Christmas tree in the home of Wilbur and Orville Wright at 7 Hawthorn Street in Dayton, Ohio, three years before their famous flight
Ilargi: I will leave the stage to our friend VK, who writes a stream of consciousness inspired article on what plagues our financial systems. For me, just this one point from the news today:
It’s time to take a closer look at the FDIC. Closing banks has become much more costly lately. The FDIC is now taking over banks outright and building bridge banks, all because no buyers can be found for the banks that are closed. Obviously, this greatly increases losses to the FDIC fund. Consequently, banks that do takeover failed peers must be getting some real sweetheart deals out there.
The FDIC plans to acquire substantial additional funding, has increased its 2010 operating budget by 55%(!) over this year, and is even attempting to securitize and sell bundles of troubled loans it gets stuck with. Obviously, then, more banks are expected to be closed in 2010 than the 140 shut so far in 2009. And the overall costs will be much higher too. How that rhymes with a recovering economy, I can't tell.
VK: The persistent notion that there's only $1-2 trillion in losses remaining in the banking system, as some people conclude from what Roubini and others may have stated, is false; that would be peanuts. The Federal Reserve printed $1.55 trillion to buy up toxic MBS plus Treasury paper. But the problem has not been cured, in particular: most of the toxic debt still remains hidden through the application of shady accounting practices. There is no solution in sight in the current political paradigm.
Think about it this way: the US government has implicitly and explicitly guaranteed, loaned, subsidized and given away about $12.8 trillion to banks while these banks have only $10 trillion or so in real assets. Why is the government giving so much assistance, a sum far greater then all assets combined of the US banking system?
Simple really, the derivatives aka bets are far larger than global GDP, estimated to be between $500 trillion and $1,5 quadrillion. JP Morgan alone holds $90 trillion or so in derivatives while the entire US GDP per annum is no more than one-sixth of that, at $14-odd trillion.
So those bets have gone bad and gone wrong and they have been kept hidden in the broom cupboard thanks to creative fictional accounting practices, in level 3 assets on bank balance sheets, and in off balance sheet items.
The losses are real, the bets went bad, and Washington is attempting a show of CONfidence to prevent a systemic collapse. But when Mr. Market calls the government's bluff, and he will, then people will realize the US Government is the naked emperor, with no money to back up those guarantees for failed and long dead enterprises.
There are three things in life that man can't prevent - death, taxes and Mr. Market calling the bluff.
See, Mr. Market is a master illusionist, is he not? Evidence you say?!
First he creates a mini panic, a preview if you will, that has many people crying out, "head for the hills", "rapids ahead!", then he deftly creates a slope of hope, which we are on now for the moment, where all the suckers who ran for the hills and paddled away from the rapids and in the process lost a few trillion here and there, realize how 'naive' they were and start buying any risky asset in sight. Gotta recoup those losses they say!
This year Mr. Market has gotten quite a leg up in emerging markets, what with Brazil rising 80% and India up by 70%, the anti-USD play evolving into a dollar carry trade and giving rise to bubbleicious bubbles in Asia, gold, stocks, and with corporate bond yields declining all year long. Alas, Mr. Market never makes it too easy and has been giving people cause for worry. What is it with those pesky 10 Year bonds yielding 3.5%, can't they sniff the inflation ahead people ask, why are they priced so high? Also, why did the difference between the long end of the curve and short end of the curve reach new highs recently?
Mr. Market gives hints to those who see and those who listen. What goes up, must come down as the old cliché goes. Bill Bonner puts it best, "The extent of the correction is equal and opposite to the deception that preceded it." And my, what deception we had! A glorious age of mankind was dawning we were told, that of stable growth, the end of recessions, scientific economic theory and a gilded age of prosperity.
So Mr. Market gives us hints, hints not to listen to the fools, the ones that missed the crisis and are now predicting its early demise. The hints are obviously the rising USD over the last few days, the considerable fall in gold, the problems re-emanating across Dubai, Spain, Greece, Ireland etc. Looks like Mr. Market is saying that the flight to safety has begun and lord knows it will be grand. When those on the slope of hope get caught up at the greasy end, when they suddenly lose grip, with horror etched on their faces as they tumble away far down into the nether regions of the world.
So the USD will rise in value much to the shock of all. The economy is worsening and it's rising people will say? Maybe even double in value from present values, it seems likely given the amount of debt deflation occurring in the world. The dollar represents 65% of the world's money and as money gets scarcer, the USD will be the One eyed King of the blind and ill, oil will fall substantially, a return to 10 dollars per barrel or less is in the cards given how much demand is going to plummet next year, so forget about Sheikhs in Abu Dhabi bailing out their hapless cousins in Dubai. Gold must fall, eventually I see Gold returning to 600 or less, maybe kissing the DOW, the bottom will be in when the Dow/ Gold ratio reaches around 1.
Emerging markets will get battered hard, bitterly hard. They rose the fastest and they will fall the fastest. The wind will get sucked out of them much faster than the US because remember emerging markets are peripheries, the flight to safety will see them crumble as money rushes to the perceived safety of the core countries. Imagine a concentric circle crumbling from outside in.
The world will groan and moan, for as yet we have not seen a real bust, whether it's the gravity defying Australian kangaroo economy which must contract sharply as China's epic credit fuelled hangover will eventually end leading to a bursting resource bubble there and in the overvalued Australian dollar or the bubbly Canadian house price boom whose vintage is decidedly toxic or those overpriced box-like hovels in England people call homes, their true value must eventually come out as Mr. Market believes in the truth and nothing is quite like the light of truth to reveal the ugly toxic glory of all credit cretins.
We will also learn that all those factories in China are worth zero, as well as those in Korea and Japan, as the buyers of their goods are fast becoming broke, unemployed and homeless and those who still have a roof over their head will find out that those houses are worth close to Zero and my how wages will fall due to the cascading effects of the deflationary spiral! It will certainly be a sight to behold. Though you may not see much in your wallet or your bank account.
Corporate bonds will get hammered and many companies will default as they simply can't pay back or up. This will grievously damage or end many too big to bailout entities and heaven help them as countries decide that saving banks isn't a particularly good idea if they have to commit national suicide in the process. Even the strongest companies are not worth the risk, as cash flow will all but dry up, much like quality entertainment on US television at present, as hardly any exists.
Let's watch cash flow drying up in greater detail for a moment; the banks you see have borrowed trillions upon trillions of dollars from the rest of the world and each other. Between today and 2012-2013 the banks need to refinance around $7 trillion at the least (that's what they're telling us, it could be much higher).
Now a basic rule of capitalism and thus banking is that you obviously want to make a profit, greed and the self are the key building blocks of our capitalist system. So banks borrow cheaply and make loans at a higher rate, the spread is how they make a profit. Now currently banks are not making many loans, in fact both European and American banks are decreasing the amount of loans they make while holding onto record reserves of cash.
What they are doing is borrowing at 0% from the FED and using that to buy Treasuries that pay around 3.5% and currently since the market is rallying they are using that to go long via speculative positions.
It sounds like a good deal but when you think about the fact that they have borrowed at a much higher rate then 3.5% and that they still hold trillions upon trillions of derivatives that require interest payments on the liabilities side of the balance sheet, and that they hold trillions in deteriorating commercial real estate loans, mortgages, businesses loans, corporate bonds etc. on the asset side, you can sniff out the trouble they are in!
Now because the vast majority of money supply is credit and that supply of credit has been declining, the amount of cash in the economy is declining and will decline further due to the unwillingness of banks to lend and the fear that borrowers have of going into more debt then they already are in. Obviously at some point the borrower realizes that swimming is fun but only if your head is above the water!
So income streams from mortgages, commercial loans, small and medium sized companies start declining as these companies lack substantial cash flow to meet their loan obligations. When the assets remain marked to myth for a longer period of time, the cash flow declines start having very real impacts. As cash flowing into the banking system declines, how can banks meet their trillions in obligations in the form of loans, bonds, deposit interest and the like? In short, they can't.
So if less income is coming in from the asset side of your business, the less likely you are to be able to pay your liabilities regardless of how high you 'book' your level 3 assets. And if ever level 3 assets are allowed to be marked to market, you'll find that the whole bada bing is worth zilch instantly; what I would call a bada boom.
So Mr. Market will start calling the banks when serious cash flow problems start emerging, in today's slope of hope rally, participants such as the banks and corporations have issued a record amount of bonds to stave off their cash flow problems and keep operations going as they can't get loans. Trying to solve a debt problem by adding more debt is just plain silly akin to 'curing' a tumorous cancer by providing the patient with adrenalin jabs to keep him alive while he writhes in agony for longer. The next deflationary wave down then hits when market participants realize how bad the real economy is due to:
1) The hidden psychological (herding) forces. A crisis of confidence.
2) Declining cash flows, cash that is vital in keeping the economy afloat.
We will see a flight to safety and a cascade down in the markets along with declines in wages, prices and an increasing debt burden as real interest rates skyrocket, provoking downturns in world trade and the whole globalization whopeedoo train!
When the proverbial smelly stuff hits the fan, the long end of the curve is an attractive place to be, the differential between the long and short ends looks far too large. 30 year bonds will shoot up in price and go substantially down in yields. I'm thinking that Mr. Market is hinting at a huge flight to safety. This could see 30 year yields at 1% or less, it all depends on Mr. Market of course, he alone is the giant amongst men.
Lest we forget the midgets amongst men, we shall honour them as well, currently Mr. Market has led resource currencies and commodities to heights far above where they should be and soon we shall find out that they are going to get hammered and hammered hard into the ground. As the Chinese crack stimulus fades and the sheer force of the contraction we are facing will wipe out all pricing support as demand will evaporates into the ether.
Obviously as we see an increasing loss of confidence, a bank run could ensue and definitely accelerate events rapidly! We could see a cascade event/ tipping point in the middle of next year or earlier as people lose confidence in the system. Once fear grips the population, I suspect Mr. Market will be looking forward to creating bank holidays and closures of the stock market. Banning those 'evil' short sellers and jawboning the slope of hope recovery, expect great oratory from President Obama next year and an attempt to take on more debt by Congress in attempt to 'recover' and 'stabilize'.
Did I mention Mr. Market loves practical jokes?
Now there's the old adage, All men are created equal but some more so then others. 'Tis the same with debt really. Not all debt is equal, some of it is more useful then other debt, for example private sector debt is more capital efficient then public sector debt though both are socially inefficient in the long run but that is a story for another day. A corporation is going to use debt more efficiently then a government is ever going to, as it has a profit motive to extract the most out of that borrowed dollar.
Now things get interesting, the time of creation of that debt is also very relevant. As credit forms 99% of the money supply and because money supply must always grow given the present monetary paradigm, it is obvious that credit/debt created 20 years ago carried more bang for the buck and that credit/debt created 60 years ago carried even more than that!
In the 1970's a car, good affordable housing, a nice university education etc cost far less then it does today and on much lower incomes as well.
So in the 70's and 80's a dollar borrowed was worth much more then it is today. You could buy more land, more house, more car, more education and more stock! Today a dollar won't do much as it has steadily devalued over time by a process we all know and love called inflation whereby your purchasing power as well as borrowing power declines over time.
Moreover, our economies have hit the big fearsome brick wall of diminishing returns. Today we have a situation where for every dollar that an individual or a company borrows, the system gets out maybe 10 cents or less of growth. In the 1950's, it is estimated that every dollar borrowed would generate 3 dollars of growth. That's a large part of the reason why all those trillions in bailouts, guarantees, subsidies, loans etc are having such negligible impact.
So we have trillions of borrowing and record spending to get a few paltry billions in 'growth'.
A debt saturated society is thus faced with two conundrums as time progresses.
1) The ability to service the debt plus interest declines steadily over time leading to cash flow problems.
2) The usefulness of that extra dollar of debt also steadily declines. Thus we are moving towards a point where for every dollar borrowed we have a contraction (I was going to use that ghastly word 'negative growth' but decided against it) due to debt saturation.
Hence, the marginal cost of taking on one more dollar of debt will become detrimental to society as a whole, as the marginal benefit of that one more dollar is negative. This is precisely how societies decline and as in our present debt based monetary system, the principal must be paid with interest by society as a whole in one form or the other.
This is either done through:
1) A deflationary depression where debt is defaulted upon and living standards plummet and millions are left broke and homeless - a societal disaster.
2) A hyperinflation that leads to the complete debasement of the currency and the utter failure of the monetary system - a societal disaster.
Some deflationistas focus on the mechanics that will make deflation the driving force initially and for the foreseeable future - constrained lending by banks, hoarding of cash, the inability of the Fed to keep pace with credit destruction and the unwillingness of foreigners to finance government deficits indefinitely as their balance sheets are constrained by declining export income (we're looking at China and Japan, the Gulf). When, but only when, an economy has become isolated enough can hyperinflation take place, and as a reaction to deflation. The American economy knows no such isolation, and can therefore not be hyperinflated at the moment. In five years, yes, but the world will be a whole different place by then.
By the way, actually paying back the debt is impossible in a system that requires constant debt creation just to keep even, remember the Red Queen in Alice of Wonderland? One has to run faster just to keep up.
So next year we look all set to see the beginning of shortages of goods and services in the western world, as companies go bust due to their target market having barely enough money to survive. Bank runs and heightened fear are highly possible, but always remember at the height of that fear, Mr. Market will once again create a slope of hope much like 2009, but much worse, because at the time it will look like a God-send, a "recovery is finally here" will be the cry across the land. Here the battered and the wounded will be given hope and motivation, only to be suckered into finding out they are yet again on a slope of hope.
The slope of hope that leads to the abyss. I hope one now appreciates and understands Ilargi's all time classic line, "Heads you lose, tails you die".
Ilargi: Did you donate to the Automatic Earth Christmas Fund yet? Wouldn't that just make you sleep so much more peacefully?
Depression on Wheels
by Bill Bonner
When the price of oil hit $150 a barrel, the first major alarm sounded. Something was wrong. Now we have a clearer idea of what it was. To make a long story short, leading economists have a one-stop solution for just about everything: stimulate consumer spending. But $150 oil warned us: continue down that road and you will run out of gas. There isn’t enough oil in the world to allow US-style consumption for everyone.
Two weeks ago, Dubai gave us another wake-up call. Thought to be risk-free, since it was implicitly backed by all the oil in the Middle East, Dubai World nevertheless stopped paying its debts. And this week yet another bell banged our eyes open. Greece announced first that it would not try to reduce its deficits…then, that it would. Hearing the news, the financial world rolled over and went back to sleep. But The Wall Street Journal offered a hint of trouble to come: "Markets force Greek promise to slash deficit," said its page one headline.
If markets could force the Greeks to trim their deficit – about 13% of GDP…not far from the US level – could they not force Britain and America too? Coming right to the point, the fixers face not just one crisis, but many. They have a growth model that no longer works. They have aging populations and social welfare obligations that can’t be met. They have limits on available resources, including the most basic ones – land, water, and energy. They have a money system headed for a crack-up, and an economic theory that was only effective when it wasn’t necessary. Now that it is needed, the Keynesian fix is useless. If a recovery depends on borrowed money, what do you do when lenders won’t give you any?
But let us backtrack to a smaller insight. Then we will stretch for a bigger one. Americans are supposed to be insatiable shoppers. For at least three decades, the world counted on it. It was the growth model for almost all the Asian manufacturing economies…and for resource producers everywhere. But as we approach the biggest shopping season of the year, a survey of consumers signals an earthquake. Americans plan to spend an average of 15% less during this holiday season than the year before. Only 35% say they will take advantage of post-Christmas sales, traditionally when the stores unload unwanted inventory. They seem to be satiable after all.
Push come to shove, Americans react like everyone else. Now, they are being shoved into a new world, very different from the one they have come to know. In 1973, the American working stiff went into a decline. His weekly earnings, in real terms, went down for the next 36 years. The typical worker earned the equivalent of $325 a week in 1973…adjusted to constant 1982 dollars. By US official accounting he was down to $275 a week in 2009. Unofficial estimates put the loss as high as two-thirds of his purchasing power.
Yet, his spending increased anyway. How? He squeezed the rest of the world. The US trade gap began to go seriously negative in 1992. By 2006-2007, foreigners were shipping to America nearly $900 billion more per year in goods and services than they received in exchange. This gave the typical American a standard of living few people could afford; too bad, he wasn’t one of them. Now he’s up against billions of Patels and Hus. They work for less. They save more. They want more stuff too. And they’re suspicious of the dollar.
Their economies are growing faster…and better. Because they don’t have 50 years of accumulated success on their backs. That’s the trouble with success; it adds weight. In their heyday, the mature economies could afford to squander and regulate. But that trend, too, is reaching its limits. Even without the cost of ‘stimulus,’ practically all the world’s leading economies are headed for insolvency. And yet, this week, Paul Krugman gave his solution to the weak results from stimulus spending so far – add $2 trillion more!
All of a sudden, the most reliable givens of the past half a century aren’t given any more. Americans were the big winners of the post-WWII period. They got used to it. At first, they wanted to make things; later they just wanted to have them. And with the benefit of cheap oil and resources, and then cheap labor and cheap credit, they were able to get more stuff than any race ever had. Now they are shackled to it, unable to move forward or to back up. Meanwhile, Europe – led by post-war neoclassical Jacques Rueff in France and Ludwig Erhard in Germany – pursued a different course. While Americans subsidized consumption, Europe taxed it. Credit was expensive, not cheap.
And then, the European Central Bank had the great advantage of having a chief banker whom no one paid any attention to. He might talk about stimulating consumption, but he did nothing. And now the world is reckoning with much more than a consumer debt bubble. It is reckoning with a depression on wheels…the end of the consumer spending era. We don’t know what kind of world will take its place. But it won’t be the one the feds are trying so desperately to save.
The Dark Gray Swan: No More Foreign Dollars With Which To Buy US Treasuries
by Tyler Durden
Could the next black/green/dark gray swan be so obvious that it has avoided everyone? Well, except for the deputy governor of the Bank of China, who just gave the world a startling reminder of economics 101, when he said that it is "getting harder for governments to buy United States Treasuries because the US's shrinking current-account gap is reducing the supply of dollars overseas." Oops.
The funny thing about natural (and economic) systems: they can only be pushed so far before they snap back to default state. With the entire world embarking on an unprecedented spree of domestic bubble blowing to mask the collapse in global GDP, everyone forgot to trade. Zero Hedge has long emphasized that the drop in world trade can only sustain for so long before it brings the current destabilized system back to some form of equilibrium.
Because with every country intent on merely printing more of its own currency, whether it is to build bridges or to make the stock of electronic book fads trade at 100x earnings, said countries ran out of non-domestic cash. Alas, this is most critical for the United States, now that Treasury monetization is over, as the US needs to constantly find foreign buyers of its debt to fund unsustainable deficits. Foreign buyers who have US dollars. And according to Shanghai Daily, this could be a big, big problem.
Here is what the BOC's Zhu Min said earlier:The United States cannot force foreign governments to increase their holdings of Treasuries," Zhu said, according to an audio recording of his remarks. "Double the holdings? It is definitely impossible."
"The US current account deficit is falling as residents' savings increase, so its trade turnover is falling, which means the US is supplying fewer dollars to the rest of the world," he added. "The world does not have so much money to buy more US Treasuries."
In a nutshell, in printing trillions of assorted securities, the Treasury has soaked up the world's dollars, which due to US banks not lending, is sitting and collecting dust in the form of bank excess reserves. These excess reserves can not be used to buy Treasuries and MBS as that would be literal monetization (as opposed to the figurative one which is what QE has been). And the world is running out of dollars with which to buy Treasuries.
Does this mean that the "world" will be forced to buy dollars, and thus spike the value of the greenback? Not necessarily:In a discussion on the global role of the dollar, Zhu told an academic audience that it was inevitable that the dollar would continue to fall in value because Washington continued to issue more Treasuries to finance its deficit spending.Critics of this line of thought can point out that China still has trillions in foreign exchange reserves. However, even as China has been selling mortgage backed securities almost as fast as PIMCO, it has not been buying treasuries: China's Treasury holdings have been flat at exactly $800 billion since May 2009. In the lesser of two maturity evils (the instantaneous, dollar bill, and the long-dated, the 30 Year) China has followed in the footsteps of so many millions of High Frequency Traders opting for that which can be liquidated instantaneously.
A different read of Zhu's statement is that the US should no longer rely on China for funding its bottomless deficits. And if that is the case, things are about to get much worse as the Fed has no choice but to turn the monetization machine on turbo.
States Scramble to Close New Budget Gaps
The patches used by states on their ailing budgets just months ago are now failing. Ohio lawmakers were expected late Thursday to vote on a compromise reached with Gov. Ted Strickland to avoid cutting education budgets an average of 10% on Jan. 1. In Arizona, lawmakers met in a special session Thursday -- their fourth on the budget this year -- to grapple with a new deficit. And in New York, Democratic Gov. David Paterson said Sunday he would postpone paying $750 million of state bills to avert a cash crunch.
Many states eliminated expected deficits earlier this year with budget cuts, tax increases, short-term borrowing, accounting moves and planned gambling expansions. But despite a slight improvement in the U.S. economy, states are now finding those measures didn't go far enough. Tax collections continue to trail projections in some states, and court rulings and political battles have blocked some gap-filling moves. Plus, some legislatures didn't fully deal with the deficits, leaving the toughest decisions to governors. All states, except Vermont, have at least a limited requirement of a balanced budget.
Only a few states now have cash-flow problems. But if revenues continue to fall below expectations, the list could grow, said Scott Pattison, executive director of the National Association of State Budget Officers. "That's certainly a concern for bond-rating agencies," he said. "It shows how bad things are." A Dec. 2 report from the budget officers' group and the National Governors Association said states have cut $55.7 billion from budgets in the current fiscal year, which for most began July 1. Even with the cuts, deficits total $14.8 billion. States' general-fund spending is expected to decline 5.4%, the sharpest drop since data collection began in 1979, the groups said.
States also have enacted tax and fee increases expected to raise $23.9 billion, the largest hike the group has recorded. In Ohio, a plan approved earlier this year to install video lottery machines at horse-racing tracks was expected to raise $851 million for schools. But the Ohio Supreme Court blocked the plan in September, saying it must be put to a statewide vote. Mr. Strickland, a Democrat, wanted lawmakers to suspend a 4.2% income-tax cut that took effect this year, to compensate for the lost revenue. Otherwise, he said, K-12 and higher-education budgets would have to be cut by $851 million. The cuts would jeopardize matching funds from the federal stimulus package.
Republicans, who control the Ohio Senate, said they couldn't get enough votes for the plan unless it was paired with changes to construction-spending laws that Democrats said shouldn't be rushed. "If the Senate majority is going to vote for a tax freeze or tax increase, we want to make sure our tax dollars are being spent as efficiently as possible," Senate Finance Chairman John Carey said. On Thursday, Mr. Strickland reached a compromise with lawmakers that involved suspending the tax cut and also includes establishing three pilot projects at universities that would use new construction procedures.
States filled 30% to 40% of their budget gaps with federal stimulus money. They were allotted about $250 billion of the $787 billion stimulus package, most of which will have been disbursed by the end of next year. The U.S. House on Wednesday passed a separate $154 billion package that includes $23 billion for states to pay teachers' salaries and $23.5 billion to pick up some state Medicaid costs.
In Arizona, Republican Gov. Jan Brewer convened a special legislative session Thursday to consider about $200 million in spending cuts and fund transfers. Although the state made $452 million in budget cuts and other changes in November, slumping tax collections mean the legislature faces a $1.6 billion shortfall. Arizona took out a $700 million credit line from Bank of America Corp. in November to pay bills, but that credit line was spent within days.
State Treasurer Dean Martin said if the state wasn't able to raise an expected $737 million next month by selling several buildings, Arizona might have to issue IOUs. The 2010 elections, when 37 governors will be chosen, are complicating the budget fights. In Illinois, Gov. Pat Quinn recently wanted to borrow an additional $500 million to address a portion of the state's $4.4 billion in unpaid bills, on top of $2.25 billion in short-term borrowings. But his rival in the Democratic primary, state comptroller Daniel Hynes, blocked the plan.
The Second Wave is Already Ashore
The second wave of ARM resets and foreclosures might come sooner than you think. According to Whitney Tilson and Glenn Tongue of T2 Partners, the experts on this subject, about 80% of option ARMs are negatively amortizing. Meaning these so-called top-tier borrowers are heading further into the hole. Once their rates reset, they could be in serious trouble.
And that could be happening very soon:
The chart above, which should look familiar, shows the two peaks in this long-term housing conundrum. The first mountain is comprised of subprime ARM resets. And the second is mostly constructed of option ARM resets. We appear to be in the eye of the storm.
That alone shook our nerves when we first discovered it. But it was a different chart in Tilson and Tongue’s most recent presentation that really got us startled… It’s also the reason I’m predicting the dollar spike in 2010.
Instead of resetting as expected after the first five years, many option ARMs are so negatively amortized that they are hitting their automatic reset cap.
That means they are resetting early…like right now — with unemployment reaching quarter-century highs every month, and a massive number of homeowners about to receive mortgage bills for two-three times what they are used to paying.
It takes anywhere between three-12 months for most homes to actually go into foreclosure. It’s tough to say exactly when the storm will come. But my guess is the second half of 2010.
US pensions go bust, gold crashes, China flops, Bunds soar, predicts Saxo
America's Social Security Trust Fund will go bankrupt; both gold and the Japanese yen will crash; and China's currency will devalue as bad loans catch up with the over-stretched banking system – all in the course of 2010. The annual "Outrageous Predictions" of Denmark's Saxo Bank are not for the faint-hearted, though there is good news for some.
David Karsboel, chief economist, thinks the US trade balance may go into surplus for the first time since the mid-1970s, benefiting from the delayed effects of the weak dollar. Yields on sovereign bonds – the goods ones, not the bonds of quasi-basket cases such as Club Med, the UK, or Japan – will plummet as deflation raises its ugly head again later in 2010. The 10-year German Bund yield will fall to 2.25pc. "Bunds are the ultimate safe-haven if something goes wrong, perhaps in Greece. We may even see some safe-haven buying of US Treasuries as well, despite the irresponsible fiscal policies in the US," he said.
The US Social Security fund will finally tip over, technically going bust. "Ever since the good years of the 1960s politicians have been taking the money and spending it instead of setting it aside for the fund, but next year it will go into deficit for the first time as US demography turns. "The fund is going to need a bail-out, financed by higher taxes, more borrowing, or more printing." Gold will spiral down to $870 an ounce from its all-time high above $1,200 last month.
"There is a lot of speculative hot money in the gold price right now that needs to be shaken out. In the long run we're bullish on gold, and think it could reach $1,500 over the next five years," he said. "In fact, we would like to see the restoration of a gold standard to prevent the sort of excesses we have seen. The world has been in a bubble since the mid-1990s. They are still blowing new bubbles to keep it all going, but each bubble is shorter and shorter. It is frightening, and is all going to end in tears," he said.
Saxo Bank is squarely in the camp of Sino-sceptics, noting that China's alleged industrial and GDP growth does not tally with weak electricity use. In any case, growth has been built on an investment bubble creating "massive spare capacity". It says 2010 will be the year when it becomes clear that there is not enough demand in the world to absorb all their excess production. The yuan will devalue by 5pc, defying near universal expectations of a sharp appreciation. As for Japan, Saxo advises clients to sell the overvalued currency as the yen carry trade comes back into vogue and the dollar rebound gains traction. The yen will weaken from 89 yen to 110 yen against the dollar.
Saxo advises clients to dump 10-year Japanese bonds, doubting that current rates of 1.26pc are remotely sustainable at time when the public debt is exploding towards 227pc of GDP. "The yield is ridiculously low. The Japanese are no longer saving much, and they have hardly any economic growth," he said. However, Tokyo's TSE index of small stocks is a buy with a price to book ratio of 0.77, just about the cheapest stocks in the world. And lastly, if you jumped on the lucrative sugar bandwagon in 2009 as India's drought played havoc with supply, get off soon. Bad weather rarely persists. Sugar is about to crash by a third. Saxo Bank offers its thoughts as "Black Swan" risks that could paddle up quietly and bite you, rather than absolute predictions. Take them in the right spirit.
If it walks like deflation and talks like deflation....
For all the talk about inflation appearing sometime in our not-too-distant future and, according to Milton Friedman, rising prices still being a monetary phenomenon, you sure don’t hear too many people talking about the broadest measure of the money supply – M3.
Reconstructed over at nowandfutures for about the last three years after the Federal Reserve discontinued it, much to the chagrin (or, maybe, delight) of those conspiracy minded individuals who viewed the move as a cover-up on the grandest of scales, it’s hard to see how consumer prices are going to be bid higher anytime soon, given a chart like the one above.
Of course, if banks ever start lending some of their massive reserves, an entirely different dynamic could quickly develop and the recent trend could quickly reverse, but, fortunately, our central bank leaders have assured us that they’re on top of that particular situation.
Seven U.S. banks closed by regulators; failures at 140
Seven U.S. banks were closed by regulators on Friday, bring the total this year to 140 as the effects of the credit crisis continued to be felt across the country. What's more, the Federal Deposit Insurance Corp. established temporary institutions to help close two of the failed banks. Atlanta-based RockBridge Commercial Bank became the 25th Georgia-based bank to fail this year. The FDIC was unable to find another institution to take over the failed bank, and so will mail checks to retail depositors for insured funds.
RockBridge Commercial Bank had roughly $294 million in assets and $291.7 million in deposits as of Sept. 30. Its failure will cost the federal deposit-insurance fund $124.2 million, the regulator said. Panama City, Fla.-based Peoples First Community Bank became the 14th to fail in that state in 2009. Peoples First Community Bank had $1.7 billion in deposits as of Sept. 30, and Gulfport, Miss.-based Hancock Bank has agreed to assume those deposits.
Peoples First Community Bank's failure will cost the deposit-insurance fund $556.7 million, according to the FDIC. New Baltimore, Mich.-based Citizens State Bank's failure will cost the deposit-insurance fund $76.6 million, with the FDIC creating the Deposit Insurance National Bank of New Baltimore to protect depositors of Citizens State Bank. The new bank will remain open for 45 days to allow depositors to access insured deposits and open an account elsewhere, the agency said. Columbus, Ohio-based Huntington National Bank will operate the DINB under contract with the FDIC.
An FDIC spokesman said the agency has created such bridge banks "several times this year and in previous years." Irondale, Ala.-based New South Federal Savings Bank also was closed by regulators Friday. The bank had $1.2 billion in deposits as of Sept. 30, which will be assumed by Plano, Texas-based Beal Bank, the FDIC added. New South Federal Savings Bank's failure will cost the deposit-insurance fund $212.3 million. Springfield, Ill.-based Independent Bankers' Bank was closed, with $511.5 million in deposits as of Sept. 30.
The FDIC said it created the Independent Bankers' Bank Bridge Bank to allow client banks of Independent Bankers' Bank "to maintain their correspondent banking relationship with the least amount of disruption." Independent Bankers' Bank's failure will cost the deposit-insurance fund $68.4 million. Two Southern California banks were closed Friday, the 16th and 17th such failures in the Golden State as a whole. First Federal Bank of California in Santa Monica was taken over by regulators. OneWest Bank of Pasadena will assume all of its deposits and take over First Federal's 39 branches, the FDIC said.
OneWest Bank agreed to purchase all of the $6.1 billion in First Federal Bank assets and did not pay the FDIC a premium for the $4.5 billion in total deposits; the hit to the deposit-insurance fund will be $146 million. Separately, La Jolla, Calif.-based Imperial Capital Bank was closed. It had $2.8 billion in deposits as of Sept. 30, the FDIC said, and its failure will cost the deposit-insurance fund $619.2 million. City National Bank of Los Angeles is assuming all of the deposits in the "least costly" resolution, according to the agency.
FDIC to securitize, sell up to $30 billion in troubled loans in Q1 2010
Latest in bad debt dumping from National Mortgage News:The Federal Deposit Insurance Corp. is contemplating securitizing at least $10 billion of delinquent and underperforming whole loans belonging to failed banks in the first quarter, according to investment banking sources who have been briefed about the plan. These sources, requesting their names not be used, said the bond issuance could rise to as much as $30 billion. The FDIC will be the issuer of record on the MBS.
"Right now it’s a prototype they’re talking about," said a source. At press time, the agency had not returned telephone calls about the matter. The FDIC has hired former secondary market executives that worked for UBS Securities and Option One Mortgage to advise them on the securitization process, said one advisor. "These are smart guys who know their way around the securitization business," he said.
The FDIC may have to guarantee payment on the bonds to lure investors.
Agencies in a Brawl for Control Over Banks
In the darkest days of the financial crisis a year ago, Sheila Bair was hailed for having predicted the housing bust. Today, the chief of the Federal Deposit Insurance Corp. is fighting for her agency's future. The FDIC was set up in 1933 as part of a successful attempt to rescue the banking system, and its deposit guarantees helped save the industry in the present crisis. But as lawmakers hash out the biggest overhaul of financial regulations since the Great Depression, the FDIC could wind up a shadow of its former self.
Connecticut Democrat Christopher Dodd, the Senate Banking Committee chairman, has proposed revoking almost all of Ms. Bair's powers to supervise banks, as part of a sweeping financial-regulation bill now under consideration in the Senate. That would leave Ms. Bair in charge of an agency whose primary role is to clean up banks after they fail, with little part in monitoring them before problems erupt. So, Ms. Bair has been working for months to beat back the idea. She has met with nearly all of the 23 lawmakers on Sen. Dodd's panel, including at least once with the chairman. In the fight to reshape regulation, Ms. Bair has clashed bitterly with Treasury Secretary Timothy Geithner, irked some of her own employees and angered bankers who say the FDIC chairman is stifling their businesses.
There are early signs her forceful lobbying may be working. The House version of the financial regulatory overhaul, which passed last week, is much more FDIC-friendly, thanks in part to her frequent presence on the Hill, say some representatives. Aides say Sen. Dodd is now considering a new proposal that would allow the FDIC to retain its oversight of smaller, community-owned banks, while creating a new agency to oversee national banks. Ms. Bair's struggle is part of a broader battle over the future shape of the apparatus that regulates the U.S. financial system.
In the wake of the crisis, virtually every agency involved stands accused of being asleep at the switch, and officials who led the response are under fire. Federal Reserve Chairman Ben Bernanke, who by the end of next month faces a Senate vote on his re-appointment to a second four-year term, is trying to fight off an assault on the central bank's powers. Mr. Geithner is frequently blasted by the left for being too close to Wall Street. "The FDIC is scrappy, we always have to fight to be heard," Ms. Bair, 55 years old, said in an interview.
Before being tapped to head the FDIC, Ms. Bair bounced between Washington, academia and the private sector in a series of mostly low-profile jobs. She studied philosophy as an undergraduate at the University of Kansas, working for a time as a bank teller, then graduated from the law school. Later, she headed to Capitol Hill as a lawyer for Sen. Bob Dole, a Republican from her state. Enamored of politics, she ran for a Kansas seat in the U.S. Congress in 1990 but lost in the Republican primary by fewer than 1,000 votes to local banker Dick Nichols. (People close to Ms. Bair say she has no plans for another run, and intends to work in academia or run a nonprofit when her FDIC term ends in 2011.)
She went back to Washington for a post on the board of the Commodity Futures Trading Commission, the agency that regulates derivatives trading, then worked in government relations for the New York Stock Exchange before being tapped in 2001 as an assistant Treasury secretary. She left after a year to teach finance at the University of Massachusetts, saying she wanted to spend more time with her family. There she wrote a children's book about financial education, "Rock, Brock, and the Savings Shock," a cautionary tale about twin brothers and the perils of overspending.
In 2006, Ms. Bair was named chairman of the FDIC, which regulates more than 5,000 lenders across the U.S. and runs the fund that insures deposits in the case of bank failures. For most Americans, the FDIC long was just a sticker in banks' windows. Financial markets were relatively calm. No bank had failed since 2004. The FDIC was dwarfed in stature by the Federal Reserve, whose banking regulatory powers overlap those of the agency.
Ms. Bair first looked into the risks of subprime lending while at the Treasury. On joining the FDIC, she directed the agency to purchase loan data from a private company to get a better sense of what a housing bust might look like. Ms. Bair says she found the figures alarming. Close to 75% of securitized subprime loans from 2004 and 2005 were the kind of loans on which payments ballooned after two or three years, creating a potential time bomb.
With this in mind, early in 2007 Ms. Bair started warning of a wave of foreclosures well ahead of other regulators, most politicians and the White House that appointed her. The industry's problems -- failures, rising losses on loans, evaporating capital cushions -- soon started to mount. Ms. Bair added staff, and has about 7,000 employees today from 4,500 when she took over. The FDIC said Tuesday it planned to add an additional 1,600 staffers in 2010 and nearly double the money in its budget to deal with an expected rise in bank failures.
As some of her predictions proved true, Ms. Bair became one of the most recognizable personas of the crisis. On Sept. 17, 2008, two days after the bankruptcy of Lehman Brothers, Ms. Bair sat alone on a House Financial Services Committee panel, warning lawmakers that more needed to be done to help homeowners avoid foreclosure. Giving the seat to a solo witness is a distinction usually reserved for cabinet secretaries and Federal Reserve chairmen.
Inside the government, however, strains were starting to show. Several people close to the FDIC say some staffers were frustrated by Ms. Bair's management style, which one described as "head-cracking" at times. They say some at the agency call her "She Bear," evoking a mother bear: fiercely protective and aggressive when provoked. A spokesman for Ms. Bair says she's not familiar with the term. Early in her tenure, Ms. Bair blasted a group of employees for handing her two staff-written economic reports with conflicting data, according to a person familiar with the matter. Several staffers say they were so worried about making the same mistake again they spent days checking and cross-checking future reports to avoid a reprimand.
In her three years at the FDIC, Ms. Bair had three different people in charge of congressional relations and three different general counsels, moves some employees say were a sign that Ms. Bair was difficult to work for. The FDIC says these departures don't reflect employee dissatisfaction, and say internal surveys show morale has steadily climbed since Ms. Bair took office.
Once the financial crisis struck, Ms. Bair and then-Federal Reserve Bank of New York President Timothy Geithner sometimes tangled. Mr. Geithner often pressed for dramatic interventions to stabilize the economy. Ms. Bair often resisted, as some of the steps might have made the FDIC liable for trillions of dollars of losses if the economy cratered, say people familiar with the matter.
One of Mr. Geithner's first tasks upon becoming Treasury secretary in January was overhauling financial regulation. FDIC officials were frequently left out of the negotiations. They weren't always consulted on key details, say government officials, such as what role the agency would play in monitoring risks in the financial system. A person close to the planning process said the FDIC was left out because the new Obama administration was keeping many decisions internal, and because it feared Ms. Bair, a Republican, might be at odds with some of the points. White House officials deferred to the Treasury for comment, and the Treasury declined to respond.
The White House's June announcement of its overhaul plan stunned FDIC officials, according to several people familiar with the matter. Mr. Geithner proposed taking away the agency's power to enforce consumer-protection laws, giving the Federal Reserve more power over financial institutions and putting the Fed chairman on Ms. Bair's five-member board of directors. The plan did envision the FDIC having more power in one area: taking over and breaking up failing financial companies, rather than just banks.
Ms. Bair viewed the plan as mostly marginalizing her agency and letting the Fed move into FDIC territory, according to people familiar with the matter. On the last Friday in July, Mr. Geithner invited Ms. Bair and several other regulators to a gathering in a Treasury conference room. Several people who attended the meeting described it as the most confrontational meeting of financial regulators in years. Mr. Geithner immediately lit into the regulators in an expletive-laced fury, at times raising his voice to the verge of shouting, according to several people familiar with the meeting. "Everyone needs to get on the same page," he said, according to one of those people. This is too "f-" important, he said.
Ms. Bair sat several seats away. There were close to two dozen officials and aides in the room, including Mr. Bernanke, but some present believed Mr. Geithner's comments were directed at her. Others at the meeting, including Mr. Bernanke, tried to smooth over the tension. A Fed spokeswoman declined to comment on the meeting. Ms. Bair quietly fumed. When she spoke, her voice was pointed and direct. She accused Mr. Geithner of not briefing regulators on details of the financial plan before it was unveiled, people familiar with the meeting said.
Ms. Bair's political struggles have been paralleled by mounting financial struggles at the FDIC. A cascade of bank failures wiped out the FDIC's deposit-insurance fund in the third quarter of this year, pushing it into negative territory for the first time since the savings-and-loan crisis of the early 1990s. After 133 failures so far this year, the balance at the end of September stands at negative $8.2 billion. One of Ms. Bair's biggest tests this year came when Sen. Dodd moved forward with his plan -- the Senate's version of the financial overhaul, which would strip the FDIC of much of its power. He envisioned a single national banking regulator, taking the place of the current four, and leaving the FDIC with one job: cleaning up failed banks.
Ms. Bair has told lawmakers that the FDIC's supervision of banks hasn't been perfect. Several FDIC Inspector General reports have found that the agency allowed some community banks to load up on speculative real-estate loans that eventually caused them to fail. Ms. Bair has argued that taking away her agency's ability to oversee banks and putting all regulatory abilities under one agency would put too much power in one centralized place. "If they do the right thing, then maybe we're OK, but if they do the wrong thing, we're really in the soup," she told a congressional hearing in October.
Sen. Dodd's proposal immediately ran into resistance, including from some lawmakers Ms. Bair met with to plead her case. A spokeswoman for Sen. Dodd says he has not backed off from a single-regulator plan, but is working with lawmakers to build a consensus. Lawmakers, meanwhile, are bristling with stories from people back in their districts about how FDIC examiners have been second-guessing loan decisions made by local bankers, leading many politicians to accuse regulators of stifling the economic recovery.
"An agency takes its culture, its direction from the top," says Sanford Brown, a former bank regulator at the Office of the Comptroller of the Currency and now a managing partner in the Dallas law office of Bracewell & Giuliani LLP. Mr. Brown says several of his bank clients have called him to complain that the FDIC is forcing them to write down the value of loans that the banks say have more value. Ms. Bair brushes aside criticism of the agency's handling of banks. Lenders are trying "to personalize this to me somehow," she says. "Just because some CEO wants to call me and get a different outcome, that doesn't happen. If that makes them unhappy, too bad."
FDIC Increases Budget on Expectations of Mounting Bank Failures
Although signs of economic recovery have begun to take shape, don’t expect the number of bank collapses to ease – that’s the opinion of the federal agency that insures the nation’s financial institutions. The FDIC is boosting its 2010 budget by a hefty 55 percent and adding staff in order to cope with another round of excessive bank failures next year. Earlier this week, the agency’s board approved a $4.0 billion corporate operating budget for the upcoming fiscal year, up from the current 2009 budget of $2.6 billion.
"The 2010 budget is a prudent and measured response to current conditions in the banking industry," said FDIC Chairman Sheila Bair. "It will ensure that we are prepared to handle an even-larger number of bank failures next year, if that becomes necessary, and to provide regulatory oversight for an even larger number of troubled institutions." The agency said in a written statement that the budget increase is primarily due to the cyclical nature of bank failures. The receivership funding component of the 2010 budget, will be $2.5 billion, up from $1.3 billion in 2009. This includes funding for the continuing work associated with bank failures that have occurred since the onset of the financial crisis two years ago.
Funding for the budget increase will come solely from deposit insurance premiums paid by individual banks around the country. The FDIC has implemented a new payment structure requiring insured institutions to prepay three years worth of fees. Collection of this extra capital begins December 30, and is expected to yield over $45 billion to help cover the cost of bank collapses. In conjunction with its approval of the 2010 operating budget, the FDIC’s board also authorized a staff increase. In 2010, the agency will employ 8,653, up from 7,010 in 2009. Almost all the additional staff will be hired on a temporary basis, to assist with bank closings, the management and sale of failed banks’ assets, and supervisory examinations of the nation’s financial institutions.
As DSNews.com previously reported, the FDIC has already opened a large satellite office in Jacksonville, Florida with a crew of nearly 500 specialists to help handle closings in that part of the country. Banks have been going under at a particularly rapid pace in Florida, as well as neighboring Georgia. There have been 133 bank seizures so far this year, compared to 25 in 2008, only three in 2007, and none in 2006 and 2005. The FDIC keeps a watchlist of what it considers to be "problem" banks, and the number of names on that list has climbed to 552 – another sign that a steady stream of institutional failures will likely characterize 2010. Bair says she expects the cost of bank failures between 2009 and 2013 to reach about $100 billion.
Moody's 'axe blow' to rating on Spanish debts
The debt crisis sweeping southern Europe has deepened after US credit-rating agency Moody's downgraded €112bn (£100m) of Spanish mortgage debt and slashed the ratings of Catalunia and a raft of regions with ballooning state deficits. Spain's media called the move an "axe blow", fearing a domino effect through the country's debt markets. Credit default swaps measuring the risk on Spanish sovereign bonds jumped 10 basis point to 101 yesterday. Moody's downgraded a third of the entire stock of Spanish mortgage bonds or "cedulas" – covered bonds deemed safer than US sub-prime securities – but also made from debt that is sliced into packages. Most were cut from AAA (Aaa) to Aa1. They are largely owned by German or French banks and pension funds.
The agency said the Spanish savings banks that issued the bonds are heavily exposed to Spain's property crash. Moody's said it had based its stress test on assumptions of a 45pc fall in house prices. The scale of yesterday's action is huge, roughly equal to a trillion-dollar downgrade in US terms. Spanish banks avoided damage from the global credit crunch because they eschewed US toxic debt, but their own internal sub-prime crisis is slowly catching up with them. Professor Luis Garciano from the London School of Economics said Spain's property bubble left an over-supply of 1.5m homes, the most concentrated glut in the world. The country topped Moody's worldwide "misery index" this week as a result of its fiscal deficit and high jobless rate – now 19pc, and 41pc for youth. The IMF expects the country to grind on in near perma-slump next year.
Spain's travails came as bonds and equities took another pounding in Greece, where Communist unions launched a 24-hour strike and workers marched in protest against austerity measures. The sole good news for battered countries on the eurozone fringes was that Ireland managed to eke out growth in the third quarter, beating the UK out of recession. The feat is unlikely to last as draconian wage cuts come into force in January. The economy has shrunk 7.4pc over the last year. It is expected to relapse next year in what amounts to a three-year depression.
Richard Bruton, Fine Gael's finance spokesman, said it would be "dangerously complacent" to assume that Ireland had turned the corner. Profits from multinationals based in Ireland inflated the GDP figures. The domestic economy (GNP) contracted by 1.4pc. Ireland has been widely praised for taking the drastic steps needed to restore credibility after swinging from boom to bust. Its flexible economy has let it switch output towards exports, which have held up well despite the strong euro. Greece and Spain have no such cushion. They are likely to pay a high price for failure to reform their labour markets during the good years.
Insurers' Claim Rejections Multiplying Lenders' Pain
Private mortgage insurers have stepped up their rejections of claims on defaulted loans, compounding the pain that banks and other lenders have felt from the housing crisis. In the second and third quarters, insurers denied 20% to 25% of claims, up from a historic rate of 7%, according to Moody's Investors Service Inc. Though the insured party is usually Fannie Mae or Freddie Mac, lenders that do business with the government-sponsored enterprises stand to lose when claims are rejected.
This is because, when insurers deny claims, they also rescind the policies. The mortgages in question typically have loan-to-value ratios above 80%, which means Fannie and Freddie cannot hold them without the insurance. So when insurers cancel policies, the GSEs in turn make lenders buy back the loans. "Buybacks are really the pink elephant on lenders' balance sheets that no one wants to talk about," said William Armstrong, the chief executive of Blueberry Systems LLC, a Greenwood Village, Colo., developer of software that captures data discrepancies to prevent repurchase requests.
Fannie and Freddie have already been forcing lenders for more than a year to repurchase greater numbers of faulty loans for reasons other than insurance rescissions. The spike in rescissions is accelerating this trend. Freddie said in its third-quarter financial report that servicers had repurchased $960 million of loans from it during the period, nearly double the amount a year earlier. Fannie does not disclose its volume of repurchase requests, but in its third quarter report, the GSE said that its repurchase requests have been increasing since the beginning of 2008, and that it expects them to remain high into next year.
Peter Pollini, a principal of the consumer finance group at Pricewaterhouse Coopers, said repurchasing a loan whose insurance has been rescinded hits the lender with a "double-whammy." "They have a nonperforming loan that has been brought onto the balance sheet, and they can't sell it, and they have to take the full risk on that loan," Pollini said.
Insurance rescissions and buybacks reflect the dramatic loosening of underwriting standards in the middle of the decade. "Certain product types were flawed the day they were made," said David Katkov, an executive vice president and chief business officer at PMI Group Inc. in Walnut Creek, Calif.
Most loans whose claims are denied have "multiple reasons why they failed," said Katkov, whose company is the second-largest private mortgage insurer as measured by insurance in force. For example, a borrower could have a low FICO score combined with a high loan-to-value ratio, no documentation of income and a questionable appraisal, he said. The combination of all those risk factors on the same loan would make it fall outside PMI guidelines. "How is that loan ever going to perform the way I priced it to perform?"
At PMI, "we're all about paying legitimate claims," Katkov said. "My policy is very explicit. If you went over here and did something that is black, and I said you need to do something that is white, I'm not going to be obligated for that loan."
But others say the mortgage insurers are incorporating rescissions into their business models, using claim denial to get through the crisis. "Lenders are not happy, and the consumers paid a premium for nothing," said Rhonda Orin, a managing partner at the Washington law firm Anderson Kill & Olick. "Lenders counted on private mortgage insurance when they made the loans, and now you have insurers saying the mere fact that a mortgage goes into default means the borrower gave false information, and they're rescinding the policy instead of paying the claim. We call that post-loss underwriting."
The seven private mortgage insurers have rejected $6 billion of claims since early 2008, Moody's said. During the same period, they paid out an aggregate $18 billion to $20 billion in claims. It is unclear how long rescission rates will remain at today's historically high level. Katkov said he is not prepared to say claims are near their peak. But he said the loans made during the middle of the decade, when now-discredited practices like not documenting borrower incomes prevailed, "are getting close to the end of their life." Claims on newer loans are more driven by economic fundamentals like job losses, he said. This suggests that future claims will be harder to deny, though Katkov would not forecast rescission rates.
Banks repurchased $7.1 billion of defaulted single-family loans from various investors in the third quarter, National Mortgage News has reported, up from $1.9 billion in the second quarter. JPMorgan Chase & Co. repurchased the most loans last quarter, $2.7 billion, the newspaper said, and Bank of America Corp. was No. 2, with $2.3 billion repurchased.
B of A did not return calls. Tom Kelly, a spokesman for JPMorgan Chase, said most of its buybacks were of loans from Government National Mortgage Association pools. Such loans are insured by government agencies like the Federal Housing Administration, a part of the Department of Housing and Urban Development. So bringing them back on the balance sheet did not affect JPMorgan Chase's reserves or chargeoffs, Kelly said. But there also is concern that the FHA, whose capital reserves have dwindled, could become more aggressive in rejecting claims.
"HUD is acting more and more like an insurer where, if they are faced with a potential loss, they will look at the file just like a mortgage insurer, and they won't pay the claim if there is a problem," said Dan Cutaia, the president of Fairway Independent Mortgage in Sun Prairie, Wis. "That's a big change because FHA has been pretty lax over the years." Laurence Platt, a partner at K&L Gates LLP, said lenders could take comfort that FHA has higher thresholds for claim rejections than private insurers, which can deny a claim if information is materially untrue. "FHA has to show the lender knew or reasonably should have known if information is incorrect," he said. "So the lender never bears the risk of pure borrower fraud unless it could reasonably have been caught."
Down-Payment Standards Eased
Some mortgage insurers and lenders are beginning to relax their down-payment requirements, in a sign of increased confidence in the housing market. The changes, which are being done on a market-by-market basis, mean buyers in some parts of the country can now borrow 95% instead of 90% of a property's value. Until recently, mortgage companies had tighter standards for these markets because of falling home prices. "We are feeling better about the economic condition of the marketplace," said Michael Zimmerman, senior vice president of investor relations at mortgage insurer MGIC Insurance Corp. Borrowers who want to finance more than 80% of a home's value must typically purchase mortgage insurance.
Earlier this month, MGIC removed New Orleans, Dover, Del., Akron, Ohio, and four other areas in Ohio from its list of restricted markets. The moves followed the company's decision in September to loosen restrictions on 11 markets, including Denver and St. Louis. Under the looser requirements, a borrower with a credit score of 680 or higher in New Orleans, for instance, can finance up to 95% of a home's value. Before the change, a borrower who wanted to finance that much of a home's value would have needed a credit score of at least 700.
In September, Genworth Financial Inc. winnowed its list of declining and distressed markets to five states: Arizona, California, Florida, Michigan and Nevada. That removed 63 markets from the list and followed an action in July that removed 136 other metro areas from the list. "We've seen some stabilization in the housing market," said Kevin Schneider, president of Genworth. While "additional home price declines" are likely, he added, tighter credit standards, including the requirement of full documentation and higher credit scores, should limit delinquencies.
Credit remains tight in some markets, such as Florida, because of concerns about additional home-price declines. Mortgage companies continue to closely scrutinize property appraisals, making it difficult for some borrowers to get financing. Amid persistent high unemployment, lenders and mortgage insurers are maintaining tough standards for credit scores, documentation and other measures of creditworthiness. In some cases, those standards are still getting tougher. Fannie Mae, the government-controlled mortgage company, last week raised its minimum credit score to 620 from 580.
But the latest moves, while modest, are an indication that some mortgage companies believe the worst home-price declines are over -- at least in certain parts of the country -- and that prices are likely to stabilize or fall slightly over the coming year. A rosier view of the housing market isn't the only factor driving the changes. Mortgage insurers also are seeking to regain market share from the Federal Housing Administration.
New insurance written by private mortgage insurers dropped by nearly 60% in the first nine months of 2009, compared with the same period a year ago, according to Inside Mortgage Finance. Borrowers without sufficient funds for a 20% down payment have been flocking to the FHA, which lends to people with as little as a 3.5% down payment. "To have any presence in the mortgage market, the mortgage insurers have to be more flexible," said Guy Cecala, editor of Inside Mortgage Finance, a trade publication. The mortgage insurers had gotten so strict, he noted, that their standards were tougher than those of Fannie Mae and Freddie Mac.
Meanwhile, some mortgage lenders are revisiting policies that were even tougher than those of the insurers. Wells Fargo & Co. executives met Friday for their quarterly review of market-based lending standards. For the first time since 2007, more markets will be moving to a less-risky status and lower down-payment requirements. Among those benefiting are parts of central California. Even in some of the country's most troubled markets, "we are starting to see...moderation" said Neil Librock, head of credit risk for the bank's home and consumer-finance group. Wells Fargo's changes could benefit borrowers the bank has been requiring to make down payments of more than 20%, he said.
New ice age for bankers
by Robert Peston
For all the furore about Alistair Darling's bonus super-tax, and for all the disclosure overnight by Deutsche Bank that it will spread the pain across all staff and shareholders around the world and not just in the UK, there is a much bigger threat to business-as-usual for banks and bankers.
The international rulemaking body for the banking industry, the Basel Committee on Banking Supervision, has proposed a series of reforms that would change the nature of banking in a profound way (Strengthening the resilience of the banking sector [282KB PDF]).
Some will mutter about stable doors and horses: it was the inadequacy of the existing Basel rules which provided dangerous incentives to banks to take the crazy risks that have mullered the global economy.
But be in no doubt. Although its reform paper, "Strengthening the resilience of the banking sector", may seem technical and obscure, it would turn a particular kind of high-paying, securities trading, global megabank - the institutions that created and defined the boom-and-bust conditions of the past decade - into an endangered species.
If I were running Barclays, or Deutsche Bank, or JP Morgan or even Goldman Sachs, I would be more than a little anxious about the cumulative impact of the Basel Committee's recommendations on the additional high-quality capital that banks would be required to hold, the liquid assets they need to accumulate and also - oh yes - the rewards banks can distribute to employees and shareholders.
Mr Darling's raid on their cash boxes looks trivial by comparison: it's just a one-off; Basel is forever.
The Basel reforms would make it prohibitively expensive for banks to do all that wheeling and dealing in securities and derivatives that yielded bumper profits and bonuses in the boom years and brought the world to the brink of depression last autumn.
Perhaps most significant would be the proposal to limit the ability of banks to pay out bonuses to staff and dividends to shareholders as and when their respective capital resources approach the minimum allowed.
The nightmare before Christmas for bankers is the tape on page 70 of the report, which sets out the new global incomes policy for them.
It will be seen by bank boards and owners as an infringement of their basic right to pay themselves what they want and when they want.
The consequences would be profound not only for the banking industry but also for the economy - which is why they will be phased in over years.
They are likely to mean that far less credit to households and non-financial businesses will be provided by conventional banks, because the cost to banks of providing credit in any form will rise.
They are also likely to force a mass exodus from banks of the more entrepreneurial, brainier, traders and financial engineers - who may either go for real jobs in the real economy (is that such a terrible idea?) or will create all manner of new-fangled financial institutions, which won't take retail deposits, won't be banks in a technical sense, and won't be subject to such onerous regulation and supervision.
Yes, the Basel plans almost certainly mean there'll be another great sprouting of hedge funds and alternative investment vehicles.
You can decide whether that's a good thing or a bad thing.
By the way, if you want a bit more granularity on how and why an ice age just arrived for banks and bankers, look no further than the recent Financial Services Authority discussion document on reinforcing the capital strength of British banks and also today's Financial Stability Report from the Bank of England [3.95Mb PDF].
The FSA estimates that financial institutions in the UK will need to raise an additional £33bn of capital to meet new rules out of the European Union designed to reduce the riskiness of their trading activities and of securitisation (of turning loans into tradeable assets).
Now the big point about that £33bn is that it does not include the additional requirements that will be imposed by the new Basel framework. The £33bn is just a beginning.
Which gives the banks two choices. They can try to raise the £33bn and whatever else is subsequently demanded of them. Or they can massively reduce their trading activities - which seems the more likely outcome.
Can they turn to the Bank of England for a shoulder to cry on. Not likely.
It makes this helpful point to banks which - it agrees - are still chronically short of capital: "reducing staff costs [at banks] by around one tenth and dividend payout rates by around a third would allow UK banks to increase retained reserves by close to £70bn over the next five years".
Crikey: five years of stunted bonuses! Grown bankers will weep.
Secrets strengthen case for CDS exchange
by Gillian Tett
Until recently, not many western politicians – let alone those in Greece – knew much about sovereign credit default swaps. Even fewer cared. But I suspect that is about to change. This year the CDS spreads on sovereign debt have swung sharply, as investors have turned to these products to hedge themselves against the danger of a government default (or quasi default). In the case of Greece, for example, the spread is currently about 240 basis points, compared with 5bp three years ago.
And since the CDS market is apt to be a leading indicator for other markets (just look, again, at the recent experience of Greece), the movement of spreads is starting to grab attention from investors and politicians alike. To many CDS fans, this is gratifying. After all, this rising focus on CDS supports the idea that these products are a useful part of the modern financial toolkit.
However, there could also be a sting in the tail for CDS lovers. As the level of attention grows, the level of regulatory and political scrutiny is likely to rise too. And if politicians do start paying more attention to the world of sovereign CDS – as they are likely to do if, say, more market turmoil erupts – there is a good chance that they could find things in this market that leave them perturbed. After all, one dirty secret of the sector is that trading volumes in the market are apt to be low, even in instruments that attract high attention (such as Greece or Dubai). Worse still, nobody really knows exactly how low volumes are (or not), because this is an over-the-counter market, conducted away from any exchange.
Thus even when spreads swing wildly on a sovereign name, it is hard to know whether that has arisen just because a big hedge fund has tried to move prices by conducting a huge trade – or whether there is truly a liquid market with sellers and buyers. Indeed, it is pretty tough for non-bankers even to get intraday prices for sovereign CDS (and though end-of-day quotes have recently become publicly available, these vary between data providers).
The pattern of investor demand also seems uneven. In the past year, plenty of investors have been buying protection against the chance of sovereign default. However, it appears that the main sellers of this protection are banks. That creates the perverse situation that (as the European Central Bank recently observed) European banks are now net sellers of insurance against the chance of their own governments going into default – even though those same banks are implicitly backed by those governments.
None of these problems, of course, is entirely unique to sovereign CDS; many other immature OTC markets are also pretty illiquid and opaque (and since sovereign CDS is just a few years old, it is still immature.) But what makes sovereign CDS so fascinating is politics. If prices swing wildly in opaque OTC equity derivatives products – or even CDS linked to small companies – politicians are unlikely to care.
However, if sovereign CDS start gyrating, and affecting government debt costs, that could create more controversy. Indeed, it already has: when the government of Iceland tipped into crisis last year, it was quick to claim that hedge funds were manipulating the price of Icelandic CDS.
Is there anything banks can do about this? Personally, I think the situation strengthens the case for moving some core corporate CDS indices on to an exchange, along with some sovereign CDS. After all – as one of the savviest Wall Street players recently pointed out to me – if you look at the other big four asset classes in the financial world today (namely equities, rates, foreign exchange and commodities) it is notable that all of those have transparent, credible benchmarks, to act as a "core", around which bespoke, more opaque, products can be built.
Credit markets, however, have developed without this, because although corporate indices such as the iTraxx are liquid, they are not as publicly credible and transparent as, say, the S&P 500, the gold price or dollar-yen rate. Now putting trading on an exchange is certainly not the only way to garner more investor credibility. But it is the easiest way to create a stronger "core" and protect the sector from political sniping too. And even if a small core of products were placed on an exchange, banks could still create bespoke products too, referencing that core.
Will this happen? Don’t hold your breath. Most large banks strongly oppose the idea of exchange trading for CDS; instead, they hope that improving the OTC infrastructure, by improving clearing platforms, will be enough.
But this seems a missed opportunity. In the long run, I believe that CDS can play a useful role in the sovereign and credit debt markets alike; but right now, the market badly needs to mature. If not, the next western fiscal dramas could soon generate more publicity for sovereign CDS – but not in a beneficial way.
Midnight in the foodstamp Economy
At 11 p.m. on the last day of the month, shoppers flock to the nearest Walmart. They load their carts with food and household items and wait for the midnight hour. That's when food stamp credits are loaded on their electronic benefits transfer cards. "Once the clock strikes midnight and EBT cards are charged, you can see our results start to tick up," says Tom Schoewe, Wal-Mart Stores Inc's chief financial officer.
As food stamps become an increasingly common currency in a struggling U.S. economy, they are dictating changes in how even the biggest retailers do business. From Costco to Wal-Mart, store chains are rethinking years of strategy as they watch prized customers lose jobs and turn to this benefit, the stigma of which is disappearing not just in society, but in corporate America. Besides staffing up for the spike in shoppers on the first day of the month, retailers are adjusting when and what they stock, updating point-of-sale systems to accept food stamps and shifting expansion plans to focus on lower-income shoppers.
Take Costco Wholesale Corp, a warehouse club operator that caters to middle income Americans who must pay $50 a year to shop in its stores. Nudged along by New York Attorney General Andrew Cuomo, who threatened legal action, Costco began accepting food stamps at a few New York stores in May. It now plans to clear the payments in all of its 413 locations in the United States and Puerto Rico. "Our view was ... we would not get a lot of food stamps because our member on average is a little more upscale," Costco Chief Financial Officer Richard Galanti said in October. "Well, I think that was probably a little bit arrogant on our part."
As of September, a record of more than 37 million people were enrolled for the government benefit, federal officials told Reuters, an increase of nearly 35 percent since the U.S. slid into recession at the end of 2007. An estimated one in eight Americans depends on the benefit to buy food. With the nation's unemployment in double digits, more people are expected to enroll. By some government estimates, up to 16 million people who are not receiving food stamps today could qualify.
What's more, unemployed Americans are finding that it takes longer and longer to get work. This suggests that food stamps will play a bigger role over the next few years, not just for people, but for stores in need of customers, according to interviews with retail executives, economists, federal and state officials and benefit recipients. "It is a very important and increasingly important source of revenue for the ... supermarkets and stores that have been approved across the country to process those benefits," Kevin Concannon, U.S. undersecretary of agriculture, said in an interview this month.
Stores have little choice but to respond. And they are. In the fiscal year that ended in September, 193,753 U.S. retailers accepted food stamps, 17 percent more than the same period two years earlier. "For some chains... it's 10 to 12 percent of their revenues," Concannon said. "Depending on how poor the area may be, it may even be higher." Tellingly, electronic benefits transfer (EBT) transactions processed by retailers jumped 53 percent this year on a same-store sales basis on Black Friday, the kickoff to the U.S. holiday shopping season, payments processor First Data told Reuters. EBT includes food stamps and other government benefits like temporary cash assistance for needy families and food assistance for new and expecting mothers.
Thelma Zambrano wants to keep shopping at Costco, but can't afford to renew her membership since losing her customer service job at a bank. Now, she takes monthly food stamp benefits of about $300 and helps others do the same at the Community Action Partnership of Orange County, California, a nonprofit that helps poor people and where she now works. "Before we made anywhere from $55,000 to $65,000, and right now... I'm lucky if I make $15,000 or $20,000," said Zambrano, a 26-year-old mother of two from Santa Ana. She and her husband have cut spending to the bone and moved in with relatives.
Most food stamp recipients subsist on earnings below the poverty line -- roughly $22,000 annually for a family of four -- and many new users are from the ranks of the working poor. Zambrano's experience illustrates how the recession also has sent many middle-income families into economic freefall. Their circumstances have, in turn, served as a wake-up call for food retailers that never thought their clientele would depend on public assistance. For her part, Zambrano let her mother know that a new membership to Costco would make a perfect holiday gift. "She got the hint," she said. "I'm sure we'll probably get our membership for the next year."
Eighty-five percent of food stamp benefits are redeemed at grocery and warehouse stores, and the program means serious business for such retailers. Nearly $55 billion in food stamps may be redeemed this year, up from about $37 billion in 2008 and $31 billion in 2007, according to The Nilson Report. The USDA expects to have more than $64 billion to spend on food stamp benefits in fiscal 2010, including nearly $6 billion in anticipated stimulus money, up 14 percent from fiscal 2009.
Dollar General says food-stamp use accounts for about 4 percent of its sales, and is growing about 10 percent year over year. Kroger Co Chief Executive David Dillon said food stamp use at the biggest U.S. grocery chain is at the highest levels that executives at the company can remember. "You go back to three or four years ago, the food stamp volume we're currently running is not quite double, but it's a lot higher. So it's very significant," Kroger's Dillon said recently.
Tina Contraeras is one of those shoppers who goes to Walmart on the first of each month. She shops at the one in American Canyon, just outside California's Napa Valley. Unemployed and on disability benefits, Contraeras, 45, has custody of her grandchildren, ages 2 and 3. She has resorted to circling the first of the month on her calendar so that when her grandchildren are hungry, she can count down the days until they can return to the grocery store. "I have to make a game out of it for the kids," she said. She feels she has no other choice.
Technology is one reason the food-stamp stigma is fading. While recipients once announced their status by pulling out bulky coupon books at the checkout counter, today's users are far less noticeable. Benefits from the food stamp program, now known as the Supplemental Nutrition Assistance Program (SNAP), and other types of government financial assistance are loaded onto EBT cards that can be swiped to make a payment, just like a debit or credit card.
Like Contraeras, other food-stamp beneficiaries appear to waste little time cashing in their benefits. According to J.P. Morgan which administers EBT programs for more than 20 states, 85 percent of food stamps are depleted within the first three days they are available. Companies like Walmart and Kroger now talk about a sales bump on those days, a phenomenon that more than a decade ago inspired a song by hip hop group Bone Thugs-n-Harmony called "1st of tha Month."
Poverty hit an 11-year high in 2008, the same year in which a government report showed that more than 49 million Americans were at risk of going hungry. And recreating the jobs lost during a downturn doesn't necessarily happen fast. It took nearly four years to regain all the jobs lost during the 2001 recession, when unemployment peaked at 6.3 percent, according to the Economic Policy Institute, a progressive think tank in Washington, D.C.
Expecting the worst this time around, retailers are trying to reposition their business for what they call a "new normal," where jobs are scarcer, and more and more Americans depend on the government to make ends meet. After years of wooing higher income shoppers, national chains are now seeing opportunity in the low end of the market. Supervalu Inc recently announced plans to open 50 new Save-A-Lot discount stores this year and to have another 100 stores in the pipeline for next year. The additions will bring its total number of Save-A-Lot stores to about 1,330. It is paying for the initiative by halving its quarterly dividend.
Family Dollar Stores Inc, which sells most of its merchandise for below $10, began realigning its business even before the downturn. It installed refrigerators and coolers in its stores, enabling it to sell perishable food like milk and luncheon meat, and upgraded its checkout system to accept EBT as payment. To accept food stamps, retailers must sell food in each of four staple food groups: bread and grains; dairy, fruit and vegetables; and meat, poultry and fish. Or, at least 50 percent of the total sales in a store must be from the sale of eligible staple food, like flour, bread or beef.
Dorlisa Flur, Family Dollar's chief merchandising officer, says the store's core shoppers have been "under pressure" for years. She describes that core shopper as a woman who earns less than $40,000 a year and lives paycheck to paycheck. This shopper was hit hard in 2005 when gasoline prices spiked in the wake of Hurricane Katrina. Then came a surge in food prices, a housing bust and recession. "When the whole housing market fell apart too, that really drove her to lean on food stamps," Flur said. "By accepting EBT, we were opening up a portion of the wallet we were not able to touch before."
Most retailers are reluctant to discuss how much money they have spent updating their point-of-sale, or POS, systems to accept food stamps as payment. J.P. Morgan said that in an effort to limit expenses for retailers as paper food stamps were phased out, EBT cards were designed to work off existing magnetic stripe technology. "The expense for updating POS terminals was more than absorbed by the savings from eliminating paper handling," according to Christopher Paton, managing director in J.P. Morgan's Treasury Services Public Sector Group.
Retailers could more than make up for their investments if food stamp ranks continue to swell, as expected. There are currently 1.25 million households receiving food stamp benefits in California, and 1.22 million households in Texas, according to the USDA. As of 2007, the latest year of available data, only half of eligible individuals in those states were enrolled to receive the benefits. Many Californians are intimidated by the application process or do not realize they are eligible, keeping food stamp usage far below where it should be, said Alameda County Community Food Bank spokesman Brian Higgins.
Calls to his food bank, across the bay from San Francisco, for emergency food help have surged. "In our first 13 years, we only went over 1,500 (phone calls) in one month twice," he said. "We've gone over 3,000 (phone calls) for the fourth month in a row and the numbers are going up." The food bank, which runs a food stamp outreach program, tells callers that they might qualify for the benefit.
Pamela Center, 48, turned to the Alameda Food Bank for help when she signed up for food stamps in November. Center, an in-home care provider, saw her monthly income shrink to about $410 from $1,500 after she lost a client. She tries to stretch her dollars by eating at her parents' house or visiting food banks, but she was still not getting enough to make it through the month. That hunger led her to overcome her own inhibitions and sign up for benefits. "With my pride, I was like, 'I really don't want to do this,' but if I don't I will have nothing left in my house," she said.
The Great Stabilisation
The recession was less calamitous than many feared. Its aftermath will be more dangerous than many expect
It has become known as the “Great Recession”, the year in which the global economy suffered its deepest slump since the second world war. But an equally apt name would be the “Great Stabilisation”. For 2009 was extraordinary not just for how output fell, but for how a catastrophe was averted.
Twelve months ago, the panic sown by the bankruptcy of Lehman Brothers had pushed financial markets close to collapse. Global economic activity, from industrial production to foreign trade, was falling faster than in the early 1930s. This time, though, the decline was stemmed within months. Big emerging economies accelerated first and fastest. China’s output, which stalled but never fell, was growing by an annualised rate of some 17% in the second quarter. By mid-year the world’s big, rich economies (with the exception of Britain and Spain) had started to expand again. Only a few laggards, such as Latvia and Ireland, are now likely still to be in recession.
There has been a lot of collateral damage. Average unemployment across the OECD is almost 9%. In America, where the recession began much earlier, the jobless rate has doubled to 10%. In some places years of progress in poverty reduction have been undone as the poorest have been hit by the double whammy of weak economies and still-high food prices. But thanks to the resilience of big, populous economies such as China, India and Indonesia, the emerging world overall fared no worse in this downturn than in the 1991 recession. For many people on the planet, the Great Recession was not all that great.
That outcome was not inevitable. It was the result of the biggest, broadest and fastest government response in history. Teetering banks were wrapped in a multi-trillion-dollar cocoon of public cash and guarantees. Central banks slashed interest rates; the big ones dramatically expanded their balance-sheets. Governments worldwide embraced fiscal stimulus with gusto. This extraordinary activism helped to stem panic, prop up the financial system and counter the collapse in private demand. Despite claims to the contrary, the Great Recession could have been a Depression without it.
Stable but frail
So much for the good news. The bad news is that today’s stability, however welcome, is worryingly fragile, both because global demand is still dependent on government support and because public largesse has papered over old problems while creating new sources of volatility. Property prices are still falling in more places than they are rising, and, as this week’s nationalisation of Austria’s Hypo Group shows, banking stresses still persist. Apparent signs of success, such as American megabanks repaying public capital early (see article), make it easy to forget that the recovery still depends on government support. Strip out the temporary effects of firms’ restocking, and much of the rebound in global demand is thanks to the public purse, from the officially induced investment surge in China to stimulus-prompted spending in America. That is revving recovery in big emerging economies, while only staving off a relapse into recession in much of the rich world.
This divergence will persist. Demand in the rich world will remain weak, especially in countries with over-indebted households and broken banking systems. For all the talk of deleveraging, American households’ debt, relative to their income, is only slightly below its peak and some 30% above its level a decade ago. British and Spanish households have adjusted even less, so the odds of prolonged weakness in private spending are even greater. And as their public-debt burden rises, rich-world governments will find it increasingly difficult to borrow still more to compensate. The contrast with better-run emerging economies will sharpen. Investors are already worried about Greece defaulting (see article), but other members of the euro zone are also at risk. Even Britain and America could face sharply higher borrowing costs.
Big emerging economies face the opposite problem: the spectre of asset bubbles and other distortions as governments choose, or are forced, to keep financial conditions too loose for too long. China is a worry, thanks to the scale and composition of its stimulus. Liquidity is alarmingly abundant and the government’s refusal to allow the yuan to appreciate is hampering the economy’s shift towards consumption (see article). But loose monetary policy in the rich world makes it hard for emerging economies to tighten even if they want to, since that would suck in even more speculative foreign capital.
Walking a fine line
Whether the world economy moves smoothly from the Great Stabilisation to a sustainable recovery depends on how well these divergent challenges are met. Some of the remedies are obvious. A stronger yuan would accelerate the rebalancing of China’s economy while reducing the pressure on other emerging markets. Credible plans for medium-term fiscal cuts would reduce the risk of rising long-term interest rates in the rich world. But there are genuine trade-offs. Fiscal tightening now could kill the rich world’s recovery. And the monetary stance that makes sense for America’s domestic economy will add to the problems facing the emerging world.
That is why policymakers face huge technical difficulties in getting the exit strategies right. Worse, they must do so against a darkening political backdrop. As Britain’s tax on bank bonuses shows, fiscal policy in the rich world risks being driven by rising public fury at bankers and bail-outs. In America the independence of the Federal Reserve is under threat from Congress. And the politics of high unemployment means trade spats are becoming a bigger risk, especially with China.
Add all this up, and what do you get? Pessimists expect all kinds of shocks in 2010, from sovereign-debt crises (a Greek default?) to reckless protectionism (American tariffs against China’s “unfair” currency, say). More likely is a plethora of lesser problems, from sudden surges in bond yields (Britain before the election), to short-sighted fiscal decisions (a financial-transactions tax) to strikes over pay cuts (British Airways is a portent, see article). Small beer compared with the cataclysm of a year ago—but enough to temper the holiday cheer.
How the Citi stock offering flopped
by Felix Salmon
The Citigroup secondary offering yesterday, which went much worse than planned, is a prime example of the difference between primary and secondary markets. A lot of investors simply assume without thinking too much about it that a rising stock price is always a good thing for the company in question, and they’re right to do so. But there are two kinds of stock price, and sometimes it can be hard to tell the difference.
The first type, which is based on perceived fundamentals, is the price that investors are willing to pay to own a stake in the company over the long term. The second type, which is based on markets, is much more speculative, and is fundamentally a bet on what other people will be willing to pay for the stock in the short term.
If you have a type-1 stock, it’s pretty easy to sell new stock at or near the secondary-market price. If you have a type-2 stock, however, it can be very hard. And a lot of people looking at the rise in bank stocks since March were wondering, in the back of our heads, how much of it was momentum trading and speculation, and how much of it was based on fundamentals.
Certainly a large part of it was speculative — a large part always is. Speculators are short-term liquidity providers, but you need long-term fundamental investors to represent a significant share of the market in order to be sure that the share price won’t collapse overnight. One of the tell-tale signs that the dot-com boom was a bubble was the tiny free floats on some of the most high-flying stocks: they might be up enormously, but that was only because the IPOs had been minuscule, and there was a mad rush for the very small number of shares available to the public. When those companies were reluctant to try to cash in on their soaring share prices by selling off more of their stock, it was a sign that the inflated capitalizations weren’t real.
Similarly, today, shares in AIG can bob around in significantly positive territory for as long as they like, but there’s no way that the company could ever get a secondary stock offering away.
Which brings us back to Citigroup. Eric Dash explains what happened:Badly misreading the financial markets, the company struggled on Wednesday to raise the money it needed to repay its bailout funds…
Citigroup officials maintain that they did a good job considering the tough market conditions and should be lauded for pulling off the largest equity offering in American history. Some analysts have their doubts.
Shouldn’t those officials have considered the tough market conditions before they made the decision to attempt the largest equity offering in American history?
At least now it’s a bit more obvious why Vikram Pandit couldn’t make his scheduled meeting with the president on Monday: he really was desperately trying to drum up interest in this share sale. Obviously he and his capital markets team didn’t do a particularly good job: Treasury told them it wouldn’t sell any of its stake at a loss, they tried to make sure that Treasury wouldn’t have to, and they failed, so Treasury withdrew its stake from the stock offer.
None of this is going to help relations between Citigroup and its largest single shareholder, the US government. Indeed, as Treasury tries to sell down its stake in the company over the next six to 12 months, it might not even use Citigroup’s equity capital markets team to do so, given the unimpressive showing that team made on Monday.
And I suspect that the real problem here was that Citi’s bankers started believing their own share price, thinking that there was much more fundamental demand for ownership of this behemoth than actually there is. Citigroup stock trades at a low nominal price on very high volume, which is like catnip to speculators who can make huge returns on relatively small changes in the share price. As a result, the nominal price is a relatively weak indication of the fundamental demand for Citigroup ownership. And debacles like yesterday’s result.
Discord Behind TARP Exits
This week's exits of Citigroup Inc. and Wells Fargo & Co. from the federal bailout program were supposed to mark a triumphal moment for the banking industry and Obama administration. But behind the scenes, the process has been marred by finger-pointing between federal officials and bank executives. There also has been in-fighting among different bank regulators, with each debating the health of giant financial institutions, say people familiar with the matter.
The conflict flared after Citigroup on Wednesday struggled to sell $17 billion in stock to pay for the company's exit from the Troubled Asset Relief Program. That forced the Treasury Department, which now holds about one of every four Citi shares, to freeze a separate plan to sell down its stake. Some Citigroup executives blame the Treasury for the flop, and say the government shouldn't be surprised by the weak performance, say people close to the bank. Vice Chairman Ned Kelly on Monday evening placed a phone call to a top Treasury aide, irate that the government was letting Wells Fargo launch a simultaneous stock sale that could siphon off demand for Citi shares, according to people familiar with the call.
Bank regulators at the Federal Reserve and Federal Deposit Insurance Corp., meanwhile, have disagreed with other government officials about banks' plans to repay government funds, and have privately complained that Treasury officials pushed them to allow banks to quickly leave TARP, according to people familiar with the matter. Treasury officials said Thursday that decisions about bank repayments are up to bank regulators at the Fed and FDIC. They added that it was Citigroup's idea to stage the ambitious stock offering, despite the government's misgivings.
The tensions come as regulators deal with a tricky and unprecedented phase of the financial crisis: how and when to unwind taxpayer support for banks. Allowing banks to repay the funds can put the banks back to work and allow them to operate normally. Withdrawing taxpayer money too soon could destabilize the banks if they face future credit problems. The unwinding also has put the government in the unusual position of financial-market participant, trying to pick the best time to launch stock offerings and gauge investor demand.
The Federal Reserve Bank of San Francisco found that Wells Fargo was healthy enough to be allowed out of TARP on relatively easy terms, by raising roughly $6 billion in new capital. Some officials at the Fed's Washington headquarters felt the bank needed to raise much more capital, said people briefed on the matter. After weeks of talks, the Washington-based camp agreed to let Wells Fargo repay the government as long as it raised $10.4 billion by selling shares, these people said. Representatives for the Fed in Washington and San Francisco declined to comment.
Earlier this fall, at the urging of the Treasury, the Fed and FDIC laid out the terms for Citigroup to leave TARP: It would need to raise roughly $20 billion in new capital. Citigroup executives said that was an unnecessarily large amount, because the bank already had ample capital. They also warned federal officials last week that such an ambitious offering could fall flat, embarrassing Citigroup and the government, according to people familiar with the matter.
Despite such worries, Citigroup executives pushed ahead, fearful of becoming the last major bank still under TARP. As the details of the repayment deal were being hammered out over last weekend, Citigroup urged the Treasury to sell some of its shares as part of Citigroup's planned stock offering. Citigroup officials argued such a sale would be an important symbol of the Treasury's confidence in the company, these people said. Treasury officials were unsure whether there would be investor appetite for their shares, but eventually agreed to sell about $2 billion of stock. Citigroup later pushed the Treasury to boost its sale to $5 billion, arguing that would send a strong message that the Treasury was serious about winding down its position. The Treasury grudgingly agreed, according to people familiar with the matter. "They pushed for that," a federal official said.
The deal was unveiled Monday morning, and Citigroup executives got to work trying to round up big institutional investors to buy more than five billion soon-to-be-issued shares. By midday, though, executives were hearing market chatter that Wells Fargo had received regulatory clearance to repay TARP, and was poised to launch its own stock offering to raise the necessary capital, according to people familiar with the matter.
Citigroup executives fumed. Wells Fargo is generally viewed as healthier than Citigroup, and the San Francisco bank's competing stock sale thus threatened to drain investor interest in Citigroup's shares.
Late Monday, Wells Fargo announced that it was selling $10.4 billion of stock in order to repay its TARP funds. Monday evening, Mr. Kelly placed the phone call to a senior Treasury aide. Sleep-deprived after government negotiating sessions and investor meetings, Mr. Kelly warned that Wells Fargo's sale was likely to soak up investor demand. As a result, he said, Citigroup might have to sell its shares for less than the $3.25 that the Treasury had paid for its shares.
By Tuesday, it was becoming clear to Citigroup executives that they wouldn't be able to get a good price on their stock offering. Executives told Treasury officials that there wasn't enough investor demand for the Treasury to sell. Adding to the bank's frustration: Citigroup had requested in September that the Treasury to sell down its stake. Citigroup shares was trading around $4.50 during the month. Citigroup fell 7.3% on Thursday, to $3.20, off 19% this week. Wells Fargo rose 23 cents, or 0.9% to $26.07.
The TARP Isn't Quite Rolled Up Yet
Don't write "fini" to the TARP era just yet. Yes, Bank of America has repaid its Troubled Asset Relief Program funds, and Citigroup and Wells Fargo are in the process of exiting as well. Many observers view the flurry of repayments as a sign that the era of bailouts is ending and the banking industry is rebounding. But it is premature to be bullish. Many banks below the top-tier national and superregional banks look unlikely to repay TARP soon. Beyond the eight original TARP recipients, only 17 of the other 69 banks who got at least $100 million from TARP have repaid the funds. The top eight's combined assets of $9.4 trillion outweigh the larger group's still sizable $2.5 trillion.
Some banks would hurt themselves or their shareholders if they repaid now. They are posting losses, have high levels of bad or overvalued loans for which they aren't adequately prepared, or have major exposure to the commercial real-estate crunch. Consider Huntington Bancshares, which got $1.4 billion in TARP money. The bank looks like it has a way to go yet. It posted losses for both the third quarter and the first nine months of 2009, and its third-quarter nonaccrual loans, those on which it has stopped accruing interest because of doubts about payment, rose 20% from the previous quarter to a high 5.85% of total loans.
Huntington has a strong Tier 1 capital ratio of 13.04%, but there is less there than meets the eye. The bank is underreserved for bad loans: Its loan-loss allowance is only 47% of nonaccrual loans, far below the 86% average for banks its size. Also, the fair value of Huntington's loans has fallen 13% below the value at which they are carried on the balance sheet. If Huntington had to take that decline into account, as accounting rule makers may soon require banks to do, and reserved enough for bad loans to bring it up to the 86% average, its Tier 1 capital would be virtually erased. Huntington says the bank "is in a position to repay TARP" and had raised $1.7 billion in capital this year. But because of the severe recession in the bank's Midwest base, "we are being very cautious."
Marshall & Ilsley also posted third-quarter and nine-month losses, and says it "will take a few more quarters to fully address our problem loans." Like Huntington, its capital isn't as solid as it looks because of underreserving and a drop in its loans' fair value. Greg Smith, M&I's chief financial officer, said there was only "a very small likelihood" it would repay its $1.7 billion in TARP funds in 2010, but said it has "a pretty good capital base." Then there is Synovus Financial, with $967.9 million from TARP. Its loan-loss allowance is only 61% of nonaccrual loans, and 5.8% of loans are nonperforming. Nearly half its loans are related to commercial real estate and development. Synovus said it has been active in preserving capital and reducing bad-loan exposure.
TARP money makes up a significant chunk of Tier 1 capital at all three banks, from 24% at Huntington to 33% at Synovus, and it would be significantly dilutive to the banks' shareholders if they had to raise fresh capital to repay it. The banks want TARP to be over, but security is better than haste. Investors understand that; witness the skepticism about Citi's capital raise to exit TARP. That means the post-TARP era, and a true banking revival, are going to have to wait awhile.
Harvard’s Feldstein Says U.S. Economy Still Mired in Recession
The U.S. economy remains mired in a recession, prospects for next year are weak and home prices may resume declines, Harvard University economics professor Martin Feldstein said.
"The recession isn’t over," Feldstein said today in an interview on Bloomberg Radio in New York. "It will be a while before we have enough information to know if the recession ended." Feldstein is a former president of the National Bureau of Economic Research and remains a member of the group’s Business Cycle Dating Committee, the panel charged with determining when recessions begin and end. His comments are at odds with those of the panel’s chairman, Robert Hall, who said early this month that the recession may have ended.
Employers in the U.S. cut 11,000 jobs in November, the fewest in 23 months, and the unemployment rate unexpectedly fell to 10 percent from 10.2 percent, a government report showed on Dec. 4. The report "makes it seem that the trough in employment will be around this month," Hall said in an interview on the day the figures were released. "The trough in output was probably some time in the summer. The committee will need to balance the midyear date for output against the end-of-year date for employment." The economy has lost more than 7.2 million jobs since the recession began in December 2007. The total number of workers collecting unemployment checks as well as those taking extended government benefits totals about 10 million, according to Labor Department statistics released today.
The Federal Reserve yesterday repeated its pledge to keep interest rates "exceptionally low" for "an extended period" and said the "deterioration in the labor market is abating." Ben S. Bernanke won backing for a second term as Fed chairman today in a 16-to-7 vote by the Senate Banking Committee. The nomination next goes to a vote of the full Senate. Gross domestic product expanded at a 2.8 percent annual pace in the third quarter after shrinking for each of the previous four quarters. Growth will average 2.6 percent next year, according to the median forecast in a Bloomberg News survey of economists early this month.
Restrained consumer spending suggests "2010 is going to be a very weak year," said Feldstein, 70, who was chairman of the White House Council of Economic Advisers during the Reagan administration. "Thrift in the long run is a very good thing, but increasing thrift as you come out of a recession is going to be a drag," he said. Regarding the residential property market, where the recession initially emerged,
Feldstein said the Obama administration’s effort to revive the housing market is a failure and home prices will continue to decline. "It was just not well enough designed," Feldstein said. "They ended up failing." That suggests the housing slump will "continue to push down house prices," he said. "We saw a little pause in home-price declines in the summer but I think that was because of the first-time home buyers program," Feldstein said. "We’re not going to get that boost."
The U.S. House voted Dec. 11 to tighten rules for derivatives and create powers to break apart healthy financial firms that pose a risk to the economy. The House rejected a "cram-down" amendment that would have given federal judges the power to lengthen mortgage terms, cut interest rates and reduce loan balances for homeowners in bankruptcy court.
Lenders permanently modified 31,382 of the 4 million mortgages targeted for loan relief under the Obama administration’s main foreclosure prevention plan through last month, the Treasury Department announced on Dec. 10. Economic reports today suggested the government’s efforts to revive growth with fiscal stimulus may be working for now, Feldstein said in a separate interview on Bloomberg Television. "The danger is we will run out of steam," he said.
The index of leading economic indicators rose for an eighth consecutive month in November, a sign growth will extend into the first half of 2010. The Conference Board’s gauge of the outlook for the next three to six months increased 0.9 percent after climbing 0.3 percent in October. Manufacturing in the Philadelphia region expanded in December for the fifth month, led by sales and employment gains. The Federal Reserve Bank of Philadelphia’s general economic index climbed to 20.4 this month. Readings greater than zero signal growth. The bank’s district covers parts of Pennsylvania, New Jersey and all of Delaware.
Pension disaster closes in
Stock market losses, richer benefits and underfunding have combined to call for a rate spike from 4.8 to 29 percent in three years.
A fiscal year loss of 26.5 percent by the Public School Employees' Retirement System has exacerbated a taxpayer rate spike projected for the 2012-13 school year. What was previously expected to be a stunning increase of the annual employer contribution rate from this year's 4.8 percent to 20.2 percent is now projected to climb to a 29.2 percent payment of each district's payroll three years from now. Just as scary are future projections of more than 30 percent a year for seven years - and that's if the pension fund manages an 8 percent annual increase.
The numbers were released last week when the PSERS board certified the annual employer contribution rate of 8.2 percent for the next fiscal year, which begins July 1. While that's nothing like the 2012-13 doomsday forecast, it is an increase of 3.4 percent over the current year. The bitter pill comes at a time when taxpayers are enduring the worst economy since the Great Depression, and unemployment sits at 10 percent with 7.3 million Americans out of work. "It was the worst year ever for the system," said Jeff Clay, executive director of PSERS, whose plan's net assets decreased from $62.7 billion to $43.2 billion in the fiscal year. "Anything below 8 percent is a loss to us."
So, in essence, the fund needs to make up a 34.5 percent gap. And, unfortunately, there's no apparent fix on the way from the General Assembly. "I'm embarrassed to tell you, no," said state Rep. Bernie O'Neill, R-29. O'Neill said this year's $3.25 billion budget hole prevented any legislative possibility of easing the oncoming pain. "There have been discussions," he said. "The budget process overtook and consumed everything. It's not a lack of wanting to do something. Look, it's Dec. 15 and we're still here working on the budget."
O'Neill, a member of the House Education Committee, worked on a task force that suggested a plan to use a portion of the education stimulus money to lessen the depth property owners would have to dig into their pockets for the 2012-13 bill. "I was for it but, unfortunately, we couldn't get it done," said O'Neill, who taught at William Tennent High School for more than 25 years. "Quite frankly, we're living day to day without planning for the future, and we need to change that." The pension increases will probably also mean hefty increases in school property taxes.
The Central Bucks School District, however, is one district that is taking a proactive stance. In its 2009-10 budget, which the state only calls for a 4.78 percent rate for pension contributions, the district has budgeted 8.1 percent. "All excess funds saved by this procedure will be used to minimize the millage increase in fiscal 12-13," the budget document states. For the 2008-09 budget, the district budgeted 7.2 percent although the state only called for 4.76 percent. But even though Central Bucks is saving money, it probably will not be enough to cover the huge jump in 2012-13 and beyond.
For example, based on Central Bucks salaries for classroom teachers and specialists, which total $72.9 million for this school year, the district would have to pay 29.22 percent or $21.3 million in pension payments in 2012-13, which is more than double what the district has budgeted for this fiscal year. And the only place the district can get that is from taxpayers, unless the Legislature steps in. In addition to stock market losses - before the 26.5 percent drop the fund lost 2.8 percent from July 1, 2007 to June 30, 2008 - the state Legislature's decision in 2001 to increase retirement benefits for state workers and school employees by 25 percent and for themselves by 50 percent added to the problem.
The next year lawmakers increased benefits for teachers who had already retired and so were left out of the 2001 pension enhancements, and they put off paying for the whole package by reducing the districts' pension contribution from 5.64 percent to 1.15 and spreading out payments over more years, thus the 2012 bubble. In addition, when the stock market was performing well, districts were allowed to lower their contribution. In 2001 the rate was 1.9 percent, 1.1 percent in 2002 and 1.2 percent in 2003. The state pays half of the pension costs.
In the meantime, 279,000 school employees continue to pay between 6 percent and 7.5 percent of their salaries into the pension fund. There are more than 177,000 retirees collecting benefits. Over the last 10 years, Pennsylvania State Education Association members and other contributors paid $7.4 billion into PSERS, while the state and school districts combined paid $3.8 billion, said Wythe Keever, PSEA assistant communications director. "The employees kept their part of the promise, and we feel that the commonwealth and the school districts need to keep their part of the promise," he said.
Clay, the PSERS director, agreed. "Although taxpayers may not believe this, they've been underfunding the system for 10 years now. It's a major fiscal issue facing the state, school districts and taxpayers. There's no silver bullet to solve this. All options require additional money. That just can't be avoided." State courts have ruled that retirement benefits cannot be reduced for current teachers or state employees covered under similar retirement plans. Pennsylvania is not the only state with pension problems. According to the January issue of Kiplinger's, Texas and Nevada increased age and service requirements for retirement. New Hampshire hiked pay-in rates, and New Mexico cut benefits for early retirees.
"Any solutions of that nature would make for a second class of employee and wouldn't impact on the pension spike at all," Keever said. "Shortsighted decisions on pension funding basically ran the fund in a wall." And taxpayers, who may not feel like they've been given a financial break, might feel that wall pressing down on them. Two Warminster men, Jerry Shesney and Jack Diamond, have traveled to senior centers to warn members of the pension bubble. Their goal is to flood lawmakers statewide with signatures and phone calls, hoping to freeze property taxes for seniors. "Only about one-quarter to one-third of the people know what is coming," Shesney said. "When we tell them they're shocked."
Dutch pension funds lose big on high-risk investments
Dutch pension funds should change their investment policy to better manage risk after losing 112 billion euros last year during the credit crisis, the Dutch pension supervisor and central bank said on Wednesday. Dutch pension funds are among the biggest in the world, and managed a total of 693 billion euros at the end of June. They include ABP, the world's third-largest state pension fund after Japan's and Norway's, which is closely eyed by investors.
"Although the causes of the losses vary, they are mostly related to innovative investments and active management. These investment strategies give additional risks," the Dutch central bank (DNB) said in its quarterly report. Spearheaded by ABP, which managed 180.5 billion euros at the end of June, Dutch pension funds diversified investments in the past 15 years to include hedge funds, private equity, commodities and other assets besides stocks and bonds.
"In addition to an independent risk management function it is important that funds change their investment policy to match their capacity and willingness to take on risks," DNB said. When giving investment mandates, pension funds gave too much freedom to the investment managers, creating additional risks, said DNB, which supervises the Dutch pension sector to make sure it remains solvent in the long term to pay future obligations. The use of derivatives, participation in securities lending programmes, and lending also contributed to the funds' losses, DNB said.
ECB Raises Forecast for Euro-Region Bank Writedowns by $268 Billion
Euro-region banks may have to write down an additional 187 billion euros ($268 billion) as loans to property companies and eastern European nations threaten the recovery in financial markets, the European Central Bank said. The ECB raised its estimate for writedowns by 13 percent to 553 billion euros for the period of 2007 through 2010. The ECB, which published its Financial Stability Review today, also said that "the surge in government indebtedness" around the world is a risk to financial stability and that some European banks are still reliant on emergency funding.
"An important reason behind the rise is the further deterioration in commercial property-market conditions," the report said. "This has contributed to an upward revision in to the estimate of potential writedowns on bank’s exposures to commercial property mortgages and commercial mortgage-backed securities." Policy makers are trying to gauge the health of the financial system to better time the withdrawal of emergency measures without unsettling markets. While Deutsche Bank AG and Credit Suisse Group are among banks reporting rising earnings, financial institutions worldwide are rebuilding balance sheets after writing down $1.7 trillion since the U.S. property slump sparked a global crisis.
U.S. commercial real estate prices have plunged about 40 percent since October 2007, according to the Moody’s/REAL Commercial Property Price Indices. The ECB said that risks to banks include the "concentrations of lending exposures" to "central bank and eastern European countries." It didn’t identify any specific nations. Banks must improve their quality of capital, increasing the amount of equity and retained earnings they hold, by the end of 2012 to be able to withstand losses better, the Basel Committee on Banking Supervision said yesterday. "The remaining losses will have to be buffered with banks’ core earnings over a relatively shorter period of time," the ECB report said. About $1.5 trillion of capital has been raised by banks globally since the crisis started, according to Bloomberg data.
As markets recover and growth resumes, the ECB has already said it will rein back its unlimited offerings of cash to banks next year. Vice President Lucas Papademos said at a press briefing today that conditions have improved "substantially in all funding sectors." At the same time, some banks "remain reliant on temporary support measures extended by the Eurosystem and governments," he said. With the public finances of some eastern European countries under scrutiny, the ECB warned that banks should be wary of their loan exposure. The Austrian Central Bank on Dec. 14 said a stress test scenario over the next two years expects about 20 percent of loans at banking units in Eastern Europe to default.
"Overall I don’t think it’s a significant problem for the euro-area financial system but it could have important implications for certain banking groups," Papademos said in an interview. European governments have spent $5.3 trillion shoring up banks since the collapse of Lehman Brothers Holdings Inc., according to European Union data. In addition to flooding banks with cash, the ECB has cut interest rates to a record low and started buying 60 billion euros worth of covered bonds. Papademos today cautioned against "timing errors" in unwinding public support. "In particular, exit decisions by governments will need to carefully balance the risks of exiting too early against those of exiting to late."
The report said pulling government support too early risks "triggering renewed financial system stresses." Waiting too long "can entail the risk of distorting competition, creating moral hazard risks" and may exacerbate "risks for public finances," the report said. Papademos also urged the Greek government to take "substantial’ decisions to cut the European Union’s largest budget deficit and ease concerns about its fiscal health. The ECB also considered a broader range of risks than in its June report, taking "better account" of collateralized debt obligations and residential mortgage-backed securities, it said. There has also been "rising distress" in the European leveraged loan market since June, with increased loan defaults and restructurings, the report said.
UK borrowing hits record monthly high of £20 billion ($33.2 billion)
UK public borrowing hit an all-time high of £20.3bn for a single month in November, official figures showed. The latest confirmation of the recession's impact on the public finances will put more pressure on Chancellor Alistair Darling. The figure is not as bad as the £23bn feared by economists but still takes net borrowing for the eight months of the financial year so far to £106.4bn. The £20.3bn is more than was borrowed by the UK for the whole of 2002 and on a par with International Monetary Fund estimates for the entire 2009 output of economies such as Costa Rica and Uruguay. Net borrowing is expected to reach £178bn for the year as a whole.
The gloomy figures also showed net debt reaching a record £844.5bn in November - or 60.2pc of the UK's annual GDP. Current tax receipts fell by £1bn on the same month a year ago while spending jumped by more than £3bn to £50.3bn. Nearly a third of this spending was accounted for by social benefits such as Jobseeker's Allowance - the so-called "bill for failure" - which hit £16.2bn. This is the highest for at least eight years, the Office for National Statistics (ONS) said. Other unwanted records thrown up by the figures include a £16.2bn current deficit - the gap between spending and receipts.
The deficit for the year so far has reached £83.2bn, although the Chancellor has pledged to halve the deficit within four years and the Government is passing a Fiscal Responsibility Bill to put the commitment on a legal footing. Last week the Institute for Fiscal Studies (IFS) warned that the Chancellor could have to find an extra £76bn, or £2,400 per family, to restore the public finances over two parliaments. The IFS also said that debt levels could remain high "for a generation" - around 60pc of national output - without policies to tackle the impact of the ageing population on Britain's public finances.
BA: Falling star
There was a time, a decade ago, when British Airways could credibly claim to be "the world’s favourite airline", as its posters proudly affirmed. Not any more. And certainly not to those passengers who were hastily booking alternatives to their BA flights this week as the threat of a long strike over Christmas loomed. The walkout was averted on December 17th, but the underlying problems that led to the standoff remained unresolved. Compounding the woe came news of a series of two-day strikes at Eurostar, the passenger-train service under the English Channel, and the collapse of Flyglobespan, a Scottish airline.
The dispute at BA centres on its desire to cut costs by reducing cabin staff on most flights and limiting wage increases. The airline’s pilots and engineers have already accepted austerity measures; cabin staff, notified of the proposed changes in July, are less inclined to compromise (though some have taken voluntary redundancy). On December 14th Unite, the union which represents almost all of the company’s 13,500 cabin staff, said they had voted overwhelmingly to strike.
The next day BA applied to London’s High Court for an injunction to stop them. The airline argued that Unite had not polled its members correctly: some votes were recorded from people no longer employed by BA, and the call for industrial action did not specify the intention to strike for 12 consecutive days precisely at Christmas. Had members known those details, fewer might have supported a strike, BA argued. The judge agreed, and ruled against the strike on December 17th. As The Economist went to press, airline and union bosses were due to resume talks to resolve future problems.
Industrial disputes are not the only issue bothering BA. More than 20 years after privatisation, it is still struggling with the legacy of state ownership. Grandfathered work practices allow cabin crew to spend two nights at a destination if the itinerary has been disrupted, which plays havoc when planes are redirected because of bad weather. According to the Civil Aviation Authority, it costs BA an average of £29,900 ($49,000) in basic pay to employ a cabin attendant, compared with £20,200 for easyJet, the next-best payer among British airlines. BA staff work a maximum of 900 hours a year in the air, far fewer than European Union guidelines allow, and most can expect generous pensions.
Willie Walsh, the airline’s punchy Irish chief executive, was appointed in 2005 to knock such practices into competitive shape. He is unlikely to yield much ground to union militancy. It seems that BA’s core shareholders support him: the share price hardly moved when the strike was announced. Many reckoned that the benefits of BA’s restructuring outweighed the likely damage from the threatened strike. Estimates of potential net revenue loss over the 12 days ranged from £60m to £160m, whereas the benefits of restructuring were put by some analysts at £60m a year.
Such numbers are in any event small change compared with other losses looming over the company. BA is already expected to report a pre-tax loss of at least £400m in the year to March 31st, and perhaps as much as twice that sum. Its important North American routes and business have been hard hit by the collapse in business-class travel. This could bounce back quickly with economic recovery in America and, provided that cost increases from environmental measures are not too onerous, the long-haul travel on which BA’s profitability depends should revive in time. But, like all former national carriers in Europe, it is facing devastating competition on its short-haul flights from low-cost airlines. The only remedy may lie in creating or teaming up with a low-cost partner.
The planned merger with Iberia, the Spanish airline, looked as if it would be a winning combination a year ago when it was first mooted. Today it seems more like a mutual rescue operation. Both airlines’ national economies are still in the doldrums; both firms are struggling with costs greater than their revenues. Iberia seems unmoved by Mr Walsh’s fight with the union. It is also reasonably sanguine about BA’s other big problem: its enormous pension deficit. But according to the merger memorandum signed in November, Iberia can call off the wedding if BA cannot reach a satisfactory agreement with the trustees of its two pension funds.
On December 14th the trustees announced that they had recalculated the deficit of the two funds at £3.7 billion, based on March 31st valuations. BA is currently making cash top-ups of £131m a year. The Pensions Regulator will help to determine whether the trustees’ valuation is adequate and what must be done to plug the deficit. If BA has to pay in a lot more cash, Iberia could opt out of the merger. Pension valuations are notoriously susceptible to assumptions, and BA’s deficit could easily lurch between £1 billion and £8 billion.
Such uncertainties limit BA’s options, as well as its attractiveness to a merger partner. Any spare cash that the airline can generate should be used to replace its fleet of 55 ageing Boeing 747s, which are an average of five years away from retirement. But how much spare cash will BA have? Less, after its dispute with cabin staff, even though it won its case in court.
Take a good look at what Obama's top economic adviser left behind at his last job
(Harvard's Interest-Rate 'Swaps' So Toxic Even Summers Won't Explain Them)
Anne Phillips Ogilby, a bond attorney at one of Boston’s oldest law firms, on Oct. 31 last year relayed an urgent message from Harvard University, her client and alma mater, to the head of a Massachusetts state agency that sells bonds. The oldest and richest academic institution in America needed help getting a loan right away. As vanishing credit spurred the government-led rescue of dozens of financial institutions, Harvard was so strapped for cash that it asked Massachusetts for fast-track approval to borrow $2.5 billion.
Almost $500 million was used within days to exit agreements known as interest-rate swaps that Harvard had entered to finance expansion in Allston, across the Charles River from its main campus in Cambridge, Massachusetts. The swaps, which assumed that interest rates would rise, proved so toxic that the 373-year-old institution agreed to pay banks a total of almost $1 billion to terminate them. Most of the wrong-way bets were made in 2004, when Lawrence Summers, now President Barack Obama’s economic adviser, led the university.
Cranes were recently removed from the construction site of a $1 billion science center that was to be the expansion’s centerpiece, a reminder of Summers’s ambition. The school suspended work on the building last week. "For nonprofits, this is going to be written up as a case study of what not to do," said Mark Williams, a finance professor at Boston University, who specializes in risk management and has studied Harvard’s finances. "Harvard throws itself out as a beacon of what to do in higher learning. Clearly, there have been major missteps."Harvard panicked, paying a penalty to get out of the swaps at the worst possible time.
While the university’s misfortunes were repeated across the country last year, with nonprofits, municipalities and school districts spending billions of dollars on money-losing swaps, Harvard’s losses dwarfed those of other borrowers because of the size of its bet and the length of time before all its bonds would be sold. In December 2004, Harvard entered into agreements that locked in interest rates on $2.3 billion of bonds for future construction in Allston, with plans to borrow $1.8 billion in 2008 after they broke ground and the remaining $500 million through 2020. At the time, the benchmark overnight interest rate set by the U.S. Federal Reserve was 2.25 percent. The agreements backfired last year after central banks slashed lending rates to zero and the value of the contracts plunged, forcing the school to set aside cash.
Borrowers use swaps to match the type of interest rates on their debt with the rates on their income, which can help reduce borrowing costs. Lenders and speculators use swaps to profit from changes in the direction of interest rates. A bet on higher rates, for example, means paying fixed rates and receiving variable. At Harvard, nobody anticipated some interest rates going to zero, making the university’s financing a speculative disaster. Harvard’s woes stemmed from misunderstanding its role, said Leon Botstein, president of Bard College in Annandale-on-Hudson, New York. "We shouldn’t be in the banking business, we should be in the education business," Botstein said in a telephone interview.
The financing plan using the swaps was developed by the university’s financial team and discussed with the Debt Asset Management Committee, an oversight group, according to James Rothenberg, a member of the President and Fellows of Harvard College, or Harvard Corp., and the school’s treasurer, a board position. The swaps plan was then approved by Harvard Corp. and implemented and monitored by the financial team, Rothenberg said in an e-mail.
Summers, who left Harvard in 2006, declined to comment. As president and as a member of the Harvard Corp., the university’s seven-member ruling body, Summers approved the decision to use the swaps. The strategy made sense in the economic climate of the time, Rothenberg said in another e-mail. Rothenberg is chairman of Capital Research & Management Co., the investment advisory unit of Capital Group Cos. in Los Angeles. "Rates were at then-historic lows, and the university was contemplating a major, multibillion-dollar campus expansion," Rothenberg said. "In that context, locking in our financing costs so that we would achieve some budgetary certainty had definite advantages."
Harvard’s failed bet helped plunge the school into a liquidity crisis in late 2008. Concerned that its losses might worsen, the school borrowed money to terminate the swaps at the nadir of their value, only to see the market for such agreements begin to recover weeks later. Harvard would have avoided paying the costs of its swap obligations by waiting. Its banks, including JPMorgan Chase & Co., headed by James Dimon, were demanding cash collateral payments -- ultimately totaling almost $1 billion -- that Harvard in 2004 had agreed to pay if the value of the swaps fell. At least $1.8 billion of the swaps the school held were with JPMorgan, said a person familiar with the agreements. Dimon, a 1982 Harvard Business School alumnus, declined to comment on the agreements through a spokeswoman, Jennifer Zuccarelli.
Drew Faust, Harvard’s president since 2007, said she experienced some of her darkest days as she watched the collapse of U.S. markets that deepened the school’s losses. "Someone would say that this happened, that had happened, they were going to bail out AIG or Lehman is failing," Faust recalled in an interview, referring to the September 2008 bankruptcy of Lehman Brothers Holdings Inc. in New York and the subsequent government bailout of American International Group Inc. in New York. "We were wondering what was going to happen tomorrow." Harvard speculated in the swap market as early as 1994, according to rating companies’ reports. Under Jack Meyer, former chief executive of Harvard Management Co., the school’s endowment used swaps to profit from interest-rate changes. The university also used them to fix borrowing costs for capital projects.
Summers became president in July 2001, after serving as U.S. Treasury Secretary. He earned a Ph.D. in economics from Harvard, and became a tenured professor there at age 28. He served from 1991 to 1993 as chief economist at the World Bank, which initiated the first interest-rate swap with International Business Machines Corp. in 1981. In the 1990s, Harvard began amassing 220 acres (89 hectares) for construction near Harvard Business School and its football stadium, located in Allston. In June 2005, Summers unveiled his vision for a campus expansion replete with new laboratories, dormitories and classrooms, renovated bridges and a pedestrian tunnel beneath the water. The Allston project was to transform an industrial and working-class neighborhood of two-family wood homes and small shops by building two 500,000-square-foot (46,000-square-meter) science complexes and a redrawn street grid.
Harvard was flush at the time, with an endowment of $22.6 billion that had returned an average of 16 percent during the previous 10 fiscal years. Summers told Faculty of Arts & Sciences professors in May 2004 that he hoped they wouldn’t be "preoccupied with the constraints imposed by resources, for Harvard was fortunate to have many deeply loyal friends," according to minutes of a faculty meeting. "Harvard would be able to generate adequate resources," according to the minutes. "The only real limitation faced by the Faculty was the limit of its imagination."
When the plan was made public in 2005, Harvard’s financial team had been busy for more than a year behind the scenes, devising a financing strategy for the project using interest- rate swaps. These derivatives enable borrowers to exchange their periodic interest payments. They typically involve the exchange of variable-rate payments on a set amount of money for another borrower’s fixed-rate payments. In 2004, Harvard used swaps for $2.3 billion it planned to start borrowing four years later. The AAA-rated school would have paid an annual average rate of 4.72 percent if it had borrowed all the money for 30 years in December 2004, according to data from Municipal Market Advisors. The swaps let it secure a similar rate for bonds it planned to sell as it constructed the campus expansion during the next two decades.
The agreements were so-called forward swaps, providing a fixed rate before the bonds were actually sold. Harvard was betting in 2004 that interest rates would rise by the time it needed to borrow. The school was also assuming the expansion would proceed on the schedule set by Summers and his advisers. While the university could have paid banks for options on the borrowing rates, the swaps required no money up front. That time frame, along with the size of the position, was unusual, said Peter Shapiro, an adviser at Swap Financial Group Inc. in South Orange, New Jersey. "There have been lots of forward swaps, but out longer than three years is relatively rare," Shapiro said in a telephone interview. That duration increases the risk, because the longer the term of the contract, the more volatile the value of the swap, he said.
Columbia University is breaking ground on a $6.5 billion expansion in New York City, and last year used an interest-rate swap for its borrowing of $113 million of bonds sold seven months later. Yale University in New Haven, Connecticut, is also AAA-rated. It had 32 separate swap agreements totaling $975 million as of Oct. 31, hedging the school’s $1.4 billion variable rate debt and commercial paper, according to Moody’s Investors Service Inc.
Corporations might use derivatives to lower their borrowing costs as many as four years before a bond sale, according to bankers who sell derivatives. Anadarko Petroleum Corp. used the swap market in December 2008 and January 2009 to secure rates for $3 billion it plans to refinance in October 2011 and October 2012, according to the Houston, Texas-based company’s third- quarter report from Nov. 3. Matt Carmichael, a company spokesman, declined to comment. Rothenberg, a Harvard College and Harvard Business School graduate, said he was among the key players involved in developing the financing strategy. His Los Angeles-based company, Capital Group, operates American Funds, the second-biggest family of stock and bond mutual funds in the U.S. He had been Harvard’s treasurer for six months when the school arranged the Allston swaps in December 2004.
Ann Berman, Harvard’s chief financial officer at the time, also played a role in developing the plan, Rothenberg said. Berman declined to be interviewed. She stepped down in 2006 when she was named an adviser to the president, according to the school’s Web site. A certified public accountant, Berman got her master’s in business administration at the University of Pennsylvania’s Wharton School of Business in Philadelphia and had earlier served as a financial planner and adviser for Harvard’s dean of the Faculty of Arts & Sciences.
Other members of Harvard Corp. in 2004 and 2005, who served with Summers and Rothenberg, were former U.S. Treasury Secretary Robert Rubin, Summers’s previous boss and predecessor at the U.S. Treasury, who was an instrumental supporter of his bid for the Harvard presidency; Robert D. Reischauer, former director of the Congressional Budget Office, who was a colleague of Summers and Rubin’s in Washington; Conrad K. Harper, a lawyer at Simpson Thacher & Bartlett LLP in New York; Hanna Gray, former president of the University of Chicago; and James R. Houghton, chairman of Corning Inc., the world’s biggest maker of glass for flat-panel televisions, in Corning, New York. All except Rothenberg declined to comment or didn’t return telephone calls.
Harvard University’s finance staff worked with JPMorgan to develop the size and the length of the forward-swap agreements, said a person familiar with the contracts. Final negotiations to set the rates were left to Harvard Management, which oversees the endowment, because it had swap contracts in place with JPMorgan dating back to 1996 that set terms for the agreements, according to a copy of the agreement obtained by Bloomberg News. The original swap contract between Harvard Management and JPMorgan was approved by Michael Pradko, the endowment’s risk manager, the copy shows. Pradko left Harvard Management in 2005, along with Jack Meyer, the endowment’s head, to join Convexity Capital Management LP in Boston, the hedge fund Meyer started.
When Harvard Management completed its swap contracts for the school, the timing was encouraging. U.S. Federal Reserve Chairman Alan Greenspan had just begun raising the overnight target rate as the economy rebounded from the bursting of the technology bubble. In the second half of 2004, he lifted it to 2.25 percent from 1 percent. For more than 20 years, investment banks such as Goldman Sachs Group Inc., JPMorgan, and Citigroup Inc., all based in New York, have been selling swaps as a way for schools, towns and nonprofits to reduce interest costs and protect against rising interest payments on variable-rate debt. The swap agreements can be terminated if either the bank or the issuer is willing to pay a fee, which varies with interest rates.
"Swaps have become widely accepted by the rating agencies as an appropriate financial tool," according to a slide entitled "Swaps Can Be Beneficial" that was used in a 2007 Citigroup presentation to the Florida Government Finance Officers Association. Debt issuers can "easily unwind the swap for a market-based termination payment/receipt," the slide said. Rothenberg said officials throughout Harvard were monitoring the school’s swap position, including members of the financial office, the budget office, the controller’s office and Harvard Management. Although the contracts required Harvard to post collateral, or set aside cash when the values reached certain thresholds, such provisions weren’t unusual, Rothenberg said in an e-mail.
"I think there are lots of swaps with collateral postings," Rothenberg said. "From fiscal years 2005 through 2008, these swaps were in place and there were collateral postings. It was not a pressing concern for the University, even though you can look at the financial statements and see that there was at least an unrealized loss in certain years. "I think the unusual nature of these swaps were two things," Rothenberg said. "One, they were large, but the anticipated capital spending program was large; and two, they were longer-dated than most people are used to thinking about, because the capital spending program was expected to last over a number of years. The problem resulted from the rapid meltdown in the markets, which culminated in November when short-term interest rates and swaps rates collapsed."
After credit markets seized up in 2007, central banks worldwide pushed some bank lending rates to zero in their effort to rescue the financial system. While Harvard Corp. is ultimately responsible for the school’s financial decisions, the losses sustained by the school in almost every financial domain -- the endowment, cash account and swaps -- suggest that oversight was lax, said Harry Lewis, a Harvard alumnus, computer science professor and former dean of Harvard College. Harvard not only lost money on the swaps last year. The value of its endowment tumbled a record 30 percent to $26 billion from its peak of $36.9 billion in June 2008, and its cash account lost $1.8 billion, according to Harvard’s most recent annual report.
"They have a structural problem," Lewis said in a telephone interview. "There’s something systemically wrong with Harvard Corp. It’s too small, too secretive, too closed and not supported by enough eyeballs looking at the risks they are taking."
Summers’s departure as president came in 2006, after he questioned women’s innate aptitude for math and science. Summers apologized formally and repeatedly for the remarks made in a speech, which he said were misconstrued, and the school said it would spend $50 million to help women succeed in science and engineering. He resigned after the faculty passed two no- confidence motions against him. That left Faust, the Civil War historian and prize-winning author who succeeded Summers as president in July 2007, to manage the Allston plans. Faust committed to its first phase: beginning construction of a $1 billion science center that would house researchers from the Harvard Stem Cell Institute, the Harvard School of Public Health and the Wyss Institute for Biologically Inspired Engineering.
By June 2005, the value of the swaps tied to Harvard’s debt was negative $460.8 million, meaning that’s how much it would have to pay the banks to terminate the agreements, according to the school’s annual report that year.
By 2008, Harvard had 19 swap contracts on $3.5 billion of debt with JPMorgan, Goldman Sachs, New York-based Morgan Stanley, and Charlotte, North Carolina-based Bank of America Corp., including the swaps for Allston, according to a bond-ratings report by Standard & Poor’s released on Jan. 18, 2008. The swaps became a financial burden last year as their value fell and collateral postings rose. In a contract with Goldman Sachs, the school agreed to post cash if the swaps’ value fell below $5 million, according to a copy obtained by Bloomberg News. The collateral postings with the banks approached $1 billion late last year as central banks slashed their target rates, according to people familiar with the situation.
Harvard wasn’t alone in being forced to set aside cash last year to meet such margin calls. The difference was the scale. Cornell University in Ithaca, New York, posted $38 million of collateral on $1.5 billion of swaps, according to a Moody’s report on the Ivy League School. Hanover, New Hampshire-based Dartmouth College, also in the Ivy League, didn’t post collateral on their swaps because their investment banks agreed to waive the requirement to win the business, according to a person familiar with the contracts. The Ivy League is a group of eight elite schools in the northeast U.S., including Harvard.
After a year during which central banks provided an unprecedented amount of money to rescue financial institutions, the credit markets unraveled along with the stock market in September 2008. Lehman Brothers filed the largest bankruptcy in history on Sept. 15. Two weeks later, the House of Representatives rejected a $700 billion bailout plan, sending the Dow Jones Industrial Average down 778 points, its biggest point drop ever.
The value of Harvard’s swaps plunged and its need for cash soared. Under contracts signed in 2004, Harvard had to post larger and larger amounts of collateral to cover the negative value of the swaps; the total amount would approach $1 billion. At the same time, the usual sources the university relied on to generate cash -- the endowment and its operating cash account -- were hemorrhaging. The school’s endowment tumbled, losing 22 percent from July 2008 through October 2008.
The Harvard endowment had more than 50 percent of its assets allocated to private equity, hedge funds and other hard- to-sell assets. The university already had borrowed to amplify gains, with leverage targeted at 3 percent of assets as of last year. When Jane Mendillo took over as chief executive officer of Harvard Management on July 1 last year, one of her top priorities was to raise cash. The school couldn’t get acceptable prices from the $1.5 billion of private equity stakes Mendillo tried to sell.
Outside managers investing Harvard’s endowment were either performing poorly or preventing Harvard from withdrawing cash. Citigroup CEO Vikram Pandit shut down Old Lane Partners in June 2008. Ospraie Management, in New York, closed its biggest hedge fund in September and Farallon Capital Management, in San Francisco, put up a so-called gate, prohibiting clients from taking out cash. Making matters worse, Harvard disclosed Oct. 16 that its checkbook fund, the general operating account, lost $1.8 billion in the year ended June 30. Lumping the cash account with the endowment was risky, said Louis Morrell, who managed the endowment for Radcliffe College, which is part of Harvard, until 1990. "They put the operating funds in the endowment --it’s like the guy who has his retirement income in company stock," said Morrell, who is also the former treasurer of Wake Forest University in Winston-Salem, North Carolina.
Rothenberg, Mendillo and Daniel Shore, Harvard’s chief financial officer, decided last year as the credit crisis deepened that the school needed to borrow money. It was at this point, in October, that Harvard officials contacted Ogilby, their bond lawyer at Ropes & Gray LLP in Boston. A 1980 Harvard College graduate, Ogilby is head of the firm’s Public Finance Group. E-mails show that Craig McCurley, the director of Harvard’s treasury management office, and his associate director, Tom Balish, contacted Ogilby, who in turn reached out to the Massachusetts Health & Educational Facilities Authority, which sells bonds for the state’s nonprofits. Ogilby declined to comment.
Harvard needed cash to pay bills, refinance outstanding debt and break its money-losing swap agreements, according to a series of e-mails beginning on Oct. 31 last year between Ogilby and staff members of the state authority that were obtained by Bloomberg News. School officials asked whether the agency could omit from a public hearing that some of the bonds would finance swap termination payments. "There is some sensitivity at Harvard about not specifically flagging the swap interest unwind payments," Ogilby wrote on Nov. 12 to Deborah Boyce, an analyst at the authority. "They still would like the ability to finance them, but would prefer to delete those references if they can do so."
Benson Caswell, the bond authority’s executive director responded Nov. 13 that the swap agreements would have to be identified and that the authority needed "timely, accurate and unfiltered information, including a balanced presentation," from issuers. Harvard disclosed the use of the bond proceeds, and only wanted to avoid telegraphing potential activity in the swap market, said Christine Heenan, a school spokeswoman. "The spirit of our inquiry was whether prematurely disclosing plans for what are inherently market transactions would in any way jeopardize the execution of those transactions," she said in an e-mail.
At its Nov. 13 monthly meeting in Boston’s financial district, the agency’s seven-member board approved a Harvard bond issue of up to $2.5 billion, about the amount of debt it sells for all schools and borrowers in a typical year. The board usually takes two meetings to approve a bond sale. In Harvard’s case it took just one meeting. "I can assure you that Harvard doesn’t get any special treatment," Caswell said. "Other borrowers have received the same service." Caswell said one board member, Marvin Gordon, is a Harvard graduate and that as long as there is no conflict of interest between his business and the use of the bond proceeds, a board member may vote on approval of a bond sale.
Gordon said while he didn’t have a conflict in voting to approve Harvard’s bond issue, "they never should have been in the position where they had to get out" of the swaps. Harvard unwound the swaps at possibly the worst moment in the history of financial markets, said Shapiro, the municipal swap adviser. Just as Harvard’s request for approval to sell tax-exempt bonds arrived in the state offices, the swap market began sliding, according to Bloomberg data. While the school waited for permission to raise money, the price to break the swap agreements escalated.
On Nov. 13, the index used to value the agreements, the U.S. dollar 30-year swap rate, closed at 4.247 percent. By the time Harvard held its bond sale Dec. 8, the swap index had tumbled to 2.7575 percent. Harvard exited three of its swaps tied to $431 million debt on Dec. 9, when the benchmark fell again to 2.6885 percent. The interest-rate swap market reached a record low of 2.363 percent on Dec. 18. Harvard’s decision to borrow money came at a time when the difference, or spread, between yields on corporate and U.S. Treasury securities was the widest since at least 1990, according to data from Barclays Plc. That meant AAA-rated Harvard was selling bonds when the market was demanding the biggest premium in at least 18 years. "December 2008 was, by an enormous amount, the worst time in history" to terminate the swaps by borrowing money, said Shapiro.
Harvard sold $1.5 billion of taxable and $1 billion of tax- exempt bonds, using $497.6 million of the proceeds to pay investment banks to extract itself from $1.1 billion of interest-rate swaps, according to its annual report released Oct. 16. Separately, the school agreed to pay another $425 million over 30 years to 40 years to the banks to terminate an additional $764 million of the swaps, Harvard’s Shore said. The school on Dec. 12 paid JPMorgan $34.5 million from the tax-exempt bond proceeds to unwind a swap tied to $205.9 million of variable-rate bonds it sold for capital projects, according to documents obtained from the Massachusetts financing authority. It also paid Goldman Sachs $41.6 million on Dec. 9 and $23.2 million on Dec. 11 to end agreements on another $226.8 million of existing debt. Harvard didn’t disclose recipients of the other termination payments because it paid them from the taxable bonds.
The timing was "less than ideal, but the surrounding context was less than ideal as well," said Shore. Harvard and JPMorgan celebrated the bond issue by hosting a cocktails-and-dinner party at the French restaurant Mistral, in Boston’s South End neighborhood, where appetizers start at $15 and entrees cost about $40, according to e-mails obtained from the state finance agency. JPMorgan invoiced the agency $388.78 for three employees who attended: Caswell, Marietta Joseph and Danielle Manning. Since then, some of the values in the swap market have recovered to their levels of December 2004 when Harvard signed the forward contracts. "If Harvard had waited, the cost of terminating may well have been lower, but they weren’t willing to take that risk," said Matt Fabian, managing director at Municipal Market Advisors in Westport, Connecticut.
Shore said that he, Mendillo and "a lot of us in senior management" contributed to the decision to break the swap agreements. That group included Ed Forst, the former executive vice president, who returned to Goldman Sachs after less than a year at Harvard, Shore said. Shore also cited Harvard Corp.’s role as bearing the school’s ultimate fiduciary responsibility. Forst didn’t return calls seeking comment. Waiting didn’t appear to be an option at the time, Shore said. "In evaluating our liquidity position, we wanted to get ourselves some stability and some safety," he said in an Oct. 16 interview this year at Harvard. "It was to take the losses now rather than run the risk of having further losses if we continued to hold on to the positions."
No one expected the indexes used for valuing swaps to fall as fast and as much as they did, said Chris Cowen, managing director of Prager, Sealy & Co. in San Francisco. "What we ended up with was an outlier event," said Cowen, who advised Harvard as it unwound its position last year. "I was taken by surprise by the falling rates."
Harvard, in the meantime, has cut its capital spending estimate for the next four years in half to about $2 billion. Before the credit crisis, it planned on spending $10 billion over a decade on capital projects, including Allston. Faust is building a team to study "financially and structurally" how Harvard can expand, and holds regular monthly meetings with top financial advisers, including Mendillo, to guard against future financial catastrophes, she said in an e-mail announcing the work stoppage in Allston.
Summers, along with Rubin and Greenspan opposed the U.S. Commodity Futures Trading Commission’s attempt in 1998 to regulate so-called over-the- counter derivatives, which included agreements like interest rate swaps. At the time, Summers was Rubin’s deputy secretary. Now Summers is leading the Obama administration’s effort to write stricter rules for the derivatives market "to protect the American people," he said in October at a conference in New York sponsored by The Economist magazine. Universities would have been better served if they had stayed away from the more complicated financial instruments being sold by Wall Street, said David Kaiser, a Harvard class of 1969 alumnus who has been critical of the high salaries paid to managers of the school’s endowment.
"They used many of the investment strategies of the big banks and hedge funds, and when things went badly they could not get a bailout," said Kaiser, a history professor at the U.S. Naval War College in Newport, Rhode Island. "It would clearly be better for any nonprofit on whom many people depend to pursue safer, more stable strategies." Pennsylvania State Auditor General Jack Wagner said Nov. 18 that the state should ban local governments from entering into derivative contracts tied to bond issues, a practice he termed "gambling" with taxpayer funds. Harvard might have considered it a conservative step to lock in rates when they were low, said Shapiro, the New Jersey- based swap adviser. "You can be very big and very rich and very smart and still get things wrong," Shapiro said.