Clam seller in Mulberry Bend, New York City
Ilargi: You can talk about the economy till you’re blue in the face, make a case for or against a possible recovery, bottoms and tops, green shoots, yellow weeds, whatever tickles your fancy and your preferred belief system. And you're sure to find at least a few handfuls of kindred souls and spirits while you’re at it. After all, with worsening data continuing to spout from the real economy, the one that pays your salary if you still have one, which pays your mortgage if you still have one and so on, while stock markets seem to be going up, there is enough confusion to go around for everyone.
But in the end, when all the convincing sounding arguments have been made in the heated discussions that fill hour after hour of street corners, TV screens, worried kitchen tables, barrooms and bordellos, day after confusing day, it all comes down to one simple four letter word. Debt.
If and when you focus on that, and only on that, a lot of the confusion may go away. Not, though, the worries.
US households owed 133% of disposable income in the first quarter of 2008, which went down to 130% at the end of 2008. If you add the perspective of foreclosures and bankruptcies to that number, that’s not much of an improvement at all. The combination of plummeting house values and stock prices cost US citizens close to $13 trillion over the past two years, which means their debts are now close to $14 trillion. Credit lines are rapidly vanishing, credit card spending room alone will be shrunk by $2.5 trillion between now and early 2010. If you realize how many people simply have no funds left to draw upon, the only conclusion is that those who do still have room to spend, spend a lot. A lot of credit, that is, not money.
Mind you, that is the overall picture of the economy, not a description of individual people or communities. There are plenty people left who can buy what they wish. That is not the problem. The problem is the fast increasing numbers of those who can't. That is what a statistic like "US households owe 130% of disposable income" depicts: a broader picture of main street.
And if people start spending less, and borrowing less, both of which are inevitable outcomes of the present situation, the US GDP will drop right along with them. Consumer spending still hovers around 70% of GDP, though it's getting a little smaller. Still, US exports are dropping too, so they won't be able to make up the difference.
Hence, GDP will fall. So will tax revenues for all levels of government. The result will be rising taxes, but that is a surefire backfire move. Raising taxes on people who get poorer is a silly short term way to go. In other words, one that is sure to be chosen by many governments.
Talking about governments, the US administration has but one answer to the debt that won’t stop increasing. The federal deficit is set to rise to almost unspeakable dimensions. The -public- rationale behind that is that if money moves, the economy will heal itself. There are several reasons why that is a dead idea. First, most of what is spent disappears in previously incurred Wall Street gambling debts, and never reaches the real economy, the one the GDP is 70% dependent on. Second, hardly a penny serves to "build activities" that can be relied upon to produce anything of value. Give a man a fish, he'll eat. Give him a rod, and he'll eat for the rest of his life. That idea. We're stuck on the wrong side of it.
Real estate values will keep coming down for years to come. There is no credit left to support present asking prices. There is the government, Fannie and Freddie, that cabal, but they don't add value. They add debt. Fannie and Freddie should be flushed down the toilet. But they won't. Having you pay for your neighbor's home is just too attractive for both bankers, and the government.
Foreclosures will keep on happening, and they will do so increasingly, for a long time. There are untold millions of "homeowners" who either now or at some point in the next few years won't be able to afford their mortgages.
Unemployment will keep rising. A service economy is a warped boondoggle of a mindfcuk. The American economy is replete in jobs that don't add anything that has any value. A boom economy can carry the burden of those jobs. A bust economy must shed them or perish.
We are, depending on your view, something like 1 year or 2 years into the crisis. The one thing that underpins it, DEBT, has not been addressed at all. On the contrary, the government adds more of it every day. Lots more.
We are on a road to nowhere, and all we seem to have in the way of a response is denial. That does not bode well.
We're not very good in dealing with four letter words, are we?
In our defense: if we would face up to what our debt burden means, life would look a lot darker than it does in our hope and faith induced version. Then again, it would allow us to finally start doing something about it.
On Borrowed Time: Consumer-Led Recovery
Before pricing in a rapid economic recovery, investors might consider the fundamentals of the economy's workhorse -- the U.S. consumer. Despite recent frugality, consumers have barely dented their debt load. The Federal Reserve will offer a fresh peek at that mountain on Thursday, when it releases its "flow of funds" data for the first quarter. By the end of 2008, households were on the hook for $13.8 trillion in debt -- nearly matching the $14.3 trillion output of the entire U.S. economy, not adjusted for inflation, that year.
Households are shedding debt; they're just not doing it very quickly. They owed roughly 130% of disposable income at the end of 2008, down only slightly from a record 133% in the first quarter of 2008. An old saw about U.S. consumers is never to underestimate their willingness to spend beyond their means. The debt-to-income ratio first crossed 100% during the 2001 recession, when debt-fueled consumer spending helped spark a recovery.
It kept rising post-recession as super-low interest rates encouraged still more borrowing. And it rose even after the Fed raised rates, as consumers piled into mortgages to chase rising home prices. Money is easy again, but unemployment is far higher and wage growth slower than at any time during the 2001 recession.
Households have also now suffered the bursting of two bubbles -- housing and stocks -- carving $12.9 trillion from their net worth since the second quarter of 2007. The recent market rally should bolster household balance sheets, the flow of funds data might show. But real estate is still the biggest household asset, at 36% of net worth, and prices haven't stopped falling. Finally, credit is still far tighter than at any point during the 2001 recession, according to a Citigroup index of financial conditions.
"Without stronger financial underpinnings, growth will likely be narrowly based and not dynamic, and deflationary undercurrents will persist," Citi economist Robert DiClemente recently wrote. Credit should improve, but the era of easy credit is over, suggesting household debt could fall closer to a mere 100% of disposable income. That could sap at least $3 trillion in household borrowing from the economy -- hardly a recipe for a V-shaped recovery.
The Still Over-Leveraged Consumer
One of the primary reasons I am not a big believer in the green shoots thesis is due to the fragile financial condition of the Consumer.
Despite spending less time at the mall, throttling back consumption, and increasing their savings rate, the US consumer still finds themselves with too much debt and too little savings. Even worse (at least for the economy), they lack the income or the equity to fund their previous lifestyles.
In my opinion, consumer spending remains an unhealthy ~68% of the economy. While this is down from a peak of ~71%, it is way up from the 63% of the 1950s. The difference over that period has been the massive increase in revolving credit and accessible secure lending (2nd mortgages, HELOCs, etc.).
“Despite recent frugality, consumers have barely dented their debt load. The Federal Reserve will offer a fresh peek at that mountain on Thursday, when it releases its “flow of funds” data for the first quarter.
By the end of 2008, households were on the hook for $13.8 trillion in debt — nearly matching the $14.3 trillion output of the entire U.S. economy, not adjusted for inflation, that year.
Households are shedding debt; they’re just not doing it very quickly. They owed roughly 130% of disposable income at the end of 2008, down only slightly from a record 133% in the first quarter of 2008.”
I am not sure that really puts this into the proper context of indebtedness. Let’s go to David Rosenberg’s recent charts on the same subject:
HOUSEHOLD DEBT-TO-NET WORTH AT AN ALL TIME HIGH
HOUSEHOLD DEBT-TO-ASSETS RATIO
Other than the scales, these two charts look identical.
The bottom line remains: Two thirds of the economy is dependent upon consumer spending, Oil is now ~$70 a barrel (gasoline coming up on $3), and the consumer’s ability to borrow, tap equity, or otherwise live a profligate, unfunded lifestyle has been radically crimped.
It’s good to see the return of chartmeister Wcw:
His point is that it’s silly to talk about the number of states where house prices are flattish. The states which matter — the states accounting for the overwhelming majority of housing wealth in the country — have seen their house prices implode. And as a result homeowners are now poorer to the tune of trillions of dollars — or, as the chart shows, almost 50% of GDP. It’s easy to see why this recession is so severe, if you think about the unsustainable consumption boom fueled by mortgage equity withdrawals between 1997 and 2006.
The loss in wealth during the dot-com bust might have been similar, but the effect on consumption wasn’t nearly as big: people weren’t borrowing against their tech stocks in order to buy new kitchens. Now, of course, all that home equity has evaporated, leaving behind nothing but a stinking pile of toxic debt. We still have no idea how long it’s going to take to clean up the mess; all we know for sure is that the equity isn’t going to return any time soon.
The next great crisis: America's debt
At this rate, your share of the load will be $155,000 in a decade. How chronic deficits are putting the country on a path to fiscal collapse.
Normally Paul Krugman, the liberal pundit and Nobel laureate in economics, and Paul Ryan, a conservative Republican congressman from Wisconsin, share little in common except their first names and a scorching passion for views they champion from opposite political poles. So when the two combatants agree on a fundamental threat to the U.S. economy, Americans should heed this alarm as the real thing.
What's worrying both Krugman and Ryan is the rapid increase in the federal debt - not so much the stimulus-driven rise to mountainous levels in the next few years, but the huge structural deficits that, under all projections, keep building the burden far into the future to unsustainable, ruinous heights. "The long-term outlook remains worrying," warned Krugman in his New York Times column. Krugman strongly supports President Obama's spending plans but bemoans the shortfall in taxes to pay for them.
Ryan flays the administration for piling new spending on top of already enormous deficits. "This isn't a temporary stimulus but a ramp-up in debt followed by a greater explosion in spending and debt," he told Fortune, predicting a day when America's creditors will start viewing the U.S. Treasury as a risky bet. "The bond markets will come after us with a vengeance. We're playing with fire." Krugman favors far higher taxes, while Ryan wants to curb spending, but for now what's so big and so dangerous that it distresses such diverse types as Krugman and Ryan - and should scare all Americans - is the Great Debt Threat.
The bill is far too big for only the rich to pick up. There aren't enough of them. America will have to lean on citizens far below the $250,000 income threshold: nurses, electricians, secretaries, and factory workers. Within a decade the average household that pays income tax will owe the equivalent of $155,000 in federal debt, about $90,000 more than last year. What the Obama administration isn't telling Americans is that the only practical solution is a giant tax increase aimed squarely at the middle class. The alternative, big cuts in spending, aren't part of the President's agenda.
To keep the debt from wrecking the economy, the U.S. would need to raise annual federal income taxes an average of $11,000 in 2019 for all families that pay them, an increase of about 55%. "The revenues needed are far too big to raise from high earners," says Alan Auerbach, an economist at the University of California at Berkeley. "The government will have to go where the money is, to the middle class." The most likely levy: a European-style value-added tax (VAT) that would substantially raise the price of everything from autos to restaurant meals.
The growing debt will burden Americans not just with heavier taxes but also with higher interest rates and slower economic growth. On June 3, Fed chairman Ben Bernanke warned Congress that heavy borrowing is one of the factors driving up rates. The trend is just beginning, according to Allan Meltzer, the distinguished monetarist at Carnegie Mellon. "Rates can only stay low if foreign investors keep buying our debt," he warns. "I predict far higher rates over the next few years."
The risk that the U.S. will follow Britain, which was warned recently that it could lose its triple-A bond rating, has risen from virtually nil to a real possibility, judging by the sevenfold jump in the cost of insuring Treasury debt in the past year. The big borrowing is already spooking the bond markets. This year rates on 10-year Treasuries have jumped from 2.2% to 3.7%. A further increase in rates would aggravate the situation, raising the interest costs on the debt and increasing its size even more.
As Krugman and Ryan point out, the problem isn't so much the big budget gaps for this year and next, though their scale is shocking. It's the policies that will allow the trend to become far worse in the future. After the stimulus spending winds down and the economy recovers, our spending will still far exceed our revenues. In 2009 the U.S. will post a deficit of $1.8 trillion, or 13.1% of GDP, according to the nonpartisan Congressional Budget Office, twice the post-World War II record of 6% in 1983 under Ronald Reagan.
Now let's look forward to 2019, the final year for the budget projections for the administration and the CBO. Even in a scenario that assumes healthy economic growth, the CBO puts the 2019 deficit at $1.2 trillion, or 5.7% of GDP. "That wouldn't be a huge number for an economic downturn, but it's extremely high in a full-employment period," says William Gale, an economist at the centrist Brookings Institution. It gets worse from there. Around 2020 the cost of the big entitlements, Social Security and Medicare, soar as the peak wave of baby boomers retire.
It can't go on forever, and it won't. What will shock America into action is the prospect of fiscal collapse, which will grow more vivid each year. In 2008 federal borrowing accounted for 41% of GDP, about the postwar average. By 2019 the burden will double to 82% by the CBO's reckoning, reaching $17.3 trillion, nearly triple last year's level. By that point $1 of every six the U.S. spends will go to interest, compared with one in 12 last year. The U.S. trajectory points to the area that medieval maps labeled "Here Lie Dragons."
After 2019 the debt rises with no ceiling in sight, according to all major forecasts, driven by the growth of interest and entitlements. The Government Accountability Office estimates that if current policies continue, interest will absorb 30% of all revenues by 2040 and entitlements will consume the rest, leaving nothing for defense, education, or veterans' benefits.
To understand why a massive tax increase, probably a VAT, is the mostly likely outcome, it's crucial to look at what's driving the long-term, widening gap between revenues and spending. Put simply, spending is following a steep upward curve, while revenues are basically fixed as a portion of GDP. Why? Because future spending is driven mostly by entitlements, which are programmed to rise far faster than national income, while revenues depend heavily on the personal income tax, which yields receipts that typically rise or fall with GDP.
Under George W. Bush, the U.S. experienced a prelude to the crisis before us: Spending rose rapidly, while revenues remained reasonably flat. Bush created an expensive new entitlement, the Medicare drug benefit (cost this year: $63 billion), and let spending on domestic programs from education to veterans' benefits run wild. Over seven years the wars in Afghanistan and Iraq added a total of some $900 billion to the budget. All told, Bush raised spending from 18.5% to 21% of GDP, setting in motion a chronic budget gap by piling on new spending without paying for it.
Under Obama the Bush trend keeps going, but this time on steroids. It's important to see the Obama budget projections as two phases, the crisis period of astronomical spending in 2009 and 2010, and the normal phase, from 2011 to 2019. Most of his stimulus and other big programs are designed to give the economy a jolt in 2009 and 2010 and then largely disappear or be offset by tax increases - at least that's the plan. Then the surge in outlays comes from two forces that would wreak budget havoc for any President: the relentless rise in entitlements and the surge in debt interest.
Making the challenge far greater: Obama's budget is packed with a wish list of expensive new programs, led by a giant health-care-reform plan. He promises to pay for them mainly with higher taxes. But if extra revenues don't materialize - and most that he's proposed now look unlikely - will he abandon many of his cherished priorities or push them through without full funding, substantially deepening the debt crisis? The answer could determine how fast America reaches the hour of reckoning that could usher in a VAT.
Let's divide Obama's budget projections into the plausible, the impossible, and the questionable. First, the plausible: It's optimistic but highly possible that spending on Fannie Mae, Freddie Mac, and the Troubled Assets Relief Program (TARP) will fall from more than $500 billion this year to around $20 billion in 2010, and keep declining from there. It's also plausible that the costs of the wars in Afghanistan and Iraq will fall to around $50 billion a year.
Now the practically impossible: Obama is using a timeworn gimmick by pledging that nonmilitary discretionary spending, outlays that require annual approval, will rise just 2.1% a year from 2012 to 2019. It won't happen. Obama is raising spending in this category, which includes education, health research, and homeland security, a generous 9% in 2009 and 10% in 2010, excluding the stimulus outlays. "It's far more likely the category will match its historical growth rate of around 6.5% a year," says Brian Riedl, an economist with the conservative Heritage Foundation. The GAO says it will rise with GDP, at well over 5%.
Let's examine one of the questionables. Obama's prize initiative - and by far his biggest - is his health-care plan. In his 2010 budget request the President proposes a $635 billion "down payment" or "reserve fund" toward universal health coverage over ten years. As the administration acknowledges, the $635 billion doesn't come close to covering the full expense of the program. Leonard Burman, chief of the nonpartisan Tax Policy Center, estimates the total cost at $1.5 trillion.
Obama plans to offset the down payment from two sources: from limiting deductions for high earners - still another hit to the over-$250,000 crowd - and from squeezing the balance from Medicare through curbing unnecessary hospital stays and ending a plan offering HMO services. Once again, Obama will most likely lose a big part of the revenue he counted on. The limitation on deductions is encountering what looks like fatal opposition in Congress. Obama and his budget director, Peter Orszag, swear that the health-care plan will not worsen the deficit. "We are committed to making sure that health-care reform is deficit neutral," Orszag told Fortune.
The administration's attachment to reform goes far beyond the campaign to provide universal care. Orszag adds, correctly, that unbridled health-care costs, chiefly for Medicare, "are the most important driver of our long-term entitlement problem." Obama is also counting on massive investment in infrastructure to reduce medical costs by spreading electronic record keeping, promoting prevention and wellness, and conducting research to determine the most effective therapies. It's impossible to predict how much money those initiatives would actually save. The administration isn't making a forecast.
Although a VAT seems inevitable, the administration isn't ready to get behind it. "While we are open to ideas to finance health-care reform in a deficit-neutral way," says Orszag, "the VAT is an idea popular with academics, but not one seriously considered by policymakers." The problem, however, is that the income tax simply won't do the job. Closing the budget deficit in 2019 by taxing only people earning more than $250,000 would require lifting their federal marginal tax rates to around 60%.
The budget already calls for them to pay, on average, $30,000 more a year than in 2008, with the biggest hit falling on households with income above $500,000. Raising income taxes on all the Americans who pay them wouldn't work either. It would require a 55% increase per household, a political impossibility. The one other major new revenue raiser on the table is a tax on employer-provided health care, but that would merely help pay for a new program to cover the uninsured, rather than closing the deficit.
A VAT, on the other hand, would tax such a giant pool of purchases that a relatively low rate of 10% to 15% could generate the revenues needed to pay for Obama's agenda and balance the budget. The VAT, which would be imposed like a federal sales tax, is paid along the chain of production by wholesalers and retailers. The cost is passed to consumers in the form of higher prices. For the Democrats, the problem with the VAT is that it falls heavily on the middle class and low earners, who use a far higher portion of their incomes to buy things than the rich do.
Some of the sting can be removed by exempting food and clothing from the VAT or sending rebates to lower-income households. But the middle class would be a big target in any event. "A lot more people will pay," says Gale. "We cannot get there from here without a VAT." That brings us back to Krugman and Ryan. Wonder of wonders, they agree again - this time that a VAT is coming. Krugman likes the idea, though he says the middle class will pay more. "There's probably a value-added tax in our future," he writes.
Ryan despises the VAT as the beginning of the end of the American empire. "The VAT is definitely the trajectory Obama is putting us on," he laments. Ryan believes that the big growth in government in Europe came from the easy money it provided. He makes a good point. It's not a destiny to be desired. And when the two Pauls agree, you can bet it's where things are headed.
The labor market has NOT yet signaled a turning point
The rate of decline in employment moderated substantially in May, according to the BLS figures released June 5, to about half the monthly rate of job loss recorded over the preceding six months (345,000 vs. 642,000). The news was received in a variety of ways.
First, the cynics. They tend to wax sarcastic at the idea of “things are not getting worse quite as fast as they were” as a good-news proposition. But a wide variety of recent data indicate that the economy is no longer in the state of free-fall that it entered last September, and this is indeed good news. To begin to level off is the first step toward the start of the recovery.
Second, the academics note (correctly) that there is little information in each individual monthly statistical fluctuation that is measured, because the data are inevitably noisy. Still, the public wants to know, in real time, what is the best we can glean from the information we have.
Third, the financial press, in particular, had been asking whether this quarter could turn out to be the bottom of the recession. The May employment report encouraged speculation that the answer was “yes.” The stock market reacted positively.
The members of the NBER Business Cycle Dating Committee (of which I am one) will be responsible for calling the trough when the time is right. We have a range of views regarding the proper place of employment numbers in such deliberations. But one can say, on the one hand, that a decline in economic activity is a decline in economic activity, and therefore still a state of recession, even if the rate of decline has moderated a lot. One can also say, on the other hand, that employment is usually a lagging indicator of economic activity. (For example, the economy continued to lose jobs long after the ends of the 1991 and 2001 recessions. Hence the “jobless recoveries.”)
Speaking entirely for myself, I like to look at the rate of change of total hours worked in the economy. Total hours worked is equal to the total number of workers employed multiplied by the average length of the workweek for the average worker. The length of the workweek tends to respond at turning points faster than does the number of jobs. When demand is slowing, firms tend to cut back on overtime, and then switch to part-time workers or in some cases cut workers back to partial workweeks, before they lay them off.
Conversely, when demand is rising, firms tend to end furloughs, and if necessary ask workers to work overtime, before they hire new workers. (The hours worked measure improved in April 1991 and November 2001 which on other grounds were eventually declared to mark the ends of their respective recessions.) The phenomenon is called “labor hoarding” and it is attributable to the costs of finding, hiring and training new workers and the costs in terms of severance pay and morale when firing workers.
Unfortunately, as reported by Forbes, pursuing this logic leads to second thoughts about whether the most recent BLS announcement was really good news after all. The length of the average work week fell to its lowest since 1964! The graph below shows that, not only did total hours worked decline in May, but the rate of decline (0.7%) was very much in line with the rate of contraction that workers have experienced since September.
Hours worked suggests that the hope-inspiring May moderation in the job loss series may have been a monthly aberration. If firms were really gearing up to start hiring workers once again, why would they now be cutting back as strongly as ever on the hours that they ask their existing employees to work? My bottom line: the labor market does not quite yet suggest that the economy has hit bottom.
The Media Fall for Phony 'Jobs' Claims
Tony Fratto is envious. Mr. Fratto was a colleague of mine in the Bush administration, and as a senior member of the White House communications shop, he knows just how difficult it can be to deal with a press corps skeptical about presidential economic claims. It now appears, however, that Mr. Fratto's problem was that he simply lacked the magic words -- jobs "saved or created."
"Saved or created" has become the signature phrase for Barack Obama as he describes what his stimulus is doing for American jobs. His latest invocation came yesterday, when the president declared that the stimulus had already saved or created at least 150,000 American jobs -- and announced he was ramping up some of the stimulus spending so he could "save or create" an additional 600,000 jobs this summer. These numbers come in the context of an earlier Obama promise that his recovery plan will "save or create three to four million jobs over the next two years."
Mr. Fratto sees a double standard at play. "We would never have used a formula like 'save or create,'" he tells me. "To begin with, the number is pure fiction -- the administration has no way to measure how many jobs are actually being 'saved.' And if we had tried to use something this flimsy, the press would never have let us get away with it."
Of course, the inability to measure Mr. Obama's jobs formula is part of its attraction. Never mind that no one -- not the Labor Department, not the Treasury, not the Bureau of Labor Statistics -- actually measures "jobs saved." As the New York Times delicately reports, Mr. Obama's jobs claims are "based on macroeconomic estimates, not an actual counting of jobs." Nice work if you can get away with it.
And get away with it he has. However dubious it may be as an economic measure, as a political formula "save or create" allows the president to invoke numbers that convey an illusion of precision. Harvard economist and former Bush economic adviser Greg Mankiw calls it a "non-measurable metric." And on his blog, he acknowledges the political attraction.
"The expression 'create or save,' which has been used regularly by the President and his economic team, is an act of political genius," writes Mr. Mankiw. "You can measure how many jobs are created between two points in time. But there is no way to measure how many jobs are saved. Even if things get much, much worse, the President can say that there would have been 4 million fewer jobs without the stimulus."
Mr. Obama's comments yesterday are a perfect illustration of just such a claim. In the months since Congress approved the stimulus, our economy has lost nearly 1.6 million jobs and unemployment has hit 9.4%. Invoke the magic words, however, and -- presto! -- you have the president claiming he has "saved or created" 150,000 jobs. It all makes for a much nicer spin, and helps you forget this is the same team that only a few months ago promised us that passing the stimulus would prevent unemployment from rising over 8%.
It's not only former Bush staffers such as Messrs. Fratto and Mankiw who have noted the political convenience here. During a March hearing of the Senate Finance Committee, Chairman Max Baucus challenged Treasury Secretary Timothy Geithner on the formula. "You created a situation where you cannot be wrong," said the Montana Democrat. "If the economy loses two million jobs over the next few years, you can say yes, but it would've lost 5.5 million jobs. If we create a million jobs, you can say, well, it would have lost 2.5 million jobs. You've given yourself complete leverage where you cannot be wrong, because you can take any scenario and make yourself look correct."
Now, something's wrong when the president invokes a formula that makes it impossible for him to be wrong and it goes largely unchallenged. It's true that almost any government spending will create some jobs and save others. But as Milton Friedman once pointed out, that doesn't tell you much: The government, after all, can create jobs by hiring people to dig holes and fill them in.
If the "saved or created" formula looks brilliant, it's only because Mr. Obama and his team are not being called on their claims. And don't expect much to change. So long as the news continues to repeat the administration's line that the stimulus has already "saved or created" 150,000 jobs over a time period when the U.S. economy suffered an overall job loss 10 times that number, the White House would be insane to give up a formula that allows them to spin job losses into jobs saved.
"You would think that any self-respecting White House press corps would show some of the same skepticism toward President Obama's jobs claims that they did toward President Bush's tax cuts," says Mr. Fratto. "But I'm still waiting."
America’s Sea of Perilous Red Ink Was Years in the Making
There are two basic truths about the enormous deficits that the federal government will run in the coming years. The first is that President Obama’s agenda, ambitious as it may be, is responsible for only a sliver of the deficits, despite what many of his Republican critics are saying. The second is that Mr. Obama does not have a realistic plan for eliminating the deficit, despite what his advisers have suggested.
The New York Times analyzed Congressional Budget Office reports going back almost a decade, with the aim of understanding how the federal government came to be far deeper in debt than it has been since the years just after World War II. This debt will constrain the country’s choices for years and could end up doing serious economic damage if foreign lenders become unwilling to finance it.
Mr. Obama — responding to recent signs of skittishness among those lenders — met with 40 members of Congress at the White House on Tuesday and called for the re-enactment of pay-as-you-go rules, requiring Congress to pay for any new programs it passes. The story of today’s deficits starts in January 2001, as President Bill Clinton was leaving office. The Congressional Budget Office estimated then that the government would run an average annual surplus of more than $800 billion a year from 2009 to 2012. Today, the government is expected to run a $1.2 trillion annual deficit in those years.
You can think of that roughly $2 trillion swing as coming from four broad categories: the business cycle, President George W. Bush’s policies, policies from the Bush years that are scheduled to expire but that Mr. Obama has chosen to extend, and new policies proposed by Mr. Obama. The first category — the business cycle — accounts for 37 percent of the $2 trillion swing. It’s a reflection of the fact that both the 2001 recession and the current one reduced tax revenue, required more spending on safety-net programs and changed economists’ assumptions about how much in taxes the government would collect in future years.
About 33 percent of the swing stems from new legislation signed by Mr. Bush. That legislation, like his tax cuts and the Medicare prescription drug benefit, not only continue to cost the government but have also increased interest payments on the national debt. Mr. Obama’s main contribution to the deficit is his extension of several Bush policies, like the Iraq war and tax cuts for households making less than $250,000. Such policies — together with the Wall Street bailout, which was signed by Mr. Bush and supported by Mr. Obama — account for 20 percent of the swing.
About 7 percent comes from the stimulus bill that Mr. Obama signed in February. And only 3 percent comes from Mr. Obama’s agenda on health care, education, energy and other areas. If the analysis is extended further into the future, well beyond 2012, the Obama agenda accounts for only a slightly higher share of the projected deficits.
How can that be? Some of his proposals, like a plan to put a price on carbon emissions, don’t cost the government any money. Others would be partly offset by proposed tax increases on the affluent and spending cuts. Congressional and White House aides agree that no large new programs, like an expansion of health insurance, are likely to pass unless they are paid for.
Alan Auerbach, an economist at the University of California, Berkeley, and an author of a widely cited study on the dangers of the current deficits, describes the situation like so: “Bush behaved incredibly irresponsibly for eight years. On the one hand, it might seem unfair for people to blame Obama for not fixing it. On the other hand, he’s not fixing it.” “And,” he added, “not fixing it is, in a sense, making it worse.”
When challenged about the deficit, Mr. Obama and his advisers generally start talking about health care. “There is no way you can put the nation on a sound fiscal course without wringing inefficiencies out of health care,” Peter Orszag, the White House budget director, told me. Outside economists agree. The Medicare budget really is the linchpin of deficit reduction. But there are two problems with leaving the discussion there.
First, even if a health overhaul does pass, it may not include the tough measures needed to bring down spending. Ultimately, the only way to do so is to take money from doctors, drug makers and insurers, and it isn’t clear whether Mr. Obama and Congress have the stomach for that fight. So far, they have focused on ideas like preventive care that would do little to cut costs.
Second, even serious health care reform won’t be enough. Obama advisers acknowledge as much. They say that changes to the system would probably have a big effect on health spending starting in five or 10 years. The national debt, however, will grow dangerously large much sooner. Mr. Orszag says the president is committed to a deficit equal to no more than 3 percent of gross domestic product within five to 10 years. The Congressional Budget Office projects a deficit of at least 4 percent for most of the next decade.
Even that may turn out to be optimistic, since the government usually ends up spending more than it says it will. So Mr. Obama isn’t on course to meet his target. But Congressional Republicans aren’t, either. Judd Gregg recently held up a chart on the Senate floor showing that Mr. Obama would increase the deficit — but failed to mention that much of the increase stemmed from extending Bush policies. In fact, unlike Mr. Obama, Republicans favor extending all the Bush tax cuts, which will send the deficit higher.
Republican leaders in the House, meanwhile, announced a plan last week to cut spending by $75 billion a year. But they made specific suggestions adding up to meager $5 billion. The remaining $70 billion was left vague. “The G.O.P. is not serious about cutting down spending,” the conservative Cato Institute concluded. What, then, will happen? “Things will get worse gradually,” Mr. Auerbach predicts, “unless they get worse quickly.” Either a solution will be put off, or foreign lenders, spooked by the rising debt, will send interest rates higher and create a crisis.
The solution, though, is no mystery. It will involve some combination of tax increases and spending cuts. And it won’t be limited to pay-as-you-go rules, tax increases on somebody else, or a crackdown on waste, fraud and abuse. Your taxes will probably go up, and some government programs you favor will become less generous. That is the legacy of our trillion-dollar deficits. Erasing them will be one of the great political issues of the coming decade.
How Trillion-Dollar Deficits Were Created
To understand the looming deficits, The New York Times analyzed Congressional Budget Office projections of the budget surplus or deficit for the years 2009-12, President Obama’s current term. The budget office has been making estimates for these years for nearly a decade now. The numbers that appear below are the average annual deficit or surplus for this four-year period.
U.S. Trade Deficit Grows as Exports Drop to Three-Year Low
The U.S. trade deficit widened in April for a second month as some of the world’s largest economies continued to contract, pushing exports to the lowest level in almost three years. The gap between imports and exports grew 2.2 percent to $29.2 billion, in line with forecasts, from a revised $28.5 billion in March that was larger than previously estimated, Commerce Department figures showed today in Washington. Foreign demand for U.S. goods dropped 2.3 percent, exceeding a decrease in imports.
Imports may be first to rebound later this year as the U.S. economy begins to expand, while exports languish until a recovery takes hold among trading partners from Japan to Germany, widening the deficit further. That danger underscores Treasury Secretary Timothy Geithner’s call for other nations to implement stimulus and financial-rescue plans.
“The U.S. will start to come out of the recession a bit before everyone else as we’ve done more to stimulate the economy,” said Jay Bryson, global economist at Wachovia Corp. in Charlotte, North Carolina. Trade “won’t contribute much to growth.” The trade gap was projected to widen to $29 billion from an initially reported $27.6 billion in March, according to the median forecast in a Bloomberg News survey of 73 economists. Deficit projections ranged from $31.5 billion to $26 billion.
U.S. stocks were little changed as a jump in commodities propelled a rally among raw-material companies, while technology shares dropped. The Standard & Poor’s 500 Stock Index was up 0.2 percent at 942.58 as of 10:33 a.m. in New York. Treasuries fell, sending yields on benchmark 10-year notes to 3.90 percent from 3.86 percent late yesterday. A growing gap means trade will not help the economy this year as much as in 2008, when it contributed the most to growth in three decades.
The drop in exports reflected reduced foreign demand for engines, machinery and metals. At $121.1 billion, the level of exports was the lowest since July 2006.
“Recovery here depends on recovery abroad,” Geithner, who departs for weekend meetings in Italy with counterparts from some of the world’s biggest economies, told lawmakers yesterday. “We are working closely with other major economies to put in place the fiscal stimulus and make the financial repairs necessary to ensure U.S. and global recovery.”
Exports to Japan dropped to the lowest level since 1994 and those to South and Central America were the weakest in two years, today’s report showed. Imports decreased 1.4 percent to $150.3 billion, the fewest since September 2004. The drop was led by declines in purchases of fuel other than crude oil, drilling equipment, computer accessories and toys from abroad. Imports of crude oil rose as the price climbed to $46.60 a barrel from $41.36 in March, according to today’s report.
Higher fuel costs will probably keep boosting the import bill. A barrel of crude oil on the New York Mercantile Exchange rose above $71 today for the first time in seven months, compared with an average $49.95 in April. After eliminating the influence of prices, which are the numbers used to calculate gross domestic product, the trade deficit grew to $39.4 billion from $39.1 billion in March. April’s reading was just above the $39 billion average for the first quarter, indicating changes in trade, so far, will have little influence on growth.
The politically sensitive trade gap with China increased to $16.8 billion from $15.6 billion in the prior month. Geithner, on a visit to China this month, avoided a showdown over its currency, the yuan. He declined to repeat his comment in January that the nation was “manipulating” the currency and instead welcomed a Chinese commitment to more flexibility over time. The yuan has gained 0.3 percent in the past six months. A narrowing of the gap prevented the U.S. economy from contracting even more last year. Trade contributed 1.4 percentage points to growth in 2008, the most since 1980.
The boost continued in the first quarter. The economy shrank at a 5.7 percent annual rate in the first the months of 2009, even as trade made a positive contribution of 2.2 percentage points. An improvement in trade will likely come too late to help global growth. The International Monetary Fund in April said the world economy will shrink 1.3 percent this year and a recovery may take place in the first half of next year. It predicted a 1.9 percent expansion for all of 2010.
Some regions are faring better than others. China may expand 7.5 percent this year, according to the median forecast in a Bloomberg survey. Still, the government cautioned this month that a recovery isn’t yet solid. Japan’s deepest postwar recession is easing, according to the government’s broadest measure of economic health released this week.
For some companies, overseas sales are helping cushion weakness elsewhere. Texas Instruments Inc., the second-largest U.S. semiconductor maker, raised its second-quarter sales and profit forecasts this week as customers slowed the pace of inventory reductions and demand improved in Asia. “Orders were strong in both April and May thus far, so all that’s looking good,” Vice President Ron Slaymaker said on a conference call this week. “Asia is the biggest driver of growth with the U.S. and Europe continuing to lag.”
Week-to-week mortgage applications fall 7.2%: MBA
Mortgage applications fell a seasonally adjusted 7.2% during the first week of June from the week before, as volumes of filings to refinance existing home loans continued their recent pullback, the Mortgage Bankers Association reported on Wednesday. With interest rates pressing higher, refinancing applications dropped 11.8% in the week ended June 5, while applications for mortgages to purchase home rose a seasonally adjusted 1.1%, according to the Washington-based MBA's weekly survey, which encompasses half of all U.S. retail residential mortgage applications.
Total application volume was still up an unadjusted 7.6% compared with the same week in 2008. The seasonally adjusted four-week moving average for all mortgages was down 8.7%. Overall, mortgage filings as tracked by the MBA had dropped 16.2% on a seasonally adjusted basis in the week ended May 29 from a week earlier, also paced by lower refinancing activity. As in the previous week, interest rates charged for home loans moved sharply higher.
The rate on 30-year fixed-rate mortgages averaged 5.57% last week, up from 5.25% for the final week of May, while the average for 15-year fixed-rate mortgages climbed to 5.10%, up from 4.80%. And for one-year adjustable-rate mortgages, the average stood at 6.75%, up from 6.61%. To obtain the rates, the 30-year mortgage required payment of an average 1.09 point, the 15-year mortgage had an average 1.04 point and the 1-year ARM required an average 0.10 point. A point is 1% of the mortgage amount, charged as prepaid interest. Refinancings made up 59.4% of all applications filed last week, down from 62.4% the previous week, the MBA said. Adjustable-rate mortgages accounted for 3.4%, up 3.0%.
Latvia’s currency crisis is a rerun of Argentina’s
by Nouriel Roubini
After a recent failed public debt auction, the authorities in Latvia are desperately trying to prevent a depreciation of the currency, the lat. The country’s predicament is similar to the one that faced Argentina in 2000-01: a severe recession driven by global financial shocks, a sudden drying up of capital inflows and the need to reduce a large external deficit worsened by an unsustainable currency peg. As in Argentina, the International Monetary Fund initially went along – somewhat uncomfortably – with the authorities’ strong preference for not letting the currency depreciate, in spite of its significant overvaluation. But a real exchange rate depreciation is necessary to restore the country’s competitiveness; in its absence, a painful adjustment of relative prices can occur only via deflation and a fall in nominal wages that will take too long and exacerbate the recession.
Draconian cuts in public spending will be required if Latvia is to improve the current account. But this is becoming politically unsustainable. And while fiscal consolidation is needed – as Argentina found in 2000-01 – it will make the recession more severe in the short run. So it is a self-defeating strategy as long as the currency remains overvalued. Of course, as in Argentina, letting the currency depreciate would lead to massive negative balance-sheet effects. The large foreign liabilities of households, companies and banks are in foreign currency; the real value in local currency of such debts would increase sharply after a devaluation. Devaluation may therefore lead to default by many private sector agents – and as the country’s banks are local subsidiaries of Swedish banks, a financial meltdown in Latvia could prove damaging for its neighbours.
Nonetheless, devaluation seems un?avoidable and the IMF programme – which ruled it out – is thus inherently flawed. The IMF or the European Union could increase financial support for Latvia but, as in Argentina, this would be throwing good money after bad. International resources are better used to mitigate the collateral damage of depreciation. An introduction of the euro immediately after devaluation could help prevent the exchange rate from overshooting, although it would require the eurozone to admit a country that does not yet satisfy the formal criteria for membership. Euroisation after depreciation is a more credible strategy for Latvia than dollarisation would have been for Argentina, as Latvia was on its way to membership and its business cycle is highly correlated with that of the EU. Euroisation without depreciation will not work, as a real depreciation is necessary to restore competitiveness. Of course, any depreciation – with or without euroisation – will make many foreign currency debts unsustainable and will require a forced debt restructuring, as in the case of Argentina.
To minimise the risk of contagion, the best strategy may be: depreciate the currency, euroise after depreciation, restructure private foreign currency liabilities without a formal “default”, and augment the IMF plan to limit the financial fallout. It is a risky strategy but – as in Buenos Aries nine years ago – when plan A does not work it is time to move to plan B sooner rather than later. Delaying plan B would only cause a bigger blowout when the unavoidable currency crisis eventually occurs. It is to be hoped the lessons of Argentina in 2001 have been learnt.
Latvia’s authorities are trying desperately to prevent depreciation by intervening in the foreign exchange market. While the very thin interbank market slows down the rate at which domestic and foreign financial institutions can short the Latvian currency and put pressure on the central bank reserves, the country is bleeding forex reserves at an alarming rate. Only a miracle or some draconian and credible fiscal adjustment (that does not exacerbate the recession) could restore the peg’s credibility and lead to a growth recovery. At this point, a currency and financial crisis is pretty much unavoidable; the issue is how to minimise the domestic and international costs of the needed change in the policy regime. As the experience with Argentina suggests, procrastinating will make the unavoidable crash – and the regional contagion – even more ?dramatic and costly.
House panel to subpoena Fed over BofA-Merrill deal
A House of Representatives committee on Tuesday said it would subpoena the Federal Reserve to force the central bank to surrender documents regarding its role in Bank of America's (BAC.N) takeover of Merrill Lynch last year. The subpoena comes two days before Bank of America Chief Executive Ken Lewis is set to testify before the House Oversight Committee, which is probing the transaction, what Lewis knew about Merrill's financial condition and potential regulatory pressure to complete the deal. Lewis, in testimony prepared for the hearing, said he became aware of "significant, accelerating losses" at Merrill in mid-December after the shareholder vote. Lewis has consistently maintained in statements that he did not realize the severity of Merrill's problems until after that vote.
The CEO, who has since been ousted as chairman, also said he told Treasury and Fed officials he was considering declaring a "material adverse change" which would have allowed it to walk away from the acquisition. "Treasury and Federal Reserve representatives asked us to delay any such action, and expressed significant concerns about the systemic consequences," Lewis said in the testimony. Fed chairman Ben Bernanke has denied previous assertions by Lewis about pressure. A spokeswoman for former Treasury Secretary Henry Paulson has said Paulson told Lewis there was no need to terminate the deal. Chairman Edolphus Towns was joined by the ranking Republican Darrell Issa in agreeing to serve the subpoena on the Federal Reserve.
The lawmakers said the Fed would only allow committee staff to review documents at the Federal Reserve's Washington offices, which they did for several days, according to a letter dated June 3 to Fed chairman Ben Bernanke. "Following the staff review, we conclude that we will need copies of these documents," they wrote. The Fed has been under intense pressure from Congress to make public more information about its lending programs, during a time when it has taken an unprecedented role in bailing out financial firms and other companies. A Fed spokeswoman said the bank was concerned that documents sought by the committee contained information that financial institutions supply regulators on the condition they maintain confidentiality.
Faced with the subpoena, the Fed will now hand over the documents, the spokeswoman said. Among the documents sought are handwritten notes from a December 19 meeting between Bernanke, Bank of America chief executive Ken Lewis and others. Lewis has said the government pressured him to pursue the deal and to withhold information about losses at Merrill from investors, but regulators have disputed this characterization. Bernanke in May resolutely refuted that claim. "I absolutely did not in any way ask Mr Lewis to obscure any disclosures or to fail to report information that should be reported," he told a congressional committee last month. The lawmakers had previously asked Ben Bernanke to turn over dozens of documents related to the merger on March 30 and April 23.
Fed Said to Retreat From Seeking Debt-Issuing Power
The Federal Reserve has backed off from seeking a new tool to forestall inflation, refraining from asking Congress for the power to issue its own debt, according to a person familiar with the matter. Putting off the issue may avoid a political clash over whether the Fed should begin winding down its emergency lending programs while unemployment remains elevated. The central bank intends to rely instead on paying interest on banks’ reserve deposits to prevent a flood of cash into the economy. After central bankers repeatedly said Fed bills would be a useful additional tool to mop up liquidity, Chairman Ben S. Bernanke omitted mention of the idea in congressional testimony last week. The person, who spoke on condition of anonymity, said the Fed hasn’t made a formal request to lawmakers.
“It’s important that we have all the tools in place” for the Fed to drain liquidity when it’s ready, House Financial Services Committee Chairman Barney Frank, a Massachusetts Democrat, said in an interview. Still, “it would be a mistake to start dealing with that before you know when, how, how much, et cetera.” House Budget Committee Chairman John Spratt, a South Carolina Democrat, said in an interview after Bernanke testified to his panel June 3 that “if it was something that the Fed needed, he wasn’t pushing it with this committee.” Wisconsin Representative Paul Ryan, the panel’s ranking Republican, said “I do not like that idea at all.”
Christopher Dodd, the Connecticut Democrat who chairs the Senate Banking Committee, has indicated he’s wary of granting the Fed additional regulatory powers. “The instances in which the Fed has failed to execute its existing authority are numerous,” Dodd said at a March 19 hearing. In testimony before the budget committee, Bernanke suggested the Fed hasn’t abandoned the idea of issuing its own debt. Beyond the Fed’s current set of tools, Bernanke said “there are still other possibilities that we’re looking at and that perhaps we can discuss with Congress at some point,” without mentioning the authority to issue debt.
“We suspect the omission from Bernanke’s litany was not a slip of the tongue,” Joseph Abate, a money-market strategist at Barclays Capital in New York, said in a research note June 4. Abate said in an interview that lawmakers may be reluctant to allow the Fed to issue debt that’s not subject to the Treasury limit and competes with other government securities. In addition, were Fed officials to ask Congress for debt-issuing powers, they would be “opening themselves up to political interference,” he said.
The Fed has replenished and added liquidity in credit markets over the past year through lending programs and purchases of securities, more than doubling assets on its balance sheet to $2.1 trillion.
Gaining authority to issue its own debt would allow the Fed to reduce reserves in the banking system and push up interest rates without having to shrink the balance sheet, San Francisco Fed President Janet Yellen said March 25.
In his congressional testimony last week, Bernanke instead highlighted the Fed’s authority to pay interest on banks’ reserve deposits as a tool that bears “very importantly” on the central bank’s ability to tighten credit.
“We can raise interest rates, and then we can tighten policy,” Bernanke said in response to a question from Representative Rick Larsen, a Washington Democrat. Lacking the power to issue its own debt separates the Fed from central banks in Japan, China, the U.K. and other countries that do have such authority.
New York Fed President William Dudley said last week that under such a program, Fed debt would probably be restricted to maturities of less than 30 days. “We’d like Congress to consider it,” Dudley said, according to a transcript of an interview with the Economist. “It’s nice to have -- as opposed to critical.” Yet seeking the power may lead to other legislation. The Senate in April passed a nonbinding resolution asking the Fed to identify borrowers, a move Bernanke has said would be “counterproductive” and result in “severe adverse consequences” for the economy. Another resolution called for an “evaluation of the appropriate number and the associated costs” of the Fed banks.
Bernanke gave Congress a similar opening last year when he sought, and received, immediate authority from Congress to pay banks interest on the reserves they kept at the Fed. The 27-word clause was part of the October law creating the $700 billion Troubled Asset Relief Program. With that legislation, Congress placed several new obligations on the central bank. The Fed was required to devise a policy to ease terms on mortgages it had acquired, and to file reports with the legislature on emergency-lending programs and bailouts.
At the House Budget hearing, a lawmaker brought up the idea of making Fed district-bank presidents subject to Senate confirmation. Currently the presidents are nominated by the banks’ boards of directors and approved by the U.S.-appointed Fed governors in Washington. Representative Marcy Kaptur, an Ohio Democrat, asked Bernanke during the hearing whether he supported the idea. “No,” the chairman replied. “The last thing the Fed wants is for its independence of monetary policy to be challenged,” said David M. Jones, president of DMJ Advisors LLC in Denver and a former Fed economist. “It’s very unlikely this debt thing would be pursued.”
The New York Fed Has Been Captured By Citigroup, Top Obama Official Complains
The New York Fed cannot effectively regulate Citi because it has been captured by the mega-bank, according to a top economic official inside the Obama administration. The close relationship between Citi executives and officials at the New York Fed is stymieing efforts to reform the bank and change its management, according to the official. The official asked not to be identified. Citi executives have told Charlie Gasparino that they are in a "regulatory purgatory," unsure about what the government's plans for them have been.
Recently, the Wall Street Journal reported that Sheila Bair's FDIC had been considering plans to oust senior management at the bank. Gasparino reported that Citi officials believe Bair herself leaked that story to the Journal in order to start the ball rolling. Earlier, we mentioned reports that Tim Geithner was reportedly advocating keeping Citi chief executive Vikram Pandit in place. Neither Bair nor Geithner, however, are the primary regulator for Citi. That job falls to New York Fed.
Was the TARP a Ruse?
The rush to repay TARP monies gives us another opportunity to consider why the hell this absurd financial giveaway ever happened in the first place. A close inspection suggests some dishonesty on the part of the prior Treasury Secretary. From its inception, the TARP never made much sense. Forcing banks that did not need money to accept government bailouts was simply irrational. The basis for the TARP went through several differing rationales — it began as a recapitalization of the major money center banks, then came the explanation of removing toxic assets, then it moved to freeing up credit and making banks lend again.
Its was $700 billion dollar pile of money in search of a justification for its existence. Most people still look at TARP the wrong way. When trying to discern what the true basis of it was, we eliminated what made no sense whatsoever, and what was left were a few strange ideas. When you eliminate the impossible, what’s left, no matter how improbable, becomes the best explanation. What was that explanation? In Bailout Nation, we discuss the possibility that The TARP was all a giant ruse, a Hank Paulson engineered scam to cover up the simple fact that CitiGroup (C) was teetering on the brink of implosion. A loan just to Citi alone would have been problematic, went this line of brilliant reasoning, so instead, we gave money to all the big banks.Bailout Nation excerpt:
“Shortly after the TARP was passed, Paulson added to its original intent—to use the funds to buy toxic debt from the banks—with a mishmash of programs and schemes, including:
- Injection of $250 billion into the nation’s banks.
- The U.S. government would guarantee new debt issued by banks for three years; this was designed to prompt banks to resume lending to one another and to customers.
- The FDIC offered unlimited guarantees on bank deposits in accounts that don’t bear interest—usually those of small businesses.
- The Treasury took preferred equity stakes in the nation’s largest banks (Goldman Sachs, Morgan Stanley, JPMorgan Chase, Bank of America, Citigroup, Wells Fargo, Bank of New York Mellon, and State Street).
Beyond those massive expenditures, Uncle Sam was to “temporarily guarantee $1.5 trillion in new senior debt issued by banks, as well as insure $500 billion in deposits in noninterest-bearing accounts, mainly used by businesses.” All told, the costs of the “bailout package came to $2.25 trillion, triple the size of the original $700 billion rescue package.” Now for the punch line: It was all an elaborate ruse, a coverup of the fact that Citigroup was busted.
As of October 2008, the other banks, while somewhat worse for wear, neither wanted nor needed the capital injection. None of them were in the same trouble as Citi. Even Bank of America’s problems via Merrill Lynch wouldn’t become acute until December 2008. Washington Mutual, the most troubled on the list, had already been put into FDIC receivership the month before.26 JPMorgan bought WaMu from the FDIC for under $2 billion, and Wachovia was swept up by Wells Fargo for about $15 billion. Thanks to a change in the tax law, Wells Fargo got to shelter $74 billion in profits from taxation. Instead of the FDIC absorbing a few billion in losses from Wachovia’s bad assets, the taxpayers lost 35 times that amount.
The hurry to repay this cheap cash confirms that the fix was in. If this banks were really in the basd shape Paulson suggested, they would hold onto this cheap source of credit. Instead, they want to throw the yoke of government monies off as soon as possible.The desire to return to their old compensation packages for executives cannot be the only factor . . .
Banks Repaying TARP to Be Freed of Bonus Curbs Imposed by Dodd
JPMorgan Chase & Co., Goldman Sachs Group Inc. and the eight other banks cleared yesterday to repay their U.S. government rescue money will be freed from legal limits on bonuses for their top 25 employees. The pay curbs, stricter than those already included in Treasury department rules, were inserted by Senator Christopher Dodd, a Connecticut Democrat, as an amendment to the Obama administration’s economic stimulus plan in February. They expire when a bank repays money received from the Troubled Asset Relief Program even if the government still holds warrants to purchase the bank’s common stock, according to the legislation.
Financial executives and recruiters warned that banks under the restrictions would have a tougher time recruiting and keeping employees. Bank of America Corp., Citigroup Inc. and Wells Fargo & Co. are the largest banks left out of yesterday’s list of companies approved by the Treasury Department to refund the government. “Stronger companies may really look to shore up their talent pool with top players and the place they’ll go hunting for them is companies with TARP restrictions,” said Steven E. Hall, managing director of New York-based Steven Hall & Partners.
For banks that had received more than $500 million of TARP money, the so-called Dodd amendment prohibits cash bonus payments to the five most senior officers and to the 20 “next most highly compensated employees.” Bonuses paid in restricted stock were allowed, as long as they didn’t vest until the TARP money was repaid and as long as the restricted stock isn’t worth more than one-third the employee’s total annual compensation.
Banks have been waiting since February for guidance from the Treasury on how to implement the rule, including clarification on how to determine which 20 employees to include. Bonus payments have traditionally made up the majority of pay for top executives on Wall Street, which capped salaries as part of an effort to tie compensation to revenue. Public scrutiny intensified last year when Merrill Lynch & Co. awarded $3.6 billion in bonuses after failing to make a profit in 18 months. Dodd’s amendment was added to the American Recovery and Reinvestment Act of 2009 after Merrill’s awards were publicized.
Some banks have already responded to the bonus limits by ratcheting up salaries. Morgan Stanley, which plans to return the $10 billion in TARP money it accepted in October, said on May 22 it was doubling the base salary of Chief Financial Officer Colm Kelleher and raising salaries for Co-Presidents James Gorman and Walid Chammah, among other top executives.
In addition to JPMorgan, Goldman Sachs and Morgan Stanley, the banks announcing yesterday that they plan to repay a combined $68 billion in TARP money were American Express Co., Bank of New York Mellon Corp., BB&T Corp., Capital One Financial Corp., Northern Trust Corp., State Street Corp. and U.S. Bancorp. Until the firms buy back warrants the government received as part of its capital injections, they remain subject to some TARP restrictions, said V. Gerard “Jerry” Comizio, a senior partner in the banking and financial institutions group at law firm Paul, Hastings, Janofsky & Walker LLP in Washington.
The restrictions include limits on common stock dividends and repurchases as well as the Treasury’s own compensation provisions, which allow banks to recoup bonuses in some circumstances and prohibit banks from agreeing to give executives so-called golden parachute payments when they leave, he said.
TARP Repayment — Some Questions for the “Perfect 10?
Good Evening: There has been no shortage of news items since I last wrote on June 2, but the S&P 500 today closed almost at the same price as it did one week ago. While equities have essentially moved sideways during this time frame, Treasury yields, the dollar, and commodity prices have all risen to varying degrees. Whether these moves are more noise than signal is debatable (I lean toward the noisier interpretation), but perhaps the confusing aspects of two of the bigger stories during the past week can be instructive.
Friday’s unemployment report and today’s announcement that 10 financial institutions have been granted permission to repay their TARP funding have, unfortunately, raised as many questions as they’ve answered. That the markets gyrated in the wake of the payrolls data and merely shrugged at the TARP story is clear. Clarity about what now lies ahead for the capital markets is what’s lacking. Bank stocks should be soaring with all the “positive” news they recently enjoyed, but they are treading water as the rest of the market rallies.
Is it possible that it has been the Fed’s quantitatively easy policies deserve more credit for the various moves in asset classes than any purported improvement in either U.S. banks or the U.S. economy? Is it also possible that investors are wondering whether or not it makes sense to set the bankers loose again before some important questions receive credible answers? The answers may not be knowable in advance, but bank stock investors, taxpayers, and equity owners of all stripes should at least be asking these questions.
Before posing these inquiries, let’s first examine last Friday’s nonfarm numbers and the uncertainty surrounding their implications. The number of those losing their jobs in May came in well below expectations (-345,000 vs. the -530,000 estimate), but the birth/death model accounted for the difference by adding 220,000 fictional job-finders at a time when the model was designed to be subtracting them. In addition, the unemployment rate ticked up to a worrisome 9.4%, while the wages and hours worked statistics both portrayed a work force that is struggling either to find work or generate enough income from the jobs they are managing to still hold.
In response to the contradictions apparent in the nonfarm figures, the green shoots crowd lifted offers for equities and hit bids for Treasurys in the early going on Friday morning, but these moves faded as the data were more closely examined. The confusion over just what the May employment data mean for the economy and securities markets lasted for the rest of the trading session as last week drew to an unsatisfactory close. Taken in context with the recent announcement that credit card delinquency rates are starting to shoot higher, my own view is that Friday’s data don’t bode well for the 70% of GDP that consumer spending comprises.
There has been little in the way of economic data this week, so let’s turn to the announcement that 10 financial institutions seem to have been given permission to redeem their TARP preferred equity securities (see below). Fresh from road shows that have swelled their capital coffers by the tens of billions, these institutions are eager to show the world they are safe, solvent, and ready to once again stand on their own. The Federal Reserve, the Treasury Department, and the FDIC would like the emphasis to be on the safe and solvent part of the previous sentence, while the managements of these firms no doubt think more of leaving behind the scrutiny and red tape that came along with Uncle Sam’s kindness. All parties concerned hope this move to repay the TARP removes any lingering stigma and engenders confidence that all is now well with the banking system.
It was these hopes, as well as higher Q2 guidance from Texas Instruments, that enabled stocks to rally as trading commenced this morning. A 0.5% pop to the upside helped extend yesterday’s late afternoon rally, but the averages soon settled back toward the unchanged mark. A weak dollar and higher commodities prices provided a tailwind for the energy, mining and materials names, and the indexes were able to set mild new highs in the early afternoon. Stocks then drifted into the closing bell, finishing with modest gains on light volume. The Dow Transports (+1.5%) led the way, while the Dow Industrials lagged by finishing virtually unchanged.
The action in Treasurys centered on both a successful 3 year note auction and a steepening yield curve. A high bid-to-cover ratio and a large slug of indirect bidders (likely central banks) pushed yields on the short end of the curve down by as much as 10 bps. The middle of the curve didn’t fare as well, and the yield on the 30 year bond actually rose 4 basis points as investors on that end of the yield curve braced themselves for more supply on Thursday. The dollar index retreated more than 1%, a move that gave a boost to the commodity complex. With oil and copper surging ahead, the CRB index was able to rally almost 2.5%.
Mr. Market seems to be withholding judgment as to whether the TARP repayment announcement actually represents the glad tidings smiling regulators and bank CEOs had hoped it would bring. It should be noted that despite all the sightings of green shoots and successful bank secondary offerings, the KBW bank stock index has made exactly zero progress since mid April. Then again, hopes for an economic recovery have led to a 40% rise in the S&P since March; credit spreads have markedly narrowed; rising Treasury yields in part reflect a flight away from perceived safety; and some prices at the short end of the yield curve seem to be pricing in a chance the Fed will actually lift the fed funds target by November (see below). Even commodities have climbed off the canvas to once again show some spunk, so why aren’t these supposedly cheap bank stocks flying right now?
The reasons may have as much to do with the monetary and regulatory climates as they do with any warming in the economic climate. With Washington trying to stimulate with both hands, and with the Fed’s fat fingers on the printing presses, it is of little wonder that some of all the money zipping around has found its way into the asset markets. At the very least, the policy moves described above have led to an increase in confidence of the type which now sees bulls easily outnumber bears in sentiment surveys. The policy responses have caused many to want to believe the banks are now safe and that the economy is on the mend. By fostering the belief that tomorrow will be better than today, our policy makers have succeeded in delivering enough of a recovery in asset prices to help recapitalize the banking system. Will it be enough? And should we now set these “perfect 10? banks free?
After seeing the rules surrounding the TARP change as often as the weather in Chicago, perhaps market participants still have a few questions before they answer either of the above in the affirmative. And before they allow the bankers to throw off the TARP and go about the business of collecting the bonuses that accrue to those who borrow and lend, many taxpayers want to know just what are the terms and conditions under which a bank can gain its freedom from the TARP. I’ve seen quite a few lists, and the following is a less than exhaustive attempt at reprising them:
- With all the chatter about responsible regulatory reform, shouldn’t the rules governing bank conduct (e.g. leverage ratios, off balance sheet vehicles, etc.) be put in place before TARP repayments flow in?
- Before TARP preferreds can be redeemed, shouldn’t the banks swear off all the other forms of federal assistance (the alphabet soup lending programs, FDIC-guaranteed debt, etc.)?
- What exactly does “fair market value” mean when a bank desires to repurchase the equity warrants issued to Treasury in return for the emergency funding given the banks through TARP? No offense to the astro-physicists the banks have on staff, but could we ask for some third party verification of the models used to calculate the fair value of these warrants?
- What happens if — Nassim Taleb forbid — a Black Swan appears (or even some continued erosion in our economy) that causes a bank or two to want to go back and ask the TARP to reissue them some preferred equity? Should we let them back in under anything other than truly onerous terms, if at all?
I bring these questions up lest we allow the hastily arranged TARP funding for banks to be repaid with equal haste and without the luxury of forethought we taxpayers should now enjoy on the far side of what was a severe financial crisis. To require anything less than some answers to these fairly straightforward questions would lead to an even greater degree of moral hazard than has already been risked on these large financial institutions. Before we let even one bank redeem their TARP preferred stock, let’s make sure we don’t continue to encourage privatized profits and socialized risks.
Banks Fleeing TARP Face $5 Billion Warrant Repayment
Ten lenders that persuaded the U.S. yesterday to sell back preferred shares for $68 billion may need to spend another $5.1 billion on warrants held by the Treasury to free themselves from government curbs. JPMorgan Chase & Co.’s warrants alone are worth $1.8 billion, followed by Morgan Stanley at $789 million and Goldman Sachs Group Inc. at $609 million, according to estimates by Linus Wilson, assistant finance professor at the University of Louisiana at Lafayette. He values warrants of all 10 companies at $3.7 billion to $4.6 billion, while Credit Suisse AG estimated $4 billion to $5.1 billion on June 2.
Lenders may pay closer to full value because they’re eager to escape restrictions on operations and perks imposed when they sold preferred stock and warrants to the $700 billion U.S. bank rescue fund. Lawmakers are pressing Treasury Secretary Timothy Geithner for higher prices after collecting as little as 32 cents on the dollar for warrant buybacks, according to Wilson. “Until you’ve basically evened-up with the government on the warrants, you’re still technically in the program,” said V. Gerard “Jerry” Comizio, a former Securities and Exchange Commission lawyer and now senior partner for banking and financial institutions at Paul, Hastings, Janofsky & Walker LLP.
At stake are warrants that carry the right to buy more than 1.4 billion common shares of stock in U.S. banks. The warrants were issued as more than $372 billion in capital was disbursed from the Troubled Asset Relief Program to more than 600 firms. JPMorgan climbed 1.6 percent to $35.82 in German trading today, Morgan Stanley slipped to $30.80, while Goldman declined to $148.66.
TARP was created last year to prevent the financial system from collapsing by providing banks with capital. The Treasury injected funds by purchasing preferred stock and also demanded warrants -- the right to buy common stock at a set price for 10 years -- so taxpayers could benefit from any rebound. Typically, the warrants equaled 15 percent of the TARP capital.
As long as the government holds the warrants, banks face some restrictions on their activities. Executive pay caps are lifted when the banks buy back the Treasury’s preferred stock in the first step of the TARP repayment process. Credit Suisse on June 2 valued all outstanding TARP warrants at $5.2 billion to $7.8 billion, while Treasury estimated $5 billion. The Credit Suisse tally for the firms on the Treasury list didn’t include Northern Trust Corp.
JPMorgan Chase and American Express Co., both based in New York, Chicago-based Northern Trust, Boston-based State Street Corp., Minneapolis-based U.S. Bancorp and Winston-Salem, North Carolina-based BB&T Corp. were among firms that said in statements or through spokesmen they plan to buy back warrants. The American Bankers Association has said the U.S. doesn’t deserve a windfall in return for holding warrants for a few months or for investing in banks that weren’t in danger of failing. The Washington-based trade group said in April the warrant buybacks create an “onerous exit fee” and a “punitive obstacle” to leaving TARP.
“We shouldn’t have had to pay a dime,” said Sun Bancorp Chief Executive Thomas Geisel, whose profitable New Jersey-based company bought back its warrants in May for what Wilson calculated was 32 cents on the dollar. “Taxpayers deserve a return for the risk they took on, but it wasn’t a risk to invest in us.” Jamie Dimon, CEO of New York-based JPMorgan Chase, said June 1 that that the U.S. should cancel half the warrants it holds “out of fairness.” JPMorgan’s warrants have a value of $1.2 billion to $1.7 billion, Credit Suisse said. Companies have the right to buy the securities “at fair market value,” Treasury’s statement said yesterday.
Banks get the right of first refusal on buying back their warrants. If they can’t agree with Treasury on a price, the government may try to sell them at auction to third parties, a Treasury official said in an interview in May. “Treasury should try to maximize their return as much as possible,” said Espen Robak, president of Pluris Valuation Advisors LLC in New York, which specializes in valuing assets that aren’t publicly traded. “The scope for disagreement is extremely wide. In some of these cases, there won’t be an agreement.”
Banks can reduce the tab by selling new stock before Dec. 31 equal to the amount they got from TARP. In that case, half the warrants may be canceled. Among the smaller banks, the government sold warrants back to Sun Bancorp for 32 cents on the dollar and to Louisiana’s IberiaBank Corp. for 46 cents, Wilson said. Ohio’s FirstMerit Corp. paid 82 cents on the dollar and Independent Bank Corp. in Massachusetts paid 74 cents, Wilson said.
The sales improved prices from May 11 when Old National Bancorp, based in Evansville, Indiana, paid $1.2 million --about 21 cents on the dollar -- to buy back a stake valued at $5.8 million, according to data compiled by Bloomberg. Banks would shortchange taxpayers by almost $10 billion if the Old National sale set the pace, Bloomberg reported on May 22.
Congressmen including Brad Miller, a North Carolina Democrat, and Sen. Jack Reed, a Rhode Island Democrat, told Geithner to press banks for fair compensation after seeing terms of the Old National transaction. The Treasury’s bargaining stance may already be hardening. Independent Bank Corp., the largest commercial bank based in Massachusetts, reimbursed TARP and paid $2.2 million on May 22 to buy back warrants Wilson valued at $3.0 million. Treasury officials “did not budge” in negotiations, said Denis Sheahan, chief financial officer.
TCF Financial Corp., the Wayzata, Minnesota-based lender that redeemed $361 million in TARP funds in April, still hasn’t reached an agreement on its warrants and wants Treasury to allow an auction to set a value, said bank spokesman Jason Korstange. “We can’t get the government to give us a price that we like,” he said.
Citigroup Begins $58 Billion Conversion of Shares
Citigroup Inc. began swapping $58 billion of preferred stock into common, a deal that will make the U.S. government the bank’s largest shareholder and close a shortfall in common equity found in stress tests last month. A portion of the Treasury’s $25 billion of preferred stock will be converted to common, the company said today in a statement, giving the government a 34 percent stake in the New York-based bank. Citigroup will also exchange as much as $33 billion of preferred securities not held by the government.
Citigroup is counting on the transaction to replenish an equity base eroded by $27.7 billion of losses last year. The bank said in April it would delay the swap until government stress tests were completed. Those results came last month. It was also held up as Federal Deposit Insurance Corp. Chairman Sheila Bair questioned the company’s leadership, people familiar with the matter said. “The faster they can resolve the share conversion the better,” said Peter Sorrentino, a senior portfolio manager at Cincinnati-based Huntington Asset Advisors, which has $13.8 billion under management, including 1.1 million Citigroup shares. “They’ve got to make their future clear and clear the smoke away as soon as possible.”
More than 17 billion shares may be issued to the government and other preferred holders, diluting existing stockholders by about 76 percent. The deal is set to expire July 24, and distribution would be made on July 30. “Citi’s management team, led by CEO Vikram Pandit, has clarified the company’s strategy,” Chairman Richard Parsons said in the statement. The bank “has taken the tough decisions to downsize the company and cut expenses significantly. We have confidence in our management and the future of our institution.”
Bair’s objections centered on whether the bank’s management has enough commercial-banking experience, people close to Citigroup said. Treasury Secretary Timothy Geithner has indicated he thinks replacing top executives now might be destabilizing, people familiar with his views said. “The FDIC has absolutely not delayed efforts of Citigroup to bring an exchange offer to market,” Andrew Gray, an FDIC spokesman, said June 8. “The FDIC strongly supports efforts of all banks to raise additional capital where possible, and improve the quality of their capital structures.”
Bair addressed Citigroup’s board yesterday to ease tensions between her agency and the bank, the Financial Times reported today, citing people close to the situation. Citigroup spokesman Jon Diat declined to comment on the report, as did FDIC spokesman David Barr. After completion of the exchange offering, Citigroup’s tangible common equity could increase by as much as $61 billion and its Tier 1 common may increased by as much as $64 billion, Chief Financial Officer Ned Kelly said in the statement. The company also said its board adopted a “tax benefits preservation plan” that would protect assets that could be lost with a switch in ownership by major shareholders. The plan does not apply to the government’s acquisitions of Citigroup common stock.
The plan “is designed to reduce the likelihood that Citi experiences such an ownership change by discouraging any person or group from becoming a 5 percent shareholder and dissuading existing 5 percent shareholders from acquiring more than a minimal number of additional shares of Citi’s stock,” the company said. The plan will stay in effect for three years, Citigroup said. The FDIC guarantees $34.6 billion of the bank’s long-term debt and $30 billion of short-term debt, filings show. The FDIC also was one of several agencies, including Treasury and the Fed, to participate in an insurance policy on $301 billion of Citigroup’s distressed assets.
The delays have frustrated investors who bought preferred stock in anticipation of profiting when the exchange closes, CRT Capital LLC analyst Kevin Starke said. Many such investors have sold borrowed shares in anticipation of paying them back after the conversion. Delays increase the cost of financing trades. Citigroup shares rose 15 cents, or 4.4 percent, to $3.56 in New York Stock Exchange composite trading at 9:53 a.m. The stock is hovering near levels in mid-February, just before it began a two-week slump that forced Pandit to seek a rescue from the Treasury.
The Fed's Mortgage Muddle
Talk about a negative feedback loop: It looks like investors' expectations for an economic recovery could end up delaying that very scenario. Fear of inflation and concerns over the long-term impact of ballooning government debt have been driving up yields on 10-year U.S. Treasury notes, which reached 3.91% on June 8 before easing back to 3.84% the next day. But hasn't the Federal Reserve been working overtime to keep rates down? The prime reason for the Fed's commitment to buying Treasury debt was to lower mortgage rates to revive the moribund housing market. That was starting to work, but economists are now warning that rising mortgage rates will stop any rebound in the housing market in its tracks and derail the broader economic recovery.
In its Weekly Credit Outlook published on June 8, Moody's said that the Economic Cycle Research Institute's (ECRI) leading index of U.S. economic activity is now showing the recession nearing an end, with the possibility of higher mortgage yields the only remaining hindrance to a recovery. The results of Freddie Mac's Primary Mortgage Market Survey, released on June 4, showed a jump in the 30-year fixed mortgage rate to an average of 5.29% for the week ending June 4, compared with an average rate of 4.91% the prior week. Last week's rate was the highest since the week ending Dec. 11, 2008. With Treasury yields even higher so far this week, the 30-year mortgage rate is being quoted as high as 5.50% on bank Web sites such as Citibank's.
Mortgage rates should trade at a premium over 10-year Treasury notes to account for the greater risk. That premium has historically been between 150 and 200 basis points. The only reason mortgage rates have been so low is that the federal government is fully backing Fannie Mae and Freddie Mac's purchases and insuring of conforming mortgages that banks have been making. If not for Fannie and Freddie, banks would be charging home buyers much higher rates and would be required to keep the loans on their own books, says John Burns, a real estate consultant in Irvine, Calif. who advises the major homebuilders.
"The rise in interest rates is coming at a really inopportune time, just as the stimulus was taking effect," says Mark Zandi, chief economist at Moody's Economy.com. "It will hurt the housing market. It dilutes the benefit of the tax credit" to first-time home buyers. With much of the weakness in the banking system having been addressed, Zandi believes the housing market is becoming the primary risk to the economy. But he also believes the bond market has gotten ahead of itself in anticipating a return of inflationary pressures. It makes sense, however. that as the economy gathers strength, the Treasury yield curve should normalize, with the 10-year note returning to somewhere between 4.5% and 5.0%, he says.
If Treasury yields are simply reflecting improvement in the economy, then it follows that the Fed shouldn't do anything to keep rates low, says Ivy Zelman, chief executive of Zelman & Associates, which focuses on housing market analysis. The discourse among policy analysts and senior financing executives is increasingly concentrating on the high-wire act the Fed must pull off to ensure it doesn't keep interest rates artificially low for too long and thereby stoke hard-to-control inflation, she adds. The Fed could rein in yields with any indication that it plans to take a lot more Treasury paper out of the system via debt purchases, but that's not likely, says Kim Rupert, managing director of fixed-income analysis at Action Economics. It's very difficult for the central bank to keep a handle on long-term interest rates since they're determined by other factors besides the amount of Treasury debt the Fed is buying.
Even if there weren't other factors, "it's a losing proposition for the Fed to try to fight an upsurge in yields via Treasury purchases" since its purchases can't keep pace with the $30 billion to $40 billion in new paper the Treasury is issuing each month to pay for the economic stimulus, Rupert says. The ultimate impact of all the stimulus is a very large inflation threat, she adds. Although over the long run the Fed certainly wants to reduce the mortgage market's reliance on the Fed's purchasing of mortgages, in the near term it can afford to increase its mortgage purchases in order to keep rates from going higher, says Zelman.
One worrisome sign, notes Zelman: She's heard the hike in the 30-year fixed-rate mortgage to 5.50% has crippled refinancing activity. Deterioration in home values has caused many owners to lose equity to the point where they would only have positive equity in their homes if they got a rate between 4.5% or 4.875%. Rising rates appear to have boosted new home purchases, however, by pulling in people who were sitting on the fence since they're increasingly afraid of missing the window of opportunity to secure a relatively low rate. Fannie Mae and Freddie Mac have been watching mortgages on their books decline in recent months to a combined balance of around $800 billion. Since their combined ceiling is $900 billion, the government-sponsored enterprises have the capacity to buy up to $100 billion in additional mortgage securities, which would help lower mortgage rates, says Zelman.
There are also ways to bring the effective mortgage rate down, such as the Obama Administration's tax credit of up to $8,000 for first-time home buyers, says Zandi. Anyone who hasn't owned a home in the past three years is eligible for the credit as long as their income isn't above a certain threshold. While the tax credit is slated to expire on Dec. 1, there are efforts to raise the limit to $15,000 and make it available to all home buyers, he says.
Higher mortgage rates in general are likely to exacerbate depreciation in home values, says Matthew Howlett, an analyst who covers the mortgage insurers at Fox-Pitt, Kelton Cochran Carolia Waller in New York. He expects home prices to fall an additional 15% to 20% over the next 18 months based on current mortgage rates and thinks they'll probably decline further if rates go up, causing more people to default on their mortgages.
Mortgage rates would also rise for people who can't afford to make at least a 20% down payment on homes they're buying if companies such as PMI Group and MGIC Investment Corp., which provide mortgage insurance, were to fail. While rising default rates and claims are making it more difficult for mortgage insurers to maintain adequate levels of capital and liquidity, Howlett doesn't believe any of them are in imminent danger of failing.
The insurers are depending on the moderate success of the mortgage modifications the Obama Administration is subsidizing in order to keep people in their homes. The Administration is targeting the prevention of 3 million to 4 million foreclosures. Any further downtrend in housing prices would hurt the chances of those modifications, says Howlett. Mounting delinquencies of Alt-A mortgages—which are riskier than prime mortgages—will likely turn into defaults, creating a "tsunami of foreclosures" that will put the housing market under even more pressure, says Zelman. And it will be much harder to get those mortgages modified since they've been securitized and are in the hands of investors instead of the banks, she adds.
Right now, the fear in the bond market is that even though the federal budget deficit is likely to moderate as the economy revives, the budget gap might stay around $800 billion for the next decade, says Rupert at Action Economics. The faster the economy can grow, the more the government will be able to boost tax revenues, and the lower the deficit will be. "For the moment, the working assumption is massive deficits as far as the eye can see, and I think that's going to be a problem for the bond market," she says. And in classic feedback loop fashion, additional problems for the bond market will spell even more pain for the mortgage market.
Industry Pushes to Extend Home-Buyer Tax Credit
Worried that rising mortgage rates could damp the prospects for a housing recovery, a business group is making a new push for Congress to boost and extend a home-buyer tax credit. In February, Congress approved a 10% tax credit for first-time home purchases, up to a maximum of $8,000. The credit, which expires Dec. 1, phases out for buyers with incomes above $170,000 for married couples and $95,000 for individuals.
The National Association of Home Builders and other industry groups have long argued that the credit isn't large enough to help reinvigorate the housing sector. Now the groups are being joined in their efforts by the Business Roundtable, an association of chief executives. The Business Roundtable is calling on Congress to increase the credit to $15,000 and extend it to all home buyers. "What is being billed as a recovery is not showing up in the cash register yet," says Richard A. Smith, chief executive of Realogy Corp. and a member of the Business Roundtable. Realogy is the parent of real-estate brokers Century 21 and Coldwell Banker.
The Business Roundtable is also urging policy makers to sustain efforts to keep mortgages at or below 5% for one year. Mortgage rates climbed to 5.74% on Tuesday a six-month high and up from 5.03% two weeks ago, according to HSH Associates, a financial publisher. Rates have fallen since the Federal Reserve stepped up debt purchases earlier this year in an effort to drive down rates. A buyer typically needs income of $92,000, assuming a 10% down payment, to qualify for a $400,000 30-year fixed-rate mortgage. With rates at 4.5%, the borrower only needs income of around $84,000, according to an estimate by real-estate firm Long & Foster Cos.
The real-estate industry made a similar push for a $22,000 tax credit for all buyers and interest-rate subsidies earlier this year as Congress considered a range of measures to stimulate the economy. Congress instead opted to increase to $8,000 an existing tax credit for first-time buyers. Business leaders say that while the first-time-buyer credit has succeeded in jump-starting the bottom end of the housing market, more needs to be done to lure "trade-up" buyers back to the market.
Realtors and builders argue that boosting sales among existing owners as opposed to first-time buyers will spur more sales because each transaction involves two home sales. "That 'move-up' buyer has got to have somewhere to go," says Mr. Smith, who warns that without more incentives for existing homeowners, the housing market's "stalemate will be nasty and protracted."
The business group's campaign also pushes for Congress to make permanent recently expanded limits for loans eligible for government backing or purchase. Congress in February boosted those limits to as high as $729,750 in the nation's most expensive housing markets, from $417,000, and the February stimulus bill renewed the higher limits through the end of the year. Those limits are set to expire at the end of the year and are tied to median home prices, which have fallen.
Senate to review work of Obama's auto task force
The task for President Barack Obama's auto task force Wednesday is to answer senators' questions about the use of taxpayer money to bail out General and Chrysler. The Senate Banking Committee will hear from Ron Bloom, a senior adviser to the auto task force, and Edward Montgomery, who serves as Obama's director of recovery for auto communities and workers. The panel is reviewing the use of funds from the Troubled Asset Relief Program, or TARP as it has been known, to help the auto companies. Lawmakers also want to know whether taxpayers will get a return on their investment. Republican members of the committee have questioned the decision by the government to take a majority ownership of GM and the use of taxpayer funds to reorganize the auto industry.
Unions in Debt
'We spent a fortune to elect Barack Obama," declared Andy Stern last month, and the president of the Service Employees International Union wasn't exaggerating. The SEIU and AFL-CIO have been spending so much on politics that they're going deeply into debt. That news comes courtesy of federal disclosure forms that unions file each year with the Department of Labor.
The Bush Administration toughened the enforcement of those disclosure rules, but under pressure from unions the Obama Labor shop is slashing funding for such enforcement. Without such disclosure, workers wouldn't be able to see how their union chiefs are managing their mandatory dues money. Alarm is coming even from inside the AFL-CIO -- specifically, from Tom Buffenbarger, president of the International Association of Machinists and Aerospace Workers, who sits on the AFL-CIO's finance committee.
Bloomberg News reports that he is circulating a report claiming the AFL-CIO engaged in "creative accounting" to conceal financial difficulties heading into last year's Presidential election. As recently as 2000, the union consortium of 8.5 million members had a $45 million surplus. By June of last year it had $90.6 million in liabilities, or $2.3 million more than its $88.3 million in assets. "If we are not careful, insolvency may be right around the corner," Mr. Buffenbarger warned.
Machinist spokesman Frank Larkin says the report is a private document and declined to share it with us. But he didn't deny the Bloomberg story, which said that Mr. Buffenbarger cites in particular the AFL-CIO's reliance on its Union Plus credit-card program. In the mid-1990s, the AFL-CIO struck a deal with Household Bank to market the cards to union members in return for royalties. In the year ending June 30, 2008, the AFL-CIO earned $35 million from Household, about half the $74 million it collects in union dues. The deal has been a windfall for the union, but that may not last amid rising credit-card losses and flat consumer spending.
As for the SEIU, as recently as 2002 total SEIU liabilities were about $8 million. According to its 2008 disclosure form, the union owed more than $156 million, a 30% increase over the $120 million it owed in 2007. Its liabilities now equal more than 80% of its $189 million in assets. Net assets fell by nearly half last year, to $34 million, from $64 million in 2007. The debt includes an $80 million loan the SEIU took out in 2003 to purchase a new headquarters in downtown Washington, D.C. But the liabilities also stem from political spending, including at least $67 million last year on political and lobbying expenses, twice what it spent in 2007.
The SEIU added to its debt burden last year with $25 million in new bank loans, including $15 million from Amalgamated Bank of New York. Amalgamated is the nation's only union-owned bank and its chairman is Bruce Raynor, who until recently was also general president of Unite-Here. Mr. Raynor has been fighting for control of that textile-hotel union, and he helped Mr. Stern conduct a raid on Unite-Here members before bolting to the SEIU.
By the end of 2008, the SEIU also owed Bank of America nearly $88 million, including its headquarters loan and another $10 million for unspecified purposes. This is the same BofA that the union has spent the past months attacking as the face of Wall Street excess. The SEIU has protested outside of Bank of America offices and demanded the resignation of CEO Ken Lewis. We assume no one forced the SEIU to invest in real estate or borrow from a bank to finance it.
An SEIU spokeswoman says the union works on a four-year cycle, in which it goes "all out for the presidential election" and then rebuilds its finances. She adds the union has paid back more than $10 million of the $25 million it borrowed last year. But it's nonetheless true that the SEIU's liabilities have continued to climb each year from 2003 to 2008.
One irony here is that the SEIU's Mr. Stern, the most powerful labor leader in America, loudly broke from the AFL-CIO in 2005 because he said it spent too much in Washington and not enough on organizing. But unions can't resist the lure of the Beltway precisely because they fare so poorly in the private marketplace. The union red ink helps explain why Mr. Stern and AFL-CIO chief John Sweeney are lobbying so hard for Congress to rig the rules to make it easier for unions to gather more dues-paying members.
The other lesson concerns union governance and transparency. Unions have a long history of corruption in part because they mix large amounts of cash from dues with political purposes and little oversight. Yet the same union leaders who denounce failures of corporate governance bitterly resisted the Bush Administration's expanded disclosure, and now they want the Obama Administration to water down those rules. The news about rising union debt shows why that transparency is more necessary than ever.
America's socialism for the rich: Corporate welfarism
by Joseph Stiglitz
With all the talk of "green shoots" of economic recovery, America's banks are pushing back on efforts to regulate them. While politicians talk about their commitment to regulatory reform to prevent a recurrence of the crisis, this is one area where the devil really is in the details - and the banks will muster what muscle they have left to ensure that they have ample room to continue as they have in the past. The old system worked well for the banks (if not for their shareholders), so why should they embrace change? Indeed, the efforts to rescue them devoted so little thought to the kind of post-crisis financial system we want that we will end up with a banking system that is less competitive, with the large banks that were too big too fail even larger.
It has long been recognized that those America's banks that are too big to fail are also too big to be managed. That is one reason that the performance of several of them has been so dismal. When they fail, the government engineers a financial restructuring and provides deposit insurance, gaining a stake in their future. Officials know that if they wait too long, zombie or near zombie banks - with little or no net worth, but treated as if they were viable institutions - are likely to "gamble on resurrection." If they take big bets and win, they walk away with the proceeds, if they fail, the government picks up the tab.
This is not just theory; it is a lesson we learned, at great expense, during the Savings & Loan crisis of the 1980s. When the ATM machine says, "insufficient funds," the government doesn't want this to mean that the bank, rather than your account, is out of money, so it intervenes before the till is empty. In a financial restructuring, shareholders typically get wiped out, and bondholders become the new shareholders. Sometimes, the government must provide additional funds, or a new investor must be willing to take over the failed bank.
The Obama administration has, however, introduced a new concept: "too big to be financially restructured". The administration argues that all hell would break loose if we tried to play by the usual rules with these big banks. Markets would panic. So, not only can't we touch the bondholders, we can't even touch the shareholders - even if most of the shares' existing value merely reflects a bet on a government bailout. I think this judgment is wrong. I think the Obama administration has succumbed to political pressure and scare-mongering by the big banks. As a result, the administration has confused bailing out the bankers and their shareholders with bailing out the banks.
Restructuring gives banks a chance for a new start: new potential investors (whether holders of equity or debt instruments) will have more confidence, other banks will be more willing to lend to them, and they will be more willing to lend to others. The bondholders will gain from an orderly restructuring, and if the value of the assets is truly greater than the market (and outside analysts) believe, they will eventually reap the gains. But what is clear is that the Obama strategy's current and future costs are very high - and so far, it has not achieved its limited objective of restarting lending. The taxpayer has had to pony up billions, and has provided billions more in guarantees - bills that are likely to come due in the future.
Rewriting the rules of the market economy - in a way that has benefited those that have caused so much pain to the entire global economy - is worse than financially costly. Most Americans view it as grossly unjust, especially after they saw the banks divert the billions intended to enable them to revive lending to payments of outsized bonuses and dividends. Tearing up the social contract is something that should not be done lightly. But this new form of ersatz capitalism, in which losses are socialized and profits privatized, is doomed to failure. Incentives are distorted. There is no market discipline. The too-big-to-be-restructured banks know that they can gamble with impunity - and, with the Federal Reserve making funds available at near-zero interest rates, there are ample funds to do so.
Some have called this new economic regime "socialism with American characteristics." But socialism is concerned about ordinary individuals. By contrast, the United States has provided little help for the millions of Americans who are losing their homes. Workers who lose their jobs receive only 39 weeks of limited unemployment benefits, and are then left on their own. And, when they lose their jobs, most lose their health insurance, too. America has expanded its corporate safety net in unprecedented ways, from commercial banks to investment banks, then to insurance, and now to automobiles, with no end in sight. In truth, this is not socialism, but an extension of long standing corporate welfarism. The rich and powerful turn to the government to help them whenever they can, while needy individuals get little social protection.
We need to break up the too-big-to-fail banks; there is no evidence that these behemoths deliver societal benefits that are commensurate with the costs they have imposed on others. And, if we don't break them up, then we have to severely limit what they do. They can't be allowed to do what they did in the past - gamble at others' expenses. This raises another problem with America's too-big-to-fail, too-big-to-be-restructured banks: they are too politically powerful. Their lobbying efforts worked well, first to deregulate, and then to have taxpayers pay for the cleanup. Their hope is that it will work once again to keep them free to do as they please, regardless of the risks for taxpayers and the economy. We cannot afford to let that happen.
Wall Street’s Toxic Message
by Joseph Stiglitz
Every crisis comes to an end—and, bleak as things seem now, the current economic crisis too shall pass. But no crisis, especially one of this severity, recedes without leaving a legacy. And among this one’s legacies will be a worldwide battle over ideas—over what kind of economic system is likely to deliver the greatest benefit to the most people. Nowhere is that battle raging more hotly than in the Third World, among the 80 percent of the world’s population that lives in Asia, Latin America, and Africa, 1.4 billion of whom subsist on less than $1.25 a day.
In America, calling someone a socialist may be nothing more than a cheap shot. In much of the world, however, the battle between capitalism and socialism—or at least something that many Americans would label as socialism—still rages. While there may be no winners in the current economic crisis, there are losers, and among the big losers is support for American-style capitalism. This has consequences we’ll be living with for a long time to come.
The fall of the Berlin Wall, in 1989, marked the end of Communism as a viable idea. Yes, the problems with Communism had been manifest for decades. But after 1989 it was hard for anyone to say a word in its defense. For a while, it seemed that the defeat of Communism meant the sure victory of capitalism, particularly in its American form. Francis Fukuyama went as far as to proclaim “the end of history,” defining democratic market capitalism as the final stage of social development, and declaring that all humanity was now heading in this direction.
In truth, historians will mark the 20 years since 1989 as the short period of American triumphalism. With the collapse of great banks and financial houses, and the ensuing economic turmoil and chaotic attempts at rescue, that period is over. So, too, is the debate over “market fundamentalism,” the notion that unfettered markets, all by themselves, can ensure economic prosperity and growth. Today only the deluded would argue that markets are self-correcting or that we can rely on the self-interested behavior of market participants to guarantee that everything works honestly and properly.
The economic debate takes on particular potency in the developing world. Although we in the West tend to forget, 190 years ago one-third of the world’s gross domestic product was in China. But then, rather suddenly, colonial exploitation and unfair trade agreements, combined with a technological revolution in Europe and America, left the developing countries far behind, to the point where, by 1950, China’s economy constituted less than 5 percent of the world’s G.D.P.
In the mid–19th century the United Kingdom and France actually waged a war to open China to global trade. This was the Second Opium War, so named because the West had little of value to sell to China other than drugs, which it had been dumping into Chinese markets, with the collateral effect of causing widespread addiction. It was an early attempt by the West to correct a balance-of-payments problem.
Colonialism left a mixed legacy in the developing world—but one clear result was the view among people there that they had been cruelly exploited. Among many emerging leaders, Marxist theory provided an interpretation of their experience; it suggested that exploitation was in fact the underpinning of the capitalist system. The political independence that came to scores of colonies after World War II did not put an end to economic colonialism. In some regions, such as Africa, the exploitation—the extraction of natural resources and the rape of the environment, all in return for a pittance—was obvious.
Elsewhere it was more subtle. In many parts of the world, global institutions such as the International Monetary Fund and the World Bank came to be seen as instruments of post-colonial control. These institutions pushed market fundamentalism (“neoliberalism,” it was often called), a notion idealized by Americans as “free and unfettered markets.” They pressed for financial-sector deregulation, privatization, and trade liberalization.
The World Bank and the I.M.F. said they were doing all this for the benefit of the developing world. They were backed up by teams of free-market economists, many from that cathedral of free-market economics, the University of Chicago. In the end, the programs of “the Chicago boys” didn’t bring the promised results. Incomes stagnated. Where there was growth, the wealth went to those at the top. Economic crises in individual countries became ever more frequent—there have been more than a hundred severe ones in the past 30 years alone.
Not surprisingly, people in developing countries became less and less convinced that Western help was motivated by altruism. They suspected that the free-market rhetoric—“the Washington consensus,” as it is known in shorthand—was just a cover for the old commercial interests. Suspicions were reinforced by the West’s own hypocrisy. Europe and America didn’t open up their own markets to the agricultural produce of the Third World, which was often all these poor countries had to offer. They forced developing countries to eliminate subsidies aimed at creating new industries, even as they provided massive subsidies to their own farmers.
Free-market ideology turned out to be an excuse for new forms of exploitation. “Privatization” meant that foreigners could buy mines and oil fields in developing countries at low prices. It meant they could reap large profits from monopolies and quasi-monopolies, such as in telecommunications. “Liberalization” meant that they could get high returns on their loans—and when loans went bad, the I.M.F. forced the socialization of the losses, meaning that the screws were put on entire populations to pay the banks back. It meant, too, that foreign firms could wipe out nascent industries, suppressing the development of entrepreneurial talent. While capital flowed freely, labor did not—except in the case of the most talented individuals, who found good jobs in a global marketplace.
This picture is, obviously, painted with too broad a brush. There were always those in Asia who resisted the Washington consensus. They put restrictions on capital flows. The giants of Asia—China and India—managed their economies their own way, producing unprecedented growth. But elsewhere, and especially in the countries where the World Bank and the I.M.F. held sway, things did not go well.
And everywhere, the debate over ideas continued. Even in countries that have done very well, there is a conviction among the educated and influential that the rules of the game have not been fair. They believe that they have done well despite the unfair rules, and they sympathize with their weaker friends in the developing world who have not done well at all.
Among critics of American-style capitalism in the Third World, the way that America has responded to the current economic crisis has been the last straw. During the East Asia crisis, just a decade ago, America and the I.M.F. demanded that the affected countries cut their deficits by cutting back expenditures—even if, as in Thailand, this contributed to a resurgence of the aids epidemic, or even if, as in Indonesia, this meant curtailing food subsidies for the starving. America and the I.M.F. forced countries to raise interest rates, in some cases to more than 50 percent. They lectured Indonesia about being tough on its banks—and demanded that the government not bail them out. What a terrible precedent this would set, they said, and what a terrible intervention in the Swiss-clock mechanisms of the free market.
The contrast between the handling of the East Asia crisis and the American crisis is stark and has not gone unnoticed. To pull America out of the hole, we are now witnessing massive increases in spending and massive deficits, even as interest rates have been brought down to zero. Banks are being bailed out right and left. Some of the same officials in Washington who dealt with the East Asia crisis are now managing the response to the American crisis. Why, people in the Third World ask, is the United States administering different medicine to itself?
Many in the developing world still smart from the hectoring they received for so many years: they should adopt American institutions, follow our policies, engage in deregulation, open up their markets to American banks so they could learn “good” banking practices, and (not coincidentally) sell their firms and banks to Americans, especially at fire-sale prices during crises. Yes, Washington said, it will be painful, but in the end you will be better for it. America sent its Treasury secretaries (from both parties) around the planet to spread the word.
In the eyes of many throughout the developing world, the revolving door, which allows American financial leaders to move seamlessly from Wall Street to Washington and back to Wall Street, gave them even more credibility; these men seemed to combine the power of money and the power of politics. American financial leaders were correct in believing that what was good for America or the world was good for financial markets, but they were incorrect in thinking the converse, that what was good for Wall Street was good for America and the world.
It is not so much Schadenfreude that motivates the intense scrutiny by developing countries of America’s economic failure as it is a real need to discover what kind of economic system can work for them in the future. Indeed, these countries have every interest in seeing a quick American recovery. What they know is that they themselves cannot afford to do what America has done to attempt to revive its economy. They know that even this amount of spending isn’t working very fast. They know that the fallout from America’s downturn has moved 200 million additional people into poverty in the span of just a few years. And they are increasingly convinced that any economic ideals America may espouse are ideals to run from rather than embrace.
Why should we care that the world has become disillusioned with the American model of capitalism? The ideology that we promoted has been tarnished, but perhaps it is a good thing that it may be tarnished beyond repair. Can’t we survive—even do just as well—if not everyone adheres to the American way?To be sure, our influence will diminish, as we are less likely to be held up as a role model, but that was happening in any case. America used to play a pivotal role in global capital, because others believed that we had a special talent for managing risk and allocating financial resources.
No one thinks that now, and Asia—where much of the world’s saving occurs today—is already developing its own financial centers. We are no longer the chief source of capital. The world’s top three banks are now Chinese. America’s largest bank is down at the No. 5 spot. The dollar has long been the reserve currency—countries held the dollar in order to back up confidence in their own currencies and governments. But it has gradually dawned on central banks around the world that the dollar may not be a good store of value. Its value has been volatile, and declining.
The massive increase in America’s indebtedness during the current crisis, combined with the Federal Reserve Board’s massive lending, has heightened anxieties about the future of the dollar. The Chinese have openly floated the idea of inventing some new reserve currency to replace it. Meanwhile, the cost of dealing with the crisis is crowding out other needs. We have never been generous in our assistance to poor countries. But matters are getting worse. In recent years, China’s infrastructure investment in Africa has been greater than that of the World Bank and the African Development Bank combined, and it dwarfs America’s. African countries are running to Beijing for assistance in this crisis, not to Washington.
But my concern here is more with the realm of ideas. I worry that, as they see more clearly the flaws in America’s economic and social system, many in the developing world will draw the wrong conclusions. A few countries—and maybe America itself—will learn the right lessons. They will realize that what is required for success is a regime where the roles of market and government are in balance, and where a strong state administers effective regulations. They will realize that the power of special interests must be curbed.
But, for many other countries, the consequences will be messier, and profoundly tragic. The former Communist countries generally turned, after the dismal failure of their postwar system, to market capitalism, replacing Karl Marx with Milton Friedman as their god. The new religion has not served them well. Many countries may conclude not simply that unfettered capitalism, American-style, has failed but that the very concept of a market economy has failed, and is indeed unworkable under any circumstances. Old-style Communism won’t be back, but a variety of forms of excessive market intervention will return.
And these will fail. The poor suffered under market fundamentalism—we had trickle-up economics, not trickle-down economics. But the poor will suffer again under these new regimes, which will not deliver growth. Without growth there cannot be sustainable poverty reduction. There has been no successful economy that has not relied heavily on markets. Poverty feeds disaffection. The inevitable downturns, hard to manage in any case, but especially so by governments brought to power on the basis of rage against American-style capitalism, will lead to more poverty. The con?sequences for global stability and American security are obvious.
There used to be a sense of shared values between America and the American-educated elites around the world. The economic crisis has now undermined the credibility of those elites. We have given critics who opposed America’s licentious form of capitalism ample ammunition to preach a broader anti-market philosophy. And we keep giving them more and more ammunition. While we committed ourselves at a recent G-20 meeting not to engage in protectionism, we put a “buy American” provision into our own stimulus package.
And then, to soften the opposition from our European allies, we modified that provision, in effect discriminating against only poor countries. Globalization has made us more interdependent; what happens in one part of the world affects those in another—a fact made manifest by the contagion of our economic difficulties. To solve global problems, there must be a sense of cooperation and trust, including a sense of shared values. That trust was never strong, and it is weakening by the hour.
Faith in democracy is another victim. In the developing world, people look at Washington and see a system of government that allowed Wall Street to write self-serving rules which put at risk the entire global economy—and then, when the day of reckoning came, turned to Wall Street to manage the recovery. They see continued re-distributions of wealth to the top of the pyramid, transparently at the expense of ordinary citizens. They see, in short, a fundamental problem of political accountability in the American system of democracy. After they have seen all this, it is but a short step to conclude that something is fatally wrong, and inevitably so, with democracy itself.
The American economy will eventually recover, and so, too, up to a point, will our standing abroad. America was for a long time the most admired country in the world, and we are still the richest. Like it or not, our actions are subject to minute examination. Our successes are emulated. But our failures are looked upon with scorn. Which brings me back to Francis Fukuyama. He was wrong to think that the forces of liberal democracy and the market economy would inevitably triumph, and that there could be no turning back.
But he was not wrong to believe that democracy and market forces are essential to a just and prosperous world. The economic crisis, created largely by America’s behavior, has done more damage to these fundamental values than any totalitarian regime ever could have. Perhaps it is true that the world is heading toward the end of history, but it is now sailing against the wind, on a course we set ourselves.
Supreme Court Clears The Way For Chrysler Fiat Marriage
The U.S. Supreme Court on Tuesday denied a hearing to pension funds objecting to the White House-assisted reorganization of Chrysler that would transfer assets and management control of the troubled Detroit icon to Italian automaker Fiat. The move by the court thus clears the way for a newly constituted Chrysler to re-emerge from Chapter 11 bankruptcy. The Italian carmaker, which manufactures Fiat, Alfa Romeo, and Lancia branded vehicles in Europe, is expected to complete its purchase of Chrysler assets on Wednesday. The deal gives Fiat 20% of the equity in Chrysler in exchange for sharing billions of dollars worth of technology and engineering assets with Chrysler. The company has an option to buy up to 35% of Chrysler down the road after taxpayer loans are repaid.
Chrysler entered Chapter 11 last month with the help of Federal loans granted by the White House auto industry task force and the U.S. Treasury out of the Troubled Asset Relief Program funding from Congress. While the automaker got major concessions from the United Auto Workers and large banks holding billions in secured debt, a group of Indiana pension funds holding about $42 million of the automaker’s debt objected to their treatment doled out in the bankruptcy process and challenged the legality of the process. Last Friday, the appellate court upheld the decision by the New York bankruptcy judge approving Chrysler’s reorganization plan with Fiat. In denying a hearing of the case, the Supreme Court issued a brief, unsigned opinion explaining its action. To obtain a delay, or stay, of the deal, a plaintiff must convince at least four of the nine justices that the issue raised is serious enough to warrant hearing a full appeal and that a majority of the court will conclude the lower court decision was wrong. “The applicants have not carried that burden,” the court said.
Indiana Treasurer Richard Mourdock, who led the cause of the pension funds, expressed disappointment with the decision and said options seem limited for opponents of the sale. “Obviously the Supreme Court of the land is the supreme court of the land,” Mourdock said. “The United States government has, I continue to believe, acted egregiously by taking away the traditional rights held by secured creditors.” The White House issued a statement applauding the decision: “The Chrysler-Fiat alliance can now go forward, allowing Chrysler to re-emerge as a competitive and viable automaker. President Obama last month predicted a swift re-emergence for Chrysler, and the bankruptcy court obliged.
Many bankruptcy experts have said in the last month, though, that the White House bent the bankruptcy laws in order to fast-track Chrysler’s reorganization. Specifically, the United Auto Workers, an unsecured creditor to whom the company owed $8 billion in health care payments, is getting $4 billion in cash and 55% of the equity in the company. The secured creditors—banks and pension funds—were forced to take a 75% “cram-down” on what they were owed. Secured creditors most often do much better in Chapter 11 proceedings because they are first in line if the assets of a company are liquidated for cash. The Supreme Court acted the same day that the bankruptcy court judge in New York approved Chrysler’s plan to sever franchise contracts with 789 dealers in a move to lower its distribution costs and cut underperforming dealers.
With the future of the company set, now comes the hard part. Fiat must integrate vehicle development and manufacturing between the Italian company and Chrysler. That will involve adapting some existing Fiat cars to the U.S. market before the companies have the opportunity to develop unique vehicles from scratch. Fiat CEO Sergio Marchionne also will serve as CEO of the newly formed U.S. company. Though he has been silent on many of the specifics, sources familiar with the planning work say that there is a strong likelihood that the Chrysler brand of cars and SUVs will be eliminated and replaced by Fiat, and sold alongside Dodge and Jeep vehicles in combined dealerships that will carry all three brands.
“Bringing the companies together in the middle of a global recession, when auto sales have been battered so, will be a very difficult task,” said John Casesa, managing partner at Casesa Shapiro Group, a New York investment and advisory firm that specializes in the auto industry. Jerome York, the former vice chairman of Chrysler who has advised financier Kirk Kerkorian in his investments in Chrysler, General Motors, and Ford, said he doesn’t know if Fiat will be successful. But he predicted it would do a “better job with Chrysler than Daimler did.” Daimler-Benz acquired Chrysler in 1998 and sold most of its interests to private equity firm Cerberus Capital Management in 2007. “Daimler did just a god-awful job” of managing the acquisition, said York.
Fair Deals and Bad Dealers
During our regular New York lunch meeting last week with The Gang - Josh Rosner, Barry Ritholtz and the former emergency room physician, recovering hedge fund trader known as "Tyler Durden" - we heard some interesting chatter about stress tests, executive changes and rate hikes. One question: Is there some reason why we are not having further bank stress tests in Q3 and Q4?
We also heard some gripping from members of the dealer community, who also get a seat at the table. They accuse us of having a "chip on our shoulders" when it comes to the debate over reforming the market for over-the counter derivatives and particularly credit default swaps ("CDS"). By way of summarizing our remarks for today's conference in Washington sponsored by Professional Risk Managers International Association, "Regulation of Credit Default Swaps & Collateralized Debt Obligations," some thoughts follow below.
Excuse us for not liking a market that is rigged in favor of the sellers, the monopoly dealers, who even today refuse to allow open price discovery in CDS among and between the other dealers. We hear about this issue constantly, from clients large and small, from hedge funds to huge pension managers. If the range of end-users from whom we hear are at all representative of Buy Side views of the CDS market, change will be welcomed.
And yes please pardon us for not putting our stamp of approval on a market structure that creates more risk in financial institutions and their clients. Every day the OTC CDS market is allowed to continue in its current form, systemic risk increases because the activity, on net, consumes value from the overall market - like any zero sum, gaming activity.
Simply stated, the supra-normal returns paid to the dealers in the CDS market is a tax. Like most state lotteries, the deliberate inefficiency of the CDS market is a dedicated subsidy meant to benefit one class of financial institutions, namely the large dealer banks, at the expense of other market participants. Every investor in the markets pay the CDS tax via wider spreads and the taxpayers in the industrial nations pay due to periodic losses to the system caused by the AIGs of the world. And for every large, overt failure like AIG, there are dozens of lesser losses from OTC derivatives buried by the professional managers of funds and financial institutions in the same way that gamblers hide their bad bets.
What offends us about the CDS market is not just that it is deceptive by design, which it is; not just that it is a deliberate evasion of established norms of transparency and safety and soundness, norms proven in practice by the great bilateral cash and futures exchanges over decades; not that CDS is a retrograde development in terms of the public supervision and regulation of financial markets, something that gets too little notice; and not that CDS is a manifestation of the sickly business models inside the largest zombie money center banks, business values which consume investor value in multi-billion dollar chunks.
No, what bothers us about the CDS market is that is violates the basic American principal of fair dealing. Jefferson said that "commerce between master and slave is barbarism." All of the Founders were Greek scholars. They knew what made nations great and what pulled them down into ruins. And they knew that, above all else, how we treat ourselves, as individuals, customers, neighbors, traders and fellow citizens, matters more than just making a living. If we as a nation tolerate unfairness in our financial markets, how can we expect our financial institutions and markets to be safe and sound?
Equal representation under the law went hand in hand with proportional requital, meaning that a good deal was a fair deal, not merely in terms of price but in making sure that both parties extracted value from the bargain. A situation in which one person extracts value and another, through trickery, does not, traditionally has been rejected by Americans. Whether through laws requiring disclosure of material facts to investors, anti-trust laws or the laws and regulations that once required virtually all securities transactions to be conducted across open, public markets, not within the private confines of a dealer-controlled monopoly, Americans have historically stood against efforts to reduce transparency and make markets less efficient - but that is precisely how we view the proposals before the Congress to "reform" the OTC derivatives markets.
To that point, look at Benjamin M. Friedman writing in The New York Review of Books on May 28, 2009, "The Failure of the Economy & the Economists." He describes the CDS market in a very concise way and in layman's terms. We reprint his comments with the permission of NYRB:"The most telling example, and the most important in accounting for today's financial crisis, is the market for credit default swaps. A CDS is, in effect, a bet on whether a specific company will default on its debt. This may sound like a form of insurance that also helps spread actual losses of wealth. If a business goes bankrupt, the loss of what used to be its value as a going concern is borne not just by its stockholders but by its creditors too. If some of those creditors have bought a CDS to protect themselves, the covered portion of their loss is borne by whoever issued the swap.
"But what makes credit default swaps like betting on the temperature is that, in the case of many if not most of these contracts, the volume of swaps outstanding far exceeds the amount of debt the specified company owes. Most of these swaps therefore have nothing to do with allocating genuine losses of wealth. Instead, they are creating additional losses for whoever bet incorrectly, exactly matched by gains for the corresponding winners. And, ironically, if those firms that bet incorrectly fail to pay what they owe-as would have happened if the government had not bailed out the insurance company AIG-the consequences might impose billions of dollars' worth of economic costs that would not have occurred otherwise.
"This fundamental distinction, between sharing in losses to the economy and simply being on the losing side of a bet, should surely matter for today's immediate question of which insolvent institutions to rescue and which to let fail. The same distinction also has implications for how to reform the regulation of our financial markets once the current crisis is past. For example, there is a clear case for barring institutions that might be eligible for government bailouts-including not just banks but insurance companies like AIG-from making such bets in the future. It is hard to see why they should be able to count on taxpayers' money if they have bet the wrong way. But here as well, no one seems to be paying attention."
When we see too many people in "agreement" on a given issue, like the rebound of equity market valuations for the largest zombie banks or the growing chorus of economists that the "recession" is ending, we usually lean the opposite way instinctively, just to keep the rowboat from capsizing. Fact is, the professional investment crowd is mad to see financials recover and is getting even madder over the prospect of any sort of reform of OTC markets, restructuring of financial regulation or links between risk taking and executive compensation.
Here's our bottom line on CDS reform, banks repaying TARP and the growing crowd at the zombie dance party:
First, the pressure bearing down on the Congress not to touch the OTC derivatives markets is enormous and stems from the fact that banks like JPMorganChase (NYSE:JPM) cannot survive without the supra-normal returns from these dealing activities. But at the same time, the risk from these activities is arguably going to destroy JPM and the other dealers unless changes are made to reduce aggregate risk-taking.
Perhaps the fact of this huge, unmanageable risk embedded in the OTC model explains why none of the major partnership exchanges have been willing to propose themselves as alternatives for the OTC derivatives model. As one Chicago insider told The IRA: "None of our members are comfortable with the economics of CDS contracts nor would they be willing to backstop settlement of these instruments as they exist today."
Second, the decision to allow the larger banks to repay their TARP money is a mistake of the first order, in our view, and illustrates the degree to which Washington is letting the large dealers call the shots on regulatory strategy. If our estimates for loss rates by US banks prove correct, many of the TARP banks repaying capital now may be forced to come back to Washington seeking more help in Q4 2009 or in 2010. And the large banks not repaying the TARP money bear a stigma that may cause regulators and bankers serious problems as the year wears on.
Whereas the regulators had rebuilt some credibility with the public as a result of the stress test exercise, allowing the largest US banks to exist the TARP before we transit the most serious part of the financial storm strikes us as very reckless. If the Fed and Treasury want US banks to be seen by the public as safe and sound, then allowing them to reduce their capital - before ending dependence on FDIC debt guarantees and Fed repurchase agreements for toxic waste - seems contrary to the public interest.
Third, the repayment of the TARP capital by some banks does not end the GSE status of all of the major banks, Chrysler, GMAC, AIG and GM. While the White House is talking about "exit strategies" for some of these zombies, the reality is that the US government could end up as the long-term owner of both automakers, Citigroup (NYSE:C), GMAC and AIG. The cost of keeping the doors of these zombies - plus the housing GSEs -- open will consume all of the discretionary cash flow that Washington thinks is available for other pressing needs. Waive "bye bye" to health care reform, Mr. President, if we are going to feed all of these zombies in 2010.
We are told by one of our favorite Democratic economists that the Obama White House is beginning to understand the concept of resource constraints when it comes to federal spending and obtaining the dollars to spend via Treasury borrowing operations. Until and unless the Obama team accepts that keeping the zombies alive will mean putting aside plans for health care and other political priorities, there is not likely to be any action to resolve any of the GSEs.
But we do see signs of change within the White House. Just as Secretary Geithner was finishing his high profile but low substance visit to China, former Federal Reserve Board Chairman Paul Volcker was observed quietly arriving in Beijing for talks with the senior Chinese political leadership. The Chinese have made it clear, we are told, that the opinions of Chairman Volcker are more reliable than the at times sophmoric statements of Secretary Geithner.
The Treasury Secretary, do not forget, is seen in China, Europe and elsewhere as a representative of the largest US banks. The Chinese and Europeans have an intense distrust of the US dealer community for causing the financial crisis, thus Geithner's ties to Wall Street work against the interests of the US, both in Europe and in many conservative investor communities throughout Asia.
Blame Reagan for our financial mess?
This week . . . a rant. First of all, let me say that I almost never read Paul Krugman's New York Times column, as I noticed several years ago that he has an uncanny ability to understand a problem but totally misdiagnose the cause. During the "W." years, Krugman would frequently outline an economic problem, then go out of his way to blame the president. A lot of poor decisions did flow from George W. Bush, as he was basically in over his head. But this Nobel Prize-winning economist was a Johnny-one-note when it came to W. But I did read Krugman's May 31 column because of its headline: "Reagan did it". I thought, wow, I need to see what this is all about. Here goes:
Krugman wants us to believe that all of our financial ills can be traced directly back to the presidency of Ronald Reagan and deregulation. As usual, he finds the source of trouble -- almost. He identifies a specific piece of legislation that he claims started us on the path to so much financial trouble: the deregulatory Garn-St. Germain Depository Institutions Act of 1982. Close but no cigar. The actual offending cancerous legislation that kicked off the move toward extra reckless lending did involve then-Rep. Fernand St. Germain, a Rhode Island Democrat. But the problem legislation was the Depository Institutions Deregulation and Monetary Control Act of March 31, 1980.
It's important to note that the law was enacted two years before the act Krugman cites -- and nearly a year before Reagan took office. The earlier legislation contained a provision that increased the limit for deposit insurance from $40,000 to $100,000 at a time when $100,000 was a lot more money than it is today. Believe it or not, I felt in 1980 that it was a bad law that would lead to recklessness. That's because the excessive increase became an incentive for depositors to be less disciplined regarding the health of their depository institutions.
I made this very point at the height of the tech mania in a speech titled "Spinning Financial Illusions: The Story of Bubblenomics," which I gave at the Contrary Opinion Forum on Oct. 1, 1999:The seeds of this bubble were sown way back in 1980 when Congress passed the Depository Institutions Deregulation and Monetary Control Act, calling for the phasing out of Regulation Q, which allowed financial institutions to compete with money market funds. A piece of that legislation was financial cancer: raising the insured deposit maximum to $100,000.
That seemingly innocuous change (thank you, Fernand St. Germain) spawned "brokered deposits," the primary driver of the reckless lending practices of the 1980s. Money sought out the highest bidder with no regard as to how it might be used. As a result, we witnessed the funding of overleveraged LBOs and the overbuilding of real estate long after the 1986 Tax Act made it uneconomical to speculate in property. It is hard to overstate the significance of this legislation in creating the excesses of the 1980s, which set the stage for the even greater excesses of the 1990s.
(The entire speech can be found in my column of Oct. 14, 2002.)
Back to Krugman's column: He wraps up his indictment with a statement that demonstrates his utter lack of understanding about what has transpired over the past quarter-century: "There's plenty of blame to go around these days. But the prime (my emphasis) villains behind the mess we're in were Reagan and his circle of advisers -- men who forgot the lessons of America's last great financial crisis, and condemned the rest of us to repeat it." That is just nonsense. The person to blame for the increase in deposit insurance was none other than St. Germain, who saw to it that the deposit insurance increase was put into place.
Besides, does anyone really think Reagan is more culpable than former Federal Reserve chief Alan Greenspan? Greenspan deserves the lion's share of the blame, and Reagan had essentially nothing to do with it (other than having had the bad judgment to appoint Greenspan). It's ironic that Krugman doesn't even understand the fallacy of his own argument. Boosting the cap by 150% took away market discipline as depositors dropped their guard about what the wild men running the savings and loans were doing with their money. In fact, that change of regulation -- i.e., fiddling with the deposit insurance limit in the deregulation legislation -- is precisely what started the lax-lending-standards problem that ballooned into "too big to fail" and ultimately morphed into "too big to bail out" in 2008.
If the remote cause of our current troubles was an unwarranted increase in deposit insurance, the immediate cause was Greenspan's incompetence -- in the form of monetary policy and "leading" the Fed's own inept effort at regulation, the twin drivers of this debacle. Greenspan personally helped give deregulation a bad name through his wrongheaded cheerleading -- an example of this being his advocating (in 1999) that the remnants of the Glass-Steagall banking regulations be repealed in the wake of the collapse of Long-Term Capital Management in 1998! (Although I happen to be generally in favor of deregulation, that doesn't mean I favor deregulation always and everywhere.)
However, even that poorly thought-out idea would not have been as disastrous as it has been had the Securities and Exchange Commission possessed the common sense not to allow financial companies to essentially leverage themselves to infinity. Also culpable are other "government-sponsored" bodies, such as ratings agencies and the Financial Accounting Standards Board. They helped perpetrate the illusion of safety while the country attempted to speculate its way to prosperity, from whence we blew up.
Deregulation didn't cause this disaster. Incompetence and greed did. The implication from Krugman's article, that regulation or re-regulation would solve the problem, is nonsense. What must happen is for people in positions of regulatory authority to do their jobs. But the Fed, the Office of the Comptroller of the Currency, the Office of Thrift Supervision and some congressional committees -- aka the "regulators" that Congress entrusted with powers of oversight -- did nothing as our financial problems built and built in plain sight. (All along the way, as these excesses built, many of us pointed them out in real time.)
New rules won't solve anything and will cost businesses and individuals more money, which they can ill afford to spend. A classic example: the Sarbanes-Oxley accounting reforms of 2002, which caused a huge increase in paperwork and costs but did nothing to help prevent the financial system from nearly vaporizing. No, Mr. Krugman, Reagan didn't do it. Greenspan did it, aided and abetted by almost everyone in the regulatory apparatus who abdicated their responsibility.
Gloomy Canada data show crisis, strong C$ biting
Canada unexpectedly posted a trade deficit in April on slumping exports while new house prices fell by the most in almost two decades, showing the economic crisis is still biting despite talk of a recovery. The trade deficit for April was C$179 million ($163 million), the third time the balance had slipped into the red since December. Until that month Canada -- which relies heavily on exports -- had posted surpluses for almost 33 years.
Analysts, who variously called the data "pretty dismal" and "simply bad news", had on average predicted a C$1 billion surplus after a C$1 billion surplus in March. Statistics Canada said exports fell 5.1 percent to C$30.79 billion, the lowest figure since the C$30.18 billion recorded in June 1999, on smaller shipments of industrial goods, machinery and equipment and energy products. It also cited a 3.2 percent reduction in prices. The figures reflect the continuing damage that the world economic crisis is wreaking on Canada, a leading commodity producer which sends 75 percent of its exports to the United States. Exports have declined by 30.6 percent since July 2008.
"Clearly, Canada's export sector continues to struggle against a tide of sluggish demand, but also the headwinds brought about from a pretty significant appreciation in the Canadian dollar, which gained a lot of traction in April," said Charmaine Buskas, economics strategist at TD Securities. "The undercurrent in trade is unlikely to significantly change in the near term. The Canadian dollar continues to broadly rally against the U.S. dollar and is poised to appreciate even further in the near term. This complicates the export profile."
April imports dropped 1.5 percent to C$30.96 billion, the lowest since the C$30.89 billion recorded in December 2004, on lower volumes of imports of machinery and industrial goods. Imports have dropped by 21.6 percent since last July. The Canadian currency slipped on the data and at 10.20 a.m. (1420 GMT) was at C$1.1101 to the U.S. dollar, or 90.08 U.S. cents, compared to Tuesday's finish at C$1.1032 to the U.S. dollar, or 90.65 U.S. cents. "The trade picture ... tends to trample on some of those economic sprouts the market has been looking for," said HSBC Securities economist Stewart Hall. "The Achilles heel of the economic recovery story has been a paucity of hard economic data supporting the survey data that has hinted at a near term bottoming out (or) stabilization."
In recent weeks Canadian government ministers have expressed optimism that the worst of the crisis might be over. To underline the general feeling of gloom, Statscan said the prices of new homes in April fell by 0.6 percent from March and by 3.0 percent from April 2008. The year-on-year decline was the largest since the 3.2 percent fall recorded in December 1991. Market analysts had expected new housing prices to fall by 0.4 percent from March. It was the seventh consecutive month-on-month drop.
Britain isolated as EU tightens grip on City
Britain has been unable to block plans for an EU regulatory machinery with binding legal powers, securing only a loose agreement at a key meeting of EU finance ministers that any proposals should not interfere with budget and taxation policy. A joint statement yesterday said that legislation to be drawn up by Brussels this autumn “should ensure that such powers should not impinge in any way on the fiscal responsibility of members of states”. Chancellor Alistair Darling said Britain had upheld the principle that “taxation is clearly a matter for member states”.
However, there was no change in the crucial proposal to give EU bodies the ultimate power to override national regulators in areas of banking, insurance and securities. The Commission aims to create three “authorities” with their own staff, full-time president and independent budget. If there is a dispute between regulators from EU countries over how to proceed, these EU bodies can “settle the matter” by binding mediation. The European Court would have final jurisdiction. The wording would appear to reduce Britain’s Financial Services Authority (FSA) to a subservient arm of the EU apparatus, limited to “daily oversight”. Britain does not have a veto since legislation that affects the “internal market” is decided by qualified majority vote (QMV).
While some East European states share British concerns, Mr Darling is largely isolated in trying to defend the interests of the City of London. EU leaders will grapple with the subject at a Brussels summit later this month. There is widespread suspicion that Paris and its allies have seized on the financial crisis to rein in Anglo-Saxon capitalism and impose their Colbertiste ideology on the City. Germany will play a pivotal role in any outcome. While Berlin favours tougher rules than the FSA’s “light touch” model, both the Bundesbank and the regulator BaFin are jealous of their own oversight powers. Finance minister Peer Steinbrück reportedly views the plan as “too ambitious”.
An EU diplomat said it was hard to gauge whether Britain can count on a blocking minority, since most countries kept quiet at the meeting. Finland’s Jyrki Katainen said a number of states may have concerns about the plan: “For instance, can the supranational body take decisions for the national supervisors?” He backed calls from the International Monetary Fund and the US Treasury for a rigorous health check of Europe’s banks. “In order to restore confidence we need European-wide credible stress tests,” he said. The idea was shot down by Mr Steinbrück. “European banks are clearly different from those in the US,” he said, adding that there was no need to probe or reveal the capital adequacy of each bank.
Bank of England's Tucker warns banks threatening recovery by not lending
Paul Tucker, deputy governor of the Bank of England and one of Britain's most senior policymakers, said the banking community was holding back recovery in the sector and could threaten the economy as a whole by refusing to lend. Speaking at an Association of British Insurers conference in London on Tuesday, he described UK bank lending as "subdued" and said that not lending would be a "counterproductive business and financial strategy" which could knock out the roots of recovery when they emerged. "There cannot sensibly be free riders," he said. "If all banks were to adopt such a strategy, recovery might end up being anaemic at best, which would feed back into the banking system itself – increasing defaults and depleting banks' capital."
Mr Tucker appeared to pour cold water on talk of recovery, describing the outlook for the economy as "highly uncertain", despite a number of positive indicators over recent weeks, notably the business surveys. A Purchasing Managers' Index published last week suggested the dominant services sector grew in May for the first time in almost a year. Despite news that some areas of the economy seemed to be improving, "a sense of perspective is needed if those apparently small steps forward are not to be fritted away", Mr Tucker said. He added it would not be until late autumn that any clear judgment could be made on the UK's economic prospects, and on whether or not bank lending was making "tolerable progress."
Economists said Mr Tucker's cautious tone reinforced the expectation that the Bank's Monetary Policy Committee (MPC) would expand its quantitative easing programme beyond £125bn as it attempts to stimulate economic growth. "These views clearly support our expectation the Bank will vote to use the remaining £25bn of its quantitative easing pot next month and also petition the Treasury for an increase to the current £150bn ceiling," said Richard McGuire, fixed income strategist at RBC Capital Markets. Mr Tucker said he had preferred the unprecedented move into quantitative easing over a commitment from the MPC that it would keep the Bank Rate low for a specified extended period, and said the MPC would "re-tighten" monetary policy when the outlook for inflation deemed it necessary.
Despite the reference Mr McGuire said that speculation over rate hikes towards the end of this year was "overdone." Separately yesterday the Economist Intelligence Unit said that after a massive erosion of confidence since the onset of the financial crisis, a majority of financial services risk professionals no longer believed the principles of risk management were sound. Of 334 senior risk professionals questioned, 53pc said they had conducted, or planned to conduct, a major overhaul of their risk management in response to the crisis. "The financial crisis has prompted a wholesale reassessment of risk management as institutions come to terms with a dramatically changed environment," said Rob Mitchell, editor of the report.
Economist Nouriel Roubini remains pessimistic about the prospects for the US economy. Dr Doom - as he is known for his continually negative outlook - has produced nine key reasons to support his pessimism, not least of which is that the financial system remains severely damaged as a result of the credit crisis. However, the economist Paul Krugman, the most recent recipient of the Nobel Prize for economics, disagrees, arguing that the US recession could be over by the end of the summer.
German exports fall 28.7% in April
German exports fell 28.7% in April compared with April 2008, according to the Federal Statistics Office. Exports fell to 63.8bn euros ($88.5bn; £55bn) from 89.5bn euros in the same month last year. Imports fell 22.9% to 54.4bn euros. It was the biggest fall since the recession began, suggesting the economy has some way to go before it recovers. Industrial production fell 21.6% in April compared with April 2008, according to the economics ministry. But the ministry's statement stressed that "the downward trend has slowed noticeably".
"The odds that industrial production has hit its lowest point have improved due to stabilising demand," the statement added. But analysts were not impressed by the trade figures. "We will have to wait longer for a recovery in exports. The figures are disappointing," said Marco Bargel at Postbank. "It will take quite some time for German exports to boom again and to support growth. There is a chance that will happen at the end of the year." There were two fewer working days in April 2009 than April 2008 because of the late falling of Easter.
Prudent Germany will reap long-term rewards
German ideas of prudence are not very popular in the English-speaking world. When US and UK consumers went on a credit-fuelled spending binge earlier this decade, the Germans astounded their friends by not joining in. When the boom underpinned by consumer debt turned to bust last year, Berlin was criticised for its reluctance to help save the world by boosting its public debt as much as the US and the UK. Many observers have even complained about German wage restraint, apparently preferring German companies to run up more debt to pay their workers more.
Yes, the critics have a point or two. It took Berlin too long in late 2008 to recognise the nature and scale of the crisis unleashed by the post-Lehman heart attack in global financial markets. In the scramble to play it safe by building cash reserves, companies around the world slashed their investment spending much more viciously than in a normal recession. As a result, the producers and exporters of investment goods, such as Germany and Japan, suffered a much deeper downturn this winter than the consumer-driven Anglosphere. But would Germany and the world really be better off if German consumers, companies and the government simply went deeper into debt? Take fiscal policy. Any stimulus is expensive. Servicing the extra debt will burden generations to come. The size of a stimulus is not crucial. What counts is whether it begets some short-term gain without causing too much long-term pain.
On both counts, Germany is doing less badly than many other countries since it finally got its fiscal act together five months ago. Beyond some very questionable infrastructure spending, likely to kick in mostly when the recession is long over, parts of Germany’s fiscal response are working well. Thanks to the €2,500 ($3,500, £2,200) subsidy for the purchase of a new car upon scrapping a creaky old one, Germans bought 30 per cent more cars from February to May than they did in the year before. In the UK, car sales were down by almost the same magnitude.
Germany has also found a way to ease the labour market pain. Many workers who have little or nothing to do can keep their job by working part-time or not at all for up to 24 months, with the government picking up the bill for their reduced wages. The scheme costs money, but not more than unemployment would. The key difference is that workers who are still employed, and who may have a good chance of returning to full work at full pay when the economy recovers, need worry less about their future than those who have been fired. Although the collapse in global business investment and exports has hit Germany much harder than the US and the UK, German unemployment is rising by much less.
Partly as a result of these measures, private consumption advanced by 0.5 per cent in early 2009 in Germany while it fell by 1.3 per cent in the UK. Real wages are now increasing faster in Germany than in Britain. Even those neo-mercantilists who seem to think that the exports of one country depress economic activity elsewhere should concede that Germany, with a slump in its inflation-adjusted export surplus from €48bn in the second quarter of 2008 to a mere €11bn in the first quarter of 2009, has done its share to rebalance the world. Almost alone in the west, Germany is already laying the legal groundwork for a gradual return to a sustainable fiscal stance after the recession. On June 12, the upper house of parliament will probably follow the lower house in passing a balanced-budget amendment to the constitution.
This would restrict federal deficits to no more than 0.35 per cent of gross domestic product after 2015 and prevent the 16 federal states from running any deficits from 2020, subject to a few escape clauses. Putting this into the constitution in an election year would be a noteworthy political feat. Monetary policy is now kick-starting a global recovery. Because prudent Germany had a better fiscal starting position, its public deficit this year will probably be half the fiscal shortfalls of 11-13 per cent of GDP that we expect for the US and UK. Germany will need to raise taxes or cut public spending less than other countries in future. It will thus pose less of a risk to a sustainable global recovery for 2010 and thereafter than those who have ratcheted up their public deficits by much more in 2009.
Eastern Germany Less Hard Hit than the West
A new government report shows that the former East Germany has been less bruised by the economic crisis than the richer West. The region has more smaller companies that are more flexible and less dependent on exports, it argues. The former East Germany has long been eclipsed economically by the richer and more industrialized West. Yet ironically the eastern part of the country is now actually better equipped to deal with the ongoing economic crisis. That, at least, is the conclusion of the government's annual report on German unity to be released on Wednesday. According to the Berliner Zeitung newspaper, which has seen the report, it states that the East's "stronger resistance to the crisis" is due to the higher number of small- and medium-sized companies there.
These are thought to be able to react more flexibly to the challenges posed by the economic downturn. Furthermore, in comparison to western Germany, companies in the former East are far less dependent on exports. Germany, a highly industrialized country, is the world's biggest exporter and has been severely hit by the slump in global trade. On Tuesday the latest figures showed that German exports had fallen by an alarming 22.9 percent in April compared with the same month in 2008. However it is big industrial outfits, like carmakers and mechanical engineering firms, which tend to suffer disproportionately when export markets dry up -- and these are much more likely to be found in the West of the country.
This year's report on German unity makes clear that, even as the country prepares to celebrate the 20th anniversary of the fall of the Berlin Wall, there are still two Germanys with very different economic structures. However, things are changing and the government expects the former East to have caught up with the weaker western regions, such as Lower Saxony and North Rhine-Westphalia, within the next 10 years. Wolfgang Tiefensee, the government minister with responsibility for the "new federal states," as the former East Germany is officially known, told the Berliner Zeitung that this would be a "considerable success." The report, which Tiefensee is to present to the cabinet on Wednesday, will show that the gap between the two parts of the country is gradually narrowing, with the per capita output in the East having risen to 71 percent of that in the West, compared to just 67 percent in 2000.
Companies' productivity, export quotas and capitalization are also showing signs of catching up with their western counterparts. Nevertheless, when it comes to achieving true unity, the so-called "Wall in the mind" still persists. The report is critical of the level of internal harmony achieved so far. According to the Thüringer Allgemeine newspaper, which has also seen the document, it states that: "The mutual recognition of the citizens in eastern and western Germany is not sufficient, despite all the progress." People from the East and West still regard each other as different, and in the East there is a feeling of discrimination, the report argues. "Overcoming differences and creating similarities is still an important aim in the continuing process of uniting Germany," it says. "Prejudices must be confronted and clichés overcome."
A darkened outlook for Germany’s banks
For Günter Verheugen, German vice-president of the European Commission, the financial institutions of his home country have shown themselves to be “world champions in risky banking transactions”. To Neelie Kroes, his Dutch colleague who is Europe’s competition commissioner, Germany’s entire banking system is “obsolete”. From the International Monetary Fund come exhortations for reform of the regionally owned Landesbanken, the most blighted part of a troubled sector – criticising their “imprudent ventures” and a wholesale funding model that causes “serious risks...to systemic stability”. Even Angela Merkel has found herself unable to leap wholly to her country’s defence.
Contemplating the years of Landesbanken disarray, the German chancellor this month sounded at once shocked, ruminative and icily cutting. “It’s an interesting question, how long you can carry on without a business model,” she observed. Two years ago next month, a profit warning and rapid bail-out at IKB, a Düsseldorf corporate lender that diversified into subprime investments, was an early intimation of the global crisis that was about to strike – and a glaring reminder of how far many German banks had strayed from their conservative roots. Now, after a banking meltdown around the world, Germany still faces accusations that it has made scant progress in overhauling an unstable financial system.
In their exposure to central and eastern Europe, in their forays into foreign property markets and in their support for troubled domestic industrial companies, many German banks continue to confirm Mr Verheugen’s view of their ability to find trouble. Adding up the losses that might arise for the next two years, one international policymaker says large German banks could lose up to three-quarters of their total equity – making them incapable of continuing unless quick action is taken to purge balance sheets and take on capital. “The government needs to take a much more forceful approach to the banking problem. It has not been decisive or robust enough,” says Beatrice Weder di Mauro, a professor at Mainz University and a member of Germany’s Council of Economic Experts.
“The ‘known unknowns’ in banks’ balance sheets have not gone away. There is a suspicion that there are quite a few banks in the German system that are near-insolvent.” The sharp tone from pundits and policymakers betrays a concern for the future of Europe’s biggest economy if its financial sector remains weak. Bank loans are the oil for the thousands of industrial companies that make up the world’s greatest export machine: banks have traditionally had cosy relationships with local companies, which have depended on direct bank finance to a greater extent than than their more market-oriented Anglo-Saxon peers. “Europe urgently needs a Germany that is again in good shape,” Ms Kroes said last week.
Some critics detect a grim prospect: that Germany’s consensual but slow decision-making will let it slip into a Japanese-style “lost decade”, with “zombie” banks kept alive rather than being properly cleaned up or shut down. The country’s general election in September, when the two parties that make up Ms Merkel’s grand coalition government will scrap it out as opponents, is another factor deterring politicians from making unpopular choices. Companies such as Opel, the German arm of General Motors, and Heidelberger Druck, an engineering company, are receiving state help; public sector banks could be pushed into helping others. “I think the Landesbanken will be used increasingly to save industries in this country if they get into trouble.
The more the crisis continues, the more there is a common interest in using the system to keep problems from turning into election issues,” says Jan-Pieter Krahnen, of Frankfurt’s Centre for Financial Studies. “It would really make it a Japanese decade for Germany if policymakers go too far in trying to protect jobs and keep unproductive banks and industries afloat.” With the economy stricken – last week the Bundesbank forecast a 6.2 per cent fall in gross domestic product this year – the turmoil of the financial crisis is set to give way to the attrition of a deep recession, in which banks will be further stretched. “The system is chronically undercapitalised and we have not seen the broad-based recapitalisation that we have seen everywhere else in Europe,” says one Frankfurt banker, adding drily: “If the economy goes into free fall there will be some issues.”
Germany’s weak banking system has long stood at odds with the strength of the country’s industry and political influence. The country has more than 2,000 banks, many of them regionally controlled and long used as tools of local economic development and social well-being. Only Deutsche Bank, the biggest bank in Europe’s most populous country, ranks among Europe’s top 30 by market capitalisation. Banking in Germany has long been among the least profitable in Europe, prompting groups to seek better returns elsewhere. Axel Weber, Bundesbank president, noted this week that in 2004-06 – world finance’s go-go years – bank lending to German industry and households grew by an annual average of only 0.8 per cent, while banks piled instead into structured products and foreign property.
The Christian Democratic chancellor and Peer Steinbrück, her finance minister from the rival Social Democratic party, can at least point to decisive action taken by Berlin last year after Lehman Brothers’ September collapse deepened the global crisis. Despite a tendency to scoff at the Anglo-Saxon world, Mr Steinbrück acknowledged that Germany had to move quickly when Hypo Real Estate, a Munich-based property lender, came close to collapse the following month. The government organised a rescue for the bank, which drew more than €100bn ($140bn, £86bn) of support. Berlin later rushed a broad bail-out package through parliament, with €500bn in capital and liquidity guarantees to the sector, making clear that no systemically relevant bank would be allowed to fail. It has also continued to nurse HRE, this month taking 90 per cent control as a prelude to full nationalisation and a multi-billion euro capital injection.
Wary of trampling on private property and ownership rights, however, Berlin has eschewed the approach of many countries and refrained from imposing a blanket requirement to recapitalise, leaving decisions to the banks themselves. Aside from HRE, the bail-out fund has handed capital only to Aareal Bank, another property lender, and Commerzbank, which needed funds to push through its takeover of the lossmaking Dresdner Bank, agreed just weeks before Lehman collapsed. Mr Steinbrück also rejects US-style stress tests of banks, saying Europe’s variety of banks would not be served by so standardised a measure. Ms Weder di Mauro disagrees, saying the German authorities should run such a test based on a joint European framework. “They should publish the results bank by bank and announce how they will deal with those banks that fail the test.”
For some, Berlin’s decision to offer support without foisting it on unwilling recipients is a strength. Deutsche has fended off concerns about its balance sheet and, by not accepting government capital, has avoided having strings attached to its business decisions. Josef Ackermann, chief executive, says the bank “has the scope to act on a full range of options”, unlike many peers: free from pay restrictions, it is hiring aggressively. Yet whatever individual banks feel, the suspicion of many in the market is that the government’s hands-off approach means banks are not acting decisively to raise capital, perpetuating a lack of confidence.
The IMF’s latest global financial stability report suggested that eurozone banks had been slow to admit writedowns, with $750bn (£461bn, €536bn) still to come this year and next, compared with $550bn for US banks. The Fund suggested euro area banks would need to raise at least $375bn in fresh capital just to keep their leverage – that is, common equity related to assets – at a moderately safe 25 times. German banks, more highly leveraged than most in the eurozone, are likely to take at least their fair share of that. In response to banks’ pleadings, Berlin has opened a “bad bank” route aimed at helping institutions offload impaired assets to preserve capital.
Balance sheets harbour an estimated €200bn of toxic securities and perhaps as much as €800bn of assets – from written-down property loans to vast portfolios of government bonds – of which banks also want to be rid. But with an election so close, lawmakers are insisting the bad bank should not burden taxpayers. Instead, banks will have to bear future losses and pay fees as well as take an initial 10 per cent haircut on assets assigned to the bad bank. Critics say the plan going through parliament offers scant incentive for banks to take part and give no real relief from toxic assets. “It is just pushing the problem to a later date and does nothing to force recognition of losses,” says one. “It is bunting, decoration.”
Dennis Snower, president of IfW, the Kiel economic institute, says the plans do not address the “many other assets” that are causing liquidity problems, such as property loans and bond portfolios. “It is also flawed,” he adds, “because it overlooks a very simple decision that policymakers have to face: where the capital is going to come from to solve the banks’ solvency concerns.” He argues that stockholders and bondholders should have a role in a much greater recapitalisation of the system than is being promoted at the moment, with debt being swapped into equity. For Germany’s corporate sector, fearing a tightening of credit, the reticence over a bad bank is dismaying. “We need stable financial markets – that is all-important for the route out of recession,” leading industrial lobby groups warned this month.
Ms Merkel has used the language of medicine to justify her government’s action. “Everyone has seen that intensive intervention was needed – if it were a hospital you would talk about the emergency room. But now the rehab phase is starting.”For some observers, though, the mistakes made in administering first aid are likely to hinder the healing. “All the literature or evidence on how to deal with a banking crisis shows you that first you need a triage of the patients. Then you deal with the cases that need to be dealt with,” says Ms Weder di Mauro. “As long as the government does not do this, or does it in ways that are untransparent, the problems will remain.”
Russia May Swap Some U.S. Treasuries for IMF Debt
Russia may switch some of its reserves from U.S. Treasuries to International Monetary Fund bonds, the central bank said today. The comment drove Treasuries and the dollar lower. Alexei Ulyukayev, first deputy chairman of Russia’s central bank, said some reserves may be moved from Treasuries into IMF debt, reiterating comments made last month by Finance Minister Alexei Kudrin. Ulyukayev’s remarks were confirmed by a Bank Rossii official who declined to be named, citing bank policy.
Treasuries fell, pushing 10-year yields toward the highest level in seven months, in response to Ulyukayev’s statement. The dollar fell against the euro on speculation that Russia will reduce its holdings of U.S. debt. About 30 percent of Russia’s international reserves, which stood at $401.1 billion on May 29, are currently held in Treasuries, Ulyukayev said. Kudrin said on May 26 that Russia planned to buy $10 billion of IMF bonds using money from its foreign reserves.
The IMF securities would give countries a different way to contribute to the fund and are unlike traditional bonds because they pay an interest rate pegged to the IMF’s basket of currencies, known as Special Drawing Rights. China is expected to buy as much as $50 billion of the bonds, IMF Managing Director Dominique Strauss-Kahn said yesterday. The IMF, which has rescued economies from Pakistan to Iceland in the past year, has never issued bonds before and is seeking more cash to finance loans and aid to member countries during the worst economic slump in the fund’s 64-year history.
Sweden's central Riksbank borrows €3bn from ECB
Sweden’s central bank on Wednesday geared up for a possible Latvian devaluation by borrowing €3bn from the European Central Bank under an existing €10bn swap agreement. The move came as Sweden’s banking regulator said that the country’s banks – which dominate the Baltic banking sector – had a strong enough capital base to withstand a financial crisis there but that nevertheless they might have to raise more capital to calm the markets. The Swedish Financial Supervisory Authority said on Wednesday that, according to its stress tests, the four big Swedish banks did not need to raise more capital at the moment and could absorb SKr150bn (€14bn) in losses over three years in the Baltic states.
“However, in extreme scenarios the market will most likely require a higher level of capital, which can place pressure on financing possibilities for banks that are most affected,” it warned. Swedbank and SEB have strengthened their capital in recent months because of their heavy exposure to the Baltic states. So far they have needed to ask the state for help only to lower their borrowing costs through guarantees. The Swedish krona on Wednesday built on strong gains it posted against the euro in the previous session as fears over the exposure of the country’s banking system to problems in the Baltic states abated. The krona rose more than 1 per cent against the euro on Tuesday after Latvia indicated it was prepared to make painful budget cuts to appease the International Monetary Fund. It continued on a firm footing on Wednesday, rising 0.4 per cent to SKr10.7610 against the euro.
Sweden’s Riksbank announced last month that it would replenish its foreign exchange reserves by borrowing SKr100bn. That announcement sparked worries in the markets as it was widely seen as designed to give the central bank more firepower to help Swedish banks if Latvia devalued and Lithuania and Latvia felt forced to follow. Wednesday’s move by the central bank appears designed to speed up the strengthening of the reserves as concern over Latvia has mounted in recent days. Devaluation of a Baltic currency would lead to big losses for Swedish banks because much of their lending in the Baltics has been in foreign currencies, typically euros. Within Latvia, a devaluation would increase the debt burden of mortgage holders and companies, triggering more defaults, deepening the recession and putting enormous pressure on an untested insolvency system.
“If the Latvian peg goes, [Swedish banks’] loan losses could go through the roof,” says one analyst. A central bank spokesman said on Wednesday that the decision to activate the €10bn swap agreement with the ECB would tide the Riksbank over until the National Debt Office had delivered the new reserves. Some two-thirds of the SKr100bn should be in place before the summer but the rest would be received by the central bank only in the autumn. “In waiting for that, we are borrowing from the ECB,” he said.
Anxious Japanese Are Working Themselves to Death
As the recession bites, cases of job-related mental illness and karoshi, or death through overwork, are rising. With Japan's export-based economy showing signs of recovery, many of the data coming out of Tokyo lately are positive. Most economists expect Japan's gross domestic product, which plunged faster than that of Europe or the U.S. after the collapse of Lehman Brothers last fall, to return to growth during the current quarter, while the Nikkei 225 stock index has increased more than one-third since touching two-decade lows in March. Yet for all the green shoots of recovery, new data released by the Health, Labor & Welfare Ministry on June 8 once again highlight the heavy burden felt by Japan's hard-pressed workers.
According to the ministry, for the financial year ended March 2009, a record number of workers suffering from job-induced mental disorders successfully filed for compensation. In total, 269 out of 927 applicants won compensation, up one from the previous year. Among them, 66 had attempted suicide, the second-highest number on record. Grimmer still, the deaths of 158 workers were attributed to karoshi—the Japanese word for working to death—a rise of 16 from a year earlier. The problem is probably much worse, according to experts who say most instances of extreme workplace stress go unreported. "There are many cases where people give up claims," says Hiroshi Kawahito, a lawyer who specializes in cases of death through overwork. Meanwhile, it's likely that many more of the 30,000 cases of suicide in Japan each year are at least in some way related to a culture of excessive working.
A further concern is that the figures don't take a full account of the current downturn. While Japan's economic plunge started in earnest after the "Lehman shock" in September, it wasn't until the end of the year that many companies began laying off workers in substantial numbers. Even as the economic outlook improves, few believe the unemployment rate, which hit 5% for the first time in 5? years in May, has peaked. Despite some genuine efforts by some companies to improve conditions, it's hard to see the lot of workers easing soon. For sure, there are some positive developments. Toyota (TM), for example, now generally limits overtime to 360 hours a year (an average of 30 hours monthly), and at some offices it makes public address announcements every hour after 7 p.m. pointing out the importance of rest and urging workers to go home. What's more, one feature of the recession is that companies, unwilling to pay overtime, are encouraging workers to leave on time and take longer vacations.
During the recent Golden Week holidays in May, for instance, many manufacturers closed plants for longer than usual, encouraging people to take holidays. Still, the recession also creates new problems for workers. At companies that have laid off employees, many are now doing the jobs of former colleagues in addition to their existing duties. Others, fearing for their jobs, will stay long into the evening for fear of looking expendable. "There may be some companies which let the employees leave early, but they are not among the mainstream of Japanese work sites," adds Kawahito. A further factor is the impact of what Japanese media call the "wage-down shock"—cuts to worker salaries to offset slumping profits, adding the pressures of financial worries to job insecurity and an excessive workload. While the figures vary from one company to another, many manufacturing workers have taken wage cuts. They've also suffered sharply reduced bonuses, which are a large proportion of pay at many Japanese manufacturers.
Meanwhile, enforced holidays, such as those during Golden Week, often include workers using paid vacation or receiving significantly less than their normal daily wage. At recession-hit parts maker Denso, for instance, one worker grumbles that overtime cuts and furloughs have cost some employees $1,000 a month out of pocket. "The mood has become somber," he says. For all that, it will take more than an improved economy to alleviate the underlying reasons for Japan's growing army of stressed workers. Many attribute Japan's high suicide rate—which topped 30,000 in 2008 for the 11th consecutive year, more than double the U.S. rate—and increasing number of mental illnesses among workers to restructuring carried out during Japan's "lost decade" in the 1990s. But as the economy recovered, and grew steadily between 2001 and 2007, leaner companies put more pressure on workers, while wages failed to keep pace with rising corporate profits. For sure, the culture of hard work, even when it risks worker health, runs deep.
One government survey found that nearly 90% of workers say they didn't even know what the term work-life balance meant. And 4 out of 5 say they would cancel a date if asked by a superior to work overtime, according to a poll by the Japan Productivity Center for Social-Economic Development, a Tokyo think tank. Analysts say young people facing an uncertain economic future feel compelled to work longer and longer hours, even if it puts their health at risk. Ominously, Shigeki Matsuda, senior director at the Dai-Ichi Life Research Institute in Tokyo, even links those fears to another one of Japan's problems: its low birthrate. "Uncertainty over the economy and employment has lowered people's motivation for marriage and having children more than expected," he says.