Night in Luna Park, Coney Island
Ilargi: There are still a lot of people out there who keep on insisting that oil has had, will have, or is already having, a substantial effect on the financial crisis, but who wouldn't want to make a bet on whether oil will be $5 or $500 a barrel 1 year from now, or 2 years. Nor would they be able to spell out what effect which price would have on the economy. For some reason this makes me think of an unrelated Susan Ertz quote:
Millions long for immortality who don't know what to do with themselves on a rainy Sunday afternoon.It may be unrelated, but millions also blame oil for the credit crisis who wouldn't recognize that crisis if it hit them squarely in their pocketbooks. Or if it did, they'd just bitch louder at the pump.
My take is that while many have a more or less working mental model of the limits inherent in the oil industry, they have a ways to go in the understanding of the financial crisis. The center of the world is not made of oil. Nor is it made of money, for that matter. The center of the world is a teeming stew of molten greed and stupidity. And it so happens we have been easily more than greedy and stupid enough to run out of money way before we'll ever get a chance to run out of oil.
Oil today, purely from a supply/demand picture, is overpriced by 100-200%, and maybe even more. Still, if it were $20 a barrel, would a substantially larger number of homeowners get to stay in their homes? Would job losses go down big-league? Would debts be paid off more or faster? Would Goldman Sachs start refusing taxpayer money?
According to the EIA, in 2008 U.S. Motor Gasoline Consumption was under 9 million barrel per day. it's way less now, but let’s keep the 9 bpd number. At $70 per barrel, the cost is some $225 billion per year, or about $450 billion at the pump, $3 per gallon, 42 gallons a barrel.
What do you think the average American spends on gas for their vehicles per year? How about $1500, for every man, woman and child? That coincidentally adds up to maybe $450 billion. So if you'd halve the gas price, what would the effect on the economy be? Well, you'd save, but less than $225 billion.
That's only slightly more than what we've spent so far just to 'save' AIG alone. It's also no more than about 30% of the Obama stimulus plan. It's less than 2% of the total estimated $13.8 trillion committed in taxpayer Wall Street 'assistance'. And it's maybe 0.75% of what estimates put total US loss of wealth at to date, some $30 trillion.
If you want to focus on oil in the financial crisis, those are a few of your numbers to work with. Finance versus oil. And sure, you're right, oil is not just the gas in your car, it's everywhere around you. But everywhere around you is shrinking, and there's no evidence that that has anything at all to do with prices or production, no matter whether one or both go up or down. Oil demand is plummeting, even as prices have long come down from their 2008 high. The credit crisis needs no help in changing what you can believe in, thank you very much.
The magnitude of the losses is simply too overwhelming to digest, I think. The $13.8 trillion ihat's been committed to rescue banks that are beyond rescue represent some $45.000 per capita, including toddlers, grannies and everyone else. And that comes on top of all the losses on the ground, in tax revenues for all levels of government, in property prices, in job losses, foreclosures, and all the other issues where "value" is being lost. Some losses are obvious, just take a look at tent cities, jobless claims and boarded up homes. But most are still hidden, and all the recovery talk depends on the fact that they remain so. Which will not happen.
The hidden damage will be exposed to daylight as we go forward. Scores of states and counties and cities that have managed to hang on until now, cutting every bit of fat they could while hanging on to their people, have nothing left to cut but the same people. Tens of thousands of companies that still employ millions of people that are no longer truly contributing to much of anything in a productive sense will have to adjust their dreams of better days to what their bottom line tells them. Those people will have to go as well. Unemployment? You ain't seen nothing yet. 15% U3 is a low estimate for 2010. Go back to Sunday morning’s Three Stooges interviews, they all say more jobs will keep being lost into the second half of next year.
And where's the alleged connection here with oil prices? Many people will argue that it's at the pump that oil becomes a real issue, and they DO notice the price changes. But it’s in the increasing job losses, the foreclosures and the soon to be raised tax bills that they will feel what the financial crisis means. And where they really hurt, much more than at any gas station. A $30 trillion loss of wealth is $100.000 per capita, since the crisis started. It’ll take you years to put that sort of money into your tank. So many years, in fact, that we may indeed run out of oil before you ever get close.
For now, going into this fall and further into next year and beyond, the one tale that matters far more than anything else for "ordinary people" is that of unwinding and disappearing credit, accumulated debt deteriorating services, vanishing jobs and boarded up homes. The cost of oil is but a bit player on that stage.
by Paul Krugman
A slight followup on my last post. The BLS conveniently provides a map of state unemployment rates across the country, which is worth looking at:
What you see, if you look at the black states — states with 10+ percent unemployment — are two great belts of suffering. One is California/Oregon/Nevada, which is about the burst bubble. The other stretches down across the middle of the country. Except for Florida, which is presumably more bubble damage, what this looks like to me is manufacturing — I know that a large part of it is “Auto Alley”, which is the south-by-east spread of the old Detroit hub that took place as foreign automakers moved in. And manufacturing, remember, has been hit especially hard in this crunch.
All of this suggests that who’s suffering most has little to do with state policies. It’s about what you happened to be doing for a living when the economy fell apart.
Offshoring by US companies surges
US companies are increasingly turning to offshoring their functions to achieve cost savings, and few plan to bring those jobs back to the United States, the Conference Board said Monday. The number of US companies with a corporate offshoring strategy in place more than doubled in the past three years, according to the fifth annual report on offshoring trends, published by Duke University in collaboration with the Conference Board.
Of the companies surveyed, 53 per cent had a corporate offshoring strategy in place, up from 22 per cent in 2005, said the Conference Board, a nonprofit business research organization. "Sixty per cent of companies that had already offshored say they have aggressive plans to expand existing activities, and very few plan to relocate activities back to the United States," it said.
Teeing Up the Middle Class
Joe the Plumber’s tax vindication is nigh
Few of President Obama’s 2008 campaign pledges were more definitive than his vow that anyone making less than $250,000 a year "will not see their taxes increase by a single dime" if he was elected. And he was right, very strictly speaking: It’s going to be many, many, many billions of dimes. Asked about raising taxes on the middle class on Sunday on CBS’s "Face the Nation," White House economist Larry Summers wouldn’t repeat Mr. Obama’s pre-election promise. "It is never a good idea to absolutely rule things out no matter what," Mr. Summers said—except, apparently, when his boss is running for office.
Meanwhile, on ABC’s "This Week," Treasury Secretary Timothy Geithner also slid around Mr. Obama’s vow and said, "We have to bring these deficits down very dramatically. And that’s going to require some very hard choices." These aren’t even nondenial denials. The Obama advisers are laying the groundwork for taxing the middle class while claiming the deficit made them do it. The liberal establishment is even further along in finally admitting that Mr. Obama wasn’t, er, telling the truth.
A piece in the New York Times over the weekend declared in a headline that "the Rich Can’t Pay for Everything, Analysts Say." And it quoted Leonard Burman, a veteran of the Clinton Treasury who now runs the Brookings Tax Policy Center, as saying that "This idea that everything new that government provides ought to be paid for by the top 5%, that’s a basically unstable way of governing." They’re right, but where were they during the campaign?
In an editorial on February 26, "The 2% Illusion," we wrote that the feds could take 100% of the taxable income of everyone in America earning more than $500,000 and still have raised only $1.3 trillion even in the boom year of 2006. The rich are fewer and less rich now, while the Obama budget is nearly $4 trillion. Democrats already plan to repeal the Bush tax cuts, but that won’t raise enough money. So they’re proposing an income tax surcharge on "the wealthy," but that won’t raise enough either. Democrats have no choice but to soak the middle class because only they have enough money to finance the liberal dream of yoking the middle class to cradle-to-grave government entitlements.
Democrats have already taxed the middle class by raising cigarette taxes to pay for the children’s health-care expansion. They’re also teeing up average earners with their cap-and-tax energy bill. Mr. Obama had hoped that cap-and-tax would raise some $646 billion over a decade, but Democrats in the House had to give most of that away in bribes to business to pass their bill. To finance ObamaCare, they’re also proposing another 10-percentage-point increase in the payroll tax on firms and individuals that don’t purchase health insurance. But this won’t raise enough money either.
So waiting in the wings is the biggest middle-class tax increase of them all: a European-style value added tax, or VAT. This tax would apply to every level of production or service, and it is beloved by politicians in Europe because it raises so much money so easily without voters noticing. Ezekiel Emanuel, a White House aide and brother of Chief of Staff Rahm Emanuel, has advocated a 10% VAT to finance national health care. Look for a VAT to be one of the prominent options when Mr. Obama’s tax reform commission issues its report later this year.
The undeniable reality is that you can’t run a European-style welfare-entitlement state without European-style levels of taxation on the middle class (and eventually without low European-style growth and high jobless rates). It’s looking more and more like Mr. Obama’s no-middle-class-tax pledge was one of the greatest confidence tricks in American political history.
Stiglitz: America at "Serious Risk of Extended Malaise"
Day by day, the "the recession is over" crowd continues to get larger and louder. But the U.S. faces "serious risk of an extended malaise" after the bursting of the credit bubble, says Nobel Prize-winning economist Joseph Stiglitz of Columbia University. Today's optimistic policymakers (current and former) and economists risk confusing the technical end of recession with a robust recovery, he says. "It would be a mistake to say ‘because we're out of a sense of freefall and may have turned a corner [that] we're on the road to recovery.'"
In the short term, there is a "very remote likelihood" the job market will turn around anytime soon, the famed economist says. Therefore, it will still feel like a recession for many Americans even if GDP does produce positive readings. Stiglitz also cited a number of potential negative speed bumps the recovery may hit, including:
- Weakness in commercial real estate.
- Huge deficits at the state level, leading to more job losses.
- Many Americans at risk of having unemployment benefits expire.
- Weakness in our major trading partners, and overall lack of final demand.
In fact, Stiglitz says the next few years may be characterized by weak growth and false starts on the road to recovery, not unlike Japan in the past 20 years or America during the Great Depression. As a result, he says the government should plan on additional stimulus packages focused on improving technology, education and infrastructure. While lamenting "there's no appetite" for additional government spending, he says these investments provide a better long-term return than tax cuts or rebates. Best to get these plans ready to go for when the current stimulus package, which Stiglitz called "too small and badly designed" last spring, starts to wane.
In sum, Stiglitz believes we should hope for the best, but plan for the worse.
'China is the biggest thing to happen in the world economy for a century'
Fund managers often talk about the "themes" that excite them and how they work those ideas into their investments. China is full of exciting opportunities but I would not call it a theme. It is much bigger than that; it is the most important thing going on in the world this decade and the next. You might find it surprising that the manager of a UK equity growth fund is as interested in China as the state of British banks and whether M&S will increase its dividend. But what is happening in China is as important to your investments as what happens here. Not to have a view on it in your portfolio would be a huge mistake.
China is a long way away; culturally and geographically. As a result, some investors here often dismiss China as something happening to someone else. Their scepticism about the scale of activity means they enjoy belittling this emerging economic superpower. The fact is, without China propping it up, the global economy would be in a worse state than it currently is. It matters to us all whether or not Chinese growth is sustainable. I have visited China several times in the past few years and my trip in June demonstrated once more China's glorious ability to astound; even after the financial crisis.
The main shopping street of any one of a hundred large Chinese cities at 10pm on a Tuesday is virtually indistinguishable from Oxford Street on a busy Saturday afternoon – perhaps with more neon! China is a reason to be optimistic about the outlook for world growth. Government finances are healthy and consumers are spending as confidence returns. Chinese people, unlike us, are not encumbered by a decade of over-borrowing. Things may be bad in the West, but it's not often that a billion people go through an industrial revolution. In fact, it's never happened before.
To ensure the Chinese economy was not engulfed by the global malaise, the Chinese government injected huge sums of money into public spending projects. Apart from being the catalyst for a stock market recovery last autumn, you can see its impact everywhere. For example, China Railways has been adding track to the network at about 1,000 kilometres a year. This will rise to 10,000 kilometres per year by 2012. To put that into context, the whole UK network is just 16,000 kilometres.
There are critics of this ''overdevelopment''. You can drive along empty eight-lane motorways and wander shopping malls with more staff than customers. Countless suburbs are being developed and redeveloped to provide larger flats and to accommodate the 400 million people moving from rural to urban areas. I visited Shenyang in north-east China, a city you might not have heard of despite having a population similar to that of Greater London. In just one corner of this one city, there is a construction site of two housing developments with a combined floorspace similar to the whole of London's Docklands.
Rather than see this as a bubble waiting to burst, I see the longer-term opportunity. Properties in Shenyang are selling faster this year than last. Before long the aspirational emergent middle class of China's mushrooming cities will be able to afford cars to fill the roads and to shop in the malls. Urbanisation begets economic growth. In a broad sense, Chinese growth is affecting asset prices, demand and supply in almost every global industry. More specifically, despite their ingenuity, capital and human resource, the Chinese still look to British companies for certain goods and services.
British technology and engineering is in demand. Longer term, local competition will catch up. Therefore, investors' challenge is to find companies with whom the Chinese will never be able to compete. London's mining sector is an obvious beneficiary of China's lack of natural resources. Less obvious strong positions are those held by Western brands. Diageo, maker of Johnnie Walker, and fashion label Burberry, enjoy premium status among Chinese consumers. It is their very ''un-Chinese-ness'' that creates opportunity.
I am realistic. Rampant growth creates imbalances. This is a long-term story and not without risk. So be careful not to become overexposed and ensure your investments are balanced against many other themes and ideas. However, I am consistently surprised by the failure of many people to appreciate and take advantage of China being the biggest thing to happen in the world economy for a century.
The Best Goldman Apology Yet
by Matt Taibbi
So you can see why Goldman alums sometimes don’t do very impressively once they leave Goldman. They find themselves in positions where no one questions their premises and it’s hard to get good feedback and pushback. (This is why Paulson employed telephone banks of analysts to call Wall Street to solicit opinions.) Outside of the Goldman womb of debate and ideas, bankers and traders lack perspective. You might say that no Goldman is an island.
And the winner of this month’s Most Retarded Horseshit Written In Defense of Goldman Sachs award goes to… Heidi Moore at Big Money! Come on down, Heidi!
This stuff is just getting funnier and funnier. Now that both Michael Lewis and Joe Hagan at New York have piled on and hammered the “magical” Wall Street bank’s reputation, the tearful, wounded apologies on the bank’s behalf are trickling in with some more urgency, especially now that, as Moore puts it, the bank faces the specter of “disastrously populist” hearings in the Senate for (and Moore left out this part) selling crap mortgages while shorting them at the same time.
This latest effort by Moore over at the Slate-run “Big Money” column is absolutely hilarious. She manages to write a fairly lengthy three-page article defending Goldman without addressing a single one of the main criticisms recently leveled at the bank. The piece is a protracted exercise in goalpost-moving, as her premise is that what Goldman’s critics accuse it of is not using the power of the state to bail itself out and enrich itself at the expense of others, but of having “designed the kind of hive mind that controls anything it touches.” According to Moore, the defense against the charge that Goldman executives have “the kind of hive mind that can control everything that it touches” is the fact that they fared so badly in their attempts at “controlling” government and popular opinion. She actually writes the following:If you believe that Goldman Sachs has designed the kind of devastating hive mind that can control any institution it touches, including the U.S. government, you also have to explain why Goldman Sachs alums have a history of not functioning terribly well outside of Goldman. Why, for instance, did Henry Paulson, by all accounts a brilliant man, flounder about in the politics of the Treasury so desperately that he was forced at one point to plead with Nancy Pelosi on bended knee? Why did the first TARP overseer, Neel Kashkari, get yelled at by Congress while performing the thankless job of managing the $700 billion kitty of the government? Why did Edward Liddy, former Goldman board member who served as the new CEO of AIG (AIG), quit in a huff over bonuses?
Moore here is arguing that because Hank Paulson actually had to beg the House majority leader for $700 billion in no-strings-attached money to bail out his buddies, and because Neel Kashkari got “yelled at” for unilaterally changing the TARP mission in defiance of congressional orders (and for refusing to provide congress with information about where TARP money went and how he chose whom to give it to), and because former Goldman banker Ed Liddy evoked popular anger for using public money to shell out bonuses to the very department of AIG that bet $450 billion without having a dime to cover it (”necessitating” the bailout), that all of this somehow is proof that Goldman does not “have the kind of hive mind that conrols everything.”
In Moore’s mind, (or, as a friend of mine would put it, “in what passes for Moore’s mind”) this is a defense of Goldman because, if Goldman was as powerful as we all say, Goldman would have just zapped its “hive mind” at Nancy Pelosi, congress, and the public, and none of those parties would have bothered to criticize the bank. Logically put! Let’s put this argument into the form of a syllogism:All all-powerful hive-mind institutions can make themselves immune to criticism,
But, Goldman Sachs failed to prevent absolutely everyone from complaining about its behavior.
Therefore, Goldman Sachs did not use public money and influence with the state to make itself billions in profits.
It gets better. Steaming ahead from there, Moore blows off the question of how Goldman made its profits this year, and simply assumes that the rest of us are not aware that Goldman has a wonderful corporate culture that is the root of its success. Among other things, the bank apparently encourages openness and disagreement (it’s funny how those of us on the outside of the bank do not notice these qualities too much)! Here she explains:It’s not that Goldman doesn’t have its egos—it surely does—but as a matter of management, the firm also has several safeguards in place to keep rampant egos from destroying decision-making. Another thing that makes Goldman different from other firms is not that all Goldman bankers agree but that they are free—and, in fact, encouraged—to disagree.
So, gosh, I stand corrected, I guess. Because I thought that Goldman made a ton of money this year because it got a special waiver (fast-forwarding through the usual five-day antitrust waiting period, thanks to their buddies in the Fed) to instantly switch to bank holding company status and make itself eligible for $28 billion in FDIC-backed lending. I thought it got $13 billion in public money via the AIG bailout and hundreds millions more in extra underwriting fees through its work underwriting stock for banks repaying TARP money. I didn’t know that it made all that money because it had internal safeguards in place to rein in egos. I feel foolish now. Moore proceeds with a touching story:John Thain once presented a case for Goldman’s IPO to the management committee, and several of his fellow partners disagreed. Thain’s reply to his vehement colleagues, according to Bloomberg: “Would it hurt you to suck up to me once in a while?” CFO David Viniar is a dragonlike protector of the firm’s balance sheet, known to shoot down trading ideas and expansion plans day in and day out. Viniar’s default answer, according to Goldman bankers, is “No,” and he is known for his even-handed rejection of expensive schemes.
Yeah, David Viniar, he’s really a demon when it comes to rejecting “expensive” schemes, isn’t he? Like the time he green-lighted that $20 billion in counterparty risk to that knucklehead Joe Cassano over at AIG, or the time he flinched when Blankfein wanted to jack the firm’s debt-to-equity ratio to 24-1 (oh, wait, he didn’t flinch. That was some other universe). And John Thain, I can see how great all of that famed Goldman humility culture has been for him. Dude only ordered a $1.2 million office renovation for himself while at Merrill (including a $1400 waste basket and the infamous $87,000 area rug) despite the fact that the firm had just seen $8.4 billion in write-downs under his management and laid off 3,300 people. Guess that ego really was reined in!
Moore goes on. It turns out — and this is another thing us critics of Goldman were not aware of — that there is a strong Attaboy! culture at Goldman, Sachs. It’s not the the firm sold crap $500-million mortgage deals with equity-to-value ratios of 99.21% as AAA-rated securities, then bet against those same securities; no, that’s not how they made their money. They made their money because management makes sure it feels just so darn good to work hard and do well there! Moore recounts:Also, Goldman bankers and traders use the voice-mail system to give colleagues frequent snaps for a job well done. I was once in the office of a Goldman partner when he left a voice mail for a junior banker thanking her for introducing him to her client. Goldman won the piece of business. The implication, as well, was that it would be remembered at her year-end review. At most other firms, that’s a rare gesture.
But that isn’t all. It turns out there’s more to the secret of Goldman’s success: clothes! You see, while the executives of other companies needlessly waste their money on fancy suits, the highly-focused men of Goldman Sachs put all their effort into the job:Goldman bankers also don’t look like other bankers on Wall Street. (And I don’t mean that they’re all bald and went to Dartmouth.) The firm has a reputation for producing menschy, nebbishy types who physically betray none of the intellectual magic ascribed to them; frayed cuffs, baggy suits, and lost buttons regularly adorn even the firm’s highest-earning millionaires and are worn as a source of pride. Goldman Sachs is suspicious of flashiness in an industry in which the most prominent bankers are beautifully dressed in snowy collars and suits so precisely tailored and finely woven that the wool fabric reflects light.
Moore wrote that passage at the bottom of page 2 in her piece. I expected the “point” to be in whatever paragraph began the next page. I clicked and read, instead:At a financial conference at the New York Stock Exchange in 2006, I saw Lloyd Blankfein waiting his turn to go onstage while standing in a crowded room of reporters. Journalists, standing three-deep, surrounded bank executives at the conference. But not one reporter in the room seemed to recognize or approach the unassuming Blankfein, who was in shirtsleeves and wearing a baggyish suit—and also, at the time, was the chief executive of one of the largest investment banks. Byron Trott, the Goldman Warren Buffett, lacks flash; he looks more like a prosperous Midwestern architect than a millionaire Master of the Universe.
Again, apologies are in order! It’s not that Goldman cooked its first-quarter profit numbers, or was using a computer program that by its own admission could be used to manipulate the New York Stock Exchange, or that it got a special waiver for the entirety of 2009 to ditch traditional accounting to make its risk appetite look lower, or that it gorged itself on public money for a year and turned almost all of that money into bonuses for its employees, in the middle of a crisis in which vast numbers of Americans are literally going hungry and losing their homes. All of that is an error of perception. Why, just look at Lloyd Blankfein! Would a man wearing a suit that baggy be guilty of such things?
This is really what Moore is saying! It’s that stupid! Enjoy it while you can, folks, because one doesn’t often see p.r. flacking this entertainingly ham-handed and idiotic. The ones who are capable of it, they usually don’t survive to adulthood; they get clipped from the herd by predators.
Moore concludes with the following passage:So you can see why Goldman alums sometimes don’t do very impressively once they leave Goldman. They find themselves in positions where no one questions their premises and it’s hard to get good feedback and pushback. (This is why Paulson employed telephone banks of analysts to call Wall Street to solicit opinions.) Outside of the Goldman womb of debate and ideas, bankers and traders lack perspective.
So let me get this straight. Goldman Sachs employees are so used to criticism and the free exchange of ideas that they flounder once they’re in public office, where “no one questions their premises” and “it’s hard to get good feedback”? Am I having an acid flashback, or is this the same Heidi Moore who 360 words ago was bitching about how Paulson, Kashkari, and Liddy faced such heated resistance to their “premises” after leaving Goldman?
This Moore piece, it shows how desperate the game has gotten for Goldman. They and their shills are reduced now to arguing that they make their money because their employees pat each other on the back and do trust-falls to instill mutual confidence in each other. The whole world is throwing heavy subpoenas and damning stacks of numbers at them, and they’re coming back with, “We succeed because we let a smile be our umbrella.” This shit is literally as weak as it gets.
Maybe Income Report’s Not As Bad As It Looks (Or Maybe It Is)
When we first saw the headline, personal income falls the most in four years, we thought, well, that’s pretty awful. And we expected to be writing a post right now explaining just how awful it was, and how much of a dent in the recovery story it puts. But, you know what, it might not be as bad as it looks. And that’s not something you read here every day. To be sure,wage growth is nowhere to be found. Wages are down overall since January, and with unemployment rising at the same time as the workweek is at a historic low, it’s highly unlikely wages are going to rise any time soon. But, you know, if you wanted, you could, maybe, possibly make an argument that they’re near a bottom.
GDP, wages, employment, retail sales and industrial production are the markers to watch for in calculating when the recession ends. When they flatline, or even turn up, you can start reliably talking about a growing economy. Now, yes, personal income fell 1.3% in June, the biggest tumble in four years. But that’s on a monthly basis, and last month included a big jump in income due to federal stimulus. Personal income in June fell by $159.8B, after jumping $155.1B in May. Excluding the government largesse, income fell $7.8B, or 0.1%, in June, and fell $2.5B, or less than 0.1%, in May. Those look like flattish, decline-in-the-rate-of-decline kind of numbers.
But since January, income is down about $134B. And from June 2008, it’s down $420B (which was right around a peak from all the way back to 2006.) Also, there’s an interesting "addenda" to the Commerce Department’s tables, which shows personal income excluding transfer payments, Social Security and the like, and measured in chained (2005) dollars. On that measure, personal income is down $328B since January, and down $453B since June 2008. Also, this series shows income falling every month this year: $9.330T in January, $9.196T in February, $9.120T in March, $9.092 in April, $9.077T in May, $9.002T in June. That’s interesting now, isn’t it? And you know what? Forget what we said earlier. The report is as bad as we thought it was.
Will Obamacare Make the U.S. More Like Europe?
by Dean Baker<
The right knows that they are supposed to hate Obamacare; the only problem is that they keep forgetting why. According to a study that they have been widely touting it promises to both increase coverage and reduce costs. Presumably these are not the reasons they oppose President Obama's plan. One of the other reasons that the right has pushed is that President Obama's plan will be a serious impediment to the growth of small business, because it will require that they either provide coverage to their workers or pay a tax to support their coverage. The right tells us that the sort of tax/mandates that President Obama wants to impose on small business will stifle entrepreneurship and make the United States more like Europe.
When our friends on the right make this sort of argument, they once again leave the facts behind. John Schmitt, my colleague at the Center for Economic and Policy Research, just did a short study compiling evidence from the OECD on the relative importance of small business in the U.S. and Europe. It turns out that by every available measure, the U.S. is way behind when it comes to the relative importance of entrepreneurship and small business.
Let's start with the most basic measure, self-employment. We all know that everyone in America wants to run their own business. 7.2 percent of the workers in this country actually do. That puts us ahead of Luxembourg's self-employment rate of 6.1 percent, but behind everyone else. France has a self-employment rate of 9.0 percent, Germany 12.0 percent, and Italy 26.4 percent. If we exclude agriculture, our 7.5 percent self-employment rate for non-agricultural workers puts us ahead of Norway, but still far behind everyone else.
Okay, maybe self-employment doesn't tell us much about the role of small business. After all, there are many small family-run retail shops in Europe. That may not be most people's idea of entrepreneurship. How about the share of small firms (fewer than 20 employees) in manufacturing employment? Well, our 11.1 percent share again beats out Luxembourg, and also Ireland, but it trails all the other countries for which the OECD has data. Maybe 20 employees is not the right cutoff for a definition of small businesses in manufacturing. How about 500? By that measure, the U.S. comes in dead last. France's 63.7 percent share beats our 51.2 percent share by more than a dozen percentage points.
Perhaps we should just ignore manufacturing, that's old economy stuff. Surely the U.S. stands out for its vibrant computer upstarts. The 32.0 percent small firm employment share in computer related services beats Spain's 27.0 percent, but is well behind everyone else. Belgium, the capital of Old Europe, more than doubles our small business share, with 63.0 percent of its workers in this sector employed by establishments with less than 100 employees. The U.S. does a hair better if we shift the focus to the research and development (including biomedical research). In the U.S., 25.3 percent of the workers in this sector are employed at establishments with fewer than 100 workers. That beats the 20.3 percent share in the Netherlands and the 22.5 percent share in the United Kingdom.
However, the small business employment share in the U.S. is far behind the 33.1 percent share in France and the 35.0 percent share in Germany. In short, the American dream of being a small business owner and the story of the United States as a nation of dynamic small businesses is largely a dream. It does not conform to the economic reality.
Will President Obama's health care plan promote small business and make us more like Europe? It very well might. One possible explanation for the relatively smaller role of small business in the U.S. economy is that concern over access to health insurance makes many people reluctant to strike out on their own and start a small business. The prospect of being stuck without health insurance has to be very scary for a 50-year old with some health problems.
Of course there are many other factors that also affect the ability of new businesses to be created and thrive, but as a simple factual matter, the idea that Europe's welfare state has strangled small businesses is not true. The politicians and pundits should be corrected when they spew such nonsense.
Obama gives powerful drug lobby a seat at healthcare table
As a candidate for president, Barack Obama lambasted drug companies and the influence they wielded in Washington. He even ran a television ad targeting the industry's chief lobbyist, former Louisiana congressman Billy Tauzin, and the role Tauzin played in preventing Medicare from negotiating for lower drug prices. Since the election, Tauzin has morphed into the president's partner. He has been invited to the White House half a dozen times in recent months.
There, he says, he eventually secured an agreement that the administration wouldn't try to overturn the very Medicare drug policy that Obama had criticized on the campaign trail. "The White House blessed it," Tauzin said. At the same time, Tauzin said the industry he represents was offering political and financial support for the president's healthcare initiative, a remarkable shift considering that drug companies vigorously opposed a national overhaul the last time it was proposed, when Bill Clinton was president.
If a package passes Congress, the pharmaceutical industry has pledged $80 billion in cost savings over 10 years to help pay for it. For his part, Tauzin said he had not only received the White House pledge to forswear Medicare drug price bargaining, but also a separate promise not to pursue another proposal Obama supported during the campaign: importing cheaper drugs from Canada or Europe. Both proposals could cost the industry billions, undermine its ability to develop new cures and, in the case of imports, possibly compromise safety, industry officials contend.
Much of the bargaining took place in July at a meeting in the Roosevelt Room, just off the Oval Office, a person familiar with the discussions said. In attendance were Tauzin, several industry chief executives -- including those from Abbott Laboratories, Merck and Pfizer -- White House Chief of Staff Rahm Emanuel and White House aides. White House officials acknowledge discussing the importation question with Tauzin but had no comment on whether there was an agreement to block future Medicare price negotiations.
Yet everyone agrees that drug companies -- Washington's leading source of lobbyist money -- now have "a seat at the table" at the White House and on Capitol Hill as healthcare legislation works its way through Congress. If nothing else, a popular president who six months ago criticized drug companies for greed now praises their work on behalf of the public good. "I think the pharmaceutical industry has been quite constructive in this debate," Obama told a small group of regional reporters last week. "And the savings that they've put on the table are real and significant and are appreciated."
The pharmaceutical industry's political transformation provides an example of Obama's approach to achieving his healthcare goals, which includes negotiation and compromise, even with those he and his allies have painted as a source of the problem. The benefits to the White House go beyond budget savings. Tauzin's trade association, the Pharmaceutical Research and Manufacturers of America, or PhRMA, is helping to underwrite a multimillion-dollar TV advertising campaign touting comprehensive healthcare legislation.
One ad resurrects Harry and Louise, the fictional couple whose caustic kitchen-table comments in ads sponsored by the health insurance industry helped sink Clinton's plan in 1994. This time, with the drug companies paying the bill, Harry and Louise have changed their view. "A little more cooperation, a little less politics, and we can get the job done this time," Louise says in the commercial, a joint project of PhRMA and Families USA, a health reform advocacy group with which the drug industry used to be at odds.
In an interview, Tauzin said he carefully negotiated his agreements with the White House, offering the $80-billion discount program in return for assurances that there would be no government price-setting in Medicare Part D, the drug program for seniors. It was important, he said, to block the threat of Medicare price negotiations, which he called tantamount to price-setting and a threat to the industry. In addition, Tauzin said the industry asked the administration not to allow the import of cheaper drugs because of safety concerns.
Linda Douglass, a White House spokeswoman, said that when drug company executives brought up the import plan, they were told that the administration believed that health reform would reduce drug prices so significantly that the legislation once backed by Obama would "not be necessary." It's far too early to tell whether the pharmaceutical industry's decision to back Obama's health initiative will pay off.
"Since Obama came into office, the drug industry has received everything it wants, domestic and foreign," said James Love, who leads an international nonprofit promoting low-cost distribution of drugs to fight the world's most devastating diseases. "Yes, the drug companies are getting tremendous sweetheart deals" from Obama, said Lawrence Jacobs, a University of Minnesota political scientist who studies the history of health reform and other major social and economic changes. "But these bargains are the price of admission for achieving substantial reform."
Tauzin, a Democrat who helped found the conservative Blue Dog coalition in the House before switching to the Republican Party in 1995, was chairman of the House committee that helped shepherd Medicare drug legislation through Congress, including the provision that the government not interfere with price negotiations. Tauzin said PhRMA's support for Obama's initiative represented no shift in the industry's basic philosophy. "Our principles haven't changed, but we are looking at a different situation today," he said. "There's an opportunity now to get a health bill passed that doesn't provide for government control of healthcare. We are participating as fully as we can now because we see an economic and moral imperative to do something when so many millions of people don't have access to healthcare."
The prescription for PhRMA's partisan activities has changed recently along with the political landscape. In 2005 and 2006, during Tauzin's first two years at PhRMA, just a third of the industry's $19.5 million in campaign donations went to Democrats. Tauzin came into the organization, he said, determined to make it more bipartisan and more generally appealing to the public.
This year, for the first time in two decades, Democrats have so far picked up more of the industry's campaign cash -- 54% -- than Republicans, according to the Center for Responsive Politics. And PhRMA, a reliable backer of conservative candidates and causes in the past, has shifted allegiance in other ways, including joining labor leaders in a high-priced ad campaign to build grass-roots support for Obama's health plan. Besides the new "Harry and Louise" ads, the industry is underwriting commercials that praise potentially vulnerable Democratic incumbents.
Other things haven't changed, including the industry's unrivaled investment in lobbying. In just the last four months, the industry has spent $68 million on lobbying in Washington, assuring its continued standing atop the nation's lobbyist spending list. Sen. Bernie Sanders (I-Vt.), a champion of importing drugs from Canada and reducing the cost of pharmaceuticals, professes continued suspicion of the industry, including its deals with the White House. "The drug companies form the most powerful lobby in Washington," he said. "They never lose."
The Horrifying Hidden Story Behind Drug Company Profits
This is the story of one of the great unspoken scandals of our times. Today, the people across the world who most need life-saving medicine are being prevented from producing it. Here's the latest example: factories across the poor world are desperate to start producing their own cheaper Tamiflu to protect their populations -- but they are being sternly told not to. Why? So rich drug companies can protect their patents -- and profits. There is an alternative to this sick system -- but we are choosing to ignore it.
To understand this tale, we have to start with an apparent mystery. The World Health Organization (WHO) has been correctly warning for months that if swine flu spreads to the poorest parts of the world, it could cull hundreds of thousands of people -- or more. Yet they have also been telling the governments of the poor world not to go ahead and produce as much Tamiflu -- the only drug we have to reduce the symptoms, and potentially save lives -- as they possibly can. In the answer to this whodunit, there lies a much bigger story about how our world works today.
Our governments have chosen, over decades, to allow a strange system for developing medicines to build up. Most of the work carried out by scientists to bring a drug to your local pharmacist -- and into your lungs, or stomach, or bowels -- is done in government-funded university labs, paid for by your taxes. Drug companies usually come in late in the process of development, and pay for part of the expensive but largely uncreative final stages, like buying some of the chemicals and trials that are needed. In return, then they own the exclusive rights to manufacture and profit from the resulting medicine for years. Nobody else can make it.
Although it's not the goal of the individuals working within the system, the outcome is often deadly. The drug companies who owned the patent for AIDS drugs went to court to stop the post-Apartheid government of South Africa producing generic copies of it -- which are just as effective -- for $100 a year to save their dying citizens. They wanted them to pay the full $10,000 a year to buy the branded version -- or nothing. In the poor world, the patenting system every day puts medicines beyond the reach of sick people.
This is where the solution to the swine flu mystery comes in. Ordinary democratic citizens were so disgusted by the attempt to deprive South Africa of life-saving medicine that public pressure won a small concession in the global trading rules. It was agreed that in an overwhelming public health emergency, poor countries would be allowed to produce generic drugs. They are the exact same product, but without the brand name -- or the fat patent payments to drug companies.
So under the new rules, the countries of the poor world should be entitled to start making as much generic Tamiflu as they want. There are companies across India and China who say they are raring to go. But Roche -- the drug company that owns the patent -- doesn't want the poor world making cheaper copies for themselves. They want people to buy the branded version, from which they receive profits. Although not obliged to, they have licensed a handful of companies in the developing world to make the treatment -- but they have to pay for license, and they can't possibly meet the demand. And the WHO seems to be backing Roche -- against the rest of us. They are the ones best qualified to judge what constitutes an overwhelming emergency, justifying a breaching of the patent rules. And their message is: Don't use the loophole.
Professor Brook Baker, an expert on drug patenting, says: "Why do they behave like this? Because of direct or indirect pressure from the pharmaceutical companies. It's shocking." What will be the end-result? James Love, director of Knowledge Ecology International which campaigns against the current patenting system, says: "Poor countries are not as prepared as they could have been. If there's a pandemic, the number of people who die will be much greater than it had to be. Much greater. It's horrible."
The argument in defense of this system offered by Big Pharma is simple, and sounds reasonable at first: we need to charge large sums for "our" drugs so we can develop more life-saving medicines. We want to develop as many treatments as we can, and we can only do that if we have revenue. A lot of the research we back doesn't result in a marketable drug, so it's an expensive process. But a detailed study by Dr Marcia Angell, the former editor of the prestigious New England Journal of Medicine, says that only 14 percent of their budgets go on developing drugs -- usually at the uncreative final part of the drug-trail.
The rest goes on marketing and profits. And even with that puny 14 percent, drug companies squander a fortune developing "me-too" drugs -- medicines that do exactly the same job as a drug that already exists, but has one molecule different, so they can take out a new patent, and receive another avalanche of profits. As a result, the US Government Accountability Office says that far from being a font of innovation, the drug market has become "stagnant." They spend virtually nothing on the diseases that kill the most human beings, like malaria, because the victims are poor, so there's hardly any profit to be sucked out.
We all suffer as a result of this patent dysfunction. The European Union's competition commissioner, Neelie Kroes, recently concluded that Europeans pay 40 percent more for their medicines than they should because of this "rotten" system -- money that could be saving many lives if it was redirected towards real health care. Why would we keep this system, if it is so bad? The drug companies have spent more than $3 billion on lobbyists and political "contributions" over the past decade in the US alone. They have paid politicians to make the system work in their interests. If you doubt how deeply this influence goes, listen to a Republican congressman, Walter Burton, who admitted of the last big health care legislation passed in the US in 2003: "The pharmaceutical lobbyists wrote the bill."
There is a far better way to develop medicines, if only we will take it. It was first proposed by Joseph Stiglitz, the recent Nobel Prize winner for economics. He says: "Research needs money, but the current system results in limited funds being spent in the wrong way." Stiglitz's plan is simple. The governments of the Western world should establish a multi-billion dollar prize fund that will give payments to scientists who develop cures or vaccines for diseases. The highest prizes would go to cures for diseases that kill millions of people, like malaria. Once the pay-out is made, the rights to use the treatment will be in the public domain. Anybody anywhere in the world could manufacture the drug and use it to save lives.
The financial incentive in this system for scientists remains exactly the same -- but all humanity reaps the benefits, not a tiny private monopoly and those lucky few who can afford to pay their bloated prices. The irrationalities of the current system -- spending a fortune on me-too drugs, and preventing sick people from making the medicines that would save them -- would end. It isn't cheap -- it would cost 0.6 percent of GDP -- but in the medium-term, it would save us all a fortune, because our health care systems would no longer have to pay huge premiums to drug companies. Meanwhile, the cost of medicine would come crashing down for the poor -- and tens of millions would be able to afford it for the first time.
Yet moves to change the current system are blocked by the drug companies and their armies of lobbyists. That's why the way we regulate the production of medicines across the world is still designed to serve the interests of the shareholders of the drug companies -- not the health of humanity. The idea of ring-fencing life-saving medical knowledge so a few people can profit from it is one of the great grotesqueries of our age. We have to tear down this sick system -- so the sick can live. Only then we can globalize the spirit of Jonas Salk, the great scientist who invented the polio vaccine, but refused to patent it, saying simply: "It would be like patenting the sun."
Obama Administration Withholds Data On "Cash For Clunkers" Program
The Obama administration is refusing to quickly release government records on its "cash-for-clunkers" rebate program that would substantiate – or undercut – White House claims of the program's success, even as the president presses the Senate for a quick vote for $2 billion to boost car sales. The Transportation Department said it will provide the data as soon as possible but did not specify a time frame or promise release of the data before the Senate votes whether to spend $2 billion more on the program.
Transportation Secretary Ray LaHood said Sunday the government would release electronic records about the program, and President Barack Obama has pledged greater transparency for his administration. But the Transportation Department, which has collected details on about 157,000 rebate requests, won't release sales data that dealers provided showing how much U.S. car manufacturers are benefiting from the $1 billion initially pumped into the program.
The Associated Press has sought release of the data since last week. Rae Tyson, spokesman for the National Highway Traffic Safety Administration, said the agency will provide the data requested as soon as possible.
DOT officials already have received electronic details from car dealers of each trade-in transaction. The agency receives regular analyses of the sales data, producing helpful talking points for LaHood, White House spokesman Robert Gibbs and other officials to use when urging more funding. LaHood said in an interview Sunday he would make the electronic records available. "I can't think of any reason why we wouldn't do it," he said.
The administration is reviewing the AP's request for detailed records, deputy White House press secretary Jennifer Psaki said. The administration already has released summary information from the detailed sales records, including the number of rebates requested, fuel efficiency information, vehicle sales information and amount of rebates requested in each state, she said. "The administration is committed to providing the highest level of information that is practical and responsible about the cash for clunkers program to the American public, which is why we have released on an ongoing basis updated numbers about transactions in the system," Psaki said.
LaHood, the program's chief salesman, has pitched the rebates as good for America, good for car buyers, good for the environment, good for the economy. But it's difficult to determine whether the administration is overselling the claim without seeing what's being sold, what's being traded in and where the cars are being sold. LaHood, for example, promotes the fact that the Ford Focus so far is at the top of the list of new cars purchased under the program. But the limited information released so far shows most buyers are not picking Ford, Chrysler or General Motors vehicles, and six of the top 10 vehicles purchased are Honda, Toyota and Hyundai.
LaHood has called the popular rebates to car buyers "the lifeline that will bring back the automobile industry in America." He and other advocates are citing program data to promote passage of another $2 billion for the incentives -- claiming dealers sold cars that are 61 percent more fuel efficient than trade-ins. LaHood also said this week that even if buyers aren't choosing cars made by U.S. automobile manufacturers, many of the Honda, Toyota and Hyundai cars sold were made in those companies' American plants.
But there's no way to verify his claims without access to DOT's data. Senate GOP leader Mitch McConnell of Kentucky has argued against quick approval of $2 billion for the program because little is known about the first round of $3,500 and $4,500 rebates. "We don't have the results of the first $1 billion," McConnell spokesman Don Stewart said. "You don't have them. We don't have them. DOT doesn't have all of it. We'd hate to make a mistake on something like that."
Ditch theory and take away the punchbowl
There are, by now, a thousand and one ideas in circulation on how to change the regulatory architecture of finance. But what about changing the central bankers – or at the very least their mindset, since their notions about how to deal with bubbles have proved extraordinarily costly for the rest of us. Fifty years ago, central bankerly wisdom was encapsulated in the splendid phrase of William McChesney Martin, longest-serving chairman of the Federal Reserve, to the effect that the job of the Fed was to take away the punchbowl just as the party gets going.
That is the polar opposite of the view of Alan Greenspan, who presided over the Fed during the bubble period. He believed that bubbles were difficult to identify and that the central bankers’ task was to clear up the mess after the bursting of the bubble rather than to make a pre-emptive strike to rectify it. The curious thing is how little debate took place over such a dramatic metamorphosis in the approach to monetary policy. What is striking is that the shift coincided with the replacement in the monetary policymaking process of old-style, market-savvy central bankers, often without formal economic training, with academic economists.
Note, in passing, that William McChesney Martin was a career stockbroker who graduated from Yale in English, not economics. He spent most of his time at the Fed fighting administrations that demanded easy money with the support of a majority of academic economists. Note, too, that the new breed of economists in central banks have been doggedly wedded to the idea that markets are efficient, despite the recurrence of bubbles throughout history – a phenomenon that makes a nonsense of this belief. And their focus was largely on consumer prices rather than asset prices which did the damage.
In responding to the celebrated question posed by Queen Elizabeth II as to why nobody foresaw the catastrophe, many academic economists have wrung their hands and repeated the mantra about the difficulty of identifying bubbles. This foolishly accepts a mistaken premise. For there were many people, from the Bank for International Settlements, to academe, to commentators in the Fourth Estate, who identified the lunacy at the time. The economist Paul Krugman remarked, with only modest exaggeration, that the last people to twig were those at the top of the Fed.
There is good reason, then, to welcome a new book by Andrew Smithers, an economist with a good record in identifying bubbles, that offers a frontal assault on flawed central bank thinking.* He provides evidence that it is perfectly possible to identify when the prices of equity, property, bond and bank loans are out of line with fundamentals. Using the "q" ratio, which relates to net asset values, and the cyclically adjusted price earnings ratio, he shows that it was possible to identify serious over-pricing in equities in 1906, 1929, 1936, 1968 and 2000. Subsequent market falls were accompanied or followed by recessions.
Using affordability metrics in housing produces similar conclusions. How should central banks adjust policy in response? The book supports the case for a macro-prudential approach to systemic risk whereby capital ratios are adjusted counter-cyclically to prevent extreme swings in asset prices. This is admittedly easier said than done, with important questions, inter alia, about how far to rely on rules or discretion. But as Mr Smithers fairly remarks, interest rate changes are currently made on the basis of judgments about the output gap, which is notoriously difficult to estimate. The difficulty of targeting asset prices may thus be exaggerated.
Yet the biggest problem in taking away the punchbowl is likely to be political, as I have argued here before. Persuading politicians and the public that it is worth risking a mild recession to pre-empt something much worse is a very hard sell. Given the mistakes that the central bankers have made of late, it could be even harder in future.
Regulate financial pay to reduce risk-taking
A bill requiring federal regulators to draw up rules for compensation structures in the financial sector was passed by the US House of Representatives on Friday and will be taken up by the US Senate. Such pay regulations, which authorities around the world are considering, will meet stiff resistance from financial institutions. Yet the case in their favour is compelling.
While the need to reform pay arrangements is now widely accepted, many believe that such reforms should be left to corporate boards and that government intervention should be limited to ensuring the adequacy of corporate governance processes. The Basel committee on Banking Supervision has urged boards to be closely involved in pay-setting; and the bill passed on Friday mandates "say on pay" shareholder votes and bolsters the independence of compensation committees. Would improvements in governance obviate the need for regulating pay structures? Not at all.
Outside the financial sector, government intervention should indeed be limited to improving internal governance, leaving choices over pay structures to shareholders and the directors elected by them. But financial institutions are special, and their special circumstances warrant a broader role for government. Regulation of pay in financial institutions is justified by the very same moral hazard concerns that provide the basis for existing regulation of the sector. Because the failure of such companies imposes costs on taxpayers that shareholders do not internalise, shareholders’ interests are served by more risk-taking than is socially desirable. For this reason, financial institutions have long been constrained by a substantial body of rules that restrict private choices with respect to loans, investments and capital reserves.
Shareholders’ interest in more risk-taking implies that they could benefit from providing executives with excessive incentives in this direction. Executives with such incentives can use their informational advantages, and whatever discretion they have been left by existing regulations, to increase risks. Regulation of pay structures is a way to counter this. It would make the executives of financial companies work for, not against, the goals of financial regulation. Opponents of such regulation will argue that the government does not have a legitimate interest in telling shareholders how to spend their money. But it does. Given the government’s interest in financial companies’ stability, intervention in pay structures is as legitimate as the traditional forms of financial regulation.
Opponents may also argue that regulators are at an informational disadvantage when assessing pay arrangements. Yet more informed players inside financial companies lack incentives to internalise the interests of depositors and taxpayers when setting pay structures. Furthermore, limiting structures that incentivise risk-taking is not more demanding in terms of information than regulators’ traditional intervention in investment, lending and capital decisions. In addition, opponents may argue that pay regulation will drive talent away. But the proposed rules would apply to pay structures and not total compensation, which financial institutions would be free to set at the levels necessary to retain employees.
The regulation of pay structures is considered against the background of news that compensation in the financial sector is returning to the lofty levels of before the crisis. It is thus worth stressing that, while the regulations under consideration would address concerns about incentives, they would not, nor are they intended to, address concerns about overall compensation amounts. Their goal is to promote the safety and soundness of the financial system, not to address shareholder concerns about excessive levels of pay.
In the US, such concerns would be best addressed by supplementing the mandated "say on pay" votes with a substantial strengthening of shareholder rights. Regulating compensation structures should become a critical instrument in financial regulators’ toolkits. It would help prevent in the future the excessive risk-taking that contributed to the current crisis.
The writer is a professor of law, economics and finance and director of the programme on corporate governance at Harvard Law School. This article builds on his testimony before the financial services committee of the US Congress and his white paper, co-authored with Holger Spamann, on Regulating Bankers’ Pay
Disarray hobbles U.S. financial regulation effort
Disagreement within the Obama administration over reshaping U.S. financial regulation flared on Tuesday, with top bank regulators defending their turf against key parts of a plan to overhaul bank supervision. The officials' defiance, voiced before the Senate Banking Committee, came despite a stern warning from Treasury Secretary Timothy Geithner on Friday about the need for administration officials to line up in support the White House's program.
In expletive-laced remarks at a private meeting, Geithner urged regulators to end turf battles and support President Barack Obama's plan, said a person familiar with the matter. Discord within the administration, not to mention clashing viewpoints in Congress itself, signal a difficult road ahead this year for Obama's push to tighten oversight of banking and capital markets, spurred by the worst financial crisis in decades.
"Without more agreement, it's hard to see how comprehensive financial regulation reform happens in 2009," said Joseph Engelhard, senior vice president at investment research firm Capital Alpha Partners, in Washington, D.C. Congressional aides said the administration should have spent more time whipping its own troops into agreement before sending a financial reform package to Capitol Hill, especially with healthcare and climate change issues also in play.
Obama is calling for creating a national bank supervisor by merging the Office of the Comptroller of the Currency (OCC) and the Office of Thrift Supervision (OTS). He wants to leave state bank supervision to the Federal Deposit Insurance Corporation and the Federal Reserve, although some lawmakers are discussing changes in this area, as well.
Geithner's persuasion session on Friday with top financial regulators seemed to have made little impression. "We do not support the administration's proposal to establish a new agency, the National Bank Supervisor, by eliminating the Office of the Comptroller of the Currency ... and the OTS," John Bowman, acting director of the OTS, told the banking committee. "The OTS does not support the provision in the administration's proposal to eliminate the thrift charter," he added.
FDIC Chairman Sheila Bair voiced support for merging OCC and OTS, but resisted more bank oversight centralization. "There is a profound risk of regulatory capture if you collapse it all into one agency," Bair said. "We think having multiple voices can actually strengthen regulation."
With the economy in deep recession, the administration is trying to modernize a regulatory system set up largely in the 1930s, partly by consolidating duties now spread across many agencies. But the reform plan has met widespread resistance, not only from banks, but also from their government watchdogs. "Some might argue there's a bit of turf protection here. That's natural," said Democratic Senator Charles Schumer. But he and Senate Banking Committee Chairman Christopher Dodd, both Democrats, said at the hearing that Congress and the administration should be looking at the big picture.
"Our job here is not to protect regulators," Dodd said. "Do we really need three federal agencies to regulate banks?" he said. Senator Richard Shelby, the committee's top Republican, said, however, that regulators should not stop criticizing the administration's reform plans. He said he hoped regulators would not be swayed by Geithner's "tirade. ... Your honesty and your candor are very important.
The White House plan would also create a Consumer Financial Protection Agency (CFPA) and charge the Fed with monitoring systemic risk in the economy, both major regulatory changes. John Dugan, comptroller of the currency, said the Obama plan would give the Fed the right to "override" the views of other regulators on supervising very large banks, which would "undermine the authority -- and the accountability -- of the banking supervisor."
Comments like these marked a stiffening of regulators' opposition to portions of Obama's plan, which still faces many more months of debate in Congress. At a tense, hour-long meeting on Friday, Geithner told Bair, Federal Reserve Chairman Ben Bernanke and the chairman of the Securities and Exchange Commission, Mary Schapiro, to end recent public criticism of the administration's plan and stop airing concerns over their potential loss of authority. Treasury spokesman Andrew Williams said the Friday meeting was to tell "regulators that we should work together to get reform done, and focus less on protecting turf."
If that message doesn't register and financial reform grinds to a halt later this year in the Senate as a single piece of legislation, it might be broken up, especially if other Obama reform efforts fizzle, Engelhard said. "If healthcare reform breaks down, I would say there's a greater than 50 percent chance that some element of financial regulation reform, such as derivatives reform, will pass in the Senate to show that the Obama administration is making progress," he said.
Bank regulators dig in against Obama shake-up
Top U.S. bank regulators will speak out on Tuesday against some key elements of the Obama administration's plan to reshape financial regulation, saying parts of it were unneeded or could be disruptive. The officials' defiance, in prepared congressional testimony obtained by Reuters, came despite a warning given to them on Friday by Treasury Secretary Timothy Geithner. In private remarks punctuated with expletives, Geithner urged the regulators to end their turf battles and show support for President Barack Obama's plan, according to a person familiar with the situation on Monday.
But that seemed to have little impact on John Bowman, acting director of the Office of Thrift Supervision (OTS), an agency slated for closure under the Obama plan. "We do not support the administration's proposal to establish a new agency, the National Bank Supervisor (NBS), by eliminating the Office of the Comptroller of the Currency ... and the OTS," Bowman said in written remarks to be given to the Senate Banking Committee at a hearing. In addition, he said, "The OTS does not support the provision in the administration's proposal to eliminate the thrift charter and require all federal thrift institutions to change their charter."
Such words marked a retrenching of regulators' opposition to portions of Obama's plans to tighten oversight of banks and capital markets amid the worst financial crisis in generations and with the economy mired in a stubborn recession. "We do not see merit or wisdom in consolidating federal supervision of national and state banking charters into a single regulator," FDIC chairman Sheila Bair said in her remarks ahead of the hearing on regulatory reform.
At a tense, hour-long meeting on Friday, Geithner told Bair, Federal Reserve Chairman Ben Bernanke and Securities and Exchange Commission Chairman Mary Schapiro to end recent public criticism of the administration's plan and stop airing concerns over their potential loss of authority. The Wall Street Journal, which first reported the meeting, said Geithner vented frustration over the plan's slow progress and told regulators that "enough is enough."
Citing people familiar with the meeting, the newspaper also said Geithner used obscenities and took an aggressive stance in his dressing down of the regulators. Treasury spokesman Andrew Williams said, "We planned this meeting as a venue to deliver a tough message to regulators that we should work together to get reform done - and focus less on protecting turf."
Under the plan conceived by Treasury, banking supervision would be significantly consolidated. But Bair, whose populist tone has won allies in Congress, in her prepared remarks for the banking committee hearing, said: "Prudent risk management argues strongly against putting all your regulatory and supervisory eggs in one basket." The Obama plan aims to bring a creaking system set up in the 1930s, with regulation spread across many agencies, into the 21st century. But it has met resistance not only from regulators, but the institutions that they supervise.
Groups such as the American Bankers Association and the Independent Community Bankers have expressed opposition. John Dugan, Comptroller of the Currency, warned lawmakers in his remarks that the existing plan would wrongly give the Federal Reserve the right to 'override' the views of other regulators when it comes to supervising very large banks. Such a move would "undermine the authority -- and the accountability -- of the banking supervisor" he said.
Federal Reserve Board Governor Daniel Tarullo argued for preserving the Fed's bank oversight powers, with enhancements. "It is essential both to refocus the regulation and supervision of banking institutions under existing authorities and to augment those," he said in prepared remarks.
Fed to Strengthen Bank Examinations With Expert Teams
The Federal Reserve plans to strengthen its examinations of banks’ lending practices and financial health with new teams composed of experts in everything from law to economics and markets. Fed Governor Daniel Tarullo outlined the step in testimony to a Senate Banking Committee hearing in Washington today. The overhaul, which would make reviews more uniform across the banking system, builds on the stress tests the central bank completed on the biggest 19 banks in May, he said.
The initiative comes as criticism spreads of President Barack Obama’s proposal to give the Fed powers to oversee systemic financial risks. Treasury Secretary Timothy Geithner last week told regulatory chiefs -- including Sheila Bair, the Federal Deposit Insurance Corp. chairman who opposes making the Fed the sole systemic-risk agency -- they should stop attempts to campaign against the administration’s revamp of rules for the industry, a person familiar with the matter said.
"We are prioritizing and expanding" the examination process to "assess key operations, risks and risk management activities of large institutions," Tarullo said in his testimony today. "This program will be distinct from the activities of on-site examination teams so as to provide an independent supervisory perspective." The Fed, like other bank agencies, has come under criticism by lawmakers and investors for not curbing excessive risk taking on Wall Street that led to the worst financial crisis since the Great Depression. Congress is weighing the administration’s proposals to toughen oversight and set new rules for banks, the biggest overhaul in decades.
Regulators have each opposed some aspect of the Obama plan. Fed Chairman Ben S. Bernanke has sought to retain authority for protecting consumers of financial products after the administration sought to create a new agency for the task. Bair and Securities and Exchange Commission Chairman Mary Schapiro have favored a council of agencies -- rather than the Fed -- to have powers to rein in risk-taking at financial firms so large or interconnected their failure would threaten the system.
Geithner, in a July 31 meeting aimed at cracking down on dissent, used strong language with the regulatory heads, reflecting concern at the fate of the administration’s proposals, the person briefed on the matter said on condition of anonymity. Tarullo, Bair and other regulators at today’s hearing said in response to a lawmaker’s question that they were giving their own views independent of Geithner’s direction. "The only people I discuss this with is the other members of the board and the staff of the Federal Reserve," Tarullo said.
The Obama plan has drawn fire from both Democrats and Republicans who argue that the central bank should focus on monetary policy. They have pointed out that the Fed, as the regulator of bank holding companies, supervised some of the biggest lenders that required rescuing, including Citigroup Inc. and Bank of America Corp. Tarullo, 56, the first Fed governor appointed by Obama, has become the central bank’s coordinator on revising the examination process. Within the Fed, he has become an advocate for increasing the board’s control over supervision. The Senate banking panel also plans to hear testimony from Bair and other regulators about how to improve bank oversight.
"The crisis has revealed significant risk-management deficiencies at a wide range of financial institutions," Tarullo said. "It has also challenged some of the assumptions and analysis on which conventional supervisory wisdom has been based." While not giving many details on the supervisory overhaul, Tarullo indicated that the examinations, now run largely by Fed district banks across the country, will be bolstered by the board in Washington.
He said the Fed is "creating an enhanced quantitative surveillance program that will use supervisory information, firm-specific data analysis and market-based indicators to identify developing strains and imbalances that may affect multiple institutions, as well as emerging risks to specific firms." "This work will be performed by a multidisciplinary group composed of our economic and market researchers, supervisors, market operations specialists and accounting and legal experts," Tarullo said.
Banks and other financial institutions have reported more than $1.5 trillion in credit losses and writedowns worldwide since the global credit crisis began. Many of those losses stemmed from mortgage-related investments that declined with the collapse in the housing market. Tarullo didn’t discuss the outlook for the U.S. economy or monetary policy in his testimony. He said the central bank will soon release guidance on how to "promote compensation practices that are consistent with sound risk-management principles and safe and sound banking."
The Fed governor also said that General Electric Co. and companies that already own finance arms or industrial-loan businesses, known as ILCs, should be able to retain them without being subject to Fed oversight of manufacturing and nonbank operations. While the Fed favors not adding more ILCs, existing structures should be "grandfathered" and not forced to separate "in the interest of fairness," he said.
GE has supported no changes to the status quo so that it can keep its manufacturing operations along with its GE Capital finance arm without having to separate under a bank holding company structure. Last week, Representative Barney Frank, a Massachusetts Democrat and chairman of the House Financial Services Committee, supported Fairfield, Connecticut-based GE’s stance. GE has said it is in favor of systemic regulations and expects change in the rules governing its finance arm.
SEC to Ban 'Flash Trades' of Stocks That Give Brokers Edge, Schumer Says
The U.S. Securities and Exchange Commission will seek to ban flash trades that give some brokerages an advance look at orders, Senator Charles Schumer said, citing a conversation with SEC Chairman Mary Schapiro. Schapiro assured Schumer in a phone call yesterday that the agency plans to ban the practice, according to a statement from his office. In a separate release, Schapiro said she has asked her staff to draft rules that "quickly eliminate the inequity" that flash orders cause.
"It’s preferencing one group over another, and that’s not the way markets should work," said Michael Panzner, author of "The New Laws of the Stock Market Jungle" who once traded for George Soros’s hedge fund. "It certainly on its face seems unfair and up until now was against the spirit, now perhaps against the actual rules, of fair play." A ban would reverse decisions since at least 2004, when the SEC first approved the systems at the Boston Options Exchange. Nasdaq OMX Group Inc., Bats Global Markets, Direct Edge Holdings LLC and the CBOE Stock Exchange give information to their clients about orders for a fraction of a second before the trades are routed to rival platforms. The technique is meant to give investors another opportunity to complete a transaction.
Schumer told the SEC in a July 24 letter to halt flash orders, saying he would propose legislation barring them if the agency didn’t act. NYSE Euronext, the world’s largest owner of stock exchanges, as well as brokerages Morgan Stanley and Getco LLC have said the practice may result in investors getting worse prices. Schapiro said any proposal to ban the transactions would require approval from SEC commissioners and public comment. SEC rulemaking is usually a two-step process. The agency’s staff proposes a regulation, and commissioners vote to solicit public feedback for between 30 and 90 days. Once the comment period ends, commissioners vote on whether to make the rule binding. The SEC can speed up the process by issuing temporary rules.
"These issues are very complex and not widely understood," said Lawrence Harris, a former SEC chief economist who is now a business professor at the University of Southern California in Los Angeles. "The consequence is that, occasionally, even experts will make mistakes. Fortunately, the SEC has mechanisms to revisit decisions that after the fact appear to be made with too much haste." Nasdaq and Bats said last week they support an industrywide ban on flash orders. In a July 27 letter, Nasdaq Chief Executive Officer Robert Greifeld urged the SEC to examine alternative systems that don’t publicly display their orders to investors. The SEC should examine whether the information in the flash trade is readily accessible and clearly identifiable to brokers who have to execute trades at the best price, Bats CEO Joe Ratterman said in a July 7 newsletter to clients.
Flash orders represented 2.4 percent of the shares traded in the U.S. in June, according to the New York brokerage Rosenblatt Securities Inc. At Direct Edge, which handles most of the flash volume, revenue from its Enhanced Liquidity Provider program has helped it cut other trading fees and more than double its market share since November. A ban would help Direct Edge’s rivals, particularly NYSE Euronext, Raymond James Financial Inc. analyst Patrick O’Shaughnessy wrote in a July 27 report to clients.
NYSE Euronext, the only one of the top four U.S. exchanges that doesn’t use flash orders, added 2.4 percent to $27.40 at 4 p.m. in New York. Nasdaq shares fell 0.3 percent to $21.39. Flash systems trace their roots as far back as 1978 to efforts by exchanges to electronically replicate how a trader might yell an order to floor brokers before entering it into the system that displays all bids and offers. Markets have evolved since the days of floor brokers’ dominance, with computer algorithms now buying and selling shares 1,000 times faster than the blink of an eye.
"This is a relatively old concept. However, the electronification of it makes it more dangerous than it used to be," Sean O’Malley, a former lawyer at the SEC’s division of trading and markets who is now a partner at Goodwin Procter LLP in New York. "Computer-based trading is going to be able to do things in a split second that no human could have done. That’s something that the SEC probably hadn’t thought about as much until this year." The proposal may be a sign regulators are moving to stricter oversight of so-called high-frequency trading, in which brokerages using advanced computers execute thousands of transactions in a second. Those strategies may account for 70 percent of trading volume, according to O’Shaughnessy.
While flash orders make up a small fraction of high-speed transactions, they have drawn the most criticism from investors and traders. Goldman Sachs Group Inc. released a statement today in light of the "complex landscape" surrounding high-frequency trading, saying the strategy accounted for less than 1 percent of its revenue and that it doesn’t use flash programs in executing client agency orders. "Unfortunately, flash trading gives a bad name to high- frequency trading," said Irene Aldridge, author of "High- Frequency Trading: A Practical Guide to Algorithmic Strategies and Trading Systems." "Most high-frequency trading has nothing to do with flash orders, so it’s going to continue as business as usual."
GE Pays $50 Million to Resolve SEC Accounting Probe
General Electric Co., the world’s biggest maker of locomotives and medical imaging equipment, agreed to pay $50 million to settle U.S. regulatory claims it manipulated earnings to meet analysts’ estimates. The company broke accounting rules four times in 2002 and 2003 to increase earnings or avoid reporting negative financial results, the Securities and Exchange Commission said in a civil lawsuit in federal court in New Haven, Connecticut, today. One violation helped GE continue a nine-year stint of meeting or beating analysts’ quarterly estimates that started in 1995, the SEC said.
"GE bent the accounting rules beyond the breaking point," SEC Enforcement Director Robert Khuzami said in a statement. "Overly aggressive accounting can distort a company’s true financial condition and mislead investors." The SEC’s investigation of GE’s accounting spanned at least four years and covered the company’s finance, aviation, health- care and energy units, twice forcing GE to restate earnings. While the examination of the company is finished, it continues with "respect to others," said David Bergers, head of the agency’s Boston office. He declined to identify anyone else under review.
GE, based in Fairfield, Connecticut, didn’t admit or deny wrongdoing. The accord bars GE from violating the antifraud, reporting, record-keeping and internal-controls laws, the SEC said. It also requires GE to make employees and officers available for interviews in any related SEC investigation. "GE is committed to the highest standards of accounting," the company said in a statement. The "errors at issue fell short of our standards and we have implemented numerous remedial actions and internal control enhancements to prevent such errors from recurring."
Chief Executive Officer Jeffrey Immelt took the helm from Jack Welch four days before the Sept. 11 terrorist attacks of 2001. Welch had run the company for two decades and was known for delivering results that rarely veered from analysts’ estimates. Under Immelt, GE’s stock has lost two-thirds of its value, much of it during the global financial crisis. GE rose 10 cents to $13.82 at 4:15 p.m. in New York Stock Exchange composite trading today. The regulator said it began examining GE because of concern that it and other companies might misuse hedge accounting to manipulate earnings. The broadening inquiry at GE ultimately uncovered four violations, the last of which the company corrected in 2008, the SEC said.
The SEC’s probe and GE’s internal investigation led the company to restate net income twice and adjust results two other times. The changes cut cumulative net earnings by $280 million, or 0.24 percent, between 2001 and 2007, based on a calculation from the company’s filings. In addition to the fine, GE said it paid about $200 million in legal and accounting expenses and gave about 2.9 million e- mails and other documents to the SEC.
The SEC faulted GE for overstating 2002 earnings by $585 million while improperly changing the way it accounted for commercial aircraft engine spare parts. In that year, and the following year, GE also improperly booked more than $370 million in revenue from expected sales of locomotives, the agency said. Rail-unit workers had helped accelerate transactions in 2000 through 2003 so that deals were recognized in the fourth quarters of those years, rather than the subsequent year, GE said in a regulatory filing in July of 2007.
In 2003, GE changed accounting methods for its commercial paper funding program to avoid making "unfavorable disclosures" and taking an estimated $200 million charge to pretax earnings, the SEC said. That year, the company also failed to correct a misapplication of financial accounting standards to certain GE interest-rate swaps. "Investors have a right to relay on financial statements," said the SEC’s Bergers. "When a company misapplies accounting rules to cast its financial results in a better light, the SEC will hold that company accountable."
GE said in a statement it has already corrected the accounting faulted by the SEC. It has also changed its system for releasing financial targets. In April, 2008, the company missed its per-share forecast after the implosion of Bear Stearns Cos. and was forced to cut its forecast once more later in the year as the financial crisis unfolded. In December, Immelt announced GE would no longer issue per-share forecasts at the urging of some analysts. Instead, GE gives investors and analysts a "framework" so they can derive their own per-share and revenue estimates.
Avoiding the Tail Wagging the Dog
I’ve written a number of pieces where I have discussed limits on derivatives. These have seemingly been among my least popular pieces, partly because I seem to argue against the free market. I’m not arguing against the free market, per se, but arguing that there are some types of contracts that should not be valid on a public policy basis. This piece is meant to integrate my thoughts on:
- Having a hard locate with shorting — (shares that have not been previously lent are located and confirmed to be borrowed).
- Insurable interest with respect to credit default swaps [CDS]. Only hedgers can initiate transactions, and if the hedger sells, he must first collapse the CDS transaction.
- Insurable interest should apply across all derivative markets, and should become a regular part of insuring systemic stability. Regulators of the various exchanges would require hedgers to divulge the assets or liabilities in question that they are hedging. The hedgers would then be allowed to buy and sell contracts up the hedging need, and no more. Speculators would bid for the right to trade with the hedgers, but could not trade with other speculators. Every transaction must have a hedger.
One of my core reasons for this is to shrink derivative activity so that it is smaller than the underlying markets. This will keep "the tail from wagging the dog." After all, if you need to do a transaction, why not buy/sell the underlying, on a forward basis if necessary? Also, let the regulators understand their clients more closely, so that they can better prevent insolvencies. My second core reason is that speculators dealing with speculators is gambling, and should be regulated that way, because there is no transactional tie to the real economy. Now, some will say,"Doesn’t all investment involve gambling?" My answer is no. All investment involves risk-taking, but there is a difference between risk-taking and gambling.
Every business/businessman takes risks. Many of those risks get externalized in public security markets because the equity and debt of the company trade on secondary markets. The prices of the shares and bonds reflect marginal perceived risk of the business. That risk is necessary risk. Unnecessary risk is two unrelated parties with no economic interest betting on whether the company can survive or not; such a bet should be regulated as gambling.
Most people buying/shorting a stock have some reason why they think they will make money. Even if they are wrong, they don’t think their actions are as uncertain as a coin flip. Few pick tickers randomly, and decide positions (buy/short) randomly. My third core reason is to reduce regulatory and taxation arbitrage. Many derivative transactions are done to escape regulations and taxation existing in the underlying markets. Let these parties abide by the rules of their regulators, and let them pay the taxes that they owe.
There are legitimate reasons for wanting to lay off short-term risk, without selling a long term asset. But on the whole, speculative markets should not exceed the demand for hedging. Similarly, markets for shorting should not exceed the amount of underlying available to be borrowed. That’s my position. Separate investment and gambling through a requirement of hedging in synthetic transactions. If some want to gamble on companies, let them go to Vegas; the margin requirments will be tighter.
I know this article won’t be popular, but I do want financial markets to have real legitimacy over the long term. Gambling, even if legal, never has moral legitimacy. Better to have smaller markets that are viewed by most to be legitimate, than to have large markets that have the legitimacy of a casino.
When I was 14, Warren Buffett wrote me a letter. It was a response to one I’d sent him, pitching an investment idea. For a kid interested in learning stocks, Buffett was a great role model. His investing style — diligent security analysis, finding competent management, patience — was immediately appealing.
Buffett was kind enough to respond to my letter, thanking me for it and inviting me to his company’s annual meeting. I was hooked. Today, Buffett remains famous for investing The Right Way. He even has a television cartoon in the works, which will groom the next generation of acolytes.
But it turns out much of the story is fiction. A good chunk of his fortune is dependent on taxpayer largess. Were it not for government bailouts, for which Buffett lobbied hard, many of his company’s stock holdings would have been wiped out.
Berkshire Hathaway, in which Buffett owns 27 percent, according to a recent proxy filing, has more than $26 billion invested in eight financial companies that have received bailout money. The TARP at one point had nearly $100 billion invested in these companies and, according to new data released by Thomson Reuters, FDIC backs more than $130 billion of their debt.
To put that in perspective, 75 percent of the debt these companies have issued since late November has come with a federal guarantee. (Click chart to enlarge in new window)
Without FDIC’s debt guarantee program, even impregnable Goldman would have collapsed.
And this excludes the emergency, opaque lending facilities from the Federal Reserve that also helped rescue the big banks. Without all these bailouts, the financial system would have been forced to recapitalize itself.
Banks that couldn’t finance their balance sheets would have sold toxic assets at market prices, and the losses would have wiped out their shareholder’s equity. With $7 billion at stake, Buffett is one of the biggest of these shareholders.
He even traded the bailout, seeking morally hazardous profits in preferred stock and warrants of Goldman and GE because he had “confidence in Congress to do the right thing” — to rescue shareholders in too-big-to-fail financials from the losses that were rightfully theirs to absorb.
Keeping this in mind, I was struck by Buffett’s letter to Berkshire shareholders this year:
“Funders that have access to any sort of government guarantee — banks with FDIC-insured deposits, large entities with commercial paper now backed by the Federal Reserve, and others who are using imaginative methods (or lobbying skills) to come under the government’s umbrella — have money costs that are minimal,” he wrote.
“Conversely, highly-rated companies, such as Berkshire, are experiencing borrowing costs that … are at record levels. Moreover, funds are abundant for the government-guaranteed borrower but often scarce for others, no matter how creditworthy they may be.”
It takes remarkable chutzpah to lobby for bailouts, make trades seeking to profit from them, and then complain that those doing so put you at a disadvantage.
Elsewhere in his letter he laments “atrocious sales practices” in the financial industry, holding up Berkshire subsidiary Clayton Homes as a model of lending rectitude.
Conveniently, he neglects to mention Wells Fargo’s toxic book of home equity loans, American Express’ exploding charge-offs, GE Capital’s awful balance sheet, Bank of America’s disastrous acquisitions of Countrywide and Merrill Lynch, and Goldman Sachs’ reckless trading practices.
And what of Moody’s, the credit-rating agency that enabled lending excesses Buffett criticizes, and in which he’s held a major stake for years? Recently Berkshire cut its stake to 16 percent from 20 percent. Publicly, however, the Oracle of Omaha has been silent.
This is remarkably incongruous for the world’s most famous financial straight-shooter. Few have called him on it, though one notable exception was a good article by Charles Piller in the Sacramento Bee earlier this year.
Buffett didn’t respond to my email seeking a comment.
What saddens me is that Buffett is uniquely positioned to lobby for better public policy, but he’s chosen to spend his considerable political capital protecting his own holdings.
If we learn one lesson from this episode, it’s that banks should carry substantially more capital than may be necessary. You would think Buffett would agree. He has always emphasized investing with a “margin of safety” — so why shouldn’t banks lend with one?
Yet he mocked Tim Geithner’s stress tests, which forced banks to replenish their capital. Why? Is it because his banks are drastically undercapitalized? The more capital they’re forced to raise, the more his stake is diluted.
He points to Wells Fargo’s deposit funding model being more robust than investment banks’, but that’s no excuse for letting tangible equity dwindle to three percent of assets. At that low level, the capital structure would have collapsed were it not for bailouts.
And by the way, the strength of Wells’ funding model is a result of FDIC insurance, among the government subsidies Buffett complains about in this year’s letter.
To me this feels like a betrayal. There’s a reason he’s Warren Buffett and not, say, Carl Icahn.
As Roger Lowenstein wrote in his 1995 biography of Buffett, “Wall Street’s modern financiers got rich by exploiting their control of the public’s money … Buffett shunned this game … In effect, he rediscovered the art of pure capitalism — a cold-blooded sport, but a fair one.”
But there’s nothing fair about Buffett getting a bailout, about exploiting the taxpaying public for his own gain. The naïve 14-year-olds among us thought he was better than this.
China’s growth figures fail to add up
China’s gross domestic product figures are among the world’s most closely watched since they can move markets or boost hopes of an imminent recovery. But the latest set of first-half numbers provided by provincial-level authorities are far higher than the central government’s national figure, raising fresh questions about the accuracy of statistics in the world’s most populous nation.
GDP totalled Rmb15,376bn ($2,251bn) in the first half, according to data released individually by China’s 31 provinces and municipalities, 10 per cent higher than the official first-half GDP figure of Rmb13,986bn published by the National Bureau of Statistics. All but seven of the regions reported GDP growth rates above the bureau’s first-half figure of 7.1 per cent. At the start of the year, Beijing set 8 per cent as China’s growth target for the year.
With the rest of the world looking to China as a beacon of expansion, the discrepancy is a reminder that statistics there are often unreliable and manipulated regularly by officials for personal and political purposes. In recent years, provincial figures have suggested consistently the world’s third-largest economy is bigger than Beijing’s published estimate, but the discrepancy appears to have widened this year. Even state-controlled media reports and editorials have in recent days raised questions over their accuracy.
The Global Times, controlled by the People’s Daily, the Communist party mouthpiece, reported that the public reacted with "banter and sarcasm" to NBS figures showing average urban wages in China rose 13 per cent in the first half to $2,142. It quoted an online poll showing 88 per cent of respondents doubted the official numbers. An editorial on Tuesday in the China Daily, the government’s English-language mouthpiece, quoted another survey that found 91 per cent of respondents sceptical of official data, up from 79 per cent in 2007.
Economists abroad have also questioned the reliability of the data in recent months. "Despite starkly limited resources and a dynamic, complex economy, the state statistical bureau again needed only 15 days to survey the economic progress of 1.3bn people," said Derek Scissors, of the Washington-based Heritage Foundation, referring to the time it took for the bureau to produce the figures after the end of the first half this year. "At worst, results are manufactured to suit the Communist party."
Some economists say provincial officials have enormous incentives to improve their career prospects by exaggerating local economic growth. The NBS itself is often wary of data provided by local governments and tends to revise down preliminary estimates using its own statistical model, according to official economists. Calls to the NBS, which like most Chinese government agencies rarely responds to requests for comment, were not returned.
The criticism has prompted the NBS to launch a campaign last week, entitled "Statistical Feelings: We have walked together – Celebrating the 60th anniversary of the founding of New China," to boost confidence among statisticians. The campaign has already produced works such as: "I’m proud to be a brick in the statistical building of the republic." In another poem, a contributor writes: "I can rearrange the stars in the sky because I have statistics."
Goldman: Please Keep Trading The China Bubble
Sometimes professional investment research resembles little more than a day trader rag with nicer charts and fancier wording to make the reader feel less guilty and more professional about the kind of "investing" he or she is actually performing.
Thus we point to Goldman's recent China "Portfolio Strategy" dated July 31st where they tell us to basically keep buying the Chinese market based on government support for the economy and a "favorable liquidity setup".
We're told to buy on dips, "stay engaged" (ie. keep generating commissions), and trade earnings suprises. Is this professional investing or what your college roommate was doing during the dotcom bubble? It's hard to tell the difference.
Market view: Stay invested; buy on dips for new money A-share market gained 12.4% in July despite a 5.3% correction, which was provoked by concerns regarding credit tightening, on July 29. We maintain our positive market view on A shares and think the government’s pro-growth policy stance, which should ultimately lead to macro/earnings recovery and a favorable liquidity setup, will continue to bode well for equities.That said, we see price volatility nudging higher as uncertainties revolving around interim earnings and the government’s monetary policy stance intersect with an above-mid-cycle multiple (24x). We would stay engaged in the market and look for opportunities to accumulate positions on dips.
Strategies: Domestic demand exposure; Trade earnings surprises We recommend investors to focus on the following themes to gain exposure to the A-share market: (1) Laggards with valuation buffers and reasonable EPS growth; (2) Pro-cyclical domestic demand, which includes banks, insurance, property, and selected consumer and materials names; (3) Stocks that are potentially subject to positive earnings surprises.
That's the front page: Trust the government to support the market, trust dumber investors to follow you (liquidity) and try to make little earnings trades hoping for pops. Oh wait. What about valuations?
Valuations: Above mid-cycle, but may persist CSI300 is now trading at around 23.9x I/B/E/S consensus P/E and 3.2X P/B on a 12-month forward basis against an average of 18.9x and 2.0x since April 2005, respectively (see Exhibits 1 and 2). On the basis that FY09 EPS growth for the aggregate market could be lower than the 15% that I/B/E/S consensus is currently forecasting, the forward P/E for CSI300 would be even higher at around 26.6x using our FY09 EPS growth assumption of - 5%. July 31, 2009
So valuations are sky high and earnings estimates might be missed. But we should hang on, because high valuations may persist. That's our upside investment case. High valuations may persist... and actually need to go higher or have upside earnings surprises to really give us upside on stock prices since they are already stretched as it is. Also, note that they compare recent valuation multiples to the average since... only 2005.. which was still a pretty bullish period for Chinese equities. So valuations are stretched even above what we saw during a pretty bullish time for China, but we should just have confidence in the government and liquidity to keep pushing things higher. This is what we are made to believe is "professional investing" rather than a gambler's punting.
China: Portfolio Strategy: China A-share Stance-at-a-Glance Goldman Sachs Global Economics, Commodities and Strategy Research 4 Resembling the market situation in 2007, the A-share market seems not primarily to be driven by market fundamentals, as ample liquidity and positive investor sentiment appear to be in the driver’s seat at the moment.
So simple translation: buy a market without respect for fundamentals. You could write it much easier: "Blind buying seems to be in the driver's seat at the moment. As professional investors we recommend you sit shotgun with these guys and just hope to jump out before they hit a tree." Now think of your parents' retirement money which they put into the China/Asia Fund by simply checking a box at work, thinking it would be professionally managed. Those funds, with their money, are some of the clients of this research, some of which will surely be trading as prescribed while their companies, and Goldman, back in the US, tout the rigorous analysis and principles they use when performing investment research. Hogwash.
While we note that a high valuation alone seldom derails a market uptrend, we caution investors that valuations and expected returns are negatively correlated.
Thanks. We are given a brief warning in the piece to make it feel more prudent, yet it is a warning which oddly conflicts with the logic of the entire piece and begs substantial further investigation because of this. "Oh by the way, usually the returns you should expect are negatively correlated to high valuations, but we think you should expect high returns from high valuations." Don't think too hard about that one. Just make a trade.
We reiterate our view that the maximum justifiable forward P/E for A shares should be around 25x, which is equivalent to: (a) discounting future earnings at a cost of equity of 8.5% (3.5% ERP + 5% RFR); and, (b) above one standard deviation above average forward P/E since April 2005. That said, we do not see risk of price multiples significantly contracting from here given the still-favorable liquidity conditions in the domestic system.
So to add insult to injury, we are near Goldman's maximum justifiable valuation, but we should be buying more? I mean, what's the upside left that has any fundamental basis? There isn't much, if any, we're just being told to ride the liquidity rocket by this piece and then given a lot of charts and financial terminology to make us feel it's about something more than that. But what's the downside risk in relation to the flimsy upside scenario? It's enormous. Just imagine lower than expected earnings plus a contraction in earnings multiples even to recent averages (at 19x on their numbers going back to only 2005, which could still be too bullish in a downside scenario) and you could take the market down as much as 50%.
I'm sorry, this isn't investment research. This is a piece of writing to get people, professionals at large funds, to punt China stocks. You could take away the Goldman name, simplify the wording, and you'd have a daytrader rag. The downside risks are enormous should valuations simply mean-revert, due to earnings disappointment or some kind of stall in the flow of China's rampant liquidity. And the upside case is so flimsy and without fundamental basis, you'd think a compulsive gambler came up with it.
(Readers will have to hunt down the piece on their own. July 31st, Goldman's "China A-Share Stance-at-a-Glance", by Thomas Deng. Part of me wants to apologize to Mr. Deng who I am sure is under substantial pressure "to perform" even if it means chasing a short term punter rally)
A new battle looms on Wall Street
by William Cohan
The traumatic upheaval that has roiled Wall Street during the past two years has produced – surprisingly quickly – a widely acknowledged new pecking order in the world of high finance: Goldman Sachs, in trading, and JPMorgan Chase, in banking, have become the undisputed industry leaders, with a hand in nearly every deal or trade. Clients can try to avoid these two, but only at their own peril.
The likes of Morgan Stanley, Barclays and Bank of America/Merrill Lynch – wounded but not fatally – continue to seek a firm footing on which to operate, while the so-called "zombie banks", such as Citigroup and Wells Fargo, remain on life support. Boutiques, such as Lazard, Greenhill, Rothschild, Evercore and Jefferies, that primarily provide advice to clients – and little capital – have been hiring broadly and have seen a resurgence of activity in their restructuring businesses, where a wave of recapitalisation and "amend and extend" deals have allowed many overleveraged companies to avoid bankruptcy filings. For the boutiques, the question remains whether, any time soon, there will be enough non-restructuring advisory business – formerly known as M&A – to justify all the new hiring.
But none of this is particularly surprising in the wake of the worst crisis to hit banking since the Great Depression produced the Glass-Steagall Act and the separation of investment banking from commercial banking. What does seem to be spooking Wall Street these days, though, is the traction that some private equity firms, such as KKR and Apollo Advisors, and hedge funds, such as Citadel Investment Group, appear to be "backward integrating" into investment banking by building up their businesses that compete with Wall Street in the lucrative underwriting of debt and equity securities.
KKR has been talking about building this effort for the past few years, ever since it announced its intentions in its own IPO prospectus in July 2007, and has hired a team to do it. "Through our capital markets and distribution function, we are able to capitalise on the current instability in financing markets by sourcing capital from non-traditional sources," Henry Kravis, KKR’s co-founder, has said of this effort. Recently, Citadel hired Todd Kaplan, a former senior banker at Merrill Lynch, to start a capital markets business at the hedge fund and is likely to hire another group of bankers to work with him. Word on the street is that Leon Black, at Apollo, is exploring a similar strategy. In a world of shrinking fees, to have your clients start to pick your pocket in this – albeit modest – way is an uncomfortable development for investment bankers.
In many ways, this effort makes perfect sense. First, for years firms such as KKR, Apollo and Citadel have been providing billions of dollars in underwriting fees to Wall Street. It is logical for them to try to siphon off a portion for themselves and their limited partners, especially in underwritings involving their own portfolio companies. KKR said as much in its prospectus: underwriting deals allows the firm to "capture certain financing fees otherwise paid to third parties". To date, KKR has underwritten four deals. Its recent distribution deal with Fidelity Investments, the mutual fund manager, gives its nascent effort another boost.
Second, these firms can take advantage of the low standing in which clients hold their Wall Street bankers. One veteran banker said he believed a "culture of cynicism" had emerged among clients who learnt the harsh reality in this crisis that in dicey situations, bankers would not hesitate to put their own interests first. Or, as another senior Wall Streeter put it, bankers are now "a lower form of life than Somali pirates".
Thus the news last week that KKR will try to take six of its companies public is the perfect moment to give its capital markets underwriting business a test drive. KKR has reportedly signed on as a lead underwriter – along with Goldman and Citigroup – of the IPO of its portfolio company, Dollar General, the discount retailer that appears to be gearing up to raise hundreds of millions of dollars in an equity offering. If KKR helps to lead underwrite the Dollar General IPO, it would mark the first time it had led one of its own deals and, of course, the first time that it was able to grab a hefty percentage of the IPO underwriting fees – generally 7 per cent of the deal – for itself.
Wall Street has much to worry about, ranging from where business and profits will come from in the future to what stiffer government regulation will mean, to a growing public backlash about how it handled itself during the financial crisis and why it paid out billions of dollars in bonuses despite losing billions of dollars. Congress has just issued subpoenas to both Goldman Sachs and JPMorgan, among others, seeking documentary evidence of fraud in the events that led to the recent financial carnage. Congress is also looking to curb bankers’ pay. The justice department is investigating Markit Group, a data provider owned by Wall Street firms, to see what role having exclusive information about the pricing and trading of exotic derivatives had in exacerbating the financial crisis.
These investigations should worry Wall Street executives in the short term. Longer term, though, it is competition from the likes of KKR and Citadel in their bread-and-butter underwriting businesses that could turn out to be the one significant development with lasting effects to emerge from the financial crisis.
Nonstop corporate bond rally raises eyebrows
U.S. corporate bonds, after rallying nearly nonstop since March, may be poised for a pullback before year end. Corporate bonds have rallied since government stress tests on banks removed fears that another major financial company would collapse. Eager to profit from a credit market recovery, investors have poured cash into corporate bonds, attracted by record high yields reached during last year's credit crisis.
The rally, however, has cut yields by more than a third, making it harder to find value even as uncertainty lingers over companies that issue corporate debt. "I don't think at this point in time there's a lot of reward for the risk you are taking in the corporate bond market in any sector," said Dan Vrabac, portfolio manager for the Ivy Global Bond Fund in Overland Park, Kansas.
Second-quarter earnings, which confounded investors' initial fears and turned out much better than expected, have given a fresh wind to the corporate bond rally. But earnings are still down 29 percent from the year-ago period for the 370 S&P 500 companies reporting so far, according to Thomson Reuters data. "Really there's no suggestion that fundamentals are getting any better right now, which means that all the trading is based on expectations and hopes," said Guy LeBas, chief fixed-income strategist at Janney Montgomery Scott in Philadelphia.
Demand has been so strong that traders are having a hard time finding enough corporate bonds to sell, especially as a summer lull in bond issuance crimps supply. Cash flow into the market has been relentless as investors chase returns that have averaged 13 percent year to date, according to Merrill Lynch indexes. "As some people enjoyed huge returns over the course of the last six months, they're starting to realize those returns just can't be repeated," LeBas said. "I think that's where a lot of the selling is probably going to originate."
Investors could begin taking profits later this year to protect the year's stellar gains, some strategists said. The stock market also could begin to compete with corporate bonds for cash, according to a recent Bank of America Merrill Lynch research note. July marked the first month this year that stocks' returns beat corporate bonds, with the S&P 500 climbing 7.4 percent for the month, while the bank's note to clients pointed out that the monthly gain was just 4.6 percent for the best-performing corporate bonds, those with BBB ratings.
After devastating stock market losses last year, investors had been shifting out of equities into less risky corporate debt, but that move could reverse if July's performance trend persists, the bank said. Some investors are still finding attractively priced corporate bonds. "There's more opportunity in lower investment grade or just below," said Keith Springer, president of Sacramento-based Capital Financial Advisory Services.
He said he has been buying some short-dated Sallie Mae notes with yields as high as 10 percent and bonds of Marshall & Ilsley, a Wisconsin bank that benefits from government support. Yields on better-quality corporate bonds are looking much less attractive than they were just a few months ago, especially relative to U.S. Treasuries. The yield gap between Treasuries and some highly rated corporate debt is now as skimpy as it was during the credit "bubble" years of 2006 and early 2007.
Colgate-Palmolive Co, for example, sold six-year notes last week at a spread of 67 basis points over Treasuries, close to the 64-basis-point spread it paid on 10-year notes in November 2006, according to Bank of America. The collapse in spreads is not reflecting the risks in the economy, said Vrabac of the Ivy Global Bond Fund.
Over-leveraged financial companies and consumers are still retrenching, which means the economy will be growing at a much slower rate than the market perceives, he said. The U.S. job market is also too weak to support consumer spending and strong economic growth, Vrabac said. "Without the consumer, which is two-thirds or more of the economy, I don't see how you can get (the economy) growing at the type of levels that the market is discounting today," he said.
Dubai Real Estate Down 50% From Peak
Home values in Dubai have fallen by about half from their peak late last year in the wake of the global real-estate slowdown, a widely watched index of Dubai property prices showed Monday. Property prices in the emirate, which had been driven sharply higher in past years as foreign investors snapped up real estate, have been sliding since the third quarter of 2008. But the decline showed signs of slowing in the second quarter, with prices falling 9% from a year earlier, after much steeper drops in previous quarters, U.K.-based real-estate consultancy Colliers International said in its quarterly price index. The measure, which collates mortgage transactions on properties open to foreign ownership since the start of 2007, is compiled using data from financial institutions accounting for 60% of the mortgage market in Dubai.
Like other places around the world, the emirate has been hit by a property slump as a result of the credit crunch. However, Colliers said continuing concerns over the availability of financing, job-security worries for the emirate's many expatriates and a lack of transparency about project delays and postponements continued to hamper the market's recovery. Property prices in Dubai were rising sharply as recently as the first half of last year. But since the third quarter of 2008, as the impact of the global crisis has drawn in on the emirate, real-estate agents have reported softening prices and a dearth of buyers, especially those buying investment properties which had earlier helped drive steep price increases.
The average price of property declined to 949 U.A.E. dirhams ($258) per square foot in the second quarter of 2009, compared with 1037 dirhams in the first three months of the year, Colliers said. Property prices are now at the same level as they were in the second quarter of 2007. Between April and June, the price of villas and townhouses was hardest hit, with prices falling 18% and 11%, respectively. Apartment prices, meanwhile, dipped 3%, Colliers said. However, the rate of decline during the quarter "decelerated dramatically" from the start of the year, when prices slumped 42% between the fourth quarter of 2008 and the first quarter of 2009.
"After a significant decline in the first three months of the year, the market witnessed a deceleration in the rate of decline in residential prices in the second quarter," Ian Albert, Colliers International regional director in Dubai, told Zawya Dow Jones in a telephone interview. "The magnitude of the decline that we saw in the first quarter was not, and is now very unlikely to be, repeated." Colliers said the deceleration was mainly due to the slow release of liquidity into the market by financial institutions, the restructuring of loan-to-value ratios and the relaxation of strict lending criteria, leading to a 50% rise in the number of property transactions during the second quarter from the first three months of the year.
"In the coming months the market will be searching for further evidence of market stabilization as we draw nearer to the bottom of market prices," Mr. Albert said, adding that he was "cautiously optimistic" about the third quarter, even though figures will be distorted by the summer holidays and Ramadan. Saud Masud, a real-estate analyst at UBS, said a decelerating price fall doesn't necessarily point to market recovery. "The underlying trends are not supportive of a recovery in the market anytime soon," he said. The decline came after quarters of red-hot growth. Prices rose 42% in the first quarter of 2008, 16% in the second quarter and 5% in the third quarter, according to previous Colliers reports.
Confidential Kaupthing corporate loan details leaked on the internet
Confidential loan details relating to failed Icelandic bank Kaupthing and its largest customers have been leaked on the internet, revealing some of the risks the bank was taking just weeks before the Icelandic financial meltdown last October. The 210-page presentation, showing a snapshot of outstanding corporate loans of more than €45m (£38m) as of September 25, has been posted on the Wikileaks.org website.
Many of the largest exposures are to British-based businesses and entrepreneurs including property investors Robert and Vincent Tchenguiz, their former brother-in-law Vivian Imerman, Simon Halabi, Nick and Christian Candy, Peter Shalson and Aneel Mussarat. The leaked document also reveals the extent to which Kaupthing had been lending to those with a major economic interest in the bank's shares. For example it sets out a complex web of loans and shares posted as collateral between the bank, holding company Exista, which owned 23% of Kaupthing, and Exista's controlling shareholders Agust and Lydur Gudmundsson.
Total Kaupthing loans to Exita and its subsidiaries reached €1.43bn, with considerable sums extended without security or covenants. Robert Tchenguiz, the second largest borrower from Kaupthing, with loans of €1.37bn, is also among those who had an interest in Kaupthing shares, as he was a major shareholder in Exista. Meanwhile veteran British retailer, Kevin Stanford, was said to rank as the fourth largest investor in Kaupthing, with 30.9m shares. Kaupthing loans to him and his companies totalled €519m, according to the leaked document.
While there is no suggestion of wrongdoing, several Icelandic authorities and Kaupthing's resolution committee are examining the complex and multi- faceted relationship between the bank and some of its largest customers prior to its collapse. They are looking to rule out conflicts of interest. The leaked document provides a snapshot of Kaupthing's loans at a critical moment before the bank's demise. Many of the borrowing arrangements shown will since have been refinanced or revalued.
Kaupthing's resolution committee has sought to have the presentation removed from the internet and has secured a temporary injunction against its publication by certain Icelandic media. A source at the bank insisted it was keen to see all questions about its collapse answered, but it was still bound by a duty of confidentiality to customers. Alongside each loan, the leaked presentation provides a brief assessment of the risk tied to the loans and, on occasion, the state of relations with the customer. "Asset rich and frequently cash poor, limiting his ability to meet margin calls", reads one summary. Another states: "Relationship ... has become strained as downturn has impacted their business model. They build for the uber-rich but sales are slowing".
A third loan risk summary states: "There is a glut of apartments in Manchester and it is questionable whether construction should be commenced. It is probable that an updated valuation would lead to a breach of covenant." In March Kaarlo Jännäri, former head of the Finnish financial regulator, published a damning independent analysis of the Icelandic banking system and its collapse. Commissioned by the Icelandic government and International Monetary Fund, the report highlighted a series of concerns about the conduct of the banks, including large exposures to individual clients and business conducted with related parties, such as those with an interest in bank shares.
Jännäri noted that at the end of June 2008, Iceland's big three banks – Kaupthing, Glitnir and Landsbanki – had a total of 23 loan exposures to individuals or corporate groups that were equivalent to more than 10% of the respective bank's funds."What is striking about these exposures is that the majority of them are to holding companies, or other institutions, or individuals whose main activity is investing in shares or other venture-capital or speculative activities," he said. "In most cases, the assets pledged as collateral for these loans are shares in the companies in which these customers had invested the funds borrowed... My judgment is that their behaviour in this regard has been very imprudent."
Serious Fraud Office intensifies Icelandic banking inquiry after Kaupthing leak
The Serious Fraud Office is gathering extensive intelligence on the Icelandic banks in the aftermath of last autumn's crash that left thousands of UK institutions nursing millions of pounds of losses.The SFO's team has intensified its inquiries following the leak of Kaupthing's loan book on to an internet site, Wikileaks.org, over the weekend, according to sources, A team is understood to be examining the document connected to the failed Icelandic bank, which had a large UK client base. It has also received information relating to the UK operations of the Icelandic banks, apparently from a number of whistleblowers ranging from employees to investors and depositors.
The SFO is now believed to be looking for further whistleblowers to step forward following the leak of Kaupthing's loan book and risk analysis. The document detailed huge sums allegedly given to companies linked to a key director of Kaupthing and its major shareholders with little or no collateral. A number of clients were also allegedly given loans to buy stakes in the bank itself with no collateral but the shares themselves. Although it has not launched a formal criminal investigation, a team from the SFO is known to have been looking closely at Kaupthing, Glitnir and Landsbanki for a number of months, following their collapse in October last year.
The three banks were nationalised by the Icelandic government, which put their foreign operations into administration, while relaunching their domestic operations as new banks with different names. The SFO's interest in Kaupthing's loan book is likely to prove embarrassing for the bank's London advisers and its high-profile banking clients, although there is no suggestion of any wrongdoing. High-profile individuals such as Kevin Stanford, the retail entrepreneur, and Robert Tchenguiz, the property investor, were among Kaupthing's biggest clients, according to the loan book.
A closer look at the document appears to give a snapshot of Kaupthing's highly unusual lending practices as they stood just two weeks before the Icelandic system failed last October. The papers show that Kaupthing's highest loans, totalling more than €6.4bn (£5.45bn), were given to companies connected to just six clients, four of whom were major shareholders in the company. Kaupthing granted its largest loans, totalling €1.86bn, to companies connected to Exista, its biggest shareholder with a 22pc stake – some of which were "unsecured and with no covenants". Mr Tchenguiz, who sat on the board of Exista, borrowed €1.74bn to finance his private investments, including stakes in Mitchells and Butler, and Sainsbury's. Mr Tchenguiz has confirmed that he was the bank's biggest client, but declined to comment further.
Northern Rock bad debts push loss to £724 million
Northern Rock made a £724m loss in the six months to June as its bad debt soared to £602m and warned that its £14.5bn taxpayer loan "will increase" once a planned restructuring is complete. The nationalised bank also confirmed that is in breach of its regulatory requirements but that the Financial Services Authority "does not currently intend to restrict the activities of the Company while the legal and capital restructuring is completed". Its core tier one capital – the key measure of financial strength – is -£794m. It would need core tier one capital of £2bn to be in line with the FSA’s current requirement for a ratio of about 8pc.
The specialist mortgage is splitting into a "good bank" and a "bad bank" under its planned restructuring and stressed yesterday that it would not require any more than the £3bn of capital from the taxpayer already earmarked. Although the loan from the taxpayer will rise, the distinction is important as capital is loss-absorbing and the state would stand very little chance of recovering any more capital injected into the lender. The additional loan facility will charge interest and will be repayable.
The underlying loss at the bank improved from £443m to £270m, largely due to higher interest rates being charged to customers. Last year, Northern Rock also had far higher costs in association with the nationalisation process. Net interest income recovered from £51.9m loss to a £74.2m gain as the underlying interest margin jumped from 0.41pc to 1.12pc. This "primarily reflects the interest rate environment and the changing nature of the book as fewer customers remortgage to other mortgage lenders following the end of their product term".
Fewer customers are remortgaging because they are unable to find a borrower to take on their debts. This is largely because about a third of the book is already in negative equity, trapping borrowers with Northern Rock. As a result, problem loans at the bank have rocketed. Arrears rates are running at 3.92pc against the industry average of 2.39pc, with the book of controversial 125pc mortgages running with 6.47pc arrears rates – a tripling of the level last year. However, repossessions are down from 3,620 to 2,522 due to efforts to help homeowners. Bad debts rose to £602m in the half from £191.6m in the first half of 2008 but below the £702.8m in the six months to December.
Northern Rock withdrew £4.2bn from the mortgage market in the past six months – equivalent to the amount HSBC revealed yesterday that it provided in credit to homeowners. In total, Northern Rock lent just £1.3bn, excluding the money recovered from repayments, and is on course to make just £4bn available this year. The bank has also lost £1.2bn of retail deposits, with savings levels falling to £18.4 in the six months due to "increased market competition, along with a more normalised customer view of the savings market and Northern Rock’s place within the market".
In total, its loan from the Government is now £14.5bn. It paid the state £309m in interest and fees in the half, compared with £1.21bn in the 11 months between February and December last year. The fall was due to a reduction in interest and a decline in the loan level by £6bn. The numbers also showed that costs to advisers in relation to its nationalisation totaled £32.4m last year, but "professional fees" in the first half totaled just £2.8m. Chief executive Gary Hoffman said: "We anticipate receiving [EU] state aid approval [for the restructuring plan] in the autumn and the legal and capital restructuring of the Company completed by the end of the year. This ultimately prepares for a return to the private sector."
EU hedge fund rules will cost pension funds billions
The European Union's proposals to regulate hedge funds could cost pension funds as much as €25bn (£21.3bn) a year, according to research by the Alternative Investment Management Association (AIMA). The trade body warned that the cost of leverage restrictions, increased compliance costs and the impact of being restricted to European funds would hit investor returns in hedge funds and private equity by an estimated 2.5pc. It is thought that the €5 trillion European pension fund industry has nearly €1 trillion allocated to alternative investments at the moment
Andrew Baker, CEO of AIMA, said: "This is an estimated figure but it shows the potentially enormous impact that the directive could have on Europe's pension funds and in the longer term, Europe's pensioners. He added: "The directive will result in a major reduction in choice for Europe's institutional investors and a big increase in costs and hence a significant reduction in returns. None of this is good for the competitiveness of the European financial services sector or indeed the economies of Europe as whole."
Kathryn Graham, director of Hermes Pension Fund Management, the executive arm of the BT pension fund, said: "It is our view that there are unintended consequences that would directly impact investments. We have two big concerns. First that the directive's passport system will restrict our choice of funds we can invest in. It seems we could only be able to invest in European based funds, for the first three years at least. The second concern is that regulatory costs will increase sharply and will be passed directly onto us."
Ms Graham said investors were not against regulation in principle but just the directive in practice. She said: "We want managers to be registered and we want to see improvements in corporate governance - we want a directive to exist. But as investors we want to be included in the process and see a proper consultation to achieve a directive without unintended consequences." In April the EU unveiled proposals to introduce radical new restrictions on hedge funds and private equity that it said was necessary to address the concerns following the financial crisis.
The directive is particularly tough on non-European fund operators. It stipulates that only funds domiciled in Europe can be marketed in the EU. An estimated 90pc of hedge funds are domiciled off-shore while the industry is also dominated by American players. The UK has led the criticism of the directive as London is home to 450 hedge funds, or about 80pc of the European total, managing a combined £250bn. Simon Walker, head of the BVCA, has called the directive "crass and unnecessary'' but warned that unless the Government and industry engaged, the current directive could be the "best-case scenario''.
Profiting from the Tooth Fairy
John P. Hussman
It is a general investment rule that by the time that a particular thesis makes it to the cover of national news magazines, it is largely discounted by the markets. On that note, this week's Newsweek cover "The Recession is OVER!" might be taken as an occasion for investors to reconsider the potential upside from this theme here. The subtitle on the cover does note "Good luck surviving the recovery," but in general, the article is about how "smart people" in government will produce a "smart economy" with bundles of government spending. The cover artist had a sense of humor though, putting the title on a big balloon, with a push-pin next to it.
Although the stock market's advance since March is taken as evidence that the economy is on the mend, the extent of that advance represents just over one-third of the prior bear market loss, which is somewhat standard (if not reliable or predictable) for bear market rallies. Interestingly, the advance since March has almost exactly matched the size and duration of the rally that followed the initial market plunge in 1929, just before the stocks and the economy suffered fresh deterioration.
That's not to say that we are assuming that stocks are still in a bear market. Nor do we assume that they are in a bull market. I don't think we can rule out a further advance, nor should we rule out a fresh loss from these levels of over 40%, extending well into next year, before this adjustment is durably behind us. We aren't investing on either as an expectation. As I've noted before, the bull/bear distinction is not a useful concept except in hindsight. The prevailing status is not observable in real time, so we rely instead on variables that are continuously measurable, focusing on full-cycle performance, and accepting that hindsight will only sometimes be kind to our assessment, and will sometimes be utterly cruel.
The recent rally never recruited the sort of price-volume sponsorship that has usually occurred very early on in prior bull markets, and we have been defensive in recent months (other than a periodic but helpful allocation to index call options). The evolution of the market's advance to recover a full one-third of the market's prior losses has been frustrating given that position.
Looking back over the past decade, there is something of a pattern to the periods of frustration that we've experienced. Specifically, neither I nor our investment methods have historically enjoyed much success profiting from the Tooth Fairy. We are not very good at "catching" gains from speculative investment themes that have a high probability of collapsing (for my part, I view the thesis of a sustained economic recovery as one of those themes). Trend following strategies do track the market well during some of these periods, but we have not found ones that outperform our existing approach.
Though I was characterized as a "lonely raging bull" in the early 1990's, by the late 1990's I missed the bubble in the dot-com stocks, and avoided the last part of the bubble in technology stocks in 1999 and 2000. Though our stock selection didn't suffer much relative to the major indices, we clearly could have earned more, at least during the rising part of those bubbles, by playing with fire. We similarly missed the boom in what I repeatedly called "garbage stocks" during the bull market that ended in 2007, avoiding financial stocks entirely, and missing the big runup that commodity stocks and other cyclicals enjoyed before they collapsed.
Momentum-based, trend-following, simplistic thinkers with a speculative bent generally do very well during bubble periods (though not over the full cycle). Such analysts appear to have no reservation about jumping in here, because they assume that there will be no consequences to the overhang of deteriorating mortgage and commercial debt, even when coupled with "trigger events" such as rising unemployment (not to mention a median duration of unemployment that is far in excess of that of previous recessions).
Such analysts – some of whom we could name because they are the same ones who recommended jumping in with both feet at the 2007 highs on the basis of the "Fed Model" – have an affinity for simple rules, and ratios, and formulas, apparently without thinking through how those relate to what matters, which is the long-term stream of deliverable cash flows that investors will receive over time from their securities.
Such analysts have no intellectual difficulty with non-equilibrium concepts, such as "government resources" (which they seem to think is just money from heaven, but is in fact merely a redistribution) and "cash on the sidelines" (which represents a mountain of money-market securities that somebody has to hold "on the sidelines" until they are retired, because they were issued in return for funds that have already been borrowed and spent). Such analysts are often able to do what we can't bring ourselves to do, which is to risk other people's financial security on raw price momentum, or on speculative themes that are contradicted by historical data, or that logically cannot be true.
If I knew we could speculate on these themes and still get our shareholders out unharmed, I would do it. But I don't know how. It's frustrating to have missed what has turned out in hindsight to be a significant rally. We simply have not had the evidence to say "Yes, the conditions we observe now have historically been associated with a satisfactory expected return, on average, given the risks involved." Still, I have no doubt we'll eventually see such conditions emerge as we work through this deleveraging process. Meanwhile, we will continue to pursue our investment approach, which has served us extremely well at contained risk, particularly over complete market cycles.
Investors can point to various indicators that "flashed buy signals" near the March lows. The problem is that many of those also went positive during during last year's plunge and then failed spectacularly (as also occurred in late January). More importantly, we can't find factors that would have made us more constructive since March and that would also have improved long-term returns if applied consistently on a historical basis.
To remove our hedges here in anticipation of a sustained economic recovery and bull market would be to assume that the events in the economy since 2007 have been psychological and temporary, that there will be no material effects from continuing delinquencies and foreclosures (not to mention the second wave of reset pressures due to begin later this year), and that the Fed can create more base money in one year than in the entire history of the nation, without any consequence. If we could treat the recent downturn as a "standard recession," that might be possible. But little is standard about this downturn, and the fundamental difficulties have deeper roots than trend-following investors seem to assume.
That said, we can't ignore the potential for investors to continue to speculate for a while, despite tepid price-volume sponsorship and deep-rooted economic challenges. The Strategic Growth Fund has just under 1% of assets in index call options as something of an "anti-hedge" to soften our position and make it somewhat more constructive in the event of a further advance. We don't intend to stand in front of a train, if investors are intent on playing a recovery theme, but the way we would participate in that case would be to let the market "take us out" of our hedge by advancing further and allowing our index call options to go "in the money" (at the risk of losing those gains if the market subsequently sells off). In any event, we don't have evidence that would provoke us to remove our downside protection against significant losses, so at present, our "constructive" exposure amounts to just under 1% of assets allocated to index calls, and a fully hedged investment stance otherwise.
As of last week, the Market Climate for stocks was characterized by moderately unfavorable valuations and mixed market action. We estimate that the S&P 500 Index is currently priced to deliver annual returns over the next decade of about 7%, which – except for the period since 1990 – is generally a prospective rate of return consistent with market peaks, not troughs. Still, stocks "look" less expensive if one assumes a permanent return to 2007 profit margins, which were about 50% above historical norms. We can't rule out the potential for investors to invest on unreasonable and largely unfounded expectations of a return to those earnings levels, which could provoke a continued willingness to pay what in our view are already elevated valuations.
From the standpoint of market action, price-volume sponsorship continues to be decidedly tepid. Indeed, trading volume on the NYSE has declined sequentially in every month since March. The market is strenuously overbought over the short term and fundamentally overvalued on long-term measures, but unfortunately, we can't stand in front of investors and say, "no, stop, don't." The Strategic Growth Fund holds just under 1% of assets in index call options as an "anti-hedge" to soften its defensive position in the event the market advances further. Otherwise the Fund is well hedged.
As is typically the case when the Fund is hedged, the bulk of our returns here will be driven by the difference in performance between the stocks held by the Fund and the indices we use to hedge. On that front, I am very comfortable with the Fund's holdings, and continue the day-to-day practice of buying higher ranked candidates on short-term weakness and selling lower-ranked holdings on short-term strength, consistently looking to build favorable valuation and market action into the Fund's portfolio in that way.
In bonds, the Market Climate last week was characterized by slightly unfavorable yield levels and slightly unfavorable yield pressures. The Strategic Total Return Fund continues to carry a duration of about 3 years, mostly in TIPS, with less than 20% of assets allocated toward precious metals shares, foreign currencies, and utility shares. In continue to expect that the U.S. dollar will face significant pressure in the coming years as the combined result of an unsustainably wide current account deficit coupled with aggressive issuance of U.S. government liabilities.
Though I don't expect near term inflation pressures, the supply of government liabilities alone have weighed on the dollar. Our investment stance in the Strategic Total Return Fund is primarily concerned with increasing purchasing power over time, and our primary activities in the current low yield environment will continue to involve adding to our exposures in bonds, precious metals and currencies on price weakness, and clipping that exposure on strength, as we don't anticipate strong and sustained directional movement in any of these asset classes until inflation pressures emerge.
Capitalism, Sarah Palin-style
by Naomi Klein
[Adapted from a speech on May 2, 2009 at The Progressive’s 100th anniversary conference and originally printed in The Progressive magazine, August 2009 issue]
We are in a progressive moment, a moment when the ground is shifting beneath our feet, and anything is possible. What we considered unimaginable about what could be said and hoped for a year ago is now possible. At a time like this, it is absolutely critical that we be as clear as we possibly can be about what it is that we want because we might just get it. So the stakes are high. I usually talk about the bailout in speeches these days. We all need to understand it because it is a robbery in progress, the greatest heist in monetary history. But today I'd like to take a different approach: What if the bailout actually works, what if the financial sector is saved and the economy returns to the course it was on before the crisis struck? Is that what we want? And what would that world look like?
The answer is that it would look like Sarah Palin. Hear me out, this is not a joke. I don't think we have given sufficient consideration to the meaning of the Palin moment. Think about it: Sarah Palin stepped onto the world stage as Vice Presidential candidate on August 29 at a McCain campaign rally, to much fanfare. Exactly two weeks later, on September 14, Lehman Brothers collapsed, triggering the global financial meltdown.
So in a way, Palin was the last clear expression of capitalism-as-usual before everything went south. That's quite helpful because she showed us—in that plainspoken, down-homey way of hers—the trajectory the U.S. economy was on before its current meltdown. By offering us this glimpse of a future, one narrowly avoided, Palin provides us with an opportunity to ask a core question: Do we want to go there? Do we want to save that pre-crisis system, get it back to where it was last September? Or do we want to use this crisis, and the electoral mandate for serious change delivered by the last election, to radically transform that system? We need to get clear on our answer now because we haven’t had the potent combination of a serious crisis and a clear progressive democratic mandate for change since the 1930s. We use this opportunity, or we lose it.
So what was Sarah Palin telling us about capitalism-as-usual before she was so rudely interrupted by the meltdown? Let's first recall that before she came along, the U.S. public, at long last, was starting to come to grips with the urgency of the climate crisis, with the fact that our economic activity is at war with the planet, that radical change is needed immediately. We were actually having that conversation: Polar bears were on the cover of Newsweek magazine. And then in walked Sarah Palin. The core of her message was this: Those environmentalists, those liberals, those do-gooders are all wrong. You don't have to change anything. You don’t have to rethink anything. Keep driving your gas-guzzling car, keep going to Wal-Mart and shop all you want. The reason for that is a magical place called Alaska. Just come up here and take all you want. "Americans," she said at the Republican National Convention, "we need to produce more of our own oil and gas. Take it from a gal who knows the North Slope of Alaska, we’ve got lots of both."
And the crowd at the convention responded by chanting and chanting: "Drill, baby, drill."
Watching that scene on television, with that weird creepy mixture of sex and oil and jingoism, I remember thinking: "Wow, the RNC has turned into a rally in favor of screwing Planet Earth." Literally.
But what Palin was saying is what is built into the very DNA of capitalism: the idea that the world has no limits. She was saying that there is no such thing as consequences, or real-world deficits. Because there will always be another frontier, another Alaska, another bubble. Just move on and discover it. Tomorrow will never come.
This is the most comforting and dangerous lie that there is: the lie that perpetual, unending growth is possible on our finite planet. And we have to remember that this message was incredibly popular in those first two weeks, before Lehman collapsed. Despite Bush's record, Palin and McCain were pulling ahead. And if it weren’t for the financial crisis, and for the fact that Obama started connecting with working class voters by putting deregulation and trickle-down economics on trial, they might have actually won.
The President tells us he wants to look forward, not backwards. But in order to confront the lie of perpetual growth and limitless abundance that is at the center of both the ecological and financial crises, we have to look backwards. And we have to look way backwards, not just to the past eight years of Bush and Cheney, but to the very founding of this country, to the whole idea of the settler state.
Modern capitalism was born with the so-called discovery of the Americas. It was the pillage of the incredible natural resources of the Americas that generated the excess capital that made the Industrial Revolution possible. Early explorers spoke of this land as a New Jerusalem, a land of such bottomless abundance, there for the taking, so vast that the pillage would never have to end. This mythology is in our biblical stories—of floods and fresh starts, of raptures and rescues—and it is at the center of the American Dream of constant reinvention. What this myth tells us is that we don't have to live with our pasts, with the consequences of our actions. We can always escape, start over.
These stories were always dangerous, of course, to the people who were already living on the "discovered" lands, to the people who worked them through forced labor. But now the planet itself is telling us that we cannot afford these stories of endless new beginnings anymore. That is why it is so significant that at the very moment when some kind of human survival instinct kicked in, and we seemed finally to be coming to grips with the Earth’s natural limits, along came Palin, the new and shiny incarnation of the colonial frontierswoman, saying: Come on up to Alaska. There is always more. Don't think, just take.
This is not about Sarah Palin. It's about the meaning of that myth of constant "discovery," and what it tells us about the economic system that they're spending trillions of dollars to save. What it tells us is that capitalism, left to its own devices, will push us past the point from which the climate can recover. And capitalism will avoid a serious accounting—whether of its financial debts or its ecological debts—at all costs. Because there’s always more. A new quick fix. A new frontier.
That message was selling, as it always does. It was only when the stock market crashed that people said, "Maybe Sarah Palin isn't a great idea this time around. Let's go with the smart guy to ride out the crisis."
I almost feel like we've been given a last chance, some kind of a reprieve. I try not to be apocalyptic, but the global warming science I read is scary. This economic crisis, as awful as it is, pulled us back from that ecological precipice that we were about to drive over with Sarah Palin and gave us a tiny bit of time and space to change course. And I think it's significant that when the crisis hit, there was almost a sense of relief, as if people knew they were living beyond their means and had gotten caught. We suddenly had permission to do things together other than shop, and that spoke to something deep.
But we are not free from the myth. The willful blindness to consequences that Sarah Palin represents so well is embedded in the way Washington is responding to the financial crisis. There is just an absolute refusal to look at how bad it is. Washington would prefer to throw trillions of dollars into a black hole rather than find out how deep the hole actually is. That's how willful the desire is not to know.
And we see lots of other signs of the old logic returning. Wall Street salaries are almost back to 2007 levels. There's a certain kind of electricity in the claims that the stock market is rebounding. "Can we stop feeling guilty yet?" you can practically hear the cable commentators asking. "Is the bubble back yet?"
And they may well be right. This crisis isn't going to kill capitalism or even change it substantively. Without huge popular pressure for structural reform, the crisis will prove to have been nothing more than a very wrenching adjustment. The result will be even greater inequality than before the crisis. Because the millions of people losing their jobs and their homes aren't all going to be getting them back, not by a long shot. And manufacturing capacity is very difficult to rebuild once it's auctioned off.
It's appropriate that we call this a "bailout." Financial markets are being bailed out to keep the ship of finance capitalism from sinking, but what is being scooped out is not water. It's people. It's people who are being thrown overboard in the name of "stabilization." The result will be a vessel that is leaner and meaner. Much meaner. Because great inequality—the super rich living side by side with the economically desperate—requires a hardening of the hearts. We need to believe ourselves superior to those who are excluded in order to get through the day. So this is the system that is being saved: the same old one, only meaner.
And the question that we face is: Should our job be to bail out this ship, the biggest pirate ship that ever was, or to sink it and replace it with a sturdier vessel, one with space for everyone? One that doesn’t require these ritual purges, during which we throw our friends and our neighbors overboard to save the people in first class. One that understands that the Earth doesn’t have the capacity for all of us to live better and better.
But it does have the capacity, as Bolivian President Evo Morales said recently at the U.N., "for all of us to live well."
Because make no mistake: Capitalism will be back. And the same message will return, though there may be someone new selling that message: You don't need to change. Keep consuming all you want. There's plenty more. Drill, baby, drill. Maybe there will be some technological fix that will make all our problems disappear.
And that is why we need to be absolutely clear right now.
Capitalism can survive this crisis. But the world can't survive another capitalist comeback.