Vicinity of Fort Collins, Colorado. Jacob Rommel and his family live in this roomy shack, well-furnished, with a good range, organ, etc. They own a good home in Fort Collins, but late in April they moved out here, taking contract for nearly 40 acres of beets, working their 9 and 10 year old girls hard at piling and topping (although they are not rugged) and they will not return until November. The little girl said, "Piling is hardest, it gets your back. I have cut myself some, topping." The older girl said, "Don't you call us Russians, we're Germans" (although most of them were born in Russia). Family been in this country eleven years
Ilargi: There are two issues in the US economy that time and again "experts and analysts" claim are the two biggest and most crucial ones. In the end, it's all about housing and employment. As Obama's poll numbers are predictably slumping along with the economy, there is still nothing I see that would qualify as a genuine effort to genuinely solve the true underlying trouble in either of the two. I don't even see a genuine effort to address the issues.
And as long as those things don't happen, the economy has only one way to go, and that is down. Moreover, it’s going there much faster than the lying stats would seem to indicate. The idea that government agencies, who arguably have the best access to data, use that access to distort those same data, seems so intertwined with how society functions these days that not only are there hardly any protests, there's not even much surprise. And that, let me say it once again, depicts an all-out political crisis.
And yes, I do realize that this crisis remains hidden for now behind the veil of constant and ongoing distortion of data-based reality and the incessant evocation of fantasies of what might be, what society should return to, what we would like and want. We can't always have what we want. But you'd never know listening to what the government says. It's the same predictable story all along, through 6 months of Obama: Wall Street is fine, Main Street is sinking.
This cannot and will not end well.
I picked a number of quotes from today's news articles to try and show you what IS really happening. Focusing on the two main components of the economy that matters to you, not the Wall Street one, it is glaringly obvious that both are getting bad rapidly, and no answer or solution is to be expected from Obama and his administration. They're not even trying. they have a different agenda than their voters do. Judging by the latest poll numbers, those voters are slowly catching up to what's shaking, But that can't undo the damage done in the first 6 months.
There are no signs, other than the make-believe ones, that unemployment is abating, or that house prices are stabilizing, or anything of the kind.
You're looking at, and living in, a world falling apart at the seams. And it makes no difference if you look around you today and think everything is pretty much the same. You don't live at the seams.
Here's those assorted quotes and numbers for today:
California's Nightmare Will Kill Obamanomics With California mired in a budget crisis, largely the result of a political impasse that makes spending cuts and tax increases impossible, Controller John Chiang said the state planned to issue $3.3 billion in IOU’s in July alone. [..] The California morass has Democrats in Washington trembling. The reason is simple. If Obama’s health-care plan passes, then we may well end up paying for it with federal slips of paper worth less than California’s. [..] The California deficit this year is now north of $26 billion. The U.S. federal deficit will be, according to the latest numbers, almost 70 times larger.
Ilargi: That is a significant number, given how poorly California is faring.
Biden Admission: Obama Plan Doomed White House projections used to sell the stimulus package to the nation. To make their case, Washington warned that without the Obama stimulus, unemployment, then at 7.2 percent, would rise above 8 percent in 2009 and peak at 9 percent in 2010.
Yet, only midway through 2009, the unemployment rate is already 9.5 percent and rising. "This is an enormous miscalculation," contends Celente. "In real world terms, it means that 2.5 million more Americans than anticipated have lost their jobs. The inaccuracy of the forecast undermines the validity not only of the plan, but also of the planners." Joe Biden sidestepped blame, pleading "guilty with an explanation."
US Continued Jobless Claims Set Another Record; Initial Claims Fall [..]... the number of people claiming continuing unemployment insurance shot up by 159,000 to a record high 6.883 mln[..]
Jobless claims drop steeply, skewed by autos The number of U.S. workers filing new claims for jobless benefits fell sharply last week but the data was distorted by an unusual pattern of layoffs in the automotive industry, which amplified the decline. The Labor Department said on Thursday that initial claims for state unemployment insurance fell 52,000, the largest drop since December, to a much lower-than-expected seasonally adjusted 565,000 in the week ended July 4, from 617,000 the prior week...
Unemployment, Not the Stock Market, Distinguishes a Recession From a Depression [..].. the Bureau of Labor Statistics computes a second unemployment rate. This broader measure includes all forms of job market slack and is a whopping 16.5 percent. Yes, one in six Americans is unemployed or underemployed right now. That’s a horrible number! And it will not go away soon.
The current plunge is structural, not cyclical. Most of the jobs lost will never come back. The real estate bubble severely distorted the economic structure. Now the world economy has a lot of rebalancing to do. And this process will last much, much longer than the “green shoots” crowd deems possible.
The United States Continues to Experience Real Price Deflation The methodology underlying the Consumer Price Index (CPI), the Government’s measure of inflation, was altered in 1983 to exclude housing prices. As illustrated in "The CPI Inflation Methodology is Deeply Flawed and Defies Housing Reality", the rationale for the adjustment was intellectually dishonest. The Government modified the methodology as a matter of convenience to report less volatile and milder price changes. A concept dubbed Rental Equivalence replaced Housing Prices.
US property market central to economy [..] ... they cheerfully insist that the town can survive the wider damage, as long as prices stabilise or rise. "But if prices fall further, it will be terrible," one realtor declared – before insisting "we really don’t think that’s likely. Nothing can keep going down for that long." Is that assumption justified? That is the $6 trillion dollar question....
not only does the health of the US consumer – and thus economy – remain tied to housing, but western bank balance sheets are tightly tangled up with property too. Most notably, America’s largest banks, such as Bank of America, JPMorgan and Citi, continue to hold a vast quantities of residential and commercial property loans on their books, in addition to all those loans that they previously repackaged as bonds, and sold on. So do numerous small banks [..]
..... these projections imply that about 25m households in America end up in negative equity.
This projection is gloomier than those made by the US government and many large US banks. But the 25m number is currently being echoed by other investment groups, such as Pimco. [..]
But the second fascinating question is what further house prices falls might do to consumer psychology. America has never experienced negative equity on this scale before. Thus nobody is entirely sure how households might respond. Will they default en masse? Will voters become so angry that they demand more populist public bail-outs of the housing sector (or financial reform)?
L.A. County's May mortgage default rate double last year
The percentage of Los Angeles County mortgages delinquent by 90 days or more in May was nearly double the rate last year, First American CoreLogic reported today. May's 9.5% delinquency rate for L.A. County was up from 5% of mortgages late by 90 days or more in May 2008. First American bases its foreclosure analyses on public records.
While the default rate has nearly doubled, the number of homes actually being sold at auction -- the final foreclosure stage -- has shrunk. In May, the L.A. County repossession rate was down to 1% of mortgages, from 1.1% a year ago. This discrepancy is the "foreclosure backlog" now looming over the housing market.
S&P Increases 2005-07 Subprime and Alt-A Loss Assumptions
Standard & Poor’s has increased its loss assumptions for projected losses for U.S. residential mortgage-backed securities (RMBS) transactions backed by subprime and Alternative-A (Alt-A) collateral issued in 2005, 2006, and 2007. "We are updating all of our 2005, 2006, and 2007 deal-specific subprime default projections. In aggregate, our remaining 2005, 2006, and 2007 default projections, as a percentage of the original pool balances, are approximately 11%, 30%, and 49%, respectively[..]
Moody’s Downgrades $7.6 billion of Jumbo RMBS
Moody’s Investor Service took the red pen to 344 tranches of 61 residential mortgage-backed securities (RMBS) backed by jumbo loans in excess of the conforming loan limit ($729,750). Together the relevant downgraded RMBS totals $7.59bn. Moody’s downgraded $4.25bn of jumbo RMBS issued by Wells Fargo. The ratings agency downgraded ratings of 104 tranches from 21 RMBS transactions backed by prime jumbo loans issued by Wells in 2004. It also downgraded 98 tranches of 18 jumbo RMBS — worth $2bn — issued from 2002 to 2004 by Bank of America.
US Lawmakers Sound Alarm About Commercial Real Estate Market
The situation is fueling concerns that property developers won't be able to refinance roughly $400 billion in commercial real estate debt coming due this year. Property values have plunged about 24% since their peak in 2007, further hampering developers' ability to obtain refinancings or loan extensions.
10 Most Broke States
- California: $53.7 billion shortfall or 58 percent of its budget
- Arizona: $4 billion shortfall or 41 percent of its budget
- Nevada: $1.2 billion or 38 percent of its budget
- Illinois: $9.2 billion or 33 percent of its budget
- New York: $17.9 billion or 32 percent of its budget
- Alaska: $1.35 billion shortfall or 30 percent of its budget
- New Jersey: $8.8 billion or 30 percent of its budget
- Oregon: $4.2 billion or 29 percent of its budget
- Vermont: $278 million or 25 percent of its budget
- Washington: $3.6 billion or 23 percent of its budget
- Connecticut: $4.1 billion or 23 percent of its budget
As ABC also noted, these deficits are almost exclusively caused by massive revenue drops in these states. Tax revenue has simply dried up. In some cases the revenue drops are the largest in history (including the Great Depression) Federal revenue, both on budget and off budget, is down 18 percent this fiscal year as compared to the same period last fiscal year. In April, the month where personal income tax revenue flows into federal coffers, tax revenue dropped a massive 34 percent from $404 billion in 2008 to $266 in 2009. This is the largest drop reported in the Monthly Treasury Statements since their inception in 1980.
States Using Stimulus Money for Short-Term Needs, Audit Shows The Congressional Budget Office estimates that only 10 percent of the Recovery Act funds have been released so far, with about half of the money expected to be spent by October 2010.[..] Issa said the latest 9.5 percent unemployment rate for June shows the stimulus is not having its intended effect. "The purpose of the stimulus was putting the unemployed back to work," the California lawmaker said. "So far the stimulus has failed to do that."
President Obama had always pitched the stimulus package as a way to "save or create" 3 million to 4 million jobs. The president announced in late May, 100 days after the stimulus bill was signed, that 150,000 jobs had been created since its enactment. However, more than 2 million people have lost jobs since the stimulus bill was signed in February. Issa said the 150,000 number for jobs created was based on "flawed macroeconomic models."
California's Nightmare Will Kill Obamanomics
Last week, we discovered that the state of California will gladly pay you Tuesday for a hamburger today. With California mired in a budget crisis, largely the result of a political impasse that makes spending cuts and tax increases impossible, Controller John Chiang said the state planned to issue $3.3 billion in IOU’s in July alone. Instead of cash, those who do business with California will get slips of paper. The California morass has Democrats in Washington trembling.
The reason is simple. If Obama’s health-care plan passes, then we may well end up paying for it with federal slips of paper worth less than California’s. Obama has bet everything on passing health care this year. The publicity surrounding the California debt fiasco almost assures his resounding defeat. It takes years and years to make a mess as terrible as the California debacle, but the recipe is simple. All that you need is two political parties that are always willing to offer easy government solutions for every need of the voters, but never willing to make the tough decisions necessary to finance the government largess that results.
Voters will occasionally change their allegiance from one party to the other, but the bacchanal will continue regardless of the names on the office doors. California has engaged in an orgy of spending, but, compared with our federal government, its legislators should feel chaste. The California deficit this year is now north of $26 billion. The U.S. federal deficit will be, according to the latest numbers, almost 70 times larger. The federal picture is so bleak because the Obama administration is the most fiscally irresponsible in the history of the U.S. I would imagine that he would be the intergalactic champion as well, if we could gather the data on deficits on other worlds. Obama has taken George W. Bush’s inattention to deficits and elevated it to an art form.
The Obama administration has no shame, and is willing to abandon reason altogether to achieve its short-term political goals. Ronald Reagan ran up big deficits in part because he believed that his tax cuts would produce economic growth, and ultimately pay for themselves. He may well have been excessively optimistic about the merits of tax cuts, but at least he had a story. Obama has no story. Nobody believes that his unprecedented expansion of the welfare state will lead to enough economic growth. Nobody believes that it will pay for itself. Everyone understands that higher spending today begets higher spending tomorrow. That means that his economic strategy simply doesn’t add up.
Back in the 1980s, Reagan’s own economist, Martin Feldstein, spoke up when he felt that the Reagan administration was pushing the deficit too far. Where are the economists with such character today? Apparently, the job description for economists has transformed from recommending policies that are defensible to defending whatever policies that the political hacks in the West Wing dream up. As bad as the California legislature has been over the years, it has never entered a fiscal crisis like the one that we face today and then doubled down with a massive spending increase. In the end, when times got tough, patriotic and sensible Californians of both parties stood up and began acting like adults.
Maybe the same thing is starting to happen in our nation’s capital. The key players in Washington are Senator Evan Bayh and 15 Senate Democrats who joined him this year in forming a coalition of moderates. One thing that has distinguished moderate Democrats from the garden variety of the species is heightened concern about fiscal responsibility. With the price tag of Obama-care likely to exceed $1 trillion, moderate Democrats face a simple choice. They can jump off the cliff with the president, or they can stay true to the principles that they have espoused throughout their careers.
There are reassuring signs that principle is winning. One of the most expensive components of the Obama plan is the so- called public-insurance option, which opponents fear would result in massive government subsidies. Senator Mary Landrieu said that she is "not open" to a public option that will compete with private insurance. Many other Democratic Senators, including Ben Nelson, Blanche Lincoln, and Tom Carper, also oppose the public option. As the cost estimates increase and support wanes, the Senate Finance Committee is even going as far as to pursue its own health-care plan, meaning that the health-care end game is now in sight.
Moderates might support Obama’s health-care objectives if the bill also included tax increases to cover the spending increases. But those tax increases would likely be unpopular, making it almost impossible to pass a bill. Given the increasing public concern about deficits that heightened significantly last week because of the California crisis, there are only two possibilities left. Either the Obama plan will come crashing down or Senate Democrats will concoct some bill that has health in the title but costs almost nothing and does even less. With Al Franken arriving in the Senate and providing Democrats with a crucial 60th vote, the latter seems most likely.
Biden Admission: Obama Plan Doomed
Vice President Joseph Biden's admission that the Obama Administration's economic recovery plan was predicated on egregiously inaccurate forecasts consigns the entire effort to failure, predicts Gerald Celente. "The plan is based upon false premises," said Celente, Director of The Trends Research Institute, referring to White House projections used to sell the stimulus package to the nation. To make their case, Washington warned that without the Obama stimulus, unemployment, then at 7.2 percent, would rise above 8 percent in 2009 and peak at 9 percent in 2010.
Yet, only midway through 2009, the unemployment rate is already 9.5 percent and rising. "This is an enormous miscalculation," contends Celente. "In real world terms, it means that 2.5 million more Americans than anticipated have lost their jobs. The inaccuracy of the forecast undermines the validity not only of the plan, but also of the planners." Joe Biden sidestepped blame, pleading "guilty with an explanation." Weaseled Biden, "The truth is, we and everyone else misread the economy."
NO! "Everyone else" did not "misread the economy." The Trends Research Institute read it correctly, and has been reading it correctly for decades. "How often does the government have to be wrong, and how wrong do they have to be before people and the media stop taking them seriously?" wondered Celente. "The first spending package didn't deliver as promised, and now Obama's advisors want another stimulus, as if doubling up on failure will achieve success."
"If we made forecasts as inaccurate as the Obama team's and implemented similarly unsuccessful plans, and then tried to salvage the situation by repeating exactly the same mistakes, we'd have been laughed out of business long ago," Celente said. Celente contends there are but three possible explanations for President Obama and his "brilliant" team of economic advisors "misreading how bad the economy was":
- They're ignorant, despite PhD's and impressive resumes.
- They are so arrogant they are incapable of acknowledging that anyone outside the incestuous Beltway circle could possibly get it right ... when they've got it wrong.
- They actually do know better, but are lying.
"None of these suffice as excuses," concluded Celente, "but the inability or unwillingness to make accurate forecasts appears to be a Vice Presidential prerequisite." This past January, departing VP Dick Cheney sloughed off his administration's central role in accelerating the financial crisis and failure to head it off, claiming, "Nobody anywhere was smart enough to figure it out."
Anyone in the media interested in interviewing one person who was "smart enough to figure it out" should talk to Gerald Celente. The Greatest Depression is at hand. The stimulus, bailout and buyout packages being forced on the nation by an Administration that "misread how bad the economy was" will only lead to "Obamageddon": The Fall of Empire America.
US Continued Jobless Claims Set Another Record; Initial Claims Fall
The number of people filing new claims for unemployment insurance in the week ending July 4 fell by a larger than expected 52,000 to 565,000, the first week first-time claims have dipped below 600k since January, the Labor Department reported today.
Labor officials said the larger-than-expected decline was due largely to a 'deflection from expectations' in the seasonal factors. An increase of 71,000 non-seasonally adjusted claims were expected, but only a gain of 17,600 were received. Many states reported that automotive layoffs typically occuring during this period have already occured or haven't materialized to the degree expected.
Economists were expecting new weekly claims to fall to 605,000 from the 614,000 claims first reported in the previous week (since revised up to 617,000). The four-week moving average of initial claims fell by 10,000 to 606,000, the lowest level since February of this year. Meanwhile, the number of people still claiming unemployment insurance shot up by 159,000 to a record high 6.883 mln in the week ending June 27.
Economists were expecting continuing claims to rise slightly to 6.710 mln from 6.702 mln in the previous week (since revised up to 6.724 mln). The four-week moving average for continuing claims rose by 12,000 to a record high 6.769 mln. The percentage of the eligible population now receiving unemployment insurance rose 0.1 percentage points to 5.1%.
Ilargi: Mike Shedlock puts the jobless numbers in a proper perspective. Not good. Numbers by now solely exist for propaganda purposes.
By the way, when people use up their benefits they drop off the roles. Most states have extended benefits and the Federal Government has also extended benefits. Those on extended benefits are not counted in the continuing claims numbers.
Notice the enormous difference between the seasonally adjusted numbers and the unadjusted numbers. To help explain the the difference, please consider Jobless claims drop steeply, skewed by autos.
The number of U.S. workers filing new claims for jobless benefits fell sharply last week but the data was distorted by an unusual pattern of layoffs in the automotive industry, which amplified the decline. The Labor Department said on Thursday that initial claims for state unemployment insurance fell 52,000, the largest drop since December, to a much lower-than-expected seasonally adjusted 565,000 in the week ended July 4, from 617,000 the prior week.
A Labor Department official said that there had been far fewer automotive and other manufacturing layoffs last week than anticipated on the basis of past experience of claims over July, when many plants are commonly idled. "I would expect the underlying trend (in claims) is probably diminishing but it's hard to tell from this number how much is noise," said Keith Hembre, chief economist at First American Funds in Minneapolis.
Regardless of how one views the dip in claims, improvement in the 4-week moving average of initial claims is on a snail's pace. The number peaked in march around 650,000 and is still above 600,000 four months later!
Unemployment, Not the Stock Market, Distinguishes a Recession From a Depression
What are the most important and enduring characteristics of the Great Depression? And what should we monitor to determine how severe today’s situation really is?
The stock market will give important clues. But the economy, especially unemployment, defines depressions.
That should be obvious. However, after the stock market rallied off its March 2009 low, the media and many pundits seem to be fixated on the financial markets to determine the severity of the crisis and to call its end.
To see if the bulls’ hopeful thinking holds water, let’s go back to 1929 and have a look at the stock market’s behavior during those horrific times …
The Bear Market Rally of 1929/30
Yes, there was a spectacular stock market crash in 1929. But a stock market crash does not a depression make. Remember 1987? There was a very similar crash … but no depression. Not even a mild recession.
The crash of 1929 proved to be only the prelude to further heavy losses in 1930-1932. After the initial crash from 381 to 199, a huge rally emerged. Prices rose all the way back to 294 for a 48 percent bear market rally. Hence initial losses were roughly cut in half!
Unfortunately, investors didn’t recognize this rally as a selling opportunity. Instead, they listened to the bullish advice of Wall Street pundits and the government’s declarations that the worst was over and prosperity was right around the corner.
As we all know, this optimism proved to be, well, premature. The huge rally turned out to be just a bear market rally … soon the market started to tank again.
First, stocks tumbled back to the crash-lows, where a second and shallower rally emerged. Then after this bout of hope had evaporated, the market cascaded lower for another two years. From the high during the summer of 1929, the losses mounted to a staggering 89 percent.
Now, let’s fast forward to …
The Bear Market Rally of 2009
After having lost more than 50 percent off its October 2007 high, a huge stock market rally started in March 2009. This rally amounted to 43 percent and had all the typical characteristics of a counter trend move. Especially noteworthy was the low and diminishing volume, which is typical bear market rally behavior.
Just as in 1929, this rally led Wall Street and official sources to conjure economic optimism. This is not a coincidence … the stock market and sentiment measures are highly correlated. But rising sentiment does not forecast a betterment of the economy. Instead a rising stock market foregoes rising optimism.
Now it looks like this bear market rally is over …
There is technical support around 880 in the S&P 500. A break below this mark would ignite another sell signal and confirm the end of the rally. The next support level is around 800. If this line doesn’t hold, it’s back to the March lows. And if these lows do not stop the slide, a very important message concerning the economy will have been given: “Depression ahead.”
I think that the next few weeks and months will not only be very interesting, but also very important. Yet hardly anybody on Wall Street seems to think about the possibility of a new, stock market low.
They should. And so should you. Remember …
Employment Is Much More Predictive Of Recessions and Depressions Than the Stock Market …
Since the start of this crisis, world industrial production and world trade have been following the pattern of the 1930s very closely. But unemployment is the most important indicator to distinguish a recession from a depression.
Take a look at the table to see the unemployment situation during the Great Depression.
Where do we stand now concerning this all important indicator?
The official U.S. unemployment rate rose from the cycle low of 3.4 percent in 2007 to 9.5 percent as of June 2009.
But the Bureau of Labor Statistics computes a second unemployment rate. This broader measure includes all forms of job market slack and is a whopping 16.5 percent. Yes, one in six Americans is unemployed or underemployed right now. That’s a horrible number! And it will not go away soon.
If you look at the chart below, showing the civilian employment to population ratio, you can see that the downtrend had already started in 2000. Then the stock market bubble burst. This was just the first act in a much longer drama …
The bursting of the real estate bubble was act two. And more is sure to follow. California’s default may be a harbinger of what the third act may look like.
The second chart shows the median duration of unemployment. Here you can see how long it takes Americans to find a job …
These statistics clearly show the severity of the current situation. Here you can easily see why this is not a garden variety post-WWII recession, but something very different.
The current plunge is structural, not cyclical. Most of the jobs lost will never come back. The real estate bubble severely distorted the economic structure. Now the world economy has a lot of rebalancing to do. And this process will last much, much longer than the “green shoots” crowd deems possible.
My suggestion for you today is to watch the stock market for hints of the beginning of the next stage of this crisis. Watch unemployment and world trade as reliable indicators of the severity of the slump. And then watch California to get a feel for the next important act of this economic and financial drama: The government funding crisis and all its related repercussions.
The United States Continues to Experience Real Price Deflation
The methodology underlying the Consumer Price Index (CPI), the Government’s measure of inflation, was altered in 1983 to exclude housing prices. As illustrated in "The CPI Inflation Methodology is Deeply Flawed and Defies Housing Reality", the rationale for the adjustment was intellectually dishonest. The Government modified the methodology as a matter of convenience to report less volatile and milder price changes. A concept dubbed Rental Equivalence replaced Housing Prices.
As is graphically illustrated below, this substitution was absurd. The Government might as well have replaced housing prices with a straight line reflecting 2.9% annual inflation. I note that Rental Equivalence was completely unaffected by the rapid rise and fall of home prices during the Housing Bubble.
Even if the 1983 methodology change was not implemented with intent, the decision had the functional effect of ignoring a large and meaningful source of inflation during the Housing Bubble and is presently under-reporting deflation.
Estimating Real Historical Inflation and Deflation by Adjusting the CPI
In an effort to demonstrate the dramatic impact of the CPI’s indefensible exclusion, I have adjusted the metric to include the cost of housing. In doing so, I am using the pre-1983 methodology and producing a measure of "Real Inflation".
There are Limits to Accurately Recasting the CPI Data
Without access to specific CPI data, I am forced to use a proxy for the nation’s housing price performance. I relied upon the Case-Shiller 20-City Price Index because it utilizes the best methodology available to capture real price changes.
Given the relatively small sample size of Case-Shiller (20 Cities), the price change of the nation’s housing as a whole is likely to be different. Furthermore, the index consists of several cities disproportionately affected by the Housing Bubble and, as such, likely overstates national price movements. At minimum, my adjusted inflation measure is an excellent estimate within these 20 cities.
The other challenge is that the relative component size of items included in the CPI changes over time. For instance, Rental Equivalence increased from 21.06% of the CPI in 1995 to a 24.43% weighting in 2008. I am unable to estimate how the relative component weighting would have evolved were Housing Prices used instead of Rental Equivalence. As such, I have maintained the historical component weighting but substituted the Case-Shiller Index. Given the dramatic increase in Housing Prices relative to Rental Equivalence in recent years, this methodology understates the weighting of housing and, as such, under reports inflation and deflation.
As a whole, the adjusted CPI figures are not precise but serve as an excellent proxy for demonstrating the inadequacy of the current Rental Equivalence methodology.
The Formula Used to Recast the CPI Index is as Follows:
"Adjusted CPI Index" = "CPI Index" + ("Rental Equivalence Component Weighting" * ("Case-Shiller 20-City Price Index" – "Owner’s Rental Equivalence Index"))
(all index values were set to 100 for January 2000)
Welcome to Reality
The Government has been understating rapid, historical inflation and the existence of current, ongoing deflation. During the mania portion of the Housing Bubble, with the exception of 2001 (September 11th), inflation ranged from 4.7% to 8.0% annually. In 2008, overall price deflation was 6.5% and continues through today.
Treasury Works on 'Plan C' To Fend Off Lingering Threats
As the financial system tries to right itself after its near-collapse last fall, the Treasury Department has assembled a team to examine what could yet bring it down and has identified several trouble spots that could threaten the still-fragile lending industry. Informally known as Plan C, the internal project is focused on vexing problems such as the distressed commercial real estate markets, the high rate of delinquencies among homeowners, and the struggles of community and regional banks, said government sources familiar with the effort.
Part of the mission is assessing which firms are the most vulnerable and trying to decipher what assets these companies hold and whether they pose a danger to the wider financial system. Plan C is a small-scale, relatively informal approach to a problem the administration hopes to address in the long term by empowering the Federal Reserve to oversee systemic risk. The team is also responsible for considering potential government responses, but top officials within the Obama administration are wary of rolling out initiatives that would commit massive amounts of federal resources, said other sources in close contact with the administration.
The sources spoke on condition of anonymity because the discussions are private. Instead, the administration thinks some ailing sectors of the credit markets should work out problems on their own, the sources said. The creation of Plan C is a sign that the government has moved into a new phase of its response, acting preemptively rather than reacting to emerging crises, officials said. "We are continually examining different scenarios going forward; that's just prudent planning," Treasury spokesman Andrew Williams said. The officials in charge of Plan C -- named to allude to a last line of defense -- face a particular challenge in addressing the breakdown of commercial real estate lending.
Banks and other firms that provided such loans in the past have sharply curtailed lending. That has left many developers and construction companies out in the cold. Over the next few years, these groups face a tidal wave of commercial real estate debt -- some estimates peg the total at more than $3 trillion -- that they will need to refinance. These loans were issued during this decade's construction boom with the mistaken expectation that they would be refinanced on the same generous terms after a few years.
The credit crisis changed all of that. Now few developers can find anyone to refinance their debt, endangering healthy and distressed properties. General Growth Properties, which owns the Tysons Galleria mall in Northern Virginia, one of the most profitable shopping centers in the nation, filed for bankruptcy this spring after it could not roll over its loans. The John Hancock Tower in Boston, one of the city's most famous landmarks, was auctioned off after its owner defaulted on its debt.
"There's going to be a lot of these stories where people relied very heavily on this high-leverage cheap availability of debt," said Kevin Smith of Blackwell Advisors, a financial consultancy. Kim Diamond, a managing director at Standard & Poor's, said the trend is expected to accelerate over the next few years, further depressing prices on some of the nation's most valuable properties. "It's not a degree to which people are willing to lend," she said. "The question is whether a loan can be made at all." The problem affects not just the recipients of the loans but also the institutions that lend, many of them small community banks and regional firms.
Thousands of these institutions wrote billions of dollars in mortgages on strip malls, doctors offices and drive-through restaurants. These commercial loans required a lot of scrutiny and a leap of faith, and, for much of the decade, the smaller banks that leapt were rewarded with outsize profits. In doing so, many took on bigger and bigger risks. By the beginning of the recession in December 2007, the median midsize bank held commercial real estate loans worth 3.55 times its capital cushion -- its reserve against unexpected losses -- according to the Federal Deposit Insurance Corp.
Borrower defaults increasingly are draining capital from many of those banks, forcing some to close. Financial analysts said losses on commercial real estate loans are now the single largest cause of bank failures. The federal government has set up bailout programs to provide relief to the commercial real estate market, but none of these efforts is big enough to address the size of the problem, industry analysts said. One Fed program to revive lending took aim at the problem. But this effort faltered in June, failing to attract much interest in the issuance of new commercial real estate loans. The central bank said yesterday that the program sparked only $5.4 billion in new loans of any kind last month, less than half the previous month's total.
Another government effort to buy mortgages, including commercial loans, off the books of banks has been shelved because of a lack of interest from industry. A companion plan to buy toxic bank assets, some of which back commercial loans, is being downsized for similar reasons. Another issue identified by the Plan C team is homeowner delinquencies, which continue to rise as large numbers of people lose their jobs and miss monthly payments. The backlog of seriously delinquent mortgages, which so far affects about 1 million borrowers, masks the full extent of the housing crisis. The trend foreshadows even more financial losses to come for lenders as many of these homeowners are expected to continue to miss payments and eventually fall into foreclosure.
The Obama administration announced last week that it would loosen the eligibility requirements for a program aimed at helping borrowers with no equity to refinance into cheaper mortgages. Acknowledging that falling housing prices have made it increasingly difficult for borrowers to qualify, officials said the program would now be open to those whose mortgage debt is up to 125 percent of their home value. The program, launched in February, was initially open only to those borrowers who owed no more than 105 percent of their home value.
US property market central to economy
by Gillian Tett
A couple of weeks ago I visited West Virginia, USA, where some friends of mine run a small real estate business. As we sat in their yard on a balmy summer evening, I heard how realtors in this pretty, small town had been devastated by the housing crash. So far my own friends have dodged the worst with canny financial footwork. And they cheerfully insist that the town can survive the wider damage, as long as prices stabilise or rise. "But if prices fall further, it will be terrible," one realtor declared – before insisting "we really don’t think that’s likely. Nothing can keep going down for that long."
Is that assumption justified? That is the $6,000bn dollar question, not just for West Virginia, but the wider financial system. After all, it was a turn in the US property market that triggered the financial crisis. And while many other financial disasters have since followed, the state of the US property market remains crucial to the banking world as a whole. For not only does the health of the US consumer – and thus economy – remain tied to housing, but western bank balance sheets are tightly tangled up with property too. Most notably, America’s largest banks, such as Bank of America, JPMorgan and Citi, continue to hold a vast quantities of residential and commercial property loans on their books, in addition to all those loans that they previously repackaged as bonds, and sold on. So do numerous small banks.
And while the prices of mortgage-linked bonds have already slumped to reflect house price falls, the value of many tangible loans have not been fully marked down, because they are lodged in hold-to-maturity books – and the banks do not believe that prices will continue to fall. Indeed, in the town that I visited in West Virginia, some local bankers are refusing to sell foreclosed properties, because they think prices will soon rise. Thus, if prices fall instead, it can only mean one thing: yet more bank pain.
So will US property prices stabilise? Not if you believe a startling presentation I saw this week from a large, global financial group. This particular bunch of analysts – who have done a remarkably good job at predicting the credit crisis during the past four years – are currently warning their clients to expect a peak-to-trough fall in US residential prices of more than 40 per cent in this cycle. The good news is that in some US regions, prices have already fallen so sharply – often by more 30 per cent – that property is already very affordable, relative to incomes and on a historical basis.
But the bad news is that houses are not yet cheap enough to prevent more price falls. On the contrary, this particular team of analysts thinks that when the problems of excess house inventory and rising unemployment are added into the model, average US house prices will still fall by another 14 per cent in the next few years – on top of the declines seen so far. That headline figure conceals some startling regional discrepancies. Colorado is reckoned to be through the worst. In New York, though, the pain has barely started. Prices there are projected to decline by another 30 per cent or so. Taken as a whole, these projections imply that about 25m households in America end up in negative equity.
This projection is gloomier than those made by the US government and many large US banks. But the 25m number is currently being echoed by other investment groups, such as Pimco. If it turns out to be correct, it raises two crucial questions. One is the degree to which the western banking system could face a secondary round of real estate losses (particularly as these analysts are even more alarmed about the commercial property outlook than the residential sector.)
But the second fascinating question is what further house prices falls might do to consumer psychology. America has never experienced negative equity on this scale before. Thus nobody is entirely sure how households might respond. Will they default en masse? Will voters become so angry that they demand more populist public bail-outs of the housing sector (or financial reform)? Will consumers cut spending further? Or will households instead act like my friends in West Virginia – namely shrug their shoulders and display that all-American sense of optimism and resilience, and just assume that somehow things will work out in the end (or that President Obama will ride to the rescue somehow?)
Frankly, I am unsure. But it is clear it will be difficult for the Obama administration to stave off any looming price falls, given the variegated nature of the mortgage market and rising debt. That, in turn, leaves me feeling it is too early to believe "green shoots" could presage a full blown recovery anytime soon – either in the verdant pastures of West Virginia, or anywhere else linked to the US mortgage world.
L.A. County's May mortgage default rate double last year
The percentage of Los Angeles County mortgages delinquent by 90 days or more in May was nearly double the rate last year, First American CoreLogic reported today. May's 9.5% delinquency rate for L.A. County was up from 5% of mortgages late by 90 days or more in May 2008. First American bases its foreclosure analyses on public records.
While the default rate has nearly doubled, the number of homes actually being sold at auction -- the final foreclosure stage -- has shrunk. In May, the L.A. County repossession rate was down to 1% of mortgages, from 1.1% a year ago. This discrepancy is the "foreclosure backlog" now looming over the housing market. It's caused by various government-mandated and voluntary foreclosure moratoriums, and possibly by lenders trying to manage the flow of repossessed homes entering the market. Nationally, First American reported 6.5% of mortgages were in default in May, up from 4% in May 2008. The national repossession rate was 0.7% in May, up from 0.6% in May 2007.
U.S. Housing Market Is Cursed by Massive Brain Freeze
If you are buying or selling a home in a market glutted with distressed properties, it’s time to change your attitude. Don’t be misled by pundits saying the bottom may be visible in this stultifying decline. The real-estate recession will continue unless a massive brain freeze thaws. Buyers are afraid of purchasing a home at the wrong price while millions of sellers are locked into unrealistic listing prices. Some good news after almost three years of deterioration is welcome, of course. In the latest S&P/Case-Shiller Home Price Index of 20 major U.S. cities, values fell 18 percent in April. That pace was slower than forecast.
That’s cold comfort as the collective psychology of the U.S. home market has been short-circuited for some time. We are largely hostage to the way our mind works. According to prospect theory, pioneered by psychologists Amos Tversky and Daniel Kahneman, the idea of losing money is a much more powerful motivator than a gain. Our brains are telling us it’s painful to price our homes to reflect 20 percent to 50 percent losses in market values. So sellers overprice houses and wait for something to happen.
A myopic, loss-averse view of the market, for example, means listing for $500,000 or more when comparable upscale homes are selling for $400,000 or less. I have seen it in my suburban Chicago neighborhood, where homes have been on the market and unsold for years. Our loss-aversion fears are so powerful that they override our logic circuits. We tend to ignore economic reality because we are emotionally anchored to our homes and values based on boom-era prices. It’s like holding on to a favorite stock long after it has tanked.
There are also influential cerebral centers for optimism and self-confidence. We hang on to properties, falsely believing that prices will rebound to the bubble years of 2005-2006. Actual market conditions don’t offer much hope, however. "Real house prices have fallen by more than 30 percent from their peaks in 2006, destroying more than $6 trillion in housing wealth," writes economist Dean Baker in his Housing Market Monitor. "They have been falling at the rate of 2 percent per month thus far in 2009. There is no evidence that this rate of price decline has slowed, much less stopped."
How do you succeed in this market? When you are selling, take into account all market conditions. Forget listing prices that you are anchored to; in most places, homeowners have lost equity that may not be restored, especially if unemployment is rising. The only way out may be a short sale for less than the mortgaged amount. What are comparable homes actually selling for and how much discounting moves a property? Are there foreclosures in your neighborhood, which will necessitate even more discounting?
Reframe your pricing decision. Focus on the benefits instead of seeing a price as loss-inducing. Will you get out of an unaffordable mortgage payment? Will your property taxes drop by moving? Will you be able to save more for college or retirement? Buyers, in contrast, should beware. There are still too many reasons to wait before you jump into this market. Congress and the Obama administration haven’t shut down foreclosures. Unemployment is the highest it has been in almost 26 years. More than 15 million homeowners owe more on their mortgages than their homes are worth.
Is help on the way? There are many carrots that Congress is considering to get buyers into the market again. Under the stimulus plan passed in February, you can reap an $8,000 rebate if you are a first-time buyer. One proposal would raise that credit to $15,000. Yet all the tax credits in the world won’t make a difference if foreclosures continue, prices keep falling and unemployment rises. Congress seems to be avoiding this reality.
More sensible ways to curb the foreclosure crisis would be to allow homeowners to write down principal or enroll in a rent- to-own arrangement. Congress should consider guaranteeing all mortgages in the primary and secondary markets through the full faith and credit of the U.S. Treasury until the market stabilizes. The government helped create the false euphoria that led to the bubble and meltdown. The least it can do is to enact sober solutions on fostering the market’s recovery.
S&P Increases 2005-07 Subprime and Alt-A Loss Assumptions
Standard & Poor’s has increased its loss assumptions for projected losses for U.S. residential mortgage-backed securities (RMBS) transactions backed by subprime and Alternative-A (Alt-A) collateral issued in 2005, 2006, and 2007. "We are updating all of our 2005, 2006, and 2007 deal-specific subprime default projections. In aggregate, our remaining 2005, 2006, and 2007 default projections, as a percentage of the original pool balances, are approximately 11%, 30%, and 49%, respectively. As a result of our increased default and loss severity estimates, we are raising our 2005, 2006, and 2007 vintage subprime and Alt-A lifetime loss projections."We are raising our remaining 2005, 2006, and 2007 Alt-A and subprime loss severity assumptions to reflect additional market value declines and the increasing inventory of real estate-owned properties.
The changes affect the projected losses on the collateral securing outstanding subprime transactions as follows:
- 2005 vintage losses have increased to approximately 14.00% from approximately 10.50%;
- 2006 vintage losses have increased to approximately 32.00% from approximately 25.00%; and
- 2007 vintage losses have increased to approximately 40.00% from approximately 31.00%.
The changes affect the projected losses on the collateral securing outstanding Alt-A transactions as follows:
- 2005 vintage losses have increased to 10.00% from 7.75%;
- 2006 vintage losses have increased to roughly 22.50% from 17.30%; and
- 2007 vintage losses have increased to approximately 27.00% from 21.00%.
'Shadow' Inventory May Slow Housing Recovery
The housing market has shown some signs of life recently. Existing home sales are up, prompting some optimism. But at the same time, an untold number of houses that have yet to hit the market are waiting in the wings. And the bigger that so-called shadow inventory, the further off the housing recovery might be. By the official count, about 3.5 million homes are on the market right now. Given the rate of home sales, that's roughly twice the normal supply.
But "that could just be the tip of the iceberg," says Stan Humphries, chief economist for the real estate Web site Zillow. It's not what is already for sale that worries economists like him; it's the number of homes that might hit the market in the months to come. "The portion of the iceberg below the waterline is inventory that's waiting to come into the market at some point," Humphries says. "And as it bleeds into the market over time, it continues to put downward pressure on prices."
Shadow inventory comes in several forms. It includes homes in or close to foreclosure but not yet put up for sale — a number that's increasing. It also includes homes that owners want to sell but are waiting to put on the market until it improves. In a recent survey, Zillow found that nearly a third of homeowners would have considered putting their homes up for sale if the market were better. Nationally, that would mean between 11 million and 30 million homes that aren't listed but are waiting on the sidelines.
The would-be sellers include people like Jennifer Dalzell. She and her husband bought a five-bedroom row house just four years ago in the shadow of the nation's capital. Her husband is in the military, so they move around a lot. Dalzell says she's watched the appraised value of their home plummet along with their retirement savings and mutual funds. Her husband will be moving to his new gig in Africa without the family, in part because they don't want to sell at what she believes is the bottom of the market.
"Because we can wait, we'll wait until we feel that we can get a better price for the house," Dalzell says. "I think the market will come back. It feels like there's money out there, and people are just sort of waiting. And I guess we're contributing to that waiting game." There are no records that quantify how many people like Dalzell there are. In fact, sizing up the shadow inventory is tough. "Unfortunately, our data are very delayed, and we really don't have a sense of exactly where we are," Former Federal Reserve Chairman Alan Greenspan said at the National Association of Realtors conference in May.
The key question, Greenspan said, is quantifying how many single-family dwellings are available for sale. But it's not clear how many more homes will be heading into foreclosure. If prices keep falling, that number is bound to grow. Government data released Tuesday showed the number of homes going through the foreclosure process jumped 22 percent during the first quarter. The number of homeowners who are seriously delinquent on their mortgages is also up. Delinquencies are growing the fastest among borrowers who had good credit scores.
And that's only part of the challenge. As banks take possession of more foreclosed homes, not all of those are listed — sometimes because they are holding back inventory so they don't flood the market. "I do know that banks are holding onto inventory, and what they're doing is they're metering them out at an appropriate level to what the market will bear," says Pat Lashinsky, chief executive of online brokerage site ZipRealty. He says this strategy has paid off for banks — even if it also pushes a full housing recovery further out.
"By not flooding the market, they were getting better pricing on the homes that they owned," Lashinsky says. "And instead of people coming in and offering less than what the prices were, they were ending up in multiple-offer situations and getting more for the homes." Lashinsky adds that a large shadow inventory is not all bad because it creates a kind of buffer. Having so many people hold back prevents a free-fall in home prices. And when the economy recovers, he says, there will be plenty of homes to buy.
Moody’s Downgrades $7.6 billion of Jumbo RMBS
Moody’s Investor Service took the red pen to 344 tranches of 61 residential mortgage-backed securities (RMBS) backed by jumbo loans in excess of the conforming loan limit ($729,750). Together the relevant downgraded RMBS totals $7.59bn. Moody’s downgraded $4.25bn of jumbo RMBS issued by Wells Fargo. The ratings agency downgraded ratings of 104 tranches from 21 RMBS transactions backed by prime jumbo loans issued by Wells in 2004. It also downgraded 98 tranches of 18 jumbo RMBS — worth $2bn — issued from 2002 to 2004 by Bank of America.
Moody’s downgraded $362m of jumbo RMBS issued by GMACM Mortgage Trust in 2003 and 2004. The agency downgraded ratings of 31 tranches from five GMACM Mortgage Trust RMBS transactions backed by prime jumbo loans. It also downgraded $115m of jumbo RMBS — nine tranches from three transactions — issued by RFMSI in 2002 and 2004. Moody’s downgraded $75m of jumbo RMBS issued by ABN AMRO Mortgage Corp. The downgrades occured in just four tranches of a single RMBS transaction backed by prime jumbo mortgages issued in 2003. Moody’s bumped the four ABN AMRO RMBS tranches to "Aa3" from "Aaa."
The rating agency also downgraded $786m of jumbo RMBS issued by Bear Stearns ARM Trust from 2002 through 2004. The agency downgraded ratings of 98 tranches from 13 Bear Stearns ARM Trust RMBS transactions. Downgrades to jumbo RMBS issued by a firm long defunct speaks to the depth of the pain unwinding in the space. "These actions are a result of Moody’s updated loss expectations on the underlying collateral relative to available credit enhancement," the rating agency says in a press statement today.
The sweeping downgrades are part of an ongoing effort by the major rating agencies to account for the increasingly poor performance of the jumbo mortgage market. Moody’s actions come weeks after Standard & Poor’s similarly downgraded ratings on 102 classes from 33 US prime jumbo RMBS transactions issued from 1998 through 2004, indicating the jumbo pain resonates from well before the height of the housing boom.
US Lawmakers Sound Alarm About Commercial Real Estate Market
U.S. lawmakers rang alarm bells about the troubled commercial real estate industry, which has been walloped by the credit crunch and an implosion of property values. "The commercial real estate time bomb is ticking," Joint Economic Committee Chairman Rep. Carolyn Maloney, D-N.Y., said in opening remarks to a hearing before her panel Thursday. U.S. Sen. Sam Brownback, R-Kansas, said he was distressed about the situation the industry is facing. Banks have yanked back on lending to developers of shopping malls, apartment complexes, hotels and office parks. Meanwhile, the securitization market - a key source of funding for the commercial real estate industry - has been in a deep freeze since last year.
The situation is fueling concerns that property developers won't be able to refinance roughly $400 billion in commercial real estate debt coming due this year. Property values have plunged about 24% since their peak in 2007, further hampering developers' ability to obtain refinancings or loan extensions. General Growth Properties, one of the largest U.S. shopping mall owners, filed for bankruptcy protection along with 158 of its properties in April, citing lack of financing.
A wave of defaults of commercial real estate loans would deal a blow to the already weakened banking industry. The U.S. commercial real estate market is roughly $6.7 trillion in size and is underpinned by about $3.5 trillion of debt. The Federal Reserve has taken steps to get lending flowing to the industry. On June 16, it announced it would accept as collateral new issuance of commercial mortgage-backed securities as part of its emergency program to thaw the securitization market. As early as next week, the Fed is expected to extend that to existing, or "legacy", CMBS already held by investors.
The commercial real estate industry believes these steps will help unleash lending to property owners and developers by spurring more investor appetite for CMBS. To the extent that CMBS investors are able to buy and sell the securities again, spreads will tighten, the Fed argues. That will allow financial institutions that make loans backing the CMBS to free up their balance sheets and make new loans to the industry or refinance existing debt.
10 Most Broke States
The economic problems of American families are now pounding many state governments which are in turn slashing services to balance their budgets in one of the most difficult years in decades. High on the chopping block are benefits to the poor, money for education, highway repairs, hours that state offices are open and even closures of state parks and recreation areas. Things are so bad that 48 states addressed or are facing shortfalls in the fiscal year that just started. The total deficit: $166 billion, according to the Center on Budget and Policy Priorities. Many states are also already predicting shortfalls next year.
Only Montana and North Dakota have so far been unscathed in their state budgets. The problem: as workers get laid off or see their pay cut, they end up owing the state less in income tax. Further compounding the issue is a shortfall in sales tax caused by consumers cutting back in the recession. Finally, companies are making less money and also paying less in taxes. "It's a revenue problem, not a spending problem," said Elizabeth McNichol, a senior fellow at the center.
Unlike the federal government, nearly every state is legally required to balance its budget. For many, the spending cuts would have been worse without the $787 billion federal economic stimulus package. No one is immune from the wide-ranging cuts. "States are really looking at everything," said Todd Haggerty, a research analyst with the National Conference of State Legislatures. "Anything and everything is on the table."
To come up with a list of the worst state budget situations, ABC News asked the Center on Budget and Policy Priorities to look at the budget gaps that states closed -- or still need to close -- as a percentage of their overall budgets. Coming in at the top of the busted list is California, which is going through a miserable budget crisis. But there are also some surprises on the list, including Alaska and Vermont.
California: $53.7 billion shortfall or 58 percent of its budget
Perhaps no state has a more daunting problem to overcome than California. Its massive deficit is larger than the entire budgets of several states. The state has almost a $27 billion gap to close before balancing its budget. The $53.7 billion figure adds in the massive gap that the state has already closed. There's very little fat to trim without residents feeling even more pain. Adding to the attention today will be Michael Jackson's memorial service, reportedly estimated to cost up to $4 million for police overtime. While the city of Los Angeles will be footing that bill -- for now -- the cost draws even more attention to the state's troubles.
The Golden State's problems are emblematic of the nation's. But whatever happens in California could actually have implications for all of us: the state accounts for 12 percent of the nation's gross domestic product and the largest share of retail sales of any state. The cash flow shortage is so bad that last week the state, which if counted as a country would have the eighth largest economy in the world, had to start issuing IOUs to make its bills. The IOUs, issued for the first time since 1992, are being given to vendors and residents who were owned tax refunds. (The IOUs pay an interest rate of 3.75 percent, better than most people are seeing in their savings accounts these days.) The state hopes to redeem the script in October.
Residents seeking to get a new driver's license or even call with questions about their IOUs might find their pleas falling on deaf ears. Governor Arnold Schwarzenegger is shutting down most of state government for three "Furlough Fridays." Voters in May rejected five ballot measures that would have helped stop the budget crisis. Now, to raise cash, Schwarzenegger has called for selling off certain state properties.
He also proposed eliminating $70 million of funding for state parks, which would likely result in the closure of 220 parks. The legislature is trying to avoid those closures through a $15 increase in annual motor vehicle registration fees. California drivers would then get free admission to the parks. To help close the gap, the state has also increased co-payments and reduced dental benefits in its children's health program. Other big cuts include state aid to local school districts, a 10,000-student enrollment cut at the California State University system and the elimination of dental and vision services for many Medicaid recipients.
Arizona: $4 billion shortfall or 41 percent of its budget
Arizona was ground zero for the collapse of the housing market. Cities like Phoenix have seen home prices plunge while jobs have dried up. Income tax collections are down 34.4 percent and the sales tax is down as sakes of building supplies and other consumer goods plunge. The governor and legislature have been battling over way to close the budget gap. At issue: more than $630 million in spending cuts, including the elimination of a welfare program for disabled people waiting for Social Security benefits.
Gov. Jan Brewer wants to temporary hike the state's sales tax from 5.6 percent to 6.6 percent. For each of the three years she expects it will take to turn around the state's economy, the hike would bring in an extra $1 billion. But lawmakers have balked. Instead they have reduced school spending, cut $40 million from the state universities, $49 million from the Health Services Department and taken $43 million in slot-machine revenues that were supposed to go to highways and used it for other spending.
The governor vetoed most of the $8.4 billion budget Wednesday, saying it "incorporates devastating cuts to education, public safety and our state's most vital services for the frail." She called lawmakers into a special session Monday to pass a budget that avoids deep cuts in part by increasing the sales tax. The government is unable to make cuts to roughly one third of the budget because voter mandates stipulate exactly how that money should be spent.
Nevada: $1.2 billion or 38 percent of its budget
Like Arizona, Nevada was hit hard by the housing market. But the state also got whacked by a drop off in tourism and gambling revenue. First, high gas prices kept tourists away. The only way to get to Las Vegas is to drive a far distance or fly. Then the recession made people less willing to gamble with their paychecks. That has put a massive strain on the state's budget. To help close the budget gap, the state is looking at decreasing teacher pay by 4 percent and giving state employees 12 unpaid furlough days, the equivalent of a 4.6 percent pay cut.
Lawmakers are considering raising some taxes -- for instance the tax on cigarettes could go from 80 cents a pack to $1.80 -- but Gov. Jim Gibbons has threatened to veto any new taxes proposed by the legislature. That includes cigarette, liquor and mining taxes. To help close the gap, the governor has ordered cuts to education, including delaying an all-day kindergarten expansion and eliminating funds for gifted and talented programs and a magnet program for students who are deaf or hard of hearing.
Illinois: $9.2 billion or 33 percent of its budget
Last week, Gov. Pat Quinn vetoed a budget proposal that would taken away $5 billion in federal funds from social services for the poor and homeless. However, the state still does not have a budget in place even though the new fiscal year began on July 1. Quinn, who replaced ousted governor Rod Blagojevich only six months ago, has stated he will veto any other budget proposal that does not call for a tax increase.
Even with the 50 percent income tax hike that Quinn has proposed, the governor's administration will carry out $1 billion worth of budget cuts that amount. These include a $185 million cut in state operations, a $140 million cut in health insurance, $175 million cut in education and $283 million cut in the Department of Human Services. More than 2,500 state workers may lose their jobs and those who stay may be required to work 12 unpaid furlough days.
New York: $17.9 billion or 32 percent of its budget
Home to Wall Street, New York state has seen its personal income tax collections fall a whopping 48.9 percent in the last year, according to the National Conference of State Legislatures. When Wall Street started laying off workers and slashing multi-million dollar bonuses, the state's coffers felt the impact. Although a divided state Senate in Albany enters its fifth week of a budget stalemate, New York's struggle to close the budget gap has dragged on for several months.
The state legislature passed a $131 billion spending plan at the start of its fiscal year, which began on April 1. The gap there was cut, in large part, due to income tax hikes on the state's richest citizens. For households with taxable income above $500,000, the tax rate went from 6.85 percent to 8.97 percent. For those earning above $200,000 to $300,000 depending on filing status but less than $500,000, the rate jumped from 6.85 percent to 7.85 percent.
In addition, New York placed limits on itemized state income tax deductions for taxpayers making over $1 million and reduced a state-funded credit on New York City's personal income tax. The changes are projected to raise more than $5 billion a year. But that won't be enough. Gov. David Paterson has proposed a $698 million reduction in school funding, $3.5 billion cuts in healthcare services and layoffs for more than 500 state government workers. To further help balance budgets, tuition at public universities also increased.
Alaska: $1.35 billion shortfall or 30 percent of its budget
The county's most-remote state had a shockingly large shortfall this year for one simple reason: oil prices plunged. Alaskans pay no state sales tax or state income tax. In fact, the state pays every man, woman and child who has lived there at least a year money to, well, live there. The so-called Permanent Fund paid $3,269 from oil taxes and royalties to the 610,768 residents who qualified last year. But signs are showing that the fund isn't so permanent. Oil production in Alaska has declined by 64 percent since 1988 but had very little impact on the state's budget because at the same time the price of each barrel of oil has shot up significantly. Then came the global recession.
Oil prices fell from more than $140 a barrel last summer to about $30 this winter before climbing back up to $64 a barrel today. That drop caused the state's corporate taxes -- essentially all oil money -- to fall 32 percent compared to last year, creating a rare budget problem for Alaska. The state easily solved it this year by taking money out of flush reserve funds, built up during oil boom years. But many state watchers questioned the future of Alaska's ability to fund its services and continue its annual Permanent Fund payments to residents. That's one problem Gov. Sarah Palin won't have to deal with. She's announced her resignation from the job.
New Jersey: $8.8 billion or 30 percent of its budget
The Garden State has seen a double-whammy of problems from a drop in Wall Street salaries and also a fall in gambling revenues in Atlantic City. To close the gap, the state eliminated 2,000 jobs by encouraging early retirement, leaving vacancies unfilled and laying off staff. About $325 million will be saved through wage freezes and furloughs, although unions have yet to formally sign on to the plan.
The state is also skipping making a $940 million payment to its pension fund. The money will have to be made up at some point and the longer the state waits, the larger the repayment will have to be.
New Jersey also raised about $1.2 billion in new taxes, mostly from tax filers earning $400,000 or more. It also scaled back and eliminated property tax rebates for people earning $150,000 or more.
The state also increased so-called sin taxes on cigarettes, lottery winnings larger than $10,000 and alcohol, except beer.
Oregon: $4.2 billion or 29 percent of its budget
With nearly $800 million in tax increases, Oregon is among a handful of states to recently approve big tax hikes. Budget cuts announced in May anticipated the layoffs of 1,700 state employees and a 14 percent budget cut in higher education, for $2 billion in cuts. Oregon's lawmakers traditionally meet just every other year, but state legislators met last month to pass a $6 billion budget for the state's K-12 schools, despite concerns from Gov. Ted Kulongski.
However, schools still have to cut back, as evidenced by bigger classes, fewer music and athletic programs and a freeze in employee pay at many districts. While public school students were spared from deep cuts, the same cannot be said for the state's working poor, seniors and disabled. The Department of Human Services will receive $387 million less than what officials say is needed to sustain their programs. Among the largest cuts is a $41 million reduction in a daycare program for low-income families. The state legislature will reconvene in February.
Vermont: $278 million or 25 percent of its budget
Compared to the other states, Vermont's $278 million shortfall might not seem like much. But then again, this tiny New England state doesn't really spend much, so the shortfall actually takes up a large portion of the budget.
After a special legislative session last month, Vermont lawmakers approved a state budget. But the state's financial woes have translated into cuts across many sectors. Lawmakers tapped money from the state's education fund to pay overall expenses, resulting in a loss in state aid of about $18.4 million to the Education Fund for fiscal year 2010. Lawmakers also enacted a provider rate cut from 4 percent to 2 percent for contracted healthcare services, impacting mental health providers, sign language interpreters and rehabilitation programs for children.
The state is also taking cuts that could impact its environment, a major selling point in its important tourism industry. Vermont eliminated approximately 10 percent of the jobs in its Agency of Natural Resources, a state department dedicated to protecting the environment. Most of the job cuts were made among the agency's solid waste management staff. Vermont now charges a sales tax for digital music downloads and liquor, has raised tobacco taxes and will shut down several highway rest areas.
Washington: $3.6 billion or 23 percent of its budget
Washington state's deficit has taken its toll on social services for residents. Lawmakers predicted budget cuts would result in the loss of 8,000 state jobs and 40,000 fewer people receiving state-subsidized health insurance. There are already 14,000 people on the waiting list for that program. In April, state legislators approved plans to cut the state's public education system by nearly $800 million, though some school districts will receive money from the federal stimulus package.
Measures passed this year will also allow the state to raise the current 7 percent cap on undergraduate tuition increases to up to 14 percent at public universities. Approximately 9,000 fewer students are estimated to be able to enroll in a state university as a result. A 70 percent cut in Medicaid for low-income seniors took effect on July 1, forcing elderly care providers to lay off staff.
Connecticut: $4.1 billion or 23 percent of its budget
Rounding out the worst 10 is Connecticut, where there is currently no budget in place after Governor M. Jodi Rell vetoed Democratic legislators' budget proposal earlier this month. Rell issued a 34-page executive order to provide $1.4 billion for state operations for the month of July. Last September, the state's Department of Children and Families budget took a heavy hit, including a more than $9.8 million cut in residential services and shelters for children in state custody. The Department of Developmental Services and the Department of Social Services lost more than $8 million and $5 million respectively. Rell's latest proposal calls for $5.4 million cuts in the state's library services.
States Using Stimulus Money for Short-Term Needs, Audit Shows
The Government Accountability Office, in a report released Wednesday, finds that the $787 billion stimulus package is being used to "cushion" state budgets, prevent teacher layoffs, make more Medicaid payments and head off other fiscal problems.
Cash-strapped states have used federal stimulus dollars to close short-term budget gaps and avert major tax increases but generally have not directed the money toward long-term expansion, according to a new report. The report released Wednesday by the Government Accountability Office, Congress' investigative arm, found that the $787 billion stimulus package is being used to "cushion" state budgets, prevent teacher layoffs, make more Medicaid payments and head off other fiscal problems.
The Congressional Budget Office estimates that only 10 percent of the Recovery Act funds have been released so far, with about half of the money expected to be spent by October 2010. That dispersed money is being used to prioritize short-term projects and needs over more ambitious goals, the GAO report states. For example, the GAO said about half the money set aside for road and bridge repairs is being used to repave highways, rather than build new infrastructure. And state officials aren't steering the money toward counties that need jobs the most, auditors found.
Taxpayers have also recently complained that the federal government has wasted money by advertising stimulus-funded construction projects with road signs which costs between $500 and $1,200 to produce. The report states that the federal money generally has not prevented state governments from dipping into their rainy-day funds or eliminated the need to take further action to balance future budgets.
Highlighting the delicate fiscal picture in many of the states, the report warned that officials are trying avoid the so-called "cliff effect" -- or problems associated with the end of stimulus funding for states. Rep. Darrell Issa, ranking Republican on the House Committee on Oversight and Government Reform, complained at a hearing to review the report that stimulus dollars have gone to the "maintenance of many jobs," and that the money has been shifted to projects it was not originally intended for.
Issa said the latest 9.5 percent unemployment rate for June shows the stimulus is not having its intended effect. "The purpose of the stimulus was putting the unemployed back to work," the California lawmaker said. "So far the stimulus has failed to do that." President Obama had always pitched the stimulus package as a way to "save or create" 3 million to 4 million jobs. The president announced in late May, 100 days after the stimulus bill was signed, that 150,000 jobs had been created since its enactment.
However, more than 2 million people have lost jobs since the stimulus bill was signed in February. Issa said the 150,000 number for jobs created was based on "flawed macroeconomic models." Acting Comptroller General Gene Dodaro testified at the hearing that by helping states relieve "fiscal stresses," the stimulus has been successful to an extent. "It's clear that the Recovery Act has helped in accomplishing one of its objectives, which was to help stabilize state and local government budgets," he said.
The GAO report, which examined 16 states and the District of Columbia, found that many states would have had to make further cuts to programs and services if not for the stimulus dollars. "Most commonly, states reported that they are using or planning to use freed-up funds to cover their increased Medicaid caseload, to maintain current benefits and eligibility levels, and to help finance their respective state budgets," the report said.
Obama pitched the stimulus as more than just a lifeline to states. Besides saving teaching jobs, he said, it would also lead to lasting education reform by permitting old schools to be replaced and new science labs to be constructed. "We can use a crisis and turn it into an opportunity," Obama said while promoting the stimulus in February. "Because if we use this moment to address some things that we probably should have been doing over the last 10, 15, 20 years, then when we emerge from the crisis, the economy is going to be that much stronger."
The 400-page stimulus includes provisions for long-term growth, such as high-speed rail and energy efficiency, but their effects will be seen later. Robert Nabors, deputy director of the White House Office of Management and Budget, said Wednesday that the execution of the stimulus is a "work in progress" but insisted the administration is making "steady progress."
After Vice President Biden said over the weekend that the administration "misread" the economy, Nabors also suggested the administration underestimated the severity of the recession.
"All of us knew the economic situation was bad," he said. "None of us anticipated just how weak the economy truly was though."
He called said the unemployment rate is "not acceptable."
Banks’ plan to refuse California IOUs as of Friday causes a stir
After taking multibillion-dollar bailouts from the federal government, some of the nation’s biggest banks are declining to lend a hand with a different financial mess: the California budget stalemate. The banks, including JPMorgan Chase & Co., Bank of America Corp., Wells Fargo & Co., Citigroup and some regional banks, are trying to pressure lawmakers to end the impasse by warning that, after Friday, they won’t accept IOUs issued by the state. The move would leave many businesses and families with pieces of paper and fewer options for getting their money immediately.
Government officials and consumer advocates say the banks should be more sympathetic, especially since they’ve been the direct beneficiaries of taxpayer dollars. "If they hold to that stance, then there’s potential for hardship being suffered by the recipients of IOUs," said Tom Dresslar, spokesman in the California Treasurer’s office. Unless recipients are able to hold IOUs until Oct. 2, the official redemption date, "they’ll have to scramble" to feed their families and meet obligations, Dresslar said.
At Rhodes Consolidated in Galt, Calif., owner Fred Rhodes said that if banks stop accepting IOUs, his family’s income will suffer and the company will likely have to stop paying its own vendors. The industrial supply company provides state agencies with plumbing and electrical parts. As California legislators haggle over how to close a $26.3 billion budget deficit, the state is expected to send out $3.3 billion in IOUs this month to private contractors, state vendors, people getting tax refunds and local governments for social services.
It is the first time since 1992, and just the second time since the Great Depression, the state has sent out notes promising repayment at a later date instead of paying its bills on time. The IOUs carry an annual interest rate of 3.75 percent. Some banks are already placing limits on the IOUs, accepting them from existing customers only. "We would like for the state to resolve its budget issues as soon as possible," said Tom Kelly, a spokesman for JPMorgan Chase. The bank said it was in contact with California state officials for several weeks leading up to the decision to start printing the IOUs.
At Bank of America, which counts the state of California as a commercial client, only existing customers can deposit IOUs — and only until Friday. "We don’t want acceptance" of IOUs "to deter the state from a budget agreement," bank spokeswoman Julie Westermann said. But that strategy could backfire for banks that already have an image problem after taking tens of billions of dollars from the government to make up for the losses they suffered on risky mortgage investments.
The banks "can come up with any justification they want, but there will be extreme anger," said Stan Collender, managing director at Qorvis Communications, a business consulting and public relations firm in Washington. If businesses and families suffer because they couldn’t cash IOUs, the banks will be viewed as "another bad guy," Collender said.
JPMorgan Chase and Wells Fargo each received a $25 billion federal bailout in October. JPMorgan repaid the U.S. Treasury last month. Bank of America and Citigroup each received $45 billion in multiple installments between October and January. Each also benefits from guarantees against losses.
The banks could also find themselves losing customers to institutions willing to keep accepting IOUs. Some credit unions have been more flexible by not setting a deadline, according to the California Credit Union League. Nearly 60 have already said they would accept the IOUs and only two might stop accepting them on Friday, league spokesman Henry Kertman said. The federal government has not so far intervened, but it could pressure the banks to continue accepting the IOUs.
SEC to call for California IOUs to be treated as securities
The recipients of billions of dollars in IOUs being issued by California soon may have a regulated market where they could sell them. Some of the nation's largest banks say that, starting Friday, they will no longer accept the IOUs. The banks want to pressure the state to end its budget impasse, but their action could leave many businesses and families with fewer options for getting their money.
The Securities and Exchange Commission is going to recommend that the IOUs, which carry an annual interest rate of 3.75 percent, be regulated by the Municipal Securities Rulemaking Board as a form of municipal debt. The guidance could come as soon as Thursday, according to two people familiar with the matter who spoke on condition of anonymity because the SEC hasn't yet acted. A regulated market for the IOUs would make it easier for individuals holding them to sell them at a fair price, analysts said.
The SEC oversees rules set by the nongovernment MSRB. SEC spokesman John Nester declined to comment Thursday. With JPMorgan Chase & Co., Bank of America Corp., Wells Fargo and Citigroup Inc. and some regional banks in the state saying they won't accept the IOUs for payment after Friday, attention has turned to the possibility of a secondary market to buy up the notes.
"A safe conclusion would be to consider them securities," said Paul Maco, an attorney at Vinson & Elkins in Washington who was a director of the SEC's Office of Municipal Securities.
A regulated market for the IOUs "makes it even more advantageous" for individuals holding them, who could sell them at a fair price, Maco said. The price they receive may be discounted in accordance with the market's perception of the risk of the state repaying the notes, but it would be an orderly market price, he said. SecondMarket, which creates marketplaces for the trading of illiquid assets, has received "decent interest" from hedge funds, municipal bond and distressed asset investors as potential buyers of the IOUs, Jeremy Smith, the New York-based company's chief strategy officer, said this week.
As California legislators haggle over how to close a $26.3 billion budget deficit, the state is expected to send out $3.3 billion in IOUs this month to an array of individuals, small businesses and local governments. It marks the first time since 1992, and only the second time since the Great Depression, that California has sent out notes promising repayment at a later date instead of paying its bills on time. The IOUs are referred to as registered warrants.
"The California registered warrants have the hallmarks of securities, and if they are securities, they are pretty clearly municipal securities," MSRB General Counsel Ernesto Lanza said. "To the extent that municipal securities dealers are involved in the sale and trading of the warrants, our rules would apply. We would be especially concerned about dealers' obligations to customers with respect to fair pricing."
China attacks dollar’s dominance
China has launched its highest-profile criticism of the dominant role of the US dollar as a global reserve currency at a meeting of the world’s biggest economies. Dai Bingguo, Chinese state councillor, raised the issue on Thursday when he joined the leaders of four other emerging economies for talks with the leaders of the Group of Eight industrialised nations – including US President Barack Obama – in the earthquake-damaged Italian town of L’Aquila.
The remarks, in front of Mr Obama, caused concern among western leaders, some of whom fear that even discussion of long-term currency issues could unsettle markets and undercut economic recovery. Gordon Brown, Britain’s prime minister, said he did not remember Mr Dai making the remarks. But he said the focus should be on moving the world out of recession. "We don’t want to give the impression that big change is around the corner and the present arrangements will be destabilised," said Mr Brown.
"We should have a better system for reserve currency issuance and regulation, so that we can maintain relative stability of major reserve currencies exchange rates and promote a diversified and rational international reserve currency system," said Mr Dai, according to the Chinese foreign ministry. While he did not name the dollar, Mr Dai was unequivocal in calling for the world to diversify the reserve currency system and aim at relatively stable exchange rates among leading currencies.
The dollar weakened in early trading, although it was difficult to tell whether this was due to the Chinese remarks or cross-currents in risk appetite and economic data. Analysts said Mr Dai’s comments – which follow earlier statements by the People’s Bank of China in March – appeared mostly political in nature. While China desires in the long run to move to a more multipolar global financial system, Chinese officials understand that there is no alternative to the dollar in the short term and may not be for many years.
By faulting the dollar Beijing can express its displeasure at US policy and exert leverage over the US in general, including in the broad debate over the future governance of the international financial system.
The challenge also serves as a shot across the bows for the US at a time when China is concerned about giant US government deficits and the Federal Reserve’s unorthodox monetary policy. Beijing wants the US to take seriously its obligation to sustain the value of China’s nearly $2,000bn in US Treasuries.
Separately, Joseph Yam, chief executive of the Hong Kong Monetary Authority, said Hong Kong might consider diversifying more of its US$200bn reserves away from the US dollar. Mr Yam said he had an "open mind" as to whether the territory would invest its reserves in renminbi-denominated assets. "There may come a time in the future when we think that a small, modest exposure to the renminbi - notwithstanding it being a non-convertible currency still - may be something that we may pursue. But we don’t have any plans at this moment, any concrete plans," said Mr Yam. "A bit of diversification won’t hurt us," he added.
Biden Defends Stimulus, Administration's Economic Policy
With opinion polls showing declining confidence in President Obama and rising skepticism about White House economic policy, Vice President Biden dropped into Ohio this morning to deliver a fiery defense of the administration and a request for patience. The address, outside a gutted American Can factory scheduled for renovation, had the tone and tempo of a campaign rally, with Biden repeatedly demanding of the administration's critics, "What would they do?"
"What would they say to those tens of thousands of teachers who got their pink slips this year, but are able to go back into the classroom" because of stimulus funds, Biden said. "What would they do . . . [let] all those cops get laid off? Would they say, 'Okay, no problem?' " Biden cited money already committed or spent on the national economic recovery effort. He urged patience and promised his audience that "you're going to see more pace on the ball. . . . Remember, we're only 140 days into this deal. It's supposed to take 18 months."
The last several weeks have been a tough stretch for Biden and the administration, with the national unemployment rate rising another tenth of a point, to 9.5 percent, and Republicans increasing their attacks. A Quinnipiac University poll of Ohioans released this week showed the president's economic approval rating dropping from 57 percent to 46 percent in the past two months. Forty-eight percent of those polled said they now disapprove of Obama's handling of the economy.
Obama's overall approval rating dropped from 62 percent to 49 percent. The most significant fall was a 21-point drop among independent voters -- a bloc crucial to Obama's victory here after former president George W. Bush carried the state in 2000 and 2004. A recent Washington Post-ABC News poll showed a decline in the number of people who believed the $787 billion stimulus package would work, or would work in the future. The drop in optimism was steepest in the Midwest. In April, 60 percent of Midwesterners said the stimulus package had already improved or would improve the economy; that fell to 49 percent in late June.
Republicans, seeking to capitalize on the bad economic news, have strongly criticized the administration's strategy. House GOP leader John A. Boehner (Ohio) blasted Biden before he set foot in the state and set up a conference call with reporters to start soon after the vice president departed for another recovery-focused event in New York. The House leader put quotation marks around the word "stimulus" and said the administration's effort "clearly isn't working."
"The people of Ohio -- like people all over America -- have a right to know: Where are the jobs?" Boehner asked in a statement relayed by the Republican National Committee. "How will he [Biden] explain the administration's promises that if we passed that bill, the nationwide unemployment rate would stay below 8 percent, when it's now at 9.5 percent and rising?" Biden responded by referring to Boehner during his speech and accusing Republicans of lacking their own recovery plan. "I hear nothing other than criticism," Biden said. "I hear nothing affirmative."
Biden did not repeat the comment he made during a television appearance Sunday, that "we and everybody else misread the economy." Obama had to take time during his overseas trip this week to clarify that remark. "Rather than say 'misread,' we had incomplete information," Obama said. He added, "There's nothing that we would have done differently. We needed a stimulus and we needed a substantial stimulus." Figures released by the administration indicate that only $56 billion of the $787 billion stimulus package had been delivered by the end of June. Another $43 billion remained in the economy in the form of taxes that went uncollected as part of the federal package.
Administration officials report that the rate of stimulus spending will increase substantially in the months to come. "It is clear from the data that there needs to be more fiscal stimulus in the second half of the year than there was in the first half of the year," White House economic adviser Lawrence H. Summers said this week. "Fortunately, the stimulus program designed by the president and passed by Congress provides exactly that."
In Ohio, where the unemployment rate is 10.8 percent -- more than a point higher than the national average -- Gov. Ted Strickland (D) said hundreds of millions in Medicaid dollars allowed the state to end the budget year in balance. Overall, the state expects $8 billion in stimulus money. "Things are very difficult now," Strickland said in an interview. "But they would be so much worse if it were not for the federal stimulus resources. It would be so much worse."
Economists Oppose More Stimulus
Most economists believe the U.S. doesn't need another round of stimulus now despite expectations of continued severe job losses. Just eight of 51 economists in The Wall Street Journal's latest forecasting survey said more stimulus is necessary, suggesting an average of about $600 billion in additional spending. On average, the economists forecast an unemployment rate of at least 10% through next June, with a decline to 9.5% by December 2010.
"The mother of all jobless recoveries is coming down the pike," said Allen Sinai of Decision Economics. But he doesn't favor more stimulus now, saying "lags in monetary and fiscal policy actions" should be allowed to "work through the system." Like most respondents, Mr. Sinai said the bulk of the stimulus wouldn't be felt until 2010. When asked how much the stimulus has helped the economy, 53% of respondents said it has provided somewhat of a boost but that the larger effect is still to come.
That sentiment echoes what the Obama administration has said about the stimulus. While some top Democrats, such as Rep. Steny Hoyer of Maryland, have said they are open to another round of stimulus, Rob Nabors, deputy director of the White House's budget office, said Wednesday that the administration isn't discussing a new package. Nicholas Perna of Perna Associates, one of the economists calling for more stimulus, said more government aid is warranted. "The most obvious reason is the need to offset the large fiscal drag just getting under way as state and local governments raise taxes and cut spending as they attempt to balance their budgets," he said. Mr. Perna also noted that extended jobless benefits and medical-insurance subsidies would be expiring in a few months.
Most economists appear content to take the wait-and-see approach, as on average they are expecting the just-ended second quarter to be the last in which gross domestic product contracts. They forecast growth rising more than 2% on a seasonally adjusted annualized basis in the first half of 2010. Meanwhile, the median forecast sees the end of the recession next month. Some economists had other reasons for opposing the stimulus. More than one-third of respondents said the government package would have only a small effect on the economy, while 6% said the stimulus has hurt the economy.
"There's no easy solution," said Ram Bhagavatula of Combinatorics Capital, who says the stimulus passed early this year will provide only a modest boost. "Every time the government gives money to consumers, it goes right into the bank. The consumer needs to rebuild savings, and that's a long, slow process." Most economists were generally supportive of the Obama administration's plan to overhaul financial regulations. Some 44% said the proposal was acceptable given political realities, while 15% said it would make the financial system safer. Still, 23% said the plan would stifle innovation and hurt growth, and 19% said it is a feeble attempt at addressing vulnerabilities exposed during the crisis.
On average, the economists said there is a 65% chance a regulatory overhaul in some form would be signed into law by this time next year. That compares with the 50% chance they placed on climate-change or health-care legislation passing in the next 12 months. "After being dragged into TARP, the administration will want to be seen as extracting a return for taxpayer," Mr. Bhagavatula said, referring to the Troubled Asset Relief Program, in which the government moved to recapitalize banks. The program, started under the Bush administration, has fueled populist anger over government bailouts. The White House is "fully incentivized," Mr. Bhagavatula added.
The administration's performance continues to divide economists. President Barack Obama and Treasury Secretary Timothy Geithner both got a median 70 out of 100 for their handling of the financial crisis, but those grades varied widely. Former President George W. Bush and ex-Treasury chief Henry Paulson got median grades of 50 and 60, respectively, when economists were asked how they handled the crisis while in office.
By contrast, Federal Reserve Chairman Ben Bernanke remains at the head of the class with a median grade of 85; 93% of respondents said he should be reappointed by Mr. Obama early next year.
Foreclosure Freeze Had Little Impact: Report
Widespread foreclosure freezes that began in late last year and ran through the first quarter of this year appear to have done little to change the outlook for troubled borrowers — and may even have made things worse, for everyone involved. A report released recently by due diligence and surveillance specialist Clayton Holdings, Inc. highlights the early returns of various moratoria put into place by servicers ahead of the Obama administration’s Making Homes Affordable (MHA) modification and refinance programs. A number of the nation’s largest servicers had released statements earlier this year announcing their intent to suspend foreclosure sales until details of the program were released, generally until the end of March.
According to Clayton’s data, halting foreclosures did little to improve the outlook for most troubled borrowers: of the loans that the firm’s analysts estimated would have otherwise had foreclosure sales completed during the "freeze" period, 93% remained in foreclosure or were moved into REO status by April among those servicers that implemented a widespread moratorium on foreclosure activity. In comparison, among servicers that did not implement a large scale freeze on foreclosures, 89% of loans estimated to have progressed to foreclosure sale by the end of March either remained in foreclosure status or had been moved into REO.
The data is featured in Clayton’s monthly InFront RMBS report, which provides an early snapshot of RMBS performance data ahead of traditional monthly remittance reports. The data seem to illustrate just how little freezing foreclosures really helped matters: Among servicers implementing a moratorium, just 7% of borrowers facing imminent foreclosure were "helped," either in the form of repayment plans, modifications, reinstatements, or short sales. That number actually grew to 11% among servicers that did not implement a foreclosure freeze — a result that is clearly at odds with reports in the popular press, which have painted the freezes as a needed step to help troubled borrowers.
Servicing executives that HousingWire spoke with suggested that the real problem is negative equity, or borrowers who have seen the value of their homes drop precipitously in the most troubled housing markets. "Negative equity puts borrowers into a precarious situation," said one servicing executive, who asked to remain anonymous. "Borrowers are over-leveraged, on homes, cars, and everything else, to begin with."
"Halting foreclosures didn’t solve for the leverage problem, or magically make equity appear out of nowhere," he said. "So it really ended up digging a deeper grave for many consumers, in the form of further arrearages and potential fees that get added to the mountain of debt that already must be repaid to bring a loan current. And I hate to see it."
Another executive, who runs a loss mitigation department at a subprime servicer and asked to remain anonymous, said his shop has "gotten really, really creative" with many of the solutions offered to troubled borrowers, but in many cases sees borrowers that are simply beyond help. "Say we’ve got a borrower that went 100 percent on a $500,000 home in California that’s now worth $375,000, using even a more vanilla interest-only loan," he said. "This borrower loses their job and comes calling. Even if we forgive some of the debt, we can’t solve long-term for a lack of income."
Servicers also note that a troubling trend is emerging, where borrowers are increasingly refusing to consider repayment plans or offers for a loan modification, believing that Obama administration’s modification plan guidelines entitle them to a larger payment reduction than what is actually possible. "It’s just misinformation on the part of consumers, but it’s certainly not helping anyone address the reality of the situation they’re in," said one of the servicing executives.
Both servicing executives HW spoke with also stressed that their operations are doing all they can to help troubled borrowers, but suggested that details on the Obama administration’s modification plans were slow to arrive, which hampered modification efforts during the moratorium period. Analysts at Clayton noted the same point in their own discussions with servicers, noting that many had said they "were given minimal detail up front, and instead relied on their own loss mitigation and loan modification programs to review loans during the moratorium timeframe."
As a result, and perhaps not surprisingly, 60+ day delinquencies for both subprime and Alt-A mortgages are now at one-year highs, according to Clayton’s surveillance data. It’s a trend that isn’t just painful for consumers: it’s a trend that is painful for investors, servicers, and lenders alike, too — all of whom must ultimately bear the cost of carrying a bad loan to some sort of finish line, whatever that finish might eventually look like (and however far away it may be).
AIG slumps after analyst warns of zero equity value
Shares of American International Group Inc (AIG.N) plummeted 22 percent on Thursday after a Citigroup analyst said the value of the troubled insurer's equity may fall to zero.
AIG shares, which have fallen more than 50 percent since its 1-for-20 reverse stock split on July 1, were trading down $2.47 at $10.63 in afternoon trade on the New York Stock Exchange. "After the reverse split, the stock is easier to borrow and more people get access to short it when it is trading at a higher price," said Paul Hickey, co-founder of Bespoke Investment Group in Harrison, New York.
After a series of federal bailouts, AIG, the recipient of $180 billion of taxpayer money, has been struggling to preserve its business operations and sell some of its prized assets to help repay government loan. The company received another setback this week when a jury ruled against it in the Maurice "Hank" Greenberg lawsuit, dashing the insurer's chances of collecting $4.3 billion in damages.
Citigroup analyst Joshua Shanker said a potential zero equity value for the AIG stock was due to the risk of more credit default swap (CDS) losses and the disposal of key assets at low valuations. "Our valuation includes a 70 percent chance that the equity at AIG is zero," he said in a note to clients. Potential markdowns in AIG Financial Product unit's CDS portfolio may result in collateral calls that would again put pressure on AIG's liquidity, the Citigroup analyst added.
Last month, AIG revised its 2008 annual report to add a new risk factor that shows it may recognize valuation losses on a CDS portfolio with notional value of about $193 billion if credit markets continue to deteriorate. "Such collateral calls could also pressure rating agencies to lower their credit ratings for the company, leading to a similar cycle to the one that the company experienced prior to the massive government intervention in the third quarter," Shanker wrote in a research note.
Shanker said despite AIG's efforts to implement the action plan devised in concurrence with the U.S. government, the uncertainty and risk surrounding AIG remain very real. The analyst kept his "hold" rating on the insurer's stock and cut his share-price target to $14 from $36 to adjust for the reverse split. AIG, once the world's largest insurer by market value, nearly collapsed last year because of losses from CDS, a bet on the credit worthiness of a debt issuer.
The analyst said while AIG may be able to repay government funds and some debt with core asset sales, the remaining businesses may be those that generate lower return on equity, handicapped by a high debt burden. In June, the federal government agreed to accept $25 billion of preferred stock in two AIG businesses as partial repayment of debt. AIG had said the agreement positions its two businesses -- American International Assurance Co Ltd and American Life Insurance Co -- for initial public offerings, depending on market conditions. Shanker said he expects AIG to carve out its commercial property and casualty business through an initial public offering in 2010.
The analyst, however, said there is high probability that selling off all operations just to cover debt will leave the holding company with little or no equity. AIG had already agreed to sell a 98 percent stake in its Russian consumer finance business to Banque PSA Finance SA, a unit of France's Peugeot SA, and is selling its credit-card business in Taiwan to Far Eastern International Bank. However, AIG's desperation to sell assets had led to the prospective buyers driving a hard bargain to knock down prices as they know it needs to dismantle itself to help repay taxpayers.
GM Will Exit Bankruptcy With $48 Billion in Debt, Judge Says
General Motors Corp., which is preparing to sell its best assets to a streamlined new entity, will carry with it liabilities of $48.4 billion, according to a judge in the case. The new GM agreed to take on those obligations to benefit creditors, U.S. Bankruptcy Judge Robert Gerber in New York said yesterday. They will be offset by their most competitive assets, such as Cadillac, Chevrolet, Buick and GMC.
Gerber previously approved the sale of most of GM’s business to a U.S. Treasury-funded buyer and said the company could complete the deal any time after Thursday, July 9, at noon. Detroit-based GM entered bankruptcy court on May 1 reporting global liabilities of $176.4 billion as of Dec. 31, 2008. The old GM will be left with GM’s remaining obligations and unwanted assets, including contaminated factory sites, a parking lot in Flint, Michigan, and a nine-hole golf course in New Jersey.
GM’s Sleepy Hollow Nightmare Shows Perils for Closing Factories
General Motors Corp. closed its minivan factory in Sleepy Hollow, New York, 13 years ago, after a record 82-year run for a company plant. Encouraged by the site’s views of the Hudson River, just 23 miles north of Manhattan, GM made development plans to help the village replace it as the biggest employer and largest source of tax revenue. "This is some of the prime real estate in the world," said Anthony Giaccio, 45, the village administrator, describing the potential that villagers and GM saw in the 97-acre site.
Potential is still the operative word. GM and New Jersey- based Roseland Property Co. spent $11 million on developing the site and on cleaning lead, methane and other toxins out of its soil before scrapping plans about a year ago to build 1,000 homes, offices, stores and a river walk, Giaccio said. The delay in developing the site is a cautionary tale for other towns about to go through the same end-of-an-era factory experience with less promising real estate. GM is abandoning 16 factories in Michigan, Indiana, New York, Ohio and other states as it uses a bankruptcy sale to put its best assets into a new entity. Many plants are contaminated, requiring costly cleanup.
"It’s going to be very difficult to sell or dispose of them," GM restructuring chief Albert Koch told the judge in charge of the carmaker’s bankruptcy on July 1. GM estimates the plants’ environmental liabilities at $530 million, he said. One property the Detroit-based carmaker is ditching is a foundry in Massena, New York, bordered by the St. Regis Mohawk Indian Reservation and the St. Lawrence River. Built to make aluminum cylinder heads for the Chevrolet Corvair in the 1950s, it generated PCB sludge and waste from hydraulic fluids.
It would have cost GM an estimated $225 million to clean up the site and restock the river with edible fish if it held on to the property, said John Privitera, a lawyer for the tribe at McNamee Lochner Titus & Williams PC in Albany, New York. Now GM creditors or the state will get stuck with the costs because bankruptcy law permits shedding such obligations. Chrysler LLC will ditch seven factories and an office building by 2010 as part of a similar bankruptcy plan that created Chrysler Group LLC, a streamlined entity now run by Fiat SpA. Chrysler’s bankruptcy plan creates the same second-act challenge for communities in Michigan, Missouri and Delaware that now have eyesores in the making.
The old Chrysler’s discarded factories and vacant real estate have a book value of about $2.6 billion and may fetch 6 percent to 12 percent of that sum when sold to satisfy creditor claims, according to court documents. GM hasn’t disclosed the book value of its discarded assets, which include a nine-hole golf course in New Jersey and a parking lot in Flint, Michigan in addition to the factories. With plans for the Sleepy Hollow site in limbo, beech saplings and weeds are about the only things that have developed there since the last GM vehicle was made. Factory buildings, where Chevy Luminas, Oldsmobile Silhouettes and Pontiac Trans Sports were produced, have long been torn down. All that’s left are cracked concrete plant floors and stumps of rusted girders.
Sleepy Hollow’s 10,000 villagers had one piece of luck. GM has cleaned up much of the toxins accumulated in the land since it started making cars there. The new GM, which is holding on to the site as an asset, will finish the cleanup, including toxins in the river, according to spokesman Tom Wilkinson. Wilkinson declined to say if GM plans to resume its project with Roseland, which might reconsider "if the deal was right," said Michael Greene, a Roseland vice president involved in the estimated $80 million project. "It’s too good a site not to be developed," he said.
One sticking point to the deal was a village demand for $22 million in amenities, such as an extra exit and entrance and a river walk, Giaccio said during an interview in the red brick village hall he shares with the fire and police departments. "We wanted a jewel on the Hudson," said Maria DeMilia, a former trustee of the village. "They wanted to make money." Expressions of interest in the site by billionaire Donald Trump and Toll Brothers Inc. came to nothing, Giaccio said. Trump and Toll Brothers didn’t return calls seeking comment.
In 1985, GM paid almost $1.5 million in taxes to the village, then called North Tarrytown, providing 49 percent of its total tax revenue. The year the plant closed, GM paid less than $1.1 million in taxes, or about 24 percent. Two years later, GM’s village taxes had dropped to about $176,000, or 4 percent of tax revenue. "I don’t like the fact that the village is suffering, and we have no income," said DeMilia, 46, whose aunt was a salaried GM employee who lost her health benefits.
The 99-cent store on Beekman Avenue, the village’s main street, is now empty. A toy store, five restaurants and bars and a tailor shop have shut down since the plant was closed. "We used to have 3,500 workers buying groceries, cigarettes and lunch," said DeMilia. "We had a florist and three more restaurants." Seeking to attract some tourist revenue, the village renamed itself Sleepy Hollow in 1996, according to village historian and real-estate agent Henry Steiner.
That gave it a link to Washington Irving, who wrote "The Legend of Sleepy Hollow," a short story that features the Headless Horseman and a gangly teacher named Ichabod Crane. Irving’s house is nearby, and he is buried in Sleepy Hollow cemetery, along with Andrew Carnegie, Walter Chrysler, Elizabeth Arden, Brooke Astor and Harry and Leona Helmsley. Sleepy Hollow is a variant of the Dutch name for a river bay that existed in Irving’s day and is now covered by the land- filled GM site, Steiner said.
Some abandoned car factories have managed new lives. GM sold an Oklahoma City assembly plant for almost $60 million last year to Oklahoma County, which leased it to the U.S. Air Force to expand its Tinker Air Force Base. The automaker turned a brownfield site in New Jersey into the Hyatt Hills Golf Complex, the nine-hole course it’s turning over to creditors. If some Sleepy Hollow project goes ahead, Giaccio said his preference is for a developer that uses the Roseland plan. Starting from scratch might stretch out the process another 10 years, he said.
Treasuries Decline as Demand Drops at $11 Billion Bond Auction
Treasuries fell as the government’s $11 billion auction of 30-year bonds drew less demand than the previous sale of the securities, the final of four U.S. auctions within a week for the first time. Yields on 10-year notes climbed from the seven-week lows reached yesterday, when investors seeking refuge from an economy whose recovery may take longer than expected submitted the most bids on record at a sale of the debt. The bid-to-cover ratio on today’s 30-year auction, which gauges demand by comparing total bids with the amount of securities offered, was 2.36, compared to 2.68 at the June offering.
"This is the supply drift," said Chris Ahrens, the Stamford, Connecticut-based head of interest-rate strategy at UBS Securities LLC, one of the 17 primary dealers that bid on the sales. "Yesterday there was a little panic going on." The yield on the benchmark 10-year note rose 11 basis points, or 0.11 percentage point, to 3.41 percent at 3:16 p.m. in New York, according to BGCantor Market Data. The 3.125 percent security maturing in May 2019 fell 7/8, or $8.75 per $1,000 face amount, to 97 20/32. The yield fell yesterday the most on an intraday basis since March 18, when the Federal Reserve said it would buy U.S. debt to cap borrowing costs.
The 30-year bond yield rose 10 basis points to 4.30 percent. The yield yesterday fell as much as 15 basis points, the most in over five weeks. The bonds sold today yielded 4.303 percent, higher than the 4.292 percent average forecast of four bond-trading firms surveyed by Bloomberg News. The offering is the second reopening of the $14 billion 30-year bond auction on May 7. The $11 billion auction on June 11 drew a yield of 4.72 percent, which was the highest since August 2007. The bid-to-cover ratio has averaged 2.28 at the past 10 sales.
Indirect bidders, an investor class that includes foreign central banks, purchased 50.2 percent of the bonds, the most since February 2006. At the June sale, they bought 49 percent. The average for the past 10 sales is 29 percent. Demand has been rising at the U.S. auctions, especially from indirect bidders such as foreign central banks. That class of investors purchased 43.9 percent of the 10-year notes offered yesterday, compared to 34.2 percent at the June sale of the securities. Indirect bidders bought 54 percent of the three-year notes sold on July 7, up from 43.8 percent in June.
The levels of indirect bidders at recent auctions may have been affected by a rule change last month that eliminated a provision allowing some customer awards to be classified as dealer bids. "What is really good is that we got the supply out of the way," said said Michael Franzese, head of government bond trading for Standard Chartered in New York. He spoke in a Bloomberg Television interview. "We are predicting that interest rates will trend and grind lower as we get through the summer."
Yields on 10-year notes touched 4 percent on June 11 on concern the government’s borrowing would deluge demand as the economy showed evidence of emerging from its deepest recession in 50 years. Since then, yields have fallen nearly 60 basis points as reports suggest the recession has further to run. The Labor Department said last week that the unemployment rate rose to 9.5 percent, the highest since 1983. "The green shoots nonsense is being tossed aside and we’re approaching reality here," said Maxwell Bublitz, who oversees $3.5 billion in fixed-income assets as the chief strategist at San Francisco-based SCM Advisors LLC. "We’ve had more buyers of risk free income."
Longer maturities have led the Treasury market lower this year as President Barack Obama borrows record amounts to stimulate the economy and service deficits. After more than doubling note and bond offerings to $963 billion in the first half, another $1.1 trillion may be sold by year-end, according to primary dealer Barclays Plc. The second-half sales would be more than the total amount of debt sold in all of 2008.
Thirty-year bonds handed investors a 21 percent loss so far in 2009, while two-year notes returned 0.6 percent, based on indexes compiled by Merrill Lynch & Co.
The Fed bought $2.999 billion of Treasuries today maturing between July 2010 and April 2011, part of its $300 billion, six- month program to reduce lending rates. The central bank has bought $200.722 billion in U.S. debt through the operations, which began March 25. Today’s purchase is followed by four more over the next two weeks. Falling Treasury yields have helped the central bank’s mission. The average 30-year mortgage rate dropped to 5.2 percent from 5.32 percent, mortgage buyer Freddie Mac of McLean, Virginia, said today in a statement. That’s the second consecutive weekly decline. The 15-year rate averaged 4.69 percent.
Yields on Treasuries are being artificially suppressed by the central bank; otherwise bonds would yield more than 10 percent, according to Lee Quaintance and Paul Brodsky of QB Asset Management in New York. "There are powerful structural forces blocking any fundamental reconciliation of value," Quaintance and Brodsky wrote. "These forces include bond markets comprised mostly of domestic and foreign investors with incentives that place them at odds with rational credit pricing, as well as central banks with unlimited spending capacity threatening, and being encouraged by all, to intervene when necessary to provide a ceiling on yields."
Lawmakers Are Warned Against Expanding Fed’s Power
Two economists with long-standing ties to the Federal Reserve warned Congress on Thursday that it would be a mistake to give the Fed broad power to supervise "systemic risk" and financial institutions that are deemed "too big to fail." In what is shaping up as a fierce political battle that cuts across party lines, one of the central bank’s most prominent historians told a House panel that the Federal Reserve had consistently failed to recognize financial catastrophes until they were well under way.
"I do not know of any clear examples in which the Federal Reserve acted in advance to head off a crisis or a series of banking or financial failures," said Allan H. Meltzer, professor of economics at Carnegie-Mellon University and author of a comprehensive history of the Fed. In written testimony prepared for the House Financial Services Committee, Mr. Meltzer ticked off a long list of financial collapses — the Latin American debt crisis of the 1980s, the savings-and loan collapse of the early 1990s, the collapse of the dot-com bubble and the recent binge in reckless mortgages — and argued that the Fed had either failed to take preventive action or made things worse.
"We all know that the Federal Reserve did nothing to prevent the current credit crisis," Mr. Meltzer said. "It has not recognized that its actions promoted moral hazard and encouraged incentives to take risk." An even broader warning came from John B. Taylor, a top Treasury official under President George W. Bush who was considered a potential candidate to succeed Alan Greenspan as chairman of the Federal Reserve.
Mr. Taylor argued that expanding the Fed’s power as a super-regulator, responsible for monitoring risks across the economy as well as regulating giant financial institutions, would create conflicts of interest, reduce its credibility and jeopardize its political independence. Giving the Fed broad new responsibilities, Mr. Taylor warned, would dilute and complicate its central mission of controlling the nation’s money supply to keep inflation low and employment as high as possible.
"My experience in government and elsewhere is that institutions work best when they focus on a limited set of understandable goals," he said in his written testimony, adding that the Fed’s credibility had already been damaged by its messy role last year in getting Bank of America to acquire Merrill Lynch. The administration is proposing to make the Fed responsible for identifying "systemic risks," like the bubble in housing prices and the explosion of reckless mortgage lending that started the worst financial crisis since the Great Depression.
But the proposal is highly controversial. Banking and Wall Street executives generally support the idea, as do current and former officials at the Federal Reserve and some Democratic lawmakers, like Representative Barney Frank, chairman of the House Financial Services Committee. But lawmakers are sharply divided. Many Democrats have criticized the Fed in recent months for being too secretive as it has helped bail out failing institutions like the American International Group. Senator Christopher J. Dodd of Connecticut, chairman of the Senate Banking Committee, is openly skeptical about giving the Fed more power.
But many conservative lawmakers and analysts are also opposed, arguing that it would amount to an expansion of "big government" and greater intrusion by regulators. Mr. Taylor and Mr. Meltzer are both conservatives. Mr. Taylor was a loyal member of the Bush administration, though he is best known among economists as the author of the "Taylor Rule," a widely used formula to predict Fed policy decisions.
Mr. Meltzer is a fellow at the American Enterprise Institute, a right-of-center policy research group in Washington, but he has long had entree to the top ranks of Fed policymakers. His three-volume history of the Federal Reserve, based on exhaustive research of Fed documents and records dating back to its creation, is considered the most comprehensive history of the central bank thus far.
G-8 leaders receive new 'world currency' gold coins
World leaders attending the Group of Eight summit opening Wednesday in Italy will each be presented with a gift from the past and one for the future. Handmade books portraying works by Neoclassical sculptor Antonio Canova, as well as gold coins representing an imaginary future world currency will be given to the participants at the opening of the three-day summit. There are 10 copies of the book, commissioned by Italy's Premier Silvio Berlusconi from the Bologna-based art publishing house Fondazione Marilena Ferrari, each with a personalized dedication for the leader who receives it.
The 28-inch by 17.5-inch (71-centimeter by 44.5-centimeter) Canova books were crafted at no cost by 23 Italian craftsmen using traditional techniques, the publishing house said. Each weighs 53 pounds (24 kilograms). The books' covers are decorated with white marble bas-reliefs and the volumes are bound with silk and gold thread. They include etchings and dozens of black and white photographs of Canova's artworks, including artistic close-ups of his statues.
The coins, made by Belgian Luc Luycx, who designed one side of the Euro coins, are called "eurodollars," in a symbolic call for a common currency to unite Europe and the United States. They have a value of euro2,800 ($3,900) and were produced by the United Future World Currency, a group pushing the idea of a global currency. The works will go to the leaders of the Group of Eight industrialized countries as well as to the President of the European Council Fredrik Reinfeldt and EU Commission President Jose Manuel Barroso. The Group of Eight is Canada, France, Germany, Italy, Japan, Russia, the United Kingdom and the United States.
G-8, G-5 Seek to Avoid 'Competitive Devaluations'
Leaders of the world’s biggest developed and emerging nations agreed to avoid devaluing their currencies to promote their exports at the expense of others, according to a draft statement.
With officials from Brazil, India, China and Russia pushing consideration of alternatives to the dollar as the dominant reserve currency, the draft’s language on foreign exchange echoed an agreement at an April summit of the Group of 20.
The leaders agreed to "refrain from competitive devaluations of our currencies," according to the draft of a statement to be released after their meeting today at the G-8 summit in L’Aquila, Italy. They also agreed to "promote a stable and well-functioning international monetary system." The global financial crisis and the surge in U.S. borrowing have prompted Russian President Dmitry Medvedev to advocate diversification away from the dollar. Russia and its counterparts have yet to come up with a viable alternative.
"We need to improve the international currency regime to have a better foreign exchange issuing and reserve currency system so that we can have relative stability in the reserve currencies’ rates and so that we can have a diversified and rational international reserve currency regime," Foreign Ministry spokesman Ma Zhaoxu said today in L’Aquila. Brazil’s President Luiz Inacio Lula da Silva wants the biggest developing nations to use their own currencies in settling trade accounts, India’s Foreign Secretary Shivshankar Menon told reporters yesterday.
The so-called Group of Five -- Brazil, China, India, Mexico and South Africa -- discussed "looking at the use of alternate currencies, not so much as reserve currencies," Menon said. "But Brazilian President Lula suggested that we should consider using our own currencies to settle our own trading accounts with each other." Menon said "everyone recognizes" that the idea of a new reserve currency "is a long-term goal."
In May, Lula and his Chinese counterpart Hu Jintao discussed ways to use their currencies in trade after China replaced the U.S. as Brazil’s biggest trading partner.
"I think that, despite whatever talk you might have heard, I don’t see that there is movement away from the notion of the dollar being that currency," White House spokesman Robert Gibbs said today at the start of the second day of the three-day meeting in L’Aquila, Italy. Leaders of the G-5 are meeting counterparts today from the G-8, which comprises the U.S., U.K., France, Germany, Italy, Japan, Russia and Canada in the second day of the summit that ends tomorrow.
Goldman Sachs Loses Grip on Its Doomsday Machine
Never let it be said that the Justice Department can’t move quickly when it gets a hot tip about an alleged crime at a Wall Street bank. It does help, though, if the party doing the complaining is the bank itself, and not merely an aggrieved customer. Another plus is if the bank tells the feds the security of the U.S. financial markets is at stake. This brings us to the strange tale of Goldman Sachs Group Inc. and Sergey Aleynikov.
Aleynikov, 39, is the former Goldman computer programmer who was arrested on theft charges July 3 as he stepped off a flight at Liberty International Airport in Newark, New Jersey. That was two days after Goldman told the government he had stolen its secret, rapid-fire, stock- and commodities-trading software in early June during his last week as a Goldman employee. Prosecutors say Aleynikov uploaded the program code to an unidentified Web site server in Germany.
It wasn’t just Goldman that faced imminent harm if Aleynikov were to be released, Assistant U.S. Attorney Joseph Facciponti told a federal magistrate judge at his July 4 bail hearing in New York. The 34-year-old prosecutor also dropped this bombshell: "The bank has raised the possibility that there is a danger that somebody who knew how to use this program could use it to manipulate markets in unfair ways." How could somebody do this? The precise answer isn’t obvious -- we’re talking about a black-box trading system here. And Facciponti didn’t elaborate.
You don’t need a Goldman Sachs doomsday machine to manipulate markets, of course. A false rumor expertly planted using an ordinary telephone often will do just fine. In any event, the judge rejected Facciponti’s argument that Aleynikov posed a danger to the community, and ruled he could go free on $750,000 bail. He was released July 6.
All this leaves us to wonder: Did Goldman really tell the government its high-speed, high-volume, algorithmic-trading program can be used to manipulate markets in unfair ways, as Facciponti said? And shouldn’t Goldman’s bosses be worried this revelation may cause lots of people to start hypothesizing aloud about whether Goldman itself might misuse this program? Here’s some of what we do know. Aleynikov, a citizen of the U.S. and Russia, left his $400,000-a-year salary at Goldman for a chance to triple his pay at a start-up firm in Chicago co- founded by Misha Malyshev, a former Citadel Investment Group LLC trader. Malyshev, who oversaw high-frequency trading at Citadel, said his firm, Teza Technologies LLC, first learned about the alleged theft July 5 and suspended Aleynikov without pay.
Aleynikov’s attorney, Sabrina Shroff, told the judge at the bail hearing that Aleynikov never intended to use the downloaded material "in any proprietary way" and that the government’s charges were "preposterous." Goldman isn’t commenting publicly about any of this, though it seems the bank’s bosses want us to believe there’s no need to worry. On July 6, Dow Jones Newswires quoted a "person familiar with the matter" saying this: "The theft has had no impact on our clients and no impact on our business." Note that this person was so familiar with Goldman that he or she spoke of Goldman’s clients as "our clients" and Goldman’s business as "our business."
By comparison, last Saturday, while most Americans were enjoying the Fourth of July holiday, Facciponti was in court warning of looming threats to Goldman and the financial markets. "The copy in Germany is still out there," the prosecutor said, according to an audio recording of the hearing. "And we at this time do not know who else has access to it and what’s going to happen to that software." "We believe that if the defendant is at liberty, there is a substantial danger that he will obtain access to that software and send it on to whoever may need it," Facciponti said. "And keep in mind, this is worth millions of dollars."
By "millions," it’s unclear if that would be enough to match Goldman Chief Executive Lloyd Blankfein’s $70.3 million compensation package for 2007. Or perhaps millions means thousands of millions, otherwise known as billions. Facciponti said the bank told the government that "they do not believe that any steps they can take would mitigate the danger of this program being released." He added: "Once it is out there, anybody will be able to use this, and their market share will be adversely affected." All Aleynikov would need to get the code from the German server is maybe 10 minutes with a cell phone and an Internet connection, Facciponti said.
The hole in Facciponti’s argument was that the government offered no evidence that Aleynikov had tried to disseminate the software during the month prior to his arrest, after he downloaded it and had left his job at Goldman. That’s the main reason the judge, Kevin N. Fox, cited in ruling Aleynikov could be released on bail. "We don’t deal with speculation when we come to court," Fox said. "We deal with facts." Meantime, it would be nice to see someone at Goldman go on the record to explain what’s stopping the world’s most powerful investment bank from using its trading program in unfair ways, too. Oh yes, and could the bank be a bit more careful about safeguarding its trading programs from now on? Hopefully the government is asking the same questions already.
Citadel sues former employees who set up Teza Tech
Citadel Investment Group, one of the world's most successful hedge fund firms, sued a former top executive in its highly successful quantitative trading unit and two others for setting up their own firm. Chicago-based Citadel, founded by 40-year-old billionaire Kenneth Griffin, said in a lawsuit filed on Thursday that Mikhail Malyshev, 40, and two other former employees had violated their non-compete clauses by starting their own firm, Teza Technologies LLC. The lawsuit was filed in the the circuit court of Cook County, Illinois.
Teza Technologies made headlines this week when it was identified as the firm that had hired Sergey Aleynikov, a former Goldman Sachs Group Inc computer programmer whom federal prosecutors had accused of stealing trade secrets from the Wall Street investment bank. Malyshev, a Russian emigre with a doctorate in astrophysics from Princeton, left Citadel's quantitative trading unit in February after the funds he helped run returned about 40 percent last year. Their performance stood out at a time when most hedge funds lost money and Citadel's flagship portfolios tumbled 50 percent.
Citadel, which manages $11 billion and one of whose flagship hedge funds returned an average 20 percent per year between 1998 and 2006, said it zealously guards the secrecy of its own computer codes. The hedge fund firm said it spent hundreds of millions of dollars to develop strategies, software and hardware, or what is sometimes referred to as the "secret sauce" of the high frequency business, court papers show.
If the information were obtained by someone else, the company, which has often been compared with Goldman Sachs for its trading prowess, said it would suffer irreparable harm.
"Defendants' activities, particularly Teza's decision to hire Aleynikov, an accused software thief, create a substantial risk that they have stolen, or may be planning to steal, Citadel's proprietary code," the hedge fund firm said in court papers.
Like all employees who leave Citadel, Malyshev faced a nine-month non-compete clause and was being paid $30,000 a month to sit out the period to at least November 2009, court papers show. Citadel found out about Malyshev's new firm only this week after Aleynikov was arrested, the firm said.. Former Citadel employees Jace Kohlmeier and Matthew Hinerfeld are also listed on the civil complaint.
A spokesman for Teza called the suit "frivolous" and said it "appears to be timed to harass Teza executives." "We knew nothing about the theft of Goldman's software until it hit the press in connection with the arrest," said Chris Gair, Teza's lawyer. "We immediately started working with the FBI. We are not going to compromise anyone's proprietary information."
2 Russian Emigres, One Spying Mess
Their paths sound so similar — two Russian emigres with a talent for numbers who arrived in the United States and quickly moved into the rarefied circles of America’s top investment firms. But Mikhail Malyshev may now regret having crossed paths with countryman Sergey Aleynikov, a computer programmer he hired for his start-up firm who is now embroiled in one of the highest-profile U.S. corporate espionage cases in years.
This week federal agents charged Aleynikov, 39, with stealing trade secrets from his former employer, Wall Street bank Goldman Sachs. Malyshev’s company, Teza Technologies, responded by suspending Aleynikov. The timing of the case could not be worse for Malyshev, who left hedge fund Citadel Investment Group in February to set up Teza Technologies with two partners, also previously employed at Citadel. While the FBI has not accused Malyshev and Teza of wrongdoing, such a controversial court case involving one of its first employees could be at the very least a distraction and embarrassment, and could turn into the biggest challenge of Malyshev’s career.
As news of the arrest captivates the hedge fund and banking communities, some details are emerging about how the men’s careers collided. Teza’s spokesman Guy Chipparoni said Aleynikov was recruited through an outside headhunter, but it is unclear whether there was much communication between the two men during the hiring process. According to the U.S. complaint against Aleynikov, he left Goldman on June 5. Requests to interview Malyshev were declined. Aleynikov did not return calls seeking comment.
Former colleagues and a professor who taught him said Malyshev, known by the nickname Misha, is a brilliant mind who easily navigates the most theoretical areas of mathematics but can discuss finance in terms that laymen can understand. "He was one of our very best students," said Nathaniel Fisch, director of the Program in Plasma Physics at Princeton University who supervised Malyshev’s doctoral thesis in 1998. "He had something extra, partly his ambitiousness and persistence and partly his flair. And he has street smarts."
Shortly after leaving the Ivy League school with a doctorate in astrophysics, Malyshev abandoned science for business, accepting a position at McKinsey, a consulting firm often hired by governments, large companies and investors. In 2003, he was hired for the quantitative trading group of Chicago-based Citadel, one of the world’s most aggressive hedge fund firms. Fisch remarked on his former student’s people skills, displayed when Malyshev helped organize reunions for former students.
Hundreds of large pension funds and Wall Street analysts have paid thousands of dollars over the years to hear Malyshev speak at industry conferences. Several said they remember him speaking comfortably about the intricacies of investing. Three former colleagues, who declined to be identified for this article, remember a different side of Malyshev, calling him an imposing man who kept to himself as others socialized. They remember his appearance as disheveled in a world where his colleagues wore shirts with cuff links and crisply pressed slacks.
By a number of accounts, Malyshev’s career was in high gear at Citadel’s quantitative group, which posted a roughly 40 percent gain last year even as the firm’s billionaire founder Kenneth Griffin’s flagship funds were off about 50 percent. As a senior executive, Malyshev helped oversee roughly $1 billion in assets in the business unit run by James Yeh. By early 2009, though, the relationship between Citadel and Malyshev crested, and in February he left with a number of associates to set up Teza. Malyshev had a nine-month non-compete clause.
Teza has an office in Chicago, but when a reporter visited on Tuesday it was void of furniture and had no receptionist. Although Aleynikov does not have the same U.S. educational pedigree as Teza’s Ivy League-educated partners Malyshev, Jace Kohlmeier and Matthew Hinerfeld, he studied at the elite Moscow Institute of Transportation Engineering. But he left before earning a degree.
Aleynikov, who is married with three children, found a niche in computer programming as a teenager in Moscow, where he worked as an application programmer at the Railroad Consolidated Computer Center, according to his profile on networking site LinkedIn.com. "He was really a good student," said fellow student Ayrat Baykov, who is now a software developer in Michigan. The two have not spoken in about two decades, but Baykov recalled Aleynikov’s quiet yet inviting personality and sense of humor. "I hope he gets out of this trouble," he said.
Aleynikov, who has dual citizenship in the United States and Russia, used contacts he met on the Internet to help him unravel complicated coding problems, posting messages with other programmers in online forums. He refined his computer skills over two decades, first working with hospitals and universities, and later with IDT Corp before moving to Goldman Sachs in 2007. Goldman Sachs, a premier Wall Street firm that spends billions of dollars on state-of-the-art technology and talent, is an attention grabber on a resume.
Morgan Stanley Plans to Turn Downgraded Loan CDO Into AAA Bonds
Morgan Stanley plans to repackage a downgraded collateralized debt obligation backed by leveraged loans into new securities with AAA ratings in the first transaction of its kind, said two people familiar with the sale. Morgan Stanley is selling $87.1 million of securities that it expects to receive top AAA ratings and $42.9 million of notes graded Baa2, the second-lowest investment grade by Moody’s Investors Service, according to marketing documents obtained by Bloomberg News. The bonds were created from Greywolf CLO I Ltd., a CDO arranged in January 2007 by Goldman Sachs Group Inc. and managed by Greywolf Capital Management LP, an investment firm based in Purchase, New York.
Two years after the credit markets began to seize up, costing the world’s biggest financial institutions $1.47 trillion in writedowns and losses, banks are again taking so- called structured finance securities and turning them into new debt investments with top credit ratings. While the Morgan Stanley deal is the first to involve CDOs of loans, banks have been doing the same with commercial mortgage-backed securities in recent weeks.
A lot of banks and insurers "cannot buy anything but AAA," said Sylvain Raynes, a principal at R&R Consulting in New York and co-author of "Elements of Structured Finance," which is due to be published in November by Oxford University Press. "You’re manufacturing AAA out of not AAA, therefore allowing those people who have AAA written on their forehead to buy." New York-based Morgan Stanley is copying a financing structure known as Re-REMICs that bundle mortgage securities into new bonds that often offer investors an additional layer of protection, or collateral, from downgrades. Credit-rating cuts may sometimes force investors to sell the debt and cause financial institutions that own the bonds to increase capital.
Moody’s reduced the $365 million top-ranked portion of Greywolf in June by six levels to A3 from Aaa as the default rate on the loans in the CDO rose to 7 percent. The rating company cut 83 loan CDOs with the top rankings from May 28 through June 26, according to Wachovia Corp. Structured finance securities fueled the writedowns and losses at the world’s biggest financial institutions since the start of 2007, helping to plunge the U.S. economy into the worst recession since the 1930s. Finance companies have been forced to raise $1.27 trillion in capital, according to data compiled by Bloomberg.
CDOs parcel fixed-income assets such as bonds or loans and slice them into new securities of varying risk intended to provide higher returns than other investments of the same rating. Greywolf is a type of CDO called a collateralized loan obligation, or CLO, which focuses on doing the same with company loans. Banks are using re-REMICs to protect against losses on residential-mortgage securities during the worst housing slump since the Great Depression.
About $27 billion of home-loan bond Re-REMICs have been issued this year, up from $17 billion for all 2008, according to a June 12 report by Bank of America Merrill Lynch. Re-REMIC stands for "resecuritizations of real estate mortgage investment conduits," the formal name of mortgage bonds. The strategy is increasingly being used for commercial mortgage debt. Standard & Poor’s said on June 26 that it may lower the rankings on $235.2 billion of bonds backed by loans on properties such as office buildings and shopping malls.
Banks have issued about $2 billion of the debt in the last three weeks, according to Barclays Capital. That compares with $5.8 billion of similar offerings in all of 2008, Credit Suisse Group data show. "Somebody does something and it seems to make magic, and the other guy says ‘Hey, let’s do that, too,’" Raynes said. New York-based Goldman Sachs plans to sell $216.9 million of repackaged commercial mortgage debt, according to people familiar with the sale who declined to be identified because terms aren’t public. The re-REMIC is being carved out of four bonds sold in 2006, said the people. Michael DuVally, a Goldman Sachs spokesman, said he couldn’t comment.
China’s Surging Loans May Add to Asset-Bubble Risk
A surge in China’s lending is boosting concern that attempts to revive the world’s third- largest economy will lead to bad debts and asset bubbles. New loans rose almost fivefold in June from a year earlier to 1.53 trillion yuan ($224 billion), the central bank said on its Web site yesterday. The June number is a preliminary calculation, the People’s Bank of China said. Chinese banks have extended 47 percent more loans this year than the central bank’s minimum target for 2009, after the government eased lending restrictions to counter an export collapse. The benchmark stock index climbed 69 percent this year, property prices rebounded, and the banking regulator cautioned this week that rapid credit growth poses risks for lenders and the financial system.
"China needs a solid economic recovery right now, not an asset-price bubble," said Sherman Chan, an economist with Moody’s Economy.com in Sydney. The Shanghai Composite Index was unchanged as of 11:30 a.m. local time. First-half lending rose to a record 7.37 trillion yuan, more than three times the amount a year earlier. June’s lending was more than double that of May. Billionaire George Soros said yesterday that China can be "one of the motors of the world economy" as the government’s 4 trillion yuan stimulus package takes effect.
Alcoa Inc., the largest U.S. aluminum producer, said that China’s measures have pushed domestic aluminum demand beyond supply for the first time since the global recession forced metal producers to curtail output. Premier Wen Jiabao is targeting economic growth of 8 percent this year to create enough jobs to maintain social stability after the global recession slashed exports and shut factories. Riots that left at least 156 people dead in the northwestern city of Urumqi highlighted ethnic tensions fueled by economic disparities. The clashes have pitted Uighurs, Turkic-speaking natives of Xinjiang province, against the dominant Han Chinese and ethnically similar Hui group.
Flooding the economy with cash may bring financial dangers. The rapid expansion of credit poses risks for the nation’s lenders and excessive concentrations of credit can undermine financial stability, the China Banking Regulatory Commission said July 7. "Excess liquidity is fueling speculation and that means asset bubbles and wasteful investment," said Isaac Meng, a senior economist at BNP Paribas SA in Beijing. "Expect credit to slow dramatically in the second half." New lending in the next six months could be as little as one quarter of the first-half total as policy makers rein in credit, Meng estimates.
That tightening may have already begun. The central bank resumed the sale of one-year bills today after almost eight months. "The message to the banks is clear," said Glenn Maguire, chief Asia-Pacific economist at Societe Generale in Hong Kong. "Stop lending and start buying bonds." China’s housing sales surged 45.3 percent in the first five months as stimulus spending stoked investment and domestic demand. Part of the surge in June lending likely reflects mortgage loans, said Wang Qian, an economist with JPMorgan Chase & Co. in Hong Kong.
UK Trade Deficit Shrank to Three-Year Low in May as Recession Curbed Imports
The U.K. trade deficit narrowed in May to the smallest in three years as imports dropped, a sign the recession and the weakness of the pound is hurting demand for foreign products. The goods-trade gap was 6.3 billion pounds ($10.2 billion), the least since June 2006, compared with 7.1 billion pounds in April, the Office for National Statistics said today in London. Imports fell 4 percent and exports declined 0.8 percent. The pound’s 18 percent slide against the dollar in the past year is making British exports more competitive and encouraging companies to shun imports.
Manufacturers have nevertheless struggled to raise overseas sales as global trade slumps, hindering a recovery from the U.K. economy’s worst contraction in five decades. "The trade picture is improving on the back of the depreciation in sterling," said David Tinsley, an economist at National Australia Bank in London and a former Bank of England official. "The drop in the pound means that the falls in exports aren’t as great, and people are also substituting home- made goods for imported ones. It’s still hard for manufacturers with no demand for their goods out there."
The trade gap was smaller than the 6.8 billion-pound median estimate in a Bloomberg News survey of 14 economists. The deficit with countries outside the European Union narrowed to 3.3 billion pounds from 4.1 billion pounds as exports plunged 8.7 percent, today’s report showed. The pound has dropped 18 percent against the dollar in the past year, and traded at $1.6250 today in London. The currency’s weakness is driving up costs for companies that rely on imports. Hornby Plc, the 102-year-old U.K. company that makes model trains, said on June 5 full-year profit dropped 31 percent because of the weak pound and supply problems.
The slump in imports may "reflect some import substitution resulting from the overall marked depreciation of the pound pushing up the price of some imported goods," said Howard Archer, an economist at IHS Global Insight in London. "Hopefully, over the coming months demand will improve in U.K. export markets." GKN Plc, the U.K. maker of car parts for Bayerische Motoren Werke AG and aircraft components for Airbus SAS, said June 18 it will sell new stock to repay debt and eliminate more jobs as the recession saps demand for construction equipment.
The International Monetary Fund yesterday said the global economic contraction will be deeper than it previously forecast this year. The world’s gross domestic product will fall 1.4 percent in 2009, the worst performance since World War II, before rebounding to 2.5 percent growth in 2010. Bank of England policy makers today stuck to their plan to aid the economy by buying bonds with 125 billion pounds of newly printed money. They also kept the benchmark interest rate at a record low of 0.5 percent.
UK mortgage products market shrinks by 90%
The number of different mortgage products available to buyers and people remortgaging has shrunk to less than a tenth of the level it reached when the housing market was at its peak in 2007, research showed today. There are now just 2,282 home loans from which borrowers can choose – less than half the number of products available one year ago and more than 90% below the 27,962 available in July 2007, according to the comparison site moneysupermarket.com. First-time buyers can access 1,195 mortgage products down from 17,756 in July 2007.
Louise Cuming, head of mortgages at moneysupermarket.com, said the lack of loan options for would-be homebuyers was an "ongoing problem" hindering a sustainable recovery in the housing market. "Until this changes, and more mortgages become available, house price growth will remain muted at best with further falls possible, and many borrowers will struggle to get a mortgage," she said. She added that the number of products was unlikely to increase in the short term. "Lenders are competing to attract the same borrowers – those that are seen to offer the least risk to the bank – and there is no sign of this trend changing."
David Hollingworth of mortgage broker London & Country said that while mainstream lenders were offering far smaller ranges of products, a large part of the drop in numbers was down to the withdrawal of specialist lenders from the market, such as those concentrating on self-certification and sub-prime loans. "They often had huge matrices of products with different deals at different loan-to-values for different types of customers," Hollingworth said. "But the specialist market has all but disappeared." This morning, the Financial Services Authority's managing director of retail markets, John Pain, told the Treasury select committee the market for specialist mortgages had "reduced to almost non-existence".
When asked if he thought lenders should be encouraged to begin offering these loans again, even though arrears levels are higher than on mainstream mortgages, Pain told MPs: "90% of these mortgage customers have had access to the mortgage market and are still sustaining their mortgage accounts so we have to think very carefully about just eliminating this part of the mortgage market, otherwise you will close off opportunity for consumers."
Hollingworth agreed that specialist loans had an important place in the market. "Self-certification was developed as a product because there was a need for self-employed people who didn't have enough years' accounts … to go back to a point where people need three years' accounts to raise a mortgage is quite a retrospective step," he said.
Ray Boulger, senior technical manager at mortgage broker John Charcol, also backed Pain's response. "The number of arrears [in the specialist mortgage market] has been lower than many expected. Many buy-to-let mortgages were offered with a loan-to-value of 85%, which gives a useful cushion. "Since house prices have fallen by around 20% the number of people in negative equity will be relatively low."
He added that many buy-to-let borrowers will have seen their mortgages revert to tracker loans, which follow the Bank of England base rate, currently at an all-time low. "For a lot of people affordability will not be a problem," he said. Boulger said the shrunken mortgage market was continuing to have a negative impact on house prices, but added that a lack of properties for sale may begin to push prices up this year. "I think we may see prices increase by 3%-4% in 2009," he said.
Bradford & Bingley's Failure to Pay Interest Triggers Credit-Default Swaps
Bradford & Bingley Plc’s failure to pay interest on some of its subordinated bonds will trigger settlement of credit-default swaps linked to about $414 million of the nationalized mortgage lender’s debt. Dealers and investors agreed today that the Bingley, England-based company’s decision not to pay interest on 125 million pounds ($202 million) of 6.625 percent subordinated bonds maturing 2023 was a "credit event," the International Swaps and Derivatives Association said on its Web site.
The ruling will prompt an auction to settle credit swap contracts even though the U.K. government changed the terms of the bank’s nationalization in February, allowing it to miss coupon payments without that constituting a default. Bradford & Bingley said in May it didn’t intend to pay interest on the notes, which form part of the bank’s so-called lower Tier 2 capital. "Credit-default swap holders can now expect a payout based on the credit event," said Louis Gargour, chief executive officer at hedge fund LNG Capital LLP in London. "It reinforces confidence in the efficient functioning of the market."
Credit-default swaps pay the buyer face value in exchange for the underlying securities or the cash equivalent should a company fail to adhere to its debt agreements. Bradford & Bingley, the country’s biggest lender to landlords before it was nationalized, missed a payment due on June 16 and the 14-day grace period expired without the interest being paid. Morgan Stanley asked the committee of swap traders to rule whether the non-payment was a credit event, ISDA said.
The extra yield investors demand to hold lower Tier 2 bonds in pounds rather than similar-maturity government debt widened to a record 7.25 percentage points on March 30, and was at 5.42 percentage points yesterday, Merrill Lynch & Co.’s Sterling Lower Tier II Index shows. Bradford & Bingley’s deposits and branches were transferred to Spain’s Banco Santander SA after it was nationalized in September.
UK facing 'energy crunch' as North Sea oil and gas cash dries up
The UK is heading for an "energy crunch" after new oil and gas exploration in the North Sea dropped 57pc in the first half of this year. A report by Oil & Gas UK, the industry group, showed that companies are cutting back on new projects as costs rise and funding is scarce during the recession. Investment in the industry fell to £4.8bn last year, down £1.2bn over the last two years, and it could drop below £3bn next year. The report estimates that £5bn a year is needed to maintain exploration.
Malcolm Webb, chief executive of UK Oil & Gas, said billions of barrels may never be extracted if the lack of investment causes oil and gas fields to shut prematurely. "Last year, we had the credit crunch, next year we are looking at an energy crunch," said Mr Webb, whose organisation represents 85 oil and gas companies. "I'm still very concerned about the lack of investment." Domestic reserves still account for about two-thirds of all the UK's primary energy needs, but reliance on foreign imports is increasing as domestic production is currently dropping by 5pc a year. Mike Tholen, economic adviser for Oil & Gas UK, said the fall was likely to accelerate to 7.5pc over the next few years.
In the worst case, the North Sea could provide just 500,000 barrels of oil equivalent per day by 2012 – or just 12pc of the UK's energy demand. If investment is maintained, domestic production could still meet 40pc of Britain's needs. Oil producers believe it is still possible to extract 37bn barrels from the North Sea. However, declining investment means as little as 11bn barrels may be recovered before fields are decommissioned. "Ministers say it would be regrettable if production is at the lower end of estimates. We think this is an understatement," Mr Webb said. Oil & Gas UK has long been calling for the tax burden on the energy industry to be cut. At its current level, the sector provides £13bn – or 30pc – of all UK corporation tax receipts.
Chancellor Alistair Darling announced measures to incentivise exploration for new fields in the Budget, but oil companies have criticised the lack of tax breaks for existing fields. Separately, Tullow Oil , the UK oil explorer, said revenues were expected to drop 23pc in the first half on reduced activity in the North Sea and the lower oil price. Revenues at Tullow Oil are expected to fall to £290m in the first half, despite the development of African fields to offset falling UK production. Its share price tumbled 27, or 3pc, to 863?p. Problems with Tullow's North Sea operations have seen output fall by 16pc to 59,000 barrels of oil a day compared with last year. The price of US crude oil fell to a two-month low of $62 per barrel on Wednesday, on fears of slower than expected economic recovery.
How not to reform financial markets
by Willem Buiter
Just how weak is the UK government’s recent white paper Reforming financial markets ? Imagine one small spoonful of tea leaves in a teapot the size of an adult beer barrel. That’s how weak. I will focus on four areas of weakness: (1) the continued subsidisation of the banking sector’s cost of capital, (2) the failure to address the too big to fail problem, (3) the unholy mess that is the UK’s Tripartite Arrangement, and (4) the foot dragging as regards the creation of new macro-prudential instruments.
(1) Ending the subsidisation of the banking sector’s cost of capital
The recent crisis has re-confirmed the view that unsecured creditors of large banks are de facto guaranteed by the state. Bank shareholders, or at any rate the holders of tangible common equity (tce), are at risk, but from the holders of subordinated bank debt on up, the credit risk is socialised by the state, free of charge. This subsidises the cost capital to banks - a weighted average of the cost of internal financing through retained profits, equity finance and debt finance.
This has two consequences. First, the size of the banking sector (measured by value added, employment, balance sheet size) is excessive. There is too much intermediation through banks. I know that the government tells us that both as regards time series and cross-country evidence, the size of the UK financial sector today (about 8 percent of GDP) is not exceptionally large. That may well be so, but this is of course quite consistent with the proposition that it is still too large. Second, since the subsidy is through the unsecured debt component of bank finance, it encourages excessive leverage, thus raising the risk that the state will indeed be called upon to bail out the bank and its unsecured creditors.
The solution to this problem of excessive banking sector size and leverage resulting from the free guarantee provided the unsecured creditors of the banks is clear: eliminate the guarantee. The special resolution regime (SRR) created in the Banking Act of 2009 for commercial banks and building societies should have the property that no public money goes into a bank (as capital or as guarantees), until all unsecured creditors have been converted into shareholders (all bank unsecured debt converted into tce). After that, the SRR should be extended to include investment banks and all other highly leveraged institutions with significant asset-liability mismatch, that are deemed to be systemically significant, severally or jointly.
(2) Breaking up banks and taxing bank size
HM Treasury are quite comfortable with large, complex and conflicted financial institutions. The white paper does recommend that all systemically important financial institutions be required to write a will and keep it up to date. This ‘will’ would contain a blueprint for restructuring, breaking up or liquidating the bank in the event of insolvency. The Bank of England is supposed to vet the quality and appropriateness of these insolvency plans, which should allow a failing back to inter the SRR on a Friday evening and for something viable and sensible to emerge again the next Monday morning.
The white paper appears to jump from the correct observation that size is not a necessary condition for systemic importance and bail-out prerogatives, to the incorrect conclusion that size is not a problem. Financial institutions can be too big, to interconnected, too complex, too international and too politically connected to fail. Much of the complexity and not a small part of the cross-border nature of many banks is part of a deliberate strategy to make the bank and its operations opaque and incomprehensible to regulators, supervisors, tax authorities, shareholders and competitors. Such regulatory arbitrage and tax arbitrage-driven complexity and internalionalisation is socially inefficient. It will be discouraged by the ‘will’ these institutions will have to file in the future.
It is possible that, because they play a pivotal role in the inter-bank intermediation system, some small banks, or clusters of small banks are systemically significant and too important to fail. I accept the point in principle. This does not, of course, provide an argument for trying to restrain the growth of banks to enormous size. Four simple instruments are available. The first is to tax bank size by making the required capital ratio an increasing function of bank size, after a certain minimum size. The second is to split narrow banking (deposit taking and lending to non-financial corporates and households) from other banking activities. The third is to break up existing big banks along lines of manifest conflict of interest. The fourth is active anti-monopoly or anti-trust policy.
(3) Sorting out the Tripartite Arrangement
Financial stability can only be maintained or restored effectively through the close cooperation of the monetary authority, the regulatory/supervisory authority and the fiscal authority. The monetary authority is the source of the ultimate unquestioned liquidity - central bank money, that is, coin and currency and reserves with the central bank. Its resources are required for liquidity support through open market operations, the discount window, lender of last resort interventions or market maker of last resort interventions. The regulator/supervisor (I roll them together, although the regulator makes the rules and the supervisor enforces them) can instruct financial institutions, other participants in financial arrangements and financial market participants in general to do certain things and to desist from doing certain other things. The fiscal authority has the non-inflationary long-term deep pockets (aka the tax payer) necessary whenever capital inadequacy is the issue, including when insolvency threatens.
The central bank as lender of last resort and market maker of last resort should have primary macroprudential responsibility and powers. That means it should have responsibility (1) for the stability of the financial system as a whole, (2) for each highly leveraged financial institution that is severally (or jointly with others) systemically important, (3) for all systemically important financial markets and (4) for the key payment, trading, clearing, settlement and custodial platforms.
The fact that the Holy Trinity of the monetary authority, the regulatory/supervisory authoritie and the fiscal authority has to be involved in financial stability, that is three functions or powers, says nothing about how many institutions should be involved. There could be just one institution involved - the Treasury. Between the nationalisation of the Bank of England and 1997, the Bank of England was just the liquid subsidiary of the UK Treasury. The Bank had the supervisory responsibility for the banking sector, but as the Treasury controlled the Bank, there effectively was a unitary tripartite authority.
You could also get the monetary authority out of the financial stability business, or at least out of any active role, by assigning the lender of last resort and market maker of last resort functions to the supervisor-regulator. This could be achieved in the UK by giving the FSA an uncapped, open-ended overdraft facility with the Bank of England, guaranteed by the Treasury. The active decisions on which bank to support with funding liquidity or which instruments to support by providing market liquidity could then be made by the FSA. As the FSA has no macro-prudential experience or knowledge, this would result in a rather nasty learning curve. The (short) tradition of the FSA is that of an institution of bean counters, lawyers and box tickers, not of an organisation staffed by persons with macro-prudential competence and interests. The current Chairman if the FSA, Adair Turner, is trying to change the culture of the place, but even if he ultimately succeeds, the UK economy cannot afford to wait for this transformation to be completed.
It therefore clearly makes sense to assign the regulatory/supervisory responsibilities, powers and instruments for macro-prudential stability, other than the fiscal competency, to the institution whose natural habitats are the economy-wide and world-wide money markets and the provision of funding liquidity and market liquidity. That means that the Bank of England should have the final say in macro-prudential management issues, as long as the tax payer is not involved. When recourse to the fiscal powers of the sovereign is involved, the Treasury has to have the final say.
HM Treasury has moved in the opposite direction. In the white paper it proposes to give the FSA a statutory financial stability mandate and associated powers that are, where it matters, superior to the Bank of England’s financial stability powers. I believe that the FSA should not have a macro-prudential mandate or macro-prudential instruments. Its prudential role should be restricted to the supervision and regulation of individual institutions. The Bank of England should have a macro-prudential mandate (together with the Treasury). It should also be able to obtain information from and give binding instructions to individual financial entities that it considers material from a macro-prudential perspective. This means that certain banks and other financial institutions could find themselves reporting to, providing information to and being harassed by both the FSA and the Bank of England. So be it. A little bit of redundancy never did much harm.
The decision to put a bank or building society (and ideally any higly leveraged institution deemed systemically significant) into the Special Resolution Regime (SRR) should be taken by the Bank of England. Under the Banking Act 2009, we have the insane situation that the FSA pulls the trigger (makes the decision as to whether a bank or building society is put into the SRR) but the SRR is managed by the Bank of England. The Bank rightly objects to this assignment of responsibility without power. Once in the SRR, a failing institution is under the authority of the Bank of England, except of course when it comes to it being taken into public ownership, wholly or in part. That decision can be taken only by the Treasury. The anomaly as regards the SRR (the FSA breaks it but the Bank of England owns it) can be remedied without necessarily depriving the FSA of all macro-prudential authority. This could be achieved by making the decision to put a bank or building society into the SRR a joint decision of the Bank of England and the FSA. In case of a disagreement, the Treasury would have the casting vote.
(4) Creating new macro-prudential instruments
The white paper is very short on concrete proposals. Countercyclical capital requirements and liquidity requirements clearly must be part of the new framework. It would have been helpful to provide some fully worked examples of such countercyclical rules based either on the behaviour or economy-wide aggregates or, as in the proposals of Goodhart and Persaud, on the behaviour of individual balance sheets or other institution-specific variables. The white paper recognises the desirability of these new instruments being introduced uniformly in as wide a range of countries as possible, to prevent distortions of the competitive playing field. Agreement at the EU level would be a good practical first step.
Much more could and should have been proposed. House price booms and busts (and other real estate price booms and busts) are so damaging because of their effects on the construction sector and because so much debt is secured against real estate. Yet in the space of a single week I read about a 100 percent government-owned bank (Northern Rock) once again giving 100 percent mortgages (mortgages with a 100 percent loan to value ratio), and a building society (Nationwide) giving mortgages with a 125% loan-to-value ratio. Clearly these institutions are nuts. They have not learnt a damn thing from the crisis and what caused it. Their CEOs should be taken out and shot after a fair trial.
Germany did not have a housing boom. Hasn’t had one since Varus lost the legions in the Teutoburger Wald. Why is that? Well, the maximum loan-to-value ratio for residential mortgages in Germany is 60 percent. It does not take an Einstein to design effective regulation. Why does the banking regulator in the UK allow these crazy loan-to-value ratios? Why not take a leaf from the German regulator and limit morgages to no more than 60 percent of the value of the property? Both Barclays Cap and Goldman Sachs are proposing new forms of securitisation whose main rationale is to reduce the amount of capital that has to be held against the assets that are being securitised. Securitisation is, in principle, a jolly good thing, as long as the originator or issuer of the securitised assets is required to hold enough of the equity tranche or first-loss tranche of the securitised assets to ensure a healthy interest in the quality of the underlying assetss or in monitoring the relationships underlying the securitised cash flows. The five percent retention ratio proposed by the EU and endorsed in the white paper is, however, far too low.
Why is it still possible, merely by moving securitised assets off-balance-sheet (traditionally into SIVs, now probably into a vehicle with a less tainted name) to reduce the amount of capital that has to be held against it? Make capital requirements neutral between institutions holding assets - a bunch of mortgages held by a bank should attract the same capital requirement as that same bunch of morgages held by an off-balance-sheet special purpose vehicle, unless the funding risk of these mortgages differs materially between the two kinds of institutions. Crazy remuneration schemes were part of the last credit boom. They too are back. A more than 70 percent state-owned bank, RBS, is recruiting talent with a promise of a two-year guaranteed bonus. Where are the regulators when we need them? Where are the owners - UKFI, presumable agents for Taxpayers Unlimited, that is, you and I? All these potentially macro-prudentially destabilising developments are within the law and don’t violate any regulations. Time to change the law and the regulations. And put some zip in it, for a change.
Crash Ideology Makes a Comeback in London
Profits and share prices are rising, so let's have another round of bonuses! In the City of London, the impact of the financial crisis is waning along with the the appetite for reform. In a sign of how the mood has changed in recent months, Britain's bankers are vocally resisting plans for tougher regulation. The film is called "What If?" and the Bank of England shows it to visitors to convey how the 300-year-old institution quietly shields the British economy from crises. The video includes a section in which Governor Mervyn King proudly explains the work of his central bankers.
There's just one slight shortcoming. It was filmed long before the current financial meltdown. To visitors who followed how the banking system came close to collapse over the last two years, the little advertising movie must seem like a satire. After all, the Bank of England failed to ward off this crisis. The bank admits the film should probably be replaced at some stage. But it doesn't appear to be in much of a hurry. The movie may even outlast this crisis -- like many other aspects of the City of London. There are increasing signs that the world's largest financial center is returning to its old ways. Share prices are rising, the banks are reporting respectable profits and as memories of the big Lehman Brothers shock last September fade, so does the reforming zeal of the financial district around the grand dome of St. Paul's Cathedral.
"We're just drifting back into business as usual, as if nothing happened," said the finance policy spokesman and deputy leader of the opposition Liberal Democrats, Vince Cable. At summer parties in the City, the talk is of bonuses, just a few months after the whole sector had to be bailed out by taxpayers. The British press has invented a new buzzword: "BAB," short for "bonuses are back." Even the government is playing along. The new head of the Royal Bank of Scotland, which has been de facto nationalized, is to receive a double-digit million sum if the share price rises above 70 pence (80 euro cents) under his leadership.
The 5,400 investment bankers of Goldman Sachs in London have been promised hefty payouts because the Wall Street-based bank expects a record year. The government bond business is booming and thanks to the collapse of so many of its rivals, Goldman has risen to become banker to indebted governments. Other banks that are doing well in the crisis such as Barclays Capital, the bank's investment arm, are busy poaching staff from their competitors. Adair Turner, the head of the Financial Services Authority, said recently there was "aggressive" hiring of bankers. Barclays has hired some 300 extra investment bankers this year by dangling attractive terms. The CEO of Barclays Capital, Bob Diamond, says he wants to turn BarCap into the world's leading investment bank in the coming years.
Even US investment bank Lehman Brothers, whose collapse in September brought the global financial system to a standstill, is experiencing a rapid resurrection under new ownership. Its US business is being continued by BarCap and its European operations went to Japan's Nomura Bank. The Financial Times reported on Tuesday that Nomura wants to become the top broker on the London Stock Exchange by the end of the year -- like Lehman used to be. And reports say that on the old Lehman trading floor in London's Canary Wharf there are signs with the sentence: "That Was Then, This is Now." The bank will soon move to new offices to complete the break with its troubled recent past.
It seems that the former masters of the universe are gradually regaining their confidence. True, the Bank of England said in its latest Financial Stability Report that the sector continues to face major risks. But the general tension is easing. "We are like goldfish," the Observer newspaper quoted Jon Macintosh, a Mayfair hedge-fund manager, as saying. "We swim once around our bowl and when we complete the circle everything looks new." Lord Digby Jones, the former head of the Confederation of British Industry, told the BBC the "arrogant and greedy" had long since left the City. The hard working bankers remained, he said, "and London needs them."
So is everything back to square one now? Politicians and financial market supervisors are alarmed and fear the wrath of the people. That's why there's no shortage of bankers warning against hubris.
"Society will be shocked if banks pay large bonuses for neglecting their commitments," the government's financial services secretary, Paul Myners, told the annual conference of the British Bankers Association. The finance policy spokesman of the opposition Conservative Party, George Osborne, has also urged bankers to show restraint. Bonus payments would be a "big mistake," he said. Instead all banks, not just those under state ownership, should use their profits to strengthen their capital base, he said.
Finance Minister Alistair Darling presented his proposals for banking reform on Wednesday which included tougher rules on executive pay and new powers for the FSA. "We need to learn lessons from the financial crisis in which banks behaved in a kamikaze manner and the regulatory system failed," he wrote in the Sunday tabloid News of the World. But the reform isn't all that radical. The British government has switched its focus towards shielding the country's financial center from outside interference. The City remains an "immense asset" to Britain, Darling told VIP guests at the annual dinner hosted by the Lord Mayor of the City of London in the mighty marble hall of Mansion House.
The main focus now is the fight against the common enemy in Brussels, a trend that triggered an outburst by Germany's easily excitable Finance Minister, Peer Steinbrück,last week. "At times," Steinbrück told the German DGB trade union federation last week, "I see a great deal of resistance to regulatory measures whenever they matter to the City of London and the British government." It's true that City lobby groups have been campaigning against the regulatory reforms. The International Swaps and Derivatives Association warned against "demonizing" derivatives which remained a "useful instrument of risk management." And the annual conference of Securities and Investment Institute was abuzz with talk that Paris and Berlin are pushing for greater international regulation in order to shrink the City down to their own levels.
Angela Knight, chief executive of the British Bankers Association, said last week it was essential that London "is not impaired by insufficient attention or prejudice." The banking industry would be pro-active in Europe, she promised. It sounded like a threat. The London establishment is also resisting the European Commission's draft guidelines on hedge funds. The plans call for greater transparency and controls of hedge funds, and government minister Myners has pledged to fight them "tooth and nail." The planned directive is seen as a pure anti-London law given that 80 percent of all European hedge funds are based in the British capital.
The major hedge funds, such as Brevan Howards, the No. 1 in Europe, have threatened they will move to Hong Kong or Singapore. A London delegation travelled to Washington last week in a bid to forge an Anglo-Saxon alliance against Brussels. The rebellion is already having an effect: Swedish Finance Minister Anders Borg, whose country has the rotating EU presidency since July 1, has already cautioned against "overzealous regulation." The mood is quite different from a few months ago when no one dared to critize the reform proposals of FSA chief Turner. Turner and Bank of England Governor King are now warning that the reforms may end up being less radical than necessary. "There is a real danger we don't seize the opportunities of this crisis," Turner recently told parliament.
Global Banking Economist Warned of Coming Crisis
William White predicted the approaching financial crisis years before 2007's subprime meltdown. But central bankers preferred to listen to his great rival Alan Greenspan instead, with devastating consequences for the global economy. William White had a pretty clear idea of what he wanted to do with his life after shedding his pinstriped suit and entering retirement. White, a Canadian, worked for various central banks for 39 years, most recently serving as chief economist for the central bank for all central bankers, the Bank for International Settlements (BIS), headquartered in Basel, Switzerland.
Then, after 15 years in the world's most secretive gentlemen's club, White decided it was time to step down. The 66-year-old approached retirement in his adopted country the way a true Swiss national would. He took his money to the local bank, bought a piece of property in the Bernese Highlands and began building a chalet. There, in the mountains between cow pastures and ski resorts, he and his wife planned to relax and enjoy their retirement, and to live a peaceful existence punctuated only by the occasional vacation trip. That was the plan in June 2008. And now this.
White is wearing his pinstriped suits again. He has just returned from California, where he gave a talk at a large mutual fund company. Then he packed his bags again and jetted to London, where he consulted with the Treasury. After that, he returned to Switzerland to speak at the University of Basel, and then went on to Frankfurt to present a paper at the Center for Financial Studies. From there, White traveled to Paris to attend a meeting at the Organization for Economic Cooperation and Development (OECD). Finally, he flew back across the Atlantic to Canada. White is clearly in demand, including in North America.
Since the economy went up in flames, the wiry retiree has been jetting around the globe like a paramedic for the world of high finance. He shows no signs of exhaustion, despite his rigorous schedule. In fact, White, with his gray head of hair, is literally beaming with energy, so much so that he seems to glow. Perhaps it is because someone, finally, is listening to him. Listening to him, that is, and not to his rival of many years, the once-powerful former chairman of the US Federal Reserve Bank, Alan Greenspan. Greenspan, who was reverentially known as "The Maestro," was celebrated as the greatest central banker of all time -- until the US real estate bubble burst and the crash began.
Before then, no one in the world of central banks would have dared to openly criticize Greenspan's successful policy of cheap money. No one except White, that is. White recognized the brewing disaster. The analysis department at the BIS has a collection of data from every bank around the globe, considered the most impressive in the world. It enabled the economists working in this nerve center of high finance to look on, practically in real time, as a poisonous concoction began to brew in the international financial system. White and his team of experts observed the real estate bubble developing in the United States. They criticized the increasingly impenetrable securitization business, vehemently pointed out the perils of risky loans and provided evidence of the lack of credibility of the rating agencies. In their view, the reason for the lack of restraint in the financial markets was that there was simply too much cheap money available on the market. To give all this money somewhere to go, investment bankers invented new financial products that were increasingly sophisticated, imaginative -- and hazardous.
As far back as 2003, White implored central bankers to rethink their strategies, noting that instability in the financial markets had triggered inflation, the "villain" in the global economy. "One hopes that it will not require a disorderly unwinding of current excesses to prove convincingly that we have indeed been on a dangerous path," White wrote in 2006. In the restrained world of central bankers, it would have been difficult for White to express himself more clearly. Now White has been proved right -- to an almost apocalyptical degree. And yet gloating is the last thing on his mind. He, the chief economist at the central bank for central banks, predicted the disaster, and yet not even his own clientele was willing to believe him. It was probably the biggest failure of the world's central bankers since the founding of the BIS in 1930. They knew everything and did nothing. Their gigantic machinery of analysis kept spitting out new scenarios of doom, but they might as well have been transmitted directly into space.
For years, the regulators of the global money supply ignored the advice of their top experts, probably because it would require them to do something unheard of, namely embark on a fundamental change in direction. The prevailing model was banal: no inflation, no problem. But White wanted central bankers to take things a step further by preventing the development of bubbles and taking corrective action. He believed that interest rates ought to be raised in good times, even when there is no risk of inflation. This, he argued, counteracts bubbles and makes it possible to lower interest rates in bad times. He also advised the banks to beef up their reserves during a recovery so that they would be in a position to lend money in a downturn.
If White's model had been applied, it might have been possible to avoid the collapse of the financial system -- or at least soften the fall. But there was simply no support for his ideas in the singular, and highly secretive, world of central bankers. The BIS is a closed organization owned by the 55 central banks. The heads of these central banks travel to the Basel headquarters once every two months, and the General Meeting, the BIS's supreme executive body, takes place once a year. The central bankers -- from Alan Greenspan and his successor Ben Bernanke, to German Bundesbank President Axel Weber and Jean-Claude Trichet, the head of the European Central Bank (ECB) -- are fond of the Basel meetings. When they arrive, the BIS's dark office building at Centralbahnhof 2 in Basel suddenly comes alive. Secretaries inhabit the otherwise deserted offices of the governors, stenographers and chauffeurs stand at the ready and dark limousines wait outside.
The penthouse at the top of the building, with its magnificent view of Basel, is decorated for the annual dinner, the nuclear shelter in the basement is swept out and the wine cellar is restocked with the best wines. At the BIS's private country club, gardeners prepare the tennis courts as if a Grand Slam tournament were about to be held there. The losers of matches can find comfort in the clubhouse, where the Indonesian guest chef serves up Asian delicacies à la carte. "Central bankers can sometimes be prima donnas," says former BIS Secretary General Gunter Baer. He remembers the commotion that erupted at one of the annual events when it became known that a certain vintage of Mouton Rothschild was unavailable.
The corridors of the BIS headquarters buildings are lined with retro white leather chairs and sofas from the 1970s. The round table where the delegates address the problems of the global economy is polished to a high gloss. But the most impressive space of all is the auditorium, with its modern armchairs in white leather and chrome, the thousands of tiny LED lights, the booths in the back where the interpreters sit behind one-way glass, and the console where the financial masters of the world do their work, centrally positioned at the front of the room. The room is evocative of the control room in "Star Trek." It was supposed to be the hub from which the financial world was to be guided through every possible hazard.
Naturally, the building is largely bugproof, the goal being to prevent anything from leaking to the outside and any unauthorized individuals from penetrating into its interior. There are no public minutes of the meetings. Everything that is discussed there is confidential. The word transparency is unknown at the BIS, where nothing is considered more despicable than an indiscreet central banker. Central bankers, proud of their independence, are intent on holding themselves above all partisan influences while taking all necessary measures to keep the global economy healthy. These traits make the BIS one of the world's most exclusive and influential clubs, a sort of Vatican of high finance. Formally registered as a stock corporation, it is recognized as an international organization and, therefore, is not subject to any jurisdiction other than international law.
It does not need to pay tax, and its members and employees enjoy extensive immunity. No other institution regulates the BIS, despite the fact that it manages about 4 percent of the world's total currency reserves, or €217 trillion ($304 trillion), as well as 120 tons of gold. "Our strength is that we have no power," says BIS Secretary General Peter Dittus. "Our meetings are generally not oriented toward decision-making. Instead, their value consists in the exchange of views." There are no across-the-board agreements on the order of: "Let's raise the prime rate by a point." Opinions take shape in a much more subtle fashion, through something resembling osmosis. Central bankers are not elected by the people but are appointed by their governments. Nevertheless, they wield power that exceeds that of many political leaders. Their decisions affect entire economies, and a single word from their lips is capable of moving financial markets. They set interest rates, thereby determining the cost of borrowing and the speed of global financial currents.
Their greatest responsibility is to prevent a bank or market crash from jeopardizing the viability of the financial system and, with it, the real economy. It is no accident that central bankers are also in charge of bank supervision in most countries. But this time they failed miserably. How could this community of central bankers, despite its access to insider information, have so seriously underestimated the dangers? And why on earth did it not intervene? "Somehow everybody was hoping that it won't go down as long as you don't look at the downside," William White told SPIEGEL. "Similar to the comic figure Wile E. Coyote, who rushes over a cliff, keeps running and only falls when he looks into the depth. Of course, this is nonsense. One falls, because there is an abyss."
But why did they all refuse to recognize the abyss? Why did the central bankers, of all people -- those whose actions are above profit expectations, shareholder pressure and the need to please voters -- keep their eyes tightly shut? Did they too succumb to the general herd instinct? "As long as everything goes well, there is a great reluctance to (make) any kind of change," says White. "This behavior is deeply rooted in the human mind." White calls it the human factor. And that factor had a name: Alan Greenspan. Greenspan was long a member of the BIS board of directors and was effectively White's superior. As a fervent champion of the free market, he advocated the model of minimal intervention. In his view, the role of central banks was to control inflation and price stability, as well as to clean up after burst bubbles. Because no one can know when bubbles are about to burst, he argued, it would be impossible to intervene at the right moment.
In his eyes, the instrument of sharply raising interest rates to counteract market excesses routinely failed. Leaning "into the wind," he argued, was pointless. He could even cite historical proof for his thesis. Between the beginning of 1988 and the spring of 1989, the Fed raised the prime rate by three percentage points, the goal being to curtail lending by raising the cost of borrowing. The textbook conclusion was that this would be toxic to the markets, but precisely the opposite occurred: Prices continued to rise. This supposed paradox repeated itself five years later. Once again, the Fed raised interest rates and, again, the market shot up.
These experiences only strengthened Greenspan's conviction that raising interest rates was an ineffective tool to counteract bubbles. However he never tried raising interest rates to a significantly greater degree than had previously been done, to see what would happen. The question of who was right, Greenspan or White, didn't exactly lead to a power struggle in Basel. The forces were too unevenly distributed for that. On the one side was the admonishing chief economist, with his seemingly antiquated model that advocated the establishment of reserves, and on the other side was the glamorous central banker, under whose aegis the economy was booming -- the killjoy vs. the party animal.
The central bankers certainly discussed the competing models. But most of them were behind Greenspan, because his system was what they had studied at their elite universities. They refused to accept White's objections that the economy is not a science. There was no way of verifying his model, they said. Besides, who was about to question success? Greenspan was their superstar, the inviolable master, a living legend. "Greenspan always demanded respect," White recalls, referring to the Maestro's appearances. Hardly anyone dared to contradict the oracular grand master. And why should they have contradicted Greenspan? "When you are inside the bubble, everybody feels fine. Nobody wants to believe that it can burst," says White. "Nobody is asking the right questions."
He even defends his erstwhile rival. "Greenspan is not the only one to blame. We all played the same game. Japan as well as Europe followed the low interest policy, almost everybody did." Meanwhile, White noted with concern what the central bankers were triggering as a result. Their policy of cheap money led to the Asian financial crisis in 1997. When the debt that banks had accumulated went into default, the International Monetary Fund (IMF) and other donors had to inject more than $100 billion (€71 billion) to rescue the world economy. In describing the failure of the markets as far back as 1998, White wrote that it is naïve to assume that markets behave in a disciplined way. But Greenspan, the champion of free markets, remained impassive.
A few weeks later, the market demonstrated its destructive power once again, when Russia plunged into a financial crisis, bringing down the New York hedge fund Long Term Capital Management (LTCM) along with it. The New York Fed hurriedly convened a meeting of the heads of international banks, initiating a bailout that remains unprecedented to this day. The global economy was saved from a systemic crisis -- at a cost of $3.6 billion (€2.6 billion). And what did Greenspan do? He lowered interest rates. Then the next bubble, the so-called New Economy, began to grow in Silicon Valley. It burst in the spring of 2000. What did Greenspan do? He lowered interest rates. This time the reduction was massive, with the benchmark rate dropping from 6 percent to 1 percent within three years. This, according to White, was the cardinal error. "After the 2001 crash, interest rates were lowered very aggressively and left too low for too long," he says.
While the economy was recovering from the demise of the dotcom sector and from the terrorist attacks of Sept. 11, 2001, cheap money was already on its way to triggering the next excess. This time it took place in the housing market, and this time it would be far more devastating. White was losing his patience. Was there no other option than to regularly allow the economy to collapse? Didn't the policy of operating without a safety net border on stupidity? And wasn't it written, in both the Bible and the Koran, that it was important to provide for seven years of famine during seven good years? This time, White didn't just want to discuss his views behind closed doors. This time, he decided to seek a broader audience.
His destination was Jackson Hole in Wyoming, a kind of Mecca for financial experts. It was August 2003. Once a year, the Federal Reserve Bank of Kansas City invites leading economists and central bankers to a symposium in Jackson Hole. Against the magnificent backdrop of the Grand Teton National Park, the world's financial elite spends its time unwinding on hiking trails and in canoes, before retreating into conference rooms to discuss the state of the global economy. Only those who can hold their own in front of this audience are considered important in the industry. "This is an opportunity we can't afford to miss," BIS economist Claudio Borio told his boss, White, as he wrote himself a few last-minute notes in his room at the Jackson Lake Lodge in preparation for his speech to the symposium.
Greenspan was in the audience when Borio and White presented their theories -- theories that had absolutely nothing in common with the powerful Fed chairman's worldview, or that of most of his colleagues. White and Borio described the dramatic changes that had taken place since deregulation of the financial markets in the 1980s. Price stability was no longer the problem, they argued, but rather the development of imbalances in the financial markets, which were increasingly causing earthquake-like tremors. "It is as if one villain had gradually left the stage only to be replaced by another," White and Borio wrote in the paper they presented at Jackson Hole. As it turned out, it was a villain with the ability to unleash devastatingly destructive forces.
It was created by what the two BIS economists called the "inherently procyclical" nature of the financial system. What they meant is that perceptions of value and risk develop in parallel. People suffer from a blindness to future dangers that is intrinsic to the system. The better the economy is doing, the higher the ratings issued by the rating agencies, the laxer the guidelines for approving credit, the easier it becomes to borrow money and the greater the willingness to assume risk. A bubble develops. When it bursts, the results can be devastating. "In extreme cases, broader financial crises can arise and exacerbate the downturn further," White wrote in his analysis. The consequences, according to White, are high costs to the real economy: unemployment, a credit crunch and bankruptcies.
All it takes to predict such imbalances, White argued, is to monitor "excessive credit expansion and asset price increases," and to take corrective action early on, even without a pending threat of inflation. This task, the authors concluded, must be performed by monetary policy, among other things. The central banks, according to White and Borio, could limit credit expansion and thus avoid adverse effects on the global economy. The Jackson Hole paper was an assault on everything Greenspan had preached and, as everyone knew, he was not fond of being contradicted. Other members of the audience glanced surreptitiously at the Maestro to gauge his reaction. Greenspan remained impassive, his face expressionless behind his large spectacles, as he listened to White. Later, during a more relaxed get-together, he refused to even look at White. White suspected he had failed to convince his audience. "You can lead a horse to water, but you can't make it drink," he says.
Now that the US prime rate is bobbing up and down between zero and 0.25 percent, and the Fed is pumping hundreds of billions of dollars into the market, White's words at the 2003 conference have undoubtedly come back to haunt many a central banker. In that speech, White had prophesied that if the "worst scenario materializes, central banks may need to push policy rates to zero and resort to less conventional measures, whose efficacy is less certain." He warned that the money supply could dry up. Markets, he wrote, "can freeze under stress, as liquidity evaporates." He also identified -- a full four years before the bursting of the real estate bubble -- the disturbing developments in the US real estate market as a consequence of lax monetary policy. "Further stimulus has not come free of charge and has raised questions about the sustainability of the recovery," he warned. From today's perspective, White's predictions are almost frightening in their accuracy.
But when push came to shove, he was unable to overturn the prevailing ideology. "We were staff," he says. "All we could do was to present our expertise. It was not within our power how it was used." Despite the disappointment at Jackson Hole, White didn't give up on supplying data, facts and analyses. Perhaps, he reasoned, this constant flow of information could help to break through mental barriers. He would repeatedly refer to the "Credit Risk Transfer" report published by the BIS's Committee on the Global Financial System in 2003. The publication describes how loans were packaged into tranches using so-called collateralized debt obligations and then marketed worldwide. For banks, the experts wrote, "CRT instruments may reduce banks' incentives to monitor their borrowers and alter their treatment of distressed borrowers."
That, in a nutshell, was the underlying problem that would eventually trigger the mother of all crises. Many US bankers lowered their guard when it came to issuing subprime mortgages, because they could be repackaged and quickly resold, for example to unsophisticated bankers at German state-owned Landesbanken in places like Dresden, Hamburg and Munich. The central bankers were also not exactly taken by surprise by the failure of the rating agencies. In their report, the BIS experts derisively described the techniques of rating agencies like Moody's and Standard & Poor's as "relatively crude" and noted that "some caution is in order in relation to the reliability of the results." But nothing happened.
In the 2004 BIS annual report, White was unusually frank in criticizing the Fed's lax monetary policy. Although Greenspan sat on the bank's board of directors at the time, the board never sought to influence the analyses of its experts. But neither did it take them seriously. In January 2005, the BIS's Committee on the Global Financial System sounded the alarm once again, noting that the risks associated with structured financial products were not being "fully appreciated by market participants." Extreme market events, the experts argued, could "have unanticipated systemic consequences." They also cautioned against putting too much faith in the rating agencies, which suffered from a fatal flaw. Because the rating agencies were being paid by the companies they rated, the committee argued, there was a risk that they might rate some companies too highly and be reluctant to lower the ratings of others that should have been downgraded.
These comments show that the central bankers knew exactly what was going on, a full two-and-a-half years before the big bang. All the ingredients of the looming disaster had been neatly laid out on the table in front of them: defective rating agencies, loans repackaged to the point of being unrecognizable, dubious practices of American mortgage lenders, the risks of low-interest policies. But no action was taken. Meanwhile, the Fed continued to raise interest rates in nothing more than tiny increments. "You can see all the ingredients of a Greek tragedy," says White. The downfall was in sight, and yet no one dared disrupt the party, no one except White, the lone BIS economist, who says: "If returns are too good to be true, then it's too good to be true." And yet the economy was humming along, and billions in bonuses were being handed out like candy on Wall Street. Who would be willing to put an end to the orgy? Clearly not Greenspan.
The Fed chairman was not even impressed by a letter the Mortgage Insurance Companies of America (MICA), a trade association of US mortgage providers, sent to the Fed on Sept. 23, 2005. In the letter, MICA warned that it was "very concerned" about some of the risky lending practices being applied in the US real estate market. The experts even speculated that the Fed might be operating on the basis of incorrect data. Despite a sharp increase in mortgages being approved for low-income borrowers, most banks were reporting to the Fed that they had not lowered their lending standards. According to a study MICA cited entitled "This Powder Keg Is Going to Blow," there was no secondary market for these "nuclear mortgages."
Three days later, Greenspan addressed the annual meeting of the American Bankers Association in Palm Desert, California, via satellite. He conceded that there had been "local excesses" in real estate prices, but assured his audience that "the vast majority of homeowners have a sizable equity cushion with which to absorb a potential decline in house prices." The Maestro had spoken -- and the party could continue. William White and his Basel team were dumbstruck. The central bankers were simply ignoring their warnings. Didn't they understand what they were being told? Or was it that they simply didn't want to understand?
In the March 2006 BIS quarterly report, the Basel analysts described, once again, the grave risks of the subprime market. "Foreign investment in these securities has soared," they wrote. They also cautioned that there were "signs that the US housing market is cooling" and warned that investors "may be exposed to losses in excess of what they had anticipated." A short time later, White argued for his model once again in a working paper titled "Is Price Stability Enough?" Low inflation rates are not a sign of normalcy, he warned, and central banks should not allow themselves to be led astray by low rates. Both the LTCM bankruptcy and the collapse of the stock markets in 2001 occurred "in an environment of effective price stability."
It was a waste of time and effort. Roger Ferguson, the then-deputy Fed chairman, ironically started to refer to the BIS's Cassandra-like chief economist as "Merry Sunshine." "There are limits to pressing your argument," White says. "If you keep repeating your point over and over again, nobody will listen anymore." Ben Bernanke, who succeeded Greenspan as Fed chief in early 2006, was especially deaf to White's warnings. When he presented his biannual report on the state of the economy to the US Congress on July 19, 2006, he made no mention whatsoever of the subprime risk. A few months later, in December, the BIS reported that the index for securitized US subprime mortgages had fallen sharply in the fourth quarter of the year. A loss of confidence began to take shape.
The first casualties began surfacing a few weeks later. On Feb. 8, 2007, HSBC, the world's third-largest bank at the time, issued the first profit warning in its history. On April 2, the US mortgage lender New Century Financial filed for bankruptcy. Bernanke remained unimpressed. "The troubles in the subprime sector seem unlikely to seriously spill over to the broader economy or the financial system," he said. It was June 5, 2007. White made one last, desperate attempt to bring the central bankers to their senses. "Virtually no one foresaw the Great Depression of the 1930s, or the crises which affected Japan and Southeast Asia in the early and late 1990s, respectively. In fact, each downturn was preceded by a period of non-inflationary growth exuberant enough to lead many commentators to suggest that a 'new era' had arrived," he wrote in June 2007 in the BIS annual report.
But even if Bernanke had listened, it would have been too late by then. On June 22, the US investment bank Bear Stearns announced that it needed $3 billion (€2.1 billion) to bail out two of its hedge funds, which had suffered heavy losses during the course of the US real estate crisis. In Germany, entire banks were soon seeking government bailout funds. Banks increasingly lost trust in one another, and the money markets gradually dried up. It was the beginning of the end. "When the crisis started, I asked myself: Is this the big one?" White recalls. "The answer was: Yes, this is the big one."
Meanwhile, the global economy is on the brink of disaster, as it faces the most devastating and brutal crisis in a century. The only reason the financial system is still intact is that governments are spending billions to support it. Central bankers have been forced to abandon their air of sophisticated aloofness and to try, together with politicians, to save what can be saved. Nowadays no one is talking about the free market's ability to heal itself. And everything happened just the way White predicted it would. This is visibly unpleasant for officials at the BIS. Even though they can pride themselves for having provided the best analyses, they have also been forced to admit that their central bankers failed miserably. "We had the right nose, but we didn't know how to use it," says BIS Secretary General Dittus. "We didn't manage to portray the global and financial imbalances in a convincing fashion."
Did White express himself unclearly? No, it was more that he represented a system that only questioned the prevailing view. "Ultimately, an economic model can only be defeated by an opposing model," says BIS Chief Economist Stephen Cecchetti, White's successor. "Unfortunately, we don't have a generally recognized model yet. Perhaps this partly explains why our warnings were less effective than would have been desirable." The group of the 20 most important industrialized and emerging nations, which is now left with the task of cleaning up the wreckage of the crisis, apparently faces less academic problems. At the London G-20 summit in April, the group decided to promote a crisis-prevention model based on White's theories.
They want to introduce what might be called his hoarding model, which calls for banks to build up reserves in good times so that they can be more flexible in bad times. The central banks, according to White, must actively counteract bubbles and exert stronger control over the financial industry, including hedge funds and insurance companies. As an adviser to German Chancellor Angela Merkel's group of experts, White helped to shape the basic tenets of the new order. And the 79th annual report of the BIS, published in Basel last week, also reads like pure White. It lists, as the causes of the crisis, extensive global imbalances, a lengthy phase of low real interest rates, distorted incentive systems and underestimated risks. In addition to improved regulation, the BIS argues that "asset prices and credit growth must be more directly integrated into monetary policy frameworks."
Even though this is what he has been saying for more than 10 years, White, a passionate financial professional, is the last person to show signs of bitterness. During a conversation in his Paris office at the OECD, he has no harsh words for those who had long dismissed him as an alarmist. For White, the BIS will always be the greatest experience for an economist. The errors made by central bankers, politicians and business executives, he says, are simply part of life. "Take the Enron example," he says. "We analyzed the disaster and found that 12 different levels of the government malfunctioned. This is part of human nature."
He is familiar with human nature, and he knows how to handle it. White is more concerned about the things he doesn't understand. New Zealand is a case in point. Interest rates were raised early in the crisis there, and yet the central bank was unable to come to grips with the credit bubble. Investors were apparently borrowing cheap money from foreign lenders. This is the sort of thing that worries him. "That's when you have to ask yourself: Who exactly is controlling the whole thing anymore?" Perhaps his model has a flaw in that regard. Could it be possible that central bankers today have far less influence than he assumes? The thought causes him to wrinkle his brow for a moment. Then he smiles, says his goodbyes and quickly disappears into a Paris Metro station. He knows that he is needed.