frankness, has said ahead of new jobless data that he expected the numbers to be bad. Economists such as Mr. Watt started watching the minister closely for clues, anticipating that he may foreshadow the results of the survey.
The Curse of the Class of 2009
The bad news for this spring's college graduates is that they're entering the toughest labor market in at least 25 years. The worse news: Even those who land jobs will likely suffer lower wages for a decade or more compared to those lucky enough to graduate in better times, studies show. Andrew Friedson graduated last year from the University of Maryland with a degree in government and politics and a stint as student-body president on his résumé. After working on Barack Obama's presidential campaign for a few months, Mr. Friedson hoped to get a position in the new administration. When that didn't pan out he looked for jobs on Capitol Hill. No luck there, either. So now, instead of learning about policymaking and legislation, he's earning about $1,250 a month as a high-school tutor and a part-time fundraiser for Hillel, a Jewish campus organization. To save money, he's living with his parents.
If asked a year ago whether he'd be tutoring now, Mr. Friedson says, "I would have laughed in your face." Trading down to a lower-skilled job isn't just a hit to Mr. Friedson's ego. It could also hurt his bank account for years to come. Economic research shows that the consequences of graduating in a downturn are long-lasting. They include lower earnings, a slower climb up the occupational ladder and a widening gap between the least- and most-successful grads. In short, luck matters. The damage can linger up to 15 years, says Lisa Kahn, a Yale School of Management economist. She used the National Longitudinal Survey of Youth, a government data base, to track wages of white men who graduated before, during and after the deep 1980s recession. Ms. Kahn found that for each percentage-point increase in the unemployment rate, those with the misfortune to graduate during the recession earned 7% to 8% less in their first year out than comparable workers who graduated in better times. The effect persisted over many years, with recession-era grads earning 4% to 5% less by their 12th year out of college, and 2% less by their 18th year out.
For example, a man who graduated in December 1982 when unemployment was at 10.8% made, on average, 23% less his first year out of college and 6.6% less 18 years out than one who graduated in May 1981 when the unemployment rate was 7.5%. For a typical worker, that would mean earning $100,000 less over the 18-year period. The impact on wages could be just as severe this time around, says Ms. Kahn. That's because of the depth of this recession and the possibility that the unemployment rate may approach the 10.8% level not seen since the early 1980s. The rate hit 8.9% in April, the Labor Department reported Friday. One reason behind declining wage potential, economists say: The caliber of jobs available in a recession, and their accompanying wages, tend to suffer. High-end firms hire fewer people and drive down salaries because jobs are in such demand.
That means many graduates end up with lower-wage, lower-skill jobs at less-prestigious firms or in firms outside their field of interest. Once the economy picks up and they try for better jobs, these workers have to learn skills they should have been developing immediately out of college. In the meantime, colleagues who graduated in a better economy have already developed these skills and progressed much further. For Brad Dechter, a 24-year-old who majored in graphic design, this could mean starting at the bottom when and if he gets a job at an advertising agency. He studied at the Art Institute of Colorado partly because the Denver school advertises that 86% of alumni get a job within six months of graduation. So far, no dice. Eight months after graduation, Mr. Dechter is making just $500 a month freelancing for bands, designing flyers and album covers. When he runs short of cash, he borrows from his friends. He spends his days on Craigslist searching for job openings instead of learning the marketing and design skills he would have picked up in his first year at an agency. "I've pretty much given up on trying to find my dream job," says Mr. Dechter.
Christine Pacheco, director of career services at the Art Institute, acknowledges that graduates face a struggle now. "They may need to take two part-time jobs and do some freelance rather than get a full-time job," she says. College graduates remain better off than those with only high-school diplomas, in good times and bad. The unemployment rate in April among four-year college graduates between 20 and 24 years old was 6.1%; among those the same age with only high-school diplomas, it was 19.6%. But a college degree isn't an automatic ticket to upward mobility, either. Even before the recession began, graduates were seeing their wages shrink. Between 2002 and 2007, according to government data, the inflation-adjusted hourly wage for men ages 25 to 35 with bachelor's degrees (and no graduate degrees) fell 4.5%. For the typical woman, inflation-adjusted wages fell 4.8%.
This year, employers say they'll hire 22% fewer college graduates than last year, according to the National Association of Colleges and Employers, an organization of career counselors. At the same time, colleges are expected to see the highest number of graduates in a decade. The average starting salary for graduates who do get jobs, meanwhile, dropped to $48,515 this spring, down 2.2% from the same time last year, according to NACE. Plenty of recent graduates are making far less than the average. Between her business marketing degree and numerous New York City contacts, Nicole Buckley, 21, figured she would find a marketing job after graduating in December from Siena College, a small Catholic liberal arts college near Albany, N.Y. She didn't expect to be working the jobs she has now, five months after graduation: As a full-time receptionist with a part-time gig as a model, promoting Bacardi rum and Grey Goose vodka to patrons at bars. But after doing two interviews a day and applying to more than 50 jobs, she had to do something to pay the bills.
"I don't think anyone went to college and said, 'I want to graduate and make $25,000 a year,' " says Ms. Buckley. She estimates her earnings at a little less than $30,000 between the two jobs. Sarah Veilleux, 22, one of Ms. Buckley's two roommates in a $1,125-a-month Brooklyn apartment, graduated in May 2008 from the University of New Hampshire with a communications degree. For a few months, she worked selling band merchandise at a music venue. Then she found her ideal job: doing promotions for Sirius Satellite Radio. But they need her only 20 hours a week. "As soon as I saw the offer for Sirius," she says, "it didn't matter how many hours a week." She spends the other half of her week doing administrative tasks for a staffing company, earning $1,500 a month -- $18,000 a year -- between the two jobs.
Still, Ms. Veilleux probably will be better off than those who take low-wage jobs outside their fields, says Till Marco von Wachter, a Columbia University economist. Mr. von Wachter, with a couple of colleagues, has looked at wage data covering 70% of all Canadians who graduated from college between 1976 and 1995, a span encompassing two recessions. His work indicates that graduates who get jobs in their fields -- even low-paying jobs -- are able to learn the right skills, and thus have an edge when the economy rebounds. Mr. von Wachter also found that what recession-era graduates studied, and where they went to school, made a big difference in how quickly they caught up to workers who graduated in boom times. People who majored in fields that lead to high-paying jobs, such as chemistry, biology, physics and engineering, tended to catch up to other graduates more quickly, primarily by switching jobs during the economic recovery and landing at better firms. In contrast, says Mr. von Wachter, the wages of humanities majors at less prestigious schools were less likely to catch up to the wages of their peers who graduated in healthier times.
For some graduates, the recession has had an unintended upside: a career path they never thought they wanted. Diane Hempe, 24, planned to be a teacher. But after graduating from the University of Maryland last year with an elementary education degree, she failed to find a job at a school. So she settled for working at a day-care center, where the $12 an hour she brought in felt like an affront. In December, Ms. Hempe went in an entirely new direction. She took a job in the customer-service department at a Wells Fargo call center in Frederick, Md. "I definitely know I can move up," she says. "I can be in customer service; I can be in collections; I can be in so many different departments." And in the meantime she's shifting her long-term goals. Instead of getting a master's degree in education like she once thought she would, Ms. Hempe says eventually she plans to get her master's in business.
Other are opting to ride out the slump doing public service. At AmeriCorps, a nationwide community-service network, applications more than tripled to about 48,500 between November 2008 and March compared to the same time period a year earlier. Teach for America received 35,000 applications this year -- 42% more than last year. About 70% of those were recent college graduates. Among the most common reasons people cited for applying, according to Teach for America, were poor job conditions and President Barack Obama's call to public service. Another alternative to unemployment or a low-paying job: Stay in school. Graduate applications for 2007-2008 were up 8% nationwide compared to the year before, according to the most recent numbers from the Council of Graduate Schools. Schools such as Northwestern University and Harvard are already tracking double-digit increases this year.
College grads who went to graduate school instead of the job market during the early '80s recession didn't suffer the same wage losses, says Ms. Kahn, the Yale economist. That's the approach John Bence is taking. A 2008 graduate of Kenyon College in Ohio, the history major worked with a temp agency and did a six-month stint at an international consulting company. After repeatedly losing out on jobs -- at museums, universities, consulting firms -- to more-qualified candidates with master's degrees, he'll head to New York University to get a master's degree in history, specializing in archival management. "I wasn't surprised I didn't get those jobs in, like, museums," Mr. Bence says. "But I was surprised that no one was willing to hire me to do anything."
Half of U.S. roads in poor shape
Half of the roads in the United States are in bad condition, and in some urban areas that proportion is closer to 60 percent, according to a report released by the American Association of State Highway and Transportation Officials on Friday. Some 72 percent of the interstate highways, though, are considered in good condition, according to the report. Urban drivers may be shouldering the biggest burden of the dilapidated roads. Those in cities with populations of more than 250,000 pay an average of $746 each year on vehicle repairs, new tires and additional fuel consumption, nearly double the $335 the average U.S. motorist pays.
Population surges in certain cities and suburbs, combined with the rising cost of road repair, have all led to the wear and tear, AASHTO said. Freight truck traffic has also taken a toll on the roads. AASHTO released the report as the U.S. Congress drafts the blueprint for federal spending on surface transportation for the next five years. The trade group said that billions of dollars for repair should be included in the bill and warned that many Americans may think the stimulus plan enacted in February, which put a little less than $50 billion toward transportation, would put the country's roads back in shape. AASHTO estimates the government should invest $166 billion in highways and bridges each year, and that half of that should go to maintenance.
The Dynamically-Hedged Economy II
All attention this week was focused on the bank stress tests. Importantly, market perceptions have shifted dramatically to the view that banking system problems are manageable and that policymakers have found the right balance in their approach. The reported total capital shortfall was nowhere near as dire as, not long ago, many had feared. Indeed, several weeks back no one would have even contemplated Wells Fargo and Morgan Stanley on the same morning tapping the market for a combined $11bn of common equity capital. And with markets having somewhat recovered - and even the impaired financial players having regained access to the capital markets- the marketplace has now largely taken the cataclysmic market “tail” risk scenario off the table. The equities VIX index dropped this week to the lowest level (31) since before the failure of Lehman, mirroring the ongoing collapse in Credit spreads.
My obsession with the Credit system began in the early nineties, as I studied the complex process of impaired banking system rejuvenation. Beginning early in that decade, innovation and rapid expansion propelled Wall Street finance into a major force of system Credit creation. Securitizations, the GSEs, and derivatives markets in particular – contemporary Wall Street risk intermediation - combined to play a momentous role in system reliquefication/reflation. This was much to the delight of the traditional banks – first promoting their recovery and later spurring incredible growth in earnings, stock prices and compensation. This new Credit system structure developed into the historic Wall Street finance and mortgage finance Bubbles.
Today, myriad forms of government risk intermediation and market intervention are spurring system Credit creation and reliquefication. I have labeled the most recent phase of risk intermediation distortions and Credit excess the “Government Finance Bubble.” One will miss important dynamics by focusing on bank Credit. It is worth noting first quarter bond issuance data from the Securities Industry and Financial Markets Association (SIFMA). Total Bond issuance (muni, Treasury, mortgage-related, corporate, agency, and ABS) jumped to $1.420 TN during the period. This was a notable 71% increase from a dismal 4th quarter to the strongest issuance since Q2 2008 ($1.598TN). If the first quarter’s pace is maintained, total 2009 issuance of $5.680 TN would trail only 2003 and 2007. First quarter bond sales were actually up 3.2% from Q1 2008, led by a 60% y-o-y increase in Treasury issuance ($326.8bn). On a quarter-over-quarter basis, Agency issuance was up 332% to $413.7bn; Mortgage-Related issuance increased 69% to $364.8bn; and Corporate issuance surged 188% to $215.1bn. Exemplifying the scope of the unfolding Government Finance Bubble, Treasury and Agency debt issuance combined for an incredible $740.5bn during the first quarter, up 59% y-o-y to a record annual pace of $2.962 TN.
This morning Fannie Mae reported a worse-than-expected first quarter loss of $23.2bn. In just three quarters, Fannie has reported losses totaling $77.4bn. No worries, however. Fannie’s debt spreads this week tightened another 12 to 31 bps (down from November’s 159bps) and Fannie MBS spreads narrowed an additional 9 to 83 (down from November’s 232bps). Despite unprecedented losses and massive capital shortfalls, the GSEs have nonetheless become major players in the unfolding Government Finance Bubble. An insolvent Fannie requested an additional $19bn of government assistance this morning.
Today from Fannie: “In March, Fannie Mae provided $93.3 billion in liquidity to the market through Net Retained Commitments of $5.4 billion and $87.8 billion in MBS Issuance… March refinance volume increased to $77 billion, nearly twice the refinancing volume reported in February and our largest refinance month since 2003. We expect that our refinance volumes will remain above historical norms in the near future… Fannie Mae began accepting deliveries of refinance mortgage originations under the Making Home Affordable program in April 2009.”
Fannie’s “Book of Business” (retained mortgages and MBS guarantees) expanded at a 12.3% rate during March to $3.144 TN (largest increase since February 2008). Fannie MBS guarantees grew at a 15.4% annualized pace during March to $2.640 TN. The $31.4bn increase in guarantees was the largest in 13 months. The company’s “New Business Acquisitions” jumped to $92.8bn from February’s $53.8bn and January’s $28.8bn. The current wave of mortgage refinancings is the strongest since the powerful – and system reliquefying - 2002/3 refi boom. The few analysts that even care are generally discounting the systematic impact of refinancings. They argue that there is today dramatically less equity available to extract and spend. From an economic perspective, I don’t have a big issue with this analysis. But from a systemic risk perspective, the unfolding refi boom is anything but inconsequential.
By the end of the year, I would not be surprised to see upwards of $1.0 TN of “private” mortgage exposure having been shifted to the various government-related agencies (Fannie, Freddie, Ginnie, FHA, and FHLB). The wholesale transfer of various private sector risks to “Washington” is a key facet of the Government Finance Bubble. Nowhere is such redistribution accomplished as effectively and surreptitiously as when the mortgage marketplace is incited to refinance by (Fed-induced) collapsing yields. Think in terms of our government placing its stamp of guarantee on hundreds of billions of risky, illiquid and unappealing mortgage securities – transforming them into coveted “money”-like agency securities. Such dynamics work wonders… Previous holders of these mortgages receive cash, while the entire marketplace benefits from higher mortgage/MBS prices.
Some years back I titled a Bulletin “The Dynamically-Hedged Economy.” The gist of the analysis was that the Financial Sphere was the driving force for the Economic Sphere – and not vice-versa. Derivatives and leveraged speculation “ruled the world.” Credit system and speculative Bubble dynamics had nurtured powerful and self-reinforcing dynamics. A financial sector embracing risk and leverage was spurring liquidity excess, higher asset prices, a more robust economic expansion, buoyant confidence, animal spirits, and an only greater degree of self-reinforcing Credit and speculative excess. As we witnessed last autumn, an abrupt reversal of these dynamics fomented system illiquidity and near systemic breakdown. Selling begat more selling - especially from the expansive derivatives marketplace. There was absolutely no way that system liquidity could absorb the combined selling pressure associated with speculative deleveraging and the hedging (and associated "dynamic" trend-following selling) of systemic risks.
The system is again rocked by yet another Bubble-related convulsion: These days, it’s the self-reinforcing unwind of bearish bets and systemic risk hedges. Washington’s unprecedented measures to intermediate risk and boost marketplace liquidity have spurred a self-reinforcing wave of bearish position liquidations and a reversal of hedging strategies. This dynamic has had a major impact in the Credit, equities and, seemingly, more recently in the currency and commodities markets. I would add that this unwinding process tends to generate liquidity throughout the marketplace. And, let’s face it, there is nothing like a big short squeeze to get the animal spirits flowing on the long side. Most will interpret these dynamics bullishly. I would caution that we are witnessing only the latest variant of Acute Monetary Disorder and destabilized markets.
The more bearish analysts argue that current economic underpinnings do not support surging stock and debt prices. Of course they don’t, but that’s not really the key issue. Rather, the question is whether the return of liquidity and securities market inflation will stoke sufficient confidence (from both spenders and lenders) to spur sustainable economic recovery. Here I must lean heavily on my analytical framework. In the short-run, I have to presume that major financial sector and market developments will work to stimulate the real economy (as they have repeatedly in the past). At the same time, it’s my view that the economy today is unusually susceptible to an artificial and fleeting recovery. The unwind of bearish hedges will at some point have run its course, concluding a period of major artificial liquidity generation. Moreover, I question the sustainability of the Government Finance Bubble (fiscal and monetary) overall.
The markets are setting themselves up for disappointment. I would posit that the more energized the markets and economy the greater the amount of Credit issuance that will need to be absorbed by the markets (debt and currency). So far, it is mainly Treasury yields that are rising. Government Finance Bubble dynamics would seem to dictate, however, that agency debt and MBS yields could provide the key to both artificial economic recovery and inevitable disappointment. And I would not expect a sinking dollar to support the markets for agency securities or Treasuries.