Wednesday, December 30, 2009

December 30 2009: The Year for Plan B

William Henry Jackson Swamp Steamer 1902
Steamboat Metamora of Palatka on the Oklawaha, Florida

Ilargi: The major difference between Tim Geithner and me, apart from my obviously superior looks, is that he is willing to gamble double or nothing with your money and your lives, and I would not be. Or, as one might also put it, he thinks the risk of misery for millions of American people is less important than his own personal career. I do not.

Other than that, when it comes to the way he defines his policy decisions, there are no differences that matter, not his experience in guiding the New York Fed, or his palliness with the likes of Bob Rubin and other self-ordained rulers of the realm, nor all the inside knowledge that comes with that. The reason none of it matters is that Geithner doesn’t know what he's doing.

The US economy has never been in a situation like the one it's in now, and Tim has nothing to draw on. At least, he has no prior knowledge to draw on. What he does have is the freedom to spend trillions of dollars, and to do so largely unchecked, other than by people who think just like him. But it's still gambling.

Even before the Obama team took over, Christina Romer said, and with her many others, that governments were in uncharted waters. Ben Bernanke proclaimed that Quantitative Easing was a no-miss (even though it had never been tried), and Geithner declared in the house that he needed no Plan B in case the stimulus wouldn’t work. Their belief systems are easy to spot as just that, belief systems.

After spending all those trillions, the boys gaze around looking for praise for having saved the planet. Even though they know as well as we do that it’s at the very least far too early to tell. Their (make that your) trillions haven't solved any problems yet. They have merely hidden some of them. Most of this has been achieved by transferring debt from the private sector (banks) to the public sector. Fiddling with accounting standards has done the rest.

So yes, Bernanke and Geithner have helped the major banks. So much so that these feel entitled to pay out more bonuses than ever in history. All because the government took over their gambling debts and gave them fresh cash to go play in the casino. That, exactly that and nothing else, made Bernanke Time's Person of the Year.

And how is the government going to pay off those debts? More taxes (which they won’t say), more economic growth (which they can’t stop saying) and most of all more borrowing. The plans are grandiose. Over $2 trillion in new debt (Treasuries) in 2010, on top of the $2.5 trillion in existing debt that has to be rolled over in 2010-11. And those are just the plans.

Is it possible that Obama and Geithner weren’t paying attention when their own chief economic adviser, Larry Summers, said in New York, October 8, that:
“We will not, as a country, as the economy recovers, be in a position to issue federal debt on anything like the scale that was appropriate to issue federal debt during a profound economic downturn.”?

Sure looks like they missed that one. Then again, they may be able to issue the debt, as long as they are willing to use your money to pay interest rates on the debt that will satisfy the bond markets. Lend out money to market makers at 0.25%, and borrow what you need for yourself at 5-6%. That looks like one lousy deal to me. Unless you’re a banker.

But not to worry, Tim says he's got it all under wraps:
Geithner: There will be no 'second wave' crisis

Treasury Secretary Timothy Geithner said [on December 22 that] the Obama administration is confident it will prevent a repeat of last year's financial crisis, the worst to hit the country in seven decades. "We are not going to have a second wave of financial crisis," Geithner said in an interview with National Public Radio. "We cannot afford to let the country live again with a risk that we are going to have another series of events like we had last year. That is not something that is acceptable."

Geithner, interviewed on NPR's "All Things Considered" program, rejected the idea that a serious new crisis could be triggered by lingering problems with commercial real estate loans or with a sudden weakening in the value of the dollar. "We will do what is necessary to prevent that and that is completely within our capacity to prevent," he said.

Am I reading his words correctly? Is he saying that the Bush administration could have prevented the first wave of the crisis ("completely within our capacity"), but didn't for some reason? Just for the record, that first wave involved Hank Paulson, right? Oh, and Ben Bernanke, I almost forgot.... Sure wonder where they are now.

I think it's quite obvious where Geithner gets these ideas about his "capacity to prevent" the next crisis. He thinks that A) everyone in the world will do what the US demands and B) if he throws enough money at a problem, it will go away all by itself.

The one issue with that is that the problem is debt. And to get the money that Geithner thinks will make the debt problem go away, he has to drag the country deeper into debt. Which in his mind will soon be miraculously disappeared by a growing economy.

But what if it takes too long for that economy to start growing again? What if it simply won’t grow, other than in government statistics? What if the economy keeps contracting after the first batch of trillions has vanished?

I’d say 2010 should be the year to formulate a Plan B. It couldn't hurt to discuss something more grounded than pure belief systems. Economic growth might just be not the best consiglieri in this particular case. And I don't understand the reluctance to talk about a Plan B to begin with. We're talking about enormous risks to the welfare of millions of people, and about policies that have never even been tried before.

70 years ago it took a world war to get out of the crisis. And the president's finance meisters today don’t even want to talk about what happens when they got it wrong? What’s up with that?

Earlier this month David Rosenberg wrote in Why 2010 Looks So Dicey:
The defining characteristic of this asset and credit collapse has been the implosion of the largest balance sheet in the world: the U.S. household sector. Even with the equities rally and the tenuous recovery in housing in 2009, the reality remains that household net worth has contracted nearly 20% over the past year and a half. That's an epic $12 trillion of lost net worth, a degree of trauma never seen before.

As households assess the damage, the impact of this shocking loss of wealth on spending patterns is likely to be enormous. Frugality is more than just the new fashion; attitudes towards discretionary spending, home ownership, and credit have undergone a secular shift toward prudence and conservatism.

Economic growth could be a long long time coming. Are you sure you want to wager all you have on that one color?

And would you do things the same way at home that your government does them for you in Washington?

Ilargi: Make sure you keep your nose pressed to the glass. Donate to the Automatic Earth New Year's Fund.

U.S. may prop up housing further via Fannie, Freddie
The government's decision to provide unlimited support to Fannie Mae and Freddie Mac probably presages more aggressive action to prop up the U.S. housing market. The government may put a mortgage-modification effort, called the Home Affordable Modification Program, or HAMP, into overdrive in coming years, pushing for reductions in the principal outstanding on home loans overseen by Fannie and Freddie, Bose George, an analyst at Keefe, Bruyette & Woods, wrote in a note to investors Monday.

The U.S. Treasury Department said on Christmas Eve that it lifted $200 billion caps on the amount of taxpayer money that can be pumped into the ailing mortgage giants over the next three years. Neither institution is near its $200 billion limit -- Treasury has put $60 billion into Fannie and $51 billion into Freddie since it seized the failing companies in September 2008. However, Treasury said the promise of unlimited government money "should leave no uncertainty about the Treasury's commitment to support these firms as they continue to play a vital role in the housing market during this current crisis." Fannie shares jumped 21% to close at $1.27 on Monday, while Freddie shares soared 27% to $1.60.

KBW's George initially found the extra support "perplexing," he said, because Fannie and Freddie are unlikely to need more than $200 billion of government money each. During the depths of the recession in March 2009, the Government Accountability Office estimated that the bailouts of the two companies would cost taxpayers $389 billion, the analyst noted. Since then, house prices have stabilized and have begun to creep up in some areas. Instead, unlimited taxpayer support will give the government "more flexibility in potentially taking more aggressive action to support the housing market," George wrote.

HAMP has so far had little effect on foreclosures. So the government may push for an enhanced version of the program that includes reductions in the principal outstanding on mortgages, the analyst said. Principal reductions are controversial because they leave banks and other major mortgage lenders with bigger losses and lessened capital. The industry prefers modifications that lower interest payments in other ways, such as extending the maturity of home loans.

Aggressive reductions in principal on mortgages overseen by Fannie and Freddie could leave the companies with significant losses and cut further into their waning capital bases. But Treasury can pump more money into the institutions to make up for that, George said. Mortgage-backed securities held by private companies are trading at big discounts, so write-downs from principal reductions may not have a big impact in this part of the market, George added. However, Fannie and Freddie hold mortgage securities in their portfolios at original cost. So write-downs from principal reductions could "meaningfully impact earnings and capital," the analyst said.

The government's original bailout of Fannie and Freddie required the companies to start cutting their portfolios of retained mortgages by 10% a year starting in 2010. That's because rampant growth earlier this decade was partly responsible for the companies' collapse last year. However, Treasury said on Christmas Eve that the 10% reduction in 2010 will be based on the maximum allowed size of their portfolios, which is $900 billion, not the actual size, which was roughly $770 billion at the end of October, George noted.

This means Fannie and Freddie won't have to cut their portfolios in 2010 and will only modestly reduce them in 2011, the analyst said. Fannie and Freddie were also due to pay a commitment fee to the Treasury, starting in the first quarter of 2010. Treasury postponed that for a year, which should give the companies' earnings and capital a boost, according to George.

Why Unlimited Help for Fannie and Freddie?
by Elizabeth MacDonald

Submarined in an "update" on the "status" of Fannie Mae and Freddie Mac, the White House quietly announced on Christmas Eve that, instead of just pumping in hundreds of billions of dollars, its support for the GSEs' damaged Hindenburg-sized balance sheets would be unlimited for the next three years. Yes, unlimited.

But what is behind this drastic move to uncap the Treasury’s credit pipeline for Fannie and Freddie, since the two have been in full implosion mode for a year and a half? Is the government quietly planning to force these two invalids, permanently stuck in the government’s emergency room, to take on rotting mortgage loans? That would present a sea-change in policy, even though it’s in the bylaws of Fannie and Freddie to take on sour loans in extreme circumstances. Fannie and Freddie were placed into conservatorship in the early fall of 2008 and are now hostage to the government's every crisis move.

The dramatic shift would come as the Obama administration is putting off any effort at reforming Fannie and Freddie, and at a time when pay czar Ken Feinberg has no jurisdiction over the two companies, both of which just agreed to pay their top executives up to $6 million in compensation for 2009. If this drastic move is made, the U.S. government would push the poisonous swamp of moral hazard beyond the tipping point. It would show it’s willing and able to not just explicitly back the biggest bailouts in the history of the country, but also continue to give support to the worst, most irresponsible crop of borrowers taxpayers have ever endured.

The government-dependent enterprises have already cost taxpayers $110 billion in losses, they’ve already drawn down $111 billion from the Treasury, and both admit in SEC filings that they will continue to bleed money for some time to come in order to prop up the Administration's effort to revivify the U.S. economy by supporting home buying.

But, Why Now? 
It’s more than just rising home delinquencies. Fannie Mae just reported that the rate of serious delinquencies - those at least three months behind - on conventional loans in its single-family guarantee business rose to 4.98% in October, up from 4.72% in September - and about triple the 1.89% rate in October 2008. It’s about bombed-out bank balance sheets. The banks are desperately struggling to raise capital, as their cushions remain wafer thin.

Meanwhile, the U.S. must roll over $2.5 trillion in debt in the next two years, banks worldwide have $7 trillion in corporate bonds due in the same time span and $750 billion in commercial real estate loans are coming due, too, says Stephanie Pomboy of MacroMavens, as quoted in Alan Abelson’s column in Barron’s. Of course, the loan securitization market is dead in the water, with securitizations off by 90%, depending on the day. That means banks can no longer offload new loans via securitization and are stuck with the soggy stuff on their balance sheets.

The Federal Reserve is now the mortgage securitization market, as it now has $910.3 billion in mortgage-backed securities on its balance sheet, out of a planned $1.25 trillion in such purchases. But it can only tread water for so long. And that Fed program is set to expire next March, which means Fannie and Freddie will need an assist once that happens.

At the same time, U.S. accounting rule makers are forcing the banks to take back onto their balance sheet securitizations and all sorts of other assets now warehoused in off-balance- sheet conduits. Barclays reckons the rule will force roughly $500 billion in off-balance- sheet assets back onto bank balance sheets in 2010, requiring even more capital raises.  Fannie and Freddie would have to pull back onto their balance sheets off-balance sheet assets, so buying back loans may help them more quickly strip down securitizations.

Credit Suisse and JPMorgan Chase Warn: It's Coming
The government’s expanded capital backstops and portfolio limits for Fannie and Freddie increase “the prospect of large-scale” purchases by the companies of delinquent mortgages out of the securities they guarantee, Mahesh Swaminathan and Qumber Hassan, Credit Suisse debt analysts in New York, wrote in a report. The two added: “This announcement increases the prospect of large-scale voluntary buyouts by removing the portfolio cap hurdle and helping funding by potentially increasing debt-investor confidence.” JPMorgan Chase is also betting on Fannie and Freddie buying out loans that back their securities in 2010. Bloomberg broke this story within the past week.

One of the best business blogs out there, Calculated Risk, quotes former columnist Doris “Tanta” Dungey as raising this possibility a few years ago. Dungey was the most influential, gifted writer on the mortgage derivatives meltdown, and has since passed away — a terrible loss for the financial markets, as her voice has never been more needed than now:
"Fannie Mae has always had the option to repurchase seriously delinquent loans out of its MBS at par (100% of the unpaid principal balance) plus accrued interest to the payoff date. This returns principal to the investors, so they are made whole. If Fannie Mae can work with the servicer to cure these loans, they become performing loans in Fannie Mae’s portfolio. If they cannot be cured, they are foreclosed, and Fannie Mae shows the charge-off and foreclosure expense on its portfolio’s books (these are no longer on the MBS’s books, since the loan was bought out of the MBS pool).

"Now, Fannie also sometimes has the obligation to buy loans out of an MBS pool. But we are ... talking about optional repurchases. Why would Fannie Mae buy nonperforming loans it doesn’t have to buy? Because it has agreed to workout efforts on these loans, including but not necessarily limited to pursuing a modification. Under Fannie Mae MBS rules, worked-out loans have to be removed from the pools (and the MBS has to receive par for them, even if their market value is much less than that)."

Questions Surround Fannie, Freddie
The government's move to ease the limits on the securities holdings of Fannie Mae and Freddie Mac has ignited a debate among analysts about what the companies will do with their longer leash. When the Treasury Department took over Fannie and Freddie last year, one of the requirements they set for the companies required them to begin shrinking their portfolios of mortgages and related investments, which total a combined $1.5 trillion. The idea was to rein in the companies' size and growth.

But last Thursday, the Treasury eased that requirement, meaning the companies won't be forced to sell mortgages next year into an already weak market and could even buy mortgages on the market, which could help hold down interest rates. The Treasury also suspended for the next three years the $400 billion cap on the bailout subsidy that the government will offer. That could give them more flexibility to modify mortgages without worrying about taking losses.

Mahesh Swaminathan, senior mortgage analyst at Credit Suisse, said the firms could use their increased capacity to purchase delinquent loans from pools of mortgage-backed securities that they guarantee. Fannie and Freddie already purchase defaulted loans as they modify them under the administration's loan-modification program, but the additional breathing room means it is now a "slam-dunk for them to speed up" purchases of delinquent loans, Mr. Swaminathan said. New accounting rules that take effect next year also could make it more cost-effective for the companies to buy out bad loans and keep them in their investment portfolios.

The relaxed portfolio limits calmed investor worries that Fannie and Freddie would be forced to sell some of their mortgage holdings just as the Federal Reserve was preparing to wind down its purchases of mortgage-backed securities next spring. The Fed's commitment to buy up to $1.25 trillion has helped to keep mortgage rates near record lows; without that support some economists have said that could rise to 6% by the end of 2010. "The alternative would have been them selling into that market, which would have been even more difficult for the market to bear," Mr. Swaminathan said.

Others said the new flexibility means that Fannie and Freddie could replace the Fed as a big buyer of mortgage-backed securities, especially if weak demand for mortgage-backed securities from private investors drives rates higher. "It's created a government-purchasing facility other than the Fed," said Karen Shaw Petrou, managing partner of Federal Financial Analytics, a research firm in Washington. A Freddie spokesman said the company has used and will continue to use its investment portfolio as "an important tool" to "keep order in the housing and housing-finance markets." A Fannie spokesman declined to comment.

A Treasury official said the more generous portfolio limits were offered to avoid forcing the companies to actively sell their holdings, and they didn't intend for Fannie and Freddie to be active buyers of mortgages. But some analysts said the government wouldn't object to Fannie and Freddie's presence in the market. "You're going to hope that because of their lower cost of capital they will be a bid in the marketplace," said Joshua Rosner, managing director of Graham Fisher & Co.

Ms. Petrou said that the recent moves "make sense in a short-term way because you avoid market volatility," but the prospect of limitless aid will make it harder to extricate Fannie and Freddie from the government. "In a long-term way, it promotes nationalization of U.S. mortgage finance. We have increasingly gigantic, increasingly federal agencies eating up every mortgage out there," she said. Although Fannie's and Freddie's core business is their role guaranteeing payments to mortgage investors, for years they earned additional profits and generated controversy by maintaining a large investment portfolio filled with mortgages and related securities.

The most controversial part of the Christmas Eve announcement was the decision to erase any caps on the amount of Treasury money that the firms can take. That gives the mortgage-finance companies and their government masters a much freer hand to respond to the housing crisis in the year ahead, possibly by moving more aggressively to modify troubled loans. Some analysts said the companies now have greater flexibility to pursue more expensive loan modifications, including by writing down loan balances, which would have generated losses, requiring more government cash. But without a bailout ceiling, the administration "needs no longer worry that anything they do would drive Fannie or Freddie over the edge into negative net worth," said Ms. Petrou.

A Treasury representative said the bailout caps were suspended "specifically to ensure continued confidence in Fannie Mae and Freddie Mac, but were not based on any considerations" related to an expansion of the administration's loan-modification program. The Treasury already has handed over about $112 billion to help shore up the companies, which were among the first big financial institutions to fall under government control in the wake of the nation's mortgage crisis. Fannie and Freddie are playing a crucial role in providing mortgage liquidity. They own or guarantee half of the nation's $11 trillion in home mortgages and together with the Federal Housing Administration are responsible for backing nearly nine in 10 mortgages.

Fannie and Freddie's Home Inequity
That was a nice holiday gift to taxpayers.As expected, the Treasury on Christmas Eve increased the amount of money it can plow into Fannie Mae and Freddie Mac to keep them solvent. Before, the U.S. had pledged up to $200 billion to each. Now, over the next three years, the Treasury can spend as much as is needed to prevent their net worth going negative. Such a change would have required congressional consent after Dec. 31. Given that each U.S. household had effectively committed $3,800 to both firms, the Treasury should have waited till the New Year so the people's representatives could have had their say.

While Congress would likely have signed off, seeking its approval would have been an opportunity to open up a serious debate about Fannie and Freddie specifically and housing subsidies in general. There are strong arguments for abolishing housing support for everyone except the poor. No other advanced economy with high homeownership levels has Fannie- and Freddie-type entities. But not only are they unnecessary, they also caused harm. In good times, they probably kept house prices above true market levels, shutting potential buyers out.

And they played a central role in the housing crash with their huge purchases of dangerous Alt-A mortgages. What is more, their politically favored status likely made it easier for executives to practice misleading accounting earlier this decade. Granted, the Treasury might not have wanted to cause jitters in the mortgage market by letting Congress get involved. But at some point the U.S. needs to be able to make economic policy without worrying about every turn in the housing market.

Bad news for US housing: Prices flattening
Home price gains earlier this year flattened out in October, according to a report issued Tuesday. The S&P/Case Shiller Home Price index, covering 20 of the largest metropolitan areas in the nation, was unchanged in October, after four consecutive months of gains. The index is down 7.3% from 12 months earlier.

"The turnaround in home prices seen in the spring and summer has faded," said David Blitzer, chairman of the Index Committee at Standard & Poor's, in a statement. "Coming after a series of solid gains, these data are likely to spark worries that home prices are about to take a second dip," he said. Just seven of the 20 cities recorded gains from a month earlier. The modest gains earlier this year were in part propped up by government initiatives. "We've seen recent stability because of low interest rates and the impact of the first-time homebuyers tax credit," said Pat Newport, a real estate analyst with IHS Global Insight. Prices are down from their all-time highs set in 2006 by 29% for the 20-city index.

Among the 20 cities, the worst tumble was taken by Tampa during the month. Prices fell 1.6% from September. Chicago and Atlanta recorded 1% losses. The biggest gainers were Phoenix, up 1.3%, and San Francisco, up 1.2%. Las Vegas sellers continued to bleed. Prices there fell just 0.1% but that marked the 38th straight monthly decline. The market in Sin City is off 55.4% from its peak. You can buy a home in Las Vegas for the same price it sold for in October of 2000. "In most of the hardest-hit markets, price declines are moderating," said Mike Larson, an analyst with Weiss Research.

Los Angeles recorded a rise of 0.3% and San Diego prices gained 0.4%. Miami, however, declined by 0.4%. According to Larson, falling supplies of homes on the market are helping to stabilize conditions. "Inventories are plunging on the new-home side and going down for existing homes," he said. Not that he's ready to break out the champagne, even with the New Year close at hand. "The market is recovering but it will be an anemic recovery," he said. 

Fed Proposes Tool to Drain Extra Cash
The Federal Reserve on Monday proposed selling interest-bearing term deposits to banks, a move the U.S. central bank would make when it decides to drain some of the liquidity it pumped into the economy during the financial crisis. The new facility is intended to help ensure that the Fed can implement an exit strategy before a banking system awash with Fed money triggers inflation. Fed Chairman Ben Bernanke has described term deposits as "roughly analogous to the certificates of deposit that banks offer to their customers."

Under the plan, the Fed would issue the term deposits to banks, potentially at several maturities up to one year. That would encourage banks to park reserves at the Fed rather than lending them out, taking money out of the lending stream. The central bank said the proposal "has no implications for monetary policy decisions in the near term." "The Federal Reserve has addressed the financial market turmoil of the past two years in part by greatly expanding its balance sheet and by supplying an unprecedented volume of reserves to the banking system," it said. "Term deposits could be part of the Federal Reserve's tool kit to drain reserves, if necessary, and thus support the implementation of monetary policy."

Michael Feroli, an economist at J.P. Morgan Chase, said "it's another step forward in the exit-strategy infrastructure, but it's been well flagged in advance, so it's not a surprise." When Fed officials decide to tighten credit, they would likely use the term-deposits program ahead of -- or in conjunction with -- adjusting their traditional policy lever, the target for the federal funds interest rate at which banks lend to each other overnight. The Fed is already testing another tool, reverse repurchase agreements, in which the central bank sells securities from its portfolio with an agreement to buy them back later. Under the arrangement, the buyers move cash from banks to the Fed, removing reserves from the system.

Fed officials also have discussed selling some of the Fed's long-term securities, a move that would take reserves from the banking system. The Fed also said Monday that its balance sheet rose slightly to $2.2 trillion in the week ending Dec. 23. The Fed's total portfolio of loans and securities has more than doubled since the beginning of the financial crisis. As part of its efforts to fight the downturn, the central bank is buying $1.25 trillion in mortgage-backed securities, a program it says will end in March. The Fed now holds $910.43 billion in mortgage-backed securities, it said Monday.

Geithner: There will be no 'second wave' crisis
Treasury Secretary Timothy Geithner said [on December 22 that] the Obama administration is confident it will prevent a repeat of last year's financial crisis, the worst to hit the country in seven decades. "We are not going to have a second wave of financial crisis," Geithner said in an interview with National Public Radio. "We cannot afford to let the country live again with a risk that we are going to have another series of events like we had last year. That is not something that is acceptable."

Geithner, interviewed on NPR's "All Things Considered" program, rejected the idea that a serious new crisis could be triggered by lingering problems with commercial real estate loans or with a sudden weakening in the value of the dollar. "We will do what is necessary to prevent that and that is completely within our capacity to prevent," he said. Geithner spoke on a day when President Barack Obama met with executives from a number of community banks, reiterating his plea for banks to do more to lend to small businesses. Obama took a more conciliatory tone with the leaders of the smaller community banks than he had in a meeting last week with leaders of the country's largest banks.

Geithner, referring to the actions of the large banks in last year's crisis, said he did not believe they yet understood that they had lost the "confidence and trust of the American people." He said bankers had a "long way to go" to restore that confidence. Geithner defended his numerous contacts with executives from the largest banks, contacts that were revealed in telephone calendars obtained in October by The Associated Press under the Freedom of Information Act. Geithner said that he also spent a considerable amount of time talking to owners of small businesses and to small banks as well.

He called it a "misperception" that he was devoting too much time conferring with the largest banks. He said the conversations he had right after taking office should be viewed in the context of the serious crisis facing the financial system last winter and spring. "I'm the secretary of the Treasury. I have to spend time figuring out what it's going to take to fix the things that are broken in the financial system," he said.

Asked about the economy, Geithner said there were a number of signs that economic conditions were beginning to improve in terms of consumer and business confidence rising. He said it was likely that overall economic growth in the current quarter is accelerating, but he cautioned that dealing with the economy's troubles would take time. "We were in a very deep hole and it is going to take a long time to repair the damage done to confidence," he said.

Commercial Real Estate Holders Decide to Walk Away: The Continuing Double Standard from the Banking Industry. Debt Ceiling Raised to $12.4 Trillion Making Room for more Bailouts.
There will be many new financial stories in 2010 but one that is certainly to garner much attention is the implosion of the commercial real estate market.  A $3.5 trillion market that has taken it on the chin alongside the residential real estate market.  The commercial real estate debacle usually follows a similar pattern.  Residential real estate pulls back followed by commercial real estate.  But in this massive decade long real estate bubble commercial real estate debt ballooned into uncharted territory.  The bust is going to be deep and has no parallel in history just like the housing bubble bursting.  Yet the U.S. Treasury and Federal Reserve have already had backroom talks about coming out with a “Plan C” to bailout this segment of the American economy.

Yet the commercial real estate bust reveals again the hypocritical nature of the banking industry.  Hank Paulson last year came out and stated that homeowners that walked away on their obligations were acting immorally.  Well Morgan Stanley just demonstrated not only that Wall Street is amoral but corrupt to the bone:

“(WSJ) So we’ve discussed the ethics of individual borrowers walking away from their mortgages. (Some say we’ve over-discussed it.) If it’s immoral, as some would say, for a borrower to walk away their mortgage, is it any different for a bank?

Morgan Stanley is doing just that. News reports on Thursday said the bank plans to give back five San Francisco office buildings to its lender-just two years after buying them at the top of the market.

“This isn’t a default or foreclosure situation,” spokeswoman Alyson Barnes told Bloomberg News. “We are going to give them the properties to get out of the loan obligation.”

Sound familiar?

Morgan Stanley bought the buildings, along with five others, in San Francisco’s financial district as part of a $2.5 billion purchase from Blackstone Group in May 2007. The buildings were formerly owned by billionaire investor Sam Zell’s Equity Office Properties and acquired by Blackstone in its $39 billion buyout of the real estate firm earlier that year, Bloomberg reports. One analyst estimates that the buildings are now worth half of what Morgan Stanley paid.”

And keep in mind that Morgan Stanley is raking in massive profits since the corporatocracy bailouts:


So they are making a conscious choice of walking away from their bad choice.  The problem with this of course is that the American taxpayer has bailed out this company that actually had a direct hand in creating massive amounts of mortgage backed securities that imploded the residential housing market.  Now, here they are moving away their commercial real estate obligations and wiping their hands of any responsibility.  Average Americans are getting the raw end of deal in so many of these banking bailouts.  The commercial real estate bailouts have no justification for the safety of our economy but hundreds of banks will implode because of local loans they made.  Yet bigger banks enjoy the safety of the U.S. government and their printing press.


Unlike the too big to fail banks smaller regional banks will fail in the upcoming year as they have in 2009.  They made loans on local businesses that simply had no way of succeeding in a new austerity that demands people cut back.  The revised GDP number is down to 2.2 percent and without the government stimulus, the economy would still be contracting.  And those great retail sales?  Where did they come from?


The biggest jump came from gasoline stations.  As you might guess there is little need for commercial real estate in this segment of the economy.  So we are left with countless buildings that now sit empty while banks try to figure out their next step.  At least with homes, there will be a price point where homes sell.  Lower the price enough like some of the foreclosures and people will buy the property.  But in some commercial real estate buildings there is little demand for properties.  It is amazing that a bank like Morgan Stanley can simply walk away while having their industry chastise average Americans who even contemplate the idea of walking away.

The hypocrisy of the corporatocracy has reached a crescendo.   Of the $14 trillion in bailouts Wall Street received 87 percent of all the money:


The above is disturbing.  What we are seeing is that the banks are basically pushing all the downside of risk to average Americans while keeping any ill gotten profits.  They are rushing to payback TARP funds because they want to be unchanged so they can go back to gambling again.  So what if another crisis hits in a year or two?  After all, the poor U.S. taxpayer will be robbed yet again.  What has changed?  Nothing has changed.  These corporate friendly bailouts don’t even reflect a healthy capitalist system.  This is socialism for the too big to fail.  The way the commercial real estate bust is handled will tell us a lot regarding our government and Wall Street.  However, given the continuous hypocrisy coming from Wall Street expect more sweetheart deals for these failed bets.

And as a holiday gift, the Congress voted to raise the debt ceiling:

“(ABC) The Senate voted Thursday to raise the ceiling on the government debt to $12.4 trillion, a massive increase over the current limit and a political problem that President Barack Obama has promised to address next year.

The Senate’s rare Christmas Eve vote, 60-39, follows House passage last week and raises the debt ceiling by $290 billion. The vote split mainly down party lines, with Democrats voting to raise the limit and Republicans voting against doing so. There was one defection on each side, by senators whose seats will be on the ballot next year: GOP Sen. George Voinovich of Ohio and Democratic Sen. Evan Bayh of Indiana.”

Bankers Get $4 Trillion Gift From Barney Frank
To close out 2009, I decided to do something I bet no member of Congress has done -- actually read from cover to cover one of the pieces of sweeping legislation bouncing around Capitol Hill.

Hunkering down by the fire, I snuggled up with H.R. 4173, the financial-reform legislation passed earlier this month by the House of Representatives. The Senate has yet to pass its own reform plan. The baby of Financial Services Committee Chairman Barney Frank, the House bill is meant to address everything from too-big-to-fail banks to asleep-at-the-switch credit-ratings companies to the protection of consumers from greedy lenders.

I quickly discovered why members of Congress rarely read legislation like this. At 1,279 pages, the “Wall Street Reform and Consumer Protection Act” is a real slog. And yes, I plowed through all those pages. (Memo to Chairman Frank: “ystem” at line 14, page 258 is missing the first “s”.) The reading was especially painful since this reform sausage is stuffed with more gristle than meat. At least, that is, if you are a taxpayer hoping the bailout train is coming to a halt.

If you’re a banker, the bill is tastier. While banks opposed the legislation, they should cheer for its passage by the full Congress in the New Year: There are huge giveaways insuring the government will again rescue banks and Wall Street if the need arises.

Here are some of the nuggets I gleaned from days spent reading Frank’s handiwork:
  • For all its heft, the bill doesn’t once mention the words “too-big-to-fail,” the main issue confronting the financial system. Admitting you have a problem, as any 12- stepper knows, is the crucial first step toward recovery.

  • Instead, it supports the biggest banks. It authorizes Federal Reserve banks to provide as much as $4 trillion in emergency funding the next time Wall Street crashes. So much for “no-more-bailouts” talk. That is more than twice what the Fed pumped into markets this time around. The size of the fund makes the bribes in the Senate’s health-care bill look minuscule.

  • Oh, hold on, the Federal Reserve and Treasury Secretary can’t authorize these funds unless “there is at least a 99 percent likelihood that all funds and interest will be paid back.” Too bad the same models used to foresee the housing meltdown probably will be used to predict this likelihood as well.

More Bailouts
  • The bill also allows the government, in a crisis, to back financial firms’ debts. Bondholders can sleep easy -- there are more bailouts to come.

  • The legislation does create a council of regulators to spot risks to the financial system and big financial firms. Unfortunately this group is made up of folks who missed the problems that led to the current crisis.

  • Don’t worry, this time regulators will have better tools. Six months after being created, the council will report to Congress on “whether setting up an electronic database” would be a help. Maybe they’ll even get to use that Internet thingy.

  • This group, among its many powers, can restrict the ability of a financial firm to trade for its own account. Perhaps this section should be entitled, “Yes, Goldman Sachs Group Inc., we’re looking at you.”

Managing Bonuses
  • The bill also allows regulators to “prohibit any incentive-based payment arrangement.” In other words, banker bonuses are still in play. Maybe Bank of America Corp. and Citigroup Inc. shouldn’t have rushed to pay back Troubled Asset Relief Program funds.

  • The bill kills the Office of Thrift Supervision, a toothless watchdog. Well, kill may be too strong a word. That agency and its employees will be folded into the Office of the Comptroller of the Currency. Further proof that government never really disappears.

  • Since Congress isn’t cutting jobs, why not add a few more. The bill calls for more than a dozen agencies to create a position called “Director of Minority and Women Inclusion.” People in these new posts will be presidential appointees. I thought too-big-to-fail banks were the pressing issue. Turns out it’s diversity, and patronage.

  • Not that the House is entirely sure of what the issues are, at least judging by the two dozen or so studies the bill authorizes. About a quarter of them relate to credit-rating companies, an area in which the legislation falls short of meaningful change. Sadly, these studies don’t tackle tough questions like whether we should just do away with ratings altogether. Here’s a tip: Do the studies, then write the legislation.

Consumer Protection
  • The bill isn’t all bad, though. It creates a new Consumer Financial Protection Agency, the brainchild of Elizabeth Warren, currently head of a panel overseeing TARP. And the first director gets the cool job of designing a seal for the new agency. My suggestion: Warren riding a fiery chariot while hurling lightning bolts at Federal Reserve Chairman Ben Bernanke.

  • Best of all, the bill contains a provision that, in the event of another government request for emergency aid to prop up the financial system, debate in Congress be limited to just 10 hours. Anything that can get Congress to shut up can’t be all bad.

Even better would be if legislators actually tackle the real issues stemming from the financial crisis, end bailouts and, for the sake of my eyes, write far, far shorter bills.

Transfer Your Money From Wall Street Banks To Community Banks

For more information, go to Move your money.

US Consumer Confidence At Crossroads As Spread Between Visions Of Present And Future Is At Record Divergence
by Tyler Durden

Yesterday's most recent data from the Conference Board's Confidence Index recapitulates very well the Economic Inquisition purgatory that living in America has become: pain and suffering now, coupled with the promise of salvation and financial bliss at some point in the future.

Of course, on a long enough timeline we are all dead, so it is only fitting that the administration, whose slogan had something to do with tangible change, is gradually encroaching on the Catholic Church's turf in an all out war for the souls of America's taxpayers as tangible becomes increasingly ephemeral and, well, intangible (save for unemployment and the wads of electronic cash deposited in Goldman Sachs' employees bank accounts - both of those are all too real).

While the CBCC number came in at about the expected reading of 52.9 (from 50.6 in November), all of the "improvement" in confidence came from rosy future expectations, which rose to a two year high of 75.6 (from 70.3 previously). As for the present: current conditions plunged to another record low of 18.8. Never before has the differential between present pain and future hope been so wide.

The impact of this divergence politically is all too obvious. The voting population, which has been extremely patient, and keeps hoping that the future will finally bring something better and in line with oh so many promises, may very soon change their mood and realize that the present is here to stay, regardless of what the Fed manipulated capital markets demonstrate. When that happens watch for some interesting election fireworks on this side of the Potomac river.

Reading between the lines of the CBCC indicates that Obama and CNBC's grand plan to get consumers to spend, spend, spend again has fizzled. Autobuying intentions dropped to 3.8 from 4.5 in November, the lowest read in over a year, when the SAAR was 10.5 million. The double dip in the auto sales will soon be upon us. Furthermore, buying intentions of major household appliances held at a weak 23.7: Cash for Bidets can't come fast enough. Most troubling, however, homebuying intentions have plunged to a near-thirty year low: at 1.9, the percentage of Americans planning on buying a house is the lowest since 1982.

And just in case you thought that shellshocked US citizens will look to get the hell out of Dodge, at least temporarily, to take advantage of that strong, strong dollar and travel abroad, think again. The percentage of Americans planning a vacation in the next six months fell to 35.7, the lowest since April. The David Rosenberg-penned "frugal consumer" is here to stay, which can only mean that both the Fed and the US Government will become buyers of first, last and everything inbetween resort, as the traditional component of US GDP (sorry David Bianco, you are unabashedly wrong in your "consumer is irrelevant" propaganda). Maybe it is time to dust off all those Russian Politics 101 manuals, in our search of how to defeat Soviet Style Communist fiscal and monetary policy, which have so thoroughly penetrated the United States of America itself.

U.S. Looks Abroad in Another Week of Big Borrowing
The U.S. government will again bank on foreign investors, including its biggest creditors China and Japan, to take a record-tying $118 billion in notes to be auctioned this week. With foreign buyers holding about half of the Treasury market, their continued appetite for government securities is essential in order to continue funding mounting budget shortfalls in the U.S. at historically low interest rates. The auctions will be the last offerings of Treasury debt for 2009, adding to a record net supply of $1.48 trillion for the year. They start Monday with $44 billion in two-year notes, followed by $42 billon in five-year notes Tuesday and $32 billion in seven-year notes Wednesday, all matching the amounts offered a month earlier.

Thinner trading conditions during the winter holiday season pose a risk for such large sales. But many market participants said the selloff of short-term notes last week has made them attractive again. The two-year note's yield, which moves inversely to its price, traded at 0.96% Thursday. It has risen nearly 0.3 percentage point this month, while the yields on the five- and seven-year notes have increased by more than 0.5 point over the same period. U.S. markets were closed Friday for the Christmas holiday.

Because the five- and seven-year notes have been the favored maturities for foreign investors in recent auctions, this week's sales are likely to fare better than the offerings earlier this month of $21 billion of 10-year notes and $13 billion of 30-year bonds, which generated only tepid demand. "The auctions have been dominated by foreign bidders, and there is no particular reason to suspect that foreign reserve managers will be any less interested because of year-end," said Carl Lantz, an interest-rate strategist at Credit Suisse Securities USA LLC, one of the 18 primary dealers who trade directly with the Federal Reserve and underwrite Treasury auctions. Amitabh Arora,

head of U.S. rate strategy at primary dealer Citigroup Global Markets Inc., said he expects "strong demand for the five-year and the seven-year auctions, mainly via Asian investors." Other investors are already looking at 2010, when the U.S. will push for even larger debt sales. James Caron, head of interest-rate strategy at primary dealer Morgan Stanley, cautioned there may be "more difficulties" placing Treasury supply next year, and sees a risk that investors may demand higher yields. Mr. Caron expects net Treasury supply to hit a new record of $1.8 trillion next year.

The central bank may start raising interest rates in the latter half of the year, a move that would push yields higher. Another factor that could affect Treasury prices is the economic recovery, however slow. Many investors could turn to riskier assets, such as corporate bonds and stocks, for higher returns. Investors also remain concerned over the fiscal health of the U.S. and the delicate timing of the Fed's withdrawal of its huge monetary stimulus.

That would mean higher Treasury yields, resulting in higher funding costs for the U.S. government in order to lure fresh buyers. Despite these headwinds, David Rosenberg, chief economist and market strategist for Gluskin Sheff & Associates Inc. in Toronto, noted that with more than $1 trillion sitting in cash, U.S. banks have ample resources to buy bonds, while other potential buyers, such as the household sector, remain underrepresented.

"Deficits are a concern, but of all entities, the federal government is least likely to get downgraded," said Mr. Rosenberg, former North American chief economist for Merrill Lynch. "I don't expect there to be anything more than brief periods of indigestion at worst from the Treasury auctions in 2010."

World Credit Market Shrinks First Time in 15 Years, Mizuho Says
The amount of corporate debt outstanding globally shrank for the first time in at least 15 years in the first half of 2009 as U.S. banks reduced the size of their balance sheets, according to Mizuho Securities Co. The volume of corporate bonds, commercial paper and asset- backed securities fell to $52.9 trillion at June 30 from $53.2 trillion on the same day in 2008, Tetsuo Ishihara, a senior credit analyst for Mizuho in Tokyo, said in a report yesterday that analyzed data from the Bank for International Settlements.

“It’s unprecedented that the global debt market shrinks,” Ishihara said in a telephone interview. “When redemptions and buybacks are greater than new issues the outstanding size can shrink, which appears to have happened here.” Financial companies in the Americas had $1.1 trillion of losses and writedowns since the credit crunch started in 2007, about 65 percent of the global total, according to data compiled by Bloomberg. The extra yield investors demand to own investment-grade U.S. corporate bonds instead of Treasuries narrowed to 1.91 percentage points from 6.03 percentage points this year, Merrill Lynch & Co. data show, prompting companies to buy back debt to reduce interest payments.

The global credit market shrank 2.2 percent between Jan. 1 and March 31 from a year earlier and 0.5 percent in the second quarter, according to Mizuho’s report, which cited BIS data back to 1994. Companies reduced net debt even as U.S. corporate bond sales climbed to $744.7 billion in the first half from $617.8 billion in the same period a year earlier, Bloomberg data show. If the size of the market shrinks further, “spreads will be well supported,” Ishihara said.

Sprott Says S&P 500 to Tumble Below its March Low
The Standard & Poor’s 500 Index will collapse below its March lows as an expected rebound in economic growth fails to materialize, according to hedge fund manager Eric Sprott. The Toronto-based money manager, whose Sprott Hedge Fund returned 496 percent over the past nine years while the S&P 500 lost 32 percent, said the index’s 67 percent rally since March reflects investors misinterpreting economic data. He’s predicting the gauge will fall 40 percent to below 676.53, the 12-year low reached on March 9.

“We’re in a bear market that will last 15 or 20 years, and we’ve had nine of them,” Sprott, chief executive officer of Sprott Asset Management LP, which oversees C$4.3 billion ($4.09 billion), said in an interview Dec. 18. Investors in Sprott’s funds have been rewarded by his holdings in gold, which has climbed 40 percent since October 2007 as the S&P 500 lost 26 percent. The metal has retreated 9.3 percent since closing at a record $1,218.30 on Dec. 3.

Sprott said the Federal Reserve has kept bond yields and interest rates artificially low through its program to buy agency debt and mortgage-backed securities. The central bank expects the securities purchase program to finish by the end of March. Expiration of the program would reduce demand for fixed- income securities, forcing up bond yields and interest rates and hurting economic growth, Sprott said.

Should the Fed renew the programs while the U.S. government continues to run record deficits, investors will lose faith in the U.S. currency, he said. “If they announce another quantitative easing, trust me, the gold price will go up another 50 bucks that day,” he said. Gold futures rose 1 percent to $1,104.80 an ounce Dec. 24, data compiled by Bloomberg show. Sprott has been bullish in gold and gold stocks, which are used as a hedge against inflation, since at least 2001, when the precious metal was trading below $300 an ounce. Gold futures have slipped 6.4 percent this month in New York as the U.S. dollar has rebounded on data that signaled a recovery in the U.S. economy.

American payrolls fell by 11,000 in November, the fewest since the recession began, while retail sales gained 1.3 percent, twice the rate forecast in a survey of economists by Bloomberg, according to government reports released this month. Sprott says investors have been too eager to see the data as signs of recovery. While the S&P 500 added 0.6 percent on the day of the employment report, a 23rd consecutive month of payroll contraction was no reason for optimism, he said. “We don’t have employment gains,” he said. “We have less of a decline. That’s a sign of weakness. The data is weak.”

Sprott said gold is the only asset about which he remains positive in the short term. His C$1.42 billion Sprott Canadian Equity Fund -- which is up 22 percent in five months -- has 34 percent of its portfolio in mining stocks and another 39 percent in bullion as of Nov. 30. He said though he has no target price for the metal he doesn’t think it has reached a ceiling after quadrupling over the past eight years. “If you get into this thing where you’ve got to keep printing more and more and more, who knows about the price of gold?” he said. “It will be the new currency in due course.”

Within the mining industry, Sprott prefers companies with smaller market capitalization, which he said have greater potential to grow. Since last year, Sprott’s firm has become the biggest shareholder of Avion Gold Corp., which mines in Africa, and East Asia Minerals Corp., which explores in Indonesia. Avion is undervalued for its projected 2010 production, he said. According to a Dec. 16 note from analyst Eric Zaunscherb of Canaccord Financial Inc., Avion was trading at 2.9 times its estimated 2010 earnings, compared with a multiple of 10.5 for its peers. Regarding East Asia Minerals, Sprott said, “I just get the feeling that these guys could find a multi-double-digit-million- ounce property.”

East Asia completed a 2,000-meter, 14-hole drilling program at its largest Indonesian property that Canaccord analyst Wendell Zerb called “encouraging” and indicative of a large zone of gold mineralization. Over the next two quarters, East Asia is to drill 45 more holes at the site and begin drilling in four more locations in the country, Zerb said. Outside of the gold industry, Sprott owns shares of Wavefront Technology Solutions Inc., a TSX Venture Exchange- listed company whose products are meant to increase oilfield production. Its technology could be used on at least two-thirds of the world’s oil wells, he said. Sprott, 65, founded his current firm in 2001 after divesting Sprott Securities, now Cormark Securities Inc., to its employees.

Morgan Stanley Sees 5.5% Note as U.S. Faces Deficits
If Morgan Stanley is right, the best sale of U.S. Treasuries for 2010 may be the short sale. Yields on benchmark 10-year notes will climb about 40 percent to 5.5 percent, the biggest annual increase since 1999, according to David Greenlaw, chief fixed-income economist at Morgan Stanley in New York. The surge will push interest rates on 30-year fixed mortgages to 7.5 percent to 8 percent, almost the highest in a decade, Greenlaw said.

Investors are demanding higher returns on government debt, boosting rates this month by the most since January, on concern President Barack Obama’s attempt to revive economic growth with record spending will keep the deficit at $1 trillion. Rising borrowing costs risk jeopardizing a recovery from a plunge in the residential mortgage market that led to the worst global recession in six decades. “When you take these kinds of aggressive policy actions to prevent a depression, you have to clean up after yourself,” Greenlaw said in a telephone interview. “Market signals will ultimately spur some policy action but I’m not naive enough to think it will be a very pleasant environment.”

Yields on the 3.375 percent notes maturing in November 2019 climbed 4 basis points to 3.84 percent at 11 a.m. in London today, according to BGCantor Market Data. The price fell 10/32 to 96 5/32. They have risen 65 basis points this month, the most since April 2004, as government efforts to unfreeze global credit markets lessened the appeal of the securities as a haven. Speculators, including hedge-fund managers, increased bets that 10-year note futures would decline more than fivefold in the week ending Dec. 15, according to U.S. Commodity Futures Trading Commission data. Speculative short positions, or bets prices will fall, outnumbered long positions by 52,781 contracts on the Chicago Board of Trade. It was the biggest increase since October 2008.

In a short sale, investors borrow securities and sell them hoping to profit by repurchasing the securities later at a lower price and returning them to the holder. Ten-year notes will end 2010 at 3.97 percent, according to the average of 60 estimates in a Bloomberg News survey that gives greater weight to the most-recent forecasts. Edward McKelvey, senior economist in New York at Goldman Sachs Group Inc., the top-ranked U.S. economic forecasters in 2009, according to data compiled by Bloomberg, expects yields to drop to 3.25 percent. Goldman Sachs says unemployment will average 10.3 percent in 2010, hindering the recovery.

The U.S. will face increased competition from other debt issuers, spurring investors to demand higher yields as the Federal Reserve ends a $1.6 trillion asset-purchase program, according to James Caron, head of U.S. interest-rate strategy in New York at Morgan Stanley. The central bank was the largest purchaser of Treasuries in 2009 through a $300 billion buyback of the securities completed in October. The Treasury will sell a record $2.55 trillion of notes and bonds in 2010, an increase of about $700 billion, or 38 percent, from this year, Morgan Stanley estimates. Caron says total dollar-denominated debt issuance will rise by $2.2 trillion in the next 12 months as corporate and municipal debt sales climb.

Mortgage rates last reached 7.5 percent in 2000 as productivity gains slowed after the demise of some Internet companies. The average rate on a typical 30-year fixed-rate mortgage climbed to 5.05 percent in the week ended Dec. 24, according to McLean, Virginia-based Freddie Mac. Yields on mortgage securities issued by Fannie Mae rose to a four-month high of 4.54 percent last week. Fannie and Freddie securities are used to guide borrowing costs on almost all new U.S. home lending.

Higher borrowing costs as the U.S. shows signs of beginning to emerge from the longest economic contraction since the 1930s puts Treasury Secretary Timothy Geithner in a situation similar to one faced by his predecessor Robert Rubin. “This is the re-emergence of the bond market vigilantes,” said Mitchell Stapley, the Grand Rapids, Michigan-based chief fixed-income officer for Fifth Third Asset Management, who oversees $22 billion. “The vigilantes are saying, OK guys you want to do this, you’re going to pay a higher price for it.”

Inflation-adjusted 10-year note yields have more than tripled this year to 1.5 percent at the end of November, according to Bloomberg data, subtracting the gains in the consumer price index excluding food and energy from the nominal yield on the securities. A surge in so-called real yields to a seven-year high in the 1990s was viewed by the Clinton administration as a sign that they needed to address growing budget deficits, Greenlaw said. “Rubin went to Clinton and said we have to do something to support the recovery, and taxes went up,” Greenlaw said. “You don’t really start to put pressure on policy makers to respond until the market sends a signal.”

Sales of existing homes rose 7.4 percent last month, following October’s 10.1 percent gain. The difference between two- and 10-year yields to a record 2.88 percentage points on Dec. 22 as traders added to bets a recovery will fuel growth and inflation. The yield curve contracted a day later after a separate report showed sales of new homes unexpectedly fell in November. “When you couple the growing probability of a belief in a recovery combined with the supply, it could mean some indigestion problems for Treasury yields,” said James Sarni, senior managing partner in Los Angeles at Payden & Rygel, which oversees $50 billion. “As long as the demand is there, the supply won’t be a problem. I think what’s going to happen is there’s going to be a problem with the demand.”

Spending by Obama and lawmakers is increasing as the Fed winds down its stimulus programs. The Senate voted on Dec. 24 to raise the limit on federal borrowing to $12.39 trillion, enough to tide the government over for about two months. The House approved the legislation Dec. 16, along with a $154 billion aid package to pay for extended unemployment benefits, new infrastructure projects and help for state governments. Greenlaw says the U.S. will probably have to offer investors such as foreign central banks and mutual funds real returns of more than 3 percent for 10-year notes to attract funding.

“There’s no free lunch, and when you take these kinds of aggressive policy actions to prevent a depression, you have to clean up after yourself,” Greenlaw said. “Foreign central banks are just not going to be able to finance these kinds of budget deficits for very long.” Monetary officials in China, Japan and other countries helped Geithner lower U.S. borrowing costs by 15 percent in the government’s 2009 fiscal year. Indirect bidders, a group of investors that includes foreign central banks, purchased 45 percent of the $1.917 trillion in U.S. notes and bonds sold this year through Nov. 25, compared with 29 percent a year ago, according to Fed auction data compiled by Bloomberg News.

The decline in interest expense was the biggest decrease since before 1989 and came even as the nation’s debt increased by $1.38 trillion this year to $7.17 trillion in November, the data show. An increase in yields may even add to demand for Treasuries, said Ian Lyngen, a senior government bond strategist at CRT Capital Group LLC in Stamford, Connecticut. He doesn’t anticipate 10-year note yields rising above 4.25 percent in the first quarter. “The data has yet to prove definitively more bullish for the economy and more bearish for the bond market,” Lyngen said. “A significant backup in rates will simultaneously make the debt more expensive for the Treasury and potentially make it more attractive for investors to buy.”

White House officials have acknowledged the bond market’s message about the need to cut the federal deficit. Rahm Emanuel, Obama’s chief of staff, said on Nov. 17 in a speech in Washington that a plan for reducing budget deficits “is foremost” on the president’s mind. “Could one imagine the market for debt being saturated? Of course,” said Lawrence Summers, director of the National Economic Council, speaking in New York on Oct. 8. “We will not, as a country, as the economy recovers, be in a position to issue federal debt on anything like the scale that was appropriate to issue federal debt during a profound economic downturn.”

Morgan Stanley’s Caron predicts the spread between 2-and 10-year yields will rise to 3.25 percentage points next year. “There is a lot of supply coming to the markets next year,” Caron said. “In 2009 there was a lot of support for that supply. The question going forward is what happens when there is not.”

A Permanent Backstop Would Be Permanent Pain
Imagine your delight if the government was suddenly prepared to guarantee all your debts. That's more or less what U.S. politicians are offering banks in legislation designed to fix the financial sector. That lawmakers are pushing a debt backstop, despite the moral-hazard risk, reveals their concerns about the ability of banks to borrow through an economic downturn. That's understandable. In the latest crisis, many firms could have failed without the Federal Reserve's emergency credit lines and the Federal Deposit Insurance Corp.'s Temporary Liquidity Guarantee Program, or TLGP.

Even so, the permanent offer of a backstop takes the system in the wrong direction. What's needed are far-reaching changes that make bank funding far safer and protect the taxpayer, not put them on the hook. The details of the backstop beggar belief. The bill passed by the House says that if a "liquidity event" occurs that could "destabilize the financial system," regulators and the Treasury can widely offer the guarantee. The bill stipulates that the guarantee can only go to "solvent" institutions, but its definition of solvency—having more assets than obligations to creditors—could let just about anyone in.

Regulators may feel they need this new backstop because they now oversee a higher number of large firms that borrow heavily in the market to fund investment-bank operations. Indeed, experience in Japan shows that a banking sector is safer if deposits are by far the predominant source of funding. In the mid-'90s, total Japanese bank loans were 25% higher than deposits, according to figures from Pali Capital. That gap had to be filled with market borrowing. Now, loans are 22% lower than deposits. Granted, this low loan-to-deposit ratio partly exists because Japanese banks are reluctant to lend. But it meant they were liquid going into the latest crisis—and thus didn't destabilize their system.

To be fair, the loan-to-deposit ratio has improved markedly in the U.S. during the crisis, falling to 97% in November at large banks, from a multiyear high of 114% in May 2008. But this measure captures only traditional loans, and doesn't reflect other assets held by securities arms for example, that are likely to be funded in wholesale markets. One way to tackle the funding problem would be to remove all government protection from bank businesses that are not mostly deposit-funded. The market would likely become more wary of funding wholesale-funded businesses, forcing universal banks to shrink such operations to less systemically risky levels or sell them

GMAC Set for Another Cash Infusion
GMAC Financial Services is close to getting approximately $3.5 billion in additional aid from the U.S. government, on top of $12.5 billion already received since December 2008, according to people familiar with the situation. The announcement, expected within days, will coincide with GMAC taking additional steps to absorb losses related to its mortgage operations, these people said. The cleanup is designed to return the Detroit-based finance company to profitability in the first quarter of 2010, according to one of these people.

A GMAC spokeswoman declined to comment on any potential government action but said, "GMAC has been conducting a strategic review of its business and evaluating options to address the challenges in its mortgage operation." The spokeswoman said GMAC wants to prepare itself to repay the U.S. government. The willingness by the U.S. Treasury to deepen taxpayer exposure to GMAC reflects the troubled company's importance to the revival of the auto industry. The company was told to raise additional capital as part of government-led stress tests of large banks conducted earlier this year. The tests were to determine whether firms would need more capital to continue lending if the economy deteriorated in 2009 and 2010.

GMAC has only filled a portion of its capital hole and, unlike other banks that participated in the stress tests, has been unable to attract much capital from private investors. The Treasury said earlier this year that it would make as much money available to GMAC as needed to fill its capital hole and projected the firm would need another government infusion of as much as $5.6 billion. GMAC's capital needs have turned out to be somewhat less than originally envisioned, in part because impact from the bankruptcies of General Motors Corp. and Chrysler Corp. was not as severe as federal regulators originally projected.

A Treasury spokesman said Tuesday: "As we stated on Nov. 9, Treasury is in discussions with GMAC to ensure its capital needs as determined last May by the stress tests are met." GMAC has argued it didn't need additional support. The Treasury has authority to provide funds to GMAC through the Troubled Asset Relief Program, the $700 billion program authorized by Congress at the height of the financial crisis. This will be the first big infusion to a single company in several months. The Treasury has been working to wind down many of the TARP programs as the financial crisis eases, and it has already seen $175 billion returned from banks.

The Treasury agreed to inject $5 billion into GMAC in December 2008, as part of a broader rescue of the auto sector, and another $7.5 billion in May after the stress tests were completed. That $7.5 billon was considered by the Treasury to be a down payment, with additional funds likely coming later. The government's existing 35.4% stake in GMAC is likely to eventually increase, a move that could give the government more control over the firm, including the right to appoint additional directors to GMAC's board. GMAC is subject to pay restrictions imposed by the government's pay czar. The additional financing comes as many other companies that received large sums of government aid have begun repaying the government, including Citigroup Inc. and Bank of America Corp.

GMAC, founded in 1919, provides wholesale financing for thousands of General Motors and Chrysler dealerships across the U.S., meaning scores of local distributors would be unable to bring cars onto their lots if GMAC were to collapse. The new capital will likely allow GMAC to avoid placing its ailing mortgage unit, Residential Capital LLC, or ResCap, into bankruptcy, these people said. GMAC had set the end of the year as a deadline for deciding ResCap's fate after losses from loans made to borrowers with shaky credit dragged down GMAC's results in 2009. The mortgage unit lost $2.7 billion through the first three quarters of 2009 following $9.96 billion of losses in 2008 and 2007.

The fate of ResCap was a flash point between the board and GMAC's former chief executive, Alvaro de Molina, who was ousted in November following clashes with the government and his directors. Board member Michael Carpenter succeeded Mr. de Molina. Some board members were upset, saying management had left out bankruptcy as an option; management's view was that it had presented all options, including a potential sale, and the board was unable to make a decision.

The mortgage-related write-downs to be announced as early as this week will affect assets held by ResCap and Ally Bank, GMAC's online bank. Ally Bank was created after the company received approval in late 2008 to convert to a bank holding company and qualify for government money under TARP. The arrangement left the Federal Reserve with regulatory authority over the parent. Ally's pursuit of deposits at high rates became a key leg of its strategy, since deposits provide a cheap form of funding, but the taxpayer-assisted approach rankled competitors and the Federal Deposit Insurance Corp. Ally and FDIC reached an agreement that requires GMAC to keep its rates at certain levels in exchange for FDIC's support, according to people familiar with the situation.

Reviving Glass-Steagall Means Escalating 'War' on Wall Street
A one-page proposal gaining traction in Congress could turn back the clock on Wall Street 10 years, forcing the breakup of banks, including Citigroup Inc. Lawmakers in both parties, seeking to prevent future financial crises while soothing public anger over bailouts and bonuses, are turning to an approach that's both simple and transformative: re-imposing sections of the 1933 Glass-Steagall Act that separated commercial and investment banking.

Those walls came down with passage of the Gramm-Leach-Bliley Act of 1999. A proposal to reconstruct them, made by U.S. Senators John McCain and Maria Cantwell on Dec. 16, would prevent deposit-taking banks from underwriting securities, engaging in proprietary trading, selling insurance or owning retail brokerages. The bill could also force the unwinding of deals consummated during the financial crisis, including Bank of America Corp.'s acquisition of Merrill Lynch & Co.

"The impact on Wall Street would be severe," Wayne Abernathy, an executive vice president at the American Bankers Association, said in a telephone interview. Resurrecting Glass-Steagall goes beyond the array of new regulatory powers that President Barack Obama has proposed to fix the financial system. It has also sparked debate among academics, regulators and legislators over whether the Depression-era law could have prevented the crisis of 2008 or might help avoid future ones.

"If you look at what happened, with or without Glass-Steagall, it would have made no difference," said H. Rodgin Cohen, chairman of New York-based law firm Sullivan & Cromwell LLP, who represented one side or the other in more than a dozen transactions stemming from the financial crisis last year, including the rescues of Bear Stearns Cos., Fannie Mae, Wachovia Corp., and American International Group Inc. Cohen and others say the law wouldn't have saved Bear Stearns or Lehman Brothers Holdings Inc., both of which were pure investment banks, from collapse.

And the government would not have been able to enlist JPMorgan Chase & Co. to take on the assets of Bear Stearns or allow Goldman Sachs Group Inc. and Morgan Stanley to become bank holding companies, giving them access to the Federal Reserve's discount window. Rather than split up banks, regulators should provide better supervision and require tougher capital requirements, said Cohen, who was also involved on behalf of banking clients in shaping the bill that dismantled parts of Glass-Steagall.

The McCain-Cantwell proposal, which has picked up four additional co-sponsors, could be considered by the Senate Banking Committee as early as January, if Senator Christopher Dodd, the Democratic chairman from Connecticut, and other members complete negotiations on a financial overhaul bill. A similar bill has been introduced in the U.S. House of Representatives by Maurice Hinchey, a Democrat from New York. The House already adopted a measure on Dec. 11 to revamp financial regulation without Hinchey's proposal. The chief sponsor of the overhaul measure, Representative Barney Frank, has said he supports giving regulators the power to apply Glass-Steagall in individual cases.

"It is fair to argue that if the bill picks up steam in the Senate, the House could have the political appetite to pass it as well," Paul Miller and four other analysts at FBR Capital Markets in Arlington, Virginia, said in a Dec. 17 note. One reason support for the idea is growing is that lawmakers see public anger building over what Obama called "fat cat bankers." As industry profits bounce back and banks repay Troubled Asset Relief Program funds—and also get set to hand out billions of dollars in bonuses—Americans are still struggling with a 10 percent unemployment rate and home foreclosures. That's leading Congress to seek ways to rein in the firms blamed for the financial crisis.

"Congress is at war with Wall Street," said former Fed Governor Lyle Gramley, now a senior economic adviser at Soleil Securities Corp. in New York. "They perceive Wall Street as being the root source of our financial crisis, and they want to do something to make sure that doesn't happen again."

Splitting banking functions needed for the smooth operation of the economy from riskier securities and trading activities was proposed earlier this year by the Group of Thirty, a nonprofit organization made up of former government officials and bankers, including Paul Volcker, a former Fed chairman and head of the president's Economic Recovery Advisory Board. The group said the crisis spread like a contagion from firm to firm, putting both commercial banks and securities companies at risk. To prevent a domino effect, systemically important financial institutions shouldn't be allowed to engage in proprietary trading that involved "particularly high risks" or "serious conflicts of interest," the group said.

While that would not bar banks from underwriting securities, as some U.S. lawmakers want, it might force them to shutter or sell trading divisions. The financial system has "failed the test of the marketplace," Volcker said in January. He added that "it's been proven that they're unmanageable, the existing conglomerates." Some Wall Street executives endorse such a split.

"What we need is a 21st century Glass-Steagall," said Gerald Rosenfeld, deputy chairman of Rothschild North America Inc. and a professor of business and law at New York University. Rosenfeld favors regulating commercial banks like public utilities, while giving securities firms and hedge funds more freedom, as long as they adhere to capital guidelines. "The important thing is we have to have a structure that prevents the contagion from spreading when there are catastrophic losses in those riskier businesses," he said.

Others are guided by the principle that smaller is better. Christopher Whalen, managing director of Institutional Risk Analytics, a Torrance, California, firm that evaluates banks for investors, said the repeal of Glass-Steagall in 1999 was based on the false premise that bigger banks would be more competitive and efficient. "I don't think there are any efficiencies of scale in banking," Whalen said. "Making them smaller would be far more efficient and also improve competition. If we had broken up Citi last year, we would have seen a couple of new market entrants buying operations. That is what creative destruction is all about."

Roy Smith, a finance professor at New York University's business school and a former Goldman Sachs partner, said reviving Glass-Steagall would affect Goldman Sachs less than other big banks because the firm focuses largely on investment banking and could give up banned businesses without difficulty.

For other firms, the fallout could be harsh, said Abernathy of the bankers' association. "If you restore Glass-Steagall, for some of them the banking operation would be an unwanted stepchild," he said. "It would be the less profitable of the two because its business would be far more constricted." Bank lobbyists are targeting the Senate Banking Committee as lawmakers negotiate provisions of a regulatory overhaul bill. They're arguing that a return to the pre-1999 era would reduce the diversity of revenue streams, make financial firms more vulnerable in a crisis, prevent them from acquiring ailing institutions, increase the cost of raising capital and undermine the global competitiveness of U.S. institutions.

"Reinstating Glass-Steagall misses the mark—a point we intend to share with Chairman Dodd and other senators on the committee," said Rob Nichols, president of the Financial Services Forum, a Washington-based trade group that represents the chief executive officers of the largest financial firms. Dodd said he doesn't favor reviving Glass-Steagall as a way of dealing with "too-big-to-fail" institutions and added "there are other things we can do to break them up."

Also lining up on the side of the banks are two sponsors of the 1999 bill that dismantled Glass-Steagall. Jim Leach, a former Republican congressman from Iowa and now chairman of the National Endowment for the Humanities, said the biggest problem was overleveraging by securities firms, not the mingling of businesses. "Virtually all of the financial difficulty banks are in today relates to activities they could do before" President Bill Clinton signed his bill in 1999, Leach said.

Phil Gramm, who as a Republican senator from Texas was another co-sponsor, said that, rather than weakening banks, the law cushioned the impact of the subprime mortgage crisis by making financial institutions more broad-based and competitive. "A lot of this is about trying to find somebody to blame," said Gramm, now a vice chairman of investment banking at UBS Securities LLC.

Hinchey, the congressman who introduced the House bill to reinstate Glass-Steagall, said in an interview that a comeback is "very questionable." "There's a lot of pressure coming from the big banks to prevent this kind of thing from happening," Hinchey said.

Those banks may have lost some of their political influence as their earnings have recovered, said William Isaac, a former chairman of the Federal Deposit Insurance Corp. "The TARP legislation and the way it was administered was political dynamite for the banks," said Isaac, now chairman of the global financial services unit of LECG Corp., an economic and financial consulting firm in Emeryville, California. "The public feels that this was all about protecting Wall Street and did nothing for Main Street, and it's largely true."

Chinese firm says won't pay Goldman on options losses
A small Chinese power generator on Tuesday rejected demands from a Goldman Sachs unit to pay for nearly $80 million lost on two oil hedging contracts, part of a long-running dispute over how China deals with derivatives losses. Goldman Sachs was one of the foreign banks, along with Citigroup, Merrill Lynch and Morgan Stanley, blamed by the state assets watchdog for providing "extremely complicated" and difficult to understand derivatives products.

Shenzhen Nanshan Power said in a statement that it received several notices from J. Aron & Company, a trading subsidiary of Goldman Sachs, for at least $79.96 million as compensation for terminating oil option contracts. "We will not accept the demand by J. Aron for all the losses and related interests," said Nanshan, in line with the stance it took last December. "We will try our best to negotiate with J. Aron and resolve the dispute peacefully...but the possibility of using a lawsuit can not be ruled out when talks fail," it added. "J. Aron told us in one notice that if we do not pay the money, they will reserve the right to launch a lawsuit and will not send us any further notice."

The State Assets Supervision and Administration Commission said in September that it would back state-owned companies in any legal action against the foreign banks that sold them oil derivatives, which resulted in losses when oil prices dived late last year. Nanshan said in October last year that two oil option-related contracts with J. Aron were signed by its officials without authorisation from the company. In December 2008 it said in a statement it had terminated the deals, and that it would not accept J. Aron's demand for payment.

Many Chinese firms, especially airliners, suffered huge losses from complex oil options trading last year as oil price collapsed to nearly $30 a barrel. A senior official from SASAC revealed last month that 68 Chinese firms suffered net losses of 11.4 billion yuan ($1.67 billion) by October 2008 on call and put options signed with foreign banks. So far no legal action has been taken and many lawyers and industry analysts believe that Chinese firms and their foreign banks are quite likely to settle their disputes privately or through arbitration, similar to a handful of previous cases in the mid-1990s.

Only 31 firms are authorised in China to trade derivatives directly in the overseas market and the regulators started strictly prohibiting others from such trading since early 2009 after losses were exposed. SASAC said last month that it had suggested companies without overseas derivatives trading licences trade on the domestic market or through domestic financial institutions.

Goldman Sachs denies betting against its clients on CDOs
Goldman Sachs has moved to justify spending millions of dollars short-selling some of the financial products it made and sold to clients. In a rare statement of defence, the American investment bank has offered a detailed explanation of its dealings in mortgage-backed products, particularly regarding collateralised debt obligations (CDOs), in the years preceding the financial crisis. The explanation was prompted by an article in the New York Times in which former Goldman employees and debt experts claimed that the bank knew the CDOs it was designing and selling to clients were highly risky. The sources claimed that rather than warning clients of the dangers, Goldman spent millions of dollars "short-selling" the instruments, reaping vast rewards when they imploded.
Sylvain Raynes, an expert in structured finance at R & R Consulting, told the New York Times: "The simultaneous selling of securities to customers and shorting them is the most cynical use of credit information that I have ever seen. When you buy protection against an event that you have a hand in causing, you are buying fire insurance on someone else's house and then committing arson.'' A spokesman for Goldman said: "We respectfully disagree with this view."

The design and marketing of the disastrous instruments - and the degree to which the arranging banks understood the risks in the years up until 2007 - are the subject of an investigation by American authorities including Congress, the Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority. Proprietary trading, or the banks' practice of trading for their own gain rather than their clients', has already been widely criticised since the financial crisis. Banks are determined to avoid any suggestion that they were also betting against and at the expense of clients.

Goldman admits that it regularly took short positions in CDOs and other synthetic instruments that it designed and sold to clients, it strongly denies that it was motivated by an understanding of the dangers. Instead it says the short positions were merely a simple hedge against its large long mortgage portfolio. In its statement Goldman said it had suffered significant losses due to its mortgage portfolio, including a $1.7bn write-down in 2008 and added that "these losses would have been substantially higher had we not hedged." The bank pointed to the fact for every buyer of a CDO there had to be a seller, due to the way the market was designed. Goldman claims that high demand from investors meant that the arranging banks like itself and others were the "natural shorts" - and that investors were always aware of this.

The danger in the CDOs was not foreseen but instead resulted in losses for "financial institutions including Goldman, effectively putting an end to this market." Separately, a small Chinese power generator said it is refusing to pay $80m lost on two hedging contracts as part of an on-going row that investment banks produced "extremely complicated" derivative products that were impossible to understand. Shenzhen Nanshan Power warned in a statement that the "possibility of using a lawsuit can not be ruled out."

Pricing a CDO - Not only Bad Math, Bad Computation too
A working paper, Computational complexity and informational asymmetry in financial products, Sanjeev Arora, Boaz Barak, Markus Brunnermeier, Rong Ge. sheds some light on the complex mathematical models upon which credit default obligations and other derivatives are based.

What Arora et al. prove is not only are many derivative mathematical models impossible to compute, never mind in real time, because they require more computing power than the world possesses, the missing information to run a mathematical model is a very good place to cheat with.

To understand what CDOs, derivatives are, see this post, complete with video tutorials. For some background on the mathematics behind derivatives, read We Want the Formula and this one on some of the probability functions.

Onto the paper. Firstly this quote:

One of our main results suggests that it may be computationally intractable to price derivatives even when buyers know almost all of the relevant information, and furthermore this is true even in very simple models of asset yields.

They ain't talking about your new PC cranking through these calculations, they are referring to massive supercomputers.
This result immediately posts a red flag about asymmetric information, since it implies that derivative contracts could contain information that is in plain view yet cannot be understood with any foreseeable amount of computational effort.

So, individual investors or even online brokerage firms can kiss it goodbye in verifying these values easily due to computational complexity of the algorithms themselves.
The practical downside of using derivatives is that they are complex assets that are difficult to price. Since their values depend on complex interaction of numerous attributes, the issuer can easily tamper derivatives without anybody being able to detect it within a reasonable amount of time.

The paper points out current variations in price can be 17% and they can give widely variable pricing evaluations, even within the same bank issuing the same tranch (little slices of rated assets) in a derivative.

Now here is the reason this paper is so mind boggling damning and I'm translating from computational research to Populist terms.

There is no friggin' way to crank these numbers in these models with typical processing power. There are not enough computers in the world. That means not only are many results invalid, but this:

Designers of financial products can rely on computational intractability to disguise their information via suitable “cherry picking.” They can generate extra profits from this hidden information, far beyond what would be possible in a fully rational setting

Translated to Populist blog speak: Derivatives are a way to scam and screw investors out of their dough through a lot of high fallutin' gobbledygook that sounds real technical.

How do sellers scam on CDOs? By taking a few of the ones they are peddling, a subset, and stuffing them with more toxic assets than the other ones. To load the derivative dice, one adds \mbox worthless crap assets = \sqrt{\mbox total assets}, to be precise. This puts that particular CDO at a much higher probability of default. So, instead of mitigating risk, one can increase risk! Supposedly one of the justifications of derivatives is to mitigate risk. Ho ho ho!

Now, because there are only some CDOs which are rigged, finding which subset of them is, in a sea of CDOs....computationally impossible. It wouldn't matter if you had gobs and gobs of super computers, and billions of years, you ain't gonna find them because one has to go through all sorts of permutations to calculate and determine them. To make matters worse, the CDO seller, can stuff CDOs with a subset of worthless assets in a way that even if one had all of the computers in the world and could crank through \mbox{n-sized subsets of} N, it won't pop up in the detection algorithm anywho due to the probability spread. In Math geek, this is technically a NP-Complete problem.

In layman's terms, the equation P \neq NP simply means even with a huge bunch of honking fast computers, one cannot get a concrete result or answer.

Then asymmetric information means that one guy has more info that you do when making a transaction. Say the seller of a house knows it has termites, but you don't and buy the house thinking you got a great deal because it was below market value.

Surely there is a way to guarantee these derivatives are not tampered with right? Uh, no! If ya can't prove these things are rigged, how ya gonna guarantee they ain't? Even more interesting, let's say a patsy buyer gets wiped out and suspects he's been scammed, this plan is full-proof because there is no evidence, thus nothing the screwed over buyer can do to get their money back.

Is there anything that can be done to make derivatives a computationally bounded problem to make them legit? Indeed there is, say the authors. One is a logic statement, an exclusive OR, although I don't recall seeing such a thing in any probability or statistical formula... (yet, there is integer mathematics) ....and then they define a more realistic bound, what is called a tree of majorities.

Now, on regulation, here on EP we've called for the regulation of the mathematical models themselves. How can one sell a product built on bad math, that is not even valid by the mathematical properties themselves? One could also incorporate the ability to validate a price computationally as part of a regulation requirement. The above type of derivatives outlined in the paper? Plain just ban them would be my druthers.

The rest of the paper is an exceptional read, but be warned, it does use many computer science theoretical terms, equations and advanced probability and statistical concepts. I've broken down a few key concepts above.

I'm personally thrilled to see some computer scientists look into financial derivatives! When we first reviewed them on this site, we were shocked that the Mathematical and Scientific community had not flagged many of these models for being theoretically flawed, from the mathematics themselves. Good work Arora et al.!

The authors have also put up a derivatives FAQ of the implications of their paper.

Treasuries Set for Worst Year Since 1978 as U.S. Steps Up Sales
Treasuries headed for the worst year since at least 1978 as the U.S. stepped up debt sales to help spur growth in an economy recovering from its deepest recession in six decades. U.S. seven-year notes were little changed before today’s $32 billion sale of the securities, the last of three auctions this week totaling a record-tying $118 billion. The Treasury sold $42 billion of five-year securities yesterday and $44 billion in two-year notes on Dec. 28. U.S. government securities have fallen 3.6 percent this year, according to Bank of America Merrill Lynch indexes, the worst annual performance since at least 1978, when Merrill began collecting the data.

“It’s the last hoop the market has to jump through in 2009,” said James Collins, an interest-rate strategist in the futures group in Chicago at Citigroup Inc., one of 18 primary dealers that trade with the Federal Reserve and are obliged to participate in Treasury auctions. “Yields have been trending higher. It’s been a response to increased supply.” The yield on the benchmark 10-year note was little changed at 3.80 percent at 11:11 a.m. in New York, according to BGCantor Market Data. It has increased 1.58 percentage points this year. The 3.375 percent debt due in November 2019 rose 1/32, or 31 cents per $1,000 face amount, to 96 18/32. The seven-year note yielded 3.31 percent.

President Barack Obama is borrowing unprecedented amounts for spending programs. U.S. marketable debt increased to a record $7.17 trillion in November from $5.80 trillion at the end of last year. The last sale of seven-year notes, a $32 billion offering on Nov. 25, drew a high yield of 2.835 percent and attracted bids for 2.76 times the amount on offer, compared with 2.65 times at the October offering. The seven-year security to be sold today yielded 3.34 percent in pre-auction trading. “There’s some attraction in yields, so it’ll be another so-so auction,” said Kazuaki Oh’e, a bond salesman in Tokyo at Canadian Imperial Bank of Commerce, the nation’s No. 5 lender. “Investors are looking for more safety and less risk. It’s easier to be safe going into the new year.”

Yesterday’s $42 billion five-year note sale drew a yield of 2.665 percent, compared with the forecast of 2.678 percent in a Bloomberg News survey. The bid-to-cover ratio was 2.59, compared with an average ratio of 2.36 at the last 10 auctions. The two- year auction on Dec. 28 drew a yield of 1.089 percent, compared with a forecast of 1.059 in a Bloomberg survey and a yield of 0.802 percent at the November sale. The bid-to-cover ratio was 2.91, the lowest since August. “With two auctions out of the way and the magic seven ahead of us, we believe that supply fears, which helped to get bonds into attractive levels, will fade for now and the next few days should be a steady grind lower in rates,” said George Goncalves, chief fixed-income rates strategist in New York at Cantor Fitzgerald LP, a primary dealer.

Holders of U.S. debt have made a return of 81 percent over the past decade, according to the Bank of America Merrill Lynch indexes. That compares with an 8 percent loss for the Standard & Poor’s 500 Total Return Index.

The so-called Treasury yield curve, a barometer of the health of the U.S. economy, widened to a record earlier this month as investors bet an accelerating recovery will fuel inflation and hurt demand for the unprecedented sales of government debt. The gap between U.S. 2- and 10-year yields widened to a record 2.88 percentage points on Dec. 22, from 1.45 percentage points at the beginning of the year. The spread was at 2.71 percentage points today.

Companies in the U.S. expanded more than anticipated in December as orders and employment grew, a report today by the Institute for Supply Management-Chicago Inc. showed. The group’s business barometer rose to 60, more than forecast in a Bloomberg News survey and the highest level since January 2006. Readings above 50 signal expansion. An index of home prices in 20 U.S. cities rose in October for a fifth consecutive month, the S&P/Case-Shiller home-price index showed yesterday. Confidence among U.S. consumers increased in December for a second month, the New York-based Conference Board’s consumer confidence index showed yesterday.

Fed Chairman Ben S. Bernanke has cited a tame inflation outlook as a reason for keeping the target interest rate for overnight loans between banks at a record low zero to 0.25 percent. Treasury Inflation Protected Securities, or TIPS, a gauge of trader expectations for consumer prices, show the improving economy may change sentiment and spark further bond declines. The gap between yields on Treasuries and TIPS due in 10 years, a measure of the outlook for consumer prices, expanded to 2.43 percentage points yesterday, the widest since July 2008. It was 2.41 percentage points today.

Australian credit binge sets new debt record
Borrowers have set a new record: for the first time we owe more in household debt than the entire Australian economy earns in a year. Reserve Bank figures show mortgage, credit card and personal loan debts now stand at $1.2 trillion, up 71 per cent from just five years ago and equating to $56,000 for every man, woman and child in the country. Our spending binge, fuelled most recently by the Government's First Home Owner Grant, means personal debt now totals 100.4 per cent of Australia's annual GDP - one of the highest ratios in the developed world.

"It's the first time household debt has cracked 100 per cent of annual GDP and it's a terrible, terrible sign," said University of NSW economics professor Steve Keen. "It shows we are living beyond our means and many highly geared borrowers are now extremely vulnerable to further rate rises - they are already saturated with debt and will not be able to tolerate much of an increase to their repayments."

Mortgages account for almost 90 per cent of annual GDP, up from 17 per cent in 1990 and by five per cent in the last year alone as first-home buyers have flooded the market. The remaining 11 per cent of GDP is taken up with $45 billion on credit cards and over $90 billion on personal loans, car finance and other personal debts. Australian families now owe more than their counterparts in the recession-stricken US - previously regarded as the credit capital of the world. American household debt stands at $US44,000 per person, or just under $50,000.

Our financial headache is likely to get worse before it gets better. We are in the midst of the peak spending season when billions goes on the plastic, yet the Reserve Bank data dates back to October's debt levels only, so that means there are another two months of First Home Owner Grant-fuelled mortgage activity still to be taken into account. The extra cost is expected to add billions to the burgeoning debt tally. Research firm Fujitsu Consulting's latest monthly survey of 10,000 families shows that with today's mortgage rates averaging around 6.5 per cent, the typical household will be paying around 39 per cent of their income on debt repayments.

"Stressed" households will be paying 41 per cent and a "severely stressed" household around 43 per cent on debt repayments. Economists fear 2010 could see a slowdown in Australia's anaemic economic growth, and possibly even a contraction into a dreaded "double-dip" slowdown as interest rate hikes push borrowers to the limit and slow retail spending. Financial markets are forecasting the cash rate to rise from today's level of 3.75 per cent to around 4.4 per cent by this time next year, implying almost three 0.25 per cent hikes.

Should banks add their own hikes on top of the RBA's, the net effect could add one per cent on to the nation's interest repayments - a total of $11.8 billion in extra interest payments across the country. There are also concerns rising rates will create a belated "credit crunch" as banks pull back on lending to heavily indebted customers. When that happened in the US and the UK, house prices plummeted. "Our debt is our Achilles heel, there's no question about that," Shane Oliver, chief economist at AMP Capital, said.

Britain's debt now a 'riskier proposition' than Italy's
Investors now view Britain as a riskier lending proposition than Italy, with its cost of borrowing rising comfortably above the 4pc mark for the first time this year. The yield on 10-year gilts rose briefly above the 4.1pc level in intraday trading and spent most of the day higher than the yield on benchmark Italian bonds, as fears over Britain's fiscal credibility continued to haunt markets. The news came as analysts warned that hedge funds and other "smart money" traders had been largely responsible for leading the exodus out of UK government debt.

The Treasury's cost of borrowing has risen by more than a percentage point since March, despite the Bank of England spending £200bn on gilts through its quantitative easing (QE) programme. Experts put the increase down to worries that this and future governments will either prove incapable of reducing their deficit or will resort to inflation in order to erode it. The combined effect has been to catapult UK government bond yields above those of Italy and Spain in the past few weeks alone.

Although the yields on all government bonds have been pushed higher in part as investors divert their money into the fast-rising equity markets, the comparison between the UK and elsewhere shows that British debt has been increasingly shunned since the pre-Budget report at the start of this month, which was widely criticised for failing to unveil a more ambitious deficit reduction plan. With the credit ratings agencies having warned that unless the next Government scales down spending more radically, they are likely to remove Britain's top-tier rating, many suspect 2010 could be the most testing year for government fund-raising in a generation.

Statistics suggest hedge funds have been betting on a possible fiscal crisis, selling more gilts than any other major investor since the Bank's QE programme began, according to Simon Ward of Henderson Global Investors. He said that "other financial institutions", which is dominated by hedge funds and fast-moving dealers, sold some £35bn worth of gilts between April and September. A number of hedge funds, including Crispin Odey's Odey Asset Management, have publicly warned that Britain may be slipping towards a fiscal crisis – something which would push bond yields higher, and send their respective prices tumbling.

However, Tim Besley, a former MPC member, said that the Bank should not be deterred from bringing its QE programme to an end in the coming months by the behaviour of the gilt market. "It's hard to think that we've got to view this all in terms of the barometer of the gilt market," he said. "It's got to be based on a much broader judgement than that." He added: "To say that we will still need some form of fiscal tightening in the future is without doubt correct. I view this very much as the beginning of a process that the first budget after the election, I hope by whichever party implements it, will be very much more serious about dealing with the long run issues."

Spanish Banks Start to Unload Property Portfolios
Spanish savings banks have begun selling off the large property portfolios they acquired as collateral from loan defaults, in an effort to improve solvency ratios, a move that risks further falls in property values that could impair the value of their asset books. In Spain, the global financial crisis that erupted in 2007 ended a real-estate and construction-based asset boom, plunging the country into a recession that has yet to end, even as many other European economies have returned to growth.

As the unemployment rate has soared to more than 19%, residential-property buyers have defaulted on loans in massive numbers, as have property developers, overleveraged in a moribund market. As lenders have assumed the collateral on defaulted loans, local financial institutions—particularly unlisted savings banks—have collected properties valued at about €8.5 billion ($12.2 billion) over the past 12 months. So far the banks have held on to the vast majority of these properties, hoping an eventual economic recovery will allow the disposal of these assets at acceptable prices—a strategy they successfully adopted during a recession in the early 1990s. Accumulating properties also stopped a sharp drop in prices, avoiding the painful write-downs banks are required to book when the value of their assets falls.

Until now the strategy has worked. Spanish property prices have been unusually resilient. Average prices have dropped by a modest 9% over the past 12 months. In the last five years of the housing bubble, average prices jumped 71%, according to Housing Ministry data. But now banks are facing new demands for liquidity that will force them to sell more property. They are drawing up sales strategies, creating real-estate management divisions and offering discounts in an effort to lure buyers.

Solvency pressures on the banks come from several directions. First, the downturn has meant smaller inflows of cash held in deposits and bank accounts. Second, the Bank of Spain recently required local financial institutions to set aside more money to cushion potential losses from a drop in the value of repossessed properties. Banks must now set aside 20%--up from 10%--of the value of a property held on their books for more than one year. Finally, a big restructuring of the savings-bank sector is in the cards, for which banks need funds to clean up their loan books.

Such incentives to liquidate property portfolios have banks looking to sell. "Three of the five real-estate companies that have sold the most properties this year are controlled by financial institutions," says Manuel Romera, head of the Financial Sector Program at Spain's IE Business School. Bank disclosure on property sales is limited. Unlisted savings bank Caja Madrid, Spain's fourth-largest financial institution by assets, said it has sold 600 properties from January to September for about €100 million and estimates it has €1 billion in real-estate assets. The bank launched a Web site, set up a call center and will have desks at some branches to sell properties.

Smaller rival Caixa Catalunya said it unloaded 800 properties from a total of 3,600 properties it reported owning as of May, while Banco Santander SA, the country's largest bank by assets, said it unloaded some 1,000 properties from January to October. In April it reported owning some €4 billion in real-estate assets. However, banks "are realizing that unwinding real-estate assets is much more complicated than expected," says José Luis Suárez, financial management professor at IESE Business School. "The short-term outlook isn't positive."

In the absence of an active real-estate market, the process of price discovery could show market values of many properties are far lower than their book values. Analysts say that some banks and saving banks, particularly small ones, could suffer losses in the first half of 2010. They say banks with high levels of expenditure to income may be in trouble. "Growth and employment prospects for Spain are markedly more pessimistic and, together with falling support from immigration and foreign demand, it is difficult to argue in favor of any near-term housing market recovery, especially in the face of a massive supply overhang," HSBC said.

The research department of Spanish bank BBVA estimated in June that Spanish housing prices would fall by 10% in 2009 and by 12% in 2010. It envisioned a total 30% peak-to-trough drop. A new review in December didn't change that forecast. According to the Bank of Spain, 70% of a total of €30 billion in real-estate assets owned by financial institutions is now in the hands of savings banks, many of which are comparatively small and regionally focused. Were BBVA's estimate of the fall in house prices to prove accurate, the value of the €30 billion of real-estate assets held by banks could fall some €6.6 billion in the next two years.

To avoid these losses from becoming a bigger problem--perhaps necessitating state intervention—the Bank of Spain is encouraging banks to look for merger partners. The central bank believes that fewer, bigger banks would improve efficiency and strengthen solvency. More than a dozen of the country's 45 savings banks are now in tie-up talks.

So far, only one Spanish financial institution, savings bank Caja Castilla-La Mancha, has needed a state bailout. But two other banks—the Andalusian savings bank CajaSur and the Catalonian savings bank Caixa Catalunya—have already run into trouble after seeing default levels increase far above the industry average because of their high exposure to real-estate development. As a result, both of the banks are now discussing mergers. Caixa Catalunya is talking with Caixa Tarragona and Caixa Manresa, which, if a deal goes ahead, would create the fourth-largest savings bank in Spain. CajaSur is talking with Unicaja and Caja Jaén, which would create the sixth-biggest savings bank in Spain by asset volume.

Euro Zone Grapples With Debt Crisis
After two years of crashing banking systems and economic recession, the euro zone enters 2010 with a full-blown debt crisis. The European Commission warns that public finances in half of the 16 euro-zone nations are at high risk of becoming unsustainable. Governments will spend the next year and beyond balancing the urgent need to fix public-sector debt and deficits -- without imperiling what appears to be a feeble economic recovery.

Even the staunchest optimists in Brussels and Frankfurt see a rocky process, with rating firms poised for more downgrades and bond markets meting out daily judgment over how governments are doing. Greece and Spain saw their ratings downgraded. Ireland and Portugal have been warned they could be next. Even broader downgrades threaten if other European governments don't shape up. Fitch warns in a December report that particularly the U.K. (which isn't in the euro zone) and Spain and France (which are) risk being downgraded if they don't articulate more-credible fiscal-consolidation programs during the coming year given the pace of fiscal deterioration.

With the young currency bloc facing the first major test of its fiscal reliability, financial markets are hedging their bets. The euro ended 2009 slipping off its highs for the year and bank stocks were sliding on perceptions that their government-bond holdings could lose value. Economists worry the fiscal damage could take years to repair. The recession that has gripped the euro zone since mid-2008 collapsed tax revenues and sent welfare costs soaring. Billions of euros dedicated to fiscal-stimulus plans and bank bailouts completed the devastation to government finances.

Investors also worry about the danger of a "double dip" European recession if governments get the timing and pace of budget consolidation wrong and choke off the recovery. That prospect comes alongside concerns of more ratings downgrades and higher default risk if governments act too slowly. Budget deficits for the region as whole in 2009 swelled to 6.4% of gross domestic product from 2% the year before. The EU forecast sees that gap widening to nearly 7% in 2010 before the worst is over.

European Central Bank President Jean-Claude Trichet says he worries that runaway government borrowing could undermine his ability to hold down inflation, and wasted no opportunity to cajole governments back into line. But ECB officials also acknowledge that countries such as Greece and Spain may need to move earlier in reducing deficits and the amount of debt flooding European bond markets.

By contrast, Germany and France will increase spending to add fresh fiscal stimulus in 2010, in France's case swelling its budget gap to more than 8% of GDP next year, according to EU projections. The concern in Berlin and Paris is that rising unemployment, a lagging indicator that continues to rise in the early stages of recovery, will do enough to limit domestic demand without the governments also turning off the taps too early.

The fiscal juggling acts within a multinational currency union frame the test that worried skeptics before the euro's launch a decade ago. They said a monetary union unsupplemented by a political union risked a fiscal free-for-all among governments, especially in a full-blown recession. The next year will be a good time to prove them wrong. The focus in early 2010 will remain on Greece and its budget deficit at 12.7% of GDP, four times the EU limit. The Greek government is trying to hammer together a political consensus in parliament for a plan to bring down public spending without triggering more social unrest seen in the country's streets at the close of 2009.

Europe has told Athens that it has to get itself into shape without outside help. Not many Europe watchers believe the euro zone would allow one of its own to go into default, discrediting the euro currency and the philosophy of a monetary commonwealth behind it. If things did get that far, euro-zone governments would be expected to rush in with a rescue plan to absorb some of Greece's debt, or issue guarantees. As if to cover all possibilities, ECB legal counsel Phoebus Athanassiou in December discussed in a working paper how and under what conditions a euro-zone country might withdraw or be expelled from the currency union.

But Brussels is still taking a hard line. The European Commission, in its latest quarterly economic report issued in December, said the strong reaction in financial markets to signs of fiscal laxness highlights the priority of getting a handle on runaway government spending. It called Greece "a source of serious concern," but urged other member states to bring public finances into sustainable parameters of borrowing and debt. The ECB is equally unforgiving. "One has to be very clear: The ECB has no mandate or intention to take into account the situation of a specific country, especially not with regard to public finances," Ewald Nowotny, the Austrian member of the ECB's Governing Council, said in a December interview with The Wall Street Journal.

That leaves it up to national leaders to take the pain to the people with varying combinations of more taxes, deeper spending cuts and scaled-back social programs. The tale of what Europe's big fiscal crackdown will look like, and how it will be received, will unfold over the next two years. The first chapter in Europe's big fiscal crackdown comes in January, when Greece is due to submit what is expected to be a radical fiscal overhaul.

Concerns grow over sovereign debt risk
Sovereign debt risk is emerging as an important concern for senior bankers, risk consultants and auditors following financial woes in Dubai and Greece. After two years of worrying about mortgage and corporate risk, attention is now shifting to managing the risk of country defaults and bankruptcies of heavily indebted regional governments and city administrations, say bankers. Bankers at some large institutions are discussing whether they need to make provisions for sovereign risks in the same way they now set aside reserves to cover losses from corporate or emerging market risks.

Auditors preparing end-of-year accounts say that the impact of sovereign debt concerns this year is minimal as only banks with exposure to Dubai World’s $22bn debt restructuring must consider provisions against potential losses. But there is growing concern about the risks related to western economies debt burdens. Moody’s has warned that sovereign debt could be sold off sharply in 2010 if central banks fail to implement successful exit strategies from the loose monetary policies adopted in the wake of the financial crisis.

John Hitchins, a partner specialising in banking and capital markets at PwC, said sovreign debt risk was a worry – but people were not yet thinking of doing “a lot of provisioning”. Some countries were “clearly struggling” so sovereign debt was on the agenda, he added. Scott Halliday, managing partner of Ernst & Young in the UK and Ireland, said the validity of sovereign bonds was on “the top of his mind” for next year. Control Risks – a risk consultancy – has seen a big increase in mandates from insurance companies and other financial institutions seeking to understand the part politics plays in sovereign default risk.

A survey of 300 debt reschedulings in 48 countries underlines that “sovereign debt bailouts are intensely political affairs,” says Michael Denison, research director.The survey shows lower risks for eurozone countries such as Greece, given the likelihood of support by other member states. But countries such as Kazakhstan, Ukraine, the Seychelles and Eritrea – “political outliers” that cannot rely on the same external support – are vulnerable to downgrades and default.

EU to Solve Financial Fiasco Alone
A growing roster of central bankers and politicians are opposed to the idea of an IMF bailout for Greece. They argue it would violate European Union law and that the bloc is big enough to solve the problem on its own. It is becoming increasingly unlikely that the European Union will allow the International Monetary Fund (IMF) to step in and provide ailing euro zone member state Greece with a bailout. A growing number of politicians and central bankers are opposed to any form of IMF intervention.

"We don't need the IMF," Axel Weber, president of Germany's central bank, the Bundesbank, said, according to a report published in Monday's issue of SPIEGEL. Weber noted that it is illegal in Europe to finance budget deficits using the kind of central bank funds which are at the IMF's disposal. With his statement, Weber joins ranks with German Chancellor Angela Merkel, who believes IMF intervention would send the wrong political signal. The EU, she believes, is strong enough to handle Greece's problems on its own.

Central bankers also feel there's another reason the IMF shouldn't intervene: Greece's case, they argue, does not involve a loss of trust in the country's currency. Instead, they say, financial markets have doubts about the credibility of the debtor, the Greek state. Meanwhile, the research service of the German parliament, the Bundestag, has also analyzed the situation. In an assessment provided to Volker Wissing, a member of parliament with the business-friendly Free Democratic Party (FDP) -- which shares power in government with Merkel's Christian Democrats -- the experts concluded that a member state cannot be kicked out of the EU if it becomes insolvent.

Nevertheless, if a euro zone member violates monetary union rules, certain rights that come with EU membership can be suspended. For example, a country could be temporarily stripped of its vote in the European Council, the EU institution comprised of the heads of government or state of the 27 member nations. For that reason, Wissing is calling for the EU, "to thoroughly examine new members in the future to ensure that they will actually be in a position, in the long term, to meet the demands of a common currency."

The Last Time That Happened Was During the Great Depression
by John Rubino

Until a few years ago, running a U.S. city was pretty easy. You added services when voters asked, you hired more workers (who were likely to vote for you come election time) to provide the services, and you promised lavish retirement benefits to cops and teachers who weren't going to retire until long after you left office. If tax revenues didn't cover day-to-day operations, no problem; Washington was sending plenty of aid to make up the difference.

No longer. The gap between what a typical city gets from sales and property taxes and what it owes its employees is a now a chasm that even trillions in federal stimulus money can't fill. So for the first time in most Americans' memory, cities actually have to live within their means. The result, according to today's Wall Street Journal, isn't pretty.

As Slump Hits Home, Cities Downsize Their Ambitions
MESA, Ariz. - The police department in this city of 470,000 has lost about 50 officers, and is hiring lower-paid civilians to do investigative work. The Little League has to pay the city $15 an hour to turn on ball-field lights. The library now closes its main location on Sundays, and city offices are open only four days a week. This holiday season, the city didn't put up festive lights along the downtown streets.

Mesa's tax receipts, depressed by the recession, will likely come back one of these days. But Mayor Scott Smith doesn't believe city services will return to prerecession levels for a long time, if ever. "We are redefining what cities are going to be," says Mr. Smith, a Republican who ran a homebuilding company before his election last year. Months after many economists declared the recession over, cities are only now beginning to feel the full brunt of it. Recessions often take longer to trickle down to local government, in part because it takes time for the sales and property-tax revenues on which municipalities depend to catch up with a depressed economy.

But the sting this time around is expected to be far more acute and long-lasting than in previous recessions. Projected deficits are especially deep in some places and tax revenues could be pinched for years as consumers turn thrifty and real-estate prices remain diminished. That means the relatively painless measures such as borrowing, deferred payments to pension plans and scattered layoffs that have been used during past episodes of fiscal strain are unlikely to be effective in some cities.

In the decade through 2008, municipal tax revenues grew at a rate of 6.5% a year, faster than the overall economy's 5.1%, unadjusted for inflation. Those revenues have started to slip. A national tally isn't yet available, but state tax collections fell 11% across 44 states in the third quarter of 2009, from the same period a year ago, according to a report by the Nelson A. Rockefeller Institute of Government at the State University of New York. In a recent survey by the National League of Cities, 88% of city budget officers said they were less able to meet their financial needs than they were a year ago.

The specter of lean budgets for years ahead has some of the nation's 89,000 local governments rethinking what services to provide and how to pay for them. From Mesa to Philadelphia, this means some combination of higher taxes and fewer services. In some places, it means more and higher fees for permits and recreation programs. Museums, pools and the like are relying more on income from fees charged to users and from nonprofit organizations, and less on taxpayers.

These cuts matter greatly to the economy at large. Local government spending accounts for 8.8% of the nation's total output, including everything from employee salaries to snowplows. The sector employs one in nine workers - 14.5 million in all, or about 8 million in education and 6.5 million elsewhere. More Americans work for cities, counties and school boards than in all of manufacturing.

More likely to be union members, government workers tend to be better paid and have greater job security than many of the taxpayers who pay their salaries. Benefits are often better, too. Virtually all full-time state and local workers have access to retirement benefits; in the private sector, about 76% of full-time employees had retirement benefits. Employment in local government peaked in August 2008 and has fallen by 117,000 since then, or less than 1%, compared with a 6.3% fall in private employment from its December 2007 peak.

In Philadelphia, where sales and corporate taxes have taken a hit, budget cuts are limited by the large fixed costs of city workers' pension and benefits plans. About one fifth of the city's $3.7 billion budget goes for health-care and pension costs for current and retired workers. The city's overall tax revenue has fallen 6% over the past two years, while pension costs have risen 6% and health-care costs 11%. Philadelphia Mayor Michael Nutter, a Democrat, is pushing union employees to pay more of their health costs and is looking to move new employees to a less generous pension plan.

The city has cut about 800 positions in the past year, mostly through attrition, and suspended some services citizens used to take for granted. It has stopped providing snow removal on some smaller, one-way streets, except in emergencies, and it suspended mechanical leaf pick-up in some spots. This fall and early winter, older, tree-lined neighborhoods like Mt. Airy and Chestnut Hill were littered with rotting leaves.

Anyone who wants to have a parade in Philadelphia now has to pick up the tab. The city's Mummers Parade, where 10,000 or so string bands and other performers don bright costumes and march up Broad Street on New Year's Day, won't receive the $336,000 in prize money that used to go to the best string band and other parade participants. The last time that happened was during the Great Depression.

Some thoughts:
  • Local governments have been able to hang on this long mainly because the federal government has borrowed trillions of dollars and handed some of it to mayors and city councils. Since federal borrowing is functionally the same as city borrowing - in the sense that U.S. citizens living in towns or cities eventually have to pay it back - this can go on only as long as someone out there is willing to lend us the money. Which is to say as long as the dollar holds up.
  • Right now the dollar is holding up pretty well, so the Feds will almost certainly step in with more aid for local governments in 2010. This will prevent wholesale cuts in public employment and pension plans, but once again at the cost of bigger problems down the road.
  • In the end we'll run out of money because our obligations exceed our income. And that means massive cuts in state and local services that First World citizens have come to see as a birthright. Pools and ball fields that used to be free will now charge users. Streets that used to be plowed after a snowstorm will be left untouched. Permits and licenses that used to cost a few dollars will now cost many. After-hours school programs will end, putting low-income kids on the street. Libraries will be closed most of the time. Fewer police will be there when needed. And let's not even think about what the DMV will be like.
  • These service cuts won't come smoothly. Public sector wages and benefits now vastly exceed those of comparable private sector workers and the public sector unions won't give up their advantages without a fight. So on the way to fewer services there will be strikes and slowdowns and tax increases. Things will get messy.
  • But the cuts will come. TINA, as Margaret Thatcher used to say: There Is No Alternative. The price of having it too easy for the past three decades will be having it a lot harder for the next three.

2009: The Year Wall Street Bounced Back and Main Street Got Shafted
by Robert Reich

In September 2008, as the worst of the financial crisis engulfed Wall Street, George W. Bush issued a warning: "This sucker could go down." Around the same time, as Congress hashed out a bailout bill, New Hampshire Sen. Judd Gregg, the leading Republican negotiator of the bill, warned that "if we do not do this, the trauma, the chaos and the disruption to everyday Americans' lives will be overwhelming, and that's a price we can't afford to risk paying."

In less than a year, Wall Street was back. The five largest remaining banks are today larger, their executives and traders richer, their strategies of placing large bets with other people's money no less bold than before the meltdown. The possibility of new regulations emanating from Congress has barely inhibited the Street's exuberance.

But if Wall Street is back on top, the everyday lives of large numbers of Americans continue to be subject to overwhelming trauma, chaos and disruption.

It is commonplace among policymakers to fervently and sincerely believe that Wall Street's financial health is not only a precondition for a prosperous real economy but that when the former thrives, the latter will necessarily follow. Few fictions of modern economic life are more assiduously defended than the central importance of the Street to the well-being of the rest of us, as has been proved in 2009.

Inhabitants of the real economy are dependent on the financial economy to borrow money. But their overwhelming reliance on Wall Street is a relatively recent phenomenon. Back when middle-class Americans earned enough to be able to save more of their incomes, they borrowed from one another, largely through local and regional banks. Small businesses also did.

It's easy to understand economic policymakers being seduced by the great flows of wealth created among Wall Streeters, from whom they invariably seek advice. One of the basic assumptions of capitalism is that anyone paid huge sums of money must be very smart.

But if 2009 has proved anything, it's that the bailout of Wall Street didn't trickle down to Main Street. Mortgage delinquencies continue to rise. Small businesses can't get credit. And people everywhere, it seems, are worried about losing their jobs. Wall Street is the only place where money is flowing and pay is escalating. Top executives and traders on the Street will soon be splitting about $25 billion in bonuses (despite Goldman Sachs' decision, made with an eye toward public relations, to defer bonuses for its 30 top players).

The real locus of the problem was never the financial economy to begin with, and the bailout of Wall Street was a sideshow. The real problem was on Main Street, in the real economy. Before the crash, much of America had fallen deeply into unsustainable debt because it had no other way to maintain its standard of living. That's because for so many years almost all the gains of economic growth had been going to a relatively small number of people at the top.

President Obama and his economic team have been telling Americans we'll have to save more in future years, spend less and borrow less from the rest of the world, especially from China. This is necessary and inevitable, they say, in order to "rebalance" global financial flows. China has saved too much and consumed too little, while we have done the reverse.

In truth, most Americans did not spend too much in recent years, relative to the increasing size of the overall American economy. They spent too much only in relation to their declining portion of its gains. Had their portion kept up -- had the people at the top of corporate America, Wall Street banks and hedge funds not taken a disproportionate share -- most Americans would not have felt the necessity to borrow so much.

The year 2009 will be remembered as the year when Main Street got hit hard. Don't expect 2010 to be much better -- that is, if you live in the real economy. The administration is telling Americans that jobs will return next year, and we'll be in a recovery. I hope they're right. But I doubt it. Too many Americans have lost their jobs, incomes, homes and savings. That means most of us won't have the purchasing power to buy nearly all the goods and services the economy is capable of producing. And without enough demand, the economy can't get out of the doldrums.

As long as income and wealth keep concentrating at the top, and the great divide between America's have-mores and have-lesses continues to widen, the Great Recession won't end -- at least not in the real economy.

Black economies shore up states, says study
Unofficial, or “shadow”, economies can help shield European countries during a recession – but illicit activity has to be on a sizeable scale, according to report by Germany’s Deutsche Bank. Countries with a high prevalence of moonlighting builders, unrecorded cash transactions, missing invoices, tax evasion or illegal activities such as drug dealing, have seen smaller contractions during Europe’s worst downturn since the 1930s than more honest neighbours, researchers at the Frankfurt-based bank have concluded.

The relationship works, however, only if the “shadow economy” is large – such as in Greece, where George Papandreou, prime minister, acknowledged this month that the public services are riddled with corruption. In spite of its growing fiscal problems, Greece’s economy has shrunk only about 1 per cent this year – compared with about 4 per cent for the European Union as a whole. At the other extreme, Deutsche Bank found that countries with a “particularly honest” population – such as Austria, France or the Netherlands had also fared relatively well during the crisis.

Indicating that its research was not to be taken entirely seriously, Deutsche Bank said the countries faring worst included Germany where inhabitants “are neither impeccably honest in their work ethic, like the Austrians, nor do they expend so much effort in circumventing the state as, for instance, the Greeks”.

The “most unfavourable level of shadow market activity”, according to Deutsche Bank’s calculations, was exactly 14.3318 per cent of official gross domestic product. At 14.6 per cent, Germany “is on the brink of the worst-case scenario”, it concluded. As a result Germany faced two options: either to follow the example of “successful countries” such as Greece and “not just employ a moonlighting painter to do the living room but to build the entire house”; or to choose the path of virtue.

Sebastian Kubsch, the report’s author, admitted he “couldn’t find a straight answer” to explain why a large, or tiny, black economy had helped shore up economies in the past year. One explanation could be that a well-functioning unofficial sector provided a viable alternative, for instance, for the officially unemployed but pervasive honesty also creates better outcomes.

Support for the idea that a large informal sector can help in a downturn came from Professor Friedrich Schneider of Linz University, Austria, an expert on “hidden” or “black” economies. “People earn extra money, and nobody works in the shadow economy in order to pay into a savings account – so the money is spent on consumer goods, boosting demand,” he said. Greece’s large black economy was “welfare increasing,” Professor Schneider added. “The only loser is the state”.

But economic prospects could also be boosted by encouraging honesty. “If people feel fairly treated by the state, and that they get a good bundle of goods and services for their taxes, then they are more likely to pay taxes – which increases revenues,” Professor Schneider said. Deutsche Bank was clear in its policy recommendations for Germany, however. Perhaps wisely, it argued that the country should opt for honesty. The financial market crisis – and, it might have added, perhaps also Greece’s woes – had shown that “morals and decency are the key to sustainable business activity”.

China redirects trillions of gallons of water to arid north
Surveying the rubble of their recently demolished village, the huddle of Chinese peasant-farmers is in an openly mutinous mood, their list of gripes and grumbles against the local government spilling out one after the other. "The land they gave us isn't fit for beggars," spits one old man squatting on his homespun wooden stool, "And the new houses have leaking roofs," adds another, "And there's no security," complains a third, "last week someone stole my chickens."

The men from what remains of Machuan village in Henan, central China are seated at the "ground zero" of China's latest feat of mega-engineering, a project so vast that it dwarfs the Three Gorges Dam in cost, scale and perhaps even controversy. Scheduled to be finished in 2050, the plan to link China's four main rivers and redirect trillions of gallons of water from China's tropical southern mountains to its arid northern plains will have taken 100 years from conception to completion.

The theory is simple enough – as Chairman Mao Tse-tung observed in 1952: "The south has plenty of water and the north lacks it, so if possible why not borrow some?" – but the reality is a truly daunting tangle of technical and logistical challenges. The villagers of Machuan, whose houses were bulldozed in August this year, were just the first of more than 330,000 Chinese peasants who will have to be delivered to new homes before the South-North Water Project is complete. At £37bn the project will cost more than twice as much as the Three Gorges Dam, delivering nearly 12 trillion gallons of water along three networks of tunnels and canals that will branch out into northern, eastern and central China.

Machuan village, and hundreds more like it, have been identified as the necessary sacrifice to create the Central section which, when completed 2014, will carry water 883 miles to the residents of several major northern cities, including Beijing. Their rough-built houses will be submerged under an enormous reservoir created by an enlarged dam at the confluence of the Han and Dan rivers in central China, which will create the header-tank for the system.

On this autumnal morning, when the quiet of the dawn is broken only by the crowing of roosters and the snuffle of well-fed pigs, it is easy to see why the peasants are reluctant to move. The land where they have lived for generations is fertile and, to judge by the piles of yellow corncobs in the courtyard homes, their harvests are plentiful. But despite their complaints, most of the peasants accept that they will have to move in the end, although the road-signs erected by the local propaganda department proclaiming they give their "full support" for the project might be an overstatement.

"We really have no choice, it is for the nation's wellbeing," says 71-year-old Li Fengi who as a young man worked the bellows of his village iron-smelter during Mao's Great Leap Forward, "When the country asks you to make a contribution, then you must do what is asked of you." But if the peasants are going to make a sacrifice for the national good, then they also want a fair deal on land allocation and an end to the corruption which they all suspect is lining the pockets of local officials charged with overseeing the moves.

As we are speaking, a man from a neighbouring village drives up on his motorbike clutching a petition signed with the smudged fingerprints of all 227 households of Heba. They demand to know why they are being moved onto land already rejected by two other villages. "It is discrimination," the petition says, "we all refuse to move." Back at the Party headquarters, the deputy-head of the local migration office Liang Zhenpei, warns against listening too closely to the complaints of villagers.

The first moves, he says, were conducted "smoothly, harmoniously" and without trouble. "People naturally have these feelings when they move to a new place," he adds, "There have been some individual quality problems apparently, but in general there have been no complaints." Finding acceptable new homes for more than 300,000 people in a country as densely populated as China is, however, only part of the difficulties facing the designers of the project whose completion date has already been pushed back three times, from 2008 to 2010 and now to 2014.

Critics of the scheme say it is both financially costly and environmentally wasteful, with huge amounts of water lost to evaporation as it travels north in mostly open canals. Other experts have warned that plans for industrial expansion along the canal's length will mean much of the water will already be heavily polluted with chemicals and heavy metals before it even reaches the thirsty new residential suburbs of Beijing.

But perhaps the "real Achilles' heal" of the project will be its huge cost, making the water prohibitively expensive for Chinese urban consumers, according to James E Nickum of the International Water Resources Association. When the government tried to put a market price on water in the early part of the decade, public opposition saw the price stalling "well below" the projected cost of delivering water to the capital by the South-North water project, he wrote in the China Economic Quarterly.

Already Beijing and Tianjin's local governments, balking at the putative price of South-North water, is reported to have cut its projected demands from the project. Given the iron-will of the Chinese Government, there can be few doubts that at least the eastern and central phases of the South-North water project will be completed, despite all the delays and difficulties. But like the Three Gorges Dam before it, which submerged 11 cities and displaced 1.3m people but is now running at less than 50 per cent capacity because of silting and landslide problems, the question is whether it will have all been worth the cost.