Chillicothe, Illinois. Changing crews and cabooses of a westbound freight along the Atchison, Topeka and Santa Fe Railroad
Ilargi: Right. So government spending, as we've of course mentioned before, is going through roofs never dreamt of until recently. The request for a higher government debt ceiling is but one of the many signs of this. One that may be far more important is the roles played by Ginnie Mae and the FHA, roles that both have been stealthily increased by stunning percentages since the present administration took office.
The idea, undoubtedly, is to take all that's bad and suspect on Fannie Mae and Freddie Mac's elusive books, wrap it up in glitzy fancy gift paper, and throw it in a vault somewhere that still has space left on top of or beneath the toxic paper it already holds. And sure, it will look good at the surface. Just propose an opaque bad bank construction for Fannie and Freddie, so you can keep hiding the losses from view, and continue the policies that led to their inevitable demise through other (semi-private) enterprises.
There's something terribly wrong here. And since it threatens to transfer additional trillions of dollars in losses to the taxpayer, that taxpayer had better beware.
Somewhere behind these ideas is the faith that the economy, and hence home prices, will rise again. It's slightly reminiscent of Hank Paulson claiming 11 months ago that the taxpayer would actually make a healthy profit off the TARP rescues. That went well, didn’t it? We’re all much better off.
If the government would move out of the housing market, which it should as fast as it can, banks would start dropping like flies. To prevent that from happening, the government keeps on piling more and more of the mortgage burden on to the taxpayer’s back.
Fannie and Freddie hold some $6 trillion in loans, plus an amount in securities you probably better not know about, and the two agencies look ready to implode. They have to present numbers some time, despite all the attempts not to do so, and when they do, the sight won't be pretty. In come Ginnie Mae. And the FHA. And in their wake presumably the FHLB system. The dream of homewonership must prevail at whatever cost to society. Actually, there's a condition attached: it must prevail at price levels that please the banks.
So what are the odds that home prices will indeed start rising anytime soon? How about close to zero Kelvin?
Zillow's yesterday said that 25% of US homeowners will be underwater by 2010, and 30% by 2011. And that looks like an understatement, when you remember that Deutsche Bank last week said the 2011 underwater rate would be 50%.
One thing these numbers make abundantly clear is that prices simply cannot rise in any meaningful way. They can't stabilize either. They can only go down.
Which ensures that the losses on the Fannie and Freddie portfolio’s will, as soon as next year, be stunning, adding up to amounts so big that they seem capable of sinking entire governments. Having those losses made public, while at the same time continuing the practices that led to those losses through different agencies, it may well turn out to be political suicide.
And that's of course just one of a myriad ways that government spending rises, yet another sidedoor way to keep money flowing into Wall Street.
Meanwhile, tax revenues, as we've also mentioned before, are increasingly confirmed as sinking through basement floors previously unknown to mankind.
Less income, more spending, and stories about recovery. Sometime soon people are going to say: "Wait a minute!", and get their money out, while those who don't, or do so too late, will lose their shirts and shoes and homes.
And then we’ll hear different stories. In a cold winter with hot debates.
Who’s afraid of the US federal budget?
Never one to shy away from a good fiscal debate, Niall Ferguson, financial history professor at Harvard, sounds the alarm on the Obama administration’s looming federal deficit problem in a Tuesday FT comment piece.
As he concludes (our emphasis):The reason is clear. While the stimulus package had a sound macroeconomic rationale, the growing structural imbalance between federal revenue and spending scares the hell out of voters. A recent USA Today/Gallup poll showed that 59 per cent of Americans think government spending is excessive. Mr Obama receives his lowest approval ratings for his handling of the federal budget deficit.Six months in, Mr Obama still has the look of a lucky, two-term president. But that could change if voters become even more disenchanted with the legislative branch and start blaming the president for the looming fiscal train-wreck. The scariest possibility for Mr Obama is that the runaway deficit could leave him with the worst of both worlds: exploding debt and flat-lining growth.
Over at Diapason Securities, meanwhile, Sean Corrigan provides us with the following visual aid to highlight the extent of that scary problem:
As Corrigan notes:Outlays are rising at 20% YOY, the fastest nominal pace since 1976. With receipts falling 14.8% YOY, their fastest drop in at least 40 years, the gap between their growth rates is also the widest in the record. The percentage cover for outlays has been a pacesettingly poor 56% so far in calendar 2009, taking the deficit to no less than 78% of receipts and to a staggering 14% of private GDP where it is on track to reach between $1.6?$1.8 trillion for the full year — equivalent to the entire GDP of Spain, Russia, or BrazilWe can see why that would be scary to voters.
Companies Don't Need To Borrow Because They Don't Want To Spend
The financing gap is the difference between capital expenditures and cash flow. Another way of putting it is that it measures the dependence of business on financing for growth. The financing gap turned sharply negative at the end of last year. This negative financing gap indicates that the business sector as a whole is generating enough cash to purchase capital expenditures without borrowing. This supports the claims of banks that demand for business loans has declined. But that isn't necessarily good news for the economy.
We’ve overlaid this with the unemployment rate to indicate that the negativity of the financing gap doesn’t tell us much about underlying economic conditions. The gap turned sharply negative in late 2005 as unemployment was falling, indicating a booming economy that generated a large cushion of liquid assets for companies to spend on capital expenditures. This time around the negative financing gap, is very different—most likely generated by a decline in expenditures rather than excess cash flow. In short, this is a recessionary negative finance gap.
We’ve actually never seen anything like this in recent memory: a growing negative financing gap coupled with growing unemployment.
Troubled Assets May Still Pose Risk
The Treasury Department’s $700 billion bailout program has stabilized the banking system, but it has done little to prod banks to fully deal with the troubled loans on their books, a Congressional oversight panel said in a report to be released Tuesday. The Troubled Asset Relief Program was originally conceived as a program for the government to buy troubled and unsalable mortgages and mortgage-backed securities.
But the Treasury has never actually used the program to buy assets, in part because it was faster to invest money directly into the nation’s banks and in part because banks have not wanted to sell their problem loans and book the loss in their value. “The nation’s banks continue to hold on their books billions of dollars in assets about whose proper valuation there is a dispute and that are very difficult to sell,” the panel said in its latest monthly report.
As a result, it warned, many banks could find themselves short of capital if the economy suffered another downturn and their losses on troubled loans soared. In an encouraging note, the panel said 18 of the 19 biggest bank holding companies would probably have enough capital even if economic and financial conditions deteriorated more than they have already. That conclusion essentially backed up the results of the Federal Reserve’s stress tests in April.
But it warned that thousands of small and medium-size banks, which it defined as those with assets of $600 million to $100 billion, might find themselves short a total of $21 billion if the conditions matched its worst-case assumptions. The panel noted that other institutions had already estimated the amount of troubled assets on bank balance sheets that had yet to be written down. The Federal Reserve estimated in May that American banks still had about $599 billion in assets to write down. Goldman Sachs and the International Monetary Fund estimated the total at about $1 trillion. And RGE Economics, headed by Nouriel Roubini, has estimated the total at $1.27 trillion.
The panel urged the Treasury to either expand its current program to soak up troubled assets, the Public-Private Investment Program, “or consider a different strategy.” The five-member oversight panel is headed by Elizabeth Warren, a professor at Harvard Law School. But one member, Representative Jeb Hensarling, Republican of Texas, dissented from the report. The recommendations seem to advocate another bailout of a failed federal program with involuntary taxpayer capital, Mr. Hensarling said in a statement. The Treasury, in a statement, said its efforts had already helped stabilize the banking system and that programs to buy problem assets could be expanded quickly if necessary.
Americans working much harder – for less pay
Feel like you’re working a lot harder these days, putting in longer hours for the same pay — or even less? The latest round of government data on worker productivity indicates that you probably are. The Labor Department said Tuesday that the American work force produced, at an annual rate, 6.4 percent more of the goods they made and services they provided in the second quarter of this year compared to a year ago. At the same time, “unit labor costs” — the amount employers paid for all that extra work — fell by 5.8 percent. The jump in productivity was higher than expected; the cut in labor costs more than double expectations.
That is, despite the deep job cuts of the past year, workers who remain on the payroll are filling in and making up the work that had been done by their departed colleagues. In some cases, that extra work came with a smaller paycheck. The higher worker output and lower labor costs have been good news for companies struggling through the worst recession since World War II. So far, some 70 percent of companies in the S&P 500 have turned in better-than-expected profits for the latest quarter.
But wage cuts and lost paychecks could seriously jeopardize the recovery of a U.S. economy that still relies on consumer spending for two-thirds of its power. “You have a very severely harmed, injured consumer in terms of income slow down, job uncertainly, job loss, wealth loss, inadequate savings, high debt levels,” said Laura Tyson, an Obama advisor who headed the Council of Economic Advisors in the Clinton administration. “The consumer, I don’t see powering us out of this recession.”
Many economists believe the current recession is on the verge of ending. And if, as many expect, the economy begins expanding again in the second half of this year, companies may begin adding more shifts and re-hiring workers as demand for their products increases. That improving trend — a slowdown in the pace of the downturn — was confirmed in this month’s Adversity Index from msnbc.com and Moody's Economy.com, which measures the economic health of 381 metro areas and all 50 states. The index includes four components —employment, housing starts, housing prices and industrial production — and classifies each as being in recession, at risk, recovering or expanding.
So far, none of the areas is in the “recovery” stage. But according to the index, 85 metro areas are now in a "moderating recession" – up from 23 the month before. “A lot of these places were contracting at a much faster pace in the first quarter than they are now,” said Andrew Gledhill, an economist at Moody's Economy.com, which prepares the index. With job cuts slowing, corporate profits improving and the housing market showing signs of a bottom, many analysts are forecasting that U.S. Gross Domestic Product will turn positive again this quarter after a sharp over the past year.
Not so fast, say other analysts. “I think there's a lot of risks ahead," said Larry Lindsay, a private economist and Director of the National Economic Council under the Bush administration. “We still have a consumer balance sheet that needs repaired. We still have problems in the housing sector. We still have ultimately to get out of a massive amount of fiscal stimulus, a massive amount of monetary stimulus. And I agree with (Fed Chairman Ben Bernanke) those are technically possible to do. But they are not painless things to do. So I do think there a little bit of ebullience out there.”
Higher productivity cuts two ways. If we all get better at our jobs and use technology to increase how much work we can do in the same number of hours, our employers can afford to pay more and everyone’s living standard goes up.
The sharp drop in labor costs last month also makes it less likely that inflation will be a problem for the Federal Reserve — which has pumped over a trillion dollars of cash into the banking system to head off financial collapse. With inflation in check, that makes it easier for the Fed to keep interest rates low without sparking another round of inflation. “The combined efforts of workers and business to grind out solid productivity gains through the recession is unequivocally good news — an underlying reality of solid fundamentals that has been overlooked by the economic doomsayers and naysayers for many months,” said Brian Bethune, an economist at IHS Global Insight, in a research note Tuesday.
But this round of productivity gains has a darker side. The recent round of strong corporate profits, even as sales have fallen, came mostly from aggressive cost cutting that included huge rounds of layoffs and, for some employees still on the payroll, cuts in hours and wages. Some 7 million works have lost their jobs since the recession began in Dec. 2007. After healthy gains in the second half of last year, hourly compensation has dropped 2.2 percent so far this year — though it bumped up two-tenths of a percent in the second quarter.
Companies have also been slashing inventories to avoid getting stuck with unsold goods. If demand picks up again, rebuilding those inventories could provide a big boost to employment and wages, as companies begin to ramp up again to restock. But it remains to be seen when, and how strongly, that pickup in demand will happen. As paychecks evaporated and work hours shrank during the recession, Americans have hunkered down and begun saving more. The personal savings rate slipped to 4.6 percent in June, after rising to 6.2 percent in May, but it was still well above the 1 percent rate in 2008.
Higher savings will help rebuild batter retirement accounts. But it also creates a headwind for a pickup in consumer spending. That's troubling when you combine it with lower incomes, which are the engine of future spending. Personal income fell 1.3 percent in June, the steepest plunge in more than four years. Businesses have also been cutting new investment to the bone until they see convincing signs that the recession is finally over and sustainable growth is picking up. Others are hoarding cash to help them weather the ongoing economic storm.
“Right now we have to worry about enough demand in the economy,” said Tyson. “So if the private sector, particularly consumers, are going to be increasing their savings rate, for every dollar they receive they're going to be spending a little less and saving a little more.” Lower wages and higher savings leaves less money to buy the goods and services that will create demand. In the past, consumers who saw their household budgets squeezed managed to pay the bills by borrowing against their home equity or by running up credit card balances. But those options are available for fewer and fewer consumers.
“What our contacts tell us is that we probably have another round of credit card and consumer credit restriction coming,” said Lindsay. “And those (restrictions) have still not caught up to the rise in the unemployment rate and to the decline in FICO (credit) scores. … So I think we're probably in the fall going to see another round of credit tightening.”
And that means companies will continue to try to squeeze more out of fewer workers.
Stocks: The latest Fed bubble
The Federal Reserve has spent the past year cleaning up after a housing bubble it helped create. But along the way it may have pumped up another bubble, this time in stocks. To head off the worst downturn since the Great Depression, the central bank has slashed interest rates while funneling money to banks. The Fed has mostly won praise for its efforts. The pace of job losses has slowed, and there has been a modest recovery in output.
At the same time, stocks have bounced back with startling speed. Since global markets hit their bottom in March, the S&P 500 has jumped 51% -- even as the outlook for economic recovery remains dim. "This is the most speculative momentum-driven equity market since the early 1930s," Gluskin Sheff economist David Rosenberg wrote in a note to clients Monday. Of course, stocks have rallied in part because investors perceive the worst-case scenario -- a 1930s-style Depression -- is off the table. And while the gains have been remarkable, they come after an even bigger decline. The S&P is still down 16% since Lehman Brothers collapsed in September.
But while most people take the rise in stocks as a hopeful sign for the economy, some see evidence that the Fed has been financing a speculative mania that could end in another damaging rout. Recent weeks have brought huge rallies in some of the lowest-quality stocks -- including firms such as AIG, Fannie Mae and Freddie Mac that are being propped up by the government and are unlikely to return to health any time soon. What's more, this year has brought an 80% surge in emerging market stocks, while the dollar has posted a 10% decline since March. A declining dollar and surging emerging markets were the hallmarks of the credit-fueled bull run earlier this decade.
"We have put the band back together on a lot of this," said Howard Simons, a strategist at Bianco Research in Chicago. "That couldn't have happened without liquidity." Though liquidity is admittedly a nebulous concept, there's no question that central bankers around the globe have poured huge amounts of money into the markets to ease the financial crisis. Given free money, investors' appetite for risk shoots higher and they gobble up stocks. That's good, except when the outlook for economic growth doesn't seem to support the higher stock values.
"Many observers are wondering whether the strong stock market rebound since mid-March is already a forerunner of the next recovery or simply driven by a reflux of liquidity into riskier asset markets," Deutsche Bank Research analyst Sebastian Becker wrote in a report last month. Rosenberg, who notes that consumer credit has dropped an unprecedented five straight months, said it's far from clear the recession is over. He says the risk of a market relapse later this year is high.
Simons said another factor that could work against recovery is that short-term interest rates could soon head higher, judging by action in futures markets. That could raise companies' borrowing costs at a time when policymakers have committed to holding rates near zero to restore economic growth.
Fed officials have stressed that they will start to unwind their financial support programs at the earliest sign of inflation. Given the cost of cleaning up after the last bubble, Becker writes that "this time, policymakers are unlikely to remain inactive should they suspect the formation of another asset price bubble." But it's clear that bankers are loath to pull back on their support for the financial system before it's clear the economy has staged a stronger recovery. And the Fed has a long and painful history of ignoring asset price inflation.
"The central bankers have this textbook belief that the only inflation is the kind that appears in consumer price indexes," said Simons. "They don't believe what they're doing could cause an asset price bubble."
For now, Fed chief Ben Bernanke and other central bankers can console themselves for now with stable consumer price inflation readings in major economies. But comparing the bankers with a driver pulled over for speeding for the umpteenth time, Simons said, "At some point, you have to say maybe your speedometer's broken."
Fed Set to End Treasuries Purchases by Mid-September
The Federal Reserve is set to halt its purchases of up to $300 billion in U.S. Treasuries in mid- September as scheduled, and will probably announce the decision next week, two former central bank governors said. “They’re clearly not going to extend that program given the improvement in financial markets that’s going on,” said Lyle Gramley, senior economic adviser with New York-based Soleil Securities Corp. and a former governor.
Plans to buy as much as $1.25 trillion of mortgage-backed securities and $200 billion of federal agency debt expire at the end of the year, so the decision on whether to extend them may be delayed, former Fed Governor Laurence Meyer said in a report. The Fed lowered its main interest rate almost to zero in December, switching to asset purchases and credit programs as the main policy tools. The Federal Open Market Committee kept the asset purchase plan unchanged in June, and will consider the program at an Aug. 11-12 meeting in Washington.
The FOMC “is unlikely to extend the life of these programs, unless, of course, either the economy or the financial markets take a significant turn for the worse,” Meyer, vice chairman of St. Louis-based Macroeconomic Advisers LLC, wrote in a report released yesterday. “We therefore expect the FOMC to announce at its upcoming meeting that it will allow the Treasury purchase program to expire in mid-September.” While a few committee members may believe a decision on the bond purchases could be put off a month, “it would be extremely surprising if they left this to be made in September, which is right at the time the program is expected to end,” Meyer said in an interview.
“Given the worries in financial markets that the Fed might be monetizing the debt, the sooner they disabuse the markets of that notion, the better off they’ll be,” Gramley said. Some Fed officials signaled in June they didn’t favor expanding the Fed’s balance sheet further. “It would take a significant deterioration relative to our outlook for me to view our current policies as inadequate,” Chicago Fed President Charles Evans said. Richmond Fed Bank President Jeffrey Lacker said, “right now, I don’t see a reason to increase” bond purchases. “It is hard to justify becoming more aggressive with stimulus when the economy seems to be improving, many forecasters are revising forecasts upward and financial conditions have improved so sharply,” Meyer said in an interview.
Economic reports in the past few weeks have suggested that the deepest U.S. recession in at least five decades may be coming to an end. Former Fed Chairman Alan Greenspan said Aug. 2 that the recession seems to be ending and the U.S. economy may expand at about a 2.5 percent pace in the current quarter. Economists surveyed by Bloomberg News last month forecast growth of 1 percent in the July-through-September period. The U.S. economy contracted at a better-than-forecast 1 percent annual pace in the second quarter, the Commerce Department reported July 31. Stabilization of the housing market and consumer spending, a lessening of financial turmoil and increased government spending all suggest the recession may be close to ending.
Underwater Mortgage Holders Approach 25% as Home Prices Fall
Almost one-quarter of U.S. mortgage holders owed more than their homes were worth in the second quarter and that figure may rise to as much as 30 percent by mid-2010 as job losses and foreclosures climb, Zillow.com said. Homeowners are being hurt by price declines. The estimated median value for single-family houses slid to $186,500 in the period, a 12 percent drop from a year earlier and the 10th consecutive quarterly decrease, the Seattle-based real estate data service said in a report today.
“The negative-equity rate will rise and spin off more foreclosures,” Stan Humphries, Zillow’s chief economist, said in an interview. “I see a substantial downside risk to prices and don’t think we’ll see a bottom until the middle of next year.” The U.S. housing market is being hindered even as the pace of job cuts and price declines slows. Payrolls fell by 247,000 in July, after a 443,000 loss in June, the Labor Department said. Home prices in 20 major cities declined 17 percent in May from a year earlier, the smallest drop in nine months, according to the S&P/Case-Shiller index.
Home values dipped in the second quarter from a year earlier in almost 90 percent of the 161 U.S. metropolitan areas surveyed by Zillow, the company said. Twenty-three percent of mortgage holders were underwater at the end of June, Zillow said. The percentage of people owing more than their properties are worth may increase to almost half of U.S. mortgage holders before the housing recession ends, Deutsche Bank AG said Aug. 5. About 25 million homes, or 48 percent of mortgaged properties, will be underwater as prices drop through the first quarter of 2011, Karen Weaver and Ying Shen, analysts in New York at Deutsche Bank, wrote in the report.
A glut of unsold homes is also pushing down prices. The 3.8 million homes for sale in June would take 9.4 months to sell at the current pace of transactions, according to the National Association of Realtors. The inventory turnover rate averaged 4.5 months in the six years from 2000 to 2005. More than 18.7 million homes, including foreclosures, residences for sale and vacation homes, stood vacant in the U.S. during the second quarter. That compared with 18.6 million a year earlier, the U.S. Census Bureau said July 24. “We haven’t seen a bottom in home prices, and it could take into 2011 before we see equilibrium in the market,” said Michelle Meyer, an economist at Barclays Capital in New York.
In June, foreclosures accounted for 22 percent of total U.S. home sales, and 29 percent of homes sold were purchased for less than what the owner originally paid, according to Zillow. The unemployment rate declined to 9.4 percent last month from 9.5 percent in June. Values declined the most in Merced, California, tumbling 40 percent to an estimated $106,500, Zillow said. El Centro, California, followed with a 38 percent drop to $117,400. Las Vegas was third with a 35 percent decline to $140,500. Madera and Modesto, in California, sank 34 percent to $144,400 and 31 percent to $140,500, respectively.
Values decreased 12 percent to an estimated $361,000 in the New York City area; 12 percent to $318,000 in Washington; 15 percent to $393,800 in Los Angeles; 13 percent to $202,400 in Chicago; 6.4 percent to $316,000 in Boston; 4.6 percent to $132,600 in Dallas; and 15 percent to $490,500 in San Francisco, according to Zillow. Fayetteville, North Carolina, had the biggest increase in median value, rising 13 percent to an estimated $120,600. Oklahoma City gained 4.8 percent to $118,700; Binghamton, New York, advanced 4.5 percent to $112,300; Burlington, North Carolina, added 4.4 percent to $124,200; and Gainesville, Georgia, climbed 4.2 percent to $139,100, according to Zillow.
Japanese prices in record decline
Japanese wholesale prices were down by a record 8.5% in July compared with a year earlier, highlighting the growing deflationary pressure in the economy. Weak demand during the downturn and the fall in the price of oil have put downward pressure on prices. On Tuesday, the Bank of Japan kept interest rates at 0.1% to try to boost consumer demand. Revised figures also showed that industrial output rose 2.3% in June, down from the initial 2.4% estimate. Recent data showed consumer prices had fallen by a record 1.7% in the year to the end of June.
Although the impact of last summer's spike in the oil price will lessen towards the end of the year, analysts expect further falls in prices. "We're going to see increasing downward price pressure from weak demand," said Takesh Minami at the Norinchukin Research Institute. "The Bank of Japan has said that the country is not entering the deflationary spiral, so it won't ease monetary policy further. The bank will keep interest rates on hold at least until March 2011," he added.
Japan, the world's second largest economy, experienced a prolonged period of deflation in the 1990s, commonly referred to as "the lost decade". But the central bank is confident that low interest rates and the stimulus packages it has already implemented will prevent deflation taking hold again. However, in keeping interest rates on hold on Tuesday, the bank underlined its cautious outlook for the economy. It said conditions in the world's second-largest economy had stopped worsening, but that unemployment would stay high and consumer spending low. Last month, the bank forecast that Japan's economy would shrink by 3.4% in the 12 months to 31 March 2010.
Stimulus Funds Bring Relief to States, but What About 2010?
As states across the country grapple with the worst economy in decades, most have cut services, forced workers to take unpaid days off, shut offices several days a month and scrambled to find new sources of revenue. The good news is that much of the pain this year has been cushioned by billions of dollars of federal stimulus money, which has allowed states and localities to avoid laying off teachers, prison guards, police officers and firefighters.
The bad news is that for the next fiscal year, beginning in July, the picture looks even bleaker. Revenue is expected to remain depressed, even if the national economy improves. There will be only half as much federal stimulus aid available, and many states have already used up their emergency reserves. Most states have just approved a budget for the fiscal year that began July 1, and their legislatures have adjourned for the summer. But in a dozen or more states, those budgets have already gone into the red less than two months into the fiscal year, by a total of about $24 billion. More than 30 states are projecting deficits for next year, according to the Center on Budget and Policy Priorities, a Washington-based think tank, and other expert estimates.
The economic picture in state capitals has looked bad since last fall, when the national economy first went into freefall and many governors called their legislatures into emergency sessions to make drastic mid-year cuts for such things as health-care services and support for public colleges and universities. But as legislatures have just completed their regular budgeting process, the extent of the fiscal disaster is only now becoming clear -- and some are already talking about additional special sessions this fall, with more painful cost-cutting ahead.
Maryland, with a $1.9 billion budget, faces a $700 million gap, according to the Center on Budget and Policy Priorities. The District has a new $650 million budget with a $150 million shortfall. Virginia, with a $1.8 billion budget, also faces a new deficit, but the size has not been determined. For the next two fiscal years, the states face a combined budget shortfall of $350 billion, according to the center and the Council of State Governments, using roughly the same projections. "I think that states are going to have to look at revenue and programs across the board, or they're going to have to raise revenue in an anemic economic environment," said Chris Whatley, deputy executive director of the Council of State Governments. "Either way you look at it, it's going to be about tough decisions in state capitals."
Already, in California, the epicenter of the states' fiscal meltdown, domestic-violence shelters have been turning people away because state funding was eliminated, and some shelters have shut down. State funding has also been eliminated for several programs run through California's office of AIDS, and for a black infant health program that helps 6,000 African American pregnant women and new mothers statewide. "This is the worst I've ever experienced, and I've been with the County of Sacramento for 23 years," said Sharon Saffold of the county's health department.
State offices across Michigan were closed Friday, but not for a holiday. It was the fourth of six furlough days for more than 37,000 state workers, with two more shutdowns due before Labor Day. New Jersey Gov. Jon S. Corzine (D), struggling in a reelection campaign, recently signed a new $29 billion budget that was $1.5 billion less than the first budget he signed as governor four years ago. But even that was not enough to stop Moody's, the Wall Street rating agency, from downgrading New Jersey's credit outlook to "negative," citing the state's huge debt and the use of one-time budget gimmicks.
Even with the national economy showing signs of improvement -- joblessness for July had the smallest monthly loss for a year -- conditions for states and localities are likely to remain dire for some time, economists and experts said. The depressed value of housing will continue to mean lower revenue from sales taxes and property taxes. Also, continued high unemployment will mean reduced income-tax receipts, more expenditures for unemployment claims and more demand for "safety net" services.
Unlike the federal government, most state governments are barred by their constitutions from running a deficit or borrowing money to cover operating costs. Their only choices are to cut services further -- although most say programs already have been pared to the bone -- or to raise revenue in the form of new taxes or fees, something legislatures are loath to do in a recession. Already, to balance their fiscal 2010 budgets, governors have increased fees, raised sales taxes and imposed new taxes on high-income earners. New Yorkers will pay more for licenses to drive, hunt, boat and fish. New Jersey has raised taxes on cigarettes, wine and liquor. Other states are said to be considering expanding sales taxes to include such services as landscaping, pest control, cable television and diaper delivery.
This year, the federal stimulus package signed into law by President Obama in February served as a lifeline. For all the intense partisan debate in Washington over whether the stimulus so far has worked, in the states there is little question that federal cash has staved off catastrophe. According to the General Accounting Office's July report, by June 19 the federal government had disbursed $29 billion to the states, with 90 percent of that money going to Medicaid, to help states maintain coverage levels, or to help them stabilize budgets and avoid layoffs.
"The stimulus has had a tremendous effect in forestalling some of the worst cuts," said Elizabeth McNichol, a senior fellow with the Center on Budget and Policy Priorities. It's absolutely worked for the states." Whatley, of the Council of State Governments, said state deficits would be 40 percent worse if not for the stimulus funds. The federal funds have given states "breathing room," he said, but he added that "the stimulus cushioned the blow of the state fiscal crisis, but it didn't blunt it." The stimulus money "is helping California weather the worst fiscal crisis in recent memory," said H.D. Palmer, spokesman for the California Department of Finance. But Palmer said the crisis is far from over: "We hope that the worst of this recession is behind us, but whoever is the next governor will face continuing fiscal challenges."
On Friday, Corzine, who has had little good news lately, was able to announce that New Jersey had received $10.5 million in federal stimulus money for homelessness prevention, and that the state's community affairs department would immediately start taking applications from nonprofit groups and local governments. The money can go to people on public assistance or victims of domestic violence.
In Los Angeles, that kind of help is desperately needed.
A heavyset, hazel-eyed woman, originally from Texas, described last week how she and her 8-year-old son spent two weeks wandering Los Angeles's streets looking for room at a shelter. She said they spent days at a McDonald's restaurant trying to stay cool, and nights sleeping on a hand-sewn quilt under the 110 Freeway in South Central Los Angeles. The woman, who spoke on the condition that she would not be identified, said she was fleeing an abusive boyfriend who had beaten her for more than a year. She had hoped to move immediately into a shelter for abused woman but was regularly turned away. "They just didn't have room," she said in her Texas drawl.
The woman eventually found a place at the Jenesse Center, near South Los Angeles. But that shelter is now full and turned others away. With state aid eliminated, the Jenesse shelter lost 30 percent of its revenue -- money used to pay for diapers, baby formula, food, paint, and plumbing repairs. The staff, after layoffs, is nearly half the size it used to be at a time when the number of homeless people seeking shelter is growing. "It's devastating to the survivors and the victims who need these services," said Adrienne Lamar, associate director of the Jenesse Center. She said she knew of at least three other domestic-violence shelters that have closed. She added: "The potential outcome for this is deadly, just deadly."
Obama Proposes New Derivatives Rules
The Obama administration on Tuesday sent Congress legislation seeking to impose broad new oversight on derivatives, the complex financial instruments blamed for hastening the global economic crisis. The plan is designed to bring transparency to, and prevent manipulation in, a $600 trillion unregulated worldwide market. Credit default swaps, a form of insurance against loan defaults, account for about $60 trillion of that market. The collapse of the swaps brought the downfall of Wall Street banking house Lehman Brothers Holdings Inc. and nearly toppled American International Group Inc. last fall, prompting the government to support the insurance conglomerate with about $180 billion.
In a point long awaited by the financial industry, the plan defines types of derivatives broadly in a way it says will be "capable of evolving with the markets." The plan sent to Capitol Hill was the final section of the administration's sweeping legislative proposal for overhauling the U.S. financial rule book to help avert a repeat of the meltdown touched off last year. It capped a series of measures rolled out in recent weeks by the Treasury Department.
Under the proposal, the big investment banks that trade the derivatives would be subject to requirements for holding capital reserves against risk and other rules. A new network of clearinghouses would be established to provide transparency for trades in credit default swaps and other derivatives. All so-called "standardized" derivatives would be required to go through clearinghouses and to be traded on regulated exchanges or electronic trading systems.
Customized derivative products, by contrast, are designed for specific users in a transaction and would remain largely unregulated – a gap that some critics fear could allow abuses. The plan defines standardized derivatives broadly. An over-the-counter derivative that is accepted by an official clearinghouse would be presumed to be standardized. In addition, the Securities and Exchange Commission and the Commodity Futures Trading Commission would get authority to prevent attempts by market players to falsely portray derivatives as customized to skirt the oversight of clearinghouses and exchanges.
CFTC Chairman Gary Gensler recently estimated that about 80 percent of derivatives could be considered standardized under the plan. Late last month, two influential House lawmakers announced an agreement on guidelines for legislation to regulate derivatives, a proposal that closely resembles the administration's plan. Democratic Reps. Barney Frank, chairman of the House Financial Services Committee, and Collin Peterson, who heads the House Agriculture Committee, said the House could vote on a bill in September. Gensler on Tuesday called the administration proposal "a very important step toward much-needed reform to protect the American people."
TARP Oversight Panel Says Smaller Banks May Need Fresh Capital
Smaller U.S. banks may need $12 billion to $14 billion in additional capital to cope with troubled loans still on their books, the Congressional Oversight Panel said today in a monthly report. The panel, which reports to lawmakers and was created to monitor the $700 billion Troubled Asset Relief Program, said the biggest U.S. banks appear prepared to handle more loan losses, particularly the 19 banks that regulators put through stress tests earlier this year. Banks with assets of $600 million to $1 billion may face bigger challenges, the panel said.
Banks of that size “will need to raise significantly more capital, as the estimated losses will outstrip the projected revenue and reserves,” the report said, citing its own loan analysis. The panel is led by Elizabeth Warren, a law professor at Harvard University. The report said the Treasury and other regulators should do more to help smaller banks deal with whole loans on their books. The Treasury and the Federal Deposit Insurance Corp. program have shelved the Legacy Loans Program, intended to use a combination of public and private funds to buy loans from banks.
“Failure to start the Legacy Loan Program raises concerns about Treasury’s strategy,” the panel’s report said. Representative Jeb Hensarling, a Texas Republican who also is a member of the panel, dissented from the report’s findings. He said the loss estimates may not be accurate and shouldn’t be used to justify another round of government assistance.
“It is possible that the toxic-asset market is already beginning to heal itself and the intervention proposed by the panel could be inappropriate -- if not counterproductive,” Hensarling said. “I am not necessarily discouraged by the results for the smaller banks since it is entirely possible that the input assumptions used by the panel were excessively pessimistic.” Treasury Secretary Timothy Geithner pledged that the department remains a “hands-off” investor in banks and auto companies, according to a letter released as part of today’s report.
“With respect to Treasury’s relationship with financial institutions in which it holds a financial interest, Treasury is a reluctant shareholder,” Geithner said in a July 21 letter. “The government will not interfere with or exert control over day-to-day company operations and, in the event the government obtains ownership interests, it will only vote on core government issues.” The Treasury also told the panel it had no plans to extend a guarantee program for money market mutual funds that is scheduled to expire on Sept. 18. “The guarantee agreements do not provide for further extension of the guarantees,” the Treasury said in its comments.
A US Government Rescue for Commercial Real Estate?
The $3.5 trillion commercial real estate market is eroding, defaults are doubling on loans for apartment buildings, office buildings, housing complexes, strip malls, hotels, hospitals, and a staggering amount of loans must be rolled over this year into refinancings, or else go bellyup.
Prices in commercial real estate have fallen about 39% from the peak in mid 2007, according to the Massachusetts Institute of Technology's Center for Real Estate, with no signs of the plunge stopping. Data from Moody’s Investors Service show similar declines.
The 39% drop in commercial real estate prices has already eclipsed the 27% decrease during the S&L crisis of the late '80s to early '90s.
And the derivatives, the ticking time bonds built on the backs of these potentially Kryptonite loans, could deepen the crater already blown wide open on Wall Street by the more than $1.5 trillion in writedowns and losses taken so far in the housing and credit meltdown.
Big banks from Wells Fargo, Citigroup, Bank of America to Regions Financial, SunTrust, KeyCorp are already getting hit with losses in their commercial property book. Both Wells’ and Morgan Stanley’s most recent quarter suffered heavy losses from commercial real estate as bad loans surged.
Regions, Marshall & Isley, SunTrust, Zions, and Comerica all spilled red ink in their last quarters, and may report losses well into 2010 as they struggle to build bad loan reserves. Already, KeyCorp, Regions and Zions trade at half their book value on a hard asset basis (after stripping out intangibles like goodwill).
Other companies like General Electric, Marriott International and the government-run Fannie Mae and Freddie Mac are seeing hemorrhaging as well.
The problem now is, the US government, meaning taxpayers, may be called upon once again for even more bailout help for this struggling sector, beyond the $23.7 trillion in gross exposures already in the bailout programs to date (gross exposures are an Armageddon scenario, although they do show what the government has committed, according to the inspector general for the Troubled Asset Relief Program, Neil Barofsky).
To date, the government’s bailout programs have been hotly criticized for not being so cinematically picture perfect, although the stock market is behaving as if it was flawlessly executed.
About $1.4 trillion of commercial real estate mortgage loans will be maturing within the next five years, and as much as $750 billion will be maturing in less than three years, says Steven Sandler, chief executive officer of the private equity firm Crosswind Capital in Rye, NY. An estimated $165 billion to $204 billion in U.S. commercial real estate loans could be maturing this year alone, analysts estimate. All of these loans will likely need to be refinanced in an already jammed-tight lending market.
And Sandler notes there isn’t enough money on the sidelines, perhaps a maximum $250 billion levered off of $75 billion in initial capitalization, to take care of the looming problems. Banks and insurance companies don’t have the balance sheet capacity to refinance the maturing commercial loans, and the securitization is virtually moribund.
In Steps the Federal Reserve—Again
By expanding the Term Asset-Backed Securities Loan Facility, or TALF program, the Fed can offer loans at cheap rates to investors to buy commercial mortgage-backed securities, or CMBSs, and not just securitizations for consumer financings such as auto loans and student loans.
And it’s quietly doing just that, on top of the $6.8 trillion in gross exposures the central bank has already taken on in the bailouts.
The Fed last May said it would open the door on the TALF, which it has said may grow to $1 trillion in size, to commercial mortgage-backed securities (CMBSs) that were issued in 2009. The New York Federal Reserve is overseeing this bailout program.
Beginning June 1, commercial mortgage-backed securities (CMBS) qualified as eligible collateral for five-year loans under the TALF.
Additionally, the Fed said up to $100 billion in TALF funds will immediately be eligible for loans with five-year maturities. The TALF lets the Federal Reserve Bank of New York make loans secured by asset-backed securities rated triple A. Also, in the case of CMBS, the securities now can be backed by mortgages originated on or after July 1, 2008.
Getting help for the commercial loan securitization market “will be important in determining the overall success of the program,” New York Federal Reserve president and chief executive officer William Dudley says. Industry groups are now pushing for the government to extend this program, due to expire in coming months, through the end of next year.
The Credit Rating Wrench
However, on May 28, 2009, shortly after the Federal Reserve provided this hopeful news to the CMBS market, S&P tossed a wrench in.
S&P at the time warned that it might downgrade billions of dollars of triple-A rated CMBS bonds because of proposed changes in its ratings methodology.
Reason: S&P said the loans made from 2005 through 2007 featured "increasingly more aggressive underwriting" than those made in prior years.
That potentially meant that billions of dollars worth of bonds would be disqualifed for TALF bailout help, and writedowns loomed.
Spooking the credit markets further, on July 14, 2009, S&P cut the creditworthiness on 19 classes of a $7.6 billion deal commonly known as GG10 (sold by RBS Greenwich Capital and Goldman Sachs Group in 2007). S&P downgraded ratings on some classes of this deal all the way from triple A to just one notch above "junk" status.
S&P Reverses Course
Then, on July 21, 2009, S&P surprised the markets by reversing some of the CMBS downgrades that it had issued just a week earlier--including restoring some triple-A ratings which would then qualify those bonds for TALF funding.
S&P cited "recently updated criteria" for assessing losses on top-ranked CMBS bonds as justifying the ratings changes.
What about the other Government Bailout Program?
The TALF would work in sync with another US Treasury plan, the Public Private Investment Program, administered by the FDIC, which aims to move toxic assets, including commercial real estate loans, off bank books.
So far, financiers haven't shown much interest in either the TALF or PPIP for commercial real estate--analysts note the banks don't want to have to book the markdowns and are instead burying these assets in other line items to avoid the profit hits (see below).
The FDIC will lend qualified funds up to seven times the leverage in play to buy bank holdings, notes Barry Ritholz of the Big Picture Typepad, a heavily trafficked website with a big following on Wall Street (bookmark this site on your favorites list, it’s a highly intelligent, informative read).
“The United States is apparently going to use more leverage to work its way out of a situation created by using too much leverage. That seems a bit like trying to drink yourself sober,” notes Ritholz in his usual sherry-dry manner in his must-read book, “Bailout Nation,” (2009, John Wiley & Sons).
Looser Rules Help, But Can’t Stop the Problem
Also, the Financial Accounting Standards Board, the board that sets U.S. accounting standards publicly traded companies use to book their earnings, recently gave companies more leeway in valuing assets and reporting losses.
Essentially companies, notably banks, can ease up on having to mark to market certain assets quarterly if they can prove they plan to hold them to maturity.
As a result, banks have been rapidly submarining impairment charges on debt securities into other line items on their financial statements, including “other comprehensive income, arguing they intend to hold onto their damaged investments until maturity, says Michael Rapoport in the Wall Street Journal. Earnings are in turn protected by the move.
Jack Ciesielski of the Analyst’s Accounting Observer figures that, without the moves, 45 banks would have booked profits a median 42% lower, Rapoport says. Wells Fargo folded $664 mn in second quarter pre-tax impairment charges in to other comprehensive income to avoid the clip to earnings, on top of $334 mn in the first quarter, says Rapoport. The move also helps the banks avoid reducing their regulatory capital, Rapoport says.
Will These Moves Help?
Commercial real estate tends to lag behind housing, which means the second wave will roll out long after the housing crisis subsides.
Worth noting too is that the Office of the Comptroller of the Currency's Survey of Credit Underwriting Practices found that, although just 2% of banks were easing their underwriting standards on commercial construction loans in 2003, “by 2006 almost a third of them were relaxing.” That willy nilly granting of loans only exacerbates the problem--just like the no doc, no income loans of the housing crisis.
The commercial real estate market is paying the price for that hysterical blindness during the bubble, a bubble that is bursting now. The US economy, and the markets, are already bracing—for the worst.
The Gifts that Keep on Taking
by Michael Panzner
There have been plenty of discussions about how much the bailouts of the financial system will cost U.S. taxpayers, with estimates ranging from $2 trillion to as high as $24 trillion. But maybe the focus should be elsewhere. Even if we assume that the lower number is closer to the mark, these efforts have proved to be much more expensive than we were led to believe, and the resources committed so far have not achieved the results predicted by policymakers.
The truth is, while the banking system has -- until now, at least -- avoided financial Armageddon, conditions have not returned anywhere close to normal. Although equity investors seem to think that the worst is behind us, the banking sector remains in critical condition and dependent on the Federal Reserve for its continued survival. Meanwhile, many markets and financing mechanisms that Main Street has traditionally relied on are still frozen or broken.
Of course, our leaders in Washington will say their efforts have been successful because they prevented a full-scale meltdown of the financial system. What they forget to mention, however, is that the various bailout measures and the alphabet soup of support programs were not just put into place to stabilize the situation, as many now claim. They were supposed to get the credit system functioning again, to help revive a damaged economy.
In reality, that is is not where things stand right now. Reports indicate that lenders are tightening standards, jacking up interest rates and fees, arbitrarily slashing and cancelling credit lines, avoiding or refusing forebearance and other requests that might stir a still moribund housing market, and directing resources away from traditional lending activities towards speculative trading and other pursuits.
More galling to some, perhaps, is that instead of doing their part to counteract the rise in inequality they helped foster during the go-go years, which some observers feel contributed to the economic hole we are in right now, many financial institutions seem intent on exacerbating the disparity. They are reducing head counts among lower-paid staff and looking to boost the compensation of those who are already near the top of the pyramid, despite the unavoidable political fallout.
The fact that the mess has not gone away and is still festering in many parts of the financial world, can't just be blamed on Wall Street, of course. In some cases, government moves to "fix" things have had the opposite effect, allowing already formidable losses to grow even larger.
Examples include the bailouts of Fannie Mae and Freddie Mac, each of which continues to bleed red ink in part because serious structural problems have not been addressed and there is no real accountability or plan of action associated with previous efforts. Just this past week, for example, Fannie Mae announced plans to tap nearly $11 billion in new aid after posting yet another massive quarterly loss, the Associated Press reported. bringing the total taxpayer commitment to nearly $96 billion for these two institutions alone.
Government-sponsored efforts to repair the damage in the financial world aren't the only area where the law of diminishing -- or even negative returns -- seems to apply. Consider the $787 billion stimulus package, which proponents claimed would get the economy moving again and stem the rising tide of unemployment. So far, at least, there's no real sign that we are getting our money's worth.
In fact, while many analysts cheered July's "better-than-expected" 9.4 percent unemployment rate and 257,000 drop in nonfarm payrolls, the truth is that we are still seeing a growing number of Americans without a job. Clearly, it doesn't make sense to exclude the record numbers of long-term unemployed or those who have thrown in the towel on finding work, as some Pollyanaish economists and policymakers have done, in assessing whether taxpayer funds are producing the desired results.
The cash-for-clunkers scheme -- to use what some might view as an entirely appropriate British synonym for "plan" -- represents yet another problem-solving attempt that could end up costing much more than the $1 billion -- plus the $2 billion just approved by Congress -- that the government has committed. Among other things, it draws funds away from many equally needy parts of the economy to help one politically-connected segment. It is also a quick fix that postpones much needed restructuring and has likely brought forward future sales that leave the industry vulnerable if, as I believe, the recent bounce proves short-lived.
Yet, instead of going back to the drawing board, analyzing where mistakes were made during the heat of the moment and thinking things through a bit more carefully, Washington has decided to adopt the young entrepreneur's mantra: If at first you don't succeed, try, try again -- and fast. While such a strategy might make sense where there is some credible basis for optimism, more than a few policymakers have admitted they are operating in uncharted territory and can't be sure any of these efforts will really succeed.
If there is a consistent theme to all of this, it is that Washington seems determined to commit more and more taxpayer funds on a moment's notice and with little to show for it. In fact, now that we have seemingly crossed the rubicon into a world where many are convinced that it is only governments, with their control over the public purse strings, that can solve all our problems, we've effectively settled for just one thing: the "gifts" that keep on taking.
Doomsday -- pros and cons
Two major entrepreneurial tycoons, in the multibillion-dollar league, with worldwide interests, speaking not for attribution, agree that the worst is yet to come. America has to reinvent itself for the 21st century, but this won't happen before another big credit-rattling shock. Millions of jobs are not coming back, they said. They were speaking about the current global financial and economic crisis.
Another humongous credit crunch is on the way, they believe, and the current optimism is simply a pause before another major downward slide. Unemployment, they forecast, will climb from the low to the high teens. A pledge to limit tax increases to those making more than $250,000 a year is a pipe dream. Someone has to pay the health piper. Major social dislocations are on their horizon for 2010.
One of the interlocutors has shunned all manner of stocks in favor of discounted corporate bonds that yield 7 1/2 percent, and gold. The other has already moved all his financial holdings into a cocktail of Asian currencies based at a new entity he created in Singapore.
"We are roughly where Britain was in 1968," said one. That year Prime Minister Harold Wilson decided to abandon all of Great Britain's obligations east of Suez. That included the entire Persian Gulf, from Oman to Kuwait, the Strait of Hormuz, British special agents in all the emirates and sheikhdoms, local constabularies with British officers, the fabled Trucial Oman Scouts (TOS) -- all for the bargain basement cost of $40 million a year.
As the British and other colonial empires faded into history, America's global empire grew topsy-turvy and since the collapse of the Soviet empire in 1989, its power grew unchallenged. The two tycoons, who did not wish to be quoted, agreed with a rapidly growing segment of the U.S. population that says America can no longer afford the astronomic costs of empire.
With more than 2.5 million U.S. military personnel serving across the planet and 737 military bases spread across each continent, and 3,800 installations in the United States, a reassessment of roles and missions is long overdue. The estimated $1 trillion in overdue infrastructure repairs and modernization strikes many as an overdue priority.
The 2010 defense budget is a shade shy of $700 billion, more than two-thirds of a trillion dollars, which now tops the rest of the world -- including major players Britain, France, Germany, Japan, Russia, China, India -- put together. Add all the defense expenditures neatly tucked into the budgets for Energy, State, Treasury, Veterans Affairs, and 16 intelligence agencies, and the numbers top $1 trillion.
With only 5 percent of the world's population, it is still remarkable that the United States can maintain global military superiority on less than 5 percent of gross domestic product. But from the world's biggest creditor, the United States has become the world's largest debtor, coupled with a rapid decline of a manufacturing sector once hailed as the arsenal of democracy and an annual per capita trade deficit of $2,000 per citizen.
U.S. share of global output continues to decline from year to year. Like General Motors Corp. and Ford, the United States has yielded share of the global market from one-third at the turn of the new century to one-quarter today. Was the rise of the rest the decline of the West?
Have U.S. commitments and responsibilities outstripped resources? The two anonymous billionaire voices were among the many now saying so in public opinion polls. They feel a paradigm shift is inevitable. We are yet to wean ourselves from the old paradigm: the $3 billion we borrow each and every day -- principally from China -- to maintain the world's highest standard of living, based on conspicuous consumption, at a time of growing world shortages. And when we are finally weaned, it will become glaringly obvious that we were living way beyond our means and that major belt-tightening is long overdue.
In his projections through 2025, Thomas Fingar, the former chief analyst for the 100,000-strong U.S. intelligence network, which includes 16 agencies with a budget of $50 billion, predicted the international system would be transformed over the next 15 years as dramatically as it was after World War II. As China rises to global prominence, the United States would be declining. "In terms of size, speed and directional flow," wrote Mr. Fingar, "the transfer of global wealth and economic power now under way -- from West to East -- is without precedent in modern history."
Following Mr. Fingar's analysis, former deputy Treasury Secretary Robert Altman wrote in Foreign Affairs, the official organ of the Council on Foreign Relations, that the current financial crisis is "a major geopolitical setback for the U.S. and Europe" that could only accelerate trends that are moving the global center of gravity to China. And this is something that a staggering $1 trillion for defense (in a budget with a projected $2 trillion federal deficit) would be powerless to reverse.
The pessimistic outlook should, of course, be tempered by the fact that IBM spins off more technology patents in a typical year than all of China. Three-quarters of the world's top universities are in America. So any loss of influence is at this stage attributable to reckless profligacy at every level of American society, beginning with the federal government and the mind-numbing bonuses that Wall Street's "Masters of the Universe," as Tom Wolfe called them in his 1987 best-seller "Bonfire of the Vanities," have lavished on themselves Roman Empire-style.
Both global entrepreneurs mentioned at the beginning of this column believe Israel will resolve its existential crisis by bombing Iran's key nuclear facilities later this year. One thought Gulf Arabs would be secretly delighted and that Iran's much vaunted asymmetrical retaliatory capabilities would fizzle as the theocracy imploded. The other could see mayhem up and down the Gulf, the Strait of Hormuz closed, and oil at $300 per barrel.
Building resilience to shocks
By any measure, losses from the financial crisis are colossal. Bank write-downs and losses currently total more than $1,500bn. The IMF has predicted losses across the financial services industry could eventually total $4,000bn, or nearly one-third of US GDP. The impact, however, is not just monetary. Banks’ ability to carry out their primary economic function has been questioned. Regulators have proposed more rigorous bank supervision, tighter risk management and higher capital requirements.
While important in the new financial architecture, the problem we face is wider than new?bank rules.?The current policy?debate fails to address key elements of the crisis: the asset-backed securities market collapse, financial markets interdependence and a largely pro-cyclical regulatory framework. These three factors combined toppled the risk management of many banks, led to huge write-downs and severed the lending capacity so critical to economies. We must shift the debate to these factors and not let the symptoms of the crisis overshadow the causes.
Looking first at the asset-backed securities market in the US, banks hold about $2,700bn of the $11,000bn mortgage market on their balance sheets. This leaves a substantial gap that banks cannot fill and private investors are currently unwilling to plug. It is essential we rebuild investor confidence to restore the ABS market and, with that, lending capacity. But we must first understand why this market collapsed under stressed conditions yet the equities, fixed-income and forex markets continued to operate. In short, it is because the ABS market lacked transparency, liquidity and standardisation. As we saw during the Great Depression, the absence of these factors destroyed investor confidence.
The Roosevelt administration fixed the US equity market in 1934 with the introduction of the Securities Exchange Act, drafted by Professor James Landis. Liquidity was generated through mandatory listing of equities, transparency created via ongoing disclosure requirements and standardisation eventually brought in through generally accepted accounting principles. We should learn from earlier pioneers in financial regulation. Providing new legislation or accounting rules could create standard ABS structures.
This would facilitate trading by market makers to generate liquidity. And service providers could produce a “live” prospectus by pooling performance data of the underlying assets to create transparency. As a result, investors could finally make “educated” decisions on their ABS portfolios. Simultaneously, we must eliminate the interdependence between financial institutions so that banks can fail without bringing down the?entire?system.?These interconnections occur on several levels.
First, payment and settlement processes, now run through banks’ balance sheets, must be bankruptcy remote. To do this, we could replicate the way national power grids are run, with settlement systems licensed by central banks to individual institutions. Importantly, the payment flows would not be part of banks’ balance sheets.
Second, we must continue to move the clearing of over-the-counter derivatives to central clearing counterparties across all OTC asset classes.
Third, to protect bank customers, we must standardise deposit insurance schemes. These schemes must include an accelerated process ensuring deposits are returned to customers instantly – rather than within weeks – of a bank failing. We must also create a process for the safe unwinding of banks.
For cross-border banks, this may require a new international regime, like we have for trade with the WTO, to ensure a fair mechanism for unwinding across jurisdictions. A bank would then be able to fail and the impact would only be borne by shareholders and bondholders, while avoiding any spillover to the wider market and insulating taxpayers. Our societies cannot afford the moral hazard of an institution being “too big to fail”.
Finally, our current regulatory and accounting systems are mostly pro-cyclical, exacerbating the crisis. For example, fair-value accounting facilitated the boom and growth of leverage on the upside and accelerated the bust on the downside. Better counter-cyclical proposals – such as more and better quality capital, stricter criteria regarding fair value for illiquid trading instruments, and dynamic provisioning – are already on the table and should be implemented with urgency. By fixing the ABS market, eliminating interconnectivity in the banking industry and utilising counter-cyclical measures, we will build a financial infrastructure more resilient to the systemic shocks of the future. Only with these measures in place will we restore investor and public confidence.
Judge Attacks Merrill Pre-Merger Bonuses
Reigniting a major controversy over Wall Street pay, a federal judge on Monday sharply criticized the bonuses that Merrill Lynch hurriedly paid out before it was acquired by Bank of America last year and pointedly questioned a federal settlement that had seemed to put the issue to rest.
A week after the Securities and Exchange Commission announced that it had settled the matter, Judge Jed S. Rakoff questioned whether the $33 million agreement with Bank of America was adequate. He refused to approve the deal, saying too many questions remained unanswered, including who knew what and when about the controversial payouts.
His ruling prolongs what has become a major embarrassment for Bank of America and its chief executive, Kenneth D. Lewis, and also deals a stinging blow to the S.E.C., which needs Judge Rakoff’s approval of its deal with the bank. Judge Rakoff ordered the bank and the commission to submit more information to him within two weeks. During a hearing in New York that was heated at times, the judge was scathing about the settlement, in which the S.E.C. accused Bank of America of misleading its shareholders. Bank of America neither admitted nor denied wrongdoing.
Bank of America and Merrill Lynch, Judge Rakoff said, “effectively lied to their shareholders.” The $3.6 billion in bonuses paid by Merrill as the ailing brokerage giant was taken over by the bank was effectively “from Uncle Sam.” The Merrill bonuses, which were the subject of a state investigation and prompted an outcry in Congress, were paid even though Merrill Lynch lost $27 billion last year. Its deepening red ink later forced Bank of America to seek a second taxpayer-financed bailout “Do Wall Street people expect to be paid large bonuses in years when their company lost $27 billion?” the judge asked.
Judge Rakoff, who took an active role in the S.E.C.’s case against WorldCom, is yet another voice in a growing chorus of critics of the Bank of America-Merrill deal, which was forged in the heat of the financial crisis last fall. Both the S.E.C. and Bank of America defended the settlement. The bank’s fine, however, represented a small fraction of the bonuses paid out by Merrill Lynch, a fact the judge and other critics seized on. In fact, at least one individual at Merrill Lynch collected a bonus totaling more than that amount.
The judge characterized the $33 million fine as “strangely askew” given the accusations made, the magnitude of Merrill’s losses and the subsequent bailout for Bank of America. The judge questioned the role of top executives at the companies, in particular Mr. Lewis and John A. Thain, the former chief executive of Merrill Lynch, both of whom signed off on a proxy statement to investors. “Was there some sort of ghost that performed those actions?” Judge Rakoff said.
The S.E.C.’s complaint focused on a document that detailed the bonuses, but which was not included in the merger agreement or proxy statement that was sent to the companies’ shareholders, who voted to approve the merger on Dec. 5. The S.E.C.’s lawyer, David Rosenfeld, said repeatedly during the hearing Monday that the agency had chosen not to make allegations against individuals in the case.
Mr. Rosenfeld spoke softly and was called up to the microphone after Judge Rakoff criticized the S.E.C. for the evidence it had presented — or failed to. The judge said the commission was remiss for not determining who at the companies decided not to disclose the bonus agreement. And he suggested that they should have interviewed the external lawyers for both companies. “You filed a rather uninformative, bare-bones complaint,” Judge Rakoff said.
Lewis J. Liman, a lawyer representing Bank of America, told the judge, when prodded, that the bank believed it had not wronged its shareholders. Mr. Liman, son of Arthur L. Liman, the lawyer who led the Iran-contra investigation in the Senate, seemed at times dismissive, saying at one point: “My God! Bonuses on Wall Street? It is not a matter of surprise.”
Merrill had little choice but to pay many of the bonuses, Mr. Liman said. Of the $3.6 billion, Merrill had committed $850 million in the form of guaranteed bonuses. Mr. Liman said the rest of the money was shared among 39,000 workers who received average payments of $91,000 — though he did not mention that there were 696 people at Merrill who made more than $1 million in bonuses. “I’m glad you think that $91,000 is not a lot of money,” the judge said. “I wish the average American was making $91,000.” Mr. Liman agreed that $91,000 was quite a lot.
Judge Rakoff said he might hold another hearing to consider evidence of whether the bonuses were needed. He said he might want to know if Merrill’s management studied how many of the roughly 39,000 bonus recipients would have left had they not received their payouts. Mr. Liman said the bank could prove in litigation that there were a number of companies that might have hired Merrill’s employees.
Mr. Rosenfeld of the S.E.C. said he had based the fine in part on a case the agency filed against Wachovia over disclosure issues in 2001. That case involved disclosure of a stock buyback program that cost $500 million. The lawyer for Bank of America periodically whispered what appeared to be suggestions to Mr. Rosenfeld. One point that Mr. Liman emphasized was that the $3.6 billion was paid with funds other than the federal bailout money, and he said that if the bonuses were a problem simply because of the bank received aid, other banks that had received bailouts might face similar allegations.
The judge was unmoved. “Money is money, the last time I checked,” Judge Rakoff responded.
Bankruptcy Filing Near for Taylor Bean
A bankruptcy filing is "imminent" for Taylor, Bean & Whitaker Mortgage Corp., lawyers representing the mortgage lender said in a federal court filing last week. The motion, submitted in the U.S. District Court for the Northern District of West Virginia, was filed on Aug. 6, one day after the privately owned Ocala, Fla., company ceased its lending operation and dismissed most of its work force. Meanwhile, an internal email at Taylor Bean dated Monday, Aug. 10, referred to a new computer folder "to assemble all of our bankruptcy detailed spreadsheets and support."
Taylor Bean shut down its lending operation on Aug. 5, the day after the Federal Housing Administration suspended the bank from submitting loans to the government for backing. Ginnie Mae, a federal agency that guarantees payments on mortgage securities backed by FHA loans, took away Taylor Bean's rights to service those loans. Taylor Bean relied heavily on income from servicing FHA loans, which involves collecting payments from borrowers and handling other administrative tasks. Taylor Bean executives have said the company would continue to service other loans for now.
Taylor Bean executives didn't respond to requests for comment Tuesday. Taylor Bean was the 12th largest U.S. home mortgage lender in this year's first half, according to Inside Mortgage Finance, a trade publication. The company originated most of its loans through smaller mortgage banks, brokers and community banks. Its troubles have forced those firms to scramble for new mortgage-lending partners.
Taylor Bean's Shutdown Hobbles Manufactured Housing
Mortgages for manufactured homes have almost disappeared. Suspecting fraud, the government last week banned Taylor, Bean & Whitaker -- the No. 1 source of financing for manufactured housing -- from making any more federally insured loans. Manufactured homes have long been the first step toward homeownership for low-income Americans, and mortgage brokers are struggling to find new sources of funding from a pool of lenders that has shrunk dramatically during the past several years.
Taylor, Bean & Whitaker funded nearly 13 percent, or $1.45 billion, of all manufactured home loans insured by the Federal Housing Administration in 2007, the most recent data available. The Housing and Urban Development Department said the company failed to submit a required financial report, raising fraud concerns. The company was also barred from issuing mortgage-backed securities for the Government National Mortgage Association, or Ginnie Mae.
The lender's exit is a ''detriment'' for this low-cost housing segment, said Thayer Long, executive vice president of the Manufactured Housing Institute. ''Hopefully, other lenders will pick up the slack where it left off.'' But the next largest lenders -- Wells Fargo Bank, Countrywide Home Loans (now owned by Bank of America) and JP Morgan Chase Bank -- aren't as active anymore, said Adam Stein, executive vice president of Cascade Pacific Mortgage Co. in Auburn, Wash. And fewer competitors will mean higher interest rates, he predicted.
Under the FHA program, Taylor, Bean & Whitaker offered loans to borrowers who could only afford to put down about 5 to 10 percent of the purchase price of their home. The interest rates on manufactured home loans also remained affordable under the government program, currently about 5.75 percent. One of Stein's clients signed loan documents with Taylor, Bean & Whitaker a week before the government raided its Ocala, Fla., headquarters. Stein scrambled and found a local lender to finance the loan. ''I'm doing my best to weather the storm,'' he said.
Manufactured houses, which are factory-built in parts and then put together at a land site, are significantly less expensive than traditional homes. The average price for a manufactured home last year was $64,900, less than a quarter of the average price of $292,600 for a single-family home, according to the Commcerce Department. ''It's often an entry-level purchase,'' said Pava Leyrer, president of Heritage National Mortgage in Grandville, Mich. ''And this has cut out an entire population of consumers who don't have large down payments.''
Owners of existing manufactured homes also may find no one to refinance their existing loans, Leyrer said, keeping them from taking advantage of lower interest rates. Taylor, Bean & Whitaker's disappearance is just another blow to a segment of the housing market that sank into turmoil long before the rest of the industry. During its heyday in the late 1990's, close to 400,000 new manufactured homes were sold annually. Last year, only 80,000 were sold. ''The manufactured housing loan market was in the toilet well before the housing crisis,'' said Guy Cecala, publisher of trade publication Inside Mortgage Finance.
Investors and lenders fled the manufactured housing market at the beginning of the decade when the industry experienced its own credit catastrophe. Banks, including big names like Wells Fargo and Bank of America, offered loans to manufactured housing borrowers with riskier credit. What followed sounds strikingly familiar: Foreclosures of manufactured homes soared; lenders took huge losses and eventually exited the market entirely. That left only a few players, led by Taylor, Bean & Whitaker, to pick up the bulk of the business. The company said last week it expects to continue servicing existing mortgages as it restructures its operations.
Lehman Contract Is Test Case for Billions of Dollars of Swaps
A U.S. bankruptcy judge may have a controlling say in resolving a dispute in a U.K. court between Lehman Brothers Holdings Inc. and a Bank of New York Mellon Corp. unit over a swap agreement that could affect billions of dollars of similar contracts. At issue is who under U.S. bankruptcy law gets paid first under two swap agreements related to Lehman’s so-called Dante program of credit-linked notes -- Lehman or investors who bought the notes. Lehman lost under U.K. contract law. The U.K. judge left the question of U.S. bankruptcy law open as Lehman appeals his ruling.
“This issue has never been tested in court in the U.S.,” said Guy Dempsey, co-chair of the derivatives group at the law firm Latham & Watkins LLP. Lehman, the investment bank liquidating in bankruptcy, says it is owed $70 million on the swaps and wants to get paid. BNY Corporate Trustee Services Ltd., acting for the note-holders, wants the case dismissed and cites a U.K. judge who said last month that note-holders are entitled to the payments under U.K. law now that Lehman is bankrupt.
The case, being considered in bankruptcy court in New York today, may affect many other swap agreements designed like Lehman’s, which includes an indenture and a sequence of payments, Dempsey and other experts said. Terms of the two Lehman transactions, named Dante after the entity that issued the notes, specify that investors have first claim on whatever money is available if Lehman defaults or goes bankrupt. While the U.K.-based contract favors the noteholders, U.S. bankruptcy law normally protects a debtor company’s assets. Lehman is asking the bankruptcy judge to rule in its favor.
Not yet tested is whether U.S. law permits the investors to use a written contract to give themselves priority claims after a bankruptcy. In the U.K., the related case was brought against Lehman by a trustee for Australian note-holders, Perpetual Trustee Co. Rating agencies could start to downgrade credit-linked notes if the bankruptcy judge says Lehman can take away assets protecting the investments, debt research firm CreditSights Inc. said in a July 12 report. Insulating such deals from bankruptcy “forms the bedrock of securitization, CreditSights analyst Atish Kakodkar said in the report.
Lehman had a similar tussle last month in the U.S. over who owed what to whom with Metavante Corp., a company involved in another swap agreement. U.S. Bankruptcy Judge James Peck, in charge of Lehman’s bankruptcy, said in that case that he believed Lehman should be paid. He postponed a decision until September to give the opponents time to settle the issue themselves, Dempsey said. Last September, Lehman filed the biggest U.S. bankruptcy ever with assets of $639 billion. It sued Bank of New York on May 20 over payments related to the credit-linked notes, issued by an entity it set up, Dante Finance Public Ltd. “The bankruptcy code protects debtors from being penalized for filing a Chapter 11 case, notwithstanding any contractual provisions or applicable law that would have that effect,” Lehman said in its complaint.
Buffett's Payouts Climb on Derivatives Tied to High-Yield Corporate Debt
Warren Buffett’s Berkshire Hathaway Inc. had to increase payouts on credit derivatives backing junk debt as the recession forced more companies into default. Berkshire paid about $825 million on the contracts in the second quarter and $350 million in July, compared with $675 million in the three months ended March 31, the company said in a regulatory filing last week. Buffett has paid out more than half of the $3.4 billion in upfront fees his Omaha, Nebraska- based firm got on the contracts through the end of 2008.
The 78-year-old billionaire’s bet that he could outwit traders he once derided as “geeks bearing formulas” may be foiled by the biggest surge in corporate failures since at least 1970 and a plunge in the amount investors recover after default. Buffett has said Berkshire may lose money on the derivatives tied to high-yield, high risk debt, which typically last about five years. “We effectively had a near-collapse of the system and default rates spiked and recoveries were extremely low” after the failure of Lehman Brothers Holdings Inc. last September, said Mikhail Foux, a credit strategist at Citigroup Inc. in New York. “That effectively killed this strategy” used by Buffett.
Buffett agreed in some trades to take the first losses if companies in high-yield indexes default, betting that upfront fees would exceed payments he had to make. He said in letters to shareholders that traders relied on models that created “wildly mispriced” trades. Buffett manages the trades personally, he said in the 2006 annual report, and Berkshire may also profit from investing the premiums. Buffett didn’t respond to requests for comment left with assistant Carrie Kizer. He disclosed the latest figures on the swaps in an Aug. 7 filing in which Berkshire said that second- quarter net income gained 14 percent to $3.3 billion on separate derivatives tied to equity markets.
Berkshire typically guaranteed the debt of groups of 100 companies for five-year periods. The first swap expires Sept. 20 and the last one matures in December 2013, Buffett said in his most recent annual letter. In a worst-case scenario, Berkshire would face a maximum of about $6.4 billion in additional payments, according to the Aug. 7 filing. At one point in 2005, Berkshire had been paid an average of 75 percent of the maximum loss upfront to take on such risk, according to Janet Tavakoli, founder of Tavakoli Structured Finance Inc. in Chicago, who wrote about Buffett’s credit swaps trades in her 2009 book “Dear Mr. Buffett: What an Investor Learns 1,269 Miles from Wall Street.”
Holders of debt issued by non-financial companies recovered an average of 45 percent during the past two recessions, according to Moody’s Investors Service. That means Buffett in 2005 was getting paid an average 75 cents on the dollar to back bonds that, if they defaulted, typically lost 55 cents on the dollar during the last two slumps. “People say he doesn’t understand derivatives,” Tavakoli said in an interview before the second-quarter results were announced. “He very much does know what he’s doing, but you have to be aware in any investment, the best you can do is build in a margin of safety.”
Historical assumptions failed in the crisis that toppled Lehman, pushed insurer American International Group Inc. to the brink of bankruptcy and sunk the global economy into the worst recession since the 1930s. Swaps sellers had to pay an average of 83.4 cents on the dollar to settle contracts on 26 companies this year, according to data from Markit Group Ltd. and Creditex Group Inc., which administer the auctions in which dealers set the payout levels. That means the recovery averaged 16.6 cents.
In January, six of the companies whose debt Berkshire had guaranteed defaulted, the company said in a filing, without naming the issuers. BH Finance LLC, a Berkshire unit, signed up for auctions in January allowing it to settle swaps linked to six borrowers including packaging-maker Smurfit-Stone Container Corp. and telephone-equipment company Nortel Networks Corp. Sellers of swaps on Chicago-based Smurfit that signed up for the auction had to pay more than 91 cents on the dollar to settle the contracts. The payout on Nortel was 88 cents per dollar. During an auction to settle contracts on Lyondell Chemical Co., which BH Finance also signed up for, the payout was set at 84.5 cents. Junk bonds are those rated below Baa3 by Moody’s Investors Service and BBB- by Standard & Poor’s.
Berkshire paid $97 million on its high-yield swap contracts in 2008, when Buffett was more optimistic about his bet. “I told you a year ago that I thought we would make money on those, but we have run into far more bankruptcies in the past year,” Buffett said in Omaha at Berkshire’s annual shareholder meeting in May. “I would expect those contracts to show a loss before investment income, and perhaps after.” Berkshire posted a $391 million second-quarter gain on all of its credit-default swaps trades, as the market value of the underlying debt improved. The figure may includes bets on investment-grade corporate bonds and states and municipalities, in addition to junk borrowers. In the first quarter, the swaps reduced earnings by about $1.3 billion.
Projecting Buffett’s future losses is difficult because he doesn’t name the companies on which he placed bets, disclose terms of his trades or say whether he has hedged against any losses, Foux said. Buffett may have fared better than investors that made similar trades using benchmark indexes that are created by the banks that dominated trading in the credit-default swaps market. A trader that bought the riskiest piece of the Markit CDX North America Investment Grade Index Series 9, for example, already would have been wiped out, Foux said.
Buffett participated in the market for derivatives including credit swaps after decrying them in a letter to shareholders in the 2002 annual report as “financial weapons of mass destruction” because investors were piling on a “massive amount of uncollateralized receivables” with the trades. Berkshire demands that its trading partners pay upfront premiums and only a “small percentage” of the contracts require the firm to post collateral when the market moves against them, he said in his letter this year. AIG, once the world’s largest insurer, was undone by its credit derivative bets because the New York-based company couldn’t meet collateral demands from trading partners after prices on the underlying debt plunged. Berkshire “always holds the money, which leaves us assuming no meaningful counterparty risk,” Buffett told his shareholders in February.
'All Fake': Key Madoff Executive Admits Guilt
A key lieutenant of convicted Ponzi-scheme operator Bernard Madoff pleaded guilty to multiple counts of fraud, becoming only the second person after Mr. Madoff to admit to complicity in the multibillion-dollar fraud. Frank DiPascali Jr., 52 years old, pleaded guilty to 10 criminal charges at a hearing in federal court in lower Manhattan in New York and was immediately sent to jail.
A Securities and Exchange Commission civil complaint also filed against Mr. DiPascali on Tuesday offers the most vivid description yet of the inner workings of the fraud, the extent Mr. Madoff, Mr. DiPascali and others allegedly went to avoid detection and how it ultimately collapsed. It details how Messrs. DiPascali and Madoff, with others, contrived to convince regulators, investors and even visitors to their office that trading was happening, when it wasn't.
"It was all fake; it was all fictitious," said Mr. DiPascali in court. "It was wrong and I knew it at the time." The plea could prove bad news for others under investigation in the case, which have included Madoff family members, employees and some large investors. Mr. DiPascali is cooperating with prosecutors from the U.S. attorney's office in Manhattan, and he may be able to lend support to document-based evidence that suggests some of Mr. Madoff's highest-profile investors knew about a fraud, people familiar with the matter say. In their criminal complaint Tuesday, prosecutors said the scheme included unnamed "co-conspirators" besides Mr. Madoff.
While Mr. DiPascali faces a maximum of 125 years, he will likely receive less based in part on his level of cooperation. "I know my apology means almost nothing. I hope my actions going forward with the government will mean something," he said. "I hope my help will bring some measure of comfort to those who have been harmed." Sentencing for Mr. DiPascali, of Bridgewater, N.J., is on hold pending the outcome of his cooperation, with lawyers and prosecutors expected to update the court on his status in May 2010. A long stretch before a sentencing isn't unusual for those who cooperate, who often are sentenced after a case in which they are a witness is resolved.
Mr. DiPascali, a college dropout, joined Mr. Madoff's firm in 1975 at age 18 and was later a key executive overseeing the bulk of the day-to-day operations of Madoff's investment-advisory business on the 17th floor at the firm's offices, where the fraud occurred, the SEC complaint said. Mr. DiPascali was the person many of Madoff's investors dealt with regarding their accounts. He said in court he believed he worked for a prestigious, successful Wall Street firm, with Mr. Madoff as his mentor. But he came to learn in the late 1980s or early 1990s that no trading was occurring in Mr. Madoff's investment-advisory client accounts.
He admitted to helping perpetuate the illusion of a trading operation by lying to clients and creating fake client documents to reflect the "specific rate of return" Mr. Madoff directed the client receive. He said he also lied under oath to the SEC in 2006 at Mr. Madoff's direction. A lawyer for Mr. Madoff declined to comment. The SEC complaint alleges that Mr. DiPascali, along with Mr. Madoff, had considerable help from others at the Madoff firm for producing everything from fake client statements to computer programming.
One strategy was to produce fake records from the Depository Trust Corp., the company that acts as the central depository for securities in the U.S. Mr. DiPascali "and others spent substantial time and effort ensuring that these reports mimicked the layout, print font and paper-type of actual DTC reports." In another ruse, the SEC alleged, Mr. DiPascali and others created and used a "random number generator program" to give trading orders the appearance of happening at variable intervals and in different increments.
Mr. Madoff ordered that old stationery and letterhead be maintained in case he had to fabricate records going back in time, the complaint says. The executives even prepared for the possibility that an investor or other outsider might ask to observe actual trading. On Mr. Madoff's instructions, Mr. DiPascali and others tested a system where one employee would enter trades in front of a visitor and another would go into an office nearby and pretend to be a trader in Europe responding to the orders, the SEC alleged.
Mr. DiPascali profited handsomely, the complaint alleges. Starting around 2002, he set up an account for himself at the firm named after his fishing yacht, Dorothy Jo. Although he never deposited any of his own money, over the years he withdrew more than $5 million for his own benefit, the complaint says. It says he received over $2 million in salary and bonus annually. Fortunes quickly turned for the firm in the financial crisis of 2008. In the summer of that year, Mr. Madoff had on hand some $5.5 billion in an account at J.P. Morgan Chase. But as the stock and bond markets collapsed that autumn, redemptions surged to more than $6 billion. By the final days of the fraud, only a few hundred million dollars was left for redemptions, the SEC complaint says.
Mr. DiPascali and Mr. Madoff discussed using that money to cash out family, friends and employees. With Mr. Madoff's approval, he had checks totaling more than $150 million prepared. Mr. Madoff was arrested before they were distributed. Mr. DiPascali's lawyer said in court that his client expects to give up his ill-gotten assets, and that the government has already seized some property and is monitoring his expenditures. Mr. DiPascali has agreed to a proposed partial judgment in the SEC case that would prevent him from committing further violations of securities laws, the SEC said. A financial penalty will be decided at a later date, the regulator said.
Prosecutors were willing to agree that Mr. DiPascali could remain out of jail on $2.5 million in bail pending sentencing.
But on Tuesday, U.S. District Court Judge Richard Sullivan denied the agreement, instead sending him to jail in Manhattan. He didn't rule out granting a different bail package in the future. Mr. Madoff, 71 years old, is serving a 150-year sentence in a federal prison in North Carolina after admitting in March to running a decades-long Ponzi scheme that bilked thousands of investors out of billions of dollars. Last month, David Friehling, Madoff's outside auditor, waived indictment and pleaded not guilty to securities fraud and other criminal charges. Prosecutors are seeking more than $170 billion in forfeiture from Mr. DiPascali, the same amount they sought from Madoff. That figure represents funds deposited by investors into Madoff's fraudulent investment operation and later disbursed to other investors.
OPEC -- those numbers just keep going up
It's that time of the month again. Some estimates of OPEC production have already appeared and the next few days will see those of the International Energy Agency and the US Energy Information Administration. The latest Platts survey of OPEC and oil industry officials and analysts shows that OPEC volumes have risen for the fourth consecutive month. Total output, including that of Iraq, is estimated to have risen by 100,000 b/d to 28.57 million b/d in July from 28.47 million b/d in June.
Excluding Iraq, volumes from the 11 members bound by quotas edged up by 80,000 b/d to 26.12 million b/d in July from 26.04 million b/d in June, the survey shows. Initial enthusiasm among the OPEC-11 for the 4.2 million b/d output cut agreed last December appeared high. Volumes dropped by 970,000 b/d between December and January and by 820,000 b/d between January and February.
Of course, production had already been sliding since the end of last summer as the world economic took a dive and oil prices headed south: Between October and November, Platts estimated that OPEC-11 output fell by 940,000 b/d. By March, the OPEC-11 had managed to reduce the gap between actual output and their 24.845 million b/d target to 765,000 b/d. Since then, however, volumes have been rising -- by 130,000 b/d between March and April, by 250,000 b/d between April and May, and by 50,000 b/d and 80,000 b/d between May and June and June and July respectively.
These volume increases may look appear minor when compared with the previous sizeable drops, but -- given that they add up to a 510,000 b/d increase between March and July -- they do suggest that OPEC's appetite for production restraint may be starting to wear thin in light of the fact that oil prices appear to have found at least a temporary equilibrium around the $70/barrel mark. A month is a long time in the world of oil, and much can happen between now and OPEC's September 9 meeting. But unless oil prices fall sharply in the next few weeks, it seems unlikely that ministers will do much more than call for stricter adherence with the current agreement.
Oil contango boosts crude storage at sea-sources
The amount of crude oil being stored at sea has risen sharply over the last two weeks, particularly in the U.S. Gulf, due to a price incentive for oil companies to hold stocks on board vessels, traders and analysts said on Friday.
Several industry sources estimated that there were 70 million barrels of oil being stored at sea. While the estimates vary from around 60 million to 100 million barrels, most sources agree offshore storage levels rose by around 10 million barrels in the last two weeks alone. A Very Large Crude Carrier (VLCC) can store up to two million barrels of crude oil. "We have seen renewed interest in chartering VLCCs for storing crude oil of late, which we believe has been stimulated by the widening of the contango in WTI futures," said Simon Chattrabhuti, head of tanker research with ICAP Shipping in London.
An oil price structure known as a contango has encouraged oil companies to store crude oil in tankers anchored at sea this year with a view to selling it for a profit later. The contango price structure -- which occurs when oil for prompt delivery is discounted to oil for delivery further in the future -- has narrowed over the last few weeks for North Sea crudes, but remains attractive for many U.S. grades, making it most profitable to store oil near the U.S. Gulf Coast.
West Texas Intermediate crude futures CLc1 for delivery next month have been trading at around a $2.00 a barrel discount to barrels for delivery in two months, more than covering the cost of around $1.00 a month of storing a barrel offshore in the United States. "The storage total is probably close to 70 million barrels, with the majority of the rise is in the U.S. Gulf," said George Los, an analyst with U.S. shipbrokers C.R. Weber. Offshore storage dipped to 60 million barrels in late July, as the contango weakened, Los said. The recent levels of floating crude stocks are still well below peaks of more than 100 million barrels in April, he added.
Another U.S. shipbroker, who requested anonymity, counted five new VLCC storage charters over the past nine days alone. They included European trader Trafigura, Russian trader Gunvor and U.S. oil major ConocoPhillip charters, all for crude oil storage off the U.S. Gulf Coast. She estimated 70 million barrels currently at sea. Among the other players currently storing contango crude are U.S. trader Koch, major Royal Dutch Shell and Swiss trader Vitol, the broker said. ICAP Shipping estimated 29 VLCCs were storing crude globally, rising from 24 VLCCs two weeks ago. It estimated that 10 VLCCs were holding crude in the U.S. Gulf, 10 off the coast of Northwest Europe, seven off West Africa, one in the Mediterranean and one in the Far East.
Frontline, the world's biggest independent oil tanker shipping group, told Reuters on Thursday around 50 VLCCs were storing crude oil, particularly in the U.S. Gulf and off Europe. A crude oil trader at a large independent trading house estimated between 70 million and 100 million barrels of crude were stored globally. Swelling onshore inventories in the U.S. may also be pushing more crude offshore, shipping sources said. Stock levels at Cushing, Oklahoma, the world's largest onshore commercial oil storage hub, have risen in six consecutive weeks.
Citigroup sued by Norwegian towns for $200m
Seven towns in Norway’s Arctic Circle have sued Citigroup for more than $200 million (£121 miilion) in losses and damages for selling them complex mortgage-backed investments that brought the towns to the brink of financial collapse. The towns – Brenmanger, Hattfjelldal, Hemnes, Kvinesdal, Narvik, Rana and Vik – and a now-defunct Norwegian brokerage claim to have lost $115 million that they paid Citigroup for fund-linked notes.
The local authorities borrowed money from DnB Nor, Norway’s biggest bank to buy the notes, which were backed by American mortgages. According to a lawsuit filed in the Southern District of New York, Citigroup marketed the notes in May and June 2007 as "safe, conservative investments". The lawsuit alleges: "In fact, [the notes] were neither safe nor conservative; within a few weeks and as a result of those sales, the municipalities had lost tens of millions of dollars and by May 2008 substantially all of their original investment was gone."
As a result, the towns, all of which have fewer than 33,000 residents, have been unable to repay their loan from DnB Nor. The brokerage, Terra Securities, has since gone bust. The experience caused Norway to bring in tighter rules on the sale of investment products to non-professional investors. Citigroup described the lawsuit as being "without merit".
U.K. Trade Gap Widens as Global Recession Persists
The U.K. trade deficit unexpectedly widened in June, a sign the decline in the value of the pound has yet to benefit exporters as the global recession persists. The goods-trade gap was 6.5 billion pounds ($10.7 billion), compared with 6.2 billion pounds in May, the Office for National Statistics said today in London. The median forecast of 15 economists surveyed by Bloomberg News was for a 6.2 billion- pound deficit. Exports rose 1.4 percent, outpaced by a 2.2 percent increase in imports.
“We remain skeptical that the U.K. is about to become an export-driven economy any time soon,” said Colin Ellis, an economist at Daiwa Securities SMBC Europe Ltd. and a former central bank official. “A return to sustained growth continues to look unlikely in the near term.” The Bank of England said last week that there is now evidence of stabilization in Britain’s main export markets, while the world economy remains in recession. Policy makers have extended their program of bond-buying by 50 billion pounds to help the economy shake off the slump.
“Volumes of exports are not particularly great and that tells you what’s going on abroad,” George Buckley, chief U.K. economist at Deutsche Bank AG in London, said before the report’s release. “Sterling has fallen but these things take a long time to take effect.” Exports to nations outside the European Union fell 2.6 percent, the statistics office said. Sales to EU countries, accounting for more than half of all exports, increased by 4.8 percent, the data showed.
Wolfson Microelectronics Plc, a Scottish maker of semiconductors, on July 28 posted its third consecutive quarterly loss as demand fell for satellite navigation devices and MP3 players.
Reports this month have added to evidence the economy is improving. U.K. service industries expanded the most since 2008 in July, Markit said last week. Consumer confidence rose to the highest level in more than a year, and manufacturing increased the most since January 2008 in June. The trade gap in the second quarter narrowed to 19.6 billion pounds, the smallest in three years, the statistics office said.
The weakness of the pound may encourage export sales. The pound has dropped 10 percent against a basket of currencies from Britain’s biggest trading partners in the past year. Glasgow, Scotland-based Weir Group Plc, the world’s biggest maker of pumps for the mining industry, said on Aug. 4 full-year earnings will be at the top end of its own estimates as currency movements boost sales.
“The world economy remains in recession, though there have been increasing signs that output in the U.K.’s main export markets is stabilizing,” the Bank of England said in a statement last week. “In the United Kingdom, the recession appears to have been deeper than previously thought.” The Bank of England will tomorrow release new quarterly forecasts for growth and inflation. The government’s move to cut sales tax last year by 2.5 percentage points shaved 0.5 point from the inflation rate in December, the statistics office said in a separate statement today.
Russia GDP Shrank 10.9% Last Quarter as Slump Deepens
Russia’s economy contracted the most on record last quarter as rising unemployment sapped consumer demand, bank lending stalled and the government failed to approve a stimulus package until just two months ago. Gross domestic product contracted an annual 10.9 percent in the second quarter, the Federal Statistics Service said today, citing preliminary data. The median estimate in a Bloomberg survey of seven economists was for output to shrink 10.2 percent. The service’s data go as far back as 1995.
Russia’s economic decline is worsening after output contracted 9.8 percent in the first quarter, ending 10 years of expansion that averaged close to 7 percent. The worst global financial crisis since the Great Depression undermined demand for Russia’s oil, natural gas and metals. Industrial production plunged as companies depleted stocks and struggled to raise funds during the credit crunch. “We can’t develop like this any longer,” President Dmitry Medvedevsaid yesterday during a meeting with political party leaders in the Black Sea resort of Sochi. “It’s a dead end. And the crisis has placed us in a situation where we will have to make decisions on changing the structure of the economy.”
The ruble weakened for a fifth day versus dollar, its longest losing streak since February, slipping 1.4 percent to 32.2419 per dollar in Moscow, the lowest level since July 13. The currency lost 1.4 percent against the euro to 45.7151. Those movements left the ruble at 38.2879 against the central bank’s target currency basket. Russia “crumbled” after commodity prices collapsed, Medvedev said. Energy, including oil and natural gas, accounted for 68.8 percent of exports to the Baltic states and countries outside the former Soviet Union in the first six months of the year, Russia’s Federal Customs Service said last week. Urals crude oil, Russia’s chief export earner, averaged $61.03 a barrel during the last quarter after reaching a record $142.5 in July 2008.
Russia failed to free itself of its reliance on commodities during Prime Minister Vladimir Putin’s tenure as President between 2000 and 2008, said Natalia Orlova, chief economist at Alfa Bank, Russia’s biggest privately-owned lender. “Because of high oil prices, capital came in; banks transferred this capital into the economy,” she said. “Rising wages fed consumer growth, so there was no reason to invest or create new production. Now capital has stopped coming in and consumption has stopped. This model has ceased to exist. We don’t have a new one.”
Putin, 56, stepped down in May 2008 after two terms in office and became prime minister under his hand-picked successor, Medvedev. The government has done “catastrophically little” to diversify the economy in the decade since the 1998 financial crisis, Sergei Voloboev, a Credit Suisse economist in London, said by phone. GDP probably shrank a seasonally adjusted 0.2 percent in the second quarter compared to the first three months, according to Credit Suisse. “The economy approached the bottom in the second quarter, basically it hit the bottom around May, June,” said Tatiana Orlova, an economist at ING Groep NV in Moscow. “We should see some better-looking data” in the coming quarters.
Russian stocks were little changed after losing as much as 1.3 percent earlier today after the release. The 30-stock Micex index was trading at 1100.31 at 3 p.m. in Moscow after yesterday’s 1.3 percent retreat. The RTS Index lost 1.3 percent to 1051.45 today. The Micex Index, which is mostly made up of energy companies, slipped into a bear market in June after falling more than 20 percent from its high on June 1, on concern a prolonged recession will cut demand for fuel. It gained 8.4 percent in July and is up 79 percent this year.
The world’s biggest energy exporter may run a budget deficit as wide as 9.4 percent of GDP this year, the country’s first shortfall in a decade, as plummeting demand for commodities threatens to cut revenue by a third, according to the Finance Ministry. Russia has earmarked 2.51 trillion rubles ($79 billion) in spending to battle the slump, including funding designated for carmakers, agriculture and construction. The “anti-crisis” program was signed into law by Putin on June 19.
“The planned fiscal relaxation might fail to stimulate private consumption in the face of significant uncertainty about future income,” the International Monetary Fund said in a report published on Aug. 7. “Absent a more determined policy intervention, there is a risk that banks will continue to struggle to adjust balance sheets, stifling credit expansion and impeding a recovery.” Russia’s economy will need between four years and five years to match last year’s pace of growth, Finance Minister Alexei Kudrinsaid yesterday. GDP in 2008 grew at the slowest pace since 2002, expanding 5.6 percent compared with 8.1 percent a year earlier. The IMF forecasts a 6.5 percent economic contraction for Russia this year, followed by growth of 1.5 percent in 2010.
The central bank’s five interest-rate cuts since April 24 have failed to spur lending as banks hold back on concern borrowers can’t repay loans. Lending to consumers dropped 1.1 percent in June for the fifth consecutive monthly decline and banks shrank their corporate loan books by 1.2 percent, according to central bank data. By the end of 2009, 17.4 percent of the population, or 24.6 million people, will be living beneath the subsistence level of $185 per month, almost 5 percent more than before the crisis, the World Bank said in a report released in June.
Rising numbers of jobless and falling wages will cut the country’s nascent middle class by 10 percent, or 6.2 million people, to about 51.2 percent of the population, the Washington- based lender said. Household consumption, “the main source of growth in recent years,” is “collapsing,” it added. The economy may start to show signs of recovery in the third quarter this year, Deputy Economy Minister Andrei Klepach said on July 23. GDP expanded a non-seasonally adjusted 7.5 percent from the previous quarter after contracting 23 percent in the first three months, the office said.
Polish Government Approves Asset Sales to Cover Swollen Deficit
Poland’s Cabinet approved a plan to sell stakes in state-owned companies including KGHM Polska Miedz SA and Grupa Lotos SA in an effort to finance its budget deficit after tax revenue slumped and public debt soared. “The plan acknowledges the need to speed up privatization,” said Prime Minister Donald Tusk at a press conference in Warsaw today. The budget “requires a cash injection to cover basic spending.”
The move will release almost 37 billion zloty ($12.5 billion) through 2010, a key contribution to financing the general budget gap, which the European Commission says may widen to 7.3 percent of gross domestic product in 2010 from an estimated 6.6 percent in 2009. That would send the shortfall to 95.52 billion zloty, nearly double the 2008 general government deficit, according to Bloomberg calculations based on the Commission’s forecasts.
The agreement sparked a workers strike earlier today at copper producer KGHM that lasted two hours. Tusk later responded with assurances that the Treasury will maintain a controlling stake in KGHM and Lotos, as well as in other power plants earmarked for divestment, after previously saying the state might sell as much as 42 percent. “The revenue from the sale will be used by the state budget, thus it will be of benefit for all Poles and not only for the workers of KGHM,” Tusk said.
Poland remains the only one of the European Union’s eastern members to have avoided a recession since the global credit crisis started. Even so, next year’s budget is vital to boost the economy and put Poland back on track for euro adoption, after the government was forced last month to abandon its 2012 euro-adoption goal. It has not yet set a new target date. “It’s high time that Poland undertook real privatization,” said economist Miroslaw Gronicki, a former finance minister, by phone. “Any revenue from privatization means a reduction in debt, and as far as the budget is concerned it’s an extremely sensible move.”
According to Stanislaw Gomulka, who served as deputy finance minister under the current government, asset sales would allow the government to circumvent political obstacles to resolving its fiscal dilemma. President Lech Kaczynski has said he would veto any attempt to raise taxes as a way of increasing budget revenue, while his twin brother and leader of the main opposition party, Jaroslaw, has ruled out cooperating on measures to augment revenue.
“The legislative route is virtually impossible for the government, so privatization is the only way out,” Gomulka said by phone. “Union protests have been a big factor in the lack of privatization in recent years -- but the situation has got so bad now this constraint might have been lifted.” The government also plans to sell stakes in its largest power groups, including Polska Grupa Energetyczna SA and Enea SA, as well as oil refiner Grupa Lotos SA, the Warsaw Stock Exchange and coal mine Lubelski Wegiel Bogdanka SA.
The sale of 67 percent of Enea, valued at 7.4 billion zloty, would be the biggest disposal since France Telecom SA bought a stake in Telekomunikacja Polska SA in 2000. The state also holds 2.5 percent of Bank Handlowy w Warszawie SA, a subsidiary of Citigroup Inc., and 1.9 percent of Allied Irish Banks Plc’s Bank Zachodni WBK SA unit. Ten-year bond yields could fall as much as 20 basis points over the next few weeks as the combination of higher asset sales and signs of economic recovery prompt investors to reassess Poland’s borrowing needs next year, said Mateusz Szczurek, chief economist at ING Bank Slaski SA in Warsaw. “The government’s plan has the potential to do some good at the long end of the yield curve,” he said.