Looking down South Street, New York City
Stoneleigh: People have been asking how we see the future unfold. In case you wonder what we stand for, much of our view of what's to come can be found in the primers on the right-hand side bar. Here is an additional brief summary (in no particular order and not meant to be exhaustive) of the ground we have consistently covered here at TAE over the last year and a half, and before that elsewhere.
- Deflation is inevitable due to Ponzi dynamics (see From the Top of the Great Pyramid)
- The collapse of credit will crash the money supply as credit is the vast majority of the effective money supply
- Cash will be king for a long time
- Printing one's way out of deflation is impossible as printing cannot keep pace with credit destruction (the net effect is contraction)
- Debt will become a millstone around people's necks and bankruptcy will no longer be possible at some point
- In the future the consequences of unpayable debt could include indentured servitude, debtor's prison or being drummed into the military
- Early withdrawls from pension plans will be prevented and almost all pension plans will eventually default
- We will see a systemic banking crisis that will result in bank runs and the loss of savings
- Prices will fall across the board as purchasing power collapses
- Real estate prices are likely to fall by at least 90% on average (with local variation)
- The essentials will see relative price support as a much larger percentage of a much smaller money supply chases them
- We are headed eventually for a bond market dislocation where nominal interest rates will shoot up into the double digits
- Real interest rates will be even higher (the nominal rate minus negative inflation)
- This will cause a tsunami of debt default which is highly deflationary
- Government spending (all levels) will be slashed, with loss of entitlements and inability to maintain infrastructure
- Finance rules will be changed at will and changes applied retroactively (eg short selling will be banned, loans will be called in at some point)
- Centralized services (water, electricity, gas, education, garbage pick-up, snow-removal etc) will become unreliable and of much lower quality, or may be eliminated entirely
- Suburbia is a trap due to its dependence on these services and cheap energy for transport
- People with essentially no purchasing power will be living in a pay-as-you-go world
- Modern healthcare will be largely unavailable and informal care will generally be very basic
- Universities will go out of business as no one will be able to afford to attend
- Cash hoarding will continue to reduce the velocity of money, amplifying the effect of deflation
- The US dollar will continue to rise for quite a while on a flight to safety and as dollar-denominated debt deflates
- Eventually the dollar will collapse, but that time is not now (and a falling dollar does not mean an expanding money supply, ie inflation)
- Deflation and depression are mutually reinforcing in a positive feedback spiral, so both are likely to be protracted
- There should be no lasting market bottom until at least the middle of the next decade, and even then the depression won't be over
- Much capital will be revealed as having been converted to waste during the cheap energy/cheap credit years
- Export markets will collapse with global trade and exporting countries will be hit very hard
- Herding behaviour is the foundation of markets
- The flip side of the manic optimism we saw in the bubble years will be persistent pessimism, risk aversion, anger, scapegoating, recrimination, violence and the election of dangerous populist extremists
- A sense of common humanity will be lost as foreigners and those who are different are demonized
- There will be war in the labour markets as unempoyment skyrockets and wages and benefits are slashed
- We are headed for resource wars, which will result in much resource and infrastructure destruction
- Energy prices are first affected by demand collapse, then supply collapse, so that prices first fall and then rise enormously
- Ordinary people are unlikely to be able to afford oil products AT ALL within 5 years
- Hard limits to capital and energy will greatly reduce socioeconomic complexity (see Tainter)
- Political structures exist to concentrate wealth at the centre at the expense of the periphery, and this happens at all scales simultaneously
- Taxation will rise substantially as the domestic population is squeezed in order for the elite to partially make up for the loss of the ability to pick the pockets of the whole world through globalization
- Repressive political structures will arise, with much greater use of police state methods and a drastic reduction of freedom
- The rule of law will replaced by the politics of the personal and an economy of favours (ie endemic corruption)
U.S. Cost of Living Decreases by Most in Six Decades
The cost of living in the U.S. fell over the last 12 months by the most in six decades, easing concern that government efforts to revive the economy will lead to an immediate outbreak of inflation.
The consumer price index dropped 1.3 percent in the year ended in May, the most since 1950, the Labor Department said today in Washington. Prices increased just 0.1 percent last month, less than anticipated, after no change in April. The lack of sustained gains in sales is one reason companies are finding it difficult to pass increases in fuel costs on to customers.
Higher gasoline prices will probably restrain Americans’ discretionary spending at a time when the economy is showing signs of stabilizing. "Inflation is not an issue," said Michael Moran, chief economist at Daiwa Securities America Inc. in New York. "There are huge amounts of slack in the economy and demand is quite soft, so it’s difficult to see how inflation can pick up for the balance of the year." Another report showed the U.S. deficit in its current account narrowed in the first quarter to the lowest level since 2001. The gap, the broadest measure of international flows because it includes trade, investment income and government transfers, fell to $101.5 billion from $154.9 billion in the last three months of 2008, the Commerce Department reported.
Treasury securities rose, erasing earlier losses, after the price report showed inflation wasn’t accelerating. The yield on the benchmark 10-year note fell to 3.61 percent at 11:44 a.m. in New York from 3.66 percent yesterday. Concern over the amount of money the Federal Reserve has pumped into financial markets and the size of government auctions to pay for stimulus efforts caused interest rates on Treasuries to shoot higher in recent weeks. Ten-year note yields reached as high as 3.95 percent at the close on June 10. Central bankers meet to discuss policy next week. Officials are considering whether to use their statement to suppress any speculation they’re prepared to raise interest rates as soon as this year.
Economists forecast consumer prices would rise 0.3 percent, according to the median of 75 projections in a Bloomberg News survey. Estimates ranged from a 0.1 percent decrease to a gain of 0.6 percent.
Excluding food and fuel, costs also climbed 0.1 percent, matching the median forecast. Compared with a year earlier, the so-called core rate increased 1.8 percent, down from a 1.9 percent 12-month gain in April. Energy costs increased 0.2 percent in May, as a 3.1 percent rise in the price of gasoline was partly offset by declines in fuel oil and natural gas. These prices may continue to rise in coming months. The average price of a gallon of regular gasoline at the pump is up 65 percent this year, reaching an almost eight-month high of $2.68 yesterday, according to data from AAA.
Should retail gasoline prices peak at $2.75 a gallon, the increase since the start of the year will deduct $50 billion at an annual rate from household cash flows, according to a forecast by Richard Berner, co-head of global economics at Morgan Stanley in New York. The loss would offset almost all the benefit of the tax cuts from the Obama administration’s stimulus plan, he said in a June 8 report. "There’s not pricing power in this otherwise very weak economy," said Richard DeKaser, chief economist at Woodley Park Research in Washington. "Inflation is going to remain very weak and over the next year will continue to weaken given the tremendous amount of slack in the economy."
Food prices, which account for about a seventh of the CPI, decreased 0.2 percent in April, reflecting lower costs for all major categories including fruits and vegetables, meats and dairy products. The core index was constrained by falling prices for public transportation, apparel and tobacco. Rents, which make up almost 40 percent of the core CPI, were also subdued. A category designed to track rental prices rose 0.1 percent. New vehicle prices climbed 0.5 percent. Car costs may decline in coming months as automobile makers slash prices or increase incentives to revive demand and lighten bloated inventories.
Chrysler LLC, seeking to restructure under bankruptcy, began offering five-year, no-interest loans on some models this month. The financing, announced June 3, runs through July 1 and is an alternative to rebates of as much as $6,000 for consumers who buy through certain credit unions and already own a Chrysler vehicle. The cash option was put in place last month. Macy’s Inc. was among retailers cutting prices to clear stockpiles. Aeropostale Inc. earlier this month was offering 20 percent off women’s dresses. American Eagle Outfitters Inc. was giving 50 percent off the purchase of a second graphic t-shirt.
America should also look to its fiscal health
by Kenneth Rogoff
America desperately needs a better framework for providing healthcare and Barack ?Obama’s administration is right to press on for change, even as the economy remains frail in (it is to be hoped) the aftermath of the financial crisis. Yet given the explosion of the federal debt, it is extremely important to craft a plan that will not excessively risk the government’s own fiscal health. The risks cannot easily be overstated. The US government is already entering a prolonged period where it is extremely vulnerable to a loss in investor confidence from the Chinese and other main holders of its Treasury securities. Foreign investors are rightly concerned about the deeply ingrained reluctance of Americans to tax themselves.
The last thing the US needs is to be viewed as one giant California, rich but unwilling to pay enough taxes to fund the services its citizens demand. A sharp rise in taxes to pay for healthcare initiatives could potentially weaken the credibility of the government’s promise to raise taxes as needed to pay off debtors. It is true many people are claiming that a new healthcare package can be a big part of the cure for US budget problems. They argue that standard measures of national debt are far too narrow and do not take into account a country’s huge commitment to future expenditures such as old age pensions and, especially, healthcare programmes.
Given generous benefits, increasing life expectancy and adverse demographics, old age benefit programmes have actuarial debts that are many times the conventionally measured national debt, even as conventional measures rise to levels last seen after the second world war. According to this logic, finding a way to contain rising healthcare costs would help more than almost anything to reduce the broadly defined government budget debt. Lower healthcare costs would also help the private sector, presumably raising investment, growth and, of course, future tax revenues. It would also be helpful, of course, to have a healthier and happier workforce.
Thus, in principle, fixing the imbalances in the Social Security and, especially, the Medicare programmes could provide a powerful offset to the huge increase in debt burdens visited by the financial crisis. Unfortunately, the idea that healthcare reform will alleviate debt problems rather than exacerbate them is far-fetched. As the US Congressional Budget Office warned this week, many proposed healthcare reforms are more likely to worsen the government’s budgetary health than to improve it. This should hardly be surprising, given that a main purpose of reform is to help provide better care for Americans who cannot afford insurance. Higher taxes to pay for healthcare are also likely to reduce US growth, making it far more difficult to escape the debt trap.
This comes at a time when other policy initiatives, such as tackling environmental degradation and income inequality, are also likely to imply higher tax burdens (the taxes are implicit in the case of cap and trade legislation to protect the environment). In addition, the continuing weakness of the financial sector weighs on growth, and it is by no means clear yet when and how some semblance of normality will be restored. This is particularly the case as the government struggles to reform regulation of the financial sector, with many political and economic puzzles to solve, not least the international dimensions of the problem.
All of these considerations appear to underscore the importance of finding ways to keep the new health plan from being overly burdensome, and to avoid unduly optimistic projections on efficiency savings. Healthcare reform is no substitute for finding a credible path to fiscal sustainability. If badly handled, it could prove the straw that breaks the camel’s back. Make no mistake, the US and much of the developed world is in a frighteningly precarious fiscal state. Exploding debt levels have remained manageable in no small part thanks to the extraordinarily low level of global real interest rates.
Should the general level of global interest rates rise substantially, perhaps owing to a pick-up in emerging market growth over the next few years, a number of developed countries, including the US, may have to tighten their belts sharply in order to maintain stable debt ratios. Countries that fail to do so will suffer severe consequences, including spiralling interest rates and, ultimately, default by direct means or through high inflation. It is a disgrace that the world’s richest country cannot provide reliable basic care for its poorest citizens. But if the politics of reform produces too extravagant a plan when the nation’s fiscal health is already so weak, the US may experience a form of financial crisis even more virulent than the one it is recovering from. Any healthcare plan would then be dead on arrival.
California's Economy: Too Big to Fail?
Despite a $24 billion budget deficit and a legislature in stalemate, California lawmakers haven't persuaded the Obama Administration to bail out the state. California's economy is in deep distress. Political gridlock is preventing tax increases and spending cuts, and the recession has pushed its deficit over the edge. Governor Arnold Schwarzenegger's proposals to fix the mess have been rejected by California voters, most recently on May 19. On June 16, Standard & Poor's put California's credit rating—already the lowest among states—on watch for a downgrade. Golden State residents are all too aware of the cuts in essential services that may result, or that some businesses or taxpayers may have to accept IOUs as payment from the state.
But will the rest of the U.S. have to share California's pain? In May, State Treasurer Bill Lockyer sent a letter to U.S. Treasury Secretary Tim Geithner urging him to consider helping cash-strapped municipalities. The pitch by Lockyer and other California Democrats is a play on the "too big to fail" argument made on behalf of bank bailouts: If you don't save this bank (or in this case, state), the financial markets and the national economy will be thrown into turmoil. "This matters for the U.S., not just for California," Representative Zoe Lofgren (D-Calif.), who chairs the state's Democratic congressional delegation, told The Washington Post. "I can't speak for the President, but when you've got the eighth biggest economy in the world sitting as one of your 50 states, it's hard to see how the country recovers if that state does not."
The Obama Administration is now seeking to answer that question. So far the Administration has declined to bail out California. At a June 16 press briefing, White House spokesman Robert Gibbs underscored that stance, saying California's budgetary problem "unfortunately is one that [the state is] going to have to solve." Later, in the evening, Republican Governor Schwarzenegger issued a statement denying he was seeking any such help. "We are in complete agreement with the White House that California should be solving its budgetary problems on its own without a bailout from the federal government," said the statement issued by Communications Director Matt David. But there remains concern that the deeper California's woes get, the more it will delay the potential U.S. recovery.
A report released by the University of California at Los Angeles on Tuesday projects the $24 billion annual state budget deficit will translate into 60,000 job losses by the middle of 2010. At the same time, the state could institute massive cuts in public services such as its welfare program, which serves 1.3 million people. The worry is that these efforts to balance California's state budget would work in a direct cross-purpose with the $787 billion U.S. stimulus package Obama signed in February. Though few experts think California will default on its debt—following the example New York City set in 1975 and Cleveland in 1978—the mere possibility is troubling for the credit markets. "If California truly defaults, I am sure it will shake the faith of bondholders and noteholders in the overall municipal finance system," says Dan Boyd, senior fellow at the Rockefeller Institute of Government. "That would undoubtedly lead to higher issuance costs to additional state and local government loans."
Investors in the municipal bond industry are monitoring the situation. "California is one of the largest states in the municipal bond market, so we have to follow it and make sure we get the call right as an investor," says Hugh McGuirk, head of municipal bond investments for T. Rowe Price (TROW), an investment firm. California is not alone in its fiscal misery. All but three U.S. states face budget gaps in the 2010 and 2011 fiscal years, with a collective shortfall of $350 billion, according to the Center on Budget & Policy Priorities, a Washington-based nonprofit. Michigan, whose economy was among the country's weakest even before the bankruptcies of General Motors and Chrysler, has also asked Washington for help.
Treasury officials are considering helping the state's auto suppliers stay afloat to prevent mass layoffs. While California is a huge state, some economists believe the harshest shocks from its distress may be confined to its borders. A hit to the technology or entertainment industry would be worse, economically speaking, for the rest of the U.S. than losses of state jobs for California services such as schools, universities, and hospitals, they say. "Losing private-sector jobs in export industries that drive the state's economy has more of a contagion effect," says Richard Ciccarone, managing director of McDonnell Investment Management in Chicago. "[Loss of] government workers have an impact, but the multiplier effect is not as big as in other industries."
Nearby states also would undoubtedly feel some pain. "The [economic] connection is not that strong unless you're talking about neighboring states with a trade connection like Nevada and Arizona," says Rajeev Dhawan, director of Georgia State University's Robinson College of Business. For example, Las Vegas would suffer if Los Angelinos make fewer trips to the city. "The further from California the state is, the less directly affected it will likely be." Still, Boyd says that a default by California or any other state—or even severe spending cuts to balance their budgets—would take considerable stimulus out of the U.S. economy when it can least afford it.
He says that state and local economies are pro-cyclical, meaning they are exacerbating the downturn even as the federal government pumps money into the economy. "States are raising taxes and cutting spending, while the feds are trying to achieve exactly the opposite." Says Dhawan: "The fiscal landscape at the state and local level is more brutal than at the federal level, where you hear talk of 'green shoots' emerging. The exterior paint may look O.K., but the inside of the house is crumbling."
S&P warns California's credit rating is at risk of another cut
California's credit rating, already the lowest among the 50 states, may be hacked again, Standard & Poor's warned today. As the debate over budget cuts drags on in Sacramento, S&P put its "A" grade on the state's $59 billion in general obligation bonds on "negative credit watch," meaning the rating is at risk of a downgrade. Using language that could further spook bond investors, S&P said, "Although we continue to believe the state retains a fundamental capacity to meet its debt service, insufficient or untimely adoption of budget reforms serve to increase the risk of missed payments in our view."
The Legislature and Gov. Arnold Schwarzenegger are facing a $24-billion budget shortfall, and Controller John Chiang has warned that the state could run short of cash beginning July 28, just one month into fiscal 2010. Noting that time is running out, S&P warned:Both the timing and magnitude of the state's impending liquidity shortfall raise significant credit concerns, in our view, particularly if the state were to begin fiscal 2010 without having meaningful budget revisions in place. We believe that without budget revisions, the state may need to defer (or issue registered warrants in lieu of making) cash payments for certain lower-priority obligations (such as vendors, student aid, and tax refunds) in order to preserve cash for required payments for education and debt service.
Were the state to do this, or if it were to adopt a budget package that relied on assumptions that we regard as too optimistic or that relied on mechanisms for bridging the projected shortfall through at least fiscal 2010 that we regard as unreliable, we may consider lower ratings.
Any downgrade could spur investors to force the state to pay even higher interest rates when it borrows. Market yields on California's general obligation bonds already have surged in recent weeks as the prices of the bonds have fallen, reflecting investor jitters. California and Louisiana had been tied for last place, at "A-plus," on S&P’s state ratings list, until February, when S&P cut the Golden State to "A." Most states are rated either "AA" or "AAA." S&P's latest downgrade warning also applies to its "A-minus" rating on the state's $8.1 billion of appropriation-backed lease revenue bonds.
S&P Says US To Keep AAA Ratings In Near Term
Standard & Poor's Ratings Services said its AAA ratings on the U.S. are safe for the near term, despite significant weakening in the economic outlook, projected fiscal deficits and the high costs of government support of the U.S. financial sector. The ratings firm said the key credit strengths of the U.S. include its high-income, diversified economy, the advantage of the U.S. dollar's role as the world's most used currency, the country's openness to trade and its stable political system.
S&P credit analyst Nikola Swann said those credit strengths continue to outweigh any weaknesses. Including the U.S., S&P has AAA ratings and stable outlooks on 17 of the 124 countries it rates. That includes Canada, France and Germany. Last month the ratings agency revised its outlook on the U.K. to negative. Since the financial crisis intensified in September, the U.S. has spent billions of dollars propping up what were once the nation's strongest financial and automotive firms in an effort to protect jobs and stem a steep drop in consumer confidence.
S&P Downgrades Wells Fargo, U.S. Bancorp, 20 Other Banks
The ratings agency lowered its ratings and revised its outlooks on 22 banks, as stress tests signal the potential for more pain ahead. Standard & Poor's Ratings Services lowered its ratings and revised its outlooks on 22 rated U.S. banks on June 17. The actions reflect S&P Ratings' belief that operating conditions for the industry will become less favorable than they were in the past, characterized by greater volatility in financial markets during credit cycles, and tighter regulatory supervision. The changes also reflect S&P Ratings' ongoing broad-ranging reassessment of industry risk for U.S. financial institutions. S&P Ratings' overall assessment of the U.S. banking industry incorporates the following key points:
- The industry is now in a transition and will likely undergo material structural changes;
- The loss content of loan portfolios should increase, but recent capital rebuilding should help banks defray these losses;
- Stress tests point to more pain in the future;
- S&P Ratings doesn't view regional banks as being highly systemically important; and
- Potential losses could increase beyond S&P Ratings' current expectations.
"We believe the banking industry is undergoing a structural transformation that may include radical changes with permanent repercussions," says S&P credit analyst Rodrigo Quintanilla. "Financial institutions are now shedding balance-sheet risk and altering funding profiles and strategies for the marketplace's new reality. Such a transition period justifies lower ratings as industry players implement changes." Possible changes include increased regulatory oversight and lower profitability. In addition, S&P Ratings reassessed the relative creditworthiness of many institutions based on their abilities to deal with the increased risks during this transition period. "We believe some firms may be better able to weather the risks ahead than others," Quintanilla adds.
"In the long term, we could foresee ourselves raising ratings if lower earnings and reduced risk are accompanied by stronger risk-adjusted capital and effective governance." As a result of the most recent downgrades, as well as those since mid-2007, the counterparty ratings on U.S. banks (at the operating subsidiary level) have fallen by an average of two notches, to BBB+ today from A before the crisis began in June 2007. However, says Quintanilla, "the high number of firms with negative outlooks suggests that the ratings could still decline if the credit cycle is longer and/or deeper."
Financial Firms Repay $66.3 Billion In TARP Funds
JPMorgan Chase & Co., Goldman Sachs Group Inc. and Morgan Stanley are among nine major financial institutions that Wednesday announced they have bought back the preferred stock they issued to the Treasury Department under the Troubled Asset Relief Program. Ten banks were given $68.3 billion last fall and received approval last week to repay the funds. So far, just State Street Corp. - which ranked 9th in terms of the amount it received at $2 billion - has yet to announce its repayment. JPMorgan, U.S. Bancorp , American Express Co., Bank of New York Mellon Corp., BB&T Corp. and Northern Trust Corp. also announced plans to buy back the related warrants associated with TARP. Goldman, Morgan Stanley and Capital One Financial Corp. didn't address the warrants.
Many of the banks that accepted TARP funds starting last fall have said they want to repay the money as soon as possible in order to avoid strict government regulations, especially those on executive pay. Last week, the government cleared 10 large banks to repurchase the preferred shares they sold to the government as part of the TARP program. U.S. Bancorp and BB&T said last week they will record small second-quarter charges related to the buyback, $6.6 billion and $3.1 billion, respectively.
Bank of New York said it expects a $197 million chargefrom its $3 billion repurchase, while Northern Trust expects a $68.6 million profit hit; it received $1.58 billion. Goldman said its earnings will be cut by about 77 cents a share for paying some $425 million in dividends on its $10 billion of preferred shares. Morgan Stanley expects an $892 million profit reduction. Financials have been among a host of companies raising capital of late through stock sales, in part to raise funds in anticipation of becoming payback-eligible. JPMorgan received $25 billion in TARP funds, while Morgan Stanley got $10 billion, Capital One $3.55 billion American Express $3.39 billion.
U.S. Bancorp Chairman and Chief Executive Richard K. Davis said Wednesday the repayment of TARP funds was a "significant step forward" and returns the company to a position of independence. Separately, Standard & Poor's earlier Wednesday downgraded 18 U.S. banks, including U.S. Bancorp, Capital One and BB&T, saying the industry's future won't be as good as the past. U.S. Bancorp was lowered two notches to A+, while BB&T and Capital One were cut one notch to A and BBB, respectively.
Why Is The FDIC Ignoring Problem Banks?
USA Today had a story Tuesday that pointed out how regulators were regularly absent as the banks they were supposed to be overseeing failed under mounting debt. Bert Ely, a longtime banking consultant, has identified a data point that highlights how far behind the regulators have actually fallen. During the savings and loans crisis and its aftermath, banks that failed had a loss ratio--or a bank's total losses divided by its total deposits--of just around 13%. Since the current recession began, that same ratio for failed banks surged to more than 37%, or nearly triple S&L crisis levels.
This means that the regulator responsible for seizing failed banks, the FDIC, is waiting much longer before taking over these doomed banks, allowing their losses to mount. As a bank's loss ratio increases, it becomes costlier for the bank, and they pass the additional expenses onto their customers. Therefore, the FDIC inaction has resulted in rising costs for regular Americans, Ely said. "The big question is why is the FDIC moving so slowly? It is very evident from these numbers that there is serious ineptitude among the regulators," Ely said. "Their incompetency is costing the banking industry, but they are passing this cost on to depositors and borrows, so we end up suffering."
As for their part, the FDIC told the Huffington Post last week that the FDIC doesn't make the decision when to seize a bank. The agency said that it merely carries out the seizure, but other regulators are responsible for determining when a bank has failed. A patchwork of agencies currently make this decision. Hopefully this type of confusion can be streamlined, spurring a quicker response time among regulators, when Obama reveals to Congress tomorrow his plan to overhaul regulatory oversight of Wall Street.
Large U.S. corporate bankruptcies accelerate
Large U.S. corporate bankruptcies have accelerated in recent weeks as the U.S. economic slowdown claims more victims, according to industry data. Eight public companies with assets of more than $1 billion have filed for bankruptcy protection in the last four weeks, compared with five multibillion-dollar company bankruptcies in the prior four-week period, according to data compiled by BankruptcyData.com and reviewed by Reuters. That is the largest number of multibillion-dollar public company bankruptcies in a four-week period since the year began, according to the data.
BankruptcyData.com tracks companies that have some form of publicly traded security such as stocks or bonds. "Corporate revenue is down in the United States and when topline revenue is down, there's less money to spread through expenses," said Brian Hamilton, co-founder and chief executive officer of financial information company Sageworks Inc. The last few weeks have brought filings from long-term lodging facility operator Extended Stay Inc, which had assets of $7.13 billion before its bankruptcy, and theme park operator Six Flags Inc, which had assets of about $3.03 billion.
The largest Chapter 11 bankruptcy case so far this year is that of General Motors Corp, which filed for creditor protection on June 1, with assets of more than $91 billion. The widespread credit crunch and economic slowdown have taken such a toll on corporations and individuals that bankruptcy courts are struggling to manage the load. Barbara Lynn, chair of the bankruptcy committee of the Judicial Conference of the United States, recommended at a congressional hearing that Congress authorize 13 new permanent bankruptcy judgeships and make 22 temporary bankruptcy judgeships permanent.
"In the 12-month period ending March 31, 2009, there were approximately 1.2 million bankruptcy petitions filed -- nearly double the number of petitions filed in 2006," Lynn said. Hamilton of Sageworks said he expects to see more bankruptcies for companies in the auto or real estate industries. "We all know the automakers are having great difficulty, but if you're producing parts for the automakers you're also having difficulties," said Hamilton, adding that "anything around real estate is probably going to have difficulty for the latter part of 2009."
Companies Signal High Anxiety With Record Share Sales Used to Retire Debts
Almost two years into the worst financial calamity since the 1930s, companies are doing everything they can to reduce their indebtedness, selling record amounts of equity to pay back bonds and loans. "Stock buybacks are a thing of the past: It’s reducing debt and bond buybacks that are in vogue," said Kathleen Gaffney, co-manager of the Loomis Sayles Bond Fund in Boston. "Stocks aren’t going to move and earnings aren’t going to move without a healthier balance sheet," said Gaffney, whose firm manages $98 billion in fixed-income assets.
More than 165 companies raised a record $87 billion in U.S. secondary share sales this quarter, and 77 percent of them used the proceeds to slash leverage, according to data compiled by Bloomberg. Ford Motor Co., the only major U.S. automaker that hasn’t filed for bankruptcy, sold $1.6 billion in equity last month to obtain cash and finance a retiree medical fund. Las Vegas-based casino owner MGM Mirage issued $1.1 billion of stock to repay debt, fueling a rally of as much as 14 cents on the dollar in its bonds.
Companies are diluting existing owners to stave off defaults during the worst economic crisis since the Great Depression. U.S. corporations have reduced the median debt-to- equity ratio for high-yield, high-risk companies by 12 percentage points since February to 54 percent and by 7 points to 32 percent for investment-grade debtors as of June 12, according to Moody’s Corp. Investment-grade corporate bonds have returned 8 percent in 2009 and speculative-grade securities are on pace for a record year, according to Merrill Lynch & Co. data, while the Standard & Poor’s index of 500 stocks recorded its steepest 67-day gain in seven decades.
Companies from Dow Chemical Co. to Hertz Global Holdings Inc. are selling shares to take advantage of a 40 percent rally in the S&P 500 between March 9 and June 12. Both were among the 54 percent of issuers since March that said they may use at least some of the money from equity offerings to repay debt, Bloomberg data show. Banks and financial companies seeking to raise capital comprised 23 percent of the sales, Bloomberg data show. JPMorgan Chase & Co. and Goldman Sachs Group Inc., both based in New York, issued stock to help return aid from the U.S. Troubled Assets Relief Program.
The benefits of selling more shares outweigh the disadvantages of dilution, said Thomas Sowanick, chief investment officer of Princeton, New Jersey-based Clearbrook Financial LLC, which manages $30 billion. "The overall cost to rebalancing the balance sheet is worthy of the dilution," said Sowanick, the former head of wealth-management strategy at Merrill Lynch. "You’re saving your interest payments and you are showing strength by being able to raise capital." With speculative-grade securities gaining about 30.4 percent through June 16, borrowers are also refinancing maturing debt in the bond market.
Companies have sold a record $682 billion of offerings in the U.S. this year, according to Bloomberg data. By focusing on credit quality, companies are putting bondholders ahead of share owners for the first time since 2003, said Christopher Garman, chief executive officer of debt research firm Garman Research LLC in Orinda, California. "When corporations are taking debt off the table, it does signify that companies are being run for the benefit of bondholders," Garman said. "Many companies were not rewarded for refusing to lever up in 2003 to 2007," he said. "There was a lot of pressure for almost a good five years there to retire equity and add debt."
Companies piled on debt in 2006 and 2007 to repurchase stock and boost shareholder returns when borrowing costs were at all-time lows. Private equity firms such as KKR & Co. and Apollo Management LP led a record $1.29 trillion leveraged buyout boom that collapsed in August 2007 along with the subprime mortgage market. The borrowing binge contributed to the almost $1.5 trillion of writedowns and losses at financial institutions worldwide. The high-yield default rate has jumped to 8.3 percent, its highest since November 2002, according to S&P. The extra yield, or spread, investors demand to own such bonds instead of similar-maturity Treasuries has ballooned to 10.5 percentage points from a record low of 2.41 percentage points in June 2007, Merrill Lynch index data show.
"Given the choice between dilution and default, they’ll opt for dilution," said John Lonski, chief economist at Moody’s Capital Markets Group in New York. "Whenever you have a rising default rate amid relatively tight credit conditions, companies have an extra incentive to repay debt with funds raised in the common equity market," Lonski said. The ratio of credit rating upgrades to downgrades climbed to 26 percent in the second quarter from 8 percent in the first three months of 2009, when increases accounted for the lowest percentage of rating changes since at least 1998, according to Bloomberg data based on S&P actions. Debt-to-equity ratios remain above their five-year averages of about 39 percent for high-yield companies and 26 percent for investment grade, Moody’s data show.
MGM sold stock to help repay debt maturing this year, remove the threat that banks would force the company into default and buy time to wait out Las Vegas’s worst gambling slump. The company, 36.99 percent-owned by billionaire Kirk Kerkorian, faced a June 30 deadline to restructure after auditors in March questioned its ability to stay in business. MGM also sold $1.5 billion in secured notes and amended its loan facility. By selling 164 million shares, MGM diluted its existing stockholders by 59 percent, according to regulatory filings.
The company’s debt-to-equity ratio has tumbled to 77 percent from 114 percent in March, according to Moody’s. S&P raised MGM’s credit rating one grade to CCC+, while Fitch lifted it two steps to CCC.
"The dilution was more than accepted by our shareholders," MGM Chief Executive Officer Jim Murren said in a telephone interview. "The reaction was that MGM dodged a major bullet, that they were able to navigate through a very tough time and had they not done that equity raise, the shareholders would be in far worse condition today."
MGM’s $298 million of 9.375 percent notes due in 2010 have climbed 14 cents to 96 cents on the dollar since May 12, the day before the offerings were announced, according to Trace, the bond-price reporting system of the Financial Industry Regulatory Authority. Its shares have fallen 46 percent during the same period in New York Stock Exchange composite trading. After earnings fell for seven straight quarters, companies are trying to reduce indebtedness in preparation for what Pacific Investment Management Co. Chief Executive Officer Mohamed El-Erian calls a "new normal" for the U.S. economy. El-Erian said in a Bloomberg Radio interview last month that the potential growth for the U.S. is "no longer 3 percent, but is 2 percent or under." Pimco, in Newport Beach, California, manages the world’s biggest bond fund.
The S&P 500’s rally since March left the index at a seven- month high at the end of last week and valued it at 14.9 times its companies’ earnings, near the highest since October. Last week, the Dow average became the last major U.S. stock gauge to turn positive in 2009 amid optimism that government efforts to revive the economy are working. "With a very modest economic recovery, survival is being able to have an appropriate balance sheet," Loomis Sayles & Co.’s Gaffney said. "It’s good common sense that, while the window is open, companies that are able to de-leverage, should."
Ford, based in Dearborn, Michigan, issued 345 million shares of common stock on May 12 and 13, increasing its shares outstanding to 3.1 billion, according to Bloomberg data. The automaker’s leverage ratio has fallen to about 77 percent from 90 percent in November, Moody’s data show. "There had been a lot of industrial names that had been selling shares; we believed there would be demand for it and the timing worked out well," Ford spokesman Mark Truby said. By using the cash from the offering instead of stock to fund the health-care trust, the company reduced the effects of dilution to shareholders, Truby said.
Ford’s $1.8 billion of 7.45 percent bonds maturing in 2031 have risen 10.4 cents to 66.25 cents since May 11, according to Trace. Shares of the automaker, which lost a record $14.7 billion last year, have fallen 6.7 percent since then. The stock is up 148 percent this year. "The market’s wide open," said Daniel Simkowitz, vice chairman in capital markets at Morgan Stanley in New York. "MGM and Ford are good underlying franchises, but they’re in a very tough part of the economy and they also had leverage. There’s a pretty broad-based set of investors that are willing to buy the optionality in these companies." Morgan Stanley, the second-biggest underwriter for U.S. equity offerings behind JPMorgan excluding self-led deals, helped manage offerings for Ford and MGM.
While secondary stock sales are surging, the market for initial public offerings hasn’t recovered, leaving out private equity firms looking to raise cash by selling their investments. The eight IPOs in the U.S. this year pulled in $1.9 billion, the lowest for any similar period since 2003, when 10 new issues raised $1.4 billion, Bloomberg data show. The S&P 500 has tumbled 41 percent from its peak in October 2007. "Companies are selling equity well below where it was a year or two ago, but realizing in the new world that’s a more appropriate capital structure," said Mark Durbiano, who manages $3 billion in high-yield debt at Federated Investors Inc. in Pittsburgh.
"You had MGM issuing equity at $7 a share and Hertz did a similar deal, though it’s not quite as stressed," Durbiano said. "It’s a price that was considerably below where it was a year ago on the realization that operating results are weak and that will continue to be the tone." Hertz, the second-largest U.S. rental-car company, sold 46 million shares at $6.50 on May 20, raising $299 million to "increase its liquidity" and for "general corporate purposes" including debt repayment, the Park Ridge, New Jersey- based company said in a statement that day. Hertz’s shares have fallen 19 percent to $6.59 since May 19. In May 2008, they traded as high as $14.49. Hertz’s $1.8 billion of 8.875 percent bonds due in 2014 have increased 6 cents to 89 cents, according to Trace. The debt yields 12.1 percent.
"A lot of our fleet debt is maturing toward the end of 2010, and this was part of a strategy to pave the way to make that process a lot easier," Hertz spokesman Richard Broome said. "Shareholders were asking us questions about the debt refinancing and how we were going to address this." Hertz’s debt-to-equity ratio has fallen to 67 percent from 89 percent in November, according to Moody’s. Dow Chemical sold 150 million shares at $15 last month, raising $2.25 billion to help repay a loan that was used to acquire rival Rohm and Haas Co. this year. Our equity issuance "speaks to our commitment to de- leverage the company’s balance sheet and maintain our investment-grade credit rating," said Bob Plishka, a spokesman for the largest U.S. chemical maker.
The sale was oversubscribed, meaning investors wanted to buy more stock than was offered, which shows "the confidence investors have in Dow’s long-term strategic direction," Plishka said. Midland, Michigan-based Dow Chemical’s $882 million of 7.85 percent bonds maturing in 2029 have gained 11.4 cents to 80.4 cents on the dollar to yield 10.2 percent since the equity offering was announced, according to Trace. Its shares are down 1.9 percent. "The trend is that what appears to be good for bondholders, equity holders feel is the same," Morgan Stanley’s Simkowitz said. "It’s very different than 2006 and 2007, where bondholders and equity holders were at odds with each other."
Gold sold like chocolate from German vending machines
Shoppers in Germany will soon be able to buy gold as easily as bars of chocolate after a firm announced plans to install vending machines selling the precious metal across the country. TG-Gold-Super-Markt aims to introduce the machines at 500 locations including train stations and airports in Germany. The company, based near Stuttgart, hopes to tap into the increasing interest in buying gold following disillusionment in other investments due to the economic downturn.
Gold prices from the machines – about 30 per cent higher than market prices for the cheapest product – will be updated every few minutes. Customers using a prototype "Gold to go" machine at Frankfurt Airport on Tuesday had the choice of purchasing a 1g wafer of gold for €30, a 10g bar for €245, or gold coins. A camera on the machine monitors transactions for money laundering controls. Thomas Geissler, who owns the company behind the idea, said: "German investors have always preferred to hold a lot of personal wealth in gold, for historical reasons. They have twice lost everything. "Gold is a good thing to have in your pocket in uncertain times."
Interest in gold has risen during the financial crisis, particularly in Germany, according to GFMS, the London-based precious metals consultancy. Retail demand reached an estimated 108 tonnes in 2008, up from 36 tonnes in 2007 and 28 tonnes in 2006. Jens Willenbockel, an investment banker who saw the machine while passing through the airport, told the Financial Times that he believed there could be a market for the venture. "Because of the crisis there is a lot of awareness of gold," he said. "It is also a great gift for children – for them getting gold is like a fairytale."
Obama's Regulatory Reform Plan: The Basics
Obama unveiled his sweeping Financial Regulatory Reform Plan today. There are fans and detractors and much more information to come, but for now, here's what he wants to add, adding to and take away:
- Financial Services Oversight Council
This Council, to be chaired by the Treasury, would, according to the Plan, "help fill gaps in supervision, facilitate coordination of policy and resolution of disputes, and identify emerging risks in firms and market activities." Proposed legislation would allow the Council to request information from any financial firm and charge it with "referring emerging risks to the attention of regulators with the authority to respond."
- National Bank Supervisor
This proposed agency is designed to "close the loopholes in bank regulation" and would supervise and regulate "all federally chartered depository institutions" as well as "all federal branches and agencies of foreign banks." The Obama Administration wants the NBS to have separate status within Treasury and be led by a single executive. The NBS would take over the prudential responsibilities of the Office of the Comptroller of the Currency, which currently charters and supervises nationally chartered banks and federal branches and agencies of foreign banks.
- Consumer Financial Protection Agency
This proposed agency would be charged with protecting consumers of credit, savings, payment and financial products and services, and the Plan therefore proposes to allow the CFPA broad jurisdiction to regulate the service providers. It should, the Plan says, "have sole rule-making authority for consumer financial protection statutes" and the ability to fill in any gaps in current consumer protection statutes. States, however, are welcome to pass stricter consumer protection laws.
- Office of National Insurance
This office within the Treasury would "promote national coordination within the insurance sector" and "gather information, develop expertise, negotiate international agreements and coordinate policy in the insurance sector."
The Plan describes six principles for insurance regulation: 1) Effective systemic risk regulation with respect to insurance; 2) Strong capital standards and an appropriate match between capital allocation and liabilities for all insurance companies; 3) Meaningful, consistent consumer protection for insurance products and practices; 4) Increase national uniformity through either a federal charter or effective action by the states; 5) Improve and broaden the regulation of insurance companies and affiliates on a consolidated basis, including affiliates outside the traditional insurance business; and 6) International coordination.
NEW and GREATER AUTHORITY FOR FEDERAL RESERVE:
- New authority to supervise all firms that could pose threat to financial stability
- Expanded authority to oversee payment, clearing and settlement systems
- Enhancement of Federal Reserve's authority over market infrastructure (i.e., "requiring all standardized OTC derivative transations to be executed in regulated and transparent venues")
- Federal Reserve emergency lending authority for increased accountability will be revised to improve accountability
- Office of Thrift Supervision
The OTS currently supervises federally chartered thrifts and thrift holding companies. The Plan states that "the nature and extent of prudential supervision and regulation of a federally chartered depository institution should no longer be a function of whether a firm conducts its business as a national bank or a federal thrift. Therefore, what was under the umbrella of the OTS will now be the responsibility of the umbrella of the NBS.
Obama: Financial Regulations Seek Balance
Sweeping changes proposed in response to the economic meltdown weigh demands of financial system and consumers, Obama says. Blaming much of the current economic downturn on "the unraveling of major financial institutions and the lack of adequate regulatory structures to prevent abuse and excess," President Barack Obama is proposing a vast expansion of federal regulatory power over financial institutions, including the creation of two new entities—a Financial Services Oversight Council and a Consumer Financial Protection Agency—as well as two new overseers of banks and insurance firms.
The proposed new regulatory scheme includes new supervisory powers for the Federal Reserve for all financial institutions whose problems could pose a threat to financial stability and a requirement for hedge funds and other pools of private capital to register with the Securities & Exchange Commission. The sweeping nature of the proposals—the widest-ranging changes to the financial regulatory scheme since the Great Depression—is generating pushback from business interests over some of the provisions.
Obama describes the changes as a balancing of the interests of business and the public, according to a transcript of his remarks released Wednesday morning. "With the reforms we are proposing today, we seek to put in place rules that will allow our markets to promote innovation while discouraging abuse. We seek to create a framework in which markets can function freely and fairly, without the fragility in which normal business cycles bring the risk of financial collapse; a system that works for businesses and consumers."
The proposed eight-member Financial Services Oversight Council is to be chaired by the Treasury Dept. and is designed to "help fill gaps in regulation, facilitate coordination of policy and resolution of disputes, and identify emerging risks in firms and market activities," according to fact sheets distributed by the White House. It will replace the President's Working Group on Financial Markets and have a permanent staff at Treasury. The new Consumer Financial Protection Agency will regulate providers' consumer financial products and services, including credit, savings, and payment services. It will set standards for promoting financial services to consumers and have regulatory powers to supervise institutions for compliance.
"This agency will have the power to set standards so that companies compete by offering innovative products that consumers actually want—and actually understand," Obama says. "Consumers will be provided information that is simple, transparent, and accurate. You'll be able to compare products and see what is best for you. The most unfair practices will be banned. Those ridiculous contracts—pages of fine print that no one can figure out–will be a thing of the past. And enforcement will be the rule, not the exception." The plan would do away with the Office of Thrift Supervision, replacing it with a system aimed at closing gaps in coverage and keeping institutions from shopping for the most lenient bank regulator.
Christina Romer, the chairman of the White House Council of Economic Advisers, said Wednesday morning that the Administration proposal strikes "the appropriate balance" and that it was "not bulldozing the whole system." Representative John Boehner (R-Ohio), the Republican leader in the House of Representatives, countered by predicting "we'll have the federal government deciding what interest ought to be charged on credit cards, having the government decide what kind of financial products are available." The Financial Services Roundtable—a trade group for the financial services industry—aid in a statement that it "applauds the Administration's announcement of a proposal for modernizing regulation of the financial services industry. Our economic recovery depends on these reforms.
The Roundtable has long advocated regulatory reform and believes reform must be comprehensive, creative, and bold." However, the group said it is opposed to the Consumer Financial Protection Agency because it separates the regulation of the institution from the regulation of the products. "Each regulator will only have half the information," the group said, adding that the possibility of individual state regulation will promote a confusing patchwork of rules. Critics of the plan also argue that it imposes too many restrictions that will harm the ability of U.S. financial companies to compete in the global economy.
Obama plan urges review of Fed system
The Obama administration's regulatory reform plan calls for a review of the Federal Reserve System's structure, which the U.S. Treasury would then consider to propose possible changes, according to a document obtained by Reuters on Tuesday. "We propose a comprehensive review of the ways in which the structure and governance of the Federal Reserve System affect its ability to accomplish its existing and proposed functions," the document states.
It said the review would be led by the central bank's Washington-based board and would take a look at the governance of the 12 regional Fed banks and their role in financial supervision. The Fed would be called upon to propose recommendations by October 1, the document said. The document said that once the Fed issues a report, the Treasury would consider the recommendations and propose "any changes to the governance and structure of the Federal Reserve that are appropriate to improve its accountability and its capacity to achieve it statutory responsibilities."
The 85-page document details wide-ranging proposals to revamp U.S. financial regulation, and proposes the Fed become a "systemic risk" regulator to keep tabs on large firms and emerging financial threats that could hit the entire economy. The U.S. central bank has faced heightened political scrutiny after a series of high-profile bailouts of financial firms that have seen it put taxpayer money at risk.
In April, Congress passed a resolution that opens the door to a study to determine the "appropriate" number for regional Fed banks and calling on the central bank to offer more details on its emergency lending to banks. While members of the Fed's Washington board are confirmed by Congress, the presidents of the 12 regional banks are named by local boards of directors, with the consent of the Washington board. Some Fed officials think some lawmakers would like to make regional Fed presidents answerable to Congress.
In addition to calling for the study, the administration will propose legislation to require the Treasury secretary to sign off on any emergency lending the central bank undertakes under its current "unusual and exigent circumstances" authority, the document states. The Fed has invoked this authority on numerous occasions since the financial crisis struck. The document said that in each case during the crisis the Fed had sought and received the approval of the secretary, but that requiring prior written approval would "provide appropriate accountability going forward."
In an interview with Reuters Television in May, Treasury Secretary Timothy Geithner, the former president of the New York Federal Reserve Bank, said the Fed's structure had served it well by providing a diverse set of viewpoints. "But we're taking a fresh look at all aspects of our financial system now and we're going to take a fresh look at the role of the Fed in the system generally. That's a useful thing for us to do," he said.
Obama Plan For Fed Power Boost Could Become Lightning Rod
The Obama administration wants a super-charged Federal Reserve, but is balancing the expansion with a regulatory council that may check the Fed's new powers. The Obama administration's "Financial Regulatory Reform: A New Foundation" recommends a council to aid the central bank in monitoring threats to the U.S. financial system. It also calls for a broad review of the Federal Reserve System structure. But, on Capitol Hill, the proposal is still likely to end up a lightning rod for criticism of the central bank, raising questions about how much new power the Fed will actually gain at the end of the day.
The administration's financial regulatory reform proposal calls for the Fed to serve as an uber regulator of all large, interconnected firms that could jeopardize the financial system. "These proposals would put into effect the biggest changes to the Federal Reserve's authority in decades," the administration wrote in a draft paper on its reform proposals. However, skepticism of the Fed runs high in Congress. Even as experts laud the Fed for launching unprecedented programs to stem the worst financial crisis in decades, lawmakers such as Sen. Bernard Sanders, I-Vt., argue that Fed should disclose the names of the companies that have benefited from its lending programs. Other lawmakers argue the central bank failed to adequately regulate financial firms and address banks' risky practices ahead of the crisis.
Additionally, critics have argued that the central bank's tasks should be scaled back so that it can focus solely on monetary policy. "There is significant opposition to increasing the powers of the Fed in Congress and significant concerns over Fed independence," said Eurasia Group analyst Dan Alamariu. "This proposal is kind of a middle ground, trying to satisfy the Congress' wishes for a council-based approach and at the same time, having the Fed play a significant role within that council." Senate Banking committee Chairman Christopher Dodd, D-Conn., and others have called for a council of regulators to police systemic risks, rather than solely giving that authority to the Federal Reserve.
The Obama administration's regulatory overhaul seems to acknowledge such concerns by recommending a council as a way to coordinate with the Fed on systemic risk issues. According to the proposal, the new council would be led by the Treasury secretary and would also include the Fed chairman and various other regulators. It would "facilitate information-sharing" and identify emerging risks and advise the Fed about firms that could threaten financial stability. It also seeks to amend the Fed's lending authority to require the central bank to win approval from the Treasury secretary before extending credit to institutions in "unusual and exigent" circumstances.
The central bank has invoked its emergency powers many times since the start of the financial crisis to help aid companies such as Bear Stearns and American International Group Inc. (AIG). Furthermore, the proposal calls for a comprehensive review of the Federal Reserve System. The administration also recommends a new, separate consumer-protection agency to protect consumers when it comes to credit cards and mortgages. The question is whether these sideline proposals to review and cap the Fed's authority will be enough to soothe Capitol Hill concerns about the larger plan to make the Fed the dominant regulator of the U.S. financial system.
That said, it's likely the plan will look much different after lawmakers have a chance to review it, hold hearings and make modifications. "There continue to be real concerns regarding the conflicts of the Federal Reserve System, a la, the abrupt resignation of the chairman of the New York Fed last month," said Lendell Porterfield, the head of a bipartisan government relations firm in Washington and a former senior adviser to Sen. Richard Shelby, R-Ala.
He referred to Stephen Friedman, who resigned as chairman of the board of the Federal Reserve Bank of New York amid concerns about his role as a director and shareholder of Goldman Sachs Group Inc. (GS).
Another sign of lawmakers' frustrations comes in the form of legislation introduced by Rep. Ron Paul, R-Texas, that would expand the Government Accountability Office's authority to audit the Fed. The plan is gaining steam, with some 232 co-sponsors, meaning that more than half of the House of Representatives back the measure. Meanwhile, Republican leaders in the House have drafted their own regulatory reform proposal that would scale back the Fed's authorities rather than boost its power.
"Some in Congress already believe the Fed has sacrificed monetary policy for the sake of the banking system. How does adding more duties complicate or compromise their existing responsibilities?" said Porterfield.
On the other hand, proponents of a dramatic boost in the Fed's powers argue that the White House's regulatory revamp should have gone further. "The need to win a consensus across all the regulators, with their different views, constituencies, and institutional interests is likely to make it excessively hard to achieve the desired systemic safety," said Brookings Institution Fellow Douglas Elliott.
The three steps to financial reform
by George Soros
The Obama administration is expected on Wednesday to propose a reorganisation of the way we regulate financial markets. I am not an advocate of too much regulation. Having gone too far in deregulating – which contributed to the current crisis – we must resist the temptation to go too far in the opposite direction. While markets are imperfect, regulators are even more so. Not only are they human, they are also bureaucratic and subject to political influences, therefore regulations should be kept to a minimum. Three principles should guide reform.
First, since markets are bubble-prone, regulators must accept responsibility for preventing bubbles from growing too big. Alan Greenspan, the former chairman of the Federal Reserve, and others have expressly refused that responsibility. If markets cannot recognise bubbles, they argued, neither can regulators. They were right and yet the authorities must accept the assignment, even knowing that they are bound to be wrong. They will, however, have the benefit of feedback from the markets so they can and must continually recalibrate to correct their mistakes.
Second, to control asset bubbles it is not enough to control the money supply; we must also control the availability of credit. This cannot be done with monetary tools alone – we must also use credit controls such as margin requirements and minimum capital requirements. Currently these tend to be fixed irrespective of the market’s mood. Part of the authorities’ job is to counteract these moods. Margin and minimum capital requirements should be adjusted to suit market conditions. Regulators should vary the loan-to-value ratio on commercial and residential mortgages for risk-weighting purposes to forestall real estate bubbles.
Third, we must reconceptualise the meaning of market risk. The efficient market hypothesis postulates that markets tend towards equilibrium and deviations occur in a random fashion; moreover, markets are supposed to function without any discontinuity in the sequence of prices. Under these conditions market risks can be equated with the risks affecting individual market participants. As long as they manage their risks properly, regulators ought to be happy.
But the efficient market hypothesis is unrealistic. Markets are subject to imbalances that individual participants may ignore if they think they can liquidate their positions. Regulators cannot ignore these imbalances. If too many participants are on the same side, positions cannot be liquidated without causing a discontinuity or, worse, a collapse. In that case the authorities may have to come to the rescue. That means that there is systemic risk in the market in addition to the risks most market participants perceived prior to the crisis. The securitisation of mortgages added a new dimension of systemic risk. Financial engineers claimed they were reducing risks through geographic diversification: in fact they were increasing them by creating an agency problem.
The agents were more interested in maximising fee income than in protecting the interests of bondholders. That is the verity that was ignored by regulators and market participants alike. To avert a repetition, the agents must have "skin in the game" but the 5 per cent proposed by the administration is more symbolic than substantive. I would consider 10 per cent as the minimum requirement. To allow for possible discontinuities in markets securities held by banks should carry a higher risk rating than they do under the Basel Accords. Banks should pay for the implicit guarantee they enjoy by using less leverage and accepting restrictions on how they invest depositors’ money; they should not be allowed to speculate for their own account with other people’s money.
It is probably impractical to separate investment banking from commercial banking as the US did with the Glass-Steagall Act of 1933. But there has to be an internal firewall that separates proprietary trading from commercial banking. Proprietary trading ought to be financed out of a bank’s own capital. If a bank is too big to fail, regulators must go even further to protect its capital from undue risk. They must regulate the compensation packages of proprietary traders so that risks and rewards are properly aligned. This may push proprietary trading out of banks into hedge funds. That is where it properly belongs. Hedge funds and other large investors must also be closely monitored to ensure that they do not build up dangerous imbalances.
Finally, I have strong views on the regulation of derivatives. The prevailing opinion is that they ought to be traded on regulated exchanges. That is not enough. The issuance and trading of derivatives ought to be as strictly regulated as stocks. Regulators ought to insist that derivatives be homogenous, standardised and transparent. Custom-made derivatives only serve to improve the profit margin of the financial engineers designing them. In fact, some derivatives ought not to be traded at all. I have in mind credit default swaps. Consider the recent bankruptcy of AbitibiBowater and that of General Motors. In both cases, some bondholders owned CDS and stood to gain more by bankruptcy than by reorganisation. It is like buying life insurance on someone else’s life and owning a licence to kill him. CDS are instruments of destruction that ought to be outlawed.
Hedge funds attack proposed EU regulations
Hedge funds have used their most prominent annual gathering – the GAIM conference in Monaco – to speak out against "disastrous" new regulatory proposals from the European Union. After a turbulent end to 2008 and an unhealthy start to 2009, managers and their investors are rallying round to fight off the new draft rules outlined in late April by the EU commission. "Hedge fund managers have been quiet for a long time on regulation because I think there’s a general assumption that it won’t come to pass," said one fund manager.
"We’ve assumed that the political will will follow the economic will. Historically that’s wrong. And now lots of us are beginning to think that maybe we’ve been a bit complacent." The EU commission’s draft directive on alternative investment fund managers controversially proposes limits on fund leverage and would require funds to be registered in EU countries in which they have investors. As well as speaking out against the EU, attendees at GAIM have also criticised an apparent lack of action from the UK government on the issue.
Several fund managers said they had previously had confidence in the UK’s ability to resist punitive regulation from Brussels, but were now fearful that the Brown government was too politically distracted to act decisively. "The [Financial Services Authority]’s hedge fund regulation has actually always been very good, and the UK has the infrastructure, the capital markets and the prime brokerages that make it ideal for hedge funds. But now we risk driving them out," said Simon Luhr, the managing partner of London-based SW1 Capital. "The prime minister can’t stand up for himself right now… I think it’s going to be a disaster." Three quarters of Europe’s hedge fund-managed assets, worth around $300bn, are managed out of London.
Other managers, though, were much more sanguine. Lobbying efforts have intensified in recent weeks and a considerable amount of behind-the-scenes work was going on said one major London-based fund partner. "I think people just need to be a bit patient. It’s only the first draft of the new rules," he said. Comments from City minister Lord Myners – himself an investment management industry veteran – have also given some in the industry comfort. Myners criticised the EU proposals as "naive" when they came out. Pierre Lagrange, a founding partner of GLG, one of the largest and most successful funds in Europe, was, meanwhile, more openly supportive of London’s future as an alternative asset management hub."My wife and I are actually planning a party to celebrate 20 years of living in London," he told delegates in a keynote speech.
Unemployment rises less than expected but experts caution against hailing recovery
The hope that Britain may be through the worst of the recession was strengthened by better than expected unemployment figures on Wednesday but economists cautioned against hailing the prospect of recovery. The number of people claiming jobless benefits increased 39,300 last month, almost half the 60,000 pencilled in by City economists. In the minutes from the Bank of England's last meeting, also released today, the central bank added that the chance of a continued sharp contraction in the economy has 'somewhat receded.'
Unemployment has historically been a lagging indicator in past recessions but economists believe that the slowing pace of rising claimant count is evidence that the labour market has opted for alternatives to job losses, including pay freezes and reduced working hours. Business leaders including the chief executives at Tesco and Home Retail Group, the owner of Argos and Homebase, have warned that rising unemployment is the biggest obstacle to the economy moving into a recovery. A broader measure of unemployment rose to 2.26m in the three months to April, taking the unemployment rate to 7.2pc.
"The claimant count unemployment data boost hopes that the rise in the number of jobless has tailed off appreciably after surging at the beginning of the year," said Howard Archer, chief UK economist at IHS Global Insight. "Even if the economy does manage to eke out some growth over the coming months, it is unlikely to be strong enough for some considerable time to come to lead to a net creation of jobs. The Bank of England revealed today that all nine members of the Monetary Policy Committee voted to keep interest rates at the record low level of 0.5pc. Although the minutes acknowledged that recent data from the economy had been 'encouraging', it cautioned that "there was no reason to conclude that the medium-term outlook for the economy, and thus inflation, had materially changed.'
Many UK business were still struggling to cope through the downturn, according to insolvency experts. "Any talk of green shoots is still grossly out of sync with the reality on the ground. From where I'm standing things are as bad now as they were a few months ago," said Alan Tomlinson, partner at the insolvency practitioners, Tomlinsons. "The small and medium-sized companies that we deal with each day are still being decimated by sharp drops in turnover, growing debts and, critically, the ongoing failure of the banks to lend."
Dutch banks' Eastern Europe exposure 11% of GDP
Dutch banks' exposure to central and eastern European countries, hard hit by the credit crisis and recession, is about 11 percent of the national gross domestic product, the Dutch central bank (DNB) said on Wednesday. Emerging Europe is suffering from the global recession and bad debt, which started to rise in the first quarter and will increase throughout the year as the region's boom comes to an abrupt end.
The Netherlands' exposure compares to 70 percent of GDP for Austrian banks, DNB said. Data from the Bank for International Settlement showed in January that Germany as a country had an exposure of 6.6 percent of GDP and Belgium 30.1 percent. The Dutch exposure covers countries such as Poland and Latvia, and DNB also included Russia and Turkey in the number, it said in its quarterly report. Based on the Netherlands' 2008 GDP of 595 billion euros ($826 billion), the exposure would amount to some 65.5 billion euros.
DNB did not name specific companies, but Dutch bank and insurer ING earned about 5 percent - or 3.3 billion euros - of its operating income last year from eastern European countries, including Turkey. Euro zone banks could see losses of 7 percent of their Tier 1 capital if worst-case scenarios for emerging countries in Europe, Asia and Latin America materialise, the European Central Bank said in its financial stability report on Monday.
Latvia: A lat to worry about
Inara Blumberga is at the centre of an unprecedented economic gamble. The librarian from the Latvian beach resort of Jurmula faces a big cut in her salary as the Baltic nation embarks on a risky plan to pull itself out of an economic crisis harsher than any other country in Europe is suffering. With the backing of the International Monetary Fund and the European Union, Riga is hoping that if it can impose enough pain on the domestic economy, it will be able to maintain its exchange rate peg to the euro. That would allow it entry into the single currency zone within the next four years. After months of dithering, the government last week put together a package of measures that will mean Ms Blumberga – who earns just 280 lats ($552, £337, €398) a month – along with hundreds of thousands of other public sector workers will suffer a 20 per cent pay cut. Even pensioners will see reductions of 10 per cent.
Latvia ran into trouble managing the unprecedented surge in credit-fuelled economic growth that rushed through central and eastern Europe, driven by EU enlargement and globalisation. As small, open economies, the Baltics were swamped with foreign loans, chiefly from Swedish banks, particularly in their overheated property markets. But while Estonia and Lithuania worked to slow the pace, Latvia’s leaders ignored calls for restraint until it was too late. The end came last autumn with a currency and banking crisis, which forced the government to go to an IMF/EU consortium for €7.5bn ($10.4bn, £6.3bn) in emergency aid. For now, the financial markets are giving Latvia the benefit of the doubt: fears of an immediate devaluation have eased since the 500m lat austerity package appeared to unlock the door to a €1.4bn slice of the pledged funds that had been withheld.
Nor have Latvians so far mounted the kind of violent protests that last winter helped bring down the previous government and paved the way for the emergence of the current centre-right coalition. As Ms Blumberga says stoically: "There won’t be protests like in January, as you can achieve nothing. People hoped for something in January but no one expects anything now." However, economists warn there are few precedents of a crisis-hit country successfully pulling itself out of trouble without devaluing the currency. Even Argentina, which has adopted one of the least conventional routes to recovery of recent years, devalued as part of its shake-out early this decade. "What they are trying to do is, to the best of our knowledge, unprecedented in economic history," Rory MacFarquahar, an emerging markets expert at Goldman Sachs, says of the Latvians. "It is politically extremely painful and I don’t know whether it is sustainable." More is at stake than the fate of this EU country of 2.3m, which regained its independence from the Soviet Union in 1991. If Latvia succeeds, it would send a powerful signal that the ex-Communist countries, having endured the turmoil of that transformation, have the resilience to cope with the current global crisis.
But if Latvia fails, it could have a knock-on effect on other troubled economies in the region, particularly those with fixed exchange rates, such as Estonia, Lithuania and Bulgaria. Around the globe, small and vulnerable countries are responding to the crisis with budget cuts. Unable to borrow their way out of trouble, as the US and the UK are trying to do, they are struggling to contain deficits by reducing public spending, including cutting pay bills by slashing government employee numbers. Some are resorting to radical measures. Iceland is preparing its biggest-ever budget overhaul. Lithuania is mulling introducing student fees. Estonia has postponed previously agreed increases in unemployment benefit. But no administration is going as far as Riga in cutting actual pay. Under the IMF/EU rescue terms, Riga has pledged to keep its budget deficit to 5 per cent of gross domestic product. But with the economy contracting much faster than then forecast, the deficit could reach 12 per cent without remedial action. Even with the latest cuts, it will be 7 per cent, a figure that breaks the IMF’s normal boundaries.
After years of the fastest growth in the EU, Riga now foresees the economy shrinking 18 per cent this year, the bloc’s worst recession. The outlook for 2010 and beyond depends on the economies of western Europe and Russia, Latvia’s main trading partners. Without dramatic improvements in the pan-European economy, Riga seems set for further rounds of tax increases and spending cuts to keep the deficit down and convince the IMF to continue its support and qualify for eurozone membership by the government’s 2013 target date. "The government wants to feed the cow less and milk her more often," says one bank chief executive. Reaching for an even more pessimistic metaphor, he adds: "In a swamp there is no bottom." Landmark property developments such as the twin Panorama Plaza towers on the road between Riga and the airport stand all but empty and shopping malls look forlorn. House prices fell by one-third last year, insolvencies are up and banks are repossessing more mortgaged properties and leased cars. "Business is in hibernation," says Gunnar Ljungdahl, who chairs the Swedish chamber of commerce in Riga.
In these circumstances, many governments devalue to spread some of the costs to foreign creditors and to boost the economy by making exports – which include wood products – more competitive. IMF officials have indicated that the organisation was divided over the wisdom of defending the lat’s peg but was finally persuaded by pressure from Riga’s EU partners as well as the Latvian government’s own refusal to contemplate devaluation. Latvia sees the currency peg as the linchpin of its economic policies. It helped drive down inflation and is the route to euro entry. Latvia’s governments have often been weak but have always defended the peg and supported the powerful central bank, where both the prime minister and finance minister used to serve. "For Latvia the peg is the last pillar of trust," says Henrik Hololei, an Estonian cabinet head at the European Commission. Also, Latvian officials argue that in a small economy, where 60 per cent of export value is in imported content, devaluation will not do much except encourage inflation. With some 90 per cent of all loans in euros, they add, it could bankrupt tens of thousands of companies and individuals. But the price of avoiding devaluation will be huge economic, social and political strains. Valdis Dombrovskis, prime minister, admits his main challenge now is "to preserve the social peace".
Some opposition politicians predict a rough autumn as unemployment rises from 11 per cent today to a forecast 20 per cent and those jobless for more than a few months find their benefits reduced to just 30 lats a month. Trade unions are planning a demonstration for tomorrow. The crisis could also exacerbate tensions between the majority and ethnic Russians, who comprise about 30 per cent of the population and sometimes hanker for closer ties with Moscow. Harmony Centre – a coalition seen by the other parties as pro-ethnic Russian – made strong gains in this month’s European parliamentary elections. Top spot went to Alfreds Rubiks, a former Riga mayor, who says: "Our government backs this budget but people do not." Yet most Latvians appear resigned to cuts. Many make light of today’s hardship compared to the Soviet era or the tough post-Communist transition. After years of big pay rises, some are reconciled to making sacrifices. Ivars Godmanis, a former prime minister, says survival will depend on the government and the people huddling together like "penguins".
These survival instincts will now be tested. Independent economists doubt whether Riga’s great gamble will work even with IMF/EU backing. Morgan Stanley analysts say: "Devaluation is inevitable and obviously getting closer." Even the IMF is unsure, warning that "correcting currency misalignment without nominal depreciation is extremely difficult". If Latvia’s stabilisation plan fails, the repercussions would be widespread. First, investors would question the strength of other fixed currency regimes, starting with Latvia’s Baltic neighbours. Estonia, with a fiscal reserve accumulated in good years, is in a stronger position than Lithuania. But both are enacting austerity budgets in the face of forecast GDP declines this year of around 15 per cent. Further afield, Bulgaria insists it can maintain its fixed exchange rate without IMF support. But its socialist government faces a drubbing in elections due next month. Elsewhere in the region, countries with floating exchange rates, including Poland, the Czech Republic and Hungary, have seen their currencies hit by market turmoil over Latvia. "We have seen the risk of contagion is still there," says Andras Simor, Hungarian central bank governor.
The brunt of any losses would be borne by Sweden’s banks, whose Baltic assets amount to $80bn, or 16 per cent of Swedish GDP. In an extreme scenario, Baltic credit losses would reach 34 per cent of loans for Swedbank and SEB, the two biggest, which the national regulator has warned to reinforce their capital reserves. The European Central Bank is also worried and has lent Sweden €3bn to guard against its banks’ Baltic exposure. As the Commission’s Mr Hololei says: "Many countries in the region are dependent on how Latvia will get out of the crisis." Cut off from international capital markets and still tens of billions of dollars in arrears with public and private creditors, Argentina has been a financial pariah since its 2001-02 crash led the country to take drastic measures to right itself – involving a $95bn debt default, writes Jude Webber. The country remains out in the cold because of its refusal to return to International Monetary Fund scrutiny of its public accounts, even after paying off its $9.5bn debts to the lender in one fell swoop in 2006.
But now, the global financial crisis has given respectable developed economies fighting with high debt, ballooning spending and lower international confidence a taste of what it feels like to be Argentina. In turn, the Latin American maverick is suddenly being viewed as a test bed for ways to restore stability. As worldwide recession bites, countries struggling to meet tough deficit limits and spending cuts the Fund has imposed on them as a condition of bailing them out are trying to assess whether Argentina’s go-it-alone stance works out any better than the fiscal medicine they are being ordered to swallow. "I wouldn’t be so quick to say that there is no alternative to the IMF," says Aldo Caliari at the Center of Concern, a Washington think-tank. He praises the exchange rate targeting and demand-led model that have been features of Argentine policy under Néstor Kirchner in 2003-07 and since then under the presidency of his wife Cristina Fernández, which led to six years of growth averaging 8.5 per cent in Argentina’s rebound from its crash.
In its transition out of chaos, Buenos Aires adopted a devalued exchange rate, kept real wages low, froze public sector tariffs and introduced a web of energy, transport and food subsidies. Together this was dubbed a "heterodox" approach, as opposed to the orthodoxy preached by the IMF. Argentina’s experience, as that of other countries struggling now, reveals that "in times of crisis, you’ll do what’s necessary to survive", says Mario Blejer, a former IMF official who headed the Argentine central bank for the turbulent first half of 2002. With governments worldwide seeking creative ways to combat the crisis – such as the US Federal Reserve buying government bonds – the eccentric has almost become the conventional, he adds. "I don’t know what is heterodox any more." Indeed, the Argentine crisis showed that "countries can default and the world doesn’t end", says a senior official at one multilateral lender. Ecuador, for instance, defaulted on $3.9bn of debt last year.
But Argentina has failed to move on by creating stable conditions for investment. As countries worldwide seek to emerge from recession, they will face the same challenges to improve competitiveness by boosting infrastructure, education, technology and labour productivity – tests that Argentina has so far failed. Furthermore, it has settled neither with private creditors, which rejected a debt restructuring in 2005 and whose legal action has barred it from tapping international markets, nor with the Paris Club of western creditor nations. Argentina last year promised to pay off its $6.7bn Paris Club arrears using central bank reserves, but that plan was buried by the international crisis. Since the default the government has, moreover, clung to the excuse of economic emergency to give it leeway to pursue its policies. That essentially allows Argentina to break contracts if necessary – alienating investors, who class it alongside Venezuela, Ecuador and Bolivia as the "bad boys" of South America.
The problems are hardly easing. They include higher-than-expected capital flight as savers take dollars abroad, and decelerating tax revenues – which according to Luís Secco, an analyst, mean Argentina is living way beyond its means. For every peso the state earns in taxes, it is now spending 1.8 pesos, he says. Mr Caliari adds: "The government cannot rest on its laurels. It needs to be more cautious about spending. Heterodox doesn’t mean you can ignore economic realities." The high outlays reflect a pre-election spending spree as Ms Fernández fights to retain a majority in Congress on June 28. The mid-term polls are being portrayed by the government as a referendum on its economic model: a choice between more of the high growth Argentines have become used to and a return to the chaos of previous years, when poverty and unemployment soared. "It isn’t important at this stage to have a programme or financial arrangement with the Fund," says Mr Blejer. "But it is important to slowly normalise international financial relations to gain access back to capital markets and improve the flow from other multilaterals."
China risks trade suicide
Beijing is playing with fire by issuing a `Buy China' edict for its stimulus package. As the world’s top exporter with a $400bn current account suplus and an economy that lives off the America and European market, it will pay the highest price if it triggers a global retreat into protectionist blocs. The Chinese elite no doubt feel provoked by what they call the "poison" of the US `Buy American’ clause, but the Obama White House managed to tone down the worst excesses of Capitol Hill and in any case the Chinese version is more restrictive.
It bans the purchase of foreign equipment for investment projects unless a special exemption is obtained. The measures apply to European goods, even though EU states have not imposed any such "Buy Europe" clause of their own. EU producers of wind turbines have already been excluded from a $5bn wind project, whether or not they have factories in China. Beijing risks making the same catastrophic error as the US Congress when it passed the US Smoot-Hawley Tariff Act in 1930. America was then the rising surplus power, like China today. It was the chief beneficiary of an open global system.
By imposing tariffs, Washington triggered massive retaliation. While nobody escaped the Great Depression that ensued, the effects were unequal. The US suffered a far steeper decline in output than the rest of the world. Britain muddled through relatively well in a trade bloc behind Imperial Preference. China’s action is extremely disturbing. It confirms what we have long feared, that the Chinese government is sufficiently worried about rising unemployment to adopt suicidal measures. Nor does this episode instill confidence in the `China recovery story’. While exports fell 26pc in April, imports were down by almost as much. There is no real rebalancing under way from external to internal demand. China is still running a massive surplus. It is flooding the world with excess goods, and exporting deflation. This is untenable. At some point, the West will react.
Alberta May Borrow as Much as C$5 Billion As Deficit Widens
Alberta, the Canadian province that sits on the largest pool of oil reserves outside the Middle East, may borrow as much as C$5 billion ($4.41 billion) over the next three years after posting its first budget deficit in more than a decade. "We haven’t let the ink dry on the final program yet, but we’re looking at bonds, and we’re looking at the opportunities," Finance Minister Iris Evans told reporters following a speech today at the Economic Club of Canada in Toronto.
The province will borrow C$1.1 billion this year and Alberta officials have been meeting with banks to indicate they may borrow more, she said. A decline in tax revenue led to the first deficit since 1993 last year, forcing the government to turn to debt markets for the first time in more than a decade. Alberta projected a record deficit of C$4.71 billion for the fiscal year ending in March, following a C$1.4 billion shortfall last year. Alberta’s gross domestic product is expected to contract by 2.5 percent this year, the steepest decline in 17 years, according to RBC Economics.
Green Green Shoots of Home
by Willem Buiter
For the past week, I have put the Green Shootometer in the garden and have taken regular readings. The upshot is: the glass is definitely half empty - or half full. Let me explain.
So far, so bad
As is clear from the most interesting blog post by Barry Eichengreen and Kevin O’Rourke, and its recent update on VoxEU, the global economy is, as regards some key activity indicators (industrial production, world trade, world stock markets), tracking the Great Depression of the 1930s with frightening precision and tenacity (see also Martin Wolf’s recent column "The recession tracks the Great Depression" on this). They date the start of the current global contraction in April 2008.
But here’s the good news
However, somewhat to my surprise, central bankers and policy makers turn out to be capable of learning, even across generations. The lessons of the 1930s appear to have been learnt. New mistakes are being made all over the place, especially as regards moral hazard, the too-big-to-fail problem and other incentives for excessive risk taking in the financial sector, but that won’t become a serious problem until the next bust following the next financial and asset market boom and bubble. Monetary policy has been vastly more expansionary in the current downturn that during the corresponding phase of the Great Depression, whether measured by official policy rates or by the behaviour of the world broad money stock. As regards the actions by the monetary policy makers, the behaviour of the narrow money stock (monetary base) or the size of the balance sheets of the central banks would show an even more expansionary thrust. Fiscal policy, unlike what happened in most of the 1930s is counter-cyclical.
In addition, the world has not launched a major trade war on itself. Perhaps I should have said ‘not yet’. Of the 19 nation states that made up the G20 at the London meeting on April 2, 2008, 17 had announced or introduced protectionist measures by the time of the November meeting in Washington DC. While none of these measures amounted to open warfare, recent words and actions from India and China are extremely worrying. In January, India banned the import of Chinese toys for a six-month period (supposedly because of safety concerns). When China threatened to take the issue to the WTO, India lifted the ban after two months. Last week, India’s Federation of Chambers of Commerce and Industry (representing SMEs) accused China of predatory pricing. Today’s Financial Times reports that China has introduced a ‘Buy Chinese’ policy. Even the watered-down version of the ‘Buy American’ policy enacted recently in the US caused considerable tension. The world is playing with fire, trying to export its unemployment problems to other planets.
Inflexion points and turning points
If you eyeball Eichengreen and O’Rourke’s updated Figures 1, 2, 3 and 4 (reproduced below), you may feel that we are just about at the point where things are not just getting worse more slowly (as regards the level of global production and trade) but may actually be getting better: we may appear to have moved past the inflection point to the turning point.
Whether that interpretation is correct depends in part on which activity index you look at. Unemployment will go on rising, possibly for several years. Both industrial production and trade focus on physical goods, rather than on services. Industrial production is a rather small share of global GDP (probably somewhere between 20 and 25 percent). It also tends to be much more volatile that the production of services, because industrial production is subject to the inventory cycle. The inventory cycle overstated the severity of the downturn, especially in countries with relatively large manufacturing sectors, like Germany, Japan and Brazil. Because of the nice property of inventory stocks that they cannot be negative, there is a natural non-linearity on the down-side of the inventory cycle. So following world-wide de-stocking, a rebound in industrial production and GDP is all but a mechanical certainty. There remain two key unresolved issues. First, what target levels of inventories relative to planned or expected sales or production manufacturers, wholesalers and retailers will want to maintain.
This drives the strength of the strength of the inventory rebound. Second, which components of final demand (private consumption, private fixed investment and government spending on good and services) will take over when inventory accumulation peters out again (exports are a source of ‘final’ demand for individual countries, but not for the world as a whole, since globally, exports equal imports). Global financial markets have normalised, in the sense that spreads have return to the levels just before Lehman fell over. I must admit to feeling, in early September 2008, that financial market conditions were far from favourable, however. So cardiac arrest may have been seen off, the patient is not about to jump out of bed and do a horlepip. Access to capital markets has been restored for many of the larger firms, but the cost of funding tends to be high. In part, the recent burst in capital market funding represents a diversion of funding demand away from the banks, which are generally still in a zombified state. It also tends to be unavailable to SMEs.
What are the prospects for final demand? Not too bright, I would argue, in the US. Households are traumatised by capital losses on equity; if they are homeowners, they will have suffered massive capital losses on their homes. While this negative wealth effect for households long housing (landlords) is balanced by a corresponding gain on those short housing (tenants), the collateral reduction caused by the house price collapse has short-term negative consequences for the ability to borrow. In addition, if the collapse in house prices represented at least in part the bursting of a bubble, the capital losses of the landlords are not matched by corresponding gains (in present discounted value terms) for tenants. US demand has been supported by the Obama administration’s fiscal stimulus package. With the Federal deficit likely to be somewhere around 13 to 14 percent of GDP this year, and public debt building up rapidly, not just as a result of these deficits but also as a result of off-budget increases in government (contingent) liabilities associated with the myriad financial support and rescue packages cobbled together for the US financial sector (and selected bits of the rust belt real economy), there is no scope for a further fiscal stimuli financed by debt issuance, unless this debt issuance were monetised by the Fed.
Monetary policy has been extraordinarily expansionary, with the official policy rate as close to zero as makes no difference and large-scale quantitative and credit easing. This too is pretty much an exhausted set of policy instruments, except in conjunction with a fiscal stimulus. Tax cuts or increased transfer payments financed by the issuance of Treasury debt that is purchased and monetised by the Fed is the real-world version of helicopter money. There exists a scale for those operations large enough to stimulate demand. The problem is their reversibility, once the output gap closes and inflationary pressures beging to build again. Increases in public spending on real goods and services could also be monetised by the Fed. Again this will stimulate demand but is subject to the same reversibility or exit problems as helicopter drops of money.
All crossborder US banks, and probably most larger purely domestic US banks are now de-facto guaranteed against insolvency by the US government. This is the moral hazard disaster I referred to earlier: too big and too politically connected to fail. Even where it could have been used (for Federally insured deposit-taking banks), the US authorities have not invoked the special resolution regime for commercial banks to force the unsecured creditors to recapitalise the big banks, through mandatory debt-to-equity conversions, haircuts or similar measures. Instead the tax payer was made to pick up the tab. But at least new capital has gone into the banks on a reasonable scale. The US stress tests, cautious though they were, did lead to banks going to the market and successfully raising capital. The fact that the methodology and the results of the stress tests are in the public domain also help build confidence. Many silly things have happened also. Two attempts at getting the toxic assets off the banks balance sheet (the first one under Paulson through the TARP, the second one under Geithner through the PPIP) have failed. This failure to adopt a consistent bad bank approach (let alone pursue the alternative good bank(s) approach), means that the surviving banks still have some of the toxic rubbish on their balance sheets, which inevitably acts as a drag on new lending.
Allowing 10 banks that had received public capital injections to repay the government is pandering to banks chomping at the bit to get the government out of their hair and return to the bad old ways that brought us the financial crisis. Perhaps a couple of banks were truly in a position to repay the government, without impairing their ability to act as banks, that is, to engage in new lending. The remaining banks will act to varying degrees like zombie banks - surviving, but engaging in little new lending and other business likely to stimulate activity and support a dynamic changing economy. Following the Japanese example of recapitalising gradually out of operating profits generating in no small part because of explicit or implicit government guarantees of bank funding and high private lending rates is likely to lead to a Japanese-style lost quinquennium or even a lost decade.
The UK’s recession has turned out to be less deep than I feared and anticipated. In part this is due to the large fall of sterling (still 20 percent weaker than before the downturn, despite the recent gains). This good news, if it sticks, is qualified by the likelihood that any recovery will be slow and meek. Household consumption has been remarkably resilient, but given the state of the UK household balance sheet, it is hard to see consumer demand growth being the internal locomotive. Private investment, including residential and non-residential construction, is bound to remain weak for the foreseeable future. Government spending will have to be cut soon in real terms if a public finance Armageddon is not to befall the country, which is in dreadful fiscal shape. Tax increases are also all but unavoidable if fiscal-financial sustainability is to be restored.
Like the US banks, the UK’s banks are surviving but to varying degrees zombified. Even those banks that have managed to stay out of the clutches of the state have had to engage in so much defensive balance sheet restructuring that they are falling way short in their supposed role as conduits for intermediation between households and non-financial enterprises. There have been stress tests in the UK, but neither the methodology or the results have been put in the public domain. They have therefore been quite useless as regards restoring confidence. In addition, the tests were performed by the FSA, which does not yet have the personnel capable of performing a proper stress test. Historically, it has been a box tickers organisation, dominated by lawyers and accountants - both quite useless skills as regards stress tests. As in the US, moral hazard has been king in the government’s approach to providing financial support to the banking sector. Concentration has increased and the too big and too politically connected to fail problem has never been more acute.
The Euro Area has performed remarkably badly in this downturn. This is partly due to the ECB, whose policy stance has been less expansionary than that of the Fed and the Bank of England. Its official policy rate still stands at 1.00 percent, around 100 basis points above the level it should be at, and the Eurosystem has expanded its balance sheet less than the Fed and the Bank of England. A more serious problem is that addressing the solvency of the banking system in the Euro Area has not yet begun in earnest. There have been government capital injections (or announcements of such) when banks were about to fall over (Commerzbank and assorted Landesbanken in Germany, ABN-Amro and ING in the Netherlands, and many other banks in Belgium, Ireland, France, Italy and now Spain), but it has been even less systematic and on a smaller scale than in the US. In addition, the Euro Area banks have managed to keep the problem assets they have on their balance sheets under wrap. No stress tests whose methodology and/or outcomes are in the public domain have been performed.
The European Commission now wants a uniform set of EU-wide stress tests, but only to give it and supervisors/regulators a sense of what the risk-map is, not as a prelude to mandatory capital raising and/or a restructuring of funding strategies. The Euro Area banks have used every accounting trick in the book to avoid revealing the existence of troubled or toxic assets and marking them to market. The ECB recently estimated the additional capital required by the Euro Area bans at between €212 and €283 bn. People close to the industry assure me that the true figure is at least twice that amount. So Euro Area banks are likely to be or become zombie banks to a much greater degree than their US and UK counterparts. They have revealed little, recognised less and are, to an unknown degree, still subject to material insolvency risk because of undeclared horrors on their balance sheets. Their high degree of leverage also makes them extremely vulnerable to further balance sheet deterioration as conventional household, industrial and commercial loans go belly-up in increasing numbers as the recessions deepens and lengthens.
I don’t understand the Japanese economy. Never have. Probably never will. I don’t understand why the official policy rate has been below 0.5 percent since 1995 - effectively in a liquidity trap. I don’t understand why, given that first fact, the stock of outstanding public debt has not been monetised to the point that Japan has an inflation rather than a deflation problem. I do understand, sort of, the inventory cycle Japan in going through and in which it now appears to have entered the inventory re-accumulation phase. Unless Japanese consumers have a major change of heart, however, it is hard to see Japan as a global locomotive.
The emerging markets are a very heterogenous bunch. Their recent economic performance and prospects range from quite good (India, Turkey, Brazil since the end of the destocking implosion), to prima facie quite good (China) to pretty mediocre or bad (Central and Eastern Europe), to dismal (Russia). Those emerging markets that (1) did not have their domestic financial sectors destroyed or excessively exposed to parent banks in the North Atlantic region; (2) are not excessively dependent on export demand and (3) are not too dependent on foreign funding are likely to do best and have a ‘V’-shaped recovery. India ticks all the boxes. Unfortunately for the rest of the world, it is still too small and too closed to be a global demand enging. Brazil is fairly export-dependent. Despite its stong net foreign financial investment position, its enterprise sector has a large foreign exposure, so there are vulnerabilities here. However, with unusually restrained fiscal policy and unusually responsible monetary policy, it had prospects for becoming the medium-sized engine that could.
China is the great unknown. It is big enough to make a global impact. It is, however, very export dependent. It will have to swicth demand towards domestic final demand, including consumption of non-traded goods and services. The potential is certainly there. The extravagant Chinese saving rate can be tackled in the household sector by introducing a nation-wide unfunded social security retirement scheme (possibly with a contribution holiday for a couple of years up front), with greater public funding of health care and with increased public funding for education. The state enterprise sector has been hoarding funds for a long time, and the Chinese government may finally be able to extract these surpluses. There also is much scope for environmental investment, investment in light industry and residential investment. A key question is whether the Chinese authorities have the implementation capacity to steer this change in the composition of production and demand towards import-competing goods and non-traded goods and away from exportables. Given enough time, they no doubt can, but it is not obvious that it will be possible to achieve this right now - over a horizon relevant to the cyclical state of the Chinese and global economy.
A map of government-sponsored investment programmes for China shows a marked concentration inland, which is consistent with the need redirection of final demand and production away from exports. Whether this is a wish list or a list of project likely to result in production during the next two or three years I don’t know. Finally, there is the usual worry about the quality and bias in the Chinese statistics. In China, as in most authoritarian states, statistics are not primarily a source of information, but a policy tool and a propaganda instrument. Corroberation is therefore important. Chinese energy (electric power) consumption historically tracks industrial production and GDP quite well. Not so since the downturn began. Power consumption has been declining despite continuing GDP growth. As there has been no big push on energy conservation in China, either through prices or through administrative methods, this coexistence of rising GDP and declining power use is strange. Bottom line is, I continue to have doubts about the strength of the Chinese growth performance, but would welcome confirmation that eight percent growth or more this year is truly achievable.
There are other indicators to support the view that the global economy may be turning. Commodity prices, including oil, are rising and well above their recent lows. This is consistent with the view that emerging markets, which are notoriously energy-inefficient, are likely to be the early demand drivers in the recovery. Survey data, in the US, the UK and the Euro Area tend to be stronger than the hard data. Of course, the hard data are not hard at all, but just survey data several times removed. Against that, sentiment is fickle and volatile. A massive sense of relief that the world is not falling apart completely may get reflected in an up-tick of consumer sentiment but may not translate neatly into an increase in consumer spending. But on balance, there are more signs that the worst is over. There are also signs that the recovery whenever it started or may start, will be slow and reluctant. Recoveries without healthy banks are possible, but more difficult. Those of you familiar with the lyrics, written by Claude "Curly" Putman Jr., of the country song and ultimate Schmachtfetzen ‘Green Green Grass of home’, will know that the last verse (spoken) starts:
"Then I awake and look around me, at four grey wall surround me and I realize that I was only dreaming."
As far as I’m concerned, I’ve been down so long, it looks like up to me.
As Iraq runs dry, a plague of snakes is unleashed
Swarms of snakes are attacking people and cattle in southern Iraq as the Euphrates and Tigris rivers dry up and the reptiles lose their natural habitat among the reed beds. "People are terrified and are leaving their homes," says Jabar Mustafa, a medical administrator, who works in a hospital in the southern province of Dhi Qar. "We knew these snakes before, but now they are coming in huge numbers. They are attacking buffalo and cattle as well as people."
Doctors in the area say six people have been killed and 13 poisoned. In Chabaysh, a town on the Euphrates close to the southern marshland of Hawr al-Hammar, farmers have set up an overnight operations room to prevent the snakes attacking their cattle. "We have been surprised in recent days by the unprecedented number of snakes that have fled their habitat because of the dryness and heat," Wissam al-Assadi, one of the town's vets said. "We saw some on roads, near houses and cowsheds. Farmers have come to us for vaccines, but we don't have any."
The plague of snakes is the latest result of an unprecedented fall in the level of the water in the Euphrates and the Tigris, the two great rivers which for thousands of years have made life possible in the sun-baked plains of Mesopotamia, the very name of which means "between the rivers" in Greek. The rivers that made Iraq's dry soil so fertile are drying up because the supply of water, which once flowed south into Iraq from Turkey, Syria and Iran, is now held back by dams and used for irrigation. On the Euphrates alone, Turkey has five large dams upriver from Iraq, and Syria has two.
The diversion of water from the rivers has already destroyed a large swathe of Iraqi agriculture and the result of Iraq being starved of water may be one of the world's greatest natural disasters, akin to the destruction of the Amazonian rainforest. Already the advance of the desert has led to frequent dust storms in Baghdad which close the airport. Yet this dramatic climatic change has attracted little attention outside Iraq, overshadowed by the violence following the US-led invasion in 2003 and the overthrow of Saddam Hussein.
The Saw-Scaled Viper is blamed for more deaths than any other species in the world.
The collapse in the water levels of the rivers has been swift, the amount of water in the Euphrates falling by three-quarters in less than a decade. In 2000, the flow speed of the water in the river was 950 cubic metres per second, but by this year it had dropped to 230 cubic metres per second. In the past, Iraq has stored water in lakes behind its own dams, but these reservoirs are now much depleted and can no longer make up the shortfall. The total water reserves behind all Iraqi dams at the beginning of May was only 11 billion cubic metres, compared to over 40 billion three years ago.
One of the biggest dams in the country, on the Euphrates at Haditha in western Iraq, close to the Syrian border, held eight billion cubic metres two years ago but now has only two billion. Iraq has appealed to Turkey to open the sluice gates on its dams. "We need at least 500 cubic metres of water per second from Turkey, or double what we are getting," says Abdul Latif Rashid, the Iraqi Minister of Water Resources. "They promised an extra 130 cubic metres, but this was only for a couple of days and we need it for months."
His ministry is doing everything it can, he says, but the most important decisions about the supply of water to Iraq are taken outside the country – in Turkey, Syria and Iran. "In addition there has been a drought for the last four years with less than half the normal rainfall falling," says Mr Rashid. Large parts of Iraq that were once productive farmland have already turned into arid desert. The Iraqi Ministry of Agriculture says that between 40 and 50 per cent of what was agricultural land in the 1970s is now being hit by desertification.
Drought, war, UN sanctions, lack of investment and the cutting down of trees for firewood have all exacerbated the crisis, but at its heart is the lack of water for irrigation in the Tigris and Euphrates. Farmers across Iraq are being driven from the land. Earlier this month, farmers and fishermen demonstrated in Najaf, a city close to the Euphrates, holding up placards demanding that the Iraqi government insist that foreign countries release more water.
"The farmers have stopped planting and now head to the city for work to earn their daily living until the water comes back," said Ali al-Ghazali, a farmer from the area. "We pay for our seeds at the time of the harvest, and if we fail to harvest, or the harvest has been ruined, the person who sold us the seeds still wants his money." Najaf province has banned its farmers from growing rice because the crop needs too much water.
The drop in the quantity of water in the rivers has also reduced its quality. The plains of ancient Mesopotamia once produced abundant crops for the ancient Sumerians. From Nineveh in the north to Ur of the Chaldees in the south, the flat landscape of Iraq is dotted with the mounds marking the remains of their cities. There is little rainfall away from the mountains of Kurdistan and the land immediately below them, so agriculture has always depended on irrigation.
But centuries of irrigating the land without draining it properly has led to a build-up of salt in the soil, making much of it infertile. Lack of water in the rivers has speeded up the salinisation, so land in central and southern Iraq, highly productive 30 years ago, has become barren. Even such rainfall as does fall in northern Iraq has been scant in recent years. In February, the Greater Zaab river, one of the main tributaries of the Tigris, which should have been a torrent, was a placid stream occupying less than a quarter of its river bed. The hills overlooking it, which should be green, were a dusty brown.
Experts summoned by the Water Resources Ministry to a three-day conference on the water crisis held in Sulaimaniyah in April described the situation as "a tragedy". Mohammed Ali Sarham, a water specialist from Diwaniyah in southern Iraq, said: "Things are slipping from our hands: swathes of land are being turned into desert. Farmers are leaving the countryside and heading to the city or nearby areas. We are importing almost all our food, though in the 1950s we were one of the few regional cereal-exporting countries."
The experts recommended that, in addition to Turkey releasing more water, there should be heavy investment to make better use of the waterways such as the Tigris and Euphrates. But this year Mr Rashid says that his budget for this year has been cut in half to $500m (£300m) because of the fall in the price of oil. The outcome of the agricultural disaster in Iraq is evident in the fruit and vegetable shops in Baghdad. Jassim Mohammed Bahadeel, a grocer in the Karada district, says that once much of what he sold came from farms around the Iraqi capital. "But today, the apples I sell come from America, France and Chile; tomatoes and potatoes from Syria and Jordan; oranges from Egypt and Turkey. Only the dates come from Iraq because they do not need a lot of water."
Rightly feared: Iraq's deadly reptiles
*Saw-Scaled Viper (Echis carinatus) About 2ft long, this viper is blamed for more deaths than any other species in the world. Its bite causes extensive internal haemorrhaging in its victims. Recognisable by an arrow-shaped marking on the head.
*Desert Horned Viper (Cerastes cerastes) The Desert Horned Viper is typically found in sandy terrain and is a common sight in Iraq's southern deserts, identified by the bony horns over its eyes. It lurks in sand, only eyes, nostrils and horns above the surface.
*Desert Cobra (Walterinnesia aegyptia) Like most cobras, it is easily adaptable to various habitats. But locations occupied by humans are a particular favourite where shelter and rodents are on offer. Whilst this glossy snake does not actively seek confrontation, it can move with lethal speed when provoked.