The Savoy Plaza and Plaza hotels viewed from Central Park, New York City
Ilargi: The later we get into the summer, the more questions there are about where the economy and the markets are going. Here at The Automatic Earth it's the same story. And since we have consistently pointed at a very substantial risk of a major downturn this fall, and stuck to it, probably even more so here than elsewhere.
Never mind, apparently, that fall is still a week away. And never mind that we point to trendlines instead of trying to emulate Delphi's fume-induced "certainties". When it comes to looking at the future, the difference between saying something "might" and "will" take place evaporates into thin air for those desperate enough to know that future before it happens. Which is not to say that we're wavering on what we’ve said over the past while. On the contrary, events follow our scenarios so closely, we can only become more convinced they will come true.
When I saw Ben Bernanke say yesterday that the recession is "very likely" over, and Tim Geithner -just about- simultaneously stated that "we don't have a recovery yet", I wondered where these two statements leave us these days.
And then it dawned on me. We are in la-la land. Where things don’t go down and don’t go up, they just sort of float where neither time nor gravity nor logic play much of a role. Where economies can be expected to "soon" recover while shedding millions more jobs, where millions of homes are foreclosed on while GDP numbers can turn positive.
La-la land, though, is as much a fantasy as Neverland, or as the place of any fairy-tale. Whereas the latter are temporary refuges for children and their innocence, and teach them lessons for their later lives in the "real world", our present day la-la land is a temporary refuge for our grown-up real world gullibility.
Most Wall Street banks, as well as many on Main Street, would be gone without government funds. Home sales would be all but absent without it. And with that in mind, where do you think the stock markets would be? We’ll never know, will we? We just know where they are now. In la-la land.
In order to know what will happen, it looks like all we have to figure out is two things: 1) how long can we continue to dwell in la-la land, and 2) who's paying for all this? It’s probably easier to answer the second question first, because it answers the first one. Of course it's us who end up paying for all the government largesse; we just like this idea that we can postpone doing so long enough for our limited brains to discard it as not important right now. Convenient though it may be, convincing it is not.
The government has to borrow the money it spends -that belongs to us but is not there-. And when the borrowing stops for lack of willing lenders, we’ll run out of borrowed time in la-la land as well. Consider the Federal Reserve such a lender -after all we pay it interest-, and one that has announced plans to back off. As, of course, have China and other lenders.
On la-la paper, we are bound to pay, but in real life we don't have a penny. So we must be borrowing as well, but who are we borrowing from? We are all borrowing from the future.
There are many voices who claim that the present market rally can go on for much longer. That would, however, require an enormous amount of investors all willing to take an enormous amount of risk. There is a dizzying number of dollars invested in companies that are not worth much of anything outside of la-la land. Much of it is there in desperate attempts to make good on previously incurred losses. It won't take much to scare that money away.
There's way too much volatility in the whole system for all these people to remain confident in the face of shorter days and colder nights. Too much risk and not nearly enough real value. Too many toxic assets and not nearly enough money to cover the losses hidden inside them.
Most of all, there is no credit. Without credit, there are no customers. And without customers, there is no economy.
People -and rightfully so- will get scared. So scared that they will volunteer to leave la-la land and try to do what they can to save what they have left. their money, their jobs, their homes, if only and perhaps most of all for their children's sake. The stock markets are not the place to do that.
U.S. credit card defaults up, signal consumer stress
Bank of America Corp and Citigroup Inc customers defaulted on their credit card debts in August at the highest rates since the onset of the recession, a sign that the banks' consumer lending woes are far from over. The trend was echoed among most other major credit card issuers, dashing optimism sparked when many banks and specialty finance companies reported lower default rates for July.
"People have gotten very bullish with the July data, and (the August data) raises the question about how fast the consumer will get better," said Scott Valentin, an analyst at FBR Capital Markets. "People were assuming the pace would be pretty rapid, and this maybe slows the pace down." The worse-than-expected August numbers bolstered the contention of some analysts that the July decline in defaults was due more to seasonal effects, like tax refunds, then an improvement in consumers' financial health.
Many analysts expect bad-loan levels will keep rising until later this year or early 2010. "The defaults are a wake-up call for those expecting a V-shaped recovery," said Elliot Spar, options market strategist at Stifel Nicolaus & Co. Bank of America said its charge off-rate -- loans the company does not expect to be repaid -- rose to 14.54 percent in August from 13.81 percent in July. Citigroup, the largest issuer of MasterCard-branded credit cards, said its charge-off rate rose to 12.14 percent in August from 10.03 percent in July.
The charge-off rates for both Citi and Bank of America, two of the biggest recipients of U.S. government bailouts, were the highest yet during the financial crisis. JPMorgan Chase & Co, the largest issuer of Visa-branded credit cards, said its charge-off rate rose to 8.73 percent from 7.92 percent, while smaller Discover Financial Services said its rate rose to 9.16 percent from 8.43 percent. American Express Co's default rate fell to 8.5 percent from 8.9 percent as the company increased its lending portfolio.
JPMorgan, Discover and Capital One Financial Corp reported late payments on credit cards -- an indicator of future defaults -- rose in August after several monthly declines. Valentin said the rise in delinquencies at some companies was double or triple the levels expected. Credit card defaults usually track unemployment, which rose to a 26-year high of 9.7 percent in August. The jobless rate is expected to peak at more than 10 percent by year-end. Considering the trend of unemployment and the increase in delinquencies, analysts have estimated credit card losses will keep rising in coming months.
Yet analysts have a rosier outlook now than they did a few months ago, expecting credit-card defaults to bottom out at an average of 11 percent to 12 percent, below earlier estimates of up to 14 percent. As credit card losses rose to record highs in recent months, credit card companies closed millions of accounts, trimmed lending limits and slashed rewards. Lenders are also raising fees and interest rates ahead of a new law that increases protection for consumers. The law is expected to shrink the industry and limit subprime borrowers' access to plastic money.
Also on Tuesday, MasterCard Inc, the world's second-largest credit card network, said the volume of payments it processed in the United States declined less in July and August than in the second quarter, a sign that the payments industry may be stabilizing. Shares of Bank of America fell 0.5 percent to $16.89 in afternoon trade, JPMorgan declined 0.7 percent to $43.45, Discover was 0.7 percent lower at $14.92, and Citigroup dropped 6.6 percent to $4.22. Capital One declined 3 percent to $37.16, and American Express was up 1.8 percent to $34.54.
US Economy Faces Big Test Next Month: Meredith Whitney
The economy remains weak and will face a big test next month when the government starts winding down its massive support programs, banking analyst Meredith Whitney told CNBC. Despite avoiding a worst-case scenario, the economy continues to languish under weak job growth and home sales, Whitney said in a live interview.
"There's not a lot of new job creation going on on Main Street—and the liquidity to the consumer and small business is still contracting," she said. "And it's very difficult to get the engine moving without a lot of government support within that. So when you slowly wean government supports, that's going to be the test that I think everyone's going to be watching starting in October."
The Federal Reserve will wind down its aggressive buying of Treasurys next month. At the same time, President Obama and Treasury Secretary Timothy Geithner have said recently that the government is looking more broadly at getting out of the bailout programs used to prop up the financial system after its 2008 collapse.
Though economists generally believe the US is pulling out of a recession, unemployment remains high and most economic indicators are still showing only modest improvement. As the economy retools, there are few areas that show any promise of generating big new jobs numbers, Whitney said. A potential complication is a leaning from the White House towards trade protectionism, most recently expressed in a trade dispute with China over tire imports.
"Where do the jobs come from?" she said. "Surely if this country becomes massively protectionist we'll build up manufacturing capability. Is that necessarily a good thing? No. There's not a lot of free capital for small business innovation—small business, period—and that's half the workforce." In real estate, she said sales numbers have been boosted by foreclosures and other distressed sales, but high-end home sales continue to languish. "The high-dollar units have not sold. So people are still shopping at Wal-Mart. People will go after value," Whitney said. "Home ownership is still less attractive to the average consumer."
David Rosenberg on the aftermath of a bubble bust
Even the most hardened of market watchers has been waiting for the powers that be to declare this recession over. Yesterday, U.S. Federal Reserve Board chairman Ben Bernanke went so far as to say that was "very likely." But there's a difference between a partial and a complete recovery. And it doesn't pay to forget the difference.
What we're watching now is a movie we've seen before – a recession dominated by asset deflation, widespread excess capacity and deflation pressures, and then a huge shock that drags the equity market to massively oversold lows. Fiscal and monetary stimulus ramp up; hope springs eternal for a capital spending revival; and riskier assets enjoy a significant rally, as earnings and economic projections get revised higher by analysts. But the history books tell us that in the aftermath of a bubble bust, it takes an unusually long time to embark on the next sustainable expansion. This by no means suggests that we will not see the odd quarter of positive growth in real gross domestic product. After all, we saw two quarters of growth in 2008 and the U.S. National Bureau of Economic Research (NBER) never said the recession was over.
What we are seeing unfold is eerily similar to the events that transpired in late 2001 and into 2002, though there are two critical differences. One, deflation pressures are far more acute now, even with the dramatic government efforts to stem the tide. And two, this wasn't just a cycle solely dominated by tumbling asset prices, but one defined by the rupture of a credit bubble. The lag between the end of the last recession (November, 2001) and the end of its bear market (October, 2002) was a reflection of the fact that it is not the official downturn that counts. Rather, it's the onset of the next sustainable economic and earnings expansion that matters most to the market.
This is a crucial point. Many pundits believe that the equity market traditionally prices in the end of the recession between three to six months in advance, but that is not really the case. What the market prices in is the onset of the recovery and there is an important distinction between the end of the recession and the expansion phase when it comes to financial market performance. For example, in the nine post-Second World War cycles before the tech-wreck in 2000-02, recessions were essentially caused by excessive manufacturing inventories, and they generally lasted 10 months (this recession, or modern-day depression, is already heading into its 20th month).
In a garden-variety recession, it does not take very long for demand-fuelled fiscal and monetary policy initiatives to work their magic and revive the economy. What's "normal" is that after the recession ends, the economy embarks on a V-shaped recovery. That is why it is typical for the stock market to bounce roughly 20 per cent in the first year off the bottom in the business cycle. It is not so much the recession ending but the fact that initial recoveries are normally extremely buoyant.
In an asset and credit cycle, however, there is generally a longer period where the economy is no longer contracting but neither is it growing anywhere near its potential even after the recession is officially over. In this economic no-man's land, where the economy is walking through purgatory, government stimulus only cushions the blow from the lingering balance sheet repair process that is typical of an asset and credit collapse. What happens in between the recession ending and the expansion beginning is that excess capacity in the labour and product market builds further and pricing power in the corporate sector continues to erode. So, while the recession may be technically over, it still feels like one to the market.
This is why the NBER's determination of when the recession ends is not enough to stop bear markets in their path. Technically, there are four key economic indicators that comprise the recession call – production, employment, real sales and organic personal income. If you go back to the recessions of the late 20th century, you will see that these four indicators bottom within two months of each other. They all tell the same story at about the same time.
But, what happened in the tech-wreck-induced recession in 2001 was that there was a 24-month gap between the first indicator to form a trough (real sales in September, 2001) and the last indicator to do so (employment in August, 2003). Real organic personal income also did not bottom until December, 2002, but the NBER ostensibly put more emphasis on sales and production when it asserted the recession officially ended in November, 2001. The reason why the equity market failed to hit bottom until October, 2002, (or even March, 2003, if you want to count the market retesting its lows) is because the economy had not yet staged a "complete" recovery.
That's why it is important to keep an eye on all four indicators and not let the rubber stamp that says "the recession is over" guide your investing decisions.
New Rules Ease the Restructuring of CMBS Loans
The Treasury, responding to the growing pain in the commercial real-estate industry, released new tax rules that make it easier for distressed property owners to restructure loans that were packaged by Wall Street firms and sold as securities. Most in the real-estate industry, which lobbied intensely for the move, applauded the action. But some warned it has opened a Pandora's box, especially for servicers of the securities who will likely come under new pressure from borrowers and competing classes of investors.
The move is the first round of "additional guidance" the Treasury is weighing to stave off what many fear will be a commercial real-estate crisis, according to people familiar with the matter. A Treasury spokesman declined to comment. A record of more than $150 billion of loans bundled into commercial-mortgage-backed securities, or CMBS, will come due between now and 2012. But as financing remains scarce and values of offices, strip malls, hotels and other types of commercial property continue to drop, more property owners are finding it hard to refinance debt as it matures.
Until now, tax rules have made it difficult for borrowers who are current on their payments to hold restructuring talks with the servicers of these bonds. Developers and investors complain that only those who are delinquent can talk to the servicers. Indeed, many property owners -- notably mall giant General Growth Properties Inc., now in bankruptcy protection -- have cited this lack of flexibility as one of the reasons for having to default on debt and give up properties.
The new guidance from the Treasury makes it clear discussions involving lowering the interest rate or stretching out the loan term "may occur at any time" without triggering tax consequences. In addition, the guidance allows servicers to modify loans regardless of when they mature. The servicer only has to believe there is "a significant risk of default" even if the loan is performing, the guidance states. "A stalemate now exists on CMBS loans that are not currently in default but need modification," said Jeffrey DeBoer, chief executive of the Real Estate Roundtable, a lobbying body for property owners and investors. "Today's announcement should help break the stalemate."
But some investors holding CMBS bonds are watching nervously because loan modifications, known as "mods," mightn't always be in their best interest. CMBS have junior and senior pieces, and the senior holders may be in a better position, when a borrower defaults, to foreclose and liquidate the property rather than modify the loan. Junior holders, on the other hand, might benefit from a mod because they mightn't get their money back in a forced sale. "The standards of care for services are to all bondholders," says Patrick Sargent, president of the Commercial Mortgage Securities Association, a trade group.
In general, servicers are required by their contracts to act in the interests of the investors and modify loans only when that can be expected to reduce losses. That puts servicers in the tricky position of trying to figure out which borrowers are basically sound and when it makes more sense to foreclose quickly. "The biggest concern is that the guidance could open the floodgate for everyone to try to get some sort of loan modifications," said Aaron Bryson, a CMBS analyst at Barclays Capital. "There is a tremendous burden on the servicers to uphold their end of the bargain."
Still, the move by the Treasury reflects the deep concern in government and industry circles over the problems looming in the $6.5 trillion market for commercial real estate. Just as the U.S. economy is struggling to regain its footing, defaults are mounting because of credit-market turmoil, along with declining property cash flows and plunging property values. In the meantime, the Treasury also is considering "additional guidance" aimed at fending off a potential wave of defaults as more commercial mortgages come due, the people with knowledge of the matter said. The real-estate industry has been pressing for a tax law change that would encourage more foreign investments in commercial property.
Until now, property owners and investors hoping to restructure troubled mortgages were hearing a tough message from most CMBS servicers: We can't talk to you unless you first fall behind on payments. This is because when CMBS offerings are created, the underlying mortgages are legally held by tax-free trusts. The trusts could have been forced to pay taxes if the underlying loans were modified before they became delinquent, according to the old CMBS rules. The new guidance applies to CMBS loans modified on or after Jan. 1, 2008. In a study for The Wall Street Journal, Trepp, which tracks the commercial real-estate market, found that, year-to-date, 528 CMBS loans valued at $4.7 billion weren't able to refinance when they matured. About 75% of these loans were backed by properties that were throwing off more than enough cash to service their debt.
No Easy Exit for Government as Housing Market's Savior
After a year of extraordinary interventions in the economy, the federal government is starting to pare its support for the private sector. It doesn't look that way to Peter Lansing, president of mortgage firm Universal Lending. The Denver home lender sees every day how dependent the housing market has become on the government. At the height of the boom, just 20% of Universal's mortgages were backed by the Federal Housing Administration, an arm of the government that guarantees loans to borrowers who can't afford big down payments. Today, the FHA accounts for more than 80% of his business. For Mr. Lansing, this represents a new way of life -- more government, more paperwork, but also a lot of sales that wouldn't have happened otherwise.
"Over 29 years in business, we've always thought of ourselves as being in the free-enterprise system. Today I think of myself as a government contractor," Mr. Lansing says. "My business strategy is to get more of my employees to embrace that idea. Plan B would be to sell pencils on the corner." In a speech on Wall Street a year after Lehman Brothers collapsed, President Barack Obama said Monday the need for the government to keep stabilizing the financial system "is waning." His administration released a 51-page report detailing rescue programs that are slowly being scaled back. But the Treasury Department, author of the report, noted that housing is one area where it's too early to exit.
Over the past year, the government has intervened heavily at essentially every stage of the home-buying process. In fact, more than 80% of the new residential mortgage loans made this year benefited from some form of government support, according to the trade publication Inside Mortgage Finance. To keep funds flowing to the housing market, the government bailed out Fannie Mae and Freddie Mac last year and now effectively owns the mortgage finance giants and their combined $5.4 trillion in loans and guarantees. To keep mortgage rates low, the Federal Reserve is on track to purchase nearly $1.5 trillion in debt issued or guaranteed by the government's various mortgage arms and an additional $300 billion in Treasurys, which set the benchmark for home lending.
And to boost sales, the government also is offering $8,000 tax credits to first-time home buyers. Those efforts appear to have had the intended effect of braking the housing market's plunge. They prompted Jonathan Swinton and his wife, Annie, to plunge into the market ahead of schedule. The couple plans to close on a $226,000 home in a suburb of Salt Lake City in the coming weeks. "We had always wanted to buy a home, but we had been planning to wait a couple of years," says Mr. Swinton, who recently completed course work for a Ph.D. in family therapy at Kansas State University and is now working at a mental-health facility in Salt Lake City. "The low interest rates and the tax credit were the two primary factors that motivated us to buy this year."
Signs of a housing-market bottom have emerged. Sales of new homes are up more than 30% from lows reached early this year, and sales of existing homes are up nearly 17%. Shares of companies that build homes have turned higher, inventories of unsold new homes are down and home prices have ticked up after steep declines. The government's efforts are the primary reason the housing market is functioning at all, economists and housing experts say. Despite the signs of improvement, the housing market is still a shell of what it was during headier times.
U.S. home prices are back around 2003 levels, having fallen by about one-third since their peak in the second quarter of 2006, according to Standard & Poor's. Sales of distressed homes still account for about one-third of existing home sales, and prices continue to fall in some markets such as the Sun Belt states. In addition, relatively few "jumbo" loans are being made -- those above the limits of what Fannie and Freddie will buy or guarantee. "At least for the next two years, and possibly longer, it is not possible that the government would say: 'The U.S. mortgage market no longer needs our support,'" says Dwight Jaffee, an economics professor at the University of California Berkeley's Haas School of Business. "Were they to say that, the mortgage market and the housing market would almost surely crash."
Promoting homeownership has been a stated goal of Republican and Democratic presidencies for decades. The Obama administration recognizes it will need -- at some point -- to rethink broadly the government's role in housing and mortgages. Administration officials also acknowledge that moment won't come soon. "Every government in the world takes a role in its country's housing market," says Lawrence Summers, Mr. Obama's top economic policy adviser. "What that role should be when normal conditions return is a crucial question we'll all be considering in coming months and coming years." He added: "It's clearly going to take time."
The government's role in housing has a long pedigree. The 1930s gave birth to Fannie Mae and the FHA, which traditionally insured loans aimed at low-income borrowers. Freddie Mac was created in 1970. Since the housing crash, these players are in some spots the only game in town. Their backing means private lenders are assured of repayment -- by the government, if not the borrower. The size of loan that can be guaranteed is capped in most parts of the country at $417,000, but can reach as high as $729,750 in high-cost areas such as parts of California, New York and Washington, D.C.
Loans above those levels are hard to obtain. Steve Walsh, a mortgage broker in Arizona, said he recently tried to arrange a mortgage for a married couple who wanted to buy a $1.5 million home in Mesa. The couple offered a down payment of $400,000, but the lender wanted $600,000, or 40%, in part because the couple had opened a law firm and didn't have two years of tax returns. That's double what was considered standard before the boom. The pair walked away, said Mr. Walsh.
The government temporarily raised the size of the loans Fannie and Freddie can guarantee in February 2008 and is unlikely to ever return to previous levels. The higher levels have been extended once, and the mortgage industry is lobbying to keep them high. At the Fed, the question of whether to start dismantling the scaffolding is a dominant one. Since the beginning of the year, the Fed has purchased $836 billion of mortgage-backed securities issued by Fannie Mae, Freddie Mac and Ginnie Mae, the federal body that securitizes FHA loans. The purchases have helped push down interest rates on mortgages guaranteed by the firms from more than 6.5% last October to 5.15% today, according to HSH Associates, which tracks the mortgage market.
That seems to have helped to put a floor under housing sooner than many officials expected. At the same time, it has created distortions in the market. When the Fed buys up to $30 billion in mortgage securities every week, regardless of price, "it makes it very difficult for the market to find its own equilibrium," says Ajay Rajadhyaksha, head of U.S. fixed-income research at Barclays. He said investors are trading instead in Treasury securities, where activity is less skewed by central bank purchases, and pushing rates lower in that market, too.
The Fed is likely to decide to carry on buying until it reaches the $1.25 trillion target it set in March and taper off the buying gradually. Some Fed officials will likely argue for stopping sooner, even as soon as next week's regular policy meeting. If the Fed stops sooner than expected, it could jolt the mortgage market and short-circuit a housing recovery. Barclays's Mr. Rajadhyaksha estimates that even if the Fed carries on as planned, mortgage rates will rise by half to three-quarters of a percentage point, simply because the Fed will cease to be as a big a presence in the market.
The Fed will face a challenge managing its portfolio of mortgage-backed securities even after it stops buying the securities. When it bought the securities, it effectively flooded the financial system with cash. Officials at some point will need to find ways to drain that cash from the financial system. If they move too slowly, it could lead to inflation. If they move to aggressively, it could damage the fragile mortgage market. Fed Chairman Ben Bernanke has laid out plans that he says will allow him to do it and to raise interest rates as needed.
The tax credit for first-time home buyers, which provides up to $8,000 for individuals earning up to $75,000 and couples earning up to $150,000, is set to expire in November. It was originally included in the $787 billion stimulus bill passed in February. Congress, increasingly preoccupied with mounting deficits, will have to decide whether to extend it. Deutsche Bank estimates the credit has helped generate 350,000 sales, about half the increase in single-family home sales in the past six months.
The tax credit's effectiveness depends largely on its longevity. That's because many of the home sales analysts think it has spurred have been stolen from the future, luring buyers into the market who might not otherwise have bought until next year or beyond. When the credit expires, that demand will disappear, too. "All it does is move demand forward in time," says Kenneth Rosen, chairman of the Fisher Center for Real Estate and Urban Economics at the University of California, Berkeley. "The last six months, we've seen signs of a housing bottom. We could easily see that disappear."
Tom McCormick, president of Astoria Homes, a private home builder in Las Vegas, says the government's efforts to prop up the housing market are making a difference, but says his own business remains very fragile. "The tax credit is what we think got people off the fence," he says. "Once that money came in back in February, the market literally jumped 10% to 20%." But, he says, most home buyers are buying existing or foreclosed homes, meaning the new home market has barely budged. At his peak in 2005, he built more than 1,000 homes. This year, he expects to do fewer than 100. "It is just real dark right now," he says.
Yet more uncertain is the future of Fannie Mae and Freddie Mac, an already difficult policy question exacerbated by the passions the pair evoke. When they were placed under government control last year, officials described the move as a "timeout" while they find a permanent solution. Fed Chairman Ben Bernanke has floated the idea of turning them into a public utility or privatizing them and offering government insurance on their bonds for a fee. The Obama administration has put off wrestling with that question until next year. It expects to issue a proposal by March 2010. "We don't feel like the world is anywhere close to us being able pull back our support," one administration official says.
The FHA brings its own tough issues. The agency, which has insures private lenders against defaults on certain home mortgages, has seen its balance sheet take a hit as risky borrowers default on those loans and is already in danger of falling below a level of reserves mandated by Congress. Yet it remains a key facilitator of loans. Teri Gifford, who runs a mortgage brokerage serving Kentucky and Ohio, says 95% of her business involves getting clients loans backed by the FHA. "It's all government loans," says Ms. Gifford, whose firm, EZ Mortgage Loans Inc., Hillsboro, Ohio, brokers between $30 million and $35 million in loans each year. "That's all that can be done anymore." Ms. Gifford fears that the U.S. will pull back if the loans it's backing start going bad. "I'm worried what the future could hold if we put all the eggs in one basket," she said.
Fight in Congress Looms on Tax Break for Home Buyers
When Congress passed an $8,000 tax credit for first-time home buyers last winter, it was intended as a dose of shock therapy during a crisis. Now the question is becoming whether the housing market can function without it. As many as 40 percent of all home buyers this year will qualify for the credit. It is on track to cost the government $15 billion, more than twice the amount that was projected when Congress passed the stimulus bill in February.
In the view of the real estate industry and some economists, all that money is well spent. They contend the credit is doing what it was meant to do, encouraging a recovery in the housing market that is gathering steam. Analysts say the credit is directly responsible for several hundred thousand home sales. Skeptics argue that most of the money is going to people who would have bought a home anyway. And they contend that unless it is allowed to expire on schedule in late November, the tax credit is likely to become one more expensive government program that refuses to die.
The real estate industry, including the powerful 1.1 million-member National Association of Realtors, wants Congress to extend the credit at least through next summer. The group hopes to expand the program to $15,000 and to allow all buyers, not just those who have been out of the market for at least three years, to qualify. The price tag on that plan: $50 billion to $100 billion.
Joseph and Chassity Myers are among the two million buyers eligible for the credit this year. The newlyweds heard they could get money from the government for something they were tempted to do anyway. "It was a no-brainer," said Mr. Myers, a commercial underwriter. "Owning something is the American family dream." The couple bought a two-bedroom condominium here in the spring for $171,000 and amended their 2008 taxes immediately, receiving their windfall by direct deposit a few weeks later. Their home is now a monument to the government’s generosity. They bought a leather couch, a kitchen table, a bed, television stand, china cabinet, kitchen table, coffee table, grill and patio set. "We did exactly what the government wanted us to do," said Ms. Myers, a third grade teacher. "We stimulated the economy."
Mortgage applications increased nearly 10 percent for the week ending Sept. 3 from late August, the largest gain since early April and the latest of many signs of life in real estate. The upturn can be attributed to several factors: the return of confidence, very low mortgage rates, and prices in some markets that are at decade-low levels. But the looming expiration of the tax credit on Nov. 30 seems to be playing a role too, particularly in relatively low-cost markets like Phoenix, Las Vegas and Dallas.
The 50-year-old complex that the Myerses live in, grandly named the Lawn at Bluffview, provides a snapshot of the credit’s influence — and limitations. Two years ago, the buildings were converted from apartments to condominiums by their owner, a local developer. In January, before the credit, only 30 of the 70 units had sold. Since then, another seven units have sold, including the one bought by the Myerses. Brian Denbow, who works for a subprime auto financing firm, also was spurred to action by the credit. He too intends to use the money for furniture. Five of the buyers did not qualify for the credit for various reasons.
The Lawn at Bluffview remains nowhere near full. Potential buyers "just want a deal," said the sales agent, Beverly Bell. Two weeks ago, the price of the unsold units was cut 10 percent. The National Association of Realtors estimates that about 350,000 sales this year would not have happened without the lure of the tax credit. Moody’s Economy.com used computer modeling to put the number at 400,000.
The government’s efforts to directly reward home buyers began more than a year ago with a $7,500 tax credit that had to be repaid over 15 years. Last winter, amid fears of another Great Depression, the Senate came up with a much sweeter $15,000 package as part of the stimulus bill. That measure was ultimately reduced to the $8,000 credit. Now the sponsor of the original Senate bill, Johnny Isakson, Republican of Georgia, is back with a new bill that would give a maximum $15,000 credit to any buyer who stays in a home for at least two years.
"The problem now is not first-time buyers, it’s the move-up market — the guy transferred from Chicago to Atlanta who can’t sell his house," said Mr. Isakson, a former real estate agent. Without a new and more generous credit, he warned, there would be a downward spiral of home sales and more foreclosures, provoking a second recession. The real estate industry is lobbying heavily for the bill, but acknowledges that in an atmosphere that is less crisis-driven than last winter it will almost certainly have to settle for less.
"There will be a lot of water under the bridge, a lot of compromise, between now" and a final bill, said Richard A. Smith, chairman of the Business Roundtable’s Housing Working Group. Economists are sharply split on the merits of another round of government help. Mark Zandi, chief economist of Moody’s Economy.com, favors expanding the credit to all home buyers, even investors, into next summer. "The risks of not doing something like this are too great," he said. "I don’t think the coast is clear." James Glassman of JPMorgan Chase echoed those views but said he favored continuing to restrict the credit to first-time buyers.
On the other side of the issue is the Tax Policy Center, a joint venture of the Brookings Institution and the Urban Institute. It labeled the original credit as one of the worst provisions of the stimulus package, on the grounds that the money is a bonus for people who would buy a house anyway. The center has an even dimmer view of extending the credit to all buyers. "Is this the best way to spend money we don’t have?" asked senior fellow Roberton Williams. Dean Baker of the Center for Economic and Policy Research called the credit "a questionable redistributive policy" from renters to home buyers, but said that he used it himself when he bought a house. He wrote on his blog: "Thank you very much, suckers!"
US Treasury to Shrink Financing Program
The Treasury Department is expected to begin winding down a temporary program created at the height of the financial crisis to address a new problem -- the government's rapidly expanding debt. According to people familiar with the matter, the step is being taken to help the Treasury avoid hitting the $12.1 trillion debt ceiling that was expected to be reached by mid-October. The decision could also be controversial, since the program was put in place to help blunt any inflationary impact from emergency actions taken by the Federal Reserve.
Since last year, the Treasury has been selling special short-term securities and placing the proceeds in an account at the Fed. The program, known as the Supplementary Financing Program, reached about $560 billion late last year, but has since fallen to about $200 billion, where it has remained throughout 2009. The Fed used the program to help finance rescues, such as its backing for the commercial-paper market. It was an alternative to the Fed simply printing money and flooding the market with liquidity. The Fed ended up doing that, too, as the crisis worsened, but not as much as it would have done without the Treasury program.
If the Treasury recalls the funds to pay off the debt, the Fed will have to find the requisite cash, which it could do either by selling securities or printing money. If the Fed ends up pumping more cash into the financial system, it could make it harder to raise interest rates later. Fed Chairman Ben Bernanke and other officials have expressed confidence they will be able to raise rates when needed. The Treasury isn't ending the program, but is expected to whittle it to possibly as little as $15 billion. Government officials want to keep the program in place in case it is needed in the future.
One of the Treasury's primary focuses now is the national debt. Shrinking the program will give it some breathing room. Treasury Secretary Timothy Geithner has already requested Congress raise the debt limit, saying that ceiling could be reached as early as mid-October, but lawmakers haven't acted on that request. If the Treasury can't borrow money, it can't make good on its obligations -- everything from Social Security payments to interest payments on the nation's debt.
Government officials estimate that decreasing the size of the Supplemental Financing Program could give the U.S. as much as six weeks of additional time. Treasury officials are concerned about a political fight over the request, as lawmakers grow nervous about the U.S. debt and budget deficit. The Treasury has been looking at ways to continue funding the government in the event that Congress hinders its ability to borrow money.
The Fed's balance sheet -- the total value of all its loans and securities holdings -- has more than doubled during the course of the crisis to more than $2 trillion. As markets stabilize, demand has begun to wane for some of its programs, but other holdings are still growing, most notably through its purchases of mortgage-backed securities and Treasury notes. The move by the Treasury creates challenges for the Fed. In repaying the Treasury, the Fed could be forced to pump even more cash into the financial system. In theory this could cause inflation, though this isn't likely right now because the economy is weak and financial markets are fragile.
At some point, the Fed will need to drain this cash out of the financial system as it raises interest rates. If it doesn't act soon enough, it could risk letting inflation rise above desired levels. Fed officials have been mapping out plans to unwind their emergency lending programs and have sought to reassure investors they will be able to do it as needed. This could complicate their efforts. Moreover, critics say, the Fed has compromised its independence by working closely with the Treasury during the crisis. The unwinding of the supplemental finance program could draw attention to that concern by highlighting how the divisions between fiscal and monetary policy have become blurred.
Chrysler Executives Say U.S. Industry Sales Plunging
Chrysler Group LLC, the U.S. automaker run by Fiat SpA, said nationwide industry sales are off 19 percent so far this month after a government purchase- incentive program ended. "We are going to see harsh reality in September," Sergio Marchionne, the chief executive officer of Fiat and Chrysler, said at the Frankfurt Motor Show. He described the U.S. industry results as a "disaster." Fritz Henderson, CEO of General Motors Co., said the market is "very weak" this month.
Chrysler sales are being pinched beyond the industry decline because of a lack of cars and trucks on dealers’ lots, Peter Fong, the Auburn Hills, Michigan-based automaker’s lead sales executive, said today in an interview. Fong, who gave the percentage decline, said Chrysler dealers currently have 83,000 vehicles on hand, about one-quarter of what they had a year ago. "For Chrysler, our story is a lack of inventory," he said. "It’s the lowest level that anyone can remember. I think it’s likely that car sales will bounce back next month." The carmaker has increased production to replenish lots and should have them restocked later this fall, Fong said.
Light-vehicle sales in the U.S. last September ran at a seasonally adjusted annualized rate of 12.5 million, which was the lowest since March 1993. A 19 percent decline would equate to a 10.1 million annual rate, higher than any of the first six months of 2009. The U.S. government’s "cash-for-clunkers" incentive to trade in older gas-guzzlers for more efficient new vehicles led to a jump in sales in July to an 11.3 million rate and in August to 14.1 million, according to Bloomberg data. The program ended Aug. 24.
"It was highly stimulative, highly successful in a fairly compact period of time," GM’s Henderson said. "Our assessment was that the payback could be sharp, but short." Chrysler expects to reveal in November its plan for integrating Fiat technology and building new products, Marchionne said. Among the decisions is how the Alfa Romeo brand will be sold in the U.S. The premium brand would require Chrysler dealers to invest in expanded showrooms and only be available to a limited number of outlets, Marchionne said.
Europe Asked to Extend 'Clunkers'
Auto makers are pushing European governments to continue their "cash for clunkers" programs, fearing that the fragile industry may face a major slowdown if the rebate programs end. The moves come as Germany and Britain are winding down their scrappage programs, which are aimed at getting buyers to turn in less-fuel-efficient vehicles and buy new cars with better mileage. Meanwhile, Ford Motor Co. and others say they are helping Russia get a scrappage program off the ground. "We would like to continue the scrappage programs or we would like a more general winddown of the programs instead of letting them just come to a quick end," John Fleming, chief executive of Ford's European operations, said in an interview."
How long Europe continues the programs and any lasting effect from them could have implications for the U.S. The wildly successful U.S. "clunkers" program boosted sales to heights not seen in years. But the program's end last month also brought worries about how much U.S. sales would decline after the rebates expired. "Everyone is bracing themselves for a major slowdown, potentially next year," said Mark Fulthorpe, the director of European vehicle forecasts for CSM Worldwide. Pete Kelly, senior director in Europe for J.D. Power & Associates Automotive Forecasting, predicted that the slowdown would begin this fall and extend into the 2010 first quarter.
Tuesday, data from the European Automobile Manufacturers' Association showed that European new-car registrations, a measure of sales, rose 2.8% from a year earlier in July and increased 3% in August. The growth varied from country to country because of variations in the implementation of the incentives. Individual European countries have implemented a dozen separate scrappage programs, and a 13th, in Greece, will go on line soon. Ford estimates that scrappage programs will support the sale of three million vehicles in Europe in 2009 and 2010 and are the key reason total industry sales in the 19 largest European markets will be as high as 15.5 million in 2009, only about 7% to 10% below 2008 levels.
"The market in Europe is still very weak," Ford Chief Financial Officer Lewis Booth said in an interview at the Frankfurt auto show. "We'd rather see the end of scrappage arrive as the economies in Europe begin to recover." France has indicated that its scrapping program will continue next year, though at reduced rates, to avoid a sharp sales drop. Currently, the French government offers €1,000 ($1,457) for the purchase of a new car if the owner scraps one that is more than 10 years old. "The French government has said it will phase it out progressively," said Philippe Varin, chief executive of PSA Peugeot Citroën SA.
But car makers in Germany doubt the popular car-scrapping program there is likely to be picked up again anytime soon. The government pumped €5 billion into the plan, which ran out at the start of this month. Nearly two million German consumers participated in the program, which largely benefited mass-market auto makers like Volkswagen AG and Ford. But skeptics say the program simply delayed a slump. Though car orders still being processed will fuel sales for a few more months, some analysts say German car sales next year could drop by one million cars from this year's expected 3.5 million. "We said from the beginning it is not what we support," said BMW AG's finance chief, Friedrich Eichiner, of the way the short-term incentives were structured. "Others demanded it, and now they got it."
Lending in Europe continues to shrink
The credit crunch in Europe worsened during the summer as corporate bond finance issuance failed to plug the gap left by a sharp contraction in bank lending. Morgan Stanley, which has compiled lending and issuance data from central bank figures and Dealogic, warned that the scant availability of bank credit would penalise smaller companies that had no access to bond markets. Net lending by banks went further into negative territory in July as companies paid back more loans than took out new ones.
Loans outstanding contracted by a net €25bn in the month, the fifth successive month of increasing supply shrinkage. At the same time, there was a retreat in recent record corporate bond issuance. Bond issuance in July declined for the first time since March, by €20bn month-on- month to €27bn, although bankers are convinced that the fall in issuance was only seasonal. Bankers said the July trends had continued into August and would hit smaller companies hardest. Huw van Steenis, Morgan Stanley banks analyst, said: "As Europe's commercial banks de-lever, lending is likely to be squeezed."
According to Morgan Stanley, there was €319bn of corporate bond issuance in the first seven months of the year and a decline of €33bn in loans made by European banks. That marked a reversal of the balance of corporate funding from a year ago, when bank loans totalled €356bn compared with corporate bond issuance of just €119bn. Last month, the CBI, the organisation of UK employers, said large companies were finding it easier to obtain new funding for the first time this year, but smaller companies saw credit lines shrink.
Banks across Europe have insisted in recent months that any decline in lending is due to a fall-off in demand, not supply. But some banks blamed a misalignment in supply and demand. Brian Robertson, group chief risk officer at HSBC, said: "Those companies you'd like to lend to don't want credit and in many cases those that do, you don't want to lend to." Another large European lender said: "Banks are eager to lend money to good companies. But many of them don't need it. We are not going to throw good money after bad on weak companies."
Hicks’s Liverpool Debt Reprieve Shows Banks Avoiding Writedowns
Tom Hicks’s agreement with Liverpool Football Club’s lenders to refinance debt shows the efforts European lenders are prepared to take to prevent highly leveraged companies from defaulting. The U.S. private equity executive, who bought the northern English soccer team in 2007 with fellow citizen George Gillett Jr., agreed in July to repay a fifth of its 290 million-pound ($478 million) debt in return for Royal Bank of Scotland Group Plc and Wachovia Corp. refinancing the rest of the loan, according to data compiled by Bloomberg. In the U.S., Hicks is facing more aggressive creditors at the Texas Rangers: lenders declared the baseball team owner in default after it missed interest payments on $525 million in loans in April.
Liverpool joins companies from Materis SA, a French maker of building materials, to Wiesbaden, Germany-based Kion Group GmbH, the world’s second-biggest forklift maker, that are being given extensions to their debt or looser loan covenants to avert default and, therefore, writedowns for their lenders. In Europe, 23 billion euros ($34 billion) of high-risk, high-yield debt, including buyout loans, was refinanced or extended in the first half, compared with 7 billion euros in all of 2008, according to Standard & Poor’s Leveraged Commentary & Data unit.
"After receiving money from the taxpayers, European banks can’t afford to report more losses and ask for more capital," said Gareth Davies, head of a team at London-based Close Brothers Group Plc that advises companies on restructuring their debt. "European lenders have taken some provisions, but they are certainly not sufficient. Taking adequate loan provisions means some would have to get more funding or go bust." Hicks, 63, who co-founded the U.S. LBO firm Hicks, Muse, Tate & Furst in 1989, said in May he may sell a controlling stake in the Texas Rangers, which he bought in January 1998 for $250 million from a group headed by former President George W. Bush. Jonathon Brill, a spokesman for Hicks and Gillett, declined to comment.
Companies have more debt, and are paying less in interest, than they did in the recession of the early 1990s, according to Jon Moulton, the founder of private equity firm Alchemy Partners LLP. A firm that had debt of more than four times its earnings before interest, taxes, depreciation and amortization in 1992 would now have debt of 10 times Ebitda, Moulton said. It would have paid 12 percent interest on that debt in 1992, compared with 3.8 percent to 5.3 percent today, he added. "The restructurings are being done today on average on too optimistic of a view for the future," said Moulton. "But that suits the banks which are involved in the transactions."
Europe’s lenders have logged $502 billion of writedowns since the start of the credit crisis in 2007, compared with the $1.1 trillion figure for their U.S. counterparts, according to data compiled by Bloomberg. European banks, which have also received $213 billion in government money, may suffer another $283 billion in losses, mainly from loans, by the end of next year, according to the European Central Bank. RBS, the subject of the U.K.’s biggest government bailout, New York-based JPMorgan Chase & Co., and Deutsche Bank AG were the top three arrangers of leveraged loans at the height of the buyout boom Europe in 2007, Bloomberg data show.
Libby Young, a spokeswoman for Deutsche Bank in London and Justin Perras, a spokesman for JPMorgan, declined to comment. Mary Eshet, a spokeswoman for Charlotte, North Carolina-based Wachovia, and Ila Kotecha, a spokeswoman for RBS of Edinburgh, both declined to comment. Banks’ willingness to negotiate with borrowers may mean the wave of defaults by private equity-owned companies predicted by Moody’s Investors Service may not materialize. In September, Moody’s cut its default forecast for European non-investment- grade borrowers to 11.4 percent in the fourth quarter of 2009, from 22.5 percent it predicted previously. The actual default rate totaled 8.2 percent in August. As a comparison, during the previous downturn, the default rate peaked at 20.1 percent in September 2002.
Paris-based private-equity firm Wendel agreed in August to set aside 29 million euros as collateral to allow Deutsch Group, a U.S. maker of electrical connectors, to operate under looser debt covenants until March. "All parties in the market are trying to avoid default in the hope that capital markets, the economy and business performance improve," said Edward Eyerman, head of leveraged finance at Fitch Ratings in London. "The whole market remains substantially over-levered. We do not have one credit in our 280 privately rated loans that can repay its debt at maturity with their cash flow."
Banks are still seeking concessions from private equity owners when they renegotiate debt. In June, Materis lenders agreed to suspend payments on the company’s 1.9 billion-euros of debt for three years in return for a 36 million-euro cash injection from owner Wendel, an increase of as much as 20 basis point in interest margin, and a 30 basis point fee upfront, Wendel deputy Chief Executive Officer Bernard Gautier said in an interview Aug. 31. "We paid very little extra fees to the banks," Gautier said. "The quality of the asset is one reason. Banks have also their own problems to deal with. They prefer securing their lending rather than swapping debt for equity."
The range of creditors has widened, making debt restructurings more difficult than in previous downturns, Close Brothers’ Davies said. Banks have sold part of their lending risk to so-called collateralized loan obligation funds.
"These investors are inflexible in restructuring talks and generally prefer maintaining the status quo even if it results in an overleveraged debtor," Davies said. "They hate writedowns and do not value equity because their funds are driven by maintaining credit ratings."
Kion’s lenders agreed to loosen covenants in return for wider interest margins and a 100 million-euro loan from owners KKR & Co. and Goldman Sachs Group Inc. The German company will pay as much as 150 basis points more in interest margins on its 3 billion euros of debt, Kion spokesman Michael Hauger said this week. Officials at KKR and Goldman Sachs declined to comment. "I don’t know if it’s just a delay of the credit crunch, but European lenders are supportive," said Wolfgang Posner, chief financial officer of Treofan Holdings GmbH, a German maker of wrappers for cigarette cartons that was taken over by lenders including Goldman Sachs after a debt restructuring in 2005.
Treofan will push back the payment of an 80 million-euro loan by a year to 2011 and raise interest margin to 650 basis points from 350, after 170 million euros of notes were converted into equity in July, Posner said. European banks are still prepared to take losses. Lenders to Monier GmbH, a German roof-tile maker owned by Paris-based firm PAI Partners, agreed to cut the company’s 2.1 billion-euro debt in half as they took control of the company with distressed-debt funds Apollo Management LP, TowerBrook Capital Partners LP and York Capital.
By postponing companies’ debts today, European banks may simply delay a more drastic debt restructuring in two to three years’ time, said Craig Abouchar, who helps manage $2.2 billion of high-yield debt at Axial Investment Management Ltd. in London. "Everybody continues to close their eyes because it’s too painful to address the problem today," Abouchar said. "A lot of these lender-led restructurings are going to be zombies; the companies won’t have the cash or flexibility to invest in the business."
Break up the big banks
President Barack Obama pledged on Monday “to put an end to the idea that some firms are ‘too big to fail.’” Though he outlined some worthy prescriptions, he failed to face up to the very size and power of the financial institutions that makes “too big to fail” possible.
For the big have gotten even bigger since the start of the financial crisis. At the end of 2007, the Big Four banks — Citigroup, JPMorgan Chase, Bank of America and Wells Fargo — held 32 percent of all deposits in FDIC-insured institutions. As of June 30th, it was 39 percent.
In total, they had $3.8 trillion worth of deposits as of June 30th. Compare that figure to the FDIC’s Deposit Insurance Fund, which showed a balance of just $10.4 billion on the same date.
The FDIC has been the most effective regulator since the onset of the crisis, closing down failed banks in order to limit risk to taxpayers. But its resources are woefully inadequate to deal with the largest institutions. (I am excluding the $500 billion credit line it has at Treasury; those are taxpayers’ resources, not FDIC’s.)
And that’s just the commercial banking side. These banks — especially Citigroup, Chase and Bank of America — have huge investment banking operations that are maddeningly complex and, systemically-speaking, very dangerous.
Obama certainly recognizes the problem — “the system as a whole isn’t safe until it is safe from the failure of any individual institution.”
But his recommendations — more stringent capital requirements, stronger rules and a “resolution authority” to cope with systemic meltdowns — won’t solve it once and for all.
To be sure, higher capital requirements are a very good start. They not only give banks a bigger cushion to deal with losses, they also limit the amount of credit they can flush through the system. This is a good thing: Too much credit is the air that inflates dangerous asset bubbles in the first place.
But higher capital requirements won’t make too-big-to-fail banks much smaller. At best they will penalize the biggest banks by reducing their returns on equity, giving smaller banks a leg up competitively.
A tax on assets is another good idea to discourage growth, but what we need is more aggressive action to force shrinkage.
For instance, resurrecting a version of Glass-Steagall would be highly sensible. Commercial banks have no business using their federally-insured balance sheets to finance risky investment banking operations. The two functions should be split.
And what ever happened to anti-trust laws? Among them, Citigroup, Chase and Bank of America control two-thirds of the credit card market. That stranglehold gives them significant leverage vis-à-vis consumers.
Another issue is derivatives, which Obama didn’t really address.
Notional exposure still totals tens of trillions at the biggest banks. Sure, many of these positions offset one another, but that assumes the daisy chain won’t break. To insure market integrity, the biggest players in it all have to get an explicit “there will be no more Lehmans” guarantee.
This gets to the heart of the issue. Though Obama says a return to “normalcy” means emergency rescue facilities can end, it’s a safe bet that they’ll come right back the next time we have a systemic event.
The only way to ensure we’ll never need them again is to eliminate too-big-to-fail banks. The fastest way to achieve that is to break them up.
Cuomo Subpoenas 5 BofA Directors
New York Attorney General Andrew Cuomo subpoenaed five Bank of America Corp. board members to testify under oath as part of his investigation into the bank's purchase of Merrill Lynch & Co., according to a person familiar with the investigation. Mr. Cuomo is seeking to discover whether Bank of America directors withheld information from shareholders.
The five subpoenaed directors were members of the audit committee in late 2008, at the time of the Merrill purchase, according to another person familiar with the situation. Mr. Cuomo subpoenaed current Chairman Walter Massey and retired U.S. Army General Tommy Franks, as well as Thomas May, John Collins and Bill Barnet, who all joined after Bank of America bought FleetBoston Financial Group in 2004. Messers. Franks, Collins and Barnet left the board this year, following regulatory demands that the bank improve its corporate governance and find more directors with banking expertise.
"We will continue to cooperate with the attorney general's office as we maintain that there is no basis for charges against either the company or individual members of the management team," said a Bank of America spokesman. Based on its investigation thus far, Mr. Cuomo suspects that the board may have been kept in the loop on mounting losses at Merrill Lynch in early December, before the shareholder vote on Dec. 5 to approve the merger between the two banks, said one person familiar with the matter.
Mr. Cuomo's investigators will ask directors how much they knew about Merrill's losses, and the role they played in decisions about whether to disclose information to shareholders. That includes whether the board sought legal advice about disclosure issues, said the person. They are also likely to ask board members about pressure by government officials on disclosure issues, as well as whether government officials threatened to remove management and the board if Bank of America didn't proceed with the deal.
Mr. Cuomo's office plans to eventually subpoena all 15 board members present in December, said the person familiar with the matter. The board's 16th member at the time, Chief Executive Officer Kenneth Lewis, has already testified.
Ireland to unveil €90bn ‘bad bank’ details
The Irish government will on Wednesday reveal the full extent of Dublin’s bank rescue plan when it details the price at which it will buy up to €90bn (£80bn, $132bn) of distressed property loans lent to developers during Ireland’s economic boom. The terms of the transfer will be outlined by Brian Lenihan, finance minister, when he presents legislation in parliament setting up the government’s national asset management agency (Nama), or “bad bank”.
With both main opposition parties – the conservative Fine Gael and the Irish Labour party – opposed to the plan, the government’s critics will use the debate to accuse the Fianna Fail-led coalition of putting at risk billions of euros of taxpayers’ money to bail out the banks and developers. Trade unions are set to voice their anger at the initiative, staging a rally outside parliament later today. The critics were joined by Dermot Desmond, the Irish millionaire financier, who warned in an article in the Irish Times that “Nama as conceived will do untold long-term damage to Ireland. It will result in paralysis for decades to come.”
Much of the interest in Mr Lenihan’s statement will focus on the size of the discount – the difference between the value of the loans on the banks’ books and the price Nama will pay. This will also determine the market’s reaction to the announcement, with analysts indicating that anything more than about 50 per cent could hit bank shares, as investors calculate that the banks will need extra capital from the government. The “bad bank” plan is a bold but untried attempt to encourage the resumption of lending in the Irish economy, by forcing the banks to crystallise their losses. The plan covers the six Irish-owned banks, although Irish Life & Permanent – which did not engage in lending to developers and speculators – is not expected to participate.
The European Commission has issued broad guidelines to ensure the scheme does not breach state aid or competition rules. The European Central Bank has given its broad backing to the plan, while warning that such schemes should not be so large as to undermine a country’s fiscal position. Mr Lenihan has already amended the draft legislation in response to opposition criticism, introducing a risk-sharing mechanism so that some part of the price that Nama pays for assets is linked to the recovery values of the loans once markets have improved.
The minister has made it illegal to lobby Nama, a measure designed to assuage criticism that the agency would be open to political interference. Mr Lenihan is also expected to announce that the courts will adjudicate on the fairness of any transfer price, again addressing market concerns that the minister could influence the pricing process. Irish bank shares have rallied in recent weeks, suggesting investors believe the Nama plan will not lead to de facto bank nationalisations. At the same time, the spread on Irish sovereign debt has narrowed, reflecting market confidence the cost to government – and thus indirectly the taxpayer – should be manageable. Parliament is expected to debate the draft bill but then to adjourn. The scheme is not expected to pass into law until late October.
Short Sellers: The Unsung Heroes of the Financial Crisis
by Dean Baker
Last year, as the collapse of the housing bubble was threatening to turn Wall Street into a pre-industrial economy, many leading financial commentators were blaming short-sellers for the meltdown. They argued that the fundamentals of the financial industry were essentially sound. The only problem was that evil short-sellers had teamed up to push the price of the stock of Bear Stearns, Fannie Mae, Freddie Mac, AIG and the rest into the toilet. In response this outcry, the Securities and Exchange Commission actually took steps to limit the shorting of financial stocks.
As should be very clear in retrospect, the problem was not the shorts. The problem was that the clowns who ran these institutions somehow failed to see the largest asset bubble in the history of the world. As a result, they made huge bets that went bad, and drove their companies into bankruptcy. The shorters were actually performing a valuable public service in calling attention to the bad financial state of these companies. At a time when Federal Reserve Board Chairman Ben Bernanke and Treasury Secretary Henry Paulson were insisting that everything was fine, and the bond rating agencies were blessing every piece of crap in sight with an investment grade rating, the shorters were telling the public that all hell was about to break loose. And of course, they were right.
There has been insufficient appreciation of the positive role that shorters played in this story. They were the ones that effectively brought the speculative party to an end. By dumping bonds and buying up credit default swaps on the sick financial giants' debt, in addition to shorting their stock, the shorters made it impossible for these companies to continue their reckless ways. Of course the shorters were not trying to perform a public service. They were trying to make money. However, in pursuing profits, they did what the Fed failed to do: they brought the dangerous inflation of a housing bubble to an end.
This is important to understand because shorting continues to be held in disrepute even though last year's shorters have been entirely vindicated by events. Shorting is often confused with stock manipulation - deliberately trading in a way to move the market. Stock manipulation is illegal and should be punished, but there is no reason to believe that it is any more prevalent on the short side than the long side. In other words, there is no reason to believe that big traders use short selling any more frequently to manipulate stock prices than they use buying to manipulate stock prices. This is just superstition. And an over-valued stock price is no more desirable than an under-valued stock price. Traders inflating a stock's price through manipulation are doing every bit as much harm as those who depress the stock price through short-side manipulation.
When it comes to the economics of shorting, it is not just the image of shorters that is at issue. Part of the story of the bank rescues engineered by the Bernanke, Paulson, Geithner crew is that they have made shorting sick financial giants a dangerous exercise. By using the taxpayers' dollars to keep these behemoths afloat, they have made a bet against Citigroup, Goldman and the rest far more risky. As a result of the bailouts, if a trader recognizes that Goldman has filled its books with bad bets or that J.P. Morgan stands to take a beating on commercial real estate, she may still not want to short the company's stocks because of the risk that Bernanke and Geithner will hand them the cash needed to make up their losses. This is another aspect of the moral hazard problem created by the rescue. It helps to undermine one of the few market mechanisms that could prevent or at least limit another dangerous bubble.
When the collapse of Lehman put the country's financial system on edge, the government had two concerns. One was to keep the financial system operating in order to limit damage to the economy. The other was to protect the interests of the major banks and their top management. The country had no reason to protect the wealth and power of this clique: these were the people who brought us this disaster. Unfortunately, the Fed and Treasury focused on protecting the major banks. As a result, the banks are still run by people who are immensely wealthy and, if anything, they are probably better situated to promote speculative bubbles in the future. And the market forces that could in principle rein in speculative excesses, like short-selling, are weaker than ever.
Nassim Taleb: ‘We still have the same disease'
On the anniversary of the spectacular collapse of Lehman Brothers, Nassim Nicholas Taleb is one of those people who can say, "I told you so." For the past decade, he's been warning that the global economy has become far more vulnerable to unpredictable events that can cause vast disruption. He famously foresaw the credit crunch that brought the financial system to its knees.
Mr. Taleb is a Wall Street derivatives trader who became an academic specializing in the study of randomness and probability. In May of 2008 he published The Black Swan: The Impact of the Highly Improbable. It argued that most economists and bankers live in a dangerous fantasy world in which they imagine they can control the future. The book takes its name from the fact that all swans were once believed to be white – until black swans turned up in Australia. He loathes bankers, central bankers, and economists, not necessarily in that order, and thinks that banks should be run like public utilities.
"My major hobby is teasing people who take themselves and the quality of their knowledge too seriously," he says. He has advised British Conservative Leader David Cameron, and last week testified before the U.S. Congress on the financial crisis. Mr. Taleb will speak Tuesday in Toronto to kick off the new season of the Grano lecture series. The theme of this season's series is risk and the next global crisis. Margaret Wente caught up with him on Friday to ask him what (if anything) we've learned.
Margaret Wente: Happy days are here again. The central bankers say the recession is over. The markets are buoyant. Can we relax?
Nassim Taleb: Not at all. Central bankers have no clue. In the first place, the financial crisis was not a black swan. It was perfectly predictable. They ignored the phenomenal buildup in leverage since 1980. They acted like airline pilots who'd never heard of hurricanes. After finishing The Black Swan, I realized there was a cancer. The cancer was a huge buildup of risk-taking based on the lack of understanding of reality. The second problem is the hidden risk with new financial products. And the third is the interdependence among financial institutions.
MW: But aren't those the very problems we're supposed to be fixing?
MT: They're all still here. Today we still have the same amount of debt, but it belongs to governments. Normally debt would get destroyed and turn to air. Debt is a mistake between lender and borrower, and both should suffer. But the government is socializing all these losses by transforming them into liabilities for your children and grandchildren and great-grandchildren. What is the effect? The doctor has shown up and relieved the patient's symptoms – and transformed the tumour into a metastatic tumour. We still have the same disease. We still have too much debt, too many big banks, too much state sponsorship of risk-taking. And now we have six million more Americans who are unemployed – a lot more than that if you count hidden unemployment.
MW: Are you saying the U.S. shouldn't have done all those bailouts? What was the alternative?
NT: Blood , sweat and tears. A lot of the growth of the past few years was fake growth from debt. So swallow the losses, be dignified and move on. Suck it up. I gather you're not too impressed with the folks in Washington who are handling this crisis. Ben Bernanke saved nothing! He shouldn't be allowed in Washington. He's like a doctor who misses the metastatic tumour and says the patient is doing very well. The first thing I would tell Chinese officials is, how can you buy U.S. bonds as long as Larry Summers is there? He's a textbook case of overconfidence. Look what happened to Harvard's finances. They took a lot of risk they didn't understand, and it was a disaster. That's the Larry Summers mentality.
MW: You argue that globalization and modern technology have made the world financial system far more fragile than ever before. How?
NT: Globalization and the Web create worldwide mass effects, whether positive or negative. We have planetary fads that cause random variables to have bigger spikes than ever before. Variables that used to move 10 per cent now move 30 per cent. The whole planet can pull its money out on the same day. The Internet is what bankrupted Iceland! You in Canada destroyed things with your BlackBerry.
MW: You also say that competition among big companies is the Achilles heel of capitalism. What do you mean by that?
NT: If you make corporations compete, sometimes the one that appears most fit for survival is really the one that is most exposed to the negative black swan. What happens is that if you make $4 a share but you're betting the ranch, like GE, the analysts will love you. But if you make only $2 a share with no risk on your book, they'll say you're not doing well. All the incentives are perverse.
MW: We here in Canada feel pretty good because our banks are in good shape and we've escaped relatively lightly. What's your take?
NT: That's true. You guys are slightly more insulated than others. But there's no way you can escape the mistakes made by others. They'll just cost you somewhat less. But if we wind up with hyperinflation, Canada will be the best place in the world to be. You've got energy and minerals. You're not overspecialized. You're self-sufficient.
MW: Up here our government is promising we can get rid of our deficit by 2015. Any views on that?
NT: Governments never got projections right before, so why should they now?
MW: So if everyone is still on the wrong track, what's the right track?
NT: My whole idea is to lower risk in society by developing a system that can resist human error, rather than one where human error rules. The first step is to make sure that no financial institution is too big to fail. Next, make sure governments don't favour big companies. Governments should also decrease the role of economists – they're no more reliable than astrologers, and they do more damage.
MW: Now that you've painted such a rosy outlook, do you have any advice on how individuals can guard against losing 40 per cent of their money in this extremely risky world?
NT: My advice is that instead of investing in medium-risk securities, you should put most of your money in very low-risk securities, and a little bit in high-risk securities. Then you might get a good black swan. Also, it's good to have more than one profession, in case your own profession goes out of style. A Wall Street trader who's also a belly dancer will do a lot better than a trader who winds up driving a taxi.
Governments must take urgent action to prevent unemployment crisis, OECD warns
Governments must take urgent action to prevent the global recession turning into a long-term unemployment crisis, the world's leading economic organization has warned, as fresh figures showed the UK jobless total hitting the highest since 1995. The Organisation for Economic Co-Operation and Development forecast that the unemployment rate, as measured by the OECD, could hit a new post World War II high of 10pc, with 57m people out of work. The current OECD rate is 8.5pc, compared with 7.9pc in Britain. "We cannot claim victory simply because certain economic indicators improve. We cannot rest until we solve the problem of high and persistent unemployment and we cannot assume that growth will take of care of this," Angel Gurría, OECD secretary, said today.
Ahead of the G20 summit in Pittsburgh at the end of next week, he called on leaders for a co-ordinated policy response. The OECD would like to see measures targeted at young people, particularly those without qualifications, to reduce the risk of a "lost generation" of young people falling into long-term unemployment. It would also like to see an increase on spending on job search assistance and training, to help people back to work. Among the OECD countries unemployment has jumped at the fastest pace in Ireland, the US and Spain, whereas the UK rate has risen broadly in line with the OECD area overall. On the UK the OECD report said "the early stages of the economic recovery are likely to be too muted to result in strong job creation."
The recession has forced companies across the UK economy to axe staff and ditch investment plans. The retail, construction and financial services industries have been among those hardest hit. However, the cuts have spread to even the more resilient industries such as defence, with BAE, which helps build the Eurofighter, announcing plans yesterday to close a factory in Cheshire. On Tuesday Andrew Sentance, a member of the Bank of England’s Monetary Policy Committee (MPC) became the latest person to suggest that the recession in Britan may be over. "When we get the figures for the third quarter, we may see some growth has returned to the economy," he told the Northern Echo newspaper.
However, Mervyn King, the Bank’s governor, warned on Tuesday that for "ordinary people" it will not feel like the recession is over even when growth does resume, because unemployment will remain high. The Office for National Statistics said on Wednesday that unemployment in the UK jumped by 210,000 to 2.47m in the three months to July. That is the highest level in 14 years. The number of people claiming jobless benefits rose by 24,400 in August to 1.61m.
World Bank: Poor Face Long Recovery
The global recession is expected to push 89 million more people into extreme poverty by the end of 2010, the World Bank said Wednesday as it called on the leaders of the 20 largest economies to engage in "responsible globalization." Although economic data show the worst recession of the post-World War II era might have ended in the United States, and global trade has begun to pick up again, low-income countries are still reeling from the effects of a financial crisis created by their wealthier counterparts.
In a paper prepared for the meeting of the Group of 20 nations next week in Pittsburgh, the bank said the sharp drop in trade, remittances, tourism and capital flows caused by the global downturn has forced governments in the poorest nations to cut spending in such critical areas as education, health and infrastructure. "We are entering a new danger zone not of free fall but complacency," World Bank Group President Robert B. Zoellick said Wednesday during a conference call with reporters. "You have pledges, you have people who have intentions, but it's not operationalized yet."
Leaders of the G-20 are expected to spend much of the upcoming summit assessing the state of the global economy and the need for further stimulus measures. They are also grappling with how to improve oversight of the global financial system by placing restrictions on executive compensation and increasing the amount of capital banks must have on hand to cover potential losses. A larger concern that has emerged from the crisis is that global economic growth was too dependent on U.S. consumer spending and led to imbalances in trade and capital flows that helped fuel the housing and stock bubbles and subsequent busts.
Zoellick said developing nations could play a vital role in helping the global economy achieve more balanced and sustainable growth by becoming another source of demand. However, to do that, they need help from developed nations with access to financing. "The April summit was for the financial sector," he said referring to the last G-20 gathering in London. "This summit needs to be for responsible globalization."
The World Bank, which is based in Washington and was created to finance development in the world's poorest countries, called on the leading eight industrialized nations to act on a pledge made at a summit earlier this year in Italy to distribute $20 billion in agricultural development aid. It also called on the larger Group of 20 top industrialized nations to do more to help finance small and medium-size businesses, which it said were key to economic growth.
The bank also called on the G-20 to set up an emergency loan program to help poor countries so they "won't be left defenseless in the face of shocks" not of their own making. In addition to the financial crisis, Zoellick also cited the run-up in food and fuel prices in 2008 as examples.
Human-made Crises 'Outrunning Our Ability To Deal With Them,' Scientists Warn
The world faces a compounding series of crises driven by human activity, which existing governments and institutions are increasingly powerless to cope with, a group of eminent environmental scientists and economists has warned. Writing in the journal Science, the researchers say that nations alone are unable to resolve the sorts of planet-wide challenges now arising. Pointing to global action on ozone depletion (the Montreal Protocol), high seas fisheries and antibiotic drug resistance as examples, they call for a new order of cooperative international institutions capable of dealing with issues like climate change – and enforcing compliance where necessary.
"Energy, food and water crises, climate disruption, declining fisheries, ocean acidification, emerging diseases and increasing antibiotic resistance are examples of serious, intertwined global-scale challenges spawned by the accelerating scale of human activity," say the researchers, who come from Australia, Sweden, the United States, India, Greece and The Netherlands. "These issues are outpacing the development of institutions to deal with them and their many interactive effects. The core of the problem is inducing cooperation in situations where individuals and nations will collectively gain if all cooperate, but each faces the temptation to free-ride on the cooperation of others."
There are few institutional structures to achieve co-operation globally on the sort of scales now essential to avoid very serious consequences, warns lead author Dr Brian Walker of Australia’s CSIRO. While there are signs of emerging global action on issues such as climate change, there is widespread inaction on others, such as the destruction of the world’s forests to grow biofuels or the emergence of pandemic flu through lack of appropriate animal husbandry protocols where people, pigs and birds co-mingle.
"Knowing what to do is not enough," says Dr Walker. "Institutional reforms are needed to bring about changes in human behaviour, to increase local appreciation of shared global concerns and to correct the sort of failures of collective action that cause global-scale problems." "We are not advocating that countries give up their sovereignty," adds co-author Professor Terry Hughes, Director of the ARC Centre of Excellence in Coral Reef Studies at James Cook University.
"We are instead proposing a much stronger focus on regional and worldwide cooperation, helped by better-designed multi-national institutions. The threat of climate change to coral reefs, for example, has to be tackled at a global scale. Local and national efforts are already failing." The scientists acknowledge that the main challenge is getting countries to agree to take part in global institutions designed to prevent destructive human practices. "Plainly, agreements must be designed such that countries are better off participating than not participating," they say.
This would involve all countries in drawing up standards designed to protect the earth’s resources and systems, to which they would then feel obligated to adhere. However they also concede that the ‘major powers’ must be prepared to enforce such standards and take action against back-sliders. "The major powers must be willing to enforce an agreement – but legitimacy will depend on acceptance by numerous and diverse countries, and non-governmental actors such as civil society and business," they add. "To address common threats and harness common opportunities, we need greater interaction amongst existing institutions, and new institutions, to help construct and maintain a global-scale social contract," the scientists conclude.
How to short-circuit the US power grid
Predicting how rumours and epidemics percolate through populations, or how traffic jams spread through city streets, are network analyst Jian-Wei Wang's bread and butter. But his latest findings are likely to spark worries in the US: he's worked out how attackers could cause a cascade of network failures in the US's west-coast electricity grid - cutting power to economic powerhouses Silicon Valley and Hollywood. Wang and colleagues at Dalian University of Technology in the Chinese province of Liaoning modelled the US's west-coast grid using publicly available data on how it, and its subnetworks, are connected.
Their aim was to examine the potential for cascade failures, where a major power outage in a subnetwork results in power being dumped into an adjacent subnetwork, causing a chain reaction of failures. Where, they wondered, were the weak spots? Common sense suggests they should be the most highly loaded networks, since pulling them offline would dump more energy into smaller networks. To find out if this is indeed the case, the team analysed both the power loading and the number of connections of each grid subnetwork to establish the order in which they would trip out in the event of a major failure. To their surprise, under particular loading conditions, taking out a lightly loaded subnetwork first caused more of the grid to trip out than starting with a highly loaded one.
"An attack on the nodes with the lowest loads can be a more effective way to destroy the electrical power grid of the western US due to cascading failures," Wang says. To minimise the risk, he says, the grid's operators should defend the west coast sections by adjusting their power capacity to ensure these specific conditions do not arise. The US Department of Homeland Security is reviewing the research, says John Verrico, the department's technology spokesman, who adds that countermeasures are already in the works.
"Our engineers are working on a self-limiting, high-temperature superconductor technology which would stop and prevent power surges generated anywhere in the system from spreading to other substations. Pilot tests in New York City may be ready as soon as 2010." These precautions are well and good, but there are easier ways to bring a grid down, says Ian Fells, an expert in energy conversion at Newcastle University, UK. "A determined attacker would not fool around with the electricity inputs or whatever - they need only a bunch of guys with some Semtex to blow up the grid lines near a power station."