Firestone Rubber, Akron, Ohio. Conversion of beverage containers to aviation oxygen cylinders. After shatterproof oxygen cylinders for high altitude flying have passed all tests in the metal division of a large Eastern rubber factory, hot air is blown through the cylinders to remove all trace of moisture. The cylinders are then sealed and stacked for painting
Ilargi: I’ll leave the financial commentary for a day, and gladly make way for an article I asked Stoneleigh to write on her view of the future of the electrical grid in connection with alternative energy forms. They are, after all, her meal ticket.
Stoneleigh: Since it is the major world conundrum with the shortest timescale, I usually focus on finance here, but alternative energy sources and power systems are my day job. Ilargi suggested that, in response to a question about the potential for renewable energy and electric vehicles (EVs), I write an article on the future of power systems.
With people hanging so many of their hopes on an electric future, it seems timely to inject a dose of reality. This is meant as a cursory overview of some of the difficulties we are facing with regard to electrical power in the future. The extraordinary technical and organizational complexity of power systems is difficult to convey, and there is far more to it than I am attempting to address here.
First off: As we are entering a depression, within a few years hardly anyone will have the money to buy an EV. Second: the grid could not come close to handling the current transportation load even if EVs could become common. An economy based on EV transportation would have to be fueled by base-load nuclear that doesn't currently exist and would take decades to build, and no one builds anything in a depression.
What they do is mount a losing battle to maintain existing infrastructure and hope they don't lose too much before better times return. This depression will last long enough that the infrastructure degradation will be enormous, even without the impact of above ground events resulting from serious societal unrest. Attempts at recovery after deleveraging are going to hit a hard energy ceiling. Power systems are critical to the functioning of a modern economy, but are almost completely taken for granted. That will not be the case in a few short years.
Here in Ontario, Canada (pop.13 million), the provincial government has just passed the Green Energy Act, and renewable energy proponents are queuing up to sign 20-year feed-in tariff contracts for power generation at a premium rate per kWh (varying by technology and reaching a maximum of 80 cents/kWh for small-scale roof-top solar).
The general assumption is that we are well on our way to building a future of renewable energy powered smart grids that will be able to accommodate not only our current demand, but much of our transportation load as well, thanks to EVs.
Unfortunately, much of this techno-positivist vision is nothing but pie-in-the-sky, thanks to the limitations of the electrical grid, as well as the low EROEI of renewable energy, the effect of receding horizons on the prospects for scaling up renewable energy development and the impending deflationary collapse of the money supply.
Investment in grid infrastructure, as with public infrastructure of most other kinds, has been sadly neglected for a long time. Much of the existing grid equipment is at or near the end of its design life, as are many of the power plants we depend on. (For instance, in Ontario we haven't got around to paying for the last set of nuclear power plants we built, that are now approaching the end of design life and have had to be very expensively re-tubed in recent years.
The outstanding debt is some $40 billion, and the debt retirement charge we pay doesn't even cover the interest.) Liberalization in the electricity sector has led to a relentless whittling away of safety margins in many places. Where we once had a system with a great deal of resilience through redundancy, that is generally no longer the case. In North America we now have an aging system with a very limited capacity for accommodating either new generation or new load, and we have great difficulty building any new lines.
As the power system was designed under a central station model to carry power in one direction only, with high voltage transmission and low voltage distribution, the modifications that would be required to enable two-way traffic, especially at the distribution level, are very substantial. Comprehensive monitoring and two-way communication would be required down to the distribution level, with central control (dispatchability, or at least the power to disconnect) of large numbers of very small generators.
The level of complexity would be vastly higher than the existing system, where there are relatively few generators to control in order to balance supply and demand in real time, and maintain system parameters such a frequency and voltage within acceptable limits.
The image above conveys by analogy the essence of power system frequency control - the easiest parameter to visualize. Frequency must be maintained at a set level by balancing supply and demand over the entire AC system. There are 4 such systems in North America - the east, the west, Texas and Quebec - and each functions as a single giant machine. The trucks in the image are generators and the boulder they tow up the uneven hill represents variable load. The trucks must pull the boulder at an even speed despite the bumps.
For a more accurate representation, one would actually need additional trucks, some moving at the same speed waiting to pick up a line if one should be dropped (spinning reserve) and others parked by the side of the hill (standing reserve). Some of the trucks would have to be able to start the boulder moving again from a standing start if it should stop for any reason (black-start).
We are looking at a world where there would be many more trucks, but each would be much smaller, and some of them would only pull if the wind was blowing or the sun was shining. The difficulty of the task will increase exponentially, and frequency management is only one parameter that must be controlled.
The mismatch between renewable resource potential, load and grid capacity is considerable. Resource potential is often found in areas far from load, where the grid capacity is extremely limited. Developing this potential and attempting to transmit the resulting power with existing infrastructure to where it can be used would involve very high losses. Many rural areas are served by low voltage single phase lines, and the maximum generation size that can be connected under those circumstances is approximately 100kW.
Even where three-phase lines exist, so that larger generators can be connected, carrying the power at low voltage is particularly inefficient, as low voltage means high current, and losses are proportional to the square of the current. Building high-voltage transmission lines to serve relatively small amounts of renewable energy would be an exceptionally expensive and difficult proposition, especially in a capital constrained future.
Renewable energy generation far from load could amount to little more than a money generating scheme, as a premium rate will be paid from the public purse for the time being, but little of the power might reach anywhere it could actually be used.
Difficulties occur when generation proposed would amount to more than 50% of the minimum load on the feeder. At this threshold, special anti-islanding measures are required that add considerable cost to the grid connection. In North America, we have large geographical areas served by a network of long stringy feeders with very low load. Adding much of anything to this system will be very challenging.
In much of Europe, where renewable energy penetration is relatively high, the population density is high enough to be served by a three-phase grid composed of relatively short feeders with high loads. Many of the limitations faced by North America simply do not apply in places like Germany, Denmark or the Netherlands. The North American grid has more in common with rural Portugal or the Greek Islands.
In this province alone, the amount of grid construction required in order to connect our renewable potential with load would cost tens, if not hundreds, of billions of dollars, and it would take decades to build. The cost of building, installing and connecting the necessary power generation equipment would also be enormous, and we would have to maintain at least some of the large plants needed for power system control and ancillary services (rapid load-following adjustments for frequency management, spinning reserve, rapid-response standing reserve, black-start capability, provision of reactive power etc).
This will be difficult as many large plants are due for replacement, large power plants take many years to complete, conventional fuels are depleting and capital will be very limited. While demand destruction will build in a temporary supply cushion, the lack of maintenance and new construction, which will inevitably follow a lack of funds, will take a huge toll in relatively few years.
Far from a future of greater high-tech connectedness under a smart-grid model, where EVs would charge at night and cover both transportation needs and power storage, we are looking at a much more fragmented picture. We are very unlikely to see massive AC grids covering anything like the area they do now, and much less likely to see power carried over large distances.
Rural areas may well be cut off and will have to provide any power they need themselves (yet another example of the core preserving itself at the expense of the periphery). This will mean a drastic cut in demand to a third world level in many rural areas, and may lead to other areas with no power production, and no money to build any, being abandoned completely or reverting to a pioneer lifestyle.
In urban areas, where dispossessed rural people migrate in very hard times, electricity provision in places down on their luck could look more like this picture of a favela in Rio de Janeiro. It's a far cry from a neat and tidy high-tech vision of efficiency.
Ilargi: Barry Ritholtz ran this graph today. It's not so much an update as it is a prediction, I would say. I suggest you look closely at where the known ends and the prediction begins. Prices fell 33% so far, the graph predicts about 10% more. Then there is a point where the line stops falling (in 2010-2011). What will cause prices to stop dropping?
Updated: Case-Shiller 100-Year Chart
Yesterday, we discussed why the Case Shiller Index, which fell 18%, was not yet cause for celebration. Regular TBP reader Steve Barry created this chart last year which projected forward the ongoing losses for Case Shiller; We first ran this back in December, and it ran all over the internet (mostly without attribution). Well, its time to update this. Here is Steve’s most recent version:
Ilargi: Calculated Risk ran this great graph, in reaction to the New York Times piece right below. The two blue lines come from a January report (PDF) by White House economist Elizabeth Romer and Jared Feldstein. The red line depicts reality.
Note: the White House, including Romer, have acknowledged the line will break 10% this summer. It is presently at 9.4%, with June numbers expected to take it to 9.6%-9.7%. Was it really all that hard to foresee 6 months ago? Or is Romer perhaps the wrong party at the wrong table? The problem with this sort of prediction, which is off by a mile and a half, is that it leads to the wrong focus, the wrong sort of spending and overall faulty policies.
Unemployment Forecast With Too Much "Hope"
Ilargi: Looks like I may have been on to something this weekend: more New York Times criticism of the Obama administration.
A Forecast With Hope Built In
In the weeks just before President Obama took office, his economic advisers made a mistake. They got a little carried away with hope. To make the case for a big stimulus package, they released their economic forecast for the next few years. Without the stimulus, they saw the unemployment rate — then 7.2 percent — rising above 8 percent in 2009 and peaking at 9 percent next year. With the stimulus, the advisers said, unemployment would probably peak at 8 percent late this year.
We now know that this forecast was terribly optimistic. The jobless rate has already reached 9.4 percent. On Thursday, the Labor Department will announce the latest number, for June, and forecasters are expecting it to rise further. In concrete terms, the difference between the situation that the Obama advisers predicted and the one that has come to pass is about 2.5 million jobs. It’s as if every worker in the city of Los Angeles received an unexpected layoff notice.
There are two possible explanations that the administration was so wrong. And sorting through them matters a great deal, because they point in opposite policy directions. The first explanation is that the economy has deteriorated because the stimulus package failed. Some critics say that stimulus just doesn’t work, while others argue that this particular package was too small or too badly constructed to make a difference.
The second answer is that the economy has deteriorated in spite of the stimulus. In other words, the patient is not as sick as he would have been without the medicine he received. But he is a lot sicker than doctors realized when they prescribed it. To me, the evidence is fairly compelling that the second answer is the right one. The stimulus package does seem to have helped. But its impact has been minor — so far — compared with the harshness of the Great Recession.
Unfortunately, the administration’s rose-colored forecast has muddied this picture. So if at some point this year or next the White House decides that the economy needs more stimulus, skeptics will surely brandish that old forecast. Worst of all, the economy really may need more help.
There is no ironclad way to judge the stimulus, because we can’t rerun the last six months in an alternate universe. But you can get a pretty good sense by looking at the size of the gap between where the economy is today and where the administration thought it would be: those 2.5 million jobs that would still exist if the forecast had been right. This gap is just far too large to be explained by the stimulus.
The plan that Mr. Obama signed definitely has its flaws. It spends money more slowly than is ideal and spends some of it on projects of little long-term value. But no stimulus package could have come close to preventing 2.5 million job losses over six months. For starters, a stimulus package doesn’t affect the job market immediately because most employers don’t hire or fire workers as soon as they sense their business shifting. That’s why economists refer to employment as a lagging indicator.
When private economists began analyzing various stimulus proposals in January, they said that none would have a major effect on the jobless rate until the end of the year. By June, the effect would be only a few tenths of a percentage point, which translates into several hundred thousand jobs. The stimulus that passed may in fact be having an impact of roughly this scale. Consumer spending, after plummeting late last year, is up slightly this year, despite a continuing rise in the savings rate. This combination suggests that spending would still be falling if not for the tax cuts in the stimulus.
"Early results," says Mark Zandi, chief economist of Moody’s Economy.com, "suggest the stimulus is performing close to expectations." Obviously, though, the economy is not performing close to expectations. It’s not fair to expect Mr. Obama’s economists to be clairvoyant. But they did make one avoidable mistake that led directly to their overoptimism. They relied on the same forecasting models that had completely failed to see the crisis coming.
These models, which are also used by Wall Street and various research firms, do a decent job most of the time. But they are notoriously bad at forecasting turning points because they are based on an assumption that the recent past will more or less repeat itself. Clearly, recent economic history is not going to repeat itself. It included two huge asset bubbles, first in stocks and then in real estate. The models came to treat those bubbles — and the additional consumer spending they caused — as the new normal. When asset prices began falling, the models couldn’t keep up, with either the pace of declines or the economic damage they were causing.
"All sorts of relationships got completely out of whack, and models couldn’t cope with that," says Joshua Shapiro, an economist at MFR, a research firm. MFR did not take the models too literally and was one of the few firms to have been appropriately pessimistic. The Obama administration believed the models. And what do these models say today? They are forecasting that the recession will end in the next few months. Administration officials aren’t quite so specific, but they are in a similar place.
Christina Romer, a senior Obama economist, argues that businesses that have spent the last few months drawing down their warehouse inventories will eventually need to rebuild them. Lawrence Summers, the top economics adviser, says that many consumers who have been delaying the purchase of a new car will eventually take the plunge. The government, meanwhile, will be pumping out close to $30 billion in stimulus money every month for months to come. A big headline across the front page of Monday’s Financial Times summed up the position: "Romer upbeat on economy."
It’s an entirely reasonable prediction. Yet it’s hard not to look back on the last six months and worry that the administration is still underestimating the severity of the situation.
Many consumers may not rush back to their old buying habits. Mr. Shapiro points out that household debt, relative to assets, remains far higher than historically normal. "It’s going to be a very long slog," he predicts. That would certainly be consistent with the aftermath of other financial crises.
The larger point is that, even if the optimists are right this time, the economy isn’t going to feel remotely healthy anytime soon. Since jobs (and incomes) are a lagging indicator, the unemployment rate will probably surpass 10 percent this year and remain above 9 percent well into next year. Long after the experts say the economy has turned, it is going to feel pretty bad. Another stimulus package may soften the blow, but it can’t prevent most of the pain. The problems are too big. So it would make sense for everyone — the administration and the rest of us — to have a sober view of what might lie ahead.
Wage Deflation in Our Midst
by David Rosenberg
A survey conducted by YouGov for the Economist magazine found that 5% of respondents had taken a furlough this year and 15% had accepted a pay cut (see The Recession and Pay: The Quiet Americans on page 33 of this week’s edition).
As wages deflate, workers are looking for ways to supplement their shrinking income base, for example, by moonlighting. Indeed, a poll undertaken by CareerBuilder.com and cited in the USA Today found that one in every ten Americans took on an extra job over the last year; another one in five said they intend to do so in the coming year. These numbers are double for the 45 to 54 year olds who now see early retirement, once around the corner, as an elusive concept.
Most pundits who crow about green shoots and about an inventory restocking in the third quarter giving way towards some sustainable economic expansion live in the old paradigm. They don’t realize, for whatever reason, that the deflationary aftershocks that follow a post-bubble credit collapse typically last for 5 to 10 years. Businesses understand better than the typical Wall Street or Bay Street economist and strategist that everything from order books, to output, to staffing have to now be restructured to adequately reflect a permanently lower level of leverage in the economy.
Indeed, by our estimates, there is up to another $5 trillion of household debt that has to be eliminated in coming years and that process is going to require that consumers go on a semi-permanent spending diet. Companies see this, which is why they are not just downsizing their payroll, but have also cut the workweek to a record low of 33.1 hours. Fewer people are working and those that are still working have seen their hours dramatically cut this cycle.
Companies are finding other ways to save on the aggregate labour cost bill as well, which may be a factor reinforcing the uptrend in the personal savings rate (see more below). For example, a rapidly growing number of employers are now suspending contributions to worker 401(k) plans. According to a joint survey by CFO Research Services and Charles Schwab, nearly 25% of U.S. companies have either suspended their plans or are planning to do so (this is up from 2% at the turn of the year). Again, how we end up squeezing inflation out of the system when the labour market is clearly deflating wages and benefits for the 70% of the economy called the consumer is going to be interesting to watch.
The op-ed column by Bob Herbert in the Saturday New York Times really hit the nail on the head on this whole ‘green shoot’ issue — how can there be ‘green shoots’ when the labour market is deteriorating at such a rapid clip fully nine months after the Lehman collapse. The full brunt of the credit collapse may be behind us, but please, the other two shocks, namely deflating labour markets and deflating home prices, are very much still front and centre. For every job opening in the USA, there are more than five unemployed actively seeking work vying for those jobs. That is unprecedented and nearly double what we saw at the depths of the 2001 recession. The official ranks of the unemployed have doubled during this recession to 14 million and if you take into account all forms of labour market slack, the unofficial number is bordering on 30 million, another record. For those who still believe that we somehow managed to avoid an economic depression this cycle because of a 13% fiscal deficit/GDP and a pregnant Fed balance sheet, the Center for Labour Market Studies at Northeastern University estimates that the real unemployment now stands at 18.2%, which is actually higher than the posted rate at the end of the 1930s.
WAGE DEFLATION IS A REALITY … FAR MORE IMPORTANT THAN THE CRB
AGAIN, HOW WE SQUEEZE INFLATION OUT OF THIS LEMON OF A LABOUR MARKET IS A VALID QUESTION.
When the recovery does come, the record number of people that have been pushed into part-time work are going to see their hours go back up, which will be good for them, but not so good for the 100,000 - 150,000 folks that will be entering the labour force looking for work with futility. The unemployment rate is probably going to rise through 2010, which is going to pose a challenge for incumbents seeking re-election in the mid-term voting season. It may also prove to be a challenge for Ben Bernanke’s re-appointment chances this coming February.
As we said above, companies have permanently reduced the size of their operations with the knowledge of how much credit is going to be available to them in the future to survive because the financial sector is going to be operating under more supervision and regulation and leverage ratios, which means the funds available to support a given level of GDP is going to be measurably smaller than what we had become accustomed to during the secular credit expansion, which really began in the mid-1980s, only to turn parabolic during the ‘ownership society’ era of 2002 to 2007.
What makes this cycle "different" is that three-quarters of the workers that were fired over the last year were let go on a permanent, not a temporary basis. A record 53% of the unemployed today are workers who were displaced permanently — not just temporarily because of the vagaries of the traditional business cycle. This means that these jobs are not going to be coming back that quickly, if at all, when the economy does in fact begin to make the transition to the next expansion phase. In turn, this implies that any expansion phase is going to be extremely fragile and susceptible to periodic setbacks. There may well be job growth in the future in health care, infrastructure, energy technology and the like, but we can say with a reasonable amount of certainty that there are a whole lot of jobs in a whole lot sectors where jobs lost this recession are not going to come back. For example, the 580k jobs lost in financial services; the 320k jobs lost in residential construction; the 1.7 million jobs lost in durable goods manufacturing; the 1.1 million jobs lost in the wholesale/retail sector; and the 380k jobs that were lost in the leisure/hospitality industry. That is over four million jobs that were shed this cycle that are not likely to stage a comeback even after the recession is over. To show you how big a number four million is, we didn’t create that many jobs in the prior expansion until it reached its fourth birthday towards the tail end of 2005.
PERMANENT JOB LOSERS SURGE TO RECORD OF NEARLY 8 MILLION
PERMANENT JOB LOSERS SURGE BY 4.5 MILLION IN THE PAST YEAR
OVER HALF OF THE UNEMPLOYED NOW LONG-TERM
THE TRUEST PICTURE OF EXCESS LABOUR SUPPLY
As Bob Herbert points out in his article in the Saturday NYT, the unemployment rate for males has already soared to 10.5% whereas the rate for females is at 8.0% in the largest gender gap in favor of women since World War II. Has anyone worked through the sociological repercussions from this divergence on divorce rates, birth rates, even crime rates?
Moreover, since employers are favouring experience over youth, and because the savings-constrained folks over the age of 55 are getting whatever jobs there are out there, a massive pool of joblessness has been created this cycle among the younger-age cohorts where the unemployment rate for 20-24 year olds has surged to 15.0% (and 23.0% for 16-19 year olds). This, too, will have social implications going forward. As Lawrence Mishel, president of the Economic Policy Institute was quoted as saying in the Bob Herbert column, "I believe this is going to leave a permanent scar on a generation of kids". Work habits and experience are honed when people are in their 20’s and this is the generation that is being most affected by the shrinking demand for labour — and this is going to lead down the road to a slower trend in structural productivity growth.
Quite frankly, we cannot imagine a more difficult environment for the stock market — the impact on both corporate earnings and fair-value estimates for the P/E multiple — than a backdrop that includes a permanently lower level of potential GDP growth alongside a record output gap. What that means is much lower volume growth and much lower pricing power over the next five to 10 years. This means that bear market rallies will come, as we have already seen repeatedly in the last two years with an obvious exclamation mark on the one posted from March 9 to May 4 … and they will go.
It is amazing how many pundits and media types believe we are in a new bull phase and yet the equity market has completely sputtered now for nearly three months above the 900 level on the S&P 500 and 8,400 on the Dow — not to mention the fact that instead of seriously breaking out above the 200-day moving average, the broad market has been struggling at this resistance level for the last few weeks, which is a sign that buying fatigue has likely set in (together with meager trading volumes).
It may well be true that the University of Michigan Consumer Sentiment index improved in June to 70.8 from 68.7 in May, but not every confidence measure showed ebullience last month. The Rasmussen index averaged 73.1, down from 74.1 in May, and the ABC News/Washington Post consumer comfort poll is sitting at -53 compared with -49 at the end of May and is a mere two points shy of hitting a new all-time low. Interestingly, the ‘personal finances’ subindex at -22 did hit a new record low and is worse now than it was back in mid-March when the equity market was cratering (was -4 at that time).
Debt Deflation in America
by Michael Hudson
Happy-face media reporting of economic news is providing the usual upbeat spin on Friday’s debt-deflation statistics. The Commerce Department’s National Income and Product Accounts (NIPA) for May show that U.S. "savings" are now absorbing 6.9 percent of income. I put the word "savings" in quotation marks because this 6.9% is not what most people think of as savings.
It is not money in the bank to draw out on the "rainy day" when one is laid off as unemployment rates rise. The statistic means that 6.9% of national income is being earmarked to pay down debt – the highest saving rate in 15 years, up from actually negative rates (living on borrowed credit) just a few years ago. The only way in which these savings are "money in the bank" is that they are being paid by consumers to their banks and credit card companies.
Income paid to reduce debt is not available for spending on goods and services. It therefore shrinks the economy, aggravating the depression. So why is the jump in "saving" good news? It certainly is a good idea for consumers to get out of debt. But the media are treating this diversion of income as if it were a sign of confidence that the recession may be ending and Mr. Obama’s "stimulus" plan working.
The Wall Street Journal reported that Social Security recipients of one-time government payments "seem unwilling to spend right away," 1 while The New York Times wrote that "many people were putting that money away instead of spending it."2 It is as if people can afford to save more. The reality is that most consumers have little real choice but to pay. Unable to borrow more as banks cut back credit lines, their "choice" is either to pay their mortgage and credit card bill each month, or lose their homes and see their credit ratings slashed, pushing up penalty interest rates near 20%!
To avoid this fate, families are shifting to cheaper (and less nutritious) foods, eating out less (or at fast food restaurants), and cutting back vacation spending. It therefore seems contradictory to applaud these "saving" (that is, debt-repayment) statistics as an indication that the economy may emerge from depression in the next few months. While unemployment approaches the 10% rate and new layoffs are being announced every week, isn’t the Obama administration taking a big risk in telling voters that its stimulus plan is working? What will people think this winter when markets continue to shrink? How thick is Mr. Obama’s Teflon?
As recently as two years ago consumers were buying so many goods on credit that the domestic savings rate was zero. (Financing the U.S. Government’s budget deficit with foreign central bank recycling of the dollar’s balance-of-payments deficit actually produced a negative 2% savings rate.) During these Bubble Years savings by the wealthiest 10% of the population found their counterpart in the debt that the bottom 90% were running up. In effect, the wealthy were lending their surplus revenue to an increasingly indebted economy at large.
Today, homeowners no longer can re-finance their mortgages and compensate for their wage squeeze by borrowing against rising prices for their homes. Payback time has arrived – paying back bank loans, whose volume has been augmented to include accrued interest charges and penalties. New bank lending has hit a wall as banks are limiting their activity to raking in amortization and interest on existing mortgages, credit cards and personal loans.
Many families are able to remain financially afloat by running down their savings and cutting back their spending to try and avoid bankruptcy. This diversion of income to pay creditors explains why retail sales figures, auto sales and other commercial statistics are plunging vertically downward in almost a straight line, while unemployment rates soar toward the 10% level. The ability of most people to spend at past rates has hit a wall.
The same income cannot be used for two purposes. It cannot be used to pay down debt and also for spending on goods and services. Something must give. So more stores and shopping malls are becoming vacant each month. And unlike homeowners, absentee property investors have little compunction about walking away from negative equity situations – owing creditors more than the property is worth.
Over two-thirds of the U.S. population are homeowners, and real estate economists estimate that about a quarter of U.S. homes are now in a state of negative equity as market prices plunges below the mortgages attached to them. This is the condition in which Citigroup and AIG found themselves last year, along with many other Wall Street institutions.
But whereas the government absorbed their losses "to get the economy moving again" (or at least to help Congress’s major campaign contributors to recover), personal debtors are in no such favored position. Their designated role is to help make the banks whole by paying off the debts they have been running up in an attempt to maintain living standards that their take-home pay no longer is supporting.
Banks for their part are slashing credit-card debt limits and jacking up interest and penalty charges. (I see little chance that Congress will approve the Consumer Financial Products Agency that Mr. Obama promoted as a flashy balloon for his recent bank giveaway program. The agency is to be dreamed about, not enacted.) The problem is that default rates are rising rapidly.
This has prompted many banks to strike deals with their most overstretched customers to settle outstanding balances for as little as half the face amount (much of which is accrued interest and penalties, to be sure). Banks are now competing not to gain customers but to shed them. The plan is to offer steep enough payment discounts to prompt bad risks to settle by sticking rival banks with ultimate default when they finally give up their struggle to maintain solvency. (The idea is that strapped debtors will max out on one bank’s card to pay off another bank at half-price.)
The trillions of dollars that the Bush and Obama administration have given away to Wall Street would have been enough to buy a great bulk of the mortgages now in default – mortgages beyond the ability of many debtors to pay in the first place. The government could have enacted a Clean Slate for these debtors – financed by re-introducing progressive taxation, restoring the full capital gains tax to the same rate as that levied on earned income (wages and profits), and closing the tax loopholes that effectively free finance, insurance and real estate (FIRE) sector from income taxation.
Instead, the government has made Wall Street virtually tax exempt, and swapped Treasury bonds for trillions of dollars of junk mortgages and bad debts. The "real" economy’s growth prospects are being sacrificed in an attempt to carry its financial overhead. Banks and credit-card companies are girding for economic shrinkage. It was in anticipation of this state of affairs, after all, that they pushed so hard from 1998 onward to make what finally became the 2005 bankruptcy laws so pro-creditor, so cruel to debtors by making personal bankruptcy an economic and legal hell.
It is to avoid this hell that families are cutting their spending so as to keep current on their debts, against all odds that they can avoid default in today’s shrinking economy. Working off debt = "saving," but not in liquid form. People are putting more money away, but not into savings accounts. They are indeed putting it into banks, but in the form of paying down debt. To accountants looking at balance sheets, savings represent the increase in net worth. In times past this was indeed the result mainly of a buildup of liquid funds. But today’s money being saved is not available for spending.
It merely reduces the debt burden being carried by individuals. Unlike Citibank, AIG and other Wall Street institutions, they are not having their debts conveniently wiped off the books. The government is not nice enough to buy back their investments that had lost up to half their value in the past year. Such bailouts are for creditors and money managers, not their debtors. The story that the media should be telling is how today’s post-bubble economy has turned the concept of saving on its head. The accounting concept underlying balance sheets is that a negation of a negation is positive. Paying down debt liabilities is counted as "saving" because one owes less.
This is not what people expected a half-century ago. Economists wrote about how technology would raise productivity levels, people would be living in near utopian conditions by the time the year 2000 arrived. They expected a life of leisure and prosperity. Needless to say, this is far from materializing. The textbooks need to be rewritten – and in fact, are being rewritten.
Most individuals and companies emerged from World War II in 1945 nearly debt-free, and with progressive income taxes. Economists anticipated – indeed, even feared – that rising incomes would lead to higher saving rates. The most influential view was that of John Maynard Keynes. Addressing the problems of the Great Depression in 1936, his General Theory of Employment, Interest, and Money warned that people would save relatively more as their incomes rose. Spending on consumer goods would tail off, slowing the growth of markets, and hence new investment and employment.
This view of the saving function – the propensity to save out of wages and profits –viewed saving as breaking the circular flow of payments between producers and consumers. The main cloud on the horizon, Keynesians worried, was that people would be so prosperous that they would not spend their money. The indicated policy to deter under-consumption was for economies to indulge in more leisure and more equitable income distribution.
The modern dynamics of saving – and the increasingly top-heavy indebtedness in which savings are invested – are quite different from (and worse than) what Keynes explained. Most financial savings are lent out, not plowed into tangible capital formation and industry. Most new investment in tangible capital goods and buildings comes from retained business earnings, not from savings that pass through financial intermediaries. Under these conditions, higher personal saving rates are reflected in higher indebtedness. That is why the saving rate has fallen to a zero or "wash" level. A rising proportion of savings find their counterpart more in other peoples’ debts rather than being used to finance new direct investment.
Each business recovery since World War II has started with a higher debt ratio. Saving is indeed interfering with consumption, but it is not the result of rising incomes and prosperity. A rising savings rate merely reflects the degree to which the economy is working off its debt overhead. It is "saving" in the form of debt repayment in a shrinking economy. The result is financial dystopia, not the technological utopia that seemed so attainable back in 1945, just sixty-five years ago. Instead of a consumer-friendly leisure economy, we have debt peonage.
To get an idea of how oppressive the debt burden really is, I should note that the 6.9% savings rate does not even reflect the 16% of the economy that the NIPA report for interest payments to carry this debt, or the penalty fees that now yield as much as interest yields to credit-card companies – or the trillions of dollars of government bailouts to try and keep this unsustainable system afloat. How an economy can hope to compete in global markets as an industrial producer with so high a financial overhead factored into the cost of living and doing business must remain for a future article to address.
Bill Gross: Greed will come again, but fear to rule for at least a generation
Bill Gross, the influential investor who runs top bond fund Pimco, said on Wednesday that greed will eventually become the norm again for consumers and investors, but fear continues to rule for now -- a mindset that will result in subdued U.S. economic growth for some time. "Greed will come again. But for now, the trend is the other way and it promises to persist for a generation at a minimum," said Gross, the co-chief investment officer of Pacific Investment Management Co.
The evaporation of at least $15 trillion in wealth suffered by American consumers since early 2007 and a U.S. unemployment rate now approaching 10 percent will have an impact on consumption patterns, Gross said in his monthly newsletter to clients, posted on www.pimco.com. "When potential spenders feel less rich by that much, the only model one can use to forecast the future is a commonsensical one" that assumes higher savings and lower consumption.
Under this scenario, Gross, who manages the Pimco Total Return Fund, which has $159 billion in assets, sees a "new normal" for U.S. economic growth rate closer to 2 percent as opposed to the recent average of 3.5 percent. "There's no magic in that number, and no model to back it up, just a lot of common sense that says this is how people and economic societies behave when stressed and stretched to a near breaking point," he said.
But Gross, whose letters to investors are as famous for their quirky asides and analogies as for their economic and market analysis, said greed isn't just good for the economy but also essential. He divined upon John Maynard Keynes' famous observation during the Depression -- that much of individual economic behavior is due to "animal spirits" rather than long-term rational calculations so beloved by economic theorists.
Keynes defined animal spirits as "a spontaneous urge to action rather than inaction" and a "spontaneous optimism" and argued that long-term rational calculation could not account for such economic decisions as opening a small business or innovating new software. In an email response to Reuters expanding on his thoughts on "animal spirits," Gross said: "But when irrationally exuberant, they can be destructive as opposed to constructive."
In his July newsletter, Gross addressed the destructive events that led to the global financial crisis. "The supersizing of financial leverage and consumer spending in concert with the politicizing of deregulation describes in 15 words our most recent brush with irrational behavior and inefficient markets," he said. Against the current climate of caution ruling consumers, Gross said the Federal Reserve's short-term policy rates will be kept low for longer than cyclical norms. He said he sees the outlook for stocks, high-yield "junk" bonds, and commercial and residential real estate as still involving risk.
Investors should favor secure income offered by bonds and stable dividend-paying equities, said Gross, who has said he sees tremendous value in high-quality municipal bonds. Wednesday, in fact, Pimco launched the Pimco MuniGO Fund, the firm's first mutual fund to offer a portfolio of intermediate maturity general obligation bonds from top-rated municipal issuers, as well as pre-refunded municipal bonds backed by U.S. Treasury and Agency securities. Pimco oversees roughly $800 billion.
Ilargi: The Wall Street recipients of $14 trillion in public largesse are doing just fine, thank you. The public itself? Not so much.
Corporate Bonds Show Lehman Doesn’t Matter With 9.2% Return
Nowhere is the recovery in financial markets more evident than in corporate bonds, where Lehman Brothers Holdings Inc.’s bankruptcy is becoming a distant memory. U.S. investment-grade company debt returned 9.2 percent in the first half of the year, outperforming Treasuries by 13.7 percentage points, the most on record, according to Merrill Lynch & Co. index data. Corporate bonds also did better than the Standard & Poor’s 500 Index of stocks, marking the first time since 2002 that the fixed-income securities outshined both Treasuries and equities.
The gains may be the clearest indication that the more than $12.8 trillion pledged by the government and Federal Reserve to thaw frozen credit markets is starting to pull the economy out of the worst recession since the 1930s. Frankfurt-based Deutsche Bank AG boosted its forecast yesterday for global economic growth next year to 2.5 percent from 2 percent. “The only way to justify the kind of valuations six months ago is if we were in the process of creating the next Great Depression,” said Joseph Balestrino, a money manager at Pittsburgh-based Federated Investors Inc., which oversees $409 billion of assets.
Yields on investment-grade company securities fell to within 3.31 percentage points of Treasuries yesterday, the least since Sept. 10, according to Merrill’s U.S. Corporate Master Index. Spreads widened to a record 6.56 percentage points on Dec. 5, and the securities lost 6.8 percent in 2008, the worst year on record, as the shock to financial markets from Lehman’s collapse Sept. 15 froze credit markets and sparked a run on Treasuries that caused bill rates to fall below zero.
The rally shows fears that Lehman’s failure would create a domino effect that brought down the financial system were “overblown,” said Arthur Tetyevsky, chief fixed-income strategist at CF Global Trading LLC, a New York-based firm that trades securities for institutional investors, primarily U.S. and European hedge funds. “Spreads on corporate debt were so out of whack coming into the year, implying default rates that indicated more than 20 percent of all speculative-grade companies would go bankrupt,” said Kevin Sherlock, co-head of loan and high-yield capital markets at Deutsche Bank in New York. “The risk appetite is far more aggressive now than it was three months ago. It’s about where we were last summer at pre-Lehman levels.”
The biggest returns came in the riskiest securities. High- yield, high-risk bonds gained 29 percent, or 34 percentage points more than Treasuries, Merrill Lynch indexes show. The performance is the best since a market for the securities was created in the 1980s by Michael Milken, according to Merrill Lynch’s U.S. High-Yield Master II index. Junk bonds are rated below BBB- at S&P and less than Baa3 by Moody’s Investors Service. Bond bulls are encouraged by signs the economy may be recovering. Consumer spending rose in May as benefits from the Obama administration’s stimulus plan spurred a jump in American incomes.
The 0.3 percent increase in purchases was the first gain in three months, the Commerce Department said June 26. Incomes climbed 1.4 percent, the most in a year, driving the savings rate to a 15-year high. Another report showed consumer sentiment rose in June to the highest level since February 2008. “The pace of economic contraction is slowing” and “conditions in financial markets have generally improved,” the Fed’s Open Market Committee said in a June 24 statement after a two-day meeting in Washington, where it kept the target interest rate for loans between banks between zero and 0.25 percent.
With little need for the safety of government debt, Treasuries lost 4.5 percent in the first half as some of the biggest yields on corporate bonds in at least a dozen years lured investors. The S&P 500 Index gained 3.2 percent, including dividends. While credit spreads are narrowing, defaults continue to rise. The U.S. speculative-grade default rate jumped to 8.1 percent in May, the highest since October 2002, and may reach 14.3 percent by the first quarter of 2010, according to S&P.
“The easy money has been made,” said Richard Lee, a managing director in the fixed-income trading department of closely held broker-dealer Wall Street Access in New York. “You could have bought any corporate credit in January and February and made out like a bandit.”
Other measures of credit also show improvement. The difference between what banks and the U.S. government pay to borrow for three months, the TED spread, has shrunk to 41 basis points, the lowest since July 2007 and down from 464 basis points in October. A basis point is 0.01 percentage point. The Libor-OIS spread, an indicator for banks’ willingness to lend, ended yesterday at 0.38 percentage point. That’s approaching the 0.25 percentage point that former Fed Chairman Alan Greenspan has said would indicate that markets were back to “normal.”
The increased demand has helped companies raise a record amount of money selling debt. Sales of corporate bonds surged 24 percent to $734.6 billion in the first half, compared with the same period of 2008, according to data compiled by Bloomberg. New York-based Pfizer Inc., the world’s largest drugmaker, raised $13.5 billion on March 17 in the biggest bond sale by a U.S. company as part of its fundraising to buy rival Wyeth, Bloomberg data show. Redmond, Washington-based software maker Microsoft Corp. sold $3.75 billion of debt on May 11 in its debut offering.
The commercial paper market has slumped the most ever as borrowers let the short-term debt mature or replace it with bonds. Unsecured commercial paper outstanding plunged 31 percent to $1.15 trillion, the lowest level since September 1998, according to Fed data. “I have been buying credit the whole year,” said Gregory Nassour, who helps oversee $36 billion as head of investment- grade portfolio management at Vanguard Group in Valley Forge, Pennsylvania. “The excess returns are gigantic.”
Britain has sunk itself deep into a fiscal black hole
This year, Britain is likely to incur a fiscal deficit of more than 12 per cent of national income. This figure is completely outside the normal experience of developed countries in peacetime. How did it happen and what are its implications? The normal rule of prudent public finance is to allow for substantial cyclical variation. Recessions cut tax receipts and lead to additional expenditure, especially on benefits. Moderate surpluses in good times turn into moderate deficits in bad times, so things balance out overall. The British government, ostensibly committed to this principle, has obfuscated to abuse it so that Britain entered the recession with a large underlying deficit.
The downturn turned a substantial gap in public finances into a chasm. This situation was aggravated by the speed and scale of the recession and the realisation that many of the earnings from financial services, which had previously boosted tax receipts, had been illusory. The contribution of financial services to public finances has been not only removed but reversed. Even if there were a rapid economic recovery, there would still be a large deficit. At least half of the current deficit will need to be eliminated by cuts in public expenditure and increases in tax rates. These will have to be very substantial.
After all, 1 per cent of gross domestic product equates to 3 per cent of public expenditure, two points on the basic rate of income tax and three points on the standard rate of value added tax. At least six such "units" of deficit budgeting will be required over the next few years. And the background is not benign. There are always upward pressures on public spending, but there are several additional ones ahead. The costs of servicing public debt will rise, as amounts and rates increase. The government will, like the banks themselves, defer accounting for the costs of the bank bail-outs as long as possible. But the reality remains that every penny that subsidises the financial system is a penny diverted from schools and hospitals.
The costs of off-balance-sheet financing have also come home to roost, as they always do. The spending of local authorities and National Health Service trusts will be squeezed by commitments they have incurred under the private finance initiative. The impact on health and benefit costs of an ageing population will begin to make itself felt over the next decade. In practice, the only successful method of reducing public spending as a share of GDP has been to impose tight curbs while the economy is growing rapidly. We shall be lucky if such an opportunity appears. The reality is that the usual victims of pressure on discretionary expenditure – nurseries and universities, culture and sport – should brace themselves for hard times, and Britain’s crumbling public infrastructure will crumble further.
Inflation reduces the value of public and private debts and makes many adjustments easier. It is much easier to fail to keep wages and salaries in line with inflation than to reduce them outright. It would be a pity to throw away the gains from a successful struggle over two decades to squeeze inflation from western economies. But the governments of Britain and the US may separately and privately conclude that such a choice is less bad than the other options they face. Even so, both countries are going to have to reconcile themselves to substantially higher tax rates.
A tax package to raise £70bn ($115bn, €82bn), probably the minimum required to stabilise Britain’s public finances, might put four points on the rate of income tax, take VAT to 20 per cent, freeze personal allowances and tax thresholds, add five points to corporation tax and collect a bit of extra revenue from the usual suspects such as alcohol, petrol and cigarettes. I wouldn’t want to be the political front person for that package. Perhaps the Conservatives should give the finance portfolio back to Kenneth Clarke. In 1997 he lost the election no chancellor would want to lose. Whoever succeeds in 2010 will have won the election no chancellor would want to win.
UK recession on par with very worst year of Great Depression
The recession is now on a par with the very worst year of the Great Depression. The dire state the UK is in emerged on Tuesday as revised figures uncovered the full extent of the country's economic contraction. The economy shrank by 4.9pc in the year to the first quarter of 2009, the Office for National Statistics said. The fall in gross domestic product was significantly greater than had previously been calculated, as Government statisticians became aware of the full scale of the fall in company activity. "Clearly this is now the worst peacetime recession since the 1930s," said Michael Saunders, chief UK economist at Citigroup. "The worst contraction then was a year of around -5pc; this year will not be hugely different."
The contraction in GDP during the first quarter alone was 2.4pc, compared with previous estimates of 1.9pc, according to the ONS. This was the biggest one-quarter fall in 35 years. Moreover, the 4.9pc annual fall was the biggest since Government records began. According to statistics compiled by economic historian Angus Maddison, the contraction was the worst since 1931 – worse than any year during the Second World War and the demobilisation that followed. The revision was partly the result of a steeper fall in construction and services output than first thought. Economists had predicted a downward revision but not on that scale. The ONS also revealed that the recession started in the second quarter of 2008, a quarter earlier than previously thought.
Simon Hayes of Barclays Capital said that although the figures were historical, they had a direct bearing on future growth. He said: "It reinforces the message that the recent signs of 'green shoots' reflect a rebound from an extraordinarily sharp fall in activity earlier in the year. We continue to be cautious about seeing them as material news about the medium-term growth outlook, which is likely to be hamstrung by tight credit conditions and the need for fiscal consolidation." Liam Byrne, chief secretary to the Treasury, said it would not be revising its growth forecasts. "There have been some tentative signs that the fall in output is moderating and I remain confident but cautious about the prospects for the economy," he said.
George Osborne, the shadow Chancellor, said: "We hope the recovery comes as soon as possible but sadly we now know this recession has been longer and deeper than we had thought. This also means that in the future unemployment will be higher and Labour's debt crisis will be even worse." There was better news yesterday from Nationwide, which said that UK house prices rose for the third month out of the last four in June, by 0.9pc to an average of £156,442. House prices were 9.3pc lower than a year ago, marking the slowest rate of annual decline since July last year. In a further blow for the UK, newly released figures from the International Monetary Fund showed that international investors' enthusiasm for Britain has dimmed further, with a third consecutive decline in the proportion of sterling held by central banks and other institutions.
Just six families helped by UK Mortgage Rescue Scheme
Britain is facing a reposession timebomb, Vince Cable warned yesterday, as it emerged just six families have been helped by the Government's Mortgage Rescue Scheme. The scheme, which cost more than 280 million to put in place, was launched at the beginning of this year, with the Government saying it would reach its 6,000 target within two years. But increasing numbers of households are struggling to meet their monthly mortgage payments and face losing their homes amid the recession. Politicians described the figures as "absolutely pitiful", saying it didn't begin to address the true extent of the problem facing Britain's home owners.
Liberal Democrat Treasury spokesman Vince Cable said: "Repossession is a ticking time bomb. "The numbers of repossessions are likely to soar in the next two years because of rising unemployment. Temporary Government schemes are deferring the problem, not solving it." And he warned: "If interest rates start to rise next year, the problem will become even more severe." Almost 1,000 home owners are being evicted every week, according to the Council of Mortgage Lenders. Repossession numbers reached 12,800 in the first three months of this year, a rise of more than 50 per cent from 8,500 this time last year. Housing Minister John Healey said: "We have put in place help for home owners struggling with their mortgage at every step of the way."
But the problem is now so severe that the Government is establishing a new team to fast-track the cases of those most at risk of repossession. Under the Mortgage Rescue Scheme, eligible families can either get an equity loan to reduce their mortgage, or sell their home and remain as tenants. It is one of several Government measures to help struggling home owners, which include the Homeowners Mortgage Support Scheme, which allows home owners facing a loss of income to reduce their monthly mortgage payments for up to two years. By the end of May, 200 households had repossessions proceedings stopped while they were being assessed for the Mortgage Rescue Scheme.
U.S. Mortgage Applications Fall 19%, Defying Obama
U.S. mortgage applications fell last week by the most since February, defying efforts by President Barack Obama’s administration to revive the housing market. The Mortgage Bankers Association’s index of applications to purchase a home or refinance a loan dropped 19 percent to 444.8 in the week ended June 26 from 548.2 the prior week. The group’s refinancing gauge declined 30 percent to the lowest in seven months, while the index of purchases fell 4.5 percent.
Unemployment, which touched a 26-year high in May, and rising borrowing costs discouraged homeowners from refinancing, while a growing number of foreclosures sidelined potential buyers waiting for house prices to stop tumbling. Pending home sales showing contracts signed in May rose 0.1 percent, compared with a gain of 6.7 percent in April, the National Realtors Association said today.
"The run-up in mortgage rates is exacting a toll in terms of depressing mortgage applications," Brian Bethune, chief U.S. financial economist at IHS Global Insight in Lexington, Massachusetts, said in an interview. "The economy is in a phase of attempting to find a bottom. Anything that comes in the way of that, like higher rates, is going to mean it takes longer." Home loan rates climbed above 5 percent the week of May 29 for the first time in three months, according to mortgage bankers’ data, and have remained elevated relative to 10-year Treasuries.
The percentage of people who said they plan to buy a home in the next six months fell to 2.7 percent in June from 2.8 percent in May, the Conference Board in New York said yesterday. The mortgage bankers’ refinancing gauge decreased to 1,482.2, the lowest reading since November, from 2,116.3 the previous week, today’s report showed. The purchase index fell to 267.7 last week from a two-month high of 280.3. The share of applicants seeking to refinance loans plunged to 46.4 percent of total applications last week from 54 percent.
The average rate on a 30-year fixed-rate loan fell to 5.34 percent from 5.44 percent the prior week. The rate reached 4.61 percent at the end of March, the lowest level since the group’s records began in 1990. At the current 30-year rate, monthly borrowing costs for each $100,000 of a loan would be $558, or about $62 less than the same week a year earlier, when the rate was 6.33 percent.
The average rate on a 15-year fixed mortgage dropped to 4.81 percent from 4.93 percent the prior week. The rate on a one-year adjustable mortgage decreased to 6.52 percent last week from 6.54 percent, according to the mortgage bankers. Home loan rates tracked by McLean, Virginia-based mortgage buyer Freddie Mac climbed along with Treasury yields through late May and early June on investor concern that a greater supply of government debt being sold to fund federal spending would fuel inflation.
This year the Federal Reserve purchases of mortgage bonds guaranteed by Fannie Mae, Freddie Mac and Ginnie Mae brought down the yields on those securities, allowing lenders to reduce rates on new loans and still sell them at a profit. Still, rising foreclosures that sell at discounted prices are flooding the market and depressing home values, according to Lawrence Yun, chief economist of the Chicago-based Realtors’ group.
This year the number of foreclosures may rise to 2.5 million, the highest on record, Yun said. Existing U.S. home sales in May rose 2.4 percent to an annual rate of 4.77 million, lower than forecast, and the median price was down 16.8 percent from the same month in 2008, according to the Realtors. It would take about 9.6 months to sell the nation’s 3.8 million unsold homes at the current sales pace, according to the Realtors.
"The worst is behind us but we’re a long ways off from a recovery in housing," said Mark Vitner, a senior economist at Wachovia Corp. in Charlotte, North Carolina. "Inventories are still elevated. We’re not expecting any strength in housing until the second half of 2010." About 20.4 million of the 93 million houses, condos and co- ops in the U.S. were worth less than their loans as of March 31, according to Seattle-based real estate data service Zillow.com.
Builders including Los Angeles-based KB Home are slashing prices and reducing the size of houses to compete with foreclosures. KB Home’s revenue fell 40 percent last quarter to $384.5 million and net orders dropped 31 percent to 2,910 homes, the company said June 26. The Washington-based Mortgage Bankers Association’s loan survey, compiled every week, covers about half of all U.S. retail residential mortgage originations.
ADP Estimates U.S. Companies Cut Payrolls by 473,000
Companies in the U.S. cut more jobs than forecast in June, according to a private report today, showing the labor market will be slow to improve even as other parts of the economy indicate the recession is abating. The 473,000 drop in the ADP Employer Services gauge followed a revised reduction of 485,000 workers in May that was smaller than previously estimated.
Job losses may mount as the bankruptcies of General Motors Corp. and Chrysler LLC ripple through manufacturing. Increased firings threaten to further restrain consumer spending at a time when the world’s largest economy is showing signs of stabilizing. "This is a weak number," Joel Prakken, chairman of Macroeconomic Advisers LLC, said on a conference call with reporters. "It’s a pretty clear indication that, while we’re not shedding jobs as rapidly as the first part of the year, the labor market is still in a state of decline."
Economists forecast the ADP report would show a decline of 395,000 jobs, according to the median of 29 estimates in a Bloomberg News survey. Projections ranged from decreases of 280,000 to 532,000. A Labor Department report tomorrow may show employers cut 363,000 workers from payrolls in June and unemployment rose to a 26-year high of 9.6 percent. The increase from May’s 9.4 percent jobless rate would be the smallest since November 2008.
The ADP report ran counter to other figures today that showed job cut announcements in June fell 9 percent to 74,393, the fewest in more than a year, from 81,755 in June 2008, according to Chicago-based placement firm Challenger, Gray & Christmas Inc.. It was the first year-over-year decrease since February 2008. The ADP report showed a loss of 250,000 workers in goods- producing industries including manufacturers and construction companies. Employment in manufacturing dropped by 146,000. Service providers cut 223,000 workers. Companies employing more than 499 people reduced their workforces by 91,000 jobs. Medium-sized businesses, with 50 to 499 workers, cut 205,000 jobs and small companies decreased payrolls by 177.000.
"We are still months away from a trough in employment and the resumption of net employment gains is going to have to wait until early 2010," said Prakken. "Given that economic gains will be modest in coming quarters, I would see employment declining several more months." The ADP report is based on data from 400,000 businesses. ADP began keeping records in January 2001 and started publishing its numbers in 2006.
Pending Sales of Existing Homes in U.S. Increased 0.1% in May
The number of Americans signing contracts to buy previously owned homes rose for a fourth consecutive month in May, a sign the four-year slump in housing sales may be bottoming out. The 0.1 percent gain in the index of signed purchase agreements, or pending home resales, followed a 7.1 percent rise the prior month that was bigger than previously estimated, the National Association of Realtors said today in Washington. The May reading was up 4.6 percent from the same month a year earlier.
Collapsing home prices, historically low mortgage rates and tax incentives are making housing more affordable for Americans, helping to stabilize sales that have fallen since September 2005. Still, with unemployment forecast to reach 10 percent this year, home purchases may languish at low levels for months before a recovery emerges. "We’re starting to see sales stabilizing," Michael Gregory, a senior economist at BMO Capital Markets in Toronto, said before the report. "We’ve probably reached bottom or are close to that."
Economists forecast the index would remain unchanged in May after a previously reported 6.7 percent gain the prior month, according to the median of 36 projections in a Bloomberg News survey. Estimates ranged from a 3 percent drop to an increase of 7 percent. Pending resales are considered a leading indicator because they track contract signings. The National Association of Realtors’ existing-home sales report tallies closings, which typically occur a month or two later. The group, whose pending data goes back to January 2001, started publishing the index in March 2005.
Two of four regions saw an increase in pending sales, today’s report showed, led by a 3.1 percent month-on-month rise in the Northeast and a 2.2 percent gain in the West. Pending resales fell 1.7 percent in the South and 1.3 percent in the Midwest. The agents’ association reported last week that home resales increased 2.4 percent in May, a second consecutive gain that reinforced the case that the slump in home sales may level out this year. The median price dropped 17 percent from a year earlier, the third-biggest decline on record.
Rising foreclosures have pulled down median home prices by nearly a third from their peak in mid-2006, boosting demand. Foreclosure filings, including default and auction notices as well as property seizures, climbed 18 percent in May from a year earlier, according to Irvine, California-based RealtyTrac Inc. Distressed sales accounted for about 33 percent of existing homes sold in May, according to the agents’ association on June 23.
Federal Reserve purchases of Treasuries and mortgage securities also brought mortgage rates down to 4.78 percent in early April, the lowest since records began in 1971. They have since risen to 5.42 percent in the week ended June 25, still low levels by historic standards, according to Freddie Mac, the biggest buyer of mortgage securities. In addition, the Obama administration’s economic stimulus plan provided an $8,000 tax credit for first-time home buyers for purchases completed before Dec. 1.
Still, tight credit and job losses exceeding 6 million since the recession began in December 2007 have turned most Americans cautious about making big-ticket purchases. Homebuilders see little relief in sight. Sales of new homes will remain little changed in coming months because of low consumer confidence and the difficulty would-be buyers have getting loans, Pulte Homes Inc. Chief Executive Officer Richard Dugas said at an investor conference June 23.
"Buyers are unwilling and unable to take on new mortgages," Dugas said at conference in Boston. "Despite the record fall in prices and the tremendous deal that consumers get relative to the 30-year mortgage rates where they are today, we’re still having difficulty convincing people to get into the market."
Amid plummeting sales, auto bankruptcy debate rages on
Automakers rolled out their June sales reports Wednesday, adding some serious heat to the debate over whether bankrupting two of the nation's biggest carmakers was the right or wrong thing to do. Of Detroit's former Big Three, Ford Motor Co. was first out with its numbers. It sold nearly 11% fewer cars and pickups than it did a year ago. According to Ford, that's great news. Given the economy, it could have been much worse. And auto industry analysts certainly expected worse, predicting a sales decline closer to 15%.
At the same time, Ford can rightfully claim to have grabbed market share away from General Motors and Chrysler, both of whom were forced to walk the plank by President Barack Obama. Obama had no confidence they could ever get back on their feet financially without a good dunking in bankruptcy court. GM's June sales fell 33% from a year ago, while Chrysler's fell 42% -- both slightly worse than analysts expected.
These numbers bolster the conviction of anyone arguing that the public will not buy a new car from a company in bankruptcy. It also stands to reason that a wary public would gravitate toward Ford, which they did -- sort of -- if we look past the fact that their sales were still well below where they stood a year ago. But that doesn't silence those who argued that extensive government meddling in the industry is bound to give GM and Chrysler an unfair advantage over Ford as they emerge from Chapter 11.
We won't know whether Ford's decision to spurn federal bailout money was the right long-term strategy until GM and Chrysler can point to a full month of sales without the stigma of bankruptcy. For Chrysler, that will be July. For GM, it's likely to be before the end of summer. By then, they will also have shed billions of dollars worth of costs that landed them in this mess in the first place.
When that day arrives, will Ford still be holding a competitive edge? Hard to say. At that point, however, the game reverts to basics. All the publicity points Ford scored for its go-it-alone attitude will evaporate under the harsh realities of price and quality. In other words, the product will trump public sentiment.
The NYC Real Estate Collapse Keeps Accelerating
We noted earlier that real-estate in the northeast--and in New York City especially--hasn't fared nearly as badly as many other places in the country. Specifically, NYC real estate is now down 21% from the peak, according to the April Case Shiller index. That compares to 54% in Phoenix. Ah, but there's a catch. Phoenix real estate has fallen so far so fast that the rate of collapse is finally beginning to decelerate. Not so, NYC. In April, the NYC price decline accelerated to 13% year over year, a new record for this cycle. And it will probably continue to accelerate, en route to at least a 40% total decline.
Cracked Houses: What the Boom Built
Robert and Kay Lynn lay in bed shortly after closing on their new home in the Blue Oaks subdivision in Rancho Murieta, Calif., abutting an 18-hole golf course. They were listening to the "pop, pop, pop" of what they thought were acorns falling onto the roof. The Lynns soon realized those were not acorns dropping on the roof. "Little did we know it was the house cracking," says Mrs. Lynn, 67 years old. Mr. Lynn, 68, says they bought the property in 2002 for $357,000 as a weekend home and an investment. The stucco house was moving and shifting, with part of it subtly pitching toward the golf course, resulting in cracks and fissures in the walls, ceiling and floors, the couple says.
Many of their neighbors say they had similar problems. In the Sacramento Valley subdivision of about 250 houses, more than half the residents have reported some type of flaw. The Lynns and dozens of their neighbors last year filed construction-defect lawsuits against the builders, and the lead case is expected to go to trial next week. They are seeking enough money to permanently repair the houses, a figure expected to total millions of dollars. A spokeswoman for the builders, Reynen & Bardis Development LLC, said they would have no comment pending litigation, but a response the company’s attorneys filed with California Superior Court said time limits for some of the plaintiffs’ claims had run out.
Whatever the outcome of the case, hundreds of thousands of people from California to Georgia say their almost-new homes need costly repairs because of construction defects. The furious pace of home building from the late 1990s through the first half of the 2000s contributed to a surge in defects, experts say. It caused shortages of both skilled construction workers and quality materials. Many municipalities also fell behind inspecting and certifying new homes.
At the height of the boom in 2005, more than two million houses were built in the U.S., according to the National Association of Home Builders, a trade group. Criterium Engineers, a national building-inspection firm, estimates that 17% of newly constructed houses built in 2006 had at least two significant defects, up from 15% in 2003. Residential construction-defect claims filed with insurance companies in the current housing slump have been receding, "but the ones that are being filed are pretty severe in terms of the total damage alleged," says Paul Amirata, vice president of claims for Axa Insurance Co. in New York, a unit of AXA SA.
James Wadhams, a Nevada lobbyist who represents builders and insurers, says homeowners are filing lawsuits mainly because home inspectors and attorneys are "prospecting" in new subdivisions. Like California, Texas and Florida, Nevada experienced a surge in construction-defect claims in recent years. Because of tumbling real-estate values, those stuck with faulty houses say repairs often cost more than the homes are now worth. Many say they can’t refinance their mortgages or sell, and they have no equity to leverage for repairs.
Defects are also a concern for those shopping for a home. Owners generally are required to disclose housing defects to potential buyers. Buyers of new homes should scrutinize purchase and warranty contracts with a real-estate attorney, with special attention to arbitration clauses and liability releases. One of the best defenses against buying a defective house is a thorough inspection by a state-licensed building-inspection engineer, experts say.
Charlene Croal, 34, a consultant, says it would cost $228,000 to fix her nearly nine-year-old house in North Branch, Minn., though the house would be valued at only $190,000 today if it were in good condition. Its interior is riddled with mold because of water seepage, partly caused by a faulty roof and poorly installed windows, she says. She and her husband relocated their family of seven because of health problems linked to the mold, says Ms. Croal, who did not name the builder.
Owners of defective properties say they’re finding it even harder to get repairs now because of rising builder bankruptcies. Some builders, especially smaller ones, also carried inadequate liability insurance, construction experts say. Other homeowners say they are hamstrung by mandatory binding arbitration clauses in purchase contracts and new-home warranties, as well as "right to cure" laws, which require homeowners to notify builders and give them a chance to remedy a defect before the homeowners can file a lawsuit. More than 30 states have some type of right-to-cure legislation, according to the home-builders group. The NAHB says it "strongly supports" the option of using "alternative dispute resolution including mandatory, binding arbitration in consumer contracts," saying litigation is an inefficient means to resolve construction-defect disputes.
In Rancho Murieta, residents say they just want to save their homes. It turned out that much of Blue Oaks Estates was built on clay soil that expands in the rainy season and contracts in the scorching summers, the builder, Reynen & Bardis, acknowledges. This is damaging the homes’ foundations and subtly twisting the frames, causing homes to slowly pull apart—as evidenced by cracking floors, walls and ceilings, separating gutters, and jammed windows and doors.
At first Reynen & Bardis made numerous attempts to address the problems, repurchasing about 50 houses, and installing new drainage systems and foundation underpinnings on scores of others, the company says. But it stopped making repairs on houses in the subdivision in November 2007, saying it could no longer afford them. By law in California and many other states, builders are on the hook for certain new home defects for up to 10 years, depending on the circumstances and state laws.
In April 2008, John D. Reynen, co-owner of the firm, filed for personal bankruptcy protection, saying he owed creditors nearly $1 billion. Months later, his partner, Christo Bardis, also filed for personal bankruptcy. The partners had personally guaranteed hundreds of millions in bank loans to buy thousands of acres of land for development from Bakersfield, Calif., to Reno, Nev. None of the business entities of Reynen & Bardis is bankrupt, says a spokeswoman.
Even Rancho Murieta residents whose homes are OK say they are being affected. Michael Yager, 61, a retired real-estate agent and firefighter, says his bank would not refinance his mortgage unless he paid for a $7,000 engineering study certifying the house is structurally sound. Mr. Yager’s home was built later with a different type of foundation and hasn’t had problems. "It’s given the whole community a bad name," he says. Mr. Lynn, a retired bank executive, says losing money on a defective house was worse than losing retirement money in the stock market. "The one thing that won’t get better is this house, which will always have foundation problems," he says. "It has driven me from retirement to doing part-time work at the golf course, and I thought I was financially stable for the rest of my life."
Too-big-to-fail concept institutionalized: Fed's Hoenig
Thomas Hoenig, the president of the Federal Reserve Bank of Kansas City, was critical of the government's "ad hoc" rescue efforts during the financial crisis, saying that those actions have institutionalized the concept of "too big to fail" in our economic system. "The current crisis has made it clear that the group of systemically important firms that might be deemed worthy of special consideration by policy-makers is larger than previously thought," Hoenig said in a Tuesday speech at New York University.
Small banks see a competitive advantage flowing to larger firms, he added.
Fed Chairman Ben Bernanke has argued that he, along with others, had behaved in the manner of an emergency crew that needs to save a burning home before it destroys an entire neighborhood -- without first asking whether the fire was started carelessly. Hoenig asked in response: "If the fire was started by a homeowner who ignored fire codes and smokes in bed, should the neighbors be required to rebuild the home at twice its original size at their expense?"
The government's rescue of Wall Street was orchestrated by a small group of Fed officials, including Bernanke and Timothy Geithner, then president of the Federal Reserve Bank of New York and now secretary of the Treasury. Then-Treasury Secretary Henry Paulson was the point man for the Bush administration. These officials and their key aides orchestrated the rescues of American International Group Inc., Bear Stearns, Fannie Mae and Freddie Mac, as well as Merrill Lynch.
With the financial crisis abating, other Fed officials have begun to question some of the decisions that were made in crisis mode last fall. "The options chosen ... raise important issues of fairness and the equity of options," according to Hoenig. Hoenig said the too-big-to-fail concept must not be allowed to stand. Systemically important banks must have simple debt-leverage standards. Prior to the crisis, regulators were focused on risk-based capital standards. But Hoenig said these have proven to be too easy to avoid.
The Kansas City Fed president also said he supported legislation that would give the government new powers to close down large banks and nonbanks. But he pointed out there were tools in place already that could have been used. The Obama administration's overhaul of financial rules is only a start of a dialogue on the issue, Hoenig commented. "The most important part of any plan ... will be the requirement that public authorities resolve such institutions by taking them into receivership and restructuring them to emerge under new and more careful management and ownership," without exceptions.
Managements and shareholders must be held accountable, he said. Answering questions after his prepared remarks, Hoenig argued in favor of putting large and small financial firms into receivership once regulators determine they are insolvent. "It saves you from the thorny issues of private-public partnership."
Asked about whether this would have been feasible with AIG and other major institutions that were bailed out by the government, Hoenig said what was done instead was the government poured a lot of capital into AIG and other firms without also taking the steps of accessing their value. "Look at what we're setting up for ourselves: We now have institutions that are twice as big as when they started."
Questioned on his views on executive compensation at institutions that received government assistance, Hoenig said he does not believe the government should be determining the income of individuals. But "if an institution is receiving government assistance, they lose that ability to set their own salary, bonuses or whatever."
One side consequence of not having a receivership system is "these too-big-to-fail banks become even bigger," said Nouriel Roubini, an economist and professor at the NYU Stern School of Business, during a panel following Hoenig's remarks. "An open question is if it's too big to fail, isn't it too big?" asked Roubini. The country needs to address the issue before getting to the issue of insolvency in a receivership system, he said.
Coming to 25 states: higher taxes
More than half of US states are responding to budget challenges with an answer that’s often unpopular with their residents: tax hikes. In some cases, the levies are modest. Still, six states are increasing personal income taxes, 11 are raising sales taxes, and eight are boosting rates paid by businesses. The wide geographic scope of the tax increases is an indicator of how much pressure an economic slump has put on state finances.
And many of the states are ones that avoided significant tax boosts earlier this decade, the last time the United States was in recession. These include Florida, Minnesota, Wisconsin, Colorado, and Idaho. In all, 25 states have moved to raise taxes so far this year. Another 12 are considering such moves as they launch into a new budget year this week, according to the Center for Budget and Policy Priorities, a Washington research group that has tracked all the measures.
Given the weak state of the economy, the tally may continue to rise as the year goes on, budget analysts say. That’s the case even though states are also cutting spending – at a 4.6 percent pace last year, which was faster than at any time since 1983. States are also getting a big inflow of federal aid from the economic stimulus plan passed earlier this year.
Often, the tax proposals are politically rancorous. On Wednesday, Arizona’s Republican Gov. Jan Brewer was still wrangling over budget matters with a Republican-controlled legislature. Lawmakers don’t support her proposal for a rise in the state sales tax, but in a statement Wednesday, she said the Legislature’s budget "incorporates devastating cuts to education, public safety, and our state’s most vital health services." Governor Brewer sought to resolve some of her concerns by using her power of line-item veto, but further sparring with legislative leaders lies ahead.
The tax wrangling comes at a time of sharpening debate about America’s fiscal health. Federal government debt is rising fast. Many conservatives say the budget pressures provide an opportunity for the public to stand firm for spending restraint – or to simplify the tax structure toward a "flat tax" model. Liberals are more likely to support a mix of tax hikes and spending cuts – and to favor steepening tax rates on high-income households. New York recently moved to raise income taxes on incomes above $200,000, while Hawaii did so on incomes above $300,000.
Overall, states’ general-fund spending has risen on average by about 1.9 percent a year since 1979, after adjusting for inflation. That pace, tracked by the National Governors Association, has been faster than population growth (about 1 percent a year) but not as fast as the growth of the economy (about 2.6 percent a year).
Many of the new tax moves are relatively small, such as expanding the services included in a sales tax. Ten states have boosted alcohol or tobacco levies. Nine are raising more money from gas taxes or fees tied to automobile ownership. Fees are also going up for people who use motels in Hawaii, hunt in Maine, or gamble in South Dakota.
California, Illinois Fail to Meet Budget Deadline
Seven U.S. states from California to Connecticut began the fiscal year today without spending plans in place as they battle over tax increases and other measures to balance budgets amid declining revenue. Democratic Illinois Governor Pat Quinn refused to sign a budget after lawmakers failed to approve raising the income tax, said his spokeswoman Ashley Cross. Connecticut is at an impasse after Republican Governor Jodi Rell rejected a tax increase passed by the Democrat-led Legislature.
The recession that began in December 2007 dealt a blow to state finances as rising unemployment, cutbacks in consumer spending and a $7 trillion plunge in the U.S. stock market last year slashed tax collections. States faced a combined $166 billion in revenue gaps that had to be closed as they tried to craft budgets, the Center on Budget and Policy Priorities said. "We have no idea when it will end," said Mississippi Governor Haley Barbour, referring to the drop in tax revenue, which he said was as much as 15 percent below estimates in the final months of the fiscal year. Barbour, a Republican, signed a budget after the Legislature passed it late last night.
California Governor Arnold Schwarzenegger said today he will shut down government offices for the first three Fridays of every month and force lawmakers into an emergency session to tackle the state’s growing budget deficit. The Legislature’s failure to produce a budget before the fiscal year began pushed the size of the spending gap to more than $26 billion from $24 billion, he said. Without revisions to account for a 20 percent drop in revenue, California is set tomorrow to begin paying some of its bills with IOUs to avoid running out of cash.
The other states that are still working on their budgets are North Carolina, Ohio and Pennsylvania. Standard & Poor’s said today it doesn’t expect to make any credit-rating changes as a result of the late budgets. "Most states have a process for continuing payments for debt service and, in most cases, operations," S&P said in a report.
Republican Arizona Governor Janice Brewer signed a budget today after vetoing portions of the plan to add back funds for "vital services and public safety." She also called for a special session of the Legislature to deal with issues including education funding. States still haven’t "hit bottom" yet, in terms of the drop in their revenue collections, according to Scott Pattison, executive director of the National Association of State Budget Officers.
"We’re still seeing shortfalls" even after spending cuts and tax increases, he said. Democratic Ohio Governor Ted Strickland is at an impasse with a Republican-led Senate that refuses to approve video lottery terminals without a voter referendum, and "other, smaller ways’ to close a deficit, said spokeswoman Amanda Wurst. In North Carolina, the biggest U.S. tobacco producer, Governor Bev Perdue, a Democrat elected in November, faces legislative opposition over her plan to raise cigarette taxes by $1 a pack.
Pennsylvania’s state credit union and several banks will offer public employees zero-interest loans of as much as $1,000 if a standoff between Governor Edward Rendell and lawmakers over an income tax increase results in delays in meeting payroll, according to Rendell’s spokesman Chuck Ardo.
Indiana’s Legislature passed a $27.8 billion two-year budget yesterday and Governor Mitch Daniels signed it at his desk in Indianapolis at 8:05 p.m. last night, said Brad Rateike, his spokesman. Delaware Governor Jack Markell signed a budget early this morning, according to his Web site. All but four states -- New York, Alabama, Michigan and Texas -- begin their budget years today. In New York, a battle over political control of the Senate has stalled legislation needed by New York City and other local governments to balance their budgets for the fiscal year that started today.
New Jersey Governor Jon Corzine, a first-term Democrat, signed a $29 billion budget on June 29 that raises taxes on cigarettes, wine, liquor and the wealthy, and implements worker furloughs and wage freezes to help reduce expenses. The Democrat-led Legislature passed the spending plan last week as all Republican lawmakers voted against it.
California businesses, local governments brace for state IOUs
With the state threatening to pay its bills with IOUs if a budget deal wasn't reached by midnight Tuesday, local government leaders, small business owners and even taxpayers counting on state checks went to bed not knowing the future of their bank accounts. "The state is having this new budget crunch and I still haven't been paid from the last budget crunch," said George McMenamin, who runs a local restoration consulting company that does state-funded work. "There's a lot of little businesses like mine that do things like construction that need to get paid, and some are having to even lay people off."
The state Controller's Office has said without a budget in place, the treasury won't have the cash to meet its financial obligations. With California law prioritizing payment to bond holders, education and Medi-Cal, the controller says, starting Thursday, IOUs will be issued in lieu of cash to businesses that contract with the state, people owed tax refunds and local governments that administer Cal Grants, CalWorks and other social programs.
"The controller has only one option at this point," said Garin Casaleggio, a spokesman for Controller John Chiang. More than $3 billion in IOUs would have to go out during the month of July, he said, about $500 million to private businesses, if lawmakers couldn't reach a budget deal by the end of the day. The governor and legislators remained in negotiations late Tuesday but still didn't appear to agree on how to close the state's $24 billion budget gap.
Santa Cruz County officials, who administer the bulk of the state's health and human services, say they hope to cover the state's financial commitments if they're given IOUs. They don't want to see any lapses in local programs, but couldn't make any guarantees. Mary Jo Walker, county auditor-controller, said Tuesday the county could front the money for about $10 million worth of services it carries out for the state, which include CalWorks programs for the poor as well as mental health treatment and drug and alcohol counseling.
But the county, like California cities, could get an additional blow if the state chooses to borrow property taxes from local governments, making it harder to sustain the local services. "I'm hoping very much we won't have to delay payments, and if we do we'll start with the least vulnerable programs," Walker said. Local education officials said Tuesday they also hope IOUs won't immediately affect programs. Many recipients of college aid, in the form of Cal Grants, wouldn't need the money until school starts in August, at which time college administrators expect the budget problems to be dealt with.
Banks could make the IOUs easier to deal for both public and private parties by cashing them, which some did the last time the state issued IOUs in 1992. The major banks, as of Tuesday, hadn't said whether they'd be willing to do this, according to the controller's office. The IOUs, the controller's office said, would be paid back Oct. 1 with interest. The interest rate is expected to be determined Thursday.
The state, though, still hasn't paid back some of the money it owes from when it withheld payments late last year because of similar cash-flow problems. "As a small businessman," said McMenamin, the restoration consultant, "I'm not a $500 million company that can just absorb this."
The cautious approach to fixing banks will not work
by Martin Wolf
With one bound the banks are free, or so it seems. Already, the panic of the autumn of 2008 is fading. The period within which lessons can be learnt and changes made is closing. Yet without radical changes, another crisis is certain. It may not even be that long delayed. In a recent speech, governor Elizabeth Duke of the Federal Reserve told an anecdote from just after the failure of Lehman Brothers last September. Ben Bernanke, chairman of the Federal Reserve, was asked: "Well, what if we don’t do anything?" To which he replied: "There will be no economy on Monday."
Instead, all institutions deemed systemically significant were saved, by shifting almost all of the risk on to taxpayers. "Never again" might be too much to ask. But "not for a generation" is essential. Governments cannot afford an early repeat, financially, politically, perhaps morally: the lives of so many cannot soon be sacrificed to the whims of a foolish few. Yet what has emerged after the crisis is, as I argued last week , an even worse financial system than the one with which we began. The survivors are an oligopoly of "too-big-and-interconnected-to-fail" financial behemoths.
They are the winners not because they are necessarily the best businesses, but because they are the best supported. It takes no imagination to realise what these institutions might now do, given the incentives for risk-taking. So what is to be done? The characteristic, but futile, response is to move the regulatory deckchairs on the deck of the Titanic. Recent proposals from the US Treasury fall partly into this category. But the financial system had to be rescued from its own mismanagement of risk. This is not going to be changed by external supervision. It is going to be changed only by fixing incentives.
The starting point has to be with "too big to fail". We need a credible system for winding up even huge financial institutions. The most attractive proposals are for "good banks", in which unsecured creditors become shareholders. That would be easier if, as President Barack Obama has proposed, and Mervyn King, governor of the Bank of England, has argued, a regulated institution has to produce a plan for an orderly wind-down of its activities. Yet bank failures are like buses: you do not see one for hours and then a fleet arrives together. The authorities cannot make a credible promise that they would be prepared to put all affected institutions through bankruptcy in a systemic crisis.
This would be a recipe for still-greater panics. "Too big and interconnected to fail" is a reality. It is so, because, as Andrew Haldane of the Bank of England pointed out in a recent speech, the financial system is an increasingly tight network.* My colleague John Kay has argued that the right response is to create "narrow banks", which are perfectly safe, leaving the rest of the financial system to go on its merry way, subject to a then-plausible threat of bankruptcy. I find this idea both attractive and unpersuasive. The attraction seems evident. It is unpersuasive in part because it is so hard to agree on what narrow banks should do. It is also unpersuasive because the narrower the banks are made to be, the more vital is the role of the rest of the financial system and so the less plausible it is that governments would let it collapse.
If institutions are too big and interconnected to fail, and no neat structural solution can be identified, alternatives must be found: much higher capital requirements and greater attention to liquidity are the obvious ones. At present, big financial institutions operate with next to no capital: in the US, the median leverage ratio of commercial banks was 35 to 1 in 2007; in Europe, it was 45 to 1 (see chart). As I noted last week, this makes it rational for shareholders to "go for broke", with the results we have seen. Allowing institutions to be operated in the interests of shareholders, who supply just 3 per cent of their loanable funds, is insane. Trying to align the interests of management with those of shareholders is then even crazier. With their current capital structure, big financial institutions are a licence to gamble taxpayers’ money.
So how much capital makes sense for systemically significant institutions? "Much more than today" is the answer. Moreover, the required capital must also not be risk-weighted on the basis of banks’ models, which are not to be trusted. Shareholders’ funds should make up a minimum of 10 per cent of assets. In the US, it used to be far higher. Higher capital is, in addition, a good way to internalise the negative "externalities" – more precisely, risks – created by one institution for the entire system. Ideally, therefore, the required capital should be correlated with the systemic significance of institutions, as the excellent new annual report from the Bank for International Settlements argues.
Moreover, the requirement should be set against all activities, on the basis of fully consolidated accounts. Within a far better capitalised financial system, it would also be relatively easy to operate a "macroprudential" regime, with the required capital rising during booms and falling during busts. Again, the bigger the stake of shareholders, the less one would worry if the rewards of managers were aligned with them. Even so, regulators have to have some sort of control on the incentives of management, as long as taxpayers bear residual risk.
Two difficulties remain: the transition; and regulatory arbitrage. On the former, a demand for much higher capital ratios today would imperil the recovery. The answer is a lengthy transition, perhaps of as much as a decade. On the latter, it is evident that the so-called "shadow banking" system cannot be allowed to operate outside capital constraints if entities within it are likely to be systemically significant, as proved to be the case for money market funds. Moreover, capital ratios would have to be imposed by all significant countries.
But the US is powerful enough to force movement in that direction by insisting that any foreign bank operating within it must be appropriately capitalised. In sum, deleveraging is the right starting point for a healthier financial system. This would work best if we also eliminated today’s huge fiscal incentives for borrowing. It is cautious incrementalism, not radicalism, that is now the risky option. Where should such radicalism start? The answer is clear: it is the incentives, stupid.
Consumers Show 'Huge Interest' in Clunkers Program
A U.S. "cash-for-clunkers" Web site got 400,000 hits in a week, signaling "huge interest" in the discount trade-in program for cars and light trucks, Transportation Secretary Ray LaHood said.
Consumers will be able to visit auto dealer showrooms as early as July 24 for credits of as much as $4,500 to purchase or lease new vehicles under federal rules now being crafted, LaHood said in a telephone interview yesterday.
"There are going to be thousands of cars sold that would’ve never been sold," LaHood said. "This is the strongest incentive I have ever seen offered by car manufacturers. If this doesn’t work, I don’t know what will."
The comments echo optimism by dealers, analysts and carmakers that the effort will help rebuild demand battered by the recession. June sales to be announced today may show drops of 36 percent at Chrysler LLC, 30 percent at General Motors Corp. and 17 percent for Ford Motor Co., according to the average of five analyst forecasts.
The federal program, commonly referred to as cash-for- clunkers during congressional debates, lets consumers get the new-car credit for turning in a lower-mileage vehicle to be scrapped. The $1 billion in federal subsidies may spark 250,000 new car sales, U.S. lawmakers have said. "When 400,000 people hit a Web site in seven days there’s a lot of interest," LaHood said in the interview. "Whether that translates into 250,000 car sales, I think we don’t know."
The National Highway Traffic Safety Administration, part of LaHood’s Transportation Department, has until July 24 to issue a rule outlining the operation of the program, which the government calls the Car Allowance Rebate System. Meanwhile, NHTSA set up a Web site to answer questions. The program may boost new-vehicle sales 10 percent through year-end at AutoNation Inc., the biggest publicly traded U.S. car retailer, Chief Executive Officer Mike Jackson said in an interview last week.
Dean Maki, chief U.S. economist at Barclays Capital Inc. in New York, said in a note to clients last week that the plan "should give an additional boost to an economy already set to recover." The annual sales rate for June was 10.1 million cars and light trucks, based on 7 analyst estimates in a Bloomberg survey. That would be down 26 percent from 13.6 million a year earlier. President Barack Obama signed the clunkers program into law June 24 after Congress approved it the previous week as part of legislation to finance the Iraq and Afghanistan wars.
The program will end Nov. 1 or when the $1 billion in subsidies expire, whichever occurs first. Congress must decide later this year whether to approve legislation extending the program into 2010. Consumers will get $4,500 vouchers if the new car they are buying gets 10 miles-a-gallon better gas mileage than the model they are trading in. For light trucks, the improvement must be 5 mpg better than the older model. For a $3,500 voucher, the improvement for cars must be 4 mpg or better, and for light trucks, 2 mpg. The trade-in vehicle must be no older than a 1984 model and get 18 mpg or less in combined city/highway fuel economy.
New passenger cars purchased with the vouchers must get at least 22 mpg in city/highway fuel economy, and light trucks must get at least 18 mpg. Domestic as well as foreign models sold in the U.S. qualify. The federal rulemaking will resolve details such as how dealers register to participate in the program and how they get reimbursed for the consumer discounts, the NHTSA said in a notice last week. The rule also aims to ensure dealers don’t substitute the credit for other rebates, and that dealers disclose to consumers the best estimate for the scrap value of the used vehicles, according to the NHTSA notice.
Bank Woes Deepening in Europe
When the financial crisis struck the global economy last autumn, European governments moved swiftly to keep their biggest banks from falling into an abyss — never mind fears over nationalization. But now, as big banks on this side of the Atlantic show signs of recovery, a number of their counterparts overseas are sinking into a spiral of deepening losses that has prompted the European Union to consider a more aggressive approach to cleaning up its banking system.
Few people outside Belgium have ever heard of KBC Bank. But the travails of this lender, based in Brussels, highlight the broader challenges Europe is facing by not having more fully confronted the deteriorating health of its financial institutions. Since October, KBC Bank has had to seek government relief three times. In all, it has received $41.5 billion in financing and guarantees to recover from disastrous mortgage bets that its financial engineers and traders made when times were good. For a bank with a balance sheet of just $425 billion, it is an astounding sum, exceeding the bailout of the Royal Bank of Scotland.
KBC is not alone. Souring loans and festering portfolios of securitized mortgages still plague a number of national banks. Moody’s, the rating agency that recently issued a warning about the credit risk at 30 Spanish banks, is expected to lower its outlook for the Greek banking sector because of a sharp rise in nonperforming loans. In Ireland, the nationalized Anglo-Irish Bank still has a contaminated loan book that has emerged as threat to the country’s sovereign credit rating.
Nonperforming loans at Russian banks are even more worrisome, composing about 10 percent of the average bank’s books, a figure expected to balloon to 25 percent by the end of the year, forcing banks to raise as much as $80 billion in new capital. And in Sweden, the imploding Latvian economy has hobbled Swedbank, a huge provider of loans in the Baltics. Scott Bugie, a European bank analyst at Standard & Poor’s, said it would be "a multiyear process" for these and other European banks to improve their capital positions and return to sound financial footing. He predicted that bad loan write-offs at Europe’s 50 largest banks would double next year.
The growing losses have raised calls for several new approaches, including a more aggressive approach by the European Union to diagnose banks’ creditworthiness. Now, regulators are debating whether to impose a regionwide stress test for banks, like the ones the United States required of its 19 largest banks. But the European proposals have raised questions bordering on incredulity with some critics.
"This has the feel of a Magritte painting," said Karel Lannoo, chief executive of the Center for European Policy Studies in Brussels, comparing the European Commission’s approach with the surrealism of the Belgian painter. "This is Belgium’s third-largest bank," he said of KBC, "and it has had three successive rounds of aid, and they still can’t target the problem."
KBC does not fit the profile of the classic overreaching bank. Its core business is serving Belgian corporations and individual investors. But as the credit boom approached its zenith, a small team of designers of exotic securitized investments pushed the envelope much further. Whether it was manufacturing high-yielding collateralized debt obligations, leveraged lending to hedge funds or buying up life insurance policies and securitizing them, these bankers, based in London and New York, cultivated an anything-goes aura that was at odds with the bosses in Brussels.
So eager were KBC salesmen to sell high-reward products like collateralized debt obligations that they effectively promised risk-free returns, which lured a number of nonexpert investors. A group of European companies that said it was told that the investments were marketed as risk-free is suing the bank. Luc Philips, the chief financial and risk officer of KBC, said, "the decisions made by KBC FP were preapproved and vetted by the market and credit risk committees at the KBC Group headquarters in Brussels." As for the lawsuits, Viviane Huybrecht, a spokeswoman, said the bank was examining them on a case-by-case basis.
The financial products team leaders, Darren Carter and Thomas Korossy, came to KBC in 1999 when the bank bought the equity derivatives business from D. E. Shaw, an American hedge fund. The atmosphere was loose and geared toward risk-taking. Employees would come to meetings dressed in shorts and flip-flops, and if a business proposal did not meet the internal standard of a 22 percent return, it was discarded, former executives say.
Angry investors claim the unit was unsupervised. They point to the bank’s unusual practice of combining the roles of chief financial and chief risk officer, a policy that is in stark contrast to the most basic of corporate governance standards. In an interview, Mr. Carter said the bank’s collateralized debt obligations were of the highest quality, and were insured by the bond insurer MBIA.
When the mortgage market collapsed in late 2007, KBC, which had one of the highest ratios of collateralized debt obligations to bank capital of any institution in Europe, soon found itself close to insolvency. In October 2008 and again this January, KBC received 7 billion euros in public funds. When MBIA said in February that it could not pay off on its riskier positions, KBC was suddenly responsible for another 14.5 billion euros in collateralized debt obligations. In May, André Bergen, the chief executive, turned to the government again, this time for a bailout of 22.5 billion euros.
The week before the latest infusion was announced, Mr. Bergen, 60, was rushed to the hospital for open-heart surgery. Late Tuesday, the bank said it was splitting the role of chief financial officer and chief risk officer, and that Mr. Bergen would step down permanently to recover, to be replaced by the interim chief Jan Vanhevel. Another crucial player, Guido Segers, resigned as the head of merchant banking, and traders and bankers have left as part of the inevitable downsizing. Still, the executives behind the collateralized debt obligation strategy remain in charge. Ms. Huybrecht said the bank was trying to put the past behind it. But in two and a half years, if its investment is converted into KBC stock, the Belgian government could end up owning as much as 25 percent of the bank.
Ilargi: Looks nice, but the perhaps main issue in this is the re-default ratio. And that is not even mentioned here.
Program saves 60 percent of homes from foreclosure
A program to avert residential mortgage foreclosures has saved almost 60 percent of its participants from losing their homes in a sheriff's sale, officials said on Tuesday. Philadelphia's Mortgage Foreclosure Diversion Pilot Program, seen as a national model to stem the foreclosure crisis, resulted in 2,776 properties permanently or temporarily saved from sale between its inception in June 2008 and May 31 this year out of 4,690 that were referred to the program, according to new data.
The program, overseen by the Philadelphia Court of Common Pleas, brings together borrowers in mortgage arrears with lenders, judges, housing advocates and attorneys who try to reach an agreement that will allow distressed homeowners to remain in their homes. Lenders are required to refer foreclosure cases to the program in the hope that a resolution can be found under which owners will resume payments they can afford and lenders will no longer need to dispose of distressed property.
"Everybody wins," said Christopher DeNardo, an attorney who represents lenders in negotiations that take place weekly in a Philadelphia court room and typically cover around 140 cases. A steering committee consisting of 15-20 stakeholders was initially adversarial but now has a "collegial atmosphere of mutual respect" as all seek a resolution, DeNardo said. Throughout the U.S. there were 321,480 residential properties, or one in every 398, in some stage of foreclosure in May, the third-highest level on record, according to RealtyTrac.
The Philadelphia program has been cited by Pennsylvania Senator Arlen Specter, who has initiated legislation to replicate it nationwide, and by the U.S. Conference of Mayors, which earlier in June called on states to pass laws requiring mortgage lenders to negotiate with distressed borrowers. Deserie Jones-Wright, 47, a retired Philadelphia police officer with three children, said she received a foreclosure notice in November 2008 after falling about five months behind in mortgage payments which jumped to $975 a month from $607 on her adjustable-rate loan.
On a police pension of $2,055 a month, she said she couldn't afford the extra payment, and negotiated a settlement under which she paid a lump sum of $5,700 toward the arrears and now pays $562 a month, allowing her to keep the home. "At first I just felt like giving up but I worked hard for this home," Jones-Wright tearfully told about 200 stakeholders in the program at a reception. Borrowers are typically six months to two years behind in their payments, representing a debt of $20,000 to $100,000, said Kari Samuels, a volunteer attorney who represents homeowners. She said she often tries to reach a settlement by persuading lenders to drop attorneys' fees or accept reduced arrears in interest charges or late fees.
Borrowers are sometimes the victims of excessive interest rates or other forms of predatory lending, and often do not understand the terms of those loans, Samuels said. Lenders may seek a settlement by offering to stretch the outstanding mortgage over a longer term, cutting the interest rate, or reducing the principal, she said. "From the lender's point of view, it makes a lot more sense to work something out," Samuels said.
The Two Sides of the Balance Sheet
Noam Scheiber at The New Republic has the inside scoop (hat tip Ezra Klein) on why Treasury is letting the Public-Private Investment Program die a quiet death (although at this point the legacy securities component may still go ahead). In short, the argument is that the point of PPIP was to help banks raise capital by cleaning up their balance sheets; since they have been able to raise capital themselves, there is no need for PPIP. According to one person Scheiber spoke to: "If you had asked–I don’t want to speak for the secretary–what’s problem number one? I think he’d say capital. Problem two? Capital. Problem three? Capital."
This represents the latest swing of the pendulum between the two sides of the balance sheet. As anyone still reading about the financial crisis is probably aware, a balance sheet has two sides. On the left there are assets; on the right there are liabilities and equity; equity = assets minus liabilities. (There are different definitions of capital, depending on what subset of equity you use.) The goal has always been to provide confidence that there is enough capital to withstand the impact of market and economic turmoil – in particular, its impact on the toxic assets that litter banks’ balance sheets. However, there are two alternative approaches to doing this.
One is to add more equity to the right side by issuing new stock (preferred or common). (This would add cash to the left side to keep them in balance.) The other is to reduce the uncertainty of the left (asset) side by helping banks sell toxic assets; even if the banks have to sell them for a little less cash than their current balance sheet value, this would have the salutary effect of reducing vulnerability, since cash does not lose value (at least not in an accounting sense). Alternatively, you could achieve the same effect by insuring the value of the assets while leaving them on bank balance sheets, because then the risk transfers to the insurer.
The initial Paulson Plan last September focused on the left side; the idea was to buy toxic assets off of bank balance sheets. Then in October Treasury did an about-face and switched to the right side, recapitalizing banks by buying preferred stock from them (TARP). In November and January, Treasury and the Fed did combined bailouts of Citigroup and Bank of America, in which they both provided fresh capital and guaranteed certain assets against falls in value.
In February and March, Treasury shifted all the way over to the left (asset) side with the PPIP, which was hailed (by its supporters, at least) as a way to cleanse bank balance sheets – something that had not been accomplished by TARP. Now, it seems, we are back to the right side; as long as banks can raise more capital, everything is fine, no matter how many toxic assets they may hold.
One key to the financial crisis has been nervousness about toxic assets on bank balance sheets. It’s nice that people aren’t so nervous anymore. But as Raghuram Rajan said to Klein, "if we reenter the downturn, and the banks begin to look shakier – we’ll wish we had moved the assets when the market was calm and stable, rather than leaving them to create uncertainty and volatility at the center of the banking system."
Harmful financial innovation
by Willem Buiter
Like most authors, I tend to cringe when I read something I wrote more than a few years ago. But when engaging in some authorial auto-archeology recently when preparing the index for a new paper (after all, if I don’t cite myself, who will?), I was pleasantly surprised with a few bits from a paper I wrote in 1999 and published in 2000 in the Bank of England’s Quarterly Bulletin, titled "The new economy and the old monetary economics". The paper takes aim at the assertion, rampant in 1999, that the behaviour in recent years of the world economy, led by the United States, could only be understood by abandoning the old conventional wisdoms and adopting a ‘New Paradigm’.
Prominent among the structural transformations associated with the New Paradigm were the the following: increasing openness; financial innovation; lower global inflation; stronger competitive pressures; buoyant stock markets defying conventional valuation methods; a lower natural rate of unemployment; and a higher trend rate of growth of productivity.I argue, first, that the New Paradigm has been over-hyped.
"…Unfortunately, the ‘New Paradigm’ label has been much abused by professional hype merchants and peddlers of economic snake oil."
Second, I argue that, to the extent that we can see a New Paradigm in action, its implications for monetary policy have often been misunderstood. I was particularly pleased that I had written following about financial innovation:
"Financial globalisation and innovation are a mixed blessing. Properly functioning financial markets improve the global allocation of resources, by offering effective vehicles for channeling saving into domestic capital formation and foreign investment and by providing the means for efficient trading of risk. Efficient risk trading means that risk ends up with the economic agents and institutions most willing and able to bear risk. The superior availability of risk capital in the United States is widely thought to have contributed significantly to the New Economy lead the United States has taken. Unfortunately, financial markets also can and do shift the non-diversifiable risk in the economy to the imprudent, the reckless, and the fraudulent. The misalignment of the private and social costs of risk that causes such perverse risk trading occurs for legal and institutional reasons and because of asymmetric information among the parties trading risk.
ICT provides unprecedented means for collecting and processing information and for tracking economic agents and performance across space and time. It also provides unprecedented means for concealing information or for creating false audit trails. Normal human greed and widespread access to the Internet, combined with ignorance and hubris, create an unhealthy and possibly dangerous stew of speculative excess at the retail level. Day traders and Internet financial chat rooms are manifestations of this. When risk is mispriced and misallocated, financial crises and collapses can occur. Financial crashes and associated defaults and bankruptcies are socially costly because they involve a waste of real resources as well as a reshuffling of property rights.
When that happens, the aggregate non-diversifiable risk in the economy is not just distributed inefficiently, but its total quantum is increased. Risk that should be diversifiable under orderly market conditions ceases to be so. Despite inadequate supervision and regulation, the financial innovation process that started in the final quarter of the 20th century probably improves overall economic performance during normal times. It does, however, increase the likelihood of abnormal times—panics, manias and crashes—occurring, and exacerbates the scope and severity of financial crises."
The purpose of this quote is not just to blow my own trumpet - although, as my father puts it, it’s OK to do so, because if you don’t who will - but also to send out a reminder as to how difficult it is to discern the scope and magnitude of a looming financial disaster, even when you pay serious attention and are naturally inclined not to believe what you are told. By early 2006 I knew that the global financial system was on an unsustainable trajectory that would end in tears. The ludicrously low spreads on anything risky and the shockingly low long-term real interest rates convinced me we were living in financial Lalaland.
But I had no idea about the scale of the excesses, the scope of the mispricing of risk and the crazy ultimate distribution of the risks - often right at the backdoor of those who thought they had sold it. I never anticipated, even when the crisis started in August 2007, that by late 2008, most of the crossborder banking system in the north Atlantic area would be insolvent, but for past, ongoing and anticipated future financial support of the tax payers.
I had no idea that central banks, regulators/supervisors and ministries of finance would decide that, give or take a Lehman or two, all crossborder banks were too big, too complex, too interconnected, too international and too politically well-connected to fail and would therefore be bailed out in a variety of ways with tax payers’ money. When it was pointed out that ‘a bank failure’ did not have to mean the army corps of engineers blowing up the organisation and permanently wrecking its ability to engage in financial intermediation and new lending and borrowing, but could merely refer to the simple legal process of converting unsecured creditors into new shareholders, in inverse order of seniority and on a sufficient scale, a new argument for not bearding the unsecured creditors of the banks rather than the tax payers was invented.
This was the inability of the unsecured creditors (often institutional investors like insurance companies and pension funds) to take the strain of a write-down or write-off of their claims on the banks, or even of a mandatory debt-to-equity conversion.
This argument is bogus. Insurance companies and pension funds, and their beneficial owners and other beneficiaries of course don’t like suffering capital losses. No-one does. But the losses are there. They have been incurred. The only question is who will bear them. The rules of the market game require hard budget constraints. Both fairness and efficiency - incentives for future appropriate risk taking and for minimizing moral hazard require that the unsecured creditors of the banks feel the pain of the banks’ misadventures before the taxpayers do.
There are also no systemic externalities associated with having the losses fall on the unsecured creditors, including insurance companies, pension funds and other institutional investors, rather than on the tax payers. So despite being a keen observer of the financial scene for many years, I did not anticipate anything like the financial disaster that has befallen us, nor the reckless disregard and staggering shortsightedness that is leading those responsible for financial stability to jointly create the mother of all moral hazard machines and thus to virtually guarantee an even bigger financial blow-out in the not too distant future.
One of the reasons for my ignorance (widely shared, I may say in my defence) was the pace of financial innovation in instruments and institutions. Most of the new instruments and institutions were motivated purely by regulatory and tax arbitrage, domestic and crossborder. But some it it was genuine. Even those that were genuine and potentially socially useful (interest rate swaps, securitisation, CDS). Even the genuine innovations were, however, often abused and became socially damaging. CDS provide an example. Just as short selling equity is potentially efficiency enhancing but naked short selling is just gambling, so insuring credit default risk is potentially efficiency enhancing when the buyer has an insurable interest and the writer of the CDS is sufficiently capitalised. Current arrangements permit ‘naked’ CDS buying (buying CDS on a security in excess of the face value of your holdings of that security).
I would not follow George Soros and ban CDS outright. I would require that any writer of CDS or other forms of credit risk insurance be properly capitalised and post additional collateral immediately when his creditworthiness is adversely affected. In addition, I would stipulate that it is only possible to buy CDS when you have an insurable interest in the security it is written on, and that you cannot make good, following default on a security, any claim under a CDS written on that security unless you can present to the writer of the CDS an amount of that security with the same face value as your claim.
Likewise, securitisation will return, but only with an obligation on the originator of the underlying assets to retain a hefty chunk of the highest risk trance (equity tranche or first-loss tranche) it is written on. The five percent figure tossed about in the EU and the US is way too low. At least 10 percent would be required to retain sufficient incentives for the originator to verify the creditworthiness of the ultimate source of the cash-flows underlying the securitisation, and to monitor the relationship over the life of the contract.
I don’t think most of the disasters with securitisation of subprime and alt-A mortgages or with CDS would have happened if there had been a proper vetting of these products before they were permitted. What I have in mind is an FDA for new financial instruments and institutions. Like new medical treatments, drugs and pharmacological concoctions, new financial instruments, products and institutions are potentially socially useful. They can also be toxic and health-threatening.
So there would be a positive list of approved financial instruments, products and institutions. Anything not on the list is forbidden. New items get on the list after thorough testing, scrutiny, gaming, pilot projects etc. It would slow down financial innovation. It would not kill it. We may delay the introduction into the marketplace of socially useful new instruments. So be it.
Sweden rides to the defence of hedge funds
Sweden, the newly installed holder of the European Union’s presidency, came to the defence of hedge funds and private equity on Wednesday, saying it did not blame them for the financial crisis and would press for improvements in EU proposals to regulate the two industries. "There is an exaggerated fear that private equity contains big systemic risk. Our opinion is that it does not," Mats Odell, Sweden’s financial markets minister, told reporters. "It is not private equity that caused the crisis, nor hedge funds.
But in some countries, the political debate portrays private equity and hedge funds as the problem," Mr Odell said. "That’s not the same as saying we shouldn’t regulate them. But the aim is to have sound regulation and not to kill the industry." Hedge funds and private equity companies, especially those based in the City of London, complain that regulatory proposals presented by the European Commission in April will, if adopted unchanged, impose unnecessarily heavy compliance burdens on them.
Some fund managers see the proposals as a misguided continental European attempt to exploit the crisis as an excuse to crack down on their activities, portrayed as emblematic of the type of Anglo-American financial capitalism that contributed to the global turmoil. "I wouldn’t say the Commission’s proposal on hedge funds is bad, but it’s a raw diamond that needs to be polished more," Mr Odell said. "It’s easy to find scapegoats. If you look at the crisis and its origins and roots and what’s been driving it. I think more important are big bonuses and wrong incentives in the financial industry – and lack of ethical standards."
He said Swedish trade unionists appreciated that private equity funds were often good for companies and their workers. "I was with leaders of the Swedish metalworkers’ union yesterday. They said their members were better off in private equity-owned companies than in listed companies. The private equity-owned companies were more involved in management, more transparent and offered better employment prospects with higher productivity and profitability," Mr Odell said.
"Perhaps I should bring the Swedish trade unionists to other parts of Europe, because I believe there is a wrong picture in Europe about this." Mr Odell said that, after talks last weekend with Lord Myners, the UK’s financial services secretary to the Treasury, he was confident that the UK would support new EU-wide financial supervisory arrangements that Sweden intends to guide into law by the end of its six-month presidency in December. The new structures include an agency for monitoring systemic risk and a system of financial supervisors to watch over the banking, insurance and securities markets.
"My bilateral contacts with my British colleagues indicate that the British are in favour of finalising it during the Swedish presidency," Mr Odell said. EU diplomats said there was continuing pressure on the UK from other countries in the 27-nation bloc to let EU-level supervisors impose binding decisions on national authorities in the event of a disagreement over how to help a stricken bank. The UK secured a compromise at an EU summit last month, under which no government can be forced by EU-level authorities to use its own taxpayers’ money to bail out a bank.
Chinese surveys show manufacturing expanding
China's manufacturing expanded in June, adding to signs the world's third-largest economy is rebounding from the collapse in global trade, but few new jobs were created, according to two surveys released Wednesday. Brokerage CLSA Asia-Pacific Markets said its purchasing managers index rose to 51.8 from May's 51.2 on a 100-point scale where numbers above 50 show activity expanding. The state-sanctioned China Federation of Logistics and Purchasing said its own PMI edged up slightly to 53.2 from May's 53.1.
"This PMI indicates the economy is midway through a recovery, despite some slowdown in infrastructure momentum," Credit Suisse economist Dong Tao said in a report. The PMI is seen by economists as a better measure of China's economic outlook than data such as gross domestic product because it includes forward-looking elements such as new and export orders. CLSA's index is based on a monthly survey of some 400 companies, while the Chinese federation surveys some 700 companies.
The figures add to mounting signs Beijing's 4 trillion yuan ($586 billion) stimulus is starting to show results, boosting domestic demand to offset lackluster exports. Consumer spending, auto sales, bank lending and investment also are up. The World Bank raised its 2009 growth forecast for China last month from 6.5 percent to 7.2 percent due to the stimulus-driven investment boom. Private sector economists also have raised growth forecasts and say China is likely to be the first major economy to emerge from the world's worst downturn since the 1930s. CLSA's measure of manufacturing output rose 53.7 in June from May's 52.5, while the Chinese federation's rose 0.2 points to 57.1. CLSA said its measure of export orders rose for the first time in 11 months to 50.9 in June, showing activity expanding slightly following a record contraction in global consumer demand.
"We believe that the rush of government-led infrastructure orders has hit a soft pocket, but the resulting moderation is shallower than we previously anticipated, mitigated by improved production activities and inventory needs," said Tao. Despite rising activity, CLSA's employment index stood at 50.2 for June, indicating the number of factory jobs grew only slightly from May, when the index was at 50.0, showing no job growth. The Chinese federation released no employment figure, possibly to avoid highlighting the lackluster job news.
As many as 30 million migrants were thrown out of work at export-driven factories when global demand collapsed last year. Some have found new jobs with stimulus-financed building projects but no comprehensive figures have been released. Beijing's stimulus is aimed at pumping money into the economy through higher spending on construction of highways and other public works. Most of the money has gone to state-owned construction companies and suppliers of steel and cement but some has begun to reach the private sector as they buy materials and hire workers.
UK banks face a new social contract
Senior ministers, regulators and bankers have outlined sweeping reforms of the UK financial system. The reforms will redraw the "social contract" between banks and the public. Lenders will have to behave more responsibly, simplify their operations and accept lower profits in return for implicit taxpayer support.
The industry has "to face the fact… that financial institutions are systemically important in a way that other businesses are not", Stephen Green, the chairman of HSBC, said. In speeches at the British Bankers’ Association’s conference, Lord Myners, the City Minister, Paul Tucker, the deputy governor of the Bank of England, and Lord Turner, the chairman of the Financial Services Authority, sketched their visions for the future. They called for:
- a complete restructuring of "too big to fail" banks to permit an "orderly wind down" in the case of failure.
- greater capital and liquidity requirements.
- an overhaul of how the deposit protection scheme is funded.
- a closer link between executive and staff pay.
Only by accepting reform will public trust be restored, they said. The proposals will "not be cheap" for the industry, which will have to accept "lower returns on equity in the future", according to Mr Tucker. Lord Turner added that extra "costs may simply have to be accepted". Mr Tucker said these are "the rules of the game, or 'social contract’, within which banks need to operate in future."
How German Banks Are Cashing In on the Financial Crisis
Central banks are making trillions in unusually cheap money available to banks in a bid to restore liquidity to the financial system. But institutions are not passing on the cash to their customers, choosing instead to invest it and make a fat profit. These days, bankers are used to bad press and being scolded by politicians. There's been no shortage of either in the past week. "Banks Hoard Money," was the headline on the cover of the Financial Times Deutschland, while the tabloid Bild sharply condemned the "Outrageous Overdraft Interest Rates."
Consumer Protection Minister Ilse Aigner railed: "It is unacceptable that the financial industry takes months to pass on reductions in the key interest rate, when it only takes a few days to pass on key interest rate increases." The new attacks on banks have been prompted by the fact that base rates are at a historic low and that central banks are injecting money into the market like never before. In the last week alone, the European Central Bank (ECB) allocated the record sum of €442 billion ($619 billion) to 1,100 financial institutions -- at a paltry 1 percent interest rate.
And yet the money is not going where the central banks want it to go, namely into the pockets of businesses and consumers -- at least not at reasonable interest rates. Instead, many companies are struggling to survive because their loans and credit lines are not being extended. Meanwhile, citizens are outraged that they are still expected to pay double-digit interest rates on their overdrafts. It seems clear that the banks would rather invest the cheap money they can borrow from central banks in safe investments, such as German government bonds offering 2.5 percent interest, than lend it to companies whose prospects, in the middle of a recession, are anything but rosy. And they are also lining their pockets with the fees they charge customers who are forced to go overdrawn as a result of the crisis. Are the banks taking advantage of the crisis to turn a profit -- at the expense of the very citizens to whom they owe their survival?
It is now almost two years since the financial crisis began in Germany, with the government's dramatic bailout of IKB Deutsche Industriebank. IKB was one of the many banks around the world who had speculated unwisely, investing billions and even trillions in new, supposedly safe securities that were essentially nothing but repackaged and securitized loans to so-called subprime borrowers. When the bubble burst, the financial world came to the brink of collapse. If the government had not come to their rescue with previously unimaginable sums, many banks would no longer exist today. The German government has already spent a total of €760 billion ($1.06 trillion), in the form of loan guarantees and bailouts, and it even took a 25 percent stake in Germany's second-largest bank, Commerzbank.
To limit the consequences for the real economy, the government also spent billions on economic stimulus programs. The bill for taxpayers is equally enormous. In the coming year, the federal government will have to borrow €86 billion ($120 billion) -- as opposed to the €6 billion ($8.4 billion) figure that was planned before the crisis. Politicians, as well as central bankers, business owners and, most of all, citizens, expect something in return: a functioning financial system -- and low-interest loans.
This is especially true now that the banks seem to have survived the worst of the crisis. In the United States, many banks have started to repay the money they received from the government under the Troubled Asset Relief Program (TARP). After last year's record losses, many institutions have reported respectable profits for the first few months of 2009, and the banks' share prices, which had fallen to all-time lows in January, have since doubled.
Nevertheless, the economic crisis threatens to get even worse, because the credit system is still not working the way it needs to, if -- in the opinion of many politicians specializing in financial issues -- greater damage is to be prevented. Ilse Aigner has asked officials in her ministry to carefully examine and document the behavior of financial institutions. She plans to release the results of the study to the public. In her view, banks that do not pass on interest rate reductions to their borrowers are operating in legally shaky territory. Her position is based on an April ruling by the German Federal Court of Justice, according to which banks cannot set variable interest rates and fees at their own discretion.
Even Axel Weber, the chairman of Germany's central bank, the Bundesbank, is relying on public pressure. He knows that banks have steadily tightened their requirements for the creditworthiness of borrowers in recent weeks and months. And he also knows that much of the money the banks have borrowed from the ECB is not reaching businesses and bank customers. In a startling move, Weber called upon the banks to pass on interest rate reductions. Otherwise, he said, "central banks will be forced to circumvent the banks and take direct measures to support the economy."
That's something they will in fact probably have to do, should politicians fail in their attempts to stabilize the financial sector. Despite the current profits and rising share prices, the banking crisis is far from over. Banks still have unimaginable amounts of toxic securities on their balance sheets. The International Monetary Fund (IMF) estimates that potential global write-downs resulting from the financial crisis could be over $4 trillion (€2.85 trillion). Crisis-related write-downs to date amount to only about $1.5 trillion (€1.1 trillion).
Although new, more generous write-down rules have eased the problem, they have not solved it. And the real solution, the establishment of functioning bad banks, is something the German government has been struggling with for months. So-called "bad" banks are companies into which banks can deposit their toxic securities. This removal of troubled assets from balance sheets frees up equity capital otherwise earmarked as a buffer against risk. It also prevents banks from being further downgraded by the rating agencies, which would mean that they would have to establish even larger buffers.
In return for relieving the banks of their toxic assets, Germany's center-left Social Democrats, and some members of the center-right Christian Democrats, have pushed through strict rules that would hamper the banks for years should they participate in the bad bank program. Under one of these rules, the banks are required to immediately pay the federal government 10 percent of the book value of the transferred securities. Exceptions are only permitted if such a payment would reduce a bank's capital base to such an extent as to sharply curtail its ability to compete.
All other potential losses are estimated and must be paid in installments over a 20-year period. A bank is only permitted to pay a dividend if its profits exceed the payment it owes the federal government. But a bank that is restricted in this way would be unable to obtain equity capital on the capital markets -- and therefore has no capital to invest. In the worst case scenario, the bank would exist in a comatose state for decades. More generous rules were not feasible, for political reasons. Bank bailouts are unpopular -- especially at the moment, when parties are campaigning in the run-up to Germany's Sept. 27 national election. It is difficult to convince voters that such aid averts far more serious consequences, especially when banks are reporting profits and their share prices are rising sharply.
The current debate over an amendment of the law governing Germany's ailing state-owned regional banks, the Landesbanken, is even more strongly marked by partisan interests. Ironically, it was these publicly owned banks that snapped up the exotic high-yield securities that have since proven to be toxic most enthusiastically during the boom years. Should they be written down, some of the state-owned banks would be forced into bankruptcy.
And should a Landesbank go bust, the state that owns it could also go bankrupt, a scenario which currently concerns the northern state of Schleswig-Holstein, for example. Hence the state-owned banks are in particularly urgent need of a way to dispose of their toxic assets. Finance Minister Peer Steinbrück is aware of this, and he is demanding something in return. He wants the governors of the states in question to finally move forward on a long-overdue consolidation of the Landesbanken. But the governors, who perceive the pressure from Berlin as unreasonable intervention, want to be allowed by law to establish their own bad banks -- while at the same time wanting the federal government to take on much of the risk associated with those institutions.
It is unclear how the dispute will end. If the legislation is not passed, the German parliament, the Bundestag, will be forced to convene during the summer recess to save one or perhaps several of the state-owned banks from bankruptcy. Two years since the start of the financial crisis, many banks are still on the brink of disaster -- with devastating consequences for the real economy. Hans-Werner Sinn, the president of the influential Munich-based Ifo Institute for Economic Research, sees the "under-capitalization of the banking system and the high levels of hidden losses that have not yet been disclosed" as the main obstacle to Germany's further economic development. No matter how much additional liquidity ECB President Jean-Claude Trichet and his staff pump into the market, banks' capital ratios remain a limiting factor when it comes to issuing credit.
The core capital ratios of German banks have declined in the wake of the crisis, but many are reluctant to bolster their capital base with the help of the government's special Financial Market Stabilization Fund, known as Soffin. The program has significant strings attached, including restrictions on bankers' salaries. Other countries, like the United States, have taken a more rigorous approach, forcing their banks to accept an injection of government capital.
A bank is only permitted to lend money or sell debt securities if a certain portion of the underlying funds is backed by bank capital. The riskier a loan or customer, the more capital the bank is required to keep in reserve as collateral. The credit ratings of US subprime mortgages or corporate borrowers are now declining faster and faster. The repackaged and resold mortgages on houses in low-income neighborhoods in the United States often lose their entire value at one go.
A similarly disastrous development is beginning to emerge among companies. According to Creditreform, a German company that collects creditworthiness data, 16,650 companies with a total of 250,000 employees have had to file for bankruptcy since the crisis began. Experts predict German banks will be hit by up to €170 billion ($238 billion) in recession-related loan defaults by the end of next year. The effect on bank balance sheets is devastating. Their relatively thin equity capital reserves are either evaporating or suddenly being tied up as mandatory reserves -- thanks to Basel II, an international set of regulations which banks agreed to in 2005 and which came into force at the beginning of 2007. Basel II was created to make it more difficult for banks to issue loans recklessly, in a bid to prevent crises. Now it is only making the current crisis worse.
Under Basel II, banks are permitted to set aside fewer reserves for loans to customers with strong creditworthiness than to those with lower credit ratings. In a crisis, however, the solvency of almost all customers declines. As a result, banks in a downturn must constantly increase their equity reserves to be able to satisfy the requirements for existing loans. In many cases, they can only do so by not extending expiring loans. The formula used to compute the required equity reserve for a security with a face value of €1 million ($1.4 million), with US mortgages as collateral, demonstrates how brutal the mechanism is.
If the US rating agency Moody's issues its highest rating, Aaa, the bank only needs to keep €5,600 ($7,840) of its capital in reserve for the security. But if Moody's lowers its rating by 10 levels to Ba1, the required reserve increases to €200,000 ($280,000). And if the rating drops even lower, to B1, the bank must keep the full value of the security, €1 million ($1.4 million), in reserve. A different computation factor applies to corporate loans, but the logic remains the same.
Politicians have been up in arms over these balance-sheet restrictions for weeks. Two Sundays ago, the SPD's state floor leaders from Hesse, Bavaria and Baden-Württemberg called for a temporary suspension of Basel II for banks. According to the three politicians, Thorsten Schäfer-Gümbel, Franz Maget and Claus Schmiedel, the rules only exacerbate the difficulties companies face in securing loans at favorable terms. Senior government officials in Berlin are all too familiar with the sensitive nature of the issue. But they also know that it is impossible for a country to go its own way when it comes to Basel II.
The German Finance Ministry is currently examining options to "provide banks with short-term relief regarding the capital requirements during this severe economic crisis," according to a letter Karlheinz Weimar, the finance minister of the state of Hesse, received two weeks ago. But the federal Finance Ministry officials also pointed out that any such efforts would have to reflect the fact that the capital requirements that apply in Germany are based, for the most part, on international and European rules "that are difficult to change in the short term."
Weimar wrote to German Finance Minister Peer Steinbrück in late May, pointing out a specific German accounting problem. In Germany, unlike most other EU countries, so-called revaluation reserves are included as part of equity capital. This doesn't present a problem as long as the stock markets are booming and security portfolios are showing high returns. Reserves increase, the capital base virtually grows by itself and bankers are perfectly happy.
But in the current situation, banks must either record the loss in value of assets on their profit and loss statements or see their revaluation reserves rapidly shrink -- together with their capital base. This clearly benefits competing banks in France and Great Britain. The government-supported Commerzbank, for example, showed more than €22 billion ($31 billion) in equity capital on its Dec. 31, 2008 financial statement. But because of the bank's negative revaluation reserve of €2.2 billion ($3.1 billion), CEO Martin Blessing was forced to book only €19.9 billion ($27.9 billion). The difference at rival Deutsche Bank, on the same date, was €882 million ($1.23 billion), while at Postbank, which Deutsche Bank acquired, it was €724 million ($1 billion).
If Weimar has his way, this mechanism will be eliminated, a move Steinbrück supports. He has told his Weimar that the federal government is "fundamentally open" to adjustments, and that the appropriate agencies would "intensively expedite" the necessary efforts. A Finance Ministry spokeswoman confirmed, however, that the banking industry will be consulted before any final decisions are reached.
Relief is urgently needed, or else equity capital will continue to shrink and banks will have to restrict lending even further -- with the consequence that even more companies will go out of business and even more business loans will have to be written off, causing capital bases to shrink even further. In other words, the crisis will become self-perpetuating. For many business customers, this means that they don't stand a chance of getting any money from banks, regardless of the interest rate or how much liquidity the central bank makes available.
This makes it all the more tempting for banks to invest the money to turn a profit. "This is a real free lunch," comments one Frankfurt banker. It is also a gift to gamblers and speculators within the banks, who are apparently prepared to put up with a bit of public outrage for such a profitable opportunity. Besides, the banks are largely immune to criticism of their behavior. For instance, consumer advocates have been outraged for decades over the banks' practice of inadequately passing on base rate changes to customers. They have sharply criticized this behavior again and again -- unsuccessfully, as is still evident today.
Since last October, the average interest rate for overdraft loans to private households has declined by about one percentage point, from 12.1 to 11.0 percent, according to the German Bundesbank. Rates on consumer loans have dropped by 0.5 points to 5.3 percent, while rates on mortgages with a maturity of up to five years have declined by 1.4 percentage points to 4 percent, meaning that rate is almost at a historic low for Germany. But the ECB's key interest rate has been reduced much further, falling by 3.25 percent in the last 12 months. In other words, this crisis is not that bad for banks after all. Provided, that is, they have enough capital to survive.
Is the United States drifting toward "war socialism"?
Jay Hanson is a well-known voice on issues of peak oil and sustainability. A systems analyst by trade, he established one of the first web sites (dieoff.org) to discuss these issues in depth in the mid-1990s. His latest web venture is a site called War Socialism on which he describes a form of governance which might become the only viable one in the coming age of scarcity unless we can muster unprecedented global cooperation to manage the decline.
By discussing "war socialism" I am not endorsing it. In fact, Hanson proposes an alternative, a global government that severely restricts human use of the global commons, that is, the natural resources upon which all of us depend. But Hanson is no lightweight. He has thought very deeply about our ecological predicament. He has tried to square what he knows about human behavior with what he believes needs to be done in the world we now face. It is clear from the organization and emphasis of his new site that he does not believe it is probable that the kind of global cooperation he would prefer will actually emerge.
To understand "war socialism" one needs first to understand that Hanson believes that the most likely (though certainly not preferable) trajectory for humanity is a massive dieoff that will claim the lives of 90 percent of the human inhabitants of the Earth. Absent the kind of cooperation Hanson would like to see in managing the coming decline, the only rational strategy may be for one's own country to work to outcompete other countries. The picture he paints is not an appealing one. But when you are trying to be one of the 10 percent who will survive the coming collapse, there is little room for sentimentality.
So, let's look at the war socialism society Hanson describes, and let's see if some of its building blocks are already in place in the United States. Here are the basic principles:
- Increase our fraction of global net energy (divert energy from competitors) directly by military action.
Comment: There is little room to deny that the United States has long engaged in military action to increase and secure its access to resources, especially energy. With U. S. troops all over the Middle East that pattern continues.
- Increase our fraction of global net energy economically by increasing asset values (e.g., pumping up the stock market and real estate prices).
Comment: This has rather successfully been done during the last 25 years though clearly it was not sustainable. We are trying to do it all over again.
- Reduce energy demand by eliminating unnecessary economic activity.
Comment: Nothing has been done in this regard unless you count the shipping of jobs overseas.
- Reduce energy demand by reducing human population levels (e.g., closing our borders, deporting as many as possible and discouraging births).
Comment: There are periodic calls for immigration restrictions but little has been done. Deportations are currently focused on people thought to be likely threats to the country and as such are part of the so-called "War on Terror." While birthrates had been declining for a long time, they have now resumed an upward trend due in part to the influx of immigrants who tend to have larger families.
- Plant “Victory Gardens” throughout the country.
Comment: The local food movement has become surprisingly vibrant in the United States. While home and community gardens still make up only a small fraction of the food supply, their popularity is expanding rapidly.
- Heavy funding for basic energy research.
Comment: While funding is large for basic energy research, much of it is directed at fossil fuels instead of renewable energy sources.
- Pollution control rollback, streamline permitting (no Environmental Impact Statements, etc.) for alternate energy. No more permits for fossil fuel power plants. No more funding for roads. No more building permits except in special cases.
Comment: While President George W. Bush did his level best to roll back environmental rules for power plants and industry and to streamline permitting, he did it primarily on behalf of fossil fuel installations instead of alternative energy projects. Road building continues apace; but the recession (depression?) has slowed new building permits to a crawl.
- Full-on conservation, local energy production to minimize grid vulnerabilities, and a crash alternate energy production program. (Conservation will help under a government that limits economic activity).
Comment: Marginal efforts have been made here and there (e.g. weatherization programs, renewable energy portfolio standards), but nothing that could be characterized as "full-on."
- Free mass transit.
Comment: While mass transit ridership has been rising as the fuel costs of owning an automobile have increased, only marginal efforts have been made to expand the availability of mass transit. In addition, fares for mass transit users have actually been rising.
The report card for the United States as a war socialist society is decidedly mixed. We seem to have the war part down. But the socialist part is lacking. The current administration wants to redistribute benefits in American society, most notably through new health care spending meant to bring all people under some kind of coverage. It has enacted funding for a plethora of public works projects, but many of them are simply more road building. The administration seeks to expand renewable energy, but has a keen interest in the coal industry through such doubtful technologies as carbon sequestration.
But one might ask why the socialism part of Hanson's war socialism society is so important? The answer is social cohesion. In the coming crisis if people don't feel they have a stake in the system, then they will be much less likely to work or fight or submit to the rules for the common good. Hanson believes that without substantial internal cooperation, no society will weather the coming storm. Instead, we may simply devolve into a lawless anarchy.
War socialist ideas are also in the news in Great Britain where the British National Party won seats in the European Parliament. This case is interesting because the BNP is explicit about the danger of peak oil and the world of shrinking resources we can expect. Some of its prescriptions sound harsh, and others seem enlightened. The party has been trying to repackage itself with difficulty because of its racist, right-wing heritage. The basic BNP response is increased self-sufficiency and isolation: 1) a military which defends Great Britain and doesn't seek foreign adventures, 2) a halt to immigration, 3) deportation of illegals and noncitizen criminals, 4) a devolution of power to local governments, 5) a reversal of the privatization of British rails and new investment to expand public transportation, 6) a selective withdrawal from the global economy and increased local manufacturing, 7) food self-sufficiency based on organic methods, and 8) cooperative ownership of power production (with wind given as a primary example).
The BNP website no longer makes it sound like a party that fits neatly within the reactionary right (though in practice its emphasis on a "white" Britain remains central). Still, some of its ideas are actually quite close to those described by Hanson as war socialism. What's not in view is an aggressive foreign and military policy designed to extract resources from competing nations, something that Britain's major parties clearly embrace. The BNP, which is a minor party, is relevant to British politics because major parties often neutralize minor ones by co-opting their ideas. And, Britain is actually further along the war socialism path than the United States.
We and Hanson can still hope for unprecedented cooperation to manage the coming decline. But he may be right that if that cooperation doesn't emerge, we may be faced with a decision about making preparations for an all-out and probably violent scramble for the world's remaining resources--a contest in which a disciplined, cohesive and militarized society has the best chance of survival. Is he missing a viable third or fourth way? Even more important, is there time to implement a different path as nations successively awaken to the realities of peak oil and resource stringency and increasingly focus on self-preservation rather than cooperation?
Obesity Rates Continue to Climb in U.S.
Eight of 10 states with highest number of obese adults are in the South
The rates of adult obesity in the United States increased in 23 states during the past year and did not decrease in any state. And the number of obese and overweight children has now climbed to 30 percent in 30 states, a troubling trend that could signal decades of weight-related health problems such as cancer, diabetes and heart disease as these children become adults. Those are just some of the worrisome findings in an annual report on obesity in America, released Wednesday by the Trust for America's Health and the Robert Wood Johnson Foundation.
"This report reaffirms that obesity is a danger both abundantly clear and almost universally present," said Dr. David L. Katz, director of the Yale University School of Medicine Prevention Research Center, who was not involved in the report. "It truly is a public health crisis of the first order, driving many of the trends in chronic disease, in particular the ever-rising rates of diabetes."
For the fifth year in a row, Mississippi topped the list as the state with the highest rate of adult obesity, at 32.5 percent, according to the report, F as in Fat: How Obesity Policies Are Failing in America 2009. Besides Mississippi, West Virginia, Alabama and Tennessee have obesity rates above 30 percent. Eight of the 10 states with the highest number of obese adults are in the South. The state with the lowest adult obesity rate is Colorado, at 18.9 percent, according to the report. In 31 states, obesity rates exceed 25 percent, and in 49 states and Washington, D.C., the rates are above 20 percent.
Overall, two-thirds of American adults are now obese or overweight, according to the report. As recently as 1991, no state had an adult obesity rate higher than 20 percent; in 1980 just 15 percent of adults were obese, the report noted. And childhood obesity continues to be a growing concern, with the rate of childhood obesity more than tripling since 1980. Mississippi also had the dubious distinction of posting the highest rate of obesity in children ages 10 to 17, at 44.4 percent. Minnesota and Utah had the lowest rates, both at 23.1 percent. The South is home to eight of the 10 states with the highest rates of obese or overweight children.
The current economic crisis could make the obesity epidemic worse, with food costs -- especially for nutritious foods -- expected to rise. And the numbers of Americans struggling with depression, anxiety and stress, which can contribute to obesity, are increasing, the report said. Not all the trends covered in the report were discouraging. Some other findings:
- Standards for school meals in 19 states are stricter than United States Department of Agriculture requirements. Five years ago, just four states had laws mandating stricter standards.
- Nutritional standards for foods sold in schools exist in 27 states, compared to six states five years ago.
- Weight screening of children and teens is now required in 20 states; five years ago it was just four states.
Still, the health risks posed by the obesity epidemic are inescapable. Baby boomer's have the highest rate of obesity, compared with previous generations. And as boomers age, Medicare will have to pay a hefty price for the chronic conditions caused by obesity, the report said. Why are so many Americans so fat? "Quite simply," Katz said, "because we can."
"Throughout almost all of human history, calories have been relatively scarce and hard to get, and physical activity an unavoidable part of survival," he said. "We have now devised a modern world in which physical activity is scarce and hard to get, and calories are unavoidable. We are the proverbial fish out of water, living in an environment totally at odds with our physiology." To help reverse the obesity trend, the report authors offered a number of solutions, including nutrition and obesity counseling and screening for obesity-related diseases, both for adults and children.
They also recommended increasing the number of programs in communities that make nutritious foods more affordable and accessible, and providing safe places for people to get physical activity. The report also called upon local, state and the federal governments to support programs that provide schools with healthy foods, make healthy foods more affordable, support more physical activities at schools, get kids to watch less TV and spend less time with computers and video games, and encourage companies to offer workplace wellness programs.