City Point, Virginia. Medical supply boat Planter at General Hospital wharf on the Appomattox.
Ilargi: Please allow me to return briefly to the botched attempts at US financial regulations reform that I wrote about yesterday in In the hands of a very few. I don't believe that people fully understand how important the issue is, for if they did, there would now be petitions going around for every American to contact their elected representatives. And I've seen them for other causes, but they're sorely lacking now.
The reform, if you can call it that, which is being discussed now will form the blueprint for for the many means and ways in which Wall Street and Washington can continue to squeeze the people, take their remaining belongings and carelessly toss them into peonage. While that may sound overly dramatic, the fact is that US citizens overall have little to no wealth left to contribute, yet their trillions handed to the banks have failed to make more than a temporary difference to the latters' balance sheets.
And if there's anyone who would like to challenge that assessment, I have a suggestion that would, if accepted, both settle that challenge and establish a good start towards a regulatory reform that would actually benefit the people.
First, if it's true what they want to make us believe, that the banks are healed enough to pay back TARP funds, it’s high time to reinstate mark-to market accounting for all assets, including those in Level 3 and off-balance sheet vaults, to un-relax FAS 57 (an insane idea to start with), and to open all books for everyone to see. If that doesn't happen, no bank should be allowed to pay back TARP. Simple. You say you're healthy? Let's see it. The very person in charge of TARP says you're not. Prove Elizabeth Warren wrong. Open your books. That's the only real stress test there is.
Second, re-instate Glass-Steagall, one of the most sensible and smartest regulatory measures ever to be written into law in the US. And make it part of the constitution while you're at it. Never give another Rubin or Summers or Greenspan the chance to ever start over what we're having to go through now. Never allow anyone to take anyone's hard earned money, leverage it 80 times, and gamble it all away at the races.
Call your Congressman. Say you want those two things. Open books, and Glass-Steagall. Without those, forget about it. Forget about restoring faith, confidence and the economy as a whole. Or, for that matter, restoring confidence in the political system. Which will be necessary because the Obama honeymoon is fast disappearing.
There'll be precious little left of it when people start to realize that there is no recovery, and never has been. That the Obama Bull market is solely based on the $14 trillion or so that have been taken from you and injected into the financial system. And which is not nearly enough to fix that system. To continue the don’t look don't tell policies enacted so far, many trillions more will be needed. Where will they come from? Not from a recovery, because there will be none.
Yesterday I posted Frank Shostak's The Fed Might Have Painted Itself into a Corner.Let me get back to that as well. Shostack explains very well what is really going on:
There is almost complete agreement among various commentators that the massive monetary pumping by the Fed since September last year was necessary to prevent a plunge in aggregate demand.
As a result, it is held, the Fed has prevented the economy from falling into a severe recession. According to this way of thinking, the increase in money supply strengthens the demand for goods and services, which in turn strengthens the economy. A stronger economy in turn feeds back into the demand and this strengthens the economy further.
Following this logic, whenever the economy is starting to gain strength and can stand on its own feet, there is no need any longer for all the pumped money. In fact keeping all the pumped money can be detrimental to the economy's health. (Keeping all the pumped money can only lay the foundation for various distortions and a higher rate of inflation some time in the future – so it is held.)
It follows that, once it has been established that the pumped money has managed to place the economy on a healthy growth path, the pumped money can be safely removed without any bad side effects whatsoever. (Again, according to this way of thinking, money pumping is required as long as the economy cannot stand on its own feet.)
Most Fed officials and various economic commentators are of the view that the US economy might be rapidly approaching a stage where it is possible to take out a large chunk of the recently pumped money without causing any harmful side effects in regard to economic activity.
Seasonally adjusted construction spending increased by 0.8% in April after rising by 0.4% in March. Pending sales of previously owned homes shot up by 6.7% in April, the biggest monthly gain since October 2001. Manufacturing activity also shows signs of strengthening. The ISM index rose to 42.8 in May from 40.1 in the month before. The new orders component of the ISM jumped to 51.1 in May from 47.2 in April. It seems that the economy is on its way to standing on its own feet.
What most commentators and Fed policy makers don't tell us is that monetary pumping has given rise to various bubble activities. These bubble activities are supported by real savings that have been diverted from wealth generators by means of pumped money. Also note that the pumped money has prevented the removal of various old bubble activities. Hence, contrary to popular thinking, the massive money pumping has actually weakened the economy's bottom line.
If the Fed were to start taking some of the newly pumped money from the economy, i.e., to curb the money-supply rate of growth, this would hurt various old and new bubble activities. It would set in motion an economic bust.
The Bear Market Never Ended
The stock market has had an eye-catching rally. Everyone is talking about the S&P 500 gaining 40% since the March 6 low. But we have to put that into perspective. The index dropped 46% from the October 2007 top to the March low. Just to get back to the level of October 2007, it needs almost a 100% gain. So far, it is quite short of that. In fact, I believe it will take a decade or much longer to get back to the 2007 top. During the Great Depression, the first phase of the bear market ended in 1930. Then the Dow Jones Industrials rallied 51%. But after that, the Dow plunged another 64% into the 1932 low.
The bulls say that we have already seen the equivalent of the 1932 bottom. To me, that seems improbable. At the 1932 bottom, the Dow had lost 89%. Therefore, the bottom this March doesn't qualify as "the bottom" at all. In fact, given that we had the greatest speculative bubble of modern times, using the highest degree of leverage, and creating $1.2 quadrillion of derivatives which are being "delevered," the final bear market bottom should be much, much lower. At a minimum, the economic contraction will be much longer. We expect it to last at least until 2017, of course with periodic rallies.
The Great Depression bear market bottom was three years after the prior bull market top. That would give us at the earliest a bottom in 2010. But remember, the 1932 bottom didn't end the Depression. Escalating inflation could reduce the amplitude of the next bear market phase by virtue of the fact that stocks could become inflation hedges, just as in the late 1970s. Then stock prices would rise in nominal terms, but not in inflation-adjusted terms. In other words, the value of the currency declines and stocks become a hedge against the declining purchasing power of the currency. With the massive money creation we are seeing, this is a possibility.
In our view, we are currently seeing a typical bear market rally. In the last bear market that started in March 2000, there was a rally late in the year going into January 2001. Many high-profile analysts proclaimed it to be the start of the new bull market and advised "loading up the truck." We gave a new sell signal late in January 2001. That was right on target. And that's when the bear market really got serious.
In early March this year, when we called the exact day of the bottom, we said the rally would go into late summer but it would be very volatile. We also said that it would be a bear market rally. We don't have a crystal ball, but we depend on our indicators to give us the clues as to the top. If we are right, this could turn into a painful trap for the bulls. It would present another great opportunity to sell short at the top.
Sentiment right now is approaching euphoric levels among the analysts. The bullish consensus of index traders is now at the level last seen at the bull market top in October 2007. Furthermore, corporate insider selling vs. buying, by the people who know how their business is likely to be over the next year, is at one of the highest levels on record. The sell/buy ratio is over 8, meaning that for every share purchased, they have sold eight. Obviously, they are not that optimistic.
The global financial crisis was caused by an implosion of excessive debt, due to uncredibly high leverage employed by financial institutions. The banking system has so far written off about $1.3 trillion of bad stuff. One very knowledgeable investment firm estimates that there is another $3.8 trillion to be written off. Geithner's PPIP plan has been shelved because no bank was interested in selling its bad assets. Why not? Because this would create a "market value," which other assets would have to be valued at. Evidence suggests that the banks are carrying some assets at almost three times current market value
The government is trying to resolve the excessive debt problem by creating trillions of dollars of more debt. That's always a strategy doomed to fail. You see, the current problem is that the excessive debt cannot be serviced. Therefore, creating even more debt which cannot be serviced only worsens the problem, especially in a deteriorating economic environment. A burst bubble can not be reflated. Be prepared.
The American Empire Is Bankrupt
This week marks the end of the dollar’s reign as the world’s reserve currency. It marks the start of a terrible period of economic and political decline in the United States. And it signals the last gasp of the American imperium. That’s over. It is not coming back. And what is to come will be very, very painful. Barack Obama, and the criminal class on Wall Street, aided by a corporate media that continues to peddle fatuous gossip and trash talk as news while we endure the greatest economic crisis in our history, may have fooled us, but the rest of the world knows we are bankrupt.
And these nations are damned if they are going to continue to prop up an inflated dollar and sustain the massive federal budget deficits, swollen to over $2 trillion, which fund America’s imperial expansion in Eurasia and our system of casino capitalism. They have us by the throat. They are about to squeeze. There are meetings being held Monday and Tuesday in Yekaterinburg, Russia, (formerly Sverdlovsk) among Chinese President Hu Jintao, Russian President Dmitry Medvedev and other top officials of the six-nation Shanghai Cooperation Organization.
The United States, which asked to attend, was denied admittance. Watch what happens there carefully. The gathering is, in the words of economist Michael Hudson, "the most important meeting of the 21st century so far." It is the first formal step by our major trading partners to replace the dollar as the world’s reserve currency. If they succeed, the dollar will dramatically plummet in value, the cost of imports, including oil, will skyrocket, interest rates will climb and jobs will hemorrhage at a rate that will make the last few months look like boom times.
State and federal services will be reduced or shut down for lack of funds. The United States will begin to resemble the Weimar Republic or Zimbabwe. Obama, endowed by many with the qualities of a savior, will suddenly look pitiful, inept and weak. And the rage that has kindled a handful of shootings and hate crimes in the past few weeks will engulf vast segments of a disenfranchised and bewildered working and middle class. The people of this class will demand vengeance, radical change, order and moral renewal, which an array of proto-fascists, from the Christian right to the goons who disseminate hate talk on Fox News, will assure the country they will impose.
I called Hudson, who has an article in Monday’s Financial Times called "The Yekaterinburg Turning Point: De-Dollarization and the Ending of America’s Financial-Military Hegemony." "Yekaterinburg," Hudson writes, "may become known not only as the death place of the czars but of the American empire as well." His article is worth reading, along with John Lanchester’s disturbing exposé of the world’s banking system, titled "It’s Finished," which appeared in the May 28 issue of the London Review of Books.
"This means the end of the dollar," Hudson told me. "It means China, Russia, India, Pakistan, Iran are forming an official financial and military area to get America out of Eurasia. The balance-of-payments deficit is mainly military in nature. Half of America’s discretionary spending is military. The deficit ends up in the hands of foreign banks, central banks. They don’t have any choice but to recycle the money to buy U.S. government debt. The Asian countries have been financing their own military encirclement. They have been forced to accept dollars that have no chance of being repaid. They are paying for America’s military aggression against them. They want to get rid of this."
China, as Hudson points out, has already struck bilateral trade deals with Brazil and Malaysia to denominate their trade in China’s yuan rather than the dollar, pound or euro. Russia promises to begin trading in the ruble and local currencies. The governor of China’s central bank has openly called for the abandonment of the dollar as reserve currency, suggesting in its place the use of the International Monetary Fund’s Special Drawing Rights.
What the new system will be remains unclear, but the flight from the dollar has clearly begun. The goal, in the words of the Russian president, is to build a "multipolar world order" which will break the economic and, by extension, military domination by the United States. China is frantically spending its dollar reserves to buy factories and property around the globe so it can unload its U.S. currency. This is why Aluminum Corp. of China made so many major concessions in the failed attempt to salvage its $19.5 billion alliance with the Rio Tinto mining concern in Australia. It desperately needs to shed its dollars.
"China is trying to get rid of all the dollars they can in a trash-for-resource deal," Hudson said. "They will give the dollars to countries willing to sell off their resources since America refuses to sell any of its high-tech industries, even Unocal, to the yellow peril. It realizes these dollars are going to be worthless pretty quickly." The architects of this new global exchange realize that if they break the dollar they also break America’s military domination. Our military spending cannot be sustained without this cycle of heavy borrowing. The official U.S. defense budget for fiscal year 2008 is $623 billion, before we add on things like nuclear research. The next closest national military budget is China’s, at $65 billion, according to the Central Intelligence Agency.
There are three categories of the balance-of-payment deficits. America imports more than it exports. This is trade. Wall Street and American corporations buy up foreign companies. This is capital movement. The third and most important balance-of-payment deficit for the past 50 years has been Pentagon spending abroad. It is primarily military spending that has been responsible for the balance-of-payments deficit for the last five decades. Look at table five in the Balance of Payments Report, published in the Survey of Current Business quarterly, and check under military spending. There you can see the deficit.
To fund our permanent war economy, we have been flooding the world with dollars. The foreign recipients turn the dollars over to their central banks for local currency. The central banks then have a problem. If a central bank does not spend the money in the United States then the exchange rate against the dollar will go up. This will penalize exporters. This has allowed America to print money without restraint to buy imports and foreign companies, fund our military expansion and ensure that foreign nations like China continue to buy our treasury bonds. This cycle appears now to be over.
Once the dollar cannot flood central banks and no one buys our treasury bonds, our empire collapses. The profligate spending on the military, some $1 trillion when everything is counted, will be unsustainable. "We will have to finance our own military spending," Hudson warned, "and the only way to do this will be to sharply cut back wage rates. The class war is back in business. Wall Street understands that. This is why it had Bush and Obama give it $10 trillion in a huge rip-off so it can have enough money to survive."
The desperate effort to borrow our way out of financial collapse has promoted a level of state intervention unseen since World War II. It has also led us into uncharted territory. "We have in effect had to declare war to get us out of the hole created by our economic system," Lanchester wrote in the London Review of Books. "There is no model or precedent for this, and no way to argue that it’s all right really, because under such-and-such a model of capitalism ... there is no such model. It isn’t supposed to work like this, and there is no road-map for what’s happened."
The cost of daily living, from buying food to getting medical care, will become difficult for all but a few as the dollar plunges. States and cities will see their pension funds drained and finally shut down. The government will be forced to sell off infrastructure, including roads and transport, to private corporations. We will be increasingly charged by privatized utilities—think Enron—for what was once regulated and subsidized. Commercial and private real estate will be worth less than half its current value. The negative equity that already plagues 25 percent of American homes will expand to include nearly all property owners. It will be difficult to borrow and impossible to sell real estate unless we accept massive losses.
There will be block after block of empty stores and boarded-up houses. Foreclosures will be epidemic. There will be long lines at soup kitchens and many, many homeless. Our corporate-controlled media, already banal and trivial, will work overtime to anesthetize us with useless gossip, spectacles, sex, gratuitous violence, fear and tawdry junk politics. America will be composed of a large dispossessed underclass and a tiny empowered oligarchy that will run a ruthless and brutal system of neo-feudalism from secure compounds. Those who resist will be silenced, many by force. We will pay a terrible price, and we will pay this price soon, for the gross malfeasance of our power elite.
Foreign demand for US financial assets falls
Foreign demand for long-term U.S. financial assets fell in April as both China and Japan trimmed their holdings of Treasury securities. The Treasury Department said Monday that net purchases of stocks, notes and bonds obtained by foreigners fell to $11.2 billion in April, from $55.4 billion in March. China, the largest holder of U.S. Treasury securities, trimmed their holdings to $763.5 billion in April, from $767.9 billion in March. Japan, the second largest holder of Treasury securities, reduced their holdings to $685.9 billion, from $686.7 billion a month earlier.
Treasury Secretary Timothy Geithner traveled to Beijing earlier this month to assure the Chinese government that the Obama administration is determined to get control of an exploding U.S. budget deficit, which is projected to hit a record $1.84 trillion this year. China's holdings of Treasury securities represent about 10 percent of America's publicly held debt.
The administration has said while its aggressive moves to fight the recession and a severe financial crisis will push up the budget deficit temporarily, it intends to reduce the deficit as soon as the economic situation permits. With the government's borrowing needs soaring, there have been some concerns that foreign interest in holding U.S. debt might falter, causing interest rates to rise. The administration contends that recent increases in the interest rates for U.S. Treasury securities were not a sign of investor unease but a reflection of improving economic conditions.
Bank of America suffering "horrific" loan losses - Bove
Bank of America Corp is now experiencing "horrific" loan losses, analyst Richard Bove said, adding that the largest U.S. bank may set aside loan loss provisions of $46 billion this year. "In the second quarter, its (Bank of America's) position as the largest lender in multiple sectors of the American financial system will haunt the company as its losses expand," the Rochdale Securities analyst wrote in a note to clients.
Analyst Bove, however, raised his price target on the bank's stock by $5 to $19, saying confidence in the company and in its management was improving. It is also becoming increasingly apparent that the acquisition of Countrywide and Merrill Lynch has been good for the company, Bove said. These two businesses may have provided the bulk of the company's positive results in the current quarter as the core business continues to suffer due to its poor underwriting practices, he said.
In addition, calls for Chief Executive Kenneth Lewis' resignation may now begin to subside as the company's stock continues to move higher, Bove said. "It is now being conceded, by even the most bearish observers, that claims that the industry was insolvent were incorrect and, therefore, banking will survive and possible thrive," he said in a note to clients.
Credit Card Default Rate Hits Record High
U.S. credit card defaults rose to record highs in May, with a steep deterioration of Bank of America's lending portfolio, in another sign that consumers remain under severe stress. Delinquency rates—an indicator of future credit losses—fell across the industry, but analysts said the decline was due to a seasonal trend, as consumers used tax refunds to pay back debts, and they expect delinquencies to go up again in coming months.
Bank of America—the largest U.S. bank—said its default rate, those loans the company does not expect to be paid back, soared to 12.50 percent in May from 10.47 percent in April. In addition, American Express, which accounts for nearly a quarter of credit and charge card sales volume in the United States, said its default rate rose to 10.4 percent from 9.90, according to a regulatory filing based on the performance of credit card loans that were securitized.
Credit card losses usually follow the trend of unemployment, which rose in May to a 26-year high of 9.4 percent and is expected to peak near 10 percent by the end of 2009. If credit card losses across the industry surpass 10 percent this year, as analysts and bank executives expect, loan losses could top $70 billion. 'Until lenders show stabilization then trend-bucking improvement over a several month period, we remain bearish on credit card lenders—and the U.S. consumer,' said John Williams, an analyst at Macquarie Research.
'We continue to believe that macro challenges and credit quality concerns will pressure U.S. card issuers over the next 12 months,' he added. 'We expect further challenges as unemployment ticks up.' However, some smaller credit card companies such as Capital One and Discover reported defaults rates grew less than expected.
Capital One said its credit card default rate rose to 9.41 percent from 8.56 percent, while Discover said its charge-off rate increased to 8.91 percent from 8.26 percent. JPMorgan Chase—the second-largest U.S. bank and the biggest issuer of Visa-branded credit cards—said its default rate rose to 8.36 percent in May from 8.07 percent in April, but it still holds the best performance among the largest credit card companies.
Credit card lenders are trying to protect themselves by tightening credit limits, raising standards and closing accounts. They have also been slashing rewards, increasing interest rates and boosting fees to cushion against further losses.
Lending by bailed out banks fell in April
The Treasury Department says the value of loans held by the 21 largest institutions getting federal bailout support fell in April, the fifth decline in six months. The department's monthly report of lending activity says that average loan balances at the 21 institutions totaled $4.34 trillion in April, down 0.8 percent from March. Treasury has been issuing reports to track lending activity at banks that received capital from the $700 billion bailout fund. While activity has fallen in five of the past six months, the administration says the declines would have been even more severe without the government support.
China wants U.S. to assume global duty of care for dollar
If you owe your bank $1,000 you have a problem, but if you've borrowed $1 million it's the bank that has the problem. Going by that old maxim, then China, which has lent the United States upwards of $1.3 trillion, has a very big problem. And it knows it. As a consequence, Beijing is diversifying its overseas investments and pressing U.S. officials for an "exit strategy" from the ultra-loose fiscal and monetary policies that China fears will eventually inflate away the value of its U.S. bond holdings and fell the dollar.
But China's pragmatic policymakers also know there is no practical alternative to the dollar as the world's main reserve currency. Which is why bankers say any rhetoric from Tuesday's inaugural BRICs summit in Russia about the need for the United States to cede power in global financial institutions should not be taken as a signal that Beijing is positioning the yuan to challenge the dollar's supremacy. The BRICs summit in the Urals city of Yekaterinburg will bring together the leaders of Brazil, Russia, India and China.
"We have seen the growing integration of the Chinese financial system into the global economy, and over time we will see a gradual enhancement of the role of renminbi," Charles Dallara, managing director of the Institute of International Finance (IIF), told a meeting of his group in Beijing last week. "Will it replace the dollar?" Dallara asked. "The fact is that I don't think this is what Chinese officials want."
For sure, Zhou Xiaochuan, the governor of the People's Bank of China, caused a stir with an essay in March arguing that the Special Drawing Right, the International Monetary Fund's unit of account, might one day displace the dollar. But diplomats and bankers who have recently visited the central bank say Zhou admits the proposal is unrealistic. They say his aim was to draw attention to concern expressed by Premier Wen Jiabao about the safety of China's vast dollar holdings.
In particular, these people said, Zhou wanted to revive a debate over the so-called Triffin Dilemma. Belgian-born economist Robert Triffin argued in 1960 that the United States could not supply enough dollars to satisfy the global appetite for reserves without triggering inflation, which in the long term would erode the dollar's value.
"Issuing countries of reserve currencies are constantly confronted with the dilemma between achieving their domestic monetary policy goals and meeting other countries' demand for reserve currencies," Zhou wrote. "The Triffin dilemma ... still exists." Concretely, bankers said Beijing was acting on its concerns by urging the U.S. government to issue more Treasury Inflation Protected Securities. Unlike conventional bonds, TIPS shield their owners in the event of a rise in inflation.
Don Hanna, acting chief economist at Citibank, said China had less to fear from the inflationary potential of the Fed's quantitative easing than from the dire U.S. fiscal outlook. Faced with huge future pension and health care liabilities, America's debt profile was not sustainable, Hanna said. But other rapidly aging developed countries were in the same boat.
"It means that if you're going looking for other assets that would be 'safer', there aren't many of them out there," he told the IIF conference. "So we should not expect any rapid alteration in the allocation of resources by the Chinese -- or aggressive changes by anyone else for that matter." Still, China is striving at the margins to diversify a national overseas investment portfolio that is massively concentrated on dollar claims on the United States.
- Beijing has said it will buy up to $50 billion worth of SDR-denominated bonds to be issued by the IMF.
- The government is pressing Chinese firms to invest overseas, especially in the natural resources sector; it has extended $45 billion in credit to Russia, Brazil, Venezuela and Angola in return for long-term oil supplies; and it has been frantically building up stockpiles of commodities.
- The PBOC has arranged currency swap deals with six countries since December totaling 650 billion yuan ($95 billion) so that trade and investment with China can be conducted in yuan, not dollars.
Hanna said these swaps were a shrewd move as they would allow China to accumulate claims on the rest of the world without increasing its exposure to the U.S. currency. "To the extent that it expands the invoicing of its trade in yuan, it is trading FX risk for credit risk," Hanna said. In a related policy innovation, China will soon allow selected firms in the southern province of Guangdong that trade with Hong Kong to settle their transactions in yuan, or renminbi.
Fang Xinghai, director-general of the Shanghai municipal government's Office of Financial Services, said the initiative was an important step toward making the yuan convertible. "Why would we want in the midst of this financial crisis to make China's financial system more connected with the rest of the world?" Fang asked rhetorically.
"As China's trade and investment has spread all over the world, it is practically impossible to keep our financial system closed as well as the currency permanently non-convertible. If anything, our trading partners will not allow us to do so." Fang's enthusiasm is linked to his ambitions to see Shanghai become an international financial center by 2020: a convertible yuan would presumably spawn keen demand from global investors for Chinese financial assets listed and traded in Shanghai.
Russia, for one, has expressed an interest in adding the yuan to its reserves once the currency is convertible. Moscow has also floated the idea of settling two-way trade in roubles and yuan. William Rhodes, the senior vice-chairman of Citi, acknowledged the growing interest in denominating trade in yuan. But Rhodes, a frequent visitor to Beijing, was circumspect. "All of this happens in stages. The Chinese are very cautious in all of this," he told Reuters.
Foreign direct investment in China falls 17.8%
Foreign direct investment in China fell in May for the eighth straight month as the global economic crisis battered trade and corporate finance, the Commerce Ministry said Monday. Foreign direct investment in May totaled $6.4 billion, down 17.8 percent from the same month last year, while the number of new approved foreign companies reached 1,649, down 32 percent year-on-year, ministry spokesman Yao Jian said at a news conference. That compared with a 22.5 percent year-on-year decline in April.
It was the first time since the 1998 Asian financial crisis that three top investment indicators -- actual foreign direct investment, contractual foreign investment and new approved foreign companies -- all declined, Yao said. Yao said the scrapping of Aluminum Corp of China's $19.5 billion tie-up with Anglo-Australian miner Rio Tinto PLC won't affect China's policy of attracting foreign investment. "This case won't have any negative impact on foreign companies investing in China," he said. "There will be no reason for us to take inappropriate actions."
Under the failed deal, Chinalco would have invested $12.3 billion in joint investments in aluminum, copper and ore mining with Rio Tinto, and spent $7.2 billion on convertible bonds in the company. China is a top destination for investment but companies have canceled or postponed spending on factories and other assets due to weakening trade and the global financial turmoil. Foreign direct investment last year rose 23.6 percent from 2007 to $92.4 billion, though growth began to weaken toward the end of the year.
China’s recovery still isn’t adding (much) to global demand
At least not for anything other than commodities, where Chinese demand — and Chinese stockpiling — clearly has had an impact. Exports to China from the US and Korea continue to be pretty weak. Exports from the US have bounced back from their winter lows, but still well below their pre-crisis levels. And exports from Korea to China are still down far more than I would have expected.
China’s industrial production is up about 10% y/y (9%) even though exports and imports are both down around 25% y/y in nominal terms.
Lets do some very rough ballpark math. I’ll start by assuming that about 40% of China’s industrial production — pre-crisis — was exported. I think that is about right, but I don’t have the actual number. Help here would be appreciated. If industrial production for export was 40% of total production and if it fell by around 25%, the 60% of industrial production that is far domestic use would need to be up around 30% to generate 9% y/y growth.
That is a big increase. And it isn’t totally implausible. Lending and investment are way up. So are stimulus driven auto sales. But it also raises the question of why it took China so long to really stimulate domestic demand if it had such latent capacity to grow without relying on exports.
Let’s also assume that imported components constituted around 60% of Chinese imports (consistent with a world where China accounts for only about half of the value-added in Chinese exports) a year ago. Here imports would fall in line with exports. But to produce an overall 25% fall in imported demand, nominal imports for domestic use also would need to fall by 25%.
Such a fall could come from a 25% fall in the price of the goods China imports for its own use (presumably a basket that includes a lot of commodities). Or from a 10% fall in the goods China imports and a 15% price fall. Or a 35% fall in price and a 10% rise in actual imports.
That brings me back to the data on US and Korean exports to China. Some Korean exports to China may be influenced by the prices of the commodities Korea itself imports. And some are components for goods that are assembled in China. Similarly, some US exports are commodities and some are components. But both presumably also at least partially reflect Chinese domestic demand. Y/y growth in Chinese imports from both the US and Korea, for example, slowed in 2004 after China implied rather draconian limits on bank lending to keep its economy from over-heating.
And right now neither US nor Korea exports are registering y/y growth. The best that can be said is that the fall in Chinese demand for US goods looks to have stopped, and that there is now some evidence of a modest recovery.
So far at least, the surge in Chinese production hasn’t spilled over into much demand for the rest of the world’s goods.
That could be because China’s recovery has been overstated a bit — as the electricity use data suggest. Or it could be because China is going through a period of import substitution, and thus able to increase industrial output without increasing imports. But right now — unless I am missing something — there does seem to be a significant gap between the strong growth in China’s own demand for its own goods and the lack of growth in Chinese demand for the world’s goods.
China’s stimulus clearly has yet to spillover into world demand for manufactured goods in a major way. That is too bad. After several years when global demand helped spur Chinese growth (as net exports contributed a significant contribution to growth), this would be a good time for China to return the favor. Net exports are likely to subtract from China’s growth this year, as the fall in real exports should exceed the fall in real imports. But it would be nice to real imports actually rise — and not just for commodities.
'Bucket of cold water' for US homebuilders
US homebuilder confidence slipped in June as rising mortgage rates cast concerns about the state of the fragile housing market. The National Association of Homebuilders’ index of homebuilder sentiment fell back to from 16 to 15 this month, dashing economists’ predictions of an uptick. The figure remains 79 per cent below the peak of hopefulness reached in June 2005 when the index rose to 72 but well above January’s record low of 8. A reading of more than 50 indicates "good" conditions.
"Home builders are facing a few headwinds, including expiration of the tax credit at the end of November; a recent upturn in interest rates; and especially the continuing lack of credit for housing production loans," said Joe Robson, NAHB chairman. The average rate of a 30-year conforming mortgage has climbed by a full percentage point since reaching a bottoming at 4.65 per cent in April, economists at Barclays Capital noted. Rising rates are stifling refinancing, and mortgage applications were down by 7.2 per cent in the week ending June 5, according the Mortgage Bankers’ Association.
"It’s a bucket of cold water," said Brian Bethune, an economist at IHS Global Insight, referring to the sharp jump in mortgage rates. "In the housing market there were only a few warm embers out there." A batch of recent housing indicators have signalled that the stricken US market could be ending its free-fall. The latest figures for pending home sales and new home sales both showed signs of improvement, as buyers took advantage of government incentives and record levels of affordability. Construction spending has also shown signs of life.
In spite of the overall decline in sentiment, the drop was focused solely in the south. The biggest housing market in the US showed a decline of 3 points, while all other regions notched modest gains. "As expected, the housing market continues to bump along trying to find a bottom," said David Crowe, NAHB’s chief economist. Home prices remain severely depressed and rates of foreclosure are historically high, leaving potential buyers wary of investing in depreciating assets.
US households lost $448 [billion] in real estate wealth in the first three months of the year. Meanwhile, foreclosure activity remains elevated according to RealtyTrac, which said that foreclosures were up by 18 per cent last month compared with May 2008, making it the third worst month on record. "Builders are taking their cue from consumers, who remain uncertain about the economy and their own situation," Mr Crowe said.
A New Financial Foundation
by Timothy Geithner and Lawrence Summers
Over the past two years, we have faced the most severe financial crisis since the Great Depression. The financial system failed to perform its function as a reducer and distributor of risk. Instead, it magnified risks, precipitating an economic contraction that has hurt families and businesses around the world. We have taken extraordinary measures to help put America on a path to recovery. But it is not enough to simply repair the damage. The economic pain felt by ordinary Americans is a daily reminder that, even as we labor toward recovery, we must begin today to build the foundation for a stronger and safer system.
This current financial crisis had many causes. It had its roots in the global imbalance in saving and consumption, in the widespread use of poorly understood financial instruments, in shortsightedness and excessive leverage at financial institutions. But it was also the product of basic failures in financial supervision and regulation. Our framework for financial regulation is riddled with gaps, weaknesses and jurisdictional overlaps, and suffers from an outdated conception of financial risk. In recent years, the pace of innovation in the financial sector has outstripped the pace of regulatory modernization, leaving entire markets and market participants largely unregulated.
That is why, this week -- at the president's direction, and after months of consultation with Congress, regulators, business and consumer groups, academics and experts -- the administration will put forward a plan to modernize financial regulation and supervision. The goal is to create a more stable regulatory regime that is flexible and effective; that is able to secure the benefits of financial innovation while guarding the system against its own excess. In developing its proposals, the administration has focused on five key problems in our existing regulatory regime -- problems that, we believe, played a direct role in producing or magnifying the current crisis.
First, existing regulation focuses on the safety and soundness of individual institutions but not the stability of the system as a whole. As a result, institutions were not required to maintain sufficient capital or liquidity to keep them safe in times of system-wide stress. In a world in which the troubles of a few large firms can put the entire system at risk, that approach is insufficient.
The administration's proposal will address that problem by raising capital and liquidity requirements for all institutions, with more stringent requirements for the largest and most interconnected firms. In addition, all large, interconnected firms whose failure could threaten the stability of the system will be subject to consolidated supervision by the Federal Reserve, and we will establish a council of regulators with broader coordinating responsibility across the financial system.
Second, the structure of the financial system has shifted, with dramatic growth in financial activity outside the traditional banking system, such as in the market for asset-backed securities. In theory, securitization should serve to reduce credit risk by spreading it more widely. But by breaking the direct link between borrowers and lenders, securitization led to an erosion of lending standards, resulting in a market failure that fed the housing boom and deepened the housing bust.
The administration's plan will impose robust reporting requirements on the issuers of asset-backed securities; reduce investors' and regulators' reliance on credit-rating agencies; and, perhaps most significant, require the originator, sponsor or broker of a securitization to retain a financial interest in its performance.
The plan also calls for harmonizing the regulation of futures and securities, and for more robust safeguards of payment and settlement systems and strong oversight of "over the counter" derivatives. All derivatives contracts will be subject to regulation, all derivatives dealers subject to supervision, and regulators will be empowered to enforce rules against manipulation and abuse.
Third, our current regulatory regime does not offer adequate protections to consumers and investors. Weak consumer protections against subprime mortgage lending bear significant responsibility for the financial crisis. The crisis, in turn, revealed the inadequacy of consumer protections across a wide range of financial products -- from credit cards to annuities. Building on the recent measures taken to fight predatory lending and unfair practices in the credit card industry, the administration will offer a stronger framework for consumer and investor protection across the board.
Fourth, the federal government does not have the tools it needs to contain and manage financial crises. Relying on the Federal Reserve's lending authority to avert the disorderly failure of nonbank financial firms, while essential in this crisis, is not an appropriate or effective solution in the long term.
To address this problem, we will establish a resolution mechanism that allows for the orderly resolution of any financial holding company whose failure might threaten the stability of the financial system. This authority will be available only in extraordinary circumstances, but it will help ensure that the government is no longer forced to choose between bailouts and financial collapse.
Fifth, and finally, we live in a globalized world, and the actions we take here at home -- no matter how smart and sound -- will have little effect if we fail to raise international standards along with our own. We will lead the effort to improve regulation and supervision around the world.
The discussion here presents only a brief preview of the administration's forthcoming proposals. Some people will say that this is not the time to debate the future of financial regulation, that this debate should wait until the crisis is fully behind us. Such critics misunderstand the nature of the challenges we face. Like all financial crises, the current crisis is a crisis of confidence and trust. Reassuring the American people that our financial system will be better controlled is critical to our economic recovery.
By restoring the public's trust in our financial system, the administration's reforms will allow the financial system to play its most important function: transforming the earnings and savings of workers into the loans that help families buy homes and cars, help parents send kids to college, and help entrepreneurs build their businesses. Now is the time to act.
Details Set for Remake of Financial Regulations
President Barack Obama is expected Wednesday to propose the most sweeping reorganization of financial-market supervision since the 1930s, a revamp that would touch almost every corner of banking from how mortgages are underwritten to the way exotic financial instruments are traded. At the center of the plan, which administration officials are referring to as a "white paper," is a move to remake powers of the Federal Reserve to oversee the biggest financial players, give the government the power to unwind and break up systemically important companies -- much like the Federal Deposit Insurance Corp. does with failed banks -- and create a new regulator for consumer-oriented financial products, according to people involved in the process.
The plan stops short of the complete consolidation of power that some lawmakers have advocated. For example, it will allow several agencies to continue supervising banks. It also won't place specific limits on the size or scope of financial institutions, but it will make it much harder for large companies to be so overleveraged that they threaten the broader economy. After Mr. Obama details his proposal, the process will quickly move to Capitol Hill, where Congress would have to pass legislation to enact the changes. Treasury Secretary Timothy Geithner is scheduled to appear before both Senate and House panels on Thursday, where he is likely to face questions and criticisms.
Lawmakers are expected to take issue with several of the plan's more thorny issues, including how to create a system that won't simply bail out large financial companies when they topple. Giving the Fed more clout -- in light of recent criticism from lawmakers, both Republican and Democratic, of its secrecy and accumulation of power -- will also be a controversial idea. Democrats in Congress could push for more consumer-protection powers and stricter limits on executive compensation than administration officials want. And bureaucratic turf wars could emerge as some authorities are reapportioned.
Administration officials say their goal is to make it less likely the economy will ever again teeter on the brink of collapse by giving policy makers more tools to arrest a crisis the next time one occurs. They envision a less volatile financial marketplace where banks are encouraged, through tougher capital, liquidity and leverage requirements, to take fewer risks that have the potential to destabilize the economy. Hedge funds would be forced to register with the government and may face federal supervision if they are large and complex enough. Mortgages and other consumer products would be monitored by a new watchdog, and there would be global transparency rules over exotic financial instruments.
"Considerations of stability, safety and systemic risk have to loom larger in the planning, thinking, and strategizing of every financial institution going forward than they have in the past," White House National Economic Council Director Lawrence Summers said in a speech on Friday. The proposal won't sweep away the confusing and sometimes overlapping patchwork of state and federal supervisors that often clash over jurisdiction. Critics say institutions have been shopping around for the regulator with the lightest touch and that systemwide problems fell through the cracks.
In fact, the proposal could lead to the abolishment of just one agency -- the Office of Thrift Supervision. With the proposed new consumer agency, the number of agencies overseeing finance would remain unchanged. Officials say the goal is to distribute power in such a way that gaps in oversight are removed and the opportunities for regulator shopping reduced. Policy makers have pushed sweeping changes over the regulation of financial markets before with mixed results. In March 2008, then Treasury Secretary Henry Paulson proposed an overhaul of supervision, but Congress didn't take up the ideas.
Other efforts have had unintended consequences. The Clinton administration won legislation that broke down Depression-era barriers between commercial banking, investment banking and insurance, among other things. Mr. Obama has criticized that law for helping create some of the financial behemoths that threatened the economy last year. The current White House, which made the revamp a centerpiece of its early months in office, is keen to move fast. "Experience teaches that once the crisis has passed, the will to reform will pass as well," Mr. Summers said in his speech.
The plan calls on the Fed to oversee financial institutions, products, or practices that could pose a systemic risk to the economy. It will create a "council" of regulators to monitor this area as well. Government officials believe this arrangement will forestall companies from growing large and overleveraged without substantial federal supervision, as happened, for example, in the case of giant insurer American International Group Inc. The Fed will likely have the power to set capital and liquidity requirements for the U.S.'s largest financial companies and scour the books of a wide range of firms. It is unclear what enforcement powers the central bank will have; that likely will be a point of contention as lawmakers debate the issue.
How the Fed interacts with this council also will be a subject of debate. Administration officials envision the council being able to recommend that a specific company, product or practice be subject to Fed supervision, with the central bank ultimately accountable for each area or company that poses the systemic risk. This could set up clashes between the Fed and the council, especially if one is more hawkish than the other.
The goal is to avoid repeating a situation akin to the collapse of Lehman Brothers Holdings Inc., where the government had no authority to smoothly unwind the failing institution. A step such as this is expected to be exercised only rarely, and it could first require approval by the Treasury Department, Federal Reserve, and FDIC, people familiar with the process said. Once a company is placed into receivership, the process will likely be run by the FDIC. It is unclear how such a program will be financed.
On some potentially divisive issues, the administration tried to find a delicate balance, people familiar with the process said. For example, it won't call for the Securities and Exchange Commission to merge with the Commodity Futures Trading Commission, being unwilling to expend political capital on the battles with congressional fiefdoms that this move would spark. But the proposal will push for much more "harmonization" between these two agencies. There has long been tension between them because many of the companies overseen by the SEC trade derivatives and other products regulated by the CFTC.
The new regulator overseeing consumer protection is expected to take some areas that once belonged to the Fed -- such as credit cards and mortgages -- but isn't expected to siphon off supervision of investment products such as mutual funds from the SEC. Mr. Obama will call for several requirements to be adopted globally, such as tougher capital requirements for the largest financial institutions and the power to wind down large, globally interconnected banks. Administration officials also are calling for more transparency over complex derivatives that are traded by large, multinational companies.
"Risk and leverage will always tend to migrate to where the constraints are weakest," Mr. Geithner said Saturday after a meeting in Italy of finance ministers from the Group of Eight major powers. "We need a level playing field globally, or the effectiveness of our national safeguards against risk will be undermined." House Financial Services Committee Chairman Barney Frank (D., Mass.) is expected to take up the measure on Capitol Hill soon and could have a comprehensive package passed by August. Senate Banking Committee Chairman Christopher Dodd (D., Conn.) said his panel could hold votes in the fall with a final measure completed by the end of the year. That is consistent with the administration's timetable.
Is Obama Flubbing the Financial Fix?
Old habits die hard—especially bad ones, and especially when they're backed by well-heeled lobbyists and a powerful congressional committee chairman. It was hard not to draw that conclusion over the past week, as Wall Street and Washington alike prepared for President Barack Obama's much-anticipated June 17 speech outlining the Administration's proposals to overhaul financial regulations.
Despite the promise of tough reforms from the President and his top economic officials, the Administration—in its decision to put off tough political battles over regulatory turf and reining in executive pay—appeared to be backing away from the stiffest moves that were on the table. With the worst of the crisis appearing to recede, the political will to take on those tough constituencies appeared to be fading as well. With it may go a once-in-a-generation opportunity to aggressively tackle some badly needed changes in the U.S. financial system.
"Is the drive for reform losing steam? Yes, absolutely," says Daniel Clifton, a Washington-based policy analyst at institutional broker Strategas Research Partners. With Congress signaling that it is unlikely to act on the President's financial-system reforms until the fall, Clifton and other observers warn that this week's regulatory plan could be highly vulnerable to attack for five months. Short of an unexpectedly sharp return of crisis in the financial sector, which would force the Administration and Congress to conclude that the costs of retaining much of the status quo intact are too high, Clifton believes the push for reform "will lose a lot more momentum by October."
The aim of the Administration's regulatory plan, largely developed by Treasury Secretary Timothy Geithner, is to create a more effective and powerful regulatory structure that would have a better chance of preventing the sort of unseen and out-of-control financial excesses that brought about the current global crisis. In an op ed article in the June 15 Washington Post, Geithner and Lawrence Summers, director of the National Economic Council, said their goal is "to create a more stable regulatory regime that is flexible and effective; that is able to secure the benefits of financial innovation while guarding the system against its own excess."
The plan will try to rein in systemic risk by "raising capital and liquidity requirements for all institutions, with more stringent requirements for the largest and most interconnected firms." It will give the Federal Reserve the power to unwind financial holding companies whose failure could threaten the world's economy. And it will try to strengthen consumer and investor protections on products ranging from "credit cards to annuities."
Much of the debate has focused on the need to create one overarching regulator with the broad authority to prevent the buildup of systemwide risk. The lack of such a "systemic risk regulator" made it harder for the Treasury, the Federal Reserve, and other banking regulators to foresee the crisis and take steps to prevent it. And regulators from Geithner on down have also argued that it made things far more difficult for them to react quickly and effectively when the credit system seized up.
Just as important, debate has also centered on how best to modernize the overlapping, often ineffective regulatory structure that now oversees the financial sector. Today, for example, four different—and often competing—regulators oversee the banking sector. Yet despite (or perhaps because of) this surplus of agencies, all failed in varying degrees to prevent the excessive risk-taking and poor practices that led to the crisis. Moreover, the sense that some agencies were easier than others on their charges allowed some financial institutions to engage in "regulatory arbitrage" in search of the overseer that interfered least in their operations.
That's why a wide range of analysts and policymakers in recent months have argued that this hodgepodge of different agencies needs to be consolidated, with clearer lines of authority and stronger regulatory rules. And, in a series of leaks and trial balloons that have hit the headlines in recent weeks, the Administration appears to have considered such a wide-ranging consolidation. But the White House apparently has tabled that consolidation for now—and the reasons for that reassessment are ominous for the prospects of attaining effective reform.
Not surprisingly, such plans sparked strong behind-the-scenes opposition from many in the financial-services industry who want to hold off radical change. Despite the industry's weakened position, it remains an enormous fund-raising source and still holds enormous sway with many on Capitol Hill. Plus, consolidating the regulatory structure would also mean reallocating the authority of the various congressional oversight committees.
It may make little sense in the modern financial world for the Commodities Futures Trade Commission to continue to regulate financial derivatives, along with the agricultural derivatives—pork bellies, corn futures and the like—that it was originally mandated to oversee. But giving up sway over those financial products would also mean a big cutback in the power, influence, and fund-raising prospects of the agricultural committees that oversee them in the House and Senate.
No sooner did reports emerge that the Administration was considering such a move than powerful congressional voices such as Barney Frank, head of the House Financial Services Committee, threw cold water on the idea. "If S&L crisis wasn't enough to radically overhaul how we regulate banks, this won't be, either," says Jaret Seiberg, a financial-services policy analyst at Washington Research Group, referring to the 1980s savings-and-loan crisis. "There are entrenched political interests in favor of the status quo; they have no interest in radical reform."
As a result, the Administration now seems to be backing away from its original reform plans. Instead, it will likely ask the Fed to take on the powerful new role of systemic risk regulator, while leaving most of the various other agencies intact. Rather than eliminating the regulatory redundancies and strengthening the survivors, Geithner plans to rely on implementing stiffer rules to improve how the regulators oversee their charges.
The question, of course, is whether that will be enough. Many are far from convinced. Simon Johnson, a former chief economist at the International Monetary Fund who has been sharply critical of the Administration's approach to the banking crisis, argues in a recent post on his widely read blog that the planned reforms are far too timid. "The wave of 'reforms' this fall will likely not solve anything," he says. Instead, Johnson argues, the U.S. is simply at the beginning of what could be a 5- to 10-year fight to change the structure of economic and political power of the financial sector in the U.S. to ensure that "it can never again run us into a crisis that results in doubling the national debt."
Greg Valliere, chief Washington policy strategist at independent equity researcher Soleil Securities, thinks the systemic risk regulator may be more aggressive than many in the financial sector are expecting. But he, too, believes the Administration is throwing away a broader chance for reform. "I do think it's a missed opportunity if we continue to have the whole alphabet soup of agencies," Valliere says.
Does the Administration's apparent pullback represent capitulation to powerful forces that oppose change, or is it simply a smart political tactic that will allow the Administration to achieve many of its goals now and come back for more later when they might be more politically achievable? "The congressional reaction has to play into their decision-making. Obama is not king; he's the President," says Clifton. Add too many devisive elements to the package, and pretty soon the coalition of interests gunning to shoot it down will be far larger than the coalition willing to support it.
Don Ogilvie, the independent chairman of Deloitte's Center for Banking Solutions and a former CEO of the American Bankers Assn., has a similar take: "People in key positions…said 'that's going to be a fight,' and fights take a long time in Washington." Citing "the old 80-20 rule," Ogilvie argues that it's easier to get 80% of something done if you leave behind the 20% that would take 80% of the effort to accomplish.
"If you want to get something done in Washington, it's always a good idea to get it done quickly," says Ogilvie, "because if it bogs down, it tends to be pretty difficult to un-bog."
Geithner adamantly denies that the recovery and a diminishing sense of crisis are lowering the impetus for reform. "I don't see any signs of that yet," he said at a press briefing before leaving for the G-8 talks over the weekend.
And following those talks in Italy, Geithner reiterated his commitment to a strong package of reforms to lessen the risks both at home and abroad. The Administration's upcoming proposals will not only include comprehensive reforms for the U.S., Geithner said in a statement, they will also offer more conservative standards for oversight of the most active international financial institutions as well as global markets such as derivatives. "Because risk does not respect borders, we will put forward several international proposals in our reform package that will help to raise standards globally," Geithner said.
Still, some critics sense that the Administration is about to fumble an opportunity—and follow a pattern increasingly seen throughout this Administration's policy agenda: strong language followed by actions that appear far weaker than the rhetoric. Take the Administration's new proposals on executive pay. For months, officials from the President on down have been talking about the need for wide-ranging changes to the executive-pay practices they believe contributed to the financial crisis.
Yet when Geithner announced a series of proposals on June 10 aimed at reigning in excessive compensation and ensuring that pay structures don't encourage traders and executives to take excessive risks to boost short-term pay at the expense of the long-term stability of their companies, the measures were much less stringent than many had expected—or corporate executives had feared.
"They've proven to be fairly moderate in this area," says Michael S. Melbinger, head of the compensation practice at Chicago's Winston & Strawn, who says the measures don't go much beyond what is already becoming best practice at many companies. Moreover, despite backing for legislation that would authorize shareholders to hold nonbinding votes on executive compensation packages—so-called say on pay measures—and tighten requirements for members of board compensation committees, it is far from clear how the Administration's proposals would truly limit the risk-taking and poor judgment that led to big pay packets followed by the collapse of many financial firms.
"The Administration has put forth several principles for executive compensation that should be followed, but people have understood these principles for a long time," says Jesse Fried, a professor at the University of California at Berkeley and co-author of Pay Without Performance: The Unfulfilled Promise of Executive Compensation. "It can't hurt to have the Treasury Secretary repeat them, though mere repetition is not that helpful. Unless the balance of power between shareholders and executives shifts, I don't see any change coming."
Or look at the frequent talk, since the crisis began, of the need to rebalance the U.S. economy away from consumption toward encouragement of more savings and more investment. Over the long run, few quibble any more with the notion that debt-laden U.S. consumers can no longer be the primary engine for growth not only for the U.S. economy but for the global economy as well. But while there is much talk of the long-term need to reduce consumption to sustainable levels, in the short run little or nothing is being done to encourage that shift.
Quite the contrary: Current policies seem designed to get consumers to crank up the debt and consumption machines again. That's the inevitable outcome of current proposals to offer large tax credits for first-time home buyers—even those with little or no savings to make a down payment—or encourage car owners to turn in their old clunkers by subsidizing the purchase of a new car. While certainly useful for getting the economy going in the short term, such moves would do little to spur the inevitable cutbacks in debt that are required.
"Consumer spending is over 70% of GDP. Obama is not going to let it drop to 65%," says Clifton. "He can do the right thing and let the consumer deleverage—and he can also be a one-term President. It's not going to happen." This isn't solely an American phenomenon. As the sense of crisis recedes, similar questions are arising across the globe over whether governments will pull back from needed changes.
As much as the U.S. needs to boost its savings and investment, a healthier global economy will also require the Chinese to lessen their dependence on exports and put more into domestic consumption. While many in China's leadership see a need for fundamental reforms, there are also plenty of others who believe that as the worst of the crisis passes, nothing that extensive is needed. "Like any leadership, there are people in government there who hope that things will just go back to the way they were," says one senior U.S. Administration official. That could be said of many in the U.S. government as well.
Scaled-Back Financial Overhaul Could Still Face Stiff Opposition
Though the Obama administration appears to be succumbing to political realities in offering a less radical regulatory reform plan for the financial sector, the measures may still have enough teeth in them to attract serious opposition both in and out of government. The plan, among other things, would create a systemic, or super, federal regulator, raise capital requirement for firms, impose more oversight over derivatives trading, establish greater protections for consumers and grant the government so-called resolution authority to deal with big institutions whose failure might threaten the overall economy.
"I think this is significant; I think they're headed in the right direction," says Lawrence White, a former White House economist and regulator. "They're trying to go up with a politically feasible proposal rather than a pie-in-the-sky one." The plan, as outlined in a Monday newspaper op-ed piece by Treasury Secretary Timothy Geithner and White House economic adviser Larry Summers, confirmed recent suspicions that the administration was backing off more sweeping changes to the existing regulatory system, such as creating a single banking regular and merging financial market regulators.
"We have had this debate about the regulatory structure every five to 10 years for the past 70 years and we can't come up with a system that is better enough to warrant all the disruption it will cause," said William Isaac, former head of the FDIC. "The system we have today is complicated, but it also has a lot of checks and balance built into it. I don't believe the current regulatory structure led to today's crisis."
The Obama administration is expected to release full details of its plan on Wednesday, one day before Geithner testifies before the powerful House Financial Services Committee, where the long and complicated process of turning the blueprint into a piece of legislation will begin. The plan bears some resemblance to the preferences of the Committee's chairman, Rep. Barney Frank, D-Mass., who will be one of several key players in shaping the legislation's final form.
Both the President and leading Congressional Democrats have repeatedly said they want a law in place by the end of the year, signifying swift and decisive action in addressing some of the systemic problems and regulatory failures that helped cause the nation's worst financial crisis in almost a century. House Republicans are also committing a lot of political capital to the issue, having just last week released their own set of detailed measures, which differ significantly.
Aside from the usual obstacles over political party differences, however, legislation of this nature is unusually tricky because it is bound to create turf wars among regulators and oversight committees in Congress. "They want to lessen the turf wars," says Ariella Herman, an associate at Turner GPA, who follows legislative affairs for corporate clients. " Still, there's no doubt there's going to be a turf battle." A Capital Hill source familiar with the legilsative agenda played down that possibility, saying, "I think we can manage that well enough. There's no reason to re-jigger the jurisdiction."
One area where that may still happen is derivatives, for which the Obama administration intends more thorough and stringent regulation. Right now, the Federal Reserve, the Securities and Exchange Commission and the Commodities Futures Exchange Commission all have some regulatory authority over derivatives. Meanwhile, different Congressional committees have oversight over those agencies, so that could pit the interest of agriculture committees in both the Senate and House against Frank's committee as well as the Senate Banking Committee.
Another key area of contention may be the enhanced role of the Federal Reserve. The Geithner-Summers outline, though still somewhat on the subject, calls for the central bank to be the systemic regulator. It also mentions some kind of council overseeing the Fed in that capacity. Congressional leaders, including Rep. Frank, Senate Banking Committee Chairman Chris Dodd, D-Conn., and its ranking GOP member Richard Shelby, R-Ala., and others strongly support a council approach.
It's also still somewhat unclear at this point whether resolution authority over to too-big-to-fail firms will go to Fed - as opposed to the FDIC, which the Treasury had proposed at one point--or, again some kind of council of regulators. Republicans-especially those in the House-adamantly oppose granting such powers to the Fed; in fact, their reform proposal strips the central bank of all its existing regulatory and oversight powers. They are also opposed to sweeping, draconian regulation of derivatives, saying regulators failed to sufficiently exercise their existing powers in reigning in companies like AIG, which suffered massive trading losses.
Industry groups thus far have been supportive of the reform process, but that partly reflects a sense of inevitability about a package becoming law. "From a systemic supervisor to resolution of non-banks and other areas, we in the industry understand the urgent need for reform and are working to provide substantive and constructive solutions as the political process moves forward," Tim Ryan, president and CEO of the Securities Industry and Financial Markets Association, Sifma told CNBC.com in a statement. (Ryan himself is a former federal regulator who worked in the aftermath of the savings-and-loan crisis two decades ago.)
Based on the most recent outline, the Obama administration's package of reform is something House Democrats "can run with", according to one senior Congressional source., who's optimistc about a speedy legilsative process, possibly even yielding a full House vote in late July. That would probably suit the White House just fine, particulary as it tries to push through even bigger, more high-priority legislative packages covering health care and energy policy. "They really want a win here and want to get something through and not be mired in negotiations and cutback," says Herman. "We're still just coming off the edge of a crisis. The Obama administration is trying to capitalize on that."
Do you see what I see?
I'm still looking for, and still not seeing, the economic recovery that everybody is talking about.
One bit of good news this week was the Census Bureau report that nominal seasonally adjusted U.S. retail and food services sales rose 0.5% in May. But of the $1.57 billion increase in total spending, almost $1 billion of it came from extra spending at gasoline stations. An optimist might read that as an indication that consumers are now prepared to spend more, and just happened to devote most of that extra spending to gas. A pessimist might worry that it portends further cuts in spending on other items ahead. But then, pessimists always find something to worry about, don't they?
National average U.S. gasoline retail price. Source:NewJerseyGasPrices.com.
Or perhaps we can take some cheer from the Labor Department report that new claims for unemployment insurance fell again this week. In principle that could be quite a promising signal. But this week's number puts the 4-week moving average barely below the value we saw May 7.
Seasonally adjusted weekly new claims for unemployment insurance (black line) and 4-week average (blue line) so far this year.
Count Jeff Frankel among the skeptics who see no hint of recovery in total hours worked.
Seasonally adjusted index of aggregate weekly hours (CES0500000034), from BLS.
So maybe all the optimism is inspired by favorable developments elsewhere on this globe. Some point to a resumption of strong economic growth from China. But Edward Hugh (via Brad DeLong) notes that any growth in China is not coming from their ability to sell more products to the rest of us.
Source: Edward Hugh.
Is China's domestic expansion so strong that it can carry this all by itself? Hugh steers us to Macro Man, who thinks that a big part of what's happening is the Chinese are simply buying raw commodities to stockpile. Their copper imports, for example, far exceed what could plausibly be attributed to increased domestic production.
Source: Macro Man.
The above graph, by the way, appears to just go through April, and China's copper imports were up another 6% from those sky-high April values in May. Macro Man has similar graphs for China's imports of coal and iron, and a slightly less dramatic picture for oil. All of which may have something to do with the fact that, despite what looks to me to still be a very weak world economy, the average commodity price in the graph below has increased by over 25% in the last three months.
Worst of global crisis yet to come - IMF chief
The worst of the global economic crisis is not yet over but there are signs that the world has started to crawl out of recession, International Monetary Fund chief Dominique Strauss-Kahn said on Monday. Finance ministers of the Group of Eight nations agreed over the weekend that the global economy was showing encouraging signs of stabilisation and started to consider how to unwind rescue steps for their economies.
The IMF managing director said on a visit to Kazakhstan that he largely agreed with their position but he appealed for caution in assessing the state of the global economy. "Their (G8) stance is that we are beginning to see some green shoots but nevertheless we have to be cautious ... The large part of the worst is not yet behind us," he said in opening remarks at talks with Kazakh Prime Minister Karim Masimov.
"We see, at the IMF, a recovery towards the beginning of 2010. 2009 is already done, we know it's a bad year," he added. "At the global economic level, the growth will be -1.3 (percent) which is the first negative growth since the Depression. 2010 may be better and we expect recovery in the first half of 2010." Pressure has been building in the G8 for plans to wind down economic stimulus as soon as it is no longer needed -- "exit strategies" that would prevent market interest rates from climbing high enough to threaten economic recovery.
Strauss-Kahn referred to credit growth as a sign that financial activity was beginning to pick up, but did not say whether the IMF was ready to help with a possible "exit strategy" once economic recovery is certain. He said an expected global economic revival in the first half of next year would help emerging market nations such as Kazakhstan to return to healthy gross domestic product growth. "...The recovery that we expect at the global level for the first half of 2010 can have a rapid effect on an economy like yours which can pick up rapidly after the global recovery," he told the Kazakh prime minister.
Like other regional economies, ex-Soviet Kazakhstan -- central Asia's biggest economy -- has been hit hard by the crisis which has ended years of double-digit growth. The IMF expects the Kazakh economy to shrink 2.2 percent this year, a more pessimistic forecast than the one percent growth seen by the Kazakh government. Strauss-Kahn said, however, that Kazakhstan's own forecast could prove realistic depending on the state of the global economy. "The forecast of the government, which is a little higher than ours, is not unreachable," he said. "We are in a time where forecasts are difficult to make."
US recession will be less severe than feared, IMF says
The American recession will be less deep and shorter than initially predicted, according to new forecasts published on Monday by the International Monetary Fund (IMF). In an analysis of the US economy, the IMF now expects that the world's biggest economy will notch growth of 0.75pc in 2010, stronger than its earlier prediction. The contraction in gross domestic product will be 2.5pc this year, less severe than the 2.8pc it expected at the time of its last forecast in April.
In a wide-ranging examination at the American economy, which included praise for the policy response of the Federal Reserve and President Obama's administration, the IMF said that the US can expect a 'gradual' recovery next year. However, the group's economists also pointed out that the US government will need to address concerns about its mounting budget deficit and the strategies it employs to withdraw the massive stimulus given to the economy. The missive from the IMF is the latest to confirm that the blitz of monetary and fiscal measures thrown at the economy in the past nine months has prevented the recession from turning into a depression. But even with signs that the data is stabilising, most economists expect unemployment and a weak banking system to prevent a robust recovery.
"The combination of financial strains and ongoing adjustments in the housing and labor markets is expected to restrain growth for some time, with a solid recovery projected to emerge only in mid-2010," the IMF said today. The IMF's emphasis on the need to set out policies to rein in the US deficit comes amid concern about whether big creditors, such as China and Japan, will be able to sustain their appetite for US government debt. "Monetary and fiscal stimulus may stoke concerns about inflation and rising debt, exerting upward pressure on interest rates," the IMF said.
"Hidden agenda" in talk about economic recovery
A union leader will today warn of a "hidden agenda" in talk of recovery from the recession, warning it could hit efforts to save jobs and crack down on tax havens. TUC general secretary Brendan Barber will say that even though some commentators and finance experts were saying the recession was over, many banks, businesses and consumers were still riddled with debt, and the price of oil had shot up, ready to choke off growth.
Mr Barber will tell a meeting of the International Labour Organisation in Geneva: "Of course we should welcome any green shoots, but a few statistics that may or may not turn out to be blips, do not make for a recovery. "Nor will a technical end to recession mean much, if it just means that we bump along the bottom without creating jobs. "With unemployment set to grow for months to come - not just in the UK but across many of the world's economies - it does not look like much of a recovery to the millions who fear for their jobs. "While of course statisticians must do their job, I see a hidden agenda in much talk of recovery. If the economy is on the mend they argue, then we can go back to business as usual.
"There is no need for further action on jobs, no need for proper regulation, no need to crack down on the tax havens. The neoliberal model is not bust, and we don't need to build another kind of economy." The economic crisis will only be over when people were back in work, in good jobs that paid decent wages, Mr Barber will argue, adding: "And unless we build a green economy out of the rubble of the greed economy, the next global crisis will surely be even worse."
Fisher Says Fed Can’t Counter 'Flood' of Treasury Borrowing
The Federal Reserve isn’t capable of offsetting the "flood" of U.S. Treasury borrowing with its bond-purchase program, which has aided a revival of credit markets, Dallas district-bank President Richard Fisher said. "The program has had its impact," Fisher said today in an interview with Bloomberg Television. "At the same time, you cannot counter this enormous flood" of borrowing "coming from the United States Treasury."
Fisher also dismissed the concerns of some central bank watchers that its record purchases of assets will cause inflation to soar. The Fed won’t "monetize" the fiscal deficit by effectively printing money to finance the shortfall, and there’s been no "pressure" from the Obama administration to do so, the Dallas bank chief said. The Fed is "constantly aware" of the need to consider an exit strategy from its unprecedented emergency initiatives during the crisis, and will end the programs at an appropriate time, he said.
Fisher, who describes himself as among the most hawkish members of the Federal Open Market Committee on inflation risks, said it’s inappropriate to be a "screeching hawk" on price pressures now, because of the amount of "slack" in the economy. Policy makers have no plan to raise the benchmark interest rate in the "immediate future," Fisher said before the FOMC gathers next week in Washington. Fisher, 60, doesn’t vote on rates this year.
Crisis of faith for high priests of rational markets
by Gillian Tett
A new realisation has dawned among the most fervent advocates of financial analysis and collective investor wisdom – markets are not always rational. For the past five decades, the Chartered Financial Analyst Institute has been teaching the tenets of analysis based on efficient markets to tens of thousands of adherents around the world who work in the banks, fund mangers and investment houses that make-up the global financial system.
Now, however, the credit crisis has forced the high priests of rational market theory to question their own creed. The British CFA recently asked its members for the first time if they trusted in “market efficiency” – and discovered that more than two-thirds of respondents no longer believed that market prices reflected all available information. More startling still, 77 per cent of the CFA group also “strongly” or “very strongly” disagreed that investors in aggregate behaved “rationally” – in apparent defiance of the “wisdom of crowds” idea that has driven much investment theory.
The shift is significant as the assumption of efficient markets is a cornerstone of the financial calculations of valuing everything from stocks to pension fund liabilities to executive compensation. William Goodhart, UK chief executive of the CFA, on Monday admitted that the results showed a new mood of “questioning” following the financial crisis. However, the trend appears to reflect a wider intellectual swing. In the past three decades, the global asset management industry has been dominated by the so-called “efficient markets” hypothesis, which has given birth to ideas such as the capital asset pricing model, that portrays investing as a trade-off between risk and return.
But the extremities of the recent market swings has sparked interest among politicians and investors in the field of behavioural finance, which asserts that markets do not behave rationally, but can be driven by human emotions such as fear. “We are seeing huge demand among clients to talk about behavioural finance now,” says James Montier, a senior strategist at Société Générale, and an expert in behavioural finance.
However, the CFA survey suggests that the finance industry is not yet ready to rip up all its creed yet. Though two-thirds of the financial professionals surveyed said they regarded behavioural finance as a useful addition to the theories of the efficient market, just 14 per cent thought behavioural finance alone could become the new paradigm. Meanwhile, the CFA itself is hedging its bets: it is now introducing more behavioural finance into its own course, but alongside classic techniques such as the captial asset pricing model.
Subprime Bloodletting Continues at Fitch
Fitch Ratings today made massive downgrades on various vintage ‘05 through ‘08 subprime residential mortgage-backed securities (RMBS), indicating the extent of the fallout related to subprime defaults has yet to subside. The rating agency slashed hundreds of RMBS ratings further into junk territory. Handfuls of Wells Fargo Home Equity RMBS saw ratings drop to single-C from double-C and to single-D from single-C.
A variety of JPMAC RMBS fell to double-C from triple-B and many from double- and triple-C to single-C. A handful of CitiGroup RMBS fell to single-C from double- and triple-C and others to single-D from single-C. Fitch said the actions reflect updated expectations of default and loss from the relevant collateral pool. In terms of losses, the agency expects 17% of the original pool balance of the ‘05 vintage, 39% of the ‘06 vintage and 47% of the ‘07 vintage.
"The home price declines to date have resulted in negative equity for approximately 50% of the remaining performing borrowers in the 2005-2007 vintages," Fitch says in a media statement today. "In addition to continued home price deterioration, unemployment has risen significantly since the third quarter of last year, particularly in California where the unemployment rate has jumped from 7.8% to 11%."
Is the housing bust about to take Manhattan?
New York City real estate prices are looking increasingly shaky as instability in two of the city's sexier submarkets -- second homes in the Hamptons, and new condos in Manhattan -- register the latest signs of a housing downturn. Property prices in the Hamptons, a fabled playground of the rich on nearby Long Island, rose steadily for almost two decades, but the prices on almost 1-in-3 of current listings have been cut an average 11 percent from the initial asking, said Sofia Kim of real estate website StreetEasy.com.
Back in town, the number of sales in new developments dropped a whopping 71 percent in April from a year earlier as condo developers enmeshed in complicated financing arrangements have been slow to slash prices even as the market corrected all around them, Kim said. But if prices on these new condo towers do not fall to match the rest of the market and stay empty as a result, then it could eventually trigger foreclosures of entire properties, forcing much bigger price cuts as lenders seek to reduce their liability.
"If you have a property not priced at market, is it going to sell? Something has to give," said Jonathan Miller, author of real estate broker Prudential Douglas Elliman's market reports. The intensifying of the malaise afflicting New York City comes as housing in parts of the country that got hit hardest by the bust are showing signs of life. Home sales in California, Arizona and Nevada -- states known for risky lending and speculation during the boom years -- have risen as foreclosures and short sales lure buyers into the market.
In New York, it's the opposite. When the rest of the country was watching new neighborhoods begin to disintegrate into foreclosure ghost towns in 2007-2008, Manhattan landlords would still publicize new buildings by hosting parties featuring pop stars, sushi and girls twirling hula hoops in a bid to convert still-airborne Wall Street bonuses into down payments. Today, that bonus pool has dried up amid job and compensation cuts in the financial services sector that drives the city's economy.
"Things are much more subdued," Kim said. "There's no money for parties." The elite in the real estate industry had once hoped Manhattan could escape relatively unhurt as other housing markets suffered. But the collapses of financial powerhouses such as Lehman and Bear Stearns destroyed such thinking. "What ended up killing us was the foreclosure crisis because that's what killed Wall Street," said Rick Hoffman, a regional senior vice president in the Hamptons for the Corcoran Group, a high-end brokerage. "It bit us in the end."
Glass towers designed to appeal to finance industry hotshots had been shooting up across Manhattan as Wall Street's bonus boom powered a surge of new development, said Barry Hersh, a former developer and a professor of real estate at New York University's Schack Institute of Real Estate. Now many developers are struggling to secure lender approval to cut unit prices, he said. Without that, they could face foreclosure and bankruptcy, he said.
Some lenders, wary of an announced foreclosure's negative effect on sales, might opt for a more subtle scenario in which they quietly take control of a property. "You walk in there as a potential buyer and there's still a developer and a broker and a marketing person but in reality the developer has been eliminated from the equation and the bank is deciding whether or not to accept your offer," Hersh said.
Of course, some condo developers are doing what must be done and lowering prices either in consultation with lenders or behind the scenes with buyers. The developers of the Georgica at 305 East 85th Street, for example, in Manhattan went so far as to address its disappointing sales by relaunching the building in mid-May with a revised marketing and pricing plan, said Beth Fisher, a director at Corcoran Sunshine Marketing Group.
Her group advised the developers not to move forward until they had negotiated the necessary price adjustments with its backers, who agreed to a range of cuts, some as much as 20 percent. "You're not going to outsmart the market," she said. "You have to give buyers what they want." Others maintain appearances but lower the real price -- often about 5 percent -- by using concessions such as extra storage or the payment of transfer fees as bargaining chips, said Brown Harris Stevens broker Elaine Clayman.
"They just don't want to look like the prices are going down," Clayman said. Hamptons owners cannot hide that. The blood out there may be blue, but Wall Street's bite is still spilling it. The average sales price in the Hamptons and in the nearby North Fork market plunged 36 percent from a year ago and 25 percent from the fourth quarter to $1.1 million in the first quarter, and the number of sales were down by half year-over-year, according to Prudential Douglas Elliman. "We track bonuses pretty closely in the Hamptons," Hoffman said.
Fat bonuses whip up the market; skimpy ones flatten it. Take one Southampton property: It offers 13,500 square feet on five beachfront acres, a pond out back, nine bedrooms, a "wine cellar/grotto" and a $20 million discount to $60 million from a previous price of $80 million, according to StreetEasy.com. As of late May, another house was on the market for $2.6 million, which was down 40 percent from $4.4 million. And the price of a third was reduced 34 percent to just under $2 million.
Hamptons owners holding out for higher bids can rent their trophy homes instead of selling them. But because so many people are opting to do that, the rental market is weak too, Prudential Douglas Elliman's Miller said. Sellers loath to lower the price are putting more property on the rental market. Tenants smelling blood are demanding lower rents. "It's a double hit," Miller said.
Auto loan delinquencies jump in 1st quarter
Those "green shoots" of economic rebound don't yet have very deep roots. While some economic indicators are pointing to better days ahead, data shows consumers continued to struggle to make loan payments in the first quarter. The latest evidence showed in the rate of auto loan payments that were 60 days or more late. The rate skyrocketed nearly 28 percent in the first three months of the year, compared with the same period in 2008. Credit reporting agency TransUnion said the 60-day auto delinquency rate rose to 0.83 percent from January through March, compared with 0.65 percent last year. While still relatively low, the rising figure shows that "consumers continue to be stressed," said Peter Turek, TransUnion's automotive vice president.
The increase echoes TransUnion data released in recent weeks that showed sharp jumps in first-quarter delinquency for mortgages and credit cards. The rate at which people fell two months behind on their mortgage payments went up for the ninth-straight quarter, to 5.22 percent for the first three months of the year. That's 62 percent higher than the first quarter of 2008. The delinquency rate for bank-issued credit cards rose 11 percent from last year, to 1.32 percent for January through March. TransUnion compiles its data by randomly sampling records from its database of 27 million consumer credit reports.
Taken together, the figures indicate continued struggles to pay household bills as the unemployment rate jumped from 7.2 percent in December to 8.5 percent in March. Auto delinquencies did edge down .03 percent from the fourth quarter of 2008 to the 2009 first quarter. But Turek said there is a strong seasonal pattern for late auto payments, and the slight improvement was not as strong as is typical. The state with the highest auto loan delinquency is Mississippi, at 1.49 percent, followed by Louisiana at 1.4 percent. Of the four states hit hardest by the mortgage meltdown, only California at 1.33 percent and Nevada at 1.28 percent, are in the top five in auto loan delinquencies. As with other types of loans, South Dakota and North Dakota have the fewest delinquent auto loans, at 0.34 and 0.35 percent, respectively.
Meanwhile, as auto sales continue to be depressed, the average outstanding balance on auto loans slipped 1.9 percent, to $12,596 in the first quarter. The decline reflects the tight credit market and few loans being made, Turek said, along with a greater reluctance among consumers to take on new debt. From the first quarter of 2008 to the 2009 first quarter, the number of new auto loans plunged 40.5 percent, he said. Meanwhile, the average auto payment fell nearly 9 percent, to $361 from $395 a year ago. TransUnion forecasts the rate of auto loan delinquencies will continue to rise through the end of the year, reaching about 1 percent. That's the same level seen during the 2001 recession, Turek said. The agency also expects mortgage and credit card delinquencies to continue rising through the end of 2009.
US Hospital Industry Bristles at Cuts
Hospitals and other medical-industry groups are pushing back against President Barack Obama's proposal to cut $313 billion in government health spending as the White House intensifies its effort to revamp the nation's health system. Mr. Obama will seek to build doctors' support for a health overhaul in a speech Monday to the influential American Medical Association in Chicago. He will make the case for controlling costs and expanding coverage, and he plans to detail more of what he wants to see in a government-run plan that would compete with private insurance companies, an administration official said Sunday.
Mr. Obama is pressing Congress to pass legislation to overhaul the country's health-care system by October. His plan would expand insurance coverage to the nation's 46 million uninsured, an effort estimated to cost at least $1 trillion over a decade. Under pressure to amplify its payment plan, the White House on Saturday outlined $313 billion in additional spending cuts over that period to health-care providers paid through Medicare and Medicaid, the federal health programs for the elderly and poor. That would bring total cost savings and tax increases identified by the Obama administration to help pay for the overhaul to nearly $950 billion.
The sharp response from the hospital industry, which under the proposal faces reductions in subsidies exceeding $100 billion over 10 years, illustrates the administration's challenge in winning the deep concessions from industry needed to pay for the overhaul. After agreeing in May to contribute to a $2 trillion reduction in health spending over 10 years, the hospital industry is now bristling at the prospect of more givebacks -- this time, cuts that would be set in law.
"We're certainly disappointed," said Rich Umbdenstock, chief executive of the American Hospital Association, an industry group. "It will be very, very difficult for hospitals to live with cuts of that magnitude." He said what concerns the group is that the cuts were being laid out before lawmakers have agreed on concrete proposals for reducing the number of uninsured. A spokeswoman for the White House Office of Health Reform said that as more Americans get insurance coverage, the need for the government to subsidize hospitals for covering the uninsured will decline.
The pharmaceutical industry recently has been negotiating with the White House and Congress over how much it would contribute to the cuts, said several people familiar with the negotiations. Drug companies were initially asked to contribute $100 billion over the next decade, but pressed for their contribution to be closer to $60 billion, they said. The industry argued that giving up too much in payments would cut into spending to develop new drugs.
"Otherwise we might all just become generic drug companies," said one industry official familiar with the talks. The White House on Saturday said it would save $75 billion over 10 years by paying better prices for drugs under the Medicare Part D prescription drug plan. The Access to Medical Imaging Coalition, which represents makers of medical-imaging equipment, said the administration's proposed cuts "will impair access to diagnostic imaging services and result in patients' delaying or forgoing life-and-cost savings imaging procedures."
So far, the hospital association, as well as other major groups representing doctors, insurance companies and drug makers, support legislation aimed at expanding health-insurance coverage and putting the nation's health system on a more sustainable path. Such changes would benefit the industry by increasing their customer base through a fresh batch of insured Americans. One hospital advocate said he saw the White House proposal as "trying to give cover to the Hill," as congressional committees work out final details of their health packages, including spending cuts to pay for it all.
"This takes some pressure off of them," the advocate said. If Congress were to propose less-severe reductions, interest groups could greet the plan with some relief, noting it could have been worse. New York City offers a window into what could happen when payments to safety-net hospitals are cut. Already running at a deficit, the city's public hospital system is looking at $150 million in state Medicaid cuts for next year. Next month, it will close some outpatient services, such as community-based primary and preventive-care offices. "We are in a position already where we are making painful decisions that require us to reduce access and services," said Alan D. Aviles, president and chief executive of the system, known as the Health and Hospitals Corp.
Fed's Conundrum on Treasury Purchases
For all the worry about how the government will finance its deficit spending, it is having little trouble so far. The Treasury Department is scheduled to release Treasury International Capital, or TIC, data for April on Monday. Tracking the flow of money across U.S. borders, it includes data on foreign demand for government debt. It's a fraught topic lately. The 10-year Treasury bond yields 3.78%, up from less than 3% three months ago. The government's creditors are charging more partly because they fear its policies will spark inflation.
The Federal Reserve has been buying Treasurys to help keep rates low, but its spending is only aggravating inflation worries and may paradoxically be pushing rates higher, threatening to smother the nascent economic recovery. Fed officials may not expand their planned purchases. Fortunately, they have help. March TIC data showed foreign central banks bought $29 billion in long-term Treasurys, the highest monthly total since January 2008. Last week's auction of 30-year notes was a hit, thanks to heavy central-bank interest. A report Friday that Japan's Finance Minister called Japan's faith in Treasurys "unshakable" helps offset a recent Russian threat to sell Treasurys.
Another important player is in the mix: so-called U.S. "households." The Fed defines households as all households plus domestic hedge funds. This camp bought Treasurys at a record $1.24 trillion annualized rate in the first quarter, nearly enough to mop up all Treasurys issued that quarter. But households likely shed Treasurys in April to chase sexier investments like stocks. Monday's TIC report may show foreign buyers doing the same thing.
Households and foreigners have financed Treasury purchases mainly by selling mortgage-related debt to the Fed -- "paying Peter to pay Paul," says Alan Ruskin, chief international strategist at RBS Greenwich Capital. If investors buy mortgage debt again, that makes the Fed's life easier on one front, but could sap demand for Treasurys. Getting investors to re-embrace risk should be a good thing, but if the Fed lets rates rise too much, then the economy will suffer and make investors risk-averse again. It's the Fed's current conundrum.
Federal Intervention Pits 'Gets' vs. 'Get-Nots'
Factory worker Dennis Davis recently stopped at the Cabela's store here to buy a $90 carrying case for the long-barreled Contender pistol he uses to shoot pesky groundhogs at his brother's farm. He paid with a store-issued credit card.
The U.S. government helped finance the transaction. Earlier this year, it recharged the credit-card operations of the Nebraska-based retailer of hunting and camping gear with nearly $400 million of federal financing. Mr. Davis was surprised to hear about the government's helping hand, and hardly pleased. "Anything the federal government, or any government, sticks its nose in fails or makes things worse," he said as he made his way across the parking lot with his son.
True or not, what's undeniable is that the federal government has burrowed its way deep into the quotidian workings of American capitalism. Since the onset of the financial crisis nine months ago, the government has become the nation's biggest mortgage lender, guaranteed nearly $3 trillion in money-market mutual-fund assets, commandeered and restructured two car companies, taken equity stakes in nearly 600 banks, lent more than $300 billion to blue-chip companies, supported the life-insurance industry and become a credit source for buyers of cars, tractors and even weapons for hunting.
The effects are rippling into nooks of the economy far beyond Wall Street and Detroit's troubled car industry. The massive intervention has shifted the way companies do business in a host of ways -- not all of them intended by the government. Increasingly, companies big and small are competing on the basis of their ability to tap government money. A divide is opening between gets and get-nots.
Thanks to federal loans, Cabela's Inc. didn't have to slash credit to its customers. But Genworth Financial Inc., a big insurer, failed to get bailout money, and has raised capital in other ways, such as cutting its dividend. Still other firms hope to gain an edge by steering clear of the government. UMB Financial Corp., a bank in Kansas City, Mo., is going after new customers by boasting that it hasn't taken any bailout money.
Government spending as a share of the economy has climbed to levels not seen since World War II. The geyser of money has turned Washington into an essential destination for more and more businesses. Spending on lobbying is up, as are luxury hotel bookings in the capital. President Barack Obama has vowed to reduce the government's role in the private sector as soon as possible. Federal Reserve Chairman Ben Bernanke says most of the central bank's emergency programs will be unwound within a few years.
But a recent Wall Street Journal poll of economists found that only 16% believed the federal government would be able to meet its goal of ending rescue programs soon without fundamentally altering the competitive landscape of the private sector. The intervention helped stabilize the economy, but could slow growth in the long-run. Some economists and business leaders worry the intervention will result in rules that hamstring the way some businesses operate, and that it will sustain unproductive zombie firms and burden the next generation with debt or inflation.
Lawrence Summers, President Obama's chief economic adviser, says the administration has intervened in the private sector prudently. The Democratic White House and its Republican predecessor have said that without an aggressive government response, the nation might have faced an economic disaster on the scale of the Great Depression. "Our approach to intervention in specific companies is recognizing the need to do what's absolutely necessary, but also recognizing that it's absolutely necessary to do no more than what is needed," says Mr. Summers.
The economic crisis, which began with turmoil in mortgage markets, washed over many companies when broader credit markets seized up. In March, the finance arm of Cabela's had $250 million in debt tied to store-issued credit cards coming due. But investors no longer had much appetite for new securities backed by credit-card debt, which is how Cabela's usually covered such obligations. The Fed and the Treasury Department provided nearly $400 million to Cabela's credit-card operations through a program aimed at reviving the consumer-loan market -- the Term Asset-Backed Securities Loan Facility, or TALF. The program lends money to investors to buy securities backed by credit-card loans and other consumer debt.
"Had we not been able to refinance this [debt], we would have massively reduced credit limits and canceled cards," says Cabela's chief financial officer, Ralph Castner. Now, Cabela's is pushing customers to borrow more. On a recent morning, employees near the entrance of the store in Hamburg encouraged customers to sign up for new cards. The prospect of dipping into buckets of federal money has ignited competitive scrambles in lots of industries. In the farm-equipment sector, Deere & Co.'s purchase of a thrift years ago qualified it in December for a government guarantee on $2 billion of its debt, through a Federal Deposit Insurance Corp. program to help banks access debt markets.
But the FDIC didn't cover competitors such as Caterpillar Inc. or smaller equipment providers. So the Equipment Leasing and Finance Association, a trade group, lobbied the Fed to expand the TALF program to sales of farm equipment and other machinery. The association's president, Kenneth Bentsen, a former Democratic congressman from Texas, met with the Fed's general counsel and followed up with phone calls and letters. The Fed eventually expanded TALF to cover Deere, Caterpillar and other equipment makers.
Some of the neediest companies don't qualify for such help. By law, the Fed's loans have to be well-secured, so for the most part the Fed can finance only borrowers with top credit ratings. That's hurting some smaller equipment-leasing firms that can't get the high ratings. They now have to pay as much as four percentage points more than higher-rated firms to borrow -- a gap about three percentage points greater than before the crisis, the firms say. Balboa Capital Corp., an equipment-leasing company that doesn't qualify for Fed financing, is slashing expenses by about 25% to try to stay alive. "We're on the endangered list," says Phil Silva, Balboa's president.
Insurance companies have cooked up their own tactics to try to get into the federal money pot. Big insurers such as Lincoln National Corp. and Genworth Financial tried to buy small savings-and-loan associations in Indiana and Minnesota, hoping to qualify as banks and become eligible for bailout funds. Lincoln National sought permission from the FDIC to issue government-guaranteed debt. MetLife Inc. ramped up its borrowings from the Federal Home Loan Bank of New York, part of a nationwide lending cooperative. Only some have succeeded. MetLife, which entered the crisis stronger than many rivals, was aided by the FHLB and FDIC, and had access to Treasury funds, which it says it doesn't need.
Genworth failed to get regulatory approval to buy a thrift and get Treasury funds. It raised capital in other ways, including suspending its dividend and selling part of a Canadian business. Lincoln National got approval to buy a thrift but lost some access to a Fed commercial-paper lending program in February when its credit rating was lowered. "What we're seeing now is greater differentiation among the companies in terms of their financial flexibility and actions that they can take to improve their capital and liquidity positions," says Robert Riegel, a Moody's Investors Service managing director.
Mr. Summers, the Obama economic aide, says the government isn't trying to pick winners and losers. "You have to distinguish between emergency cases and broader policies," he says. "In the case of broader policies, the effort is to set rules of the games that affect all companies, certainly not to choose between companies." All the jockeying for money has energized Washington's lobbying industry. Overall spending on lobbying this year is on track to reach the $3.3 billion spent in 2008, according to the nonpartisan Center for Responsive Politics. The 2008 total was an 80% increase from the $1.8 billion spent in 2002, when businesses were fighting the Sarbanes-Oxley accounting and corporate-governance legislation.
The public is cooling a bit on the notion of a powerful government role. A Wall Street Journal/NBC News poll conducted at the end of April found Americans split 47% to 46% on whether the government should "do more to solve problems" rather than leave it "to businesses and individuals." Two months earlier, respondents had favored more government involvement by a margin of 11 percentage points.
Some businesses are trying to tap this antibailout sentiment. Worthington National Bank has erected billboards around Forth Worth, Texas, boasting that it hasn't been bailed out -- a shot at a crosstown rival that took federal cash. Victor Stabio, chief executive of Hallador Petroleum Co., a Colorado coal and oil producer, recently got mail from UMB Financial, a bank in Kansas City, Mo., that advertised it hadn't taken a penny from the Treasury's Troubled Asset Relief Program, or TARP. Mr. Stabio says he was impressed. He moved $8 million of Hallador's money to UMB. "I didn't like the whole TARP program to start with," he says.
In addition to its lending, the government is showering money on the private sector through direct spending. Federal outlays are expected to swell to 28.1% of gross domestic product this year, a bigger percentage than any time since the 41.9% hit during World War II. The $787 billion fiscal stimulus program is meant to favor certain sectors, including telecommunications, health and green energy. Companies are trolling for those dollars.
Gideon Ben-Efraim of Mountain View, Calif., says he is seeking money from Washington for the first time in his career as a telecommunications entrepreneur. His latest start-up, PureWave Networks Inc., a wireless telecom firm, scrapped plans to sell equipment initially in emerging markets. Instead, he retained the Washington law firm Patton Boggs to figure out how to tap the $7 billion the government is setting aside for broadband networks in the U.S. American Electric Power Co., a large utility based in Columbus, Ohio, is helping state officials get funding for a carbon-capture-and-storage demonstration project aimed at burning coal more cleanly.
The bailout help won't be available forever, which is only adding to the urgency. Fed Chairman Bernanke, asked to look ahead five years, says that by then "the government's financial interventions in the market will be largely liquidated." He is implementing a strategy to unwind the Fed's programs over time. Some are designed to end as markets recover. Sticking to that timetable could be a challenge. Fed lending initiatives already have been extended well beyond their original expirations. Other Fed lending programs -- such as the TALF program and the rescue of American International Group Inc. -- involve making loans that could last five years or longer.
The Fed is accumulating a huge portfolio of mortgage-backed securities. Buying them helped push mortgage rates down. Selling them, if the Fed decides to do so, could meet political resistance because it would push rates up. One of the most important pieces of the federal intervention is the rewriting of financial regulations, which the administration expects to propose this week. Under the plan, firms deemed "systemically important" would be regulated more heavily than other firms, to limit the chance they fail and threaten the broader economy.
Government backing could help banks, hedge funds, private-equity firms and others considered too-big-to-fail firms to gain an advantage by being able to borrow at rates below their smaller competitors. But there's a catch. The government could demand these big firms hold more capital or limit their dependence on debt, discouraging them from gambling with taxpayer backing. That would limit both their risk-taking and their potential profits.
Josef Ackermann, chief executive of Deutsche Bank AG and an economist, says business has itself to blame for the government's heavier hand because it spawned problems it couldn't handle. "A trusted third party was needed -- and I hate to say this as a market economist -- and that was the state," he said on a recent visit to the U.S. "The pendulum will probably swing back to a larger role for the state than is sensible for long-term growth."
Summit hears calls for new US economic strategy
The United States needs a clear strategy to remain a competitive leader in industry and other sectors of an economy in crisis, business leaders told a national summit that opened Monday. The three-day summit in Detroit, Michigan aims to develop a national consensus on policies for technology, energy, environment and manufacturing. "Our goal is to develop a to-do list of actions that will revitalize and revive our economy," said Bill Ford, executive chairman of Ford Motor Co. and co-chair of the summit's opening session.
Ford said the global economic crisis "increases the urgency to begin a national dialogue on the economy." The meeting reflects growing momentum for the United States to formalize an "industrial policy" similar to those used in Asia and elsewhere to help nurture businesses in a tough global environment. The summit also seeks to define policies on energy, environment and technology. Although industrial policy is often equated with protectionism, Ford and other speakers said the US needs to be tougher with trading partners to maintain prosperity. "Having no policy is a bad policy," Ford said.
"Other countries understand this and they work hard to maintain a strong industrial base," he said. "They bend or even break the rules to maintain a competitive advantage over the us. We need to do something different." Echoing those calls, fellow co-chair Andrew Liveris, chairman and CEO of Dow Chemical Co., called for "a modern-era industrial policy, one built for the 21st century." "The life force and strength of this country has to be rebuilt," Liveris told the gathering of several hundred people. "It has to be rebuilt by American industry."
Liveris said that "maybe we all became enamored with the idea of making money from money. And we forgot that making real things, real innovative things, still matters." Michigan Senator Carl Levin said the notion of industrial policy for many years was "anaethema to many people ... it was a killer label." But he said there is a growing recognition including at the White House of the need for more government involvement in the economy. "There is a recognition finally in this country that our global competition is not just with companies, but with the governments that support those companies," Levin told a summit forum. "It's a fundamental awakening."
Thomas d'Aquino, president and CEO of the Canadian Council of Chief Executives, acknowledged the need to shift policy. "There is a perception that America has been weakened by the financial calamity," he said. "I think the US has been too much the boy scouts, and we're working in a different environment." One note of caution came from Bud Peterson, president of the Georgia Institute of Technology, who warned against following the models of some countries that invest directly in companies. "In this country, we have invested in universities in research, and that drives the technologies that create the companies that create jobs," he said.
The summit, which may continue as an annual event, grew out of conversations at the Detroit Economic Club about the future of the US economy. The speakers include chief executives Richard Anderson of Delta Air Lines, Steve Ballmer of Microsoft Corp., Vikram Pandit of Citigroup, Fritz Henderson of General Motors and Alan Mulally of Ford. From government, new US chief technology officer Aneesh Chopra and Commerce Secretary Gary Locke will appear among the 90-plus speakers.
Called last September, the summit has taken on new importance amid a recession that is the worst in decades, costing more than six million US jobs. A group of protesters planned to march on the Detroit Renaissance Center where the event was being held to call for a shift away from a corporate focus. A statement from organizers said the economic summit "will be strategizing on how to further increase their profits at the expense of the ever-shrinking middle class, the vast working class and the growing millions living in utter poverty."
Optimism is not enough for a global recovery
Last week, the green shoots shrivelled. In South Korea, China and Germany, exports were declining once again. In the US, the Federal Reserve’s Beige Book said "economic conditions remained weak or deteriorated further during the period from mid-April through May". The March signs of revival turned out to be little more than a technical inventory correction, with no change in the underlying trend. The world economy is still contracting, though perhaps not quite as fast as at the start of the year.
As an analysis by economists Barry Eichengreen and Kevin O’Rourke* shows, global industrial output is still on the same trajectory as it was during 1930. The only question is whether we can avoid 1931 and 1932. The answer is yes, but on conditions that seem increasingly implausible if we extrapolate current policies. We can avoid calamity if monetary and fiscal policies remain supportive throughout the duration of this crisis, if we fix the banking system and if we impose regulations to constrain a resurgent financial sector. We also have to be lucky to avoid another round of market turbulence in the near future.
In other words ... the answer may well be no. Central banks and governments therefore risk moving too swiftly out of a recession-mode strategy. When Axel Weber, president of the Bundesbank, publicly talks at this time about how to communicate a rise in interest rates, it tells me that the danger of a premature exit, at least in Europe, is clear and present. Fiscal policy exit strategies were at the top of the Group of Eight finance ministers’ agenda on Saturday, with the Europeans in greater haste than others. Nobody is solving the toxic asset and recapitalisation problems of the banks. Financial regulation does not seem to be extending much beyond populist pseudo-measures on tax havens. Plus there is still financial meltdown potential in the system.
Latvia, for example, is a ticking time bomb. So at this point, I see the chances as roughly even between a global slump and a return to quasi-stagnation. What is so galling about this scenario is that it is avoidable. The central banks took the right decisions. But the political reaction has been near-catastrophic almost everywhere. Instead of solving the problems to generate a recovery, the political strategies have consisted of waiting for a recovery to solve the problem. The Europeans are relying on the Americans to generate growth. The Americans are relying on the Chinese, who in turn are waiting for the rest of the world.
Even if the US were to generate some growth, as is likely after this summer, it would not benefit global exporters; China may be one of the fastest growing economies in the world, but it is only about half as large as the eurozone in dollar terms. And as Brad Setser** has pointed out in his blog, there is absolutely no evidence that China contributes to a global recovery. While Chinese investments are up by more than 30 per cent from last year alone, imports are down 25 per cent.
All this hype about decoupling and China pulling the world out of recession is baloney. The data tell us that China’s exports and imports are both falling, and that imports are falling faster. As everybody expects the others to move first, nobody ends up moving. In the meantime, the problems grow worse. US house prices, which are down by a little over 30 per cent from their peak, still have some way to fall. Until the US housing market hits rock bottom, perhaps sometime in 2010, there is no chance of a recovery in the securitisation market, without which there may not be sufficient credit growth.
As the recession continues, the number of personal and corporate insolvencies will rise, which in turn will aggravate the problems of the banking sector. I am not surprised that the Bundesbank’s Mr Weber resists the publication of stress tests for the banking system. It would show that the German banking system was insolvent – and that bad and potentially bad assets were equivalent to about one-third of gross domestic product. The only potentially good news in the past three months has been the receding threat of a currency crisis in central and eastern Europe. But I am not even sure that this is for real. The persistent refusal by eurozone policymakers to concede fast-track euro accession for central and eastern member states could yet prove destabilising.
Last week, the ECB had to provide €3bn in euro liquidity to Sweden’s Riksbank, in the absence of which Sweden may have experienced its second banking meltdown in less than two decades. The inevitable collapse of Latvia will have ripple effects on the Baltic region and may cause panic among investors in other central and east European countries. This is why last week’s news about the withering green shoots is so important. It tells us that the non-strategy of waiting until things get better is not working. The March signs of life reinforced complacency. Optimism will get us out of this crisis only if it is founded in reality. Last week showed us that this is not the case.
Eurozone banks face $283 billion writedowns
Eurozone banks face additional losses of more than $283bn this year and next as continental Europe’s severe recession intensifies strains on its financial sector, the European Central Bank has warned. The fates of the eurozone economy and its banks have become increasingly interlinked, the ECB reported on Monday in its latest "financial stability review" with banks losses expected to be focused on their loan exposures. Risks to the stability of the financial sector remained high, it said, while "uncertainty prevails" over the shock-absorbing capacity of the banking system. Its stark comments could fuel calls for European politicians to step up the "stress-testing" of the Continent’s banks to restore confidence in the system.
Weaknesses in continental Europe’s banks have come under increasing global scrutiny recently, with finance ministers facing pressure at a G8 summit in southern Italy at the weekend to follow the lead set by the US. Lucas Papademos, ECB vice-president, said that "a negative interplay" between the financial sector and the economy had become clearer since the start of this year. He stopped short of calling for more rigorous stress testing or the publication of review results saying the issue "remains the responsibility of national authorities". The ECB, which acts as the monetary authority for the 16 countries that share the euro, is not a bank supervisor. However Mr Papademos repeated the ECB’s plea for banks to ensure they had sufficient capital and liquidity buffers and to take advantage of government support schemes.
Despite the scale of the bank losses that the ECB saw as still facing eurozone bank, it was strikingly less gloomy than the International Monetary Fund, An IMF report in April put expected write-downs this year and 2010 at US $750bn, although taking account of loss provisions and write-offs up until May this year would reduce that to about $540bn. The gap was due to different assumptions, for instance on the performance of loans. The ECB also expressed confidence that the eurozone’s largest banks could endure any further economic deterioration, saying "most … appear to be sufficiently well capitalised to withstand severe but plausible downside scenarios".
Among the main risks to the eurozone’s financial system identified were: a renewed loss of confidence in the financial strength of large banks; balance sheet strains facing insurers; larger-than-expected further falls in US house prices, and "an even more severe than currently projected economic downturn in the euro area," Mr Papademos said. Banks also faced the risk that they had become "possibly too reliant" on emergency liquidity provided by central banks since the start of the financial crisis, according to the ECB report. While attention had so far focused on write-downs related to asset-backed securities and derivatives, the report said that "increasingly … attention is focusing on corporate debt and the likely loan losses that may materialise as the turmoil continues and the real economy endures a significant slowdown."
The ECB does not expect the eurozone to return to positive quarterly growth until the middle of 2010. The ECB also warned about the threat posed by an intensification of the difficulties facing central and eastern Europe economies. But it concluded that even if the "worse case" scenario materialised this year in the European Union’s newest member states, Asia and South America, the balance sheets of the eurozone’s largest banks would, overall "not be unduly strained" – although some individual banks would be significantly worse affected.
European recession will worsen, says economist
The worst of the recession is yet to come, European finance chiefs warned today. And there is still "something rotten" in the banking system in Europe, despite the spate of recent state bailouts. Erik Berglof, chief economist at the European Bank for Reconstruction and Development, and EU Competition Commissioner Neelie Kroes were speaking at the Forbes CEO Forum in Gleneagles today. "I don't think the worst is behind us," Mr Berglof said.
"We've not seen everything yet." There may be a bit of upturn in the economy before a slow recovery sets in, he added. Ms Kroes said: "There's still not the trust in the banking world. "It's a major thing that banks are lending, otherwise the economy will not function. "There's still enough bankers who are doing this because they realise there is still something rotten in the closet."
Mr Berglof called for a US-style approach to publicise the bad debts in the system, during a question and answer session with Steve Forbes, chairman and editor of Forbes magazine. "There's a sense that we don't know yet what's in our banking system," Mr Berglof said. "There's a need not only to find out but also to make public like you did in the United States. "That was a model for how to do it and it certainly helped to stabilise the system. "We need the same thing in Europe now and we need to make it public."
Ms Kroes told delegates that she recently held a series of meetings with representatives of the banking sector, who were blaming each other for the problems. "Quite a number of them were denying the situation in their own institutions," she said. Banks have to start lending money to allow smaller business to operate, Ms Kroes said. "They need loans - nothing more or nothing less.
"We're not yet at the end of the result of the consequences of this recession." The crisis in the car industry, including firms such as General Motors going into administration, is down to mismanagement, Ms Kroes said. She said: "There was over-capacity. There was more than 25% over-capacity in the production of cars before the crisis - the consequences of this are now on us."
UK resists EU plans for stricter financial regulation
City minister Paul Myners will visit Stockholm this week to cement an alliance with Sweden in the hope that the two governments can scupper plans made at the weekend's G8 summit to push ahead with stricter regulation of London's financial sector. Myners, who is spearheading the government's resistance to proposed EU regulations governing hedge funds and private equity firms, will meet up with his opposite number Mats Odell, the Swedish minister for local government and financial markets.
They are concerned about the "Lecce Framework" put forward by the Italian finance minister, Giulio Tremonti, and named after the southern Italian town that played host to G8 finance ministers at the weekend, including Britain's Alistair Darling. The framework was put forward as a "set of common principles and standards regarding the conduct of international business and finance". Details of how the framework will operate have yet to be sketched out, but Tremonti set out five areas where countries should agree international rules: corporate governance, market integrity, tax co-operation, transparency of macro-economic data and policy, and financial regulation and supervision.
While ministers publicly welcomed the framework, several EU countries including Britain and Sweden are concerned that Brussels will use the banking crisis as an excuse to clampdown on "Anglo-Saxon" financial institutions that are deemed to take excessive risks. Plans are already on the table that would shift regulation of markets in equities and derivatives to EU institutions, in effect stripping London of its ability to supervise its own and take account of cultural differences Pan-EU authorities for securities, insurance and banking supervision would have binding powers over member states.
industry. Myners has warned that attempts to intervene in the supervision of Britain's banks will be rebuffed by the Treasury. He has attacked a directive that would clampdown on hedge fund managers, claiming that it would undermine London as Europe's hedge fund centre. Adair Turner, chairman of the main City regulator, the Financial Services Authority, said at the weekend that he expected a compromise to be found.
The plans must be adopted by EU governments and the European parliament to come into force. Germany, France and Italy have already thrown their weight behind the plans, which are due to take effect in 2010. "We believe we will end up with something that is a reasonable way forward," Turner told Reuters at the annual meeting of the International Organisation of Securities Commissions (IOSCO) in Tel Aviv said.
"If one was absolutely confident that European supervision was going to be completely politics-free, in a neutral, technocratic fashion, we would be more relaxed about it." Next month Sweden takes over the presidency of the European Union and is expected to oversee the implementation of Europe-wide regulations to prevent a repeat of the financial crisis. Odell was in London last week where he said that neither the hedge fund industry nor private equity could be blamed for the financial crisis. He has put forward plans for a compromise that would leave supervision with individual states other than in exceptional circumstances.
He said Britain must concede greater information sharing, while the EU must agree not to use the information unless an emergency warranted intervention. Myners said: "What we could not live with is an agreement at a European level that would have had domestic fiscal consequences for domestic governments. "That is why sSupervision of individual institutions must remain a matter for national supervisors. We will strongly defend this principle at the forthcoming European Council meeting."
Greek banks start to feel the heat
After a decade of explosive loan growth triggered by Greece’s entry to the eurozone, the country’s banks are experiencing the downside of a financial cycle for the first time as the economy stutters in the global downturn. Exports are declining, the tourist season has got off to a poor start and the Greek economy is projected to shrink by about 1 per cent this year, according to the International Monetary Fund. Years of excessive spending have pushed up the public debt to almost 98 per cent of gross domestic product.
So far the banks have shown some resilience, assisted by a €28bn government support package that included a €5bn capital injection in preferred shares, and there have not been any government bail-outs of individual banks. Also, Greek banks managed to avoid exposure to the toxic assets that caused such a problem for their global peers because the domestic and regional retail sector provided sufficient opportunities. Greece is still underbanked compared to the rest of the eurozone.
The country’s four big lenders all suffered a drop in first-quarter profits but all managed to stay in the black. National Bank of Greece, the country’s biggest financial group, posted a 21 per decrease compared to the same period in 2008. The other three - EFG Eurobank, Alpha Bank and Piraeus Bank – reported year-on-year falls of more than 60 per cent after doubling provisions for non-performing loans. However, the situation may be about to worsen with analysts forecasting bad loans will rise this year from 3.8 per cent to about 6 per cent before peaking in the first half of 2010. Meanwhile, Fitch, the ratings agency, last week warned the banks’ performance for the rest of the year would likely be hit by higher loan impairment charges.
Large Greek banks have reported worsening asset quality in the past two quarters, mainly in retail lending. “All expect a further deterioration for the rest of 2009, also from their small and medium [sized] enterprises and corporate loan books,” Fitch said. Worst-hit by the crisis are small and medium-sized Greek family-owned enterprises that benefited from the banks’ competitive rush to extend credit during the boom years.
Cost-cutting has become a priority for the banks, in spite of union opposition and rigid labour regulations. EFG Eurobank is committed to a 5 per cent reduction this year, while National, Alpha and Piraeus all expect costs to stay flat. Domestic credit expansion is forecast to decline to 7-12 per cent this year from 16 per cent in 2008. But in south-east Europe, where the four big lenders together claim an 18 per market share, credit expansion is forecast to fall from about 28 per cent to less than 5 per cent.
With Serbia, Romania and Bulgaria all likely to see their economies shrink 4-6 per cent this year after a prolonged period of high growth, fuelled to a large extent by a credit boom, Greek banks have frozen plans for further network expansion. Stylian Vatev, chief executive of United Bulgarian Bank, National’s Sofia-based subsidiary, said: “The focus has changed ... the challenge now is to keep asset quality in good shape.” Banks have stopped transferring funds to regional subsidiaries, citing a sharp fall in demand for loans.
However, as the domestic market matures, banks will rely more on growth opportunities in south-east Europe. Before the crisis, analysts’ projections showed regional subsidiaries contributing about 30 per cent of profits by 2010. “Any thought of withdrawing from the regional markets, which have sound long-term prospects, would be a disastrous mistake,” Mr Nanopoulos says. In the short term at least, the liquidity squeeze has eased due to the Greek government’s support package. Banks have borrowed €4.4bn from the European Central Bank, using as collateral zero coupon bonds provided under the government rescue plan.
Interest margins are improving, according to analysts. Rates for time deposits, which reached 6-7 per cent as banks competed aggressively for funding early this year, have fallen to 2-3 per cent and spreads have widened on new lending. “I believe that after mid-year, taking into consideration signs of improvement in the business environment, we’re likely to return to a more satisfactory rate of profitability,” says Nikos Nanopoulos, chief executive of EFG Eurobank.
The magical world of credit default swaps once again
by WIllem Buiter
To think I believed I had seen it all as regards creative uses and abuses of credit default swaps (CDS). But then came Amherst Holdings. A credit default swap written on a security (a bond, say) is a contract that pays the owner a given amount when there is a default on that security. In the simplest case, the owner of the CDS receives from the issuer or writer of the CDS the face value of the bond that is in default.
The writer of the CDS sells insurance against an event of default. The insurance premium is the price of the CDS. The buyer of the CDS buys insurance against default. If the default does not occur, the writer of the CDS wins, because he has received the insurance premia, but has not had to pay out on the insurance policy.
An obvious problem with CDS is that you do not have to have an insurable interest to purchase the insurance it provides. You have an insurable interest, as a purchaser of insurance, if the occurrence of the contingency you are insuring against would not make you better off (even when the insurance pays out). However, the CDS market is first and foremost a betting shop.
You can buy CDS written on a given class of bonds, in amounts well in excess of the total face value of the bonds you own in that class. Indeed you may not own any bonds in that class and still buy CDS that pay off in the event a default occurs on bonds in that class. That is, CDS can be used not to hedge risk you already are exposed to, but to take on additional risk. CDS can be used to place pure bets.
The morality of gambling, through CDS or any other way
Betting and gambling, including lotteries, are frowned upon by many religions and by many who do not have a religious conviction. Gambling is not explicitly forbidden in the Bible, but it is a vice that goes against many biblical principles. It sits uncomfortably with the great command "love your neighbour as yourself", it exploits the poor (gambling is regressive), it undermines the work ethic, it encourages greed and covetousness, it violates responsible stewardship of the resources one is entrusted with, it ‘leads into temptation’, and it can be highly addictive.
It is also often associated with deception. Against that, ‘casting lots’ is a common way of making decisions in the Old Testament especially. The phrase ‘casting lots’ is used 70 times in the Old Testament and seven times in the New Testament (including the reference to the soldiers at the cross casting lots for Christ’s garments).
Classical Judaism shares the views on gambling found in the Hebrew Scriptures with Christianity, but also draws on more recent traditions. As I understand it, the classical Jewish tradition says that it is forbidden to make gambling your occupation, but it does not forbid a little friendly gambling every now and then. Islam prohibits gambling. It also prohibits any game or other activity which involves betting, that is, which has an element of gambling in it. The Prophet Mohammed says, ‘He who says to his friend: ‘Come, let us gamble,’ must give charity’ (in penance).
The fact that gambling, including betting and lotteries, is both addictive and regressive in its distributional impact has not stopped governments all over the world from encouraging and promoting it. It is just too useful a source of revenue to resist. Even countries like the UK that do not tax the winnings from gambling (whence the explosion of structures, like spread betting, that turn contingent financial claims into bets), do tax the profits of the gambling industry. State lotteries are ubiquitous.
Indian reservations in the US, which have a form of sovereignty or extraterritoriality in certain matters, have been allowed to open casinos in states where this is not otherwise legal. All derivatives trading is, from a mathematical point of view and in economic substance, equivalent to the creation of lotteries.
Sometimes these lotteries are used to hedge risk (when the purchaser of the lottery ticket has an insurable interest; other times and, I would argue, most of the time, these derivative-mediated lotteries are designed and used to take on additional risk - to gamble - generally with other people’s money. The indulgent attitude of the government towards these activities can be explained, as with conventional gambling, by the important source of government revenue that the profits from derivatives trading represent.
All these religious and moral objections (including objections based on the addictive powers of gambling and its regressive distributional impact) apply even to bets or gambles where the event that is the subject of the bet or the gamble cannot be influenced by those participating in the bet or gamble. That is, in the context of betting by buying or selling CDS, it applies even if there is no moral hazard involved in the relationship established by the contract.
Traditional moral hazard occurs when the insured party (in the CDS example the purchaser of the CDS) can influence the likelihood of the insured against event occurring (in the CDS example, if the purchaser of the CDS can influence the likelihood of default on the underlying security in a way that cannot be fully reflected in the terms of the contract). There is asymmetric information in the insured-insurer relationship, and the insured party has the informational advantage - private information.
The standard economics or insurance story of moral hazard involves an informational advantage for the purchaser of the insurance. With no-fault automobile insurance and third-party coverage, I may drive less carefully. If I could take out life insurance on a third party, I might be able to expedite the demise of the insured party.
In the CDS world, the most common reported abuse of the instrument involved a party that owned both CDS and the underlying security, but had a net short position in the security. To be precise, assume I own $X worth of bonds of type j (at face value) and have purchased CDS on bond j that will pay out $Z if default occurs. If X < Z, I don’t have an insurable interest in bonds of type j: I am better off if default occurs.
Now assume that, as a bond holder, I can influence the likelihood of a default occurring. A possible scenario is where the company that issued the bond is in dire straits, but has a good enough chance of recovery and survival, that, from a social or economic efficiency perspective, it is undesirable to incur the real resource costs associated with a default. Assume the issuer of the bond has asked the holders of the bond to roll over the bonds, or to voluntarily extend their maturity. All bondholders but me have agreed. I am the holdout and the veto player.
By refusing to go along with the voluntary restructuring (which, by assumption, would not be an act of default), I now can trigger a default, making a gain of $(Z-X). It’s socially inefficient; it may cause unnecessary human misery, but it is profitable and so, as homo economicus, I do it. Because of my hold-out position, I can drive the probability of default to unity, or 100 percent. This is the mother of moral hazard.
But now comes the mother-in-law of moral hazard. This time it is not the purchaser of the CDS (the insured party) who is afflicted by extreme moral hazard, but the writer of the CDS, the insurer. There is asymmetric information, but the informational advantage is with the insurer. Assume there is an amount $X of some bond of type j outstanding. Assume that the issuer of the bond is generally considered to be at significant risk of default. I now write (sell) CDS on that bond.
Because there is no limit to the amount of CDS I can issue as long as there are willing takers, I can sell CDS to anyone who wants to have a flutter on the default of that bond. If I price my CDS aggressively (accept a low insurance premium per $ of bond j insured), I may be able to have a revenue from the sale of these CDS, $R, say, that exceeds the face value of the total stock of bond j outstanding. This would only happen if the total notional value of the CDS I sell (the total value they would pay out in the event of a default on bond j) is a multiple of the face value of bond j outstanding.
Having received revenue from the sale of CDS written on bond j well in excess of the face value of the entire stock of bond j outstanding, I then buy up, at a price above the prevailing market price (if necessary at face value or even above it!), the entire outstanding stock of bond j. As long as I can be sure I have the entire stock of bond j in my possession, I can be sure than no event of default will ever be declared for that bond.
I, the writer of the CDS on bond j , and now also the owner of the entire outstanding stock of bond j , could simply forgive the debt I just acquired. The insurer has, ex-post, reduced the probability of default to zero. Those who bought the insurance (bought the CDS), wasted their money (their insurance premia).
Instead of buying up the entire outstanding stock of the bond directly and holding the bonds to maturity without calling a default, or forgiving the debt, I could instead, if the bond were some asset-backed security, purchase enough of the assets underlying the bond at prices in excess of their fair value to ensure that the issuer of the bond would have sufficient funds to pay off all the bond holders, should the bond be ‘called’, that is, retired prematurely. If in addition, I could make sure that the bond would indeed be called, I would again, through this financial manipulation, have reduced the probability of default on the bond to zero.
The scheme is beautiful in its simplicity, absolutely outrageous, quite unethical, deeply deceptive and duplicitous, indeed quite immoral, but apparently legal. This in essence, is what has been reported to have happened recently, when a small Austin Texas-based brokerage , Amherst Holdings, which had sold CDS (default protection insurance) on mortgage bonds, then purchased the property loans underlying these bonds at above-market prices to prevent a default that would trigger payments to buyers of the contracts.
Some mortgage bonds can be "called," or retired early, when the amount of loans backing the debt is reduced to certain levels by refinancing, loan repayments or defaults. The mortgage bonds targeted by Amherst fell into that category. So the mechanism through which Amherst made sure enough money would be available to the issuer of the mortgage bonds to pay the obligations due on these bonds, also caused the bonds to be called. The bonds were paid off in full, and the CDS Amherst had sold on these mortgage bonds became worthless.
Many household names in Wall Street and the City of London were at the wrong end of this transaction. Amherst has been reported as selling more than $100 million worth of CDS on $29 million of mortgage bonds outstanding - a tidy profit of at least $70 million. It certainly beats working for a living. The problem of moral hazard on the holder’s side or on the writer’s side of the CDS market is not a market design problem that can be addressed by creating a central clearing facility and requiring all CDS to be traded on organised exchanges.
Requiring writers of CDS to post collateral or, in the case of an organised exchange, requiring a variation margin or maintenance margin (a daily offsetting of profits and losses between the short and long positions on the exchange, made possible by mark-to-market and the fact that the number of long contracts has to equal the number of short contracts) would not solve the problem that both holders and writers of CDS can, under many circumstances, influence the likelihood of default on the asset the CDS are written on.
The first of the two real-world examples I referred to had the holder of the CDS (the purchaser of the default insurance protection) raise the probability of default on the underlying security to 1, that is, to 100 percent, because he also owned a small amount of the underlying security and was in a position to trigger an event of default.
The second example had the writer of the CDS (the seller of the default insurance) reduce the probability of default to zero, by causing the bonds to be called after making sure that the issuer had enough money to pay off all the bond holders in full. Both practices and anything like them are unethical and quite likely socially inefficient and harmful. The way to stop them is to destroy the incentive to issue CDS with a notional value in excess of the underlying securities these CDS are written on.
This post does not lead to a proposal for banning the writing and owning of CDS. Provided the purchasing party has an insurable interest, CDS are useful instruments for hedging risk. It is an argument for requiring that a claim for payment of $X under a CDS contract written on security j , when the default event has indeed occurred, is valid and enforceable only if the owner of the CDS can hand over $X worth of security j when he submits his CDS claim. The moral hazard that can afflict both sides of the CDS market is such that requiring a CDS owner to have an insurable interest seems the only reasonable response.