Christmas tree, Madison Square, New York City
Ilargi: Many people today feel happy and positive when they look at the stock markets, because they think these reflect the real economy, and since the markets are up, things must have changed for the better in the past year.
But they haven't, not below the surface. It's all veneer and no substance. What actually has happened is that -virtually- no debt has been paid off in our economies, in fact we’ve added trillions of dollars more in debt. What is different from a year ago is that a huge part of the old debt and all of the new debt has been transferred to the public, and away from private business, in particular financial institutions (and, to an extent, carmakers).
So it comes down to the fact that people feel happy for being deeper in debt, and quite a bit deeper. Being the humans we are, we focus on the short term gratification which can be found in the Dow and a whole slew of increasingly fabricated numbers and government reports, while we conveniently ignore the enormous increases in debts, both public and private, that we will have to pay off down the line.
But, you say, it's not as bad as it may look, because when the crisis is over, we will return to growth, and that will take care of the debt. That and shrewd dollar-inflation strategies by the wizards at the Fed and Treasury.
Really? What if the crisis lasts, let's say, ten years? All that needs to happen for that is for home prices to keep falling, or even stagnate. And that seems a near certainty.
The US has no private mortgage market left, or even a viable housing market. Neither do Canada, Britain, Holland and many other countries for that matter. Homes are sold and mortgages approved only because the state takes them off the lenders' hands and books the minute the deals are closed. The loans are then securitized and sold on to, in America's instance, the central bank. In other words, all of the risk for all of the entire loans processed in this fashion lies squarely with the taxpayer.
And that is not a good thing if prices keep dropping. When unemployment won't come down. When governments start raising taxes because sovereign debt goes through the various rooftops.
The main problem's not even paying off the principal of the debt. That won't start happening for years to come, if ever. It’s paying the interest on the debt that will become the most immediate headache.
In a world where money is lent at record low near zero interest rates, Britain pays close to 4% on its 10-year Gilts, the UK Treasury bonds. Why? Look here:
[..] Britain is nearing the eye of the storm as the Bank of England starts to unwind quantitative easing. "The Bank has bought more gilts over the last nine months than the Government has issued. It has magically eradicated the cost of financing the deficits, but this is going to twist dramatically the other way in early 2010. Markets know this. They are demanding a risk premium on sterling."
Many other nations face the same issues. And that includes the US. Borrowing money will become dramatically more expensive. It’s the market mechanism at work in its full glory. The global supply of sovereign bonds is way bigger than the demand.
Talking about US Treasuries, Canadian investor Eric Sprott has been trying to figure out who bought them in 2009. In a report entitled Is it all just a Ponzi scheme?, Sprott and David Franklin suggest that it's impossible to find who was the second largest buyer. Of the $1.885 trillion dollars in public debt the US added in 2009, $704 billion (annualized) was bought by "Other Investors", a collection of buyers they find defined in the Federal Reserve Flow of Funds Report as the "Household Sector". the $704 billion is 35 times more than this sector bought in the prior year, 2008, according to Sprott and Franklin. They phrase it like this:
Amazingly, we discovered that the Household Sector is actually just a catch-all category. It represents the buyers left over who can't be slotted into the other group headings. For most categories of financial assets and liabilities, the values for the Household Sector are calculated as residuals. That is, amounts held or owed by the other sectors are subtracted from known totals, and the remainders are assumed to be the amounts held or owed by the Household Sector. To quote directly from the Flow of Funds Guide,"For example, the amounts of Treasury securities held by all other sectors, obtained from asset data reported by the companies or institutions themselves, are subtracted from total Treasury securities outstanding, obtained from the Monthly Treasury Statement of Receipts and Outlays of the United States Government and the balance is assigned to the household sector."
So to answer the question - who is the Household Sector? They are a PHANTOM. They don't exist. They merely serve to balance the ledger in the Federal Reserve's Flow of Funds report.
Our concern now is that this is all starting to resemble one giant Ponzi scheme. We all know that the Fed has been active in the market for T-bills. [..] they bought almost 50% of the new Treasury issues in Q2 and almost 30% in Q3. It serves to remember that the whole point of selling new US Treasury bonds is to attract outside capital to finance deficits or to pay off existing debts that are maturing. We are now in a situation, however, where the Fed is printing dollars to buy Treasuries as a means of faking the Treasury's ability to attract outside capital. If our research proves anything, it's that the regular buyers of US debt are no longer buying, and it amazes us that the US can successfully issue a record number Treasuries in this environment without the slightest hiccup in the market.
Translation: the Sprott report accuses the US Treasury and/or the Fed of buying US treasuries themselves, in much larger numbers than they acknowledge. Wonder what the Chinese will make of that. Then again, they may already know or suspect this. At this point, we should be wondering also what US taxpayers think of this. Alas, they've been lulled into another dream of growth and greatness from which they won't wake until it makes no difference anymore what they think.
The Christmas Eve zinger for 2009 (in the tradition of the Federal Reserve Act being pushed through the House exactly 96 years ago) is that the Treasury in a last-minute December 24 announcement has stated that is has removed any and all caps on financial support for Fannie and Freddie. If they weren't all yours before, with all the trillions in debt they carry, America, they sure are now. It's a fine American political tradition, inflicting the worst hurt when nobody‘s looking.
2009 has been the year in which "Moral Hazard" lost its meaning and then disappeared altogether, precisely at the moment when that meaning could have become obvious to everyone. Well done by the media. No morals, no hazard, right?
2010 will be the year of the Debt. It will bury entire nations like Greece and Ukraine, and states like California, and threaten to topple scores more. China will turn out to have built a thousand time more useless real estate than Dubai. And the US and other "rich" governments will need to choose between additional bail-outs, which this time will turn out to be even much more expensive, or come clean with their people and accept certain and instant political defeat.
Yes sir, of course ma’am, one round of bail-outs coming up.
They’re on the house.
Ilargi: The Automatic Earth Christmas and New Year’s fund (see top of page, left hand side) humbly and gratefully accepts your kind donations in the name of all the millions in need of spiritual and practical enlightenment.
Is it all just a Ponzi scheme?
by: Eric Sprott and David Franklin
In our May/June Markets at a Glance, "The Solution is the Problem", we discussed how much debt the US government would need to issue in order to balance the budget for fiscal 2009. We calculated they would need to sell $2.041 trillion in new debt - or almost three times the new debt that was issued in fiscal 2008. As a thought experiment, we separated all the various US Treasury owners and asked our readers whether each group could afford to increase their 2009 treasury purchases by 200%. In the end, we surmised that most groups couldn't, and prepared our readers for the worst.
Almost seven months later, however, nothing particularly bad has happened on the US debt front. There have been no failed auctions, no sovereign defaults, no downgrades of debt and no significant increase in rates not so much as a hiccup in the treasury market. Knowing what we discussed this past June, we have to ask how it all went so smoothly. After all it was pretty obvious there wasn't enough buying power to satisfy the auctions under 'normal' circumstances.
In the latest Treasury Bulletin published in December 2009, ownership data reveals that the United States increased the public debt by $1.885 trillion dollars in fiscal 2009. So who bought all the new Treasury securities to finance the massive increase in expenditures? According to the same report, there were three distinct groups that bought more than they did in 2008. The first was "Foreign and International Buyers", who purchased $697.5 billion worth of Treasury securities in fiscal 2009 representing about 23% more than their respective purchases in fiscal 2008. The second group was the Federal Reserve itself. According to its published balance sheet, it increased its treasury holdings by $286 billion in 2009, representing a 60% increase year-over-year.
This increase appears to be a direct result of the Federal Reserve's Quantitative Easing program announced this past March. Most of the other identified buyers in the Treasury Bulletin were either net sellers or small buyers in 2009. While the Q4 data is not yet available, the Q1, Q2 and Q3 data suggests that the State and Local governments and US Savings Bonds groups will be net sellers of US Treasury securities in 2009, while pension funds, insurance companies and depository institutions only increased their purchases by a negligible amount.
So who was the third large buyer? Drum roll please,... it was "Other Investors". After purchasing $90 billion in 2008, this group has purchased $510.1 billion of freshly minted treasury securities so far in the first three quarters of fiscal 2009. If you annualize this rate of purchase, they are on pace to buy $680 billion of US treasuries this year - or more than seven times what they purchased in 2008. This is undoubtedly the group that made the US deficit possible this year.
But who are they? The Treasury Bulletin identifies "Other Investors" as consisting of Individuals, Government-Sponsored Enterprises (GSE), Brokers and Dealers, Bank Personal Trusts and Estates, Corporate and Non-Corporate Businesses, Individuals and Other Investors. Hmmm. Do you think anyone in that group had almost $700 billion to invest in the US Treasury market in fiscal 2009? We didn't either.
To dig further, we turned to the Federal Reserve Board of Governors Flow of Funds Data which provides a detailed breakdown of the owners of Treasury Securities to Q3 2009. Within this grouping, the GSE's were small buyers of a mere $5 billion this year; Broker and Dealers were sellers of almost $80 billion; Commercial Banking were buyers of approximately $80 billion; Corporate and Non-corporate Businesses, grouped together, were buyers of $11.6 billion, for a grand net purchase of $16.6 billion. So who really picked up the tab?
To our surprise, the only group to actually substantially increase their purchases in 2009 is defined in the Federal Reserve Flow of Funds Report as the "Household Sector". This category of buyers bought $15 billion worth of treasuries in 2008, but by Q3 2009 had purchased a whopping $528.7 billion worth. At the end of Q3 this Household Sector category now owns more treasuries than the Federal Reserve itself.
So to summarize, the majority buyers of Treasury securities in 2009 were:
- . Foreign and International buyers who purchased $697.5 billion.
- . The Federal Reserve who bought $286 billion.
- . The Household Sector who bought $528 billion to Q3 which puts them on track purchase $704 billion for fiscal 2009.
These three buying groups represent the lion's share of the $1.885 trillion of debt that was issued by the US in fiscal 2009.
We must admit that we were surprised to discover that "Households" had bought so many Treasuries in 2009. They bought 35 times more government debt than they did in 2008.
Given the financial condition of the average household in 2009, this makes little sense to us. With unemployment and foreclosures skyrocketing, who could afford to increase treasury investments to such a large degree? For our more discerning readers, this enormous "Household" investment was made outside of Money Market Funds, Mutual Funds, ETF's, Life Insurance Companies, Pension and Retirement funds and Closed-End Funds, which are all separate reporting categories. This leaves a very important question - who makes up this Household Sector?
Amazingly, we discovered that the Household Sector is actually just a catch-all category. It represents the buyers left over who can't be slotted into the other group headings. For most categories of financial assets and liabilities, the values for the Household Sector are calculated as residuals. That is, amounts held or owed by the other sectors are subtracted from known totals, and the remainders are assumed to be the amounts held or owed by the Household Sector. To quote directly from the Flow of Funds Guide,"For example, the amounts of Treasury securities held by all other sectors, obtained from asset data reported by the companies or institutions themselves, are subtracted from total Treasury securities outstanding, obtained from the Monthly Treasury Statement of Receipts and Outlays of the United States Government and the balance is assigned to the household sector."
So to answer the question - who is the Household Sector? They are a PHANTOM. They don't exist. They merely serve to balance the ledger in the Federal Reserve's Flow of Funds report.
Our concern now is that this is all starting to resemble one giant Ponzi scheme. We all know that the Fed has been active in the market for T-bills. As you can see from Table A, under the auspices of Quantitative Easing, they bought almost 50% of the new Treasury issues in Q2 and almost 30% in Q3. It serves to remember that the whole point of selling new US Treasury bonds is to attract outside capital to finance deficits or to pay off existing debts that are maturing. We are now in a situation, however, where the Fed is printing dollars to buy Treasuries as a means of faking the Treasury's ability to attract outside capital. If our research proves anything, it's that the regular buyers of US debt are no longer buying, and it amazes us that the US can successfully issue a record number Treasuries in this environment without the slightest hiccup in the market.
Perhaps the most striking example of the new demand dynamics for US Treasuries comes from Bill Gross, who is co-chief investment officer at PIMCO and arguably one of the world's most powerful bond investors. Mr. Gross recently revealed that his bond fund has cut holdings of US government debt and boosted cash to the highest levels since 2008. Earlier this year he referred to the US as a "ponzi style economy" and recomended that investors front run Uncle Sam and other world governments into government debt instruments of all forms. The fact that he is now selling US treasuries is a foreboding sign.
Foreign holders are also expressing concern over new Treasury purchases. In a recent discussion on the global role of the US dollar, Zhu Min, deputy governor of the People's Bank of China, told an academic audience that "The world does not have so much money to buy more US Treasuries." He went on to say, "The United States cannot force foreign governments to increase their holdings of Treasuries. Double the holdings? It is definitely impossible."
Judging from these statements, it seems clear that the US cannot expect foreigners to continue to support their debt growth in this new economic environment. As US consumers buy fewer foreign goods, there are less US dollars available for foreigners to purchase future Treasury securities. Foreigners are the largest source of external capital that can be clearly identified in US Treasury data. If their support wanes in 2010, the US will require significant domestic support to fund future debt issuances. Mr. Gross's recent comments suggest that their domestic support may already be weakening.
As we have seen so illustriously over the past year, all Ponzi schemes eventually fail under their own weight. The US debt scheme is no different. 2009 has been witness to spectacular government intervention in almost all levels of the economy. This support requires outside capital to facilitate, and relies heavily on the US government's ability to raise money in the debt market. The fact that the Federal Reserve and US Treasury cannot identify the second largest buyer of treasury securities this year proves that the traditional buyers are not keeping pace with the US government's deficit spending. It makes us wonder if it's all just a Ponzi scheme.
Treasury removes cap for Fannie and Freddie aid
The government has handed its ATM card to beleaguered mortgage giants Fannie Mae and Freddie Mac. The Treasury Department said Thursday it removed the $400 billion financial cap on the money it will provide to keep the companies afloat. Already, taxpayers have shelled out $111 billion to the pair, and most analysts hadn't expected the companies to hit the limit. Treasury Department officials said it will now use a flexible formula to ensure the two agencies can stand behind the billions of dollars in mortgage-backed securities they sell to investors. The formula will provide the companies with a sufficient cushion based on projected losses over the next three years.
By making the change before year-end, Treasury sidestepped the need for an OK from a bailout-weary Congress. But the timing of the announcement on a traditionally slow news day raised eyebrows. "The companies are nowhere close to using the $400 billion they had before, so why do this now?" said Bert Ely, a banking consultant in Alexandria, Va. "It's possible we may see some horrendous numbers for the fourth quarter and, thus 2009, and Treasury wants to calm the markets."
Fannie Mae and Freddie Mac provide vital liquidity to the mortgage industry by purchasing home loans from lenders and selling them to investors. Together, they own or guarantee almost 31 million home loans worth about $5.5 trillion, or about half of all mortgages. Without government aid, the firms would have gone broke, leaving millions of people unable to get a mortgage. The biggest headwind facing the housing recovery has been the rise in foreclosures as unemployment remains high. Treasury said its latest move could allow Fannie and Freddie to play a bigger role in restructuring mortgages for troubled borrowers.
Treasury officials will provide an updated estimate for Fannie and Freddie losses in February when President Barack Obama sends his 2011 budget to Congress. Though the administration has yet to disclose its long-term plans for the two companies, they are unlikely to return to their former power and influence. The news followed an announcement Thursday that the CEOs of Fannie and Freddie could get paid as much as $6 million for 2009, despite the companies' dismal performances this year.
Fannie's CEO, Michael Williams, and Freddie CEO Charles "Ed" Haldeman Jr. each will receive $900,000 in salary, $3.1 million in deferred payments next year and another $2 million if they meet certain performance goals, according to filings with the Securities and Exchange Commission. The pay packages were approved by the Treasury Department and the Federal Housing Finance Agency, which regulates Fannie and Freddie. That pay is far less than what their predecessors earned. Former Fannie CEO Daniel Mudd received $10.2 million in 2008 and former Freddie CEO Richard Syron pocketed $13.1 million. Both execs were ousted when federal regulators seized the companies in September 2008. The federal government blocked exit packages for the pair worth up to $24 million.
The chief executives' pay could spark new criticism about the government's numerous bailouts, but that may be unfounded, said Mark Borges, principal with management consulting firm Compensia. Haldeman and Williams each could command between $5 million and $10 million in a similar position in the private sector, Borges estimated, and without the notable challenges and public scrutiny they face at these companies. "I doubt too many people would look at these jobs and say, 'Gosh, I would love to go there for my next career move,'" Borges said. "The government is getting top notch executives to solve problems that are not easy to solve." The bulk of their pay is also not guaranteed, Borges said, so these executives can't pocket and run and must meet certain long-term goals or risk giving some of it back.
Freddie Mac's board sets the performance goals for the chief executive, which won't be disclosed until next year. Fannie Mae's filing outlined its corporate goals including "being a recognized leader in the housing recovery," "protecting taxpayers," and "managing risk more effectively." Fannie Mae and Freddie Mac declined to offer further details on CEO performance goals.
Public anger over Wall Street pay boiled over earlier this year. In response, the Obama administration imposed pay curbs on banks that received government bailouts. All the major banks have since repaid their federal money, largely to escape caps on executive pay. Former Bank of America Corp. CEO Ken Lewis, for example, agreed to forgo his salary and bonus this year under pressure from the government. Last year, he pocketed more than $9 million in total compensation. Bank of America received $45 billion in government assistance, which it has since repaid.
Freddie Mac hired Haldeman, a former mutual fund executive, in July. At the time, the company disclosed his annual salary of $900,000 but did not disclose other incentive payments. In September, the company hired a new chief financial officer, Ross Kari, and said his pay package would be worth up to $5.5 million. Williams, formerly Fannie Mae's chief operating officer, took over as CEO in April after the first government-appointed CEO, Herbert Allison, took a job at the Treasury Department. Williams earned a base salary of $676,000 last year, plus a retention award of $260,000. Washington-based Fannie Mae was created in 1938 in the aftermath of the Great Depression. It was privatized 30 years later to limit budget deficits during the Vietnam War. In 1970, the government formed its sibling and competitor McLean, Va.-based Freddie Mac.
2010: The Year to Focus on Sovereign Debt
by David Kotok
"Whatever it is, I fear the Greeks even when they bring gifts." This is one of the English translations of Virgil’s Aeneid. It refers to the Trojan horse that Greece used to deceive Troy and gain entry into the city. "During the Depression about half the population of Oklahoma moved to California and the intelligence level in both states went up." Will Rogers, the great American commentator from Oklahoma, hatched this quip decades ago in his analysis of California’s governmental policies and its finances.
If we were writing a play on the theme of sovereign debt, we might use the following characterization. The US and the EU are the setting: two currency zones. The Fed and the ECB are the dominant members of the cast: two central banks responsible for the two currencies. Greece and California are in leading roles: two states within the two currency zones.
In the United States, California constitutes about 13% of America’s GDP. If CA were a standalone economy, it would be about the seventh largest in the world. The currency in use in California is the US dollar. The CA government determines its own budget, has its own constitution, operates an internal legal system, and decides its own state tax structure. It is also one of the 50 sovereign members of the USA and has legally bound itself to the rules promulgated in Washington, while attempting to preserve some state rights within our highly federalized legal system.
CA and most other states have a requirement to balance an annual budget. There are provisions for emergencies in many of these states, and in the coming year we expect the concept of a financial emergency to be deployed and tested in various state courts. CA recently issued "script" during a short-lived budget crisis when it ran out of cash and until its legislature passed a revised budget. That was not the first time script has been used. We do not expect it will be the last.
In the euro zone, Greece is about 3% of the GDP. It is a sovereign state (country), one of the 16 members of the euro monetary system, and one of the 27 members of the European Union. GR maintains its own budget, although it has pledged to adhere to EU budget rules, which it is currently violating along with most other members of the EU. Under present agreements, penalties will occur if GR is not making a sufficient effort to improve its fiscal situation within a year. We do not expect those penalties to be imposed on GR nor on the other EU states in difficulty. Greece has its own tax structure, constitution, and internal legal system. GR is also covered by the newly developed EU Lisbon Treaty and, like other EU member states, is gradually moving into a Europe-wide economic structure.
California and Greece are both lowly rated by the agencies that appraise the creditworthiness of sovereign debt. CA and GR are also on the top of the list of possible default candidates in their respective currency zones. That list is prepared by CMA DataVision, a service that scrutinizes credit default swap pricing in order to determine market-based assessments of default probability over the next five years. CA and GR are both poorly rated, and their scores (default probabilities) are about the same
CA is a problem for the Federal Reserve because the state is a very large part of the US economy and because it is suffering from the financial crisis and the collapse of the housing bubble. If CA defaults, it will lose access to credit markets and contract a governmental economy that is 1/7 of the US. That would be a huge blow to the nascent American economic recovery. The Federal Reserve doesn’t directly place its funds in California’s debt; the Fed does function as the central banker for nearly all of the financial entities that underwrite and distribute CA debt. Commercial bank direct holdings of CA’s $76 billion debt are relatively small, due to the construction of the US tax code, which discourages banks from holding tax-free municipal bonds.
GR is a problem for the European Central Bank. The ECB doesn’t own Greek sovereign debt, but it does extend credit to Greece’s national banks in the euro zone, and they hold Greek debt. Furthermore, the ECB must consider the non-Greek euro zone banks, since they too hold Greek sovereign debt. There are rules in place that will disqualify the Greek sovereign debt from use as acceptable collateral in ECB lending operations to banks. These rules apply because of the credit rating downgrades of Greece and will take effect within a year if they are not suspended or deferred. This should motivate the Greek bank lobby to spur the government of Greece to action.
Moody’s (December 22, 2009) describes the Greece situation like this: "Government action has been swift. We believe they know what they need to do and are under a great deal of external pressure to deliver. Trend growth is likely to be slower than in recent years, which means that growth will not make a significant contribution to addressing the problem. The government is likely to meet its fiscal targets in 2010. What happens in 2011 and beyond is uncertain."
PMI reports that in California about one out of 20 (5%) of all prime mortgages are in foreclosure. Worse is that one out of five subprime mortgages are in foreclosure. CA house prices fell 8% in the year ending September 30. Payroll employment dropped 4.6% in the year ending October.
The continuing saga of California’s budget crisis is well-known, so we won’t recount details here. In a recent report (November 23, 2009) Moody’s said: "Last Wednesday, the California Legislative Analyst’s Office (LAO) released a report stating that California’s current-year budget gap is approximately $6 billion and that the gap for next year is $14.4 billion. Gaps of this magnitude were expected, however, and were built into our current rating for the State of California (currently rated Baa1, with a stable outlook). This new report, therefore, does not affect California’s long-term or short-term rating. Although the size of the budgetary gap is important in determining the state’s rating, actions taken by the state to resolve the gap are even more critical because it is within the state’s power to address these large imbalances. If the gaps were to grow significantly from what has been announced by the LAO, however, or if the state cannot execute a plan to address these gaps in a timely fashion, this difficult situation could signal credit deterioration beyond our expectations. Downward pressure on the state’s ratings could result."
To sum this up: these are two central banks, the Fed and the ECB, with two currencies, the euro and the dollar, operating within two federations of sovereign states, the USA and the EU. The EU is new and only recently became the world’s largest economy, if you add up the entire 27 member states’ GDP. The 27 states are divided into three groups: those in the euro zone, those that want to be in and are trying to get in; and those that have elected not to go in or cannot qualify to get in. The US has a seasoned 50-state membership and is over 200 years old. It started as a loose and weak federation of strong sovereign states and has gradually and solidly tested a constitutional structure of strong central government, which now dominates its states.
About 75% of the combined debt of the entire world is pegged to one of these two currencies. The benchmark interest rate on the euro is the 10-year German government bond; it is paying about 3.25% interest. The benchmark debt of the US dollar is the 10-year US Treasury note; it is paying about 3.75% interest. Both the EU and the Fed are central banks whose jurisdictional boundaries have involved them in episodes of hyperinflation and depression. Both civil and international wars are parts of that history.
Both banks have the same problem. What do they do with policy when they have weakening credit among their sovereign member states? Greece is not the only problem for the ECB. It has to also keep an eye on other weak member states, like Ireland, Portugal, Italy, and Spain. California is not the only problem for the Fed. It has to deal with issues that are surfacing in places like Michigan, New Jersey, and Florida. Both central banks face huge issuance of more sovereign debt, as the budgets within their jurisdictions are in large deficit.
Can any of these states in either system default? Of course they can. California actually flirted with it when it issued script for a brief period. Will the action of a state cause the federal currency to collapse? That is the key question plaguing the markets. We think the answer is no, but acknowledge that this is an untested question. Can the currency’s relative value be maintained by the monetary authority when a state within the currency zone defaults? We think the answer is yes, but with a qualifier.
At Cumberland, we do not expect to see a mass of sovereign defaults. The issues involved are political, and the political price of default is more severe than that of toughening up budget standards. In the end, politics will raise taxes and restrict spending to avert defaults. And actual default comes about when economic pressures cause it and when they leave the political body without a choice. In our view defaults are rarely politically expedient, because default threatens a change in the political regime. Therefore, we expect both Greece and California will pay their debts.
Furthermore, we do not expect the sovereign debt of any of these mature economies to default. The 27 EU member countries and the 50 US states are not anywhere near the same types of cases as Argentina or Venezuela. Those possible defaults are driven by economics and are a result of desperate politicians who have run out of room. Argentina and Venezuela are isolated, not in a currency zone and are victims of terrible politically driven policies. It is in no neighbor’s interest to help them financially.
History shows that most governments do not pay off their debts. They refinance them indefinitely, and their governing central bank applies its directives and mandates and accommodates its sovereign states within that context. It is in the difference between the Fed and the ECB that we may find the outcomes for 2010 and beyond. The ECB is a governmental entity structured under a treaty that clearly established its independence and directs it to maintain inflation under and close to 2%. The Fed is a creature of Congress and is under the most intense political pressure we have seen in the US in a very long time. The Lisbon Treaty did not affect the independence of the ECB. All of the various proposed legislation in the US Senate or the House removes or diminishes some aspect of Fed independence. None enhances it.
Since governments do not pay off their debt and, instead, use their political mechanisms to refinance it, that is what we should expect to see in 2010 and beyond as this large post-crisis infusion of sovereign debt is issued. Here is where the central banks come in and assist with the issuance. And here is where the market may be misjudging the impact. Debt service is the key issue, not the debt aggregate. And since the principal is not paid off, it is the interest burden alone that constitutes the debt service item. So the market-related issue is, how much of the annual budget will be consumed in paying the interest, since that is where the debt-service cost will be applied. Furthermore, this burden is placed in the cash market only and not as an accrual. Markets seem to ignore accrued liabilities until they become real payments.
Another aspect of this construction about sovereign debt is that it is deflationary. Rising debt burdens consume greater and greater portions of income. They restrain spending. That is why the assumption that the increasing debt will bring on a large inflation is not necessarily correct. Japan is testimony to this outcome. In order to get the inflation that can accompany large sovereign debt issuance, the central bank has to monetize the debt at very fast and accelerating rates for a prolonged time. In Japan, that policy shift is now a subject of debate, since they are weary of fifteen years of deflation. In Europe the ECB has a clear mandate to avoid an inflationary outcome. Only in the US is this a question, and the Federal Reserve continues to say it will provide liquidity for as long as is needed but will withdraw it slowly and after the economy achieves a more sustainable growth path. The Fed is counting on a new policy-management tool for this purpose. The Fed’s own quarterly FOMC long range forecasts confirm its commitment to avoid a rising inflation rate over the next several years.
The pressures on the Fed will intensify as the sovereign debt loads in the US rise, and especially as the difficulties of finance expand in many of the sovereign 50 states. Rising interest rates hurt the economic recovery, and particularly in the troubled states. Higher mortgage rates slow the incipient housing recovery, and they raise the debt burden of refinance. Help from the US federal government will certainly be forthcoming for the states, as it already has been, but the federal deficit is quite large and not likely to shrink. Remember that federal aid to a state is merely the substitution of one type of sovereign debt for another.
In sum, we expect government bond issuance and higher debt burdens to slow the recovery and to dampen inflation tendencies. That means the Federal Reserve is likely to have the room to continue its "extended period" construction for most of 2010. Hence, we believe the short-term interest rate in the US will remain quite low. The same is true in most of the rest of the world and certainly in the euro zone, the UK, and Japan. 90% of the world’s debt is linked to one of these four currencies: the US dollar, the euro, the British pound, or the Japanese yen. For 2010, the average short-term rate of the four is projected to be between zero and 1%.
Bond portfolios are best deployed in spread products and not in the debt of these sovereigns. Forward rate analysis helps in determining where on the yield curve to position. And individual credit work is needed to ascertain and select the single issues that are desired. Sovereign debt issues will drive markets in 2010. We think they will dominate the headlines all year. It is a fascinating time to manage bonds.
We wish all our readers the very best for the New Year.
China tightening could undo risk markets
The key decision for global markets in 2010 will very likely not be made in Washington but Beijing, where emerging inflation and a property bubble may push China to begin reining in expansionary policies earlier than will suit the developed world.
After returning to a breakneck pace of growth with amazing speed, there are already signs that China is weighing steps to curtail the bank lending that has been a huge source of stimulus, helping to drive property and other asset prices sharply higher. "We emphasize the role of the reserve-requirement ratio, although the ratio was internationally seen as useless for years and it was thought central banks could abandon the tool," Chinese central bank Governor Zhou Xiaochuan said at a Beijing conference on Tuesday. "Besides benchmark interest rates, we also put emphasis on managing the gap between deposit and lending rates", Zhou said.
Put simply, that implies that China may take steps to limit the amount of money banks are allowed to lend and to drive the margins between what they pay in interest and what they charge higher, both steps which will cool growth and speculation. China's central bank on Wednesday followed up by promising to exercise tighter control over bank lending next year while reaffirming a long-standing pledge to maintain "appropriately loose" monetary policy. Even if you don't own a million dollar apartment investment in Shanghai kept empty of course because cash flows are for the little people this could spell trouble.
Zhou "today signaled the end of the global market bounce that has been in progress since the end of last winter," Lombard Street Research economist Charles Dumas wrote in a note to clients. "The only major addition of liquidity in the world economy over the past year has been in China. That is about to be withdrawn. Risk assets look like an unwise place to be in early 2010, especially commodity futures and the government bonds of countries with large deficits and/or debts. For risky investments worldwide, this could mark a turning point from 2009's massive rally."
China's banks will lend about $1.4 trillion in 2009, roughly double 2008's allocation. Official estimates put inflation at a tepid 0.6 percent for the year to November, but this is in contrast to media reports about bulk-buying by Chinese consumers concerned about a rapid rise in the price of staple foods.
Reflationary efforts in China have almost certainly had a positive impact on global economic conditions, possibly affecting market prices for securities more than fundamental demand. On the broadest measure, money supply in China is growing at an astonishing 30 percent annual clip, more or less double its usual rate of growth this decade. By Lombard Research's reckoning, China has been doing the heavy lifting. Even with a range of extraordinary policies such as quantitative easing, combined money growth in the United States, euro zone, Japan and Britain is barely positive. But adding in China's efforts, this rises to a more normal 6 percent range.
But China could be cutting back through loan controls, interest rates and ultimately by allowing the yuan to rise in value just as other sources of liquidity such as the U.S. quantitative easing program are withdrawn. Perhaps this is all part of the grand plan, and perhaps the rise in asset prices over the past nine months will be confirmed by a self-sustaining recovery even without further growth in stimulus.
There are at least three other possibilities. First, it may be that tighter policy in China retards a recovery and hurts asset prices. But there is also a chance that China genuinely needs tighter policy but the United States, Europe and Britain do not. If so, further signs that China is serious about addressing its nascent property bubble and inflation should be quite nasty news for equities and other risky assets. Finally, there is the possibility that China is the bellwether for inflationary issues that will crop up elsewhere soon, though this seems a long shot.
Risk assets could get hit if it looks like the Fed's hand is being forced regardless of what the U.S. central bank does about interest rates and its exit plan. Withdrawing monetary stimulus will hurt, but what might hurt even worse is if the Fed were forced to extend measures to the point at which it starts looking desperate rather than masterful. We are operating under a common narrative in markets: that the authorities are both willing and able to do what it takes. This may or may not be true, but it gains tremendous force simply because people subscribe to it. China may make this simple narrative quite a bit more complicated.
Gilts (UK bonds) sell-off as Britain joins Italy in debt house
The cost of borrowing for the British Government has surged to within a whisker of Italian levels as global markets issue their punishing verdict on the Government’s spending plans. The yield on 10-year gilts spiked Wednesday to 3.97pc, 46 basis points higher than costs on French bonds. Britain and France were neck and neck as recently as last month, before Labour’s pre-Budget report raised deep concerns among Chinese, Arab, and Russian investors about the credibility of British state. But what has caught market attention is the narrowing gap with Italian bonds, once mocked as the symbol of an ill-governed nation in thrall to the Dolce Vita.
Yields on 10-Italian treasuries have been hovering just above 4pc despite the eurozone’s Greek crisis, dropping as low as 3.98pc earlier this week. Julian Callow, Europe economist at Barclays Capital, said Britain is nearing the eye of the storm as the Bank of England starts to unwind quantitative easing. "The Bank has bought more gilts over the last nine months than the Government has issued. It has magically eradicated the cost of financing the deficits, but this is going to twist dramatically the other way in early 2010. Markets know this. They are demanding a risk premium on sterling."
"On top of this you have all the uncertainty over the election. We have the highest deficit in the EU as a share of GDP after Latvia and Ireland. It is not clear whether the next government will have the nerve to push through the tremendous fiscal tightening we need," he said. Britain is vulnerable to a "gilts strike" because foreign investors own £217bn of UK debt, or 28pc of the total. These are footloose funds and likely to sell large holdings if Britain loses its AAA rating. They have other tempting places to park their money, such as Turkey, Brazil, or India, where demography is healthy and growth prospects are better. Chile has already undercut British debt yields on some maturities.
Simon Derrick, currency chief at the Bank of New York Mellon, said global markets are unimpressed by the pre-Budget report and do not believe the UK Treasury forecast for 3.5pc growth in 2011. "The Government will have borrowed an extra £700bn by 2014. And the national debt will reach £1.5 trillion, which is equal £48,000 per head of the working population. The market response is entirely rational," he said Italy has its own problems, of course. Public debt was much higher before the crisis began. The IMF expects it to reach 120pc of GDP next year. However, this debt is mostly owned by high-saving Italians, who are less fickle than foreign funds.
Italy’s household debt was 34pc of GDP in 2007, compared to 100pc in the UK. "If you look at private and public debt together, they are in better shape," said Marc Ostwald from Monument Securities. "Unless our Government gets a grip soon were going to see Gilt spreads widen to 120 basis points over Bunds, with the risk of 150 if there is no clear winner in the election," he said. For Italy, this may just be the calm before the storm. Markets assume that Germany will ultimately bail out Greece if necessary, preventing contagion to the rest of the Club Med bloc.
This is a questionable judgement. Volker Wissing, head of the finance committee of the German Bundestag, said it must be made explicit that "Germany will not take responsibility for Greek debts". Mr Wissing said that ex-finance minister Peer Steinbruck was speaking for himself – not for the German state – when he hinted at rescues for eurozone laggards. His comments should be repudiated.
Banks Bundled Bad Debt, Bet Against It and Won
by Gretchen Morgenson and Louise Story
In late October 2007, as the financial markets were starting to come unglued, a Goldman Sachs trader, Jonathan M. Egol, received very good news. At 37, he was named a managing director at the firm. Mr. Egol, a Princeton graduate, had risen to prominence inside the bank by creating mortgage-related securities, named Abacus, that were at first intended to protect Goldman from investment losses if the housing market collapsed. As the market soured, Goldman created even more of these securities, enabling it to pocket huge profits.
Goldman’s own clients who bought them, however, were less fortunate. Pension funds and insurance companies lost billions of dollars on securities that they believed were solid investments, according to former Goldman employees with direct knowledge of the deals who asked not to be identified because they have confidentiality agreements with the firm.
Goldman was not the only firm that peddled these complex securities — known as synthetic collateralized debt obligations, or C.D.O.’s — and then made financial bets against them, called selling short in Wall Street parlance. Others that created similar securities and then bet they would fail, according to Wall Street traders, include Deutsche Bank and Morgan Stanley, as well as smaller firms like Tricadia Inc., an investment company whose parent firm was overseen by Lewis A. Sachs, who this year became a special counselor to Treasury Secretary Timothy F. Geithner.
How these disastrously performing securities were devised is now the subject of scrutiny by investigators in Congress, at the Securities and Exchange Commission and at the Financial Industry Regulatory Authority, Wall Street’s self-regulatory organization, according to people briefed on the investigations. Those involved with the inquiries declined to comment. While the investigations are in the early phases, authorities appear to be looking at whether securities laws or rules of fair dealing were violated by firms that created and sold these mortgage-linked debt instruments and then bet against the clients who purchased them, people briefed on the matter say.
One focus of the inquiry is whether the firms creating the securities purposely helped to select especially risky mortgage-linked assets that would be most likely to crater, setting their clients up to lose billions of dollars if the housing market imploded. Some securities packaged by Goldman and Tricadia ended up being so vulnerable that they soured within months of being created.
Goldman and other Wall Street firms maintain there is nothing improper about synthetic C.D.O.’s, saying that they typically employ many trading techniques to hedge investments and protect against losses. They add that many prudent investors often do the same. Goldman used these securities initially to offset any potential losses stemming from its positive bets on mortgage securities. But Goldman and other firms eventually used the C.D.O.’s to place unusually large negative bets that were not mainly for hedging purposes, and investors and industry experts say that put the firms at odds with their own clients’ interests.
“The simultaneous selling of securities to customers and shorting them because they believed they were going to default is the most cynical use of credit information that I have ever seen,” said Sylvain R. Raynes, an expert in structured finance at R & R Consulting in New York. “When you buy protection against an event that you have a hand in causing, you are buying fire insurance on someone else’s house and then committing arson.”
Investment banks were not alone in reaping rich rewards by placing trades against synthetic C.D.O.’s. Some hedge funds also benefited, including Paulson & Company, according to former Goldman workers and people at other banks familiar with that firm’s trading. Michael DuVally, a Goldman Sachs spokesman, declined to make Mr. Egol available for comment. But Mr. DuVally said many of the C.D.O.’s created by Wall Street were made to satisfy client demand for such products, which the clients thought would produce profits because they had an optimistic view of the housing market. In addition, he said that clients knew Goldman might be betting against mortgages linked to the securities, and that the buyers of synthetic mortgage C.D.O.’s were large, sophisticated investors, he said.
The creation and sale of synthetic C.D.O.’s helped make the financial crisis worse than it might otherwise have been, effectively multiplying losses by providing more securities to bet against. Some $8 billion in these securities remain on the books at American International Group, the giant insurer rescued by the government in September 2008. From 2005 through 2007, at least $108 billion in these securities was issued, according to Dealogic, a financial data firm. And the actual volume was much higher because synthetic C.D.O.’s and other customized trades are unregulated and often not reported to any financial exchange or market.
Goldman Saw It Coming
Before the financial crisis, many investors — large American and European banks, pension funds, insurance companies and even some hedge funds — failed to recognize that overextended borrowers would default on their mortgages, and they kept increasing their investments in mortgage-related securities. As the mortgage market collapsed, they suffered steep losses.
A handful of investors and Wall Street traders, however, anticipated the crisis. In 2006, Wall Street had introduced a new index, called the ABX, that became a way to invest in the direction of mortgage securities. The index allowed traders to bet on or against pools of mortgages with different risk characteristics, just as stock indexes enable traders to bet on whether the overall stock market, or technology stocks or bank stocks, will go up or down.
Goldman, among others on Wall Street, has said since the collapse that it made big money by using the ABX to bet against the housing market. Worried about a housing bubble, top Goldman executives decided in December 2006 to change the firm’s overall stance on the mortgage market, from positive to negative, though it did not disclose that publicly. Even before then, however, pockets of the investment bank had also started using C.D.O.’s to place bets against mortgage securities, in some cases to hedge the firm’s mortgage investments, as protection against a fall in housing prices and an increase in defaults.
Mr. Egol was a prime mover behind these securities. Beginning in 2004, with housing prices soaring and the mortgage mania in full swing, Mr. Egol began creating the deals known as Abacus. From 2004 to 2008, Goldman issued 25 Abacus deals, according to Bloomberg, with a total value of $10.9 billion. Abacus allowed investors to bet for or against the mortgage securities that were linked to the deal. The C.D.O.’s didn’t contain actual mortgages. Instead, they consisted of credit-default swaps, a type of insurance that pays out when a borrower defaults. These swaps made it much easier to place large bets on mortgage failures.
Rather than persuading his customers to make negative bets on Abacus, Mr. Egol kept most of these wagers for his firm, said five former Goldman employees who spoke on the condition of anonymity. On occasion, he allowed some hedge funds to take some of the short trades. Mr. Egol and Fabrice Tourre, a French trader at Goldman, were aggressive from the start in trying to make the assets in Abacus deals look better than they were, according to notes taken by a Wall Street investor during a phone call with Mr. Tourre and another Goldman employee in May 2005.
On the call, the two traders noted that they were trying to persuade analysts at Moody’s Investors Service, a credit rating agency, to assign a higher rating to one part of an Abacus C.D.O. but were having trouble, according to the investor’s notes, which were provided by a colleague who asked for anonymity because he was not authorized to release them. Goldman declined to discuss the selection of the assets in the C.D.O.’s, but a spokesman said investors could have rejected the C.D.O. if they did not like the assets.
Goldman’s bets against the performances of the Abacus C.D.O.’s were not worth much in 2005 and 2006, but they soared in value in 2007 and 2008 when the mortgage market collapsed. The trades gave Mr. Egol a higher profile at the bank, and he was among a group promoted to managing director on Oct. 24, 2007. “Egol and Fabrice were way ahead of their time,” said one of the former Goldman workers. “They saw the writing on the wall in this market as early as 2005.” By creating the Abacus C.D.O.’s, they helped protect Goldman against losses that others would suffer.
As early as the summer of 2006, Goldman’s sales desk began marketing short bets using the ABX index to hedge funds like Paulson & Company, Magnetar and Soros Fund Management, which invests for the billionaire George Soros. John Paulson, the founder of Paulson & Company, also would later take some of the shorts from the Abacus deals, helping him profit when mortgage bonds collapsed. He declined to comment.
A Deal Gone Bad, for Some
The woeful performance of some C.D.O.’s issued by Goldman made them ideal for betting against. As of September 2007, for example, just five months after Goldman had sold a new Abacus C.D.O., the ratings on 84 percent of the mortgages underlying it had been downgraded, indicating growing concerns about borrowers’ ability to repay the loans, according to research from UBS, the big Swiss bank. Of more than 500 C.D.O.’s analyzed by UBS, only two were worse than the Abacus deal.
Goldman created other mortgage-linked C.D.O.’s that performed poorly, too. One, in October 2006, was a $800 million C.D.O. known as Hudson Mezzanine. It included credit insurance on mortgage and subprime mortgage bonds that were in the ABX index; Hudson buyers would make money if the housing market stayed healthy — but lose money if it collapsed. Goldman kept a significant amount of the financial bets against securities in Hudson, so it would profit if they failed, according to three of the former Goldman employees.
A Goldman salesman involved in Hudson said the deal was one of the earliest in which outside investors raised questions about Goldman’s incentives. “Here we are selling this, but we think the market is going the other way,” he said. A hedge fund investor in Hudson, who spoke on the condition of anonymity, said that because Goldman was betting against the deal, he wondered whether the bank built Hudson with “bonds they really think are going to get into trouble.”
Indeed, Hudson investors suffered large losses. In March 2008, just 18 months after Goldman created that C.D.O., so many borrowers had defaulted that holders of the security paid out about $310 million to Goldman and others who had bet against it, according to correspondence sent to Hudson investors. The Goldman salesman said that C.D.O. buyers were not misled because they were advised that Goldman was placing large bets against the securities. “We were very open with all the risks that we thought we sold. When you’re facing a tidal wave of people who want to invest, it’s hard to stop them,” he said. The salesman added that investors could have placed bets against Abacus and similar C.D.O.’s if they had wanted to.
A Goldman spokesman said the firm’s negative bets didn’t keep it from suffering losses on its mortgage assets, taking $1.7 billion in write-downs on them in 2008; but he would not say how much the bank had since earned on its short positions, which former Goldman workers say will be far more lucrative over time. For instance, Goldman profited to the tune of $1.5 billion from one series of mortgage-related trades by Mr. Egol with Wall Street rival Morgan Stanley, which had to book a steep loss, according to people at both firms.
Tetsuya Ishikawa, a salesman on several Abacus and Hudson deals, left Goldman and later published a novel, “How I Caused the Credit Crunch.” In it, he wrote that bankers deserted their clients who had bought mortgage bonds when that market collapsed: “We had moved on to hurting others in our quest for self-preservation.” Mr. Ishikawa, who now works for another financial firm in London, declined to comment on his work at Goldman.
Profits From a Collapse
Just as synthetic C.D.O.’s began growing rapidly, some Wall Street banks pushed for technical modifications governing how they worked in ways that made it possible for C.D.O.’s to expand even faster, and also tilted the playing field in favor of banks and hedge funds that bet against C.D.O.’s, according to investors.
In early 2005, a group of prominent traders met at Deutsche Bank’s office in New York and drew up a new system, called Pay as You Go. This meant the insurance for those betting against mortgages would pay out more quickly. The traders then went to the International Swaps and Derivatives Association, the group that governs trading in derivatives like C.D.O.’s. The new system was presented as a fait accompli, and adopted.
Other changes also increased the likelihood that investors would suffer losses if the mortgage market tanked. Previously, investors took losses only in certain dire “credit events,” as when the mortgages associated with the C.D.O. defaulted or their issuers went bankrupt. But the new rules meant that C.D.O. holders would have to make payments to short sellers under less onerous outcomes, or “triggers,” like a ratings downgrade on a bond. This meant that anyone who bet against a C.D.O. could collect on the bet more easily.
“In the early deals you see none of these triggers,” said one investor who asked for anonymity to preserve relationships. “These things were built in to provide the dealers with a big payoff when something bad happened.” Banks also set up ever more complex deals that favored those betting against C.D.O.’s. Morgan Stanley established a series of C.D.O.’s named after United States presidents (Buchanan and Jackson) with an unusual feature: short-sellers could lock in very cheap bets against mortgages, even beyond the life of the mortgage bonds. It was akin to allowing someone paying a low insurance premium for coverage on one automobile to pay the same on another one even if premiums over all had increased because of high accident rates.
At Goldman, Mr. Egol structured some Abacus deals in a way that enabled those betting on a mortgage-market collapse to multiply the value of their bets, to as much as six or seven times the face value of those C.D.O.’s. When the mortgage market tumbled, this meant bigger profits for Goldman and other short sellers — and bigger losses for other investors.
Selling Bad Debt
Other Wall Street firms also created risky mortgage-related securities that they bet against. At Deutsche Bank, the point man on betting against the mortgage market was Greg Lippmann, a trader. Mr. Lippmann made his pitch to select hedge fund clients, arguing they should short the mortgage market. He sometimes distributed a T-shirt that read “I’m Short Your House!!!” in black and red letters.
Deutsche, which declined to comment, at the same time was selling synthetic C.D.O.’s to its clients, and those deals created more short-selling opportunities for traders like Mr. Lippmann. Among the most aggressive C.D.O. creators was Tricadia, a management company that was a unit of Mariner Investment Group. Until he became a senior adviser to the Treasury secretary early this year, Lewis Sachs was Mariner’s vice chairman. Mr. Sachs oversaw about 20 portfolios there, including Tricadia, and its documents also show that Mr. Sachs sat atop the firm’s C.D.O. management committee.
From 2003 to 2007, Tricadia issued 14 mortgage-linked C.D.O.’s, which it called TABS. Even when the market was starting to implode, Tricadia continued to create TABS deals in early 2007 to sell to investors. The deal documents referring to conflicts of interest stated that affiliates and clients of Tricadia might place bets against the types of securities in the TABS deal. Even so, the sales material also boasted that the mortgages linked to C.D.O.’s had historically low default rates, citing a “recently completed” study by Standard & Poor’s ratings agency — though fine print indicated that the date of the study was September 2002, almost five years earlier.
At a financial symposium in New York in September 2006, Michael Barnes, the co-head of Tricadia, described how a hedge fund could put on a negative mortgage bet by shorting assets to C.D.O. investors, according to his presentation, which was reviewed by The New York Times. Mr. Barnes declined to comment. James E. McKee, general counsel at Tricadia, said, “Tricadia has never shorted assets into the TABS deals, and Tricadia has always acted in the best interests of its clients and investors.” Mr. Sachs, through a spokesman at the Treasury Department, declined to comment.
Like investors in some of Goldman’s Abacus deals, buyers of some TABS experienced heavy losses. By the end of 2007, UBS research showed that two TABS deals were the eighth- and ninth-worst performing C.D.O.’s. Both had been downgraded on at least 75 percent of their associated assets within a year of being issued. Tricadia’s hedge fund did far better, earning roughly a 50 percent return in 2007 and similar profits in 2008, in part from the short bets.
Are Big Banks Pumping Up Stock Prices?
Even though big banks have received untold billions in bailout funds, banks are not lending. Where did all the money go? Much of it went right back to the government as banks have loaded up on all sorts of Treasury bonds. But where did the rest go?
Real estate prices are still falling, unemployment is sky-high, consumer spending is down and corporate profits are nowhere near to last year's levels. The only thing that provides comfort for the masses is rising stock prices. The S&P 500, Dow Jones and Nasdaq have gained in excess of 65% in less than ten months against a backdrop of continuously less than stellar news. The government, banks and other financial institutions have a vested interest in rising stock prices.
Things would look grim if it wasn't for the hope provided by the Dow and S&P's of the world. But more than hope is at stake. Another drop in investor's perception would send real estate and equity prices tumbling. It could also push many financial institutions to the brink of ruin and discredit all government efforts. Looking at what's at stake and the motivations involved, could it be that some of the big players are manipulating the market to keep prices artificially afloat?
A secret committee
Don't you hate it when juicy news is making its rounds but you are kept out of the loop? Welcome to the club. Already back in 1988, Ronald Reagan signed an executive order to establish a specific committee designed to prevent major market collapses. As per this order, the Secretary of the Treasury, the chairman of the Federal Reserve, the chairman of the SEC and the chairman of the commodity futures trading commission make up the core of this team. By extension, major financial institutions like JP Morgan Chase and Goldman Sachs are used to execute their orders.
The existence of this team is said to have been confirmed by former Clinton advisor George Stephanopoulos on Good Morning America. Last year, former Treasury Secretary Hank Paulson called for this 'financial fraternity' to meet with greater frequency and set up a command center at the U.S. Treasury designed to track global markets and serve as headquarter for the next crisis. There is much more to this unique arrangement designed to keep a lid an potential market meltdowns and use major Wall Street firms as marionettes to accomplish this goal. A detailed report about this secret team is available in the most recent issue of the ETF Profit Strategy Newsletter.
Artificially inflating prices, how?
Supply and demand drives prices. Where the demand comes from does not matter. In emergency situations, the Federal Reserve is said to lend money to major banks, which serve as surrogates who will take the money and buy markets, predominantly futures, through large unknown accounts. The timing of those buys will be such that those shorting the market will be forced to buy back shares. In theory, this eliminates the most pessimistic investors and causes others to buy. Soon sideline money from mutual and hedge funds comes in and the rally gathers a life of its own.
A close ally
One of the obvious suspects to serve as surrogate and carry out the government's plan would be Goldman Sachs. For years, the ties between the U.S. government and Sachs have been too close for comfort. Earlier this year the ETF Profit Strategy Newsletter touched on a case of 'indiscretion' which never received much publicity. Stephen Friedman, the chairman of the New York Fed was instrumental in orchestrating the multi-billion bailout for Goldman and AIG. AIG used nearly $10 billion of the initial $85 billion to pay Goldman.
Chairman of the New York Fed was not the only title Mr. Friedman held. He also happened to be on Goldman's board during that time and was Goldman's CEO in the 1990s. Also during that time, Mr. Friedman was actively buying Goldman stock and generated profits worth millions of dollars. Other ties between government and Sachs include Hank Paulson, former Secretary of the Treasury and former Goldman CEO. When Mr. Paulson needed someone to oversee see the government's first $700 billion bailout, Paulson recruited an inexperience, 35-year old, former Goldman investment banker. The list continues, but we'll stop here.
Putting the odds in your favor
The Financial Times reported that Goldman Sachs suffered only one losing day during the 65 business days of the third quarter. On 36 separate days during the quarter, the firm's trades netted more than $100 million. In addition, Bloomberg reported that Goldman Sachs' effective income tax rate for 2008 was 1%. In dollars, Goldman's tax liability was $14 million. For the same year, Goldman reported a $2.3 billion profit and paid out $10.9 billion in bonuses. One could argue that a record of 90%+ winning trades and a 1% tax rate could only be accomplished with certain connections to high-ranking government personnel.
Is it possible?
The notion that prices can be inflated artificially makes sense and sounds good in theory. Based on the evidence, this kind of maneuvering even seems to be more common than we think. But a simple look at the chart shows that even the government and big banks do not have superhuman powers, at least not unconditionally. In 2000, 2002, 2008 and 2009, the major indexes a la S&P 500, Dow Jones and Nasdaq declined 30% or more. It is now known, as it was back then, that the nation's most powerful financiers got together on October 24, 1929 to prevent a major meltdown. Their plan succeeded on that very day which came to be known as Black Thursday. The recovery on Black Thursday was as remarkable as the selling that made it so Black.
On Friday, the Times reported that the financial community felt 'secure in the knowledge that the most powerful banks in the country stood ready to prevent a recurrence of panic.' In a concerted advertising campaign in Monday's papers, stock market firms urged to pick stocks at bargain prices. The rest is history and the Great Depression unfolded in all its cruel ways. One of the flaws of artificial buying is that all the money used to buy stocks will eventually have to be taken out. As we know, banks are not immune to greed and once prices start declining, banks are likely to be the first to cut their losses and flee the sinking ship.
What goes up ...
In summary, we can conclude that there seems to be an organized committee with the job description of lifting markets. Quite likely, their efforts have contributed to the protracted rally in stock prices. However, as we've seen, the market is too wild to be contained. Normal market forces still apply. One of those age-old forces is investor sentiment, possibly the best known and most accurate contrarian indicator around. Extreme levels of pessimism tend to signal market bottoms while extreme levels of optimism tend to signal tops.
The ETF Profit Strategy Newsletter used this contrarian indicator as a foundation to issue the March 2nd Trend Change Alert which foretold a massive rally with a target range of Dow 9,000 - 10,000 a mere seven days before the March lows were reached. Now once again, we see an extreme of investor sentiment - this time it's optimism. According to the Investors Intelligence survey, this week saw the highest percentage of bulls since December 2007. More importantly, the major indexes are butting up against levels of resistance that have been years, even decades in the making. Those different resistance levels converge in the Dow 10,100 - Dow 10,500 range, which is the very range the Dow has been stuck in for over three months.
The ETF Profit Strategy Newsletter includes an analysis of predominant, and probably formidable, levels of resistance along with a short, mid and long-term forecast, and a target range for the ultimate market bottom. If history is a guide, and it usually is, the market will do what it wants, regardless of the government's efforts. The question is this: Who are you putting your trust in, the market or big banks?
Taxpayer Burden Eases to $8.2 Trillion as Obama Supplants Fed
Congress and the Obama administration are taking a bigger role in the rescue of the economy from the Federal Reserve, shifting the strategy to stimulus spending from central bank lending. The amount the Fed and U.S. agencies have lent, spent or guaranteed has fallen 15 percent since September to $8.2 trillion, the lowest in a year, based on data compiled by Bloomberg. Spending on infrastructure, tax breaks and other fiscal measures account for 52 percent of the total, up from 39 percent in March, as central bank loan programs are phased out.
The change marks a new phase of public intervention in the economy. Congress and the administration’s $4.2 trillion portion, which amounts to 30 percent of everything produced in the country this year, also complicates any future exit strategy. It may be tough for elected officials to quit spending, prolonging the bailout and adding to the federal budget deficit. “There’s a danger of getting addicted to fiscal stimulus programs,” said David Wyss, chief economist with New York-based Standard & Poor’s, in an interview. “The Fed can print money. Government has to raise taxes or borrow more.”
The U.S. House of Representatives last week increased the federal government’s debt ceiling $290 billion to $12.4 trillion. It also passed a $154 billion economic aid package to pay for extended unemployment benefits, new infrastructure projects and help to state governments. Commitments by Congress to spend more than $984 billion, or about 8 percent of the national debt, include stimulus packages championed by President Barack Obama and President George W. Bush and a November 2008 change in the tax code to encourage large banks to buy smaller ones.
The U.S. has run 14 consecutive monthly budget deficits and 7.3 million people have lost their jobs since the beginning of the recession in December 2007, according to the Treasury Department. Monthly budget shortfalls have outnumbered surpluses almost 2 to 1 this decade, according to Treasury data. “We can’t continue to spend as if deficits don’t have consequences, as if waste doesn’t matter, as if the hard-earned tax dollars of the American people can be treated like Monopoly money,” Obama said Dec. 21 at the White House.
The Obama administration still has about half its $787 billion stimulus package to spend, according to the Office of Management and Budget. The Fed has shut or is phasing out the 10 support programs it created after August 2007 as the financial system recovers from the longest recession since the 1930s.
As the economy improves, policy makers are pulling back liquidity to prevent inflation and asset bubbles. The European Central Bank last week raised the interest rate on its tender of 12-month loans to the one-year average of the bank’s benchmark, a departure from its policy of offering the money at a fixed 1 percent. The ECB said it will also cease lending for six months at the end of the first quarter. The S&P 500 Index has climbed 24 percent this year, its second-biggest annual percentage gain this decade. That has helped banks make money outside of Fed programs. In the first nine months of the year, Goldman Sachs Group Inc.’s trading revenue doubled to a record $27.3 billion, while JPMorgan Chase & Co.’s climbed 122 percent to $17.9 billion, according to company reports.
Spreads on U.S. corporate debt, which show the risk premium that investors demand to own them instead of government bonds, have plunged to below 2 percentage points from more than 6 percentage points at the start of the year, according to the Merrill Lynch U.S. Corporate Master Index. That’s the most spreads have narrowed this decade, the data show. The Fed’s plan to buy $1.25 trillion of mortgage-backed securities is its largest spending program. The Fed holds $901.2 billion of the securities and is scheduled to complete the purchases in the first quarter.
That will leave the central bank “walking a tightrope” between blocking economic recovery and sparking a rise in prices, according to Dan Greenhaus, chief economic strategist at Miller Tabak & Co. in New York. The Fed’s balance sheet ballooned to $2.24 trillion in assets as of last week, up 142 percent from the beginning of 2008. Selling some of those assets to take money out of the economy has its risks, Greenhaus said. “You have to ensure economic expansion without fanning inflation and assess prospects for asset bubbles while bringing down the unemployment rate,” Greenhaus said in an interview. “The difficulties can’t be easily dismissed.”
Consumer prices rose 1.8 percent in November compared with a year ago and have increased by an average 2.6 percent over the last decade, according to the U.S. Bureau of Labor Statistics. As U.S. banks have rebuilt their balance sheets after taking $1.1 trillion of losses and writedowns, according to data compiled by Bloomberg, they’ve tapped the central bank less. The Fed said there’s been no borrowing from the Term Securities Lending Facility since mid-August and from the Primary Dealer Credit Facility since mid-May. The central bank will phase out both programs. The Asset-Backed Commercial Paper Money Market Fund Liquidity Facility hasn’t attracted customers since May. The Fed has indicated it will expire Feb. 1.
The Fed will shorten the maturity dates of primary credit loans at the discount window to 28 days from 90 days starting Jan. 14 as banks are better able to find funding themselves. The central bank said it will close the Commercial Paper Funding Facility, the Primary Dealer Credit Facility and swap lines with foreign central banks on Feb. 1 and the Term Asset-Backed Securities Loan Facility, or TALF, on June 1. The Money Market Investor Funding Facility, known as MMIFF, was shuttered on Oct. 30. The Fed’s planned purchase of $300 billion of longer-term Treasury securities was also completed at the end of October.
US state unemployment funds going ‘absolutely broke’
The recession's jobless toll is draining unemployment-compensation funds so fast that according to federal projections, 40 state programs will go broke within two years and need $90 billion in loans to keep issuing the benefit checks. The shortfalls are putting pressure on governments to either raise taxes or shrink the aid payments. Debates over the state benefit programs have erupted in South Carolina, Nevada, Kansas, Vermont and Indiana. And the budget gaps are expected to spread and become more acute in the coming year, compelling legislators in many states to reconsider their operations.
Currently, 25 states have run out of unemployment money and have borrowed $24 billion from the federal government to cover the gaps. By 2011, according to Department of Labor estimates, 40 state funds will have been emptied by the jobless tsunami. "There's immense pressure, and it's got to be faced," said Indiana state Rep. David Niezgodski (D), a sponsor of a bill that addressed the gaps in Indiana's unemployment program. "Our system was absolutely broke."
The Indiana legislation protected the aid checks, Niezgodski said, but it came after a give-and-take this spring in which Gov. Mitchell E. Daniels Jr. (R) said the state had been providing "Rolls-Royce benefits" and several thousand union workers countered by protesting proposed cuts at the state capitol. In January, the legislature is slated to consider a bill to delay the proposed tax increases intended to refill the fund. In Nevada, Gov. Jim Gibbons (R) and legislators have feuded over the unemployment program, which is $85 million in debt to the federal government, with Gibbons accusing the legislature of "callous disregard" for not setting a tax rate.
And last week, a state task force in Kentucky recommended cutting benefits about 9 percent and imposing a week's delay in their payment. The average benefit check there is about $309 a week. The task force also proposed raising taxes. "There were some moments of high anxiety" during the negotiations between industry and labor groups, said Joseph U. Meyer, the state's acting secretary of education and workforce development. "But in the end, the realistic options became fairly apparent."
State unemployment-compensation funds are separated from general budgets, so when there is a shortfall, only two primary solutions are typically considered -- either cut the benefit or raise the payroll tax. Industry and business groups often lobby against raising the payroll tax on employers, while unions and other worker groups protest benefit cuts. "We want to make sure Kentucky remains competitive and also maintain an environment of fairness," Meyer said of the negotiations. Nationally, the average tax is about 0.6 percent of payroll; the average weekly check is about $300.
The troubles the state programs face can be traced to a failure during the economic boom to properly prepare for a downturn, experts said. Unemployment benefits are funded by the payroll tax on employers that is collected at a rate that is supposed to keep the funds solvent. Firms that fire lots of people are supposed to pay higher rates. The federal government pays for administrative costs, and in a recession, it pays for the extension of unemployment benefits beyond 26 weeks. But over the years, the drive to minimize state taxes on employers has reduced the funds to unsustainable levels.
"The benefits haven't grown -- that's not the problem," said Richard Hobbie, director of the National Association of State Workforce Agencies. Even so, he said, he expects to see unemployment checks reduced. A shortfall in a state unemployment fund, he said, "usually means cuts in eligibility or benefits." In Virginia, the unemployment program has borrowed $89 million from the federal government, while Maryland has not borrowed, according to the federal data.
Wayne Vroman, an expert in unemployment insurance at the Urban Institute, said that entering the recession, state programs were on average funded at only one-third the level they should have been, according to generally accepted funding guidelines. "If you fund a program adequately, you don't need to come to these kinds of difficult decisions," he said. Before the recession, he said, the funding guidelines "were rarely honored." While the amount of the states' loans from the federal government is expected to grow rapidly, it is not expected to add to the federal debt. "In the past, the federal government has always gotten its money back," Vroman said.
In the meantime, however, more states are struggling to fill the gap. West Virginia imposed a freeze on benefit levels this year, and legislators in South Carolina are considering one.
"We've obviously got problems with the fund," said South Carolina House Majority Leader Kenny Bingham (R), blaming the trouble in part on the state's unemployment rate of more than 12 percent. The state owes about $654 million to the federal government for unemployment payments. "We're not trying to cut benefits," he said. But "if you jack rates up, those business that are struggling to hang on, you make things more difficult."
Schwarzenegger to seek federal help for California budget
Facing another huge deficit, the governor wants $8 billion or threatens massive cuts in social services. He also plans to renew push for offshore oil drilling.
Facing a budget deficit of more than $20 billion, Gov. Arnold Schwarzenegger is expected to call for deep reductions in already suffering local mass transit programs, renew his push to expand oil drilling off the Santa Barbara coast and appeal to Washington for billions of dollars in federal help, according to state officials and lobbyists familiar with the plan. If Washington does not provide roughly $8 billion in new aid for the state, the governor threatens to severely cut back -- if not eliminate -- CalWORKS, the state's main welfare program; the In-Home Health Care Services program for the disabled and elderly poor, and two tax breaks for large corporations recently approved by the Legislature, the officials said.
Schwarzenegger also will propose extending a cut in the state payroll that is scheduled to expire this summer. That cut has translated into 200,000 state workers being furloughed three days a month, the equivalent of a 14% pay cut. Lawmakers would have the option of extending the furloughs, imposing layoffs or some combination of the two. The governor is scheduled to unveil his plan publicly early next month. Administration spokesman Matt David declined to comment on the details.
The governor and lawmakers have already had to close shortfalls this year totaling $60 billion, as tax revenues plummeted at rates not seen in California since the Great Depression. Amid the continuing budget crisis, the state ran short of cash needed to cover its bills and was forced to issue IOUs over the summer. Activists were particularly alarmed by the potential cuts to social service programs, which have taken big hits recently.
"Families are struggling, we have an incredibly high unemployment rate, and we can't afford to cut these programs any more," said Nancy Berlin, director of California Partnership, a statewide coalition of advocates for the poor based in Los Angeles. "Sacramento has got to pull it together and find another way out of this. They can't take more from low-income families. If they do, we will find more people on the streets."
Jean Ross, executive director of the California Budget Project, a think tank focused on how budget policies affect low-income Californians, was similarly critical of the proposals for CalWORKS and in-home healthcare. But she said the administration was justified in pushing for more federal dollars. "There is a strong case not only here in California but across the country for continued federal aid to the states," she said. "Absent additional assistance we could see state governments prolonging the national economic downturn by continuing to cut their budgets."
Schwarzenegger's pitch for federal assistance will hit on familiar themes: Californians pay substantially more in federal taxes than make it back to the state, the crushing burden of unfunded federal mandates, the way funding formulas have made it impossible for the state to trim certain programs. The governor sent a letter to the state's congressional delegation Tuesday night in which he demanded more money for federal healthcare programs for which the state is paying part of the tab. He warned that the historic healthcare reforms poised for passage in Congress may add to the burden, costing the state as much as $4 billion annually.
Senate President Pro Tem Darrell Steinberg (D-Sacramento), in an interview last week, said: "I'm planning to spend a lot of time in Washington. I have to. . . . The national economic recovery is tied to California's economic recovery." California's budget deficit has grown so large -- roughly 20% of the general fund -- that some measure of cuts to social service programs may be inevitable regardless of how Washington responds.
Big business may also take a hit. The governor is prepared to support rolling back two large corporate tax breaks that GOP lawmakers inserted into recent state spending plans. The $1 billion in mass transit and other transportation money the governor will propose raiding is supposed to be off limits to the state for plugging budget gaps. Court rulings have declared previous attempts to get at it illegal. The administration will seek to get around those rulings through a complex gas tax swap. As part of the scheme, an existing sales tax on gasoline would be eliminated and, at the same time, a new per-gallon excise tax would be imposed. The price at the pump would drop about 5 cents per gallon
The shift would gut a voter-approved measure, Proposition 42, that protects how current gas taxes are spent. Public transit -- buses, rail and other forms of mass transportation -- now receives 20% of all gas sales tax. After the tax swap, that requirement would disappear. The tax swap could also cost schools -- as it would result in the share of tax revenues they are entitled to under state law dropping by more than $800 million.
Jim Earp, executive director of California Alliance for Jobs, a group that advocates for public works spending -- including on transportation -- derided the plan as a scheme "to rob Peter to pay Paul." "We're not solving any problems. We're just moving money around from one cup to another," Earp said.
One new source of revenue in the budget: Schwarzenegger will revive a plan to allow offshore oil drilling from an existing platform off the Santa Barbara coast. The proposal was so controversial during last summer's budget debate that after the Assembly voted down the plan, members expunged the vote, erasing it from the public record.
Bill Magavern, a Sierra Club lobbyist, said the drilling proposal has already been rejected by the State Lands Commission, which typically has jurisdiction over such matters. "This would be the first new offshore oil drilling in state waters in decades," he said. "It is something that should be considered on the substance at the State Lands Commission. It should not be decided as part of budget politics."
Schwarzenegger would count $200 million in revenues from the new oil drilling for the budget. Most of the governor's plans probably will confront stiff legislative opposition. That includes his proposal to continue the furloughs of state workers, which he implemented through executive order this year. "We need to find an alternative for one or two days," Steinberg, the Senate leader, said last week. "Beyond one day is just unfair and fiscally it doesn't make sense."
Small-business bankruptcies rise 81% in California
The Obama administration's new plan to give a boost to small businesses reflects continued trouble in that sector, which is facing new failures even as much of the nation's economy is stabilizing. As credit lines have shrunk and consumers have cut back on spending, thousands of small businesses have closed their doors over the last year. The plight of struggling firms has been aggravated by the reluctance of banks to lend money, said Brian Headd, an economist at the Small Business Administration's office of advocacy.
"While bankruptcies are up, overall, small-business closures are up even more," Headd said. California has been particularly hard hit. The latest data show small-business bankruptcies up 81% in the state for the 12 months ended Sept. 30, compared with the previous year. Filings nationwide were up 44%, according to the credit analysis firm Equifax Inc. The actual number of small businesses in trouble is probably higher, experts said, because many owners file for personal bankruptcy rather than seek protection for the business.
Dennis McGoldrick, a bankruptcy lawyer in Torrance, said his clients are all stuck in similar situations -- capital is hard to come by, customers are tough to attract and debt is piling up. "We can't keep up," McGoldrick said. "There's more people that want to come in every day than I can see." Cecily McAlpine, who filed for bankruptcy protection for her Cold Stone Creamery franchise this spring, said the experience was humiliating but she had no choice. Receipts at the fledgling Compton ice cream shop plunged dramatically during the recession, and by late 2008 she was paying her employees out of her pocket.
"When the refrigerator died, that was it; I'd just had it," McAlpine said. "That was the day I broke. I just started throwing stuff away." McAlpine recently withdrew her bankruptcy filing after selling all the store equipment and paying off her creditors. She is slowly paying off some back-rent and utility debt, and will officially dissolve her business in the next couple of weeks, she said. "I still feel scarred and like a loser," she said. "Even though I'm not in it anymore, it's still there."
Recognizing the problems of business owners like McAlpine, the Obama administration has proposed using federal stimulus money to help funnel more loans to small businesses. The White House has also asked Congress to eliminate capital gains taxes for one year on new investments in small-business stock, and called for a new tax incentive to encourage small businesses to hire more employees. On Dec. 14, Obama called a meeting of executives of Wells Fargo & Co., Citigroup Inc., Bank of America Corp. and nine other large banks, and told them that they owed it to the nation to make more loans to small businesses and help rebuild the economy.
In California, the need is great. Over the last year, the Los Angeles, Riverside/San Bernardino and Sacramento metropolitan areas have led the nation in small-business bankruptcy filings, said Tim Klein, a spokesman for Equifax. About 19,000 small businesses filed for bankruptcy in California during the 12 months ended Sept. 2009, up from 10,500 the previous year. During September alone, 2,229 small businesses filed for protection, up from 1,503 filings in September 2008, the firm reported.
Kathleen March, a bankruptcy lawyer in Los Angeles, said she often pushes her clients to file for personal bankruptcy instead of a business filing because it's easier. Many people also close down their businesses thinking that will solve their problems, only to find their companies' debt lives on, March said. "The norm is if you're running a small business, you will have to either cosign or personally guarantee the significant debts," she said. "The business itself can shut down, but the people cosigned all the debts. So, the individuals are then saddled with these huge debts."
A client who owned a surf shop was paying for business expenses from the client's own funds long before filing for personal bankruptcy, she said. "In this economy, anything that isn't a necessity is a tough business to be in," March said. "And the majority of my clients have waited too long to file for bankruptcy and in the process made things worse on themselves financially as a result."
New Home Sales Plunge 11.3%
Sales of new homes in the US dropped 11.3% to an annualized rate of 355k units in November. The consensus was for a rise of 2.3%. to 438,000 from 430,000 a month earlier. This is a really ugly number, far lower than the anticipated decline. It comes on the news of a 30K downward revision to 400k units annualized in October. New home sales are down 9.0% compared to November of last year when the annualized sales pace stood at 390k. That's right: new home sales are worse than they were at the height of the financial crisis.
Some additional data points:
- The median new home sales price was $217,400, a 3.8% increase over the month and a 1.9% decline over the past year.
- The average new home sales price increased 9.5% to $280,300 over the month, reflecting a 3.4% decline over the past year.
- The inventory of new homes available for sale at the end of the month dropped to a 7.9 month supply. That's a decline of 5,000 to 235,000 units.
- Over the past year, new homes available for sale are down 36.5% while the inventory of new homes is down 30.7%.
- The South took the worst beating, with a decline in new home sales of 21.1&. The West saw a decline of 9.2%. The Midwest saw the strongest performance, with sales rising 21.4% over the month.
Regulator approves $6 million salaries for Fannie, Freddie execs
The top U.S. housing regulator said on Thursday it approved 2009 pay packages of up to $6 million each for the chief executives of government-controlled mortgage giants Fannie Mae and Freddie Mac. The approvals were part of a wider decision by the Federal Housing Finance Agency on executive salaries at both firms. FHFA Acting Director Edward DeMarco said, on average, executive pay at the companies had dropped 40 percent from where it stood before the government seized them last year.
In filings with the Securities and Exchange Commission, the companies said Fannie Mae CEO Michael Williams and Freddie Mac CEO Charles Haldeman would each receive up to $6 million in total compensation for 2009. Freddie Mac said the same figure would apply to the Haldeman's pay package for next year, as well.
Fannie Mae and Freddie Mac, which play a role in funding three-fourths of all U.S. residential mortgages, were seized by the government and put into conservatorship in September 2008 at the peak of the credit crisis. To continue playing that role in the U.S. mortgage market, Fannie and Freddie must "attract and retain the talent needed to accomplish these objectives," DeMarco said. The announcement came less than 24 hours after the Obama administration's pay czar, Kenneth Feinberg, approved millions of dollars in pay for top executives at GM and GMAC. Feinberg oversees compensation plans at firms receiving money from the government's $700 billion financial rescue fund.
FHFA said the Fannie Mae and Freddie Mac compensation plans use the same basic structure as the Feinberg plans and were approved in consultation with the U.S. Treasury. Pay curbs imposed by Feinberg sent financial giants Citigroup Inc and Bank of America Corp rushing to exit the government bailout program to avoid compensation restrictions. Fannie and Freddie do not have that luxury because the government now controls nearly 80 percent of each company.
The CEO compensation packages are "more than what is needed for them to serve their function," said Thomas Lawler, founder of Lawler Economic & Housing Consulting in Leesburg, Virginia. "To give to someone that much to just stay on makes you question just how critical they really are." Still, the pay packages at Fannie Mae and Freddie Mac represent a sharp departure from the practices in place at the height of the U.S. housing boom. Former Fannie Mae Chief Executive Franklin Raines was paid $91 million between 1998 and 2003, some of which was clawed back in a settlement with regulators over his role in an accounting scandal at the company. His successor, Daniel Mudd, was paid $13.4 million in 2007.
Williams took the helm of Fannie Mae in April when the company's previous CEO, Herb Allison, took a job at the Treasury Department overseeing the financial bailout fund. Allison, who had declined to take a salary while at Fannie Mae, now makes in the low six figures annually. Haldeman took the Freddie Mac position in July and the company then disclosed he would be paid $900,000 in salary without disclosing other forms of compensation. Haldeman is the former chief executive of Putnam Investments in Boston. The companies and their regulator said the executive pay packages for 2009 and 2010 would consist of a base salary, performance-linked incentive pay and a deferred salary.
Treasury still gripped by Fannie and Freddie
Deep inside the US Treasury building a small team of officials is working on a high-stakes project – Fannie Mae and Freddie Mac: the Sequel. Early in the New Year we will get the trailer for the movie. And it should make interesting viewing. In July 2008, before the wider world had heard of Lehman Brothers, Fannie Mae and Freddie Mac were the focal points of the financial crisis. The two government-sponsored enterprises – companies with private shareholders operating under government charters – had issued several thousand billions of dollars of mortgage guarantees and debt against a thin cushion of capital.
As the housing crash eroded that capital, lenders drew back, forcing the Bush administration to step in, putting the firms under the control of regulators and lining up $100bn (€70bn, £63bn) each to recapitalise them as needed to keep them out of bankruptcy. Since then the two GSEs have continued to support mortgage finance with Federal Reserve help. It has bought more than $1,000bn of their securities. The Obama administration doubled the amount of funds lined up to invest in Fannie and Freddie to $200bn each in March but deferred detailed discussion of their future to 2010.
However, on December 31 the administration’s authority to increase the $200bn per firm without recourse to Congress expires, forcing it to decide whether to increase the amount first. Fannie and Freddie have already drawn $112bn between them. Barclays Capital estimates Fannie will ultimately need $130bn and Freddie $100bn. But in a stress scenario Fannie would need about $180bn – close to the $200bn limit. Increasing the limit would be prudent – but politically costly. The administration might lower the interest rate it earns on its investment in them instead, which would amount to a further backdoor bail-out.
Then in February the administration is due to flesh out its thinking on the future of Fannie and Freddie. Options include the pre-crisis status quo; nationalisation; wind-down; transformation into regulated utilities; conversion into providers of insurance for covered bonds; and break-up into mini-GSEs. Team Obama does not start with a blank sheet of paper and will have to come up with a model that it can move to with minimal disruption. But it is important that the plan creates proper incentives, minimises and makes explicit the risks the taxpayer is being asked to bear and answers three basic questions.
- First, function. Does the US benefit from public goods provided by Fannie and Freddie? The answer is arguably yes. They standardise the mortgage market by providing credit guarantees such that the credit risk of all mortgage pools that meet their standards is the same. This ensures liquidity and the supply of mortgage finance in times of crisis.
- Second, subsidy. Does the government need to subsidise the provision of credit guarantees in order to achieve the public goods? The answer is surely no. It should make all guarantees explicit and charge a market-based price. One way to do this would be to auction blocks of guarantees. Alas it would be surprising if subsidy were eliminated, as that would raise the cost of finance and upset voters.
- Third, structure. What is the best structure to deliver public goods in housing finance with minimal subsidy and risk to taxpayers? Surely not the hybrid GSE model with all its conflicts of interest.
A good case can be made for nationalisation. Alternatively, the government could auction off a dozen Fannie and Freddie-style charters, giving the winners the right to purchase government credit guarantees. Even if the guarantees were underpriced, the government would recoup much of the subsidy through auctioning the right to buy them. In any event successor entities should not be allowed to retain large portfolios of their own securities.
There will be pressure on the administration to duck tough choices and produce a bland options paper in February. Let us hope not. Legislation to restructure Fannie and Freddie may not be feasible until after the 2010 mid-term elections in November. But private sector players need at least a good preview of the role the government wants to play in housing finance before they can reconstruct the private markets that sit alongside it. The longer they have to wait, the slower the recovery in housing will be.
FDIC Draws Brisk Bidding on Loans by Failed Banks
Investors are jostling for the chance to buy a $1.1 billion package of commercial real-estate loans extended by failed banks, as these once-toxic assets attract growing interest. More than a dozen investors, including Texas banker Andrew Beal, have submitted bids to the Federal Deposit Insurance Corp. for the portfolio of loans held by Franklin Bank, IndyMac Bank and other failed lenders, according to people familiar with the matter. But the portfolio represents only a fraction of the real-estate loans held by the FDIC and the volume is mounting as more banks fail.
The FDIC, which declined to comment on pending transactions, is expected to announce the winning bidder within weeks in what will be its second-largest bulk sale of commercial-property assets since the downturn. The largest deal involved the sale in October of about $5 billion in condominium loans and other property made by now-defunct Corus Bank. Demand for these assets, at a discounted price, has grown intense. Investors have amassed billions of dollars to buy distressed loans and property much as investors like Sam Zell did in the early 1990s. "A lot of investors are anxious to invest cash they have raised," said David Tobin, a principal with Mission Capital Advisors, a loan-sale adviser.
But many banks won't sell. Some, especially community and regional banks, haven't marked down the value of their existing loan portfolios to current market rates—something that could jeopardize the survival of weaker lenders. Many hope the low cost of funds offered by historically low interest rates will let them earn their way out of trouble. "They don't want to be blowing the entire mess out at the low point of the cycle," says John Howley, an executive director and specialist in loan sales at Cushman & Wakefield, a real-estate firm. That makes the FDIC practically the only game in town. The agency has to sell off a growing pipeline of real-estate assets acquired from banks that collapsed after lending too aggressively to owners of offices, shopping malls, apartments and other commercial property.
Demand for its current package of loans is a consolation of sorts for the FDIC, which is trying to limit taxpayer losses and shore up its deposit-insurance fund. An avalanche of bank failures wiped out the fund in the third quarter of this year, putting it at negative $8.2 billion at the end of September. While the loans are expected to be sold for a steep discount, experts say, the competition should drive the price higher. Also, the FDIC is structuring the deal so taxpayers will share in the upside if the market improves.
Despite the strong interest from investors, the FDIC faces growing challenges to unload the assets. A total of 140 banks have gone belly up so far this year. Currently, the FDIC has about $30 billion in real-estate debt held by failed banks that is available for sale for the next 12 months, according to the agency. That figure is double the level a year ago. In most FDIC deals involving failed banks during the current downturn, the agency has lined up buyers to take over loans, deposits, branches and most other assets when the banks have failed. But for some failed banks like Corus, Franklin and IndyMac, the FDIC has decided to sell some hard-to-value assets separately. These bulk sales use a public-private partnership structure pioneered by the Resolution Trust Corp., a federal agency formed to clean up the savings-and-loan mess in the early 1990s.
The set-up enticed private investors to buy distressed real-estate assets while giving the government the opportunity to make money on behalf of taxpayers should the assets rise in value Since last year, the FDIC has sold residential and commercial loans through eight such partnerships, with the agency's equity interest ranging from 50% to 80%. Those partnerships bought loans at discounts ranging from pennies on the dollar to more than 50 cents on the dollar of face value. These structured deals, however, carry additional risk for the FDIC and, by extension, taxpayers. Because the agency takes a big chunk of the equity and provides financing, it stands to lose more if the markets continue to decline.
Under the options being considered for the $1.1 billion package, the FDIC would likely hold a 60% stake and provide financing. Deutsche Bank AG is advising the FDIC on the auction. The portfolio consists of mostly nonperforming commercial property loans. Both Franklin, led by mortgage-bond pioneer Lewis Ranieri, and IndyMac were best known as home-mortgage lenders. But they also lent heavily to home builders and other property developers during the boom times, in states from California to Texas.
According to Foresight Analytics, Franklin had a total of $1.6 billion in commercial real-estate loans as of the third quarter of 2008, before its closure last November, and IndyMac had about $2.8 billion in such loans before its failure in July 2008. Among the bidders for the portfolio is Mr. Beal, whose Beal Bank laid low during the boom years and avoided much of the real-estate bust. It has since gone on an opportunistic buying and lending binge, increasing its assets to more than $9 billion from $2.9 billion in 2007.
"We're in the business of buying loans," said Mr. Beal, a math whiz who likes to drive racecars in his spare time. "There are good opportunities, but investors have to be careful of what they buy and what they pay for."
He said the bank's goal is to buy performing loans at discounts. If the borrower defaults, the bank may modify the terms to bring it back to current. The bank would make money as long as the borrower stays current on modified terms.
Under(lying) Today's GDP Revisions (Or: "The Church of the Third Revelation")
by Marla Singer
We probably can't get more relevant commentary on today's absolutely massive downward GDP revision than that penned today by Goldman Sachs' Edward F. McKelvey:This was a much larger than normal revision for the third pass on a given quarter, knocking what once was a fairly robust 3.5% bounce down to a mediocre 2.2% (from 2.8% prior to this revision). All sectors except the trade balance -- a focal point of last month's downgrade -- saw some downward revision. Revisions were particularly deep in business investment -- to -5.9% from -4.1%, worth two tenths of the revision -- and in inventories (also worth nearly two tenths).
That would be those sectors that should, one would think, be among the easiest to count in the first place, especially on the second try.
Goldman is being very kind here. Goldman started off the day with this from GS Breakfast Bytes:GDP for Q3 (third estimate)... not much change, though risks lie to the downside. GS: +2.8%; median forecast (of 73): +2.8%, ranging from +2.5% to +3.7%; last (Q3 second estimate) +2.8%. The third cut on a given quarter does not usually produce much of a change in the growth estimate. In this case, the risks against our assumption of no change lie to the downside, reflecting large downward revisions to construction spending for August and September. Like many others, we do not see a meaningful probability of changes in the +0.5% estimate for the GDP price index or the +1.3% figure for the core PCE price index. (Emphasis ours).
It is difficult to get a more direct sense for how much mind share government bailouts (and government figures) have managed to command. That even the most pessimistic member of the "consensus" (n=73) managed to overshoot the mark by nearly 14% and the average sailed full speed into a 27% pop-up should remind us of three things:
- The Bureau of Economic Analysis of the United States Department of Commerce has ceased to be (if it ever was) a reliable outlet for economic data. (Be this the result of misfeasance or malfeasance depends on the reader's propensity to credit conspiracy theory).
- That what passes for the professional prognosticator class these days is pathologically incapable of realistic appraisal.
- That the largest single expression of a Keynesian "injection" in the history of Keynesians or injections (or the planet) struggled to create even the most anemic growth. Net the double counting of stimulus funds it seems difficult to imagine even a remotely encouraging (or positive) "growth" figure could be tortured out of the economic realities that would be so plain if one but looked out the window to forecast them.
If it isn't clear to everyone by this time that the United States remains firmly in the grips of a massive "shadow recession," then we can only credit this ignorance with some unshakable and deeply rooted form of denial or a seriously reckless case of willful blindness.
Either way, we would like to commend the current powers that be for their tour de force performance in establishing themselves firmly both as the most masterful of bullshit artists to occupy the beltway (and that's saying something) and simply the most economically inept (and expensive) team ever to hold national office. The risk adjusted returns on this particular ruling clique would make the pre-dollarization Zimbabwe carry trade look attractive.
If there is a silver lining to be found here it is probably that this little experiment might finally drive a splintered wooden stake through the heart of John Maynard Keynes' ghost (or at least irradiate Paul Krugman's ravings to within 50 rads of his professional life).
Top Ten Reasons Why the Yield Curve Will Flatten (Hint: This Is a Different Sort of Recession)
by David Goldman
As I told Larry Kudlow on CNBC Monday night, the employment recovery will be poorer than the market appears to expect, for reasons I’ve posted on this site during the past two weeks. The yield curve is at record steepness. I think that’s an overreaction. In fact, the steep yield curve in the present environment is NOT a harbinger of recovery — it’s a brake on recovery because it encourages banks to own Treasuries rather than risky assets (see below). Here are my top ten reasons to expect the yield curve to flatten.
10) The Treasury is shifting issuance to the long end of the curve, and the market is front-running the Treasury in anticipation of higher issuance. This effect is temporary.
9) Employment won’t come back because the unvarying source of employment recovery — small business — is flat on its back. The credit crunch for small business (with bankruptcies up 44% year on year) keeps getting worse (click to enlarge):
8) The health care bill (as Goldman Sachs observes) will put onerous requirements on the two out of five small businesses that do not presently have a health care plan and thus discourage future hiring;
7) Inflation on a CPI basis will remain muted because an all-in unemployment rate of 22% (including forced part-time and long-term discouraged workers) will keep wages down;
6) The steep yield curve will encourage banks to simply fund the Treasury deficit rather than add loans or non-Treasury securities to their balance sheets (click to enlarge):
As the graph makes clear, banks are buying massive quantities of Treasuries but cutting back on other securities as well as commercial and industrial loans. That is quite new: the long-term data don’t reveal a pattern quite like this any time in the past sixty years. But then again, this is an entirely different sort of recession.
5) The savings rate remains too low: for the Boomers to replace the wealth destroyed in the present crisis (including $6 trillion in home equity since 2007) it needs to exceed 10%. It’s only at 5% at present.
4) The Fed’s trillion-dollar infusion of credit into the economy (mainly through the purchase of mortgage-backed securities) will level off, suppressing the tax- and balance-sheet-driven uptick in the housing market (click to enlarge):
3) Continuing credit problems in Europe will weigh on global recovery;
2) Asia’s economic growth simply isn’t of sufficient scale to drag the US out of the recession;
1) And the top reason for the yield curve to flatten is: banks are swimming in money and have nowhere to put it except into the Treasury curve. Securitization of assets is a fraction of previous levels, business loans are shrinking, and the world economy simply can’t create assets at a rate to match bank requirements. But governments are creating assets–and that’s what the banks will buy.
Top hedge funds bet on problems, big rise in yields
The recent rise in long-term US interest rates comes as good news for several leading hedge fund managers, including John Paulson, who have positioned their trading books to benefit from higher yields on US Treasury securities. Mr Paulson, who made big gains earlier this decade by betting against the subprime mortgage market and whose firm, Paulson & Co, manages $33bn, has said he believes that government stimulus efforts would inevitably lead to higher inflation and a corresponding rise in rates.
"It will be difficult for the government to withdraw the economic stimulus," Mr Paulson said in a speech. "An increase in the monetary base leads to an increase in the money supply, which leads to inflation." Bond prices fall as yields rise, and Mr Paulson told the Financial Times last week that he has been hoping to benefit in the Treasury market by buying options that would become profitable if rates headed higher. TPG-Axon’s Dinakar Singh has been making similar options trades, according to a person familiar with the matter.
Julian Robertson, the hedge fund manager, has pursued a related strategy, hoping to benefit from a bigger difference between short-term and long-term interest rates, known as a steeper yield curve, a person familiar with his trades said. The yield on the 10-year Treasury, which hit a crisis low of 2.055 per cent last year, has moved from 3.2 per cent last month to 3.75 per cent on Tuesday.
Hedge fund managers, however, have been hesitant to engage in short sales of Treasury bonds to profit from the rising yields – and falling prices – because of the Federal Reserve’s heavy involvement in the market. This has led some to buy options – dubbed "high strike receivers" – that would enable them to profit from sharply higher Treasury yields, hedge fund managers say. These trades, which are relatively cheap to execute because they are so out of the money, are based on the thesis that yields could hit 7 or 8 per cent. "If they are right, and the world ends, they will make a fortune," said one fund manager who is sceptical of the idea. "If they are wrong, they haven’t lost much."
Some traders are cautious because many peers lost large sums betting that rates would rise in Japan in the 1990s – as yields fell to less than half a percentage point. The trade was termed the "black widow" because it left so many victims. "Nobody understood the extent of deflation and economic weakness in Japan," said Dino Kos of Portales Partners, a research consultancy, who was then a Fed official. "More money was lost on that trade than on any other single trade. Everyone piled in when rates were at 3 per cent and then at 2.5 per cent and then at 2 per cent."
Fitch warns that Britain and France risk losing their AAA rating
Fitch Ratings has given its bluntest warning to date that Britain and France risk losing their AAA status unless they map out a clear path to budget discipline over the next year. Highlighting the "unpleasant fiscal arithmetic" facing states across the Old World, Fitch said that none of the "arguably" benchmark AAA states can safely rely on their top rating for much longer. Public debt in both Britain and France will reach 90pc of GDP by 2011, higher than the 80pc (net) level when Japan lost its AAA rating earlier this decade.
Japan's error at the time was the failure to set out any serious plan to rein in spending, a lesson that the Europeans need to study closely. "The UK, Spain, and France must articulate credible fiscal consolidation programmes over the coming year, given the budgetary challenges they face in stabilising public debt. Failure to do so will greatly intensify pressure on their sovereign ratings," it said. Brian Coulton, Fitch's global strategist, said Labour had fallen well short in the pre-Budget report. "They did not articulate fully what needs to be done," he said.
One comfort is that revisions to the UK's Asset Protection Scheme have cut potential bank losses from 32pc of GDP earlier this year to just 14pc, and perhaps zero in the end. Mr Coulton said the surprise "mauvais élève" has been France, which has let its budget deficit balloon to 8.5pc of GDP next year - or higher including an off balance sheet "Grand Loan" of €35bn (£31bn) for investment projects - despite having suffered a mild recession. "It is one thing to run a large deficit when your economy has shrunk sharply, but this is self-inflicted. They are moving close to double digits. It is a concern," he said. The Dubai crisis has been a timely reminder that "contingent liabilities" are hazardous, coming back to haunt sovereign balance sheets.
Will The Last Person Please Burn The Building Down; It Is Time To End The Farce That Is The SEC
by Tyler Durden
The SEC sure has a sense of humor. With everyone screaming for the agency's blood unless it does something to curb rampant and blatantly speculative high frequency trading, as well as to tighten insider trading regulation, what does the Mary Schapiro-lead circus do? Just the opposite. And even as the commission is weeping that its $1 billion budget is woefully inadequate, the agency decides to reduce its own projected revenue in the form of Section 31 fees, to benefit the High Frequency Scalping brigade. The schizophrenic, sociopathic, deranged lunatics have certainly taken over the asylum at 100 F Street, NW Washington.
Zero Hedge has written previously about Section 31. We also, prophetically, pointed out, that the SEC is massively conflicted on the topic of HFT as the paradigm generates revenues for the agency. We, however, did not realize just how conflicted Mary Schapiro is, and just how pervasive the HFT lobby power is: in order to make the lives of High Frequency Traders easier (and their lobby ever wealthier), the SEC is willing to axe one of its own revenue streams. All this is happening even as the SEC is bleating daily that its catastrophic corruption and incompetence can be easily fixed by just one or two $100 million budget boosts. And with the US taxapayer raped daily by the administration, certainly not an ounce of KY will be needed to fill the... budget shortfall from making the P&Ls of HFTs even more artificially propped up.
Yes, we are not making this shit up. Read the following SEC press release and weep:Effective Jan. 15, 2010, the Section 31 fee rate applicable to securities transactions on the exchanges and over-the-counter markets will decrease to $12.70 per million dollars. Until that date, the current rate of $25.70 per million dollars will remain in effect. The Section 31 assessment on security futures transactions will remain unchanged at $0.0042 per round turn transaction. The Office of Interpretation and Guidance in the Commission's Division of Trading and Markets is available for questions regarding Section 31 and may be reached at (202) 551-5777 or by e-mail at firstname.lastname@example.org.So much for inflation:Under the Investor and Capital Markets Fee Relief Act, the Commission is required to adjust the filing and securities transaction fee rates on an annual basis to levels the SEC estimates will generate collections equal to numeric targets set in the statute. A copy of the Commission's April 30, 2009, order regarding fee rates under Section 6(b) of the Securities Act of 1933 and Sections 13(e), 14(g), and 31 of the Securities Exchange Act of 1934 for fiscal year 2010 is available at http://www.sec.gov/rules/other/2009/33-9030.pdf.And here is the piece de resistance that proves that the SEC is convinced only illiterate apes who have access to a busted abacus fetish read its press releases:The adjusted fee rates will not affect the amount of funding available to the Commission. The Commission will announce the new fee rates for fiscal year 2011 no later than April 30, 2010. These fee rates will become effective Oct. 1, 2010, or after the Commission's fiscal year 2011 appropriation is enacted, whichever is later.
We are certain that the GETCO et als of the HFScalping world have sent numerous "To Cash" checks and Christmas cards expressing their gratitude to the email@example.com address. We urge all our readers to do the same. After all, the ponzi casino has to be kept up one way or another, lest everyone realize just how hollow the US stock market truly is.
And since bullshit rarely travels alone, why should the SEC's public excretions, er, relations, machine be any exception. The other SEC press release that caught our eye is simply a stunner. It appears that the SEC is planning to gradually repeal Reg FD. Long live insider trading. They caught Raj Raj (and SAC is allegedly going down next) - so their quota for the next 20,000 years is now fulfilled.
If you feel like blowing chunks at your monitor, please read the following insanity:Washington, D.C., Dec. 22, 2009 — The Securities and Exchange Commission today announced that it has proposed amendments to Rule 163 under the Securities Act to further facilitate the ability of certain large companies to communicate with broader groups of potential investors and gauge the level of interest in the market for their securities offerings.
In other words, Reg FD can be circumvented in order to make sure that the 18,274th in a row follow-on offering for DDR or Kimco will go through without a glitch, 1E^1,000,000,000 dilution be damned.The proposed amendments would apply to companies that are "well-known seasoned issuers" (WKSIs) and would allow them to authorize an underwriter or dealer to communicate with potential investors on their behalf about potential securities offerings prior to filing registration statements for such offerings. Under the current Rule 163, only WKSIs are permitted to communicate directly with potential investors before filing a registration statement.
A WKSI is an issuer that is current and timely in its Exchange Act reports for at least one year and has either $700 million of publicly-held shares or has issued $1 billion of non-convertible securities, other than common equity, in registered offerings for cash in the preceding three years.
Thanks for the politically correct thesaurus SEC, but we all know that anyone looking up the definition of "well-known seasoned issuers" will see the logo of every single REIT/ML client extraordinaire for 2009.All other current requirements of Rule 163 would continue to apply, including that all communications made by or on behalf of the WKSI in reliance on the rule would be subject to Regulation FD (Fair Disclosure).
Oh really - and who gets to enforce Reg FD in this exclusionary context? You SEC? Last time we checked you were still in a dark corner attempting to discover your gluteus maximus using a taxpayer subsidized 1 megawatt flashlight, and still shellshocked by just how it happened that one Judge Rakoff managed to expose you for the greedy, corrupt, pathetic, sycophantic, incompetent, worthless and soon to be hopefully disbanded and prosecuted den of thieves you truly are.
The rise of Germany belies the chaos a strong euro is causing
The super-strong euro is having sharply varying effects on the different countries in the eurozone and causing the rift between north and south to widen further, according to a new report by Standard & Poor's (S&P). Jean-Michel Six, the agency's Europe economist, said Italy, Spain, Greece and Ireland have all seen sharp deteriorations in their real effective exchange rates since 2005. This is likely to reach the pain barrier soon if rate rises by the European Central Bank (ECB) push the euro to $1.70 against the dollar by the end of next year, as S&P expects. "Anticipate some lively debates among eurozone policymakers about the level of the euro in 2010," Mr Six said.
The exchange forecast is contentious. BNP Paribas and Morgan Stanley expect the euro to weaken for a while as America's recovery gathers pace, leaving Europe behind with a debt crisis in Greece and hamstrung banks that have yet to come clean on their losses. The headache for the ECB is that Germany seems well able to cope with a strong currency after screwing down wages and raising productivity, even if Club Med is squealing. German firms have gained some 18pc in labour cost competitiveness against Italy and 15pc against Spain since 2005, and far more going back to the mid-1990s when the exchange rates were set in stone. Jobs are already telling the story. Unemployment fell slightly to 7.5pc in Germany in October, but continued rising in Spain to 19.3pc. The underlying rate in Greece has jumped to 18pc with the expiry of workfare schemes.
The slow-burn damage of sliding competitiveness in the Club Med bloc was concealed for a long time, at first because Germany entered monetary union at an over-valued rate, then because the credit boom masked all sins. Mr Six said that weaker EMU states are being hit on every front at once. They face de facto appreciation both within the EMU against Germany and outside against the majority of the world's currencies. Sterling and Sweden's krona have crashed. So have the Russian rouble, the Turkish lira and a host of East European currencies. China has kept the yuan rigidly tied to the dollar since the crisis began, piggy-backing on Greenback devaluation by intervening massively in the exchange markets. The weak pound and wage compression in the UK have given British firms a big trading advantage. S&P said UK unit labour costs have fallen more than 35pc against Italy since mid-2007, and by 18pc against Germany.
It typically takes two to three years for the full effects of such currency shifts to become evident. Even so, signs are already emerging in Eurostat industrial data. UK output was down 7.9pc in October from a year earlier, compared to -11pc for the eurozone as a whole. S&P said that other powerful forces are at work. America is rapidly regaining its edge against Europe. US productivity rose at an 8pc rate in the third quarter of this year, while unit labour costs fell 2.5pc. Almost exactly the opposite has occurred in Europe, where job support schemes have encouraged firms to hold on to surplus workers, leading to sharp falls in productivity. This prevents the Schumpeterian process of "creative destruction" that clears dead wood with each cycle and nurtures economic dynamism.
Why the Federal Reserve's and Administration's Policies Will Not Work
by James Freeze
The Fed's Worst Enemy, The Mortgage Vigilantes, Are Back
by Tyler Durden
Following up on Mr. Freeze's prior post as to the ultimate futility of the Fed's market intervention, remember what one of the side effects of inflation is? Yes, rising prices. And the expectation of a rise in rates. Alas Ben, you can't have the taxpayers' mortgage cake and have Goldman eat record bonuses at the same time for ever. Thus the mortgage vigilantes come out again.
And if there is one thing the Fed hates more than losing control of the stock market, it is losing control of the mortgage market. In the past few days, in addition to FFIP going off the charts as Fed Fund futures traders start panicking, we have seen a gradual divergence in the 10 Year - 30 MTG spread. Will this continue? Yes, until such time as Goldman HoldCo and OpCo decide to kill equities one more time before the March expiration of QE.
The rush to safety (which unfathomably still includes MBS and agencies) should collapse the spread for the last time before the hyper [deflationary/inflationary] collapse finally sets in. In the meantime equity traders, i.e., the guys who trade 3 shares amongst each other, are hoping the top is at least one more day away. But at this point who cares about a bidless market: with so many HFT programs, it just. can't. happen.
China Think Tank Sees More Unrest
At the close of a year where Beijing struggled to contain some of the worst riots in its recent history, the government’s top think tank has warned that next year could be even harder as public frustration over growing income gaps and anger at government corruption erupts. The annual report by the Chinese Academy of Social Sciences was released Monday. Hard copies in Chinese can be ordered here.
It warns that social unrest and crime are both up, laying most of the blame on growing income gaps, especially the chronically lagging incomes in the countryside versus the richer cities.
The report calls into question the success of the Communist Party’s new catchphrase “Harmonious Society,” a goal increasingly under pressure, as we wrote here.
Interestingly, the pessimistic outlook was addressed by the Chinese media, which is still closely monitored and censored by the state.
According to a translation by media project China Digital Times of a posting on the mainstream Chinese site Netease, one of the key findings was the growing influence of Web tools like microblogging to uncover news and sway public opinion.
The Internet certainly helped sway public opinion in the case of Deng Yujiao, a hotel worker whose murder charges were dismissed after she claimed she had acted in self-defense when an official and his colleague tried to rape her.
By far the deadliest unrest, however, was ethnic rioting in China’s Western province of Xinjiang, where the local Turkic-speaking, mainly Muslim Uighur ethnic group clashed with Han Chinese, the country’s majority ethnic group.
An opinion piece on the state-backed English-language China Daily suggested that the solution to the growing problems would be an independent judiciary that could function as a fair mediator between local governments and disgruntled citizens.
It’s a nice thought, but despite real improvements in China’s courts, it appears the Communist Party still believes some limits on freedom are key to greater stability and control.
China’s Speeding Bullet-Train Program May Brake Economic Growth
Train C2019 covers the 120 kilometers betweenBeijing and Tianjin in 30 minutes, passing peasants in fields burning corn stalks and warrens of shacks occupied by people who aren’t sharing in China’s economic boom. The line is part of China’s 2 trillion yuan ($292.9 billion) investment in a nationwide high-speed passenger-rail network that may be too much train, too fast.
The time savings that the new system delivers may not justify the cost, creating a potential drag on long-term growth, said Michael Pettis, former head of emerging markets at Bear Stearns Cos. The losers are Chinese consumers, who will have to wait for new health-care and old-age benefits while the government focuses on public-works spending, he said. While the expanded service will be a "trophy" for China, the country "already has probably the best infrastructure in the world for its level of development," said Pettis, now a finance professor at Peking University.
China accelerated its high-speed-rail development plan last year in the wake of the global financial crisis, saying it would increase the passenger network by a third to 16,000 kilometers (9,944 miles) by 2020.
Montreal-based Bombardier Inc., the world’s largest maker of passenger locomotives, and Munich-based Siemens AG are helping to build the system. Bombardier’s Chinese joint venture won a $4 billion contract in September to build 80 high-speed trains. Siemens, Europe’s largest engineering company, and Chinese partners received a 750 million-euro ($1.08 billion) order in March for 100 trains.
The centerpiece of the service is a 1,318-kilometer line with 16 kilometers of tunnels that will cut the trip between Beijing and Shanghai to five hours from 10. Set to open by 2012, the 221 billion-yuan project currently employs 127,000 workers and is the most expensive engineering program in Chinese history, eclipsing the Yangtze River’s Three Gorges Dam, the world’s biggest hydroelectric project, which cost 203.9 billion yuan.
Spending on railroads is growing faster than on any other area of investment, rising 80.7 percent to 464.6 billion yuan in the first 11 months of the year from the same period in 2008, according to China’s National Bureau of Statistics. Investment in fixed assets such as factories and the rail network accounted for more than 95 percent of China’s 7.7 percent growth in the first three quarters of 2009 and made up 45 percent of GDP, which is higher than any major economy in history, according to Morgan Stanley Asia Chairman Stephen Roach.
Without a surge in consumer spending and with export growth stalled, investment must rise even further to stoke growth, he said in a Dec. 18 Beijing speech. "These are ridiculous, unsustainable numbers for any economy," he said. China may be hit with a slowdown next year as the impact of the investment-led expansion wears off and shipments to the U.S., the traditional external source of growth, fail to pick up, Roach said in an October report. He didn’t specify how much growth might slow.
Some economists say the high-speed network is symbolic of a stimulus program that places too much emphasis on infrastructure spending and not enough on raising living standards in a Communist country where the average urban worker made 28,898 yuan last year, a tenth of the $39,653 average wage in the U.S., according todata from the U.S. and Chinese governments. Most Chinese rail travelers won’t pay the premium to ride on the fast trains, Zhao Jian, a professor of economics at Beijing Jiaotong University, said in a September interview on Chinese television.
A second-class one-way ticket for the half-hour Beijing- Tianjin trip costs 58 yuan, about three-quarters of the workers’ average daily pay. A so-called hard-seat ticket on a slower train, which covers the distance in two hours, sells for 11 yuan. Passenger reluctance means revenue from the high-speed lines won’t be enough to service the debt if railway expansion continues at its current pace, Zhao said in the TV interview. China’s Ministry of Railways has 383 billion yuan in bonds outstanding.
"If America had its subprime crisis, in China we have a railroad-debt crisis, or you could call it a government-debt crisis," Zhao said in the TV interview. China’s railway ministry says the new system makes economic sense: A two-track bullet train can transport 160 million people a year, compared with 80 million for a four-lane highway, it said in a Dec. 21 faxed statement. "The safest, fastest, most economical, most environmentally friendly, most reliable mode of transport is high-speed rail," the ministry said.
The fast trains leave from Beijing South railway station, a new glass and steel structure that looks like a flying saucer. The slower trains depart from the half-century-old Beijing Station, where the clock tower marks the hour by playing "The East is Red," a tribute to Mao Zedong that was popular during China’s 1966-76 Cultural Revolution. Sitting on the stiff green benches in car 13 of train 4401, Yuan Hong, 40, says she doesn’t mind the old line’s extra 90 minutes. "It’s a huge price difference," says Yuan, who works as a cleaner in Tianjin. "This is the train the common people take."
UK families make biggest savings ever to clear debt
Families are putting aside record amounts of savings as they take drastic measures to pull themselves out of debt. The average household saved almost £300 a month in the three months to September – the biggest amount in any quarter in British economic history, according to the Office for National Statistics. The ONS said that families saved 8.6p of every pound of disposable income they earned in the third quarter – the highest ever proportion. In total, households saved some £21.4 billion in those three months alone.
Families will have used the cash to put money into savings accounts, other investments and pensions. But it is thought most of the savings will have been used to clear debts: the Government's official definition of saving includes paying off debt. Alongside the savings statistics, Tuesday's economic output figures showed that, unlike its G20 counterparts, Britain remained in recession during the autumn - a major blow for Gordon Brown and Alistair Darling, the Chancellor.
The disclosure is the latest evidence of how families are having to put aside unprecedented amounts of cash in order to rebuild their balance sheets, in the face of the longest recession since the Second World War. The news marks a stark contrast from early 2008 when statistics showed that, for the first time, British families were having to borrow in order to fund their everyday lives – something which contributed to the subsequent recession. However, economists said that the consequence of families saving more is that it would constrain high street sales and could help prolong the economic downturn.
Ben Read, of the Centre for Economics and Business Research said: "We are seeing people paying down their debt, which effectively means saving more than they are spending. "People do tend to save more during times of uncertainty: because of unemployment, because of falling wages and the threat of business losses. But they almost always do it too late. Even in late 2008, the savings ratio was negative, when people should have been improving their finances.
"Before the Blair-Brown years people were a lot more prudent in general, whereas this time around people seemed to have forgotten how to save. One hopes people are becoming more prudent now. After all, this has come as a rude awakening to a lot of people." Revealing how low interest rates are helping families, the figures showed that the amount of their disposable incomes that households were spending on mortgage interest had fallen from 10.2 per cent in the first quarter of 2008 to 4.9 per cent in the latest quarter.
"With interest rates set to remain low for a sustained period of time, this deleveraging process can continue, while allowing a return to healthy household consumption growth by the end of 2010," said Melissa Kidd of Lombard Street Research. The British picture compares favourably with the United States. In the US, although the economy is now out of recession, this has been achieved partly by encouraging families to save less, and the savings ratio actually fell in the third quarter.
A further sign of the pressures facing households came yesterday with new research which showed that only a quarter of older workers plans to retire early, with 43 per cent intending to work even beyond retirement age, into their late 60s and 70s, many to counter the financial effects of the recession. A survey from the Department for Work and Pensions showed that some 25 per cent of workers intend to stay in employment for another few years after the official retirement age, with a further 12 per cent planning to work for "a long time" after this date, and another 6 per cent planning to work longer for another employer. The findings come amid growing speculation that a future government may raise the pension age in order to compensate for the increased costs of an ageing population.
The ONS said Britain lost 6 per cent of its economic output over the past 18 months. The economy shrank by 0.2 per cent between July and September – slightly better than the 0.3 per cent statisticians had previously estimated, but still comfortably in negative territory. Andrew Goodwin, senior economic adviser to the Ernst & Young ITEM Club, said: "We remain the only G20 country in recession but all indicators suggest that it will finally come to an end in the fourth quarter. Survey data has continued to point to expansion, while the car scrappage scheme will continue to offer support and consumers are likely to bring forward big-ticket purchases to avoid the VAT increase.
"But the upturn is being largely driven by short-term factors, some of which are merely displacing demand from next year and, with consumers still credit-constrained and the fiscal squeeze on its way, the recovery is likely to be a long and drawn out process."
Huge cash cuts to hit teaching at British universities
Universities will have to make severe cuts after Lord Mandelson abruptly slashed teaching budgets by millions of pounds yesterday. Departments are expected to close, degree courses will be scrapped and students will have to pay higher fees. Academics were furious at the plan to claw back 135 million and condemned the timing of the announcement. Universities had already been ordered to find 180 million in savings in the next 18 months. When savage spending cuts were announced in the Pre-Budget Report, schools were given immunity but universities were not. The cuts mean that funding per student has fallen in real terms for the first time in ten years.
A review of tuition fees that began last month and will conclude after the general election is expected to recommend that they be raised considerably from the current 3,225 a year. The Business Secretary said that universities should move from the three-year, full-time undergraduate degree model towards a "wider variety of provision", such as foundation and fast-track degrees. They will be encouraged to focus more on the skills and knowledge demanded by employers rather than on academia for its own sake. Those that disobeyed the Government by taking on too many students this autumn will be penalised in next year's grants at a rate of 3,700 per extra full-time student.
Lord Mandelson made his position clear in the Secretary of State's annual letter to the Higher Education Funding Council for England. He said: "My predecessor repeatedly made clear the risks of student over-recruitment putting unmanageable pressures on our student support budgets." The council will inform universities of their individual grants in March.
Lord Mandelson said that teaching grants would be cut by 51 million but urged universities to minimise the impact on teaching and students. The remaining 84 million will come from capital budgets. After adjustments, the overall higher education grant will fall from 7.8 billion to 7.3 billion. The Times reported earlier this month that universities were already slashing thousands of jobs, scrapping courses and putting campuses out of use to meet budget constraints. The 10,000 extra unfunded places the Government allowed this year for science, technology, engineering and maths degrees will disappear next year, even though the recession means that unprecedented numbers are expected to apply for places.
Universities UK, which represents vice-chancellors, said that the cost of subsidising tuition fees would jeopardise the quality of the student experience. "The sector will not be able to deliver more with less without compromising our longer-term sustainability and international competitiveness." Sally Hunt, general secretary of the University and College Union, said: "You cannot make these kinds of cuts and expect no consequences. We will see teachers on the dole, students in larger classes and a higher education sector unable to contribute as much to the economy or society."
Wes Streeting, of the National Union of Students, said: "The Government was quick to take credit for avoiding a student places crisis earlier this year, but is now shamefully cutting teaching funding to the very universities that helped it achieve it." The university research grant is protected, meaning that newer universities that focus mainly on teaching will feel extra pressure. Professor Les Ebdon, chairman of Million+, which represents some of these institutions, said: "December 22 will go down as a good day for the Government to bury bad news for universities and students. David Willetts, the Shadow Universities Secretary, said: "Universities are being fined for meeting targets set by this Government. Higher education should be available to all those who are qualified by ability and attainment to pursue it, and who wish to do so."
Moody's turns Delphic on Greek debt
Ratings agency Moody's decision to downgrade Greek sovereign debt by less than many investors had feared relies partly on a self-fulfilling prophecy. In downgrading the debt to A2, Moody's ensured that Greek (and other) banks will still be able to swap Greek bonds for cheap funding from the European Central Bank, assuming that nothing has changed by this time next year when the ECB will only accept bonds rated A-/A3 or above as collateral by at least one agency.
Both Standard & Poor's and Fitch have cut Greek bonds to BBB-plus this month, meaning if Moody's cuts Greece to an equivalent level, Greek banks are likely to face difficulties in getting access to liquidity as analysts estimate more than half the collateral they have submitted at the central bank is in government bonds. Yet Moody's explained the decision as partly due to its expectation that the ECB will keep accepting Greek debt as collateral, a decision which hinges on Moody's itself keeping Greece's rating above the watermark. Unless of course the ECB backflips and lowers its standards before December 2010, although ECB Vice-President Lucas Papademos has said the euro zone central bank will not bend the rules for Greece.
Greek bond yields have soared compared to the euro zone benchmark and the cost of insuring against default has risen as the country struggles to get its finances in order.
Greece to slash spending with austerity budget
The Socialist majority in the Greek parliament early today approved the country’s 2010 Budget, which aims to cut the country’s huge deficit by slashing spending and boosting tax revenues. After a tense, five-day debate in the 300-seat chamber, all 160 members of the Pasok party backed the Government’s line that economic recovery can best be achieved by addressing tax evasion and corruption rather than by slicing public sector pay. A total of 139 members from four opposition parties opposed it and one was absent. George Papandreou, the Prime Minister, told Parliament: “We can’t take aspirins to deal with this problem ... We have to change course." He blamed Greece’s struggling finances largely on corruption, tax evasion and government waste.
He has given few details of his much-heralded tax reform programme so far. His Government’s plan to raise the corporate tax rate is still vague and jittery money is already leaving the country. About €5 billion (£4.5 billion) is believed to have fled to the friendlier business environment of Cyprus over the past two months. Greece has promised to reduce the budget deficit from a projected 12.7 per cent of GDP in 2009 to below 9.4 per cent next year and as low as 8.7 per cent if further cuts are successfully implemented. George Papaconstantinou, the finance minister, said: “There is no margin for error. The only margin there is is to improve our targets, and that is why we ... are aiming for a 4-point reduction in the deficit.”
According to figures in the budget, the national debt is set to reach €325 billion next year, while GDP in 2010 is estimated at €244 billion, with national output contracting 0.3 per cent next year. However, the risk that Greece could default on its growing public debt next year still looms large after this week’s move by Moody’s, the ratings agency, to downgrade the country’s credit status. That followed similar moves by Standard & Poor’s and Fitch. The public sector remains bloated by decades of patronage by both Right and Left. Trade unions are threatening strikes next month if public sector pay is frozen. “If this situation continues, I give the economy six months,” Dimitris Daskalopoulos, president of Greece’s employers’ organisation, said. Greece's unemployment rate has risen to a four-year high of 9.3 per cent, according to figures released last week.
With people in their forties receiving monthly pensions of up to €2,800 thanks to public service early retirement schemes, Andreas Loverdos, the Employment Minister, has warned that state pension funds will be empty by June. In October, George Provopoulos, the Governor of the Bank of Greece, revealed that the country’s budget deficit was approaching 13 per cent of GDP after years of runaway spending and credit expansion. Previous official figures had claimed that the deficit was half that. Greek public debt is proportionately the highest in the eurozone, at about 125 per cent of GDP. Over the past decade, governments have borrowed heavily to keep public sector salaries high, fearing that unions would otherwise paralyse public services.
IMF turns down $2 billion loan to Ukraine
The International Monetary Fund has turned down recession-battered Ukraine’s plea for a $2bn emergency loan before the New Year, a senior Ukrainian official said on Wednesday, citing his country’s failure to adopt a fiscally prudent 2010 budget and muster political consensus ahead of a hotly contested presidential election. But officials said the financially-stretched government had other last-minute options that could allow it receive the needed $2bn in coming months, enough to cover natural gas import bills to Russia’s Gazprom, as well as citizens’ pensions and wages.
Ihor Umansky, Kiev’s finance minister, said Ukraine could revive negotiations with the Fund early next year, but added: “It will be impossible before the end of the year” to receive a fresh IMF disbursement. The IMF was not immediately available for comment. It has provided $11bn in aid this year to keep Kiev financially afloat amid a 15 per cent drop in gross domestic product, but froze assistance in November due to a lack of reforms and political infighting.
Kiev’s political leaders are bitterly divided, with President Viktor Yushchenko, Prime Minister Yulia Tymoshenko and ex-premier Viktor Yanukovich all campaigning for a January 17 presidential election. The political temperature is not expected to cool down until after a second round run-off is held in February. Without fresh cash, Ukrainian officials have said they could struggle to cover Russian gas import bills in coming months. The scenario could spark a repeat of last January’s stand-off with Russia that disrupted European supplies.
Government officials have also recently warned that escalation of their country’s financial woes could “spill over” into other regions. European banks hold a 40 per cent market share in Ukraine. Alexander Ginzburg, an advisor to Ms Tymoshenko, told the Financial Times on Wednesday that her government was in “a really tough situation”, but could still manoeuvre to meet financial obligations. Mr Ginzburg said the IMF’s board could on Wednesday sanction Kiev’s central bank to transfer into government accounts billions of dollars from its reserves that were built up with IMF money this year. “The cash supply could come out of the central bank if the IMF agrees to lower the floor for its reserves,” Mr Ginzburg added.
With almost $27bn in central bank reserves, and Ukraine’s currency stabilised after a more than 40 per cent drop in late 2008, Mr Ginzburg said there was “enough to put the money on the table”. But “political rivalries at play” ahead of the presidential election could block this option. Heavily influenced by Ms Tymoshenko’s opponents, the central bank could refuse to assist the government. Such an outcome would be the most recent of many attempts this year to starve Ms Tymoshenko’s government of cash, thereby “sabotaging her presidential candidacy”.
Late on Wednesday, Mr Yushchenko pledged to continue blocking the transfer of central bank reserves, which Ms Tymoshenko’s government hoped to use for covering the widening budget deficit.. Borrowing from Russian banks is another option, but it could be more expensive and come with political strings attached. Moreover, it would not be “easy to borrow from Russian banks at this stage,” Mr Ginzburg said. “The timing is very tight with the holidays.”
by Jim Kunstler
As the end-credits rolled for James Cameron's new movie, Avatar, the audience burst into rowdy applause. It seemed to me that they were applauding the sheer computerized dazzlement of the show -- but in the story itself they had just watched the US suffer a humiliating defeat on a distant planet. In the final frames, American soldiers and the corporate executives they had failed to protect were shown lined up as prisoners-of-war about to embark on a death march.
More to the point, the depiction of our national character through the whole course of the film was of a thuggish, cruel, cynical, stupid, detestable, and totally corrupt people bent on the complete destruction of nature. Nice. And the final irony was that Cameron had used theatrical technology of the latest and greatest kind to depict America's broader techno-grandiosity -- as the army's brute robotic warriors fell to the spears and arrows of the simple blue space aliens. Altogether, it was a weird moment in entertainment history, and perhaps in the American experience per se. No doubt audiences overseas will go wild with delight, too, but perhaps with a clearer notion of what they are clapping for than the enthralled masses of zombie Americans.
The infatuation with technology, and the disgusting cockiness that goes with it (so well-captured in Avatar), is but one facet of the psychosis gripping the nation -- and by that I mean the profound detachment from reality. We have no idea what is happening to us and, naturally, no idea of what we are going to do. I sat in a bar Friday evening with a financial reporter from a national newspaper, trying to explain the peak oil situation and what it implied for our economy. He had never heard it before. The relationship between energy resources and massive debt was new to him. (It also came up in conversation that he could not tell me what the Monroe Doctrine was about, despite a history degree from Yale.) There you have a nice snapshot of the mainstream media in this land.
This year, America can look for a nice lump of coal in its Christmas stocking. That lump will be called "the recovery."
This recovery consists of a massive self-deception, made up of accounting tricks and falsified statistics, with a sugar-coating on top of sheer disbelief that the outcome could be anything but a particular happy ending -- namely, the continued levitation of the unsustainable. What is most amazing about Mr. Cameron's holiday blockbuster is the explicit message that America is a society that deserves to be punished (and humiliated!) by others who manage their own relations with reality better than we do. I wonder how much that will secretly account for its popularity. I wonder what the leaders of China will make of it.
The other current embodiment of national character failure, Tiger Woods, golfer, has also dazzled the American public. Personally I find it much more interesting to learn that he was a really lousy tipper than that he got a lot of action on the side with opportunistic bar girls, porn stars, and other denizens of the sports-entertainment netherworld. Is it not also amusing that golf is even taken seriously as an athletic pursuit? I mean, why not pancake-flipping? Or dice? Or shooting rats at the landfill? This is the kind of knucklehead culture we have become after six decades of the softest life imaginable. Anyway, I'm not shedding any tears for Tiger. Even if all his endorsements dry up and his ex-wife takes him to the cleaners for a hundred million or so, he'll still be left with enough cash to pay for porn stars and lobster tails until the end of time, especially if he keeps his tipping policy at its current level
Call this a recession? It isn’t the Dark Ages
As we face an uncertain and worrying New Year, we can at least console ourselves with the fact that we are not living 1,600 years ago, and about to begin the year 410. In this year Rome was sacked, and the empire gave up trying to defend Britain. While this marks the glorious beginnings of "English history", as Anglo-Saxon barbarians began their inexorable conquest of lowland Britain, it was also the start of a recession that puts all recent crises in the shade.
The economic indicators for fifth-century Britain are scanty, and derive exclusively from archaeology, but they are consistent and extremely bleak. Under the Roman empire, the province had benefited from the use of a sophisticated coinage in three metals – gold, silver and copper – lubricating the economy with a guaranteed and abundant medium of exchange. In the first decade of the fifth century new coins ceased to reach Britain from the imperial mints on the continent, and while some attempts were made to produce local substitutes, these efforts were soon abandoned. For about 300 years, from around AD 420, Britain’s economy functioned without coin.
Core manufacturing declined in a similar way. There was some continuity of production of the high-class metalwork needed by a warrior aristocracy to mark its wealth and status; but at the level of purely functional products there was startling change, all of it for the worse. Roman Britain had enjoyed an abundance of simple iron goods, documented by the many hob-nail boots and coffin-nails found in Roman cemeteries. These, like the coinage, disappeared early in the fifth century, as too did the industries that had produced abundant attractive and functional wheel-turned pottery.
From the early fifth century, and for about 250 years, the potter’s wheel – that most basic tool, which enables thin-walled and smoothly finished vessels to be made in bulk – disappeared altogether from Britain. The only pots remaining were shaped by hand, and fired, not in kilns as in Roman times, but in open ‘clamps’ (a smart word for a pile of pots in a bonfire).
We do not know for certain what all this meant for population numbers in the countryside, because from the fifth to the eighth century people had so few goods that they are remarkably difficult to find in the archaeological record; but we do know its effect on urban populations. Roman Britain had a dense network of towns, ranging from larger settlements, like London and Cirencester, which also served an administrative function, to small commercial centres that had grown up along the roads and waterways.
By 450 all of these had disappeared, or were well on the way to extinction. Canterbury, the only town in Britain that has established a good claim to continuous settlement from Roman times to the present, impresses us much more for the ephemeral nature of its fifth to seventh-century huts than for their truly urban character. Again it was only in the eighth century, with the (re)emergence of trading towns such as London and Saxon Southampton, that urban life returned to Britain.
For two or three hundred years, beginning at the start of the fifth century, the economy of Britain reverted to levels not experienced since well before the Roman invasion of AD 43. The most startling features of the fifth-century crash are its suddenness and its scale. We might not be surprised if, on leaving the empire, Britain had reverted to an economy similar to that which it had enjoyed in the immediately pre-Roman Iron Age. But southern Britain just before the Roman invasion was a considerably more sophisticated place economically than Britain in the fifth and sixth centuries: it had a native silver coinage; pottery industries that produced wheel-turned vessels and sold them widely; and even the beginnings of settlements recognisable as towns.
Nothing of the kind existed in the fifth and sixth centuries; and it was only really in the eighth century that the British economy crawled back to the levels it had already reached before Emperor Claudius’s invasion. It is impossible to say with any confidence when Britain finally returned to levels of economic complexity comparable to those of the highest point of Roman times, but it might be as late as around the year 1000 or 1100. If so, the post-Roman recession lasted for 600-700 years.
We can take some cheer from this sad story – so far our own problems pale into insignificance. But Schadenfreude is never a very satisfying emotion, and in this case it would be decidedly misplaced. The reason the Romano-British economy collapsed so dramatically should give us pause for thought. Almost certainly the suddenness and the catastrophic scale of the crash were caused by the levels of sophistication and specialisation reached by the economy in Roman times.
The Romano-British population had grown used to buying their pottery, nails, and other basic goods from specialist producers, based often many miles away, and these producers in their turn relied on widespread markets to sustain their specialised production. When insecurity came in the fifth century, this impressive house of cards collapsed, leaving a population without the goods they wanted and without the skills and infrastructure needed to produce them locally. It took centuries to reconstruct networks of specialisation and exchange comparable to those of the Roman period.
The more complex an economy is, the more fragile it is, and the more cataclysmic its disintegration can be. Our economy is, of course, in a different league of complexity to that of Roman Britain. Our pottery and metal goods are likely to have been made, not many miles away, but on the other side of the globe, while our main medium of exchange is electronic, and sometimes based on smoke and mirrors. If our economy ever truly collapses, the consequences will make fifth-century Britain seem like a picnic.