"The close of a career in New York."
Ilargi: I'm not going to try and find what the CBO this time last year projected the 2009 US budget deficit to be, but I'm willing to bet a lot of bread crumbs that it was a lot less than the $1.4 trillion it turned out to be (three times the 2008 deficit). Today's CBO projection of a $1.35 trillion 2010 deficit inevitably needs to be seen in that pale shade of light.
If you can find any government projection number these days that turns out to be more positive after time, congrats: you're a rare species. With present policies in place, the known total deficit one year from now may well be sharply higher than $1.35 trillion. Even if interest rates don't rise. Which they will.
Obama will announce a "discretionary budget freeze" in the State of the Union, but that's really just for showcase purposes, and not the smartest ones either, by the looks of it. For one thing, 83% of the budget will not be affected at all by the freeze. For another, the 3-year freeze is expected to save $10-15 billion per year initially, and a total of $250 billion over 10 years. If the budget deficit averages $1 trillion for that next decade, the freeze will shave 2.5% off of the overall deficit. And to achieve that, the president will have to fight bitter battles with representatives who rely on that part of the budget to look good in their districts.
I’d say you’d need to save at least 10 times the $250 billion to have any effect (not that that would suffice), but while this can be put up for debate, I would suggest when the President gets to that part of his speech tomorrow night you might as well go get some cold ones. And then take a deep breath and let reality sink in.
Not only has Obama already committed himself to runaway deficits, he now urgently needs to come with a job creation plan that produces real results. And that will cost. A lot. Of money. That’s not there.
To get from today's U3 number of 15.3 million unemployed, a 10% rate, to a 5% rate and 7.65 million jobless by 2015, the US needs to add 1.53 million jobs each year, on top of the 150,000 per month or 1.8 million per year needed just to play even. That means needing 277,500 jobs every month for 60 months. And that's just if you use U3. Take the far more realistic U6 number, and you're looking at a demand of around 400,000 jobs every single month.
Really, do you believe it? Well, whether you do or not, you’ll hear a lot about job creation in the President's speech, and in the weeks and months that follow. Me, I’m wondering what all those people would do in their new jobs. How many burgers does one nation need flipped? And what would they be paid? Enough to pay for health care? To buy a home?
Speaking of homes. Mortgage rates are at a record low, the government buys and guarantees just about any and all loans in the market, gives $8000 premiums to buyers, and settles for a 3.5% downpayment. And in that environment, the November-December monthly drop in the number of existing homes sold was 16.7%, the biggest in over 40 years, in fact since records began. Now you ask yourself: how much more attractive can you make buying a home? And, alternatively, if and when the government withdraws and interest rates go up, what will happen to housing market prices? And if those go down, as they are bound to do, what happens with the taxpayer trillions put into Fannie and Freddie et al?
30% of Americans are hovering around the poverty line, and their numbers are growing rapidly. But poor as they may be, they still stand to lose a lot more money through their federal mortgage "possessions" when that housing market inevitably starts tanking for real. Oh, and Washington needs to bail out state and local governments. So when the poor have become the destitute, the government will start raising taxes. It will have no choice. And how do you think that will influence the pool of prospective home buyers?
I happens to me quite often these days that when I read through the numbers, I see these images of Katrina in my mind's eye, but this time the destruction's nationwide, and there's nowhere to go, even as the country's going nowhere.
And everybody keeps having the wrong conversations. It’s no longer about how to return to prosperity, it’s about how to stave off mayhem, misery, hunger, violence. But that’s not what the president will talk about. And why, then, would his people? It's much more attractive to deny it all a while longer. And be as unprepared as you can be.
More red ink: CBO projects $1.35 trillion 2010 deficit
New deficit estimates Tuesday project a $1.35 trillion shortfall for the coming year even as Congress debates creation of a bipartisan commission to propose long range steps to relieve the mounting debt facing the nation. The 2010 deficit projection is only modestly less than the $1.4 trillion wave of red ink that the government experienced in 2009, as revenues continue to lag with the slow economic recovery forecast by the Congressional Budget Office
Even in 2011, the Congressional Budget Office is projecting a nearly $1 trillion shortfall, and that picture could well be worse depending on the costs of the war in Afghanistan and what Congress decides on long term tax policy. CBO projects that unemployment will average slightly above 10 percent in the first half of 2010 and then turn downward in the second half. But the building debt carries with an added burden. Once the economy improves, CBO says, higher interest rates will come back and bite the Treasury trying to finance the accumulated deficits. “Interest payments on the debt are poised to skyrocket,” CBO says. From 2010 through 2020, it projects the annual costs will triple in nominal terms from $207 billion to $723 billion and more than double as a share of GDP.
Release of the numbers came as the Senate was poised to vote before noon Tuesday on a proposal creating an 18-member fiscal commission empowered to force House and Senate action on deficit reduction steps after the November elections. If this effort fails, the White House has pledged to step in with its own alternative created by executive order. But the landscape ahead is clearly a difficult one in terms of the fresh numbers churned out by CBO and the even rawer politics in Congress.
Both President Barack Obama and Scott Brown, the senator-elect from Massachusetts and the Republican hero of the hour, have endorsed the proposed deficit commission. But old guard Senate interests in both parties are working against passage, and the initiative could very well fail because of election-year politics intertwined with a pending debt ceiling bill. In light of the deficit picture, Democrats wants a $1.9 trillion increase in the federal debt ceiling to help carry the government past the November elections into the spring of 2011. Republicans would prefer what is jokingly referred to as a “debt ceiling installment plan” forcing multiple votes in the same period to bleed the majority politically.
Passage of the bipartisan deficit commission would be a victory then for the White House, helping Obama pull Democrats together behind the debt bill. To further show its commitment, the administration is also proposing a three-year freeze on “non-security” appropriations after the buildup in spending in recent years. Pressed by anti-tax activists and conservative editorialists, top Republican leaders are working against the commission for a mix of ideological and practical political reasons. But the issue has also split the party with fiscal moderates trying to help get to the 60 votes needed.
“For it to win the president will have to more than endorse it,” said Sen. Lamar Alexander, chairman of the Senate Republican conference, told POLITICO. “ I think he’ll have to produce a Democratic majority in favor of it, and if he does, I think there will be a significant number of Republican votes to go with it.” “The president’s the agenda setter. The debt’s the issue. And if this is his proposal he needs to produce the votes to pass it."
December home sales down nearly 17 percent
Sales of previously occupied homes took the largest monthly drop in more than 40 years last month, sinking more dramatically than expected after lawmakers gave buyers additional time to use a tax credit. The report reflects a sharp drop in demand after buyers stopped scrambling to qualify for a tax credit of up to $8,000 for first-time homeowners. It had been due to expire on Nov. 30. But Congress extended the deadline until April 30 and expanded it with a new $6,500 credit for existing homeowners who move. "It's 'exit stage left' for first-time homebuyers," wrote Guy LeBas, an analyst with Janney Montgomery Scott.
December's sales fell 16.7 percent to a seasonally adjusted annual rate of 5.45 million, from an unchanged pace of 6.54 million in November, the National Association of Realtors said Monday. Sales had been expected to fall by about 10 percent, according to economists surveyed by Thomson Reuters. The report "places a large question mark over whether the recovery can be sustained when the extended tax credit expires," wrote Paul Dales, U.S. economist with Capital Economics.
The median sales price was $178,300, up 1.5 percent from a year earlier and the first yearly gain since August 2007. However, some of that increase could be due to a drop-off in purchases from first-time buyers who tend to buy less expensive homes. Sales are now up 21 percent from the bottom a year ago, but down 25 percent from the peak more than four years ago. The big question hanging over the housing market this spring is whether a tentative recovery will stumble after the government pulls back support. The Federal Reserve's $1.25 trillion program to push down mortgage rates is scheduled to expire at the end of March -- a month before the newly extended tax credit runs out.
Last year, first-time buyers were the main driver of the housing market, but their presence is on the decline. They accounted for 43 percent of purchases in December, down from about half in November, the Realtors group said. The inventory of unsold homes on the market fell about 7 percent to 3.3 million. That's a 7.2 month supply at the current sales pace, close to a healthy level of about 6 months. Total sales for 2009 closed out the year at 5.16 million, up about 5 percent from a year earlier. That was the first annual sales gain since 2005. But prices fell dramatically last year, declining 12.4 percent to a median of $173,500, the largest decline since the Great Depression.
Though the results missed Wall Street's expectations, the Realtors' group says there are signs the market is finally stabilizing. "There is some sustainable momentum building in the housing market right now," said Lawrence Yun, the group's chief economist. However, he cautioned that the recovery will depend on whether the economy starts adding jobs in the second half of the year.
Many experts project home prices, which started to rise last summer, will fall again over the winter. That's because foreclosures make up a larger proportion of sales during the winter months, when fewer sellers choose to put their homes on the market. Despite fears that home prices are starting to fall again, some analysts still believe the worst is over. "We do not believe it is fair to consider this a double dip in the housing market," Michelle Meyer, an economist with Barclays Capital, wrote last week. "The recovery is still under way, but hitting some bumps in the road."
US Home Prices Declined in November
U.S. home prices fell in November, according to the S&P Case-Shiller home-price indexes, as yearly declines continued to abate. The indexes showed prices in 10 major metropolitan areas fell 4.5% in November from a year earlier, while the index for 20 major metropolitan areas dropped 5.3% on the year. Both indexes declined 0.2% compared with October. Adjusted for season factors, the 10-city index was flat on the month, while the 20-city composite fell 0.1%.
Separately, U.S. consumer confidence rose for the third consecutive month in January, according to a report released Tuesday. David M. Blitzer, chairman of S&P's index committee, noted how for the first time in at least two years, some markets posted home-price increases year-over year. Dallas, Denver, San Diego and San Francisco finally entered positive territory. As of November, the 10-city index is down 30% from its mid-2006 peak, and the 20-city is down 29%. Nationally, home prices are at levels similar to late 2003.
Compared with a year ago, Las Vegas continued to be hit the hardest. It, along with Charlotte, Seattle and Tampa, posted new low index levels as measured for the past four years, meaning any gains they saw in recent months have been erased. Las Vegas posted a drop of 25%. Phoenix followed with a 14% decline. The best year-on-year performer was Dallas, which posted a 1.4% increase. Phoenix also led month-to-month gainers, posting a 1.1% gain. Chicago and New York fared worst, falling 1.1% and 1% respectively. Mortgage rates declined throughout November to hit record lows near month's end.
The data are the latest documenting an unsteady recovery in the U.S. housing market. This week, the Commerce Department reported that existing-home sales plunged in December after three straight months of increases lifted by a government tax credit. The previous week, the department said new home construction fell far more than expected in December, although building permits were issued at much higher-than-expected rate. The Conference Board, a private research group, said its index of consumer confidence increased to 55.9 in January from a revised 53.6 in December, which was originally reported as 52.9. The January reading was better than economists' projection of 54.0, according to a survey conducted by Dow Jones Newswires.
The present situation index, a gauge of consumers' assessment of current economic conditions, rose almost five points to 25.0 from a revised 20.2, first reported as 18.8. Consumer expectations for economic activity over the next six months increased to 76.5 from a revised 75.9, first reported as 75.6. "Consumer confidence rose for the third consecutive month, primarily the result of an improvement in present-day conditions," said Lynn Franco, director of the Conference Board Consumer Research Center. "Consumers' short-term outlook, while moderately more positive, does not suggest any significant pickup in activity in coming months."
Sentiment about the current labor markets improved in January. The percentage who think jobs are "hard to get" fell to 47.4% from December's 48.1%. And those who think jobs are "plentiful" rose to 4.3%, from 3.1%. The employment outlook showed signs of expected stability. The percentage of consumers expecting more jobs in the months ahead fell to 15.5% from 16.4% in December, while those expecting fewer jobs fell to 18.9% from 20.6%. But those expecting the same number of jobs in the next six months rose to 65.6% from 63.0% in December.
Australia's tighter credit rules to halve home loans
Australia is facing a credit squeeze that will prevents tens of thousands of borrowers from buying a property because they do not have big enough deposits.Last week Westpac cut its loan-to-value ratio (LVR) for new customers to just 87 per cent of the property's value - a new low for a big bank. Although it may appear relatively small, such a cut has a disproportionate effect on how much people can borrow and can halve the value of the property they can afford to buy.
"If you have a $50,000 deposit and you can get a 95 per cent loan, you are able to bid on a property worth $1 million," said Steve Keen, associate professor of economics at the University of Western Sydney. "But if the LVR is cut to 90 per cent, your $50,000 deposit is only equivalent to 10 per cent deposit on a $500,000 property, so the amount you can spend is halved."
Westpac's reduction from a maximum LVR of 92 per cent means that buyers with a $50,000 deposit will see the maximum that they can afford to pay for a property slashed from $625,000 to $384,615. Somebody with a $20,000 deposit would see the amount that they could spend reduced from $250,000 to $153,846, says Professor Keen.
Experts are worried that, if other banks follow suit, credit to the property market will be choked off and property prices could collapse. According to research by broker Mortgage Choice, fewer than half of all new home buyers have a deposit of more than 10 per cent of the property's value. "Westpac's move could affect many thousands of buyers and they will be forced to go to new lenders," a spokesman said. "It's a very worrying development because if others follow suit, we could see the majority of first-home buyers priced out of the market."
Further restrictions now appear to be inevitable. Lisa Davis, managing director of GE Money - part of one of the world's biggest finance companies - said Australian banks were facing higher costs that would limit the amount they could lend. "We definitely see further tightening in the lending market," she said. "Australian lenders have a significant amount of debt that they need to refinance in 2010 and funding costs are continuing to increase." As a result of these cost pressures, GE pulled out of the home loan and car finance market almost 18 months ago.
"As a US company, we got hit early - but we are a leading indicator," she said. "And banks can't go on lending forever." Lenders have gradually been cutting back the size of loans that they are prepared to offer home buyers. Just over a year ago, 100 per cent - or even 105 per cent - loans were relatively common. But over the past 12 months, the LVR has fallen steadily to 95 per cent, then to 90 per cent, and now to 87 for new borrowers approaching Westpac. It was this same tightening of credit that led to the collapse of property prices in the UK in 2008, even though the country was still suffering from a massive shortgage of homes at the time.
30% Of Americans Rapidly Approach Poverty, Or Are Already There
A shocking report from Brookings exposes just how massive America's poverty problem is. While substantial reductions in poverty were made during the 1990's, America's poor have been rocked by the dual economic downturns since 2000.
The result is that poverty grew at twice the rate of U.S. population growth from 2000 - 2008, and now encompasses 39.1 million Americans.
If one were to expand the definition of poverty to merely 'poor' (yet still very poor), then a eye-popping 30% of the nation lives no higher than twice the poverty base line.
Brookings: In 2008, 91.6 million people—more than 30 percent of the nation’s population—fell below 200 percent of the federal poverty level. More individuals lived in families with incomes between 100 and 200 percent of poverty line (52.5 million) than below the poverty line (39.1 million) in 2008. Between 2000 and 2008, large suburbs saw the fastest growing low-income populations across community types and the greatest uptick in the share of the population living under 200 percent of poverty.
Here's where it gets even more ridiculous -- If you break down the data to individual areas, then there's at least ten U.S. cities with poverty rates of around 30%. Moreover, Brookings latest research highlights how poverty has been getting worse especially fast in the suburbs, thus the U.S. is faced with the challenges of suburban poverty like never before:
California and Florida have been hit especially hard:
Finally, this bad news has likely become far worse already. This research doesn't include 2009 since full data hasn't come out yet. When it does, expect a huge up-tick in poverty rates given since that's when the real brunt of the recent crisis hit 'Main St.'.
Unfortunately, our regression analyses suggest that these metro areas are not likely to see such decreases in 2009, a year in which no metro area proved exempt from increased unemployment rates. Although the Census will not officially release poverty rates for 2009 until fall of next year, job losses alone foretell a substantially larger increase in the metropolitan poverty rate than the 0.3 percent reported from 2007 to 2008, when unemployment increases were just beginning to accelerate.
Read the full report here >
Obama wants to freeze discretionary spending for 3 years
President Obama will announce in Wednesday's State of the Union address that he's proposing to save $250 billion by freezing all nonsecurity federal discretionary spending for three years, according to two senior administration officials. The proposed freeze, which could help position Obama in the political center by sharpening his credentials on fiscal discipline, would exempt the budgets of the departments of Defense, Homeland Security, and Veterans Affairs, along with some international programs. "We are at war, and we're going to make sure our troops are funded adequately," one of the senior officials said.
The officials would not reveal the details of which domestic programs would be cut, as they prepare to face major pushback from liberals in the president's own party because popular education and health spending could be on the chopping block. The details will be officially unveiled February 1, when the president publicly releases his next budget blueprint for fiscal year 2011 -- which starts October 1 -- and beyond. "We've got to make some tough decisions," the second senior official said. "Everybody is not going to get what they want."
Under the proposal, which would need to be approved by both houses of Congress, all federal discretionary spending would be frozen at its current level of $447 billion per year. Within that parameter, however, individual federal agencies would have the power to give some programs increases, while cutting money elsewhere. Besides burnishing his fiscal discipline credentials, the move could also help the president force Republicans' hand on whether they're serious about meeting Obama halfway on some of his policy proposals. Immediate Republican reaction was split, with some senior GOP aides saying the freeze is something they could support, while others said it did not go nearly far enough.
"Given Washington Democrats' unprecedented spending binge, this is like announcing you're going on a diet after winning a pie-eating contest," said Michael Steel, a spokesman for House Minority Leader John Boehner, R-Ohio. "Will the budget still double the debt over five years and triple it over 10? That's the bottom line." The senior administration officials acknowledged that discretionary spending is only about one-sixth of the entire federal budget, and that much larger savings would come from cutting entitlement programs like Medicare, but the White House believes that cuts need to start somewhere. "We're not here to tell you we've solved the deficit," said one of the senior officials, adding that the federal government has to go through the "very same process that families" across America have had to go through in their personal budgets.
The move will also spark a major debate within the president's own party, with senior Democrats already saying the cuts would be tough to swallow. A senior Senate Democratic aide said it will prompt a major fight after the Bush administration "underfunded domestic programs for so long." "Why would we want to play into the Republicans' hands like this?" the senior Senate Democratic aide asked. But it could also help Obama break ranks with an unpopular Democratic Congress. "Do I expect this to win us a lot of kudos on Capitol Hill? No," one of the senior administration officials said.
Obama Unveils Tax Initiatives to Help Middle Class
Previewing some of the main themes of this week's State of the Union address, President Barack Obama proposed Monday an expansion of the child-care-tax credit, a cap on student-loan payments and other initiatives designed to help the middle class. At a meeting of the White House's Task Force on Middle Class Families, Mr. Obama and Vice President Joe Biden announced their support for a near doubling of the child- and dependent-care tax credit for families that make less than $85,000 a year. The tax-credit rate would be boosted to 35% from 20% of qualifying expenses.
Faced with continuing double-digit unemployment and public unease over his handling of the economy, Mr. Obama is expected to zero in on economic issues during Wednesday's State of the Union and ahead of November's midterm congressional elections. The proposals he unveiled Monday will be included in the administration's fiscal 2011 budget proposal, set for release in a week. "Joe and I are going to keep on fighting for what matters to middle-class families," Mr. Obama said at the White House. "None of these steps alone will solve all the challenges facing the middle class... but hopefully some of these steps will reestablish some of the security that's slipped away in recent years."
Under its proposal, the White House says all eligible families making under $115,000 a year would see a bigger dependent-care-tax credit. Families could claim up to $3,000 in expenses for one child or $6,000 for two children. Families making less than $80,000 annually could claim a maximum credit of $2,100, up $900 from current law. Mr. Obama also proposed limiting a student's federal loan payments to 10% of his or her income above a basic living allowance, requiring all employers to give employees the option of enrolling in a direct-deposit IRA, expanding the "saver's tax credit," and adding $52.5 million to a program that helps families care for aging relatives.
It's unclear how much the series of initiatives would add to the federal deficit, which is expected to top $1.5 trillion this fiscal year. Mr. Obama, who has endorsed a bipartisan congressional panel to address fiscal issues, is expected to address deficit fears in the State of the Union speech. Under the administration's student-loan proposals, remaining debt would be forgiven after 10 years of payments for those in public service work and 20 years for others. The White House said the monthly payment for a single borrower earning $30,000 who owes $20,000 in loans would be $115 a month, compared to $228 a month under the standard 10-year repayment plan.
The proposed changes to the saver's credit would provide a government match of 50% of the first $1,000 of contributions by families earning up to $65,000 and provide a partial credit to families earning up to $85,000. The tax credit would be refundable under the administration's plan. The automatic IRA enrollment and saver's credit, were included in last year's budget proposals, though the new version of the saver's credit is more generous. Republican opposition to the plans is likely to center on the impact of the automatic-enrollment proposal on small businesses, and the overall cost of the measures. House GOP Leader John Boehner complained that none of the initiatives would boost jobs.
"The American people don't need more photo-ops; they need new policies that create jobs. Republicans have been offering common-sense solutions to help create jobs for struggling families and small businesses," Mr. Boehner said in a statement. Treasury Secretary Timothy Geithner, appearing at the White House with Messrs. Obama and Biden, said the proposals are needed to help people rebuild their savings after the debt-fueled financial crisis. "This crisis did a huge amount of damage to people's confidence in their job security," Mr. Geithner said. "Right now, the middle class is nowhere near as strong as it needs to be," Mr. Biden said.
How to spend $1.5 trillion without Congressional approval
by John Hussman
Step 1: Federal Reserve purchases $1.5 trillion in Fannie Mae and Freddie Mac securities, creating $1.5 trillion of monetary base to pay for these purchases.
Step 2: U.S. Treasury quietly announces unlimited support for Fannie Mae and Freddie Mac on December 24, 2009, exploiting a loophole in a 2008 law that was originally written to insure a maximum of $300 billion in total mortgage principal (not losses, but principal).
Step 3: Over the next several quarters, the U.S. Treasury issues $1.5 trillion in new Treasury debt to the public, taking in the $1.5 trillion in base money created by the Fed in Step 1.
Step 4: U.S. Treasury hands that $1.5 trillion in proceeds from the new debt issuance to Fannie Mae and Freddie Mac.
Step 5: Fannie Mae and Freddie Mac use the proceeds to redeem the $1.5 trillion in mortgage securities held by the Fed, thus reversing the Fed's transactions in Step 1, without the need for any other "unwinding" transactions (watch). The base money created by the Fed comes back to the Fed, and the mortgage securities purchased by the Fed disappear, by burdening the American public with a new, equivalent obligation in the form of U.S. government debt.
Outcome: The Federal Reserve closes its positions in Fannie Mae and Freddie Mac securities, the quantity of outstanding Fannie Mae and Freddie Mac liabilities declines by $1.5 trillion, thus allowing their remaining assets repay the remaining liabilities without a $1.5 trillion hole of insolvency, and the outstanding quantity of U.S. Treasury debt expands by $1.5 trillion in order to protect the lenders, while ordinary Americans continue to lose their homes and jobs.
Throughout this crisis, the ultimate objective of Bernanke and Geithner has consistently been to protect the bondholders. This objective will not change unless the leadership changes.
SEC mulled national security status for AIG details
U.S. securities regulators originally treated the New York Federal Reserve's bid to keep secret many of the details of the American International Group bailout like a request to protect matters of national security, according to emails obtained by Reuters. The request to keep the details secret were made by the New York Federal Reserve -- a regulator that helped orchestrate the bailout -- and by the giant insurer itself, according to the emails.
The emails from early last year reveal that officials at the New York Fed were only comfortable with AIG submitting a critical bailout-related document to the U.S. Securities and Exchange Commission after getting assurances from the regulatory agency that "special security procedures" would be used to handle the document.
The SEC, according to an email sent by a New York Fed lawyer on January 13, 2009, agreed to limit the number of SEC employees who would review the document to just two and keep the document locked in a safe while the SEC considered AIG's confidentiality request. The SEC had also agreed that if it determined the document should not be made public, it would be stored "in a special area where national security related files are kept," the lawyer wrote.
In another email, a New York Fed official said the SEC suggested in late December 2008, that AIG file the document under seal and then apply to the regulatory agency for so-called confidential treatment, if central bankers wanted to stop the information from becoming public.
The emails were included in the mountain of documents the New York Fed turned over last week to the House Committee on Oversight and Government Reform, which will hold a hearing Wednesday into the AIG bailout and the New York Fed's role in trying keep the specific terms of that Fed-engineered rescue in November 2008, from being made public. More than a year later, the Fed's bailout of AIG remains controversial because it funneled nearly $70 billion to 16 big U.S. and European banks that had bought credit default swaps from AIG. Banks like Goldman Sachs Group Inc, Societe Generale and Deutsche Bank had bought those insurance-like derivatives to guard against defaults on hundreds of securities backed by subprime mortgages.
Lawmakers on Capitol Hill have labeled the AIG bailout, in which the New York Fed created a special entity to purchase those securities from the banks at essentially their face value, a "backdoor bailout" for the 16 financial institutions. The new batch of emails, along with others that have become public in recent weeks, reveal that some at the New York Fed had gone to great lengths to keep the terms of the bailout private and the SEC may have played a role in contributing to some of the secrecy surrounding the AIG rescue package.
"The New York Fed was orchestrating what can only be characterized as an extreme effort to ensure that details of the counterparty deal stayed secret," Rep. Darrell Issa from California, the ranking Republican on the House Oversight Committee, said through a spokesman. "More and more it looks as if they would've kept the details of the deal secret indefinitely, it they could have." In March, some of the secrecy surrounding the AIG bailout began to fall away when the insurer, under pressure from Congress and the SEC, agreed to publicly name the 16 banks that got money in the rescue package and how much each received.
But AIG, largely at the prodding of the New York Fed, refused to make public all of the information in the controversial document, officially called "Schedule A -- List of Derivative Transactions," according to the emails turned over by the central bank to Capitol Hill. AIG continued to seek confidential treatment from the SEC for the redacted portions of the five-page filing.
Last May, the SEC did grant AIG's request for confidential treatment for the remaining redacted portions of the Schedule A filing. The redacted parts include the CUSIP, or trading ID, number for each security on which AIG wrote a CDS contract, as well as the face value of each individual security that AIG had insured against default. The SEC agreed to let AIG keep that information confidential until November 2018 -- or the 10th anniversary of the bailout. Critics contend that without the redacted information, it is difficult to determine which of the 16 banks had held the worst-performing securities, and which banks originated the worst of the troubled securities.
The New York Fed has argued the information needs to remain confidential to enable BlackRock Inc, which manages the portfolio of securities bought from the banks, to compete with hedge funds on an even playing field. U.S. Treasury Secretary Timothy Geithner, who has drawn fire for his role in the bailout, was set to testify before the House Oversight Committee on Wednesday. Geithner, who led the New York Fed at the time of the AIG bailout, has said he was not privy to the discussions about what information AIG should or should not release to the public and the SEC.
New York Fed spokeswoman Deborah Kilroe said on Friday that the more than 250,000 pages of documents provided by the central bank to Congress "demonstrate that the FBNY's actions assisted AIG in ensuring the accuracy of its disclosures and protected important U.S. taxpayer interests." For its part, SEC has said it pushed AIG to make public the list of banks getting bailout money and only signed off on the request for confidential treatment after the insurer released that information. SEC spokesman John Nestor said: "The SEC required AIG to make public all of the information in Schedule A that was material to an investor in AIG."
But this latest round of emails reveals that it was an official with the SEC in December 2008 who recommended that AIG and the New York Fed could seek confidential treatment for the Schedule A document as an alternative to making the entire document public. In November, a New York Fed lawyer, in another email, had said he thought it was "highly unlikely" the SEC would grant confidential treatment for the document.
AIG and the New York Fed took the SEC's advice and filed a heavily redacted version of the Schedule A on January 14, 2009, and at the same time requested confidential treatment for the redacted portions. The emails also discuss that BusinessWeek magazine had submitted a Freedom of Information Act request for the document and the confidential treatment request was a way of dealing with that and other possible requests by the media for the document.
Neil Barofsky Opens Probe into AIG's Payout to Partners
A U.S. government investigator is opening a probe into disclosures made as part of the government's rescue of American International Group Inc. when the company's trading partners were paid billions in November 2008. Neil Barofsky, the special inspector general for the $700 billion Troubled Asset Relief Program, plans to tell a U.S. House panel Wednesday that he is investigating whether there was any "misconduct relating to the disclosure or lack thereof" surrounding the deals, in which banks who had traded with the giant insurer got paid in full on $62 billion in bets on soured mortgage securities.
Mr. Barofsky said he is also reviewing the Federal Reserve's cooperation with his office. Issues raised in recent weeks "call into question whether the government has been and is being as transparent as possible with the American people," he said in prepared remarks for a Wednesday hearing before the House Committee on Oversight and Government Reform. The probe is likely to ratchet up the heat on the Federal Reserve, which lately has been under some of the most intense scrutiny from Congress it has ever faced. Chairman Ben Bernanke is the focus of a heated debate in the U.S. Senate over whether he should be confirmed to serve a second term as head of the central bank.
The Fed's New York office has been a main overseer of the U.S. bailout of AIG. Wednesday's hearing will include testimony from Treasury Secretary Timothy Geithner and the top lawyer from the Federal Reserve Bank of New York, which Mr. Geithner headed when AIG was first rescued. Panel Republicans, in a memo prepared for the hearing and distributed Monday, said Mr. Geithner "needs to explain his role" in the November 2008 negotiations between the government and AIG to help stabilize the insurer by paying off its counterparties at 100 cents on the dollar.
A Federal Reserve spokeswoman said Mr. Bernanke last week invited a top-to-bottom review of AIG-related matters by a congressional watchdog group, offering to make all resources available. The New York Fed on Monday night said that it "has fully cooperated with the Special Inspector General for TARP and will continue to do so." Among the issues that have emerged in recent weeks and months are why the Fed resisted releasing the names of AIG's trading partners and why it was reluctant to acknowledge that they received 100 cents on the dollar when they agreed to tear up their contracts with AIG.
The Republican memo cites a New York Fed employee's email from March of last year acknowledging the names of AIG's trading partners would likely come out. "There were too many people involved in the deals—too many counterparties, too many lawyers and advisors, too many people from AIG—to keep a determined Congress from the information," James Bergin emailed. The Treasury Department has said Mr. Geithner wasn't involved in the discussions over whether AIG should publicly disclose the names of its trading partners, which included Goldman Sachs Group Inc. among others. Thomas Baxter, general counsel for the New York Fed, told congressional investigators that the discussions didn't reach the level of Mr. Geithner.
New documents reviewed by The Wall Street Journal further suggest that New York Fed officials were reluctant to disclose in writing that AIG's counterparties were being paid off at 100%. In November 2008, a Fed official urged deleting a reference to the 100% payouts from a request for proposals being sent to service providers. The RFP was for the so-called Maiden Lane III structure, formed to facilitate the New York Fed's financial assistance to AIG. A draft of the RFP said that "As consideration for the transactions, the counterparties will be paid aggregate consideration equal to the total notional exposure ..." But an email from a New York Fed official, Alejandro LaTorre, says: "Let's eliminate the second sentence that starts with 'As consideration....' As a matter of course, we do not want to disclose that the concession is at par unless absolutely necessary. In this case, not sure it is necessary because this has nothing really to do with the ML III structure."
The sentence was subsequently deleted from the draft RFP, according to documents. Rep. Darrell Issa of California, the committee's top Republican, criticized the deletion as "secretive." A Fed spokeswoman pointed to an earlier comment in which the Fed denied that it encouraged AIG to withhold information, and said that the 100% payouts to AIG's counterparties were "widely understood at the time." The RFP was intended for a limited number of potential service providers, and the amounts paid to counterparties were not relevant for those bidding to provide services, according to the New York Fed.
The Volcker Rule & AIG: Hedge Funds and Prop Desks Are Not the Problem
by Chris Whalen
There are certain basic things that the investor must realize today. In the first place, he must recognize the weakness of his individual position [T]he growth of investors from the comparative few of a generation ago to the millions of the present day has made it a practical impossibility for the individual investor to know what is occurring in the affairs of the corporation in which he has an interest. He has been forced to relegate his rights to a controlling class whose interests are often not identical to his own. Even the bondholder who has superior rights finds in many cases that these rights have been taken away from him by some clause buried in a complicated indenture The second fact that the investor must face is that the banker whom tradition has considered the guardian of the investors' interests is first and foremost a dealer in securities; and no matter how prominent the name, the investor must not forget that the banker, like every other merchant, is primarily interested in his own greatest profit.
False Security: The Betrayal of the American Investor
Bernard J. Reis and John T. Flynn, Equinox Cooperative Press, NY (1937).
Watching the President announcing the proposal championed by former Fed Chairman Paul Volcker to forbid commercial banks from engaging in proprietary trading or growing market share beyond a certain size, we are reminded of the reaction by Washington a decade ago in response to the Enron and WorldCom accounting scandals, namely the Sarbanes-Oxley law. The final solution had nothing to do with the actual problem and everything to do with the strange political relationship between the national Congress, the central bank and the Wall Street dealer community. We call it the "Alliance of Convenience."
The basic problems illustrated by the Enron/WorldCom scandals were old fashioned financial fraud and the equally old use of off-balance sheet vehicles to commit same. By responding with more stringent corporate governance requirements, the Congress was seen to be responsive -- but without harming Wall Street's basic business model, which was described beautifully by Bernard J. Reis and John T. Flynn some eighty years ago in the book False Security.
A decade since the Enron-WorldCom scandals, we still have the same basic problems, namely the use of OBS vehicles and OTC structured securities and derivatives to commit securities fraud via deceptive instruments and poor or no disclosure. Author Martin Mayer teaches us that another name for OTC markets is "bucket shop," thus the focus on prop trading today in the Volcker Rule seems entirely off target -- and deliberately so. The Volcker Rule, at least as articulated so far, does not solve the problem nor is it intended to. And what is the problem?
Not a single major securities firm or bank failed due to prop trading during the past several years. Instead, it was the securities origination and sales process, that is, the customer side of the business of originating and selling securities that was the real source of systemic risk. The Volcker Rule conveniently ignores the securities sales and underwriting side of the business and instead talks about hedge funds and proprietary trading desks operated inside large dealer banks. But this is no surprise. Note that former SEC chairman Bill Donaldson was standing next to President Obama on the dais last week when the President unveiled his reform, along with Paul Volcker and Treasury Secretary Tim Geithner.
Donaldson is the latest, greatest guardian of Wall Street and was at the White House to reassure the major Sell Side firms that the Obama reforms would do no harm. But frankly Chairman Volcker poses little more threat to Wall Street's largest banks than does Donaldson. After all, Chairman Volcker made his reputation as an inflation fighter and not in bank supervision. Chairman Volcker was never known as a hawk on bank regulatory matters and, quite the contrary, was always attentive to the needs of the largest banks.
Volcker's protg, never forget, was E. Gerald Corrigan, former President of the Federal Reserve Bank of New York and the intellectual author of the "Too Big To Fail" (TBTF) doctrine for large banks and the related economist nonsense of "systemic risk." But Corrigan, who now hangs his hat at Goldman Sachs (GS), did not originate these ideas. Corrigan was never anything more than the wizard's apprentice. As members of the Herbert Gold Society wrote in the 1993 paper "Gone Fishing: E. Gerald Corrigan and the Era of Managed Markets":"Yet a good part of his career was not public and, indeed, was deliberately concealed, along with much of the logic behind many far-reaching decisions. Whether you agreed with him or not, Corrigan was responsible for making difficult choices during a period of increasing instability in the U.S. financial system and the global economy. During the Volcker era, as the Fed Chairman received the headlines, his intimate friend and latter day fishing buddy Corrigan did "all the heavy lifting behind the scenes," one insider recalls."
The lesson to take from the Volcker-Corrigan relationship is don't look for any reform proposals out of Chairman Volcker that will truly inconvenience the large, TBTF dealer banks. The Fed, after all, has for several decades been the chief proponent of unregulated OTC markets and the notion that banks and investors could ever manage the risks from these opaque and unpredictable instruments. Again to quote from the "Gone Fishing" paper:"Corrigan is a classic interventionist who sees the seemingly random workings of a truly free market as dangerously unpredictable. The intellectual author and sponsor of such uniquely modernist financial terms such as "too big to fail," which refers to the unwritten government policy to bail out the depositors of big banks, and "systemic risk," which refers to the potential for market disruption arising from inter-bank claims when a major financial institutions fails. Corrigan's career at the Fed was devoted to thwarting the extreme variations of the marketplace in order to "manage" various financial and political crises, a role that he learned and gradually inherited from former Chairman Volcker."
As Wall Street's normally selfish behavior spun completely out of control, Volcker has become an advocate of reform, but only focused on those areas that do not threaten Wall Street's core business, namely creating toxic waste in the form of OTC derivatives such as credit default swaps and unregistered, complex assets such as collateralized debt obligations, and stuffing same down the throats of institutional investors, smaller banks and insurance companies. Securities underwriting and sales is the one area that you will most certainly not hear President Obama or Bill Donaldson or Chairman Volcker or HFS Committee Chairman Barney Frank mention. You can torment prop traders and hedge funds, but please leave the syndicate and sales desks alone. Readers of The IRA will recall a comment we published half a decade ago ('Complex Structured Assets: Feds Propose New House Rules', May 24, 2004), wherein we described how the SEC and other regulators knew that a problem existed regarding the underwriting and sale of complex structured assets, but did almost nothing. The major Sell Side firms pushed back and forced regulators to retreat from their original intention of imposing retail standards such as suitability and know your customer on institutional underwriting and sales. Before Enron, don't forget, there had been dozens of instances of OTC derivatives and structured assets causing losses to institutional investors, public pensions and corporations, but Washington's political class and the various regulators did nothing.
Ultimately, the "Interagency Statement on Sound Practices Concerning Complex Structured Finance Activities" was adopted, but as guidance only; and even then, the guidance was focused mostly on protecting the large dealers from reputational risk as and when they cause losses to one of their less than savvy clients. The proposal read in part:"The events associated with Enron Corp. demonstrate the potential for the abusive use of complex structured finance transactions, as well as the substantial legal and reputational risks that financial institutions face when they participate in complex structured finance transactions that are designed or used for improper purposes."
The need for focus on the securities underwriting and sales process is illustrated by American International Group (AIG), the latest poster child/victim for this round of rape and pillage by the large Sell Side dealer banks. Do you remember Procter & Gamble (PG)? How about Gibson Greetings? AIG, along with many, many other public and private Buy Side investors, was defrauded by the dealers who executed trades with the giant insurer. The FDIC and the Deposit Insurance Fund is another large, perhaps the largest, victim of the structured finance shell game, but Chairman Volcker and President Obama also are silent on this issue. Proprietary trading was not the problem with AIG nor the cause of the financial crisis, but instead the sales, origination and securities underwriting side of the Sell Side banking business.
The major OTC dealers, starting with Merrill Lynch, Citigroup (C), GS and Deutsche Bank (DB) were sucking AIG's blood for years, one reason why the latest "reform" proposal by Washington has nothing to do with either OTC derivatives, complex structured assets or OBS financial vehicles. And this is why, IOHO, the continuing inquiry into the AIG mess presents a terrible risk to Merrill, now owned by Bank of America (BCA), GS, C, DB and the other dealers -- especially when you recall that the AIG insurance underwriting units were lending collateral to support some of the derivatives trades and were also writing naked credit default swaps with these same dealers.
Deliberately causing a loss to a regulated insurance underwriter is a felony in New York and most other states in the US. Thus the necessity of the bailout -- but that was only the obvious reason. Indeed, the dirty little secret that nobody dares to explore in the AIG mess is that the federal bailout represents the complete failure of state-law regulation of the US insurance industry. One of the great things about the Reis and Flynn book excerpted above is the description of the assorted types of complex structured assets that Wall Street was creating in the 1920s. Many of these fraudulent securities were created and sold by insurance and mortgage title companies. That is why after the Great Depression, insurers were strictly limited to operations in a given state and were prohibited from operating on a national basis and from any involvement in securities underwriting.
The arrival of AIG into the high-beta world of Wall Street finance in the 1990s represented a completion of the historical circle and also the evolution of AIG and other US insurers far beyond the reach of state law regulation. Let us say that again. The bailout of AIG was not merely about the counterparty financial exposure of the large dealer banks, but was also about the political exposure of the insurance industry and the state insurance regulators, who literally missed the biggest act of financial fraud in US history. But you won't hear Chairman Volcker or President Obama talking about federal regulation of the insurance industry.
And AIG is hardly the only global insurer that is part of the problem in the insurance industry. In case you missed it, last week the Securities and Exchange Commission charged General Re for its involvement in separate schemes by AIG and Prudential Financial (PRU) to manipulate and falsify their reported financial results. General Re, a subsidiary of Berkshire Hathaway (BRK), is a holding company for global reinsurance and related operations.
As we wrote last year ('AIG: Before Credit Default Swaps, There Was Reinsurance', April 2, 2009), Warren Buffett's GenRe was actively involved in helping AIG to falsify its financial statements and thereby mislead investors using reinsurance, the functional equivalent of credit default swaps. Yet somehow the insurance industry has been almost untouched by official inquiries into the crisis. Notice that in settling the SEC action, General Re agreed to pay $92.2 million and dissolve a Dublin subsidiary to resolve federal charges relating to sham finite reinsurance contracts with AIG and PRU's former property/casualty division. Now why do you suppose a US insurance entity would run a finite insurance scheme through an affiliate located in Dublin? Perhaps for the same reason that AIG located a thrift subsidiary in the EU, namely to escape disclosure and regulation.If you accept that situations such as AIG and other cases where Buy Side investors (and, indirectly, the US taxpayer) were defrauded through the use of OTC derivatives and/or structured assets as the archetype "problems" that require a public policy response, then the Volcker Rule does not address the problem. The basic issue that still has not been addressed by Congress and most federal regulators (other than the FDIC with its proposed rule on bank securitizations) is how to fix the markets for OTC derivatives and structured finance vehicles that caused losses to AIG and other investors.
Neither prop trading nor the size of the largest banks are the causes of the financial crisis. Instead, opaque OTC markets, deliberately deceptive structured financial instruments and a general lack of disclosure are the real problems. Bring the closed, bilateral world of OTC markets into the sunlight of multilateral, public price discovery and require SEC registration for all securitizations, and you start down the path to a practical solution. But don't hold your breath waiting for President Obama or the Congress or former Fed chairmen to start that conversation.
Is the "Volcker Rule" More Than a Marketing Slogan?
by Simon Johnson
At the broadest level, Thursday's announcement from the White House was encouraging -- for the first time, the president endorsed potential new constraints on the scale and scope of our largest banks, and said he was ready for "a fight." After a long, tough argument, Paul Volcker appeared to have finally persuaded President Obama that the unconditional bailouts of 2008-2009 planted the seeds for another major economic crisis. But how deep does this conversion go? On the "deep" side is the signal implicit in the fact that Volcker stood behind the president while Tim Geithner was further from the podium than any Treasury Secretary in living memory. Where you stand at major White House announcements is never an accident.
Increasingly, however, there are very real indications that the conversion is either superficial (on the economic side of the White House) or entirely a marketing ploy (on the political side). Here are the five top reasons to worry.
- Secretary Geithner's spin on the Volcker Rule, Thursday night on the Lehrer NewsHour, is in direct contradiction to what the president said. At first, it seemed that Geithner was just off-message. Now it is more likely that he is (still) the message.
- The White House background briefing on Thursday morning gave listeners the strong impression that these new proposals would freeze the size of our largest banks "as is." Again, this is strongly at odds with what the president said and seemed -- at the time -- to indicate insufficient preparation and message drift. But who is really drifting now, the aides or the president?
- At the heart of the substance of the "Volcker Rule," if the idea is literally to freeze the banks at or close to their current size, this makes no sense at all. Why would anyone regard twenty years of reckless expansion, a massive global crisis, and the most generous bailout in recorded history as the recipe for creating "right" sized banks? There is absolutely no evidence, for example, that the increase in bank scale since the mid-1990s has brought anything other than huge social costs -- in terms of direct financial rescues, the fiscal stimulus needed to prevent another Great Depression, and millions of lost jobs. On reflection, perhaps the president really still doesn't get this.
- Since Thursday, the White House has gone all out for the reconfirmation of Ben Bernanke, whereas gently backing away from him -- or at least not being so enthusiastic - would have sent a clearer signal that the president is truly prepared to be tough on big banks and their supporters. Unless Bernanke unexpectedly changes his stripes, his reappointment at this time gives up a major hostage to fortune -- and to those Democrats and Republicans opposing serious financial reform.
- As the White House begins to campaign for the November midterms, how will they answer the question: What exactly did they "change" relative to what any other potential administration would have done in the face of a financial crisis? How will they counter anyone who claims, citing Rahm Emanuel, that: "The crisis is over, and we wasted it." No answer is yet in sight.
The Geithner strategy of being overly nice to the mega-banks was not good economics and has proven impossible to sell politically -- the popular hostility to his approach is just common sense prevailing over technical mumbo jumbo. But selling incoherent mush with a mixed message and cross-eyed messengers could be even worse.
The economic case against Bernanke
by Steve Keen
The US Senate should not reappoint Ben Bernanke. As Obama’s reaction to the loss of Ted Kennedy’s seat showed, real change in policy only occurs after political scalps have been taken. An economic scalp of this scale might finally shake America from the unsustainable path that reckless and feckless Federal Reserve behavior set it on over 20 years ago. Some may think this would be an unfair outcome for Bernanke. It is not. There are solid economic reasons why Bernanke should pay the ultimate political price.
Haste is necessary, since Senator Reid’s proposal to hold a cloture vote could result in a decision as early as this Wednesday, and with only 51 votes being needed for his reappointment rather than 60 as at present. This document will therefore consider only the most fundamental reason not to reappoint him, and leave additional reasons for a later update.
Misunderstanding the Great Depression
Bernanke is popularly portrayed as an expert on the Great Depression—the person whose intimate knowledge of what went wrong in the 1930s saved us from a similar fate in 2009.
In fact, his ignorance of the factors that really caused the Great Depression is a major reason why the Global Financial Crisis occurred in the first place.
The best contemporary explanation of the Great Depression was given by the US economist Irving Fisher in his 1933 paper “The Debt-Deflation Theory of Great Depressions”. Fisher had previously been a cheerleader for the Stock Market bubble of the 1930s, and he is unfortunately famous for the prediction, right in the middle of the 1929 Crash, that it was merely a blip that would soon pass:
“ Stock prices have reached what looks like a permanently high plateau. I do not feel that there will soon, if ever, be a fifty or sixty point break below present levels, such as Mr. Babson has predicted. I expect to see the stock market a good deal higher than it is today within a few months.” (Irving Fisher, New York Times, October 15 1929)
When events proved this prediction to be spectacularly wrong, Fisher to his credit tried to find an explanaton. The analysis he developed completely inverted the economic model on which he had previously relied.
His pre-Great Depression model treated finance as just like any other market, with supply and demand setting an equilibrium price. In building his models, he made two assumptions to handle the fact that, unlike the market for, say, apples, transactions in finance markets involved receiving something now (a loan) in return for payments made in the future. Fisher assumed
“ (A) The market must be cleared—and cleared with respect to every interval of time.
(B) The debts must be paid.” (Fisher 1930, The Theory of Interest, p. 495)
I don’t need to point out how absurd those assumptions are, and how wrong they proved to be when the Great Depression hit—Fisher himself was one of the many whose fortunes were wiped out by margin calls they were unable to meet.
After this experience, he realized that his equilibrium assumption blinded him to the forces that led to the Great Depression. The real action in the economy occurs in disequilibrium:
We may tentatively assume that, ordinarily and within wide limits, all, or almost all, economic variables tend, in a general way, toward a stable equilibrium… But the exact equilibrium thus sought is seldom reached and never long maintained. New disturbances are, humanly speaking, sure to occur, so that, in actual fact, any variable is almost always above or below the ideal equilibrium…
It is as absurd to assume that, for any long period of time, the variables in the economic organization, or any part of them, will “stay put,” in perfect equilibrium, as to assume that the Atlantic Ocean can ever be without a wave. (Fisher 1933, p. 339)
A disequilibrium-based analysis was therefore needed, and that is what Fisher provided. He had to identify the key variables whose disequilibrium levels led to a Depression, and here he argued that the two key factors were “over-indebtedness to start with and deflation following soon after”. He ruled out other factors—such as mere overconfidence—in a very poignant passage, given what ultimately happened to his own highly leveraged personal financial position:
I fancy that over-confidence seldom does any great harm except when, as, and if, it beguiles its victims into debt. (p. 341)
Fisher then argued that a starting position of over-indebtedness and low inflation in the 1920s led to a chain reaction that caused the Great Depression:
“(1) Debt liquidation leads to distress selling and to
(2) Contraction of deposit currency, as bank loans are paid off, and to a slowing down of velocity of circulation. This contraction of deposits and of their velocity, precipitated by distress selling, causes
(3) A fall in the level of prices, in other words, a swelling of the dollar. Assuming, as above stated, that this fall of prices is not interfered with by reflation or otherwise, there must be
(4) A still greater fall in the net worths of business, precipitating bankruptcies and
(5) A like fall in profits, which in a “capitalistic,” that is, a private-profit society, leads the concerns which are running at a loss to make
(6) A reduction in output, in trade and in employment of labor. These losses, bankruptcies, and unemployment, lead to
(7) Pessimism and loss of confidence, which in turn lead to
(8) Hoarding and slowing down still more the velocity of circulation. The above eight changes cause
(9) Complicated disturbances in the rates of interest, in particular, a fall in the nominal, or money, rates and a rise in the real, or commodity, rates of interest.” (p. 342)
Fisher confidently and sensibly concluded that “Evidently debt and deflation go far toward explaining a great mass of phenomena in a very simple logical way”.
So what did Ben Bernanke, the alleged modern expert on the Great Depression, make of Fisher’s argument? In a nutshell, he barely even considered it.
Bernanke is a leading member of the “neoclassical” school of economic thought that dominates the academic economics profession, and that school continued Fisher’s pre-Great Depression tradition of analysing the economy as if it is always in equilibrium.
With his neoclassical orientation, Bernanke completely ignored Fisher’s insistence that an equilibrium-oriented analysis was completely useless for analysing the economy. His summary of Fisher’s theory (in his Essays on the Great Depression) is a barely recognisable parody of Fisher’s clear arguments above:
Fisher envisioned a dynamic process in which falling asset and commodity prices created pressure on nominal debtors, forcing them into distress sales of assets, which in turn led to further price declines and financial difficulties. His diagnosis led him to urge President Roosevelt to subordinate exchange-rate considerations to the need for reflation, advice that (ultimately) FDR followed. (Bernanke 2000, Essays on the Great Depression, p. 24)
This “summary” begins with falling prices, not with excessive debt, and though he uses the word “dynamic”, any idea of a disequilibrium process is lost. His very next paragraph explains why. The neoclassical school ignored Fisher’s disequilibrium foundations, and instead considered debt-deflation in an equilibrium framework in which Fisher’s analysis made no sense:
Fisher’ s idea was less influential in academic circles, though, because of the counterargument that debt-deflation represented no more than a redistribution from one group (debtors) to another (creditors). Absent implausibly large differences in marginal spending propensities among the groups, it was suggested, pure redistributions should have no significant macroeconomic effects. ” (p. 24)
If the world were in equilibrium, with debtors carrying the equilibrium level of debt, all markets clearing, and all debts being repaid, this neoclassical conclusion would be true. But in the real world, when debtors have taken on excessive debt, where the market doesn’t clear as it falls and where numerous debtors default, a debt-deflation isn’t merely “a redistribution from one group (debtors) to another (creditors)”, but a huge shock to aggregate demand.
Crucially, even though Bernanke notes at the beginning of his book that “the premise of this essay is that declines in aggregate demand were the dominant factor in the onset of the Depression” (p. ix), his equilibrium perspective made it impossible for him to see the obvious cause of the decline: the change from rising debt boosting aggregate demand to falling debt reducing it.
In equilibrium, aggregate demand equals aggregate supply (GDP), and deflation simply transfers some demand from debtors to creditors (since the real rate of interest is higher when prices are falling). But in disequilibrium, aggregate demand is the sum of GDP plus the change in debt. Rising debt thus augments demand during a boom; but falling debt substracts from it during a slump
In the 1920s, private debt reached unprecedented levels, and this rising debt was a large part of the apparent prosperity of the Roaring Twenties: debt was the fuel that made the Stock Market soar. But when the Stock Market Crash hit, debt reduction took the place of debt expansion, and reduction in debt was the source of the fall in aggregate demand that caused the Great Depression.
Figure 1 shows the scale of debt during the 1920s and 1930s, versus the level of nominal GDP.
Figure 1: Debt and GDP 1920-1940
Figure 2 shows the annual change in private debt and GDP, and aggregate demand (which is the sum of the two). Note how much higher aggregate demand was than GDP during the late 1920s, and how aggregate demand fell well below GDP during the worst years of the Great Depression.
Figure 2: Change in Debt and Aggregate Demand 1920-1940
Figure 3 shows how much the change in debt contributed to aggregate demand—which I define as GDP plus the change in debt (the formula behind this graph is “The Change in Debt, divided by the Sum of GDP plus the Change in Debt”).
Figure 3: Debt contribution to Aggregate Demand 1920-1940
So during the 1920s boom, the change in debt was responsible for up to 10 percent of aggregate demand in the 1920s. But when deleveraging began, the change in debt reduced aggregate demand by up to 25 percent. That was the real cause of the Great Depression.
That is not a chart that you will find anywhere in Bernanke’s Essays on the Great Depression. The real cause of the Great Depression lay outside his view, because with his neoclassical eyes, he couldn’t even see the role that debt plays in the real world.
If this were just about the interpretation of history, then it would be no big deal. But because they ignored the obvious role of debt in causing the Great Depression, neoclassical economists have stood by while debt has risen to far higher levels than even during the Roaring Twenties.
Worse still, Bernanke and his predecessor Alan Greenspan operated as virtual cheerleaders for rising debt levels, justifying every new debt instrument that the finance sector invented, and every new target for lending that it identified, as improving the functioning of markets and democratizing access to credit.
The next three charts show what that dereliction of regulatory duty has led to. Firstly, the level of debt has once again risen to levels far above that of GDP (Figure 4).
Figure 4: Debt and GDP 1990-2010
Secondly the annual change in debt contributed far more to demand during the 1990s and early 2000s than it ever had during the Roaring Twenties. Demand was running well above GDP ever since the early 1990s (Figure 5). The annual increase in debt accounted for 20 percent or more of aggregate demand on various occasions in the last 15 years, twice as much as it had ever contributed during the Roaring Twenties.
Figure 5: Change in Debt and Aggregate Demand 1990-2010
Thirdly, now that the debt party is over, the attempt by the private sector to reduce its gearing has taken a huge slice out of aggregate demand. The reduction in aggregate demand to date hasn’t reached the levels we experienced in the Great Depression—a mere 10% reduction, versus the over 20 percent reduction during the dark days of 1931-33. But since debt today is so much larger (relative to GDP) than it was at the start of the Great Depression, the dangers are either that the fall in demand could be steeper, or that the decline could be much more drawn out than in the 1930s.
Figure 6: Debt contribution to Aggregate Demand 1990-2010
Bernanke, as the neoclassical economist most responsible for burying Fisher’s accurate explanation of why the Great Depression occurred, is therefore an eminently suitable target for the political sacrifice that America today desperately needs. His extreme actions once the crisis hit have helped reduce the immediate impact of the crisis, but without the ignorance he helped spread about the real cause of the Great Depression, there would not have been a crisis in the first place. As I will also document in an update in early February, some of his advice has made America’s recovery less effective than it could have been.
Obama came to office promising change you can believe in. If the Senate votes against Bernanke’s reappointment, that change might finally start to arrive.
This is an advance version of my monthly Debtwatch Report for February 2010. Click here for the PDF version. Please feel free to distribute this to anyone you think may be interested–especially people who may be in a position to influence the Senate’s vote.
A Blueprint for Financial Reform
by John Hussman
1) Immediately vest the FDIC (or other regulator that has a strict consumer-protection mandate) with the authority to take receivership / conservatorship of distressed bank and non-bank financial institutions, including bank holding companies, in the event of insolvency.
It is essential for the public and policymakers to understand that the "failure" of a financial institution does not generally imply losses to customers or counterparties, but only to its stock and bondholders. The FDIC efficiently handles scores of bank "failures" annually by taking receivership or conservatorship of the whole bank, typically selling its assets and non-bondholder liabilities as a single going concern (which can then be recapitalized), wiping out stockholder equity, and providing partial recovery to bondholders with any residual. This receivership process works.
Bank failure through the receivership process - even involving major banks - does not create economic harm or even loss to depositors. Witness the seamless and almost forgettable receivership of Washington Mutual two years ago, which was the largest bank "failure" in history. We should not be devoting public funds to bail out such failures, outside of the receivership process. What should, and must be avoided are disorganized Lehman-style failures requiring piecemeal liquidation of going entities. This distinction is crucial. The disruption created by Lehman's disorganized failure need not have occurred if the FDIC had been vested with authority to take the going concern into receivership and to provide partial recovery to bondholders with the proceeds of Lehman's intact transfer.
2) Require a significant portion of the capital of bank and non-bank financial institutions to be in the form of convertible debt (contingent capital).
When the assets of a company decline below the value of its liabilities, the only buffer between solvency and bankruptcy in the present system is shareholder equity. For example, if a company has $100 of assets, $95 in liabilities and $5 of shareholder equity, a decline in the value of assets of anything over 5% will make the institution insolvent, even if a large proportion of those liabilities are to the company's own bondholders. This bondholder capital can only be accessed as a buffer against customer losses if the bonds default or "fail." Requiring a significant portion of bondholder capital to be in the form of convertible debt would avoid this problem. If the company approached or became insolvent, a portion of bondholder capital would undergo a mandatory and automatic conversion to equity, providing an additional buffer against losses to customers and counterparties, without requiring public funds, and without requiring bond defaults. This approach has also been proposed by William Dudley, president of the New York Federal Reserve.
Though a like provision is included in H.R. 4173, that bill also quietly provides the Treasury and Federal Reserve up to $4 trillion in bailout authority for the banking system, with recklessly thin restrictions (e.g. maximum Congressional debate of 10 hours in the event of future emergency funding requests). This provision should be stripped or made subject to drastically stronger oversight and restrictions on what constitutes emergency funding. Revisions should emphasize safeguards to ensure full recovery, implement repurchase provisions and other built-in exit strategies to extract government provided capital, and should subordinate both equity and bondholder claims to those of the government in the event of eventual default (preferred stock investments are inappropriate in this regard).
3) Abandon the misguided and dangerous notion of "too big to fail" by making regulatory receivership / conservatorship a credible threat, and encouraging insolvent financial institutions to exercise the option of voluntary debt-equity swaps as an alternative to regulatory intervention.
In virtually all cases, the liabilities of these companies to their own bondholders are capable of fully absorbing all losses without the need for public funds. This layer of bondholder capital is sufficiently thick that neither customers nor counterparties of the institution need be affected by the "failure" of major financial institutions. By providing public funds to defend the bondholders of these financial institutions, each dollar of debt that should be written off survives as two - one being the original dollar of debt, and the second being a new dollar of public debt that must be issued to finance the bailout. Presently, the bondholders of even Bear Stearns stand to receive every penny of principal, with interest, on their debt securities, thanks to the American public. This absurdity owes itself to the inability of the FDIC or other regulator to take Bear Stearns into receivership in 2008 - an inability that stunningly continues to exist because Congress has not acted to provide this authority.
4) Approve the Volcker Rule.
The abandonment of Glass-Steagall a decade ago has proved to be a massive and failed experiment, allowing financial institutions to conduct speculative activities with cheap credit, piggy-backing on banking protections that were designed strictly for the benefit of the public. Ideally, the Volcker rule should be extended to encompass the restrictions of the original Glass-Steagall Act (which was passed in 1933 following the Great Depression). The failure to separate the banking system from leveraged, non-banking activities such as underwriting and speculation creates countless interdependencies and implicit subsidies. It also creates difficulties in protecting bank depositors from losses without also inappropriately protecting counterparties to much more speculative activities. This lack of delineation has been a clear contributor to the difficulties that the U.S. economy now faces.
5) Prohibit the use of credit default swaps except for bona-fide hedging purposes.
Credit default swaps act essentially as insurance contracts, which pay out in the event that the bonds of a financial institution go into default. Large speculative books of credit default swaps have been created, often in excess of the value of the actual debt of the underlying institutions. These swaps create a risk of contagious losses for the counterparties of these swaps if the debt of some institution goes into default, even if the party receiving payment has no position in the impaired bonds. Such large-scale speculation inappropriately amplifies the disruption caused by the failure of a financial institution. Credit default swaps are appropriate hedging devices provided that the holders have equivalent positions in the same or like financial debt. Their use as naked speculative vehicles should be prohibited.
6) Require the originator or arranger of securitized mortgage loans to retain a substantial unhedged equity exposure to every securitization deal.
This recommendation was included in a March 2008 staff report by the New York Federal Reserve (Understanding the Securitization of Subprime Mortgage Credit). Among the principal causes of the recent mortgage crisis was the incentive created by deregulated financial markets to initiate mortgage loans regardless of the creditworthiness of the borrower, and to package these loans into mortgage pools that were securitized and quickly sold to yield-hungry investors, institutions and hedge funds. These buyers were either misled by inaccurate ratings on these securitized mortgages, or presumed that they would ultimately be protected against losses by the U.S. government.
By failing to require any equity exposure on the part of the originating lender, or the arranger of the securitized mortgage pool, all incentives were removed to allocate capital to credit-worthy borrowers. The profit-maximizing action was to initiate as many mortgages, at the easiest terms, as quickly as possible. The enormous overhang of Alt-A and Option-ARM mortgages (largely interest-only loans due to convert to interest plus principal shortly) was a predictable result of this process, and a fresh spike of delinquencies on these mortgages will be an equally predictable outcome in the coming quarters.
7) Recognize that "toxic assets" remain on bank balance sheets. They have merely (and most probably temporarily) been written up, in an environment where FASB rules provide "significant discretion" in the valuation of these assets, and where "off balance sheet" assets will not be required to be brought onto balance sheets until first quarter reports are released.
In this context, the widespread payment of record 2009 bonuses by institutions that received public funds or were made whole by receiving the bailout funds of rescued entities (such as AIG) appears to be little more than unscrupulous opportunism. While it is not clear that the bank tax proposed by the Obama Administration is the most appropriate response, at minimum, bonus payments made by these institutions should be required to be in the form of restricted equity with a mandatory 5-year holding period (if the government does not demand it, the shareholders of these institutions should).
In the likely event of a second wave of credit difficulties (see below), Congress should allow “toxic asset” purchases using public funds only to the extent that the entire issuance of various securitized mortgage pools can be purchased “all or none” at a moderate percentage of face value. This would allow the underlying mortgages to be restructured - ideally writing them down to a similar percentage of face - reducing their foreclosure risk, and increasing the likelihood that public funds will be recovered.
8) Discharge and replace Ben Bernanke and Timothy Geithner.
Since the beginning of the credit crisis, both of these bureaucrats have proven themselves to be ardent defenders of bank bondholders but a danger to the interests of the public and to the clearly defined prerogatives of Congress under the U.S. Constitution. Defending the public emphatically does not require the public to defend the bondholders of mismanaged financial institutions against loss. Both Bernanke and Geithner have made repeated end-runs around Congressional spending authority in defense of these institutions.
Witness the Federal Reserve's actions during the Bear Stearns crisis. As I noted at the time, "The troubling aspect of the Fed's action was not that it lent to a non-bank entity. That ability is clearly authorized by Section 13(3) of the Federal Reserve Act. The problem is that it made its “loans” as “non-recourse” funding – meaning that it would not stand to be repaid if the collateral itself was to fail, even if Bear Stearns and J.P. Morgan survived. This feature converted the “loans” by the Fed into unauthorized “put options,” benefiting private entities at potential public expense. This is a terrible precedent, and it deserves far more scrutiny and reluctance before we accept that this was the only available option."
Likewise the Treasury's quiet Christmas Eve surprise, pledging unlimited support for Fannie Mae and Freddie Mac, circumvents the proper authority (or at least the clear intent and prerogative) of Congress. Geithner constantly speaks the language of prudence to Congress, defends his actions by erecting straw men among which the defense of bondholders is presented as the only surviving option, and has repeatedly committed the public to needless expense. To reiterate my prior remarks about the pledge to Fannie and Freddie, "Put simply, in a single, coordinated stroke, the Treasury and the Federal Reserve have encroached on spending powers that are enumerated for the Congress alone. Under the Housing and Economic Recovery Act of 2008 (HERA), the Treasury has no such open-ended authority. Indeed, the applicable portion of the Act explicitly limits the total amount of mortgage principal (not losses, but total principal) as follows:
"LIMITATION ON AGGREGATE INSURANCE AUTHORITY.—The aggregate original principal obligation of all mortgages insured under this section may not exceed $300,000,000,000."
"That's $300 billion of original principal. If there is some loophole by which the Treasury's action is legal, it's clear that it was no part of Congressional intent , and certainly not broad public support. Taxpayers are now being obligated by the Treasury and the Fed to make good on a potentially much larger volume of bad mortgage loans, made by reckless lenders, guaranteed by Fannie Mae and Freddie Mac in return for a pittance (called a “G-fee”), and packaged into securities which are now largely owned by the Federal Reserve, which has acquired them through outright purchases (not traditional repurchase agreements)."
The tape that plays in Ben Bernanke's head appears to be a rather short phrase "We let the banks fail during the Great Depression, and look what happened." And then the tape repeats. The difficulty is that this story line ignores the distinction between a disorganized unwinding (e.g. Lehman) and a straightforward receivership process (e.g. Washington Mutual). We do not need to avoid bank "failures," nor does the public need to protect large banks under the illusion that they are "too big to fail." What we need is a well-organized capital market where individuals who accept risk actually bear the cost when those risks go awry. To create any other system is to sponsor a cycle of recklessness and constant misallocation of capital.
The only thing that the Bernanke-Geithner team has done is to defend the bondholders of mismanaged financial institutions - making them whole while ordinary citizens continue to lose their jobs and homes. This defense of bank bondholders has contributed to a $3.62 trillion increase in the quantity of government liabilities (Treasury securities and monetary base) issued to the public over the past two years. This represents a 61% addition to the entire quantity of publicly held government liabilities that the United States had created from its founding through the third quarter of 2007.
There are far more thoughtful, principled candidates for leadership of the Federal Reserve and the U.S. Treasury. Martin Feldstein comes immediately to mind, though his conservative leanings toward tax policy may make it difficult for a Democratic administration to advance him as a choice. Paul Volcker, though perhaps not in the running himself, doubtless would be able to identify more principled leadership than Bernanke. Wall Street would survive his loss - though there are large problems in the pipeline whose effects might be mistakenly attributed to worries about Bernanke's replacement in any event (as I suspect was the case last week).
Finally, with due respect to Warren Buffett who, when asked about Bernanke's possible non-confirmation, answered "Let me know a day ahead of time so I can sell some stock," I suspect that a full completion of that sentence would have been "specifically, Wells Fargo." Without a doubt, Bernanke has been a great benefactor of bank stockholders and bondholders. This does not mean that his policy approach has been good for the country. The full assessment of Bernanke and Geithner's impact on the U.S. economy will most likely take years, as the probable inflationary effects of their massive fiscal and monetary experiment take hold in the second half of this decade.
Given the revolving door between Wall Street and Washington D.C., there is every prospect that Bernanke and Geithner will have an easy time obtaining employment among the firms that benefited from their tenure. It is interesting that Neel Kashkari, who headed the TARP and worked on the rescue of Fannie Mae and Freddie Mac, was just hired by PIMCO (which was among the largest holders of their subordinated debt).
Wall Street rewards continue: Pay Czar
Resetting the Moral Compass
by Gretchen Morgenson
It was great to see President Obama renew his focus on financial reform last week, even if it looked like an attempt to distract voters from his party’s stunning loss of the Senate election in Massachusetts. Even so, by promoting the ideas of Paul Volcker — the esteemed former Federal Reserve chairman — the White House is finally elevating the discourse on how best to rein in risky behavior at banks and protect beleaguered taxpayers from future bailouts of Wall Street.
Those discussions are especially important, given that Congressional efforts to overhaul the financial system have thus far done little to ensure that we will never again have to fork over hundreds of billions of dollars to rescue bankers from their own bad bets. “Too big to fail” turned out to be “too hard to tackle” for lawmakers. So the proposals from Mr. Volcker, a man whom the White House has marginalized in the strangest of ways until now, are a step in the right direction. That’s because they aim to keep highflying traders and other gamblers inside of banks from getting their hands on or putting at risk the old-fashioned savings of average depositors.
A main element to the plan would bar banks from making proprietary trades — using their own money to place directional market bets that are unrelated to serving customers. Another change would prevent institutions from investing their own money in hedge funds or private equity operations. “I think something will actually come of this proposal because, unlike health care and the environment, this is an issue that resonates on both sides of the aisle,” said Richard Sylla, economic and financial historian at the Stern School of Business at New York University. “The message you are sending is a good one — that maybe we let the bankers do too much of what they wanted to do and some of it came back to haunt us. So now we are going to lay some restrictions on them going forward.”
The proposal has its weaknesses. In the pantheon of risk-taking at banks, it is hard to argue that proprietary trading involves substantially greater peril than that inherent in commercial lending. Just ask the banks that are sitting, nervously, on huge loans backed by commercial real estate that were made during the mania. And some may wonder why the proposal’s spotlight is so trained on proprietary trading and hedge fund operations, since these were not where banks experienced their greatest losses in the crisis. The biggest money pits were a result of securities underwriting, especially in the mortgage arena. When the mortgage spree ground to a halt, firms like Lehman Brothers and Merrill Lynch were stuck with toxic securities they had underwritten but had been unable to persuade customers to buy.
Moreover, the entire financial system over the last two decades became linked in a potentially viral network of derivatives contracts that won’t go away simply because traders decamp to a different neighborhood than depositors. Still, singling out proprietary trading, hedge funds and private equity units does make sense for a couple of reasons. First, the proposal moves us closer to resolving pieces of the “moral hazard” issue, that uncomfortable state of affairs that occurs when companies don’t worry about bet-the-ranch risks because they know that someone (usually the taxpayer) is waiting in the wings to save them if they blow it (as they so often do). So reducing the number of ways in which banks can engage in morally hazardous activities is a positive move.
There is another morality problem that the Volcker plan would address: insider trading. Proprietary trading, hedge funds and private equity units are three lines of business where Wall Street firms can profit mightily on inside information and data gleaned from their customer relationships elsewhere in the company. As financial firms have become more vertically integrated in the past 10 years, adding to their stable of businesses, the potential for profiting on nonpublic information has increased exponentially. Meaningful information can emerge from a client’s securities holdings, from pending transactions the client wants to make or from a firm’s knowledge of the customer’s financial standing.
Of course, banks maintain that they have built impenetrable walls in their organizations to prevent seepage of material information. But suspicions remain about the effectiveness of these barriers, and with good reason. Even if the so-called Volcker Rule takes effect, it won’t do much to eliminate the fact that regulators and legislators will continue to see large financial institutions as too big or too interconnected to fail. Even if Goldman Sachs gave up its bank holding company status to escape new restrictions on proprietary trading, does anybody think the government wouldn’t bail it out if it gambled so poorly that it landed on the precipice?
And even if the new rules are put in place, it will be hard for regulators to differentiate between transactions that a bank makes for its clients from those made in its own account. In addition, you can be sure that armies of Wall Street lawyers are even now studying ways to circumvent such rules if they are enacted. More troubling, said Christopher Whalen, editor of the Institutional Risk Analyst, is that the Volcker Rule would do nothing to solve the most disturbing problem to have emerged in the crisis: how Wall Street created flotillas of toxic securities and sold them to investors.
“We are tilting at stereotypes of what we think is the problem,” Mr. Whalen said. “But the bottom line is, we have prostituted our standards of securities underwriting and sales of securities to investors. When the Street starts justifying stuffing customers and saying, ‘It’s O.K., caveat emptor,’ that requires a public policy response. We need to say to the Street, ‘In all the things you do, especially if it is sold to a pension fund, you have a duty of care to every party in the transaction.’”
This seems quaint indeed, given the prevailing view on Wall Street that if a sophisticated investor buys a pool of poisonous mortgage loans, the seller has no obligation to keep the “big boys” from harm. But bringing a sense of duty back into the sale of securities to customers, regardless of their sophistication, is a worthy goal. And it is one that Wall Street should welcome if it hopes to regain investor confidence anytime soon.
Fed Weighs Interest on Reserves as New Benchmark Rate
Federal Reserve policy makers are considering adopting a new benchmark interest rate to replace the one they’ve used for the last two decades. The central bank has been unable to control the federal funds rate since the September 2008 bankruptcy of Lehman Brothers Holdings Inc., when it began flooding financial markets with $1 trillion to prevent the economy from collapsing. Officials, who start a two-day meeting today, have said they may replace or supplement the fed funds rate with interest paid on excess bank reserves.
“One option you might want to consider is that our policy rate is the interest rate on excess reserves and we let the fed funds rate trade with some spread to that,” Richmond Fed President Jeffrey Lacker told reporters on Jan. 8 in Linthicum, Maryland. The central bank needs to have an effective policy rate in place when it starts to raise interest rates from record lows to keep inflation in check, said Marvin Goodfriend, a former Fed economist. Policy makers are concerned that the Fed funds rate, at which banks borrow from each other in the overnight market, may fail to meet the new target, damaging their credibility and their ability to control inflation as the economy recovers.
The choice of a benchmark is the “front line of defense against inflation, and also it’s at the heart of the central bank being able to precisely and flexibly guide interest-rate policy in the recovery,” said Goodfriend, now a professor at Carnegie Mellon University in Pittsburgh. The Federal Open Market Committee is likely to maintain its pledge to keep interest rates “exceptionally low” for an “extended period” in a statement at about 2:15 p.m. tomorrow, economists said. The Fed probably won’t raise interest rates from record lows until the November meeting, according to the median of 51 forecasts in a Bloomberg survey of economists this month.
Fed Chairman Ben S. Bernanke, in July Congressional testimony, called interest on reserves “perhaps the most important” tool for tightening credit. Banks’ excess reserves, or deposits held with the Fed above required amounts, totaled $1 trillion in the two weeks ended Jan. 13, compared with $2.2 billion at the start of 2007. The Fed created the reserves through emergency loans and a $1.7 trillion purchase program of mortgage-backed securities, federal agency and Treasury debt. By raising the deposit rate, now at 0.25 percent, officials reckon banks will keep money at the Fed and not stoke inflation by lending out too much as the economy recovers.
The new policy may be similar to what the Bank of England does now, said Philip Shaw, chief economist at Investec Securities in London. The U.K. central bank’s benchmark interest rate, now at 0.5 percent, is the rate it pays on the reserves it holds for commercial banks. It may drain excess liquidity from the system by selling back the gilts it has purchased through its so-called quantitative easing program, Shaw said. Policy makers will need to adopt a communications strategy to explain the new benchmark because “people might have had a hard time getting their mind around the idea that the official rate had become the interest on reserves rate,” said Kenneth Kuttner, a former Fed economist who has co-written research with Bernanke and now teaches at Williams College in Williamstown, Massachusetts.
Without a federal funds target, banks might have to find a new way to set the prime borrowing rate, the figure most familiar to consumers that that is now pegged at three percentage points above the fed funds target. In the past, the Fed had controlled the rate by buying or selling Treasury securities, adding or withdrawing cash from the system. That mechanism broke down when the Fed started flooding the system with cash after the bankruptcy of Lehman Brothers to prevent a financial meltdown. The deposit rate would help set a floor under the fed funds rate because the Fed would lock up funds by offering a fixed rate of interest for a defined period and prohibiting early withdrawals.
“In general, banks will not lend funds in the money market at an interest rate lower than the rate they can earn risk-free at the Federal Reserve,” Bernanke said in an October speech in Washington. The New York Fed has been testing another tool, reverse repurchase agreements, as a way of pulling cash out of the financial system. In that case, the Fed would sell securities and buy them back at an agreed-upon later date. There could be complications to using the deposit rate. Banks may be able to generate more revenue by lending at prime rate rather than by earning interest at the Fed, said William Ford, a former Atlanta Fed president at Middle Tennessee State University in Murfreesboro.
Also, the Fed’s direct control over a policy rate --instead of targeting a market rate -- could skew trading and financing toward short-term borrowing once investors know the rate won’t change between Fed meetings, said Vincent Reinhart, a former Fed monetary-affairs director. The new reliance on reserve interest could also increase the policy clout of Fed governors in Washington at the expense of the 12 regional Fed bank presidents, Reinhart said. Congress gave only the Fed governors the authority to set the deposit rate. The presidents have historically favored higher rates and voiced more concern about inflation. “The Federal Reserve Act puts a very high weight on comity,” said Reinhart, now a resident scholar at the American Enterprise Institute in Washington. Using interest on reserves for setting policy “can change the tenor of the discussions, and I don’t know how they get around it.”
Independent Group to (Also) Look at Ways to Reduce Debt
Just as President Obama and Congressional Democrats are trying to create a bipartisan commission on reducing the debt, some well-known former elected officials and veterans of past administrations are announcing their own task force on Monday, underscoring the mounting concern over the nation’s fiscal future. The timing of the group’s formation is coincidental, organizers said. Yet the outside group, including prominent Democrats and Republicans, could provide pressure and political cover for the parallel effort by the administration and Congressional leaders to consider both unpopular spending cuts and tax increases.
The blue-ribbon group of 18 to 20 members will be led by Pete V. Domenici, a Republican former senator from New Mexico who for years was the chairman of the Senate Budget Committee, and Alice Rivlin, a Democrat and former budget director for both Congress and President Bill Clinton who is also a former vice chairwoman of the Federal Reserve. Their goal is to, by December, give Congress and Mr. Obama a multiyear plan to raise tax revenues and pare spending, especially for the Medicare and Medicaid programs, which are the biggest factors driving the projections of future high deficits, Mr. Domenici and Ms. Rivlin said in a joint interview.
That puts their task force on the same timetable as the commission that the president and senior lawmakers, including a few Republicans, are considering. The Senate is to vote Tuesday on bipartisan legislation that would create an 18-member commission, consisting mostly of lawmakers and administration officials, and would bind Congress to vote on its recommendations in December, after the midterm elections. But the bill is expected to fail, despite Mr. Obama’s endorsement on Saturday, because most Republicans say it would force higher taxes and some liberal Democrats oppose the prospect of cuts for entitlement programs.
If the bill is defeated, Mr. Obama is poised to announce, perhaps in his State of the Union address on Wednesday, that he is establishing a bipartisan commission by executive order. While he could not require Congress to hold votes on any recommendations of a presidential commission, Democratic leaders have tentatively agreed that they would. House and Senate Republican leaders have indicated that they will not cooperate in any commission that considers raising taxes.
“Spending is the problem,” Senator Mitch McConnell of Kentucky, the Senate minority leader, said on the NBC program “Meet the Press” on Sunday. “I do worry that if we construct this commission in the wrong way, it will be kind of an indirect way to raise taxes.” And “raising taxes in the middle of a recession is not a good idea,” he added. But Mr. Domenici said: “We have to consider everything. We have to put taxes on the table.” Both he and Ms. Rivlin also emphasized that the task force would not be recommending spending cuts or tax increases that could undermine the economy’s recovery and job creation. Instead, they said, it will propose long-range policy changes.
Mr. Domenici said that some elected officials in his party mistakenly argue that “Republicans shouldn’t have to do this because Democrats accrued all the debt last year.” In fact, most of the current $12 trillion debt results from policies adopted in the past decade when Republicans controlled the White House and Congress. “There is nothing good for America that will come out of arguing which part of the debt each party is responsible for,” Mr. Domenici said. The outside group is sponsored by the Bipartisan Policy Center, which was formed by four former Senate majority leaders — Bob Dole and Howard Baker, Republicans, and Tom Daschle and George Mitchell, Democrats. Mr. Baker and Mr. Daschle will outline the task force on Monday. Other members will include two former governors, James J. Blanchard, Democrat of Michigan, and Frank Keating, Republican of Oklahoma.
Schwarzenegger's budget plan puts unions in the cross-hairs
Gov. Arnold Schwarzenegger has put organized labor squarely in his cross-hairs in 2010, opening a fight that will largely determine the shape of his final year in office. Schwarzenegger's proposals would cut the size of the union workforce, reduce pay, shrink future pensions and roll back job protections won through collective bargaining. Labor and the unions' Democratic allies are already girding for battle. "It's a continuing jihad against organized labor," said Steve Maviglio, a Sacramento-based Democratic strategist. "The governor thinks public employee unions are Enemy No. 1."
Among the plans in the governor's budget: privatize prisons, which would strip members from the influential guards union; curtail seniority protections for teachers, a key union-won protection; and reduce the number of sick, disabled and elderly Californians cared for through the state's In-Home Supportive Services program -- almost all union jobs -- while cutting what their caregivers are paid. Schwarzenegger also wants to permanently lower state workforce salaries by 5% without returning to the bargaining table with public-sector unions. And he would require state workers to chip 5% more into their retirement plans.
"The public sector also has to take a haircut," Schwarzenegger said, arguing his policies would save California billions of dollars, now and in the future. Matt David, Schwarzenegger's communications director, says the governor's proposed budget makes hard but necessary choices, given a $20-billion deficit. "This budget wasn't about attacking any specific group," he said. "It was about trying to fix what's broken in this state and prioritize the funding we have so we can protect education." Yet even in nonbudget proposals, union leaders see an antilabor agenda. For example, Schwarzenegger has pushed to limit seniority protections for teachers and expand charter schools, which are largely staffed by nonunion teachers. He argues both moves would improve the quality of schools.
Union leaders see their members as the targets. "That seems to be his goal, to basically change a unionized sector of the economy to a nonunion sector," said Marty Hittelman, president of the California Federation of Teachers. The unions have spent millions to thwart some of the governor's past initiatives and hope to do so again. "To go after unions means tearing down the middle class," said Laphonza Butler, head of United Long Term Care Workers, a branch of the giant Service Employees International Union that represents 180,000 in-home services workers.
Democratic lawmakers, who hold the majority in the Legislature and are the largest recipients of union campaign money, thus far have given the governor's plans a chilly reception. "I did take note that in his State of the State address [the governor] said that we had only Sophie's choices," said Sen. Mark Leno (D-San Francisco). "Do we harm seniors, do we harm the disabled, do we harm the poor? But you didn't hear him suggest there were tax loopholes we could close to pinch corporations."
State Treasurer Bill Lockyer, a Democrat, explained the legislative balance of power during impassioned legislative testimony last fall: "It's impossible for this Legislature to reform the pension system," he said. "I don't think anybody can do it here -- because of who elected you," he added, making a barely veiled reference to labor's power. Top Democratic lawmakers have suggested Schwarzenegger is driven by a corporate special interest agenda. Assembly Speaker Karen Bass (D-Los Angeles) dismissed the governor's prison privatization plan as a sop to "another special interest, and that's the private prisons industry." One company that operates private prisons, the Corrections Corp. of America, donated $100,000 to the budget ballot measure campaign championed by the governor last year.
From his earliest days as a candidate, Schwarzenegger has railed against the grip of "special interests" on Sacramento. More often than not, he has defined them as organized labor. Joel Fox, a business advocate who worked closely with the governor during his last big union battle in 2005, said that agenda "goes back to his election in the recall." "He had a mind to fix the problem and restructure the way government operates," Fox said. "The structure right now is heavily controlled by the unions." In 2005, Schwarzenegger went to the ballot with four measures that would have rolled back pensions, unions' abilities to collect dues and job protections.
The unions fought back with a $100-million campaign and defeated all four of the governor's proposals. Schwarzenegger vowed a more contrite approach en route to his reelection in 2006. But 2010 has seen a return to confrontation. In part, that's driven by the state's huge deficit. In some state programs, particularly healthcare, most of the money pays directly for services. But in most other parts of the state budget -- schools, prisons, parks -- cutting spending mostly means tackling payroll.
One notable shift from the 2005 battle is that Schwarzenegger has moderated his tone. This year he justified privatizing prisons because it would "save us billions of dollars." In 2005 he vowed to put "the corrupt people in our prisons on the same side of the bars." The strategy of softening rhetoric while still pressing severe proposals dovetails closely with the negotiating philosophy of his influential chief of staff, Susan Kennedy: Always leave interest groups with something to lose.
The California Correctional Peace Officers Assn. has responded to the governor's plans with a TV ad declaring itself part of the solution for "real reform" in the state's beleaguered prison system. The union stopped short of attacking Schwarzenegger directly. "It's politically smart not to scream bloody murder for your own pet cause when everyone is being slashed," said Maviglio, the Democratic strategist. But he predicted that Schwarzenegger's "divide and conquer" strategy -- forcing each union to defend its turf simultaneously -- could result in a reprise of labor's united, multimillion-dollar political fight of five years ago. "It wouldn't surprise me," he said, "to see the same 2005 coalition resurrected."
States’ Fiscal Agony: No End In Sight?
“This may be the most calamitous fiscal year states have known in decades,” reports Rob Gurwitt in Governing magazine, the 23-year-old bible on state and local governance across the continent. And the coming fiscal year, experts are predicting, may be almost as grim as the states run out of budget gimmicks, rainy-day funds and the infusion of federal stimulus money that helped them, finally, to balance their current budgets. The states’ cumulative 2010 and 2011 budget shortfalls may be about $350 billion — a third of a trillion dollars — estimates the Center on Budget and Policy Priorities.
Why such grim news? Sales and personal income tax receipts, which soared in the last decade because of the hot, credit-driven consumer economy, cratered with the recession. Those pre-recession revenue levels, Governing reports, “will either take an unusually long time to recover or may never do so.” Indicators of prolonged fiscal migraines run from the ravages of industrial decline in the Great Lakes states to the mortgage crises that have tripped the Sun Belt’s perpetual growth machines.
All states face increasing health care costs for their needy. And then there’s the long-term debt that states have incurred — in bonds they’ve sold, in pensions and post-retirement health benefits, in replacement or maintenance of physical infrastructure that can’t be permanently ignored. Governing columnist John E. Petersen comes up with a startling $2.4 trillion of “aggregated indebtedness” the states carry. And they’re unlike the federal government, which, with an accumulated debt of about $12 trillion, can at least print money and borrow (up to a point) at will.
Ironically, if crisis has hit the states, it’s also hit Governing magazine itself. Its former parent corporation, the St. Petersburg Times, late last year insisted on unloading it for cash. And there’s fear the magazine itself may never again be what it was in its heyday under founder Peter Harkness. The top bidder and buyer, e.Republic, does publish credible trade magazines such as Government Technology. But, as The New York Times reported, the fact that e.Republic’s top managers are members of the Church of Scientology has caused some uneasiness.
The first move by e.Republic was to slash Governing’s staff, including more than half the magazine’s top brain trust of such editor/writers as Alan Ehrenhalt, Christopher Swope, Penny Lemov, Ellen Perlman and Alan Greenblatt, plus deputy publisher Elder Witt — almost anyone earning a high salary.
I recall hoping through the ’70s and ’80s that someone would start up a quality magazine focused on states and cities. Then Governing, a class act, appeared. Now there’s just hope — and little more — that the junior writers and free-lancers the new management relies on will be able to keep up the quality. And hope, to be candid, may be all we can harbor for the states too. “The realization has started to dawn,” Gurwitt reports, “that fundamental assumptions about how state government operates need rewiring.” Or in the words of Indiana Gov. Mitch Daniels, “that we’re facing a near-permanent reduction in state tax revenues that will require us to reduce the size and scope of our state governments.”
California, with its monstrous deficits, its emblematic issuance of IOUs instead of real money, and its furloughs of state workers, has received the most national attention. But Michigan Gov. Jennifer Granholm warns that her state’s budget may need another 20 percent cut, after last year’s 10 percent gouge. Granholm suggests shrinking the state government from 18 departments to eight. Florida’s budget is down 28 percent from its peak in 2006. Illinois faces a yawning $12 billion hole in a $26 billion budget. Check New Jersey, New York, Arizona, Georgia, Oklahoma — indeed all but a few resource-rich states such as Wyoming — and you find more of the same fiscal agony.
And money is not the only problem. Fierce partisanship and prolonged legislative standoffs — reminiscent of today’s Congress — have impacted states nationwide (as Alan Greenblatt describes in another Governing article). The legal progeny of California’s infamous Proposition 13 of 1978 — requirements of supermajorities to pass tax increases, either state or local — make accords in tough times incredibly hard to forge.
“I’d like to see states think a lot more strategically — where they can and should be in 10 years,” says Scott Pattison, executive director of the National Association of State Budget Officers. But too little is happening, he acknowledges. States don’t yet have the political will to extend sales taxes to services — the growth area of their economies. America is dramatically “overincarcerated” by world standards, but legislators fear political blowback if they release even low-level offenders. The new talk is of cutting seriously into school and university budgets, where there are clearly inefficiencies — but also the danger of a society failing to seed its future.
Bottom line: State governance in America is in for an incredibly rough ride. And all of us with it.
Governor’s Budget Brings Doom to City, Says Mayor
Mayor Michael Bloomberg cut to the chase in Albany on Monday. He testified in front of the state Legislature, saying that the budget Governor David Paterson proposed last week would cut $1.3 billion in funds for New York City and cut 19,000 jobs. The governor's proposal “utterly fails the test of fairness,” said Bloomberg. “And that is why I am here this morning—to tell you that the people of New York are counting on you in the Legislature to help create a budget that is both responsible and equitable.”
One of the main points addressed in Paterson's $134 billion proposal is for the state to close a $7.4 billion budget gap. Among other cuts to education, health care, and state agencies, the proposal also raises taxes on cigarettes and sugary drinks. The budget still faces revision in state Legislature, which must give it approval. Over 10,000 public workers and over 8,500 teachers will be cut from the workforce if Paterson's budget proposal is signed into law by the Legislature, said Bloomberg. Approximately $500 million would be cut from the city's education plan under the governor's proposal.
Among the public workers, approximately 3,150 police officers will be laid off “reducing the NYPD’s operational strength to 1985 levels,” said Bloomberg. Around 1,050 firefighters would be laid off, causing the close of firehouses and 900 correctional workers in jails and prisons would be laid off “which is only possible if we simultaneously reduce our daily inmate population by almost 1,900 prisoners,” said the mayor. Other than personnel cuts, the city would cut garbage can pickups by about half and curbside garbage pickup would be reduced by about a third due to the cuts. Overall, funding for the city's various agencies other than education would be reduced by $656 million.
“Not only does the budget impose new mandates without real mandate relief. And not only does it impose unfair burdens on city agencies compared to those placed on state agencies,” said Bloomberg. “It also eliminates—let me say that again, eliminates—state revenue sharing for New York City, and New York City alone.” New York City produces approximately half of all revenues for the state, but would not get a proportionate amount of funding from the state. The state and the city depend heavily on taxes generated from Wall Street revenues, which suffered heavily during the recent financial downturn.
Bloomberg touched on free student MetroCards, which the Metropolitan Transportation Authority is planning to phase out. The governor's budget proposal would mean a significant cut to the funds that could keep the free student MetroCard system afloat. “We’re disappointed that full funding for student MetroCards has not been restored in the executive budget, as the governor promised it would,” said Bloomberg.
“For years, the city, state, and MTA had an agreement to fund student MetroCards,” the mayor said. “This year, the state has dramatically cut its share of the funding, which could force children and their families to pay thousands of dollars a year in school transportation costs.” On the topic of education, the mayor also called for legislators to lift the cap on charter schools, saying that around 36,000 school children in New York City are waiting for “firstrate education.”
On Monday, New York City's Panel for Educational Policy will vote to close around 20 schools around New York City. Bloomberg added that 500 workers will be cut from the city parks system, 500 soup kitchens will be closed, and 15 senior centers will be shut down. Bloomberg said he will further address this during his budget proposal for the city on Thursday. Questions remain on whether or not the mayor will take the governor's proposal into account when outlining his plan.
New Mexico State Legislator Introduces Bill To Move State's Money
New Mexico state representative Brian Egolf has introduced a bill to move the state's money out of Bank of America and into banks and credit unions chartered in New Mexico. "I saw the Move Your Money video the day it came out and thought it made a lot of sense," Egolf told HuffPost. So the Santa Fe Democrat wants to move as much money as he possibly can -- that would be $1.4 billion. Egolf's bill would direct the New Mexico Department of Finance and Administration to "give a preference to a community bank to act as the fiscal agent of the general fund operating cash depository account."
Egolf said the account, which is essentially the state's checking account, holds $1.4 billion and is managed by Bank of America. Egolf's bill directs state officials to study the feasibility of dividing up the account and distributing it between community banks and credit unions throughout the state. He said he discussed the measure with Gov. Bill Richardson (D) for an hour on Thursday, and that the governor supported the measure. Egolf said moving state funds into local banks or credit unions would benefit the New Mexico economy by freeing up local credit. "The potential size and impact of moving this money is monumental. The biggest bank in the state right now has $2 billion in assets."
He added that he hasn't heard any opposition to his proposal from any of his colleagues in either party in the New Mexico legislature and expects the measure to be taken up in the next three weeks. His goal is to move the money by the end of the year. "The only concern I've heard really is, 'How soon can we do it?'" he said. "I'm not getting any defense of the big banks. There's a huge appeal to keeping our money local. The income Bank of America earns from managing this money goes straight to New York."
Bank of America doesn't seem very intimidated by the bill. "We are pleased to have the State of New Mexico as a client and look forward to continuing that relationship," said a bank spokesman in an email. Egolf said he was in the process of moving his own money to the Los Alamos National Bank.
Ending My "Abusive Relationship"
by Rep. Jan Schakowsky, Congresswoman from Illinois
I am happy to report that I have taken the first very important steps in ending the abusive relationship I am in. That's right. I am breaking up - with my "too big to fail" bank. Bank of America, bye-bye. It started out innocently enough. When I first started banking as a young woman, I went to the Norshore National Bank, a friendly community bank in my neighborhood. And then it was bought by a bigger bank, and then by a bigger bank, and then by LaSalle Bank, a large but esteemed institution in the Chicago area, and finally by Bank of America. The transitions were pretty smooth, and frankly, I admit I took the easy way out and stayed put.
Hello, Devon Bank! Yesterday I went to the bank that my parents patronized for many happy years. It's in the neighborhood I grew up in, near my house, in my district. The friendly bankers were happy to see me and helped me open a new checking account. I can still bank on line, get a debit card, and use without charge a network of ATMs that are conveniently located. They gave me a map that I'll keep in my car. Not only that, they will pay me 4.15% interest on my balance up to $20,000 and they gave me a very nice pen set and a clock!
I hadn't even realized how good it would feel. Over the last year, I knew in my heart, that I had to get out. I saw, along with millions and millions of my fellow Americans, that my long gone community bank wasn't the only one being swallowed up. Our entire economy was being digested by the big, greedy, reckless behemoths that could care less about me or any of us. With only four banks holding nearly 40% of all deposits, we learned the hard way just what "too big to fail" really means. It means to save our own necks, we had to rescue the monsters, or to carry on the first metaphor, our abusers.
Now we are seeing just how incorrigible they are. Often in abusive relationships, the perpetrator cries and begs forgiveness and promises never to do it again. We didn't even get that. No sooner did they get our money, they doled it out it in huge chunks to their unrepentant co-abusers, leaving us doing the begging for forgiveness for our late mortgage payments and crying for a loan to keep our businesses afloat. What are we, chumps? Enablers? The House of Representatives and the White House got the message. We in the House passed a bill to force them to change the worst of their ways, and now the Senate needs to follow suit.
This week the President got really tough with Wall Street, demanding our bailout money back, proposing to restrict the size and scope of banks, and reviving the depression-era act (Glass-Steagall) that prevented banks from engaging in reckless speculation. Rep. Peter Welch (D-Vermont) introduced a bill to levy a 50% tax on the big bonuses, and I jumped right on it. On my journey to a healthy banking relationship, I want to thank Arianna Huffington for leading the way and Bill Maher for properly naming the ugly situation I was in. You can check them both out at the Huffington Post and at MoveYourMoney.info, where you can find a solid and solvent community bank near you. If I can do this, so can you!
Signs Of The Apocalypse: The Return Of The Layoff
Layoffs in unrelated industries, even when close together in time, are just that: unrelated. That is until they begin to grow rapidly in number.
Three of America's largest firms announced firings or signaled them during the last week. Wal-Mart cut the deepest, which is frightening because it is the most financially healthy company in the world. In a surprise announcement, the world's largest retailer said it would cut 10% of its Sam's Club division, which means nearly 12,000 workers will get axed. The news cannot be good for the staggering retail sector. Christmas was weak, but Wall St. assumed that Wal-Mart was doing as well as if not better than its smaller competitors.
The Wal-Mart move will give other retail firms "permission" to take fresh looks at their staff levels without the stigma of announcing firings ahead of other large store chains. Xerox also unexpectedly said it would cut 2,500 people. It did so at the same time as it posted good earnings. That means Xerox believes that it can still wring more productivity from the people it will continue to use. The tech sector is still on a bumpy ride while consumers and IT managers try to decide if they can afford to upgrade to new equipment. The beginning of 2010 could cause a fresh round of reviews of how much blood can be squeezed from the employment pool stone. Large firms that made layoffs last year can now look at four quarters of what those layoffs have done to them or for them financially. If cuts worked once, they might work again.
Oracle is close to closing its deal to buy Sun Micro. Sun's remarkable history of large layoffs is an example of what happens to a company when its products lose most of their relevance and R&D efforts cannot bring the firm back into alignment with customers demands. Sun will now become one of the many divisions of Oracle and that almost certainly means that many management and sales people will be gone by the end of the quarter.
The early part of 2009 was marked by an unprecedented number of large cuts as America's most well-known companies. In some weeks over 100,000 American were put out of work by "downsizings" at these firms. That process has slowed a year later, but there is a growing body of evidence that it is not going away.
The most critical difference between last year and this is that 10% of Americans, 17% by some measures, are without jobs. The economy has not started to add new jobs yet. Each person that a Wal-Mart, Xerox, or Oracle lets go now is put into jobless pool with a record low number of openings for each job seeker. That means there is no Dutch Boy at the dike to prevent the ongoing effects that unemployment has on housing, credit, and the government's ability to improve income to the IRS.
The employment mess, a tragedy beyond description, is still going on.
Repo fears over US bank levy plan
The Obama administration’s proposed bank levy is threatening the $3,800bn repurchase market, an obscure but fundamental source of funding for financial groups and the US Treasury, executives and analysts have warned. The potential impact of the $90bn, 10-year levy on the repo market could also complicate Federal Reserve efforts to drain the huge amounts of liquidity it injected into the financial system during the crisis. Banks use the repo market, where securities such as US Treasuries are used as collateral in exchange for loans, for short-term funding. But they also provide funding for investors wanting to buy the securities, earning a profit on the difference between the interest rate at which they borrow and the one at which they lend.
Wall Street executives say the proposed levy, which would charge banks a 15 basis point fee on their liabilities minus insured deposits, will prompt them to reduce repo exposure to cut short-term liabilities. They say the profit they make on repo contracts – about five basis points – would be wiped out by the levy, making repo transactions loss making. “It is a serious issue for financial markets,” Colm Kelleher, Morgan Stanley’s finance chief, said. “[The authorities] will have to look at secured funding markets unless they want to close them down.”
Jamie Dimon, chief executive of JPMorgan Chase, one of the biggest operators in repos, has voiced concerns at the effect of the proposed fee on that market. Brad Hintz, an analyst at Bernstein Research, estimated in a recent note to clients that banks could reduce their levy’s bill by about 10 per cent if they scaled back their involvement in the repo market. But other analysts say a reduction in banks’ involvement in the repo market could be consistent with the levy’s aim of reducing financial groups’ reliance on short-term funding. A reduction in repo activity could create problems for the US Treasury, which uses the market as an important conduit to sell bonds used to fund its deficit. “Most of the repo market is associated with Treasury financing and this will make the market function less efficiently,” said Dominic Konstam, head of interest rate strategy at Credit Suisse.
The Fed has also tested “reverse repos” – selling assets such as Treasuries to bankers for cash, with an agreement to buy them back later at a slightly higher price – as part of its exit strategy from the stimulus provided during the crisis. Some analysts believe the negative effect of the levy on repo might lead the authorities to exclude that market when details of the plan are finalised. The levy on bank liabilities is part of a package of proposed regulation announced over the past fortnight by the government. Last week, Barack Obama proposed new limits on banks’ size and riskier operations.
Jim Chanos: China Faces A Property Bubble
Jim Chanos continues to make the rounds, explaining his controversial (though increasingly less so) view on the Chinese bubble. A point he emphasizes: he's not betting against China, the economy, or currency. He's specifically negative on property. How's he betting on that? Betting against the companies that supply raw materials for the building boom -- iron ore, construction etc.
One eye-opening stat: There's currently 30 billion square feet of Chinese real estate in the works, which would work out to a 5x5x5 cubicle for every man, woman, and Child in the country.
China's runaway growth train on a dangerous course
Professor Yu Yongding says he is ''one of 50 well-known Chinese economists in China''. Some respected market economists say he has a better grasp of China's macro-economy than anybody else, full stop. Either way, he has been one of the country's strongest advocates for a more liberal currency regime and other pro-market reforms, including when he sat on the monetary policy committee of the People's Bank of China in 2004 and 2005. So when the first line of an email from Yu a fortnight ago began "John, I think your overcapacity story the other day is basically wrong" - it was time to rethink the China story.
I had argued on November 30 that the endless talk in China and abroad about the country's overcapacity problem was premature. China would not have overcapacity in heavy industry (and therefore the Australian economy would remain underwritten by Beijing) for as long as it kept spraying highways and pushing up skyscrapers across the country, and that was going to be for a few years yet.
Yu, the recently retired director of the Institute of World Economics and Politics at the Chinese Academy of Social Sciences, did not explicitly say I was barking mad. But his email continued: "When a country has an investment rate over 50 per cent [of] GDP and rising, you say this country is not suffering from overcapacity! … are you serious? ''To judge whether there is overcapacity you cannot just do a head account. With a 1.3 billion population and human greed, China's needs are unlimited, you can say that China will never suffer from overcapacity!" The email noted that, on my logic, no developing country could ever suffer from overcapacity until it became rich and that the world should never have suffered a Great Depression in 1929.
Since that salutary critique, Yu has elaborated further on his views. He believes China is trapped in a cycle where constantly rising growth in investment is constantly increasing China's supply, but consumption has conspicuously failed to grow fast enough to absorb it. And so China is forced to increase investment in order to provide enough demand to absorb the previous round of increased supply, thus creating ever-widening cycles of oversupply. In this manner, the investment share of gross domestic product has increased from a quarter of GDP in 2001 to at least half. "There is sort of a chase - demand chasing supply and then more demand is needed to chase more supply," he says. "This is of course an unsustainable process."
From 2005 China's overcapacity problem had been "concealed" by ever-increasing net exports - but that strategy was interrupted by the financial crisis. Then came last year's globally unprecedented stimulus-investment binge, which might not have been so worrying if it were delivering things that people needed. But the Government's hand in resource allocation has grown heavier since the crisis without reforms to make officials more responsible for what they spend. "As a result of the institutional arrangements in China, local governments have an insatiable appetite for grandiose investment projects and sub-optimal allocation of resources," as Yu previously said, in his Richard Snape lecture for the Productivity Commission in November.
So there are now airports without towns, highways and high-speed railways running parallel, and towns where peasants are building houses for no reason other than to tear them down again because they know that will earn them more compensation when the local government inevitably appropriates their land. It's great for Australia in the short term, because we supply the materials, but it's unsustainable. One day China's overcapacity problem will become real.
That will be the Wile E. Coyote moment: when the resource-exporting world falls off a cliff. It turns out that Yu and I have less to disagree on than we thought. I had just watched more American cartoons than he had. "I realised that our opinions were not really very different when I realised what the Wile E. Coyote moment meant," Yu says. I have no idea how long China's unsustainable growth pattern can be sustained. Yu says "it cannot last for more than five years".
This year, he says net exports might again provide an escape valve for China's overcapacity, provided the US does not slip into recession. "The swing in contributions of net exports to GDP growth from 2009 to 2010 could be as high as 6 percentage points, if the current momentum of exports can be maintained," Yu says. "The arrival of your Wile E. Coyote moment will be postponed once again." And when the export engine fails again, China can again recapitalise its banks and reopen the fiscal and monetary floodgates. Yu believes the cycles of ever-increasing exports and investment can be broken if the Government unleashes a new productivity boom by opening up the services sector. But this requires the Government making some very bold moves to loosen its grip, when all the signs are pointing the other way.
"If we do not reduce government monopolies in services to reduce policy distortions, then productivity in services cannot grow rapidly and might even stagnate," Yu says. "I'm not very optimistic about the services sector." China will eventually make the transition when it has no other choice. ''China has defied predictions of economic demise repeatedly over the past three decades," Yu says. "I am still basically optimistic about China's economic future. When China is pushed into the corner, adjustments will come. When a decision must be made, the decision will be made."
UK Household Debt (Credit Cards, Mortgages & Loans) Now Exceeds Annual GDP
According to a recent research study by ThinkingMoney, UK Household debt has reached a staggering GBP1.35 trillion in June, more than the country's Gross Domestic Product, which is estimated at GBP1.33 trillion. This means the UK's 60 million people currently owe more than the entire country can produce in one year. With the UK having the seventh largest GDP in the world, this is deeply concerning. Those carrying the bulk of the debt include young families and 20-something adults who have just purchased their first home. Today, many members of this demographic carry GBP10,000 to GBP15,000 worth of student debt, in addition to a mortgage that equates to three times their annual income.
Thirty years ago, this simply wasn't the case, since mortgages would only require one and three-quarter years worth of income. Also contributing to the problem is wages, which remain relatively unchanged during the past thirty years when compared to the rising costs of living. As a result, the number of county court judgements for debt, bankruptcies, repossessions, and insolvencies has skyrocketed while credit scores fall. To prevent these problems and improve credit, says Tahera Dudhwala, Editor of ThinkingMoney, consumers need to shop around for their financial products.
"Consumers need to be cautious about the credit cards and financial solutions they choose. An affordable interest rate is just one important feature. Zero interest on balance transfers and purchases for a certain time can save individuals a large sum of money, even if it doesn't seem like much at the time. Even two percent interest can add up to thousands quite quickly," says Dudhwala. Consumers have numerous options available to them to help reduce their debt load and stay out of the financial trap many are finding themselves in these days. UK credit cards with a low or zero percent introductory interest rate is a great start.
To save money, consumers need to be wary when reading the fine print. Choosing a card with 15% instead of 21% interest can save money and eliminate the balance sooner, but yearly fees and usage charges can quickly eat any possible savings. Many different UK rewards credit cards are available to help offset some of the costs. Reward or cash back cards return money to the consumer's pocket while charity cards send a percentage of the money spent to a non-profit organisation. Specialty solutions such as football or travel cards allow individuals to earn points on every GBP1 spent, which they can then use to acquire everything from airfare to clothing.
While financial experts do believe the recession is starting to ease, they feel its effects will hold on for many years to come. This makes it vital for Britons to select smart financial solutions and be wary of deals that seem too good to be true.
Are Canadians rubes? When it comes to figuring out what to spend our money on, apparently. Let’s do a little comparison with our American neighbours – you know, those subprimates we’re always dissing as being trailer park while we’re so smart.
US family income, on average, is $67,348. Canadian family income (in US dollars) is $68,305. Almost a dead heat there. Household debt as a percentage of disposable income is 132% in America and 145% here. Whoops, we lose that one, but not by much. We’re all spending beyond our means. Retirement savings in the US, as measured by the average 401k plan, is $62,900. In Canada, the average RRSP balance seems to be about $64,000, or $60,800 in US dollars – about the same. Mortgage rates are, hmmm, similar. In the States a short-term home loan is 3.7%, while here is it 2.65%. But the Americans have the edge in being able to lock in a 30-year mortgage at 5.14%, while we have to renew at market rates every 5 or 7 years.
But what’s a very similar comparison breaks down entirely when it gets to real estate. The average US resale home costs $178,000. In Canada, the national average right now is $337,410, or in US dollars $300,294.
So, a house to the south costs 2.64 times income, and here it is 4.4 times income – which is damn close to twice the price. Not only that, but Americans are able to write off 100% of the interest on their mortgages from taxable income, as well as property taxes. They also enjoy the same capital gains-free status on their homes in essence as we do. The federal government will give new homebuyers $8,000, free, and move-up buyers can get $5,000 as a gift. Oh yeah, then they can sign up for a mortgage rate which will not change for three decades.
And still, with all those incentives – free money, interest-deductibility, rate stability – house prices in that country of 304 million are exactly half what they are here, in a land with one-tenth the people and more land mass. Makes ya wonder, doesn’t it?
I thought of that when I opened my email and found a note from a couple in a city I’d just visited: “We have sold our condo here in Kelowna, and are looking for a house and we are open to moving out of this city, but are not too crazy about living in snow country, we are looking for some insight into what and where is the best place to invest in real estate. We are 71 and 66 years old, so don’t want to move to an area that is really isolated. We have a RRIF as well as our government pensions, but wish to protect what we have and spend it wisely.”?
Of course in Kelowna, like in Oakville or Sherwood Park or Delta or Red Deer, it’s hard to find a decent SFH for less than $450,000 – which is a third higher than the national average. So why would a couple of seniors (who would never qualify for a mortgage) be considering slamming a big chunk of their retirement cash into a piece of real estate? Are they nuts? In a word, yes, of course they are. Buying a home with irreplaceable retirement savings when you are 70 or so, at the top of the real estate cycle, is madness. It constitutes real and immediate risk, while it augments daily living costs. It’s also exemplifies one reason there’s such a premium to reside in Canada: We live in a puddle. A vacuum of information. A regional backwater of a country where so many people lay down their savings, unquestioningly.
Real estate costs what it costs because of supply and demand. When demand rises, so do prices. There is every reason to believe Canadian house values are wildly inflated, and by almost any measure. Our market was beginning a worthy correction in late 2008 – sales and prices started to collapse as it became apparent to people houses had passed the ability of average families to afford them. This correction was halted in its tracks by the actions of the Bank of Canada, acting in concert with the federal government. By dropping the central bank rate to just 0.25%, for the first time in history, the feds engineered emergency mortgages in the 2-3% range, while Ottawa offered insurance for anyone leveraging 95% of a house purchase.
The result was predictable – an explosion in demand. As a result, the average house price in Canada rose last year by 19%, or twenty times the rate of inflation and average wage gains. This will not last. It cannot last. Real estate at these levels is enveloping the Canadian middle class in debt. As interest rates begin their inexorable rise in a few months, all of this debt will eventually become far more costly, more difficult to pay and a greater burden on family incomes, which are unlikely to keep pace. It’s almost as if the federal government, desperate to create inflation by any means possible, staving off deflation and political disaster, engineered a real estate bubble.
Could it and the Bank of Canada have known what 2% mortgages would do? Could they have surmised the creation of a housing mania? Did they care the impact would be unaffordable shelter for most families? Ballooning household debt levels? Luring young buyers without savings into a financing trap? Convincing 70-somethings real estate is now riskless? There’s no reason a home in Canada should cost almost twice what it does to the south, in equal neithbourhoods, in a similar society, among families making the same money and with comparable budgets. How long this can endure is now the question.
Massive Earthquake Reveals Entire Island Civilization Called 'Haiti'
Less than two weeks after converging upon the site of a devastating magnitude 7.0 earthquake, American anthropologists have confirmed the discovery of a small, poverty-stricken island nation, known to its inhabitants as "Haiti."
Located just 700 miles off the southeastern coast of Florida, the previously unaccounted-for country is believed to be home to an estimated 10 million people. Even more astounding, reports now indicate that these people have likely inhabited the impoverished, destitute region—unnoticed by the rest of the world—for more than 300 years.
"That an entire civilization has been somehow existing right under our noses for all this time comes as a complete shock," said University of Florida anthropology professor Dr. Ben Oliver, adding that it appeared as if Haiti's citizens had been living under dangerous conditions even before the devastating earthquake struck. "Of course, there have been rumors in the past about a long-forgotten Caribbean nation whose people struggle every day to survive, live in constant fear of a corrupt government, and endure such squalor and hunger that they have resorted to eating dirt. But never did we give them much thought." Added Oliver, "Had it not been for this earthquake, I doubt we would have ever noticed Haiti at all."
Though anthropologists said they still did not know much about Haiti's history, they claimed that, by observing the Haitians' reactions to this particular disaster, and studying the way the people had come together and taken solace in one another's sorrows, it appeared as if most of them were accustomed to tragic, even horrific, events. Researchers also came to the "startling" conclusion that Haiti's inhabitants must have at some point in their history been exposed to the English language, as many seemed capable of uttering such phrases as "Help us," and "Please don't abandon us again."
"They are normal people just like you and me," said Harvard University's Aimee Coughlin, who before last week had never come across any mention of the struggling island republic, whether in conversation, on television, or while scanning the front pages of newspapers. "They communicate with one another, they have families and loved ones, and they value religion. However, judging by the way they are fending for themselves—a position they seem almost resigned to—it's clear these mysterious Haitian people don't have much else."
According to Coughlin, the Haitian civilization was discovered on the night of Jan. 12, when relief workers were rushed to several resorts in the Dominican Republic to see if any American tourists had been injured in the quake. During an aerial tour of the island of Hispaniola, members of the Red Cross noticed signs of human life coming from Haiti. "When we first landed there, I thought, 'No person could possibly live here,'" Oliver said. "Not only did the arid landscape look incapable of sustaining any sort of agriculture, but there was absolutely no infrastructure either. Had we known about this desperate, desperate place sooner, perhaps we could have shared some of our technological advancements with them."
"I've vacationed just miles away in beautiful St. Kitts many times," Oliver added. "Never did anyone say anything about this Haiti place." Members of the world community were equally shocked at the discovery of such an impoverished civilization. U.N. representatives noted that Haiti's location puts it in the direct path of recent natural disasters such as Hurricanes Jeanne, Hanna, and Ike, disasters that probably caused massive flooding, disease, and death.
Likewise, leaders from a number of Western nations announced Tuesday that they were dumbfounded to learn people were still living without decent shelter, hospitals, or regular access to food and water. "They must have had no way of communicating with the outside world, because had we known about these Haitians, we would have done everything in our power to help them," U.S. Senate Majority Leader Harry Reid said. "Of that I have no doubt."
"Fear the Boom and Bust" a Hayek vs. Keynes Rap Anthem
“If you’re living high on that cheap credit hog
Don’t look for cure from the hair of the dog
Real savings come first if you want to invest
The market coordinates time with interest
“Your focus on spending is pushing on thread
In the long run, my friend, it’s your theory that’s dead
So sorry there, buddy, if that sounds like invective
Prepared to get schooled in my Austrian perspective”