Peanut stand, 230 Grand Street, New York CIty
Ilargi: All I really want to say today is: "Watch out people, the whole thing is falling apart. Assume that it will, and act accordingly. The risk of not doing so is simply too great." I'm not talking about money, or only about money at least. It's time to take a good look around and see where you are. Where is your family, where are your friends? Can you bring them closer to you, can you wake them up? What can you provide for yourself in you present setting? Can you feed yourself, your kids, your parents?
For those of us who follow the economic news it must be clear by now: there are no green shoots. And there never have been, as I've consistently maintained throughout. It was all just make believe from the get-go. The Obama administration never believed their own stories either (they're not that "thick"), they were just playing for time. If the polls tell you that the truth will take away the grip on power you worked so hard to achieve, you steer clear of the truth. It's called politics.
People often ask me why I think politicians would keep on repeating things they know are not true. Why, if they know better, they don't warn their voters. And it's really as simple as that: politics is a form of brain damage. Those of us who don't have the drive to seek power have a hard time understanding what it is that makes some of us so eager to make decisions that influence the lives of countless others. But those who have that power will do -almost- anything to hold on to it.
And every single time they are challenged as to their past predictions and speeches they can always use the line US Vice-president Joe Biden used yesterday: "Nobody saw this coming (i.e. so you can't blame me)". Likewise, there are tons of people questioning the value of what I do on this website, The Automatic Earth. The reasoning: Nobody can predict the future.
Now, while that is partly true, it is not entirely. Racing a car without breaks towards a massive brick wall at 200 miles an hour tends to lead to a pretty predictable picture, especially during the last few yards. Parts of the future are predictable, and we’ll all acknowledge that when provided with the right examples.
The Automatic Earth, certainly since yesterday, but in reality all through the time we've been here, is on record as predicting a looming massive debt deflationary period. It remains to this day, and undoubtedly into tomorrow, a contested prediction. Many of the counterarguments, and their proponents, look to be cast in immovable stone. Still, those arguments themselves remain weak.
Perhaps I should clear up a point that Stoneleigh didn't emphasize in yesterday's The unbearable mightiness of deflation. We fully expect inflation to set in in the US, and likely in many other parts of the world. But that will become an issue only after debt deflation, propelled by a deleveraging that boggles the mind, will have run its course. And, as I've indicated before, the damage to our societies caused by this deflation scourge will be so severe that inflation will be the least of your worries.
The deflation we're talking about will be a scourge of truly Biblical proportions. And it won't be so short that it can be brushed off, either, as I saw Peter Schiff contend recently. Our economic and financial system lived the high life off the credit expansion of the past few decades. Now the bill is presented in the (yes, predictable) form of a credit contraction, and there's no way we can escape it, or wish it away, or outsmart it by creating more debt -as our political class tries to make us believe-.
Yes, there is a huge risk of inflation, but it's not now. And when we get there, we will all have completely different concerns from the ones we have now. Or, at least, that is, should have.
We are not alone in warning of this debt deflation. Today alone, I can present Steve Keen, Martin Weiss, Hugh Hendry, Niels Jensen, John Mauldin, Antal Fekete and Minyanville's Mr. Practical. They all predict deflation. Not bad for one day, if I may say so. And many more will follow, while most of those who don't will be held back by the immovable stone their ideas are held captive in.
Meanwhile, we've explained it numerous times, and we will continue to do so. The danger ahead simply is too grave to be silent.
As for the recession -which would be called a depression by any logical standards-: Honey, we're just getting started, and everything our governments have done to date only serves to make it infinitely worse. That's what politicians will do to hold on to power. You got to snatch it from their cold dead hands.
US lurching towards 'debt explosion' with long-term interest rates on course to double
The US economy is lurching towards crisis with long-term interest rates on course to double, crippling the country’s ability to pay its debts and potentially plunging it into another recession, according to a study by the US’s own central bank. In a 2003 paper, Thomas Laubach, the US Federal Reserve’s senior economist, calculated the impact on long-term interest rates of rising fiscal deficits and soaring national debt. Applying his assumptions to the recent spike in the US fiscal deficit and national debt, long-term interests rates will double from their current 3.5pc.
The impact would be devastating by making it punitively expensive to finance national borrowings and leading to what Tim Congdon, founder of Lombard Street Research, called a "debt explosion". Mr Laubach’s study has implications for the UK, too, as public debt is soaring. A US crisis would have implications for the rest of the world, in any case. Using historical examples for his paper, New Evidence on the Interest Rate Effects of Budget Deficits and Debt, Mr Laubach came to the conclusion that "a percentage point increase in the projected deficit-to-GDP ratio raises the 10-year bond rate expected to prevail five years into the future by 20 to 40 basis points, a typical estimate is about 25 basis points".
The US deficit has blown out from 3pc to 13.5pc in the past year but long-term rates are largely unchanged. Assuming Mr Laubach’s "typical estimate", long-term rates have to climb 2.5 percentage points. He added: "Similarly, a percentage point increase in the projected debt-to-GDP ratio raises future interest rates by about 4 to 5 basis points." Economists are predicting a wide range of ratios but Mr Congdon said it was "not unreasonable" to assume debt doubling to 140pc. At that level, Mr Laubach’s calculations would see long-term rates rise by 3.5 percentage points.
The study is damning because Mr Laubach was the Fed’s economist at the time, going on to become its senior economist between 2005 and 2008, when he stepped down. As a result, the doubling in rates is the US central bank’s own prediction. Mr Congdon said the study illustrated the "horrifying" consequences for leading western economies of bailing out their banks and attempting to stimulate markets by cutting taxes and boosting public spending. He said the markets had failed to digest fully the scale of fiscal largesse and said "current gilt yields [public debt] are extraordinary low given the size of deficits". Should the cost of raising or refinancing public debt in the markets double, "the debt could just explode", he said, adding that it would come to a head in "five to 10 years".
'Time bomb' in commercial mortgages poses big test for the Fed
The US Federal Reserve is trying to defuse a "ticking time bomb" of hundreds of billion of dollars of maturing loans made to finance shopping malls, office blocks and other commercial property.The ability to refinance commercial mortgages at low interest rates has been hit hard by the credit crunch.
Commercial mortgage loans to the value of $400bn are due to be repaid this year. If the debtors default, the properties backing the debt could be put up for sale, which is likely to push declining prices lower still. "I am very concerned about the ticking time bomb we face in commercial real estate lending," Democratic congresswoman Carolyn Maloney said at a Congressional hearing last month. Her comments are echoed in private discussions with regulators, who fear the sector poses risks to the financial system. Commercial mortgage financing is split into two sectors. One consists of traditional loans - mostly held by banks or insurance companies. The other consists of bonds backed by pools of loans, so-called commercial mortgage-backed securities (CMBS).
It is this latter sector that the Fed needs to fix. Next week it will offer cheap loans to investors, which they can use to buy CMBS. This method is already being used to pump up demand for securities backed by credit card and auto loans. Extending the plan - the term asset-backed securities loan facility (Talf) - to property is highly complex, not least because of the greater risk of losses. Recently, more than $200bn of CMBS with triple A ratings were downgraded. "It is very important that the CMBS market revives at some point and that the Fed's plans work," says Aaron Bryson, analyst at Barclays Capital. "It is too much to ask for banks and insurance companies to refinance all the maturing commercial mortgages. The CMBS market is needed, too, to avoid a worsening of the refinancing problems."
With interest rates on some of the $3,400bn of outstanding commercial real estate loans high, it has been difficult for developers to obtain new loans. Commercial mortgages tend to be made only once banks believe they can either sell the loans or finance them via CMBS. William Dudley, president of the Federal Reserve Bank of New York, which runs the Talf, stresses that fixing CMBS is the biggest test yet of attempts to revive the securitised markets. Its roll-out "will be important in determining the overall success of the programme," he says.
Say "securitisation" and people "think of on-off balance sheet, manipulation, Enron and Parmalat . . obscure language, high fees and toxic assets classes", as PriceWaterhouseCoopers, the consultancy, wrote recently. But the technique emerged long before these scandals. In the 1970s bankers hit on the idea of issuing bonds backed ("secured") by cash flows, such as interest payments, generated from a pool of assets, such as loans. Typically a bank or company places assets in a legally separate special purpose vehicle and the SPV then issues notes to investors - sliced and diced to reflect different levels of risk. In theory, thisallows the original company to shift assets off its balance sheet, dispersing risk around the banking system and making room for new loans.
Ilargi: Hugh Hendry gets it all exactly right in this interview with Gillian Tett. I recommend you listen closely.
Hugh Hendry: Deflation remains the major risk to economic growth
Economic Stress Up In States, Counties Across Nation
California, Michigan and South Carolina suffered the most financial pain in May as unemployment, home foreclosures and bankruptcies rose, according to The Associated Press' monthly analysis of economic stress in more than 3,100 U.S. counties. The latest results of the AP's Economic Stress Index show the worst financial crisis since the 1930s causing lingering damage even as other signs suggest the recession is winding down. The average county's Stress score, fueled by worsening unemployment, foreclosures and bankruptcies, rose to 10 in May, from 9.7 in April.
In May 2008, the average Stress score was 6.2. The pain was lower then because the economy was still expanding. In fact, the second quarter of 2008 was the last time the economy grew. The AP calculates a score from 1 to 100 based on each county's unemployment, foreclosure and bankruptcy rates. The higher the score, the higher the economic stress. Under a rough rule of thumb, a county is considered stressed when its score zooms past 11. In May, 36 percent of the counties scored 11 or higher, up from 34 percent in April. But the latest reading was slightly better than February and March, when nearly 40 percent of counties were at or above that threshold.
Federal Reserve Chairman Ben Bernanke and many other economists predict the recession will end later this year. Even if it does, unemployment, foreclosures and bankruptcies are likely to keep climbing and cause further harm in many communities, economists predicted. "The pain will linger well after the recession is over, making for a subdued economic recovery," said Richard Yamarone, economist at Argus Research.
Many economists say the recession eased from April to June and that the economy might start growing again as soon as the current July-to-September quarter. Among states, California, Michigan and South Carolina showed the most economic stress in May, with their counties' scores averaging 16, 15.9 and 15, respectively, the AP analysis shows. California has been battered by the housing bust, and Michigan has absorbed the brunt of the auto industry crisis. "And South Carolina is a little bit of everything," said Sean Snaith, economics professor at the University of Central Florida. "Manufacturing and construction jobs have been hard hit in the state."
One common thread running through all three states is heavy jobs losses. Rising unemployment, in turn, is escalating foreclosures and bankruptcies. The rising economic stress comes as California, saddled with a whopping $24.3 billion budget deficit, and other states are scrambling to cope with fiscal crises. Over the past year, South Carolina, Oregon and Indiana have suffered the most stress. The loss of manufacturing jobs has deepened Indiana's and South Carolina's woes. And Oregon has been hurt by the real-estate bust and falling demand for construction materials like plywood and windows that are produced in the state.
North Dakota and Nebraska were the least stressed states in May, with county scores averaging under 5. Those Plains states also fared the best over the past year. North Dakota has been helped by the oil business. Nebraska has benefited from the relative strength of two of its main industries: agriculture and food-production. "Those are also some of the few places that didn't experience the housing boom and therefore escaped the intense problems of the housing bust," said John Silvia, chief economist at Wachovia.
At the county level, the highest scores in May for those with populations of at least 25,000 residents were Imperial County, Calif; Merced County, Calif.; Yuma County, Ariz.; Lauderdale County, Tenn.; and Stanislaus, Calif. Merced and Stanislaus have endured some of the nation's highest foreclosure rates in the past year. And even in good times, Imperial, Lauderdale and Yuma have been among the most impoverished U.S. counties. The counties (of at least 25,000 residents) that suffered the sharpest increases in stress scores over the past year were manufacturing communities: Williams County, Ohio; Elkhart County, Ind.; Huntingdon County, Pa.; Howard County, Ind.; Union County, S.C.; and Noble, Ind.
AP's analysis also found that foreclosure rates climbed over the past year in areas hardest hit by the housing crisis: Arizona, California, Florida, Nevada and metro Atlanta. Foreclosures also jumped in some Utah counties that had experienced rapid growth in the past decade. "It was a speculative bubble, and when the economy popped, it hit us hard," said Dean Cox, administrator for Washington County in southwest Utah, where the foreclosure rate more than doubled to 4 percent in the past year.
Bankruptcy rates also grew in areas where the housing bust struck hardest: Southern California, southern Oregon and Las Vegas. "It's not surprising, since the inability to make your mortgage payment is a pretty good proxy of the financial situation households are in," said Samuel Gerdano, executive director of the American Bankruptcy Institute. Gerdano says he foresees an estimated 1.5 million bankruptcy filings this year _ the most since the nation's bankruptcy laws were tightened in 2005.
California downgraded to one notch above junk
California's bond rating is far from golden. Citing the Golden State's ongoing budget upheaval, Fitch Ratings on Monday downgraded California's long-term debt to BBB, one notch above junk bond status. Fitch also maintained its so-called negative outlook on California. "[I]nstitutional gridlock could persist, further aggravating the state's already severe economic, revenue and liquidity challenges," Fitch wrote.
While Gov. Arnold Schwarzenegger and lawmakers battle over closing a $26.3 billion budget gap, the state's controller last week was forced to issue IOUs for the first time in 17 years.
Some county agencies, state vendors and taxpayers are getting paid in paper. The IOUs help the state controller stave off a deficit of nearly $3 billion for July. California has the lowest bond rating of any state, and therefore must pay higher interest rates than its peers when it issues debt. The other two major ratings agencies -- Standard & Poors and Moody's -- had previously placed the state on watch for a possible downgrade. They did not follow Fitch's lead Monday and have maintained California's ratings at several levels above junk.
Moody's put the state on watch in mid-June after Controller John Chiang warned of the pending cash shortfall. Standard & Poors affirmed its rating last week "We believe California retains the ability to take the actions necessary to meet its debt service payments in full and on time, although we remain concerned about the state's financial liquidity," wrote Standard & Poors analyst Gabriel Petek.
California Has Successfully Created Its Own Currency
We put out an offer of 50 cents on the dollar for California IOUs last week, and while we got a lot of debate about what they're worth, we got absolutely zero offers. Admittedly it was a real low-ball bid, considering that banks (for now) are accepting them, they're paying yield, and at least some assume they carry an implicit backstop from Uncle Sam. We were just hoping to shake out some weak hands somewhere.
The FT reports on some inchoate efforts to create a market in these IOUs. It notes that some people are offering to buy them on Craigslist, though to be honest the market there seems real thin --- just a few people (like us) trying to shake out the desperate. They also point to some guy who tried to set up an online IOU marketplace, though that appears to have no activity at all. The attention from this FT piece will probably be its high point. On the other hand, some hedge funds and the like are apparently interested in trading them.
All of this suggests that California has basically created its own currency. When legitimate financial institutions are willing to trade them (at least for now), and there's no gray market on Craigslist, where big discounts to face value can be had, then you know that the California IOU is basically being treated like cash. It's just more paper for our paper-filled economy.
The California IOU is like the currency of some third-world country that has to pay its debt in dollars. The only thing California can't do is demand residents treat the IOUs as legal tender (that would be a violation of the Constitution [yeah, that ol' thing]), but in a cash-short economy, some will probably choose to do so anyway. In the meantime, expect a paucity of stories about California's 11th hour crisis. They've solved it! What's the rush to cut spending?
Calls for More Stimulus Spending Grow in U.S.
Vice President Joe Biden said the Obama administration "misread how bad the economy was" and didn't foresee unemployment levels nearing double digits, in comments likely to intensify calls for the administration to do more to counter job losses. Some economists are pressing the White House to enact a second round of stimulus spending or find some other way to avert a prolonged job and wage slump. But the White House is in a tough spot.
Officials want to give the $787 billion stimulus package passed in February time to work -- only 10% of the spending is out the door so far -- and there is little appetite in Congress, particularly among Republicans, for spending more money at a time of record deficits. The gloomy job picture threatens any economic recovery. The unemployment rate hit 9.5% last month, figures released last week show, and many now expect it to stay high for a long time, eventually reaching double digits. At the same time, wage growth is slumping. People facing unemployment or wage cuts are less able or willing to spend the money needed to stimulate the economy.
Already, job losses are hindering recovery in the housing market as foreclosures among people with good credit who have been laid off compound the problems with risky mortgages that triggered the sector's implosion. "They're in a bind because the recovery package is just starting to generate positive benefits but, to the extent we know something about the future, unemployment is too high and is going to stay high for a long period," said Lawrence Mishel, president of the Economic Policy Institute, a left-leaning Washington think tank. "When we hit 10% unemployment, which we will within months...even those who don't lose a job will be affected by the squeeze on wage growth, furloughs and the cutbacks in [retirement] plans," he said.
White House economists are discussing whether a second round of stimulus is needed, but a decision isn't expected until at least the fall. "We remain focused on putting thousands of Americans back to work" through implementation of the February stimulus act, an administration official said Sunday. "Any discussion of a second stimulus is premature at this point." That timetable isn't fast enough for some economists, who say quick action is necessary to avoid a protracted period of joblessness.
"A second stimulus should be the one they should have done the first time, something that is relatively fast and thoughtful," said Phillip Swagel, a professor at Georgetown University's McDonough School of Business. Mr. Swagel, a former Treasury assistant secretary for economic policy under President George W. Bush, said a more-effective package could include more assistance to struggling state and local governments and personal tax cuts. So far, though, politicians of both parties are showing little eagerness to tackle another stimulus bill. Republicans have attacked the current stimulus package as wasteful and ineffective, labeling it as government bloat at a time of record deficits. As the GOP seeks to reclaim the mantle of fiscal discipline, many are loath to support another round of government spending.
"This was supposed to be about jobs, jobs, and jobs. And the fact is, it turned into nothing more than spending, spending, and more spending on a lot of big government bureaucracy," House Minority Leader John Boehner of Ohio said on "Fox News Sunday." Many Democrats, too, said they're disappointed with the recovery program so far but, for now at least, are resisting calls for a second package. "I don't think anybody can honestly say that we're satisfied with the results so far of the stimulus," House Majority Leader Steny Hoyer (D., Md.) said on "Fox News Sunday." But he said it was too soon to push for more. "We certainly want to see how this develops over the next few months."
Mr. Biden, in an interview with ABC News's "This Week," said the 9.5% jobless rate is "much too high" and acknowledged that the administration didn't anticipate the severity of the economic problems. "There was a misreading of just how bad an economy we inherited," he said in the interview, which aired Sunday. He and other White House officials say the administration relied on consensus economic figures in January when they were developing the stimulus package. But he said it was premature to consider a second stimulus, saying the $787 billion will be spent over a period of 18 months and would take time to work
Administration plans for end of 'too big to fail'
They are the biggest of the big — the Citigroups, the Goldman Sachses, the AIGs and other financial behemoths. The Obama administration doesn't want so many around anymore. Financial regulations proposed by the president would result in leaner and simpler institutions that don't carry the weight of the system on their marble columns. Around Washington and Wall Street they have come to be known as TBTF — too big to fail. It's not just size, though.
These companies are so far-flung, so intertwined and so precariously leveraged that a single one's collapse can create systemwide tremors that imperil the finances of millions of Americans. With that fear in mind, the government stepped in to bail out Citigroup Inc., Bank of America Corp. and American International Group Inc. with tens of billions of public money last year. Looking to avoid such a costly intervention, President Barack Obama's regulatory plan calls for large, interconnected companies to pay a heavy price for the systemwide risk they pose.
So far, however, congressional debate has centered on the administration's plan to put the Federal Reserve in charge of these "systemically significant" companies. Less attention has focused on the potential effect on the institutions and the financial system's hierarchy. Under the administration's proposal, companies such as Citi, Goldman Sachs and others in a broad top tier engaged in complex transactions would face stricter scrutiny and have to hold more assets and more cash as cushions against a downturn.
They also would have to anticipate their own demise, drafting detailed descriptions of how they could be dismantled quickly without causing damaging repercussions. Think of it as planning their own funerals — and burials.
Obama's plan, in short, aims to make it far less appealing to be so big. That was the middle ground the administration sought, a step short of an outright ban on systemically risky companies. "Without banning them we're providing some pretty heavy penalties for entering" the top group of institutions that could pose a risk to the entire financial system, said Diana Farrell, deputy director of the White House's National Economic Council.
"The regulator might say to a large institution, 'Make sure there is very good reason to allow yourself to get that big, or that interconnected, or that complex because the penalties will wipe out any advantages, such as lower cost of capital, you might have.'" Some companies, such as Citi and Goldman Sachs, might bite the bullet and take on the added burden; in global capital markets some firms need to be large. Others might choose to reduce their financial footprint.
"It's a very sophisticated and very effective way to force institutions to deconsolidate," said Karen Shaw Petrou, managing partner at Federal Financial Analytics, a consulting firm that advises financial institutions
One nonbank giant is already fighting back. General Electric Co. has come out against a proposal that would tighten rules limiting companies from mixing banking and commerce. That could require GE to get rid of GE Capital, its sizable financial unit. Analysts say some of the top banks that had Fed stress tests, such as Wells Fargo & Co. or Morgan Stanley, might have to weigh the cost of meeting new regulations against the benefits of their size and reach.
The severity of the conditions remains to be seen. Under Obama's plan, those details would be worked out by the Fed and a council of regulators led by the treasury secretary. Congress would have to agree to that framework, however, and lawmakers from both parties have voiced misgivings about putting the Fed in charge. "If I was a big player, I'd be very interested in what the specific requirements were likely to be so I would know whether I needed to restructure," said Oliver Ireland, a partner in the financial services practice of the law firm of Morrison & Foerster. "It creates an uncertainty for a significant period going forward."
In the end, there will be institutions that meet top tier specifications and will not break themselves up to escape the tougher oversight. But others whose business would place them just inside or outside of that classification could end up divesting or reconsidering expansion or acquisitions. "Where you're going to see the impact of that regime affecting size and complexity decisions of management is on the cusp," said John Dearie, executive vice president of the Financial Services Forum, a group made up of chief executives of 17 of the largest and most diversified financial institutions doing business in the United States.
For those that qualify for top tier designation, the administration proposes a system that would dismantle them quickly if they get into financial trouble. Right now, the government has authority to step in and take down troubled banks, but not the conglomerates that pose greater risks to the economy. That lack of authority prevented the government from dissolving Bear Stearns Cos., Lehman Brothers and AIG in an orderly manner. Under the administration's plan, the Treasury could decide to take a company swiftly through a bankruptcy-like process, appointing the Federal Deposit Insurance Corp. as a conservator or receiver. The FDIC currently now only has the authority to take over troubled banks.
If a swift end could cause a systemwide risk, the administration would allow a government intervention that still could require taxpayer money up front. The administration recommends that the cost of any taxpayer infusion be paid later with fees assessed on bank holding companies. Farrell noted that capitalization requirements for the companies would help lessen the infusion of government money. The government would be aided by the failing company's own plan to wind down.
Anil Kashyap, an economist at the University of Chicago School of Business, said simply creating a "funeral plan" could lead some companies to reconsider some of their business strategies. "The ones that would be more complicated would have to explain to their shareholders why they are so complicated and why they would have to have more capital" to cover their dissolution, Kashyap said. "That would be a very productive outcome."
The Unwinding of Lehman Brothers
Bryan Marsal, CEO of Lehman Brothers Holdings, has been unwinding Lehman Brothers since the firm’s historic collapse. He discusses the process with CNBC.
Like Roaches, Wall Street Survives
It is said that roaches would survive a nuclear conflagration. But Wall Street is proving similarly resilient to financial Armageddon. Despite the collapse of Lehman Brothers, the wobbles of big banks and the scarcity of financing across the world, the investment banking business just keeps going.
For every firm that has gone under, a new competitor — lured by the juicy fees on advising mergers, trading securities and underwriting stocks and bonds — seems to have sprung up. In the case of Lehman, one failure even begat two entrants. As in the auto business, where, despite bankruptcies, companies are still geared up to make too many cars, banking overcapacity could sow the seeds of trouble. Ambitious new rivals traditionally bid up pay scales and undercut pricing to win business, slamming profitability for the entire industry.
Wells Fargo is the latest to muscle in. The San Francisco-based bank, which once declared anything east of the Mississippi might as well be in China, plans to beef up the second-tier Wall Street operation it picked up when it rescued Wachovia. John Stumpf, Wells Fargo’s chief executive, boasted on Monday: "We have an enormous opportunity to become one of the top customer-focused investment banks."
Getting Wells Fargo Securities into fighting trim will be a costly endeavor. While never among the top of the crop, the Wachovia arm has dropped to 15th place from 12th a year ago in Dealogic’s ranking of global investment banking revenues. Its market share slid by a quarter to a paltry 1.4 percent. To offer its enlarged client base higher-margin products, Wells Fargo will need to invest and hire bankers. The trouble is, while the downturn may have put talent on the market, Wells won’t be alone in competing for top producers.
Notably, there are the two pretenders to the bulge bracket spawned by Lehman’s demise, which are already fighting over talent and deals. Barclays Capital bought Lehman’s United States arm, and Nomura grabbed its European and Asian businesses. But to offer their clients global solutions, both need to complete their geographic and product footprints — for BarCap that’s meant hiring big-shot bankers in London and Hong Kong, while for Nomura, it means filling in holes in New York. Like roaches, Wall Street names may come and go, but they rarely die off altogether.
A formula to fix: Securitisation runs out of road
by Gillian Tett and Aline Van Duyn
When the European Securitisation Forum held its annual meeting in June 2007, thousands of bankers descended on Barcelona to drink champagne and dance to a bankers' rock band called D'Leverage. Last month, when the trade body representing financiers engaged in slicing and dicing debt held its 2009 event, a mood of grim austerity prevailed. Instead of a seaside resort, the proceedings took place in a hotel on Edgware Road, a traffic-clogged London street better known for cheap takeaways. In place of plentiful champagne, there was coffee. D'Leverage were nowhere to be seen, since dancing was "inappropriate", as one organiser explained.
No wonder. Until two years ago, most bankers, and economists, were celebrating the fact that securitisation appeared to be on an unstoppable roll. In recent decades, bankers have become adept at repackaging all manner of credit, from mortgages to commercial loans, into bonds that can be sold to investors. And five years ago, this activity started to explode at a startling rate, both reflecting and amplifying the wider credit bubble. However, since mid-2007, it has all come to a dramatic halt as investors have taken fright. Whereas $2,500bn (€1,800bn, £1,500bn) of loans were securitised in 2007, in the US last year almost none were sold to private-sector buyers.
"The securitisation market has seized up," says Tim Ryan, head of the Securities Industry and Financial Markets Association, a trade body. For those banks whose business models assumed securitisation would only ever grow, this has all come as a brutal shock. It also creates a huge macroeconomic headache. Precisely because banks have become adept at repackaging their loans into bonds for sale - and thus removing them from their balance sheets - they have been able to provide more credit than in earlier decades. Or, to put it another way, during the past decade it has been investors holding securitised bonds, not just banks, that have been acting as key lenders to the economy.
Citigroup, for example, calculates that in 2008 the securitisation markets were supplying between 30 per cent and 75 per cent of the credit in different sectors of American finance. The western economy has become akin to a twin-engine plane: driven by one motor of "traditional" banking - and another from securitisation. But the freeze in securitisation markets has led to a dramatic shortage of lending power - a "credit crunch". Thus the policy question now is whether there is any way to restart or replace this securitisation "motor" to stop the economy slowing further.
"About $8,700bn of assets are currently funded by securitisation [globally] . . . and [if] this securitised leverage matures with no replacement, global economies will be forced to contract," warns Citi in a report. In the past year, governments have experimented with stop-gap measures to plug the financing hole. Western central banks have conducted "repurchase operations", where banks can post unwanted securitised bonds as collateral to borrow funds from central banks. The US government has been running the term asset-backed securities loan facility (Talf) programmes, which give investment groups access to cheap leverage so they can buy securitised bonds. Western politicians have urged banks to increase "traditional" lending.
But so far none of these measures has fixed the problem. Banks cannot hope to fill the hole left by the implosion of the securitisation market with traditional lending, since they are under pressure from regulators to improve capital ratios. Central bank repurchase and Talf schemes are intended to be temporary. Most politicians vehemently oppose the idea of further taxpayer-funded subsidies to the financial sphere. So what most bankers and many policymakers are trying to do is find ways to restart securitisation markets. In recent months, the European Commission has been pushing a package of reforms that would make them appealing for investors again by imposing more transparency. This is based on the widely held view that credit markets spun out of control because securitisation became so opaque that it was impossible for creditors to monitor risk.
"Securitisations have become ridiculously complex," Francesco Papadia, director-general of market operations at the European Central Bank says. "Structures should become simpler, plain-vanilla deals." The Commission is therefore demanding that rating agencies and bankers disclose more information about deals. Banks should also keep 5 per cent of any securitised bonds that they arrange, so they have enough "skin in the game" to monitor credit risks properly.
Similar proposals have been unveiled by the US administration. Tim Geithner, US Treasury secretary, and Lawrence Summers, President Barack Obama's chief economic adviser, said in an article that securitisation should, in theory, reduce credit risk by spreading it more widely - but that the breaking of the direct link between borrowers and lenders "led to an erosion of lending standards, resulting in a market failure". They have proposed measures that would "impose robust reporting requirements on the issuers of asset-backed securities; reduce investors' and regulators' reliance on creditrating agencies; and . . . require the originator, sponsor or broker of a securitisation to retain a financial interest in its performance".
Even before such proposals bite, some bankers are embracing simplicity. For example, Tesco, the UK retail group, raised £430m last month by selling a bond backed by a collection of commercial mortgages on its stores. The deal, arranged by Goldman Sachs, was striking: not only was it the first commercial mortgage securitisation for two years but it was also designed to be extraordinarily simple, easy for investors to understand. This was in stark contrast to the deals popular in early 2007.
Moreover, the investors were mainstream asset managers - rather than the "shadow bank" entities, such as structured investment vehicles, that bought most securitised debt during the credit bubble. "This was like the deals that used to be done 20 years ago," says one banker. Or as Ralph Daloisio of Natixis, the French investment bank, notes: "If yesterday's securitisations were plagued by an oversupply of highly varied, complex, opaque and illiquid investments, tomorrow's should be simpler, more standardised, transparent and liquid."
But this drive towards "transparency" and "simplicity" comes with a catch: reform tends to raise the cost of finance. Deals such as the Tesco bond are likely to be more costly and time consuming than the structures used during the credit boom and if banks are forced to keep 5 per cent of any deal on their own balance sheets, that will raise costs further. Another problem is investor demand. Before the credit crash, shadow banks provided a significant source of demand. Now many of those entities have collapsed and traditional asset managers are often wary of the field. "Investors want to see the performance over time [of the new proposals]. They need to see evidence that [the market] works better," says Deborah Cunningham, of Federated Investors, who is involved in attempts to reform credit ratings.
A few brave investors are still dipping a toe in the market by buying existing securitised bonds. Two months ago bankers successfully sold triple A rated securitised bonds formerly held by Whistlejacket, a collapsed SIV. Henderson, the asset manager, says this was "an important watershed" for the market. Some banks are also busy recycling old, sometimes toxic, assets from their balance sheets. Barclays Capital, for example, has developed tools to conduct what it labels "smart securitisation", which enables clients, including the Barclays parent company, to cut the capital they must hold.
This works by pooling the assets with those of other clients into a securitisation vehicle large enough to be rated by a credit rating agency. With a decent rating, such a vehicle requires a lower level of capital to be held against it. "The securitisation market is absolutely not dead. My team is busier than it's ever been," says Geoff Smailes of Barclays Capital. Yet the $9,000bn question is whether activity such as this can actually restart the business of repackaging new loans - and on that front much still rests with politicians, not bankers. After all, as one central banker notes, at the heart of the whole debate there is a crucial "paradox": though politicians hate the credit crunch, many also remain deeply suspicious of the whole securitisation idea.
Thus when the securitisation conference took place in Edgware Road last month, Paul Sharma, a senior official at the Financial Services Authority, the main UK regulator, admitted that while he personally believes that securitisation will "return and have a significant and irreplaceable role in the financial system" one "should not assume that this is the majority view". Or as another senior European regulator says: "There are voices saying we should go back to simpler banking . . . to stop all this financial engineering."
The banking industry, for its part, is trying to fight back by pointing out that a clampdown on innovation is likely to raise the cost of capital. Sifma, the lobby group, recently started conducting discreet opinion polls to assess public attitudes towards banking. "We are convinced that getting securitisation started again is the single most important question facing the capital markets today," says Mr Ryan. Meanwhile, the American Securitization Forum announced that its 2010 conference will take place in Washington - not Las Vegas, the casino resort that has hosted recent events. But nobody expects this new dance with politicians to yield results soon: for the moment, in other words, the world seems destined to fly with one of its credit motors spluttering or stalled. It will be a long time before champagne flows freely at securitisation conferences again.
Securitisation reinvented to cut costs
Investment banks, including Goldman Sachs and Barclays Capital, are inventing schemes to reduce the capital cost of risky assets on banks’ balance sheets, in the latest sign that financial market innovation is far from dead. The schemes, which Goldman insiders refer to as "insurance" and BarCap calls "smart securitisation", use different mechanisms to achieve the same goal: cutting capital costs by up to half in some cases, at the same time as regulators are threatening to force banks to increase their capital requirements. BarCap’s structures involve the pooling of assets from several clients into a secured financial product that can be sold on to other investors and rated by a credit rating agency, potentially reducing the capital allocated against the assets by between 10 per cent and 50 per cent.
These new mechanisms are in some respects similar to the discredited structured products, which were widely blamed for fuelling the financial crisis. But the schemes’ backers argue there are two significant differences. First, they involve the securitisation of banks’ existing assets, rather than of new lending. Second, bankers argue that the new products do not disguise the transfer of risk. "This is the world of smart securitisation," said Geoff Smailes, managing director of global credit solutions at BarCap. "It’s not securitisation for leverage and arbitrage purposes any more. This is all about restructuring portfolios of assets to achieve risk, capital and funding efficiency in a transparent and less complex way." However, some regulators may be wary of the invention of new pooled asset derivatives, especially if they are perceived as a way to avoid regulatory capital requirements.
Some rival bankers also view the schemes with scepticism. "This is a system of capital arbitrage," said one senior banker at another investment bank. "The need for capital just miraculously disappears." BarCap has worked on portfolios worth hundreds of billions of pounds in recent months, including those of the Barclays’ parent company. Investors in the securitised products typically include the original banks, plus third parties, such as hedge funds and private equity firms, as well as BarCap itself. Separately, Goldman is working on what bankers said was a private-sector version of the UK government’s asset protection scheme. The goal would be similar – to reduce the capital that would need to be held against the assets – although Goldman has yet to find a balance between the risks and rewards that would be attractive to investors.
Investment banks do not believe they can compete with the government-sponsored APS, mainly due to scale. RBS and Lloyds between them are putting £560bn ($914bn) into the scheme. Under Goldman’s idea, it would sell an insurance product to a bank with a toxic portfolio, effectively shifting the risk of the underlying assets off the balance sheet. The insurance would require far less capital to be carried against it than the original assets. Deutsche Bank engineered a comparable structure to facilitate the dismantling of risk at failed insurer AIG, although bankers close to that transaction said without government involvement the cost of such a structure would be commercially unfeasible.
US home foreclosures expected to surge in coming months
Moratoriums from banks, government to expire, setting off new wave of default actions
Just as the nation's housing market has begun showing signs of stabilizing, another wave of foreclosures is poised to strike, possibly as early as this summer, inflicting new punishment on families, communities and the still-troubled national economy. Amid rising unemployment and falling home prices, mortgage loan defaults have surged to record levels this year. Until recently, many banks have put off launching foreclosure action on many troubled properties, in part because they had signed up for the home-stability plan from President Barack Obama's administration, which required them to consider the alternative of modifying loans to make it easier for borrowers to make payments.
But with many government and self-imposed foreclosure moratoriums expiring, the biggest lenders indicate they are likely to move more aggressively to clear a backlog of troubled mortgages. Home sales have been steadying nationally, thanks largely to an abundance of cheap foreclosed properties, government incentives and record low mortgage rates. Housing construction starts have flattened out, helping to bring supply into balance with demand. The rate of housing price declines has slowed as well, even turning up again in some communities.
But rising foreclosures will depress home values, pushing more homeowners underwater. Mark Zandi of Moody's Economy.com estimates that 15.4 million homeowners, about one in five of those with first mortgages, owe more on their homes than they are worth. Also, consumer confidence is already exceedingly low -- and another jolt to the housing market could further crimp spending, which has been pummeled by the deep recession and persistent weakness in the job market. The latest unemployment rate, for June, rose to 9.5 percent, and many analysts predict that it will keep rising until the middle of next year.
The rapid pace of layoffs is of particular concern. Employers shed nearly a half-million payrolls in June. Homeowners who have lost jobs have little chance of getting their mortgages modified. That puts many homeowners on a collision course with banks that are preparing to take a more aggressive stance on loan modifications. "Absolutely," said Chase spokesman Tom Kelly when asked about an impending spike in foreclosures.
Since April 6, Chase said, it had approved modifying 138,000 loans under the Obama program. But an undisclosed number of other Chase borrowers didn't meet modification eligibility, and many of those homeowners face possible foreclosure. Separate from that group, Kelly said, Chase is proceeding to deal with an additional 80,000 default borrowers whose foreclosure process had been voluntarily halted by the lender starting late last year.
Bank of America, the nation's largest servicer of home mortgages, also did not release the volume of likely foreclosures. The bank said it had extended offers to modify loans to more than 45,000 borrowers under the Obama plan. Bank of America spokesman Dan Frahm said the company was projecting a "slow increase" in the number of monthly foreclosures, potentially reaching 30 percent above previous normal levels. Just how big the foreclosure wave will be is unclear. Much will depend on how quickly lenders can push the process along. It generally takes three months to a year from the time a borrower receives a notice of default to a foreclosure sale, in which case the lender usually takes title of the property.
Government and company reports show that the number of completed foreclosures nationwide slowed sharply late last year and into early this year, largely because of various moratoriums in effect during the first quarter. Recent reports hint at the next wave of foreclosures. In the first quarter, 1.8 million homeowners nationwide fell behind on their loans by 60 to 90 days, a 15 percent increase from the prior quarter, according to Economy.com. The research firm said that loan defaults rose sharply as well, to 844,000 in the first three months of this year.
The Obama administration is racing to avert as many foreclosures as possible. So far, more than 240,000 distressed borrowers have been approved on a trial basis under the Home Affordable Modification Program, in which their loans are being reworked so monthly payments are targeted at 31 percent of their gross income, said Seth Wheeler, a senior adviser to Treasury Secretary Timothy Geithner. "We're very unlikely to implement another moratorium," Wheeler said but noted that the Treasury will monitor how many foreclosed homes are dumped into the market, suggesting officials could take other steps to prevent a flood of lender-owned properties.
S&P raises loss expectations for risky US mortgages
Standard & Poor's on Monday boosted its expectations for losses on risky loans backing U.S. mortgage securities to as much as 40 percent, suggesting a darkened outlook for the troubled housing market. The more dire assessment will likely "significantly impact" bonds originally carrying AAA ratings, S&P said in a report. Increased assumptions for total losses on subprime and Alt-A residential mortgage-backed securities come amid declines in market value of the debt and a surge in the inventory of bank-owned properties, S&P said.
It is another blow to investors who are already suffering from downgrades to their portfolios over the past two years as the housing market fell to the weakest levels since the 1930s. Many bonds are trading for cents on the dollar as investors value them based only on remaining interest payments that may be received. S&P boosted loss projections for subprime loans made at the peak of the market in 2006 and 2007 to 32 percent and 40 percent from 25 percent and 31 percent, respectively. For 2005 loans, loss projections rose to 14 percent from 10.5 percent.
For Alt-A loans, which were made to borrowers that provided reduced proof of their ability to repay, loss projections for 2006 and 2007 mortgages rose to 22.5 percent and 27 percent from 17.3 percent and 21 percent, respectively. S&P expects Alt-A loans from 2005 to post losses of 10 percent, up from its previous estimate of 7.75 percent. Loss severities, which include the costs to foreclose and liquidate a home and declines in property value, are expected to rise to 70 percent for 2006 and 2007 subprime bonds and 60 percent for Alt-A bonds issued in those years, S&P added. Some severities have already exceeded 100 percent, it said.
"We have observed increases in loss severities and we expect them to continue to rise until we reach the trough of the market value decline, which we believe will be in the first half of 2010," S&P said in the report. Rating companies, including S&P, have frequently revised expectations for losses on subprime, Alt-A and prime loans to reflect the deteriorating environment since 2006.
S&P said it now forecasts defaults on subprime loans issued in 2005, 2006 and 2007 at 11 percent, 30 percent and 49 percent, respectively.
So Many Foreclosures, So Little Logic
Last week, the stock market tumbled on news that housing foreclosures and delinquencies rose again in the first quarter. The Office of the Comptroller of the Currency said that among the 34 million loans it tracks, foreclosures in progress rose 22 percent, to 844,389. That figure was 73 percent higher than in the same period last year. But the comptroller’s office also said that amid the gloom, there was promising data about loan modifications: they rose 55 percent in the quarter. That growth came on a very low base, of course, but the move encouraged John C. Dugan, head of the comptroller’s office.
"As the administration’s ‘Making Home Affordable’ program gains traction and helps offset the impact of this very difficult economic cycle," he said in a statement, "we should continue to see progress in future reports." A glimpse of second-quarter mortgage data, however, indicates that the progress Mr. Dugan and his colleagues in Washington are hoping for may take longer to emerge — raising questions about whether policymakers and banks are moving quickly or intelligently enough on the foreclosure problem.
Foreclosures remain one of the great financial ills for the economy. The Bush administration largely overlooked foreclosures affecting average homeowners, focusing instead on propping up elite, troubled financial institutions with taxpayer funds. The Obama administration has said it wants to wrestle the foreclosure issue to the ground by encouraging mortgage loan modifications, but its efforts have gotten little traction.
Loan modifications occur when a lender agrees to change terms of a troubled borrower’s mortgage; the most common approach is to reduce the loan’s interest rate. Cutting the amount of principal owed — an option that could be of more help to a borrower — is rare because it means homeowners pay less money back to the bank over time. Lenders and their representatives, however, don’t like to modify loans through interest rate cuts or principal reductions because, of course, it reduces the income they receive from borrowers. No surprise, then, that loan modifications have been a trickle amid the recent foreclosure flood.
Enter the government, with the program it announced in March to encourage modifications. It offers incentives to loan servicers to change mortgage terms, providing $1,000 for each loan they modify. The program focuses on making payments more affordable through lower interest rates, but delinquent amounts and late fees are typically tacked onto the mortgage balance. "Making Home Affordable" does not compel lenders to reduce mortgage balances.
Servicers signed on to the program in April. The program’s early months were not covered by the O.C.C.’s first-quarter report. But other figures on modifications conducted in April, May and June are available. And they show a decline in modifications, not an increase as the government hoped. Alan M. White, an assistant professor at the Valparaiso University law school in Indiana, analyzed data on 3.5 million subprime and alt-A mortgages in securitization pools overseen by Wells Fargo.
The loans were written in 2005 through 2007; data on their performance is provided to the trusts’ investors. Mortgages handled by five of the nation’s largest loan servicing companies — Bank of America, Chase Home Finance and Litton Loan Servicing among them — are contained in the Wells Fargo data. Mr. White found that mortgage modifications peaked in February and have declined in all but one month since. While servicers modified 23,749 loans in these trusts in February, they changed only 19,041 in May and 18,179 in June. This is exactly when servicers were supposed to be responding to the government’s loan modification urgings.
Foreclosures, meanwhile, keep rising. In June, 281,560 were in process, slightly above the 277,847 in May. Last January, there were about 242,000 foreclosures in the pipeline among the Wells Fargo trusts. "I was hoping we would see some impact in June of the government’s program," Mr. White said. "Is ‘Home Affordable’ working? My short answer is no."
To be sure, the government’s data differs from that which Mr. White analyzed, and its loan modification figures for the second quarter may look better as a result. The O.C.C. includes prime loans as well as subprime, for example, while the Wells Fargo data contains no prime loans. Nevertheless, Mr. White has collected the figures since November 2008, and he said that in the months since, the performance of the 3.5 million mortgages that he analyzes tracked the O.C.C. data pretty closely.
The Wells Fargo data is illuminating. It shows that in June, 58 percent of modifications cut the payments that the borrower has to pay, a slightly smaller percentage than in April or May. The average reduction in June was $173 a month. But the most fascinating, and frightening, figures in the data detail how much money is lost when foreclosed homes are sold. In June, the data show almost 32,000 liquidation sales; the average loss on those was 64.7 percent of the original loan balance.
Here are the numbers: the average loan balance began at almost $223,000. But in the liquidation sale, the property sold for $144,000 less, on average. Perhaps no other single figure shows how wildly the mortgage mania pumped up home prices. It also bodes poorly for the quality of the mortgage-related assets lurking in banks’ books. Loss severities, like foreclosures, are rising. In November, losses averaged 56.1 percent of the original loan balance; in February, 63.3 percent.
Given losses like these, Mr. White said he was perplexed that lenders and their representatives were resisting reducing principal when they modify loans. His data shows how rare it is for lenders to reduce principal. In June, for example, 3,135 loans — just 17.2 percent of the total modified — involved write-downs of principal, interest or fees. The total loss from these write-downs was just $45 million in June.
And yet, the losses incurred in foreclosure sales involving loans in the securitization trusts were a staggering $4.59 billion in June. "There is 100 times as much money lost in foreclosure sales as there was in writing down balances in modifications," Mr. White said. "That is not rational economic behavior." If banks have written down the value of these loans to the 40 cents on the dollar that they are fetching on foreclosures — the only true value for these homes right now — then why don’t they bite the bullet and reduce the loan amount outstanding for the troubled borrowers? That type of modification would be far more likely to succeed than larding a borrower who is hopelessly underwater with yet more arrears.
"You can reduce payments with a lot of gimmicks similar to those built into subprime loans — temporary rate reductions that defer a lot of principal, balloon payments," Mr. White said. "To me that leads to a situation where American homeowners are paying 50 to 60 percent of their incomes for mortgages which reset in 2011 and 2012. That is not solving the problem." Certainly not for borrowers, that is. And because many of these losses will ultimately be passed on to taxpayers, it’s not solving our problem, either.
Not Much Relief
Four months into the Obama administration’s antiforeclosure effort, the White House’s best guesstimate is that "over 50,000" at-risk loans have been modified so that homeowners can afford their payments and keep their homes. A Treasury official told The Times’s Peter Goodman there is no precise data because a tracking system has yet to be completed. Still, the official predicted that by the end of August, the program would modify 20,000 bad loans a week.
That would be an enormous jump. But even 20,000 weekly modifications, starting two months from now, would most likely be too few. Unless substantially more relief is forthcoming, Moody’s Economy.com projects that some seven million homes will fall into foreclosure this year and next. Of those, nearly 4.5 million will result in distress sales, prolonging the recession by adding to the downward pull on house prices, home equity and household wealth. And those dire projections may prove too optimistic.
Banks say they are overwhelmed by the clamor for relief and are working hard to meet demand. We have heard that before. In May 2007, a group of banks and loan servicers went to Washington to promise a solution for troubled borrowers. The problem has only gotten worse. A more plausible explanation is that banks feel no great urgency to act. They are being buoyed by immense government support. And the Obama plan — which provides up to $75 billion in subsidies and incentive payments to help lenders and borrowers come to new loan terms — imposes no real penalty on lenders if the modifications don’t happen.
So instead of moving forcefully on foreclosure relief, the players in the mortgage chain — lenders, servicers and investors — have spent months parsing whether the incentives are adequate. Administration officials have spent countless hours clarifying the rules, trying to iron out the differences and pressing the industry to do more. The longer it takes, the worse the problem gets. Foreclosures cause price declines and contribute to economic weakness. That causes more foreclosures and other financial problems, making it harder for troubled borrowers to afford even reduced payments.
Last week, President Obama loosened the rules on his mortgage-refinancing program so that borrowers who are current in their payments, but lack home equity, may be able to switch to a loan with a lower interest rate. The borrowers most in need of help, however, are those who are in imminent danger of foreclosure and who cannot refinance, generally because they owe far more on their loans than their homes are worth. A big drawback of the Obama plan is that it emphasizes lowering monthly payments rather than reducing the loan’s principal.
Reducing principal is a better idea because it restores equity to borrowers, which gives them more of an incentive to keep paying their loans and makes redefault less likely. Banks generally loathe principal reductions, in part because they result in upfront losses, and the administration has not championed the idea.
The president and his aides must be prepared to rethink their position. Done correctly, a loan modification should benefit everyone. For a troubled borrower, it is a chance to stay in the home. For lenders, it means that they will make more money than they would make from a foreclosure. For taxpayers, the cost of subsidizing the right sort of modifications will be far less than the damage to the economy from millions of more foreclosures.
Debt tripping up Canadians
More than 500,000 at least 90 days behind on credit payments as delinquency rate rises 19%
More than half a million Canadians have fallen behind on their various credit payments, fuelling a 19 per cent rise in the average national delinquency rate in the one-year period ending May 31, 2009, says a new report from Equifax Canada. The credit bureau called the double-digit jump "alarming," noting the average delinquency rate for Canada hit 1.52 per cent at the end of May. Much of the trouble stemmed from missed payments on credit card bills and for sales finance purchases of items such as furniture and electronics.
Equifax defines delinquent bills as those that are at least 90 days overdue. Its latest snapshot on delinquencies comes just days after a Senate committee released a report urging the federal government to take more aggressive action to shield consumers and small businesses from rising interest rates and fees in the credit and debit card markets. Finance Minister Jim Flaherty continues to review all input on credit cards and will announce his final intentions once that process is complete, a spokesperson said.
While his office gave no timeline, Pierrette Ringuette, the Liberal senator who spearheaded the study, appeared to up the ante yesterday by vowing to introduce legislation in September if the government fails to act by then.
Legislation, except money bills, can be introduced in the Senate, although most originates in the House of Commons. It was unclear what kind of support such a bill would garner in a minority Parliament. The Senate report, released Tuesday, recommended the government create an "oversight board" and also take steps to clamp down on the rates and fees paid by consumers and merchants for the use of Visa, MasterCard and other card brands.
If Flaherty takes no action by the fall, "I'm going to be very, very disappointed," Ringuette said in a phone interview.
"The small and medium businesses of this country are not asking for a bailout," she said. "They're only asking for fairness – just like consumers are only asking for fairness. I think it's high time that government paid attention to them." The Equifax report, meanwhile, was the latest study to suggest that increasing numbers of Canadians are struggling to pay their bills. Nadim Abdo, an Equifax vice-president, stressed the "sharpest increase" in delinquencies resulted from credit card and sales finance purchases, which have risen by 38 per cent and 58 per cent, respectively, since May 2008.
Rising delinquencies in those areas are troubling because consumers tend to miss payments on those unsecured credit products before they fail to pay back collateral-backed loans such as mortgages, bank loans and lines of credit, Abdo said. While that's likely to spell higher loan losses for banks, consumers who skip payments will also suffer longer-term consequences because of tarnished credit scores. "When economic conditions get better, whenever that is, if they want to go get a mortgage or get a line of credit – with a negative rating on their credit file, that's not going to help them," Abdo said.
The Equifax data follows a Bank of Canada report last month that suggested climbing debt levels have put households under increased financial strain amid the recession. The Financial System Review also said that households are increasingly vulnerable to "adverse shocks" such as higher unemployment.
Microsoft Plans for Worst as U.S. Companies Show No End to Fear
During the last week of May, treasurers representing America’s bluest chip companies gathered at the Park Hyatt hotel in Philadelphia for a conference dubbed "Survival Skills." Instead of discussing ways to take advantage of the drop in borrowing costs to expand their businesses after the Federal Reserve cut interest rates to near zero, representatives of New York-based Colgate-Palmolive Co., International Business Machines Corp. in Armonk, New York, and dozens of other companies had other plans.
After watching credit dry up almost overnight as the subprime mortgage contagion spread in 2007 and 2008 and Lehman Brothers Holdings Inc. collapsed in September, companies were more preoccupied with stockpiling cash and extending debt maturities by selling a record $301 billion of investment-grade bonds in the first half. Those events were "fresh in everyone’s memory," said Brad Fox, chairman of the National Association of Corporate Treasurers and treasurer of Pleasanton, California-based grocery chain Safeway Inc. "We spent a lot of time talking about the aftermath of the fourth quarter."
Microsoft Corp., the world’s largest software maker, and Pfizer Inc., the maker of the cholesterol fighting drug Lipitor, led at least 262 non-financial borrowers in the first half, the most since at least 2001, according to data compiled by Bloomberg. Bond sales are rising even as the economy struggles to pull itself out of the deepest recession since the 1930s. "There’s still a good deal of precautionary borrowing taking place," said John Lonski, the chief economist at Moody’s Capital Markets Group in New York, a unit of Moody’s Investors Service. "There are a number of unresolved issues regarding access to capital."
The $3.75 billion sale May 11 by Redmond, Washington-based Microsoft was its first ever and was done even though regulatory filings show the maker of Windows computer operating systems had $25.3 billion in cash and short-term investments as of March 31. "It’s always better to issue when you don’t have to," said Microsoft Treasurer George Zinn. "Microsoft has been evolving its capital structure over a long period of time. This is just part of that logical evolution."
While treasurers are anxious, signs the worst of the recession may be over is spurring demand for corporate bonds. 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. They 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 this year in investment-grade corporate bonds compare with the loss of 6.82 percent last year. High-yield, high-risk, or junk, bonds returned 29 percent, after losing 26 percent, Merrill Lynch index data show.
"Demand for high-quality credit is still exceeding the supply," said Mark Kiesel, global head of corporate bonds at Pacific Investment Management Co., which oversees $747 billion from Newport Beach, California. "You can get equity-like returns by owning corporate bonds." Consumer spending rose in May as benefits from the Obama administration’s stimulus plan spurred a jump in 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.
Gross domestic product may grow 1.9 percent in 2010 after contracting 2.7 percent in 2009, according to a Bloomberg survey of economists. The number of non-financial companies issuing bonds in the first half was up from 205 last year and was the most since at least 2001, when there were 264, according to Bloomberg data. When including high-yield, high-risk borrowers, sales overall, totaled $744 billion, compared with $590.2 billion in the same period of 2008.
"The broad participation has really advanced throughout the second quarter and we believe that will continue," said John Cokinos, head of high-yield capital markets at Bank of America Merrill Lynch in New York. "There’s more of a willingness by the investor base to look at challenging names because the spreads have tightened so much." While the extra yield investors demand to own investment- grade company debt rather than Treasuries narrowed to 3.31 percentage points from 6.04 percentage points, it’s still almost triple the average for the decade ending in 2007, Merrill Lynch data show. Yields have declined 1.67 percentage points to 6.14 percent on average.
Martin Feldstein, a member of the private panel that dates the start of recessions and recoveries, said the U.S. economy will grow for a few quarters and then contract again. "We’re going to see a temporary substantial improvement," Feldstein, the former head of the National Bureau of Economic Research and a Reagan administration adviser who is now a professor of economics at Harvard University, said in a July 1 interview on Bloomberg Radio. "I emphasize the words temporary and substantial."
After the economy shrank at a 5.5 percent annual pace in the first quarter of the year, the change in GDP will be "closer to zero" or "even a small plus" for the April-to- June period, Feldstein said. Optimism about the pace of the recovery was damped July 2, when the Labor Department in Washington said payrolls declined by 467,000 last month following a 322,000 drop in May. The jobless rate rose to 9.5 percent, the highest since August 1983, from 9.4 percent.
Underscoring Feldstein’s concerns, the treasurer’s conference May 27 to May 29 included sessions on "Liquidity Management in Volatile Markets," according to the program titled "High Profile Treasury: Survival Skills." The group’s board includes IBM Treasurer Martin Schroeter and Colgate Treasurer Edward Filusch. "This year we’ve seen a structural shift in the market," said Mark Bamford, head of global fixed-income syndicate in New York at Barclays Capital, the biggest underwriter of bonds worldwide this year. "We’ve had crises before, but we haven’t had such concerns about the global banking sector as we had over the course of the past year."
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 in the next 12 months, Standard & Poor’s says. Yield spreads will likely remain wider than the average of the last 10 years, said David Kelly, the chief market strategist for J.P. Morgan Funds in New York. The unit of JPMorgan Chase & Co. oversees $438 billion. "There will be a new normal," Kelly said. "When we have that strong evidence the economy is beginning to recover, we’ll see wider spreads than we saw in the middle of this decade because those numbers themselves were a bit of an aberration."
There are signs that banks are still wary of lending. Financial institutions arranged $38.4 billion in leveraged, or high-yield, loans in the first half, an 80 percent drop from the same period in 2008, according to Bloomberg data. A record $978.5 billion of leveraged loans were made in 2007 as banks competed to finance the largest buyouts ever. No longer able to rely on banks for a steady supply of capital, borrowers are selling bonds and using the proceeds to repay short-term debt and loans.
Unsecured commercial paper outstanding plunged 31 percent to $1.15 trillion, the lowest level since September 1998, Fed data show. Proceeds from about 60 percent of high-yield bond sales this year through May were used to pay down bank debt, according to S&P’s LCD. That compares with 17 percent in the same period of 2007. Las Vegas-based Harrah’s Entertainment Inc., the world’s biggest casino company, sold $1.375 billion of notes in May to repay parts of a $9.18 billion senior secured credit facility used to finance Apollo Management LP and TPG Inc.’s buyout of the company in January 2008, according to a regulatory filing.
On June 17, Terremark Worldwide Inc., a provider of information-technology infrastructure services, sold $420 million of 12 percent senior secured notes due in 2017 in the company’s first bond offering in two years, Bloomberg data show. "Most of the bank market has really been, to some degree, nonexistent or very slow," said Jose Segrera, the Miami-based company’s CFO. "The market opened up a little bit and we thought for us it was a great avenue to fund."
New York-based Pfizer, the world’s largest drugmaker sold $13.5 billion of bonds in March to repay bank loans coming due in December that were used to finance its $64.7 billion bid for Madison, New Jersey-based Wyeth.
While the cost of issuing the bonds was about 1 to 2 percentage points higher than it would have been a year earlier in terms of the interest rate, demand from corporate debt investors made it a good time sell the securities, said Frank D’Amelio, Pfizer’s CFO. "The permanent financing compared to the bridge financing is economically very sound," D’Amelio said. "Which is part of why I wanted to do it as quickly as I could, and two, it was clearly a nice market opportunity."
Investor demand prompted Anadarko Petroleum Corp. to lengthen maturities on bonds to 30 years, said Robert Gwin, CFO of the company, based in The Woodlands, Texas. The second- largest independent U.S. oil and natural gas producer sold $2 billion in debt this year, Bloomberg data show. "On an absolute basis, cost of capital is attractive, and on a relative basis, certainty today is better than uncertainty in the future," Gwin said.
Anadarko increased the size of an offering of 5- and 10- year notes to $900 million from $750 million on June 9 and added a 30-year maturity after requests from investors, Gwin said. "Since there hasn’t been as much long issuance, that’s what we understood drove their interest," he said. "If you can put some relatively low-cost capital out very, very long, it gives you the ability to earn returns and continue to reinvest that capital without being subject to refinancing risk."
Money vs. Wealth
Deflation will take its course -- whether government wants it to or not.
Over time people have become confused between money and wealth. This is precisely what central bankers have had to do to convince consumers to borrow and spend recklessly. If any part of the US government/ Federal Reserve/ banking system is operating well, it's their public relations/ advertising/ media division. At any period, there's a certain amount of wealth in the US economy, yet government has created much more "money" over very short periods to intermediate that wealth. Thus wealth per "dollar" has been diluted vastly.
How have they done this? By lowering the cost of debt both to the lender and the borrower and increasing leverage in the system through the fractional banking system. In our credit-based system, money equals debt: We've been spending credit, not wealth.
Recognizing the fact that economies more and more influenced by central banks that attempt to stimulate economies (consumption) by creating debt many years ago, I began physically moving my assets around the world, shifting my wealth from time to time to the country I felt would devalue its currency the least: When a central bank creates debt, it essentially creates more of its currency, and thus devalues that currency.
Inflation is the creation of superfluous debt that chases unproductive assets (assets that produce little or no income for the risk undertaken). It devalues currency and drives up prices -- especially import prices. A central bank cannot create inflation by itself; through loose monetary policy and lower margin requirements, it can only encourage a fractional banking system to lend too much money in various ways.
Deflation is the destruction of superfluous debt. It is a corrective process that undoes artificial stimulus (inflation) driven by central banks that control fractional banking systems.
Deflation, which tends to lower overall prices, is good for the common man without debt. As long as he can keep his job (a big question), the lower prices make things more affordable. Lower price is the mechanism by which private capital is released from savings: Collateral prices are low enough to provide protection, and investment prices are low enough to provide an adequate return for risk. I find it ironic that the government is trying to get lending started again at the wrong price. It's futile.
Money is not wealth. We can create as much money as we want through an operating fractional banking system by creating associated debt -- that is, until there's so much debt that even at zero percent rates we can no longer service that debt.
People talk about all the "cash" on the sidelines fueling the next leg up in stocks. Those people aren't connecting the dots: That cash is there because of debt. Take the following example. Joe has $500,000 in stocks, a $750,000 house, and $20,000 in cash as assets. He has a $500,000 mortgage and $20,000 in credit card bills as liabilities. His net worth is $750,000. Over a 6-month period, his stocks and his house go down in price by 50%. He's forced to sell his stocks, because he took on too much risk. He now has $270,000 in cash and a house worth $375,000 as assets; his liabilities still amount to $520,000. His net worth is now only $125,000.
Does anyone think that $270,000 in cash is coming back into stocks anytime soon?
Those without debt and with assets have real wealth. As Joe found out above those that have used debt to purchase inflated assets have no real wealth. The government seems determined to reflate asset prices to make people feel wealthy again. This is either because they don’t understand what real wealth is (productivity) or they want to fool the populace. The reason they would want to fool the populace is to stay in power. Most voters have a lot of debt.
It is going to be very hard if even possible to reflate asset prices from these levels. It is very important to understand this: in a credit based system it is necessary for people to lend and borrow through the fractional banking system, which multiplies debt, in order to drive asset prices higher. So consumers must have the ability to borrow.
With consumer debt as a percentage of disposable income at a near high of 130% (normal is 50%), the consumer is clearly in no shape to borrow again. The Fed is powerless without a functioning fractional banking system. In fact, every time the Fed or the government has another bailout or stimulus package, that money is very low powered: there is no multiplier effect. All it does is replace debt that is being destroyed and perhaps slows the pace of deflation.
We have wasted vast resources bailing out the equity prices of large banks. Maybe one of our politicians can explain to us why. We could have protected peoples’ savings and deposits without this waste. Politicians fear deflation, but the average man should not. Deflation is merely a corrective process.
Capitalism did not fail us, government did. Capitalism is us, the market. Sure big players can hurt small players, but that is why we have rules (regulation). Government eliminated good regulation like Bretton Woods and Glass-Steagle (with a lot of help and money from bank lobbyists) and over time reduced margin requirements, letting big players run amok. But the big secret is that the big players and the little players alike could never have created this much debt without the Federal Reserve keeping interest rates negative and margin requirements at banks basically zero for years.
Some prices will rise (necessities); some will fall (discretionary assets) over the next several years. But deflation (debt reduction) will take its course -- whether government wants it to or not. Risk is high.
Bankruptcy judge OKs GM sale plan
A bankruptcy judge has ruled that General Motors Corp. can sell the bulk of its assets to a new company, potentially clearing the way for the automaker to quickly emerge from bankruptcy protection. U.S. Judge Robert Gerber said in his 95-page ruling late Sunday that the sale was in the best interests of both GM and its creditors, whom he said would otherwise get nothing. "As nobody can seriously dispute, the only alternative to an immediate sale is liquidation -- a disastrous result for GM's creditors, its employees, the suppliers who depend on GM for their own existence, and the communities in which GM operates," Gerber wrote in his ruling.
The ruling comes after a three-day hearing that wrapped up Thursday, during which GM and government officials urged a quick approval of the sale, saying it was needed to keep the automaker from selling itself off piece by piece. "This has been an especially challenging period, and we've had to make very difficult decisions to address some of the issues that have plagued our business for decades," GM President and CEO Fritz Henderson said in a statement early Monday. "Now it's our responsibility to fix this business and place the company on a clear path to success without delay."
But attorneys for some of GM's bondholders, unions, consumer groups and individuals with lawsuits against the company argued for its rejection, saying that their needs were being pushed aside in favor of the interests of GM and the government. It was unclear early Monday if any of those groups planed to appeal Gerber's decision. The deadline to appeal is noon Thursday, after which point Gerber's order takes effect and the sale is free to close. Last month, a group of bondholders and others took their objections to Chrysler LLC's sale plan all the way to the Supreme Court, delaying the Auburn Hills, Mich.-based automaker's exit from bankruptcy protection.
Several consumer groups have objected to provisions in the sale that free the new company from liability for consumer claims related to incidents that occurred before GM went into bankruptcy protection. That means that people injured by a defective GM product in connection with an incident that occurred before June 1 would have to seek compensation from the "old GM," the collection of assets leftover from the sale, where they would be less likely to receive compensation.
Joanne Doroshow of the Center for Justice & Democracy said in a statement the issue "is far from over. It is morally reprehensible that GM will pay for injuries and deaths that occur after the bankruptcy process, but not for the hundreds of victims who have already been hurt by defective GM cars," Doroshow said. GM's government-backed plan for a quick exit from Chapter 11 hinges on the sale, which will allow the automaker to leave behind many of its costs and liabilities. The Treasury Department has vowed to cut off funding to GM if the sale doesn't go through by July 10.
The Detroit car maker's Chapter 11 filing on June 1 was the fourth-largest in U.S. history. GM will leave bankruptcy court with significantly reduced debt and labor costs, as well as fewer dealerships and brands. But it's still operating in an environment where fewer American are buying cars. At the current pace, automakers will sell around 9.7 million vehicles this year. That's a reduction from sales of more than 16 million vehicles as recently as 2007. In June, the automaker captured 20.3 percent of the U.S. market. GM has estimated that it can maintain a market share between 15 and 17 percent, reflecting its plan to sell off three brands and end its Pontiac line.
GM has several new cars coming to market next year, including the Chevrolet Volt, a plug-in hybrid electric car. The Volt might be a promising vehicle, but with an expected $40,000 price tag it might only be a niche player, said James E. Schrager, clinical professor of entrepreneurship and strategy at the University of Chicago Graduate School of Business. Upcoming small-car models such as the Chevy Cruze and Spark may fare well, but will face heavy competition from foreign automakers already in that segment of the market and from Ford Motor Co.'s new Fiesta, which the company has already started advertising.
Overall, GM's major challenge will be winning back customers who have migrated to foreign competitors. Some newer GM models have received good reviews for quality and performance, but that hasn't persuaded enough consumers to buy GM cars. "The problem is the status of General Motors' brands," Schrager said. "They have to have some really breakthrough products that work and resonate with consumers. And they may have to slowly, over time, turn the image around."
The company has received $50 billion in taxpayer funds. In exchange for those funds, the government will own about 61 percent of the "new GM." The Obama administration has said it does not plan to interfere with the day-to-day running of the company, though government has been involved in the selection of the new company's 13-member board of directors and change of control transactions. The company, in consultation with the government, named former AT&T Inc. CEO Ed Whitacre to chair the board. Whitacre is in the process of choosing four new directors.
The United Auto Workers union, which gets a 17.5 percent stake through its health care trust for retirees, has selected Stephen Girsky, a former GM adviser and Morgan Stanley analyst, to serve on the board. The Canadian government, which will control an 11.7 percent share, also will pick one member. Henderson, who succeeded former CEO Rick Wagoner in March when the Obama administration forced Wagoner to resign, has said he expects to remain at the helm of the automaker as it comes out of bankruptcy.
Henderson has already said he would cut about 34 percent of GM's executive ranks by the end of the year. Assets that GM does not sell to the new company will become part of the separate "old GM," which the company said Monday will be known as Motors Liquidation Co., and will be sold to the highest bidder under court supervision. The old GM will include a smattering of properties, several of which are facilities already slated to be closed. Other assets to be filed under the old GM include brands like Hummer, Saturn and Saab, for which GM has lined up buyers.
They also include all current GM common stock, which -- despite its active trading on over-the-counter markets -- will soon be worthless. The old GM will remain an entity until all of the facilities are sold off, a process that could take months or years to complete. The government has said it plans to provide about $1.18 billion to fund the wind-down process.
The influence of computerized trading programs
It may be that computer software is already in charge of our futures. In 2005, I posted an article called "A new mystery: Why is the P/E ratio remaining constant?" I noticed that the S&P 500 price/earnings ratio had remained almost constant for over a year, something that had not occurred in the previous century or more. In that article I described something called the "Fed Model," a simple trading algorithm which, I understood, was widely followed by many traders and financial institutions.
The Fed Model was based on a 1997 Federal Reserve report that related price/earnings ratios to changes in long-term Treasury yields. I inferred from the evidence that most traders and financial institutions were all following the same buy/sell strategies based on P/E ratios, as a result of which the P/E ratio was remaining constant. If you look at the bottom of the home page of this web site, you'll see the price/earnings ratio chart that gets updated every week. Here's last Friday's version of the chart:
S&P 500 Price/Earnings ratio and S&P 500-stock Index as of 26-June-2009. (Source: MarketGauge ® by DataView, LLC)
As you can see from this chart, the mystery of the constant P/E ratio continued long after 2005. The P/E ratio was in the 18-20 range for years, starting in 2004. This happened despite the fact that the S&P index was going up and down (mostly up). This behavior was interrupted for a few months in 2008, and was abandoned completely in 2009. I've written about this a number of times since 2005. My conclusion was that the only way that this could be happening was if programmed trading algorithms at different financial institutions were very similar to one another.
Speaking as a software development consultant, I've worked at a number of financial institutions, and I know that programmers tend to move from one company to another over time. Thus, it's not surprising at all that the trading algorithms at different financial institutions were similar to one another. So I'm not saying that there was any conspiracy. I'm simply saying that the trading algorithms were and are common knowledge across the industry, so different institutions are likely to implement roughly the same algorithm. And it seems clear that a P/E valuation of 18-20 has been a part of those common algorithms.
But it's clear from the above chart that something changed early this year, as I wrote two months ago in "Stock market rally raises cautious, anxious hope among investors." The change was triggered by fourth quarter earnings last year -- which were negative. This caused the P/E ratio index to shoot up to 60. This led to a lot of lying and prevarication in the financial media. (See "Wall Street Journal and Birinyi Associates are lying about P/E ratios" and "Laszlo Birinyi provides insight on his fantasy price/earnings computations." The Wall Street Journal recently completely reversed its policy, as I described in "Wall Street Journal sharply revises its fantasy price/earnings computations.")
This lying about P/E ratios should be major industry news, but I've never seen anything about it in the mainstream media, nor in any of the financial blogs, including Nouriel Roubini's blog, Michael ("Mish") Shedlock's blog, the Calculated Risk blog, the Sudden Debt blog, the MinyanVille blog, Yves Smith's Naked Capitalism blog, and theFinancial Times alphaville blog. I don't check all of these blogs every day, but as far as I know, this P/E ratio issue is never mentioned by any of them.
If you look at the "official" S&P 500 P/E index spreadsheet, you can see that the Q2 P/E is 133.62. If you look at the latest WSJ chart, with its newly revised more "honest" reporting, then you see that the S&P 500 P/E index is 35.38. But if you listened to Bloomberg TV today, then you heard "the P/E index is around 15, and there are many stocks with very low valuations." I have no idea where this figure of 15 comes from. Mainstream financial reporting has gone completely off the rails. It's almost completely total nonsense, catering to brokers and investment bankers who make fat commissions and fees off of traders, and who don't want anyone rocking the boat by reporting a P/E ratio of even 20, let alone 133.
But we're still left with a mystery. What algorithms are the computerized buy/sell trading programs using today? They're obviously not pegging the algorithm to a P/E ratio of 18-20 any more; that's been thrown out. But what algorithms are they using? The answer to the question was provided by an interview of Joe Saluzzi of Themis Trading on Bloomberg TV on Tuesday. The following is my transcript: "I'm a realist. I like to cut through the garbage that we hear constantly from hopeful politicians and hopeful corporate executives, trying to tell you they see things are good.
Let me see some numbers. Show me the quarterly earnings. Are you going to prove to me that second quarter was good, in the retailing sector when the savings rate is sky high, and consumers aren't spending? No, I don't believe it. I'm a cynical person at heart, I guess, but I'm also a realist, and it keeps me out of trouble a lot. ... The problem is that most people are pessimistic on this market right now, but they're afraid because they see the market running.
What my job is during the day is I'm an institutional trader for large mutual funds and hedges. So my job is to trade for them, and to not get caught upin the noise.
The volume that you see during the day, sometimes as high as 12 billion across all three exchanges, is fictitious. It's not real. I'm going to say that 60-70% of this volume that you see coming across -- it's volume, but it's done by what they call 'high frequency traders.' These are machines. The biggest machine out there wins the game nowadays. And these people deal in sub-seconds. 50 milliseconds is a huge amount of time. Anything over that and you're a dinosaur in the business.
So what they do all day long is they buy and sell and they try to collect liquidity rebates from the exchanges, who basically in partnership with them, and they trade for no apparent fundamental reason, and this is my problem. And being that we're all in a bullish tape right now, they're all just buying. ... I trade for my clients. I'm an agency-only trader. My job -- they make the decisions, I execute around the noise. Some of the clients buy, some of them sell, we deal with all different types. Some short, and so on. Some are sector based.
But my job is to make sure -- that during the day when a program gets shot through, -- by the way, a billion shares a week going through certain broker on the exchange principally with programmed trades -- it's a way to get the market to go in your direction. And what happens is -- since we're all electronically linked, the algorithms that all these programs use, according to the guys that I talk to, chase the stocks and artificially inflate the prices. It cuts both ways. Since we're in a bull tape, everyone is jumping on board, but here's the trick: They could run for the trap door tomorrow, and if everybody becomes a seller, they'll all just go the other way. They don't care about the prices any more."
According to Saluzzi, these computerized buy/sell programs are dominating the market these days. But there's more -- a remarkable concept. What he's saying is that the computerized trading algorithms are essentially doing panic buying (though he doesn't use that phrase). He's saying that these trading programs are programmed to push stock prices up. Once again, I'm not implying any conspiracy or collusion. Let me put on my computer programmer hat again. I've never had to implement an algorithm of this sort before, but I can imagine what kind of algorithm I'd implement if a client told me, "Assume that the market is going up, and program the computer to stay ahead of the market and make money." If I assume that the market is going up, then I'd program the computer to pursue a strategy that pays a little more as time goes on.
And now, once again, we know that computer programmers move from company to company, and we can conclude that all the financial institutions are implementing roughly similar algorithms. There's a remarkable concept. We normally think of panic buying as based on human emotion, but Saluzzi is essentially saying that the computers are panic buying, pushing up the stock market prices. This is a weird concept since, as we all know with absolutely certainty, computers are mechanical devices totally lacking in emotion. Presumably then, the reason that computer programs "artificially inflate the prices" is because the programmers tweak the program parameters to do so.
However, Saluzzi points out that this won't go on forever. He says that there's a "trap door," and this could reverse very quickly. If I were a computer programmer for such a client, I'd parametrize my software algorithms so that if my client suddenly said, "Assume that the market has stopped rising, and it's going to fall for a while," then my software would instantly change its strategy. Instead of panic buying, my software would be panic selling. And so would everyone else's software algorithms. So what I'm suggesting is this: The the computerized trading algorithms have changed drastically in the last year.
Since 2004, these algorithms have been pegged at maintaining a P/E ratio of 18-20. Obviously that's out the window now, as the P/E ratio is well above 100. Is any other peg being used? I'm certainly not aware of anything. This gives meaning to Saluzzi's statements: "And what happens is -- since we're all electronically linked, the algorithms that all these programs use, according to the guys that I talk to, chase the stocks and artificially inflate the prices." In other words, the computerized trading algorithms are specifically designed to create a bubble. Once again, I'm not saying that this is a conspiracy, any more than the Tulipomania bubble was a conspiracy. I'm simply saying that the "human emotions" or "animal spirits" that normally cause a bubble have been encapsulated in computer algorithms and programs, resulting in computers that create bubbles.
As I've said for decades, "To err is human. To really screw things up takes a computer." And that seems to be where we are. These computer programs make decisions in microseconds, far faster than human beings can react. In the 1929 stock market crash, it was human beings using the telephone to flood their stock brokers with sell orders that clogged the ticker tapes for hours. What Saluzzi is telling us is that we're headed for a different kind of crash, where blindingly fast computers will be competing with each other to sell as quickly as possible. As I've been saying for years, Generational Dynamics predicts that we're headed for a generational panic and crash, the first since 1929. Some people believe that the stock market has already crashed, but it hasn't been even close.
Here's how I've described this several times in the past:
"A generational crash is an elemental force of nature, like a tsunami. You'll have millions or even tens of millions of Boomers and Generation-Xers in countries around the world, never having seen anything like this before, not even believing it was possible, and in a state of total mass panic, trying to sell all at once. Computer systems will crash or will be clogged for hours, or perhaps even for a day or two. People who had hoped to get out just as the collapse is occurring will be totally screwed, and will lose everything. Brokers and other institutions will go bankrupt."
This might happen tomorrow, next week, next month or thereafter. We can't predict when it will happen, but it's coming soon with absolute certainty. What Saluzzi's comments tell us is that the crash will be led more by computers than by humans.
Ilargi: From what I see, the only way this could get interesting is if Aleynikov's lawyer brings up Goldman's spying on its own clients. Goldman may come to regret calling to the police.
Ex-Goldman programmer out on bail in theft case
A former Goldman Sachs Group Inc (computer programmer accused of stealing secret trading codes from the financial firm has been released from federal custody after posting bail, authorities said on Monday. Sergey Aleynikov, 39, was arrested by the FBI on Friday and charged with "theft of trade secrets." He met the terms of his $750,000 bail and was released Monday, said FBI spokesman James Margolin. Aleynikov is accused of misusing computer codes that belong to his former employer, a New York-based financial institution that authorities did not identify in court papers but sources say is Goldman Sachs.
A transcript of Aleynikov's appearance before U.S. Magistrate Kevin Nathaniel Fox in Manhattan on Saturday also shows that Aleynikov worked for Goldman. His lawyer, Sabrina Shroff, said at that proceeding that Aleynikov told authorities after his arrest that he did not intend to sell the information or use it "contrary to my employment agreement with Goldman Sachs." Goldman has not seen its business or clients harmed by the purported computer breach, a source familiar with the situation said on Monday. The firm declined to comment.
The case could shed light on the workings of intricate trading systems developed by Goldman. It also raises questions about the security of lucrative Wall Street proprietary trading operations. However, the New York Stock Exchange said on Monday there was no connection between the alleged security breach and an error that dropped Goldman from a trading report the NYSE issued last week. Aleynikov, a Russian immigrant living in New Jersey, was arrested on Friday night as he got off a flight at Newark Liberty International Airport, according to an FBI affidavit filed in the case.
Aleynikov had been held at the Metropolitan Detention Center in Brooklyn. Terms of his bail required a $750,000 personal recognizance bond to be secured by three financially responsible people. The bail also included $75,000 in cash, and Aleynikov was ordered to surrender his travel documents and not to access the computer data at issue in the case. A preliminary hearing was scheduled for Aug. 3. Authorities contend Aleynikov stole codes used for sophisticated automated stock and commodities trading.
They say Aleynikov, who earned $400,000 a year at Goldman, improperly copied proprietary computer code and then uploaded it to a computer server in Germany. After he was arrested, he told authorities he had only intended to collect "open source" files on which he had worked but "later realized that he had obtained more files than he intended," the FBI agent said in the court papers. The FBI said Aleynikov worked at the financial institution from May 2007 until June 5, when he left to work for a new company focused on high-volume automated trading. Aleynikov's wife, Elina, told Reuters on Sunday that her husband is innocent. She said in a phone interview from the couple's New Jersey home that her husband worked hard for Goldman and has been a good citizen who has lived in the United States for 19 years.
Dollar's Days of Dominance Are Over
While it may not constitute the final "nail in the coffin", India commemorated the 4th of July by joining China and Russia in announcing they were seeking "alternatives" to the U.S. dollar (as "reserve currency"). With yet one more "prop" removed from the gangrenous greenback, this left only the submissive Japanese as the last major holder of U.S. dollars who strongly supports its continued status.
Bloomberg reported Saturday that the economic advisor to Indian Prime Minister Manmohan Singh has publicly and explicitly recommended that India reduce the U.S. dollar component of its currency reserves. "The major part of India reserves [totaling $264 billion] is in U.S. dollars – that is something that's a problem for us," said Suresh Tendulkar. These remarks come only one day after China's former Vice Premier, Zeng Peiyan stated, "There should be a system to maintain the stability of the major reserve currencies."
Several comments need to be made with reference to this remark. First, China commonly uses "voices" of those associated to but not in the government to indirectly reveal its thoughts on issues. Thus the fact that Zeng is a former Vice Premier should not be taken to mean that his remark is not indicative of the position of the Chinese government.
Second, there were two subtleties which should cause Americans (and the Obama regime) serious concern. First, Zeng spoke of "major reserve currencies" - making it explicitly clear that he (and China) no longer consider the dollar the sole "reserve currency" today. The other point to ponder is Zeng's reference of a "system to maintain stability" in currency markets. The U.S. dollar was that system.
There is much more at stake here than economic prestige. As the Obama regime floods the world with trillions of dollars more in U.S. Treasuries, the Federal Reserve has already been forced to buy-up a significant part of those Treasuries (i.e. monetizing debt). Monetizing debt alone guarantees the steady decline of the U.S. dollar versus other currencies (with the exception of the British pound and Japanese yen) because other economies have not been weakened to the point of such desperation.
However, as major economies continue diversification out of the U.S. dollar, even as economic growth in these other countries produces growing budget surpluses once again, few if any of those surpluses will be channeled into U.S. dollars. The process is already well underway. China alone has engaged in currency swaps and trade agreements which by itself, reduces the demand for U.S. dollars by hundreds of BILLIONS per year. Many other countries are also engaged in similar measures – with varying speeds.
Countries either indifferent or antagonistic to the U.S. (Russia, Iran and Venzuela) come to mind, are already well-advanced in practically eliminating the use of dollar in their foreign trade. However, even many of the U.S.'s "allies" (with the Western-dominated Persian Gulf countries coming to mind) are also well down the path of reducing the U.S. dollar to merely one of their major currency holdings.
Indeed, the combination of rapid, extreme dilution of the U.S. dollar, along with rapidly diminishing demand mean there is no "floor" visible for the dollar – at any price level. Reinforcing a future of endless declines for the dollar are the U.S.'s totally unsustainable mountains of debt ($57 TRILLION in total public/private debt + another $70+ TRILLION in unfunded liabilities. In comparison, real U.S. GDP is a puny $11.5 trillion/year – not nearly enough to even keep up the payments on the debt (let alone ever actually paying-off a dollar).
The only possible way for the U.S. to delay national default on these debt-mountains is to devalue the U.S. dollar to such an extreme that the real value of all those trillions in debt becomes sustainable. This will obviously necessitate at least a 75% decline in the dollar's grossly-inflated current value – and even then the viability of the U.S. economy is extremely dubious, unless there are huge reductions in spending to accompany the massive devaluation of the dollar.
Keep in mind that due to the success of the U.S.'s relentless propaganda-machine, most other countries are just beginning to comprehend the dynamics of the U.S.'s unsupportable debts. As that awareness grows, the decline of the U.S. dollar is certain to accelerate rapidly.
Yuan starts on long slog to reserve currency status
It's time for markets to take a deep breath: the yuan will not become a reserve currency, let alone dethrone the dollar, this year, next year or any time soon.
Will China's currency be increasingly used to settle trade in Asia and, who knows, maybe even to denominate commodities? Yes. Does China worry that lax U.S. monetary and fiscal policy will debase the dollar, today's dominant global currency, and with it a chunk of its $1.95 trillion stockpile of reserves? Yes. Does China want to enhance the legitimacy of the International Monetary Fund -- and gain more clout in the process -- by adding the yuan to the basket of currencies that make up the Special Drawing Right, the fund's virtual currency? Yes.
Expect to hear more on these subjects at this week's Group of Eight summit in Italy, which President Hu Jintao will attend. But conflating these considerations into the conclusion that China is ready, economically or politically, to do what is needed to turn the yuan, also known as the renminbi (RMB), into a reserve currency is wide off the mark. "The renminbi will clearly internationalize significantly over the next 5-10 years. Over a longer period (10-20 years) it may emerge as a secondary reserve currency like the Japanese yen, although this is not certain.
"For it to replace the dollar as the main global reserve currency would require many decades and a combination of improbable events," wrote Arthur Kroeber in the China Economic Quarterly, a journal he edits. Kroeber rightly draws a distinction between facilitating the use of the yuan as an international currency for current account purposes such as trade and tourism and enabling its use on the capital account for portfolio investment and reserve holdings.
For that, China would have to scrap capital controls: central banks and other foreigners would have to be able to invest freely in onshore yuan financial assets such as stocks, bonds and bank deposits and to freely repatriate their capital. For foreigners to hold yuan on a large scale, Kroeber writes, they would also have to be convinced China's markets are trustworthy and fairly free of rigging by the government. "Technical difficulties aside, this will require a significant retreat from the current state-dominated model of credit allocation. This cannot happen quickly," he concludes.
Brendan Kelly, an analyst with Pacific Forum CSIS in Honolulu, agreed that completely eliminating capital controls was a policy transformation that would clash with the ruling Communist Party's craving for control. "Investors would also likely require significant reforms in the rule of law, raising the question of whether an authoritarian government could ever gain the trust required to be a reserve nation," he wrote in a study.
Furthermore, Kelly doubted whether China had the deep, liquid capital markets that money managers demand of a reserve currency, a shortcoming that he says helped stunt Japan's international ambitions for the yen. "Significant further development of China's bond markets over the upcoming decades will be required to support a role for the yuan as a reserve currency," said Kelly, a former China country director for the U.S. secretary of defense. On the positive side of the ledger, Kelly reckons a currency acquires credibility through trial by fire.
As such, he mused, historians may look back on China's stable economic performance and the steady hand of its policymakers during the current turmoil and the 1997/98 Asian financial crisis as building blocks of Beijing's reputation and leadership. Eswar Prasad, a Cornell University professor of trade who used to head the IMF's China desk, said China's sheer economic size would propel the yuan to reserve currency status.
"If they can get the technical part fixed up -- having a more convertible currency, deeper financial markets -- even if they do not do very well in terms of institutional factors such as the rule of law, they can in fact end up having the RMB become a major reserve currency," Prasad said in Beijing last week. The key question, he said, is whether Beijing is willing to live with the exchange rate volatility that an open capital account generates.
This exposes the Beijing paradox. While logic dictates that a reserve currency must rise and fall with the flows of global capital, China has tightened, not relaxed, its grip on the yuan. "The Chinese authorities view convertibility as quite feasible over a five-year horizon, but the financial crisis has shifted that to some extent," Prasad said. Worried about export job losses, Beijing has prevented the yuan from appreciating against the dollar for the past 12 months.
"China's stated aspirations -- to have the yuan play more of an important role in international finance, for Chinese companies to go abroad and invest -- are consistent with a gradual opening of the capital account, and in practice that has to go hand in hand with more flexibility of the exchange rate," said David Dollar, who ran the World Bank's Beijing office until last week. Joseph Yam, who heads the Hong Kong Monetary Authority, hopes the yuan will become fully convertible so it can play the role of a regional monetary anchor alongside the dollar and the euro.
"The possibility of it becoming a reserve currency is there. I think that is one reason why certain steps have been taken in mainland China to promote the greater use of the renminbi internationally. It's early days yet, but I think they are taking the right moves," Yam told Reuters during a recent meeting of the Bank for International Settlements in Basel, Switzerland.
China: USD To Remain Major Reserve Currency For Years
Chinese Vice Foreign Minister He Yafei said Sunday that the U.S. has the responsibility to maintain the stability of the U.S. dollar, but the dollar will stay as the world's most important major international reserve currency in years to come, the official Xinhua News Agency reported. He is accompanying Chinese President Hu Jintao to visit Italy and attend the annual summit of the Group of Eight powers and emerging economies. Speaking at a pre-G8 summit briefing, He said it's "natural" for China to voice concern of "safety of assets in the United States", according to the Xinhua report.
China holds nearly $2 trillion worth of foreign-exchange reserves, a large part of which is U.S. treasury bonds. He Yafei said the U.S. has been moving in the right direction to safeguard the dollar's stability. Meanwhile, creation of a supranational reserve currency has been discussed "among academic circles", He said, adding that "It is not the position of the Chinese government," the Xinhua reported.
Société Générale warns on €1.3 billion CDS hit
Société Générale expects to take a €1.3bn ($1.8bn) hit from credit default swaps when it reports its second-quarter results on August 5, weighing on an otherwise solid operational performance and muting the French bank’s return to profitability. SocGen said it expected to register only "slightly positive" net income in the second quarter in spite of strong results from its corporate and investment banking arm, as it forecast a "significant negative impact" from CDS used to hedge loans, and from mark to market losses on its debt.
The bank added that the cost of risk was expected to reach a comparable level to its level in the first quarter and that it would continue to reduce its exposures. In May the bank surprised the market with a first-quarter net loss of €278m, confounding expectations for a €350m profit, due to worse-than-expected writedowns. Shares in SocGen fell 3.1 per cent to €36.69 in mid-morning trade, while the CAC 40 in Paris was down 1.6 per cent. In a statement, the bank said its second-quarter income had suffered as credit spreads tightened significantly due to the sharply improved market environment and reduced risk aversion since mid-March.
Analysts said other banks could suffer losses on their hedging activities as investor sentiment had returned more quickly than expected. Olivia Frieser, senior credit analyst at BNP Paribas, said: "The market has tightened significantly and in that sense, the CDS losses are not surprising. SocGen will not be the only bank to suffer from this, and from the mark-to-market losses on its own debt. As far as hedging the loan book is concerned, the bank’s been rather conservative in the recession, and now as the market has improved, it’s been hurt by the tightening of credit spreads."
Ms Frieser added: "The amount, €1.3bn, is pretty big but it seems to be a one-off. SocGen are saying their operational performance is solid and the cost of risk will remain similar so I’m not too concerned." SocGen released the trading update as the bank held an extraordinary general meeting on Monday, to allow shareholders to vote on whether Frederic Oudea, chief executive, should also become chairman in the wake of Daniel Bouton’s exit in May. The vote was passed by a majority of 80 per cent.
Liquidity injections alone are not enough
by Wolfgang Münchau
Monetary policy’s various guises from near-zero short-term interest rates, to massive liquidity injections, to quantitative easing and its relatives have so far had no traction in this crisis. While the global economy is no longer shrinking at quite the speeds seen at the beginning of the year, it is still trapped in a bad recession. The main reason for its longevity is the state of the banking sector. The European Central Bank has recently pumped €442bn ($620bn, £380bn) in one-year liquidity into the system, but the money is not reaching the real economy. Japanese-style stagnation is no longer possible – it is already here. The only question is how long it will last. Even in an optimistic scenario, global economic growth will be weighed down by a combination of credit squeeze, rising unemployment, rising bankruptcies, rising default rates, and balance sheet adjustment in the household and financial sectors.
I would expect the US to have something approaching a genuine recovery at some point in the next decade, but probably not in 2010 or 2011. Judging by the co-ordination failure at the level of the European Union, the persistent failure to deal with the continent’s 40 or so cross-border banks at European level, and in particular Germany’s inability to sort out its toxic-asset contaminated Landesbanken, the economic prospects for the eurozone are infinitely worse. From comments by senior central bankers in the US and Europe, I am sure they understand the gravity of the situation very well. Janet Yellen, present of the Federal Reserve Bank of San Francisco, warned last week that the recovery would be agonisingly slow, that unemployment could stay high for many years, and that interest rates might stay low for a long time.
I would also interpret the decidedly downbeat statement last week by Jean-Claude Trichet, president of the European Central Bank, as a sign that the ECB is getting more worried – when others are getting more optimistic. In Europe, there is some evidence that the credit crunch has deteriorated in recent weeks. Much of that evidence is anecdotal, but these anecdotes are disquieting. Companies who file for bankruptcy increasingly blame the banks, and the number of bankruptcies is rising rapidly. Only a fool would take comfort from the strength in economic indicators. During a financial crisis, these indicators could be a metric of its respondents’ degree of delusion. The problem is that the trillions of dollars and euros in liquidity are not getting through. There is no point in blaming the banks. Mr Trichet appealed to the banks to behave responsibly. Over the weekend, German politicians also made desperate and implausible threats against the banks unless they increased lending. Not only is this a waste of time but the banks are, in fact, behaving responsibly when they deny credit to customers whom they judge to have lost creditworthiness.
Left to its own devices, banking is inherently pro-cyclical. This is one of the reasons restoring the health of the banking sector by whatever means necessary is a precondition for an economic recovery. Liquidity injections by a central bank, however large, cannot restore health to the banking sector in a sufficiently short period of time if the underlying problem is lack of solvency. Nor do accounting tricks that allow banks to freeze their bad assets in bad banks without any resolution mechanism, such as the German law passed last week. And since the European economies are far more dependent on the banking sector than their Anglo-Saxon counterparts, the need to sort out the banking sector is even more urgent there.
The interactions between the financial sector and the real economy have both a short-term and a long-term, or structural, component. The European Commission’s most recent quarterly report on the eurozone states bluntly that the crisis will lead to a permanent loss in economic output, unless EU member states begin to pursue very different kinds of economic policies. With several European countries now obsessing with premature crisis exit strategies, which may kick in as early as 2010, the chances of a vicious cycle of fading economic growth, falling tax receipts, deficit cuts and further output losses are high. If Ms Yellen is right about the US economy, there will be no bail-out of the European and Asian economies through the US consumer. If the situation persists even for only five years, it will lead to a structural slump for some of those export-reliant economies on the European continent.
The Europeans have a bigger task and they operate in a more difficult political environment. The economic policy framework of Europe’s monetary union only barely succeeded during a normal economic cycle, during which its most important framework of policy co-ordination, the stability and growth pact, was dislodged. The policy framework proved utterly dysfunctional during this economic crisis, as leaders like Angela Merkel or Nicolas Sarkozy have resorted to their nationalist instincts. It would take an even bigger crisis for them to agree on a joint resolution strategy for the banking system. There is a good chance they might get it.
Public Pensions Cook the Books
Here's a dilemma: You manage a public employee pension plan and your actuary tells you it is significantly underfunded. You don't want to raise contributions. Cutting benefits is out of the question. To be honest, you'd really rather not even admit there's a problem, lest taxpayers get upset. What to do? For the administrators of two Montana pension plans, the answer is obvious: Get a new actuary. Or at least that's the essence of the managers' recent solicitations for actuarial services, which warn that actuaries who favor reporting the full market value of pension liabilities probably shouldn't bother applying.
Public employee pension plans are plagued by overgenerous benefits, chronic underfunding, and now trillion dollar stock-market losses. Based on their preferred accounting methods -- which discount future liabilities based on high but uncertain returns projected for investments -- these plans are underfunded nationally by around $310 billion. The numbers are worse using market valuation methods (the methods private-sector plans must use), which discount benefit liabilities at lower interest rates to reflect the chance that the expected returns won't be realized.
Using that method, University of Chicago economists Robert Novy-Marx and Joshua Rauh calculate that, even prior to the market collapse, public pensions were actually short by nearly $2 trillion. That's nearly $87,000 per plan participant. With employee benefits guaranteed by law and sometimes even by state constitutions, it's likely these gargantuan shortfalls will have to be borne by unsuspecting taxpayers.
Some public pension administrators have a strategy, though: Keep taxpayers unsuspecting. The Montana Public Employees' Retirement Board and the Montana Teachers' Retirement System declare in a recent solicitation for actuarial services that "If the Primary Actuary or the Actuarial Firm supports [market valuation] for public pension plans, their proposal may be disqualified from further consideration." Scott Miller, legal counsel of the Montana Public Employees Board, was more straightforward: "The point is we aren't interested in bringing in an actuary to pressure the board to adopt market value of liabilities theory."
While corporate pension funds are required by law to use low, risk-adjusted discount rates to calculate the market value of their liabilities, public employee pensions are not. However, financial economists are united in believing that market-based techniques for valuing private sector investments should also be applied to public pensions. Because the power of compound interest is so strong, discounting future benefit costs using a pension plan's high expected return rather than a low riskless return can significantly reduce the plan's measured funding shortfall.
But it does so only by ignoring risk. The expected return implies only the "expectation" -- meaning, at least a 50% chance, not a guarantee -- that the plan's assets will be sufficient to meet its liabilities. But when future benefits are considered to be riskless by plan participants and have been ruled to be so by state courts, a 51% chance that the returns will actually be there when they are needed hardly constitutes full funding. Public pension administrators argue that government plans fundamentally differ from private sector pensions, since the government cannot go out of business. Even so, the only true advantage public pensions have over private plans is the ability to raise taxes.
But as the Congressional Budget Office has pointed out in 2004, "The government does not have a capacity to bear risk on its own" -- rather, government merely redistributes risk between taxpayers and beneficiaries, present and future. Market valuation makes the costs of these potential tax increases explicit, while the public pension administrators' approach, which obscures the possibility that the investment returns won't achieve their goals, leaves taxpayers in the dark.
For these reasons, the Public Interest Committee of the American Academy of Actuaries recently stated, "it is in the public interest for retirement plans to disclose consistent measures of the economic value of plan assets and liabilities in order to provide the benefits promised by plan sponsors." Nevertheless, the National Association of State Retirement Administrators, an umbrella group representing government employee pension funds, effectively wants other public plans to take the same low road that the two Montana plans want to take. It argues against reporting the market valuation of pension shortfalls.
But the association's objections seem less against market valuation itself than against the fact that higher reported underfunding "could encourage public sector plan sponsors to abandon their traditional pension plans in lieu of defined contribution plans." The Government Accounting Standards Board, which sets guidelines for public pension reporting, does not currently call for reporting the market value of public pension liabilities. The board announced last year a review of its position regarding market valuation but says the review may not be completed until 2013. This is too long for state taxpayers to wait to find out how many trillions they owe.
UBS: 'The disaster in Spain will continue'
This is a translation of a Spanish-language article from Finanzas.
For UBS, there is no debate about the economy’s green shoots despite the improvement in employment and the slowest fall in consumption and industrial production. In a harsh report on Spain, the Swiss bank says that the worst is yet to come, and that unemployment will reach 20% of the population.
The institution ensures that the latest figures released "have shown a marked deterioration in the situation." For the bank, the problem began with an unprecedented housing bubble, both in size and price, which now has spread to other sectors as demonstrated by the collapse of industrial production – which has fallen by nearly 30% and contributed more than the construction sector to the fall in Gross Domestic Product (GDP).
"We see very few reasons to be optimistic in the short term. The future will be much better, "say UBS analysts, none of them Spaniards, whose work has been supported by another study on the domestic banking sector. "The labour market will continue to deteriorate rapidly, with devastating effects on the rest of the economy!" they say. According to their calculations, unemployment will exceed 20% at the end of 2010.
In the view of the Swiss group, the construction sector has gone from employing 2.7 million workers in the second quarter of 2007 to 1.97 in March of this year. That is to say, 760,000 jobs have already disappeared, reducing its weight in the economy to 10%. In Europe, this figure is 7.5%, so building could lose another 500,000 jobs by the first quarter of next year.
The Swiss bank added that as a result of the aforementioned, the government fiscal situation has deteriorated, as it has subsidised work schemes to revive the economy. Moreover, it has suffered lower revenues as well due to lower contributions to the Treasury. However, UBS believes that the Government has ample room to manoeuvre because the debt burden is still low and because the level of taxation is low compared to other European countries. However, they qualify this saying that the State has little capacity for new large stimulus packages due to the huge public sector deficit.
The price of houses
Regarding the real estate sector, UBS says that in late 2007, Spain was the country with the more overvalued house prices in Europe. It amounted to 55%, followed by Ireland, with about 30%. For the bank, the situation has not changed much since the prices of homes have only fallen by 6.5% from the peak.
The bank says that this market behaviour is logical because sellers do not want to dispose of assets if it is no at an attractive price. This attitude leads to a collapse in the number of transactions, which are ever increasing supply, which results in a longer fall of the house prices. According to their estimates, this fall will be at least 20%.
Recession may get worse, Gordon Brown warns world leaders
The worst of the recession may be yet to come and world leaders are in danger of hampering the recovery, Gordon Brown will say today. As he begins a week of meetings with world leaders, the Prime Minister will strike an unexpectedly gloomy note about the prospects of an upturn and will demand that fellow heads of government "sound a second-wake up call for the world economy". Soaring oil prices, rising 75 per cent this year, protectionist measures contributing to a 10 per cent drop in trade and the failure of banks to start lending again could all put the recovery at risk, according to Downing Street.
The remarks are a departure from Mr Brown’s usual rhetoric. His forecast that the British economy will emerge from recession by the end of the year is expected to form the basis of Labour’s general election campaign. Downing Street sources denied that the remarks were a change, saying that he had not spoken about the international economy for a while. Mr Brown will sound the warning when he travels to Evian in France for talks with President Sarkozy today. On Wednesday he is heading off to L’Aquila in Italy for the G8 summit of world leaders, including President Barack Obama.
"If we do not take the necessary action now to strengthen the world economy and put in place the conditions for sustainable world growth, we will be confronted with avoidable unemployment for years to come," he is expected to say today. Mr Brown will also say that although public finances need to be sustainable in the long term, "now is not the time for fiscal contraction". His aides said that he was referring to Britain’s public finances this year and that he was not attempting to start a debate about a second international fiscal stimulus.
But Mr Brown will be keen to protect the legacy of the international fiscal stimulus package he forged at the G20 summit in London three months ago. He faces opposition from the Swedish Presidency of the EU, which is calling for "exit strategies" from stimulus measures during its tenure, which ends in December. Lord Mandelson, the Business Secretary, told The Times: "We in Europe have to be mindful of the need not to become complacent and not to relax. If we continue to get our reaction to the crisis right we can make Europe stronger."
Mr Brown’s remarks may be a sign that he will blame other governments for holding back the recovery if the British economy does not improve in time for the election. The Prime Minister’s downbeat assessment was echoed by Alistair Darling, who confirmed yesterday that the state of the economy was worse than at the time of April’s Budget and warned that public sector pay had to reflect the squeeze affecting the rest of the workforce. Figures from the Office for National Statistics last week revealed that the economy had slumped at its fastest for 50 years, shrinking by 2.4 per cent rather than the 1.9 per cent believed previously.
The Chancellor acknowledged that public spending faced "much tighter" limits as a result of the recession. Reports in The Sunday Times suggested that some government departments are expecting to have to cut budgets by up to 20 per cent. Mr Darling did not deny the claim, saying: "It is not attributed to the Treasury." He also acknowledged that he had almost been sacked as Chancellor. Asked if Mr Brown wanted to replace him with Ed Balls, who remained Schools Secretary in the last reshuffle, he said: "Some conversations I never ever repeat. In politics you have to be grown-up about it. I am here now and I have a job of work to do."
Sir John Major, the former Conservative Prime Minister, said that government must "downsize", suggesting that expanding the State further "is a route that ends in national bankruptcy". He said that it should reduce its size by a third, including cutting the numbers of ministers and civil servants. The recession presented Britain with a "philosophical opportunity" to reassess the role of the State.
China's elderly will overwhelm the nation
For three decades China's one-child policy helped power this nation's economic rise. With fewer mouths to feed, families saved. Poverty fell. Living standards improved. But a social experiment that worked well in some respects is now threatening the country's hard-won gains. China's working-age population -- the engine behind its prolific growth -- will start shrinking within a few years. Meanwhile, the ranks of elderly are projected to soar. By the middle of this century, fully a third of China's population will be age 60 or older, compared with 26% in the United States. China's projected 438 million senior citizens will outnumber the entire U.S. population.
With fewer workers to support an aging society in need of care, China faces the same demographic squeeze confronting Western nations. The difference: China's family-tinkering policy has accelerated a shift that the country is ill-prepared to manage and finance. "The problem is the age wave is coming while China is still relatively poor," said Richard Jackson of the Washington-based Center for Strategic and International Studies. "China may be the first major country to grow old before it grows rich."
The challenge is profound. Advances in family planning, nutrition and healthcare have resulted in longer life spans and fewer babies across much of the globe. The populations of developing regions such as Latin America and Asia are still much younger than those of U.S. and European societies. But they're aging much more quickly, lacking the time and resources to stitch together old-age social safety nets on par with those of rich, industrialized nations. Shanghai provides a window into China's demographic future. Already China's largest city, it's also its grayest. More than one-fifth of its population is at least 60 years old. That percentage is projected to nearly double to 40% by 2030.
Seniors crowd public parks to do tai chi exercises in the morning and play checkers in the afternoon. They natter with one another on city buses, where everyone 70 and older rides free of charge. So many residents have reached retirement age that city officials are urging local companies to persuade their aging staffs to stay on the job longer. The government has injected $618 million into the public pension system over the last two years to keep it solvent. Lu Yiwen, a 45-year-old factory technician in Shanghai, is years away from retirement. But she's already anxious about her dotage.
"I'm not sure what we're going to do when my husband and I get old," she said. "We have one son and we just hope he can take care of us. Maybe he'll have his own business. But it's a lot of pressure for one child." Despite its dazzling economic growth, China is still a low-income country. Its per-capita GDP in 2008 was just over $5,000, one-ninth that of the United States. Only about a third of China's workforce is covered by a pension system; most of those covered are urbanites. Families save copiously, but it's rarely enough to support them through old age. Average life expectancy is 73 years -- up a stunning 32 years since the People's Republic was founded in 1949.
For most Chinese, social security still means relying on extended family. But that bond is being strained by low birthrates and the migration of tens of millions of young people from the country to jobs in far-off manufacturing plants. When the retirement center at 2 Ruijin Road opened 15 years ago, the thought of packing loved ones off to an old-age facility was still taboo. "If you sent your parents to a home, people would accuse you of treating them badly," said Li Hong Mei, the center's chief physician. "Parents would just refuse to go."
Today, Li regularly turns the elderly away. The 60-bed center is often filled to capacity. To ward off social catastrophe, China's central government has pledged to introduce a national pension system. The challenge will be crafting a plan that's generous enough to keep seniors from poverty but doesn't unduly burden the young. Today in China there are 5.4 working-age adults for every elderly person, according to the Center for Strategic and International Studies. That ratio will plummet to 2.5 by 2030 and to 1.6 by 2050.
"Other than lifting the one-child family policy or allowing immigration, there's not much they can do about demographic realities," said Susan Shirk, a professor at UC San Diego and author of "China: Fragile Superpower." Introduced in 1979 by China's paramount leader Deng Xiaoping, China's one-child policy aimed to slow the nation's population growth and boost living standards. The rules apply mainly to married, urban couples, with exemptions for ethnic minorities and rural residents. The policy is estimated to have prevented between 300 million and 400 million births to date.
From the beginning the program was controversial, criticized for boosting abortions, sterilizations and infanticide. It is also blamed for China's gender gap. The cultural preference for boys has resulted in 32 million more males than females under the age of 20, according to one study. China's fertility rate now averages 1.8, less than replacement. Falling fertility is common as countries become more prosperous; China's rate has been declining for decades. But there's no question that the one-child policy reduced fertility faster and sooner, a process some have dubbed "premature aging."
Still, lifting the one-child rule probably wouldn't result in a population surge, experts said. Chinese have become accustomed to having smaller families and enjoying a bit more disposable income. "The momentum makes the problem difficult to see," said Baochang Gu, a demographer at Renmin University of China. "It creates an illusion that we won't need to do anything. But it may be too late." China's shrinking working-age population is projected to shave 0.7 percentage points annually off China's GDP starting in 2030. But the sick and aged will require an increasing share of resources.
Bachelor Zhu Zi Ran moved into the Ruijin Road retirement facility six months ago after he suffered a blood clot in his brain. The diminutive man in oversized Harry Caray-style glasses said he felt lucky to be there considering how few beds were available. He spends about $200 out of his $250 monthly pension to stay at the retirement home.
"I have to save the rest because my health is not good," Zhu, 67, said. "The only thing I spend money on is cigarettes. I'm not that addicted, so I only smoke half a pack a day." The fate of seniors from the countryside is even more precarious. Xu Gang Kai, a 60-year-old native of central China's Henan province, was told he was too healthy to be admitted to his village retirement home. So he left for Beijing a year ago to find work. Xu said he could not count on his only child for help. "I've got nothing back home," he said. "No land, no housing, no plans."
India’s Mukherjee to Borrow Record to Fund Budget Gap
India’s Finance Minister Pranab Mukherjee announced plans to borrow a record 4.51 trillion rupees ($93 billion) to fund budget spending on roads, power and aid for the poor. Stocks, bonds and the currency slumped. Unveiling the budget for the year to March 2010, Mukherjee said India’s fiscal deficit is expected to widen to a 16-year high of 6.8 percent of gross domestic product from a revised 6 percent. Indirect taxes will be streamlined through a goods and services tax, he said in his speech in New Delhi today.
Prime Minister Manmohan Singh’s government is spending more to speed up economic growth and reduce poverty in a nation where malnutrition is worse than Sub-Saharan Africa. Stocks and the currency weakened on investor disappointment that Mukherjee didn’t announce major asset sales and concerns a ballooning budget deficit may lead to a credit-rating cut. "The budget has failed to instill confidence as to how the government will achieve fiscal consolidation," said Rupa Rege Nitsure, chief economist at state-owned Bank of Baroda in Mumbai. "With this kind of a deficit, there is a possibility that India’s rating may be downgraded."
The Bombay Stock Exchange’s Sensitive Index fell the most in six months, declining 5.8 percent to 14,043.40 at the 3:30 p.m. close in Mumbai. The rupee weakened 1.3 percent, the most in almost six weeks, to 48.5375 against the dollar. The yield on the most-traded 6.07 percent note due May 2014 surged 22 basis points, the most since March 17, to 6.45 percent. Mukherjee, 73, provided for only 11.2 billion rupees this year from the sale of stakes in state-run companies. Advisors to the finance minister, in a report on July 2, estimated the government could raise as much as 250 billion rupees annually over the next five years from asset sales.
Investor expectations of an acceleration in asset sales had surged after Prime Minister Singh won a stunning re-election victory in May, reducing his dependence in parliament on allies such as the communists who had opposed such offerings. "Any downgrade would adversely affect the outlook for foreign investments into the country and hurt growth," said Chetan Ahya, a regional economist at Morgan Stanley in Singapore. Standard & Poor’s, which places India’s long-term local currency rating at BBB-, their lowest investment-grade level, said the 6.8 percent budget deficit for the year to March 2010 is "within the boundary of our expectation," downplaying the risk of an immediate rating downgrade.
Moody’s Investors Service has a rating of Ba2, two levels below investment grade, on India’s local-term local currency bonds, while Fitch Ratings have a BBB- long-term rating on India, their lowest investment-grade level.
Prime Minister Singh’s government plans to overhaul subsidies and is banking on 8 percent to 9 percent economic growth in the next two years to boost tax revenue and reduce the budget deficit to 5.5 percent of GDP by March 2011 and to 4 percent in the following 12 months.
"The proof of the pudding will be in the eating on this one," said Robert Prior-Wandesforde, regional economist at HSBC Group Plc in Singapore. "India remains a long way from achieving a 9 percent growth rate on a sustained bases and will need a lot more in the way of infrastructure spending." India’s record growth of close to 9 percent in the five years ended March 31 helped tax revenue more than double since 2004. The $1.2 trillion economy expanded 6.7 percent last year, the slowest pace since 2003.
Today’s budget also allocates more to ports, power, roads and other infrastructure, where inadequacies shave about two percentage points off India’s growth rate, according to the finance ministry. A goods and services tax will be introduced from April 1 next year, which will subsume all indirect taxes and will levy only value-added production so that manufacturers don’t pay taxes twice. The fringe benefits tax will be scrapped. Mukherjee, who ran a closed economy as the finance minister in Indira Gandhi’s cabinet from 1982 to 1984, returned to the portfolio this year after serving as the defense and foreign minister during the bulk of Singh’s first five-year term.
To fulfill the government’s election promise, Mukherjee announced plans to provide rice and wheat at a subsidized rate of 3 rupees a kilogram. He also raised wages under the National Rural Employment Guarantee Act, which provides 100 days of work in a year to one member from a poor family. Singh’s government wants to sustain growth rates of over 9 percent to help reduce poverty. The World Bank estimates 76 percent of Indians live on less than $2 a day, compared with 72 percent in the Sub-Saharan African nations. According to India’s National Family Health Survey, the child malnutrition rate in India is 46 percent, double that in Sub-Saharan Africa. "The first challenge is to revert the economy back to the high GDP growth rate of 9 percent per annum at the earliest," Mukherjee told parliament today. "The second challenge is to deepen and broaden the agenda for inclusive development."
Fiat Money in Death Throes
by Antal Fekete
"Banking was conceived in iniquity and born in sin. The Bankers own the earth. Take it away from them, but leave them the power to create deposits, and with the flick of the pen they will create enough deposits to buy it back again. However, take away that power, and all the great fortunes like mine will disappear — as they ought to in order to make this a happier and better world to live in. But, if you wish to remain the slaves of Bankers and pay the cost of your own slavery, then let them continue to create deposits."
Sir Josiah Stamp (1880-1941), one time governor of the Bank of England, in his Commencement Address at the University of Texas in 1927. Reportedly he was the second wealthiest individual in Britain.
Make no mistake about it: in this credit collapse we are witnessing the death throes of irredeemable currency. In vain have governments and their client banks tried, for hundreds of years, to graft this repulsive and degenerate bastard on the living organism of society. The result was always the same: the healthy organism rejected the unnatural implant in its own good time. The present episode is no different from earlier ones except, perhaps, in the degree of the conceitedness of the perpetrators, and in their contempt for the native intelligence of man.
When on August 15, 1971, Richard Nixon defaulted on the gold obligations of the United States and declared the irredeemable dollar the "ultimate" means of payments and liquidator of debt, he was relying on the expert advice of Chicago economist Milton Friedman. Five years later the world’s oldest central bank, the Swedish Riksbank would bestow upon Friedman the prize it established in memory of Alfred Nobel. The reward would be in recognition of the brilliance of Friedman’s idea that if a central bank robs the people piecemeal (read: it dilutes the currency at a fixed rate of, say, 3 percent per annum) then the victims would not cry "we wuz robbed!" They would never notice the robbery.
In all previous episodes shame and disgrace were part and parcel of the government’s default on its promises to pay. Not so in 1971. In this latest experiment with irredeemable currency there was a new feature: far from being a disgrace, the default was presented as a scientific breakthrough; conquering "monetary superstition" epitomized by gold; a triumph of progress. Sycophant governments and central banks overseas that were victimized by it and had to swallow unprecedented losses due to the devaluation of the dollar were not even allowed to say "ouch!" They were forced to celebrate their own undoing and hail the advent of the New Age of synthetic credit, irredeemable currencies and irredeemable debts.
The regime of the irredeemable dollar was put to the test soon enough. In 1979 the genie escaped from the bottle. The price of oil, silver, and gold were quoted at twenty times that prior to 1971; in the case of sugar the rate of increase was more like forty times, so much so that the Coca Cola Company found it too expensive to put into coke and started using corn syrup instead. Interest rates were quoted in double digits well past the teens. There was panic across the land and around the globe. Hoarding of goods became a way of life. Everybody was expecting the worst.
It was at this time that the notion of "targeting inflation" was invented. Previously the claims of central bank power were rather modest. Central banks were supposed to target short-term interest rates. Later they graduated to targeting the money supply. Now they were claiming supernatural powers of micromanaging price increases. It was apparently working, and the genie was put back in the bottle.
In the intervening three decades policymakers and mainstream economists became ever more confident that in inflation-targeting they have found the holy grail of irredeemable currency. Professor Frederic Mishkin of Columbia University, a former governor of the Federal Reserve, published the gospel of inflation targeting with the title Monetary Policy Strategy in 2007. In his book he calls inflation targeting "an information-inclusive strategy for the conduct of monetary policy."
Martin Wolf, the chief economic columnist of the Financial Times of London explains: inflation targeting makes allowance for all relevant variables — exchange rates, stock prices, housing prices and long-term bond prices — via their impact on activity and prospective inflation. This, then, is the new modified holy grail. Cast your net wide enough to catch all that you want to control. If you do it boldly, you will make people believe that the government can control everything it wants to control. It is amazing how much can be accomplished by piling prestidigitation upon prestidigitation.
Ironically, disaster struck just at the time when the prophets of inflation-targeting became cocky beyond any measure of modesty. They actually had a whole debate going on in American journals, but also English ones. Ben Bernanke, who in the meantime was made the chairman of the Federal Reserve, contributed the keynote address and the title to the debate: "The Great Moderation". Their description, up to and including the beginning of 2007 of what was happening in the macro economy, was a reduction in the volatility in the trade cycle: more consistent growth, less bouts of inflation, more stability.
The London Times published a jubilant piece as recently as early 2007 with the title "The Great Moderation" which began with the line: "History will marvel at the stability of our era." It was not meant to be a joke. It was meant to be believed. Complacency about the almighty nature of monetary policy reached its peak. They celebrated the success of inflation targeting just when it started to unravel. Policymakers, central bankers, and their lackeys in academia and journalism, felt inordinately proud of themselves. They thought they held the whole world in their hands.
The celebration and self-congratulation was premature. Bernanke & Co. did not know that they were about to be humbled by the markets. Blinded by the glare of their own glory, none of them foresaw the coming disaster.
Martin Wolf in his column on May 7 talks about "this unforeseen crisis" as an unmitigated disaster for monetary policy. It leaves fiat money with just one last chance to put its act together and save its hide. He says: "The holy grail turned out to be a mirage. If fiat money is not made to work better than it has, who knows what our children might decide to do in desperation. They might even decide to bring back and embrace gold". Oh horror of horrors! Wolf still considers the gold standard an absurdity.
It’s kind of strange. It is not the regime of irredeemable currency, whereby governments are supposed to create wealth by sprinkling some ink on little scraps of paper, that is considered an absurdity. Of course, Mr. Wolf has the right of wanting to be pilfered and plundered. But he has no right to advocate that the rest of us be cheated through this crudest form of plunder forever and ever.
He is also mistaken when he assumes that Bernanke & Co. still has one more chance. The chance they just blew was the last. We are witnessing the closing of the regime of irredeemable currency and irredeemable debt. We may not know how long its death throes will take, but there will be no other chance. Financial journalists and mainstream economists, in their blind stupor acting as cheerleaders for the disastrous monetary policy of the government and the insane credit policy of the banks, have exhausted and destroyed their own credibility for once and all.
* * *
Martin Wolf, like most of his colleagues, is a victim of brainwashing inspired by Keynes that has been going on to discredit the gold standard for some 75 years, but which got a new lift after Friedman inspired Nixon to default. Here are the facts about the gold dollar that should be made available to the world through the opening of the Mint to gold, as demanded by the U.S. Constitution.
The gold standard is an indispensable prerequisite of freedom. Without it individuals are helpless in facing the constant and ongoing encroachment of their property rights by the government and the banks. The right to demand gold in exchange for bank notes and bank deposits far transcends the mere technicality of exchange of one form of money for another. It is the only way to check the unlimited power of the government manifested by the unlimited creation of bank deposits. The combination of governmental power and the power of the banks to create deposits is especially dangerous for the freedom of the individual, because of the double standard involved. The government exempts banks from the effects of contract law in exchange for the banks’ special treatment accorded to government debt.
Gold hoarding is not a blemish on the gold standard; it is its main excellence. When a sufficient number of individuals are disturbed by the encroachment of this combination of powers, or disapprove the monetary policy of the government and the credit policy of the banks, they are not helpless under a gold standard. They can withdraw bank reserves, namely gold, from the system, thereby putting the government and the banks on notice that unless they mend their ways, and stop their adventures in debt creation, they will find themselves insolvent and out of power. The gold standard gives people the upper hand.
It is no accident that all dictatorships set out by limiting the people’s access to gold. It makes no difference whether they march under the banner of national or international socialism. All totalitarian regimes inflict irredeemable currency on the people as an instrument of servitude and bondage. Martin Wolf should know this. The ideal of limited government is meaningless unless reinforced by a gold standard denying to the government the power of issuing unlimited amounts of currency. There is no other way of doing this than making the promises of the government redeemable in something other than more promises of the same shabby kind.
Once the government makes the currency irredeemable, it puts itself in the position to curtail the rights and freedoms of the people as it sees fit. Constitutional government is effectively overthrown. Once the government usurps the public purse, its power becomes uncontrollable. Budget debate in Parliament or in Congress becomes an annual farce. Nothing stands in the way of unscrupulous politicians to undermine constitutional government. The purchasing power of the currency is constantly undermined year in, year out. The banks are freed from constraints on them exercised by the people under the gold standard. Pandora’s box of corruption is opened and its contents contaminate the nation’s economic, political, and social system.
Governments which employ irredeemable currency grab unconditional control over foreign trade, exchange rates, foreign investments and travel, even the amount of currency an individual can take in or out of the country. The more powerful governments will buy the allegiance of the less powerful. Out of this feudalistic web of allegiances financed by irredeemable currency come various adventures in fomenting and waging wars in far-away lands, spilling the blood of the young people of the nation for causes alien to them.
Under a gold standard prolonged budget deficits and prolonged unfavorable balance of payments cannot occur. There are forces limiting persistent losses of gold which tend to correct the underlying distortion. By contrast, under the regime of irredeemable currency economic distortions can persist indefinitely. They ultimately become destructive. This is so because government bureaucrats cannot possibly provide the same level of wisdom that a people free to act in their own interest can.
As problems in foreign trade mount, governments will find ever more excuses for ever more controls. There is no end to the expansion of government power over the individual until the nation regains the benefits of a gold standard, requiring that the government retire to its proper role of umpire and relinquish its role as dominant partner and dictator.
A government can take total control of the people either by the use of military force, or by the use of irredeemable currency. The former is readily understood, while the latter is a subtle national drug that is not generally recognized as such. Rather, it is readily embraced by its victims. For these and similar reasons irredeemable currency is the favorite device of modern governments that want to bring people under total control. Indeed, it enables the government to succeed in controlling the masses while, at the same time, earning their approval and even their enthusiastic support. Irredeemable currency must be seen as the habit-forming drug that the government uses to intoxicate people. Under this intoxication people will want more and more national spending, more and more government control, and more and more debt.
This intoxication obscures the sad end that arrives when the merry-go-round is coming to a jerky halt, when credit is exhausted or withdrawn, and the kitty is found empty. The nation is facing a most serious economic disaster followed by prolonged economic pain. Unfortunately, government economists, university professors, and financial journalists have taken their share of the fun and they failed miserably in their duty to forewarn people of the coming disaster.
It is useless to expect a mass movement on behalf of a sound currency. The daily experiences of people provide them with a warped outlook. They confirm in their minds the alleged virtues and benefits of an infinitely inflatable currency. People lack sufficient understanding of monetary science to see that no currency can be made infinitely inflatable without inviting disaster. Like a drug addict, people exposed to irredeemable currency do not regard it as a dangerous and undermining narcotic agent. Even the loss of purchasing power does not disturb them to any great extent. Their response is to demand more money, and they take pride in the fact that the government listens sympathetically to their demand. They welcome the soaring stock indexes and real estate prices, and put great stores on them. Heavy taxes and burgeoning debt are not regarded with anxiety. A frequent and common agitation is for ever more government spending.
* * *
If we are to be saved from the ultimate evil consequences of the regime of irredeemable currency, needed action must come from the leadership of the opposition party when it is its turn to take over government. The new President and his Secretary of the Treasury, or the new Prime Minister and his Secretary of the Exchequer must be statesmen. They must act as informed and tough monetary surgeons, men who can and will persuade Congress or Parliament to reinstate redeemable currency.
Once that step is taken, the people should experience a breath of fresh air. Government would once more be subordinated to the Constitution, bringing greater freedom to the people. Optimism should be wide-spread, because the currency of the people would once more had integrity. Business should prosper, domestic and foreign trade expand. Imbalances in foreign trade should rectify themselves. Gold should start to circulate and flow in from abroad. The control of the public purse would be returned to the people where it belongs if human freedom is to be preserved and responsible government is to be obtained.
But as the last presidential election in the United States has shown, the needed leadership is lacking. The party of the opposition is just as much in thrall to the same toxic ideology as the governing party. The last change of guards took place in the middle of a financial and economic crisis involving the destruction of quantities of wealth unprecedented in all history, with more destruction coming. Yet when the new president appointed officials at the Treasury, confirmed others at the Federal Reserve, and named economic advisors, they turned out to be the same men who were responsible for the credit collapse in the first place. Not only do these officials continue the dangerous course of the previous administration; they increase the stakes by several orders of magnitude in announcing more bailouts, more stimulus packages, hence more government spending, more government debt, and more fiat money creation.
The situation is no better in the United Kingdom, another important country expecting a change of guards, which could take the initiative to put a peaceful end to the regime of irredeemable currency now in its death throes. Rather than initiating a national debate on the utter failure of the present financial system which was supposed to end bank runs, deflations and depressions, serial bankruptcies and unemployment for once and all, and on the return to sound money and sound book-keeping, Her Majesty’s Loyal Opposition is plotting a course how to cure the collapse of bad debt with the injection of more bad debt.
What this means is that there is no hope for change through peaceful means. When change finally does come, it will be through violence. When the economic pain inflicted on the people reaches unbearable heights, law and order will break down, anarchy and chaos will ensue.
Looking at the ruins of our civilization will be a bitter reminder of what the great monetary tradition of the English-speaking countries, in ruling out irredeemable currency and mandating a metallic monetary standard, was designed to prevent.
Were in the Middle of a Crash - Nassim Taleb
Make Sure You Get This One Right
by Niels C. Jensen
"You can't beat deflation in a credit-based system."
As investors we are faced with the consequences of our decisions every single day; however, as my old mentor at Goldman Sachs frequently reminded me, in your life time, you won't have to get more than a handful of key decisions correct - everything else is just noise. One of those defining moments came about in August 1979 when inflation was out of control and global stock markets were being punished. Paul Volcker was handed the keys to the executive office at the Fed. The rest is history.
Now, fast forward to July 2009 and we (and that includes you, dear reader!) are faced with another one of those 'make or break' decisions which will effectively determine returns over the next many years. The question is a very simple one:
Are we facing a deflationary spiral or will the monetary and fiscal stimulus ultimately create (hyper) inflation?
Unfortunately, the answer is less straightforward. There is no question that, in a cash based economy, printing money (or 'quantitative easing' as it is named these days) is inflationary. But what actually happens when credit is destroyed at a faster rate than our central banks can print money?
A Story within the Story
Following the collapse of the biggest credit bubble in history, there has been no shortage of finger pointing and the hedge fund industry, which has always had an uncanny ability to be at the wrong place at the wrong time, has yet again been at the centre of attention. And politicians, keen to divert attention away from themselves as the true culprits of the crisis through years of regulatory neglect, have been quick at picking up the baton. Admittedly, the hedge fund industry is guilty of many stupid things over the years, but blaming it for the credit crisis is beyond pathetic and the suggestion that increased regulation of the hedge fund industry is going to prevent future crises is outrageously naïve.
If you prohibit private investors from investing in hedge funds which on average use 1.5-2 times leverage but permit the same investors to invest in banks which use 25 times leverage and which are for all intents and purposes bankrupt, then you either don't understand the world of finance or you don't want to understand. Shame on those who fall for cheap tactics.
Let's begin by setting the macro-economic frame for the discussion. I have been quite bearish for a while, suspecting that the growing optimism which has characterised the last few months would eventually fade again as reality began to sink in that this is no ordinary recession and that 'less bad' doesn't necessarily translate into a quick recovery. I still believe there is a good chance of enjoying one, maybe two, positive quarters later this year or early next; however, a crisis of this magnitude doesn't suddenly fade into obscurity, just because the economy no longer shrinks at an annual rate of 6-8%.
Going forward, not only will economic growth disappoint, but the economic cycles will become more volatile again (see chart 1) with several boom/bust cycles packed into the next couple of decades. This is a natural consequence of the Anglo-Saxon consumer-driven growth model having been bankrupted. Growing consumer spending over the past 30 years led to rapidly expanding service and financial sectors both of which will now contract for years to come as overcapacity forces players to downsize.
This will again lead to higher corporate earnings volatility which will almost certainly drive P/E ratios lower, making conditions even trickier for equity investors. At the bottom of every major bear market in the last 200 years, P/E ratios have been below 10. As you can see from chart 2 overleaf, few countries are there yet. The next decade is therefore not likely to be a 'buy and hold' market for equity investors. The combination of low economic growth and pressure on valuations will create severe headwinds. The most likely way to make money in equities will be through more active trading.
So now, two years into this crisis, where do we stand and where do we go from here? History offers limited guidance, as we have never experienced the bursting of a bubble of this magnitude before. The closest thing is the collapse of the Japanese credit bubble around 1990. As the Japanese have since learned, recovering from a deflated credit bubble is a long and very painful affair.
Governments and central banks on both sides of the Atlantic are pursuing a strategy of buying time, hoping that a recovery in economic conditions will allow our banking industry to re-build its capital base. The Japanese pursued a similar strategy back in the early 1990s. It failed miserably and set the country back many years in its recovery effort. Ironically, the Japanese approach was almost universally condemned as hopelessly inadequate. It is funny how you always know better how to fix other people's problems than your own. A little bit like raising children, I suppose.
Another lesson learned from Japan is that once you get caught up in a deflationary spiral, it is exceedingly hard to escape from its grip. The Japanese authorities have used every trick in the book to reflate the economy over the past two decades. The results have been poor to say the least: Interest rates near zero (failed), quantitative easing (failed), public spending (failed), numerous attempts to drive down the value of the yen (failed); the list is long and makes for painful reading.
We are effectively caught in a liquidity trap. The Bank of England, the European Central Bank and the Federal Reserve have all flooded their banking system with enormous amounts of liquidity in recent months but what has happened? Instead of providing liquidity to private and corporate borrowers as the central banks would like to see, banks have taken the opportunity to repair their balance sheets. For quantitative easing to be inflationary it requires that the liquidity provided to the market by the central bank is put to work, i.e. lenders must lend and borrowers must borrow. If one or the other is not playing along, then inflation will not happen.
This is illustrated in chart 3 which measures the growth in the US monetary base less the growth in M2. As you can see, the broader measure of money supply (M2) cannot keep up with the growth in the liquidity provided by the Fed. In Europe the situation is broadly similar.
There is another way of assessing the inflationary risk. If one compares the total amount of credit destruction so far (about $14 trillion in the US alone) to the amount spent by the Treasury and the Fed on monetization and fiscal stimulus ($2 trillion), it is obvious that there is still a sizeable gap between the capital lost and the new capital provided.
If we instead move our attention to the real economy, a similar picture emerges. One of the best leading indicators of inflation is the so-called output gap, which measures how much actual GDP is running below potential GDP (assuming full capacity utilisation). It is highly unlikely for inflation to accelerate during a period where the output gap is as high as it currently is (see chart 4). Theoretically, if you believe in a V-shaped recession, the output gap can be reduced significantly over a relatively short period of time, but that is not our central forecast for the next few years.
I can already hear some of you asking the perfectly valid question: How can you possibly suggest that deflation will prevail when commodity prices are likely to rise further as a result of seemingly endless demand from emerging economies? Won't rising energy prices ensure a healthy dose of inflation, effectively protecting us from the evils of the deflationary spiral (see chart 5)?
Good question - counterintuitive answer:
Contrary to common belief, rising commodity prices can in fact be deflationary so long as demand for such commodities is relatively inelastic, which is usually the case for basic necessities such as heating oil, petrol, food, etc. The logic is the following: As commodity prices rise, money earmarked for other items goes towards meeting the higher commodity price and consumers are essentially forced to re-allocate their spending budget. This causes falling demand for discretionary items and can in extreme cases lead to deflation. We only have to go back to 2008 for the latest example of a commodity price induced deflationary cycle.
A price increase on a price inelastic commodity is effectively a tax hike. The only difference is that, in the case of the 2008 spike in energy prices, the money didn't go towards plugging holes in the public finances but was instead spent on English football clubs (well, not all of it, but I am sure you get the point) which have become the latest 'must have' amongst the super-rich in the Middle East.
For all those reasons, I am becoming increasingly convinced that the ultimate outcome of this crisis will turn out to be deflation – not inflation. Inflation may eventually become a problem, but that is something to worry about several years from now. The Japanese have pursued an aggressive monetary and fiscal policy for almost 20 years now, and they are still nowhere.
So why are interest rates creeping up at the long end? Part of it is due to the sheer supply of government debt scheduled for the next few years which spooks many investors (including us). And the fact that the rising supply is accompanied by deteriorating credit quality is a factor as well. But countries such as Australia and Canada, which only suffer modest fiscal deficits, have experienced rising rates as well, so it cannot be the only explanation.
Maybe the answer is to be found in the safe haven argument. When much of the world was staring into the abyss back in Q4 last year, government bonds were considered one of the few safe assets around and that drove down yields. Now, with the appetite for risk on the increase again, money is flowing out of government bonds and into riskier assets.
Perhaps there are more inflationists out there than I thought. Several high profile investors have been quite vocal recently about the inevitability of inflation. Such statements made in public by some of the industry's leading lights remind me of one of the oldest tricks in the book which I was introduced to many moons ago when I was still young and wet behind the ears. 'Get long and get loud' it is called; it is widely practised and only marginally immoral. Nevertheless, when famous investors make such statements, it affects markets.
The point I really want to make is that the inflation v. deflation story is the single biggest investment story right now and being on the right side of that trade will effectively secure your investment returns for years to come. If I am wrong and inflation spikes, you want to load your portfolio with index linked government bonds (also known as TIPS for our American readers), gold and other commodities, commodity related stocks as well as property.
If deflation prevails, all you have to do is to look towards Japan and see what has done well over the past 20 years. Not much! You cannot even assume that bonds will do well. Recessions are bullish for long dated government bonds but a collapse of the entire credit system is not. The reason is simple - with the bursting of the credit bubble comes drastic monetary and fiscal action. Central banks print money and governments spend money as if there is no tomorrow, and all bets are off. Equities will do relatively poorly as will property prices. But equities will not go down in a straight line. The market will offer plenty of trading opportunities which must be taken advantage of, if you want to secure a decent return.
All in all, deflation is ugly and not conducive to attractive investment returns. It is also not what governments want and need right now. With a mountain of debt hitting the streets of Europe and America over the next few years, as the cost of fixing the credit and banking crisis is financed, one can make a strong case for rising inflation actually being the favoured outcome if you look at it from the government's point of view. The problem, as the Japanese can attest to, is that deflation is excruciatingly difficult to get rid of, once it has become entrenched. I am in no doubt which of the two evils I would prefer, but we may not have the luxury of choosing our own destiny.
It’s the Deleveraging, Stupid
by Steve Keen
"Gentleman, you have come sixty days too late. The depression is over." - Herbert Hoover, responding to a delegation requesting a public works program to help speed the recovery, June 1930
"The past may not repeat itself, but it sure does rhyme." Mark Twain
In the last six months, the phrase “Green Shoots of Recovery” has entered the economic lexicon. It appeared to some observers that the global recession was coming to an end, while Australia itself was likely to barely feel its impact.
I would be as pleased as anyone if these “green shoots” were true harbingers of a genuine end to the economic downturn–not because I would enjoy being wrong for the sake of it, but because my expectations for the future are so bad that I’d prefer to see them not come to pass.
Unfortunately, on current data I expect that “green” is a better description of the knowledge level of those making the optimistic predictions, than of the colour of any budding economic recovery.
Of course, it could be argued to the contrary that many of those making such optimistic forecasts are highly trained professional economists, and not merely market commentators who migh have a vested interest in putting a positive spin on the news.
This is true–but far from being a reason to trust these forecasts, it is yet another reason to be sceptical of them.
Almost every holder of a PhD in economics who works for a formal economic body like the Treasury, the RBA or the OECD has been deeply schooled in “neoclassical” economics, often without knowing that there is any other way of thinking about how the economy functions. They think they are simply “economists”, and anyone who objects to their analysis or models must be uneducated about economic theory.
In contrast, virtually all University Departments of Economics contain at least one economist who rejects neoclassical economics, and instead subscribes to a rival school–like Austrian, Marxian, Post Keynesian, or Evolutionary Economics.
These contrarian academic economists often disagree amongst themselves, sometimes vehemently–you couldn’t get two more opposed points of view than Austrian and Marxian economics, for example–but they tend to be united in regarding neoclassical economic theory as pompous drivel.
There are probably many reasons for this dichotomy between University economics departments which almost always have a handful of dissidents, and official economics bodies like the OECD and Treasury that are almost exclusively staffed by neoclassical economists. But I suspect the main reason is tenure: universities offer it, while formal economic advisory bodies don’t.
As a result, academic economists who “turn feral” and reject neoclassical economics can still teach and publish and hang on to their jobs, even if their neoclassical Department Heads wish they would go away. OECD and Treasury economists who do the same thing probably find their employment coming to an end–because they don’t have tenure.
So anything published by a formal economic body like the OECD will be the product of a neoclassical economic model–and therefore, in my opinion and that of a sizable minority of academic economists, drivel (there was one exception–the Bank of International Settlements while Bill White, a supporter of Hyman Minsky’s “Financial Instability Hypothesis“, was its its Economic Adviser).
Of course, disputes between academic economists don’t matter in the real world, and most newspapers report the announcements of bodies like the OECD as statements of wisdom about the future–until, that is, a crisis like the Global Financial Crisis makes a mockery of the OECD’s neoclassical fantasies.
And what a mockery. This was the OECD’s forecast for the world economy in June 2007:
EDITORIAL: ACHIEVING FURTHER REBALANCING
“In its Economic Outlook last Autumn, the OECD took the view that the US slowdown was not heralding a period of worldwide economic weakness, unlike, for instance, in 2001. Rather, a " smooth" rebalancing was to be expected, with Europe taking over the baton from the United States in driving OECD growth.”
“Recent developments have broadly confirmed this prognosis. Indeed, the current economic situation is in many ways better than what we have experienced in years. Against that background, we have stuck to the rebalancing scenario. Our central forecast remains indeed quite benign: a soft landing in the United States, a strong and sustained recovery in Europe, a solid trajectory in Japan and buoyant activity in China and India. In line with recent trends, sustained growth in OECD economies would be underpinned by strong job creation and falling unemployment.” (OECD Economic Outlook, Volume 2007/1, No. 81, June 2007, p. 7)
Yeah, right. Instead the global economy was already well into the greatest economic crisis of the last 60 years. The next two years tore the OECD’s 2007 forecasts to shreds.
One might hope for some soul searching as a result of this–and hopefully some is occurring behind closed doors. But in a clear sign that the OECD hopes to see “Business as usual” restored in its modelling approach as well as the actual economy, its current Economic Outlook discusses the process of recovery from an economic crisis that it completely failed to foresee:
EDITORIAL: NEARING THE BOTTOM?
“OECD activity now looks to be approaching its nadir, following the deepest decline in post-war history. The ensuing recovery is likely to be both weak and fragile for some time. And the negative economic and social consequences of the crisis will be long-lasting. Yet, it could have been worse. Thanks to a strong economic policy effort an even darker scenario seems to have been avoided. But this is no reason for complacency; the need for determined policy action remains across a wide field of policies…”
“In summary, it looks as if the worst scenario has been avoided and that OECD economies are now nearing the bottom. Even if the subsequent recovery may be slow such an outcome is a major achievement of economic policy. But this is no time to relax — ensuring that the recovery stays on track and leads towards a long-term sustainable growth path will call for major policy efforts going forward.” (OECD Economic Outlook, Volume 2007/1, No. 81, June 2009, pp. 5 & 7)
With its utter failure to see this crisis coming, why does anyone still take the OECD seriously? Probably for the same reason that people still generally obeyed the Captain of the Titanic after it had struck the iceberg: authority counts for a lot in a crisis, even if the person in authority actually caused it.
But it’s also because it takes repeated failures before someone who asserts authority is rejected–one failure alone won’t do. So rather like Napoleon in exile in Elba, the OECD is still taken seriously by economic commentators–as with Peter Martin’s report (”Australia’s downturn to be shorter than expected“, The Age June 25th 2009):
“AUSTRALIA is set to soar out of its economic downturn sooner and more sharply than forecast in the budget, according to forecasts from the Organisation for Economic Co-operation and Development understood to have the backing of the Australian Treasury.
The OECD says the local economy should shrink 0.3 per cent this year, less than any other OECD economy and far less than the contraction of 1 per cent that underlies the forecasts in the May budget.
Next year the economy should roar back 2.4 per cent, also above budget forecasts and more than any other OECD economy apart from those recovering from collapse in 2009.
The Treasurer, Wayne Swan, greeted the forecasts released overnight in Paris as evidence Australia was “outperforming every other advanced economy in the face of the recession”.
The forecasts show Australia’s unemployment rate reaching 7.9 per cent late next year rather than the 8.25 to 8.5 per cent range assumed in the budget.”
A little scepticism in this report would have been appreciated, given the OECD’s track record–and if a political journalist had written the report, that might well have occurred. But it was written by an economics correspondent, and most of them have–like the OECD’s economists–been schooled only in neoclassical economics, and don’t know how flimsy the theory itself is (there are exceptions here, like Brian Tookey whose book Tumbling Dice is an excellent critique of neoclassical economics). So we get a report like this trumpeting good times and green shoots, with no irony (Peter Martin was far from the only one to present the OECD’s views without any scepticism–see also “Earth-destroying bomb defused – just” by Michael Pascoe or Glenn Dyer at Crikey “That’ s no green shoot, that’ s Australia in full bloom: OECD“).
Clearly it will take a few more predictive and policy failures before economic journalists realise that with the global financial crisis, neoclassical economics–and hence the OECD–is facing its intellectual Waterloo.
To be fair, official economic bodies and their uncritical fans were not the only source of “green shoot” euphoria. A large part of this feeling that the worst was over also came from the global experience of a recovery in stock markets from their recent lows.
The Dow has indeed had an impressive rally, from the low of 6547 on March 9 to the peak of 8799 on June 12–a rise of 34% in under a quarter of a year. This has led to many of the usual suspects proclaiming that the bear market is over, and a new rally is underway. Comparisons with 1929 are, of course, unjustified…
On closer inspection, reports of the death of the bear market are somewhat exaggerated.
Firstly, though the index has rallied by 34% from its low, it is still down 40% from the all time peak of October 2007.
Secondly, rallies like this came and went ad nauseam in the early 1930s, until the market hit rock bottom at 41.22 points on July 8th 1932–89% below the September 3rd 1929 peak of 381.17.
The biggest such rally occurred very soon after The Crash in 1929, starting on November 13th 1929 when the market was down 48% from its September peak. It then rose almost 50% from its low in under 6 months–and it was this recovery that inspired Hoover’s Oval Office gaffe.
But the market had only recovered half of what it had lost when the rally ran out of steam–a 50% fall followed by a 50% recovery still leaves you 25% below where you started from–and the inexorable slide of the Great Depression dragged the market down with it.
This current rally took a lot longer to start than its 1929 cousin, though it began from a comparable bottom (55% below the peak versus 48% below it in 1929), and it still has to go on for much longer and drive the market much higher to match its antecedent–let alone to proclaim the 2007 Bear Market is over (note also that Eichengreen and O’Rourke, using global data, argue that the current decline is far worse than in the Great Depression, with global markets down 50% on average 12 months after the crisis versus just 10% down after 1929–see Figure 2 here).
Meanwhile, in the Real World…
Though the stock market was providing some good cheer in the USA (at least until last week), the real economy continued to disappoint. To get an idea of just how bad the downturn has been, and how little inkling of it that conventional economists had, consider the Economic Report of the President, prepared by the US President’s Council of Economic Advisers, in 2008 and 2009.
The 2008 Report made the following forecasts–note in particular the “forecast” that unemployment would be below 5 percent between 2008 and 2013.
The 2009 Report, submitted to Congress and the incoming President in January of this year, made a mockery of the 2008 Report but still drastically underestimated the severity of the downturn: it forecast that unemployment would peak at 7.7% in 2009, growth would remain positive for the next five years.
Despite the frequency with which numerous economists who failed to anticipate the Global Financial Crisis continue to report sightings of “green shoots of recovery”, the actual economic data continued to be grimmer than even their most pessimistic revised forecasts.
The clearest evidence here is that the Federal Reserve’s “stress tests” for its Supervisory Capital Assessment Program assumed that even under an adverse scenario, unemployment would be below 9 percent by mid-2009. It is currently 9.4 percent. The tapering process that is built into neoclassical economic forecasts is not evident in the data to date.
Deleveraging and Economic Breakdown
The reason that most economists continue to underestimate this downturn is because (a) the downturn is being driven by deleveraging from literally unprecedented levels of private debt, and (b) the neoclassical theory of economics, which dominates academic and market economics alike, ignores the role of private debt in the economy.
The reason that I anticipated this crisis four years ago is that I reject the mainstream “neoclassical” approach to economics, and instead analyse the economy from the perspective of Hyman Minsky’s “Financial Instability Hypothesis”, in which private debt plays a crucial role. In our credit-driven economy, demand is the sum of GDP plus the change in debt. If debt is low relative to GDP, then its contribution to demand is relatively unimportant; but if debt becomes large relative to demand, then changes in debt can become THE determinant of aggregate demand, and hence of unemployment.
That is manifestly the case in America today. Under the stewardship of neoclassical economics in the personas of Alan Greenspan and Ben Bernanke, the growth in private debt has not merely been ignored but has actively been encouraged, in the dangerously naive belief that the private sector is being “rational” when it borrows.
This apparent indictment of the private sector as therefore “irrational” is in fact really an indictment of neoclassical economics for abuse of language. What neoclassical theory means by the word “rational” is “able to correctly anticipate the future”–which is the definition, not of rationality, but of prophecy.
There is nothing “irrational” about being unable to predict the future–it is fundamentally uncertain, while modern economic theory hides from this reality just as Keynes’s contemporary economic rivals did in the 1930s when he wrote that:
“I accuse the classical economic theory of being itself one of these pretty, polite techniques which tries to deal with the present by abstracting from the fact that we know very little about the future.” (Keynes, “The General Theory of Employment”, Quarterly Journal of Economics 1937)
Instead, in the uncertain world in which we live, the private sector necessarily speculates about the future–and some of those speculations will be wrong. The role of regulation and government economic policy should be to confine those speculations, as much as is possible, to productive pursuits rather than gambles about the future path of asset prices–a pasttime that has always in the past led to Ponzi asset bubbles.
This time, with government policy driven by neoclassical economics and its deluded attitudes towards the future, policy has actually encouraged the private sector to borrow to indulge in two giant Ponzi Schemes–the stock market and (belatedly) the housing market. It has gambled with borrowed money that share and house prices would always rise faster than consumer prices.
That gamble worked for some decades, but it then failed–in 1987-89. Had the Greenspan Fed not intervened then to “rescue” Wall Street, there is every possibility that the US would have experienced a mild Depression then–mild because the level of debt was lower then that at the time of the Great Depression (165% in 1989 versus 175% in 1929), and crucially because the rate of inflation then was high (5% in 1989 versus 0.5% in 1929).
The lower level of debt would have meant that less deleveraging would have been required to return to a predominantly income-financed economy in 1989 than was required in the 1930s, while high inflation would have meant a lower likelihood of deflation during the Depression itself, and possibly that inflation alone could have eroded the debt burden. It still would not have been pretty–certainly it would have been worse than the 1983 recession, when unemployment as it is currently defined peaked at 10.8 percent.
But what we face now will be far worse, because deleveraging from the now unprecedented debt level of almost 300% of GDP will drive America into a Depression that could easily be deeper than that of the 1930s.
This is already becoming apparent in the data, as economic historians Barry Eichengreen and Kevin O’ Rourke point out in “A Tale of Two Depressions“:
“To sum up, globally we are tracking or doing even worse than the Great Depression, whether the metric is industrial production, exports or equity valuations. Focusing on the US causes one to minimise this alarming fact. The " Great Recession" label may turn out to be too optimistic. This is a Depression-sized event.”
The comparison of unemployment rates (which Eichengreen and O’ Rourke didn’t make) bear this out: using the current OECD definition of unemployment, this downturn is well ahead of the 1979 recession even though unemployment started from a lower level; and using the much broader U-6 definition, which is more strictly comparable to the NBER definition used during the Great Depression, unemployment now is as bad as at the same stage of the Great Depression, and increasing as rapidly.
Deleveraging is already extreme: the most recent flow of funds data shows that private debt is falling rapidly and therefore subtracting from aggregate demand rather than adding to it. As noted in earlier Debtwatch Reports, in the modern debt-dependent economy, changes in the demand financed by changes in private debt are strongly negatively correlated with the unemployment: when debt’s contribution to demand falls, unemployment rises.
The turnaround in debt growth in the USA is unprecedented in the post-WWII period. Even during the 1980s and 1990s recessions, debt continued to grow both in nominal terms and as a percentage of GDP. Now debt is falling at arate of almost US$2 Trillion a year (which equates to 14 percent of GDP).
This is why the crisis exists, is so much worse than the official economic forecasters expected, and will continue and be much deeper than they currently believe: the crisis is being driven by deleveraging, and neoclassical economists do not even include private debt in their models.
As noted in earlier Debtwatch Reports, there is a very strong link between the rate of growth of debt and unemployment: when debt grows more quickly, unemployment falls; when debt grows slowly or falls, unemployment rises.
This is not because debt is a good thing, but because our economies have become so debt-dependent that changes in debt now have a far stronger influence on economic activity than do changes in GDP.
The US Government is attempting to “pump-prime” its way out of trouble by public-debt-financed deficit spending, which raises 4 further issues:
- this so-called Keynesian remedy can work when private debt levels are relatively low, and government policy to attenuate private speculation is strictly adhered to (see my 1995 paper Finance and Economic Breakdown);
- however, in our rampantly speculative economies, this policy has only worked when it has re-started the private debt binge, resulting in rising debt levels over time;
- this can’t happen this time around, because all sectors of the private economy–businesses both real and financial, and households–are already debt-saturated. There is no “greenfields” group to lend to, as was possible in 1990 when household debt was a “mere” 60% of GDP, and the derivatives market in finance had yet to explode; and finally
- the scale of the private debt bubble is just too big to be countered by substituting public debt for private debt.
This last point is evident in the data. Even though the US government has thrown the proverbial kitchen sink at government spending, the increase in public debt (which adds to aggregate demand) is more than counteracted by private sector deleveraging (which subtracts from aggregate demand):
Total US Debt is therefore falling. Though in the long run this is a good thing–we must return to a non-debt-dependent economy and once we have gotten there, stay there–the transition will be as pleasant as Cold Turkey is for a heroin addict.
The Great Lie of 2009
Just as the authorities were touting the “end of the financial crisis,” all heck has broken loose again …
We have a new surge in unemployment, and even without counting those who are excluded from the official numbers, 14.7 million are now jobless, the most since records dating back to 1948. Worse, for the first time since the Great Depression, every single job created after the prior recession has been wiped out.
We have industrial production falling at the same pace as it did in the early 1930s …. and global trade falling at twice the pace of the early 1930s.
We have California — the nation’s most populous state, with the largest GDP and the greatest impact on the entire U.S. economy — collapsing.
We have consumers slashing their spending, small businesses laying off their workers, cities and states forced to gut their budgets.
We see the most radical government countermeasures in a 100 years, the biggest federal deficits in 200 years, plus the swiftest swings — from greed to fear and fear to greed — ever.
Yet, for the past four months, virtually every policymaker in Washington and every pundit on Wall Street has been telling you …
The Great Lie of 2009:
“A Recovery Is Around The Corner”
On March 15, Fed Chairman Ben Bernanke told CBS News’ “60 Minutes” that he detected “green shoots” in the economy. And every day since, economic soothsayers have been surveying the landscape, sifting through crops of weeds, trying to find those green shoots.
But from the very outset, editors Claus Vogt, Mike Larson and I have told you this is not a garden-variety recession. It’s merely the first phase of a far longer, deeper depression.
And now, just within the past few days, the myth of “green shoots” has been shattered, the reality of the still-sinking economy revealed.
By late April, famous Wall Street gurus were lining up to declare “the end of the bear market,” and every day since, brokers have been cajoling you to buy the very same stocks they want to sell.
But from the very beginning, we’ve told you this rally was merely the calm before the next big storm, a big selling opportunity.
And now, with the Dow already down 500 points from its June high, it looks like the smarter investors in the world are finally beginning to act on that advice.
In early June, Obama labor officials declared “a big turnaround in nation’s job market,” proudly announcing that “only” 345,000 jobs were eliminated in May.We immediately issued a report demonstrating these numbers were extremely deceptive. Even if you accepted them at face value, we said, “less bad news” and “slower disasters” are not exactly signs of a turnaround.
And now, with the new government data released Thursday, their thesis is already being proven dead wrong.
One week ago, California officials publicly declared that they would never default on their obligations, directly refuting the forecast of default I made in this column on June 22: According to the BusinessJournal, Tom Dresslar, a spokesman for state Treasurer Bill Lockyer told the press “Mr. Weiss’ analysis and recommendation, to put it kindly, is misinformed.”Just two days later, California defaulted on its short-term debt obligations to countless vendors and taxpayers, unilaterally issuing millions of dollars in i.o.u.’s that no one wanted and few financial institutions accepted.
These examples barely scratch the surface of the misconceptions, distortions and outright deceptions that are being perpetrated by high authorities, flooded through the media and used to permeate the American psyche — all the while ignoring the elephant in the room …
The Giant Accumulation of High-Risk Debts and Bets Called “Derivatives”
The nation’s mountain of derivatives is not a mirage on the future horizon. Nor is it merely a phenomenon of our distant past.
It’s real. It’s here. And it’s huge.
Just ten months ago, it reared its ugly head and shoved the U.S. and Europe to the brink of a global meltdown.
And just last week, the U.S. Comptroller of the Currency (OCC) issued its latest report showing that, despite all the talk of reducing risk and reforming the financial system, U.S. commercial banks still hold record amounts. The latest tally: $202 TRILLION in notional value derivatives. And even that pales in comparison to the global tally by the Bank of International Settlements, now at $592 trillion.
Yes, there have been some liquidations. But the totals are still massive.
And yes, notional values may overstate the magnitude of the problem. But the OCC’s measure of credit risk does not: Despite some shedding of risk here and there, every single one of the five largest derivatives players is still grossly overexposed to defaults by trading partners:
Bank of America has total credit risk in this sector to the tune 169 percent of its capital; Citibank, 216 percent; JPMorgan Chase, 323 percent; HSBC Bank USA, 475 percent; Goldman Sachs, a whopping 1,048 percent, or over TEN times its capital.
If we were back in early 2007 … before the collapse of Bear Stearns, Lehman Brothers and Merrill Lynch … before the implosion of Fannie Mae and Freddie Mac … or before the near-collapse of AIG and Citigroup … then, maybe, folks could get away with ignoring this sword of Damocles hanging over the financial markets.
If we were back in a bygone pre-Bernanke, pre-Geithner era … before TARP (Troubled Asset Relief Program), before PPIP (Public-Private Investment Program), before TALF (Term Asset-Backed Securities Loan Facility), before TLGP (Temporary Liquidity Guarantee Program), before CAP (Capital Assistance Program), before TIP (Targeted Investment Program), before HASP (Homeowners Affordability and Stability Plan), before CPFF (Commercial Paper Funding Facility), before AMLF (Asset-Backed Commercial Paper Money Market Fund Liquidity Facility), before MMIFF (Money Market Investor Funding Facility), or before the alphabet soup of all the other hastily-conceived government efforts to contain the giant elephant in the room … then … maybe we could make believe it’s not there.
Or if all of our nation’s top officials were mute about this monster still in our midst, perhaps that, too, would justify the current aura of bliss that has temporarily shrouded Washington and Wall Street.
But even that is no longer the case. Some officials are finally finding the courage to speak out, issuing some of the same warnings today that we issued years ago.
Nearly three years ago, in our Safe Money Report of November 7, 2006, entitled “Global Vesuvius,” Associate Editor Mike Larson and I wrote:“Even as the Dow makes new highs, Wall Street and the world’s financial markets sit atop a gigantic mountain of derivatives — high-risk bets and debts that total a mind-boggling $285 trillion. That’s over six times the 2005 output of the entire world economy ($44.4 trillion) … 22 times the total value of the entire Standard & Poor’s 500 Index ($12.7 trillion) … and 25 times the entire U.S. federal and agency debt ($11.3 trillion).Now, in the thirty months that have ensued, each of these events has come to pass:
“It’s a global Vesuvius that could erupt at almost any time, instantly throwing the world’s financial markets into turmoil … bankrupting major banks … sinking big-name insurance companies … scrambling the investments of hedge funds … overturning the portfolios of millions of average investors.” (Page 1)
The world’s financial markets were thrown into turmoil.
The largest banks in the U.S., the U.K., Germany, and even Switzerland were bankrupted.
The world’s largest insurance company collapsed.
The investments of hedge funds were trashed; the portfolios of average investors, slashed in half.
But it’s not over. And the reasons are quite straightforward: The volcano is now far larger; its tectonic forces, more powerful.
In our 2006 “Global Vesuvius” issue (download the pdf), we identified five major threats:
Major threat #1. The sheer size of the derivatives market. At that time, the global market for derivatives was $285 trillion.
Now it’s $592 trillion. Its six-year compound rate of growth: A shocking 34.5 percent per year!
Major threat #2. The Lack of Transparency. We railed against over-the-counter (OTC) derivatives, representing 96 percent of all derivatives held by U.S. commercial banks. We warned about the lack of disclosure to investors, the lack of standard pricing and the fact that “two financial institutions can trade whatever the heck they want … and no one but the parties involved knows precisely what the contracts are, or what their value really is.” (Page 3)
Now, in Senate Banking Testimony, SEC Chairman Mary Schapiro has admitted that“OTC derivatives are largely excluded from the securities regulatory framework by the Commodity Futures Modernization Act of 2000. In a recent study on a type of securities-related OTC derivative known as a credit default swap, or CDS, the Government Accountability Office found that ‘comprehensive and consistent data on the overall market have not been readily available,’ that ‘authoritative information about the actual size of the CDS market is generally not available,’ and that regulators currently are unable ‘to monitor activities across the market.’”
Also before the Senate Banking Committee, Henry T.C. Hu, Chair in the Law of Banking and Finance at the University of Texas, has testified that“Regulator-dealer informational [gaps] can be extraordinary — e.g., regulators may not even be aware of the existence of certain derivatives, much less how they are modeled or used.”
Major threat #3. Too much in the hands of too few. In our 2006 “Global Vesuvius” report, we wrote:“There are close to 9,000 commercial and savings banks in the U.S. But at midyear … 97% of the bank-held derivatives in the U.S. are concentrated in the hands of just five banks.” (Page 3)
Today, virtually nothing has changed. The five largest commercial banks still hold 95 percent of the total! And if you include the recent shotgun mergers and restructurings, such as Bank of America’s acquisition of Merrill Lynch, the concentration of risk today is even greater.
In her recent testimony, the SEC Chairman puts it this way:“The markets are concentrated and … one of a small number of major dealers is a party to almost all transactions, whether as a buyer or a seller. The customers of the dealers appear to be almost exclusively institutions. Many of these may be highly sophisticated, such as large hedge funds and other pooled short-term trading vehicles. As you know, many hedge funds have not been subject to direct regulation by the SEC and, accordingly, we have very little ability to obtain information concerning their trading activity … “
Also testifying before the Senate Banking Committee, Christopher Whalen, co-founder of Institutional Risk Analytics, points out that“Perhaps the most important issue for the Committee to understand is that the structure of the OTC derivatives market today is a function of the flaws in the business models of the largest dealer banks, including JPMorgan Chase [JPM], Bank of America and Goldman Sachs [GS]. These flaws are structural, have been many decades in the making, and have been concealed from the Congress by the Fed and other financial regulators.
“Many cash and other capital markets operations in these banks are marginal in terms of return on invested capital, suggesting that banks beyond a certain size are not only too risky to manage — but are net destroyers of value for shareholders and society even while pretending to be profitable …
“No matter how good an operator of commercial banks JPM CEO Jamie Dimon may be, his bank is doomed without its near-monopoly in OTC derivatives — yet that same OTC business must eventually destroy JPM and the other large dealers. Seen from that perspective, the rescues of Bear Stearns and AIG were meant to protect not investors nor the global markets, but rather to protect JPM, GS and the small group of dealers who benefit from the continuance of their monopoly over the OTC derivatives market.”
Major threat #4. Shenanigans in Credit Default Swaps (CDS). In our 2006 “Global Vesuvius” report, Mike Larson and I also wrote …“The global market for these credit derivatives is absolutely exploding. It was just $180 billion in 1996. That grew to $893 billion in 2000 … $1.95 trillion in 2002 … and a stunning $20 trillion this year. It’s hard to believe. But that’s a 111-fold expansion in just a decade!
“The problem: Now, hedge funds and other investors are using these derivatives to spin the roulette wheel. In fact, the $1.2 trillion hedge fund industry now holds 32% of the credit default swaps, up from 15% two years ago. Think about that for a minute: Thinly capitalized, gun-slinging hedge funds are now essentially taking on the responsibility for insuring billions of dollars in bonds.” (Page 5)
Now, in his Senate testimony, Institutional Risk Analytics’ Whalen explains it this way:“In my view, CDS contracts and complex structured assets are deceptive by design and beg the question as to whether a certain level of complexity is so speculative and reckless as to violate US securities and anti-fraud laws. …
“Pretending to price CDS contracts or complex structured securities using ‘models’ is a ridiculous deception that should be rejected by the Congress and by regulators. And members of Congress should remember that federal regulators and the academic economists who populate agencies like the Fed are almost entirely captured by the largest dealer banks. Even today, the Fed and other regulatory agencies raise little or no questions as to the efficacy of OTC derivatives and the absurd quantitative models that Wall Street pretends to use to value these gaming instruments.”
Major threat #5. Outstanding derivatives dwarf the trading in the underlying securities. In our “Global Vesuvius” report, Mike and I wrote:“The sheer volume of derivatives outstanding … is dwarfing the amount of underlying debt securities. That’s causing major market distortions.
“Take last October. Auto supplier Delphia filed for bankruptcy. At the time, it had just $2 billion in outstanding bonds. But there were a mind-boggling $20 billion of default swaps on its debt!
“To settle those contracts, derivatives players had to scramble to buy underlying bonds. That drove their prices up substantially even as the company was going broke!
“Similar distortions occurred when Delta, Northwest, and Calpine defaulted on their debt.
“End result: The impact of bankruptcies, instead of being minimized by derivatives, can often be multiplied far beyond what you’d normally expect.”
In his testimony, Whalen adds:“What makes credit default swaps like betting on the temperature is that, in the case of many if not most of these contracts, the volume of swaps outstanding far exceeds the amount of debt the specified company owes.”
And he sums up all the threats nicely with this concluding comment:“Jefferson said that ‘commerce between master and slave is barbarism.’ All of the Founders were Greek scholars. They knew what made nations great and what pulled them down into ruins. And they knew that, above all else, how we treat ourselves, as individuals, customers, neighbors, traders and fellow citizens, matters more than just making a living. If we as a nation tolerate unfairness in our financial markets in the form of the current market for CDS and other complex derivatives, then how can we expect our financial institutions and markets to be safe and sound?
Phosphorus Famine: The Threat to Our Food Supply
As complex as the chemistry of life may be, the conditions for the vigorous growth of plants often boil down to three numbers, say, 19-12-5. Those are the percentages of nitrogen, phosphorus and potassium, prominently displayed on every package of fertilizer. In the 20th century the three nutrients enabled agriculture to increase its productivity and the world’s population to grow more than sixfold. But what is their source? We obtain nitrogen from the air, but we must mine phosphorus and potassium. The world has enough potassium to last several centuries. But phosphorus is a different story. Readily available global supplies may start running out by the end of this century. By then our population may have reached a peak that some say is beyond what the planet can sustainably feed.
Moreover, trouble may surface much sooner. As last year’s oil price swings have shown, markets can tighten long before a given resource is anywhere near its end. And reserves of phosphorus are even less evenly distributed than oil’s, raising additional supply concerns. The U.S. is the world’s second-largest producer of phosphorus (after China), at 19 percent of the total, but 65 percent of that amount comes from a single source: pit mines near Tampa, Fla., which may not last more than a few decades. Meanwhile nearly 40 percent of global reserves are controlled by a single country, Morocco, sometimes referred to as the "Saudi Arabia of phosphorus." Although Morocco is a stable, friendly nation, the imbalance makes phosphorus a geostrategic ticking time bomb.
In addition, fertilizers take an environmental toll. Modern agricultural practices have tripled the natural rate of phosphorus depletion from the land, and excessive runoff into waterways is feeding uncontrolled algal blooms and throwing aquatic ecosystems off-kilter. While little attention has been paid to it as compared with other elements such as carbon or nitrogen, phosphorus has become one of the most significant sustainability issues of our time.
My interest in phosphorus dates back to the mid-1990s, when I became involved in a NASA program aiming to learn how to grow food in space. The design of such a system requires a careful analysis of the cycles of all elements that go into food and that would need to be recycled within the closed environment of a spaceship. Such know-how may be necessary for a future trip to Mars, which would last almost three years. Our planet is also a spaceship: it has an essentially fixed total amount of each element. In the natural cycle, weathering releases phosphorus from rocks into soil. Taken up by plants, it enters the food chain and makes its way through every living being.
Phosphorus—usually in the form of the phosphate ion PO43-—is an irreplaceable ingredient of life. It forms the backbone of DNA and of cellular membranes, and it is the crucial component in the molecule adenosine triphosphate, or ATP—the cell’s main form of energy storage. An average human body contains about 650 grams of phosphorus, most of it in our bones. Land ecosystems use and reuse phosphorus in local cycles an average of 46 times. The mineral then, through weathering and runoff, makes its way into the ocean, where marine organisms may recycle it some 800 times before it passes into sediments. Over tens of millions of years tectonic uplift may return it to dry land.
Harvesting breaks up the cycle because it removes phosphorus from the land. In prescientific agriculture, when human and animal waste served as fertilizers, nutrients went back into the soil at roughly the rate they had been withdrawn. But our modern society separates food production and consumption, which limits our ability to return nutrients to the land. Instead we use them once and then flush them away. Agriculture also accelerates land erosion—because plowing and tilling disturb and expose the soil—so more phosphorus drains away with runoff. And flood control contributes to disrupting the natural phosphorus cycle. Typically river floods would redistribute phosphorus-rich sediment to lower lands where it is again available for ecosystems. Instead dams trap sediment, or levees confine it to the river until it washes out to sea.
So too much phosphorus from eroded soil and from human and animal waste ends up in lakes and oceans, where it spurs massive, uncontrolled blooms of cyanobacteria (also known as blue-green algae) and algae. Once they die and fall to the bottom, their decay starves other organisms of oxygen, creating "dead zones" and contributing to the depletion of fisheries.
Altogether, phosphorus flows now add up to an estimated 37 million metric tons per year. Of that, about 22 million metric tons come from phosphate mining. The earth holds plenty of phosphorus-rich minerals—those considered economically recoverable—but most are not readily available. The International Geological Correlation Program (IGCP) reckoned in 1987 that there might be some 163,000 million metric tons of phosphate rock worldwide, corresponding to more than 13,000 million metric tons of phosphorus, seemingly enough to last nearly a millennium.
These estimates, however, include types of rocks, such as high-carbonate minerals, that are impractical as sources because no economical technology exists to extract the phosphorus from them. The tallies also include deposits that are inaccessible because of their depth or location offshore; moreover, they may exist in underdeveloped or environmentally sensitive land or in the presence of high levels of toxic or radioactive contaminants such as cadmium, chromium, arsenic, lead and uranium.
Estimates of deposits that are economically recoverable with current technology—known as reserves—are at 15,000 million metric tons. That is still enough to last about 90 years at current use rates. Consumption, however, is likely to grow as the population increases and as people in developing countries demand a higher standard of living. Increased meat consumption, in particular, is likely to put more pressure on the land, because animals eat more food than the food they become.
Phosphorus reserves are also concentrated geographically. Just four countries—the U.S., China, South Africa and Morocco, together with its Western Sahara Territory—hold 83 percent of the world’s reserves and account for two thirds of annual production. Most U.S. phosphate comes from mines in Florida’s Bone Valley, a fossil deposit that formed in the Atlantic Ocean 12 million years ago. According to the U.S. Geological Survey, the nation’s reserves amount to 1,200 million metric tons. The U.S. produces about 30 million metric tons of phosphate rock a year, which should last 40 years, assuming today’s rate of production.
Already U.S. mines no longer supply enough phosphorus to satisfy the country’s production of fertilizer, much of which is exported. As a result, the U.S. now imports phosphate rock. China has high-quality reserves, but it does not export; most U.S. imports come from Morocco. Even more than with oil, the U.S. and much of the globe may come to depend on a single country for a critical resource. Some geologists are skeptical about the existence of a phosphorus crisis and reckon that estimates of resources and their duration are moving targets. The very definition of reserves is dynamic because, when prices increase, deposits that were previously considered too expensive to access reclassify as reserves. Shortages or price swings can stimulate conservation efforts or the development of extraction technologies.
And mining companies have the incentive to do exploration only once a resource’s lifetime falls below a certain number of decades. But the depletion of old mines spurs more exploration, which expands the known resources. For instance, 20 years ago geologist R. P. Sheldon pointed out that the rate of new resource discovery had been consistent over the 20th century. Sheldon also suggested that tropical regions with deep soils had been inadequately explored: these regions occupy 22 percent of the earth’s land surface but contain only 2 percent of the known phosphorus reserves.
Yet most of the phosphorus discovery has occurred in just two places: Morocco/Western Sahara and North Carolina. And much of North Carolina’s resources are restricted because they underlie environmentally sensitive areas. Thus, the findings to date are not enough to allay concerns about future supply. Society should therefore face the reality of an impending phosphorus crisis and begin to make a serious effort at conservation.
The standard approaches to conservation apply to phosphorus as well: reduce, recycle and reuse. We can reduce fertilizer usage through more efficient agricultural practices such as terracing and no-till farming to diminish erosion. The inedible biomass harvested with crops, such as stalks and stems, should be returned to the soil with its phosphorus, as should animal waste (including bones) from meat and dairy production, less than half of which is now used as fertilizer.
We will also have to treat our wastewater to recover phosphorus from solid waste. This task is difficult because residual biosolids are contaminated with many pollutants, especially heavy metals such as lead and cadmium, which leach from old pipes. Making agriculture sustainable over the long term begins with renewing our efforts to phase out toxic metals from our plumbing. Half the phosphorus we excrete is in our urine, from which it would be relatively easy to recover. And separating solid and liquid human waste—which can be done in treatment plants or at the source, using specialized toilets—would have an added advantage. Urine is also rich in nitrogen, so recycling it could offset some of the nitrogen that is currently extracted from the atmosphere, at great cost in energy.
Meanwhile new discoveries are likely just to forestall the depletion of reserves, not to prevent it. For truly sustainable agriculture, the delay would have to be indefinite. Such an achievement would be possible only with a world population small enough to be fed using natural and mostly untreated minerals that are low-grade sources of phosphorus. As with other resources, the ultimate question is how many humans the earth can really sustain. We are running out of phosphorus deposits that are relatively easily and cheaply exploitable. It is possible that the optimists are correct about the relative ease of obtaining new sources and that shortages can be averted. But given the stakes, we should not leave our future to chance.
Fertilizer runoff and wastewater discharge contribute to eutrophication, uncontrolled blooms of cyanobacteria in lakes and oceans, often large enough to be seen from orbit. Cyanobacteria (also known as blue-green algae) feed on nitrogen and phosphorus from fertilizers. When they die, their decomposition depletes the water of oxygen and slowly chokes aquatic life, producing "dead zones." The largest dead zone in U.S. waters, topping 20,000 square kilometers in July 2008, is off the Mississippi delta; silt from the river is visible in a 2001 satellite image at the right. More than 400 dead zones now exist worldwide, covering a combined area of more than 245,000 square kilometers.
Researchers disagree about which element—phosphorus or nitrogen—should be the main focus of cost-effective water treatment to prevent eutrophication. Cyanobacteria living in freshwater can extract nitrogen from the air, so limiting phosphorus runoff is essential, as was confirmed in 2008 by a 37-year-long study in which researchers deliberately added nutrients to a Canadian lake. "There’s not a single case in the world where anyone has shown that you can reduce eutrophication by controlling nitrogen alone," says lead author David Schindler of the University of Alberta in Edmonton. Cyanobacteria living in seawater seem unable to take in atmospheric nitrogen but may get enough phosphorus from existing sediment, other researchers point out, urging controls on nitrogen as well.