Last run of Barney, Gene, and Tom, District Fire Department horses, Washington, D.C.
For more, See July 18 2009 Washington Post story
Ilargi: I've been thinking a lot about Fannie and Freddie, and I haven't figured out what is going to happen, or how. Whatever it is, it will be shocking, there’s no escaping that.
A bad bank "solution" for Fannie and Freddie is what I see contemplated. With half of the $12 trillion US mortgage market soundly underwater by 2011, and 9 out of 10 Alt-A's and OptionARM’s in that sort of trouble, I am trying to wrap my mind around the sort of bad bank that will have to be, and what it will mean for the people in the street. And I'm sure the loans are not the worst kind of paper in the books, it's got to be the securities. China owns so much of that, it's scary, and that's reason enough to transfer the losses to unsuspecting Americans. And just take a look at this:
In 1999, when [Larry Summers] was Treasury Secretary, he warned lawmakers that Fannie Mae and Freddie Mac had grown so large that if they stumbled, the damage to the U.S. economy could be staggering.
Ten years ago, before the start of the housing bubble that would never have existed if Fannie and Freddie hadn't been there to facilitate it by buying up all the loans from the big lenders, Larry Summers of all people predicted they could bring the entire house down then. So this line should hold no surprises:
The revamping of the firms was almost included in the administration's June white paper that proposed an overhaul to the federal regulation of the financial system. But after determining that they had to craft a careful exit of the government's aid for those companies, Summers and Geithner decided to put the issue off.
A bad bank would serve to:
- Absorb the losses the Chinese et al will suffer when half of the US will be underwater
- Absorb the losses of the lenders who originated the loans and traded the securities
- Allow the game to continue and/or start afresh
Fannie and Freddie have $5-6 trillion in loans on their books. If half go toxic, that's a $2-3 trillion loss right there. Securities written on the loans have undoubtedly been hugely leveraged, and moreover the losses on them are incurred much faster, so we could be easily be looking at $20-30 trillion that is being considered for a transfer to the books of the nation's people.
It’s no wonder that there are such desperate attempts ongoing to make you believe we’re climbing out of the hole. The boys have seen how deep the hole is, and they don't want you to get a look at it. At least, not until all you have left is their losses.
It's nice and all to find out the the Fed is buying more and more Treasuries, in order to keep up appearances of actual sales. But what else did you think would be happening in the face of sales four times bigger than ever before?
I say, watch the Fannie and Freddie drama unfold. If real estate prices in 2011 are where Deutsche Bank yesterday said they will be, the amount of taxpayer money involved and consequently lost in the insane game of having the taxpayer prop up home prices, will be, to use Summers' word, staggering. Just with an extra 10 years of stagger added. When Summers issued his warning, the market was maybe $5-6 trillion. It's $12 trillion today.
If you want to be politically involved in America, here's what I suggest. Contact your representative(s), and demand they publicly reveal the total dollar amount in securities and, more broadly, derivatives, that are outstanding anywhere in the vicinity of Fannie and Freddie. Here's betting that you won't get nowhere. Nobody wants to be seen touching those kinds of amounts. That's no way to build a political career. They'd much rather see them quietly transferred to your accounts and keep their seats. But give it go: forget about auditing the Fed, it's waste of time, there's no authority for that. Push for an audit of Fannie and Freddie instead.
This is not about real estate, it's not even about the economy. It's about politics.
Fannie Mae to Tap $10.7 Billion in Treasury Capital
Fannie Mae, the mortgage-finance company taken over by the government, asked the U.S. Treasury for a $10.7 billion capital investment as an eighth straight quarterly loss drove its net worth below zero once again. A second-quarter net loss of $14.8 billion, or $2.67 a share, pushed the company to request money for the third time from a $200 billion government lifeline, Washington-based Fannie Mae said in a filing today with the Securities and Exchange Commission. Today’s results bring the company’s cumulative losses over the last two years to $101.6 billion and will bring its total draw on the Treasury to $44.9 billion since April.
The credit quality of loans and mortgage bonds that Fannie Mae owns or guarantees have deteriorated as a recession that began in December 2007 pushed more homeowners into foreclosure. A record 1.5 million U.S. properties received a default or auction notice or were seized in the first half of this year, 15 percent more than a year earlier, as employers cut jobs and temporary programs to assist homeowners came to an end, RealtyTrac Inc. said July 16.
Fannie Mae said it expects the quality of its assets to worsen further and to continue accumulating losses as it executes President Barack Obama’s efforts to modify or refinance loans for as many as nine million homeowners. "We do not expect to operate profitably in the foreseeable future," the company said in its filing. "We expect that we will experience adverse financial effects as we seek to fulfill our mission by concentrating our efforts on keeping people in their homes and preventing foreclosures."
Fannie Mae and smaller competitor Freddie Mac, which own or guarantee almost half of U.S. residential mortgage debt, are integral to Obama’s plan to help homeowners. In February, the government doubled its emergency capital commitment for each company from $100 billion, which the Treasury makes through preferred stock purchases. McLean, Virginia-based Freddie Mac has tapped $50.7 billion in aid in since November as the value of its assets dropped below the amount it owed on obligations. The companies’ regulator, James Lockhart, said yesterday that he is stepping down to pursue opportunities in business. His departure comes as debate grows over the future of the mortgage-finance companies once they emerge from the housing crisis.
Fannie Mae’s net worth, or the difference between assets and liabilities, was negative $10.6 billion as of March 31, compared with negative $18.9 billion on March 31 and negative $15.2 billion on Dec. 31, according to company statements. Fannie Mae and Freddie Mac are the largest U.S. mortgage- finance companies, owning or guaranteeing about $5.4 trillion of the $12 trillion residential mortgage debt. The Federal Housing Finance Agency put the companies under its control Sept. 6 and forced out management after examiners said the two might be at risk of failing amid the worst housing slump since the Great Depression.
The company increased reserves for future credit losses to $55.1 billion last quarter from $41.7 billion in the previous quarter. The amount of nonperforming loans that Fannie Mae guarantees for other investors rose to $144.2 billion from $121.4 billion in the first quarter, according to the filing. Fannie Mae also owned $26.3 billion in non-performing loans as of June 30, up from $23.2 billion in the first quarter. The fair value of Fannie Mae’s assets was negative $102 billion last quarter, compared with $110.3 billion at the end of March.
Fannie Mae and Freddie Mac shares, which were above $30 in March of last year, have been trading at less than $1 since December, except for one day in March when Freddie closed at $1.01. Fannie Mae closed at 79 cents today on the New York Stock Exchange, and Freddie Mac finished the day at 84 cents.
Fannie Mae was created in the 1930s under President Franklin D. Roosevelt’s "New Deal" plan to revive the economy. Freddie Mac was started in 1970. The companies were designed primarily to lower the cost of home ownership by buying mortgages from lenders, freeing up cash at banks to make more loans. They make money by financing mortgage-asset purchases with low-cost debt and on guarantees of home-loan securities they create out of loans from lenders.
U.S. Considers Bad Bank Option for Fannie Mae, Freddie Mac
The Obama administration is considering an overhaul of Fannie Mae and Freddie Mac that would strip the mortgage finance giants of hundreds of billions of dollars in troubled loans and create a new structure to support the home-loan market, government officials said. The bad debts the firms own would be placed in new government-backed financial institutions -- so-called bad banks -- that would take responsibility for collecting as much of the outstanding balance as possible. What would be left would be two healthy financial companies with a clean slate.
The moves would represent one of the most dramatic reorderings of the badly shattered housing finance system since District-based Fannie Mae was created by Congress to support mortgage lending during the Great Depression. Both Fannie Mae and Freddie Mac, based in McLean, have government charters to buy home loans from banks, which they then repackage and sell to investors. The banks can then use the proceeds to offer more loans to home buyers.
The leviathans became emblematic of the financial crisis when they were effectively nationalized in September amid a market meltdown that revealed much of their holdings to be troubled. The government has since pledged more than $1.5 trillion, including $85 billion in direct aid, to keep the mortgage market working through Fannie Mae and Freddie Mac. The proposal, which is preliminary and one of several under discussion, is scheduled to be taken up by the White House's National Economic Council on Thursday.
It should come as no surprise that the administration is thinking through" wholesale changes to these companies, said Andrew Williams, a Treasury Department spokesman. "We are in the preliminary stage of the process, the systematic development of options has not taken place, and no decisions have been made." Internal discussions over the future of the companies began earlier this year during the regulatory reform planning process and now are entering a more serious phase. National Economic Council Director Lawrence H. Summers has long wanted to overhaul the companies. The government's efforts so far "have taken the risk out of those two firms," Treasury Secretary Timothy F. Geithner said in a recent interview. "The only question that remains is what form, what structure they ultimately will take."
In an interview Wednesday announcing that he would step down later this month, James B. Lockhart III, the chief regulator of Fannie Mae and Freddie Mac, said there needs to be a "good bank, bad bank" structure. The "bad bank" would be a depository for Fannie Mae's and Freddie Mac's toxic assets. Then, the government could create new companies, if it chose to do so, that would attract private investment in support of mortgage finance. Options for the "good banks" include consolidating the firms into one government agency, leaving mortgage finance to private banks or maintaining a hybrid model.
The National Economic Council has looked at the "bad bank" option, among many others, in several internal policy papers. Any final decision would come after talks involving the White House, the Treasury, the Department of Housing and Urban Development and the Federal Housing Finance Agency. A major problem is that the firms own and insure trillions of dollars of existing mortgages. With the economy still in a deep recession, joblessness rising and defaults on home loans expected to continue to go up, there is great uncertainty over the size of future losses at Fannie Mae and Freddie Mac. That, in turn, is likely to drive investors from committing money to the companies.
Fannie Mae and Freddie Mac existed for years as odd hybrids, created by government to support housing but owned by private shareholders. (They are now majority-owned by the government.) Over the years, the unusual status has fed concerns that the firms exploited their quasi-governmental role to borrow money at very low rates and therefore grow far larger than was sustainable. At the same time, they had a duty to shareholders to maximize profits, leading them to take on bigger risks.
Until the future of the firms is worked out, the Obama administration has been using them to carry out its housing recovery program, including restructuring mortgages to avoid foreclosures. In addition, the Federal Reserve has bought well over $1 trillion worth of mortgage-related securities and debt from Fannie Mae and Freddie Mac. That further helped to lower interest rates on home loans. The government also has pledged up to $400 billion in direct investments in the firms.
Summers has long thought that the old structure of the companies posed a danger to the financial system. In 1999, when he was Treasury secretary, he warned lawmakers that Fannie Mae and Freddie Mac had grown so large that if they stumbled, the damage to the U.S. economy could be staggering. Few heeded him. Now, once again a leading voice on economic policy, Summers has the platform to restructure the mortgage giants. The revamping of the firms was almost included in the administration's June white paper that proposed an overhaul to the federal regulation of the financial system. But after determining that they had to craft a careful exit of the government's aid for those companies, Summers and Geithner decided to put the issue off.
Fannie, Freddie Debate Not Hurting Mortgage Rates
The increasingly public debate over what the government will eventually do with mortgage giants Fannie Mae and Freddie Mac, taken over last fall, leaves the mortgage market still waiting for a decided resolution, analyst said Thursday. The Obama administration is considering a variety of options to overhaul mortgage giants Fannie Mae and Freddie Mac, including folding the companies into a new federal government entity, the Washington Post reported Wednesday.
One option is to split the companies and putting their troubled assets in a new federally backed corporation, and possibly let to more viable portion of the company resume being shareholder-owned. The important but unclear aspect is whether the entities, in any form, continue to carry the government's implicit support of their debt to keep their borrowing costs low. The so-called government sponsored entities sell their own debt to finance purchases of mortgage-backed securities, which are bundles of individual mortgages. Their ability to finance those purchases at a low cost enable them to accept mortgages with lower rates, which helps homeowners.
"As long as the government guarantees are there, the products will trade as they do," at rates far below what fully private companies have to pay, said Kevin Giddis, managing director of fixed income for Morgan Keegan & Co. "Any change would more than likely have a negative impact on the housing market." Mortgage rates have risen over recent months as the economy appears to be improving, pushing up yields on Treasurys, which are the benchmark for a broad array of securities including mortgage debt. The rate on a 30-year fixed rate mortgage rose to 5.65% in the latest week, according to Bankrate.com. They fell to a low around 4.85% in the April. More likely than such a "good bank/bad bank" arrangement for Fannie and Freddie, the firms may be structured like a public utility, said bond strategists at RBC Capital markets.
"The firms would be even more highly regulated than they are today, with products and pricing approved by a government board, commission or agency," said Ira Jersey, head of U.S. interest-rate strategy at RBC. "Assuming adequate capital ratios were kept, the GSEs would be allowed to pay out a significant amount of profits as common share dividends." But in any case, the amount of debt held by the entities is also likely to be "dramatically" smaller, he said. The entities have been instructed to reduce the amount of debt they hold - currently near half of all outstanding home loans.
In all likelihood, the agencies will probably look rather different than they were, said Matthew Mac Donald, a bond portfolio manager at DWS Investments. The firms, one which grew out of the Great Depression, will go back to their more traditional role of facilitating a basic social goal: extending mortgages so more Americans can own homes. Their basic role was standardizing underwriting rules and pooling loans and relieving some of the credit risk for investors interested in owning mortgages.
"The uncertainly isn't rattling the market at all," he said. "It's a healthy discussion as long as the government doesn't indicate it may pull support for existing programs and securities." Fannie and Freddie have long been strange hybrids of government and private institutions and may, at least initially, end up closer to the government end of that spectrum because of lack of confidence in ratings for securitizations, MacDonald said.
Of all the possible outcomes, if they government chooses to make the entities fully private, "surely rates would increase," said Jeana Curro, a mortgage strategist at UBS Securities. "If they lose their implicit government guarantee, investors would need increased compensation." Investors in mortgage-backed debt currently demand yields about 0.90 percentage points above Treasurys to compensate for the different credit structure, analysts said. Spreads between corporate bonds and Treasurys are almost three times that.
New Jobless Claims Drop By 38,000, Beating Estimates
The number of newly-laid off workers seeking unemployment insurance fell last week, the government said Thursday, fresh evidence that layoffs are easing. The Labor Department said that initial claims for jobless benefits dropped to a seasonally adjusted 550,000 for the week ending Aug. 1, down from an upwardly revised figure of 588,000 in the previous week. That's much lower than analysts' estimates of 580,000, according to a survey by Thomson Reuters. The four-week average of claims, which smooths out fluctuations, dropped to 555,250, its lowest level since late January.
The tally of people continuing to claim benefits rose, however, by 69,000 to 6.3 million, the department said, after dropping for three straight weeks. The continuing claims data lags initial claims by a week. Many economists expect initial claims to continue to decline this year. "Claims should fall over the next few months, as the economy appears more or less to have stabilized," Ian Shepherdson, chief U.S. economist at High Frequency Economics, said in a note to clients before the department's report.
When emergency extensions of unemployment are included, the total rolls climbed to a record 9.35 million for the week ending July 18, the most recent data available. Congress has added up to 53 extra weeks of benefits on top of the 26 typically provided by the states. The increase in the number of people continuing to claim benefits is a sign that jobs remain scarce and the unemployed are having difficulty finding new work.
Despite the improvement, weekly jobless claims remain far above the 300,000 to 350,000 that analysts say is consistent with a healthy economy. New claims last fell below 300,000 in early 2007.
The recession, which began in December 2007 and is the longest since World War II, has eliminated a net total of 6.5 million jobs. The unemployment rate is expected to rise to 9.6 percent when the July figure is reported Friday. The jobless rate of 9.5 percent in June marked a 26-year high. More job cuts were announced this week. The publisher of the Milwaukee Journal Sentinel said it would slash 92 jobs as the current advertising slump continues to ravage the newspaper business.
Elsewhere, about 6,000 General Motors Co. blue-collar workers have taken the latest round of early retirement and buyout offers. But GM wants to cut about 13,500 workers, setting the stage for more layoffs. Among the states, Ohio had the biggest increase in claims, with 891, followed by Oklahoma, Mississippi, Louisiana and Alaska. State data lags behind initial claims data by one week. North Carolina had the largest drop in claims, with 9,809, which it said was due to fewer layoffs in the textile, furniture, rubber and plastics, and industrial machinery industries. Michigan, Florida, Georgia and Alabama had the next largest declines.
US food stamp list tops 34 million for first time
For the first time, more than 34 miilion Americans received food stamps, which help poor people buy groceries, government figures said on Thursday, a sign of the longest and one of the deepest recessions since the Great Depression Enrollment surged by 2 percent to reach a record 34.4 million people, or one in nine Americans, in May, the latest month for which figures are available.
It was the sixth month in a row that enrollment set a record. Every state recorded a gain in participation from April. Florida had the largest increase at 4.2 percent. Food stamp enrollment is highest during times of economic stress. The U.S. unemployment rate of 9.5 percent is the highest in 26 years. Average benefit was $133.65 in May per person. The economic stimulus package enacted earlier this year included a temporary increase in food stamp benefits of $80 a month for a family of four.
The Fed's UST-POMO Pyramid Scheme Exposed
In a brilliant piece of investigative reporting, Chris Martenson (original article here) has uncovered that the Fed, merely a week after issuing $28 billion in 7 year bonds (which Zero Hedge discussed previously) via its puppet, the US Treasury, of which $10 billion ended up being purchased by primary dealers, has turned and bought 47% of the primary allocated bonds in Open Market Purchases. This is undisputed monetization removed simply via one primary dealer and less than 5 days of temporal separation in order to leave no easy trace. As Martenson points out:
"A more honest and open approach would have been for the Fed to simply buy them outright at the auction but this way, using "primary dealers" and "POMOs" and all these other extra steps the basic fact that the Fed is openly monetizing US government debt is effectively hidden from a not-too-terribly inquisitive US press and public."
The question is did the Fed implicitly tell the primary dealers they are merely holding the treasuries for a flip, and that it would acquire them immediately. Absent this $4.8 billion in effectively monetized bonds, what would the Bid To Cover have been for the primaries? Would this have been the second practically failed auction for USTs after the deplorable 5 year auction results a day prior? One wonders if there would have been 62% indirect interest in these bonds (which the day before had a measly 32.5% indirect bid) if the purchasers were aware of the Fed's immediate prompt monetization of a large part of the directs' balance.
It is truly a sad state of affairs when the Fed has to manipulate public and media perception in this way, and has to cover up for the complete lack of interest in US Treasuries.
Here is the evidence Martenson dug up:
Martenson's conclusion needs no elaboration:
"The speed of the shell game is accelerating.
This immediate repurchase of newly auction bonds by the Fed tells us that demand for these bonds is not nearly as high as advertised, and that things are not quite as strong as represented.
And oh, by the way, don't expect any stock market weakness while so many billions are being shoveled out the Fed and into the pockets of the primary dealers. They'll have to do something with all that freshly minted cash....."
Zero Hedge salutes CM for this brilliant piece of sleuthing: now if only the MSM would have the guts to demonstrate the pyramid scheme that the US Bond and Equity markets have become.
Why a major revision is coming for the nation's employment numbers
Tyler Durden: Why is it that people who base their opinions on facts come off significantly less amusing than the clownshoes who predict a future based on hope and personal conflict of interest bias. Watching a boring TrimTabs' Biderman debate with some guy named John Herrmann (not to mention some other "portfolio manager" named Ron Insana) who sounds like he just came out of accounting one oh one in Rose-Colored Glasses community college is simply deliciously hilarious. Also, listen to Biderman for some objective truths about the economy and labor statistics.
PS My system doesn’t like the CNBC video format. If you have the same experience, here's the Youtube version of the same video, which isn’t great either: it's out of sync.
< American Incomes Head Down, Threatening Recovery in Spending
Household income in the U.S. is weakening as the influence of the government’s stimulus plan wanes, prompting economists, Federal Reserve officials and a Nobel laureate to warn that consumer spending may struggle. "Consumers have started to change their behavior and they are going to save more," said Richard Berner, co-head of global economics at Morgan Stanley in New York and a former researcher at the Fed. "You have pressure on wages, you have employment still declining."
Wages and salaries, which drive recoveries in spending, fell 4.7 percent in the 12 months through June, the biggest drop since records began in 1960, according to Commerce Department figures released yesterday. The Obama administration’s tax cuts, extended jobless benefits and a one-time Social Security bonus have helped mask the damage done by the worst employment slump since the Great Depression. Personal incomes, which include interest income, dividends, rents and other payments as well as wages, tumbled 1.3 percent in June, more than forecast and the biggest drop in four years, yesterday’s Commerce report showed.
Excluding the effects of the stimulus plan, June incomes would have dropped 0.1 percent after no change in May, according to the report. In May, one-time additional payments to Social Security recipients boosted incomes 1.3 percent. One of every 10 American workers will be without a job by early 2010, economists project, shaking the confidence of those still on payrolls and discouraging spending. It may take as long as 15 years for consumers to fully repair finances battered by the decline in home values, stocks and employment, said Edmund Phelps, winner of the Nobel prize in economics in 2006.
Decreasing pay is not the only hurdle for consumers. Plunging home prices and stocks reduced household net worth by a record $13.9 trillion from the third quarter of 2007 through this year’s first quarter, according to figures from the Fed. "Households are going to have to do an awful lot of rebuilding of their wealth," Phelps, a professor at Columbia University in New York, said this week in an interview on Bloomberg Television. "Even if that rebuilding goes on at a pretty good clip, it will take 12 or 15 years for households to get to the wealth level that they had several years ago. Consumer demand is going to take a long time to rebuild to normal levels."
In the second half, incomes and spending will be hurt by the loss of transitory factors such as lower fuel prices, decreased tax rates and the one-time payment to retirees, William Dudley, president of the Fed Bank of New York, said in a speech last week. "Consumer spending is unlikely to rise much faster than income" because of the need to boost savings, he said. "Weak income growth will be an effective constraint on the pace of consumer spending." Companies continue to trim expenses, threatening further cuts in pay and benefits. Tenneco Inc., the world’s largest maker of vehicle-exhaust systems, temporarily lowered pay and hours worked to reduce labor costs by 10 percent. Earlier this year, the Lake Forest, Illinois-based company suspended contributions to employees’ 401(k) retirement accounts and cut pay for the top 50 executives.
Government assistance such as the "cash-for-clunkers" program will help postpone the inevitable increase in savings and slowdown in spending as more baby boomers approach retirement, said David Rosenberg, chief economist at Gluskin Sheff & Associates Inc. in Toronto. "Spending is in desperate need of gimmicks like cash-for- clunkers in order to grow on a short-term basis," he said. The program, which offers as much as $4,500 for trading in older, less fuel-efficient cars, ran through its $1 billion fund in about a week, and Congress is considering adding $2 billion. Auto industry data this week showed sales jumped to an 11.3 million annual pace last month, the highest level since September.
Mounting joblessness is among reasons that economists such as Rosenberg say will prompt Americans to save more. Unemployment, already at a 26-year high of 9.5 percent in June, may top 10 percent by early next year, according to the median estimate of economists surveyed by Bloomberg last month. Economists estimate that a Labor Department report at the end of the week will show employers cut an additional 328,000 workers from payrolls in July. That would bring the total loss of jobs since the recession began in December 2007 to 6.8 million.
The savings rate in June fell to 4.6 percent as incomes dropped, yesterday’s Commerce Department report showed. The rate, which reached a 14-year high of 6.2 percent the previous month, is likely to keep climbing, Rosenberg said. A rate as high as 15 percent can’t be ruled out, he said. "This is a different consumer than we had in the past 20 years," Rosenberg said. "People are going to increasingly be putting more money into cookie jars, rather than into buying more cookie jars."
It's All About Jobs!
What brings together the President of the United Steelworkers from Pittsburgh, a Corporate CEO now living in New York, and the former senior U.S. Senator from Michigan? It's all about jobs -- and the urgent need for millions of new ones. While President Obama has spoken forcefully about laying a new foundation for the economy, one that creates good jobs and rising incomes and that moves us from an era of borrow-and-spend to one where we save and invest and are able to produce more at home than we consume, we believe that the Administration still needs to address two glaring shortcomings in its economic program.
First is the failure, aside from the emergency restructurings of Chrysler and GM, to enact an all-of-government national manufacturing and industrial policy designed to simultaneously ensure the competitiveness of US-based businesses and grow high-value jobs in America. And second is the need to begin the promised reform of our trade policies with those economies, particularly China's, that do not play by the same rules we do and occasionally even cheat.
It is also by now very clear that the economic stimulus plan passed by Congress in February will not move us toward anything approaching full employment, since by the Administration's own estimate, the plan will "save or create" (but mostly just save) only 3.5 million jobs over two years, which are just a quarter of the 13.3 million jobs effectively lost since this recession began in December 2007 and just 12% of the workers already effectively unemployed.
Even in past recessions, the number of unemployed workers not included in the official Bureau of Labor Statistics monthly figure -- that is, workers who are either part-time of necessity, marginally attached, or have quit the labor force out of frustration -- has almost never exceeded a third or so of that official number. Now, however, there are nearly a million more uncounted unemployed than counted ones, making the total number an unprecedented 30.2 million workers, instead of the official 14.7 million, and the effective unemployment rate is a staggering 18.7%, instead of 9.5%.
When, 19 months after this recession began, nearly 19% of the nation's workers are still effectively unemployed and when even the nation's current full-time employees are working only an average of 33.1 hours a week, which are the fewest hours on record since the BLS began counting in 1964, it is clear that we are already deep into a jobless recovery. And by now it is just as clear that this jobless recovery will be particularly susceptible to a new downturn, because of the way it is already feeding back on itself, and that there will be little relief for the 47 out of 50 states, whose budgets have been absolutely blasted by falling tax revenues.
Significant and timely job retention and creation overall must be an urgent priority, certainly on a par with health care reform, but these dismal macro unemployment numbers tell only the big picture part of the jobs deficit story.
Importantly, we need to be just as worried about the fact that our economy has mostly hemorrhaged jobs in the very sector -- manufacturing -- that must grow in order for us to move permanently away from debt-financed consumption as the principal engine of economic growth.
And it is the current and now decades-long persistent manufacturing jobs collapse that unites the three of us as friends and as colleagues, despite coming from very different backgrounds. Just since this recession began, manufacturing has lost 13% of its workforce; manufacturing industries now represent a meager 11.7% of GDP; people working in manufacturing now account for only 8.7% of the jobs in the country; a quarter of the nation's 282,000 remaining manufacturing companies -- 90,000 in all -- are now deemed severely "at risk"; and we have run an average annual trade deficit in manufactured goods of more than $500 billion over the past five years.
Congress and the Administration, working together, need to immediately enact a robust industrial policy that puts American workers first and is comparable to the policies of our major trading partners. And then we need to integrate this policy with efforts to be the world's dominant manufacturer of green technologies and components, which offer us such enormous opportunities.
Perhaps the biggest example today, in dollar terms, of what the failure to have our own manufacturing and industrial policy has wrought is California, which has just confronted the largest annual budget deficit in the history of the Union. California would have had a dramatically smaller deficit, or maybe even none at all, if in the state manufacturing workers today simply represented the same share of total workers as they did in the year 2000, which was 12.8%. Instead, California lost, over this period, more than 400,000 manufacturing jobs which, after considering multiplier effects, would have benefited its budget on the order of $300 billion of cumulative income taxable wages.
The need for an elaborate American industrial policy was first widely observed as far back as the early 1980s, and by 1993 some in the Clinton Administration and especially some enlightened members of Congress tried to enact such a policy. Regrettably, against great opposition from the country's major multinational companies and the "free traders," they failed, and now 16 years later, we still don't have one.
Even if some in our political leadership today still don't understand and accept this basic imperative, America's main trade competitors sure do. Each of the other members of the G-20 has such a policy, and together they are using them now to great effect to resuscitate their broken economies and further weaken ours. Germany, Japan and South Korea are doing everything possible to preserve their significant manufacturing bases, while China, which consistently accounts for 60% of the US trade deficit in manufactured goods, is particularly accelerating its efforts to grow its manufacturing sector. We believe that two things are currently holding us back from having our own manufacturing and industrial policy -- and both need to be quickly disabused.
First, some in the Obama Administration, along with others of influence, wrong-headedly believe that one job is as good as another, whether it is in manufacturing or service. This is simply not true, and even the simplest comparison of the two sectors shows that:
- Compensation in manufacturing jobs is 20% greater than in non-manufacturing jobs;
- Service jobs do very little to help America's balance of trade, and mostly just move incomes around the country; and
- Manufacturing has by far the largest multiplier effect of all job sectors, creating 1.40 of additional economic activity for each 1.00 of direct spending, 2.5 other jobs on average for each job in it, and, at the upper end, 16 associated jobs for each high-tech manufacturing job.
Second, these same individuals assume, again with no supporting evidence, that new jobs associated with exported services will make up for past and future manufacturing job losses. One Administration official even said recently that America's export future resides in exporting "consulting and legal services, software, movies and medicine," which is simply impossible in dollar terms. In fact, in the future, high-quality service jobs are at least as much at risk of being offshored as are manufacturing jobs, as India and China are especially keen on seeing such jobs domiciled on their own shores.
In addition to throwing its full weight behind an all-of-government manufacturing & industrial policy, the Administration must also be willing to:
- "Pick winners" from Main Street and then support them, because all other developed nations and China do so every day, to great competitive effect. (Right now, the only "winners" being picked and seriously supported seem to be those residing on Wall Street, which is sadly ironic since it was largely these very same financial institution that just brought our economy to its knees.) The Administration has moved modestly in this direction with proposals to encourage private investment in wind and solar energy and by making certain modest targeted federal investments. However, it needs to do much more if we are to create new comparative advantages in these and other industries.
- Fund a 10-year (not the current two-year) program of significant public investment to upgrade and rebuild our nation's infrastructure, which will provide the much-needed foundation for higher-value added production and advanced business services.
- Adopt "Buy American" requirements related to all federal procurement, which now makes up about 20% of the US economy. America appears to be the only nation among the major developed nations and China without a significant "buy domestic" procurement program, and we need one desperately for our own economic recovery and global competitiveness.
- Enact major corporate tax reform to incent corporations to create jobs here and to eliminate the current incentives for them to relocate manufacturing and service jobs abroad. This reform should include reducing the corporate income tax and payroll tax and moving to a value-added-tax or VAT to replace that lost revenue.
- Make loans and credit facilities readily available to the nation's small and medium size businesses and manufacturers, which desperately need them while the likes of Goldman Sachs and the major banks are succoring off of US Government guarantees and TARP monies but not lending to these smaller companies. (How foolish indeed was it to let CIT, which every day loans money to 950,000 small and medium size businesses, essentially fail for lack of an "angel" in the Treasury Department, while Treasury continues to resuscitate but barely reform the errant Wall Street banks that precipitated this financial crisis.)
However, not even a broad new national industrial policy can right our economic ship without there also being complementary trade policies that prevent other economies from gaining unfair competitive advantages. The Administration and Congress also need to immediately move away from our past decades of misguided trade policies and demand trade agreements that have meaningful labor and environmental standards and forbid illegal subsidies and currency manipulation. At the same time, we need to dispense with "one size fits all" trade agreements that ignore significant differences in levels of development, forms of government, and reciprocity.
But most immediate and most important, we still need the fundamental reworking of our trade relationship with China that was promised during the Campaign, which despite two major Administration encounters already with them has yet to occur. China's massive trade surplus with the United States -- a staggering $277 billion of manufactured goods just in 2008 -- is mostly the result of its severely undervalued currency, massive legal and sometimes illegal subsidies to its own manufacturers, and very aggressive policies to induce foreign corporations to shift their production facilities and technology to it. These policies have already cost us millions of jobs, and they will keep costing us jobs until they are fixed.
Challenging China over its unfair trade practices is not just necessary for the future of US manufacturing jobs -- it is also critical for the world economy. The global economy simply can't function if the third-largest individual economy runs current account surpluses on the order of 8 to 10% of GDP, as China has done consistently for the past few years. These are truly unprecedented times, and thus looking at past business cycles and responses for the answers is likely to be of only very limited relevance and utility, as too many in the Administration and Congress seem to do by ideological reflex.
Instead, we need, as soon as possible, an Emergency National Summit on Manufacturing, to be attended by relevant Cabinet officers, the bipartisan leadership of both Houses of Congress, and a small number of the top corporate and labor leaders on this issue. We also need an activist executive branch and Congress willing both to turn around the excessive laissez faire and deregulatory approaches of the last eight and, in some cases, the last thirty years, and to enact that national manufacturing & industrial policy we are calling for.
Our national goals, in the medium term, must be to near fully employ those 30 million currently unemployed American workers, and in the process to more than double the number of Americans working in manufacturing, which is the least amount needed to get our economy back on track sustainably. It's all about jobs -- whatever it takes!
The Beginning of the End for Treasury Bonds
On Tuesday, Treasury suffered its worst five-year auction in history. Yet that news barely made a headline. It’s not the first time Treasury has struggled to sell its paper...and they're certainly not alone. The Germans – among several other Euro-zone credits – have struggled to auction their debt since last October with four failed or reduced bond auctions (even the Chinese endured a failed bond auction this July).
That’s almost mind-boggling...especially since I’d consider the Germans the best government credit in the world, possibly along with the Swiss and Norwegians. The United States, like several other European governments, is struggling to sell a truckload of Treasury’s this year. Investors are advised that this slow bleed can easily magnify into a full-blown crisis over the next few years if the global economy fails to recover. But government debt has enjoyed a great run for the last thirty years...
From 1981-82 until December 2008 Treasury bonds enjoyed a secular bull market as interest rates collapsed from a Volcker Fed peak of 20% in 1981 to 2.25% in December of last year. Zero-coupon bonds – long-term bonds on steroids – have earned big double-digit gains over the last 28 years as rates tumbled, handily outpacing most global stock markets. But the big bond bull market is over.
Faced with an unprecedented funding gap thanks to the worst credit collapse since the 1930s and plunging tax revenues, the United States is now issuing more debt than ever to finance its expenditures. About $2 trillion dollars is estimated to be auctioned this fiscal year. And what it can’t finance, Treasury simply monetizes vis-à-vis the Federal Reserve, as we all already know, through the process of "quantitative easing." Several other central banks are doing the same thing this year, including the Swiss National Bank and The Bank of England.
Yet nobody has a debt the size of America’s. Deficits are clearly out of control with no political resolve to reduce spending. At some point, a major lenders’ strike looms as foreigners balk at financing this paper. If that happens, the United States could be forced to impose a deficit-financing tax or a VAT consumption tax to finance its explosive debt and the interest required to service outstanding Treasury bonds. The Chinese are stuck with about 40% of this paper, the Japanese about 25% and the British about 10%. Rightfully concerned, the biggest holders of U.S. Treasury debt outside of Japan and England have increased their rhetoric lately, as they grow nervous about their declining dollars. The Chinese and the Russians are the most vocal, fed-up with dollar depreciation.
Last week, Treasury was successful in selling its tranche of seven-year Treasury bonds. But for the second time in a week, Treasury attracted poor demand for the sale of five-year and two-year notes. That raises the cost for Treasury as it relies on the Fed to absorb unwanted notes.
Five Reasons the Market Could Crash This Fall
With all this blather about “green shoots” and economic “recovery” and new “bull market,” I thought I’d inject a little reality into the collective financial dialogue. The following are ALL true, all valid, and all horrifying…
1) High Frequency Trading Programs account for 70% of market volume
High Frequency Trading Programs (HFTP) collect a ¼ of a penny rebate for every transaction they make. They’re not interested in making a gains from a trade, just collecting the rebate.
Let’s say an institutional investor has put in an order to buy 15,000 shares of XYZ company between $10.00 and $10.07. The institution’s buy program is designed to make this order without pushing up the stock price, so it buys the shares in chunks of 100 or so (often it also advertises to the index how many shares are left in the order).
First it buys 100 shares at $10.00. That order clears, so the program buys another 200 shares at $10.01. That clears, so the program buys another 500 shares at $10.03. At this point an HFTP will have recognized that an institutional investor is putting in a large staggered order.
The HFTP then begins front-running the institutional investor. So the HFTP puts in an order for 100 shares at $10.04. The broker who was selling shares to the institutional investor would obviously rather sell at a higher price (even if it’s just a penny). So the broker sells his shares to the HFTP at $10.04. The HFTP then turns around and sells its shares to the institutional investor for $10.04 (which was the institution’s next price anyway).
In this way, the trading program makes ½ a penny (one ¼ for buying from the broker and another ¼ for selling to the institution) AND makes the institutional trader pay a penny more on the shares.
And this kind of nonsense now comprises 70% OF ALL MARKET TRANSACTIONS. Put another way, the market is now no longer moving based on REAL orders, it’s moving based on a bunch of HFTPs gaming each other and REAL orders to earn fractions of a penny.
Currently, roughly five billion shares trade per day. Take away HFTP’s transactions (70%) and you’ve got daily volume of 1.5 billion. That’s roughly the same amount of transactions that occur during Christmas (see the HUGE drop in late December), a time when almost every institution and investor is on vacation.
HFTPs were introduced under the auspices of providing liquidity. But the liquidity they provide isn’t REAL. It’s largely microsecond trades between computer programs, not REAL buy/sell orders from someone who has any interest in owning stocks.
In fact, HFTPs are not REQUIRED to trade. They’re entirely “for profit” enterprises. And the profits are obscene: $21 billion spread out amongst the 100 or so firms who engage in this (Goldman Sachs (GS) is the undisputed king controlling an estimated 21% of all High Frequency Trading).
So IF the market collapses (as it well could when the summer ends and institutional participation returns to the market in full force). HFTPs can simply stop trading, evaporating 70% of the market’s trading volume overnight. Indeed, one could very easily consider HFTPs to be the ULTIMATE market prop as you will soon see.
TAKE AWAY 70% of MARKET VOLUME AND YOU HAVE FINANCIAL ARMAGEDDON.
2) Even counting HFTP volume, market volume has contracted the most since 1989
Indeed, volume hasn’t contracted like this since the summer of 1989. For those of you who aren’t history buffs, the S&P 500’s performance in 1989 offers some clues as what to expect this coming fall. In 1989, the S&P 500 staged a huge rally in March, followed by an even stronger rally in July. Throughout this time, volume dried up to a small trickle.
What followed wasn’t pretty.
Anytime stocks explode higher on next to no volume and crap fundamentals you run the risk of a real collapse. I am officially going on record now and stating that IF the S&P 500 hits 1,000, we will see a full-blown Crash like last year.
3) This Latest Market Rally is a Short-Squeeze and Nothing More
To date, the stock market is up 48% since its March lows. This is truly incredible when you consider the underlying economic picture: normally when the market rallies 40%+ from a bear market low, the economy is already nine months into recovery mode. Indeed, assuming the market is trading based on earnings, the S&P 500 is currently discounting earnings growth of 40-50% for 2010. The odds of that happening are about one in one million.
A closer examination of this rally reveals the degree to which “junk” has triumphed over value. Since July 10th:
- The 50 smallest stocks have outperformed the largest 50 stocks by 7.5%.
- The 50 most shorted stocks have beaten the 50 least shorted stocks by 8.8%.
Why is this?
Because this rally has largely been a short squeeze.
Consider that the short interest has plunged 72% in the last two months. Those industries that should be falling the most right now due to the world’s economic contraction (energy, materials, etc.) have seen the largest drop in short interest: Energy -90%, Materials -94%, Financials -86%.
In simple terms, this rally was the MOTHER of all short squeezes. The fact that it occurred on next to no volume and crummy fundamentals sets the stage for a VERY ugly correction.
4) 13 Million Americans Exhaust Unemployment by 12/09
A lot of the bull-tards in the media have been going wild that unemployment claims are falling. It strikes me as surprising that this would be true given the fact that virtually every company that posted the alleged “awesome” earnings in 2Q09 did so by laying off thousands of employees:
- Yahoo! (YHOO) will cut 675 jobs.
- Verizon (VZ) just laid off 9,000 employees.
- Motorola (MOT) plans to lay off 7,000 folks this year.
- Shell (RDS.A) has laid off 150 management positions (20% of management).
- Microsoft (MSFT) plans to lay off 5,000 people this year.
So unemployment claims are falling, that means people are finding jobs right? Wrong. It means that people are exhausting their unemployment benefits. When you consider that there are 30 million people on food stamps in the US (out of the 200 million that are of working age: 15-64) it’s clear REAL unemployment must be closer to 16%.
And they’re slowly running out of their government lifelines.
The three million people who lost their jobs in the second half of 2008 will exhaust their benefits by October 2009. When you add in dependents, this means that around 10 million folks will have no income and virtually no savings come Halloween.
Throw in the other four million who lost their jobs in the first half of 2009 and you’ve got 13 million people (counting families) who will be essentially destitute by year-end.
How does this affect the stock market?
The US consumer is 70% of our GDP. People without jobs don’t spend money. People who are having to work part-time instead of full-time (another nine million) spend less money than full time employees. And people who are forced to work shorter work weeks (current average is 33, an ALL TIME LOW), have less money to spend.
Wall Street makes a big deal about earnings (earnings estimates, earnings forecast, etc), but when it comes to economic growth, sales are the more critical metric. Companies can increase profits by reducing costs temporarily, but unless actual top lines increase, there is NO growth to be seen. No revenue growth means no hiring, which means no uptick in employment, which means greater housing and credit card defaults, greater Federal welfare (unemployment, food stamps, etc), etc.
So how will corporate profits perform as more and more consumers become part-time, unemployed, or destitute? Well, so far profits have been awful. And that’s BEFORE we start seeing millions of Americans losing their unemployment benefits.
click to enlarge
With the S&P rallying on these already crap results… what do you think will happen when reality sets in during 3Q09?
5) The $1 QUADRILLION Derivatives Time Bomb
Few commentators care to mention that the total notional value of derivatives in the financial system is over $1.0 QUADRILLION (that’s 1,000 TRILLIONS).
US Commercial banks alone own an unbelievable $202 trillion in derivatives. The top five of them hold 96% of this.
By the way, the chart is in TRILLIONS of dollars:
As you can see, Goldman Sachs alone has $39 trillion in derivatives outstanding. That’s an amount equal to more than three times total US GDP. Amazing, but nothing compared to JP Morgan (JPM), which has a whopping $80 TRILLION in derivatives on its balance sheet.
Bear in mind, these are “notional” values of derivatives, not the amount of money “at risk” here. However, if even 1% of the $1 Quadrillion is actually at risk, you’re talking about $10 trillion in “at risk.”
What are the odds that Wall Street, when allowed to trade without any regulation, oversight, or audits, put a lot of money at risk? I mean… Wall Street’s track record regarding financial instruments that were ACTUALLY analyzed and rated by credit ratings agencies has so far been stellar.
After all, mortgage backed securities, credit default swaps, collateralized debt obligations… those vehicles all turned out great what with the ratings agencies, banks risk management systems, and various other oversight committees reviewing them.
I’m sure that derivatives which have absolutely NO oversight, no auditing, no regulation, will ALL be fine. There’s NO WAY that the very same financial institutions that used 30-to-1 leverage or more on regulated balance sheet investments would put $50+ trillion “at risk” (only 5% of the $1 quadrillion notional) when they were trading derivatives.
If Wall Street did put $50 trillion at risk… and 10% of that money goes bad (quite a low estimate given defaults on regulated securities) that means $5 trillion in losses: an amount equal to HALF of the total US stock market.
This of course assumes that Wall Street only put 5% of its notional value of derivatives at risk… and only 10% of the derivatives “at risk” go bad.
Do you think those assumptions are a bit… low?
Bank of England warns recession is 'deeper than previously thought' as it extends 'printing money' scheme by £50 billion
Hopes for a quick economic rebound crumbled today after the Bank of England dramatically expanded its controversial money-printing operation. In a move that stunned the City, the Bank voted to pump an extra £50 billion into the markets over three months - a rate of over half a billion pounds a day. The official interest rate was also pegged at an all-time low of 0.5 per cent, as the Bank warned the recession was proving ‘deeper than previously thought.’ Today’s decision blindsided many City analysts and traders, because recent figures on housing and business activity pointed to a tentative recovery.
Sterling slid as much as 1 per cent to $1.6826 against the dollar, while the FTSE 100 index leaped as much as 1.6 per cent before later losing some ground. But while the Bank acknowledged there are signs that a ‘trough in output is close at hand,’ there are no signs Governor Mervyn King is letting up in his efforts to battle the recession. A statement pointed the finger squarely at Britain’s banks, saying they are continuing to reduce the supply of credit to hard-pressed businesses. This will suppress the economy’s potential to grow, the Bank argued. Financial conditions remain ‘fragile,’ it added, and interest rates on loans remain ‘elevated’.
‘The need for banks to continue repairing their balance sheets is likely to restrict the availability of credit, and past falls in asset prices and high levels of debt may weigh on spending,’ the statement said. Economist Danny Gabay of Fathom Financial Consulting said: ‘This is not a positive sign about the economy. It is rather an honest reflection of how parlous a state the UK is in at the moment.’ While the City welcomed the additional cash, the Bank’s so-called Quantitative Easing (QE) programme is hugely controversial.
Some analysts fear creating such large sums of fresh money could ultimately lead to Weimar Republic-style hyper-inflation - although the Bank today insisted the credit crunch is ‘bearing down’ on price growth. And the vast bulk of the new cash is being used to purchase government bonds, leading to accusations that the Bank of England is tacitly helping the Treasury finance its own deficit. ‘They are leaving themselves open to that charge,’ said Mr Gabay. ‘It is becoming easier and easier to lay the charge at their door that this is simply a very elaborate smokescreen.’
Conservative Treasury spokesman Philip Hammond said: ‘The decision to continue QE is an attempt to counter the contraction in the economy in the second quarter and the continuing slide in lending to businesses. But every extension of QE also adds to the longer term risk of fuelling inflation when the economy recovers.’ Before today’s decision, the majority of experts had believed the Bank’s money-creation scheme was nearly finished - or that the Bank would at least pause for a few months to survey the impact of its efforts to date. However, Alan Clarke of BNP Paribas said the Bank is now unlikely to stop at £175 billion.
He said risks of outright deflation are so dire that Mr King may ultimately have to create £300 billion of new money - equal to the entire national output of Belgium. Mr Clarke said: ‘It is the right decision to expand this scheme. There are serious downside risks for (the economy and inflation). Ultimately we may hit £200 billion or even £300 billion.’ Under the QE scheme, the Bank purchases government and corporate bonds off City firms and pays for them with newly created money. The hope is that this should boost the amount of cash flowing around the economy and bolster bank lending.
It should also suppress the interest rates on gilts - the main form of government debt - and as a consequence push down borrowing costs across the economy. Yet as the Bank’s own statement acknowledged today, the scheme has thus far failed to bring an end to the credit crunch. Indeed, there is strong evidence that banks are hoarding cash at their Bank of England current accounts rather than lending it to their consumers. The Bank’s own figures show that lending to businesses tumbled by a record £14.7 billion between April and June - the biggest fall since records began.
And earnings figures from Lloyds Banking Group on Wednesday showed the firm is continuing to reduce the quantity of credit it has offered to businesses. With firms and families also trying to borrowing, and with joblessness rising quickly, the economic outlook remains bleak , experts said. ‘Households remain under severe stress,’ said James Knightley of ING bank said. ‘The pick-up in activity will be more muted than previous recovery periods - especially with credit being so heavily restricted.’
Despite Bailouts, Business as Usual at Goldman
Lloyd C. Blankfein has a story about the cataclysm that nearly brought down all of Wall Street. It goes something like this: One by one, lesser banks were swept away by the financial storm of 2008. And as the floodwaters rose, no one, not even Goldman Sachs, seemed safe. The question, in Mr. Blankfein’s eyes, was how high the water would rise. But Washington stepped in with all those bailouts before the surge reached Goldman.
The story, which was recounted by several friends and colleagues, represents a sobering private admission from Mr. Blankfein, Goldman’s chief executive. Publicly, it is a different story. Now that Goldman is minting money again, the bank insists that it was never in any real danger. Mr. Blankfein, in an e-mail message this week, disputed his private account, saying Goldman’s survival was never in doubt. Other Goldman executives reject the notion that the bank was rescued at all.
"We did not have a near-death experience," said Gary D. Cohn, Goldman’s president. The government saved the financial industry as a whole, but it did not save Goldman Sachs, he said. Rarely has the view from inside a company been so at odds with the view outside it. Could Goldman Sachs have lived if all those other giant banks had failed? Could it alone survive financial Armageddon?
Goldman executives are dismissive, even defiant, when critics argue that the bank is playing a heads-we-win, tails-you-lose game with American taxpayers. And yet the questions keep coming. Last month the story of Goldman’s postcrisis success — and conspiracy theories surrounding it — leapt from the business pages to the cover of Rolling Stone. The idea that nothing has changed for Goldman Sachs strikes many outsiders as absurd. In this era of mega-bailouts, Goldman is widely perceived, on Wall Street and in Washington, as too big and important to fail. If its bets pay off, Goldman profits and its employees get rich. If its bets go bad, ultimately taxpayers will have to pick up the bill.
"Many observers on the market believe that Goldman and others of its size now have a free insurance policy," said Elizabeth Warren, the chairwoman of the Congressional oversight panel for the $700 billion bailout fund. "Whether they do or not is less important than the fact that many in the market believe they do. That means at some level Goldman is playing with the American taxpayers’ future." Is Goldman gambling at America’s expense? Of course not, Mr. Cohn said. Should it change its business strategy in the wake of the gravest financial crisis since the Depression? No. Is Goldman taking big risks to make big profits? Courting more outrage over Wall Street pay with its plans to pay lavish bonuses? Throwing its weight around in Washington? No, no, no.
Goldman executives dispute suggestions that high-stakes market gambles are behind its big profits — $3.4 billion in the second quarter. And they are dumbfounded when people like Ms. Warren suggest companies like Goldman, which paid back its bailout money last month, now operate with an implicit taxpayer guarantee. After so many wrenching changes on Wall Street and in the economy, it might come as a surprise that the post-bailout Goldman is virtually indistinguishable from the pre-bailout one.
The bank has strengthened its capital base and reduced its use of leverage — the borrowed money that turbo-charges profits on the way up and can prove devastating on the way down. But Goldman sees little reason to change the way it does business. In fact, its executives are surprised that anyone would suggest it should. Even Goldman’s conversion to a traditional banking company at the height of the crisis — a step many predicted would clip Goldman’s gilded wings — has been deftly sidestepped.
It is, in other words, business as usual at Goldman — and what a business it is. Quarter after quarter, Wall Street executives scour Goldman’s results hoping to figure out how the bank makes so much money. Mr. Cohn and other executives, in recent interviews, sketched the broad outlines of an answer. Mr. Blankfein declined to be interviewed for this article. During the second quarter, Goldman bet, correctly, that the financial markets would calm down. It wagered that market volatility would decline and that certain securities tied to the troubled home mortgage market would revive. Its securities underwriting business bounced back too.
A vast majority of profits came from trading on behalf of clients like big mutual funds, pension funds and endowments, rather than from staking Goldman’s own money in the markets, Mr. Cohn said. Proprietary trading now accounts for about 10 percent of profits, down from 20 percent in 2005. Goldman dominated institutional trades linked to changes in a closely watched stock market index, the Russell 2000, and is benefiting because old competitors like Bear Stearns and Lehman Brothers are no longer around. "We don’t have to outsmart the market today," said Mr. Cohn. "We just have to do what our clients want us to do."
But unlike some of its rivals, Goldman is not shy about taking risks. The bank stood to lose as much as $245 million on any given day during the second quarter, based on a common measure known as value at risk, or VAR. That was up from $184 million in mid-2008. But VAR captures only about a fifth of Goldman’s market risks and excludes investments that are difficult to value. "Our risk appetite continues to grow year on year, quarter on quarter, as our balance sheet and liquidity continue to grow," Mr. Cohn said. He and other executives say Goldman carefully manages its risks, which, for the most part, it has.
Goldman’s latest quarterly disclosures to the Securities and Exchange Commission, filed on Wednesday, provide another glimpse into the bank’s activities. Aided by cheap credit, Goldman generated more than $100 million in daily revenue from trading on 46 separate days during the second quarter — a record. Since late 2007, Goldman has reduced its exposure to illiquid investments, which can pose dangers because they are traded so infrequently, by 8 percent. Its total exposure to these so-called Level 3 assets still stood at $50.4 billion. While VAR is up, other risk measures were down, and the bank’s capital base has grown significantly. Lately, Goldman has been taking more risks in stocks, but fewer in fixed income, currency and commodities.
Some of Goldman’s recent practices are drawing scrutiny from government officials. In its filing Wednesday, Goldman said various government agencies had inquired about its compensation practices, as well as its role in the market for credit derivatives, which fueled the financial crisis. But over all, the events of the past year have not changed the way Goldman views or manages the risks it takes, said David A. Viniar, Goldman’s chief financial officer. "There are a few business units that are taking a little more risk. Most are taking less," Mr. Viniar said.
Mr. Cohn, Goldman’s president, acknowledges his bank is systemically important, meaning that its failure would probably send financial shock waves around the world. But he said that the implications of this status were unclear and that Goldman had no government backing. David A. Moss, a professor at Harvard Business School, disagrees. He says the painful lessons of the financial crisis show the federal government now stands behind all systemically important financial institutions.
"We’re in a situation where we’ve extended important guarantees, both explicit and implicit, to almost all major financial institutions, yet we don’t have the regulations in place to control the excessive risk-taking that could result," said Mr. Moss, the author of "When All Else Fails: Government as the Ultimate Risk Manager." In any case, Goldman has certainly helped itself to government programs that were put in place to stabilize the financial industry. For instance, the bank has issued billions of dollars of bonds guaranteed by the Federal Deposit Insurance Corporation. Since March it has sold $3.4 billion worth without government backing.
And Goldman’s conversion to a bank holding company, executed at the height of the crisis, gives the bank access to money from the Federal Reserve. In exchange, Goldman had to increase its capital, reduce its leverage and accept Fed oversight. Many analysts predicted that switch would force Goldman to rein in riskier businesses like proprietary trading and parts of its commodities operation. But Goldman has largely carried on as usual. It has received standard exemptions that give it two years to comply with federal regulations governing bank holding companies.
"They are very happy to go back to a business model that year-in and year-out has made them untold wealth," said John C. Coffee, a professor of securities law at Columbia University. Mr. Cohn concedes that Goldman, along with other banks, bears some responsibility for the financial crisis. "There’s no performance angel in this," he said. But he bristles at all the fingers being pointed at Goldman. "Every bank has to accept a degree of responsibility, but it sometimes feels like we’re being disproportionately blamed," he said.
BNP Paribas bonuses spark anger in France
French bank BNP Paribas said Wednesday it expected to pay out over one billion euros in bonus payments to traders, executives and some 17,000 staff in its investment banking divisions this year. A spokesman told AFP that an average of 59,000 euros (85,000 dollars) per person was being anticipated, but he said that the bank would "scrupulously respect" guidelines agreed by Group of 20 major economies in April. The scale of the bonuses sparked anger in France when revealed by the left-wing Liberation daily newspaper, with Socialist opposition leader Martine Aubry issuing a statement that termed the amount "a veritable scandal."
Industry Minister Christian Estrosi told French radio that France's central bank will "supervise" the payments in the interests of "transparency and guarantees" that rules drawn up by political leaders in London are adhered to.
But the bank said it had to offer renewed bonuses and was "worried that many of our rivals, notably in the United States, are no longer applying the rules" the spokesman said have been in force internally since last year.
The spokesman said G20 leaders did not suppress bonus payments, but agreed to clamp down on guaranteed bonuses over multiple calendar or financial years, or their calculation on net earnings after write-downs on risk.
The return of the big bonus culture for top banking executives will trigger new "dramas" in the financial sector if tougher regulation is not applied, International Monetary Fund chief Dominique Strauss-Kahn said last month.
"I am appalled at what I see," the Fund's managing director said in reference to multi-billion-dollar bonus provisions set aside at the likes of Wall Street's Goldman Sachs and top London firms. French banking rivals Societe Generale were nearly made insolvent last year by huge exposure on trading positions associated with trader Jerome Kerviel, and it said Wednesday that it would heed the lessons of that experience. "When we come to evaluate remunerations, we will take into account not only results, but also behaviour," said chief executive Frederic Oudea. "We will take into account (acceptable) parameters as much as risk," he added.
Max Keiser on France24 - Criminal Banking Syndicates
US firm closes down factory after French workers beat up boss
US electronics firm Molex Inc announced on Wednesday its factory in Villemur-sur-Tarn in southwestern France was temporarily closed down to reassess security after a labour dispute turned violent. Angry French workers facing lay-offs beat up a senior American executive after he visited the factory, an executive said on Wednesday. Union members said workers had only jostled and thrown eggs at development director Eric Doesburg on Tuesday night when he left the factory in Villemur-sur-Tarn in southwestern France, which Molex plans to close down.
But director-general Markus Kerriou said Doesburg had to be escorted away by bodyguards after he was "really beaten" by about 40 workers. "A medical examination confirmed the injuries, and we’ve decided to file a lawsuit," Kerriou told Reuters. Workers at the factory have been on strike since July 7 over its planned closure but Molex said there would be no further talks over a possible re-start. A union leader at Molex said only "a few small incidents" occurred on Tuesday night. He did not say whether he was present at the events.
"Essentially, egg-throwing and maybe a light scuffle. But no one was injured," Guy Pavan, a member of trade union CGT, told Reuters. "Egg-throwing has never caused serious injuries." Labour disputes in France, which has a strong tradition of protest, have been escalating over the past few months as the economic crisis forces one factory after another to shut down.
After a spate of "bossnappings" in which workers locked up their bosses, protesters in several towns threatened to blow up their factories unless their demands for better lay-off terms were met. Industry Minister Christian Estrosi said a scheduled meeting with Doesburg over the future of the unit had to be cancelled because of the director’s injuries. "(The minister) strongly condemns these acts of violence committed by a minority, which are a disservice to the workers’ cause and make the negotiations even more difficult," the ministry said in a statement.
"Morning Meeting" Panel Uses Masterpiece Theater To Explain Credit Rating Agencies Corruption
A key actor in causing the financial crisis were the credit rating agencies. In a setup doomed to cause major problems, rating agencies were paid by banks to rate the mortgage packages the banks wanted to sell. By design this would give the agencies more incentive to rate loan packages higher than they deserved, otherwise the banks would just take their business, and the fees they paid, to another rating agency. Perhaps due to a feeling that reform of the agencies is not getting enough attention, the panel at "Morning Meeting" decided to try to change that with some Masterpiece Theater, acting out the corruption inherent in the ratings system.
SEC chief in call for funding shake-up
The US Securities and Exchange Commission should fund itself directly from industry fees, a system that would allow it to tackle more complex investigations and invest more in technology and skilled people, Mary Schapiro, its chairman, told the Financial Times. The SEC already rakes in more than $1bn annually in registration and transaction fees but, unlike other US financial regulators, cannot spend any of it without going to Congress each year to get its budget approved. That process has made it difficult to plan ahead and invest in multi-year information-technology projects.
"Self-funding has been discussed over the years but I think it may now well be the moment," Ms Schapiro said. "Some stability in funding would be an enormous benefit because it would help with long-term planning in such areas as technology and staffing." Her comments, which come as Congress and the Obama administration are redesigning the US regulatory framework, highlight the SEC's perennial resource problems. The agency oversees everything from mutual funds to credit ratings agencies but has seen its budget decline or stay flat in recent years.
Now, the SEC is under tremendous pressure to be more aggressive after oversight failures that include missing Bernard Madoff's investment fraud. In recent days, the SEC has reached high-profile settlements with Bank of America and General Electric, and it is also likely to gain new responsibilities in the overall regulatory revamp, including oversight of the credit derivatives market. "Self-funding will help us to avoid periods of drought," Ms Schapiro said. "Think about what the markets were doing in terms of growth and innovation at the same time the SEC was in a hiring freeze."
US banking regulators, including the Federal Deposit Insurance Corporation and the Federal Reserve, can use whatever they collect in fees, deposit insurance premiums and interest income. Similarly the UK Financial Services Authority is entirely self-funded. The SEC, by contrast, expects to collect $1.3bn in 2009 but it may only spend the $960m authorised by Congress. For 2010, the administration has asked for an SEC budget of $1.026bn, while the SEC expects to collect $1.5bn in fees. Top Democrats in Congress are divided. Paul Kanjorski, who chairs a subcommittee on capital markets, recently said Congress should consider "moving the agency outside of the appropriations process," but Barney Frank, who chairs the House Financial Services Committee said he did not "entirely agree" with the idea.
America needs a single bank regulator
by Mark Warner
In recent weeks our financial markets have shown signs of recovery thanks to unprecedented action to stabilise markets and stimulate the economy. Yet this crisis has many distressing qualities. Perhaps most dispiriting is the sense that we have seen this movie before, and it wasn’t very good the first time, either. When President Bill Clinton came into office in the early 1990s, the US faced, among other challenges, waves of thrift and bank failures, huge hits to its deposit insurance system, and enormous piles of "toxic assets" in need of taxpayer-financed liquidation. It was a colossal regulatory failure.
Determined to identify the causes, Lloyd Bentsen, then Treasury secretary, proposed legislation to consolidate all four federal banking regulation and supervision agencies into a single body. That proposal went nowhere. The Federal Reserve opposed any reduction in its turf. Lobbyists fiercely asserted the benefits of "competition" among regulatory agencies. After months of struggle, the legislation died an ignominious death. Nearly 20 years later, our financial regulatory system has failed us again, on a scale so massive as to make the failures of the late 1980s and early 1990s seem quaint. Once again, we have a new president determined to overcome a legacy of inattentive financial regulation.
President Barack Obama and Tim Geithner, his Treasury secretary, deserve credit for their willingness to tackle modernising financial regulation. There is little political reward for taking on these issues. It is no-fun technical stuff, poorly understood by the general public and the media. And as past administrations have learnt, the status quo has many stakeholders who will bitterly oppose even the most objectively meritorious change. But unfortunately, the Obama administration’s proposal contains too much status quo to protect taxpayers against the costs of future bank failures. While Bentsen’s proposal in 1993 would have shrunk the federal banking regulators from four to one, Mr Geithner’s would eliminate only the Office of Thrift Supervision through consolidation with the Office of the Comptroller of the Currency.
This approach leaves a single regulator for federally chartered banks, plus two federal regulators, the Federal Deposit Insurance Corporation and Federal Reserve, for banks chartered by the states, plus an additional regulator, the Federal Reserve again, for all companies that own banks. As complicated as this may appear it has a clear consequence: it would allow financial groups to continue to shop for the weakest regulator. The opportunity for regulatory arbitrage will encourage money to migrate to the most weakly regulated parts of the system. This system is inefficient, unaccountable, and expensive to administer. It is inconsistent in its approach and would be uneven in its results. It is poorly equipped to identify industry-wide trends and conditions early. Competition among federal regulators makes no more sense in banking than in food safety or air traffic control.
We need a single agency combining the OTS and OCC while absorbing the responsibilities of the FDIC and Federal Reserve for prudential regulation and supervision of banks and their holding companies, affiliates and subsidiaries. This agency should have a level of independence commensurate with the FDIC and Federal Reserve (including an independent chair) with the authority to oversee banks from top to bottom and end to end. Through this reorganisation we can create a more powerful and effective federal bank regulator while preserving the dual banking system with both state and federal chartering and allowing the Federal Reserve and FDIC to focus on their core responsibilities for monetary policy and deposit insurance, respectively.
We need a system that can tolerate risk and promote safe innovation. We cannot afford hobbled regulators that can be played off one another, forced to pull punches for political reasons, or that are too compromised by other missions to act. Of course this is hard. But we need real solutions, not half measures. Because we have not learnt from history, we have been doomed to repeat it: in just 20 years, our federal bank regulatory system has twice failed our country, at massive risk and expense to taxpayers. It is time to change the ending to this movie.
The writer is the US senator from Virginia and a member of the Senate’s banking committee
Lawmaker Demands Bank of America Documents on Merrill Losses
A U.S. House lawmaker is demanding Bank of America Corp. turn over new documents to investigators about its decision to not publicly disclose ballooning losses at Merrill Lynch & Co. ahead of a shareholder vote last December. Rep. Edolphus Towns (D., N.Y.), who chairs the House Committee on Oversight and Government Reform, on Thursday sent a letter to Bank of America Chief Executive Kenneth Lewis asking for a wide range of documents covering the details surrounding the deal for Merrill Lynch.
The documents requested include emails and documents dealing with losses and loss projections at Merrill Lynch; records covering negotiations with the federal government on bailout funds received by the bank; and the details of any legal advice received by the bank on disclosure of the losses or government aid. Mr. Towns set a deadline of noon EDT on Aug. 14 for Bank of America to turn over the documents. The request is the latest twist in an ongoing investigation being conducted by the Oversight panel that has seen Mr. Lewis, Federal Reserve Chairman Ben Bernanke and former Treasury Secretary Henry Paulson all testify under oath before lawmakers in recent months.
Investigators are requesting the documents in response to a Wall Street Journal story on Thursday that suggested company documents challenge Bank of America's claims that the losses at Merrill Lynch didn't begin to swell until after the Dec. 5 shareholder vote. A Dec. 3 email cited in the Journal story revealed that the loss projections for Merrill Lynch swelled by nearly $2 billion in the days leading up to the vote, but that company executives decided they were not material enough to disclose publicly to shareholders.
Behind BofA's Silence on Merrill
Bank of America Corp.'s loss projections for Merrill Lynch & Co. swelled by nearly $2 billion two days before shareholders approved the securities firm's takeover, but bank executives concluded that the losses weren't severe enough to disclose publicly before the vote, according to company emails and people familiar with the situation. In a Dec. 3 email sent at 6:51 p.m. to several top bank executives, Bank of America Chief Accounting Officer Craig Rosato wrote: "4Q revenues need to be adjusted down by $3B." That revision changed the estimated fourth-quarter net loss to $8.98 billion, worse than the previous Merrill forecast of $7.06 billion sent to a top Bank of America executive earlier the same day.
The emails and attached documents challenge Bank of America's insistence that the losses at Merrill didn't begin ballooning until after shareholders approved the takeover on Dec. 5. Bank executives said nothing publicly about Merrill's problems until they spiraled into a net loss of $15.84 billion for the fourth quarter and the government bailed out Bank of America in January. There was disagreement inside the bank about whether to tell shareholders about Merrill's losses, which companies must do if they suffer materially significant financial hits, people familiar with the discussions said. The debate continued until executives concluded the night before the vote that the losses weren't material, one person said.
James Cox, a professor of corporate and securities law at Duke University, said it "is highly likely" that a change of $2 billion in Merrill's forecasted net losses "would be material, but it is even more likely to be material if this was indicative of conditions at Merrill that were deteriorating." Critics have claimed that Bank of America Chief Executive Kenneth Lewis and other executives withheld key information that shareholders should have been told before voting on the deal. The Charlotte, N.C., bank also faces shareholder lawsuits and investigations by U.S. and state regulators stemming from its disclosures about the takeover and government assistance.
Bank of America spokesman Robert Stickler said the internal documents reviewed by The Wall Street Journal "support what we have said all along." Internal projections by Merrill were "forecasting fourth-quarter losses prior to" the shareholder vote, but the forecast "increased significantly in the week following the vote," he said. Asked if there was internal disagreement on whether the losses were material, Mr. Stickler said Bank of America followed the advice of its securities attorneys. "We were not taking this lightly; we were honestly trying to determine what our requirements were and what the best course was," he said.
After swooping in last September to save Merrill from potential collapse as Lehman Brothers tumbled into bankruptcy, Mr. Lewis has been haunted by the deal almost ever since. In April, he lost his duties as chairman as investors blamed him for the decision to buy Merrill despite its deepening problems. On Monday, Bank of America agreed to pay $33 million to settle a civil lawsuit alleging that it misled shareholders about billions in bonuses promised to Merrill employees as part of the takeover.
A U.S. District Court judge has called a hearing Monday to discuss the original allegations from the Securities and Exchange Commission, saying in a Wednesday order that the proposed settlement "would leave uncertain the very serious allegations made in the complaint." Rep. Dennis Kucinich (D., Ohio) urged the SEC in a letter Tuesday to expand its probe of the bank for possible securities-law violations. Mr. Lewis, 62 years old, has told lawmakers and prosecutors that Merrill's losses grew to alarming levels only after the deal was approved. In June, the CEO told a congressional committee that Merrill's losses "accelerated dramatically" in mid-December.
Testifying under oath before New York's attorney general in February, Mr. Lewis said Merrill's projected losses grew from $9 billion at the time of the vote to $12 billion about a week later. Some of the additional losses reflect higher marks taken against Merrill's operations as they continued to deteriorate in late 2008. Estimated revenue fell from negative $7.6 billion on Dec. 4 to negative $12.5 billion at the end of the month. Write-downs on Merrill's exposure to insurers and commercial real estate also worsened.
Non-interest expense rose to $8.9 billion at the end of December from $6.4 billion as of Dec. 4, reflecting a $2.3 billion goodwill impairment charge relating to Merrill's ownership of lender First Franklin, said a person familiar with the situation. An internal forecast circulated on Dec. 3 and reviewed by the Journal assumed "no goodwill write-off." Mr. Lewis has continued to insist that Bank of America had no choice but to proceed with the deal. On Dec. 17, Mr. Lewis warned Federal Reserve Chairman Ben Bernanke and then-Treasury Secretary Henry Paulson that he might pull out of the merger. That disclosure led to weeks of secret talks, threats from the U.S. to go through with the deal and the bailout.
Messrs. Bernanke and Paulson have defended the government's response. Mr. Rosato's email about Merrill's losses before the shareholder vote hasn't been disclosed as part of the ongoing investigations. Another Bank of America email earlier that day also warned that losses could be adjusted higher. "December may take some further hits," Neil A. Cotty, acting chief financial officer for Bank of America's global wealth and investment-management business and a key liaison to Merrill's merger team, wrote in a Dec. 3 email to Merrill Chairman and Chief Executive John Thain. "Turning a profit in December may prove to be challenging." A spokesman for Mr. Thain declined to comment.
"The team," Mr. Cotty wrote in the same 1:31 p.m. email, "is still sizing the marks, but I believe there could be another $1B in downside to November's numbers." The email from Mr. Cotty discussed Merrill's latest forecast, which showed a net loss of $7.06 billion and "assumes incentives of $3.5 bln for FY08." That was a reference to the controversial bonuses that Merrill paid employees at year-end. Mr. Cotty couldn't be reached for comment. About five hours later, the 6:51 p.m. email from Mr. Rosato asked that Merrill's estimated fourth-quarter revenues be lowered by $3 billion, to a negative $7.62 billion from a negative $4.62 billion. "Use these changes in your models," he said. The revised forecast circulated on Dec. 4 predicted Merrill would have a net loss of $8.98 billion for the quarter. Last month, Mr. Cotty was named Bank of America's chief accounting officer, succeeding Mr. Rosato, who took another job at the company.
Mr. Stickler said the acceleration of Merrill's losses and the level those losses reached in mid-December are "what caused alarm" inside the company. Mr. Stickler also cited an earlier statement Mr. Lewis made about the $9 billion net loss estimate, noting that $3 billion of the $9 billion was a "plug" added shortly before the vote for "conservative reasons." Four days after the shareholder vote, Bank of America Chief Financial Officer Joe Price used the $9 billion net loss estimate in a presentation to Bank of America's board. The "magnitude" of the losses "is quite significant," he said, according to a person familiar with the meeting.
Geithner Takes Regulators to Task on Turf Battle
In what has become a routine spectacle, financial regulators went to Congress this week and raised objections to major portions of President Obama’s plan to overhaul financial industry rules. The dissident regulators — senior officials at the Federal Reserve, the Federal Deposit Insurance Corporation and the Office of the Comptroller of the Currency — told the Senate banking committee on Tuesday that the new consumer protection agency the president proposes to transfer some of their authority to would never be as effective as they have been.
But instead of modifying or withdrawing the plan, the Treasury secretary, Timothy F. Geithner, has taken the regulators to task, warning them that they are partly responsible for the economic crisis and that their public objections are playing into the hands of industry groups seeking to kill the plan, officials involved in those discussions said. Mr. Geithner also told the regulators that if the plan fails in Congress, it will be partly a consequence of their public challenges, which coincide with the views of the banks they supervise.
Mr. Geithner, in a brief interview on Wednesday, said he was confident that Congress in the end would adopt legislation embracing the administration’s core principles. He said it was understandable that the regulators had tried to preserve their jurisdiction over consumer issues. But he said he also warned them not to lose sight of the broader objective — getting approval of legislation that all of them largely support — instead of being used by opponents of the plan to kill or substantially dilute the legislation because of relatively modest policy differences. "I have told them, ‘Don’t let your effort to defend your turf add to the complexity of getting legislation done,’ " Mr. Geithner said. "I said, ‘You all have a huge amount of credibility at stake.’ "
Banks and regulators have resisted a proposal to create a new agency to regulate credit cards, mortgages and other consumer debt. Ben S. Bernanke, the chairman of the Fed, has told Congress that it would be better policy for the central bank to continue to write the consumer product rules. Sheila C. Bair, the head of the Federal Deposit Insurance Corporation, and John C. Dugan, the comptroller of the currency, have said that bank examiners at their agencies should continue to be the primary enforcer of consumer protection laws at those banks they already regulate for safety and soundness issues.
Ms. Bair, Mr. Bernanke and Mr. Dugan all head up independent agencies and were originally appointed by President George W. Bush. Industry lobbyists could not be happier about the regulators’ opposition. "It’s entirely appropriate for the senior bank regulators, which lead independent agencies, to express different views because it makes for better policy making," said Camden R. Fine, head of the Independent Community Bankers Association. "They are team players — for the American people and for the banking industry. Just because they disagree over certain provisions does not mean that they do not share the same goals as the administration, which is creating a better system. They just have different approaches."
Edward L. Yingling, the veteran top lobbyist for the American Bankers Association, said that no one should be surprised by the public challenges to the proposal that have been raised by regulators. "Each of these people are known commodities and people on the Hill and you and others know where they are coming from and their philosophies," he said. "John Dugan was Republican counsel of the banking committee. Sheila has had strong views since she arrived at the F.D.I.C.. Ben Bernanke is very highly respected."
But the public dissent, which brought to the surface long-running debates that had been going on behind closed doors while the administration was drafting its plan, has taken senior Obama aides by surprise. The administration fears that it feeds industry opposition that has delayed action in the House and reinforced challenges in an already hostile Senate. Administration officials, confirming an account first disclosed in The Wall Street Journal, said Mr. Geithner upbraided top regulators at a Treasury meeting for airing their views. The participants included Mr. Bernanke, Mr. Dugan and Ms. Bair.
One participant in the meeting said that the bank regulators felt that Mr. Geithner treated them like children being reprimanded by a parent. But the meeting appeared to do little to discourage the regulators from once again returning to Congress to express their concerns with elements of the plan, as Mr. Dugan and Ms. Bair did on Tuesday before the Senate Banking Committee.
There is a rich history of independent regulators taking positions that have frustrated the administrations they served. Franklin D. Roosevelt tried to remove a conservative member of the Federal Trade Commission in 1933 over policy disagreements, leading to a landmark Supreme Court decision, Humphrey’s Executor v. United States, that limited the authority of the president to dismiss leaders of independent agencies for such reasons.
L. William Seidman, the top regulator of savings and loan institutions during that industry’s crisis in the 1980s and 1990s, was a frequent public critic of proposals by the first Bush administration, and often ran political circles around senior officials. He once ridiculed a White House proposal to levy new fees on bank depositors to pay for the bailout, calling it a "toaster tax" because, instead of the banks giving a toaster to new depositors, the bank would take one. The appellation stuck and killed the proposal outright.
More recently, William H. Donaldson was pressured by the White House to step down as head of the Securities and Exchange Commission after his endorsement of proposals that administration officials opposed.
TARP bailout money we can kiss goodbye
One of the things they teach in Successful Investing 101 is to cut your losses short and let your winnings run. But when it comes to the Troubled Assets Relief Program, the government is stuck doing the opposite. Its gains are being cut short, because its most profitable investments are being closed out, yet its losses will continue running. The big gains come from stock-purchase warrants that Congress insisted the Treasury get as part of the $244 billion of TARP loans it made to 662 banks and bank holding companies. Warrants, which give holders the right (but not the obligation) to purchase stock at a fixed price for a fixed period, are designed to offer taxpayers a chance to make some serious money if the stock prices of the bailed-out banks rise.
To induce relatively sound banks to borrow, the Bush Treasury Department adopted very liberal rules on the warrants, giving early TARP repayers the right to force the government to sell them back rather than continue holding them. The price is determined by negotiation, auction, or complicated appraisal proceedings. The government's two biggest scores -- 26% a year from American Express and 23% from Goldman Sachs -- came from Amex and Goldman having redeemed their warrants for $340 million and $1.1 billion, respectively. Profits on the warrants, which were outstanding for only a brief period, accounted for 21% and 18%, respectively, of those returns. The rest came from the 5% annual borrowing charge for most TARP borrowers.
So far, 34 of the banks that got TARP money have paid it back, according to SNL Financial, a Charlottesville-based research firm whose statistics I'm using throughout this piece, with about half the institutions paying a total of $1.7 billion (including Amex and Goldman) to redeem their warrants. That's the good news. The bad news is that we've now seen most of the good news, because the remaining TARP borrowers -- 628 that owe the government $174 billion -- are considerably weaker as a group than the ones that have repaid.
It's what economists call "adverse selection." The strongest borrowers -- the ones whose warrants are likely to produce serious profits for the Treasury -- are bailing out of TARP as rapidly as possible to avoid pay restrictions and other rules that the Obama administration adopted after inheriting TARP from the Bush administration. These stronger firms would also like to capture as much of their stocks' potential upside as possible, so they're trying to buy back the warrants based on today's share price rather on what they assume will be a higher price in the future.
Even though only strong banks were supposed to be deemed TARP-worthy, there are plenty of weaklings in the pool. The biggest: Citigroup, where the government has converted $45 billion of its TARP investment into regular preferred and common stock to try to strengthen the bank. The odds of us taxpayers getting back our $45 billion -- plus the 5% to 8% Citi was supposed to pay on its borrowings -- are remote. Then there's the $54 billion in TARP money tied up in GMAC and American International Group. Not exactly prime credits.
Finally, there's my favorite: 17 borrowers that SNL Financial says have failed to pay the dividends due on their total of $500 million of TARP borrowings. I'm sure we can kiss a good part of that money goodbye.
The government still has some warrant gains to collect -- 16 firms, including JPMorgan Chase, have repaid their TARP borrowings but the government still hasn't sold the warrants -- but I doubt we'll see percentage returns anything like what we got on Amex and Goldman.
Even if the government gets the $1.1 billion value that the TARP Congressional Oversight Panel places on the JPMorgan Chase warrants, we'd have a far lower return than on Amex and Goldman. That's because these firms bought their warrants for 10% and 11%, respectively, of their TARP loans, while $1.1 billion is only about 4% of JPMorgan's $25 billion TARP borrowing. So let's be happy with what we've gotten for our warrants, taxpayers. But let's not kid ourselves. TARP was designed to bail out the financial system, not to make money. If we break even, we'll be doing well.
Purloining the People’s Property
Every week, Marcia Carroll collects examples of privatization (that is, corporatization of the peoples’ assets). Looking at her website, privatizationwatch.org, will either make you laugh helplessly or make your blood boil. The "off the wall" giveaways at bargain-basement prices of what you and other Americans own eclipses imagination. The latest escapes from responsible government are called "public-private partnerships" and are designed to enable the likes of Morgan Stanley and Goldman Sachs to take over highways, meter-collecting, and public buildings in deals that are loaded with complex tax advantages for the investors.
Here are two of her latest entries. Arizona lawmakers and Governor Jan Brewer are moving to fill a $3.4 billion budget shortfall by selling state-owned buildings. These include not only prisons, but also the House and Senate buildings. That’s the state legislature, fellow Americans! Metaphor becomes reality! The proposed sale has bipartisan support and will require a leaseback by the buying corporation to the lawmakers with the right to repurchase the premises within twenty years. The Arizona Republic reports that the deal, which includes 32 state properties, would bring in $735 million in upfront money and entail state lease payments totaling $60-70 million a year.
"We need the money," State Minority Whip Linda Lopez, a Tuscon Democrat said, adding, "You’ve got to find it somewhere." Well, why not rent out the backs of the state legislators to their favorite corporate funders? At least the public would get full disclosure of ownership. "I look at it as taking out a mortgage," practical Arizona House Majority Leader John McCormish, a Republican, told the Wall Street Journal.
The second item comes from the Denver Post, which reports that the foreign consortium, auto-estradas de Portugal (Brisa), operating the toll road Northwest Parkway under a 99-year lease, objected to improvements on a nearby public road. Under the complex leasing contract, the company could cite the improvements as an "adverse action" reducing toll revenue and the number of vehicles using the parkway. This action would presumably entitle this foreign company to compensation from Colorado taxpayers.
Last year, Pennsylvania Governor Ed Rendell tried to push through the legislature a complex, 75-year lease of the storied Pennsylvania Turnpike in exchange for $12.8 billion up front. All kinds of tax breaks and trap-door evasions filled the 686 page lease. The Governor was prepared, for example, to agree to pay the consortium of foreign investors if new safety measures or emergency vehicles entered the toll road and affected the flow of traffic. Fortunately, the legislature rebelled and blocked the deal. The Indiana Toll Road was turned over to private companies in 2006. The 75-year lease was for $3.8 billion, which is a little more than the cost to repair the Woodrow Wilson bridge over the Potomac River between Virginia and Washington, DC. Tolls on the Indiana Toll Road have already doubled and are expected to double again within ten years, according to the Dallas Morning News.
Last year, Mayor Richard Daley of Chicago privatized the city’s parking meters. Chicago’s inspector general concluded that the meters were worth nearly twice as much to the city as the $1.15 billion that the city received under an agreement rushed through the City Council with no civic input. A fourfold increase in meter rates this year has driven many motorists to residential neighborhoods in search of free parking spaces.
Indiana, a leader in outsourcing governmental functions to private corporations, gave the servicing of the state’s welfare program to IBM. According to the Indianapolis Star, error rates since corporatization have risen 17.5 percent last November and 21.4 percent in December.
The myth that corporatization is "better, faster, and cheaper" is falling apart. This year, the IRS announced that it will end the use of private tax collectors after consumer groups argued that taxpayers were subjected to immediate payment demands by private collectors while IRS employees would offer citizens an array of options to help pay their tax debt. Then there are the corporatized water systems where the companies deliver poorer service at higher cost.
Since the 19th century, privatizing public functions has opened the doors to kickbacks, price fixing, and collusive bidding.
New depths of corruption were reached in Pennsylvania recently when two state judges pleaded guilty to taking bribes in return for sending youths to privately-owned jails. After reading report after report about the vast, relentless waste, fraud, and abuse arising out of corporate contractors to the Pentagon in Iraq, why should readers be surprised at this domestic scene whereby taxpayers pay through the nose for corporations to govern them?
So, you’re not surprised. But are you indignant? Are you ready to make sure the politicians hear from you in no uncertain terms, hear from you to stop this recklessness and restore public control of the public infrastructure under accountable government? If the state politicos try to pull a fast one, demand public hearings with thorough reviews of the proposed contracts or leasebacks. Better yet, in states like Arizona or Colorado, require any such proposals go through the open, state-wide referendum voting process. Corporatizations such as the above just pass on to our children the burdens that our generation should have assumed itself to run government within its means funded by fair taxation.
The $100 Million Banker
Citigroup trader Andrew Hall appears to be living a dream life. Among the smartest, gutsiest players in the energy markets, he works at a converted Connecticut farm, pulls down $100 million a year, leaves work to go rowing in the afternoons, and collects modern art. A naturalized citizen, he represents the classic story of a person coming to America to chase opportunity. Except that taxpayers are now standing behind his huge bets on the price of oil.
Fearing the political backlash about Mr. Hall’s mega-payday, Citigroup has been refusing the $100 million it owes him for 2009 under the terms of his contract. Given that the federal government is now Citi’s largest shareholder, the compensation is difficult enough to defend in the press, and it may be impossible to get past new Obama pay czar Kenneth Feinberg, who is reviewing compensation at the seven firms receiving the largest taxpayer bailouts.
Still, as we went to press Citi hadn’t cut Mr. Hall loose. That’s because his largely autonomous Phibro LLC trading unit has been contributing more than $600 million a year into Citi’s coffers. Mr. Hall is reportedly seeking to put Phibro in the hands of a new owner who won’t mind paying him that $100 million.
We think a contract is a contract, and if Mr. Hall is owed $100 million then Citigroup ought to pay it. But an equally important issue—especially for taxpayers—is whether Citigroup ought to own a high-risk trading operation like Phibro. As a bank holding company, Citi is funded in part with deposits insured by the taxpayer. And we know from painful experience that regulators think Citigroup is too big to fail. Citigroup executives and board love the revenue and profit that Mr. Hall generates, and they’ve left him on a long leash because his risky bets on the direction of oil prices have generally paid off. But if those bets go wrong and they jeopardize Citigroup, then taxpayers get hit with the bill.
In Phibro and Citi, we can see writ small the debate over financial regulation that took place inside the Obama Administration. Former Fed Chairman Paul Volcker has been warning for months that such proprietary trading is incompatible—and intolerable—with a taxpayer guarantee against failure. But he was opposed by the Obama Treasury, White House powerhouse Larry Summers, not to mention the ghost of former Treasury Secretary and Citigroup exec Robert Rubin and most of Wall Street.
Mr. Volcker’s advice would have meant restraining bank risk-taking in ways that would also limit bank profits. But this is politically hard to do in the face of Wall Street opposition. It’s so much easier to preach about the wonders of a new "systemic regulator" and roar against $100 million bankers. But for all of their banker-baiting, Democrats in Washington still want to let the biggest banks place enormous bets with taxpayer guarantees. High-risk, high-reward businesses play a vital role in the American economy, but Fannie Mae should have taught us that disaster for taxpayers is inevitable when private reward is combined with socialized risk.
Whining about Andrew Hall’s bonus is the cheap way to avoid answering the difficult question of "too big to fail" while appearing to seek financial reform. Of course, if the question were answered, there would be no need to address compensation at all. Smaller, more tightly regulated banks do not run the risks that generate huge returns and huge salaries. And if Phibro is on its own and fails, it’s a smaller tragedy and no threat to the financial system. Citi employees and those of other banks should be free to make what the market will pay them—as long as it’s really the market paying them.
Appetite for risk returns to derivatives
The appetite for risk has returned to derivatives trading, MF Global, the world’s biggest broker of exchange-listed futures and options, said on Thursday as it reported quarterly profits ahead of Wall Street expectations even as they dropped by two-thirds from last year. The broker said it made a net loss of $33m or 27 cents per share in the three months to the end of June, compared to net income of $14.4m or 2 cents per share in the same period last year. However adjusted for extraordinary charges and excluding stock compensation, eearnings before interest, tax, depreciation and amortisation was $31m, or 5 cents per share, slightly ahead of analysts’ average forecasts of 4 cents per share. Revenues in the quarter were $271.5m, down from $374.7m last year.
The economic crisis has led financial institutions to slash derivatives trading desks, resulting in slumping volumes at brokerages and exchanges. However, in recent months, listed futures and options volumes have shown some tentative positive signs. In an interview with the FT, Bernard Dan, MF Global’s chief executive, noted that the company’s revenues were up sequentially, rising 6 per cent from the previous quarter, with exchange-traded volumes 11 per cent higher and revenue from Asia up 20 per cent. "The macro-drivers in our industry are starting to stabilise," Mr Dan said. "Risk aversion is abating, the banks have been taking more risk to drive their earnings and we’re seeing greater hedge-fund and asset-manager participation. Open interest in the last two quarters has gone up. More people are taking positions."
Mr Dan pointed to healthy trading at the CME Group, the largest US futures exchange, in June. However, CME volumes dipped again last month, underlining concern that the derivatives industry faces a drawn-out and uncertain recovery. Credit Suisse analysts wrote last week on MF Global: "We remain neutral rated given limited near-to intermediate term earnings power due to the headwinds of a weaker macro outlook, slower customer activity levels and the absolute low level of [interest] rates." Mr Dan agreed that the climate had been grim, but added: "In this atmosphere, I can only focus on what I can control. To beat expectations by a penny is a great result."
As well as economic factors, lack of clarity over the emerging shape of post-crisis US financial regulation has also weighed on investor sentiment. In spite of the continuing uncertainty over how the debate in Washington will play out, the MF Global chief said most of the proposed changes to derivatives trading – such as mandating the central clearing of over-the-counter contracts – would end up benefiting the exchange-listed broker at the expense of the big banks that are the main dealers in the privately negotiated bilateral agreements.
Mr Dan said the results also showed how MF Global was successfully expanding away from its traditional focus as an exchange-traded interest-rate broker. The company has sought to benefit from the turmoil on Wall Street by hiring fixed-income staff, a strategy Mr Dan said was starting to show results. "It’s probably our most diverse quarter," he said. MF Global drew unwanted attention last year when a wheat trader at its Memphis office racked up $141m of losses in unauthorised trading in the largest trading scandal ever to hit agricultural commodity markets. The fall-out from the incident claimed the scalp of Kevin Davis, the company’s erstwhile chief executive, who bowed to investor demands to resign last October and was replaced by Mr Dan, a former chief executive of the Chicago Board of Trade.
Clunkers Plan Deflates Mechanics
Who doesn't like the government's "cash for clunkers" program? Your mechanic, for one. Owners of automotive repair shops say the program to help invigorate sales of new cars is succeeding at their expense. Bill Wiygul, whose family owns four repair shops in Virginia, said he has already had five or six customers decide against repairs. A man who sits on the board of Mr. Wiygul's bank traded in his car rather than repair it. "He'd been a customer at our Reston store since it opened," Mr. Wiygul said.
The clunkers program, formally known as the Car Allowance Rebate System, offers subsidies of as much as $4,500 to consumers who trade in older vehicles and buy new, more fuel-efficient models. The program was initially given $1 billion. That money was spent in one week. The Senate reached a deal to extend the clunkers program Wednesday night, agreeing to vote on a measure Thursday that would add $2 billion to the program, the Associated Press reported. The House approve a $2 billion extension last week.
For Mr. Wiygul and other mechanics, until now the recession has brought them more customers as people fixed cars rather than go into debt for new ones. He has hired five people and is expanding one of the shops. Auto dealers who offer the rebates on new cars in exchange for clunkers must agree to "kill" the old models by disabling the engines and shipping the dead vehicle to a junkyard. The loss of such potential work -- as many as 250,000 vehicles will be destroyed in the program's first round -- prompted Mr. Wiygul to question the federal program's focus on dealers and big business at the expense of the little guy.
"How do we get on the special interests, special treatment bandwagon? How much is it going to cost me and to whom shall I send the check?" he said. "Who picks the winners in this game 'cause obviously the game is fixed."
Betty Jo Young, co-owner of Young's Automotive Center in Houston with her husband for 35 years, said her concern is that the federal program, unlike her state program, AirCheck Texas, doesn't give car owners the option of repair. The Texas program, created for low-income residents, provides $600 vouchers for repairs to bring older cars up to emissions standards. Participants have to make a co-payment of $30. It also offers up to $3,500 to replace the vehicle.
"I have found my customers want to keep their cars. They're doing good to make the $30 co-pay, much less buying a new vehicle," Ms. Young said. "Why aren't we putting money into repairs as long as the car is running?" The auto-repair segment of the car industry, with about 164,000 independent shops, is a small portion of the automotive aftermarket that includes maintenance shops, parts suppliers and companies that remanufacture engine parts, among others.
The automotive aftermarket, a $250 billion industry that employs about 4.6 million people, could be among the biggest losers in the clunkers program, said Kathleen Schmatz, head of the Automotive Aftermarket Industry Association: "It's everybody from the Fortune 500 parts manufacturer all the way through the supply chain to the independent repair shop." The group that lobbies for independent mechanics in Washington agreed. "This package will hurt mechanical repairs without question. You are taking older vehicles that are still fine to use and removing them," said Robert Redding Jr., the Automotive Service Association's Washington representative. "If you're taking hundreds of thousands of vehicles that you normally service off the road with no consideration, it hurts people."
Mr. Redding said the organization originally suggested a repair option be included in the plan that would have allowed some customers to opt for repairs to reduce emissions and extend mileage. The association's May letter to members of Congress said "a fleet modernization program without a repair option could be devastating to independent repairers. Arbitrarily removing older vehicles from America's highways would take vehicles out of independent repair bays costing jobs and potentially closing small businesses." It went on to suggest that California and Texas, which have modernization programs that include money for repairs, could serve as models for the clunkers program.
Commerzbank Feels Germany's Pain
It's not easy being Commerzbank. Whereas other European heavyweights like Barclays, Societe Generale and BNP Paribas have reported strong second-quarter profits, boosted by a turnaround in investment banking, the German lender's heavier dependence on retail banking resulted in a second-quarter $1 billion loss on Thursday. And with Europe's biggest economy expected to shrink 6% this year, the pain is not over yet.
Commerzbank said on Thursday it had sharply increased its loan-loss provisions in the second quarter, to 1.8 billion euros ($2.6 billion), an increase of more than 300% over the year. Corporate lending was the big culprit, with the German small-to-medium-sized business segment--or "Mittelstand"--throttled by the recession. In April, the latest month for which official data is available, German insolvency filings were up by 7.1% over the year.
"I think provisions will increase in the coming quarters," said Tutku Bagriyanik, an analyst with BHF Bank, who recommended selling Commerzbank shares. "Maybe we will see a peak in the third or fourth quarter." He added that Commerzbank was unlikely to post a net profit before 2011. Commerzbank said that its loan-loss provisions in 2009 would be on a par with those of 2008, which came in at 3.6 billion euros ($5.2 billion).
Shares of Commerzbank fell 1.2%, or 7 euro cents (10 cents), to 5.84 euros ($8.40), during afternoon trading in Frankfurt. The stock had initially rallied after the lender's results came in better than expected, with a narrower operating loss of 201 million euros ($289 million). But Bagriyanik thinks investors may have also initially misinterpreted Commerzbank's promise of returning 5 billion euros ($7.2 billion) in state guarantees as repaying part of the government's 25% stake in the bank. Once Commerzbank gives up the 5 billion-euro slice of loan guarantees, it will save 440,000 euros ($632,668.83) per month in payments to the state.
Although Deutsche Bank also reported heavier-than-expected loan loss provisions in the second quarter, its share price has only fallen 26% over the year, while Commerzbank's is down 73%. Commerzbank itself admitted that its lower exposure to investment banking revenues was the cause, and said that it and fellow commercial banks would be forced to take "significant" writedowns on their credit portfolios. Commerzbank has pushed to expand its investment-banking exposure by buying Dresdner Bank from Allianz. The acquisition led to a charge of 216 million euros ($310.6 million) in the second quarter.
Merkel moves on failing banks
Angela Merkel would give the German banking supervisor powers to dismiss the management of failing banks and suspend shareholders’ rights if re-elected chancellor next month, according to legislation drafted by her economics minister. The text, a copy of which was obtained by the Financial Times on Thursday, would give Bafin, the regulator, sweeping powers to fire managers and restructure systemically relevant banks that are threatened with insolvency.
Such rules, if implemented, would replace the temporary laws rushed through parliament late last year as the government scrambled to stabilise the banking sector with a permanent legal framework. They would also address the risk of banks reverting to excessive risk-taking in the knowledge that they would be bailed out, a Berlin official said. The draft, a reform of Germany’s insolvency law, would allow the regulator – with approval from an inter-ministerial body – to take the reins of failing banks and prevent the type of chain reaction caused by the failure of Lehman Brothers in the US last year.
"This would give Bafin the tool to completely restructure problematic banks without the state actually having to take them over," an economics ministry official told the FT. The bill, drafted by Karl-Theodor zu Guttenberg, economics minister and an ally of Ms Merkel, is both a reaction to the financial crisis and a political gesture following the controversial nationalisation of Hypo Real Estate, a distressed mortgage and public sector lender, earlier this year. Berlin’s financial sector rescue fund acquired HRE shares through a public tender offer, giving it enough votes at a bank shareholder meeting to push through a further, massive capital increase to which only the government could subscribe.
The government succeeded in taking control of roughly 90 per cent of the lender’s shares partly because it had threatened to expropriate shareholders if unsuccessful under emergency laws passed in the wake of HRE’s near-collapse. The threat of expropriation – a tool used liberally by the Nazi and east-German dictatorships – nonetheless raised eyebrows, particularly among conservatives and economic liberals, prompting the cabinet to mandate the economics and justice ministries to come up with new legal tools of crisis management.
The bill has little chance of becoming law before next month’s general election, not least because it would require the backing of Frank-Walter Steinmeier, the Social Democratic vice-chancellor and his party’s candidate to succeed Ms Merkel in the chancellery. But given the high likelihood of a Merkel re-election, as predicted by opinion polls, economics ministry officials are confident the law would be implemented by the next government. The SPD-led justice ministry has also developed its own, softer version of the legislation, under which Bafin would need shareholder approval before taking control of bank’s management.
Letter to the Editor FT: Investors assume deflation will not be permitted
From Mr Andrew Gundlach.
Sir, I would guess that the key reason so few investors predict deflation is not (as Gillian Tett writes) because they have never seen it, but rather that they assume, in a fiat money system, that governments elected democratically by a multitude of the population would never permit sustained deflation (“Investors are floundering in post-traumatic syndrom”, Insight July 24). Not a bad bet to make, except perhaps when the multitude of the electorate consists of retirees and pensioners.
Also, I think there is a reason that investors “panic” once they no longer “dare assume that the world is benign”. The money management industry considers itself as stock pickers focused on the fundamentals, who claim that the global macro is not part of their core mandate. It works most of the time, except when big sea changes occur in the international political economy. As Larry Summers famously said at Davos a few years ago (borrowing from Niall Ferguson’s work), the European bond market displayed no volatility and traded within tight spread ranges even six months after the Austrian archduke was shot in Sarajevo on the eve of the first world war. Are investors any different today, or just as myopic to the bigger picture?
No question – we live in a very uncertain world with the potential for extreme outcomes. Policy choices today and through the next years will determine where we go, and cases can be made for both inflationary and deflationary outcomes. There are certain investments that ought to do well in both environments (or at least better than other investments), and that is where to focus, in my view.
Arnhold and S. Bleichroeder Advisers,
New York, NY, US
Bank of Japan Said to See Deflation Stretching Through 2011
The Bank of Japan will probably forecast that declines in consumer prices will extend into 2011 even as the economy recovers, according to two people familiar with the matter. The estimate would be included in policy makers’ first economic projections for the financial year ending March 2012, scheduled for release in October, said the people, who declined to be identified ahead of the report. Central bankers have already predicted prices will fall 1.3 percent in the current year and 1 percent in fiscal 2010.
Prospects for a third year of deflation make it likely Bank of Japan Governor Masaaki Shirakawa and his colleagues will keep interest rates near zero through next year, analysts said. It would also erode profits at companies such as Aeon Co., Japan’s second-largest retailer, which has been forced to offer discounts to attract consumers whose wages are tumbling. "The Bank of Japan will hold the key rate at 0.1 percent at least through March 2011 to stop deflation from becoming deeply entrenched," said Jun Ishii, chief fixed-income strategist at Mitsubishi UFJ Securities Co. in Tokyo. "The central bank will probably consider further policy-easing action" should the risk of spiraling deflation mount, he also said.
Japan is beginning to emerge from its worst postwar recession as exports improve and manufacturers boost production to replenish inventories. The revival has yet to spread to consumers, who are facing record declines in paychecks and an unemployment rate that economists say will reach an unprecedented 5.8 percent early next year. Deflation may escalate as households, whose spending accounts for more than half of the nation’s gross domestic product, delay purchases on the expectation that goods will get cheaper, restraining a recovery in the world’s second-largest economy.
The central bank cut the key overnight rate to 0.1 percent in December, and has since begun buying corporate debt from lenders and offering them unlimited loans backed by collateral to channel funds to companies. The policy board last month extended the credit steps by three months to Dec. 31; some analysts said they’ll need to extend them again. "With little room left to trim the key rate, the Bank of Japan will have no choice but to keep the current extraordinary policy measures, including the credit-easing programs, for a long time," said Akio Makabe, an economics professor at Shinshu University in Matsumoto, central Japan.
Subdued consumer prices have helped keep Japan’s debt yields from climbing even as the government enacted fiscal- stimulus measures. Benchmark 10-year bonds yielded 1.435 percent at 10:16 a.m. in Tokyo, down from the year’s high of 1.57 percent in June and an average of 1.47 percent the past decade. Japan endured years of deflation earlier this decade, only defeating it in 2005. A central bank forecast signaling a return of the trend would come weeks after a new government takes office. The opposition Democratic Party of Japan leads the ruling Liberal Democratic Party in polls ahead of the Aug. 30 general election.
The central bank is bound by law to maintain price stability, and policy makers have indicated that inflation is steady within a range of zero to 2 percent. The prospect that prices will stay below that scope will force the central bank to keep the key rate unchanged at least through 2010, according to 10 of 13 economists surveyed by Bloomberg News.
Prices excluding fresh food, the central bank’s preferred gauge, slid a record 1.7 percent in June, in part because oil traded at about half of last year’s levels. Central bank Deputy Governor Hirohide Yamaguchi said last month that it will take "some time" before consumer prices return to the policy board’s range. He added that there is no need for the bank to implement additional policy-easing measures for now, with the risk of a deflationary spiral being low.
Retailers are discounting products in an effort to maintain sales amid the recession. Chiba-based Aeon in July started selling house-brand beer that’s 20 percent cheaper than the equivalent products of major breweries. The company, which last month reported its fourth net loss in five quarters, cut prices on more than 6,000 items in March as rivals including Seven & I Holdings Co. and Seiyu Ltd., a Wal-Mart Stores Inc. unit, also discounted products. "Retailers are slashing prices to appeal to households, which are tightening their purse strings in response to job losses and wage cuts," said Ryutaro Kono, chief economist at BNP Paribas in Tokyo. Kono anticipates the Bank of Japan will in October forecast prices will fall about 1 percent in fiscal 2011 because a growing number of consumers and companies are expecting price declines.
A measure of the gap between supply and demand in Japan’s economy widened to a record in the three months ended March 31, according to the Cabinet Office. "It’s inevitable that the Bank of Japan will forecast price declines for a third year," given that slack in the economy has widened and growth will be subdued, said Seiji Shiraishi, chief economist at HSBC Securities Japan Ltd. in Tokyo. "The central bank will continue to focus on the economy’s downside risks."
The dash to flash
No matter how rapidly the human eye can blink, a computer trading system on Wall Street has already left it for dust – carrying out a transaction 1,000 times faster, at just 400 microseconds. It is a frenetic, technology-driven world of which few ordinary investors are even aware.
But this "high-frequency trading" is estimated to account for well over half of daily volume in US stocks, up from estimates of 30 per cent in 2005. It is based on extracting tiny slices of profit from trading small numbers of shares in companies, often between different trading platforms, with success relying on minimal variations in speed – or "latency", in the trading vernacular. It amounts to a transformation in equity trading that has lowered dealing costs virtually all round and, many argue, has created a more efficient market for both retail and institutional investors.
But amid all this hectic activity, a certain type of stock order has raised anxiety among market participants, competing exchanges, members of Congress and now the Securities and Exchange Commission. Mary Schapiro, no-nonsense new chairwoman of an SEC that had been accused of being largely supine till the credit crunch began to batter markets two years ago, this week served notice that the days of so-called flash orders are likely to be numbered. Flash orders occur when, as some exchanges allow, traders’ computers get a glimpse of share order flows a fraction of a second before the broader market. The concern is that some of them then "flash" an order to the exchange’s members, giving them an unfair advantage over other market participants. By posting a trade, the firm even gains a rebate from an exchange hungry for its business.
These orders comprise only around 3 per cent of overall flows, according to Sang Lee, managing partner at Aite Group, a consultancy. He says a lot of high-frequency traders do not use them. But flash orders were thrust into the limelight after some investors and lawmakers, including New York Senator Charles Schumer, urged the SEC to ban the practice late last month. Ms Schapiro said on Tuesday that she had instructed her staff to find "an approach that can be quickly implemented to eliminate the inequity that results from flash orders".
The SEC has been looking into flash orders as part of a review of what are called "dark pools" – electronic trading venues that do not display public quotes for stocks. "Flash orders are a very small part of trading flow, but it has caught the attention of regulators that a certain class of investor may be getting a preferential look at order flow," says Larry Tabb, founder and chief executive of Tabb Group, a research and strategic advisory firm. "Flash orders can be looked at as providing a two-tier market," he adds. "All agree that everyone should have a fair shake at seeing all orders."
The use of flash orders is not confined to high-frequency traders. Retail brokers, institutional investors, proprietary trading firms and automated market-makers also deploy them. Nor are flash orders the only manifestation of the revolution in electronic trading that has taken place in less than five years – such as the ability for a trading firm to shave microseconds off the time it takes for a trade to be done by physically locating its trading systems in an exchange’s data centre – known as "co-location". The dilemma for regulators is what to do about this technological revolution – especially as many orders are cancelled almost as soon as they are posted. By flashing orders so quickly, some traders could be trying to ascertain where other investors want to buy and sell stocks. Cancelling the order before it is executed means the flasher could potentially squeeze a better price from the investor.
Regulators in the US are already smarting from having failed to spot glaring holes in the way the opaque over-the-counter derivatives market functioned. Few ordinary investors had such complex investments in their portfolios, yet ownership of shares in the US is widespread. So the SEC, whose prime congressional mandate is investor protection, is highly sensitive to the flash trades issue. But as many market participants point out, there has never been equal access to information in the markets. In the old days of trading floors, dealers were able to achieve better prices than rivals often by overhearing information uttered by a rival standing a few feet away. In cynical recognition of this disparity, traders at banks and brokerages routinely describe orders originating from "mom and pop" retail investors as "uninformed order flow". It also has long been common practice for banks to conduct huge amounts of share dealing, between each other and on behalf of clients, in the over-the-counter or off-exchange markets.
The SEC has acknowledged the dilemma. In a recent speech, James Brigagliano, a senior staffer in its trading and markets division, said securities markets had thrived as "competitive forces have led entrepreneurial industry participants to innovate with new technologies and new trading tools". He described the challenge for the industry and regulators as having to "monitor these changes and update a market’s structure when needed". How the SEC undertakes this challenge of technology is the compelling question. Richard Balarkas, chief executive of Instinet Europe, a broker owned by Nomura of Japan, says there is a risk that regulators could go too far. That could hobble many of the technology-enabled trading processes that have resulted in tighter bid-ask spreads and greater liquidity in markets.
"The dilemma for the regulators in the US seems to be this assumption that their job is to ensure there is absolute equality of information amongst all market participants and it all boils down to this efficient market hypothesis," he says. "In reality there are a couple of thousand tiers of information in the market and there always have been. If the regulators want to insist on this single-tier philosophy, where do they stop?" In the US, Stuart Schweitzer, global market strategist at JPMorgan’s private bank, says: "The issue in the market has long been, do you always get the best execution? I understand some may point a finger but I think it’s being exaggerated."
BATS Trading and Direct Edge, two dealing platforms that have been competing with NYSE Euronext and Nasdaq OMX, argue that their existence has helped expand liquidity in the markets. William O’Brien, Direct Edge chief executive, says: "Our customers like flash orders and the way it provides them with access to liquidity in the market they would not normally reach." Flash orders were pioneered by Direct Edge some three years ago. At that time there was little fuss, but Direct Edge’s share of average daily equity volume in the US has since climbed to 12 per cent from 1 per cent. Competitors such as BATS and Nasdaq OMX have felt compelled to offer flash orders in order to compete for market share. Mr O’Brien argues that the debate over the use of flash orders "reflects competition among exchanges, rather than being a true burning regulatory issue".
NYSE Euronext, operator of what was long known as Wall Street’s "big board", does not allow flash orders and has been a vocal critic of the practice. The SEC’s move on Tuesday sparked a rally in the exchange’s own share price.
Aite’s Mr Lee says: "Flash orders are a legitimate issue as it creates a private network for trading. We will have to wait and see if it’s a complete ban or whether certain aspects of flash orders are stopped." Exchanges and main participants appear at least to some extent open to a curb. Joe Ratterman, chief executive of BATS, has called for a collective ban on flash orders, although he plays down concerns that have been raised about their use. Themis, an institutional brokerage, says other trading practices need reform as well. "It’s a good first step that the SEC has taken, but this just scratches the surface," says Joe Saluzzi, its co-head of equity trading. Inducements from exchanges to traders such as paying a rebate to posters of orders should be abolished, he adds.
The rebate model, which the London Stock Exchange has decided to abandon from next month, underlines how competitive the equity trading business has become in the US over the past decade. Computer systems or algorithms that can break down a large order into tiny slices and execute them all across different trading venues at somewhere near the speed of light has become the new way of doing business. The size of the average trade has fallen to 250 shares, down from more than 1,000 units a decade ago, according to Aite. It is business that the exchanges and platforms such as BATS are keen to attract – hence the rebates. Here, the dilemma for regulators is not high-frequency traders per se. Indeed, firms such as Getco, a market-maker that uses some high-frequency trading strategies and is a shareholder in BATS, are often just as much "takers" of orders from platforms as they are posters of orders, meaning they do not solely harvest rebates and often add liquidity to a market.
But some high-frequency traders are also starting to use "dark pools" and the SEC is concerned about the practice of sending electronic messages on to the trading platform to "test" the likelihood of an incoming order finding a match in it – so-called "indications of interest". Yet dark pools are supposed to be used to trade large blocks of shares, with prices posted publicly only after trades are done. Indications of interest merely increase their opacity.
Another area of concern for the market is "sponsored access", whereby a trading firm that has a relationship with a broker can use it to access trading flow directly at an exchange or trading platform. Technologies such as these seem unstoppable. But what seems certain is that the practices they are leading to face intense scrutiny. "I would not be surprised to see the SEC take a look at a number of strategies and trading practices," says Mr Tabb. How far regulators follow up that scrutiny with action will decide the shape of markets for years to come.
American traders cross the Atlantic for arbitrage opportunities
Six months ago, Olof Neiglick and a team of trading experts in the Nordic region were busy setting up Burgundy, the latest alternative share-trading platform to emerge in Europe. He recalls telephoning the high-frequency trading companies that have recently migrated to Europe from the US, as well as some of the region’s own companies. None returned his calls.
But since Burgundy started trading in 600 Swedish, Finnish, Norwegian and Danish stocks in June, his phone has started ringing. "It’s amazing. They are asking me about latency ... how much capacity you have, that sort of thing. I must be doing something right," the Burgundy chief executive says. As debate continues in the US over the influence of high-frequency traders, Europe is just starting to experience the phenomenon. The focus is Amsterdam, where there has been options trading since at least the late 1970s. Companies that sprang from that culture include Optiver, All Options and Van der Moolen.
US high-frequency traders have been setting up in Europe, mostly in London and Dublin. Getco, based in Chicago, has a branch overlooking the Thames; Susquehanna and Madison Tyler of the US are based in Dublin. They are drawn there because forces unleashed by the European Commission’s 2007 markets in financial instruments directive are bringing about changes that mirror what happened in the US more than five years ago: competition and adoption of new technologies. High-frequency companies are attracted by arbitrage opportunities offered in the battle between exchanges and "multilateral trading facilities" such as Chi-X and BATS Europe. Technology such as "smart order routing", helping direct orders to places they are most likely to be matched, and technology allowing faster connections to exchanges have helped. This week, Deutsche Börse began installing infrastructure giving UK-based traders access to its markets in less than five milliseconds.
Some of the companies have taken stakes in MTFs, giving them a say in fee policies. Some also account for a significant share of trading on a single MTF, giving them huge influence. Phil Allison of UBS says the high-frequency traders are useful in providing liquidity to the markets but adds it is important "to be at least aware of how they shape the overall market structure". He adds: "My real concern is that these high-frequency traders have an enormous ability to influence our market micro-structure. If you remove one of the highest-volume traders off Chi-X, for example, you will materially change their overall market share, which means their power as a client of the MTFs is incredibly high.
If there is one thing that infuriates many high-frequency firms, it is the accusation that they are secretive. Some are also at pains to demonstrate that they do not all use the same trading strategy and so should not be lumped together under one heading. Yet many do not help themselves by revealing very little in public – on their websites, for example.
Jump Trading, which like many is a product of Chicago’s futures and options trading realm, says it is a privately funded company "on the cutting edge of high-frequency trading, expanding the limits of what algorithmic trading means today".
Jump also says it re-invests "a good portion" of its profits into research and development and recruits at various university campuses. But it provides no address or telephone number.
Getco recently revamped its site and is now one of the few to offer a range of information, including contact details, company history, a section headlined "What’s best for the market?" and a letter on the "flash orders" issue submitted to the Securities and Exchange Commission. Indeed, the main slogan on its website hints that the industry might just be starting to open up: "Open minds. Better markets".
Sick for Profit
A new video puts denied health insurance claims on United Health Care CEO Stephen Hemsley's doorstep. The video, made by Brave News Films' Robert Greenwald, intercuts stories of people suffering because of denied claims with images Hemsley's fancy homes, along with details about how much money Hemsley's got ($744,232,068 in unexercised stock options, for example). Holly Bailey says in the video that United Health Care refused to pay for medicine she couldn't live without.
"They kept telling my local pharmacy...'Oh we're just waiting for one more letter, or we're just waiting for one more script, and then we'll start paying,'" Bailey said. "This went on for six months, and December 4th both the pharmacy and I received a letter from United Health Care saying they deemed it medically unnecessary and that they were not going to pay any of it. "I tried to explain to them that if I do not have this, I will die. And the only response she gave me was, 'OK.'"
Joanna Joshua, whose child's treatment was denied, asks, "Stephen Hemsley, how are you able to sleep at night?" The piece aims to gin up the sort of pitchfork-style outrage against health insurance CEOs that so beset Wall Street executives after their industry was bailed out by the government. "It's definitely similar and in some ways worse, because these are dollars are literally being taken away from you that could help save lives in order to build bigger mansions," said Greenwald in an interview with the Huffington Post. "We hope it will begin a part of the discussion that has not happened: Who is gaining from the current system, and why are they resisting?"
Along with the video, Greenwald's group unveiled a website detailing compensation for five other health insurance company CEOs. United Health Care said in a statement that the company supports health reform and making coverage available to all Americans. "Reforming and modernizing health care is serious, complex work not advanced by attack videos or rhetoric, so we will continue to focus productively on expanding coverage for all Americans," the statement reads. "Health companies, such as UnitedHealth Group and its peers, were among the first of the stakeholders to come to the table with a comprehensive proposal to reform our own sector. Our industry's proposal brings everyone into the system, guarantees coverage for all Americans, does away with pre-existing condition limitations, and ends rating based on health."